Goldman: “Sell the rallies not buy the dips”

Via Goldman’s Brian Levine:

Thought I’d consolidate a bunch of thoughts and themes gathered throughout the week and try to make some sense out of the 10% correction we’ve seen the past two weeks from a market that had gone a record period of time without even a 5% drawdown!

  • Trigger? I’ve heard many “write-off’ this correction as being technical in nature. Well, yes, that was the trigger, but if you’re hanging your hat on that, you’re missing the bigger picture. The market had effectively quadrupled over the past 9 years. Why? Obviously numerous variables contribute, but it would be hard to dispute that unprecedented, globally coordinated easy monetary policy was your primary driver to force investors out on the risk curve. Sure, rates have been gradually rising the past few years, which the stock market has easily digested, but there’s always a threshold that sparks a seminal change. And I don’t think it was a coincidence that the S&P topped out on the very same day 10-year yields made 4-year highs (a week ago Monday the 29th)….and rates have backed up a further 15 bps to 2.8% currently. The fact that bonds couldn’t rally in the equity selloff is evidence of a regime change in the multi-year equity bull market.
  • “Bulletproof Psychology” is punctured — It’s generally a late-stage bull market when the greatest justification for buying equities is “there’s nowhere else to put my money” and conformist performance-chasing. Hence, we’ve recently witnessed countless red-flashing warning signals about positional complacency — just in the past few weeks, we saw:
    • GS Risk Appetite indicator hit record highs
    • Both the Conference Board AND the University of Michigan surveys showed a record percentage of investors expected the stock market to be up this year
    • Investors Intelligence weekly survey of 130 market newsletters showed bullishness hit 32-year highs (that’s over 1000 datapoints)
    • AAII Sentiment weekly survey of investors’ bullishness hit 8-year highs
    • Historically, a high Sharpe return in S&P (steady rises with minimal vol) often presages a major correction, and two weeks ago the 1-month trailing Sharpe of the S&P 500 was over 6!

My response to common justifications for a rebound back:

  • “It’s been a non-panicky selloff’ — True, but historically shocks of this magnitude find their troughs in panicky selling. I’ve been amazed at how little “capitulation selling” we’ve seen on the desk, despite outsized market share. The “buy on the dip” mentality needs to be thoroughly punished before we find the bottom.
  • “The corporate bid will stabilize the market” — corporates make up —8% of market volume, and —2/3 of buybacks are now bought systematically via 10b5-1 programs. Historically they were far more discretionary in buying sharp declines (not that down 5-10% from all-time highs would really qualify), so although we are seeing increased volumes in corporates this week, generally they haven’t matched the increase in market volume. Longer-term, I believe buybacks increase significantly over the course of the year, but don’t think that’s a major factor over next week or two’s action.
  • “This is technical to equities — credit is hanging in” — Well, that was earlier in the week. High yield is really starting to break down vs. equities today (not to mention that HY didn’t participate in the equity rally last month to begin with).
  • VIX E’TN post-mortem — Well, it worked as structured…..obviously a +100% daily move drives a short fund to zero — was unfortunate how many didn’t seem to understand that risk (as $3B+ of assets virtually disappeared on Monday)……but it also serves as a cautionary anecdote for market tops. Any short or levered product can go to zero in a day. Ironically, the strategy of selling vol can ALSO work for a long period of time until it knocks you out…..both ultimately proved true. In regards to the stock market, the vol-selling strategy has provided quite a bid to the equity market in recent years —remains to be seen what happens to this trend, but I would expect VIX to ultimately settle back closer to its historical range in the high teens.
  • Systematic Flows: per our resident expert Paul Leyzerovich (who has nailed this, btw), the supply baton is currently being passed from Vol-control funds to Risk Parity, and CTA supply has been heavier in EMEA and moving to the US. Overall, he believes we are in the “sweet spot” of supply over the next 1-2 weeks, with about $20b/day of supply
  • expected globally. About 3/4 of this supply you should see via futures. It is also important to note that the longer we’ve stayed at these levels, the more supply becomes “irrevocable” — ie. the supply will come even if we rally back.
  • Fundamental Flows: Just two weeks after the largest Global Equities INFLOWS ever (+$33B), we get the largest weekly OUTFLOWS ever (- $30B….over half was SPY). Again, this appears to be a flashing sentiment shift, but a week doesn’t make a trend. That said, the above does make a mean sound bite though.
  • Client positioning: As of yesterday, client gross positioning ROSE 5% to new highs (and we heard similar at a top competitor). Nets came down, but to find a floor in a 10% 2-week-long correction, you need to see some real portfolio reduction ie adhering to the words of Colonel William Prescott, don’t fire until you see the whites of their eyes.

Other datapoints that are relevant:

  • SPY call open interest at all-time high (bearish)
  • Are you glass half-full or half-empty? I’ve heard bearish arguments driven by “the S&P still trades at 21 times earnings!” and bullish arguments driven by “the S&P is trading at only 16 times NEXT YEAR’S earnings!”
  • Technically, the 100-day moving average has proved critical support for the past couple of years, but we sliced through it yesterday. SPX 2540 is the 200-day, which we haven’t breached in 20 months.
  • SPX currently down 3% YTD. Through yesterday client performance is hanging in, with both Equity Long/Short and Quant performance in range of flat to down 1%.

Bottom line, we haven’t reached the short-term bottom, but you’ll know it when you see it (or at least 5 minutes later!). But longer-term, I do believe this is a genuine regime change, one where you sell-he-rallies rather than buy-the-dips.

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