Final Update -Eyeing the Market Dance: Not Yet Ready to Step In

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Update no.3 (Last one) on September 18th 2024

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We will manage a re-entry today during Powell's speech into UWM if market dosent flip, which is a 2X leveraged ETF that tracks the Russell 2000. Here is a very short summary (so I can post it in time for the press conference) of why we chose this index and why we are re-entering.

We think that if the market goes up after the first rate cut of the year, it should have a positive impact on companies that rely on borrowing for functioning. Some companies in the S&P 500 fall into this category, but the Russell 2000 is more representative of these types of businesses. Indeed, in most times that the Fed cut their rate and that didn’t lead to a recession, history suggests that they do see some good run. I would say that they really tend to shine when rates approach very low levels, but we often see a rally after the first rate cut. In these instances, they typically already started in anticipation, which is the case here, so if the case for a soft landing continues to be credible for a while, they could continue to rise and maybe outperform the S&P 500. We need to recall that while the S&P 500, the Nasdaq, and the Dow Jones have all already made new all-time highs from their 2021 highs, the Russell is still 10.6% below its high. We took a 2X leveraged position to align with a volatility that matches more closely with UPRO, since the Russell is typically more volatile than the S&P 500.

Now the reason why we go back in the market although our risk index did not reach back to the level of one is due to the current setup we are seeing and the potential opportunity of being invested in the market after a rate cut. Indeed, although our risk index is still at 2, the reality is that 2 of our indicators are in the bullish zone, but all 3 indicators are trending bullish.

This is very different than other setups when our risk index went back from 4 to a level of 2 but where all metrics were either trending bearish or often very close to being neutral. In fact, the option model has a bug that I want to fix that when it is triggered by almost nothing and bounces, it gets into a position where it cannot immediately flip back. This is what happened in February. The thing is that the option model does have a good hit rate even with this bug, so we shouldn’t be too quick to discard it but I will need to find a way to solve this issue while getting at least a similar return. But, the version 1.0 that had other bugs but not this one, is currently still in the green which would mean a risk index of 0. Outside of this, we see that VIX is not concerned with the market in the long term and our market breadth-related index trending down, which is bullish.

Also our Margin Risk indicator, which is good at flagging overheated market is at the lowest color blue, which suggest lot of room for a great run.

If this entry proves to be unsuccessful, we should promptly hedge our position as soon as our risk index returns to 4 or when our hedge signal activates. Conversely, if this marks the start of a new uptrend, we should quickly leverage the remainder of our cash in a UPRO position to capitalize on the upward movement.

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Update no.2 on September 10th 2024

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We just added to our position. Since it is still very risky, we decided to use SPY to avoid the distortion caused by a leveraged position. I'll keep the explanation brief so I have time to publish it before the market closes. Besides, this trade is actually quite simple, so the text should be short.

Our risk model is still at a level of 2. If it reaches a value of 4 or if our hedge signal triggers, we will go back to market neutral.

But the question is, how close are we to seeing the risk index reach a level of 4? Very close, actually !

Our implied correlation signal is already red. The NYSE derivative volume is also not far from going red, and our option model is almost exactly at the threshold. This means that either tomorrow we flip red and exit the market, or this is the ultimate point of reversal, and these metrics start to improve from here. This is yet another trade where the risk-reward looks very asymmetric—while the downside could be limited as we are right at the threshold, if we bounce from here, it could generate considerable upside. This is why we are taking this trade, not because we believe there is no risk in the market. In fact, these metrics are telling us that risk is extremely high.

However, we do see some encouraging signs. One is that market breadth seems to be slowing its ascent.

VIX is slowly going back into contango, and the width of the ribbon is increasing, except for the VIX9D, which is still inverted. This means that fear is now confined to the very short term.

The last encouraging sign is the SKEW. After consistently rising for almost five weeks, the SKEW has started to cool down considerably over the last two days. In fact, it dropped from 163, which was in the 99th percentile of its historical high, to 140, representing a cooldown of 23 points.

The average cooldown in a single leg of a correction is 16, and the maximum we've ever seen is 32. For comparison, during the entire COVID drop, the SKEW cooled down by 29 points. So seeing it cool down by 23 points is significant. The only nuance to note is that it was coming down from one of the highest readings we've ever witnessed, and in absolute terms, a SKEW at 140 is still relatively high by historical standards. I could see it shedding a few more points, which could happen tonight when the CBOE reports the value for the day at 5:30 PM.

Conclusion

We are now back in the range where we took our UPRO position last week. Our indicators still suggest that the level of risk in the market is not negligible, and our risk index is now almost exactly on the threshold to increase to a value of 4 or even 5. If this happens, it would prompt us to exit the market. Knowing that our exit conditions are so close behind us, we decided to risk a bit more and add to our market position by using one-third of our capital in a non-leveraged position (SPY). It is highly possible that we may have to exit this position as soon as tomorrow, but if our option model doesn't flip, we could potentially hold it into a new uptrend. If we hold this position, the rest of our cash will be deployed when our risk index drops back to 1 or below, as backtesting suggests that this is a safer entry point.

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Update no.1 on September 5th 2024

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We re-entered UPRO with a 1/3 allocation this afternoon. This is not at all the usual play we do as this is rather a risky one. I consider this play risky because currently, we don’t have all the signals we want to see for a less risky market. There are metrics that continue to trend toward bearish territory. I went over most of what we expected in my post yesterday and will probably wait to see these signs before adding to my position. A simple proof of that risk is that our Novel Risk Index is already at 2 out of a range of 5. I also consider this play risky because as inflation fears start to recede and it becomes clearer that the Fed is going to act in a few days, the radar of investors has shifted to the unemployment number. This data for the last month will come out tomorrow morning and nobody knows what it will be, but it could confirm the trend that has already triggered the Sahm rule last month.

But I don’t take that risk blindly. First, philosophically, although we didn't ride the market to perfection over the last years, we haven’t really lost much cash for a while, and we sit not so far from ATH and well over our personal 2021 top (as funds in the WUF have been transferred by us). So, we are in a position to take some risks. But the thesis that has me take this risk is this:

1. We have been down all week and we may be due for at least a small bump.

2. Options have cooled down incredibly today. The option model has risen significantly and several data points have seen a considerable drop. Our option impulse has actually recorded a strong impulse today. This tells me that people may be jumping out of their puts and risk some calls, which is usually bullish. One other example is Put to call ratio at the index level being down 33.1% today.

3. The VIX is cooling down across all durations. The one that surprises me the most is the VIX9D, which is usually on the rise before an event that the market is anticipating.

4. This tells me that maybe an unemployment rise is already priced in by the move that the market made this week and a bullish report could actually lead to a strong bounce.

5. With our new Risk Index already at a value of 2, we know that our downside is limited as we will exit if it climbs to 4, something that should come rapidly if the market drops. But if the market bounces, the upside could be more considerable. I usually love initiating a position when the risk/reward ratio looks asymmetric to me.

I hope seeing us taking more risks will entertain you. We will see if it pays off tomorrow or in the next few days. Our main thesis, driven by the volatility event of August 5th, was that we could see a considerable rally but that it would probably fail and revisit something not so far from where we were on August 5th. This thesis was derived from looking at similar events in the past that I presented to you in my previous post. This, for us, represents the most realistic case of a pessimistic scenario. If this happens, we should buy the rest of our position at a lower price.

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As you know, we have been out of the market for a few weeks as we were waiting for a new entry point. The reason we haven’t re-entered is that we have seen many signs of risk in the consolidation since August 19th. Our optimal scenario was another leg down that would give us a price below the one at which we sold our position, while also signaling that the level of risk had greatly lowered. We were also okay with re-entering at a higher price, considering we usually hold leveraged positions such as UPRO and thus prefer being in the market when we see many signs of low risk.

I was supposed to write this market update last weekend after completing the release of our new Risk Index, but although we worked hard all weekend, we didn’t manage to complete it until this morning. That being said, while I would have had a harder time making my point about the market sending many risk signals this weekend, the horrible price action we had yesterday made the point for me. The question now is whether the red candle we saw yesterday was an isolated incident that is behind us, or should we expect more damage before re-entering the market.

Signs of Risk

The rebound we had since August 5th made several technical indicators move from oversold to overbought. One of the metrics we were monitoring was the SKEW, which was already at a very high level when our hedge signal suggested re-entering the market. Usually, this metric needs to cool down at some point before the uptrend can continue. That being said, this is not what happened. When we started to consolidate around August 19th, instead of cooling down, the SKEW continued to rise, peaking yesterday at a whopping value of 163.60.

In all its history, the SKEW has only reached such a value twice: during the summer of 2021 before the 2022 bear market and last February. Such a strong reading doesn’t necessarily mean that the markets are going to crash now, but it tells us two things: 1. Per history of SKEW above 150, there is an 84% chance of seeing a 10% to 20% correction in the next 6 months; and 2. People are still incredibly fearful, as the distribution curve of what the options market is expecting is highly skewed toward the bear. This again doesn’t mean we will plunge into the abyss now, but it suggests that we should see strong volatility that matches this level of fear (which we did yesterday). Volatility is the enemy of leveraged ETFs, both from the psychology of holding a leveraged position in such an environment as well as due to Leveraged ETFs that create a path that decays in a volatile environment. Therefore, for us, seeing the CBOE SKEW cooling down is one of the things we were and are still waiting for before re-entering the market.

The VIX also started to rise to a high level across all durations, which tells us that risk is still present.

Buying the market when the VIX is above 20 has been a great strategy over the last 2 years and also in other instance in the past, but this time could be different. That being said, we are less focused on finding the bottom of this move than on confirming the next one.

Our market breadth indicator is now starting to rise, but the slow rate at which it rose yesterday while the market was going down is actually encouraging, although it did continue to rise steadily today despite a relatively neutral day.

Seeing it curve down will be one thing we would ideally want to see before re-entering the market.

Our new Risk Indicator has started to rise today. It currently indicates a score of 2, which is under our threshold of 4 for exiting the market.

Being out of the market when it rises presents a certain opportunity. Depending on the price action tomorrow, I could be tempted to initiate a position, knowing that this new index, not being far from the threshold, could be a very good way to manage my loss while risking an entry that could capture a potential upward move. This is one strong possibility, and if we move ahead with it, we will inform you rapidly.

Now, if we look under the hood of that indicator, the reason for this model rising to 2 is our also novel implied correlation signal.

This indicator, which looks at how the implied volatility of the top 50 individual stocks of the S&P 500 matches the index's implied volatility, is currently on the rise, indicating that the current fear in the market is starting to spread to almost every asset. This is usually an indication of further downside. But our option model, despite moving down today, has not reached its threshold, and our NYSE and Nasdaq derivative volume indicator is still relatively bullish despite closing down a bit today. Some could say that the option model is currently very close to its line where it would switch to red, but it is common in an uptrend for this indicator to come very close to its line in a few instances.

Conclusion

Overall, the data are not overwhelmingly pessimistic, even though they are trending into bearish territory. This is normal given the current poor price action, which may simply be a volatility foreshock of the main earthquake we experienced on August 5th (remember what we said in our previous blog: volatility comes in clusters). We might be tempted to re-enter the market in the next 1 or 2 days, as I believe the risk-reward ratio could be favorable. On one hand, we could be well-positioned for a bounce that might be triggered by a not-so-bad unemployment report on Friday morning, while our downside could be limited by our Risk Index, which would likely trigger quickly in case of further declines.

The main factor that has so far prevented us from re-entering is the continuously climbing SKEW. Its high level indicates that fear in the market remains incredibly high, and therefore, we should brace for greater market sensitivity to both bad and good news. I suspect that a better-than-expected unemployment report, since it was the preceding report that initiated the SKEW's upward movement, could be the catalyst to reduce this fear and lower the SKEW. A rapid cooling off of the SKEW would likely prompt us to re-enter the market swiftly.

If these conditions do not materialize, it likely means that the downward trend is continuing, in which case we could receive a hedge signal, even though we maintain a market-neutral stance. In such a scenario, receiving an unhedge signal or seeing our novel Risk Index revert to a value of 1 would lead us to consider re-entering the market.

The development and release of our new Risk Index kept me coding into the evenings over the past several days. Now that this intense phase is behind us, I'll have more time to keep you closely updated on our market observations. Given that we're approaching a critical decision point, you can expect another update by tomorrow or Friday as the market continues to evolve.