Coiled Spring Capital Macro Report 9/8/24

What a difference a week makes. The stock market moves quickly, and the constant fluctuations can be dizzying, especially in the realm of algorithmic trading. Trend-following quants (CTAs and volatility strategies) can whip markets around when certain levels are breached and indicators are triggered. In a previous report, we emphasized the importance of the 5550 level for the SPX, a key point where these CTAs would initiate selling. This selling is not driven by fundamentals or emotion; it is purely mechanical, with sell orders executed relentlessly until specific exposure levels are reached.

Since the SPX broke through that 5550 trigger, we’ve witnessed a dramatic decline, leading to one of the worst weeks for the stock market in years — and that was with one fewer trading day. Yet some still argue that technicals don’t matter. We find that notion laughable; in reality, technical structure is everything. With 70% of all stock market movements driven by technical and quantitative trading, dismissing their importance seems not only naive but also irresponsible.

We can illustrate our point with a single chart. The SPX failed to break above the critical red gap resistance zone — the gap formed during the mid-July drawdown that initiated the August selloff. This simple structural change in July prompted us to increase our defensive positioning in the market, allowing us to largely sidestep the early August Nikkei-induced mini-crash. At that time, we even recommended shorting semiconductors (with the SOX index dropping another 22% to its August lows in just three weeks).

The green arrow on our chart marks the final day of August, when it seemed the market was poised to break to new all-time highs. Instead, the market pivoted from that strength into a violent selling regime — a move that, in hindsight, was pricing in a weak payroll report. Just as the rejection from all-time highs in July signaled the start of a corrective move lower, the sharp rejection from this key pivot area (the red gap window) sent the same message. This was the rationale behind our mid-week report, "Defense Wins Championships."

It was clear that it was time to get defensive, and since the end of August, the SPX has fallen 4.3%.

Why was the 5550 level so crucial for the CTAs? This level marked the second significant gap down since the mid-July peak, coinciding with the Mag 7’s disappointing earnings reports. It was tested again in early August, only to be rejected following a weaker-than-expected ISM release. Gaps occur when the majority of investors are caught offside, making them highly significant at the index level — a key reason they form one of the cornerstones of our technical analysis.

In our mid-week report, we advised getting defensive for good reason—we believed that Friday’s payroll report could disrupt the markets. Did we know for certain that the report would be poorly received? No, but the rapid changes in index construction made it highly probable that the market was primed to stumble. You can argue with our reasoning, but with our experience, we know that significant shifts in index structure rarely reverse without a major catalyst, and the payroll report was unlikely to be that catalyst.

The report reinforced the view that the labor market is cooling and revived concerns about a hard landing. Interestingly, the bond market backed off from expecting a large rate cut at the September meeting, with the probability dropping from 44% on Wednesday to 33% by Friday's close, according to Fed Fund Futures. While this isn't a major shift, the change in direction is noteworthy. It's somewhat surprising that the equity market reacted so strongly on Friday, while the bond market suggested the economy remains on more stable footing. This highlights the impact of emotionless trend-following algorithms at work.

Concentration risk certainly has something to do with the index retreat last week as the bull market darling NVDA has been decimated since reporting their earnings. The direction of NVDA has an incredible influence on the rest of the market.

Consider that the equal-weight version of the SPX is still outperforming the cap-weighted index. This after making a new ATH at the end of August, which is now down 3.3% from the high and outperforming big brother by 100 bps points.

This highlights the concentration risk in the market and why we flagged elevated sentiment readings in last weekend’s report as a significant risk for a potential drawdown in September (though our timing was off by about a week).

We also have inflation data coming out this week, but unless it comes in significantly higher than expected, it seems that the inflation threat has receded for the foreseeable future. The options market is currently pricing in one of the smallest CPI-day moves this year, which contrasts sharply with Friday’s employment report, which had an implied SPX move of 1.1%.

With all the recent volatility and growing market anxiety, it's no surprise that the VIX has surged. On Friday alone, it jumped 12.5% and nearly 50% for the week, putting it 52% above its average for the year.

As we enter the Fed’s quiet period ahead of the September FOMC meeting, we might see a reduction in volatility as we approach the event. Given last week’s turmoil, could the market now be primed for a potential counter-trend trade?

Let’s review.

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