October 2018: “Buy the dips” replaced by “sell the rally” strategy
We believe that 10 years of QE-driven low- volatility markets created a goldilocks environment for investors as bonds and all risky assets had risen in tandem. Yet we think we saw an inflexion point at the beginning of 2018, and the official switch from QE to Quantitative Tightening (QT) was in October. Indeed, this is the first month when the cumulative purchases and sales of the three main central banks turn negative.
Markets are between Scylla and Charybdis: a possible GDP & Earnings growth deceleration in 2019, and the Quantitative Tightening, or shrinking liquidity from the Fed’s ongoing balance sheet reduction and the ECB’s tapering. In this uncertain environment, the willingness of the Fed to continue its tightening puts US equities in overvalued territory compared to bonds. It adds a new headwind to the cohort of other issues like trade wars, coming margin compression, US midterm elections, hard Brexit, Italexit or Iran sanctions. We believe the environment is shifting from one where dips should be bought to one where rallies should be sold. In the medium run, as long as the Fed does not pause its tightening and a US/ China trade deal is not signed, we believe there may be more pain for the stock market to come.
On the very short term, most of our sentiment indicators say that equities should bounce sharply on short covering from current oversold conditions – but going forward these rebounds should be just “dead-cat” bounces. They should be fast, short-lived and should be sold into rather than chased. This is exactly the contrary of the bull market we had from 2013 to 2017 (slow rising market with a few fast sell-off, after which you should have bought every dip). At the end of the month, we closed our hedges in US and EM to play that bounce according to the same pattern than in January 2016 or February 2018: if we use the S&P500 as a benchmark, one should expect a rebound to 2850, followed by a sell-off to a higher low than October like 2660.