CIO Insights: Falling Knives and Trends

Our start of the year, somewhat non-consensus view of “growth giving way to growth concerns”, is no longer so non-consensus, as most market strategists are now looking at an outright recession, advocating defensiveness. Rightly so – when facts change, views must change. That the tariff announcements are a bargaining tool is a view we share (and already those with lesser economic muscle are “falling in line”) – but the problem is the fickleness in policy making that is likely to keep uncertainty (and hence volatility) elevated. Navigating uncertainty is a game of probabilities, especially when underlying drivers are less than logical.

The macro outlook is clouded by recession and potential stagflation risks. A substantial adverse growth impact appears likely, led by deferral of consumption and investment decisions and downside risks to jobs. Similarly, corporate earnings have further downward revision headwinds. As for price action itself, trend and momentum are negative. While extreme bearish sentiment (a contrarian signal) and oversold levels make it’s tempting to bottom fish, falling knives hurt. There is weak support around current levels but firmer in the 4850-4900 area. No doubt there will be relief rallies, and violent ones, these will be selling opportunities.

source: Lighthouse Canton

Ours is clearly a bearish prognosis – here is how to position.

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Can There, Will There be a Relief Rally - Should One Lean into The Wind?

The trend for major indices is distinctly bearish in the intermediate term with the long-term trend also under threat. However, extreme readings in volatility, sentiment, positioning and breadth make the case for a relief rally, even a violent one.

While in the past, 10% drawdowns have been buying opportunities, provided these aren't followed by a recession, the current 13-14% drawdown from peak (20% for NDX) comes with an elevated recession probability. Any relief rallies are opportunities to sell/ reposition defensively.

Not for the faint hearted, but we do see merit in using elevated volatility to harvest premium, building in larger downside buffers, especially for long-term investors.

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Highest Volatility Readings since COVID/ % of S&P Stocks above 200 dma down to Oct'23 lows (mainly comprised of defensive sectors)

source: tradingview.com

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Sentiment is At Extreme Bearishness - Fear & Greed Index down to May 2022 Lows

source: CNN.com

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Sentiment is Bearish - AAII Survey - Bears Out number Bulls 3:1

source: AAII

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Extreme Volatility

source: Optioncharts.io

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Highest Put Volumes in 5 years

source: Ycharts.com

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Macro – Past, Present and Future

Lighthouse Canton Proprietary Economic Nowcaster

source: Lighthouse Canton

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It’s been remarkably resilient on the macro front and up until as recently as end Jan, our proprietary economic nowcaster was solidly robust – easing inflation, stable labor conditions and consumption have been a hallmark of the past year.

More recent data shows some deterioration, but only modestly so. There is moderate easing in labor conditions and consumption and inflation has been somewhat sticky. Business confidence had also shown some resilience although consumer confidence has taken a hit. In aggregate, the environment has been nothing short of goldilocks - but that is the past...

Higher tariffs are likely to lead to substantial demand scale-back. We do not believe demand is inelastic enough to drive prices higher and keep consumption elevated at the same time. Compounding this is the likelihood of corporates resorting to lay-offs as margins get squeezed and demand tails off. Equally, businesses are likely to defer investment decisions, despite the promise of a “friendlier” environment for re-shoring. As for interest rates, this is one area where we do agree with President Trump – The FED is yet again being reactive and will most likely need to course correct through an aggressive easing cycle.

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Inflation - Sticky at the Bottom - AND the FED Doesn't Want to Cut - YET - Market Pricing in 4 Rate Cuts by end 2025

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Consumption is Weakening

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Labor Market in Balance - Deterioration from Hereon can Accelerate

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Business Indicators - Stable, But Weakening - Elevated Risks

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Earnings & Valuations

Lighthouse Canton Proprietary Earnings Nowcaster

source: Lighthouse Canton

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Dec’24 quarter delivered a consensus beating, and highest since late 2021, growth of over 18%. While consensus continues to see an upward sequential trajectory (11% in 2025 and 14% in 2026), revisions have trended down. With guidance continuing to be negative, estimates continue to have downside risks.   

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Earnings Guidance Negative & Revisions Trending Down

source: Factset

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...yet - Consenus Still Optimistic of Sequential Growth

source: Factset

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Valuations have retrenched from extreme expensive levels and closer to the 5-year average (although still above the 10-year average). Importantly, its premature to

classify valuations as “cheap”, especially with downside risks to earnings.

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Valuations - Normalized - BUT not Cheap

source: Lighthouse Canton

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Market & Price Signals

Our proprietary market signals model shows extreme trend weakness and despite oversold levels, aggregate levels are in bearish territory.

• Sentiment – Bearish extreme – contrarian indicator – suggests scope for relief rallies.

• Market Positioning – Substantial negative gamma positioning – break below 5000 risks deeper declines. Large open interest at 4850-4900 suggests support levels in that area. Highest Put volumes in last 5 years.

• Volatility – Elevated at extreme levels (IV is 99% percentile).

• Trend – Primary and Intermediate Trends are DOWN. Risks to long-term trend.

• Momentum – Bearish – BUT Deeply oversold – c3std dev. Below average.

• Support – 5000-5100 initial support, although weak. 4850-4900 strong support.

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S&P - 5000-5100 Weak Support/ 4850-4900 Strong Support

source: tradingview.com

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NDX - 17200-17700 Support

source: tradingview.com

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Rotational Trends - Distinctly Defensive

source: stockcharts.com

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Fixed Income Markets

The recent market turmoil has also impacted bond markets - positive for treasuries as the market is now pricing in more rate cuts (see earlier) but not so for corporate bonds. Credit spreads have widened materially across the risk spectrum. While the move has come from record lows, and credit spreads still remain nowhere near panic levels, the marginal move makes the case stronger for treasuries relative to corporate bonds.

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Credit Spreads Have Risen Materially from Record Lows

source: tradingview.com

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HYG's Outperformance vs. LQD Under Threat/ TLT Breakout vs. HYG & LQD - Treasuries Better than Corporate Bonds

source: tradingview.com

All investments carry risk, for more important information please read this disclaimer.

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