The Week Behind

Fostered by cooperative treasury yields and a “goldilocks” payrolls (August Nonfarm) report, equities appeared to be on track for a neutral, or even slightly positive, week. However, news broke that Nord Stream, the pipeline responsible for transporting Russian natural gas to Europe, would be shut off indefinitely. Reminded of looming geopolitical and inflationary risks, the budding rally folded, giving way to another Friday sell-off. Overall, the DOW lost ~3%; the S&P ~3.3%; the NASDAQ ~4.21%. 

Highlights

• Despite yields backing off Friday, the US2YR and US10YR remain elevated, reflecting the tighter financial conditions desired by the FED. 
• August Nonfarm Payrolls Report came in weaker-than-expect: 315k actual v 318k estimate; wage growth, while positive, slowed MoM as labor force participation increased, primarily in the youngest and oldest demographics, contributing to the increase in unemployment to 3.7% from 3.5%.
• Midday Friday, Nord Stream was shut off indefinitely to address an “oil leak”. Typically, such an issue would not require complete closure. Consequently, consensus is that this is energy-weaponization as Russia’s war continues. 

Q2 Deja Vu

Friday’s session gave me deja vu to 22Q2 (2nd Quarter, 2022). Any time markets rallied on good news, they were always one headline out of Europe away from an emotional downside reversal. The only force in Q2 with similar effect was interest rates, specifically the treasury yields on the 2-year and 10-year. Sound familiar?

Without getting too granular, August Payrolls was ideal for the current economic mood: not hot enough to embolden the FED, not cold enough to revisit recession. Good news in hand, the screen is green. Suddenly, a headline concerning another predictable act of Russian aggression emerges: Nord Stream is 100% shut off, indefinitely. The screen goes red. Today’s trading environment feels familiar to the 2nd Quarter’s trading environment. Therefore, it feels like the opportune time to dust off the 22Q2 playbook until the situation changes. We will do exactly that to conclude the brief. I suspect it’ll be especially viable until the last week in September. By then, the focus should be squarely on the FED meeting and balance sheet reduction.  

Before continuing, my characterization of Russian aggression as “another predictable headline” is meant to highlight the similarities between Q2 and Friday’s session to build a compelling case for Q2’s playbook. It is in no way meant to minimize the human impact of their actions. Q2’s market kept trading lower on news it either already had or should have expected, just as Friday’s market did when indices traded lower on Nord Stream’s closure, which everyone knew was coming; ie: “another predictable headline”. 

Let me be clear: Russia’s invasion is unjustifiable. Its impact on the region and the people of Ukraine: cruel. I am building a case for using Q2’s playbook, not trivializing the impact of Russia’s actions.  

The Week Ahead

While U.S. markets are closed for Labor Day, European markets will open Monday, providing them their first opportunity to trade the Nord Stream news. Consequently, as U.S. markets open Tuesday, I suspect there will be a “flight to safety”, meaning both stocks and yields will trade lower as U.S. equity markets will get their first opportunity to reflect Europe’s Labor Day session, which I suspect will feature buying risk-free U.S. treasuries, thereby decreasing their yield, with funds generated by selling stocks, causing stock prices to fall. 

On Wednesday, the FED’s Beige Book will be published. Conversation will center around any potential insights it holds on the labor market. 

Concisely, in the absence of economic releases and bellwether earnings, I suspect price-action will be driven by headlines, especially as we can expect greater volumes with summer vacation season officially over.

Revisiting the Q2 Playbook

We will touch on both stock selection and capital deployment. What to buy and when to buy. The former will be kept intentionally broad. It is important for every investor – big or small – to implement their own stock selection strategy. Without it, whether up or down, you are unable to adequately manage your positions. I will elaborate more on the latter because I think the Q2 playbook is more applicable across a broader range of stocks and trading environments.  

Stock Selection

• “Top 5 Idea” Bucket: Money is becoming more expensive; so, you cannot afford to chase any and all opportunities. You need to be more selective as the cost of capital increases.
• High Conviction: Do you have enough strength in your conviction to avoid selling on a day down 5-15%? You need to. Statistically, stocks are most volatile below their 200d SMA. This level of conviction is only forged by familiarizing yourself with a company’s financial statements, business model, and future prospects.
• Net Income and Free-Cash-Flow Positive: If a company isn’t making profit or generating FCF, then it will need to add debt or sell stock to continue operating. Both are dilutive to shareholders and are headwinds to profitability, dividends, and buybacks.

Capital Deployment

• VIX is 30 or greater.

AND/OR

• 90-10 Declining-Advancing.
• Bond yields are stable or trending downward.

In Bonds We Trust

The Q2 playbook trusts bonds more than stocks. If stocks and yields are both rising, then this playbook would have you err on the side of bonds. In this instance, you would be a holder or seller because bonds are telling you this is a false rally. 

3-Day Rule

If we see stocks and bond yields trading lower together while the European energy crisis or Russia-Ukraine is in focus, then we are in the midst of a “flight to safety” trade, which is meant to hedge geopolitical risk. It could take days for investors to determine how much risk they want to take out of stocks to reallocate to “risk-free” treasuries (bonds). If encountered, I recommend the “3-Day Rule”, which stipulates you do not buy until the lows hold for 3 consecutive sessions. 

My Eyes Are On The US10YR

Personally, I think the US10YR is on a collision course with its previous highs. Until the 10YR revisits or convincingly begins a new downtrend, I will exercise patience. It will be interesting to see how the market responds to the 10YR at 3.4-3.5% or greater. If the June lows hold as we revisit or surpass the year’s tightest financial conditions, I will get less patience and be more constructive. Furthermore, if this occurs while the 2YR is still ~3.4%, it implies the 10-2 yield curve will have reverted, which I believe is integral to sustained multiple expansion and a clear sign the economic outlook is improving.