Less Stretched Markets Can Focus on Positive Fundamentals
New cases have now been falling for 24 consecutive days. What this means is that we could be below 50,000 new daily cases by Valentine’s Day. Hospitalizations are also down as are daily deaths. Even in South Africa, where a feared variant originated, cases are collapsing significantly despite the presence of B.1.351. These items should serve as a sanity check that markets can now begin to focus on re-opening.
The United States is also seeing greater penetration of vaccinations. Now 42% of the United States has vaccinated more than 10% of residents. We believe a key turning point will be 100% of the US reaching at least 30% vaccination rates.
The market rout last week that was most notably experienced by Long/Short Hedge Funds has led to an evolution of our thinking on the near-term path of markets. Given that downward price pressure, and the largest corrections, are driven by the overextension of capital, particularly institutional capital, we think there is a high possibility that the scope and scale of the position squaring and ‘blood-letting’ that occurred last week was great enough to make the occurrance10% correction that we and the consensus were predicting highly unlikely. Thus, our base-case has changed.
One of the primary drivers of our evolving thinking is that the S&P 500 Volatility Index experienced its most rapid 3 day drop in its’ entire history. Yup. One of the things we typically monitor when we are trying to identify good entry points and changes in market direction is when the VIX is inverted, or in backwardation.
The normal relationship between volatility in time is usually pretty straightforward; the more time there is, the more things can go wrong. However, when the stock market is experiencing significant levels of stress, fear, and uncertainty the VIX literally implied the opposite that there is more volatility in the short-term than over time. We use the 4M-1M VIX futures contracts to act as a proxy for VIX inversion. We suspect that the high-intensity market route that occurred actually saved us from the correction we were predicting and now markets can focus on positive fundamentals.
We have been focusing on the cyclical economic recovery that the data says is coming. For example, the steepening yield curves (30Y-10Y and 10Y-2Y) have been signaling increasing expectations for a robust economic recovery.
In addition to this, we are predicting a major corporate profits recovery from the Epicenter Stocks. Our base case has been altered. We think the prior leadership resumes. Be sure to check out our Trifecta Epicenter stock list to see which names we think will benefit from the drop in volatility.
Every single time this cadre of stocks margins have dropped to similar levels to where they are now they have rapidly and significantly recovered. We think other longer-term distortions in the VIX, like the fact it was in backwardation for most of last year, also support our thesis that to play the reflationary and cyclically expansive forces we are detecting in the economy, you want to be OW Epicenter aka. Value/Cyclicals.
As you can see what is suggested by the purely historical data is that a massive corporate recovery is underway. Take a look at the EBIT margin chart. The dark blue line is Epicenter EBIT margins (industrials, Discretionary, Materials, Energy, and Financials). The 2020 collapse clearly mirrors the Global Financial Crisis, in fact they have nearly bottomed at the same level. There are multiple reasons to think that the 2021 profit recovery should be even stronger. Thus we think EPS beats as one of the primary reasons to be overweight Epicenter stocks. Be sure to check out the list.
Bottom Line: Our Base Case is no longer predicting a Q1/Q2 correction. Healthcare data and economic fundamentals are pointing to a strong recovery. Epicenter will have high EPS.
Figure: Way forward ➜ What changes after COVID-19
Per FSInsight
Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
