Are We Beta-Catching?
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When institutional funds want to maintain equity exposure but de-risk their portfolios they use a technique called “Beta-Catching”. This entails selling out of individual stocks and using the proceeds to buy the index, usually a liquid and hedge-able index like the S&P 500 (SPY). They do this when they rally gets old and individual stocks are generally overvalued. The benefits of Beta-Catching are manyfold:
Reduce Volatility: By selling individual stocks, they reduce volatility and stock-specific business risk, also called “idiosyncratic” risk.
Keep Up With the Index: By owning the SPY, their performance keeps up with the S&P 500.
Longer Trends: The SPY Is often the last to fall. First the high valuation (or negative earnings) and high risk stocks fall, as large cap, defensive and blue chip stocks become the flight to safety trade. The SPY also benefits from rotations, which prolong it’s uptrend.
Liquidity: A fund can easily punt the SPY and suffer little slippage. If a fund punts a small-cap stock it would be hard to get out at a decent price.
Option-able: Indexes like the S&P 500 (SPY) and Nasdaq 100 (QQQ) are option-able. So if a fund wants to hold onto their shares through a pullback, they can protect their downside by selling covered calls, buying puts or doing both (collars).
Funds may be employing this Beta-Catching technique right now as small-cap and mid-cap stocks fall on deteriorating breadth, while the S&P 500 continues higher. More specifically, last week only Mega-Cap stocks fared well, while anything smaller suffered.
Market Conditions: An Early Warning
The SPY was up 1.26% last week and is holding at all-time highs. Our strategy of trend-following the 21 Exponential Moving Average (EMA) has been fruitful, however the ascent of the SPY is masking underlying weakness below the surface. If the trend holds up then its possible the SPY reaches the R1 Pivot Point target of $540 or even the R2 Pivot Point target at $553, but many factors have to be considered:
Global Liquidity: An Increase in Global Liquidity (black line in chart below) appears to be supporting the uptrend. This can be an indecisive factor and is often at the mercy of inflation. If the lack of progress on inflation continues, its possible that liquidity does likewise.
Relative Strength Index: The RSI logged in a lower high as the SPY made a higher high. That is a bearish divergence, which shows a lack of strength in the current uptrend.
Net New Lows & MACD: Since 5/23 we have been alternating between Net New Highs and Net New Lows. Friday logged in Net New Lows. The MACD is above 0 and that supports the uptrend, however the histogram seems lethargic. This is not a robust Swing Traders’ Market.
Breadth: The McClellan Oscillator, Percent of Nasdaq Stocks Above the 5 SMA (NCFD), Advance/Decline Line (ADL), Advance/Decline Volume Line (ADV) and the Zweig Breadth Indicator (ZMBTI) all show deteriorating breadth. This is not a great look as the market hits new highs and increases the chance of a reversal.
Volatility: The VIX is at a low and this has been providing a positive lift for stocks. It is however at a low extreme and susceptible to a reversal higher.
The Intermarket picture is also deteriorating, as the US 10-year Treasury Rate (TNX) and US Dollar (DXY) both spiked higher on Friday. The US Dollar even closed above its 21 EMA. If it holds above the 21 EMA it would be in a new uptrend, which is bearish for risk assets. Could this be a sign of investors cashing out at as the SPY hits a new high?
Looking at Sentiment, Greed appears to be increasing again. Although this is often a sign that accompanies uptrends, considering the weak breadth it could also be manufacturing a rug-pull for unsuspecting investors.
Finally the Russell 2000 (IWM) is giving an early warning of its own. It has 6 Distribution Days in 17 trading days (less than 4 weeks). According to the work of William O’Neil and Investors Business Daily, the market often experiences 4 to 6 Distribution Days within 4 to 5 weeks before a reversal. This is a clear warning. IWM is below the 9, 21 EMAs and 65 SMA telling us it is in a downtrend. It is currently in the Ichimoku Cloud but if it breaks below the lower cloud (around $198) and the high volume node on the Volume Profile, which ends at around $193, price could fall quickly. RSI is below 50; MACD is below 0 and CCI is below 0, all of which indicate that IWM is weak and in a downtrend. Finally it is in an “M” pattern which many cycle analysts consider as a topping pattern before a decline.
Conclusion: Our strategy has always been to profit from the uptrend in the stock market as long as it lasts, but protect capital when the trend breaks. The trend continues, but many factors are telling us that the strength of the uptrend is weakening. Next week is a heavy economic data week, with CPI and the FOMC Meeting on Wednesday, Initial Jobless Claims and PPI on Thursday and the Fed Monetary Policy Report on Friday. These news drops could easily reintroduce volatility back into the market.
We also know that a 4-Year Cycle peak and decline is expected this year from now until November 2024 and these drops average 19%. It may be time to follow the institutions and Beta-Catch. It may also be wise to tighten stops and not be caught off guard when a reversal occurs.
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Disclaimer - All materials, information, and ideas from Cycles Edge are for educational purposes only and should not be considered Financial Advice. This blog may document actions done by the owners/writers of this blog, thus it should be assumed that positions are likely taken. If this is an issue, please discontinue reading. Cycles Edge takes no responsibility for possible losses, as markets can be volatile and unpredictable, leading to constantly changing opinions or forecasts.