Kvarn X Pro Weekly Report 45

Quick recap: last week

A week ago, the Kvarn X Pro Weekly Report was written in a distinctly cautious mood. The S&P 500 index's progress, which still looked promising in early October, appeared to be stalling, and the index had fallen below all of its key short-term moving averages. We also noted the continued weakness of growth stocks, which pointed to investor caution. On the other hand, we observed that defensive sectors still looked strong, and we had not yet seen a sell-off across the equity market as a whole.

S&P 500 below 7,600 points

Over the past week, the equity market has largely continued along the lines we identified last week. The S&P 500 index has continued to fall and is currently clearly below its 10-, 20- and 50-day moving averages. In recent days, the index has also slipped below 7,600 points, which we have regarded as an important watershed. A break below this level forces us to take the possibility of an even deeper correction more seriously than before.

The Nasdaq 100 index has clearly underperformed the S&P 500 in recent weeks. The index has fallen about ten percent in a few weeks and is already touching its 200-day moving average.

The small-cap Russell 2000 index, on the other hand, looks somewhat stronger than the two indices above. It remains above its 10- and 20-day moving averages, but below its 50-day moving average.

Within the equity market, we continue to see investors clearly avoiding the technology sector and favouring other sectors. The ratio of the Nasdaq 100 to the S&P 500 appeared to recover briefly last week, but in recent days it has fallen back below all of its moving averages.

The RPG/RPV ratio, which compares growth and value stocks, has also been falling steeply since the start of October, and over the past week it dropped to its lowest level since March.

It therefore looks as though the equity market is currently split in two in an interesting way: a weak technology sector and relatively strong other sectors.

In recent days, technology sector ETFs have started to approach the levels seen in the sudden drop at the end of July.

At the same time, outside the technology sector the equity market still looks to be trending higher. The SPXT fund, which invests in the S&P 500 excluding technology, has been rising since the start of October and is currently close to its record high.

The equal-weighted S&P 500 index is also right around its record highs.

From a market breadth perspective, the equity market looks remarkably strong. More than 65 percent of S&P 500 stocks are currently above their 50-day moving average.

The equity market therefore presents an interesting contradiction right now: tech is falling and investors favour defensive stocks, yet most S&P 500 stocks are still in a strong uptrend.

This contradiction allows for two very different readings. The optimistic reading is that this is simply a healthy rotation, in which investors are shifting their focus from tech stocks that rose strongly earlier this year to other sectors. The more pessimistic reading would be that investors' shift to a defensive stance is the first warning sign of an approaching correction, in which investors would also start selling stocks other than tech.

Which one is it?

Of course, we will only know for certain in hindsight. While the situation is unfolding, we look for signs of market nervousness that could increase the likelihood of a correction.

As long as the strengthening of defensive sectors was combined with low volatility, it could be dismissed as a natural rotation. Over the past few weeks, however, we have seen the VIX index climbing higher, and in the last few days rising above 20.

This clearly points to elevated volatility expectations. As long as this remains the case, we have to take seriously the possibility that this could be more than just a rotation between sectors.

Implied correlations have also been rising in recent weeks, and in the last few days they have moved above their 200-day moving average. In our view, this too is a clear warning sign that forces us to take the risk of a correction seriously.

Right now, then, we see quite a few dark clouds over the equity market, and possibly already the first raindrops.

It should be stressed, however, that even these observations do not necessarily mean a downpour. The market's nerves may well start to settle in the coming days as the results of the US midterm elections start to come in.

We want to make it clear, however, that right now there are many warning signs pointing to a correction. The presence of these signs does not mean that a correction will happen, but once they have appeared, a possible correction can no longer come as a surprise.

Gold below $4,000

Precious metals have continued to fall. Gold's $4,000 level, which still acted as support in July, was broken last week, and at its lowest the price has already dipped below $3,900.

For the other precious metal, silver, the decline has been even steeper. The silver price has fallen about 20 percent in a month and has dropped not only below the $55 level but also below $50.

So right now it looks as though investors are not seeking safety, even amid the market nerves, in the traditional safe haven of gold, but instead favour more defensive stocks.

The declines in precious metals are so steep that they are starting to look somewhat oversold. Gold has fallen more than 15 percent from its late-August peak, and silver almost thirty percent. We would not be surprised to see some kind of bounce in both soon. It should still be stressed that both are in clear downtrends, and reversing them would require considerable strengthening.

Bitcoin at a watershed

The price of the largest cryptocurrency, bitcoin, is in an interesting position that allows for different readings.

A pessimist can naturally point out that the bitcoin price is clearly below its 50-day moving average, and that this average has already turned lower.

An optimist, however, could point out how little the bitcoin price has fallen, given that over the past week we have been reading about the largest crypto theft in history, targeting Binance, the world's largest crypto exchange.

The fact that the bitcoin price has dipped only a few percent on this news is quite an interesting sign, and could point to underlying strength in the market.

With these alternative readings in play, we set the $75,000 level as an important watershed. This level acted as a floor in mid-September, and as long as the price stays above it, the bitcoin price can still show features of an uptrend. A break below this level, on the other hand, would make it hard to hold on to any kind of upward-trending reading.

Within the crypto market, we see crypto investors' caution continuing. The ratio of the total altcoin market value to bitcoin's total market value is below all of its moving averages. Such sentiment can hardly be considered particularly surprising after the news of the Binance hack. An optimist might even see it as positive that this ratio has not fallen significantly over the past week.

In summary, the financial markets appear to be in a very interesting situation. Tech stocks have weakened sharply, but the rest of the equity market still looks strong.

If this is just a rotation within the equity market, an excellent buying opportunity in tech stocks and other higher-risk assets may be emerging. If, on the other hand, it reflects growing investor caution, we could see clear moves lower across the market in the coming weeks.

The coming week and the US midterm elections may well tell us which of these two very different scenarios is playing out.

Wherever the market goes, we will keep following the situation and keep you up to date, so stay tuned!