Window Of Vulnerability
While the major averages finished last week roughly flat, intra-day volatility has steadily increased, which has implications for algorithmic trading strategies. The S&P 500 may still be near its all-time high, but it is actually lower now than it was back on October 6th and 2.6% off its October 29th record high. Anyone focusing solely on this Mega-Cap Tech-dominated index is missing the forest for the trees, as there is a lot of damage taking place below the surface. More on this below, but the S&P 500 has been flirting with its 50-day moving average (~6,700), and a sustained break below it will prompt systemic trend followers to flip from buyers to sellers.
Small-cap equities had a rough go of it last week, with the S&P 600 now off nearly -4.0% from its nearby peak and completely flat since August 13th. That’s two months of nothing while the lower-quality Russell 2000 is down by over -5.0% from its peak and has been directionless since the end of August.
What is catching my attention of late is the budding skepticism around the AI theme and lack of enthusiasm following a very strong Q3 earnings season. At this point, we have had more than 90% of the companies in the S&P 500 report results with aggregate EPS growing +13% YoY, yet investors have reacted in a far more discerning fashion with the S&P 500 up 1.5% since JP Morgan kicked off Q3 results on October 14th. More than likely, this is a classic case of markets looking through the windshield rather than the rearview mirror, seeing a horizon with more clouds than a couple of months ago. The high beta momentum trade has taken a big hit since the middle of October, which has continued into November, where the Goldman Sachs non-profitable Tech basket is down 15–20% MTD, speculative corners (Drones/Quantum/Space) are off 25–30%, and crypto continues its own unwind. What really stands out is the bifurcation in performance of Mega-Cap Tech vs Non-Profitable Tech, which last week logged its best week since February – a reminder that hope underperforms reality when positioning tightens.
A popular pair trade being run by a lot of hedge funds and institutional strategies is long a basket of profitable/high-quality AI companies vs. short a basket of vulnerable/low-quality AI companies. Below is a breakdown of each of these respective baskets according to Goldman Sachs. Anyone wondering why some of their high beta names have gotten hammered over the last three weeks may want to have a look at which basket they fall in.
Another victim of the ongoing squeeze in liquidity and risk unwind is Bitcoin, which closed last week below $95,000 and is down around 25% from its recent peak. We purchased a position in Bitcoin for the first time during the post-liberation sell-off based on broadening industry participation, expanding credibility as a financial asset class, its scarcity characteristics, and diversification benefits in a portfolio. None of those long-term considerations have changed, but I’d be remiss in not mentioning that the price of Bitcoin has broken below some very important long-term momentum indicators. Such a breakdown has occurred two other times since 2014, where each time Bitcoin went on to experience a drawdown of 60-70%.
A lot of considerations enter into the equation when managing other people's capital, with risk management and discipline near the top of the priority list. With that being said, nearly 25 years of market experience tells me it would be unwise to ignore such a meaningful breakdown of a long-term momentum indicator. I’ve learned long ago that you love your wife, children, and family, but never fall in love with your forecast or investments. What is also fascinating about this breakdown in Bitcoin is how gold has barely flinched, with it still topping the performance scorecard of the year for the major asset classes.
One thing that has been clear over the past decade – and even more obviously over the past three years – is that central banks around the world have been diversifying their reserves into gold. Bitcoin, not so much, at least from what I can tell. No, I’m not writing Bitcoin’s obituary, but the two hedges against the U.S. dollar are clearly moving in opposite directions as gold managed a +2.1% rebound last week (even if it was down over -6.0% from the nearby high), while Bitcoin succumbed to a big -9.0% loss (Ether too) and is now off more than -25% to below $95,000 (a six-month low), after touching an all-time high of just over $126,000 back on October 6th.
It’s a big week ahead, with Nvidia’s results coming out on Wednesday. Thursday’s jobs report for September is far less important, but the fact that we have no fewer than sixteen speaking engagements from Fed officials will be key, because with market-based odds near 50% for a December rate cut, heading back to 100% or going down all the way to 0% will have some major implications, especially for Treasuries. The one caveat to all the data that will be released in the coming weeks is that they will be tainted by the distortions from the government shutdown, so it may not be until January that we see clean sets of numbers. This is perhaps one reason why the Fed is signaling a standpat stance at the next FOMC meeting. This repricing may continue in the coming weeks, and that is a risk for both bonds and stocks, but would certainly benefit the U.S. dollar.
I’m in the camp that thinks the Fed is making a policy mistake if they do not continue to nudge monetary policy towards more accommodation. The price action over the past couple of weeks in asset markets is a repricing of a less accommodative Fed; a deeper move lower would be the market's way of saying the Fed is on its way to a policy mistake. Look, I’m sympathetic to the position the Fed finds itself in, where the labor market is weakening, but not yet contracting, while inflation is above target and at just as much risk of rising as it is falling. It’s a ‘damned if you do, damned if you don’t’ proposition aggravated by a K-shaped economy where the upper-end of the K remains firm and somewhat insulated from an increase in inflationary pressures, while the lower-end of the K is just the opposite.
All of this was echoed in the most recent University of Michigan consumer sentiment survey, which is becoming difficult to dismiss relative to other less negative data points. The report was very concerning as the headline came in at the second-lowest level in the 73-year history of the series, and far below the lows posted during all recessions dating back to the early 1950s. Sentiment is at a record low for the low-income households, and now this loss of confidence is bleeding into the middle class. High-end income earners are faring relatively better, but in absolute terms, we are seeing erosion as well — even with the bloated equity portfolios and stock market sentiment remaining at the high end of the historical range.
Let's get back to the big events of the week, which are earnings from the largest company in the world, Nvidia on Wednesday, and a host of consumer-facing companies, Home Depot and Lowe's on Tuesday, with Walmart to follow on Thursday. The results and what these companies have to say will serve as critical readouts on the health of the AI capex cycle, as well as on the K-shaped household consumption cycle.
It’s not just the fact that Nvidia is at the epicenter of the AI infrastructure mania, but that it commands an 8% share of the S&P 500 market cap and 10% of the Nasdaq. So, it can move the entire market — the risks or potential for a $5 trillion valuation. Since the launch of ChatGPT in November 2022, the stock price has skyrocketed by +1,000% and has been the tide that has lifted all boats — spreading to Financials, Industrials, and Utilities.
Coming into the report, Nvidia is up by +38% for 2025, with expectations running very high. Since late May, analyst revenue estimates for the next fiscal year have ballooned by +15% to $285 billion (according to LSEG data). With expectations elevated, how the company guides is going to be the most essential part of the earnings release. What has changed in recent weeks, as we have seen take hold in other corners of this space, is that investors are scrutinizing these large-scale AI investment announcements more than before, and are now at the stage where there needs to be some evidence of what the cash returns are going to be from this debt-fueled investment spending binge.
Oracle is the canary in the coal mine, and its shares are down by around -25% in the past month, and Meta (the next worst-performing hyperscaler) is down by about half of that. The plunge has now reversed more than all the advances posted after it disclosed its deals with OpenAI two months ago. According to the Financial Times, the price of Oracle’s debt has fallen by -6% since mid-September. CDS spreads have more than doubled just in the past two months! Ergo, we are now on the other side of the mountain where investors are getting more concerned than enthused about all the huge capital expenditures going on, especially now that it's being fueled by an aggressive debt issuance program.
Nobody is questioning the fact that we are in the midst of a powerful AI spending boom that has spread its tentacles throughout the economy and capital markets. But absent the AI capex boom this year, the U.S. economy might very well be in a recession. To go one step further, absent the equity wealth effect, which is being driven in large part by the AI boom, the upper end of the K-shaped economy would look a lot more like the low- and mid-end consumer.
Let me end with some closing thoughts on markets, which unfortunately have me more focused on vulnerabilities than opportunities. No, we have yet to make any dramatic adjustments to portfolio allocations, but we are tweaking around the edges, having pruned lower quality holdings, adding to the quality factor within the equity market, and carrying a bit higher cash position. At the top of mind is the question of whether we have moved past the point of peak liquidity and peak global monetary policy easing. If so, then we have likely experienced the trough for easy financial conditions. The below BofA chart from Michael Hartnett highlights the deceleration in central bank rate cuts from 2024 and 2025 as we head into 2026. Don’t kid yourself, as this mattered for how well risk assets performed over the past 24 months. Another key will be whether the US dollar stays below the $100 level, as it has acted as a big support for the improvement we’ve seen in global markets and economies in 2024/25.
Another key data point to watch is inflation and/or affordability. What we’ve seen in these off-year election results is that affordability has become a key motivator for voters, making it a critical issue for politicians to be mindful of. Anyone paying any attention to the news is likely aware of the latest bipartisan feud over the price of this year’s Thanksgiving basket relative to last year's. Look it up for yourself, as I’d prefer to steer clear of this minefield, but it should come as no surprise to anyone that a politician would lie or spin reality to fit their narrative. It was the former President of the European Commission who called it like it is:
“When it becomes serious, you have to lie.”
In a nutshell, I see this week as a pivotal one for the year-end rally. We have a lot of data, VIX option expiry on Wednesday, and November option expiration on Friday. Should we get through this week without breaking key levels to the downside (that’s in jeopardy as I type…), the setup into year-end improves materially. Keep in mind that where we are at the end of the week matters more than where we are right now (6,640). Nvidia results are going to be a big factor, and a VIX spike from what is already an elevated level of 23 will force CTA and volatility-control funds to hit the sell button more aggressively. Keep in mind, and I dislike writing this as much as you dislike reading or hearing it, but risk assets needed a cleansing that resets excessively bullish sentiment and positioning. I still lean in the bullish camp on an intermediate-term time frame, but that doesn’t mean the path from here to there won’t have some uncomfortable moments.
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