MARKET COMMENTARY:
Summary of our views is as follows:
- We continue to believe that the US inflation rate won’t be able to return to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed. Additionally, we see both Presidential candidates as inflationary based on a willingness to grow Government spending. Of the two presidential candidates, Trump may be even more inflationary as protectionism (tariffs) can drive the price of imported goods higher and tighter immigration policies can drive the cost of labor higher. The most inflationary scenario would be a clean sweep (presidential seat and same party domination of congress) in our opinion.
- • Portfolios should have robust exposure to real assets and other strategies that can perform in this type of persistently inflationary environment. A simple portfolio consisting of equities and bonds only will be suboptimal if our view is correct.
- The concentration of the largest names in the S&P 500 has never been greater. This is worth watching, as if the market’s mega-darlings start to falter beyond a typical pullback, the negative impact on the price of the S&P500 could be significant.
- The concentration of the largest names in the S&P 500 has never been greater. This is worth watching, as if the market’s mega-darlings start to falter beyond a typical pullback, the negative impact on the price of the S&P500 could be significant.
- Demand for downside protection in the US equity markets remains anemic. Strategies that sell volatility are in high demand, and the demand is increasing. Additionally, 0 DTE options are now roughly 50% of daily option volume. Don’t underestimate the potential for a violent downside repricing in equity indices if the volatility sellers are caught offsides.
August started with an explosion of volatility and appears to be ending with increased certainty, at least with respect to the Federal Reserve’s reaction function.
On July 31st, the Bank of Japan hiked their interest rates by 15 bps to 0.25%, in an unexpected move. The market was pricing in a very small probability of a rate hike. This rate change led to an unwind of the “yen carry trade” which can be summarized as borrowing money in Japan at extremely low interest rates and then investing the proceeds into higher returning assets. Borrowing in Yen and investing in high yielding emerging markets, in US equities, and even in Japanese equities were all variations. With the rate hike, the subsequent strengthening of the Yen against other currencies, and declines in global equity markets, forced liquidations occurred.
While the US equity markets declined only moderately, the VIX index spiked significantly. Japanese equities were hammered - the Nikkei was down 6% on Friday, August 2nd and another 12% on Monday, August 5th. Friday and Monday’s losses in Japan erased seven months of gains for Japanese equities. Monday’s return was the worst for the Nikkei since 1987.
There were significant declines elsewhere in Asia as well. Taiwan stock market saw its largest decline in 57 years, and the South Korean benchmark KOSPI saw its worst day since the 2008 financial crisis declining almost 9%.
There were also reports of abysmal liquidity in equity, bond and options markets, most likely exacerbating the moves. This was a subtle reminder that portfolio tail hedges need to be in place before the event happens, as it may be impossible to get the liquidity to add them as the tail event arrives.
Since the events of early August, equity markets have recovered. The decline in the VIX from elevated levels was the fastest ever on record, possibly due to the continued large demand for short volatility strategies.
Sundial family office portfolios are invested in tail strategies designed to perform in these sorts of extreme events. Fortunately, our tail strategies performed very well. A modest amount of profits were realized in the tail event, while also maintaining significant exposure in case it got worse. This strong mark-to-market performance combined with realizing some positive P&L allowed us to selectively buy into the equity market weakness with confidence.
It is a rare occurrence to make money on both sides of that trade, meaning capturing some profits on the tail strategies in addition to buying the equity market dip, followed by a rapid recovery. We are thrilled with the result, but we are also wary of follow-on tail event risk as historically explosive volatility in markets tends to cluster.
The end of August brought far more certainty on the path (but not the magnitude) of the Fed Funds rate. Chair Powell was crystal clear stating “The time has come for policy to adjust.” He also confirmed that they are not looking for any additional weakness in the labor market before acting, and that their confidence has grown that inflation is on a sustainable path back to their 2% target. The market is pricing in roughly a 75% change of a 25 bps cut at the September meeting, and that is what we expect the Fed to do.
How many rate cuts and the frequency of cuts is less obvious to us. After the speech, Fed Governor Bostic indicated that in his mind a neutral Fed Funds rate is perhaps around 3.5%. While that might be a nice target in theory, it is unclear if the Fed will get there anytime soon, particularly if inflation turns back up as we suspect it may. Lastly, what is also relevant is that with the willingness of the Fed to start cutting rates, also comes a higher probability that if the economy weakens more than expected, the Fed will get more aggressive with rate cuts. The Fed put is back in business. That perhaps truncates the left side of the distribution at least until a series of economic data calls into question the Fed’s stance.
In terms of seasonals, the equity market is heading into the widely known bearish September seasonality. Seasonality is never a guarantee, but it does have a statistical basis and also a substantial grounding, partially based on stock buyback blackouts. With September less than a week away, there could be some frontrunning selling attempts, particularly as the S&P500 is almost back to the recent highs and gamma is positive (read mean reversion tendencies) and thus the risk of a powerful upward move is arguably less probable. The negative seasonal period doesn’t come to an end until mid-October, so patience may be rewarded for new money being allocated into the US equity market.
Sundial Trend Table:
Date: 8/26/2024
Podcast Recommendation:
The Algorithmic Advantage Discussion with Andreas Clenow
https://thealgorithmicadvantage.com/podcast/022-andreas-clenow/
Andreas is a favorite of ours and much of his published work was instrumental in the development of our Sundial
systematic equity strategies. This is a great interview along with his latest project of bringing his systematic
investing framework to the small investor. For those interested in investing in Hush, reach out and we can
connect you to its founders.
STRATEGY COMMENTARY:
As a reminder, our Sundial Dynamic All-Weather Portfolios attempt to achieve positive returns regardless of the macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
- Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets • Utilize both active (tactical) and passive (buy and hold) strategies
- Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non-correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our systematic equity strategies continue to be our highest conviction equity exposures. These strategies have generally done an excellent job of identifying single name equities that can outperform the overall market, and they have also managed risk well in overall market drawdowns. We continue to methodically dial up exposure to these strategies as they are performing as expected and the environment is very constructive. We also capitalized on the equity market dip in early August to add new exposures for our most recently onboarded clients.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. These positions are mostly in ETFs and other diversified exposures. We have started to increase the weighting of energy and healthcare in portfolios, but this is simply a rotation of existing risk. With equity indices close to all-time highs, and concentration in the largest names so heavy, we prefer to wait for a significant pullback before adding any additional exposure.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects the attractive opportunity set. There are so many strategies that can generate a high single digit and even mid to high double digit annual returns with modest risk. We continue to utilize mostly alternative yield generating investments that focus on private credit, bridge lending, commercial real estate deals, and tranched insurance risk related strategies. Private credit is the only investment where we are starting to pair back exposures, simply by no longer reinvesting coupons. Specifically related to commercial real estate, our highest focus is industrial properties. Both flex industrial and specialty properties such as luxury garages are where we believe the best risk reward is right now.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: We continue to believe the uncertain macro environment is constructive for “dislocation seeking” trend following strategies. We were never believers in the stock and bond only portfolio, and we continue to hold the view that owning government bonds will not act as much of a portfolio hedge as long as inflation remains above target. Trend following strategies are a far better portfolio diversifier.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: August was an epic month for these strategies both in terms of mark-to-market and realized gains, and also in terms of proof of concept to our newer clients. We continue to maintain maximum exposure to these strategies, and when we take on a new portfolio, this is also one of the first positions we initiate.
CHARTS & TABLES:
Disclaimers
This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities nor does it
constitute tax advice. This information is for informational purposes only and is confidential and may not be reproduced or transferred
without the written consent of Sundial. Past performance is not indicative of future results. Statements and opinions in this publication are
based on sources of information believed to be accurate and reliable, but we make no representations or guarantees as to the accuracy or
completeness thereof. These materials are subject to a more complete description and do not contain all of the information necessary to
make any investment decision, including, but not limited to, the risks, fees, and investment strategies of an investment.
This correspondence may include forward-looking statements. Forward-looking statements are necessarily based upon speculation,
expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive
uncertainties, and contingencies. Forward-looking statements are not a promise or guarantee of future events.
Benchmarks and indices are presented herein for illustrative and comparative purposes only. Such benchmarks and indices are not
available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions
and costs, management or performance fees, and have limitations when used for comparison or other purposes because they, among
other things, may have different strategies, volatility, credit, or other material characteristics (such as limitations on the number and types
of securities or instruments) than the Firm. It should not be assumed that your account performance or the volatility of any securities held
in your account will correspond directly to any comparative benchmark index. We make no representations that any benchmark or index is
an appropriate measure for comparison. The S&P 500® Index is a stock market index from S&P Dow Jones Indices. It is a market
capitalization weighted index of 500 of the largest U.S. companies, designed to measure broad U.S. equity performance.
Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses.
There are no assurances that an investor’s return will match or exceed any specific benchmark.
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