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Good morning partner,
Few things to cover this morning:
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Friday’s Session
As we headed into the weekend, Friday showed participants another round of the classic tug-of-war that’s been present for over an entire quarter by now.
Hyperscalers rallied at the expense of some of the semis/memory names, at the same time boosting other quality/value factors in companies that generate stable and healthy cash flows.
Over the weekend, however, a few more developments were reported around the AI complex specific to OpenAI and its rogue agents.
Not only did these agents hack other corporations and the government of Australia, some user images were leaked as well to create another wave of regulatory concern and added costs to the technology.
Human supervision, liability insurance, and timing hurdles are my expectation, which will significantly change how AI profit timelines look into the future.
That’s one reason why markets are now paying a lower P/E for most of the AI leaders, as their expectations for the future become more pessimistic.
And then there’s the proof from last week in Oracle’s data center delay.
Let’s take a look at Friday’s leaders and laggards:
Technology, Financials, Industrials.
As mentioned, hyperscalers were responsible for the technology rally on Friday, so there’s very little edge in figuring that action out.
Where I think things become interesting is in the other leaders.
Financials can be explained by bank rallies, especially as the 10y-2y yield curve in the U.S. spiked by a sudden 0.16% despite a 10-year bond yield still closing in on 5.2%.
A steepening yield curve is good news for bank profits, which then takes the capital requirements and reserves into a more flexible/accommodative range to continue the AI financing mania going.
I believe this explains the industrials rally, particularly in the electrical equipment and cooling materials attached to data center construction projects.
Notice here that, despite the Oracle news, data center components can still rally on the back of more accommodative yield spreads and banking relief, which turns to contracted cash flows rather than promises of future growth.
That’s why semis/memory didn’t rally, because they are not guaranteed the benefits of these cash flows and rather rely on promises of growth.
Reading these dynamics, and putting the puzzle together, is extremely important as you try to navigate your idea pipeline and understand your portfolio behavior.
Complacency
If I were given a million dollars today, I would not attempt to DCA into the S&P 500 regardless of what everyone else recommends.
The reason is simple…
Stocks now offer a ~2.0% yield on earnings while 10-year bonds offer ~5.2% with much less risk attached.
Adjusted for inflation, I would be losing money by buying the S&P right now, though the same cannot be said for some individual stocks in the “coiled springs” areas of the market.
That’s for another day though, what matters is this:
Institutions, wealth managers, and savvy investors know this
Which is why the S&P 500’s forward P/E ratio continues to decline as the 10-year bond yield rises; there is a direct relationship between investors wanting to pay more for stocks relative to how much they can lock in through bonds.
I believe we could see massive selling pressure on stocks if a 10-15% drawdown hits the index, as most of these participants will realize the headaches are not worth the exposure, and rotate into bonds instead.
Mind you, this is NOT a timing tool, but a decision-making one.
I have chosen to adopt a long/short approach in my portfolio, look for “bunts” rather than home runs, and squeeze whatever is left in this bull cycle.
Home runs will eventually show up again, as they did in software during June-July.
That’s the importance of portfolio/strategy management, markets are not linear and neither should be your approach to them.
News
Trump Rejects Hormuz Offer from Iran, escalating the conflict for longer and attempting to ease the pain of fuel costs through an excess diesel export ban. This is great news for our diesel spread trade idea as refineries will be forced to shut production for now.
OpenAI Pauses Model Training after user images were leaked, government entities were hacked, and over 20 rogue agents were caught misbehaving. This changes the entire economic model for AI models as added insurance/human supervision costs will be called for.
The Fed Eases on Banks as a risk-weighted asset threshold is raised, letting banks take on more risk and leverage before they become a red flag for regulators, usually what happens when a bad apple begins spreading.
Costco Keeps on Winning even through a record-low consumer sentiment reading, showing just how resilient the value/quality proposition is for outperforming in the coming months/years.
Movers & ES Levels
Humana 📈 Gained just under 5% after analysts upgraded the stock citing better premiums and profits coming up. Remember I broke down the auction during a morning digest telling you markets were looking to bid healthcare on inflation?
Microsoft 📈 Rose 3.6% after showcasing its new Copilot AI capabilities, which we all know is the laggard model in the market, so I will credit this rally to a broader hyperscaler move higher on Friday.
Zscaler 📉 Lost over 9% on the new OpenAI hack reports, which should have naturally been a good thing for cloud security companies like this one, unless the market’s take is an outright slowdown and stop of the technology’s growth.
Meta 📉 Slipped 3.3% as markets doubt Zuckerberg’s strategy on Muse AI. Goes to show Microsoft’s rally and Meta’s decline had nothing to do with model announcements but rather the market’s treatment of cash flow quality that day.
Now let’s get into some ES levels for today.
$7,825 to $7,700 seems to be the opening balance for the week, with a bullish bias given the market’s ability to rebound on aggressive buying from the $7,700 cutoff level.
A close above with such volume confirms buyers are looking for a value agreement higher, though at roughly $7,800 the risk/reward doesn’t seem attractive to me unless we manage to break out of $7,825 on aggressive volume and close above it.
With PMI, GDP, and NFP data this week, I would be very careful of trying to catch these breakouts and would much rather wait until we reach an extreme in the market profile.
In fact, closer to $7,800-$7,825 I would be trying some small short positions on the index due to the reason that the MOVE index is now spiking ahead of the S&P.
100% of the time this ends in a selloff.
Zooming out in the market profile, the quarter shows me a “b” shape cutting off at ~$7,635 to be roughly 2.1% below today’s prices.
Not at all outside of the realm of possibilities for this week.
Portfolio
Another great run in the long/short portfolios, keeping everything else afloat while direction makes up its mind on some of the long-only positions I have on.
In particular, I have regressed some of these long-only back to the state of the diesel and yields trade, finding that they are themselves becoming a subset of coiled springs ready to spike when/if the yields and fuel situation normalizes.
Therefore, I am happy to hold them even through small drawdowns since the long/short “bunts” are doing their job in pushing out 1-3% returns per month on the portfolio.
This week, as we get a PMI update, I will refill the pipeline with several ideas to pursue in the coming weeks, and add more of these long/short positions to further diversify the portfolio risk.
Everything else looks under control, and the performance is demonstrating that fact with an outperformance to the S&P while still carrying less than half the VIX’s volatility.
That’s what professional portfolio management looks like.
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