Stocks crash from oversold levels.
This is fact.
They also rally from oversold levels.
So, which is it?
I continue to believe that Phase 2 of the credit event is likely to hit toward the end of the month, and that the rally we’ve seen here won’t last for much longer. My short-term signals outlined in The Lead-Lag Report remain very close to flipping back to risk-off again.
Let’s say conditions do indeed favor credit spreads widening, as they have been doing recently, but an accident never comes. Let’s say the rally does persist into year-end, and the bulls are right. What’s the way to play it? Many would argue to just follow the playbook that’s already worked – large-cap tech stocks.
I disagree. If indeed markets were to continue to melt up and we get past the end of October, then I believe the play should be emerging markets and small-cap stocks on a return to breadth.
Why emerging markets? Because we are at a point now where the dollar’s strength, in the absence of a risk-off period, becomes harder and harder to justify. A turnaround in the dollar as risk-ON conditions return would help dollar-denominated assets overseas. Emerging market stocks would likely be beneficiaries of this.
https://twitter.com/leadlagreport/status/1713938294868783128
What about small-caps stocks? They’ve been garbage all year. But if you believe in mean reversion, the ratio of small-caps to large-caps looks ridiculously oversold. Again – markets crash from oversold levels, but if you believe in “buy low sell high,” how could you not be a little bit intrigued by small-caps playing catch up here?
The Bottom Line
I want to stress for those reading this that this is NOT me backing away from my argument that we are in the credit event. This is about scenario analysis.
I believe conditions overwhelmingly favor a tail event likely starting in the weeks ahead on the lagged effects of what’s happened to Treasuries permeating into corporate credit. But the role of an analyst and portfolio manager is to consider all possible scenarios. And yes, there is a scenario where there could be some meaningful catch-up trades outside of U.S. large-cap tech. I just don’t believe it’s high probability.
Regardless, I maintain the idea that this is the kind market path that screws with everyone – bulls and bears alike. And that the time to remain vigilant is here for literally any extreme to happen at any moment in time.
Conditions favor it.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
