Yesterday’s The Plodding Fed report remains highly relevant, but for now you can just skim through the work on the Fed basing its decisions on questionable data. We need to focus on why we remain bearish on equities. This will expand on the work covered in Worse Than Adult Swim and Earnings & The AI Story.

This report is a quick update on our fears for the market, which are playing out in real time. We believe that figuring out how these risks play out will be crucial in determining the bottom of this sell-off.

• The carry trade and the move in the Japanese yen apparently triggered the sell-off. The Nikkei is down 12% overnight and almost 20% in August! The Japanese yen is back to 142, a level not seen since the start of the year. Presumably, the yen needs to stabilize for markets to stabilize, but will that be sufficient at this stage, or has too much been triggered?
• De-Risking. We have not seen fund flows show any form of capitulation. We continue to watch that closely and expect that we should finally see some serious de-risking, which will be a requirement to form a bottom.
• Vol selling strategies. Picking up nickels in front of the steamroller is always risky (even when it works for extended periods of time and doesn’t seem too risky). Expect this to put pressure on stocks and to heighten volatility. Need some exhaustion here, which we haven’t seen yet.
• Fake passive. “Passive” sounds, so, well, “passive” but when 50% of every dollar invested in a major index goes to relatively few stocks, it becomes more momentum than passive, and this unwind could just be starting.
• Liquidity is abysmal – in both directions. While we still don’t think the lows are in, some major 2% moves could easily occur.

Then there are a few things that we need to add to the list of worries and concerns:

• Geopolitical Risk. We have been seeing a divergence between our estimate of geopolitical risk and the market’s perception of geopolitical risk. From Iran, to North Korea, to Russia, the market is suddenly catching up to us on the risk of escalation and expansion.
• Buffett sales. Certainly not something we pay close attention to, but announcements of Warren selling down certain positions doesn’t seem to have helped anything.
• Watch for discount to NAV to increase on fixed income ETFs. For the first time in ages, I have some concerns about credit. Lower yields and risk off do not bode well for high yield (the best hedge for interest rate risk in high yield is typically to own Treasuries). The Russell 2000 futures are now back to early July levels (before their historic pop) and high yield tends to be more correlated to the Russell 2000 than other equity markets. If we see selling and outflows from high yield (and I expect that we will), I will be staring closely at the discount to NAV that the ETFs trade at. I am worried about the ETF Spiral™ where the arb community selling bonds to buy the ETFs puts more pressure on bonds, triggering new waves of selling. This is not my base case, but I am watching it closely.
• Don’t expect help from the Fed, or even the BOJ, though the latter seems more likely to do something to slow that appreciation in the yen.

Less bearish now that we’ve added another 4% or so to stock market declines, but I don’t see signs of a bottom yet (the 200-day moving averages remain my targets, with an increased risk of going through them). While we are likely going to get some tradeable bounces, don’t get too “cute” trying to buy this dip. At least not yet!

Good luck and so much for a nice quiet summer!

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