We timed this one for an afternoon when the market was going haywire, so we could talk about the selloff and the monthly recap at once. As of recording, the S&P was down roughly 2.5%, the Nasdaq composite about 4%, and small caps about 3.5%.
Here’s the context that matters: this is a bad day in a very extended market. The long-term trend is clearly favorable and price had stretched well above it — expecting that to persist all year was never realistic. We’d already moved to a somewhat more cautious stance as the extension built, so a pullback like this is genuinely welcome rather than alarming.
We’re not concerned about the trend right now — it looks good and earnings have been strong. But here’s what we watch, and the specific levels that matter:
1. The VIX sustained above 20. A volatility spike during a pullback is ordinary, and the spike here came off extremely low levels. What we don’t want is the VIX pushing above 20 and staying there for more than a couple of days. That’s when you enter a volatility regime where money moves sporadically and price action gets genuinely uncomfortable. We saw it at the start of the Iran conflict. We’re not there.
2. The dollar index above 100.50. This may be the most important chart of the three. When the dollar strengthens against everything else it acts as a massive liquidity squeeze — liquidity gets sourced from wherever it can be found. Sustained moves above that level are typically where you start seeing central bank intervention, and relying on central bank action means markets have lost the plot. A day or two above is unremarkable; it’s happened several times in the past year. It’s currently moving the wrong way, but remains reasonable.
3. The 10-year yield above ~4.50%. We reached about 4.65% in the thick of the Iran conflict, came back down to where we like it, and are now creeping back above 4.50%. We don’t love that.
A rising VIX, a rising dollar, and rising rates together are a serious liquidity drain — and if they persist, the market trends will respond. That’s the sequence we’re prepared for.
The semiconductor index had gone parabolic — defying gravity in a way that stopped making sense. Parabolas don’t last, and sure enough the index fell about 9% in a single day. But look at where it landed: back at its 21-day average price. In other words, it merely returned to where it traded three weeks ago.
The pullback isn’t the abnormal event. The two-week parabola was. Semiconductor earnings have been indisputably strong — these companies have become the new industrials, in the sense that the world simply cannot operate without their products, which is what drove the advance in the first place.
Worth explaining, since people ask why the list looks the way it does. The M5 is a momentum factor with a quality overlay and a standard-deviation overlay. That combination is why the names are generally large and recognizable rather than speculative — we’re looking for the best quality with the best momentum, not momentum alone.
It’s also why the same names recur month after month. When a trend is durable, the process is designed to stay with it rather than churn for the sake of activity.
Trend is king. While the trend remains favorable, we stay constructive and view pullbacks as opportunity. If the trend turns negative — or the VIX holds above 20, the dollar holds above 100.50, or yields hold above 4.50%–4.60% for an extended stretch — that hurts the economy and the trend will respond. At the moment, none of those conditions are met.
So on today’s pullback: don’t worry about it. Go golfing this weekend, enjoy your family. We’ll try to do the same.
David Flanders: Hi everybody, and welcome to episode number six of the Above the Red Line webcast. We chose this afternoon specifically because the market seems to be going haywire today, and we thought we could give everybody an update on what’s happening with this downturn as well as the monthly recap — at an opportune time, to give you some weekend research you can focus on.
If we get right into the red line: the long-term trend is clearly favorable. We can also see that we clearly got extended, and then — Blake, point out today’s drop right at the end there. So you notice we have a big drop today in a very extended market. This is very normal price action. To think that we were going to stay this extended for the rest of the year just isn’t very realistic. We didn’t think we’d get this extended, as we were as of yesterday. So as you know if you’re following the portfolio, we’ve taken a bit more of a cautious stance, and this pullback is very welcome to us because we think it’s completely normal to see pullbacks like this.
As of this recording, the S&P is down about two and a half percent, the Nasdaq composite about 4%, and small caps about three and a half percent. So it’s a bad day today — but as you can see, a bad day in a very extended market.
Here’s the Nasdaq 100, once again in a very clearly defined uptrend. This pullback is welcome. It would not surprise me to see it come back down and maybe put in a double bottom with the last pullback, which was only about a month ago. Totally normal price action here.
Here’s our momentum trend. Again, clearly favorable — and also very clearly extended. Notice how much green is in the middle versus earlier in the year when we were in an uptrend. That’s the difference between a generally uptrending market and a market that’s simply getting extended. Very normal price action, and this most likely is not going to flip any of these trends negative, even if we have another bad couple of days Monday or Tuesday. So the momentum trend is clearly favorable and we’re happy about that — and happy about this little pullback, because I do think it will present some opportunities.
I threw some new slides in because I want you to see what does concern me. Presently I’m not concerned about the trend; it looks very good and the earnings have been fantastic. But here’s what does concern me.
We’re getting a spike in volatility, which is typically not a big deal — when the market pulls back like this you usually get a spike. But look at the level we were coming from: extremely low volatility just two days ago. For volatility to spike while the market has this little pullback is completely normal. But let me point out where I’d be more concerned. We don’t like to see the VIX spiking or trending above 20 for very long. Typically it doesn’t — but when you have big drops like we did with the Iran war, it went above 20 and stayed there a while. In those volatility regimes it gets very sporadic, money moves quickly back and forth, and the price volatility becomes uncomfortable. So we look for that, and we don’t want to see the VIX above 20 and staying there more than a couple of days. That’s one negative on our radar — but as you can see, we’re not even there yet.
Same on the negative front: you don’t want the dollar index rallying. When the dollar strengthens against all other currencies it’s like a massive liquidity squeeze — liquidity becomes needed and it comes from wherever you can get your hands on it. Anything above 100.50, we really don’t want to see it go above there for more than a day or two. This is probably the most important chart, because when it happens it’s such a massive liquidity drain. Typically that’s where you see central bank action — but we don’t want to rely on central bank action, because that means the markets are losing control. Again, we’re not there. If we went there for a day or two, we’ve done that a few other times in the last twelve months, so it’s not a one-day “this is the end of times.” It’s just what you don’t want to see. It is moving in the wrong direction, however — but perfectly reasonable at the moment.
And interest rates, same thing. In the thick of the Iran war we got up to about 4.65 on the 10-year. We came back down to where we’d really like to see it, under 4.50. Now we’re creeping back up above 4.50, and we don’t like that.
So those are the three things, if you needed something to worry about — which obviously you don’t: a rising VIX, a rising dollar, and rising interest rates. You don’t want to see them go above the levels we’re looking at, because that’s a massive liquidity drain. And what you’ll notice if that happens is that the market trends will go negative — which, again, at this moment in time we are completely prepared for.
This is the semiconductor index, which completely went parabolic. I mean, this was defying gravity. When you get into what they call a parabola, it just doesn’t last — and sure enough, here we are, it’s not lasting. You’re getting this sharp pullback today; the semiconductor index is down 9% today, in one day. But again, that’s normal. Look at how you’re simply coming back to that blue line — the 21-day moving average. So we’ve got the last 21 days’ average price, and it’s only at that price right now. This is just normal. What wasn’t normal is the parabola we saw over the last two weeks.
Semiconductor earnings are indisputably amazing — this buildout and the insatiable demand. These are honestly the new industrials. The world cannot operate without these products, which of course is why the price had such a massive advance. So these pullbacks are very normal. Here’s the last time this happened, just a month ago, and we came down to the 21-day. Same thing. Totally normal price action. I’d love to see it come back down to the low of that last pullback — in my opinion that would present a good opportunity.
Now the M5, the top momentum names in our universe. As you know, the M5 is a momentum factor with a quality overlay and a standard-deviation overlay. That’s why you’ll notice these are generally recognizable, larger companies — because we’re looking to stay with the best quality with the best momentum. The other thing you’ll notice is that the same names keep coming around; a couple have been consistent presences on the list for some time.
Looking at the charts: the memory name shows today’s pullback, and we’re not even back to the price of three weeks ago. This is a healthy pullback. The ideal scenario would be a bit more downward move followed by a two-to-three-week sideways move — that would be really healthy, just chopping around for a while, because the earnings there are spectacular.
The consumer technology name is almost like a staple — the cell phone is practically an appendage in today’s society. When things start getting shaky, that kind of stability tends to attract funds.
Our largest-cap name finally stopped making new highs and is doing the thing we don’t mind: a bit of a sideways move. Clearly still in an uptrend, and it’s probably one of the most diversified beneficiaries of the whole AI buildout from every angle you can imagine.
Another semiconductor name is a blast from the past — they entered AI chips and GPUs a while ago and happen to be a very diversified player in chips, so they’re capitalizing on this trend.
And one more had a massive drop off the highs — a big correction over the last few days, but still a very clear uptrend. If you get a chance, look at the earnings report they put out a couple of days ago; it was incredible, growing from every angle.
Blake, do you remember a few months ago when the memory name had the most stellar earnings report we’d ever seen — and the stock went down on it? And that pullback didn’t last long before it went parabolic. There’s a similar situation now. The challenge is that when a company has been doing this well, good earnings reports are simply expected. There’s no shock and awe when AI revenue doubles, even though we should be in awe of that kind of result — now the stock goes down on it. But that’s okay; a little pullback gives us opportunities, and everything continues to look good.
The three things we keep an eye out for — well, obviously the trend is king. We follow the trend, and as long as the trend’s favorable we stay optimistic and look at pullbacks as opportunity. However, if the trend goes negative, or the VIX spikes above 20 for very long, or the dollar goes above 100.50, or yields hold above 4.50 to 4.60 for long periods, that’s going to hurt the economy and you’re going to see the trend respond to it.
So again, no worries at this time. Today’s pullback — don’t worry about it. Go golfing this weekend, have a good time, enjoy your family, and we’ll try to do the same. Thank you, we appreciate you, and have a great weekend.
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