Stocks dropped 5% last week due to 1) the European Central Bank being more hawkish than expected, 2) a US inflation report being worse than expected.
We analysed the situation on the weekend and decided to take the risk level of the portfolio down massively to an exceptionally low level because:
1. Technical support on the $SPX500 at 3900 was breached. This leaves the index vulnerable to a possible vertical drop to 3400.
2. The Italian 10-year yield broke above its 2018 resistance level of 3.6%. That makes Italian debt potentially unsustainable. Yields on other European peripheral debt surged, too.
3. Bitcoin ($BTC) breached technical support at $30,000. This could potentially lead to selling of stocks as individual investors de-risk across the board.
We were wrong about the sustainability and duration of the May bear market rally and failed to de-risk quickly enough. We’re happy to admit this because in markets you have to stay flexible and not hold onto positions which keep going against you, if the fundamental or technical backdrop changes.
It’s rare for us to hold significant amounts of cash. The last time was in March 2020. However, we are uncomfortable holding cyclical stocks in the current situation. The risks are simply too high until central banks start to send signals that the tightening of financial conditions has gone far enough.
Fundamentally, it may be that high inflation has lowered the fair value of $SPX500 to only 15x earnings, meaning to 3400 currently.
And if there is a recession next year, $SPX500 could trade as low as 2900. That’s another 25% downside from here.
The failure to de-risk last week erased a couple of % points of our strategy’s outperformance for this year, but we’re still ahead of the index by around 14 percentage points. We make aggressive strategic and tactical calls – sometimes it leads to significant outperformance, sometimes the opposite.
The majority of risky positions in the portfolio were sold, leaving only a few cheap Financials and three non-cyclical stocks from the Pharma industry: $SAN.PA (Sanofi), $AZN.L (AstraZeneca) and $ROG.ZU (Roche Holding Ltd) .