Thus far, there has been very high dispersion between the unwind in momentum and the overall index, which has remained relatively resolute. Is the index, then, about to roll over as well?
We have seen a really aggressive de-leveraging and momentum unwind across the AI sector, and broader momentum names, yet the overall index, tracked mostly by US500 and ES, here, still remains relatively supported.
We see that clearly from the dispersion index.
https://preview.redd.it/uof13oj9mdeh1.png?width=1400&format=png&auto=webp&s=d4313a68cfe8031a5f07bb484345bbe7f73b89d4
The risk here is that correlations begin to spike higher, from multi year lows on COR1M, which would mean stocks start to move together rather than trading on an individual basis. If that were to occur, the recent dispersion would fade, and the elevated single-stock volatility we've been seeing would likely begin translating into higher headline index volatility and a fade on the overall index.
Right now, that is my base case. I believe that we are likely to see the index start to roll over into the end of this month and potentially spilling over into early next month. I think that given the fact that momentum is already 30-40% off its highs, momentum is likely to bottom before the overall index, but my thinking is that neither will bottom until we see the overall index start to roll over.
The weakness in the AI sector is mostly disconnected to fundamentals. Primarily, it has been a de-leveraging event, as we see with the reset to positioning within memory names:
https://preview.redd.it/chdqeegamdeh1.png?width=1386&format=png&auto=webp&s=c4c04a9044cd64ccdab17d9db2b8f4fd847ec950
But fundamentals continue to be supportive. TSM earnings and ASML earnings were both met with news failure as they failed to rally on strong prints, but both earnings reiterated the fact that the fundamental story around AI continues to remain robust. TSM guided for accelerating earnings into Q3 and indeed Q4, whilst ASML provided commentary around an insatiable AI demand.
This week, we have a number of catalysts that will confirm the story. The main risk and bearish argument following the META excess compute news a couple of weeks ago has been that we may have reached peak CAPEX from these hyperscalers. This was compounded by news of Kimi, which was essentially another Deepseek moment, where the question was whether cheaper Chinese alternative models are indicative of an overspend by hyperscalers, that will need to be curtailed at some point.
TSM is one of the best read throughs for the overall index since they are the foundry for almost all of the major chipmakers and therefore have the best read on AI demand. They raised guidance and expanded their own CAPEX. So I certainly do not expect to see any surprises with Hyperscaler CAPEX at their earnings over the next 2 weeks. But the market is waiting for confirmation.
GOOGL will be the first datapoint this week.
We also have TSLA earnings,which will give us some further visibility into the ramp on humanoid robots, and could be a catalyst like VPG etc which are designed into those robots.
The Wall Street research desks including Goldman, Morgan Stanley, BofA, Bernstein, Jefferies and Evercore continue to expect expanding hyperscaler CAPEX, with capex reaching an estimated $1T next year. This will provide the confirmation we need from the fundamental side around the AI narrative, and we will get individual data points also from LITE etc for the photonics sector.
Whether or not we get news failure to hyperscaler capex as well is yet to be seen, but it will at least be a fundamental confirmation that the bear case around AI is overblown right now.
I think the momentum name reset will be viewed as a buying opportunity when we look back in October or November, but I do not yet think we are at the bottom, as my expectation is that despite hyperscaler earnings likely to confirm the AI thesis, a roll over on the index level will likely spill over into more selling on these momentum names.
We could, of course, have a decoupling where semiconductor names (as CAPEX recipients) rally whilst MAGS leads weakness on the index level, but for the most part I do not see semiconductors as being able to sustain a strong rally higher if the Index does indeed start to roll over as I suspect it will.
As such, advice to those with cash would be gradual DCA with emphasis on gradual or hold off for a bit longer. I think we will see very shortly the situation on the index.
One could try to sell positions into this anticipated weakness. I think I am reasonably high confidence that we will see the index take more of an impact soon, especially in light of the Abi signals, but timing the re-entry is going o prove difficult, especially with these names massively off the highs already, so there can always be a very strong overnight candle to the upside. For that reason, I'm holding but am holding a fairly sizeable short position on the index to try to offset any equity decline.
TO hedge against a potential roll over on the index, which I believe to be more likely than not, you could use puts against the index, or a Simple hedge could be 8/21 SPX 7300/7150 put-spreads for 28ish to make 150.0
The momentum reset has been the largest momentum reset in over 40 years. And it is important to continue to view your portfolio decline against that. Yes, more diversification would have helped and in hindsight there's something there I will learn from in composing the portfolio so that the volatility is easier for the average person to stomach, but the portfolio represents a bullish bet on AI infrastructure, and nothing in the fundamentals has disproved that.
To highlight the extent of the recent momentum unwind: TMT Momentum has fallen roughly 40% in just 17 trading days, making it both the fastest and deepest drawdown ever recorded over that time frame. For comparison, the previous record occurred in early ‘21, when momentum was down roughly 29% after 17 trading days.
Most of this is a result of crowded positioning and leverage rather than a true deterioration in AI fundamentals.
Now attached is research from Citadel's Scott Runner, who is an analyst that I do respec the opinion of:
He noted that for the first time in a while, retail actually net sold momentum names on the latest moves down versus buying the dip. He does note that normally this is the bottom before a sharper move higher in SOXX.
https://preview.redd.it/q5k3qntcmdeh1.png?width=1400&format=png&auto=webp&s=5c41f9c1bb92df9aeea6b2ef0d5310fa6d937e68
I hope that that is the case, but it isn't my base case and I am hedged accordingly, as I see overall index weakness to first precede a true and more durable bottom on semiconductors.
Now if we look at the overall index:
https://preview.redd.it/f1sc6bavodeh1.png?width=1400&format=png&auto=webp&s=23a48dd636f9f927e5a52d80f5568176f2135120
Nasdaq is higher in premarket, but we do have a technical wedge breakdown, and a 2nd close below the 50d EMA.
It was the first close below the 9W EMA since the rally started in April. Certainly signs for caution.
Now if we look at ES, it's stronger, but we still closed below the 7575 warning shot level.
https://preview.redd.it/3i841t8wodeh1.png?width=1400&format=png&auto=webp&s=c9969764fa9e99d58186b5ee4d8947bc1987611e
Sell offs below this level are likely to gain a lot more traction than below this level.
This coincides well with the gamma regime we are in.
On US500, the current trading price is 7483. The gamma flip level is at 7512. This means to say that we are in negative gamma. Under this scenario, the dealer hedges in the direction of price action which exacerbates the volatility in either direction. A trump TACO for instance, would likely lead to a bigger move to the upside, but a negative catalyst would lead to sharper downside.
We do have a few negative catalyst on Iran over the weekend, with 2 US servicemen being killed and Trump threatening to 'open the doors of hell" on Iran, but for the most part the market has been shaking this news off.
Oil has been rising, currently trading at 81. Above approximately 88, the path of least resistance is to 100.
That will be An additional inflation risk for the market, but for the most part, last week's inflation data was positive for the macro picture, pushing back on a July rate hike.
We have CTAs sellers right now. CTA selling plus negative dealer gamma is often a recipe for more index selling, which again supports my suggestion that the index will likely roll over.
We have the Abi signals from last week. We didn't get one on Thursday or Friday, but we had 7 consecutive signals before that.
https://preview.redd.it/4silzkfxodeh1.png?width=1400&format=png&auto=webp&s=ac5687ccb4d20073990bc279e4de681fcc6b0ee8
Typically, Abi signal clusters foreshadow 50% expansions in VIX. The timing isn't always clear as the Abi signal isn't a great timing tool, but we were currently only 30% off the lows last Thursday, so more vix epxnaison is likely at some point soon.
VIXperation may be a. key catalyst here. We have seen strong put delta on VIX keep a suppressive lid on VIX.
This week, we see a lot of that suppressive vix positioning expire. If we move above 20 in that time, we likely see a lot of repositioning with OTM calls, which will put a structural bid on VIX.
https://preview.redd.it/dj713p1zodeh1.png?width=1400&format=png&auto=webp&s=496df063bc6a88e8a4e2a16d13bbaccd9857ba91
The signs are definitely lining up for more weakness in my opinion on the index level.
I marked on the ES chart above a number of intermediary supports in green. We could launch off of these supports, particularly if supported by a Trump TACO, but I would not be surprised to see the lowest green support tagged once the index begins to roll.
The Vol curve is for the most part healthy still. In contango and trading below the front of the curve. When spot price rises above the first 2 months, we likely transition from buy the dip into sell the rip, which may exacerbate downside risk.
https://preview.redd.it/gage7690pdeh1.png?width=1400&format=png&auto=webp&s=7ec2de342b5fdaf159f6c3ec08e7d9fda7e6f270
Overall, then, I do believe that the AI sector is fundamentally fine. I think we will see a strong rally back there. Hyperscaler CAPEX will be a fudnematnal confirmation.
But I do not see the momentum basket meaningfully bottoming until SPX rolls over. IT is possible that the dispersion index's highs could be resolved with SMH rallying hard and stock correlation syncing up like that, to the upside, in which case we will be out of the woods sooner than later, but the Abi signal in combination with the dispersion index and the COR1M rising from its lows, to me, suggests the more likely outcome will be the index to roll over first, before momentum bottoms.
My base case is still 7800 into the midterms. So a sharp rally will ensue, likely led by momentum names which are now oversold vs other parts of the index. The selling has reset leverage and positioning and at some point the market will look at these semi names and say they are "too cheaP". At that point they will rally strongly, but for now, I still recommend DCA gradually, or hold off, until e see what the index wants to do, as I think there is a significant chance the index starts to decline into the end of the month or just past this.
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