🗞 A Literal Silver Bullet

WHILE YOU POUR THE JOE… ☕️
Wake Me Up When September Ends

Bankers, traders, and other Wall Streeters came back from the Hamptons this holiday weekend and a throbbing hangover headache was the least of their worries.

The S&P 500 sold off by over 2% 📉 to start the month of September, which is historically not a good month for stocks (that’s why the song ‘Wake me up when September ends’ was made… right?).

Anyway, we have been calling for a correction in the market for a couple of weeks now, and we do think the $SPY ETF could be headed toward $540-545 this week if no responsive buyers step in and bid.

Let everyone else panic, we got you covered as to where the next big opportunity could be. By the way, did you catch our short thesis on $TOL stock on Monday? That stock was down over 3% yesterday.. brushes shoulder.

Speaking of pinpointing the weaknesses, let’s get on with today’s email 📧…

ECONOMIC DATAPOINTS
Are We Going Under?

The ISM manufacturing PMI index came in yesterday morning, with its cousin the services PMI index coming out tomorrow morning.

As a reading below 50 on this index means economic contraction, we are worried that this now marks the 22nd consecutive month of contracting activity in manufacturing.

Historically, the S&P 500 has a 12-18 month lag to the contractions in this index, as seen in every major recession followed by a period of below 50 PMI.

Notice 2000-2002 as the tech bubble burst, then late 2007 right before the financial crisis, then late 2019 conveniently right before COVID-19, and now, right before God knows what blows up.

Reading this index is not that cut and dry, as it covers up to 18 sectors and indicators within it to help investors and traders form a proper view of the market, so let’s take a look. 👀 

New Orders

Down by a factor of 2.8 on the month, and that means that fewer businesses and consumers are looking to buy stuff made by America’s manufacturing arm.

That makes sense, as the strong dollar right now will make it harder for everyone to buy American exports, which makes us think that a potential dollar devaluation might be on its way.

Production

Logic follows that if there are no new orders, then there is no need to ramp up production right? Bingo.

Falling by a factor of 1.1 on the month as brought production to its worst contraction since COVID-19, that’s English for the economy being in some deep doo doo.

Inventories & Prices

Now, here’s where I saw something unexpected. Inventories rose over the month by a factor of 5.8 📈, making them the most active segment in manufacturing.

In our opinion, this one has a twofold effect. First, it works to lower prices on the supply side, as there is now much more supply. The second effect is not so nice.

We now want to dig into the industries that drove these inventories higher on no new orders (no demand), because they will be sitting on a lot of inventory for a long time and probably need to mark it down to sell fast, so their margins (and therefore earnings per share) will likely contract. 📉 

Check it, it is Electrical Equipment, Furniture, and Plastics that saw the most obvious acceleration in contraction for new orders.

We can assume that these three are potential short candidates so far, basing our belief on the demand side.

But, it is time to check the supply side through inventories, are they starting to sit on more stale and depreciating inventory to bring their margins and earnings down?

It looks like only Furniture is, while Electrical Equipment and Plastics are still tightening their supply to keep margins high.

You know what this reminds me of? The weakening housing sector in the United States, which caught a lot of homebuilders like our short in $TOL by surprise.

More than that, furniture companies likely expecting to see demand from housing probably loaded up on inventory that they are now going to have to mark down in order to liquidate.

I love the smell of shorts in the morning!

We will probably have some play or stock to write about in Friday’s issue. Meanwhile, follow us on Twitter for more up-to-date developments in this idea.

Here’s a spoiler though, can you guess who we will be picking? 🎯 

TRADE OF THE WEEK
Silver Bullets and Golden Guns

Bank of America now expects we are heading into a major commodity cycle, which is good. Still, it needs to be clear which offers the most upside.

By looking at the one commodity that has already had a bull run in the face of a deteriorating US dollar, gold is the one to take first place.

However, something odd happens in its second best of kin, silver.

Since we are not futures traders, much less physical gold or silver buyers, we have to look into ETFs to get some exposure to these two metals.

Our choice for gold is $GLD and $SLV for silver. Here’s how these two pair on a correlation basis:

Pretty neat and expected, right? 87% correlation between Gold and Silver.

Since these two are supposed to move together most of the time, it worries us that Gold has made such an aggressive run while Silver has yet to catch up.

So, we considered the correlation and decided to graph their spread ($SLV minus price of $GLD). Here’s what that looked like:

This is the volatility and correlation-adjusted spread, which can be normalized through a hedge ratio (that long number at the top).

This means that when you graph SLV—0.12286076610696905 * GLD, you should get the above graph no matter which platform you use for charts.

Anyway, the red dashed lines represent the spread’s average value; green ones are the first standard deviations, and blue ones are the second standard deviations.

Ideally, we want to buy or short this spread when it gets too far away from the mean value in red, which is now just over the first standard deviation.

How do we know it will go back to the mean? We don’t, but here’s some math to make us feel better:

It looks like this spread is stationary in a P-value score of 0.04, meaning we are 95% certain 🎯 that we will return to the mean from these deviations.

Great, so all we have to do now is put on this trade by the respective hedge ratio, and we’re good to go.

To do this, using easy numbers here, we can buy 100 shares of $SLV and then short (100 * hedge ratio) = 12 shares of $GLD; then, we should be in place for a nearly risk-free trade here.

This is a chart of the spread with a volume profile. We just hit a low-volume area here, where prices tend to pivot aggressively, as they did yesterday.

This is a medium-term trade, which means we will have to check back with you in about 1-3 months, but I’m sure we can both be cheering over our profits, assuming you follow us. 💵 

NOW GO AND MAKE IT HAPPEN
One Way Bets

This custom of making one-way, seemingly riskless bets is the first thing I learned while at Goldman Sachs, and it’s something some of the greatest investors in the world share.

Today’s book recommendation 📖 is about making bets like these, how to think about them, and how to manage expectations and realities when going through them.

To your success,

G. 🥃