Postcards: What This Market and Children's Soccer Have in Common...

With NVIDIA reporting earnings on Wednesday, we'll see how the crowd behaves. Our signal again avoided the Nikkei crisis, while the oversold trade provided an opportunity out of the chaos. ͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­ Forwarded this email? [Subscribe here]() for more You are a free subscriber to Postcards from the Florida Republic. To upgrade to paid and receive the daily Republic Risk Letter, [subscribe here](. --------------------------------------------------------------- [Postcards: What This Market and Children's Soccer Have in Common...]( With NVIDIA reporting earnings on Wednesday, we'll see how the crowd behaves. Our signal again avoided the Nikkei crisis, while the oversold trade provided an opportunity out of the chaos. [Garrett {NAME}](floridarepublic) Aug 27 floridarepublic   [READ IN APP](   Dear Fellow Expat: It’s nearly fall in Maryland, which will soon deliver my favorite weather anywhere on the East Coast. After five years of 90-degree September heat on the Gulf Coast, I return to cool morning temperatures requiring layers of clothing. Oh, to wear a hoodie at noon! This period coincides with many parents’ favorite event: Back to School season. And some parent’s most trying… Youth soccer practices start tonight. This evening, we’ll all gather around bags of orange slices to watch six-year-olds ignore all of their coaching. The kids will run around the ball in a pack - or a school of fish - chasing the ball. Some will indiscriminately kick it as far as they can, while others will just follow like drunken minnows. My brain will say: “No, Amelia, run over there away from the ball and wait for someone to pass it to you.” I’ll be quiet instead. The last time I said this to her, Amelia was three. She ran into the goal, stood there, picked flowers, and sucked her thumb instead. We all know how these kid’s games end. The crowding around the ball. The chaos of that motion. The inevitable spill that follows. The parents who’ll run out on the field when one kid trips in the pack, and they all topple too like dominos. It’s inevitable. All we can do is prepare for it. But we see this behavior every day - this type of crowding - in the stock market. And with chip-maker NVIDIA (NVDA) reporting earnings tomorrow, we’d better prepare for a spill. [Upgrade to paid]( Crowding Around the Chips? Instead of 12 kids all running around the ball, kicking at one another’s shinguards… Imagine even more reckless adults. They’re all piled around the same stock positions - eager to move in the pack because everyone else is doing it. Here at Republic Research, we like to be the kid on the other side of the field, waiting for an opportunity to emerge. But all the action is traveling in that pack. The over-concentration of the S&P 500 happens when a few massive companies start to dominate the index. This occurs because the S&P 500 is weighted by market capitalization, meaning larger companies have more influence. When tech giants like Apple, Microsoft, or Amazon grow rapidly, they take up a bigger index slice. Today, the top 10 stocks by weight on the S&P 500 comprise 34.45% of the index. Source: Slickcharts.com The chart below shows the top 10 positions heading into the third quarter. As you can see, we’re at levels that surpass the COVID-19 frenzy and the Dot-Com Bubble. It’s been a regular phenomenon since about 2018 when the Fed pivoted on interest rates and started to rebuild its balance sheet. When COVID-19 hit (and QE4 followed), the practice turbocharged. So, what’s happening here? What’s driving this behavior? Well, you know, I’m going to say there is a massive upswing in liquidity and QE programs around the globe. But there’s certainly more to that oversimplification. Factors driving this include the growth of these companies' market caps due to investor enthusiasm, strong financial performance, and their outsized role in the economy. And don’t forget the buybacks that are aiding share prices as well. Additionally, passive investing strategies that track the S&P 500 can amplify this effect, funneling more money into the biggest companies. The Risks and the Reasons? There’s no shortage of investment banks asking the same questions repeatedly: “[Is the S&P 500 Too Concentrated?]( asked Goldman Sachs earlier this year. In short, yes, but no one wants to do anything about it. America won’t unwind passive investment vehicles, which I explained [was a significant factor in this market behavior in my 1993 series](. Plus, BlackRock and Vanguard benefit from the practice. Goldman offers a solid exploration of the impact of momentum and overconcentration that gets almost everything right. Everyone agrees that the entire index could take a significant hit if dominant companies falter. However, there is a fundamental issue: This concentration reduces diversification, meaning that the S&P 500 should be more broadly representative of the market. It creates vulnerability, making the index more volatile and more susceptible to the performance of a few key players. In addition, these companies are highly susceptible to broader macro liquidity events, such as what happened on August 5 in Japan. That day, concerns about the Yen carry trade saw the Nikkei experience its worst day since 1987. NVDA shares plunged to roughly $90 per share, down from $117 a few days prior. Shares have since rebounded after the Bank of Japan shifted its policies, signaling it wouldn’t alter rate policy until we saw more “market stability.” However, as I’ll note, there’s no such thing as stability with such overconcentration. And with NVDA set to report earnings tomorrow, index investors are holding their breath. NVIDIA Reports Earnings Tomorrow Tomorrow, the “It” company of 2024 reports earnings in a vulnerable period for the market. NVIDIA trades at a staggering EV/EBIT ratio of roughly 63, higher than 86% of the semiconductor sector. NVIDIA became a massive force in over-concentration this year after its previous earnings reports prompted rapid buying at the institutional level. Funds added the stock to ETFs to accommodate their mandates, a form of forced buying—funds must add shares to properly allocate their weights. I’ve beaten the desk over and over: many ETFs and related thematic funds have abandoned their social concepts and shifted to “hug” or replicate their benchmark. [This is especially notable in my favorite example, the S&P 500 Catholic ETF (CATH)]( which abandoned its initial mission and instead built a portfolio practically identical to the weighted positions of the SPDR S&P 500 ETF Trust (SPY). It’s not just passive investing funds but [also active managers actively seeking to replicate those benchmarks](. The problem for investors chasing these gains is that a significant earnings surprise can spark sizable selloffs. After tomorrow's earnings report, the options market anticipates a 10% move in NVDA stock. That said, I worry less about the earnings reports. Instead, I am more concerned about macroeconomic events that impact system liquidity and typically require intervention by central banks or groups like the U.S. Treasury Department to stabilize the system and keep the music playing. What Can We Do About It? Here at Republic Research, we give away a macro-momentum reading each day in our letter Postcards to help you navigate the broader picture of liquidity and stability in the system. You typically see this reading each day when Postcards arrive. We are in the business of avoiding significant downturns amplified by overconcentration. And we look for opportunities to buy back into these crowded names when the panic has reached manic levels. I try to keep this simple unless you want to discuss technical and multivariate analysis in depth. The SPY represents our broader reading on institutional flows in the S&P 500, the Nasdaq is based on the QQQ, and the Russell is based on the IWM. When our S&P 500 reading turns negative, it’s a sign that challenges lie ahead for the index and its over-concentrated components. For example, our last negative reading occurred on August 1, 2024, prompting an email for Republic Risk readers with the subject line “[We’re Red Across the Board]( The signal detected rising volatility and hinted at unknown problems on the horizon. I honestly don’t know the underlying problem when the signal turns red. But two trading days later, the Nikkei implosion happened. This was the latest successful warning, which previously included institutional flows out of the market before the April Tax Selloff, the October 2023 yield surge, the March 2023 regional banking crisis, the October 2022 GILT crisis, and the late February 2020 signal before the COVID-19 crash. I always highlight the 2023 regional banking crisis as a prime example of our ability to detect events that no one has seen coming. Our readings turned red on March 7, 2023. We didn’t know why at the time. But we got out of the way. A week later, every newspaper blared a headline about a regional banking crisis. But if you look at Google News before March 7, only one article (in American Banker) discusses stress in the banking system—just one. A week later, the markets had melted down. As always, we advise investors to use these downturns to poke around their favorite stocks when markets hit oversold simultaneously on [the Relative Strength Index and the Money Flow Index readings of 30 and 20, respectively](. The recent selloff in August is the fourth time in two years that markets promptly bounced back from oversold RSI and MFI levels. Don’t be shocked if we see a fifth ahead of November. Stay positive, Garrett {NAME} Disclaimer Nothing in this email should be considered personalized financial advice. While we may answer your general customer questions, we are not licensed under securities laws to guide your investment situation. Do not consider any communication between you and Florida Republic employees as financial advice. Under company rules, editors and writers cannot recommend their positions. The communication in this letter is for information and educational purposes unless otherwise strictly worded as a recommendation. Model portfolios are tracked to showcase a variety of academic, fundamental, and technical tools, and insight is provided to help readers gain knowledge and experience. Readers should not trade if they cannot handle a loss and should not trade more than they can afford to lose. There are large amounts of risk in the equity markets. Consider consulting with a professional before making decisions with your money.   [Like]( [Comment]( [Restack](   © 2024 Garrett {NAME} 548 Market Street PMB 72296, San Francisco, CA 94104 [Unsubscribe]() [Get the app]( writing]()