Risk Off, Right on Schedule

By Michael Salvatore, Editor, TradeSmith Daily

In This Digest:

Did you act during those 10 ominous days?
Markets quickly shift risk-off…
A sector check-in…
Which areas to own and dump this month…
The worst stock of the worst sector…
A bearish healthcare idea from Predictive Alpha Options…

15 trading days ago, we warned you to focus on profit-taking…

We suspected markets would, in time, find a reason to sell coinciding quite conveniently with the seasonal weakness of the late-summer months.

Seasonality wasn’t the only factor for our big call.

Stocks were overbought on technical metrics and losing momentum. Meme names were getting frothy. And the riskier side of the crypto market was catching a ludicrous bid.

And it was all heading towards a wall of data: GDP, FOMC, payrolls, and the epic tariff deadline that’s turned out to be not as rock-solid as advertised.

Imagine our lack of surprise when we turned out to be correct.

Even more correct than anticipated.

The S&P 500 didn’t just erase the past 15 days’ worth of gains, going back to when we first warned you. It took out all of July:

Pundits will tell you the trigger was the jobs report miss, showing a lot fewer new payrolls (73,000) than expected (104,000)…

Even though that raised rate cut expectations, which is what everyone and their dog has been begging for…

They might also point at a “slew of new tariffs” – 10% on countries with a trade surplus (as has been the case since April 2) and 15% to those with a deficit (a reduction for many countries and slight increase for others).

But I hope you can see the picture I’m painting here.

The catalyst does not really matter because the catalyst was, as we warned you, inevitable.

Now, stocks are falling. The risk-on euphoria is turning to risk-off panic.

If you didn’t heed our warning and trim risk heading into the end of July… well, you missed out on a month of gains, but that shouldn’t stop you from lightening up now.

There’s no telling if and for how long markets will continue sliding. But if it lasts any longer than Friday’s meltdown, which it very well could, then we’ll have to get a plan going…

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Today, I’m shouting ‘BUY NOW’ before it’s too late.”

In 2000, Eric Fry told Barron’s magazine that investors should sell a very popular dot-com stock just before it plunged 90%. Today, Eric is saying the exact opposite about it – “BUY NOW!” This same company is now the lifeblood of AI data centers – yet it’s completely undervalued. He says anyone who owns Nvidia stock would be well-served to sell those shares and buy this under-the-radar play instead. Get Eric’s full take on the situation right here…

Let’s first look at the risk-off/risk-on ratio…

Risk sounds like a nebulous thing. Truth is, it’s easy to fix a number to it in all sorts of ways.

Let’s divide sectors by sectors to get one number: the ratio of risk-off Consumer Staples stocks (XLP) against the risk-on Technology stocks (XLK).

XLP has been bleeding against XLK since the peak of tariff panic back in mid-April, falling more than 27% in relative terms.

Through the last month, though, we can see more evidence of waning risk-on momentum. The Relative Strength Index for the XLP/XLY pair has made higher lows and higher highs, while the pair itself has made lower lows and lower highs:

There’s pent-up energy for a big reversal here.

But let’s dive deeper on the sectors – with a check-in on the July returns and a seasonal study on what could happen in August.

Here are your sector leaders and laggards for July…

I was surprised to see Utilities top the list here, rather than technology.

You’ll remember last month we showed the seasonal tailwind was chiefly behind technology. Tech tends to do well in July, with a historical average positive return of 4% and a win rate of 86.7%. Utilities also tend to trade well in July, with an average gain of 3.4% and a 73.3% win rate.

Other sectors defied the seasonal trend. Health care has historically gone up 3.2% over the last 15 Julys with a 73.3% win rate but was the worst of the lot this past month as UnitedHealth (UNH) continues to drag the sector. Staples stocks, typically performing well in July with an 80% win rate and an average win of 2.8%, also fell last month.

It’s an important lesson in seasonality. Seasonality is simple statistics – not a crystal ball. It can give you an edge of where to look and when, but it cannot be the sole reason for a trade.

In any case, let’s look at the seasonal track record for August and see what edge we can find…

Funny thing about August. The two sector ETFs with the least trading history – Communications (XLC) and Real Estate (XLRE) – have the highest win rates by far and some of the better average returns.

I hesitate to recommend trading them given this short history, but when you also consider the relative performance, it might be an area worth looking at.

The not-so-funny thing about August is exactly what we’ve been warning you about. On average, most market sectors trade lower… with eight out of 11 sectors falling over the past 15 years.

The worst of these is energy. Energy has been higher just five of the last 15 years in August – likely due in some part to the fact that energy demand peaks in June and July before slowing throughout the year.

Because energy performed well in July, it’s an especially clear target for a seasonal downside trade in August. Here are the top 10 XLE ETF holdings and their individual seasonal trends. And those bearish on the energy sector in August are spoiled for choices of downside trades:

The largest holding of XLE, ExxonMobil (XOM), has been higher in just 20% of the last 15 Augusts, for an average loss of -3.88%.

Even bigger, though, are the average losses in Chevron (CVX) at -4.2% and a 20% win rate… and with a higher, but still poor win rate in EOG Resources (EOG) at 33.3% and an average loss of -7%. Another tantalizing track record is in Schlumberger (SLB), with a 40% win rate but second largest average loss and the largest overall average trade counting wins and losses.

In no uncertain terms, this data tells us to get bearish on energy. Though it’s just one piece of the puzzle.

Let’s zoom in on the chart of SLB. It just so happens to be in a devilish chart pattern – the head and shoulders. This is when a stock’s local high is flanked by two lower highs of a similar level:

We also have waning momentum on the Relative Strength Index (RSI), which is the purple shading above… and the stock testing its 2025 lows.

These patterns tend to resolve to the downside, with a good price target being the distance from the top of the head to the “neckline” – or the local lows.

That’s a solid setup. Either the stock will bounce from here and hold the 2025 lows, or the pattern will complete and fall more than 10%.

There’s a whole world of other great bear setups awaiting…

Our Predictive Alpha Options tool is ideal for bear-tilted environments like this. This software uses a combination of a stock’s volatility, price action, and our own AI algorithm to make projections on a stock’s short-term future.

Below, for example, is a bearish projection on healthcare stock Elevance Health (ELV).

Here, Predictive Alpha projects ELV to fall -6.3% by Aug. 14 – next Thursday. And that’s based on the 10-day Prime projection which has a historical accuracy of 78.1%:

Recall that Healthcare tends to underperform in August just as it did in July… making this a potentially great trade.

Predictive Alpha Options even recommends what type of trade to make based on the unique volatility picture – in this case, primarily selling calls and secondarily buying puts.

Subscribers can then take this a step further and find our algorithm’s top options trade recommendation – including the strike and expiration date – to take advantage of the projection.

In fact, with August being such a pivotal month, we have proactively tasked the AI with a trade alert next week.

For those of you who missed the new “TradeSmithGPT” upgrade for Predictive Alpha Options in June, now’s your chance to remedy that. We’re re-opening the service to new traders through midnight tonight – click here to find out more and get on the list.

Risk Off, Right on Schedule