Research - Outperform in Indecision
Research - Outperform in Indecision
In choppy markets, a trader's job is to identify pockets of certainty and lean on them to navigate the rough waters. This newsletter issue discusses two such pockets of certainty.
I write this at over 30,000 feet in the air, flying close to the speed of sound, and yet too late to be there for the passing of a childhood friend that grew too old too fast. Moments with loved ones are tragically brief yet priceless because of their transience.
This newsletter issue is dedicated to the indomitable and loving spirit of Lassie, who couldn’t hurt a fly. I’ll see you on the other side!
Readers that have been following the markets recently know that it's in a zone of indecision. There's the crowd that believes that there's more to fall (let's call them the Superstorm Sandy's, thanks Jamie Dimon) and there's the crowd that believes the worst is behind us (let's call them the September Pause's since they think rate hikes will slow in September). This has resulted in a temporary SPY rally from the Snapchat lows more than two weeks ago and a period of trading in a range between $410 and $415. With the impending release of May's CPI numbers, the market sold off to $400 on Thursday (at the time of publishing, the CPI numbers were released and they don’t look good). So much, at least in the short-term, hinges on these numbers. If CPI remains high, the market will continue Thursday’s sell-off, confirming the bear market rally and foreshadowing more selling to come. If CPI cools, we are likely to extend this ongoing rally.
The point of this issue, however, is not to predict whether CPI will be high or low but to present a way to trade this very difficult and risky zone of indecision. So much hinges on future happenings that we have no way to predict. Who knew, at the end of last year, that a land war will break out in Europe followed by intense lock downs in China. Who knew that oil would get so expensive that in some parts of California, it's breaking $7 a gallon. Things are moving fast and the events that will move markets are unpredictable.
High Risk Assets as an Early Signal
What is certain, is that there's lots of uncertainty.
But that doesn't mean it's impossible to navigate these rough waters. One way you could do so is to be an expert on geopolitics and macroeconomics and keep up-to-date with every news event from East Europe, East Asia, and the Federal Reserve. Most readers don't have the time to do this. Even if you had perfect geopolitical and Fed information, there's still the risk of misanalyzing a situation. Another better way to do so is to let the market tell you where it's headed. There are several possible canaries in the coal mine that will give you a heads up about the market's long term trajectory. The most important of which, in my opinion, is the price movement of high risk assets (e.g. growth stocks and crypto). Let me explain.
During the 2020 bull market rally, while SPY was slowly chugging upwards but below its prior peak, growth stocks like SHOP were already making new all-time-highs. The market was clearly in high risk mode and pouring money into high risk assets. Although the market felt precarious so soon after a major crash, the sprinting of growth stocks into new all-time-highs so soon after the 2020 crash signaled the relentless bull market of the second half of 2020 and into 2021. On the flip side, the early decimation of growth stocks in the second half of 2021 while large cap indices held steady signaled a major impending pullback in even the highest quality of large cap stocks in 2022.
The principle here is that when the overall market's trajectory starts to drastically change, some market undercurrents often shift first. The early movement of high risk assets offers the best signal for the rest of the market. This is because the flow of funds into/from high risk assets represents the market's overall risk appetite and this asset class is a playground for high-alpha hedge funds (hedge funds that try to outperform the market). These funds have a wealth of market information and they telegraph their perspectives through how they position their money in high risk assets.
As such, if you're looking for a sustained long-term stock market bounce, watch for how high risk assets are behaving. If they start to consistently print higher highs and higher lows, thus reducing the chance of a bear market bounce from shorts covering, then it's likely that high-alpha hedge funds are starting to establish long-term positions in them in anticipation of a new bull market.
There are certainly many other canaries in the coal mine one can watch out for to spot major shifts in market sentiment before they happen, but I think the movement of high risk assets is the best and easiest one to watch out for.
The Fed’s Mindset, and Conundrum
The fact of the matter is that the Fed realized through this prior bull market that if they loosen monetary policy too much, it'll jumpstart a relentless consumption boom in a country that loves to consume, among other things. The boom will permeate all aspects of American society, in the government through the passing of multi-trillion-dollar stimulus bills, in corporations through the raising of trillions in corporate debt, stock issuance, and ill-advised SPAC deals, in high net worth individuals through impulsive buys of deca-billion-dollar social networks, and in the average American through bidding wars for overpriced homes and the financing of expensive Peloton exercise bikes with Buy Now Pay Later schemes.
The problem is, all this happens in a country where the supply chain satiating this pervasive desire for consumption lies halfway across the world, managed by countries with completely different ideologies than the US. This creates the perfect situation for uncontrollable inflation, especially if said supply chain comes under strain and the US government gets addicted to passing stimulus. The US can drive consumption but can't control the machine that satisfies the resulting demand.
Over the last year, the Fed painfully learned that it can't foot the bill for this relentless consumption, lest the country is plunged into an uncontrollable inflationary wage-price spiral. The remedy to this predicament is to raise rates across the entire interest rate curve. Higher rates discourage governments, companies, and individuals from borrowing too much to spend. Part of this process is to raise short-term rates through raising the Fed Funds Rate, which they are already steadily doing, and raising long-term rates through selling debt assets from its massive $9 trillion balance sheet that ballooned from $4 trillion at the start of 2020.
This balance sheet primarily consists of US Treasuries and Mortgage Backed Securities, and shrinking it will have profound contractionary effects on the stock, bond, and real estate markets. The Fed has never expanded its balance sheet at the scale it did in the last two years, and it has never contracted its balance at the scale it intends to right now.
The Federal Reserve is one of the biggest buyers of US Treasuries. It will soon disappear from Treasury market bids and may even become a seller. Without the Fed, there is no one there to support the price of Treasuries. US primary dealer banks are already topped up (regulatory requirements) and large foreign sovereign buyers are topped up as well (i.e. China and Japan). The direct effect of this is exactly what the Fed wants, falling Treasury prices which directly translates into higher long-term interest rates.
The one unfortunate market that must foot part of the bill, but is ill-equipped to do so, is the stock market. As bonds fall in price, funds rebalance out of stocks into bonds. The stock market doesn't have enough liquidity to sponsor the flow of money into bonds without serious contractions.
Finally, the Fed is also compelled to liquidate a significant portion of its multi-trillion-dollar Mortgage Backed Securities portfolio. The Fed doesn't want to own these assets and only bought them as an unprecedented response to an unprecedented situation of a major global financial crisis in 2008. It’s still trying to unwind them to this day, with 2020 reversing their efforts. We know this will be painful for the real estate market, but the unprecedented scale of the sell-off means that we don’t know how painful it can get.
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Just like we can rely on high-alpha hedge funds to telegraph their proprietary research and expectations through high risk assets, we can rely on the Fed's mindset to know where the market is headed. These are just two examples of the overall principle of finding certainty amidst uncertainty. In choppy markets, a trader's job is to identify these pockets of certainty and lean on them to navigate the rough waters.