August 29th
Here we go again, the narrative of rate cuts.
Today, the financial markets are experiencing robust buying activity, with a particular emphasis on long-duration assets, particularly within the technology sector. This surge is partly attributed to the labor market, which is displaying initial signs of vulnerability. Following the release of today’s Department of Labor (DOL) Job Openings and Labor Turnover Survey (JOLTs) report, the market exhibited significant activity, with July’s job openings totaling 8.827 million, falling short of the consensus forecast of 9.5 million.
Examining the Federal Funds Rate tracker provided above, we can discern the bond market’s favorable response to this development. Notably, the front end of the yield curve, as represented by the 2-year yield, has seen a noteworthy decline of -3.30%, surpassing the 20-year yield by nearly 2%. In light of these dynamics, the probability of a 25 basis points (bps) interest rate hike in November has diminished, dropping from an initial 67% to the current 51%.
In our previous communication, as outlined below, our strategy was to adopt a bullish stance on the technology sector, anticipating a robust second half of the year. However, considering recent developments, it may be prudent for investors to reevaluate their exposure to long-duration assets, particularly in the technology sector. We believe this reconsideration is warranted, especially as the NASDAQ futures approach the 15,700 level.
While it remains uncertain whether the current labor market participation weakness will evolve into a sustained trend, given the current economic backdrop, we anticipate the NASDAQ index to demonstrate relative strength compared to the S&P 500. This expectation is based on the belief that sectors such as financials, consumer services, energy, and materials may experience selling pressure in the face of weaker economic conditions, even if the market irrationally begins to price in the possibility of rate cuts in Q3 2024 once more.
It is essential to remind investors that there are no risk-free investments despite the impressive market performance observed over the past decade. Moreover, should the labor market exhibit a downward trajectory, the subsequent lag effect on the broader economy is a factor that should not be underestimated. As we continue to monitor these market dynamics, we encourage investors to remain vigilant and adapt their investment strategies accordingly.
As for the S&P 500 futures, short-term investors (14 to 30 days) could start derisking at 4,498, and for medium-term duration (70 to 90 days), investors should wait for 4,575.
August 19th Note
Today’s note we wanted to highlight our NASDAQ call from August 13th, as technology has been the leader to the downside with this recent textbook reversion lower. The NASDAQ futures came within 65 handles from hitting our initial measured move for our model’s reversion to the mean. The model now sits at -21, as seen above; any weakness, in our opinion, if rates remain within the current range, will now be bought. We can expect this weakness to potentially get the model back to 0, which will then see dips be bought with higher volatility and allow the NASDAQ to consolidate before momentum can be re-engaged for a possible rally into year-end, excluding any significant MACRO economic weakness.
August 14th
Clarity on the S&P, NASDAQ, Sectors, Treasury, Yields, and Liquidity.
As elucidated in our ongoing dialogues throughout the trading year of 2023, the prevailing landscape and the peculiar liquidity dynamics within the financial system have rendered this period notably arduous. The unceasing torrent of capital towards various sectors and industries has perpetuated a state wherein the index level displays a remarkable fortitude, thus presenting a formidable challenge. Once again, we are now undergoing yet another reversion to the mean in the most extended areas of the market, like semis, and seeing bids within under-owned areas such as value and energy.
Before we discuss the markets, let us reiterate some views we have had over the last four weeks.
On August Friday 4th, we stated the following:
In today’s trading, the S&P 500 exhibited an impressive surge, gaining 36 points to reach 4,562, only to pivot swiftly and relinquish 67 points, reaching a low of 4,493.75. Closing below 4,507, settling at 4,496, our focus now turns to the 4,445 level in the early days of the upcoming week. There exists potential for a more substantial move toward 4,372, as previously discussed on July 27th. It’s worth noting that this movement wouldn’t even represent a full historical reversion emerging from an 87-to-0 reading on our model. Unless a positive catalyst emerges next week, we anticipate that rallies will continue to be met with selling in the interim. Until we get better clarity on the S&P model, re-engaging on the long side seems premature.
On Agust Wednesday 2nd, we stated the following:
S&P 500 (Futures) Must hold 4,511 and close below 4,507 will cause significant sells to be triggered by medium-duration system traders. At the same time, we can see some bids coming in to defend this level on a closing basis. The NASDAQ Must hold 15,380 and not close below 15,355, or the next stop is 15,015.
On July Thursday 27th, we stated the following:
In view of the current circumstances, we advocate for the strategic selling into rallies, particularly around the 4,640 level, as a prudent approach to reduce long equity exposure or decrease portfolio beta with a hedge. However, we are not entirely convinced that today was the catalyst for a more substantial market pullback. In fact, we anticipate that potential buyers will likely emerge around the 4,507 level should the S&P test this support in the days ahead. A failure to hold at 4,507 will bring 4,372 into play.
S&P 500
As we discussed in our last note, once volatility starts expanding off exceptionally extreme exhaustion levels, momentum rarely will reengage strength until the excesses are cleared off. The following chart from Nomura shows how much vol has increased intra-day, which is rather obvious.
Of paramount significance, our reliance is resolute upon our proprietary models to proffer insights into the trajectory of the S&P 500 across its trend, momentum, and mean reversion cycle. While we prognosticated a few months ago that this cycle was progressing towards imminent attainment of a 90 reading in our model, it transpires that the pinnacle was reached at 87. As the graphic depiction below illustrates, it is poised to be an exceptionally exceptional event should the model deviate from its customary behavior of retracting to lower levels subsequent to cresting in the high 80s and not at least descending to the 50 mark.
As elucidated during our communication last week, our historical observations align with the usual pattern of a reversion to at least a 0 reading. Nevertheless, the substantial liquidity inundating the financial landscape, a conspicuous phenomenon of late (Feds double of their balance sheet), has incited a rotation across sectors that, intriguingly, serves to avert a complete downturn of the S&P 500 index.
Click to Enlarge
Click to Enlarge
If you haven’t looked at the balance sheet in a few months, it is back to the lows of July 2021 of roughly 8.2 trillion. This is down $500 billion from the recent highs of $8.7 trillion when the Fed increased the discount window for the collapse of SVB in March, which is clearly hard to argue a main factor of technical multiples increasing euphorically.
The NASDAQ is still massively exhausted to the upside, where historically, buyers wait for lower levels to step in. Below we are looking at our proprietary mean reversion model for QQQ, the more negative, the higher the risk of mean reversion. In the chart below, we are only going back to 2013, and in fact, this current period only got to a low of -76 with a current reading of -68. Out of the eight observations, six periods since 2013 were more exhausted than July 2023 for the NASDAQ. In all eight observations, all periods’ mean reverted to at least a -40 reading. A move from the low of -76 to a -40 will give you a total measured move of roughly 6%, giving you a target of 14,550 on the NASDAQ futures.
August 4th
The S&P & NASDAQ line in the sand was washed away.
On Agust Wednesday 2nd, we stated the following:
S&P 500 (Futures) Must hold 4,511 and close below 4,507 will cause significant sells to be triggered by medium-duration system traders. At the same time, we can see some bids coming in to defend this level on a closing basis. The NASDAQ Must hold 15,380 and not close below 15,355, or the next stop is 15,015.
On July Thursday 27th, we stated the following:
In view of the current circumstances, we advocate for the strategic selling into rallies, particularly around the 4,640 level, as a prudent approach to reduce long equity exposure or decrease portfolio beta with a hedge. However, we are not entirely convinced that today was the catalyst for a more substantial market pullback. In fact, we anticipate that potential buyers will likely emerge around the 4,507 level should the S&P test this support in the days ahead. A failure to hold at 4,507 will bring 4,372 into play.
Looking ahead – More downside to come
Despite encountering solid buying interest at the previously highlighted volatility stop levels (4,511 for the S&P 500 and 15,380 for the Dow Jones), the subsequent disruption of momentum after reaching a state of exhaustive metrics has steered investor sentiment toward a disposition of selling in response to subsequent rallies. This aligns with a recurring pattern of mean reversion, and historical trends suggest that further selling could transpire early next week as both indexes closed at their Vol stops that are often used by CTAs to derisk.
Over recent days, the trajectory of Treasury Yields has hinted at the possibility of revisiting cyclical highs, a development that, in our analysis, triggers legitimate concern about the sustainability of bids supporting the indexes. However, in light of this morning’s labor market report, an intriguing narrative emerged as yields across the yield curve embarked on a downward trajectory. This shift in yields was catalyzed by the realization that the labor metrics extended beyond the headline figure of 187,000 jobs added—a slight miss on consensus. Of particular note was the fragility evident within the core of the workforce, primarily comprised of weaker full-time employees. The numerical enhancement was notably skewed towards an uptick in part-time employment, underscoring a more subdued economic outlook upon closer examination.
Although this labor market data doesn’t serve as the catalyst for further reversion, it contributes to the historical pattern of selling rallies as momentum weakens post-exhaustion. Historically, our model would anticipate a zero reading before a complete reversion to the mean within momentum dissipates. However, given the current anomaly of liquidity within the system, we anticipate that a return to zero might not manifest this time.
In today’s trading, the S&P 500 exhibited an impressive surge, gaining 36 points to reach 4,562, only to pivot swiftly and relinquish 67 points, reaching a low of 4,493.75. Closing below 4,507, settling at 4,496, our focus now turns to the 4,445 level in the early days of the upcoming week. There exists potential for a more substantial move toward 4,372, as previously discussed on July 27th. It’s worth noting that this movement wouldn’t even represent a full historical reversion emerging from an 87-to-0 reading on our model. Unless a positive catalyst emerges next week, we anticipate that rallies will continue to be met with selling in the interim. Until we get better clarity on the S&P model, re-engaging on the long side seems premature.
August 2nd
S&P & NASDAQ line in the sand levels to watch
In view of the current circumstances, we advocate for the strategic selling into rallies, particularly around the 4,640 level, as a prudent approach to reduce long equity exposure or decrease portfolio beta with a hedge. However, we are not entirely convinced that today was the catalyst for a more substantial market pullback. In fact, we anticipate that potential buyers will likely emerge around the 4,507 level should the S&P test this support in the days ahead. A failure to hold at 4,507 will bring 4,372 into play.
The prevailing trigger behind the present market downturn remains nearly inconsequential, given the predisposition of short-term long-oriented traders to seek an impetus for divestiture. (Downgrade nor higher rates are the real issues at hand now). If the middle and long end of the curve takes out their cycle high then we can discuss yields as a headwind to long-duration assets.
The recent ascent, as meticulously delineated by Goldman Sachs (see chart below), notably constituted one of the most substantial instances of hedge fund de-grossing since the year 2016, characterized by short-covering dynamics.
In a manner akin to the phenomenon of market melt-ups, the unwinding of positions is imbued with a certain intensity, further magnified by the calculated strategies of quantitative and Commodity Trading Advisors (CTAs) who judiciously navigate through volatility-laden terrains via adaptive stops that emulate a step-function framework. Regrettably, these stops invariably appear to be triggered with an alacrity disproportionate to their placement during the downturn, thus underscoring the swifter descent in such scenarios.
S&P 500 & NASDAQ Levels to watch.
S&P 500 Futures:
Close 4,536.50
Must hold 4,511 and close below 4,507 will cause significant sells to be triggered by medium-duration system traders. At the same time, we can see some bids coming in to defend this level on a closing basis. However, we also have to be aware of where the S&P 500 was coming from on the blended model, which was reading 87. While we never made it yet to the 94 reading, historically, the 94 reading sees an average 8% decline 88% of the time. A measured move from 4636 of the recent cycle high to 4500 is just shy of a 3% decline. Certainly, not a decline that historically is observed from such high S&P model readings.
No hold of the 4,507 level selling pressure will pick up with 4,435 in the crosshairs.
NASDAQ Futures:
Close 15,450.25
Must hold 15,380 and not close below 15,355, or the next stop is 15,015.
S&P 500 Update
In the preceding trading session, markets experienced a mid-afternoon sell-off triggered by the resurgence of old yet revised reports surrounding the Bank of Japan (BOJ) and its augmented yield control measures, unsettling vulnerable long positions. Irrespective of the specific catalyst, we maintain that when markets venture into the high 80 range (87 current today’s open) on our proprietary S&P 500 model, susceptible long positions tend to liquidate expeditiously.
While the market exhibited characteristics suggestive of a technical key reversal yesterday, our perspective inclined towards a more constructive outlook in yesterday’s note, suggesting that a more substantial selloff was not yet imminent. Subsequently, at approximately 2 am, the BOJ publicized a shift towards a less stringent approach regarding yield control, propelling the futures market higher. So all noise and no real risk off event for lower pricing.
In conclusion, today’s closing holds paramount importance for the constructive stance of long positions. While there exists a minor constraining level at 4,615 on the S&P 500 futures, our attention remains firmly fixed on the significant threshold at 4,640. As the trading session draws to a close, the likelihood of achieving the coveted 90 reading we have previously discussed appears to be on the rise.
It is crucial to bear in mind that while a 90 reading holds significance, it should not be perceived as the ultimate Holy Grail, as our focus eventually shifts to the pivotal 94 reading, wherein substantial risk should be prudently mitigated. In quantitative investing, sometimes it’s a game of inches, and we can make no assurance that the S&P will not fail prior to reaching a 94.
Over the course of the past 17 observation period of moving above 90 since 1992, a mere two instances managed to reach the 100 reading mark, highlighting the rarity of such occurrences. Additionally, in approximately 88% of the observations, the S&P faltered at the 94 reading, heralding an average correction of 8%. Notably, the two most notable instances of overbought conditions were observed in 1995 and 2018, which coincided with President Trump’s implementation of corporate tax cuts. Such instances warrant careful attention and strategic decision-making in the ever-evolving financial landscape.
July 18th
We still have not seen that last push higher yet, according to our S&P model.
As previously anticipated, we had been observing the potential for a 90 reading, propelling S&P 500 Futures towards the 4,650 level. Yesterday, futures reached a high of 4,566 but encountered some selling pressure towards the end of the session. The S&P does seem to be in a holding pattern until we get more clarity on earnings, or at least unwilling to see any selling. With the upcoming earnings reports from key players such as MSFT, AMZN, GOOG, and META next week, the risks in the market are mounting.
Presently, there are no evident signs of an imminent reversion for the S&P 500. Furthermore, it is worth noting that our proprietary measure of breadth—the Strong Buy to Strong Sell ratio—continues to exhibit divergence. This ratio assesses the number of strong buy signals relative to strong sell signals based on our models within the S&P 500. The count of strong buys is steadily expanding, approaching the 400 mark and sitting at 353—an occurrence not observed since February 2023. As you will know, we like to add to long-risk exposure once the number of strong buys crosses above the strong sells, which occurred on June 9th.
1/5/2010 = -76.16 / – 9% peak to trough decline
2/18/2011 = -75.10 / – 8% peak to trough decline
9/10/2014 = -73.85 / – 8.30% peak to trough decline
6/9/2017 = -87.55 / -6.1% peak to trough decline
1/25/2018 = -90.66 / -9.7% peak to trough decline
2/15/2020 = – 88.57 / -28.7% peak to trough decline
9/3/2020 = -79.94 / -10.7% peak to trough decline
9/1/2021 = -74.36 / -7.7% peak to trough decline
7/17/2023 = -7081 ???
Upon analysis, it becomes evident that the current state of the NASDAQ falls outside the realm of the top 8 most overbought periods observed since 2009. However, this observation alone does not provide definitive insight into the proximity of a correction or the likelihood of the NASDAQ reclaiming its all-time highs in the near future. It does, however, serve as a reminder that we have encountered even more extended overbought conditions on the NASDAQ on eight occasions since 2009.
Our focus lies in identifying a substantial upward thrust, accompanied by one to two counter-trend increases below the threshold of -70, which would signify the development of a meaningful reversal. To put this into perspective, for the NASDAQ to exhibit readings akin to those witnessed in 2017, 2018, and 2020, it would necessitate a significant breakthrough of all-time highs by a substantial margin.
Considering the considerable sum of over $6 trillion held in money market funds, coupled with the influence of AI and investment managers positioning their portfolios, the current market scenario holds the potential for unforeseen outcomes that may defy conventional fundamental realities.
Here is the latest JPMorgan manager survey if you questioned how much this market is disliked.
For the first time in a while, we are seeing strength in almost all markets; even China, on weakening eco day, has improved to a neutral reading. Remember, a 100 Score is max strength in terms of bullishness.
We have seen other world markets increasing within our model’s strength as well. Below we can see EWG (Germany) ticketing up to its highest reading in months.
July 6th
We will need a bigger catalyst than more rate hikes to get this market down.
The S&P 500 futures experienced a sizable downturn, reaching a low of 4,419 or 64 handles before recovering almost 45% of its days draw down, as interest rates surged across the yield curve. This was triggered by a stronger-than-anticipated ADP jobs report, which revealed a figure of 497,000 jobs added, surpassing the expected 228,000. Moreover, the ISM index demonstrated robust performance, registering 53.9, surpassing the projected 51.
The market has become accustomed or desensitized to higher interest rates over the last .90bps on the 10-year yield, particularly in the realm of cutting-edge technology, where profit margins have expanded consistently over the past two quarters. As a result, the strategy of selling high-quality, long-duration (+28% ROE + Low Debt to equity) assets is no longer effective. However, should rates continue to climb, we anticipate challenges for small-cap stocks, companies with high-leveraged balance sheets, companies highly dependent on the financing of Capex, and of course, technology firms that are yet to turn a profit. Any weakness within the afforded areas will be contained; it will only be when interest rates across the entire yield curve ascend to break their previous cycle highs will we witness a general rise in equity correlations, potentially leading to a more substantial market correction in our opinion.
We say this because, presently, Fed Fund futures are pricing in a 79% probability of an additional 0.50 basis points increase by September. However, the significance of this development may be questioned. With a cumulative 500 basis points of rate hikes, the most rapid ascent on record, one must ponder its impact on GDP and earnings. We have already observed the lowest point or trough in earnings per share (EPS) and GDP, leaving us to wonder about the anticipated lag effect. Where is this lag everyone is waiting for? Despite the challenge of envisioning a consensus of 250 EPS for 2024 compared to the projected 220 for 2023, the abundance of liquidity in the financial system mitigates the need for substantial or any earnings growth. As evidenced in 2023, the S&P 500 saw no growth in its EPS for 2023. So multiple expansions can persist as long as market participants perceive that the Federal Reserve will adopt a more gradual approach after September.
Today’s ADP can be shot down as a season anomaly that included lower-income jobs in the hospitality and service sectors, it remains a representative measure of labor market health, and rates took it as a hotter data point.
Looking ahead, the potential challenge for equity markets arises if or when the yield on the 10-year Treasury note approaches a retest of the highs reached in November 2022, which stood at 4.20%. This level serves as a critical threshold, and a breach of this mark could have significant implications for equity performance. As astute observers of market trends, we closely monitor these developments to inform our investment strategies and provide valuable insights to our clients.
S&P 500 Model
Our S&P 500 model still remains strong at the 79 reading. While we mentioned the failure of the index to break lower coupled with the best 14-day seasonal period statistically, the S&P 500 is not yet failing unless earnings season paints a picture of a slowdown and compression in margins. A test of 4,380, barring the absence of a new cycle highest on the 10-year yield, is a local place investors will get long.
Also, keep in mind JOLTS data today came in lower than expected, and just because ADP was stronger with a potential seasonal anomaly; this might not correlate with higher wage pressure as jobs are being taken out of the system represented in the JOLTs data. So we don’t really know if there is cause for alarm on the wage pressure front and higher rates just yet.
June 30th
We failed to fail, and now… we go parabolic.
The S&P 500, but more notably, the NASDAQ found themselves poised on the precipice of a significant downturn throughout the preceding week, a precarious situation that caught both shorts and under-allocated investors strategically off-sides as they awaited an impending pullback off guard. However, the remarkable resilience demonstrated by the indexes, defying its anticipated failure, has triggered a frenzied scramble among shorts to cover their positions of a failed reversion lower while long-only investors fervently chase after what could turn out to be another unprecedented parabolic ascent that is on the average of getting our S&P 500 model to the 90 reading we have mentioned.
Over the past five days, Goldman Sachs has been disseminating a note that exerts immense pressure on every investor causing, in our opinion, some FOMO, compelling long-only investors to engage in panic buying following the previous market setback. As elucidated by Goldman Sachs in the provided chart above, historical data dating back to 1928 highlights the first 14 days of July as the market’s most propitious period.
While this data is an insightful analysis, it elucidates the underlying rationale behind the many traders who preemptively want to capitalize on or front-run the forthcoming July seasonal 14-day rally. However, more than anything, if the market was going to break, it would have broke last week, especially the NASDAQ, and it didn’t. While this seasonal data shows empirical evidence from 1996 onwards reveals that July is the most favorable month for capital inflows during the summer season, this is by no account unknown. Anyone with yahoo finance knows this. However, it is creating panic to buy within a market that continues to be extremely resilient, caused by more liquidity than we, as investors, have ever seen before.
As we sit at yearly highs, this type of plain vanilla data point could easily cause a self-fulling prophecy where everyone attempts to jump on the train in fear of missing the next potential move to 4,650. After 4,500 on the S&P 500 futures its all air “GAPS”. This would is a level we discussed if our S&P 500 model reached a 90-reading.
And here is why traders are front-running the July move, according to Goldman.
The first 15 days of July have been the best two-week trading period of the year since 1928. July 17th is when equities start to fade.
Since 1928, July 3rd has the highest hit rate for the S&P of positive returns (72.41%), followed July 1st (72.06%), and other statistically significant trading days during the first two-weeks of July.
NDX has been positive for 15 straight July’s, with the best days of the year July 1st (91.67%), July 2nd / 3rd (75%), and July 5th (77.78%). Returns are front loaded and early in Q3.
After yesterday, stronger-than-expected GDP and today’s core PCE inflation expectations were perceived as less hot, even with rates exploding higher yesterday, the market is giving investors a clear message.
One thing we are watching and pointed out is the 2/10 yield curve for new lows. As we mentioned, the curve, the vix, and volume are not good indicators, and we only care about the curve making a new low at this juncture. A new low could break something within the credit markets, causing a risk-off catalyst like SVB.
The S&P 500 futures hit a new year high at 4,497, surpassing June 16th’s high of 4,493.75, and actually closed at 4.483. Which seeming doesn’t seem like a double top coming into the best 14 days of the year.
On June 6th, we discussed 4 potential outcomes based on our S&P 500 model. However, the scenario did not play out exactly as written or thought as such in the markets. Our model failed at 78.40, which is the current reading now. The model only had 2 decreased to 77.50, then 76.40; we would have expected more than a 100-point sell on the S&P 500 after a decline coming off a 78.40 reading. However, we are now back at the 78.40 reading, and at this juncture, we can expect scenario 1. is in the cards.
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Moving from the current 77 to a 90 reading on the model would take the S&P 500 (futures) to 4,650, which I find hard to fathom in this current trend/momentum cycle of 100 to 150 days.
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A 95 reading from 1992 88% of the time has resulted in an average S&P 500 correction of 8%.
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The model must stop advancing right in this area and not exceeding 82, or the S&P 500 has a strong chance of going parabolic.
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Tomorrow’s close will be exceptionally important. If the S & P 500 futures close above today’s highs of 4,485, I expect to see one large push higher on the model quickly, resulting in 4,555, where I start to de-risk or buy S & P puts.
June 27th
Strong Macro Data has now put back another 25bps of hikes for July.
Drawing upon the aforementioned chart of Fed fund futures, it becomes apparent that the market has now integrated an additional .25 basis points of rate hikes into its pricing for the upcoming month. This adjustment carries a 76% likelihood, marking a notable surge from a mere 55% probability merely 30 days ago on May 27th.
Today’s strong eco data
First off, you had stronger-than-expected durable goods; however, this alone is not enough to push the market higher, as the futures barely moved after the release of this data.
Then you had housing data, which has been on fire for months, indicated by building materials and the home builders, so this should not come as a surprise. is on fire. The Bloomberg US Housing and Real Estate Market Suprise Index shows that it is a level not last seen since 2003. Powell is certainly not helping first-time home buyers enter the market!
What did come as a surprise and caught the market off guard and caused some panic buying was the Consumer Confidence number from The Conference Board. The data came in exceptionally better than expected levels not seen since mid 2021 coupled with consumers’ inflation expectations coming in lower.
Still Watching Technology to Add Exposure
In continuation of our previous note on Friday, we would like to provide an update on the counter-trend movement in the technology sector, specifically focusing on the QQQs. While XLK can be similar to QQQ, we recognize that the majority of investors closely monitor QQQ, making it an important reference point.
Analyzing the QQQ counter trend (red bars) above, we observe a noteworthy trend since the strong buy signal on March 17th. The counter-trend has exhibited a remarkable constant descent, reaching a reading of -73.36 as of June 18th. However, this is a very typical move for the index or asset classes that sees a typical parabolic advance. Historically, a mean reading around -70 tends to indicate a slowdown in the index’s rapid ascent. It is crucial for the counter-trend not to reverse or increase from such low or negative levels for long only investors for them to remain bid. Typically, the initial mean reversion cycle is met with selloff that gets bought, leading to a consolidation phase as investors maintain confidence in the market’s upward momentum. It’s worth noting that A-Systematic sell-offs across any asset classes or the market as a whole are typically not observed unless there is a significant macro catalyst. So any sell-off typically happens over the course of a week or two, not days.
However, it is important to acknowledge that the current counter-trend appears to have maxed out at -74.20 for the QQQ and now has increased 3 times with a reading of -69.50. It is rare to reverse the momentum now and for the CT to decline off this move for higher index levels. It seems logical, based on historical analysis more clearing off or becoming more positive is in the cards for the QQQs counter-trend at this juncture.
As we mentioned previously, we were closely monitoring the NASDAQ futures’ critical level of 14,740, which must hold to avoid a more aggressive pullback to 14,200. As for the rest of the market, there is so much liquidity and shorts in the S&P 500 that money coming out of tech will find a new home and narrative until weak long only tech investors and shorter-term system traders are out of their long tech exposure as long as this market is as hated as represented by the number of shorts in the S&P 500.
When to add to technology?
While recognizing past accomplishments or what attributed to the S&P gains in 2023, the focus now shifts towards identifying future opportunities for investors to capitalize on the AI trade. Rather than dwelling on past events, the key question becomes identifying avenues where investors can strategically enhance their exposure to the AI sector.
Back on June 15th, we stated
On May 21st, the counter-trend was at -41.09; today, it’s now -66.50 for XLK. (More negative is more overbought) We mentioned that mean reversion starts to set in on average around -64 since 1998. So IF or When the market starts to correct the NASDAQ or, in this case, XLK is most at risk of a larger mean reversion.
At Trowbridge, we adopt a proactive approach rather than a reactive one when it comes to anticipating market corrections. Although it is challenging to predict the timing of a correction accurately, we prioritize prudence and caution when our models indicate a mean reading, historically signaling potential corrections in the asset. To provide you with valuable insights, we present a historical analysis of the counter-trend movement since 1998. We can see that XLK is reaching historical levels of overbought; however, selling an asset because it overbought is not a great methodology. What we attempt to do is once the historical mean of overbought is triggered, a signal is then generated after a few increases on the counter-trend. The more overbought, the fewer increases it will take to generate a sell signal.
Reversions to the mean or corrections tend to occur at a slower pace if there are no large catalysts, as long-only investors typically seek to capitalize on the initial pullbacks by buying into the strength we are currently witnessing. Only after several unsuccessful attempts to maintain stability do shorter-term dip buyers step back from further purchases. This gradual unwinding process characterizes the correction dynamics.
While it is impossible to accurately predict the short-term trajectory of any asset, including XLK, the statistical analysis provides valuable insights. In the case of XLK, it is notable that historically, the model tends to retreat from overbought levels and often reverts from a mean -64 reading to zero. However, considering the current AI theme and potential heightened demand for these stocks, it is uncertain if the pattern will deviate. Nevertheless, from a risk/reward perspective, adopting a cautious approach and aiming for a zero reading seems prudent for investors who have missed out on the technological advancements before considering aggressive allocations to the “magnificent 7” (AAPL, NVDA, TSLA, GOOG, AMZN, MSFT, META). Trowbridge has long positions in MSFT and GOOG.
Without delving into specific levels on XLK, QQQ, or the NASDAQ, it is preferable for the counter-trend to alleviate the excessive negative positioning before actively seeking long opportunities. This approach ensures a more favorable risk-to-reward ratio and allows for a clearer assessment of potential long-term prospects. For those of you who are die-hard level watchers, XLK must hold on a close today $167.50 or $162 is in play which will wipe away a good amount of the counter-trend’s negative reading. As for the NASDAQ futures, the critical level to watch that we need to hold is 14,740, or we will experience a more aggressive pullback.
Example MSFT
You can click on the image to enlarge. Since MSFT went to a strong buy on Feb 1st, June 20th was the first increase in the counter-trend off of a -74, which is expressing some risk to the downside is present.
June 15th
Today’s News of More China Stimulus Pushed Markets to New Yearly Highs
From our vantage point, the prevailing trend over the past few weeks has predominantly revolved around the system and trend-following traders who strategically align themselves with increasingly robust market trends. Moreover, we have consistently emphasized the resilience of this market, given the under-participation of long-only investors in this rally, which can be attributed to the limited number of stocks leading the market higher. Consequently, we have said over, and over any minor declines prompt a swift response from these investors to enter the market that they have missed out on in 2023.
While there have been discernible signs of progress within the domains of construction materials, housing, and travel companies, it remains evident that the broader expansion primarily stems from AI factors. These factors are propelled by the prospects of multiple expansions and the eager anticipation of breakthroughs in artificial intelligence. Consequently, the interplay of these elements fosters collective optimism, augmenting expectations for margin expansion and propelling the ongoing upward trajectory of market prices. Like all new cycle game-changing technologies, multiples will be stretched in the beginning. Only a few names warrant immediate repricing from AI as Goldman pointed out, it will take 10 years for the S&P 500 to witness 400bps of margin expansion from AI.
On June 6th, we stated
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55% of the time, when the S&P 500 blended model hits a 60/70 reading, it will fail and revert to an equal or less than 0 reading, resulting in a 5% decrease. On the other hand, the remaining 45% of the time, once the model moves above a 70 reading, it pushes to a 90 reading.
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If the S&P blended model were to rise from its current reading of 54 to 90, it would represent a 6.5% to 7% increase, potentially pushing the S&P 500 futures toward our scenario b. discussed last week, approximately 4,440/4,480.
In today’s trading session, the S&P 500 soared to a remarkable peak of 4,485.5, surpassing our previously highlighted upper boundary in the second bullet point of 5 points. As we had anticipated, a decisive breach above 70 on our S&P 500 model was poised to trigger a staggering surge in the index. Currently, the model rests at approximately 78, as indicated in the first chart below, exhibiting a level of buoyancy that suggests further upside potential. In this context, we must momentarily set aside fundamental considerations and acknowledge the potential explosiveness of the upcoming move, if unencumbered by any discernible market risks. As we venture into the 4,500 mark on the S&P 500 (futures), the gaps in price levels become increasingly significant, propelling our projections toward the 4,600 level.
Our S&P 500 model
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Moving from the current 77 to a 90 reading on the model would take the S&P 500 (futures) to 4,650, which I find hard to fathom in this current trend/momentum cycle of 100 to 150 days.
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A 95 reading from 1992 88% of the time has resulted in an average S&P 500 correction of 8%.
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The model must stop advancing right in this area and not exceeding 82, or the S&P 500 has a strong chance of going parabolic.
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Tomorrow’s close will be exceptionally important. If the S & P 500 futures close above today’s highs of 4,485, I expect to see one large push higher on the model quickly, resulting in 4,555, where I start to de-risk or buy S & P puts.
In the current cycle of trend strength, we do not foresee a 95 reading materializing in the foreseeable future, as achieving this level would necessitate propelling the S&P 500 to all-time highs of 4,800. Since 1992, the model 88% of the time fails at a 95 reading causing an average correction of -8% in the S&P 500. Nonetheless, we must remain open to the potential of unexpected developments, given that the Federal Reserve seemingly has one more interest rate hike left in its arsenal then potentially finished and has shown a high level of reluctance in scaling down its balance sheet to pre-COVID levels of $4 trillion, with the current figure standing at $8.389 trillion. The presence of ample liquidity, a subject we have consistently discussed over the past decade, has transformed market dynamics and pricing behaviors. There is just too much liquidity seeking too few opportunities. While prudence and caution are advisable in light of the current circumstances, we must acknowledge that the possibility of attaining unprecedented heights and embarking on a parabolic ascent remains within the realm of possibility.
Click the chart to enlarge 30 years of S&P 500 model readings.
“The Street” caved. So now what?
In recent weeks, a number of esteemed Wall Street Sell Side strategists have exhibited a shift in their bearish prognostications for the S&P 500, which can be attributed to the anticipatory stance of their discerning clientele yearning for a recessionary downturn. While we hold a firm conviction that these strategists’ astute market forecasts are firmly grounded in meticulous analysis and logical bottom-up methodologies, it must be acknowledged that historical parallels no longer hold sway as pertinent analogies. Though such a realization may elicit a sense of frustration, we have been earnestly advocating the notion that the liquidity infusion orchestrated by the Federal Reserve and other esteemed central banking entities remains the sole harbinger of market performance.
Recent Upgrades
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Bank of America’s esteemed market analyst, Savita Subramanian, recently adjusted her year-end target for 2023 from 4,000 to 4,300, displaying a shift in her initial stance. Incidentally, we find ourselves in alignment with her discerning analysis that advocates an equal-weight methodology for seizing the opportunity to catch up. In light of this, we have taken the initiative to augment our exposure accordingly. It is worth noting, however, that the efficacy of the equal-weight approach to the S&P 500 has been somewhat subdued. Furthermore, we explored the possibility of employing a proportional allocation strategy in the Russell index as a means of attaining alpha, which has demonstrated relative resilience when compared to the S&P 500 and NASDAQ. Regrettably, the outcomes thus far have not yielded substantial alpha generation. As we noted last week, the monopolistic nature of the largest technology companies with wide moats, and no debt vast R&D continue to see their margins expand, making these companies the most desirable plays for the foreseeable future.
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Next up, you had Goldman’s Chief equity strategist Kostin last week take his 2023 S&P 500 target up from 4,000 to now 4,500. Yet he remains at a $224 EPS without taking up earnings estimates for the index.
Here is a chart provided by BofA showing that excluding the top 50 stocks that S&P 500 trades at a 15 multiple, one of the reasons we believe that if the soft landing narrative caught a bid, the equal weight would outperform the cap-weighted index.
Tomorrow on Tuesday, we are getting CPI, and then Fed notes. If CPI is in-line across the board, it’s a pain for the shorts as this sit eh make of break pivotal moment for the S&P 500 futures, where things are about to go parabolic. Last week we wrote the S&P 500 was at a critical reading of 70, which has been breached to the upside (see here).
“Here we are finally at a 70 reading which will be pivotal for the S&P 500 to go parabolic to the 4,440 level of rollover here after a few more attempts to close above 4,300; however, before we get too bearish.”
Below is our S&P 500 model (click to enlarge)
S&P 500 model at a critical reading.
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55% of the time, when the S&P 500 blended model hits a 60/70 reading, it will fail and revert to an equal or less than 0 reading, resulting in a 5% decrease. On the other hand, the remaining 45% of the time, once the model moves above a 70 reading, it pushes to a 90 reading.
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If the S&P blended model were to rise from its current reading of 54 to 90, it would represent a 6.5% to 7% increase, potentially pushing the S&P 500 futures toward our scenario b. discussed last week, approximately 4,440/4,480.
So here we are finally at a 70 reading which will be pivotal for the S&P 500 to go parabolic to the 4,440 level of rollover here after a few more attempts to close above 4,300; however, before we get too bearish. Since the Fed’s additional $4 trillion balance sheet expansion, the markets have seen a greater risk on – risk off within different sectors as the equity markets are flooded with capital, not to mention multiples to be elevated as a result of excess liquidity. We would suspect historical multiples will not be seen again unless the Fed ever takes the balance sheet back to pre covid levels of $4 trillion, which is never happening. So even if the broad index level moves lower, there may be areas within the market where we will see outperformance.
Despite ongoing discussions in financial circles regarding stagflation and a potential recession, the consensus bullish case could gradually shift towards a more optimistic growth narrative. It is crucial to note that consensus projections for S&P 500 earnings in 2024 stand at $241. Based on these projections, the current valuation of the index stands at 17.7 times next year’s 2024 earnings, or 18.5, at a level of 4,440. These valuation metrics do not appear excessively inflated, thus prompting the question of the source of the expected $26 earnings growth. The S&P 500 is trading at 19.5 times the current earnings per share (EPS) of $215.
Considering that only seven companies within the S&P 500 are projected to contribute to the necessary EPS drivers, it becomes evident that the eight sectors that have remained stagnant or experienced declines in 2023 must witness improvements in their earnings performance. The challenge lies in identifying how these sectors can generate the required growth to bridge the $26 delta, as the S&P 500 currently tracks $215 of EPS.
In the short term, the bearish case primarily revolves around the potential risks associated with replenishing the Treasury General Account (TGA). While this is a genuine concern, limited data prevents us from accurately predicting the impact of these actions, such as the identification of the marginal buyers for new issuances and the timing and dispersion of these actions. Additionally, every investor is aware of this risk and is concerned, which leads us to believe this will not be a tail risk event.
The longer-term bearish case primarily centers on earnings and if margins can expand. The leading technology mega caps demand a premium as their monopolistic characteristics witness continued margin expansion. If the underperforming sectors within the market, which represent the remaining 90% of the S&P 500, can demonstrate improved earnings growth, it will ultimately dictate whether the index can achieve significant upward movement. It is worth noting that if we were to exclude the seven largest constituents of the S&P 500 or examine an equal-weighted S&P 500 index, the current multiple would approximate 14.5 to 15 times forward EPS. This perspective underscores the importance of analyzing the broader market beyond the influence of the leading companies driving the majority of the index’s performance.
As we mentioned last Friday, for investors looking to gain some alpha, increased IWM, and an equal weight allocation seems warranted if the market takes a leg higher as investors will look to allocate to laggards of 2023.
June 2nd
Was today the start of a new regime change from the largest variance between QQQ Vs. IWM?
Today’s jobs data and yesterday’s ADP report revealed an interesting combination of low-wage and robust job growth. In our assessment, this blend was the primary driver behind the two-day market rally, rather than the reports of increased liquidity from China amidst concerns about housing and economic data or the progress on the debt ceiling resolution. Notably, if one has been closely monitoring ADP over the past six months, it has proven to be more accurate than the official payroll report, which often undergoes revisions. ADP’s calculations, conducted by a private company, are considered more efficient than government data. Nevertheless, both reports painted a similar picture of stronger payrolls and a stable unemployment rate, while hourly earnings remained flat, indicating no significant wage pressure.
Just Mean Reversion or New Cycle?
In today’s market performance, notable outperformance was observed in small caps, consumer cyclical sectors, energy, financials, and the S&P 500 equal weight index, surpassing the NASDAQ and the cap-weighted S&P 500. However, it is imperative to discern the underlying implications of such a phenomenon within the context of a potential early-cycle recovery regime. Thus far, we have merely witnessed the nascent stage of the upward trajectory, prompting us to evaluate two plausible scenarios at this juncture carefully.
The first scenario entails a genuine regime change, signifying a more enduring and pronounced shift toward early-cycle areas of the market, which would likely present longer-lasting upside potential. The second scenario involves a shorter-lived reversion to the mean, characterizing a temporary phenomenon across two asset classes. Discerning which scenario is unfolding remains challenging, ascertaining the true nature of the market dynamics. Nonetheless, it is crucial for investors to allocate capital, adapting their strategies accordingly and proactively. If it proves to be a transient reversion to the mean, prompt exposure reduction would be warranted. We only favor the case for mean reversion because of the 20-year performance spread between the Russell and the NASDAQ. The equity markets are flooded with capital as the Fed’s balance sheet is still roughly $8.1 trillion, so these rolling rotations are always seeking oversold underperforming assets after one area of the market seeming has peaked in the short term.
Back on May 16th, we stated the following:
This is the greatest variance we have seen in a long time. IWM to QQQ, the largest variance since 2000. Small caps will be one of the most incredible long sets up vs. big cap tech, or small caps are correct on its economic forecast
Only one game in town until now?
Throughout the year, Trowbridge has maintained an allocation to the low volatility factor, primarily focusing on defensive sectors and healthcare and only recently getting long semis and AI-related themes (AMD, MRVL (sold), AVGO, MSFT & GOOG). However, investors have not been rewarded with a defensive stance, the iShares SPLV Low Vol ETF, a benchmark for low-volatility investing, has experienced a decline of 4.5% year-to-date. Additionally, our equal-weighted portfolio strategy has not performed as favorably as the cap-weighted index, as only six stocks have accounted for 90% of the S&P 500’s returns.
While we cannot predict with certainty whether this marks a genuine regime change in early-cycle behavior or a false start as capital looks for oversold areas, it is prudent to assess allocations and consider a heavier weighting towards early-cycle factors and styles. Given the recent risk-reward dynamics (largest variance of IWM to QQQ since 2000), characterized by a substantial variance in potential mean reversion between small caps, cyclicals, and growth stocks, there is an opportunity to capitalize on the potential onset of a new cycle or just a shorter term reversion. However, we acknowledge the possibility of a false start and remain adaptable and agile in our approach. If the macroeconomic backdrop undergoes significant changes, we will be prepared to adjust our exposure to these new positions accordingly.
Our call to reduce 4300 S&P 500 (Futures) exposure
At Trowbridge, we have consistently emphasized the significance of risk reduction on the S&P 500 (futures) at the 4,300 level, based on our previous discussions. Today, we observed the market reaching a high of 4,297, which has led to a diminishing level of concern regarding risk reduction on the S&P 500. As a result, we are actively pursuing opportunities in areas of the market that have experienced relative underperformance while reducing exposure to segments that appear to be expensive.
Our Focus
Our objective is to capitalize on potential price increases where mean reversion is possible and avoid crowded trades, even if they are of short duration, within a timeframe of one to two months. In light of recent developments, our attention is particularly drawn to the Russell index (small caps), which has exhibited the largest lag to the NASDAQ in 20 years. This area presents an intriguing prospect for us. Furthermore, we will conduct a thorough evaluation of the consumer discretionary sector and carefully consider select energy names for potential exposure as these areas have been massive underperformers that should be bid if this is a true early cycle regime change.
Our rating value and counter-trend models on IWM just made a massively bullish improvement. The Rating value went from a strong sell to neutral, and the shorts have covered significantly.
As we navigate the evolving market landscape, our team at Trowbridge remains committed to identifying strategic opportunities and providing actionable insights to ensure optimal outcomes for our valued clients.
S&P 500 4,300 & Risk
While we maintain a cautious stance, we also value embracing quantitative pricing dynamics and undertaking calculated risks to augment alpha generation. Our meticulous analysis indicates that the most propitious approach to leverage the anticipated upward trajectory would be to concentrate on the largest laggard of 2023 or alternatively contemplate the S&P 500 equal weight index as an efficacious vehicle to participate in the unfolding upward momentum or mean reversion.
In light of the perpetually evolving market dynamics, it becomes imperative to exhibit nimbleness in the allocation strategy within this intricate interplay of potential new cycle dynamics. The potential resurgence of the TGA via $1.2 trillion of new T bill insurance by December can engender discernible alterations to the current market dynamics, particularly within the nascent stage of the cycle recovery, impacting sectors that are most susceptible to economic fluctuations.
April 30th
Next up, here comes the liquidity drain fear.
As expected, equity markets sold off, and bonds were bought on the news of a debt ceiling deal being solidified.
Last Tuesday, the 23rd, we wrote,
Sell the rip: In terms of risk management, as previously mentioned in our analysis of the Treasury General Account (TGA) (read the post regarding the TGA), it would be prudent to reduce some long exposure in the event of a significant debt ceiling resolution that drives the market towards the levels of 4,220 and 4,250, respectively. It is worth noting that the greater the current de-risking, the greater the odds of a counter-trend reversal towards 4,220 becomes (which should be sold). While the direct impact of liquidity drainage on equity pricing remains uncertain, there is a growing herd mentality surrounding this thesis. Therefore, any massive counter-trend rally will be sold.
Today the S&P 500 futures hit a high of 4,243 with a close at 4,214. While we don’t try to predict future market prices, we can see a scenario where only technology AI-related names will be bought on larger pullbacks.
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S&P 500 (futures) support 4,080
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NASDAQ (futures) support 13,780
Now what?
In our analysis, it is important to reiterate that the performance of the equal-weight S&P 500 index remains negative on a year-to-date basis, currently standing at -0.50% in contrast to the noteworthy +9.50% return of the traditional S&P 500. This discrepancy emphasizes the significance of considering different perspectives. Notably, the cap-weighted S&P 500 index is currently trading at a level of 19.50, while the equal-weight S&P 500 index stands at 14. Observing the equal weight index gives a more accurate depiction of the underlying economic reality, shedding light on pertinent market dynamics.
For the last 2 weeks, we have discussed the Treasury needing to refill the TGA (read here if you missed the rationale behind a liquidity-drained selloff). Now that every investor agrees that filling up the Treasury account will cause a liquidity run in equities, it might become less evident. Groupthink or herd mentality never produces the outlier moves in the market, neither up nor down. Today Goldman Sachs is out with further detail of how this TGA rebuild will look. Goldman is saying that this rebuild will decrease banking reverses by 7-8% from today’s levels over the June and July period if 505 of the rebuild comes from reverse repo purchases. Remember, investors don’t want to see banks being the marginal buyers of T-bills as this will impact reserves, causing the most amount of liquidity to be removed from the system.
If we rely on Goldman Sachs’ analysis, we can anticipate notable outflows from reverse repos (RRP) into Treasury Bills, leading to significant reductions in US reverses during the months of June and July. According to their assessment, a TGA rebuild amounting to $550 billion would result in a substantial 15% decrease in reverses compared to current levels. However, Goldman Sachs acknowledges that the initial rebuild is likely to be $250 billion, which corresponds to a more modest reduction of -7.7% in reverses.
What does this all signify? It is essential to recognize that liquidity has played a pivotal role in driving equity markets over the past 14 years. Consequently, any forthcoming reduction in liquidity warrants our close attention. In summary, Goldman Sachs’ research involves comparing monthly asset returns during periods when reserves decline by more than 2.5%, providing further insight into the potential implications of such liquidity shifts. So if we do see -7.7%, we can see on average that both the S&P 500 and NASDAQ saw -1.32% & 1.43%, respectively, in a one-month period.
May 25th
All hail AI as NVDA guides 50% higher
The recent extraordinary performance of NVDA, which saw a remarkable 50% upward guidance for a large-cap company, is a noteworthy event that has captivated investors. This surge resulted in the largest market capitalization gain ever, soaring by 28% or $200 billion. Such a feat deserves recognition as it surpasses any previous record set by a U.S. company.
As we have extensively discussed, the AI revolution holds substantial potential for technology firms and those outside the tech sector. Goldman Sachs highlighted this fact last week, emphasizing that the integration of AI-driven efficiencies is set to expand the S&P 500’s margins by an impressive 400 basis points. This projection underscores the tangible impact AI is poised to have on various industries.
While the current momentum of AI shows promising signs of continued growth, it is crucial to exercise caution regarding the valuation of these publicly traded equities. As with any emerging innovation, there is a possibility that market exuberance may drive valuations beyond levels supported by rational and realistic earnings growth. Prudent evaluation and careful consideration of such factors are imperative to navigate the evolving landscape of AI-driven advancements. While this run is far from over, we can see a playbook for many AI-hopeful companies fall short and reverting significantly.
Debt Ceiling & The Markets
Our previous communication outlined a strategy to capitalize on the market by increasing our exposure to technology-related AI amidst recent market weakness. While the debt ceiling issue has garnered attention, we believe it serves as a mere sideshow compared to the actual risk lurking in the markets right after a debt ceiling resolution.
As previously discussed, we anticipate a potential issuance of a max $1.2 trillion to replenish the Treasury General Account (TGA), which has the potential to create a liquidity drain, as elaborated in Saturday’s note found here. This liquidity drain is expected to affect bank reserves somewhat, even though many banks may not actively purchase or expand their treasury bill exposure. This could result in a significant reduction in liquidity in equity markets, which have been instrumental in supporting equity prices.
If this liquidity drain negatively impacts equities, we will exploit the situation by deploying some of our 30% cash. This allows us to allocate our resources and capitalize on potential market movements strategically.
As we started on Tuesday, “For the average long-only manager, remember that the equal weight S&P 500 index is down -.20% vs. 8.40% for the cap weight S&P 500 YTD. These managers will bid for all the names that have been working on a behavior biases reaction on the first sizable decline in the index”.
Tuesday’s 23rd S&P 500:
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The index found some support at the closing level of 4,159. The median level. Dobut, this holds without positive Debt ceiling news.
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Medium Conviction Buy: I suggest considering adding partial position size to higher conviction longs at the 4,078 level.
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High Conviction Buy: I would be an aggressive buyer at 4,040 for those with a higher conviction longs.
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Sell the rip: In terms of risk management, as previously mentioned in our analysis of the Treasury General Account (TGA) (read the post regarding the TGA), it would be prudent to reduce some long exposure in the event of a significant debt ceiling resolution that drives the market towards the levels of 4,220 and 4,250, respectively. It is worth noting that the greater the current de-risking, the greater the odds of a counter-trend reversal towards 4,220 becomes (which should be sold). While the direct impact of liquidity drainage on equity pricing remains uncertain, there is a growing herd mentality surrounding this thesis. Therefore, any massive counter-trend rally will be sold.
What a liquidity drain looks like
In the event of reduced bank reserves, the sectors most susceptible to impact would be those heavily reliant on credit expansion. Consequently, banks may experience downward pressure, as would retail stocks and businesses with highly leveraged balance sheets. However, it is worth noting that many large-cap technology companies are less dependent on credit and working capital, which potentially positions them to outperform other sectors during such a scenario.
Additionally, we have observed that numerous fixed-income investors have, in our assessment, been anticipating the potential issuance of $600 to $1.2 trillion in new bill offerings. This anticipation has likely played a significant role in the recent rise in interest rates. However, it is essential to recognize that today’s rate increase is primarily driven by a stronger-than-expected (hotter) GDP print, reflecting the overall economic conditions.
Conversely, be on the lookout for potential counter-trend reversals if the 10 year-yield does hit a fail 4%. Two areas to look at that could be positively impacted are utilities and gold.
As we wrote on May 16th, “Market Sentiment is so bad we must go higher” has given tremendous support to the equities. This is why and on dips, large-cap tech will be bought because mutual funds are still underweighting them. Below is a great chart from Goldman Sachs, look at how underweight back on March 31st, 2023, mutual funds were in META, AAPL, TSLA, MSFT, AMZN, NVDA & GOOGL.
May 20
The new risk everyone is worried about… Liquidy being drained
If you have been keeping up with financial publications or sell-side research from Wall Street’s prominent macro analysts, you may have come across several rate strategists expressing a common concern regarding the aftermath of resolving the debt ceiling issue. These market experts strongly believe that a reduction in liquidity is imminent. The more we hear this and the consensus agrees, the less likely it will be a real risk; however, highlighting it’s probably a good idea. As you may be aware, liquidity significantly influences the direction of equity flows and all assets, whether they rise or fall. At Trowbridge, we greatly emphasize understanding and assessing liquidity dynamics due to its critical role in shaping market outcomes.
In our note on March 16th, we said:
Was the demise of SVB the end of the Bear Market for Technology? As you will recall, on February 9th, we said something would break in the economy if the inversion of the 2/10 spread broke below -.94%, at which point, three weeks later, the curve proceeded to invert to -1.08%. Several days later, we had the world discussing HTM (Held To Market) securities losses on Bank’s balance sheets and run-on bank deposits”.
Irrespective of one’s personal convictions, there exists a discernible relationship between the 8% returns observed in the NASDAQ index following the SVB collapse we discussed on March 16th and the injection of an additional $400 billion by the Federal Reserve for the discount window. While causation cannot be definitively established, the correlation between these events is undeniably robust, suggesting a potential interplay between the expansionary monetary measures and the market performance.
Now here comes the drain of liquidity
However, this time many strategies are now concerned with the potential risks of the Treasury’s need to replenish the TGA (Treasury General Account) and the potential impact of a reduction of liquidy impact risk assets.
The acronym “TGA” typically refers to the “Treasury General Account,” which is an account held by the U.S. Department of the Treasury at the Federal Reserve. The TGA plays a crucial role in managing the government’s cash flows and serves as a checking account for the Treasury.
What is the TGA
The funds flow into the TGA when the Treasury collects tax revenue or issues debt. Conversely, when the government spends money, the funds flow out of the TGA. The balance in the TGA fluctuates based on the government’s fiscal activities.
Now, regarding the impact of increasing the TGA balance on liquidity in the equity markets, here’s how it works:
- Cash Drain: When the Treasury’s cash balance in the TGA increases, the government accumulates more cash than it is spending. This can occur, for example, if the Treasury issues debt beyond its immediate spending needs or experiences a surplus in tax revenue. As a result, the excess cash is held in the TGA account, effectively draining it from circulation in the broader economy.
- Liquidity Impact: Increased TGA balances can reduce liquidity in the equity markets because the cash that would have otherwise been available for investment or spending remains idle in the TGA. When money is withdrawn from circulation, it reduces the overall supply of available funds in the economy. This can potentially limit the amount of cash available for investors to purchase equities or for businesses to invest and expand their operations.
- Treasury Securities: In some cases, when the Treasury accumulates excess cash in the TGA, it may issue Treasury securities to absorb the surplus funds. These securities, such as Treasury bills, notes, or bonds, are financial instruments that the government sells to investors to raise capital. When investors purchase these securities, they effectively transfer their cash from the private sector to the government, further reducing liquidity in the equity markets.
It’s important to note that the impact on equity market liquidity due to changes in the TGA balance depends on various factors, including the overall state of the economy, government fiscal policies, investor sentiment, and market conditions. Therefore, the relationship between TGA balances and equity market liquidity can be complex and influenced by multiple factors beyond the TGA alone.
If we were to sample the observations of the TGA and its relationship going back to 2015, there aren’t many data points, but the one that shows significant increases and decreases in liquidity does seem to impact the S&P 500 both positively and negatively.
Banking Issues could continue to have negative implications.
The risk is that the Fed has to replace $600 billion to the upper range of $1.2 trillion into the TGA; this will impact medium and smaller banks’ access to higher liquidity, igniting once again less liquidity as this will drain banks’ reserves. We assume Janey Yellen realizes this and the reason for her remarks on Friday that more M&A is coming in the banking space. Furthermore, we can conclude that rates have been increasing in anticipation that the treasury will have to fund the TGA with the new issuance and increase the supply of new bills.
Increasing funds to the Treasury General Account (TGA) can potentially affect banks’ liquidity due to the following reasons:
- Absorption of Excess Reserves: When the TGA receives additional funds, it effectively absorbs excess reserves from the banking system. Banks typically hold reserves at the Federal Reserve to meet regulatory requirements and facilitate daily transactions. By increasing the TGA balance, funds that would have otherwise been available as reserves for banks are diverted to the Treasury, reducing the overall pool of liquidity accessible to banks.
- Reduced Interbank Lending: Banks often engage in interbank lending to manage their liquidity needs. When the TGA accumulates more funds, banks have fewer excess reserves to lend to each other, limiting the availability of short-term borrowing in the interbank market. This reduction in interbank lending can restrict banks’ ability to access liquidity and manage their cash positions efficiently.
- Lower Money Supply Growth: Increasing the TGA balance reduces the amount of money available in the broader economy. When funds are held in the TGA instead of circulating in the financial system, it restricts the growth of the money supply. As a result, banks may face a tighter supply of funds, potentially impacting their lending activities and overall liquidity position.
- Impact on Treasury Securities Market: In some cases, when the TGA balance increases significantly, the Treasury may issue additional Treasury securities to absorb the excess funds. Banks, as major participants in the Treasury securities market, may be inclined to invest their available funds in these securities, diverting liquidity away from other lending and investment activities.
However, diverting funds from the banking system to the TGA can potentially tighten liquidity conditions for banks and impact their ability to meet short-term obligations and support lending activities.
RRP Reverse Repro Facility may be impacted as well
As for the increase in RRP operations since 2021, it is crucial to understand the broader context of the Federal Reserve’s monetary policy and market conditions during that period. The Federal Reserve increased the size of its RRP program as a tool to manage short-term interest rates and provide liquidity to financial institutions.
- Abundance of Cash in the Financial System: During the COVID-19 pandemic, the Federal Reserve implemented various monetary stimulus measures, including large-scale asset purchases (quantitative easing) and emergency lending programs. These measures injected significant cash into the financial system, increasing liquidity. As a result, financial institutions had excess cash they sought to invest, leading to increased demand for the RRP program as a safe and short-term investment option.
- Liquidity Management by Financial Institutions: Financial institutions, including money market funds and banks, utilized the RRP program as a means to manage their liquidity and fulfill regulatory requirements. The RRP allowed them to park excess cash with the Federal Reserve overnight, providing a low-risk investment alternative compared to other market instruments.
- Higher Short-Term Interest Rates: The increase in RRP usage in 2021 coincided with periods of higher short-term interest rates in the money markets. The Federal Reserve increased the interest rate offered on RRP transactions as a way to manage the level of short-term interest rates and prevent them from falling below the target range. This made the RRP program more attractive to financial institutions, driving higher utilization.
Regarding the difference between the RRP and the Federal Reserve’s balance sheet, it’s essential to understand that the RRP is an instrument used by the Federal Reserve to manage short-term interest rates and provide liquidity to financial institutions. On the other hand, the Federal Reserve’s balance sheet represents its holdings of assets, such as Treasury securities and mortgage-backed securities, acquired through various monetary policy operations, including quantitative easing. While the RRP program affects the overall level of reserves in the banking system, the Federal Reserve’s balance sheet represents the total assets and liabilities held by the central bank.
Deposit Inflows
As mentioned earlier this week, we do not believe the banks have resolved the issue. There were excessive deposits because of the RRP and well above the long-term banking deposit mean. If we were to see deposits within the U.S., bank institutions would revert to their historical long-term trend line that puts you around $14 trillion. This would have a significant impact on credit availability and bank solvency. This will impact the long-end consumer the most and consumer discretionary, leveraging hard-to-borrow companies. However, this will turn out to be a buying opportunity if equities decline as the Fed will need to resort to evermore liquidy.
May 18th
The Game is on for the chase.
While we have maintained a fundamental skeptical view towards the markets on a discretionary basis since January 2023, we have always acknowledged the presence of a market backstop supported by The Fed’s liquidity. Unlike many Wall Street strategists who predicted a break below the 3,600 lows for the S&P 500 at the onset 2023, we held a different perspective.
We stated on January 11th the following:
If you have recently read Morgan Stanley’s Chief Strategist Mike Wilson’s note, you are now liquidating your portfolio and going to 100% cash. While he makes a lot of very valid arguments for his bearish view and we agree the market is expensive and corporate margins will compress further based on the fundamental backdrop. However, we disagree about one vital thing, markets care more about QT/QE (quantitative Tightening/ Quantitative Easing) over earnings.
In Wilson’s latest very bearish note, he believes (CPI) inflation is crashing much faster than the Fed realizes. By the time the Fed can do anything about saving the economy, it will be too late, as earnings will already be collapsing. He does realize that falling inflation is a positive, although he believes this takes a back seat to margins compressing. He believes earnings collapsing supersedes inflation normalizing as companies operating leverage will decline and hurt companies’ margins (earnings) as costs fall faster than end prices. This makes complete logical sense; unfortunately, for over a decade, the market traded more on liquidity and no true price discovery from the Fed’s $9 trillion balance sheet bubble addiction.
Wilson believes the S&P 500 earnings are vastly overstated and writes the market has 20% lower regardless of how much inflation declines. In his note, he suggests that the S&P 500 will ultimately earn around $190 base case and $180 bear case vs. consensus $225. Wilson writes that the equity risk premium will need to rise, which will cause the S&P 500 P/E to fall to 13 times forward earnings.
This is where we disagree. The first sign of a pivot from a decelerating trending CPI, multiples will expand regardless of how bad earnings start to compress. The market will get more expensive. The markets are upwardly biased and addicted to easy monetary policy more than quality earnings. This is why the S&P is not currently trading more at an equilibrium of 15 times and why stocks multiple expanded 3X over the last few years. The market only cares about easy money.
In reference to our January note, we would like to underscore the significance of the Federal Reserve’s liquidity injection and its profound impact on equities. Our previous analysis correctly predicted the expansion of multiples from 16.50 to 19.50, while the S&P’s EPS witnessed no growth. This expansion was facilitated by the recent growth in the Fed’s balance sheet, specifically to accommodate the discount window.
Furthermore, it is imperative to note that since that time period, projected Fed Fund rates indicate an anticipated 200 basis points reduction over the following 12 months. This rate-cut expectation further emphasizes the influential role of monetary policy in shaping market dynamics.
Acknowledging that our investment approach is strictly quantitative and systematic, focusing on price and time series analysis is crucial. We are neither fundamental nor discretionary investors. Remarkably, for the first time since 2015, this strategy has experienced lower-duration holding periods for trades due to the rapid and transformative shifts in various factors over the past six months. Our conviction in these factors, particularly within the realms of risk and quality, stems from the oscillation between soft and hard landing scenarios and the subsequent induced liquidity expansion.
However, reflecting on the strategy’s misjudgment regarding the low beta position from higher cash levels, coupled with allocating to defensive sectors such as consumer goods and healthcare, is essential. These sectors have displayed a stagnant performance, and our modest underweight position in technology has also contributed to this discrepancy. Additionally, for the last several months, we felt the 4% to 4.6% investors could receive on an almost risk-free money market cash substitute was an excellent place to wait and hide for better allocation opportunities.
Presently, we find ourselves in a position that hovers around our anticipated levels for the S&P 500 and NASDAQ, a forecast we have made since March 16th, as depicted below. In this juncture, it would not be imprudent to accelerate and expose oneself to additional risk. As we indicated in our previous reports, we anticipate substantial growth in S&P 500 margins in the post-AI era over the forthcoming years. However, this projection should not be misconstrued as a call for increased risk-taking. Undoubtedly, there may exist the further potential for upward movement within the upper ranges we have outlined, yet such developments are predominantly influenced by technical factors, which prevail amidst a market backdrop despised by many.
NASDAQ Futures:
- Previous: 13,600
- Revised: 13,718
- Top End Range: 14,334
- Today’s close: 13,920
- A weekly close at this level would be significant and potentially lead to a move towards 14,334. If we reach this level, I recommend reducing risk exposure significantly.
S&P 500 Futures:
- Previous: 4,250/4,300
- Revised: 4,330
- Today’s Close: 4,216
- The S&P 500 appears relatively weaker compared to the NASDAQ for apparent reasons. However, if the mid-cap banks can continue this short covering, it will allow underperforming economically sensitive sectors to help the S&P 500 outperform the NASDAQ over the coming weeks.
S&P 500
NASDAQ
The S&P 500 has the highest net short positions since late 2011, providing a. the sentiment of the investor b. the short covering rally possibilities.
The Cyclicals had their most significant one-day move in the last 12 months verse Defensives yesterday.
May 17th
Everything is awesome bank short covering rally.
NASDAQ Futures:
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Previous: 13,600
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Revised: 13,718
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A weekly close at this level would be significant and potentially lead to a move towards 14,334. If we reach this level, I recommend reducing risk exposure significantly.
S&P 500 Futures:Previous: 4,250/4,300
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Revised: 4,330
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The S&P 500 appears relatively weaker compared to the NASDAQ for apparent reasons. However, if the mid-cap banks can continue this short covering, it will allow underperforming economically sensitive sectors to help the S&P 500 outperform the NASDAQ over the coming weeks.
Russell:
Russell discussed yesterday and presented an interesting situation.
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It currently shows the largest variance to QQQ (Nasdaq-100 Index) since 2000. While it is oversold, it does not fall within the top quartile of oversold levels in the last decade.
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According to Jeffreies’ relative valuation model, the Russell is currently in the 9th percentile, a level last observed in March 2003.
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Today’s catalyst for the IWM to outperform, besides systematic investors being heavily short, was all about Western Alliance news of attracting $2 billion in deposits in the previous quarter, resulting in a 7.36% short-covering rally in KRE (SPDR S&P Regional Banking ETF). This caused significant short covering of incredibly sensitive and economically retail-sensitive stocks to catch a hard build, especially in retail.
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While some minor positive developments have been regarding the debt ceiling, investors have yet to significantly reduce their risk exposure in response. The likelihood of default remains at a mere 3%, which needs to provide more reassurance to prompt widespread de-risking.
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Keep an eye on the $40.70 level for KRE if you are investing within these economically sensitive groups, as it could attract more buyers in regional banks and potentially benefit small caps, cyclical sectors, and credit-sensitive companies with leveraged balance sheets. Under this scenario, the most oversold underperforming retail names might continue to outperform. A close above $40.70 will develop into a constructive environment for the weakest areas of the market.
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IWM based on its positioning, will need to test and close above $179, to bring in long-only system traders.
Nonetheless, we are skeptical about the potential for significant further gains in the regional bank trade with KRE. A measured move counter trend rally would take KRE to about $42.80. I view it merely as a more significant counter-trend reversal rather than a sustained trend. The ongoing accumulation and subsequent unwinding of deposits into money markets currently offering a 4.60% yield are unlikely to cease, as we previously discussed below abruptly. It isn’t easy to believe that the case of (WAL) will represent a widespread trend where bank depositors return to only generate a 0.20% return on equity from cash holdings.
As you know, we are big believers in the AI cycle; however, as we wrote on Saturday, that doesn’t necessarily mean owning the AI companies. We believe it will increase efficiency across all companies, even the most mundane old-school companies. Thus this will increase profit margins for the S&P 500. Today we came across work done by Goldman Sachs research note on AI and S&P 500 margins. They said, “Artificial intelligence represents the biggest potential long-term support for profit margins. Our economists’ productivity estimates suggest AI could boost net margins by nearly 400 bp over a decade“
Goldman provides this great chart below showing how AI will affect industry groups and employment, saying that 1/4th of current workers could be automated. So the bad news is we all will eventually be unemployed; the good news is we will be rich as the S&P 500 will be significantly more profitable and keep moving higher!
May 15th
Market Sentiment is so bad we must go higher
With earnings now behind us, surpassing initial concerns of a substantial 6% decline and instead settling for a more modest 1% reduction, one must consider the possibility of an unforeseen cataclysmic event, akin to a black swan, capable of exerting downward pressure on the S&P 500 (futures) even in the presence of a robust support level at the previously mentioned 4,057 mark we alluded to two weeks prior.
As we addressed in our previous communication, it is essential to acknowledge that the market has duly incorporated all relevant information, currently reflecting the S&P 500’s valuation at 19 times the anticipated earnings for 2023 and 17 times the forward earnings projection for 2024. However, skeptics are inclined to highlight the incongruity between an expected 15% growth in S&P earnings for 2024 and the market’s implied anticipation of a substantial 220 basis points reduction in interest rates by the conclusion 2024. Interestingly, BofA Fund Manager Survey only showed a 1% probability of 10% EPS growth.
Of utmost significance is the impending question of how the S&P 500 will attain the projected 15% growth in earnings while simultaneously holding the belief that the Federal Reserve’s policy errors have triggered a momentous deviation in its course, as evidenced by the Federal Funds rate signaling a 220 basis point decrease.
The present state of the market is characterized by thin trading volumes and an overwhelmingly bearish sentiment not observed in over a decade. Mutual funds are exhibiting the lowest level of beta exposure witnessed in three years, short interest in the SPX index is at its highest point in a decade, and market breadth has not demonstrated such fragility since the year 2000 on the NASDAQ. However, the market refuses to let long-only investors have an opportunity to get long at lower pricing. As we all have read by now that 90% of the S&P 500’s 2023 returns are five stocks, as the S&P 500 equal weight ETF is actually down -.57% for the year. This dynamic has investors who are not allocated to large-cap tech bidding for them at every dip lower, thus supporting prices. Not even to mention the large-cap AI frenzy that gaps prices 5% to 10% in a day on PR of new AI product lines.
Back on March 16th,We said “A NASDAQ (futures) close, especially a close on a Friday (weekly) above 12,800, would be a powerful trigger and take the index to 13,600. This is because, for 14 months, the NASDAQ futures has rejected every volatility stop the break-out attempt. Like the 15,200 and 13,600 levels we said to sell into and take down growth exposure. This is now a fundamental & technical potential game changer signaling that the rate hiking cycle is over. Unless Powell completely shocks the markets on the theory of future rate pauses, the NASDAQ will probably finally break above its volatility stop”.
Back on March 21st, we stated, “Yet, while it will take months to see the current restrictive credit implications, if Powell does indeed signals they are on hold for the foreseeable future tomorrow, the next stop is 13,600 (NASDAQ Futures) & 4,300 S&P 500 futures”.
Back on March 31st, we dicussed Glodmans L/S net long SP&P 500 positoning, and we asked “Can the S&P 500 reach 4,300 and the NASDAQ take out 13,600 for the ultimate test of 14,500? Investor positioning is so bad it’s conceivable”.
Charts to digest
220bps of cuts by Dec 2024
Was that the start of the correction or will large-cap tech hold up the indexes?
Last Thursday, April 20th we stated, “Although our confidence to start shorting any 40 to 50 handle rallies into 4,200 is growing stronger. I would prefer to encounter a situation where there is a significant risk on day to de-risk. I could anticipate that this scenario could arise during options expiration on a gamma squeeze or a relief rally around Apple or MSFT earnings.”
Tomorrow just might be this risk-on day to start de-risking or go very neutral on your book. Today we saw a risk-off day as FRC lost $100 billion in deposits and the bank now needs to balance the loan book by selling assets, which will result in most likely taking tangible capital below requirements. If FRC can sell these loans at current values with a positive warrant incentive, then the crisis will be averted. The real issue is deposits across all regional and smaller banks will continue to shrink and loan growth is going to continue to seize up.
For those who have missed our last few notes, let me reiterate:
- On March 25th, I indicated a high likelihood of our blended S&P 500 model reaching a reading between 60 to 70, which would take the S&P 500 futures to 4,250 and 4,300 on an overshoot. I recommended being an aggressive seller at this level. Unfortunately, this scenario has not played out.
- On April 20th our S&P 500 model held a 55.40 reading and saw its first small decline since March 24th. However, the decline as discussed on Friday was not significant enough to have a strong conviction for shorting the S&P 500. We were looking for a parabolic move higher that would have caused a key reversal, which did not materialize.
- After today’s move, I believe that large rallies should be used as an opportunity to reduce long exposure, higher beta, and economically sensitive names with low ROE within your groups or buy puts. Regardless of after-the-hours positive earnings (MSFT +9.30%, GOOGL +3.00%, V +1.59% CMG +7.85).
- As someone who has been using ChatGPT for the last 4 weeks, I can attest to the game-changing technology and time-saving applicational use it is, however, this is a secular move. Additionally. MSFT trading at $300 has a significant overhang.
- For those of you I have spoken with regarding GOOGL, I am still a seller at the $109/109.80 level. So if tomorrow is a risk on the day and this is tested, I would continue to be a seller here.
- It will take a significantly positive catalyst at this juncture to close above 4,200 as our model is breaking lower.
- Intra-day reversal play tomorrow: I would look to sell into 4,146 on the S&P 500 futures. A close above here the index will move to 4,187.
- Without a Macro positive catalyst, I don’t see a test of 4,200 breaking out to our original targets. However, if tomorrow’s risk on the rally is carried further by positive Apple and Meta earnings, I suggest being an aggressive seller or buying puts on the S&P 500 at 4,200.
- At this point, it will take a significant macro event, rather than earnings, for our model to shift positively after the recent click lower tonight and for the index to close above 4,200. If the S&P 500 does, however, eventually close above $4,200, expect a quick parabolic move higher to our original target levels.
April 20th
Rate-cut probabilities are the only thing holding up this market.
I maintain our cautious approach in reducing long equity risk at the target levels we set forth on March 25th. Yesterday we saw the first small tick or weakness in our S&P 500 model which we discuss below. The economic backdrop continues to be deteriorating, as evidenced by yesterday’s LEI and Philly Fed report (see below), combined with a mixed picture of earnings. JPMorgan reported a decline in one-month net global EPS revisions, from -7.2% to -15%, and three-month net global revisions are now at -13.7%, down from -13.2% in recent weeks. This has resulted in the Fed Fund Futures increasing the probability of a 25bps cut in September 2024 and 200bps of cuts by year-end 2024. If you missed our discussion on rate moves on Tuesday see April 17th post below. Nevertheless, these projected cuts remain the leading factor in my opinion supporting the S&P and NASDAQ.
As a point of reference, we have been emphasizing since March 25th that our S&P 500 model seemed likely of reaching a reading between 60 to 70, which would put the S&P 500 in a sticking distance of 4,250 before we reduce our long exposure or hedge our risk. Presently, the model is holding steady at 55.20 and yesterday saw a small bearish tick lower, nothing meaningful. Consequently, we anticipate that it would require substantial negative movement for the model to decline. Although our confidence to start shorting any 40 to 50 handle rallies into 4,200 is growing stronger. I would prefer to encounter a situation where there is a significant risk on day to de-risk. I could anticipate that this scenario could arise during options expiration next week on a gamma squeeze (since no one is long) next week or a relief rally around Apple or MSFT earnings.
Rate cut probabilities have increased in the last 48 hours
Apart from a few semi-conductor earnings today, namely LRCX and TSM, which provided a better-than-feared forecast for the latter half of 2024, the economic data is deteriorating, as demonstrated by today’s Philly Fed and LEI reports, which is not entirely surprising. This has already been factored into the market, as reflected by the Fed Fund futures projecting 200bp of cuts going up to the end of 2024.
However, the NASDAQ & S&P 500 index has not shown any compelling indication for a high conviction reversal as yet, with the odds continuing to increase for a 0.25bps cut in September 2023. The probability of a 0.25bps rate cut in September 2023 has risen from 36% to 40% probability in the past 24 hours, as shown in the first chart above. In addition, another response to this weaker economic data was a bull steepening of the 2/10 yield curve spread today. If you have not positioned your book/portfolio for a hard landing, then you will not want to see a scenario where we get significant steepening of the 2/10 spread (e.g. -.24bps SVB), as this would be a strong signal of a hard landing scenario.
Dislocation will cause the reversion everyone is looking for
As we highlighted earlier this week, the divergence between the Fed Fund Futures projections and the Fed’s messaging has never been more pronounced. This mismatch is creating a significant dislocation that is likely to result in pricing breaking lower, causing market disappointment. Despite the increase in the probability of rate cuts today, the Fed Presidents remain steadfast in their hawkish stance.
- Fed’s Bowman (voter) said the Fed is focused on lowering inflation and commented that a strong labor market has made finding workers extremely difficult.
- Fed’s Logan (voter) said inflation has been much too high and they are to assess if they have made enough progress, while they are watching for a further, sustained improvement in inflation.
- Fed’s Waller (voter) said with SVB, there was no way to process collateral for Discount Window lending fast enough and need to think about how to assess and process collateral faster, while he added that things have kind of calmed down in the banking sector.
We had two rather negative data points today LEI ( Leading Economic Indicator).
- In the first Chart of LEI, we see the index drop -7.80 year-over-year.
- In the second Chart of LEI, it hit the lowest level since Oct 2020.
Lastly the balance sheet.
As we pointed out on Wednesday since the Fed balance sheet has fallen $100 since March 29th so has the NASDAQ by 200 handles. As seen below, gaps get filled and the BS is rolling over, thus it’s my belief the NASDAQ will continue to struggle under this scenario and follow the BS.
April17th
Tug of War rages on between the Fed and the market.
With regard to our S&P 500 and NASDAQ levels, we have not observed any discernible shifts worth reporting. However, as we approach our targets, we must remain cautious and contemplate the de-risking of portfolio beta exposure as we get closer to our goals. Despite appearances, markets are not experiencing a full recovery and everything does not point to an economic and earnings trough.
Our focus today is the striking incongruity between the Federal Reserve’s unwavering stance on a higher-for-longer glide path and their constant communication that there will be no rate cuts in 2023 versus what the Fed Fund Futures believe is the true state of the economy. It is common knowledge that the markets, especially the S&P 500, are highly efficient over the long term. However, at present, the markets are exhibiting remarkable resilience causing a massive dislocation between economic reality and price behavior by projecting 200bps of rate cuts by the end of 2024 (see first & second chart below), thus causing a massive backstop for declining multiples. This is where dislocations from reality come into play as investors set themselves up for the significant disappointment of the false delusion rate cuts coming as soon as September, which will result in significant de-risking in the second half of the year.
Just like when we wrote on Febuary 9th once the inversion of the 2/10 spread made new cycle lows below -100bps it would break something within credit markets causing bank lending to seize up. This two, we believe presents severe risk to equities as the market continues to build upon the rate cut theory.
The markets have repeatedly shown skepticism over Powell’s commitments in the last six months, refusing to accept his messaging as gospel. He cannot waver now or face a credibility issue.
The S&P 500 has surged an impressive 8.5% or 330 handles since the SVB lows roughly four weeks ago. Nonetheless, small business credit has continued to tighten since the SVB collapse. As we discussed last week, the Small Business Optimism Index plummeted at a rapid pace to levels not seen since 2011 (see third chart). It is crucial to note that 65% of all C&I lending in the United States is done at the regional and community banking level. If you doubt the impact small business lending has on the labor market, see the high correlation between small business loans to job creation (see fourth chart). Thus, a few strong earnings from the Money Center Banks (BAC/JPM), is a zero-sum game for smaller regional banks, and do not accurately reflect the actual state of lending for small businesses.
Moreover, ISM currently sits at 46.3, and historically, it has never fallen below 45 without the United States experiencing a recession (see fifth chart), something we pointed out from BofA research last week. Clearly, the market is concerned enough about economic conditions to warrant pricing in 200bps of cuts by the end of 2024.
- Before the SVB collapse, the market predicted a 0.50bps rate cut by mid-2024.
- During the SVB failure, the market began pricing in 120bps of cuts by mid-2024.
- Currently, as of today, Fed Fund Futures are pricing in a 200bps cut by the end of 2024, as depicted in the first & second charts below.
- We cannot recollect any other period in the last two decades where the variance between the Fed’s messaging and market pricing has been so pronounced.
- Additionally, (the sixth chart below) displays the market pricing in a 0.25bps rate hike on their next move, with a 64% probability.
- Finally, the (seventh chart below) depicts the market forecasting a 37% chance in September of a 0.25bps rate cut.
As we discussed several times our base case (scenario a.) is where ultimately, either the Fed will disappoint the market by failing to meet these predicted cuts or the market’s supposition that the economic data will lead to significant weakness resulting in 200bps of cuts will come to fruition.
Either case does not bode well for the S&P 500 beyond 4,300. As we wrote on Saturday, EPS for the S&P 500 has seen a 6% reduction (haircut), giving a consensus for 2023 of about $220, which results in a 19.50 X 2023 earnings. However, you may then suggest that investors are looking beyond 2023 EPS already. Well according to BofA, EPS for the S&P 500 doesn’t recover until 2025 as seen in the ninth chart below.
The only positive catalyst this market has going for it is that investors have a strong disdain for being long in this market and are under-allocated which always causes a squeeze higher. Long-only investors are sitting with 5.5% of cash according to BofA for 17 months, the longest period since 2001 (see ninth chart). Not to mention some of the lowest net long exposure in three years by Long Short hedge funds.
Lastly, tech is looking sluggish!
Back on March 29th, when the Fed’s Balance sheet was sitting at $8.7 trillion, we said that was Goldilocks and we didn’t want to see an increase (bad for credit and lending) or decline (bad for liquidity). Since that time the BS has declined by $100 billion (see the tenth chart) and the NASDAQ has been range bound to down 130 points as of today’s close from its recent March highs. As credit stress continues to ease this will be a headwind for technology. As we have said since 2018 the correlation of the BS is just too great to ignore.
Saturday 15th
The big catalyst is upon us and will be the moment of truth for the markets.
Despite the constructive appearance of the index levels, individual equities have displayed a highly volatile and erratic trading pattern. In many cases, the price swings have been extreme, resulting in a choppy market environment. On Thursday, April 13th we said, “Despite traders’ widespread awareness of the potential for a VERY weak retail sales number, we anticipate any initial sell-off into the small support level of 4,140 tomorrow would be bought.”
Friday saw yield across the curve move higher as the University of Michigan inflation expectation jumped from 1% to 3.6% in March to 4.6% for April, the largest jump since May 2021 as seen below. This coupled with Fed’s Waller’s hawkish remarks about inflation pushed the 2-Year Yield to close up at 3.30% on Friday at 4.10%.
The Momentum of Truth
For the past few weeks, we have strongly believed that our S&P 500 blended model would pick up momentum after hitting a -20 reading and stabilizing as our breadth indicator started to see expansion, leading us to believe the model could reach a 60/70 reading. However, the model has now reached 54.40, and our conviction is beginning to falter, especially with the start of the earnings season upon us. For the model to move from the current 54.50 to a 70 reading that would take the index to our original scenario a. target range of 4,250/4,300.
Our blended model serves two purposes: a) to manage tail risk and b) to provide a high-level historical overview of the S&P 500’s trend strength, as well as periods of both enthusiasm and stress. Typically, high conviction setups occur at the extremes. For example, going back to 1992:
- 88% of the time, when the model reaches a 95 reading, the S&P 500 corrects by an average of 8%.
- 70% of the time, when the model falls below -50, the S&P 500 corrects by an average of 7%.
- 84% of the time, when the model moves back above -50, the S&P 500 experiences a counter-trend rally of 10%.
- There are a few other high-conviction moves we will discuss in later notes.
We are almost at a make-or-break reading.
- 55% of the time, when the S&P 500 blended model hits a 60/70 reading, it will fail and revert to an equal or less than 0 reading, resulting in a 5% decrease. On the other hand, the remaining 45% of the time, once the model moves above a 70 reading, it pushes to a 90 reading.
- If the S&P blended model were to rise from its current reading of 54 to 90, it would represent a 6.5% to 7% increase, potentially pushing the S&P 500 futures toward our scenario b. discussed last week, approximately 4,440/4,480.
- However, given the current economic backdrop, which includes factors such as high rate volatility, decelerating ISMs & PMIs, 5% CPI, declining labor participation, and a -.58bps yield curve, it is challenging to envision a scenario where the S&P 500 model goes parabolic reaching a 90-reading. Hence, our view is that the model will fail within the 60/70 reading or S&P 500 4,250/4,300.
S&P 500 breath continues to expand helping the indexes to remain buoyant. On Friday even though trading was very choppy, the number of strong buys crossed above the number of strong sells.
Without carefully examining each industry group or sector level, it’s easy to overlook the rapidly shifting rotation within the S&P 500 index. The strongest performers in terms of price and time series have not been stable and have been changing more rapidly than over the last several years. The rotation has been quite severe, as seen in the recent shift in the top percentile of performing stocks. For instance, just a couple of weeks ago, 50% of the strongest 20 stocks within the S&P 500 were in the technology sector, but that number has since dropped to 20%. Meanwhile, Consumer Discretionary stocks, which previously made up only 5% of the top 20 performers, now comprise 30% as traders attempt to anticipate or front-run the end of what the market perceives as the end of Quantitative Tightening.
Consensus is not long the market
As you know, our base case scenario (scenario a.) is for the S&P 500 to fail at the 4,250/4,300 level, resulting in a shift in market sentiment from anticipating the end of the rate hiking cycle to focusing on economic data and deceleration of EPS and revenue leading to selling pressure. However, there is a less likely scenario (scenario b.) that could potentially lead to a parabolic move driving the S&P 500 toward a target of 4,440/4,480 or a 90 reading on our S&P 500 model. Typically, such moves occur when the consensus is offside.
The first chart from Morgan Stanley Prime Brokerage reveals that hedge fund positioning in cyclical areas has reached the 0% percentile, excluding energy and semiconductors. Additionally, momentum in some semis has reached exhaustion and areas appear to be waning. However, because of the massive amount of liquidity, finding a new home in underperforming sectors has been the playbook thus far.
One example of exhaustion in the semi-space is (NVDA). While this is not a market tell, it is 5.40% of the NASDAQ and 2% of the S&P 500. Over the last 4 trading secessions, NVDA has seen some weakness on our mean reversion model indicating the run or future advancement remains challenged. (No positioning NVDA)
Then we have this chart from JPM on CFTC positions in equity futures by leveraged funds and Asset managers. Again, not very long.
Then we have banks negative on Q1 earnings. As Golmans points out sentiment for Q1 earnings is very negative and in-line earnings will hold up the markets if not move them higher.
Then you of BofA expecting Q1 earnings in line with expectations where the S&P 500 Q1 consensus EPS has been cut 6% YTD, more than the average 4% pre-season-cut. BofA’s second chart shows how fast consensus is cutting for HY2 EPS.
March 11th
So is this the start of the melt-up?
While we have taken a more positive outlook on the S&P 500 in recent weeks (starting Mid March), it is important to note that this is not a longer-term breakout or a reflection of our stance on value versus growth stocks or one factor over another. Rather, our perspective is rooted in capitalizing on the current market environment. Our bullish sentiment is largely driven by our confidence in our priority S&P 500 blended model, as shown in the first chart below, which indicated that the index had room to potentially test a 60/70 reading before encountering significant headwinds. However, it is important to recognize that not if but when the model stalls, the momentum in the model will likely revert back between a 0 to 20 reading, which is a very standard outcome.
Before today’s close, the model was reading 46, and expect to see 50 shortly if not tomorrow. (click the image to enlarge)
Moreover, we find the impressive breath expansion over the past three weeks that started around March 23rd, as measured by our Strong Buy to Strong Sell model, to be compelling, even though the thrust of the move has slowed somewhat in recent days. Overall, we believe that these developments “created” a favorable backdrop for the S&P 500. Once we get the number of strong buys within the S&P 500 to cross the strong sells that will provide some additional breadth thrust.
Despite the sector-level volatility in recent trading, all sectors have shown signs of improvement, with little to no medium-term trends lasting more than a few days. As we noted in our March 31st update, every sector within our models has improved, except for financials.
To reiterate a few calls over the past month.
Back on March 16th, We said “A NASDAQ (futures) close, especially a close on a Friday (weekly) above 12,800, would be a powerful trigger and take the index to 13,600. This is because, for 14 months, the NASDAQ futures has rejected every volatility stop the break-out attempt. Like the 15,200 and 13,600 levels we said to sell into and take down growth exposure. This is now a fundamental & technical potential game changer signaling that the rate hiking cycle is over. Unless Powell completely shocks the markets on the theory of future rate pauses, the NASDAQ will probably finally break above its volatility stop”.
Back on March 21st, we stated, “Yet, while it will take months to see the current restrictive credit implications, if Powell does indeed signals they are on hold for the foreseeable future tomorrow, the next stop is 13,600 (NASDAQ Futures) & 4,300 S&P 500 futures”.
Back on March 31st, we dicussed Glodmans L/S net long SP&P 500 positoning, and we asked “Can the S&P 500 reach 4,300 and the NASDAQ take out 13,600 for the ultimate test of 14,500? Investor positioning is so bad it’s conceivable”.
As outlined in a recent note, we continue to hold our views on two scenarios. While Option 1 remains unchanged, we will make a game-time decision on Option 2 based on how the models read when they reach the specified readings.
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A strong case can be made for the projected scenario that the market may experience a rally in the range of 4,250 to 4,300 after the anticipated final rate cut. However, this rally could be short-lived as the market is likely to face rejection and undergo a retest of around 4,000. We attribute this recent market strength not only to the Fed’s liquidity injection but also to investors’ attempts to front-run the last rate hike, which is likely to result in a “sell the news” type of event at a significant level. Moreover, if the Fed fails to cut rates as expected in the fall of 2023, we anticipate significant disappointment among investors, leading to a subsequent downturn in the market.
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The weaker case that seems least likely is a weekly close above 4,300 and the blended model with a reading between 70/80. This would cause a significant move in the model to make a run to 90 or roughly equating to 4,480 on the S&P 500 futures.
In conclusion:
If investors are lucky enough to be given the opportunity for the S&P 500 and NASDAQ (Futures) to test 4250/4300 and 13,600 respectively, reduce long exposure or hedge beta. The narrative always changes and at these levels, it will be no different from this time.
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If bonds sell off into this rally like today, look to add long 2-year treasury exposure
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Reduce exposure to the most heavily levered companies in your group
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Reduce exposure to the lowest ROE stocks in your groups
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Reduce exposure to cyclical and most tied to the low-end consumer
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Look to sell unprofitable tech
Chart of the Day from TS Lambard. As the TSL points out all four major Central Banks ECB, BoE, Fed, and BoJ have reversed from their previous declines. Always follow the liquidity.
April 11th
A few things to look at as we await tomorrow’s pivotal CPI.
In a previous report on March 24th, we noted that credit stresses were easing and advised investors to look for sectors with capital-intensive leveraged balance sheets to outperform technology, such as energy, industrials, and materials, as credit spreads normalize to pre-SVB levels.
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While some areas of credit stress have eased up, OIS spreads remain slightly elevated but have decreased by 0.35 bps from their highs and are currently at 31, while the 2/10 yield curve remains range-bound.
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It’s important to note that long-only investors do not want to see worsening economic data, such as a decrease in NFP or lower ISM/PMIs, combined with a significant curve steepening, as this has resulted in a recession 100% of the time over the past 70 years.
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Bank of America provides an informative 2/10 spread chart below that shows the relationship between the yield curve steepening and recessions.
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The most recent steepest 2/10 spread was around -0.24 bps during the collapse of SVB, and if the yield curve moves above -0.24, it will be something to watch for in terms of equities breaking lower.
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Under this scenario, we expect to see a stronger bid for treasuries (particularly the short end of the curve). Leveraged balance sheet companies and low ROE companies that are closely tied to the consumer are likely to underperform.
While credit market stresses appear to be easing, access to credit is tightening, as evident from today’s NFIB Small Business Credit Conditions report on loan availability. The decline may be the most significant since 2011. It’s worth noting that while 2011/2012 saw a similar decline, it was only a blip and did not signal an economic downturn. However, the current economic environment is vastly different from that period of expansionary growth.
Tomorrow is the big day for CPI which could be what triggers the next trend for the indexes for at least a few days.
Here is the consensus:
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Headline Month over Month .2%
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Headline Year over Year 5.1%
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Core Month over Month .4%
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Core Year over Year 5.6%
Although it is uncertain how the market will respond to tomorrow’s print, we anticipate a potential for a milder outcome if the latest higher frequency data is incorporated into the CPI. The data is rolling over so hard and fast, it is hard to draw a conclusion of a hotter print. In fact, we can envision a scenario where even if the headline or core CPI meets or slightly surpasses the expected headline or core by just a 0.10bps increase, resulting in a temporary market decline that it is quickly overlooked and eventually purchased. We base this view on the notion that credit accessibility is rapidly falling off a cliff, combined with the recent decline in ISM and the first tick lower in labor weakness. This will create a narrative that a hotter CPI is not adequately reflected in the most recent data/print. However, please note that this is purely an observation and not a definitive forecast.
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Hotter than the 5.4% headline the NASDAQ (futures) has the likelihood of testing 12,700 and the S&P 500 4,118.
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Cooler than 4.8% headline that 4,300 S&P 500 and NASDAQ 13,600 seems like reality and should be used to derisk.
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The inline headline 5.1% with shelter costs abating S&P 500 4,185 seems possible.
Below is every line item that Goldman is looking for.
April 11th
Random S&P 500 & NASDAQ thoughts as markets await CPI
While we anticipate the release of CPI and the possibility of an upcoming catalyst to propel the markets beyond the current 10% trading range that the S&P 500 has been confined to since June 2022, we find it prudent to preview some charts and examine pertinent data points.
S&P 500
Despite the apparent sluggishness of the S&P 500 and NASDAQ indices over the last 10 trading days, an in-depth analysis reveals otherwise.
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Presently, our S&P 500 blended model exhibits a noteworthy reading of +45. As we previously noted in late March when the model was recuperating from a -20, a typical rally could potentially elevate the model to a 60/70 reading.
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As you may be aware, we often resort to this model as a point of reference to discern the S&P 500’s trend cycle in a historical context. The second chart, which can be enlarged by clicking on it, displays the model’s performance since 1992. This model is an exceptional instrument to manage tail risk, and we rely on it extensively for this purpose. Notably, risk-off events tend to be magnified when the model attains a 90 reading or when the model drops below -50.
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In the past, the S&P 500 has demonstrated a loss of momentum at a 60/70 reading, which would translate to a further 3% increase from the current 45 reading, potentially propelling S&P 500 futures to approximately 4,250. While this level may not be particularly noteworthy, in the event of an upward thrust, the critical level to monitor would be 4,300. Any potential failure to breach this level could result in significant implications for market performance.
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The third chart provided below illustrates our method of tracking S&P 500 breadth, which currently indicates a steady expansion, albeit at a relatively slower pace compared to the past four weeks. As you are aware, a crucial point to consider is when the Strong Buys (green line) surpass the Strong Sells (red lines) or vice versa, which would signify a further expansion or collapse in breadth. As we have witnessed many times before, breadth expands as liquidity fuels the rotation from one sector to another. Money needs to find a home, remember, money market funds are at their highest level ever in history as capital leaves low-bearing deposit banks. Some of this liquidity might be finding a new home in equities in theory to have some positive impact on equities.
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As fundamental Macro investors grapple with the perplexing deceleration of economic indicators such as ISM, now cracks in labor coupled with one of the worse accessibility to credit in history (as depicted in the fourth chart), the market’s price behavior appears to defy conventional economic logic. Despite this, the fifth chart reveals that the S&P 500 has consistently remained above its downward trend, and a surge to 4,300 following the last .25bps hike could prove to be an excruciating experience for many macro and fundamental investors. As we have mentioned over the last several weeks, the first test of 4,300 should be used as an opportunity to take down equity risk.
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A strong case can be made for the projected scenario that the market may experience a rally in the range of 4,250 to 4,300 after the anticipated final rate cut. However, this rally could be short-lived as the market is likely to face rejection and undergo a retest of around 4,000. We attribute this recent market strength not only to the Fed’s liquidity injection but also to investors’ attempts to front-run the last rate hike, which is likely to result in a “sell the news” type of event at a significant level. Moreover, if the Fed fails to cut rates as expected in the fall of 2023, we anticipate significant disappointment among investors, leading to a subsequent downturn in the market.
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The weaker case that seems least likely is a weekly close above 4,300 and the blended model with a reading between 70/80. This would cause a significant move in the model to make a run to 90 or roughly equating to 4,480 on the S&P 500 futures.
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Our models indicate that all sectors, with the exception of Financials, have witnessed an upswing in strength over the last four days, as evidenced by the sixth chart below. While Healthcare, Energy, Industrials, and Materials are still in negative territory, they have managed to recover somewhat from their lowest readings in previous weeks.
Despite some weakness observed on our mean reversion models, it appears that the test of 13,600 on the NASDAQ futures is still a possibility in what has proven to be a frustrating year thus far. However, we maintain that unless the NASDAQ closes below 12,700, there is no significant change at the index level. We would use 13,600 as an opportunity to take down growth exposure on the first attempt.
As highlighted in our previous report, there was a possibility of a downside surprise in the Consumer Price Index (CPI), dependent on the speed at which the March ISM data was incorporated into the CPI. The seventh chart below indicates that the markets had already adjusted for the spike in February’s ISM figures, followed by another downturn in last week’s ISM. However, the eighth chart provided below shows a significant surge in inflation expectations in the last month on a forward basis, based on the New York Fed’s March Survey of Consumer Expectations. This development may impact our thesis for Wednesday’s softer CPI, though only time will tell.
Just when almost everyone was getting back in the water.
The primary driver of this downturn was the release of the JOLTS (Job Openings and Labor Turnover Survey) data, which revealed a significant drop in job openings from 10.824 million to 9.93 million in February – the first time it has fallen below 10 million since May 2021. Notably, the largest decreases in job openings were observed in professional and business services, health care and social assistance, and transportation, indicating a loss of middle to higher-income earning jobs. Additionally, the number of hires fell by 164,000 to 6.163 million, further reflecting weakness in the labor market.
Despite today’s worrisome sector-level action, we do not believe the upside move in the markets is over yet. Even if Friday’s NFP data turns out to be exceptionally weak, its impact may be limited following today’s shockingly poor JOLTS report. The real game changer and pivotal move for the market will be next week’s CPI data, as the market remains undecided on whether the Federal Reserve will make a 0.25 basis point move in the near future.
Today was the first data point where we saw more of an inverse correlation between the Growth factor and bonds. Something we really have not seen. While it remains uncertain if this trend will continue, it is worth noting that support levels across the treasury curve have been breached, and ongoing uncertainties in the labor market and interest rate fluctuations are affecting sectors such as industrials, materials, energy, and cyclical. As a result, investors should maintain a cautious stance on these sectors until rates stabilize and there is the confidence that a hard landing scenario is off the table.
March 28th
Did investors just front-run April or is there more to this move?
Before we look at the current data, let’s review a few critical calls we have made over the last several weeks that remain relevant and front and center.
Something will break
Febuary 9th, “We don’t find this yield curve too ominous as this has been widely published for longer than we can remember. As we discussed a month ago, this will become an issue if the 2/10 year completely breaks down to the lows of the 1980’s -1.60bps, thus causing some real structural issues for the markets. This will cause banks to pull back on lending as risk of lending will rise and this is always how credit events begin.
NASDAQ Breakout:
March 16th, We said “a NASDAQ (futures) close, especially a close on a Friday (weekly) above 12,800, would be a powerful trigger and take the index to 13,600. This is because, for 14 months, the NASDAQ futures has rejected every volatility stop the break-out attempt. Like the 15,200 and 13,600 levels we said to sell into and take down growth exposure. This is now a fundamental & technical potential game changer signaling that the rate hiking cycle is over. Unless Powell completely shocks the markets on the theory of future rate pauses, the NASDAQ will probably finally break above its volatility stop”.
March 24th we discussed a slower easing in credit stress would be ideal for the most levered and economically sensitive companies, specfically energy, materials, and industries would see a massive counter-trend rally. We said worse the balance sheet the greater the rip. Concersley, we thought technology would have underperformed these more levered sectors which was the case this week, eventhough the NASDAQ outperofmred the S&P 500. Energy since last Friday was the winner, outperforming the QQQ’s by 3%, Materials by 1% and Industrials by .90%.
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Credit Spreads EASED: Check! BAMLHOA1HYBBEY vs 2-Year Note, declined -80bps from 3.65% to 2.86%.
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Libor- OIS spreads EASED: Check! Spreads declined 10bps from 45 to 34.
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The yield curve Bear STEAPENED Check! 2/10 spread inverted -.30bps to -.58% from .24%. Remember, this is a sign that the market is taking back the chances of peak 120bps rate cuts from a week ago peak.
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Fed’s Balance sheet No INCREASE: Check! Lastly, we said we need the balance sheet to remain constant, not significantly increase or decrease, for the markets to move higher. Well, check that last box; the Fed’s Balance Sheet declined by $27.8 billion, basically a non-event.
Fed’s Balance Sheet
As for those few Wall Street strategists who said the Fed’s Balance sheet correlation to a beta move higher and was a garbage reason for equities to catch a bid. All we have to say is it’s been a 13-year tight correlation, and old habits don’t die quickly.
NASDAQ price to BS
Unfortunately, we can only look at all available information that is in the market right now and attempt to forecast critical trends that are taking place. That means not just equity trends but more importantly credit trends. The most significant outlier we discussed last Friday as the most bearish catalyst for equities, especially technology, is a fast resolve of credit tightness back to pre-SVB failure. If this happens, that 120bps worth of cuts projected by mid-2024 will quickly dissolve, and equities will be liquidated faster than we can say, HEADFAKE.
It will be a very fluid game-time decision to increase or decrease beta exposure. However, right now is not the time to take risk-off, even if we see some back and fill come Monday of the new quarter. Currently, the setup seems to be leaning towards the following outcome. However, this is certainly subject to change.
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Both NASDAQ (Futures) test the 13,600 level and the S&P 500 at 4,250, possibly 4,300, under the following easing conditions. Both levels should be used to de-risk equity exposure if all of these bullets line up.
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Credit Spreads: Spreads on BAMLHOA1HYBBEY vs 2 Year Note = or less than 2.60%
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Libor- OIS spreads: Below or less than 15 to 10
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The yield curve: 2/10 spread inverted back into the -75bps to -.85bps levels.
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Fed’s Balance sheet: The balance sheet starts declining by over $100 billion. We are in the camp, yes this matters. Meaning banks don’t need the Window and liquidity taken back.
S&P 500 Breadth
The breadth is not constructive obviously, yet once again that is turning off weaker levels. For those unfamiliar with our Strong Buy to Strong Sell ratio, let us describe what you are looking at below.
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We grade every stock in the S&P 500; on a high level, we look only at the number of Strong Buys vs. the Strong Sells for the breadth of the S&P 500.
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When they cross each other, this can cause a risk-on or risk-off event.
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In this current case, we see the number of Strong Sells in red reversing lower and the number of Strong buys in green increasing off a low base.
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Set up low participation that is turning constructive.
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No one is long, although several stocks within the S&P 500 are becoming more constructive.
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From our historical experience, it would be a rare occurrence under a normal distribution or expansion for the number of solid buys to stop here. Both the number of strong buys and strong sells will likely get close to converging before any meaningful sell-off occurs.
Next up, In the larger picture going back to 1992, the S&P 500 (futures) is range bound at 4,250 to 4,300 (today’s close is 4,140). We say 4,300 because our S&P 500 blended model is sitting at a .05, and if it means reverts to a typical short-term rally of a 50/60 reading, which would be in line with historical rallies, that would give you roughly a move to 4,250/4,300. We are not suggesting the model can gain that type of momentum to a 50; we are only making an observation.
However, 4,300 would be a gift to decrease beta risk if we start to see that 120bps of cuts are being walked back. We will see these being walked back with a few of the simple high yield and credit spreads and 2/10 spreads. For those who use Bloomberg, you can track the terminal rate and Fed Fund projections on those functions.
If we move higher, we need to see greater participation besides tech. Consumer Goods and Consumer Cyclicals had the most significant rating value increase this week in our models. Industrials, then materials followed. Health care looks so bad coupled with energy; you might see some catch-up here if the S&P 500 can reach the 4,250 target.
Can the S&P 500 reach 4,300 and the NASDAQ take out 13,600 for the ultimate test of 14,500? Investor positioning is so bad it’s conceivable. Consensus does not generate alpha that is for sure. While we do not look at any sell-side research within our models, we thought we would pass along some charts. Goldman Sachs Prime Brokerage chart showing Long/Short Net factor exposure while not actionable; it does show you how the industry is positioned.
Everything is lining up for some significant off-sides non-consensus push higher that will draw everyone into much higher levels. Once we reach that point it will be an almost certain setup that the 120bps currently forecasted rate cuts will be removed causing a short-term momentum crash in technology.
March 29th
The next move on the Indexes will all come down to how credit starts normalizing.
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The 120bps of the projected rates by mid-2024 will be returned/walked back once the market pushes higher and credit starts to normalize.
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The recent credit tightening did not result in at least 100bps of rate hikes that were believed would slow down inflation, as consensus believes to be the case.
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If you believe that 65% of all C&I lending that Regional and Community banks do in the country will have little impact on the economic growth or earnings in the coming months for small businesses.
As we stated in our last commentary, the worst thing that can happen now for Technology and the NASDAQ for long only investors is a quick de-escalation of the bank crisis that starts taking back the 120bps of rate cuts priced in as of last week. This has not happened yet, but if or when we see normalization of the recent credit stress to previous pre-bank SVB failure, the NASDAQ / Technology will not enjoy this outcome. We can see this narrative playing out.
Our last post discussed the initial loosening of credit stress would be a positive for the most economically sensitive and levered companies. We thought the S&P 500 would have outperformed technology, although that only lasted all but two days. As of now, we are still watching the following data below for a narrative change to the Fed can not pivot, and it won’t be inflation data.
The fast these data points normalize, the worse for the Fed Pivot narrative.
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Credit Spreads: Spreads eased from a high of 3.63% on Friday to 3.08% today. It’s good enough for the markets to celebrate for now. However, if we ease into the mean level of 2.70%, this is where we surmise some rate cuts will be taken back, and this will be a negative for all equities.
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OIS Spreads: As discussed with the OIS spreads, this is important for interbank lending and liquidity. On Friday, spreads were around 45, and as of yesterday, they were 38. Unfortunately, we don’t have real-time data on this and are unsure if Bloomberg provides real-time either. We see less stress than the 65 spread reading from a week ago. Markets want to see this spread normalize to 10 to 20. However, this normalization will hurt the Fed put removing some rate cut expectations.
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2/10 Yield Curve: As discussed, the 2/10 was another indicator to monitor if the banking crisis was being discounted. As we said, if the 2/10 spread becomes more inverted, this is pricing in less banking stress and removing some of the 120bps of rate cuts that were priced in. Since Friday, we have inverted -.10%. Nothing meaningful as of yet, but if we get down to -70 to -80, it will negatively impact the market’s hopes and dreams of further cuts.
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Feds Balancehseet: Last but not least important, we wanted to watch the Fed’s balance sheet. The Feds website has not updated the data yet today. We do not want to see the BS expand beyond the current or last week’s $8.733 trillion. While yes, it could provide fuel or liquidity for the indexes, it will also worry credit markets that liquidity is a concern. So current levels will be goldilocks.
Index Level Look
The question is how quickly will credit start to ease and by how much. The slower the ease, the more opportunity for the S&P 500 and NASDAQ to grind to their major inflection points. If credit spreads normalize too quickly along with OIS coupled with no Fed balance sheet contraction or usage from the discount window, we can see the narrative change quickly to one of concern that the Fed rate cuts are off coming off the table.
In the first scenario of a potential slow normalization of credit easing (not quick), the S&P 500 and NASDAQ have more upside.
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In the first chart below of the Strong Buys to Strong Sell Ratio in the S&P 500, we can see the breadth of the market is terrible. As we pointed out back in mid-February, the S&P 500 started to see cracks and thus a high probability of risk-off. Today we are seeing the inversion of this setup; the number of strong buys (green line) is building off a low level, and strong sales (red lines) are starting to decline.
For the last five or six weeks, we have discussed the NASDAQ futures 12,800 level as a pivotal level. We said a close, especially on a Friday, could quickly take the index to 13,600. Regardless if we believe the S&P or the NASDAQ should be trading at these levels, the market is giving us this setup.
One interesting fundamental statistic is the Semis are trading at one of if not the highest premiums to the S&P 500, at roughly 30 times. At the same time, there is no historical sell trigger based on this fundamental data, which makes it statistically non-relevant for an imminent reversion lower from here. Even though we don’t look at fundamentals, if the market does start to walk back the recent 120bs cuts, semis are getting to a relative variance level vs. the S&P 500, not seen since Nov 2021.
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Only three times since SOX was incorporated in 1995 has there been this wide of a technical variance.
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To reach 1995 levels, the SOX index would have to climb another 30% to 40% from the current level. 1995 resulted in over a 50% peak-to-trough loss.
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To reach 2000 levels, the SOX index would have to climb another 20% from the current levels. 2000 resulted in over a 60% peak-to-trough loss.
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To reach 2021 levels, the SOX index would have to climb another 10% to 15% from the current levels. 2021 resulted in over a 22% peak-to-trough loss.
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For Drawdowns calculations, we are only looking at the annual basis and not the multi-year or decade, which would be far worse, as you can see.
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As long as the Fed can continue to hold QE, no worries for this industry!!!
We would suggest once again if credit starts flowing in a normalized fashion and everyone is sucked into the NASDAQ for the 13,600 level, it will be a painful correction starting with the semis. Of course, if the data finally shows large NFPs (Non-Farm Payrolls) negative prints, coupled with cracks in prices paid we will back to discussing QE for a larger breakout within the NASDAQ. Both seem very, very unlikely at this juncture based on the high-frequency data over the last 5 days.
In summary, 13,600 would be a significant opportunity to reduce growth factors or technology unless PCE and CPI have game-changing declines in the next print.
March 27th
The signals are apparent; there is no direction.
This weekly wrap-up is more about looking at different data & charts than forming opinions. Even attempting to forecast the next move in this tape is insanity.
As our March 16th note stated, “It is possible that if the Fed delivers a message of .25bps next week and they are on hold, the NASDAQ will finally break out of that massive 12,800 level on the futures we have been discussing for months (see below). A weekly close above 12,800 on the NASDAQ futures will take the index back to 13,600 without blinking“.
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Today the NASDAQ (Futures) finally had a weekly close above its volatility stop seen in red dots (see first chart below), which failed at all attempts in the previous 14 months. Does this have any strong statistical relevance; no, however, I would not bet just yet against the NASDAQ moving to 13,600 before a meaningful mean reversion any time soon.
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What will cause the NASDAQ to give back its recent gains will be the bank credit crises mostly (not -entirely) averted and the 110bps of rate cuts in 2024 being taken away as fast as they were added (see the fourth image of Fed Funds Outlook). The gradual add-back of the rate cuts will look like this and how to play it:
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Credit spreads tighten up from between .40bps to .60bps (see second chart below). We look at the BAMLBBEY vs. the U.S. two-year note, although you can use any credit spread you like. This will provide a good enough look at how worried the market is about small capitalization, and levered companies will access much-needed capital.
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Libor- OIS spreads will decline as well. They will move back to 10bps to 20bps signaling calm and removing stress from the interbank lending market (see third chart below). Spreads reached 60bps a week ago and now sitting at 35 after the Fed created the dollar swap arrangement last Sunday. The Libor-OIS spread is the difference between Libor – the floating rate at which banks lend to each other and the overnight index swap rates that central banks set. So this is a good indication of stress with interbank lending.
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Not as essential, but something to watch on Wednesday is when the Fed updates its Balance sheet, investors will want to see if it has seen significant expansion from banks accessing the discount window. You can find the data on the Fred website. If there is little to no change, that will be very very positive.
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The yield curve will bear steepen, signaling fewer cuts are coming. Today the 2/10 spread steepened to -.27bps before closing at -.40bps. It was only a week ago the curve was sitting at -1.08bps. (See fifth chart 2/10 yield curve)
How this scenario plays out:
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This scenario will be ideal for the most levered companies. Sectors to catch a significant bid will be Energy, materials, and industrials will see massive counter-trend rallies. On a factor basis the worse the balance sheet the greater the rip. Counter, tech may not sell off, but it will underperform.
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Bonds across the entire curve will be stuck in limbo with continued volatility.
NASDAQ
Remember, as we discussed last weekend, every time the 2/10 yield curve steepened like the one we just saw resulted in a recession 1 to 3 months later, 100% of the time over the last 70 years. Not sure if this matters on the index level; however, it will be within factors.
Goldman Sachs shows this chart below of CTA positioning within SPX. While it screams unweighting the S&P 500, we don’t know how this correlates with the S&P 500 historical mean reversion. So we take this with a grain of salt.
As Simon White, the Bloomberg macro strategist, points out, 2/3rd of QT was just reversed in the last two weeks, coupled with bank reserves 30% higher.
(click to enlarge the chart below) Ultimately, if we are concerned with the S&P 500, we only care about our S&P 500 composite blend model, as that is our go-to model. We stated back in January we were looking for a 70 reading before any mean reversion. Unfortunately, the model only reached 58. We thought a reversion to 0 would be in play, and currently, we sit at a -20. There is no high probability set up here. For those sitting in cash, a move to -50 would be very advantageous to get long the S&P.
Powell balanced his speech as best as possible until Yellen tripped him up.
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Around 3:00, credit spreads jumped/widened by .30bps (see first chart) after it was reported Janet Yellen, as seen in Nick Timiroas’s tweet below, is not considering universal-wide deposit insurance. Granted, some of this widening of credit spreads resulted from Powell’s remarks, but the bulk seemed to come from Yellen’s statement.
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The statement lacks details; however, if accurate, it’s a significant blow to the trust in the banking system and credit markets. (see chart below for bbb corporates vs. 2-year spread). It was only 24 hours ago that Yellen said there would be implicit support for small banks. There is a lack of communication here, and it looks messy. If she can explain this away tomorrow, we can expect credit spreads to firm up once again and the most economically sensitive and balance sheet-challenged equities to catch a bid. Unfortunately, who knows what she meant yet and if she and the Fed are working on a different path to sure up depositors’ risk.
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On the technical side, you could argue that today was a textbook key reversal/island reversal that did transpire on both indexes. The NASDAQ futures rallied to 13,082 before reversing to close at 12,687, unable to hold that 12,800 level. However, the growth trade is not yet finished under the current economic backdrop. High ROE, Low Debt to Equity, and increasing Free Cashflow companies will see fund flows if growth is perceivably challenged and credit remains constrictive.
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Unless Yellen can return her comments quickly or devise a different plan to guarantee depositors, the S&P 500 next stop is 3,888, with materials, energy, industrials, and financials leading the market lower. The current pattern for the S&P 500 does not instill confidence.
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Even though Powell repetitively said he and the Fed are not entertaining rate cuts or “not their base case,” the Fed Funds Futures are certainly saying they are coming.
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As we mentioned, the restrictive credit would be deflationary, and apparently, the Fed is well aware of this in their rate glid path. Powell said some members recognize the impact of the financial system crisis on credit tightening, which could do the job of some rate hikes.
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The market has been fighting Powell for a year; seeing this struggle is incredible. Bloomberg is now putting the odds of a 25bps increase in May from 70% to below 50%. Goldman Sachs was way off with their call of no 25bps today and three more 25bps over the next three months.
So was that the start of a new bull in the NASDAQ we discussed on March 16th?
“Was the demise of SVB the end of the Bear Market for Technology? As you will recall, on February 9th, we said something would break in the economy if the inversion of the 2/10 spread broke below -.94%, at which point, three weeks later, the curve proceeded to invert to -1.08%. Several days later, we had the world discussing HTM (Held To Market) securities losses on Bank’s balance sheets and run-on bank deposits”.
In the March 16th post, we said a NASDAQ (futures) close, especially a close on a Friday (weekly) above 12,800, would be a powerful trigger and take the index to 13,600. This is because, for 14 months, the NASDAQ futures has rejected every volatility stop the break-out attempt. Like the 15,200 and 13,600 levels we said to sell into and take down growth exposure. This is now a fundamental & technical potential game changer signaling that the rate hiking cycle is over. Unless Powell completely shocks the markets on the theory of future rate pauses, the NASDAQ will probably finally break above its volatility stop.
Negative Senario tomorrow:
However, if Goldman Sachs is correct tomorrow and Powell does not raise .25bps, there will be an issue. In this case, the S&P 500 will potentially rally 100 handles to 4,130 and reverse into the red, causing significant concern that he sees real-time credit collapsing.
The Balance sheet’s false signal
Many investors, including ourselves, thought the initial $300 billion of the Fed’s balance sheet expansion from the BTFP program was enough of a positive liquidity event for long-duration assets to catch a bid. However, what we did not realize was only $12 billion, as of last Friday, of the $300 billion was accessed for liquidity purposes by banks. So there isn’t any more liquidity yet to say this current move is from a typical QE move and more of future rate pause protections. This was positive for credit and the markets as banks might not have felt pressure to access the window. However, it would seem logical to some investors to align the two relationships (QE expansion + Price multiple expansion) based on the 13-year solid correlation.
Price is reality when all else doesn’t add up.
We believe the price is truth; however, for fundamental discretionary investors, it is difficult to wrap your head around unfathomable situations of a breakout of the NASDAQ when credit is on the verge of contracting. The odds of a worse economic contraction are increasing. Just look at Bank of America’s FMS growth outlook this month. However, this is the herd, and consensus never generates alpha.
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In terms of assigning tomorrow’s outcome, everyone assumes the market will be disappointed regardless after a 600 NASDAQ point rally as every trader just tried front-running one of the most vital Fed decisions in a decade.
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Yet, while it will take months to see the current restrictive credit implications, if Powell does indeed signals they are on hold for the foreseeable future tomorrow, the next stop is 13,600 (NASDAQ Futures) & 4,300 S&P 500 futures.
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However, since the Fed is reactionary or what they call data dependent, we don’t believe Powell will signal they are finished and more of a wait-and-see, which will give back most of today’s gains. This 12,800 NASDAQ futures are a pivotal level, so it won’t be so easy on a weekly basis to finally get confirmation of a breakout.
As pointed out a few days ago, based on our models, 50% of the strongest 20 stocks in the S&P 500 are now technology. Leadership does not change this drastically fast, leading us to believe this could be a genuine regime change. Even though Semis and some “GARP” names didn’t participate, today was more of a story about credit spreads easing and more levered stocks participating, like energy, materials, and industrials.
How long can markets defy gravity from their comfortably numb state?
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The S&P 500 futures closed at 3,940, about 17.50 times forward earnings on a consensus of $225 per share. How can this be logical based on crashing PMIs, ISMs, 6% CPI, a yield curve that, as of 7 days ago, was -1.08%, and now credit is tightening? This seems to defy the basics of economic and fundamental logic.
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While this bank mini-crisis was not a complete black swan event, it’s close enough and flipped almost all sectors, excluding technology, to express that EPS compression is coming. Energy, Materials, Consumer Cyclicals, and Industrials went from expansionary signals to economic contraction within one week.
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With our Dynamic Alpha strategy, the strategy is now in the process of rebalancing securities that are heavily tied to a restrictive credit cycle. Unfortunately, the reality of credit tightening and being long capital-intensive businesses highly connected to credit cannot be held without expecting further downside. Instead of hoping and praying that credit markets will recover, the systematic strategy has made significant adjustments to accommodate the current economic reality. While we cannot forecast if this situation turns out to be a more restrictive credit event, risk needs to be removed from the portfolio from these market areas.
When does economic reality ever supersede the Fed’s Balance sheet?
We have seen this story before as 25% of the S&P 500 comprises ten stocks, all highly correlated to the Fed’s balance sheet or long-duration stocks. GOOG 3%, AMZN 2.5%, MSFT 5.59%, AAPL 6.62% NVDA 1.74% and TSLA 1.66%. We have never witnessed a Fed using its balance sheet to fight economic disaster until the great recession of 2008. This has caused a lot of textbook cycle investing to be thrown out the window as price discovery has been irrelevant and a significant reason the S&P 500 is sitting close to 4,000. After 12 months of QT (Quantitative Tightening), the market believes or hopes QE (Quantitative Easing) is back. The Fed’s balance sheet expanded by $300 to $400 billion this week, causing long-duration assets (AKA Technology) to increase significantly. While this helped technology, it also caused panic in other sectors as credit tightened.
A few strategists were out this week calling this move higher in tech “garbage” due to Fed Balance Sheet expansion. While it may be a silly catalyst, the 12-year relationship does exist between the Fed’s balance sheet and technology, as seen in the first chart below. Although we agree, the massive amount of borrowing ($300 plus billion) from the Fed’s discount window is screaming a lack of confidence seen in the second chart from Bank of America. One of the main reasons we believe both Small Business Optimism and Lending Standards are tightening is seen in the third chart provided by Bank of America.
Now keep in mind, as with any data, this chart does have one caveat. Historically, all banks borrowed from the Discount Window were made public, causing a negative stigma. This is no longer the case, and banks are not required to disclose if they access the Window. If or when the balance sheet starts to reverse lower, this will help the most economically sensitive or capital-intensive sectors (energy, materials industries, airlines and cruise lines, and autos) catch a bid. Conversely, you might see some selling within technology.
Over the next few months, the market will learn the fate of just how much economic contraction has occurred with restrictive credit caused by this current banking issue. As we discussed for many months, a credit event would be the only way a strong enough recession would begin to see a negative non-farm payroll. The economy’s lifeline is small businesses, and once capital is restricted, cap ex slows down, and jobs are lost.
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As Sandford Bernstein shows in the chart below, it takes 1 to 3 years. In the last two cycles unemployment lags behind falling GDP. However, the market seems to be already pricing this in when many areas of the market.
Even though credit spreads have not widened for a strong signal of credit slowing, the markets suggest otherwise. First, the most levered and capital-intensive sectors and industries, excluding banks, materials, industrials, and consumer cyclical, are down 20% within seven trading days. The 2/10 yield curve had a massive bull steepening from a low of -1.08bps to -.45bps. In every recession in the last several decades, the 2/10 yield curve significantly steepens within three months of a recession.
But remember, as Morgan Stanley shows in this chart below, equities rally 6 to 9 months before earnings reach their lows in previous bear markets.
Unfortunately, the Fed has made this cycle more challenging than ever, as they have destroyed true price discovery. It’s rather apparent that the S&P 500 still trading at 17.50 times forward earnings under the current economic conditions is nothing short of highly generous.
We have said for a year this reduction of liquidity was going to take a long time, as just last month, both private and public companies were trading at 245% of GDP, well above the historical mean of 100.
As for technology, the NASDAQ futures hit 12,800 and was rejected. Does the index finally break out? Only time will tell. But a breakout only because the balance sheet grows and rates move lower on further banking stress is a head-scratching catalyst.
March 16th
Was the Credit Market cracks the start of a new technology bull market?
Was the demise of SVB the end of the Bear Market for Technology? As you will recall, on February 9th, we said something would break in the economy if the inversion of the 2/10 spread broke below -.94%, at which point, three weeks later, the curve proceeded to invert to -1.08%. Several days later, we had the world discussing HTM (Held To Market) securities losses on Bank’s balance sheets and run-on bank deposits.
We said over the past weekend, the Fed had an obligation to help the banks out, and 10 hours later, they did just that with a friendly discount window program called “BTFP” (Bank Term Funding Program) to lend on the bank’s HTM securities for one year at par. However, what happened along the way is a small but rapid credit spread widening. This caused levered companies’ stocks to implode as the market worried about lending and access to liquidity. As we have pointed out, a recession occurs only once a credit event transpires and spreads blow out. Credit spreads are not getting wider and have improved after today’s move. We are 200bps well before real credit contagion risk crushes equities.
But two positive catalysts have just emerged from this banking issue for technology or growth mainly:
- This little credit event just helped Powell with his fight against inflation, as 20% to 30% of all U.S. lending happens outside of the large Money Center Banks. Thus this means that loans and credit, or at least the markets believe, will tighten as smaller banks’ margins will be compressed as they will need to pay up for deposits after this little issue we witnessed. So this is not highly bullish for lending, which is deflationary.
- Conversely, we might have more liquidity, possibly QE, as the balance sheet will need to expand for BTFP. As JP Morgan strategist Nick Panigirtzoglou points out, this BTFP could result in tremendous liquidity in the system, as he says.
“Fed officials have reportedly said that “the BTFP is big enough to cover all uninsured deposits in the US”. Of the close to $18tr of domestic deposits, around $7tr are uninsured. With the largest banks unlikely to tap this facility, we believe the max usage envisaged for this facility stands closer to $2tr which is the par amount of bonds held by US banks outside the five largest.
It is worth noting that there no limit on the amount an individual bank can obtain; i.e. any individual depository institution may borrow up to the par value of eligible collateral. In addition, while the US Treasury will backstop the BTFP with $25bn from the Exchange Stabilization Fund, this does not necessarily limit the potential size of this program as it can be levered multiple times. Moreover, the Fed said it does not expect to tap these funds because the loans under the program have recourse beyond the pledged collateral.”
NASDAQ Breakout?
So while the industrials, energy, and materials might signal an economic slowdown, growth will be bought as investors pay up for 1. Earnings Growth 2.) Technology has been the only sector to see a trough in earnings. 3.) The Fed might signal next week they are pausing. If the Fed delivers a message of .25bps next week and they are on hold after that, the NASDAQ will finally break out of that massive 12,800 level on the futures we have discussed for months (see below). A weekly close above 12,800 on the NASDAQ futures will take the index back to 13,600 without blinking. However, this does not mean the cyclical and more economically sensitive stocks will participate.
Between Microsoft sounding amazing today at their AI conference and expanding AI into their office 360 and Adobe’s solid earnings and a valuation rest
So, the trillion dollar question is what plays out more, the amount of liquidity being thrown back into the system or the past historical correlation of previous bear markets. This chart below from Teir1Alpha displays a pattern that, without more liquidity, prices are still on firm ground. The only thing so far that matters is, yes, liquidity.
Call me or reply to this email to set up a time for a Webex to learn more.
March 12th
A pivotal Monday for the Banks. The Fed needs to step up to the plate to calm markets.
Even though we touched upon SVB’s failure on Friday, it would be appropriate to touch upon a potentially significant market development that is becoming very fluid over the weekend.
Besides capital/equity, trust and faith are our financial system’s bedrock. Over the weekend, the mainstream media is doing their best to drive clicks by selling fear to the general public about SVB’s failure. Several sell-side research firms have been discussing other regional and smaller banks with similar depositor bases to SVB that could run on deposits as early as this week.
The reality is the Fed and Treasury should do their best by Sunday night or before business Monday to make sure dispositors receive 100% of their cash as quickly as possible to avoid further fear. The last thing that needs to happen is for the general public to see SVB depositors only receive 50% of their cash within the next week and receive the remaining 50% over the next few months. Without an expedited recovery of depositors’ cash, there will be a massive loss of faith.
The point of this note is not to worry investors or feed into the hysterics. Nor will we discuss individual stocks being discussed as possible bank runs. This note provides the mechanical structural issues of what this means for the financial system.
First, let’s provide a rehash for those who still need to read the last couple of posts regarding the issue facing SVB and similar banks.
The basics of banking:
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Banks are leveraged institutions; they typically can lend up to 10 times on their equity or what is known as TBV (Tangible Book Value).
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Loans must typically match 80% to 90% of the bank’s deposits.
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Banks TBV is considered to be Tier 1 capital.
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Banking regulators require at least 4.5% Tier 1 capital before a bank is forced to raise money. Most banks have 7.5% of tier 1 capital which is considered healthy.
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Bad loans that are unrealized or realized go against Tier 1 capital.
Now that we got the basics out of the way, the bottom line is a bank’s equity and capital ratio are vital for survival. Every bank in the county, not sure of any that doesn’t have some amount of their equity in HTM Securities (Holding to Maturities). HTM can range from money markets, long and short-duration treasuries, Commercial and Mortgage back bonds, and municipal bonds. This is a widespread practice.
Some banks over the years took more duration and credit risk as there was no yield/return in money markets, leaving banks with more duration risk within HTM exposure. Since the Fed embarked on the fastest rate hike in history, this has caused a lot of unrealized losses for banks. The Fed is and should take some blame and pressure off the banks as this could create systematic market disruption. These HTM losses are applied against equity but only realized once sold; if bonds rally or mature, the equity will reverse and increase TBV. Only when the HTM securities are sold will the bank realize the losses and applied against the TBV. Remember that HTM is constantly marked to market by the bank regulators, and TBV is being adjusted.
A general look at banks’ HTM and equity
The following institutions (data provided by BankRegData.com) show the bank’s equity and HTM losses. It’s clear that if there is a liquidity event, meaning depositors want their cash immediately, these banks need to generate liquidity instantly. If they don’t have enough money (liquidity), they would most likely need to sell their HTM securities (currently) at a loss, negatively impacting their equity. If a bank’s equity brings its TBV below 4.5%, it must raise capital. A few companies below don’t show the holding company’s total cash, so you can only see the brokerage firms singularly. However, this gives you a sense that HTM losses are not just an SVB story.
Below is an excellent chart from TS Lombard showing how smaller banks are having a more challenging time than large banks bringing in new deposits.
The bottom line is that the Fed is responsible for taking extraordinary measures as they partially result from these HTM losses and must calm fears before panic ensues. Other banks run a risk of systemic.
March 10th
Fear of contagion is spreading, but does SVB really matter?
So what just happened today?
Besides the obvious of Silicon Valley Bank being shut down. Is there a real risk of contagion?
Back on February 8th we stated:
“We can see where credit spreads start to expand if we take out the lows of this cycle and move to the next support area (2/10 yield curve) of -.942%. I would assume the narrative will shift to one of concern, where markets will focus on the credit markets and the potential for slower lending to the most risky parts of the cap structure”.
Well Silicon Valley Bank was the first casualty of this stress within credit and yields. But! It was not from their loan book, it was from their fixed income investments.
This is why we believe the situation is different than most banks out there except maybe 5 or 10. SVB had extraordinarily large amount of securities on their balance sheet. We are not sure how a commercial bank was allowed to own 50% of its assets in Treasuries and Agencies securities as technically the FDIC does not allow this type of concentration. The bank had 57% of its assets in bonds as a reference point. JP Morgan has 19% and Bank of America 30% (which is why BAC is down a lot more than JPM). The bank with the second highest exposure to treasuries is CFR Cullen Frost at 42%.
That means Silicon Valley’s $212 billion in assets was $120 billion in fixed income ($57.7BN are Held to Maturity (HTM) Mortgage Backed Securities and another $10.5BN are CMO, while $26BN are Available for Sale with $16BN). As rumors started to swirled around a potential run on the bank, SVB needed to sell treasuries and MBB and CMO’s at what we can surmise massive losses. As depositors asset for more money SVB needed to sell more Treasuries. These losses go against the banks tier 1 capital and as tier 1 capital declines the bank must increase its equity. If tier 1 capital is not maintained at a certain level let’s say 10%, the FDIC will shut you down in very fast order.
After 2008, most other local banks realized there was no need to buy SVB as they would most likely receive the deposits for free after SVB’s failure. So why take on any risk of buying a bank where 50% of its assets are fixed income?
So is there a risk that other banks can follow the same demise? Well there are only 7 banks who have greater than 30% of their balance sheet assets in fixed income securities. So it’s not as dramatic as SVB. The real issue is how credit spreads have moved .20bps in the last 2 days. This is why the markets are worried, it’s not really about SVB failing in of itself. This had an obvious impact on the most debt laden companies, they were absolutely crushed in the last 2 days. This is how a credit crunch begins as spreads widen and grind to a halut as lenders tighten lending standards. Credit spreads currently are only around 1.97, historically when the world is blowing up credit spreads will have already blown out to 5% to 7%.
Now What?
Well the good news is the S&P 500 NASDAQ have already worked off a lot of their excesses and weak longs have sold. We can see a test and bounce off the S&P 500 (futures) 3,800 next week as long as President Biden was right. IF you missed it, the market turned green today at one point after the President eluded to a good CPI next week. However, I am very doubtful he knows the number.
Levels really are not a factor here, what matters is credit spreads and if they can calm their widening investors will feel less anxious about contagion.
Growth Update
As we mentioned next week we will be going live on Envestnet with All Weather Growth. Today we took down all of our TLT exposure and welcome more growth opportunities at better values. If you have not reviewed the All Weather Growth portfolio visit the link below, you will not find another Growth Asset Allocation like this.
S&P 500
Back on February 9th we said we were watching closely our Strong Buy to Strong Sell S&P 500 ratio saying the following.
“First, I am basing a lot of this on my Strong Buy to Strong Sell ratio getting up to that 380 strong buys that I referenced prior, as it is now mean reverting already. We sucked in enough longs at 390 strong buys on Tuesday to cause some weak longs to sell and get a nice unwind.”
As of yesterday’s close we have fully reverted and crossed, so a lot of weak long’s are now out of the market. As long as this cantaigna doesn’t become systemic next week we should at least see technology / growth get bid if Biden was correct on next weeks CPI.
Lastly, to put the S&P 500 in a longer term perspective, we have a chart of our S&P 500 sentiment model going back to 1992. You can click on it and it will give you a large image. We are currently just about a 0 reading, which is basically neutral. However, if you believe if the S&P 500 is oversold after a peak to trough decline of 340 points, think again. This model does not become oversold until a -50 reading at a minimum. We are not saying we get there, we are only referencing what oversold is on the model. If credit spreads widen more next week, this model will move lower.
What just happened today?
Today in our opinion there were two very different negative catalysts.
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After the Challenger Gray & Christmas data this morning, machines and investors tried front running what Goldman Sach’s says will be a big miss to the downside on Non farm payrolls. This sent yields much lower as expected and now the markets narrative flipping to bad job data is bad for the markets. It was only a few days ago good jobs data was bad for the markets. The most economically sensitive sectors and industries were sent much lower even as the indexes were well into the green in early trading.
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Then risk spread as SIVB Bank played significant havik across all financials as investors fear that a once $20 billion market cap bank (now $6 billion) is now a donut even after raising capital. This bank let us remind everyone is a tiny $200 billion in assets and the loans are not your typical commercial or regional lender old school real estate & business loans.
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Challenger Gray & Christmas data showed U.S.-based employers announced 77,770 job cuts in February. It is 410% higher than the 15,245 cuts announced in the same month last year. (See first chart)
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Just like that the markets flipped factors starting a little yesterday and in full rotation today selling the most economically recessionary sensitive sectors.
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Today also did not help the banks and fears of risk spreading as SIVB lost 60% of its $14 billion market cap alone today on bad loans and needed a capital injection. However, this is certainly an overaction for the bloodbath the Money Center & Regionals saw today and especially in non-lending financial institutions like insurance companies. SIVB loan book is a completely different animal than traditional banking institutions. However, passive indexing always exacerbates the tail risk across all names initially. Even non lending insurance companies that we own that are low beta .40 to .50 like RE -3.38%, ENM -3.07%, HIG -2.06%.
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Something just seems off with the BLS stats with 3.4 unemployment, yet the total number of Americans on some form of unemployment benefits is near the last 12 month highs. Almost every sell side bank finds the Dept of Labor’s numbers to be fuzzy at best at this juncture. This brings us to both Goldman and Deutsche Banks note below. (see second chart)
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Goldman Sachs Jan Hastzius was out today saying they expect to see a large spike in claims.
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Lastly, Jim Reid from Deutsche Bank who does a better job than most of his peers thinks it’s a matter of time before the Dept of Labors drop to a negative number as seen below. We have mentioned many times over the last few months that a few negative prints will be the time to get long technology. (see third chart)
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The bottomline: Over the last few days the market has attempted to front-run the risk of tomorrow’s NFP number in a number of areas of the market. If the number does come in significantly lower than 200k, technology and growth dips (NASDAQ 11,750) will be bought and the S&P 500 will underperform growth as the market will price in quickly here come the rate cuts once again.
March 8th
Rates
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While equities remain exceptionally resilient, the market smells economic growth slowing more as long duration yields were flat today with the short end moving higher. This caused a new cycle inversion on the 2/10 spread for a close at -1.081%. As we mentioned back in December, once valuations reset within growth investors will seek higher growing companies once a potential recession is imminent. This could be an explanation for the continued NASDAQ outperformance of the S&P 500 and more defensive Dow.
JOBS DATA
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JOLTs: As we reported yesterday, Goldman Sachs was looking for a 800k drop in the number of job openings, well they were off by 390k. The US had 10.824 million job openings. (see first chart)
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There are now 5.13 million more jobs than unemployed workers, which is not that far off from the all time high of 6.055 million in March 2022.
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ADP beat expectations of 200k jobs with 242k, but the good news was wage growth seemed to be slowing. Pay growth for job stayers slowed to 7.2 percent in February, the slowest pace of gains in 12 months. Pay growth decelerated for job changers, too, falling to 14.3 percent from 14.9 percent. (see second chart)
Powell
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Powell said nothing new today in his prepared remarks. The most amusing part was listening to the committee members with their remarks and statements.
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The market did get excited because Powell threw an “IF” into his opening statement, noted by the WSJ Nick Timiroas.
“If — *and I stress that no decision has been made on this* — if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
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While at the short end of the curve the 2 year yield moved up to 5.07%, technology especially semiconductors were well bid coupled with a stronger U.S. dollar. The 2022 play book of selling off long duration assets is over for now. The multiple reversion is over and now we need to see earnings trough for the next the next major move in the indexes.
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Powell said nothing new and is still data dependent and needs to see the JOLTS , the NFP report Friday, and next week’s CPI he said and has made no decision on Marchs move. The next 5 trading days are certainly going to be pivotal for the next several weeks.
Food For thought
While this is not a trade or an investment recommendation, XLU is looking interesting as it is currently yielding 3.45% and starting to catch a bid from being oversold. Of course, utilities have a lot of competition right now from Treasuries. However, this will make for a very favorable set up if XLU can move lower into the $62 level on a move higher in yields seems compelling.
No opinions today, we are just providing data. Nothing too earth shattering this week to report and most noise and a traders market based upon technical levels. This week was mostly noise caused by Fed officials, some hotter economic data and mostly mechanical moves on the index level from system traders. Let’s take a look at a few things that are already priced into the market and what the market already collectively knows.
2/10 Yield Curve
Money Market Flows
While Market Flows is not a leading indicator, or even an indicator at all, here is a data point to be aware of. We have reached an all time high in Money Markets as rates are giving investors a safe haven with a decent yield. This more importantly demonstrates just how much liquidity and cash is on the side lines. If inflation does start to show signs or the labor / wage data do decline pusing yields lower, this could be a massive amount of bullish firepower.
S&P 500 & the Terminal Rate
As we are all aware, after the last three weeks of stronger PMI/ISM’s, Prices Paid and Jobs /Wage data, the terminal rate went from 4.70% to 5.40% (see chart below). Thus removing 175bps of rate cuts for 2024 to only .25bps. But what is impressive is the resilience of the S&P 500. Granted the S&P 500 did just decline from peak to trough (4,202 to 3,921) 6.66%. However, the S&P 500 just recovered 3% from its Thursdays lows. Now, the 3% recovery is not that impressive. What is impressive, however, is we bounced on no economic data or weaker inflation data and concurrently yields across the entire curve all closed close to their highs. Now you know how we feel about why we moved, system traders coupled with discretionary traders could only remain short for so long as the indexes refused to stay below their 200 Day averages on 4 attempts in 2 days.
Now many of you will say the markets made their initial short covering rally after Fed President Bostic said the Fed would slow the pace and HOLD them there maybe by the summer, however, he isn’t even a voting member. But there was no doubt at the time of his statement the S&P 500 rallied 40 handles in a straight line. More importantly, however, what the market didn’t seem to care about was his other side of the argument saying the following:
“I’m going to stay open to any possibility that if data come in stronger than expected then I will adjust my policy trajectory,” Bostic said. “There is the case that could be made that we need to go higher. Consumer spending is strong and labor markets remain quite tight and that those suggest that the economy’s strength could be a bit more than people think, which means we might need to do more.”
The bottomline is this was just noise and a reason for a technical bounce. The Fed cannot forecast future economic development better than anyone else and investing based upon long term economic forecasts is silly.
If you don’t think the recent rise in rates is that sensitive to consumer behavior, just look at the chart that Bank of America provides below. US mortgages to purchase applications just hit their lowest level since April 1995.
Until there is a game changing catalyst with either 1.) inflation 2.) true earning trough 3. or a recession, this market will be a traders market that will continue to trade in a wide zone frustrating the crowd. After 14 years of easy money and central bank liquidity bubbles, we can experience this type of volatility a lot longer than everyone expects.
For the last few weeks we thought without the backstop of the market pricing in 200bps cuts and moving to only 25bps, that the S&P 500 (futures) could test 3,800. This week the S&P 500 only tested 3,921 before closing at 4053 on Friday.
Looking at the S&P futures on a 4 hour time frame below, the index has been rallying off its 3 standard deviations below its upperward trend mean and conversely correcting at 3 standard deviations above its mean. We can surmise that 4,100 and even possibly 4,200 are now in play at this juncture, especially if Powell on Tuesday remains dovish coupled with a weaker than consensus 200,000 BLS jobs print this Friday. The two previous variables are just not worth commenting on as they can’t be forecasted. Furthermore, the fact the S&P 500 failed to break this upward trendline from November this past week should in the short term continue to bring in shorter term long system traders as well as 0TDE (Zero Days to Expiration) option traders to buy dips.
0TDE as we discussed has been all the rage recently and used as the bogeyman for why the markets have been moving the way they have. (In every market period there always needs to be someone to blame for rising or falling markets). While there is no empirical evidence that these Zero Day to Expiration Options have been the culprit in impacting the markets negatively or positively, we will have to hypothesize based upon the sheer volume there is an impact on the markets. The recent surge in S&P 500 0TDE option activity is astonishing as pointed out by Goldman Sachs in the second chart we have highlighted before. 50% of all SPX options trades are now intra-day.
US Manufacturing saw Prices Paid Jump and bonds were not happy, which caused some equity pain!
The 10 Year Yield rallied to 4% and closed at 4.01%. In our opinion most of these stickier inflation prints like today’s Manufacturing number is already known and priced in as yields have already move .60 bps from the recent lows. If a lot of this wasn’t already priced in growth stocks and the NASDAQ would have been down a lot more. Unless you have not been watching the economic data this should have not come as a surprise that prices remain sticky. As we discussed before, if the 10 Year Yield can retest that 4.20% level from 2022, this would be a good entry point going out 6 to 12 months on medium duration bonds.
The saving grace for the S&P 500 and NASDAQ today was hugging the 200 day moving average. The indexes saw 3 failed attempts of staying below the 200 day moving average. This was nothing more than a trading opportunity, it is meaningless longer term. As we have mentioned before, we don’t believe the 200 Day Moving Average historically does not have very good predictive capabilities of future prices. So the fact we bounced off the 200 day on both indexes is not that relevant to us.
As you will recall:
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We told investors who are risk averse to sell the NASDAQ (futures) at 12,800. Today the index closed at 11,953
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We told investors who are risk averse to sell the S&P 500 (futures) at 4,130 and 4,170 respectively. Today the index closed at 3,955.
Without 200bps of rate cuts the market was pricing in 3 weeks ago for mid 2024 and only now projecting .25bps, It’s hard to justify the current multiple on the indexes.
As we wrote mid February, if the number of strong Strong Buys within the S&P 500 didn’t break above 400 the S&P 500 would set up for some reversion lower. Here we are on March 1st and this is exactly what has happened. We are now seeing 218 strong buy’s down from 390 and 129 strong sells up from 49. What does this all mean? Based on historical patterns, we would expect the number of Strong Buys to converge with the Strong Sells, thus causing more downward pressure on the index. Where the index finds support is anyone’s guess and we are not in the business of guessing. However, just based on the previous levels discussed, below 3,940 on the S&P 500 provides no sigficant support until 3,800 as seen in the second chart below.
February 28th
Please take your seat, we are in a “Holding Pattern” until further notice
As we discussed in December, earnings do not matter for the S&P 500 and multiples can remain high (18, 19 even 20 times forward earnings) as long as the market is discounting future Fed rate cuts. Well this is no longer the backdrop and puts the S&P 50 under shaky footing. The markets went from the Fed cutting 200bps by mid 2024 2 months ago, to now only .25bps by year end.
We have jobs data on Friday and regardless if we believe the BLS data, the head lines will impact the projections of inflation expectations. If breakevens on the 2 year does not start to level off and reverse, equities will be challenged.
February 24th
Let’s reiterate what we have been telling investors for the last few weeks.
S&P 500: Reduce exposure to the S&P 500 at 4,130 & 4,170 respectively. Today’s close was 3,973.25.
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On Feb 9th we said (here) the following, “S&P 500 Futures 4,059 is now in play and that is being a generous support level. I am leaning towards an unwind that will take you to that big level we discussed at 3,989″.
NASDAQ: Reduce the growth factor exposure once the NASDAQ futures reached 12,800. Today’s close was 11,994.25.
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On Feb 9th we said (here) the following, “NASDAQ 12,300 is in play and this is being very generous as this has little support. Remember that 12,000 is the real key level”.
Emerging Markets/China: If you joined our last webinar we said SELL emerging markets and China. We also highlighted these sells in our emails as well as we believe there are better allocations to allocate to with less volatility.
Fixed Income: For the last several weeks we have wanted to add to our fixed income exposure. Remember, our All Weather models coming into 20223 were 50% to 70% less weighted to bonds than 60/40 or 80/20. We will be adding to our last and final allocation IF and when longer duration yield retest their 2022 highs. In this case our portfolios will underweight their benchmarks by 30% to 40% within fixed income.
S&P 500 Review.
Strong Buy / Strong Sell Ratio:
We highlighted on Feb 9th that our Strong Buy to Strong Sell ratio getting up to that 380 strong buys was starting to mean revert already. We sucked in enough longs at 390 strong buys on Tuesday to cause some weak longs to sell and get a nice unwind.
Furthermore, we highlighted our composite forecast model and mean reversion model starting to mean revert too early for this current rally to continue higher.
This model is a great view of the S&P 500 during periods of duress and exuberance going back to 1992. We use this model to manage tail risk for our own Dynamic Alpha strategy (see here how we mitigated drawdown)
As we discussed in the past month a failure would come close to a 70 reading, however the model only reached 58 before starting to revert lower.
Even though we have remained defensive thus far in 2023, we are pleased that we did not get drawn into chasing technology at the recent highs of 12,930 on the NASDAQ. As of today are currently in 30% cash and welcome a larger opportunity to allocate this capital. Today we bought our first growth stock in 12 months PAWN as we sold two insurance companies (CB & TRV) as yields move higher. We do currently own HPE & ORCL but these are in the value basket.
Data & Charts We are Watching
Below is a chart from Goldman Sachs FICC and Equities Markets strats Team showing the estimated Global Equity positioning of Global Macro or CTA’s.
So now that the market has almost taken back 200bps of rate cuts that was anticipated by mid 2024 to just over .25bps, does the market have support? We have always said this is the only thing that matters not the fundamentals. While we at Trowbridge don’t invest based upon S&P 500 levels, this is too binary of a process for our portfolios, although support is eroding as weak long only’s will continue to sell and CTA’s are most likely finished aggressively buying equities. The only positive is that hedge fund shorts have significantly increased during this recent run up on the index according to Goldman. This could provide some floor in the interim.
What is after the interim??? As seen below, it’s easy to see that 3,809 is the next large area of support. If and when we do get to 3,800, I don’t think it will be that easy to wait for a retest to buy 3,600 on the S&P 500 futures. This set up is very consensus.
