January 30, 2022
The markets appear to be having something of a re-run of early 2016, probably the last time that they worried about a tightening cycle. An early January rotation out of the MegaCaps into value and cyclicals by institutional investors on a reflation trade is hitting retail hard – especially leveraged retail in tech and crypto space. Meanwhile, a rush for put protection is triggering the derivative market mechanics of forced selling – the inverse of the call buying effect from last year. Throw into the mix the giant hit to long bonds in early January and the associated deleveraging by risk parity funds and all the ‘on’ switches have been flipped to ‘off’. If 2016 is to be something of a template, then this may continue for the rest of the quarter and, once again, we will be looking at the March options expiry for our guide.
Following on from last week’s post about the headline numbers versus the underlying components, it seems clear that the S&P500, having just broken its long term moving averages, is triggering some deleveraging and something of a VaR shock – Value at Risk models are used by trading desks to monitor leverage, but unfortunately are also often (mis)used by long only risk managers. There has been a clamour to buy the puts ‘for protection’ that were being shunned only a month ago and as a result the VIX (which is better thought of as the price of puts rather than as a ‘fear’ index) has spiked up past 30 once more. That rise in volatility then triggers certain risk managers to take down leverage and sell more underlying, putting pressure on the remaining leveraged longs and so on. Meanwhile after a near 10% hit to long bonds at the start of January due to the steady realisation that if the Fed isn’t buying bonds, why should we? (see the Real Problem with bonds) and the spike in volatility in bonds as well as equities, the risk parity funds are deleveraging such that the technical gamma squeeze that caused upward crashes flipped to causing conventional downward ones – as we discussed last year (see for example FOMO + LOL = OMG)
What is also going on is that the retail investor is now cutting and running. If we look at the American Association of Individual Investors (AAII) surveys for example, we can see that the US retail investors is even more bearish than at the start of the Pandemic! The Orange line shows bearishness at the highest level for 3 years and Bullishness (the white line) at the lowest level, leaving the net spread of bull minus bear down at levels not seen since 2016.
Investors haven’t been this bearish since 2016
When we last looked at this index back in November, it was up at very bullish levels and we noted that while this is sometimes a simple contrarian indicator (as it certainly would have been), it is also a good indicator of possible rotation – in this case from growth to value – which indeed it was. We also speculated that ARKK may have been the NASDAQ ‘whale’ whose distressed selling was hitting mid cap tech in particular. Events appear to be backing that up, to which we would add that the fact that Kathie Wood owned a lot of Bitcoin (via the Greyscale Trust) would also help explain the cross contamination from NASDAQ to Crypto.
Our model portfolios, which were largely in cash for the Thematic portfolios at year end, remain at elevated risk levels, with the Global Factor models also all now at maximum risk levels. As such, while there already are some bargains in the value space, the bigger opportunities in the growth space need to wait for this market indigestion to settle down.
Back in 2016, markets were worried about a tightening cycle and a slowdown in China – remember 2015 had seen a inverse crash up in China followed by a conventional one down – not dissimilar to the US in the second half of 2021 in mid cap tech. Gold had bottomed at the end of 2015 and had a 20% run as expectations of a tightening cycle became a sell on the rumour, buy on the fact situation and this is something it is attempting to do again – albeit struggling to beat the previous highs achieved after a very strong 2019. This time however, the ‘fear’ seems to be that the Fed won’t tighten enough to stop inflation rather than that it will kill growth. Either way, the fundamental we need to look at is liquidity/leverage rather than growth.
Of course, an awful lot has changed since 2016, back then we were also just about to discover populism, with Brexit and Trump – not that the markets knew it at the time- and since then we have fully embraced the Triple Zero policy errors of Zero Interest Rates, Zero Covid and Zero Carbon. As we noted in our January Market Thinking, the reality is that the three Zeros are actually all ‘done’, even though their architects are very reluctant to acknowledge it. Perhaps this is really what the markets are telling us?