Market Thinking

making sense of the narrative

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The first few weeks of January have been as ‘bad’ as December was ‘good’, but much of this is a confusion between the headline numbers dominated by the megacaps and the reality beneath the surface, which is one of considerable rotation.

As previously discussed, January is often best thought of as the second month of the year in so far as the shorter-term trading funds tend to flatten their books in the run up to Thanksgiving. As such, when they are the marginal investor (such as was the case in late 2021) they tend to set the calendar for the overall market as well, meaning that the Santa Claus rally in December was really early positioning by trading funds for 2022. Here we saw a rotation out of midcap tech/growth into MegaCap tech, exaggerating the concentration effect and leaving Apple with a market cap greater than the whole of the FTSE100. Meanwhile, the crowded trades in midcap tech that had started to falter under profit taking in November saw a round of liquidity-induced distressed selling in early December and a sharp pick up in volatility as the worst two day period all year was immediately followed by one of the best one day performances. The poster child for this distress was the giant ARKK ETF, which has now given back all its outperformance against the Russell 2500 Growth index over the last two years and is now even the subject of a ‘Downfall’ meme video ( a true sign that you have gone viral).

Thus while we saw the best December performance for the MSCI World for a decade, it didn’t really feel like it. We saw both an ‘upward crash’ in MegaCaps and a conventional downward one in crowded meme stocks and midcap tech, both mainly due to (il)liquidity effects. As the Downfall video put it “Anyone that has recommended a stock in the last six months that is down 50%, leave the room” (almost everyone leaves).

As a consequence, January opened with a continuation of this trader rotation, only to be followed by a different type of rotation from the medium term asset allocators and longer term investors. These latter two groups have revisited the reflation trade that was attempted in early 2021, before it was derailed by supply chain disruption and the triple hit from the three Zeros of Zero Covid, Zero Carbon and Zero Interest rates. As we noted in our year ahead piece, these Three Zeros are now all basically over as policies – even if some of their most ardent fans refuse to believe it. A consequent focus on Commodities, particularly energy, may have been heightened by the ramping up of Geo-Political tensions with Russia (see The lamps are going out) but mainly by the recognition that, for all the COP26 rhetoric, the supply demand equation for conventional energy is pointing to much higher near term prices. Indeed, some traders are now actively seeking to short ‘clean energy’ against long conventional energy, which is causing a headache for the rapidly emergent ESG industry, which has been trying to persuade people that Green outperformed as well as being virtuous. The trade is 60% in favour of conventional energy over one year and 25% year to date. Still at least the ESG crowd may have the option of being allowed to by Uranium and Copper soon.

That Clean Energy v Dirty Energy bet working out quite expensive for the ESG guys

Meanwhile the worst performance for global bonds for 20 years and the realisation that the Fed are not going to continue to buy long bonds has led some investors to question why they should own any bonds at all if they don’t have to (see the Real Problem for Bonds). This has stimulated a search for higher dividend yielding stocks instead and the fact that these are often found amongst Financials and conventional Energy stocks completes the narrative for a rotation to ‘value’ stocks, even if that isn’t really the driver of events.

Bottom Line. Traders closed out crowded mid cap tech trades in November and rotated into Mega Cap. While liquidity issues are causing mid cap tech to continue to overshoot to the downside, asset allocators and long term investors appear to have started their New Year with a different strategy, rotating out of US megacap into cyclical stocks, particularly energy, boosted by the traders jumping back in on a long conventional/short Clean energy trade. This is also starting to feed through into a tentative position in Emerging Markets and especially some bottom fishing in China ADR stocks.

Meanwhile, a long overdue move away from bonds on the back of an end to Fed intervention has led to a search for higher equity yields which is appearing to support a ‘rotation to value’ even if that isn’t really what is happening – although, as always, the narrative is shifting this way rapidly. Experience tells us that while there is still (some) value in some of the cyclical stories, they rarely make good buy and hold positions and can get overbought very quickly. On the flip side, once distressed selling and illiquidity stop working against the thematic stocks we believe there will be an opportunity to capture meaningful returns (just as there was in 2020).

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