Market Thinking

making sense of the narrative

February Market Thinking

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The sharp bounce back in early February for the headline indices on Equities will have come as a relief for many – although not for those forced to close positions or buy protection at the end of the month. Of course, those very market mechanics are exactly why the market behaved like it did in January. Accordingly in the piece, we revisit the concept of market mechanics before our usual process of looking at uncertainties, risks and themes.

Revisiting Market Mechanics – it’s all about positioning

One of the central aspects of Market Thinking is what might broadly be categorised as Behavioral Finance – the notion that the market price reflects the behaviour of disparate groups and that at any time one group can be setting the price ‘rationally’ while others are declaring it irrational. For simplicity, we break down the market into three groups, based around their time horizons – short term traders, who focus on uncertainty, medium term asset allocators, who focus more on risk and long term investors, who focus more on trends– hence our categories in the monthly Market Thinking notes.

Against that background we have the framework of what we call Market Mechanics, the system behaviours that are frequently, and usually incorrectly, attributed to so called fundamentals. The most regular and consistent of these are the options expiries – particularly in March and September – when the buying (or not buying) of put protection by asset allocators triggers automatic buying or selling of the underlying stocks by the market makers (the so called delta hedging). To this has been increasingly added the next level of mechanics, the Gamma trading of short term traders effectively using options not for hedging, but for leverage. This was particularly important on the call option side last year, where aggressive retail buying of short dated options in stocks like Tesla forced market makers (who had sold the calls) to scramble to buy the underlying as the price ripped higher, exaggerating the price moves. Later on in the year the traders doubled down and sold puts to buy calls, which meant that in early December, as prices fell they had to scramble to unload the stock. Gamma works in both directions.

The reason for the reminder on Market Mechanics is that it is this, rather than any fundamental shifts, that best explains what just happened in January. Most short term traders had switched their long mid cap tech positions to long mega cap tech in early December, which is the start of the new trading year for many of them, leaving a large number of retail investors heavily exposed to losses via vehicles like ARKK and triggering a round of redemptions and forced selling by ARK group that we described in our January Market Thinking and also here, here and here.

Thus the marginal buyer/seller in early January was the short term trader, either being forced out of a position or actively going short, but then as the Medium Term Asset allocator arrived in mid January they put in a different rotation. Mostly they were under-exposed to midcap tech, (unlike retail) but, thanks largely to market cap weighting effects, they were heavily exposed to MegaCap Tech. As both a risk adjustment and an anticipation of a return, they put on a sell growth/buy value trade similar to the reflation trade attempted last year, with an emphasis on energy, largely for the sort of reasons that we outlined here. That pushed the headline index down sharply, as the Market Cap effect that had stimulated December headline indices up almost 5% reversed sharply and triggered a series of market mechanics – as just described.

This sharp sell off certainly scared a lot of people, with, as we noted in 2016 redux, Individual Investor bearishness now higher than during the pandemic. The market commentators have reached for their box of proximate causes and brought out ‘The Fed’ and while this is indeed plausible, after all it was the press conference where Jerome Powell refused to rule out any rate rises that seemed to trigger a rush for the exits, we don’t really share that view. The problem is that, for many market commentators, especially from the rates, FX and commodities world of noise trading, the Fed is the only variable that they believe matters – hence their long and ongoing obsession with the theatre of the non farm payrolls every month. However, the prospect of Fed tightening and even more so the prospect of them tapering – i.e. not buying in US Treasuries and other fixed income – has been ‘in prices’ for months. Our hypothesis about Market Mechanics is also supported by what we have just seen in the last few days, as headline markets bounced sharply in what looked like a classic bear squeeze – too many short term traders had gone short. And got caught. As ever, we are indebted to our good friends at Redburn for pointing out that the bounce in the S&P is almost an exact Fibonacci retracement. More prosaically, we could just note that we are back to where we were at the start of December.

As you were….

A Fibonacci Retracement takes us back to where we were in early December.
Source Bloomberg, Market Thinking

As to whether this is a ‘dead cat bounce’, a market bottom, or indeed the start of a long term sideways move, it is still too early to tell. Traders have given over to asset allocators and longer term investors and we need to watch carefully how then now behave.

Short Term Uncertainties.

The bounce in the headline numbers suggests that the selling has largely been confined to the traders and retail, with asset allocators and long term investors buying the dips – or rather more importantly not selling the rallies as they did in 2020. In our view this starts to bring risk levels down and our model portfolio readings – which had moved to cash over the last two months – are starting to reflect this.

Meanwhile, the headlines in the west have been dominated by discussions about Russia and Ukraine. We have discussed this in more detail elsewhere, but have to conclude that this looks like Theatre rather than War. Back in the autumn, we regarded the theatrics over Taiwan as ‘tin rattling’ by the Pentagon rather than sabre rattling by China and that has so far proven to be the case – the Pentagon rapidly got its $780bn budget and the new ships to ‘counter the threat in the South China Sea’ and the whole ‘crisis’ has disappeared. Presumably until the next Budget round. Now it is NATO’s turn to justify 2% of everyone’s GDP to be spent on weapons and despite frequent (and evidence free) claims that Russia is about to invade Ukraine we see no realistic prospect – or more importantly reason – for them to do so. Indeed, this is a view shared by the leaders of France, Germany and Ukraine themselves. Should the Ukrainian military move into the Donbas, in violation of the Minsk agreement that no one talks about, then it is likely that the Russians would respond, but even then it is unlikely that any troops would set foot on Ukraine soil. Rocketry and air superiority would be the most likely course of action.

We have got used to emotional arguments accusing Russia of everything from election rigging to poisoning, with the accusers (western governments) avoiding the burden of proof and demanding instead that Russia proves they are not doing that which they are accused of. Politics and Propaganda are about emotions, but the reality of war is much more about logic. There are many emotional reasons to accuse Russia of threatening to invade (including perhaps a claim to have ‘scared them off’) but there is no logical reason to invade and hopefully the parties most affected by these theatrics – Europe and Russia – will settle this all down. Meanwhile NATO and the MIC can continue with their “Nice country you have here, shame if anything were to happen to it” routine.

Medium Term Risks

As is often the case, the focus on the headline equity numbers tended to obscure the, arguably bigger problems, in the Bond Markets during January and we believe that it is in bonds, rather than equities, that the bigger medium term risks lie. Bonds fell sharply across the board in January, extending the losses from what was already the worst year since 1999 for global bonds in 2021. This simply reinforced the view that we discussed in greater detail in our series of posts (Four Problems and a Solution), that Bonds are no longer fit for purpose for long term investors. This mean that, with both bonds and equities lower in January, and with bonds underwater in 2021, not only did Balanced funds have their worst year since 2008, (as this article from Bloomberg points out), but in January they also had their biggest monthly loss since March 2020.

But it’s not just the absolute loss. Along with the fact that dis-inflation is over, that there is no evident diversification benefit (see 2020), little or no yield and diminishing downside protection, bonds are also now seeing rising volatility, as shown in the chart of the MOVE index (bond volatility) – shown below alongside the VIX index of equity volatility.

Bond Volatility still rising

source Bloomberg, Market Thinking

At this point it is perhaps worth a short digression back into market mechanics. The Risk Parity complex is a major player in the quantitative part of institutional space and basically it involves leveraging bonds – seen as lower risk – and balancing out against equity – seen as higher risk. Given that the key measure of risk is volatility, this means that many funds essentially target overall volatility and thus if volatility rises/falls they are ‘automatic’ sellers/buyers of those assets. As a result, these quants have been another important factor in market behaviours in recent months.

The above chart ‘normalises’ volatility for both equity and bonds over the last 3 years to demonstrate the slow but steady rise in bond volatility. As we discussed in our four problems series, the shift in the nature of bonds is a problems for traditional balanced funds (the problem for balanced funds), but this rise in volatility is clearly also a problem for the Risk Parity funds, many of which were sold as an alternative to the traditional balanced fund. To recap – we proposed our own solution to the dilemma of the managed fund, a blend of Thematic and Factor Equity, one that would have been largely in cash since mid December and thus certainly offered better downside protection.

Because most of our long term themes were registering at the highest risk levels in December/early January, our model portfolios were largely in cash and are only now starting to ease on the risk measures. Because we believe in the themes – Robotics and automation, digitalisation, digital security, digital health, Fintech, emerging market consumer and clean energy – we would be looking to add back as and when the risk levels fall back further. Of course, another long term theme – that of Crypto- has been hit as hard as any of the mid cap tech stocks in the sell-off, not least we believe because of the cross ownership, leverage and need for margin. At the higher level, ARKK had a big holding in the Greyscale Bitcoin Investment Trust and will thus undoubtedly have been a ‘supplier of stock’ to the market. As such, the two are probably too closely interlinked at the moment to determine which price is driving which asset, but equally it means that once the distressed selling is done, we can expect some stabilisation in both.

Can’t separate ARKK from Bitcoin right now

Bloomberg, Market Thinking

All this starts to point to some possible contrarian positioning in addition to exposures to the cyclical recovery, although please note that we are NOT making recommendations here (As Grant Williams puts it ahead of every one of his excellent podcasts – this is for information and hopefully entertainment purposes only). After the Dec/Jan sell-off in tech mid caps, thematics are starting to look a better value trade, as are the ‘solutions’ to the Climate issue – copper and Uranium, while braver souls may want to look at the ‘no war’ option and accumulate some ‘Russia’. Real contrarians will be watching out for a bottom in ARKK and Bitcoin, but for now that is for traders. As we noted earlier this months, the similarities to 2016 are such that we suspect clarity will start to emerge around positioning as we head towards the ‘original’ market mechanics of the March options expiry.

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