Market Thinking

making sense of the narrative

November Market Thinking

Seasonality in markets often has underlying market mechanics behind it. The end of October for example is the deadline for tax loss selling by US mutual funds, something overlooked in a bull market, but obviously highly important this year, while the end of November is Thanksgiving, which has tended to represent a year-end for many macro funds, likely some of the few looking to lock in any profits and performance fees for 2022. Thus we are seeing both an end to selling and some likely short covering squeezing markets higher. It is too early to tell if this is a genuine market bottom, but our confidence indicators across bonds, credit and equities are all showing (small) signs of life.

Importantly, markets turn before the economy does, not least because they are the transmission mechanism for the money supply. Massive money printing in 2020 has delivered the inflation we now see in 2022, the market booms in 2020/21 were a lead indicator of inflation, just as the collapse in the Money supply and the equivalent collapse in the markets are a lead indicator of economic hardship to come in 2023/4. Markets will be encouraged by the stabilisation in the discount rate as Central Bankers realise the risks of hiking rates too far, but the hit to certain areas and the damage to earnings is already baked in to the economy, if not yet into estimates.

Markets

Our confidence indicators are showing some small positives again. This is not of course the first time this year, we have had previous tentative steps to move our model portfolios away from their dominant cash position, but they have proved to be merely bear squeezes, false signals only to be met with selling into the rally. Our indicators are multi facetted, but one short-cut way to express this market behaviour visually is to look at the Bloomberg Fear and Greed Index for the S&P 500. This is a technical index known as an oscillator and is designed to try and capture which directional movement is more ‘powerful’ at any point. In fact, what we see in the markets themselves is that so far this year, almost all the buying is in fact short covering, hence the moves around month and quarter ends and particularly around major options expiries. To put in a meaningful low, the rest of the players need not so much to be greedy, as a bit less fearful.

S&P 500, Fear and Greed Index – a bit less fear

Source Bloomberg

There is of course a different fear, fear of giving up returns accrued, which makes us consider if short covering may this time lead either to some follow through buying on value grounds, or at the least a lack of renewed short positions as the CTA traders lock in their returns for 2022. To that end, we notice that the same Fear and Greed for the TIPS, US index linked bond ETF has given a reversal signal – unlike equities in general it has been pretty bearish all year, as have High Yield bonds (albeit they have been understandably more like equities in their behaviours). Looking at other factors such as flows into the relevant ETFs also suggests some modest buying appearing in these areas.

Short Term Uncertainties – short term covering and book flattening

November is Thanksgiving and the effective year-end for many of the Hedge Funds that have dominated the markets year to date and as discussed above, we wonder if books will be flattened early to lock in those (previously elusive) performance fees. Certainly last November was when we started to see the cracks in the leveraged long trades – ARKK peaked on November the 1st last year at 125.1 and looks to have bottomed (so far) around 14th October at 34. Tesla, a major holding in ARKK and also dominating the retail options markets had a massive ‘greed’ reading a year ago and is now down almost exactly 50% over the same period. As did of course the Grayscale Bitcoin Trust, another big ARKK holding, down closer to 75%. It certainly feels like the short trades are being wound in and while we would certainly expect value investors to come into Bonds rather than Bitcoin, the prospect of an extended bear squeeze in certainly concentrating a few minds.

Also interesting to note in the wake of the FAANG gang having a tricky reporting season, that the Equal weighted S&P500 has outperformed the market cap weighted version by 7% year to date – something we discussed back in January as part of Our Four Problems and a Solution series (the problem with passive equities), where we highlighted the problem with the Market Cap Equity Indices being too heavily geared to the top 5 or 10 names. Year to date, the top 5 names from January are down on average 32%, compared to ‘only’ 17% for the index. The fact that tech is down so much and stocks like Exxon +79% has also presented a huge headache for a number of ESG funds that were essentially running the long tech short energy trade. It also may explain some of the survey results such as in the latest Credit Suisse, Single Family Office Survey where the percentage of people in Asean reporting sustainable investing as being in their top three priorities is…0%.

Meanwhile, the long $ cash trade remains the most crowded at the moment and is a key focus for traders. The recent weakness took support at an almost exact Fibonacci reversal (23.6% of the rally this year), which suggest that the traders (who use such technicals) may still be betting on a long term bull for the $. Incidentally, the recent rally in the S&P500 was a similar Fibonacci Reversal, this time a 23.6% reversal of the weakness so far this year and a 38.2% reversal of the post Jackson Hole sell off, which will also have the shorter term traders’ attention.

Medium Term Risks

The apparent bottoming in some of the worst hit parts of bond and equity markets is likely too early for any of the asset allocators to do anything much beyond the automatic rebalancing in bond/equity portfolios, but some long term investors will have been pleased to pick up Gilts at almost 4.5% thanks to the Bank of England effectively ensuring some forced sellers. The deleveraging that has characterised 2022 so far has led to some other distressed selling and a lot of value starting to appear in assets, notably those associated with cash flows and in non $ currencies, suggesting to us at least that 2023 will see a sharp pick up in M&A. Thanks to the Yen, Japan is looking extremely good value, especially to a $ investor. The next key issue in our opinion will be how and when China opens up again, the Covid associated lockdowns having actually been extremely helpful in limiting global demand for commodities at a time of interrupted supply. Indeed, we should be thankful rather than critical that China has taken so long to open up again. Now that the Party Congress is out of the way, we are seeing signs that the Zero Covid restrictions are easing and that commodity markets are staring to pick up speed.

In that sense, we see some resonance from 1998/9, where, following the sharp and enforced deleveraging in the wake of the LTCM debacle, a sort of concentrated version of the carry trade unwind that has been taking place all year, consensus economic forecasts were for a global recession – or ‘Armageddon’ as my then colleagues at UBS termed it, in rather hyperbolic fashion. This (misplaced) view had left commodity related stocks looking incredibly good value, not least as the flight to quality that resulted from LTCM collapse had also pushed the $ higher. As this reversed, the commodity stocks benefited from the $ effect as well as the strong cash flows relative to share prices, making them a powerful source of return in H1 1999, even as the world focussed on the Dot-Coms. History doesn’t repeat, as Mark Twain said, but it often rhymes.

A strong $ is often associated with weak commodity prices (and vice versa) as the balance of global demand is from non $ economies who accordingly see the price of commodities in domestic terms rise, and thus demand fewer of them (allowing for price elasticity and a host of other factors of course). Mining and related stocks have some benefit, as their costs are in (weaker) local currencies and their revenues in the stronger $, but generally will tend to track the underlying commodity price. Of course, this time around, there have also been some/many ESG related sellers of mining stocks. If, as we believe, China is now opening up, demand should start to increase and as and when the $ starts to slide, this will then accelerate the shift towards commodity and commodity stocks, including, we suspect, at the corporate, M&A level.

Long Term Trends – Economics and earnings

Monetary Policy works via the asset markets and thus the collapse in asset prices already seen this year is consistent with slowdown in economic activity in 2023. Interest rates are the price of leverage, they affect the markets directly, but the economy only indirectly. A meeting last week in Hong Kong with John Greenwood (of International Monetary Monitor and the ‘inventor’ of the HK$ peg) was a timely reminder of the Monetary mantra that inflation is always and everywhere a monetary phenomenon and as John points out, “What matters for the economy is the rate of growth in the Money Supply” – and, having exploded since 2020 as the central banks chose to monetise the fiscal response to Covid, the Money Supply in western economies is now contracting sharply. Thus having set up in 2020 for the inflation coming through in 2022, the contraction in Money Supply since April has set up not only the contraction in multiples this year, but the contraction in the economy likely for 2023/4.

The Expansion in Money in 2020 set up today’s inflation, the contraction is setting up 2024 recession

Source Bloomberg, Market Thinking

Thus after a year of de-rating, earnings are going to come to the fore next year. There remains a genuine risk of stagflation, given the alacrity with which the central bankers have abandoned their previous love of Zero Interest Rates ( as recently as December Christine Lagarde said the ECB would not be raising rates in 2022) and are now rushing to raise rates with all the zeal of a recent convert, something we discussed many times including this a year ago (After a year of bad policy the risk is that the central bankers say ‘Hold my Beer’. While on the one hand it is necessary to raise rates back to neutral, to prevent further misallocation of capital, the fact that different countries have very different debt exposures, particularly consumers to short rate debt, means that it needs managing carefully in order to avoid unnecessary recession, instead of an equal and opposite ‘one size fits all’ policy. Sadly, the BoE and the ECB appear more likely to simply track the Fed and with a similar contraction in Money Supply, the prospects for the high inflation economies of the west look quite alarming. By contrast, countries like Japan, China and India did not have the dramatic increase in money supply, so their inflation is likely to be more transitory.

People talk of the $ as being the ‘least dirty shirt”, we prefer to think of Monetary Policy in those terms. The risk of stagflation is highest in the west and lowest in Asia, thanks to Monetary Policy errors in both directions

Meanwhile, the biggest long term trend remains the shift away from the $ as the dominant unit of currency for trading. This is not to insist on a new Reserve Currency, indeed, as we discussed on a number of occasions (including here) there are multiple options, ranging from a SDR based trading currency like Keynes’ proposed Bancor, to the simple fact of ‘The West’ working with $s for trade, while ‘The Rest’ work on bilateral exchange with a growing role for the Rmb.

The long term picture continues to look to us to be a shift in Geo-Politics equivalent to the impact of the $ coming off gold in 1971, with multi-polarity, no single Reserve currency and the emergence of a commodity super-cycle driving capital flows away from financialisation and towards ‘real’ assets.

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