What The Fed Is Happening In Markets Right Now?
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Piecing It Together, Slowly
When you are in the business of securities analysis, you find yourself cursed with the inability to ever stop thinking about securities. Unless you engage in some kind of whole-brain-consuming activity, like playing golf wronghanded whilst also brushing your teeth with the other hand, some part of your grey matter is forever trying to reconcile fundamentals with technicals with option flows with what is going on outside the office window and then checking that against charts stored in wetware EEPROM and then checking again with the technical indicator known as your gut.
Securities Analysis Be Like ….
Right now, if you think about it too much, markets are painful to contemplate. There are two solutions to this.
Ignorance Is Bliss?
One, don’t worry about why markets are moving in the way they are, just worry about trying to stay one step ahead of the shoe shine by following price trends faithfully. Nothing wrong with this. That in fact is what technical analysis is for. And right now, technical analysis is pretty useful.
Let’s take the S&P500. You can use multiple different methods to conclude that the present selloff is not in fact The Final Decay Of Western Civilization but more a mean-reversion (when looking through a parallel channel lens) or a Wave 4 (when using an Elliott Wave & Fibonacci lens.
Here’s the S&P500 index (SPX) since the dawn of Boomer Time.
Not so complicated, right? Meanders up and to the right, bounded to the upside and the downside by that parallel channel. The middle line also acts as support and resistance at different times. And unless you think that for some reason it is the final decadent end of the West, you might conclude that the SPX will probably find support no lower than that middle line, which corresponds to around 3500 or, in new-fangled ETF money, SPY at around $350/share.
What about everyone’s most-hated form of voodoo, the Elliott Wave & Fibonacci chart?
From the 2016 lows, SPY puts in a Wave 1 up, then a Wave 2 down as Covid hits, troughing at the 0.786 retracement of that W1. Then we get a textbook Wave 3 up, peaking right around the 1.618 extension of W1 - that’s the all time high in Q4 2021. This current move down? So far a textbook Wave 4 that has bottomed just below the 0.382 retracement of the W3 up. Should it fall further there’s a good chance it can find support at the 0.5 retracement of that W3 which is .. wwwaaaaiiittttaminute …. $350?!! TOO SPOOKY!!!!
This, you see, is the value of technical analysis. Do a little coloring-in, draw a few lines, check with a couple different methods, go find someone who disagrees and have them tell you why your chart is wrong and what you should have done instead. Argue it out. Reach agreement. End of technical analysis - place your trades and stops and off you go. Your is not to wonder why, yours is only to adjust your chart if you got it wrong.
And this is how investing and trading should be done. Low stress, no emotion, just a chart, numbers, lines, and to misquote a recent issue of Not Boring, “if you do it right you can buy a house. then another house. and so on”.
Pretty much the worst thing you can do as regards securities analysis is to wonder why something is happening. It’s like wondering why did it just start raining and then trying to answer that in more depth than, because some clouds just blew over.
But What If I Need To Know WHY?
But if you, like us, can’t stop the brain spinning around after the screens get switched off, and you have to investigate Two, What On Earth Is Going On And Why? - then here’s our take on Just What The Fed Is Happening Right Now.
1 - Stonks Ran Up A Lot
It’s relevant that in Q4 2021, SPY hit the 1.618 extension of the prior Wave 1 up. QQQ hit the 2.618 extension of its prior Wave 1s up. That’s a likely topping level for a major index, and to our credit we said so, loudly, in our premium, real-time Growth Investor Pro service.
When stonks are up a lot they tend to go down some. So, that’s the first element. In addition the rally was very skewed towards high growth tech names and they became crowded trades such that the valuation multiples (of revenue, earnings and cashflow) reached high levels. This again is usually a moment when weakness strikes the market.
2 - The Supply Of Money Into The Market Is Slowing
As the economy weakens, rates rise, and the Fed tightens monetary policy, one consequence is that less money is available to both hedge funds (because the leverage facilities provided by their prime brokers is reducing in quantum and becoming more expensive) and retail investors (because gas costs so much more and we aren’t joking here - the high beta stocks that led the rally you could think of as consumer discretionary items themselves - when the truck costs 2x the amount to refill, you probably aren’t going to be trading as many Cloudflare calls tomorrow afternoon as you were yesterday; that means less momentum and that means less obligatory buying by funds). Lower money supply = lower volume of buying = lower demand for stocks = lower prices. This week saw the fastest deleveraging of fund positions since, er, ever apparently. Faster than when Covid hit. Faster than when Lehman blew up. That fast.
3 - Monetarism Is Dead But Nobody Told The Fed
As everyone knows, inflation is running hot. Literally everyone is now a macro expert and will tell you that inflation at 8% or whatever is dangerous and must be stopped. And that the tools to stop it are held by the central bank. “The Fed Is Behind The Curve” bleats everyone. Well, we hate to say it, but, the notion that the Fed tweaking rates here and there is going to have much impact on inflation is to us just that, a notion. The monetarist orthodoxy to which the Fed and many other central banks around the world clings assumes that inflation is going up because there is excess demand. There isn’t excess demand. Because, again, gas costs $ [fill in your own amount depending on when you read this] / gallon. So nobody is running around buying too many iPhones. Raising rates in the hope of persuading consumers to stop frittering money on gadgets and instead keep their money in the Bank of Mary Poppins, pausing only to spend twopence per bag for bird seed? This is nonsense in our humble opinion. If bored, take a moment and ask around, see if you can find anyone who has too much money and is spending it willy-nilly. We’ll wait for you.
[A Grue Has Entered The Room]
Anyone? Bueller? Thought not. No, inflation isn’t running hot because of excess demand, it’s running hot because of supply side factors like food and oil costs. Items which consumers have to buy, at least in the short run. In a year yup I might own an EV but right now I own a big ol Leviathan which eats gas and I need to fill it up but it is going to cost me my weekly groceries shop on top of the usual gas cost in order to do so. Oh and by the way the dang groceries cost like 20% more now too. Eight percent lol.
And why, you might ask, are these supply side costs rising? Well, oil is expensive because various governments around the world have been pretending for a long time that we lived in a post-fossil era and therefore investments in new productive oilfields have slowed dramatically, as the development permits and other motivational titbits were directed toward wind, solar and other such generative methods. But not nuclear, which is doubleplusunfashionable still. Oh and then one of the major oil producing nations on the planet decided to invade one of the major grain producing nations on the planet whereupon sanctions on the former have driven up oil prices even more, and the ruined harvest and inability to export from the latter have driven up food prices even more.
Thus we have big runups in inflation but not, in our view, caused primarily by excess demand. But financial markets are still of the view that the relationship between inflation and interest rates is a linear one and so have been calling for the Fed to raise rates. First the Fed resisted, and now is reacting. So financial markets (which would likely have been selling off anyway because of that extension hit in Q4 2021) have decided that they are selling off because Fed. Unless the Fed puts rates up by more than expected in which case markets might go back … up. Yes really. That is what folks are saying. Rates were too low so the market went up too far, then rates weren’t raised fast enough so the market went down, but if rates are now raised too fast then the market might go up. It’s almost as if …. the stock market and interest rates aren’t so closely linked after all.
4 - Equities Are Derivatives
As you know from Capital Markets 101, options and futures are derivatives of equities. The ‘underlying’ equity is the important thing because it’s tied to something real called a company that has revenue and earnings and a balance sheet and such. Options and futures hang off of the equity and just amplify whatever moves the stock makes which are driven primarily by its earnings.
Er, except if that was ever true, it isn’t true now.
In the very long run, over the course of years, decades, it is probably true to say that revenue and earnings growth is the primary driver of the relative performance of one stock vs. another. But it is most certainly true to say that sentiment is also a HUGE driver of the stock market as a whole - in the short and long term. That’s why technical analysis works and why it takes no account of underlying company performance.
In the short run - days, weeks - particularly around specific contract dates when options expire - it is often the case that stocks are actually derivatives of futures and options. And that’s because the quantum of capital at work in futures and options markets at key points in the calendar is enough to move the market considerably. Right now, market volatility is exacerbated by the degree of bearish sentiment. If bearish, investors buy puts, either as a hedge for long equity positions, or as a pure bet on market direction. Options dealers make money from dealing, not from taking a directional position, so, if the market is buying puts, dealers are selling puts; that means the dealer is long the market, so has to hedge by shorting stocks and/or futures. So investor bearishness » investors buy puts » dealers who have sold puts hedge out by shorting stocks or futures » market goes down » confirmation bias amongst investors » more bearishness until sentiment reverses, or until a large number of contracts expire and dealers unwind their positions (at least temporarily).
This is a whole dimension of the market that many investors either are aware of but don’t fully respect or understand, or, worse, are unaware of. (By the way, if you want to get smart on this, check out the excellent Spot Gamma site, here. There’s a huge amount of free stuff there to be learned and used).
5 - Sector Rotation
Sector rotation is another dastardly Big Money trick that is generally underappreciated. Large investors don’t hold much in the way of cash, because cash underperforms equities for the most part. In order to get cash, they sell profitable positions and re-invest in undervalued (as they see it) assets. And this often happens by sector. It is true to say that energy stocks are up this year because of the real-world matters we talk about above, but it is also true to say they are up because they were the most beat-up asset class coming into 2021. So you would expect Big Money to be harvesting gains from growth stocks and recycling it back into energy. Sell high, buy low, duh.
Here’s how money has flowed out of other sectors and into energy in the last twelve months.
Now, remember what we said about stonks having run up? Well, now, energy has run up. So whilst all the fundamentals indicate that long run, years, energy stocks can keep rising - if you run Big Money funds today and you are eyeing some of those beat-up sectors to go buy cheap stocks … where are you going to get the filthy lucre to do that with? Margin? Not for the grownups. No, you are going to be thinking about selling some of those energy stocks to cash in the banzai gains you have scored this year.
So maybe, just maybe, a little heat will come out of the energy sector. Something like this - maybe.
That’s the SPDR energy stocks ETF, $XLE. If that starts to sell off some, we could see those beat-down sectors, high growth names in particular (as they are the most abused YTD), move up again. Same is true for oil itself, so, watch for drops in the $USO ETF for instance.
Well, turns out investing is hard, that’s so what. Who knew? (Well, er, everybody, apart from idiots). We’re at a key point in markets right now, and how you know that is technical analysis. Most technical analysis tools now point to this being a potential turning point for stocks, be that up or down. We believe that the critical issue determining that direction isn’t actually corporate earnings, recession etc (earnings look strong to us, at least in the stocks we cover). Our view is that it comes down to government response. The oft-repeated clarion call of, ‘Don’t Fight The Fed’ might be true if you are investing your own retirement funds, but if you are Big Money, a key weapon in your arsenal is to Actively Bully The Fed and indeed Actively Bully Government In All Its Forms. Right now you have 401(k) stress everywhere and extensive criticism of the Fed. People will be writing to their politicians saying, I can’t retire, do something. Big Money knows this and one of the reasons the selling has been incessant of late is that what you see here isn’t a run on the bank but a run on the government. It’s a move to try to pressure the Federal government in all its flavors to turn more market-friendly, so stocks can go back up, 401(k)s rise and everyone be happy ever after once again.
The next step in this pound-a-thon is FOMC today where the Fed announces its next rate rise and the market reacts. Since it is always Opposite Day in markets, it could be that a 75bps rise, the expected move, causes a further selloff by anyone who didn’t get the memo yet; or a move up because it has already been discounted. Nobody knows. You also have a huge set of options expiries this month - Vix options, single-stock options, index options - just to make things even crazier.
All you can do right now is watch the market itself and react accordingly. The leading indicators for us are energy stocks and oil - we view these as a potential source of funds - and high-beta growth names - which we see as undervalued. If energy and oil start to decline and high beta appreciate, then we have more sector rotation underway and probably that’s a train that can be ridden for some time. And the main indicator is whether the S&P500 and the Nasdaq have bottomed - at around the 38.2% and 50% retracements from their respective highs, both of which are common technical reversal points - or not.
Stay tuned for what this means for the stocks we cover in this newsletter.
Cestrian Capital Research, Inc - 15 June 2022
With thanks to our many guest authors and active subscribers who have contributed to the work sat behind this post, including @YiminX, @karan1, @dan.treforze, @slammy25, @asantana86 and many more.
DISCLOSURE: Cestrian Capital Research, Inc staff personal accounts hold, inter alia, long positions in TQQQ and short positions in XLE and USO.