CHG Markets Round Up Issue #2: Change

This is a cross-post from?CHG Market Commentary on Substack. If you're subscribed to this newsletter you should consider subscribing for free on Substack to get this when it comes out on Mondays and receive more frequent market updates on?Substack Notes?as well as other exclusive content.

Change manifests in the markets the same way it does in our everyday lives. Something new is introduced and it can be rejected, accepted, or something in between. The longer the change is not rejected it builds into a habit and gains acceptance. Say you start going to the gym in the New Year and this time you actually keep going, the effort you expend going to the gym on a regular basis decreases over time as you gradually accept the new behavior and it becomes wired into your brain as a habit. It changes the measuring stick for any new things that come along in the future by changing the status quo; if you stop going to the gym you will experience disruption as the gym had become your new normal, and your biology needs to adapt to a new, new normal. This is something universally accepted, but perhaps not thought about on a daily basis. It is a simple, yet extremely complex process and it is in that distinction where we can gain insight into what is happening in the markets.

First, lets review the markets where there has not been any change because it is in those markets where there tends to be the most risk. The FX market is the most important market where despite a lot of expectations to the contrary there has not been a lot of change over the past 17 months. This is a typical reaction after the sharp, Fed-induced, directional move we saw in 2022. After breaking out above 2018 highs the market has come back into that prior range but has not made a decision whether it will keep going to the gym (higher dollar) or not.

Despite a lot of attention and focus the US Treasury market remains in a trading range this year. After finding a peak in interest rates last year we have seen rates back off from those levels and recently start to move back towards those highs. The trend is higher for interest rates after breaking out of the secular downward channel in 2022, but we are very early in the process of changing a habit that has been in place for more than forty years. The initial reaction to the change was violent but the inability to continue through prior support levels reveals a lack of underlying conviction in the trend higher.

That lack of conviction is primarily due to the uncertainty surrounding the economy's ability to operate with higher interest rates. The yield curve is telling us that the market expects lower growth and inflation in the future due to higher interest rates. The yield curve has seen no change as it remains inverted and has failed several times to return to positive territory. This belief is the primary force keeping the dollar and rates in balance, and it is these sorts of beliefs that often cause the most violent change if they are violated.

Crude oil is the final market we will cover where there has been no change. After peaking near $130 per barrel, crude has carved out an increasingly narrow trading range as it digests the change that initially propelled the commodity to $130. The retracement from $130 has been primarily due to the lower growth expectations in the market due to higher interest rates. The dollar, rates, and oil are coiling which represents a build up of potential energy from the force of the belief in lower growth which has been exerted on them.

Now turning to markets where we have seen change this year we find several foreign equity markets topping the list. First up is Japan where the stock market has broken out higher as the Japanese economy appears to have finally emerged from its long slumber which is attracting investment dollars from around the world into a market that has been long forgotten amongst global investors. There is speculation that money is flowing from China into Japan as the former retrenches but the big test will come as the BOJ has started the process of unwinding their extreme monetary policies which will eventually put pressure on the Yen and could represent a headwind for the Japanese stock market which has so far benefited from weakness in the Yen. It is not surprising to see the market pause near the early 1990s highs amidst this uncertainty as investors take advantage of the opportunity to either take gains or exit positions that had been underwater for the past thirty years.

Next we have the long-struggling UK which has been mired in post-Brexit turmoil but has finally broken out from a six-year trading range. The UK has decided to start going to the gym and has gotten through the first week and whether it can sustain the effort is yet to be seen, but the change has manifest.

Not to be left behind, continental European stocks have also surged past pre-GFC levels but remain in a twenty year trading range bracketed by the early 2000s highs and the post-GFC lows. These are notable changes to long-held beliefs about the European, UK, and Japanese economies and relate to more broadly held beliefs about the growth and value factors.

While the twenty-plus year trend of growth outperformance is still intact we have seen a notable bounce off the 2001 low which is an initial change to the prevailing trend. There was a short period of value outperformance in the wake of the internet bubble which was followed by a long outperformance of growth since the GFC. What comes next is anyone's guess, but we are seeing an accumulation of small signs of change in regional markets that are associated with the value factor. Just like new behaviors take time to entrench themselves into durable habits, it will take time and more of these smaller signs of change to accumulate before the value factor can emerge into a new trend of outperformance.

We can gain a better appreciation for how small changes build into big changes by looking at the US equity market as represented by the S&P 500. We have been in a secular bull market since the GFC that was only temporarily disrupted by the 2016 election and COVID until experiencing a deeper and longer pullback amidst the Fed's historic rate hiking campaign in 2022.

After finding a local low in October 2022 the market spent much of 2023 in a range. We can see this how this trading range developed by zooming in to the daily bar chart.

After finding an excess low in October 2022 we experienced an initial knee-jerk relief rally. Once that reflex exhausted itself the market experienced a pullback but it was limited and shortly thereafter the market returned to challenge the prior high. It is typical for sellers to appear at prior highs and it is unusual for a market to take out those highs on the first attempt unless there is real underlying strength in the market. It wasn't until the third attempt that the market was able to breakout higher and then establish a new, higher trading range. You can see how the market mechanically stair steps higher which reveals that the buyers are not overly strong but also that the sellers are not highly convicted. This detail provides the insight that we have an upside breakout in a market that is primarily trending higher, but we are seeing signs that market leadership is weakening which is a sign that the primary trend is aging.

Finally, we have gold which has broken out higher from a nearly four-year trading range. In this case we can see how a long trading range can accumulate risk that can make a breakout in any direction very violent. The initial move excites passions that have been strengthened by time and also causes long-held positions to be unwound. This presents a very difficult situation in the early stages of such a change. The magnitude of the change is extreme but the time has not been long enough to form a durable habit or new trend. Risk is extraordinarily high in these situations because of the distance travelled in such a short period of time. It is like going to the gym for the first time and trying to bench 300lbs within the first month. You might be able to get in one rep, but the more you persist the more risk of injury you take. If you don't injure yourself you will be much stronger as a result but if you do the injury could be severe.

We'll wrap up this review with something new to demonstrate how we translate this sort of analysis into a portfolio. This analysis is just one part of the overall portfolio construction process, but it is probably the most important part. Investing is part art and science and this is where the science of portfolio construction meets the art of market understanding. Below is a table showing my personal risk allocations to different factors; this is distinct from the traditional approach of showing market value allocations to asset classes, it also does not necessarily sum to 100% because I exclude smaller, less meaningful risk exposures.

If you enjoyed this article you can subscribe for free to?CHG Market Commentary on Substack, explore my?Knowledge Base, and find more of my writing at the?CFA Institute's Enterprising Investor Blog?and on?Medium.