CHG Markets Round Up Issue #4: Fast Markets

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.

...the contemplative life is a life in which we constantly move from opaqueness to transparency, from the place where things are dark, impenetrable, and closed to the place where these same things are translucent, open, and offer vision far beyond themselves. Henri Nouwen

Pattern recognition and prediction are so closely linked in our minds. Our prehistoric ancestors survived by recognizing the pattern of the rustling bush and lion attacks. As we have evolved and our world has become more complex this simple pattern recognition is insufficient for continued success. The wealth management world is filled with indicators, systems, and star managers that tout successful track records which we naturally extrapolate to future success despite the aphorism that past performance is no indicator of future returns. On a more personal level we notice behavioral tendencies in our friends, coworkers, and spouses and we start to predict what they are going to say and do. When our significant other comes to us exasperated the refrain is often "don't overreact." For anyone that has been in this situation it is well known how that supportive intention can be received as dismissive and is not always met with an appreciative response. Quick judgments of the markets or people are superficial and error prone but we make them without even thinking about them which clouds us in darkness. In fact our constant searching for the truth or the right answer tends to distract us from the important details and information that is hiding in plain sight.

Last week was amazing not because of the volatility but because of how one tiny detail on Tuesday after the MSFT earnings was so important to understanding what was really happening. The market was getting short heading into the earnings as there was mechanical selling on Sunday night, Monday morning, and again on Tuesday morning. The short-term trend had turned lower and short-term traders were pressing their advantage but we had five recent session highs all in the same proximity which indicated the sellers were price-based and their efforts were yielding diminishing returns.

?After MSFT reported the knee jerk reaction was lower, but since everyone had already spent all their ammo, it was time to start covering their shorts. Apparently the consensus idea amongst fast money traders last week was to get short heading into MSFT earnings which makes sense with the recent narratives and factor unwind taking place in the market. However, what this created was a market that needed to rally before it could break.

This happens when the short-term trend is lower but the weakest traders drive the market too far and have to cover their shorts before the primary trend can resume. This phenomenon is very difficult to discern from a corrective pullback amidst a rally which can actually strengthen a market, but on Tuesday night the shorts started to cover at the prior Thursday's low, another mechanical reaction which is a sign of fast money trading at exacting levels, and took the market back above the levels they were selling earlier in the week which demonstrated that the buying was the corrective response and not the primary trend.

Once the rally got underway on Wednesday the market set it sights on filling the downward gap from the prior week. Once again when markets move from widely recognizable levels in a mechanical fashion it is a sign that fast money is dominating the flows. It couldn't fill the gap on Wednesday, despite the close proximity, which was a sign that the market was not as strong as price made it seem . The gap was filled on Thursday's open but sellers came out after the ISM disappointed and we got a failed upside breakout which quickly tested the prior range low.

Friday's NFP report delivered a downside breakout from that balance in the S&P and a return to the prior range high for the Russell 2000 which had been the strongest of the major US equity indices recently. This morning's gap lower across the equity markets has now taken the Russell to the prior range low; this is what we called fast markets on the floor and something Harley Bassman calls "Adult Swim."

Strangely the factor trade unwind that caused vol to pop from 12 to 16 two weeks ago also supported the other indices until the short covering was over and new buyers failed to show up. Now the broader market is not supported by the Russell strength as fears of a slowdown proliferate and S&P implied vol has spiked into the 20-handle and the VIX hit 65 this morning.

Gold is showing some interesting dynamics as it was be supported by "risk off" flows which got the market too long and we saw gold sell off hard on Friday with stocks, but the selling appears to have only been liquidation of those weak hand longs from Wednesday and Thursday. The structure of Friday's market in gold suggests good odds of a return to the Friday high. Gold gapped lower amidst this morning's liquidity panic but has found an excess low, while cleaning up all the weak structure from the prior two weeks and has filled the gap.

?The upside breakouts in Europe and Japan took some serious heat last week, especially in Japan as the BOJ hiked rates while the Fed indicated it would be easing; this had the impact on the Yen that you would expect and overnight the Nikkei plunged by over 12% which puts the long-term upside breakout from last year in jeopardy; 30,714 is important support on the Nikkei.

?We have a lot of observations so what do we do with them? How do we synthesize and compile these into portfolio construction? We are constantly pulled to prediction and judgment. “This is too far too fast”; “the Fed has to do an intermeeting rate cut”; “the economy is falling off a cliff.”

It’s funny to hear about the macro being weaker now. The economic numbers have been slowing for some time but it's not until the market goes down that you hear more about the macro being weaker; Price drives narrative. The treasury market has already delivered interest rate cuts for the economy which will be supportive of growth and we are basically back to the late 2023 lows in interest rates.

?The S&P ceased OTF higher on the monthly, has taken out the June low, and is back into May's range. We are sitting on the next downside reference at the May pullback low which is followed by the May and April lows before we get back to the January 2022 high.

?Investing is the most competitive endeavor you can undertake because of the money involved. The allure of finding the right mix of indicators draws in the vast majority of investors and the most insidious thing about these indicators is they work just enough to keep investors coming back even though they don't deliver consistent results. This is because the right indicators attract investors which for a period of time serves to make the indicator MORE useful in a reflexive, self-reinforcing process, but eventually that indicator gets too crowded, something changes, or a new indicator starts to work. No matter how high or low resolution you go with your strategy and indicators you end up being subject to the same forces of competition. The reflexive nature of the market is widely recognized but only narrowly understood.

Investors tend to think of price very narrowly, they don't distinguish price as just one dimension of the overall market, they don't think of price as the probability of an expectation, and they don't think of price as a risk premium that can provide investors returns and also cost the economy money. Price is an advertising mechanism: it offers odds on certain bets, utility to investors, cost of capital for enterprises, and a level for two-way trade to take place (aka. liquidity). Price is far more than a blinking number on a screen. Options provide a way to decompose price down into a market-implied distribution of outcomes. The market profile charts above show us the three dimensions of the continuous two-way auction process: time, price, and volume. What we are seeing today is a re-pricing of liquidity: the markets need to lower price until they find buyers willing to offer liquidity to the investors who are in need of it. Then the reflexive process restarts. The cost of equity capital is more expensive while the cost of debt financing is cheaper and capital providers are probably less willing to advance capital when the price of liquidity (volatility) is so high.

The markets are an ongoing conversation between market participants and price is the primary language that we use to communicate. To hear the market crying out in exasperation and to respond "don't overreact" fails to appreciate the complexity and depth of what is really being said.

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