The Market Mystery
October 10, 2022 | Allio’s Chief Investment Officer, Raymond Micaletti , shares his thoughts on the recent market performance and what we can expect in the upcoming week.?
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The market rose 1.6% last week, but it felt like a loss. We saw a big two-day rally of nearly 6% to start the week, followed by a large 2-day selloff to end the week—a selloff that gathered steam after the NFP report showed that both the unemployment rate and labor participation rate had decreased.
In between, there were several notable developments, but before we dive into those, let’s give a big-picture recap of where we are and how we got here.
It’s our continued belief we’re in a secular bear market driven by high inflation—a regime that will likely last 10-20 years and we’re only 1-2 years into it. Such regimes are characterized by positive correlations between stocks and bonds and by certain inflation-sensitive sectors outperforming (e.g., gold, commodities, emerging markets). These regimes always follow secular bull markets driven by high real earnings growth (earnings grew at over a 20% annualized rate from 2010-2021, compared to long-term growth of ~6%). Don’t expect inflation to get anywhere near to 2% (durably) again during this regime.
?The COVID pandemic led to an enormous expansion of the money supply, which, coupled with supply disruptions and a change in the labor force (people dropped out and are not coming back) caused the highest inflation since the 1970s. This inflation was experienced worldwide and amplified by the war between NATO and Russia.
After stubbornly insisting that this inflation was ‘transitory’ for most of 2021, the Federal Reserve finally capitulated and began raising interest rates. The anticipation and actual follow-through of these rate hikes led to a strengthening of the dollar, which weakened currencies around the world and exacerbated local-currency inflation. Sovereigns, who hold $7.5 trillion in U.S. Treasuries (USTs), have had to sell dollar-assets both to buy energy (the price of which has soared in Europe due to sanctions on Russia) and to defend their currencies. Global foreign currency reserves have plummeted worldwide as a result.?
This unloading of USTs has put upward pressure on yields and, according to some, has destabilized bond markets (e.g., U.K. gilt market, U.S. corporate bond market). Even the market for USTs—putatively the biggest, safest market in the world—seems to be thin.?
When Japan intervened in the yen a couple weeks ago, it sold $21 billion in USTs (a drop in the bucket of the $7.5 trillion owned by sovereigns) and long-term UST bonds fell 3%.?
The MOVE index, a measure of UST volatility, is at crisis levels and the index’s creator says the Fed has already lost control of the bond market. The Fed seems to be in a race against time to bring down energy prices before destabilizing the system (and thus being forced into pausing rate hikes or restarting QE into already-elevated inflation).
In the background, we have geopolitical tensions between the energy-poor and debt-laden West (whose financial systems need cheap energy and negative real interest rates to function) and the resource-rich non-West (who have tired of American hegemony and smell blood in the water).?
As to how events will unfold, market commentators appear to have coalesced into two camps. The first takes the Fed at its word and believes the Fed will continue hiking—without concern for selloffs in either the equity or bond market—until inflation has been tamed. The second believes the Fed can’t hike much more than it already has without bankrupting the U.S. government and thus expects a pause or pivot of some kind in the near future.?
The upshot is the entire market appears to be one single trade at the moment: dollar up, rates up, risk assets down OR dollar down, rates down, risk assets up. When the former is in play, markets seem fragile and ready to crack. When the latter is in play, it buys the Fed time (which eventually leads back to dollar up, rates up, risk assets down because any potential intervention has been delayed).?
With that context, let’s look at what happened last week:
In light of the state of the world and markets, the one mystery to us is why are equity markets not substantially lower? U.S. equity markets have had ample time and opportunity to break decisively below the June lows and stay there—but haven’t yet been able to. They visited this area in May, June, early July, late September, and now early-mid October. The large selloffs in recent weeks have all been orderly.
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Real interest rates have soared and the relationship between P/E ratios and real interest rates suggests the S&P 500 multiple should be closer to 14x than its current 17x. When one considers a) the likelihood that earnings might disappoint, b) the relentless (verbal) hawkishness of the Fed, and c) the draining of liquidity since April via quantitative tightening, why haven’t equities sought support at lower levels??
Of course, this week might be the week the market finally gives in, as we await both the PPI and CPI inflation reports (Wednesday and Thursday, respectively) as well as the kickoff to third-quarter earnings. Hotter-than-expected inflation or softer earnings would likely lead to further selling in equities.?
But the state of investor positioning, sentiment, and some statistical extremes might help explain the relative resilience of the market as it clings to support.
To begin with, institutions are still more relatively bullish than retail traders in equity markets, a condition that has been in play since late June. Moreover, speculators—who tend to get the direction of the dollar correct—are rapidly turning bearish on the dollar as it goes vertical (while retail is buying). If the dollar stops its ascent, risk assets likely benefit.
Many have compared the trajectory of the equity market in 2022 to the trajectory in 2008, and the market does seem to be following the 2008 trajectory quite closely. But in 2008 institutions were relatively bearish on the equity market and speculators were relatively bullish on the dollar—both the opposite of today.?
In the latest Sentix sentiment report, professional investors have signaled their highest strategic bias in equities since right before the July-August rally. They are much more confident than retail traders about the return prospects for both equities and bonds (at current levels). Do they sense a cooling of inflation? A firmness in earnings? A potential short-squeeze rally? A Fed quasi-pivot (to buy the Fed time)? Or are they completely off-base??
The S&P 500 closed more than 4% below its weekly high last week for the fourth consecutive week—an occurrence that has only happened three times before (October 24, 2008; March 6, 2009; March 20, 2020). Each time the market rallied 10% the following week.?
Additionally, the Nasdaq 100 ETF (QQQ) has closed below its 20-day moving average for 34 consecutive days (and given the distance between the current price and the average, likely will for several more days as well). This has happened only 5 times before. Each time QQQ was at or near a short-term low.?
One piece of positioning that might give us pause, however, is the institutional positioning in gold. Institutions are currently the most relatively bullish in gold since August 2008–January 2009. During that time, gold went sideways while equities fell 40%. While gold may not rise here (as soaring real rates weigh against it), it will likely hold up relative to equities if equities take another leg lower.?
Coming into today, we were of the opinion that the market had little chance to rally. But after seeing the Sentix report, coupled with the market’s stubbornness at holding the current level and the belief that the Fed’s hawkishness is a sign of desperation rather than strength, we now think it’s conceivable (if not likely) we could bounce here.??
Ultimately, we think equities will go substantially lower, but the timing is uncertain. Let’s see what this week brings.
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Allio Advisors, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.