“Storytime on Wall Street”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

September 5, 2023 - DJIA = 34,837 – S&P 500 = 4,515 – Nasdaq = 14,031

There is a constant effort to assign a reason behind every squiggle and waggle in the capital markets.? The stock market trades lower, and investors scour the internet looking for a headline.? Bond yields move higher, and Wall Street assumes that there is an economic development.?

Of course, it’s natural to look for a cause.? After all, we are logical beings (most of the time) and have a curiosity and desire to understand what is going on.? However, the problem is that in our chaotic world, we often stop the investigation process once a connection is found.? Often, especially if financial journalists and talking heads on TV say this is the reason for the move, we are on board.? And too many times this causation is erroneous or only part of a bigger answer. ???

We need only to look to late August for an example.? Federal Reserve Chairman, Jerome Powell, gave a speech on August 25th in Jackson Hole Wyoming.? The speech reinforced that the Fed remains worried about inflation and that there will likely be another interest rate increase before the end of the year.?

As expected, the stock market fell on the hawkish comments.? Wall Street’s bulls were hoping for some signals that interest rates increases were ending and, maybe, a possible pivot to a rate cut was forthcoming.? Powell’s message was a big disappointment to many and stock prices reacted accordingly.?

This selloff was surprisingly short, and the stock market stabilized and then strongly rebounded throughout the afternoon.? The S&P 500 and Nasdaq were both up around 0.75% on the day and over 1% from the morning’s lows.? Interestingly, there were no headlines or speech restatements that would explain the stock market rally.?

CNN posted this headline after the markets closed, “Wall Street closes higher after Fed Chair Powell delivers a 'Goldilocks' speech” (CNN.com, August 25, 2023).? The article highlighted that the Fed chairman mentioned ‘economic strength’.? There was no mention of inflation fears and future interest rate increases.? A narrative for the move was offered and that was all that was needed.?

A more accurate reason for the shakeout and rally involved option trading.? Powell’s speech was scheduled as part of an annual gathering of monetary bigwigs and the investing world was aware of it.? Traders, institutions, and dealers had put on material hedges to protect positions.? Once the event was over, these players cashed in the hedges and squared their portfolios which involved buying.? Some were caught wrong footed and had to chase prices higher which fueled the move.?

The Jackson Hole speech and the trading action is just one page of 2023’s capital market script.? The year has seen many instances of market moves that appear to be contradictory to the fundamentals and headlines.? Is it possible that the economy and corporate earnings have decreased as a driver of the financial market? ??

The U.S. stock markets are having a good year and, to be sure, GDP has been positive in the first two quarters and is forecast to show growth in Q3.? However, there are some obstacles that the markets haven’t faced in decades.? The Federal Reserve has raised interest rates 4 times in 2023.? The fed funds rate was at 0.25% in March 2022.? It is now at 5.25%.?

Inflation has declined on a year-over-year measurement but remains well above the target of 2%.? Further, recent data signals that it may re-accelerate, which would continue the tight monetary conditions.? ??There have been historic bank failures this year.? Corporate earnings are declining – see recent releases from Apple (flat year-over-years revenues), Deere (bloated inventory because high interest rates), and Dick’s Sporting Goods (declining margins).? ??

Additionally, the yield curve is historically inverted which is a sign of an oncoming recession.? The 30-year mortgage is hitting cycle highs and impacting the consumer.? Delinquencies are growing across all sectors.?

So, why is the stock market up and what is replacing economic data/corporate developments as market influencers? ?The answers have many parts.? Funds flows, hedging, algorithmic and AI driven trading, systematic investing, and derivative trading have become important parts of today’s markets.?

Last year the markets began trading daily expiring options on the S&P 500 ETF (symbol = SPY) and the Nasdaq 100 (QQQ).? These options are referred to as 0 DTE (0 days to expiration).? This has become a big deal as there are many days where over 50% of total option trading is tied to 0 DTE positions.? This can be a large part in the direction of daily trading and, depending on positioning, can force the dealers to buy and perpetuate the move.? ?

Systematic investing has a growing role in the markets.? This involves periodic investing in an index mutual fund, or a target dated mutual fund.? The mechanics of this process is that a dollar going into these funds gets automatically invested in the market.? There is no thought about valuation or timing – the dollar gets invested in the index immediately.? This also forces the largest stocks of the index to get bigger as they get more of the invested dollar.?

Assigning a narrative to the markets is much easier than digging into the minutia of trading.? And if the narrative is inaccurate, it is further deceiving.? Fund flows, 0 DTE trading, and systematic investing have grown in scale during the past couple of years and are playing a bigger role.? It is possible that the combination of them along with other systems is hiding and distorting risks.?

These strategies may eventually decline in their market impact.? At some point, interest rates, inflation, and economic strength will again drive the capital markets.? But in the meantime, having an awareness and a basic understanding of them is important.? ?The markets are hard enough to figure out using fundamental approaches.? Competing with software, fund flows, and trader hedging, while not understanding the landscape, is exponentially more difficult.?