Observations by David Robertson, 11/11/22
The week was highlighted by good news on the inflation front and a midterm election that, due to a number of close races and new election rules, is becoming more of a “season” than an “event”. If you have questions or just want to get some perspective on the whirlwind of happenings, let me know at drobertson@areteam.com.
Market observations
In a year in which volatility has been the name of the game, the chart for CVNA stock is as representative as any. Three distinct phases are clear. First, from 2018 until Covid, growth stocks went up on very little pretense. Rates kept going down and long duration, pie in the sky stories won out over real economy businesses.
Covid initially sent a big scare into markets early in 2020, but after loads of fiscal spending was sanctioned to “ease” the burden, huge amounts made it into the market and stocks took off on an even higher trajectory.
The third stage started right around April 2021. Inflation started popping up in places and bottlenecks were creating problems. The very most speculative stocks were hit first, but after the Fed signaled intent to act on inflation - and subsequently started tightening policy significantly - most of the rest of the market followed suit.
One takeaway is a lot of stocks with weak business plans and poor financial performance got bid up way more than they ever had a right to be. While the selloff has been brutal in many cases, it is just the mirror image of the weak pretenses for appreciation before. As long as inflation remains above the target of 2% and the Fed keeps rates at a more “neutral” level, the incrementally higher rates will continue to pose a financial burden on weak businesses. We’ll be seeing a whole lot more charts like this.
Market Sit-Rep November 9th, 2022
https://mailchi.mp/974707bea15f/market-sit-rep-november-9th-2022-crypto-debacle?e=1814b2df79
Over the past several months, an unusual event has occurred as the bear market advances -- demand for index calls is rising sharply, leading the green "10 delta" strike to rise. These are out-of-the-money call options on the S&P 500 typically used to "protect" an underinvested portfolio from the risk of a sharp rally. At the same time, demand for downside put protection, the white 90 delta, has fallen sharply. In English, market participants are far more worried about missing upside than they are about protecting downside.
Some really good color here from Tier1alpha - that also comports with recent observations. If it seems like the market just wants to keep going up regardless of news, that’s because it basically does. Positioning is far more weighted to “fear of missing out” than it is to avoiding a big downside crash.
As I am wont to say, one data point does not a trend make, but sometimes it does point to an important change. That certainly appears to be the case with this chart on housing, especially given that it comports with much of the andecdotal evidence. Signs keep pointing to the notion that Covid has fundamental changed a number of things, not least of which is the nature of our work/life relationship.
Cryptocurrencies
Some of the biggest news of the week came out of the cryptocurrency world. In just a matter of a couple of days one of the biggest crypto exchanges, FTX, went from having a reputation as "the JP Morgan of crypto” to being insolvent.
The details are widely available (Robert Armstrong and Ethan Wu ($), John Authers and Isabelle Lee ($), and Almost Daily Grant’s (11/8/22)) provide good summaries) but the basic story is one of misrepresentation and lack of regulation. Neither of these characteristics are conducive to a high level of trust but are all-too-familiar in the crypto community.
The impetus of the whole affair was a run on the bank. Runs are successful when insufficient monies back outstanding claims. The nature and liquidity of that backing is exactly what got called into question - and failed to deliver.
By all appearances, this shortcoming was not just some innocent accounting mistake. As @AlderLaneEggs calls out, FTX’s founder, Sam Bankman-Fried, “is a Fraud”.
The outcome is stark and will probably be a lesson for some crypto investors. What was considered to be the safest store of value in a sea of uncertainty and flawed fiat currencies, will likely return just a few cents on the dollar. And that return will only come after extensive litigation. It is hard to imagine after this disastrous experience there won’t be some wholesale reconsideration of gold as a useful store of value.
Oil
This chart from themarketear.com/premium ($) reveals a common relationship - and a recent change. While oil and the energy sector ETF, XLE, normally follow a very similar path, XLE broke off from oil over the summer.
One possible interpretation is stocks are more accessible speculation vehicles for retail investors so the differential performance we have seen recently is simply an expression of speculative interest.
Of course, there is a good case to be made for oil longer term, but as @UrbanKaoboy points out, that time does not appear to be now, at least not convincingly so.
Could this be some pre-election positioning? Sure. Since most polls have Republicans gaining the House and in good position to take the Senate too, there are clear pathways for oil to be a beneficiary.
Could this be a case of “buy the rumor, sell the news”? Absolutely. It may well be that just the prospect of a better policy environment for oil was pretense enough for some punters to take their chance on oil stocks. Given the relatively tepid response of oil and oil stocks to the election and to the softer inflation number, this appears to be at least partly the case.
Politics
US midterms: What we know and what we don’t ($)
https://www.gzeromedia.com/us-midterms-what-we-know-and-what-we-dont
What’s more, many of the candidates that Trump backed – including Michigan's John Gibbs and Tudor Dixon, running for the House and governor respectively, as well as Pennsylvania gubernatorial contender Doug Mastriano – had very bad nights. Predicting that the riffraff of election deniers and provocateurs would not appeal to American voters, Dems – yes Dems – poured millions of dollars into propping up these GOP candidates in primary races, and the strategy seems to have paid off.
A few summaries of the midterms here with some takeaways. One point is Trump did not do well and by extension, more extreme candidates did not do well. Indeed, Dems applied this hypothesis strategically to set up races with more extreme, and therefore more beatable, Republican candidates. Increasingly, the vote is not so much for someone, as against someone else.
The Red Wave That Never Was ($)
https://thedispatch.com/newsletter/morning/the-red-wave-that-never-was/
As economic conditions worsened, however, that conventional wisdom began to shift on both the right and the left. Maybe candidate quality doesn’t matter, pundits began to argue. Maybe the political environment is such that any jamoke with an R next to their name could ride the Red Wave no, Red Tsunami, into office, personal or political baggage be damned.
Nope! Turns out voters are more than capable of discerning between strong and weak candidates and more than willing to withhold their support from the latter.
Relatedly, candidate quality definitely seemed to be an issue in this election. Voters seem less concerned with specific political affiliation than whether the candidate is remotely competent and not a whack job.
How History Might Remember—or Forget—the Next Congress ($)
So if you’re looking for Congress to impeach Joe Biden and investigate his son Hunter—two actions that are way downstream from most peoples’ lives—then you’ve got lots to look forward to if and when the Republicans retake the House. But if you’re looking for this Congress to fix inflation, to control crime, to reform immigration, or to regulate abortion (the top issues on most voters’ minds), then you’re likely to be sorely disappointed.
A couple of points here. While I believe David French overstates his case that this election might “be one of the least important elections of my [his] lifetime”, he is absolutely right to put it into context.
As he highlights, issues that really matter to voters such as inflation, crime, immigration, and abortion rights are extremely unlikely to be fixed, or even addressed, by this Congress. What remains will be kabuki theater - going through lots of machinations to achieve very little of importance.
Inflation
The CPI report came out on Thursday and came in a bit lighter than expected. Headline CPI was up 0.4% month-to-month and 7.7% year-over-year. That represents a deceleration from the annual pace of 8.2% last month. Goods inflation was down, services inflation was up.
More interesting than the results themselves was the market reaction: S&P 500 (futures) shot up over 3% on Thursday after the report, opened up 3.5% and was up over 4.5% for a good part of the session. Long rates got clobbered. Clearly, traders have been waiting for the opportunity to make a big directional bet.
The read-through is less clearly positive for markets. While it is good to see a decline from the peak, that alone is hardly indication of a rapid and uninterrupted return to the 2% target. The hugely positive market reaction suggests expectations are too high for inflation to be vanquished quickly and effectively.
Although goods prices fell, there are virtually no indicators suggesting weak supply growth across a wide array of commodities has improved. In other words, it is most likely only a matter of time before goods prices will be heading up again. Add a little bit of economic growth and some improved mobility in China from Covid lockdowns and commodity supply won’t be able to keep up.
Services prices were up and may well keep going up. Since services are labor intensive and real wages have been falling, it is fair to expect continued pressure on wages - and therefore the pricing of services.
While the market was cheered by the CPI report for sure, that mood is likely to be cooled by the ups and downs of various inflation components and by the length of time the Fed needs to remain at higher rates in order to keep inflation under control. This isn’t over by a long shot.
Investment landscape
This graph from themarketear.com/premium ($) provides some helpful context for markets. Both volatility measures, MOVE for fixed income and VIX for stocks, have told similar stories since last summer. The main part of the story is both measures have been continuing to go up with a clear pattern of higher lows. Most recently, both measures are off from recent highs, but still within fairly clear upward trend channels.
It is certainly possible that volatility in both stocks and bonds has run its course and both are set to moderate going forward. This would be consistent with the “back to normalcy” viewpoint.
Neither VIX nor MOVE have definitively broken out of their upward trajectories, however. As a result, the most viable forecast would be for a resumption of their upward paths. If that is indeed the case, it should be starting fairly soon and would forewarn of a bumpy run into year-end.
There are a number of interesting nuggets in this thread but the overarching theme is the same one I have professed here many times: We are in a different investment landscape now. Market beta and levered market beta won the day in the last decade-plus of Fed-sponsored liquidity. But that is over.
This has two important implications. One is simply being exposed to market beta (i.e., owning stocks) will not be enough to get you ahead. It was fun while it lasted, but it will no longer be enough.
The flip side of this is that in order to get ahead, you will have to find the right assets and the right securities and constantly be managing risk. In other words, it is going to take solid investment analysis and lots of work. For those who can do it, it will be good times. For those who can’t, not so much.
Monetary policy
I can quibble with a few points in this thread but the main points are spot on. First and foremost, with the Fed’s massive intervention in markets, liquidity is the name of the game. Fundamentals really don’t matter when money keeps flowing in. When it starts flowing out, that is another issue entirely and that’s where we are today.
I have highlighted the impact of Quantitative Tightening (QT) several times. An important point made in this thread is that TGA (Treasury General Account) and RRP (The Fed’s reverse repo facility) can also have significant effects on liquidity. This is especially relevant since there has been movement in both pools recently.
As a result, it is the combined effect of changes in each of the three pools of money that matters for net liquidity, and therefore market conditions. While QT exerts continuous downward pressure on liquidity, the unwinding of RRP is positive and TGA indeterminate. Recently, TGA has been depleted from its target of $700B down to $531B (as of Monday) and this has been positive for liquidity.
One point is the thread contains links to the data sources so investors who want to follow along can certainly do so. As such, some patterns can be ascertained which can provide guidelines for market action. For example, since the year-end goal is to have $700B in TGA, that account can be expected to draw about $175B on liquidity through the end of December. Combined with the continued draws from QT, this will provide a significant headwind for stocks.
In a broader sense, these three levers of liquidity also illustrate the various moving parts the Fed has to guide liquidity and markets in a certain direction. To that point, recent talk of Treasury buybacks was perceived very positively since it could add to liquidity. Yes, it could. But it would also have to be factored in with what is going on with QT, TGA, and RRP in order to determine a net effect. Monetary policy is not just about rates any more.
Implications for investment strategy
Wow. While some people have a talent for massively propagating drivel in 240 characters or less, some others have a talent for striking right at the heart of important challenges with an incredible economy of language.
One point is “uncertainty is a time to make sure you are getting paid”. Yes it is. That means it is not a time to meander aimlessly while waiting for a payback. This is exactly why companies that aren’t earning money and/or have bad business models are getting hit so hard in the market. This is a time to make sure you are getting paid.
Another point is “uncertainty is a time to make sure you are … going in with your eyes wide open as to a range of outcomes”. Yes again. By its very definition, the specific outcome to uncertainty is unknown, and unknowable. Calibrate accordingly. If you bet all your chips on one particular outcome, be ready to lose them. Otherwise, spread the chips around.
A related idea is to go in with eyes wide open as to the types of possible outcomes. One function of uncertainty is it can produce results that are entirely outside of recent (or any) experience and completely surprise people. Uncertainty demands we all keep our eyes wide open to possibilities, but to keep our imaginations open as well. When conditions get really crazy, so can the outcomes.
Note
Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.
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