November 14, 2022 | Allio’s Chief Investment Officer, Raymond Micaletti, discusses possible scenarios after last week’s seismic market move.
If only every week could be like last week.
Going into the week, several signs—including the likely future path of inflation—had all aligned, suggesting equities would move higher in the near term.
With the cooler-than-expected CPI report on Thursday, equities surged. And, importantly, the S&P 500 and Nasdaq broke through their respective downtrend resistance lines from August’s interim high—each tacking on an average year’s worth of returns in just two days.
Now, the picture is a bit murkier.
What makes the analysis particularly difficult is that the forces (higher rates, plunging money-supply growth) that led to lower inflation (and equity jubilation last week) may soon lead to slower growth, lower corporate earnings, and less consumer demand (and eventually equity immiseration).
For much of the year, the equity market has intermittently rallied on hopes of a Fed policy pivot. But a chart making the rounds on Twitter suggests that equities fall when the Fed finally relents and lowers rates—mostly because during previous episodes the Fed pivoted only when the economy revealed it was in bad shape.
In last week’s commentary, we sketched out a potential scenario in which the market rallies in anticipation of a Fed pivot (because of falling inflation, a falling dollar, and falling yields) but sells off when the pivot actually arrives.
We still think that is a reasonable scenario going forward, but presumably, a lot of the expected return has already been realized given last week’s large move.
Moreover, as equities rise and financial conditions loosen, the Fed may feel emboldened to raise rates faster or higher than markets are currently pricing. I.e., rising equities could be a self-defeating phenomenon.
We will get more insight into Fed thinking this week as upwards of 10 Fed speakers make the rounds. Perhaps they jawbone the market lower again. Or perhaps they are fine (for now) with a higher equity market given it removes a sense of fragility in the bond market (whose lack of liquidity has been exposed recently with the Fed draining liquidity via QT, Treasury issuing more bonds than expected, and sovereigns selling Treasuries to buy oil).
Regardless, the bullish case for equities is much less clear-cut than it was last week and the bearish case has reawakened. We’ll briefly examine both.
The Bullish Case for Equities
After last week, the bullish case for equities is rooted in continued speculation on inflation, technical factors, investor positioning, and investor psychology.
Speculation on Inflation
It’s possible that the reason the S&P 500 had a hard time staying below 3600 (even though from a valuation perspective it was likely still too high relative to where real yields were) was because the market had sniffed out that inflation would fall faster than expected. Thursday’s CPI report may be the first indication of such a dynamic.
If inflation continues to fall in the coming months, the Fed may be able to pause its rate hikes soon enough to engineer a soft landing for the economy. If that were to happen, it’s conceivable equities could rally much higher than many currently expect.
From a technical perspective, the higher the market goes, the more CTAs have to buy. According to one report, if the S&P 500 surpasses 4057 (it closed Friday at 3992), CTAs will have to buy $100 billion in equities.
Further, there are volume nulls (areas on the chart where few trades took place because the market was falling precipitously) and gaps overhead that the S&P 500 (and Nasdaq) could potentially fill.
Those chart areas tend to be associated with the handful of beatdowns the market took on account of Powell speeches or inflation data.
From a flow perspective, lots of puts were bought to hedge the outcomes of the midterm elections and the November CPI report. Now that those events are behind us and the world hasn’t ended, there will be a need for dealers to unwind their hedges, which will lead to a need to buy back their short equity positions. (Volatility guru, Cem Karsan, said in the days leading up to the midterms and CPI report not to be caught short after those events had passed, precisely for the reason outlined above.)
We will also have $10 billion in corporate share buybacks every day until the end of the year.
Equity markets tend not to top until institutions have become 2-3 standard deviations shorter than their typical equity positioning. As of the last reading, institutions were still longer than average and it will likely take several weeks for them to become substantially short. Thus, if past trends hold, equities are likely to remain firm until institutions become much shorter (and retail and speculators become much longer).
Turning to the dollar, speculators (who tend to get the dollar direction correct) have recently become relatively bearish and so far the dollar has fallen 7.5% from its September high. If the Fed is slowing its pace of rate hikes while the rest of the world remains relatively more hawkish, that could continue to drive the dollar lower—which would likely support risk assets.
On the rates front, institutions are bullish long-duration bonds relative to retail traders. This long-bond positioning, in conjunction with bearish dollar relative sentiment suggests yields may fall further. Falling yields and falling real yields would likely support a further equity rally.
Most investors seem to believe this rally in equity markets is just another bear market rally. Many investment managers have sizable cash positions and low allocation to equities and may be nursing large losses on the year.
If equities and bonds were to continue to rally such that by year-end each had recovered a substantial portion of their year-to-date losses, many investment managers would likely feel pressure to chase the market higher—possibly causing additional equity gains.
The pressure to chase would be immense if the Fed were somehow able to craft a soft landing. In that scenario, it’s conceivable equities could rise near to (or even surpass) their prior all-time highs.
The Bear Case for Equities
The bear case in equities is rather straightforward. It rests on poor valuations, a resolute Fed, a slowing economy, and the removal of tail-risk hedges.
Despite the year-to-date selloff in global equity markets, U.S. equity valuations suggest only a 3% annualized return over the next decade. Inflation will almost certainly annualize at a higher rate during that time.
Thus, U.S. equity investors can expect negative real returns from holding the broad market from this point onward (certain sectors and industries will do better than others, however).
The still-poor valuations speak to how absurd valuations were at the market peak in late 2021.
A Resolute Fed
The Fed already appears to be pushing back on the equity market, with governor Waller saying on Sunday evening that the equity market got “waaaa-aaaay out in front… I just cannot stress this is one data point. We’ve still got a ways to go.”
The pattern we have observed all year is that the Fed speaks in conciliatory tones when the market appears to be falling off a cliff and actively attempts to push equities lower when equities have rallied. That now appears likely to continue.
The question is whether it will have any effect at this point if the market thinks inflation will be falling precipitously.
A Slowing Economy
Although heretofore the U.S. economy has appeared to hold up rather well, the cumulative effect of tighter financial conditions, especially the outright contraction of the money supply (something that hasn’t happened on a year-over-year basis in at least 60 years), might cause growth to drop sharply with little forewarning to investors caught up in a rising equity market.
Many mega- and large-cap companies have reported layoffs or hiring freezes in recent weeks, which suggests tighter financial conditions are finally starting to bite.
Thus, the forces that caused inflation to drop more than expected in October may also cause growth to slow dramatically as well. Slower growth could affect consumer demand and corporate earnings. (Let’s keep an eye on yield-curve inversions as a potential tell.)
Lack of Tail-Risk Hedges
Lastly, one of the impetuses for the recent rally off the lows was the extreme bearish sentiment and positioning (via put options). That bearish positioning is disappearing as investors sell their puts as the market rises. But on the next down leg in markets, a rush to buy puts may lead to a situation where dealers (again) have to sell the market as it falls, potentially creating some nasty downside tail effects.
Given all the potential landmines the market is likely to face over the next 8 weeks (more inflation data, another Fed meeting, Q4 corporate earnings), it would be surprising if there weren’t at least one that causes the market to rethink its current bullish stance.
We tend to be reflexively contrarian—if everyone is on one side of the boat, we generally like to be on the other. While last week we had a bullish disposition, the strength of last week’s rally on—as governor Waller said—only one data point, causes us to think the market may very well have gotten ahead of itself.
However, we have also learned from experience that we often underestimate how far markets can run in the near term (and become bearish prematurely).
Thus, we tend to think that Sentix, a German provider of sentiment data, might be right when it comes to what we should expect from markets over the next several weeks. Sentix’s view, backed by historical data, suggests:
The equity market will consolidate over the next two weeks (i.e., go sideways, digesting the recent gains) before resuming its upward move.
The euro will continue to strengthen against the dollar.
Conditions are likely to remain supportive for bonds and gold.
Such action would allow equity markets to fill gaps and repair prior technical damage, get more investors convinced the bear market is over, and allow institutions to unload their previously-acquired long positions well above their cost-bases.
That tends to be how markets operate.