Time For a Breather
Equities are set up to follow in the footsteps of the Fed and take a breather from the torrid rally underway here in 2023. Sure, I have been and continue to be in the ‘camp of skeptics’ that this move is sustainable, and not willing to buy into this being a new bull market, but if such a view ends up being wrong, I can handle that. What’s important is that you compound capital effectively over time and that is done by risk managing / preserving capital on the downside and capitalizing on the upside. Being perfect on both sides is an admirable aspiration, but impossible to perfect. Nevertheless, the broadening out in market breadth over the past several weeks has left enough crumbs in segments of the market that were left behind for investors more broadly exposed than the “magnificent 7” to capture some upside.
I’m going to keep my comments this week short and sweet because I came across a piece of research penned by Larry McDonald at the Bear Traps Report Blog that I think is so spot on that I wish I had written it myself. But rather than try and recreate it, I’d rather just give credit where credit is due and encourage you to read it for yourself. In lieu of my babbling, do yourself a favor and digest the crux of what’s penned in this piece, linked below.
The Great Hijacking | The Bear Traps Report Blog
As for my thoughts on the markets:
Over the past six weeks the one-sided positioning and sentiment residing stubbornly in the ‘bear camp’ coming into this year has been begrudgingly unwound. This repositioning by investors to not get left too far behind the major averages is no longer a tailwind for risk assets and makes for a much more balanced risk/reward setup (if not skewed a bit to the risk side at this point) going forward in the equity market.
Market direction will be more sensitive to fundamentals with where we are in the cycle. The economic ‘soft landing’ has been repriced into equities which leaves the possibility of a ‘hard landing’ as the bigger repricing risk should it play out. However, there will be no ‘hard landing’ and I’d posit no recession repricing without negative payroll prints (note the use of the plural ‘s’ on prints – as in more than one)
Inflation is yesterday’s news and with it so is the Fed rate hiking cycle. Sure, futures markets are priced at 70% probability for another 25-basis point hike in July, but we’ll see how rate hike expectations change with incoming data going into the next Fed meeting in July. My guess continues to be that the Fed is done, and whether they do or don’t do another 25-basis points at the next meeting is a non-event for the economy. A Fed that is near or at the end of a tightening cycle is a market positive in that it removes uncertainty from the investment equation as it pertains to the Fed.
Biggest headwinds going into the back half of the year are the withdrawal of liquidity from Treasury issuance and Quantitative Tightening. Markets have actually experienced an increase in liquidity so far in 2023 due to the drawdown in the TGA and the introduction of the Bank Term Funding Program (BTFP) following the regional banking crisis in March. But these are now reversing.
Additionally, the economy will now be contending with the lagged impacts of 500 basis points of interest rate hikes since March 2022. This has pushed up the cost of capital for every financing transaction and runs right into a maturity schedule that ratchets higher in H2 of 2023, 2024, and 2025. Not to mention a labor market that is slowing, bank lending that is rolling over, and the end of the college loan forbearance program in late-August.
Bottomline, I just don’t see very much in the markets that excites me right here right now. Valuation metrics for the broad equity market are stretched (20x P/E multiple for the S&P 500) on a historical basis. Sure, AI, robotics, cybersecurity, select commodities, specific foreign markets, parts of the healthcare sector, onshoring, a U.S. industrial renaissance, and the energy transition are all long-term thematic opportunities that are investable, but I wouldn’t say right here right now is the best time and price to put the full exposure on. Incrementally adding too an exposure, while building out a position, sure, but Patience with a capital P and Discipline with a capital D are what investors should be adhering to today.
Get out and enjoy the nice weather as it’s likely the upcoming quarterly options expiration at the end of the month will keep the S&P 500 pinned below 4,400 for the next two weeks and highly probable it gets pulled down to 4,320 by months end.
As for the piece highlighted above and reposted below by Larry McDonald, don’t overlook nor underestimate the structural change that has taken shape in the markets over the past two decades. The growth of passive investing is a huge structural force that requires a deeper understanding of what is moving markets, as fundamentals (while still relevant and important) no longer take top priority. The likes of Vanguard, BlackRock, and State Street have created a monster through the guise of low cost, tax efficient, and thoughtless capital allocation decision making. The change in market structure from passive investing becoming the dominate investment decision making criteria versus active managers (who conduct extensive fundamental analysis) in setting the price of investments has ushered in a regime where market participants know the ‘price’ of everything, but the ‘value’ of nothing. This regime change has been magnified by daily trading flows with passive indexing representing more than 50% of overall investor exposure and upwards of 90% of daily trading activity. Couple this with the expansion of the options market into 0DTE contracts (zero days to expiration) and we’re looking at equity markets that are dominated by algorithms setting the marginal price of a security not based on anything fundamental, but rather by flows and a constituents respective weighting in an index.
The Great Hijacking | The Bear Traps Report Blog
Whether you like this regime shift or hate it, is irrelevant. What’s important is that you understand it and adapt to it.
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