Party People

January 31, 2023

t’s certainly been an exciting start to the year! High beta stocks have been absolutely flying. Why? I would guess it’s a trifecta of China reopening, bets on the Fed pivoting soon, and a belief that investors are underinvested. Throw in the Treasury effectively stimulating the market with T-Bill issuance, and apparently, you can have quite a party!

Unfortunately, Dad (Powell) is coming to the party, and it seems reasonable to expect that he’ll be pissed. He’s been working hard to tighten conditions to stop inflation, but a combination of the Treasury and investor actions have set him back to conditions we saw around Jackson Hole, five months ago. Inflation is still elevated, so it seems unlikely the Fed is ready to hang up the ‘Mission Accomplished’ banner. Honestly, this seems like a recipe for ‘tighter for longer’ being even tighter and longer, which in turn raises risks the ultimate recession will be that much worse.

Over the years, investors have become increasingly short-term oriented. I’ve heard some investors recently claim VIX is meaningless, because it measures volatility 1 month out, which is too far in the future to matter! That’s fine, the point is that there is a chunk of investors who don’t care about recession risk that’s probably months away, they care about tomorrow, or maybe the next week.

What happens next week, then? The bulls had fairly clear sailing for the last month, as large investors put money back to work after cleaning up balance sheets for the year-end. Now, the FOMC, ECB, and BoE central banks all have meetings this week, where we’ll likely see pushback on the market party. Additionally, the T-Bill party should be running out of steam in the next few weeks. As we approach Tax Day, T-Bill issuance is likely to slow and reverse. Can the market bulls overcome that?

I don’t want to make it sound like this move upward is certainly over, it’s just that we’re finally seeing potential problems ahead. In addition to central bank activity this week and T-Bill issuance likely to slow markedly this month, we also have to consider how much gas is left in the tank after this fast start. As 42Macro points out, we’ve seen a fast move into Goldilocks that historically, at least, tends to take a break at these levels. Lastly, the VIX and the volatility curve are amazingly complacent, particularly considering the risk events that are imminent. I really don’t try to predict crashes, but those two indicators speak to heightened crash risk ahead.

Again, while I personally suspect we’ve seen the end of this high-beta move, I freely admit it’s best to be flexible. We should know a lot more in a week, as we see how the market resolves all those central bank meetings and continued high-profile earnings. In theory, if we can survive this next week in reasonable shape, could we see continued inflows to support more upside? Even then, looking at the reasonable bull targets, we’re probably only looking at another 4% of upside.

Unsurprisingly, it’s likely we won’t see the Fed panic until there’s something to panic about. Right now, financial conditions have eased significantly and the VIX is near 1-year lows. That’s the opposite of panic. We’re not going to see real Fed action until inflation is good and dead, or we see significant problems. Right now, we have neither, so effectively the Fed is still the market’s enemy.

Sharp contra-moves are a feature of bear market rallies, particularly earlier on. The picture below shows the Nasdaq 100 from 2000 to the end of 2002. There were plenty of bounces to chew people up and spit them back out. If you can successfully time some or all of those bounces, then great. Most people can’t though, and from 2000 to 2002, the Nasdaq 100 lost about 75%. I’m not saying that’s what’s going to happen here, but it’s worth having perspective. There were times in there where being cautious looked pretty stupid and felt pretty bad, but a solid strategy is going to do much better than FOMO, over time.

For our part, we would love to participate in good rallies. Long bear markets can take a lot of time, and we’re willing to be pretty patient until we see the skies clear. The ultimate end is likely to come when we are in a clear recession. That’s when we can get unambiguously positive. Until then, more hard times are inevitable, if history is any guide.

If we can get sufficient investor fear, we can probably get a lower-risk, shorter-term entry point to make excess returns before the ultimate bottom is in. That certainly doesn’t describe the current situation, though. Right now, this week is a big week, and we need to see how the environment evolves from here. Limiting drawdowns is the most important thing to focus on in a bear market, and right now, risks are way too high.


About the Author:

Colin Symons

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About the Author:

Colin Symons

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