Drama Queens

Oct. 24, 2018 11:51 PM ETIVE, IVW, KRE, MTUM, NFLX, QQQ, SOXX, SPY, TLT, XHB, TBT252 Comments112 Likes
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The Heisenberg
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Summary

  • U.S. stocks are on pace for their worst month since 2009, and the Nasdaq fell the most since 2011 on Wednesday.
  • Amid the selling, folks have started with the hysterics, and in a nod to my January promise to readers, I'm going to be the voice of reason.
  • If you'll lend me your ear, I'll explain how we went from basking in the glow of all-time highs to pondering a correction in the short space of a month.
  • This is probably one of the more important posts I've penned for this platform.

A long-standing contention of mine is that when markets finally return to some semblance of normality, you will quickly discover that everyone is suddenly trafficking in "hysterics", and not because they're trying to get attention or otherwise exacerbate the situation, but rather because even the veterans have become so accustomed to the post-crisis reality that the return of two-way price action will be greeted with extreme incredulity and/or panicked attempts to make sense of things.

When that day finally comes, my tone will seem measured by comparison.

That excerpt is from a January post I penned for this platform called "Hysterics", and I've been patiently waiting for the right time to redeploy it. On Wednesday, that time finally arrived.

October is on pace to be the worst month for the S&P (SPY) since early 2009. U.S. stocks are on the verge of a correction just a little over a month after hitting all-time highs.

(Heisenberg)

This week's selling feels a bit different from what happened earlier this month and in February. I'll explain why below, but first let me speak a bit to the quote excerpted above. Predictably, the financial media and the blogosphere are inundated with stories about the selloff. The rhetoric is shrill, and in some cases even gleeful, as long-time bears and Johnny-come-latelies alike seem to be impressed with how much money you might be losing.

Well, just as I promised back in January, my demeanor and tone have not changed. The stock market is not a casino. It is a price discovery mechanism and a means by which investors can hitch their financial wagon to the long-term fate of the U.S. corporate sector. The rules have been suspended for nearly a decade, thanks to ultra-accommodative monetary policy, but now, thanks in part to the Fed's newfound data dependence, the "state of exception" (to quote Deutsche Bank's Aleksandar Kocic) is being lifted. Markets are being re-emancipated. Two-way price action is returning, and as should be expected given the Fed's role in prolonging the cycle, the re-emancipation of markets is coinciding with the end of said cycle precisely because there can be no other outcome. The same policies that stopped the clock on the cycle also perpetuated the proliferation of the short volatility trade in all its various manifestations. So, now that those policies are being rolled back, two-way markets are returning just as the cycle turns.

What you're seeing in markets this week is not some kind of aberration. You should not be surprised to learn that stocks can go down as well as up. It should not surprise you that investors appear to be pricing in "peak earnings" (more on that below). Nor should it surprise you that the Fed, under Jerome Powell, has decided to do what the economic data dictates rather than allowing the market to co-author the policy script.

In short, there is nothing to be incredulous about. There is no need for hysterics or for whooping and hollering and carrying on at all hours of the day (CNBC is running another one of their "Markets In Turmoil" specials tonight).

If it's hysterics you're looking for, you won't get them from me.

All of that said, you should distinguish between what appears to be going on this week and what happened earlier this month and also in February. There is something to be alarmed about when it comes to flash crashes driven by systematic unwinds, programmatic selling and forced de-risking.

With that in mind, what I want to do below is take you through how we got to where we are now from where we were just last month. This description of the evolving narrative will underscore how the technical rout on October 10 morphed into a more fundamentals-based selloff (that's not to say systematic selling didn't play a role on Wednesday - it probably did).

There is no mystery as to what's happened since September. Early last month, the August payrolls report was accompanied by an average hourly earnings print that betrayed the fastest pace of wage growth since 2009. That, combined with other signs that the U.S. economy was still firing on all cylinders, presaged a bond (TLT) selloff and a possible flip in the equity-rates correlation (i.e., a scenario where stocks and bonds sell off together).

Later, during the week of September 17, bonds did indeed sell off, but nobody noticed. Fast forward to the first week of October and bonds were routed after a big ADP beat and an extremely hot ISM services print. This time, people took note. Here's an annotated chart that shows daily moves in 10-year yields during notable bond selloffs and rallies this year:

(Heisenberg)

The early October selloff in the long end bear-steepened the curve, which in turn catalyzed a rotation out of popular "slow-flation" plays (e.g., Growth and Tech). That rotation set the stage for an unwind in Momentum, which played out the following week when the iShares Edge MSCI USA Momentum Factor ETF (MTUM) had its worst day on record.

At the time, the equity selloff was technical in nature; that is, it was driven by systematic flows, as the sign flip on the equity-rates correlation hit risk parity and balanced funds, while momentum signals turned bearish, forcing CTAs to de-risk into a falling market. Option hedging exacerbated the situation materially on October 10.

It's important to keep in mind that up until October 4, equities had digested rising yields with relative alacrity. Remember, the extent to which stocks can stomach a selloff in the long end is largely down to how markets interpret rising yields and, at least as important, how rapidly yields are rising. As long as rising long-end yields are seen as the bond market catching up to economic outperformance, rate rise can be seen as a positive development. The decomposition of rising yields matters too (Is it real yields leading, or breakevens? Is the term premium getting rebuilt?), but irrespective of the decomposition of yield rise, rapidity matters. Generally speaking, if 10-year yields rise two standard deviations within a month, that's trouble for stocks, and that's what you saw early in October. Because the bond selloff was accompanied by bear steepening, a side effect of the bond rout was a Growth-to-Value rotation, and because Growth/Tech is where the leadership is concentrated, that rotation was bad news.

What you should take away from the above is that earlier this month, equities were to a certain extent a victim of circumstance and also a victim of their own success, where that success is everywhere and always defined by the performance of Growth and Tech. The economic data that drove the bond selloff by all rights suggested the economy is growing faster than the Fed is tightening - a state of affairs that's easily digestible (and perhaps even bullish) for stocks. But because the bond rout was accompanied by bear steepening (which is anomalous late in a hiking cycle), Tech and Growth got hit. That, in turn, started tipping dominos. The result was October 10.

Since then, the narrative has changed. Thanks in part to President Trump's persistent characterization of the Fed as "too tight", the market has come to believe that we're tightening faster than we're growing (to adapt a line that shows up over and over again in the daily musings of Nomura's Charlie McElligott).

In addition to the President's warnings that the Fed is tightening too quickly, the market has seemingly woken up to the fact that Q3 marks "peak earnings". I'd say I've been "warning" about that for quite a while, but that wouldn't be an accurate way to phrase things. "Warning" suggests I know something you don't, and there is exactly nothing controversial or otherwise novel about suggesting that earnings growth for U.S. corporates is likely to decelerate from here.

Record profit growth stateside was a direct result of the tax cuts. If you don't believe that, have a look at the following chart which shows actual and forecasted EPS growth (yellow dots) versus EPS growth ex the impact of the tax cuts (orange bars):

(BofAML)

Clearly, that impulse is going to fade going forward, as is the buyback impulse, which means bottom line growth is going to decelerate as the effects of the stimulus wane. The market knows this, and so, earnings beats aren't being rewarded this season (people are frontrunning the expected deceleration, or at least that's my take).

I talked about this at length last weekend in "The Titans Must Not Fall". Here's an excerpt (and the quotation marks indicate verbatim quotes from a Goldman note cited in the article):

The "rapid [earnings] growth prospects of [Tech]" can only "continue to drive share price gains" if the market responds to earnings beats and that's why the lack of convincing follow-through from Netflix's earnings report is concerning.

That lack of convincing follow-through for Netflix (NFLX) was readily apparent on Wednesday, when the shares plunged the most since 2016, falling for a fifth day in six.

(Heisenberg)

That leads me neatly to Tech itself. Over the past four weeks, I've consistently suggested the market isn't ready to handle the Growth-to-Value rotation that took hold earlier this month (as described above). While that rotation was initially sparked by the bear steepening that accompanied the early October bond rout, it's now seemingly driven by an outright fear of crowded trades and overvaluation in a market that's spooked.

Growth (IVW) underperformed Value (IVE) by ~1.2% on Wednesday, one of only a handful of such instances in 2018 (other notable occurrences of the same underperformance are annotated on the chart):

(Heisenberg)

That is trouble, and as you're probably aware, the Nasdaq (QQQ) fell the most since 2011 on Wednesday.

(Heisenberg)

Playing out alongside all of this is a complete breakdown in all of the things you'd expect given where we are. As the above-mentioned Charlie McElligott wrote on Wednesday morning before things started to go horribly awry, "the ongoing collapse in U.S. Cyclical Bellwethers remains a powerful warning-shot that is feeding into the negative Equities-investor psyche".

I'm not going to run through the entire chart recap (those interested can check it out here), but suffice to say homebuilders (XHB), autos and regional banks (KRE) are all in an egregious tailspin. And that's not even to mention the semis (SOXX), which are having their worst month since the crisis days.

(Heisenberg)

Hopefully, you can see what I mean when I say the narrative in October has morphed from a tale of systematic, forced de-risking following an acute bond rout (i.e., a repeat of February) into a fundamentals-based story about end-of-cycle dynamics, peak earnings and Fed jitters.

Speaking of Fed jitters, the market is starting to think Jerome Powell might get cold feet. EDZ9-0 is inverted again, which means the market is pricing no more hikes after mid-2019:

(Bloomberg)

Additionally, EDZ8-9 is behind the dots:

(Bloomberg)

The problem here is that there's no "easy" way out of this for the Fed. If the economy rolls over, that will, of course, give them scope to stop hiking, but it would also mean they've already hiked too much. If the data continues to come in strong (or "worse", stronger than expected), then it's possible Powell will lean even more hawkish, an outcome that would invariably exacerbate the dollar liquidity squeeze (in money markets). It didn't help risk sentiment on Wednesday that the Bloomberg dollar index touched its highest levels of the year.

The "best" thing would be for the data to cool off enough to give Powell plausible deniability to lean dovish, but at this juncture, market participants are going to be inclined to exaggerate (in their minds) any upside or downside surprise, which means the whole concept of "just right" (a nod to the "Goldilocks" story that underpinned 2017's low volatility regime) no longer exists.

This is all set against a rather unfortunate situation in Italy, where the European Commission has rejected the populist government's draft budget, setting the stage for a protracted dispute over fiscal policy.

At the same time, trade tensions between the U.S. and China are still running hot. I'm not sure if you're keeping tabs on it or not, but the Shanghai Composite index is now the most volatile major market in the world. Have a look at this:

(Heisenberg)

The wild intraday swings represented by the higher purple bars reflect the push-pull dynamic between, on one hand, souring sentiment, lackluster economic data and forced selling tied to margin calls on pledged-stock loans, and on the other hand, official jawboning and outright equity buying by the vaunted "National Team".

The point with those latter two paragraphs is just to underscore the notion that the Italy problem and the trade war are still very much on the frontburner, and you can be absolutely sure that's contributing to traders' dour mood.

All of the above certainly seems daunting, but I didn't set out to pen a bearish post. Rather, as alluded to here at the outset, my intent here is to help you make sense of things by putting the puzzle pieces together. What you're seeing this month is indeed something of a perfect storm. Investors have seen it all over the last three weeks: A bond selloff that flipped the equity-rates correlation, a harrowing systematic selloff, fundamental concerns about peak profitability, Fed jitters, Italy woes and volatility in China. Simply put: If it was on your list of worries, you've seen it play out.

But remember that none of this is "new" - per se. These are all concerns that folks have been raising for months (and in some cases years). I'm not sure it pays to panic right now or to otherwise find yourself swept up in the hyperbole. What you need to do is assess everything said above and make a determination about what it means for your near- and medium-term allocation strategy. I, for one, am not wholly convinced that the Growth-to-Value rotation is here to stay, nor am I convinced that there won't be another bounce before this whole thing finally tips over for good.

So, you know, don't be a drama queen about it, ok?

What I would say in closing (and this is, I suppose, the obligatory nod to bearishness that you've all come to think I owe you) is that the more days like Wednesday we get, the more likely you are to see another 1,000-point (or more) down day for the Dow. Modern market structure is such that these dramatic selloffs will everywhere and always be exacerbated by some manner of programmatic selling pressure. That's a guarantee.

Further, I continue to worry that at some point ETFs won't be able to handle the burden that's on their shoulders. ETFs were 41% of the consolidated tape on October 11. That was 7% more than the historical relationship with the VIX would have predicted and a full 9% more than the 32% of the tape that ETFs comprised through October 16 (and do note that the 32% figure is itself high).

(Goldman)

Ok, that's all I've got for you on Wednesday. As ever, I hope it was the best macro analysis that found its way to your inbox today.

This article was written by

The Heisenberg profile picture
29.15K Followers
Perhaps more than any other time in the last six decades, the fate of markets is inextricably intertwined with the ebb and flow of geopolitics. It's become increasingly clear that one simply cannot fully comprehend market movements without a thorough understanding of concurrent political outcomes. Drawing on extensive experience in both politics and finance, Heisenberg will help demystify a world in which investors can no longer hope to conceptualize of markets as existing in anything that even approximates a vacuum.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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