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(April 19, 2021): The Equity Markets Head For A Window Of Peak Performance In The Short-Term, As Good Economic Data May Tip The Fed Reserve Into Changing Its Rhetoric And Policy

Mar. 23, 2021 8:30 AM ET
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APRIL 19, 2020

The major indices - along with investor sentiment - have reached multi-year highs, thanks in no small part to the recent outperformance of leading mega-cap names.

Indeed, indexes like the S&P 500, the Dow Jones Industrial Average (DJIA) and the Nasdaq 100 all remain perched at record highs as of third week of April. Meanwhile, the big-name tech mega-cap leaders, including Facebook, Alphabet, and Microsoft are also showing conspicuous strength.

But for many participants, including us, this doesn’t feel like a “runaway” bull market. Moreover, some areas of the market - most notably the formerly strong tech cloud stocks - are conspicuously lagging. This bull market is very peculiar. We also make the case that there are fundamental, liquidity issues that are starting to crop up, and the Fed Reserve’s reaction function may be starting to change. We discussed this issue at length in the Bond Yield report for this month.

We also see possibility of an above-normal increase in volatility during the upcoming earnings season (due to waning internal momentum), which means that tech-oriented investors in particular will need to be defensive. It looks like the market is already front-running those expectations – the tech sector has started to lag behind its peers.

The case study starts with a view on whether or not investors are aggressively allocating capital to equities. In a strong, runaway-type bull market there should be a powerful and sustained flow of money into riskier areas of the market like high-tech and biotech shares. A simple way of gauging this is the so-called Aggression Index, made famous by growth stock analyst Mike Cintolo. It is essentially a relative strength comparison of the Nasdaq Composite Index versus the defensive-oriented consumer staples sector.

By comparing the Nasdaq with the Consumer Staples Select Sector SPDR ETF in several ways, it helps answer the question: “How aggressive are big institutional investors being with their money right now?” We went beyond the scope of the original work and showed other aspects of relative strength as illustrated in the chart below.

We show the comparison on comparative strength between the two sectors (left hand scale in the chart above), which illustrates that NDX outperformed XLP sector by a wide margin. Then we added a ratio between NDX and XLP (NDX/XLP) and added two sets of moving averages to show how that ratio compares with what institutionals use to measure relative strength.

We see that the ratio remains well above the 200 Day Moving Average (long-term relative strength gauge), but barely stays above the quicker 50-Day moving average, which is said to show near-term relative strength. And that exactly describes our assessment of the situation of the market. Simply put, good longer-term outlook, but perhaps some strong degree of trouble in the near-term.

It does look like risk appetite has dwindled, and continues to dwindle in the near term. The connotation is that the big institutional buyers are leaving the tech (high-risk) market, and starting to turn defensive. As long as this is the case, the current market tends to be a low-energy affair, and will tend to be very susceptible to external shocks, like changes in monetary and fiscal policies, and to liquidity flow issues, which we discuss in some detail below.

We continue the focus on the higher risk, high-tech, biotech and small cap sectors to gauge the appetite of the market for risk, and juxtapose that to the current systemic liquidity flows originating from the US Treasury and the Federal Reserve. We find that these markets are fast approaching a window of peaking performance over the next two to three weeks, as shown by the chart below.

And indeed, systemic liquidity flows are tightening. One such event stands out, because it has started a chain of events which will eventually impact both stock and bond markets (see chart below).

The US Treasury will reduce the Treasury General Account balance from what was $1.6 trillion early in April to less than $500Billion by end of June 2021. Most of these funds will flow to the newly enhanced Fed O/N RRP facility, the likely destination for these funds which need to find a home.

After the SLR waivers ended at the end of March, the G-SIB large banks don't want the trouble those deposits bring to their capital ratio calculations. Therefore, term money had to move out, and there aren’t many places to go. The RRP is the safest and less onerous place for these funds to go to.

The problem is that TGA flows to RRP facility counteracts liquidity inflows, tightens systemic liquidity; reduces bank reserves, and therefore undercuts equities, push long-term yields lower. See chart below.

Why so? When an investor enters an RRP transaction with the Fed, the Fed sells a security to the investor with an agreement to repurchase that same security at a specified price at a specific time in the future (0 percent in this case). Securities sold under the RRP facility continue to be shown as assets held by the Fed, but the RRP transaction shifts some of the liabilities on the Federal Reserve’s balance sheet, specifically from deposits held by depository institutions (also known as bank reserves) to reverse repos (also on the liabilities side) while the trade is outstanding.

In other words, RRP transactions reduce the stock of bank reserves. It is the change rate of bank reserves which power the rise and fall of financial asset prices -- which is why the drain towards the O/N RRP facility will hurt financial asset prices at some point. That point is fast approaching (see chart above).

It's also worthwhile noting that global (G-5), US (Fed and Treasury) supplied systemic liquidity flows are receding (see chart below). While systemic liquidity nominals are still rising, it's their change rates which link to prices (which are flows, by definition). Apples to apples comparison is needed in this kind of analysis, as comparing nominal levels to flows do not provide coherent answers.

VIX, and all measures of volatility, are very sensitive not only to market liquidity but also (in larger, fundamental scale) to flows of US and global financial systemic liquidity, as shown in the chart above.

Finally, we resort to some options-based construct to derive some kind of timing for our so described “window of peak performance (see chart below).

The correlation coefficient between the S&P 500 and the VVIX has led almost all major peaks in the equity markets well ahead, sometimes by several day. The sharp decline to negative correlations warns of a short-term weakness ahead.

It therefore makes sense to designate coming two to three weeks as window of forthcoming weakness in the equity markets.

There are also narratives which should be closely watched, as these developments can completely skew current expectations in the marketplace. We expound on it as follows:

The forthcoming earnings season, after a massive run in the markets, calls for what should be some natural profit taking. Also, an imminent tax season plus one year of profitable longs also calls for profit taking selling flows. Moreover, as described and shown earlier, liquidity seasonality wanes as we head towards early May and that could last until end of June.

But probably the most important aspect is Fed that is more likely than expected to begin walking back its ultra-loose rhetoric sometime soon, as we continue to see upside surprises in Non-Farm Payroll, in stock market earnings, and in the dramatic acceleration in vaccination and a reopening of the domestic economy.

In April 27-28, the FOMC will meet. There is no much expectations of change for this meeting, but the Fed’s Bullard has already floated the idea that a tapering conversation should begin when 75% of the population vaccinated, and all signs point to this occurring sometime before mid-June. The June 16th FOMC meeting is therefore shaping up as providing a potential surprise change in Fed rhetoric and monetary policy.

The last chart below provides an example of how changes in the US Treasury and Fed Reserve policy mix impacts equities and bonds. For the markets, total aggregate liquidity is the net difference of the US Treasury’s debt issuance, and the amount of securities purchased by the Federal Reserve. It is therefore crucial to know if the Fed is tightening while the Treasury continues the pace of its debt issuance. And vice versa.

The TGA drawdown reduces need for corresponding Debt Issuance, and SOMA Trans that generates, which combine to depress systemic liquidity flows. The delta (difference) between Debt Issuance and SOMA determines growth of Bank Reserves. The implications here is that the YoY change rate in SPX is about to fall in a major way as it follows the shrinkage of bank reserves (see chart above).


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Here is the current status of the PAM flagship Swing Fund, which includes open and closed trades.

During the twelve months of 2020, PAM delivered phenomenal real-dollar Hedge Fund trading performance, the best at Seeking Alpha:

PAM's flagship Swing Portfolio, year-to-date (December 31, 2020) delivered $100, 181,522.77 net profit on $11,172,813 margin capital.

Year-to-date performance: 860.27%, on 888-98 win-loss trades.

January 2021 spreadsheet here:

February 2021 spreadsheet here:

Year to date 2020 spreadsheet here.



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