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Further Weakness in Equity Markets Seems Likely

Updated: Sep 1, 2022

Inflation hasn't gone on vacation

The disparity between G7 policy rates and inflation is among the largest ever, suggesting that not only do central banks have powerful motivation to keep tightening, but also that if inflation isn't brought down imminently through demand destruction, it could become even more deeply structurally embedded in to advanced economies.


Intractable inflation seems like such a strange notion after decades of disinflationary economic growth powered by a combination of globalization, technology, demographics, and abundance.


But the era of abundance seems to be coming to an end, whether we're talking about natural resources or capital. Many structural changes are happening underneath the surface that suggest inflation is likely to become a secular quandary moving forward.


Not the least of which is the imbalance of supply vs demand, whereas exploration, production, and transportation remain woefully insufficient. While demand can be destroyed, and inflation's velocity temporarily subdued, longer term these entrenched factors are likely to be increrasingly problematic in the next several credit cycles.


As a result it is reasonable to expect shorter, more shallow bull markets, and compressed credit cycles.


Economies seem set to continue slowing

While inflation remains robust, US and EU macroeconomic data is softening, suggesting that G7 countries are more likely to see continued economic weakness, which will likely drag emerging markets down with them.


Weak economic data is unlikely to convince central banks to pivot back toward easing, however, as inflation is the primary concern and economic weakness is actually necessary to achieve policy goals of destroying demand to subdue the velocity at which prices are increasing.


Therefore, unless the Fed truly breaks something or manage to subdue inflation, their path toward hiking further and reducing their balance sheet, with QT set to accelerate to a run rate of $95 billion per month in September, is likely to remain on course.

Global economic weakness is likely to pull down equities in combination with further central bank tightening. Earnings could decline about 20%, as the average earnings decline during a recession is 17.2% and it is unlikely that this will be a shallow and short recessionary period.


Therefore, when factoring for the cost efficacy of capital allocation, bear in mind that the E in P/E may drop by about 1/5th. As a result equities may not be as discounted as they may appear to be, at least in some areas of the market.


Watching the trajectory of Fed policy

Fed Funds Futures are now looking at a potential terminal rate as high as 4% to be achieved in the first half of 2023. This is a step up from the former ceiling seen at 3.75%.


Meanwhile, unfounded talk of an imminent Fed pivot led equity and bond markets to rally since the July Fed meeting, as well as after the CPI and PPI data sets from the same month, where energy volatility gave the impression to some that peak inflation was behind us.


An impression that may be proven wrong, but even if not, does not deter the Fed from their policy objectives of tightening to subdue inflation on a longer term basis.


2-year note rates suggest the Fed is at least targeting a 3.25% terminal rate, and we've seen no sign of the 2-year note completing its decline in price and rise in yield, something that often prefaces policy changes.

With QT set to accelerate in September, as the Treasury has also increased issuance in Q3 by 2.5 fold, it is likely that this will add to distributive pressure within risk assets as well as credit. Important to be mindful that the Fed and other central banks helped to juice this entire post-GFC party with 13 years of near constant emergency-level monetary stimulus and artificially low rates.


That is why the correlation between central bank balance sheets and the S&P 500 matters, and why QT is likely to cause further selling. Because central banks backstopped the global financial system for so long that many have forgotten exactly why stocks rallied as much as they had, with the S&P 500 rallying from 666 in March of 2009 to 4,818.62 in January of this year.


Much of this rally was predicated on low rates, QE, TINA (there is no alternative to stocks, as credit was mispriced), and massive amounts of share buybacks. We're now seeing rising rates, more alternatives to stocks as real rates begin to creep positive, and a significant slowdown in planned buybacks.

We've also witnessed the velocity of central bank liquidity collapse from early 2021 into 2022, where it has now reached a negative y/y change — with more likely to come as QT accelerates.


Notice that the peak of central bank liquidity's velocity correlates with the huge boom in highly speculative risk assets, such as SPACs, unprofitable growth, crypto, and others. Many of which topped out as this velocity peaked.


Speculators are still speculating

Margin debt has fallen significantly, bringing equities down with it, but we're still significantly elevated from where the post-GFC credit cycle started. While that doesn't mean margin debt has to normalize to those lower levels, it does suggest that there's plenty more room for a decline as rates rise, and thus it costs speculators more to maintain leverage.


During such conditions they often flatten their books, incurring less leverage, and bringing risk assets down as a result. The deleveraging from November of 2021 to the present was nothing short of historic in nature, with plenty of room to go.

We've also seen the jaws widen between TLT and QQQ. Every time this has happened this year, where QQQ has gotten too excited vs its long bond counterpart ETF, QQQ has caught down. I don't suspect that this time will be different.

Breadth, positioning, and sentiment: reversal time?

Volatility: We've seen the VIX fall since the countertrend rally began, from over 30, to just 20.60 now. But 1-month realized volatility remains lower at 17.45, meaning volatility is well supplied in a relatively well hedged market. This suggests that we aren't likely to see waterfall declines, but more orderly stepping down in price.


HY spreads: With financial conditions having eased over the last two months, the spreads between high yield and investment grade corporate debt narrowed, but that's not likely to be sustainable as there's plenty of central bank tightening to come, and seeing junk debt (as well as other long duration speculative risk assets) bid up gives central banks more motivation to hike and shrink balance sheets.


NYMO (inverse): We saw a breadth swing negative to end the week. Often, but not always, when we see a negative breadth reversal like this it also comes with a reversal in market trend. Since the short term trend was up, we could certainly see that flip negative with so many caught off sides from being positioned at higher prices.


CBOE equity put/call: Last week we flipped from bullish extremes to a mildly bearish reading on the CBOE equity put/call ratio. This sort of swing between extreme bullishness and mild bearishness often does come at turning points. Much of the recent bullish call buying was focused on unprofitable growth, meme stocks, and other squeezes. Such activity has also market interim market tops in February of 2021, November of 2021, and April of 2022.


NAAIM (inverse): Managed money was slightly less bullish last week, but most surveyed still remain long with leverage, meaning they may have to exit in a bit of a rush if prices continue to decline. Often is the case this year that NAAIM's survey has shown money managers buying rips and selling dips, churning based on short-term market bias, making it a valuable contrarian indicator that is giving us a sell signal.


Rydex bear/bull ratio: One word — complacency. People just aren't scared, even with declining fundamentals, deteriorating macro, and precarious technicals. That tells me we could have more room to the downside.


Sentiment reached historic levels of bearishness, but positioning did not. In fact, US households have the highest percentage of equity exposure to net worth ever, even after we saw the US stock market enter a bear market with one of the worst starts to a year ever.


This means we haven't really seen anything resembling a flush out from stretched positioning, which is usually a sign that a bottom is in. Without that flush, it seems we could explore new lows, or at least re-test the prior lows.


Seasonality

September is often a weaker month for markets. Over the last 20 years 55% of the time the S&P 500 is down an average of 0.6%. Will this year be different? Only time will tell, but tactically speaking the bears are likely to be favored.


In conclusion

There are risks growing in equity, bond, and crypto markets that are likely to be priced in during the weeks ahead. We've just come off of a spectacular run where momentum chasing trend followers, short covering, and dealer positioning-driven passive flows were bidding up the market significantly.


Now the hangover comes as Friday's $2.1T OpEx not only saw a cessation of those flows, but many are reversing, bringing about increased potential for weakness.

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