State of the markets - Special edition Feb 20th 2023
Markets: What I am watching and doing in the markets this week
Today, we will deviate from our regular, weekly SOTM format to discuss several important recent data points and what they are telling us about the current health of the markets.
Since Jan 1st 2023, the DJI has risen 2%, the SPX has gained 6% and the Nasdaq has shot up by 13%. Investor portfolios that are overweight tech have recovered more than all these indexes put together, and in a very short time….6-7 weeks.
Now the questions on everyone’s mind are:
Are these YTD gains for real? Will they last?
What will the markets do from here on? Rise or fall or meander?
What should I do with my portfolio? What should I buy or sell or trim?
In order to answer these questions, I have been paying special attention to several market signals and research reports for clues.
Before we take a closer look at my findings, here is what Beachman wrote about last week. Throughout this earnings season, he has been informing his subscribers about which companies are on a viable, pivot path and which are still trending in the wrong direction. Beachman does not look at just the next quarter’s estimates. He uses backward 5-quarter and forward 5-quarter trends for his analysis which results in a more informed investing decision.
Beachman’s posts from last week
If in cash and FOMO, what now? - An update using current market signals
Indexes continue to trend lower since the beginning of Feb 2023. This is true for the DJI, the SPX and the Nasdaq. Lower highs and lower lows for the past two weeks is not a bullish trend for sure.
GS recently published some insightful data that helps explain why the markets have risen so much so quickly. Since the end of Jan 2023, 80% of the rise in tech stocks has been due to short position covering and only 20% has been due to investors buying long positions in these stocks. This is the 2nd largest such short-covering based rise in markets over the past decade and ranks in the 99.5th percentile. Investors who are positioning their portfolios based on macro signals have been very bearish on tech stocks since Nov 2022. Meanwhile computerized trading systems (CTAs) are configured to switch trading directions on a dime based on intra-day trading conditions. During the last two weeks, as some of the most beaten down stocks caught a little more interest with investors, the CTAs tacked on and went on a buying spree, further accelerating the upside move and the short squeeze.
Investors are increasingly placing bullish Call options bets on the indexes and they are doing so even more on individual equities. Last week Friday, was the monthly options expiration. True to form, we had a volatile Wed and Thu - this happens every time during an options expiration week. Now Friday comes along and investors have to pick a side (bullish or bearish) for the next week, for the next month. Clearly they have picked the bullish side for now.
Remember what we said about how these options bets impact market swings?
When investors buy more bullish Call options, market makers (MM) take the other side of the trade i.e. they sell the Call options to the investor. This leaves the MM in a bearish position. However, MMs always hedge their portfolio to maintain it as neutral because they make money on the fees and not the trade outcome. So to stay neutral, they have to buy the underlying stocks, which leads to higher prices for these stocks.
This is the reason why markets likely ended flat on Friday…trying to find a balance between increasing investor nervousness (and profit-taking) about potential higher rates and options market forces described above. This effect can reverse itself very quickly leading to lower stock prices if bearish put options volume rises.
According to GS, for every 1% move up or down in the SP 500, MMs have to buy or sell $1B worth of shares to hedge their portfolio and stay neutral. Given the rise in options trading over the past few years, about 40% of all equity markets volume is driven by MM hedging.
0DTE stands for 0 days to expiration. Traders are increasingly trading options positions with very short expiration dates…1 day or even 1 week. According to the CBOE, about 45% of daily options volume are 0DTE trades. Another 15% of daily volume are for 1DTE options. So about 60% of daily options volume is going to expire within 24 hours. This further accentuates the options market on equity market effect described above, but on a much shorter timescale….leading to market squeezes up or down depending on the direction of majority of the options in play on a particular day.
Now the VIX, the traditional measure of market volatility, is not able to reflect this increased volatility because it takes into account options positions of between 23 - 37 days expiration. Therefore, even though markets are swinging up and down more than usual on an intra-day basis, the VIX has been hovering in the 18-23 range since the start of 2023.
We have recently been reading more about how liquidity in the financial markets is low or drying up. What does this mean and how does it impact stock prices?
The simplest way to understand this is by the following:
For the past 10 years or so, the US Feds were on a QE path. They bought US govt bonds and the cash they used to pay for those bonds was injected into the market in terms of liquid cash. This liquid cash was then available for companies to borrow at very low or 0% interest rates to growth their businesses
Now the US Feds have stopped QE and are in fact selling the US bonds on their balance sheet. This results in less liquid cash in the financial markets, less for businesses to borrow and in fact it increases borrowing costs for businesses that need a loan to operate their company
When companies are struggling to borrow money at rates that they can afford, investors get nervous about their ability to grow and in some cases even survive. This is why margin expansion, cashflow margins and debt to cash ratios are so important in a rising rate environment. Beachman has been trumpeting the importance of these fundamentals since Dec 2021 and tweaking his portfolio accordingly during this timeframe.
High yield bonds are some of the best proxies for measuring trends in market liquidity. When liquidity goes down and companies find it harder to borrow money, their bond issuances get fewer takers, resulting in lower prices for their bonds. High yield bonds are bonds issued by some of the riskiest companies and they are currently trending lower in price and signaling future market weakness. When high yield bonds “catch a cold”, the rest of the market usually “gets a sore throat”.
Corporate share buy backs are still more muted than normal YTD. 80% of SP 500 companies are outside their buy back black out window, yet they are not buying as much as they did last year at this time. I suspect (general observation here) that they think their stocks are over-valued and they prefer to wait for better lower prices.
We also got some new insider-selling data last week that showed a more wait-and-see stance among corporate insiders. Vickers Stock Research regularly publishes an insider sell/buy ratio report which averages around 2.50…meaning insiders sell stock about 2.5 times more often than when they buy stock. This represents the norm because management teams sell stock for many reasons (usually reflective of their personal portfolio management principles), but when they buy stock in larger quantities, it is considered a bullish sign for that company.
That said, the index has been at a 5.00 reading for most of Jan 2023, signaling much more selling and much less buying. Over the last two weeks, it jumped even higher to 7.31 for NYSE companies and 6.34 for Nasdaq stocks. The 8-week rolling average is also rising, currently at 3.68 versus 2.44 a month ago. Insider selling is trending higher in sectors like healthcare, financials, technology, and consumer discretionary.
The pause in share repurchases and insider buying could be explained by looking at historical valuation multiples. SP 500 companies are currently trading at about 18.2x forward earnings, close to the peaks in 2018 and 2020. The long term norm is 15-16x. If markets move higher, then forward multiples will increase to nose-bleed levels (20x+) similar to what we saw during QE times. Well, we have already seen above that liquidity in the market is trending lower and any further rise in stock prices might be harder to support. Even if the US Feds pause rate hikes, it will take a while for market liquidity to normalize because QT is scheduled to continue for several months more and earnings are expected to drop over the next 2-3 quarters.
Buyers into the stock market today are hoping for one or both of the following:
Lower interest rates than estimated by the end of 2023
Higher earnings growth than currently expected
Other important macro updates
Copper prices are running 34% higher than their long-term average and are 12% higher in the past quarter mostly driven by the China reopening thesis
Warehouse and distribution center rates are slowly climbing higher (11%yoy) as inventory levels rise in the face of lower consumer demand for manufactured and imported goods
Jan CPI (consumer price index) report came in at 6.4%yoy, lower than the Dec 6.5% reading, representing the 7th straight month of declines since the peak of June 2022 (9.1%). Core CPI also dropped to 5.6% in Jan after Dec’s 5.7% reading. I was happy to see the decline in hourly labor rates - this is on the radar screen of the FOMC. I have always questioned the reason for the US Feds 2% inflation target. In fact, I believe that the US economy has a slightly higher tolerance for 3-4% inflation (read my thoughts on the matter) and the FOMC might pivot or at least pause rate hikes when this is in sight
Jan PPI (producer price index) come in at 6.03%yoy, lower than the Dec 6.47% reading. Core PPI for Jan was 5.37%yoy, again lower than Dec’s 5.78%
Jobless claims for the week dropped to 194,000, lower than the estimated 200,000. Continuing claims rose to 1.696M last week, a smidge higher than the previous week’s 1.68M. Meanwhile, layoff announcements keep coming in - this week included DOCU, F, IRBT, TWLO and Yahoo
Retail sales for Jan were up 3%mom, much higher than the 1.9%est. The US consumer is strong and still opening their wallets in support of 70% of the US economy
So what are all these signals telling us? Have they given us answers to the questions we raised at the beginning of this post?
Here is how I am reading these market tea leaves and what I plan to do with my portfolio…