Market Commentary:
Summary of our views is as follows:
• The price of money is a significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever in the US. The full impacts will show up with a lag.
• The distribution of potential outcomes in many markets is wide, and much wider than it has been in decades. We caution using a lens from the 2000 – 2021 period as a mechanism to evaluate the markets today.
• While inflation is clearly declining, we doubt it returns to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed. It is quite uncertain what the Fed’s response will be if inflation only declines to 4% and remains there. Will the Fed keep target rates higher for longer, or will they blink as the markets expect?
• From 1968-82 the equity market experienced multiple violent rallies and subsequent selloffs, and 70% of purchasing power was lost to inflation. We could see a mini period that is similar -> sideways markets and steady erosion of purchasing power. If so, active management should generate far better risk reward than buy and hold in equity indices.
• Demand for downside protection in the US equity markets remains anemic. Put option skew remains low, while market liquidity has been on a general downtrend. Don’t under-estimate the potential for either a grind lower or a gap lower in equity indices at some point in 2023.
• The mark-to-market of private assets into 2023 could be an additional drag. Many will show losses, which may result in less ongoing demand, and possibly a desire to pair back exposure. This all brings elevated risk to public and private equities.
Despite the strong start for US equities in 2023 and some improvement in our key technical indicators, we aren’t convinced a new bull market is in full swing. Plenty of uncertainties remain, along with a seemingly persistent disconnect between the market and the Fed in terms of a Central Bank pivot.
While a decline in S&P 500 earnings is widely expected, we remain uncertain on how significant the decline will be. Adding to the murky outlook on US equities and the economy is that thus far the Fed has only shrunk balance sheet by 5%, and it is a long way to their targeted decrease of as much as 35%. Perhaps they don’t make it all the way, but as of right now, QT has only just begun. Studies have shown, that when liquidity is ample, financial assets outperform, while when liquidity is contracting, hard assets outperform.
The recent price action could simply be a countertrend rally in a bigger market downtrend. Bear markets are not only characterized by large declines but also face ripping rallies and high volatility. These huge countertrend rallies can give false hope that a new bull market has started, before the bear market is truly over.
Whether or not this has been a bear market rally, we expect volatility in markets to remain elevated. The cost of capital continues to go higher, and market liquidity continues to shift lower. While a retest of the October 2022 lows or worse a breach of them isn’t a high conviction view, it certainly is within the range of reasonable expectations.
We also continue to expect bonds to not hedge stocks very well, leading to the potential for another period of pain for traditional 60/40 portfolios in 2023.
One indication that much of the recent move higher in stocks has been at least partially driven by short covering, is that many momentum stocks have not participated in the move. There is an interesting breakdown between the correlation of the momentum type stocks and the overall market.
Below is a graph of the Momentum ETF (MTUM) in Blue vs the S&P Midcap ETF (MDY) in Red. The Green section on the bottom is the historical 20-day correlation between the two. Notice how the correlation has recently broken down, and that hasn’t happened in a long time.
Source: TradingView
While the market environment may yet not be truly heathy, we admit it has shown signs of improvement. Below is our updated table of the various “trend” indicators that we like to monitor on a variety of equity indices. There has been quite a shift from red to green since we published this table last month, and that has us more optimistic at least from a tactical perspective.
Additionally, our tactical equity strategies that are all systematic in nature have been getting steadily more invested in 2023. While exposures are still below longer-term average amounts, they are no longer close to fully in cash like they were for much of 2022.
The Great Disconnect: The Market vs. the Fed.
While we don’t doubt that the Fed is close to the end of this rate hiking cycle, we continue to believe there is a disconnect between Fed speak (high rates for longer) and the markets anticipation of rate cuts starting in 2023. It feels like the markets are setting up for quite a disappointment if the Fed sticks to their articulated gameplan.
The big question isn’t where the Fed Funds rate tops out. It is how long it stays there. The markets are pricing in a quick pivot to rate cuts, driven by a belief that Powell will see enough economic weakness to then embark on a rate cutting cycle. However multiple Fed officials continue to talk tough on inflation and rate path, which puts them at odds with the market pricing.
The belly of the US Government bond market is ground zero for this disconnect. While 2Y Treasury yields are at 4.50%, 5Y yields are at 3.91% and 10Y yields are at 3.70%. The belly of the yield curve isn’t convinced that the Fed will be able to keep rates high for a sustained period. Their track record would imply intermediate bonds are going to be right, however the Fed sounds much more resolute today than they did at the end of 2018, which was their last quick pivot.
The challenge with a tight labor market is that it is difficult to sustainably get the demand side of the inflation equation down. And the reality is with unemployment at generational lows, the consumer demand side of the equation remains robust. This doesn’t argue for rate cuts anytime soon, and perhaps highlights another disconnect: strong consumer behavior vs. declining leading economic indicators and business surveys.
0DTE:
One of the most interesting market developments is the explosion in demand for zero day to expiration options. February 2, 2023 was one of the largest US Equity Options volume days ever, as 40 million contracts traded. On this same day, the top 2 most active options were zero day to expiration (0DTE) SPY options with strikes of 416 and 417. There were also some massive purchases of 0DTE call options on TSLA (2.7mm calls vs. 1.6mm on average); AAPL (1.3mm calls vs. 600k average); and AMZN (1.8mm calls vs 600k average).(1)
These high gamma options helped drive some massive moves in underlying stock and ETF prices, along with a “stock price up & implied volatility up” behavior. The massive move in stock and ETF prices was partially driven by dealers hedging the call options sold to speculators. As the underlying stock price moved higher, the option price and required delta hedge increased, forcing those same dealers to increase their underlying stock hedges. This “weaponized” gamma can create a positive feedback loop: stock and option price up -> dealers buy more stock to increase the delta hedge -> which pushes prices higher -> dealers need to increase the delta hedge even more through more buying.
These sort of situations can be very explosive, but they also tend to end abruptly once the momentum subsides, or the option expires, in this case at the end of the day. And often, the stock isn’t able to remain at that higher level the following day unless another round of 0DTE options are purchased.
Monthly Podcast Recommendation:
This month we are recommending 2 podcasts as they both provide a good primer on the portfolio benefits of classical trend following strategies.
Top Traders Unplugged. Episode #229. Interview with Andrew Beer.
https://www.toptradersunplugged.com/podcast/229-systematic-investor-series-ft-andrew-beer-february-5th 2023/
Top Traders Unplugged. Episode #123. Interview with Russell Korgaonkar – CIO of Man AHL https://www.toptradersunplugged.com/podcast/ttu123-russell-korgaonkar-cio-at-man-ahl/
STRATEGY COMMENTARY:
As a reminder, our Sundial Dynamic All-Weather Portfolios attempt to achieve positive returns regardless of the macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
• Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets • Utilize both active (tactical) and passive (buy and hold) strategies
• Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non-correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our systematic tactical equity strategies continue to increase long exposure, which is no surprise given the improvement in the trend table above. These strategies are now generally more than 50% invested in equities, which is much more bullish than the ~90% cash type exposures for much of 2022. However, these strategies are still below their longer-term average long exposures which we view as not yet signaling an “all clear.” We continue to watch changes in exposures closely as these systematic strategies have traditionally done a fine job of sniffing out improving market conditions and also the new market leaders. We believe that the next market leaders will be different than the previous ones (AAPL, MSFT, TSLA, META, etc). Our single name based tactical equity exposures have been adding Industrials and FinTech type companies over the past month. We continue to believe this is an environment for individual stock picking, and not investing in equity indices, despite the recent moves and also relative outperformance of the indices since the start of the year. Most importantly, should the recent US equity rally turn out to be nothing more than a bear market rally and aggressively reverse, our tactical equity strategies would be expected to decrease exposures quickly and go back to capital protection mode.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. These positions are mostly in ETFs and not in single names. We don’t intend to significantly increase exposures here until the outlook for the equity markets becomes more clear. We also continue to utilize option strategies around the margin to adjust exposures, either through covered call selling when markets reach overbought levels, or through selling of puts as a targeted purchase at strike prices that we deem a more attractive entry.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects our defensive stance. We continue to utilize mostly alternative yield generating investments and avoid Government and corporate bonds. In our opinion, a 3.70% 10Y US Treasury yield doesn’t offer enough compensation for the duration risk and level of inflation risk. Quality deal flow coming to us in commercial real estate continues to increase. We are conducting due diligence in 2 deals right now. We will continue to be choosy as we do expect prices in general to continue to adjust lower, however, we get the sense that sellers are starting to come to reality, as their existing low interest rate loans against properties are coming due. Our other preferred strategies such as litigation finance and reinsurance continue to have nice tailwinds and we view their risk/reward has far superior to traditional fixed income investments.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: Classical trend following strategies have started out 2023 in a drawdown, and we are using this pullback to increase exposures where appropriate. Many of the strong 2022 trends have run out of steam or reversed. The macro picture remains murky in our view, and we aren’t proponents of trying to predict markets anyway. We believe the macro environment continues to be constructive for “dislocation seeking” trend following strategies. We tell anyone who will listen that they should be using this opportunity to initiate or add to exposures while these strategies are in the midst of a pullback.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: These investments have done a whole lot of nothing for the past year, which isn’t surprising as there really hasn’t been a tail event. The grind lower in equities along with an absence of a significant spike in implied volatility was the pain scenario for these strategies in 2022. That being said, these strategies really didn’t lose that much considering how weak the opportunity set has been. As mentioned above, the cost of tail protection (skew) is quite low, the potential for a left fat tail is increasing, and we are strong proponents of this exposure in all portfolios. This is another area where we tell anyone who will listen to initiate or add to exposures while to cost of protection is cheap.
CHARTS & TABLES:
S&P 500 earnings forecasts continue to decline.
Source: Bloomberg LP and The Daily Shot
US earnings are still at a record high, well above their historical trend.
Source: Ayesha Tariq, CFA @AyeshaTariq
https://twitter.com/AyeshaTariq/status/1617845537679749120?s=20&t=YpmW5hurs68ahvg3VBMFlQ
Interesting Historical Perspective on Fed rate cut campaigns and equity market performance:
Source: https://twitter.com/leadlagreport/status/1598312746713489410
Source: Hedgeye Risk Management
The trend and current level of the Weekly Leading Economic Index is negative. It is currently at levels where the US economy was starting or already in a recession. Historic stock returns have tended to be poor when leading indicators were in negative territory and in a downtrend. Previous bear market bottoms have coincided with leading indicators bottoming and starting to trend higher.
Source: https://twitter.com/Global_Trader/status/1615192811590062081?t=LOJ0_9WRM2DyKAgGAzd5nQ&s=09
Options Volumes continue to increase.
Source: SpotGamma
0DTE Options Volume has exploded higher.
Source: Tier1 Alpha https://twitter.com/t1alpha/status/1619059542385467392?t=5SJ8y8HlaG_L8KPqr1ayfQ&s=09 The markets and the Fed are not on the same page in terms of embarking on a rate cutting cycle:
Source: Michael Lebowitz, CFA@michaellebowitz
https://twitter.com/michaellebowitz/status/1618988066391334913?t=J13Y-uksnWy3OnwvTlg-WA&s=09
Housing market data continues to struggle:
Source: https://twitter.com/MacroAlf/status/1624836986367270916?s=20&t=Id-zJpJkLknmVa3j1RlLYQ At least partially driven by affordability.
Source: https://twitter.com/JeffWeniger/status/1617929471289397250?s=20&t=YpmW5hurs68ahvg3VBMFlQ
The Era of negative yielding bonds looks to be coming to an end:
Source: https://twitter.com/UrbanKaoboy/status/1611033521904308226?t=Os3gWzfYJQ1qFP1WsiuOUg&s=09
(1): Sources: CBOE, Bloomberg, Hedgeye Risk Management
Disclaimers
This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities nor does it constitute tax advice. This information is for informational purposes only and is confidential and may not be reproduced or transferred without the written consent of Sundial. Past performance is not indicative of future results. Statements and opinions in this publication are based on sources of information believed to be accurate and reliable, but we make no representations or guarantees as to the accuracy or completeness thereof. These materials are subject to a more complete description and do not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees, and investment strategies of an investment.
This correspondence may include forward-looking statements. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties, and contingencies. Forward-looking statements are not a promise or guarantee of future events.
Benchmarks and indices are presented herein for illustrative and comparative purposes only. Such benchmarks and indices are not available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, management or performance fees, and have limitations when used for comparison or other purposes because they, among other things, may have different strategies, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments) than the Firm. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. We make no representations that any benchmark or index is an appropriate measure for comparison. The S&P 500® Index is a stock market index from S&P Dow Jones Indices. It is a market capitalization weighted index of 500 of the largest U.S. companies, designed to measure broad U.S. equity performance.
Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses. There are no assurances that an investor’s return will match or exceed any specific benchmark.
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