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.
∙ 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 ‐> rangebound choppy markets and steady erosion of purchasing power.
∙ Active management has the potential to generate superior performance than passive long positions in the most widely followed US equity indices or mega‐cap stocks. The market’s new leaders are most likely not the leaders of years past.
∙ 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.
Many of the views we have shared over the past few months look to be playing out as anticipated.
US employment, consumption & input prices continue to run hot. We’re probably past peak inflation, but we’re not yet at peak prices. In the March 7th testimony to Congress, Chairman Powell clearly reiterated that the central bank is likely to lift interest rates higher and potentially faster than previously anticipated. And finally, over the past month the Interest rate markets have been increasingly pricing in a more hawkish scenario, removing all of the rate cuts that were priced into the back half of 2023 (see graph in the Charts & Tables section).
The irony about the markets previously pricing in a “dovish pivot” is that historically, equities initially rally on a Fed pause, and then they decline again as a looming recession becomes the focus. The equity lows have also historically come closer to the last Fed rate cut, and not the first (Source: David Rosenberg).
We expect much more of the same over the next few months, meaning the bulls and bears slug it out and the equity indices trade sideways and at times with significant volatility. We recognize this isn’t a novel view‐ as the 50 day, 100 day and 200 day exponential moving averages have again converged. From a long term perspective, current S&P 500 price is nothing to get excited about. It is simply in the middle of a long term upward channel.
Source: TradingView
Source: TradingView
Overweight Active (Tactical) Equity Strategies
While a bull market in indices isn’t obvious, there are many individual stocks that are in strong bull markets. As often is the case, tomorrow’s market leaders are different than yesterdays, and the strongest stocks enter a new bull market before the indices do.
We continue to think this is an opportune environment to overweight tactical equity strategies and keep risk lower in passive long equity index positions. Zooming out from the S&P 500, there are some positive setups. The Industrials sector is perhaps only 4% away from all‐time highs. Our tactical strategies have long positions in a variety of single name equities with prices hitting all‐time highs for multiple days in a row. Industrials, technology and financials are the sectors with the largest exposures.
This type of performance shouldn’t be surprising ‐it is similar to what transpired in the 1968‐82 period that we have repeatedly referred to.
Last year these strategies protected capital by being mostly in cash while seemingly all equities were in downtrends. And this year these strategies are identifying and buying the new market leaders before the masses have discovered them.
Yield Curve Inversion:
There is a lot of movement in US yield curves, and with that the MOVE Index (VIX for rates) has been steadily increasing. The 3 month vs. 2 year portion of the yield curve has completely un‐inverted, while the 2 year vs. 10 year yield curve inversion deepens. The 2Y‐10Y spread is now at ‐100 bps, a level not seen since the late 1980s. Jim Bianco frequently discusses the curve inversion and is quick to point out that recessions tend to come 10‐18 months after the initial inversion. Yield curves stared inverting in mid‐2022, so that indicates recession could be anywhere from 4Q 2023 through 2Q 2024. And of course, this isn’t an exact science. He also points out that a deeper inversion (like we have now) doesn’t equate to higher probability of recession.
Be Long Short Duration and be Short Long Duration.
There is good value in short maturity Treasuries. As of March 7th, six month Treasury Bills are yielding 5.10% and one year Treasuries yield 5.25% (Source: Trading View). As we have mentioned in previous publications, we see little value in 10 year Treasuries with yields at 3.97%, and also see limited benefit from them providing any hedge to long equity positions, particularly when inflation is elevated and sticky (See Chart below on Equity vs. Bond Correlation).
0DTE Option Reflexivity
There has been lots of published research and commentary on 0 day to expiry options volume over the past month.
Two comments worth noting come from Bank of America and JP Morgan. BOA published an interesting graph on how 0 DTE options trade closer to the Ask price (Buyers) in the morning and closer to the Bid price (Sellers) in the afternoon. This makes sense with the price action recently where seemingly runaway moves appear in the first part of the day, and then are reversed into the close.
JP Morgan in a recent report discussed the highly reflexive nature of 0 DTE options and their potential risk to market stability. Volumes in 0DTE options have grown to be very large, with some days notional volume exceeding $1 trillion. If there is a large market move and sellers are forced to close out the positions or hedge, the resulting flows could result in extreme directional moves.
Monthly Podcast Recommendation:
This month we are recommending 2 podcasts as they both are so timely and instructive in terms of portfolio construction.
The Derivative. Volatility as an Asset Class
https://www.stitcher.com/show/the‐derivative/episode/volatility‐as‐an‐asset‐class‐with‐jason‐buck‐zed‐francis‐ rodrigo‐gordillo‐and‐luke‐rahbari‐212263195
The Derivative. Meb Faber
Spoiler alert: What a quote in this one: “There’s going to be no asset that disappoints more than private equity over the next 10 years. https://www.stitcher.com/show/the‐derivative/episode/you‐still‐dont‐have‐enough‐trend‐following‐or‐foreign‐ equity‐exposure‐with‐meb‐faber‐300124922
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 significantly increased long exposure over the past month. These strategies are now generally more than 65% 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 see little reason to tinker with the positions until the outlook is more clear, as discussed at the top of the publication.
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. We continue to modestly increase exposures to our preferred strategies such as litigation finance and reinsurance. Additionally, there have been some new alternative yield generating ETF launches and our due diligence with the sponsors has been positive, so we have started to weave them into portfolios. With so many choices to generate yield, convexity and non‐ correlated returns to equities, there is no reason for any portfolio manager to still be endorsing a 60% equity / 40% bond type portfolio in our opinion.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: 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 recently due diligenced a private fund manager that seems quite complimentary to the rest of the instruments and funds we utilize and we plan on incorporating their strategy into our portfolios over the next 2 months. It is amazing the amount of high quality managers we have gotten introduced to though other managers we know and through the podcasts of hosts that we know well. Gone are the days of only meeting new managers through prime brokers or conferences.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: 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 didn’t lose much in 2022 and have generally made a little bit of money in 2023. 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:
Probably the most relevant chart of the past month: Fed Pivot in 2023 no longer priced in.
Source: https://twitter.com/LizAnnSonders/status/1633413255308922880?t=vTOEJYeYMVmjr_4UL3yEbg&s=09
MOVE index is on the Move Again
Source: TradingView
Prior to 2019, tightening cycles weren't over until fed funds caught up to the trend in nominal GDP growth.
https://twitter.com/WillieDelwiche/status/1628859273684963328/photo/1
Historically, a pivot in the Federal Funds rate is BEARISH FOR STOCKS. The Fed pivots mostly BEFORE major drawdowns in the S&P 500.
Source: https://twitter.com/leadlagreport/status/1598312746713489410/photo/1
6‐month T‐bills yield vs S&P 500 earnings yield is the narrowest spread since 2001
Source: https://twitter.com/kgreifeld/status/1625849335509565446
Source: https://twitter.com/CheddarFlow/status/1632939133583904768?t=QHyJx_266SGUPJS1RFeCoQ&s=09
Source: https://twitter.com/JeffWeniger/status/1626615958528835585?s=20
What if 0DTE goes the other way, heavy puts rather than calls?
Source:
https://twitter.com/Mayhem4Markets/status/1626419306769575938?t=S_Wy80Xo9JgeG_75LvWmKA&s=09
Bonds don’t hedge equities in an inflationary world.
Source: https://twitter.com/MikeZaccardi/status/1625523822530117634
Locked in low Mortgage rates could be a driver of the decline in existing home sales:
Source: https://twitter.com/SamRo/status/1628064187564916742
Source: https://twitter.com/MacroAlf/status/1624836986367270916?s=20&t=Id‐zJpJkLknmVa3j1RlLYQ
Source: https://twitter.com/Mayhem4Markets/status/1632944562476916737/photo/1
Source: JP Morgan Research. US Equity Strategy : The Cost of Higher for Longer
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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