Market Commentary:
Despite a strong equity market rally into the end of October, our big picture cautious view on risk assets has notchanged.
We recognize that November & December is a seasonally strong period for the US equity market, and the sameholds true for the period after midterm elections. Fewer business days in the holiday months along with thepassing of event risk (elections) both tend to drive implied volatility (VIX) lower which is typically bullish for equityprices. We aren’t inclined to fade this seasonal, but we expect it to be short lived.
A closer look under the surface doesn’t inspire confidence. We have seen multiple references on the lack ofliquidity in the S&P 500 futures, as measured by the width of the bid-ask spread and also the depth of the book.Additionally, from a simplistic trend following perspective, the overall equity markets look dreadful (exception isthe Dow Jones Industrial Average).
We believe that we are squarely in an environment of “bad news is good news” as it means the Fed may “slowtheir roll” on their aggressive rate hikes. We also believe the market will soon transition back to “bad news is badnews” if an earnings recession shows up (probably 4Q22 data), and if inflation doesn’t decline fast enough to theFed’s target. We expect both of these to happen.
It is worth revising why we don’t see inflation returning to the 2% central bank target for a long time. The globaleconomies are transitioning from collaboration to competition. Cheap goods, cheap labor, and cheap energy allkept inflation low for a very long time, and all of these are now gone and perhaps won’t reverse for many years.This could be a very persistent, disruptive force. Thus we expect the higher volatility in rates, equities,commodities to remain into the first part of 2023 at a minimum.There is yet another interesting development in the options markets.
There has been a massive increase in thetrading of options with zero days to expiration (i.e., expires at the end of the same day that the position wasinitiated). This can be a destabilizing event, as if they are close to at-the-money strikes, they are very difficult fordealers to hedge due to their very high gamma. This has also helped drive options volumes to record highs yetagain.
Also interesting in the options markets is the complete collapse of downside skew (i.e., demand for put optionsfor portfolio protection). Downside skew is in the zero percentile historically. This could be because so many2investors believe the selloff is complete so it is foolish to own portfolio protection, or perhaps it is theabandonment of allocations to tail hedge type funds. Whatever the reason, we find it interesting in anenvironment of multiple possible tail events, the price of tail protection is at the lows. (Tail events we are thinkingabout are 1) Russia - US tensions increasing around the Ukraine war, 2) the potential for China to invade Taiwan,3) inflation and subsequent central bank reaction function uncertainty, 4) the impacts of the largest and fastestrate increase in US history). Ironically, as downside protection has been abandoned, the probability of itperforming well in a violent unexpected equity market selloff increases in our mind, which is an attractiveasymmetry to us.
It almost seems too easy to subscribe to the view that equity markets will rally into year end, and then selloffagain in the 1st quarter of 2023, as investors are generally sucked back into being bullish and continue to have lowlevels of protection. However, we do think there is a decent chance of this exact scenario playing out.
In summary, the views we first published in our midyear 2022 publication remain the same (reposted again at theend of this publication for those who missed it).
Our view also continues to be that traditional stock/bond only portfolios are to be avoided. Period end of story.Economic cycles are running faster and hotter, and so are policy responses. Asset allocation, which is based onpredominantly passive, stability seeking traditional investment holdings only, is in our opinion “choosing to drive ahorse and buggy in a world of automobiles.”
STRATEGY COMMENTARY:
As a reminder, our Sundial Dynamic All-Weather Portfolios attempt to achieve positive returns regardless of themacroeconomic 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 strategies
• Recognize that some investments are stability seeking (short volatility bias) and others are instability ordislocation 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 throughtactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive inconstructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: These systematic strategies generally disengaged from the equity market at the very beginning of2022, and have remained in a cash heavy, capital preservation stance since, which has been beneficial. There hasbeen little re-engagement thus far. This is an important signal to us as the tactical equity strategies tend to onlybe fully invested in healthy markets, which we don’t believe we are in. We maintain a full allocation at the topend of the range as we believe there is significant potential positive asymmetry that stems from the currentdefensive stance which can very quickly shift to an offensive stance when the appropriate signals materialize.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range, and they have been there sincethe fall of 2021. We see little reason to increase the allocation until our quantitative and qualitative metricsindicate a more constructive environment.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects our defensive stance. We continue to utilize mostly alternative yieldgenerating investments and avoid Government and corporate bonds.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: This asset class continues to be the star performer in 2022, as there have been some huge trends, such as a stronger dollar, higher government bond yields, lower equity indices and higher commodity prices. We continue to believe that the global markets are in a great repricing of risk, and that dislocation seeking strategies like trend following are best suited for this environment.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: These investments have done a whole lot of nothing in 2022, which isn’t surprising as there reallyhasn’t been an “extreme tail event” this year. The grind lower in equities along with an absence of a significantspike in implied volatility has been the pain scenario for these strategies. As we do believe the great repricing ofrisk is not over, and there are multiple potential tail events to come in 2023 (China – Taiwan; More aggressivethan expected Fed; More persistent than anticipated inflation) we are committed to the full allocation.
We encourage readers to reach out to us if they would like to discuss in more detail the instruments and funds thatSundial utilizes within each of these categories.
CHARTS & TABLES:
My favorite chart of the past month: HOPE (housing, orders, profits, employment).
Topic: Energy
Graph of the Strategic Petroleum Reserve. What happens when the selling stops….only halfway to go until the SPR is completely empty.
Topic: Inflation
If you are not already signed up to read Harley Bassman’s monthly commentary, sign up! Here is yet another interesting chart illustrating that inflation is declining, but it is not coming down fast enough to get to the Fed’s 2% target by the time that the interest rate futures markets are pricing in an end to the Fed rate hikes and then the beginning of a rate cut cycle.
Topic: Equity Markets
There continues to be no demand for owning put options to protect portfolios from a further decline in the US equity indices. This graph from SpotGamma is a measure of the price of put options relative to call options. The more negative the metric is, the higher put options (downside protection) are priced relative to call options (upside participation). Their general view which we agree with is that this relative pricing is being driven more from put selling in a high volatility environment vs. ferocious call buying demand. Reminds us of the mantra of the option seller…. “collect the premium and live the dreamium.”
Here is a nice chart illustrating the growing demand for extremely short dated options.
Here is another data point yet again confirming that the markets are in a regime change / great repricing of risk. Buying the dip in equity indices has become a painful strategy… not surprising with the transition from massive amounts of excess liquidity to an absence of it….
Topic: Bond Markets
The MOVE Index is the “VIX of the bond market.” No stability and calm here. Just another example of the “great repricing of risk” that we wrote about back in our 2022 Midyear Review publication (email us if you would like a copy).
Mortgages are looking cheap. Here is a graph of the yield spread between the Par mortgage rate vs the 10Y constant maturity swap (AA credit proxy) rate. The Fed’s “Operation Break Sh*t” as it has been called is breaking Sh*t!
Topic: Stock vs. Bond Correlations
We have repeatedly shared our strong opinions on this topic since August 2021. A long-term history (back to the 1970s) shows that bonds only have been a good hedge to stocks in very recent times, that there are very long time periods where Stocks and Bonds didn’t hedge each other at all, and that lack of hedging has been higher in periods of elevated inflation. For those investors who still have (or ever had) a 60% stock / 40% bond portfolio, this has been a very painful year.
Topic: Interest Rates & Inflation
This chart nicely sums up what we have been concerned about for 5 months now. Specifically, is the market underpricing the risk of higher for longer central bank rates. Quote from Prometheus Research: During past periods of stagflationary nominal growth (highlighted in grey), policy rates need to be in excess of nominal growth to break the inflationary spiral (instances circled):
Topic: Housing
Interesting long-term chart on housing price changes.
Here is a very long-term graph of the 30-year mortgage rate. This has been the greatest upward rate of change in history. Operation Break Sh*t is full steam ahead.
Here is a chart of the rate of change of monthly mortgage payments.
NAHB Housing Index.
NAHB Housing Index and Mortgage rates (inverted scale)
Cities that CRASHED the Hardest during the last Housing Downturn.
Topic: Consumer Spending:
Topic: Consumer Goods
Used car prices are firmly declining.
Luxury goods prices are also falling…. Rolex prices for example. This chart is an average of the 30 best-selling models in US dollars.
And along the same lines, the cost of importing goods has cratered as well…. the cost to send 40-ft container from Shanghai to Los Angeles has fallen by 74% from peak and is back to August 2020 levels
Topic: China
Interesting macroeconomic factor.
Repost of our writing from our midyear 2022 publication that was referenced above:
The distribution of outcomes (i.e., potential price swings in capital markets) is quite wide, and much wider than it has been over the past few years. Yes, there was a lot of uncertainty in Feb/March 2022, but the Federal Reserve stepped in at that point with so much accommodation that the range of outcomes very quickly narrowed. They are now programmatically removing accommodation, and this will be the biggest removal of accommodation ever.
Why are the distribution of outcomes wider?
• For the first time in 40 years, the US has real secular inflation
• If long term inflation expectations remain elevated, then 1) corporations and consumers adversely change their spending habits (i.e., hoard products for fear of price increases) and 2) sophisticated investors will borrow at negative real rates (borrowing rates below inflation) and buy real assets and capital goods, which could also accelerate demand ahead of supply. These scenarios can create a "doom loop" of persistently high inflation, which historically has proven very difficult to reverse.
• The Russia invasion of Ukraine invasion is contributing to the food and energy price inflation as well. • The Federal Reserve has little ability to directly reduce inflation, particularly in food and energy. • The Federal Reserve’s most powerful tool is the “wealth effect” and it is much more impactful than the
level of their Target rate. Some have referred to the current Fed playbook as “Operation Break Shit” meaning move swiftly and in large increments until something breaks in the economy or in markets, kicking the negative wealth effect into high gear.
• The Federal Reserve is effectively “selling upside call options on the stock market.” They are aggressively removing accommodation through rate hikes and Quantitative Tightening. The more the equity market rallies, the more aggressive they can be in the removal. Weaker prices for risk assets = negative wealth effect = less demand for goods from corporations and consumers = lower inflation as fewer dollars are chasing a still limited supply of goods.
Our views can be summarized as follows:
• While it is difficult to say if the US economy will experience a minor, a major, or no recession, what is more obvious to us is the high potential for an earnings recession meaning corporate earnings decrease. We don’t believe this is yet priced into the equity market as consensus estimates have not come down.
• Until there is a change in rhetoric from the Fed, we probably haven’t seen the ultimate cycle bottom in the equity markets. And a change in Fed rhetoric won’t happen until inflation levels are clearly improving (not one weak print).
• Look for violent bear market rallies but until the trend in inflation is clearly lower, the secular trend in the equity markets is still lower.
• We could see a 3-year rolling equity bear market but expect some big bear market rallies. In 2000 to 2002, there were multiple 20% rallies within a declining trend in prices. The price action was similar in 2007 to 2009.
• From 1968 to 1982 the equity market went nowhere but lost a lot of value due to inflation. In this period (14 years), there was zero nominal growth in the market. And on inflation basis, lost 67%. There were multiple 20% declines along the way. This is a plausible scenario if inflation remains elevated for a long period.
We could be entering a sustained period where active management will generate far better risk reward than passive investing in equities and bonds.
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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