The market's response to last week's CPI report, which showed that core inflation seems to be slowing down, was very positive. Keep in mind that one data point does not necessarily indicate a trend, and the Fed has been very blunt that it will not stop raising rates until inflation is in check. The trend is decisively down, and we will be patient and let the market tell us when to buy and when to re-enter the market.
The Ivory Hill RiskSIGNAL is still red, and we are sitting on roughly 76% cash for our noninstitutional clients.
As I wrote in my last report, our signals told us lower volatility was expected, implying the market was due for a rally, and that's exactly what happened. The S&P 500 rallied 7% in eight trading days.
BUT in the same period of time, gold rallied 8%. Traders normally flee to gold during times of uncertainty or during periods of high volatility, so why would gold be rallying along with the stock markets if volatility was down and stocks were up?
Let’s ask that question from a different point of view. Let’s say that gold is a hedge against inflation. It’s not, but for the sake of this post, let’s assume some traders would buy gold as a hedge against inflation before the inflation report. The inflation report showed that inflation went down, so that doesn’t make sense. But why would investors buy gold when stocks are clearly a better choice?
This question is easy to answer: traders are rapidly covering their short positions. Short covering is the process of buying back securities that have been borrowed so that an open short position can be closed at a profit or loss. It requires purchasing the same security that was initially sold short, and handing back the shares initially borrowed for the short sale. This type of transaction is referred to as a "buy to cover."
Gold is still clearly in a bearish downward trend along with the market, but what happens when traders start covering both stocks and bonds? Well, we are seeing it right now with the "everything rally."
Asset class selection is crucial:
The Vanguard Value ETF (VTV) is down 3.72% this year while the comparable Growth ETF (VUG) is down more than 28%, which underscores just how important investment style selection and individual sector allocations have become. Boring value stocks are outperforming growth stocks this year.
If you have been following the horror movie/comedy show that is FTX, Sam Bankman-Fried and the crypto space in general, I want to explain to you how this dumpster-fire is a scaled-down version of a broader macroeconomic trend that some are calling "The Mother of All Bubbles."
That bubble appears to be bursting.
For those of you who are not up to speed on this situation:
FTX is a crypto exchange just like Coinbase, Binance, and Gemini. The FTX exchange, which used to be one of the largest in the world, filed for bankruptcy last week, and its CEO and founder also quit. Hours later, the trading firm said there had been “unauthorized access” and that funds had disappeared. Analysts say hundreds of millions of dollars may have vanished.
On Friday, FTX filed for Chapter 11. CEO Sam Bankman Fried resigned. Billions of customer assets are caught up in the crypto exchange’s epic mismanagement.
The pre-collapse mania has been supported by a long list of carnival barkers. That list includes Michael Saylor, Raoul Pal, Anthony Scaramucci, and a rotating cast of clowns on CNBC. They convinced millions of uneducated investors that crypto was their only hope. Since the climax of this insanity, more than $2 trillion in crypto market cap has been erased.
What's happening today in crypto is not symptomatic or even pointing to a potential bottom.
Think about this for a minute. People have invested a lot of their hard-earned capital into crypto, and then this happens after this entire space has crashed. Can you imagine?
If you invested $1,000,000 in Bitcoin at it's peak in November of 2021, you only have $250,000 in your account today. Bitcoin is down 75%.
This situation is beyond out of control. To quote one of my marine colleagues, the crypto space is FUBAR.
About this time last year, Elon Musk was pushing Dogecoin. It literally started as a joke.
Here's another example. I was scrolling through my Instagram feed this morning and came across this targeted ad. This is advertising the benefits of trading crypto futures with 150X leverage!
When you invest or trade with leverage, you use borrowed money to improve your trading position beyond what you could do with just your cash on hand. Through margin trading, which borrows money from the broker, you can use leverage with a broker account.
Do any of you want to mortgage your house to buy cryptocurrency? For a lot of people, that isn't too far off from what they did. They took out debt to buy crypto and then lost it at an accelerated rate when they got margin called. When you get your margin called, you either need to put more money in your account or you need to sell your position down to the minimum amount. Typically, margin calls result in increased selling.
If you are trading anything at 150X leverage, that means you are getting 150X the gains while also taking 150X the losses. Think this space has finally got out of control?
There is more leverage in the crypto space than there is actual cryptocurrency! To my point, the entire market (including stocks) is just one big leveraged trade that is being margin called.
Overconfidence leads to leverage. Increased leverage has led to every single major market crash in history.
Here's how this plays out in the broader market: margin calls trigger increased selling, increased selling turns into oversold markets, and oversold markets turn into major market crashes.
This is not an indication that the bottom has been reached. This is most likely a sign of what's to come in the global capital markets.
Here's a quick recap:
$2 trillion in crypto market cap … GONE
$10 trillion in aggregate equity market cap ... GONE
We do not own any crypto right now, and when we did, it was in an ETF, and we were quick to take profits.
REALITY CHECK: If you've been following Ivory Hill, you know that our proprietary quant-based indicator flipped red in January when we moved our clients to 60%-70% cash.
Let's take a step back and review what needs to happen in order for us to start thinking about a bottom.
No bear market in history has every bottomed without seeing the VIX blowout above 45+. With the VIX being at 22, this tells us we still haven't seen a bottom yet. We need more fear.
We also need to see credit spreads blow out. Spreads have been stubbornly stable over the last few months.
The 10s2s yield curve has inverted at 52 basis points. We still need to see the yield curve UN-invert because historically the market tends to sell off even more after the reversion.
The Fed is still raising rates. Based on history every single time the Fed raises rates, they go way to far and completely choke off economic growth. This time they are raising rates into declining economic conditions.
I don't really care if the Fed reduces their amount of their rate hikes. For example, If the Fed reduces the next rate hike to 0.50% from 0.75% that does not materially impact our process. Why? Because the Fed is still raising rates! A reduction in rate hikes is still a rate hike. I follow the path not the prediction.
Let's take a look at fundamentals before we wrap up
While fundamentals tend to get thrown out the window during market turbulence, I find it helpful to gauge where the market could go based on fundamentals and then see where it overlaps in our quantitative process.
There was improvement in the November Market Expectations Table because the spike in global yields, which caused the S&P 500 to hit fresh YTD lows, stopped as U.K. Prime Minister Truss resigned and her replacement, Rishi Sunak, regained the market’s confidence. The removal of “Global Yields” as an influence in the MET was the biggest positive change this month.
While that was positive, it was a small correction and as such it doesn’t materially help the macroeconomic outlook. That’s because the major headwinds on stocks, Fed Tightening and Inflation, remain very much in place, albeit with some deterioration.
Additionally, we’ve seen economic data weaken while inflation remains resilient, and if both those respective trends continue then we are talking about stagflation.
Q3 earnings season was “okay” but the chances of 2023 S&P 500 EPS staying at $230 (where they’ve been for months) is declining rapidly, so I am lowered the outlook for 2023 earnings by $5 across the board to reflect the increased downside risk to 2023 S&P 500 earnings.
Here's what the changes mean for us: The “Fair Value” range for the S&P 500 in this month’s MET did rise as the removal of spiking global yields allowed the fair value market range to return to 16X-17X (from 15.5X-16.5X). But that’s not an improvement from two months ago and we’re really no better off than we were in September before Truss-o-nomics (we’re actually sitting slightly worse).
Think of it like this: Let's say you and I went out fishing and our boat motor died leaving us stranded in the ocean. To make matters worse, our boat sprung a leak and we fixed that leak, we’ve improved our current situation but this doesn't fix the motor or get us back to dry land.
The MET is clear: We’re still no closer to fixing the two major issues facing this market: Fed tightening and inflation.
From a value standpoint, the positive is that for the current macro set up, we’re still in the “fair value” range and only slightly above the midpoint of that range. So, the market isn’t vulnerable to a quick intense pull-back unless we get further deterioration in macro influences. At the same time, I think we do need to note that “fair value” for this market ends as we get towards and past 3,800, and that will hold even if this market continues to rally now that we have a split government.
Current Situation: Stocks are now more fairly valued.
The current situation reflects relative improvement in the outlook as spiking global yields are no longer pressuring stocks. But that’s about the only positive we saw over the past month.
First, J-Powell hinted that terminal fed funds could be 5% or higher (by stating it could be higher than previously expected) which meets our “Get Worse If” scenario from last month. Inflation, meanwhile, still isn’t declining (although it has likely peaked).
Economic data is showing more signs of rolling over, and there’s no progress towards a ceasefire in Russia/Ukraine (although there are some rumors of progress, but nothing concrete yet).
Bottom line, global yields aren’t spiking anymore and that’s good, but we’re still facing multiple market headwinds and there hasn’t been much progress.
Things Get Better If:
The Fed signals that the terminal rate will be below 5.0%
Inflation drops sharply (actually drops, like by multiple percentage points)
Economic growth remains resilient and falls slower than inflation, Russia and Ukraine take steps towards a ceasefire.
Things Get Worse If:
The Fed signals that the terminal rate will be well above the current 5.00%
Inflation does not drop quickly
Economic data falls faster than inflation increasing stagflation worries
Russia uses a nuclear device in Ukraine or credibly threatens the use of one.
Markets simply can’t sustainably rally until we get to “Peak Hawkishness” from the Fed and in this outcome markets would aggressively price in a recession (so 15X-16X multiple) with downside risks to earnings, economic growth and financial stability.
The S&P at 3,300ish should be thought of as a “worst case,” but given market momentum a technical-driven violation of that level can’t be ruled out in the short-term.
Bottom Line
There was improvement in the November MET and the rally in stocks since the October lows is legitimate. But the result of that rally is that the S&P 500 has fully priced in that progress.
For additional gains in stocks to be fundamentally validated, we must see real improvement in 1) Inflation 2) and Fed tightening. Until then, anything materially above 4,000in the S&P 500 should be considered too optimistic, and we should be prepared for a pullback of 5% or so if fundamentals deteriorate.
But to be clear, we are far from being able to confidently say this broader equity bear market is over from a technical perspective.
Zooming out on the charts, this accelerating rally strongly resembles the other bear market rallies we have seen so far in 2022 and up to this point there is no reason to believe this is anything different.
Remember, we saw four bear market rallies of 20%+ before a bottom was in during 2000. These underlying market conditions are worse than 2000 and 2008 so these types of rallies should be expected.
Real bear market bottoms are formed on the back of investor capitulation and fear, something we have not yet seen with the 2022 market. Additionally, there are almost always multiple “tests” of a newly formed bottoms as it is built out as a formidable support level.
This rally can extend as high as 4,100-4,200, or beyond, but without a series of higher lows and higher highs being realized over a more significant time frame (multiple quarters, not weeks) then I will remain skeptical of the rally from a purely technical perspective and keep an eye out for a retest of the lows.
We are going to sit on our pile of cash and take small nibbles at macro opportunities until the Ivory Hill RiskSIGNAL tells us where the bottom is.
Be prepared to be sitting in this position for a while. Our macro forecasting model is telling us we could be sitting here until at least the second half of 2023.
And remember – the one fact pertaining to all conditions is that they will change.
Feel free to reach out to me and use me as a sounding board.
Best regards,
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Direct: 952.828.5336
Email: kurt@ivoryhill.com
—Written 11.12.2022