Will Deleveraging Unwedge and Unhinge Markets?
U.S. stocks climbed on Friday, finishing the volatile week on a high note as stocks benefiting from a successful economic reopening outperformed again.
The Dow Jones Industrial Average closed 453.40 points higher, or 1.4%, to 33,072.88. The blue-chip benchmark was up only 65 points earlier in the day. The S&P 500 rose 1.7% to 3,974.54, hitting a record closing high and bringing its 2021 gains to 5.8%. The Nasdaq Composite erased a 0.8% loss and ended the session 1.2% higher to 13,138.72.
All three major benchmarks rallied to their session highs into the close with the Dow jumping tacking on more than 150 points in the final 8 minutes of trading. It was broad-based late buying. Beaten-up tech like Apple rallied into the green in the final minutes. Banks, energy and materials were all big winners in the final minutes and on the day.
President Joe Biden on Thursday announced a new goal of having 200 million Covid vaccination shots being distributed within his first 100 days in office. As of Friday, 100 million coronavirus vaccinations had been given since Biden was inaugurated.
Financial stocks rose after the Federal Reserve announced that banks could resume buybacks and raise dividends starting at the end of June. The central bank originally said it would lift pandemic era restrictions in the first quarter, but even the delayed move gives investors more clarity. Shares of JPMorgan rose 1.7%, while Bank of America advanced 2.7%.
Fears of rising inflation eased after data showed tame price pressures. The core personal consumption expenditure price index, which strips out volatile food and energy prices, rose 0.1% month over month, matching expectations from economists polled by Dow Jones. Year over year, the gauge climbed 1.4%, slightly lower than a 1.5% estimate.
“Softer-than-expected PCE deflator data support the idea that Treasury yields will likely consolidate over the short-term,” said Edward Moya, senior market analyst at Oanda. “The lower the baseline for inflation, the easier markets can become convinced that the upcoming pricing pressure surge will be transitory.”
The 10-year U.S. Treasury yield came off its high following the inflation data, and inched back up throughout the day. The benchmark rate rose 6 basis points to 1.67%.
Meanwhile, consumer sentiment in the U.S. continued to rise amid the vaccine rollout. A University of Michigan survey released Friday showed the final reading of the index of consumer sentiment was 84.9 in March, up from 76.8 in February. Economists polled by Dow Jones expected a reading of 83.7.
The Dow and the S&P 500 posted modest gains for the week, up 1.4% and 1.6%, respectively. The Nasdaq fell 0.6% on the week, however. The market rally has slowed down in recent weeks as rising interest rates and valuation concerns hit tech names.
“The market has felt like more of a grind lately, and this may become more of the norm as we enter year two of the recovery,” said Larry Adam, chief investment officer at Raymond James. “These periods, like most, do not move in straight lines, as drawdowns will occur along the way. This is not troubling, but investors should expect some weakness and take advantage as it occurs.”
What a crazy day, someone obviously wanted to ramp up the markets going into the close but all this talk of "record" close on the S&P500 is misleading.
Apart from the last eight minutes of trading today, it was a god awful week, with heavy selling/ deleveraging in some stocks/ sectors which was downright scary.
But first, before I forget, take the time to read François Trahan's latest market comment on the Fed trade nobody is talking about. You can view it here.
Recall, last week, I went over why François thinks we are in the fourth inning of a cyclical leadership.
This week, he explains why rate hikes are coming sooner than you think and what that means for your investments:
The Federal Reserve has been THE big topic in recent weeks. Signs of inflation and the infamous "Dot Plot" from the Fed's March meeting have revived expectations of eventual rate hikes amongst investors. Truth be told, our thinking was already there. In our minds, the U.S. economy looks set to rebound strongly as the pandemic fades courtesy of near-zero rates and a $1.9T fiscal stimulus. This makes rate hikes inevitable. It's a question of WHEN, not IF.
The Fed has a big influence on equity leadership that is not always recognized. Its conduit is through long-term rates and the impact they have on valuation, and "Long-Duration" stocks in particular. The Fed Trade as we see it is "Short-Duration" stocks, a basket that is already up more than 20% in 2021. Needless to say, the "Long-Duration" stocks are lagging equities this year. More importantly, history shows that the performance gap between these two buckets continues to widen as long as bond yields are moving higher (i.e. as long as the Fed is raising rates).
To be clear, by "short-duration" stocks he means cyclicals like Financials (XLF), Industrials (XLI) and Energy (XLE) and by "long-duration" stocks he means Utilities (XLU), Tech (XLK) and Real Estate (XLRE).
François is an exceptional strategist, one of the best there is, so please take the time to read his thoughts and I personally think every institutional investor should be a client of his, he's not only that good, he's also a great guy.
Now, do I think the Fed is about to start tightening a lot sooner than the market anticipates?
Well, as François states, the bond market has already begun to price in an eventual tightening cycle and there are a lot of reasons to believe the Fed will need to hike sooner than it is currently telegraphing:
- Vaccine rollout in the US is going extremely well and President Joe Biden on Thursday announced a new goal of having 200 million Covid vaccination shots being distributed within his first 100 days in office.
- Brookings believes this will not be another jobless recovery. If their GDP forecasts prove accurate, they estimate that monthly payroll employment gains over the next 10 months will average between 700,000 and 1 million per month, a lot faster than many forecasters anticipate.
- According to BlackRock, Federal Reserve policy, the fiscal boost from the $1.9t stimulus, pent-up demand due to personal savings levels rising, and rising production costs will push inflation expectations higher.
- US economic activity is picking up and this may force the Fed to start talking up a rate hike. In fact, this week, Dallas Fed President Robert Kaplan said an interest rate hike could come as soon as 2022.
But there are also reasons to believe the Fed might hold off as long as possible this time around:
- In a post-pandemic world where uncertainty abounds, employment gains may be muted until businesses feel more certain to increase their payrolls.
- There's a fight gearing up over Biden's plan to raise taxes on rich, corporations. If his administration successfully passes a tax plan that targets the rich and corporations, it will restrict financial conditions and force the Fed to wait before embarking on a tightening campaign.
- Since 2008, markets have consistently priced in a more aggressive path of Fed rate hikes than what ultimately happened. Consider the situation in late 2008: traders were already bracing for several hikes in the years ahead, according to data crunched by JPMorgan Chase & Co., but policy makers held off on tightening until 2015.
- The Federal Reserve has vowed to continue keeping policy loose, even in the face of surging asset valuations.“We won’t be preemptively taking the punch bowl away,” San Francisco Fed President Mary Daly said this week.Some investing experts are leery of the Fed’s stance, but Bank of America is advising clients to take advantage.
- Tensions with China and North Korea are on the rise, will geopolitical risks weigh in the Fed?
- There's a tremendous amount of leverage in the financial system and the housing market. The mere hint of a rate hike can cause an avalanche of deleveraging.
The last theme is what I want to focus on today because this week was a lot more brutal than the Dow Jones or Nasdaq lead you to believe.
On Friday, ViacomCBS and Discovery shares plunged on a new downgrade and block trades:
A rally in ViacomCBS Inc. and Discovery Inc. that pushed the media companies to the top of the S&P 500 Index this year further unraveled on Friday after another major Wall Street firm said the stocks were overvalued.
ViacomCBS and Discovery posted their biggest declines ever in the aftermath of a downgrade by Wells Fargo, which joined a chorus of firms that have also turned more bearish on the stocks this year.
ViacomCBS closed 27% lower to $48.23, down from a high of $100.34 on March 22. Discovery also slumped 27% to $41.90, down from $77.27 on March 19. Other media stocks tumbled, too, with AMC Networks Inc. losing 6.4% and Fox Corp. retreating 6.2%.
All of these companies are crowding into the streaming market, where they face intense competition from established leaders like Netflix Inc., Walt Disney Co. and Amazon.com Inc. They have less to offer in the breadth and popularity of their programming and face a tough fight. At the same time, they are losing traditional pay-TV customers to the bigger players.
“We do see gravity pulling the multiples closer to prior norms,” Wells Fargo analyst Steven Cahall said in a note.
Both stocks saw their valuations stretched by ferocious rallies this year. Viacom, at its peak price just over $100, was trading for almost 25 times analyst estimates for 2021 adjusted earnings compiled by Bloomberg, its highest multiple in a decade. At $77.27 on March 19, Discovery fetched almost 27 times.
The selloff began on Monday when ViacomCBS reported an offering of $2 billion in shares after closing at a record high. The stock fell 9.1% the following day, dragging down Discovery. On Friday, large block trades on both shares said to be offered via Goldman Sachs and Morgan Stanley, added to the selling pressure.
Viacom and Discovery shares are echoing volatility in a host of companies that soared on lockdown trades, including Zillow Group and Peloton Inc. and to some degree the entire blank-check SPAC space.
Did you catch the part about large block trades on both shares offered via Goldman and Morgan Stanley?
That doesn't happen every day, it happens when large hedge funds want to liquidate their positions, pronto!
In fact, this is what happened. A liquidation of holdings at several major investment banks with ties to Tiger Cub Archegos Capital Management LLC contributed to an unseen daily decline Friday in shares of stocks including Discovery, Inc. and ViacomCBS Inc., according to people familiar with matter.
Not surprisingly, the price action on both stocks was brutal today on massive volume:
Those are weekly charts with weekly candles and it was just brutal today.
So what if some highly levered hedge funds or trading outfits had to liquidate their positions? More opportunities for BlackRock, Vanguard, Fidelity and global pensions and sovereign wealth funds to scoop some shares at a deep discount, right?
Well, yes and no, because it's not just these two stocks that got slammed this week.
Look at shares of Chinese electric-vehicle maker NIO (NIO) which got slammed today after the company said it will halt production at its Hefei factory for five days due to the global semiconductor shortage:
Again, so what? The stock ran up from $2 to a high of $67 over the past year and is now falling back to earth.
Well, not that simple because a lot of big quantitative hedge funds were levered long here and the selloff in this stock might be something to worry about.
In particular, is there some sort of deleveraging going on underneath the market surface?
Look at biotech shares (XBI) which have been slammed hard this month:
Same thing with solar stocks (TAN), they keep getting pounded on every pop:
Now, this could be end-of-quarter rebalancing from hedge funds but biotechs and solars represent RISK-ON appetite and my point is the mindset is clearly RISK-OFF.
The same thing goes for hot IPO stocks, they're getting clobbered:
Then there's the unARKing of the market which I warned of in mid-January:
Well, so what? A bunch of hyper-growth and highly speculative stocks are getting the hot air let out of them, why does it matter?
It matters because if the selling continues, it can take a life of its own and then deleveraging mini tremors can turn out to cause a massive earthquake as the deleveraging spreads across the entire market.
Bullocks! As long as Financials (XLF), Industrials (XLI) and Big Tech (XLK) continue to grind higher, the market is perfectly fine!
Maybe but if you look at Big Tech (XLK is mostly Apple and Microsoft but they're all in the same trading pattern, flat to down), you'll see it has been stalling over the past two months as financials, industrials and energy rallied.
Now, I don't doubt some hedge funds will be buying some Big Tech names going into Q2 while others will just continue adding to banks, industrials and energy, but even financials and industrials have run up a lot recently, so my big worry is the entire market might get stuck in this sea of liquidity.
And just like one ship stuck in Suez Canal is causing so much disruption, my big worry is that there may be a series of deleveraging trades done by big hedge funds/ large trading outfits that are going to cause massive market disruptions.
Also, just like there may be structural damage on that ship as it remains wedged, my fear is that a rising rate environment, if it persists, might expose some serious structural damage in markets.
If a full-blown deleveraging storm spreads across the entire market, starting with the weakest most highly speculative stocks, then the Fed trade nobody sees coming is a Fed rate cut/ more QE, not a tightening cycle, and that won't be good for markets.
Alright, before I end off, have a look at small cap stocks:
This too is a RISK-ON trade which looks set to reverse as it's forming a head and shoulders pattern.
Deleveraging in small caps will be particularly brutal as they ran up the most.
Anyways, below, the best performing large cap stocks this week:
And here are how the S&P sectors performed this week:
As you can see "long-duration" safe sectors outperformed "short-duration" cyclical sectors but the latter got ramped up during the last eight minutes of the market today.
We shall see what April brings us but this past month and quarter is one for the history books.
Just keep an eye on deleveraging in the most speculative sectors (AI, biotech, solars, EV stocks, ARK, etc.) and not so speculative areas of the market (like small caps) to see if things get better or worse.
And remember to read François Trahan's latest market comment on the Fed trade nobody is talking about here.
Below, in the latest episode of Influencers, Bridgewater Associates founder, Ray Dalio, discusses the volatility in the stock market, Bitcoin as a substitute for gold, and the rise of China as an economic superpower with Yahoo Finance Editor-in-Chief Andy Serwer. Take the time to watch this episode.
Ray Dalio thinks cash is trash, I'm started to really believe cash is king, especially if deleveraging spreads to rest of the market.
And CNBC's "Halftime Report" team discusses what they're watching in the market and the US economy.
Lastly and most importantly, remember what Jeremy Grantham said in late January, bubbles don’t burst all of a sudden, first you see the high-flyers get trounced, the overall market keeps grinding higher, but more and more stocks/ sectors start getting hit and then it catches up to the overall market.
Margin calls are hitting some highly levered hedge funds. You’re going to see more of this in coming weeks and months, it will impact a lot of stocks that ran up a lot over the last year.
Is the bubble slowly bursting? Nobody knows but it could be which is why it’s worth listening to Grantham’s interview again if you haven’t seen it (see what he says around 30 minute mark).
Update: On Monday morning, Bloomberg reports that Billions in Secret Derivatives at Center of Archegos Blowup. Zero Hedge covered these "CFDs" noting this:
As Bloomberg reports, much of the leverage used by Hwang’s Archegos Capital was provided by banks including Nomura and Credit Suisse - who have most recently admitted huge losses - as CFDs, which are made off exchanges, allow managers like Hwang to amass stakes in publicly traded companies without having to declare their holdings (far in excess of the 5% stakes that require regulatory reporting).
Crucially, as Bloomberg notes, this means Archegos may never actually have owned most of the underlying securities - if any at all - as the CFD is akin to a privately-arranged (i.e. off exchange and bespoke) futures contract where the differences in the settlement between the open and closing trade prices are cash-settled (there is no delivery of physical goods or securities with CFDs).
What makes the situation worse is that Archegos reportedly took positions in these CFDs with various prime brokers - and because these positions are by their nature not centrally cleared or aggregated, this left prime broker X unaware of their client's exposures with prime broker Y... which in this case was huge.
Full coverage is available here. I'm pretty sure when Warren Buffett noted that “derivatives are financial weapons of mass destruction,” he was referring to this.
One thing is for sure, all those stocks that were levitating up last year and in Q1 had nothing to do with day traders and the WSB/ Reddit crowd, they just added fuel to this leveraged insanity. It was all one giant leveraged carry trade!
And it's not only Bill Hwang, he's the poster child for this leverage virus which has spread all over the world. The problem is investors and risk managers are wondering how many more shoes will drop?
Just remember one thing, when large investment banks tell you it's "contained" and officially deny anything else is wrong, start to worry, really worry...official denial is the first admission of culpability (at least that's what Tom Naylor taught us at McGill).