February 2019: Charybdis, Scylla and Circé
Since 2015, we have compared the market behaviour with Homer’s Odyssey, at the specific time when Ulysses gets rid of Circé grips but in his escape faces two equally dangerous monsters: Scylla and Charybdis. For us, Circé which drugs Ulysses and transforms his soldiers into pigs is comparable to our ultra-dovish central banks injecting its own QE drug; then, when markets try to navigate more freely without the drug QE, they must face the first monster “Charybdis”, characterized by higher rates, a higher dollar and volatility though rising equities. For the last years, it has ultimately ended with Scylla, or an equity sell-off, with gold & bonds rising. Then, the wheel turns again and Circé recuperates the wounded navigators and feeds them with her new doses of QE drugs. We are back in Circé world: Equities have strongly rebounded thanks to the new dovishness of central banks and bonds are skyrocketing again. An earnings season initially thought to invoke a long-volatility bias is turning out to be a short-volatility opportunity, thanks to Circé. So what does this paradigm tell us now: can we get more Circé drugs as bonds seem to forecast (and we know rates are often more right than equities), or should the drug transition be short this time and trigger Charybda or worse Scylla?
After the worst December in a century, January’s tape has been enjoying a FOMO (fear of missing out)-induced chase-related bid. A combination of better-than-feared earnings season, light positioning, a dramatic Fed pivot, and a (likely) further cooling of US- China trade tensions created powerful tailwinds for equities and bonds. This rally is reminiscent of the 2010-2017 era with bonds and equities correlated and rising, thanks to positive sentiment driven by QEs.
Unfortunately, greed is back. While the S&P hasn’t been able to climb back above its 200-day average, sentiment has swung back into greed mode. There is a big fight right now between shorter-term signs of excess, bearish medium-term trends, and poor seasonality versus the impressive thrust in price and breadth.
Furthermore, the VIX has slipped to a multi- month low and is at the same level as in November when the market made its second leg down. This has consistently led to trouble over the short to medium-term as the ebbing of concern showed that investors were too quick to price in lower volatility.
Our conviction back in the end of 2017 was a change of market regime driven by higher rates and the switch from QE to QT. This switch has a possibility to trigger a similar crisis than in 2008 for the following reasons: (1) liquidity evaporating , (2) fragile market microstructure (Rising weight of passive vs active funds that get rid of the buy the dip value tilt associated with active managers, Systematic quant funds that sell on weakness) , (3) de-equitization versus illiquid private assets, creating the socle for a structural and painful unwinding of illiquid assets. A negative feedback loop that runs from inadequate bad policy choices to falling asset prices to tighter financial conditions and then to a weaker economy and corporate earnings should fuel this bear market. This should be associated with much higher levels of long-term Implied Volatilities (IV). Thus, our core overlay is a long convexity through 6 months to 18 months option on index that should benefit from this switch.
Since the Jan. 4 follow through, more stocks have been hitting new highs vs. new lows. The Nasdaq’s advance-decline line has risen nicely for nearly seven weeks. And most breakouts have been working as institutional demand for equities is still heavy. Then, with respect to positioning and sentiment, net exposure from hedge funds is at its worst in 7 years for US , which could fuel this disliked rally. On the other side, every positive element has a devil inside: our sentiment indicators (see chart below) are giving cautious signals for the coming days in every region . Specifically, one of the parameters of our SC US Sentiment index, the AAII survey shows that retail investors returned to a near record level of exposure to the stock market, which has led to generally poor returns.
This is why we expect a period of congestion or even correction. Then, more positively even if market retests their lows we expect less momentum and less volatility than in 4Q, this is reflected on the better short term and medium grades from our matrix. In this configuration, our quantamental process recommends increasing our gross equity exposure which has been historically weak since the summer 2018. The goal is to gradually put capital to work “with patience”. Our long single stocks exposure should gradually increase from 70% of NAV to 100-120% though the purchase of an equally-weighted list of the best stocks emerging from our quantamental process; and single stocks shorts from 20 to 50%. One sign is confirming this increase of equally-weighted number of invested stocks: the equal-weighted S&P500 has beaten the cap-weighted gauge for six consecutive weeks.