Markets Are Stretched, So I'm 'All-In Short'
My recent column Not So Super Tuesday highlights why I believe markets are tipping over to short-term bearish, while my Top 10 Reasons to Sell Stocks Now piece incorporates most of my intermediate-term concerns.
That's why I moved to "all-in short" on Friday during the market's post-jobs-report ramp-up. I believe stocks' recent rally from their mid-February low has stretched valuations and drastically altered the risk-vs.-reward ratio.
I'd also note that Friday's seemingly good February U.S. jobs report wasn't quite as "clean" as the strong headline number of 242,000 non-farm job gains suggests. For instance, average wages dropped by 0.1%, while average hours worked fell by 0.2 -- a decline usually seen in recessions. (Previous similar drops occurred in February 2010 and December 2013.)
It's also worth noting that while the S&P 500 enjoyed a 12-handle rally early Friday afternoon, those gains reversed during the last hour or so of trading. S&P 500 futures are also down another eight handles or so this morning.
Nonetheless, the S&P 500 was still about 7% higher at Friday's close than my fair-market-value calculation calls for.
A Large, Developing Market Top
My recent missive Fire and Ice outlined my "big-picture" concerns and made the case for a large, developing and important market top (which might have actually commenced 10 months ago).
I believe the S&P 500 has been deteriorating since late November 2014, as leadership narrowed and a smaller and smaller number of stocks were doing the heavy lifting. And since the S&P 500's May 2015 peak, we've also seen four declines and subsequent rally attempts -- none of which managed to achieve new highs. As measured by the SPDR S&P 500 ETF (SPY):
* The market's August-to-September rally topped out at $203.
* An October/November ramp-up peaked at $212.
* The recent January-and-February rally maxxed out at $194.
* The February-to-March rebound reached a possible peak of $201 on Friday.
All of this came amid numerous technical divergences, faltering global economic fundamentals (China reduced its growth target over the weekend) and a weakening U.S. profit picture. (Estimates for first-quarter S&P 500 profits are running -8.4% year over year.)
I embraced all four of the market's dips since last summer, then I sold the subsequent rallies. But with profit forecasts growing more impaired, I suspect stocks could be approaching another near-term peak within the wider context of a more meaningful, broadening market top.
Why You Shouldn't Trust This Rally
In my recent missive I'm Now Bearish Both Short- and Intermediate-Term, I outlined my near-term concerns in the face of a spirited short-term rally that had little in the way of corrections before Friday afternoon's session. (My Real Money Pro colleague James "Rev Shark" DePorre noted this lack of corrections on Friday.)
Persistent bidding has been a feature of our latest rally, likely the product of gamma hedging, risk-parity trading and other quant strategies. This raises the possibility that any momentum reversal could have an outsized role in taking stocks lower in the weeks and months ahead, just as it did during stocks' rally over the past two weeks.
Check out this chart from Marko Kolanovic, JPMorgan Chase's head of quantitative trading (via Zero Hedge):
The chart shows that the S&P 500 has staged a meaningful rebound since mid-February. But systematic strategies look like they've played an important role in both the S&P 500's January selloff and February rally, just as they likely did in last year's August selloff and subsequent October rally.
In a research note quoted by Zero Hedge, Kolanovic recounted the magnitude of these strategies' buying impacts, which are disengaged from income statements and balance sheets:
"Short-term equity momentum turned positive around the 1,930 level and six-month momentum turned positive a few days ago. This would have resulted in CTAs covering most of their short equity exposure and inflows in $50 billion to $70 billion (also confirmed by the equity beta of CTA benchmarks).
The market moving higher also changed the index option (gamma) imbalance and resulted in daily hedging flow that suppressed realized volatility. Lower realized volatility in turn led to some (albeit smaller) equity inflows into Volatility Targeting strategies (around $10 billion) and Risk Parity strategies around $10 billion to $20 billion.
All in all, over the past two weeks, equity inflows from systematic strategies totaled around $80 billion to $100 billion. Taking into account the low liquidity (S&P 500 futures-market depth) and assuming that total equity market depth is about 4x that of futures (including stocks, ETFs, and options), we estimate that more than half of the market rally in the second half of February was driven by these systematic inflows."
What's the current rally's fate? According to Kolanovic (again via Zero Hedge):
"In terms of technical flows, more inflows would come if three- and 12-month momentum turn positive, which would happen at around 2,025 and 2,075 (on the S&P 500) ,respectively. (The precise level depends on the timing of potential moves).
If volatility stays subdued, volatility-managed strategies could also increase equity exposure. However, equity momentum is also vulnerable to the downside, and a move lower could be accelerated by six- and one-month momentum unraveling at around 1,950 and 1,900 (on the S&P 500), respectively.
From the perspective of systematic strategies, downside and upside risks are balanced. However, equity fundamentals remain a headwind. In our recent strategy note, we showed that historically, periods of consecutive quarterly EPS contractions are often followed by (or coincide with) economic recessions (about 80% of the time over the past roughly 120 years). EPS recoveries that follow two consecutive EPS contractions (around 20% of times) were typically triggered by some form of stimulus (fiscal, monetary or exogenous).
We expect market volatility to stay elevated and investors to remain focused on macro developments such as the Fed's rate path, developments in China and releases of U.S. macro data. Elevated volatility and EPS downside revisions will provide a headwind for the S&P 500 to move significantly higher (via multiple expansion)."
The Bottom Line
It's my view that quant strategies that worship at the altar of price momentum and allocate capital based on volatility played an important, disproportionate role in stocks' recent rebound.
So, I believe the latest rally might not be on terra firma -- and could prove short-lived. Mr. Market's journey of a broadening and significant market top seems to me to remain on course.