Dealing Desk Notes: Stock Market Sentiment Extremely Negative
Major stock indexes have closed down for seven straight weeks (the is down for eight straight weeks, its worst in 90 years).
The was briefly down >20% against ATH on Friday before rallying at the close. Virtually all sectors, except , fell.
Estimates of global stock market losses = ~$25 trillion, or more than a full year of US GDP.
BofA Bull/Bear indicator
Liquidity is thin (as people pull back), has been poor, and near-term price action has been stunning (DJIA fell nearly 1,000 points early on Friday, then rebounded around 700 points to fence.)
The S+P has doubled from the 2020 lows and is up about 7x from the 2008 lows. Perhaps a correction was due after such dramatic gains.
S&P 500 EPS vs trend
Flows to global equity funds
The 40-year downward trend in interest rates has helped drive up asset prices
Interest rates hit 1000+ year lows in the summer of 2020 (when the US Treasury yield hit 0.50%) but have trended higher since then, with a sharp rise to from last fall when the market started pricing in central bank tightening even as the Fed was talking “transient.”
In this chart, falling bond prices = .
The Fed now seems determined to cool (“there will be pain, but the pain will be much greater if we don’t bring inflation down”), and the now fears that the Fed will tighten in a recession.
1-Year Federal Funds Forward Rate
Retail Expense Table
The futures market has more than fully priced in this cycle of Fed tightening and corrected. June 2023 hit a low of around 9625 on May 4 and fell 50 basis points.
May 9 peaked at ~3.12% and fell to around 2.8%.
Market return on UST 2 years
Who suffers as the Fed fights inflation?
In previous posts, I wondered if the Fed would be willing to “throw the purse under the bus” to calm inflation, especially since inflation would be a HUGE problem in the run up to the midterm elections.
A declining stock market tightens financial conditions, so in that respect the Fed is likely fine with the recent decline.
Full employment is part of the Fed’s mandate, but job losses happen because the Fed wants to curb inflation by reducing demand. The Fed would like to organize a “soft landing,” but they admit it may be out of their control.
INJCJC Index Table
Inflation
As Richard Russell said, “Everyone loses money in a bear market.”
The US dollar index hit 20-year highs but retreated
Capital is flowing into troubled countries, and it is also flowing into the USD in search of opportunities. The recent strength of the USD reflected both of these motivations.
The combination of a risk-averse environment and the perception that the Fed would raise interest rates more aggressively than other central banks contributed to the USDX’s 7% rise from late March to mid-May .
But this week, the correlation between a feeling of intense risk aversion and a rise in the USD has reversed: stock indices have fallen sharply (risk aversion), but so has the USD.
Maybe the market senses that “clamp peak” has already happened and/or the stunning recent USD strength was overdue for a correction.
Are recession worries cooling energy prices?
The bullish energy narrative has been strong and prices have . Demand has increased, but the prospect (and current reality) of supply shortages has driven prices up.
OPEC continues to increase its production targets, but it cannot meet these targets while warning that spare production capacity is limited.
I have written many times about regressive government energy policies with costly consequences, but the sad reality is that energy production cannot meet demand without recession.
One thing seems inevitable: much more money will have to be invested in energy markets to increase production, from all sources.
US Stock Market Energy Weighting
CAPEX vs Dividends + Buybacks
Food shortages?
The cover of The Economist this week was “The Coming Food Disaster.” Although The Economist (and other magazine covers) are used to pointing out market reversals, they may be right.
I sincerely hope they are wrong, but there is a real risk that it could have unimaginable consequences.
The economist’s article
Top 10 wheat producing countries
My short term trading
I started this week flat, but thought the stock indices and USD might reverse recent trends. In last week’s article, I wrote that I would buy if sentiment turned risky.
I bought the CAD and stock indices (S+P and ) several times this week. I traded small positions with tight stops; I had some good winners but suffered several small losses.
At the end of the week, my P+L was down 0.50%. I bought the S+P 30 points off the low on Friday and stayed long into the weekend (still thinking this market was going to bounce back!)
On my radar
Stock market sentiment is overwhelmingly negative, and any sign of a rebound could lead to a quick rally in the bear market. I’ll be looking for a follow up to Friday’s late rally.
There are seven trading days left before the end of the month. I expect to see significant rebalancing (buying) in pension funds and mutual funds. Corporate takeovers could also be a factor.
On Friday, the S+P briefly broke below a double bottom (made a bunch of stops?) but quickly bounced back above that support level. A failed failure can signal a rally.
USD weakness this week, especially when risk aversion sentiment was so strong, could signal a change in trend.
Trade Thoughts
This week has been an example of good defense. I was fundamentally wrong in thinking that risk aversion sentiment should rebound, but my risk management limited the damage to my P+L.
Trading is clearly not about economics; it’s a question of psychology, and the mood of the market has been darker this week, not brighter.
What is “risk management?”
One of the great things about writing these articles is that I get great questions, comments, and suggestions from readers that I otherwise would never have met. This week, a reader in Poland asked, in essence, what I mean when I say I make money by managing my risk, not having a big crystal ball.
The more I thought about his question, the more I realized it was a great question, so I will write weekly on different aspects of risk management.
Here is my (modified) answer to his question:
My risk management style has changed over the years. For example, in the early 1980s, when I was a currency analyst for a large US commodities company, I traded very aggressively, meaning I took positions much more large (compared to the size of my account) than now.
I also believe that every trader should find a style of risk management that matches their personality and trading style.
Risk management defines a trader’s style – its essence is to “live to trade another day.” Since “everything can happen,” I deal with probabilities, not certainties; I want to organize my trading to limit losses.
I’ll think about it a bit more, and I might create a new “Risk management” section in my TD Notes. Thanks for giving me this idea!