Weekly Preview / March 13
Notable Events on our Weekly Watchlist:
Monday: Consumer Inflation Expectations
Earnings: N/A
Tuesday: Inflation Rate
Earnings: LEN
Wednesday: PPI, Retail Sales
Earnings: ADBE, PATH
Thursday: Initial Claims, ECB Interest Rate Decision
Earnings: FDX, DG, SIG, WSM
Friday: Michigan Consumer Sentiment
Earnings: N/A
ETFs to watch: SPY, TLT
Bank run
Before getting into this week’s newsletter, we’d like to announce the availability of the new Valuation Wizard Instrument! This tool allows you to input your assumptions about a company’s growth prospects and outputs a fundamental Price Target and EPS Growth Rate by creating a DCF Model for you.
These results can be then used in conjunction with our Technical Analysis Instrument, to view the results on a chart. You can find the new instrument under Fundamental Analysis. The Fundamentals Explorer Instrument has also been optimized for speed and now works 10x faster.
There are times when writing a financial media newsletter is challenging due to the fact that there is simply not enough happening. Stocks move because that’s what they do. As a writer, you’d need to struggle to find cause and effect relationships, and contort narratives in order to fit the price action. This is not one of those times - we have plenty to unpack, as last week gave us a lot “stuff” to comment on.
The point of that intro is to always keep in mind one principle: there are “set-ups” and then there are “catalysts”. A set-up is a scenario that makes a certain event more likely. Similar to an unexploded bomb. A catalyst is a spark that lights the fuse. When the resulting explosion is large enough, “everyone is surprised” because “nobody could have seen that coming”. It’s always the same.
We are in a rising rate environment. The Fed is enacting the most aggressive monetary policy in 40 years. A bank fails. Stocks tumble on the news. Lo and behold “the surprise nobody was expecting”. We’ll leave the financial media to cover the SVB debacle, as there is no need for us to go into the details of why a top banking institution has failed. We will comment on the banking sector as a whole later on, but first let’s focus on the price action for SPY:
SPY Analysis
The MACD Signal has failed to trigger a BUY, for now. The signal will likely trigger at a lower level, possibly coinciding with a trend reversal signal (as SPY is now significantly oversold in the medium term); however, any potential opportunity to increase exposure MUST happen above the key M-Trend level in order to be valid in our system.
The market violated critical support very fast. The key level to watch now is $394 in the event of a bounce, and $380 in the case of further selling pressure. Below $394, algos and systematic traders will NOT buy any dip. As discussed in our article here, we are back to a “Mean-Reversion” trading environment, typical of a bear market. This aligns very well with our high level assessment of equity market expectations.
Despite wild fluctuations in the futures market over the weekend (at the time of writing, ES was up by +1.80%, then fell to +0.03%), one thing is certain: bull’s hope for a pivot have evaporated. The SVB story is not the only important development, as Powell’s ultra-hawkish testimony earlier in the week holds important clues for the Fed’s monetary policy stance to come. Of course, one of the key transmission mechanisms of monetary policy is the banking and the real-estate sector.
Not a cryptocurrency chart. This is KRE - regional banking ETF
The ETF of Regional Banks (KRE) dropped sharply. Fears of a liquidity crisis spread, as a concern of “one roach in the kitchen” may mean a lot more at risk for different smaller banks. Keep in mind smaller banks have exposure to real estate, consumer, and small business loans that are more sensitive to increased borrowing costs. Steven Blitz of TS Lombard explains:
“Banks – and especially small banks – are now sitting with reserves pretty much at their lowest comfort level, There is not much of a cash-to-asset cushion left for small banks as a whole, so a funding crisis can easily get rolling if large depositors decide too many loans in commercial real estate and other areas are about to go bad. The Fed will make funds available to keep these banks afloat, but that alone will get some push-back from Congress because of the increased concentration of bank deposits in an increasingly smaller number of banks.”
As you may know, banks are heavily reliant on deposits and capital. If deposits start leaving banks (such as what happens during a bank run), more failures will occur. As risks increase visibly, the remaining banks will raise their capital ratios and make funding more difficult to obtain. This is the textbook definition of financial conditions tightening.
Powell’s Testimony
“If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
That was the key excerpt from Powell’s ultra-hawkish speech. Given inflation has not subsided as fast as hoped, and with a labor market that remains tight, the Fed is in no position to let up on interest rate hikes. Odds of a 50bps increase at the March meeting have shot up to 76%, from exactly 0% one month ago. Presently, Goldman has come out saying that there will be no rate hike at the March meeting. With the February inflation report coming out tomorrow, it remains to be seen how the Fed will handle systemic risk / inflation balance.
Bull’s hope of a risk-asset friendly “pivot” have been destroyed. Moreover, terminal rate expectations have shot up to 5.5% from 4.9% previously. Currently, the terminal rate is closer to 5% at the time of writing.
In an economy comprised of 70% consumer spending that is increasingly reliant on credit, these kinds of interest rates are simply unsustainable. With each rate hike, the risk that the Fed will “break something” increases exponentially. This happens especially since there is a considerable lag in the effect of monetary tightening.
We are just passing the one year anniversary of the first 25bps rate hike. Going forward, the effect of the other rate hikes will be felt, and the reversion in economic strength will most likely surprise to the downside.
The “Flight to Safety” trade
Growth ETFs ARKK, QQQ, IVW (orange) vs. Long Term Gov. Bonds TLT (white)
One of the factors that we are watching in order to help assess the overall economic environment is the correlation regime of long term treasuries and growth stocks. As the chart shows, there has been a clear high correlation regime for the past 2 years. Last week, we have seen the first innings of a possible trend reversal. Bonds advanced to the point they are short-term overbought, while growth stocks slumped.
This is precisely the expectation we have had in a “crisis event”.
Takeaway - How we are trading it
Our previous attempt to increase equity exposure was technically correct, given the price breakout and positive breadth developments.
While last week’s price violated our key support level for SPY (M-Trend, now at $394), we would look for a bounce to deploy hedges into. However, current levels are short term extremely oversold, as our Market Internals Instrument shows. It makes no sense to buy risk protection right now.
We will resume selling on a technical bounce, with a stop-loss (for short positions) at SPY $394.
While being cautious will likely underperform near term, reducing capital destruction allows for a quicker return to profitability. We are keeping the longer-term picture in mind.