Since the short-term bottom in the S&P 500 on October 3 after September's repo market and dollar funding liquidity debacle, the index has spear-headed higher to finish October right back on its highs -- as though September was one bad dream. It has rallied 5.5% back to within a whisker of its 3025 high, although it has not broken that top, but then again, we still have three days left in October. The wonders of this market never cease to amaze me.
The last few weeks have witnessed an intoxicating cocktail of good news for equity investors. We had Fed rate cuts at the end of July, then the ECB announcing it would start its QE by adding 20 billion euros/month starting from November for as long as it is needed, followed by our own U.S. Fed who announced a $60 billion a month balance sheet expansion, all while reiterating "economy is in a good position." Two weeks ago, Trump decided to stir on the algorithms by confirming "substantial progress" had been made for Phase 1 in a U.S./China deal.
In summary, there was no shortage of good news that allowed futures traders to keep buying the market on any dip and getting it back to the top end of its range. Despite all this, the market has still not been able to break to new highs, which is slightly worrying.
Gauging the state of the economy by just looking at the overall index is a futile venture. We all know the economy is not the market, except Trump of course! Growth has been disappointing across the board as can be seen by several Emerging Market economics cutting rates to provide support. The weakness has now spread to the infallible U.S. economy too.
It was only a matter of time. Whether one observes new capex orders, ISM or PMI, the fact of the matter is that the U.S., too, is starting to slowdown and various growth subsectors of the equity market are representing that outlook. The sectors that have outperformed this year have been Utilities and Consumer Staples (defensives) -- at the cost of Materials, Industrials, Retail and Financials (cyclical). Subsector performance breakdown tells us much more than what the overall index does.
The bullish investors argue maximum pessimism and recession risk in people's sentiment, highest cash outflows in equities this year, valuation not too expensive and the last but certainly not the least important, the "where-else-should-I-park-my-cash" argument. The last one seems to be the most ominous to me. When investors have a fear of FOMO and cash burning a hole in their pocket, being sucked into the market for all the wrong reasons is usually the worst rationale. As much as it makes sense longer-term, timing is of the essence. Would you rather buy today at highs and risk losing 10% or rather wait for things to settle so you can catch the bottom and not worry about marked-to-market losses, hoping for a much bigger rally to cover the initial losses.
The bearish arguments are very Macro in nature, hence it is easy for the average equity-only-focused investor to ignore the risks and use the market's trend for their long justification. This rally has not been on very significant volume, one needs to be aware of this.
What is most worrying is the U.S. Fed is hiding the truth from the public about the state of dollar liquidity in the market. The repo crisis was clearly not a one-off event, so much that the Fed has increased daily injections all the way until Jan 2020 to $120 billion in overnight allocations. Yet every day, there is demand from banks to source about $60 billion-80 billion. It does not add up, either some bank is in some serious trouble or is anticipating one to hoard up all that daily cash. The U.S. Fed, instead of investigating who and why they need so much daily liquidity, is instead throwing more and more at them every day hoping the problem goes away -- a one-time plumbing issue, as Powell calls it!
De-risking and economic wobbles always come from the very top (macro) asset classes, usually the ones most leveraged and hidden from the average investor. The leveraged loan market has shown signs of stress since July as spreads are widening and loans are trading below 100 cents on the dollar. A lot of the issues relate to energy -- for good reason, given the high yield market is closed off to shale players on their disastrous performance and low oil prices. But it is also showing up in other sectors too. The ratio of downgrades to upgrades has picked up in recent months to +106% year over year, the highest level since the energy crisis.
No one mentions the Motor Vehicles Loan market, but it is an around $1.2 trillion market, and sub-prime auto loans are defaulting at the fastest rate since 2008. Banks have been issuing auto loans that default within months of being issued, only to be bought back by some of the banks depending on the covenants, which means that more and more nonperforming loans are sitting on some of these banks' balance sheets. These banks worried about high costs issue yet more bonds to greedy uninformed investors suffering from FOMO without proper credit due diligence checks. But who cares, it is off "their" books. Sound all too familiar?
So, when equity investors tell me "no one is invested" and that "equities are cheap" or "look at the trend," alarm bells go off. We all know what happened in 2007 and 2008. Equities are always cheap, they are 20-year+ discounted instruments, no doubt about that. The question is, do you buy them today and now? As history has taught us, the cracks appear in broader, more sophisticated asset classes. By the time it hits equity markets, it is already too late.
We have a great line up of events this week. The Fed FOMC deliberates on October 30. It shall be even more crucial to see where U.S. interest rate policy is headed now after 3 rate cuts (assuming they cut this week, as the market expects). Especially if "substantial progress" is made on trade talks and market is cheering at all-time highs, the Fed would be better suited to take its foot off the gas for a bit lest it needs to provide some support later. Even a remotely hawkish or "we are done for now" inclination and the market will be disappointed and dollar will rally.
China Industrial profits fell 5.3% this September from a year earlier to 575.6 billion yuan ($81.48 billion), data released by the National Bureau of Statistics (NBS) on Sunday; a 2% drop from a month earlier. As long as the dollar is strong and data in China is weakening, Base Metal Commodities like Copper, Iron-ore and oil and their related equities will continue to remain weak even after a 5%-10% bounce in September.
All eyes are on the Fed, can Powell live up to the market's expectations?