For the better part of a month the market has been chopping back and forth. Occasionally it looks like we might break out higher on stocks, with occasional setbacks.
The one-month and one-week returns for the S&P 500 are about 1% and 0%, respectively. I have to admit, though (being cautious here -4 on a scale of -10 to 10), it feels worse than that.
Maybe because days like Friday are so strong and powerful, it hurts, or maybe that it is just the trader's dilemma that the bad days always feel worse than the good days.
In any case, as we head into this week:
Banking Problems Are Not 'Created' and 'Solved' in a Week
We started the week with increasing concerns about a "domino" effect as more banks seemed to teeter on the edge as their stock prices were hammered. That reversed, to a large degree on Friday, in no small part due to headlines about potential short-sale investigations or bans. My experience tells me that short-sale bans tend to do very little if the underlying issues aren't addressed and if another wave of selling starts, it is fast and furious because there is no short-covering bid. That part of last Friday's bounce seems highly dubious.
Recessions Are Not 'Created' and 'Solved' in a Week
While not quite as pronounced as the "banking crisis" "resolution" we saw WTI plunge to $68 from $77, only to power back to $73 in pre-market trading on Monday. Yes, the Jobs numbers were good, as we wrote on Friday, but the reaction seemed extreme.
I don't like that daily moves seem disproportionately large relative to the news, in both directions.
I do like that Friday was a true "risk-on" day. The data were decent. The bond market responded by selling off, as the data leaned towards the inflationary side, giving the hawks at the Fed ammunition to possibly hike at the next meeting. It certainly, for now, took off the table a rate cut that was getting priced in briefly. If the stock and commodity markets can't rally with bonds selling off, it indicates a resilience to me that I like.
Increasingly Concerned About Tail Risks
On the other side of the equation, I'm increasingly concerned about tail risks. I am having difficulty articulating the tail risk, and it isn't keeping me awake at night, but it is nagging at me. I'm trying to turn it into a cohesive theory, with some executable ideas, but it is linked to the risk that more and more bond and loan portfolios hit the auction block, creating price pressures, which in turn bring more and more portfolios out for sale, overwhelming the potential buyers.
Banks and commercial real estate are at the heart of this issue. Again, it isn't an obvious outcome, but it may be more realistic than is priced in.
Two things I live by when thinking about bond markets (and the broader financial markets) are:
1. Any crisis is typically started by "safe" assets becoming "unsafe." It might be counterintuitive, but "safe" assets are where positions sizes grow large, leverage builds up and loss provisions are negligible. That setup creates major problems if it starts to unwind (like AAA mortgages during the Great Financial Crisis, or sovereign debt during Europe's sovereign debt crisis).
2. Far more bond losses come from forced selling than ever come from defaults. So much time is spent on managing default risk, relative to managing forced selling it is almost shameful. Especially when it is forced selling that typically creates far bigger losses for most institutions (Silicon Valley Bank as a recent reminder).
The forced selling, is often from leverage but can be from management deciding they have far too much exposure to a single asset (or asset class) and it would be prudent to reduce exposure (this typically only happens once the prices of that asset or asset class have dropped, or issues have been exposed in the markets).
The combination of 1 and 2 is what creates tail risk, and I'm not sure they can be completely ignored, as we have been ignoring them.
I will keep my risk tolerance at -4 (on a scale of -10 to 10) and all the same recommendations from last week. I was tempted to move it to -2 on Friday's "good news is good rally" but my concerns about the banks and tail risk (and maybe some stubbornness) are keeping me at a -4.
