Bond market volatility continues to lead all markets lower, triggering a further round of deleveraging. Cryotos have been crushed and Credit markets appear to have hit capitulation, even if equities have not. FX volatility, especially in the Yen, is also causing, as well as reflecting, distress in terms of forced buying/distressed selling and is being exaggerated by the (VaR) volatility based risk management models that trigger further deleveraging of balance sheets. The focus on the Fed and US inflation is driving the narrative and the CTA hedge funds are the only ones making money at the moment, with some quite aggressive short positioning.

The small uptick in confidence at the beginning of June proved to be an anomaly, with the S&P500 now having fallen for 9 out of the last ten weeks. So far however, it has not been a ‘crash’, but rather a steady grind down and we believe that this is because the real stress remains in the fixed income markets, leaving equities in the role of (semi) safe haven. This is actually consistent with the inversion of the relative roles of equities and fixed income under QE, where equities were providing income and bonds providing capital gain. The poor US inflation number for May triggered a renewed spike in volatility in the bond markets as fixed income traders (correctly) anticipated a more aggressive Fed response, and while Jerome Powell went out of his way to emphasise that the Fed did not want to deliberately crash the markets and the economy, the relief rally from the traders met a wall of ‘sell the rally’ actions from long only asset managers. VIX remains low, however, suggesting that rather than hedge positions, long only managers are simply raising cash, something supported by the fact that previously ‘defensive’ sectors, that had been benefiting from sector rotation, were also sold off, adding to the feeling that there was nowhere to hide.

We like to think of the markets as having three components 1) short term, leveraged, traders with a focus on absolute return 2) Medium term, unleveraged asset allocators, with a focus on relative return and risk management against a benchmark 3) Long term, unleveraged, investors with an absolute return focus. Sometimes they are all moving in the same direction, sometimes in apparent contradiction and it is from those ‘differences’ that risk return opportunities arise. To that end, the following charts from our good friends at Redburn, sourced from Twitter, are instructive.

The first shows how Macro Hedge Funds are now heavily short as momentum switches aggressively in that direction and they will be the ones ‘helping’ to set the narrative. ‘Bad news’ is sometimes promoted as ‘Good News’, but not this time. Not for a while. We are likely to hear mostly negative stories for a while we suspect.

Chart 1. CTAs are negative and in charge of the narrative

Just as we discussed how the Retail ‘Reddit Crowd’ in the June Monthly are now back to flat over the last two years, having sold all the equity they bought in the Stimulus Check Stock Speculation Stampede, (or watched it go to zero), so long only Asset managers are positioned at historic lows in Equities.

Chart 2. Long Only are Bearish

According to BoA, the biggest negative at the moment is in European Equities, associated less we suspect with the concerns over inflation as with the Economic impacts of the sanctions on Russia. Also we note that the perception of the most crowded trade is the other side of the European stress – long commodities and oil.

As part of narrative management, we are hearing broad consensus on ‘A Bear Market’. Rather than picking a percentage drop as defining a Bear Market, we would look for when long term investors are selling the rallies rather than buying the dips, something that is clearly happening now. Certainly sentiment is now rock bottom, both in Financial Markets and among US consumers and the number of memes emerging about comparisons with historic Bear Markets is rising. We are not great believers in these types of charts, but they are visually appealing and are clearly now helping the CTAs to ‘Shape’ a Bear narrative.

Pick an analog

With the traders encouraging a negative narrative, we have something of a buyer’s strike combined with a general ‘don’t fight the Fed’ approach, i.e if the Fed appears to have written calls on the Market, as opposed to its old stance of selling The Fed Put, then it makes sense to sell into strength and accumulate cash. For all the discussions about ‘cash is trash’ in an inflation environment, money managers are paid on nominal returns and ‘flat is the new up’.

In terms of how low it can go, valuations are actually of little help, fundamentals only matter when the outgoing rush of liquidity is over. Market bottoms are at extremes and these in turn are a function of distressed selling which is valuation blind. It’s only when the capitulation selling stops and the long term investor starts to buy the dips that we shift out of the Bear phase. If we had to put a rough number on it, we quite like the Occam’s Razor approach taken by JP Morgan, of dropping EPS estimates by 20% and then putting that on 15x to give the (increasingly popular) round number of 3000 on the S&P. Another way of looking at it, suggested by BoA is that ‘this is the 20th bear market of past 140 years, so based on ‘averages’ (and acknowledging the dominance in the numbers of the 1929-1932 and 1937 to 1942 period)

– Average peak to trough bear decline = 37.3%
– Average duration 289 days.

So if history is a guide (which we aren’t sure it is, but then we aren’t setting the narrative) then today’s bear market would end on Oct 19th 2022 with the S&P 500 (also) at 3000. Of course that would be the 35th anniversary to the day of the 1987 ‘crash’, the sort of ‘spooky coincidence’ that the emotional end of the market is attracted to. The fact that the above analogues would also point to something in this region makes it likely that the ‘informed consensus’ will settle around this as a round number. For context, after the sell off in 2008, when the SPX touched an intraday low of 666 (yes really), the bears cane out in force with forecasts of 500, only for the market to dramatically move in the other direction.

No capitulation yet in Equities and it may never come, but the Bear is here and sentiment is going to remain grim for while.

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