Bear Market Rally Vol.2
This will be the last article from myself and the rest of The Spark team until mid-August. However, I will continue to update the portfolio over the Summer months, so if you would like to receive live updates please ensure to sign up for our email subscription. On to the article:
Central Banks Go Fast and Furious
The market turmoil continues. Around the world, Central Banks are becoming serious about inflation (with the exception of the Bank of Japan). This has caused a repricing downward of risk assets (stocks), alongside a spike in bond yields (fall in price) - Yields move in the same direction as interest rates. There seem to be few places to hide in the market today (see below).
Gold & Cash the only assets not losing since risk-off signal in November 2021 - Gold (Orange), S&P500 (Green), NASDAQ 100(Pink), US 20-Year Treasury Bonds (Blue), Emerging Markets (Turquoise), Risk Parity (Yellow), Source: Bloomberg
The Federal Reserve (Fed) Chair, Jerome Powell, made two interesting comments in the last few weeks. Firstly, he said that the Fed will reduce inflation at any cost and acknowledges this could cause a recession. Secondly, in a Senate meeting this week, he mentioned that a 100bp (or 1%) interest rate hike was not off the table. This is significant, not because of his comments, but because of the market’s reaction.
The market did not continue to reprice risk assets downwards and increase the terminal interest rate in the US – the highest interest rate the market believes the Fed will hike to before cutting rates again (see below). This means that the bond market is now calling b*****it on Jerome Powell, believing he cannot raise rates any more than the 3.5% currently priced in.
US Forward OIS - US interest rates expected to rise to 3.5% before rate cuts come in 2023, Source: The Spark & Bloomberg Data
A major reason that the stock market has been so volatile this year is because of the steep rise in discount rates due to a rise in interest rates (i.e., rise in bond yields - see below).
US 2yr Treasury Yield, Source: TradingView
The market calling BS on Powell could therefore lead to a stabilisation or fall in bond yields from here, as investors believe the aggressive tightening by Central Banks will lead to demand destruction, driving the economy into a recession – just look at the spike in mortgage rates this year!
US 30yr fixed rate mortgages, Source: TradingView
This means two things. One, the stabilisation in bond yields (and therefore prices) means there could be an opportunity to buy bonds soon, however, I would prefer inflation numbers to print lower before jumping into this asset class. Bonds may do well as investors begin to worry about a recession. It also means that the downward repricing of risk assets may be over… for now.
Discount Rate Flat, Earnings Still to Come
The constant movement of the goal posts (i.e. interest rate hikes) by Central Banks at the beginning of the year was the reason for a lot of the fall in bond and equity markets during 2022 so far. This uncertainty may now be behind us.
What are the implications of this? The denominator has stopped rising (see below – moving from 1% to 3.5% reprices a company’s earnings downwards). Thank God! But… the numerator hasn’t changed yet!
Central banks such as the Fed have made it clear they will do anything to stop inflation. The steep rise in interest rates will cause demand destruction and we are already seeing this. Consumer confidence in the US and UK are at record lows, Retail sales are turning lower, and the spreads between weaker EU countries (Italy) and stronger ones (Germany) are blowing out. This demand destruction will likely drive the economy into a recession as the population’s pockets are squeezed by heightened rates at a time when inflation is already doing so.
The next stage is a downward repricing of the numerator for ‘Stock A’ above, i.e., a drop in earnings expectations (See blue arrow: £12 in earnings moves to £11, £10, or £9….). We have seen consumer staples like Target (NYSE: TGT) miss earnings estimates over the most recent earnings season, and it’s likely the casualties are only beginning. The S&P 500 is predicted to grow earnings at 12% this year. I see this as unlikely. As companies miss/downgrade their estimates for future revenues and profits, their stock prices will fall further to reflect this. This will cause the next leg down in the current bear market.
How could I be wrong? If inflation numbers begin to take a short, sharp reversal downwards, central banks don’t need to raise rates as quickly as they currently are expected to. I see this as unlikely. Otherwise, we will know the market has bottomed when bad news continues to flow in but the stock market stops falling. I don’t believe we've reached ‘max pain’ yet.
What’s On My Watchlist
Above you can see my current watchlist. This watchlist shows;
Column 1 - The company
Column 2 - Current price
Column 3 - 1-week price return
Column 4 - 1-month price return
Column 5 - 3-month price return
It also colour codes the returns based on standard deviations, so you can see how harsh the stock’s moves are compared to its average volatility. I have included Coinbase, Plug Power, and Shopify to show you how harsh some market moves have been this year. This is by no means a suggestion that I would own any of these three companies.
We can see from this watchlist that CoinBase has had a 2-3 sigma fall over the last 3 months (significant!), while Palantir has had a 1-2 sigma move in the last week.
Looking at the watchlist you can see I have a bitcoin miner in Cleanspark (CLSK) which seems good value today. I also have Palantir Technology’s (PLTR), and Darktrace (DARK) as more speculative plays on AI and cybersecurity. Further down I have Pool Corp (POOL), a company that services Pools - with a price return of 855% in the last 10 years! Finally, I have a Gold mining ETF and two bond ETFs. As yields stabiliise/fall, bonds could become a place to hide once again. This would benefit Gold if inflation remains high but yields fall (Real rates fall). However, my one concern with Gold Miners is that a high oil price could hurt their margins further, and they are a more speculative holding at a time when investors are dashing for cash.
Portfolio Return Year-to-date: -3.5% vs S&P500: -19%
Total Return since inception (20/09/2021): 2.3% vs S&P500: -10%
The Spark team will be taking a break for the Summer and will return to writing articles in the middle of August. For live updates on any portfolio changes by me please do sign up to the email list here.
See you in August,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.