Month: February 2022

Authored by Charles Hugh Smith via OfTwoMinds blog,

When the crash can no longer be denied, the drop is widely recognized as having been obvious and inevitable…

The last chance to exit is well-known in stock trading circles, but the concept can be applied much more broadly. The basic dynamic at work is a mismatch between the fundamentals (i.e. the real world) which are deteriorating due to structural changes and the psychology of participants which continues to be confident and upbeat.

A wide spectrum of emotions and human traits are in play, but the core dynamic is our desire to discount signs of trouble rather than deal with a long-term change in the tides. The long uptrend supports confidence that the uptrend will continue moving higher more or less permanently, and the desire to keep minting money by staying fully invested in the uptrend encourages cherry-picking data to support the idea that the fundamentals are still solid.

Selection bias, denial, complacency and greed all play parts in this continuation of the psychology of an uptrend even as the S-Curve has shifted from growth to stagnation as the fundamentals have deteriorated beneath the surface.

This asymmetry between the fundamentals of valuation and the psychology of valuation cloaks the change in trend so few recognize it as the last chance to exit. Participants, so well trained by years of profits to “buy the dip” and anticipate future gains, see the initial dip as an opportunity to buy rather than as a warning sign.

This complacency is reinforced by the prompt reversal of any dip and a new high in valuations. Again, this dynamic is not limited to stocks; the ascent of housing valuations feeds the same complacency and selection bias: housing can’t go down because…the litany of supportive narratives is always long and illustrious.

The last chance to exit is also present in states, cities, industries, jobs, institutions, groups and neighborhoods. The decay is ignored as everything seems to remain glued together and the rot is papered over by various pronouncements and policies.

There is typically a period of consolidation that further supports a complacent confidence that the present is immutable: the uptrend is permanent. But this consolidation is misleading: it’s not a continuation of the uptrend, it’s the result of first-movers selling to True Believers in the immutability of the present and getting out of Dodge.

When the S-Curve rolls over, the rapidity of the descent surprises True Believers, who assure themselves that the rebound will start any day. They find reasons to ignore the acceleration down as those who had hesitated to sell suddenly hit the sell button, list the house for sale, etc.

When the crash can no longer be denied, the drop is widely recognized as having been obvious and inevitable. Hindsight is 20/20, but the damage done to those who didn’t sell at the the last chance to exit cannot be repaired; the losses are too deep.

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It’s almost difficult to remember now, but February started with a lingering focus on the Omicron wave of the virus and the expected business interruptions that COVID was again causing. The virus has since faded in the US although it still has a very real presence in Asia.

The realization that inflation does not appear to be temporary and may be more persistent than recent past bouts of higher prices has also caused markets to increase expectations for the number of rate hikes that the Fed is likely to initiate in the imminent hiking cycle.

And as we exit February, Goldman’s Chris Hussey notes that attention is now divided between what the Fed will say (and do) on March 16th and how the situation between Russia and Ukraine will evolve. Against this backdrop of rising inflation, rates, and geopolitical risk, Energy and Materials outperformed again in February.

Most worryingly, cracks are appearing in the global financial system’s plumbing. The cost of dollar liquidity is suddenly rising fast…

Source: Bloomberg

Russian default risk has exploded…

Source: Bloomberg

The Ruble has imploded…

Source: Bloomberg

Can Vlad and his oligarch mates dodge these sanctions bullets?

Bank stocks puked with Europe hit harder than US…

Source: Bloomberg

Safe-havens were bid with bond yields tumbling, gold spiking (then chopped around)…

And crypto surging (Bitcoin tagged $42k)…

Source: Bloomberg

Equity markets traded chaotically but on the bright side, given it was the 55th day from the record high, we did not crash like in 1987 or 1929…

Source: Bloomberg

To quote one trader who was trading the last time the Ruble collapsed, “what a f**king day!” US equity futures opened down hard – giving up all of Friday’s gains – and then were met by the now ubiquitous momo ignition that somehow levitated Small Caps, then Nasdaq, then the S&P 500 (briefly) into the green for the day. Then… Russia-Ukraine talks ended around 1200ET (just around the time of the European market close) and things went south in US equities. The last hour saw a bid return, making some wonder if were seeing some rebalancing flows… The last hour was just insanely volatile minis swings in all the major indices, desperately trying to get back to even…Nasdaq outperfomed in the end (green like Small Caps) with the S&P and Dow red. Nasdaq swung 4% from its lows…

Tech was twatted on the month…

Source: Bloomberg

Inflation expectations accelerated in February, with US 5Y Breakevens hitting record highs…

Source: Bloomberg

As February comes to an end, 2022 has seen the US Treasury market suffer the 3rd worst start to a year ever…

Yields were higher across the curve in Feb with the short-end dramatically underperforming…

Source: Bloomberg

Notably the 10Y yield tried and failed numerous times to get back above 2.00%…

Source: Bloomberg

Real yields utterly collapsed today (10Y real yield dropped 20bps (catching up to gold’s recent rise)…

Source: Bloomberg

Forward inflation expectations suggest Ethereum has another leg higher to come…

Source: Bloomberg

The Nasdaq has seen the worst first two months of a year since 2008 (S&P worst since 2009).

It was an ugly month for most stocks with Nasdaq leading the charge lower, down over 12% at one point (and Small Caps somehow battling back to unchanged)…

 

Rate-hike odds were shocked higher by The Fed’s Jim Bullard then pushed lower by geopolitical chaos but while the odds of a 50bps hike in March dropped modestly (just 13% or so now), the odds of a 6th rate-hike in 2022 went up from around zero to over 60% (even with the recent dovish push)…

Source: Bloomberg

And at the same time, the odds of a rate-CUT (in 2024) have soared…

Source: Bloomberg

The dollar ended the month very modestly lower, after surging on the start of war but being unable to make any more gains since…

Source: Bloomberg

Cryptos managed modest (for crypto) gains on the month, thanks in no small part to today’s surge in prices following Putin’s ban on foreign FX transfers…

Source: Bloomberg

Commodities were all higher on the month with the geopolitical chaos of the last week or so sending Russia-specific assets (oil, nattie, wheat, aluminum) soaring the most. Copper lagged as precious metals also surged…

Source: Bloomberg

Brent closed above $100 today for the first since 2014.

Gold held above $1900…

Finally, the best news of all in February, COVID cases have collapsed…

Source: Bloomberg

So the only excuse The Fed has now is ‘geopolitical concerns’ – which in and of themselves will actually cause inflation to worsen!

Authored by Ron Paul via The Ron Paul Institute for Peace & Prosperity,

When the Bush Administration announced in 2008 that Ukraine and Georgia would be eligible for NATO membership, I knew it was a terrible idea. Nearly two decades after the end of both the Warsaw Pact and the Cold War, expanding NATO made no sense. NATO itself made no sense.

Explaining my “no” vote on a bill to endorse the expansion, I said at the time:

NATO is an organization whose purpose ended with the end of its Warsaw Pact adversary… This current round of NATO expansion is a political reward to governments in Georgia and Ukraine that came to power as a result of US-supported revolutions, the so-called Orange Revolution and Rose Revolution.

Providing US military guarantees to Ukraine and Georgia can only further strain our military. This NATO expansion may well involve the US military in conflicts unrelated to our national interest…

Unfortunately, as we have seen this past week, my fears have come true. One does not need to approve of Russia’s military actions to analyze its stated motivation: NATO membership for Ukraine was a red line it was not willing to see crossed. As we find ourselves at risk of a terrible escalation, we should remind ourselves that it didn’t have to happen this way. There was no advantage to the United States to expand and threaten to expand NATO to Russia’s doorstep. There is no way to argue that we are any safer for it.

NATO itself was a huge mistake.

When in 1949 the US Senate initially voted on the NATO treaty, Sen. Roberg Taft – known as “Mr. Republican” – gave an excellent speech on why he voted against creating NATO.

Explaining his “no” vote, Taft said:

… the treaty is a part of a much larger program by which we arm all these nations against Russia… A joint military program has already been made… It thus becomes an offensive and defensive military alliance against Russia. I believe our foreign policy should be aimed primarily at security and peace, and I believe such an alliance is more likely to produce war than peace.

Taft continued:

If we undertake to arm all the nations around Russia…and Russia sees itself ringed about gradually by so-called defensive arms from Norway and Denmark to Turkey and Greece, it may form a different opinion. It may decide that the arming of western Europe, regardless of its present purpose, looks to an attack upon Russia. Its view may be unreasonable, and I think it is. But from the Russian standpoint it may not seem unreasonable. They may well decide that if war is the certain result, that war might better occur now rather than after the arming of Europe is completed…

How right he was.

NATO went off the rails long before 2008, however. The North Atlantic Treaty was signed on April 4, 1949 and by the start of the Korean War just over a year later, NATO was very much involved in the military operation of the war in Asia, not Europe!

NATO’s purpose was stated to “guarantee the safety and freedom of its members by political and military means.” It is a job not well done!

I believe as strongly today as I did back in my 2008 House Floor speech that, “NATO should be disbanded, not expanded.” In the meantime, expansion should be off the table. The risks do not outweigh the benefits!

As we noted yesterday, in his “Sunday Start” note Morgan Stanley’s Michael Wilson – better known here as Wall Street’s biggest bear (although BofA’s Michael Hartnett is certainly trying to steal that title) explained that while the market is obsessing over the ever-escalating situation in Ukraine, where nobody has any edge and where traders are at the whim of the Johari window’s “unknown unknowns“…

… what investors should be focusing on instead, is the arrival of what Wilson calls “ice” (i.e., a sharp slowdown in the economy coupled with a plunge in earnings), now that the market has finally accepted the other part of his ying-yang narrative, i.e., “fire” which means higher inflation = Fed tightening.

Admitting that he was premature to introduce for the “ice” anchor to his bearish last October, Wilson says that he pushed the timing of ice out to 1Q, in other words now, and sure enough, he cautions that “evidence is now building that earnings forecasts are increasingly at risk.” First, he points to the negative-to-positive guidance ratio during 4Q earnings has spiked to 3.6x – the highest since 1Q16, when we were mired in a global manufacturing recession: “At no time during the Covid recession did we see a ratio this high.”

Wilson then went on to note that earnings revision breadth is also falling fast and approaching negative territory, which leads next-12-months EPS forecasts.

Tying it all together with the Ukraine war, Wilson urged clients to ignore the day-to-day gyrations there – “while there are many people who know quite a bit about such matters, geopolitics are very difficult to analyze and therefore very difficult to price” – and instead to continue selling into any rally (if not shorting) as the invasion simply “adds another risk to the mix that’s unlikely to disappear quickly. In a world where valuations remain elevated and earnings risk is rising, last week’s tactical rally in equities will likely run out of momentum in March as the Fed begins to tighten in earnest and the earnings picture deteriorates.”

On Monday, in his latest Weekly Warm-up note (available to pro subscribers in the usual place), Wilson frames how he sees this coming selloff, first reminding readers that he presented a price-analog comparing the S&P 500 today to what happened in 2018 as a guide for trading the near-term set-up. As we detailed in “Why Wall Street’s Biggest Bear Sees Stocks Tumbling To 3,800 By Late March“, Wilson suggested that the Russia/Ukraine conflict might provide a perfect reason for the S&P 500 to re-test its January lows “a re-test that investors should buy or at least cover up shorts.”

And indeed, Russia’s invasion on Wednesday night led to a very sharp sell-off on Thursday and led to the “textbook” re-test Wilson was looking for. The positive divergence on lower volume provided the opportunity to cover shorts and even get long some of the most beaten up areas of the market for those nimble enough to do it (Exhibit3).

But while this technical set-up was (and maybe still is) bullish in the very near term, Wilson warns that “it does not look good for the intermediate term with all of the major averages below their respective 200-day moving averages and the 50-day moving average negatively sloped.” Furthermore, Wilson warns that the S&P 500 looks the strongest but it’s severely damaged and it will take time to repair before it can make a real swing at new highs. This weak technical picture in the primary index now mirrors the technical damage that’s been building for months under the surface; it also reflects the challenging fundamental backdrop of tightening financial conditions colliding with slowing growth — the core message in Morgan Stanley’s outlook for2022 in mid November.

Going back to the “2018 price analog” discussed last week, Wilson updated the chart to show that we’re still very much on track for what looks like an extremely challenging March/April after this short-term rally exhausts itself in the next few weeks.

Looking at the chart above, the MS strategist says that equity markets could rally/hold up for another week or two “but we would be very careful if the S&P 500 approaches 4500 again.”

The bottom line, according to Wilson, is to “let the market work off its still oversold condition but use further strength to reduce risk in profitless growth stocks, low-quality cyclicals and stocks that are likely to be vulnerable to payback in demand from last year’s binge and escalating costs that can no longer be passed along so easily.”

To be sure, it’s important to point out that these price analog charts always break down at some point – as Wilson himself concedes – so we can’t use them for longer-range price forecasting. Furthermore, as he notes, one major difference with 2018 is the fact that the Fed is just starting a new tightening campaign today, while in December2018 they were at the end of that tightening cycle, which started several years prior with the tapering of QE (then again there is nothing preventing the Fed from going NIRP and or doubling down on QE).

In other words, Wilson would not be at all surprised if this price analog breaks down after the next decline which will take place in “late March/April. This is because the Fed won’t be able to pivot so dovishly like they did in early January 2019.”

Here Wilson takes a step back and zooms out in the chart, reminding readers just how far stocks have rallied during this pandemic due to extraordinary policy “that drove both valuations and earnings to unsustainable levels.” True, we are now trading below the 200-day moving average for all the major averages, but stocks remain “extremely extended relative to the 200-week moving average which is the true long-term support to consider if things get rough when this tactical rally ends as we expect.”

Why does this matter? Because interestingly, it was the 200-week moving average that provided the support in 2018 to stop the decline. As such, Wilson strongly suggests taking this into account when thinking about risk-reward and committing new capital.

Lastly, Wilson flags that even after the recent turmoil, valuations still remain extended:

• at the S&P 500 index level,
• at the median stock level within the S&P 500…

• … and under the surface of the market.

The median stock forward P/E for the S&P is still 19x (94th percentile of historical levels back 40 years). This, according to Wilson, supports the idea that multiples across the index have room to compress due to his Ice thesis, even after discounting the geopolitical developments of the last couple of weeks as well as a hawkish Fed.

As a reminder, the full note is available to professional subs.