Is This The Beginning Of A New Bull Market?

The Market Rally Could Continue

Fair to say the stock market loved Powell’s apparently dovish tone during this week’s FOMC presser. Not only did the Fed chair avoid pushing back on the easing of financial conditions as many expected him too, but according to Bloomberg’s AI model, it was the most dovish Powell has been in about a year.

Source: Bloomberg

Not only was this taken bullishly by the markets, but exacerbating the move higher (or perhaps driving it) were the vanna flows associated with the elevated ‘event vol’ that can accompany such market moving events. What we saw leading into this week’s FOMC was that implied volatility had been bid for options expiring the day of FOMC (typically as a result of traders buying puts to hedge their downside in case of a hawkish surprise), resulting in dealers being short the underlying stock against these options positions as a means to delta hedge their books. As implied volatility collapsed following the event (which is what would have likely occurred regardless of Powell’s tone) as these options were either sold or expired, this led to dealers buying back their shorts and thus assisting to drive markets higher, squeezing plenty of shorts in the process. We saw similar dynamics unfold following the 2016 and 2020 elections.

Regardless of the underlying dynamics, the trend of markets is clearly positive for now. Along with the exceptional market breadth that has been present during this rally, cyclical participation has been strong. As we can see below, my pro-cyclical index - which compares the relative performance of the most cyclically sensitive areas of the stock market to the broad index itself - has been leading the charge. Market internals matter, and for now they remain relatively healthy. The market is now all in on the ‘transitory goldilocks’ narrative, be it true or not.

Despite the quarry of headwinds facing markets on a cyclical basis, highlighted by both the impending growth slowdown along with the continued extraction of liquidity and tightening of financial conditions by the Federal Reserve, there remains a scenario where stocks could continue to rally over the coming months in spite of such headwinds. As I noted recently, in terms of net liquidity, we may see continued short-term relief as the US Treasury moves to draw down their Treasury General Account, which the Treasury has signaled their intention to do so as the debt ceiling approaches as they reduce their idle cash on hand. A reduction in the TGA would boost dollar liquidity as this would in effect be a transfer of reserves from the Fed’s balance sheet to bank balance sheets, temporarily offsetting Fed QT. Liquidity matters.

Source: Steno Research

From a positioning perspective, despite much of this rally being fueled by short-covering and CTA's/vol targeting funds re-entering the market, positioning remains light and thus there remains much fuel on the sidelines to chase rallies. When everyone is short or in cash, the biggest risk to investors and managers is missing out on the rally, which is one of the reasons we have seen the VIX trade in a more correlated manner to stocks of late.

Nowhere is this positioning dynamic truer than in the hedge fund space, whose beta to the S&P 500 remains near its lowest levels in years as it has done since mid-2022. Career risk may not be as pertinent when markets are falling and a manager underperforms, but when markets are rallying, your job is on the line if you underperform. Expect the flows to come if we see markets trend higher over the coming months.

Source: Variant Perception

Over the next quarter or so, the risk to the stock market remains to the upside.

There may be short-term risks ahead however

Zooming in to an even shorter-term time frame, we are seeing signs that perhaps this rally is due for a bit of a rest. Indeed, many of the short-term and tactical indicators I monitor are suggestive of exhaustion. This is true of short-term breadth where we several non-confirming divergences having emerged following the recent highs, as we can see below. Likewise, in the volatility space several measures of the implied volatility term structure have also diverged bearishly from the recent highs. What this means is that implied volatility is being bid higher for shorter-dated optionality relative to longer-dated optionality (such as the regular VIX relative to the six-month VIX), suggesting that near term uncertainty is rising. Such divergences generally resolve themselves with stocks following suit, though upside call chasing may well be the cause of said dynamic, thus compromising the efficacy of such indicators.

Also diverging negatively are the currency market flows via the FX Weathervane (per the unique work of Chris Carolan). This indicator effectively highlights how strength and weakness in the Yen filters through to global asset markets. Again, such divergences generally resolve themselves with stocks correcting the downside.

Despite the upside potential for net liquidity over the coming months as mentioned above, on a short-term basis, net liquidity is not supportive of the recent move higher. I have proxied net-liquidity here by looking at central bank reserve balances of commercial banks. Why? Because central bank reserve balances are money for commercial banks, as are effectively the mechanism with which liquidity flows (i.e. Fed balance sheet, reverse repo and Treasury general account) actually impact asset prices. When reserve balances rise, the functioning of repo market improves as does overall risk taking, which in turn generally finds its way into risk-assets.

From a seasonality perspective, February is historically only a so-so month for stocks, while the months following tend to be more favourable. This lends credence to the idea that stocks may be overdone in the short-term, but the potential for upside throughout the Q2 remains.

Technically speaking, things are getting interesting. Despite a strong uptrend underway, we have just triggered a daily 9-13-19 DeMark Sequential sell signal on the S&P 500, whilst also testing the 50% Fibonacci retracement level of the all-time highs. To me, this suggests we are probably due for a pull-back - perhaps a test of the $4,100 area which has turned from resistance to support - or at the very least a consolidation. However, it is hard to deny there looks to be a bit of a head and shoulders bottom pattern potentially playing out, something bulls will no doubt hope rings true. Whether this proves prescient or not remains to be seen.

Underscoring these trends have been the recent movements in the dollar. Like yields, the dollar has been very much negatively correlated to risk-assets of late, with the September/October bottom in stocks coinciding in the top for the dollar. Though I remain bearish long-term, I have been expecting a bounce in the dollar for some time (as I opined here), but that call has so far been dead wrong. Currency markets tend to trend, so I very much doubt we will see a re-test of the highs in the dollar index even if we do enter recession at some point this year. From a technical perspective however, the descending wedge pattern seemingly forming in the DXY could see said bounce ensue if we see a bullish breakout, and should recent correlations hold, this would likely be bearish stocks.

After all, February is generally a fairly favourable month for the dollar.

Don’t lose sight of the big picture

Regardless of the outlook for stocks over the next few weeks to the next few months, we shouldn’t lose sight of the big picture. Remember, there is actually a reason why many investors are positioned so bearishly. We have the leading indicators of the growth cycle and liquidity cycle continue to suggest a recession is likely at some point this year, and, we have a Federal Reserve intent on still raising interest rates and extracting liquidity into a growth slowdown despite the head of the Federal Reserve noting the effects of the monetary tightening have yet to be fully felt. Macro is slow moving and these dynamics have long and variable lags. They are certainly not conditions conducive of simply buying and holding stocks or high-beta risk assets on a cyclical basis.

Although market internals are healthy for now and positioning is still relatively bearish, these dynamics are likely to only take stocks so far. In order for me to happily buy stocks on a set-and-forget basis, the growth cycle, liquidity cycle and financial conditions would need to be tailwinds rather than the significant headwinds they remain at present.

It is not the time for investors to be getting overly greedy. Especially when we consider the fact that valuations are still expensive. Over the long-term, valuations are still the best predictor of future returns, and they are not at all supportive of a buy-the-dip mentality for the time being.

For long-term stock market investors, cash still provides the greatest level of optionality.

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