Wednesday, June 8, 2022

Morning Note: Underlying Forces

As mentioned in yesterday's note, and as I'll illustrate shortly in our mid-week market snapshot video, our base case remains that the ultimate bottom for the equity market's malaise has yet to be explored.

However, at the moment, our economic base case remains that the next US recession will likely not be a 2022 affair.

Of course our base cases are subject to change as this all plays out going forward.

So why, if we remain sanguine on the economy, doesn't the 3800-ish recent low for the S&P 500 (a ~19% decline) suffice? 

Well, while we don't (at this moment) see an economic recession on the near-term horizon, we do sympathize with Bloomberg macro strategist Simon White's view that a "profit recession" is likely in the offing:

"There are pervasive and increasingly pronounced signs that US equities will be in a profit recession before the end of this year. Target’s warning on margins yesterday is emblematic of the problems faced by firms in an inflationary regime. Even if an economy-wide recession is avoided, the backdrop for equities is set to get worse before it gets better.

Inevitably -- given the unequivocal message from leading indicators earlier this year -- the emphasis in the market debate has shifted from inflation to growth. Higher rates and tighter liquidity have a more immediate effect on growth than inflation, and while inflation has yet to conclusively peak, growth is beginning to show the cracks you’d expect in the face of a Fed on the warpath."

As he said, while we can't yet conclude that inflation has peaked, our view is that it likely has. However, we (at this juncture) see the likelihood of a reversion back to the Fed's 2% target as an utter non-starter -- outside of recession, that is...

In yesterday's equity market action we saw stocks claw their way back from a notable early session selloff. As I type, we're seeing similar action so far this morning (but we're only 20 minutes in, mind you). 

Per our newest premium research source, the amount of options hedging underlying today's market is such that it potentially moves the needle (in a not-small way) in terms of short-term directional action. When, for example, options dealers (sellers) are on the hook for a great deal of put (bets on, or hedges against, the market dropping) exposure, they short the underlying stocks (or indices) in order to hedge their own downside risk. I.e., they sold the puts, so they're on the hook if the market tanks. Shorting the underlying securities protects them against potentially devastating losses in that scenario.

Now, let's think about that action among the options dealers. If they're shorting (selling) stocks into a broad selloff it can exacerbate the overall downside momentum. However, if the market actually rallies, they stand to lose money on those short positions. I.e., by shorting they've borrowed and sold shares, or futures contracts, that they ultimately have to pay back. Imagine the carnage if they have to buy them back at significantly higher prices than they originally sold them at. I.e., As the market rises they're in good shape on the puts they sold, and, aside from being dangerously exposed with their short positions, their need to hedge lessens, so they cover (buy) those short positions, potentially exacerbating the upside move. 

I know, that all gets confusing, sorry... Just suffice to say that the next really big options expiration date (6/17) is meaningful with regard to the action between here and there, and what happens when those options expire and dealer hedges are exited and rebooted...  And understand that when market moves seem to make zero sense with regard to what you believe you know about the world at large, there are underlying forces at play that have more to do with traders, hedgers, dealers and so on jockeying for position than they do anything fundamental...

Asian equities leaned green overnight, with 11 of the 16 markets we track closing higher.

Europe's struggling this morning, with 15 of the 19 bourses we follow trading down as I type.

US stocks are mostly lower as well to start the session: Dow down 178 points (0.52%), SP500 down 0.43%, SP500 Equal Weight up 0.11%, Nasdaq 100 up 0.11%, Nasdaq Comp down 0.67%, Russell 2000 down 0.72%.

The VIX sits at 24.29, up 1.12%.

Oil futures are up 0.96%, gold's up 0.09%, silver's down 0.54%, copper futures are down 0.05% and the ag complex (DBA) is up 0.27%.

The 10-year treasury is down (yield up) and the dollar is down 0.02%.

Among our 38 core positions (excluding cash and short-term bond ETF), 10 -- led by uranium miners, Disney, communications stocks, base metals futures and emerging market equities -- are in the green so far this morning. The losers are being led lower by Dutch Bros, MP Materials, base metals miners, water stocks and Nokia.

"The professional concerns himself with doing the right thing, rather than with making money, knowing that the profit takes care of itself if the other things are attended to."

--Jesse Livermore 

Have a great day!