October 16, 2018
No way-out facts, no closing quote, no sector charts today. Just some common sense about the market.
Thursday, I got a call from a high-up trader at a $2 billion hedge fund. He wanted to know my thoughts on this rough spot in the U.S. stock market. His question was, “What’s causing the sell-off, and when will it end?” Given that everyone else was asking the same question, I’ll just give you the answer I gave him.
When breadth dried up, buying slowed down. I saw big buy signals dwindling at my research firm. That’s the signal for algorithmic traders to test shorting the market. Less buying means aggressive offers. They try to crack the market, because these algorithmic traders (mostly High Frequency Trading firms) make their money for the year on big down days in the market. Bid/offer spreads blow out, liquidity dries up, and they can do whatever they want. This is in part why “it always goes down faster than it goes up.”
They usually need a news catalyst to do this. These HFTs have algorithms that parse the text of news headlines to influence how they trade. They also pay exchanges and brokers for order flows to see if people are better buyers or sellers. Negative news and no bids translate into “party time” for these guys.
Fears from China’s markets and U.S. rate fears were enough bad news to dry up buying and offer a chance for HFTs to sell on Monday. When a wave of selling hits, everyone wonders who is doing it, because we ourselves are not hitting the sell button. Conversations in big trading firms go like this:
“Did you sell anything?”
“No! Did Bob?”
While dogwalkers everywhere in the U.S. are having that conversation, the algo traders are sipping their champagne. We watch the market go down without seeing the “real selling” until eventually the tipping point comes, and technical levels trigger sell programs. Then ETFs get sold by model managers.
Let’s say a manager sells $100 million in ETFs to a broker like Morgan Stanley. Morgan’s ETF trader (or more likely computer) is now long and needs to hedge. So, what does he do? He sells $100 million worth of the individual stocks that make up the ETFs. Where are those stocks going? Not up!
Still, you’re not selling, right? “I mean I’m not selling… right? But should I?”
As selling becomes more and more real – now everyone is thinking something like: “Holy-moly! The market is already down 6%. But who sold? I didn’t sell! Did you sell?”
When the real sellers come in – like retail managers, who say on TV, “Growth is over, it’s time to buy value – I’m starting to lighten up,” that means he already sold. He just doesn’t want to be the guy who says it first. When he sells, retail investors are selling. Volume picks up. That means the bottom is near.
I’m not convinced. I want to see an exodus from equities and a rush to quality, meaning bonds. The other day, the 10-year yield was RISING while equities were falling! We need people leaving equities rushing into bonds, NOT selling stocks and also selling bonds like we saw last Tuesday and Wednesday.
On Thursday, we finally saw yields fall because people were selling equities and finally buying bonds. That’s what we need to see for a bottom. It’s at that point that selling can exhaust itself. If that becomes the near-term low, with a massive observed sell count, which I saw Thursday, that might be the bottom.
Next up is a “re-test” of the lows and a bounce. This could be a V-shaped recovery like many we’ve seen, or it could be the bounce and “chill-out” period and a slow rebuild. Ultimately, we want to see a big flush-out coupled with a flight to bonds, compressing the yields, followed by a bounce and a retest of the lows.
Then it should be “game back on.” After all, where else is the money going to go? Is a smart manager really swapping out double-digit sales and earnings growth equities for 3.25% on 10-years? C’mon!!!
China is a mess. Emerging markets are a mess. Energy is rallying, but that’s not the bastion for future growth unless financials also catch a bid and we move into the next phase of the bull market.
The Role of Sectors in the Next Stage Up
It is my belief that Tech and Consumers fuel the bull’s initial explosion. When they exhaust themselves, we should see continued growth through Financials, HealthCare, and Energy. When they peter out, we should see a push into Utilities, REITS, Staples, and Telecom, at which point the equity bull cycle could end, but then it could also perhaps back up and rebuild for another run up.
That makes sense, right?
Technology enables progress and cheaper products for consumers flush with cash. Then rates creep up – and consumers say “OK, I have enough toys for now,” – and they reel-in spending. They worry their credit card balances are high as rates to finance them rise. Their cost of debt creeps up and they stop spending on discretionary stuff. Suddenly, gas is more expensive, too. Banks and Energy company profit margins should expand during this part of the bull cycle. (Meanwhile, equities are still going up, by the way!)
When banks and energy companies get too greedy, the banks lever up to lend at higher and higher rates and pay less attention to default risk. Trump-era deregulation should enable that possibility, too. Banks will bundle up debt just like the mezzanine-junk from the housing bubble days. But next time, I think it will be consumer-credit bundling or something altogether new. Banks lend happily, so they will get out over their skis again. Energy companies will be bloated with profit, but there is still cheese on the table. Fat margins become irresistible and O&E companies start borrowing heavily to get their share of the pie.
Soon cracks start. Energy prices will start flushing out small over-levered O&E companies. They go bust and default. That hurts banks. When the news breaks, the market cracks. People flee to Utilities, Telecom, Health, and Staples. We know those things happen when things get bad, but that’s not the bull’s last gasp.
This is how it will play out, so in my opinion we are closer to the fifth inning than the 9th. I believe the market has not fully realized tax-reform impacts on earnings growth and equity buy-backs. In fact, more equity buy-backs have been announced. We may see over $1 trillion this year! There is still an inherent bid for U.S. stocks and unparalleled rates of growth and return. The U.S. is a haven in financial markets.
One final thought: Trump is heading into midterms with a nicely-engineered correction, in my opinion. Now is a PERFECT time to come out and say “I, Lord Trump, have fixed the trade dispute and we are meeting to hash it out. China realizes they need to work with us, so all is good! Go vote Republican!”
Earnings are about to pick up with another record season. Some companies will talk about trade-impact on their earnings calls, but if Trump eases their nerves by saying he is fixing it, this forward discounting may not be brought up. I believe Trump needs a humming stock market in the next three weeks. He’s smart enough to know he needs rising markets to get votes and secure Congress. Too much is at stake.
This is a burp, plain and simple, a time when smart algo traders measure the drying up of buying liquidity and pounce on it. The correction will end with a bounce, a retest of the lows, and a calming of volatility.
Then we go up.
Maybe a lot more.