Week of March 20
Post banking crisis, Powell steps up to the plate...
Recap of last weeks action:
Towards the end of last week was when the SVB situation just began to unfold, I had a good hunch that market had to explore lower levels based on what I was seeing in /VX futures. Sure enough we proceeded to trade about 50 pts lower from the 3860 $SPX close into the 3800 handles.
Although sentiment was extremely bearish on the weekend, I urged my followers to only look at longs as I felt we were close to a short term bottom at ~3800. That level bounced for about 150 points, which should have made your entire week if you even banked half or a third of that move.
I always preach this, and i’ll say it again. Trading for me is about taking a few high quality setups a week, make your money, and then log the hell off your broker. Don’t get too caught up in the routine and ceremony of trading. If you’re not careful you start treating it like a game, looking for a dopamine fix and that when your risk management gets sloppy and you blow up. For me, I have been looking for this long for months now, because 3800 was such strong support in early January I knew if it was retested it would likely bounce quite strongly the first time, and it did. I nailed this trade, and the week was made, and I wasn’t very active for the rest of the week because the easy money was made and without a high reward/low risk setup I was happy to just relax and wait for the next fat pitch.
Of course let’s not forget CPI day. I sent this tweet a couple hours before the print, short term Vol looked very expensive to me. I happened to be right, and the $VIX sold off over 10% in mere hours and most puts were destroyed. When vol is rich, there are many instruments you can use to express a short vol position. Long $SPX, $VIX puts, long SVIX 0.00 ETF are a couple good options.
I also sent a warning/trade idea last Sunday on bond yields. This is an $SPX focused trading plan, but I do want to educate my readers on bonds a little and how they affect other asset classes. Even if you don’t trade bonds, what happens in that market plays a big role in trading the $SPX.
I theorized that there would be a large and frantic flight to safety for firms looking to protect and keep liquid their cash and cash equivalents. Many withdrew their liquidity from smaller regional banks (absolute carnage) and instead used to purchase short term bonds (Treasury bills) which are guaranteed by the US Government and essentially risk-free. When the demand for bonds go up the yields then go down. Many algorithms are programmed to buy technology/Nasdaq/$QQQ when yields go down, as they represent the price of borrowing money (risk-free rate) and technology is largely priced and discounted based on future cash-flows, which are directly effected by what interest rates are. As yields go up, the future value of the cash flows earned by technology companies are worth less in real terms, which are then repriced discounted in real time. Long story short:
Bonds bid, yields down, tech up, Nasdaq up, S&P up (because large tech weight)
Bonds offered, yields up, tech down, Nasdaq down, S&P down.
Now this ended up being the trade of the year. Yields had their biggest drop in 26 years (!), with a bigger drop than even the Great Financial Crisis, the Dot-Com bubble, all the way back to the 1987 stock market crash. If you were long bonds, or long technology, you probably had one of the biggest trades of your entire life here.
If you had even just longed the Nasdaq $QQQ, you scored a massive win, with it up 8% on the week at point, closing up “only” 6.5% on the week.
Next move for markets?
Up. Although we may possibly sell off a bit early in the week depending on how the hedging flows play out into such a massive FOMC, I do believe that is a dip to buy. Once again we are post a monthly (and quarterly) OPEX here. So a lot of supportive flows from vanna/charm have just come off and the market is able to move more “freely“ due to less cluttered dealer positioning. Here is a quick summary for readers again explaining the OPEX supportive flows.
As market participants put on long hedges before a pivotal FOMC, dealers need to hedge their short put positions by selling S&P futures. So any large hedging flows will lead to some selling pressure when there isn’t much natural support for the market post the OPEX.
Continuing my train of thought from before, the large flight to safety from firms looking to protect their cash has lead to an absolute destruction of short term yields. This supports technology stocks, which supports the Nasdaq, which will support the S&P. There was and still is significant fear in the markets, the GFC is still haunting markets even 15 years later, but important to note the banking system was overhauled by policymakers and the Federal Reserve and the situation is simply very different now. The banks utilization of leverage is much more conservative and the overall stability of the system has been drastically improved. But fear is not rational, and markets are not rational (in the short term) which is a good thing because it affords us the opportunity to profit on the eventual repricing once the market realizes it priced in a worse case type scenario that never actually came to fruition.
In this flight-to-safety disposition the market is in, we will likely continue to see the Nasdaq bid as entities who must deploy a certain amount of their cash into assets flee more uncertain investments (financials anyone?) into the old faithful big tech stocks (Microsoft, Google, Apple, Meta) which are cashflow heavy and will not encounter a liquidity problem in the foreseeable future. As the S&P is a cap-weighted index, a bid for mega-cap tech which we will see in the form of
1. systematic buyers indexed to bond yields
2. funds re-grossing into cash-heavy liquid “safe” names
will support the index and float it higher.
Image A: Nasdaq closing up quite strong on the week, close to yearly highs.
Image B: CTA upside convexity in bonds. Source: Goldman
Remember CTA’s? They trade bonds too. The upside in bond convexity is simply astounding. If they catch momentum to the upside the bid will be enormous. Which will further suppress yields and support tech here.
I sent this warning earlier on Twitter and I need to reiterate this here. The S&P 500 is cap-weighted and it will move in the direction where tech moves for the most part. If Financials are trading down, and Tech is trading up. You want to be swimming with tech. Plain and simple.
Image D: Tech has roughly 3x the weight of financials in the S&P. This chart is not super recent but it illustrates my point.
Now onto FOMC featuring the man of the hour Mr Powell. This is one of the most important FOMCs in recent memory, and I promise I don’t say that every time! Why is that? Before Powell had essentially one thing on his plate - to fight inflation. Now with the SVB bank crisis, with some cracks in the financial economy starting to show, I would think that puts a bit of a damper on any potential hawkishness this coming Wednesday. His already formidable task now requires an even more delicate touch and bit of a balancing act. Inflation remains uncomfortably hot with a firm stubborn upwards medium term trend, and now things are starting to break. Recall this infamous chart from BofA then I have referenced in the past.
Image C: Every tightening cycle ends in something breaking. The fastest cycle in decades this time, will it be different? Doubt it. Source: Bank of America
Now one of the Fed’s and Powells main tool is jawboning. Jawboning is the act of sounding hawkish (hinting to a restrictive monetary policy) to ostensibly tighten financial conditions and curb speculation in asset markets. The Fed knows the market hinges on its every word and if they come out hawkish they can achieve essentially the same effect of tightening, without actually withdrawing liquidity from a financial system still stressed and having never really truly recovered from the damage incurred during the financial crisis. This is a market hooked on QE, easy and cheap money, and secularly declining interest rates. We need only to look at the UK gilt bond crash from late last year to remember how sensitive the market really is to an unsupportive Central Bank.
We have spoken in the past about how monetary policy works with a lag. This cycle especially is something different that we have not seen before. The real economy, household balance sheets were absolutely flush with cash leftover from the fiscal stimulus and helicopter money that governments worldwide handed out during COVID to artificially jumpstart the economy. So that has been a counterforce to the tightening financial conditions we have seen the past two years. It’s been two years now. We are slowly approaching a point where excess household savings are starting to run out and the real effects of a 4.75% jump in interest rates in less than a year are starting to bite. We are starting to see cracks in the system. Banks are trading like crypto. This is not normal. Powell knows this, and in my opinion we will see this reflected in his presser. He knows he cannot go full hawk, Jackson Hole/Paul Volcker this FOMC as things are more fragile than they appear. We are also closer to the bottom end of the range trade thesis I posited last week of 3800/4200 so we may get a more dovish side of him.
A frequent bear thesis I see often on Twitter is “Don’t fight the fed”. But important to note here, that wanting to cap upside and “sell calls” to the market is not the same as wanting it to crash. I believe the Fed wants to curb frothy speculation in the markets, and a subdued S&P 500 but that is NOT the same as wanting a stomach churning market plunge to sub 3000 lows. I think when SPX is approaching that 3500-3800 range Powell will lean more dovish, and over 4100 on SPX he will lean more hawkish. Essentially Powell wants to babysit SPX into a bit of a range trade, allowing it to correct over time while he deals with inflation. Remember with CPI around 7% here, if the SPX stays flat for the year it technically dropped 7% in real terms. The Fed will never want the market to crash, and in this scenario the wealth effect of booming asset prices will add further fuel to the fire in the battle against inflation so he is also not keen on a frothy pricing on the SPX either.
Powell also knows better than anyone we still have yet to see the full effects of the fastest fed hiking cycle in decades work its way through the real economy.
Fed funds futures are pricing in a 75% chance of a 25bps hike in this meeting. Down from 50bps the market was pricing in only a week ago. I imagine he will get many questions and may speak on bank liquidity concerns. Ultimately, this whole situation has severely complicated his mission and he will continue to try and fight inflation with one hand tied behind his back. Juggling bank system liquidity fragility while fighting an all-out war with inflation that all signs are pointing to him losing at the moment.
I am tactically bullish here, but long term I think we may atleast retest the October 2022 lows of 3500 $SPX. But as I always talk about, markets have a natural inertia, to go up. Shorting is more difficult and I prefer leaning long and only shorting when the opportunity is simply too good to pass up. That is not here. That is not now. I will like the short side again maybe post-Powell in the 4050-4100 $SPX range and beyond.
Regarding the oil selloff. I am hugely bullish on oil in the next decade, I see it as the next big tobacco. Ultimately a hated industry, but it simply makes so much money that the valuations are a bargain now. A lot of hedge funds blew up last week with the 15 standard deviation move in bonds (that I warned about!) and a popular trade was the long inflation trade. Funds were short bonds (which lose value in periods of high inflation) and long commodities (oil). As the widow maker move in shorter dated bonds played out, many were liquidated/margin called and had to unwind any/all positions to meet margin requirements. So I think mainly a positioning based cleanse that may be bought back up in time.
I want to remain long and buy dips here in that 3800 to 3850 range on $SPX to test 4000-4100 or higher. I prefer longing the Nasdaq here for reasons stated above. Either QQQ 0.00 or TQQQ 0.00 or QQQ 0.00 calls or call spreads.
I remain long XLF 0.00 here at 31 and will increase size at 30. Shares only, long term portfolio. I like its exposure to bluechips such as Berkshire Hathaway, JPM, and American Express.
Long OXY 0.00 via options structure. Sell the April 14 $56 put (last 1.80) to buy the April 14 60/63 call spread (last 1.16). Happy to own the shares if I get assigned.
Until next week, happy trading!