February 2023 Update
The burst of the supply side economic bubble
Everybody is worried about a recession that will cause a decline in the market because of layoffs leading to reduced spending leading to reduced earnings, etc. But that is not what drives markets. We’ve observed below trend economic growth for more than 20 years now (since the new millennium) yet markets have performed spectacularly due to the massive liquidity injections by CBs around the world.
Entering a period of secular reduction in liquidity
We are shifting away from a supply side economy that drove a financial bubble to a demand pushed economic bubble. Much like in the 60s-70s, a demand pushed economy drives much stronger GDP growth in real terms compared to any supply side economies. However, with the reduction in liquidity and the higher price of money, alternatives for equities look much more attractive. As many have pointed out, markets at 4800 was much cheaper than it is now given where interest rates are. Equities are a dangerous place to be at these valuations.
The high January employment number and warmer than expected CPI gave room for excitement to CEOs and people in the real economy
People thought that there was going to be a bad recession and since there is still no recession and inflation is turning lower, stocks are going to perform a lot better. Sentiment across the board is also improving. Unfortunately, those numbers (employment, CPI, PPI, PMI, PCE) also mean that the Fed at its core is likely to be pushed back in to reduce liquidity and increase interest rates. And we believe this is likely to happen increasingly faster than people expect.
Knowledge is vol dampening
About a month and a half ago, Goldman warned about mid feb, JPM’s Kolanovic also issued a warning on Feb13th, and even ChatGPT, when asked what the most likely outcome for the next several months is, claimed a feb15th market crash is in the cards. These cautionary tales ultimately put a stop to the countertrend rally as everybody joined in on the feb15 market crash band wagon. So here we are, sitting on a pullback since feb14th, but without a blow off top rally as we would’ve hoped for, it will be difficult to crack this market.
Outlook for March
Newly added vol supplies has dramatically reduced the odds of some type of liquidation. It doesn’t mean that we won’t decline further, but it means we’re more likely to see something tepid. And if we begin to see a time period where that decline does not turn into something bigger and vol is still well supplied, this pullback may very well come to an end on feb27-28 (tomorrow). There’s a real potential right tail as we move forward into mid march that could squeeze shorts.
- If vol stays under control by feb28th, it begins to look like another buying opportunity
- Given how cheap vol and skew have become, index puts and VIX calls can represent significant opportunity if this market breaks.
- Watch for another short squeeze, forcing even more underinvested investors back into the market, maybe even into April, May.