The weight of the evidence suggests that the current market rally may persist. The Fed’s aggressive stimulus measures, along with other central banks’, are having the desired effect of reducing risk premiums and reflating risk assets. The “reflation trade,” involving the most economically sensitive assets, confirms that the central banks’ actions are working. Below is an articulation of this bullish viewpoint. Before getting into the specifics, I want to share a personal story about my career.
It was April 2009 and I was 28, working in my first buy-side job as a strategist for Caxton, one of the largest macro funds in the world. I was the equity strategist, advising macro portfolio managers at the firm on how to express macro trades in the equity market. I was extremely bearish, as were most investors at the time. Unemployment was skyrocketing, reaching 9% from 4% a year earlier. Non-farm payroll had just printed -800k, the largest decline since 1949. S&P 500 EPS had fallen 50% and was about to decline further.
Most macro investors were bearish at the time, and I had advised portfolio managers to aggressively short banks because banks were the roots of the crises. The economy was crashing and many banks would shortly be insolvent due to massive writedowns wiping out any remaining equity. Sure the bank stocks were down 60-70% and valuations were starting to appear attractive relative to history. But I argued valuations didn’t matter since the fundamentals would deteriorate and the companies were insolvent.
For about 6 weeks after March 9, 2009, equities had staged a significant rally. From my perspective, it was clearly a bear market rally since the fundamentals were so negative. The CIO of the firm, Andrew Law, called me into his office as the firm was losing money on the short banks trade I was recommending. He wasn’t one for small talk and got right to the point. “You’re bearish on Financials, but the technicals are bullish and suggesting something has changed. The market is saying you’re wrong. You need to listen to the market.” He pulled up the price chart of the XLF on his CQG system and drew some squiggly lines on the screen.
I was taken aback. As an analyst who was grounded in fundamentals, I resented the suggestion that I should consider technical analysis in my approach. After all, I had a finance degree from Rutgers University (a top 50 business school) and there was a reason I had studied for three miserable years for the CFA! I told him I don’t believe in technical analysis. Who cares what technical analysis was saying, the Excel model that I had meticulously built suggested much more downside for financials. He said it’s irrelevant whether I believe in technical analysis because it works. Then he ordered me to read John Murphy’s technical analysis book. (If you want to learn about technical analysis, Stockcharts.com has excellent tutorial articles for free.) Andrew and the technicals were right. Equities started an uptrend in March 2009 that lasted for 11 years.
The most powerful part of technical analysis is that it removes your emotions from the equation and helps you understand what the market is saying. Technical analysis separates what SHOULD happen based on fundamental projections from what IS happening. Currently, the market is loudly saying the Fed Bazooka worked to turn the tide, and risk assets are going higher.
The Fed “reflates” the economy by injecting liquidity to stimulate borrowing and reduce risk premiums. Historically this has been accomplished by lowering rates, and today it’s being implemented through lower rates and QE. It’s important to note that in previous bear markets the Fed gradually stimulated the economy by slowly cutting rates. If this bear market was much shorter than other bear markets, it’s because the speed and magnitude of Fed actions in March dwarfed anything previously done. The Fed balance sheet has expanded from $4 trillion to $6.3 trillion in a month and will increase by $300 billion every week at the current pace.
Fed Balance Sheet has expanded more rapidly compared to 2008
The reflation trade is starting to work
When the Fed is effectively reflating the economy, the most cyclical assets in the market break their downtrend and start forming uptrends. This is called the reflation trade. The definition of the trade isn’t taught in universities but is widely understood in the macro world. The most common economically sensitive assets used by macro investors for this trade are Copper (HG1), Materials (XLB), Miners (XME), Transports (IYT), Small-caps (IWM), Germany (EWG) and South Korea (EWY).
Technical analysis is used differently by people and there’s no “right” way to do it. The basic concept is observing the historical price chart and identifying highs and lows to define a trend. An uptrend is defined by higher highs and higher lows while a downtrend is defined by lower highs and lower lows. Frequently an asset will have no trend when price is moving sideways. Many novice investors get overwhelmed with the seemingly limitless technical indicators available. Experienced investors use the basic framework of identifying uptrends and downtrends.
Switching away from theory and to the current market, risk assets across the board were in a well defined downtrend until March 23. After the Fed and US government introduced record stimulus, risk assets reversed course. The most economically sensitive assets, the reflation trade, is in a new uptrend. There aren’t any cyclically sensitive assets that remain in a downtrend. Some investors will point to spot oil prices making new lows, but that situation is muddied by oversupply from OPEC. Besides, the longer-dated oil futures bottomed in March and have not made new lows.
My personal favorite barometer for reflation is Freeport-Mcmoran (FCX) because it’s a large cyclical miner with underlying exposure to copper which itself is highly cyclical. In 2009, FCX stock was an effective barometer to understand when the market started to signal that the reflation trade was working. In 2008, FCX was in a clear downtrend. After incrementally aggressive actions by the FED and Treasury department, FCX stock broke its downtrend in January 2009 and started a new uptrend.
Freeport-Mcmoran was an effective barometer in 2009 to understand when the Fed’s actions started to work
A similar pattern is playing out today. FCX was in a well defined downtrend and bottomed on March 18, five days before the S&P 500. This was the day when the Fed announced new liquidity provisions. Since then, FCX has made higher highs and higher lows, suggesting that the reflation trade is working. Another technically bullish signal is that since the bottom, the volume on up days is significantly higher than volume on down days.
Freeport McMoran is in an uptrend over the past month with higher volume on up days vs. down days
The current reflationary theme is confirmed by the underlying stocks in the Transports ETF (IYT). None of the underlying companies have made new lows since March, and all are in an uptrend.
Transports are highly cyclical. The largest stocks in the Transports ETF (IYT) are in an uptrend
Another bullish signal comes from the Exchange stocks. These stocks are sensitive to trading volumes and bear markets are notoriously low liquidity environments. The uptrend of exchange stocks is indicating that the bear market is over. These stocks include NDAQ, CME, ICE, MKTX and CBOE.
Exchange stocks rebounded strongly since March and suggest the bear market is over
How the market rallies in the face of a depression
The most difficult part of being bullish in the current environment is that the economic and fundamental data is overwhelmingly negative. Jobless claims have spiked to record levels as businesses navigate the national shutdowns. Earnings will decline significantly in 2Q. Our previous two blog posts laid out the bear case.
Negative data is the reality around market bottoms. If this rally continues, the negative data will become less bad on the margin over the next several months. In 2009, the market started rallying in March 2009 and the non-farm payrolls report didn’t turn positive until November. Throughout the entire rally, the bears hung their hats on the fact that the economic data was bad (which it was). But the negative data became less bad each month.
The S&P 500 bottomed in March 2009 while non-farm payrolls didn’t turn positive until November 2009
The discussion around income inequality, which was vigorously debated in the US prior to COVID-19, will likely intensify throughout the year. Stock prices will increase more rapidly than improvements in jobs and the economy. Additionally, the Fed will need a path for reducing its balance eventually which will be negative for risk assets. This dilemma will need to be addressed in 2021 or 2022, not this year.
The bond elephant in the room
If the Fed has successfully started to reflate the economy as many assets suggest, the bond market will need to confirm this trend. Bond yields are currently trading near historical lows, with the 10-year yield at 0.64%. In a reflationary environment, the yield on long term bonds like 10Y and 30Y should increase, and the yield curve should steepen. As bond yields move higher, bond-like equities with high dividend yields like Utilities will likely underperform.
Historically, the start of QE has led to higher yields. If bond yields don’t start moving higher in the next 4 weeks, this would be a major signal that the reflation trade is not working.
Increased QE historically leads to higher 10Y yields
Equity Trade ideas
Tech (QQQ) and Biotech (IBB) are the leaders of the current rally and trading near the highs. Technical analysts will tell you to buy the leaders. If the current risk rally persists, the leaders will likely continue to go up. However, stocks that have gone up quickly are prone to pull backs and consolidations, and risk needs to be managed accordingly. On the stock side, large-cap candidates which have led this rally are NFLX, AMZN, MSFT, AMD, ICE, NDAQ, MKTX, GILD, REGN, SGEN, LULU, CMG, MCD and NKE.
Cyclical equities have traded higher from their lows but still significantly below their highs. If the current risk rally continues, cyclical stocks would do well. Many cyclical sector ETFs like XLB, XLE and XLI fall into this category but the broadest and simplest implementation is through Small-Caps (IWM).
The laggards in the current rally are sectors which were the hardest hit by the shutdowns including Airlines, Sports, Entertainment and Travel companies. While some are benefactors of current government support programs and these sectors may rally in the short-term, it’s unlikely the stocks will regain their highs in the medium term even if equities continue to rally. The world will be different post COVID, and in that new world, travel and large gatherings will occur less frequently for the foreseeable future.
If this is a bear market rally, the uptrend in reflationary assets will break
While the bullish view outlined above is currently supported by technical analysis, it can change with the circumstances. The biggest macro risks to this rally are that the Fed stops its QE program or that the US government can’t pass further stimulus measures which are likely needed. Another risk is prolonged government-mandated lockdowns which last past May.
If the uptrend of the reflation trade breaks down, the bull argument is null and void. Another complication is that even in an uptrend, S&P 500 pullbacks of 5-10% are common with VIX at 40.
As many investors and CEOs have said, this environment is like nothing we’ve ever seen. The bear argument is solidly backed by negative developments in the news every day. The forced shutdowns in many countries are unprecedented and the resulting economic damage will be significant. On the flip side, the current stimulus from the FED, BOE, ECB and BOJ dwarfs anything in history. Regardless of your fundamental view, listen to the markets.
The analysis in this blog post was done using Koyfin which offers financial data and analytics to research stocks and understand market trends. Create a free account on our website.