The US market is currently in a phase of resilience, where the exact reasons behind the strength of the main indexes are uncertain. On the Streets, you can find individuals who are confident that the so-called "bear market rally" is nearing its end and that the AI-frenzy will soon fade away. There are indeed several reasons to support such beliefs. However, Lord Keynes already warned us about moments like that:
Markets can remain irrational longer than you can remain solvent
How can the market be so optimistic when rates will remain high for so long and fixed income will drag down or at least compete for liquidity in stocks for so long?
What about the economy? Why is the market so calm when the US is supposed to go into a recession ... or possibly a credit crunch?
But at the same time, who wants to stay ahead of a tech-gang that dominates the mother of all trends right now - the one and only FOMO?
Narratives, always the narratives. The greatest power of the markets is their ability to comprehensively explain past price action, regardless of direction or intensity. It doesn't matter if they went up or down a lot, we can always come up with an explanation. We've got a bunch of reasons ready to use whenever we need to explain what's going on.
And then, we just hope that the price movement keeps supporting our explanation. Sometimes, self-fulfilling prophecy also helps with that. Right now, the market has an explanation to keep rallying given stronger-than-expected data or even in a slowdown situation.
When Bad is Good
That's the easy part, you know. When the US releases weak data on things like unemployment, consumption, sales, or inflation, hinting at a slowdown in the economy, that's when we should increase riskier assets. It's because when the data reaches the Fed table, they'll have to change their approach and get ready to be dovish.
Then, the markets will do their job and start pricing rate cuts, promoting a bull steepening in the yield curve. This is music for long-duration assets, like bonds and stocks. Especially in the stock market, long-duration stocks, like growth stocks, will see their value rise even if their short-term earnings aren't so good (I'm talking about the next 2 or 3 quarters). What matters more is the flow of medium and long-term prospects.
We're in this situation right now, where the US economy is walking a tightrope but isn't showing any signs of a recession, which is a good thing too.
The US Dollar might be the only one facing potential losses in this situation, but that outcome will depend on how the Eurozone's growth momentum unfolds, which is currently showing signs of slowing down.
When Good is Good
Ah, the Goldilocks, why not?
Throughout 2022 and the first quarter of 2023, the market reacted negatively to every piece of positive data, causing pain for investors. The Fed is expected to step in and raise rates, which creates a blurry outlook for risk appetite.
However, nobody really wants a recession. A recession may benefit assets once you're already in it, but when you're approaching its borders, it's the worst time for price action. Currently, there are no signs of a recession in the US economy, which leaves us with two options:
i) Stay in a growth environment, accepting the possibility of enduring higher rates for a longer period.
ii) Move towards a potential recession in the future and hope it turns out to be mild and short-lived, so the pain is minimized. In that case, we can gradually add risk back to our portfolio.
The challenging aspect here is that both scenarios provide options. In the first scenario, we could potentially experience a "goldilocks" situation where the economy remains strong, and inflation naturally fades towards the Fed’s target or near it. This would allow for the possibility of rate cuts in 2024 while sustaining earnings expectations, creating an optimal environment for risk assets.
On the other hand, in a recessionary environment, things could potentially be worse than expected, leading to additional troubles like stagflation. In such a scenario, the economy and the market would face contraction (especially earnings) while inflation remains stubbornly high. It's important not to underestimate the possibility of stagflation and not blindly rely on the Phillips curve.
Currently, when we receive positive data, the market still leans towards the first scenario, the goldilocks narrative. This sentiment has been reinforced by stronger May payroll numbers and PCE consumption print.
The trend is your friend and the narrative is the last resort of the desperate. Currently, it appears that the market has chosen to embrace both the positive and negative aspects, acknowledging the existence of both the good and the ugly. However, it's important to remember that these narratives have an expiration date. It is crucial to remain vigilant and prepared to switch to the next narrative and follow the new trend when the market chooses its next target.
Or you can simply select a broad market ETF, forget about the daily illusions of Streets and go to the beach or work on your business. I prefer the latter option, but I enjoyed watching the guys on the battlefield of the Bid-Ask table.
The technicality of low volatility
On May 4th, MSCI provided a solid explanation for the low volatility observed in the stock market. This low volatility has driven every VIX-buyer crazy:
One of the reasons behind suppressed equity volatility could be the technology sector’s outperformance, which offset negative returns from other sectors, such as financials, energy and health care.
A second reason could be the fact that short-dated options have high gamma exposure, meaning market makers would be more sensitive to market moves and buy and sell futures more often to remain delta-neutral. To understand the impact of short-dated options on market makers’ hedging activity, consider the following positions:
If market makers are long gamma, to remain delta-neutral, they would consider selling (buying) futures when the market rises (falls). In effect, this could dampen realized volatility.
If market makers are short gamma, to remain delta-neutral, they would consider buying (selling) futures when the market rises (falls). In effect, this could amplify realized volatility.
If we assume investors are short calls (i.e., market makers are long gamma) and long puts (i.e., market makers are short gamma), then based on April 2023 expirations for U.S. options, market makers would need to buy (sell) USD 16.5 billion for each 1% down (up) move in the index. In theory, buying pressure during market declines and selling pressure during market rallies may have had the effect of dampening volatility.
