On Monday, the market sold off slightly. The sell-off was either a continuation of the selling pressure caused by the market being overbought after the Trump-speech rally or because the stock market finally realized rate hikes are coming fast and furious this year. In my opinion, the market shouldn’t have rallied after Trump’s speech because it didn’t have many policy details. I said the idea that the market thinks uncertainty is now a positive is ludicrous. The speech wasn’t necessarily a negative because he didn’t say anything that was against business, but he also didn’t explain the details of his tax plan or his views on health care. The S&P 500 has given up about 2/3rds of that huge rally on Wednesday of last week.
Secondly, as I mentioned, the stock market may be realizing the Fed is about to raise rates 3 times this year. That’s a quick pace considering, it hasn’t raised rates once this year. Historically, this is still a slow pace, but in recent history the Fed has raised rates 25 basis points per year, so it’s fast. The market is a fickle beast. In the past, stocks have shivered at the idea that rates would be raised once and now they’re accepting three hikes. In fact, they’re rallying when the Fed talks hawkishly. I don’t agree with the concept that bond yields can rise, while stocks remain expensive. The point bulls have been making for years is that multiples are high because bond yields are low. I understand that logic and now want them to remain consistent on it.
The chance for a rate hike in March is 86.4% which was an increase from 79.7% on Friday. It’s almost a done deal that the Fed will raise rates next Wednesday. The only thing that can move the needle is the jobs report on Friday. Given the low jobless claims, I don’t see how it will be bad enough to change the Fed’s decision next week. Three rate hikes by December is the most likely policy to occur according to CME Group. There is a 55.4% chance at least three rate hikes will happen this year.
The insiders agree with me, as you can see from the chart below. The insider selling to buying ratio on the NYSE is 11.47 to 1 which is a 3.5 standard deviation move. The chart below shows there are 5.98 buy transactions for every one sell transaction. When I discuss the concept that the indicators aren’t working anymore, this is a prime example of what I’m referring to. Stocks are levitating as if insider selling has become a good thing. The froth in the market is high.
The chart below shows another example of frothiness in the market as both macro hedge funds and long/short hedge funds are in the 95th percentile beta to equities. Some people who aren’t involved in finance may say to themselves that hedge fund managers are among the smartest in the world. How could they foolishly buy stocks at insane valuations? The answer is that hedge fund managers are not foolish, but they must chase performance. If you ignored this rally because you thought QE was inflating stocks for an eventual crash, you would be out of a job years ago. Investors don’t want to be in an underperforming fund for one year, let alone three or four years. Being a disciplined investor is much harder than it seems. You looked silly if you didn’t own tech stocks in the late 1990s. Prudence is ignored for short term performance, especially when the short term lasts a few years, like it does in many bubbles.
As I mentioned, central banks’ balance sheet expansion is the main reason why stocks are so overbought even while valuations are high, insiders are selling, and the Atlanta Fed is expecting 1.8% GDP growth in Q1 following the weakest GDP growth year in this cycle. The balance sheets are about to slow their rate of growth soon. As you can see from the chart on the right, the rate of growth decline has been caused by the Bank of Japan.
The European Central Bank is about to slow its asset purchases down significantly. In April, the ECB will start to taper its buying from $80 billion per month to $60 billion per month. In the next two months, we will get a glimpse of what the market will look like when the ECB takes away all the purchases. Either volatility will increase or it won’t and the ECB will taper again in December, possibly ending the program completely. The Fed is talking about shrinking its balance sheet; it doesn’t look like the ECB’s tapering will be made up by any central bank. This means the market will be held out to dry with very high valuations. It’s like when the government encouraged homeowners to get adjustable teaser rate mortgages and then Alan Greenspan raised interest rates.
The final chart I will discuss is shown below. It shows the short positions in the 10-year treasury passing the record number of shorts in November of last year. It will be interesting to see how this trade unwinding will affect the bond market. When the record long position in 2007 unwound, it led to plummeting yields. The short treasury trade unwinding could lead to yields rising. If yields rise, the stock market’s multiple will fall, meaning a selloff is likely.
Conclusion
Investors are overleveraged at a perilous point because central bankers are about the take away more of the punch bowl. The large rally may be part of the reason why the punch bowl is being taken away because central bankers may feel the market can handle it. The insider selling being at 3.5 standard deviations is a giant caution sign which should not be ignored. It doesn’t mean stocks will immediately crash, but it should make you question why you are buying stocks at these levels. The final point I made was treasury yields may increase when the short treasury trade ends.
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