Hello investors,
Today, I wanted to talk about the recent market actions.
I think it's imperative to assess the current market environment given not only the magnitude of the changes in the rates markets but also the speed at which it happened.
If this were the sort of correction that occurred in September 2020, I wouldn't reassess at all because that was simply a large whale in the market coming in and driving up the prices and eventually the market corrected itself. Not much movement in yields or other markets.
This time is a bit different as yields have moved significantly, which has a significant impact on not only risk assets (stocks particularly) but also fiscal and monetary policies.
If you recall from the recent market commentaries (see below), I mentioned that in the short to intermediate-term, risk assets are driven by fiscal and monetary policies.
Dramatic changes in interest rates can impact the policies so it is time to reassess where we are.
I typically take four steps to pick out the securities I want to trade and these steps include macroeconomics, technicals, and fundamental analyses. As I've repeatedly said before, the name of the game is piecing together different pieces of puzzles to create a whole picture. You can't just ignore what's happening at the White House when picking out securities.
That leads me to make one additional comment, the memos in this subreddit are only for those "actively buying and selling securities", not for those buy and hold ("BH") group.
Don't get me wrong, I am a huge believer in BH strategy. In fact, I suggest you read Warren Buffett's annual letters which went out this past week.
Yes you get to spend less time on markets, pay little taxes, and grow your wealth with discipline.
I have a friend who is an ardent BH person and he keeps trying to convince people "just buy and hold Disney and Amazon for 20 years!" Everyone knows that BH is a good path to wealth creation. Don't need to reiterate that or even try to convince people to do that.
I actually do BH on half of my portfolio and actively trade on the other half.
My point is if you are a huge BH believer and don't want to actively trade, please stop trying to convince me or others to do it. We all know it is a good strategy and this is a game against yourself.
Enough with the intro, here are the main topics for today's memo.
4 steps I take to determine what to trade.
- Determine where we are in the market cycle
- Decide how we should position ourselves
- Select which securities will give you the highest return for a unit of risk
- Allocate appropriate weights
These steps are not mine but a mixture of what I was recommended to do by my mentors, bosses, and other resources.
This accomplishes a few things:- It forces you to step back and see the bigger picture.
- It allows you to be more objective.
- It allows you to assess your performance.
1) Determine where we are in the market cycle
How is the current market environment? Bullish or bearish? Euphoric or panicky? What changed?
Well, let's look at a few charts to see what's changed.
Equity markets
S&P futures
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Nasdaq futures
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We are just starting to test the 50D MA for the S&P and have already broken 50D MA for the Nasdaq. It's hard to make any conclusions from these so we move on.
Bond markets
10-year yield
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10-year rose almost 100 bps from the lows in August 2020. This is attributable to economic recovery, inflation expectations, and Georgia run-offs.
What's more fascinating is how much the yield curve bear steepened since the peak of the pandemic.
This was what the majority of the market participants were expecting throughout 2020 and post-election but I was very off on the timing of the events. The majority of the steepening happened towards late 2020 and early 2021.
This is an expected development as the economy recovers, inflation expectations soar and treasury market is flooded with new issues.
Below is what's making me more concerned.
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The MOVE index is basically the VIX for bond markets. The higher the index the higher the expected volatility in rates. It's still at relatively low levels but the rate at which it is skyrocketing is certainly disturbing.
Why is this all happening?
From what I have gathered, it's the Janet Yellen bomb.
On 2/16, Janet Yellen, the Treasury Secretary, announced her plans to drawdown on TGA (treasury general account, a sort of checking account for the federal government).
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What this means is that the Treasury will offload its enormous amount of cash ($1.6 trillion) into the banking system for the banks to be able to perform PPP lending and do all sorts of fiscal policy-related activities in the next 3 months.
The magnitude of this balance is simply enormous. Take a look at the chart below.
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We have never ever had TGA balance running above $500 billion and now we have close to 3x that flooding into the banking system.
From another perspective, we have about $3T reserves in the banking system. So that $1.6 trillion adds about 66% over the next few months to the banking system.
This video nicely summarizes what happens in the next few months.
This provides so much liquidity to the banking system that banks will be buying tons of treasuries, which may push short term rates to the negative territory and experts like the guy in the video anticipate that the Fed may have to actually raise IOER (interest on excess reserves) to prevent rates from falling below zero.
Now, what does all of this mean for the equity markets?
I mentioned before that majority of the bear markets must have some sort of liquidity problems, whether that be short term borrowing rates rising, bid-ask spread widening, or short term rates spread widening.
Right now, there are some signs that the bond markets are volatile but the short term funding rates are so low and so liquid due to the expected TGA drawdown and Fed purchases.
In conclusion, the way I see it, we are likely still in the recovery phase of the market cycle but we are experiencing intermittent corrections on the way. The Fed has not changed its policy stance, the gov't is continuing to push its stimulus plans, and the markets are flooded with liquidity.
Yes, higher long-end rates will inevitably bring down the valuations because by definition, higher rates result in higher discount rates and thus lower present value of future cash flows.
Yet, take a look at the chart below published by Bloomberg.
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During most of the periods when the 10-year treasury yields rose, S&P rose together. And this makes sense because yields rising indicates that the economy is growing, which translates to bullish equity markets.
2) Decide how we should position ourselves
My mentor once told me that you can never guess where the rates or stock price will move, but you can probabilistically bet on those movements.
Let's say you are betting on 10yr treasury futures. Do you think it's more likely to go from 1.4% to 2% by the end of 2021 or 1.4% to 0.8%?
We can never guess where it's going to go but I think we can all agree that it is more likely to move up than down.
Same for stocks. You can never guess where NVDA will go but in the next 2-3 years, it will likely be higher than it is now.
My point is that we should position ourselves to benefit from a probabilistic standpoint, not predicting rates movement or stock price movements.
This brings us back to the idea of convexity. As long as we make bets that yield asymmetrical returns, you just need to win half of your bets because on average, you will be up ahead.
Theoretically, out of ten stocks, you only need to win five and those five will asymmetrically outperform your losers. If your losers lose 10% on avg, your winners will win 20% on avg and you end up winning on net.
Given that it is more likely that we are still in the recovery phase of the market cycle, I believe that we should position ourselves cautiously aggressive.
I don't believe we are headed for a bear market, yet. We will likely see an intense correction (5-10% drawdown on S&P) but we won't see anything like 25-30% for a bear market period of 8 months.
Therefore, however deep this correction may go (and it may go further), it is a buy-the-dip opportunity.
With that said, don't underestimate how long this potential correction may last. It may last for 1 month, 3 months, or even 10 months. Buy the dip is not as simple as buying when the markets go down but you have to think about your carrying costs if you use options (theta decay) or margin calls.
Remember, Nasdaq had five +15% corrections on its way to the 2000 top.
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Therefore, I am buying the dips in small amounts. I would spend 5-10% of your capital on every dip that happens on a daily basis. This way, you get at least 2 weeks worth of time to deploy your capital.
3) Select which securities will give you the highest return for a unit of risk
This really depends on your risk appetite and your views. I will simply share mine in hopes to provide a guide for everyone but it is up to you to do your due diligence and make sure you are comfortable with what you are holding.
At the moment, below are my plays.
Stocks
- Short-term, leveraged longs (options, margins, etc.): OZON, FUTU, FVRR, FRHC, ENVA, TIGR, OPEN, SKLZ, PDD
- Long-term, BH longs: TTD, ETSY, NTES, JD, TWLO
Bonds
- Long 5/30 spread
Commodities
- Long gold
Currency
- Bitcoin
4) Allocate appropriate weights
Weight allocation is just as important as security selection, as it expresses your conviction and magnitude of expected price moves. Below are my allocations (rough percentages because it's hard to compare futures and shorts in percentage terms).
Stocks (80%)
- Short-term, leveraged longs (options, margins, etc.): OZON, FUTU, FVRR, FRHC, ENVA, TIGR, OPEN, SKLZ
- Long-term, BH longs: TTD, PDD, ETSY, NTES, JD, TWLO
Bonds (10%)
- Long 5/30 spread
Commodities (5%)
- Long gold
Currency (5%)
- Bitcoin
Summary
Look at the bigger picture, see what's happening across not just equities but other asset classes, and determine where we are in the market cycle.
Be very careful with security selection and do not put all eggs in one.
I am also constantly learning. I had no idea the yield would take this long to break 1.5%. I had no idea gold would underperform. It's a game where you learn constantly and I would also appreciate any critiques on any topic I discuss.
Thank you for reading and happy investing!
