I Would Do Anything for Dove (But I won't sell that...)
MON 24 JAN 2022
From our perch, market sentiment and consensus beliefs edged closer to outright panic or capitulation on Friday in the United States. While that might seem counter-intuitive given the global risk proxy (the S&P500) is only 9% below the record intra-day high, there has clearly been considerably greater damage to profitless hyper-expensive growth names underneath the surface.
On the positive side, a few of our tactical indicators are close to the extremes in sentiment seen at the pandemic low in 2020 and similar to 2008/2009 levels. On the negative side, the rationale for the correction; the withdrawal of super-abundant liquidity is genuine. Moreover, in contrast to previous buy-the-dip moments through the bull market, the capacity of the Fed to dovish pivot is constrained by unacceptably high inflation (from a political perspective).
As we noted on Friday, our sense is that the impulsive and emotional nature of the price action, combined with the very large drawdown in popular growth names, suggests that there is reasonable odds of a counter-trend rally over the coming days. While spot implied volatility (and volatility-of-volatility) is still below the panic levels seen during Q4 2018 and financial conditions have only tightened modestly, there has been a larger capitulation in other measures of market sentiment. For example, the AAII Investor Survey of Net Bulls minus Bears is below March 2020 levels and not far above 2008 capitulation extremes (chart 1). Similarly, the demand for put options versus call options on the CBOE has increased close to previous market extremes (chart 2).
Of course, previous sentiment extremes often occurred within the context of a bull market. The challenge in the current episode is the genuine shift in liquidity conditions. Moreover, as we have noted since late last year, the legitimate constraint of the highest inflation rate since 1982. The FOMC has a challenging communication issue at the January meeting this week. Do they validate the reason for the correction in equities? Or do they capitulate and risk undermining their inflation credibility? Our sense is that it will be difficult to convey a dovish message given the current inflation backdrop. On the positive side, this observation is now widely appreciated and probably the prevailing bias among most investors.
In conclusion, markets are probably set up for a counter-trend relief rally leading into the January FOMC meeting this week. However, this is NOT an opportunity to take on profitless hyper-expensive growth equity. While the ARKK Innovation ETF is around 55% below the record high, most investors are now below their VWAP (entry level) and outflows are accelerating. That will likely lead to self-reinforcing liquidation of smaller concentrated positions. The additional challenge more broadly is the legitimate inflation constraint on the Fed in this episode. Therefore, liquidity unwind is likely to continue in spite of the correction in equities and tightening in financial conditions.
In this region, the good news is that China has signalled further easing in liquidity and the valuation starting point is considerably more attractive compared to US equity. We will gradually scale up our long exposure in the region with a focus on; high free cash flow, growth and low balance sheet leverage. The dollar index is also interesting in this context given the competing elements of the “smile” (risk aversion versus selling of US assets). More on that tomorrow.