10-Year Yield Target, Vol Playbook Update, Energy Stocks

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Nick here, with a quick note for clients: Jessica is temporarily indisposed with a really nasty flu. Since she is the one who makes the reports look so good, for the next few days our notes will appear a bit more spartan. We will also be running our “holiday format”, which condenses “Markets”, “Data”, and “Disruption” into one section with several individual components. Lastly, there are no links or market summaries today but we’ll have those back in the mix later this week. As always, we thank you for support!

With that, there is plenty to discuss about today’s market action so let’s dive right into today’s content (3 parts in total):

#1: A reminder of our 3 basic rules for trading equity market volatility:

First: Crashes (one day S&P 500 declines of more than 5 percent) don’t happen when markets are overbought; they happen when markets are already oversold. Whenever we see equities churn lower, as they have this year, we are mindful that the risk of a meltdown grows rather than diminishes.

For example, there were two days in 2020 when the S&P 500 fell by more than 5 percent: March 9th (-7.6 percent) and March 16th (-12.0 percent). The first occurred after US large caps were already down 8.0 percent for the year, and the second when the S&P was down 16.0 percent on the year. You’d think a hard-hit market would be less likely to drop dramatically, but history shows that is not the case.

Second: We want to see the CBOE VIX Index hit 28, 36, or 44 before calling a bottom. That is 1, 2 and 3 standard deviations (8 points) from the long run mean (20).

Over the last 12 months there were good entry points for the S&P 500 when the VIX reached 37 (January 27, 2021), 29 (late February, early March), 28 (May 12th), and 28-31 (late November, early December). Those levels fit reasonably well with the standard deviation math noted above.

Lastly: Buying the dip is a process when markets become truly volatile, not a single day event. The approach we used in 2020 was to nibble at every down 3 percent day after the first one. A 3 percent decline is 3 standard deviations away from the S&P’s average long run daily return of 0.03 percent. While statistically uncommon in normal times, 3 percent down days cluster around market turning points. There were 8 in early 2020 and buying those closes was obviously a profitable strategy as US equities recovered through the rest of the year.

Takeaway: making money during periods of market volatility requires preset rules and respect for the tape. While the concerns now are certainly very different from Q1 2020 (pandemic then, interest rates now), the common factor is uncertainty about future economic conditions. And so it is with almost any market dislocation, which is why the rules are the same. Wait for days of maximum stress (VIX, 3 pct down days) and be mindful that 5 standard deviation events (down +5 percent days) happen far more often than they statistically should. To be clear, we are not calling for a crash. It’s simply better to have a game plan for that outcome than to hope everything just gets better on its own.

#2: The recent move in US Treasury yields is an excellent reminder that, over the short term, momentum is the most powerful force in markets. Two thoughts on this point:

First: it is not just 10-year yields moving higher – 2-years are doing so as well, and with a vengeance. Yes, 10-year yields are up to 1.88 percent but that’s not much above their 1.75 pct high from March 31st of last year or the 1.78 pct last week. By contrast, 2-year yields of 1.04 percent today compare to 0.16 pct last March and 0.90 pct last week. Neither is remotely near the current 7 percent CPI inflation rate, but real rates are becoming less negative by the day.

The big question now is, of course, when do 10-year yields stop rising? One way to think about an answer:

  • We see the recent move in long-term yields as a “Runoff Tantrum”. Markets are concerned that the Federal Reserve seems set on reducing its balance sheet this year to dampen inflationary pressures. With less Fed demand for Treasuries, markets are resetting the clearing price for this paper. Also, as we’ve noted several times recently there is no historical precedent for a simultaneous rate liftoff and balance sheet runoff.
  • The Taper Tantrum of 2013 saw 10-year yields rise by 0.9 points over 4 months, from 2.0 percent in May to 2.9 pct in September. After a pullback, 10-years ended 2013 at a 2.9 percent yield but (and this is a big “but) yields subsequently retreated and we didn’t see them get close to 3.0 percent until mid-2018.
  • If we use a 1.4 percent as a starting point for the current “Runoff Tantrum” and overlay the 2013 experience, we get a 2.3 percent target yield on the 10-year.

Second: Fed Funds Futures are showing their own momentum, discounting ever-higher probabilities of more aggressive monetary policy this year.

  • A week ago, the odds of 3 rate hikes was 28 percent. Now: 20 pct.
  • A week ago, the odds of 4 rate hikes was 30 percent. Now: 32 pct.
  • A week ago, the odds of 5 rate hikes was 18 percent. Now: 27 pct.
  • A week ago, the odds of 6 rate hikes was 6 percent. Now: 12 pct.

Macro Takeaway: there is so much air between today’s 1.88 percent 10-year yield and the Taper Tantrum period-implied target of 2.3 percent that the only sensible approach is to remain cautious until yields settle out. Put another way, markets respect and fear momentum in equal measure. Volatility will remain high, in our view, until yields find their level. It seems unlikely that will happen until we hear from the Fed and Chair Powell at next week’s FOMC meeting.

Micro Takeaway: it is worth remembering that 2013 (the year of the Taper Tantrum) was an excellent one for US equities (S&P 500 +32 percent) and the entire tantrum-related pullback (May-June) for large caps was 5.8 percent. The S&P 500 is down 4.6 percent from its January 3rd all-time high, so we are closing in on the point where stocks factored in 2013’s Taper and started to stabilize again.

#3: Four other issues to raise with you:

First: US retail investors were a net buyer of stocks today, but trading volumes were lighter than usual from this cohort. We use Fidelity’s data here, and we are used to seeing +10,000 buy orders for the most heavily traded names. Today, the most-traded name was TSLA, but with only 7,700 Buy orders. These did outnumbered “Sell” orders, but only just (6,115 Sell tickets).

Other top-10 most-traded names with Buy imbalances were: Microsoft, AMC, NVIDIA, Apple, Tencent and GameStop.

Takeaway: retail is still buying, but there’s fewer active traders in the market than there were just a few weeks ago.

Second: the Russell 2000 closed today just 1 percent off its 1-year low, at 2,096 versus 2,074 (on January 29th, 2021). By contrast, the S&P 500 is still 23 percent its levels of last January. More remarkably, perhaps, the S&P 600 Small Cap Index is still 13 percent higher than a year ago.

Why would the Russell so badly underperform the S&P 600? Two reasons.

  • S&P has a requirement that a company be profitable before it enters the 400 (Mid Cap), 500 (Large Cap) and 600 (Small Cap) indices. The Russell has no such rule, so it has many more consistently money-losing companies (about a third across a business cycle).
  • The S&P 600 has a much smaller weighting in Health Care than the Russell (11 percent versus 17 percent). Small Cap Health Care made a new 1-year low today (check out the chart for PSCH). Other groups where the S&P 600 has a higher weighting (Financials and Industrials, for example) are holding in much better.

Takeaway: the parlous performance of the Russell 2000 (-7 pct YTD) tells us investors have grown very wary of money-losing companies. The odd thing is that US corporate high yield spreads remain very tight (309 basis points) and show no signs of widening. Since this is the market that provides capital to marginal companies, it is strange that it is not similarly concerned. We tend to think of high yield investors as a pretty savvy bunch, so the dichotomy here is strange. There is certainly a great trade shaping up in the Russell, but given current market conditions we think it is too early to make that call.

Third: let’s talk about Energy stocks. Regardless of geography, these remain our favorite cyclical recovery play. WTI and Brent crude oil made fresh 1-year highs today. As much as markets may worry about the state of the US/global economy in 2022, they also see rising demand for energy.

It’s worth remembering that the Energy sector is still just 3 percent of the S&P 500, 4 percent of MSCI EAFE and 6 percent of MSCI Emerging Markets. There are several companies (Apple, Microsoft, Amazon, Taiwan Semi) that have larger weightings in their respective indices than the relevant Energy weighting in each. Nothing against Big Tech, but the valuation differential here still seems too wide.

Takeaway: one of our central investment mantras is “money has to go somewhere”. Markets are in the midst of a regime change, cycling out of what worked over the last two years and into stocks and sectors that offer the possibility of upside earnings surprises. Yes, Energy had a strong 2021, but we think there is plenty more left for this group. Surging oil prices tell us we are on the right track with this call.

Fourth (and last): the ARK Innovation ETF (ARKK) was off 4 percent today is now officially down more than 50 percent from its February 2021 high (-50.9 pct). Last week we mentioned that ARKK was the most “NASDAQ 2000 – 2002” thing we’ve seen in this cycle. The NASDAQ was down 80 percent from peak to trough in the early 2000s. ARKK is now more than halfway to matching that result.

Takeaway: market momentum cuts both ways. We will be interested to see if ARKK can stabilize here, since a 50 percent decline in less than a year is remarkable. Our bet, however, is that ARKK still has some rough waters ahead. As we said in the prior section regarding the Energy sector, money has to go somewhere. It also has to come from somewhere, and the sorts of stocks in the ARKK portfolio appear to be at the headwaters of current US equity capital flows.