As investors wait for the next shoe (tweet) to drop on U.S. / China trade discussions and whether or what kind of extension the United Kingdom (UK) receives from the European Union to avoid the 10/31 Hard Brexit deadline, it feels like markets are at a standoff between bullish and bearish risk positioning, neither of which seems to be offering much premium for sticking one’s neck out for taking either position.
What do we mean by ‘premium’? For market bulls or investors with a more sanguine market outlook, equity valuations and fixed income risk premiums (term structure, corporate credit) leave little room for error as both are trading at near-cycle highs/narrow levels (refer to 3D’s 3Q2019 Market Commentary for quarter-end valuation levels). In addition, cracks are appearing underneath the market surface as investors crowd into the ‘safer’ areas within equities and fixed income.
Figures 1 and 2 both come from the Bear Traps Report (10/25/2019) showing the outperformance of consumer staples versus discretionary (i.e. preference of consumer defense over cyclicals) and the widening gap between what investors are willing to lend BB-rated companies (versus BBB-rated) and CCC-rated companies (versus B-Rated). Both highlight a conundrum facing the bulls as further advances in equity and credit valuations are being driven by a rush-to-safety – not exactly a picture of robust market sentiment.
Figure 1 – Consumer Staples Outperforming Discretionary as S&P 500 Advances Higher
Source: Bear Traps Report, 10/25/2019
Figure 2 – Yawning Valuation Gap Between BB Credit Spreads (Relative to BBB-Rated) versus Relative CCC-Rated (Relative to B-Rated) Points Towards Lower Market Confidence
Source: Bear Traps Report, 10/25/2019
So, bullish investors betting on further market advances are increasingly paying up for ‘safer’ participation by hiding out in the more defensive, higher quality segments of the market. Cracks in the credit markets are beginning to appear, but little to suggest a major breakdown in credit market dynamics.
Bullish investors are also counting on the Federal Reserve to ‘respond’ to market volatility through easier monetary policy and interventions such as injecting reserves into the overnight repurchase-agreement (repo) market, although some have expressed concerns that the Fed is trying to mask what’s actually clogging up the financial system’s plumbing.
In addition, selling risk or shorting volatility has not been profitable in 2019 despite the S&P’s advance. The S&P Put-Write Index (selling in-the-money put options on the S&P) is only up 8.7% through 9/30/2019 compared with the 20.6% return of the S&P 500 and has not recovered from its peak reached a year ago (Figure 3). And despite the lackluster performance, short volatility (via short positioning in the VIX futures) appears to be a crowded trade (Figure 4).
Figure 3 – S&P Put-Write Index Still Below the Peak Reached Last Year
Figure 4 – Crowded Trade Forming in Net Short VIX Futures Positioning
Finally, as 3rd quarter earnings are being released, the overall earnings trends for U.S. large and small cap companies appear to be flattening or buckling (Figure 5). Analysts covering S&P companies have largely written off the rest of 2019 and are banking on strong earnings recovery in the first half of 2020.
Figure 5 – After Recovering September, Earnings Estimates (White Lines) for U.S. Large and Small Caps Appear to Be Topping Out
Bearish investors may find downside protection cheap in this market, but the passage of time grinds away at the value of downside insurance as this cycle further extends itself. Potential resolution of near-term overhangs such as U.S./China trade conflicts and BREXIT could serve as further catalysts for future market advances. And barring a major credit default or a breakdown in the earnings outlook, volatility can remain subdued despite the overcrowding in short volatility positioning.
Consumer staples have been outperforming discretionary; however, the relative performance of broader cyclical sectors versus defensive sectors (as measured by the Morgan Stanley Cyclicals vs Defensives Index) continues to trend positively, although it has stalled out these past few months (Figure 6).
Figure 6 – Cyclical Performance Versus Defensives Is Trending Positively
So, we appear to be at a standoff as the positive macro backdrop for risk appetite remains set against a backdrop of stretched valuations and overcrowded sentiment. Of course, one bad miscalculation on U.S./China trade discussions or BREXIT passage could serve as a catalyst for another volatility-driven sell-off that we witnessed last August. But the U.S. economy does not appear to be teetering on recession; that and an accommodating Federal Reserve should keep a bid on risk asset pricing.
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