October 10, 2022 | InsiderSentiment.com Team
The stock market song continues.
The popular Olivia Rodrigo song could just as well be about the stock market:
I'm the love of your life until I make you mad
It's always one step forward and three steps back
Do you love me, want me, hate me? Boy, I don't understand
No, I don't understand
We had a summer up 20% only to be followed by 20% down after Powell suddenly discovered a stiff backbone at Jackson Hole. Last week was a second installment of the same song. So what was the good news this week that caused the market to go up almost 6% in two days? These days, market participants are looking for anything to feel good about. The PMI, or Purchasing Managers Index, came in a little weak, falling to a contraction level for the first time since 2020. Therefore, the market went up because more bad news helps increase the chance of a Federal Reserve pivot. Given the downward trend we have seen this month, any morsel of a pivot from the Federal Reserve could easily send the market up by 10%, only to be disappointed. On Friday, however, the jobs report was especially strong, unemployment was actually down to 3.5% with 263,000 jobs added in September. Stock market futures turned down sharply again.
This raises the question of if and when the Fed will pivot. No one knows when and what the likelihood of a pivot is. We think it will be entirely driven by the future path of inflation.
Additionally, Wells Fargo reported this week that a hedge fund bought $31 million of call options on the S&P 500, which is why market pivoted on a dime upward. Why does such a small trade turn the market on a dime? It is not so much the trade itself, but rather the fact that it is a derivative trade that promises a huge upside to the buyer of calls. Is this coming from an insider? If so, what do they know? It is an enticing question. Could it be a leak from a Fed official? It can't be ruled out after Fed officials Rosenberg, Kaplan and Clarida’s resignations due to possible insider trading allegations in September 2021. Who would have thought that sitting on the Open Market Committee would be a top source of insider trading information?
Saudi Arabia used to be the US's BFF, but not any more. Even the famous fist-bump between Biden and MBS in Riyadh seems to have faded into distant history. OPEC+ recently announced they are cutting oil output back by 2 million barrels per day. Have the Saudis become Russia’s BFF now? The reasons given are economic but it is all political in nature. Simply put, pariahs do not like being called a pariah. The problem is that no one can think more than one move ahead. Perhaps they can learn a thing or two from chess grandmaster Hans Niemann.
Oil prices have already reacted upward since the announcement of the cut, with Brent pushing past $95 and WTI following suit as well. Given how strongly Biden seems to have threatened MBS not to do this, it seems like we do not have the influence we used to have in the Middle East. The possibility of gasoline costing more than $4 in November will keep any democrat up at night, especially given recent memory the Keystone pipeline debacle. Chickens seems to have a habit of coming home to roost.
The US did manufacture some minor relief from elevated gas prices recently, by drawing on the Strategic Petroleum Reserve (SPR), which is down to almost 400 million barrels from 660 million barrels. It is supposed to be for emergencies like wartime, but the administration is instead using it to manage prices at the pump. But, there really isn't enough oil in the reserve to do that - the US uses about 20 million barrels a day, meaning the entire reserve only consists of a 30-day supply. Furthermore, the Saudis can cut a lot more than US can release from SPR. The SPR has truly turned into the SMR, the Strategic Midterm Reserve.
Or is it actually "Debit Suisse," as some are calling it? Both CS and DB have been doing terribly for many years. Credit Suisse has had unique problems with management credibility, top-level turnover, and risk management. They lost $5 billion when Archegos blew up, $2 billion on Greensill and were was taken to cleaners by the likes of Goldman Sachs and JP Morgan. These gaffes have shown that the quality of the management at CS is questionable. Deutsche Bank is a similar sad story. The concern is that one or both of them will become insolvent, just like Lehman Brothers. However, the numbers do not justify this yet. In the credit default swap market, where insurance on the event of these banks defaulting is traded, there is a spread of about 3% over the next year. It is not zero, but not signs of an imminent default just yet.
The UK government thinks it is still the world’s eminent power, believing that they can cut taxes and spend their way out of financial difficulties and too much debt. If you have too much debt, just print more money and issue more debt, they seem to think, even when the standard advice that Greeks and other developing markets get by the likes of IMF and World bank is to tighten their belts, consume less, and reduce their debt. Ms. Truss got a rude shock when the bond market dropped by 24% in a couple of days in reaction to her plan to eliminate the top tax rate and increase spending. Perhaps it's time to call the IMF again hat-in-hand, like what happened in 1956 post-Suez?
If you are, in fact, a world leading economy and you have a recession or have too much debt, you can just lower the interest rate and stimulate the economy. However, the UK is finding out the market instead treats them as an emerging market economy, similar to Greece and Turkey, for example. So when they announced they would be cutting taxes and stimulating the economy, what happened? The market said, "You can’t do that. You have too much debt already." The price of their government bonds, called gilts, reacted immediately, driving the yield of the 30-year gilt up to over 5% at their peak on that day, it's highest level since 2002.
The elimination of taxes meant that the government would have to sell more bonds. On top of that, the Bank of England said they would raise interest rates, and would also have to sell bonds. So bond prices fell substantially, and pension funds with leverage received margin calls. So they also had to sell bonds to cover their margins. If everyone was selling bonds, who would buy them? Not many, as it turns out.
In order to avert catastrophe, the Bank of England changed course 180 degrees and indicated that they would start to buy bonds for 14 days. This temporary move appeared to support the market, as the Bank of England apparently has some credibility left. However, the relief will only last two weeks, and then the BOE will resume selling again. So the big question is, is the problem gone, or did it just go away for two weeks? We will find out soon. If the price of gilts fall again, it indicates there is a very serious credibility issue at hand.
What you see here is like the right hand doing the opposite of the left hand. One side wants to tighten, the other wants to stimulate. They cannot decide what they want to do. These kinds of shenanigans, where the government is facing record inflation and then decides to add more money while telling BOE to sell more bonds and remove liquidity from the market, typically don't happen in developed nations like the UK.
With all this talk about the UK, it is not like US is in a radically different place. It has more debt than the UK, and prices are down across the board from highs: 20+ year treasuries are down 27%, the S&P 500 is down 24%. It suggests that there may be hidden problems. US bonds are down 27%, yet these are supposedly risk-free bonds issued by the Treasury.
Mortgage rates are up to 6.6% and housing prices are down two months in a row. With so many cracks forming, the Federal Reserve held a secret meeting this week to discuss what's called the "discount rate". The Federal Reserve discount rate is the interest rate it charges to banks it loans to directly. Not to be confused with the Federal Funds rate, which is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.
The discount window is available to US banks in emergency situations, and it has a terrible stench associated with it. Even talking about it implies there is an emergency. No bank can dare to borrow at the discount rate for that reason. If they were to go to the discount window, all the other banks would assume they are insolvent and shun them. If other banks shun them, their problems will only accelerate. So, banks cannot just go to the discount rate and borrow unless they are desperate.
The Federal Reserve Board of Governors meeting is secret, and unusually, we do not know exactly what they talked about. They held a closed meeting, which they can do under "expedited procedures". It appears that they are talking about reducing the discount rate and taking the stigma away. One way they can do this is to force every bank to borrow at the discount rate, regardless of how many of those banks actually need it or not. This way, the banks that are in trouble can hide among the crowd and get the liquidity they need without raising a three-bell alarm. Again, this is just speculation. If it is the case, it suggests the Fed is trying to be proactive to prevent what happened in the UK from happening here.
GDP has gone down for two straight quarters, indicating a "technical" recession, but the labor market is really strong. How do we reconcile this? GDP has come down for two quarters, but we note that the prior growth in GDP was stronger than the corresponding growth in the labor market. Therefore, the economy was never able to hire at a level that would have been implied by the growth in GDP we experienced. Many people prefer not to work for various reasons. Some feel that the salaries are too low, some are retired, and some folks have enough savings and decide to postpone work.
Given the actions undertaken during the pandemic, many firms have been running on an emergency basis. Now they are trying to hire to make up the gap, which is why there are labor shortages. Moreover, the decline in GDP we have seen recently is not that big, with less than 1% declines each quarter. Initial jobless claims are still low, suggesting the labor market is still strong. It does not feel like we are in a real recession yet, even though GDP has fallen for two straight quarters. That pain of course, could still be yet to come.
If you found the above content informative, you may be interested in the new service we just launched in collaboration with University of Michigan Ross School of Business Professor Nejat Seyhun. Intended for money managers, day traders, and investors of any size, insidersentiment.com tracks aggregated insider trading indicators for a variety of investment styles and can help you stay ahead of the market. Additionally, you can also follow this free blog, where we write on insider trading in general as well as recent trends.