Green Shoots lead to (Over?) Confidence

• 15% of Leisure and Hospitality Jobs return in May;
• S&P 500 ~46% Rally in 11 Weeks; and
• 10-Year Yield Rising… Could Debt Pain be Coming?

The market is 1000% confident this recovery will be v-shaped. 

At one point today the Dow was 1,000 points higher…  extreme optimism is in the air. 

And who knows – maybe the market will get it right?

For me, the general theme for stocks over the past 11 weeks has been either:

(a) bad news isn’t actually bad news (i.e. best ignore it); and
(b) any hint of good news is great news. 

For example, so called bad news like “20-40M” jobs lost was irrelevant.

Who cares (especially if we have the Fed to buy all assets at any price)? 

But give the market a breath of good news (e.g., advances with therapeutics or vaccines) and the market took it with both hands. 

Today was a good example of the latter…

The Labor Department surprised everyone with the news that 2.5M jobs were added for the month of May. 

That’s an impressive number when you consider we are barely two-three weeks into reopening the economy. 

Here’s the thing:

The US economy lost no less than 20M+ jobs over the past two months or so… so it’s fantastic to see maybe 10% of these return. 

Question is… what’s going on with the balance? 

Largest Monthly Jobs Gains Ever

The word unprecedented is now an overused term this year. 

But there is a good reason… almost every metric to hit the tape is just that. 

It’s been a crazy year…  and we’re barely half way.

Remember:

There’s a Presidential election in a few months… who knows what mass hysteria (from either side) that might bring (another conversation). Political tensions are at extreme levels in the US…  moving on.

This week we had the largest monthly jobs gain ever recorded (which makes sense after the largest ever monthly loss)

But don’t be fooled…

This chart from CNBC shows the change from the previous month only.

Put another way, what it doesn’t show is the aggregate change.

In other words, those 20.7M jobs lost in April are not all back (however the chart gives that impression)

There’s no surprise the jobs being added were in the sector which was immediately hit.

For example, leisure and hospitality added 1.2 million jobs… which helps to offset some 7.7M jobs lost in the sector over April.

You could say the industry has re-hired ~15.5% of the gig-economy workforce.

Readers may recall me suggesting about four weeks ago that I would personally like to see 50% of the jobs recovered within three months. 

Anything less – and we might have a longer-term problem.

15.5% in the hospitality and leisure sector is a good start for the first month of reopening. 

Green Shoots?

Grannis asks the right questions. For example, are

(a) stocks overbought; or are
(b) investors over-confident?

I suspect it’s a little of both…. and it’s hard to pinpoint if it’s more of one or the other. 

I will take a look at the weekly chart (with various indicators) shortly to see if we can answer (a).

But first – let me share three of the “greener shoots” from his blog… 

Financials Conditions Index

Grannis points to something called the Bloomberg Financial Conditions Index. 

He says:

“… thanks to aggressive Fed action to supply much-needed liquidity to the banking system, over financial conditions have improved dramatically. We’ve never seen such a rapid rate of financial healing after a recession.”

Sure…

We could equally suggest we have never seen an incremental $3 Trillion added to the Fed’s balance sheet in a handful of weeks.

Right?

Not sure the right word is “healing“… but I understand the sentiment; i.e.. companies that were barely solvent (e.g. Ford, Cruise Lines etc) are now kept alive thanks to the Fed backstopping higher risk debt. 

Whilst I appreciate (and recognize) some of the early green shoots coming through…  there’s a long way to go. 

But we have to start somewhere… 

The self-inflicted economic damage from the government is going to take time to repair. 

As an aside, I think much of this is spilling over to the civil unrest in the US (i.e., not all of this uprising is in relation to the brutal murder of George Floyd by a few bad actors in the police force)

Beyond this (and purely from a market perspective) – what I worry most about is any rise with this 10-year bond yields:

The last chart from Grannis I wanted to share was what we see with ISM service sector (and its recovery)

5-Year Credit Default Swaps

Credit default swaps are key to the financial markets health. 

Any sharp spike in these instruments has typically led to a painful recession. 

Grannis regularly explains that when liquidity is abundant and the economy is expanding, the risks to corporate profits decline.

Spreads are still somewhat elevated, but they have retreated meaningfully from the edge of the abyss (again, mostly due to the Fed’s injection)

ISM Service Sector Survey

The last chart from Grannis I wanted to share was what we see with ISM service sector (and its recovery)

We see a sharp bounce from the lows – consistent with the broader recovery sentiment. 

But not unlike what we see with the jobs – things are still a long way underwater and we need to see several more months of follow-through. 

A good start – but more to do. 

Rate Pain Ahead for Borrowers?

Whilst I appreciate (and recognize) some of the early green shoots coming through…  there’s a long way to go. 

But we have to start somewhere… 

The self-inflicted economic damage from the government is going to take time to repair. 

As an aside, I think much of this is spilling over to the civil unrest in the US (i.e., not all of this uprising is in relation to the brutal murder of George Floyd by a few bad actors in the police force)

Beyond this (and purely from a market perspective) – what I worry most about is any rise with this 10-year bond yields:

US 10-Year Yields – 90.2 bps – June 5 2020

Today bond yields on the 10-year are just 90.2 basis points. 

The “good news” is they are off their lows of 54 basis points in March. In other words, bond investors are feeling slightly more optimistic about the recovery. 

I would not use the word optimistic — as they are still below 1% — but there’s been a slight improvement.

The “bad news” is any rise in the 10-year yield means rising interest rates (as they two enjoy a close correlation)

For example, CNBC reported today “… the average mortgage shopper may see rates on the 30-year fixed as much as a quarter point higher, said Matthew Graham, COO of Mortgage News Daily, which runs daily averages from lenders”

As I say – ‘good news’ in the sense the bond market is feeling slightly less risk averse – but ‘bad news’ for an economy loaded with debt (which includes home borrowers, corporates and of course the government). 

To be clear… the rate on the 10-year note is not a concern today. 

Put another way – I don’t see some massive exodus form bonds – in turn sending yields sharply higher. 

However, should the economy begin to recover, then we should expect yields to rise. 

On the other hand, if yields fail to gain traction, then it tells me the bond market remains less convinced about any so-called v-shaped recovery. 

S&P 500: Record Highs this Year?

If you had forecast the stock market was going to make a record high this year after falling ~35% less than three months ago – I would have asked what drugs you were smoking?

Then again, if you told me the Fed Reserve was about to inflate their balance sheet to $6 Trillion ($3T incremental to where we were last year) and for the government to pass over $2+ Trillion in relief funding… I would have also asked the same question. 

But here we are… ~6% off the all-time high. 

Mind blowing from where we were on March 23. 

But as I said last week…. momentum is with the bulls and there’s reason it can run further.

S&P 500 June 5 2020 – 46% Rally in 11 Weeks

As it turns out, the weekly-MACD indicator (not shown on the chart above) was right with its bullish signal 5 weeks ago. 

I said to readers this has a tendency to warn of immediate buying pressure (despite the weekly trend remaining bearish)

Today I want to draw your attention to the Relative Strength Indicator (lower screen)

Not unlike the weekly-MACD – I don’t like to use this as a trading indicator in isolation (however I appreciate that many people might). 

But what this potentially shows me is extreme overbought or oversold dynamics. 

Highlighted are the previous two overbought (and oversold) instances over the past three years. 

What’s important is these conditions can remain in these extreme zones for several weeks. For example, the overbought situation in the last quarter of 2019 was in play for 6 weeks before the market eased. 

Today the RSI(14-period) value is 58. 

This is not even close to the overbought range of 70. Put another way, this rally could easily extend for a few more weeks. 

I don’t think you can short the market here (not aggressively) – but I also think it’s dangerous to buy. 

Put another way, I think the downside risk taken here outweighs the upside reward (especially given how optimistic the market is on the various unknowns).

This means I have not participated (in a meaningful way) once the market exceeded 2800.

I have placed a handful of small trades (e.g., selling naked puts on JPM, AAPL, BAC) and some credit spreads (not all of them profitable) – but nothing to move the needle on my portfolio’s performance. 

As I was saying recently, when I place a trade, I want the upside reward to be at least 2x the risk taken. 

That’s my personal minimum (but this will be a function of your own trading model).

Example of Risk / Reward Logic

Let’s say I bought the S&P 500 here at 3191.

As part of that trade – I identified a stop-loss at 2800.

In other words, if we traded through 2800, I would cut the trade 

That would represent 12.3% of downside risk – where I would allocate capital that only saw me lose no more than 2% of my total capital.

Therefore, with this risk profile – the question is does placing a long trade at 3191 mean I will realise at least 25% upside? 

I don’t see it. Maybe you do?

Now I would not be surprised to see perhaps 5-10% upside (best case)… but not much more in this environment.

So why take the trade? 

My preference is to wait for a pullback to say 2700 to 2800. 

Here I might place a stop at 2500 – which would mean a potential downside move of 11%. 

Again, I would allocate capital that meant if the trade dropped 11% — I would only lose 2% of my total portfolio’s capital.

But the same question applies…

Do I see a 22% upside reward if entering at say 2800 (vs the 11% downside risk)? 

That would mean the market rallying back to the previous February high of 3400.

To me that is a higher-probability trade (and the way I think about it).

As a final note – this reminds me of how I traded through December and January last year. For example, my portfolio was mostly flat during that time – as the market looked overbought (as I showed above). 

Guess what – the market went on to outperform me by ~5% to close the year (after I was in-front all year).

In early March – all that changed.

At the time, I sat mostly in cash (excluding a long position in Amazon and a short on the AUD) – the market collapsed however my portfolio was mostly protected. It saw some downside (as Amazon was initially sold off) – but not the extremes we saw on the broader market. 

Today things feel somewhat similar.

The market outperformed my portfolio last month by a good 5-6% as I didn’t participate in the rally post the level of 2800. 

And that’s fine.

I will choose to trade when I think the risk/reward is more favourable. This means under-performance in some months… and out-performance in others.

Putting it All Together

I might sound like a broken record (and I might be wrong) – but I think you tread carefully here. 

So far, it has favoured the risk takers (and I tip my hat to them). 

I’m far more conservative with my own trading… because it suits my risk profile. 

In closing, I still think it’s too early to say “… the job numbers show the market got it right” (as Jim Cramer from CNBC suggested). 

Better language might be “… the market might have it right”

One hot month certainly doesn’t make a summer. 

Again, only 2.5M of over 20M jobs lost have been added back.

That’s encouraging but let’s cheer loudly when we see “5M more” of those jobs added back in July (and then 5M more the month after that). 

Yes – there are green shoots – but you won’t see me running any “victory laps” just yet.

My sense is there’s a lot more work to do before we recover from this self-inflicted (government-led) mess. 

Regards
Adrian Tout