[Covariance]

I know it's impossible to tell until well after the fact, but I'm wondering if we might be in an actual bear market now. Looking at VT for world stocks, it looks to me like a down-trend. I think the more worrying part is that the MSCI EAFE is falling sharply due to the war and worsening business conditions in Europe.

Normally one would say "don't worry, the Federal Reserve will juice the markets and rescue stocks any moment" but they should be raising rates soon.

Or maybe the Fed will now give up, and leave rates alone? It would really be "out of character" for the Fed to actually go ahead with ending QE, while stocks are declining. But if they actually go ahead with rate hikes and ending QE, I cannot see how stocks can possibly go up.


What I'm doing: sticking with my existing asset allocation plan. I'm still 31% stocks today, more or less on target. However I do have a strong Canadian equity bias, and they've been holding up very well so far.

I'm not counting on the Fed to react to Equity prices, unless the market becomes dysfunctional or goes a lot lower.

Stability of bond market is where I'm focused. It is essential as it is the funding mechanism for mortgages, corporate and government financing and liquidity. It is a matter of fact that equity is of value only if claims to bond holders can be met. As a consequence bringing stability to the bond market, in turn brings stability to equities.

Vol and yields in the treasury bond market, and OAS spreads.

 

[Covariance]

Where it sits at the moment I would not be surprised to see the Fed and ECB diverge on rates here. And ECB put liquidity support measures back in or extend (did they ever really stop?).

That said, we are in a constantly evolving situation and it's all in play.

 

[Covariance]

The Fed does have one more tool up their sleeve: Yield curve control

Otherwise we could see an inverted yield curve

No, these are really inconsistent in this context. YCC acts on long yields and is used instead of going negative on short term yields to stimulate the economy (looser monetary policy). We invert when the short term yields go up, not down. Which happens because the Fed tightens.

 

[Covariance]

Do you mean the article is inconsistent?

I mean these two tools would not be used as suggested in the post as they would fight each other, not work together.

 

[Covariance]

Spill over coming out now. Initial hedge fund closures and the Nickel issue. Looks manageable thus far, but contangion is still a known unknown. Stay nimble.

 

[Covariance]

I think the down-market has resumed. I think we now get the next leg down.

Concentrated in US / tech / momentum stocks as before.

I also think ZWU (BMO's US low volatility index) has done a good job picking stocks that aren't vulnerable to this bear market. Year to date, ZWU is +7.5% compared to ZSP -7% which is incredibly good.

They are selling volatility and the up-side return potential of their stocks (covered call strategy). So they are actually just betting the stocks they own will go down, or increase less than predicted in the option market.

 

[Covariance]

Dudley, the former head of the NY Federal Reserve, said yesterday that the Fed has to tighten policy enough to make stocks fall, so that pain is felt in the stock market.

That's a flamboyant statement but is just stating the obvious and sometimes it's hard to take those people seriously. It's not their true objective of course, which is fighting inflation, but is an outcome none the less. The whole point of raising rates and QT is to reduce demand in the economy. If it is successful it will at minimum reduce pricing pressure on goods and services sold in the economy.

As an aside the only governors I listen to are the chair and vice chair. The rest are political, talking to their local audience.

 

[Covariance]

Anybody putting together a list for when the bear comes out of hibernation? Many interest rate sensitive stocks have already moved in anticipation of higher inflation and higher interest.

I've got a couple of different game plans mapped out, depending on how events unfold. That said, a bear is one scenario but not my base case. The economy is just to strong (at the moment anyway). Not that I see any run-up either.

 

[Covariance]

A nice video from a Bridgewater analyst.

The truth of this situation is: rising interest rates are just a bad environment for investors. It's going to hurt. That's because interest rates are the discounting rate for all future cashflows. Higher rates simultaneously lower the value of stocks, bonds, and real estate. That's just how the math works!

For years, I've been talking about how stock markets are propped up by low interest rates and central bank liquidity. Liquidity has driven such insane gains for 10 years, so I think it's natural to assume that stocks decline quite a bit when liquidity is removed.

I'm a bit overweight in Canadian equities and I think Canadian stocks will hold up better than American stocks. These American analysts are always mentioning "emerging stocks" but Canadian stocks actually have many similarities, with resource exposure and lower valuations. So I feel more confident about my Canadian stocks at the moment.

Wait 'til next Thursday. (Fed is out on Wednesday)

 

[Covariance]

Very high US inflation has increased the probability of more hawkish Federal Reserve action.

@Covariance any thoughts?

CPI is not PCE but it gave us a look, and the message is no slow down in the cadence of increases in Q3. Base case for some time has been 50 next two meetings (June, July, no Aug meeting). Sept looks like another 50 unless we have two or three prints of moderating core. The PCE for June release ( in July) is going to be a big day.

 

[Covariance]

By the way, check out the movement today in lower grade debt. Junk bonds (HYG) fell hard, -1.73%

Thanks. Had my eye on that but it’s completely normal. High yield and equities are correlated.

 

[Covariance]

Wow, bonds ETF are super scary, more than stocks.

Look at this on Portfolio Visualizer.

100% US Stock Market is currently in its 10th worst drawdown of the past 50 years.
100% 10-year Treasury is currently in its 2nd worst drawdown of the past 50 years.

Maybe by the end of this month it'll take the first place!

Not done yet, but somewhere I read the bond market had not previously done two negative return years in a row (in the modern era). I may have that wrong. Either way we are in exceptional times.

 

[Covariance]

I thought benchmark treasuries were now in the largest drawdown ever in history, but I could be wrong.

What's that thing people always say to me on this board? "Why would anyone ever hold a GIC?"

Cash has zero beta and zero duration. On a relative return basis it’s killing it this year.

 

[Covariance]

@Covariance are you leaning towards market timing (staying in cash) or staying fully invested, as a way to beat inflation?

I personally think that sitting in cash is a dangerous game.

Agreed. Sitting in cash is dangerous. I’m not a passive index investor so I don’t see it as moving in and out. My equity allocation is unchanged (from my TAA) although I would think people would call the sector exposures defensive and tilted to oil. Cash is part of FI allocation for me. I view as a zero duration floater and I’m comfortable market timing duration. So for the moment it’s a good place to be. We’ll see what the data tells us in the weeks ahead.

 

[Covariance]

Is it possible? A real bear market where the Fed doesn't swoop in to save the day immediately?

The last time we saw that was 2000-2002. Ever since then, the Fed has immediately rescued investors. This has conditioned stock investors to be fearless.

We will find out Wednesday. Maybe

 

[Covariance]

The Fed funds rate today is just 0.83% and even with a 50 bp hike, it will still be a paltry 1.33%

So when I say chicken out, I don't mean right now (they absolutely have to raise). Bigger question is whether they get to the 3% that the derivatives market expects near year end.

These rates are still VERY low. Even a 3% rate is extremely low, and we don't even know if they'll dare raise it that much.

Understood. I was referring more to their comments beginning in the press conference after the rate decision, and in days beyond when they expand on the cadence and quantum of future increases.

 

[Covariance]

I just got an update from my Bay Street contacts who say the derivatives market now points to 3.5% policy rate at year end.

And if we are referring to the US Federal Funds Rate the futures show it peaking a touch over 4% next May.

 

[Covariance]

El Oh El … ECB is already giving early signals of capitulation :

European Central Bank announces emergency meeting to discuss market rout

The issue is a more nuanced. Within the bloc the spread between rates of different countries sovereign debt has widened because of the different riskiness of some countries (eg Greece, Spain versus Germany). They need to keep the spread under control or the Euro will be no more. Expect measures to control the spread, not an about face on tightening.

 

[Covariance]

I hate to say this, but late last year my parents were happy to tell me that their financial advisor finally convinced them to buy a bit of stocks (they were 100% GICs). Something like 20% of their portfolio. Maybe because they could afford a bit more risk, maybe because I kept talking how I was 100% stocks, maybe because I said stocks aren't risky when they are part of a diversified portfolio.

Not sure how they feel at the moment. Not sure how their financial advisor deals with their reaction.

When someone bought GICs their whole life and their first experience in stocks is a -20% drop within a few months, that's one cold shower, even if it's only 20% of their portfolio in stocks.

I guess the right way to see this is their whole portfolio only dropped -4%.

FYI It’s Fathers Day this weekend.

 

[Covariance]

This is potentially a bigger deal than just the stock market declining. Pinging @Covariance

Some junk bond ETFs are trading at steep discounts to NAV

HYG was 1.2% below NAV
JNK was 1.8% below NAV, the worst dislocation since 2016

This means liquidity in junk bonds is very poor. This is showing credit stress. It doesn't necessarily indicate a crisis, but does show liquidity disappearing.

It might also make the Federal Reserve more cautious about aggressive tightening.

Article is referring to market conditions before the Fed meeting, over a week ago. It’s -0.11 now. Not to dismiss out of hand but that was a while ago. I can expand on credit indicators if interested, there are better signals.