Lots of moving parts - pulling it all together

 There are so many moving parts and these parts are moving quickly rapidly. I endeavor to look at the market through three separate lenses - fundamental, behavioral and catalyst. Each week I look at one category and then pull it together in the last week of the month. However, with the developments in Ukraine (pray4peace) leading to rapid spikes in the commodity complex which affects central bank policy, a lot has happened in the last month. 

The biggest deterioration we have seen in our view of the market has been in the Fundamental section. At the start of January, the Fundamentals of the economy and therefore risk assets still looked pretty good. Yes, the economy was set to decline but gradually and from multi-decade highs. Inflation was high but thought to come a bit lower as well so we knew the Fed and other central banks would remove liquidity but there were only about 3 hikes priced in at that time. Everything seemed to be normalizing at a digestible pace. By February, it was clear inflation was not an anomaly as many thought (we have been naysayers on the transitory argument for over a year) and the Fed was solidly in play. The number of rate hikes moved rapidly up to 7 in the next 12 months. Combined with the tightening moves by other central banks globally, the expectation was that we were in stagflation and there was a risk of deflation (falling growth and inflation). Here we are now as we exit February and those smaller odds of deflation (recession) have ticked even higher due to the invasion of Ukraine by Russia and the expectation this global uncertainty and spike in prices will weigh on global consumer behavior. This is now the working assumption of many in the markets I would suggest. 

First, if we look at some charts from Nancy Lazar at Piper | Sandler who is consistently ranked in the top 2 of Wall Street economists, we can see this recession view taking hold. These are her models of global growth using global short rates and the price of oil. It is a decent fit and even if she is only 2/3 right, it paints an ugly picture:

 

If I combine the views of JPM economics team, this growth scare will be met by persistently high prices such that the central banks have to continue to tighten even with falling growth. I think it is more than just anecdote at this point that we are all feeling the pain of materially higher prices in everything we buy. 

 

This is your classic stagflation. In this phase of the economic cycle the only risky assets that do well are commodities and commodity stocks. Incidentally, that is exactly what is happening right now:

 

The concern here is that we tip into deflation when the only thing that does well is cash, and right now cash pays us nothing. 

We know the economy drives earnings and earnings drive stocks. This is the relationship of forward earnings and GDP:

 

This is the relationship of forward earnings and stock prices:

 

Yes multiples do matter. Multiples are horrible short-term timing indicators but matter considerably in the long-run. The price you pay affects your returns. However, multiples are impacted by real interest rates. As these rise, multiples will contract. Thus, we cannot expect much support from this:

 

So we need economic growth to drive earnings and therefore risky assets. It just doesn't look like it will happen. ISM leads GDP so we care about where it is going. What are good anticipatory indicators of ISM? The ratio of new orders to inventories as well as the yield curve. On both fronts, the picture on economic growth does not look good:

 

Over the next week will get more economic data that could sway our opinion as well as the Fed's. However, as it sits now, the fundamentals for risk do not look that attractive. 

The next lens I look through is the supply/demand view of the market. I call this the behavioral view. I look at a variety of measures that consider flows, sentiment, options markets and charting. This is one area that has been negative all year long and moved me to the sidelines early. At this point, there are some signs that we might be at peak fear as I wrote on Linked In this week. On others, it reminds me of the quote in Harry Potter: "Hold on Ern, it's gonna be a bumpy ride". 

If I could only look at one metric it would probably be the ratio of put volume to call volume or Put/Call ratios. I look at the equity only measure and smooth it out to eliminate some noise. However, when this turns higher, it is clear investors are getting nervous. When it turns back lower, regardless of the absolute level, it is time to take some risk. Right now, there is still a good measure of nervousness and caution in the market. The flows yesterday after the war started showed some amount of closing or rolling hedges so this might turn back lower soon. For now, it signals caution:

 

Another way to see this caution and to try and measure the extremes is to look at the shape of the VIX futures curve. Routine hedging tends to be down 3, 6 or 12 months out. However, when investors are nervous, it comes to the front part of the curve. So the futures curve tends to be in contango but can switch to backwardation for periods of nervousness. Implied volatility is mean-reverting and we will go back eventually to the normal condition. Thus I look at the shape of the curve for a guide to extremes. Extremes are when the front month moves about 5 points higher. We aren't even close yet: 

Another measure to consider for extremes is the global financial stress index or GFSI. It is definitely elevated, however, you can see there is a lot more it could do:

 

There are a couple measures that point to some extremes. The first is the ARMS Index which measures the volume of down stocks vs. the volume of up stocks. This got extreme and even started to reverse. This was some of the price action we have seen in the last two days. This is a positive but it is a very short term indicator:

 

Finally, there are many surveys I consider but probably the best single one is the AAII bulls minus bears index. It measures how many bulls are out there relative to the number of bears. When one groups gets more than 20 percentage points above the other, we tend to see reversals. We are there:

  

I look at daily, weekly and monthly technicals. I will just tell you it is a clouded picture. Short term charts are oversold, medium term look like they are breaking down and longer term charts still suggest the uptrends are in place. So the charts really depend on your time horizon. 

Pulling together the behavioral section, while we have seen some extremes, some metrics showing peak fear, we are not there yet across the board. 

The final section I look at is the catalysts section. I historically look at three components - earnings surprises, economic surprises and geopolitics. I will briefly touch on the first tow because geopolitics is all that matters.  Economic surprises right now are pretty muted. The idea that we are still gradually moving into a slowdown is priced into the market. Here I look at US, EU and China:

 

Earnings season was largely a positive however there are diminishing marginal returns. The sales and earnings surprises were at the slowest rate in several quarters and the reactions to the news were generally negative:

 

I don't need to show you a chart to tell you the picture in Ukraine and the end of the post Cold War period is a negative for risk. There will be more fallout for all of us. Sanctions will be a tax on all global consumers to some extent. There is the potential that the lack of a reaction toward Russia in attacking the Ukraine will embolden China and Iran. All three may see a fractured NATO which has weak leaders in every single country. The citizens of these countries have little appetite for actual war. Despots in Russia, China and Iran know this. The only question will be how much they push the envelope. 

When I pull it all together, it is difficult to come out as anything but negative. The fundamentals are weakening, we are not yet to extremes in fear and the catalysts are all neutral to negative. Yes, I can see scope for a bounce near term. I can see data that prompts the Fed hawkishness to back off. I can see Russia installing a puppet government and things going quiet for a bit. However, the best I can say is the market is going to be rangy and volatility. The worst is that we could still test lower. I would urge you to continue to maintain as convex a portfolio as you can. 

Most importantly - Stay Vigilant.  

(All thoughts are my own. All charts are from Bloomberg unless indicated. This is not investment advice, I just want to help you ask the right questions. Please do your own research.)