February 12, 2023 – Entering 2023, the consensus outlook forecast that the first half would feature weak stock market performance with a recovery in the back half of the year.
As is usually the case, the consensus has been way off thus far. Nevertheless, the equity market got off to a rockin’ start after a bear market in 2022.
In addition to the broad-based rally in risk assets, there has been a surge in the most speculative investments, augmented by a particularly nasty short squeeze. The lowest quality and most shorted stocks were up more than 20% on average a few weeks into January.
Source: Wall Street Journal
In fact, January’s returns can be characterized as the exact opposite of 2022. What got crushed in 2022 has produced leading returns year-to-date, and what outperformed last year has done poorly recently.
Source: Goldman Sachs
A portfolio of meme/YOLO stocks, money-losing businesses, and highly shorted securities have outperformed significantly while last year’s winners suffered. This dynamic is sometimes referred to as a “dash for trash”.
Unfortunately, one of the key lessons of 2022, that mindless speculation is damaging to one’s net worth, has been quickly forgotten.
A market rally that is driven by technical factors such as short covering instead of fundamentals such as attractive valuations or an accommodative Federal Reserve likely lives on borrowed time.
Supporting the rally in speculative assets is an army of unsophisticated retail traders. As a result, what once was thought of as a unique phenomenon related to Covid, retail stock speculation has come roaring back.
Retail investor participation in the stock market has jumped to fresh all-time highs. Retail participation is the indicator that tends to peak at the market highs, not the lows.
During the pandemic, a not insignificant portion of Government stimulus cheques was utilized by retail investors to speculate on leveraged stock market bets via call options.
This activity did not die when people gave up as would-be day traders and went back to work. The speculative juices are flowing well as daily call options volume has spiked to new records.
Extreme greed now rules the roost in the capital markets. Several market indicators are flashing warning signs to intelligent investors. As the greatest of all time once said, be “fearful when others are greedy, and greedy when others are fearful.”
Just as Icarus got burned when he flew too close to the sun, overexposed investors risk potential ruin by making risky bets if the market’s sentiment pendulum swings in the opposite direction. The recent surge in speculative investment has made the capital markets vulnerable to a sudden and sharp decline in asset prices.
After January’s speculative fervour, fear is nowhere to be found while a myriad of signals is flashing greed. Discerning investors should take heed of what the market is telling them.
The jump in highly speculative securities, the surge in retail participation, and the spike in call options activity are hallmarks of a reckless market environment. These market signals highlight investors’ expectations that the market environment of late 2020 will return, meaning the potential for 0% (or negative) interest rates.
Given the inflation rate is still above 6%, and the Federal Reserve has indicated that its rate hiking cycle will continue, a return to the YOLO market of the post-Covid, 0% interest rate-driven rally seems rather unlikely.
In last month’s memo, “Diversification Pays Off“, the yield curve was highlighted for its effectiveness as a recession indicator:
“The best recession indicator we have is the yield curve. It has correctly forecast, through a yield curve inversion, each of the past five recessions (a much better track record than any economist!).
Currently, the yield curve is at its steepest inversion in more than 40 years. This leading indicator is screaming recession.”
The most consistent and effective predictor of a future recession, the 10-3 yield spread, is now signalling an economic downturn within the next twelve months. This spread has gone negative only eight times in the past fifty years and all eight times have been followed by recessions.
Another effective economic indicator is the unemployment rate. Many push back on a 2023/2024 recession forecast given the low unemployment rate, supporting the view that the economy is healthy and won’t suffer a setback.
Unfortunately for the recession skeptics, the unemployment rate is always the lowest before a recession commences.
Historically, the boom-and-bust business cycle has featured an overheated labour market and too-high inflation which the central bank tightens monetary policy to tame. Traditionally, the central bank raises rates and puts the economy into recession to get inflation and the labour market back under control. Unfortunately, this cycle is playing out once again.
While market prognosticators have paid much attention to technical factors and recession indicators, ultimately, what drives the stock market returns is earnings. Ergo, earnings growth can be a potent elixir for the stock market bulls while a decline in earnings usually satiates the bears.
From a fundamental perspective, the current trend in earnings should give investors pause.
Consensus forecasts now point to a year-over-year decline in S&P 500 earnings this year for the first time since 2020 and the fifth time since 2000.
Historically, bear markets and market corrections have commenced after earnings growth goes negative. The double-digit decline in earnings of 2001, 2008, and 2020 produced memorable bear markets for stocks.
After a speculative surge caused by technical factors to start the year, the stock market faces a possible Minsky moment, in which a seemingly stable market suddenly experiences a rapid decline in asset prices, leading to a loss of confidence and a chain reaction of selling, exacerbating the decline.
They often say “history doesn’t repeat, but it does rhyme.” The best playbook we have for the current market environment is the past growth stock bubble more than twenty years ago.
The last time the NASDAQ index was up more than 10% in January was in 2001. This rally occurred after a significant multiple contraction the year before. After the index’s bear market rally of January 2001, the NASDAQ continued to go down by more than -50% for the rest of the year.
After dropping nearly -40% in 2000, some stock market bulls got drawn back in during January 2001’s 11% bear market rally. Unfortunately, fundamentals, rather than technicals, drove the returns as the NASDAQ continued its sharp decline, falling -21% in 2001 and -33% in 2002. From peak to trough, the revered growth index fell by nearly -80%. Comparatively, amidst the popping of the current growth bubble, the NASDAQ is barely down -25%.
The central bank has significant influence over the direction of the stock market. Specifically, low interest rates lead to easing financial conditions and an environment conducive to a bull market. In contrast, high and rising interest rates lead to tightening financial conditions, which is not supportive of a long-term bull market. It is imperative for investors to observe that the Federal Reserve has given strong indications of a “higher for longer” interest rate environment, which will make for a potentially perilous environment for those long the highly speculative stocks that have skyrocketed lately.
If one adheres to the maxim to be fearful when others are greedy, now would be a good time to ease off the gas pedal, diversify, and implement some market hedges along with uncorrelated asset classes.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
ARB gained 0.6% in the first month of the year while its benchmark, the S&P Merger Arbitrage Index, fell -2.0%.
The Fund’s positive performance was buoyed as merger and SPAC yields declined by approximately 200 bps. In addition, specific positions, including the APE/AMC dual share class arbitrage, contributed positively as the spreads tightened with the deals nearing their closing dates.
Deal flow remains robust, with 23 M&A deals worth approximately $55 billion having been announced year-to-date in the U.S. and Canada. In addition, there have been 22 SPAC mergers announced in 2023 worth an aggregate of $11.5 billion along with 4 SPAC IPOs refilling the pipeline.
Currently, the ARB portfolio is allocated two-thirds to SPAC arbitrage and one-third to merger arbitrage. The Fund’s gross exposure (longs + shorts) sits at approximately 1.3x.
HDGE fell -4.2% in January as its short portfolio struggled amidst a challenging short squeeze.Specifically, multifactor long-short portfolios had their worst month in recent history, with the U.S. multifactor long-short portfolio dropping -16.0% and the Canadian multifactor long-short portfolio falling -14.1%. The momentum factor took it on the chin, as the short momentum portfolios surged more than 20% amidst the short squeeze while the long momentum stocks struggled, barely gaining 200bps in January. In addition, the value factor declined by approximately -10% as low-quality stocks rocketed higher amidst the speculative fervour.Given its high-beta short portfolio and low/negatively correlated return stream, HDGE generally does well in markets like 2022, when the S&P 500 dropped nearly -20%, but struggles mightily in speculative markets when junk stocks are soaring, as we saw last month.
In any event, robust risk management kept HDGE’s monthly decline far more manageable than the multifactor portfolios experienced. On a positive note, early February is trending positively for HDGE, as much of the speculative move in January has been reversed.
ONEC gained 5.7% in January, with nearly all allocations generating positive performance.
Bitcoin led the pack last month with a 39.1% boost, lifted by the dramatic increase in risk appetite. The other major alternative currency, gold, also saw a turnaround in investor sentiment as the yellow metal’s price gained 6.1%.
After suffering last year, real assets rallied back with real estate gaining 7.2% and infrastructure rising 3.3%. Similarly, risk parity bounced 6.5% for the month after a rough 2022 while the enhanced equity allocation gained 4.2%.
The private credit allocations generated low-single-digit returns, with the leveraged loan portfolio gaining 2.4% and the mortgage portfolio up 2.1% in January. Arbitrage served its role as a fixed-income diversifier and hung in there with a 0.6% monthly return.
ATSX gained 4.2% while its benchmark, the TSX 60, rose 7.4% last month. The Fund’s multifactor overlay declined by -3.2% as the short portfolio of junk stocks experienced a jump amidst the challenging short squeeze environment.
Similar to HDGE above, the Fund’s systematic risk management processes kept the long-short overlay portfolio’s losses far lower than the Canadian multifactor long-short portfolios -14.1% monthly drawdown.
While multifactor long-short investing can reliably produce alpha for investors over the long term, occasionally it loses money (specifically, during a highly speculative market). In addition, the Fund’s long-short overlay portfolio has historically added all of its outperformance during down markets.
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.