Weekly Plan 3/19/23

Traders-

A week may last only 168 hours, but there is a lot to unpack from the events of last week. Let’s give it a shot.

I am not going to get into the events of last week, which by now are common knowledge amongst market participants. I am instead going to share how I personally see them shape the future in plain English devoid of any technical “mumbo jumbo” jargon.

Last week was eventful. No doubt about that.

How will it impact the current trajectory of market momentum? Let us dial back about a year or so to gain a higher level perspective on what has been shaping the recent price action:

1. I had been bearish on several smaller cap names and funds like ARKK even before 2022 even started. Market momentum in these names, the likes of which we see in the Russel index, had started turning south in late Summer, Fall of 2021 itself. By end of 2021, many of these had been cut in half. Some even more.

2. Then at the start of 2022 is when the contagion spread to larger caps , the ones we tend to see in the S&P500 and Dow Jones. This is where I turned bearish on the general market to see it cut down by almost a fourth by Fall of last year.

3. Last Fall or so, some life has been infused back into these battered stocks and many of them are now up quite impressively. Names like TSLA and NVDA have more than doubled.

This ebb and flow in the markets has been dominated by a handful of themes. In fact if you relied on these themes, you have been able to identify these 400-500 point ranges in the S&P500 index all through last year and a half. I have myself been actively sharing these ranges in this Substack as part of my personal blog and journal on where I see potential support and resistance come in. In fact as recent as last September/October, I shared my views how I see the market bounce up from 3500 into 4100 or so. As recently as February I shared the 4200 key level with my opinion how I see a 400 dollar move come out of that level to trade back into 3800-3900. These are but a couple of ranges that have formed in last year or so which I have shared in this Substack with folks.

So what are these themes that have driven the market action? By and large, no more than 3-4 main factors:

1. Inflation- inflation has ran hot in last year and a half. Hotter than any one expected. Much hotter than the averages of last few decades.

2. FED response to this - the FED has aggressively raised interest rates in face of 40 year high inflation. Albeit they started slower than many expected, they did make up a lot of ground and brought rates from near 0 to almost 5%, within a year or so. While FED has been aggressive with the rates, it has been a sloth when it came to unwind of it’s balance sheet.

3. War and supply chain issues- there also has been a war ongoing for over last one year now in Europe. There are also lingering impacts from the Pandemic response, specifically to the labor markets and distribution channels. The long term characteristics of the labor market and how companies source their products or raw materials have been impacted by these issues.

Western economic system is a credit based system. Most advanced Western countries do not produce a significant number of finished products but are at the forefront of innovation in science, technology and financial engineering/services. Debt is an essential part of the Western economic system. Most of us at an individual level know debt first hand in one or all of 3 ways - a) Home loans, b) Car loans, c) Credit card debt. Then there are debts that deal with the Corporate America - which is a different topic altogether.

Bottomline- the American economy in large part is a function of credit/debt, which in turn is a function of the interest rates. When you dial down the interest rates to near 0, credit creation blooms, the economy takes off which in turn fuels the markets higher. Similarly, when you dial the interest rates up, credit dries up, which cools down the economy and can lower the market returns. The Federal Reserve uses these interest rate levers to try and control the economy, in a belief that this can regulate the prices of products and services. They have to. Price stability (aka lower inflation) is one of the founding reasons for the FED to exist. We will not get into the discussion whether this is the only (and better?) ways to regulate inflation in this particular blog.

However, the FED has other roles as well, some of them are not as well marketed as “Max” employment and Price stability.

Before there was ever a FED, a 110 years ago, there used to be bank runs. A lot of them. Unlike today, there were no FDIC protection or bailouts for the depositors. There was also no Federal level income tax before the FED. So, the FED does have a role to play in effective functioning of the US banking system, which can be read of as making sure there are no banking panics and crises.

Why do I bring this up?

Two reasons.

Both stem from the fact that whenever the FED raises interest rates, it ends up breaking something. This has always been true and this time was no exception.

1. The events of last week could fundamentally alter the main assumptions or thesis that the market participants have been leaning on for over last one and a half year now.

2. This may call into question the FED resolve and inclination to fight inflation.

Simply put, last week’s events have generated extra questions for this market to resolve:

1. Are we now seeing a QE5? Has the FED embarked on a massive Quantitative easing program yet again?

2. What is the extent of the rot that led to events of last week? Are there many other financial institutions at brink of ruin?

Regardless of what any one else says, I am not sure about # 1 above. And I am pretty sure about # 2 above that there will be more shoes to drop.

I personally think, unless you can answer both # 1 and # 2 above, there will be a cloud of uncertainty hanging over markets AND markets do NOT like uncertainty.

If you were active in 2000 and 2008, you know how widespread the systemic damage done by follies of those crises was. It was several hundred billions of dollars worth of damage.

In 2023, it is different.

Let us assume the current crisis is solely due to banks’ unrealized losses due to their exposure to government issued debt. While this is extremely unlikely, but let us assume this is indeed the only cause to worry and there are no other problems in the system.

Given this assumption, can any one say with any surety that the SVB and FRC were the only 2 banks in trouble with this?

I can not.

Look, the US government bond market is the largest market in the world. Nothing comes even close to it. Not even the daily turnover in all S&P500 stocks. To say that only 2 regional banks made bad trades in this market, is a little strange to my ears. What is a a bad trade in this case anyways?

Are we saying buying US treasuries is a bad trade now? If so, I am afraid there could be trillions of dollars in bad trades out there, not just in the US, but globally.

So where do we go from here?

I see broadly two paths emerge from here. I favor one of these more. I will share below which one I favor more so keep reading.

1. The FED is going to give up it’s fight against inflation by starting a massive QE 5 program again.

2. The FED is going to keep trying to fight inflation but will probably minimize or even eliminate any collateral damage to the American public. In this case, they are acting as a temporary lender to banks in turmoil but are not adding any extra liquidity in the system thru asset purchases.

Wanna guess which is more likely? Cast your vote below.

For me, this comes down to bigger of the two evils. It is as simple as if inflation is worst or a complete collapse of the US (and probably global) banking system. Depending on who you ask, the answer may differ.

Due to all these newly introduced uncertainties, there won’t be formal levels for this week.

Nah ;) Sharing my most favored outcome and a few levels of interest to me below.

There is no doubt we have seen an increase in uncertainty over last few days. No one likes uncertainty in their life, the markets certainly hate it.

But is all uncertainty created equally? What is this uncertainty all about?

The cause of this latest bout of uncertainty is a bank run. Depositors were set to lose millions. The FEDs stepped in and saved the depositors. The balance sheet exploded in one week and the market assumed it is a new round of QE.

But is it?

FED balance sheet. Source: FRED

My take on this is that the government had to step in. They had to, there was no other choice. What will you do? I would not read too much into this. I do not think this one episode really fits the definition of a classic bailout. Atleast not for me. Atleast not yet.

However, I will leverage the FOMC event set for next Wednesday, the 22nd to glean some key clues.

I have always maintained the markets may be close to a bottom when the FED begins panicking and I will be looking for this panic next Wednesday. To quantify the FED panic, I have the below 3 key scenarios with one outlier: