iCapital Market Pulse: Fear Plus Terrible Liquidity Equals a Correction

---

You have to go back to March 2020 to find a drawdown similar to that experienced so far this month.
 
The S&P 500 entered correction territory on Monday—down 10% from its recent peak—while the Nasdaq is down 15% so far this month¹. Any recent rebounds have been fleeting, ending in sharp reversals by close of trading.
 
In this week’s commentary, we look at: what’s going on, when it might stop, and what investors should do in the meantime.
 

Negative fundamentals and terrible, horrible, no good, very bad technicals

The markets are clearly frightened of persistently high inflation and are concerned that the Fed has been behind the curve in reacting to it and must now play catch up. Compounding this, earnings growth is slowing, labor costs threaten corporate margins, and pandemic bottlenecks persist.

This is already a bad combination, and it is being exacerbated by market illiquidity as severe as in March 2020 and immense amounts of selling pressure from all corners of the markets.

• Liquidity: Indeed, the number of S&P 500 futures contracts on offer last Friday was the lowest since April 2020². This made it very difficult to move large amounts of risk in such a thinly traded market. And when selling pressure is so overwhelming, all else equal, this exacerbates moves to the downside.

• Selling pressure: Hedge funds, volatility-targeting funds, commodity trading advisors (CTAs), fund managers, and retail investors are all selling risk positions, though not yet to extremes.³ There are also non-economic sellers like trend-following managers that have to sell (irrespective of fundamentals) if the trend dictates. This could be when key moving-average levels are breached, like the 200-day moving average on the S&P 500 and Nasdaq, or when the VIX (a popular measure of stock market volatility expectations) spikes, as it did recently.⁴ In retrospect, many (including ourselves) underappreciated how much repositioning was needed after two years of (mostly) one-directional market upside, underpinned by extreme policy accommodation and a rebound in economic activity. This drove up certain valuations to extremes as investors crowded into the same trade – long risk, which now has to unwind as circumstances change.

It might take some time to work through this process to find a true bottom and, importantly, we need a catalyst (or two) to help find it. We could get one this week.

It stops when the Fed narrative changes

The Fed started this, and the Fed could stop it. Wednesday’s FOMC meeting will be crucial. Markets are terrified of the combo of slowing growth and tightening monetary policy. Fed vice chair nominee Lael Brainard’s statement that, “We have a set of tools—they are very effective—and we will use them to bring inflation back down”⁵ enflamed market concerns. It may be best for the Fed to deliver the message that growth is still solid, though slowing, and withdrawing accommodation is prudent when economic growth is strong—U.S. GDP growth is expected to be 3.9% this year. If the Fed Chair clearly delivers this message, markets might calm down, provided that the Fed indicates that there will be no more than four rates hikes this year and only hints at mid-year balance sheet run-off for now, in line with market consensus.⁶

But will it? What about 5.5% core inflation?⁷ How much does the Fed have to hike to stem this?

We think that the Fed does not have to hike rates for 7% headline or 5% core inflation, but rather enough to control 3% core inflation. According to estimates, pandemic-related supply constraints are responsible for close to half the current inflation overshoot.⁸ If the Fed hikes rates as if it is trying to control 5% core inflation, it risks overtightening and exacerbating the current slowdown.

The Fed cannot control employee absenteeism due to COVID. Instead, public policy measures to end the pandemic are the best tool to reign in this portion of inflationary pressures. In combination, the current Administration, state governors, public health authorities, and corporations can act to resolve these bottlenecks. Thus, we think the dovish surprise could be that the Fed focuses on inflation it can actually control, which should not require the degree of tightening that has spooked markets.

“If you are going to panic sell, panic sell later and get a better price”

This is one of my favorite quotes from a podcast we recently recorded (“The Long and Short of Tech Stocks”) with Honeycomb Asset Management’s David Fiszel, which he ascribed to Steve Cohen, his mentor for many years.⁹ Today it does feel like it is too late to panic sell many growth equities, some of which are down much more than the S&P 500. However, now that we are in a broad market correction and concerns about Fed policy mistakes remain, what should investors do? We offer 2 suggestions:

1) Rotation opportunities still make sense. One way or another we will be living in an environment of high shelter inflation, higher interest rates, and lower economy activity for the next one to two years. That’s the base case. Against this backdrop, we like opportunities in private credit and commercial real estate, which we highlighted in our 2022 Outlook. In public markets, we do not think investors should chase the value or cyclicals trade, as both manufacturing and services PMIs have been declining of late. Instead, add to dividend-paying and/or dividend-growing equities.

2) We recommend building a Tech stock shopping list with a 12 month-plus time horizon. When the dust settles after the Fed’s policy announcements, market volatility, and latest wave of the virus, we will likely be faced with a notable shift in market leadership. There will be no more easy pandemic trades, no more cheap reopening trades, financials will no longer be a slam dunk, assessing cyclicals and value stocks may not be as straightforward, and high-multiple, unprofitable tech may still be tough without low rates to underpin valuations. Amidst that, targeted opportunities in non-pandemic-dependent, reasonably priced tech (including software) should shine. Info Tech net profit margins are roughly 24%, double the S&P 500 average of about 12%¹⁰, which could give the sector a lot more room to absorb higher costs and the economic slowdown.