Pessimism is Easy. Optimism is Less Easy. Preparedness is Downright Hard

My weekend Twitter feed is replete with market pundits calling for a crash, everywhere from US stocks to NFTs. It's easy to be pessimistic.

A clear bull case remains, but being optimistic is always harder: If we are in a financial markets crash, it will be the most well telegraphed one in recent memory. Market crashes tend to occur when the largest number of participants least expect it, leading to the greatest amount of pain. What if cooler heads prevail in the Ukraine standoff, the Omicron wave is brought under control with better outcomes, life normalization means less stimulus is needed and inflation tempers, less stimulus means the Fed doesn't need to raise rates four times in 2022,  corporate profits expand due to tempering inflation, technology innovation continues unabated, households are sitting on large sums of wealth, intelligent politicians win on both sides?

Nonetheless, financial markets are complex systems, and they experience sudden shocks and extreme events far more often than most are willing to acknowledge. The best you can do is be prepared. Being prepared is incorrectly confused with pessimism. When you approach a blind curve in the road ahead, most drivers slow down. Not because you assume someone is crossing the street with a toddler around the curve - but because the odds of that black swan, life changing event have gone up from around zero on a straight road. It makes sense to prepare. The same goes for pandemics, climate change, disruption from conflict, and much more. In a world of complex systems, fortune favors the prepared mind.

Let's review what we know that gives us caution:

Presence of Critical Slowing Down

Like the the Bitcoin market, the S&P 500 is exhibiting rising variance although not rising autocorrelation. This suggests that the market is potentially experiencing critical slowing down, an early warning signal for a significant transition.

The full code for this analysis can be found here.

Price Trend in US Stock Indexes

Last week, the S&P and NASDAQ indexes both closed below their 200-day moving average, a widely followed, albeit lagging indicator of price direction. The Russell 2000 index tested its 200-Day MA in late November and late December, only to recover. However, it broke below those lows last week.

A number of investors such as momentum traders, commodity trading advisors, and managed futures funds employ trend following strategies based on indicators such as moving averages. They typically sell into drops, trying to ride the trend. This could put pressure on prices for some time.

However, these levels also serve as price memory. Since recovering its 200-Day MA in 2009 post the GFC, the S&P 500 has tested it every year except 2013, 2017, 2021. And it has recovered every time. A strong bounce would simply be what it's done most of the time for over a decade.

Major World Indices

Globally, it's a mixed bag. Many indexes have held up better than the U.S. Is that better pandemic management, or something else?

Valuation Indicators to Watch

Investor Allocation to Equities

The Aggregate Investor Allocation to Equities, an excellent proxy for supply and demand of stocks relative to other financial assets such as bonds and cash has hit levels last seen in early 2000. Of course, the Fed Funds rates was around 6% then so this time it may be different.

Stock Market Valuation to GDP

Often (mistakenly) referred to as Warren Buffet's favorite indicator, Composite Stock Market Value to GDP is at an all-time high. Again, does it matter with interest rates so low?

Concentration Risk

Much has been made of the fact that the NASDAQ Composite Index is down a lot less than many of the companies in the index. Performance has held up due to the relative contribution of the biggest companies, names like Microsoft, Apple, Amazon, and Nvidia. See Jeremy Grantham's discussion about it here.

Most worrisome, with the dramatic rise of ETFs, today many investors are actively and overly long these big names without realizing it:

In other words, out of roughly 1750 ETF’s, the top-10 stocks in the index comprise approximately 25% of all issued ETFs. Such makes sense, given that for an ETF issuer to “sell” you a product, they need good performance. Moreover, in a late-stage market cycle driven by momentum, it is not uncommon to find the same “best performing” stocks proliferating many ETFs. Source

If there is a rush to the exits in these names, can the market withstand it? What if all of these ETFs want to sell Apple at the same time. A clearing price might be much lower than people think.

Crypto

We will find out soon enough if crypto is just a bubble inflated by easy money. And will further drops bring other markets down?

Crypto's Intrinsic Value in a Falling Market

In a falling market, investors will point to the income producing nature of stocks as a price anchor. It is hard to do that with Bitcoin’s (or other cryptos), at least until use cases expand. The primary value remains the promise of higher future prices. That may well change in the future, but not today.

Crypto Leverage

It seems to be very likely that there is massive leverage in the crypto market. Even Bitcoin patron saint, MicroStrategy CEO Michael Saylor says so:

You have a lot of leverage offshore. You have a lot of crypto exchanges that can trade with up to 20x leverage. And those crypto exchanges have many, many tokens that are cross-collateralized. Between them and the decentralized finance [DeFi] exchanges, you can get much higher than 20x leverage. So that’s the second source of volatility.” Source

Crypto research firm CryptoQuant shows that open interest relative to coin reserves across all exchanges remains elevated despite the recent price drops.

It will be a good idea to keep tabs on forced liquidations, which have slowed a bit this weekend, but reached over $1BN this past week.

Growth Tech Investors Also Love Crypto

The air coming out of tech stocks could make the crypto crash even worse.

It is a sure bet that many of the same hedge funds that have entered the crypto are heavily invested in growth tech stocks. These funds may be forced to liquidate crypto positions to address other issues in their portfolio.

Any opinions or forecasts contained herein reflect the personal and subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. The accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.