Forget the Fundamentals
Macro Monitor March 6, 2023
My last post was subtitled “Broken Record,” and for that reason, I will limit repeating the fundamental reasons for the bear maret outloook to a simplified summary.
1. Recent price indicators show that we are in a phase of “dis-dis-infla-tion” (inflation receding at a slower-than-expected pace).
2. This inflation dynamic means that the Fed will be raising rates more than what was expected two months ago.
3. A longer cycle of higher rates postpones eventual interest rate cuts, implying that the reduction of the Fed’s balance sheet, “Quantitative Tightening” (QT) will last longer and drain more liquidity probably into 2024.
4. Risks of a very hard landing have increased as the Fed may damage the economy if it inadvertently overshoots setting higher rates for longer.
5. Stock valuations including Price Earning Ratios (PE’s), Equitiy Risk Premia (ERP), and Dividend Yields (DY) are historically expensive, despite the risk of a hard landing and especially after the 6% year-to-date rally in the S&P.
6. Geopolitics remain volatile.
Now let’s for the fundamentals and turn to the “technicals.”
Technical analysis is a very broad term. To sum it up, technical analysts are first historians. They study data from the past and interpret it. Where they differ from historians is they use their technical studies to make price predictions.
When I started in the markets in 1985, some of the bond traders in the Fixed-Income Division of PaineWebber would have a roll of green and white graph paper on their desks and would plot market prices on “point-and-figure” charts.
Every fifteen minutes, they would by pencil pile in perfect vertical columns letters and numbers, each representing the prices traded during that time interval. As minutes became days, days weeks, months years, and years a career, a thick roll of finely crafted points and figures would come to resemble as noble a manuscript as the Dead Sea Scrolls, or even the Torah. One of the trading managers even cut out a section of his market scroll, had it framed behind glas,s and hung it on the wall across from his corner office desk. It showed the rally of in the thirty-year Treasury bond during the stock market crash of 1987.
Today, technology enables and encourages technical trading by both individuals and institutions and the art of handmade charting has become rare.
Day traders who may know nothing of macroeconomics pay homage to the God of Fibonacci, retracing and projecting market moves based on magical percentages to predict the next. The newbies use the technical analysis tools on Yahoo Finance or Investing.com for free.
Mammoth hedge funds like Renaissance Technologies are so good at technical analysis that they charge their clients 40% of profits. Its founder Jim Simons is said to be worth over $20 billion dollars. These institutions that employ what is known as “quantitative trading” hire scores of mathematicians, statisticians, and engineers whose algorisms scour history, backtest it, and formulate computer-driven trading strategies to manage risk while generating profits of this magnitude.
I have always found it interesting to ask young individual investors who use technical analysis why it works. I respect those who answer “I have no idea, but it does.” Others less worthy of respect insist that it works because it is a self-fulfilling prophecy. In other words, they claim, if enough traders are using the same predictive model, flows from these traders move prices in the direction their charts suggest.
Who am I to question the methods of others, when my method is far from perfection?
My more fundamental approach meant I missed the January rally but got the February sell-off right. Although the macroeconomic and geopolitical risk factors have persisted, as evidenced in this week’s Macro Monitor, the month of March has started with madness.
Let’s look at the most basic form of technical analysis to see if we can understand what might explain the newfound euphoria.
Everyone knows what an average is, but just in case, is the sum of a series of numbers divided by the number of those numbers. Applying this to the market, over time the moving average is the average closing price of the stock for a given period recalculated after every new period has passed and the next closing price is available. It is a series of averages over time and can be charted just as the price of a stock can be charted.
“Candlestick” charts are have largely replaced the old school point-and-figure charts. They are easy to understand – if the body is green, the closing price of that month was higher than its opening price, red means that the closing price was lower, and the thin tails above and below each candle indicate the extremes – the high and low prices traded that month. is a “candlestick” chart of the S&P future going back five years, with each candle representing one month of trading.
The 12-month moving average is plotted on the same timeline as the price chart. It shows what the average closing price was over the previous twelve months. In a classic bull market, prices rise and the market stays above the moving average, as we can see clearly in the months following the three red months of the early 2020 Covid sell-off.
In January 2021, the red candles took over, and because the decline was sharp, the price of the S&P diped below the moving average price of the past twelve months, indicating a classic bear market.
Since the October bottom, the S&P has traded higher for four months, and the rally has put it even with the moving average. That is a signal that the bear market might be ending.
Now let’s look zoom in on a shorter period. This is the S&P daily candlestick chart beginning in September of last year.
Looking back 252 days (a year’s worth of trading days), last week’s March Madness took us right to the 252-day moving average. In other words, an investor who bought an equal amount of the S&P at the close of each trading day since early March of 2021 is breaking even at Friday’s close of 4050.
Why did I pick 252 days? What is so special about a look-back period of a year? Macroeconomics and geopolitics do not cycle neatly with an arcadian rhythm. The environment stays in a stasis until a one or a cluster of shocks pushes it to another stasis. The one year interval is completely arbitrary.
Again, what do I know about technical analysis to question it like this? Not enough, so I defer to billionaire investor Paul “Peanut” Tudor Jones. Check out his Rules of Trading.
1. “The market is going to go where it is going to go.”
2. “You always want to be with whatever the predominant trend is.”
3. “At the end of the day, your job is to buy what goes up and to sell what goes down.”
4. “Never overtrade.”
5. “I am always thinking about losing money, as opposed to making money.”
6. “Risk control is the most important thing in trading.”
7. “When I am trading poorly, I keep reducing my position size.”
8. “Don’t ever average losers.”
9. “Increase your volume when you are trading well”
10. “The most important rule of trading is to play great defense, not great offense”
11. “Every day I assume every position I have is wrong.”
12. “One principle for sure would be to get out of anything that falls below the 200-day moving average.”
13. “I always believe that prices move first and fundamentals move second.”
14. “I try to avoid any emotional attachment to a market.”
15. “Don’t focus on making money, focus on protecting what you have.”
Peanut Jones swears by the 200-day moving average in Rule 12. Why 200 and not 252? No idea, but if we look at the 200-day moving average on the chart above, we can see that since the middle of January, the market has traded above it. Just as Peanut Jones would “get out” of a long position if the market trades below this average, he would get out of a short position when it trades above it.
If you look even more carefully at the chart, you can see that at last week’s lows around 3940, the S&P kissed the 200-day moving average with barely any penetration (forgive the innuendo), and promptly hightailed it through 4000 in the sharp rally I am calling March Madness. The 200-day moving average worked like a charm as a key support level.
The long and short of it: I have considerably less conviction in the short position I have carried since late January via options. I have reduced the position, but given my read of today’s risky macro fundamentals, I have zero fear of missing out (FOMO) on a rally. Perhaps some good news is coming, and the market intuitively knows it, as Peanut pithily puts it in Rule 13.:
“I always believe that prices move first and fundamentals move second.”