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Q4'23: "G"uardian Angel

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By: Jack Schibli

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TLDR – "too long; didn’t read." We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary:

  • A flood of U.S. Treasury issuance in 2024 is likely to drive longer-term interest rates higher, making Q4’s reprieve temporary.
  • The private sector will bear the brunt of government issuance, crowding out private investment and further slowing the real economy.
  • The headline economic “resiliency” has been generated by deficit spending, masking a turning business cycle. An election year may postpone any austerity, though it will be hard to top 2023’s government credit card tab.
  • Gross Domestic Income, now in contraction, might be trying to tell us something that Gross Domestic Product doesn’t want us to know.
  • The ongoing extinction of active managers is driving the market toward “flow” based movement rather than fundamental merit.
  • Can skipping a few days around options expiration every month generate outperformance? It sure seems like it, as the options tail wags the equity market dog.

Catfished by Janet & Jay? 🐟

Financial markets didn’t just climb the “wall of worry” in the fourth quarter; they flew over it in a 747 (all screws and doors firmly attached). The S&P 500 jumped nearly 12%, and for the first time in 2023, the rally broadened beyond the Magnificent 7, as the Russell 2000 gained 14%. Before this “everything rally,” the average stock in the S&P 500 was up just 0.31% on the year – quite the window-dressing job if you ask us. We believe the market may be prematurely celebrating a decline in long-term interest rates. The 10-year Treasury yield closed the year at 3.86%, well below its October 19th high of 4.99%. Janet Yellen kicked off the party with the Quarterly Refunding Announcement (QRA) on 10/31, when her Treasury department surprised markets by favoring a larger proportion of bill (short-duration) issuance than expected relative to coupon issuance (long-duration). This reduction in long-term bond supply supported prices and drove yields lower. As we highlighted last quarter, significant bill issuance has been absorbed by the large balance in Overnight Reverse Repurchase Agreements (Repos). Higher interest rates on T-Bills have lured funds out of the Repo market (lower yields), but this capital base isn’t limitless. The RRP is down to $570 Billion from $2.2 Trillion in May of 2023, which at this rate suggests depletion sometime in late March, at which point the Treasury may find fewer willing buyers of their fresh issuance, causing some strains in funding markets. We believe Treasury issuance is now a more significant driver of interest rates than the Federal Reserve. 

The next contributor to declining yields in the quarter was the October CPI report released on November 14th. After a multi-month increase in year-over-year inflation readings from June (2.97%) to September (3.7%), U.S. inflation fell to 3.13% (better than expected) in October. Yields fell further on the news as markets began to price in interest rate cuts from the Federal Reserve on the basis that its 2% inflation target is in sight. Powell et al took the market’s temperature and ran with it during the December FOMC meeting. An unmistakable dovish shift in tone and accompanying projections for roughly three 25bps rate cuts in 2024 once again drove yields even lower. However, at year-end, the market was pricing a December 2024 Fed Funds Rate of 3.75%, quite optimistically lower than the FOMC projected 4.65%.

For Illustrative Purposes Only

Simplistically, there are two drivers of a stock’s price – the earnings the company can generate and the multiple of those earnings the market is willing to pay. The latter can be heavily influenced by interest rates, as evidenced in DCF models, where the discount rate used to discount future cash flows to present value is among the most sensitive levers to current value. Thus, there is an inherent inverse theoretical relationship between interest rates and stock prices – higher interest rates drive multiples (and prices) lower, and vice versa. The market “machine” – aka algorithms, which drives most of today’s trading – is highly attuned to this phenomenon and bid stock prices up as interest rates fell in the fourth quarter. While little more than a single percentage point decrease in the absolute level of the 10-year yield, this was more than a 20% decline in the effective interest rate.

We believe the interest rate relief will prove a counter-trend rally and temporary. The favorable QRA adjustment in October was a “kick of the can” (favorite government pastime) to 2024, when Treasury issuance will rise dramatically across all maturities at an average of 23% from 2023[1]. Considering investors seemed to have had some difficulty absorbing long-term issuance last year, we expect 10-year yields will need to rise beyond the 4.99% peak in ’23 to entice sufficient buyer demand - particularly given the structural decline of foreign buyers. This rise in yields would certainly pressure current stock market exuberance and, more importantly, continue to slow the real economy. Higher-for-longer interest rates will not only directly impact private sector lending, but the need for the private sector to absorb such significant Treasury issuance will further crowd out investment elsewhere. 

When Life Gives You Lemonade? 🍋

Despite the headline narratives of resiliency, the economy continues to weaken under the surface of massaged and self-emboldened government statistics. In all likelihood, without the government’s frivolous spending (that’s big “G”) in 2023, the U.S. economy would have entered recession by now. This year’s government deficit, roughly 6.2% of GDP, was more akin to wartime levels or those seen during previous recessions. In fact, excluding the pandemic and wake of the GFC, it was the largest deficit on record since WWII. Mind you, this is during a period of near-record-low unemployment, we worry – what happens to deficits when unemployment rises? As shown below, we borrowed $1.68 last year from future generations to generate $1 of nominal GDP.

For Illustrative Purposes Only

We also highlight the increasing discrepancy between GDP and GDI (Gross Domestic Income) readings. Both are measures of economic output but are calculated from either side of the equation, as GDP measures spending and GDI measures income. Theoretically, these should be roughly equal and usually are quite close. However, over the last twelve months, real GDP growth has diverged significantly from real GDI growth, which most recently contracted (-0.1% in Q3). This same phenomenon occurred in 2007 before the Great Financial Crisis, which prompted Former Federal Reserve staff economist Jeremy Nalewaik to investigate the divergence. He found GDI was a better predictor of future GDP growth due to its higher sensitivity to business cycle fluctuations and that GDP revisions tended to fall more in line with GDI readings[2]. In the bridge from GDP to GDI given in the U.S. Bureau of Economic Analysis reports, this growing differential is listed as a “statistical discrepancy.” If Nalewaik's work is right this time around, the gap between GDP and GDI should close and not in a favorable sense. 

For Illustrative Purposes Only

While we have been early in our assessment of the economy reaching recessionary territory, we still believe just that – early. Consumers’ excess savings continue to deplete, credit card and auto loan delinquencies continue to rise, leveraged corporate borrower default rates are inflecting higher, bank lending is nearing contractionary levels, and job growth is moderating. That said, we are aware this is an election year, where the impulse to spend and stimulate the economy in the name of securing votes reaches a four-year pinnacle.

Surfing the Flows🏄‍♂️

We’ve discussed market flows at length in the past, and we continue to believe they are among the most influential drivers of short/medium-term price action. Market structure has changed dramatically over the last several decades. It used to be that stock market participants were primarily brokers, institutional investors, and individuals – all seeking to invest based on their perception of an individual company’s fair value. Conversely, today, active managers are an endangered species. Instead, most stocks are bought and sold in broad swaths through ETFs, algorithms, and other value-insensitive strategies. The result is stocks can move up (or down) based on factors outside their fundamental value.

The rise of passive investing is an example of value-insensitive flow, as each dollar invested in an ETF follows a single rule set – buy shares of every company in the index with no regard for what those shares might be worth. If that index is the S&P 500, dollars are being allocated to companies based on 1) their inclusion in the index (determined by a committee, not so passive after all!), 2) the size of the company – Apple, the largest company in the index, receives $7 of every $100 invested. A recent study found that inclusion in the S&P 500 dulls the impact of exogenous fundamental information on prices by looking specifically at the effect of foreign currency fluctuations on stocks that had been added to or removed from the index. Morck & Yavuz found stocks included in the S&P 500 experienced a 60% lower idiosyncratic currency sensitivity than stocks not in the index[3]. The irony is passive investing was created to ride the coattails of active investors’ informational arbitrage, the concept that active investors arbitrage informational inefficiencies and, therefore, a passive investor can simply follow along. However, today, dollars invested in passive strategies exceed those in active strategies, and their flows are undermining the foundational premise on which they were built – stock market informational efficiency. Taken to the extreme, an entirely passive market would move strictly on the flow into and out of passive vehicles rather than individual companies’ fundamental achievements (and failures).

Therefore, it’s increasingly important to understand what drives passive flows. Among the most prevalent contributors to passive indexing strategies are 401(k) flows, which invest a portion of every participating employed American’s paycheck across a series of ETFs. Recently, we analyzed the American Funds 2065 Target Date plan, which is roughly 95% equities and 5% fixed income. Target date funds use a sliding scale based on your age to determine the allocation between equities and fixed income. We found that among the 14 equity funds allocated, 13 funds held Microsoft, the largest position in 12 of them. Roughly $4.56 of every $100 invested in this plan flowed into Microsoft. You might say, well that’s great, Microsoft has been up, up, and away, don’t we want to own Microsoft? Sure, but a major reason it is up, up, and away might be these very flows, which are not investing based on fundamental value. Plus, the better Microsoft performs, the greater the share of every $100 in a 401(k) it receives – it’s nice to be king. This same phenomenon applies to all the top stocks in the indices; Microsoft just happens to be the largest beneficiary in this specific plan. Combine this phenomenon with an increasingly inelastic market, whereby there is little change in the supply of shares for a given increase in price – probably because most shares are now held by the very passive vehicles we are discussing. Maybe this might explain some of the Magnificent 7 dominance. In any case, employment figures now carry stock market importance beyond their economic impact, as employment is a major direct contributor to flow via 401(k)s.

To close our flow section this time around, we wanted to explore the impact of option expirations on markets in 2023. When you buy or sell call and put options, you almost always transact with a dealer who wants to avoid taking the other side of your trade. Instead, these market makers hedge their exposure to your trade based on the “Greeks” (delta, theta, and vega). The terminology is rather unnecessarily complex, but the key takeaway is the value of the option changes based on price changes in the underlying asset (delta), time decay to the options expiration (theta), and the volatility of the underlying asset (vega). Most longer-term options are tied to monthly expirations, meaning a specific date on the calendar (the third Friday of every month). Notably, the value of an “out-of-the-money” option associated with time and implied volatility is asymptotic. As the expiration date nears, the likelihood of it landing “in-the-money” decreases exponentially, all else equal. Dealers are dynamically adjusting their hedge exposure along the way, thus buying back the underlying asset, which provides increasingly supportive flows to the broader market in the period monthly expiration date. Conceptually, we expect these soothing flows to result in a slow grind higher or “pinning” action, and the absence of their support immediately following expiration allows the market to move more freely.

We have been following this phenomenon for several years and decided to analyze how avoiding the days immediately following monthly options expirations impacted market performance in 2023. The following chart displays the return of the S&P 500 price index versus the return of the “Ex-OpEx” strategy, which involves selling out of the S&P 500 the day before the monthly VIX-expiration and buying back a calendar week later. Admittedly, this is just a single year of data, but the results are fascinating. By skipping roughly one week per month (~28% of trading days), this hypothetical strategy returned over 41% versus the 24.2% for the S&P 500. We ran the same strategy, skipping only a single day per month (VIX-expiration), which generated a 31% return, missing just 4.8% of trading days.

For Illustrative Purposes Only. This hypothetical analysis does not depict actual trading of any Ex-OpEx strategy or any strategy actually implemented. It is unknown whether this strategy would, in fact, produce results similar to those generated in its hypothetical analysis. This analysis was performed to investigate our hypothesis around options flows. 

Remarkably, eight of the worst eleven days in 2023 occurred during this post-OpEx window. The key takeaway isn’t that the market will decline in each window; in fact, sometimes it appreciates marginally, but rather, any corrections are much more likely to happen during this period as indices aren’t subject to the pinning effects of options dealers’ hedging flows. This is yet another example of the importance of flow awareness, as the marginal dollar sets the price, and the marginal dollar doesn’t come from an active manager assessing fundamental value anymore.

Thanks for Reading!


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All financial data is sourced from Refinitiv Data or Federal Reserve Economic Data (FRED) unless otherwise noted. 

[1] Slok, Torsten. 2024 Economic and Capital Markets Outlook: What’s Next After the “Fed Pivot.” Apollo Global. December 2023

[2] Nalewaik, Jeremy. The Income- and Expenditure-Side Estimates of U.S. Output Growth. Board of Governors of the Federal Reserve. Brookings Papers on Economic Activity. Spring, 2010. 

[3] Morck, Randall & Yavuz, Deniz. INDEXING AND THE INCORPORATION OF EXOGENOUS INFORMATION SHOCKS TO STOCK PRICES. National Bureau of Economic Research. December, 2023.