LD Capital Weekly Report Will the FOMC Deliver the Expected Increase? It’s Time to Do Downside Protection

LD Capital Weekly Report Will the FOMC Deliver the Anticipated Rate Hike? Time to Consider Downside Protection

Source: LD Capital

Market Overview

Last week, European and American stocks performed strongly, with the unexpectedly positive non-farm payroll data causing only minor fluctuations, and ultimately US stocks ended higher for the day. However, the Chinese and Japanese stock markets underperformed, with China mainly due to Moody’s downgrade and Japan due to a sharp appreciation of the yen. The upcoming stability of interest rates by the Federal Reserve may become the catalyst for a rotation from the winners to the laggards this year. In the past three weeks, the Magnificent 7 stocks have lagged behind small-cap stocks by 7%, creating catching up opportunities for the lagging market.

The decline in bond yields, along with the improvement in economic growth expectations in risk asset markets, suggests that stock investors, including cryptocurrency investors, do not see further easing policies by the Fed as equivalent to an increased probability of economic recession. Recently, the sentiment of goldiloc, which is normally associated with lower real yields and a stronger stock market pricing of economic growth, has spread. This usually leads to the strongest stock return cycle.

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However, due to weak economic conditions entering early 2024 and the overpricing of the interest rate market, risk appetite may decrease before increasing. Bonds and alternative investments, such as traditional defensive sectors, may present opportunities as the economy weakens in early 2024 and then recover with growth, while opportunities for small-cap stocks and growth stocks may reappear at a later stage.

Last week, the best-performing sectors were still those with high loan dependency, such as interest rate-sensitive industries, discretionary consumer goods, and real estate.

In recent weeks, there has been a stalemate in the strength relationship between cyclical and defensive stocks, with US stocks slightly outperforming global stocks:

In recent weeks, there has been a trend reversal between growth and value stocks. Growth stocks have started to decline, while value stocks have started to rebound. However, this reversal is not as evident as the trend reversal between large-cap and small-cap stocks. Combining position data, we can see that the market sentiment for risk is strong, with a focus on adding small-cap positions and not wanting to give up on high-growth stocks:

The main reason for the 11% rise in the S&P 500 index over the past month is valuation expansion, not improvements in earnings fundamentals. The SPX equal-weighted price-to-earnings ratio has increased from 14 times to a moderate 15 times, while the standard price-to-earnings ratio has increased from 17 times to a slightly lower 18.7 times, below the high point in July.

Actual yield decline: As the actual yield (i.e., interest rate adjusted for inflation) decreases, the cost of market funds becomes cheaper, thereby pushing up stock prices:

Historical data shows that after the end of a Fed rate hike cycle, valuations and prices usually rise, but economic growth remains the determining factor. In the past 8 Fed rate cutting cycles since 1984, the S&P 500 index typically rises 2% in the first 3 months after the first rate cut and 11% over the next 12 months. The expectation of a Fed rate cut usually means that the stock market tends to rise before the first rate cut. However, the range of results is wide, with the subsequent 12-month return ranging from +21% (in 1995) to -24% (in 2007).

The economic background of the United States in 1995 was:

• Economic growth slowed down, but the absolute level was still good, with GDP growth rate falling from 4.0% in 1994 to 3.0%.

• Inflation rate increased, but the absolute value was not high, with year-on-year CPI growth rate rising from 2.8% in 1994 to 3.0%.

• Unemployment rate declined, with unemployment rate falling from 5.5% in 1994 to 5.2%.

The economic background of the United States in 2007 was:

• Economic growth slowed down, with GDP growth rate falling from 2.6% in 2006 to 2.2%.

• Inflation rate increased, with year-on-year CPI growth rate rising from 3.2% in 2006 to 4.0%.

• Unemployment rate increased, with unemployment rate rising from 4.6% in 2006 to 5.1%.

Comparison with the economic background of 2023:

• The expected GDP growth rate for the United States in 2023 is 2.1%, the same as in 2022;

• The expected year-on-year CPI growth rate for the United States in 2023 is reduced to 3.3%, a significant decrease from 7.9% in 2022;

• The expected unemployment rate for the United States in 2023 is 3.9%, basically unchanged from 3.8% in 2022.

The Fed began raising interest rates in February 1995 to curb inflation. However, as signs of an economic slowdown became increasingly apparent, the Fed stopped raising interest rates in July 1995 and began cutting rates in August 1995. Overall, the economy was relatively healthy, and significant technological advances (computing and the internet) occurred in the mid-1990s, so the stock market soared both before and after the rate cut. Earlier in 2007, the expectation of a rate cut boosted market sentiment, combined with the housing bubble, leading to a significant increase in the stock market in the first half of 2007. However, with the subprime crisis and economic recession, investors began to realize that rate cuts could not solve the underlying problems, and as a result, the stock market started to decline.

So, the economic recession is still a key issue: when a recession occurs shortly after the first rate cut by the Federal Reserve, stocks historically perform poorly, as seen in 3 out of 8 cycles:

If you find the stock market hard to predict, you can consider the bond market. Historically, there is an 8/12 probability of a decline in yield three months after a rate cut, with an average drop of 34 basis points. On average, the yield drops 15 basis points three months before the rate cut. This indicates higher certainty in this asset:

Last week, the market saw a slight rebound in yields due to the better-than-expected NFP and consumer confidence survey. The degree of yield curve inversion has deepened, giving some support to the US dollar. However, the Bank of Japan hinted at a rate hike, causing the yen to strengthen significantly, putting pressure on the US dollar index. Nevertheless, USDJPY only fell 1.14% for the whole week. This is because many people are not optimistic about the negative impact of the Japanese economy and rate hikes:

Digital currencies continue to maintain their strength, but last week, altcoins (+8%) outperformed BTC and ETH (+6%) for the first time in four weeks, indicating a spread of speculative sentiment. Gold plummeted 3.4% for the whole week, and oil prices continued to decline. However, coal, iron ore, and lithium ore prices rose. Chinese lithium carbonate futures contracts hit their daily limit for two consecutive days, indicating a potential short squeeze:

Large BTC futures speculators slightly reduced their net short positions, but they remain at historically high levels. Market makers, on the other hand, hit a new record high of net short positions last week, contrasting with the historically highest net long positions of asset managers:

Interest Rate Expectations

The current market predicts a 71% probability of a rate cut in March next year, and a 100% probability of a rate cut in May. This means a total of 120 basis points or 5 cuts for the whole year, which is quite extreme compared to the expectation of 150 basis points during the banking crisis in March this year:

The decline in market interest rates has pushed the Financial Conditions Index to its lowest level in four months:

Extreme expectations are not unfounded. The current level of inflation is much lower than previously anticipated, especially in Europe where there are indications of dramatically lower inflation than expected. The following chart shows the 2-year inflation expectations based on Zero-Coupon Inflation Swap, with the US being close to 2% and the Eurozone inflation expectation already below the European Central Bank’s 2% target at only 1.8%:

In the US, if we remove the lagging impact of housing costs, the core Consumer Price Index (CPI) has already reached the Federal Reserve’s target of 2% in the past two months. The sharp decline in rental price increases should lower housing inflation for most of 2024. The biggest uncertainty comes from oil prices, but for now, it seems that supply is still exceeding demand:

Moderate Cooling in the Job Market

Last week’s data focused on employment, providing mixed results that did not reverse the cooling trend already in place, which is what the Federal Reserve wants to see:

• In November, the US economy added 199,000 new jobs, slightly higher than expected, and the unemployment rate fell to 3.7% (a four-month low) with an increase in labor force participation. All of these indicate a healthy labor market. However, the return of striking auto workers and entertainment industry professionals caused a 47,000 increase in wages. Looking at the three-month and six-month averages, the level of actual growth remains relatively stable.

• In October, job vacancies decreased for the third consecutive month (8.733 million), a larger decline than expected, reaching the lowest level since March 2021. However, it is still higher than the pre-pandemic average of around 7 million and higher than the total number of unemployed individuals (6.5 million). At the same time, the number of resignations remains stable, indicating some relief in the tight labor market. Historically, the resignation rate has been a leading indicator of wage growth, and the latest data is at the lowest level in nearly two years, suggesting limited wage growth in the future.

• In terms of sectors, the education sector added 99,000 jobs, the government sector added 49,000 jobs, and the leisure industry added 40,000 jobs. These three sectors accounted for almost all of the new jobs in November. This has been a characteristic of the US job market this year, with a total of 2.8 million non-farm jobs added in the past 12 months, of which 2.2 million came from these three industries, including 1 million in education, 640,000 in the government sector, and 530,000 in leisure. Excluding government employees, employment in the private sector has reached its lowest point in the previous cycle.

The stock market is rising and job vacancies are decreasing, a situation that is not often seen in history.

Funds and Positions

According to Goldman Sachs PrimeBook data, hedge funds (HF) have net bought US stocks for the first time in four weeks, mainly macro products. However, individual stocks have seen net selling for the fifth consecutive week, despite active buying from retail investors. Short-term trading continues to increase. Most investors are in a wait-and-see mode, reluctant to make large-scale trades ahead of next week’s CPI data and Fed meeting. But some long-term investors have started buying small positions in the technology sector.

Recent data shows that the buying volume of retail market options has decreased, indicating that the short squeeze may have peaked.

The cumulative net flow of trades shows that cyclical stocks have dropped to new lows, mainly due to net selling in the energy and financial industries, as well as in technology, media, and telecommunications (TMT) stocks: TMT stocks have seen net selling for the fourth consecutive week, led by short selling. However, compared to the situation where long-term selling dominated in November, the selling rate has significantly slowed down. After active selling in recent weeks, the Mag 7 stocks have achieved net buying this week, with net buying occurring every trading day in the past three days:

In the past week, stocks and high-yield bonds have seen capital inflows, but investment-grade bonds and government bonds have experienced large-scale capital outflows. This indicates that investors are shifting from safer assets to more speculative assets.

It is worth noting that despite the sharp drop in Chinese stocks, open market funds saw the largest weekly inflow in 11 weeks:

Sentiment

Goldman Sachs sentiment indicator has remained “extreme” at 1.0 or above for the third consecutive week

Bank of America’s Bull & Bear Indicator has surged to 3.8, indicating a significant improvement in investor pessimism. However, the indicator is approaching the neutral zone, suggesting a shift in market sentiment away from favorable to risk assets.

AAII investor sentiment survey shows a slight decrease in bullish sentiment and a slight increase in bearish sentiment:

CNN Fear & Greed Index remains at high levels since early August with little change last week:

Institutional Views

[GS: Optimistic scenario already priced in, consider downside protection]

The overall P/E ratio of the S&P 500 index is only 5% lower than Goldman Sachs’ optimistic scenario. Goldman Sachs’ optimistic scenario is based on a real yield of 1.5% and a P/E ratio of 20. However, the current real yield is around 2% and the P/E ratio is close to 19. GS believes there could be three possible scenarios in the future:

• If the real yield further decreases moderately due to inflation and the loose policy of the Federal Reserve, the P/E ratio could reach 20.

• If the real yield moderately increases due to the elasticity of economic growth, the P/E ratio could be 18.

• If the real yield further decreases significantly due to concerns about economic growth, the P/E ratio could be 17.

In addition, other factors to consider are:

• The market has already priced in a 130 basis points rate cut by the Federal Reserve in 2024, which is higher than the expectations of Goldman Sachs economists. Bank strategists believe that the market is finding it difficult to price in further rate cuts optimistically.

• Goldman Sachs sentiment indicator has risen from a neutral reading in October to a “+1 standard deviation” stretched state today. This indicates that investors have increased their holdings of risk assets in the recent rebound.

In conclusion, considering that the optimistic scenario may already be reflected in the current stock prices, GS suggests that investors may need to purchase downside protection, such as by constructing bearish option spreads:

• Buy put options: Investors can buy put options on the S&P 500 that have a strike price 2% lower than the current level for a duration of 3 months.

• Sell put options: At the same time, investors can sell put options on the S&P 500 that have a strike price 7% lower than the current level for a duration of 3 months.

The difference between the two strike prices is 5%. The potential maximum return of this put option spread, with a 5% width, ranks in the 95th percentile based on historical data from the past 28 years. This indicates that this strategy has a relatively high potential return compared to other strategies (the belief behind this strategy is that normal market pullbacks in the US stock market do not exceed 5%):

The advantage of this strategy is that if the market declines, the purchased put options will increase in value, but if the market decline is less than 7%, the sold put options become ineffective, maximizing profits. Therefore, the overall loss is just the net premium received. In contrast, investors who purchase individual put options bear the risk of the premium they pay.

【GS: Bet on High-Growth Companies Next Year】

According to GS’s macro model, when economic growth approaches its trend level, economic growth slows down, and interest rates and inflation decrease, growth stocks outperform value stocks. Goldman Sachs economists expect the US GDP growth rate in 2024 to be 2.1%, and interest rate strategists predict that interest rates have already peaked, which will favor the performance of growth stocks over value stocks. If weak data leads to further interest rate cuts, growth stocks are also expected to lead, unless the economy enters a recession. Significant acceleration in economic growth can also lead to value stocks outperforming growth stocks. However, Goldman Sachs believes that this scenario is unlikely to occur.

The following chart shows the stocks selected by GS that have high growth and reasonable valuations compared to their industry peers. These stocks rank in the top 20% in terms of growth within their industries, but their valuations do not rank in the top 40% or the bottom 20% within their industries:

Focus for Next Week

The last monetary policy meetings of the year for the European and American central banks. Recent weak economic data supports the Federal Reserve’s downward revision of economic outlook, including the interest rate expectations depicted in the dot plot. However, Powell’s speech may continue to maintain a strong tone to preserve the Fed’s credibility. If these events occur, they will not be at least a negative factor for the market, but given the recent optimistic sentiment, it is not ruled out that some profit-taking may occur after the recent gains. The biggest surprise could be if the adjustment in the dot plot is not significant enough, such as a forecast of interest rate cuts by the end of next year that is lower than 50 basis points. This could lead to major disappointment in the market. Currently, most institutions predict interest rate cuts of 100 basis points or more next year, for example, ING predicts 150, UBS predicts 275, Barclays predicts 100, and Macquarie predicts 225.

Before the FMOC meeting, the inflation data for December will be announced. Analysts predict that the core CPI, which excludes food and energy, will remain stable at 4% on an annual basis, with a monthly increase of 0.3%, which is basically the same as October’s 0.2%. The decrease in costs for automobiles, electricity, heating, and gasoline prices is significant. Overall, this data may indicate that inflationary pressures are clearly weakening. Due to last month’s nominal CPI being 0% on a monthly basis, if this number were to fall into negative territory, it would significantly boost risk sentiment.

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