AFMC - Pain Trade
Summary
- Investors were shedding risk late in 2022 in preparation for the well-signaled recession courtesy of the Federal Reserve. Then the January effect happened.
- Short-term option trading has become increasingly popular in recent years. This type of trading has the potential to create significant volatility in the stock market. That can be plainly seen in the swift selloff late on Friday that took the Dow Jones Industrials down 150 in the last 30 minutes of trading.
- Additionally, given the price action in 2022 and the low level of investor exposure to the equity market, recent price action has only increased the fear of missing out.
Timing is everything. After a depressive year in stock market prices, the market was ripe for an upswing. For weeks, we have been saying that the pain trade was higher in the market. Investors were shedding risk late in 2022 in preparation for the well-signaled recession courtesy of the Federal Reserve. Then January happened.
The January effect is the phenomenon that stocks, particularly small-cap stocks, tend to experience a price increase during the month of January. This is believed to be due in part to tax-loss selling that occurs in December. This selling pressure can lead to lower prices in December, which can then be followed by a rebound in January as investors return to the market and buy shares at the lower prices. This is known as the January effect.
Short-term option trading has become increasingly popular in recent years, and its effect on the stock market has been significant. Option trading allows traders to speculate on stock price movements over a short period of time, often with high levels of leverage. This type of trading has the potential to create significant volatility in the stock market, as traders aggressively buy and sell options in response to changing market conditions. In recent days, over 50% of options traded expire on the same day. It is like rocket fuel to markets. That can be plainly seen in the swift selloff late on Friday that took the Dow Jones Industrials down 150 in the last 30 minutes of trading.
Additionally, given the price action in 2022 and the low level of investor exposure to the equity market, recent price action has only increased the fear of missing out ((FOMO)). Investors have been flocking to popular stocks and sectors, eager not to miss out on potential gains. This has created a sense of mania in the market, with prices skyrocketing as demand outpaces supply. As more and more investors jump on the bandwagon, the fear of missing out only intensifies, fueling further buying activity. While this FOMO-driven behavior can lead to short-term gains, it can also create a bubble that is susceptible to rapid deflation. The recent stock market action serves as a reminder of the powerful influence that FOMO can have on market dynamics.
As you know, the Federal Reserve’s balance sheet and the performance of the S&P 500 are closely connected, as the Fed’s monetary policy actions can have a significant impact on financial markets. The Fed’s balance sheet refers to the assets and liabilities that it holds, which includes Treasury securities and mortgage-backed securities. The Fed uses these assets to control the money supply and interest rates, which can have a direct impact on the stock market. For example, when the Fed decides to increase its balance sheet by buying Treasury securities, it is injecting more money into the economy, which can lead to a rise in stock prices. Conversely, when the Fed decides to reduce its balance sheet by selling Treasury securities, it is taking money out of the economy, which can lead to a decline in stock prices. While the Fed has been trying to tighten policy, other central banks like Japan have opened the floodgates and the world’s central bank balance sheets are increasing, and that is helping stocks.
Another critical development is the looming debt ceiling fight in Congress. While Congress dithers, the US Treasury department is using extraordinary measures to keep paying the bills. This is also flooding the market with extra dollars, so the Fed’s efforts are going for naught.
Depressed stock market prices late in 2022 led to a rebound in stocks. That rebound has been exacerbated by single-day options expirations. That led to a fear of missing out on the rally. Here we are with loosening financial conditions and the Federal Reserve trying to tighten. Financial conditions are looser by 100 bps since the Fed came out aggressively in August of 2022. What do you think that they will say this week when their meeting ends this week? I don’t think it will be all lovey dovey.
Investors have moved on from the inflation story (where bad news was good news) and moved on to the recession story (where bad news is bad news). This is a very difficult part of the cycle. Investors will believe that the storm has passed, believing it won’t be as bad as one thinks. The market could rally higher into the 4200 area. We have some risk-on and would prefer the market head lower and give us an opportunity to buy cheaper stock, but we are also comfortable receiving 4.5% on our cash holdings and the optionality that it brings.
Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Pain Trade