The ‘Ultimate Pain Trade’

No one is talking about the inevitable dovish pivot. Or almost no one, anyway.

In part, that’s because the hawkish pivot isn’t even real yet. Until March, it’s still theoretical — it exists in the minds of Fed officials, but the only place it’s actually manifested is in markets, from front-end rates to real yields to equities.

One of the most interesting things about recent weakness at the index level (and accompanying chatter about bursting bubbles) is that the most blatant examples of speculative excess began to unwind a year ago.

If you listen to various pundits, you’d be inclined to believe that bubbles abound, and that none of them have popped. In fact, they’ve been popping all around us. Crypto is down ~50% or more. The Cathie Wood complex is in flames. Profitless US tech was nearly cut in half. And so on.

The simple figure (above) suggests the market isn’t as inefficient as some critics charge.

“The good news is that markets have been digesting this tightening for months,” Morgan Stanley’s Mike Wilson said. “Despite the fact that the major US large cap equity indices are down only ~10-15% from their highs, the damage under the surface has been enormous and even catastrophic for many individual stocks,” he went on to write, noting that “the froth is coming out of an equity market that simply got too extended on valuation.”

And it’s not just “the froth.” “1,288 out of 3,042 ACWI global stocks are now in bear market,” BofA’s Michael Hartnett observed, in his latest, noting that you could say the same thing for 2,648 Nasdaq stocks. Nearly 1,700 Nasdaq stocks are more than 50% from their 52-week highs, he wrote, adding that “speculative themes” have simply “crashed.”

And all of that is to say nothing of major benchmarks in Asia, which are beset. A-shares are in a bear market. So is the Kospi. Benchmarks in Japan, Australia and New Zealand are in corrections. And mega-cap Chinese tech (i.e., the Hang Seng Tech Index) is a graveyard. It’s so bad in South Korea that regulators and the central bank have convened meetings to discuss what can be done, while Beijing marshaled state media to shore up sentiment.

Hartnett was whimsical. “Manias and crashes, t’was ever thus,” he said, before conceding it’s “very rarely” the case that manias unravel “before the Fed has actually hiked.”

Everything’s been faster this time around. The plunge in March of 2020 was among the most harrowing in modern history. The rebound in equities and credit among the swiftest and most dramatic (figure on the left, below).

The same is true of retail sales (figure on the right, above) and the economy more broadly. The labor market is still short a few million, but some of that is down to early retirements and voluntary unemployment.

With inflation scorching, it’s obvious the Fed intends for the forthcoming tightening cycle to be among the fastest in a generation — a dramatically hawkish pivot befitting of the urgency with which the initial dovish rescue mission was undertaken.

But considering i) the flattening impulse in the curve, ii) how quickly the Fed will approach the implied terminal rate if the Committee does indeed hike aggressively, iii) the markets’ propensity to bring forward expected future outcomes and iv) the possibility that speculative assets started to price-in 2022’s prospective hikes last year, one can’t help but wonder if this might all be over before it even starts.

BofA’s Hartnett touched on that in the same note cited above. “We believe the ‘Fed put’ is >150bps on IG corporate bond spreads and <4,000 on SPX,” he said. Once those levels are breached, 30-year Treasurys would be “a screaming buy” and the US dollar a “screaming sell,” he remarked, calling one Fed hike the “ultimate pain trade.”

That’s not, of course, BofA’s base case. Or anyone’s base case, for that matter. Rather, it’s a tail risk. Hartnett described how anyone who harbors such a wildly dovish contrarian view might be thinking about things. “[The] Fed won’t end up tightening many times as just a few hikes and QT are enough to unwind excesses and threaten [a] recession” in the second half, he wrote, noting that a “disorderly US dollar surge would be the best indicator of a forthcoming Wall Street ‘event’.”

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7 thoughts on “The ‘Ultimate Pain Trade’

  1. This is a very worthy post, thanks.

    If we’re in a period when valuations matter – quaint, but let’s suppose – then we should decide if we think the SP500 is undervalued yet.

    I’ve been doing some work on that. Take every name in the SP500, build a DCF for each using consensus FCF as well as a multiple-based valuation (PE or PS, PB), and roll it up by sector and for the entire index. Then play with rF, ERP, FCF, terminal growth, multiples, and so on. See what it looks like.

    With stress testing, of course. Don’t use today’s rF, use the expected rF by mid-year. Don’t use today’s consensus FCF, give it a haircut for the expected economic slowdown. Don’t use multiples from the past two years, use multiples from the last period rF was at the expected level. And so on.

    No strong conclusions yet, at least none I feel are strong enough to share pending more work. But so far, I’m not seeing that the SP500 is obviously and significantly undervalued – yet. Some sectors do look to be, as well as some big names.

    Again, fussing over valuation is quaint, it matters little in the ultra short term and can get run over by + and – catalysts in the short and medium term. If PCE falls to 4% next month while ISM crushes on the upside, valuation may no longer matter – for a time.

  2. As a retail trader who got caught out in cannabis and some IPO/SPAC growth names, I applaud this post. However, I would still claim there’s some still a bit of froth out there (SHOP, GME, AMC, MSTR, TSLA), and sorry H, crypto.

    1. AMC is down 80%. I mean, I still wouldn’t buy it, but I wouldn’t buy ARKK either. The point isn’t that this stuff can’t go lower. It’s not a comment on the prospects for various manifestations of “froth” and hyper-growth. And I’m not trying to call the bottom on the indexes down a mere 10%. The point is just that there’s been quite a bit of damage done without a single rate hike and with QE still going on.

      On crypto, you don’t have to apologize. It’s still less than 1% of my invested assets. If it all went to zero on Monday I’d care more about writing a good article on it than I would the money lost.

  3. Hartnett’s tail risk is almost my base case. The 5-7 hike scenario with balance sheet reduction only works if Covid is an afterthought by June. If you believe that I have the Brooklyn Bridge for sale….

  4. BTW, stocks are sentiment driven at least for the next 3 months. If you think valuations matter over that time frame, you will be disappointed. Sentiment is in the process of bottoming out in my view. We probably have another few weeks before we get a real bounce back rather than churn.

NEWSROOM crewneck & prints