Market report March 2021

day 29.03.2021 * Reading time: 10min.

 
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Market report March 2021

European equities have lagged behind developed market counterparts because the region’s economy has been particularly badly impacted. However, selective stock investors might uncover excellent return possibilities in undervalued firms set to revive in a post-pandemic environment. Europe’s equity markets are still struggling. After failing significantly in 2020, the MSCI Europe Index lagged the MSCI World Index this year through February. The performance of regional value stocks has been considerably worse. Last year, the MSCI Europe Value dropped by 11.4 percent, behind the MSCI World Value.
Europe’s vulnerability in the aftermath of the epidemic might suggest an appealing opportunity, particularly for value investors. European markets feature significantly more cyclically sensitive stocks that should do well when macroeconomic growth resumes its upward trend.

Chart: European Stock Markets Contain More Cyclically Sensitive Stocks

Past performance and current analysis do not guarantee future results. As of February 28, 2021
Cyclicals: energy, financials, industrials and materials. Growth/defensive: communication services, consumer discretionary, consumer staples, healthcare, technology, real estate and utilities.
Source: FactSet, MSCI, S&P.

In this scenario, value investors are well positioned. The value investing theory is based on spotting market overreactions to controversy and purchasing stocks with unrealized potential that other investors are dumping. There are three sorts of opportunities in today’s environment:

Businesses that are resilient—companies that are far more enduring than they are thought to be;

Companies that successfully adjust to the new world are known as transition champions;

Normalization plays – companies that stand to gain as consumer and business practices become more common.

Finding potential investment opportunities necessitates a clear emphasis on company fundamentals and cash-flow creation rather than depending on numerous expansions, which have fuelled high-growth firms in recent years based on future assumptions. Digging for value in robust firms, transition champions, and normalization plays throughout Europe can help to position a stock portfolio when conditions improve.

Are you also the Robin Hood of the financial markets?

The recent US equities market surge, which saw some company values multiply by 10x to 15x in a week, illustrates the development of a new type of “all-in” individual investor, one who is increasing leveraged trading via the derivatives market, especially through call options. This unusual market action has generated speculation about a structural shift in the way financial markets operate. However, this is not a novel situation: despite the fact that the tools, outreach and amplification of the stock rally have been substantially altered by the widespread use of social networks and other online platforms, the majority of the contemporary equity rally’s features are rather visible in the late equity cycle stage. Here are the most important factors that influenced this development:

  • widespread and simple access to options trading, which has been provided via trading applications since 2018;
  • liquidity availability with minimal opportunity costs: The first lockdown resulted in an increase in the saving ratio (in Q2 2020, 26 percent of disposable income, disposable income grew by 13% year on year), despite decreasing interest rates on bank accounts and constrained spending options;
  • a considerable reduction in transaction costs for derivatives and transactions in the small-cap market segment, where they may quickly become prohibitively expensive: Some trading applications reduced transaction costs to near zero in early 2020 (but merchants pay a bigger bid-ask spread);
  • the increased use of social media and the growth of social media influencers as opinion leaders have resulted in an informal and ‘new’ manner of mobilizing capital (e.g. targeting heavily shorted stocks).

Many small merchants have lost a lot of money as a result of extreme positioning in particular equities. Retail and speculative investors have been hopping between numerous single stocks and sectors from the beginning of the market rise, from electric cars to technology, gaming, silver, VIX, and others. However, with an investment philosophy of “small, micro, and penny stocks,” they have largely targeted tiny, micro, and penny stocks. We feel that the fact that these severe market swings are occurring in this specific market area is no accident, as it is in the essence of delta/gamma squeezing techniques. To be effective, they must use a demand shock to cause an unstable equilibrium share price in order to clear the market at a new higher equilibrium. Two things are required for this: (i) enough wealth and (ii) access to at least 2:1 leverage. The firms targeted by retail investors must be small enough for their money to matter but also large enough to have tradable options.

This stock-picking preference also explains why “distressed” or “struggling” firms are preferred, as a little change generates a huge, almost distinct rise. However, as is often the case when things go up quickly, they also go down quickly. Extreme market rallies typically occur in a staggered fashion, and this one was no exception: Some early bidders enter the stock, causing small initial readjustments in future return expectations and causing the stock to appear on the daily equities leaderboard. These first bids are usually followed by large investors who see the upward trend and invest appropriately. The quick price rise causes a “call” or “FOMO” (Fear Of Missing Out) effect, causing many small investors to engage in the “expected” disproportionate upside potential. However, the call impact is widely recognized, since the rational inattention hypothesis predicts that a 5-sigma event combined with certain market influencer suggestions may be sufficient to induce such an extreme repositioning. Most small investors face a hard reality as a result of this illogical impact, when they enter the market around its peak. Overall, this conduct produces an unwelcome “Ponzi scheme” dynamic that disproportionately affects those who arrive last.

Much has previously been stated regarding central banks’ puts and their influence (distortion) on risk-seeking behavior: by assuming the downside risk, central banks incentivize market players to take larger risks than they would otherwise. One method is to sell volatility by selling out-of-the-money options, particularly puts. That is, risks are guaranteed by central banks, which means risks are eventually mutualized by society.

To some extent, the rise of Exchange Traded Funds (ETFs) is a testament to central banks’ puts: if investors were not so sure that they would be backstopped if required, they would be less eager to accept pure market risk, and less inclined to prefer beta over alpha. However, ETFs have their own influence on market behavior. They put stock security selection on autopilot by following stock market indexes, limiting the possibility for rotation, and ensuring that winners stay winners. They increase the likelihood of the positive outcome. Buying out-of-the-money calls on stock market indexes becomes a type of sure or one-way leveraged gamble when central banks’ puts are combined with ETFs. As a result of these factors, the amount of outstanding call options on stock market indexes should continue to grow.

There are compelling grounds to assume that the options market, which is ostensibly a “derivatives” market, has become the tail that wags the dog. To hedge their delta and gamma positions, professional sellers of call options must buy futures, more so as the market rises, assuring a spillover from the options market to the futures market. Because futures and spot prices must have a specific connection — a relationship that arbitragers both monitor and enforce – an increase in futures prices inevitably spills over into the spot market, validating the purchase of shares.

The rise might continue, but the distribution of possible outcomes is shifting to be increasingly skewed to the downside. The likelihood of a market downturn considerably outweighs the likelihood of a continuing market rise. This judgment, however, is based on the assumption that fundamentals matter and that market forces tend to return fundamentally unbalanced stocks to their long-term fundamentals. We do not believe that ‘new’ retail trading on capital markets will pose an immediate threat to the financial system’s regular operation. However, the enormous growth in options trading (not only by individual investors) may likely result in some instances of temporary liquidity shortages, which should not be structural but may generate some undesirable volatility and raise some doubts about „new” brokers liquidity.

 

US yield curve – The Fed’s reputation is jeopardized, and the money market may be destabilized

Indeed, we believe that the risks at the short end of the US yield curve are presently greater than those connected with the rise in long-term interest rates. First, the Fed risks losing credibility since it has consistently spoken out against negative interest rates. If money market rates, particularly effective Fed Funds rates, break through the crucial rate corridor (now 0-25bp) to the downside, it may appear that the Fed is losing control of the fundamental area of its monetary policy: ultra-short rates. It would not be long until market participants put the Fed’s credibility to the test in the long run. The Fed would therefore be in the unenviable position of trying to combat both decreasing short-term interest rates and increasing long-term interest rates. Second, negative interest rates might put money market funds under strain. With approximately USD4 trillion in assets under management, US money market funds are a major pillar of the US money market, and the global financial system’s stability is dependent on the efficient operation of the US money and repo markets. Many depositors see them as bank accounts since their NAV is usually constant at USD.

As a result, it is almost certain that the Fed will boost money market rates if the downturn continues. What might such an intervention entail? Raising the IOER (interest on excess reserves) or overnight repo rate might be a suitable approach. Raising the IOER from its present level of 10bp to 15-20bp may already considerably alleviate downward pressure.

Source: Sources: NY Fed, Refinitiv.

To compensate for the reduction in collateral (T-bills), the Fed may ramp up reverse repo operations at the same time. These two actions would have the net impact of draining liquidity from the economy. “Operation Twist” (simultaneous acquisition of long-term and sale of short-term securities) would really avoid negative interest rates at the short end while also counteracting an excessive steepening trend at the long end.

Global stock markets

The table shows rates of return in Pounds Sterling (GBP), Local Currency (Loc.) and Relative (Rel.) Date 24/03/2021.
Source: RCieSolution Research

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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The views expressed in this document do not constitute research, are not investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.