31 January 2022 - Enough is enough (?)



A big Friday rally in US equities saved the day. It was a week of very high volatility and big intraday reversals on both directions, while the S&P500 touched a 10% correction from its highs and the Nasdaq reached almost the bear market territory of 20% from the recent high. The current oversold environment as well as he sentiment of fear among investors are usually contrarian signals that caused the significant rebound at the end of the week. Have markets corrected enough? It appears so for now, but volatility will remain high. The corporate results, which continue to surprise positively, should provide a floor at equity valuations, as the market is trying to reassess the current environment.


China’s stock markets will be closed for the week, as the country celebrates the New Year (of the Tiger). They finished the previous week on a negative note, as the US rally came after the Asian close. Investors chose to reduce risk ahead of the one-week holiday and as the global markets were correcting lower.


The FED meeting is now out of the way and the expectations for interest rate hikes have increased significantly. The central bank pre-announced that March will be the month of the first increase, while J. Powell said in the press conference that they could raise as many times as necessary, but this will depend on the incoming data. The market is now pricing almost 5 hikes, which will bring the rate at 1.25% by year end. Even more importantly for equity markets, the FED said that it will begin the reduction of its balance sheet (draining liquidity from the system) after the first rate hike, which means that this could happen in April or May. Just as a reminder it was not more than 6-9 months ago that the market was expecting maybe one or two hikes this year and no balance sheet reduction until the end of 2023.


Strong economic growth in the fourth quarter of 2021 was announced in the US. The quarterly GDP came in at 6.9% (annualized) vs expectations for 5.5%. At the same time, the weekly initial jobless claims dropped again after rising for three weeks, painting an overall robust picture for the US economy. Consumer confidence dropped in January, but the drop was less than expected (113.8 vs 111).


The January Eurozone PMIs (Purchasing Managers Index) were mixed. Services both in France and Germany were below expectations but remained comfortably above 50, while Manufacturing was very strong, particularly in Germany (60.5 vs 56.7).


Technology’s powerhouses (Apple, Microsoft) provided superb earnings reports, which was one of the primary catalysts for the stock market to recover after a very volatile week and a hawkish FED. Both companies beat expectations comfortably, but most importantly provided good guidance for the next quarter. In other news, Volkswagen announced an alliance with Bosch on developing software for automated driving, which could eventually be sold to competitors as well (much like Tesla is doing).


We are entering a period of significant reduction in Covid19 restrictions in parts of Europe. Denmark became the first country to completely abolish all Covid19 related measures, while Switzerland is contemplating of abolishing the quarantine requirement for the positive patient, as well as removing some of the remaining measures (mask wearing, working from home etc).


Long-term US government bond yields moved lower for the week, a perverse reaction to the FED meeting. If these can remain within the current levels for some weeks, it would provide some room to equity markets to move higher. The US 10-year traded down to 1.78%, from the high of the week at 1.85%.



Charts of the Week


The left chart shows one metric of investor sentiment in the US. Without going into details on the specific metric, one can clearly see from the chart that we are back in “fear mode”, at levels similar to spring and summer of 2020, when the pandemic had first appeared. Most of the times, investors wish to participate in the markets when sentiment is very positive, which has some rationale and merit. However, history has shown that the best time for an increase in equity holdings is when fear is at extreme levels. The best time to invest was at the onset of the pandemic in 2020 (April), just few weeks after the initial cases and deaths. Understanding that this approach goes against human instincts, the second-best advice is to avoid selling in panic but wait for a rebound which usually takes place after such oversold conditions, like now.


This is the chart of the 10-year yield of the US Government Bonds, since 2012. One can see that for most part of the decade, yields were hovering between 1.5% and 3.0%, while the pandemic caused their drop to a low of 0.5%, Since then however, yields are trending higher, and we are now at levels of 1.80%. Given the high inflation and the intention of the FED to raise short-term interest rates several times this year, the 10-year yield is expected to move higher than 2%, and potentially approach 2.5% again by year end. Long-term yields are important for the pricing and valuation of long duration assets, with equities being the asset class with the highest duration. Within equities, companies with negative cash flows and expensive valuations are most at risk, as the first month of trading has demonstrated already as 1/3 of Nasdaq are down more than 20%.



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