When skepticism shifts to euphoria as quickly as it has in 2023’s stock and bond markets, the comeuppance is apt to be swift.
(Bloomberg) — When skepticism shifts to euphoria as quickly as it has in 2023’s stock and bond markets, the comeuppance is apt to be swift.
That was the tale of the tape this week, when bulls on everything from Treasuries to equities and credit took lumps in one of the year’s fiercer bouts of concerted selling. Even with Friday’s bounce in bonds, an exchange-traded fund tracking equities, fixed income and commodities still managed to cough up its second-worst week of the year.
Behind the deluge was a steady ramping in speculative positioning that had left traders exposed to the least dose of bad news, which came in the form of a Fitch Ratings’ downgrade of the US sovereign credit rating that followed hawkish central bank posturing in Japan.
The vulnerability can be seen in a measure of equity positioning kept by Deutsche Bank AG, which hit an 18-month high in July, as well as in stock options, where disdain for protective hedges has reached unprecedented levels. Meanwhile, wagers on higher oil and copper prices jumped in the futures market, and ETF traders piled into long-term Treasuries at a near-record pace.
The dash for risk has been aggressive enough to push asset yields out of joint, historically speaking. In what one brokerage termed an “upside down” market, the Russell 1000 index of stocks had rallied hard enough to send its earnings yield below payouts on investment grade bonds — a rare event — while a similar reversal is visible comparing profits for mid-size companies to rates offered by junk credit.
“If the ball starts going downhill, there is potential for a large downdraft given recent new longs,” said Scott Rubner, a managing director at Goldman Sachs Group Inc. who has studied flow of funds for two decades. “Fitch is the match, but it was already in motion.”
A bout of program selling may have contributed to Friday’s afternoon reversal in stocks, he added. By his model, bulled-up rules-based traders who allocate assets based on trend or volatility signals are poised to sell in coming weeks after price swings widened and market momentum weakened. The quant cohort has boosted exposure to elevated levels after chasing equity gains for better part of the year.
Stocks fell for the first time in four weeks, with the S&P 500 losing more than 2%. The Nasdaq 100 dropped 3% for the worst week since March, weighed down by Apple Inc.’s disappointing sales and a spike in bond yields. The RPAR Risk Parity ETF (ticker RPAR), a gauge of cross-asset performance, slipped 2.3%.
At the center of the tempest has been long-dated government bonds, dropping in part because larger-than-expected increases in auctions by the US Treasury, along with the Fitch downgrade, put focus on the nation’s deteriorating fiscal outlook.
The iShares 20+ Year Treasury Bond ETF (TLT) sank more than 3%. Last month, the fund attracted $4.8 billion of fresh money — the second-highest inflow on record.
“The market has priced in a lot of optimism and become too exuberant at a time of a still uncertain environment and economic deceleration,” said Michael O’Rourke, chief market strategist at Jonestrading. “There’s been a lot of hype in the system lately. The Fitch downgrade was an excuse to sell.”
Major ETFs tracking investment-grade bonds, high-yield credit and commodities also slipped on the week, marking an everything selloff that was the mirror image of July, when lockstep cross-asset rallies occurred two weeks in a row.
Investors, who largely came into the year defensively positioned only to be caught out by the market resilience, are now leaning squarely in the other direction. Their unusual risk appetite is illustrated most explicitly in the multiples that they’re willing to pay for stocks versus bonds despite falling three quarters of falling profits.
Since the turn of the century, investors have mostly demanded higher returns on riskier assets. But that’s not how it’s been this year. In July, forward earnings yield for the Russell 1000 — the reciprocal of its price-earnings ratio — stood at 4.8%, below the 5.4% payout offered by investment grade corporate bonds. Morgan Stanley strategist Andrew Sheets found that only happened 2% of the time in the last two decades.
Similarly, mid-cap stocks fetched an earnings yield of 6.4%, trailing the 8.3% payout from high-yield bonds, Morgan Stanley data showed. Sheets also noticed pricing dislocation in real estate and leveraged loans.
“Across asset classes, the capital structure increasingly looks ‘upside down,’” he wrote in a recent note. “This compression, and even flipping, of the capital structure suggests that growth expectations have now moved a long way since the start of the year.”
In the derivatives market, small-fry investors loaded up on calls and sold puts, buying a $4 billion equivalent of stocks via options while selling $7.5 worth of volatility, in the week through Wednesday, according to data compiled by JPMorgan Chase & Co.’s Peng Cheng. That resulted in the largest order imbalance in favor of bulls since the firm started tracking the flows in 2020.
Ebullient sentiment has helped propel the S&P 500 as much as 28% higher from its October low. Now that the bull camp has grown and the economic uncertainty lingers, this week was a reminder of the potential downside risk should inflation pick up or growth slow, according to Sonia Meskin, head of US macro at BNY Mellon Investment Management.
“It could be technicals or positioning that just needed a mild catalyst,” she said. “The market is not positioned for reacceleration or sticky core inflation, nor is it pricing in the tail risk of potential challenges to credit spreads should rates stay higher for longer.”
–With assistance from Isabelle Lee.
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