While most readers and followers will know me from company-specific analyses we shouldn’t forget share prices are not only steered by financial results but also by sentiment. And it’s exactly that sentiment that may be disrupting the efficient market theory. Are markets efficient? In the large-cap segment you can perhaps indeed say they are “somewhat” efficient, but that’s for sure not the case in the lower market cap segments.
And let’s not forget about the European flash crash earlier this week when a fat Citigroup-fingers pushed Scandinavian stocks lower by several percent. The very same algorithms that were supposed to contribute to a more efficient market jumped in and accelerated the flash crash.
But even in an efficient market and assuming no human error, sentiment can make share prices do strange things. And that’s both the problem as well as the opportunity when investing. It’s a problem because it causes and creates irrational behavior (think about the negative oil price in 2020) but it also is an opportunity for those investors who understand the situation and dare to act on it.
So where’s the market nervousness coming from? Surely not the rate hike?
The main markets turned very red in the first trading day after the Federal Reserve hiked the rates by 50 bp. Perhaps surprising or a coincidence as that rate hike did not come unexpected at all. The size and timing of the rate hike were pretty much “as expected.” However, it’s starting to look like “meeting the expectations” actually was a disappointment to investors as suddenly the market started doubting the capability of the Federal Reserve to fight the high inflation without causing a recession. The word “stagflation” is bon ton again. And perhaps not undeservedly so.
On Thursday, in excess of $1T in value was lost on the markets. And that’s just Wall Street. If you’d throw in the losses on the European and Asian markets as well, the total amount of wealth that evaporated in the course of just 24 hours was staggering. And is this all because of the sudden fear for a stagflationary period?
I think there are four interesting elements playing in the background which may not have caused the sell-off but may have contributed to the fire-sale on the markets. It would be naïve to pretend these four elements are decisive. But I feel they did play a role in the greater scheme of things.
The elephant in the room obviously is inflation. In fact, the inflation rate has reached the highest level since the eighties and even right before the Global Financial Crisis we haven’t seen the 8.5% inflation rate we are currently experiencing.
I was one of the first people to make fun of the comment “inflation will be transitory.” Yes in the end all inflationary cycles come and go. So in a way, inflation is per definition transitory, but I don’t think that’s what the Federal Reserve meant with its comments.
However, there will be an important part of the inflation that may very well be transitory: Energy. Energy price increases accounted for about a quarter of the total inflation rate. The inflation rate excluding energy and food was “just” 6.5%. Still too high, don’t get me wrong, but it already puts things in a different perspective. If the energy prices no longer climb, the contribution of energy to the total inflation rate will drop to zero.
A lower cost of energy also will immediately have spill-over effects into other consumption-related elements. That pack of coffee you opened this morning could be 10% more expensive today compared to when you bought it. And that’s not necessarily because of the coffee beans price increase. Think about the packaging and transportation of your pack of coffee. Those two elements will be closely correlated to energy prices as well. Plastic is made from oil while the semis transporting the coffee to your local grocery store are still mainly running on combustion engines.
More than anything else, the current inflation issue is caused by energy prices. And that could and perhaps should spark a debate about a country’s policies. A good example is for instance the US where under Biden’s presidency drilling for oil is discouraged, the Keystone XL pipeline was vetoed while the magical solution now seems to be to import oil from Saudi Arabia (and other countries) using polluting tankers. Or as Jason Kenney, the premier of Alberta, Canada’s main oil producing province says, he’s happy to discuss resuscitating the half-built Keystone XL pipeline.
Energy will be the key element to solve the current inflation problem. It will not solve a tight labor market, but it will solve a large portion of the issues. And strangely, it also is (or maybe was) one of the easiest hedges for investors. It’s easy enough to get exposure to the energy sector which will act as a buffer against the impact of the high energy-induced inflation elsewhere. As long as hydrocarbon-related sources of energy remain important in our daily lives, it makes sense to have exposure to them from an investment perspective and a portfolio perspective as it could help to create a “communicating barrels” strategy. In my personal portfolio I’m losing money on my conventional positions on a YTD basis, but this is more than fully compensated by the gains on my oil and gas producers in my portfolio (which make up a low double-digit percentage of my portfolio now although the initial weight was in the single digits).
We knew the inflation was increasing, we knew there was a war going on in Ukraine and we knew supply chains were still quite disrupted. Perhaps the market was expecting too much from the companies reporting results. In most cases the Q1 results were still decent but it’s the comments and outlook for the second quarter and the rest of the year that are causing the unrest.
The first real correction for unexperienced “COVID” investors
Another potential contributor to the panic on the markets could have been caused by the fact this is the first “real” correction experienced by investors/speculators that started investing/speculating during the COVID crisis. The past two years have been relatively “easy” and it was difficult to lose money on the markets between Q2 2020 and now.
Volatility levels are increasing, the world economy is more or less normalizing, which means that it’s getting increasingly important to do your homework and the strategy of “buying stocks and hoping for the best” is no longer valid. While the markets have been shaky for the past few months, there have been more bad days than good days lately and the next chart provided by Bloomberg shows there have been several larger moves this year. To the upside and to the downside.
It’s not unlikely unexperienced investors have trimmed their positions now they see their performance of the past two years is not exactly representative of how markets usually work. Robinhood (HOOD) reported a lower ARPU which is indicative of lower trading frequency by its customers. Additionally, the total amount of active users fell by 8% in just one quarter. Perhaps some of those users moved to brokers that better suit their needs, but it looks like a bunch of investors is just giving up. That being said, we should not be too concerned about this as this will likely only have played a minor role in the selling pressure we saw in the past few months. But if anything, it means there are fewer potential buyers in the system.
The margin debt will start to get expensive
The Fed increasing interest rates also will have an impact on trading behavior. According to FINRA data the total amount of margin debt on the accounts had been steadily increasing since the start of the COVID pandemic. As of the end of March 2020, there was about $480B of margin debt in the system. This continued to increase throughout the subsequent 18 months to a total level of in excess of $935B as of the end of October. Fortunately, the total amount of margin debt on the accounts has been decreasing since (to $800B as of the end of March) but this could also explain the weakness in the past few months as investors started to reduce risks by cutting margin debt.
I’m looking forward to seeing the updated FINRA numbers for April and May as I think we will see a further reduction of the margin debt. Not only because we’re likely facing more uncertain times, but because maintaining margin debt will become more expensive as rate hikes progress. Just to give you an example, Interactive Brokers calculates the cost of margin as the Fed Funds Rate plus a mark-up. The Fed Funds rate was at 0.33% earlier this week after the first rate hike (it was at 0.08% before) but has now been hiked to 0.83% after the recent Federal Reserve rate hike. This means that the cost of margin debt has increased by 75 bp. And applying this to a total margin debt of $800B means the cost of buying stocks on margin has increased by about $6B per year.
And this obviously wasn’t the last rate hike. The market is already pricing in an additional 200bps in rate hikes as you can see below on the Target Rate probability for November 2022 as provided by the CME Group.
An additional rate increase to 2.75% would further increase the cost of margin debt by $16B to a total of $22B. So it’s not illogical to see investors using margin accounts scaling back their portfolios to avoid a sudden increase of the interest expenses on the account.
Rather than pointing at one specific cause, I think the weakness we are currently seeing on the markets is caused by a combination of elements. And unfortunately, there’s no easy solution for investors other than understanding the companies and businesses you invest in and to understand the implications of inflation and interest rates on the financial performance of your investments.