With the S&P closing above 3,100 and the Dow sprinting higher in the last seconds of Friday trading to close above 28,000 for the first time ever, one can argue that the long awaited melt-up has finally arrived.
After a year of relentless retail and institutional outflows from equity funds yet which has seen a record buyback tide prop up the entire stock market (just last week BofA recorded its 6th busiest week on record for client buybacks, up 26% from the already record buyback pace in 2018 and making a mockery of the so-called buyback blackout period), equity flows are finally picking up as bond flows slow down. According to EPFR, flows into bond funds (+$4.2bn) slowed sharply this week from the very strong pace seen for most of this year ($10bn a week on average), while flows into equity funds (+$9.6bn) on the other hand remained strong for a third straight week, in contrast to the trend for almost a year (-$5bn a week since December) according to Deutsche Bank. Indeed, over the last three weeks, flows into equity funds ($33bn) overtook those into bonds ($23bn), for the first time since early December 2018 over comparable rolling three week periods.
Yet with most pieces in place to explain the melt up, there was one minor glitch in the matrix: even as US stocks soared in the past few weeks with just 2 down days the entire month of November, equity flows are rotating away from the US. Within equities, US (-$0.4bn) funds saw outflows this week which were more than offset by strong inflows into EM (+$3.2bn), Europe ($1.5bn) and funds with a global mandate (+$5.2bn). Within global funds in particular, Deutsche Bank noted that those which invest only outside the US saw very strong inflows ($3.1bn), their strongest since March of last year. Meanwhile, for European funds, inflows over the last four weeks have been the strongest since March of last year.
Actually, it's not just outflows from US stocks that doen't fit the narrative: recent US data has been unexpectedly disappointing, with the Citi US economic surprise index sliding back in the red after surging from deep negative in June, until it hit the most positive print in the past year at the end of September.
At the same time, various GDP Nowcasts and consensus estimates have tumbled, with the average Q4 GDP print now expected to come in at around 0.83%, down sharply from just last week's 1.25%.
Then there are US corporate earnings: according to Factset, with 92% of the companies in the S&P 500 reporting, the blended earnings decline for the index for the third quarter is -2.3%. Meanwhile, consensus EPS forecasts have tumbled in recent weeks, and Q4 EPS growth is now also in the red, suggesting US corporations are knee-deep in an earnings recession.
What is amusing, is Goldman strategist Alessio Rizzi summarizes these recent transformations, writing on Friday that "since the end of the summer, the baton has been passed from monetary policy to global growth, supporting a sharp re-rating of risky assets led by the underperformers in the first part of the year."
This is, in a word, laughable: not only has the baton not been passed to global growth, as US growth is once again backsliding, and Germany just escaped a recession by literally the smallest of possible margins growing at just 0.1% in Q3, the same dismal growth as Japan, but the latest Chinese data have been downright miserable, with GDP now expected to print below 6% and China's credit impulse just barely rebounding from cycle lows at a time when China's total credit injection was the lowest in years.
Perhaps what Rizzi meant to say is that the baton has been passed from monetary policy to NOT QE as investors has plowed into risk assets following the Fed's recent decision to buy $60 billion in T-Bills per month (which as both Bank of America last week, and Citi's Matt King on Friday now admit IS in fact, QE). Incidentally, anyone who wishes to understand what is really going on in the market is urged to read Matt King's latest "Has the monetary tsunami restarted?" (spoiler alert: yes).
Yet where the Goldman strategist is right is that as a result of the Fed's latest intervention, the bank's Risk Appetite Momentum indicator - also known as Goldman's "euphoria meter" - is now at all-time highs.
This is a problem, because while Goldman may have totally butchered the cause and effect of the recent NOT QE (but really QE)-driven meltup, where it does provide some actionable information is that record high levels of its Risk Appetite Momentum, those above 1, have historically signaled negative asymmetry for equity returns.
And while the sharp increase in risk appetite has likely been exacerbated by bearish positioning, the high RAI Momentum suggests that investors have started to price in a bottoming of the growth slowdown, which thanks to the market's reflexivity, increases the risk of disappointments: after all, the catalyst for the Q4 2018 crash was the collapse in central bank liquidity and fears that the Fed would hike even more (obviously, all that ended in Q1 of 2019 after the market's mini bear market on Christmas Eve 2018).
There is another risk according to Rizzi - one where investors turn from overly bearish to overly bullish, or as he put it, as markets shift from TINA (there is no alternative) to FOMO (fear of missing out), "there is a risk of an overshoot vs. the data, especially as noise around growth is likely to remain high."
So far, early signs of FOMO are coming from the options market, where call options have been well bid. Indeed, after a record high at the end of September, implied volatility skew has declined sharply across assets, equity spot-vol correlation has become much less negative and call vs. put volume has risen materially.
That said, for now it appears that euphoria is largely confined to the near future with longer-term option pricing still pointing to a less constructive stance. To wit, "while 1m equity call skew has become more expensive, long-dated call skew still looks considerably cheaper."
In addition, equity put skew has only marginally declined and the volatility term structure is now very steep, as long-term volatility has materially lagged the decline in short-term vol. This suggests investors’ concerns over 2020 remain high, likely owing to the US political agenda - i.e., will Warren beat Trump in the 2020 presidential elections - and uncertainty around the growth upside.
Add to the above observed euphoria the fact pointed out at the very beginning of this article that investors are finally throwing in the towel on defensive positioning and rotating into risk assets, and one can correctly conclude that the latest melt up has arrived.
Goldman's Rizzi is not fully convinced just yet, noting that "overall positioning does not appear very bullish" but as he warns "with market prices moving sharply higher recently and our RAI Momentum indicator being at historical highs, the hurdle rate for further positive surprises that sustain the strong momentum seems to have increased."
As such, Goldman concludes that "a moderation in the pace of the ‘risk on’ move is now more likely, unless a more sizeable improvement in the macro and political outlook materializes", or, more accurately, unless the Fed doubles down on its NOT QE. Alternatively, it is quite possible that the blow-off top accelerates into year end without any justification - besides the Fed's latest massive liquidity injection which have boosted the Fed's balance sheet by nearly $300 billion in the past 2 months, a faster rate than that observed during QE3.
Incidentally, the last time we had a similar market melt-up was in late January 2018, just before vol sellers overextended themselves, resulting in the overnight annihilation of the entire inverse VIX ETN complex, and the market collapsed. Back then, however, the Fed and other central banks were actually on hiatus from explicitly supporting risk assets; this time, however, with the Fed and ECB once again engaging in full-blown debt monetization, a sudden loss of confidence in risk assets - and by extension central banks - could prove catastrophic, especially with a record number of investors shorting the VIX...
... potentially setting up the biggest VIX short squeeze in history.