"Capitulation": Nomura Explains What Is Behind The Market's "Freak Out"

On Monday morning, when the market's moves were still relatively orderly, Nomura's Charlie McElligott made a prescient observation why momentum stocks were getting slaughtered, and why the "value to growth" rotation was about to leave hedge funds with even greater losses.

To those who listened and unwound, congrats, because on Tuesday, with the Dow down almost 600 points at its lows, McElligott writes that the cross-asset markets de-risking continues, which somewhat surprisingly is occurring in conjunction with a collapse in market expectations for 2019 Fed implied hikes, down to just 31.5bps.

This is a clear shift in market sentiment, because even as the market prices in a dovish Fed, stocks are getting crushed.

This "Best is Behind Us” / “Fed has tightened us into a slowdown” view is entrenching itself alongside the weekend escalation of Trade War Cold War between China and US, which is clearly now bleeding into the supply-chain and broad sentiment, the Nomura strategist writes today and notes that signs of capitulation are visible across the asset spectrum, as "VaR-down" behavior becomes apparent via new local- and multi-year lows/wides being made, with the credit blow out accelerating and HYG down for 8 days in a row (the record is 9).

VaR-down with liquidation of "longs" and 100-500bps of outperformance from shorts:

Meanwhile, contrary to what JPM suggested recently when it saw no further selling pressures in the quant space, yesterday’s US Equities Momentum factor unwind (with the market-neutral strategy -3.5% on session) was a 1st %ile event dating back to 1983, with the selloff of “Momentum Longs” (-4.5%) in particular was a 0%ile move, i.e., extremely rare.

What happened was that as hedge fund liquidations continue, whether due to redemption requests or otherwise, uber-crowded longs in the US Software industry were being liquidated according to McElligott, with GS basket of Software Cos trading 8x’s EV / Sales -10.0% on the day, an impossible -8.7SD move across all returns in its 2.5 yr history; Elsewhere, S&P Tech was -3.8%, Russell 2k Tech -4.6%; Finally, the Nomura strategist notes, or rather warns, that Nasdaq 100 30d volatility sits at 35, the highest level since late 2011, which just means more mechanical “VaR-down” is coming for these “longs”.

Going back to today's market, here are some additional observations from McElligott: 

  • Overnight we see US 10Y yields break their post-Labor Day range though 3.05% to the downside, while I also note that front Eurodollar too break to the upside through both 50- and 100- DMA’s over the past week, and are nearing a break of the 200- DMA for the first time in 13 months
  • Global Credit selloff becoming particularly acute as the “cycle psyche” turns, with US IG CDX back through pre-2016 election levels and EU HY (iTraxx Crossover) making new 2 year wides / EU SubFin 1.5 year wides
  • EU periphery sovies getting ugly again, in particular the BTP-Bund spread out to 327bps, the widest in 5.5 years
  • US inflation Breakevens show both 5Y- and 10Y- kind making now YTD lows
  • Cryptocurrency selloff moves to unprecedented levels with Bitcoin -30% MTD / Ethereum -33% MTD / Litecoin -35% MTD respectively, and greater than $700B+ of market value destroyed since the “mania” peaked in January, as the chief proxy of “QE-era speculative excess” is defenestrated into an existential crisis

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So what is the root cause behind this seemingly relentless market freakout?

To McElligott, the answer is the theme where “tighter financial conditions” bleed across and reset (lower) risk-asset term premium—is picking-up steam, ESPECIALLY now that the Fed’s pivot to a “softer tone” perversely acts to “confirm” the market’s multi-month “tightening ourselves into a slowdown” worst fears.

Here, after markets were spooked by Powell's Octoebr 3 line that policy is "a long way from neutral", over the past week, multiple Fed speakers seemingly attempted to “walk-back” the hawkishness of that comment with a more moderate data-dependent tone, with Powell himself acknowledging last week that the Fed is “…well aware of” the three key challenges to growth in 2019—fading fiscal stimulus, slowing demand abroad and the lagged-impact of the prior policy normalization.

Two days later, the "tantrum-ing" market then further seized on Vice Chair Clarida’s Friday commentary where he “moved the goalposts” of Powell’s October “…long way from neutral” statement, instead saying “…I think being at neutral would make sense”—which to McElligott was "effectively a RATE CUT with regards to prior forward expectations" as we discussed yesterday.

But instead of being a “dovish relief story,” it instead did the opposite in the minds of investors who are seemingly committed to pulling-forward the “end of the cycle” trade.

Meanwhile, as tighter financial conditions / higher interest rates eventually slow the real economy (see yday’s NAHB sentiment collapse / “miss”), Charlie's thesis continues to expect timing of said slowdown coming after the March 2019 hike, "at which point I believed the market would “sniff” said slowdown and thus REMOVE HIKES from the front-end as the Fed would be forced to “pause”—in turn, steepening the curve."

Instead, some in the market are pulling-forward this “end of cycle” view into the NOW, which is being exacerbated by already ugly performance and year-end illiquidity / dealer balance sheet “tightness” leading to capitulatory behavior—with the concurrent volatility in-turn is nuking legacy QE-era “curve flattening” derivative trades, i.e. the consensual U.S. Equities “Growth over Value” positioning

And, as the Nomura strategist has said before, this Trasury curve bull steepening would act as the ultimate “end of cycle” risk-off signal, telling traders that we were at the end of Fed policy normalization—because growth trajectory is decelerating, fiscal stimulus impacts are rapidly diminishing, financial conditions are net / net “tighter” and that policy has approached the level where it is no-longer “stimulative”

Which brings us to McElligott's conclsion, in which he notes that "in the sense that I still believe that in this current state the Fed will hike two more times (Dec18 and Mar19) before the “gig is up,” I am surprised that the market is taking this current (and still somewhat modest Fed language shift reversal) as THE “Fed pause / slowdown” cue; but regardless of the timing-scenarios, the risk now is that the market de-risking only FURTHER acts to tighten financial conditions (especially in Credit) while bleeding sentiment further in a vicious cycle."

Finally, adding insult to injury is the mega Fed balance-sheet shrinkage tomorrow, when $27.1BN of combined Treasuries and MBS- mature, acting to further “tighten” financial conditions.

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And, as a bonus, for any funds still desperate to position themselves, here is McElligott's take on how to position in Growth vs Value during this turbulent period:

Growth LONGS are “expensive stuff” that gets CRUSHED at the end of cycles because they will see the largest cuts in forward EPS—and we’re seeing said “revisions lower” within “Growth LONGS” in real-time

Only later then does “Value” get the additional kicker from “Value LONGS,” as after we hit slowdown / recession, the market begins to price-in the next Fed EASING cycle, and these primarily “economically sensitive” stocks see the highest re-weighting / benefit to the rate cuts through their cyclicality

This is not going to be a “linear” path; there are periods where both Growth- and Value- can work—however, I believe that relatively speaking, Value continues to outperform over the next 1Y window, continuing its enormous outperformance QTD:

  • Value: Dividend Yield +11.5% QTD; EBITDA / EV +11.0% QTD; Predicted E/P +7.8% QTD; E/P +7.8% QTD; Dividend Payout +6.5% QTD; B/P +5.6% QTD; Sales / Price +5.6% QTD; Cash Flow / EV +3.1% QTD
  • Growth: Predicted 1Y EPS Growth -9.8% QTD; Predicted LTG -8.4% QTD; Sales Growth -5.1% QTD; 5Y EPS Growth -2.4% QTD; PEG -2.2% QTD