EPIC meltdown in progress

comparing the past QT period to the present

At the start of today’s trading session, we are seeing an epic reversal of yesterday’s post-FOMC announcement gains. Jerome Powell’s attempt at a dovish hike and the resulting cheer-leading from the mainstream financial press has done nothing to hide the obvious. That is, higher rates will crush growth companies. Unfortunately, good, productive companies are getting sold off today as well.

Outside of my puts on non-profitable tech stocks, everything else is getting crushed and stopped out. Even with gold and oil up, the related drillers and miners are down. This shows me that the big boys who hold a lot of shares are creeping toward panic mode. They are indiscriminately selling in an attempt to raise cash for the coming redemptions.

Private equity firms (PE) and hedge funds (HF) operate on their ability to generate a return (called alpha) back to their investors. Due to SEC rules, they are only able to take money from accredited investors. These are investors either have an annual income exceeding 200k per year or have $1 million in net worth. There are a few other ways to become an accredited investor but these are the two primary ways. Neither of these factors cause an accredited investor to be well educated in the ways of the market. Most aren’t. They’ve made their money in a different field (doctor, lawyer, business owner) and have been given the option to hand their money over to an “expert”. Previous returns for PE and HF groups drive more accredited investors to those funds. When these funds begin to under-perform their peers, accredited investors pull their money and look for a new home for it.

In an effort to not fall behind their peers, these companies all load up on the same stocks. So when these accredited investors see their statements and demand their money back, PE and HF groups have to sell their holdings to raise cash to pay back investors. This creates a doom-loop where more redemptions beget more redemptions. At the same time, we have been witnessing a contraction in the amount of margin that traders are utilizing. This is pushing the market into a major deleveraging event. This gets exacerbated by the Fed’s QT program.

What the Fed is doing is two-fold. First, they are raising interest rates in a stated effort to combat inflation. In reality, the Fed will need room to cut interest rates when the next recession hits and they know they are behind the curve. Secondly, the Fed is attempting to reduce their balance sheet. This is called Quantitative Tightening. I received a question yesterday on this topic.

What can we use to estimate the impact and duration of the fed clearing $100B off the books every month? My understanding is the last time it was done it was very little, very painful, and stopped very quickly. Is it time to buy Puts against tech indexes? Will 6+ 50 basis point raises gain traction against inflation ?

The last time the Fed ran a QT program, they were attempting to reduce their balance sheet by $50B per month. This was split $30B of Treasuries, $20B of mortgage-backed securities (MBS). The Fed’s balance sheet hit a high of $4.48T in April of 2017. The QT program didn’t really take off until the beginning of 2018. It stopped abruptly at the end of August in 2019 with the Fed reducing it’s balance sheet to $3.76T. That was a reduction of $720B or roughly 16%.

During this period, we saw repeatedly choppy and erratic market action.

When the Fed runs their QT program, they are removing liquidity from the market. This leads to the wild, choppy action. Even though the market action was rough, the S&P gained 24.7% between the balance sheet peak to the end of QT.

I would caution that this period was different than our current period due to the state of the economy. From 2017-2019 we saw a very robust business environment. Inflation was low and transportation costs were very subdued. The global economy was functioning without hiccups and US GDP was between 4-6% on a year-over-year basis.

This time around, we are facing the exact opposite. The economy is headed towards a slowdown. We already have one negative real GDP quarter under our belt. On top of a slowing economy, we are dealing with inflation in excess of 8.5% and transportation costs that continue to surge higher.

This current round of QT is much more aggressive than the prior period. The Fed wants to double their prior per month reduction to $100B. This will be a serious liquidity drain on the market. It will exacerbate the current trend, which is lower. Until earnings show improvement, stock prices are going to be under pressure.

Is it time to go short? In a word yes but I caution those who have never had the experience. Going short the market is a dangerous proposition. All it takes to sink your portfolio is a surprise Fed announcement that they will restart QE and provide unlimited liquidity. I think the best mode of action is to buy put options on the non-profit tech companies. I highlighted some of these in this post from April 26th. I am currently holding puts on MDB, CVNA, and TWLO. They are all long-dated with a September 16, 2022 expiration.

Buy using option contracts, you limit your downside to the principle you pay for the contract. As an example, the CVNA 50 Put that expires 9/16/22 is currently trading around $13.10. Each contract is worth 100 shares, so if I were to buy this contract right now, it would cost me $1,310 per contract. This caps my loss at $1,310. I would never lose more than the principle cost of the contract.

If you decide to go short in the traditional sense, you sell shares on the market and receive that money. You have to pay a borrow cost for the shares that are sold and you’ll need to buy them back at some point. This leaves you open to unlimited loss in the event that the stock or index rockets to the moon.

Also know this, I am not qualified to give advice on how you should profit from this turbulent market. The best I can do is show you what I’m doing and how I handle my portfolio. I’m not a CFA or investment advisor. There are inherent risks in every investment. You need to personally understand those risks and do your own due diligence before attempting this at home.