Markets were rangebound in May as the S&P 500 and Bitcoin both ended the month +0.3% and -6.9%, respectively. After a strong rally off the 2022 lows, risk assets are now consolidating as investors and traders continue to contemplate if we’re at the beginning of a new bull market or in the eye of the macro bear market storm. Although the global liquidity cycle did bottom in October 2022, we do not believe this is a durable inflection and expect a double-sided liquidity contraction (from the U.S. Treasury and Fed) in U.S. markets once the debt ceiling is resolved.
Layering on our quantitative tools, our top-down macro and bottom-up volatility models are signaling the following market regimes:
Top-Down Macro Model – Signals project directional asset class returns with a 3-month time horizon back-tested across 20 economic and market indicators.
Stock Market - BULLISH
Bond Market - BEARISH
U.S. Dollar – BEARISH
Commodities – BEARISH
Bitcoin – BEARISH
Bottom-Up Volatility Momentum – Understanding that volatility is a leading indicator of price, we track the volatility momentum across select assets to project real-time price floors and ceilings.
S&P 500 – BULLISH
10-Yr UST Yield - BULLISH
U.S. Dollar – NEUTRAL
WTI Crude Oil – NEUTRAL
Bitcoin - NEUTRAL
All told we do not subscribe to the idea that the recession was fully priced into markets last year. Our indicators suggest we’ll soon enter a period of cross-asset volatility, and we believe the bulk of the risk is still ahead of us. We would caution investors to not buy into the “new bull market” FOMO.
Base Case - We Are Late Business Cycle
First introduced by Michael Kantrowitz, Chief Investment Strategist at Piper Sandler, the HOPE (Housing, Orders, Profits, and Employment) framework is used to track an economy’s progress through the business cycle. We’ve also added Inflation which is the most lagging indicator in the economy. Based on our analysis of historical recessions, we learned that on a median basis:
HOUSING – Breaks down 18 months ahead of a recession
MANUFACTURING ORDERS – Break down 10 months ahead of a recession
CORPORATE PROFITS – Break down 6 months ahead of a recession
EMPLOYMENT – Breaks down coincident with the start of the recession (also historically when markets peak)
INFLATION – Breaks down 7 months after the start of a recession
Based on our analysis of the current business cycle:
HOUSING – Broke down 22 months ago
MANUFACTURING ORDERS – Had negative inflections 14, 12, 8, and 4 months ago
CORPORATE PROFITS – Broke down 4 months ago
EMPLOYMENT – Still strong
INFLATION – Still strong
In summary, it’s clear we’re late stage in the business cycle and expect the labor market (employment) to break down within the next 1-2 quarters, which coincidently may also line up with the stock market peak. While every business cycle is different, the Fed is already predicting a recession by year-end, and we do not expect them to panic-cut interest rates and print money when unemployment begins to rise. The Fed must satisfy its price stability (inflation at 2%) mandate before easing monetary policy again.
Source: 42 Macro
Upside Risk - Extreme Crowding in Mega Cap Tech
With the S&P 500 and NASDAQ up 11% and 32% YTD as of writing, one would think we’re in a raging bull market. However, if we look underneath the hood, we see that there has been a significant divergence between the S&P 500 (market-cap weighted) and the RSP (equal-weighted S&P 500), suggesting that the strong YTD performance has been driven by a few stocks. Diving deeper, Meta, Apple, Amazon, Netflix, Google, Microsoft, Nvidia, and Tesla have been responsible for essentially all the market performance since March 8 (around the time when Silicon Valley Bank collapsed).
Curious enough, sell-side estimates show the largest earnings contraction of -7% in 2Q23, followed by flat growth in 3Q, 7% growth in 4Q, and 9% growth in 1Q24, meaning – consensus believes the worst earnings will be right now. Although we’re not sure how much further upside the market has from here, we suspect there is an asymmetric risk to the downside given how lofty estimates are for the 2H and how much crowding we’ve seen in only a few companies while small-cap companies continue to massively underperform mega caps. Be cautious when others are greedy.
Source: Netizen Capital
Downside Risk - Liquidity Contraction This Summer
Speaking of asymmetric downside risk – aside from the obvious recession indicators, what gives us pause on chasing the market at these levels is that for the past 5 months, the U.S. Treasury has been adding liquidity back into the market, essentially sterilizing the Fed’s quantitative tightening ahead of the debt ceiling. We expect the debt ceiling resolution will be a sell-the-news event.
On our current course, the U.S. fiscal deficit is likely to be another $1.1 trillion in 2H23. In addition, we expect the U.S. Treasury will rebuild its Treasury General Account by $450 bn, all while the Fed continues to do $90 billion a month in quantitative tightening. All combined, we expect the U.S. Treasury to issue $2.1 trillion (or 70% of full-year global GDP growth!) in USTs in 2H23, which will be a severe liquidity drain on financial markets in the coming months.
This effective net UST issuance will accelerate the likely phase 2 credit contraction we’ve discussed in previous letters, as the U.S. government, commercial real estate, and venture capital firms all compete for increasingly scarce capital. This would result in a “USD up, interest rates up, and assets down” regime, like what we saw last year. In short, we suspect 2H23 will be very difficult for risk assets as liquidity contracts again.
Source: Crossborder Capital, FFTT LLC
Bitcoin Searching For Equilibrium
There was a notable divergence between Bitcoin (-6.9%) and Nasdaq (+7.6%) in May. Over the past month, we’ve seen Bitcoin unable to hold above $30k as network and exchange activity have all slowed. Notably, Bitcoin’s monthly realized volatility dropped to 34%, more than 1 standard deviation below normal, which historically accounts for only 19% of Bitcoin’s trading days. We would note that periods of very low realized volatility typically precede periods of very high realized volatility. The question for us then is, “In what direction will Bitcoin break out?”
The low volatility and declining on-chain activity suggest we are in some type of equilibrium phase. The Net Unrealized Profit/Loss (NUPL) metric allows us to examine the dollar value of the total net profit/loss as a percentage of Bitcoin’s market cap. This allows us to define 4 phases in Bitcoin’s market cycle:
Bottom Discovery = NUPL < 0
Capitulation/Recovery = 0 < NUPL < 0.25
Equilibrium = 0.25 < NUPL < 0.5
Bull Market Euphoria = NUPL > 0.5
Source: Glassnode
Currently, NUPL is at 0.26, suggesting we’re on the lower boundary of equilibrium. Historically, Bitcoin’s price gaps through the Capitulation/Recovery zone, which suggests that NUPL at 0.25 may be an important pivot point for Bitcoin. In terms of putting real numbers on upper and lower boundaries, we believe that until the phase 2 credit cycle downturn is complete (in 4Q23 or 1Q24 based on current estimates), we wouldn’t expect Bitcoin to get above its Active Investor Cost Basis ($33.5k) or below its Investor Realized Price ($17.6k) in a worst-case scenario. As such, we will look to be buyers in the low $20k’s if we get another opportunity this summer. For what it’s worth, unless Binance or another exchange/fund collapses (which is a serious possibility), we don’t think Bitcoin will get below $15k.