Novum Alpha - Daily Analysis 28 January 2021 (10-Minute Read)
Top of the Thursday to you as markets were roiled by a dour economic outlook by the U.S. Federal Reserve.
In brief (TL:DR)
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What a difference a day makes.
Prior to comments from the U.S. Federal Reserve, investors sat on the sidelines.
Yet as the Fed promised to keep the status quo and pump money into the U.S. economy, fears are growing that the endless flow of liquidity were insufficient to buoy sentiment.
While historically, excess liquidity has seen risk assets bid higher, investors had also bet on a resurgent economy.
But you can't have your cake and eat it - you can't have both loose Fed policy as well as economic recovery on the charts.
What the U.S. Federal Reserve Chairman Jerome Powell did make clear though was that even when there are signs of an economy heating up, the Fed wouldn't just withdraw intervention suddenly.
And despite all the ingredients for a bigger bubble to be inflated, investors decided to cash out of risk, go figure.
In Asia, stocks were uniformly lower in the morning trading session with Tokyo's Nikkei 225 (-1.01%), Hong Kong's Hang Seng Index (-0.71%), Seoul’s KOSPI (-1.04%) and Sydney’s ASX 200 (-1.93%) all in the red.
1. There's No Such Thing as "Smart Money"
“A rose by any other name would smell as sweet.”
– Romeo & Juliet, Act 2, Scene 2
If the last few years were anything to go by, it’s not to underestimate the power of the people, or the wisdom (or lack thereof) of crowds for that matter.
Because the sheer impact of retail traders on the markets has been nothing short of incredible.
Whether it’s been to fire up the stocks of Tesla (-2.14%), or fueling the relentless rise of GameStop (+134.84%), the easy access of zero-fee trading apps such as Robinhood and SoFi has reset the balance of power in markets away from Wall Street, and into places like r/wallstreetbets, a Reddit forum dedicated to “making money and being amused while doing it.”
So how do retail traders wield so much power?
Exploiting a structural weakness in markets, one way is to buy stock options (the option to buy or sell an underlying security after a set period of time) in order to try and squeeze share prices higher.
The key is not how much retail investors can shift the markets, but how much leverage they push into the system in the process of doing so.
Take a simple example of someone who buys a US$3,250-strike weekly call option contract on Amazon (-2.81%) stock for August for US$1,500, an option which gets sold thanks to a market maker.
But the market maker, who sits at a large dealer bank isn’t taking the other side of their bet, that’s not their job, so the market maker wants to hedge the position, by buying Amazon shares based on the delta of the position (how much the option will change in value based on the price of the underlying stock).
Let’s say that the market maker now calculates they need to buy US$66,100 worth of Amazon stock to “neutral” this position.
Right away, that US$1,500 option has translated into a US$66,100 buy order for Amazon stock.
If the price of Amazon goes up, the market maker will have to pay out on the option, but at least it will be offset by the gains in the Amazon stock.
But because markets are dynamic, market makers need to keep rebalancing their portfolios to keep their risk neutral.
If Amazon’s stock price indeed goes up, even by say 5%, the market maker will need to buy even more stock, as much as US$230,000 more just to cover the exposure.
In other words, that US$1,500 option has now transmogrified into a US$230,000 buy order for Amazon stock.
Collectively, enough options activity can have a ridiculous impact on the markets themselves, but the key is how to harness and direct the power of the collective.
And that’s where places like r/wallstreetbets comes in.
The same way a school of mackerel has a collective intelligence, forums on Reddit can muster tremendous amounts of options activity to take advantage of what’s known as “gamma squeeze” betting that as the value of a stock gets closer to an option’s strike price, market makers will need to go out and buy more of the underlying stock to risk neutral their positions.
That dynamic may be enough to send a target share price upwards, now drawing in other investors, sparking increased buying of call options into a frenzied self-perpetuating feedback loop.
Is it sustainable?
In the past, stock prices used to be capped by earnings multiples and valuations and based on the analysis of tie-wearing wonks on Wall Street.
Excess liquidity in the markets has changed all that and the ease with which retail investors can now participate in the markets means that there’s no such thing as “smart money” anymore, there’s just money.
And investors will need to go where the money flows, fundamentals be damned.
2. Keep Us Well Fed
U.S. Federal Reserve Chairman Jerome Powell delivered a somber message on the state of the U.S. economy on Wednesday that spooked markets, even though they ought to have rallied.
Noting that a return to normal was still far away for the world’s largest economy, Powell reinforced the central bank’s determination to keep pumping massive amounts of monetary stimulus into the economy, which under normal circumstances should have sent shares higher.
Instead, the dour prognosis of the U.S. economy saw shares experience their worst day of the year, with losses accelerating even as Powell spoke to reporters.
But Powell had to set the stage for justifying the continued loose monetary policy.
Some analysts had expected the Fed to taper support by reducing the scale of its asset purchases, including for U.S. Treasuries and mortgage-backed securities, and Powell needed to paint a portrait of an economy that was still struggling to justify the lack of a taper.
Had Powell come out with an optimistic tone, stocks might have fallen anyway, on fears that interest rates would go up sooner than expected.
But Powell also reassured jittery investors that any talk of tapering was “premature” and if nothing else, the Fed had every intention to communicate any intention to taper to the markets, well ahead of the fact.
Speaking at a press conference, Powell said,
“The economy is a long way from our employment and inflation goals, and is likely to take some time for substantial further progress to be achieved.”
While stocks may have pulled back in the interim, on concerns that the economy may not be recovering as quickly as hoped, it also means status quo, and thus far, more liquidity has almost always translated into higher prices for risk assets.
And if the Fed is concerned about inflation, Powell dismissed such fears,
“Frankly we welcome slightly higher, somewhat higher inflation. The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time.”
3. Bitcoin Tests US$30,000 Support Again
How many times can you strike a dam before it bursts?
As Bitcoin dipped below US$30,000 for the second time this week, traders are guessing where the bellwether cryptocurrency is headed to next, as it struggles to regain momentum after sharply correcting from an all-time-high near US$42,000 earlier this month.
Falling by as much as 9% at one stage, Bitcoin dipped below US$30,000 before rebounding just as quickly.
Having surged by over 300% in 2020, amid speculation that institutional investors were piling into Bitcoin with interest rates near-zero, companies such as Square (-3.21%) and MicroStrategy (-3.52%) have put a portion of their balance sheets into Bitcoin.
Technical analysts are suggesting that Bitcoin has room to correct lower, with Bitcoin having dipped below its 50-day moving average.
And some analysts are suggesting that Bitcoin’s lackluster performance of late is because retail flows have moved into other speculative corners of the market, bidding up shares of video game retailer GameStop and embattled movie theater operator AMC Entertainment Holdings (+301.21%).
Because retail trading apps such as Robinhood make it easy for retail investors to buy options, there is some suggestion that retail buying has moved into the speculative options market, with flows being withdrawn from the cryptocurrency markets.
Fundamentally though, little has changed for Bitcoin.
Assurances by the U.S. Federal Reserve that it’s not tapering its asset buying program and continuing to pump liquidity into the markets ought to be seen as a longer term positive for Bitcoin which is prized for its alleged deflationary properties.
And the expansion of institutional-grade investment options as well as the erosion of the Grayscale Bitcoin Investment Trust premium are all signs of a maturing market.
Add to that the prospect that PayPal (-4.59%) will be empowering spendable cryptocurrency and the macro outlook for Bitcoin continues to be bullish.
In the interim however, volatility and the trading range for Bitcoin might actually expand from US$25,000 all the way up to US$35,000.
Considering that US$20,000 for a single Bitcoin was once considered the destination, Bitcoin still very much remains in bull market territory, as unreasonable as that may seem.
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Jan 28, 2021
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