The stock market was insanely strong last week. And we don’t mean strength within normal boundaries either — as in, “the market had a strong performance” or “the market looks strong.”
This was strength well beyond the bounds of normal. It was strength so freakish, the standard explanations cannot account for it.
Here is Mark Hulbert, a columnist for MarketWatch, describing the market on May 30:
…94% of S&P 500 stocks now trade above their 50-day moving average (according to FactSet). Moreover, most stocks are not only in uptrends, the uptrends are accelerating. For stocks listed on the NYSE, 90% are now trading above their 20-day exponential moving averages…
When 94% of S&P 500 names are above the 50-day, and 90% of NYSE-listed stocks are above the 20-day — against a backdrop of Great-Depression-level unemployment, spiking COVID-19 cases, and protests across the country — “normal” has left the building.
An explanation exists. The thing is, it has nothing to do with the economy, or recovery, at all.
A great many analysts tie stock market strength to optimism around the country’s reopening. Jim Cramer, for example, routinely makes this connection on CNBC. “I think it’s about the reopening and to see how that goes,” he said on June 1.
Others say the market’s strength is down to a willingness to look past 2020, in anticipation of a V-shaped economic recovery.
But neither of those views pass the smell test. Optimism around the reopening wouldn’t give stocks the superhuman levels of buoyancy we are seeing (especially with COVID-19 cases starting to flare up again). And money managers don’t believe in the V-shaped recovery anyway — a recent Bank of America survey showed just 10% of them supporting that narrative.
At the same time, a new survey of the CNBC Global CFO Council, which represents public and private companies with a collective $5 trillion in assets, saw American chief financial officers (CFOs) give the U.S. economic outlook its worst rating in survey history.
So much for the “V” notion. Why, then, is the market so strong?
We previously pointed to a one-off combination of bored sports gamblers, zero-commission trading accounts, and stimulus checks. But moving forward, we would say it’s all about “flows.”
And flows have nothing to do with the economic outlook, the earnings picture, the fate of the reopening, COVID-19, or any of that.
There are market forces — call them “flows” for shorthand — that influence the price level of equities wholly independent of fundamental factors.
Flows can push stock prices up — and sometimes down — with absolutely zero regard for the future outlook, or what stocks should be rationally worth, or any fundamental inputs of any kind at all.
If the market is being driven by flows, and a Wall Street analyst says “The market is forecasting such-and-such,” or “The market sees a strong recovery,” that view might as well be gibberish. Flows are not an economic forecast or a valuation judgment. They are just flows, plain and simple.
To imagine how flows work, picture a gigantic municipal water reservoir, partially filled up with water. The level of the water line represents the price level of the S&P 500.
Now imagine this water reservoir has a ring of valves all around its circumference. These valves are reversible, which means they can push water into the reservoir or they can suck water out.
When flows are coming into the market, it is like water coming into the reservoir through the valves. The new flow pushes the water line — equivalent in our metaphor to the price of the S&P 500 — to a higher level than before, with no regard for where the water line actually is. The flows don’t make judgments.
Conversely, when flows go out of the market, it is like water being sucked out of the reservoir, drained away by the valves. This causes the water line to go down, equating to an S&P 500 decline.
These flows are often driven by agnostic forces, with no consideration of values or forecasts at all.
Consider, for example, how the S&P 500 recently pushed past the 3,000 level.
This level was strategically important because, in addition to being a psychologically powerful number, the 200-day moving average of the S&P 500 index was hovering at 3,000, too. (As of this writing it is 3,002.99.)
Why does this matter? Because large pools of capital are governed by computerized programs that pay attention to things like where price is in relation to the 200-day moving average — without caring about fundamentals in any direct way.
There is a group of funds known as “trend-following funds.” This group has a large degree of overlap with a comparable group known as Commodity Trading Advisors, or CTAs.
These funds tend to use mechanical, quant-style price strategies to ride long-term market trends. When trend-following funds are forced to reverse their positions at key price levels, they tend to do so en masse.
And according to Charlie McElligott of Nomura Securities, trend-following funds were a major source of short-covering in global equities, with $380 billion worth of buying hitting the market since March.
“CTA Trend buying has been a mammoth source of ‘buy to cover’ flows in global equities,” McElligott told his clients last week. “Yet there is still more fuel for the fire.”
This is where the S&P 500 breach of the 200-day moving average comes in.
That level is critically important because a great many quant-style trend-following funds are likely to reverse their positions as a result of crossing it. Not only are they forced to close out shorts, they may be forced to go long. The higher the S&P goes, the more buying pressure is placed on these funds, in a kind of flow-based feedback loop.
Now, ask yourself: If there are large funds pumping money into the market as a group, for entirely technical or mechanical reasons having to do with a 200-day moving average, what does that have to do with the economic outlook, or the shape of the recovery, or any of that? Absolutely nothing at all.
The possibility of trend-following funds covering hundreds of billions of dollars’ worth of short positions — and potentially flipping from short to long en masse — is just one example of how flows can impact the market.
The capital that flows into markets from 401(k) contributions is another example. To the extent these flows are automated, the money comes in no matter what. In an absence of countervailing selling pressure, these flows can push the market higher with no regard for outlook.
The key concept is that these flows are not judging the reopening or the recovery. They aren’t even attempting to make a judgment.
And so, when analysts say “the market believes this” or “the market is forecasting that” in an environment dominated by flows, they are unintentionally gaslighting their audience. They are assuming a cause-and-effect relationship that doesn’t have relevance at that point, and missing a set of drivers that is far more dominant (though inconveniently tricky to explain).
As a general rule of thumb, we should all get used to markets behaving in a way that is totally detached from reality. Because this behavior profile — markets seeming to be in their own twilight zone, not reflecting the contours of reality — is only likely to get more extreme.
If you want some really extreme food for thought, ponder this: Based on what the Federal Reserve does in its coming fight-to-the-death with deflation, it is possible we could see the S&P 500 go to 5,000 and the Dow to 40,000 — because of Fed-induced flows — even as the real economy experiences a full-blown Great Depression and corporate earnings plummet.
That isn’t our base case, but the possibility is real.
We’ll explain more in the coming days, but the short version of how something that crazy could happen is that the worse reality gets, the bigger the policy-induced flows will get — as the powers that be fight the grip of deflationary gravity with every legal tool they can find (and some that aren’t legal at all).