Thursday (March 4) was a pleasantly bullish day with plenty of green on the tape — if you were long energy stocks, that is.
The crude oil price shot higher, with West Texas Intermediate in the $64 range, after a surprise decision from the Saudis to maintain their million-barrel-per-day production cut. This was excellent news for oil and gas-related names, which were already at 52-week highs.
For most of the market, however, Thursday was a sea of red. For overinflated technology stocks, it was full-on bloodletting.
Emblematic of the inflated tech space is Virgin Galactic Holdings — ticker SPCE — which was down 49% in less than three weeks as of Thursday’s close. This is not the return from orbit bulls were hoping for.
Meanwhile, fund managers are casting a wary eye on the ARK Invest family of ETFs — and especially ARKK, the flagship — in the same manner all eyes were on Long-Term Capital Management (LTCM), a famous hedge fund, in fall 1998.
As LTCM discovered back in 1998, it’s a very dangerous thing to have a huge book of illiquid portfolio holdings that you can’t easily sell, with all of Wall Street watching in the knowledge that redemptions are forcing you to sell.
“ETF analysts and traders worry that a combination of broad market declines and additional outflows could create a snowball effect across ARK’s portfolio,” the Wall Street Journal reported this week, adding that this “could potentially cause some of its more-illiquid, small-cap holdings to trade sharply lower.”
Indeed. The whole thing smells like a market structure event, where investors are forced to dump positions en masse for reasons unrelated to sentiment.
A similar feel is taking hold in the U.S. Treasury market, where a sell-off in bond prices is driving yields higher. To our ears the new chatter about “bond vigilantes” makes little sense: The forced sellers of USTs are not trying to punish markets or make a statement here; they are selling because they have to.
Take the average yield on a 30-year fixed-rate mortgage, for example, which rose above the 3% threshold this week for the first time since July 2020.
Rising mortgage rates mean that institutional investors in the mega-sized mortgage-backed securities market (the U.S. has roughly $17 trillion worth of mortgages) will be closing out of long-end U.S. Treasury bond positions for technical reasons, in a process known as “unwinding convexity hedges:”
This source of downward pressure on long-end bond prices, and upward pressure on rates, has nothing to do with vigilantism, or with any type of macro opinion at all in regard to inflation or the proper level for long-term yields: It’s a market structure thing.
This is why, on Feb. 26, we explained the drivers for a market structure meltdown event; unfortunately those drivers are in full effect now, as evidenced by Thursday’s close. (Who knows where Friday will close — we are finishing this note on Friday morning.)
As long as the pain in tech stocks is confined to high-flying speculative names, the Federal Reserve can pretend not to care. “You pays your money and you takes your chances,” the old saying goes.
Real trouble may hit, though, if the pain spreads to the tech juggernauts, where staggering sums of capital are now at risk. Consider the following numbers:
- As of the March 4 close, the combined market capitalization of five tech juggernauts — Apple, Amazon, Google, Facebook, and Tesla, in descending order by size — was $5.6 trillion.
- The market capitalization for the entire S&P 500 index — all 500-plus companies’ worth — was $31.3 trillion as of January 2021, per YCharts data.
- The market capitalization for just five mega-weighted tech companies — Apple, Amazon, Google, Facebook, and Tesla — is thus nearly 20% of the entire S&P 500.
What kind of world is it where five megacaps can have a combined weighting that amounts to 20% of the entire S&P 500 index? An extremely out-of-whack world, that is what kind, given that all the juggernauts have price-to-sales ratios wildly inflated by the “lower for longer” long-end yield assumption that now appears “wrong and wronger.”
We’ve explained repeatedly how the macro-inflated share price of, say, Apple (AAPL) could fall by 40% in a rising rate environment with no change to the underlying business model or cash flows; with long-end rates rising relentlessly, we are a big step closer to seeing that scenario play out.
Meanwhile the Federal Reserve is offering no help here: The Fed keeps going on about staying accommodating on the short end, and keeping short-term rates near zero; but the long end is where all the action is, and where the intensifying source of pain is as the “lower for longer” case evaporates.
You can see investors’ distress in the steepness of the yield curve, which basically measures the difference between short-dated U.S. treasury yields and long-dated ones. With the Fed actively suppressing the short end, but letting the long end run free, the yield curve is taking on a parabolic feel.
In another ominous sign, there was hope that Jay Powell, Chairman of the Federal Reserve, would calm the stock market with prepared remarks on Thursday; instead, his words made things worse.
Powell took pains to confirm that the Fed would stay easy, which means no rate hikes at the short end of the curve; but as we’ve explained, the short end isn’t the pain point.
In a virtual interview with the Wall Street Journal, Powell was asked about the long-end spike in yields. His answer implied the Fed would continue to do nothing — unless the pain gets significantly worse.
“If conditions do change materially, the committee is prepared to use the tools that it has to foster achievement of its goals,” Powell said.
That is Fed-speak for “we’re not worried about it yet” — which means something big may have to break before the Fed is roused into action.
And that in turn means technology stocks could get slaughtered — including the juggernauts — to a far more extreme degree than has already been seen, before the Fed decides to “do something” about the long end of the curve.
Then, too, Powell might be playing it cool for the sake of hiding something.
Powell may be fully aware that, if the Federal Reserve tried to calm down the stock market by capping bond yields at the long end of the curve, the Fed’s actions could actually make everything worse.
Why is this the case? Because, in order to keep long-dated yields under control — to keep them from spiking — the Federal Reserve would have to agree to buy long-dated U.S. Treasuries in unlimited quantities.
That is what “yield curve control” (YCC) means. It is buying all the bonds that others want to sell, which creates a floor for the bond price and a ceiling for the corresponding yield.
YCC is currently being deployed by various central banks around the world, including the Federal Reserve, in modest amounts. But it is mostly being used at the shorter end of the curve, meaning, they are buying maturities of five years or less, not the 10-year and 30-year issuance.
That is because, if you go for full YCC — and try to fully control the long end, even as fiscal spending greatly increases the quantity of issuance coming to market — you can wind up with the optics of full-on debt monetization, in which open-ended quantities of bonds are exchanged for open-ended quantities of newly created currency without limit.
What this means, in practice, is that technology stock investors hoping for the Fed to “save” them may not only be engaged in last-ditch wishful thinking, they may be hoping for the impossible.
It could simply be that, with roaring economic growth in the cards for the U.S. economy in 2021 — by credible estimates the U.S. could grow more than China this year! — the Federal Reserve simply cannot risk the appearance of full-on debt monetization at the long end of the curve (the de facto result of yield curve control), with long-run inflation expectations already a problem.
For example, imagine Powell in effect telling the market, “To keep rates low, we will buy all the treasuries available at a certain price floor — so that the yield never goes above X — and in so doing we will replace all the bonds we buy with dollars.”
Were Powell to do that, one could see two immediate responses: First, central banks around the world that had been waiting to sell their excess USTs in bulk would dump them en masse, knowing the Fed was a guaranteed buyer regardless of incoming supply volume; and second, the price of oil could easily go straight to $100, with food price inflation in various agricultural commodities (already becoming a problem) exploding through the roof.
It would potentially create an even bigger problem than before, and a bigger problem than the stock market getting shellacked, were the Fed to try and keep the U.S. treasury bond market in a “lower for longer” reality even as the U.S. economy transitions to “rapid growth” reality.
This also neatly explains why energy stocks can be breaking out to new 12-month highs all over the place, on the same day that tech stocks get destroyed. The outlook for super-strong U.S. GDP growth is the game changer in this mix.
When the economy is growing, logical reflationary bets (like energy stocks) that aren’t yet hyper-valued get bought with both hands, whereas the “lower for longer, inflation will never happen” type stuff — the goofy bets predicated on science fiction or return payoffs 20 years out — gets aggressively dumped.
To the extent this environment continues — and it should; we are in early innings for the U.S. growth story — tech stocks are in serious trouble.
Be very clear on this: “Buying the dip” is seriously questionable advice for anything that has fallen precipitously as of late; it is less catching a falling knife and more like catching a falling safe.
Then, too, it will be fascinating to see what Powell does if the mega-cap tech names — Apple, Google, and so on — start melting down along with the low-liquidity hype vehicles and futuristic space junk.
If the Fed still refuses to reign in a long-end yield spike and bond market tantrum, even as a true market structure event unfolds — in U.S. treasuries, in small-cap tech, in mega-cap tech, or all three — then you’ll know the Fed has been rendered powerless by the macro picture, as long-end debt monetization for the sake of yield curve control (their only move left in an effort to cap yields) could be like pouring kerosene on an inflation-expectations fire.