Still in tactical no-man’s land after the ramp

I have been on the road this week visiting institutional and individual investors.  There is clearly a sense of frustration with the political shenanigans in D.C., but relief the Fed has likely stopped raising rates and stocks have bounced.  Each meeting discussed the lack of structure in the market in both directions, but clearly when there is a market “whoosh” lower it is more in focus.  We believe there are historically four main sources of stability that have been largely marginalized to help create the extraordinary volatility we have seen this cycle:

1. Specialists and market makers – The move to decimalization removed profitability enough that a seat on the NYSE has largely gone the way of a taxi medallion following Uber’s entrance.  Specialists and market makers have been a stabilizing influence during periods of volatility, but no longer can compete with the algorithms.  They are not there to stabilize markets anymore.
2. Banks and Brokerage firms – Following the Financial Crisis, the “Volker Rule” was initiated that no longer allows these institutions to hold financial instruments as an investment for their own account and only act as an agent.  If there are no buyers in a “whoosh” lower, these institutions can not provide liquidity even if there is a clear opportunity.
3. Active management funds – The move into passive indices and ETFs is well documented, and if active investment managers are not getting new money into their funds because of the move to passive, there is no new cash to buy as the markets are selling off.
4. The uptick rule – a historically stabilizing influence during periods of pronounced weakness was that you can not short a stock unless it is on an uptick.  The momentum based programs that accelerate activity (in both directions) have nothing to stop them given the first three plus this.

Again, these things affect the market in both directions, but it is much more accelerated on the downside because fear kicks in, as evidenced by the worst 4^th quarter since the middle of the Great Depression.  Even the bears would not argue the fundamental backdrop is anything like that.  We are all going to have to get used to more dramatic moves in both directions that would have historically taken place during periods of market uncertainty.

So far this week, there has been a ton of bluster in Washington, but very little progress in either direction in the markets.  The daily volatility in the government shutdown, and the prospect of a resolution has kept both buyers and sellers at bay.  There has been nothing wrong with the expected reflex rally for the markets since the Christmas Eve low, but the major equity indices are trying to work off their overbought condition.  As we have been saying, there really isn’t a strong near-term edge, so we remain focused on our expectations for new highs in 2019 on the back of solid credit, a more dovish Fed, and a more stable economic backdrop following improved clarity from the shutdown resolution, trade tensions with China, and Brexit negotiations.

All expectations and data points are sourced from Bloomberg as of 1/25/19 unless noted otherwise.