The S&P 500 has surged more than 9% so far in November, its biggest gain since the April rally in U.S. stocks, while in contrast, the yield on the U.S. 10-year Treasury note has fallen to around 0.87%. Stocks and bonds are gradually moving in the opposite direction in terms of returns.
However, there appear to be four risks lurking ahead of U.S. stocks that could explode the market at any time.
Pension Rebalancing Momentum Sells $36 Billion in Stocks
As the end of the month approaches, investment banks are releasing their forecasts for the impact of pension rebalancing on stock and bond liquidity. According to NewsSquawk, a 24-hour global market data tracking site, stocks have significantly outperformed bonds in the past month, with a total return of 10.50% for the S&P 500 and 0.05% for the U.S. 10-year Treasury, meaning that equities have outperformed fixed income by 10.45%.
As a result, Goldman Sachs estimates that pension funds will sell a net $36 billion in equities at the end of the month. Notably, according to Goldman Sachs, this would be the fourth-largest record sale since 2000.
The rebalancing mechanism of pension fund administrators is important for stock and bond markets.
On the one hand, through the rebalancing mechanism, pension funds can maintain the actual asset allocation in line with the target framework, thus overcoming short-term fluctuations and obtaining long-term returns.
For example, during the 2007-2008 financial crisis, Norway’s GPFG, the world’s largest sovereign pension fund, strictly implemented rebalancing operations and was the largest buyer of global equity markets at the time, subsequently achieving strong returns in 2010; Canada’s CPPIB pension fund voluntarily shortened its “rebalancing” to daily operations during the stock market volatility of 2009-2011 to catch mispricing in a timely manner.
On the other hand, the rebalancing behavior of pension institutions can help to smooth out market volatility when it is highly volatile: for example, the end-of-quarter rebalancing of U.S. pension funds in late 2018 helped to smooth out the stock market downturn since the fourth quarter of 2018.
How exactly does the pension rebalancing mechanism work? Gary Norden, Vice President of ING, a Dutch international group, explains.
“Many balanced funds typically choose a ‘60% stocks, 40% bonds’ asset class ratio and composition, and these funds tend to manage large amounts of money.
Assuming a fund has $100 million in assets under management, its asset allocation in the first quarter might be $60 million in stocks and $40 million in bonds. After the stock market plunges and the value of stocks drops by 20%, the original $60 million in stocks is now worth only $48 million, and the price of bonds rises slightly in the first quarter, perhaps from $40 million to $43 million, adding up to $93 million, with the equity ratio dropping from 60% to 52%.
Many funds will then choose to adjust at the end of the quarter, buying stocks again and selling bonds appropriately to bring their ratio back to 60:40, which means that the fund will have to buy at least $6 million in stocks, which is a lot of money, so it’s not surprising that the stock market is going up.”
Conversely, if the stock market rallies (as it did in November) so that the ratio of stock value is greater than 60%, then many funds will often choose to sell stocks and buy bonds to rebalance their portfolios.
In addition, the timing of pension rebalancing can be flexible, and pensions may act early at any time at the end of the month, especially now that market liquidity is back at depressed levels.
Topping pattern brewing, bullish momentum fading
Technically, U.S. stock indices are also forming topping patterns.
The percentage of stocks in the S&P 500 that have broken the 200-day moving average is now about 88%, a record since 2014. The previous record was 94% in 2009-2010, which caused the S&P 500 to experience two pullbacks, the first at 9.5% and the second at 17.1%. This was followed by high percentages in 2011 and 2013, resulting in sharp pullbacks of 7.5% and 21.5%, respectively.
So looking back historically, Michael J. Kramer, founder of Mott Asset Management, concluded that when a large number of stocks in the S&P 500 are trading above their 200-day moving averages, a significant pullback or period of stagnation in U.S. stocks is imminent.
After Pfizer announced positive vaccine trial results last Monday and the S&P 500 took out a new high of 3,625, the index has stagnated and the RSI has not made new highs with points, thus forming a bearish divergence and the S&P 500 is starting to lose bullish momentum. 3250 Points.
Options short bets on stock indexes to fall in a big way
In recent days, there has also been a growing number of short options bets on the S&P 500 ETF (SPY), and in November traders placed two large bets on SPY, both of which are set to expire on December 18. The first trade was a put option with a strike price of $300. According to the data, the trade, which took place on Nov. 10, increased open interest by nearly 280,000 contracts at a bid price of $0.60 per contract, a premium of $25.2 million.
Another put option with a strike price of $290 also added 280,000 open contracts for a premium of about $16.8 million. In other words, the trader splashed a total of $42 million on the S&P 500, betting that the index would fall over the next month.
Inflation expectations diverge from stock indexes
Let’s go back to bonds and the bond market has also sent some pessimistic signals.
Over the past year, Mott Asset Management has tracked 5-year/5-year forward inflation swap rates relatively closely and they have now deviated from the S&P 500.
The 5-year/5-year forward inflation swap rates provide a market view of forward inflation and reflect whether the market believes there is enough ammunition in the central bank’s policy toolbox to keep inflation within the target range.
The rate indicates that inflation expectations have begun to turn lower, while the S&P 500 continues to move higher. Coupled with the recent release of weaker-than-expected retail sales data and a weak Consumer Price Index (CPI), the bond market may be seeing a lower inflation outlook. Overall, the bond market may be betting on signs of a potential double-dip recession and its impact on the U.S. economy, which could depress equity markets.
After an unprecedented rally, it looks like U.S. stocks have run out of energy in the less than a month and a half remaining in the year and may eventually have to turn around and fall.
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