Lower Liquidity
Markets reaching extreme levels of optimism vs. the prospect of a large liquidity withdrawal through year-end.
Highlights
Practice, prepare, gain experience, and execute. Having trust in oneself is partially built upon confidence.
AAII Investor sentiment reaches extreme bullish skew (crowd euphoria). Over the last two years, this has been associated with market drawdowns.
Net Liquidity has been a dominant factor within markets at least for the past decade being both positive and negative. Debt ceiling resolution has been reached and the negative liquidity withdrawal is set to proceed.
Good Morning
Been blessed throughout the past week with the opportunity to have spent time with many of my exceptional friends from the University of Florida. Go Gators (don’t cancel)! One of those friends is named Nico Rocca and he was my freshman-year roommate. He lives in Colorado now but was in town so we took the time to catch up. During the conversation, we talked about trust. What is trust for oneself as he defined it?
“Trusting oneself is a conscious decision. Trust is deciding to take action when the outcome is uncertain (think of a trust fall game). Taking the time to clear the mind and exercise confidence allows individuals to make clear decisions”.
As we had this conversation the wheels started turning in my head because this basic concept can apply to various aspects of life such as trusting oneself to make an optimal choice for which university to attend, making a decision on a career path, and other determinations throughout life’s journey. I began thinking about how this applies to markets, trading, and investment decisions as well. Please do not interpret this as “close eyes and pray for returns on risky illiquid investments”.
Multiple decisions are made when constructing an investment portfolio, and this process can repeat daily. The challenge is making these decisions in the face of uncertain outcomes and a potentially stressful environment. There is never full 100% certainty when trading markets unless the individual wants to end up wearing an orange jumpsuit (insider trading). Confidence plays an important role in building trust. How does an individual build confidence and trust in oneself?
An answer as this applies to both real life and markets is practice, preparation, and experience. In the book, Do Hard Things by Steve Magness, there was a specific line that stood out to me. He states, “Arrogance sits on inexperience and confidence sits on experience”. The more times an individual has taken action, the more comfortable they may become when making future decisions. Those repetitions matter, and provide a person with the ability to learn from both successes and particularly failures. I cannot expect to walk into the Braves stadium today and hit a home run off Spencer Strider during my first at-bat after not playing the game in ten years. Such an expectation would be an example of arrogance and is unrealistic. Overconfidence can be a problem, specifically when the operator believes that a specific outcome is all but certain. In my short career thus far, “all but certain outcomes”, are troubled waters.
One other book I want to mention briefly is The Leadership Secrets of Nick Saban by John Talty. This story goes into detail about the deliberate study and preparation that goes into each and every Alabama football game. There might not be any other coach throughout history that has gone through the rigorous preparation as Nick Saban. Such actions enable the players to go into the game with confidence and trust their abilities to make the play when the opportunity presents itself. The results speak for themselves as Alabama has won six national championships under Nick Saban as head coach.
Similar to playing sports and life’s journey, action must be taken in markets whenever an opportunity exists. The operator must trust in themselves to make the final decision. This trust is supported by the individual’s practice, preparation, and research. For such an occasion, an important aspect is an experience, which one must acquire over time. This may translate to weeks or months of deliberate study before making an investment decision. Afterward, another few weeks or months may pass before the desired outcome is achieved. Perhaps the aforementioned decision was a failure. That happens as well. Just because an individual did all the work, as previously mentioned, there is never 100% certainty. However, the preparation and experience allow the operator to build confidence to support the trust in themselves amidst a pool of uncertainty.
Macro
Sentiment
The most recent AAII sentiment survey demonstrates a significant rise in optimism, and the highest level since November 11, 2021. Will show a chart and provide more detail below.
What is AAII Investor Sentiment Survey? The AAII Sentiment Survey offers insight into the opinions of individual investors by asking them their thoughts on where the market is heading in the next six months and has been doing so since 1987.
Investor sentiment is measured with a weekly survey conducted from Thursday at 12:01 a.m. until Wednesday at 11:59 p.m. Tracking sentiment gives investors a forward-looking perspective of the market instead of relying on historical data, which tends to result in hindsight bias (source AAII website).
*Source: AAII
*Source: AAII
The first chart above is AAII bullish sentiment (blue line) vs. bearish sentiment (orange line), and the second chart is the SPX closing price for the week the survey was taken. Use both for observational comparison. The bullish sentiment at 44.5% is the highest level since November 11th, 2021 which was 48%. Keep in mind that the Russell 2000 and BTC both peaked on the same day, November 8th, 2021. The bearish sentiment at 24.3% is lower than both 2/9/23 (25%) and 3/31/22 (27.54%), which both represented massive short-covering capitulation events. When observing both charts above (dating back to 8/26/21), the majority of lower highs for the SPX and subsequent market sell-offs occurred when there were large spikes in bullish sentiment and declines in bearish sentiment.
This does not guarantee future results but is a solid demonstration of the shift in sentiment of market participants. No surprise given the positive momentum particularly in seven companies and a multitude of riskier growth names. Additionally, calls for a new bull market are prevalent, so there should be no surprise that shorts are giving up during challenging times, and the majority of money managers have dramatically increased their long exposure. See the screenshot from a recent Barron’s article below.
*Source: Barron’s
In Ned Davis's book, Beware Of The Crowd At Extremes, there is an entire chapter about inaccurate cover stories, which mark the tops and bottoms of markets (extremities). In fact, there is a chart within the book that shows some of Barron’s publications during the 1970s. Examples: “Not a Bear Amongst Them” (Barron’s 1/1/1973), “1200 on the Dow” (Barron’s 1/8/1973), “Subdued- But Bullish” (Barron’s 12/31/1973), and “Seven Bulls, One Bear” (Barron’s 1/10/1977). All of which occurred right before large market declines. Great book to read and learn.
One may call this cherry-picking, but I am just having fun. In no way am I insinuating that this article is the end all be all, but the history is funny. Barron’s is not the only company that has fallen victim to the extremes, others include Time, Newsweek, BusinessWeek, Economist, and Fortune.
“The Boom That Just Won’t Stop” (BusinessWeek 11/2/1968)
“How Bad?” (BusinessWeek 11/2/1987)
“High Anxiety” (Time 10/15/1990)
“How to Survive in a Scary Market” (Newsweek 4/11/1994)
“Looking Beyond the Bear” (Time 3/26/2001)
Looking at the articles above reminds me of this is an image of “soft landing” headlines throughout time. Source unknown from Twitter.
*Source unknown from Twitter
Net Liquidity
Over the past few weeks, we have spent time talking about liquidity dynamics specifically relating the treasury general account. Net liquidity can be defined as the Fed’s balance sheet - (the treasury general account + reverse repos). This is elaborated within a previous publication that I wrote named “Slow Motion”. Now that a debt ceiling agreement has been reached, the treasury will have to fill up the TGA (treasury general account) which has a negative liquidity draw on the market. Over the past several months leading up to the recent debt ceiling resolution, the treasury general account spending has proven to be stimulative to asset prices and offsetting to quantitative tightening.
Now, the reversal is a threat to the markets as there will be quantitative tightening in the background along with the issuing of debt to re-fill the near-empty TGA account. Both are negative for the Net Liquidity dynamic. Drago Milosevic (Hedgeye Analyst) and Mike Green (Simplify Asset Management) have noted there is a potential for a -$1T liquidity withdrawal through the end of the year. Below is a chart of what that could look like.
*TradingView
Above dating back to 2007, the blue line represents Net Liquidity and the Orange line represents the SPX. The vertical red lines represent periods of peaking net liquidity which preceded market declines. Note that this is not a completely perfect relationship, but visually the similarities exist over time. As shown in the chart, historically, this dynamic also works both ways with large increases in Net Liquidity proving to be positive and stimulative to asset prices. Some of the largest increases in Net Liquidity have occurred during quantitative easing. The recent TGA spend leading up to the debt ceiling resolution has created market conditions and behavior similar to that during QE. I have included the white horizontal line because this is plotted on the chart approximately -$1T lower than the current market Net liquidity position.
Conclusion
Practice, prepare, gain experience, and execute. Having trust in oneself is partially built upon confidence. Important to support self-confidence by putting in the real work, which facilitates the individual to make stressless and fast decisions. There is never a degree of 100% certainty, but by practicing, preparing, researching, and grinding, one can increase their odds of success. Additionally, this supports decision-making during periods of elevated stress and uncertainty.
According to the AAII Investor Sentiment Survey, bullish sentiment has reached the most extreme point since November 11, 2021. Another reminder that both the Russell 2000 and BTC both peaked on the same day in a period of high speculation (11/8/23). There has been an observable relationship between extreme points in sentiment and market drawdowns dating back to 8/26/21 (see chart in the publication above). The chart is indicative of shorts capitulating and quitting. The recent environment has made it incredibly difficult to be short unless it has been the right name. That being said, there are plenty of opportunities given the SPX minus the 7 large companies that everyone owns is basically flat on the year. Long positioning by money managers has significantly increased.
Net liquidity is set to decline, and while not an absolutely perfect relationship, historically has been negative for asset prices. The debt ceiling resolution has been reached and the treasury can now resume the normal actions to finance the government and refill the TGA. Add the slowing economic growth and deteriorating manufacturing data and the risks have piled on top of one another. Of course, in the face of these risks, good thing the market is getting long once again.
Happy Friday,
Aaron David Garfinkel
Resources
“Do Hard Things” by Steve Magness
The Leadership Secrets of Nick Saban by John Talty
AAII Investor Sentiment Survey
Beware Of The Crowd At Extremes- Ned Davis
Slow Motion, by Aaron Garfinkel
Drago Milosevic (Hedgeye Analyst)
Mike Green (Simplify Asset Management)
Opalesque Risk Briefing: Debt Ceiling Déjà Vu? (Discussion with Mike Green 6/7/23)
TradingView
you present a ton of great information. You have put in the hard work and the research and you have an opinion. Yet, you are downplaying the conclusions of your work or not trying to make an aggressive call. You said, "the preparation and experience allow the operator to build confidence to support the trust in themselves amidst a pool of uncertainty." The current environment is full of uncertainty, but you have prepared and have enough experience to have the confidence to make a call here. Perhaps none of the work you site by itself is enough to make a call, but you can build a mosaic around those pieces and others to make that tough and aggressive call :-)
Thanks for another great read!