Stocks Took a Rough Ride - Your Money December 17th 2021
Posted by Steve Bokor
After weeks of wondering, Jay Powell at the Federal Reserve confirmed the central bank’s approach to rising inflationary pressures. The term “transitory” was indeed transitory as in it is no longer being used to describe the current inflation outlook. Granted most pundits believe the recent spike will unwind as 2022 progresses and inventories and supply chains normalize. However, in my opinion, you could make the case that we are in the beginning stages of a secular rise in inflation driven in part from both Covid and its iterations and the massive stimulus cheques handed out to individuals and businesses in response to government mandated shutdowns.
If nothing else, it provided a large segment of the labor force to re-evaluate their long-term employment goals. Modern technology has created a shift in how businesses use labor in their operations whether it be DocuSign for contracts and billings or Zoom to host remote meetings. (Actually, I am still stymied as to how and why Microsoft which owns Skype and Cisco which owns Webex allowed a start up like Zoom to steal the lion’s share of online meetings.) I only have to look at our own operations at PI Financial to see the reduced demand for physical office space and the technology which permitted a large portion of our staff’s daily tasks to be done remotely. On a larger scale, it could create a hollowing out of office towers and an increase in suburban home offices. As 5G technology rolls out, we will likely see an even greater exodus from urban settings and cramped living conditions to extend to suburban and rural based operations.
However, the shutdowns may have also created a re-examination by millennials and Gen Z’s to a different work/leisure lifestyle with more emphasis on leisure. White collar boomers think nothing of a 50-hour work week whereas the incoming generation will eschew the same work environment. The last time I checked, the Jolts index aka “job openings and labor turnover survey” stands at 11 million in the US, far surpassing the seven million peak in 2019. One could assume that there is either a disconnect between the skills required for the existing job postings or, there is a building segment of the work force demanding higher pay and fewer working hours. In either case, employers will likely have to spend additional funds to retrain workers or hike its hourly wage to entice workers back into the labor market. We may be on the cusp of a new surge in union-based labor markets. You may recall last week’s headline of the first Starbucks franchise to unionize.
Rising unit labor costs will cause businesses to either raise their prices which is inflationary or keep prices steady and watch their profitability drop. Both scenarios will not be good for equity markets (in my opinion). Right now, it seems that businesses are passing the prices on to consumers who have wallets stuffed full of stimulus cheques and don’t care about the price increases. That will all change when the programs wind down and it could kickstart a cost push inflation cycle as consumers fight to maintain their standard of living.
Furthermore, the trillions of dollars injected into the monetary system has led to an increase to the wealth effect. If we look at the profile of the average worker idled by covid shutdowns, we have seen an explosion of day traders making all kinds of money in both stocks and crypto currencies. Factor in a sizable increase in home prices and the average consumer is feeling very optimistic. It is leading to increased demand from consumers willing to pay whatever the costs to satisfy their immediate need.
This was a long-winded explanation of why Jay Powell at the Federal Reserve accelerated the central banks timeline for reducing its bond buying program and hiking short term interest rates. Initially investors rejoiced because it was not as bad as some thought but reality set in yesterday when high P/E growth stocks saw profit taking followed by some sector rotation into defensive stocks. Today, even the defensive stocks sold off but in fairness that might have more to do with the quadruple witching day when options, indexes and futures contracts all expire at the same time. In New York, the NYSE traded 3.6 billion shares of stock today versus 1 billion shares last Friday. Today the Dow dropped over 500 points and one of the bigger losers was Home Depot. On Wednesday, the stock moved up $5 after the interest rate announcement and traded 4.4 million shares. Today Home depot fell $11.55 on 11 million shares traded. No news, just a wind down of option positions.
And sorry I need to explain why this happens. Small investors cannot generally buy 1000 shares of Home Depot because at $400 per share, the purchase would cost $400,000. However, a small investor can buy 10 call options that permits him to gain exposure to the performance of 1000 shares of Home Depot. Ten calls of the January 400 strike price can be purchased for about $3900 dollars. In isolation his trade will not move the needle very much. However, for every buyer there is a seller and, in many cases, it is a designated “market maker” or professional trader creating the contracts to sell to the new buyer. In other words, the options are in essence created out of thin air. However, in most cases the market maker at this point does not actually own the underlying stock of Home Depot., he just counts on the stock falling price and the option expiring worthless like some did today. Remember the buyer of the options pays $3900 to the option seller.
NOW, if the price of Home Depot starts to rise, the market maker starts to incur losses on the sale of his option to the “millennial” buyer. And again, if it is just one millennial buying 10 contracts, the market maker can keep a running tally of his wins and losses on his side of the contract and won’t get too nervous all things considered. However, if 1,000 millennial day traders each buy 10 call options, the market maker is now exposed to the performance of 1 million shares of Home Depot. Theoretically every dollar Home Depot rises above agreed exercise price of the option contract, the market maker is down $1 million dollars.
To offset the liabilities on the option contract, the market maker is forced to step in and buy an ever-increasing block of Home Depot stock to protect his option positions.
Fortunately, when the options expire en masse, like they did today, the market maker will settle up on the change in price of the options he has sold and then sells off any Home Depot bought to hedge his liability. That is one of the reasons Home Depot traded 11 million shares and dropped $11.50 in price. BUT I DIGRESS.
Now aside from the options expiration cycle “aka quadruple witching” and the feeding frenzy of trading coupled with the building fear of rising interest rates, Investors rotated back into both stay at home stocks like Disney (thank you Spiderman), Novavax (courtesy of Omicrom), Carnival (aka the Cruise lines) and Live Nation (revenues should really rebound in 2022). More importantly they also stepped in and bought Fedex which jumped $11 after the company released stellar earnings. Interestingly we also saw rotation into safe haven assets like bonds and gold bullion neither of which perform well in a rising interest environment. And Sadly, crude oil and natural gas sold off this week putting an even bigger dent in some Canadian names. Longer term we think most of them are bargains.
Next week we think we may see the resumption of the Santa Claus rally as institutional investors sell their dogs and buy the stars of Wall Street. We will also get a smattering of earnings led by Nike, Micron Technology and General Mills. Speaking of earnings, or lack thereof, yesterday one of Wall Street’s hottest “SPAC offerings” (think of it as an initial public offering with very little due diligence) that soared last month came tumbling down yesterday. I am referring to Rivian, the upstart electric vehicle manufacturer….I use the word “manufacturer” lightly, because they posted a $1.2 billion dollar loss for the third quarter. The stock tumbled $11 to close at $97. But with almost a billion shares outstanding, it still has a market cap of apx $97 billion dollars. Ford owns a block of Rivian but even with it, Ford has a market value of only $81 billion.
Investors will also have to digest US Leading Indicators, Consumer Confidence, Personal Spending and PCE Prices, the last one being the preferred measure of inflation by the Fed. October came in at 0.6% so any upward surprises could spell and end to the Christmas Rally.
In Canada we will fall whim to October GDP stats on Tuesday (0.8% Increase expected) followed by retail sales on Wednesday (expected 1% increase) plus the weekly oil inventories. Keep an eye on bond yields. If economic stats surprise to the upside, expect a sell off in bonds which could be good for bank and insurance companies. With oil still above $70 a barrel, the longer-term outlooks looks very good.
Happy Trading and Stay Safe.
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