March 11-15, 2024

Tactical Signal 9

Overall momentum slightly paused for the week due to economic softness, but not enough to pivot from the accumulated strength gained. Our technical indicators and mainstay strategic positioning remain in a positive position (100%).

Depth and breadth finally win again. Yes, the overall headline figures of the S&P 500 & Nasdaq Composite declined by -0.23% and -1.15% last week, respectively. Yet, if you looked below the surface, you would find 8 of the 11 economic sectors charted positive gains, and only the Technology, Communication Services, and Consumer Discretionary sectors posted negative returns, bringing down the S&P 500 index, a market-cap-weighted index. The S&P 500 Equal-Weighted index posted a positive return of +0.97% vs. the S&P 500 index of -0.23%, pointing to stock selection matters and how capitalization can impact returns, an ongoing theme of 2024. As the momentum of the 'Magnificent Seven' stocks paused as five of the seven stocks paused last week, the broader market showed resilience and vigor as reflected by the following:Sectors Chart

To further highlight the point, Mid-cap stocks gained +0.83%, Small-cap stocks gained +0.34%, followed by international stocks gained 2.47%, a pleasant change albeit still lagging the S&P 500 overall YTD. While the semiconductors sold off last Friday, declining by 4%, stocks like NVIDIA still soared a whopping +6.38% overall for the week, resulting in a YTD gain of +76.75%.

The breadth observed was reassured by Chairman Powell's congressional testimony that monetary policy has reached its peak tightening cycle and that market expectations of easing interest rates from the latest U.S. unemployment unexpectedly rose to 3.9%. A number of weaker economic conditions were confirmed by factory orders declining by -3.6%, wholesale trade sales declining by -1.7% and consumer credit rising to $19.49 billion, well above expectations. Weaker economic data also helped cut into weakness in bonds this year as bond yields narrowed by 10 bps for the 10-yr and 20-yr. Last week, the Bloomberg US Aggregate index gained +0.81% but is still in negative territory YTD.

There are plenty of important indicators for the coming week, including inflation rate, business inventories, and industrial production. But all that culminates in the following week's FOMC meeting on March 19, the state of monetary policy, and the Fed's narrative on interest rates.


"We believe that our policy rate is likely at its peak for this tightening cycle. If the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year. But the economic outlook is uncertain, and ongoing progress toward our 2 percent inflation objective is not assured. Reducing policy restraint too soon or too much could result in a reversal of progress we have seen in inflation and ultimately require even tighter policy to get inflation back to 2 percent." 

– Chair Jerome Powell, Semiannual Monetary Policy Report to the Congress, March 7, 2024.

China's Recent Liquidity Crisis - Another Quant Quake Tale


From February 5th to 8th, 2024, in the final four trading days before the Chinese Lunar New Year, China's quantitative investment community experienced an unprecedented earthquake. Quantitative market-neutral products of China's leading hedge funds saw widespread declines of over 10%, roughly equivalent to erasing investors' entire annual return expectations. The unprecedented liquidity crisis, with a rare and massive pullback and intense volatility, affected countless quantitative products and hedge fund managers in just four days. Interestingly, despite many investors having more or less foreseen some clues of this storm, when the time came, it spread swiftly and affected nearly the entire Chinese quant market, resulting in the conclusion of numerous quantitative products.

In this crisis, market-neutral products and DMA products (Direct Market Access, commonly referred to as a kind of leveraged-neutral product) are the most severely impacted. These strategies, aiming at generating pure alpha, involve taking long positions in assets with higher expected returns and short assets with lower expected returns. This creates a portfolio designed to hedge out beta volatility. Analyzing historical data from 2023 reveals that the overall market performance was unattractive, except for microcaps. Therefore, although the quant models do not necessarily incorporate market size as an initial input factor, many portfolios started showing increased exposure to these smaller names due to their value-tilted or momentum-tilted models. Despite the well-known liquidity risks associated with microcap investing, most fund managers find it challenging to forgo potential returns, driven by the imperative to outperform peers for survival.

Indeed, as early as late November to early December 2023, there were indications of liquidity problems in the Chinese microcap market. On December 8, there was an intraday flash crash in the microcap segment. Some investors took note of the clues pointing to microcap bubbles. Unfortunately, predicting the scale of the crisis proved challenging without witnessing it unfold. Given the uncertainty and the surviving pressure, most quant managers tended to bet on continuing the prevailing trend rather than anticipating an imminent turning point with uncertain timing.

The ultimate trigger for this crisis was the "snowball" derivative, typically tied to CSI500 or CSI1000 indexes as its underlying asset. Snowball offers investors a bond-like coupon if the underlying asset doesn't reach a predetermined "knock-in" level, often set at around 80% of its initial value. In simpler terms, if the index doesn't drop more than 20% from the purchase date, the snowball provides a fixed income, and given the index's nature, this is usually the case. However, in the latter half of 2023, the overall performance of the Chinese stock market was dismal, leading to numerous snowballs hitting their knock-in levels by the end of the year. Once a snowball is knocked in, it transforms from delivering fixed income to functioning like an index ETF. Investors then experience gains or losses corresponding to the index at maturity, and market makers will reduce positions that surpass the nominal principal, which puts pressure on the index futures market. Neutral quant products initiated the closure of positions by selling off the microcaps they held, thereby exacerbating the underperformance of the microcap market. As of January 22, 2024, following the annual discount of over 30% in index futures, an increasing number of quant products were compelled to close their long positions to manage risks. Faced with substantial selling, the liquidity risks associated with microcaps became glaringly apparent to quant investors. Quant managers found them facing a genuine prisoner's dilemma: either to make the best effort to liquidate microcaps as soon as possible and exacerbate the crisis or become victims themselves.

Around February 5, the straw that broke the camel's back occurred when Central Huijin Investment, humorously nicknamed the "secret power" signifying the Chinese government's stance, acquired large-cap index ETF in substantial quantity, signaling an intervention to uplift the large-cap market. Consequently, neutral and DMA products are now grappling with simultaneous pressures from both long and short positions, resulting in a concentrated compelled liquidation. The micro-cap stock liquidity crisis has now reached its zenith.

On February 8, with Central Huijin Investment commencing the purchase of CSI2000 ETF, the forced liquidation of these quant products ended, and funds began flowing into undervalued stocks. Some of the products that endured the crisis partially recovered their losses. The farce that lasted just four days but had a huge impact concluded on the eve of the grandest Chinese festival, but numerous products that couldn't survive the crisis did not make it into the new year.

Following the crisis, critics sought a specific reason to explain it. Currently, most conclusions attribute the issue to the snowball derivatives. However, it resembles the gently flapping wings in the butterfly effect more. The snowball is not the sole "snowball" that triggered this avalanche. Unchecked exposure to low liquidity assets, unregulated capital clustering in specific areas, investors' inherent fear of missing out, imperfect regulatory actions, and fragile market sentiment all played a role in the emergence of this domestic crisis.

Economic Reports March 12-16
Select Indices as of 3/8/24

Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.


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