Novum Alpha – Daily Analysis 28 September 2020 (8-Minute Read)

Welcome to the start of a brand new week and the last week of September! 

In brief (TL:DR)

  • U.S. stocks ended up last week, with the S&P 500 (+1.60%), tech-heavy Nasdaq Composite (+2.26%) and blue-chip Dow Jones Industrial Average (+1.34%), but still notched four weeks of declines.  
  • Asian stocks surged higher on Monday as investors took their cue from Wall Street. 
  • The U.S. 10-year Treasury rose last Friday as yields slid to 0.659% from 0.668% in the previous session and are expected to remain flat on Monday when markets open. 
  • Oil rose was more or less unchanged entering the weekend with November contracts for WTI Crude Oil (Nymex) (-0.47%) at US$40.06 from US$40.25, with little change by way of supply or demand. 
  • The dollar was steady against most G-10 peers early Monday.
  • Gold slid against a strengthening greenback with December contracts for Gold (Comex) (-0.09%) at US$1,864.60 from US$1,866.30 in the previous session. 
  • Bitcoin (+1.12%) rose slightly heading out of the weekend and is now tantalizingly close to the US$11,000 level of resistance, entering Monday (GMT 0000) at US$10,900.62. 

In today’s issue…

  1. No Inflation? That’s What They’d Like You To Believe 
  2. Small Investors Have A Big Impact on the Market 
  3. Banked Stablecoins Could Juice the DeFi Market Even More 

Market Overview

It’s the last week of September and global stocks will need to pull off nothing short of a miracle to prevent this month from becoming the first month of declines in stocks since March. 
Whether it’s the changing seasons, the a watershed moment or merely a speed bump in the relentless rise of stocks is harder to call. 
With mounting risks to an economic recovery and fresh waves of the coronavirus sweeping across countries that had appeared to have things under control, governments and central banks will need to do more to prevent the narrative from switching from one of recovery, to one of a long drawn-out decline. 
In the morning trading session in Asia, stocks were up, taking their cue from Wall Street, with Tokyo’s Nikkei 225 (+0.72%), Seoul’s KOSPI (+1.29%), Sydney’s ASX 200 (+0.02%) and Hong Kong’s Hang Seng Index (+0.52%) all up. 

1. No Inflation? That’s What They’d Like You To Believe

  • Don’t let the headline news about a lack of inflation fool you, it’s there if you look hard enough 
  • Actual tools to measure inflation will have grave impact on all asset classes and investors are well advised to monitor the right measures that the U.S. Federal Reserve uses 
To hear the U.S. Federal Reserve put it, it seems as if nothing they do can stoke inflation.
Yet how many of us can personally attest to many of the things we buy either decreasing in quantity with no change in price, or increasing in price for the same quantity?
Because while economists would like us to believe that inflation is like the rain – in that it falls on the rich and the poor alike, the reality is that inflation affects different goods and services differently.
One of the biggest problems of course is how we measure inflation.
Some stuff has gotten cheaper – but it’s not the stuff that we buy, whereas the stuff that we do buy has gotten more expensive – yet somehow both categories of goods and services are lumped together to create a somewhat misleading picture of inflation. 
In the U.S. for instance, the cost of eating food at home has soared by 4.6% in August from a year earlier (because most of us were locked up at home), whereas the cost of food in the now empty offices and school cafeterias fell by 3% for the same period.
And of course, clothing (because who can be bothered to shop when we’re lounging in sweatpants all day), makeup and air fares have all fallen dramatically.
But books, newspapers, medical care and higher education (despite being virtual) have all risen.
Do the differences really matter? Absolutely.
Because the Fed has pledged not to consider raising rates until inflation clears 2%, it’s important to know what the Fed means by that.
There are two major measures of inflation used in the United States, the consumer price index (CPI), which is based on a weighed average market basket of consumer goods and services and then there’s the personal consumption expenditures price index (PCE).
The Fed uses the PCE to determine inflation, a measure of the actual and imputed expenditures of households and includes durable and non-durable goods and services.
While the CPI uses predetermined weightages for several years, the PCE is updated every month.
And the divergence between the CPI and PCE has been accelerating.
While the PCE showed a rise in prices for 0.4% over a rolling three month period, the CPI was still showing prices falling over the same timeframe.
And what the Fed uses to measure inflation matters.
Because investors looking at CPI may be looking at a clock set to the wrong time, which will dramatically affect their expectations on the performance of Treasuries, stocks and the dollar.
While stimulus measures and deglobalization, as supply lines move closer to target markets, are inflationary, the pandemic, social distancing, lockdowns and unemployment are deflationary.
For now at least, deflationary forces are in ascendance, while inflationary forces are in retreat – as can be witnessed by the recent pullback in gold and stocks and the relatively flat performance of Treasuries.
But if Congress and the Treasury take up the free money that the Fed is doling out, then the recent price increases could become a trend, and investors can expect to see gold, tech stocks and Bitcoin surge again.
More likely than not however is that politicians get it wrong, either withholding too much stimulus – in which case we get deflation, or putting in too much stimulus, in which case we get inflation – the true test is to look at the actual consumption patterns instead of headline numbers.
Even a broken clock tells the time correctly twice a day. 

2. Small Investors Have A Big Impact on the Market

  • Using a measurement of fund flows, the true impact of retail investors on stock markets can be measured and used to predict market direction 
  • Fund flows provides yet another tool as to where stocks or any other asset may be headed to next
An ant can lift several times its own body and weight and when it comes to U.S. stocks, it appears that retail investors can move markets several times the size of their own trades.

Or so the theory goes.

If there’s one thing 2020 will be remembered for (apart from the apocalyptic pandemic), it’ll be the rise of the retail trader on American stock markets.

As compared to most other stock markets, American bourses tend to be dominated by institutional players, including pension funds and algorithmic traders, while retail investors typically make up for a small fraction of market activity.

The coronavirus pandemic has changed all that however, and today retail investors have risen to represent as much as a fifth of daily trading volumes.

In fresh insight on how retail traders may be the tail that wags the dog, academics from Harvard University and the University of Chicago, in a paper entitled, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis” postulate how retail investors can have outsize influence on stock prices.

Xavier Gabaix and Ralph Koijen suggest that institutional managers are largely insensitive to prices because whether they buy or sell a stock is more a function of their investment mandate, rather than its price at any particular point in time.

For instance, an institutional investor may have a restriction to sell stocks should profits reach a certain hurdle rate or if their portfolios surpass certain concentration limits. 

Which means that for the most part, these investors sit on the sidelines and it’s retail investors who generate most of the volatility.

According to Gabaix and Koijen, the rise of day-trading flows could have had an impact many times their actual size.

And while no one can say for sure how much retail money has poured into markets, anecdotal evidence suggests that it is substantial, given the surge in sign ups at zero-fee trading apps like Robinhood and SoFi, as well as other traditional brokerages.

As has the rise of Apple (+3.75%) and Tesla (+5.04%), which split their stocks into bite-sized chunks (think of it as Reese’s minis) so that retail investors could still get the full flavor, without the fat.

Given this new factor in stock prices, Gabaix and Koijen suggest that it may be more useful for investors to monitor flows as an indicator of where stocks could be headed next.

For instance, a rise in the dollar is typically synonymous with falling equity prices, and could be the first sign that foreign investors are pulling out of American stocks.

Whereas the rise of Tesla and Apple on the lead up to their stock split could almost certainly be attributed to retail investor fever.

In increasingly uncertain market conditions, it becomes harder to draw clear correlations between fundamentals and stock performance, let alone traditional correlations between stocks and bonds.

Gabaix and Koijen at least provide an elegant answer in observing flows. 

3. Banked Stablecoins Could Juice the DeFi Market Even More

  • U.S. Comptroller of the Currency gives the greenlight to U.S. banks to accept dollar-deposits to back stablecoin issuance 
  • Outside of Ether, dollar-backed stablecoins are the second largest smart contract component and generating annual yields for depositors as high as 4% 
You’ve heard about DeFi, but what you may not know is that outside of Ether, one of the most common trading pairs for smart contracts is dollar-based stablecoins.
Dollar-based stablecoins are typically backed by real dollars (whatever that means) in bank accounts.
Until fairly recently, banks which received such deposits operated in a legal gray area, with no certainty that receiving such deposits was even legal to begin with.
But all that looks set to change as Acting Comptroller of the Currency, Brian Brooks, a former executive at regulated cryptocurrency exchange Coinbase, has issued an interpretive letter under the auspices of the Office of the Comptroller of the Currency (OCC), that banks can now safely receive such stablecoin-based dollar deposits.
Last week, the OCC, which regulates large U.S. banks, including Wells Fargo (+1.37%) and JPMorgan Chase (+0.87%), issued an interpretive letter defining stablecoins narrowly as applying only to those with 1:1 backing that represent a U.S. dollar.
In other words, Facebook’s (+2.12%) Libra, if it ever gets off the ground, would not fall under the definition of a stablecoin, because the original plan for Libra was to have it be weighted to a basket of securities including Treasuries and other currencies.
The OCC’s clarification could not have come at a better time.
With negative real yields and the prospect of inflation crossing 2% (if the Fed has its way) the certainty of stablecoin deposits could rapidly increase the demand for stablecoin liquidity pools which pay as much as 4% interest annually.
Compared with the amount that is paying on savings deposits, these DeFi smart contracts and dollar-stablecoin lending may be one of the few ways that dollar deposits can actually beat inflation.
But before depositors start betting the literal farm on DeFi farms for better yield, it’s important to remember that smart contracts are not infallible.
As a result, the actual dollars may be safe in an OCC-regulated bank account, but their digital equivalent maybe have been siphoned away from unforeseen smart contract vulnerabilities. 

Novum Digital Asset Alpha is a digital asset quantitative trading firm.

Exclusive access to Novum Digital Asset Alpha’s Daily Analysis is made in conjunction with Bitcoin Malaysia.

The information and thoughts laid out in this analysis are strictly for information purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws.

It does not constitute a recommendation or take into account the particular allocation objectives, financial conditions, or needs of specific individuals.

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