What Makes Stock Markets Turn?

Most people assume that the stock market reacts to fundamentals. This is a popular view, given the tendency of mainstream journalism to simply attribute the latest stock market move on a seemingly relevant news story. Inevitably, these views run into trouble as the stock market runs counter to expectations. You then see anger and judgement on financial twitter about the apparent lack of intelligence of investors or people in general.

I think everyone goes through that phase when they start investing. Many people never quite break out of it, because the prevailing narratives are all about fundamentals driving stock prices. A big eye opener for me was the stock market in late 2020. I was actually convinced in 2020 that if the bulk of the world went under lockdown, that had to be far worse for stocks than Trump tariffs, so we should fall below that level. Live and learn, right?

The current narrative that has been sticking is money printing and inflation. Everything is compared to the Fed’s balance sheet. Why did stocks turn higher AFTER the failures of Silvergate, Silicon Valley Bank, And Signature Bank? Why continue even higher after Credit Suisse fell? The most common narrative I see is that the Fed balance sheet went up. It doesn’t matter that the balance sheet was rising as record numbers of US regional banks were pulling money from the Fed discount window and their new lending mechanism, or that record amounts of US dollar swaps are being pulled by foreign central banks to backstop their banking sectors, the narrative simply says as the Fed’s balance sheet rises, so do stocks.

There are number of problems I have with this narrative. First of all, it doesn’t match the charts.

Second, the money printing narrative is all about excessive liquidity, so why would the stock market stay strong despite the large number of banks scrambling for liquidity to shore up their balance sheet losses from the recent record rate hikes?

Third, the federal reserve is not allowed to give away money like the US Treasury – they are only allowed to offer “reserves” for assets. When they take illiquid assets and offer more liquid bank reserves, it does increase liquidity. When they take highly liquid assets such as short-dated treasury bills and swap for slightly less liquid bank reserves, it does not increase liquidity.

So what does move markets? I’ll start by re-posting a chart from 2 weeks ago:

A few things I distinctly remember during that time were discussions on the Motley Fool boards about a “mutual fund puking” as money was being removed from stock funds and put into money markets or bond funds. I also remember a man at my work who had moved his 401k entirely to bonds and was determined to leave it there because stocks were just too risky.

Unfortunately, data on 401k allocations over time is extremely difficult to come by. Statistica has some charts that look like they might be helpful for $39/month, but that’s too high for me. The closest I came to a helpful chart was this one from the good old reliable FRED database:

So my final answer to what makes stock markets turn? Money flows. There are several different sources of money going into the US stock market. Here are a number of them:

1. Stock buybacks, are more prevalent in expansions. It just doesn’t look good to lay off a lot of people and then announce large share buybacks.
2. 401k flows just routinely go in with payrolls. Every paycheck, regardless of any other considerations, money flows into 401ks and is allocated between stocks and bonds. The preferred allocation can change over time, and higher rates encourage higher allocation to bonds.
3. Foreign captial flows tend to rise when trade deficits are high, and trade surplus countries invest their excess dollars.
4. Foreign investment flows tend to rise when interest rate differentials are high, especially after accounting for currency hedges.
5. Actively managed funds are a relatively small portion of fund flows, but they can shift between maximum short positions and maximum long positions. This is the only portion of fund flows which directly act on fundamental data, and they are often overwhelmed by the other flows when they anticipate a drop that doesn’t happen. If these guys are near max short after news of a bank collapse hits, then there is simply no one left to sell and stocks can move sharply higher.

Any significant market crash, like the one in March 2020, happens when there is forced selling, typically due to margin calls. Once that force stops, the market has a reflexive rebound as many funds are left under-allocated and margin debts go back to a rising trend. I like looking at charts of margin data like you can find here, but there is no data point past January 2023 so I won’t bother posting it: https://ycharts.com/indicators/finra_margin_debt

That’s all for now – I’ll be keeping my eyes on that unemployment rate before I put significant money into more hedges like short-term market puts or TLT calls.

I actually did some trading last week, as I sold covered calls on a number of my precious metals mining stocks last Monday – focusing on a 6-9 month timeframe and strikes that are significantly out of the money. I still think these things are significantly undervalued, so I’m reluctant to sell them too cheaply. As for Uranium stocks, they went down a lot this week so I added more cheap Jan 2025 calls in DNN. This one has a fairly small market cap, an active options market, and a decent chance at a significant spike in coming years. It’s good to have at least one chance at an outsized win.

Here are my latest allocations:

• HEDGES (8.9%)
  • TLT calls (7.0%)
  • AAPL puts (0.7%)
  • LEN puts (1.2%)
• PRECIOUS METALS (41.7%)
  • AG w/ cc (6.0%)
  • EQX w/ cc (4.9%)
  • MTA (5.1%)
  • SILV w/ cc (4.7%)
  • LGDTF (3.4%)
  • SLVRF (3.3%)
  • SAND w/ cc (2.6%)
  • MMNGF (2.5%)
  • MGMLF (1.9%)
  • SSVFF (1.9%)
  • BKRRF (1.5%)
  • RSNVF (1.5%)
  • DSVSF (1.4%)
  • HAMRF (1.2%)
• URANIUM (25.6%)
  • CCJ w/ cc (3.8%)
• DNN shares (3.2%)
  • DNN calls (1.4%)
  • UEC (3.3%)
  • UUUU (3.6%)
  • BQSSF (4.0%)
  • UROY (2.9%)
  • EU (1.6%)
  • LTBR w/ cc (1.7%)
• BATTERY METALS (11.8%)
  • NOVRF (5.3%)
  • SBSW (4.7%)
  • EMX (3.2%)
  • PGEZF (1.8%)
• CANNABIS (10.6%)
  • AYRWF (0.5%)
  • CCHWF (0.6%)
  • CRLBF (1.2%)
  • CURLF (1.4%)
  • GTBIF (2.5%)
  • TCNNF (1.4%)
  • TRSSF (1.2%)
  • VRNOF (1.7%)
• OTHER TRADES (5.6%)
  • DOCN cloud computing, w/ cc (2.1%)
  • XRP crypto token (3.5%)
• CASH (-7.2%)

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