The New Pain Trade?

Investors need to concern themselves with whatever the next “pain trade” might be.  There is frequently a consensus that some set of circumstances will cause the market to move in a given direction.  This is not a bad thing per se, but when the consensus becomes overwhelming – and backed with leverage – a change in consensus can turn violently in the opposite direction.  That is when the “pain trade” occurs.

As I look at the current market environment, there are two obvious pain trades.  One would result if investors’ mentality toward megacap tech stocks, or the “Magnificent Seven” turned abruptly.  We recently discussed how investor attitudes toward these stocks have been resolutely positive, despite the recent pullback.  As we noted,

…those seven stocks have seen their average 12-month forward P/E’s fall faster than the other 493 stocks in recent months; however, the former group’s P/E fell to 27 from 34, more than the latter group’s fall to 16 from 18.

Those statistics tell me that investors are still paying a significant premium for the growth they anticipate from these mega-cap tech companies.  It is indeed less of a premium, but a significant premium, nonetheless.

Investors perceive that these stocks combine the best elements of growth and value stocks, with unassailable market positions and enviable earnings growth.  If that belief abruptly changes, however, market capitalization weighted indices would have no choice but to suffer.

But that isn’t the pain trade that concerns me most right now.  The more worrisome one would occur if there is a change in the bond market’s belief in continually rising rates.

A recent article in the Financial Times reported that regulators are expressing concern about over-leverage in the bond “basis trade” brings to mind concerns both about the current potential for a pain trade with uncomfortable historical precedents.  The trade in question involves shorting Treasury futures and buying similar bonds.  This isn’t exactly the positioning that brought down Long Term Capital Management roughly 25 years ago this week, but the notion of extremely high leverage in a seemingly safe area of fixed income is.   

Yet as we consider the recent plunge in bond prices (rising yields) amidst a seeming inability to catch anything more than a very modest bid, it is fair to consider why that key market has a definite bearish whiff to it. Yields have been rising pretty much steadily throughout the year – a key worry that the equity market has been climbing over – but the character of the bond selloff in recent weeks seems to echo a bear market.  Few seem willing to catch a falling knife as yields have risen.  A bear market hallmark is when investors can’t be interested in owning stocks (or bonds or whatever) even as lower prices might uncover values.

Today’s ADP report brought some relief to bond prices and consequently stocks as well.  The 89,000 increase in the ADP Employment Change was smaller than even the lowest economist estimate, and well below the consensus 150,000.  Weakness in employment reduces pressure on wages, and thus inflation.  The 10-year yield is about 6bp lower right now, and would probably dip further if ADP was not widely considered to be an imperfect – at best – harbinger of Friday’s Payrolls report.

But this is where the potential for a pain trade comes in.  If Friday’s report is similarly light, then that could be perceived as a signal for a broader reversal in the recent bond plunge.  As we noted in February 2022, as stocks bounced after a rocky January only to plunge later, “bear market rallies are short, sharp, and ferocious.”  A bear market rally in bonds that results from lighter than expected payrolls could have some ferocity to it.  Combined with an oversold bond market, that could lead to a very significant short-term rally.

Of course, combined with excessive leverage, who knows what could happen.  No one really should want to see a pain trade come to fruition, but one should always be vigilant about its possibility.