Since the fourth quarter of last year, the bullish U.S. stock market has suddenly weakened recently: the S&P 500, the strongest performer in the U.S. stock market, has fallen for three consecutive weeks, totaling a 5.5% decline, shrinking its year-to-date gain to 4%.

The Dow and Nasdaq have also reduced their year-to-date gains to only 1-2%. Globally, except for the A-shares stock disaster before the Spring Festival, the average decline in other markets is around 4.5%-5%.

Last week, we saw the unexpected rise in U.S. social zero data leading to an increase in U.S. bond yields, noticed the mixed performance of AI leaders in covering financial reports, and the frequent alerts of Israeli-Palestinian conflicts every day.

So, what has happened in the past three weeks, especially the last week, to cause such a market turmoil? What led to the major retreat in the U.S. stock market? The following are some observations provided by Dolphin Jun.

1. Is the Surging U.S. Retail Sales in March the Issue?

Retail sales in the U.S. surged again in March, following the hot employment and CPI data in March, another hardcore economic data. The seasonally adjusted month-on-month growth rate of retail sales in March increased by 0.94% after a 0.72% growth in February.

Structurally, it is very clear that optional categories such as auto parts, 3C electronics, clothing, and sports hobbies are relatively weak, but essential categories with a high proportion in retail sales, such as general daily necessities and non-store retail, are very strong.

After excluding dining, auto parts, gas stations, and building materials, the core retail sales month-on-month growth rate reached 1.1%, accelerating.

In other words, the March retail sales indicate that, despite the high interest rate environment, consumers have reduced spending on optional goods that require loans to purchase, and have shifted more spending to online and essential items.

With the support of high employment, total consumer goods spending is still growing rapidly and has not decreased; and the previously expected depletion of excess savings that would negatively impact consumption has not occurred.

As a result, this retail sales data has pushed back market expectations for interest rate cuts, coupled with the current unrest in the Israeli-Palestinian region, it seems that oil prices have gained an additional upward momentum beyond the natural growth brought by global economic recovery, and the timing of inflation may be prolonged.

Amid various expectations, the yield on the 10-year U.S. Treasury bond has remained above 4.5% since April 10, while the yield on the 2-year Treasury bond, which is sensitive to interest rate expectations, has risen to nearly 5%. Compared to the actual benchmark interest rate of 5.33% set by the Federal Reserve, the current market no longer holds much hope for a rate cut in 2024, with one rate cut this year being sufficientThe macroeconomic fundamentals data has been challenging market optimism since the beginning of this year, and the March social zero data can only be described as adding insult to injury. From a macro perspective, the fundamental data can be interpreted in two ways in the short term under different market sentiments - on the one hand, it dampens market expectations for interest rate cuts, but the data itself indicates economic resilience, suggesting a favorable economic trend. For individual stocks, especially cyclical companies, the probability of a sudden collapse will also be relatively low.

2. Under high valuations, is the liquidity drainage during the tax season the real trigger for the sharp drop in US stocks?

Dolphin mentioned in last week's strategy weekly report when observing the US March fiscal revenue and expenditure that the majority of US tax revenue is related to individual taxes, accounting for over 40% of federal tax revenue. About 40% of this tax revenue is withheld and paid by enterprises, while the remaining 60% is self-declared by individuals.

The total amount of tax withheld and paid by enterprises is highly correlated with the employment situation and wage levels of the year, while the 60% self-declared by individuals generally includes interest dividends and other income, as well as capital gains tax from the sale of stocks, real estate, and other assets.

The tax amount from the self-declared part is clearly driven by the returns on US stocks. The tax season for US stock residents runs from January to April each year, with April 15th being the deadline (extended on holidays).

We have already begun to feel the increase in federal government tax revenue from January to March 2024, with the explanation being that the tax refunds to residents have decreased compared to the previous year. Dolphin's understanding is that the reduction in refunds is due to the increase in capital gains tax corresponding to the bullish stock market last year, leading to a decrease in tax deductions.

Last week was the final week for residents to self-declare taxes, and after a large amount of tax payments were made, funds flowed from residents' accounts to the government's accounts. Corresponding to the balance sheet, funds shifted from the highly liquid bank reserve balance account to the less liquid TGA account (a deposit account opened by the Treasury at the Federal Reserve).

Last week, due to the concentration of tax payments by residents, the bank reserve balance, which represents market liquidity, shrank by nearly $290 billion in a single week, while the TGA account balance surged by nearly 40% within a week, expanding from a somewhat strained $670 billion to $930 billion

In addition, the Federal Reserve added insult to injury by selling a large amount of medium and long-term nominal/inflation-linked bonds that week, shrinking the Fed's asset side by nearly $33 billion.

Ultimately, on the Federal Reserve's balance sheet, the expansion of the liability side TGA account and the sale of Treasury bonds on the asset side last week both caused the market's liquidity indicator - bank reserve balances - to take the blame, leading to a rapid marginal tightening of liquidity last week.

By comparison, during the tax season of 2023, due to the bear market in 2022, the weekly shrinkage was only $180 billion. The only more intense liquidity tightening than this time dates back to the tax season in April 2022, when, due to the bull market in US stocks in 2021, bank reserve balances shrank by $450 billion in a single week at the end of the 2022 tax reporting week, corresponding to several weeks of stock market correction.

Moreover, looking back at past tax reporting cycles, in addition to the significant liquidity contraction during the reporting week, there usually follows an additional 1-3 weeks of overall liquidity neutrality or slight tightening.

Currently, with liquidity tightening due to tax reporting + ongoing reversal of expectations for interest rate cuts in the stock market, any slight movement in individual stocks during the earnings season can become the trigger for price adjustments. In this earnings season, whether it's ASML, TSMC, or Netflix, faced with mixed performance results, funds are more inclined to sell on negative news while turning a deaf ear to positive news.

Following the poor performance of AI stocks last week, this week sees a major earnings week for downstream applications of AI - Tesla, Meta, and Google have successively released their earnings reports. In the absence of significant easing of liquidity, if earnings do not substantially exceed expectations, funds this week are still likely to focus more on bearish information in the earnings reports rather than positive information.

However, it is important to note that once the liquidity disturbance caused by the tax season subsides, the current US government still leans towards expansive fiscal policies (unless there is a fundamental change in fiscal policy, which is not currently visible). The excess funds in the TGA account are likely to be quickly injected into the real economy, efficiently creating a money multiplier effect to boost fundamental economic growth. Consequently, this round of stock market correction is likely to be a technical correction, and an overcorrection may actually provide good buying opportunities for quality stocks.

III. Portfolio Rebalancing and Returns

Due to the weakening of domestic macroeconomic fundamentals and the increasing external liquidity and valuation pressures, on April 19th, Alpha Dolphin's virtual portfolio adjusted by removing the Beta Income Index KWEB, believing that the current yield on US bonds exceeding 4.6% has already fully priced in the risk of no interest rate cuts, and Dolphin Jun increased its position in US bondsWeekly Performance:

At the end of the week, the portfolio's return fell by 2.2%. Despite the significant decline, it still outperformed most indices except for the CSI 300 (+1.9%) and MSCI China (-1.9%), including Hang Seng Tech Index (-5.7%) and S&P 500 (-3%).

Absolute and Excess Returns:

From the start of testing to the end of last week, the portfolio's absolute return was 30%, with an excess return of 56% compared to MSCI China. From the perspective of asset net value, Alpha Dolphin's initial virtual assets of $100 million have now risen to $132 million.

Individual Stock Profit and Loss Contribution:

In this recent downturn, companies with high declines have clear characteristics: either poor fundamentals, high valuations, or a combination of both.

Stocks that had previously seen high increases also experienced significant declines in this round. The tightening of liquidity clearly indicates a decrease in valuations.

Observing the positions in the portfolio, companies like Helen of Troy, Wolfspeed, Tesla, and holdings like Luckin Coffee and Li Auto all exhibit relatively weak fundamentals.

On the other hand, companies like NVIDIA, TSMC, and Micron are seen by Alpha Dolphin as having their valuations impacted by the squeeze in AI, with strong performance but high valuations. Conversely, companies like SMIC, despite facing soft demand in traditional processes released by TSMC's performance, are not affected due to their low valuations.

Portfolio Asset Allocation:

After clearing KWEB and increasing holdings in US bonds, Alpha Dolphin's virtual portfolio holds a total of 21 individual stocks and equity ETFs, with 5 core holdings and the rest as underweight equity assets, along with gold, US bonds, and US dollar cash.

As of the end of last week, Alpha Dolphin's asset allocation and equity asset weight distribution are as follows: