Monday, March 11, 2024

Ripe for a Conflagration

The conditions are getting closer for a raging inferno.  The weeds have grown like mad, with no fires to keep the growth in check.  The Fed and US government are complacent, confident, and content with no major blazes in the past year.  In particular, US politicians have passed the buck and blamed inflation on everyone but themselves.  Same with the Fed. 

Looking at the SPX chart, we are in the late stages of a blowoff top.  The launch angle of this rally is getting steeper, with limited consolidation.  Ever since the market blew through 4800 in mid January, its been a steady, epic run, going up almost 400 points with no pullbacks lasting more than 2 days for the past 50 days.  Let's look back at some past parabolic rallies that made new all-time highs with hardly any pullbacks.  Maybe we can find a pattern.

May 2013 top
This one was a minor blowoff top, as the buildup wasn't that extended and there wasn't the euphoria or speculative excess seen in other parabolic moves.  The trigger for the drop was a sharp rise in bond yields in May/June.  The selloff only lasted a few weeks, and it was followed by further rallies throughout the year to make for a huge up year.  

 

January 2018 top

This was a significant blowoff top, when VIX selling became popular as the VIX went under 10.  In the final stages of this top in January, you can see the uptrend getting steeper.  The post Trump tax cut euphoria as well as the relentless uptrend in 2017 got investors complacent and greedy in early 2018.  A huge spike in the VIX caused the short VIX ETN XIV to get liquidated in a panic.  There was no news catalyst, the market just collapsed on itself.  The market traded sideways to higher for the next several months.  

 

February 2020 top

Who knows how much further the rally would have gone without Covid, but the market was vulnerable to a selloff as a breakout above 3000 in October 2019 resulted in a 10+% rally making all time high after all time high for over 3 months with hardly any pullbacks.  Even without Covid, the market was ripe for a decent correction.

 

September 2020 top

This was a minor blowoff top to new all time highs, 5 months after the Covid panic bottom.  This rally was led by tech stocks and the speculation was quite hot in Nasdaq names.  There was no catalyst for the selloff, although there were rumors of Softbank buying calls on QQQs and big cap tech stocks which could have caused a short squeeze in late August/early September.  

If you go back farther, there are other instances of parabolic rallies in SPX, most of which ended with sharp pullbacks.  On occasion, there were mild pullbacks with a several week consolidation period to digest the gains and get investors used to buying at higher prices.  But those were the exception, not the norm.  The general pattern for these parabolic rallies when they end is a sharp, steep pullback, not a gentle, calm selloff. 

The intermediate term(1-2 month) risk/reward is now getting more skewed to favor shorts over longs. At current levels, shorts are likely to only lose a small amount if wrong, but have possible big gains if right.  On the other side of the coin, longs are risking big losses with small possible gains. Yet, despite conditions becoming more favorable for shorts than longs at the present time, I expect them to get even more favorable, i.e., a bit more of a rally higher before the correction.  You still have CPI coming up and the Fed meeting next week, and I expect both to be fuel for bulls to get more bullish.  Expectations seem to be leaning for a hot CPI number, as many are still in the strong economy, sticky inflation camp.  Market pricing has come down quite a lot for rate cuts in 2024, with less than 4 rate cuts priced into the SOFR curve.  That gives a lot of room for more cuts to get priced in if the data gets soft.  The crowd seems to have fully bought into the soft landing, even some no landing scenarios and the STIRs pricing reflects this. 

There is a fly in the ointment for the bear case.  Looking at futures positioning from the COT data, you have seen asset managers pullback from their extreme net long position in the past few weeks, despite the SPX going higher during that time.  This is a bit unusual, as asset managers are usually adding to their net long positions as the market goes higher.  

SPX Net Positions for Asset Mgr and Dealers

Asset manager net longs were highest on Jan 30, when SPX was at 4951.  With SPX at 5085 on Mar 05, their net long position have reduced by 51K contracts.  You can also see dealers reducing their shorts from early January to March 05.  For the best shorting opportunities, you want to see asset managers getting longer and dealers getting shorter as the market goes higher.  Either a speculative blowoff top with steep gains in the coming days or asset managers getting longer/dealers getting shorter in the upcoming COT reports will provide more confidence in putting on shorts.  

On Friday, we got a little glimpse of how fragile this market is with NVDA trading in a 100 point range on no news, as it sold off hard from extreme overbought conditions.  The air is thin up here, especially for the most speculative AI related names.  You can smell the dry tinder getting close to the smoking point, before you get the huge wildfire.  There is a lot of dry underbrush that's been growing wild since the last fire, providing the fuel for the next conflagration.   

I am still sticking with my late March/early April top prediction.  You still see analysts on CNBC and Bloomberg fighting this rally, being cautious, which makes me wary of putting on shorts at the moment.  I need to see asset managers all in on the long side before I go all in on the short side.  Until then, I would only put on a small starter short position and nothing sizeable.  Still long bonds, which I will look to close out in the coming weeks.

Thursday, February 29, 2024

Tight Corporate Spreads

For those looking for an immediate bear market, its quite unlikely.  Corporate bond spreads are getting tighter over the past few months.  Ahead of previous bear markets or near bear markets (Aug 2015, Dec 2018), corporate spreads always were widening before the SPX downtrend started.  

There are 2 exceptions however:  2011 when corporate bond spreads were already historically elevated before going even higher and 2020 when Covid happened.  So based on this alone, it looks quite unlikely that there will be a credit event that triggers a big move lower in SPX.  It doesn't preclude a short term panic lower like late Jan-Feb 2018, when corporate spreads were tightening but SPX went down big anyway because the index was massively overbought and going parabolic.  

Despite tight corporate spreads, I am a believer that SPX upside is limited given current high valuations, the length of the rally (4 months since the last meaningful bottom), and future prospects for growth (poor). 

Usually what happens in a market like this is the market grinds higher, and suddenly, there is a sharp pullback, which causes corporate spreads to widen, with Treasury yields going down.  Then, the market recovers the losses from the pullback as the crowd expects the Fed to turn dovish, and yields stay lower, and corporate bonds don't tighten as the SPX rallies from the pullback.  This is what happened in 2000, 2007, and 2015.  

Last week's blowout earnings from NVDA has helped to keep the parabolic trend intact, and its still a stock that I would avoid shorting given its strength relative to the market.  I am a non-believer in the AI hype, and the current investment spending on AI from venture capital to big tech will likely fizzle out sooner than people expect as the return on that investment will be poor.  The only real immediate impact from AI is its use in graphics, and that market is not big enough to support all this spending.  Once big tech realizes that AI is more like the metaverse than the internet, they will do what META did a few years ago and stop spending.  The biggest beneficiary of that AI spending is NVDA, so you can guess what will happen to NVDA's stock when that spending contracts.  

With regards to the current SPX rally and when it will top out, my best estimate is late March/early April.  These strong rallies usually go on for 4-5 months before a meaningful pullback, and this one will probably lean more towards 5 months because the current price action is not indicative of a topping market.  What you need to see is more optimism about the Fed (with bond yields going lower) to get the excitement and euphoria going.  That's still missing.  I don't see this market going into a sustained downtrend based on a hawkish Fed.  You need to see weaker economic data (lower jobs, lower inflation) to get the bond yields lower and higher anticipation for lower rates.  Only after that happens, along with another few percent move higher in SPX can you think about shorting this monster.  

Reduced my bond position, but will increase it again if I see yields go a bit higher.  Still think the next big correction in the SPX will be accompanied by bond yields going lower, not higher. 

Wednesday, February 21, 2024

Hot Air Balloon

The balloon keeps floating higher, the view gets better and better.  But remember, this balloon is floating up on hot AIr.  AI is the hot gas that keeps this going up and up.  Eventually the balloon will run out of gas.  

For much of January, we began to see divergences in the stock indices, as the haves (mostly tech growth stocks) kept going higher, while the have nots (most of the remaining sectors) went lower.  We also saw the stock/bond correlation break down, with stocks going higher even as bonds kept going lower.  Last week, the higher inflation prints finally put a little crack into the stock market.  Although being down 1.5% from all time highs isn't much, looking at the big picture.  Especially after the run the SPX and NDX have had over the past month.  

But the speculation and complacency are building.  Look at the 20 day moving average of the ISEE call/put ratio (buy to open orders only), its at the highest levels in the past 5 years, which includes the most speculative market I've ever seen (2021).  Its maintained this high level since late December. 


And the poster child of this market's speculative froth:  SMCI.  It went parabolic going into February opex as the options speculation went through the roof, and we got one of those bubble blowoff tops.  


The high call options activity, the optimism about the US economy and AI, historically high valuations, and a Fed that is on the cusp of an easing cycle are all dry tinder for the upcoming fire.  All you need is one drop of a match to light a huge blaze in the market.  The bulls will say that there is no better game in town, that the US government continues to run a high pressure economy with big budget deficits which feeds into corporate profits, and that fiscal dominance makes tight monetary policy less relevant.  I would agree if those big budget deficits were happening along with strong growth in bank credit/lending, but its not.  The US government has effectively crowded out the private sector with its inflationary deficit spending which has raised interest rates to the point that the private sector has pulled back on borrowing.  And many banks are stuck with bad MBS and Treasury supply bought at low yields a few years back, and are in survive not thrive mode.  Both the government and the private sector were on a credit binge from 2020 to 2022, and while the public sector has continued on since 2023, although at a lower, but still high level, bank credit growth has stopped growing.    

When the government takes over the role of increasing the money supply rather than private enterprise, you naturally have less productive use of the new money that's created.  That's ultimately creates an inflationary structure to the government dependent growth model that the US has embarked on since 2020.  With an inflationary structure, yields naturally go higher and stay higher.  We are still in a disinflationary cycle because of the lack of new credit from the banks, and due to most of the deficit spending going towards the old and rich, who have a lower propensity to consume their extra cash than the young, poor, and middle class.  But if we get the banks lending freely after the Fed has cut rates to more palatable levels for small business (<3%), then you will get another inflation wave as the underlying cause of the inflation hasn't been addressed.  

No, we are not going back to world of low inflation, ZIRP forever, and TINA investing.  With higher inflation comes higher bond yields, and more opportunity to get yield without taking equity risk.  There is a lot of private lenders who are getting 8%+ yields for relatively safe credits with good collateral.  The extra competition for cash in a higher inflation world will put a lid on stock valuations.  It makes little sense to pay a 25 P/E for stocks when you can get 8+% in much safer investments.  People forget that loans/bonds are higher up on the capital stack than equities and thus usually offer lower long term returns than equities.  The way equities offer better long term returns than bonds/loans is through lower valuations, not higher.  

With US population growth running around 0.5% over the past several years, with an aging society and a labor force that's growing less than the population, there isn't that much organic demand for credit.  Why would a small business borrow money at high rates to make investments when its business isn't growing nearly as fast as the borrowing rate?  The tight labor market is a function of a workers to population ratio which is falling, not a strong economy.  You can't even compare the US to where it was 25 years ago, during the dotcom bubble.  The demographics were younger, the population growth was higher, and deflationary wave of cheap, high skill labor in China was just getting started.  Now its an inflationary wave of less domestic labor, less cheap overseas labor, older population and less population growth.  All negatives for economic growth.  Yet you have so much optimism about the economy and the stock market at near all time high valuations.  These are almost ideal conditions for a long bear market.  At best, these are conditions that lead to a long term sideways market with minimal capital gains for equity investors for the next several years.  That is the big picture view of the current market.  In the short term, its more random but there are intermediate term signals mentioned above that are flashing amber lights.  

Still a stuck long in bonds, which I will hold until I see a better setup to short stocks.  NVDA earnings are coming after the close today.  No lean on that, neutral on the name.  I still think this AI bubble has one last burst higher left in it, it could come after the NVDA earnings, or it could come in the spring.  But the bubble isn't at the popping point by looking at what I see in the financial media.  From this point onwards, the big money will be made in shorting stocks in 2024, not being long stocks.  But timing is always tougher on the short side so waiting for more ideal conditions and for the rally to get a bit older. 

Monday, February 12, 2024

Feast or Famine Business

Trading is not a steady income business.  Those that try to make it a source of steady income like a normal 9 to 5 job usually go the daytrading/scalping route.  Without a doubt daytrading has the highest failure rate of all forms of speculation.  There just aren't many edges out there on a day to day basis.  The edges which do come regularly are dominated by HFT firms which easily beat out retail traders.  If you are a retail trader, its an act of supreme overconfidence and hubris to think that you can outscalp these HFTs which specialize in front running and being the first in line on the bid and offer queue.  Not to mention the slippage and transaction costs add up quickly the more often you trade.  

Trading is a feast and famine business.  Its usually long periods of famine with brief periods of feast.  Those that try to make steady income during the long periods of famine are trying to squeeze water out a rock.  Those that are satisfied with making a steady income during feasting periods are minimizing the opportunity set available during those good times, making a little when they could make a lot.  If you have been in this business long enough, you get better at recognizing what are tough trading markets and what are good trading markets.  

Usually, the more volatile the markets get, the better it is for trading.  The main reason for this is because markets often get volatile when investors are losing money and panicking out of positions.  Predictability correlates with volatility but not always.  Sometimes you get volatile markets that are unpredictable.   For example, the bond market in 2023 was quite volatile but were hard to predict (Silicon Valley Bank going bust in March, long end panic in September/October).  I remember seeing rampant call buying in TLT into a strong downtrend, thinking that it was unlikely so many options punters would make money buying in a market so weak.  But they were right, which is uncommon.  

Right now, people are making money, volatility is calm, and investors are not panicking. Its a tough trading market.  But I stay in the game, keep watching the markets, put on trades, not trying to hit home runs or make steady income, but to get a feel for when its about to get good again.  What trades I make during these tough times are probably slightly negative expected value (EV).  But observing the market and making trades helps with timing the next big trade, the time when the markets get good again, when there are many positive EV trades.  

Usually the longer the famine, the bigger the feast on the other side.  While 2023 was a good market for investors, it wasn't a great trading market.  Especially for those with a bearish lean.  For those natural born bears out there, its about to be your time again.  We have the ingredients for a bear market lining up.  

1.  High valuations and large asset allocations towards equities among individual investors.

2.  Investor optimism and complacency about the economy.  Soft landing consensus.

3.  A bubble in AI with greedy investors bidding up other high beta assets like bitcoin.

The rally off the late October low is now 3.5 months old.  Looking at past strong rallies like this off of V bottoms, the average length of the rally is from 4 to 5 months.  So we are getting close to the end of this bull run.  From a price perspective, this rally has exceeded my expectations.  But that just makes for a even more lucrative short setup in the coming weeks.  This is opex week, and with how relentless the uptrend has been, you are setting up for a Friday opex day climax top.  I don't expect that to be the final top of this rally, but a 3 to 5 day post opex selloff coming off that climax top would not surprise.  Something similar to what happened after June 16 2023 opex. 

The goal now is to keep a close eye on the market and participate but not lose too much money while waiting for the good times to arrive.  Still long bonds and waiting for a climax top to short SPX.  The AI bubble keeps growing, but its still too strong and too early to short.  We have NVDA earnings next week, which could serve as a catalyst for the final blowoff top in the name.  The sharpest moves occur at the late stages of a rally, so timing is everything when it comes to trying to pick tops in bubbles.  I would like to see more 2nd tier and 3rd tier AI bubble plays flying higher to get more confidence that a top is near.  We haven't seen that yet, so holding my fire for now.  The AI skeptics are mostly gone, and nearly everyone believes is will be a huge breakthrough technology, almost like the 2nd coming of the internet.  This usually the parabolic phase of the bubble where the sharpest moves higher happen.  Probably in the 7th or 8th inning of this AI bubble, so not much time left for those playing that game.  

Tuesday, February 6, 2024

Crocodile Jaws

The jaws are widening.  SPX keeps going up, and the Russell can't keep up.

The Russell 2000 lagging the SPX is getting egregious.  The market is splitting wider and wider, into a small minority of haves, and a majority of have nots.  We also got 2 more Hindenburg Omens on the Nasdaq in the past week.  That's a total of 5 Hindenburg Omen signals year to date.  When you see a cluster of these Hindenburg Omens show up, its a warning shot that the rally is on borrowed time.  It can pullback right away, or it can pullback in a month, but there is usually a correction within 2 months at the latest.  

Russell 2000/SPX ratio


 

We are also seeing asset managers get more aggressive in adding SPX futures long exposure, as we are now at a 52 week high in asset manager net long positioning.  Dealers also got more short, although not at 52 week lows in positioning.  These are not outright sell signals, as rallies in bull markets can last for several months without a correction.  But this adds to the weight of evidence tilting the odds in favor of a down move over an up move in the next 3 months.

SPX Net Positions of Asset Managers and Dealers
 

Two main things we learned over the last week: 1. Powell is going to try to delay rate cuts into at least May, if not longer 2. AI tech bubble is getting even bigger.  

Powell is getting brainwashed by all the soft landing talk, about how its too early to cut in March from the investment community, and he followed through.  Powell is known for lacking backbone, and he proved it once again, going with what Wall St. wants.  Even when acted like the second coming of Volcker in 2022, it was only because Wall St. was going crazy over inflation and he had to do something about it.  So Powell will let these higher rates deal a bit more punishment to small business.

NVDA is now over 700.  META went up nearly 20% in one day.  The breadth is getting narrower as the haves keep roaring higher, and the have nots just stagnate or drip lower.  One thing you have to realize about big tech stocks like META, GOOG, MSFT, AAPL, AMZN, NVDA, etc. are that they are not a net positive for other companies.  They are a net negative.  Big tech stocks back in the old days used to be drivers of economic growth.  Now they are just rent seekers, parasites trying to push profit margins up as high as possible, seeking the maximum point on the profit curve.   

META raising prices on ads, reducing or completely eliminating exposure for non paying accounts in favor of accounts paying the most ad money to Facebook/Instagram.  META is trying to squeeze out as much ad money from their customers to the crying uncle point, because there are almost no alternatives in internet advertising.  GOOG doing similar things, although not as egregiously as META.  AAPL pushing out the same phones with just slight tweaks and charging more for it because their customers are addicted and/or don't know how to switch to Android.   NVDA selling overpriced graphic cards and trying to bundle it with other services which are also overpriced.  These companies are becoming kings of rent seeking, not innovation.   MSFT and AMZN are basically a data center duopoly, and can push up pricing at will because its such a huge pain to go from outsourcing to making and running your own data center.  

There is such a huge bubble in AI, where the hype is so thick that big tech companies are shooting first (investing in AI) and asking questions later.  They don't have the slightest clue on how they will monetize whatever they develop with AI, but it sounds cool, and Wall St. loves it, so they keep doing it.  NVDA is the main beneficiary of this shoot first mentality, but how long does this last for?  Will companies continue to send billions to NVDA for overpriced chips to build up their AI capabilities when its all just money going down the drain?  I know this sounds like a crazy comparison, but the AI craze reminds me a bit of META going bonkers about the metaverse back in 2020 when people were holed up in their homes.  We know how that ended up.

This bloated Mag 7 led rally is just rotten at the core.  There is no natural economic growth behind it, just some additional deficit spending that puts a few more dollars in the pockets of the rich, the elderly, and lobbying companies.  The current misallocation of capital from nilly willy government spending will haunt future generations.  They all say how the economy is so great because of all the job creation.  But they forget to mention that part-time jobs are where the growth is, and its coming from the poor needing 2 jobs to get by.  Tax withholding data so far this year is showing total wages basically stagnant on a year over year basis.  That data is much more reliable than whatever surveys the BLS uses to measure NFPs.  Yet when we got the big jobs number on Friday, the Wall St. crowd went into a tizzy, celebrating the great unstoppable machine that is the US economy.  Such a great US economy that small cap companies are massively underperforming large cap ones. 

The market is slowly grinding to a top, but the last missing ingredient is the excitement and exuberance you often see at tops.  I see less denial than a week ago, but there is not the typical exuberance that one would expect at market peaks.  Timing cycle patterns for the SPX still give this rally about 4-6 more weeks to run.  So I'm reluctant to get short SPX/NDX until I see more overt signs of a top.  I am still long bonds, and investors are overreacting to the nonfarm payrolls and Powell's reluctance to cut rates anytime soon.  The bond market will rally big not when Powell decides to cut, but when the data and market conditions urges him to cut.  We are not there yet, but with how bubbly the SPX is, I wouldn't be surprised to see a big risk off selloff in stocks coinciding with a strong rally in bonds in the coming months. 

Monday, January 29, 2024

Fighting the Last War

People tend to extrapolate the stock market to the real economy. 

When the stock market is strong, the economy is considered strong.  When the stock market is weak, the economy is considered weak.  The stock market is strong.  The SPX is around all time highs.  So right now, the bias in the investment community is to be positive on the economy.  But its clear that the economy is slowing.  If the economy was so strong, why would unemployment rates go up in so many states?  Why isn't the Russell 2000 stronger than the SPX in an up market?  The Russell 2000 usually outperforms when the economy is strengthening.  



Russell 2000/SPX ratio

The signs are there that the economy is slowing.  But all I hear on CNBC is how the economy is strong enough that the Fed doesn't need to cut, that too many rate cuts are priced into STIRS.  But that's flawed logic.  The market rallied strongly in November and December because of increased rate cut expectations, not in spite of them.  If you take away those rate cuts priced into STIRs and the rest of the yield curve, then the stock market weakens, and financial conditions tighten.  

I rarely hear anyone say that the market pricing is about right, or that its not pricing in enough rate cuts because the economy will weaken in 2024.  People are fighting the last war, inflation.  There are more people worried about inflation re-igniting than about a hard landing.  I still hear talk about how Jerome Powell doesn't want to repeat the mistake of cutting early like Arthur Burns.  Are we still in 2022?  I thought we found out a while ago that Powell is no Volcker.  Disinflation is likely to continue.  There are so many biases built into the CPI and PCE that understate inflation that's its not easy to get high inflation numbers showing up in the government stats.  With the lagging effect of lower rents feeding into owner equivalent rents in the CPI, expect inflation to slowly go down over the next few months.  

As for the jobs market, its hard to keep getting big jobs growth when the working age population is hardly growing.  The post Rona catch up hiring done from 2021 to 2023 is behind us.  Yes, the jobless claims numbers haven't gone up, and NFPs are still showing solid job numbers, but government tax receipts are weak for January, month to date. 


You have seen quite a few layoff announcements this month.  Its nothing alarming, but companies usually don't do layoffs if they think the economy is strong.  

Could it be that the effects of the Covid stimmies are starting to wear off and the lagged effect of 525 bps of rate hikes are starting to slowly kick in?  I heard so much talk about the lagged effect of Fed rate hikes in 2023, but now, when they should start to kick in, its crickets.  Higher interest rates work quickly in the financial economy, but they work slowly in the real economy.  Even if the Fed cuts 125 bps (what is priced into Fed funds futures for 2024), that doesn't really stimulate the economy.  Its just less restrictive.  It wouldn't  keep the stock market from going down, if god forbid, we actually got this bubble market to pop and go down.  125 bps of cuts would still keep real rates positive, and 5 year corporate bonds would still be rolling over at more than 200 bps higher yields than 2019.  

The Fed doesn't usually mess around with 25 bps paper cuts when jobs numbers are getting weak in a disinflationary environment.  The Fed took its time in 2019 to cut because rates weren't that high, and the economy wasn't that weak.  This time around, real rates are much higher, monetary policy much tighter, and I would argue the global economy is weaker now than back then.  Back in 2019, at least you had Europe and China that were relatively strong compared to now.  Those countries help contribute to disinflationary pressures for goods in the US.  

I wouldn't be surprised if the Fed funds rate was below 3% by year end.  That's 250 bps of cuts, most of which would come in the form of 50 bp increments.  I could see the Fed doing 25 bps/meeting for 2 meetings in the spring, realize that its too little as stocks continue going lower, NFPs continue coming in weaker, forcing them to up the pace to 50 bps/meeting until year end.  If they start in May, they could cut 250 bps in 6 meetings in 2024 under that scenario.   I see that as being much more likely than the Fed dot plots of 3 rate cuts for 2024 as the economy just hums along without any worries.  

We got some geopolitical worries hitting the overnight markets as crude oil went up, but has since settled back towards unchanged.  Crude oil already rallied the past few days going into the weekend ahead of potential Middle East risk, so its not that surprising that there was little reaction from crude oil.  After the trauma from higher oil prices in 2022 after the Russian invasion Ukraine, you still see overreactions to any piece of news coming out from the Middle East.  Geopolitics is now always considered a concern for investors, even though it had no real effect for the two decades prior to 2022.  

Its a heavy event week with big tech earnings lined up, QRA and FOMC on Wednesday, and nonfarm payrolls on Friday.  With the SPX in a strong up trend going into these events, I don't expect much selling after any of these events.  If there is a dip, it will be brief and immediately bought up.  As is typical for an event packed week in a strong uptrend, the odds favor the bull side for both stocks and bonds.  I bought some bonds late last week, looking to hold for the next few weeks.  No position in stocks at the moment, but the COT data came out bullish with dealers covering shorts into the rally, and asset managers selling.  It jives with what I am hearing on CNBC, which is skepticism about this rally.  Its going to take time to form a top, definitely not seeing signs of a top yet in the positioning data. 

Wednesday, January 24, 2024

Split Market

Its a tale of two cities.  The haves and the have nots.  The tech stocks are doing great. The rest of the market has been mediocre.  In particular, small cap stocks have been lagging badly.  Tech stocks are the anointed ones in this environment, as they are valued based on AI hype and its halo effect, while the rest of the stock market has to deal with reality.  The reality is that the fundamentals and lackluster earnings growth don't support higher valuations for most of the market.  

For a big chunk of the Russell 2000, higher yields are a big drag on earnings, as they are less profitable or unprofitable, with weak cash flows, making them more reliant on debt.  The S&P 600 (small caps) has a net debt to EBITDA ratio that's 3 times that of the S&P 500 (large caps). 

There is no free lunch in running the economy hot with big budget deficits.  Higher inflation leads to higher yields which increases the cost of debt capital.  It also leads to higher wages which increases labor costs.  When interest expenses and labor costs go up, that squeezes profit margins, forcing nonprofitable or barely profitable companies to borrow more.  Increasing leverage makes the bottom of the capital stack, equity, riskier, which is reflected in lower stock prices and valuations.  

We've reached a point where the benefits of higher revenues coming from a stronger economy are less than the costs of higher interest and labor expenses.  Its why the stock and bond market correlations have gotten so positive.  This is a symptom of higher inflation coming from fiscal dominance, as expansive fiscal policy initially helps the stock market (2020, 2021), but this leads to tighter monetary policy which ends up hurting the stock market (2022).  When the lagged effect of tighter monetary policy slows down the economy and reduces inflation, the stock market front runs the loosening of monetary policy by going up, even as earnings growth is weak.  This is where we are in the cycle, as stocks front run the rate cut cycle, expecting a soft landing.  But the variable this time are the large budget deficits and the need to keep issuing $2T+ of Treasury debt each year to keep the game going.  The Fed either lets long end rates stay high to keep the economy from overheating and inflation in check, or they go back to QE and low rates to keep the economy from going into recession, risking a resurgence of inflation.  

We are in an interesting spot where the lagged effect of higher rates is hitting small caps and small businesses, while the rich keep getting richer as the SPX goes higher and they collect 5% on their excess cash, most of it coming from the government's huge interest expense.  Its a torturous trickle down effect where the rich with excess cash get paid higher interest from the government and corporations at the expense of small businesses having to pay more interest on their borrowings.  Since the rich are so flush with cash, as stocks keep making new all time highs, and collect lots of interest, that money finds its way into the stock market.  Its a virtuous cycle fed by the government running big deficits.  

So what breaks this virtuous cycle?  A couple of scenarios would do it. 

1. Enough small businesses and small cap companies start cutting back on labor to protect their profit margins, leading to higher unemployment, and less revenues and thus lower earnings.  More corporations have to start feeling the pain from higher interest and labor costs for this to happen.  

2. Inflation makes a comeback, rebounding to higher levels, keeping the Fed from making big rate cuts.  This is what most people seem to fear more than a surge in job losses.  Although my view is that job losses are much more likely than another inflation surge in 2024.  

With the SPX making a big breakout towards new all time highs, investors don't have much concern about either of the above scenarios.  A soft landing is the base case for most.  While there is quite a bit of skepticism about the rally and it going up too far too fast, its based mainly on the belief that the Fed will not cut rates as much as the market expects.  I've written in the past few blog posts about this consensus belief, which I believe will be wrong as the economic data comes in weaker in the coming months.  Since investors are skeptical about the magnitude of the Fed cuts coming, that's a positive catalyst that still remains to fuel this market higher.  You should only consider putting on a longer term short position in US stocks after the consensus starts to buy into the Fed cutting rates more aggressively this year.  There is still that wall of worry out there about rates staying higher for longer.  

We've seen the Russell 2000 lag the SPX badly since the start of the year.  Here's a look at a couple of other times where the Russell 2000 lagged the SPX so much during a strong uptrend.  They both eventually resulted in a sharp correction of 10% within a few months.  

September-October 2014 correction

January-February 2018 correction

Timing these tops is hard, as it takes months of this SPX-RUT divergence to eventually lead to the SPX breaking down.  Things like the Hindenburg Omen which flash warnings of a split market of lots of new 52 week highs and new 52 week lows as the SPX makes new highs have started to fire up.  A couple of them on the Nasdaq composite over the past week.  Along with the high valuations and general complacency out there (low put/call ratios, high CTA equity exposure), a deep correction is waiting in the wings.  The key will be not to get short too early, as momentum in these type of up markets last longer than most people expect.  

SPX is gapping up again, this time to another all time high, as SPX is around 4885 as I write.  Given how effortlessly its gone up since breaking 4800 on Friday, it looks like a break of 5000 is going to happen within the next 30 days.  This bubble reminds me a bit of 2000, when the Nasdaq broke out above 5000, as there was a frenzy for tech stocks.  I distinctly remember semiconductor stocks flying higher in February of 2000, a month before the bubble top.  Right now, semiconductors are the hottest sector in the market.  History doesn't repeat, but it does rhyme. 

Thursday, January 18, 2024

Brainwashed by the Fed

If you repeat a lie enough times, eventually people begin to believe it.  That is what the Fed has done with both its higher for longer mantra, and now brainwashing the financial community into believing its dot plot of 3 rate cuts for 2024.  Since when has the Fed been an accurate predictor of future rate moves?  Its counterintuitive, but the STIRs market has been more accurate in predicting future rates than the group that actually makes the interest rate decisions. 

Stocks and bonds are all just one market now.  The correlation can hardly get more positive between the two.  The consensus view is that the STIRs market is pricing in too many rate cuts (150 bps) for 2024.  Its been the recent weakness in the bond market that's infected the stock market, leading to horrible breadth.  Russell 2000 has lagged badly since the start of the year, just as the crowd was warming up to small caps, and expecting them to outperform in 2024.  You are also seeing the VIX make higher highs even though the SPX is hardly going down.  It all looks like a possible perfect storm, but I just don't see it happening.  People are too pessimistic about the rate cut path. 

Investors are worried that the Fed will disappoint the market expectations of 150 bps of cuts this year.  I'm in the minority view that 150 bps is the minimum amount that the Fed will do if there is a no landing scenario (very unlikely given weak global growth in Asia and Europe, lower fiscal impulse in the US).  In a soft or hard landing scenario, the Fed is likely to cut in 50 bps increments, not 25 bps as most expect.  It will only take 3 meetings to get 150 bps of cuts in that case.  That can be done over a period of 3 months.  In past economic slowdowns, the Fed has almost always made chunky rate cuts of at least 50 bps increments.  There is nothing to make me believe that they'll stick with 25 bps moves when unemployment is rising and inflation is falling.  

Fed Funds rate probability for Dec 18 2024 FOMC

Just as rates rising didn't have much of a restrictive effect on the US economy, rates falling won't have much of a stimulative effect.  So I can definitely see a situation where the medicine of a few rate cuts is too weak, forcing the Fed to give the patient even stronger medicine in the form of 50 or 75 bps cuts at a time.  

You see some leading indicators which seem to have bottomed, but much of it is coming from the steepening of the yield curve and reduction in credit spreads, basically financial conditions.  Financial conditions are overrated as an economic leading indicator when there is so much fixed debt outstanding that is unaffected by interest rate/yield moves.  Too many are jumping the gun and trying to front run the turn in the cycle.  There just is not that much pentup demand in manufacturing (inventories not low enough), as we never got the recession cleanse that was needed to restart a strong up cycle.  The excess savings of the bottom 50% is gone (wages not keeping up with inflation), and many have to pay back student loans, which just restarted a few months ago.  

The job market is slowly loosening, with fewer temp work (leads permanent work in the cycle), meaning higher unemployment and fewer wage increases for 2024.  The key is profit margins of small businesses, which are likely getting squeezed as the Rona stimmies are now gone but the higher rates on loans remain.  With lower profit margins at small businesses, they either have to cut workers or reduce working hours.  Both will slowly feed into less wages and lower consumption.  Just looking at how weak the Russell 2000 has been so far this year, as well as for most of 2023 (vs SPX).  That gives you an idea of how smaller companies are doing in this higher rate, higher labor cost environment.  

You likely won't be seeing a recession, just because of the huge government deficits driving nominal GDP growth, but the weakness of small businesses and reticence to make big investments ahead of the maturity wall coming up in 2025 will lead to a noticeable growth slowdown, IMO.  Its being ignored for now because rates came down so hard in November and December, and the stock market went up so much.  Probably the best sector to be invested for the year will be in defensive sectors like consumer staples and utilities, as you are going to get a slower economy leading to chunky rate cuts by the summer, and people are not positioned for that.  The Fed has even stated that even without labor weakness, they will make rate cuts as long as inflation is falling. 

With the recent rise in yields, bonds are getting interesting here for a swing trade, as I don't see yields able to keep rising ahead of a rate cutting cycle which is being underestimated by the majority.  The bond market is sending a strong signal when the yield curve keeps steepening despite the widespread belief among the financial media that too many rate cuts are priced in.  

Because I don't think yields will keep going higher, I am a reluctant short here in SPX.  This trade was mainly a play on the seasonally weak January opex week as well as the somewhat overbought nature of the market last Friday.  I will be looking to close out my short by Friday, as some of the January opex weakness has been brought forward this week.  Also, don't want to hold a short position going into tech earnings season starting next week.  Once we consolidate this month, I am expecting a strong February for stocks and bonds as weaker economic data starts to come in, moving investors more towards my view of a more aggressive rate cutting cycle than is being priced in. 

Thursday, January 11, 2024

A Market Made for Ray Dalio

My framework for 2024 is the underestimated Fed dovish pivot.  This makes me bullish risk parity (long stocks and bonds) for the next few weeks, buying on dips in bonds as 10 year yields go above 4%, and when SPX gets down towards 4700.  Downside will be contained until there are more believers in the Fed dovish pivot, and fewer believers of higher for longer in 2024.  It will take several weeks for the migration to play out, as our monkey brains can't handle going from bearish to bullish so quickly.  Many are still in denial in the bond market. 

Its a type of market that Ray Dalio would love.  Collecting 2 and 20 by just holding long bonds along with the SPX, and calling it an all weather portfolio.  

That 10 year yield chart is amazing.  It is what you would say is the mother of all capitulations in US Treasuries.  All you heard was talk about bonds in September and October.  You even had someone on CNBC calling for 13% 10 year yields!  Charts can play mind games on investors.  Past price action really influences how investors view the future.  Its not just about price.  Its about path that changes our views.  Let's play this game on the 10 year yield chart: 

Actual 10 year yield chart since start of 2023

Fake 10 year yield chart since start of 2023: September, October, and November 2023 changed.

I believe most people looking at the first chart would think that the move down in yields is overdone, and that yields are due for a further bounce higher.  Most people looking at the second chart would think that yields made a double top around 4.30% and that yields look to be trending lower.  

These are the mind games that financial markets play on our monkey brains. By simply reversing the psychology and doing the opposite of what feels right can be an edge.  Of course, you need to see how speculators are positioned, as well as what the investment community is thinking to get a bigger edge.  Here is what the latest JP Morgan bond survey shows:  

JP Morgan clients' net long positioning dropped the most over 1 week since 2020.  It only took a 20 bps rise in yields to get bond investors bearish again. 

The bond market has an asymmetric payoff profile at the moment.  Its because of the Fed's new dovish bias and upcoming rate cut cycle.  We know with a fair amount of certainty what core CPI will do over the next few months, because of the lagged effects of owner's equivalent rent (biggest weight in CPI) and other butchered calculations which foreshadow future CPI readings.  With rents having come down a lot in 2023, and owner's equivalent rent lagging real rents, you will likely have core CPI coming in low month over month until the summer.  Some of this is priced in, but the Fed is laser focused on the data, especially data confirming their now dovish bias, so with lower CPI readings, they have an excuse to cut rates.  At 5.33% Fed funds, real rates are quite high, meaning they have a lot of room for rate cuts even if the economy remains steady.  That's the Fed backstop for the bond market right now.  Especially the short to intermediate part of the curve, from 2 yrs to 7 yrs.  

This Fed backstop wasn't present in 2022 or 2023 because the Fed had a hawkish bias due to the zeitgeist on high inflation at the time.  But investors have a hard time turning on a dime.  Especially when a market like the US bond market, has been in a bear market for nearly the past 4 years.  As a result, I see a lot of denial on CNBC and Bloomberg, about future rate cuts.  Many don't think the Fed will cut 5-6 times, like the SOFR curve is pricing in at the moment.  They are still somewhat stuck in the higher for longer theme that the Fed repeatedly bashed into the brains of investors in order to tighten financial conditions.  The consensus I see among the "pros" is similar to the Fed dot plot, which is 75 bps of cuts for 2024.  In my view, 75 bps is the absolute minimum they will do this year, if there is a no landing/delayed landing/inflation rebound scenario.  Even in a consensus soft landing where growth is slowing and jobs numbers are going down, they will cut much more than 3 times, more likely the 5-6 times that the SOFR curve is pricing in.  

Its this denial about the coming fast and furious rate cutting cycle even without a hard landing which makes me nervous about getting short SPX too soon.  Yes, the market went up a lot over the past 2 months, so its likely to consolidate its gains instead of rocketing higher at these high valuations.  But I don't see a lot of downside in the market until the majority of investors abandon their higher for longer bias and accept that the Fed will cut rates even without much of an economic slowdown.  The closer we get to the March FOMC meeting, the more certainty will come to the crowd that this is no longer a "higher for longer" Fed, but a "find any excuse to cut" Fed.  When the consensus of "pros" (not SOFR traders, but loudmouths on CNBC and Bloomberg) shifts to my view on the Fed's rate cutting cycle, that's when I'll be looking to aggressively short SPX.  Until then, I am only willing to play the short side for quick swing trades.  

The broadening out of the stock market rally has already fizzled out.  The Russell 2000 has badly lagged the SPX over the last 2 weeks.  It has given back all of its massive outperformance since the FOMC day rally in mid December, and is now underperforming SPX by over 2% over the past 4 weeks.  

This has made me revise my view on how the next few months play out.  I was expecting a chase for high beta in small caps for the first quarter but that doesn't look like its going to happen.  Instead, we are likely to see you typical grind higher with breadth deteriorating towards a final top, as the economy slowly weakens.  The economy is just not strong enough to justify rampant speculation in small caps, many of which are nonprofitable and/or have weak balance sheets.  So no blowoff top with a big move higher in Q1.  Its going to be your typical grind it out top, with no climax moments.  That's going to make timing the top a bit tricky, as these grind it out tops take longer to play out, and are more frustrating to trade.  Going into the year, I was thinking March as the month that the market makes a climactic top.  But now, its probably April or even May when it makes a meat grinder of a top.  

Still long SPX, but trimmed some yesterday and will likely sell the rest today.  I put on a long position in Treasuries for a short term trade going into today's CPI, which I will close out either later today or tomorrow.  Anything above 4% 10 year yields is a low risk long entry point at this juncture.  If the CPI comes in lower than expectations, I may begin to put on SPX shorts, as SPX 4800 is going to be tough resistance as its near all time high territory, and the chart looks short term overextended. 

Friday, January 5, 2024

Wingsuit Landing

Everyone is talking about a soft landing.  It is the zeitgeist of the moment.  The current environment reminds me of those wingsuit jumpers who dive off cliffs and high places, gliding down like a  flying squirrel.  It looks way more fun than your ordinary sky diver who just drops straight down towards the ground.  I actually don’t have a strong argument against a soft landing.  The ingredients for a soft landing are present:

1.  Large budget deficits (6-7% of GDP) in a low unemployment environment.

2.  Energy and commodity prices which are stable to lower.

3.  Fed policy pivoting to preemptive rate cuts in a non-recessionary economy.

4.  Inventories de-stocked to normal levels.

5.  Strong balance sheet for the top 50% as home prices remain high, and most have low rate mortgages from 2020-2021 refis.

With everyone focused on the short term, macro is always at the forefront.  Thus, this soft landing thesis is talked about quite often.  Based on my read of sellside research reports and listening to CNBC and Bloomberg, the consensus for 2024 is a soft landing, with a lean towards weak growth.  This is not the kind of backdrop that usually forms bubbles, but here we are.  The SPX forward P/E ratio is the highest outside of the 2021 everything bubble period over the past 20 years.  This is with Fed funds rate at 5.33%, with a 10 year yield close to 4%. 

With all the talk about a soft landing and the Fed’s dovish pivot, investors are forgetting about price.  The most important part of the market.  The stock market is richly valued.  This is for a developed economy with a naturally low growth rate.  Without lots of fiscal stimulus, the US economy cannot grow much.  If you do have a lot of fiscal stimulus, inflation will be high, causing long term yields to go higher, which lowers the present value of future cash flows.   Its almost a no win situation for the stock market at current valuations.  Unless we are at a permanently high plateau for stock valuations, buying the SPX today will underperform cash sitting in a money market fund for the next several years.  You cannot totally eliminate the possibility of being at a permanently high plateau.  Anything is possible.  But a permanently high plateau for valuations would be the first time ever in US stock market history.  And given the historically high equity allocations among households and an aging demographic, its very likely that equity allocations go down, especially with bonds now offering decent yields.  

The stock market is not the economy.  But you would think it is based on what you hear on CNBC.  Its the backdrop for almost every conversation about the market.  In October 1987, when the Dow crashed 19% in one day, the US was not in a recession.  GDP growth was strong.  In February 2018, when the VIX went from 14 to 50 in 3 days, the US was not in a recession.  GDP growth was strong.  Stocks can go down hard and the VIX can spike without a weakening economy.  The common trigger for these sharp drops in stocks is a big run up higher into all time highs and rich valuations.  The current setup is not quite there yet, as the SPX has not hit an all time high, and the run up is not as steep as 1987 or 2018.  But if the SPX keeps rallying for the next few months, the setup will be ripe for a sharp drop and a vol explosion.  It won’t be as dramatic as 1987 or 2018, because the rise is unlikely to be so steep.  But it will cause some damage.  More than March 2023.  More than October 2023.  

2024, being an election year, will have a lot of political headlines which will be a convenient rationalization for any selloffs.  Don’t buy into any of it.  The winner of the election, whoever it is, will not be able to cut spending.  They will not be able to raise taxes.  That’s all that matters for the market.  The stock market loves the government overspending while cutting/not raising taxes.  Rising budget deficits are a boon for stocks.  No matter how much the permabears spin it as a negative.  There will be no fiscal austerity, even if the bond vigilantes have a fit.  Congress and the White House didn’t even blink an eye when the 30 year yield went from 4% to 5% last fall.  Nothing will stop the deluge of Treasury issuance.  Nothing.  

Sure, the market hates uncertainty, and there is a subset of chicken little investors who think Trump will hurt the market.  But after what they’ve seen of Trump and Biden the past 8 years, the election will be viewed a positive catalyst in their eyes, not a negative.  This Goldilocks theme based on a soft landing, Powell dovish pivot, and the near certainty of more government cowbell with either Trump or Biden winning in November, what is there to fear?  Mainly one thing: the return of inflation and the ghost of Arthur Burns.  An economic slowdown is not the real fear.  It can be dealt with by bazooka stimmies from the Fed and US government.  The real fear is inflation picking up again during the Fed cutting cycle.  Commodities are underpriced compared to the growth of the money supply over the past 4 years.  It won’t take much for inflation to surge back up on the back of higher food and energy prices and a weaker dollar.  

In a low inflation environment, like what you had from 2000-2020, bonds are the best hedge for equity downside.  In a high inflation environment, like what you have since 2021, commodities are the best hedge for equity downside.  As the economy gets more financialized, like the US, stocks and bonds become more positively correlated, so bonds become a poor hedge for stocks.  This will lead to more volatile markets than in the past, because of that lack of hedge from the fixed income side. But the current market is pricing volatility as if it was a similar environment to the 2010s, when you had bonds act as a positive carry risk off hedge, when that's no longer the case.  2022 was a wake up call.  Inflation is a bigger long term problem than a potential recession from higher rates.  

We are getting a nasty little pullback off the end of year rally, as the post FOMC day gains have all been erased.  I started a long in SPX slightly above 4700, thinking that the bulls would defend that zone, but it fell easily.  This is just a short term trade, and it still has merit, because I don't see a sustained selloff in bonds at the moment.  But I won't hold this for more than a week or two at the most.  Once again, stocks have a hard time rallying when yields are going higher.  Ten year yields are back above 4%.  Nothing has changed.  The bond market is in control here.  

After this pullback in bonds from the year end rally, I am neutral to positive for the next few weeks due to the impending rate cut cycle, seasonal weakness in most commodity markets, and the skepticism that I see among Wall St forecasters who still think too many rate cuts are priced into the SOFR curve.  It is this wall of worry about higher for longer that the stock and bond market will likely be climbing for the next couple of months.  This makes me more constructive on stocks as well, since the stock and bond markets are connected at the hip these days.  

 We have nonfarm payrolls and apparently the higher than expected ADP number and lower than expected jobless claims numbers have both bond and stock investors nervous.  These economic data releases are overblown in their importance, so I wouldn't jump to any conclusions based on this jobs number.  Powell seems hellbent on going for a soft landing so he'll ignore strong data and cling to anything supporting rate cuts, like lower CPI, lower job openings, etc.  Its all about politics now for the Fed, even though most people will think that's just a conspiracy theory. 

The Fed will find almost any excuse to cut rates this year.  Those clinging to the higher for longer thesis are playing last year's playbook.  This year will be the year of Powell the "Caveman Lawyer".  Eventually the SPX will form a long lasting top, once you get the majority of investors to completely buy into the coming fast and furious rate cut cycle.  It probably will take a few more hints from Powell and company for the message to be understood, loud and clear:  they are coming with preemptive rate cuts to prop up Biden and stop Trump.  I could care less who wins in 2024.  But the Fed is definitely going to be rooting for Biden and helping him out as much as possible.  Powell and Yellen are on the same team now. 

Friday, December 29, 2023

Its an Art Not a Science

The stock market is irrational.  Its based on numbers, but its not math or science.  There are no set rules.  There is no iron law in finance.  Its an art that people try to make into a science.  This isn't physics or math.  The closest thing that comes to mind is fashion.  There is no real logic when it comes to fashion.  Its based on feel, personal taste, emotion, societal trends, etc.  The thing about fashion is that it really doesn't matter how you feel about your clothes, its how others feel about your clothes.  That's the stock market.  It doesn't matter what you feel.  It matters what others are feeling.  

Having a quantitative mindset, it was bewildering to see how investors would get more excited about the stock market the higher it went.  The rationalization, the excuses, the reasons for the moves.  They are arbitrary but are quickly clamored onto like indisputable facts by the crowd.  There is no wisdom of crowds in the stock market.  That's BS.  Its the madness of crowds.  Its herd behavior coming from our primal instincts, that evolved over tens of thousands of years when survival was always the priority.  That way of thinking, the emotions and actions that all evolved when there was no stock market, when there was no crowd gambling on a huge scale.  

Trying to put logic or numbers into this game is like trying to put a square peg into a round hole.  Its an art, and it will always be art, even when AI or machines take over.  There is no science here.  The stock market is just a huge, glorified casino.  In fact, its less quantitative than a casino, where the odds are set.  In the market, the odds are unknown.  Its this mystery that keeps the hope alive, that provide fertile grounds for snake oil salesmen and subscription sellers.  The day that I start a substack to try to sell subscriptions is the day that I admit that I no longer can beat this game, and can only make money selling dreams rather than living the dream.  

Its an illogical game, but there are patterns to it.  Arbitrage has been sucked out of the market and there is very little alpha in that space. The main edge in markets is finding patterns and playing them over and over again.  Those patterns are derived from human psychology and they repeat.  Some patterns are long term, some are very short term.  But they repeat.  Successful speculation is about finding the patterns and anticipating the next move to come in the pattern.  There are seasonal patterns, patterns around events, etc.  Some patterns are higher probability than others.  And the probabilities change and are unknowable, but intuitively, you can sense what patterns are reliable and which ones are less so.  But to do so, you have to stop thinking about what's going on in your head.  But what's going on in the head of those moving the market.  

First order thinking is what you are thinking about the situation.  Second order thinking is what you are thinking about what others are thinking about the situation.  First order thinking doesn't help you much in this game.  Its second order thinking which is the foundation for market analysis.  No one cares about what I think.  No one cares about what you think.  I'm not the one who's going to drive the next move.  I want to know what the big money is thinking and what's their next move.  

The current bull run in stocks is puzzling from my view of how markets should be valued, but it really doesn't matter what I think.  If others are in a risk seeking mode, and past patterns of risk seeking behavior play out, we are not done with this uptrend.  That doesn't make me want to play this uptrend at the current time, even though the probability is high that the market will be higher 2 months from now.  Its the risk/reward thats not attractive here.  There is more downside risk in the short term than upside risk, even though its more likely to go up than down.  

These big bull runs, which we are currently on, tend to last 4 to 5 months before facing its first real test/correction.  Since this rally started at the end of October, that means a rally that likely lasts until late February to late March.  This also jives with the psychological importance of the Fed and the first rate cut, which looks like will happen at the March FOMC meeting.  Its a classic buy the rumor, sell the fact setup happening over several months.  This will be the framework with how I trade the market for the 1st quarter of 2024.  Its too early to think about shorting for longer than a couple of days, so I'd rather not play that game.  

No imminent trades at the moment, but I will be buying dips in SPX and Treasuries in January, as I expect the uptrend to continue into March. 

Monday, December 18, 2023

Late 1999, Late 2020 Flashback

Its getting bubbly out there.  Parabolic moves in heavily shorted names like UPST, CVNA, COIN.  A huge squeeze higher in Russell 2000, up over 20% in less than 45 days.  This is feeling like late 1999.  Like early 2021.  The difference this time versus the previous two times is the economy.  The economy in late 1999 was on fire.  Same with 2021.  Now?  You have the market not excited about earnings, but about the Fed.  That's a whole different type of euphoria, something that will have a shorter lifespan.  Also the fact that we had a bubble burst just 2 years earlier makes it much less likely this bubble will get as big or last as long.  People have short memories, but not that short. 

In 1999, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 1999 to early 2000.  

 

In 2020, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 2020 to early 2021.

 

In late 2023, you are starting to see the Russell 2000, which has been lagging the SPX for the past 18 months, go on a huge rally, massively outperforming the SPX over the past 2 weeks.  

It is human nature to feel FOMO, when others around you are getting richer.  Investors and traders then try to catch up by playing more aggressively, going into riskier stocks with more beta, to get more bang for their buck.  It happened in late 1999/early 2000, in the later stages of the dotcom bubble.  It happened in late 2020/early 2021, at the peak of the SPAC/bitcoin/meme stock/everything bubble.  And it is happening again here.  

But can the economy stay strong enough to keep the animal spirits going, to keep the soft landing hopes alive?  That will be the question for the first quarter of 2024.  There are some who believe that the higher stock and bond prices will feed back into higher consumption by the wealthy, which will boost the economy in early 2024.  There is some merit to that thesis, but relying on the wealth effect as the main pillar of future consumption is not something I would put too much money on.  Plus, you have already front loaded so much of the Fed pivot rally in the past few weeks, that there isn't that much squeeze left to play for, unless things get really crazy.  And as I mentioned earlier, due to recency bias, and being burned the last time, I just don't see things getting as crazy as early 2021.  

One thing I do have conviction on is that Powell will cut way more than what the dot plot predicts for 2024.  But with 150 bps of cuts already priced into the SOFR curve, its not a great risk/reward at current levels.  You probably make money buying SOFR Dec. 2024 futures and hold them to expiration, but it could be a bumpy ride for the next few months.  I would have been much more confident betting on lower short term rates if Powell didn't signal a pivot, as that would have left a lot more potential in the trade.  As it is, its not a compelling trade at the moment.  

A factor that people are not thinking about enough is how the 2024 election and the looming Trump nomination will have on the Fed's reaction function.  The Fed will have an easy trigger finger on cuts in 2024 to try to help Biden (and hurt Trump).  I know there are still those who believe everything they hear from the Fed and believe they won't be political and will follow the data, but I'm cynical on how the Fed operates.  Their default position is to be on the side of easy money in the first place, so even a slight bit of motivation to keep Trump out of office will have them leaning towards more cuts than fewer.  Plus, with the stock market front running these rate cuts so aggressively with a big rally, I could picture a scenario where stocks actually go down after the rate cuts start.  This will hurt consumer sentiment as the election gets closer, which will encourage the Fed to be even looser and do more rate cuts.  I can imagine a snowball effect of the stock market being disappointed with just a few rate cuts and having a temper tantrum, inducing the Fed to cut even more.  

It's interesting that in 2022, even with surging inflation, everyone was so skeptical about the Fed hiking rates a lot after they signaled no rate cuts until 2024 just a year earlier.  After brainwashing investors and Wall Street with higher for longer for the past 12 months, now almost everyone seems skeptical about the Fed cutting rates a lot in 2024, even though Powell has already pivoted and started talking about cuts.  I see the current situation as a mirror image of 2022, with the Fed likely to surprise dovishly throughout 2024, steepening the yield curve in the process.  The economy is just not going to be as strong as 2023 due to the lower fiscal deficits on both the state and federal level, and with the resumption of student loans and the end of the employee retention fraud that many were taking advantage of.  Employment should get softer, as less bank credit and shrinking margins at small businesses will lead to job cuts.  

Short to intermediate term, its not an easy spot here for shorts or longs.  I put on a small short on Thursday and Friday in SPX and NDX, but those trades I intend to close out this week.  I may even play the long side for a quick trade ahead of the seasonally bullish last week of the year.  For longer term trades, I'm inclined to play small ball or just not swing until I see a fat pitch.  My best guess is that you will grind higher into the first rate cut in March, but not a huge amount of conviction.  Because things have been pulled forward so much, it wouldn't surprise me if we had a sharp pullback before March.  Its probably not a bad time to just park money in money market funds at 5% and wait for things to play out for the next couple of months.