General Complacency

The market has gone up for so long, and without any scary corrections, that investors are getting greedy.  Their demand for puts is down and the demand for calls is up.  Take a look at the long term chart for the CBOE equity put/call ratio.  It is at extremely low levels. 

The chart resolution is bad, but we're basically at the lows of the year and hovering there for weeks now.  Usually these type of low equity put/call readings are fleeting.  But they have lasted all month.  Ever since tax cuts have been passed, there is a growing optimism about 2018 which looks overblown. 

Many investors will be reluctant to lock in capital gains for 2017 when 2018 rates will be lower, so there is probably a fairly big supply of waiting sell order in early January.  Counteracting that, there will be of course some automatic inflows that often start at the beginning of the year.  But I am leaning towards a pullback in early January, so I think next week will be a good time to start a short position.  Not expecting any big pullbacks, but it should be some range bound trading to start the year, with current levels near the top of the range. 

The uptrend has lasted for quite a long time, so I don't expect it to change to a downtrend right away. It will take a few months of choppy trade before it tops out.  So it should be a good market for counter trend traders in 2018. 

Manipulation of Inflation

I find it fascinating how the masses believe everything spoon fed to them by the media.  It permeates into financial research, and muddies the reality of the current financial and economic situation.  I don't wear a tin foil hat, but I also don't take for granted everything told by the public as being straightforward and true.  Sites that reveal the true nature of the government statistics like Shadowstats are ignored as biased and fringe economic research. 

One of the most basic economic statistics, inflation, as measured by the CPI, has undergone drastic changes in its calculation over the years.  From the 1980s to the early 1990s, the CPI went away from having a fixed basket of goods to being an adjusted basket of goods that used substitution effects for higher priced items to another "similar", but lower priced item to suppress the inflation readings.  The government also used hedonic pricing to deflate a newer, more expensive item as being less expensive because it had better features.

As you can see, based on 1990 calculation of the CPI, the CPI should be closer to 6%, not 2% as is being reported by the government.  The government has an obvious incentive to suppress inflation readings lower, because it allows the government to provide lower cost of living adjustments for Social Security and other government benefits, which are adjusted annually by the CPI reading.  This also has the effect of allowing the government to issue bonds at lower interest rates, because the reported level of inflation is lower.  For the politicians, it allows for the real GDP readings to be inflated higher, because inflation is being manipulated lower. 

What is interesting about the above chart is that since the early 2000s, the difference between 1990-based CPI and officially reported CPI numbers has widened, from about  2.5% to almost 4.0%. 

This brings me back to what seems to be a growing fear in the current market, about potential inflation next year.  It is funny, because searching for higher inflation in the CPI is like looking for the right card to choose when playing 3 card monte in the streets of Manhattan.  They are trying to find something they can't because its a rigged game.

It leads to some really inane arguments on CNBC about how the Fed should get rid of its 2% inflation target.  When the premise is all wrong, since PCE and CPI inflation as the Fed measures it is not really inflation.  Its a butchered, manipulated government tool to reduce government benefits and hide the debasement of the dollar.

Is 2% inflation at all times absurd? Billionaire investor Druckenmiller thinks so

CNBC's Kelly Evans spoke to Stan Druckenmiller, who said he thought the Fed's mandate for 2 percent inflation was absurd. Jim Cahn, Wealth Enhancement Group; Stephen Guilfoyle, Sarge986; and CNBC's Rick Santelli discuss Druckenmiller's comments.

No Fear

Gradually, like the shifting sands in the desert, you are going from doubt and pessimism to acceptance and optimism.  It has taken over 8 years for the transformation of investor psychology.  The scars from 2008 are still there, but the rally has been so strong, so long, and without enough corrections to scare investors.  I remember back at the beginning of 2014 when there were doubts about the stock market going up without Fed QE.  I don't hear those doubts anymore.  Not many people are worried about the ECB tapering QE and the BOJ reducing their QE purchases.  There isn't even much concern about the Fed raising interest rates almost every quarter. 

A steadily rising, low volatility up trend will give investors confidence about stocks.  Rarely do the daily buyers and sellers care about valuation, its about what is going to happen in the next hour, the next day, the next week, the next month.  And it has been up, so they extrapolate the past 8 years into the next 8 years.  It's the monkey brain that humans have not completely evolved from which still lingers.  It's why you have recency bias, why so many people believe in fake news, and why hearing repeated proclamations about how strong the economy is from CNBC and financial social media makes investors believe it.  In fact, US GDP growth has been basically stuck in a narrow range around 2% since 2010. 

Now with the tax cuts about to be passed, the optimism is through the roof as analysts extrapolate all the after tax earnings growth in the coming years, forgetting that the new tax rates are not permanent.  The investor sentiment surveys, which I usually ignore, are at astronomical levels, which is something I cannot ignore.  The put/call ratios have been very low for the past 3 months.

I remember back in the late 1990s when No Fear bumper stickers and t-shirts were so popular.  It is no coincidence that it happened late in an economic expansion with a booming stock market.  It is something you would have never seen in 2008.  It feels like a similar mood now, as consumer confidence readings hit extreme highs, as credit card debt explodes higher, just like the late 90s. 

Unlike the 2015 top, which led to just a 15% correction in the SPX, the amount of froth and optimism is clearly greater this time around.  Once we top out in this uptrend, which I expect in 2018, what follows will be a bear market, not a correction.  Until then, I will play the short side conservatively in order to preserve capital for when the real profit potential arrives.

1999 Flashbacks

The SPX strength is relentless.  There is widespread optimism about the global economy and Fed rate hikes are being ignored as a negative catalyst.  With tax cuts due to pass this week, no one wants to be short when it is officially in the books.  Also, with the big gains for the year, most investors will be withholding their stock sales to push their capital gains to 2018.  This should create an upward drift for stocks for the remainder of the year.  Will not try to fight this uptrend for the remainder of the year.  There are easier battles to take.

I will be interested in the short side starting from January, as the delayed selling should kick in.  Plus, after tax cuts, there is not much of a positive catalyst, unless you think infrastructure will get passed in 2018.  With Trump's low popularity and with tax cuts already passed, the motivation to get it done by Republicans will be low.

After some profit taking at the beginning of 2018, we should have one last strong rally to form the final top, some time in the spring.  It is extremely difficult to predict tops, so this is just a broad outline that I have for the coming months, things will probably be quite different than I expect, but in general, we are very late in this rally and things should get choppier as we form a top.

Unlike 1999, there is not the unbridled retail enthusiasm for stocks, and you don't have the flood of IPOs and supply that hit the market like you did leading up to the top in 2000.  So the top will be trickier than it was back then, but the institutions are basically all in on stocks.

I expect bitcoin to make a top after the SPX, so probably summer or fall of 2018.  I will have a different mindset when trading the markets next year.  If things go according to projections, it will be less waiting, and more trading.

Lagging Global Stocks and Extreme Valuations

The SPX rally is ongoing as the Eurostoxx,DAX, and Shanghai Composite lag badly over the past 2 months.

The stronger euro and the built in structural weaknesses in the Eurozone and China pulling back stimulus is being overlooked by rear view mirror analysts who rave about global growth and a tight labor market.  A tight labor market is not a sign of a strong economy.  It is a sign of a shrinking percentage of the working age population relative to the total.  The developed economies:  US, Europe, and East Asia are getting older, reducing the working age population, thus fewer workers available to support a growing number of elderly, keeping unemployment rate low.  That is not what strong economic expansions are made of.

That is why the Fed funds rate is 1.25-1.50%, even after a 9 year bull market.  If short term interest rates were anywhere close to 5%, you would have a deep deep recession.

The US stock market is in the most vulnerable position since 2008, as the exorbitant  stock valuations leave very little margin for error.  Even if there is just a flattening out of earnings growth, stocks will be punished because they are priced for perfection.  Reported earnings (GAAP, not the NON-GAAP operating earnings nonsense) for the S&P 500 is $107 for the trailing 12 months as of November.  The market is currently priced at a trailing P/E of 25!  The only time you had such a big multiple during an earnings expansion was in 2000, when the S&P went up as high as P/E of 28.  Even the top in 2007 was less expensive, with a trailing P/E of 18.

So you have a high probability of a bear market within the next 2 years, just based on the optimism and high valuations, with low earnings growth.  By the way, stocks are priced off of perpetual earnings, and these corporate tax cuts will last 8 years before they expire.  The budget deficit will be so massive in 8 years that I am sure there will be a BOJ type of ongoing QE by the Fed at that time to keep interest rates low.

The VIX has gotten obliterated today.  It is now down to 9.5, near the lowest levels of the year.  The VIX shorts have been getting paid handsomely, even without VIX going lower, just by rolling over their shorts with the steep contango.  You would figure that the VIX longs would have had enough and demanded a flatter VIX curve for taking on long volatility positions.  It seems like there is more risk holding a long volatility position than a short one!  Its an upside down world, as the lack of volatility is perpetuating ever larger vol adjusted stock positions at funds, keeping the uptrend going.

It looks like we will finally get the tax cut bill passed next week.  There has been so much hype about these tax cuts, that I can't imagine that they are not priced into the market.  Isn't that what the Trump trade was all about since November 2016?

Shorts will have their time in the sun soon enough.  The bitcoin mania has masked what is probably the more insidious bubble:  US stocks.

Fed Optimism and Rate Hikes

The market loves to make the same mistake over and over again.  The key to making money in the market is not trend following or being a contrarian.  It is to repeat a strategy that keeps working because of a market bias.  For example, all of the gains for the S&P since 1993 have been from overnight gap ups.  If you only went long during regular market hours in the S&P, you would have made no money, despite the market going up 500% during that time period!  That is a simple strategy of just going long S&P at the close and selling at the open.  The reason the strategy has worked so well is because stock traders are afraid of overnight gap risk, and those who take that overnight risk collect the premium. It is an irrational fear, because the market can easily go down rapidly during regular market hours, as the flash crash in 2010 or even the massive dump in the S&P on Flynn news a couple of Fridays ago. 

This brings me back to the Fed.  There is a market bias of believing the Fed and not believing the interest rate markets when it comes to future rate moves.  The Fed has always been overly optimistic on raising rates, and usually they fail to deliver on their promises.  In the few times that they do deliver those rate hikes, it is because the S&P is screaming higher.  And no, the S&P isn't always going to trade like it did this year.

The market bias now is that the Fed is going to hike 3 times next year and flatten the yield curve.  The market has fallen into the trap of believing the Fed again.  The Fed is always going to try to cheerlead the market by giving overoptimistic projections of the economy and interest rate hikes.  They are in the business of providing confidence to the market, not in correctly predicting future rate moves. 

Betting on the Fed hiking rates 3 times in 2018 is like betting that the S&P will go to 3000 next year.  Because if the S&P isn't going up, the Fed will stop their rate hiking cycle dead in its tracks.  I have a much more bearish view on 2018 than most so I am bullish on bonds.  The fear of inflation is still present in the market, and that is keeping yields higher than they should be given how late cycle this economy is.

Do not be surprised next year if Powell comes in and is dovish as the stock market struggles to go higher.  If for some reason he wants to try to raise rates as the stock market struggles in 2018, he will invert the yield curve in a hurry, exacerbating the downfall of this market.

Looks like it will be a no touch market for the S&P for the rest of the year.  Its fitting to cap off the year with more of the same boring grind higher.

First Dip Bought and Bitcoin Thoughts

Of course, they were going to buy that first dip off of the SPX 2665 high.  Same thing they've been doing all year.  Plus its December, a bad time to short.  The dip buyers came out of in bunches, protecting 2625 level and grinding the market back up.  As I have stated before, I will only take perfect short setups, and a move back to 2660 this week will not be a perfect short setup.  There is a big difference shorting a euphoric gap up into new highs on good news (high probability trade) and shorting the same level coming up from a short pullback with no news (a coin flip).

Market participants have turned their focus away from the stock market towards bitcoin.  It really shows you that there are a lot of loud market observers, but not a lot of loud market participants.  Its like you have a few people in a casino playing baccarat and a bunch of people watching those people gamble.  If I had no plans on trading bitcoin, I wouldn't pay any attention to it.  But I am very interested in getting involved on the short side in the future so I have been watching the action from afar, waiting for the CME opening on bitcoin futures and also bitcoin ETFs to possibly short.

I will not play the long side in bitcoin, because I don't like to trade with a short term view.  I want to be able to hold my position long term, and that is something I refuse to do long bitcoin.  The bitcoin longs will have their profits front loaded in this parabolic rise higher, so if you are going to be long, you have to be long on the way up, not when it is consolidating.  Those looking to buy a bitcoin pullback are the ones who will be absorbing the risk.  Whenever there is a pullback, there is always a risk that the uptrend is over, and prices keep heading lower towards its intrinsic value, close to zero.

I am on the sidelines here and probably not doing much for the rest of the year in S&P futures.  Bonds are trading in a tight range, and not that interesting either.  No wonder they are talking about bitcoin, there is no action anywhere else.

Back to the Cave

Ok, that was a nice little mid hibernation beef snack for this bear in hibernation.  I covered the short and back to flat.  I am not on an aggressive short prowl yet, and I wasn't even looking to short until the conditions were near perfect,and the good news big gap up on Senate tax bill passing was irresistible.  Unless there is a screaming short in SPX, I don't plan to revisit until January. 

I don't want to make a big deal out of the past 2 days, but it is days like Monday which give little hints that the top is near.  I don't recall so many traders getting so bulled up over something(tax cuts) that has been advertised for so long.  Earlier this year, I was waiting for the tax cuts to be priced in before I got aggressive on the short side.  The move over the last few days from SPX 2600 to 2660 went a long ways towards pricing in those tax cuts and getting investors excited about the market.  If you look at the TD Ameritrade Investors Index, a measure of how much buying the active traders there are doing, it is going parabolic.  A lot of investors on the fence jumped to the bull side in November.  It is at the highest level ever recorded, over the past 7 years.

Europe is back below the post French election levels seen in May, and China H Shares have gotten destroyed over the past 2 weeks, dropping 7 percent, going back down to September levels.  Also, for those looking at fundamentals, copper took a beating, as copper dropped 4.6% yesterday, the most in any day in 3 years! 

China is slowing, Europe looks like it can't handle a stronger euro, and yield curve continues to flatten.  2018 will be very interesting indeed.

Feeding the Ducks

Give them what they want.  More stock.  I am feeding the ducks this morning as we have hit an all time on the passage of the Senate tax bill and a retraction of the Flynn rumors by ABC News.  It was a massive move intraday on the release of the rumors that Flynn would testify against Trump, but the rumors weren't exactly correct, and it seems less likely to be the smoking gun to impeach Trump.

I couldn't really understand why it was such big news anyway.  The market is not going up because of Trump, it is going up because Republicans have control of the White House (regardless of impeachment, it just puts Pence in there) and Congress.  So even if Trump is impeached, there is still a Republican president.

Controlling the executive and legislative branch is powerful, because it allows for  unpopular bills to be passed with total disregard for the masses.  These tax cuts have been bought and paid for by the big time donors and lobbyists, and it has been a great investment for them.  There was no guarantee that a Republican was going to win in 2016, so they did take a small risk in giving so much money to Republicans.  But the lobbyists give to both parties, its not a tails I win, heads I lose situation.  It is more like tails I win a lot, heads I win a little.

Now that we have the good news mostly reflected in the market, it is time to get bolder on the short side.  I have been waiting patiently for this time to come, so I can start trading more actively.  This year has probably been the least I have traded intraday in futures in quite a while.  These slow years tend to set up very active years from past experience.  One of the key ingredients to getting more future volatility is having a market that is overvalued and well above its long term trend.

Friday's price action was a preview of the higher volatility that I think comes in 2018.  I have started a short at these pumped up levels this morning, and it is significantly bigger than the mistimed position I took last week.  Looking for a move back down to SPX 2625 this week.

Volatility Picks Up

It is not common to see the VIX rise so much with the market.  The VIX was trading as low as 9.5 on Tuesday and by Thursday, after 2 big up days, we are at VIX 11.3.  I see this as a sign that we are running on fumes for this rally.  With volatility a bigger part of portfolios, it has become a stronger indicator of future SPX direction.  Although there have been some stumbling blocks on the way to the Senate passing its tax bill, it looks like the holdout Republicans are saying yes, one by one.  Although with the very few deficit hawks out there, it looks like it will be watered down and scale back the corporate tax cuts sooner than expected. 

Will the tax cut bill passing be the sell the news top?  I don't think it will be that easy, but it will probably be the start of the topping process which should last several months, much like 2015.  I see a lot of parallels this year with 2014 from a rally duration and sentiment perspective.  Except the big difference is that the dollar was strengthening in 2014 and it is weakening now.  The USDJPY is quietly trading in a range that is below the highs set in 2015. 

It doesn't seem to make sense that the dollar is weakening as the Fed tightens and keeps its promise of 3 hikes this year.  Also, we are on the cusp of a tax cut which is supposed to boost US growth, which should be dollar positive.  But yet the dollar can't seem to go up.  What I see as a possible trigger for even further dollar weakness is the global economy actually weakening, which would force the Fed to stop its rate hikes, which would suddenly make dollar bulls turn into dollar bears.  Right now, we are still seeing a lot of disbelief that the euro is so high against the dollar even as the Fed keeps tightening. 

We are seeing more volatility in the S&P these last 2 days.  At turning points, you tend to see volatility rise, even at tops. I think we are close to one of those turning points.  Early December can still be weak for the stock market, so there is still a little bit of time for bears to go to work here. 

Shorted Too Early

Why did I even bother trying to play for a small pullback by shorting the top.  You had no post Thanksgiving hangover in the market.  Thanks to more feel good news on tax reform from the Senate, the S&P went straight up from the opening bell.  I still have a small short, but will look to get out before the end of the month. 

Fast Money crowd were raging bulls yesterday.  All the good news from Senate tax reform debates did its job.  With the extremely low put call ratios and the seasonal weakness for this week, it was worth a shot but the momentum is just too strong, and those with big gains seem reluctant to sell this year.  It feels like a toned down version of 1999.  Instead of retail being excited about stocks, it is the institutions.  Retail has flocked to bitcoin, the institutions have flocked to stocks. 

Eventually the shorts will get paid well, probably next summer, but timing the top is key.  It is very hard to stick with a losing position that will pay off big and suddenly.  In order to catch that sudden down move, you have be willing to hold a short position for the long run.  Not easy to do when long term shorts have been a one way ticket to the poor house. 

Don't see any long term signs of a top yet, but we sure are building a lot of air underneath.  It will make the volatility all the more crazy when the market goes back to trading a more reasonable valuation.

Bitcoin Shopping Spree

Bitcoin is the hottest item this holiday season.  It is the hardest to trade legitimately, but still the most popular among retail.  It figures that retail these days will flock to something that is anti-establishment, much in the way they flocked to Trump.  Of course, Trump didn't end up being anti-establishment, he is hyper-establishment, looking to give big business donors a huge gift in the form of tax "reform".

Socioeconomically, the underlying distrust of government and desire for alternative investments (the masses don't seem to have real enthusiasm for stocks anymore) has led to this dash for cybertrash.  You can't really compare this to the dotcom bubble or housing bubble.  At least there was some underlying value there, but cryptocurrencies have no real underlying value.  I am sure the bitcoin maniacs will argue with me on this, but unless governments give up their printing press in favor of bitcoin, it has no underlying value.  And what government would be dumb enough to give up one of their main sources of power to throw their monetary fate into bitcoin?

This really tops the cake among bubbles that I have seen.  You had stamps in the late 70s/early 80s, baseball cards in the late 80s/early 90s, and Beanie Babies in the late 90s, but this is on a global scale and larger.  At least for the above bubbles, there it at least some nostalgic/sentimental value for the asset, but that is absent with bitcoin.  It may be the closest thing to the tulip bubble.

Investing in bitcoin is not investing in block chain technology.  Block chain is a transaction mechanism, not an investment.  And the number of transactions that bitcoin can process is less than 5 per second, which makes it quite slow, compared to a VISA which can process more than 24000 transactions per second.  So that just makes bitcoin a store of value, which is not backed by any governments.  It is essentially competing with gold and silver, or even art and antiques, except it has no physical uses, which makes the value even more ethereal.

If I had to make a guess, it would be similar to gold, a weak dollar play, so a weakening US economy, and thus a more dovish Fed would help bitcoin sentiment, so I think there is another leg higher for this bubble in that case.

I am in no rush to short bitcoin because I do believe the dollar will get weaker over the next couple of years, and that could trigger another rush into bitcoin.  It will be interesting to see how bitcoin trades once futures trading is available on the CME and CBOE.  If the longer dated futures contracts have sufficient liquidity, I would be willing to take a long term short position in bitcoin sometime next year.

The seasonally strong period before Thanksgiving and Black Friday played out, and that sets a possible pullback this week.  I took a small short looking for a pullback this week.

Tax Cuts and a Weaker Dollar

The institutions are throwing caution to the wind and diving into risk.  In both stocks AND bonds.  When you have this much complacency and fearlessness, you see buyers of stocks and buyers of long bonds.  They don't want the shorter duration stuff anymore in fixed income, because the Fed is going to raise rates a bunch more times, flattening the yield curve, according to the "experts".

With bond, stock, commodity, and FX volatility so low, it encourages bigger positions in stocks and bonds.  The best way to get a big position in bonds is to go for the 30 year bond, the biggest bang for your buck.  The best way to get a big position in stocks is to go for Nasdaq stocks, also the biggest bang for your buck.  The S&P is at 2600!  Who would have expected that with revenue growth at 5%? Of course, US corporate profit margins are at all time highs and those who said it was mean reverting are saying its different this time.  This is due to quasi monopolies in existence in the US, thanks to the big corporations lobbying on Capitol Hill to extend and expand patents, keep competition to a minimum, etc.

And now you have the big time corporate tax cuts coming down the pike, which seems to be unpopular among those who actually have seen the proposals, which is a small minority, of course.  This should help corporations expand their profit margins further, at expense of a weaker dollar.  Yes, a weaker dollar.  Fiscal stimulus that lead to higher deficits with limited economic impact are dollar negative, not positive.  And this tax cut will just be another way for corporations to expand their stock buyback programs.  With individuals getting very small tax cuts, it provides limited economic stimulus.

The Republicans have deftly crammed down a very business friendly bill, at the expense of the value of the dollar, because the Fed will end up printing the money to pay for the deficits anyway to keep the Treasury's interest rates low.  If Japan can do it, for sure the US can do it with the world's reserve currency and a Fed that is a slave to financial markets.

If you follow the most likely course of events over the next 5 years, it is as follows:   You will have massive budget deficits, thanks to an aging population which raises Medicare and Social Security spending, and of course, the Trump tax cuts.  The proposal appears to have a giant loophole for individuals to incorporate themselves in order to benefit from the lower business tax rates for S corps and LLCs.  So the deficit will likely go up a lot more than projected.  Of course, the deficits which will be funded by Treasuries, will eventually be financed by Fed QE, when there is the slightest downtick in the economy.  And when Fed starts cutting rates again, the dollar will get destroyed and you have 2010 to 2012 all over again, as the Eurozone can't handle a strong euro.

Back to the current market.  It is a pig of a stock market.  There is no value.  It is what it is.  I am looking at a possible small short for Friday, as CNBC Fast Money seemed wildly bullish.  And is usually a sign that upside is limited.

But during this time of year, you may get a slight pullback in late November, early December, but that is about it.  You almost never see weakness starting from mid December to year end.  So if you want to short, you want to keep it short term, and the pullbacks will be small.  Next year will be the time to get aggressive on shorts, not now.  Tops usually last a long time, so the opportunity to short at high prices will be there for a while.  No rush.

Questioning the Effect of QE

The ECB will reduce their QE to 30 billion euro starting next year, and there are rumblings about the potential effect of central banks pulling back stimulus in 2018.  Unlike other investors, what is more of a dark cloud on the equity market is the high valuations relative to the growth rates. This overvaluation is conveniently rationalized by low interest rates, which is easily debunked when you compare the valuations of Europe and Japan versus the US.  If low interest rates are the reason for a higher multiple, then how come NIRP Europe and ZIRP Japan are priced cheaper in all valuation metrics compared to PIRP US? 

The light blue line is the S&P 500, the dark blue line is Eurostoxx 50.  Since March 9, 2015, when ECB QE started, the S&P has outperformed the Eurostoxx, 25.2% to 8.4%.  While the US was tapering and tightening, the ECB was pumping out 60 billion euro per month, and Europe still can't outperform the US.  So maybe QE isn't the end all, be all for the stock market. 

When investors can't understand why stocks are going up, the most convenient rationale is the expanding balance sheet of the global central banks.  Not many people question this belief, even though the divergence in US and European equity performance since ECB QE simply doesn't support the case. 

This brings me back to the current market.  Europe has been getting pummeled in November.  I guess there is no positive seasonality in that market.  The US has tried hard to ignore the scarecrow European market, going up on gap down opens for 2 straight sessions.  Today will market another day of a healthy gap down thanks to Europe.  Europe has usually been a good forecaster of future US performance, so this European weakness should foreshadow future weakness in the US. 

Perhaps the long awaited 3% correction comes after Thanksgiving, since the US doesn't like to selloff ahead of that festive time period.  So expect the market to stabilize soon, as Europe is approaching strong support levels in the Eurostoxx made post French election and late September, just above 3500.  S&P should stay above 2550, but be capped under 2600 till Thanksgiving. 

Sentiment wise, it feels a lot like fall of 2014, after the market V bottomed in mid October, and went straight up till end of November.  That was the last time I have seen this kind of exuberance and complacency for equities.  Investors spent much of 2013 and 2014 getting max exposure to equities, as the market complacency finally kicked in the internal greed algo.  Same as post November 2016.  I can picture a 2018 that will be an even uglier version of 2015, purely due to the extent of the overvaluation.  Remember, the higher they go, the harder they fall. 

Bonds and Stocks Going Down Together

An interesting thing happened on Thursday and Friday last week, which hasn't been common this year.  Both the stock market and bond market sold off.  While the drop in stocks isn't that much, the VIX has gotten perkier, going above 11.  The selloff in bonds wasn't trivial, the 30 year sold off 11 bps in 2 days, which is a large move these days. 

Bonds and stocks going up together is quite common, and so are stocks going down and bonds going up, or stocks going up and bonds going down, but both stocks and bonds going down is pretty rare.  I don't have the numbers this year, but I don't recall bonds going down this hard while stocks were also down.  In 2015, both bonds and stocks going down together was more common, as stocks topped out ahead a vicious correction in August-September, and then again in January 2016. 

Just another straw on the camel's (bull's?) back. 

We have VIX trading higher again this morning, and with the S&P hardly down on the day.  The long side seems saturated and the VIX sellers are feeling some pressure.  There is subtle sell pressure across asset markets, and this is something new for this market. 

On a side note, with CME announcing they will be introducing bitcoin futures later this year, I have noticed the extreme volatility over the past few days.  It reminds me of the volatility in late 1999 of the dotcom bubble.  Also the talk on social media has changed from calling it an outright bubble this summer, to more of an acceptance/belief of blockchain as a revolutionary technology.  Seems like bitcoin too is nearing its final legs of a bull market, although I do believe it will top out after the S&P, not before it. 

Don't Ask Don't Tell Gap Down

These are the most powerful gap downs.  When no one knows why it's going down.  And in premarket, of all times.  Usually you are getting the no news moves higher in premarket, not this.  Don't ask, don't tell.

For the first time in months, I am seeing signs of buyer exhaustion as the Russell 2000 continues lower while the S&P continues higher.  The Russell finally couldn't keep it together and cracked on Tuesday, going down 1%.  A 1% move in any US stock indices is considered a big move now.  We are in that kind of low volatility grind. 

This week, the calm in the S&P has masked a Eurostoxx that is starting to lag, even with a weaker euro, continued lagging breadth in the US indices, as the leadership is becoming thinner.  And now this, a gap down for no reason. 

By the way, isn't tax reform supposed to be that great catalyst for another move higher?  Well, clearly the market doesn't think that there will be any significant growth boost from the package, as bonds rallied after last week's announcement, even as the S&P was grinding higher.  The flattening yield curve, as the 5-30 spread has gone below 80 bps, shows skepticism about future growth, as well as the ample liquidity out there in fixed income.  The money has to go somewhere.  And usually its either stocks and bonds.  And with stocks at these levels, there is a lot of money that needs to go to bonds to make a more balanced asset allocation. 

The equity fund flows are also flashing a warning sign, as October had heavy inflows.  It is feeling like the topping process has begun, and we should have a hard time rallying much more from here.  The only fly in the ointment is seasonal positive time period of November and December, which is amplified by the incentives to postpone capital gains due to possible tax cuts for 2018.  So while the topping process has probably begun, it should take a few months before we go down the mountain.  The bear suit has gathered enough dust, I will have to dust it off and put it on soon.

Heavy into Equities

Retail is heavily overweight equities.  The Fed issues a quarterly review of the financial accounts of United States which includes flow of funds and the levels of financial assets and liabilities for households.  The numbers surprised me.  I bought into the belief that more money flowing into bond funds and out of stock funds since 2008 was a rebalancing by households as stocks went higher.  But it pales in comparison to the amount that equities have rallied compared to fixed income.  It really has been a TINA market, There Is No Alternative.

In essence, for retail, as of 2017 Q2, they are holding more in equities ($16.9 trillion ) than checking, savings and money market funds ($1.1 + $9.1 + $1 trillion) and bonds ($3.9 trillion) combined.  For reference, in 2009 Q4, they held $7.2 trillion in equities, $0.9 trillion in checking, $6.7 trillion in savings, and $1.4 trillion in money market funds, and $4.6 trillion in bonds.  Basically, households have more than doubled their allocation to equities while reducing their allocation to bonds over the past 8 years.

What is interesting is that even at the peak in the S&P in 2007, household equities holdings was still at $6.1 trillion, which is less than at the end of 2009 ($7.2 trillion), when the S&P was much lower.  So it has been a long term trend of households rebalancing towards more equities and less fixed income over the past 10 years, regardless of what the stock market has done.

This runs counter to the claim that this is the most hated bull market in history.  The flow of funds is speaking loudly, and it is overweight stocks.

We have hit another new high today.  It's another day, another new high.  VIX is below 10, so no need to start looking for a top.  I will not try to pick a top and go short unless I see more volatility.  This is a nightmare market for shorts, and a pretty bad market for traders.  It is heavenly for buy and hold investors.  The trader's time to shine will eventually come.  Make sure you are one of the traders left with sufficient capital to take advantage of the other side of the mountain.  That is why I am doing very little here, especially in S&P.  I see a few opportunities here and there in other markets, but nothing to get excited about.

Fed Chair

The market has been waiting for Trump's Fed chairman nomination and the suspense was building up until Friday, when a trial balloon seems to have made it almost a lock that Jerome Powell becomes the next Fed chair.  Trump got what he wanted with the Powell trial balloon.  The stock market rallied strongly as did the bond market.  I am sure Mnuchin will be in Trump's ear telling him Taylor as Fed chairman will tank the stock market. 

Powell is a low interest rate guy, someone who follows orders, and I am sure Trump has asked him for a pledge to keep interest rates low if he were to be Fed chairman.  Unlike Taylor, Powell seems more interested than Taylor in playing politics and strategically being dovish to increase his chances of getting future government and corporate gigs.  That's why he was basically a yes man to Bernanke and Yellen.  That is why Neel Kashkari has taken the strategy of being the dovish outlier, the crazy dove who thinks rates should be lower in the face of near consensus rate hikes, complaining about the lack of inflation.  That is how he is able to get himself into the conversation for Fed chair nominee even though he's only joined the Fed board recently. 

By the way, on inflation, and the Fed still looking for that 2% inflation rate.  Well, good luck with that, because it is clear as day that the CPI and PCE inflation numbers have been so manipulated to the point that it can really only spit out low inflation readings unless there is hyperinflation.  Hedonic pricing, substitution, and "new" valued added features compensating for higher prices of goods, etc.  It was comical in the middle of  2008 to see the government pump out low single digit % CPI numbers as the dollar weakened against everything, corn went from $3.50 to $7.50/bushel, and oil went from $50/barrel to $147/barrel from 2007 to mid 2008. 

Anyway, the Fed chairman job, if Trump is looking for someone who will obey his commands and keep interest rates low, Powell is his guy. 

On Friday, we took a page out of 1999 and got a huge surge in the high flying big cap Nasdaq names, while the rest of the market was doing nothing.  It is a bubble, but there are so few of those high growth stocks remaining in this market that the supply just can't meet the demand unless prices go higher.  Even at these levels. 

Hoping (however, not expecting it) we could maybe get a sustained VIX rise for once, but it petered out again after the Powell rumors and Nasdaq surge on Friday.  Back to the same old low VIX grind. Again.

Worried About Rates

Now we see Fast Money bring up the bond market excuse for stock market weakness.  This often happens late in a down move for bonds, as those who usually don't care about that market suddenly get interested, almost like passers by who stare  at two people yelling and pushing each other, and about ready to start a fist fight.

You've got to have a long term fundamental basis for your trades if you really want to be able to hold on through the volatility and drawdowns.  The current levels for bonds are quite compelling from a long term view.  I don't believe the global economy can take much higher rates, which means that rates can't go up much before the stock market has a tantrum, and in a circular loop, that will keep rates low.

But we live in a short term driven hedge fund world, so the short term price action can run counter to your long term view, even though the view is still valid.  While you are seeing stronger economic data recently, a lot of it is based on rebound effects from the 2016 slowdown, and the extra confidence boost provided by a rising stock market.

You cannot rule out the bubble expanding, especially since volatility is still low and it doesn't appear like we have topped out.  But longer term, beyond the next few months, into the next few years, you are looking at future stock market weakness, that could persist for quite some time.  The valuation levels just are too high for this type of earnings growth.  You are looking at a demographic headwind of Japan, Europe, and U.S. getting older, with many retiring and reducing consumption.  That is a powerful headwind that could only be held back by massive amounts of global QE, and that was just to keep the developed economies growing at low single digits.

At an S&P of 2560+, you are pricing a continuation of the past 5 years of steady growth because of low interest rates.  Yes, the monetary policy will be easy in the future and interest rates will probably stay low, but the market has gotten used to low rates, and priced it in, so that's not a positive catalyst anymore going forward.  Monetary stimulus works because you are changing conditions by making them easier, not by keeping them easy.  So just keeping rates low will not stimulate anything.  You will have to have growth, for stocks to keep going higher from these levels, and that will be harder to come by in the future.

Short term, this a hard market to trade, although buying intraday dips like yesterday usually works, at least until the dips become more frequent, in which case, the dips become more dangerous to buy.  We are not at that point yet, but a few more intraday down days like yesterday in the near future, and you will likely see that weakness go all the way to the market close.

Waves from China

The trigger for the gap down today is the late day selloff in Hong Kong.  It is no coincidence that the last time we had meaningful sustained selling was on worries about China.  Hong Kong is basically a proxy market for foreigners to trade China.  We are just back to levels of last week, so this is nothing meaningful, but it does show you that the weak point for global equities markets remains in China, so that is where you have to look for signs of weakness. 

The top is a while away, and you will have these "scary" gap down days, this just happens to be on the 30th anniversary of the Oct 19 1987 crash.  So it puts a look of extra psychological pressure on stock holders today.  If we bounce right back within a couple of days, which I expect, then this down day only confirms future strength.  However, if we can sustain selling for more than a couple of days, then this market is giving us something to think about, which could be significant or not. 

The positive seasonality is hard to fight with the lack of volatility and persistent strength.  November is historically a strong month, and it is also the heaviest time for corporate stock buybacks, so definitely a tailwind for this market after earnings season is over. 

Not only is the stock volatility really low, so is bond volatility.  The MOVE index is hugging the lows for the year, even though rates have been trending higher over the past several weeks.  Usually, bond volatility tends to rise with rates.  It seems the bond market isn't too scared of a Fed determined to hike in December or a more hawkish Fed chairman.  That is basically the story of the year.  No fear and no action.

Grind Can Last a While

It is not at all unusual for the market to grind higher like this for several weeks in row, or even several months in a row.  It happened for nearly 12 months straight, with one brief interruption (in late Feb 2007), from August 2006 to July 2007.  It was a regular feature of the powerful bull market in the mid 1990s.  It just hasn't really happened since 2008, even with an 8 year old bull market.  You had regular meaningful dips from 2009 to 2016, which would scare out those who had 2008 flashbacks, only to V bottom higher.  This year, you had a few shallow dips, almost as if the dip buyers were so thick that they stopped the dips from getting deep.

It is the triumph of the dip buyers.  They have won. They have been so successful that the dips are now so shallow and brief, that even a 3% correction looks like a monster buying opportunity. 

When does it end?  You want to see a VIX that is rising when the S&P is rising.  That is the first and biggest clue.  You want to see less inflows into bond funds and more inflows into stock funds.  And you want to see China's markets do worse, because they often foretell broader global stock market weakness. 

It is a grind these days, and there is not much new to add.  I don't want to repeat myself, but the top is months away, so either be long (if you can ride bubbles) or in cash.  Just don't be short. 

By the way, I will be writing fewer posts with the lack of action.  If things pick up, I will write more.

On their A-Game

They are on their A-game.  I am talking about fund managers.  It is easy to not make big mistakes when you are making money.  An equity market at all time highs and a bond market that is stable is about as ideal an investing environment for institutions.  They will not do anything rash under these conditions. 

While you can question their long term positioning, in the short term, they are not making the mistake of puking out positions on a short term dip, because they have learned their lesson.  They realize it is a loser's game to set tight stops and regularly get stopped out, only to see the market reverse right away and go higher. 

It is a lot like poker players, when they are making money, they play more optimally and make better bet, call, and fold decisions.  There is no feeling of desperation to make their money back, so they can play more calmly and without need.  Usually those that are losing money start to play more hands, try to win more pots, and go on tilt.

Right now, the players in the game are making money, and not making any short term mistakes.  To try to make short term money in this market is like trying to squeeze blood out of a rock.  I would rather just play high stakes poker.  At least that game is more interesting than trading this market.

Here is the thing about playing the money game.  You have to want it, but not need it.  Those that can trade without a need to make money can play the long game, looking out months and years ahead.  Getting caught up in the day to day market action can often prevent one from catching the longer term opportunities.  That is where the real money is. 

Finding Distractions

Dabbling a bit in stocks, anything to keep me occupied and away from making any big trades.  There isn't much of an edge trying to make a stand here against this type of momentum, with the VIX so low.  This type of calm upward, relentless momentum reminds me of late 2006, early 2007.  If you remember, the market didn't top till summer of 2007, so if this market follows that analog, then we've got about another 6 months of uptrend remaining. 

We are seeing a lot of speculation in small cap stocks, which is also similar to what you saw in 2006/2007, as well 2014/2015.  They proceeded tops by about 6 to 12 months. 

So there are couple of very early warning signs that the clock is ticking.  But lots of time left before we hit the apex.  If you can't ride the bubble higher, just stay away.

Hedge Funds and Risk Tolerance

With the low volatility, the day to day trading edges are very slim.  Sure, these days there are a few small cap speculative stocks where you have insane and irrational moves, but there are lots of trading frictions in those markets, the difficulty in finding borrows, exorbitant borrow fees, extreme tail risk, and lower liquidity.  The liquidity is the big thing.  You can't move large size easily in small cap stocks, which limits the scalability of a strategy.  So that pretty much leaves either large cap stocks or futures/options.  Since the large cap stocks provide little leverage, futures/options are a much more attractive area for speculative trading. 

I recently heard that hedge funds are making a comeback, with inflows over $80B this year.  I also noticed that their YTD returns are 5.1%.  The SPX is up 12% this year.  Bonds are also up.  Once again, a simple 60/40 stock/bond risk parity strategy which can be put on for near zero fees is beating the hedge funds again.  I recently saw that a hedge fund of funds manager, Mark Yusko, made a bet with Warren Buffett that he could beat a SPX index fund in 10 years, net of fees.  I think Yusko will lose that bet.  Just because of the fees.  Even with the SPX highly overvalued, hedge funds are basically a more costly, lower beta play on the stock market. Hedge funds don't really provide alpha anymore, just damped down beta covered in a thin veil of secrecy to protect their 2 and 20 business model. 

The reason I bring up hedge funds is because they are the main reason there are short term market dislocations.  If you take away hedge funds, that removes a lot of the speculation in the futures and options space.  Most of the money going into mutual funds and ETFs don't make big bets on FX, interest rates, and commodity prices.  The hedge funds are there to provide more fuel to the fire, making trends last longer, going to prices they probably shouldn't go to. 

Most hedge funds in the futures space are trend followers, so in general, they will blindly buy strength and sell weakness.  In the past, when trends lasted a long time, it was a good strategy.  Nowadays with so many following the same strategy, as well as low inflation and money printing central banks, you don't have as many long term trends in FX, interest rates, or commodities.  So they have been getting churned and burned since 2008. The returns of the Barclays Hedge CTA index (survivorship bias inflates these returns) is basically flat since 2008, while the S&P has gone up over 200% in the same time period. 

These CTAs built up a lot of their record when the futures markets tended to have long trends, and before their strategy got overpopulated, splitting what little edge they got from following the trend with other hedge funds.

Whether it is hedge funds liquidating positions that have gone bad all at the same time, or piling into a position with a herd mentality, there are opportunities created in their trading.  But the only real way to capture those opportunities is to extend your time frame beyond the hedge funds' time frame.  The hedge funds' time frame is constrained by their inability to accept big losses, since institutions don't want a lot of volatility in a fund's performance. 

This is their big handicap. Risk tolerance.  Hedge funds cannot withstand big drawdowns, which means they have to cut their losses before they get too big.  This creates opportunities during their liquidations, because often, they are liquidating not because they suddenly discovered a fundamental change in the market, but because they hit their loss limit on the position and they had to get rid of it.  That is where the opportunity lies.

On the other hand, the individual trader can trade more aggressively and trade more optimal size because they can weather big drawdowns and don't have to worry about redemptions.  They don't have to puke out their positions as much.  Yes, sometimes the individual gets a trade wrong and has to get rid of it, but it should be based on criteria of market behavior and price action, not a loss limit.  Remember, the fastest way to grow your account size is to follow the Kelly criterion.  This exposes your account to big drawdowns, because you are betting your edge, basically. A 10% edge on a 1 to 1 bet calls for a 10% bet. A 99% edge on a 1 to 1 bet calls for a 99% bet! 

Most hedge funds can't bet that way.  They are reluctant to lose more than 2% on any one trade.  That is a big disadvantage.  They follow a much, much less risky money management strategy, which while safer, offers much lower potential returns.  This is why I believe profitable traders are much better off accumulating their own capital and trading it aggressively, rather than try to gather assets and trade more capital, but in the process be pigeon-holed by their investors' lack of risk tolerance.  Plus, its a headache dealing with all the paperwork and regulations of managing a fund.

I expect the hedge funds to be the ones to push this equity market towards its ultimate top, taking prices too high.  I also expect them to be the ones who liquidate their positions en masse as the trend changes.  That is what you saw in 2015/2016, and I think you see that again in 2018. 

Long Way to Go

The S&P just won't quit.  It is going to surprise the mean reversion traders here, as this thing will grind them to dust, as they look for that 5% correction.  The problem is, the 5% correction will probably finally happen about 10% higher than here.  There is nothing worse than being an early short in a bull market.  And pretty much anything except for shorting within 2-3% of the top is too early.  Which leaves a LOT of time for being early as a short seller. 

I don't know why this thing is going up. I just know that with high probability, we are nowhere close to the top, in both time and price.  The driving force higher could be a few things:  animal spirits, bubble psychology, and momentum building on itself.  It certaintly isn't improving fundamentals, not with the Fed looking to continue to raise rates.  Those tax cuts aren't going to move the needle unless they get everything that they want, which is unlikely.  And even if they did pass those huge tax cuts, the pain in the bond market from higher deficits and more Treasury supply would temper any stock market gains off the euphoria. 

These are the type of markets that favor those who are expert bubble riders, riding it to the top, and getting out when they sense the volatility rising and signs of a top building.  It is not easy, and its something I definitely will not do, just from the inherent vulnerability of a market that is trading so high with no fundamental backing.  I don't think we crack, but it does feel like being long is the equivalent of selling cheap put options.  And I don't use a put selling strategy. 

The only real comfort I can take from this type of market is that it is building up potential energy for the market to get exciting again when the SPX does finally top out.  I think that happens in spring/summer of 2018.  In the meantime, I will focus more of my energy on other markets which have better opportunities, such as bonds, commodities, or individual stocks.

Big Tax Cuts are Dollar Negative

FX traders tend to base every currency based on interest rate differentials, and the difference of the near term policy direction of the various central banks.  The generally accepted view is that big tax cuts which provide fiscal stimulus should strengthen the dollar, based on its effect on monetary policy.  It is assumed that you get tighter monetary policy with tax cuts.  But that overlooks recent history.  

One of the main reasons the Fed started QE in 2009 was because it wanted to lower the interest rate burden of the large budget deficits after the recession, because large Treasury supply was going to have to be taken down, and the only way that was going to happen was either by selling at higher yields or by having the Fed by a huge chunk of the supply.  If the market had to digest all that supply at higher yields, you would have had an absurdly steep yield curve, higher rates for corporations and small businesses to borrow at, and higher mortgage rates that would be a negative for the housing market.

With the rising trend in mandatory spending on Social Security and Medicare, the budget deficits are set to rise substantially anyway, without any tax cuts.  You add the proposed budget buster tax cuts to the mix, and you will see $2 trillion budget deficits within a few years.  That is why the market didn't skyrocket yesterday on the Trump tax cut plan.  Rising interest rates with low GDP growth don't mix.  And these tax cuts aren't going to do much for GDP growth, as it's mostly going to those who will pile it back into savings in the form of stocks and bonds, not consumption.  

So what will end up happening is the higher interest rates will more than offset any fiscal stimulus from lower taxes, and when you get the economy slowing down, the budget deficits will skyrocket and you will get huge amounts of Treasury supply coming down the pipe.  The Fed will react like they always do when the economy slows down in the face of rising interest rates due to excess debt:  they will lower them, and then do another QE.  

So these tax cuts will eventually lead to Fed rate cuts and then QE in a couple of years.  Which will lead to dollar weakness, not dollar strength.  Tax cuts are a long term negative for the dollar, due to the higher budget deficits and subsequent larger Treasury supply.  Just look at how the dollar performed in the years after Ronald Reagan's tax cuts in the 1980s and George W. Bush's tax cuts in 2001.  

So if you see any large tax cuts pass, keep this in mind when it comes to the dollar.

Dollar Index (43 year historical chart)

A Budget Buster

Based on Trump's tax plan, there is no way the Republicans can stay within their budget guidelines of $1.5 trillion more debt over 10 years.  Politically, most of those deductions have no shot of getting eliminated, with the power of Washington lobbyists behind them.

But the bond market thinks that there will be huge debt fueled tax cuts. For Treasuries, it seems like shoot first, ask questions later at the moment.  This is definitely a budget buster, and will increase Treasury supply enormously over the next 10 years. With the trend of higher mandatory spending for Medicare and Social Security as the baby boomers retire, you could see $2 trillion annual deficits.  Without a QE, that will roughly quadruple the size of the Treasury coupon auctions.  And there is no way that much supply is taken down at these yield levels without a recession.

That is based on the premise that Trump gets everything that he's asking for.  That's probably unlikely, even though the Republicans are desperate to pass anything to save their hides in 2018 elections.  Most likely, the tax cuts get watered down, with no deductions removed, and the corporate tax rate gets cut modestly and you get a little increase in the standard deduction.

But the bond market is hating the uncertainty of a possible whopper of a tax cut passing, and with ECB tapering coming up in late October, a suddenly hawkish Yellen, and VIX hovering around 10, it is fragile times for bond investors.  Once the dust settles, you should get to lower bond price levels which should hold up, but the question is how much lower.  Worst case scenario, if the SPX keeps making new highs till year end, we could revisit 2.60% 10 year yields.  More likely, I think we get up to 2.40-2.50% and find a top there.

In SPX land, the realized volatility is at 3 over the past 10 days, compared to a VIX around 10.  So even at a VIX of 10, vol is actually expensive here!  Just horrible for the ES day trader.

Stalling With VIX Under 10

They could not have ordered up a more boring year than this one for S&P traders.  I am glad that I branched out from being almost exclusively an S&P trader back in the early 10s.  I wouldn't know what to do if I had to trade S&P this year.  Probably just swing trade and wait for the once in 1-2 month dip, scale in and buy, and sell after it hits an all time high.  I don't think there is any other strategy that would have been very profitable this year.  Shorting such a low VIX market is so tough, especially when it grinds higher bit by bit and hardly dips.

The bad part about this market for the trader is that the crowd is very reluctant to go to emotional extremes, either on the downside or the upside.  It is almost as if the crowd has finally realized the stupidity of dumping in a panic on a correction, or chasing prices higher, that they are mostly sitting still, holding their stocks or their cash and just waiting.  Many are waiting for a correction to buy, but what is the point if you are going to let the market go up 10-15% while waiting, and then buying a 5% correction?  You end up paying 5-10% more that way.

The best approach is either:
1) You think the market is too expensive, and wait for a bear market to buy, or
2) You think the market will become more expensive, a bigger bubble, and buy now and hope it goes higher.

The worst approach is just waiting and waiting, until the market goes so high and the volatility starts picking up, and then buying the 5% dip during the topping phase, and panicking out once it becomes a bear market.  Sure, we could have a 5% dip and then keep rising and rising like we did several times in 2012, 2013, and 2014.  But VIX was higher then, and the market much more skittish than it is now.  This is such a complacent market that the tolerance for bad news headlines is very high, and it would take multiple stabs at this beast before the crowd sells in full force.

I am obviously in the 1) camp, thinking the market is too expensive and waiting for a bear market to buy.  That is why I am not buying here even though I see SPX likely to grind higher into the beginning of 2018.

There was a leak of the Republican tax cut plan released this past weekend.  It calls for a top individual tax rate going from 39.6% to 35%, corporate rate from 35% to 20%, and pass through (small business) rate from 39.6% to 25%.  This looks like a fantasy for the Republicans, but if they are all on board, then it will pass Congress because they only need a simple majority using reconciliation.  It would be a big weight on Treasury bulls if the full cuts go through, as the budget deficit will balloon to huge numbers, probably up to $1.5-2 trillion.  That would cause a definite steepening in the yield curve as the large supply would weigh heavily from 10 years to 30 years.  The short end would be anchored by the Fed funds rate, so less bearish for that end.  Anyway, it will probably take several weeks before the plan becomes a reality, so not an immediate negative for bonds, but a big potential negative catalyst for sure.

Fed Dot Plots

Looking at the Fed dot plots for September, I find it interesting how the long run projection is still at 2.75%, albeit down from 3.00% in June.  What happened in 3 months that would cause a long run projection of interest rates to go down 25 bps?  Nothing happened, other than the Fed throwing the bond market a bone, to try to keep the bond vigilantes at bay, while they announced balance sheet tapering. 

Everyone with any money on the line knows that the Fed dot plots are a running joke.  They have consistently inflated future interest rate projections, only to bring them down in drip drip fashion.  Is that the Fed's way of increasing optimism about future economic growth?  I don't know if the Fed is being dishonest, or if they're just incompetent.  Probably the latter. 

If you look closely at that dot plot, there is one guy who keeps the projection at the current Fed funds rate level, at 1.00-1.25% till end of 2020, but somehow manages to put the longer run projection at 2.25% or higher.  I know this is Neel Kashkari, the super dove.  He's a bit controversial, and an attention seeker, but he's got the best forecast of them all, which isn't saying much.  Although his longer run projection seems way too high, unless he's thinking something like 2040 as longer run. 

The eurodollar market is pricing in 3 rate hikes over the next 3 years.  That would put the Fed funds rate at a 1.75-2.00% range by September 2020.  I feel like that is a bit ambitious considering that when pricing in future interest rates.  If you consider that there is a decent chance that the economy could enter a recession within the next 3 years and the Fed could cut rates, then there should be a lot less than 3 rate hikes priced in over 3 years.  Remember, you must come up with a probability weighted average of all possible interest rate scenarios, not just the mostly like one. 

The median Fed dot plot is between 2.75-3.00% by end of 2020.  Do they realize that when GDP growth went from 2.9% in 2015 to 1.5% in 2016, they stopped rate hikes dead in its tracks, and were scared stiff.  The economy doesn't even need to go to recession for them to stop rate hikes.  It just needs to slow down to under 2%.  Considering the heavy debt load, low productivity, and low population growth among the developed economies, it is more likely that growth will slow down from here over the next few years, not pick up. 

Add to that Trump's inclination to choose a dovish Fed chairman because he's a low interest rate guy.  Therefore, you have a bond market that is mispriced.  And a Fed dot plot that is even more wrong.  Now I could be wrong and the global economy could have a huge boom and the S&P could become a giant bubble, but that's not likely given the data.  There is always some uncertainty in predicting the economy and the financial markets, which is why there are mispricings in market.  This game is about probabilities, and it is the difference in how market participants weigh the likelihood of various scenarios which provide the long term opportunities. 

The S&P didn't disappoint yesterday.  Once again, it found a way to bounce back after the hawkish Fed statement.  And do it in a non-volatile manner.  It has proven its boring nature AGAIN.  Just untradeable.

Fantasy Land at the Fed

There is lot of projections that the Fed spews out, the most egregious and error-prone, being the dot plots for interest rates.  These Fed officials must have used a time warp, going back to the 1990s when the neutral Fed funds rate was at 6%.  They still fantasize about a neutral Fed funds rate above 3%.  Conveniently ignoring the 2% GDP growth rate and the heavy debt burden this global economy is running on.

It is funny that they can't even fathom the thought of consecutive 25 bp hikes at Fed meetings, especially since one of them would not have those "informative" press conferences, but they have the audacity to state that the Fed should reach a Fed Funds rate of 3.5% in a couple of years!

Then when it comes time to actually follow through on their projections, they chicken out with any excuse they could find, such as China in September 2015, the strong dollar and falling oil in March 2016.  Only after the S&P just keeps grinding higher, and the dollar grinds lower do they finally back up their fantasy land projections (at least for a few meetings), and put in rate hikes.

Ok, enough of the ranting, now time for how to play this upcoming Fed meeting.  I expect the S&P to be a snoozer, as it is about as boring as a market can be.  But for the bond market, it is a bit more interesting.  You have seen bond yields bounce back up strongly after bottoming a couple of weeks ago on hurricane and nuclear war fears.  Now that investors have regained their senses, they realized that they pushed rates too low, and we are getting the payback over the last several days.  At 2.23% 10 year yields, as I write, it is still in the middle of the 2.00% to 2.40% range that we seem to be stuck in at the moment.  With my expectations of the stock market to continue to be strong, I don't see how rates can break below 2.00%.  At the same time, there is just too much investor demand at higher rates for the 10 year to get much above 2.4% without seeing dip buyers charge in.

I do expect the Fed to talk tough, now that the S&P is at an all time high, and with rates well within their comfort zone.  Balance sheet runoff will be slow, and probably they won't be able to keep it going for as long as they say, because as soon as the market has a correction, they will stop dead in their tracks.  Guaranteed.  Think we could get more weakness in bonds over the coming weeks, and probably more of a grind higher in equities.

VIX is the Guide

In recent S&P 500 history, you have not had a market top out when the VIX was under 12.  In July 2007, the VIX was ~15 when the market topped out.  Also in May 2011, the VIX was ~15 when the market topped out.  2015 was a bit of an unusual case because the market topped out when the VIX was at 12, but you did have the market flatten out and chop for almost 6 months without any major breakouts, and it was quite a bit more volatile than it is now.

Right now, we have a VIX around 10, with realized VIX in the mid single digits.  Plus, we've made new highs since last week, and now easily above the 2500 SPX psychological barrier.  These are the types of markets which grind higher as investors watch in disbelief that there is hardly even a 5% correction.  Since we had the washout in late August, and nervousness till last week, this move higher has at least 2 more weeks to go, and probably well more than that.

It is a slow motion bubble, so it looks innocuous, with the low volatility, but it is building up a lot of potential imbalances when the top is reached.  When will that top happen?  That is one of the hardest things to predict, the top of an equity bull market.  It is clear that there are still not enough signs.  So while I will not participate in any upward moves from here, I definitely will not get in the way and short it until we start seeing more volatility.  The VIX has to sustain above 12 even after several days of rallying in order for me to be interested in the short side.

Traders: What Not to Do

It is a fact that most traders end up losing over the long term.  In order to be part of the minority of traders who win long term, you must trade differently than the majority.  That is just simple logic.  Then the first step is to identify what the majority of traders do.  The second step is to avoid doing those things.  By reading books about traders (Market Wizards series is a good starting point), seeing what traders say on Twitter, Stock Twits, stock message boards, etc. you start to get a sense of what the majority do.

What most traders do:

1. Bet too big.  In equities, it is betting it all on one stock.  In futures and options, its using too much leverage by buying or selling as much as you can.  Even if you have good pattern recognition skills and accurate analysis of the long term macro situation, there is still a lot of uncertainty in this game.  Good traders still lose a fair number of times.  It is just part of the game, you can't be perfect in this business.  If you bet too big, you can have a string of winners and then that one big loser will eliminate all your gains plus more.  Or even blow you up and take you out of the game.

In my early career, I had a habit of trading only one or two stocks at a time, and using full 2 to 1 margin.  It led to some exciting times, lots of wins and losses, and I was lucky to have survived.  I had a very effective strategy and it worked about 90% of the time, but the 10% of the time that it didn't, I lost huge on the trade and it would eliminate all the progress I made building up my account.  This happened a number of times and I still didn't fully understand why I couldn't really breakthrough to the next level. 

It wasn't because I didn't have an understanding of the market or good pattern recognition skills.  I was just constantly betting too big. And although that led to rapid growth in account size during the good times, I would inevitability trade a stock that would act like an outlier and end up losing anywhere from 50% to 90%.  Remember, if you lose 90% of your money, you need to make 900% to get back to even.  900%!

Try this math exercise:  you bet 50% of your account on a 1 to 1 payout, with 60% chance of winning, 40% chance of losing.  See where that account value goes over the long term.  The effect is the opposite of compounding. 

2.  Try to make money everyday.  I am lucky that I didn't have to work for too long before I was able to just trade for a living.  I never developed that worker's mentality.  Although in the short amount of time I did work, I quickly developed a dislike for having to wake up early in the morning to do something that I didn't want to do, just for money and my "career".  So when I started trading for a living, I tried to make as much money as I could, so I could amass enough money to not have to find a job ever again.  Unfortunately, that led me to trade too big, and go all in too often, because of my greed and overzealous desire to build up my account as fast as possible. 

But I never really chased prices, and would often let halfway decent opportunities go by because I didn't feel like I needed to make money every day.  If a good opportunity was there, I would plunge in. And usually there was.  But if not, I didn't do any trades.  I watched TV, read a book, and tried not to stare at the trading monitors.  I didn't make money that day, but I didn't care.  I never treated trading like work, so I never expected to get paid based on the hours I put in.  I was willing to wait for the next good trade.

On the topic of daily trading, one of the dumbest things that a good trader can do is to quit for the day because he made his daily profit goal.  Unless that trader has some psychological problems dealing with winners, he should try to make as much as possible when the going is good because most of the time, they aren't.  Especially these days.  As Stanley Druckenmiller says, "it takes courage to be a pig". 

More importantly though, a trader shouldn't force trades and trade bigger to try to make a "comeback" for the day and turn a losing day into a winning one, to make yourself feel better.  I have made this mistake countless times and at the end of the day, when I stare at a huge loss on my trading screen, I think to myself, "What the hell am I doing?"  Its the same feeling a gambler would get at the casino when he keeps hitting the ATM to try to comeback and recover his losses, only to end up with a huge loser when the night is over.  Trading is a long term game, not a daily one. 

3. Think short term.  It is hard to come up with good trades, especially long term trades.  If you turn a good long term trade into a good short term trade, that is a big mistake.  Yes, it is a higher level mistake.  For those who have traded for a while, and made some money at it, it is a common mistake.  I have made it numerous times throughout my career.  If only I had just stuck with the trade for another few days, another few weeks, another few months.  Then I would have had a home run.  Those who have bought dips in the SPX know what I am talking about.  Same goes for those who bought dips in Treasuries this year. 

That is why it is so important to thoroughly analyze what the current long term opportunities are in the market and then when the market gives you a chance to get in at a good price, you need to ride it for as much as you can.  You can only do this if you have a lot of conviction on your trade, and your short term view aligns with your long term view of the market. 

How do you develop conviction that is usually accurate and helpful rather than irrational confidence?  Through studying, experience, and gut feel.  Some of it can be taught and developed, but the gut feel is usually more innate.  This conviction is something that I am constantly trying to improve, both in accuracy and breadth.  Some markets and time periods are just easier than others.  Right now, we are in a bit of a difficult time period, low volatility and very few good medium term opportunities.  However, that should pave the way for some monster long term opportunities.  There is a good long term opportunity developing, but it will only come to fruition once the price action and higher volatility confirms the topping phase of this US equity bull market.  So I am trying to preserve capital for what I view as interesting trading opportunities in 2018.

S&P Strength and Bond Weakness

The two big things that have happened over the past 2 days is the rise in the S&P 500, but more importantly, the disproportionately big drop in bonds relative to the SPX strength.  In a short term risk on move, you usually get about a 0.04% rise in 10 year yields for a 1% rise in the SPX.  We have gone up 0.12% on the 10 year since Friday, while SPX has gone up 1.2%.  In normal circumstances, the 10 year should have gone up only about 0.05%.

Obviously it does speak to the overshoot short squeeze higher that happened in the bond market last week while the stock market was only slightly down.  But it also re-emphasizes what I believe to be the new en vogue hedging strategy for the hedge fund manager.  They are now going long bonds as a hedge for their long stock positions.  In the past, they would have just used VIX or shorted SPX for a more direct hedge.  It probably means that you will not likely see much more upside in bonds this year until you start seeing stock weakness.  At these levels, I find it hard to believe that both stocks and bonds will just keep going higher without a break in that positive correlation.

I do expect the SPX to stall out here as we are right at that psychological 2500 level, which should provide short term resistance.  Also the weakness in bonds should be a bit of a headwind for stocks to go even higher.  Due to the near term SPX resistance, I don't think bonds will sell off much more, but I don't see much of a bounce either.  So while near term downside in bonds is limited, the near term upside is also limited.  It looks like last week took out most of the weak hands in both bonds and gold.

SPX should flat line around these levels right under 2500, and then expecting a dip next week. That should help bonds have a bounce, which probably won't last long, just as I don't expect any dips in stocks to last long.  Low conviction here, so I won't be putting on big positions.  October should provide better levels to make longer term trades. 

Irma and N. Korea Hype

You know how the media like to blow up headlines to draw eyeballs to their articles.  It is slightly, just slightly more refined form of click bait. 

The algos didn't bite and refused to selloff the market on Friday ahead of the fear mongering.  As I said last Friday, the algos are getting much smarter.  There is definitely AI and machine learning going on, because they have gotten more sophisticated from even a few years ago.  If you had the same headlines and weekend risk 5 years ago, the S&P would have likely dipped at least 3% ahead of the event, led by emotional hedge fund managers, and then rebounded like a screaming banshee as those same hedge fund managers bought back what they sold ahead of the "scary" events. 

Nowadays, the hedge fund managers don't even do much manual trading, their performance reviews have shifted their funds to more quant based, AI and machine learning strategies.  This makes the market much less emotional and more price action based, which shows you the muted market reaction to the North Korean nuclear test last week, and less derisking ahead of the fears of a North Korean missile launch and Hurricane Irma this past weekend.  All in all, it makes the market tougher to trade, as there always has to be someone on the other side of your trade.  And AI computer based trading programs are much tougher opponents than trigger happy hedge fund managers.

We are getting a repeal of the risk off moves in Treasuries and gold this morning, along with a gap up in the S&P.  It is notable that the Treasuries and gold are selling off much more than expected for a 0.5% gap up.  It tells you that traders have resorted to hedging not by shorting S&P, but by buying Treasuries and gold.  They have finally caught up to the risk parity hedging strategy.  It could make for a nasty move if Treasuries can ever go down and stay down while stocks are flat.  But that's a story for another day.  Expecting a dull market this week in S&P land.  The bond market should be a bit more interesting, but it too is probably going to have a low volatility trade after today's selloff.

Short Squeeze in Bonds and Gold

Yesterday, you had heavy volume as bonds and gold both squeezed higher, after the ECB decided to postpone the taper.  This was what most expected, but you still had a significant minority that thought Draghi might provide more details of their future tapering plans.  He didn't give the bears an inch, and provided the usual dovish spiel, while throwing the euro bears a bone by saying that he is keeping an eye on the euro and its strength.  Draghi definitely likes to bring out the "whatever it takes" line on various topics, this time, it was on getting to 2% inflation.  He sure talks like a determined dove, but he can't solve the scarcity of German government bond supply problem when it comes to following the capital key guidelines for QE.

You basically had a perfect storm in the form of ECB can kicking, and of course North Korea and Hurricane Irma over the weekend.  That was just too much for bond and gold shorts to deal with and they finally capitulated and bought in a panic. We got remnants of that buying wave this morning, but with the current price action, it seems like most of the weak hands have been taken out. All this while the S&P trades in a sleepy range from 2350 to 2370 this week. 

I expect their to be a little relief buying in stocks on Monday, after the weekend event risk is behind us, but it should be a small pop because the market just hasn't gone down much ahead of these uncertainties.  It is clear that the US stock market has gotten smarter, as the market is very reluctant to provide a good buying opportunity even in the face of bad news.  If we had similar news flow 5 years ago, the market would have pullbacked a lot more, and then subsequently rebounded a lot more.  Now, its short and small pullbacks on bad news, and short and small rebounds after the V bottoms.  After seeing the volatility on Tuesday, I was expecting much more this week.  But it's been a dud for S&P traders. Just a dreadful S&P trading market.

Debt Ceiling Deal and Dovish Draghi

We should be much higher considering we got the debt ceiling extension without any headaches and then a dovish Draghi at today's ECB meeting. So we had a good news wave that peaked out at SPX 2470 this morning.  That is the high optimism price point in this market.  Last week's low of SPX 2430 on North Korean missile launch is the low optimism price point.   Keep that in mind when trading this chop over the next couple of weeks. 

There is a lot of caution that I hear from financial TV, but the put/call ratios and the low VIX tell me that real money is not doing much here.  The low VIX is a tell that the pullback should be shallow, as the VIX is a very good predictor of near term potential losses in the market.  You would think with North Korea and a massive hurricane heading towards the US, the market would be a bit more nervous.  But this market has been so resilient for so long that the algos are all programmed to buy dips and support the market on down days.  That is why you got the V bottom on Tuesday, saving the market from an ugly close. 

Remember that last week, after North Korea fired a missile past Japan, there was a sense of optimism that the market was able to shrug off that event and head towards 2480.  The crowd got back to being bullish.  Now they feel like they are offsides. They don't turn on a dime.  I expect them to take a few days to sell off some positions to get to a more risk off stance.  One supporting factor, a big one, is the strength in bonds in the face of a flat stock market. The lower interest rates will help to keep the stock market from completely falling apart here. 

If we do selloff again towards 2430, I would expect there to be a lot of fear mongering on CNBC.  It should be a point where one should put on longs for the eventual ride higher.  This bull still has a while to go, and you need to keep that in mind when trading during these choppy times.