Topping Process In Motion

The global equity indexes are too high.  They can only sustain high levels if interest rates stay low.  It is all one big connected market place.  You cannot ignore the bond market if you want to predict the stock market.  Since risk parity strategies are en vogue on Wall Street, it seems appropriate that you get the topping process started with bond weakness leading stocks lower.

Just like Tuesday, when bonds and stocks both fell hard, we have the same situation again today.  Yesterday was the day that dip buyers came roaring in, like salivating hound dogs buying up everything.  Now that those eager buyers are out of the way, We get back to selling.  These are the kind of moves that are the hallmarks of a topping process.  It is hard to call the top, but it's not so hard to identify the topping process:

1. Usually you get a flattening out of the uptrend and increased day to day, week to week volatility.  Definitely happening this week.
2. More speculative, high beta stocks are in favor.  A few weeks ago it was the Nasdaq 100 stocks.  More recently it has been biotech.
3. Breadth narrows as the fundamentals worsen, leading investors to pile into the few stocks that still have good growth and fundamentals.
4. Put/call ratios get low, and stay low.  That has definitely been happening this month.
5. Bullish sentiment has topped out.  This is the tricky part.  Contrary to what most contrarians think, investor sentiment usually tops out before the stock indexes do.  This can be rationalized by the breadth measures.  If most stocks in a portfolio start going down, while the index remains higher, naturally the mood will sour a bit.  This also happened, as there was a lot of bullish sentiment at the end of last year and early this year due to Trump trade, and more recently, with Macron winning the French elections.

This topping process can last several months, like 2015, or be briefer, like 2007.  3 to 6 months seems to be the average length.  If the topping process has started this month, that means that we will form a big top this year and enter much weaker markets in 2018.  That aligns with my long term view of the market.

There is still time to wait for a good entry to short, preferably on a rally back towards all time highs.  But for those active traders, it is now a much more favorable market to short rallies, with a high probability of a dip within a week.  Equities feel saturated now.  And the central banks are not looking to help right away.  A big difference from the 2010, 2011, and 2015 tops.

First Cracks in Risk Parity

Yesterday was a significant day in the markets.  For the first time in I don't know how long, we got a big selloff in the bond market along with a big selloff in the stock market.  This happened quite often in 2015, as Bunds led the weakness in the fixed income space.

We had Draghi talking about not worrying about deflation anymore, and talking about the current economy reflating.  Well, it seems like he didn't like the reaction in the bond market, because the ECB has retracted his statements to state that his outlook wasn't hawkish, but more neutral.

These central bankers are such micro managers, they have turned into daytraders.  They are watching every tick out there.  It makes me believe that the market has it right this time, ignoring the Fed dot plots which say 4 more hikes by end of 2018.  They know that the central bank put is at a high strike price.  Despite what they say about an inflated market, or worries about financial stability, they have the market's back.  They built this monster.  They're going to try their hardest to keep Humpty Dumpty together.

It seems we've finally gotten to a point where bonds have gone too far given current economic conditions.  Stocks will have to take a break going higher now that we've reached resistance in bonds.  A rally back towards 2450 will be a shorting opportunity.  I am guessing that we'll get one soon.

Risk Parity Heaven

The volatility is super low.  The stocks are rising.  And so are the bonds.  These are perfect conditions for risk parity strategies.  They hedge equity risk by buying long term bonds.  It has been the right strategy this year.  Going long puts and VIX futures/options is going out of style.  The performance drag is too high, so funds have found cheap and actually positive carry hedges in the form of long bonds.

This is not a foolproof strategy, but it is nearly foolproof when the Fed put is out there.  It is always out there.  The question is where is the strike price?  Obviously, investors believe the strike price is much higher than what the Fed wants the market to believe.  If the S&P went down to 2300, would the Fed stop interest rate hikes and balance sheet normalization?  If so, then the market has it right.  If not, the market is being too complacent here thinking the Fed will rescue the market on any market corrections.

On the one hand, it seems the market is too complacent when it comes to the vulnerabilities of the stock market, thinking long bonds will go up enough to cover a sharp drop in stocks.  It's very possible that while long bonds go up in an equity market correction, but not as much as it has in the past 10 years.  The 30 year yield is not at a point where you will get explosive moves up in bonds.  In fact, I think you would more likely see a steepening of the yield curve where the shorter term maturities rally strongly on an equity market correction, while the 30 year rallies only mildly.

We have a gap up Monday in SPX.  And bonds are also higher.  And VIX is dying out there.  It is the overflowing with liquidity trade again.  Until bonds actually start going down, the equities are not likely to go down much, if at all, even with the complacency building up.  It's a dead market and a tough market.  A good time to sit on your hands and wait for a good setup.

Bonds Will Be the Signal

The relentless rally in the long end of the bond market continues.  The Treasury yield curve is aggressively flattening ever since the market interpreted Yellen as being hawkish.  Let's not pretend like the Fed actually watches the real economy.  If they did, they would be doing nothing.  They would have done nothing for the last 3 years because nothing has really changed.  No, they look at the stock market and the stock market is telling them to tighten.

I am waiting for one of two things:
1) VIX rising with the market.
2) Bonds selling off when stocks are flat to down.

We are not getting either at the moment and that makes me reluctant to short.  Market tops can seem to last forever.  I've learned that a market gives you many opportunities to short a top but few opportunities to buy a bottom.  So there is no rush to short and miss out on the top.  There will be plenty of time to get in there and blast away at the short side at good levels.

I will be taking a blog break for the rest of the week.  Will be back next week.

Still Waiting to Short

It is getting closer to the right conditions to short but I continue to be cautious.  10 year yields are still too low, and I would like to see the put/call ratios come down a bit before I proceed.

I am surprised at the healthy gap up post opex today, as usually post opex during the summer is equity negative.  I figured there would be some more nervous hands coming into this week after the dip in tech stocks and with a hawkish Yellen.  It almost seemed like too good of a set up to short.  I'd rather short when there is a lot of good news, not when there is worry.  Last week, I could feel that investors were a bit worried.  It showed up in the market data statistics.

It's looking more like there needs to be another test of the highs in SPX before we can get another move down.  I will wait wait it out at least another day or two, and reassess the situation.   The last thing I want to do is short too early in this dull grinding up  market.

Fed Normalization

The crowd has interpreted a lot from the FOMC meeting on Wednesday.  The consensus is that the Fed is hawkish and barring a big correction in the stock market and/or lower inflation, they will remain on the war path towards "normalization".  I put quotation marks around normalization because I think ZIRP is the new norm, and should not be considered extreme policy anymore.  This isn't the 20th century.  In the 21st century, ZIRP should be considered the baseline.  NIRP should be considered accomodative, and PIRP (positive interest rates, even 1%) should be considered tight.

I believe the crowd has overreacted again to the Fed.  In the statement, they stated they are monitoring inflation closely.  Codeword for they are worried about not reaching their inflation target.  Or Fed speak for they will probably not hike in September.  The Fed was boxed into a corner this meeting.  The Fed funds futures were pricing in a 90+% chance of a hike, and of course, they will hike if the market prices it in.  They don't want to spook the market in either direction, but especially in a hawkish direction.  What if the Fed funds futures were pricing in just 50% odds of a June hike?  Then I think they would have gone their normal dovish route, and not hiked rates.

You had the 5-30 yr Treasury yield spread shrink from 109 bps to 102 bps since the meeting.  The bond market is pricing in more hikes into the belly of the curve, and saying that will lead to lower long term rates.  I believe this is an overreaction.  Despite what the dot plots say, the economic data is telling you that the Fed will have a hard time pushing forward with normalization.  The Citi Surprise index has been dropping like a rock.  CPI, retail sales, and NFP have been lower than expectations.  It seems like the rate hikes are starting to work in slowing down credit growth.

Don't even get me started on balance sheet normalization.  The hints they are giving are of a turtle like pace of reducing repurchases that you will likely see another recession before they can even reduce the balance sheet 10%.   Then in that recession, what took them 2 years to reduce will be made up in 3 months of QE.  It is like worrying about how you will spend all your stock market gains in 20 years when the S&P goes to 10,000.

Right now, the stock market still doesn't show any overt signs of weakness, but its a matter of money flows into equities, a FOMO trade gone into overdrive.  But the signs are starting to creep in that the equity uptrend is near an end:

- The suddenly spastic one day dumps that happened on May 17 and again June 9.
- The lagging Eurostoxx despite continuous heavy inflows.
- Crude oil trading at $45.
- 10 year yields rising yesterday despite S&P being down 15 points intraday.

Just like 2015, it is not going to collapse without giving the dip buyers a few pullbacks to snap up.  Then suddenly the next pullback turns into a trench, like August 24, 2015.  I see a similar situation here.  I see the pullbacks becoming more frequent, the resistance above more defined, and then the bottom falling out into a panicky selloff down to SPX 2260-2280.

Pent Up Demand

The release of pent up demand in the bond market has been explosive since the March FOMC meeting.  From election day in November till the March FOMC meeting, allocations to the bond market were either moved to cash or the stock market.  You have to remember that since 2008, most of the inflows into financial assets have been to bonds, not stocks.  This is a secular trend that will last for many years, as the developed world population ages, and goes towards less risky assets.  It doesn't hurt that you have had massive QE in the US followed by Japan and Europe.

People don't want to stay in cash for long, they need to get longer in duration and down in credit quality to get yield.  That is why corporate bonds are so popular, because it provides extra yield without having to take bigger risks as with equities.  All that demand that was postponed because of fears of massive tax cuts and infrastructure spending have been for naught.  Now that bond investors feel less fearful of a big rise in interest rates, they are piling back into bonds.

I have not been bullish enough on bonds this year, although I did manage to capture much of the move higher from March to April.  I missed the second wave higher in May/June.  The though process was simple.  I didn't think stocks would go down much, if at all, and would likely grind higher or be range bound in a tight range, at worst.  Therefore, the upside in bonds would be limited and since bonds were overbought, I thought it would give me another opportunity to buy at lower prices.  But bonds started to go up with stocks in late May and early June, and the plan went awry.

This little episode over the past month was a big missed opportunity.  Also there was a  sudden surge in the number of speculators getting long 10 year Treasury notes, and I viewed that as a contrarian signal.  It is a contrarian signal only if the market itself is not in the middle of a strong trend.  When in the middle of a strong trend, the market will go where it needs to go, with or without speculators along for the ride.  Right now, bonds are in the middle of a strong trend higher.

One can come up with reasons, such as underperforming economic data or the dissipation of the Trump trade, but the main underlying reason is the demand for fixed income at this time and at these levels.  It reminds me to never lose sight of the big picture when trading.  You want to put on trades that you are comfortable holding long term, not just short term.  It helps to avoid trying to capture every little squiggle, even those opposite of your long term outlook.

We have an FOMC meeting today, it should be a boring one.  The Fed is still not in a position to be overtly dovish because of the strength in the stock market.  But that is the direction they will be heading towards, because their dot plots for 5 more rate hikes till the end of 2018 is grossly misaligned with the pricing in short term interest rates markets.  And just like 2016, I expect them to come back towards the market's point of view, which means they will have to talk more dovish going forward.

I am getting more interested in shorting the S&P now that we've retraced the down move from Friday.  Usually opex week during a futures expiration month is bullish for stocks, so I will wait to see what Yellen says, and will hope that there is a pop higher which I can short with confidence.  I will be leaning short for the rest of the month as long as we are above 2420.  A move to 2400 is probably right around the corner.

Volatility Rising

These are just baby steps, but volatility is coming back.  I haven't seen that kind of out of the blue Nasdaq selloff since October 2007.  What I mean is that the Nasdaq was rising steadily, everything was fine, and without warning, it just dumped a load, not at the open, when it usually would happen, but during the middle of the trading day, after S&P had hit an all time high.  And on no news.

It's funny.  Nothing bad happened on Thursday after the Comey hearing.  And when the supposedly scary news about the UK vote leading to a hung Parliament (whatever that is) led to a small spike down in futures, it rallied all the way up till mid day US trading hours on Friday.  And then the dump on no news.  A perfect way to trap those who waited for the all clear sign to buy.  They were greeted with nasty little selloff to head into the weekend.


I don't want to make too much of one day, but we've been seeing a lot of volume go towards stocks that are going down and not that much volume go to stocks that are going up for the past few weeks.  And the ones that are going up got stopped in its tracks on Friday.  The selling pressure was building underneath the surface, as the indices showed that everything was fine.  Energy trades like a dog with fleas.  Similar to summer of 2015.  You know what happened soon after.

Fast Money on Friday was complacent, and viewed the Friday selloff as a one off move, nothing meaningful.  They seemed to want to buy the dip.  I disagree.

I've been cautious with putting on shorts but Friday was a clear signal that it is time to be less cautious to short.  I still want to wait for a couple of rally days before I short, but I won't be waiting for all time highs anymore.  A move to SPX 2435 would be enough to get me interested.

Bonds are not acting that strong considering the recent equity pullback.  It could be combination of 3/10/30 supply coming up, Fed meeting on Wednesday, and more bullish positioning by speculators.  I see limited upside and downside for bonds at the moment.  Looking out beyond the next few weeks, I would look for a continued move lower in yields as the economy is just not as strong as most traders believe.  We are late cycle in the economic expansion, and the Fed is putting the final nails in the coffin with their belated rate hikes, which should have started in 2013.

Think stocks rally from here into the FOMC meeting on Wednesday, but not playing the long side.

That Elevated Quickly

Wow.  Not very common to see a massive Friday afternoon Nasdaq selloff after hitting an all time high earlier in the morning.  What's even more interesting is that usually bonds would be screaming higher on this kind of equity selloff but its only been able to work its way back to unchanged on the day.

The weakness in the bond market while equities were flat was the tell.  This stock market is heavily dependent on low rates.  When there is any kind of bond market weakness, the air is just too thin up here above SPX 2400.  Not enough oxygen to keep the pumps going when money becomes even slightly more expensive.

That is why you will not see a big bond selloff to say 3% 10 year because then the wealth effect central bank game would be up.  And there is no way central banks are going to throw in the towel at this point.  With the world up to their eyeballs in debt, any significant move lower in bonds is enough to pressure equities lower.

After today, Nasdaq is officially on my short watchlist of macro markets.  The hot money is in Nasdaq, and whenever the hot money starts to crack, it grabs my attention.  This down move (with bonds not going up) only strengthens my conviction that we are topping out this month.  Get ready to short any rallies next week.  Best to put on a short during opex week, as post opex and corporate buyback blackouts (from Monday June 19) could be painful for longs.

No Worries

Well Super Thursday (ECB meeting, Comey hearing, UK vote) is past us with nothing but quick little dips that were all buying opportunities.  Same old, same old.  Now we are making marginal new highs this morning, and I can only say that this is feeling very toppy here, with very low put/call ratios and without much acceleration once we reach new highs.  The market looks overbought and exhausted, running on fumes.

I am trying to hold back on laying out the short till next week, but it is very tempting to start here with SPX trading 2442.  Bonds are finally starting to selloff and that is a good sign here that the move higher is not going to last long.  It seems like CNBC optimism on bonds did the job in forming the top for this move.  I expect 10 year yields to trade 2.15 to 2.25% for the next several days.

The second half of the year should trade very differently than the first half.  The complacency is so thick you can cut it with a knife.  Expecting a lot more volatility in the second half, as these kind of up moves in emerging markets and Europe are signs of investors reaching for more beta and catch up plays.  A bad sign for the intermediate to long term.

Bonds vs Stocks

Was looking at some CNBC videos yesterday, as there is plenty of downtime in this sleepy market.  You rarely get CNBC pundits talking about bonds.  It is a stock focused network, and rightfully so, because talking about bonds is pretty boring.  Stocks are where the action is.  But you had a lot of talk about bonds yesterday.  If you look at the chart of the 10 year yield, you can guess that it was bullish talk about bonds.

The interesting thing about this bond market move over the past few months is that stocks are also rising.  This happens more often than people think, as stocks and bonds are not as tightly correlated as believed.  Just looking at what happened from 1995 to 1998 as the 10 year was downtrending as stocks skyrocketed.  Same thing for the 2009 to 2012 period.

Since CNBC is talking about bonds, one can guess that the up move is over.  Yes, probably in the short term.  But I actually believe that bonds will rise in the intermediate to long term, looking out more than a few months.  It is getting clearer that the bond market overreacted to Trump's election and it was sell first, ask questions later.  The reflation trade has mostly been hype, as inflation hasn't upticked like many expected, and growth has been mediocre.  And this is supposed to be the easy part of the cycle, as inventories are re-stocked, after destocking to lower levels in 2016.

I have said this before, but all else being equal, a strong bond market is a positive for the stock market.  The amount of leverage on corporate balance sheets has been increasing steadily, and anytime they can borrow at lower rates, it is a bonus.  Some may interpret the bond market strength as a sign of future stock market weakness.  That is what I heard from a couple of CNBC guests yesterday.  But its more often the opposite.  In any case, using the bond market to predict the stock market is not very reliable.  But if you had to make a guess, bond market strength is better for stocks than bond market weakness.

The put-call ratios have been quite low the last few days.  That's usually a short term indicator of weakness.  Sure enough, we got a little bit of weakness on Tuesday.  I still don't think its the right time to short just yet, as I'd rather play it conservatively on the short side.  Next week could be a good time after the Fed shows their hand.  There are some events tomorrow, the ECB meeting, UK vote, and Comey hearing.  Usually the market comes away higher after those type of events, not lower.  So expecting a rally tomorrow and Friday.

Economy Slowing Stocks Don't Care

The initial economic thrust off of the 2016 mini dip in economic activity is running on fumes.  The inventory restocking cycle off the destocking in 2016 has mostly played out.  The economy is now running closer to its natural level, with no pent up demand.  You have seen that playing out in the economic surprise index over the last few months.

This shows you Wall Street getting ahead of itself in projecting increased consumer/business confidence into stronger hard data, and that hasn't panned out.  Also, you are getting the usual lagged effect of the few Fed rate hikes appearing in the economy.  Yes, even going from 0.5% to 1.00% is meaningful to the economy.  I continue to believe that the neutral interest rate for the economy is closer to 0% than PIMCO's new normal 2% that they often espouse.

The higher global debt ratios amidst a slower growing economy requires lower interest rates.  Otherwise, you get a scenario like Europe post 2008, pre NIRP, when you had really slow growth because the interest rate levels were too high to support such an indebted economy.  Now that NIRP has worked its way deep into the Euro financial system, it has boosted growth to levels that are long term unsustainable, but feels good while they pump.

In the next 12 months, you will see the other side of the complacency, as fear and worry will makes its way back into the markets with a vengeance, as the value buyers will only be willing to put in bids if you get back under 2000 in the SPX.  There is a lot of air underneath, it just doesn't feel dangerous because of the super low volatility.  But when the hedge funds and the index fund fans start seeing minus signs in their asset holdings, they will get nervous, like they always do.

Itching to get short, but will probably wait till the FOMC gives another dovish hike and inadvertently pumps this balloon even more.  SPX 2450-2460 area looks like a strong sell zone.

Tailwind from Rising Bonds

The market is enjoying its Goldilocks scenario.  The bond market is rising as the stock indexes hit new all time highs.  This weak nonfarm payrolls number is only making it better.  The bad news is good news theme continues.  The stock market wants low rates, and this NFP number is helping to continue that trend.

The last thing this market needs is a hawkish Fed as the economy is just mediocre, and with fiscal stimulus getting pushed back further into the future.  This nonfarm payrolls number all but guarantees that the Fed will tone down on their hawkish talk, and although they have pretty much committed to a rate hike in June, it probably puts them off the table in September and probably December.  And if the stock market tops out soon, as I suspect, then June could be the last rate hike of this cycle.

At the end of a long bull market, you would expect the crowd to be fully on board, and enthusiastic about stocks.  But a mediocre economy and deep scars from 2008 prevent that from happening.  It could be one reason why this bull market has lasted so long, because there hasn't been a huge burst of equity inflows by retail to exhaust the buying power.  It has come in small increments, along with heavy inflows into bonds, helping to keep the bond market strong, which in turn supports the stock market indirectly.

How does this bull market end?  The most obvious way is for the economy to get weak enough that corporate profits start dropping meaningfully, more so than in 2015/2016 when oil was going down.  A financial shock from China wouldn't really be a big enough hit to the US.  It would have to be more internal in nature, such as the US economy entering recession.  It will happen eventually, but until then, you will not get a bear market unless you see a bubble form and then pop.

I just have a hard time seeing a bubble form with the economy just not strong enough to lift investor psychology into buying stocks with reckless abandon.  So that means we can have 5-10% corrections, or even 15% corrections like late 2015/early 2016, but not a downtrend into a full blown bear market.

SPX is above 2430, I see perhaps 1% upside and then we should chop into a range from 2450 to 2400 for a while.  That is my not so confident forecast, as the low volatility makes it harder to predict market direction.