Tough to Time

This thing is taking its time at the top here.  I would have liked to see more volatility up here and some more weakness following last week's post FOMC intraday reversal.  But its reverting back to the same boring small range trade that it has been doing for months.  My conviction has been reduced a bit so I have accordingly reduced my short.  Still think we will go down to 2420 this month, but that probability is going down bit by bit with this kind of boring trade.

Crude oil is getting supported by Saudi Arabia, who seems to be cutting production to keep prices close to $50.  OPEC is basically Saudi Arabia, and they are trying to keep prices afloat ahead of the Saudi Aramco public offering.  Look for crude oil to go back down after the IPO since Saudis don't want to be the only one supporting oil here.

Will be taking a blog break for a few days, next post is likely going to be next week.

2015 Similarities

There are growing parallels to 2015.  First, you have the big inflows into Europe on optimism in the Eurozone.  That helps rally the euro off low levels and drags down the Bunds and Treasuries.  Then the risk parity cracks begin to emerge as stocks and bonds start selling off more frequently, and often on the same day.  Also, the momentum tech stocks outperform the broader market.

Not everything is the same, you don't have the Chinese stock market crash or yuan devaluation, or any worries about Greece.  But you also have much higher prices now compared to 2 years ago.  And volatility was definitely higher and markets choppier in 2015.  That is the one fly in the ointment.  The super low volatility is unlike any long lasting top I have ever seen.  I don't think you can just blame vol sellers for that phenomenon.  Realized vol is still significantly lower than implied vol.   So that takes away my conviction on a long term top, but I think we can definitely have an swing top with these low vol conditions.

I do think as volatility increases, we will revisit that 2480 area again a few times.  But I remain a better seller of rallies and will be reluctant to buy dips.  Yesterday's sudden selloff even caught me off guard, as I expected a quiet day after the first hour was basically actionless.  But there is a lot of complacency out there and air pockets underneath.  Expect to see more of that type of price action in the coming month.

Blood of the Bears

The financial markets are built on blood.  After a long bull market, the blood of the beaten down bears is used to feed the next bear market.  And vice versa after a long bear market.

The early bears' pain is the timely bears' gain.  It is difficult to time the top of a market, much more difficult than timing the bottom.  One of the early signs is when the markets go from pricing in better fundamentals to just valuation/multiple expansion.  This phase of the cycle can last quite a while, which is why it is an early sign.  It is a basic ingredient for the next phase, which is the topping phase.
The tricky part about the topping phase is that sentiment actually gets a bit less bullish while prices chop around.  This can fool the contrarian into thinking that there is still a wall of worry to climb, when in fact the wall of worry is blocking higher prices.  There are nuances to this game which makes it so important to develop feel and intuition when trying to predict future price moves.

I hear cliches from traders about "trade what you see, not what you think".  Like many cliches, they have a kernel of truth, wrapped around a lot of myth.  Yes, it is true that if you hate Trump, then you would think the US stock market rally post election is irrational, so not trading what you think would be a good thing.

But if you aren't thinking about the future and only focused on the present price action, that is a recipe for chasing and getting chopped up.  A quote from someone before he became a bloated macro hedge fund asset gatherer, when he was a great trader who made spectacular returns trading macro in the 80s and 90s:

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.” - PTJ

It feels like a market turn is coming soon.  Since we haven't topped out yet and are still making new highs, it is speculative at this point.  But I am looking at the next few weeks where ECB tapering, Fed balance sheet reduction, and debt ceiling are on the horizon.  Those should be bear catalysts.

Europe Lagging

Feels like 2014 and 2015 again.  Europe and Japan have topped out as the US marches higher, led by tech stocks.  Even during a positive year in 2014, there were sizeable dips, one in January, one in August and one in October.  While January's dip was led by US, those in August and October were led by Europe, which topped out way before the US did.  Europe has signaled a saturation of global risk appetite for much of this 8 year bull market.

This time, Europe topped out in May, right after the good news pop from the French elections, and is down about 6% while the US is up about 4% during that time period.  That is Europe lagging the US by 10% over 2 months.

In much the same way that the yen has become a funding currency, so has the euro.  When you have negative interest rates, traders like to short that currency against one that offers a higher interest rate.  So the yen carry trade has morphed into a yen/euro carry trade.  Both are stronger lately.  While a dovish Yellen has masked the symptoms of this FX move, it still hasn't taken the pressure off these carry trades.

Remember back in August 24, 2015, the euro and yen both spiked higher on that infamous SPX limit down day.

By the way, I was watching CNBC Fast Money on Friday and they were universally bullish on tech stocks going into earnings this week.  It feels like a setup to pullback post tech earnings.

Finally Short

It finally feels like it is time.  I have gotten short SPX.  The final catalyst came out.  A dovish Draghi.  The good news is out there for the public to embrace.  Investors scared of tightening central banks have now gotten back into the pool.

The 2500 SPX psychological barrier is also another part of it.  Very few mention it, but most investors who set targets also put in sell orders around those big round numbers.  And the tendency is to put them just before that big round number.  So there should be plenty of this type of big round number-based resistance at these levels.

There are bearish catalysts out there on the horizon as well.  The budget battle/debt ceiling, potential ECB taper announcement in late August (Jackson Hole) or at the meeting in September, etc.  Also seasonally it is a weaker time of year for stocks, from mid July to September.

This is an intermediate term short, looking for a move down to 2420.  It should take a few months to chop around before the trend reverses, so no long term short yet.

Playing the Downside

The market has "plunged" 10 SPX points from pre market Draghi highs, and is clawing back as I write.  Yes, he was dovish.  But the market knows that unless the ECB changes the capital key rules or goes into buying stocks, they will run out of Bunds to buy in 2018.  So they have to reduce QE or change the rules.  Of course Draghi will never admit that, but that's the main reason they want to taper, not because of a stronger European economy.  Europe is Japan 2.0.  It is unrecoverable.  The European economy will be right back to  near zero growth as the benefits of a lower euro dissipate, now that the euro is heading back up.  Based on the inflows into Europe and emerging markets this year, it seems like retail has fully embraced the "value" in European and emerging market stocks.  In 2015, that signaled a topping phase after a long uptrend.  I see a similar situation here, but with more dire consequences on the other side of the mountain.  Just because this time, the mountain and the air underneath is so much bigger.

There are a few options for playing the downside after the market makes a top.  And I really believe the top is coming soon.  These tops tend to come slightly below big round numbers for the S&P 500.  The 2007 top occurred right under 1600, at 1576.  The 2011 top happened at 1370.  The 2012 mini QE 3 top happened at 1475.  You get the idea.  It would not surprise me to see this market make a top right below the big 2500 psychological number.

You are getting a steady stream of low put/call ratios ever since the French elections removed a pall of uncertainty from the market.  While the super low VIX is not something I like to see when trying to pick a top, I believe that stems from investors selling volatility for income, artifically lowering volatility.  The tech stocks are acting bubbly, much like they did in 2015.  And we have gotten the good news from a dovish Yellen and today, from a dovish Draghi, which provide the final wave of FOMO buying which often forms a top.

I see three good ways to play the downside.  1.  Shorting equity indexes.  US, Europe, emerging markets, they will all work.  2.  Buying longer dated SPX puts, with SPX volatility so low, actually a good risk/reward.  3.  Buying 5-10 year Treasuries, with an equity market correction reducing the odds of future Fed rate hikes.

Bubble Times

It will end badly.  But timing the top gets harder when the Fed keeps its cautious rate hiking campaign.  The bond market has called the Fed's bluff.  They don't believe in 4 more rate hikes till end of 2018.  They are pricing in 1.5.  Janet Yellen blinked when the 10 year went from 2.10% to 2.39% and went back to being dovish.  That was the green light for investors to party on and make the bubble bigger.

But that is short term thinking.  Ironically, because of 2008, investors are now thinking short term and unwilling to tolerate big risks.  But that makes them get caught up in buying when things are optimistic, and dumping quickly when things start going down beyond a certain pain threshold.  And with the VIX so low, that pain threshold is pretty low, because investors have been lulled to sleep by such low volatility.  A 10% move down would seem like a shock to the system, when it's a fairly normal stock market volatility.

The end point will be the same.  It is just a matter of how much higher it can go before it gets back to more normal valuations.  And with normal valuations, we are talking a P/E of around 15 times GAAP earnings, not the pro forma nonsense that is used by the Street to tout stocks.  That would put the S&P around 1600 based on 2017 earnings estimates.  A 35% correction from these levels are needed to get to average valuations, which is where the market was in 2013.

After 8 years of a steady uptrend, with only a few corrections, it is hard for most traders to picture a scenario where the market goes down 35%.  All it would take would be for the economy to get bad enough that corporations wouldn't have the cash flow or the borrowing capacity to do stock buybacks.  You can guarantee that there will be equity fund outflows.  So without the buying power from corporations or retail, you will have to get to levels where value investors step in aggressively to counter retail outflows.  That level is probably around 1500-1600.

We have the ECB tomorrow and the Fed next Wednesday.  Those will likely be market positive, so I will probably wait till after Draghi does his usual dovish dance before going short.  We are at levels where the risk/reward is quite positive on the short side so am definitely eager to get started.

Economy and Markets

There is a reason the wealth effect from a rising stock market isn't improving the economy.  It's because most people own a negligible amount of stocks.  It's another one of the reasons why the Fed are clueless.  Bernanke believed in the wealth effect of rising stock prices, which is why he tried to goose the economy by doing 3 QE programs.  He only goosed the stock market.  He thought that people would spend more money if their stocks and funds went up.  The problem with his thinking was the people who didn't need more spending money were the ones who got all the benefits.  The people who did need it got none of them, and in fact got punished with higher rents and home prices.

The wealthy will just keep investing more if they have more money.  They already have almost everything they want.  The marginal utility of a third home is much less than a first home.  Same with cars, electronics, etc.  They don't need more stuff.  So when they got higher stock prices thanks to Bernanke's repeated QEs, they just put it right back into financial assets, not the real economy.  That's why you aren't getting the big inflation numbers despite all the central bank money printing.  All that money is just sitting there in brokerage accounts of the wealthy, or stuck in some luxury real estate.  

It is a little bit like the 1920s, except the average person isn't involved in the stock market.  The financial markets have become its own ecosystem, mostly detached from the real economy.  That is why the stock market would rather have a mediocre economy and low rates than a good economy and higher rates.  Higher rates mean much less wealth for the fixed income portion of the wealthy's portfolios.  A stronger economy isn't enough to offset that.  The market pundits think tax cuts will boost this market further but it would probably be a net negative as it would push up interest rates, which would curtail stock buybacks.   

Labor is cheap now.  There is too much supply of global labor.  That keeps wages low, profit margins high, and fuels the growing inequality and mediocre economy.

The only way the economy gets better is helicopter money.  Universal basic income.  If you gave everyone $1,000,000, consumer spending would rise so fast your head would spin.  Economic growth would skyrocket.  But the power players in Washington don't want it, because that would crush their fixed income portfolios, and they are just fine with the status quo of low rates and high equity prices and will lobby aggressively to maintain it. 

Market is a bit stronger than I expected.  It really does seem like investors were worried about a Fed that was too tight.  Now that monkey is off the back, we are getting a wave of buying.  Not ready to fight it yet, but the higher it goes, the more interesting the short side looks.  

Bad Data is Good for Stocks

We are back to the bad economic data is good for stocks price action.  Retail sales came in less than expectations, as well as inflation, and with yields going lower, stocks are pressing back up towards 2450 again.  It didn't take long for the market to forget last week's worries about higher interest rates.  We are getting to interesting levels on the short side this morning, but I don't want to pull the trigger because of the strength in bonds.  I would much rather just short the market when only stocks are going up.

I anticipate bonds being strong all summer, so it's not going to be easy pickings to short stocks unless data gets really bad.  And right now, data is just mediocre, enough to keep yields from going up, but not so bad that it affects earnings.  The only way I see yields going up for more than a few days is if tax cuts go through.  Oddly, the tax cuts that equity investors so badly want would probably be the nail in the coffin for this bull market.   While tax cuts would be a short term positive for stocks, it would be a long term negative because it leads to higher yields from greater bond issuance.  The small economic gain from tax cuts would be taken away by the negative effect of higher yields.

In 2015, you had an attack on risk parity (bond yields were reluctant to go down as stocks went sideways) which was the precursor to the 2016 down move.  Right now, you don't have that.  You did for a few days at the end of last month, but Yellen went right back to looking away from asset bubbles.

She gave her seal of approval to this bull trend in stocks, which is not surprising because the Fed talks a tough game but usually doesn't follow through.  At least Yellen was honest that the Fed boilerplate message of transient inflation and strong labor markets was just a pretext to put through a  few rate hikes.  Now that the Fed fund rate is back above 1%, she doesn't feel the urgency to keep hiking.  Unless the stock market keeps making new all time highs and busts out over 2500, what Yellen said on Wednesday should be the new boilerplate message.

This year, unlike 2015, bonds are looking bullish and that should make it harder for stocks to go down without some kind of shock to the system, which is lower probability.  I am still leaning bearish, due to valuations, but current financial conditions are still loose enough that stocks could grind a bit higher than expected before getting hit with a correction.

Yellen to the Rescue

Here they come again.  The Fed is back with a giant fire hose to blow out a little brush fire.  I guess Yellen had seen enough of the rise in bond yields from 2.10% to 2.39%.  29 bps was all it took to go from hawkish(supposedly) to dovish.  Talking out of both sides of her mouth.  Saying the Fed will keep raising rates and that neutral rate is 3% and saying that not many rate hikes left till they get to neutral.

The market did overinterpret the last FOMC meeting when she kept to the script of balance sheet rundown and another rate hike this year.  That was just her staying on script, not really revealing what she had in the back of her mind.  We got the truth today.  She is worried about low inflation and worries about high asset prices is way down on the priority list.  The tightening theme of global central banks taking back liquidity was dealt a blow today.  It had become popular on TV to say that central banks tightening policy would keep stocks from going higher.  The market was offsides for a dovish turn by Yellen.

How quickly those emails from Trump Jr are forgotten.  Now the bulls will think its clear sailing.   Overall, the conditions are still the same.  I never was banking on a hawkish Fed to take down the stock market.  That's not going to happen this time around.  They are chicken littles who will coddle the stock market if it has a tantrum.  My bearish view was more fundamental to overvaluation, low economic growth, and investor positioning.   Those things are still there.  I would like to see a slight break above SPX 2450 to all time highs to put on my shorts.

Fed is Late Again

They did it again.  Same mistakes, different time.  The Fed has set a pattern for their monetary policy which is:  they react to economic weakness quickly and react to economic strength slowly.  They will cut rates in 50 bps chunks at every meeting, and even between meetings, because they can't wait a few weeks.  You ever see the Fed raise rates between meetings?  For interest rates, it is  the staircase up, elevator down.

Starting with the Greenspan years, you had the 2004-2006 rate hiking cycle, in 25 bps increments, as the housing bubble was getting bigger and bigger.  They started too late and went too slowly.  Now the Bernanke/Yellen years.  Stretching out tapering over a year.  And that was with a 3 month delay because they hinted at it during May/June 2013 and should have done it in September but didn't do it till December.  Did they ever start QE gradually and build it up to full size in one year?  No, it was huge from the start.

And you wonder why the bond market doesn't believe the Fed when they predict 1 more rate hike this year and 3 more rate hikes in 2018.  Because the Fed overreacts to market weakness, and will either stall their rate hiking campaign or go to cutting again if we get a correction.  And odds are high that we will get a correction.  Don't believe the Fed when they say they are worried about high equity prices.  They will change their tune as soon as the S&P drops 10% and start worrying about stock prices getting too low.  They are Tony Larussa (retired micromanaging baseball manager) on steroids.
It has been a painfully slow rate hike cycle, and the Fed has lost their credibility when it comes to controlling asset bubbles.  They have babied the markets for so long, there is a expectation built in for  them to come to the rescue on any big dips.  And they will again.  Just like they did by delaying rate hikes in 2015 and 2016.  Now they have suddenly gotten brave with their 25 bps hikes every 3 months as the S&P has only gone up.

The financial pundits really do have a short memory.  They suddenly fear the Fed and their tightening cycle hurting stocks when they should be more afraid that the market is just a big fat bubble whether rates are at 0 or 3%.  

It looks like another boring summer day.  "Goldilocks" nonfarm payrolls number got traders positive again on stocks.  That shouldn't last for long.  Expect a move down this week to take back those Friday gains.  Chop continues.

Relentless Bond Selling

They are crushing them again today in the bond space.  Led by the Bund, which is leading this selloff as the Europeans are starting to freak out about ECB tapering.  Draghi opened up a little crack in the door for tightening and traders have busted it wide open.  The equities keep reacting negatively to the higher rates, a bad sign considering where we are in the cycle.

This is reminiscent of what happened in May and June of 2015 as a German Bund bull market came screeching to a halt, at 7 bps, and rallied into the 90 bp range.   It was a preview of the risk parity fiasco of August 2015.  By the way, the SPX topped out in May of 2015 at 2134.  After that, stocks really couldn't go anywhere, and chopped around for another 3 months.  This is something that has been on my mind all year, the similarities to a 2015 type market, as the market tops out and chops for months on end, and then drops suddenly.

I don't know why those financial experts on CNBC think that low Treasury yields are something to worry about.  We had Treasury yields going lower for most of this year till last week, and the indices were doing great.  Now that you get this bond selloff since Draghi opened his mouth last week, you have a more volatile stock market that can't find any upside.  No, it is higher rates that stocks have to worry about.  And also a bunch of other things, which are a bit less urgent.

The recent price action is a signal that there are way too many assets in risk parity strategies.  Stocks are very fragile at these price levels, considering its sensitivity to what is happening to bonds.  I was listening to a podcast the other day and I heard a pension fund asset allocator talk about risk parity as a risk mitigating strategy that they use as a hedge for equities.  How about just having less equities and more cash in the portfolio?  Oh yeah, they need to meet their target annual return of 8%.  Good luck with that at these asset price levels.

There are way too many funds using long bonds as a hedge for their equity holdings.  It leads to these short term dislocations when bonds don't go up when stocks go down.  As volatility has died out, VIX as an equity hedge is now frowned upon, especially with its heavy negative carry.  The fund managers have smartened up, and gone to bonds as a hedge.  But this sets up vulnerabilities that you have seen recently.

The biggest pain trade right now is an explosion higher in VIX, which would lead to a cascade of selling in stocks, and muted upside in bonds.  The VIX sellers would be panicking as volatility exploded only exacerbating the situation.  That is what happened in August 24, 2015, but this time, the move could actually be much bigger with so many more assets in risk parity and so many more bearish on VIX.

In the long term, the stock market weakness on weaker bonds will keep the Fed from tightening much more, because they will be much less hawkish when stocks are going down.  So while I view this stock market price action as bearish for stocks, I think it is long term bullish for bonds.  These bond selloffs tend to last about 2 weeks, and then peter out.  So we could be getting closer to a bond bottom by early next week, depending on what happens with nonfarm payrolls.  A strong nonfarm payrolls number will probably make the bottom come quicker, perhaps even by tomorrow.

By the way, Nasdaq is going down much more than the S&P 500 on down days recently.  Also, biotech has been popular.  Chasing high beta sectors is late cycle behavior.  The fund managers chased tech stocks higher to catch up to the averages.  Now they are loaded up to the gills and have to sell when they start feeling the pain.  I expect volatility to increase this summer as the topping process continues, setting up a nasty correction in late summer/early fall.

Tightening Theme

There is a new theme out there in the markets.  The bond guys have caught on to it, expecting tight monetary policy from the Fed and after last week's Draghi speech, the ECB.

Most of the time, you get news stories that try to fit into the price action.  When you see a sudden selloff in the bond market, which also coincides with a weaker selloff in stocks, the knee jerk reaction is to blame rising rates and hawkish central banks for the weakness.  But higher rates were mostly ignored by stocks post-election in November and December.

The key here is investor positioning.  Back on November 9, right after Trump won, investors were cautious on stocks.  Also, there is a big difference when SPX is at 2100 and at 2440.  At 2100, the market can absorb higher rates, but at 2440, higher rates will cause equity volatility.  That is what you saw last week, as what Draghi said didn't seem significant.  Draghi had to come out more hawkish because the equity markets are rising and as the ECB runs into mandated percentage limits for the purchase of bond issuance for Germany.  Unless they increase the percentage of issuance that the ECB can purchase, they have to taper, or start buying more corporate bonds or expand the program into stocks.  The natural thing for him to do at this point is to downplay lower inflation and talk up future inflation.

The bond market didn't take his words well, even though it wasn't anything news breaking.  When you have had a torrent of bond ETF inflows this year, and more aggressive long speculator positioning, the pain trade was for bonds to weaken in the short term.  And today, you get a stronger ISM number and with economic expectations back to being relatively low, you are going to get more economic upside surprises, which also reinforce the bond weakness theme.

In the long term, the central banks tightening despite mediocre economic data only makes stocks more vulnerable to a nasty drop.  We got the first signs of that last week.  But this macro background of tighter monetary policy works slowly, and in the short term, they can lead to bear traps.  It is something to keep in mind, but it's more important to see the SPX uptrend flatten out more, and to see day to day volatility increase.  That is your sign that the market is saturated with buyers and sellers are starting to meet demand more eagerly.

This is a US stock market holiday week, and the beginning of the month, both positive forces that can last a few days.  Perhaps by Friday, these positive factors will disappear and we'll see what the sellers can do.  I am expecting a drop to 2400 to be fairly easy work, but below that level, the dip buyers will get more aggressive and since they haven't had too many opportunities to buy deep dips over the past 2 months, they will be out there providing a bid between 2350 to 2400.  The game plan is to short strength  from Friday onwards, hopefully near all time highs around 2450.  My threshold to short is lower now.  No longer waiting for the perfect conditions.