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.