Italy Following Greece

Greece gave you a rough template for how these political fights between anti-Euro and Euro establishment play out.  The first thing that happens is that these weak economies in the EU breed populist uprisings, which plant anti-Euro populist politicians into their parliaments.  The first thing they want to do, like most politicians, is to spend like drunken sailors hoping to spend their way past their problems.  This can happen when there is monetary and fiscal sovereignty, but under the euro construct, monetary policy is set by the ECB and enforced with fiscal stipulations that limit budget deficits.  This effectively prevents expansive fiscal policies these populists desperately want. 

So what happens is that the populists threaten to break EU laws to increase government spending, but want to stay under the euro currency.  So they want all the benefits of the euro currency without any of the drawbacks.  When Greece did this, eventually they ended up kicking the can down the road, and that is the most likely scenario for Italy.  Italy is in a much stronger position that Greece, so they are not completely comparable, but since February, it is sell first, ask questions later.  Italy doesn't have as much an economic problem as a political problem.  Italy is basically the same crappy economy since 2008.  Unless the populists go all the way and actually leave the euro (it would be a long term benefit for Italy, which badly needs a weaker currency), then they accomplish nothing but higher yields and a worse economy for Italy.  But that is exactly the most likely scenario, as Italy want all the benefits of the EU without having to abide by its arbitrary budget rules.  Eventually they will cave in, just like Greece, and stay in the EU and it will be all for naught.  Only when the EU economy is absolutely going downhill will there be some incentive to leave the EU and try to print their problems away.  Until then, Italy will be Greece Extra Light. 

The only thing new that we've discovered over the long Memorial Day weekend is that Europe's financial market is fragile, and it never went away even with the massive QE and super low rates.  That is why the Eurostoxx isn't able to bubble higher like the SPX all these years, even as the European economy got stronger. 

Don't let the VIX fool you.  There are lots of risk underneath the calm surface.  Tighter Fed policy being the main one, but overvaluation is not far behind in catalyzing big down moves with relatively insignificant news.  Under these panicky headlines, you can clearly see that bond yields are plunging,much more than stock indices are.  That tells you where the pain trade is: rather than lower equities, it is probably lower yields.

Fed Forward Guidance

The financial markets have come full circle since 2008.  2018 is the first time in 10 years where market consensus is pricing in a hot economy and higher inflation.  Just looking at the Eurodollars pricing LIBOR at 3.00% in 2020, assuming a TED spread of 40 bps, You are pricing in a Fed funds rate of 2.50-2.75%, which would mean 4 more rate hikes by 2020.  The Fed has come out and said that it believes the long term neutral rate is 2.50-2.75%.  This the same Fed that thought in 2014, when the US economy was stronger than it is now, that the long term neutral rate was 3.75%.  So that gives you an idea of how wrong the Fed has been in the past. 

In my opinion, a Fed funds rate of 2.50-2.75% is the best case scenario, not a base case scenario.  I would put the base case scenario at 2 more rate hikes this year, taking Fed funds to 2.00-2.25% by year end, completing the cycle.  After that, I expect the cumulative effects of higher interest rates to show up in the economic data, which will scare the Fed into pausing, and eventually easing when the economy rolls over.  The Fed already is starting to come out a bit more dovish than they were in March, such as considering subtle steps such as raising interest of excess reserves at a smaller increment than Fed funds rate at the next meeting, or changing their inflation target into a symmetrical target, tolerating as much time above 2% as it was below. 

Forward guidance has misled the market into believing the Fed is omniscient and can predict the future.  They have been wrong about the rate hike path since QE started.  When QE was initiated in 2009, it was assumed to be a fairly short term emergency program.  The Fed managed to drag it out for almost 5 years, out to the end of 2014.  In December 2015, when the Fed got off the zero bound and raised 25 bps, the Fed forward guidance called for 4 rate hikes in 2016.  There was only one.  Finally in 2017, the Fed finally followed their script, only this time, it was less ambitious, with 3 rate hikes and the start of QT considered a tightening step, letting them skip a hike at a conference call meeting. 

Now that the Fed is following its unambitious 75 bps/yr rate hiking cycle, all of sudden the market believes the Fed will actually keep to their guidance, when they've been fooled so many times before.  Partly this is due to the stock market's resilience in the face of 10 year yield around 3%, and also due to the optimism about the economy.  But higher borrowing costs slowly work to weaken growth.  Loans and bonds are usually done at a fixed rate, and a big portion of them don't mature for several years.  So bit by bit, as loans and bonds are renewed and rolled over, the fixed rates are set at a higher level, not a lower level like they were for most of the last 10 years.  That makes interest payments higher, offsetting a lot of the tax cuts or even overwhelming the tax cut effects. 

The 3Ds: debt, demographics, and deflation should really be just 2Ds: debt and demographics.  Deflation is the boogieman that is made up by central bankers who need an excuse to print money and pump up the financial markets.  In the long term, debt and demographics are significant.  Japan is the obvious model for this, with easily the highest government debt to gdp ratio of any country in the world, and probably the oldest demographics as well.  They are stuck at zero and their bond market is dead.  Europe is not too far behind in the debt and demographics department.  And while the US doesn't have the same aging demographics and has higher population growth, it pales in comparison to the US of the 1940s-1990s, when population was growing strongly, and the nation was relatively young. 

We are seeing some European jitters as PIIGS debt yields are surging higher.  Italy 10 yr spiked above 2.50% and EURUSD is at 1.166.  This seems like a 3 day weekend risk off selling, not anything fundamentally new.  Europe will stay cobbled together until Draghi's term is over.  So there shouldn't be any major problems till Germany gets their guy as ECB president, at which point, the QE option will likely be taken away which would be punishing for the PIIGS.  But that won't happen till late 2019, so nothing to worry about now. 

The SPX has been quite resilent in the face of these European headlines, a stronger dollar, and with 10 yr yields back below 3%, I expect another attempt to break out above 2740.  If Powell comes out dovish at the June Fed meeting, that could be the last hurrah top before the move back down to 2600.  Right now, it looks like its best to wait to get short SPX.  I don't expect the market to runaway to the downside (or to the upside) anytime soon. 

Italy: A Page Out of Modern History

How quickly we forget about all those EU headlines that moved markets in 2010-2012(PIIGS), 2015(Greece), and even as recently as 2017(French elections).  It is Italy this time.  And it looks like Italy wants their cake and eat it too.  They want to increase government spending and thus their budget deficit, which would break EU budget laws, while remaining in the Euro.  I am sure Draghi wouldn't mind, but Germany would be furious if the EU gave a deal to placate the Italians.  Probably much ado about nothing, as Italy will be neutered by the Brussels technocrats.  But this is another sign that populist governments are becoming more common and want to blow up the budget to give out freebies and pump pump pump.

If you eventually get a bunch of populist government policies around the world blowing up huge deficits, you will end up with countries dependent on ZIRP and QE, because they can't deal with the financial turbulence that comes from high rates that would naturally occur with rising government bond issuance.  Instead, they would have to placate the financial markets by lowering rates (US), or by doing QE (Europe/Japan).

Back to the current market.  I get a sense that the current bullishness is a mile wide and an inch thick.  There isn't strong conviction by bulls here, but they are still beholden to the "great" fundamentals, so their natural tendency is to stay bullish, but are easily scared by headlines, like the ones we'll get today about Italy.  This is not like your past dip buyer's market.  It is a short the rally market.  In 2017, there were probably just as many bulls, but they had higher conviction and were very sticky to stay bullish because of the lack of volatility.  This year, you have shaken the conviction out of many of the bulls and put in a seed of doubt about a continued rally with the increased choppiness.  They remain bulls, but with less conviction.  The best environment to trade on the short side is when you have a lot of low conviction bulls who get easily scared and sell quickly.

It is looking like we are forming an intermediate top this month, and while it could be extended out a few weeks into June, I see lots of room for this market to go lower in July and August as a slowing global economy with tighter monetary conditions does it work.  SPX 2740 resistance held like a rock, and even if we do break that level later this month or in June, I expect only a minor break higher, perhaps up to as high as 2760, before forming a top and plunging back down below 2600. 

Breaking Down Wall of Worry

This market is taking a battering ram against the wall of worry.  The US-China trade "agreement" has gotten the bulls more optimistic, even as interest rates stay above 3.00% and the dollar stays at year to date highs.  This is part of the top building process.  It takes time to turn around the big up trend from January 2016 to January 2018.  Usually a top is not a point, but a choppy period of increased volatility where strong hands sell to weaker, more desperate hands. 

The defining character of this bull market has been a market that spends very little time near the lows, and a lot of time near the highs.  All those V bottoms meant that longs had very little time to buy at low prices, and usually had to chase higher if they wanted to get long.  That has now changed.  From February to May this year, the market has traded in a choppy range, spending more time near the year to date closing lows of 2581 than the year to date closing highs of 2872.  Since the April U bottom, the market has spent a lot more time below 2700 than above 2700. 

Despite this change in character of the market, the general attitude towards stocks is that of deeply ingrained fundamental bullishness, with only sporadic bearishness based on technicals or some news headline.  That is similar to 2000.  Even in 2007, you didn't see this kind of optimism about the fundamentals.  That leaves a lot of room for investors to switch sides towards the bears. 

The stock market is in a pickle now.  It can't have strong economic growth for fear of a tight Fed, so it needs mediocre growth and hope that is enough to sustain this overvalued market and keep interest rates from going even higher.  A mediocre economy with a neutral Fed is a better backdrop for stocks than a strong economy with a tight Fed. 

I covered my short term SPX short on Friday, and am waiting for another shot to short, but will probably want to wait till at least Thursday or Friday. 

Panic at the Bond Disco

The stock market has hit a brick wall in the 2720-2740 zone as a surge higher in bond yields is putting pressure on interest rate sensitive names.  It also doesn't help that the market has rallied for almost 2 weeks straight and is overbought.  The put call ratios have been dropping steadily, and investors have gotten more comfortable taking equity risk. 

It is stock buybacks vs the Fed.  The Fed usually gets what it wants, even if its more than they expected.  They are looking to cool down asset prices, and what better way to do that then by raising interest rates and reducing their balance sheet at the same time.  it takes time for the higher interest rates and bond rolloff to affect the economy.  It is affecting bonds first, and next come stocks, and then finally the economy.  Each happens with a lag, as the tighter monetary conditions slowly put a burden on the economy which isn't as strong as the pundits make it seem.  The fiscal stimulus is less stimulative than the Bush tax cuts in 2001 and 2003.  Those tax cuts gave a bigger percentage of the cuts to the lower and middle class than the Trump tax cut, which made them more stimulative to the economy.  The 2018 tax cuts will provide a small economic boost, but its not going to net out to anything meaningful,  when you consider the higher interest rate burden for borrowers. 

Usually when the financial media is worried about something, its usually meaningless and irrelevant for stocks.  But this time, the bond rout is much more meaningful than what the pundits think.  It is not about inverting the yield curve, but the absolute level of yields which is a burden for the stock market.  If the  2 year was at 2% and the 10 year was at 1.50%, it would be a much better environment than the one we are in right now, which has the 2 year at 2.58% and the 10 year at 3.10%.  In the first case, you have a negatively sloped yield curve of 50 bps.  The current yield curve (2-10s) spread is positive at 58 bps.  The market would much rather have the inverted yield curve at much lower interest rates. 

The main thing a flattening yield curve signals is that the Fed is tightening, and there is not a large supply of long dated bonds, which is obvious.  In other words, it doesn't provide much new information. 

We had the big bond rout on Tuesday along with stocks, and surprisingly, stocks rebounded yesterday without bonds rallying.  At 10 year yields of 3.10%, a long lasting stock rally will be hard to sustain.  I put on a small daytrading short on SPX this morning, looking to cover either in the afternoon or tomorrow. 

Equity Fundamentals

What I often hear from the traders and amateur investors is that the fundamentals are great for stocks.  I don't hear much about valuations or tightening monetary conditions anymore.  Its funny.  There was a bigger fuss about stocks being overvalued back in 2014 and 2015 than there is now.  It is almost as if the corporate tax cut somehow made the long term prospects of US corporations that much better.  But let's not forget that stocks are priced off of a perpetual cash flow.  There is no guarantee that corporate taxes will remain at this level forever.  With the giant budget deficit, and the likelihood of future populist policies, an increase in the corporate tax rate is definitely not out of the question.  It would not be surprising to see the Democrats nominate a populist candidate due to the failure of Hilary Clinton and the moderates. 

It has been big corporations that have mostly benefited over the past 9 year bull market, as low wage growth and less competition has helped raised profit margins.  I realize the masses are mostly ignorant of what is really going on in the economy, how Congress is bought and paid for by corporate lobbyists to siphon federal dollars to the big corporations.  But the 98% in the lower to middle class probably realize that the rising stock market is not really helping them, as their situation is not getting any better, while the rich, who own most of the financial assets, have been getting much richer. 

The only way for the world economy to get much stronger is to transfer wealth from the rich to the poor and middle class.  The rich spend a much smaller portion of their wealth than the poor and middle class, thus reducing consumption and keeping the economy growing slowly.  Inequality is a big factor in holding back economic growth. 

Corporations have not been investing in future growth, because they realize they can get more bang for their buck by buying back stock, rather than investing.  Investments only pay off if there are a growing number of consumers who are looking to spend.  But the consumer is cash strapped, because of low wage growth and inflation that is underreported by the government.  Also, the lower population growth rates and an aging population in developed countries reduce overall consumer demand. 

Tax cuts are providing a short term boost, but most of the benefits are going to the rich, so it won't be a game changer.  And with higher interest rates, the interest burden has increased, offsetting much of the fiscal stimulus. 

To sum it up, I don't agree that equities fundamentals are great, or even good.  It looks similar to 2000, without the strong growth.  The price/book, price/sales, and price to cyclically adjusted earnings are the highest since the 2000 bubble.  It is an environment ripe for a bear market.  That is probably why I was too eager to sell last week at 2680  when I should have at least waited a few days to see how far the bulls could take it higher.  Sometimes it is better to wait to sell, even if stocks reach your price target, just because uptrends usually don't end after 4 trading days, which was how long the rally was when I sold. 

Anyway, that is history.  I can only trade the current market, and with the SPX at 2740, it is getting much closer to ideal long term short levels.  Thinking 2780-2800 zone is an area to consider shorting for a move back to 2600.  The drop back to 2600 won't happen right away, but there is a good chance it happens by July/August.  Right now, the momentum is too strong and the uptrend off the May 3 low is still too young for a good short signal. 

Not Looking Good

At SPX 2680, after what the market has shown over the last 3 months, the risk reward doesn't favor longs anymore.  I tried to be as patient as possible but this market just doesn't have the upside lift, and the bond yields just aren't going down which makes me nervous holding longs.  I have sold my SPX long and will now just wait.  It was a bad trade, wasted capital and too big of a drawdown.  It is possible that it could grind higher, or it could go right back down after hitting resistance here.  I see it as almost a 50/50 situation, not something I want to tie up my capital in. 

The tighter money is having a noticeable effect on SPX and emerging markets price action.  The dollar is getting stronger and at these valuations, even with all the stock buybacks and "good" earnings, it just can't go much higher.  In the long term, I am bearish on the global economy, and slightly less bearish on the US economy, so under that scenario, the dollar will likely get weaker, just because the US is the only developed economy that can significantly reduce interest rates.  That would dramatically reduce the interest rate differentials between the US and Europe/Japan, causing most of the positive carry of a long dollar position to disappear.  That is the long term.

In the short and intermediate term (anything less than 6 months for FX), it is hard to predict what the currency markets will do.  Forex tends to be a momentum market, but much less so than in the 1970s-1990s, making it a hard to either be a trend follower or a counter trend trader with much conviction.  The only thing that plays out consistently long term is that positive carry currencies generally provide better real returns than negative carry currencies.  But since the dollar is overvalued on a purchasing power parity basis, and also historically, it negates some of the long term positives of being a positive carry currency. 

So I won't factor my long term views on currencies in my shorter to medium term trades.  Besides the recently stronger dollar, there are many more negatives for this stock market.  Late cycle behavior, high valuations, higher bond yields and tighter monetary conditions, etc.  The only positives were the long uptrend in stocks (rising 200 day moving average) and stock buybacks.  Without those 2, there really is no reason to be buying stocks here.  Not bearish yet, but not bullish either.  If the traders seem to be getting excited again about stocks, I will definitely be looking short.  Sentiment feels neutral at this moment, so I am not getting any good timing tells yet. 

Stronger Dollar and Buybacks

The forex market doesn't follow patterns that you see in the stock market, which makes it less predictable.  There tends to be overshoots when there is a long term trend and that is what happened in January.  It is one of the main reasons that I don't trade it, because the short term movements often go counter to how you would see stock or bond traders position ahead of key news and events.  Also, the reaction to economic data or to central banks is also often counter to what many would expect.  

For example, last week, the Fed emphasized symmetry in their inflation target, implying that the Fed will not rush interest rate hikes due to inflation meeting their 2% target.  Also you had the nonfarm payrolls on Friday come in below market expectations.  So what happened?  The dollar initially dipped but then rallied after the FOMC announcement, and is rallying after the nonfarm payrolls report.  This after already rallying into the FOMC announcement for the past week, going from 1.24 to below 1.20 over the past 3 weeks ahead of last week's events.  And the dollar rallied anyway, despite the Fed being more dovish than expected and despite weaker than expected jobs numbers.  That is why I don't trade forex.  

Back to stocks.  Despite the stronger dollar, the SPX is higher again, around 2680 as I write.  Odds favor the dollar rally to stall out here around EURUSD 1.19, as that is near the top end of the range in late 2017, and I don't expect the Fed to be able to do as many rate hikes as the market expects.  I usually don't even pay attention to the FX market, but the recent dollar strength has turned the SPX into a global equity index laggard, so I have been watching the dollar to see how tight the correlation is.  

Friday and today, the SPX has been able to rally despite a strengthening dollar, which is a sign that the corporate stock buybacks are coming in hot and heavy, now that earnings season is mostly over, with AAPL leading the way.  I don't think stock buybacks will be a longer term driver for this market to go higher, but after the cash repatriation earlier this year and the dip from January, it is definitely a positive catalyst for stocks in the next few weeks, when buyback flows should be heaviest.  I will try to ride this buyback wave so I can dump stocks a bit higher than here, probably sell at 2710-2720.  

Bonds look like they have found a floor right about the 3% yield area, as Powell seems to have blinked and global economic data is coming in weaker.  There is limited downside with moderate upside for the next few weeks.  10 year yield should trade down to 2.80% yield support by the second half of this month.  

Working off Excesses

There was a lot of excessive speculation in stocks in late 2017/early 2018.  It is taking the market a long time to reduce this speculation by trading sideways to down and wearing out the dip buyers (me included), making them sick of this fading, range bound market which has no lift.  In hindsight, I should have been more cautious entering longs in March, thinking the worst was over.  But with valuations too high considering the weakening fundamentals, I gave the crowd too little credit for coming to their senses and assumed they would blindly buy overvalued stocks after a few week break.

Clearly, it is taking a lot longer for this market to accelerate higher off the bottom, a change of character from the past 9 years when most bottoms were fleeting and resulted in quick V recoveries.  We are no longer in that type of market, and the past 3 months of price action is screaming that fact to traders.  It hasn't helped the bulls' case with the bond market staying weak (although it looks like it bottomed last week at 3.03% 10 yr) and with the dollar suddenly acting stronger. 

This is definitely not a strong enough market that can just shrug off negative factors like it did for the past 9 years with ease.  While it has been painful to see stocks so differently than recent history, it is a great tell showing how close we are to the top of this bull market.  It would be very surprising if the market doesn't make a top for this 9 year bull cycle this year (probably already happened).  But with corporate stock buybacks coming out in full force this month, I am still leaning bullish despite this recent weakness on good news (strong tech earnings, dovish Fed).  There is room for this to go down to 2580-2600 if panic arrives, but I see upside to 2720 later this month, especially if bonds can continue to rally, and 10 year yields start trading around 2.80% instead of 3.00%.  The difference seems minor, but a move back down to 2.80% is a signal of yields stabilizing rather than it being an important level.  Since I am bullish on bonds here, at SPX 2620, the odds favor stock longs over shorts. 

Afraid of the Fed

The Fed is no longer the market's friend.  How else can you explain the post Powell reaction after his Humphrey Hawkins speech in February (S&P tanked from 2790 to 2647) and his first FOMC meeting in March (S&P tanked from 2740 to 2560).  Now the fast money traders are going to sell first and wait to see what bombshells Powell will drop this time.  He definitely doesn't feel like a Yellen clone to me, as many proclaimed when he was nominated last fall.  Yellen would have softened her tone on rate hikes after a steep drop in February, but Powell kept the same rhetoric, slow and steady rate hikes with expectations for higher but stable inflation and low unemployment. 

It is clear that Powell has decided not to provide a Fed put anywhere close to current stock index levels.  But will he act this brave when the yield curve gets even flatter, and the global economy slows even more?  I doubt it.  The Fed is an institution that is there to save financial markets, not drive them into a brick wall.  Europe and China are now slowing, and considering the long term fundamentals of both of those economies, the most likely scenario is continued slowing which will pressure the ECB to give up on their rate hike plans and encourage China to postpone any deleveraging that they thought they could push through.  Instead, you have the PBOC pushing through RRR cuts already and are done with their tightening cycle. 

The US economy is still showing steady growth, but the tax cut effects will start to wear out quickly if the stock market doesn't go higher.  The shrinking portion of the US economy that actually is economically sensitive is now heavily dependent on the wealth effect of stocks.  The poor will stay poor and have no effect on stocks.  The middle class has acted more like the lower class since 2008, so their behavior is not as variable as in the past.  The wages are stagnant with low growth, so their spending can only go up so much before the credit cards and loans are maxed out.  The demand for cooks, waiters, and waitresses is less economically elastic than most other sectors.  And most of the new jobs have been in the lower paying service sector.  So I don't expect a big spike in unemployment in the next recession, it will just be even less wage growth and lower inflation. 

The S&P 500 is trading much weaker than I expected, and the only thing I can point to is bond yields staying near 3% and the dollar getting stronger, as it is sniffing out weakness in Europe and Asia.  A weaker dollar is what helped the S&P levitate effortlessly last year, so a strengthening dollar is a definite negative, especially for big caps.  With the Fed meeting tomorrow, I don't expect any surprises from Powell, he probably just repeats what he said in March, as nothing much has changed except the S&P being lower by about 3%, and the yield curve slightly flatter and dollar a bit stronger.  That might make him lean less hawkish than at the last meeting, but I wouldn't count on it.  Powell seems hell bent on inverting the yield curve by bashing the short end into oblivion.