Tech Stocks Weakening

There is a widely held belief about stock market breadth being a leading indicator of market direction.  The more stocks that are going up, the better it is for future market performance.  I've looked at a lot of these studies, and they don't work well for predicting a medium to long term top or bottom.  They are hit and miss.  It basically assumes that small cap stocks lead the market, which is sometimes the case, and sometimes not.  However, what does seem to help predict market direction is the tech stocks, or basically the Nasdaq 100 index. 

So far, the Nasdaq 100 has been outperforming the S&P 500 this year, and basically every year since 2009.  But in a somewhat rare situation since 2009, the Nasdaq 100 is actually lagging the S&P 500. 

Over the last 5 years:

Over the last 3 months:

As the uptrend was building, the Nasdaq 100 outperformance over the S&P 500 was also growing, but over the past few weeks, that has changed to an underperformance, even before Facebook plunged after earnings.  Since then, the underperformance has only grown. 

Considering the high expectations built into the valuations of the FANG stocks, and the difficulty of growing strongly with such big market caps, expect more earnings disappointments in the future.  Similar things happened in 2000, when the big cap Nasdaq stocks just couldn't sustain their earnings momentum due to growing expectations and law of large numbers. 

Apple reports after the close today, so it will be interesting to see how tech stocks trade afterwards.  The put/call ratios have been elevated the last 2 trading days, a bit more than one would expect considering the mild down days.  After hearing Brian Kelly on CNBC Fast Money yesterday, it seems like there are still very few worried about the market having topped out, especially considering the "good" news on trade we got from the US/EU meeting last week.  Yet the USD/CNY keeps going higher.  This market is getting dangerous, entering a period of weak seasonality over the next 3 months. 

FANG + Trade Deal Top?

There is a FANG+ Index that includes the following 10 big cap tech stocks:  FB, AAPL, NFLX, GOOG, BABA, BIDU, NVDA, TSLA, and TWTR.  Here is the YTD performance: 

That chart doesn't include the after hours drop in FB.  While the SPX index has made a higher high since the June local top, the FANG+ index has not.  And for the first time this year, the big cap tech stocks has lagged the SPX.  It reminds me a little bit of 2000, when during a Fed tightening cycle and a weak bond market, the Nasdaq topping out first in early March, and the SPX topping out a few weeks later, marking the top of that bull market. 

With earnings disappointments in NFLX and FB near an all time high for Nasdaq, the signs of a top are slowly building up.  The FB reaction to a small earnings miss is especially harsh and speaks to the level of expectations that are built up in these nosebleed valuations.  It looks like those that want to get in on the FANG+ names are already in.  Those that aren't already invested are probably not going to touch these stocks unless they trade at a much lower valuation. 

We finally got the good trade news as the US made a deal with the EU, and we had a monster short squeeze into the close yesterday.  Then the euphoric atmosphere was ruined by FB bombing earnings.  The weakness in bonds is something that adds to the vulnerability of the equity market.  I was looking to short today after that euphoric close, but FB's big drop has put a pause to those plans.  I am still looking to add short, but would like a more clear setup, since I am going to be picky about adding to an underwater short. 

S&P 500 Price to Sales

Sometimes we need a reminder of how expensive the US stock market is.  The S&P 500 price to sales ratio is higher than the 2000 dotcom bubble high.  

This market makes the 2007 SPX valuations look cheap by comparison.  Sure, there has been a big boost to corporate profit margins, and thus lower price/earnings ratio than the 2000 top, but there was more "potential" back then.  Interest rates were much higher, so there was more potential monetary stimulus, and budget deficits were lower, so there was more potential fiscal stimulus.  

Right now, interest rates are below the rate of inflation, and you just had huge fiscal stimulus which is blowing up the budget deficit.  Also, since a lot of the corporate profit margin gains have come from heavy M&A activity and the subsequent reduced competition, how much more can that juice be squeezed?  At some point, the consumer can't keep up, as wage gains are minimal, and the economy goes downhill.  

These are all long term negatives for the US stock market.  

Yesterday we got an intraday reversal after a gap up and strong morning session.  The air looks too thin up at SPX 2825.  The market is running out of oxygen, the fund managers have had over 3 months since the April bottom to reallocate back into equities.  The bus seems very full here, and the bulls seem as arrogant as ever.  If we get back towards yesterday's highs this week, I will add to the SPX short.

Interpreting the Yield Curve

At this point in the economic cycle, when the Fed is still on the rate hiking path, signals from the yield curve are taken and over interpreted.  Yes, a flatter yield curve is a signal from the bond market that the Fed has limited room to tighten further, but a steepening yield curve at this point is not the opposite signal.  A steepening yield curve (has to be more than a few days phenomena) is usually a sign that the economy is getting worse and that the Fed should stop tightening all together.  It is almost always a bull steepener, so it can't be like the move you saw on Friday (bear steepener, where the long end rates go up higher than short end rates). 

The most economically sensitive part of the 2s to 30s yield curve is the belly (5-7 yrs), and after that short to intermediate (2-5 yrs), and then the 10 yr, and lastly the long end.  So what you see in a bull steepening yield curve that persists after several rate hikes is a warning sign to markets that the Fed's next move is more likely to be an easing than a tightening. 

I am looking for that bull steepening in the yield curve that lasts for several weeks as the first sign that the trend in the bond market has changed and instead of making higher highs in rates, we will be making lower lows.  We still have not seen a sustained bull steepener during this rate hiking cycle, so it is still uncertain if we have seen the highs in 10 year yields.  But once we do get that bull steepener, it is almost a lock that the bond market will be entering a bull market. 

The SKEW index is pointing to a lot of risk aversion in the coming weeks, and usually that predicts weakness more often than strength.  The uptrend looks exhausted, and a weakening bond market is another burden for stocks.  I shorted a small amount of SPX late last week, and will look to put on a bigger position in the coming days. 

China in Trouble

The Chinese yuan is getting punished along with the Chinese stock market.  China has topped out and they have started an easing cycle in earnest.  This is the first stage of a popping of a massive credit bubble.  The stock market goes down, underperforming global equity indices, and then the central bank tries to put out the fire with a hose of liquidity.

We haven't seen a divergence this wide between the Shanghai Composite and the S&P 500 performance since the A Shares bubble popped in 2015.  

And when the central bank eases, you will see the currency react, and the Chinese authorities are keeping their powder dry, learning their lesson from 2015 when they used up a huge chunk of FX reserves trying to slow down the fall in the CNH.  Now, they are letting the yuan go where it wants to go, which is much lower.  And you can't just blame it on a stronger dollar, because the dollar has been trading sideways for a month and the yuan keeps going down.  

The US stock market is ignoring China for now, but for how much longer?  Back in 2015, it eventually caught up with the S&P 500, and you had a waterfall decline in SPX from 2100 to 1840 in a week during August 2015.   And that was a market with more reasonable valuations and a looser Fed than now.  Overall, its a much more bearish picture in 2018 than 2015, which probably means the decline coming up will be much bigger than a 15% decline from the top in 2015.  

I am getting more bearish as each day passes by at this price level, I am looking to put on a SPX short any day now, with a finger on the trigger.  

Flattening Yield Curve

There has been a lot of talk about the yield curve possibly inverting by the end of the year, and how that is a recession warning signal.  That is confusing causation and  necessity.  The best recession warning signal is a falling stock market and a rising bond market.  An inverted yield curve is a near necessity when the bond market almost always acts ahead of the Fed in setting interest rates. 

The brief history of ZIRP/QE in the US has left very few precedents on how the yield curve reacts ahead of recession.  In fact, the ZIRP era has never faced a recession in the US, since it is less than 10 years old.  Thus, most fixed income analysts and prognosticators attach historical data from the pre ZIRP time period (pre 2008) to try to predict outcomes in a post ZIRP world. 

The biggest difference between now and pre 2008 is financial repression, with real interest rates kept negative to induce growth and risk taking.  In the past, even during recessions, real interest rates were positive, and were usually at least 2-3% during up cycles.  Now, you have real interest rates that are deeply negative most of the time, and only after a long economic up cycle do they get close to zero. 

So naturally, with blatant financial repression and interest rates kept too low compared to historical norms, it is harder to get a inversion of the yield curve.  Yet, that is what investors are now waiting for to predict a recession.  The Fed is even come out and stated that they don't want to see an inverted yield curve.  How often does the Fed talk about preventing an inversion of the yield curve during boom time?  Never. 

In the future, it will be rare to see the yield curve invert.  That is what happens when interest rates are kept too low, it makes it nearly impossible for bond investors to drive longer term yields below short term yields.  Japan has been a trailblazer for what a ZIRP world will look like in the future.  I recommend any fixed income investors/traders take a look at the past 40 years of JGB yield data to see how a bond market transforms when it goes from a normal interest rate market into a ZIRP market. 

In Japan, the 10 year yield has been higher than the 2 year yield since 1991.  The yield curve has not been inverted for 27 years.  According to the so-called yield curve experts, that would mean the Japanese economy was never in danger of being in recession since 1991.   Yet the Japanese economy has been at recession or near recession the whole time! 

You have Powell coming to speak in front of Congress today.  I expect the same tune that we heard from his past speeches, the Fed chairman usually tries to talk up the economy and show an optimistic picture on growth, labor market, and inflation.  But the bond market has now calibrated its expectations to Powell towards the hawkish side, because of what he's said the last 2 Fed meetings.  So it will be harder for Powell to surprise the market bearishly in the next few meetings.  Thus, I expect a bullish reaction to whatever he says today, and expect the SPX to go back above 2800 later this week. 

Breakout over 2800

Waiting for the breakout over 2800, not to buy, but to short.  Yes, the much talked about resistance level of 2800 is probably going to crack and it should be all the bulls need to forget about trade wars and declare the all clear signal.  I will be out there feeding the ducks over 2800, looking at shorts around the 2820 level. 

The high put call ratios once again marked a bottom, as anything with the word "war" in the headline automatically scares investors, even though it has negligible influence on earnings.  It is typical for corporations to whine about even the slightest of tax increases in the form of tariffs, when they remain silent after their whopper of a tax cut.  And so much for the corporations using their tax cut windfall towards higher wages, as wage growth has been stuck around 0.2% monthly gains despite the tightest labor market in decades. 

It is corporate America's dream, having Trump take the credit/blame for policies that the corporate lobbyists are jamming down the throats of politicians on Capitol Hill.  They like to work in the background, squeezing as much as they can from Washington to minimize taxes and competition, through loopholes and exceptions carved out in the tax code, as compensation for financing the campaigns and golden parachutes of the members of the deep swamp. 

Anyway, it is no coincidence that the vast majority are howling over these Chinese tariffs and fear mongering hard on the trade war, as they have been brainwashed by the corporate lobby machine.  The post 2000 bubble economy (2000 to present) has proven to be a huge winner for capital, and a huge loser for labor.  The key pillar of that is global labor arbitrage, which effectively eliminates any leverage that labor had, and keeps wage growth low.  The growth of mergers and acquisitions due to weakening anti trust legislation which helps create oligopolies is another.  Globalization is great for US corporations but not so great for US workers. 

These selloffs and rallies are starting to remind me of 2015, technically.  From a sentiment perspective, investors are more bullish now than at the top in 2015.  Economically, it can be argued that it is stronger now than 2018, but only from a short term point of view.  Longer term, higher interest rates, higher leverage, and higher valuations make this a much more toxic situation than 2015.  But markets trade on the short term, which provides opportunities for those that trade on the long term.  Long term, this is the time to find assets that benefit from a slowdown, not a boom.  It is too late to bet on a boom and have positive risk/reward. 

Scary $200B Tariff Headline

Here comes another scary headline:  Trump plans tariffs on $200 billion in Chinese imports.  They forgot to mention that the tariff is a measly 10%, or $20 billion.  $20 billion doesn't even get you a week of QE in this day and age.  So with 25 percent on $50 billion and 10 percent on $200 billion, that adds up to $32.5 billion in possible tariff taxes.  By comparison the tax cuts and government budget bill are $550 billion and $150 billion per year of fiscal stimulus for the next 10 years.  So $700 billion vs. a possible maximum $32.5 billion. 

That is why the US market is shrugging off the trade war.  Its a lot of fear mongering from so-called financial analysts who parrot each other.  Now I am sure there will be those that say look at the reaction to the news in after hours yesterday on the $200 billion in goods waiting for tariffs.  However, the SPX is still trading near the highs post February.  Trade war sounds scary, just because it has the word war in the headline.  This is not a war, it is just taxation of certain imports, which is completely overwhelmed by more than an order of magnitude by the tax cuts earlier this year.  But you will never hear that on CNBC or any of the other financial networks. 

I am long term bearish for various other reasons, and this trade war has been a red herring obfuscating what really matters for this market. 

Trade War Hype Fading

It was a bunch of hype, and blown way out of proportion.  $34B in tariffs, which is likely to be backtracked or put in a deal to get favors from China.  If you think Trump is going to shoot himself in the head and tank these markets with these tariffs, you have forgotten the past 18 months, where his report card has been the stock market. 

The stock market will have to fall on its own weight, not some self inflicted policy error.  Although the Fed tightening too much could be considered a policy error, its only an error if you think popping a bubble before it gets even bigger is worse for long term growth than letting the bubble get as big as possible before it implodes on itself. 

The SPX is now back towards the recent highs before the whole trade war fear mongering dominated the headlines.  I expect the market to try to break 2800 and squeeze some shorts this week, before topping out around 2800-2820.  And then it should go back down towards 2700.  I haven't put on any shorts yet, but I am waiting for a few more days to pass before going in.  Any sales around 2800 should be profitable by August. 

In bonds, there isn't anything interesting going on.  The volatility has gotten even lower, and 10 year yields look like they have topped out and are consolidating the big move earlier this year.  Since I am leaning bearish on stocks, I am leaning bullish on bonds.  But unlike past risk parity friendly markets, this time, I have a hard time seeing bonds going up much at the same time stocks are going up.  So it is a harder market to be profitable in when bonds need to rely on equity weakness to find strength.  One big positive is the flattening trend has continued and long term, that is bullish for Treasuries, all across the curve, not just the long end. 

Counterintuitive Move

The jump up in the S&P 500 futures on the start of tariffs was a classic counterintuitive move.  You have a well known deadline that traders are supposed to be fearful of, and obviously, most will either be fully hedged going into that date, or have sold some of their longs going into it.  Thus, when the date finally arrives, all those who were scared of the tariffs and the escalation of the trade war have no more stock to sell.  Leaving just the strong hands holding stock.  That is why you are getting this lift higher on tariff day.  It is not what most traders expect, and it causes 1. short squeeze 2. fund managers who add back exposure to keep up with the indexes. 

I expect the market to drift higher in the coming days, we had higher put/call ratios for several days, and there was enough pessimism and weak hands taken out for this market to climb this wall of worry (trade war) again.  I am by no means bullish long term, but the trader in me knows how post-event trading usually goes.  I will consider a short once the FOMO money and shorts have bought back their stocks.  It should take about a week.  In the past, it would take a lot longer but there is such a fear of missing out on further upside that most of that sideline money will be urgent to get back in. 

It is interesting to see Treasuries are stabilizing just above 2.80% 10 yr yields.  With the continuous flattening, it is clear that the bond market is leaning towards lower yields this summer.  Global bonds are clearly back into a strengthening mode, as the Bund is back to 0.30%.  The global economy is slowing, and the US markets can only ignore that for so long before it catches up and causes Treasuries to strengthen. 

Building a Top

We are currently in the top building phase.  The last 2 weeks have been your first scare after a 2 month rally.  Usually these pullbacks don't last this long, so it is a worrisome sign.  But at the same time, the damage is being contained to 3% on the SPX.  That is a bit shocking considering how weak the emerging markets and even Europe are trading.  All the risky investment flows have been flowing into US stocks, and that is proving strong support during these "scary" trade war headlines. 

I don't have much too add on the trade war.  It is much ado about nothing.  But that doesn't make me bullish on stocks.  I am bearish on stocks for other more important reasons, which the news driven fund managers are not really thinking much about.  Overvaluation, tighter money, thin but wide bullish sentiment, etc. 

We should have one more rally off this pullback, as the past several trading days have seen traders load up on put protection, so that should keep the market afloat for the next week or two.  After that, I would expect the selling to come back, and with more vigor, with SPX 2600 probably taken out sometime in August or September.