Tariff Out of the Blue

Well, that was random.  Trump pulled that one out of the rabbit's hat.  With the limited cards that he can play without having to go to Congress, the good ole tariff card was pulled out. 

Are we going back to the 1930s with the tariffs?  No, because back then, trade protectionism was popular.  Now, clearly, with the 15 minute attention span of the public, any negative reaction in the stock market makes it unpopular.  Which means that these tariffs that are popping up left and right will either go away before November 2020, or we will have a Democratic president starting in 2021. 

In either case, the tariffs will be removed.  But here is the thing.  The economy is going downhill over the next 2 years, regardless, tariffs or not.  Tariffs will just give it that little extra push down the hill, so instead of going downhill at 55 mph, it will be 60 mph.  The destination is the same, the speed at which it gets there will be slightly different. 

There is a perfect storm brewing which has little to do with the trade war, and lot more to do with the fading fiscal stimulus, limited monetary easing ammunition, increasing equity supply from big IPOs, and business cycle that is ripe for a down leg.  The Fed going from 2.25% to 0% will not be enough because that will probably only take the 10 year yield down to about 1.5%, which isn't going to be a game changer from the current 2.2%. 

There is no natural demand.  It will be up to governments to run huge budget deficits and have their central banks do full blown QEs to keep this ship afloat.  It will happen of course, we've seen that movie before, but the Fed will probably wait until its too late before they go full blast with the liquidity. 

The best potential opportunity for a trade is to get good news on the trade war, and have the market rally for a couple of weeks.  At that point, you can set up a free fire zone on the short side. 

It looks about as bad as it can get with the news flow.  There is probably an oversold bounce coming next week. 

Covered Up by Fog of Trade War

Sometimes you just miss the entry.  Being overpatient can lead to too many missed good trades.  But this bull market has punished early shorts for most of its duration, so I took the cautious approach.  And who knows if this market would have dipped down so hard if not for the sudden tariff threats from Trump on May 5th.  It was right on the cusp of a monster short, but headlines got in the way this time. 

Although in my view, the long term trade to make is to be short US stocks (not even emerging markets or Europe anymore), because that is where the most overvaluation and the rosiest outlook is priced in. 

Shorting is not easy, because inherently the market has a tendency to rise over time, so you are fighting the odds, as long as valuations are not excessively high.  But these are one of the times where valuations are excessively high. 

There are some clues over the past few weeks, non trade war related, which are flashing red lights on this bull market.  First is the performance of the most economically sensitive sector, semiconductors, SMH ETF, compared to defensive sectors:  utilities ETF, XLU, and the consumer staples ETF, XLP. 

As you can see, the utilities and consumer staples are both up ~6% over the last 3 months.  Semiconductors are down ~4% during that time period. 

Another sign of a weakening economy is the 5-30 yield spread.  That is now ticking 62.5 bps.  It started the year around 50 bps.  The spread was in the 20s for much of 2018.   Bull steeping in bonds is one of the last signs you get before the crap hits the fan in the economy.  That is what happened in fall of 2000 and fall of 2007.  1 Year chart of the spread below.

The trade war is a distraction for what really ails this market, an economic slowdown.  Eventually it will show up with the dollar weakening as the interest rate differentials get pressured lower.  The best opportunity for short sellers is for a equity market squeeze higher on a trade deal, because it is not going to affect the economy as much as people think, and that would get rid of the last positive catalyst for this market. 

I am not going to get into game theory or trying to get into Trump and Xi's head, like the other 5 minute macro traders are busy doing.  All I know is that the market is very nervous about the trade war, which means that there will be an asymmetric response to positive and negative news.  Positive news will have a much bigger impact on stocks than negative news at this point.  That is the only enemy of the bear at this point.  All the fundamentals, even with a trade deal, favor the bears.

Delaying Tactics

Yesterday, Trump started to feel some heat of the backlash against tariffs and he relented by delaying auto tariffs for 6 months.  It is a preview of things to come with China.  It has been my view that this 10 year old bull market will end with a whimper, on no news and no blowoff top.  Ending with just classic chop at the top with a saturation of demand for risk assets leading to a lasting downtrend. 

The trade war started by Trump at the height of the stock market in early 2018, was initiated with confidence and a belief that the US stock market was invincible, and could withstand tariffs on China.  That ended up being true, because the SPX ended up making higher highs, and only was taken down by higher interest rates and hawkish talk from Powell. 

The whole strategy of Trump is to threaten and then delay, delay, delay, and then threaten and delay, delay, delay.  He wants to score political points by being tough on China, without the pain of a lower stock market from higher tariffs.  So what would be his ideal strategy?  Talk tough, threaten China, and then delay and delay to placate the stock market. 

Right now, we are in the talk tough and threaten phase of this trade war game.  The next phase will be to delay and act like there is progress by having talks with China to try to boost the stock market. 

A clue to yesterday's comeback from another gap down open was not the headlines on auto tariff delays, but a super strong bond market which protected fund managers via risk parity.  When bonds are falling, stocks are on their own, but when bonds are rising strongly, that is a wind at back of fund managers, as they have protection from their bond proxies and fixed income holdings. 

That is contrary to the 5 minute macro analysts out there who think that a strong bond market signals a weaker economy, and thus a weaker stock market.  It doesn't work like that anymore.  This isn't the 1980s.  With the business cycle all but killed by central banks, the economy is basically in a static state of low growth, so a strong bond market doesn't signal much, except that investors are making money on their bonds which provides them protection and makes them less likely to sell their stocks. 

China Patience

China is in no rush to make a trade deal.  Their backtracking on making changes to Chinese law shouldn't be a surprise.  It would have been a surprise if China gave up their legislative powers to the US just to get back to the status quo of no tariffs and free-for-all technology theft and piracy.  China, unlike the US, is willing to blatantly intervene in their stock market to support consumer confidence.  Xi doesn't have to worry about elections or the economy.  He is president for life.  He is on a completely different time table than Trump.  Trump is worried about the economy in 2020 because that will determine his fate in the next election.  Xi is only worried about securing his power, which he has a firm grip on.  Just like it is popular for Trump to be tough on China, it is popular for Xi to be tough on the US.  The Chinese are much more nationalist than Americans, so it is an easy sell to the Chinese public to wage a trade war with the US that they can blame Trump for starting. 

From a game theory perspective, the only way a trade deal gets done is if Trump caves in and signs a weak US China deal that doesn't really change anything.  And that is what the market wants and is expecting.  Its just that the time line for that getting done has been extended, since the only real catalyst for a deal is a weakening stock market, which will make Trump more anxious to do a deal. 

Paradoxically, a weaker US stock market will eventually lead to a higher US stock market.  If the SPX stays above 2800, Trump will feel comfortable enough to drag this out and hope that China blinks.  But China won't blink.

SPX is on a mission to test 2800, the last support zone during the post March FOMC pullback.  The market is in show me mode now, the BS about constructive talks is not going to do it anymore when the actions speak much louder than words (China just retaliated with their own set of tariffs on US goods starting June 1).  The uncertainty on trade is toxic for this market, and hedge funds are long enough that they will be forced to puke out their positions lower, and won't be able to buy the dip. 

Expecting a test of SPX 2800 this week, likely sooner than later. 

Trade War for Dummies

Promise a great deal.  Extend deadline.  Get mad.  Add tariffs.  Promise another great deal.  Extend deadline.  Get mad.  Add more tariffs.  

We were supposed to have a trade deal with China already and the SPX was supposed to top out and selloff after the good news spike.  Instead, we are getting the worse possible outcome if you are a bear.  An extension of a trade deal positive catalyst, kicking that "positive" catalyst can further down the road so the market can still have that carrot hanging in front of it.  The supposed nirvana of a stock market that doesn't have to worry about a trade war and can keep going higher because Powell folded like a cheap lawn chair and promised not to raise rates.

You have to give China credit for waiting Trump out, making him mad, and realizing that the US consumer will just bite the bullet and buy cheap Chinese goods because even after a 25% price hike, its still cheaper than the alternative.  At least until US corporations move their supply chains to another country, something that will take years to get done, and probably something they would rather not spend money on, instead focusing on more important things, like using their cash on stock buybacks to boost stock prices so insiders can dump shares at inflated prices, and to meet stock price based incentive bonuses.  

Don't expect a trade deal anytime soon, as long as the SPX stays above 2800.  If we start going down violently, which is possible because this market is so overextended and it seems like hedge funds are finally back in the pool, then you can start thinking about Trump panicking and putting together a China friendly deal he will brag about as being a great deal.  

Expecting weakness in the 2nd half of the day, no one wants to hold longs over the weekend, with most now realizing there will be no trade deal progress.  The Chinese are waiting it out, shrewdly, to get under Trump's skin and force his hand.  

Crocodile in Wait

Staying underwater, waiting days and weeks for the kicking legs, conserving physical and mental energy.  This is the life of the cold blooded predator.  Let the eager shorts go after the hard prey, the fast and healthy.  We wait for the easy prey, slow and hurt.  This bull is old as sh*t, but still healthy as a horse. But there are some signs of weakness creeping in.  Like the point guard whose lost a step and can't get by his defender like he used to.  Like the quarterback whose lost a little zip on the long ball and can't hit his receiver on time on deep throws.

Up until Powell opened his mouth last week, the up trend off the December 24 bottom has been too steady and strong for there to be a good risk/reward short.  

But over the past several days, we got a few good signs that this up trend is getting closer to the end.  

1.  We broke out to a new all time high, but came right back down under 2900, in volatile back and forth action over the last week.  A fake break out.  

2.  The Fed told the market that it isn't ready to do a preemptive rate cut, which is what the bond market and the equity market were both starting to expect.  That increases the likelihood that the Fed will keep rates too high for too long until the US economy reaches the point of no return and heads downhill.  

3.  Bonds have stopped going up along with stocks.  This is the big one.  Since 2000, you have had drops of greater than 20% in the SPX only when bonds were going down while stocks were going up.  In spring of 2000, summer of 2007, and spring of 2011, you had bond market weakness while stocks were going higher before waterfall declines a few months later.  

One of the main reasons stocks continued to go higher so relentlessly this year is because bonds were also rallying at the same time.  That is straight out of the early 2016 playbook.  When risk parity is working so well, there is no incentive to sell stocks when bonds are acting as a perfect hedge that provides both interest and capital gains even while stocks are going up.  

Unlike what most paper napkin/5 minute macro experts think, a weak bond market is not a sign of a healthy stock market, it is a sign that monetary policy will be getting tighter to fight the up trend.  Conversely, a strong bond market is not a sign of an unhealthy stock market fighting economic fundamentals, because it means that monetary policy is getting looser even as the stock market goes up.  

It has only been a few days, but I am finally seeing the relentless bond rally since November 2018 slow down, just as the SPX is at nosebleed levels, with complacency rising, and as the uptrend is starting to flat line.  If the SPX stays under 3000 for the next 2 months, that will probably mean that the equity market is saturated with bulls and the weakening economic fundamentals will come to bear on the market.  

With so many hedge funds underexposed to equities during this relentless rally, they will be adding exposure and providing buying support on pullbacks for the next several weeks.  But once that phase is over, and hedge funds are back to normal to high exposure levels, the SPX will be vulnerable to a waterfall decline like December 2018.  That is the time to start the short campaign.