Trade War Headlines

There has been a pattern to these trade war headlines that some observant traders will have noticed.  In general, when the market has been rising for a few days, near SPX technical resistance levels, a negative trade war headline usually pops up and brings the market down quickly (last two Fridays).  Then a positive trade war headline shows up during low liquidity hours or over the weekend (last two weekends).  On triple witching expiration day, Friday September 20, the China canceling the Montana farm visit dropped the SPX 25 points in a flash, then the White House denied that China canceled and said it was the US that canceled.   Same with the China investment ban headline.  Also denied over the weekend. 

The White House is treating the US stock market as their personal piggy bank manipulating the markets regularly and profiting through offshore corporate shells that are trading on their behalf.  I don't wear my tin foil hat much, and almost all conspiracy theories are bogus, but the amount of market manipulation based solely on US/China trade headlines is unprecedented.  It puts to shame any kind of trial ballooning that the Fed used to do to test the effect of certain policies. 

If the White House is putting out these trade headlines and profiting from them through trading them through offshore accounts in other people's names, then they have no incentive to make a decision on a trade deal.  The ideal situation for them would be to continue to keep the market on its toes, providing a sliver of hope, and then taking it away, escalating tariffs, and then delaying them.  Politically, making a trade deal with China only benefits Trump if the stock market continues to go higher after the deal.  There is no guarantee that will happen, especially if a trade deal is accompanied by a more hawkish Fed. 

Most people are skeptical of a long lasting US-China trade deal, and rightfully so.  So expectations have been lowered quite a bit.  That means a mere delay of some Chinese tariffs that were recently introduced should be enough to provide a relief rally.  At this point, the best strategy for both sides would be kick the can on tariffs and agree to future talks with nothing concrete happening. 

SPX is stuck in a 2950-3000 range for the past week.  The pullback from the trade war optimism of 2 weeks ago makes it less likely that you will get a sharp drop if the US and China don't agree to do anything.  The trade talks are scheduled from October 10-11, so there will be a lot of fast money traders that will look to get out of their positions before that date.  Since it seems like most of the fast money is short, we could see some short covering a few days before October 10, so it could start late this week/early next week.  If there is another dip down towards 2950 this week, I will consider a small trading long position.

Triple Witching Hangover

This week is turning out to be a classic post quarterly options expiration week.  The artificial buying pressure late last week after FOMC has been taken back plus more as the fund managers' puts expired out of the money.  It is going to take a few more days of nervous trading for the investors to get back to their normal level of put protection.

Also, it has been 1 month since the triple bottom around 2825 was hit on August 26, so the tailwind from fund managers getting back to their normal level of equity exposure is gone.  It doesn't mean the uptrend is over, but the probabilities are more even for up or down price movement.  We are in a chop zone and it favors the counter trend traders for the next 2-3 weeks.  After that, we'll probably go back to trending higher if the bond market cooperates and doesn't selloff too much.  Anything under 1.90% 10 year is enough to provide support for equities for the remainder of the year, as the fundamentals aren't bad enough to cause a sustained equities selloff with interest rates this low.   

The impeachment news is a distraction, as everyone realizes that Trump will not get impeached with a Republican majority in the Senate.  The House can call for impeachment, but the Senate will decide not to do it.  The impeachment has no impact on the US China trade deal, the Chinese were never going to give what the White House wanted, and some agriculture and pork/beef purchases won't be enough to get Trump to roll back the tariffs.  Its probably enough to keep tariffs where they are and avoid further escalation.  It seems both sides would rather just kick the can and keep things where they are, instead of giving in to the other side. 

Neither the long side or the short side excites me here.  If I had to put on a trade, I would reluctantly be a buyer of SPX around 2950-2960 support, and be a seller around 3010-3020 resistance.  The positive for the market is the low expectations for a US China trade deal, so there won't be much disappointment if nothing major happens.  The negative for the market is long term weakening earnings growth and overvaluation. 

Various Thoughts

1. When traders learn a pattern over an important event (FOMC meeting) and prepare for that event as if things will repeat, then the pattern is less likely to work.  The pattern was to sell ahead of the FOMC meeting and buy the dip a few days later after Powell disappoints and Trump ignites trade war angst.  

Ever since Powell has been FOMC chair, the performance of the S&P has been weak, much weaker than an average trading day.  But this time, Powell disappointed with a rate cut and no promise of future eases or repo facilities or whatever else the market dreamed of.  After the initial fakeout dip to draw in the Powell bears, we had a face ripper into the close.

2. One of the most popular hedge fund trades is to bet on an extended rate cut cycle via long Eurodollar futures and call options.  The December 2020 Eurodollars futures contract settled yesterday at 98.45, which is pricing in a LIBOR rate of 1.55% at the end of next year.  LIBOR-OIS spread is usually between 10-40 bps, with occasional spikes higher above 40 bps.  So assuming about a 25 bps spread, that is pricing in a Fed funds rate of 1.30% by the end of 2020.  

With the current rate at 1.88%, that's pricing in about 2.3 rate cuts (58 bps) over the next 15 months.  While I don't disagree with the long Eurodollar futures trade, a better way to make that bet would be to just go long 2 year Treasury notes at 1.74%.  If the Fed cuts 58 bps, the Eurodollar trade breaks even.  However, the 2 year note yield would definitely trade much lower than the current 1.74%.  

3. A lot of traders and investors are reluctant to be long stocks and are long bonds because they fear a recession in 2020.  I don't agree about the recession call for 2020 because of the lack of overcapacity, lack of commodity inflation, and the huge budget deficits providing a lot of fiscal stimulus to the US economy in the background.  But I do agree that being long stocks is a bad risk reward now, not because of recession risk, but because of high valuations, no earnings growth, and political risk.  Political risk is not the trade war, but the risk of Elizabeth Warren becoming the Democrat nominee in 2020, with betting odds favoring her to beat Trump in the next election.  

Lower Bar for Powell

Wall Street has a short memory, but the memory tends to last longer when they are associated with big down days and the beginning of a sharp decline.  Almost every trader will remember that the August selloff was kicked off by a less than dovish Powell, and his mid-cycle adjustment comment, and the bear ball went further down the hill with the help of some Trump tariff announcements.  

That August selloff has all been taken back by the stock market.  But with the FOMC meeting closing in, with the accompanying dotplots and the Powell press conference, short term traders will probably be leaning bearish going into the meeting.  That means that expectations from Powell are much lower this time than back on July 31.  Powell has a lower bar to jump over to please the market this time, which makes it a bad risk reward proposition to be short going into the FOMC rate decision.  In fact, I see a higher likelihood of a short term pop rather than a short term drop after the Fed announcement.

There are also opex forces at work this week, with a bullish bias going into the quarterly options expiration.  The Saudi oil news and subsequent pullback probably provided enough fuel for a run higher into the Friday cash open SPX options expiration.  Market makers are usually short options, especially put options.  Although they hedge their exposure, they stand to gain more if markets go higher into the expiration, not lower.  

At current SPX levels of 3000, investors don't seem to be leaning bearish or bullish.  Other than the factors mentioned above, there isn't anything else that really presents an edge here.  The Saudi oil news is relevant for oil, and that's about it.  Oil doesn't really matter to the broader economy anymore because its only a small percentage of consumer spending.  And higher oil prices helps the oil producers just as much as they hurt oil consumers, so it mostly evens out in the stock market.  

Flashback of 2015

Just like 2014, 2019 has provided a huge rally in both the stock and bond market, feeding on the blood spilled by the bond bulls in the prior year (2013 and 2018 respectively).  That sets up a payback period in the following year, usually triggered by a big bond market correction.  In 2015, the correction happened from February to June.  In 2019, it is starting in September.  And it is likely to last a few months, so bond bulls, be prepared.  It will be choppy trading over the next 3 months. 

The top chart shows the SPX and 10 year yield overlapped from March 2014 to March 2015.  The bottom chart is the SPX and 10 year yield over the past 12 months. 

What isn't shown in the chart is what happened over the next 12 months.  And boy were they a rocky 12 months.  From May 2015 to August 2015, the SPX went from 2132 to 1867.  If 2019/2020 were to follow the same script after the bond market rally ended, it gives the market about 5 months before the bottom falls out of the market just like August 2015.   That approximates to February-March 2020. 

Nothing follows a script exactly, but the general concept is that bonds will no longer provide that great hedge against equity selloffs like it has over the past 9 months.  That eliminates a vital hedge which prevented investors from fully panicking out of the stock market during periods of weakness. 

So the stock market is now like a ticking time bomb ready to go off without notice, now that the low interest rate fuel has been used up. 

In fact, the August 2015 selloff was accompanied by a rather meek bond market rally, with the 10 year dropping only about 35 bps during the August 2015 waterfall decline. 

With the overvaluation being much greater now than in 2015, it is easy to imagine a waterfall decline in 2020 to be much steeper than the August 2015 decline.  There are a number of triggers that I can think of right now which will do it, the main one being the Democratic primary winner being either Elizabeth Warren or Bernie Sanders.  Odds of that are about 50% according to betting markets.  And the current polling shows Democrats ahead of Trump in the 2020 presidential election.  That would be a huge game changer as the main reason for the 2017 rally was a the corporate tax cuts, and a Warren or Sanders would likely raise taxes on corporations and the rich, which would be a huge negative catalyst for the stock market. 

We've had another big rally in SPX this week, thanks to positive trade talk.  Remember, the trade war is a distraction to what really matters.  The slowing economy, no earnings growth, and the potential of an anti-corporate welfare Democrat winning the White House in 2020.  There is resistance around the all time highs at 3025, but given the participation of small caps in this rally this week, there should be new all time highs coming up.  Still cautious on long term shorts, but I am getting much more constructive on putting on short term shorts because of the bond market weakness.   However, I will wait till after FOMC meeting and opex next week. 

Risk Parity Paradise

The SPX went from 2906 to 2978 in 3 days last week.  The main reasons traders cited was China yielding to Hong Kong protesters to China setting a date for US trade talks in October.  But its odd how the price action doesn't match how skeptical most investors are of a possible trade deal between US and China.  Sure, it was "good news", but most are assuming that the talks will end up achieving nothing. 

So how does the SPX go up 72 points in 3 days on nothing substantive happening?  Because the trade war isn't as important as most people think.  If the market was trading solely on how the trade war was going, the SPX would be down over 20%.  But there are other things that most investors don't think about that are much more important. 

The most important factor that has changed from now since July, the last time the market traded at these levels is interest rates.  Really, raising tariffs 5% on Chinese goods versus a 50 bps drop in 10 year yields is like comparing a bb gun (5% tariffs) vs a M16 machine gun(50 bps lower 10 year yields).  The attention is focused on the tariffs and US/China talks, but the big fundamental change since July is the much lower interest rates. 

At SPX 2980, the lower interest rates makes me more bullish about stocks than when 10 year yields was 50 bps higher, as it was in July.  It doesn't make me bullish, but it makes me less bearish. 

The above chart is beyond ridiculous and it is something that almost nobody would have forecast at the beginning of the year.  If someone told you on January 1st, that the 10 year yield would drop down to 1.42%, most would guess that the SPX would be lower than 2500, not higher, and even if it was higher, not near 3000! 

The bond market rally this year is reminiscent of 2014, when bonds rallied strongly after a bad 2013, despite an economy that was still growing, and nowhere near recession.  That year, the SPX went from 1850 to 2060, for a 12% gain, while the 10 year went from 3.02% to 2.17%.  So far this year, SPX is up from 2500 to 2980, almost 20%, yet the 10 year has gone down from 2.68% to 1.55%.  2014 and 2019 are turning out to the be 2 best risk parity years since 2008. 

If bonds sell off hard and the 10 year yield goes above 1.75%, then I will get more bearish and consider putting on shorts.  Right now, it is an uphill battle for short positions when the bond market is so strong without recessionary data.  It is almost a Goldilocks scenario for the US stock market to get such low interest rates without a really weak economy.  The US Treasury market is more reflective of global weakness than US weakness. 

Usually in markets good for risk parity strategies, like we are in now, stocks have a hard time sustaining big selloffs.  The hedging effects of a strong bond market take a lot of pressure off of money managers who don't have to panic sell stocks because bonds are providing a great hedge.  Good news for bears is that the year after strong risk parity years is usually much less bullish, mainly because most of the positive stimulus from lower rates is used up, i.e. 2015. 

It is a FOMO market now, the weak hands sold a ton in August (see the equity fund outflows data for August), making the market less heavy with supply and more likely to grind higher in the coming weeks.  There is a weak seasonal period starting from September 20 after options expiration, as stock buyback window closes until late October.  So if I want to consider a short postion, it will be after the FOMC meeting next week. 

Too Good to be True

It just seems too obvious to be short here.  Being given so much time to short at high levels, too much data to prove that the right side is the short side.  My trading gut would be giving me ulcers at this point, as the fundamentals collide with the gut feeling that there will be another WTF moment in the SPX, where the phoenix rises from the ashes AGAIN, and the bears and reluctant investors are left behind, pounding sand. 

Yes, the gut with ulcers tells me that the bears will snatch defeat from the jaws of victory.  This doesn't change the long term fundamentals of this market, which is driven by valuations, earnings growth, and interest rates.  Valuations are extremely negative for stocks now.  Earnings growth is a moderate negative.  Interest rates are a moderate positive.  That is the fundamental side. 

The technical side doesn't match the longer term fundamentals.  The stock market trades a lot stronger than it should.  And the only plausible explanation is the huge plunge in global interest rates in August, which has acted as a support system for the weakening fundamentals and news flow in the stock market.  But that support system only works because the Fed is cutting rates before the coincident economic data is getting bad.  They will not cut rates for too long if the data doesn't get noticeably worse.  So there is a limit to how much lower interest rates can go in a non-recessionary environment. 

To get a 10 year yield to 1% or below, will require recessionary economic data in the US.  And since the 10 year is already below 1.5%, the support system, pre-recession, is mostly used up. 

The reason the SPX can stay afloat at such high valuations is because pressure on the financial system from a weakening global economy has been relieved through much lower interest rates, but that release valve isn't an infinite source of support.  Once rates go down, that monetary "stimulus" is used up, and reflected in the equity market. 

We've seen 3 tests of SPX 2830-2840 support in August, with negative trade headlines recession fear mongering, and each time, support held and bounced quickly towards 2930-2940.  That is a sign of underlying strength in the SPX, and it cannot be ignored.  This technical strength is not to be used for a long term investing plan, but just a short term bullish sign that stocks are acting better than most people expect. 

Also, the Eurostoxx made higher lows on the last retest of SPX 2830-2840, signs of selling exhaustion in Europe. 

Technicals should only be used as a short term tool, not something to base long term investment decisions.  Right now, the technicals are bullish.  Fundamentals are somewhat bearish, and getting worse.  The plan is to wait for a intermediate term rally, and see what the market is like at that point, and then decide how much to short.