Setting Up for a Sell in January

There are a few things going for the SPX bulls that will last till the end of the year: 

1. Stock buybacks, which are large in December, averaging 10% of the annual buyback volume.  January averages 3%, the smallest amount for any month.  So we go from a big stock buyback spree in December to almost no buybacks in January. 

2.  Reluctance to sell stocks with big gains in the final 2 weeks of the year to delay capital gains taxes for 1 year.  This effect will be gone by January 2. 

3.  Portfolio window dressing for year end, after a big up year, most fund managers are reluctant to reduce their longs and want to show that they have a lot of long exposure at year end to their investors. 

4.  Seasonally, the last week of December is very bullish.  A significant part of that is psychological, as investors are in a better mood and less likely to sell. 

So why do I think it is setting up for a sell in January?  Because when you push things higher in December due to deferred selling due for tax reasons, stock buybacks, and seasonality, that gives you a bloated market that is higher than it should be. 

I have to admit that I didn't expect this kind of strength in the SPX in November and December.  I expected much smaller gains, but I underestimated how many weak hand investors were just waiting to buy once the US/China phase 1 trade deal was finalized.  Those fast money/weak hand investors are the ones that have been buying over the past week.  That sets up the SPX to a window of vulnerability in early 2020 when the above mentioned bullish factors disappear and the Democratic primaries get closer. 

The best time to put on an SPX short is probably December 30-31.  Waiting patiently and seeing a lot of opportunity on the short side next year. 

US/China Trade Tunnel Vision

It seems like traders have a really bad case of focusing on one thing, and the thing isn't even that important from first order effects.  I would like to offer a controversial take on the US/China tariffs.  They are equity market positive because they are bond market positive. 

The total value of the tariffs imposed on China is $88 billion, but that doesn't take into account the farm aid given out since the tariffs went into effect, which adds up to $28 billion.  So its a net $60 billion tax, which can easily be removed by either Trump or a new President after 2020 election.  The US government is running over a trillion dollar budget deficit, reducing that deficit by less than 6% with some tariff taxes seems like a pretty minor effect, no? 

And what has the Fed done after the markets took a dip in May and August?  3 rate cuts and QE4 or, QE lite, whatever you prefer to call it.  Of course, the QE was not called QE but just some massive buying of T-bills masked as repo operations to keep short term funding rates closer to Fed funds.  The reason you are getting the higher short term funding rates is because of the trillion dollar deficit, not because of some "plumbing" problems as some pseudo experts like to call it.  There were no "plumbing" problems when the budget deficit was half of what it is now, all of a sudden, the regulatory capital requirements is too burdensome and banks don't want to lend at Fed funds rates anymore? 

No, the banks are stuffed to the gills with T-bill paper, and that is tying up their reserves, so less money to go around for short term funding. 

And since the Fed is always going to come to the rescue whenever the market has a temper tantrum, in effect, big budget deficits in the future that naturally result in higher short term funding rates due to huge amounts of extra T-bill supply will be monetized by the Fed.  That is why in the short term, big fiscal stimulus is dollar positive, in the long term, it is dollar negative because it eventually leads to money printing.  That is in the first page of the Banana Republic 101 textbook. 

Anyway, the Fed has overreacted again to short term equity market weakness and come to the rescue.  That is why we are having a risk parity party this year, why SPX is making new all time highs, while the bond market remains strong. 

The good news for traders in the long term is that stock market overvaluation sets up future volatility which should make things interesting for 2020 and 2021.  This bull market is unlike a lot of the past bull markets because it is being fueled by stock buybacks and not retail and institutional inflows.  So the only way to get a sustained bear market will be to weaken the cash flows at corporations enough so that stock buybacks are reduced.  That can either happen through a weakening economy and thus weaker revenues and earnings or through higher taxes.  If a Democrat wins in 2020, there will be a lot of pressure to fund spending by increasing the corporate tax rate and income tax rates on the rich. 

So if you think the Trump Twitter bombs and trade news headlines are nervewracking, wait till the market reaction to the release of Presidential poll numbers and Democratic primary results.  2020 and the election will make 2019 and the US/China trade war look like a walk in the park. 

Fundamentals: What Me Worry?

This may be the trickiest stock market of all time.  Usually when you have a stock market bubble, with extreme overvaluation, there is a lot of euphoria surrounding it.  There is nothing close to a feeling of euphoria.  Even when stock investors were at their most optimistic, both in regards to the stock market and the economy, January 2018, you didn't get a feeling of euphoria.  It was just widespread complacency as volatility selling was en vogue.  Now, everyone knows that the global economy is slowing, and will be slow in 2020, but that hasn't stopped the SPX from making all time highs almost every day over the past 5 weeks. 

We haven't had a deep correction this year.  The May, August, and October pullbacks all stopped after 6-7% moves.  What was more surprising during those downturns was the reaction to them, instead of treating them like a normal pullback with relatively little fear, there was definite sense of gloom during those brief periods. 

Some are saying that the recent breakout higher in the SPX is because Elizabeth Warren is falling in the polls.  I don't think traders and investors are thinking that far out.  It still seems like everyone is focused on US/China trade, and the global central banks, to a lesser extent.  But it is interesting to see that the person benefitting the most from Warren's slide in the polls in Peter Buttigieg, who's been compared to Alfred E. Neuman by Trump.  What Me Worry? 

The only true guiding light in this kind of market is sticking with the view that the stock market will not go down hard unless the bond market is showing overt weakness.  And at no point in 2019 has the bond market shown overt weakness.  Therefore, you could never be short with conviction.  That is why I rarely tried to short this year, sticking by the conservative principle that there must be real bond market weakness before you get real stock market weakness. 

Those who have ignored the bullish signs coming from the bond market have probably shorted stocks regularly this year, seeing the stock market go up despite a weakening economy, no earnings growth, and high valuations.  More and more, the economy is having less of an effect on the stock market while the bond market is having a bigger effect.  This makes sense when you realize that debt has grown enormously over the past 20 years while the financial markets have become more closely aligned with the economy.  With very low population growth and almost no productivity growth, you have a moribund economy that can only find growth through financial repression, i.e., forcing investors to take more risk and increase the velocity of investment capital by going from Treasuries to corporate bonds and then to stocks and private equity.  That push is fueled by the central banks buying the Treasuries and MBS, giving investors the cash to buy riskier assets. 

So naturally, lower bond yields will keep the Ponzi scheme going longer as corporations have lower interest payments, and can issue more bonds at less interest expense.  Those bonds being sold to investors helps fund the massive stock buybacks which are the backbone of the demand for stocks in the SPX.  But at some point, bond yields are so low that unless they go negative, (very unpopular and unlikely in the US as they hurt the banks), you aren't going to have a meaningful impact on investor behavior with incrementally lower yields.   We are not at that point yet, but I would guess that if 10 year yields get below 1%, further decreases in yield will have diminishing positive effects for stocks. 

At that point, earnings will be all that matters, and that will be dependent on economic growth and margin expansion, both which don't look to be future positive catalysts for stocks. 

If we step back from the news cycle and take a long term view, there is really no good place for a long term investment in either stocks or bonds.  Which means that you can't sit on a 60/40 stock bond portfolio and ride the risk parity gravy train like you have been able to for the last 35 years.  And when investors are not making money, they get more nervous, and volatility rises.  So that should make the next 10 years much more volatile than the previous 10 years.  2009 to 2019 has been a great 10 years for long term investors.  It hasn't been so great for most traders.  Even with all the quants and HFTs making the markets more efficient, it should be a more favorable environment for traders in the coming 10 years when investors are dealing with losses more frequently.   Nothing provides a catalyst for volatility like losses. 

Of course, the global central banks and governments could go on an MMT printing and spending frenzy over the next 10 years and make everything go higher in nominal terms.  While I see that as a distinct possibility in the US, I doubt that has the support from citizens in most other countries. 

First day of December, and we are seeing one of those rare days where the bonds are noticeably weaker while stocks are flat.  If we get further bond weakness while stocks trade either sideways or down, it will be the first sign that we are making a top.