In Fed We Trust

Throughout the madness this week, it makes you wonder what is driving the sudden burst of speculation the last couple of weeks? 

Its not what I think that matters, its what the majority thinks that matters.  And it matters until there aren't anymore people willing to come to the majority view, and then pendulum swings back the other way.

And the majority right now are expressing their optimistic view loud and clear in the options market. It is so extreme that I find it hard to imagine even more extreme bullishness with the economy so horrible.

Take a look at the call volume this week, and I want you to compare to other periods of high call volume. 

 June 1 - 5, 2020

 January 8 - 17, 2020

January 12 - 26, 2018

January 12-26, 2018 period was the 2 weeks right before the SPX fell off a cliff, going from 2872 to 2530 in less than 2 weeks.  January 8-17, 2020 period was followed by a grind higher and then the SPX fell off a cliff, going from 3390 to 2174 over 5 weeks. 

And this time, the call volume is considerably higher(look at the June 3 - June 5 volume) and the put/call ratios are lower.  This is historic levels of call activity, rampant speculation that surpasses anything since 2000. 

The current zeitgeist of investors is the stock market has to go up because the Fed is printing so much money, and if there is a correction, the Fed will just print even more money to rescue the market.  Not only do a lot of investors believe that there is a Fed put, they also believe there is a Fed call, where they are actively trying to push the stock market higher, even after a huge rally. 

Here are the facts:  The Fed is not buying stocks, they are buying bonds.  And while there is a certain benefit that lower corporate spreads and overall bond yields have for corporations, it doesn't eliminate solvency risk.  Yields are already so low that incrementally lower yields has only marginal benefits for the borrowers.  And these low yield spreads guarantee losses in a deep recession like we are having now.

All the Fed liquidity allows is for companies to issue even more bonds, but the money borrowed has to be repaid, plus interest.  So ultimately, businesses have to generate enough cash flow to cover interest and repay principal, or get even more into debt.  The corporate sector is already highly leveraged from a historical perspective. 

Highly levered companies are more vulnerable to a recession, and if the recession is long and severe enough, it will force them to raise capital with either more debt or equity.  That's why you saw a mountain of debt and equity issuance over the last 2 months.  Most of these companies are choosing to issue debt rather than equity, and the reason is obvious.  The company insiders don't want to dilute and hurt the stock price, which a lot of their compensation is based off of.  It just makes these companies more fragile as more debt is piled onto the balance sheet.  Eventually, the debt market will shut them off and force them to either dilute massively and/or provide super high yields to buy their debt.  It is a debt house of cards.

The change in investors' attitude towards risk over the past 10 years is astounding.  Who would have thought that investors would now chase bankrupt companies like HTZ and frauds like LK and ramp them up hundreds of percent in days?  These kind of speculative manias always end badly. 

The timing has been difficult, as this steep rally has gone beyond a lot of people's imaginations.  It is one thing to go up 9% in days right after a panic bottom, that's rather common.  What's unusual is going up 9% in 9 days right after a 2 month period of going up 40%. 

The corporate insiders have been dumping a lot of stock into the rally.

All the signs are there that an important top is being formed now, something that will lead to a huge selloff.  We are well past the point of playing for small moves.  If you have been short and in pain, covering early on the next downleg is a mistake.  These type of parabolic rises/blowoff tops have sharp selloffs:  see January 2018, February 2020 for 2 recent examples.  And if you want to go back to the old days, numerous blowoff tops in 2000, bear market rally blowoff tops in 2001 and 2002.

Its no longer a time to play for singles and doubles.  We are now looking for home runs.  When you get a fat pitch like this, you swing for the fences.