A Choppy 2022

There are two main types of traders:  trend followers and countertrend traders.  If you try to be both, you usually end up getting the worst aspects of each.  I've been a countertrend trader since I started.  I've tried trend following and had limited success.  Its not say that countertrend trading is better than trend following.  There are good and bad aspects for each. 

For trend following, since you look for price confirmation of strength or weakness before entering, its easier to know when you are wrong and can stop out more easily.  If the trend goes against you, you are wrong, and you get out.  Take your loss and move on.  Its part of the system.  For countertrend trading, you are going against price action and buying when its going down and selling when its going up.  You don't know if you are wrong or if you are early.  In fact, the more a position goes against you, for a countertrend trader, theoretically the better the opportunity becomes.  It makes it hard to stop out of a position and take a loss.  

So overall, trend followers have big wins and small losses but a low winning percentage, while countertrend traders tend to have small wins and large losses, but a high winning percentage.  Most traders want a high winning percentage, so naturally most traders end up being countertrend traders with a high winning percentage (selling winners quickly), but taking big losses when they are wrong (holding on to losers).  

Obviously if you were countertrend trading in a relentless uptrend and you tried to short in 2021, you had a tough time.  And as a countertrend trader, there were few opportunities to buy a decent sized dip to put on size.  2020 and 2021 were favorable for trend followers, both in stocks and bonds.  In 2022, I am expecting a change with more choppy markets, shorter trends, and more fakeouts on both the upside and downside.  It should finally be a good year for countertrend traders, like a 2015, like a 2018.  Despite the big drop in early 2020, both 2020 and 2021 were great years for buy and hold investors.  With the SPX now at nosebleed levels, and with both monetary and fiscal policy less supportive, look for more air pocket drops and fewer V bottom rallies.  Fundamentals and valuations are big negatives and it is on the back of the mind of investors.  I can sense a little uneasiness among the bulls, even if they are still fully invested.  You can feel the lack of conviction among the bulls, as the Fed will soon be raising rates and Biden is having a tough time pushing out more pork in DC.

With most investors now conditioned to be bullish on stocks no matter what, and with above average bullish positioning among speculators and households, but with conviction that seems to be weakening, you have a formula for a 2015 type market.  A lot more weak hands in the market that will be pushing the eject button when the turbulence rises.  

Added to my SPX short yesterday, still have another bullet to put in the chamber, so will add that last bullet either today or on Friday.  Getting set up for early January weakness.

Year End Surge

They faked me out.  Monday Dec. 20 was bear bait and I took it and got too bearish.  It was just a springboard to new all time highs.  Sold the long way too early, and missed out on almost 150 SPX points in less than a week.  Big mistake, but this move to all time highs and heading towards 4800 does set up a good risk/reward short for January.  I took a starter position short SPX yesterday, with plans on adding later this week.  

With investors now focused on catching the year end rally and more up moves in January, you are seeing a lot of front running of seasonal trends and a reluctance to sell from 

1. Long term investors unwilling to sell due to tax implications of capital gains in 2021.

2. Year end portfolio window dressing from hedge funds.

3. Short term year end rally chasers.

There is also a big systematic JP Morgan equity fund that does the same quarterly zero cost collar at the end of each quarter.  With their short call position deep in the money and with a delta of 1, while their out of money put spread has a delta of 0, they will reset their collar at higher strikes for both, and with the accompanying dealer hedging, dealers will end up having to buy back a significant portion of their SPX short position, probably around $10B worth of SPX futures buying that needs to be done on December 31 at the close.  

This isn't a big secret, as options dealers and institutions that are well aware of these year end flows are going to front run this event.  In liquid times with regular trading volumes, $10B of SPX futures isn't so big that it moves the market a big amount, but during illiquid periods like now, they can have an inordinate effect on short term moves.  

Looking beyond the short term, into January, there will be quite a bit of pent up selling due to capital gains tax reasons.  Also, January is a strong month for fund inflows, but a very weak month for stock buybacks.  So if you consider that a wash, then the capital gains selling pressure early in January should favor the bearish side.  With bullishness rising quickly and short term players now leaning more bullishly, it sets up a situation where short term traders are offsides and selling into any January weakness, exacerbating the down move. 

Not looking for a break down to under 4500, but I see a definite possibility of a gap fill retest towards SPX 4560, which is more than 200 points below current pumped up levels.  At SPX 4800,  I would give much higher odds of SPX going to 4560 in January than 5000, even though 5000 is closer.  Don't want to add too early to the short, letting the year end flows play out a bit more, but I am getting ready to put on a sizeable SPX short this week.  

Going long Treasuries will also work, in my view, if the SPX sells off in early January, and is probably the safer play considering the liquidity flows from funds in January, but it gives you less bang for your buck, as the reward is greater from shorting SPX at all time highs.  I would not be surprised to see 10 year yields go to 1.30-1.35% in January.  

Its another gap up in the works, the strength is immense, so waiting for the dust to settle a bit before adding the short.  Who knows how far they take this thing, this market is so unhinged from past market behavior that you can't be self-limiting in your outlook.

Positioning Going into 2022

To predict the next year, you have to examine what happened this year and imagine how investors will react to future events.  Here are the main known events for the following year:

1. Fed tightening.  Powell has finally crossed the bridge into tightening and focusing on inflation, not employment.  He's given up on the transitory lie on inflation, now that he's been reappointed.  He is so late to tightening that to maintain a tiny shred of credibility on price stability, he needs to raise rates at least once.  This will happen even if you get volatility in the stock market (see December 2015) just because his reputation is on the line.  Not only his reputation, but the political forces are in favor of the Fed fighting inflation, not ignoring it.  

2. Midterm elections.  The results of the November 2022 midterm elections are almost like a fait accompli, with Biden at a very low approval rating and the natural tendency for voters to vote against the party in power in the White House.  With the Republicans look set to take over both the House and Senate, you will start to hear talks about fiscal austerity again.  Even if they win just one of the Houses of Congress, they will stop any attempts by Biden to stimulate the economy ahead of 2024.  This guarantees limited fiscal stimulus for 2023 and 2024, which will get priced in the closer you get to the election.  I am expecting the fall 2022 to be a tumultuous season, making this past September/October look like child's play.  Something similar to October/November 2018 is very much in the cards for 2022.  

Here is how the futures market participants are positioned as of December 14, 2021.

Commercials (taking the other side of speculators) are now the most short in SPX and NDX for the past 52 weeks.  Let's take a look at how the SPX and NDX positioning looks compared to the the last 10 years:

SPX COT (Dec. 2011 to Dec. 2021)

Commercial positioning (in black), is short, but not yet at the extreme shorts of 2018.  So there is still room for speculators to get longer before you really get into treacherous territory.  

NDX COT (Dec. 2011 to Dec. 2021)

 Commercial positioning (in black) is short, but much less short than they were from 2012 to 2017.  However, current levels are similar to 2018.  

The speculator positioning will be something to watch in 2022 as it is showing investors getting bolder in taking long positions just as the fundamentals look to be getting worse.  At the very least, the tailwind of having almost no speculative long positioning in SPX and NDX futures for most of 2021 has gone away, and speculators will be feeling more pain and more likely to panic sell when you see stock index corrections.  

With the double negative catalysts of a Fed about to embark on a rate hiking cycle and a midterm election that will signal the end of fiscal largesse for 2023 and 2024, you are looking at a double whammy of monetary and fiscal tightening.  I hear the media talk about the Fed tightening, but almost no talk about the implications of Republican majority in Congress leading to fiscal tightening.  I am sure you will start hearing more about that as you get closer to the fall of 2022 and the polls start to clearly show the Republicans taking the majority in Congress.  

My general take on 2022 is the SPX topping out in early spring of 2022, with a waterfall decline sometime in late spring/early summer, volatile and wide ranges during the summer, perhaps making a double top, and then the beginning of a long downtrend and the start of a bear market in the fall of 2022. 

We are getting a late Santa Claus rally, as the market made one more scary looking dip on Monday to shake out the remaining weak hands before the year end rally.  With SPX futures near 4700, it is looking like most of the year end rally has been compressed into the past 3 days.  I am looking to get short SPX soon, as long as it is above SPX 4700.  I see very good risk/reward for a move back down towards 4520-4540 by middle of January.  Although I eventually expect the SPX to make new all time highs by February 2022, I am looking for one last scary looking dip towards 4500 in January, hopefully with lots of put buying to set up a strong rally into February.  

Expecting Treasury strength, SPX weakness starting from the last couple of days of the year and extending into mid January.  Will be positioning accordingly by early next week. 

No More Build Pork Better?

From March 2020, we've been on a relentless run of higher highs and higher lows, spending most of that time well above the 100 day moving average, and above the 200 day moving average since June 2020.  For 2021, its been shallow dips followed by steady rips.  But we've finally reached a price level where the market is struggling to make new highs, and you're seeing a sharp drop in speculative fervor, akin to what you saw in the spring of 2000, and throughout 2015.  

With the massive fund inflows in 2021, the crowd is now about as loaded up on equities, if not more than the peak of 2000, just as we're on year 12 of this secular bull market (the QE bull market).  History doesn't repeat, but it does rhyme.  And human nature has reared its ugly head again in the investment world, getting investors to get bulled up and pour almost all their stimulus money near the bubble peak.  This is setting up for a nasty long bear market in the years to come, as bubble valuations with slowing growth all but guaranteed (unless Democrats miraculously win the 2022 midterms) for the next 3 years.  

The bombshell news of the weekend is not Omicron, but Joe Manchin looking out for his political future and distancing himself from the Dems and Biden by refusing to say yes to the Build Back Better plan.  It should be renamed BPB:  Build Pork Bigger.  Its a cash giveaway and paid for with tax increases, which always gets heavy corporate pushback.  With Biden's poor approval rating, Manchin didn't want to hitch his wagon to that bus that's falling off a cliff.  Manchin may as well be a Republican at this point, he's not going to get re-elected supporting Biden.  He's in one of the most Republican states in the US, so he has to lean right any chance that he can get.  

There are some people trying to make the case that Omicron is a positive because it will outcompete Delta and other variants and make Covid milder.  Wrong.  Omicron is basically a new virus.  Its mutated so much from the original Covid virus that there is almost no immunity you get from it that protects you from other variants.  So you can have Delta and Omicron flourishing side by side.  Its not a competition.  Its just now two types of Rona that can get you.  

I don't expect Omicron to have much of an effect on the economy.  Most people have adjusted to the Covid rules and governments are going to be reluctant to go with heavy handed lockdowns due to their unpopularity.  So I expect little economic impact.

There is a popular poll done every weekend, and I was a bit surprised at the results:  

Usually after 2 straight down days going into the weekend, the crowd gets bearish.  But this was the opposite, the majority are buying the dip and expecting a Santa Claus rally.  When you see that many bulls as the market is trading weak, that's usually a bad sign. 

Despite the bearish signals, I still expect a Santa Claus rally, just because its been such a strong year in the market.  It probably starts sometimes this week, after whatever weakness you see today/tomorrow.  I would be looking to buy dips to sell rips.  You can't overstay your welcome both on the long and short side.  So when you get a good move, its better to be safe than sorry.  Better to take profits a little too soon than trying to squeeze out as much as possible from each trade and risk missing the exit ramp.  

I would be looking to buy dips down towards SPX 4520-4540 today/tomorrow, with a price target around 4650-4680 for later this week or early next week.  This bull is on its last legs, but its not going to die quietly.  Its going to go out kicking and screaming. 

Violent Swings

The S&P 500 is lingering close to all time highs but the intraday swings have gotten more violent.  Technical analysis 102:  Volatilty at the top of the range is bearish.  Volatility at the bottom of the range is bullish.  We are seeing the former at the moment.  

Even with the strong bullish seasonal forces that are going to be at work in the final 2 weeks of the year, the underlying tape is one of distribution by the big hands.  Yes, you will get your typical snapback rallies off a short term flush out, like you did after the Friday December 3 low, or Tuesday Dec. 14 low, but they don't last for long because the buyers aren't eager to chase this tape.  

Sentiment is a contrarian signal at the extremes, but with a lag when at a bullish sentiment.  In other words, the best times to buy are when sentiment is at the most bearish, but the best times to sell is not when bullish sentiment hits a optimistic peak, but when it is trending down while the market grinds higher after a sentiment peak.  

You are not going to get an accurate read on the health of this market in the last 2 weeks of the year.  The seasonal bullish forces are especially strong at the end of the year after a big up year, due to delayed capital gains motivations and portfolio window dressing.  Also, those that are the most eager to sell and reduce risk have already done so, taking out most of the urgent sellers for the last 2 weeks of the year.  

Already, you can see the eager beaver end of year rally players who bought at yesterday's close or in the overnight market getting tested as the exuberant overnight highs in SPX and NDX are a distant memory as the top Nasdaq names get smashed ahead of the Friday opex.  There is a lot of motivation for dealers to sell their long stock inventory as a lot of their short call inventory in AAPL, MSFT, etc. will expire at tomorrow's close (huge options expiration).  They will have to sell those stocks anyway, might as well crush the long call holders in the popular individual names in the process of flattening their books.  

The options volumes have gotten so big, that they are the tail wagging the dog.  Especially around the big triple witching options expirations happening every quarter.  Delta hedging from dealers is a huge driver of index flows these days, as shifts in IV and the effects of time decay play a major factor in changing the index put deltas outstanding.  In general, as the put deltas decline as the market either rallies and/or IVs drop as the monthly opex gets closer, the dealers have to reduce their short index position to stay delta neutral.  That is the primary force driving the market when the hedge funds are not splashing around in the market.  And often times, the hedge funds often are doing the same thing the dealers are doing as a market rallies, which is when you get explosive moves to the upside (i.e. yesterday after FOMC announcement).  

We've seen quite a shake out in gross positioning for hedge funds based on prime broker data over the last 3 weeks.  That should be enough to clear the way for a year end rally.  But remember, this year end rally is more about hedge funds having already done most of their year end selling, leaving the year end rally players, window dressers, and options dealers to dominate the price action in that vacuum.   I would not be surprised to see new all time highs being hit next week in that environment.  But it is a mirage.  The real action will return in January, and that should bring back the volatility that we've seen the last 3 weeks.  

Not much to say about the FOMC meeting and the Powell press conference.  The Fed will always do too little, too late, and they're just catching up to what they should have been doing 9 months ago.  They say 3 hikes for 2022, but those hikes, especially the 2nd and 3rd one, are conditional on the stock market staying calm.  Somehow I doubt the SPX will be so cooperative after having rallied 110% over the past 21 months based mainly on a super dovish Powell doing what the market wants.  If Powell tries to hike 3 times and/or talk tough while the SPX is trending down, you can almost be guaranteed of a long overdue and unanticipated waterfall decline. 

A Phase Transition

What a face ripper.  In less than 48 trading hours, the SPX has gone from 4500 to 4650.  That's why you can't play for downtrend continuation when the longer term uptrend is still intact.  Good things happen for the stock market when the 50 and 200 day moving averages are rising, no matter how bad the breadth is.  Breadth is a distraction.  People who mention it think they've discovered some secret sauce to predicting the future direction of the market.  What they've discovered is something that used to work in the past but doesn't work so well anymore because of the dominance of passive investing.  

Some will say that the bad breadth in the broader market has caught up to the SPX, causing it to go down.  No, what caused the SPX to go down was hedge funds getting crushed on their crowded longs, having to cut risk to stem the bleeding.  Add to that a newly hawkish Powell who acts like he doesn't have to worry about his job anymore, so he can talk tougher on inflation, and thus less supportive of the stock market.  

It feels a bit like the summer of 2007, when hedge funds were severely underperforming as the SPX was making new all time highs.  It feels a bit like early 2015.  With rate hikes and liftoff from ZIRP being priced in for the next 1-2 years.

Its a tricky juncture, a transition from a relentless uptrend to a choppy range trading environment.  A phase transition from laminar to turbulent flows.  Almost at the end of a bull market but the old bull still has its legs kicking, even as the lion has its jaws wrapped around its neck.  

Your mindset and view on the big picture is important when trading this type of market.  There is less regret when missing long entries, just because its a weaker market, less forgiving than before on early buys.  There used to be no regret when missing short entries, but now, there is some regret when I miss those premium short opportunities like you saw after the short squeeze on Powell renomination on November 22 towards SPX 4743.  It is a more balanced market.  I didn't even give it much of a thought to short SPX this year.  But now, shorting needs to be seriously considered in the trading arsenal for the SPX.  

I will be pickier when it comes to long entries, and also be more careful when sizing up on longs, knowing that a big waterfall decline is probably happening sometime in the next 6 months.  At the same time, I will now add shorting to the mix, taking advantage of those situations when the market has rallied and the crowd is complacent, to put out shorts and to buy puts.   

What sticks out in this market is how high the VIX has gotten with a less than 5% drawdown in the SPX.  Its a bit mind boggling, because it looked a lot more dangerous of a market in September than it does now, and the highest VIX close was 25.71 on September 20.  On December 1, the VIX closed at 31.12, and 30.67 on December 3.   

I have some theories about why VIX is trading so high versus previous strong uptrending periods, but the biggest factor is the changed behavior of systematic vol sellers.  It appears March 2020 took a big chunk out of the systematic vol selling community, and the remaining vol sellers are more conservative and less willing to sell volatility during risk off environments.  Another is the rise of options volumes, especially on the call side, juicing up the IV of those options, and as a byproduct, increasing the IV on the put side as well.  

Volatility has remained overvalued all year long, and its only becoming even more overvalued.  The recent VIX readings are reminiscent of 1999 and 2000, when actual realized vol was much higher than it is now.  If we ever get the realized vol of 1999 and 2000, who knows how high the VIX will be trading, perhaps 30 to 40?  

I can only imagine realized volatility rising as the Fed gets closer to its first rate hike, just like 2015, when the market preemptively sold off ahead of the first hike, a warning shot to the Fed that it better be careful.  I can picture a similar scenario in 2022, especially if the Fed speeds up its tapering and the market keeps pricing in a June 2022 rate hike.   

SPX is above 4650.  Stealing the RTH move as always on the upside.  I was hoping for a breakdown below 4500 to scoop up longs, but that's not happening.  I missed the move, and although I think we hit new all time highs by Christmas time, I will not be chasing longs in this environment.  

Yields look like they have made the top for this cycle.  A move above 1.75% 10 yr looks unlikely for 2022.  2.00% 10 year is a pipe dream.  With the power flattening of the curve, the Fed won't be able to hike much before they have to cry uncle and reverse course, high inflation or low inflation.  Economic weakness stops all Fed hiking cycles, no matter the inflation rate.  Expecting a very bullish 2022 for the bond market. 

Volatility is Off the Hook

You are getting some wide intraday ranges in the SPX that is causing systematic selling, namely vol targeting funds and CTAs.  Also you have the news-based sellers that got nervous after some hawkish talk from Powell, and of course omicron headlines.  When was the last time you saw a puny headline from a CEO talking about Covid causing a huge plunge in afterhours?  That's what you call fragility.  After a bounce on Monday, the market was vulnerable to another down move, and any tiny headline was like lighting a match to a gasoline covered haystack.  

The end of month selling has been vicious during risk-off settings, as the September 30 and November 30 selloffs show.  In some of those month ends, there is a big JP Morgan fund that puts on an SPX collar (buying an out of money put spread and selling an equal dollar amount of calls), but in others, it seems like window dressing and position squaring due to balance sheet constraints.  Whenever you have price insensitive sellers in a risk-off environment, they can cause short term market plunges, as you saw after Powell officially retired his pet, the word "transitory".  

The best thing the bulls had going for it, a very strong up move in bonds during this selloff, due to a Fed that was quick to get nervous and turn dovish at a moment's notice, was quashed by Powell's focus on inflation.  His job is safe for another 4 years, so he's more willing to throw cold water on the bull's hopes, if it means maintaining some credibility on inflation and not being seen as a complete dovish pansy.  Plus, it seems like the politicians are feeling a little heat on inflation, and are willing to sacrifice a few hundred SPX points as long as it keeps inflation expectations somewhat in check, and keeps commodities prices down.  

You can play for the bounces, like buying in the hole after the big intraday plunge yesterday, but you need good entries to make the risk/reward compelling.  You also have to lower your price targets and holding times.  This isn't your raging bull BTFD market anymore.  We are entering the transition phase from mature bull to old bull.  Its a bit more treacherous to go in there and buy in the hole.  

In the short term, it doesn't look like this market is close to being done on the downside.  I would use today's strength to sell, in order to have the dry powder to buy on the next dip, which probably happens either Thursday or Friday.  With the market nervous about a faster taper and omicron, I don't see a sustainable bounce until you see more blood letting and risk reduction. It probably takes another week or so before it will be safe to hold for longer term swing longs.  

Big picture, we are now entering the transition phase where volatility rises and the market is choppier, so its now actually worth it to consider shorting SPX.  But also still a good market for dip buying.  So an ideal market for traders, but not a good market for investors that have a weak stomach.  

Technical support area is the September top zone, around 4525-4550.  Market abhors a vacuum, and there is an air pocket of very little trading between 4500 and 4550.  It would not surprise me to see one or two more waves of selling to take us down to that area.  I expect that area to hold due to year end dynamics which favor bulls in the last 2 weeks of the year.