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.