No Recession But a Weak Stock Market

The stock market is trading like the economy is about to enter a big growth slowdown, and possibly even a recession.  I am hearing lots of talk about the Fed breaking something and having a hard landing.  This reeks of myopic market focused thinking, with total disregard for the real economy, and the absurd fiscal policy that's still pumping huge amounts of money into the economy in the background.  

It was fashionable to talk about the massive Covid fiscal stimulus and QE double bazooka in 2021 as the markets kept going higher.  Now its fashionable to talk about a hard landing as the Fed does 50 bp hikes and QT in the coming months.  While monetary policy is definitely going to be much tighter, there is still $1.7 trillion of excess liquidity looking for a home that is stuck collecting 25-50 bps in the Fed repo facility designed to sop up all the QE created excess liquidity.  There is no shortage of liquidity in these markets.  QT will keep bond yields higher than if there was no balance sheet reduction, but I'm betting that Yellen will be financing a big portion of the deficit with T-bills, not coupon bonds.  That will have a less negative effect on Treasuries than if coupon bond issuance was expanded. 

I still believe we're entering a bear market, but not because the Fed will break something and cause a recession, its just because investors got way too exuberant and overweight equities over the last 18 months.  It will be a lot more like 2000 to 2002 than 2007 to 2009.  I don't even think that the US economy will get as weak as it did during the post dotcom bubble economy of 2001 and 2002.  Back then, there were even budget surpluses, and the budget deficits were a tiny percentage of GDP, around 1-2%.  Now its at 6.4% of 2022 GDP, and that after 13% of GDP in 2021.  We are in a totally different planet when it comes to the fiscal pumping of the economy.  That will keep inflation higher than normal and disappoint those looking for a crash landing and a recession.  

 

Now the economy in Europe and Asia are a different story, but those stock markets are already reflecting a much weaker economy, more so than US stocks are.  There is no valuation froth in Europe and Asia, so its not priced for perfection like US stocks were before this recent swoon.  So even though I expect the US economy to outperform expectations vs Europe/Asia, the US stock market likely underperforms because of the big overweight investors have in the US.  

There will be some wealth effect related weakness in the economy this year, and that will counteract some of the positive growth effects from the government spending, but overall, growth probably goes back to the mediocre 2012-2019 level, which is enough to keep the commodities bull market going and keep the stock market from a total crash scenario, as some are forecasting.  

The price action this week seems to confirm the gut feel that market is bottoming and found another bottom at similar levels made in March at 4170-4180 SPX.  This should take the market higher over the next 3 weeks as the big earnings reports are now behind us, and FOMC meeting of 50 bps and QT announcement will likely be sell the rumor, buy the fact in my view.  Not sure how far we bounce up to in the coming weeks, anywhere from 4500 to 4600.  By early June, I expect the market to have either already topped out or be very close to a local top, so a short opportunity will be there.  That will be the time to put on short positions to ride lower during the summer.  

Don't lose track of the big picture:  lots of fiscal pump and small reversal of monetary pump.  That is the mirror image of what was happening from 2010 to 2017, before the Trump tax cuts and Covid pork stimmy fest.  We know what happens when there is a lack of fiscal stimulus and a lot of monetary stimulus:  a strong bond and equity bull market, but a low growth economy.  How about when we get a lot of fiscal stimulus and a lack of monetary stimulus, like what we will see over the next several months?  Probably a weak bond market and stock market, but a surprisingly strong economy.  Basically a great backdrop for commodities. 

Its a Bear

The bull is dead.  Its over.  Its a bear market.  We haven't seen a bear market since 2008.  Investors are not ready for it.  I wasn't ready for it to happen so quickly.  After 14 years, memories of 2008, and 2000, have faded.  After losing money trying to buy the dip a few times since the start of the year, its getting more and more apparent that we aren't turning back.  No more multi-month continuous rallies that go to new all time highs.  No more V bottoms that don't give you much time to buy the lows.  Now you will see messy bottoms that only lead to short term rallies that are a few weeks, not months.  

The topping phase and the transition from bull to bear has been shorter than I expected.  I see no way this market goes back to SPX 4700 this year, and probably the next rally off this oversold market, will likely only take it up to 4500-4550, at the maximum.  The stock market is smarter than back in 2007, and 2000.  The markets now realize how important monetary policy is to stocks, unlike back in 2000 or 2007.  Its almost gotten to the point where basic macroeconomic fundamentals don't really matter to investors, its just monetary policy. 

In order to fuel a stock market that is fundamentally overvalued, new equity inflows have to come in and/or corporate stock buybacks.  After the heavy equity inflows since the November 2020 election, you have a heavily invested community that has just started turning tail, and it would not surprise me if these equity outflows turn into bond inflows, which has turned negative.  Ever since 2008, these kind of heavy outflows have proven to be near intermediate term peaks in the 10 year yield. 

Equity Fund Flows (Jan. 2020 to Apr. 2022)

Bond Fund Flows (Dec. 2021 to Apr. 2022)

At this point, you have a huge investor base, broadened considerably post 2020 with the retail frenzy into speculative names, all underwater and bleeding, with a hawkish Fed and reduced liquidity going into an economy that is slowing.  A bad mix would be an understatement. 

For this bear market:

The match:  Fed liquidity from +$120B and ZIRP to -$95B and 2.00+% Fed funds rate.

The fuel:  High valuations.  

The only thing that the bulls have going for them is the negative sentiment, but sentiment doesn't change a trend.  If investors aren't willing to get bullish, negative sentiment will stay negative, or just get less negative.  And given how much the financial markets these days are obsessed with the Fed, I don't see how you get that big bullish turn in sentiment that would drive stock prices higher unless you get Powell throwing in the towel on tightening.  I don't see that happening until at least another 125-150 bps of hikes being done.  That takes you to possibly at the earliest, the September FOMC meeting where they signal a pause or less hawkish rhetoric.  

So from that standpoint, I don't see a bullish catalyst that lasts until you get the Fed throwing in the towel on their inflation "fight", and go back to what they are comfortable doing, pumping more liquidity into the system and backstopping the stock market.  But the problem is that I don't see inflation, at least commodity/food inflation coming down.  I believe we're in the middle of a strong secular bull market in commodities due to the lack of investment over the years in new oil/gas production and nuclear energy, as well as the rush to invest in low ROI energy sources such as solar and wind.  That's causing a shortage of energy, that either needs to be resolved through demand destruction through higher prices or additional production, which will take a few years to come online, because these things don't turn on a dime. 

For the first time in 13 years, it will be safer and much more profitable to short rallies than to buy dips.  I don't say that lightly, because the buy the dip strategy has been a huge winner over the years.  

It looks like the bond market has finally reached a point where buyers are willing to step in and take a stand, which is at 3.00% 10 year yields.  There is still time to enter bonds at good levels, so I don't see a need to rush in here.  I don't see much upside or downside for bonds as I expect it to be slowly forming a bottom in the next 2 months, before you get that trend change which will spawn a new bull market for bonds.  But I don't expect it to be as strong as the bond bull markets from 2008-2009, and 2011-2012, 2014-2016, and 2019-2020.  Those bull markets were fed by a steady downtrend in commodity prices, Chinese offshoring led deflation, and less expansionary fiscal policy.  

Now we've entered a strong bull market regime for commodities, and the low hanging fruit of Chinese export led deflation is gone.  Plus, you're seeing in the US, and even some in Europe, more of a willingness to hand out stimmy checks and deficit spend their way to short term prosperity.  That's inflationary, so bonds will not have the same type of crazy moves lower in yields as you've seen in the past 13 years.  With that said, I don't expect a secular bear market in bonds, but more of a range bound market for several years that probably trades between 1 to 3% 10 year yields depending on what the Fed is doing at that particular moment in time.  

Into the weakness this week, I have stayed away from the temptation to buy SPX and have focused on buying some of the strongest stocks in the strongest sector, energy.  I expect energy to be the best hiding place for stocks over the next 2-3 months.  And after that, I don't think it will be safe to hold anything, as I expect stock investors to become more and more indiscriminate and urgent in their selling, as it becomes obvious that we're in a bear market.  

I am still long a small SPX long position, its small enough where I can weather the storm and not worry, but I will be selling it on any trip back towards the 4400-4500 resistance zone.  With a much feared FOMC meeting next week, and with big tech earnings out of the way after this week, given this oversold nature of the market, I expect a strong rebound for stocks in May, maybe the last golden exit opportunity for bagholders like me to dump their stocks and either buy bonds or put on a short position. 

A Mess of a Market

The SPX doesn't know where it wants to go.  It looks weak, but its still in a rally window after the fear based W bottom in February/March.  Unfortunately, I overestimated the strength (maybe timing is just off and it rockets higher this week?), and bought the first major dip off the thrust higher in early April.  In a more constructive market, where the Fed governors aren't trying to outdo themselves by trying to be the most hawkish banker, you would see another burst higher after that big bottom in March.  But its been chopping downwards, although a big thrust higher the past 2 days.  

Looking at the options data and commitment of traders futures positioning, the readings are neutral and provide very little edge.  Despite the weakness over the past 2 1/2 weeks, there was not a lot of heavy put buying, which is usually a negative.  Investors speak bearishly, but they aren't acting out on their opinions, as equity inflows are still historically high for the past 3 months.  

Instead of focusing on the macro markets, I should have been focusing on specific sectors which are in strong bull phases with lots of room to run higher on a fundamental basis, in particular the energy sector.  The SPX and NDX are a choppy mess right now and in a phase transition, so probably the best strategy there is just to wait for a bullish extreme, hopefully on "good news", in order to put on a short position.  You can be your own worst enemy just focusing on your main market when the market is directionless.  

I sold a lot of my underwater SPX long yesterday into the rally, although still holding some just in case we keep going higher.  The price action isn't that great so I have reduced.  Will be focusing on buying energy stocks, which seems to be the only place where I can see a big rally for the year.  Don't see much of an edge in the overall market, and my preference will be to sell remaining longs and go short the SPX or NDX  after hopefully a relief rally in May after the FOMC meeting.  

Bonds continue to trade horribly, and the 10 year yield nearly touched 3% in overnight trading before BOJ came to the rescue and caused a little short squeeze.  Longer term, these are good levels to buy bonds, but short term, its not a great time to buy the dip with just 2 weeks left till the FOMC meeting in May, where you will be getting the double barrel tightening of 50 bps and QT.  Its not an event that bonds are likely to rally into, so its probably better to wait till right before the meeting to buy.

This market trades like there is a huge amount of overhead supply, those heavily long US stocks who are looking to reduce their exposure on a rally towards SPX 4600-4700.  The crowd has made an 180 degree turn, rightfully so, from bullish to bearish, and realize that with the Fed reducing their balance sheet + hiking aggressively, with the federal government about to enter gridlock after the midterms, its asking for trouble, as the economy slows and you get both fiscal and monetary tightening. 

Time Arbitrage

There is a lot of noise in short term price moves.  Moves that are hard to predict because in the short term, a big institution or group of institutions suddenly deciding to increase or decrease their equity exposure will move the market for the next hour or two, or if they are looking to move very large size, for a day or two.  That could be in the direction of the intermediate term move, or against that direction.  The longer you go out in time, the less one or two big institutions can influence the direction of the market.  Its much easier to forecast what the overall crowd will do, rather than one or two of the big participants.  

Some may say that the longer out in time you go, the more exposure you get to news headlines and unpredictable events.  That's true, but most of the time, these news events don't affect the market for more than a few minutes or hours.  It is not common to get a market event that affects the market for more than a few days/weeks.  Covid type of market game changers are rare.  Even September 11 2001 doesn't come close.  In 2008, which could be considered a slow motion event, wasn't a black swan type of unpredictable market mover.  It was building steadily over the previous years.  The Russia/Ukraine war this year, which definitely caused the selloff to last longer than it would have otherwise in February/March, is already an afterthought compared to what is always on the minds of most investors: the Fed. 

Daytrading is profitable as long as retail investors are heavily involved in the market.  If retail is not active, daytrading gets a lot harder.  Daytrading against institutional order flow is possible, but much harder than against retail order flow.  Institutions are more disciplined, more knowledgeable, less predictable, and make fewer mistakes than retail traders.  The only place you will find retail traders making up a significant amount of the volume is in small cap stocks that are in play.  That is the only place where consistently large edges exist.  That is where beginner traders who are looking for an edge should specialize.  The big drawback from focusing on the small cap stocks is having to find shares to short, lack of deep liquidity (not being able to put on large size for more than the day that its active), and long periods of fallow periods with few opportunities when stocks are in a downtrend and/or retail speculation is subdued.  

But in order to play with the big boys and be able to scale up, one needs to trade markets where institutions dominate, and retail flows are mostly irrelevant.  These are usually macro markets that are covered by futures, such as stock indexes, fixed income, commodities, and currencies, and also large cap stocks.  That is where another type of edge appears which is not talked about much.  The edge from having longer time frames than institutions that trade frequently, in particular, hedge funds.  Hedge funds in particular are judged on a month to month basis, and extended drawdowns are avoided whenever possible.  Hedge funds always worry about drawdowns because it looks bad on their record and its frowned upon by their investors.  So they often get stopped out of long term positions that are in a long term downtrend.  These stop outs are not fundamentally driven decisions, based on investment merit, but based on risk management and fear of big drawdowns.  When you have investors that are making trading decisions based on risk management rather than fundamentals, there is an opportunity.

Let's call it time arbitrage.  This arbitrage comes from being able to enter positions that are currently out of favor and in extended downtrends, with some liquidations and stop losses exacerbating the trend.  These opportunities occur when something is fundamentally undervalued, but currently out of favor on Wall Street.  This arbitrage can also happen in the other direction, where a market is in a bubble and extremely popular, and fundamentally overvalued.  But usually its more difficult and more dangerous to try to short an overvalued market in a bubble than going long in a undervalued market that is in a bear market.  

In the current market, the only market which I see this time arbitrage opportunity is in bonds.  I see no long term time arbitrage opportunity in stock indexes or in commodities.  For currencies, there is definitely a long term opportunity in the yen, as its selloff is related to Fed policy, so highly correlated to bonds.  And buying Treasuries is a better expression of the Fed turning dovish on a weakening economy than going long yen.  

Yes, the best long term "time arbitrage" opportunity is in bonds, not because I think inflation will go down a lot more than market expectations.  Its because I believe the Fed won't be willing to hike as much as the market is pricing in, based on the global economy weakening, even though I expect inflation to remain sticky, due to continued commodities and housing inflation.  We saw in 2007 and 2008, in the face of rising inflation, mainly due to commodities, while the economy was noticeably weaker, the Fed was aggressively easing, and didn't care about inflation in that environment.  Now I don't expect a financial crisis or a great recession, but I do see a US/EU recession coming in 2023, like many are predicting.  That is another aspect of this opportunity which makes it interesting.  Its the fact that so many investors are now expecting much weaker growth or a recession by 2023, but most are not positioned for it, except for crowding into defensive sectors in equities.  But the best way to play economic weakness is not in defensive stocks, but in bonds.  They are for the most part eschewing fixed income, due to 1) continuous downtrend 2) Fed hawkish rhetoric 3) inflation fears.  

The investment flows out of fixed income and towards stocks have been sizeable since the beginning of 2021.  Investors were already historically overweight equities vs bonds going into 2021, with the flows since then, its become even a bigger overweight in equities.  This makes the weak equities scenario much more harmful for the overall economy, as the most dynamic part of the US economy is US equities.  Growth is low, without massive fiscal stimulus, so the wealth effect from equities is a much bigger factor than many are willing to admit.  So a few more hikes will cause stock market to go down even more, and thus, a weaker US economy via the reduced wealth effect channel.  That's not even factored into the leading indicators which are already rolling over hard. 

But the Fed is hawkish now, when the current Fed funds rate is 0.25-0.50%.  This isn't a tough time to be hawkish.  But the more important issue is this:  Will they remain hawkish after 3 rate hikes (50 in May, 50 in June, 25 in July), with the Fed funds rate at 1.5-1.75% and the stock market in a strong downtrend as the economy is clearly weakening (likely August/September scenario)?  That's not something many investors are considering at the moment, even though its probably the most likely scenario in 4-5 months time.  And no, I don't expect the bond market to be weak until August/September.  Unlike 2018, when the bond selloff was extended as the Fed slowly hiked 25 bps every other meeting, this time, they are looking to do 50 bps per meeting, so 4 times faster, plus a much faster QT than in 2018.  And leading indicators are more ominous now than in 2018, mainly because the economy didn't get so hot and inventory didn't get so bloated as they have now.  

I haven't entered any long term bond positions, but its the best market for those looking to play the long game, and can withstand short to intermediate term drawdowns (unlike hedge funds), with fundamentals that are unfavorable now, but will soon turn favorable. That's an opportunity for those willing to make a long term investment in an asset with a very bad looking chart that is in a slow motion liquidation cycle.  

Its brutal price action for the SPX.  It usually feels this way at the end of a downswing, unless of course you are in the middle of a protracted downtrend, which I don't believe is the case.  I could be wrong, but this looks like a deep dip in a 2-3 month countertrend up cycle that started in mid March.  I agree with the majority that the longer term picture looks weak, but disagree about the short term, mainly due to light fund positioning.  Still long, looking to hold for a couple of weeks.

Peak Fed Fears

This is about as hawkish as the Fed will get.  They are tripping over themselves to act like they weren't the same tools who kept pumping in $120B/month of QE and doing nothing but jawboning about transitory inflation to justify their inaction and stock market pumping for all of 2021.  The public loved it, as stocks skyrocketed, at least until their meme stocks kept going down while the inflation kept going up.  Then the public suddenly wanted their low inflation again, and the politicians got the message.  

No, the Fed won't be regaining their credibility on inflation with their sudden tough talk.  Actions speak louder than words.  And let's face it, they are only talking tough while the market is still calm.  When you get those nasty 10%+ corrections, like you saw earlier in the year, then the Fed suddenly get timid again, as seen by their 25 bps bb gun shot in March.  A whimper of a first barrel.  Its easy to sound tough on inflation and threaten 50 bps hikes while stocks are going up, its a lot tougher to do it while the stock market is entrenched in a nasty downtrend and pressure is on them to do less, not more. 

To put it another way, the Fed has no guts.  They just want the glory.  As I mentioned before, they want gutless glory.  Powell is the farthest thing from Volcker.  He wants to be revered like a Volcker, but couldn't even carry his jockstrap.  Powell is the slickest, most political Fed chairman ever.  He will suck up to the Republicans when it serves his interest, and then flip back towards sucking up to the Democrats if that's what's necessary, even if he doesn't believe any of the crap that he spews out.  Powell folded like a cheap lawn chair in early 2019, under pressure from Trump, Mnuchin, and most of all the stock market.  And with his nomination up in the air in 2021, he did the gutless easy thing:  continuous pumping through QE and blatant lies on inflation as being transitory to goose the stock market, using the Rona as convenient cover, even as inflation and the economy were red hot.  

Powell hasn't changed.  He's still the same guy who folded in early 2019.  He's still the same guy who tried to win the nomination by spewing transitory inflation BS until he got renominated.  He will cave in under the pressure of a falling stock market + weakening economy and stop the tightening later this year.  Its not a matter of if, but when.  Will it be September? October? November?  My bet is on one of those 3 months.

So with that baseline assumption of a gutless Fed clearly stated, the Fed has slowly backed themselves into a corner.  They have to back up their tough rhetoric even if stocks go down, just to keep what little inflation fighting credibility they have left, after they lost a lot of it last year.  So with the Powell/Brainard hawkish talk over the past 2 weeks, they are signaling 50 bps in May and 50 bps in June, and if the stock market isn't falling apart by late July, probably another 50 bps in the July meeting.  If the stock market and or the economy is weakening, they either do 25 bps or pause and completely cave in. 

One of the reasons that investors are so skeptical of the Fed's sudden hawkishness is because they've always folded under the pressure of a weakening stock market.  See 2016.  See late 2018.  So to get their hawkish message across, they basically have to bring down the hammer and be over the top.  Otherwise, investors won't get the message.  Well, stock investors are finally starting to get the message, much later than the bond investors.  And from what I am hearing, even bond investors are still trying to pick the bottom, saying the high for yields is just around the corner.  But the price action and looming deluge of supply with a net $215B/month change from Fed buying to Fed selling Treasuries + MBS is a HUGE thing to overcome. 

The only way Treasuries will be able to have a sustained rally under the barrage of supply is if the economy or the stock market actually starts to noticeably roll over.  For the real economy, its still a few months away, as the fumes from the 2020/2021 stimulus are still there, with a decent amount of leftover buying power still available.  For the stock market, with hedge funds having low net exposure, and from the COT positioning data and dark pool activity (DIX index from @SqueezeMetrics), fast money speculators are lightly positioned in stocks at the moment.  There has been higher than normal dark pool short selling activity, meaning passive flows have been steadily buying since January, so about 3 solid months of continuous buying.  But with weak fundamentals (QT+rate hikes, weakening economy in 2nd half), speculators and hedge funds just getting back to neutral levels of stock exposure would be enough to bring back the window of vulnerability to this market.  About 1-2 more months of calm and rising markets should be enough to get exposure back to neutral levels. 

Just a note on the crowd: they are not as dumb as widely perceived.  They got the big picture right by being bullish for most of 2021, rightly noting that the monetary and fiscal largesse were big tailwinds and the economy would get red hot.  And they are right on the big picture now, noting that aggressive Fed tightening will likely lead to a hard landing and a possible recession, and be bad for stocks.  But trying to time when the stock indices will go down for several weeks to months is one of the toughest things to do.  Its much easier to time when the stock indices will go up.  Basic math tells you that since bull markets are much longer than bear markets, and stock indices usually drift upward, its going to be much easier to time a profitable long entry than a short entry.  

I expect further weakness in the bond market until the May FOMC meeting, where the Fed has to back up their talk and do 50, otherwise they might as well take their ball and go home.  Usually a weak bond market is bad for stocks, due to risk parity effects, but there was such a huge purge of speculative positioning in stocks from January to March, its going to take a while for the fast money/hedge fund crowd to get back to even neutral levels, which usually happens as long as the economy holds up over the next 2 months, which is the most likely scenario.  Coincidence and short leading indicators are still strong, while long leading indicators are getting weaker and weaker.  

I did buy SPX on Tuesday and Wednesday, looking to play for a short term bounce.  I will look to sell if it bounces back close to 4600.