Bear Market Behavior

No V bottoms here.  As if you needed more proof that we are in a completely different trading environment than 2009-2021, just see how much the market has pulled back off the top of the rally, almost 200 SPX points in less than 48 hours.  That would have been unthinkable back in the bull market days.  

A couple of days ago, you heard a lot of talk about quarter end rebalancing from stocks to bonds, about a big rally into the end of the quarter, as if the market would conveniently cooperate with the plans of a bunch of short term traders.  A group who have about as much conviction in their trade as Powell does with "fighting" inflation.  In other words, almost none.  

You have to play by bear market rules.  Only buy when there are deep, deep pullbacks, big oversold conditions.  And don't get greedy after buying, when you get a short covering rally for a few days and the crowd starts getting excited, you have to push the eject button and sell.  If you missed the bottom, don't chase stocks higher.  If you are waiting to short, wait for the bulls to push the market to short term overbought readings, preferably after at least a week of rallying, and near previous resistance levels (now around 3900-3940) and then short and wait for the sellers to come back, as they usually do quite quickly.  

My favorite short term indicator of retail investor behavior (DIX dark pool buying) has popped above 50 for the past 2 days.  DIX > 50 is usually quite rare, although it has been much more common in 2022.  A high DIX used to be very bullish during the bull market, but the indicator has flipped on its head, and its now a contrarian indicator.  Retail buying (high DIX) used to be a bullish sign, especially with a low/negative GEX reading, but now its the complete opposite.  Low DIX after a big selloff is bullish, High DIX after a bounce is very bearish.  

With 2 consecutive DIX readings above 50, we are well into the danger zone.  It flashed warning signs in early February after a rally, late March after a rally, late May/early June after a rally, and now in late June after a rally. 

My theory on this indicator is that retail buying (high DIX) used to work when the institutions would occasionally be dumping their holdings aggressively, usually in a pullback during an uptrend (2011-2021 was mostly a huge uptrend).  Retail as is their tendency, was to buy the weakness, and as institutions stopped selling, and got back to buying, the market rebounded quickly.  That's no longer the case.  Institutions have only gotten back to buying in short spurts, which have left retail holding the bag when they bought the dips and chased after they thought they saw a V bottom (early February, late March, late May/early June, and now), only to have the rug pulled underneath them.  

Low DIX environments are when institutions are more aggressively buying than selling, and retail is not actively buying or participating.  Those are environments when fundamentals are favorable and conducive to buying the dip.  This is not one of those environments.  It is an environment that the DIX database has never covered until this year, a bear market (like 2001-2002, 2008).  That's why you see so many of the stat based market trading systems fail because they are mostly mean reversion strategies that are effectively just buying the dip, and it worked fabulously since 2009.  That's no more.  Its a true bear market, something 2020 didn't prepare anyone for.  The quick 20% "bear markets" that people were used to like 2010, 2011, 2018, 2020 were never real bear markets.  They were short term panics in a raging bull, with an activist Fed looking to rescue the markets whenever they went down.  Comparing 2010,2011,2015, 2018, 2020 with 2022 is like comparing oil and water.  Totally different situations.  Totally different price action.  

That's why so many have been frustrated by the market this year, because its acted totally different than what investors have seen over the past 13 years.  And we are still seeing equity fund inflows.  When was the last time you saw equity fund inflows into such a weak market?  Its unprecedented.  I don't expect a real bottom until you see lots of fund outflows.  Nowhere even close to that.

Wow, last week's rally fizzled fast.  Going into Monday, its the first time this year I've seen short term traders on TV or Twitter so bullish.  I should have taken that cue and aggressively shorted the rally on Monday.  I still believe the bear market rally which started on triple witching opex has more time left.  But after how deep this pullback has been, I expect this bear market rally to struggle to even get to 4000, much less the 4100 that many seem to be predicting. 

The Coming Bull Trap

Here is the baseline view that biases the market projection for the next few months:  

1. Post bubble environment where households overweight in equities start to sell amid the continued downward pressure on stocks as the fundamentals don't support current equity valuations.  A re-valuation to more normal valuations. 

2. Fed will continue to tighten, longer than stock investors want, with their inflation credibility on the line, they will be reluctant to pivot until they see more overt signs of recession.  Too many are anticipating a dovish pivot before the Fed even gets to restrictive rate levels, at 3+% Fed funds. 

3. Lack of organic growth means without a constant flow of fiscal and monetary stimulus + wealth effect, economic growth will be very low.  Working age population growth rate among developed nations is near 0.  Productivity isn't increasing due to lack breakthrough technologies over the last 20 years.  The last major productivity boost was the internet.  Smart phones and electric cars don't boost productivity.  Nominal GDP growth in the future will be all inflation, no productivity growth.  This will show up in earnings over the next few quarters.  Corporations will have to reduce guidance as forward earnings estimates are too high.  Stocks will get re-rated lower from the bottom up, with big cap tech feeling the most heat.  

I find it interesting that the bull's top 2 reasons for buying stocks is 1. potential Powell pivot as inflation goes lower and growth slows down 2. bearish sentiment.  The first reason would most likely happen in a risk-off environment where equities will be the worst performing asset class.  So in order to get 1., stock have to go down first!  The second reason, bearish sentiment, assumes that survey participants being bearish, have been actively selling stocks and hold lots of cash and underweight stocks.  But the equity funds flow data for 2022 show people buying the dip while they respond as being bearish in the surveys.  

This is not like 2007-2008.  This is like 2000-2001.  There wasn't much excitement for US stocks at the peak in 2007.  The excitement was in real estate.  In 2020-2021, the excitement was in US stocks, the most since 2000.  We are in the aftermath of a massive speculative bubble that's the biggest in US history.  Even in 2000, there were hated sectors of the equity market, but at the peak in 2021, almost everything was loved, even bonds, as 10 year yields were trading 1.1% at the start of 2021.  

For bears that have been waiting for the exquisite moment to get short, I think its coming in the middle of July, after you get the CPI numbers come out and you see more investors buzzing about inflation peaking, and they will try to front run a Fed pivot.  The bulls will be way too early.  

We've been ripping higher since triple witching, the oversold levels gave the bulls the slingshot move higher.  I've noticed quite a change among the CNBC Fast Money crew, they are much more optimistic now, and I'm hearing targets like 4100 SPX and even higher.  The bulls main argument mostly seem based on technical analysis, while the bears main argument is mainly based on fundamental analysis.  

I don't expect commodity prices to go down much in a recession, contrary to what many think.  There just isn't enough of a supply response and energy demand destruction from a recession is overrated.  Emerging markets continue to be more and more energy hungry as they develop.  

Not much to do in SPX  here, giving the bulls some room to roam and take this market higher.  I expect the rally this time around to last longer than the one in late May that took SPX up over a week, and then went sideways a few days and immediately plunged. 

They Only Care About Bond Yields....for Now

It is a head scratcher of a market.  Suddenly, over the past few days, the bond market has been on fire, as recession is getting priced in for 2023, along with a Fed dovish pivot.  Take a look at the Eurodollars future strip for the next 2 years:  

 

The market is now pricing an end to Fed rate hikes by December, with a Fed funds rate of 3.5-3.75%.  So 200 bps of hikes priced in for July, Sep, Oct, and Dec.  And then 40 bps of rate cuts in 2023.   The bond market is now pricing in a Fed pivot by year end. 

The stock market is loving the big drop in yields, as the STIRs is pricing in an end to Fed tightening by year end, mainly due to recession fears, from.... higher yields.  Apparently, the cure for higher yields is higher yields.  You cannot make this stuff up.  The stock market is conveniently skipping out on the recession is bad for earnings and going straight towards the Fed dovish pivot is good for valuations part of the story.  

Some may argue that SPX at 3800 prices in a recession, so a dovish pivot is good for stocks, even if a recession is a prerequisite for such a pivot.  If the SPX at 3800 in January 2021 was pricing in a huge economic boom with 10 year yields at 1.2%, how can it be considered reasonable to price the SPX at 3800 in June 2022 with 10 year yields at 3.1% going into a recession?  Dubious logic from Wall St., what's new.  

But in the short term, the market trades a lot on technicals and investor psychology.  After a huge drop from the end of March to now, you are getting oversold signals on an intermediate term time frame, while still being overvalued from a long term time frame.  The SPX is a notorious mean reverting instrument, so there are lots of countertrend rallies even in a bear market.  It's very possible that you get a bear market rally based on market hopes of a Fed pivot later this year as economic data comes in cool over the coming months.  I agree about the NFP and CPI coming in lower than expectations for the next few months, but the market is forgetting about the accompanying earnings misses that will come along at the same time.  

Investors are conveniently forgetting about earnings as its all Fed, all the time, but the weakness in the semiconductors over the past 3 months is a huge flashing red light about the state of the economy.  Semiconductors are the new Dr. Copper, as they are everywhere in the modern day manufacturing process.  People forget that technology is a very cyclical sector, sensitive to corporate spending plans and ad budgets.  In fact, I would argue that semiconductors are as sensitive, if not more sensitive to economic growth as oil and gas.  But people consider energy as a very cyclical sector, and tech as being more growth than cyclical.  But when technology is such a huge part of overall SPX earnings, and the market caps so big, they are the economy, not some specialized sector, less sensitive to the economic cycle.  

So we are in the middle innings of this bear market, very little capitulation, still hopes of a coming Fed pivot while they are still signaling multiple 50-75 bp hikes, and the ostrich head in sand behavior when it comes to forward earnings estimates.  I am open to a bear market rally that consolidates the steep drop over the last 3 months, recharge the bears, and then see another steep drop in the fall as the stock vigilantes come on board, selling off stocks to get the Fed to pivot towards a rate pause.  

Its been a painful selloff in energy stocks, even when the fundamentals are rock solid, you have PTSD from past energy stock bear markets that scare the crap out of the newer investors in the space.  Its a deep cleanse of positioning, getting rid of weak hands and shaking out the fast money hedge funds who were loading up on the momo train.  The strength in crack spreads and the products speak to strong demand even as you hear talks of demand destruction amid high prices and recession fears.  

My long term thesis for energy isn't based on the economic cycle, its just supply and demand.  In fact, the news flow over the past several days have been bullish for oil and gas, in particular Putin slowing down gas flows to Europe, which will incentivize gas to oil switching for power generation, as well as more long term LNG flows from the US to Europe.  Also the gas tax holiday just subsidizes gas consumption, which is the last thing this tight of a market needs, but politicians will always take the short term sugar high over the long term, more nuanced solution.  

Got a big gap up as we broke 3800 in overnight hours, the classic stealing the RTH move gap up.  I am neutral on SPX, its still feeling the afterglow of lower yields this week, and are at intermediate term oversold (way below a very downward sloping 50 day moving average) levels.  Don't know how long the bounce lasts, but if SPX can get close to the 4050-4100 area on what I expect to be weaker than expected econ. data in July, it will be worth a shot on the short side. 

No Signs of Capitulation

I regularly look at the options market to see if the fast money / speculative money is leaning bullish or bearish.  After the carnage that you saw last week, one would expect there to be a lot of put buying.  I thought I was the only one seeing things when the SPX, SPY, and QQQ options data was telling me that there was actually more put selling than put buying, and more call buying than put buying last week in the index options space.  

I listened to a podcast recently from Benn Eifert, an options guy, and his statements collaborate with what I'm seeing.  

They are:  

1. Little demand for short-dated puts, as it seems many have gotten burned buying expensive puts that didn't pay out even during the downtrend this year.  

2. Quite a lot of demand for index calls, looking to play a bear market rally.

3. Very little skew, showing the lack of demand for out of the money puts from the investor community.  

4. Not many volatility sellers since March 2020 black swan event for vol funds.  So fewer volatility short squeezes as there aren't many weak handed vol sellers.  

And from what I am reading on Twitter, I can basically sum up what the mood is of the crowd.  Short term bullish, looking for a bounce, but maintain long term bearishness due to Fed rate hikes and high inflation.  That is a bad combination, in fact, you would rather have short term bullish and long term bullish sentiment vs. short term bullish, long term bearish.  Because the short term view will be easily shaken among those long for a trade.  

The weak hands are on the long side, it remains that way.  Until you get down to low enough levels with signs of capitulation (lots of put buying, little call buying) and positioning has been cleansed to more neutral levels, you will see rallies fade away quickly, and it will be a better market to short than to go long.  

In the investor psychology cycle, you are somewhere between denial and fear, and heading towards desperation and panic in the coming months.  

The move lower is still not done, you got a big gap up which is quite tempting to short, I might put in a small short today to hedge some of my energy long exposure. 

Populism is Inflationary

What can turn this weak market around?  The only thing that could really turn it around is Powell pivot, part 2.  The first one in January 2019, was a catalyst for a huge rally.  This time, it will be a catalyst for a huge sucker's rally, that could last 1 to 2 months, depending on when he pivots.  Unlike the 2019 pivot, you will have a situation where the Fed will have had an inflation scare.  Remember, the Fed always fights the last battle, and is scared of repeating mistakes.  Which means they will cut, but not as aggressively as before, and that won't be enough for a market that is poorly positioned (historically high household wealth in equities).  It will eventually come, but probably not until you see a couple of below expectation CPI prints and some weakening NFP numbers.  So late August, at the earliest.  Probably September or October.

If you are a commodities bull, you can't really be long term bullish on the stock market.   Inflation will stay elevated, and the poor will have less discretionary income, which will dampen demand, hurting corporate earnings.  Of course, once recession is clear to everyone, the governments will rip another page out of the Covid bazooka playbook, and flood the economy with helicopter money, and in that case, demand will remain strong, at the price of boosting inflation even higher.  

The only thing that can boost the stock market is either highly expansionary fiscal stimulus or a highly expansionary monetary stimulus.  Zero rates won't do it anymore.  Budget deficits at 5% of GDP is now the baseline needed to keep low growth going.  If the market is left to its own, I'm not even talking about QT or rate hikes, just no QE and zero rates, the growth rate in that environment, considered wildly expansionary in the past, would maybe be enough for 1% real GDP growth in the US.  The labor force growth isn't there.  The productivity isn't there.  The energy required to keep growing isn't there (unless they go full bore nuclear, which is doubtful). 

The politicians are short sighted and dumb enough to fight inflation with more fiscal stimulus, and of course, the Fed will fall in line and buy up all the debt that's issued, to keep yields from exploding higher.  That will just end up stoking another huge inflation wave which will then be fought by issuing more stimmy.  Its a virtuous cycle for a politician, getting the masses hooked on stimmy and helicopter drops, and then trying to solve the problem of their own creation by dropping more dollars from heaven.  

The only sustainable solution to an inflation problem is to stop growing the money supply, by increasing taxes, less government spending, and reducing the Fed balance sheet.  Only 1 of those 3 things have happened so far, and the Fed has only just started balance sheet reduction and I doubt it lasts as long as they say it will, because they'll panic during the next recession and probably start doing QE again. There is no way in hell they are raising taxes or cutting spending.  Just not what the public wants.

The public doesn't care about budget deficits, and most are too dumb to know that low taxes and lots of government spending is leading to the high inflation.  They see no relation between inflation and budget deficits.  No relation between money supply and inflation.  I'm sure a bunch of them think Putin and evil oil companies are to blame for high energy prices, or they believe that tired excuse of supply chain bottlenecks causing price increases.  

Politicians pander to the lowest common denominator.  And they all think short term.  Losing buying power because of high inflation?  Here's some stimmy checks for you.  Or some more child tax credits.  Or some student debt canceled for you.  Its not just one party.  Its both.  Republicans love tax cuts, but then complain about inflation.  Democrats love pork spending, but then blame others for the inflation.  They both love stimmies, one of those rare things that receive bipartisan support.  Everyone is a populist, and populism is inflationary.  

Don't confuse brains with a bull market.  We are separating the wheat from the chaff in 2022.  No longer can you just blindly buy the dip and expect future buyers to bail you out, like you saw from 2009 to 2021.  Investors have been conditioned over those years to believe selloffs are brief and great buying opportunities.  Just like the scars of 2008 left the investors nervous and shaky in 2010 and 2011, with frequent scary selloffs, all that money made by the bulls over the last 10 years are keeping them hopeful and reluctant to sell in 2022.  Hopefully, these hopeful bulls will turn this market around and provide a good risk/reward short. 

For the 3rd FOMC meeting in a row, we got a relief rally as Powell was less hawkish than expected.  I'm noticing a pattern here.  Maybe its...... Powell is a pansy?  He doesn't have the guts to surprise the market hawkishly.  He doesn't have the resolve to kill inflation.  After the last 2, we got a really vicious selloff.  Obviously there were some gamma squeezes happening to take the market down, as today is triple witching opex.  But the underlying conditions are very weak.  The daily trading action speaks loudly.  At SPX 3700, its not enough blood letting for a low risk long, and still too short term oversold for it to be a good risk/reward short.  Positioning is still not bearish enough for a sustained bounce.  Still not seeing enough index put buying.  Take a look at these equity fund flows over the past few weeks.  Does this look like capitulation?  

From 2008 to late 2020, even during the times when investors were optimistic, they mostly put money into bond funds and took money out of equity funds.  After the 2020 election, you saw an inflow into equity funds unlike anything since 2000.  There was an absolute deluge of money that poured into US equity funds in 2021.  And while no longer a deluge, its still a steady stream in a weak 2022.  And all that money is underwater right now.  We've created a huge pool of US equity bagholders.  The only reasonable comparison is to the late 1990s and 2000.  I don't want to hear about bearish positioning at the hedge funds.  They are on the right side for once.  And they are still net long.  And their capital pales in comparison to the combined size of retail and non-hedge fund institutional money.  And the fund flows show that the overall positioning of US stock investors is awful.  

Forward Guidance for Dummies

The Fed, not wanting to shock the market, put out a WSJ piece to signal 75 bps, to get the market prepared for that 75 bps hike.  What's the point of signaling 50 bps for June and July and then changing your mind and going 75 bps a few weeks later?  Hey Powell, its real simple.  Any ape can do it.  Just shut up!

Forward guidance is useless, and the Fed is still using it to try to baby the market, to coddle it so it doesn't have a temper tantrum.  And the market still buys it, thinking that Powell actually can keep his word, when over half the stuff he says is mealy mouth word salads meant to placate the market.  He knows he's up shit creek, but he tries to act confident, and unworried.  

Let's not forget the ridiculous forward guidance of zero rates into 2024 in the 2020 FOMC meetings.  That's been swept under the rug, just like those calls for a longer run 3.75% Fed funds rate in the Fed dot plots in September 2014.  

The Fed has not only lost credibility with their transitory inflation nonsense last year, but its lost credibility from all the other unnecessary forward guidance they've put out over the years.  In particular, the dot plots are a joke, but the market still likes to make market interpretations based on it.  Unreal.  They are micromanagers, and they don't know how to just sit still, and say nothing.  Even the terrible Greenspan would come up with all kinds of polysyllabic obfuscation to give nothing away in his speeches.  

They are arrogant beyond belief.  They think they are Nostradamus, able to see into the future.  They act like they know everything, and those shills at the press conferences eat it up and disseminate it to the masses. If you brought in someone from an Amazon  tribe from the jungle and let them watch those Powell press conferences and translate it, they would think its all pure theater.

Talk about government waste: having all those Fed governors, economists, their assistants, etc.  You can get rid of the Federal Reserve and all its employees.  Put in a wide range of acceptable short term rates, say 1-4%, and let the supply and demand for money do its job within that range.  Hand over the interest rate powers to the market, and if the government thinks the markets are panicking and getting out of line, step in and keep it in line. Not only would it save billions of dollars, it would make for much better monetary policy.

Let's get back to the market.  There are some out there who think the Fed going for 75 bps instead of 50 bps is better for stocks, because it signals that the Fed is more serious about getting inflation under control.  No, its not good for stocks, its good for bonds.  Because the more the Fed tries to get inflation under control, the more they hurt the economy, which will spill over into corporate profits.  As for bonds, they have gotten crushed with all the extra hikes priced into the short end, which has cascaded to liquidations in the long end.  

The long end of the yield curve wants a Fed that is looking to aggressively tighten and make the economy weaker, because it will ensure lower rates later.  The short end doesn't have that luxury, as it has to deal with the upcoming rate hikes during that process of making the economy weaker.  So expect a power flattening over the next couple of months, I expect 2-10s to get inverted by at least 20 bps by the next FOMC meeting in late July.  Its +6 bps now, so at least a 25 bps move in the 2-10s.   After that, I expect a bull steepening starting in the fall, when it becomes clear to everyone that the economy is clearly hurtling off the cliff at 55 mph.  There is no way the Fed can keep this tightening path for the rest of the year as the STIRs market is forecasting, a terminal rate of 3.75%.  No way.  

Economy is rapidly weakening, the leading indicators are all flashing red, the wealth effects are all negative (big losses in stocks and bonds over past 6 months, big rises in food/energy costs over past 6 months), and the Fed is still on the warpath.  Its going to be a lot faster U turn than people expect.  Once the employment numbers turn south, and its probably going to start at the next release, you will once again see the bond market act as a good hedge for stocks.  You had a ton of baby boomers who felt rich and financially invincible as both their stock and bond portfolios skyrocketed the past 10 years, and especially sharply over the last 5 years.  They are getting a rude awakening this year, and some are going to have to go back to the labor force to strengthen their financial position.  

The Fed is in a bind.  They are not the only ones to blame for the inflation, it started with Trump/Mnuchin and their insane corporate tax cuts, corporate welfare, plain and simple, which helped blow out the budget deficit to trillion plus during an economic expansion, 5% of GDP, unheard in previous eras.  Those Mnuchin led PPP / Covid bailouts were beyond excessive, trillions going down a black hole to who knows where.  I'm sure Mnuchin and friends had a field day with that one. And then you had Biden double down on excessive fiscal policy by spending trillions more on stimmies, and lots of pork, when the economy was rocketing higher in early 2021, adding fuel to the inflationary fire: creating a massive bubble in bitcoin, meme stocks, big cap tech, and real estate.  

The US is well on its way towards becoming a rich man's Argentina.  Trillions in net new Treasuries issuance every year will have to find real buyers, if the Fed isn't QE-ing.  That's not going to be easy when its becoming more apparent that the US government is abusing their exorbitant privilege of having the world's reserve currency, by running huge budget deficits, along with a huge trade deficit, while running bazooka QE campaigns on a regular basis.  That's a playbook for a future banana republic.  

Back to the current market.  We're seeing the worst possible situation for stocks.  A hawkish Fed looking to get more hawkish, a slowing economy that's not readily apparent to the masses because of the high inflation hiding the weakness underneath, but will be clear to everyone as the wealth effect acts a wet blanket on the economy, which has no organic growth due to the lack of growth in the working age population, meaning without constant wealth effect increases and fiscal stimmy packages, the global economy is going nowhere.  Zero growth organically is the new base case without massive fiscal stimulus and rising stock and bond markets.  With plunging stock and bond markets, its negative growth.  The only thing keeping the global economy from completely falling apart is all that money floating around in the system, which has kept house prices high.  

I did put on a SPX long on Monday, looking to play the pre FOMC rally, which hasn't happened.  I'll give it a few more hours and get out before the announcement.  I see no edge post FOMC for either side, so I'll go back to the sidelines, and use my dry powder if the SPX really plunges lower (3400-3500) and creates collateral damage in the energy sector, where I will add to longs there.

Hot Commodities

Back in the mid 2000s, when I thought more highly of Jim Rogers than I do now, I read his book, Hot Commodities, looking for some insight.  He had some good points, but he vastly underestimated the supply response to higher prices which resulted in a steady increase in the supply of oil/natural gas, grains, and the metals throughout the 2010s.   A lot of his bullishness was due to increased Chinese demand, which couldn't keep up with the increased supply that would eventually drown the commodities market, especially oil and natural gas.  

This time around, its a different animal.  You still have increasing demand coming from the emerging markets, but you are not getting much of a supply response to keep up with the demand increase, even if they are smaller than in the 2000s.  Remember, oil is not water, its not something where you just turn on the tap and supply increases.  You have to actually spend significant capital on exploration and get machinery and skilled labor to drill wells.  Unlike the 2000s, there is no easy pickings like you had in the US shale plays for oil/gas, as the current technology has already sought out the most desirable locations to explore and drill.  

Oil and natural gas production declines as you deplete reserves, so new locations and wells need to constantly be drilled to just keep overall production steady.  To actually increase overall production takes a lot of investment and time.  

But you aren't getting that much investment in oil and gas, because due to some dubious projections made by the EIA and so-called oil experts, many were forecasting peak oil demand and/or were projecting ridiculous oil supply increases as if the trend over the past 20 years would go on for the next 20 years.  Both supply and demand forecasts are wrong, and since the Russian invasion, people are waking up to this reality.

Some may say that this is a similar situation to 2008 when oil exploded higher as stocks were weakening ahead of the financial crisis, but as bad as the economy will get over the next several months, you don't have the same weakness in household balance sheets and the overextension of home equity loans that you did back then.  Back in 2008, house prices were cratering, which has a huge wealth effect.  Now, house prices are still much higher than a year ago.  And most people haven't tapped much into their home equity, unlike 2008.  Also, budget deficit is much bigger this time around, so that will buffer some of the economic weakness. Back in 2008, politicians weren't looking to cancel student debt or handout gas stimmies like they are now.  

And its much harder to get a financial crisis in an inflationary environment.  Debt payments are naturally easier to make and there aren't as many defaults as you would see in a deflationary environment when corporate cash flows are dramatically shrinking while debt payments remain stable.  

Yes, the economy will get weak, due to negative wealth effects from stocks and bonds getting crushed and food/energy prices surging higher, but you aren't going to see mass defaults when corporations are paying such low interest rates, which are very manageable in a stagflationary environment.  

Really, there are really only two possible things that can stop oil prices from continuing to go higher, and they are:

1. Severe recession.  Possible, but unlikely given the things I mentioned above.  You are seeing a situation more like post 2000 than post 2007.  The 2001-2002 recession was mild, even though the SPX went down 50%.  

2. Hamfisted, long lasting Chinese lockdowns.  This is actually more likely than the above, just because how zealous Xi is in keeping his zero Covid policy ahead of his renomination in November.  So it is a risk until November, but after that, China will slowly relax their rules, when they eventually realize that Zero Covid isn't a long term solution, and I'm sure he's not so dumb to keep that policy after renomination seeing how it wrecks the Chinese economy and stirs up huge discontent among the locked down.  They'll eventually give up on zero Covid and oil demand will keep rising, while oil supply is unable to keep up.  

Even when you've been in this business for decades, there are always new things to learn, or things to improve upon.  As you get older,  brainpower slowly dissipates, but to counteract that, you have to gain wisdom.  A lot of this is the wisdom gained from painful experiences, both of actual big losses, and regrets at missing great opportunities.  

My biggest losses happened when:

1. Market regime changed and I was still trading the past regime. (hard to avoid) 

2. Doubling down to make back my losses as quickly as possible. (easy to avoid, just have to be mentally tougher).

My biggest regrets were when :

1. I sold too quickly after getting a quick profit, only to see the market go my way for several more months.  

2. I tried to avoid a short term drawdown by selling core positions, only to see the thing go higher and higher without a correction, leaving me behind with no position. 

That brings me back to the current market.  When I look back at this time period 2 years from now, what will be my biggest regret?  Having a short term drawdown on my energy longs because I didn't sell at a local top, or missing the biggest commodity bull market in my career because I was trying to avoid a short term drawdown?  I think its much more likely to be the latter, so I want to make sure I keep my position, even if my short term view is bearish risk assets.  

Wow, did I read that wrong.  Did not expect a 200 point plunge in SPX (combined Fri./Mon.) on a slight beat in CPI.  That just shows you what markets are vulnerable and which ones aren't.  Commodities aren't too fazed by this big plunge in stocks, or expectations of a more hawkish Fed.  In risk off days, you see which ones are filled with the weak hands and which ones aren't.  There are very few weak hands in commodities.  In stocks and bonds, you have a lot of weak hands.  That shows up on days like Friday, when you get a risk off move, the weak hands are the most aggressively selling on days like that.  

Even though I was expecting a rally after CPI, fortunately I didn't play it.  As I've mentioned before in a previous post, betting on a short term move against your long term view is like picking dimes in front of a bulldozer.  You will often succeed, but the times when you get hit, you will get hit hard.  That's why I didn't get long SPX, even though I was expecting a rally after CPI.  Now my biggest regret is missing that golden shorting opportunity around SPX 4150 (NDX 12700), looking to short around 4200-4250 SPX (12800-13000).  I was a dick for a tick, trying to be Mr. Perfect, and it cost me a great opportunity on the short side.  I am not selling anything so I can be honest.  Lot of so-called traders selling snake oil and subscriptions, they know they can't admit mistakes, they always have to show the utmost confidence, put bad calls and mistakes under the rug, like a politician, in order to appear "strong" and "competent".  Confidence doesn't equal competence.  Especially in the markets.  

We are close to SPX 3800, and the market has a memory.  The market bottomed around these levels and ripped 400 points in less than 10 days, so there will naturally be dip buyers around here.  You have some heavy options forces at play due to the huge outstanding open interest in June 17 SPX expiration, along with the heavy monthly opex for stocks and ETFs on that day.  Lots of gamma squeezes going on, you are seeing a lot of dealer hedging as the deltas move wildly with expiration only a few days away.  In general, when you have a huge selloff going into an FOMC meeting (see Mar./May FOMC chart patterns), you have a rally the day before the meeting into the day of the meeting.  This is a combination of vanna and charm flows as the theta and IV both decay rapidly as you get closer to expiration.  Since most dealers are short puts, they have to buy back their shorts to cover as the deltas on their short OTM puts goes closer to zero.  I expect a similar setup this time.  

And I will not be following my previous advice, just because I have a set time frame for the long SPX trade (buy on Monday, sell on Wednesday, no matter what).  I am looking to put on a moderately sized long to play this short term move.  There is a very high likelihood that you will bottom today and rally into the FOMC meeting at 2:00 PM ET.  Beyond that, is anyone's guess, but I would still lean bullish, although wouldn't play it past Wed. 2:00 PM, as I could see Powell do whatever he can to sound like a super hawk while just raising 50 bps (talk tough, act soft).   Let's see how this goes, as I am breaking one of my rules, but this time, I am not going to give the trade much rope to strangle me, so I have a time stop (Wed. 2:00 PM ET) and not putting on big size. 

Pending Energy Crisis

After the US government/Fed money bazooka in 2020 and 2021, people lost their minds and went all in on garbage SPACs and investing in stuff that people don't need: crypto mining, fintech fantasies, EVs, etc.  The drop to negative oil prices created an illusion that oil demand had peaked and energy was plentiful.  Energy is only plentiful when you have hamfisted lockdowns.  In an normal environment, there is just not enough energy.  

After the brutal oil bear market in 2015-2016, capital expenditures at oil and gas producers were pared back to historically low levels, which became even lower after the lockdowns of 2020.  All the while the government kept printing enormous gobs of money in various forms of pork stimulus and helicopter drops.  People with lots of money, with no corresponding increase in productivity, speculating in bitcoin and FANG stocks, while energy companies battened down and spent as little capital as possible, trying to just survive.  Those are your ingredients for a future energy crisis.  And we are getting closer to the beginning of that energy crisis.

People forgot that the emerging markets still have a voracious appetite to increase their energy consumption, as its the quickest way to economic growth.  India, China, and Southeast Asia are still growing, they have hundreds of millions living in poverty that are working to increase consumption of goods and services, all of which require more energy.  For them, net zero and climate change are rich country problems, not something they can afford to worry about.  

As the US and Europe are shutting down their refineries, the Middle East and Asia are building new ones to satisfy the demand for diesel and gasoline.  The energy policy in the US and Europe, with its focus on renewables and its fantasy about peak fossil fuel demand, have resulted in a shortage of refinery capacity, leading to huge crack spreads and diesel prices that would normally happen with crude oil prices over $160/barrel, not $120.  

The shutting down of nuclear plants and replacing them with wind and solar has been a key factor in the huge demand growth for nat gas as a fuel source for power generation, even while the government makes it hard to build more gas pipelines out of existing gas fields, which are limited by midstream infrastructure, not production capacity.  

Above is a chart of global oil inventories, with Q2 shaded.  Q2 is normally a time for oil inventory builds, as its the shoulder season with refinery maintenance and less discretionary driving and heating needs.  But despite the China lockdowns (China oil demand decreased more than Russia oil exports decreased over the past 2 months), there have been oil inventory draws.  It is amazing to me to see net US inventory draws in Q2 despite SPR pumping out 1M barrels/day to try to balance the market. 

Even with the right government energy policies, it wasn't going to be easy to supply enough oil and gas to meet growing demand, but with the obsession over renewables and marginalization of future oil and gas production, as well as nuclear, the policy makers have exacerbated a bad situation and made it catastrophic.  The inventory declines in oil and seasonally low levels of nat gas in storage are huge warning signs that this is a long term problem, something that's not going to be fixed by SPR releases or additional production from OPEC+, which is pumping near total capacity.  It can only be ameliorated by aggressive oil and gas exploration and capital spending to increase production, which will only pay dividends several years later, due to long lead times.  Shale oil production has peaked, and it was never a long term solution anyway due to low recoverable reserves and high decline rates.  

We've had warnings from MSFT and TGT, and INTC talking down their quarter.  All in the past week.  And we're not even in the heart of Q2 earnings warning season, which is late June.  The market has traded sideways and have bounced back after these bad news announcements, but what's more important is that the market is wasting time during this rally window to get to higher levels.  In a bear market, there is only so much time that the market can rally before the bearish forces return and the predominant trend continues.  There was a lot of carnage in April and May, so it makes sense that there is a countertrend rally and a period to consolidate the losses, but that reprieve won't last much longer.  I give it until the FOMC meeting next Wednesday, and then things should get shaky again for this market.  Seasonally, things are weak after triple witching opex, and that's coming up starting next Friday.  

I am looking to put on shorts if we get a rally after the CPI number is released tomorrow.  Target for short entries are between 12800-13000 in NDX.  

Not Reinventing the Wheel

“I’ve Never Made A Play Up. You Just Steal From Other Coaches. Brad Stevens Draws Up Great Stuff. Dave Joerger Runs Really Good Stuff Too.” - Steve Kerr, Golden State Warriors head coach 

The internet is a great equalizer.  Institutions used to have a huge information advantage back in the old days.  And most of the information is free, and people willingly give away valuation information, which is sort of their way of doing philanthropy.  I know there are many traders that don't like to reveal how they make money, or give out their investment ideas, thinking that letting others know will dilute their edge, or make it go away if too many people trade it.  But even if you give people a profitable trade idea or strategy, most of them will figure out a way to make it much less profitable or even unprofitable. 

My experience from talking to other investors, who trade their own money, most of them who are just dabbling part time, is that they have pretty big egos, and often don't follow recommendations, or if they do, only partially.  People like to do their own thing, and think they are usually right.  That's why investors like to hold on to losers, not just because they don't want to admit defeat, but its because they think they are right, even when the market is telling them they aren't.  I actually fall into that trap myself.  Although I've gradually improved at admitting defeat and taking the loss.

A few months ago, I spoke to an acquaintance, a novice investor.  He asked me what he thought were a good investment, and I mentioned a few oil and gas stocks.  I gave him my reasoning, and he bought a couple of them, but then promptly took a profit a month later, saying that they went up quickly and he thought they were short term overbought.  I told him I was still long, but he clearly didn't have the same view. In fact, he actually shorted an oil ETF after the Russian invasion, when WTI was around 110, because the chart looked overbought, despite my pleas to not short oil.  Last time I spoke with him, he was still short.  

This gets back to information that you find on the internet.  There is a lot of bad or irrelevant information out there, so its hard to separate signal from noise.  But what I've noticed is that you would be surprised how often widely available information is actually not fully priced into the market.  

Investing is not reinventing the wheel, a lot of its looking around, finding other people's good ideas, doing some due diligence, and making an investment.  Not much creativity or direct hands on research is involved, a lot of it is just stealing other people's stock ideas.  But that's the tricky part, because you have to pick the right people to follow, a lot of people are just talking their book, and not being rigorous or objective about the investment prospects of a stock.  There's a lot of misinformation, bad research out there.  Honestly, I'm much better at picking and choosing who to follow, figuring out what is good research than I am at actually doing good research myself. 

This brings me to the commodities market.  The underperformance of commodities vs US equity indexes since 2008 have biased people's views and asset allocation.  Despite the overtly bullish fundamental supply/demand situation that's developed over the past few months, there doesn't seem to be a huge rush of capital flowing to the energy sector.  I think most of the recent strength has not been from eager new buyers, but from corporate buybacks and those already invested less willing to sell at current prices.  

At first, I was also skeptical about a new up cycle in commodities, in particular oil, after the big drop in 2020 because I was expecting OPEC+ to cheat, and boost production much more quickly than they did, keeping inventories high.  They were actually quite disciplined in staying under their quotas, a change from past behavior, which went a long way towards eating away at the inventory surplus that had built up in the the first half of 2020.  By late 2021, global oil demand had basically come back to pre Covid levels, even without much international travel to Asia and even some parts of Europe, so I knew the inventories were going to have a hard time building back up. 

All the research reports and articles from informed sources in the energy space were coming to the same conclusion: supply was not able to keep up with demand.  Capital investment in future production was low and not growing, even as prices were going higher, and demand was going up much faster than expected in the emerging markets.  Perhaps it was due to the big drops in oil prices from late 2014 to early 2016, in late 2018, and in spring 2020 that gave pause to oil company CEOs from spending more money on investment and exploration, and they stayed conservative and disciplined.  

 

Due to the natural decline of oil wells, especially shale oil, you need continuous capital investment to maintain production, and that's not happening.  In the above chart, you can see the drop in capital expenditures from 2014 to 2021 is steep for 3 large oil producers.  Whether its scars from oil bear markets, peak oil demand concerns or ESG compliance, oil & gas companies have dramatically reduced capital spending in the past few years.  That's not a good sign for oil supply.  Most oil projects that are not shale require a few years to ramp up production, and its safe to say that most of the easy pickings have been drilled, so the stuff that's left over is going to take longer and require more investment.  

There is lots of other research that have confirmed both less capital investment, higher than expected demand in emerging markets, and relatively inelastic demand in developed economies to higher gas prices (much higher than implied by crude oil prices, due to extremely high crack spreads).  And that's not even mentioning the ridiculous energy policies in Europe and America, that have focused on renewables and have shut down nuclear power plants, slowing the growth of power generation capacity, increasing demand for natural gas, even to the point that natural gas was twice as expensive as oil in Europe, prompting power companies to switch from gas to oil.   

From everything I read, from reviewing the data, from the price action in oil, natural gas, and coal, it all points to a super tight market for energy.  An energy shortage looks to be inevitable, its a perfect storm where the market can only be balanced in the short term by demand destruction.  And energy demand is much less elastic than people think.  People in America complain about $5-6/gallon gas, but that would be considered an absolute bargain in Europe.   Its going to take a big sustained increase in energy prices to get the required demand destruction to balance this market.  It won't be able lean on SPR releases, or count on China regularly locking down and keeping a zero Covid policy forever.

The plan is to hedge my energy longs with shorts in NDX and overpriced tech (ARKK, TSLA, etc.) after the CPI on Friday.  Still giving the bulls more room to roam, I have a feeling that they'll get excited and bullish after the CPI report this Friday.  Also you tend to get that upward drift into the FOMC meeting in the days ahead of it.  Plus VIX expiration, which will close out a lot of VIX call options, more than puts of course, which should help to suppress vol next week.

Follow Your Long Term View

In this game, you have to learn from your mistakes and play to your strengths.  I've learned over the years what my strengths and weaknesses are.  And they are not conducive for daytrading.  Like a lot of newbie traders, I am bad at taking losses, which is deadly if you are daytrading.  But less so if you are position sizing smaller and looking at longer time frames.  

I thought about all the mistakes I've made this year and they all began when I tried to play for short term moves which were in the opposite direction of my long term view.  Earlier in the year, I thought Treasuries were short term oversold but knew that they were likely to go down more later, and lost.  I was a bit too early in buying the dip in SPX during the weakness in February, even though I knew the bubble was about to burst soon, and lost.  I thought the SPX would have a longer counter trend rally off the bottom in March and bought the dip in early April, expecting a short term bounce higher and lost.  In all those instances, my short term view of the market was the opposite of my longer term view.  

Its a lesson that was learned from previous experiences, but forgotten, since I was usually playing on the long side of SPX from late 2020, and my short term view was the same as my longer term view of the market for quite a while.  

My longer term view of the SPX is bearish, so unless things get really oversold and panicky, I am avoiding the long side.  Still haven't taken an outright short on the market, as I was giving the bulls the benefit of the doubt and giving them room to see how high they could take the market.  And they have disappointed me.

The price action this week has revealed a lot.  We haven't gotten an extension higher off the furious 3 day rally from Wed. 5/25 to Fri. 5/27.  Instead, the market has decided to go back down and test the lower end of the range for those rally days.  The less time the market spends at the recent highs, the less strength its showing.  The overnight rally on Monday that took SPX up to 4200 was quickly sold off during the regular hours on Tuesday and Wednesday.  We got a strong rally off the dip on Thursday despite the MSFT earnings warning and have taken most of that back today.  

In the end, the long term fundamentals of this market has not changed.  The Fed will stay on their rate hike course even though the signs of a slowing economy are growing.  Investors are still in hope mode, hoping that the Fed is less hawkish, that they are closer to their dovish pivot, hoping that a slowing economy and inflation peaking will make the Fed less aggressive in their tightening.  But none of the economic data this week will allow the Fed to make a pivot anytime soon, even though I do expect them to cave in eventually when stocks go much lower.  But here is the important thing:  stocks have to go much lower before they cave in!  If stocks stay here or go higher, the Fed will put on a brave face and act tough, because the only time they get nervous is not when inflation is high, its when stocks are low.