Crazy Pills

The economy.  Its going to get real in a matter of weeks to months.  Many think that we are already in a recession (like me), but that's still not a consensus view, considering how many rate hikes are priced into the STIRs market.  Its pricing in a peak of 3.55% Fed funds rate by Jan. 2023, or 185 bps more hikes by year end, which is 110 bps more after the near certain 75 bps at the July FOMC meeting.  

I find it hard to imagine a Powell led Fed hiking to above 3% while NFPs are printing around zero and credit spreads are blowing out as earnings disappoint in the latter part of the year.  This is a Fed that is nervous about keeping the markets in a cloud of uncertainty over whether its going to be 75 bps or 100 bps.  Look at that panicky piece they fed the Wall Street Journal about them hiking 75 bps in July while they are now in a quiet period.  Even during their quiet period, they can't shut up.  

Deep down inside, Powell is a market sycophant.  A pleaser.  A caver.  I don't think Powell wants to go back to the twilight zone like December 2018, when he tried to force another rate hike and got heavily criticized while the stock market revolted.  And this time, the economic backdrop is much worse with a worse inflation picture, weaker global economy, and a more overvalued stock market.  

Despite my view that Powell will eventually relent to the market, he's not going to do it when the SPX is trading 3800-3900.  Not when IG spreads are trading 90 bps.  He needs to see CPI come down for 2 straight months, and not by just small amounts, and he needs to see some pain in the stock market and corporate credit.  He's very comfortable with the economic conditions as they are right now, which means he'll go ahead and try to do what the market is pricing in, which is 3.5% Fed funds by year end, which would be an absolute hurricane to the financial markets if it goes through.  Its one thing to price it in for the future, its a whole another thing when investors can collect a risk free 3.5% in reverse repo in a crap economy while corporations have to pay up to issue short term paper.  At those rates, money will flood into cash and short term bonds out of equities. 

The market seems rather placid recently.  There are still a majority who don't think the US economy is in a recession, or going to be in recession soon.  Most think its due in 2023, or even later.  You can see their lack of fear in the options market.  The desire for put protection is going down, as the IVs on index puts are going down, down, down.  Dealers, who are usually heavily long index puts and short calls, have very neutral positioning, which is uncommon.  Meaning, customers are lacking their usual put protection, as they either monetized them in the recent downturn, and didn't replace them, or just got frustrated seeing OTM puts not payoff during a market selloff, and stopped buying them.  

This leaves the market more vulnerable to liquidations if there is a big selloff, as the Street is not well protected right now.  Yes, hedge funds have low net exposure, but I don't see them increasing their net exposure until you see a Powell pivot.  And I don't think they are in the mood or in the risk seeking position to try to anticipate it either.

Maybe I am just crazy for thinking that we are getting a good shorting opportunity this week into the renewed optimism from the longs after the "good" market reaction to a bad CPI report.  And the market is having a relief rally from the Fed's assurance that they won't go 100 bps next week, and do just 75 bps, as if that's ok.  It's a bizarre world out there.  If people would have told you in May at SPX 3900 that the CPI would be at 9.1% and the Fed would be raising 75 bps for the 2nd straight meeting, into an economic slowdown and upcoming earnings revisions, they wouldn't want to be anywhere near equities.  Now, at 3900, they want to be buyers to "play" for a bear market rally. 

Of course, you have the permabulls who say its all priced in, everyone is too bearish, and that there is a good chance for a soft landing and/or a dovish pivot soon. 

I hear a lot of talk about a bear market rally, and about all the bearish sentiment, but I look at what investors are saying on Twitter, Stocktwits, CNBC, Bloomberg, etc., and it seems like the action on Friday has made the crowd lean bullish again.  Many are looking for a rally this week, and have upside targets like 3900, 3950, even 4000 and above for the short term.  Admittedly, most of them think it will just be a bear market rally.  Which means that they are short term bullish, long term bearish.  That's another way of saying that they are long but holding a weak hand, looking to sell soon.  

When people tell you both their short term and long term view on the market, almost all of them are positioned with their short term view.  I would argue that the fast money is bullish, and either already long or looking to get long early this week, but sell quickly.  Which means that this rally off the CPI pullback will probably be brief.  Take a look at this survey from @hmeisler over the weekend:

Actually, this doesn't mean that the market will go down right away, the crowd is often right in the short term.  In a bull market, investors being very bullish doesn't tell you much.  But in a bear market, it tells you a lot.  Investors don't like to sell for a loss, especially retail investors, and most are still hanging on, expecting this to be another great buying opportunity like all the other corrections in the past 13 years.  This is not a good sign for the intermediate to long term outlook, as there aren't any big stimmy checks coming through that door, and their discretionary income is being squeezed by inflation, so less money for investing.  And they already have a heavy allocation to equities and a low allocation to bonds, which will make them even more nervous if the market keeps going lower. 

To be objective, there are 2 things that are a positive.  

1. Futures positioning in equity index futures among asset managers is very low, and have often coincided with bottoms over the last 7 years.  The counterpoint would be that they are always low after a 15-20% selloff.  And that is also true.  Correlation doesn't equal causation.  Dealers are long futures, so they are either hedging their short call and/or long put positions.  Which just confirms that the Street doesn't have on much put protection. 

2. Hedge fund / CTA positioning is light.  Hedge funds are notorious for being jumpy and being afraid to be on the wrong side of a trend.  I would argue that light hedge fund exposure is like lighter fluid, it can lead to explosive rallies if the fire can get ignited.  There needs to be a reason for the fire to start.  They are not getting back in because everyone is so-called bearish.  Its going to require something fundamental.  It will have to be a Powell pivot, and I don't see that coming until recession signs become more obvious and apparent to even the clueless politicians, who is the group that Powell aims to please.   

Getting a big gap up today.  Looking put on short Nasdaq positions and close out long energy positions this week.