Terrible Backdrop for Stocks

This is just a terrible environment for stocks.  Its not just Powell with his appetite for destruction as he acts tough and gets egged on by financial media to be like Volcker on inflation.  While this is going on, you have an economy that is in a weak position to deal with all these rate hikes as the fiscal impulse is in contraction with nominal M2 money supply flat for the last 6 months, basically unheard of in the modern, post gold reserve era.  Add on top of that the negative wealth effects from stock and bond weakness, as well as much higher rents and food/energy/services costs and you have a consumer that is going to reduce consumption.  That will eventually feed into weaker manufacturing and services, and the inflation rate will go down with a lag of a few months.  

Stock valuations are based off of earnings and the multiple on those earnings.  Earnings are estimated based on the macro conditions.  The multiple depends on financial conditions, mostly the rate at which corporations can borrow.  These are the highest rates for borrowing for corporations looking to issue 5,10,20,30 year bonds since 2010.  Back then, the S&P was trading between 1000-1260.  Its basically 4 times that level now.  No, earnings haven't gone up 4 times.  The forward P/E ratio, which was estimated based off of post recessionary levels, were still just 12 times earnings.  Now, estimates based off of post fiscal boom levels, are trading at 16.8 times earnings.  Somewhat similar interest rate levels, except for short term rates being much higher now than back then, when it was hovering around 0. 

I can't think of a much worse time to be a stock investor after the biggest financial bubble in history just popped, and you still have valuations that are quite elevated with central banks trying to hammer the market anytime it rallies.  

If there is one thing to be learned this year, is that the longer time frame moves are based on macro fundamentals and liquidity, while short term moves are based a lot on positioning, either a wave of stop losses on the selloffs, or big time short covering on the rallies.  We had the short covering rally from mid June to mid August, now its back to the primary trend, which is down.  And I don't see why that trend would end, with the Fed hell bent on hiking to 3.5-4%, and then staying there for a while.  Sure, they'll eventually pivot to the dovish side, but after how much carnage? If there isn't much of a selloff, the Fed will just keep hiking until something breaks, or when the very lagged inflation numbers come down in the middle of 2023, as base effects bring it down sharply. 

I mentioned before that I preferred playing the coming weakness by going long bonds rather than shorting stocks, and that's true from a longer term view, in the short term, its probably better to just short stocks because the market has no appetite for taking on duration risk, and that's probably going to stay that way until the US economic numbers get much worse.  That could take 2-3 months.  In the meantime, stocks could keep getting hammered while bonds go nowhere, stuck between hawkish central banks talking tough and economic data that is weakening, but not falling apart enough to get them to pivot or talk more "gently".  

This market is really out to get counter trend traders.  Straight up and then straight down.  If you are trying to short tops and buy bottoms, its tough out there.  I am hoping for a 1-2 day relief bounce/short squeeze to give a good short entry but its not looking like its happening anytime soon.  And tough to just short the weakness, although it does seem so weak, almost as if the options data showing very little hedging over the past several weeks is coming to haunt the long only managers. Just watching, and waiting for a fat pitch.

Head First Into the Wall Again

We're back to the April to June playbook of selling everything on hawkish central banks.  There is a twist this time.  The economic data is significantly weaker and inflation is much better publicized now than back then.  That tells you the playbook is starting to get old, and the market won't be there to hand out free money to short sellers of both stocks and bonds like last time.  

In the short run, bonds can get pushed around by the central banks, but in the intermediate to long run, economic growth and inflation moves the market.  Its a more favorable environment now for bonds than it was a few months ago as now both growth and inflation are going down.  The level matters, but the direction is also important.  I get the sense that everyone is bearish on the European economy but think the US will come out of it with a "shallow" recession.  The crowd is too optimistic on the US (lowest M2 growth of the G20 this year), not considering the low organic growth rate for the US.  Some people are even saying the Inflation Reduction Act and the student debt cancellation will contribute to more growth and inflation, but that's small and spread out over a few years.  There is a big difference between giving someone $10K and reducing $10K from their pile of debt.  When you reduce the debt, they don't have the option to add $10K more in debt in order to spend it.  

Let's not forget that investors paid a lot of capital gains taxes this year, that's money they're not getting back when they lose back the gains.  That's contributing to the fiscal contraction vs 2021.  There is a bigger wealth effect from stocks and bonds than in the past.  The US economy has gotten more financialized, as a bigger portion of overall household assets are in stocks.  That negative wealth effect will remain unless there is a big run up higher in stocks again, which looks unlikely given the valuations, economy, and liquidity conditions.  

The CPI will remain high for several months mainly due to the lagged effects of owner equivalent rent calculations, but the reduction of pent up demand for services, negative wealth effect, tight liquidity working its way through the system, commodity weakness coming from zero Covid and housing bubble popping in China, and a stronger dollar will contribute to lower inflation in the next several months.  

In that kind of environment, inflation going down and economy getting much weaker, the Fed would be fighting both the stock and bond market in continuing to tighten, or even by just pausing at higher rates.  Contrary to what many think, the Fed wasn't the reason the stock market plunged.  It was inflation.  The market wasn't ready for inflation to get so high and remain there for so long, which prompted the selloff in the bond market, which then caused stocks to selloff.  In fact, the Fed has been following the market's orders in getting more serious about dealing with inflation, and that stopped the bleeding in June (along with short covering and put hedges being monetized by investors) as the Fed regained some credibility on that issue.  Once the Fed got the message, after that 75 bps hikes in June, and with oil prices going back down, the stock market soon bottomed, along with bonds.  

But this time, the stock market is not going down because of the inflation shock, its because its sniffing out a weakening economy and seeing that the Fed is still fighting the last war (inflation).  That's not good for the economic outlook, and earnings outlook for the next 12 months.  Yes, everyone still talks about inflation, but that's looking in the rear view mirror like the Fed.  Its the growth outlook that's going to be moving markets for the rest of the year.  And with Powell trying to be Mr. Hawk and the second coming of Volcker, that's only going to make things worse.  

Its really unbelievable how bad the central banks are at their jobs.  They keep making one error after another.  They overstay their welcome, especially on the easy money side, and that leads to future mistakes.  They tried to create more inflation by printing gobs of money from 2008 to 2021, and all they did was build a huge house of cards and a bloated stock market, along with a bunch of zombies addicted to low rates.  This time around, they blew it by being so slow to hike rates and stop QE, forcing them to panic hike and now they are fighting the last war and will be hiking and keeping rates high while the house of cards collapses.  And that will cause them to make the next mistake, cutting rates down to zero, and keeping rates too low again.  Running head on into a wall without a helmet, getting up, and then going in the opposite direction sprinting head first into the wall again. 

So what happens when stocks and bonds move on from inflation and start to focus more on the slowing growth?  In my view, stocks go down, bonds go up.  In the short term, they can go down together as they are afraid of a hawkish Fed and ECB, while inflation is still high, but its not going to last.  The leading indicators are pointing to 2008 like economic conditions for the next several months.  But unlike 2008 when the Fed was cutting to zero and soon embarking on QE to come to the rescue, its the opposite this time.  The Fed will be exacerbating the slowdown and make it that much worse.  

Once they realize their mistake, they will do a quick 180 and act like what they said a few months before never happened.  When does the Fed realize they've made another policy error and make a U turn?  Usually its when the stock vigilantes (selling off hard) or the reverse bond vigilantes (really inverting the yield curve) send the Fed a message by having a temper tantrum.  Its when the "experts" on CNBC and Bloomberg go from the Fed can't pivot now because inflation is too high, to the Fed is making a policy error by keeping rates too high because the economy is falling off a cliff.  They often coincide with economic data that is rapidly weakening, which is usually accompanied by a very weak stock market.  But these days, the stock market is so tied to low rates, that really bad economic data might not crush the stock market if the bond market rallies big and stock investors start anticipating a dovish pivot.  

But in any case, credit spreads will soon be blowing out as the economic weakness doesn't mix well with a hawkish Powell still conjuring up his inner Volcker, thinking this is a repeat of the 1970s.  

Got another weak Friday close, Monday morning big gap down in the works.  Similar amounts of SPX call buying and put selling on those big down Fridays.  Its a tricky time, as the futures speculators are massively short, but the options hedging investors are complacent and quickly monetizing their hedges or outright using index calls as stock replacements.  One force is bullish for stocks, once force is bearish.  Right now, the bearish forces are winning, and will probably keep winning due to where we are seasonally, a very weak period, along with where we are in the liquidity cycle, which is very tight.  

If the speculators weren't so short, I would have held my shorts like the Rock of Gibraltar, not moving an inch and holding it and holding it.  But just didn't feel comfortable holding a short position when speculators were up to their eyeballs in shorts.  But now that the speculators are not bleeding so profusely from the bear market rally, they are no longer the weak hands that they were when the SPX was above 4200 going towards 4300+.  The bears are on the right side, and those still short survived a heck of a short squeeze there in July and August.  

I'm looking to get short again, not at these levels, but if there is a little short covering post Jackson Hole, perhaps the SPX can get back up to 4150-4200 area.  That would be a spot to re-short.  I don't see the SPX being able to get back up to 4300, not with how unhedged investors are at the moment.  If I see a lot of hedging in the coming days, I can change my mind, but I doubt it.  It looks like the bear market rally is over, and we're on the other side of the hill looking to get back down to under 3800.  

Cyclical Disinflation Secular Inflation

We are on the downside of the cyclical inflation up move that started in April 2020 with negative oil prices and peaked in June 2022.  This cyclical inflation down cycle should not be confused with a return to the heyday of the Chinese offshoring / labor arbitrage era of the 2000s and 2010s.  That's not coming back unless India becomes China, and I just don't see that happening anytime within the next 10 years.

Supply and demand in the labor market is favoring workers for the first time since the 1970s.  Its a workers' market.  The aging population, with growing percent of the population retired, has kept labor force growth flat, even with population growth.  Corporations were able to fill the labor supply gap over the years by outsourcing production to China, but China's labor force is also flattening out, so that source of cheap excess labor has mostly been used up.  

A tight labor market may loosen up a bit with a deep recession, but we're not going back to the post 2008 labor market, when outsourcing to China was booming and demand for US workers was lower than supply.  Its the opposite now.  Especially for services, which can't be outsourced to China, and need a local population of workers.  That shortage of workers in services will increase their wages, which increases the cost of goods and services which are labor intensive, keeping inflation elevated.  Wage increases in the lower end of the income spectrum fuels inflation, as the bottom half of the income earners consume a huge portion of their income, unlike the rich who save and invest most of their income.  The buying power of the bottom half, boosted by higher wages, will fuel the inflationary fire as their consumption and ability to pay increasing rents keep the flame going.  

Its going to be a wage price spiral, with fiscal handouts like student debt forgiveness, gas tax holidays, and future stimmy checks and child tax credits spewing gasoline on the fire.  You have to rethink what the financial markets will be like in this secular high inflation environment.  

In a high inflation environment, bonds don't act as a good hedge for stock market volatility.  In fact, the correlation becomes more positive, so bonds act more like stocks.  And with high inflation, higher interest rates can be tolerated because everyone's cash flows increase.  Even retirees, who have cost of living adjustments baked into their Social Security payments, get bigger and bigger checks the higher inflation goes.  

But will the Fed actually take interest rates above the inflation rate, like it last did in the mid 2000s?  Highly unlikely.  There is just too much debt in the system to go back to positive real rates.  That's a fantasy now.  What blows up the system won't be allowed to happen.  Keeping interest rates above the rate of inflation will blow up the system in a zero growth rate environment.  And we are in a zero growth rate environment.  GDP numbers only will show positive readings due to the underreporting of inflation.  With accurate and real inflation numbers, organic GDP growth is around zero for the foreseeable future.  This is a function of no productivity (maybe slightly negative) growth, and very low population growth in the developed world, mostly in less productive elderly population.

In a secular high inflation environment, the go to play is to buy real assets:  real estate, commodities, and stocks that produce real assets.  The coming cyclical downturn and what I expect to be a deep recession will temporarily deflate these real assets and that's your opportunity.  I don't see a bright future for tech stocks, the thing that has been working the best over the past 13 years. 

We are in a precarious position now with cyclical and secular forces going in opposite directions, and in most cases, the cyclical forces win out in the short to intermediate term.  The next 3-4 months will show increasingly weaker economic data and that will likely help the bond market for the latter part of the year.  But that's not where the big money will be made over the next 5 years.  The big trade will be to invest in real assets and ride the inflationary wave back up, when the cyclical forces are no longer weighing down on the secular trend of higher inflation.  

Its tricky trying to time the cyclical moves, as the secular moves are longer term and easier to predict.  But I have a hard time going long commodities into a seasonally weak time period of the year as the economic data just starts to get really bad, with stocks still priced for a "softish" landing.  

On the current market, neutral on SPX at the moment, don't see much of an edge either way, would rather short rallies than buy dips as the seasonal equity weak period is coming up, which is early September to mid October.  Corporate stock buyback blackout period starts around mid to late September, so the bid coming from companies will be much lighter in a few weeks.  Also, angst over the coming winter in Europe with sky high gas and power prices, along with the continued strong dollar headwinds should keep investors from getting too bulled up.  On the other hand, the positioning data still shows hedge funds with huge futures short positions, and systematic funds with low equity exposure.  So a big plunge during this seasonal weak period is unlikely.  Thinking a move to SPX 3900 by October is possible.

Bonds really weakening over the past week, it looks like fear of a Fed overtightening and caution ahead of Jackson Hole.  This phase could last a few more weeks but the trend of higher and higher yields is unsustainable when the leading economic indicators are this bad.  So looking for a possible opportunity to get long bonds sometime in  September as the fear of an aggressive Fed gets more palpable. 

Fed is a Follower Not a Leader

Jackson Hole is now the event where Powell is supposedly going to put on his hawk costume and scare the markets into believing that he's going to be very aggressive hiking rates to control inflation.  I'm not holding my breath for that.  Powell has proven to be just another cookie cutter dovish Fed chair who seems more concerned about breaking something than about runaway inflation.  I know I am in the minority view, as most people now believe, unlike 6 months ago, that the Fed will keep hiking until the CPI comes way down, closer to the 2% level.  Balderdash.  

The Fed was only hiking big the past 3 meetings because the bond market was having a fit over the Fed sleeping at the wheel and not doing much about 8%+ inflation.  If the STIRs market wasn't aggressively pricing in hikes for 2022, and the stock market wasn't dropping big because it was afraid that the Fed was not doing enough to control inflation,  Powell would still likely be twiddling his thumbs.   The Fed are market slaves.  They are not thought leaders.  They are followers of the market.  

The Fed didn't raise rates 50 bps in May, 75 bps in June and July despite a falling stock market, it was because of a falling stock market, which was panicking over the Fed doing too little to fight inflation.  From what I read on Twitter and sell side research reports, it seems most are of the view that the Fed has to raise rates because year over year CPI is too high, even if inflation has peaked and month over month #s are going down sharply.  They ignored the fixed income market as rates went up earlier in the year, skeptical that Powell would go more than 25 bps a meeting, even as the bond market was screaming to the Fed to get on with the Fed hiking, and quickly.  Now they are ignoring the message from the bond market again, this time believing the Fed hawkish talk over what the bond market is saying.  

2s-10s are inverted 31 bps.  The STIRs market is pricing in a high in Fed funds rates in March 2023, and then 100 bps of cuts over the next 2 years into March 2025.  Its pricing in a long term neutral Fed funds rate of 2.5%.  It betting that whatever hikes that the Fed does from now on, will not be sustainable and will eventually be taken back starting from 2023.  The Fed is fighting back on this projection, saying they will keep rates restrictive and not cut so as to keep it at a higher "plateau" to fight inflation.  I don't buy it for a second. 

For the rest of 2022, the Fed projections and the STIRs pricing is similar, so there has been no temper tantrum in the stock market.  But if/when the bond market starts to price in rate cuts (wouldn't surprise me if the rate cut pricing gets pulled forwarded as the economy continues to weaken), and the Fed pauses at 3.5%+, the stock market will not be happy.  If the Fed deviates too far from market pricing, especially if it keeps rates higher than the bond market prices in, it will just exacerbate the yield curve inversion as the bond market prices in even more future economic weakness due to the tightness and the stock market will weaken as it starts projecting lower earnings coming from future economic weakness.  

After thinking about the markets and doing some reading, I've adjusted my strategy for the next few months.  My main view is that there will be a deep recession and I thought it would be best to play that by being short SPX or NDX.  But the cleaner and more direct expression of that view is to just get long Treasuries rather than short SPX or NDX.  With inflation having peaked and all leading indicators showing disinflation for the next several months, along with a rapidly slowing economy, I don't see a lasting scenario of bond market weakness + stock market weakness.  

And the advantage of being long bonds over being short stocks is that bonds will benefit greatly from a dovish pivot, while being short stocks could be quite risky when that pivot happens.  Considering how low net equity exposure is among systematic and CTA funds, there is a non negligible risk of stocks going up while the economic data comes in weaker as it tries to front run a dovish pivot. 

The bond market is making the initial steps in moving on from inflation to focus more on economic growth being the main variable for Fed policy going forward.  It started happening from mid June, as 10 year yields dropped from 3.48% to 2.52% as the economic numbers started coming in weaker (all except the NFP).  Now we've got a big pullback in Treasuries as the Fed tries to talk down the bond market with hawkish talk.  In the long run, the bond market always wins over the Fed.  The Fed can try to talk it down and keep rates higher than the market wants, but it eventually throws in the towel and pivots when credit markets starts to tighten up and stock markets have a temper tantrum. 

We are getting closer to the late 2018 stage of the Fed hiking cycle where each incremental rate hike and continued hawkish rhetoric starts to weigh on the stock market, and the bond market stops going down on hawkish Fed jawboning.  

We may have another few weeks of a choppy uptrend due to crowded short positioning but the stock market can't fight fundamentals forever.  During this economic interregnum, the stock market will feel like Goldilocks, as rates are coming down while the economy still seems resilient, the best of both worlds.  That doesn't last long, as it soon gives way to obvious signs of a recession and an increase in earnings warnings, which will fuel stock market weakness and bond market strength.  Soon enough, as SPX resumes its downtrend, the stock market will be demanding a dovish pivot, not skeptical of one as it is now.   

Covered some NDX shorts on Friday, to get to a more moderate position, and will be covering the rest today as I transition from being short equities to being long bonds.  Many are expecting a lot of hawkish talk from Powell at Jackson Hole, and the stock and bond markets have been pricing that in since late last week.  Now I very much see a possible sell the rumor, buy the news event at Jackson Hole.  This current bond selloff could last a few more weeks into mid September, as the stock market chops around, but eventually, I see a big bond rally waiting to happen later this year and into early 2023. 

Dollar Wrecking Ball

A move is always more meaningful when very few talk about it.  There was a lot of noise about a strong dollar when stocks were getting pummelled in June, but very little talk about it now after a huge rally.  But the dollar just won't quit.  Honey badger dollar doesn't care about a dovish Fed minutes.  Its getting stronger.  EURUSD is knocking on parity's door again as the dollar carry trade is growing wings, reaching levels that it last saw in the early 2000s. 

Add the stronger dollar with a weaker bond market and you have a double whammy of higher yields and a stronger currency, hurting overseas revenues for US multinationals.  I don't really put much weight on currencies unless they are extreme moves.  The dollar is getting quite strong against the EUR, JPY, emerging market currencies, etc.  Its another obstacle for the US stock market, along with monetary tightening and a rapidly slowing economy.  

Really the only thing that the bulls have going for them is positioning, which is still showing a decent short base, although hedge funds seem to have reduced their shorts and gotten their net exposure up to near neutral levels, the index futures positioning needs to follow for this to be a slam dunk setup.  We will find out a lot today at 3:30 PM ET when the COT data comes out covering up to 8/16, which encompasses the moves from SPX 4120 to 4300.  If we don't see a substantial reduction in spec short positions, that will be shocking, and will ring alarm bells and make me more cautious on the short side.  

I never feel comfortable holding a short position when the crowd has the same opinion.  Almost everything I hear on CNBC, Bloomberg, Twitter, podcasts, etc. emphasize that this is a bear market rally and that the Fed is not going to pivot anytime soon.  That makes me a bit nervous when the crowd has the same thoughts as I do, although I do differ on their thoughts on the Fed.  

In my view, the Fed will make a dovish pivot sooner than investors think, mainly because the US economy will get much weaker than most forecast.  The economic weakness should be much worse than 2001, although not as bad as 2008.  Its not going to be shallow and brief like most are expecting, as bad inflation (food, energy, rent) will be high and good inflation (asset prices) will be be low.  Basically bad for the rich and poor, and really only good for commodity producers.  Right, you have a cyclical commodity downturn, but it is still a secular bull market.  The long term supply problems have not been solved, and China will not stay with zero Covid forever.  

Still short, but looking to cover some on weakness today and Monday.  Don't see anyone mentioning month end pension fund rebalance, which is usually don't over a few days ahead of the last day of the month, and front run by traders who sniff out the flow ahead of time.  So expect stock selling and bond buying from pensions next week.  Plus today is options expiration, which has become a weak part of the month, along with the Monday after opex.  It used to be the week after opex having most of the weakness, but that has been front run by the investment community who are more savvy to gamma hedging flows, and now the weakness often starts a few days before opex.  

Economic Interregnum

The stock market does a great job of driving traders crazy.  I don't remember a time when a market going up so much was confounding so many as I do now.  Even during the spring of 2020, when there was a lot of nervousness, it didn't give the shorts much time to get short, as it was a huge V bottom.  There wasn't a lot of time spent near the lows.   This time was different.  The market gave shorts plenty of time (and rope) to hang themselves by chopping back and forth between 3750 to 3900 for about 4 weeks after the June bottom, before blasting off into hyperspace.  

Now you are in a market where most of the shorts are underwater, and in pain.  When traders are in pain, they make mistakes, and do things that they don't want to do, which is to close out their position based on their P&L, not based on logic or historical patterns.  That is what you have seen since the CPI report, as the SPX blasted higher from 4120 to 4320 in less than a week, a lot of that driven by short covering.  The prime broker data confirms that hedge funds have been aggressively covering shorts in the past week, but they haven't really been adding longs.  This brings up an interesting situation, after most of the short covering is finished.  

When everyone knows that we are in a bear market, and the fundamentals aren't improving, investors will not just blindly go long because everyone is bearish.  That's not how things work.  They will have positioning that is on a spectrum of bearish to neutral in this kind of environment.  It is extremely unlikely for them to get bullish positioning when the fundamentals are poor, even if the technicals and the charts look great.  They only get bullish when the economy is forecast to get stronger and/or the Fed is forecast to become dovish.  Neither is the case now.   

Right now, hedge funds are very close to neutral positioning based on last Friday's Morgan Stanley prime broker data (0.48 net exposure, historical avg. of low 50s).  There may be a little bit more short covering but hedge funds are mostly done buying here, barring a big fundamental change, which I actually think will be for the worse, not better.  

While I still hear more bearish arguments, now there is at least some talk about a soft landing.  That's because the leading indicators and the tightening financial conditions haven't worked their way through the economy, and earnings are still relatively unscathed.  That should change starting from Q3/Q4, when the weakness in leading indicators start showing up in coincident indicators.  It takes time for the weakness to flow through an economy, and we are in that interregnum where employment and inflation still show a hot economy but all the leading indicators and soft data show a sharp slowdown.  That interregnum should be over by Sep/October, at which time I expect there to be a big drop in stocks, ala January 2016.  Remember in December 2015, the Fed actually raised rates 25 bps to get off ZIRP for the first time in over 7 years.  So the Fed was actually not your friend in that time period too.

January 2016 was the only time I remember when stocks actually went down a lot when investors were quite bearish leading up to it.  Investors were quite bearish in December 2015 but positioning was neutral after a big rally in October and sideways chop in November/December.  I could see a similar move this time around.  I don't see investors getting bulled up in this market, the Fed is still tightening and the economic data will be coming in really weak in the coming months.  As long as positioning is close to neutral, you can get a big move down even while most are bearish.  The key is positioning.  In this market, positioning is everything.  Just getting positioning to near neutral is enough to reset the wheels for another big move lower. 

Looking to cover some shorts on a move down towards the SPX 4200-4220 area, in order to have some dry powder to add shorts if it goes even higher.  Put/call ratios have been low for the last 4 days, the bulls seem to be getting cocky here.  Opex week has been bearish lately, especially late in the week, and post opex Monday has historically been a weak day of the month. 

Pushing Them to the Limit

This is a different kind of torture for the underinvested:  seeing others make money (fully invested) while making nothing (in cash) or losing (being short).  Its not a fun place to be, its almost as bad as losing your ass with the crowd as the market plunges.  

The COT data on Friday is not good news for the shorts.  The speculator short positions grew even larger, these are massive short positions that will take weeks to unwind, so that is a big thorn in the side of the bears.  I am assuming that after the CPI number on Wednesday, you got a lot of short covering afterwards going into Friday, so the number should be quite a bit lower next week, but specs will still be quite short.  

The worrying part about the huge spec short position is that they are deep underwater, and close to the stop out point, which could usher in even more short covering in the days ahead.  This has nothing to do with fundamentals, but pure positioning and money flows, which favor the bulls here, despite a huge rally of over 600 SPX points in less than 2 months.  

There are 2 instances of large spec short positions while the market was ripping higher off an deeply oversold bottom, 2015 and 2020.  After a huge rip higher in October 2015, you had a 50 day consolidation from November to December 2015, during which shorts covered, before plunging again to new lows in January 2016.  In May 2020, after a huge rip higher, you didn't see shorts cover for several months as the market grinded and higher, grinding the shorts to dust and making new all time highs during the process.  

A sample size of 2 is not big enough to draw huge conclusions, but the liquidity conditions now are more similar to fall 2015 than spring 2020.  In December 2015, the Fed had its first rate hike in over 9 years, while in the spring of 2020, the Fed was embarking on bazooka QE while maintaining ZIRP.  The key will be to see how much short covering we get in the weeks ahead.  The more short covering you see in the COT data, the better the setup gets for the bears.  If however the bears remain stubbornly short like in 2020, then you could see a grind higher for much longer than most expect despite the poor liquidity conditions.  

If there is one thing I've learned over the years, its the importance of positioning in increasing or decreasing the probability of a trade.  The less popular my position is among the speculator community, the higher the win probability, especially for longer time frames.  

The bottom line is this:  everyone knows that the liquidity conditions are unfavorable for stocks, with Fed tightening into an economic slowdown, but the light positioning reflects this reality.  Everyone is focused on the Fed, and not focused enough on the economy, which is much weaker than the stock market is pricing in.  Will the economic weakness be big enough to overwhelm the light positioning and force retail investors (still high equity allocations historically) to dump their stocks as we see more earnings warnings in the coming month?  I give that a high probability of happening, but you probably need to see shorts cover first before you see that big move lower.  

The marginal buyer or seller is what moves the market.  There has been a lot of short covering this week, which has increased the net positioning of hedge funds, but the question is will they put on shorts again as the economy weakens or will they add to their low long exposure and cause a chase for performance as the market grinds higher?  It is a reflexive situation here.  I don't expect hedge funds to aggressively buy dips if the economy gets really weak, leading to mass earnings warnings, which likely leads to a retest of the June lows.  If the economy holds up for the next couple of months and Q3-Q4 earnings meet expectations, while the 10 year yield stays under 3%, you are likely to see a chase for performance and a grind higher to SPX 4600-4700.  

The difficulty in markets these days is that investors rightly focus on liquidity conditions when determining whether to get bullish or bearish, which makes everyone follow the same gameplan.  This leads to crowded positioning when the Fed is very loose (lot of bulls) and when the Fed is very tight (lot of bears).  Even 2 years ago, it wasn't like this, as the Fed was very loose, yet you still had a lot of bears.  Investors have learned their lesson over the years, and it is to not fight the Fed.  That leads to the widespread skepticism you are seeing about this so-called bear market rally.  It causes the market to trade in ways that seem irrational and manipulated, but its just because too many are leaning in one direction (short) and have to stop out of their positions as the losses get too big for comfort.  This is what has happened since the CPI release, and was the number 1 reason I waited till after the CPI came out before embarking on a short campaign, due to the crowded short positioning near the edge of getting stopped out.  

In the short term, the past few days squeeze higher looks like a blowoff top inducing massive short covering.  According to Goldman PB data, it was one of the fastest pace of short covers in the past decade:

This is one piece of news that finally shows that the pain has gotten too great for a lot of funds and they are cutting and running.  This is what I want to see more of to gain confidence on the short side.  Just a neutral level of positioning in this liquidity and valuation environment would present a high probability short setup for SPX and NDX shorts.  As of now, its a favorable risk/reward on the short side, but not high probability setup yet.  More data confirming lots of net buying (prime broker, COT, options) would generate a near can't miss shorting opportunity.   

Due to the speed of the up move and the heavier call buying activity in popular single name stocks (TSLA, AAPL, AMZN, MSFT), I put on a short NDX position on Friday with plans to add to it if I see more data coming in that's favorable for the bears.  

Its a tough time for bears as this is near ideal fundamental conditions for a big leg down, but its a crowded trade, and that makes the destination that much more difficult to arrive at as many shorts are in quite a bit of pain and at their wit's end, close to throwing in the towel, if they didn't late last week.  Hopefully, I won't be one of them!

Still Fighting It

Shorts are quite stubborn these days.  They won't throw in the towel.  You would think with a 2%+ face ripper to a new local high and above 4200, a lot of shorts would finally cover and cut their losses, but that's not what I'm seeing in the options market.  The put/call ratio ended up at 0.85, which is a bit high considering the rally and positive news on CPI.  A bit shocking really, but the shorts are hanging on, sticking to their belief that this is a bear market rally.  I agree, but I don't want to get run over as they rush to cover, so I've been patiently waiting.  

I am stretching to find signs that speculators are changing their tune and becoming less bearish on this market, but its been mostly the same regardless of the price action.  Everything is received negatively, even a lower than expected CPI brought out the skeptics who feel like its ridiculous for the market to rally so much on an 8.5% CPI number.  Its just not what I want to hear when I am looking to put on a short position.  I trust the numbers and the data, and don't put much weight on the Twitter/CNBC talk, but they are both confirming the same thing:  shorts are not covering, and keep coming up with excuses to fight this rally.  

I am now resigned to the fact that nothing barring a continuous mind boggling rally to new all time highs will convert these bears to being bulls.  It doesn't mean that the market will just keep rallying because the shorts don't reduce their positions, but it does make catching a top riskier and lower probability.  Would like to see some kind of a blowoff top with signs of aggressive call buying/lack of put buying before I get aggressive on the short side.  

If we get another 1% move higher, that would take the SPX above 4250, a high enough level where I feel comfortable putting on shorts and taking some heat in the short term because of the skewed risk/reward.  

There are a few things that would increase the probability that a top is coming soon:  

1.  Weakness in bonds, with 10 year yields going back towards 3%+.  

2.  A big reduction in short positions among speculators in the COT data coming out tomorrow.  

3.  Total put/call ratio below 0.80 for 2 straight days.  

Looking back over the past 20 years, the only time I remember investors being so stubbornly bearish (2020 was almost like this, but not to this degree) was the fall of 2015, after the face ripping rally off the double bottom in late September, taking the SPX all the way back over 2100, an 11% rally in a month, taking back all the losses from the previous selloff.  The market chopped around for a couple of months and speculators took off a big portion of their futures short positions, and then the SPX fell off a cliff soon afterwards.  In late 2015, after a huge rally in October, traders were quite skeptical about the market in November/December and most expected another big selloff and they were right, one of the few times when the consensus was bearish over the past 20 years and it played out that way. 

P.S.  (10:40 AM ET)  As we squeeze higher here, it finally looks like we are getting a blowoff top with panicky short covering and put/call ratios are quite low, but still a lot of time left in the day.  Also notable is the weakness on lower than expected CPI and PPI in the bond market, as we will need to see yields go higher to increase the odds of a top.  Good signs so far for a near term top.  Looking to scale into shorts later today and Friday. 

Investors are Smarter

Its been 54 days since the bottom on June 16.  That's quite a long rally while still staying under the 200 day moving average.   You would think that a rally that's lasted so long and gone up 14% from the bottom would suck in more believers, more FOMO money.  But anecdotally, all I see are calls for a near term top and an end to the bear market rally.  Are investors just smarter than they were in the past and know not to fight the Fed and the liquidity cycle?  

In many ways, today's investors are smarter than they were 10-20 years ago, back when the Fed wasn't the main focus all the time.  After 13 years of a liquidity bull market via the Fed, investors seem to have finally caught on to the game, that its all about liquidity, how much money is being pumped into the system.  The economy doesn't matter, its all about Fed words and actions.  And that's reflected in a deeply rooted skepticism of this rally that is going on despite Fed hawkish rhetoric and deteriorating economic leading indicators.  

But still, I can't bring myself to join the crowd in the bear camp when the speculator short positions are so large in the face of a huge rally.  It is downright dangerous to short when there is such a huge short position that is on the cusp of being unwound as the drawdown is nearing the stop loss point for most of those holding index futures shorts.  I would like to see at least some moderation in that short position as well some good news (lower than expected CPI number?) before I put on the bear suit.  If we do get a reduction in shorts (looking for a reduction of at least 50%) in the COT data, then I'll gladly join the bears and put on a Nasdaq short, as we are back to levels where risk/reward is skewed towards the downside.  

The last 2 days, we've gotten warnings from semis in NVDA and MU, which isn't surprising considering they are at the front lines of the economic slowdown.  Software/cloud companies are at the back of the line, but not immune, they just feel the effects of the slowdown with a few months lag.  Fundamentally, tech is the most overvalued and also one of the most exposed to a broad economic slowdown.  Its assumed that growth outperforms value in a recession because value names are more cyclical, but tech is no longer a niche sector.  Tech is not so much a secular growth story anymore when it dominates the weightings in the S&P 500, it has basically become the highest beta portion of the market.  

We are seeing the retail investors go crazy again chasing meme stocks like AMC and BBBY.  That doesn't tell me too much about the institutional side, but its at least an early warning sign that fear has dissipated to such a point that retail is now willing to chase garbage stocks and play the musical chairs game again. Put/call ratios are inching lower, but not to levels that are extreme yet. 

Perhaps a relief rally after the CPI number on Wednesday that takes the SPX close to 4250 could be the blowoff top of this bear market rally to cleanse positioning to less short levels, get the crowd more complacent, and allow for the bearish fundamentals to reassert themselves on this market.  I can't comfortably short at this point with so many shorts still hanging on waiting for the market to go much lower to bail them out.  Usually the market seeks out the weakest hands (the shorts at this point) and squeezes them out before eventually going to its preferred destination (much lower, IMO, but could be wrong). 

Cheap Lawn Chair

People are underestimating the recession that is ongoing.  The base case I see from most forecasters is that the economy is either in a shallow recession now or will enter a shallow recession later this year or in early 2023.  Almost all deep recessions start as shallow recessions.  During most recessions, the Fed is either ready to cut or already cutting rates during this part of the business cycle.  Here we are, they are still raising rates and doing QT.  Post bubble.  Increasing the odds of the recession becoming a deep and painful one.  

You can toss out the last 13 years of price data, that's almost a different world.  Breadth thrusts, new highs vs new lows, and other data mined statistics from a sample that covers mostly just a raging bull market lead to obvious conclusions that don't tell you much about the current regime.  You have to think 1973, 2001, 2008, to get a sense of what kind of market we're in.  

But unlike those time periods, the profit margins are even higher.  Profit margins can only go up so much before it sucks the living life out of the real economy, turning workers into voluntary slaves who toil for their corporate masters with no alternatives due to the oligopoly based "capitalist" system.   This system prevents new competition from forming, allowing for extreme pricing power, feeding into the inflation dynamics which are already well embedded by populist fiscal and easy monetary policy.  

Antitrust legislation is toothless, and corporations are taking on rent seeking attributes, due to their pricing power, and shedding their product supplying attributes.  The thing about rent seeking is that there either needs to be more renters (population growth) or renters need to have increasing incomes to keep feeding the beast of economic growth.  If they don't, consumption decreases and corporate revenues follow.  

Inflation is one way to keep feeding the beast, but that invites another set of problems as investors will eventually balk at receiving deeply negative real interest rates if the government keeps going with its inflationary policies.  The inflation will feed on itself as investors look for alternatives to government bonds and look to store wealth in real assets like real estate, gold, commodities, and even stocks.  Governments will eventually realize that all that stimulus and money printing has long term consequences, the main one being a lack of trust in their currency.  The weaker currency feeds the inflation cycle until you get an Argentina situation or a voluntary depression from halting money supply increases in order to regain trust in the currency.  Bad choices come from bad policies.  Bad choices lead to bad outcomes. 

Let's not forget that the overall growth profile for the US, as well as for most of the big economies (EU, China, Japan, etc.) is totally different than 2001 or 2008.  Organic growth is much lower, so the dependence of monetary and fiscal stimulus is much greater.  Without it, things get ugly.  Its something that I hear very little of amongst economists who are arrogant beyond belief despite poor track records.  Trend growth is near zero, and what little growth that shows up in the GDP and other econ. data is from inflation being underreported, which shows up as real GDP growth.  Most of the real GDP growth now is really just inflation in disguise.  

So what does that have to do with the current market?  You have to look at the big picture to more accurately forecast what's likely to happen.  In an organically low growth global economy, Fed funds rates over 2% are restrictive, not neutral.  Its not about the real interest rates.  The neutral rate for the economy is negative real interest rates, and QE!  That's hard for lots of investors to wrap their heads around, especially over the last 20 years when inflation has been relatively low.  Fed funds rates have spent most of the time at zero (with QE ongoing).  And the brief moments above zero were mostly spent under 2%, and if it did go over 2% (briefly in late 2018 to mid 2019, and now), it caused an economic slowdown and things started to break (repo in 2019).  

The neutral rate for the US economy is probably around 1% doing light QE, just enough to sop up about 1/3 of new issuance, while the neutral rate for the EU is probably around -0.5%.   The very concept of a neutral rate is an interest rate that is common, that maintains the economy at a desired growth rate, not too high, not too low.  That's not 2.5%.  A 2.5% Fed funds rate and QT over an extended time period will significantly slowdown the global economy, to levels much lower than the Fed's long term desired growth rate. That's not neutral.  That's restrictive.  

Soon many will find out as the Fed tries to take Fed funds rate above 3% how damaging it is to the economy and that's when you start getting very loud noise from the Street demanding a dovish pivot.  Hoping for a dovish pivot and demanding one are 2 very different things.  Hoping for a dovish pivot happens when stocks are going up.  Demanding a dovish pivot happens when stocks are going down.  Eventually, the Fed will fold like a cheap lawn chair.  It is what they do.  Hawk talk is cheap when stocks are going up.  Neel Kashkari can act like a tough guy on inflation and dismiss the bond market's message when stocks are ripping higher.  Give me the same talk when stocks are going down in savage selloffs.  You will hear crickets. 

We are still in the hoping for a dovish pivot stage of the rate cycle.  This is the fairly benign phase.  When the market starts getting agitated seeing that growth is really weakening, they will have a temper tantrum, looking to induce a Fed pivot.  And usually when the Fed tries to deny what the market wants, the market throws an even bigger fit and eventually gets rewarded by the Fed with dovish language and future rate cuts. 

I still see a lot of denial on TV and social media about this rally, dismissing it as a mere short term bear market rally.  They are probably right in the long term, but it makes it tougher to time a short entry when there are so many market skeptics.  This skepticism tends to extend these type of counter trend rallies.  Finally starting on Wednesday, there were the first signs of more call buying and a bit less hedging in puts but nothing excessive considering the big rally on Wednesday.  You can sense that retail is getting bulled up, but would like to also see institutions follow.

Speculation is making a comeback, a small echo of the 2021 crypto/tech/EV mania that excited retail traders like it was 2000.  Its getting closer to that exquisite moment where you can enter a position with a very skewed risk/reward proposition. The two things holding me back is the futures positioning data and downtrend in 10 year yields.  We'll find out more when the commitment of traders report comes out today.  It should show a large reduction in speculator short positions.  If it doesn't, that's a warning sign that its still too early to short.  

Short term, the market looks overbought, and we still have the big monthly data event which is the CPI next Wednesday.  So it would not be surprising to see some consolidation and pullback from such a big up move going into that number next week.  

A Bond Led Rally

Has patterns in the stock market forever changed and its just all about monetary policy, and earnings / economic cycles are considered meaningless?  Sometimes it feels that way.  

Really, the only meaningful selloff you've had that's lasted more than 3 months since 2009 was due to the Fed raising rates more quickly than expected along with bonds selling off rapidly.  Earnings were just fine in the first 6 months of the year and PMIs were well above 50.  Yet stocks got destroyed.  Now that there are clear signs that the economy is slowing, bonds are rallying hard along with stocks, which are reacting to the lower bond yields by ripping higher.  

Its almost as if all that matters is bond yields, and by extension, monetary policy.  Its unprecedented how singularly focused the stock market is on the Fed.  Earnings don't seem to matter.  The economy only seems to matter when it has an effect on bond yields, so the worse, the better.  Bad news is still good news after 13 years!  Yet it still surprises people when stocks rip on bad economic data.  Have they lived in a cave for the last 13 years?  Do they have such thick skulls that they can't absorb new patterns, even when its been reinforced for 13 years?  Yes, I know it feels unnatural for stocks to go up when data shows that the economy is weakening, but that's usually what happens.  Why do people keep fighting it?  

If the valuations weren't so high and the bubble so big in 2021, I would join the bull camp and buy dips and play for short term rallies.  But its hard to overcome my bias and experience of seeing post bubble markets go down for years with only short term rallies that always fade.  And 2021 was probably the biggest bubble ever in US stock market history.   US stocks are still historically expensive with a long term growth picture that doesn't look bright.  And US stocks are still considered the best long term investment by most investors, even those outside of the US.  

But with 10 year yields now only slightly higher than the Fed funds rate, with a likely 50 bps in September which will make short term rates higher than 10 year rates, its asking a lot for bonds to keep rallying without either 1) economic data completely falling apart or 2) a dovish pivot.  You just can't have the bond market keep rallying as stocks rally without a dovish pivot.  A hope for a pivot isn't enough.  It has to be expected within months, and with authority, like in January 2019, not a mealy mouth neutral stance.  

So my assumption is that a bond led rally without a Fed pivot is nearing its end, maybe it has one last burst higher on a lower CPI that proves inflation peaked, but I would use that as an opportunity to short any euphoria/relief rally that comes with it.  

I am focused on futures and options data lately, as I want to see positioning get more neutral before I short, and according to the COT data as of 7/26/22 (before the huge Fed and post Fed rally), the speculators just got even shorter S&P 500 futures.  Its getting to really big amounts here, something that can't be ignored.  Yes, the data is a bit outdated because I am sure speculator positions are much less short now, after that huge rally (much of it was probably short covering), but its still not a good sign for those who are short here. 

Options data showed a divergence between index options and single name equity options activity.  In index options, especially SPX, you saw a huge amount of call selling and put buying (about $16B notional on Friday), and SPY was also a big negative delta number.  Counteracting that, there was heavy call buying in TSLA, AAPL, and AMZN, so speculators are chasing tech names here.  

Would like to see much less investor hedging in the coming days for me to get more comfortable about shorting.  But in any case, I'll still probably wait till after the CPI number to consider short sales.