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.