Bond Market Fear and Loathing

The bond market has come unglued in the last few days.  This kind of bond volatility (to the downside) in a weakening economy must be taking out some leveraged players that we may hear about later.  As much as Treasury yields have moved recently, yields in Europe have been even more violent.  Treasuries have started pricing in the worst possible scenario for Fed tightening, and the massive losses in the past few days have infected the long end of the curve, as the short end led the selloff late last week, and this week, its been the long end taking the brunt of the punishment.  

Bond investors and stock investors are just different.  Those who buy bonds are conservative, and are looking to protect capital while collecting some yield.  They eschew risk, and are more easily unnerved when losses get big.  2022 has been a heart attack for bond investors, and I'm sure a lot of retired elderly parked out in bonds expecting their assets to be safe have gotten a rude awakening.  That's why you've had this big selloff when everyone realized that the Fed really has blinders on, hawkish blinders, raising rates relentlessly, economy be damned.  Bond investors have been taking more punishment than stock investors, as you can see by this chart:

Take a look at the 3 month performance of TLT, AAPL, and TSLA.  TSLA is up 19.7%, AAPL is up 6.7%, and TLT is down 9.6%.  

Stock investors have quite a different view of the current market than bond investors.  As much as I hear stock investors being bearish and pessimistic, they haven't sold much, while bond investors have been more quiet, but much more terrified of this market, selling down, as you can see in the fund flows for stock and bond funds.  

They are no longer piling into equity funds, like they did in 2021, but they haven't really sold much either. 

Based on relative valuations and the outflows that have already happened in bonds, I am getting quite bullish on the prospects for the bond market over the next 3-6 months.  At 10 year yields near 4%, you are turning the tables on the risk/reward for bonds vs stocks, making this the best time to be in bonds vs stocks since 2000.  I expect the inflation rate to be higher over the next 5 years than it was between 2000 and 2005, but the organic growth rate of the US is much lower than it was back then.  And the level of indebtedness is much greater now than back then, with a much more financialized economy that can't function well with higher rates.  So 4% in 2022 is akin to 6% in 2000.  

There is recency bias in the markets that has encouraged US stock investors to hold on when the markets go down, because it always goes back up.  Since the end of the bear market in 2009, deep losses in 2010, 2011, 2015/2016, 2018, and 2020 were all erased in less than 6 months, usually taking less than 3 months.  This has conditioned stock investors to just hang on and not sell, which has been the main reason they haven't budged despite sounding off about their bearishness in those sentiment surveys which have become nearly useless in 2022.  A bunch of fully invested bears.  2022 has been the first time in 13 years that you've actually had an established downtrend that has made lower lows and lower highs for more than 6 months. This is catching a lot of investors off-guard, way overexposed to risk parity, with not enough cash to buffer the volatility. 

Unlike stocks, there is not much of a recency bias in the bond market.  Bond investors are normally much more cautious and less sanguine about future bond returns.  They are just looking to get some yield while not risking too much money.  They don't expect ever higher prices and lower yields.  And with all the talk about inflation and how hawkish the central banks are, you are getting levels of pessimism that are quite extreme, and don't reflect the reality that leading indicators of inflation which are trending lower.  If you look at money supply growth and commodity markets, you can expect inflation to come down more than people expect in the first half of 2023.  That will coincide with the end of the Fed rate hiking cycle. Those are 2 potent bullish catalysts for bonds.  

The momentum is clearly bearish in the bond market, but the past few days since the FOMC meeting have been panicky selling, more than a big repricing of inflation or Fed rate hike expectations.  I am still holding a small bond position, while remaining short SPX/NDX.  Still see too many dip buyers who expect a short term rally, so rallies are likely to be quickly sold.  The fundamentals are much worse now than it was back in June at the same price levels.  And we are that much closer to the real economy entering a big slowdown.  

What the Bank of England did yesterday shows how much stress is accumulating from the plunging global bond markets.  Optimism from one off interventions are not bullish for stocks.  Only continuous interventions via QE programs can affect market pricing for the intermediate to long term.  Saving the market with these interventions without any change to their monetary policy will do nothing for the long term trajectory of the market.  They are just short squeeze events.  

More so than a strong dollar, a weak global bond market is more troublesome for stocks and the economy.  Until you see a strong sustained bounce in bonds, which doesn't look likely until at least the next CPI release, on October 13, stock rallies will be quickly sold as there will be nothing fundamental to latch on to for the bulls.  The bears are trading the fundamentals.  The bulls are trading the technicals (hoping for an oversold bounce).  

I think 4% 10 year yields should provide a short term floor for bonds, but there is so much damage going on in the bond market, bonds are trading like distressed assets.  There is potential for overshoots to the downside.  But once you get past the next couple of weeks, I think the sidelined buyers in fixed income will come back as the dust settles on the carnage, with good values left behind. 

No More Free Lunch

The 1980s to 2021 has been a great time to be a stock and bond investor.  Risk parity seemed like a free lunch of protecting downside while collecting coupons through bonds and getting dividends and capital gains through ever rising stock prices. The best of both worlds.  Downside protection through bonds and upside through stocks.  Both positive yielding.  That free lunch is over. 

Its been an amazing time to be a US stock investor for the past 13 years.  And its mainly because of one thing: profit margins.  The profit margins for S&P 500 companies has gone from a cycle peak of 7.5% in 2000, 9% in 2006, 11% in 2018, and 13% in 2021.  Those are fat profit margins.  

The rise in profit margins from the 1990s to 2021 coincides with a decrease in the cost of debt funding, as investment grade corporate bond yields have steadily gone lower, tracking the fall in 10 year Treasury yields.  

Notice how the recent sharp increase in investment grade bond yields coincides with the sharp drop in profit margins in 2022Q2.  

There are other factors that have contributed to the sharp drop in profit margins recently.  First, the revenue boost from massive fiscal and monetary stimulus has come and gone.  Second, the rise in commodity and housing inflation are net negatives for corporate profit margins, as discretionary spending gets reduced when the cost of necessities increase (food, energy, housing).  Less consumer spending on discretionary items hurt the S&P 500 as a whole.  The main beneficiary of commodity/housing inflation are a small portion of the SPX and are not well-represented in public financial markets (private market real estate investments).  

If you are a believer in secular commodity and housing inflation like I am, you have to believe that stocks will struggle in the coming years.  

I haven't even gotten to the cost of labor.  In a tight labor market where the working age population as a percent of total population is steadily shrinking, the productivity of the overall population decreases, as the growing elderly population are net consumers, and produce very little, while collecting Social Security and consuming subsidized medical services via Medicare.  This is a net drag on productive capacity in the US, while increasing federal outlays.  With fewer workers relative to the total population, you end up getting increases in the cost of services, as wages go up, a supply-demand phenomena exacerbated by huge federal budget deficits.  

Higher wages for the same productivity, or less, considering the growing trend of work from home (reduces productivity), and that hurts profit margins.  And that doesn't even get to globalization and labor arbitrage scraping the bottom of the barrel in China, where the excess labor coming from rural areas is near its end, and higher political cost of outsourcing to China as US-China relations continue to get worse.  

With the oligopolistic pricing power of many of the S&P 500 corporations, can't they just raise prices to maintain their profit margins?  Yes, they can, and that will exacerbate the inflationary pressures in the economy, and just guarantee that inflation stays high and the Fed keeps rates higher than they would otherwise.  In a labor and energy restrained world, inflation is the release valve, to relieve the pressure caused by a supply limited environment.  Also, at some point, raising prices on consumers is counter-productive as they will just either find alternatives or will be constrained from buying due to high energy/housing costs. 

Seeing how the US, UK, and other countries have reacted to high inflation, they've decided to fight fire with fire.  Basically handing out more money to the public either through stimmy checks or by capping prices on electricity bills/reducing gas taxes.  That's a recipe for a secular stagflation where central banks will either have to go back to financial repression and negative real rates to keep the economy going at the cost of high inflation or have positive real rates and kill the economy to keep inflation under control.  Its no longer a free lunch environment where cheap overseas labor and ever increasing oil and gas supplies allowed the Fed to print gobs of money without any inflationary consequences.  Under resource constraints, the Fed has to now weigh tradeoffs between lower inflation/lower growth or higher inflation/higher growth.  No more free lunch.  

Its been a sharp selloff after the FOMC meeting, much quicker than I thought would happen.  It just underlines the weakness in this market, where it gives you very little time to sell rallies and gives you plenty of time to buy weakness.  I remain short and not in a rush to cover.  Sure, the put/call ratios got very high on Friday and you are seeing some dislocations in the FX market.  But considering how weak the bond market is, I would expect the June lows to crack sometime soon and that will probably usher in some panic as we hit new 52 week lows in SPX and finally start flushing out some of those diamond hand retail investors who haven't budged in their equity allocations.  The low DIX reading on Friday (40.3%) after high readings for the past few weeks is the first sign of the retail investor cracking.  Will need to see several more days like that to have me believe that we can put in a tradeable bottom, where I will cover shorts. 

Ignore the Noise

There are so many wiseguys out there, they lose the forest for the trees.  Sometimes I am one of those wiseguys, but the macro situation is just so over the top bearish that you have to resist the urge to play the long side when you see these huge face ripper rallies happen from time to time during this bear market.  It is tempting to try to make money playing both sides, especially in a bear market when big moves happen quickly, and markets go up just as fast as they go down.  

But 2022 is the polar opposite of the 2021 market.  In 2020 and 2021, stocks spent very little time at the short term bottoms, as most of the bottoms were V bottoms with almost no consolidation near the lows.  It didn't give investors much time to buy the lows, which is very bullish.  So longs had a much wider margin for error, as they could take their time to sell, because most of the time, the markets were spending their time near the highs, so they didn't have to be precise when exiting their longs.  For the shorts, it was hell, as if they missed the occasional short term bottoms to cover, they were squeezed relentlessly as the markets grinded higher.  In 2022, you are getting repeated chances to buy short term lows, and the longs don't have a big margin for error.  The market is spending a lot less time at the short term highs, as longs are eager to sell any strength.  On the other hand, shorts have repeated chances to cover near the lows (sole exception was from mid July to mid August), giving them a much larger margin for error when exiting their positions. 

All this week, leading up to the FOMC meeting, I heard fast money traders and investors proclaiming that 75 bps was priced in, and that the market would have a relief rally after the FOMC announcement.  They probably won't admit it, but huge rallies in the March, May, and July FOMC meetings seeped into their brain, and they were subconsciously conditioned to believe that the market rallies on Fed days, even after big hikes.  Well, yesterday's selloff was the payback for investors being complacent about the FOMC meeting, even as Powell gave you a warning shot at Jackson Hole, that he was going to be as hawkish as possible.  I am sure yesterday's big selloff probably reset that conditioning and put in some doubt about the market outcome at the next FOMC meeting.  

One of the most important things that you can learn when playing the markets is that you will regularly lose.  Fear of losing, or giving back gains, is what leads to overtrading and trying to play every wiggle in the market, trying to buy low and sell high.  You have to have humility in this game, and realize that you can't predict all the ups and downs.  I am guilty of micro trading, trying to avoid drawdowns, but most of the time, it doesn't really add value.  

But you can predict some ups and downs, and that's when there is opportunity.  In trade selection.  Most of the time, there is no short term edge.  However, there are often longer term edges, which is less obvious because they play out over several weeks and months.   Having the luxury to play longer term time frames and be able to take drawdowns to ride the position to fruition, through the ups and downs is an edge.  One of the main reasons hedge funds underperform is because of month to month reporting, which shortens their time frames, making them unwilling to take short term pain for long term gain.  

I've been pondering how to play the upcoming economic downturn which many are underestimating.  Short SPX/NDX or long Treasuries/STIRs?  The trend obviously favors short equities, as that trade is working and it has fewer holes in the thesis, as it works when the Fed remains hawkish and inflation stays high.  But it is vulnerable to Fed pivot risk, which I believe is closer than most think (probably by November or December).  The long Treasuries/Eurodollars/SOFR trade has the obvious big hole of a Powell that is trying to be Volcker Jr., and panic puking of positions from those losing money in bonds if there is further weakness.  But the long bonds/STIRs trade will work great when the Fed pivots, and could explode higher when that happens.  Also, the positioning in bonds is light, which would make it easy for investors to increase their bond allocations from both cash and equities.  At the moment, I'm both short SPX/NDX and long Treasuries, with a bigger allocation to my shorts than my longs.  

In the coming weeks, if bonds continue to selloff and I see more signs of capitulation there, I will likely reduce my short equities position to increase my long Treasuries position.  At the moment, I prefer the short equities trade because of the uncertainty that's looming over the bond market, with regards to how far Powell will hike and how much pain he's willing to take before he cries uncle. 

Re-shorted yesterday pre-FOMC meeting, and will hold that short until I see some signs of panic, nowhere close to that yet.  The bond weakness tells me there is going to be a lot of pain ahead for the stock market.  Valuations are ridiculously high considering the financial conditions.  I know they say everyone is bearish, but ignore the crowd and focus on the fundamentals. 

Tightening the Noose

The lagged reaction function of the global central banks is wreaking havoc on historical patterns of the economic cycle and stock and bond market prices.  In a typical economic cycle, you see the central banks steadily raise interest rates after the recovery is well underway, with unemployment rate going down and inflation going up.  This allows for the economy to slow down more gradually.  This time, due to political reasons, Powell disseminated the lie of transitory inflation in order to keep rates low and ensure another term as Fed chair.  He had to fight off Lael Brainard for the spot so he put on a very dovish front in order to seal the nomination last fall.  That delay only exacerbated the bubbly animal spirits at the time and extended this high inflation period by several months.  

Remember, inflation acts with a lag, especially core inflation, so whatever fiscal and monetary policy enacted in 2021 will still have lasting effects well into 2022.  The unprecedented rise in M2 money supply in 2020, coming mainly from monetized stimmy checks, forgiveable PPP loans, giant child tax credits, and huge pork packages was the rocket fuel to feed the inflationary fire that's lasted for the past 20 months.  Forget about what the 15 minute macro experts say.  Inflation didn't come from Putin's war or from supply chain issues.  It came from a massive printing of money and enormous stimmy packages.  If you don't hand out free money to fuel record breaking demand for goods, you don't have supply chain problems.   

Just 5 months ago, the Fed funds rate was 0.25-0.5%.  Interest rate increases work quickly in the financial markets, but act much more slowly in the real economy.  The real economy will feel the brunt of the rate hikes in 2023, well after the top in bond yields.  This lag effect will be especially painful this time around, due to the speed of the rate hikes, going from 0 to 400 bps in 9 months (assuming market pricing is correct and the next 3 meetings have hikes of 75 bps-50bps-50bps).  Really the only way for the tighter monetary policy to quickly affect the real economy is by tightening financial conditions so much that you start seeing much lower stock prices and real credit stress,  which quickly leaks into the economy as corporations have to sell bonds at abnormally high yields to raise capital, and cost cutting becomes more urgent.  We're not quite there yet, but that's the direction we're heading.  And more quickly than people think.

I am already hearing anecdotes about corporations issuing high yield debt having a hard time getting deals done.  Fedex earnings warning was just the tip of the iceberg.  There will be more canaries in the coal mine, as higher rates, tighter monetary conditions, and much weaker global growth start to weigh on corporate earnings.  In this type of toxic environment, where the central banks are tightening the noose on the neck of the bulls, you have to throw out the 2009 to 2021 playbook.  Sentiment will be bearish, and you have to accept that as the norm now, as bearish sentiment is the default stance of market participants in this environment.  Bearish is the new neutral.  Neutral is the new bullish.  Only when things look really horrible, and after extreme price moves, can you lean on bearish sentiment as a tell for an imminent rally.  In the past, this kind of bearish talk among the investment community usually led to a big rally that lasted weeks, but these are not normal times.  75 bps for 3 straight meetings is NOT normal.

I covered yesterday after seeing some signs of dip buying and short covering, and to avoid the upward drift that is common a day or two ahead of the FOMC meeting.  Big selloffs going into the meeting often result in short covering rallies a day or two ahead of the event.  Once the event is over, the shorts usually come back to sell what they covered.  We've rallied big in the past 4 FOMC meetings.  That will be on the mind of the short sellers who are still short, and I expect some short covering from them heading into the meeting.  

Its a little bit of game theory, but this FOMC meeting should play out a bit differently than the others, just because Powell has put himself in a box by his hawkish words at Jackson Hole.  He almost has to come out and put on his most hawkish act, just so he doesn't look like a pivoting pansy again.  That could pour cold water on any expectations of him doing his usual dovish mealy mouth press conference, leading to a selloff during his press conference.  

The shorts I covered yesterday, I will probably put back on tomorrow ahead of the FOMC meeting.  I feel empty without having shorts on in this environment. 

Bonds are weak again today, I'm long a bit from late last week, and not too eager to add more right way.  After such huge losses in bonds this year, its going to take a while to consolidate at these higher yields before you get the change in trend.  There will have to be more overt signs of recession before you can get more investors selling equities and buying fixed income.  Equities have been the place to be for so long in the US, that its going to take some time to shake that BTFD psychology.  As that psychology changes, you will see retail equity holdings as a percentage of assets go down.  Its still near the highs of the past few years.  That will be the future supply that fuels the next leg down of this bear market.  The first leg down was fueled by hedge funds reducing equity exposure.  The next leg down will be retail reducing equity exposure. 

Overtightening Fears

The market teaches you a pattern and investors eventually adjust to it, and then the pattern changes again.  This year's lesson is that stocks and bonds can go down together, and that inflation was not transitory.  The Fed, always late to the game, finally realized that inflation wasn't going down and slowly reacted to the bond market signals in the spring which was pricing in many more hikes than the Fed was saying in their forward guidance.  If the bond AND stock market wasn't going down so much due to high inflation, you think Powell would have gone from 25 bps to 50 bps and eventually to 75 bps?  I doubt it.  The market was panicked about high CPI prints that kept beating expectations, and the Fed got the message, and reacted with bigger hikes and more hawkish talk.  

Fast forward to now.  The bond and stock market are both going down, but is it really because of high inflation?  The CPI number on Tuesday would have many believe that the market is going down again because inflation is way too high and not coming down fast enough.  But I think its for another reason.  The stock market is going down not because of inflation, which real-time reports show as slowing down, even housing.  The market is going down because they think Powell will now go unhinged, hell bent on trying to be Volcker Jr., and overtighten and make the recession even worse.  Its no longer inflation fears, its Fed overtightening fears.  A big difference. 

The whispers are beginning.  They aren't strong statements at the moment, but they will get louder and louder as time goes on.  Its the market's fear of a Fed policy error, this time, by being too hawkish and hiking rates too much.  I am already hearing some talk of a Fed policy error being discussed by those esteemed members of CNBC Fast Money.  I also heard a CEO come on CNBC saying that the Fed is hiking too fast, and should slow down, as the economy is weaker than most think.  

If you can sense when the Fed will pivot, you have the keys to the castle.  A Fed pivot at this point would just be to signal a pause, not even rate cuts.  Now that most market participants and analysts seem to have bought in to Powell's hawkish rhetoric, you are seeing some extreme pricing in the STIRs market.  The 2 biggest short term interest rate markets are now shared by Eurodollars and SOFR.  SOFR is a better representation of the Fed funds rate, as it removes bank credit risk.  

 

The SOFR futures are pricing in a Fed funds rate at 4.40% by March 2023 .  The current Fed funds rate is around 2.35%.  That's 205 bps of rate hikes priced over the next 6 months.  75 bps is basically guaranteed next week, so after the Fed goes to 3.00-3.25%, there is another 130 bps of hikes priced in.  During these big moves, when pricing starts looking irrational, its usually longs who are getting squeezed and having to dump their position to cut their losses.  Its mostly forced selling, as Eurodollars and SOFR longs are bleeding profusely.  

With Fed funds soon to be 3.00-3.25%, and some analysts and corporate CEOs on TV already saying that the Fed is going too fast, can you imagine what they will say if the Fed tries to take rates above 4%? 

If Powell tries to be Mr. Tough Guy, and hike to 4% and above, the stock market will revolt.  It probably revolts on the way there, not after you get there.  The market will give Powell a pass for 75 bps at this meeting, because its ready for it, and 3-3.25% is still a reasonable rate.  But if he tries to do 75 bps or more for the rest of the year, its going to be chaos out there. 

This much I can foresee:  if the SPX is making new yearly lows in the 3600s and below, stock investors will be complaining, loudly.  Especially if the economic data is coming in really weak.  And all the leading indicators are forecasting that scenario.  

Remember, the Fed follows the market, it doesn't lead the market.  But they usually act with a bit of a lag, which is where the opportunity arises.  I soon expect the equity market to really have a temper tantrum as short term cash will become quite an attractive alternative at above 3%, and especially at 4%+.  It will siphon more money out of equities and into cash, creating the conditions for a very weak stock market, and thus, a weak credit market, as the economy rapidly slows down.  Those are conditions when the Fed is cutting rates, not hiking rates.  I can't imagine Powell, who has a history of caving to the markets, trying to fight the credit and stock market by continuing to hike when things break. 

Things breaking will probably happening sometime within the next 2 months, a seasonally weak period after mid September when you have corporate buyback blackout period, thus fewer buyers, and also earnings coming up, which I expect to be gloomier than last quarter.  As time passes, the leading indicators will start showing up in the coincident indicators, and that's when the stock market gets really worried about a Fed that's too tight.  

Staying short here, not a huge position, so I'll let it ride and see how it goes into the traditionally weak Friday opex and post opex Monday.  Now that SPX has broken 3900, I don't see much technical support till you get towards 3800-3820.  Also with hawk Powell waiting on deck for Wednesday, I have a feeling there will be some more selling ahead of that event, and without options protection, the institutions will be likely do some selling today and early next week.  Bonds are getting interesting here, you are starting to see a slow motion capitulation in fixed income, especially in the short end of the curve.  Starting to slowly put on longs in Treasuries, with 10 year yields close to year highs at 3.50%.  I expect stocks and bond correlations to revert back to being negative in the coming months, as future equity weakness will force the Fed to pause rate hikes. 

Nothing Has Changed But Price

There was a change when the market went down from SPX 4300 to SPX 3900.  It was Powell reiterating what all the other Fed governors were saying, and that is that they will keep hiking to 3.75-4%, and/or until they break things.  They also went back to that dirty well again, forward guidance.  They couldn't resist flapping their gums and bringing out their cloudy crystal ball, to forecast that there will be no rate cuts in 2023.  And they repeated that mantra enough that the STIRs market took out almost 2 rate cuts in 2023, and are now pricing in only 40 bps of rate cuts after the peak in Fed funds rate in March 2023, which has also gone up to 4%, from 3.25% in early August.   

That is a huge move in the fixed income market, and during that time, the SPX has gone sideways, and is trading at the same levels as early August.  Is the stock market so strong that it can ignore the bond market and remain in its own world?  I don't think so.  Unlike before Q2 earnings in July, the setup for the Q3 earnings in October is much different.  This time, investors are much less worried about earnings revisions or weak guidance.  Just watching CNBC and you can see the lack of fear about earnings.  Also, the options market is much less hedged now than where it was back in June/July, which increases the likelihood of a left tail move, as investors don't have that much index put protection.  

What I am seeing since the bottom last week is the growing optimism about inflation having peaked and about a soft CPI number today, which explains the recent strength.  I see it as a combination of shorts covering ahead of the CPI, and longs getting more comfortable buying stocks, trying to play for a short term rally.  Also, the news coming out of Ukraine, with their recent success in gaining back territory from Russia has helped investor sentiment on the margin, with some hopes that the war will end sooner than originally thought. 

This short term greed, is not a big picture change in investors' views.  They all believe that the Fed is still going to keep hiking, and stay hawkish, regardless of the number, but they feel like it can't get any worse and all the "bad" news on Fed and ECB hawkishness is reflected in the market.  

Unlike during the rally from mid July to mid August, this latest rally isn't being joined by the bond market, and has a much flimsier foundation of peak inflation optimism, which would make more sense if the bond market was playing along with that view.  

Its a bit of an irrational rally, aided by the triple witching options expiration this coming Friday, which has created gamma squeezes that spillover into the indices. Just look at TSLA and AAPL, the 2 biggest options volume names in the market.  They have been outperforming the SPX since last Wednesday.  Add the time and IV decay of index puts that speeds up as you get closer to expiration, especially in a rising market, and you get a technical squeeze with no fundamental basis. 

This gamma squeeze is providing those with dry powder and a bearish bias an opportunity to put on shorts at good risk reward levels.  I have had a tendency to short too early after these bounces off of big selloffs, so I've been waiting and holding my fire.  The game is about learning from your past mistakes.  After the CPI release, especially if we get a soft number, I will be looking to aggressively put on short positions in both SPX and NDX, as well as some individual names that have short squeezed. 

Powell putting himself in a box again and trying to rekindle the spirit of Volcker just makes me more bearish on the market than a few weeks ago.  Monetary policy works with a lag, but after the September hike of 75 bps, short term cash will be able to collect over 3%, which is quite attractive for such a bad risk asset environment.  I expect a steady exodus out of equity funds (hasn't happened yet, still flatlining after big inflows from late 2020 to early 2022) and into cash and money market funds, earning over 3%, in the coming months.  The more hikes that Powell does, the more incentive there is for investors to sell equities and collect interest on their cash.  

Running with the Herd

Investing is hard.  Sometimes it favors the contrarians and the trend fighters.  Sometimes it favors the majority and the trend followers.  When there isn't a strong case for the market to go up or down, its probably better to be a trend fighter and play the ranges.  But when there is a strong case, usually its better to keep things simple, and just follow the herd, no matter how "crowded" the trade is.  Right now, there is a very strong bearish case for stocks.  

If you are a short seller, you have to pinch yourself to realize that its not a dream, but a reality.  Who would have thought at anytime before 2022 for the Fed AND the ECB to aggressively hike rates, at 75 bps increments, and do QT, while stocks are in a bear market?  Who would have guessed that it would be politically feasible for the central banks to torpedo BOTH the stock and bond markets in order to fight inflation?  Who would have thought that an energy crisis, that rivals that of the 1970s, to happen so quickly?  And all of this happening right after the biggest financial bubble in US history!  Into some of the weakest leading indicators of the economy since 2008. 

That combination of factors converging this year, and how bearish it is for stocks, is underappreciated by many portfolio managers.  Sure, most hedge funds are underweight their historical net exposure, but they are still about 50% net long.  And there has been a flood of money going into passive funds over the years, and the net inflows into equity funds, especially US equity, over the past 20 months is historic.  There have been minimal outflows from US equity funds during the carnage. 

I know a lot of people like to point out historical studies, statistics and data that mostly cover a bond bull market, with inflation that was relatively low, with central bank policy that favored stocks.  But there is nothing in US stock market history that matches the level of overvaluation, inflation, and corporate profit margins as the current time period.  Remember, corporate profit margins have historically been mean reverting, although they have trended higher since 2000, into nosebleed territory.  When you have globalization with labor arbitrage, low inflation as a result allowing for record low interest rates, a toothless antitrust policy that allows competition to be reduced through mergers and acquisitions, you have a recipe for fat profit margins.  

The tailwind from globalization is fading, as China's cheap labor has mostly been used up, and there are no other emerging markets that has the infrastructure or the skilled labor force to replicate it.  In the developed world, the labor force to total population ratio is shrinking, as demographics are aging, and that decreases productivity and increases wages and thus inflation.  

Add on top of this the lack of investment into energy (not unreliable, intermittent, and low efficiency solar/wind) that can actually power a grid reliably, you have supply constraints for further growth.  Economic growth requires more energy.  Its that simple.  Russia's war with the Western World just brought forward that crisis by a few years.  And the politicians are clueless, focusing on manipulating prices by putting on price caps, subsidizing electricity users, and doing everything but the right thing, which would be looking to increase nuclear power capacity as well as using more coal, while letting higher electricity prices do their thing, which is to kill marginal demand.   

These days, there are more doomsday predictors who are super bearish and usually they are completely wrong, but the situation is so bearish out there, that what they are predicting is somewhat reasonable.  It may take several months for the markets to get to where they predict it, but in this environment, its very possible.  

I don't feel comfortable when a lot of people are thinking the same way, but when there is such a strong case for one direction, you have to just run with the herd.  In most cases, its not a good time to short when investors are bearish, but there is a difference between investors feeling bearish and being positioned bearishly.  While it can definitely be argued that hedge funds and CTAs are positioned bearishly, they aren't the whole market.  There is a huge retail investor base that's still positioned heavily long stocks.  And in the options market, the investor community is very lightly hedged. 

Looking at the intermediate term, at these valuations, there is a lot of room to go lower.  SPX 3000 is not a crazy price target.  That would have been an all time high in 2018.  And the selling will come from retail, who are up to their eyeballs in US stocks.  When they eventually throw in the towel, you will see big outflows from equity funds, week after week, during this process.  Most of the wealth is held by the baby boomers, who will be looking to get into safer investments as they age, increasing demand for fixed income and reducing demand for stocks.  

Retail is hanging tough, and corporations still feel comfortable enough and have enough free cash flow to keep buying back stock.  But in the next 6 months, what the leading indicators show will start showing up in coincident indicators (employment, corporate earnings, etc.).  That's when corporations start cutting back their stock buybacks, and retail start selling their stocks.  That's when things really get ugly.  And that's going to happen even with a Fed pivot, which is all but guaranteed.  Don't forget that the final bottom of the bear market in summer/fall of 2002 and spring of 2009, came after the Fed had been cutting rates for years, not months.  Its going to take time for this process to play out.  

We are getting a relief rally after the ECB 75 bps hike and the Powell speech, which was hawkish as expected.  Now the market is looking forward to the CPI for next Tuesday, which most are expecting to show a continued decline in the inflation rate.  Since many are expecting the CPI to be a bull catalyst, its quite likely that you will squeeze some more shorts in the coming days and have a very short lived pop on the CPI data release.  If the SPX can get close to 4100 after the CPI is released, that is a very tempting spot to go short and ride it down into the seasonally weak post September opex time period, going from mid September to early October.  

A sustained equity bounce like you saw from mid June to mid August was possible due to a big down move in 10 year yields, with some hopes of a less hawkish Fed.  That lifeline has been thrown out the window for the time being, probably not coming until you see labor markets weaker and inflation going down for a couple more months.  Without a Fed pivot, and with leading indicators showing a big slowing of the global economy in the coming months, and the well advertised EU energy crisis that will be much feared ahead of the winter, you have all the ingredients for a grind lower.  Until the Fed cries uncle.  And that's probably going to require the SPX to make new yearly lows. 

Trading Regrets

There is the cliche that in order to be a good investor, you have to act without emotion, be like a machine.  It assumes that one can do that, which is very unlikely, even if you run a "system".  The development and tweaking of the system is ultimately discretionary, and, thus not pure.  So even for systematized strategies, human discretion and emotion are involved.  Even if you really wanted to take the emotion out of investing, you can't do it.  

Maybe its actually good to feel emotions when trading, to actually improve your decision making and learn from past mistakes.  There are those blind optimists who say that they live with no regrets.  But for most of us, we have regrets about the past, and its not a bad thing.  If you don't regret touching that hot stove, then you probably will be just as careless around that hot stove the next time.  I spoke with a trader in the past and asked whether he felt regret about selling his long term stock holdings after the initial bounce in April 2020, fearing that there would be more weakness.  He said no, the conditions were unprecedented and it seemed like a bear market rally at the time. 

That's completely different from how I felt after covering my short way too early for a small gain a few days after the market topped in mid August.  I felt regret almost immediately, realizing that I left a ton of money on the table, and ignored the signals from the options market, which were actually pointing to a lot of complacency in the face of the selloff.  

Losses are the best teacher, but huge missed opportunities are not far behind.  If you don't feel that disgust after exiting too early and taking a small profit when a big profit was just around the corner by holding a few more days, then you are probably going to keep exiting too early when having a small profit.  It works the other way as well, holding on too long (usually when holding a loss) and letting the trade go against you even more, changing the original exit plan to avoid taking that loss.  

Why do we do this to ourselves?  Why do we hate to take losses and love to take those small gains?  Its that reptilian brain that feeds off of dopamine hits, disregarding the long term or past history.  Gain = dopamine hit, and its not proportionate to the size of the gain, so small gains have almost as big of a dopamine hit as a large gain.  Thus encouraging suboptimal trading behavior.  

Loss aversion also feeds into this tendency, as traders book their gains quickly for fear that they will turn into losses, and avoid taking small losses, for hope that those small losses will turn into gains.  That's what a lot of these HFT algos run on, pushing the market in one direction as they know that most discretionary daytraders will be stuck on the losing side, and will eventually puke out their losers later in the day.  The video below is a classic example of loss aversion, during the January 21-22 2008 huge gap down (scarier than the March 2008 Bear Stearns liquidation). 

 Quite a few regrets about 2022, missing one of the great shorting opportunities in SPX, multiple chances at low risk entries on the short side, and missed most of them, and the one that I did catch, took profit way too early.  Not taking at least a small long position into the heart of the inflation fears in mid June, even though stocks were highly oversold and due for at least a short term bounce.  

Underlying most of these missed opportunities was a fear of getting short squeezed, and still having memories of the relentless dip buying and chasing in 2020 and 2021.  The bear market is more mature now, but there is still a lot of fat left on this pig.  Sometimes we make the game harder than it is.  Usually you have to put a big weight on positioning and some weight on what you hear repeatedly on CNBC, Bloomberg, Twitter (from a contrarian view), and that has interfered with the big picture view of a Fed that doesn't want to see financial conditions loosen (stocks and bonds going up) and is hell bent on tightening despite many signs of a slowing economy.  Worsening liquidity + overvalued stocks in a post bubble environment + Fed showing no signs of letting up on the brakes = a time to short aggressively.  Its simple logic, and a rare set of conditions which heavily favors the short sellers.  Let's not lose sight of that when making our decisions for the rest of the year.  

From Wednesday to Friday last week, I finally saw a change in options activity showing investor concern, as we no longer saw the heavy call buying and put selling on the dips, and instead saw call selling and put buying (not nearly enough to reverse the monster call buying and put selling from August 19 to August 30).  Its a sign that the steep drop is probably over, and that we're likely to see a few days of consolidation of the losses before the next downleg.  I will be looking to put on shorts during this consolidation phase, especially if there is a rally after the CPI report next Tuesday.  Expecting no significant rallies (more than 100 points) from these levels. 4000-4050 is probably about as high as it can get before its gets hammered back down by sellers.  

We have bonds giving up most of its post NFP gains overnight, and it looks like central bank fears are still quite high and should stay that way until we get to the FOMC meeting on Sep. 21.