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.