Kid Gloves

We will find out in 2 days whether Powell continues his Volcker Jr. act or he screws up the acting and let's his guard down, revealing his inner dove, which is much closer to what he really thinks.  Psychoanalysis is not my specialty, so I will not dig into that rabbit hole.  But you got a glimpse of how this Fed feels through the writings of WSJ Nick Timiraos, who is undoubtedly in regular contact with the Fed.  Timiraos is the loudspeaker for the micro-managing Fed, who feels like the market is a baby that needs regular coddling and supervision.  After all the resilience this market has shown towards the rate hikes, the Fed still uses kid gloves.  They are afraid that something might break, but at the same time, trying to control inflation expectations with as much forward guidance BS as possible.  

The past 6 months have been an anomaly.  It is not normal, and will be uncommon.  Don't ever forget the default stance of the Fed.  It is to pump up the financial markets.  It is to baby the markets, and err on the dovish side.  High inflation is something that just got in the way of their normal pumping operations.  In no way will they keep fighting inflation if the economy breaks bad.  And so far, the leading indicators have only just begun to creep into corporate earnings and the more coincident indicators.  With a labor shortage, the nonfarm payrolls numbers have been resilient, so it will take time for the employment data to get really bad.  It eventually will get bad, because without heavy fiscal and monetary pumping, you don't have any growth.  But the lagged effect of monetary policy can be stretched out a bit when stocks refuse to go down and stay down.  These counter trend bear market rallies aren't helping with pulling forward weak demand. 

On Sunday, after a furious 1 week rally, Timiraos was on the beat again, talking about how the economy was still strong, with consumer excess savings still high.  That could have been written when 10 year yields were at 4.30%, nothing has changed, but it looks like the Fed gave him a hint to ratchet down the expectations for the upcoming FOMC meeting, as the expectations were starting to get quite dovish and the big rally in stocks isn't what the Fed was looking for.  If they could help it, they would just like to see Treasury bonds go up without stocks going up along with it, but that's not something they can control.  

So the question going into Wednesday is will they try to save the bond market and allow stocks to go wild to the upside along with an easing of financial conditions and inflation expectations?  The RBA, Bank of Canada, and ECB have all responded with less hawkish rhetoric and below expectations rate hikes and/or guidance.  But those regions are either more sensitive to interest rates due to variable rate mortgages or have weaker economies.  Don't forget the US poured the most fiscal and monetary stimulus in 2020 and 2021, and has the one of the stickiest inflation situations among the major economies, so they have more work to do, but are they going to chicken out early?  

Its a tough call, I never like to bet on a Fed being hawkish because their history has shown that they almost always surprise on the dovish side.  If they have a hawkish surprise, its usually well telegraphed.  But I can't imagine Powell liking the reaction in the stock market when he sent whispers to the WSJ to try to save the long bond as it was getting crushed, only resulting in a much bigger rally in stocks rather than the bonds themselves.  With expectations raised for a less hawkish Fed and with a big rally post earnings, it is very possible stocks will be disappointed with what comes out of the FOMC meeting.  But I am cautious about putting on a bigger short position due to the seasonality effects of post-earnings buyback wave + the potential for inflows post FOMC, midterm election, and CPI.  Would have preferred to get out when I had the chance post AMZN earnings bomb, but was a bit too lax on the short position management going into Friday, due to the small position size.  

At the moment, neutral on the bond market, and slightly bearish short term on stocks.  There are no easy opportunities at the moment, hence the light positioning.  The big picture remains as bearish as ever, and the fact that the talking heads on CNBC/Bloomberg are more bullish makes me more confident in my long term view that this bear market has a lot more to go. 

Unsustainable

It can't continue like this.  Yields trending higher and stocks trying to rally.  It is puzzling to see the eagerness with which stock investors are looking for a bear market rally, going from pessimism to optimism in a matter of days.  Its that recency bias kicking in.  The 13 years of mental conditioning.  And all it took was a hint of a Fed step down (hinting at a 50 bp hike in December) via WSJ's Nick Timiraos before the Fed quiet period started.  The Fed showed their true colors again.  They got nervous that the bond market would go haywire while they were in their quiet period, afraid that the long end of the yield curve would get unhinged, like the UK gilts market a few weeks ago.  The Fed, along with Yellen, came to the rescue (not a true rescue, but a sneak peek), trying to calm the bond market to prevent any further liquidations.  

For a moment there, I thought the Fed were united in brainwashing the market to believe that they would pull a reverse Draghi and do whatever it takes to crash the economy to bring down inflation.  Apparently, it was all an act, as I suspected.  Powell has long lasting dovish credentials, and its not going to fade away after 2 months of talking tough on inflation.  

It doesn't make me bullish on stocks, I suspect stocks will change its focus in the coming months to falling corporate earnings away from rate hikes and bond yields.  I eventually expect a massive bull steepening in the Treasury market as the market starts pricing in the turn, and gets more aggressive with second half 2023/first half 2024 rate cuts.  A bull steepening based on a weakening economy is what happened from late 2000 to mid 2003, late 2007 to mid 2009, and from late 2018 to mid 2020.  It was a very bearish time period for stocks in 2 of those 3 instances.  The last one, the economy just didn't get weak enough to hurt corporate earnings, very different than the current situation.  

The stock market will be competing for capital with a liquidity starved Treasury market that cannot function under the current lopsided supply/demand situation.  The last few weeks are a glimpse of what the Treasury market will be with no QE.  Actually, its negative QE, or QT. There aren't enough natural buyers of long end Treasuries at these levels when the Fed is so determined to take short rates higher.  The supply demand doesn't match when you have trillion dollar deficits needing funding + nearly $100B/month in Treasury/MBS balance sheet runoff.  Especially when the biggest recipient of dollars from the US (China) goes on a Treasury buyer's strike, as buying US bonds doesn't align with their political interests.  Also, it doesn't help that the US is ratcheting up the pressure on China by banning certain chip exports, and froze Russia's overseas dollar assets.  China would rather own commodities or US real estate, than Treasuries, and I don't blame them.  

So if you no longer have China buying Treasuries, then the US has to make up for it with mostly domestic demand, which requires higher yields to bring in buyers.  And if the long end yield gets too high, that puts an even bigger squeeze on housing, which got priced based on much lower mortgage rates, pre 2022.  

Its just unsustainable.  The Fed is pushing the bond market closer to the systemic edge, with its hawkish talk and 75 bps raises, as well as the silent killer, QT that is running in the background, slowly taking liquidity out of the system.  Its causing a supply demand mismatch, something this liquidity addicted market can't handle in the long run.  What is unsustainable in the long run eventually stops.  But the market is very short term focused, because hedge funds are short term focused, and because retail money is even shorter term focused (dopamine addicts who are pouring huge sums into 0DTE options).  So you don't have too many looking out beyond the next few days or weeks.  That's why you see so many who are long term bearish, but are short term bullish looking for a bear market rally.  By the way, when most of the fast money tell you that they are short term bullish and long term bearish, it means they are positioned long and looking to get out quickly, which is NOT a bullish scenario. 

The irony of this market is that the more that investors hold on to Fed pivot hopes and not sell, keeping stocks afloat, the longer it will take for the Fed to pivot as they see no need to rush to the rescue to save the market.  These rate hikes work with a lag in the real economy, so the economic data hasn't gotten weak enough for the Fed to pivot without blowback.  If they pivot at the upcoming Fed meeting, there will be a lot of observers who will criticize the Fed for being so soft on inflation with unemployment so low.  So barring a big slowdown in employment or a big drop in inflation, the only out for a Fed pivot is a very weak stock/credit market.  And the stock market dip buyers are not throwing in the towel to provide a pretext for the Fed to offer the market a get out of jail free card.  

Yes, the inflation and jobs numbers will slow down in the coming months, but the stress is more in the financial economy than the real economy.  The real economy eventually gets infected by the weakness in the financial economy, but it will take a few more months.

Not only are there a lot of bottom pickers in stocks, I am also seeing some bottom pickers in the bond market.  This is not a great sign for those looking for a real durable bottom where they can aggressively play for a trend change.  A recent JP Morgan Treasury client survey showed the biggest net long responses since 2020.  And the COT data for Euro FX showed speculators as being quite long, something that is unusual considering how weak the euro has been versus the dollar.  All this tells me that the most likely scenario over the next 3 months is further dollar strength, stock market weakness, and a bond market that will probably be range bound at best.  Over the next 2-3 weeks, the fast money and underinvested hedge funds can chase this market a little bit higher, but that just sets up another huge bull trap, like mid August to end of September.  

A quick word on earnings.  Once again, this earnings season proves that being short in the middle of earnings season is a bad trade.  Even with weak MSFT, GOOGL, and TXN earnings where each of them dropped after their reports, the SPX brushed it off like it was nothing and actually managed to squeeze all the way up to 3880 yesterday.  Proving once again that the SPX doesn't trade based on its individual components, even the big dogs.  It trades based on short term investor flows and the macro picture.  

I am short, but small size, and only looking to play for a shorter term swing.  If they try to push it towards 3900 this week, I will be adding to shorts. 

Lizard Brain

Trading is such a mental game.  Its something I didn't really think about until the past few years when I realized I would have these long losing streaks and also long winning streaks.  It was because I was doing stupid things when I was losing money.  I would get desperate to quickly make back my losses.  Forcing trades.  Rushing to make it back.  In the process, I would take mediocre trades, get in too early.   I would dig the hole a little deeper.  It was a self-reinforcing cycle of losses leading to more losses.  A trading hamster wheel in hell. 

Only after a big win would I be able to stop that vicious losing cycle.  Why do we do this to ourselves?  Its that lizard brain that lingers after millions of years of human evolution that hates losing and wants to make that feeling go away, as soon as possible.  

Another remnant of that lizard brain is the desire to follow the herd.  It has less to do with getting more bullish when things go up and bearish when things go down, and more to do with following what others are doing.  Its like following the latest fashion trend, the latest fad.  Monkey see, monkey do.  Going on Twitter, watching CNBC and Bloomberg, and thinking that those guests and hosts know what they are talking about.  But its quite the opposite. In finance, those that know the most talk the least. 

How about that other thing we have in common with our ancient ancestors.  Recency bias.  How soon that we forget Powell's forward guidance in 2021, when he said he  wouldn't hike until 2024.  Now we believe his every word, taking it as gospel, that he will keep hiking the US economy into a depression!  I am old enough to remember when all the talk was about secular stagnation, deflation, and the worry that robots were taking away jobs.  Now we can't seem to find enough workers.

The financial markets are still stuck in that recency bias of believing that stocks always goes right back up.  Its that buy the dip mentality, the stocks for the long run crowd who believe that its their god given right to have 11% annualized returns, without a thought as to where that return will come from.  Valuations are an afterthought, its just about staying invested, dollar cost averaging, and investing for the long run.  A lot of bad habits and erroneous assumptions have been built based on the backs of the 2 biggest bull markets (1987 to 2000, 2009 to 2022) in recent history.  The stats nerds lap up every dip like its a lifetime buying opportunity, a guaranteed way to make money. 

Its that American Exceptionalism creeping in.  It assumes that the US will always be the best place to invest, the best currency, the cleanest dirty shirt, the best house in a bad neighborhood, etc.  All I see is a US that is becoming more of a bureaucratic country like Europe, that relies on fiscal policy to boost economic growth, with very little organic growth.  Productivity that is going down as the public sector gets bigger along with the ballooning budget deficits.  A country that has no vision, that just tries to throw money at problems with no scientific or logical plan for energy, healthcare, infrastructure, etc. 

Over the next 10 years, I can see a US stock market that goes sideways with 0% return, as the cost of both goods and services goes much higher, mainly from populist inflationary fiscal policy that aims to throw money at problems instead of looking for long term solutions to a lack of energy, labor, and productivity growth.  I can see financial repression coming back as negative real rates for US Treasuries are a fixture as the US government can't afford to enter a high debt, high interest rate, high inflation death spiral.  The Fed will eventually be forced to cut rates and restart QE to fund the massive budget deficits from an undisciplined and populist Congress that spends more and more but refuses to raise taxes to pay for it. 

Back to the current markets.  We are seeing both the Fed and the Treasury show early signs of caving.  On Friday, it was the Fed whisper at the WSJ hinting that the Fed will be looking at a smaller rate hike in December, followed by Yellen on Monday talking about Treasury buybacks and worries about liquidity.  Its funny they only worry about liquidity when bonds are going down (now), not when there is no liquidity when bond are going up (October 2014).  The stock market is running with the Fed/Treasury pivot hopes, while bonds are less sanguine about the prospects of the cavalry coming to the rescue.  

I have noticed a big shift in sentiment recently, as the bulls are coming out of their ratholes, thinking that the all clear is here, at least for the rest of the year, and they are getting bulled up again.  Even the permabears on CNBC Fast Money,  Dan Nathan and Guy Adami are pontificating on a bear market rally.  They may have a few weeks where the SPX stays above 3640, the lows from last week, but there is a lot of overhead supply and I can't picture this thing going much above 3900.  Just too many playing for a bear market rally without long term conviction, those who will be selling on strength, creating overhead supply.  Also, this market is running out of suckers who will chase stocks after a big rally.  They got smoked countless times this year, and they are quickly becoming an endangered species.  

Waiting for a short term rally in the bond market to pump the SPX higher a bit more, before I put on shorts.  SPX close to 3800 is a good short level, but want to wait for a bit higher for a lower risk short. 

Bond Market Carnage

Stocks are trying to fight the Fed and the bond market and its struggling.  The pain is real in the bond market these days.  This is probably the weakest bond market in the last 50 years.  SOFR/Eurodollars are pricing in 5% Fed funds for March 2023.  That's another 190 bps of hikes in less than 5 months.  There are some cracks forming in the bond market, as you are getting indiscriminate selling in the long end of the curve.  The Treasury auctions over the past several weeks have been quite weak, a sign that foreign buyers are not in a buying mood and US domestic demand is just not there as investors are still piling more money into stocks than bonds.  

There are so many things going haywire outside of equities (USDJPY hit 151!), yet US stocks remain remarkably well bid, refusing to make new lows as Treasury yields make new highs.  A few days ago, Jim Bullard, the loudmouth at the Fed, showed some signs that hawkishness has reached its peak, as he put conditions on the Fed rate hike path after December.  Its not much, but its a small sign that the Fed is starting to get a bit nervous about the economy, without wanting to give the financial markets any hints of a Fed pivot.  

The bond market is now taking the Fed's hawkish rhetoric and running with it, seeing how far they can take yields higher until either the stock market starts sinking to new lows or the Fed take their foot off the brake.  It appears that the stock market will have to sink to new lows before the Fed really changes its rhetoric.  There are still too many dip buyers holding up the markets, which just means the bond market will have to keep pushing rates higher until the stock market gets the message.  At these level of yields, further bond market weakness will flow directly to the stock market.  These are dangerous levels, running straight towards the edge of the cliff, without a parachute.  

As I am writing this, we just got a WSJ article from the Fed whisperer, Nick Timiraos, who is hinting that the Fed could slow down to 50 bps rate hike at the December meeting.  It doesn't sound like much, but the STIRs market was pricing in a 5% Fed funds rate, so a slowdown to 50 bps or less in December would be a sign that the Fed is aware that things are on the edge of breaking.  You had Yellen come out with a word about Treasury market liquidity last Friday, and now Timiraos getting word that the Fed wants to slow things down a bit in December.  

This little sign from the Fed will not reverse the damage that has been done to the economy by signaling a year end Fed Funds rate well above 4%.  But it could be enough to prevent a UK gilts type of scenario from happening in the US Treasury market.  A less hawkish Fed in November and December, which is probably the most likely scenario, will be a short term positive for stocks, and both a short and medium term positive for bonds.  It could spark a 3-4 week bear market rally, but not something that lasts into 2023.  You have a return of stock buybacks in the end of October, with most earnings out of the way.  November and December are historically heavy stock buyback months.  However, there just hasn't been enough of a reset in retail positioning in stocks, or the usual outflows that you see around bear market bottoms.  So there is still a long ways to go.  

Missed the SPX short waiting for a bit higher levels to put on a position, so just waiting on the sidelines for a higher probability trade.  The volatility is just immense in this market, something that the VIX is underestimating.  Regularly seeing 2-3% intraday moves.  The SPX is trading more like the Hang Seng index than a steady blue chip index.  The longer the SPX lingers under 3750, the more likely the top of the next countertrend rally will be under 3900.  Its the opposite of what you had to do for 13 years.  Instead of buying the dip, its short the rip. 

G-Force

Interest rates are the gravitational pull on equities.  It is what keeps equity valuations grounded.  The current Fed funds rate, 3-3.25%, is about to go to 3.75-4% in 2 weeks.  And then you will probably get another hike at the December meeting, taking Fed funds over 4%.  This is what the equity market is fighting.  The higher the interest rates, the more incentive stock investors have to sell their stocks and put them in either cash or bonds.  To put things in perspective, you haven't seen this level of interest rates since early 2008, but at that time, the Fed was forecast to cut rates even further, unlike now, when its the exact opposite.  

Yet valuation measurements such as P/E and P/B are not anywhere close to early 2008 levels.  Its at levels far above those you normally see at bear market lows.  Valuation is one thing.  You also have to look at supply and demand.  With elevated equity allocations among households as a group, and with an aging population that will tilt towards more conservative investments as time passes, you will see a steady allocation shift from stocks to bonds over the next several years. Corporate earnings will go down in 2023, everyone knows that, and when earnings go down, corporations reduce stock buybacks.  Its that simple.  

Its fascinating to see how investors think after the popping of the biggest bubble in our lifetime.  Its no wonder the downtrend after bubbles lasts for so long, and has many countertrend rallies on the way down.  People can't shake recent history, all those years when BTFD worked great and when downtrends ended within a couple of months, at most.  So even if they say they are bearish, they are not positioned that way.  Because it hasn't paid to be positioned bearish for the last 13 years.  13 years is a long time to condition the mind.  Its human psychology at work, and it keeps repeating throughout history. 

You can't be super bullish on anything, including bonds, over the next several years.  If I had to choose a long term investment, it would be commodities, but I expect a very rough stretch over the next 3-6 months for anything commodity related as you haven't seen a purge in investor expectations yet in that space.  There are still too many that are sticking to their bullish energy thesis based on Russian sanctions, the war, the shortage of natural gas in Europe, etc.  But the macro environment is horrible for energy right now.  China is sticking with zero Covid in the middle of their deflating property bubble.  OPEC+ didn't cut production just to defend price, they are seeing the demand going down and they didn't want to get caught with their pants down when it gets even worse.  

As for short term investments, I would choose bonds over stocks easily.  Its not even close.  Despite the poor performance this year, at 10 year yields around 4%, they are definitely going to be able to provide a risk off hedge in 2023.  Further Fed hikes beyond this year is wishful thinking as the economy goes into the tank.  I don't understand all those who are so negative on the economy, yet also so negative on bonds.  Its as if they assume that Powell will just keep hiking no matter what, which is ridiculous.  He showed his true colors for years before he even got picked by Trump, who loves low interest rates.  Why do you think Trump picked him?  Because Mnuchin told him that he was a dove.   He's not the second coming of Volcker or Arthur Burns.  He's even worse.  He's more like the second coming of Ben Bernanke than any of those guys from the 1970s.   

I look at the SOFR curve, and its pricing in a Fed funds rate of 4.90% by March 2023.  I look at that and I realize the front end of the yield curve is the most mispriced right now.  In the front end of the yield curve, you don't really have to worry about falling demand from foreign investors or increasing supply from QT.  Its going to move with short term rate expectations.  I expect Fed funds rate to be either 4.1% or 4.35% after the December FOMC meeting.  That would imply 75 bps in November and either 25 or 50 bps in December.  After that, I think the economy will be too weak for the Fed to continue hikes.  If they do, they will seriously wreck things up that will force them to cut quickly.  The stock market is not going to hold up into year end if the Fed signals another 75 bps for December.  Its already struggling, and any remaining dip buyers will be totally spooked if the Fed tries to follow through with current STIRs market pricing.  

We got another face ripper on Monday, basically the worse situation for bears as it gapped up huge off an ugly Friday and just kept going higher, similar to Monday October 3.  That rally lasted until the close on Tuesday, and took the market up 200+ points.  This time, a similar move would take the market close to SPX 3800 again.  That would be a level I would eagerly short.  With bonds acting like this, I don't see much room to go higher than 3800.  I don't expect another move towards 3500 until you get more bulls trapped and sucked in with a counter trend rally into November, which could take SPX up to 3900.  So we are in the consolidation/countertrend rally phase, and it should last from 3 to 5 weeks, before the next sharp drop.  I don't see a long and strong bear market rally like August, the conditions are just completely different with how much weaker bonds are now than back then.  Also, Fed funds rate is much higher now so the competition from cash is much more compelling as an alternative to stocks. 

Another Classic Event Day

What a face ripper.  Yesterday took the face off the shorts with a dull knife from open to close.  Its the crack cocaine for investors, the intermittent face rippers that get paper napkin chartists excited about bullish hammers and the paper napkin statisticians excited about breadth thrusts.  It has no meaning for the destination of this bear market.  And it has only a small edge in predicting the short term path.  

It all goes back to investor positioning around event days.  With the fear and uncertainty of another possible big down day on a hot CPI number, you had the market selloff for 5 straight days into the CPI number.  Investors have short memories.  They remember the cliff dive drops from past CPI numbers this year, and they were proactive in taking down long equity exposure ahead of it.  When long exposure is light ahead of a big, bad feared event, the weak hands have mostly sold, so while you can get a knee jerk reaction down on bad data, as stop losses get hit and short term liquidations occur, it can't stay down because a lot of investors who were nervous already sold down their positions.  And there were quite a few who were waiting to buy after the CPI, so you had buyers waiting for the uncertainty to clear to go in.  It only helped the situation for the bulls when the gap down was so large that it felt like a short term capitulation that flushed out any remaining weak longs. 

And as the market started rallying, you got the short squeeze for those who put on daytrading shorts after the hot CPI release.  And don't forget all the put hedging that went on the past few days, to hedge the event risk.  All of that got unwound as dealers had to delta hedge their short put exposure by buying index futures as the market went higher.  And this is a negative gamma environment, so dealers exacerbate moves because they have to buy when it goes up and sell when it goes down.   

A day later, after the dust has settled, that hot CPI number doesn't really change anything.  The STIRS market was already pricing in nearly 100% odds of a 75 bps hike in Nov., and it remains that way.  It did price in much higher odds of a 75 bps hike in Dec., as well as a higher terminal Fed funds rate, up to 4.85%.  If you think the Fed will still remember this CPI number at their December FOMC meeting, or any meeting after that, I have a bridge that's for sale at a bargain price.  

And no, the Fed will not go 100 bps due to this number at their November meeting.   If they did, it would invert the yield curve like you wouldn't believe and crash the stock market so fast it would actually speed up their pivot, not slow it down.  

If you read the FOMC minutes, it was more neutral then the initial hawkish reaction in September.  Here is a quote from the minutes that tells you they are not completely oblivious to the damage going on:  “it would be important to calibrate the pace of further policy tightening with the aim of mitigating the risk of significant adverse effects.” 

The stock and credit markets are likely to have major convulsions before the CPI or NFP numbers get to levels that the Fed is comfortable with.  Then it will be up to Powell to make his call.  Cause an even bigger recession waiting for the CPI to get down close to 2% or cry uncle and make a U turn, making everyone at the Fed look like fools again for their shoddy forward guidance.  Looking at Fed history, I'll put my money on the side that he cries uncle and gives up on his Volcker Jr. act.  

It appears the bond vigilantes are back in some countries, with the UK being the latest addition.  U-turn on the mini-budget that caused a huge stir, sacking Kwarteng, the guy who came up with that mess, etc.  If the UK gilt market didn't selloff so hard, none of that would have happened.  Without QE, the bond market can put extreme pressure on politicians trying to pass budget buster legislation.  But that trend will not last for long.  The temptation to do QE to act as a quick fix is too great.  Its always much easier politically to have the central bank buy up the bonds that they issue to finance their huge deficits, keeping rates artificially low and letting the currency be the release valve.  More people will complain about losing money in their stock and bond portfolios than about a drop in the value of their home currency.  

Post CPI, the SPX has room to run up higher, as the biggest event for the month is over.  With all that de-risking you saw over the past few weeks, there is a decent amount of potential energy for a bounce.  You could definitely see a relief rally back up towards 3750-3800 by next week.  It would be another good short selling opportunity if it happens.  Neutral at the moment.  I would focus on retail favorites as the best short candidates in the next bear market rally.  Unlike hedge funds, retail investors are still highly overweight stocks and will eventually be underweight by the time you reach the bottom of this bear market. 

Repeating Lies

"If you tell a lie big enough and keep repeating it, people will eventually come to believe it."  - Joseph Goebbels, Nazi propagandist

Lies = Fed forward guidance.  The Fed is as united as they have ever been.  Its almost as if they met and said, "hey, we've got to talk hawkish to get inflation expectations down and financial conditions tighter, no matter what."  And they've repeated their hawkish rhetoric, all of them, over and over again, to the point that investors who are losing money are getting sick of hearing it.  For the few weeks where they backed off of forward guidance in the middle of the summer, they soon realized how insignificant they felt, how the market was going where it thought it should go (higher stocks and bonds), and they didn't like it.  So they went right back to doing forward guidance, but this time all in synchrony and on full blast.  

The Fed's forward guidance has such a terrible track record, that its puzzling to see the Fed governors complain about the STIRs market pricing in a rate cut in 2023, contrary to forward guidance for no cuts in 2023.  Frankly, I'm surprised the STIRs market is pricing in just one 25 bps rate cut for 2023, because the Fed has a history for terrible predictions about future policy, and they've tended to cut fast and big when they see the economy getting very weak.  And most signs are pointing to a very weak economy in 2023.

The Fed is fighting the bond market, and its winning, for now.  Whenever the curve is inverted this much, its because Fed policy is too tight.  But the bond market is an arbiter of truth (as long as the central banks don't do QE), and will eventually break the shackles of Fed forward guidance when the recessionary evidence starts mounting.  And it is starting to add up.  The weak ISM number last week, the big drop in job openings, and the various earnings warnings over the past few weeks.  There is a global recession happening, but the data that the Fed watches lags, so the Fed has cover to talk a hawkish game.  But not for long. 

All that consumer spending on goods in 2020 and 2021 means many pulled forward their purchases with the help of fiscal stimulus.  That fiscal stimulus is mostly gone, there is still a bit here and there, gas stimmies, electricity bill stimmies, etc, but those are minor compared to the big bazooka in 2020 and 2021.  Inflation has also done a good job of eating into consumers' purchasing power and excess savings, reducing demand.  M2 money supply growth is barely positive for 2022, which is a huge break from trend, when its averaged around 7-8% annually since 2000.   M2 supply growth feeds to inflation with a 12-18 month lag. 

With limited fiscal stimulus in 2022, and likely to be limited new fiscal stimulus in 2023 and 2024 with Washington gridlock, the biggest driver of inflation, excessive fiscal spending/tax cuts, will be absent.  Add to that, a Chinese economy that will be dealing with the popping of a huge property bubble and Europe that will be dealing with high electricity prices for the next few years (reducing discretionary spending), and you have the ingredients for a disinflationary wave.  Very few people are talking about this possibility.  Almost all I hear from the 5 minute macro experts is secular inflation, energy and commodity inflation due to supply concerns, a tight labor market, stagflation, etc.  I hear very few talk about a disinflationary cycle that lasts until 2024, due to the lack of a big fiscal stimulus wave and low population growth in the developed economies and China.  

The dirty little secret about inflation is that fiscal policy is more important than monetary policy in determining the inflation rate.  Powell can try to be Volcker Jr. as much as he wants, if the White House and Capitol Hill go on a deficit spending binge, inflation will go up, even with higher rates.  Just look at Argentina.  Last I checked, their interest rates were at 75% and their inflation is out of control.  In fact, over the long run, it can be argued that if you keep rates high, the interest income that flows from the Treasury to bond investors is a stimulus paid for by higher deficits. 

It is interesting that there are more people trying to play for a technical bounce in stocks than in bonds, even though the main catalyst for a bounce would be weaker economic data / lower inflation numbers, which usually benefits bonds more than stocks.  Really the only fundamental reason for buying stocks is to play for a Fed pivot based on peak hawkishness.  All of the leading indicators are showing earnings going down bigly in the next few quarters, so earnings will be a drag on stocks.  And valuations are still too high considering the higher risk free rate and dropping forward earnings estimates. On a pure valuation basis, stocks are expensive to bonds, but there have been more inflows into stocks than bond funds in 2022. 

There is a lot of talk about the Fed pivot, but there is no clear definition of it.  Its generally accepted that the Fed is a long ways from pivoting, or at least there needs to be a few weaker than expected CPI reports and nonfarm payroll numbers.  Unlike what most investors think at the moment, the bar has actually been lowered for a Fed pivot because the Fed funds rate is already 3-3.25%.  If the Fed funds rate was 1-1.25%, even some things breaking wouldn't get the Fed to pivot.  But at a Fed funds rate of over 4% by year end, which is almost guaranteed, it won't take much for the Fed to start talking less hawkish or gasp, even a bit dovish.  And I expect the economic data will start coming in much weaker which will also make it easier for the Fed to take their foot off the brake and stop and assess the damage. 

Covered the remaining shorts yesterday and now just long some Treasuries.  Don't want any short exposure going into the CPI number on Thursday, as I think a lot of the selling since Friday has been investor positioning ahead of the CPI.  This is a very different situation than before the CPI in September.  The SPX is down over 500 points from pre CPI levels in Sep., and bond yields are also much higher.   The hurdle to get the market to selloff on a hot CPI is much higher.  Neutral on stocks at the moment, but a bounce later in the week wouldn't surprise me. 

Spring Season for Bears

Shorting is not natural for most investors.  It presents a unique edge for those willing to go short just as easily as they are to go long.  During a bull market, that edge actually turns into a handicap, as those with a willingness to short don't put a short leash on that dog.  They short when the odds aren't completely favorable, or even during a raging bull market, when the market doesn't give short sellers any air.  But that handicap turns into an advantage in a bear market.  

My bearish tendencies has been a big handicap since 2008.  Its made me short in suboptimal spots, and more importantly, I missed a lot of good chances to get long and ride the bull trend.  And valuations weren't outrageous for the first few years of the bull market, yet I was still too cautious.  Huge opportunity costs along the way.  I did eventually adjust to playing the game in a QE world of excess reserves and TINA, but it was a rough road to get there.   

Shorting has been difficult for so long since the US stock market has spent most of its history in a long, strong bull market.  This has taught investors that shorting is hard, and a loser's game, as you can see from the miniscule amount of money in short only hedge funds vs long/short, macro, event driven, etc.  Its taken for granted that the stock market will always go up, cranking out average returns between 8-10% per year.  But that's a false assumption.  Just look at Europe, Japan, China, etc.  Stock markets that have been in sideways to down markets for several years to decades.  Investors in those regions have a much different view on stocks than those in the US.  It is no wonder that the equity valuation gap is the biggest its ever been between the US and Europe. 

At least the bulls and bears have one thing they can mostly agree on:  we are in a bear market.  The best way to profit in a bear market, especially an inflationary bear market, is to short stocks.  In non-inflationary bear markets, its actually much easier and safer to just buy bonds.  That's what's made this environment so nerve-wracking for investors.  They are used to having bonds provide a hedge against stock market weakness.  Its been a positive carry equity hedge for 40 years.  Shattering that hedge has big consequences forthe  risk appetite for investors.  Those consequences don't go away after a run of the mill bear market that ends in 9 months. 

But in a strong bear market, especially after it comes from a long, extended bull market that ends in a huge bubble, playing the short side becomes easier than playing the long side.  Its an uncommon time, in stock market history, but one that gives an edge to those who are willing to take on short positions and hold them for weeks.  There aren't too many speculators who are willing to do this.  Those that are have been burned numerous times over the years shorting in a downtrend, only to see it end prematurely due to easy Fed policy.  So you have a fairly small group now that are actively shorting the indices for longer term moves. 

If you a natural bear, you have to take advantage of this bear market because so many things are lined up in your favor.  Its rare to have the central banks actually on your side!  In a post-bubble, downtrending market.  Its so uncommon that its actually confused a lot of stock investors, making them feel bearish, but years of bull market conditioning make them reluctant to sell their stocks so far down from the highs.  Retail investors were brainwashed into buying stocks at the top in 2021, in the largest volumes since 2000, the total opposite of what they were thinking from 2008 to 2016, when they were reluctant to buy stocks after the 2008 carnage.  And they've only recently started to sell, and its been just a trickle.  They are heavily invested.  

The Fed pivot, the great hope of the bulls, will not be the savior that many think.  A Fed pivot would be good for bonds, but if the Fed pivoted with SPX where it is now, stocks will still be too overvalued given the fundamentals.  High interest rates are not the only problem for stocks.  Its a economy that can now only grow strongly on a nominal basis with a expansionary, populist fiscal policy.  A midterm election with Republicans taking the House (almost guaranteed) would be gridlock, so it will be almost impossible to pass pork stimulus in 2023-2024.  There is no more organic, secular growth in the US.  The internet was a once in a lifetime game changer.   Globalization and labor arbitrage on the scale that happened over the past 20 years will not be repeated.  There are no positive game changers coming in the near term horizon.  

We got OPEC+ cutting 2mb barrels of production at a time when oil is trading above $80/barrel.  OPEC+ is now using their price fixing skills to maximize revenues as much as possible without getting too much pushback and complaints from the rest of the world.   This is a negative for those hoping that inflation will come down quickly.  It also makes the Fed's job harder as it is now fighting both sticky inflation in housing/services as well as a potential rebound in energy prices due to OPEC price manipulation.  

I am a bit surprised that OPEC drew the line at $80/barrel but it seems like they see demand dropping a lot more than they are willing to admit.  The oil market is not as tight as all the energy bulls will have you believe.  Otherwise, OPEC would not need to do productions cuts.  Long term, I do expect oil prices to go a lot higher due to supply constraints, but cyclically, its not a bullish time for commodities.  

Bonds seem to have found a top in yields as the 4% 10 year yield area has lots of resistance, going back to 2009 and 2010, and is close enough to the terminal rate of this rate hiking cycle to attract fixed income buyers.  The stock market rally on Monday and Tuesday is largely based on the hopium of the Fed being less hawkish based on bad news like Credit Suisse, gilt market last week, and a disappointing ISM number.  But it looks like the stock market is running with that hopium a lot more than the bond market, which has given back most of its gains that it made earlier this week.  It once again reaffirms the belief that the stock bulls are still clinging to hopes of a "strong" bear market rally, like what you saw from June to August, while the bond bulls have mostly been extinguished and are reluctant to buy the hope of a Fed pivot until they actually see much weaker econ. data come through.  

Re-shorted what I covered on Friday into the rally on Tuesday.  Keeping it simple.  Covering on deep dips to free up cash to sell short term rips.  With nonfarm payrolls on Friday and CPI next Thursday, expecting investors to be reluctant to pay up going into those data points. 

The Elephant in the Room

If you are usually a bear, these are the times where you have to rack up your points, because bear markets don't come around often. And when they do, they usually don't last anywhere as long as bull markets.  Most investors are natural bulls, as they have faith in past stock market history continuing forever, believing that the last 100 years will repeat over the next 100 years, and that annual 8-10% stock market gains are a given.  Bears like me think that's preposterous, thinking that kind of future return is only possible in a high inflation environment that's tolerated by the central bank, politicians, and the masses.  That kind of optimism in the US stock market ignores what has happened in the stock markets in Asia and Europe in recent history, even during a falling rate environment.  

Those who are pessimistic about the market point to valuations, past bear markets, leading indicators, current economic trends, structually higher inflation from commodities, and a higher interest rate environment with a hawkish Fed as reasons to be bearish.  Those who are optimistic about the market point to bearish sentiment and the oversold technicals.  One side carries a lot more fundamental backing while the other side is expecting some greater fools will start chasing stocks again when there is a rally, creating a tradable bounce.  Anything can happen, but when the weight of the evidence overwhelmingly favors the sell side, then I just end up having conviction and better luck trading that side.  The buy side seems to be looking at the markets from a much shorter term time horizon, looking for a bear market rally, and that speaks volumes about how much conviction they have.  There are many that are looking to sell a bounce.  And I don't see too many who would be willing to chase prices higher for more than a few days.  So logically, the rallies should be short lived.  

This is not like the June lows, when there was still hopes of a quick, relatively painless Fed rate hiking cycle, as reflected by the big rally in bonds from mid June to early August.  Also there were still lots of hope for a soft landing.  This time, the Fed has been more concrete about their rate hike plans, and Powell has backed himself into a corner, and he would lose face, as well as some credibility if he didn't back up his tough talk with tough actions for at least another meeting or two.  And now, most expect a recession, unlike 3 months ago, so they won't be as many suckers with FOMO zealously chasing the market, as if the bear market is over.  

You are seeing more signs of stress in the FX and fixed income markets, as governments are resorting to interventions to keep things under control.  That's not a sign of a healthy environment.  And I don't think Credit Suisse is a big deal.  That's a red herring.  That's meaningless.  The elephant in the room is the Fed, and they are taking a huge dump on asset markets.  It is all that matters.  Even if they pivot, its not going to lift markets for long unless they start signaling cuts.  A pause and less hawkish talk will not be enough, especially if Fed funds is over 4%. 

Its an odd market.  Usually when you see such a sharp move down, basically straight down since the CPI release 3 weeks ago, you get more fear and a reluctance to buy the dip.  But its almost as if I see more fear from those short who are looking to lock in gains for fear of losing it back in a bear market rally.  Up until late Friday, I could sense the dip buying bulls looking at that double bottom on the charts, feeling confident that there would be a short term rally before further selling.  You could see it in the mediocre put/call ratios for a big down day on Thursday, and even more complacency on Friday on a small up day, with put/call ratio trading below 1 until the last 30 minute selloff.  

And the COT data confirms this, as speculators were heavy buyers while the SPX went from 3855 to 3647 from 9/20 to 9/27.  That's a pretty bearish combination, a sharp selloff and speculators buying into it. 

The lack of any counter trend rallies during the post CPI downtrend tells you a lot about the market.  Its not common to see such consistent selling, with almost no relief for the bulls.  The one big up day last week was immediately taken back the next day.  

One bullish sign, albeit small, is that you are finally seeing the generals get punished, as AAPL and TSLA are now selling off more than the market.  Its when investors start liquidating the winners that you are getting late in the selloff.  Its not an exact timing tool, but it does make me want to reduce shorts a bit, all else being equal. 

 Its been a while since we've had a nasty close.  Even on some big down days lately, there has been that closing hour mini ripper into the close, just to put a little seed of doubt into the short sellers, and give a bit of hope to the bulls.  It was probably daytrading short sellers who wanted cover and not take home shorts overnight.  

I actually covered half of my shorts near the Friday close just to have some more dry powder just in case the bulls try to run it up again this week, as fund flows in the new month could provide a bit of a bounce.  There are still too many looking for a bounce for me to want to cover all my shorts, although we are inching closer to my target of SPX 3520.  

We have a gap up in stocks and bonds off that weak close on Friday, as first day of the month automatic fund flows buoy the market.  This is inelastic money so its going to buy regardless, and there are still die hard bulls who blindly just plow money into stocks on a regular basis.   And now that the much feared September behind us, you have the optimists with renewed hopes of a better market.  With nonfarm payrolls and CPI coming up in the next several days, I don't expect buyers to aggressively chase the market higher.  If we get a rally today towards Friday's highs, I will probably put on those shorts again that I covered.