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.