Recession Consensus

Almost everyone seems to realize that a recession is coming, but they are not selling stocks.  You are seeing some equity fund outflows after some inflows, but not a continuous trend of outflows.  They are also not buying bonds.  Instead, they are just adding to cash, and waiting.  If stock valuations were much lower and we weren't in a post-bubble environment, my natural inclination would be to lean bullish stocks.  But that's not the case.  Less than 12 months have passed since the top of the biggest bubble in US stock market history.  Stocks are still historically overvalued.  US stocks are considered a "good" asset class.  The big picture is very bearish.  Even without a potential recession and future earnings downgrades.   

If you zoom in and focus on light hedge fund/systematic positioning and somewhat bearish investor psychology, you can figure out a way to be bullish, but its a bit of a stretch.  I am not willing to undergo contrarian mental gymnastics to rationalize a bullish equity position in this environment.  Even if most people are expecting a tough 1st half of 2023 and a mild recession, which is the base case for most investors.  

As I have said in the past, overall, the institutional investor base is wiser than they were in the past.  They now put less focus on economic fundamentals and more focus on monetary and fiscal policy.  That's a better way to invest than to focus on the cyclical swings in the economy.   That is why studying past historical patterns of stock market behavior and reaction to monetary policy could lead to faulty conclusions.  In the past, earnings projections and current economic conditions had a much bigger impact on stock price movements than they do now.  Investors have wisened up.  They now view loose monetary policy with the corresponding weak economic conditions as an overall benefit to the stock market.  That's why you didn't get that big flush out of panicked investors selling on earnings disappointments that you saw in Q3 in October, because they are willing to look past the current downturn if monetary policy becomes more favorable.  

Yesterday's cooler than expected CPI number doesn't change much.  It may change your view if you thought that inflation was going to be stickier than expected.  But I've been of the view that disinflation is here and all the high frequency price data for housing, goods, and transportation costs are pointing to the same thing.  It was just a matter of time when the high frequency data would flow through to the CPI.  Since government data is lagging and often inaccurate, putting too much weight on is asking for trouble. There were so many ludicrous price targets from the sellside if the CPI was lower than expected or higher than expected, and with IVs juiced way too high, the market quickly faded after the initial spike higher.  I didn't expect a fade so big, otherwise I would have gotten short, but I suspected that it was not going to play out like it did after the November CPI.  With FOMC today, it seems like there is some leftover trauma from the past 2 cliff drops after the FOMC in September and November.  

Some may disagree with this view, but Powell is a natural dove.  He sounds mealy mouth and noncommittal if you listen to him.  That's what the Fed chair position does to people.  They get scared of spooking the markets.  So it took him some time to have the balls to spook the market to tighten financial conditions and raise rate expectations.  His Jackson Hole speech, and the past 2 FOMC meetings did that job.  With Fed funds rates projected to top out close to 5% in the spring of 2023, there is no need to act hawkish when the rate expectations are already so high.  It was a different story when the inflation data was not going down and the market was still pricing in a less hawkish Fed.  Who knows, maybe Powell flip flops from his November 30 speech and puts on his full hawk act again, but the economic data is trending much weaker now than it was 3 months ago when he went on a rampage.  The Angry Powell phase is over.  He may still try to sound tough, but he's lost his edge.  Even if he tries to fight the bond market this time, I don't expect it to gain much traction.  The data is showing weakness and with it, the more frequent recession calls for 2023.  

All the fund flows data for 2022 has shown a stubborn willingness to buy the dip in stocks and a fear that bonds will keep going lower.  After the first quarter where you saw hefty equity inflows, you went sideways with no meaningful net flows from April to November.  During that time, bond outflows accelerated and the household percentage of bond assets is historically low.  With an aging demographic and higher yields than almost anytime since 2008, bonds will attract inflows in 2023.  There is a notable sentiment shift from outright hate and fear to gradual acceptance.  It will take time from investors to fully get back on board the bond bus.   The supply/demand picture is not optimal with such huge budget deficits and QT for Treasuries, so I don't expect a huge rally from bonds right away.  But with the economic weakness and the secular stagnation thesis still very much alive, rates at these levels are not sustainable.  When the economy gets really weak and the shit hits the fan, they will cut big and fast.  The bond market is telling you as much.  Take a look at this inverted SOFR yield curve.  Its pricing in a drop to 2.75% Fed funds by 2025. 

Its almost the exact opposite of what investors were expecting in late 2021, with the SOFR curve quite steep, yet many expecting just gradual rate hikes for the next 2 years.  The bond market isn't always right, but it is more often right than Fed forecasts.  The Fed forecast of higher for longer is dubious.  Its what they say to try to tighten financial conditions, but it has no bearing on future monetary policy.  Forward guidance is just empty promises to try to trick the market to do its work for them.  Those who believe Fed forward guidance for 2023 are making the same mistake, the other way around as they did in 2021, when the Fed said lower for longer.  

Missed the short after the big gap up on the cool CPI, as my base case was shorting after the FOMC today.  It looks more apparent that there is a somewhat soft ceiling above SPX 4100 and soft support at SPX 3900.  Dare I say that we'll be range bound for the next month?  Its not flashy, but that's my projection.  If we get a rally after the FOMC that takes the SPX toward 4100, will enter shorts.  Although I am leaning towards a rally post FOMC, if there is no rally, I'll wait on the sidelines.  Definitely not interested in the long side.  This is still a hit and run market.  Seasonally, its not a favorable time for the bears.  I usually ignore seasonality, but the end of the year when liquidity is light is one of the few times that seasonal influences are strong.  Its not a market to bear down and take long term positions.  There are no great short term setups here.  Let the market come to you.