Its an Art Not a Science

The stock market is irrational.  Its based on numbers, but its not math or science.  There are no set rules.  There is no iron law in finance.  Its an art that people try to make into a science.  This isn't physics or math.  The closest thing that comes to mind is fashion.  There is no real logic when it comes to fashion.  Its based on feel, personal taste, emotion, societal trends, etc.  The thing about fashion is that it really doesn't matter how you feel about your clothes, its how others feel about your clothes.  That's the stock market.  It doesn't matter what you feel.  It matters what others are feeling.  

Having a quantitative mindset, it was bewildering to see how investors would get more excited about the stock market the higher it went.  The rationalization, the excuses, the reasons for the moves.  They are arbitrary but are quickly clamored onto like indisputable facts by the crowd.  There is no wisdom of crowds in the stock market.  That's BS.  Its the madness of crowds.  Its herd behavior coming from our primal instincts, that evolved over tens of thousands of years when survival was always the priority.  That way of thinking, the emotions and actions that all evolved when there was no stock market, when there was no crowd gambling on a huge scale.  

Trying to put logic or numbers into this game is like trying to put a square peg into a round hole.  Its an art, and it will always be art, even when AI or machines take over.  There is no science here.  The stock market is just a huge, glorified casino.  In fact, its less quantitative than a casino, where the odds are set.  In the market, the odds are unknown.  Its this mystery that keeps the hope alive, that provide fertile grounds for snake oil salesmen and subscription sellers.  The day that I start a substack to try to sell subscriptions is the day that I admit that I no longer can beat this game, and can only make money selling dreams rather than living the dream.  

Its an illogical game, but there are patterns to it.  Arbitrage has been sucked out of the market and there is very little alpha in that space. The main edge in markets is finding patterns and playing them over and over again.  Those patterns are derived from human psychology and they repeat.  Some patterns are long term, some are very short term.  But they repeat.  Successful speculation is about finding the patterns and anticipating the next move to come in the pattern.  There are seasonal patterns, patterns around events, etc.  Some patterns are higher probability than others.  And the probabilities change and are unknowable, but intuitively, you can sense what patterns are reliable and which ones are less so.  But to do so, you have to stop thinking about what's going on in your head.  But what's going on in the head of those moving the market.  

First order thinking is what you are thinking about the situation.  Second order thinking is what you are thinking about what others are thinking about the situation.  First order thinking doesn't help you much in this game.  Its second order thinking which is the foundation for market analysis.  No one cares about what I think.  No one cares about what you think.  I'm not the one who's going to drive the next move.  I want to know what the big money is thinking and what's their next move.  

The current bull run in stocks is puzzling from my view of how markets should be valued, but it really doesn't matter what I think.  If others are in a risk seeking mode, and past patterns of risk seeking behavior play out, we are not done with this uptrend.  That doesn't make me want to play this uptrend at the current time, even though the probability is high that the market will be higher 2 months from now.  Its the risk/reward thats not attractive here.  There is more downside risk in the short term than upside risk, even though its more likely to go up than down.  

These big bull runs, which we are currently on, tend to last 4 to 5 months before facing its first real test/correction.  Since this rally started at the end of October, that means a rally that likely lasts until late February to late March.  This also jives with the psychological importance of the Fed and the first rate cut, which looks like will happen at the March FOMC meeting.  Its a classic buy the rumor, sell the fact setup happening over several months.  This will be the framework with how I trade the market for the 1st quarter of 2024.  Its too early to think about shorting for longer than a couple of days, so I'd rather not play that game.  

No imminent trades at the moment, but I will be buying dips in SPX and Treasuries in January, as I expect the uptrend to continue into March. 

Late 1999, Late 2020 Flashback

Its getting bubbly out there.  Parabolic moves in heavily shorted names like UPST, CVNA, COIN.  A huge squeeze higher in Russell 2000, up over 20% in less than 45 days.  This is feeling like late 1999.  Like early 2021.  The difference this time versus the previous two times is the economy.  The economy in late 1999 was on fire.  Same with 2021.  Now?  You have the market not excited about earnings, but about the Fed.  That's a whole different type of euphoria, something that will have a shorter lifespan.  Also the fact that we had a bubble burst just 2 years earlier makes it much less likely this bubble will get as big or last as long.  People have short memories, but not that short. 

In 1999, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 1999 to early 2000.  

 

In 2020, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 2020 to early 2021.

 

In late 2023, you are starting to see the Russell 2000, which has been lagging the SPX for the past 18 months, go on a huge rally, massively outperforming the SPX over the past 2 weeks.  

It is human nature to feel FOMO, when others around you are getting richer.  Investors and traders then try to catch up by playing more aggressively, going into riskier stocks with more beta, to get more bang for their buck.  It happened in late 1999/early 2000, in the later stages of the dotcom bubble.  It happened in late 2020/early 2021, at the peak of the SPAC/bitcoin/meme stock/everything bubble.  And it is happening again here.  

But can the economy stay strong enough to keep the animal spirits going, to keep the soft landing hopes alive?  That will be the question for the first quarter of 2024.  There are some who believe that the higher stock and bond prices will feed back into higher consumption by the wealthy, which will boost the economy in early 2024.  There is some merit to that thesis, but relying on the wealth effect as the main pillar of future consumption is not something I would put too much money on.  Plus, you have already front loaded so much of the Fed pivot rally in the past few weeks, that there isn't that much squeeze left to play for, unless things get really crazy.  And as I mentioned earlier, due to recency bias, and being burned the last time, I just don't see things getting as crazy as early 2021.  

One thing I do have conviction on is that Powell will cut way more than what the dot plot predicts for 2024.  But with 150 bps of cuts already priced into the SOFR curve, its not a great risk/reward at current levels.  You probably make money buying SOFR Dec. 2024 futures and hold them to expiration, but it could be a bumpy ride for the next few months.  I would have been much more confident betting on lower short term rates if Powell didn't signal a pivot, as that would have left a lot more potential in the trade.  As it is, its not a compelling trade at the moment.  

A factor that people are not thinking about enough is how the 2024 election and the looming Trump nomination will have on the Fed's reaction function.  The Fed will have an easy trigger finger on cuts in 2024 to try to help Biden (and hurt Trump).  I know there are still those who believe everything they hear from the Fed and believe they won't be political and will follow the data, but I'm cynical on how the Fed operates.  Their default position is to be on the side of easy money in the first place, so even a slight bit of motivation to keep Trump out of office will have them leaning towards more cuts than fewer.  Plus, with the stock market front running these rate cuts so aggressively with a big rally, I could picture a scenario where stocks actually go down after the rate cuts start.  This will hurt consumer sentiment as the election gets closer, which will encourage the Fed to be even looser and do more rate cuts.  I can imagine a snowball effect of the stock market being disappointed with just a few rate cuts and having a temper tantrum, inducing the Fed to cut even more.  

It's interesting that in 2022, even with surging inflation, everyone was so skeptical about the Fed hiking rates a lot after they signaled no rate cuts until 2024 just a year earlier.  After brainwashing investors and Wall Street with higher for longer for the past 12 months, now almost everyone seems skeptical about the Fed cutting rates a lot in 2024, even though Powell has already pivoted and started talking about cuts.  I see the current situation as a mirror image of 2022, with the Fed likely to surprise dovishly throughout 2024, steepening the yield curve in the process.  The economy is just not going to be as strong as 2023 due to the lower fiscal deficits on both the state and federal level, and with the resumption of student loans and the end of the employee retention fraud that many were taking advantage of.  Employment should get softer, as less bank credit and shrinking margins at small businesses will lead to job cuts.  

Short to intermediate term, its not an easy spot here for shorts or longs.  I put on a small short on Thursday and Friday in SPX and NDX, but those trades I intend to close out this week.  I may even play the long side for a quick trade ahead of the seasonally bullish last week of the year.  For longer term trades, I'm inclined to play small ball or just not swing until I see a fat pitch.  My best guess is that you will grind higher into the first rate cut in March, but not a huge amount of conviction.  Because things have been pulled forward so much, it wouldn't surprise me if we had a sharp pullback before March.  Its probably not a bad time to just park money in money market funds at 5% and wait for things to play out for the next couple of months. 

Event Trading

The market hates uncertainty.  There is an edge that comes from that human tendency.  Whenever you go into a hyped up event (FOMC meeting, hyped up nonfarm payrolls/CPI data releases, earnings announcements, elections, etc.), there are patterns that emerge.  In order to predict how markets react around these events, you have to make a basic assumption.  The assumption is that active traders/investors are usually long financial assets.  Its rare for even hedge funds to be net short equity or bond exposure.  And long only funds cannot short.  I made a post about event trading several years ago and it still holds true. 

Let's go into how active investors/short term traders behave around an event.  

1. They often reduce their net exposure.  The more feared the event, the more exposure that is reduced.  Since they are almost always net long, it means they reduce their longs.  The result:  you often see a pullback ahead of an event, from several days before, for big events like an election, to just a few days before, for smaller, less feared events like economic data releases or FOMC meetings. 

2. Since investors and traders have already reduced their exposure ahead of the event, usually at least a day ahead of time, there is a lack of selling pressure from active traders right ahead of the event (a few hours ahead) and after the event.  This often explains the common upward drift ahead of FOMC/NFP/other hyped up event  for the few hours ahead of the release.  Here is a recent example: 

FOMC Meeting November 1 2023

3. The intermediate term trend (2 to 8 weeks) ahead of the event is usually resumed after the event.  The exceptions are very big events where investors AND traders prepare several weeks ahead of time (e.g.: Presidential elections).  In those cases, the long to intermediate term trend (3-6 months) is usually resumed after the event.  

FOMC Meeting May 4 2022 / CPI Release Sep. 13 2022

2020 Presidential Election November 4 2020

4. For most events, since active investors and traders have reduced their positions ahead of the event, after the event, you usually see a rally.  Especially when active investors and traders have been building up long positions in a rally for the previous month. 

5. In the long run, the market pays a risk premium to those that are willing to take on long exposure ahead of events, especially feared events.  That premium is usually paid out in the form of an immediate one day rally after the event, for economic data releases, or for several days after the event, for really big events like a 2020 Presidential election.  

We have a CPI release this morning and the "feared" 30 year Treasury auction at 1:00 PM ET.  Considering how bad the 3 and 10 year auctions went, expectations are low for the most important Treasury auction of the month.  Add to that, the FOMC meeting on Wednesday, and you have a slew of events that the market will be faced with.  Since we've had a strong uptrend in both stocks and bonds going into this week's events, its likely that they will rally after the FOMC meeting is behind us.  

Bigger picture, the SPX is in the middle of a late stage bull market rally where fundamentals are ignored and valuations are very high.  It presents a great opportunity for the short side in 2024.  For those inclined to play the short side, save your ammo and don't burn capital trying to play for a pullback.  Its not worth it to short it here, both from a seasonal perspective and a technical perspective.  The brutal selling in September and October needs to be completely forgotten and gone from the rear view mirror before the risk/reward for a short is compelling.  When the timing is ripe for a short, it will be a whopper of a short.  The potential energy building up on the short side is immense.  But if you short too early, you won't be able to hang on for the ride to the other side of the mountain.  I can't bring myself to chase longs in this bloated market even though I think it goes even higher.  I still see too many consistently wrong Fintwit posters skeptical about this rally. 

Probably will have to wait until March or April for the SPX to top out.  Until then, keep powder dry and protect capital. 

From Eagle to Pigeon

The United States economy is just not dynamic anymore.  The United States used to be a manufacturing powerhouse, and was subject to the whims of the capitalist boom and bust cycles.  It used to be like an eagle soaring high and swooping low.  Now its more of a pigeon that just walks around, with short bursts flying higher, and then back to the ground, where it lingers.  The amplitude of the ups and downs of the business cycle has gone down.  But the average height has also gone down.  The highs are lower, and artificial, a result of massive fiscal stimulus, while the lows are less dramatic, also because of massive fiscal stimulus.  Its not as bad as Europe, where the government is such a huge part of the economy that the business cycle has essentially turned into a flat line, at a very low level. 

One of the benefits that you get with an aging population and more services and less manufacturing is a less cyclical economy.  Old people don't spend much money on stuff, other than food and fuel.  It spends a lot of money on services, such as health care, hospitality, and restaurants.  Old people keep getting government money for nothing, and keep spending it on services.  Services for doing nothing.   And that story is being repeated millions of times (more millions each year as baby boomers retire).  That's inflationary.  But it also helps to keep the economy out of recession. 

The old boom bust cycle was based on manufacturing being a big portion of the US economy.  Now, manufacturing is minor, almost an afterthought.  Offshoring has dramatically changed the US.  Sure, you hear talks about re-shoring, but much of that is government subsidized and not "natural".  The US is not cost competitive with Asia when it comes to most manufacturing.  Labor costs are just too high.  In the past, when you had a manufacturing heavy economy, the cycle of overbuilding, overcapacity, overproduction, and big inventory builds would make an economy vulnerable to a recession.  Sure, rate hikes sped up the process of tipping over a vulnerable economy, but the underlying forces of the economy were very cyclical.  You had almost exclusively variable rate mortgages.  More variable rate bank loans rather than long term fixed rate bond issuance. 

Now, you have an economy that's mostly services.  Manufacturing, construction, and transportation/warehousing are less than 20% of the US share of GDP.  With such a small share of GDP in those cyclical sectors, there needs to be big down moves in those areas to drive the economy into a recession.  That's unlikely when you didn't have the overinvestment and overconstruction in the first place. 

The US economy is now a less cyclical, lower growth economy.  The biggest source of growth in the US is the government.  Government spending is the growth driver of the US.  Its not AI.  Its not data centers or high tech.  Its pork.  That's the sad state of what was once a very dynamic economy that had lots of competition and much more laissez faire markets.  Now you have an economy that's become more rent-seeking, more financialized, with less innovation and lower productivity.  Corporations have formed oligopolies, which requires less investment spending, and more spending on lobbying and regulatory capture.  

The foundation of America is slowly rotting and government spending is like the paint job covering all the mold and mildew underneath.  Killing the business cycle is not a good thing.  Economists like to think of recessions as being negative, and booms as being positive.  But boom and bust cycles are what keep the herd fit.  Imagine what those zebras and wildebeests would have evolved to if there were no lions and hyenas.  They would probably be fat, slow, and unable to run away from predators.  The business cycle is like the lion in the African plains.  It weeds out the weak and unfit. 

Staying out of recession because of big budget deficits isn't a sign of strength.  Its a sign of desperation and weakness.  The politicians have little tolerance for short term pain.  The same goes for most of the public, who absolutely loved the huge stimmies in 2020 and 2021.  

All these calls for a slowdown/mild recession in 2024 are using the old playbook for the old America.  The new playbook needs to account for the elephant in the room: the government.  The government has unlimited cash and can never go bankrupt.  It can always just spend more money.  This acyclical factor that keeps getting bigger is what has kept the US out of recession since the big rate hiking cycle in 2022.  The US has evolved into an economy that's reliant on huge fiscal budget deficits for growth.  Keeping track of projected government spending in 2024 at the state and federal level is probably your best guide to what to expect in the economy.  It seems like the consensus FY 2024 budget deficit projection is around 6-7% of GDP.  That's a lot of money going from the government to the private sector.  It will be less than 2023, thus you will get some economic slowdown, which you are seeing, but it also means getting a US recession in 2024 is not as likely as many think.  

The move over the past month was based on the Treasury reducing their planned coupon issuance, and also the dovish shift at the Fed.  Even if the Fed isn't outright saying they are done and will start cutting in 2024, the fact that they aren't pushing back strongly tells you a lot.  First, it tells you that Powell is no Volcker.  He's not playing for legacy, to avoid being Arthur Burns, to be like Volcker, as many postulate.  He's playing for longevity.  He is power hungry.  He wants to get re-elected Fed chair in 2025.  He's not going to get that done by being Mr. Hawk in an election year, and making Trump the next president.  Trump will get a lackey for Fed chair who will be dovish, no matter what.  He doesn't trust Powell, and will fire him in 2025.  

The Fed trajectory for 2024 is all based on politics and I fully expect Powell to surprise dovish throughout 2024.  I expect preemptive rate cuts, an attempt at a soft landing, and the Fed put whenever the stock market has a temper tantrum.  And I don't expect an economy as weak as many are projecting, especially for the 1st half of 2024.  So you will likely be seeing a much steeper yield curve as the Fed policies will be inflationary.  Treasury bonds are usually a good investment right before a typical Fed cutting cycle, but I don't think that will be the case in 2024.  Sure, you could get to 3.50%-3.75% in the 10 year yield if the stock market panics, causing Powell to panic cut.  But I don't expect a sustained move lower in yields like you would have seen in past cutting cycles.  Its because the market will sniff out that inflation and big budget deficits is a secular story and will price in higher long bond yields to compensate for the future supply. 

You are getting your garden variety pullback off a huge upward thrust.  I still see very little edge playing the SPX here, but I do expect it to break out above 4600 before year end.  I am surprised at the bond market strength, and it probably means you are not going to get much of a pullback in SPX this week or next.  While you could play for a quick bond short here tactically, I don't see much upside as I expect yields to remained contained for the next several days.  With the Fed going from hawk to dove, the animal spirits are returning and the volatility is dying.  Its not worth it to fight the rally in stocks at this stage.  You probably need to wait till spring of 2024, when we are on the doorstep of a preemptive rate cut before you can aggressively short SPX/NDX.  Right now, I'd rather be a buyer of dips than a shorter of rips.  But not that good of an opportunity, so mostly on the sidelines. 

The New Game

Markets change.  This isn't your 1999-2000 late cycle market, or your 2006-2007 late cycle market.  Markets of the past put a lot of weight on the business cycle, as recessions would lead to stock indices falling into bear markets.  So investors were focused on getting ahead of the business cycle, by selling before the recession, near the peak, and buying during the recession, near the bottom.  That's the old game.  The old pattern.  Front running the business cycle.  Selling stocks when its late cycle and after the Fed has finished its hiking campaign, ahead of the recession. 

The new game has moved 2 steps ahead.  It's not so much about getting out of stocks ahead of the recession.  Its about getting out of stocks just ahead of a big increase in bond yields, even as the economy is hot.  Bond yields have now become more important to the stock market than economic growth.  That is what the 2022 bear market was all about.  Investors assumed that much higher rates would then lead to a recession, ignoring lag effects and fiscal policy.  With no recession in 2023 and SPX going much higher despite higher rates, most forecasters were wrong.  They don't want to be fooled again, so they've given up on their hard landing call, and have tilted towards a soft landing view. 

Higher rates have done little to hurt the US economy, so many assume that it will do little to hurt the economy going forward.  Thus, their consensus view of higher for longer and a soft landing in 2024.  But the fiscal support that was there in spades in 2022 and most of 2023, will be fading in 2024.  Most of the fiscal largesse is going to cash rich buyers of Treasury debt, who have a much higher propensity to save than consume.  There will still be a big deficit, but less stimulative than previous years.  All of this while banks are issuing fewer new loans, slowly choking out growth in future years. 

Investors don't have patience to wait anymore.  What is happening now is assumed to be a good guess for what will happen in 6 months.  After having egg on their face for calling for a recession due to higher rates and monetary tightening, they are now jumping on the lower inflation numbers and calling for a gentle path lower in rates.  Once again, jumping the gun, thinking that lower rates will immediately mean a mild slowdown, with little pain.  With the Fed taking their foot off the break gently, they assume that the economy will have a feathery, soft landing that will keep corporate profits growing and job losses at a minimum.  

In this new game, its all about bond yields.  Investors now try to stay long throughout the easing cycle, even if its during a weak economy, and get out during the start of the rate hiking cycle, just before bond yields surge higher.  Modern day markets are infatuated with liquidity and monetary policy.  Its more important than the business cycle, and the ups and downs of corporate earnings tied to that cycle.  The market would rather have a weak economy with monetary policy getting easier than a strong economy with monetary policy getting tighter.  The simplest way to measure monetary policy is through the change in bond yields.  

The game has changed because of what happened after 2008.  From March 2009 to January 2022, over a span of just over 12 years, SPX went from 666 to 4818.  That is a 623% return, not including dividends, over 12 years, with ZIRP almost through the whole time period.  Investors have been shown one of the biggest divergences between the real economy, where growth has been low, and the stock market indexes, where growth has been high.  That has never happened before. 

Its human nature to always fight the last war.  Recency bias.  The bias among investors is that low rates and QE lead to high stock market returns.  But what market historians forget is that valuations were very low in March 2009, and super high in January 2022.  It was not just ZIRP and QE that created huge returns.  It was the much lower valuations after the GFC that was the potential energy unleashed by recklessly loose monetary policy.  So while investors still have the same playbook, with expectations of great returns when the Fed eases (e.g.: 2019, March 2020 to Dec. 2021), the potential energy is no longer there.  Valuations are very rich.  Household allocations to equities are historically high, and only surpassed by the bubble period in 2021.  In fact, this time, instead of a coiled spring, its a stretched out spring with no potential energy.  

That being said, its not like 2000-2002 or 2007-2008.  This time around, fiscal policy is much looser.  Big budget deficits are mostly going towards enriching the top 10%, who are big financial asset owners.  When you have so much interest income, subsidies, and pork thrown at the rich and lobbying corporations, they won't feel any pressure to hold a fire sale or issue more equity to re-liquify.  Even in a recession.  With such profligate fiscal policy aimed at shooting more dollars at the wealthy, I don't see how you get a 40-50% drop in the stock market.  Anything is possible, but the US is clearly on an inflationary path, and that's incongruent with extended deflationary stock price movements.  We could still get another bear market, but I think it will be like the 2022 bear market, a 20-25% drop without a surge higher in volatility. 

With the current high valuations, returns will be muted, and organic growth and productivity are very low.  All future growth will come from the money printer coming straight from the US Treasury, if the Federal Reserve doesn't play ball.  If the Fed also joins the party, then the dollar will be wrecked.  T-bill fueled deficit spending is essentially fiscal QE, because T-bills are essentially treated like cash.  Most of future real growth will come from under-reported inflation via CPI hedonic/substitution manipulation lower of the inflation rate. 

In this cycle, there will be two local maximums.  One at maximum economic growth, which was in late 2021.  The other local maximum is when the hopes of a soft landing reach their highest, right before the Fed begins its easing cycle.  That's likely to come sometime in the spring of 2024.  The timing will be the hard part, as the Fed will wait till the last minute to reveal that they are on the cusp of cutting rates.  That's going to be the last gasp higher for this bloated stock market, and will likely mark the beginning of another roller coaster ride lower.  

Volatility has made a round trip from 12.50 to over 80 and back down to 12.50 over the last 4 years.  Low volatility environments encourage overreach by investors looking to sell options premium, more leverage use, and slow grinds higher.  Its not a conducive environment for buying puts, even though they are cheap.  This is the kind of market that's best to just avoid if you are a trader.   Don't see much to do here.  Perhaps a small short in bonds and crude oil as potential short term plays.  There is nothing juicy out there.  Laying low in the weeds, like a sniper.  Long periods of boredom which could be  interrupted by short periods of sudden action.

Doublethink

The US stock market is back to Goldilocks pricing as the SPX is now well above 4500 with 10 year yields below 4.5%.  The Fed gave the market an inch, and investors have run with it and taken a mile.  With gradual rate cuts priced in for 2024, investors are breathing a sigh of relief that the worst of the bond bear market is over.  With the high correlation of stocks and bonds over the past 2 years, investors are thinking a bond market that rallies will propel stocks even higher.  In the short term, I agree with consensus.  The tight positive correlation of stocks and bonds should continue for 1-2 more months.  But that should be the end of it as I expect the stock-bond relationship to return to the negative correlation that we experienced for much of the past 2 decades.

Powell is no Volcker.  Those who think Powell will keep rates higher for longer because of his legacy forget one thing:  Powell is no hero.  He's not made of the same stuff as Volcker.  Volcker actually had deep core beliefs about the value of money and keeping inflation in check.  Powell doesn't.  Powell is a politician and a power hungry one at that.  Powell's goals are similar to that of Greenspan's:  take as much credit as possible and deflect as much blame as possible to remain in power.  He wants to be Fed chair for the next decade, and he won't get that opportunity if he torpedoes the stock market and the economy in 2024 by trying to be the next Volcker. 

If he tries to act like a hawk in 2024, he's going to hand the presidency to Trump, where he'll promptly be fired when Fed reappointment choices are made in 2025.  Powell is not that dumb or clueless to put his own head on the chopping block trying to be Mr. Tough Guy.  That's why I am not enamored with trying to pick a top shorting the Mag 7 or NDX.  I'll make a few moves here and there for swing trades, but not for long term holds.  Despite growing overvaluation, its too early to fight it because the Fed is going to be more dovish than people think.  There will be plenty of time to short those egregiously overvalued megacap tech stocks at decent levels in 2024.  The next few months will frustrate bears as the economy deteriorates but the stock market doesn't go down.  

While my short to intermediate term view on the SPX/NDX are fairly neutral, my long term view is getting quite bearish.  It is difficult to keep time frames in separate compartments and not rush to make long term short trades when the market is at levels that are attractive for shorting.  But that's what will be necessary to avoid premature losses fighting the uptrend as the FOMO kicks into an even higher gear. 

We have re-entered the low volatility regime of 2013 to 2019, where the VIX would go down to these very low levels after big rallies.  In those low volatility regimes, you had up moves that grinded higher with shallow pullbacks, until the complacency built up over a couple of months, leading to a sharper pullback that led to a VIX spike to anywhere from 20 to 30.  

Unlike that ZIRP/QE period for most of 2013 to 2019, I don't expect this low volatility regime to last long.  The valuations are too high, bond yields are higher, the fiscal situation is much worse, and the public's allocation to US stocks is near an all-time historic high.  There will be less spending at the state and local level in 2024 as the Covid surpluses are run down.  At the federal level, there will be more taxes collected in 2024 as there were higher cap gains from both higher interest income on bonds and stock market gains in 2023.  The fiscal impulse is negative.  Credit creation has been minimal in 2023, which will feed into weakness in 2024.  The only thing holding this up is the fiscal largesse from huge budget deficits, but most of that money is funneling to the wealthy who are collecting much higher interest income thanks to higher rates on T-bills and T-notes.

These are fertile grounds for a bear market.  At best, they are conditions that lead to sideways to down stock market for several years.  In these times, you can't look too far ahead because there are huge dark clouds way out in the distance.  You have to bide time and stay patient as a bear.  Tops are a process, and take longer than most forecast.  Plus, I am sure that Powell will throw a wrench into the bears' plans with timely dovish actions in 2024.  

Over the past 3 weeks, asset managers have gone from being defensive to chasing the year end rally.  There are some signs of saturation in the megacap tech stocks.  Asset manager net long position in NDX futures is at a 6 year high.  

Hedge fund positioning in the megacap tech is back to all time highs:

 

 

This bifurcation between the megacap tech stocks with the small cap Russell 2000 is eerily similar to what was happening in 1999 as the Nasdaq index powered higher, dragging the SPX higher with it, while the Russell 2000 lagged.  What happened in early 2000 was a dramatic outperformance of small cap stocks over large cap stocks in the first quarter of 2000, getting the crowd excited with strong breadth, which was near the peak of the market.  I could picture a similar situation in early 2024 as the Fed becomes more dovish as jobs numbers come in weaker.  Under that situation, bonds would rally on the weaker economy helping the Russell 2000 more than the Nasdaq 100.  That would be the ideal scenario to fade the crowd getting bulled up as breadth improves.  

For the current market, we are getting close to good risk/reward levels to short long bonds.  Also close to good levels to short is crude oil, as it trades weak vs other risk assets and is in a seasonally weak time period.  It could be a buy the rumor, sell the news event for the OPEC meeting as many are expecting more production cuts.  SPX is still a no touch.  There are a few laggards which I am keeping an eye for shorts, like TSLA, but I'm holding my fire for now. 

Elevator Down

2023 defied the skeptics who were forecasting a recession and bonds got crushed again. Those that played the long side in STIRs and 2 yr futures got hurt the most.  Even though the yield curve steepened, there were more losses on a risk adjusted basis from holding long positions in SOFR and 2 yr Treasury futures than in holding longs in Treasury bond futures.  It was all due to the extreme negative carry of holding leveraged long positions in STIRs when the yield curve is inverted to this extent.  It is costly betting on short end yields going lower.  But if you get the timing right, the move can be explosive, as could be seen in March when the regional banking "crisis" caused 2 year yields to drop 1.25% in less than 10 days.  

The pace of rate hikes and rate cuts are not symmetrical.  Historically, the Fed takes the stairs up when hiking rates, and the elevator down when cutting rates.  This time, with the Fed viewing the current Fed funds rate as being sufficiently restrictive, the bar to cut rates is lower than people think.  Sure, you hear higher for longer being repeated over and over again from the Fed and the parrots in the media.  But following the Fed's forward guidance has been a short cut to the poor house.  I put very little weight on the Fed's insistence that they will keep rates higher for longer until they reach their 2% inflation target.  When the economy goes south, they always put more importance on jobs than inflation.  If you get a weaker jobs market in 2024 and inflation is similar to what it is now, they will cut rates.  If they try to fight the market by not cutting, the SPX will force their hand by panicking lower.  Either way, the market will get what it wants if the jobs market is weak:  rate cuts. 

You have 85 bps of rate cuts priced into SOFR Dec 24 futures.  That is pricing in a small chance of a big drop in rates.  With the current Fed funds rate at 5.33%, even if there is no recession, a mere slowdown in growth would be sufficient to get the Fed to cut at least 50 bps next year.  The Fed hates to price in cuts into their dot plots, because they always want to sound optimistic about the economy, which justifies higher rates.  But even the dot plots have 50 bps of cuts in 2024 as the median forecast.  There is limited downside, lots of upside in SOFR futures for 2024.  In a hard landing scenario, where you have more job losses than expected, the Fed could easily cut rates down to 2.5-3% within 6 months.  That would take SOFR futures to 97.0-97.5.  They are currently trading 95.45. 

There are some that think inflation will remain sticky and keep the Fed from cutting rates until late in 2024 or not all.  Inflation won't be a big issue because inflation is only relevant when its rising strongly.  With the CPI hedonic pricing manipulation, lagged effect of housing which will reflect the much lower rent growth in 2023 in the 2024 numbers, etc., CPI inflation will likely be trending stable to lower for 2024.  Although the secular forces for higher inflation are strong, cyclically, inflation is coming down as you have a slowing economy with weak bank credit/M2 money supply growth.  The lower inflation in 2024 should not last long, as I am sure politicians will pump more stimmies in due time, probably starting in 2025. 

Next year, its going to be all about jobs.  We are getting to a point in the cycle where corporations will have to make a choice about taking high interest rate loans or working with less capital.  If they continue to borrow despite higher rates, then you won't have job losses.  But if they decide its more economical and profitable to run leaner with less capital and less labor, then they will borrow less and start cutting workers.  Interestingly, I saw a recent projection based on an employment model that points to higher unemployment rate over the next several months.  

Based on how weak the Russell 2000 has been, its fairly obvious that small corporations, and especially those that aren't even public, are having their margins squeezed by the higher cost of capital.  Companies aren't welfare institutions.  Their goal is to maximize profits, not create jobs.  If margins are getting squeezed due to higher rates, they will cut costs.  And the biggest cost is labor. 

Even with inflation data coming in hotter than expectations, Powell didn't really talk hawkish.  He was just mealy mouth and seemed like he didn't want to pound the market lower anymore.  I know its popular to say the Fed is clueless, but they are getting reports of the economy slowing.  Its not yet flowing into the economic data which is lagging, but you can see the weakness from how bad the breadth is in the market. 

Its only a matter of time before you see those job cuts start to ramp up.  Its coming.  The nonfarm payrolls number will be the biggest market moving data for 2024.  And unlike 2023, I expect the numbers to come in weaker than consensus for the next several months.  I'm sure the BLS will still be busy counting part time jobs as if they are full time jobs, and calling that jobs growth, but the info on the ground will tell a completely different story.  Labor hoarding is a thing of the past.  You don't continue to hoard labor when you are bleeding cash and interest rates are high. 

With a weakening jobs market, the move in short term rates is straight forward.  But the move in equity markets will be trickier.  I expect a bull steepening move, with short rates going down much more than long rates.  The SPX is more sensitive to long bond yields than short term rates, so a bull steepening is actually not that great for stocks.  And of course the lower consumer spending that comes with a weakening jobs market is going to hurt earnings.  So its 2 forces going against each other:  lower bond yields, which is good, but weaker earnings, which is bad.  So I don't have a strong view on how the SPX will do in 2024.  Going long SOFR and 2 yr futures looks like a much cleaner bet on a weaker economy and an imminent Fed cutting cycle than shorting the SPX.

Last thing to remember is that the Fed is political.  In particular, Powell's job is on the line based on the result of the 2024 election.  It appears Trump is going to be the favorite to win, as a weakening economy and preliminary polls showing him leading Biden in the battleground states give him the edge.  Powell will be motivated to stimulate the economy as much as possible ahead of the 2024 election, trying to keep the stock market as high as possible to help Biden.  If Biden wins, Powell gets re-nominated.  If Trump wins, Powell will be fired.  Powell is no dummy.  He knows this.  The weakening jobs market and stable to lower CPI will give him cover to make aggressive rate cuts in 2024. 

Bottom line, the dominoes are lining up for a big reversal of the rate hiking cycle in 2024. Higher for longer has been repeated for so long by the media and Fed officials, it's become a mantra.  If you repeat a lie for long enough, eventually people believe it.  It means that people aren't positioned for a big move lower in short term rates.  You don't benefit from a big move lower if you are in money market funds or T-bills.  The most effective way to make money in this situation is to make a leveraged long bet in the STIRs market.  With the heavy negative carry in holding leveraged long positions in STIR products, you have to wait for the right timing to put on the trade.  I don't think there is much time left, maybe till the end of this year, to be able to put on longs in STIRs at good levels.  A couple of bad NFP reports should ignite the short end of the yield curve.  With CTAs loaded up short in short term interest rates, and the Street still believing in higher for longer, the setup is ripe.  

SPX is grinding higher despite the bond market's weakness since the horrible 30 year bond auction.  Still not seeing the put/call ratios go down much even with the steady move higher.  From watching CNBC, there is still a wall of worry out there, which is only slowly being climbed.  The Moody's ratings warning on US sovereign debt was only good for a few hours of weakness, and the beach ball bounced up again.  The price action is strong.  The leaders, the Mag 7 are performing.  Monthly opex is this Friday.  The forces pushing this market higher should remain strong until later in the week.  Staying long with a moderate long position. 

US Fiscal Expansion and the Dollar

It sounds absurd, but the immense amount of government spending in the US with huge budget deficits is actually helping the dollar get stronger vs almost all the world's currencies.  Logically, it makes no sense for the value of a nation's currency to go up vs more fiscally sound countries.  Shouldn't more dollars in circulation from all that government pork spending/lower tax revenue make the dollar less valuable?  It can only happen in a world where the US is the reserve currency.  A similar thing happened in the early to mid 1980s when the US government ran big budget deficits, which kept the economy hot, and thus interest rates high.  The USD kept going up during that time, because of interest rate differentials and a growing use of the USD as a reserve currency due to expanding world trade.  This time, its mainly due to interest rate differentials.  There is a belief in the market that the US will be able to keep interest rates higher than all the other developed economies because of its Argentina-style fiscal policy.  If Argentina tries to run this policy, its currency gets crushed and interest rates soar because of the high inflation.  

 Eventually, water finds its level.  Currencies don't permanently have more value when the government decides to go crazy and go on a spending binge on the nation's credit card.  The dollar went sky high and then straight back down in the 1980s.  By the way, there was no recession during this period, as the government was running big deficits at the same time there was a productivity/labor boom as more women entered the labor force and computing power skyrocketing. 

The circumstances between now and the 1980s is totally different.  There is no productivity boom.  And its the opposite when it comes to the labor force, as its not growing, which is inflationary.  It used to be commonly believed that aging demographics was deflationary, mainly due to what happened in Japan.  But Japan had deflation not because of an aging population, but because it had low M2 money supply growth, a trade surplus, keeping its currency strong, and from importing cheap goods from China.  When you have fewer workers, and more retirees that receive government benefits while doing nothing but consuming, that reduces the ratio of labor output to money in circulation.  That's inflationary.  That leads to wage inflation.  That's what's happening in the US.  There is no free lunch from huge fiscal expansion.  It is at the root of almost every high inflation episode in human history.  

Inflation will be a long term problem for the US because there is no political will to cut back on spending, reduce Social Security/Medicare benefits, and to raise taxes.  The mantra is still deficits don't matter.  Ironically, people cared more about the national debt and big budget deficits in the 1980s and even 1990s, when it was a much less serious problem.   Now, when its a big problem, the public just doesn't care.  They want their stimmy checks and government cheese.  At the same time, they complain about inflation.  They can't connect the dots.  So the politicians continue to pander to them and hand out freebies for votes.  

The Fed is effectively the central bank for the world, and its forcing other central banks to follow its course or have its currency devalued.  Japan is a prime example of a country that has decided to go at its own pace, ignoring the Fed's tightening monetary policy, which has resulted in the market crushing the yen.  Europe, Australia, Canada, South Korea, etc. have decided to follow the Fed's tightening to a certain extent, allowing their currencies to depreciate more gradually.  But they pay a price for this.  Those economies are more interest rate sensitive than the US, mainly due to variable and short term fixed rate mortgages being the norm in those countries.  In particular, the other developed economies outside of the US have a larger percentage of bank loans based on LIBOR/SOFR type money market rates, and less long term funding from bond issuance.  Thus, you are seeing a much slower economy in the developed world outside of the US because they decided to follow the Fed.  Either keep interest rate differentials small and really slow down the economy, or face a brutal currency devaluation like Japan. 

The fight against inflation started by the Fed and followed by many other central banks has been more effective at slowing growth and killing inflation overseas than in the US.  European inflation numbers are heading down quickly, and likely to easily go below 2% in 2024, opening the door for Europe to start rate cuts before the US.  Europe is also suffering more from the higher rates as the policy transmission has been much quicker and pervasive.  Germany is already in a recession, and will likely soon be followed by many others in Europe.  There has been and will be less fiscal expansion in Europe and Asia vs the US, which contributes to the growing GDP gap.  

We are now at the point where the monetary policy is starting to be felt in Europe, as the PMIs are very weak and signs point to a very hard landing with Lagarde in the cockpit wearing an owl costume.  Its looking like the US recession people were calling for at the beginning of 2023 is going to happen to Europe at the beginning of 2024.  Remember, about 40% of the S&P 500 revenues come from overseas.  Most of that is from Europe and Asia.  While I don't expect the US economy to do as poorly as many predict in 2024, I do expect the European and Asian economies to be even weaker than consensus.

Last week was all about Yellen trying to play Fed chairman by manipulating the supply of bills and coupons.  Its like rearranging the deck chairs on the Titanic.  There is only so much you can do to "improve" on a horrible situation.  The coupon supply will still be huge and hard to digest at these yields unless you get more weak econ. data and more dovish cooings from Powell and co.  We've seen time and time again when the going gets the tough, the authorities come to the rescue.  Yellen and Powell caving to higher bond yields was the story for last week.  Considering how much hedge funds reduced net equity exposure in October, you had a lot of dry tinder soaked in gasoline waiting for a match to ignite it.  Yellen and Powell were the matches.  

When you see such an explosive move like you did last week, something that blew me away, its usually got some staying power.  I doubt its the start of a huge rally that lasts several months like in March, but more like a 3-4 week rally that takes us to strong resistance near the top of the range, up to around 4450-4500.  

For the bond market, in a rare occurrence, the call options punters were right to bet on a big bounce in TLT.  I don't have much confidence in the long bond sustaining a long rally, but will not short it until you get closer to the August highs in 10 yr yields around 4.30%.  At current levels, I see very little edge in a short term trade.  Overall, still leaning bullish on stocks and neutral on bonds. 

Out of the Cash Bunker

Many were safely huddled into their cash bunker, hunkering down for a wave of bad news.  When investors pre-sell ahead of events, the desperate sellers are gone, and only price sensitive sellers who are bagholding from higher levels are willing to provide supply in the face of a surge of demand for stocks and bonds.  I did not expect a V bottom off that weak Friday close last week.  Its been straight up with almost no dips as you have gone from SPX 4100 to 4250 in nearly a straight line over 3 trading days.  

Hindsight is 20/20, but its now clear that many investors cleared house last week selling off their beloved tech names, as Nasdaq was under the most pressure, and you got technical sellers panic selling as we broke below the much touted SPX 4200 support level.  Reasons to sell were numerous and well known:  

1. Geopolitical risk in the Middle East ahead of the Israel ground invasion into Gaza

2. Bad price action after tech earnings 

3. Technical breakdown below 4200

4. Upcoming QRA where Treasury were expected to announce a huge increase in coupon issuance (Yellen chickened out)

5. Fed meeting where most were expecting a hawkish pause

The above 5 reasons to sell are all behind us and the markets are now 150 points higher leaving behind many investors in the dust.  I, along with many other investors are now begging for a dip to buy, but as is often the case, the market usually doesn't oblige, and keeps going higher until the move is over, after which the dips are toxic and to be avoided. 

Given that the feared events are mostly behind us, there are only 2 left:  AAPL earnings, where expectations are very low, and nonfarm payrolls, which will be anticlimactic just after the QRA and Fed meeting, and will be long forgotten by the time the FOMC meets again.  Plus, it appears the job market has cooled down if ADP and tertiary data points are to be believed.  So the NFP is not going to be a game changer.

Add to that, historically the biggest stock buyback month coming in November and you have a potent mix of underinvested fund managers who will be chasing the indexes looking for a year end rally.  I don't think this rally will make it to year end, but the setup is there for it to make to November opex on November 17, which gives over 2 weeks for this thing to test the upper boundaries of the range, which could be as high as 4450, but more likely to be 4350-4400.  I would not underestimate the short squeeze and chase potential of this stock market at this time of year.  Unfortunately, I am among those in chase mode, but its better to chase early than to chase late.  

The bond market has calmed down and for the time being, the supposed negative catalysts (QRA, Fed meeting) are behind us and it looks like it could rally a little bit more, which would set up a nice shorting opportunity.  Still overall bearish on bonds as there has been too much speculation and talk about bonds being a great buying opportunity when the supply demand fundamentals remain poor and with too many people bearish on the economy.  Too many are expecting a weakening economy to bail them out of bad bond positions.  But the supply/demand situation continues to deteriorate with the Fed doing QT and the Treasury issuing loads of coupon notes/bonds.  Despite the missed call on recession in 2023 by the majority, most of the same people are expecting the global economy to crack at any time under the weight of all these rate hikes.  But that's a tall order.

Higher borrowing costs in the US have less effect when the biggest interest expense for households, their mortgage, is fixed at low rates for the vast majority.  And most of the accumulation of new debt over the past 5 years has come from the government, which doesn't have a borrowing limit.  And politicians are in no way looking to self-impose a limit on their pork spending and handouts.  That is the core problem right now, fiscal profligacy.  The government spending is out of control, and they are unwilling to cut spending or raise taxes to control the deficit.  This is something that a recession doesn't fix, but only exacerbates.  

I doubt you will get that whoosh lower in stocks and a "credit event" that so many bears are waiting for when consumer balance sheets are so strong.  You probably need to keep these higher rates for at least another year or two before you see real cracks starting to form.  And with the Fed and ECB basically done, they will try for that soft landing, loosening financial conditions, keeping credit spreads lower, extending the time that it takes for the higher rates to cause a recession.  

I am bullish for the next 2 weeks, but that's about it.  This is not a strong bull market where you can just hold on to longs and take your time to sell, with prices lingering at the highs.  Its not a bear market or a bull market.  Its a range bound market, and you can't overstay the long or short side over the coming months.  The bears overplayed their hand a bit in October, pushing down the indices low enough where you can get a big short squeeze and chasers to come out of their bunkers to push prices even higher.  But I don't expect it to last as I don't expect the bond market to accommodate such a move higher by not going back down.  

The price action over the past 3 months has clearly shown that this is a not a bull market you can trust.   You can't buy dips recklessly and wait a few weeks to sell higher.  The SPX has spent a lot of time lingering at lower levels, making U bottoms, giving investors a lot of time to buy the lows.  That's not bull market price action.  The drops haven't been steep, and volatility has been contained, so you can't call it a bear market either.  We're range bound, between SPX 4100 to 4600.  

We have another gap up today, on the afterglow of Treasury announcing less than expected coupon issuance, and with FOMC out of the way.  It looks like too much of a move in such a short period of time, so I'm holding off on adding to longs, but it feels like it wants to go much higher over the next 2 weeks. 

Catching the Falling Knife

They are not making it easy for bulls in this market.  You have to fight and claw your way for small gains, big gains remain elusive, and rallies have not lasted for long. 

What I have seen so far this week isn't all that encouraging for longs.  You had a clean breakdown below the much touted SPX 4200 level, yet you didn't see a big jump in the put/call ratio, and in fact, you have seen quite a bit of call volume this week.  The ISEE index measuring the options bought to open ratio of calls to puts shows the complacency.

Its concerning to see this while big tech earnings lead to intense selling of tech stocks.  The COT futures positioning data comes out later today, so that should reveal how much positioning has changed since the selloff started last week.  Bulls need to see asset managers significantly reducing longs to have more confidence in buying the SPX.  So far, you haven't see enough fear and panic to get a tradable bottom.  

The complacency extends over to the bond market, where investors seem to feel more sanguine and bullish than they are on stocks.  It boggles the mind to see the option traders come in day after day to buy up TLT calls, as if its a generational buying opportunity in long bonds.  And they keep getting creamed, with hardly any signs of life from the weakest major market in the world.  Not only are they hoovering up "cheap" TLT calls, they are piling in to TLT itself, with huge flows in the past 2 days, with back to back $1+ billion inflows (Oct. 25 and 26).  Also from what I hear from most of the financial experts, they are bearish on the economy and most seem to be calling for a recession in 2024.  The weak price action in bonds along with the overall bearish view on the economy from the pundits tells me a lot of bond investors are offside here and feeling a lot of pain.  I don't expect that pain to go away until you see a flush out capitulation with 10 years breaking above 5%, and getting much closer to the Fed funds rate of 5.33%.  

The bond market continues to cry for help, and its only been answered by limited ammo call punters and knife catchers in TLT who are quickly losing their fingers.  Politicians in Washington DC have totally ignored the message that the bond vigilantes are sending.  That message is simple:  cut your reckless spending and raise taxes.  Instead, you see Biden ask for another $100B to spend on wars, touting it as a good for the economy and providing more jobs!  And the Republicans are more concerned about being anti-woke and keeping immigrants out of America than they are about the huge budget deficit from Bidenomics and ballooning national debt.  And most of the voting public can't put two and two together, and think the plunging bond market is because of Fed rate hikes, not the reckless spending in Washington DC.  

The cavalry is not coming to save the bond market.  Powell isn't coming to the rescue until you see blood in the labor market.  And if he does, that's going to help the short end much more than the long end, as I don't think he's going to do QE when the Fed funds rate is so high.  Bottom line, if you are going to make long term bets on the bond market, being leveraged long in the short to intermediate part of the curve will be much more profitable than being long in the long end of the curve when the economy slows.  The steepening will continue for a while.  

And I don't see the economy slowing fast enough to rescue the TLT buyers.  There are way too many doom and gloomers hoping to profit off of TLT calls expecting a credit event like 2008.  The excesses just aren't there in the private sector.  Only from an unwind of a private sector credit boom can you get a credit event.  The balance sheets of most households is rock solid, as the US government and the Fed re-liquified everyone with massive debt fueled spending mostly financed by QE over the past few years.  

The only way you get a recession is if corporations decide to get much leaner, reduce debt by not reissuing at higher rates, and cut labor as a result.  The next recession will have to come from CEOs and small business owners who choose not to issue bonds/take out loans at high rates, and instead choose to match the lower capital with less labor.  You are not going to get a recession from a financial crisis, there is just way too much liquidity out there, with the Fed's balance sheet still bloated and with the US government pumping out multitrillion dollar deficits during expansions.   And you definitely will not get the US government to cut spending or raise taxes, so they won't be the cause of any future demand weakness.  All in all, its just a terrible fundamental situation for long term Treasuries. 

While I don't like the price action in stocks recently, and the complacency in the options market lately, I still think we are close to an intermediate term bottom due to oversold conditions and a seasonally favorable time with lots of stock buybacks coming in the next 2 months. 

Expect the weakness to continue into Monday/Tuesday of next week, where I will be looking to buy the dip. 

More Bond Pain Ahead

Bonds are the focus of attention in financial markets.  You have the geopolitical monkeys who get excited whenever the media goes overboard reporting on fighting overseas, but they can only move markets for a couple of days before prices mean revert.  So geopolitics doesn’t matter.  Bonds are where the action is. 

Here’s my theory on why bonds are getting crushed.  At the start of the year, the vast majority was expecting a recession sometime in 2023 due to:

1.  Huge move higher in yields in 2022 and a hawkish Fed

2.  Bullwhip effect leading to too much inventory, leading to a big slowdown in the manufacturing and goods economy

3.  Drawdown of Covid era excess savings leading to reduced consumption

But the US economy in 2023 has been well sheltered by low fixed rate mortgages refinanced in 2020 and 2021, low term rate bonds and loans issued in 2020 and 2021, and implementation of Bidenomics fiscal pork bills like CHIPs, IRA, and infrastructure.  Add in the COLA adjustments higher for Social Security checks to the elderly and you had a huge blowout in the budget which kept the economy buoyant in the face of higher rates.  

So we never got the recession and stocks surged higher, which was responsible for the 10 year yield move from 3.60% to 4.20%.  How about the move from 4.20% to 5% since the start of September?  We didn’t have any significant economic data and the Fed has actually become less hawkish, showing their reluctance to hike further.  Many people point to supply, but the supply of coupon bonds has been large and steady throughout the year, so there's not much change there.  It appears that the move comes down to simply having price sensitive buyers up to their eyeballs in bonds, so the marginal buyer could only be found at lower prices.  The supply/demand mismatch has been present since the Fed started QT.  There has been a continuous deluge of USTs being issued since 2020, due to the monster budget deficits.  This was masked by a bazooka QE in 2020 and 2021. And then in 2022 and first half of 2023, by temporary duration demand from those thinking recession in 2023.  But that marginal bid went away after it became apparent that the US economy was much stronger than forecast.   What you are seeing now is a Treasury market normalizing to a non-recession US economy with rate cuts nowhere in sight.

The yield curve was absurdly inverted as recently as August.  You had Fed funds at 5.33%, 2 year at 5%, and the 10 year at 4%.  The yield curve was pricing in an imminent rate cutting cycle, and if that rate cutting cycle doesn’t come soon, the yield curve has to steepen to reflect the lack of cuts.  That’s what happened.  During the bear steepening, you have seen a parade of investment managers and analysts talk about how cheap bonds are, how attractive they are, etc.  There’s been no real fear on TV.  The only fear you see is the fear of missing out on a "generational" buying opportunity in bonds.   

Despite the huge selloff in bonds, active money in the JP Morgan US Treasuries survey was most bearish at the start of the year, and was the most bullish earlier this month.  That's not what you normally see at bottoms for financial assets.   And you have the options punters who rarely make money coming out and buying huge amounts of TLT calls, making leveraged bets on a quick recovery in long bonds.  You see much less volume in TLT puts, even though the trend is firmly lower, and puts are the ones that have been paying.  So from a positioning standpoint, it still looks like more blood needs to be shed before you can get a tradable bottom in bonds. 

Fundamentally, in order to get a big move higher in bonds, you need an environment where the Fed is likely to start cutting.   Its not going to be inflation sliding lower, because that's going to take too long.  You need the unemployment rate to go up.  The labor market holds the key to the future of Fed policy, as its much more likely that the labor market cracks before you get a CPI low enough to induce the Fed to cut quickly.  Fed only cuts quickly when there are job losses, not when there are low CPI prints.  I doubt you see a credit event come to rescue underwater bond holders, like some well known, but usually wrong market gurus are warning about.  

 

Higher rates work more like low kicks than high kicks to the side of the head.  Credit events are high kicks to the side of the temple.  Events that most people don't see coming.  If you saw the head kick coming, you would duck and avoid it.  But if it hits you, it means that you didn't see it coming until it was too late.  Lagged effects of monetary tightening are like low kicks to the calf.  Big difference.  The low kicks take time to accrue damage and the result isn’t devastating like being knocked out.  What’s most likely to happen in this cycle is corporations will slowly reduce labor to match the reduced capital rather than borrow at high rates that don’t provide a positive return on investment.  Only when the labor market weakens enough will you grab Powell’s attention.  I don't see that as being imminent, as the US is quite well buffered against rate hikes, and the budget deficit, will remain large, although most likely to decline somewhat. 

 

Bottom line, we all underestimated the power of fiscal stimulus in 2023 and still underestimate it now.  But without a doubt, 2024 will have less fiscal support for the economy than this year due to higher capital gains (more tax revenues from higher SPX, NDX), resumption of student loan payments, less COLA boost for Social Security due to lower CPI, and lower spending at the state and local level due to drawdown of  excess Covid funds.  Below are projections for 2024 state spending in a few states.  This will work to reduce demand at the margin. 

 

While bonds have sold off a lot, I don't view them as a bargain, like some some eager speculators.  I am hesitant to buy this dip (more like a trench) in bonds.  The supply/demand equation is unfavorable, and expectations are quite low for the economy in 2024, so its not going to be easy to surprise to the downside.  This is why I am not bearish on SPX, because of those low expectations.  Its not everyone on recession alert like end of 2022, but you don't see much optimism about the economy in first half of 2024 from those on CNBC or Bloomberg.  The most likely scenario for the next few months is the US economy gradually slowing down, but not more than the low expectations people have.  That should keep stocks in a range, around SPX 4200 to 4500.  During that time, I expect bonds to settle down, but I don't expect a big move lower in yields, probably lingering somewhere between 10yr 4.6%-5.2%.  Unless the labor market gets much weaker, you will not get that big rally in USTs.  That's going to take a few months, because the labor market is always lagging, and the US economy is just not weak enough yet for mass job cuts.  

 

Missed the graceful exit on my SPX and NDX longs last week.  Sold a bit on Friday to reduce risk, and reduced a bit more on Tuesday, as the price action is quite weak, and I want to have some dry powder just in case we get a bond panic as 10 year yields decisively break above 5% and SPX decisively breaks 4200.  If that happens, I will buy that dip.  This stock market is trading much weaker than expected, so my confidence level on a strong rally has gone down.  Its very much possible we just get a underwhelming dead cat bounce towards 4300, but that's not the base case.  Base case is a move towards 4400-4450 by mid November.  Looking like you won't see any strong uptrends or strong downtrends in stocks for the time being.  Looking more and more like a range bound market for the next several months as the earnings momentum will not be strong enough to get stocks meaningfully higher, but at the same time, expectations seem too low and I don't think the economy in 1st half of 2024 will be as weak as many are forecasting.    Plus many are hiding out in the comfort of cash so there is a lot of dry powder waiting to be deployed in stocks out there.  So that will keep downside contained.

Avoiding the Roller Coaster in Cash

The most popular asset right now are cash equivalents, i.e. money market funds, T bills, and CDs.  There is informational value in that.  When the US government has national debt of over $33 trillion, over 120% of GDP, a ton of interest income is being spewed out to the private sector.  The US budget deficit is nearly $2 trillion, with a big chunk of that going out as interest income.  When investors are losing money in bonds, that reduces their percent allocation to bonds, at the same time, the influx of cash from interest income increases their allocation to cash, and reduces their allocation to equities.  Slowly, investors are getting overweight cash as bonds are going down and stocks are range bound.  

You also have to look at flows of supply into cash, bonds, and stocks.  The huge US budget deficit is increasing the supply of cash, in the form of interest income, as well as the supply of bonds, in the form of Treasury issuance and QT, which combined is running at well over $2 trillion this year.  Meanwhile, the supply of equities is not going up due to the approximately $1 trillion annual run rate of stock buybacks.  So while I see many argue that the value fundamentals are favorable for cash and bonds over stocks at current yield levels, the supply demand fundamentals favor stocks.  I hear very little about this favorable supply demand situation when people discuss stocks.  Its always the overvaluation relative to bonds, the talk about a low equity risk premium, and how equities are a poor value.  

 

I cannot disagree, those are legitimate long term concerns, but in the short to intermediate term, supply demand plays a bigger role than long term valuations. And as long as corporations can maintain big stock buybacks, and earnings are sustained, its difficult to get a bear market under those conditions.  You need earnings to go down 20% to get a bear market.  With huge budget deficits from past pork bills and massive Treasury interest expense set to continue for the next few years, that fiscal expansion will make it tough to get nominal growth negative.  And you need nominal growth to go negative to get a meaningful drop in earnings.  Even the much feared stagflation would mean that corporate earnings aren't dropping much due to the benefits of inflation for revenue growth.  You need to see deflationary impulses in the economy to get a big drop in earnings, and politicians will zealously fight a weak economy and deflation with stimmies and pork at the drop of a hat. 

Right now, the surge in long bond yields is the excuse for selling off the equity indices, but the big cap tech stocks and other mega caps which drive the SPX are not feeling much pain from the higher yields, as they are cash rich and have loaded up on long term debt.  On the other hand, small caps are more rate sensitive due to having higher debt/equity ratios and with more shorter duration maturities on their balance sheet.  The maturity wall won't really hit for them until 2025, but its close enough that investors will sell off these stocks anytime yields surge higher.  That's why you continue to see the big divergence between SPX and Russell 2000.  It is similar to what you saw in 1999 when the Fed was raising rates and yields were rising.  

Since I remain somewhat bearish on the US bond market, I expect the SPX and NDX outperformance over Russell 2000 to continue for the rest of the year.  The US economy has continued to be underestimated by the investment community and I still hear too much talk about a US recession in the first half of 2024 due to higher bond yields and the lag effect.  I am skeptical of those prognostications as the very fact that investors are worried about an economic downturn in 2024 means that pentup demand is building for investment.  The Covid bullwhip effect is over, and the inventory build cycle is favorable for goods for 2024 and 2025.  There is no shortage of liquidity out there.  The Fed balance sheet is still egregiously huge relative to US GDP.  People forget how much QE the Fed did in 2020 and 2021.  It dwarfs the mini-me QT that is ongoing now.  

Its easy to sit in cash and collect 5% when stocks AND bonds are both going down.  But that was also the case when I heard the "experts" on CNBC and Bloomberg tout cash in March, April, and May of this year.  The SPX rocketed higher soon afterwards. Stocks and bonds tend to not continue to go lower when investors are hunkered down in the safest asset around: cash.  FOMO is always around the corner, waiting to get unleashed as soon as cash starts to underperform either stocks or bonds, or both.  

On to the markets.  The VIX had a mini spike on Friday out of the blue, much more than the move in SPX would warrant.  And on a Friday, when VIX usually declines due to the weekend effect.  That caught my eye, as the indices haven't really moved that much and the IV is much lower than the historical vol on a 1 month basis.  It can only be summed up as one thing:  investors have some fear.  You don't pay up for VIX or puts if you aren't concerned.  The news media has done its job of getting people worried about war.  The monkey inside us can't resist the temptation to buy into the hype and get scared.  That was the reason for the Friday selloff and the VIX spike.  The big move higher in crude oil, gold, and even a small short squeeze in the weakest of them all, the long bond was able to catch a safe haven bid.  That's how nervous the market was heading into the weekend.  Monday quickly reversed that move, when nothing happened, but the reluctance to embrace this rally remains.  Price moves before emotions.  Emotions catch up later.  That's why traders who trade on emotion are always late to buy on the way up.  

A lot of puts were bought over the past few weeks, meaning that if the market grinds higher into this Friday's monthly opex, dealers will have to buy futures in size to delta hedge as puts melt lower from both a rise in price and a drop in vol.  The VIX at over 17 with this kind of volatility is overpriced.  Remain long as SPX trades very well considering the renewed weakness in bonds and the elevated VIX.  But will not stay long for much longer, as I expect more two way trade and chop after this week, as there are worries about the technical setup and the U bottom that I mentioned several days ago.