Turn of the Year

Its not common to see bonds trade with more volatility than stocks but that's been the case for the past 2 weeks.  Ever since the BOJ tweaked their yield curve control levels, bonds have been in a free fall, exacerbated by fund managers looking to cut their bond losers and not wanting to show them in their year end portfolios.  The fear of hawkish central banks took over.  But as soon as it turned into 2023, its been nonstop buying in the bond market, especially Europe, which fell the steepest over the past 2 weeks on a hawkish ECB.  Its a battle between the disinflationary forces which are becoming more apparent and the stubborn hawkishness of the perpetually lagging central bankers. 

In the meantime, the stock indices have vacillated between weakness and strength, with that Santa Rally missing but no plunge into deeper negative, even with the weak bond market.  I hesitate to read too much into the price action in the last 2 weeks of 2022, and the first 2 trading days of 2023, but there are hints of a shift in investor psychology.  You are seeing the stock-bond positive correlation that's been prevalent in 2022 fade away as the focus moves from inflation to economic weakness.  In a high inflation environment, both stocks and bonds suffer as yields move higher.  But in a weak economic environment which is likely for 2023 and 2024, stocks suffer from lower corporate earnings while bonds benefit from weaker inflation due to weaker growth and an expectation of future rate cuts.  

Investors are still overweight equities and are still emotionally holding out hope for a recovery after a bad 2022, just because that's what's always happened since 2009.  The resilient nature of the SPX is what keeps investors hooked and hoping for a recovery out of the blue, as has happened so often the past 13 years.  But their intellectual side is telling them that stocks are still overvalued so they aren't very willing to add more.  They are underweight bonds after the last 2+ years of a steep bear market and are slow to embrace the better values found with the higher yields.  But their intellectual side is telling them that bonds are the go to asset class in a disinflationary, weak growth environment, even if it feels scary to fight the Fed, ECB, and BOJ who are still hawkish.  Lastly, investors are overweight cash as it's finally yielding a good return and stocks and bonds have been such poor performers in 2022.  They are comfortable holding cash.  Almost too comforting, which usually doesn't work out in the financial markets.  But the thing about cash is that it historically performs the weakest in the long term vs stocks and bonds, so its not something that investors will want to hold on forever.  

From my vantage point, 2022 was quite an unpredictable year because the Fed totally changed its behavior, turning into super hawks, and its something that took many by surprise.  Those trading based on pattern recognition and past historical data were hammered.  At the same time, as an institution, the Fed is the same political animal that follows what the politicians and market participants think.  As soon as the worry over inflation fades away in this disinflationary environment, as growth weakens and the economy enters a full blown recession, the words from politicians, economists, investors, etc. will be screaming policy error, begging for rate cuts, and putting immense pressure on Powell and the crew to deliver.  Its hard to imagine now, when they are still hawkish, saying they won't cut rates in 2023, when the unemployment rate is still very low, and the worries about inflation are still there, but fading.  But you get paid in the market when you can accurately predict change and make the proper bet that will pay off in such a scenario.  

The highest probability scenario in 2023 is the one where the economy gets much weaker than many expect, so weak that it will force the hand of the Fed, despite losing more credibility as they have to go back on their guidance of no rate cuts for 2023.  In that scenario, the Fed will probably start cutting sometime in the summer, perhaps July.  The stock market will have been plunging for several weeks due to an intransigent Powell who's trying to gain an inflation fighting reputation and admiration like Volcker, only to be making another policy mistake, keeping rates too high for too long and causing an economic mess.  

In this environment, being overweight bonds, underweight stocks, and holding some cash for optionality is the optimal portfolio mix.  But that's not how most investors are positioned.  Most retail investors are overweight big cap tech, with almost no fixed income exposure.  That's probably the worst portfolio for 2023, with already the first day of 2023 highlighting that fact.  Its a worse version of the post dotcom bubble period from 2000-2002, because this time, housing is much weaker, organic growth rates much lower, and productivity gains going in opposite directions from that period (up in 2000s, down in 2020s).  It feels like being long tech stocks now is akin to being long tech stocks in early 2002, looking cheaper after a big selloff the previous year, but still facing another big swoon in the coming year.  

In the first week of the year, I haven't made any big moves, holding some Treasuries, no real position in stocks, and waiting for the right time to add.  Looking to add more bond exposure (short end of the yield curve) and add some short tech stock exposure (hopefully after a bounce sometime this quarter) when the time looks ripe.  Both would be for longer term positions that could be held for a few months, so I see a lot of opportunity in those trades, something that you can ride for a big move.  Looking for the stock-bond correlation to turn negative with a vengeance as soon as the Fed finishes their last rate hike, mostly likely to happen after the March FOMC meeting.