Retail Frenzy and Hedgie Caution

That nonfarm payrolls report is still having repercussions in the market.  The market has jumped from the immaculate disinflation to sticky inflation.  I am hearing talk about a strong job market, higher prices for used cars, strong new car sales, more optimism in real estate, etc.  I heard none of these things 2 weeks ago.  Its amazing how fast Wall St. jumps from one side of the fence to the other.  Now its clear that investors have come right back to the 2022 mindset of high inflation/good econ. data is bad news.  

However, that trend doesn't seem to have staying power.  Wall St. has no patience for things to play out.  If the economy doesn't immediately crater after rate hikes, then the economy is deemed to be impervious to rate hikes and very strong.  As the saying goes, monetary policy works with long and variable lags.  Most say the lags are anywhere from 12 to 18 months.  If that's the case, the bulk of the rate hikes happened after June, so that would be anywhere from June till next March for the full effect of the rate hikes to work their way into the  economy.  That monetary policy transmission takes time, its slow but the effects accumulate, like body punches in a boxing match.  One body blow usually won't knock anyone out, but they accumulate to weaken the opponent over the course of a match. 

The retail traders have regained confidence as the soft landing/no landing view gains popularity.  I am seeing some crazy action in pump and dumps the past couple of weeks.  Its almost as crazy as 2021, when you regularly saw multiple 100% daily gainers in a day.  But that confidence is missing from the hedgies, as they've been covering shorts and also reducing longs, pulling back on their gross exposure and not raising their nets, even with the growing economic optimism out there. 

Its a confusing time for macro based investors.  The leading indicators are telling you one thing, but there are bits of coincident data that remain strong, like employment, which gives out soft landing/no landing vibes to the public.  This seems to happen at the beginning of every downturn.  During this "Goldilocks" period, people play down the importance of the yield curve inversion, the accuracy of the leading indicators, and point to the strong jobs market as proof that the economy remains strong.  

The thinking out there is that there is still a lot of excess savings, and will keep the consumer spending for some time.  But average hourly earnings has been growing less than the CPI for the past 18 months, and we all know that the CPI underestimates inflation.  So consumers' buying power is probably the worse it has been for several years, as wage growth hasn't kept up with inflation.  

Logically, with government spending taking up a bigger percentage of GDP than in the past, the economy becomes less efficient.   Government waste and lost productivity manifests itself as inflation.  Government workers get paid more than their labor is worth, so the money that they get paid isn't made up for by increasing the productivity of the country, leading to more inflation, and less buying power for the private sector. Government spending to GDP ratio hit 37% in 2022, after reaching over 43% in 2020.  In the late 1990s/early 2000s, government spending to GDP was in the low 30s.  Government creep into the economy lowers productivity as their activity crowds out the more efficient private sector.  This is one of the trends that is a tailwind for higher inflation in the future.  While it doesn't have a big effect near term, over time, waste and inefficiency in the public sector gradually decreases the purchasing power of the dollar.  

While I am a believer in the secular inflation thesis, its going to be overwhelmed by cyclical forces.  In this part of the business cycle, you have disinflationary forces which are quite powerful, with high inventories, higher cost of capital forcing some businesses to close, negative wealth effect from housing and financial asset depreciation, and banks tightening credit standards and giving out fewer loans.  The recession callers at the end of last year weren't wrong.  But they jumped the gun by thinking that the Fed tightening would choke off the economy right away.  It may take a few more months than they thought.  

Noticing some interesting price action the past few days.  Even with the strong nonfarm payrolls report and a weak bond market, the bulls were aggressive, and pushing stocks up until yesterday.  Especially super speculative stocks that retail traders love to push around.  Greed is percolating out there.  You are seeing more optimism show up in the investor sentiment surveys, which are showing the highest levels of bullishness since early 2022.  It makes for a dangerous market to get long, with all these newfound bulls.  It makes it safer to short, but I would like to see less fear in the bond market in order to really get the bulls worked up and feeling invincible.  

Right now, there still seems to be a bit of apprehension among hedge fund managers, which still have relative low net exposure to equities.  Retail is almost all in, so that's a good sign to short the retail favorites.  But for the indices, its less clear cut.  I would like to see the hedgies increase their net exposure a bit more here.  The systematics and CTAs have been buying the past few weeks, so they are have used up most of their buying power.  Have been shorting retail driven stocks this week, but I will wait to short the SPX.  I missed a good down move yesterday but I think there will be at least one visit above 4200 before this bear market rally is done.  Gut feel tells me that this bear market rally will last longer than the one you saw from June to August of 2022.  So its going to be trickier to maintain a long term short this year.  Still think we see a big move lower eventually, but probably only after you suck in a few more bulls into the ring.