Economy =/= Financial Markets

People are negative.  The pessimism about the economy is similar to what we saw in late December 2022, when you had a lot of investors calling for an imminent recession and a difficult first half of 2023.  That also happened to coincide with a significant pullback from SPX 4100 down to below 3800, during a volatile time period.  SPX realized vol was around 20.  This time, you hardly have any pullback in the SPX, as it is lingering near the highs, with very little volatility.  Realized vol is now around 10.  So you have half the volatility that you did compared to last time people were similarly gloomy on the economy. 

SPX Realized Vol

The knee jerk contrarians will view this as a bullish sign for the stock market, as you have investors who are bearish on the economy.  But the economy doesn't act like the stock market.  And people don't trade the economy.  They trade stocks.  If you look at investor positioning, you get a different story now than at the end of 2022.   GS Prime Broker data shows net leverage about 5% higher now than versus the end of December. 

GS Prime Broker Hedge Fund Positions

ES Futures Asset Manager Net Position

Not only is the SPX about 300 points higher, hedge fund net leverage is about 4% higher, and asset manager net long position in ES has grown by over 100K contracts from end of 2022 to April 18.  It is asset managers, not leveraged funds which are the better historical fades in the CFTC COT futures reports.  

So investors are acting like they are scared of a recession.  In any case, it seems almost everyone expects a mild recession, where earnings won't go down much. 

Let's get back to the economy.  There are times when the crowd is too pessimistic on the economy, too optimistic on the economy, and when they are about right.  So while you have almost everyone on CNBC/Bloomberg/Twitter talking about a coming recession, like they did in late December, they are positioned much more bullishly than back then.  You got a surprisingly strong start to 2023 for the economy due to Social Security COLA adjustment higher, higher tax brackets lowering percent of taxes withheld starting in 2023, and a strong stock/credit market.  Those positive catalysts are fading as the stock market has stalled out under SPX 4200, the credit market has tightened with bank lending, and Fed funds rate is about to be 75 bps higher in a few days versus late 2022.  Let's not forget about the lagged effect of rolling maturities from the lowest rates in financial history to levels 3-5% higher across the curve.  This doesn't even get to the reflexive feedback loop from the inventory de-stocking cycle which continues to chug along.  

In some ways, the crowd doesn't seem to be beared up enough relative to what the economy will look like in the 2nd half of the year.  Contrary to late 2022, when they were too bearish on the economy before credit tightened enough and before some of the lag effects took hold.  Its been so long since we've had a real recession (2020 was fake) that investors seem to have forgotten how a very weak economy causes a domino effect where weakness begets more weakness until the Fed or the government comes in with big time stimulus.  I doubt the government with come to the rescue considering the House is majority Republican, and they are not in the business of pumping up the economy ahead of November 2024 when a Democrat president is seeking re-election.  

The debt ceiling debate will be the perfect opportunity for McCarthy and the Republicans to take a stand, knowing that any short term blow back for not giving in to Biden and the financial markets will be made up for big time by an economy that will be weaker without ever increasing government spending, easing the way for a Republican victory in 2024 as the economy is in a deep recession.   

So expect no fiscal pump, leaving the Fed as the Lone Ranger who needs to come to the rescue.  And considering how much rhetoric Powell has spewed about killing inflation and higher for longer and not repeating the mistake of the 1970s, there will need to be some notable economic pain before Powell comes in with the bazooka this time.  He will eventually, but I would expect a few small cuts here and there in late 2023/early 2024 that won't be enough, which will force the Fed to go even bigger in the middle of 2024, possibly back to ZIRP.  

While the markets are quite boring these days with volatility going back to 2019 levels, the coming earnings disappointments in the 2nd half of 2023 along with more layoffs and a weakening jobs market should bring back the volatility which will make it a more favorable environment for traders.  This is a fallow period, setting up the harvest later in the year.  I've put on a small short position in some retail favorite stocks, but I am waiting for the May FOMC meeting to put on an SPX/NDX short.  The May meeting could be the final bull catalyst for the bulls who will likely celebrate the end of Fed rate hikes, which will be the worst time to go long/best time to go short.  A false break above SPX 4200 would be an exquisite shorting opportunity.