On Commercial Real Estate, Risk Parity, and SPX

The SPX just keeps chugging along, going up again, despite OPEC putting in a production cut which squeezed oil prices higher, and a recessionary ISM number.  No matter how many times investors see markets go up on bad economic news, they still don't get bulled up during those situations.  It just feels unnatural for the stock market to go up as the economy gets worse. The market loves to climb a wall of worry, and there are lots of things its worrying about.  Financial contagion, inflation, recession, commercial real estate, etc. 

Risk parity is such a dominant force in the financial markets, that anytime you see bonds rally, usually on bad economic data, its hard for stocks to selloff a lot.  The exceptions, which are deep recessions and financial crises, are uncommon, so the odds are against you to short stocks when bonds are rallying hard.  The foundation of the whole pension industry is based on risk parity, a portfolio of stocks and bonds, with bonds providing diversification and a "free" hedge against stock volatility.  Of course, its not a free hedge, when inflation is rampant, but in all other cases, its a great hedge, as its a positive carry hedge, unlike being long volatility.  With bonds repriced much lower after the carnage in 2022, I expect it to provide that risk-off hedge that will mitigate against investors panic selling stocks unless we get a deep recession, which is definitely possible, but probably less than a 50% chance of happening. 

Just watching CNBC, you can sense the skepticism that the "professionals" have towards this rally.  They always fight the last war.  The last war was inflation, which wreaked havoc in 2022, and that's left some fresh wounds that get people nervous about being long stocks while inflation is still high, but falling.  This mindset is the reason that oil, which has been in a huge downtrend since last summer, gets the crowd all bulled up at the first sign of strength.  Disregarding the fact that OPEC production cuts have happened due to underlying demand weakness that necessitated those cuts.  It was a veritable love fest for energy on Fast Money yesterday, which should make oil bulls nervous.  

Speaking of past wars, all I hear these days is about how there will be another crisis because of commercial real estate and how it's like residential real estate in 2007-2008.  Its fashionable these days to be short commercial real estate stocks/REITs.  I am no real estate expert, but residential real estate is owned by both the middle class and the rich.  The GFC in 2008 affected a huge swath of the income spectrum, and the real estate bubble at that time was huge compared to this past one.  And you had a lot less money in the system sloshing around back then.  Unlike residential, commercial real estate is owned by just the rich.  And the only real negative sector of commercial real estate is office space, which is in oversupply, but is generally in prime locations where the value of the real estate is more in the land than in the property built on that land.  If office real estate gets cheap enough, there will be buyers who just tear down/renovate the building to residential as soon as they get permits to do so.  And based on how popular cash is these days, there are a LOT of potential buyers waiting to pounce on any good opportunities.

Anyway, I'm of the lonely opinion that work from home is a fad, and corporations will soon realize that they are getting much less productivity from their workers when they are not in the office.  Even if it means having to pay for office space, having workers together in an office is always going to be more productive than when they are at home.  Being productive is a burden for the worker, which is why they want to work from home, where they don't have to constantly look over their shoulder and can slack off as their boss isn't around.  But with the lack of competition in the US, corporations have the bargaining power over labor, despite the tight labor market.  That's the gilded age for you, with oligopolies in almost every sector of the economy. 

From a class perspective, the wealthy are not going to be the weak point in the next recession.  The government's deficits are the private sectors' surpluses.  The deficits have been huge since 2020.  And most of it went to the top of the income spectrum.  The wealthy amassed a giant financial war chest from fiscal profligacy over the past 3 years, and are bathing in cash that's earning 5% by doing nothing.  The trickle down effect from some commercial real estate developers losing money and some banks writing down losses is overestimated, in my view.  That's literally a drop in the bucket for the wealthy, who will only feel pain if you get a repeat of 2022, which is not going to happen, as inflation has peaked and the Fed is looking set to pause very soon. 

What's more likely to be the weak point in the next recession is the majority that is not in the top 20%, the group that are renting, have no home equity, and are feeling the squeeze from higher inflation (as corporations use their oligopoly pricing power to expand profit margins) outpacing their wage growth.  Also, quite a few will get laid off as the economy enters recession due to a credit contraction caused by deposit flight at the banks. This bottom 60%, will be the ones cutting back on consumption, both goods and services, later this year and in 2024.  This is not just a US phenomena.  Its happening in Europe and Asia.  A synchronous global slowdown.

Here is a simple way of looking at the timeline from Fed rate hikes to rate cuts.  

Fed raises rates  ----> Less loan demand at higher rates + more deposit flight from banks to money markets ----> Tighter credit + less money flowing through the economy ----with a lag ---->  Recession leading to job cuts -----> Fed cuts rates

Some can argue about the Fed reaction function now that we've had high inflation, many feeling as if the Fed will be late to cut rates and be less aggressive than in the past.  That's possible, but seeing how quickly the Fed came to bailout a two-bit bank in SIVB at the drop of a hat, I think people are overestimating the hawkish resolve of Powell and company.  They are doves at heart.  They only put on the hawk costume when it suits their political motives.  

Back to the SPX.  When I look at the CFTC COT report, I want to see the net position of asset managers, which are the best fades over the intermediate term.  They got a bit long in the middle of February, and the SPX promptly had a selloff that lasted 4 weeks.  If anything, that 4 week selloff tells you that we're not in a bull market.  You rarely get 4 week selloffs in a bull trend.  But positioning did come down in March, and while net longs are not as low as it was last fall, it has dipped back towards more neutral territory.  On a longer term basis, asset manager net position is on the lower end of historical averages.

SPX Futures Net Position of Asset Managers

But the price action has been quite bullish ever since SIVB went under, and based on hedge fund positioning reports from last week, it appears that hedgies have low net equity exposure and are the ones that are probably scrambling the past few days chasing stocks higher.  Once again, hedge funds have proved that they exist to absorb market risk, while siphoning off fees from investors. 

Based on a combination of investor positioning, seasonality, and recent bond strength, it appears that the path of least resistance for the next few weeks is higher, although the bulk of the gains for this rally are behind us, as I see limited upside above SPX 4200, which is just 2% away.  For the bears among us, less is more this month.  May will be a different story, but no need to jump the gun.