Road to Argentina

Politicians and the public are enamored with stimulus.  They are popular.  It feels like a free lunch.  Every time the government goes on a massive spending and/or tax cut binge, the economy gets stronger.  It happened after the Trump tax cuts in 2017, and it happened after the ridiculously huge Covid stimulus in 2020/2021.  During the period from 2014 to 2020, when the price of crude oil went from $110 to $40, and when the US budget deficits were regularly breaking $1 trillion annually, the MMT crowd were running amok, telling the public that deficits don't matter, that the government can keep spending and cutting taxes to maximize the economy without increasing inflation.  Of course, what these academics don't factor in is the psychology of money and inflation.  

Take a look at the year over year change in the money supply/CPI index ratio.  This is a measure of how much money supply changed vs the CPI.  The higher the number, the more money supply increased vs CPI.  The lower the number, the less money supply increased vs CPI.  This is a great look into the psychology of inflation and inflation expectations in the economy.  When money is viewed as a store of value, the M2/CPI ratio should go up.  If money is viewed as a depreciating asset, it should go down. 

 

The only precedents for such a low year over year change in the M2/CPI ratio was the stagflationary 1970s era, when inflation expectations kept pushing inflation higher even more than the supply of money.  The shaded areas are recessions, and each spike lower in the M2/CPI ratio in the 1970s was during a recession.  This speaks to the insidious nature of inflation expectations, which fuel higher wages, which lead to higher cost of goods, which lead to higher CPI which then results in even higher wages.  The fuel for this wage price spiral are the massive government budget deficits which pump trillions of new dollars into the economy every year.  

The big plunge in the M2/CPI ratio speaks to the loss of trust among the public in the authorities in regards to inflation.  The tide has shifted from a deflationary mindset in the 2010s, where people kept money in the bank collecting 0% interest, to an inflationary mindset, where people are now seeking yield on cash, to keep up with inflation.  The consequences of the government going deep into debt to keep recessions at bay have resulted in stagflation.  

Nominal retail sales are up big over the last 2 years, but real retail sales are actually down from 2 years ago.  That is the definition of stagflation.  And it tricks the public into thinking the economy is strong when nominal numbers keep going higher (revenues), even though volumes are shrinking.  No wonder crude oil is trading so weak.  

Nominal Retails Sales

 

Real Retail Sales

When you've squeezed so much out of the economy with low rates and financial repression over the past 15 years, monetary policy becomes impotent in stimulating the economy.  Unlike what most investors think, fiscal policy is now the bazooka.  Monetary policy is the pea shooter.  And with budget busting fiscal policy, the Fed is fighting a losing battle over inflation.  As much as I view Powell as being incompetent, he's not the one who caused the inflation problem.  Its the White House and Congress, with their egregious multi-trillion dollar spending packages during Covid, the child tax credits, the ridiculously long pause on student loans, etc.  And they have no interest in doing anything tangible to reduce inflation, such as cut spending and raise taxes, as it is politically toxic for their base.  Instead, you get gimmicks like SPR releases to lower oil prices or states issuing stimmy checks to cover the rising cost of food and energy.  Fighting inflation with cash stimmies!  Only politicians could come up with such asinine solutions.  When these policies fail, you just get the blame game from these politicians, pointing fingers at anyone but themselves.  And these inflationary, populist policies continue, as the public doesn't care about deficits. They just want their Social Security checks and other handouts. 

The debt ceiling "crisis" could have been an opportunity for both sides to do something about the inflation problem by reducing spending.  But it was clear to see during this debt ceiling debate that Republicans were more worried about preventing defense spending from going lower than they were about the number of years of spending caps.  And Democrats were half hearted in their attempt to raise taxes, and were steadfast in keeping spending caps as short as possible.  In the end, the deal had almost no effect on future spending. 

The long term side effects of these budget busting policies have not fully come to bear.  The US is slowly becoming the rich man's Argentina.  If it were not for the exorbitant privilege of having the reserve currency, the US would be dealing with a situation like the UK in fall of 2022, where there was a revolt in the bond market, as investors no longer wanted to buy the debt of a country that spends and borrows so rampantly even in the face of high inflation.  

When you abuse the reserve currency by running absurd budget deficits as a % of GDP, you risk losing that privilege.  The US government is doing its best to try to speed up the process of losing reserve currency status.  It probably happens within 20 years.  I don't expect another country to become the reserve currency.  The mindset will shift from keeping money in the bank to keeping gold bars in a vault.  Instead of holding cash, investors will have to hold stocks/gold/real estate as a store of value.  Financial repression will continue, as interest rates will be held below the rate of inflation to keep the economy from falling apart in stagflationary times.  Anything to lessen pain, to kick the can, and to keep the drugged up economy from crashing.  

The AI hype has taken over the stock market.  The put/call ratios are plunging, as call speculation in the big cap tech names and QQQ continues.  One of the worst performing ETFs out there, NOPE, is now long 90% QQQ.  That fund manager was long a bunch of gold miners right before they got smashed heading into the debt ceiling.  The energy is building for a substantial drop.  I don't expect it to come until after the market is confident that the Fed is done with rate increases, which could come as soon as June with weakening economic data.  Once you get the celebratory buying on a Fed that is done with the economy weakening, the market will come back to the ironic reality that there will not be rate cuts until the stock market goes down.  That reality should hit sometime this summer.  Tops are always difficult to time, but you can still profit if you are close enough and give yourself room for error by using proper sizing.  Still short individual stock names, but not big positions, so I will be looking to add soon.  Staying away from shorting NVDA for now, but it is definitely on my radar. 

Hedgies Coming Back In

Its not been easy for short sellers in 2023, starting off with the big rally in January, followed by the almost nonstop rally post SIVB from SPX 3850 to 4200 over the past 2 months.  Its been even worse for those who have bought puts, because not only has the market grinded higher, volatility has dropped like a rock, absolutely killing put holders.  Its been a meat grinder for those skeptical about the economy and the stock market.  For the bears who still have dry powder, this provides an opportunity to take advantage of the market's resilience.  

“Risk managers at big institutional firms are saying, ‘Look, the markets are going up, and you can’t sit around and do nothing, you have to participate,’"

Recent hedge fund positioning data coming out of Goldman, Morgan Stanley, and Deutsche Bank confirm that net equity exposure has been going up rapidly in the past 2 weeks, near a one year high, but at neutral levels going back to the past 10 years.  The hedgies could marginally increase their nets, but looking at the macro landscape with rates above 5%, its hard to imagine them getting aggressively long here.   Systematic equity exposure is back towards early 2022 levels, and is above the long term average.  Discretionary exposure is still below average, but has risen in the past 2 weeks.  If discretionary exposure can get closer towards neutral like systematics, that would be the no-brainer setup.  We're not quite there yet. 

With overall hedge fund exposures close to neutral levels, the scary short covering portion of this rally is over.  Now, it will require either strong inflows into equities or a chase for performance, ignoring the weakening macro conditions.  That is a higher bar for a continued rally than what we had earlier in the year.  With very positive skew and lower VIX, put spreads haven’t been this cheap since 2021.  A long term short position in SPX either outright short or via put spreads is at attractive levels.  

The love for tech stocks is getting excessive, especially the AI related stocks.  We have the famous investors pumping it now, after a huge move higher.  Whenever Steve Cohen, Stan Druckenmiller, and Paul Tudor Jones are touting something after a big move, run away.   They aren’t in the charity business, they are looking for exit liquidity.  The chart for NVDA looks ridiculous.  AAPL is trading like its totally recession-proof, and goes higher even as its revenues and earnings are stagnant.  These are the moves that make you shake your head.  Moves that make long/short hedge funds trading on fundamentals throw in the towel.  

 

Its been painful for those holding bonds as well.  Especially long bonds.  We are almost back to 4% on the 30 year, as you get banks reducing their duration to belatedly protect against interest rate risk.  But that horse is already out of the barn.  Those that hedge too aggressively here could be in a world of hurt if the economy enters a deep recession and their credit loan books get crushed while not having enough duration to soften the blow.  Its a mess out there for the banks, as this rise in long bond yields is not doing them any favors, amidst a steady outflow of deposits seeking higher yield.  

On to the news of the day.  Debt ceiling deal looked promising on Thursday, and then suddenly the two sides were far apart on Friday, and now back to constructive on Monday.  Wax on, wax off.  The people who were going to hedge for a potential debt ceiling debacle already have either hedged or reduced their positions.  So don't expect any last minute snags to plunge the stock market.  The only thing that will cause a debt ceiling selloff now is if there is an actual default, which would happen in June, if it did.  I wouldn't make that bet.  

Counterintuitively, the debt ceiling debate has been a positive for stocks by taking the focus off a weakening bond market (especially long bond yields), and the ongoing regional bank issues which have not gone away.  Those are actual real issues that can cause a real crisis, unlike the debt ceiling, so being able to worry about an artificial crisis instead is a relief if you are a stock market bull. 

I've kept my shorts in individual stocks, along with long positions in short to intermediate term bonds.  Still not ready to short the indexes, but it is getting more tempting.  Probably need to get the debt ceiling deal out of the way so that the chicken littles finally jump into equities, which could be the exquisite moment to put on index shorts/puts.  Not a big fan of shorting the index during a period of uncertainty, especially when its over a fake crisis.  Probably should have reduced some individual stock shorts when people first started talking about the debt ceiling issue in early May.  Could have, should have.  Can't turn back the clock.  At these levels, I'll just hang on.  Probably very little downside for this market until the debt ceiling deal is done, so looking at a market that won't go down much until early June.  Should be boring until then. 

Financial Engineering in US, Europe, and Japan

The US, Europe, and Japan have literally become the McDonald's of sovereigns over the past 40 years.  For those unfamiliar with the McDonald's story, here is a good recap of what they've done.  In essence, McDonald's management team has turbocharged the stock price by issuing gobs of debt to finance stock buybacks.  The executives have used that liquidity to cash out of their stock options for fat gains.  The surge in the stock price also coincides with the recent demand for recession-proof, safety stocks as the economy slows.  

The US, Japan, and many countries in Europe are in the middle of a similar case of financial engineering.  Instead of it being McDonald's balance sheet, its the sovereign balance sheet of these nations blowing out with huge deficits to finance more spending and tax cuts.  The public sector's deficits become the private sector's surplus, which keeps economies stronger than they would otherwise be.  

In the case of McDonald's, the extra cash from selling debt was used to buyback stock, goosing share prices.  

For the sovereigns, the extra cash created from deficit spending/tax cuts, heavily  monetized by QE,  gooses the pocketbooks of the private sector, artificially boosting demand beyond what would naturally happen in a capitalist system.  The government debt/GDP ratios have gone up sharply since 2008, as governments have been the ones taking on extra debt, taking the baton from private borrowers after the GFC. 

Once these countries get such large debt to GDP ratios, they have to either engage in QE to keep bond yields low or exacerbate the problem by having to pay even more interest on the debt, creating a debt spiral where more debt needs to be issued to pay the interest.  

Aging demographics is just making the problem worse, as you have more government outlays to retirees through programs like Social Security and Medicare, while you have the same or fewer working age population paying the taxes to try to balance the budget. Its a losing battle for governments, as raising retirement age and decreasing benefits is extremely unpopular, and old people love voting, so its politically toxic to even mention it. 

So you will continue to see budget deficits grow in the developed economies, as entitlement programs pay out more to the retired and not have enough workers paying taxes to keep up.  All of this extra cash that the government hands out by blowing out its budget ends up as savings for households and businesses.  We know what happened in 2021 and 2022 when the private sector gets excess savings from an expansion of budget deficits:  high inflation.  

If the interest rates are set too low, the private sector will eschew investing in government debt, which causes longer term yields to rise, which forces the Fed to use ZIRP/QE to keep yields down to prevent the economy from slowing down.  We've yet to reach the point where the value of labor/amount of government outlays has gone high enough to cause chronic, rampant inflation, but its much closer than people think. 

Over the long term, inflation is a monetary phenomena.  If you keep expanding the money supply through fiscal largess and QE, and labor supply / production can't keep up with the demand, prices need to go higher to balance supply and demand.  And demand goes higher as the amount of money in circulation increases.  This is guaranteed with the current political climate of populism, government handouts and pork when economies weaken.  2021/2022 was a preview of the limits to fiscal spending to boost the economy.  Beyond a certain point (definitely surpassed that point in 2021 and 2022), it just creates pure inflation and the credibility of the central banks AND the currency come into question if financial repression (negative real interest rates) is used to keep the economy afloat in a period of stagflation. 

The Japan experience from the 2000s to today is an anomaly.  Japanese households and corporations de-levered even as interest rates were suppressed near zero, keeping the money supply growth rate at very low levels, even as the BOJ went to ZIRP, and then to QE and even NIRP.  This kept inflation very low.  That also coincided with a period of massive deflation coming from cheap goods being outsourced from China.  That is unlikely to happen again.  Also, in the West, the propensity for the public, and thus politicians to tolerate chronically low growth, near recessionary conditions is much lower than in Japan, which is basically a one party country.  Politicians will always look for the easy way out, the best political strategy, and that is to spend more, and tax less.  An inflationary strategy.

Just as you see the stock price of McDonald's rise along with the increase in its debt used to fund stock buybacks, you will likely to see a continued rise in the value of private sector assets as the sovereign balance sheets in the US and Europe continue to expand with more debt issuance.  When those asset values rise due to an increase in the amount of money in circulation and not due to an increase in production (a logical assumption when considering the increasing incompetence and waste in the public sector as it grows, and the growing handouts to the elderly), you naturally get the price level of everything going higher.  Consumer goods and service prices, along with asset prices like stocks. 

While I believe that inflation will slow down a lot this year due to credit contraction and a recession, the secular inflation theme that was all the rage in 2021 and 2022 is valid for the long run.  The inability or the lack of desire to tackle government debt levels among the public all but guarantee more populist policies like stimmy checks, crony capitalist pork projects, more military spending, deficit financed tax cuts and tax credits, and of course, a continuation of generous Social Security and Medicare benefits.  It is purely inflationary spending.  Money for nothing.  

This is why you cannot consider government debt a good long term investment like you could in 1980, the last time you had an inflationary wave.  The debt levels, the demographics (US, Europe, and China), and politics (much more populist now) is much more conducive to higher inflation and lower real growth.  The inflation cat is out of the bag, and it will have major ramifications for the future of stocks and bonds, which just had a golden age of 40 years of spectacular compounded gains, in real dollar terms.  In the future, most of gains will come from inflation, not real growth.  

The markets these days are boring.  Low volatility begets low volatility as there is very little motivation to trade when prices don't move.  Less trading = less volatility.  That is until one side stops buying/selling.  Right now, its almost a stalemate, as the buying coming from corporate buybacks and vol control/systematic funds is almost equal to the selling from value investors, hedge funds, and discretionary investors.   I believe the break of this stalemate will come when the volatility increases from a weakening earnings picture in the 2nd half of the year, forcing corporations to reduce buybacks, which will be front run by hedge funds and followed by systematics who will follow the trend, and also sell due to the increase in volatility.  I expect it to happen suddenly, as is often the case in these slow grind environments with high SKEW levels.  The options market is usually correct more than its wrong, and this time, it is starting to price OTM put options much higher than OTM call options, more than anytime in 2022.  

Usually you will get a warning sign about 1-2 months before the waterfall decline, with one significant dip that gets bought, softening up the belly before the sellers strike again for the big decline.  You saw that in 2011, you saw that in 2015.  In October-December 2018, there was no warning sign, no softening of the belly, it just sold off.  In any case, warning sign or not, I am expecting a waterfall decline within 3 months.  

For the short term, the debt ceiling just doesn't mean much for the overall economy so I am leaning towards nothing burger, deal or no deal by the X-date.  Even without a deal by then, the deal will happen quickly enough afterwards that its not something that will have any lasting effects.  An artificially created crisis is not a real crisis if it doesn't affect the economy.  And even if there are spending cuts in the deal, they will be far enough away and small enough that they won't matter anyway.  If there is a selloff as investors get nervous and we start seeing headlines on it, that would be a good time to reduce short positions and even take some longs for a trade, as I would expect an immediate bounce back. 

Heaven and Earth

We are in a new Gilded Age.  A time of extreme inequality, which has spurred a populist wave in politics, which ironically has just exacerbated the inequality.  This inequality originates from corporations financing campaigns and using lobbyists, who have bought out politicians, ensuring favorable taxes and regulations.  These regulations and lack of anti-trust enforcement, has created a M&A boom, which has effectively turned most US industries into oligopolies, providing corporations with unprecedented pricing power, which they have exercised to full effect over the past 2 years.  Excess money supply from fiscal pork stimulus, along with greedflation, are the 2 main reasons you had an inflationary wave after 2020.  

Corporations had a convenient excuse to continually raise prices with all the talk about supply chain issues, and rising commodity prices.  And now that commodity prices and raw material input costs have come down, they are sticking with their margin over volume strategy, sacrificing some revenues for higher margins and higher net profits.  This margins over volume strategy requires less labor, as there is less production.  This should embolden companies to be more willing to layoff workers, not a great sign for the economy.  

Corporations can only get away with this strategy if there is limited competition.  And that's the case for most industries, as competitors have been acquired, leaving fewer players left on the field.  The fewer the competitors, the easier it is to raise prices and quietly collude to maximize profits.  This pricing power flows through to the bottom line, as can be seen by the trend in profit margins as a percent of GDP. 

Having few competitors also means you can pay workers less because there are fewer competitors for that labor.  

 

The over the top Covid stimulus of 2020 and 2021 ended up flowing mostly to the wealthy, a kind of reverse trickle down effect.  When most of the poor get money, they spend it, or if they do invest it, its often in bad investments such as meme stocks, random crypto coins, or they just leave the cash in the bank collecting 0% interest.  So whatever stimulus money the poor receive, it eventually ends up trickling up to the top.  That's what has played out over the past 3 years.  So the excess savings, while declining, is also changing in composition.  A higher percentage is now concentrated among the upper class, those who have much less propensity to spend their income and wealth than the lower and middle class.  

How does a 5.25% Fed funds rate affect this situation?  Well, you can break it down into those who have excess cash to invest in high interest savings accounts/money market/T-bills and those who need to borrow money.  It is heaven for those with excess cash, as the high interest rates provide passive, risk-free income.  On the other side of the coin, it is back to earth for those that need to borrow money to either operate businesses or to maintain their current standard of living.  Don't forget that those who want/need to borrow money have a much higher propensity to consume and spend their excess cash than the wealthy who won't change their consumption patterns based on receiving a few extra percent on their cash.  

For those benefiting from the higher interest on cash, they won't be much affected by the extra income.  But those that are hurt by the higher interest will either find it difficult to get loans or credit extensions, or just be unwilling to pay the high interest rates (for those looking to make investments/run a business).  In particular, those that rely on leveraged loans (variable rate), are feeling the pain.  

This ties back to the current environment of a working population that is flatlining, especially without all that illegal immigration of the past.  When you don't have a growing working population, you don't have a vibrant economy.  The only growth you are seeing is in the elderly population, and they are mostly consumers, who are not providing productive capacity to the economy.  The elderly are just fueling more inflation by consuming while not producing.  I sometimes hear arguments about how tight the labor market is, how wage growth is strong and thus the economy will be strong.  Let's play a hypothetical game.  Let's say you cut the working age population by 90%, and wages go up 1000%.  The labor market would be super tight and the wage growth is super, duper strong.  Is that a sign of a strong economy?  No, its just a sign of a tight labor market.  Tight labor market =/= strong economy.  Just look at Japan and their sub 3% unemployment rate.  No one would consider the Japanese economy as being very strong.  

 

What the crazy amounts of fiscal pork in 2021 and 2022 has done to Wall Street is confuse a short term crack up helicopter money fueled boom with a sustainably strong economy.  The US is not an organically strong economy.  Population growth rates, among those age 15-64, is miniscule.  What's been fueling the strength since 2020, and to a lesser extent since 2017, is an increase in budget deficits through a combination of tax cuts and increased government spending.  That's poor quality, inflationary growth that comes purely from handing out cash to the private sector from the money printer.  As you can see below, inflation (in red) is the vast majority of the contribution to nominal GDP growth since 2020. 

 

While big budget deficits are still continuing, its the fiscal impulse (change in budget deficits) that affects economic growth.  And the fiscal impulse is only marginally positive for 2023, mainly from less capital gains taxes being paid and a slowing economy.  The main driver of US economic growth, big budget deficits, won't be able to overcome the tightening credit conditions which should lead to the well advertised recession later this year.  

 

Consumer demand should continue to trend lower as the labor market weakens, inflation remains sticky due to greedflation/oligopoly pricing, and as credit tightens, reducing the cash flowing to consumers.  While it is consensus that we will be getting a recession later this year or in early 2024, investors are not optimally positioned for it.  You are seeing big overweight in equities and cash, and big underweight to fixed income.  The best performer in a recession is fixed income, even if inflation remains sticky.  The Fed has been adamant that they are higher for longer, and that they will not cut rates this year.  If that is the case, which I don't believe, that would just make the economy even weaker than if they were more willing to cut.  So in a paradoxical way, Powell's stubborness and unwillingness to cut will create conditions which are optimal for fixed income.  Yet, that's not how most investors view the current situation.  They believe that a hawkish Fed that keeps rates too high and doesn't cut early is bad for bonds, when in reality, its actually great for bonds. 

The markets these days have slowed down and many days just feel like a holiday, with not much happening.  This market has gotten complacent, but not bullish.  There is a difference.  People are not fearful, but they also realize that economic conditions are not favorable for equities.  This creates a situation where the market remains sleepy and trading in a small range until the cumulative effects of the monetary tightening and deposit flight bear their weight on the banks first, and then to the overall market.  

 

Investors who are unwilling to chase stocks higher as the economy slows is not an environment where the SPX can grind higher.  It will probably just be range bound.  I can picture a similar situation to what happened in 2015, as the volatility compressed for several months until it exploded higher in August 2015.  

The latest news these days is the debt ceiling, and how catastrophic it would be if the US defaulted on its debt.  It would just be a technical default, as they would just delay payment until the debt ceiling was raised.  And it will get raised eventually.  What's interesting this time is that the House Speaker McCarthy is in a bit of a hot seat, as he can be kicked out of his post quite easily, the deal he made to become speaker after failing multiple votes.  This will incentivize him to get a palatable deal for his party, which means he would rather default than pass a clean debt ceiling deal.  So at the margin, this should reduce government spending a bit for the next budget.  In any case, the volatility will just be temporary and will be much about nothing, just taking the focus away from the important issues to the market, which is the tight monetary conditions and the continuing deposit flight from the banks.  

Not much to do these days, added to some individual stock shorts that rallied last week.  Expecting continued low volatility for the next few weeks, with occasional dips  that get bought, similar to what you saw from April to July 2015, before you get the big waterfall decline. 

Culling the Herd in Banks

Powell just pulled forward the date of the first cut by hiking again.  Now you will have a reverse repo facility offering over 5% on cash, while banks pay next to nothing on deposits.  That magical 5% number sounds much higher than a rate with a 4 handle. 

People are bad at math.  You have people with savings accounts that pay less than 1% interest while holding credit card debt they are paying over 20% interest on.  Many don't understand how much interest income they are giving to the banks by not moving excess cash from their bank to a money market fund.  $100,000 earning zero at the bank is basically giving up $5,000/year to the bank in income.  

But things are changing.  Interest on cash is now in the news.  You have interest from a money market account on a magazine cover.  Cash earning market interest rates are popular.  Banks need sticky deposits, that don't care about the interest they get.  People didn't care when rates were at zero because they weren't losing out by keeping excess cash at the bank.  Since SIVB, people are starting to care.  That's bad news for the banks. 

In the age of social media, news travels fast.  The more that regional banks are in the headlines, the more negative exposure they get, which encourages more deposit flight.  It doesn't help when you see banks plunging on news that they are looking to sell (PACW).  Its not evil short sellers attacking these stocks.  These companies are up for sale because in a 5% Fed funds rate environment, deposits are no longer sticky, and money starts to move to where there is yield.  

With the crap long duration mortgages and low fixed rate loans on their books, if these banks have to make up for the deposit losses with wholesale funding at market rates, they can't make money.  They become walking zombies.  And for a bank, when you become a zombie, the stock price goes down a lot, which makes depositors nervous, which induces more deposits to leave, creating a vicious circle.  Sure, PACW can survive in the current state if none of the deposits leave.  That goes for all the regional banks whose stocks have been getting pounded.  People selling these regional stocks are not worried about the current state.  They are worried about the future state.  A future with much fewer low cost deposits as deposit flight continues to those seeking higher risk free yields.  People are dumb, but not that dumb.  Eventually they catch on to the banks ripping them off on their .01% yielding deposits. 

These regional banks can't survive for long unless Powell takes rates drastically lower, and quickly.  In all likelihood, a bunch more of the regional banks will have to go bust first before those big rate cuts happen.  Its survival of the fittest for the regional banks.  Those with the fewest CRE loans and long term debt on their books will survive.  Those that got greedy seeking yield in 2020-2021 on their assets by going out in duration will be the most vulnerable to getting culled in the coming months.  

This culling process is going to be disastrous for bank lending.  The demand for credit was already going down before the SIVB debacle happened.  At these elevated rates, with a slowing economy, it just doesn't make sense to make long term investments.  That's the demand side.  The supply side situation for credit is even worse.  Regional banks make up a huge portion of commercial real estate and C&I lending.  Seeing how their deposit base is getting less sticky, they will be making big cutbacks on lending to the real economy.  Credit is starting to freeze.  

Credit is the best leading indicator for the economy.  More money flowing through the economy generates growth.  Turning off that spigot eventually catches up to the economy as new loans get turned down and loans coming up for renewal are not extended.  Its not going to be a sudden event, but more of a slow squeeze, sucking oxygen out of the patient.  Once you get to a critical point of too little oxygen, its game over. 

The SPX is hanging tough, just selling off a couple of percent before the dip buyers come back in and rally the market again.  A lot of this bid over the past month has been coming from dumb beta systematics that are upping their equity exposure as the volatility goes down.  Corporate earnings still haven't reached the precipice of the cliff, so the buybacks are still heavy.  Investors are a bit nervous, but they aren't selling.  Take a look at the flows into technology funds since 2007.  It went parabolic in 2020-2021.  And they haven't sold. 

Tech stocks are still loved.  Going into a recession that will probably be deeper than most expect.  Not a great set up for Nasdaq.  It boggles the mind to think that AAPL, MSFT, and META are considered safe havens in a recession.  Those are 3 economically sensitive stocks with slow growth.  The love affair for big cap tech stocks is so deeply ingrained in investors that they act as a safety blanket when you have these bank crisis headlines. 

Its gotten to the point where I think it will be better to just short Nasdaq instead of SPX when the time is right.  Maybe it happens after the debt ceiling gets done and investors breathe a sigh of relief.  From past experience, its risky to short when you have bad news headlines dominating the tape like you have this week with the regionals.  

In all likelihood, the Fed is done with its hiking cycle, especially with the continued stress in the regional banks.  I made a wrong assumption that a Fed hiking while not making any mention about future tightening would be celebrated.  But investors just couldn't sit still on the banks and started selling the banks aggressively right before the FOMC meeting.  That was definitely unexpected, especially after the uncertainty of FRC was taken off the table as JPM took them over.  The grace period after that was less than 24 hours.  Now the market's main focus is on the banks, and that's not an environment where you will get institutions chasing stocks higher even after the Fed basically said in their round about way that they are pausing.  So I missed a good short there in SPX on the end of April rally. 

Its been 7 weeks since the SIVB panic so that's plenty of time for this rally to exhaust itself and run on fumes.  It appears we won't be getting that run to SPX 4200 on a Fed pause.  There's nothing bullish about a Fed that stays stubbornly above 5%, barring things breaking.  An FDIC guarantee on all deposits doesn't matter.  Its about yields now.

A Calm Interlude

People forget sometimes how often the stock market is boring.  After the crazy volatility in 2020, 2021, and 2022, and even the first quarter of 2023, when you get a boring month like April after the craziness in 2022, it feels abnormal.  But its actually what was going on most of the time from 2012 to 2019.  If you go back for the past 30 years, I would say more than half of those years were "boring years" (1993 to 1997, mid 2003 - mid 2007, 2012-2019), where realized volatility was much less than what you saw in 2020 to 2022.  

If you look at what years were volatile, it basically comes down to 2 types of regimes:  bubbles and bear markets.   2020 and 2021 were a combination of a panic + bubble market, and 2022 was the popping of a huge bubble, which is always the most volatile (eg. 2001, 2008).  I still believe its a bear market, so this interlude of calm shouldn't fool anyone to thinking that the worst is over.  We're just going from a panic phase from a combination of a huge bubble popping and a big decline in bond prices last year, so any kind of stabilization on both fronts will be viewed positively.  This grace period for the stock market should not be misconstrued as a resumption of the bull market.  Systematic funds reallocating to both stocks and bonds is not a long term bull market driver.  Bull markets don't have much fuel when they are at these kind of lofty valuations, with the Fed still trying to fight inflation with Fed Funds 500 bps higher than a year ago.  If it is the start of a new bull market, then I will have to go back to the drawing board to figure out what's changed in current markets that make it so different from past markets.  

The economic fundamentals are weakening, and the soft data is clearly showing this, and the hard data is close to showing this.  There are leading signs of weakness in the labor market such as lower working hours, weakness in temporary work, which leads nonfarm payroll weakness.  Also the weakness in commodities is a lead on producer prices, which leads consumer prices.  It was just a month ago that OPEC announced a supply cut and crude went from 75 to over 80, and last week it filled that gap and crude has been trading weak relative to the SPX for the past 2 weeks.  

Counterintuitively, this coming economic weakness should be just weak enough to get the Fed to stop hikes after May, but not so weak that it worries equity investors into thinking that there is going to be an imminent hard landing.  A poor man's Goldilocks, if you will. 

One thing that gives me pause about shorting right here is that the price action is just too strong given the skepticism I see among the investing public out there, and we've still not gotten any "good" news that get bears throwing in the towel and bulls getting excited.  Recession seems to be the base case now for the majority of the analysts and fund managers I see on TV.  Sure, we had some tech earnings beats but they didn't really excite the bulls or scare the bears.  

You are going to need to see investors get more confident that Powell is done with rate hikes.  Although I don't think he will sound hawkish at this coming FOMC meeting, I also don't think he will be going out of his way to forward guide the market towards a potential easing by signaling a pause.  While I doubt he says that more tightening is necessary, he will definitely leave things open ended to keep the market on its toes and not get too comfortable by pricing the end of the rate hiking cycle.  So I don't think it will be the FOMC that ignites the last leg of this bear market rally. 

What probably needs to happen for the bulls to get excited and the bears to throw in the towel are both technical and fundamental.  Technically, you will need to see the SPX break out above 4200 to stop out the fundamental bears, who are right, but close to their uncle point.  Next, you need some fundamental news to create the reasoning for that kind of move.  My best guess is a softer employment report (somewhere between 50K-130K jobs?) and a weaker than expected CPI number in May would do the job, and take the SPX above 4200.  That would make bears nervous, and bulls feeling invincible, and comfortable knowing that Powell is done with hikes.  That's the point where you want to feed the ducks while they're quacking.  With where the VIX is now, SPX puts will be very attractive to own into coming economic weakness.

Why would I still be bearish when the Fed is done hiking?  Well, its the credit contractions that you will start seeing in the coming months that will slowly suck the oxygen out of the economy.  Its not a flashy bank contagion situation that's going to take this market down.  It will be from an old fashioned credit contraction led by banks reducing lending which feeds into more job cuts and less consumption, leading to recession.  It won't happen in a flash, but it will slowly build momentum and by Q4 this year, it should be a freight train of weakness and negative feedback loops.  Not much to do now, but wait for a fat pitch which I think is coming in the next 2 weeks.