Cruising for a Bruising

The stock market is doing its own thing, and fundamentals don't matter.  They say that the stock market is valued on the future discounted cash flows of all the public companies combined, but more often than not, its values fluctuate on short term positioning changes based on economic data, volatility, and recent earnings announcements.  There is no rhyme or reason for the price action from a purely fundamental view point.  Earnings haven't kept up with the rise in the SPX, so this rally seems based on renewed hopes for strong earnings for the 2nd half and a soft landing, or a delayed landing.  Or maybe its just investors chasing the market to keep up with the averages and not fall further behind.  

Its not easy to predict irrational confidence coming from stock investors, although there were signs in April and much of May before the debt ceiling deal that there was some hesitancy and leftover bearishness from the regional banking "crisis" in March. Overcoming those hurdles = higher prices.  With the removal of the wall of worry (banks, debt ceiling, etc.), you have discretionary and systematic hedge fund positioning back to Q1 2022 levels. 

Now that bulls no longer fear a banking crisis, and most do not fear the Fed (although short term bond investors seem to), they have been adding net exposure to levels that are the highest since early 2022.   Still lower than the bubble times from late 2020 into early 2022, which was an exceptional period of unfettered speculation by both retail and institutions, but no longer can you say asset managers are underweight.  In particular, they are longer NDX futures than even the bubble times in 2021.

SPX Futures Asset Manager Net Position

NDX Futures Asset Manager Net Position

With hedge funds and asset managers back to above average levels of net equity exposure, it will require continued resiliency in the economy and a delay of the recession as well as low volatility to meaningfully increase buy flows from here.  That is a high bar to jump over as all the data seems to be turning weaker (except jobs).  And the labor market is usually the last domino to fall before a recession is recognized by the public.  And jobless claims came in higher than expectations last week, as well as Canada surprising the market with job losses in their employment report.  So job losses don't seem to be too far behind here.  

The current positioning is not extreme, but you only get extreme bullish positioning when fundamentals are positive from both a forward-looking earnings basis and from a monetary policy perspective.  You have neither right now.  And you have high valuations, which matters, no matter how little the markets seems to care.  It is lot to ask to expect even dumber money to come in and pay up more than current prices without a significant change higher to earnings expectations, or a sudden shift to a Fed looking to cut before a lot of economic weakness.  Those buying now are looking to sell to greater fools or expecting a sudden change in the Fed reaction function.  Those are low probability bets. 

To add to the bearish mix, the central banks are still hiking as if the economy is fine and inflation is still a big problem.  Australia and Canada "surprised" markets with 25 bps hikes, and that has spooked the front end of the yield curve.  It almost feels like an echo of the early March period when the economy was resilient and the central banks were hawkish beyond belief, and the yield curve was bear flattening expecting a lot of future hikes. 

But unlike early March, the real economy is now weaker, more time has passed since credit really got tight, and the equity positioning is now much more bullish.  Add to that the low VIX, and you have a good setup to buy puts for the first time since early 2020.  I usually don't recommend put options for making a bearish bet, due to time decay, but with the bombed out VIX and recent SPX rally, they are cheap.  The VIX is totally mispriced here.  They are being priced off the recent low realized vol, not on the potential vol that could happen when the economy enters a recession and earnings forecasts get revised lower.  As most forward looking indicators point to.

Stocks are priced for earnings to be steady to higher, with very rich valuations for such an adverse monetary policy environment.  You have an economy that is slowing even before the lagged effects of rate hikes and credit tightening have fully been absorbed into the system.  SPX components have a big chunk of their earnings coming from overseas.  And the economies in Europe and Asia are doing worse than the US, and are also dealing with higher rates and tighter credit.  This is a synchronized global slowdown happening, with stubbornly hawkish central banks, yet the stock markets are looking beyond the leading indicators, focusing on the strong labor market.  

This week, the final bit of the wall worry should be climbed after the FOMC meeting this Wednesday, where many are expecting a hawkish pause.  I doubt you get anything from this week's meeting that will scare any bulls.  A hawkish pause is like jumbo shrimp.  Its an oxymoron.  I guess Powell could outright say that he's going to hike again, but that's not his style.  He'll usually be mealy mouth, and say the same crap such as data dependent, inflation is still above target, etc.  Cookie cutter comments that he uses at every meeting.  And I expect the market to have a small rally on that.  The positioning is no longer conducive anymore to big rallies, unless you've had a big dip.  So from here, I could see a bit more of a grind higher this week, before you start seeing some volatility and more 2 way trade later this month. 

The central bankers are like misguided cruise ships that keep going in one direction, and only after they hit an iceberg, and after doing a lot of damage, they realize they went too far, and then turn around and go in the opposite direction until they hit an iceberg again a few years later.  I have a feeling that they are approaching an iceberg at high speed and are irrationally confident that they can cruise along with only "mild" bumps along the way.  

With some ridiculous moves in stocks like TSLA, I am dusting off the bear suit to put on this week.  The rise in speculation in the market recently is setting off alarm bells.  The call volume has been quite elevated.  The put/call ratios have stayed low.  All while the fundamentals are getting worse.  Its been a while since I've seen such a bearish setup.  This is giving off some summer 2007 vibes.  I don't expect any fireworks for the next few weeks, but do expect a dip down towards 4150-4200 later this month that will likely be bought.  But that dip will be an omen for future high volatility later in the summer.  Tops are a process, so I would not be surprised to see SPX trade mostly between 4150 to 4350 for June and July, lulling the bulls into complacency.  Then you could see a  waterfall decline in August or September, as jobs numbers finally start to weaken amidst tight monetary conditions and recession worries come back with vengeance.  Remember, the only way Powell will react with what the market wants, rate cuts, is if the stock market goes down hard.  That is the irony of the current environment, as the longer the SPX stays above 4000, the more likely money stays tight and the more likely you get a bad outcome.  

CPI is Tuesday, and based on how the bond market is positioned, its more likely to be a bull catalyst than a bear catalyst.  Same goes for the FOMC meeting.  So its probably best to wait till after the CPI and FOMC results come out before initiating any new short positions.  This is triple witching opex week, so odds are high that you get a climax top before a tradable down move.