Longs Pushing Their Luck

The stock indices are moved by institutions, not retail.  Institutions and retail operate under vastly different conditions.  Retail investors are not competing with others to keep their jobs. Institutional investors are.  In particular, the subset of institutional investors which trade the most, and have the most outsized influence in the short to medium term are hedge funds.  They've been underinvested relative to their benchmarks since early 2022, and while it worked great in 2022, its been a disaster in 2023.  They've been underweight tech stocks for a while now, and they have been scrambling since the debt ceiling deal to increase their overall beta to keep from falling further behind.  

Sure, there is a bit of fundamental basis for their added long exposure, mainly earnings holding up better than expectations so far, and the labor market still appearing strong.  That's caused the crowd to be more confident that the economy won't be as weak in the 2nd half as many feared.  The stock market is no longer afraid of the Fed.  The market is seeing right through their hawkish rhetoric for what it really is:  a bunch of bluster.  You can't talk hawkish on the one hand, and then say you want to see how the economy reacts to the lagged effect of rate hikes by pausing.  The whole skip talk is another way of trying to manage market expectations, trying to keep the market from pricing in rate cuts. 

Some of the worries going into 2023:   

1) Sticky inflation forcing the Fed to aggressively hike rates

2) An imminent recession in 2023 due to the rapid rate increases and the above mentioned sticky inflation keeping the Fed hiking in big chunks.  

3) Earnings coming in weak because of the factors mentioned above.  

All 3 have not come to fruition so far, which is main reason that the SPX has gone from the 3800s to the 4200s in less than 6 months.  But there is a difference between not and not yet.  A recession has not come yet.  Earnings have not gone down yet.  With the lagged effect of rate hikes and bank credit tightening showing up more and more as the year goes on, 2 of the 3 worries mentioned above have merely been delayed, not eliminated.  Those worries should resurface in Q3 as tighter credit slows down the economy, along with the restart of student loan payments in September.  Also, a lot of those severance packages that white collar workers received late last year, early this year will be running out and that will force some in the upper middle class to reduce spending to match their reduced income.  

High frequency transaction data from credit/debit cards and ACH transfers show a notable slowdown over the past 2 months.  Recent earnings conference calls at retailers and consumer facing businesses have noted the spending slowdown.  It appears the excess savings are mostly used up for the bottom 80%.  The stock market is telling you a similar story, as the SPX and the NDX are masking the weak performance of economically sensitive sectors heavily represented in the Russell 2000.  

In the past 2 months, the stock market has climbed the wall of worry about a regional banking crisis, the debt ceiling, and now the huge T-bill issuance that is supposed to be a liquidity drainer that will torpedo this stock market.  I'm skeptical about T-bills doing anything bad for the stock market.  Replacing RRP funds with T-bills is replacing one cash equivalent with another.  No one was buying stocks because there weren't enough T-bills to buy.  There isn't a shortage of cash in the financial system.  There is a growing shortage of dumb money leaving large cash balances at the banks collecting near zero interest.  That's a much bigger worry than a bunch of T-bills flooding the market.  

Once the worries over the TGA being refilled and the T-bills being issued die down, hopefully the bears will capitulate, and the last wave of chicken little bulls come in to put in one last rally into the market to provide a selling opportunity.  The exceedingly low put call ratios and the heavy volume in megacap tech calls are clear signs that the animal spirits are back, and they aren't backed by fundamentals, just AI hype and soft landing hopes.  

I have refrained from putting on index short positions for several months, mainly to avoid these grind higher rallies that we've seen.  But the risk/reward has changed drastically not only because of higher prices, but also because of the deteriorating economic conditions that are not getting much attention.  As for options flows, June triple witching opex is coming up on June 16.  There is huge futures and options open interest on that expiration.  As we get closer to that date, negative deltas will melt away and expire (puts),, and lots of call deltas will get closer to 1, forcing more dealer buying of hedges.  Most of the dealer position squaring should be complete by early next week, right ahead of the FOMC meeting on June 14.  Its almost time to put on those SPX and NDX shorts.