Waiting for Bulls to Overplay It

Stocks often enter a bear market during recessions not only due to earnings going down, its because valuations are usually high going into one.  They say valuations aren’t a good timing tool.  I would disagree.  If you are timing an entry point for weekly options, yes they are a bad timing tool.  If you are trying to set up a long term allocation for stocks, they are a great timing tool.  And most investors would care much more about the latter than the former.  Its unusual to see such strength here when valuations are this high with competing assets like corporate bonds providing a higher yield than the free cash flow yield on the SPX. 

The forward P/E for the S&P 500 is now higher than all periods over the past 25 years except the bubble period of late 90s/early 00s and late 2020 to early 2022.  Those periods were a bubble for a reason:  earnings were growing at a high rate, unlike now.  

We live in extraordinary times.  It is not normal for stocks to rally so much and get so expensive when earnings are expected to show little to no growth, and as the Fed is tightening monetary policy.  These are the type of markets that make impatient investors give up on fundamental analysis and just become chart jockeys following price and momentum.  This market is making a mockery of stock market history.  The extreme divergence among the large and small cap stocks are luring the fundamentalists into buying the laggards because they look cheap relative to the market.  Only to likely see the laggards get crushed alongside the leaders when the correction arrives.  

If there is one thing I’ve learned from the new market dominated by passive index ETF flows, divergences last for a long, long time.  Big tech outperformance lasted for 13 years from 2008 to 2021.  Big tech was always more expensive relative to value stocks, and remained that way.  Only in 2022 did some mean reversion happen, and in 2023, that mean reversion has been completely reversed and then some. 

Its been a long term loser trying to be the wise guy who thinks he can just look at relative value, or play out their macro views to make money buying certain stocks and shorting others.  It gives hedge funds an excuse to collect 2 & 20 despite having no alpha, although it sounds great during a Power Point presentation to prospective clients.  The very fact that so much money is allocated to hedge funds is itself evidence that most asset allocators don’t understand the market and are overflowing with hubris despite underperforming a 60/40 portfolio almost every year since their existence.  Really, the most alpha seems to come from playing for unwinds of crowded hedge fund trades.  There is one thing that's a near certainty:  hedge funds have a low pain threshold.  When hedge funds are caught off sides and all on one side of the boat, it doesn’t take much for the market to go the other way and make them run for cover.  

The road to profitability lies in realizing that most of the time, there are no trading opportunities.  (This applies for trading big markets like equity index, bonds, commodities, FX, and big cap stocks)  The only consistent source of short term trading alpha is from fading retail traders, which means you have to play the short side of speculative small cap stocks that are flavors of the week/month.  And even that space is getting crowded as the number of retail short sellers has grown by huge amounts since 2020.  So you get occasional insane short squeezes that take away several months of profits in a day. 

Year to date, in a market that doesn’t really fit my style, I’m glad I haven’t gotten buried.  I would have never guessed such a strong rally would happen with the Fed just marching along with rate hikes beyond 5% with total oblivion.  Especially at these high valuations.  This market makes very little sense here.  It looks like an accident waiting to happen.  But instinct and intuition kept me from aggressively shorting the markets in May and early June.  I know from gut feel that its usually a bad time to short when you have investors worried about nothing burgers (debt ceiling, massive T-bill issuance to refill TGA).  And then it looked like a real possibility that there could be a call frenzy in the 2 weeks ahead of June triple witching opex, which felt like a perfect storm for early bears who were set up to get delta squeezed during opex week.

 

I feel no envy seeing longs making money in this strange market while I’m losing a bit here and there.  I don’t feel FOMO relative to others.  I feel FOMO relative to opportunities that I see.   My opportunity set will be a tiny subset of all the opportunities out there in the market.  The goal is to keep increasing my knowledge base and edge in the markets to be able to recognize more good opportunities than I did in the past.  So far this year, the opportunities have been few and far between.  But with the big rally and the optimistic mood change on the economy, I am starting to see setups that could arrive in July.  The potential energy is building, and while some of that was released over the past week, there is a lot left to get unleashed.  Coiled spring/ticking time bomb type of market here. 

Its been 6 trading days since the top on June 16, triple witching expiration.  Its been quite a low volatility move lower, and there's been no fear on this move down.  It means that if there is a bounce, it likely won't be a strong one that takes us back to the highs.  I covered the remaining shorts on Friday and Monday, and am looking to reload shorts at a later date.  Playing hit and run.  For singles and doubles.  

 

With these sharp moves higher, you usually get a consolidation for a few weeks to digest the move and for investors to get used to these higher prices.  There is a sticker shock element to stocks as well.  After a few weeks, that fades away and gives room for the market to make another push higher towards new highs.  Its at that point where I will be watching closely at the Russell 2000 and Eurostoxx to see how they perform relative to the SPX.  If we see a resumption of relative weakness for the Russell and for Eurostoxx, that's going to be a green light to load up for a more aggressive short trade for July and August.  Watching and waiting for the bulls to overplay their hand.