Government Fueled Bull Market

Those who still think its a bear market are not facing up to reality.  You can hate on this rally because its based on multiple expansion and AI hype, but you can't deny it.  I've been skeptical of the stock market and have been wrong.  I've underestimated the risk appetite of investors, who's default move is to buy US stocks when nothing bad happens.  And I took my eye off the US government largesse, which is the gift that keeps on giving. 

When the US government keeps pumping so much money into the economy via $2 Trillion budget deficits, 8% of GDP, a lot of that liquidity ends up in the stock market.  All that interest that the government is paying out with higher rates is going straight to the rich.  They were comfortable holding all that cash when the stock market looked shaky, but now that you are back in a strong uptrend, FOMO takes over, and they are diving back into risk assets.

Also, don't forget the big COLA adjustments at the beginning of the year which boosted Social Security payments by almost 10% vs. 2022.  And with so many baby boomers entering retirement age and starting to collect Social Security, that will just serve to blow out the budget deficit even more. 

In a perverse way, the Fed rate hiking cycle has expanded the US budget deficit, providing even more cash to the rich at the expense of those who need to borrow.  In the long term, when the government debt to GDP ratio is so high, you can't solve an inflation problem by raising rates.  You need the government to spend less money and/or raise taxes.  Those are not happening anytime soon.  So the path of least resistance is higher financial assets and real estate prices. That's not likely to end until you get a huge bout of stagflation that shakes the masses into demanding changes and less fiscal profligacy.  Not going to happen for several years, if ever.  Populism is here to stay.  The US is well on its way to being the rich man's Argentina.  The US dollar will be the sacrificial lamb during this process which will happen over several years.  I expect the recent dollar weakness to continue as the Fed probably only has 1 or 2 more hikes left before it goes on cruise control.  

The FX market is also about supply and demand.  The US, more than the Eurozone, and China/Asia, has the biggest budget deficits as a percentage of GDP and thus need to issue the most debt.  While you would think that a Fed that is doing QT would shrink the excess liquidity provided by that debt, you cannot ignore the repo effect of those holding Treasuries, who use them as collateral to buy stocks and other risk assets.  So while there is no net cash being issued with these giant budget deficits, there is so much Treasury supply that is being used as effectively cash in the investing world that big budget deficits are in effect the government printing money to spend beyond tax receipts.  That is stimulation for the overall economy even with QT, as long as bank lending doesn't go into contraction.  But we're getting close to that point where banks are cutting back on so much credit that we could still see a recession despite the insane levels of deficit spending into a strong labor market.  Its still probably at least another 6 months before you see notable signs of economic weakness. 

Even as recently as 2 months ago, there was still some uncertainty about whether the bear market was over or not.  That uncertainty kept a lot of investors holding cash, waiting to buy stocks later at lower prices.  That never happened.  Instead, those holding cash have been left in the dust as the SPX/Nasdaq powers higher.  Remember when the majority of those coming out on CNBC and Bloomberg in March/April were touting cash earning 5% like it was the greatest thing on earth?  Well, you don't hear that line much anymore.  

You don't get this kind of price action in a bear market.  You don't get a 28% rally over 9 months, with the 200 day moving average going back to an upward slope, in a bear market.  The 2022 down trending market is over. 

Since this is a bull market, you have to play by bull market rules.  They are different than bear market rules.  At the most basic level, the market will be much more forgiving of buys than sells.  The market will give you a lot more time to sell the highs and a lot less time to buy the lows.  You will linger near the highs, not just stay there for a brief period like in 2022.  Remember those rallies in March 2022, July/Aug 2022, and Jan/Feb 2023?  The market didn't stay at the highs for long, before selling off again.  The market has changed.  That's the first step to making better decisions for the remainder of 2023.  

In a bull market, the downtrends are there to shake out the late comer bulls, to get the crowd scared.  They are brief, sharp, and a bit scary.  While I believe we are due for one of those downtrends in the next 2 months, I am not expecting it to last more than 3 or 4 weeks.  The days of the extended downtrends are behind us.  If I would have to make a comparison to the current market, it feels a bit like 2019, although not as bullish.  In 2019, you had a very strong bond market, with yields trending lower, and the global economy was doing better than it is now.  So my base case is a less bullish 2019 type of market.  

SPX 2019

SPX 2023 YTD

In 2019, you had a sharp 4 month rally off the December 2018 panic low, making a local high in late April.  That was followed by a very extended 1 month selloff in May.  And then you had a choppy uptrending market from June to October, until the rally went vertical again in November to close the year with a very big gain.  

While I eventually expect even higher highs, and a revisit of the SPX 4800 level this year, I don't expect that to happen until you get to Q4.  The stock market has a tendency to consolidate such sharp gains before resuming an uptrend, especially when these rallies happen during the summer.  August and September are relatively weak months for the SPX, so the seasonal patterns line up just as we have a very overbought market.  This is about as good of a short setup that you will get in a bull market.  While I don't have full position on right now, if we get one more rally after FOMC today and into Thursday, I will probably add some more shorts to get to a full position to ride out into August.  

The sharp move higher off of the 4390 low on July 10 looked like a good time to put on shorts, but this market has retraced only a small portion of that rally, showing immense strength.  I was expecting a bit more weakness off such a parabolic move higher going into MSFT and GOOG earnings on Tuesday, FOMC meeting today, and ECB on Thursday.  This market continues to surprise to the upside.  Perhaps we'll get one last its all clear rally after the Fed hikes 25 bps and ECB does the same.  If that were to happen, you probably get the SPX to break above 4600 later this week, which would have seemed preposterous just 2 months ago.  

Still not seeing enough weakness in Russell 2000 for my liking, but Eurostoxx and Dax are trading much weaker than the SPX.  If the Russell 2000 fails to keep up with the SPX in the coming days, that will increase my conviction on shorts.  I am seeing some early signs of less risk appetite among the big cap speculative stocks, but need to see more to go fully short. 

Feeling the Squeeze

Tops are difficult to time.  Unlike bottoms, the market often has a tendency to linger near the highs, rather than make a blowoff top going down sharply afterwards.  Just looking at past tops, you often trade 2-3 weeks near the highs before you get that meaningful correction.  That's time that puts doubt into those who sell, time for put options to decay in value, and also time for short sellers to throw in the towel (saw a lot of that last week and some this week).  

The rally off the March low has had 3 phases:  

1.  Mid March to end of March: sharp rebound off the panic low on the so-called banking crisis. 

2.  Early April to end of May:  consolidation of gains into a narrow range between 4050 to 4200.  

3.  Early June to now:  explosive, steep rally off the 2 month consolidation.  

The rally appeared close to its exhaustion point when I saw the research notes about hedge funds covering index shorts en masse last week.  But its gathered even more steam off these already very overbought levels, much of it from underinvested investors who have to keep up with the averages.  The buying has fed on itself as this is monthly opex week, which can cause extreme gamma squeezes.  That should be over by Friday, and we should see a pullback off this parabolic move higher.  I am not expecting a big move lower right away, the first pullback is often bought, but the next rally off that pullback should be relatively weak, as we are already at nosebleed levels, and heading towards a less favorable seasonal period starting in late July.  

It has been over 4 months since the panic low in March on the SIVB bank run.  We have not had a meaningful correction of 5+% during that time, even though the SPX has gone up 20% over that time period.  That's a huge move.  From looking at the past, these strong rallies usually starting selling off into a meaningful correction (over 5% down) 4-5 months from the bottom.  That would put the timeline somewhere from mid July to mid August for the start of this correction.  

This rally has been odd.  Usually you get those big moves when the market is front running a rebound in the economy, often due to Fed easing.  But this time around, its purely underinvested investors who are moving some of their cash into stocks to balance their portfolio.  In a perverse way, the gobs of interest income created by these Fed rate hikes towards RRP and T-Bill buyers is slowly funneling back into the stock market, as soft landing optimism grows, not because leading indicators are suddenly turning strongly.  Its because things aren't getting weaker than expectations.  So while the Fed rate hikes will slow down business investment and credit creation, its not slowing down FOMO from cash to stocks.  

Only when you see notable signs of economic weakness in the form of job losses and weak NFP reports will you slow down this flow from cash to stocks.  At over 5% Fed funds rates and rising, with inflation now much lower than the rate at which businesses can borrow, it doesn't make much sense for businesses to make investments by tapping into credit lines or new loans.  And banks aren't willing to loan much anyway.  

What the banks taketh away, the goverment giveth.  The big source of liquidity is now the government, as it is going to pump out $2+ trillion more into the economy than it takes in for 2023.  I know trillions are thrown around like its nothing by the US pork machine, but that is a huge driver of liquidity throughout the economy.  $2 Trillion is 8% of US GDP.  It is hard to get a recession when the US government is running an 8% budget deficit when the economy is near full employment.  A lot of that deficit is due to interest payments on the gigantic national debt, but that interest payment is the private sector's interest income.  And the US government has an unlimited ability to issue more debt and rollover existing debt.  And unlike corporate bonds and loans, a lot of Treasuries are used for  collateral via repo, effectively acting as a source of funds for investors.  So even massive Treasury issuance without QE is pumping liquidity via repos into the financial system.  

Back to the current markets.  Its getting hairy out there for the bears.  I thought I waited enough and put shorts close enough to the top, and then it squeezes again.  Its been a brutal run for the short sellers and the skeptics of the US stock market.  There are signs of global weakness and that is being reflected in the very weak Chinese market, as well as a badly lagging European stock market which still can't get close to its June highs, while the SPX is much higher than those June levels.  The European and Asian indices have not participated in the most recent rally as the SPX went from 4500 to 4560.  That is a sign of hope for the bears.  

However from the small cap world, things aren't so great for those looking for an imminent top.  You have the Russell 2000 starting to catch up to the SPX, as its been outperforming for the last several trading days.  From past studies and observations of SPX tops, its usually a lagging Russell 2000 that is a foreshadow of a looming correction.  That's still not happening.  Perhaps the way that the Russell 2000 lagged the SPX and Nasdaq for the first few months of the year, even during a strong rally phase, is a much broader tell on the overall health of this rally.  That was one of the most unusual divergences that you will see coming off a panic low and lots of pessimism.  Usually, the Russell 2000 is keeping up or outperforming the SPX after a big bottom.  Not this year.  

Short entries from Friday, Monday, and Tuesday are mostly underwater.  Its a scary market for short sellers, as the rallies off dips have been fast and furious.  But expecting much of this gamma squeeze to be reversed on Friday monthly opex day.  Surprisingly, the Microsoft Activision merger has been delayed, so that cash is still waiting to enter the market, and we still are getting continued strength.  If we get a pullback by Friday/Monday, I may have to reduce some shorts just to free up dry powder just in case there is a further rally on FOMC next Wednesday and afterwards.  Its hell for the shorts now, but things should look much better in August as I see nothing backing up the sudden optimism on the economy and these sharp rallies are often retraced quickly on the way down. 

Front Running the Acquisition

Its getting close.  With the lower than expected CPI number on Wednesday, we've climbed over the "higher bond yields, lower stocks" wall of worry that lasted all of about 3 trading days!  Of course, after clearing that hurdle, you have higher prices.  

There is one more buy catalyst in the form of a giant, $69 billion all-cash acquisition going through over the weekend, ahead of the Monday open. That is $69 billion of cash handed to Activision shareholders at the open on Monday, a huge chunk which will be immediately re-invested into stocks by passive index funds. 

Of course, the hedge funds won't be letting this go on without doing some front running of buy flows coming from institutions holding Activision, most of whom will immediately put money to work in the stock market next Monday and Tuesday.  With how actively the hedgies front run these big flows (like last month's quarter end bond-stock rebalance), they could pull forward the top towards Friday, even before the acquisition closes. 

You have nirvana for the bulls at the moment:  VIX is going lower, inflation is going down more than expectations, the economy is still resilient, and you have huge acquisition related buy flows in a few trading days.  Last week's mini-scare, where I noticed the chicken littles get beared up because bonds were weak and VIX "spiked" to 17, just reset the meter, delaying the top.  You need complacency and low VIX for the exquisite short setup, not nervousness and Fast Money commentators talking about a pullback. 

There is a small fly in the ointment to this exquisite short setup coming in a few days:  Russell 2000 is outperforming the SPX, and Eurostoxx bounced back strongly in the past few days, also outperforming the SPX.  The risk appetite is still there.  You need to see signs of that fading away before you get that all clear signal to short SPX.  Despite this, if the market keeps rallying into next Monday, it will be so overbought that I will take short positions based purely on price.  But I would not be looking for that long awaited correction until I see the other stock indices show relative weakness to SPX.  However,  we're at levels where you have to have some shorts on just in case of an out of the blue selloff.  Rug pull risk is getting higher and higher, and there is a lot of air underneath.  There isn't much support until you get down towards SPX 4250.  

Probably starting some shorts on SPX and individual names on Friday, with plans on adding more on Monday and Tuesday.  The home run trade is getting closer, but probably will have to wait till August to see that big move lower. 

Fiscal Dominance

The world is becoming less capitalist and more socialist.  That's not a political statement.  Its a purely objective statement based on the ratio of total government debt to GDP for the G20 nations.  When government debt increases as a share of total debt, as well as a share of GDP, its a sign of governments taking more control of the economy to shape it to its desires.  And the desire since 2016, when Trump got elected, followed by Biden in 2020, is to pump up the economy to win votes.  The politicians want to spend more, tax less, and put everything on the Treasury debt plan.  It is popular.  And the politicians know it, which is why they continue with the policy, and went overboard in 2020 and 2021.  It looked innocuous at first, but the government's footprint on the economy has gotten so big that it can no longer be ignored.  But oddly, despite growing into being the elephant in the room, its being ignored in the economic analysis of the macro pundits.   

The biggest error that I see among the macro pundits on the Street is they overestimate the effect of monetary policy and underestimate the effect of fiscal policy.  From 2008 to 2012, the Fed maintained ZIRP and did 3 rounds of QE, and it didn't do much for the US or global economy.  Sure, you had some credit contraction from the aftermath of the GFC, but monetary policy was very stimulative in the US and Europe.  And economic growth was anemic.  The reason?  Fiscal policy was not expansive enough, considering how weak the economy was.  Fast forward to 2020 and 2021.  This time around, fiscal policy went full bazooka mode.  $5 trillion of fiscal stimulus.  Most of it just pure handouts to the population in the form of PPP, stimulus checks, child tax credits, clean energy subsidies, and other random pork thrown everywhere.  It was a giant money spew.  Much of it sent to people who were going to spend the money, not buy more stocks and bonds.  And you get a totally different result than 2008 to 2012. 

Despite the huge boom in the US economy in 2021 and 2022, the focus of most economists is still squarely on monetary policy, which has been tight for the past 10 months.  Thus, most made the error that the economy would enter recession in 2023.  Yet, it still hasn't happened.  The economists and macro experts forgot about fiscal policy, which was still expansive, as the student loan payments were still suspended, you also had the delayed implementation of infrastructure spending from various pork bills that passed in 2021, which started kicking in this year, as well as the spending caps that were raised by big chunks last fall, for the FY 2023 budget.  Don't forget about the COLA (CPI adjusted) adjustments that boosted Social Security and disability payments for the elderly and handicapped/disabled.  

The huge budget deficits, now on pace for ~$2 trillion for FY 2023, are a giant stimulus for the US economy.  Basically money for nothing.  Yet, I see most economic bears ignore this huge stimulative effect of big budget deficits in their analysis.  Because it doesn't fit into their neat narrative that's based purely on models that focus on leading indicators, PMIs, and other soft data.  But those models have a heavy skew towards monetary policy effects, which are quite restrictive, while mostly ignoring the government's effect on the economy.  Which is only getting bigger and bigger as the government's share of GDP grows.  

In a perverse way, the big rate increases have massively boosted interest income for the wealthy, which is mostly coming from the government, as government debt as % of GDP has grown astronomically over the past 3 years.  That interest is not a zero sum force.  When private borrowers pay interest to private creditors, there is a net zero effect in income.  But when public borrowers (US government) pay interest to private creditors, that is a net positive income stimulus effect for the economy.  That's because the government runs continuous deficits, so debt is just rolled over, and new debt is issued to pay off interest payments, not paid off and eliminated.  

That being said, monetary policy still has an effect on the real economy, but just not as big an effect as people think, due to the lags involved and the vast majority of fixed rate bonds and mortgages set at very low interest rates.  The residential housing market hasn't felt the full force of higher rates, due to all the re-financing that was done when the 30 year was trading sub 2% in 2020.  The most interest rate sensitive part of the economy are those that are dependent on short term variable rate loans, such as commercial housing loans, small business loans, and private credit.  That doesn't show up in the SPX, or even in the Russell 2000, as exchange listed companies have mostly fixed rate debt, and have hardly felt the pressure of higher rates that the private market has.  

And while higher interest rates put pressure on borrowers, it doesn't have a one shot knockout effect like a big uppercut to the jaw.  Its more like low kicks to the opponent's thigh, which has cumulative effects that take their toll over time.  Expansive fiscal policy has ameliorated a lot of the negative credit effects from tighter credit and higher borrowing costs.  But that effect will be lessened with the restart of student loan payments in October, as well as the lack of additional stimulus bills passed in the past 18 months, which will reduce the fiscal impulse at least until the next election in 2024. 

Add to that the lag effect of tighter bank lending conditions and less credit flowing from the banks and you have an overall situation that should skew the economy from being resilient to being vulnerable as the months pass by.  

Macro is hard.  Being dogmatic in this business is the way you underperform and become irrelevant.  I see many who are pessimistic on the economy who can't admit that they were wrong.  Being early in calling for a recession by a month or two is OK, but being early by over 6 months is not OK.  Those who can't admit their mistakes will never learn from them.  I was completely wrong in calling for an economic slowdown in the US in 2023.  It was a consensus view, so there were definitely some losses associated with my call.  It has made me re-think my view of the current US economy.  I didn't consider fiscal policy enough when forming my view on the US economy.  

Haven't thrown in the towel on my pessimistic view, especially considering how much the consensus has shifted from hard landing to soft landing from January to July.  The bond market pricing is much more conducive to making bets on the economy weakening and Fed having to cut than it is to make bets on higher for longer.  As prices have changed, the odds have changed.  They now favor the bears.  

The global economy is noticeably slowing, especially Europe and Asia, yet the ECB remains focused on inflation and not weakening growth, and they are likely to put Europe into a deep recession.  Asian growth is horrible because Chinese growth is horrible.  The Chinese economy is basically real estate, and that looks to be in a long term downtrend due to oversupply, overvaluations, and lack of natural, non speculative demand.  The only way that's fixed is either through housing deflation or massive money printing.  It looks like the Chinese government is leaning towards housing deflation, based on their policy actions to date.  The negative ramifications of spending just to meet GDP targets is something China is now aware of, which makes it less likely they'll repeat another giant stimulus like they did after 2009. Don't expect the Chinese economy to suddenly roar back until they go full bazooka like the US did in 2020/2021.  I wouldn't bet on it happening. 

Still in watch and wait mode, as the pullback in the SPX on bond market weakness is not a great time to short, as I expect bonds to bounce back due to the irrational view that the economy is so strong that yields need to keep going higher.  Russell 2000 has shown relative strength vs. the SPX, so that gives me a bit of pause about entering shorts.  We've got Eurostoxx underperformance. Just need to see Russell 2000 underperformance for the higher probability short setup in SPX.  

Rate Ripples

The bond market scare has come back to visit the stock market.  Thursday saw a mini return of the 2022 dynamic of bond weakness leading to stock weakness.  Its interesting to see the VIX unable to even get to 15 on the 6 day, 120 point pullback from SPX 4448 to 4328, but on a 70 point pullback in 2 days, the VIX pops to above 17.  It appears that the weakness in the bond market is having a bigger effect on the VIX than the SPX.  For the moment, that tells me that vol sellers are pretty close to max saturation on their short positions. 

While I believe the SPX is vulnerable to a correction in the next 2 months, its not because of a strong economy.  That's nonsense.  Yesterday's ADP number and Service PMIs are stop run catalysts, not an indicator of a re-surging economy.  One of the most misunderstood aspect of PMIs is that they are diffusion index vs the prior month, so even if you have a slight bump higher in sentiment among purchasing managers, that can have a big effect on the number.  Magnitude is not measured in that index.  As for the ADP numbers, they have butchered their process for coming up with numbers that try to mimic the nonfarm payroll number, rather than accurately measure labor market changes, which was their original goal.  

No, the economy is not as strong as all these pundits spew on CNBC and Bloomberg.  Yes, the leisure and travel sector is still hot, because there is still pent-up demand for travel for those who canceled plans in 2020 and 2021.  And usually middle to upper class of the economic spectrum are traveling, and they are doing relatively well, due to excess savings, a higher stock market, and more interest income on their cash.  But the propensity to spend the marginal dollar among the rich, who are doing well, is much lower than the poor, who are not doing well.  So once travel season is behind us, there should be a definite slowdown in services spending.  Add the restart of student loan payments in October, which disproportionately affects the groups who have the highest consumption rates, and you have a rude awakening setting up in the fall and winter.  

The financial markets have a much shorter time frame than people think.  Just look at the herky jerky moves on economic data which will have limited influence on what the Fed does in July (25 bps almost guaranteed).  And these data points, especially jobs numbers, are heavily revised.  And lately, revised lower more than revised higher.  And they aren't predicting the future, which is where the edge is.  

So the premise that the economy is so strong that its bad for stocks because the Fed will have to raise more than expected is spurious.  As soon as the panic selling subsides in bonds (could take a few more days), you probably get a reflexive rally in stocks on bonds not going down more. So selloffs based on "strong" economic data and a hawkish Fed just don't have staying power. 

The only true sustained selloff will be when the economy weakens noticeably, affecting corporate profits and leading to more job cuts.  That's when corporations pare back on stock buybacks and the animal spirits in the stock market are stuffed back into a box.  I expect that to start happening in the fall, and increasing in intensity in the winter. 

With 10 year yields back above 4%, all the news lately is about the rise in bond yields, its probably a good time to buy some bonds into the weakness, as I just don't see a sustained economic recovery when banks are tightening credit to this extent and you have small businesses, which have more variable rate exposure, dealing with borrowing rates that are probably close to 10% (SOFR + 4 to 5%).  And that is if they can get loans. The lags are going to work big time over the next 6 months, just as you see renewed optimism on the economy.  

One last thing, Europe and Asia are definitely much weaker than the US, as their governments didn't spew as much money.  About 30% of S&P 500 earnings come from overseas, so you don't need a weak US economy for the stock market to go down.  A weak global economy is enough to pressure SPX earnings, especially if the Fed is still hiking rates.  Although I do expect the US data to come in weaker than expectations starting in the fall.  

Still watching and waiting for the right spot to put on shorts.  I am starting to see negative divergences in the Russell 2000 and the Eurostoxx which are canaries in the coalmine.  All we need to see is the SPX bounce back higher once the bond market settles down.  That probably happens in the next 1-2 weeks.  Hopefully by that time, the SPX will be around 4500 to set up a meaty short opportunity.  Got to be super precise on the short side because the trend is higher, so its easy to get squeezed caught short at a suboptimal price.