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.