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.