The Other Side of the V

This is not the side that the shorts want to be in.  The other side of the valley.  You can't be greedy when you are shorting the SPX.  It is a monster.  The 2nd half of 2022 was bear bait.  It sucked in the doom and gloom crowd and gave them hope that their long awaited stock market crash was going to happen.  Its done the opposite.  Ever since the regional banking "crisis", its been one huge short squeeze and a chase for performance.  

I got sucked into the banking "crisis" hype in the spring and bought Treasuries, awaiting more regional banks to go under and yields to go lower.  It was a bit painful but I took the loss and moved on.  If you don't take the bitter pills that the market gives out, the market will change them from bitter pills to cyanide pills.  You've got to be a graceful loser in this game to survive.  If you survive long enough, you give yourself a chance to learn.  Our reptile brain psychology isn't developed for investing/trading.  That's why experience is so important to avoid past mistakes.  And to show that primal instincts are counterproductive for trading.  It's one long game so having a losing day/week/month/year doesn't matter.  Its being able to stay in the game that's the most important.

The stock market has done it again.  It has once again stopped the bears right before they were about to celebrate.  Listening to CNBC, Bloomberg, and reading the WSJ, etc.  the consensus view this month was that the SPX would need to test 4200 support by September, before it could resume the uptrend.  It was a bit puzzling to me, as the SPX wasn't even able to get close to 4300 support, much less 4200.  People were looking for a big move when the market was making small moves.  The VIX during this downtrend never got above 20.  It even struggled to stay above 17 for most of August.  The realized vol was meager.  The moves had no energy.  The only way you are going to generate selling is to scare out the longs.  0.5-1% down days just aren't that scary.   And most of the down days in August were in that range.  The most the market went down was 1.4% in early August just as the selloff got started.  After that, most of the down days were less than 1%.  As much as the crowd was ready for a "healthy" correction, the market just refused to give it.  Even my original target of 4300 seemed too ambitious as I saw the selling peter out.  I had to abandon ship on the short side above my target levels before the bulls chased me away.  

When you are shorting a bull market, you not only need to have a price stop but also a time stop.  Once the correction starts, the bears are on the clock and they need to go to work fast.  Most bull markets have brief corrections, normally lasting 1-3 weeks.  but if they do get extended, they last at most 20 trading days.  As of Friday, August 25, we were on trading day 19 of the selloff that started on August 2.  The bears ran out of time, and they didn't do much damage during that time.  Despite my great expectations for an August correction, it was a mediocre selloff and a bit disappointing.  But you have to take what the market gives you, just staying around hoping for sellers to appear because it didn't reach your target is asking for trouble.  In the end, August has proved that the easier side to make money for the rest of 2023 is actually on the long side, not the short side.  

In addition to not being able to cover around 4300-4325 as originally planned, I missed the long entry that I was looking for at those levels.  Strong markets don't give you the price that you want to buy at, and spend very little time at the lows.  You can say that the economy is slowing and the lag effect of rate hikes will eventually bite, but the stock market is brushing off those economic concerns, reminding us that the stock market =/= the economy.  

Of all things, it was a weak JOLTs report that ignited another leg higher in stocks, and squeezed bonds higher.  It could be that the market is sensing that the economy is slowing enough to keep the Fed on the sidelines but strong enough to keep corporate earnings growing with no recession.  In other words, the Goldilocks/soft landing scenario.  Anytime the economy slows down, it can either halt the slow down and maintain lower growth or accelerate the slow down and enter a recession.  In either case, the slow down can be initially interpreted as Goldilocks because the future path is uncertain.  But when stocks are going up, the optimistic view is much more likely to take hold.  That appears to be what is going on at the moment.  And likely to continue for the rest of the year.  Sure you have the restart of student loan repayments, but you also have loads of pork projects and government spending from the infrastructure bill, CHIPs act, inflation reduction act, etc. coming down the pike.  Fiscal spending is not going away, no matter how high interest rates are.  That fiscal largesse can go a long way towards staving off a recession that many people are forecasting for 2024/2025.  And don't forget all that interest income that is being shoveled towards the rich, as cash is yielding over 5%, and most of that is coming straight from the government.

I am not an optimist on the economy, but neither are most macro pundits at this moment. It is clear that China is very weak, and Europe also rapidly weakening.  Everyone knows that.  Yet the European markets hold up well, and the SPX mostly seems unaffected, as it is trading near the highs of June, which is less than 3% away from YTD highs.  I see the high put/call ratios for this month, the drop in bullish sentiment in the investor surveys, and the seasonality bears, those who think that Septembers are usually bad for the market.  It looks like a setup to squeeze shorts into September triple witching opex.  I missed the long, and I'm definitely not shorting this bounce here.  Around SPX 4500, the risk/reward for shorts or longs isn't compelling.  If I had to choose a side, I would be long for the next 2 weeks.  Its looking like it will be an uneventful week and probably nothing to do until you get closer to September triple witching.  If SPX gets back towards 4600 by mid September, I am willing to try another short, although with less size than last time.  

For bonds, its looking likely it will trade in a tight range from 4% 10 yr to 4.4% 10 yr.  Not much opportunity in that market.  What could have been a nice setup for longs into a capitulation never happened, and the bond market just doesn't have the strength to keep going up without a much weaker stock market.  I think the US economy will hold up for the next 6 months, so I don't see any catalyst for a big move higher in bonds. 

On Seasonality, Analyst Calls, and Jackson Hole

If everyone is afraid of a weak September, wouldn't they be looking to sell in August and/or wait to buy after September?  There is a lot of talk about seasonal weakness in September/October these days.  It seems the pros are reluctant to get really long ahead of September.  Of course, you didn't hear much about that in late July when the SPX was hovering around 4600.  It just goes to show you how unimportant fundamentals are for short term/intermediate term moves in SPX.  Seasonality should be meaningless if the stock market was efficiently priced.  But its not, maybe it has to do with days getting shorter and less sunlight which makes people less optimistic.  Who knows for sure.  But past data has shown that the SPX performs the worst in September.  I wouldn't hold my breath hoping for that to happen this time around.  The market seems to have pulled forward that September weakness into August. 

Aside from seasonality, the focus these days seems to be on two things:  China and bond yields.  While Chinese stocks and Treasury bonds have performed poorly lately, I sense that people are much more pessimistic on Chinese stocks than they are on Treasury bonds.  It almost feels like spring of this year in natural gas.  Or spring 2020 in crude oil.  Once something goes down so much, people are naturally attracted to buying that dip, viewing it as a once in a liftetime opportunity.  For crude oil, it was, but the contango was so steep that most of those dip buyers didn't make any money, even when crude rebounded, because most of them got in too early and were getting eaten alive by the super contango when the ETFs would roll futures contracts.  Same went for natural gas.  This time, its Treasury bonds.  While there is no supercontango in Treasury bonds to worry about, the buy the dip mentality is similar.  

I find it interesting that most oil analysts are calling for $90-100 crude oil by year end, yet the biggest driver of crude oil prices, China, is viewed as having a very weak economy with lots of problems in the property sector.  Almost everyone I see on CNBC talk bullish about energy, as one of their favorite sectors.  It doesn't make much sense, unless there is some supply shortage that is going on.  If it is, its one that's being artifically created by Saudi oil cuts, which have a limit, because if they really try to squeeze oil prices higher, they will be getting push back from the US and China.  The last thing China wants to have are high commodity prices along with a weak economy. 

In fixed income, I see most analysts call for 3.5-3.75% 10 year yields by year end.  That analysis is incongruous with the higher calls for crude oil.  HIgher crude oil prices usually will lead to higher bond yields. And no, fixed income analysts are not always calling for lower yields.  In fact, it is usually the opposite, as from 2009 to 2019, they habitually called for higher bond yields, even in an ongoing bond bull market.  And they were almost always wrong. It does give me a pause when I consider buying this dip in Treasuries when I see so many looking to buy that dip, so many looking for lower yields into year end, even in a weak bond market.  Longer term, I agree with their bullishness, as these are decent levels to buy longer dated bonds, but it is not the great short/intermediate term opportunity that some view it as.  And while most are focusing on the long end as being the great buying opportunity, I think its the short to intermediate end of the yield curve which has better value.  In a weakening economy, the short to intermediate term yields go down the most, with long term yields going down the least.  

Suddenly, we are seeing all these articles on China as if the problems suddenly came out of nowhere.  China had the biggest real estate bubble known to mankind from 2000 to 2020!  The Chinese treat empty apartments with no interiors like they are blue chip stocks that should be kept forever.  And it is pervasive.  Almost all the rich in China got that way through real estate.  When that fever breaks, its not a 1 or 2 year downcycle.  It lasts for decades or until the PBOC and the CCP goes full bazooka and pulls out a giant inflationary stimulus package.  If that happens, the yuan has to be sacrificed to save the real estate market.  China can't maintain a strong yuan and a strong real estate market.  Its not a reserve currency like the US, which can get away with fiscal largesse with few repercussions.  If China engages in expansionary fiscal and monetary policy, the currency will be the release valve.  Xi is making the right move, and letting the bubble deflate, while Western economists, all of whom are Keynesians, are hoping for China to do another big stimulus, as they think more cowbell is the solution to all economic problems.  

We have the much awaited Jackson Hole meeting, which is getting extra attention because of the poor performance of Treasuries.  There are talks of a higher r*, which bond investors are afraid of.  It looks like its setting up a sell the rumor, buy the fact setup in bonds around Jackson Hole.  Powell is not the kind of guy who wants to shock and awe the markets.  Last year was an anomaly, because inflation was high.  Its not now.  So I doubt you see a big selloff on Friday.  However, I would much rather buy the dip in stocks than the dip in bonds.  SPX is still in a strong uptrend, and Treasuries are in a strong downtrend.  There is a huge difference between buying short term weakness in a strong market(SPX/Nasdaq) than in a weak market(USTs).  We are late in the selloff so if the bounce fails and it weakens later this week, I will start buying. 

When the SPX gapped down, and rallied into the Friday close, it must have ignited some of the repressed bullish feelings among investors.  I noticed over the past weekend, a very different tone, as people were now looking for a bounce this week, even if just briefly.   You saw a lot of buying in the high beta techs (TSLA, NVDA) on Monday, and Nasdaq outperforming on the day, while Russell 2000 lagged badly.  The Russell 2000 relative strength as a tell on future market direction is usually most effective after an extended rally.   You are looking to see the Russell go down while the SPX rises or goes sideways, as a sign of reduced risk appetite and future SPX weakness.  After a pullback, the Russell 2000 doesn't mean much, because you've already made the move.  The Russell 2000 relative performance is a better gauge of future direction after rallies, not selloffs.  So not much meaning at this point.

I don't see a big edge being short here, but I am still holding some SPX shorts and very little left of individual stock shorts that I'm stubbornly holding out for the price target that I initially looked for.  I'll look to close those out before J-Hole.  Looking at mutual fund and ETF flows, there has been minimal equities selling into this selloff.  We probably need one more move lower to shake out the weak hands and have a more sustainable bounce higher.  If we keep bouncing from here and last Friday was the low, I don't expect that move to have much momentum and it will likely stall out quickly.  Overall, its been a low energy selloff with muted volatility.  Surprised the VIX isn't below 16.  Its been a bit disappointing as a bear, since I had greater expectations of weakness this month.  But you take what you can get on the short side in a bull market.  The selloff probably has at most 1 week left.  So its near closing time for the bears. 

Closing in on the Bottom

The fear is getting palpable.  Its not extreme, but this is the first time since SIVB in March where you have stock investors face some real heat, and they are not used to it.  Or prepared for it.  On Thursday, there were some signs of fear and that we are close to a bottom:  1) Puking out of Treasuries as we broke the Oct. 2022 highs in 10 year yields.  2) Aggressive selling in retail favorite high beta names:  TSLA, PLTR, COIN, etc.  3) Panic selling and stops triggered as BTC nosedived after Thursday's close.  4) 3 straight weak closes in SPX, with that highly touted 4400 support level broken convincingly. 

After covering the short, it will be time to start legging into long positions in SPX/NDX. I expect this market to bottom before Jackson Hole on Fri. August 25, as the weak hands who are underwater after chasing the rally in July will likely want to lighten up into that event.  

Despite the high valuations and weakening economy, the SPX is still the strongest equity market in the world and still in an uptrend, so a V bottom is the most likely scenario once this market finds a floor.  While the fundamentals are not favorable for a long term long, the technical strength for SPX on 3 month timeframe is undeniable.  You don't get these explosive moves higher, going parabolic when you don't have sustained, underlying demand.  The excuse for the coming rally will probably be bond yields that stop going higher amidst a weakening economy that will make investors think Goldilocks and a Fed that is done, not an early sign of an impending recession. 

I expect bonds to find a bottom very soon, but the bounce off that bottom should be fairly weak, as there is still a ton of overhead resistance and underwater longs who will look to sell on rallies.  I don't like to see so many bottom pickers as I have noticed in Twitter.  The fixed income "experts" were mostly calling for 3.50%-3.75% 10 year by year end as recently as last month.  So there hasn't been any washout in that asset class, even with the weakness and horrible price action.  

This correction since the beginning of the month has been a classic example of the downside of trying to be cute with a position.  Those that tried to micro-trade their short position to sidestep a bounce probably never were able to re-enter their short position and ended up with much less profit than if they just held the position to their target price / timeframe when the trade was entered.  I've learned from past mistakes that microtrading a profitable position is usually counterproductive.  

Once we do find a bottom in this correction, the potential upside over the next 3-4 weeks is to 4550-4600.  If I do get long, I would look to exit about 3 weeks after entry.  The thing about trading on the long side is that you can be late on your exits and not be punished.  The window for a graceful exit with longs is always wider than for shorts in a bull market.  My presumption here is that we remain in a bull market.   These are bull market rules.  

We could see some sharp selling today/Monday.  The final stage of a correction is usually the scariest and incites the most fear.  With this 30 point gap down in SPX, we are getting close to support around 4300-4325.  I will be looking to cover all shorts into any intraday weakness today off the gap down. Lastly, while I am still short, I do not recommend shorting any bounces for the next 2 weeks, as you have V bounce risk. 

Dominoes are Lining Up

Its starting to get real out there.  SPX managed just a one day bounce on Monday, and then reverted to steady selling yesterday as the sellers, not the buyers are more eager to transact in this market.  Country Garden is the latest piece of bear bait that is being used as an excuse for the selling, harking back to September 2021, when Evergrande was being used by the media to conjure up some fear.  Unlike September 2021, the Chinese real estate implosion is now more evident and the Ponzi that is Chinese property is finally buckling under the weight of too much debt, and too much household exposure to speculative real estate used as a store of value, not as a place to live.  For the Chinese, the real estate market is like the stock market for Americans.  But the problem with Chinese real estate speculation is that most Chinese keep their real estate investments empty, to preserve its value, so there is no cash flow.  At least with an investment in SPX and Nasdaq, you have positive cash flow via dividends and stock buybacks.  Albeit meager vs the price that you pay to receive those cash flows.

The point of recognition is hitting the Chinese like a ton of ghost city bricks.  The Chinese real estate bubble is bursting and they have no idea how to react.  Other than to cut spending and stop buying apartments.  They are naive investors who have never seen a real estate down cycle.  They have only been able to buy property since the 1990s.  Remember, China is a communist state, they give out 70 year leases on real estate.  Technically, the state still owns all the real estate in the country.  So much of the Chinese economy is built on the property market that the collapse of that bubble will have much bigger ramifications for China than the popping of the internet bubble had on the US in 2001/2002.  Since China is a closed financial economy, this isn't going to have a huge effect on US stocks, but it does hurt the global economy, especially the commodity producers.

I would never short based on China economic fears, so this is just another talking point for the bears, which is irrelevant for my short thesis to work, and doesn't change the destination (SPX 4300).  But it can speed up the process of getting to that destination.  In some ways, it is a red herring for the deflation of the speculative excesses of the AI bubble in June and July.  

This leads me to the reasons for being short (haven't covered, staying short until there is more FUD):

1. Asian and European stocks = kids that get constantly bullied in elementary school / canaries in the coal mine.  These aren't even stage 1 bosses.  They are just run of the mill enemies that go down when you just stomp on their head.  Europe has been lagging the US for a few months now.  Since the SPX got above 4100 in early April, Eurostoxx has been chopping sideways even as the SPX went parabolic in June and July.  

After holding up relatively well vs SPX in early August, Eurostoxx has started to lag again this week.  The Chinese equities have been underperforming this whole time since March and even rate cuts are being ignored as that could barely make the indexes jump for more than a couple of hours on Tuesday.  Relative weakness in Europe/Asia are leading indicators for the US.  A check mark for the bears. 

2.  Bonds are used just as much as a hedge for equities as it is for its fixed cash flows / potential capital appreciation.  In the old days, when US stocks weren't considered the premier asset class around the world, bonds were considered more for their safety and predictable cash flows than for their hedging capabilities when stocks went down.  That changed in 2001 when bonds exploded higher after the internet bubble burst.  People realized that bonds were a positive carry hedge (unlike S&P put options) for protecting against equity market downside.  That negative correlation during stock corrections, and the overall downtrend of yields made bonds more of a hedging instrument than a cash flow instrument.  The belief in bonds as being the ultimate stock market hedge reached a peak in 2020, with 30 year yields getting close to 1%.  That belief has taken a huge hit ever since as investors are realizing that bonds don't always go up when stocks go down.  And bond investors see the reckless politicians increasing spending and not taking in any more revenue, blowing out the US budget deficit to 8-9% of GDP in non-recessionary times.   That could explode to 20-25% of GDP in recessionary conditions!  Argentina type fiscal policy.  Madness.  No wonder bonds can't find a bid. 

In this August SPX pullback, bonds have traded weaker, not stronger.  Normally, you should see the TLT rally while the SPX falls like in March or even like in late June.  That's not happening this time, despite the huge selloff in TLT vs SPY over the past 3 months.  That's another checkmark for the bears.  As an SPX short, you would always rather see a weak bond market than a strong one.  From 2000 to 2020, bond market strength was viewed as a risk off harbinger, a sign of concern among the so-called smart money in the bond market.  That has always been a myth and 2022 proved it in spades that bonds going down is not good for stocks. 

3. SPX: the final boss.  It is the go to asset class for the wealthy, not just in the US, but now worldwide.  Rich people have made the most money investing in US stocks over the last 10, 20, 30, 40 years.  Those memories and that track record are why they piled in this year as soon as they realized that the US economy was doing ok despite 500 bps of hikes.  That is why the P/E ratio is so high for the SPX.  In order to take down the final boss, you need to get through the midget bosses: Hang Seng, Dax, CAC, FTSE, Eurostoxx, etc.  So far this month, we are seeing the final boss show some weakness, not as overt as what you see in other markets, but definitely noteable, especially the relative weakness in Nasdaq and Russell 2000.

The Nasdaq and Russell 2000 relative weakness vs SPX often foreshadow a sharper selloff.  That's because when the highest beta stocks are being sold, that's a sign that investors are saturated in that space and are starting to get defensive.  After a big run higher, that leaves the SPX vulnerable to a wave of selling.  Here is how these corrections usually progress:  initial weakness in Russell 2000/high beta names leads to sector rotation towards defensive stocks, keeping SPX weakness contained.  As the correction develops, further weakness leads to investors selling all stocks, including the defensive stocks, causing the SPX to follow the Russell 2000 lower.  However this time, the defensives have not held up well, mainly due to higher bond yields.  The breadth of the weakness is quite broad, as this pullback, while mild so far, have hurt almost every sector and asset class.  Very little remain unscathed in August.  And slowly but surely, you are seeing the regional banks lagging the overall market again. 

After the relentless, steep rise in June and July, it is natural for those on the sidelines or shorting to want to buy stocks on this dip, seeing it as a buying opportunity in a longer term uptrend.  That is why you've seen muted declines so far, as the dip buyers have come in to provide buying support.  In the market, you have two main types of buyers.  Those that buy on weakness, and those that buy on strength.  Currently, there are dip buyers, but not many strength buyers.  Those who wanted to buy on strength have mostly done so since May.  The strength buyers are already long.  And with each passing day of this pullback, the dip buyers are closer to reaching saturation.  At that point, the market gets notably weaker and in order to entice more buyers, the market has to go down, not up.  It appears we are close to that point.  

Noticing some complacency among investors here.  The consensus seems to be that volatility will be muted, that this pullback is a buying opportunity for a move higher into year end.  Many citing SPX 4400 as a strong support level.  If people are afraid of volatility in September and October, wouldn't they want to sell ahead of September, to get ahead of everyone else?  I hear how all the big boys are on vacation, that the junior crews are manning the commands and are ordered not to do anything rash, keeping volatility low.  Everyone involved in finance looks at the market, whether at work or on vacation.  If the big boys want to sell, they will sell, whether its from the beach or at the office.  Europe may be on a 6 week summer vacation now but that didn't prevent the European market to selloff sharply yesterday at their cash open.  The market will go where it wants to go, whether its the summer or the fall.  

Don't know if/when the big flush out occurs.  The temptation to try to trade this chop is there, but I resist as I don't want to miss the big move lower.  It appears imminent, but have no precise timeline.  Remaining short until I see more volatility and fear.

Retail Saturation

Its been an unconventional rally this year, with the Nasdaq big cap tech names leading the market all year and the Russell 2000 doing nothing until the market exploded higher in June and July, taking everything higher.  In August, its been the biggest winners that have taken the biggest hits, as the tech earnings just weren't good enough to justify further moves higher in the 2 big boys, MSFT and AAPL.  Just looking at the SPX, you would think this is just a healthy correction, a consolidation of the big gains in the previous 2 months.  But if you look at what usually leads a market higher, the high beta mega cap tech stocks, they are trading much weaker than the SPX.  In particular, the 2 giants, MSFT and AAPL.  The 2 highest beta mega cap names, and retail favorites, NVDA and TSLA, have also been relatively weak, even weaker than what their high beta would suggest.  Since we've not yet flushed out the late longs, these are ominous signs for the coming weeks. 

What drives the market higher is greater risk appetite.  But there are limits to risk appetite.  When it gets too high, you get saturation, and that's when the market goes the other way.  You have had high risk appetite for 2 months, and the market is way up on the year, going into a seasonal soft spot for stocks.   Looking at the high beta stocks, you can see that risk appetite is declining much quicker than what the SPX reflects.  This is the first time in 6 months where I see potential for an extended pullback, not the 3-5 day, blink and you missed it type of dips like in April, May, June, and July. In trading, sometimes you just have to trust your gut instincts.  This just feels different than the other dips that we've had over the past 4 months.  

When I see highly speculative retail favorites getting crushed, along with the tech leaders, its a clear sign that the market went too far, got too greedy in the high beta space.  With how overextended these charts are, its going to take both time and price (lower) to get investors to come back and bid up these stocks again.  There is nothing scientific about what's going on.  Its the rhythm of the market as it goes from fear to greed, and back towards fear.  Once you reach a saturation point in investor greed, the sellers are more eager to transact than the buyers.   

You have seen retail investors pile in to calls with reckless abandon, you keep hearing about how big AI will be, you have heard endless talk of a soft landing, you have seen put/call ratios reach the lowest levels since early 2022.  The commitment of traders reports show asset managers continuing to add to their net long exposure in SPX and NDX, which is now at the high end of the 2 year range, with dealers adding shorts, putting their net exposure near the low end of the 2 year range.  These are environments that are like ticking time bombs, waiting for a trigger to explode.  The magnitude of the explosion is usually proportional to the length of time since the last big correction.  Its been almost 5 months since the last time we've had fear in the market, so the explosion is not going to be small, IMO.  

Last year's big worry, inflation and higher interest rates, have gone away.  Inflation is lower, but not interest rates.  The level of real interest rates is what determines how tight monetary policy is.  So as inflation goes lower, real interest rates go higher as Powell sticks with higher for longer for now.  That is not a long term sustainable monetary policy for an economy with a low natural growth rate (low population growth + low/zero productivity growth).  In a low growth world, real interest rates that are positive is sufficiently restrictive to slow down the economy.  Either inflation has to go back up or interest rates have to go back down.  

Over the next 6-9 months, inflation probably doesn't go up or down much from here, so somewhere around 3-3.5%, depending on how much BLS manipulates the CPI.  If the stock market is in an uptrend, and the unemployment rate stays below 4.5%, both of which are likely for the next 6 months, IMO, then Powell will not be cutting rates.  That means real interest rates, which were negative, basically from all of 2008 to 2022, will be over 2% for the next 6-9 months.  That will hurt small businesses and private equity owned businesses that borrow mostly at short term yields, who will have to try to make a return on debt that exceeds 8-12% (SOFR + 3-5%), which is what they will have to borrow at for the foreseeable future.  As a result, it will be mainly small and privately owned businesses who will be feeling the pain over the next several months, not S&P 500 companies.  That is a huge swath of the US economy that will have a big headwind. 

The money flows from the rich towards the SPX/Nasdaq will mask a slowing overall economy and leave passive stock investors vulnerable to a big slowdown in 2024.  Not many businesses will be profitable at 8-12% interest, unless inflation is high.  But I don't see another big inflation wave without another big fiscal stimulus which dumps cash on the masses.  In order to see continued high inflation, corporations and landlords need pricing power.   Since most of the excess savings are gone, its going to be tough to continue to raise prices at the high rates of 2021 and 2022.  For sustained commodity inflation, you will need more than Saudi supply cuts.  You will need China to be booming again, to drive commodity demand and thus higher food and energy prices.  Very unlikely.

Could the next inflation wave come from the gigantic fiscal deficit?  The deficit is huge, but its mostly going to the wealthy in the form of interest payments on the debt, pork to corporate donors, and endless subsidies to clean energy leeches.  Some of it trickles down, but most of it stays in the rich man's economy, which are luxury items/services and financial assets (stocks, bonds, and luxury/cash flow generating real estate).  So even with a deficit of over 8% of GDP, its not that inflationary unless the lower/middle class get a bigger share of that government pie.  It may sound ridiculous now, but it looks like bonds will be a better asset class to invest in than stocks until you get the next big fiscal stimulus which dumps cash on the non-rich.  

I have no idea when that will happen, but its going to either require a Democrat president with both houses controlled by Democrats (very unlikely), or will require a Republican president (about 50% odds).  Republicans are no longer fiscally conservative, they are populist, and they know that spending a lot of money on stimulus to pump up the economy is very popular.  However, Republicans are also political predators, they will not agree to big stimulus if it helps a Democrat in the White House.  That's not how they roll.  Democrats, on the other hand, always welcome big fiscal stimulus.  So counterintuitively, you will need Republicans back in the White House to get another big fiscal stimulus because its very low odds that the Democrats can win the White House and both houses of Congress.  Even just the Senate or House controlled by the Republicans will be enough to keep free spending Democrats under control as Biden (or another Democrat if elected) won't be able to pass those monster spending bills like he did in 2021 or 2022.  With a Republican in the White House, both Democrats and Republicans will support lots of spending and/or tax cuts which could re-ignite inflation to 2022 levels.  

We have CPI on deck today.  No edge in predicting how the numbers will come out, but I sense that most people on the Street are leaning towards a lower than expected inflation number, especially core CPI.  That leaves the market vulnerable to a selloff as it seems like investors have now been conditioned for the market to rally on CPI days.  Remain short individual stocks and SPX.  If we get a mini-flush today or Friday down towards SPX 4400-4420, will look to cover some of the position, to free up dry powder to reshort on a bounce.  Otherwise, just sitting on my hands.

Change in Perception

Its not the news that matters, its the reaction to the news that matters.  This Fitch downgrade of US debt is a nothingburger, and the reasoning for it is ridiculous.  The debt ceiling fight was just a dog and pony show, the US government will always do whatever it takes to keep increasing debt and pay back its debt with……. more debt.  A rolling loan gathers no loss.  The government can always print money to pay back its debt.  So the market shouldn’t be gapping down on this news, but it is.  The market goes where it wants to go, news or no news.  

The US debt downgrade and  BOJ letting yields go higher are sideshows to what’s really going on.  Those don’t have lasting effects on US financial markets.  The move from SPX 3800 to 4600 this year can be explained by the following:  

1) Entering 2023, a recession sometime later this year was consensus, as the big rate hikes and weak leading economc indicators were viewed as guaranteeing a weak economy.  That hasn’t happened.  Unlike past rate hike cycles, you didn’t have so much fixed rate, long term debt as a percentage of total private debt outstanding.  Even as recently as the 2000s, variable rate mortages were quite common in the US.  Now most mortgage debt is fixed rate debt, most re-financed at record low rates in 2020 and 2021.  Corporations also took advantage and issued tons of long term debt in that super low yield environment.  That’s buffered most of the tightening effect of rate hikes, which are mostly affecting small businesses, private equity, and commercial real estate investments on variable rate debt.  That’s not insignificant, but its not the hurricane affecting all borrowers that people were bracing for after all those rate hikes.  

2) Hedge funds, systematic vol control/risk parity funds, and investors in general had low net equity exposure at the beginning of the year.  That was due to both the weakness and higher volatility in stocks and bonds in 2022.  Risk parity got crushed last year.  What do fund managers do when they lose money?  They sell.  With low net exposure, stock market strength and lower volatility was the catalyst for lots of buying, especially after the so-called regional bank crisis turned out to be tempest in a tea cup.

3) FOMO among retail and investors who are back to 2009 to 2021 TINA mode.  With bonds going nowhere due to US economic resilience, stocks are once again viewed as the best of all the asset classes.  It is a rally based on valuation expansion, not earnings expansion.  Perception becoming reality.  But perception changes over time.  Valuations are one of the best long term predictors of forward returns.  This year’s rally based on higher valuations just steals from future returns.

On the psychological/sentimental aspect of the market, we’ve finally got a lot of capitulation among the sellside research community when it comes to the US economy, and by extension, the stock market.  That is the biggest change over the past 2 months from the research reports and pundits that spew the same things over and over again on CNBC.  Earlier in the year, it was cash was king, earning 5% risk free was considered a no brainer vs stocks, and even talks about a banking crisis, debt ceiling angst, T-bill deluge worries, etc.  Now you hear talks of a soft landing, a resilient US economy and a strong consumer.  People are now questioning those who are pessimistic on the economy, with almost everything viewed through an optimistic lens.  Sure, US data has mostly come in better than expectations, but not that much better.   Economy is not doing as great as those on Wall St. would have you believe.  And there is very little talk about the deteriorating European economy, as well as weak growth in Asia.  With all this soft landing talk, economic expectations have been raised, and thus, more room for disappointment in the coming months, as the slow moving effect of tighter bank credit comes to bear, along with the restart of student loan repayments.  

Watching CNBC, Bloomberg, Twitter, and listening to podcasts, the change in tone is noticeable.  From pessimism to optimism over the past 4 months.  Last Thursday when there was that ugly looking reversal from 52 week highs to closing near the lows on BOJ news, people got worried and bearish.  But as soon as the market bounced back on Friday, most people brushed it off and got right back to being bullish.  That quick of a turn from bullish to bearish to bullish was surprising.  In the past, you would see the bearishness linger, but now, after seeing every minor dip bought since mid March, people have been conditioned for full on BTFD mode, and are quick to get bullish.  That is a big change in how investors are viewing this market.   In particular, you have seen a lot of hedge fund short covering and some chunky inflows into equity ETFs since June.  This level of optimism doesn’t match the earnings fundamentals, as you have seen much more mixed reactions to earnings reports this time, compared to 3 months ago, when seemingly all tech post earnings reactions were positive.  

To add to this, bonds are trading weak, and not reacting well when you get risk off days in the stock market.  When bonds aren’t providing a good hedge for equity weakness, that forces more stock selling on down days.  Examples of this include Q4 2018, and all of 2022.  When bonds are not acting well, fund managers have less risk tolerance for stocks.  

As we enter the seasonally weak period of the year, after a near parabolic move higher in SPX, with hedge fund equity exposure above neutral, with a mediocre earnings environment, the risk/reward for index and individual stock shorts is about as good as you can hope for in a bull market.  You are seeing a lot of froth and speculation in meme stocks (TUP anyone?), heavily shorted names, and retail favorites.  And finally, you are starting to see VIX catch a bid even when historical vol is low.  Dealers aren’t willing to sell cheap vol here even when the index isn’t moving much.  

Bottom line, I am short the indices along with various high beta individual stocks that have run up huge over the past 2 months.  I have no intention of micro trading this position.  These type of parabolic rallies based on perception/sentiment changes usually correct quickly and violently to shake out the late comers.  The initial target level for the SPX is 4400, where we could get a bounce, but ultimately looking for 4300 by late August.