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.