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.