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.