Catching the Falling Knife

They are not making it easy for bulls in this market.  You have to fight and claw your way for small gains, big gains remain elusive, and rallies have not lasted for long. 

What I have seen so far this week isn't all that encouraging for longs.  You had a clean breakdown below the much touted SPX 4200 level, yet you didn't see a big jump in the put/call ratio, and in fact, you have seen quite a bit of call volume this week.  The ISEE index measuring the options bought to open ratio of calls to puts shows the complacency.

Its concerning to see this while big tech earnings lead to intense selling of tech stocks.  The COT futures positioning data comes out later today, so that should reveal how much positioning has changed since the selloff started last week.  Bulls need to see asset managers significantly reducing longs to have more confidence in buying the SPX.  So far, you haven't see enough fear and panic to get a tradable bottom.  

The complacency extends over to the bond market, where investors seem to feel more sanguine and bullish than they are on stocks.  It boggles the mind to see the option traders come in day after day to buy up TLT calls, as if its a generational buying opportunity in long bonds.  And they keep getting creamed, with hardly any signs of life from the weakest major market in the world.  Not only are they hoovering up "cheap" TLT calls, they are piling in to TLT itself, with huge flows in the past 2 days, with back to back $1+ billion inflows (Oct. 25 and 26).  Also from what I hear from most of the financial experts, they are bearish on the economy and most seem to be calling for a recession in 2024.  The weak price action in bonds along with the overall bearish view on the economy from the pundits tells me a lot of bond investors are offside here and feeling a lot of pain.  I don't expect that pain to go away until you see a flush out capitulation with 10 years breaking above 5%, and getting much closer to the Fed funds rate of 5.33%.  

The bond market continues to cry for help, and its only been answered by limited ammo call punters and knife catchers in TLT who are quickly losing their fingers.  Politicians in Washington DC have totally ignored the message that the bond vigilantes are sending.  That message is simple:  cut your reckless spending and raise taxes.  Instead, you see Biden ask for another $100B to spend on wars, touting it as a good for the economy and providing more jobs!  And the Republicans are more concerned about being anti-woke and keeping immigrants out of America than they are about the huge budget deficit from Bidenomics and ballooning national debt.  And most of the voting public can't put two and two together, and think the plunging bond market is because of Fed rate hikes, not the reckless spending in Washington DC.  

The cavalry is not coming to save the bond market.  Powell isn't coming to the rescue until you see blood in the labor market.  And if he does, that's going to help the short end much more than the long end, as I don't think he's going to do QE when the Fed funds rate is so high.  Bottom line, if you are going to make long term bets on the bond market, being leveraged long in the short to intermediate part of the curve will be much more profitable than being long in the long end of the curve when the economy slows.  The steepening will continue for a while.  

And I don't see the economy slowing fast enough to rescue the TLT buyers.  There are way too many doom and gloomers hoping to profit off of TLT calls expecting a credit event like 2008.  The excesses just aren't there in the private sector.  Only from an unwind of a private sector credit boom can you get a credit event.  The balance sheets of most households is rock solid, as the US government and the Fed re-liquified everyone with massive debt fueled spending mostly financed by QE over the past few years.  

The only way you get a recession is if corporations decide to get much leaner, reduce debt by not reissuing at higher rates, and cut labor as a result.  The next recession will have to come from CEOs and small business owners who choose not to issue bonds/take out loans at high rates, and instead choose to match the lower capital with less labor.  You are not going to get a recession from a financial crisis, there is just way too much liquidity out there, with the Fed's balance sheet still bloated and with the US government pumping out multitrillion dollar deficits during expansions.   And you definitely will not get the US government to cut spending or raise taxes, so they won't be the cause of any future demand weakness.  All in all, its just a terrible fundamental situation for long term Treasuries. 

While I don't like the price action in stocks recently, and the complacency in the options market lately, I still think we are close to an intermediate term bottom due to oversold conditions and a seasonally favorable time with lots of stock buybacks coming in the next 2 months. 

Expect the weakness to continue into Monday/Tuesday of next week, where I will be looking to buy the dip. 

More Bond Pain Ahead

Bonds are the focus of attention in financial markets.  You have the geopolitical monkeys who get excited whenever the media goes overboard reporting on fighting overseas, but they can only move markets for a couple of days before prices mean revert.  So geopolitics doesn’t matter.  Bonds are where the action is. 

Here’s my theory on why bonds are getting crushed.  At the start of the year, the vast majority was expecting a recession sometime in 2023 due to:

1.  Huge move higher in yields in 2022 and a hawkish Fed

2.  Bullwhip effect leading to too much inventory, leading to a big slowdown in the manufacturing and goods economy

3.  Drawdown of Covid era excess savings leading to reduced consumption

But the US economy in 2023 has been well sheltered by low fixed rate mortgages refinanced in 2020 and 2021, low term rate bonds and loans issued in 2020 and 2021, and implementation of Bidenomics fiscal pork bills like CHIPs, IRA, and infrastructure.  Add in the COLA adjustments higher for Social Security checks to the elderly and you had a huge blowout in the budget which kept the economy buoyant in the face of higher rates.  

So we never got the recession and stocks surged higher, which was responsible for the 10 year yield move from 3.60% to 4.20%.  How about the move from 4.20% to 5% since the start of September?  We didn’t have any significant economic data and the Fed has actually become less hawkish, showing their reluctance to hike further.  Many people point to supply, but the supply of coupon bonds has been large and steady throughout the year, so there's not much change there.  It appears that the move comes down to simply having price sensitive buyers up to their eyeballs in bonds, so the marginal buyer could only be found at lower prices.  The supply/demand mismatch has been present since the Fed started QT.  There has been a continuous deluge of USTs being issued since 2020, due to the monster budget deficits.  This was masked by a bazooka QE in 2020 and 2021. And then in 2022 and first half of 2023, by temporary duration demand from those thinking recession in 2023.  But that marginal bid went away after it became apparent that the US economy was much stronger than forecast.   What you are seeing now is a Treasury market normalizing to a non-recession US economy with rate cuts nowhere in sight.

The yield curve was absurdly inverted as recently as August.  You had Fed funds at 5.33%, 2 year at 5%, and the 10 year at 4%.  The yield curve was pricing in an imminent rate cutting cycle, and if that rate cutting cycle doesn’t come soon, the yield curve has to steepen to reflect the lack of cuts.  That’s what happened.  During the bear steepening, you have seen a parade of investment managers and analysts talk about how cheap bonds are, how attractive they are, etc.  There’s been no real fear on TV.  The only fear you see is the fear of missing out on a "generational" buying opportunity in bonds.   

Despite the huge selloff in bonds, active money in the JP Morgan US Treasuries survey was most bearish at the start of the year, and was the most bullish earlier this month.  That's not what you normally see at bottoms for financial assets.   And you have the options punters who rarely make money coming out and buying huge amounts of TLT calls, making leveraged bets on a quick recovery in long bonds.  You see much less volume in TLT puts, even though the trend is firmly lower, and puts are the ones that have been paying.  So from a positioning standpoint, it still looks like more blood needs to be shed before you can get a tradable bottom in bonds. 

Fundamentally, in order to get a big move higher in bonds, you need an environment where the Fed is likely to start cutting.   Its not going to be inflation sliding lower, because that's going to take too long.  You need the unemployment rate to go up.  The labor market holds the key to the future of Fed policy, as its much more likely that the labor market cracks before you get a CPI low enough to induce the Fed to cut quickly.  Fed only cuts quickly when there are job losses, not when there are low CPI prints.  I doubt you see a credit event come to rescue underwater bond holders, like some well known, but usually wrong market gurus are warning about.  

 

Higher rates work more like low kicks than high kicks to the side of the head.  Credit events are high kicks to the side of the temple.  Events that most people don't see coming.  If you saw the head kick coming, you would duck and avoid it.  But if it hits you, it means that you didn't see it coming until it was too late.  Lagged effects of monetary tightening are like low kicks to the calf.  Big difference.  The low kicks take time to accrue damage and the result isn’t devastating like being knocked out.  What’s most likely to happen in this cycle is corporations will slowly reduce labor to match the reduced capital rather than borrow at high rates that don’t provide a positive return on investment.  Only when the labor market weakens enough will you grab Powell’s attention.  I don't see that as being imminent, as the US is quite well buffered against rate hikes, and the budget deficit, will remain large, although most likely to decline somewhat. 

 

Bottom line, we all underestimated the power of fiscal stimulus in 2023 and still underestimate it now.  But without a doubt, 2024 will have less fiscal support for the economy than this year due to higher capital gains (more tax revenues from higher SPX, NDX), resumption of student loan payments, less COLA boost for Social Security due to lower CPI, and lower spending at the state and local level due to drawdown of  excess Covid funds.  Below are projections for 2024 state spending in a few states.  This will work to reduce demand at the margin. 

 

While bonds have sold off a lot, I don't view them as a bargain, like some some eager speculators.  I am hesitant to buy this dip (more like a trench) in bonds.  The supply/demand equation is unfavorable, and expectations are quite low for the economy in 2024, so its not going to be easy to surprise to the downside.  This is why I am not bearish on SPX, because of those low expectations.  Its not everyone on recession alert like end of 2022, but you don't see much optimism about the economy in first half of 2024 from those on CNBC or Bloomberg.  The most likely scenario for the next few months is the US economy gradually slowing down, but not more than the low expectations people have.  That should keep stocks in a range, around SPX 4200 to 4500.  During that time, I expect bonds to settle down, but I don't expect a big move lower in yields, probably lingering somewhere between 10yr 4.6%-5.2%.  Unless the labor market gets much weaker, you will not get that big rally in USTs.  That's going to take a few months, because the labor market is always lagging, and the US economy is just not weak enough yet for mass job cuts.  

 

Missed the graceful exit on my SPX and NDX longs last week.  Sold a bit on Friday to reduce risk, and reduced a bit more on Tuesday, as the price action is quite weak, and I want to have some dry powder just in case we get a bond panic as 10 year yields decisively break above 5% and SPX decisively breaks 4200.  If that happens, I will buy that dip.  This stock market is trading much weaker than expected, so my confidence level on a strong rally has gone down.  Its very much possible we just get a underwhelming dead cat bounce towards 4300, but that's not the base case.  Base case is a move towards 4400-4450 by mid November.  Looking like you won't see any strong uptrends or strong downtrends in stocks for the time being.  Looking more and more like a range bound market for the next several months as the earnings momentum will not be strong enough to get stocks meaningfully higher, but at the same time, expectations seem too low and I don't think the economy in 1st half of 2024 will be as weak as many are forecasting.    Plus many are hiding out in the comfort of cash so there is a lot of dry powder waiting to be deployed in stocks out there.  So that will keep downside contained.

Avoiding the Roller Coaster in Cash

The most popular asset right now are cash equivalents, i.e. money market funds, T bills, and CDs.  There is informational value in that.  When the US government has national debt of over $33 trillion, over 120% of GDP, a ton of interest income is being spewed out to the private sector.  The US budget deficit is nearly $2 trillion, with a big chunk of that going out as interest income.  When investors are losing money in bonds, that reduces their percent allocation to bonds, at the same time, the influx of cash from interest income increases their allocation to cash, and reduces their allocation to equities.  Slowly, investors are getting overweight cash as bonds are going down and stocks are range bound.  

You also have to look at flows of supply into cash, bonds, and stocks.  The huge US budget deficit is increasing the supply of cash, in the form of interest income, as well as the supply of bonds, in the form of Treasury issuance and QT, which combined is running at well over $2 trillion this year.  Meanwhile, the supply of equities is not going up due to the approximately $1 trillion annual run rate of stock buybacks.  So while I see many argue that the value fundamentals are favorable for cash and bonds over stocks at current yield levels, the supply demand fundamentals favor stocks.  I hear very little about this favorable supply demand situation when people discuss stocks.  Its always the overvaluation relative to bonds, the talk about a low equity risk premium, and how equities are a poor value.  

 

I cannot disagree, those are legitimate long term concerns, but in the short to intermediate term, supply demand plays a bigger role than long term valuations. And as long as corporations can maintain big stock buybacks, and earnings are sustained, its difficult to get a bear market under those conditions.  You need earnings to go down 20% to get a bear market.  With huge budget deficits from past pork bills and massive Treasury interest expense set to continue for the next few years, that fiscal expansion will make it tough to get nominal growth negative.  And you need nominal growth to go negative to get a meaningful drop in earnings.  Even the much feared stagflation would mean that corporate earnings aren't dropping much due to the benefits of inflation for revenue growth.  You need to see deflationary impulses in the economy to get a big drop in earnings, and politicians will zealously fight a weak economy and deflation with stimmies and pork at the drop of a hat. 

Right now, the surge in long bond yields is the excuse for selling off the equity indices, but the big cap tech stocks and other mega caps which drive the SPX are not feeling much pain from the higher yields, as they are cash rich and have loaded up on long term debt.  On the other hand, small caps are more rate sensitive due to having higher debt/equity ratios and with more shorter duration maturities on their balance sheet.  The maturity wall won't really hit for them until 2025, but its close enough that investors will sell off these stocks anytime yields surge higher.  That's why you continue to see the big divergence between SPX and Russell 2000.  It is similar to what you saw in 1999 when the Fed was raising rates and yields were rising.  

Since I remain somewhat bearish on the US bond market, I expect the SPX and NDX outperformance over Russell 2000 to continue for the rest of the year.  The US economy has continued to be underestimated by the investment community and I still hear too much talk about a US recession in the first half of 2024 due to higher bond yields and the lag effect.  I am skeptical of those prognostications as the very fact that investors are worried about an economic downturn in 2024 means that pentup demand is building for investment.  The Covid bullwhip effect is over, and the inventory build cycle is favorable for goods for 2024 and 2025.  There is no shortage of liquidity out there.  The Fed balance sheet is still egregiously huge relative to US GDP.  People forget how much QE the Fed did in 2020 and 2021.  It dwarfs the mini-me QT that is ongoing now.  

Its easy to sit in cash and collect 5% when stocks AND bonds are both going down.  But that was also the case when I heard the "experts" on CNBC and Bloomberg tout cash in March, April, and May of this year.  The SPX rocketed higher soon afterwards. Stocks and bonds tend to not continue to go lower when investors are hunkered down in the safest asset around: cash.  FOMO is always around the corner, waiting to get unleashed as soon as cash starts to underperform either stocks or bonds, or both.  

On to the markets.  The VIX had a mini spike on Friday out of the blue, much more than the move in SPX would warrant.  And on a Friday, when VIX usually declines due to the weekend effect.  That caught my eye, as the indices haven't really moved that much and the IV is much lower than the historical vol on a 1 month basis.  It can only be summed up as one thing:  investors have some fear.  You don't pay up for VIX or puts if you aren't concerned.  The news media has done its job of getting people worried about war.  The monkey inside us can't resist the temptation to buy into the hype and get scared.  That was the reason for the Friday selloff and the VIX spike.  The big move higher in crude oil, gold, and even a small short squeeze in the weakest of them all, the long bond was able to catch a safe haven bid.  That's how nervous the market was heading into the weekend.  Monday quickly reversed that move, when nothing happened, but the reluctance to embrace this rally remains.  Price moves before emotions.  Emotions catch up later.  That's why traders who trade on emotion are always late to buy on the way up.  

A lot of puts were bought over the past few weeks, meaning that if the market grinds higher into this Friday's monthly opex, dealers will have to buy futures in size to delta hedge as puts melt lower from both a rise in price and a drop in vol.  The VIX at over 17 with this kind of volatility is overpriced.  Remain long as SPX trades very well considering the renewed weakness in bonds and the elevated VIX.  But will not stay long for much longer, as I expect more two way trade and chop after this week, as there are worries about the technical setup and the U bottom that I mentioned several days ago.  

Geopolitical Monkey Brain

War bad.  Peace good.  War starts ---> Sell.  War ends --->  Buy.   That's the monkey brains behind the knee jerk reaction that you saw Sunday/Monday in the overnight futures.  About the only move that made some logical sense was the move higher in crude oil, but even that is a bit of a stretch, only because it could maybe make it harder for Iran to sell some of its black market oil barrels.  Maybe.  But probably not.  

The primal urges tell the average investor to sell and ask questions later.  I bet you if this happened in the middle of Africa, let's say in Nigeria (where crude oil is actually produced), people could care less.  Some lives are more equal than others.  Black lives (especially African) and Muslim lives are definitely less equal than Jewish lives.  People were getting massacred in Syria (on a much bigger scale), and most people could care less.  The markets sure didn't care.  But its happening in Israel, and there are a lot of people in finance who manage a lot of money who are Jews.  And they have intense interest in this event.  That amplifies the kneejerk reaction to the news.  Nothing against the Jews, but they have a lot of power.  They are a minority group that control a lot of money. 

This is nothing like Russia invading Ukraine.  Russia is a huge country.  Israel is not.  Russia produces a ton of commodities, including 10% of the world's oil, and a huge amount of natural gas.  Israel does not.  That was a legitimate market mover, because of the great uncertainty, but even that turned out to be a relative non-event for the crude oil market in the long term.  War in Israel matters to Israel.  It doesn't matter to the rest of the world.  But you'll see the 5 minute Middle East geopolitics experts come out of the woodwork using mental gymnastics on how this war in Israel has a huge effect on the world, espousing their expertise on Twitter as if its a public service!  I'm just a simpleton who believes that wars are local, and have local effects.  World Wars happened 2 times in the last millennia.  They are the exception, not the rule. 

Its painful to listen to CNBC, but its part of the job.  Trading alone, the quickest way to get exposure to the zeitgeist of the market is through Twitter, CNBC, and Bloomberg.  The doom and gloom was palpable.  The crowd was already leaning heavily bearish after that "blockbuster" NFP report, but this just put them over the edge.  It didn't match the 0.6% gap down in the futures.  If you had only heard the financial media and seen the tweets, you would have thought the SPX futures were down 80 points.  They were down 30.  Its going to take a big move higher from here to get rid of that gloom and doom.  Gloom and doom is a not a long term stable psychological condition.  Its temporary, and when it subsides, stocks are usually higher. 

Most of the last 3 weeks have been risk off days, with the focus squarely on the plunging bond market.  Now that you have a war in Israel, which should be a nothingburger for the bond market, but with emotions high, and bond shorts nervous, its has provided a backdoor bailout for stuck longs in long end of the Treasury market.  I don't expect this bond bounce to last long, but it probably keeps the shorts away for at least a few days to give the beaten up longs some breathing room before the shorts pounce again.  That breathing room should be enough to provide some upside fuel for stocks in the coming days.  We've had a slow motion capitulation over the past 2 weeks, it culminated with a panic gap down on the blowout NFP number, which cleared out the last remaining nervous longs, to allow for this bounce.  With the war leading to Treasuries now showing some signs of life, you can't be negative on stocks, not until you get a healthy bounce into real resistance, which is around 4450-4500 SPX.  There is a lot of air up above current levels, between SPX 4340 to 4450.  That air pocket means that if investors decide to reallocate to stocks, you could see a quick move up to 4450, possibly by early next week.  

Back to fundamentals.  On Monday, you saw a parade of Fed speakers come out and voice their views, as they love to do.  These Fed governors feel so self-important, and are always out there giving their two cents.  It seems like the tide is slowly changing from hawkish to dovish.  Yes, they are still on the hawkish side, but overall, they seem much closer to neutral than hawkish when you hear them.  Lately, in response to the big move higher in long term yields, they seem to view that as doing the Fed's work for them by tightening financial conditions, making it less necessary to hike again.  Its looking less likely that the Fed will hike in November, and Fed funds futures are pricing in only a 14% chance of a hike at the next meeting.  A month ago, the hike probability was at 44%. 

With the Fed quiet period less than 2 weeks away, Powell or Nicky Leaks of the WSJ will have to signal a rate hike soon if they want to get a hike done at the next meeting.  But I don't sense any urgency on the part of Powell to do that.  He seems content to go for that soft landing, even as he tries to talk out of both sides of his mouth by saying there could be a hard landing.  Actions speak louder than words.  His actions appear as if he's intent on going for that soft landing to prevent Trump from getting elected in 2024, which would be a de facto termination of his tenure soon afterwards.  

So what did we learn since the nonfarm payrolls report on Friday and the start of the war on Saturday?  

1.  The NFP and CPI are now nonevents as far as determining future Fed rate hikes.  They will become important market events again when the Fed is getting closer to rate cuts in 2024.  

2.  Bond yields appear to have overshot the upside in a panic last week, and there are few sellers left at these levels, at least for the next several days.  Even with that jobs number on Friday, and then the big move higher in crude oil, the flight to safety bid was actually able to overpower the higher crude move.  Now with the flight to safety premium in play until market players calm down, you have a short window where bonds won't be a huge headache for those long stocks.  This is the window of opportunity for the SPX to make its move higher.  

3.  Geopolitics is overrated.  And overhyped.  It usually pays to fade the geopolitical kneejerk reactions in the market, especially when they happen over the weekend. 

The price action in stocks and bonds with the news flow has given me more conviction in my short term bullish view on SPX.  Staying long.

Low Rider

 Not a good sign for the bulls.  The SPX is staying under 4300 for several days in a row.  Its lingering down there.  Setting up camp in low territory.  It doesn’t change the outlook for the next few days, but it does change the outlook for the next few weeks.  Even if the SPX has bottomed, its been a U bottom, not a V bottom.  Big difference between the 2.  A U bottom is not necessarily a bottom shaped like a U.  Its a bottom that spends a lot of time trading close to the lows.  U bottoms give you a lot of time to buy cheap.  U bottoms spawn rallies that are choppy, with less upward thrust, and less likely to rally to new highs.  They also often happen in bear markets. 

V bottoms are the opposite, the rallies are longer lasting and cleaner, with minimal pullbacks on the way back to previous highs or new highs.  V bottoms don’t give you much time to buy near the lows.  V bottoms have been more common than U bottoms because the SPX has mostly been in a strong bull market since 2010.  

Examples of  U bottoms since 2010 are June 2011, June 2012, April 2018, March 2022, June/July 2022, September/October 2022, and December 2022.  It is no coincidence that more than half of the U bottoms happened in 2022, after one of the biggest stock market bubbles in financial market history.  U bottoms generally happen in chronically weak markets.  Not temporarily weak markets.  

 

As you can see in the charts above, the messier and longer it takes to recover from the lows, the rallies coming out are usually shorter, choppier, and have less upside than V bottom rallies that were common place in 2013, 2014, 2017, 2019-2021. 

This kind of messy U bottom was not what I was expecting.  After the strong rally in the summer, after a correction, I was looking for a V bottom, which obviously has not happened.  While the hysteria over higher long bond yields is overblown here, its a much more valid reason to selloff than past vacuous reasons like Grexit, Brexit, upcoming elections, trade wars, etc.  So you can’t totally brush it off as meaningless, like you could for so many of the news based corrections in the past.  

There is some fundamentals behind this selloff, as higher yields definitely have negative consequences for earnings growth, as well as reducing both the supply and demand for credit.  However, based on the trends in the commodity market (oil down over $10 in the past week), as well as apartment rents, the bond selloff is more a positioning story than a new fundamental weakness story.  There are lots of bond holders who are deep underwater and feeling pressure to lighten exposure and cut losses.  Politicians and the Fed basically ignoring the cries for help from the bond market are not helping the cause.  So it appears that bond yields will have to stay elevated for the next several weeks, as I don't see the US economic data coming in weak enough to rescue the bond market on its own.  Plus, I already see so many economists and investors bearish on the economy, its not going to be easy for economic data to really surprise to the downside.  

Recent options market data is showing continued high levels of put volume relative to call volume.  Even on the days that the market is flat to slightly higher (Wednesday and Thursday), you saw some very high put/call ratios.  And with the VIX above 18 and realized vol at much lower levels, a few days bounce could really crush IV levels.  That should in turn result in dealer hedging the IV drop by buying stocks and index futures.

You can get a technical rebound soon in the bond market, just based on how much attention and how fast long bond yields have gone up, and with the big move lower in crude oil over the past few days, which is a huge relief for bond investors.  Bond yields have tended to lag crude oil prices with a few days lag.  At least you have inflation that is not getting worse, so once you get through the forced sellers and weak hands, you probably can get a consolidation of the big move and range bound trade for the next several weeks.  Even a range bound bond market should be enough to provide a decent bounce from stocks at these levels, but it won't be a powerful bounce that you can just ride for months.  Bounces from here are probably 1-2 weeks in length.  And then a pullback, and then back up again.  It should be a choppy rebound.  Still long and hanging on, but definitely not adding more, and staying away from bonds.