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.