Its an Art Not a Science

The stock market is irrational.  Its based on numbers, but its not math or science.  There are no set rules.  There is no iron law in finance.  Its an art that people try to make into a science.  This isn't physics or math.  The closest thing that comes to mind is fashion.  There is no real logic when it comes to fashion.  Its based on feel, personal taste, emotion, societal trends, etc.  The thing about fashion is that it really doesn't matter how you feel about your clothes, its how others feel about your clothes.  That's the stock market.  It doesn't matter what you feel.  It matters what others are feeling.  

Having a quantitative mindset, it was bewildering to see how investors would get more excited about the stock market the higher it went.  The rationalization, the excuses, the reasons for the moves.  They are arbitrary but are quickly clamored onto like indisputable facts by the crowd.  There is no wisdom of crowds in the stock market.  That's BS.  Its the madness of crowds.  Its herd behavior coming from our primal instincts, that evolved over tens of thousands of years when survival was always the priority.  That way of thinking, the emotions and actions that all evolved when there was no stock market, when there was no crowd gambling on a huge scale.  

Trying to put logic or numbers into this game is like trying to put a square peg into a round hole.  Its an art, and it will always be art, even when AI or machines take over.  There is no science here.  The stock market is just a huge, glorified casino.  In fact, its less quantitative than a casino, where the odds are set.  In the market, the odds are unknown.  Its this mystery that keeps the hope alive, that provide fertile grounds for snake oil salesmen and subscription sellers.  The day that I start a substack to try to sell subscriptions is the day that I admit that I no longer can beat this game, and can only make money selling dreams rather than living the dream.  

Its an illogical game, but there are patterns to it.  Arbitrage has been sucked out of the market and there is very little alpha in that space. The main edge in markets is finding patterns and playing them over and over again.  Those patterns are derived from human psychology and they repeat.  Some patterns are long term, some are very short term.  But they repeat.  Successful speculation is about finding the patterns and anticipating the next move to come in the pattern.  There are seasonal patterns, patterns around events, etc.  Some patterns are higher probability than others.  And the probabilities change and are unknowable, but intuitively, you can sense what patterns are reliable and which ones are less so.  But to do so, you have to stop thinking about what's going on in your head.  But what's going on in the head of those moving the market.  

First order thinking is what you are thinking about the situation.  Second order thinking is what you are thinking about what others are thinking about the situation.  First order thinking doesn't help you much in this game.  Its second order thinking which is the foundation for market analysis.  No one cares about what I think.  No one cares about what you think.  I'm not the one who's going to drive the next move.  I want to know what the big money is thinking and what's their next move.  

The current bull run in stocks is puzzling from my view of how markets should be valued, but it really doesn't matter what I think.  If others are in a risk seeking mode, and past patterns of risk seeking behavior play out, we are not done with this uptrend.  That doesn't make me want to play this uptrend at the current time, even though the probability is high that the market will be higher 2 months from now.  Its the risk/reward thats not attractive here.  There is more downside risk in the short term than upside risk, even though its more likely to go up than down.  

These big bull runs, which we are currently on, tend to last 4 to 5 months before facing its first real test/correction.  Since this rally started at the end of October, that means a rally that likely lasts until late February to late March.  This also jives with the psychological importance of the Fed and the first rate cut, which looks like will happen at the March FOMC meeting.  Its a classic buy the rumor, sell the fact setup happening over several months.  This will be the framework with how I trade the market for the 1st quarter of 2024.  Its too early to think about shorting for longer than a couple of days, so I'd rather not play that game.  

No imminent trades at the moment, but I will be buying dips in SPX and Treasuries in January, as I expect the uptrend to continue into March. 

Late 1999, Late 2020 Flashback

Its getting bubbly out there.  Parabolic moves in heavily shorted names like UPST, CVNA, COIN.  A huge squeeze higher in Russell 2000, up over 20% in less than 45 days.  This is feeling like late 1999.  Like early 2021.  The difference this time versus the previous two times is the economy.  The economy in late 1999 was on fire.  Same with 2021.  Now?  You have the market not excited about earnings, but about the Fed.  That's a whole different type of euphoria, something that will have a shorter lifespan.  Also the fact that we had a bubble burst just 2 years earlier makes it much less likely this bubble will get as big or last as long.  People have short memories, but not that short. 

In 1999, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 1999 to early 2000.  

 

In 2020, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 2020 to early 2021.

 

In late 2023, you are starting to see the Russell 2000, which has been lagging the SPX for the past 18 months, go on a huge rally, massively outperforming the SPX over the past 2 weeks.  

It is human nature to feel FOMO, when others around you are getting richer.  Investors and traders then try to catch up by playing more aggressively, going into riskier stocks with more beta, to get more bang for their buck.  It happened in late 1999/early 2000, in the later stages of the dotcom bubble.  It happened in late 2020/early 2021, at the peak of the SPAC/bitcoin/meme stock/everything bubble.  And it is happening again here.  

But can the economy stay strong enough to keep the animal spirits going, to keep the soft landing hopes alive?  That will be the question for the first quarter of 2024.  There are some who believe that the higher stock and bond prices will feed back into higher consumption by the wealthy, which will boost the economy in early 2024.  There is some merit to that thesis, but relying on the wealth effect as the main pillar of future consumption is not something I would put too much money on.  Plus, you have already front loaded so much of the Fed pivot rally in the past few weeks, that there isn't that much squeeze left to play for, unless things get really crazy.  And as I mentioned earlier, due to recency bias, and being burned the last time, I just don't see things getting as crazy as early 2021.  

One thing I do have conviction on is that Powell will cut way more than what the dot plot predicts for 2024.  But with 150 bps of cuts already priced into the SOFR curve, its not a great risk/reward at current levels.  You probably make money buying SOFR Dec. 2024 futures and hold them to expiration, but it could be a bumpy ride for the next few months.  I would have been much more confident betting on lower short term rates if Powell didn't signal a pivot, as that would have left a lot more potential in the trade.  As it is, its not a compelling trade at the moment.  

A factor that people are not thinking about enough is how the 2024 election and the looming Trump nomination will have on the Fed's reaction function.  The Fed will have an easy trigger finger on cuts in 2024 to try to help Biden (and hurt Trump).  I know there are still those who believe everything they hear from the Fed and believe they won't be political and will follow the data, but I'm cynical on how the Fed operates.  Their default position is to be on the side of easy money in the first place, so even a slight bit of motivation to keep Trump out of office will have them leaning towards more cuts than fewer.  Plus, with the stock market front running these rate cuts so aggressively with a big rally, I could picture a scenario where stocks actually go down after the rate cuts start.  This will hurt consumer sentiment as the election gets closer, which will encourage the Fed to be even looser and do more rate cuts.  I can imagine a snowball effect of the stock market being disappointed with just a few rate cuts and having a temper tantrum, inducing the Fed to cut even more.  

It's interesting that in 2022, even with surging inflation, everyone was so skeptical about the Fed hiking rates a lot after they signaled no rate cuts until 2024 just a year earlier.  After brainwashing investors and Wall Street with higher for longer for the past 12 months, now almost everyone seems skeptical about the Fed cutting rates a lot in 2024, even though Powell has already pivoted and started talking about cuts.  I see the current situation as a mirror image of 2022, with the Fed likely to surprise dovishly throughout 2024, steepening the yield curve in the process.  The economy is just not going to be as strong as 2023 due to the lower fiscal deficits on both the state and federal level, and with the resumption of student loans and the end of the employee retention fraud that many were taking advantage of.  Employment should get softer, as less bank credit and shrinking margins at small businesses will lead to job cuts.  

Short to intermediate term, its not an easy spot here for shorts or longs.  I put on a small short on Thursday and Friday in SPX and NDX, but those trades I intend to close out this week.  I may even play the long side for a quick trade ahead of the seasonally bullish last week of the year.  For longer term trades, I'm inclined to play small ball or just not swing until I see a fat pitch.  My best guess is that you will grind higher into the first rate cut in March, but not a huge amount of conviction.  Because things have been pulled forward so much, it wouldn't surprise me if we had a sharp pullback before March.  Its probably not a bad time to just park money in money market funds at 5% and wait for things to play out for the next couple of months. 

Event Trading

The market hates uncertainty.  There is an edge that comes from that human tendency.  Whenever you go into a hyped up event (FOMC meeting, hyped up nonfarm payrolls/CPI data releases, earnings announcements, elections, etc.), there are patterns that emerge.  In order to predict how markets react around these events, you have to make a basic assumption.  The assumption is that active traders/investors are usually long financial assets.  Its rare for even hedge funds to be net short equity or bond exposure.  And long only funds cannot short.  I made a post about event trading several years ago and it still holds true. 

Let's go into how active investors/short term traders behave around an event.  

1. They often reduce their net exposure.  The more feared the event, the more exposure that is reduced.  Since they are almost always net long, it means they reduce their longs.  The result:  you often see a pullback ahead of an event, from several days before, for big events like an election, to just a few days before, for smaller, less feared events like economic data releases or FOMC meetings. 

2. Since investors and traders have already reduced their exposure ahead of the event, usually at least a day ahead of time, there is a lack of selling pressure from active traders right ahead of the event (a few hours ahead) and after the event.  This often explains the common upward drift ahead of FOMC/NFP/other hyped up event  for the few hours ahead of the release.  Here is a recent example: 

FOMC Meeting November 1 2023

3. The intermediate term trend (2 to 8 weeks) ahead of the event is usually resumed after the event.  The exceptions are very big events where investors AND traders prepare several weeks ahead of time (e.g.: Presidential elections).  In those cases, the long to intermediate term trend (3-6 months) is usually resumed after the event.  

FOMC Meeting May 4 2022 / CPI Release Sep. 13 2022

2020 Presidential Election November 4 2020

4. For most events, since active investors and traders have reduced their positions ahead of the event, after the event, you usually see a rally.  Especially when active investors and traders have been building up long positions in a rally for the previous month. 

5. In the long run, the market pays a risk premium to those that are willing to take on long exposure ahead of events, especially feared events.  That premium is usually paid out in the form of an immediate one day rally after the event, for economic data releases, or for several days after the event, for really big events like a 2020 Presidential election.  

We have a CPI release this morning and the "feared" 30 year Treasury auction at 1:00 PM ET.  Considering how bad the 3 and 10 year auctions went, expectations are low for the most important Treasury auction of the month.  Add to that, the FOMC meeting on Wednesday, and you have a slew of events that the market will be faced with.  Since we've had a strong uptrend in both stocks and bonds going into this week's events, its likely that they will rally after the FOMC meeting is behind us.  

Bigger picture, the SPX is in the middle of a late stage bull market rally where fundamentals are ignored and valuations are very high.  It presents a great opportunity for the short side in 2024.  For those inclined to play the short side, save your ammo and don't burn capital trying to play for a pullback.  Its not worth it to short it here, both from a seasonal perspective and a technical perspective.  The brutal selling in September and October needs to be completely forgotten and gone from the rear view mirror before the risk/reward for a short is compelling.  When the timing is ripe for a short, it will be a whopper of a short.  The potential energy building up on the short side is immense.  But if you short too early, you won't be able to hang on for the ride to the other side of the mountain.  I can't bring myself to chase longs in this bloated market even though I think it goes even higher.  I still see too many consistently wrong Fintwit posters skeptical about this rally. 

Probably will have to wait until March or April for the SPX to top out.  Until then, keep powder dry and protect capital. 

From Eagle to Pigeon

The United States economy is just not dynamic anymore.  The United States used to be a manufacturing powerhouse, and was subject to the whims of the capitalist boom and bust cycles.  It used to be like an eagle soaring high and swooping low.  Now its more of a pigeon that just walks around, with short bursts flying higher, and then back to the ground, where it lingers.  The amplitude of the ups and downs of the business cycle has gone down.  But the average height has also gone down.  The highs are lower, and artificial, a result of massive fiscal stimulus, while the lows are less dramatic, also because of massive fiscal stimulus.  Its not as bad as Europe, where the government is such a huge part of the economy that the business cycle has essentially turned into a flat line, at a very low level. 

One of the benefits that you get with an aging population and more services and less manufacturing is a less cyclical economy.  Old people don't spend much money on stuff, other than food and fuel.  It spends a lot of money on services, such as health care, hospitality, and restaurants.  Old people keep getting government money for nothing, and keep spending it on services.  Services for doing nothing.   And that story is being repeated millions of times (more millions each year as baby boomers retire).  That's inflationary.  But it also helps to keep the economy out of recession. 

The old boom bust cycle was based on manufacturing being a big portion of the US economy.  Now, manufacturing is minor, almost an afterthought.  Offshoring has dramatically changed the US.  Sure, you hear talks about re-shoring, but much of that is government subsidized and not "natural".  The US is not cost competitive with Asia when it comes to most manufacturing.  Labor costs are just too high.  In the past, when you had a manufacturing heavy economy, the cycle of overbuilding, overcapacity, overproduction, and big inventory builds would make an economy vulnerable to a recession.  Sure, rate hikes sped up the process of tipping over a vulnerable economy, but the underlying forces of the economy were very cyclical.  You had almost exclusively variable rate mortgages.  More variable rate bank loans rather than long term fixed rate bond issuance. 

Now, you have an economy that's mostly services.  Manufacturing, construction, and transportation/warehousing are less than 20% of the US share of GDP.  With such a small share of GDP in those cyclical sectors, there needs to be big down moves in those areas to drive the economy into a recession.  That's unlikely when you didn't have the overinvestment and overconstruction in the first place. 

The US economy is now a less cyclical, lower growth economy.  The biggest source of growth in the US is the government.  Government spending is the growth driver of the US.  Its not AI.  Its not data centers or high tech.  Its pork.  That's the sad state of what was once a very dynamic economy that had lots of competition and much more laissez faire markets.  Now you have an economy that's become more rent-seeking, more financialized, with less innovation and lower productivity.  Corporations have formed oligopolies, which requires less investment spending, and more spending on lobbying and regulatory capture.  

The foundation of America is slowly rotting and government spending is like the paint job covering all the mold and mildew underneath.  Killing the business cycle is not a good thing.  Economists like to think of recessions as being negative, and booms as being positive.  But boom and bust cycles are what keep the herd fit.  Imagine what those zebras and wildebeests would have evolved to if there were no lions and hyenas.  They would probably be fat, slow, and unable to run away from predators.  The business cycle is like the lion in the African plains.  It weeds out the weak and unfit. 

Staying out of recession because of big budget deficits isn't a sign of strength.  Its a sign of desperation and weakness.  The politicians have little tolerance for short term pain.  The same goes for most of the public, who absolutely loved the huge stimmies in 2020 and 2021.  

All these calls for a slowdown/mild recession in 2024 are using the old playbook for the old America.  The new playbook needs to account for the elephant in the room: the government.  The government has unlimited cash and can never go bankrupt.  It can always just spend more money.  This acyclical factor that keeps getting bigger is what has kept the US out of recession since the big rate hiking cycle in 2022.  The US has evolved into an economy that's reliant on huge fiscal budget deficits for growth.  Keeping track of projected government spending in 2024 at the state and federal level is probably your best guide to what to expect in the economy.  It seems like the consensus FY 2024 budget deficit projection is around 6-7% of GDP.  That's a lot of money going from the government to the private sector.  It will be less than 2023, thus you will get some economic slowdown, which you are seeing, but it also means getting a US recession in 2024 is not as likely as many think.  

The move over the past month was based on the Treasury reducing their planned coupon issuance, and also the dovish shift at the Fed.  Even if the Fed isn't outright saying they are done and will start cutting in 2024, the fact that they aren't pushing back strongly tells you a lot.  First, it tells you that Powell is no Volcker.  He's not playing for legacy, to avoid being Arthur Burns, to be like Volcker, as many postulate.  He's playing for longevity.  He is power hungry.  He wants to get re-elected Fed chair in 2025.  He's not going to get that done by being Mr. Hawk in an election year, and making Trump the next president.  Trump will get a lackey for Fed chair who will be dovish, no matter what.  He doesn't trust Powell, and will fire him in 2025.  

The Fed trajectory for 2024 is all based on politics and I fully expect Powell to surprise dovish throughout 2024.  I expect preemptive rate cuts, an attempt at a soft landing, and the Fed put whenever the stock market has a temper tantrum.  And I don't expect an economy as weak as many are projecting, especially for the 1st half of 2024.  So you will likely be seeing a much steeper yield curve as the Fed policies will be inflationary.  Treasury bonds are usually a good investment right before a typical Fed cutting cycle, but I don't think that will be the case in 2024.  Sure, you could get to 3.50%-3.75% in the 10 year yield if the stock market panics, causing Powell to panic cut.  But I don't expect a sustained move lower in yields like you would have seen in past cutting cycles.  Its because the market will sniff out that inflation and big budget deficits is a secular story and will price in higher long bond yields to compensate for the future supply. 

You are getting your garden variety pullback off a huge upward thrust.  I still see very little edge playing the SPX here, but I do expect it to break out above 4600 before year end.  I am surprised at the bond market strength, and it probably means you are not going to get much of a pullback in SPX this week or next.  While you could play for a quick bond short here tactically, I don't see much upside as I expect yields to remained contained for the next several days.  With the Fed going from hawk to dove, the animal spirits are returning and the volatility is dying.  Its not worth it to fight the rally in stocks at this stage.  You probably need to wait till spring of 2024, when we are on the doorstep of a preemptive rate cut before you can aggressively short SPX/NDX.  Right now, I'd rather be a buyer of dips than a shorter of rips.  But not that good of an opportunity, so mostly on the sidelines.