A Market Made for Ray Dalio

My framework for 2024 is the underestimated Fed dovish pivot.  This makes me bullish risk parity (long stocks and bonds) for the next few weeks, buying on dips in bonds as 10 year yields go above 4%, and when SPX gets down towards 4700.  Downside will be contained until there are more believers in the Fed dovish pivot, and fewer believers of higher for longer in 2024.  It will take several weeks for the migration to play out, as our monkey brains can't handle going from bearish to bullish so quickly.  Many are still in denial in the bond market. 

Its a type of market that Ray Dalio would love.  Collecting 2 and 20 by just holding long bonds along with the SPX, and calling it an all weather portfolio.  

That 10 year yield chart is amazing.  It is what you would say is the mother of all capitulations in US Treasuries.  All you heard was talk about bonds in September and October.  You even had someone on CNBC calling for 13% 10 year yields!  Charts can play mind games on investors.  Past price action really influences how investors view the future.  Its not just about price.  Its about path that changes our views.  Let's play this game on the 10 year yield chart: 

Actual 10 year yield chart since start of 2023

Fake 10 year yield chart since start of 2023: September, October, and November 2023 changed.

I believe most people looking at the first chart would think that the move down in yields is overdone, and that yields are due for a further bounce higher.  Most people looking at the second chart would think that yields made a double top around 4.30% and that yields look to be trending lower.  

These are the mind games that financial markets play on our monkey brains. By simply reversing the psychology and doing the opposite of what feels right can be an edge.  Of course, you need to see how speculators are positioned, as well as what the investment community is thinking to get a bigger edge.  Here is what the latest JP Morgan bond survey shows:  

JP Morgan clients' net long positioning dropped the most over 1 week since 2020.  It only took a 20 bps rise in yields to get bond investors bearish again. 

The bond market has an asymmetric payoff profile at the moment.  Its because of the Fed's new dovish bias and upcoming rate cut cycle.  We know with a fair amount of certainty what core CPI will do over the next few months, because of the lagged effects of owner's equivalent rent (biggest weight in CPI) and other butchered calculations which foreshadow future CPI readings.  With rents having come down a lot in 2023, and owner's equivalent rent lagging real rents, you will likely have core CPI coming in low month over month until the summer.  Some of this is priced in, but the Fed is laser focused on the data, especially data confirming their now dovish bias, so with lower CPI readings, they have an excuse to cut rates.  At 5.33% Fed funds, real rates are quite high, meaning they have a lot of room for rate cuts even if the economy remains steady.  That's the Fed backstop for the bond market right now.  Especially the short to intermediate part of the curve, from 2 yrs to 7 yrs.  

This Fed backstop wasn't present in 2022 or 2023 because the Fed had a hawkish bias due to the zeitgeist on high inflation at the time.  But investors have a hard time turning on a dime.  Especially when a market like the US bond market, has been in a bear market for nearly the past 4 years.  As a result, I see a lot of denial on CNBC and Bloomberg, about future rate cuts.  Many don't think the Fed will cut 5-6 times, like the SOFR curve is pricing in at the moment.  They are still somewhat stuck in the higher for longer theme that the Fed repeatedly bashed into the brains of investors in order to tighten financial conditions.  The consensus I see among the "pros" is similar to the Fed dot plot, which is 75 bps of cuts for 2024.  In my view, 75 bps is the absolute minimum they will do this year, if there is a no landing/delayed landing/inflation rebound scenario.  Even in a consensus soft landing where growth is slowing and jobs numbers are going down, they will cut much more than 3 times, more likely the 5-6 times that the SOFR curve is pricing in.  

Its this denial about the coming fast and furious rate cutting cycle even without a hard landing which makes me nervous about getting short SPX too soon.  Yes, the market went up a lot over the past 2 months, so its likely to consolidate its gains instead of rocketing higher at these high valuations.  But I don't see a lot of downside in the market until the majority of investors abandon their higher for longer bias and accept that the Fed will cut rates even without much of an economic slowdown.  The closer we get to the March FOMC meeting, the more certainty will come to the crowd that this is no longer a "higher for longer" Fed, but a "find any excuse to cut" Fed.  When the consensus of "pros" (not SOFR traders, but loudmouths on CNBC and Bloomberg) shifts to my view on the Fed's rate cutting cycle, that's when I'll be looking to aggressively short SPX.  Until then, I am only willing to play the short side for quick swing trades.  

The broadening out of the stock market rally has already fizzled out.  The Russell 2000 has badly lagged the SPX over the last 2 weeks.  It has given back all of its massive outperformance since the FOMC day rally in mid December, and is now underperforming SPX by over 2% over the past 4 weeks.  

This has made me revise my view on how the next few months play out.  I was expecting a chase for high beta in small caps for the first quarter but that doesn't look like its going to happen.  Instead, we are likely to see you typical grind higher with breadth deteriorating towards a final top, as the economy slowly weakens.  The economy is just not strong enough to justify rampant speculation in small caps, many of which are nonprofitable and/or have weak balance sheets.  So no blowoff top with a big move higher in Q1.  Its going to be your typical grind it out top, with no climax moments.  That's going to make timing the top a bit tricky, as these grind it out tops take longer to play out, and are more frustrating to trade.  Going into the year, I was thinking March as the month that the market makes a climactic top.  But now, its probably April or even May when it makes a meat grinder of a top.  

Still long SPX, but trimmed some yesterday and will likely sell the rest today.  I put on a long position in Treasuries for a short term trade going into today's CPI, which I will close out either later today or tomorrow.  Anything above 4% 10 year yields is a low risk long entry point at this juncture.  If the CPI comes in lower than expectations, I may begin to put on SPX shorts, as SPX 4800 is going to be tough resistance as its near all time high territory, and the chart looks short term overextended.