Tight Corporate Spreads

For those looking for an immediate bear market, its quite unlikely.  Corporate bond spreads are getting tighter over the past few months.  Ahead of previous bear markets or near bear markets (Aug 2015, Dec 2018), corporate spreads always were widening before the SPX downtrend started.  

There are 2 exceptions however:  2011 when corporate bond spreads were already historically elevated before going even higher and 2020 when Covid happened.  So based on this alone, it looks quite unlikely that there will be a credit event that triggers a big move lower in SPX.  It doesn't preclude a short term panic lower like late Jan-Feb 2018, when corporate spreads were tightening but SPX went down big anyway because the index was massively overbought and going parabolic.  

Despite tight corporate spreads, I am a believer that SPX upside is limited given current high valuations, the length of the rally (4 months since the last meaningful bottom), and future prospects for growth (poor). 

Usually what happens in a market like this is the market grinds higher, and suddenly, there is a sharp pullback, which causes corporate spreads to widen, with Treasury yields going down.  Then, the market recovers the losses from the pullback as the crowd expects the Fed to turn dovish, and yields stay lower, and corporate bonds don't tighten as the SPX rallies from the pullback.  This is what happened in 2000, 2007, and 2015.  

Last week's blowout earnings from NVDA has helped to keep the parabolic trend intact, and its still a stock that I would avoid shorting given its strength relative to the market.  I am a non-believer in the AI hype, and the current investment spending on AI from venture capital to big tech will likely fizzle out sooner than people expect as the return on that investment will be poor.  The only real immediate impact from AI is its use in graphics, and that market is not big enough to support all this spending.  Once big tech realizes that AI is more like the metaverse than the internet, they will do what META did a few years ago and stop spending.  The biggest beneficiary of that AI spending is NVDA, so you can guess what will happen to NVDA's stock when that spending contracts.  

With regards to the current SPX rally and when it will top out, my best estimate is late March/early April.  These strong rallies usually go on for 4-5 months before a meaningful pullback, and this one will probably lean more towards 5 months because the current price action is not indicative of a topping market.  What you need to see is more optimism about the Fed (with bond yields going lower) to get the excitement and euphoria going.  That's still missing.  I don't see this market going into a sustained downtrend based on a hawkish Fed.  You need to see weaker economic data (lower jobs, lower inflation) to get the bond yields lower and higher anticipation for lower rates.  Only after that happens, along with another few percent move higher in SPX can you think about shorting this monster.  

Reduced my bond position, but will increase it again if I see yields go a bit higher.  Still think the next big correction in the SPX will be accompanied by bond yields going lower, not higher. 

Hot Air Balloon

The balloon keeps floating higher, the view gets better and better.  But remember, this balloon is floating up on hot AIr.  AI is the hot gas that keeps this going up and up.  Eventually the balloon will run out of gas.  

For much of January, we began to see divergences in the stock indices, as the haves (mostly tech growth stocks) kept going higher, while the have nots (most of the remaining sectors) went lower.  We also saw the stock/bond correlation break down, with stocks going higher even as bonds kept going lower.  Last week, the higher inflation prints finally put a little crack into the stock market.  Although being down 1.5% from all time highs isn't much, looking at the big picture.  Especially after the run the SPX and NDX have had over the past month.  

But the speculation and complacency are building.  Look at the 20 day moving average of the ISEE call/put ratio (buy to open orders only), its at the highest levels in the past 5 years, which includes the most speculative market I've ever seen (2021).  Its maintained this high level since late December. 

And the poster child of this market's speculative froth:  SMCI.  It went parabolic going into February opex as the options speculation went through the roof, and we got one of those bubble blowoff tops.  

The high call options activity, the optimism about the US economy and AI, historically high valuations, and a Fed that is on the cusp of an easing cycle are all dry tinder for the upcoming fire.  All you need is one drop of a match to light a huge blaze in the market.  The bulls will say that there is no better game in town, that the US government continues to run a high pressure economy with big budget deficits which feeds into corporate profits, and that fiscal dominance makes tight monetary policy less relevant.  I would agree if those big budget deficits were happening along with strong growth in bank credit/lending, but its not.  The US government has effectively crowded out the private sector with its inflationary deficit spending which has raised interest rates to the point that the private sector has pulled back on borrowing.  And many banks are stuck with bad MBS and Treasury supply bought at low yields a few years back, and are in survive not thrive mode.  Both the government and the private sector were on a credit binge from 2020 to 2022, and while the public sector has continued on since 2023, although at a lower, but still high level, bank credit growth has stopped growing.    

When the government takes over the role of increasing the money supply rather than private enterprise, you naturally have less productive use of the new money that's created.  That's ultimately creates an inflationary structure to the government dependent growth model that the US has embarked on since 2020.  With an inflationary structure, yields naturally go higher and stay higher.  We are still in a disinflationary cycle because of the lack of new credit from the banks, and due to most of the deficit spending going towards the old and rich, who have a lower propensity to consume their extra cash than the young, poor, and middle class.  But if we get the banks lending freely after the Fed has cut rates to more palatable levels for small business (<3%), then you will get another inflation wave as the underlying cause of the inflation hasn't been addressed.  

No, we are not going back to world of low inflation, ZIRP forever, and TINA investing.  With higher inflation comes higher bond yields, and more opportunity to get yield without taking equity risk.  There is a lot of private lenders who are getting 8%+ yields for relatively safe credits with good collateral.  The extra competition for cash in a higher inflation world will put a lid on stock valuations.  It makes little sense to pay a 25 P/E for stocks when you can get 8+% in much safer investments.  People forget that loans/bonds are higher up on the capital stack than equities and thus usually offer lower long term returns than equities.  The way equities offer better long term returns than bonds/loans is through lower valuations, not higher.  

With US population growth running around 0.5% over the past several years, with an aging society and a labor force that's growing less than the population, there isn't that much organic demand for credit.  Why would a small business borrow money at high rates to make investments when its business isn't growing nearly as fast as the borrowing rate?  The tight labor market is a function of a workers to population ratio which is falling, not a strong economy.  You can't even compare the US to where it was 25 years ago, during the dotcom bubble.  The demographics were younger, the population growth was higher, and deflationary wave of cheap, high skill labor in China was just getting started.  Now its an inflationary wave of less domestic labor, less cheap overseas labor, older population and less population growth.  All negatives for economic growth.  Yet you have so much optimism about the economy and the stock market at near all time high valuations.  These are almost ideal conditions for a long bear market.  At best, these are conditions that lead to a long term sideways market with minimal capital gains for equity investors for the next several years.  That is the big picture view of the current market.  In the short term, its more random but there are intermediate term signals mentioned above that are flashing amber lights.  

Still a stuck long in bonds, which I will hold until I see a better setup to short stocks.  NVDA earnings are coming after the close today.  No lean on that, neutral on the name.  I still think this AI bubble has one last burst higher left in it, it could come after the NVDA earnings, or it could come in the spring.  But the bubble isn't at the popping point by looking at what I see in the financial media.  From this point onwards, the big money will be made in shorting stocks in 2024, not being long stocks.  But timing is always tougher on the short side so waiting for more ideal conditions and for the rally to get a bit older. 

Feast or Famine Business

Trading is not a steady income business.  Those that try to make it a source of steady income like a normal 9 to 5 job usually go the daytrading/scalping route.  Without a doubt daytrading has the highest failure rate of all forms of speculation.  There just aren't many edges out there on a day to day basis.  The edges which do come regularly are dominated by HFT firms which easily beat out retail traders.  If you are a retail trader, its an act of supreme overconfidence and hubris to think that you can outscalp these HFTs which specialize in front running and being the first in line on the bid and offer queue.  Not to mention the slippage and transaction costs add up quickly the more often you trade.  

Trading is a feast and famine business.  Its usually long periods of famine with brief periods of feast.  Those that try to make steady income during the long periods of famine are trying to squeeze water out a rock.  Those that are satisfied with making a steady income during feasting periods are minimizing the opportunity set available during those good times, making a little when they could make a lot.  If you have been in this business long enough, you get better at recognizing what are tough trading markets and what are good trading markets.  

Usually, the more volatile the markets get, the better it is for trading.  The main reason for this is because markets often get volatile when investors are losing money and panicking out of positions.  Predictability correlates with volatility but not always.  Sometimes you get volatile markets that are unpredictable.   For example, the bond market in 2023 was quite volatile but were hard to predict (Silicon Valley Bank going bust in March, long end panic in September/October).  I remember seeing rampant call buying in TLT into a strong downtrend, thinking that it was unlikely so many options punters would make money buying in a market so weak.  But they were right, which is uncommon.  

Right now, people are making money, volatility is calm, and investors are not panicking. Its a tough trading market.  But I stay in the game, keep watching the markets, put on trades, not trying to hit home runs or make steady income, but to get a feel for when its about to get good again.  What trades I make during these tough times are probably slightly negative expected value (EV).  But observing the market and making trades helps with timing the next big trade, the time when the markets get good again, when there are many positive EV trades.  

Usually the longer the famine, the bigger the feast on the other side.  While 2023 was a good market for investors, it wasn't a great trading market.  Especially for those with a bearish lean.  For those natural born bears out there, its about to be your time again.  We have the ingredients for a bear market lining up.  

1.  High valuations and large asset allocations towards equities among individual investors.

2.  Investor optimism and complacency about the economy.  Soft landing consensus.

3.  A bubble in AI with greedy investors bidding up other high beta assets like bitcoin.

The rally off the late October low is now 3.5 months old.  Looking at past strong rallies like this off of V bottoms, the average length of the rally is from 4 to 5 months.  So we are getting close to the end of this bull run.  From a price perspective, this rally has exceeded my expectations.  But that just makes for a even more lucrative short setup in the coming weeks.  This is opex week, and with how relentless the uptrend has been, you are setting up for a Friday opex day climax top.  I don't expect that to be the final top of this rally, but a 3 to 5 day post opex selloff coming off that climax top would not surprise.  Something similar to what happened after June 16 2023 opex. 

The goal now is to keep a close eye on the market and participate but not lose too much money while waiting for the good times to arrive.  Still long bonds and waiting for a climax top to short SPX.  The AI bubble keeps growing, but its still too strong and too early to short.  We have NVDA earnings next week, which could serve as a catalyst for the final blowoff top in the name.  The sharpest moves occur at the late stages of a rally, so timing is everything when it comes to trying to pick tops in bubbles.  I would like to see more 2nd tier and 3rd tier AI bubble plays flying higher to get more confidence that a top is near.  We haven't seen that yet, so holding my fire for now.  The AI skeptics are mostly gone, and nearly everyone believes is will be a huge breakthrough technology, almost like the 2nd coming of the internet.  This usually the parabolic phase of the bubble where the sharpest moves higher happen.  Probably in the 7th or 8th inning of this AI bubble, so not much time left for those playing that game.  

Crocodile Jaws

The jaws are widening.  SPX keeps going up, and the Russell can't keep up.

The Russell 2000 lagging the SPX is getting egregious.  The market is splitting wider and wider, into a small minority of haves, and a majority of have nots.  We also got 2 more Hindenburg Omens on the Nasdaq in the past week.  That's a total of 5 Hindenburg Omen signals year to date.  When you see a cluster of these Hindenburg Omens show up, its a warning shot that the rally is on borrowed time.  It can pullback right away, or it can pullback in a month, but there is usually a correction within 2 months at the latest.  

Russell 2000/SPX ratio

 

We are also seeing asset managers get more aggressive in adding SPX futures long exposure, as we are now at a 52 week high in asset manager net long positioning.  Dealers also got more short, although not at 52 week lows in positioning.  These are not outright sell signals, as rallies in bull markets can last for several months without a correction.  But this adds to the weight of evidence tilting the odds in favor of a down move over an up move in the next 3 months.

SPX Net Positions of Asset Managers and Dealers

 

Two main things we learned over the last week: 1. Powell is going to try to delay rate cuts into at least May, if not longer 2. AI tech bubble is getting even bigger.  

Powell is getting brainwashed by all the soft landing talk, about how its too early to cut in March from the investment community, and he followed through.  Powell is known for lacking backbone, and he proved it once again, going with what Wall St. wants.  Even when acted like the second coming of Volcker in 2022, it was only because Wall St. was going crazy over inflation and he had to do something about it.  So Powell will let these higher rates deal a bit more punishment to small business.

NVDA is now over 700.  META went up nearly 20% in one day.  The breadth is getting narrower as the haves keep roaring higher, and the have nots just stagnate or drip lower.  One thing you have to realize about big tech stocks like META, GOOG, MSFT, AAPL, AMZN, NVDA, etc. are that they are not a net positive for other companies.  They are a net negative.  Big tech stocks back in the old days used to be drivers of economic growth.  Now they are just rent seekers, parasites trying to push profit margins up as high as possible, seeking the maximum point on the profit curve.   

META raising prices on ads, reducing or completely eliminating exposure for non paying accounts in favor of accounts paying the most ad money to Facebook/Instagram.  META is trying to squeeze out as much ad money from their customers to the crying uncle point, because there are almost no alternatives in internet advertising.  GOOG doing similar things, although not as egregiously as META.  AAPL pushing out the same phones with just slight tweaks and charging more for it because their customers are addicted and/or don't know how to switch to Android.   NVDA selling overpriced graphic cards and trying to bundle it with other services which are also overpriced.  These companies are becoming kings of rent seeking, not innovation.   MSFT and AMZN are basically a data center duopoly, and can push up pricing at will because its such a huge pain to go from outsourcing to making and running your own data center.  

There is such a huge bubble in AI, where the hype is so thick that big tech companies are shooting first (investing in AI) and asking questions later.  They don't have the slightest clue on how they will monetize whatever they develop with AI, but it sounds cool, and Wall St. loves it, so they keep doing it.  NVDA is the main beneficiary of this shoot first mentality, but how long does this last for?  Will companies continue to send billions to NVDA for overpriced chips to build up their AI capabilities when its all just money going down the drain?  I know this sounds like a crazy comparison, but the AI craze reminds me a bit of META going bonkers about the metaverse back in 2020 when people were holed up in their homes.  We know how that ended up.

This bloated Mag 7 led rally is just rotten at the core.  There is no natural economic growth behind it, just some additional deficit spending that puts a few more dollars in the pockets of the rich, the elderly, and lobbying companies.  The current misallocation of capital from nilly willy government spending will haunt future generations.  They all say how the economy is so great because of all the job creation.  But they forget to mention that part-time jobs are where the growth is, and its coming from the poor needing 2 jobs to get by.  Tax withholding data so far this year is showing total wages basically stagnant on a year over year basis.  That data is much more reliable than whatever surveys the BLS uses to measure NFPs.  Yet when we got the big jobs number on Friday, the Wall St. crowd went into a tizzy, celebrating the great unstoppable machine that is the US economy.  Such a great US economy that small cap companies are massively underperforming large cap ones. 

The market is slowly grinding to a top, but the last missing ingredient is the excitement and exuberance you often see at tops.  I see less denial than a week ago, but there is not the typical exuberance that one would expect at market peaks.  Timing cycle patterns for the SPX still give this rally about 4-6 more weeks to run.  So I'm reluctant to get short SPX/NDX until I see more overt signs of a top.  I am still long bonds, and investors are overreacting to the nonfarm payrolls and Powell's reluctance to cut rates anytime soon.  The bond market will rally big not when Powell decides to cut, but when the data and market conditions urges him to cut.  We are not there yet, but with how bubbly the SPX is, I wouldn't be surprised to see a big risk off selloff in stocks coinciding with a strong rally in bonds in the coming months.