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.