Perpetual Boring Machine

The SPX is a perpetual motion machine that goes up in a 30 degree angle on the charts.  The last 5 months would be a textbook example for a book on trend following.  Yet I still plenty of fast money traders reluctant to embrace this rally, to get bullish and excited.  There are still lingering fears about sticky inflation and doubts about how much the Fed can cut in 2024 and beyond.  And the technical traders are still complaining about how there's been no pullback, which makes the uptrend "unhealthy".  You continue to see stubborn short sellers take shots at this market, thinking that a correction is due, and they just keep getting squeezed on the next rally to all time highs.  

Last week, OCC data on buy to open puts vs calls showed higher put activity than the week before even as the market kept going higher.  There were net negative deltas for SPX, SPY, and QQQ options for most of last week, so options traders were reducing long exposure.  Even with the dovish FOMC announcement and the breakout to new all time highs.  There continues to be profit taking and hedging in the options market.  

In a sign that some investors are slowly adding back long exposure, asset managers added to their net long position in SPX and NDX futures last week after reducing exposure for the past two weeks.  Net SPX futures long positions are basically flat since the beginning of the year, despite the SPX having gone up 500+ points during that time frame.  The last time you saw a pattern of the SPX going up so much with asset manager net longs staying flat was from January to May 2021, and July to Dec 2021.  Before that a similar pattern was seen from May 2017 to December 2017. 

We have yet to see overt signs of excess speculation or euphoria in the futures and options market.  This reminds me of the late 2017 market when the volatility died down, the market kept grinding higher, yet you didn't see a lot of speculation or investor excitement.  That market was also led higher by tech stocks.  That late 2017 was characterized by low vol, options selling to collect premiums, and shorting VIX to collect positive carry as the VIX curve was in steep contango.  If things play out like late 2017, then we could have several more weeks of a grind higher into a monster blow off top, like what you saw in January 2018.  It would be mind boggling to see, but it cannot be ruled out considering how little Powell and the Fed seem to care about loose financial conditions or a bubbly stock market. 

So what is the plan for this bubble?  The original plan is in the scrap heap, as a top in late March seems very unlikely based on current conditions.  The rally off the late October low is now 5 months old, so we are now in the danger zone where the market is vulnerable to a correction.  But we've seen longer rallies without any meaningful pullbacks, such as in 2017 and 2021.  In fact, based on current futures positioning, volatility, and investor psychology, those analogs are quite relevant for this market.  If in 2024 does play out similarly to 2017 and 2021, you probably have just one decent correction (5-10%) all year.  That would be a brutal market for a short seller.  Still leaning towards a more bearish picture for 2024 than either 2017 or 2021, but the data doesn't support that view.  

Its easy to fall into the trap of putting on positions based on the market that you want, rather than the market that exists.  I'd be thrilled to put on shorts into an overvalued bubble market that looks to be topping out and make a quick score with little heat.  But that doesn't fit the reality of the situation which is a strong bull market that doesn't give dip buyers any good opportunities to get in.  

Despite the sky high valuations, you haven't seen the excessive optimism that you saw in late 2017/early 2018 and most of 2021.  Even a dovish Powell in the face of higher than expected NFP, CPI, and PPI numbers didn't get investors excited.  You can't force trades as a short seller in a raging bull market.  Being super selective is the only way to survive for those with bearish leanings.  As for longs, playing musical chairs and buying after 5 months of a relentless rally is just not a great risk/reward situation.  Even though I expect SPX and NDX to keep going higher.  Sold the rest of my bond position.  Its boring, but keeping powder dry and waiting for better signals.

Waiting Game

Many people were surprised by how sanguine Powell is about inflation despite the hotter than expected CPI and PPI over the past 2 months.  Powell basically telegraphed his views in front of Congress a couple of weeks ago.  His default position is to cut 3 times this year, and to start in the summer.  Its going to take a lot of bad inflation data and hot jobs numbers to get him off that position.  

The knee jerk reaction from looking at a soaring stock market is that Powell is making a mistake by making financial conditions too loose.  But investors basically are living in a bubble of their own making.  For investors, the economy is secondary in importance to the stock market.  Since the SPX is making new all time highs on a regular basis and is on a rocket ship higher, investors think the economy is doing just as well.  Because they are getting richer.  But if you get down to the real economic numbers, its a mediocre economy.  Full time jobs are in a downtrend, something usually seen right ahead of or in recessions.  Retail sales are also flattening and going lower.  

I hate to admit it, but Powell made the right move to not waffle on his original position of cutting 3 times this year, even though you got hotter inflation prints.  The real economy is just not as strong as the stock mongers will have you believe.  

The most common reason I hear for continuing strength in the economy is the large budget deficits and fiscal dominance.  There is a bit of truth in that, but a lot of that fiscal stimulus is being offset by both the reduction in the Fed balance sheet and the reluctance of banks to lend and businesses unwilling to borrow at high rates.  Loan growth is non existent, and much of the fiscal budget deficit now goes to paying interest on the debt, which is money that mostly flows to the rich, who have a high propensity to save rather than consume that interest income.  Before 2020, a big portion of the increase in money in circulation was coming from increased bank lending.  That money was going to high propensity to consume/invest borrowers which boosted the economy more than the current setup of force feeding high interest to buyers of Treasuries and money market funds.  

Big fiscal deficits are not a cheat code for strong economic growth.  Unless its accompanied by central bank bond buying, it leads to crowding out of private borrowers via higher yields.  

That is why this bubble in the SPX and NDX is so puzzling.  Bubbles usually happen when the economy has been hot and growing rapidly, not when investors are confident in a soft landing and lower interest rates in the future.  But the high valuations, investor psychology, and rampant speculation in AI and bitcoin show we are clearly in bubble territory.  While bubbles usually end badly, they go on for longer than any rational person could assume.  Its why I've been cautious about shorting this market.  To short a super strong bubble like this, you need almost everything to line up perfectly to put on a good risk/reward short where you don't have to take too much heat.  Entering shorts too early and taking heat in this type of  market is asking to get squeezed and stopping out at the top.  

Here are some missing ingredients for a top which I am still looking for:

1) Asset managers in the COT data getting aggressively net long SPX futures.  While they are quite long, they have been reducing long positions as the market has been going higher.  That's not an ideal short setup.  

2) More good news from economic data.  You need to see the CPI and PPI numbers coming down, and coming in below market expectations.  SPX has been marching higher despite bad inflation numbers.  You want to see good economic data, Treasury yields going down, excessive optimism, and short term overshoots.  These bad inflation numbers are keeping investors somewhat cautious, which is not a good setup for shorts.  

3) Fewer investors looking for a pullback.  Some of the most reliable contras on Twitter are fighting this rally, and looking for a correction, which keeps me away from shorts at the moment.  I want to see more investors embrace this rally as it goes higher.  Not seeing that yet.  

From a long term perspective, this stock market seems nuts but you have to be data driven and process oriented.  The data is still not overwhelming enough for me to get short, and it may take longer than I originally expected (late March) to reach the top of this move.  We may need to see some more favorable economic data / higher confidence in the Fed cutting 3 or more times this year to get the euphoria needed to form a top.  That means we could be waiting till mid April to early May before we top out.  I'll let the data and positioning guide my views.  Definitely not going to take a stand here just because the SPX is higher than my initial price target to start a shorting campaign.  Powell gave the green light for further speculation with his dovish stance.  That could be the catalyst to get more investors excited to form a blowoff top.  Waiting for it patiently.  Still long bonds, but will trim some if they rally further in the coming days. 

Ripe for a Conflagration

The conditions are getting closer for a raging inferno.  The weeds have grown like mad, with no fires to keep the growth in check.  The Fed and US government are complacent, confident, and content with no major blazes in the past year.  In particular, US politicians have passed the buck and blamed inflation on everyone but themselves.  Same with the Fed. 

Looking at the SPX chart, we are in the late stages of a blowoff top.  The launch angle of this rally is getting steeper, with limited consolidation.  Ever since the market blew through 4800 in mid January, its been a steady, epic run, going up almost 400 points with no pullbacks lasting more than 2 days for the past 50 days.  Let's look back at some past parabolic rallies that made new all-time highs with hardly any pullbacks.  Maybe we can find a pattern.

May 2013 top

This one was a minor blowoff top, as the buildup wasn't that extended and there wasn't the euphoria or speculative excess seen in other parabolic moves.  The trigger for the drop was a sharp rise in bond yields in May/June.  The selloff only lasted a few weeks, and it was followed by further rallies throughout the year to make for a huge up year.  

 

January 2018 top

This was a significant blowoff top, when VIX selling became popular as the VIX went under 10.  In the final stages of this top in January, you can see the uptrend getting steeper.  The post Trump tax cut euphoria as well as the relentless uptrend in 2017 got investors complacent and greedy in early 2018.  A huge spike in the VIX caused the short VIX ETN XIV to get liquidated in a panic.  There was no news catalyst, the market just collapsed on itself.  The market traded sideways to higher for the next several months.  

 

February 2020 top

Who knows how much further the rally would have gone without Covid, but the market was vulnerable to a selloff as a breakout above 3000 in October 2019 resulted in a 10+% rally making all time high after all time high for over 3 months with hardly any pullbacks.  Even without Covid, the market was ripe for a decent correction.

 

September 2020 top

This was a minor blowoff top to new all time highs, 5 months after the Covid panic bottom.  This rally was led by tech stocks and the speculation was quite hot in Nasdaq names.  There was no catalyst for the selloff, although there were rumors of Softbank buying calls on QQQs and big cap tech stocks which could have caused a short squeeze in late August/early September.  

If you go back farther, there are other instances of parabolic rallies in SPX, most of which ended with sharp pullbacks.  On occasion, there were mild pullbacks with a several week consolidation period to digest the gains and get investors used to buying at higher prices.  But those were the exception, not the norm.  The general pattern for these parabolic rallies when they end is a sharp, steep pullback, not a gentle, calm selloff. 

The intermediate term(1-2 month) risk/reward is now getting more skewed to favor shorts over longs. At current levels, shorts are likely to only lose a small amount if wrong, but have possible big gains if right.  On the other side of the coin, longs are risking big losses with small possible gains. Yet, despite conditions becoming more favorable for shorts than longs at the present time, I expect them to get even more favorable, i.e., a bit more of a rally higher before the correction.  You still have CPI coming up and the Fed meeting next week, and I expect both to be fuel for bulls to get more bullish.  Expectations seem to be leaning for a hot CPI number, as many are still in the strong economy, sticky inflation camp.  Market pricing has come down quite a lot for rate cuts in 2024, with less than 4 rate cuts priced into the SOFR curve.  That gives a lot of room for more cuts to get priced in if the data gets soft.  The crowd seems to have fully bought into the soft landing, even some no landing scenarios and the STIRs pricing reflects this. 

There is a fly in the ointment for the bear case.  Looking at futures positioning from the COT data, you have seen asset managers pullback from their extreme net long position in the past few weeks, despite the SPX going higher during that time.  This is a bit unusual, as asset managers are usually adding to their net long positions as the market goes higher.  

SPX Net Positions for Asset Mgr and Dealers

Asset manager net longs were highest on Jan 30, when SPX was at 4951.  With SPX at 5085 on Mar 05, their net long position have reduced by 51K contracts.  You can also see dealers reducing their shorts from early January to March 05.  For the best shorting opportunities, you want to see asset managers getting longer and dealers getting shorter as the market goes higher.  Either a speculative blowoff top with steep gains in the coming days or asset managers getting longer/dealers getting shorter in the upcoming COT reports will provide more confidence in putting on shorts.  

On Friday, we got a little glimpse of how fragile this market is with NVDA trading in a 100 point range on no news, as it sold off hard from extreme overbought conditions.  The air is thin up here, especially for the most speculative AI related names.  You can smell the dry tinder getting close to the smoking point, before you get the huge wildfire.  There is a lot of dry underbrush that's been growing wild since the last fire, providing the fuel for the next conflagration.   

I am still sticking with my late March/early April top prediction.  You still see analysts on CNBC and Bloomberg fighting this rally, being cautious, which makes me wary of putting on shorts at the moment.  I need to see asset managers all in on the long side before I go all in on the short side.  Until then, I would only put on a small starter short position and nothing sizeable.  Still long bonds, which I will look to close out in the coming weeks.