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.