Lighter Positioning

When you are on the sidelines watching but not actively engaging in the market, you often miss the good entry waiting for the perfect entry.  I hardly traded the SPX all year until this month, and it was the wrong side.  A lot of regret over what happened this month, not so much getting long too early, but not catching the good short opportunity in late March/early April.  That last gasp rally after Powell's dovish performance at the March FOMC was the "nothing to worry about" top.  

Part of my reluctance to get short in late March was the strong seasonal tendencies for April, which is historically one of the strongest months of the year.  But it also coincided with a big capital gains year in 2023 which would cause some selling to raise cash for tax payments.  But I ignored my own analysis about rallies being vulnerable to a sustained selloff after 4-5 months of nonstop uptrend price action.  It just so happened that the top on April 1 was almost exactly 5 months after the October 27, 2023 bottom in SPX.  

Definitely a lot of regret about how I've played it, but there will be more chances this year as the upper bound of the SPX seems to be somewhat defined, as I expect SPX 5250-5300 to be a ceiling for at least the next few months.  For at least the next 3 months, there should be range bound trading which will favor fading short term moves to catch intermediate term mean reversions.  With how steep the uptrend has been after the SPX broke 4800 and went to all time highs, it will take a few months to consolidate those gains as valuations are very high.  Also, with rate cuts being pushed out, the positive catalyst that many had relied on as their backstop is in question.  With consensus now focused on sticky inflation, after 3 hotter than expected CPI numbers, that thinking has permeated to the Fed, who always acts with a lag.  I expect a less dovish/more hawkish Powell in the next couple of months, regardless of the inflation numbers and economic data that come out.  That should put a ceiling on any rallies in the next 3 months.  

But there are also bullish data points that are popping up after the past 3 weeks.  Positioning has gotten lighter among asset managers in the COT data.  Asset manager net longs in SPX are now down to mid September 2023 levels, when the SPX was trading in the 4500s.  Historically, large asset manager net long positions are when the market is most vulnerable to a sudden big selloff.  The purge in positioning makes it less likely you get much more sustained selling in the short term. 

 

Here is positioning data for funds coming from Factset.  The data seems a bit off, considering what I hear on CNBC/Bloomberg, but it shows funds as being positioned quite defensively with overweights in low beta stocks and non-cyclicals.  

Here is more positioning data from JP Morgan Intelligence.  It shows the 4 week change in positioning.  Long positioning is now much lighter after the intense selling in the past few weeks. 

CTA trend follower data that I have been tracking show the biggest trend following ETF (IMGP) now net short SPX.  It appears the CTA have mostly abandoned ship and will no longer be providing more selling pressure to this market. 

With a huge group of earnings announcements coming out this week, we will be coming out of stock buyback blackout period by next week, which should bring supportive corporate buyback flows in May.  I still see some headwinds from a very weak bond market, which I think could extend into early May, after what I expect to be a hawkish Powell at the May FOMC meeting.  That keeps me from becoming really bullish here.  But by middle of May, I see room for a medium term move higher for SPX.  

We got nasty META earnings yesterday, giving us a healthy gap down.  I trimmed longs earlier this week, and will look to re-add exposure on any dips today and tomorrow.  I still expect a few more days of a bounce after the intense opex selloff last week. 

Options Expiration Selloffs

The selloff is persisting beyond expectations.  This selloff is coinciding with monthly opex week, which is the week of the 3rd Friday of each month, which can exacerbate moves with dealers delta hedging, bringing on gamma squeezes.  I have found a few examples of persistent selloffs into monthly options expiration, like we are witnessing this week, for historical reference.  I have circled the monthly options expiration week where there was heavy selling.  Many of these options expiration week selloffs were climactic, especially if the market was in a long term uptrend and the selloff had started a couple of weeks prior.

 

SPX March 2011 opex week

SPX May 2012, November 2012 opex week

SPX June 2013 opex week

SPX October 2014 opex week

SPX 2022 opex weeks

SPX August 2023, October 2023 opex weeks

The typical pattern after these heavy opex week selloffs is for the market to bottom either on Thursday or on the Friday of monthly options expiration.  In 2022, when the SPX was in an entrenched downtrend, the bounces after opex week selloffs were either weak or didn't come at all.  But for most of the other options expiration week selloffs, you had a strong bounce the following week.  

The current selloff looks similar to the August 2023 options expiration week selloff, in which the SPX was in an uptrend, but trending down for 2 weeks going into opex week.  As you can see above, the SPX bottom on Friday, August 18, 2023, opex day, and rallied strongly for the next 2 weeks.  

While market pundits will come up with various rationalizations and news to support the reason for the market selloff, the simple explanation is that the rally was quite mature at 5 months from late October to early April, and was vulnerable to a selloff based on any negative: whether it was higher CPI numbers, geopolitical events leading to investor fear and higher oil prices, or weaker than expected earnings.  Now that the SPX has sold off ~5% from the highs, with opex forces exacerbating the downmove, we are set up for a strong bounce next week.  

Regrettably, I missed the selloff and wasn't able to time a short, and to make matters worse, I am underwater on my longs as I got in too early, but I'll hang on and sell on the next bounce.  It should be a trader's market for the next 2-3 weeks, as I expect some violent choppy movement as the SPX tries to make a short term bottom.  I don't see much downside beyond SPX 4950, and I expect all bounces to face serious resistance around 5150.  Its time to get active again trading the waves in stocks, as the volatility has picked up.  

As for bonds and commodities, the bond market looks quite weak, with geopolitical events only providing very brief blips higher before going lower again.  Lately, oil has shown this pattern as well, with it selling off hard today despite the Israel retaliatory attack on Iran overnight.  The geopolitical fear trade appears to have all been played out already, which probably means lower oil and higher SPX in the coming weeks.  The pessimism towards bonds is getting a bit extreme, with many calling for 5% 10 year yields again, although this time, we're not seeing the same level of long bond selling as last October.  Bonds look close to bottoming, as most of the bad news (no long dovish Powell, sticky inflation) is reflected in the prices.  Maybe one more wave of selling moving yields towards 4.80%, but that should be the final move before yields reverse. 

Lay of the Land

Here are the things that I am looking for to time this market and predict when this monster will top out: 

1) Market positioning.  This is a combination of CFTC COT futures positioning data, asset allocation percentages vs historical averages, hedge fund positioning, and ETF flows.  

2) Duration and magnitude of the uptrend.  Intermediate term uptrends off of a significant bottom like last October usually last from 4 to 6 months.  That is not a guarantee, but a guideline.  The farther the SPX is above the 100 day moving average, the more potential energy builds up, setting up a possible big move lower.  

3) Investor psychology.  There are certain behaviors that are common as a move becomes mature and vulnerable to a correction:  more call options speculation/less put buying,  growing optimism about the economy, buying laggards and high beta names to bet on a catch up trade, etc.  

This is the current situation on the above 3 factors: 

1) Market positioning.  Here is a look at GS prime broker hedge fund equity exposure:

Net leverage is off the highs this year, and even below the highs in 2023, and still nowhere near the high levels seen in 2021.  Hedge funds are not fully invested here so there is room for a chase for performance among the hedgies.  Bullish sign for the market.

The latest COT data as of Tuesday Apr. 2 shows dealers adding to shorts, getting to net short levels that were seen from June 2021 to January 2022.  Dealers usually build big short positions after an uptrend is very mature and overbought.  They tend to be on the right side of the trade ahead of a big move, which is usually during a trend reversal.  This time, they are setting up for a big down move. But they are often early and can hold these large short positions for months as the market goes higher, like they did from mid 2021 to early 2022.  Overall, this is a bearish sign. 

2) Duration and magnitude of the uptrend.  Take a look at when you had corrections since 2018.  With the exception of 2021 (an exceptional year in many ways), you had meaningful pullbacks after 4 to 6 months of an uptrend.  

The up trend off the October 30 2023 bottom is now 5.5 months old.  This is well into the danger zone time frame of over 4 months for uptrends without a meaningful pullback.   The time bomb is ticking.  A bearish sign.  

3) Investor psychology.  No charts for this one, as this is one of the factors where screen time, watching CNBC/Bloomberg, reading Twitter and financial media are necessary to gauge investor behavior and sentiment.  The overriding sentiment now is a worry about inflation, especially after that hot CPI number yesterday.  But even before then, the primary worry was about sticky inflation preventing the Fed from cutting rates.  This has kept investors from becoming overly bullish.  The prevailing view I hear is that the market needs to pullback, it is short term overextended, but that the overall economy is strong so they expect higher prices later this year.  Despite the cautiously bullish stance I hear over and over again, the SPX refuses to really pullback here.  A bullish sign.  

A quick word on the macro situation.  The economy in 2024 is weaker than the one in 2023.  The labor market is less tight, retail sales are weaker, and GDP growth is lower.  Yet investors are much more optimistic about the economy now than they were in 2023.  The consensus view is that the US economy is strong, that we will either get a soft landing or a no landing situation, something you didn't hear much in 2023.  

The market is pricing in less than 50 bps of rate cuts for 2024, clearly running with the view that the US economy doesn't really need rate cuts and that the economy will remain strong enough/inflation will be sticky enough to keep Fed from cutting anytime soon.  The risk/reward now seems more skewed towards betting on a hard landing than at anytime since the hiking cycle started.  

Considering how much the SPX has run up this year, I would favor shorting SPX over getting long SOFR or short term Treasuries.  Also, shorting the SPX is positive carry (for futures traders) while going long SOFR or 2 yr Treasury futures is negative carry.  Those little things add up every day and make a big difference over the long run.  This is of course a more long term view, so I am still waiting for the right timing to short this market.  In the meantime, I will just make smaller tactical trades as I await for that exquisite opportunity to put on a larger SPX short position. 

Given the strong uptrend and cautious optimism that I hear and the bullish seasonal factors coming up (mid April to early May is historically bullish, and corporate buybacks comeback), I am leaning bullish for the next couple of weeks.  I am talking my book, because I did get long late last week, and will look to add more on a further dip this week around SPX 5100-5120.  This is picking up dimes in front of a steam roller, so not recommended for long term traders/investors.  

Higher bond yields could definitely be a problem if things get unhinged again like last October.  But unlike last fall, the front end is leading the selloff, or a bear flattening.  Bear flatteners are more benign selloffs as the market is signaling to the Fed that it is about to make a hawkish mistake, and can't continue to stay tight.  Last October was a bear steepener, which is the most bearish selloff you can get in bonds, as the the long duration bonds are the most interest rate sensitive.  That's when the market is signaling that Treasury supply is overwhelming demand.  Neutral to slightly bullish on bonds here, but the trend is firmly lower, and there are lots of feared events coming up (Fed, NFP, inflation data, and Fed).  Its a fear and loathing market so I would rather let the dust settle than try to pick the bottom. 

In Front of the Bulldozer

High prices and calm markets breed conditions for intense future volatility.  Well, we're getting a sneak preview of future volatility as you got a 2% selloff in the closing 2 hours of the trading day, something you haven't seen for a long time.  Some people will blame 0DTE options for the move, but its the complacency that's been building up that sets the market up for these cascade moves lower. Moves like this actually reduce the overbought conditions quickly and flatten out the uptrend, making them more sustainable in the intermediate term. 

For trend followers in 2024, it has been heaven.  For countertrend traders, it has been hell.   Valuations are getting unhinged from the realities of higher discount rates.  Yields are going higher along with stocks. 

Will we go back to the old normal of yields in the 4-6% range like you saw pre 2008?  It depends on fiscal policy.  If the government ignores the deficit and keeps growing the the deficit to GDP ratio to even higher numbers, then you will.  We could be back to a higher plateau for Treasury yields along with higher, sticky inflation.  Fundamentally, the U.S. is becoming a more closed society, with the population wanting less immigration, while wanting more government handouts and low taxes.  This leads to ever growing budget deficits, as politicians will always do what is popular.  Fiscal stimulus and low taxes are popular.   These loose fiscal policies will continue.  In the long run, the large fiscal deficits and the lack of supply growth for labor will lead to higher yields.

With Trump likely to win the White House in November, you get a scenario where a Republican president and a Republican or Democrat Congress produces big budget deficits.  The only combination which has proven to lower budget deficits in the past is a Democrat president and a Republic controlled Congress, and that looks extremely unlikely in 2024.  So more fiscal pump to come in the years ahead.  

But this isn't really an edge.  It's consensus.  Almost everything I read and hear is that the US is entering an era of fiscal dominance, where monetary policy has little effect on the economy compared to fiscal policy.  Now almost everyone thinks recession is unlikely because of the big budget deficits.  But I question whether big budget deficits lead to sustained economic growth.  Just taking a look at the big budget deficits in Japan and the low growth there over the past 30 years, public sector borrowing can crowd out private investment and lending.  You have actually seen some of that in 2023 with bank lending flattening out to no growth, which is unusual in a non-recession.

Lately, the market has run with the fiscal profligacy and government debt fueled boom thesis by selling Treasuries and buying stocks and commodities.  The Project Argentina end game is the right long term thesis, but is it the right short to intermediate term thesis?  The US dollar is still the reserve currency, and its not going to be easy to move to another form of money for global trade.  For example, hard money like gold or even bitcoin are too supply constrained and not what central banks want as the main form of money.  The politicians would never let it happen and would lose too much power in the process.  For now, the Fed still has some inflation credibility by keeping rates high for the moment.

The market is fixated on sticky inflation, and a belief that the US economy is strong, and that the Fed is too dovish.  Thus the rush into commodities and stocks. Looking at the price action, this belief appears almost fully priced into the market.  There is almost no talk about a hard landing or the lagged effect of 5.25% of rate hikes.  You heard that constantly in 2023, when recession was a big concern.  Now, with the real economy slower than it was last year, you have more optimism on growth.  But as I've mentioned previously, Wall St. overestimates the wealth effect from higher stock prices.  There aren't many out there selling stocks at high prices to consume more goods and services.  Those with the largest equity allocations are mostly the wealthy, and their propensity to consume more based on higher stock prices is low.

You have a bifurcated economy, with the rich doing well, and the poor and middle class not so well.  Inequality helps to keep the inflation somewhat under control, since the poor and middle class have the highest propensity to consume their income.  A less prosperous lower 50% is a brake on inflation.  And wage income is growing slower than inflation, despite the BLS making up the inflation numbers to make it appear lower than it actually is.   

This explains the dichotomy of a surging stock market but a low approval rating for Biden.  Most people aren't doing well, no matter how much Wall St. touts the US economy as being strong.  The Wall St. economy is strong, not the real economy.  The real economy is mediocre at best, and growth is overstated since inflation is understated.  

This week, we've finally got a pullback that lasts more than 2 days.  The market selloff started 4 days ago and is now down more than 2% from the highs.  That doesn't sound like a lot, but we haven't had a 2%+, 4+ day pullback in the market since early January.  Its been 3 months since we've seen this type of price action.  That 4 day pullback was a spring board to a huge rally in the 1st quarter.  I don't expect this pullback to lead to a rally anything like that with the market so much more extended.  

But when you haven't had a 2% pullback in such a long time, that pullback is usually bought up quickly and you go right back to the previous highs or close to the highs within weeks.  That is my base case for the current market, and I've actually done the unthinkable and bought this dip in SPX for a trade, expecting higher prices in the weeks ahead.  This a purely tactical trade, and not recommended for long term investors/traders.  Still believe the market will have a much deeper pullback in the coming months, although we may go a bit higher before that happens.  I continue to see many investors who are looking for a pullback and who have gotten nervous this week because of either higher yields or higher oil prices.  I don't expect either of those trends to continue for much longer.  Its the geopolitical bid that's squeezed oil higher recently, and geopolitics is almost always a fade.