Second Warning Shot

This market is wobbling.  AI is the only game in town.   NVDA is holding up the Nasdaq.  There is a growing number of individual names showing weakness underneath the surface of calm in the S&P 500 and Nasdaq.  This triggered a Hindenburg Omen signal for the Nasdaq on May 23.  

The last 2 signals were triggered on March 12 and 13, so it was early in forecasting a correction then.  It also triggered 6 times from mid January to early February without any negative consequences.  A cluster of these signals are more meaningful, but even one signal is a negative for the intermediate term.  A cluster of Hindenburg Omen signals  preceded corrections by firing off on November 2021, February 2020, July/August 2019, August/September 2018, and July 2015.  In the past 10 years, it provided false signals in December 2014, June 2017, August 2017, and November 2017.  The hit rate is about 60% for predicting a correction within a month, which is actually a strong bearish signal because any random 1 month period in the S&P 500 historically has gone down less than 40% of the time.  

The COT futures positioning data also supports the bear case for an imminent pullback.  As expected, asset managers chased the market as it went higher and net longs in SPX futures are back to late March levels.  Dealers also added to shorts, taking net shorts down to late March/April levels.  Positioning is now saturated, making the market vulnerable again. 

Speculation is rampant again among small cap daytrader favorites.  Two weeks ago it was the meme stocks.  Last week was NVDA and various small cap stocks that spiked out of long term downtrends amidst intense daytrader speculation.  This week has been tertiary AI names that have rallied.  This kind of activity in small cap stocks happen when optimism is high and positioning is quite long already.  This is not a perfect indicator and is usually early, but its another sign that bulls have gotten too aggressive taking the market higher and a pullback is likely within the next month.  

NVDA has been catching my attention since its earnings report came out.  It has gone up 20% in the past 4 trading days, taking its market cap to nosebleed levels.  NVDA's market cap is now almost the same as AAPL, and only 10% less than the biggest of them all MSFT.  Its market cap is $700B larger than GOOG.  $1000B larger than AMZN.  From a 30,000 foot view on NVDA's long term return prospects versus AAPL, MSFT, GOOG, and AMZN. I would take all 4 over NVDA all day long.  NVDA is being valued as if this AI capex build out will go on in perpetuity.  There is so much hype surrounding AI, while the use cases are so much more limited than the amount of enthusiasm about the technology.  I am looking into putting on a long term short position in NVDA within the next 3 months.  You could get one last bubble spurt higher post-split, as the lower stock price will trick investors to think its less expensive. 

On the macro front, bonds trade horribly both in the US and Europe.  The slightly lower than expected CPI number happened to be the top for both Treasuries and Bunds.  Since then, its been a downhill slide for bonds, despite almost no economic data of consequence.  Treasury auctions have tailed badly and demand is not strong enough for the huge supply deluge.  And this is during the seasonally strong mid to late May time period post refunding auctions for 10 and 30 year Treasuries.   This is not a good sign for June, especially if Powell finally stops trying to force his dovish bias onto the market and accepts that the market wants to price yields higher given sticky inflation, the strength of the stock market, and tight credit spreads.  This bond market weakness is likely to persist into the election, as bond investors will not want to get too long ahead of what has been bad news for bond investors in the past 2 Presidential elections (selloffs after 2016 and 2020 elections) with 2 deficit loving Presidents.

We have price action in individual stocks giving a bearish signal (Hindenburg Omen), we have positioning back to near max long in SPX futures, and lastly, we have the complacency, lack of fear, and rampant greed among individual investors as meme stocks and AI stocks like NVDA have gone crazy.  This is lining up for a high risk/reward short going into June.  The only fly in the ointment that I see is that CTAs that I track are still not long SPX, based on correlations with daily hedge fund CTA return data and positions in the most popular trend following CTA ETF, DBMF.  If they did start getting longer, that would be the final piece that would line up for a super bearish setup.  As it is, its still a bearish setup but I don't like to short in the hole when the SPX is in such a strong uptrend.  I am not seeing much euphoria or enthusiasm about the SPX so that gives me pause about shorting into this market right away.  The next rally that takes it towards last week's highs would probably be a good short opportunity, but we'll need to see how the indicators and investors react to it.

First Warning Shot

Yesterday was the first warning shot from the bears since the post CPI relief rally on May 15.  This takes on more significance with the rally off the geopolitics/higher rates fear bottom on April 19 is now 5 weeks old.  That April bottom wasn't really capitulative, so it didn't provide enough of  reset to fuel this market higher for 5 months like the August-October selloff, which was exhausting and purged a lot of positioning.  So run of the mill dips like April's fuel up moves for a few weeks, and then enter a window of vulnerability where sudden dips and corrections occur.  

Until yesterday, there wasn't much to say, as the market was flat as a pancake and VIX was in the 11s.  The VIX is still quite low here in the 12s, but part of that is the lack of important econ. data in the next week and the long weekend coming up.  When the market is flatlining and doing nothing, like it did from May 16-22, there is no edge.  There is no signal to trade off of.  When you get the next movement off of this quiet period, which was to the downside, is where you get the signal.  

Thursday's selloff coincided with the post NVDA earnings blowout euphoria which took ES up towards 5368, or almost SPX 5350, and the bond selloff triggered by higher than expected S&P Flash PMI numbers.  That tells you something about the weakness in bonds when third tier econ. data can take bonds down so easily.  Notably, you saw NVDA strength unable to lift tech stocks, even semiconductor names.  A sign of buyer exhaustion.  That being said, usually the first small dip is bought and the highs are retested.  I expect this dip to be bought and another run towards the SPX 5350 area where I expect sellers to come out once again.  

COT Futures positioning data showed that asset managers have aggressively re-added to their net long SPX position, almost back to the highs set earlier in the year.  Dealers remain heavily short, a long term bearish signal.  This data is as of Tuesday, 5/14, so doesn't include the CPI rally where I am sure asset managers added to their longs.  That puts us back to saturated positioning among asset managers, which means most of the fuel for this rally has been used up. 

The complacency is evident in how cheap options have gotten, with the VIX back to levels last seen in 2019.  Volatility is just too low for how high this market is, but it just shows you the short term nature of this market.  As well as the popularity of selling options for income, which have sprouted more option selling income ETFs.  This is the kind of thing you see when there is little fear of a big selloff, and when investors feel confident and comfortable.  Not a great sign for long term returns when you see this kind of investor behavior at historically nosebleed equity valuations.  

On the sidelines waiting to put on shorts into the next rally, as I see good risk/reward for index shorts as well as individual names for the next few weeks.  The bond market is weak, so it is a no touch at this moment.  Shorting SPX is a superior trade to being long Treasuries for a risk off scenario.  That is quite the sea change from the 2009 to 2020 era where long Treasuries was almost always the superior trade to being short SPX.  But this is a totally different regime to back then, so adjustments need to be made. 

Releasing the Tension

The move you saw off that CPI number which was just slightly cooler than expectations was a sigh of relief rally.  So much tension was built up over the 1st quarter regarding inflation that CPI became the most feared event on the calendar.  

Yesterday, you got the most feared economic data point released and that caused a buying stampede in stocks and bonds.  The biggest wall of worry has been inflation, and the CPI report has taken on renewed importance in the past few months.  Whenever investors focus on an event like this, you get distortions in price action and before and after effects which are more predictable than your random non event day.  As much as they say that algo trading and systematic strategies have taken over a big portion of trading, its still humans who pull the strings.  What you saw yesterday was a release of tension that comes from putting a feared event in the rear view mirror.  With that release of tension, investors became more eager to buy stocks and bonds even though yesterday's CPI won't really change Powell's reaction function.  But just not having something bad happen, which many feared, especially after the higher than expected PPI number on Tuesday, was enough to rocket this market higher.  That release of tension and reduced uncertainty usually leads to higher prices.  And that's exactly what happened yesterday. 

Sure, there are still your inflationistas who fear that inflation will remain sticky and that the Fed will not get that beautiful soft landing that so many are forecasting.  But even the inflationistas will admit that inflation is bad for bonds, not necessarily bad for stocks.  All you have to see is the performance of TLT vs. SPY over the past 18 months.  While yields have been going higher, so has the SPX.  

These days, you see very few who fear a hard landing/recession.  Even with the softer economic data lately (hard data, not soft data this time), most are looking at forward looking indicators (mainly financial conditions aka stock prices/credit spreads) which point to no signs of a recession anytime soon.  It is a consensus view, but its also likely the correct view for the next few weeks.  So you can't fight it, even at these lofty valuations.  

But let's not forget that even hard landings and recessions have a period of time before things get really bad where a slowdown is viewed as a soft landing.  You saw that in the fall of 2000, and in late 2007. 

With new all time highs comes opportunity, as the higher the SPX goes, the more potential energy builds for a sharp correction.  April proved to be the dip that refreshes, clearing out weak hands like CTAs and trend traders.  You also got enough of a purge in long positioning among asset managers in SPX futures to enable this market to go higher with fewer weak hands.  Asset managers have started to rebuild their net long positioning as of last Tuesday, May 7th.  It probably takes at least another 2 weeks for the latecomers to come on board, and then it will time to look for downside plays.  Over the rest of the month, we are likely in that low volatility grind higher/flattening out part of the rally.  The coming reduced volatility will likely lull investors into complacency again and then we can have another dip.  Right now, just on the sidelines waiting for the market to develop for a potential short play. 

Rock and a Hard Place

We are between a rock and a hard place.  There are sweet spots in the charts where you have good risk reward for a swing trade, for example after a flush out move lower in a strong uptrend (April monthly opex day), or the first retrace lower on bad economic data/earnings (after META disappointing earnings and higher than expected PCE inflation in GDP report) after the initial jump higher.  Right now, most of the bull fuel feeding off of the strong oversold levels have been used up. 

Over the past few days, the market has thrown some curveballs.  First, which was a surprise for most, including me, was Powell doubling down on his dovish rhetoric, believing that disinflation will continue and allow him to cut rates later this year.  He was way too early in celebrating the disinflation in late 2023 by forecasting rate cuts for 2024, and he's not backing off.  People are driven by incentives, and his incentive is to stay in power as Fed chairman, and that means keeping Trump out of the White House.  He won't admit as much, but Powell knows he's going to be fired at the first opportunity by Trump if he's elected.  If its Biden, he probably gets renominated as Fed chair.  So Powell is incentivized to help Biden as much as possible leading up to the election in 2024.  That means keeping the economy as strong as possible, ignoring high inflation as much as possible without losing his credibility.  

I thought Powell was going to cave in to public pressure to be more hawkish and sound tougher on inflation, but his hunger to remain in power has overwhelmed any kind of public backlash on inflation.  The dovish Fed was initially met with a strong rally, but sold off the same day, but then recovered quicker than I expected with the weaker than expected nonfarm payrolls which helped to put a big bid in to bonds, which reflexively kicked off a strong rally in equities.  This violent chop was definitely not expected, but it also shows how nervous the market was.  Despite the nerves, the lasting selling pressure just wasn't there, as most of the eager sellers had already sold.

On the macro front, it appears that traders are backing off the no landing scenario after the latest pullback in stocks and the weaker than expected nonfarm payrolls, PMIs, and ISM report.  But with bonds going up, they are now back to the soft landing scenario and believing that the Fed will have this market's back if there even a slight sign of labor market weakness or disinflation.   So back to optimism again on macro matters.

That is being reflected with SPX almost back to 5200, levels where upside is limited.  But downside also looks limited, with the market showing more strength than I expected.  The last COT futures report showed asset managers and small speculators reducing longs as of April 30, before that dovish Fed meeting.  Asset manager net long position in SPX futures is now back to levels of July-September 2023, when the SPX was trading around 4500.  Dealers also covered some shorts, but they still have a large net short position.  Historically, whenever dealers had such large short positions, a big correction was due within 6 months. 

 

A lot of the speculative froth has been wrung out of this market in April, which makes it dangerous to short in the near term.  But I just don't think the market is bullish enough or the fundamentals good enough to chase longs after such a big bounce off the April 19 low at 4967.  

This leaves traders between a rock and a hard place, with no easy trades.  Don't want to force anything here, there are no good risk reward opportunities in the SPX or in bonds.  For individual stocks, the opportunities are a little bit better but also mediocre.  Haven't been reading the market well for the past few months so the market will have to induce to me to put on positions by getting to prices where I want to buy or sell.  Right here, I don't want to do anything. 

Dusting Off the Hawk Costume

Powell celebrated too early.  At the Decemember 2023 FOMC meeting, he spiked the football at the 10 yard line, before getting to the end zone.  Bonds and the yen are taking the brunt of the pain this year for that premature celebration.  Powell is a politician, and he flows with the crowd, and the crowd is worried about sticky inflation.  After 3 straight higher than consensus CPI reports, he cannot come out sanguine and dovish at this FOMC meeting.  Even if he wants to be dovish, he just can't do that again.  He would look completely out of touch with reality if he did it.  So expect Powell to dust off the hawk costume from 2022 and try to reestablish some inflation fighting credibility.  You already heard him at his last speech getting rid of his rate cuts forward guidance for this year.  He'll likely go even further into hawk mode at this meeting.  

The bond market and the currency market (especially the Japanese yen) have already caught on and expect the Fed to stay higher for longer.  Its basically the consensus view at this point, which means its going to take a lot more hot inflation data to selloff the bond market further.  The odds are now skewing more in favor of betting on rate cuts again, as the Fed is still looking to cut as soon as the data cooperates.  And with consensus CPI expectations going higher, it will make it more likely that the CPI actually comes in cooler than expectations.  The CPI is such a manipulated and manufactured number that hedonic pricing influences will always keep the number lower than it should be.  Add to that the seasonal effects that gave hotter CPI numbers for the 1st quarter.  You are likely to have the opposite effect in the next few months, pushing the numbers lower than it should be.  Plus the owners equivalent rent calculation is so lagged that it still hasn't priced in the lower rent inflation of 2023.  That should flow into lower housing inflation numbers in coming months. 

From a big picture perspective, my views are still the same.  High valuations and excessive economic optimism (most believe either in a soft landing or no landing, see below). 

Futures positioning is also unfavorable for the next several months, as you have commercials go net short ES over 200K contracts over the past few weeks.  Commercial net positioning of -200K or more has been seen near tops in January 2018, October 2018, and late 2021.  Also, small speculators have been building up long positions throughout this year, which is also bearish long term.  It isn't great for short term market timing, but its a good indicator for showing that the market is vulnerable to a big down move within a few months. 

ES Commercial Net Position

ES Small Speculator Net Position

10 year yields at 4.68% is getting close to a decent short term buying opportunity, although I would wait for the FOMC hammer before buying Treasuries.  Perhaps 10 year yields of 4.80%-4.90% would be place to put in bids for a return to a move towards 4.40%-4.50%.  If we do get the Powell hawkish hammer that I am expecting, that should also push SPX down towards 4900-4950, breaking the previous lows from monthly April opex at 4953.  That could be the final flush out of this move, which would coincide with how many of these extended selloffs usually last, which is ~ 1 month.  This selloff from the all time high started on April 2, so we are closing in on 1 month.  

I sold the rest of my SPX longs yesterday.  Now looking to buy dips on SPX and Treasuries after FOMC.  If the SPX can get to that 4900-4950 zone, the plan is to get long and hold for a intermediate term move higher that could last 4-5 weeks.