The Hamptons Spread

The stock holders seem to be on vacation, with hardly a worry, as their portfolios keep increasing in value, with little urgency to sell.  It appears to be a Alfred E Neuman offshoot of the O'Hare Spread.  Instead of going all in on futures and flying to O'Hare to get out of the country, just in case you lose it all plus more, its going all in on US megacap tech stocks and going to the Hamptons, without a worry in the world, looking to spend your stock market gains before they happen.  With the confidence that megacap tech stocks will keep going higher, those buying the Hamptons Spread go ahead and plan their vacation looking to spend their growing wealth from their large cap, tech heavy portfolios. 

There is little excitement about the overall market.  I don't see the enthusiasm for the SPX.  There is complacency, but very little enthusiasm outside of a few big cap tech stocks that are riding the AI gravy train.   So with so little excitement, how can this market just keep going higher and higher, with just tiny pullbacks, with seemingly more upside vol than downside vol.  The moves higher are quick and fast, while the moves down seem slow and labored.  The strength is uncanny.  Its hard to explain, other than those holding big cap stocks and index funds are just not very eager to sell.  Its not a lot of buyers that are moving stocks higher, it is the dearth of sellers (in the Hamptons?  on yachts cruising to Europe?) that allow for this steady move higher with minimal resistance.

Historical patterns just aren't holding anymore.  In the past, when the Russell 2000 lagged the SPX so badly, usually a pullback in the SPX was just around the corner.  Not anymore.  The Russell 2000 weakness vs SPX didn't signal anything in 2023, as the SPX just kept going higher and higher despite the Russell lagging all the way.  Same thing is happening in 2024.  The Russell 2000 is no longer providing that leading signal for the SPX, as its just trading in its own little world, often times opposite of the SPX.  Its almost as if some pod shops had on a huge pair trade long Nasdaq 100 and short Russell 2000.  Maybe that is what explains the bid in Russell 2000 on Monday despite the Nasdaq 100 weakening.  

I didn't have a great feeling about the SPX short position last week when I saw so many mentions of the bad breadth and narrow leadership of the market, implying that the market was due for a pullback.  It is never a good feeling to have your thoughts repeated by those on CNBC.  I'd rather be on the other side of their trades than have them join my side.  But I still can't ignore the risk off signals from the poor performance of economically sensitive stocks, poor breadth overall, as well as weakness in risky assets like bitcoin.  They have been leading indicators of future SPX weakness in the past.  Maybe there is just so much government money sloshing around that the rich don't feel a need to sell stocks to continue their conspicuous consumption.  But I'm not willing to make that bet.  As much as this market is frustrating the bad breadth bears, the SPX is so overextended and overvalued, that the better risk reward is the short side from mid July to early October. 

Of particular note on Monday was the sharp drop in NVDA, even though the Nasdaq 100 and SPX were only down a few bps.  With hindsight it looks clear now that we got the blowoff top in NVDA last Thursday, as the uptrend was just too steep, the optimism and hype just too thick, for the move to sustain for much longer.  It is an important marker for the AI trade, as you saw a lot of big reversals in AI related names like AVGO, TSM, MU, ARM, and DELL.  This is either the final top of the AI bubble, or first of a double top topping pattern in all likelihood.  That double top could have a slightly higher high for the 2nd top, but no big breakout from the highs made last week.  Looking back at past momentum bubbles, we probably get some consolidation at this new higher range, with one final last gasp rally sometime near the end of the year.  After that, you likely see a brutal bear market for all the AI plays in 2025.  

It still feels a bit early to put on a longer term short, as the selloffs have been minor and the bond market has been strengthening lately.  10 year yields are around 4.25%, down from 4.70% in April.  Its enough of a rally to keep stocks from falling too much from here.  If you get some renewed weakness in the bond market and more optimism about the economy in the coming weeks, that would be a better spot to go short.  

The COT data showing futures positioning came out yesterday, and it looks like asset managers didn't add longs into the 2% SPX rally from Jun 11 to Jun 18.  Asset managers positions hardly moved.  It appears this rally is not being met with a lot of new buying.  It looks to be a mix of short covering, dealers delta hedging options on the way up, and corporations buying back stock, just before the stock buyback blackout period starts near the end of the month.  

I was expecting more weakness into the post triple witching opex time period.  While we are pulling back, I was looking for more, considering how much the SPX went up the last 2 weeks, and how weak the AI names have been.  With the post opex weakness window shortened by the upcoming end of quarter, I got out of most of my shorts yesterday and will cover the remaining shorts today.  The short play was disappointing, but we are entering a seasonally strong period of the calendar surrounding the end of June and early July, which for some reason (summer complacency, lack of eager sellers during the summer holidays) are usually a strong period for the equity market.  I will not fight that seasonality and will be on the sidelines waiting for a better spot to put on shorts.  Its tough fighting such a strong momentum market, so one has to be picky choosing when to enter shorts and look for a reversal.  However, a reversal does feel like its due within the next 1-2 months, given all the secondary signals showing weakness as mentioned in previous blog posts.  I won't be staying on the sidelines for long, perhaps coming back to the short side in the middle of July.  

Bubbling Up Into a Slowdown

Most bubbles occur in an environment of economic optimism with strong global growth, rising commodity prices, and rising bond yields.  That is what happened in 1999/2000, in 2007 (not a stock bubble, but a housing/credit bubble), and 2021.  This is unlike any of those bubbles.  This economy is slowing down, as shown by both the economic data and real world price signals such as commodities.  Here is a list of some industrial/housing commodities which are showing weakness in the face of this SPX/NDX bubble.  

We are seeing a huge disconnect between tech stocks and the rest.  Institutional investors are fleeing stocks showing weakening growth trends and crowding into the few remaining favored growth names, which are blessed with the AI halo effect.  In the internet bubble in the late 1990s/2000, you had strong economic growth worldwide.  In this AI fueled bubble, you have economic growth that is inflated by under reported inflation and US fiscal largesse.  Yet even the butchered government data is showing a slowdown. In addition to the economic data, which are lagging and often heavily revised, you can just look at the performance of the majority of US stocks to see proof that the economy is slowing.  

The equal weight S&P 500 ETF, RSP, is lagging SPY badly in the past few weeks.  

 

While breadth is an overrated short-term indicator, over the long term, weakening breadth in a very overvalued stock market is a reliable sell signal.  It warned of impending bear markets/corrections in summer/fall of 2000, fall of 2018, and fall of 2021.  

While the fundamentals are getting more bearish as prices go higher, you have to respect the upward momentum which attract more funds into the SPX and NDX complex.  Foreign holdings of US financial assets in equities is at an all time high, rivaling those levels last seen in late 2021, and slightly higher than the peak in 2000.  Foreigners are usually late coming into a trend and notorious for chasing hot assets and dumping them when they lose favor.  

 

The warning signs are piling up.  It is happening at a time when valuations of US stocks, in particular, large cap tech stocks, is in nosebleed territory.  While these large cap tech stocks have great asset light businesses with fat profit margins, they will have problems maintaining growth as most of their businesses (aside from AI) are becoming mature with slowing growth rates and running into the law of large numbers.  AAPL is already showing basically no revenue growth, as the smart phone market is now saturated and no longer a growth business.  Same goes for internet advertising, which is dominated by GOOG, META, and even AMZN.  Future sources of earnings growth for these tech giants will have to come from cutting expenses (reducing head count), which is a net negative for the economy. 

There is still 6 months left in the year, and momentum bubble markets like this usually don't make major tops in the summer.  The Nifty Fifty bubble topped out in January 1973.  The Nikkei bubble topped out in late December 1989.  The dotcom bubble topped in March 2000.  The everything bubble topped out in early January 2022.  With an election coming in November, and with recent memory of big post election rallies in 2016 and 2020, its likely that you will see investors chase US stocks higher into year end.  Odds favor a top happening either in late December or early January.  That doesn't mean that you won't see pullbacks along the way, and you cannot rule out this market bucking past stock market history and topping out in the summer.  

Remain short and added more into the rally yesterday.  Still playing for a pullback for the remainder of June.  Considering the strength shown recently, the pullback is probably going to be weaker than originally expected. 

Late Stage of the AI Bubble

The internet is to AI what the airplane is to auto pilot.  Yet here we are, with investors comparing the current AI bubble with the internet bubble of the late 90s/2000.  The use cases for the internet were enormous.  The practical use cases for AI are limited and more specialized.  The internet actually saves energy, while AI consumes huge amounts of energy.  As the years go by, technological innovation continues, but the productivity gains get smaller and smaller.  Mankind have mostly picked the low hanging fruit when it comes to productivity gains through technology.  The internet was a huge productivity booster.  AI will be much less so, and at much higher costs due to the high energy use for unreliable, flawed results.  

While this AI bubble is much smaller than the internet bubble, it is more ridiculous because none of these big tech companies spending multi billions on AI have a clue on how to profitably monetize the technology.  Considering how much they have to pay to NVDA for the chips and the high maintenance costs, it requires a lot of revenue to cover the expenses.  We are still in the grace period where spending willy nilly on AI is still rewarded and even encouraged by the stock market, but that won't last forever.  Look at what happened with Facebook stock when they spent all those billions on the metaverse.  It got crushed and only recovered when Zuckerberg gave up on his dreams.  I see a similar situation where the stock market will start expecting results from all the AI spending, and will start punishing companies that keeping pouring money into the AI fire pit.  This is a controversial statement, but AI is closer to the metaverse bubble than the internet bubble.

Since the AI bubble began in 2021, first as a small niche and now as a burgeoning sector of the stock market, the hype, mentions, buzz, and excitement about AI is as intense as ever.  It is getting irrational out there.  NVDA exploding higher was the main catalyst, but its spawned "satellite" AI plays in semiconductors like TSM, AVGO, etc., in hardware like DELL and HP, utility companies that would benefit from greater electricity demand, and now, end users like AAPL, which ended up being a buy the rumor, buy the news reaction on their AI plans at the WWDC conference.  That is how big this AI bubble is becoming.  Even with AAPL just using OpenAI and not getting paid for any of the extra AI features, its getting a big boost and up 25% in less than 2 months.  The chase for anything AI related, based on extremely optimistic projections has infiltrated the stock market, and gotten retail investors buying into the hype.  Like all bubbles, retail investors are the last to get the memo and buy the most right before the bubble pops, add on the way down, and ride it all the way to the bottom.  

It is uncommon for such a bubble to happen so soon after a previous bubble, the Everything Bubble of 2020/2021, burst just 2 and 1/2 years earlier.  But investors have short memories, and the FOMO mentality is pervasive among retail investors as well as institutional investors.  The US stock market, in the form of SPX and NDX, are the gift that keep giving, which reinforces the uptrend.  It is fascinating to see investors so confident even as bond yields stay higher than most expected.  Here is a look at the household percentage of financial assets held in equities as of end of March.  This number is higher now as the S&P 500 is up another 2% since then.  

These are nosebleed levels for equity allocation among households.  Even during the dotcom bubble in 2000, the equity allocation wasn't this high.  Its slightly higher than those crazy times in 2021 when it seemed everything went up huge with investors all in on stocks.  This high of a level of equity ownership among households magnifies the wealth effect of stocks.  Don't be surprised to see consumer spending vacillate with the ups and downs of the SPX in the coming years.  The US economy is now heavily financialized, making the stock market the most powerful leading indicator of the US economy.  

As you can see from the above chart, when equities held as a percentage of financial assets gets high, a bear market is just around the corner.  

We have the CPI report and FOMC meeting today.  There seems to be quite a bit of complacency going into these events.  Based on what I hear on CNBC and Bloomberg, most are expecting a dovish Powell and a rally after the FOMC meeting.  Since the Powell dovish pivot in October 2023, the market has rallied at almost every FOMC meeting, as Powell has talked dovish at each one.  Will he repeat his dovish performance again?  I wouldn't be surprised if he did, as he seems more worried about his reappointment by the next President than he is about appropriate monetary policy.  

There continues to be breadth divergences as we got another Hindenburg Omen in the Nasdaq and more signs of a split market where a select group of tech stocks keep going higher, while a majority of stocks are unable to rally and keep up with the SPX and NDX.  Global risk appetite appears to be abating as Europe and Asia trade much weaker than the US.  Bitcoin, gold, and silver are starting to falter.   The leadership is getting narrower, and other periods where SPX kept making new highs with so many laggards led to a sudden pullback, e.g September 2014, July/August 2015, October 2018, April/May 2019, July/August 2019, and November/December 2021.  The only time within the past 10 years where the market ignored these divergences and kept going higher was in 2017.  That cannot be ruled out, but 2017 had much lower valuations than now and investors had much lower equity allocations, leaving them with much more room to add equities.  

Remaining short SPX and holding.  Looking for a 4-5% pullback from current levels to reset the bullishness and consolidate the big gains so far this year. 

Warning Siren

The warning siren is getting louder.  Since last week, we're seeing more signs of weakness underneath the indices, masked by the strength of big cap tech stocks.  You are seeing more volatility in individual stocks but they are not showing up in day to day SPX volatility.  But we are seeing a pickup in intraday SPX volatility, which is interesting.  Last Friday, May 31, you had quite a bit of intraday volatility that is unusual when the VIX is so low, and when the market is less than +/- 1% on the day.  You had an 89 point day range in the SPX and the VIX closed at 12.92.  

On Monday, after another big intraday drop with another big closing rally, investors finally started to notice that the cyclical stocks were weak, especially industrial and energy names.  On CNBC and Bloomberg, macro views are shifting from a strong economy with worries about inflation, to now worries about economic slowdown with weaker ISM and PMI data with oil leading the way lower.  You can see the asset flows shift from equities to bonds as lower yields haven't really helped stocks rally, which is a break from the pattern of lower yields, higher stocks.  In particular, for the past year, whenever yields went lower, Russell 2000 would outperform SPX.  But the RUT is actually underperforming SPX even as bonds rally.  That speaks to how weak the small cap stocks are in this environment.  

The IWM:SPY ratio made a new YTD low even though 10 year yields are more than 30 bps lower than the highs set last month.  And you are still seeing the rampant speculation in meme stocks, like GME on Monday gapping up huge on a pump by Roaring Kitty, a blatant pumper.  You are still getting low float daytrader stocks going up 300% in a day on spurious or no news.  This is about as unhealthy of a market that you can see that is less than 1% from all time highs.  

Last week's COT data shows asset managers back towards their highs in net long position in SPX futures.  Asset managers are now fully loaded and have very little room to add more to their already heavy long positions.  Remember, asset managers usually chase strength and sell weakness.  So they are potential sellers if we get a pullback.  Dealers have gotten even shorter, and their net short position is almost the biggest for the past 12 months. 

Pontificating on the macro situation is interesting but usually there is no alpha there.  But it appears that the strong stock market rally from the October lows to the April highs had a stimulative effect on the economy, and with the uptrend flattening out and getting choppy, that SPX rally "stimulus" is fading.  I know that it is en vogue to talk about the huge fiscal deficit and how much that is stimulating the US economy, but it seems very few talk about the wealth effect of a rising stock market boosting consumption and investment.  

The financialization of the US economy is now so deep and firmly rooted that its the tail wagging the dog.  The tail, the S&P 500, is wagging the dog, the US economy.  The dynamism has been sucked out of the US economy as the government has taken a bigger share of the borrowing and spending, making the private sector less influential.  That is what happens when you have low population growth, minimal productivity growth, and aging demographics with a stagnant labor pool.  The cyclical ups and downs are smaller, as the government can print money and borrow anytime they want to.  And politicians are willing to push the deficits higher and higher as they chase populist goals and feed more stimulus to an addicted population.  In the long run, this keeps the recessions at bay, or very mild if they do happen, but also keep inflation elevated.  

We have a big gap up as the market anticipates more bullish news in the form of an ECB rate cut tomorrow, a weaker than expected NFP that should rally bonds and stocks, as well as the WWDC conference next week where AAPL will introduce whatever AI hype machine that they can come up with.  Also don't forget the NVDA split happening on Friday, which is widely anticipated by the tech bulls and next week's CPI and FOMC which bulls will believe to be further bullish catalysts. 

I have initiated a short position in SPX and will add more later today and tomorrow.  This is a swing trade looking for a down move to happen for the next month.  You probably need to get past the CPI and FOMC before you get a real big move lower, but this market has been teetering and it could selloff sooner than even I expect, which explains the short entry this week.