Turning Defensive

Things changed dramatically in July.  While you hear a lot of talk of a soft landing and limited economic weakness, the price action in the stock market tells otherwise.  Maybe there is something to this economic slowdown that is being underestimated by investors, as they remain heavily invested in stocks. 

The SPX is back to mid July levels above 5600, but underneath the surface, investors have been moving from offensive sectors to defensive sectors.  This can be measured by the performance of low beta, defensive sectors such as consumer staples (XLP) and health care (XLV) vs. the Nasdaq 100, filled with high beta tech stocks.  During the past 3 months, the QQQ is flat but the XLP is up over 10% and XLV is up over 7%. 

This coincides with the AI peak that we saw in late June/early July, when NVDA went over $140.  Looking back, it is becoming more and more clear that the AI hype reached its peak this summer, and will unlikely reach that same level of mania even if the SPX goes to new all time highs later this year.  

This sector rotation, with many defensive stocks reaching 52 week highs, and many economically sensitive stocks reaching 52 week lows, as the SPX trades above the 50 day moving average, has fired off a few Hindenburg Omen signals last week.  A cluster of signals gives a strong warning of a looming correction.  A lot of people ridicule this indicator, but it has a much better than random track record of identifying short term market tops.  The last signal was in mid July, correctly warning of an impending selloff.  

Getting more and more 2000 vibes as this year plays out.  In early 2000, semiconductors were the hottest sector, even hotter than internet stocks.  We reached a similar level of semiconductor/AI mania this past summer.  Here is a chart of the SPX and Nasdaq Composite in 2000.  While the Nasdaq topped out in March 2000, the SPX lingered close to the highs for a few months until September 2000, before both indices went down in a vicious bear market in the final quarter of the year.  

Year 2000 SPX vs Nasdaq

Similar to 2000, you have very high allocations to equities as a percentage of total assets.  We are at late 2021 levels of equity allocations as of the end of June.  Even at the peak in 2000, you never got to these nosebleed equity allocations, and that's when everyone was talking about stocks.  Stocks are almost viewed as a no-brainer investment over bonds over the long run.  Of course, that's with average valuations, not coming from a point when stock valuations are around the highest in its history. 

Let's not forget about aging demographics in the developed world.  The baby boomers hold a huge chunk of the equities owned by households, and their current age range (born 1946 to 1964) is from 60 to 78.  The developed world was much younger in 2000.  Now you will have baby boomers disposing of equities due to either death (inheritance taxes/spending inheritance will lead to stock sales), elder care/nursing homes (selling stocks for cash), allocation shifts from stocks to bonds to reduce risk, etc.  

On the economy, this is just my 15 minute macro take, so not to be taken too seriously.  But could it be that the lack of money supply growth since 2022 is finally having an effect on the economy? No one talks about the money supply anymore, but it hasn't grown at a rate that's consistent with a strong economy.  Of course, a lot of that is payback from the crazy jump higher in 2022 in 2020 and 2021, but inflation already reflects that jump higher in M2.  So low money supply growth in a slowing economy with less fiscal impulse should result in a weaker economy.  M2 money supply grew 5-6% from 2010 to 2019, and growth was slow during that time period.  

And the distribution of the money is different now than it was before 2020.  Sure the pie is bigger with all the money printed, but the percentage distribution is even more skewed towards the wealthy, who have more money than they know what to do with.  The wealth inequality continues to expand.  Corporations and the wealthy have so much political power with all the money they spend on lobbying and donations, they shape regulations and tax rules that favor further wealth accumulation.  In the end, unbridled crony capitalism ends up with something that you see in a place like Russia, where a small group of government officials and oligarchs hold all the country's wealth, and the rest of the population are basically wage slaves. 

The Commitments of Traders data for SPX futures continues to show asset managers remain near all time highs in net long positioning, as they hardly budged during the selloff in the first week of September.  As a percentage of open interest, in the third quarter of 2024, asset managers have never had greater net long positioning in its history.  Mainly due to a reduction of short positions.  Fund managers are extremely lightly hedged.  Along with the SPY and QQQ short interest data that I wrote about in July, you have all the ingredients for the start of a long bear market. 

On Friday, you finally saw call buying come back, with the total put/call ratio falling to 0.68.  Also seeing signs of Twitter traders re-embrace the bull side, and wanting to be positioned bullishly ahead of the Fed's first rate cut of this cycle on Wednesday.  Given that quarterly opex is this Friday, and with election uncertainty about to come on stage, I expect a bearish post opex week.  The Street will want to re-add put hedges that come off on the Friday expiration, and/or sell stocks to get back to lower net long positioning.  Investors will not have much tolerance for market weakness due to how lightly hedged they are.  You got a preview of that in the first week of September, when the SPX fell 240 points over 4 trading days.  

In the bond market, you continue to see strength, and the bullishness is palpable.  Its almost taken as fact that bonds will rally when the Fed cuts rates.  That may be true for short term T-notes, but definitely not true for long bonds.  The monster budget deficit will need to be funded with lots of bond issuance.  The 1982 to 2020 bond bull market was fueled by labor arbitrage to China, reducing manufacturing costs, faster CPUs leading to rapid productivity growth, growing globalization increasing free trade, and gradually decreasing budget deficits as a percentage of GDP for much of that time period.  You have the opposite now, with budget deficits exploding higher, as well as an aging demographic, reducing the working age population / total population ratio, which contributes to higher services inflation.  

In the short term, bonds will face headwinds due to election uncertainty and the potential for more tax cuts and/or fiscal stimulus.  Both candidates are free spenders and could care less about controlling fiscal deficits.  Populism is inflationary, and politics worldwide (except China) has never been more populist than now. 

Did not expect that the market would give me another chance to short around the August highs but here we are.  Admittedly, I was a bit too eager to start shorting, jumping the gun by shorting last Thursday, before the SPX squeezed higher later in the day and on Friday.  One could argue that weak markets don't give you a lot of time to short the highs.  That is usually true, but markets that are transitioning from a bull market to a bear market exhibit some bull market tendencies while the market tops out.  It appears that we are in that transition phase as the stock market goes from bull market to bear market.  This is based on investor positioning data, equity valuations, and price action.  

Could the market get even bubblier and make a blowoff top (SPX 6000+) into year end? Its possible, but I would give it less than 25% odds.  And even if it were to do so, I would expect most of that blowoff move to happen in November, when I would loathe being short.  In fact, I would actually welcome a blowoff top, even though its unlikely to happen.  

I see too many viewing the Fed as a backstop to support this weakening economy despite monetary policy losing a lot of its potency.  When you take away the refinancing option for the vast majority of home owners who are on very low fixed rates, that reduces a lot of the monetary stimulus provided by lower rates.  Same goes for corporations, many who are locked in at lower rates, and will be re-issuing at higher rates even with Fed rate cuts, since bond yields now are much higher than 5 and 10 years ago.

Fed rate cuts reduce interest income, a big source of cash going straight from the Treasury to households.  When you have such a huge US national debt, oddly enough, interest rate cuts can actually reduce income for a substantial portion of the population, as well as for banks.  Remember, the US Treasury funds interest payouts not by reducing spending, or increasing taxes, but by issuing more Treasuries.  So reducing interest payments with a lower Fed funds rate is actually a fiscal contraction, not an expansion for the government. 

Will the Fed go 25 bps or 50 bps at the upcoming meeting?  Based on the leak from Nick of WSJ on Thursday, Powell is itching to cut 50 bps to pump up the stock market, to increase the chances of Trump losing.  He can force his way to cut 50 bps with dissents and that will reduce the power of his pump attempt, and look bad, but he also doesn't seem to have full support for 50 bps among the committee because it looks so blatantly political.  Powell wants to get 50 bps with no dissents, having his cake and eating it too, but not so sure the rest of the committee will agree to let him have his way with inflation not slowing down fast enough and with economic data that doesn't warrant a 50 bps cut at this point.  

Either way, 25 bps or 50 bps, it will be forgotten by Friday, and it will be on to more pressing issues, such as the upcoming election as well as the newly feared data release of the month, nonfarm payrolls.  

Looking to add to shorts today or tomorrow, to play for a correction over the next few weeks.  Seasonal weakness coincides with corporate buyback blackout period starting this week, and the big triple witching options expiration this Friday.  Add the November election to the mix.  Its looking like a coin toss according to election betting markets and the uncertainty will likely lead to some volatility soon.