Speculative Fever

In the late stages of a bull market, the fear of missing out is greater than the fear of losing.  FOMO happens when your friends and neighbors are making money and you are not.  People don't live in a vacuum, they notice what others are doing, whether they are doing well or not.  Envy is a great motivator for investors to do things that they would otherwise not do.  Rationality goes out the window in these environments.  That is when you see parabolic moves.  Speculative waves go from one sector to another.  The hottest sector among speculators was AI in the spring and summer of this year, with NVDA, SMCI, AVGO, DELL, and TSM blasting higher.  The speculators' baton is now being passed from AI to Bitcoin. 

Exhibit A:  MSTR/Bitcoin.  This is at the heart of the speculative bubble that is happening right now.  When you see massive short squeezes and irrational price moves that defy the fundamentals, you are near the peak of the mania.  After the crazy squeeze this month, the market capitalization of MSTR stock is now over 3 times the value of the Bitcoin on its balance sheet.  MSTR's non-bitcoin related business is meaningless compared to its bitcoin holdings.  This reminds me of the 3COM/Palm spinoff during the dotcom bubble, where Palm was valued way more than the Palm holdings of 3Com, considering that 3COM stock holders owned a huge chunk of Palm.  It was one of those cloudy arbitrage situations where rampant speculation led to a supply/demand mismatch that overwhelmed the arbitrageurs' capital and willingness to hold the long 3COM, short Palm position.  The same is happening with the arbitrageurs' willingness and capital to hold the long Bitcoin/short MSTR position.  IBIT, the biggest Bitcoin ETF, is up 43% over the past 6 months, compared to 150% for MSTR.  As recently as September, the returns were equal for IBIT vs MSTR. 

Exhibit B:  TSLA.  TSLA is a $1.2 trillion company that is trading like a Trump meme stock.  It is one thing to have a small cap trade like this.  It is another thing to have a trillion dollar company gaining 65% in a month based on hopes that a Trump administration will slash all transportation regulations and allow TSLA to do whatever it wants with full self driving and autonomous vehicles.  Never mind that TSLA full self driving is not ready for prime time and requires the driver to hold the steering wheel and be alert at all times.  The dreams of Robotaxis roaming the roads has clouded any kind of judgment on the stock.  Reality is not on anyone's mind.  Its a speculative frenzy that is only taking a backseat to the Bitcoin mania.   

 

Exhibit C:  QUBT/IONQ.  Quantum computing is suddenly a big thing among speculators.  It had its 15 minutes of fame back in 2021 along with various other themes, but this one is running super hot recently.  Never mind that these 2 companies, in particular QUBT, are basically just prototype companies that are more interested in pumping up the stock and selling shares to the public than actually running a profitable long term business.  

Its a speculative frenzy out there.  The current environment rhymes with 2000 and 2021, but 2024 is more focused on certain themes and less broad based.  Just like 2000 and 2021, investors are heavily loaded up with equities with few worries about the economy or the stock market.  Valuations now are historically in the 99th percentile, just like 2000 and 2021.  From a seasonal perspective, the end of year in a big up year like 2024 is usually strong.  You rarely get big pullbacks during the holiday season after such huge gains, with long term investors incentivized to delay stock sales into 2025 to push out capital gains taxes to 2026.  Seasonally, this is a bullish time of year, although most of the bullishness happens around the last 10 days of November and the last 10 days of the year.  

The ISEE options data shows heavy call buying for much of 2024, higher than 2021 when complacency and speculation was very high.  Call options speculation is overwhelming any kind of demand for put protection, causing the put/call ratios to plummet. 

 

The COT data as of Tuesday, November 19, when SPX closed at 5917, shows non-dealers buying the dip, reinforcing their complacent positioning.  Usually asset managers are reducing net longs into selloffs, but not this time.  Its almost as if everyone knows that all dips are to be bought, not sold.  Only suckers sell on dips.  SPX asset manager net longs is at the highest levels since early 2020, and around the highest levels of the past 10 years.  Other times when we've reached this level of asset manager net longs and dealer net shorts, was in early 2018, early 2020, and now.  We had a huge selloff after the blowoff top in January 2018, where SPX dropped 11% from the highs.  We all know what happened after the top in early 2020, and now we're in a similar point with regards to positioning.  Seeing similar extremes in net longs among asset managers in Russell 2000 futures, reinforcing the overall bullish positioning out there. 

SPX COT Positions

Russell 2000 COT Positions

 

 

 

The ratio of leveraged long vs leveraged short ETF assets is now at a 3 year high, last time being above 12 in December of 2021.  That just happened to be the top of the market right before the start of the 2022 bear market.  

 

Still holding a small long position that I didn't exit gracefully after the post election moves up and down.  I will be selling the remaining long today and watch and wait to look for a short entry.  Despite the positive seasonal influence on the market, I see an opportunity to put on shorts to play for a pullback in the coming weeks.  The way the market just dropped on just a hint of less Fed easing from Powell and some overblown nuclear war fears after Russia's threats show that long positioning is quite saturated.  With VIX back around 15, the positive influence of reduced vol on equities will be limited.  Upside should be capped around SPX 6025 and downside on a pullback could take it to SPX 5800.  Based on last week's price action, you are not getting the same reflexive buying pressure on dips like you did earlier in the year.  Its a sign that positioning is stretched and there are not many buyers waiting to get in. 

Getting a gap up based on optimism that Trump's Treasury pick, Scott Bessent, will be positive for the stock and bond market.  I disagree, considering how little power the Treasury has compared to what Powell can do for the next year and a half to spoil Trump's party.  Trump, not Bessent will be making the final calls on tariffs and spending plans/tax cuts.  Back in Trump's first term, Mnuchin was basically a Trump lackey, doing whatever he was told.  That's why he lasted so long in the Adminstration, unlike others who actually had a backbone.  Bessent either becomes Trump's lackey or he gets fired.  That simple. 

Powell will be incentivized to play for legacy and be hawkish on his way out, so don't expect any dovish gifts for the next several months unless the economy really craters.  More and more, the non-consensus trade of a weaker US economy vs the past year is coming into view, as any focus on cutting government spending, raising tariffs, reducing immigration, and reducing the deficit will not be a positive for the US economy.  Of course, in the heat of the moment, speculators only see dollar signs ahead, and have blinders on.  This blind optimism phase doesn't last long, especially when everyone is already loaded up long. 

Topping Process Begins

"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” - Sir John Templeton 

2022 was pessimism.  2023 was skepticism.  2024 is optimism, now bordering on euphoria.  You are seeing euphoria in the parabolic price action in high beta Trump trade risk assets like bitcoin and TSLA.  Investors got euphoric on NVDA this past May/June and are still very bullish on the name.  The ingredients are there are for a durable, long lasting top.  Since the election, investors got high on the Trump win but are now experiencing a hangover.  

The post election move from Nov. 6 to Nov. 11 has been completely taken down, just as quickly as it was taken up.  It catches my attention when all the bullish talk on Twitter, CNBC, and Bloomberg doesn't match the price action.  Investors can't seem to imagine a world where the Trump led US economy disappoints.  You are seeing that with bond yields grinding higher and higher.  It appears the supply/demand fundamentals are just too poor in US Treasuries to get a sustained rally even with Fed rate cuts.  A fundamentally weak bond market due to excessive deficit spending and inflation that is sticky above 2%.  That bond market weakness eventually catches with the stock market. 

From past experience trading tops in SPX, they are a process.  Greed is a less intense emotion than fear, but greed lasts longer.  Bull markets usually don't end with a defined blowoff top, but end with a choppy consolidation that can last for a few months.  During the topping process, optimism slowly fades even while prices stay high.  That sets up the trap door when the crowd slowly head to the exits which eventually suddenly turns into a stampede leading to a waterfall decline.  

This post election price action has revealed the boundaries for the upside and downside for the next few months.  The upside should be capped around 6050-6150, with the downside capped around 5700-5800.   Range traders will be able to play both sides for the next few months, selling the upper part of the range, and buying the lower part of the range.  For this strategy, I prefer the short side, just because of the topping process and trap door risk with the very large net long positioning.  At least for the next 3 months, the probability of a waterfall decline (+10% down move in a short period) are low enough that you could probably play the long side as well with decent risk/reward.  

It has been hell for countertrend traders in 2024.  These one way bull trends with high net equity exposure among fund managers and retail investors set up the conditions for a bear market.  We saw this happen in late 2021, where high equity exposures led to a very weak market over the next 12 months.  The catalyst for the selloff in 2022 was the Fed rapidly raising rates to slow down inflation, causing a bond market panic which led to a bear market in stocks.  The downside catalyst this time seems less clear.  If I had to guess, it would be that US growth disappoints, and earnings fail to meet expectations.  With these kind of high net equity positioning, it doesn't take much to catalyze a big drop. 

The COT data for SPX futures as of Tuesday, Nov. 12 shows asset managers hitting new 52 week highs in net long positioning, joined by the small speculators who are also the most net long over the past year.  On the other side of the coin, dealers are now massively short, biggest net short in the past 10 years.  This is about as bearish of a long term setup that you will see. 

SPX COT

Russell 2000 futures also show extended net long positioning among asset managers, adding another bearish piece to the puzzle. 

Russell 2000 COT

The bond market remains weak amidst potential inflation concerns from a Trump economy.  A less dovish Powell on Thursday stating that rates could be normalized slowly added to the weakness.  Its not a great environment for either stocks or bonds here.  In the short term, I would rather be long stocks, but in the long term, I would rather be long bonds. 

The trend is still up in the SPX, but the price action is not as bullish as you would expect considering the widespread optimism on Wall St.  WSJ articles like this are another warning sign:  

"U.S. equity exchange-traded and mutual funds drew nearly $56 billion in the week ended Wednesday, the second-largest weekly haul in records going back to 2008, according to EPFR data. Such funds have drawn inflows for seven consecutive months, the longest streak since 2021,"

Those kind of heavy ETF inflows after a huge move higher are tell tale signs of late bull market FOMO among investors.  Valuation expansion has been the main driver of this bull market, as earnings can't keep up with the pace of increase in SPX prices.  This is 1999-2000 type FOMO.  Now you just need to see volatile, choppy price action to confirm that a top is being made.  

Missed the exit on the partial long SPX position that I have.  I'll hold for bit longer before selling.  Will be looking to put on a short on the next bounce, if it takes SPX above 6000.  I see limited upside above 6000 this year, so good risk/reward to put on shorts at those levels. 

Debt Treadmill to Hell

Its sad seeing what the US government has become.  Not only have they embarked on horrible long term fiscal policy.  But they've also created a market that makes it harder to trade bonds.  It eliminates a liquid, versatile weapon available in the trading arsenal.  The long bond trade.  Bonds used to have an asymmetric payoff profile.  The downside was limited, because inflation was contained, but the upside was more open ended due to recession risk and an overactive Fed.  That asymmetric payoff is now gone.  The payoff profile is now more balanced, with inflation risk now just as high, if not even higher than recession risk.  Add to that the poor supply/demand fundamentals in the Treasury market with lots of supply coming from the huge deficits and less demand coming from creditor nations like China. 

When fiscal deficits and inflation were much lower, trading from the long side in bonds was both forgiving and high probability.  The long term trend was towards lower yields, and you rarely had extended down moves.  Bonds had much lower volatility than stocks, making the bond's risk adjusted return far superior to that of stocks.  Also, during that time, the yield curve was quite steep, making the long side a positive carry trade.  Treasury yields could go up a bit and you could still make money on the long side because of that positive carry. 

2020 created a sea change in the bond market.  With the enormous Covid fiscal stimulus in 2020 and 2021, the fiscal budget blew out and inflation came roaring back.  At first, bond traders couldn't believe what was happening, and remained skeptical about the ability for the US economy to stay strong with high interest rates.  That's why the SOFR curve has continuously priced in many more rate cuts than have actually happened.  Its why the yield curve was so inverted, and remained that way for so long.  Its because the majority of bond investors expected the Fed to normalize rates (cutting them to neutral) much more quickly than they have.  

Of course, the rate cuts this fall, which have come much later than many expected, are too little too late for bond investors.  To add insult to injury, you have seen the biggest 10 year yield increase ever following the first rate cut of the cycle.  Its been hell for bond investors for the last 3 years.  It is the exact opposite of how bond investors felt for the 10 years prior to 2021.  Instead of having both positive carry (upsloping yield curve) and yields trending lower, you have negative carry (inverted yield curve) and yields trending higher.  A bearish double whammy.  Levered longs in the bond market have gotten killed. 

The golden days for the bond investor are over.  The cat is out of the bag.  There is no turning back when you embark on permanently high fiscal deficits to keep the economy out of recession.  It is no longer politically or monetarily feasible to get back to low fiscal deficits with this amount of national debt.  The interest on the debt itself is so enormous that its a vicious cycle of issuing more debt to pay the interest on the current debt.  Its a national debt treadmill to hell.  If the US government even starts on a lower deficit trajectory, it would crush the stock market and the economy so fast that they would quit right after they started.  

The US government is acting like KKR.  They are acting like the Carlyle Group.  They are levering up via Treasury issuance to funnel liquidity to the top 5% in the country, which the top 5% are using to buy large cap US stocks.  The public balance sheet gets worse and worse, loaded to the gills in debt, and the private balance sheets gets better and better, loaded up with financial assets.  There is no magic to the US economy.  Its the US government acting like private equity, using debt to indirectly buy up US stocks through the liquidity that they pour to the rich.  Sacrificing the bond market to boost the stock market.  It creates the illusion of a strong economy, but its all a money illusion created by nominal growth, which is almost all inflation. 

This bond market fragility makes this aging bull market in US stocks so precarious.  Stocks and bonds are linked.  Investors demand higher equity returns when bond yields are high.  Otherwise, investors would rather just invest in the less risky asset with the higher yields.  To get higher equity returns, valuations have to be lower.  That is why most of the worst selloffs in the post 2008 era have happened after bond yields were rising: August 2011 (European sovereign yields rising), August 2015 (the first Fed rate hike since ZIRP, causing bond yields to rise ahead of the rate hike), October-December 2018 (a rate hike every other quarter for several quarters with 10 year yields rising from 1.32% to 3.24% over 2+ years), and January 2022-October 2022 (most rapid rate hiking cycle in recent history).  

The bond market weakness is not an immediate concern, when risk appetite is so hot and heavy like it is now.  But it will matter when this rally cools off and the Trump euphoria wears off.  I suspect that will happen early next year, as Trump enters office and the reality is less than what it was hyped up to be.  

We finally got some liquidation of long positions among asset managers in SPX futures ahead of the election, as shown by the COT data as of last Tuesday, Nov. 5.  The absolute net long level is still quite high, but off of the very high net long levels reached in October.  That was part of the reason that the risk on rally was so strong last week, as asset managers scrambled to re-add risk, while dealers had to delta hedge their short put positions by covering shorts, as the IVs got crushed, taking the OTM put deltas down with it.  

This bid is spilling over into the new week, as we are getting a gap up and enthusiasm is rampant.  Bitcoin is over 82K, TSLA is mooning, and speculators are out in force pushing things higher.  It is too early to try to be cute and short this monster.  This is a freight train that is running over the knee jerk contrarians.  Sold part of my SPX long position, but still long some to ride the Trump hype train.  Will look to sell the remainder of longs this week if we get a further rally into November opex.  Not thinking about fading this train until late November/early December, after more chasers have gotten on board.  For the remainder of this month, I would rather short a counter trend bounce in Treasuries than a further rally in stocks.  Its a tough time to try to short in November and December, with so many capital gains in stocks that will likely be delayed into 2025.  For those with bearish thoughts, or natural born faders, its a good time to take a 2 week break. 

Election Uncertainty

There are tendencies in the financial markets.  These tendencies revolve around investor behavior.  In particular, behavior surrounding hyped up events.  There are very few bigger hyped up events than a Presidential Election.  This event trading phenomena is repeated over and over again in the markets, as written in a blog post about events last year.  The upcoming Presidential election is the next big event.  What has surprised me is how little concern there was regarding the election up until last week, when we had that big one day drop on Thursday.  Once again, it takes negative price action along with event risk to get investors' attention.  Just an upcoming event is not enough.  You need to see weakness ahead of the event to get traders concerned about adverse outcomes.  

Investors are almost always long financial assets.  Their asset allocation will be dependent on the market environment.  The current market environment is an expansionary fiscal policy with loosening monetary policy with little concern about inflation.  This type of loose fiscal and neutral to becoming loose monetary policy is favorable for equities, and somewhat unfavorable for bonds.  That's what's happened over the past couple months.  The upcoming event, the election, will not change the fiscal situation.  Both candidates don't care about the huge government budget deficit, and are becoming more populist.  Both Republicans and Democrats have thrown fiscal conservatism out the window, and are raging spenders and tax cutters.  Throughout the campaign trail, you have heard both Trump and Harris talk about no taxes on tips, tax credits for new home buyers, no taxes on overtime, etc.  

So once the election is over, investors are likely to go back to buying stocks once the uncertainty is eliminated.  This will happen during a very bullish time period for stock buybacks, as November and December are historically very heavy buyback months. Those 2 months account for 23% of buybacks historically.

As for monetary policy, there will be no change over the next year, since Powell will still be Fed chair, but from 2026, the Fed could go in 2 different directions.  Since the markets are so short term thinking, I won't go deep into what could happen from 2026 depending on Trump or Harris winning, but its easy to see a more explosive situation arising if Trump wins and Powell is fired.  

Powell is quite political, and power hungry, as he has shown most recently with the 50 bps rate cut ahead of the election to try to boost the markets higher to help Harris.  If Harris wins, Powell, will have more incentive to be dovish, as he will have a legit chance of getting renominated.  If Trump wins, Powell will realize he has no shot of getting renominated, and will have no incentive to be over dovish as he is now.  

The markets are worried about higher inflation under Trump, as its likely a Republican Sweep if he wins, meaning he'll be able to get more tax cuts passed.  Tax cuts stimulate the economy, as well as blow out the budget, both bad things for bonds.  The bond market has sniffed this out, and has sold off relentlessly since the Fed rate cut in September.  Its clear that bond investors are much more scared of the election outcome than stock investors.  Bond investors remember getting crushed in late 2016 when Trump got elected.  They have PTSD from that episode, and are exercising caution this time around, and are delaying any bond purchases till after the election.  

More recently, stock investors have gotten nervous as the gap between Trump and Harris odds of winning narrows, creating more uncertainty, and a greater possibility of a contested or undecided election for an extended period.  The market hates uncertainty, even if the fiscal policy effects are not that much different between the 2 candidates.  You saw some nervous longs reduce their equity exposure and there have been many more bearish postings on Twitter.  

Over the weekend, you had a poll showing Harris ahead by 3 percent in Iowa, a number that was completely out of the blue, in a historically a deep red state.  It seems like everyone still believes the polls.  The polls have shown in both 2016 and 2020 that they just do not cover Trump accurately.  Trump voters have a much less propensity to participate in these polls.  And it makes sense.  In general, Trump supporters are more anti-establishment than Harris supporters.  Many of them don't like to be involved in polls.  Plus it seems like there are a lot of shy Trump voters.  That is why the polls vastly underestimated his support in 2016 and 2020.  There is no legitimate way for pollsters to correct for these errors.  They can't just put in more Trump votes to try even out the polls and make them more accurate.  They can try to weigh the sample to cover more Trump supporters, but that adds a huge margin for error for the results.  That makes the polls even more useless, as the pollster is pushing his thumb on the scale, to try to come up with a result that he thinks is the most accurate.  

If you look at what issues are the most important for voters, the economy is clearly the most important.  These polls are more accurate than polls over who wins because its less partisan, and don't involve Trump.  Any polls that include Trump will just not be very accurate for the reasons stated above.  With the economy the most important issue, and with more voters thinking Trump is better for the economy than Harris, you should expect a lot of independent voters to lean Trump.  In particular, many independent voters who invest in stocks will naturally lean towards Trump because they will believe that Trump is better for the stock market.  And with the high inflation under Biden, those that are hurting from inflation will also naturally lean towards Trump.  

If you add race, gender, and name value into the equation, they all favor Trump.  It may seem ridiculous, but a lot of voters will vote for who they know, even if they aren't supporters.  That is why incumbents have a natural advantage over a challenger in Congressional races.  Males have an advantage over females.  Whites have an advantage over blacks.  In particular, liberal female candidates are always going to be at a disadvantage in a general election.  They have very little crossover appeal.  That is why you've seen so many right wing female prime ministers in Europe (Thatcher, Merkel, Meloni, Le Pen) and almost no left wing female prime ministers.  Female candidates tend to attract female votes, in addition to party votes.  If most female voters are in the same party as the female candidate, then there are fewer additional female voters (independents and the other party) to pickup.  Since males lean to the right and females lean to the left, there are much fewer female Republican voters to pick up for left wing female candidates.  While right wing female candidates have many more potential female Democrat voters to pick up. 

Harris is the anti-Trump candidate.  Very few will be voting for Harris because they see her as a good candidate.  She was basically anointed as the candidate, with no voting involved.  I doubt she would have won the Democratic primary if Biden had dropped out sooner.  She is not popular.  Its hard to win as an anti-candidate unless you have several factors in your favor.  And she doesn't.  Biden is unpopular, and that gets passed on to Harris, on top of her original lack of popularity.  

Short term, if Harris wins, you likely see a reflexive, mild dip in stocks and a strong rally in bonds.  If Trump wins, you likely see a reflexive, mild dip in bonds and a strong rally in stocks.  I don't expect an extended selloff for bonds or stocks under either scenario.  Bonds have already front run a lot of weakness, so there isn't much more juice left in that short bond trade.  Stocks have corrected most of the post Fed cut rally, and are in a favorable macro environment of loose fiscal, and neutral and loosening monetary policy.  Plus, stocks have strong upward momentum and favorable seasonal factors.  Both stocks and bonds would be a buy on dip scenario if there is a little panic, post-election.  Based on the high VIX readings and the low realized vol, there is a lot of potential vol compression that could happen after the election.  The current COT readings for VIX futures show speculators with a slight long position.  Historically, speculators have held large net short VIX futures positions.  They rarely get long, except during panicky markets, such as Covid panic of 2020, VIX panic in early 2018, and the heavy selloff in late 2018.  I expect a big vol crush post election, which will be favorable for equities as delta hedging from vanna flows will cause dealers to cover shorts.  

Bought the dip last Thursday to get long SPX for the next few weeks, expecting a Trump win.  This is mostly an election trade, looking to catch a post election rally that could last from 2-4 weeks.  Longer term, I remain bearish due to high valuations and high equity allocations.  A post election rally could be the beginning of the topping phase for this raging bull market.  Tops are a process, so expect choppy range bound trading with lots of ups and downs over the next 6 months before the transition to a long term downtrend.