Volatility in December

Well that elevated quickly.  We went from SPX 5930 to 6049 over 3 trading days, in normally a slow time of year, and then gave back a huge chunk of the gains as there were no bids on Friday.  I don't like to make a big deal out of a couple of weeks, but the way the market is selling off is eerily similar to what happened in late 2021.  In 2021, despite a rising market, the VIX was regularly in the high teens, low 20s.  But this market has seen VIX in the low teens for most of the year, and realized vol has been low, until this month.  And its not as if the market is that much off the highs, we're around 2 percent off of all time highs, so its unusual to see VIX jump so much this month, in what should be a less volatile time of year. 

While we did get that low volume bounce last week, I wasn't able to capitalize on it.  The plan was to sell either last Friday or Monday of this week, expecting a grind higher for a few more days.  It is a change of character to see the market go down after a quick rally so soon after having flushed down only a few days prior.  Usually the market will linger near the highs for at least a few days after the sharp rally as the latecomers buy, but not this time. 

It show that saturated long positioning seems to be weighing on the up moves, and any small bit of concern among investors is enough to create sharp selling.  The move higher in yields seems to have dampened the risk taking psychology that was pervasive before the FOMC meeting.  You still see pockets of rampant speculation as retail investors chase momentum in small cap pumpers, but the move back under $100K for Bitcoin is a barometer of less risk appetite for the moment.  

On CNBC, the consensus view was that the low volume move lower was no big deal, and not to take too much meaning from a low volume, slow moving time of the year.  From past experience, I would take the opposite view.  The action in December is often a preview of things to come for the next year.  In December 2021, you saw a sudden rise in volatility and very weak breadth, a precursor to the market weakness to come in 2022.  In December 2014, you had quite a sharp pullback out of nowhere, and that was a prelude to a choppy and weaker 2015.  

There could be some selling in the next 2 trading days, as the last day of the year is actually not that bullish historically.  There could be some front running of capital gains tax related selling in early January, as well as late rebalancing flows looking to sell equities and buy bonds.  I do expect the bulls to come back in early January, so I don't expect really severe selling until after the Trump inauguration.  

The options market still shows a lot of call buying and over lack of put hedging among investors.  The ISEE index remains in nosebleed territory, and only briefly went down during that post FOMC selloff.  Its right back to where it was when there was hardly a worry in the world.  

ISEE Index

After the heavy selling in the bond market over the past few weeks, we're now at 10 year yields around 4.60%, which make it interesting for an intermediate term trade.  I will be looking to buy bonds early this week as the lack of bids seems to be year end liquidity related and I expect buyers to come back in January.  I am not so optimistic on the US economy as compared to the crowd, and think the Fed can quickly change their tune if you see lower inflation prints or a slightly weaker labor market.  

I don't think this market is strong enough to just come right back after just 1 day of selling.  There is no real support at this 5950-5970 level.  You need to get back down to the 5850-5900 zone to get more motivated buyers to step in.  While I am long, I will likely trim some of my position today to setup to buy lower and/or to buy bonds.  

The Power of Triple Witching

Everyone has blamed the selloff on a hawkish Fed even though they went through with another 25 bps rate cut.  If you look at the price action, it seems to make sense, but then you look at the elephant in the room, that no one notices.  Its the options market, and in particular the SPX, which controls a huge amount of the the market's total notional exposure.  This is especially pronounced during the 4 quarterly expirations coinciding with the futures expiration, well known as triple witching expiration.  The hedging and systematic positions that get built up are disproportionately focused on those 4 expirations in March, June, September, and December.  Of the 4, December is by far the biggest, which can often lead to large outsized moves around the quarterly expirations, when they are unexpected.  

Coming into the FOMC meeting last week, the market was grinding lower slow, but with very little volatility.  And with FOMC meeting days having a bullish bias all year, it appears a lot of hedgers decided to delay their annual rollover of put buys/calls sells for 2025 into the latter part of last week, after the FOMC.  Also a lot of fast money momentum traders were probably looking to exit late last week after what they thought would be the start of the Santa Claus rally.  Well when you have an elephant (SPX hedgers) try to exit along with a bunch of fast money bulls at the same time, you can get violent down moves like you saw last Wednesday.  

Last week's move doesn't change my outlook at all for 2025.  These sudden sharp drops are just a symptom of a market that is saturated with long positions, with few discretionary traders left to buy when there is a dip.  The vol control funds had gotten back to near max long positioning.  The biggest trend following ETF, DBMF, increased their SPX positioning to the largest of the year.  At last check, they are holding a $556 million long position in SPX futures, with a total net asset value of $1,237 million.  They are nearly 50 percent long their fund in SPX.  Not to mention they are long over $200 million in MSCI and MSCI emerging market futures, making them net long 62% equity index futures. That is a huge long position for them.  All of the systematic funds were back in the pool as of early last week.  It may be a different picture today, but I doubt it.  It takes most of these trading systems several weeks to go from net long to neutral, and a few weeks more to go from neutral to net short.  

Was it a coincidence that once the SPX quarterly options expired on Friday AM at the open, the market shot up over 100 points?  The CNBC Fast money crowd will credit the PCE and whatever Fed talk happened that day with the move, but it looks like the options market was a huge driver of the price action from Wednesday to Friday.  

The force that options are having in this market reminds me a lot of 2021, when you had rampant speculation in short term calls.  Just like the past 2 monthly options expirations, you had lots of selling around the options expiry.  A lot of it due to call selling from the speculators who don't have the funds to exercise their ITM options, thus being forced to sell before they expire.  You see a big drop in the open interest after these expirations, and with much more call activity than put activity, it leads to a lot of net deltas that come off the dealer's books, forcing them to sell their longs which they used to hedge their short call positions.  These options dynamics are a symptom of call options speculation run amok.  

By last Thursday, you did finally see the put activity increase as investors go nervous and the volatility increased.  The ISEE index plunged on Thursday and Friday, back to levels not seen since the Monday ahead of the 2024 election.  

While we don't have the COT data from Wednesday to Friday, we did see asset managers reduce their net long positions, although small specs remained heavy long. 

I would assume that the asset managers pared back a lot more of their long positions into the weakness from Wed. to Fri., as they are usually trend followers.  We'll know for sure in next week's COT report.  

Given the intense selling and prices getting close to 5800-5850 strong support, I did some buying of SPX on Thursday and Friday.  With the exaggerated moves due to opex and time-sensitive sellers last week, I expect that to setup for a Santa Claus rally this week.  We already saw part of that start on Friday as soon as those SPX AM options expired.  Looking for a further rally as we enter a very seasonally positive part of the year, along with big capital gains held by most investors.  These investors will likely to be very reluctant to sell for the remainder of the year, in order to delay their capital gains tax hit for 1 more year.  It probably means that whatever selling that was delayed for tax reasons will likely hit the market hard in early January.  

Big picture, I remain bearish on stocks, as there are numerous signs of long positioning being saturated, and with asset managers unwilling or unable to increase their net long positions much further from here.  Volume will go down a lot this week, and low volume markets usually favor the long side.  The urgent sellers did their selling late last week, so that should give room for a healthy bounce this week, to potential resistance around 6050-6090. 

Nasdaq is the Leader

The Nasdaq massively outperformed both the SPX and the Russell 2000 last week.  On Twitter, it seems like the paper napkin technicians are suddenly concerned about the weakening breadth out there.  In the distant past, until 2018, breadth was a good predictor of future broader market weakness.  You would see breadth weaken as the market grinded higher, and that would be a reliable signal of an impending pullback.  But things have changed since 2018.  Weak breadth no longer provides a reliable signal.  

Instead, it is strong breadth, with Russell 2000 outperformance, which has become a more reliable signal of an impending pullback.  Russell 2000 has become a barometer of investor exuberance.  Whenever investors feel super bullish, they gravitate towards the more speculative Russell 2000 for the extra juice.  The surge higher in Russell 2000 as the Nasdaq 100 lagged the SPX and Russell 2000 foreshadowed the local top in July.

Nasdaq 100/Russell 2000 Price Ratio

As you can see in the ratio chart above, the QQQ/IWM ratio topped out a few days before the SPX made its top in mid July and early September.  Those happen to be the only 200+ point pullbacks in the past 6 months. 

When the Nasdaq is outperforming the SPX, it is usually bullish for the market.  When the Nasdaq is lagging, it is usually bearish for the market.  What you saw in October and November is an anomaly.  The Nasdaq was noticeably lagging the SPX during that time and the market kept going higher.  You can credit the Trump hype effect for that phenomena.   Investors incorrectly viewed a Trump presidency as being bearish for tech stocks, and bullish for small caps.  Fast money piled into small caps after the Trump win, only to sell when they realized that there were no greater fools willing to pay a higher price for small caps.  Small caps are merely trading vehicles, not something that investors believe in for a long term investment.  They have underperformed large caps because their earnings have underperformed.  The Russell 2000 is merely a sideshow.  The total market cap of the Russell 2000 is about the same as the market cap of AAPL.  That shows you how insignificant the Russell 2000 is to the big picture.  

So the very mild pullback last week is actually a bullish short term sign, with Nasdaq 100 regaining its leadership.  Remember, investors are not going to pay nosebleed valuations for financials, utilities, and other so-called benefactors of the Trump trade.  Those sectors can only go up so much before they flatten out.  You don't get investors excited about momentum building up in low growth names.  You need to see the momentum in mega cap tech and high beta tech to pump the SPX to even more nosebleed valuations.  Investors are willing to pay sky high prices for tech stocks if they are going higher.  They are not willing to pay sky high prices for other, more boring sectors.  

Longer term, the highly concentrated rally focused on tech stocks is a sign of a weakening economy.  But shorter term, its a bullish sign that we're still not at the top of this bull market.  In an interview with the Interactive Brokers CEO last week, he noted the following:  

You can see that over 70% of trading volume is in Mag 7 stocks.  And outside of that, its mostly crypto related companies and cryptos.  That tells you where the individual investors are putting their money.  They are almost all in on high beta and spec names.  Very reminiscent of late 1999 and 2000, but that's a story for another day.  

You will not see real pain in the overall stock market until you see Nasdaq 100 really underperform.  The US economy is now extremely financialized.  With the heavy allocation to equities among households, and in particular megacap tech, a Nasdaq 100 bear market would cause a reverse wealth effect, slowing consumer spending, leading to an economic slowdown.  That's not something on many investors' bingo cards for 2025 and 2026. 

Not much movement in the CFTC COT positioning for the major stock indices, with asset managers and small speculators remaining heavily long.  You continue to see lots of call buying on the ISE.  There is a lot of options speculation in individual names, in particular TSLA.  With just 2 weeks till the end of the year, I would expect the recent big gainers to hold their gains as many investors will want to delay capitals gains into 2025.  That is also part of the reason that you are seeing Russell 2000 underperform, as many small caps are tax loss candidates. 

While the Nasdaq 100 strength was a bullish factor last week, the suddenly weak bond market and rise in yields was a bearish factor.  If you consider both, the current situation is about neutral.  I did cover some of my shorts on Friday, and now only hold a very small short position which I will likely close out today.  With volatility staying low even during last week's pullback, that is a good sign for the bulls.  A market that doesn't want to selloff much even with such bullish positioning makes it tough to stay short for long.  Just a 1% pullback, and even that's been a struggle to get for the bears.  On the short side, you have to take your points when they come and not get greedy.  The pullback started last Monday, so its on day 6.  I doubt the market can go down much more this week before bouncing again.

I don't see much edge at current levels, with bullish seasonal factors about to really kick in as we get closer to Christmas.  The opex forces from triple witching coming up this Friday could induce a bit of volatility as institutions do some last minute position squaring and year end hedging before the holidays.  But its not worth betting on much movement this time of year.  The complacency and lack of fear, high amounts of call buying, and heavy bullish positioning are potentially bearish elements.  But its been that way since the election, and still we grind higher.  Nothing compelling here, although if we do get a further move down towards SPX 6000 this week, it could be worth a small long play to ride the seasonal tailwinds. 

Trump Mania

Just when you thought things couldn't get crazier than 2021, they are getting crazier.  Compared to 2021, the breadth of the insanity is less, but the intensity is greater.  From late 2020 to late 2021, you had a speculative surge that included graded sports cards, pie in the sky NFTs, hundreds of worthless SPACs, meme stocks, and lots of tech stocks.  In 2024, you started with the AI mania, which is still ongoing, but the fast money speculators are now migrating to the Trump mania, with Trump meme stocks like TSLA and PLTR leading the pack with bitcoin and its related names like MSTR and COIN.  

You have fewer stocks participating in this speculative bubble, mainly because a lot of newbies got burned the first time around in 2021, and don't have the stimmies or the income to buy up the flavors of the day this time around.  The survivors of the 2021 bubble popping are wealthier, more selective in their speculations, but still very reckless and fearless.  2022 wasn't painful enough, and was too short of a bear market to discourage these hogs from chasing momentum.  That's why you are seeing such a quick comeback to now form a second bubble, just 3 years after the previous one popped.  It's probably the first time in financial history that you have one bubble emerge so quickly after the previous one popped in the same asset class. 

The 2021 bubble was about trillions of dollars of fiscal stimulus liquidity sloshing around looking for a home.  The 2024 bubble is about US superiority, capped off with a Trump election victory, where almost everyone believes that the US has the best economy, and that US stocks are the best investment.  The European and Asian stock indices have lagged the SPX badly this year, especially since April.  The 2 biggest manias that we've seen this year, AI and Trump, are based in the US.  You can only play both manias through US stocks.  For AI, its basically NVDA, and a few tertiary names like AVGO, DELL, etc.  For Trump, its TSLA, PLTR, bitcoin, and bitcoin related stocks.  Sure you have some quantum computing names going crazy recently, but those are all small cap names, and a drop in the ocean compared to the AI and Trump related names.  

Investors are moving their money in response to what they believe is US superiority.  The inflows into US equity ETFs and mutual funds are the greatest in history.  As a percentage of market cap, they are higher than anytime since 2000, including 2021.  

The highest ratio of calls to put in the ISE since it started in 2006.  The demand for put protection and bearish bets is historically low.  

Despite this lopsided buying of calls over puts, the SKEW index is showing out of the money puts as being historically rich vs. out of the money calls.  In fact, the SKEW hit its highest level in history last week.  In the past, high SKEW readings have portended corrections in the SPX. 

The ominous signs just keep piling up.  If history is our guide, 2025 should be a massive inflection point, which will catch many investors off guard.  Those are the moments where those who can look at the big picture will thrive.  

When will this mania for US stocks end?  It ends when the perception of a Trump presidency being bullish for the US economy and US stocks is broken.  That could take several months into his term.  The hype is greater than the substance.  People are talking about deregulation and tax cuts but those are vague, and even if concrete steps are announced, the firepower will be limited.  It won't be enough to overcome less immigration, tariffs, and possibly less government spending (due to DOGE, blocking Biden stimmy spending, etc.).  Tax exemptions on tips or overtime is a drop in the bucket.  Corporate tax rates are already low at 21%, lowering to 15% won't do much, and it may be hard to pass as its not something that's very popular among the public. 

If there is no noticeable improvement in the US economy by the 2nd half of 2025, then you could see an exodus like you've never seen before in such a big asset class.  A lot of the recent inflows into US stocks are coming from foreign countries, so they will have less tolerance for pain, especially if the US dollar weakens along with the SPX.  A lot of FOMO money is rushing it.  At the highest valuations in history.  Resulting in the highest US household allocation to equities in history.  There is a lot of hot money betting on this thing to continue.  This isn't long term money being put in.  Its fast money looking for fast returns.  They'll run for the exits if things go downhill.  

Don't expect much movement for the next 3 weeks, investors will be looking to delay capital gains into 2025, which should push out a lot of potential selling into January.  At the same time, market looks overextended short term and overexuberant.  There should be some systematic year end hedging coming in the next 2 weeks as December is the biggest hedging month for SPX options.  Above average amounts of OTM call options sales / put option buys are likely to be initiated.  Still holding a small short in SPX which I am stuck in.  With the bond market suddenly looking stronger, not expecting heavy selling, so I'll look to exit sometime on any mild pullback within the next 10 days, to re-enter sometime at the end of the year or early next year. 

Greater Fool Theory

Investors are not oblivious to valuations.  They just put less importance on valuations when markets are either 1) in a bubble 2) in a crash.  During a bubble, investors don't care that markets are overvalued because prices keep going up and they continue to make money.  During a crash, investors don't care that markets are undervalued because prices keep going down and they continue to lose money.  

Market conditions where investors ignore fundamentals are not stable.  I.e., those conditions do not last for long.  In bubbles, the greater fool theory is hard at work, as investors believe that someone else will buy their stocks at higher prices, sometime in the not too distant future regardless of valuations. 

The crowd is not stupid.  They can easily figure out that stock valuations are high.  Its out there in clear view.  In fact, many will admit that the market is overvalued.  But they believe that the market will stay overvalued and go up anyway.  That is what defines bubble psychology.

Fundamental value becomes less important.  Price momentum becomes more important.  A survey of individual investors done by the Yale School of Management shows the following results over the past 25 years.  

Proximity to Platonic Ideal of 100% Believe Overvalued, 100% Believe Market Up Next Year

The underlying belief that arises from bubbles is that investors think that prices will rise in the short term, regardless of what they think about the long term.  Investors have high conviction that prices will rise in the short term, but they also know that eventually the party ends, so they are not as positive about prices going up in the long term.  Short term positive, long term neutral to negative.  The stock market tends to do much better in the long term when investors are short term negative, and long term positive.  

It is this greater fool theory which makes investors' time horizons shorter.  It also causes investors to chase after high beta, volatile, and rising stocks.  MSTR is a perfect example of the type of stock that comes into favor near the peak of a bubble.  Boring, slow moving stocks are ignored.  When people see others making all this money in bitcoin and related stocks, big cap tech stocks just don't have the same appeal. 

In this bubble environment, put protection is an afterthought, and considered a waste of money.  Call volume rises and put volume falls.  In the options market, more and more evidence is building that investors are leaning very heavily towards calls over puts.  Individual stock put/call skew in S&P 500 stocks shows heavy bullish positioning.  

Conference Board survey of consumers shows record levels of optimism towards stocks, with 56.4% expecting stock prices to be higher in one year.  

No one knows when the party ends.  But when you see so many signs of highly bullish positioning, pervasive optimism, and an extended uptrend at historically very high valuations, usually there isn't much time left.  The long term risk/reward for long positions is quite poor.  On the other side, it presents an opportunity for great risk/reward for long term short positions.  These parabolic moves due to short squeezes, speculative fever, or just plain FOMO are hallmarks of a bubble market.  They always end with long term down trends.  Over the coming weeks, as we get closer to year end, I will look to put on some long term shorts in individual stocks which I can see go down 60-80% over the next 2 years.  

We got another move to an all time high in the low liquidity, low volume Black Friday session.  It looks overextended in the short term, so have put on a starter short position. Not looking for anything big here, something around a pullback of 3%.  The bonds have been acting strong lately as Treasuries catch a bid with European bonds trading higher over the past several days.  This will help limit any downside for stocks this month, along with positive year end seasonal forces, so wouldn't get aggressively short.  The time to look for bigger down moves will be early 2025, so keeping a lot of powder dry until then.