DeepSeek News Bomb

Will DeepSeek be the straw that broke the camel's back?  We'll find out within the next few weeks, but my view is that this is another hyped up story that ends up being ignored in a couple of weeks.  Most investors think that AI is the next big thing.  They think it will be a game changer that makes a big chunk of human labor obsolete and drive huge productivity gains.  In theory, if you combine AI with advanced robotics, that could happen.  If it was so easy and obvious, why hasn't it been done already?  Robots have been around for a long time.  So has AI.  Faster GPUs are what's making this all possible?  Or even DeepSeek?  

I admit that I am skeptical about lots of new techologies that get hyped up.  One that I was definitely not skeptical about from the start was the internet.  It was obvious from the get go how huge it would be.  Most could feel the difference right away.  There was no abstract theories or views of the future that was needed to get people to believe.  Just being able to send email and browse the internet with Netscape was enough to get people to see the immense possibilities.  

With AI, you have to be believe in the unknowable future, an abstract, theoretical view of how AI will change people's lives.  Its mostly theory, currently with limited practical uses that are expansive.  ChatGPT and making AI generated videos is nice, but its not a sweeping technology that changes the way people communicate and get information.  They talk about all the productivity enhancements from AI, but if so, why aren't more people getting fired from the big tech companies that are getting this great AI productivity boost?  Higher productivity means less workers needed.  

The reaction to the news is surprising, given how much bonds are up.  It definitely feels like a lot of weak hands got long last week after the inauguration, so this is probably some stops getting hit, as well some dealer delta hedging overnight as IV goes up as prices go down.  Moves like this does show how much more fragile and dangerous this market.  When you have so much money that's flowed into US stocks, many by late to the party, less informed weaker hands, you can get these big gyrations out of the blue.  It speaks to the saturation of long positioning among investors.  There is no other way to explain these sudden drops in the market, like what you saw at the last FOMC meeting, and now again overnight on DeepSeek fears.  

There were no big changes in the COT data as of Tuesday, January 21.  Asset managers have aggressively reduced net longs, but from a historical view, its still a big net long position.  The pullback from mid December to mid January did purge some overextended long positioning, so the market now is not as dangerous as it was in December.  But big picture, you will get these big one day drops more often going forward because of the higher valuations.  

Based on the price action you saw overnight, it is definitely weaker than it should be given the news.  So whenever I see a huge move like this that doesn't make sense, I prefer to wait and let the dust settle before making any big moves.  I do believe its a shakeout type of move that will eventually reverse, so its at least worth taking a small position looking for a bounce.  I put on a small long in the overnight session, looking to hold for several days.  If we didn't have such a big up move over the past 2 weeks, I would be considering a bigger position.  But we're not at great levels for longs, so only going with a small position.  

Easy E Market

US equity investors have had a wonderful ride over the past 16 years.  You can really say that there was only one real bear market, the one from January to October of 2022.  The Covid crash went down over 30% in February and March 2020, but lasted less than 2 months from top to bottom.  And it basically went straight up from the bottom.  That's not a real bear market.  So one real bear market over 16 years, which lasted just 9 months, and then another rocket ride higher immediately afterwards in 2023 and 2024, going up over 70% in 2 years.  

This market is straight outta Compton, its an Easy E market.  Being a passive investor in stocks, just buying index funds, shouldn't be this easy.  Stock investing was never meant to be this painless.  The reason you get higher returns in equities over bonds is because there is more risk, due to be being lower in the capital structure, and thus more volatility.  But it seems as if bonds are now more risky than stocks!  

These kind of unusual, one way markets, with valuations reaching historical extremes, have not had happy endings.  1929. 1973. 2000.  2021.  All of those market tops (except 2021, which was a plain liquidity and stimmy bubble) were characterized by a select few group of large cap stocks leading the market higher.  In 2024, the small and mid cap stocks continued to lag the large cap names, and for good reason.  The earnings growth has been concentrated in the large cap stocks, in particular, big cap tech.  Those who are looking for a mean reversion towards small cap stocks are ignoring the earnings fundamentals of those smaller companies.  They have lower profit margins, many are unprofitable, and many are in decaying businesses with low barriers to entry and lots of overseas competition.  

More and more, capitalism is becoming more crony and concentrated, with regulatory capture and lack of antitrust enforcement leading to more oligopolies and monopolies.  This is unfavorable for smaller companies that have to compete against much more profitable and powerful companies, who can bully the smaller players.  Like Walmart using their buying power to squeeze their suppliers for lower prices.  Same goes for Facebook and Google squeezing their advertising customers for higher ad rates because there are no alternatives.  The larger companies expand their margins at the expense of the smaller companies and consumers, resulting in the rich getting richer, and the middle class and poor getting poorer.  

None of this changes with Trump back as President.  I don't expect much change at all despite all the optimism about tax cuts and deregulation.  Washington is a huge swamp, and there are tons of lobbyists and insiders who don't want change.  

The hype surrounding tariffs is overblown, just like it was in 2018 and 2019.  At least this time, it seems like most investors are seeing tariffs for what they really are, just a negotiating tool to try to coax better trade deals, not a long term strategy to increase US manufacturing.  The problem for Trump is that China and the other major US trading partners know this and will go to the brink, because they know that Trump won't sacrifice the US stock market and the US economy to try to win trade deals.  

What is priced in, and expected by the majority of investors is an optimistic outcome for the US economy.  So even if there are no long term tariffs implemented, there is a lot of room for the US economy to disappoint.  I see very few discuss the implications of less immigration into the US, which is negative for growth.  In a low cost labor shortage situation that the US is in, less immigrants puts a constraint on growth, while also increasing wage inflation, which will hurt margins for businesses relying on cheap, immigrant labor.  

Due to an aging population and less population growth, economic growth will likely disappoint over the next 4 years.  Bonds should make a better investment than stocks during Trump's 2nd term, something that would surprise many.

The COT data for SPX futures shows some dramatic positioning changes among asset managers.  They have aggressively pared back their monster net long position, to now get to levels that were seen nearly a year ago.  All the build up of those longs from May to December 2024 have been liquidated.  

This is similar to the asset managers reducing their extreme net long positions in the 2nd half of 2021, even as the SPX was making higher highs and higher lows.  It appears that we reached a sentiment top in the market in early December, and while we likely reach new all time highs, it will be with less enthusiasm among the investor community.  That is actually a bearish sign, because all of the major tops over the past 25 years (2000, 2007, 2021) happened as optimism topped out months before prices topped.  There is probably a few more months left for the market to grind higher amidst waning numbers of bulls, based sheerly on momentum.  But once that momentum dries up, which it likely does sometime in the next 6 months, there is a lot of downside fuel with all the overvaluation and high US equity positioning among households and foreign investors.  

Last week we got the fake breakdown panic move under SPX 5800, which spring loaded the market to shoot up after the CPI came in softer.  It looks like the 1 month long pullback starting with the sharp FOMC day drop on December 18 is now over.  That is about standard course for choppy pullbacks in a bull market.  You rarely see more extended pullbacks in an uptrend like this, unless of course, the uptrend is over.  But that is not my base case.  Considering how much asset managers purged their SPX futures long positions, I would expect another spurt higher in the coming weeks.  

Unfortunately, I sold too early last week, expecting a short term pullback which never came.  I am looking to get back in the long side, in small size, if we get some retracement this week.  I am not sure I will be getting it, as this market now seems poised to make new all time highs within the next couple of weeks.  

Bond Rout Flashbacks

The market is getting a flashback to past bond routs seen in much of 2022, and fall of 2023.  This time, its happening despite inflation stabilizing around 3% and with the Fed no longer in its higher for longer stance.  Instead of being led by a weak short end with higher for longer fears, now its being led by the long end with Trump induced supply concerns about lots of coupon bond issuance, tariffs, and more tax cuts. 

I remember back in October 2023 when the 10 year was approaching 5%, Rick Santelli of CNBC suddenly went crazy and talked about 13% 10 year yields as if he was being time transported back into the early 1980s.  Yields topped out soon afterwards and went straight down for 2 months.  

While we don't have the Rick Santelli contrarian indicator this time around, I am getting similar vibes about investors' opinion on the bond market, without a lot of fundamental changes.  

Sure, Trump will threaten and probably slap on some tariffs, but that increase on prices on imported goods will be offset to some degree by less consumption in services and non-imported goods.  I would be more worried about a resurgence of inflation if China and the emerging markets were suddenly running hot, with commodity prices surging higher and the dollar much weaker.  I just don't see why anyone would get excited about the current inflation picture.

As for growth, I just don't see a sudden surge in the global or the US economy that would justify a big bond market selloff.  That strong nonfarm payrolls number doesn't tell you much.  You saw a bunch of hot nonfarm payrolls numbers in 2023 and they were wholesale revised in 2024.  The NFP data collection process is broken and its a dinosaur which doesn't give you an accurate picture.  Based on worker behavior, they are clearly less confident about the labor market, as you see much fewer job quits.  They all say that deregulation and Trump bump for the economy will increase growth in the US, but there is nothing concrete to those proclamations.  Its parroted commentary from the investor community that induces people to sell bonds.  

This particular bond selloff has less merit than the one you saw for much of 2022 and fall of 2023.  First, the Fed has actually cut 100 bps, so you have a yield curve that is upward sloping, which makes it more attractive and positive carry for leveraged funds to buy longer maturity Treasuries.  Second, Trump will be looking to replace Powell and appoint a much more dovish Fed chair for 2026, so its unlikely that you will see a selloff in bonds catalyzed by front end weakness like much of the past 2.5 years.  Third, with reverse repos outstanding down to much lower levels, the end of QT is coming sometime this year.  Lastly, the idea that tariffs are bad for bonds isn't proven, and its unlikely to be the case because tariffs are a tax on consumption, which will hurt growth, which is arguably the more important factor for bond prices than cost push inflation.   

That being said, I would prefer to buy stocks than bonds in the current environment because this belief that Trump policies are bad for the bond market can go on for several more weeks until its disproven later in the year.  

I just can't picture an end to this grand bull market in US stocks ending on yields going up.  The much more likely scenario is that growth and earnings disappoint, and you get a selloff in stocks based on growth fears, not inflation/higher yield fears.  

Back to the stock market.  The COT data as of 12/31/2024 shows asset managers purging more of their net long positioning, selling 57,000 more ES contracts to get down to a net long position last seen in early November, and early September, before the FOMC 50 bps rate cut and the Presidential election.  It reminds me of the asset managers reducing their large net long positions in the 2nd half of 2021, as the SPX was in the last innings of its rally.

You finally saw an increase in the put/call ratio on Thursday and Friday, as investors finally started buying puts.  ISEE index dropped down sharply last week, to levels last seen in October.  A lot of the froth has come out of the speculative names as well, especially the quantum stocks that got hammered last week.  

Last week was wild, and didn't get bulls much time to sell the rally, once again, even less time than the brief rally around Christmas.  Thus, I missed the graceful exit and unfortunately didn't cut losses on the way down.  I'm not holding a big position, but I don't intend to add to it as there could be one more move lower towards SPX 5700 on this down wave.  

Not much to do here, I will hold on to the long position, and ride it out here, I do expect a rally soon, and it could be a lasting bottom if you see some panic and capitulation this week.  

Coal in the Stocking

The Santa Claus rally, which is supposed to start on Christmas Eve and last until the 2nd trading day of January did not deliver on the hype.  The SPX ended up down during that period, only 0.5%, although it felt worse than it actually was.  The dips are sharp and scary when they happen, but shallow.  The 3 day post election rally from November 6 to 8 covered a range of SPX 5865 to 6012.  The market has traded mostly in that small range for the past 2 months.  Yet the VIX has gone from 14.94 on November 8, to 16.13 on January 3.  The market is hurriedly moving up and down in a range, but ultimately going nowhere.  

The speculation in volatile, momentum stocks remains hot.  There has not been a noticeable flush out of weak hands, even with that VIX spike above 28 after the December FOMC meeting.  Its been a listless back and forth movement that doesn't signify much.  While a lot of investors were caught off guard when there was no year end rally, it just shows you that the fast money was offsides, but it hasn't permeated to the larger, slower money.  

With the COT data delayed by 1 business day, you don't have futures positioning data that covers the post Christmas selloff.  The pre Christmas data that covered the big drop and recovery post FOMC showed asset managers with nearly the same net long position, although open interested dropped huge after the quarterly triple witching expiration.  It was mostly dealers covering shorts and hedge funds adding to shorts.  

It appears that the post Christmas selloff was traders and fast money investors front running the potential delayed capital gains tax related selling in January.  When too many investors look at the calendar to make their selling decisions, you have price insensitive flows that roll over bids with reckless abandon.  That's what you saw happen from December 27 to January 2.  With Friday's all day rally, it looks like the most eager, price insensitive sellers are mostly done.  

You happened to see a lot of the selling on the first trading day of 2025 concentrated in the biggest winners of 2024 like AAPL and TSLA.   It shows that there were a lot of investors just waiting for the calendar year to change to take profits in their big winners, in order to delay capital gains taxes.  Of course, they could do that by selling in February or March, but apparently the Fed's "hawkish" cut made them nervous and eager to sell as soon as possible in 2025.  

The selling in the big winners in early January is not a sign of a weak 2025.  What is a sign of a potential weak 2025 are the high equity allocations, excessive Trump fueled optimism about the US economy, and sky high valuations.  Add to that the bond market weakness, and you have a potentially explosive situation to the downside sometime this year.  

The vibes coming out of CNBC and Twitter is still a lot of complacency, but less bullish enthusiasm and much fewer calls for a melt up.  It is likely that we've reached the sentiment top for this bull market in early December.  That doesn't necessarily mean that we've reached a price top yet, but it does mean that upside is limited from current levels.  I would be surprised if the SPX went above 6400 this year.  In general, you need investors to get more bullish for prices to keep rising in perpetuity.  When investors are getting less bullish, prices can go up in the short and medium term, but not for the long term.  

The put/call ratios continue to show a lack of put buying and lots of call buying in individual names.  But the excessive call buying is gone. This supports the view that we're probably going to be stuck in this range.  

Missed the graceful exit during that brief Christmas rally, as I was expecting the market to give bulls more time to sell at the highs.  But alas, too many were trying to play for that Santa Claus rally and the exit was too narrow for everyone to get out at high prices.  I believe there will be a chance to exit more gracefully this week after most of the eager capital gains related profit takers have sold already.   Looking for a potential move back up to SPX 6050.  This time, I will be more quick to sell, as I do not want to be stuck holding the bag again on the next swift move lower, which likely will happen again this month.