Air Pockets

The FOMC meeting where many feared a sell the news reaction picked the wrong asset class.  It was bonds that sold the news, not stocks.  We got a continuation of the equity squeeze higher, led by the most speculative quantum and nuclear stocks.  Shorts are getting punished again.  They are being targeted and focus fired by retail and hedge funds looking to squeeze out other hedge funds.  Shorts are in a world of pain.  The market is on a mission to squeeze out as many shorts as possible, leaving behind only the most well capitalized and stubborn shorts.  Only the shorts who can survive this barrage and stick around will be rewarded on the other side of the hill.  

The realized vol remains low, but VIX remains sticky with a floor around 15.  This kind of realized vol doesn’t merit a VIX at 15.  This kind of dull price action would normally cause VIX to trade around 12 to 13.  Yet options markets are not willing to price put options with such a low IV.  The options market doesn’t believe this low volatility grind higher can continue for long.  I agree.  Even with IV high relative to realized vol, I would not be selling options here.  Those looking to continue to collect premium by selling puts or selling covered calls are picking up quarters in front of a bulldozer. 

Relentless rallies like the past 5 months set up corrections that plunge through air pockets.   Air pockets form when the index rallies to all time highs and blast higher without much time / volume spent at each level.  Three examples include January 2018, November 2021/January 2022, and July 2024.  The crash in October 1987 is a classic example of an extremely overbought market forming big air pockets along the way, setting up an environment susceptible to a waterfall decline.   

January 2018 top

November 2021/January 2022 top

July 2024 top

SPX 6 month chart

The move from 6100 to 6670 happened in less than 3 months, with little time spent at each new all time high.  That's where the air pocket has formed.  Based on how big this air pocket is, the next correction should prove to be violent.  

The COT data was interesting for the SPX as of September 16.  Into the Fed meeting and after a 90 point rally in a week, leveraged funds went heavily short SPX and dealers took the other side.  Its not unusual for leveraged funds to fade moves, but it is unusual for dealers to follow the trend and reduce shorts into a rally.  This positioning might have gotten unwound into triple witching opex.  There was a big expansion in open interest so it seems to be triple witching related, but we'll have to see the COT this coming Friday to confirm.  But initial thoughts are that its not a good sign for bears.  If you are a bear, you want to see dealers add to shorts when it rallies, not reduce.  

Disaggregated COT data which show asset managers, leveraged funds, and dealers seperately is most useful when looking at SPX data.  The legacy COT data does have some uses.  Unusually, commercial traders have maintained a large long position since April as the market has continued to rally.  They are usually trend faders.  The last time commercials were very long as the SPX was rallying and making new all time highs amidst hedge fund skepticism was the summer and fall of 2007.  In the short term, this is a bullish factor for the SPX.  But long term, fundamentals, valuations, and investor positions in stocks are more important than futures postioning.

Its insanity out there.  The stocks with the worst fundamentals are performing the best.  Its a meme stock bubble riding on top of a US stock market bubble.  Intuitively, this feels like a blowoff top thats near the apex, which makes it dangerous for both longs and shorts.  The most shorted stocks are ripping, as well as retail favorites.  There is some overlap between the two, as some of the retail favorites are heavily shorted.  

For longs, they are taking on massive left tail risk once the insanity ends.  For shorts, if the insanity continues for even a few more weeks, it can be quite painful as shorts get squeezed even harder.  Based on the COT data, I am scared that this thing squeezes out the shorts even more before violently reversing.   It is hard picking tops in an irrational bubble, you cannot stay short for long if prices are going against you.  That’s the position that shorts are in right now. As a short seller, you have to be nimble.   Only when prices are going down and staying down can you maintain shorts for more than a few days.  

The price action in bitcoin and ethereum is interesting.  You had a huge wave of euphoria in crypto in July and August, and a lot of these crypto treasury ponzi schemes used the liquidity to unload loads of new shares on the public to buy cryptos.  Now all that stock issuance is coming home to roost.  There just isn't much more demand to buy these crypto treasury stocks or the cryptos themselves.  MSTR has been trading very weak vs. bitcoin since July.  Bitcoin has been trading weak vs SPX since July.  You would figure that a Fed cutting cycle would be favorable for cryptos, but that market seems saturated with retail bagholders who don't have an appetite or the ability to buy more.  

As the quantum and nuclear plays skyrocket, the crypto names have been left behind and trade very heavy.  They used to all go up at the same time (like in July), but that's not happening despite SPX squeezing to new all time highs almost every day.  This shows that there are limits to the retail traders' capital that prevent all boats from rising.  Its not like 2021.  There is no massive fiscal stimulus helping to fund all the insanity.  The job market is weakening.  The fiscal juice is just not the same as it was a few years ago.  It means that stocks can jump, but they can't fly.  And when they jump, its hard for them to all jump up together.  There just isn't enough retail trader ammo to pump all the speculative stocks together. 

As for the SPX and NDX, those are another story.  They are dependent on institutional flows, not retail flows, which only help a bit at the margin.  Institutions are still believers in the AI theme, and are still bullish based on Fed easing.  But I think that's a fragile bullishness that's based on looking at the rear view mirror on AI, and orthodox thinking that Fed easing is always bullish for stocks.  

This time, the Fed is not the one in charge.  Its the White House and Congress, and they are mostly on the sidelines after the OBBB passed.  The fiscal largesse is not what it used to be.  Yet almost everyone on finance TV and in podcasts talk dollar debasement, and giant fiscal deficits as if 2025 is like 2021.  Its not.  There isn't a bottomless well of money looking to go into the stock market.  In fact, the cash balances are near record lows at mutual funds.  At SPX 6205, percentage of financial assets in equities was 45.4%. Based on current SPX of 6664, the percentage of financial assets in equities among US households is nearing 50%(roughly 47-48%).  For comparison, during the dotcom bubble, it only got up 38%.  And during the 2021 everything bubble, it got up to 42.4% at the top.  

American households are heavily positioned in stocks, which makes the US economy extremely dependent on the stock market to keep it going.  If you do get a bear market, it will have big ramifications for the US economy as the wealth effect is bigger than ever.  The US economy is completely financialized, meaning the stock market has a huge effect on the economy.  

Holding large postions short in SPX and heavily short/ meme stocks.  I will be looking to reduce those positions this week, hopefully into seasonal post Sept. opex weakness.  I have a gut feeling that only after the seasonality bears and macro short sellers throw in the towel can you get a final top for SPX.  I do expect the meme stocks and retail favorites to top out before the SPX.  If we don’t selloff within the next 2 weeks, I expect seasonality bears to give up, and also macro bears after the next NFP report on October 3.  I want to hold on for a long term short but can't be stubborn when the price action is going against me.  Will look to get out sometime this week to reload at a later date.  It still feels like we could have a bit more of a rally, as absurd as its been.