The Fed Trap

We are in an era of fiscal dominance.  You wouldn't know it by how much market observers are obsessed about the Fed.  Lots of talk about the next Fed chair, with Kevin Hassett being the big favorite, but Trump trying to act like he hasn't decided and mentioned Kevin Warsh as the other possibility on Friday.  The excitement over the latest FOMC meeting, where investors were expecting a hawkish cut, but it didn't turn out to be as hawkish as they expected.  It wasn't jumbo shrimp this time.  

People are still following the monetary policy playbook from the 1970s to the 2010s.  This is a different era of monetary policy.  Back then, private debt was the dominant driver of the economy.  Bank lending was the primary source of liquidity.  Now bank lending has taken a back seat to the federal government, which is now the driver.  

What we saw on Wednesday, Thursday, and Friday after the FOMC meeting will be repeated many times over the next couple of years.  You get a rally on optimism that the Fed is riding to the rescue, being dovish, and then a letdown when reality takes over.  Fiscal dominance means fiscal policy drives economic growth, not monetary policy.  The US public debt to GDP ratio is around 120%.  Back as recently as 2007, it was around 60%.  So the debt to GDP ratio has doubled in less than 20 years.  That is what happens when government spending gets out of control, when taxes are cut, instead of being raised.  Politicians don't care about deficits, because the public doesn't care.  The public loves those stimmy checks, tax cuts, child tax credits, Obamacare subsidies, Social Security and Medicare, and government pork for this and that.  Of course, the public doesn't like inflation, but they can't put two and two together.  They want the stimmies but don't want the inflation.  

When government debt dominates the bond market, lower short term rates actually can be a reduction in stimulus, as government interest payments go down, lowering the amount of interest income going out to the public.  Sure, some private borrowers tied to short end rates will have lower interest expense, but that is more than offset by private borrowers who borrow long term, which is less tied to short term interest rates and more tied to long term inflation and fiscal policy.  Loose fiscal policy keeps long end yields elevated.  That's why even after the Fed has cut rates from 5.25% to 3.50% over the past 15 months, 30 year yields have gone much higher.  At 120% of public debt to GDP, public borrowing is more important than private borrowing.  Lower interest rates reduce the fiscal deficit.  A reduction in the fiscal deficit slow downs the economy.  That's why these rallies based on the Fed being dovish will be faded as the economy weakens, despite lower and lower Fed funds rates.  

The other important events beside the FOMC was the ORCL and AVGO earnings reports.  They both sold off big after their earnings announcements, on fears of a slowdown in AI capex.  We are slowly going from AI capex being loved no matter what, to AI capex being a boondoggle money pit.  Clearly ORCL has been put in the penalty box, and the market is skeptical about all the investment that its making in AI data centers.  META is heading towards that penalty box, but not quite in just yet.  Just the fact that the market is now punishing debt financed AI capex means these hyperscalers will be more reluctant to just keep growing their capex with regards for future returns.  That ends up hurting NVDA, AVGO, and the hardware/chip companies more than the AI spenders.  

On investor positioning, without COT data, we need to rely more on prime broker data.  GS Prime broker data shows hedge funds slowly increasing their net long equity positions, now up to February levels, before the tariff panic.  

So we have hedge funds with high net equity exposure, and as we know, retail is heavily weighted towards stocks as well, being the biggest net buyers of equities, more than hedge funds and institutions.  Looking at the cumulative equity ETFs inflows for the past few years, the rate at which investors are piling in is increasing, now at a rate that is 4 times greater than in 2022.  That is what happens when investors chase performance, and get complacent.  When investors are heavily long, complacent, and valuations are high, the marekt is vulnerable to a sharp correction at anytime.  

You are starting to see that complacency show up in the options market, with the ISEE index of calls to puts opened back towards high levels.  It looks like a dovish Powell was enough to get investors very optimistic again, even as the Nasdaq lags the SPX, usually a bad sign for the market.

 

We are beginning to see signs that this rally off the November 21 low is running out of gas, with the sudden selling on Friday coming out of nowhere, with AI related stocks lagging badly, and investors going into defensive sectors.  Last week, consumper staples and health care were at the top weekly performers, with info tech at the bottom by a mile.  That's not a market that I want to be long, even if we are near year end with positive seasonal forces coming up in about a week.  

 

I think we are setting up for a good shorting opportunity at year end, with the Nasdaq lagging, with the most important segment of the market, AI, trading the weakest.  Add to that the heavy long positioning in both retail and hedge funds, and you have an environment ripe for a correction.  We should be getting the Supreme Court decision on tariffs any day now, and that could be a short term positive catalyst for stocks when Trump tariffs are deemed illegal, but it is somewhat expected (76% odds on Kalshi).  Not bearish for the next 2 weeks due to the likely delay of profit taking into January for capital gains tax purposes.  But that sets up for a weak January.  A Santa Claus rally after December triple witching opex would set up a good entry point for shorts going into January.  

Back to Boring

The SPX gained 21 points last week, going from 6849 to 6870, while trading in a 96 point range for the week.  That's less than 1.5% for a week of trading.  By comparison, the SPX's range on November 20, the day after NVDA earnings was 236 points, which is 3.5% for one day.  With volatility going down so fast, the VIX is getting crushed.  It closed at 26.42 on Nov. 20.  On Dec. 5, it closed at 15.41.  Whenever the VIX is going down this fast, the opportunities go away and its usually just best to sit and wait.   

You finally got the dead cat bounce in bitcoin, all the way to 94K last week, but the bounce has been fading .  Bitcoin continues to trade heavy, and it being one of the best indicators of risk appetite, is a bearish factor.  BofA client flows show retail being net sellers for the past 4 weeks, a big change from their behavior during past dips, and also the past 52 weeks, where they have been the biggest net buyers.  

Hedge funds continue to show that they don't believe in this market, as they quickly went back to selling stocks after being heavy buyers during the weakness in November.  CTAs and vol target funds sharply reduced equity exposure in November, and have only slightly bought back some of what they sold.  DBMF, the biggest trend following ETF, shows a much smaller S&P 500 position now than what it was during June through October.  Those systematic funds slowly adding back long exposure is supportive for stocks in the short term.

Big picture, retail investors are very heavily allocated to stocks.  They've been buying aggressively since mid 2024. Recent activity seems to indicate that they are close to saturation.  Their stock allocation is the highest since 2021.  There is a lot of downside when this bull market ends.  Its just a matter of how long the topping process takes.  Best guess is that it started in late October, and the process will last for 5 to 6 months.  Bitcoin seems to be acting like a canary in the coalmine for the stock market.

There are mixed signals out there.  Sold the remaining longs last week, and now on the sidelines.  I don't see much of an edge at current levels.  The November pullback shook out a decent amount of weak hands, with put volumes going up and retail investors selling. That shake out could be enough to sustain a rally into the year end.  On the other hand, bitcoin is trading very weak relative to the SPX, and retail investors seem to be low on ammo, with many retail favorite stocks much closer to their November lows than their October highs.  

The most likely scenario is that we get a grind higher to the end of the year, making a marginal new all time high (SPX 6950-7000).  Then I would expect a selloff in January from a mix of delayed capital gains related selling, and a lack of bullish catalysts.  If the Supreme Court doesn't make a decision on Trump tariffs by year end, that would make it trickier to short in January, as that is probably the biggest positive catalyst left for this market.  But I would expect the Supreme Court to make their decision this month, because delaying it just creates a bigger headache unwinding and refunding the tariffs.  

FOMC is the big event this week, but also have AVGO and ORCL earnings which will be a good barometer for risk appetite in AI related names.  A hawkish 25 bps cut is mostly priced in.  I expect Powell to do what he usually does, which is talk about data dependency, be mealy mouth and non-committal.  It is absurd to talk about a hawkish rate cut.  Its like jumbo shrimp.  Forward guidance is a joke.  I expect the market to see through any hawkish tone, realizing that they got another 25 bps cut, and steepen the yield curve and probably rally stocks.  Not a high conviction view, however.

It is interesting to see 10 year yields go up last week even though you had rumors that Kevin Hassett is likely the next Fed chair, and you had weak jobs data (ADP, Challenger).  It appears the bond market is seeing through the weakness and expecting a rebound in the economy in coming months.  Also, overseas yields on the long end in Europe and Asia is putting some pressure on long bonds in the US.  All else being equal, higher yields is bad for stocks.  But that may be offset by the coming OBBA Trump stimmies in the first half of 2026.  Overall, not much to do here.  Watching and waiting. 

Retail Saving the World

Retail investor opinions on the stock market have changed dramatically over the past 20 years.  In the early years of the bull market that started in 2009, most of the population didn't want anything to do with stocks.  Daytrading was dead.  Only the hardcore traders and investors were around.  Then as the market kept rising, they slowly crawled back into the market feeling FOMO starting around 2017.  And it went into overdrive after the Covid money spew and lockdowns gave retail investors the time and ammo to go wild in the stock market.  The rest is history.  

Its been a retail driven market since 2020.  They have only gained in importance as they continue to allocate more of their assets into stocks, and out of bonds and cash.  Retail investors will determine what happens to the stock market in the next 1-2 years.  Hedge funds are no longer the market movers.  The baton has been passed to retail.  

In the early part of the bull market in the 2010s, it was corporate stock buybacks that were providing the endless bid for the SPX.  That trend reached a peak in 2024, and has come down as more corporate cash flows go towards AI capex and less towards buybacks.  Ironically, the popping of the AI bubble and a drastic reduction in AI capex could result in a strong rebound in stock buybacks, which would soften the blow of the AI bubble popping.   

Over the past 12 months, private clients have been buying stocks, while institutions and hedge funds have been selling. 

But on November opex week, from November 17 to 21, retail investors broke from their trend of buying the dip and sold into the weakness.  Looking at how retail favorite stocks and bitcoin massively underperformed in November, it looks like retail investors are running low on dry powder to buy more stocks.  In a turn of the tables, it was hedge funds and institutions buying the dip, as retail sold into the hole.  

Foreign investors have been a big source of the retail buying demand for US stocks.  Looking at the below chart, foreign investors have had a knack for buying heavily before bear markets.  See 2000, 2007, and 2021.  They have bought huge over the past 12 months, buying into the US exceptionalism story.  Not a good sign for the future of this bull market.  

History doesn't repeat, but it rhymes.  2025 is rhyming with 2000.  With 2021.  Stock buybacks are decreasing, while stock prices are higher as hyperscalers reduce buybacks to spend on AI.  The corporate buyback bid is weaker than earlier in this bull market.  

The bull market is now dependent on continued retail investor flows into stocks even as they hold all-time high asset allocations in US equities.  Retail investor behavior this year is one of FOMO + saturation.  Those who want to buy into US stocks have mostly done so.  And they have gone in heavy, leaving them with little dry powder.  The Reddit crowd brags about having diamond hands.  But the big down move in bitcoin, along with recent ETF outflows show that's all talk.  As most traders know, the bigger your position, the weaker your hand. 

Retail investors are holding large asset allocations in equities/crypto with limited dry powder to buy more.  This provides a simple game plan in the coming months.  Short retail favorite stocks.  In the large cap space, here is a look at what retail investors have bought the most over the past 12 months:

 

As expected, NVDA and TSLA lead the pack in cumulative retail purchases over the past 12 months.  Those are 2 good stocks to short in 2026.  Of course, outside of the Mag7, there are plenty of other retail favorites out there that will have much more beta to the market.  Like PLTR, MSTR, BMNR, IONQ, RGTI, OKLO, etc.  Ape Wisdom is a good site which shows the trending stocks on Reddit.  It gives you a good idea of what retail is talking about.   

Sold some of the longs bought during November opex week but still holding about half, looking for more upside.  SPX is getting closer to where the buying should slow down.  But the strength has been surprising and greater than expected, which means it probably goes higher than expected.  SPX 6900 is possible sometime in December.  In hindsight, it looks like we got the panicky bottom after the sell the news reaction to the NVDA earnings beat.  So many traders have been taught that good news, bad price action is bearish. That kind of  thinking probably exacerbated the selling on Thursday and Friday, causing weak handed retail traders to throw in the towel.  

We have a big gap down as there is a Thanksgiving holiday hangover.  However, the strength off the November 21 bottom keeps me holding some longs looking for a bit more follow through buying.  It will get choppier as the fear has subsided quite a bit, so looking to sell remaining longs soon.  Also, the continuing relative weakness of bitcoin is a bit worrisome, although most of those negative effects should be behind us.  There are some positive catalysts remaining such as the Supreme Court decision on tariffs and Trump's pick for Fed chair.  So I'm reluctant to put on shorts before either of those news events come out.