Economic Balderdash

Something just doesn't feel right.  Almost everyone that comes out on CNBC/Bloomberg are telling me stocks are expensive, as global bond yields keep going higher, as central banks stay hawkish, yet SPX is trading around 4000, which would have been unthinkable just 3 years ago, and Eurostoxx is almost at an all time high.  You have the crowd last December being certain that recession is coming soon  to now almost certain that there is no recession in 2023 and that a soft landing is very possible. 

 

The global stock markets have been amazingly resilient in the face of the fastest tightening cycle in recent history.  The stock market is fighting the Fed, and holding up well.  So is the credit market.  The Fed keeps raising, yet credit spreads are much tighter than they were last fall.  

The easiest explanation for the high asset prices is the massive amounts of fiscal and monetary policy in 2020 and 2021.  It is the gift that keeps on giving.  It also explains the resilience of the global economy in the midst of a huge increase in interest rates all across the curve.  Everyone talks about the excess savings as a reason for the strength of the consumer.  But don't forget about the super low rates from early 2020 to early 2022.  They have made a lasting impact.  Households were able to buy or refi into very low rate mortgages.  Corporations were able to issue tons of debt at low rates.  Most corporations and households are holding low interest loans/bonds that will slowly roll over into much higher interest rate loans/bonds.  It is a gradual process.  Wall St. doesn't have any patience, so when they don't see an immediate recession, they jump to conclusions like soft landing/no landing.

Here is the Federal Reserve balance sheet: 

Despite all the QT fear peddling from the permabears, the Fed's balance sheet is still sky high.  Their QT program is painfully inadequate.  They have only reduced the balance sheet by $600B in the past 10 months, after adding $4800B from February 2020 to April 2022.  That is $4.2 trillion extra Treasuries and MBS that are on the Fed balance sheet and not in private hands, $4.2 trillion of ammo for private investors to buy financial assets with.  That is the elephant in the room the Fed doesn't talk about.  It is what is keeping a bid under stocks.  It is why the yield curve is so inverted.  There is just too much damn liquidity out there.  That is why it will take time to erode that bid for stocks as the economy gradually weakens. 

So if there is so much liquidity out there, why am I negative on the economy?  Its because of secular stagnation (demographics, lack of productivity, etc).  Without big time fiscal stimulus and very low interest rates, many businesses aren't viable in a zero population growth world.  In 2023 and 2024, you will see many businesses go out of business.  The last time you had 5% Fed funds rates was in 2007, and the global economy couldn't handle it.  There wasn't enough organic growth to sustain that level of rates.  People talk about the bursting of the housing bubble and the ensuing financial crisis in 2008 as the causes, but they don't talk much about the slowing organic growth of the developed world since the early 2000s, aging demographics, and slowing population growth rates.  That trend has only gathered momentum in the past 5 years, masked by big budget deficits and massive fiscal and monetary stimulus.  If the US government ran a balanced budget now, like it did in 2000, the US would be in the depths of a deep, deep recession.  The only growth you are seeing in the US is from government pork and entitlement spending.  If they just stay at current levels for the next few years, you will have zero growth.  

The inflationistas out there, which have grown in number quite a bit over the past year, are forgetting that the main cause of the huge rise in 2022 inflation was the 2020 and 2021 Covid bazooka stimulus that was the largest stimulus EVER in US history.  That was a one time bonanza for the financial markets and the economy, and it resulted in an inflationary surge with a 12 to 24 month lag.  The main cause of the inflation, a 40% rocket higher in M2 money supply from mid 2020 to end of 2021, is gone.  The M2 money supply is going in reverse, almost unheard of in US financial market history.  The monetary contraction starting from late 2021 and still ongoing will be the reason that inflation cools down in 2023 and 2024.  

All things being equal, inflation going lower in a high inflation environment is bullish for the financial markets, but this time, the cooling inflation will be accompanied by a big drop in economic growth with high interest rates.  Unlike the higher for longer crowd out there, I don't think the economy will hold up for long under this current high rate regime.  Do you really think the stock market will be happy with Powell sitting there, keeping short term interest rates above 5% for several months, while the economy deteriorates, like nothing is happening?  

If the Fed truly commits to its higher for longer rate regime, then they will have to do it in the face of a falling stock market, disinflation, rising credit spreads, and increasing unemployment.  Powell is not dogmatic.  He's from the Church of What's Happening Now.  He's not going to ignore incoming weak economic data just so that he can fulfill his forward guidance promise of higher for longer.  Just like he didn't fulfill his promise of rates at zero till 2024 in his forward guidance in 2021.  There is a high probability that the data will cause Powell to pivot later this year.  By that point, the stock market will probably be much lower than current levels, and it will have to be, in order to get Powell's attention.  If the stock market just meanders around 4000, give or take 200 SPX points, he's probably going to stay with high rates. 

Corporations will be sharply cutting back on investment, as the hurdle for productive use of debt in a 5% risk free rate world is much, much higher than it was when it was hugging zero.  If you can't make money borrowing money at 7,8,9%, why would you borrow at those rates?  If corporations cut back on debt issuance, that just means less investment, less stock buybacks, and less economic activity.  Businesses can't keep raising prices in perpetuity when the money supply isn't increasing.  The customers just won't have the money to buy the goods and services.  There has to be more money in circulation to keep inflation going.  

While I respect the price action in the bond market, as the sovereign bond market is trading extremely weak, I don't expect that to be a long term trend.  Short term, you have worries about econ. data continuing to come in hot, as the lag effect of higher rates has yet to really work its way through the economy.  The chart looks horrible for bonds.  It is also a seasonally weak period for bonds, as they tend to sell off in March and April.  

 

 

Longer term, bonds are a much better investment than stocks here.  I just don't believe high interest rates are sustainable for the developed world.  Its just a matter of when, not if the dam breaks and the economy buckles under the pressure.  The only way high interest rates can be sustained is if inflation sustains at a high level.  I don't think that's happening over the next 2 years.  Maybe starting from 2025 after you get either a Democratic president + both Houses with Democratic majority or a Republican president, then you create conditions for another fiscal bonanza as the populists take over and spew money everywhere.  But until then, fiscal policy just won't be loose enough to create the conditions for high inflation. 

Maintaining my equity shorts and just watching the SPX/NDX for now.  The stock selloff likely continues if the bond market stays weak.  CTAs, after getting long in January and February, started dumping SPX last week, so they are probably either flat or slightly short now.  Volatility is still relatively low so vol control funds are not selling here.  Don't have a lot of conviction on the indices, so just watching and waiting for a better spot.

Don't Call it a Comeback

"Don't call it a comeback.  I been here for years."

The retail trader is back.  Retail is aggressively buying stocks and crypto in 2023.  I am a bit skeptical about how they obtain data on retail investor flows, but everything I see points to them being generally correct.  The outperformance of daytrader favorites such as TSLA, bitcoin, meme stocks, etc. so far in 2023 are trademarks of retail investor inflows. 

Daily Net Inflows by Retail

 

Bitcoin vs SPY 6 mo. chart

Obviously retail investors are hooked on stocks.  2020 was the turning point for the stock market.  That is the year when the stock market went from being a casino occupied mostly by institutions to being a casino now being filled with both institutions and retail investors.  Individuals have found a new outlet for their gambling addiction:  the stock market.  Retail investors are the drivers of stocks like TSLA, even with its $600B+ market cap.  They are the ones that move around bitcoin.  This creates long term opportunities.  Retail are the least informed investors and the best fades over the long term.  

Fundamentals eventually determine the stock price.  Dislocations in retail dominant names can only last as long as the retail investors keeping pumping money into the same stocks.  Once they buy in, then the next step is not if, but when they sell.  As we saw with tech stocks and retail favorites like TSLA in December 2022, when retail investors start losing lots of money, they panic just as much, if not more than institutions on the way out.  

Retail investors have been buying into the soft landing/no landing thesis perpetuated by the institutions. Institutions have been coming back in and steadily increased net equity exposure this year, while retail has been piling back in and trying to relive their glory days in 2020 and 2021.  

In a bear market, the investor positioning among institutions rarely gets much above average, as the fundamentals are just not strong enough to change enough minds to have the majority all bulled up.  We are near a point where positioning will only get much more bullish if you see signs of earnings forecasts rebounding and inflation going down sharply to justify a pause and eventual rates cuts from the Fed.  That's a high hurdle, considering all the forward looking economic indicators and the lagged effect of higher interest rates working to slow down credit growth and thus economic growth.  

The options market is also showing signs of complacency, as the put/call ratios have been trending lower in 2023.  The 20 day moving average of the CBOE equity put/call ratio is back towards mid August 2022 levels.  That just happened to be when the SPX topped above 4300 and went down 800 points over the next 2 months.

 

If this is still a bear market, which I still believe, then you have limited upside from current levels, maybe a few percent at most in the SPX, and lots of downside.  A skewed risk/reward ratio in favor of shorts.  I was hesitant to go too heavy on the short side when I saw the lack of selling after bad inflation numbers and hot retail sales.  I missed the juicy short above SPX 4140.  Just too cautious and overthinking things as I was already short some high beta retail high flyers.  Given how much CTAs and systematics have added to the stock buying over the past few weeks, there is not much more ammo left on the bull side.  

The weakness in the bond market is the biggest barrier for a sustained stock market rally.  The bond market could of course reverse and start rallying, but looking at the charts and the distance from prior lows, its not looking great for bonds either.  The 10 year yield is at levels where the SPX was trading in the 3800s in late December.  Either the bond market is too low or the stock market is too high, or a combination of the two.  The divergence is getting extreme between stocks and bonds, and I wouldn't be surprised to see pension funds do a hefty rebalance out of stocks and into bonds going into the last few days of the month. 

Big picture, it looks like a topping process is ongoing in the SPX/NDX and the bottom could fall out at anytime.  There is serious rug pull risk here. 

Irrational Rally

This rally is even more confounding than the one you saw in July/August 2022 because at least back then, the bond market was rallying with the stock market.  This time, stocks are going up despite the bond market weakness and the additional Fed hikes priced into the yield curve.  Yes, its the soft landing hopes that are driving this rally. 

The market went from hard landing to soft landing in a hurry.  That strong nonfarm payrolls number really got investors believing in either a soft landing or a no landing!  Incredible how all the other economic indicators are immediately forgotten and investors latch on to the blowout jobs number.  That's classic Wall St. behavior.  What have you done for me lately thinking.  

One thing I've learned about shorting the SPX/NDX since the QE era began in 2008:  The rallies can go on much longer than you think possible.  Especially when investors are not totally bought in on the long side.  Sure, we've gone a long way since last October in adding bulls, in getting CTAs/vol control/systematic funds to add equity exposure.  But hedge funds still are below their average net equity exposure.  Here is a recent look at hedge fund positioning from Deutsche Bank:  

On CNBC/Bloomberg, I am still hearing some reluctance from institutional investors to embrace this rally, even as they say that the economy is unlikely to go into recession, as previously feared.  This is just another survey, which I put less weight in than positioning, but I was surprised to see these numbers after the equities rally so far this year:

It does make me want to wait for a more ideal spot to put on shorts, as the SPX could definitely grind higher until you see more overt signs of an economic slowdown, which probably will take a few more months.  During that time, who knows how far the chase for performance and trying to keep up with the indexes will do.  Its totally irrational, as extending the high rate regime by having non recessionary data for the next few months will just make the landing that much harder.  But so much of Wall St. is caught up in playing the short term game and not able to deal with underperformance or worse, big drawdowns.  So they have to often chase even though they know the fundamentals don't support the rally.  

Since they've reduced their shorts via massive short covering in the past few weeks, I don't expect much more juice left in the popular short names in the speculative tech.  That's where I've put on short positions.  I've stayed away from shorting the index until I see more of a blowoff top or signs that hedge funds are back to at least neutral positioning.  I like the risk/reward long term from shorting the SPX here, but with some single stock shorts, don't want to go all in by shorting indexes as well, until I see more signs of a top.  

Stocks shrugged off the higher than expected CPI number, while Treasuries went lower.  The price action does speak to the effect of puts losing value and being delta hedged by dealers, which is to buy back shorts.  Also this is opex week, so you get a lot of influence from options.  It feels a bit too neutral for my liking, so will wait and see.  

Retail Frenzy and Hedgie Caution

That nonfarm payrolls report is still having repercussions in the market.  The market has jumped from the immaculate disinflation to sticky inflation.  I am hearing talk about a strong job market, higher prices for used cars, strong new car sales, more optimism in real estate, etc.  I heard none of these things 2 weeks ago.  Its amazing how fast Wall St. jumps from one side of the fence to the other.  Now its clear that investors have come right back to the 2022 mindset of high inflation/good econ. data is bad news.  

However, that trend doesn't seem to have staying power.  Wall St. has no patience for things to play out.  If the economy doesn't immediately crater after rate hikes, then the economy is deemed to be impervious to rate hikes and very strong.  As the saying goes, monetary policy works with long and variable lags.  Most say the lags are anywhere from 12 to 18 months.  If that's the case, the bulk of the rate hikes happened after June, so that would be anywhere from June till next March for the full effect of the rate hikes to work their way into the  economy.  That monetary policy transmission takes time, its slow but the effects accumulate, like body punches in a boxing match.  One body blow usually won't knock anyone out, but they accumulate to weaken the opponent over the course of a match. 

The retail traders have regained confidence as the soft landing/no landing view gains popularity.  I am seeing some crazy action in pump and dumps the past couple of weeks.  Its almost as crazy as 2021, when you regularly saw multiple 100% daily gainers in a day.  But that confidence is missing from the hedgies, as they've been covering shorts and also reducing longs, pulling back on their gross exposure and not raising their nets, even with the growing economic optimism out there. 

Its a confusing time for macro based investors.  The leading indicators are telling you one thing, but there are bits of coincident data that remain strong, like employment, which gives out soft landing/no landing vibes to the public.  This seems to happen at the beginning of every downturn.  During this "Goldilocks" period, people play down the importance of the yield curve inversion, the accuracy of the leading indicators, and point to the strong jobs market as proof that the economy remains strong.  

The thinking out there is that there is still a lot of excess savings, and will keep the consumer spending for some time.  But average hourly earnings has been growing less than the CPI for the past 18 months, and we all know that the CPI underestimates inflation.  So consumers' buying power is probably the worse it has been for several years, as wage growth hasn't kept up with inflation.  

Logically, with government spending taking up a bigger percentage of GDP than in the past, the economy becomes less efficient.   Government waste and lost productivity manifests itself as inflation.  Government workers get paid more than their labor is worth, so the money that they get paid isn't made up for by increasing the productivity of the country, leading to more inflation, and less buying power for the private sector. Government spending to GDP ratio hit 37% in 2022, after reaching over 43% in 2020.  In the late 1990s/early 2000s, government spending to GDP was in the low 30s.  Government creep into the economy lowers productivity as their activity crowds out the more efficient private sector.  This is one of the trends that is a tailwind for higher inflation in the future.  While it doesn't have a big effect near term, over time, waste and inefficiency in the public sector gradually decreases the purchasing power of the dollar.  

While I am a believer in the secular inflation thesis, its going to be overwhelmed by cyclical forces.  In this part of the business cycle, you have disinflationary forces which are quite powerful, with high inventories, higher cost of capital forcing some businesses to close, negative wealth effect from housing and financial asset depreciation, and banks tightening credit standards and giving out fewer loans.  The recession callers at the end of last year weren't wrong.  But they jumped the gun by thinking that the Fed tightening would choke off the economy right away.  It may take a few more months than they thought.  

Noticing some interesting price action the past few days.  Even with the strong nonfarm payrolls report and a weak bond market, the bulls were aggressive, and pushing stocks up until yesterday.  Especially super speculative stocks that retail traders love to push around.  Greed is percolating out there.  You are seeing more optimism show up in the investor sentiment surveys, which are showing the highest levels of bullishness since early 2022.  It makes for a dangerous market to get long, with all these newfound bulls.  It makes it safer to short, but I would like to see less fear in the bond market in order to really get the bulls worked up and feeling invincible.  

Right now, there still seems to be a bit of apprehension among hedge fund managers, which still have relative low net exposure to equities.  Retail is almost all in, so that's a good sign to short the retail favorites.  But for the indices, its less clear cut.  I would like to see the hedgies increase their net exposure a bit more here.  The systematics and CTAs have been buying the past few weeks, so they are have used up most of their buying power.  Have been shorting retail driven stocks this week, but I will wait to short the SPX.  I missed a good down move yesterday but I think there will be at least one visit above 4200 before this bear market rally is done.  Gut feel tells me that this bear market rally will last longer than the one you saw from June to August of 2022.  So its going to be trickier to maintain a long term short this year.  Still think we see a big move lower eventually, but probably only after you suck in a few more bulls into the ring. 

Blowout Jobs

The higher for longer crowd got a boost when they saw the big nonfarm payrolls job number on Friday.  Instantly, you saw them sell everything, stocks and bonds, and with a delayed reaction, even commodities.  The nonfarm payrolls print just shows you how wild these BLS numbers are, how much they depend on the massaging of numbers, seasonal adjustments, population normalizing measures, etc.  The ADP number was much weaker, and the Challenger job cuts was higher, so this nonfarm payrolls number is totally out of whack from the other employment data, which shows some signs of weakening.  

The only real effect that the nonfarm payrolls report has on financial markets is how it affects monetary policy and I doubt this number will move the needle.  The Fed's number one goal is to reduce inflation, not to reduce jobs.  If reducing jobs is required to reduce inflation, then they're willing to force that situation, but if its not, they won't keep hiking if jobs are steady and if inflation continues lower at the current pace.  Powell is much more worried about wage inflation than the total number of jobs.  If wage inflation stays under control (trend is toward more lower paying service jobs and fewer higher paying tech/middle management jobs), as it has for the past few months, he's not going to kill the economy just because of strong NFP numbers.  The Fed's focus is still on inflation.  And based on base effects (energy was up huge from February to June 2022) and current high frequency data on rents, the year on year CPI numbers will be dropping dramatically unless oil prices surge back over $100 in the coming months.  This isn't a forecast for how inflation will be, its just simple math based on how CPI is calculated.  

It seems like I'm in the minority when it comes to betting on a big drop in inflation/even some deflation for 2023, here's a Twitter poll taken just recently:

In fact, I was quite surprised that so many bet on higher for longer, when the leading indicators are pointing to further decrease in inflation, as well as significant economic weakness.  Maybe this time is different, and the Covid stimulus is the inflationary gift that keeps on giving, but I have a hard time seeing high inflation and higher for longer when you have the housing market essentially frozen, with current listed home prices not reflective of where the actual market is, as sellers always are reluctant to lower prices at the beginning of a housing downturn.  Unlike the stock market, the lack of liquidity in real estate means bid and ask spreads widen at tops, as sellers are the only ones who list their prices.  There is only an ask price in house listings, there are no bid prices listed.  In the goods sector, inventories have built up bigly over the past 12 months, while demand is falling, a deflationary force that will play out in 2023 and feed into the CPI. 

In the heat of battle, its easy to go back to the last playbook and expect it to repeat.  The 2022 playbook was to sell bonds and stocks on strong economic data, and buy bonds and buy stocks on weak economic data.  I believe that playbook is on its last legs as the focus shifts from inflation to economic growth in the coming months.  When the focus turns towards growth, weak economic data will be considered a negative, as that just signals lower earnings in the future. 

The expectation here is that economic weakness for the next month or two will be taken as a positive, as investors still latch on to the last remaining bullish talking point: employment.  But when the economic weakness persists and the nonfarm payrolls numbers start to turn down, the talk among investors will shift from 1) the Fed needs to keep tightening, 2) the labor market is too tight, 3) inflation will be sticky, to: 1) the Fed is out of touch with the economy,  2) the economy is looking horrible, 3) when will the Fed come to the rescue?  It will happen sooner than people think, it always does. 

These outlier economic data prints (especially nonfarm payrolls) get investors so heated up and leaning towards one side, that it provides opportunity to take the other side, especially when the longer term trend is in the other direction.  The blowout jobs number is providing a good entry to get long bonds.  I was previously looking to enter SPX/NDX shorts, but I think I'll be able to get a better short entry point when the effects of this nonfarm payroll number wear off and everyone goes back to focusing on disinflation and a Fed that is almost done with the rate hiking cycle.  

These bear market rallies are seducive, and they suck in the technical traders who worship at the altar of price, and fund managers that have to keep up with the indexes, only to chew them out when the fundamentals come back to weigh on the market.  

After a huge rally in the SPX over the last month, the bar has gotten raised much higher for the economy.  Now you will need not only a continued disinflation to keep the Fed from overtightening, you will also need earnings to not go down much in order to justify all the recent optimism about a possible soft landing. 

A combination of long bonds and short stocks looks to be the ideal mix at these levels.  Based on how financial markets react, usually what happen is that bonds rally as it sniffs out economic weakness and future Fed loosening, and stocks react positively to that bond rally by rallying at the same time, but after a brief period of stocks and bonds going up together, the economic weakness becomes more pervasive and investors start worrying about recessionary impact on earnings, leading to weak stocks, and bonds going up even more as the feedback loop of weak stocks ---> weaker credit markets ----> weaker economy leads to a flight to safety.  

It appears we're still in the honeymoon phase with occasional flashbacks to the nightmare 2022 scenario of weak bonds/weak stocks (last Friday).  This honeymoon phase could last until the Fed finally says it is ready to pause its rate hikes, keeping the SPX above 4000, and then leading to one last relief rally, only to be met with the reality of an economy headed for a hard landing.  At that point, I expect a steady downtrend that lasts for months, and will be when you see retail start to throw in the towel on stocks that they bought up in January and February. 

Stupid Season

It must be that 6 month cycle working again.  Not many will remember this, but going into the earnings season in late July, ahead of the FOMC, the big worry was about bad earnings and a coming recession.  Fast forward 6 months.  The big worry was about weak earnings going into the new year, and a coming recession.  The market has climbed that wall of worry about downward earnings revisions, as all I heard in January was that earnings estimates for 2023 are too high from everyone that comes on CNBC or Bloomberg.  They were expecting earnings to disappoint and for stocks to go down.  Earnings disappointed, but stocks went up.  That is positioning at work.  People sell ahead of anticipated bad news, and buy ahead of anticipated good news.  No one is waiting for bad news to sell, when they know its coming.  That's the story for this earnings season.

Investors have not experienced this kind of chop market for a very long time.  You had smooth uptrends for most of the past 14 years, with every deep correction being over within a few months.  That is 14 years of investor conditioning to believe that the stock market always bounces back and eventually makes new all time highs.  Thus you get these fervent rallies when people think the market has bottomed, because it usually goes up for months on end.  

Its more than a year since the start of the bear market, and that belief in the stock market is still there.  I don't see the big outflows.   We've had 2 straight weeks of strong inflows into equity funds.  There is STILL a ton of speculation in shitcos, shitcoins, and meme stocks.  There are so many out there:  AMC, GME, CVNA, COIN, BYND, etc.  There is even an ETF that wraps up all of it in a nice little turd package known as ARKK.  All you need to do is look at the ARKK chart and you can tell that rampant speculation is picking back up.

The catalyst for all this movement?  Apparently it was because Powell didn't push back on the recent stock market rally and loosening of financial conditions by saying that financial conditions are tighter, and attempting to go for that soft landing.  Going for a soft landing = less likely to overtighten.  Powell is no longer looking for the market to feel pain to get inflation lower.  He thinks that inflation will go lower without much pain. It seems he has bought into the immaculate disinflation story that is getting quite popular these days.  That's why your seeing a strong rally in both stocks and bonds so far in 2023.  One rally looks sustainable.  The other looks to be running on hot air.  

Its hard to tell the difference between a mild economic slowdown and a deep recession at this point in the cycle.  We are just entering the fat cutting stage of the business cycle, as worker hours are reduced, layoffs announcements start up in a few bloated overstaffed sectors of the previous upturn.  Now is when investors and economists both get optimistic, as they see inflation coming down, growth slowing, but without the rise in unemployment.  This optimism is fueled by both the stock and bond markets going up, as it confirms their beliefs.  Fundamentally, the situation is worse than 6 months ago.  

July 28, 2022 (day after FOMC):  SPX 4072, 10 year 2.68%, Fed funds rate 2.33%

February 2, 2022 (day after FOMC): SPX 4179, 10 year 3.40%,  Fed funds rate 4.58%

The SPX is 100 points higher, the 10 year is 70 bps higher, and Fed funds is 225 bps higher.  The environment for the conservative investor is much more favorable, as he is getting 225 bps more on cash and 70 bps more on 10 year Treasuries than 6 months ago.  

The 2 main bear thesis are either:

1) Inflation will remain sticky, the Fed will keep their word, and not cut in 2023, and stay higher for longer, pulling down both stocks and bonds.  

2) Inflation goes down but the economy goes into a deep recession that hurts corporate profits and pulls down stocks but pushes up bonds.  

I am in camp number 2.  The disinflation is happening, but its not going to be immaculate.  This disinflation is happening mainly because demand is going down.  When the biggest asset in most people's portfolio, their house, is frozen, as transactions disappear in the face of higher mortgage rates and lack of demand at current prices, you will see sellers lower their offers.  That reverse wealth effect, combined with a bear market in stocks, is a toxic combination.  Don't forget that organic growth is meager now in the developed world, mainly due to low population growth and having squeezed all the economic growth possible from financial repression and low rates over the past 14 years. 

What you are seeing now is stupid season, when investors get enamored with the bullish side of the story, forgetting about the negatives.  These are the moments where you can take long term short positions.  Its what I've been waiting for while playing small.  Its getting very close to the time to go big on the short side.  I am not smart enough to pick the top, so I'll scale into the shorts, focusing more on heavily shorted and more speculative names at first, and then adding index shorts.  It is time to short the speculative, heavily shorted garbage, but I would wait a few days to short the SPX.  The strength in the bond market and the lower volatility means that you will see more inflows into risk assets as vol control and systematic funds add equity exposure.  It should mostly be played out by the end of next week.  

AAPL threw some cold water on this rally.  Rallies don't end on bad earnings reports.  The speculators are looking for blood.  Bear blood.  As I mentioned a few days ago, a strong rally after FOMC with Powell not going full hawk would make the bulls feel invincible.  That's where we are.  Its time to go to action on the short side, with any rally from here over the next couple of weeks likely to just be temporary, and all of it and more will be given back in the coming months. 

Insanity

Sometimes you just have to shake your head.  It can feel like you are the one who's insane when everyone else is doing something else and making money at your expense.  That's what its felt like for the past 2 weeks.  I've been patient with the shorts, waiting for the bulls to regain their sanity, and they haven't.  Is it a new bull market, making me the one who's insane, or is it just a bear market rally, which is making the crowd insane.  We'll find out in the coming months.  

I'm not a Twitter trader, so I can admit to losing.  It's part of the game.  That being said, haven't seen that kind of mania in speculative stocks since last August, when I made the mistake of assuming that the market would linger near the rally highs around 4150-4300, covering shorts too early.  Of course, the market folded like a cheap lawn chair and went straight down for the next 45 days.  

On to the bond market.  2022 wasn't easy if you had any faith in the bond market, which I did and still do.  2023 should be quite a different story.  The coincident indicators are starting to show weakness, although employment remains stout, which keeps the soft landing crowd believing in stocks.  Leading indicators, however, are a horror show.  I'm noticing some interesting parallels between now and 2019 for the bond market, except this time, Powell is being stubbornly hawkish, not making a quick dovish pivot.  Here is a look at the leveraged funds position in 5 year and 10 year Treasuries back then and now:

5 year Treasury Futures COT Leveraged Funds Net Positions

10 year Treasury Futures COT Leveraged Funds Net Positions

Leveraged funds are hedge funds: a mix of CTAs, macro, and fixed income funds that use Treasury futures to either hedge their cash bonds or to make outright bets on rates.  They are trend followers, but they stick with the trend even when its going against them in the short term if the long term trend is still intact.  Of course, long term trends start from short term trends.  I believe we are at one of those inflection points in the bond market, as the long term trend has been down for over 2 years, since mid 2020 to late 2022.  But now, it looks like there is a battle going on, between the bulls and bears.  I lean on the bullish side as I am more bearish on the global economy than most, and less of a believer in the central banks' forward guidance, which changes quicker than people think.  

As you can see above, leveraged funds are putting on big short positions in both 5yr and 10 yr Treasuries, the shortest they've been since late 2019 in 10 yr Treasuries.  But the price action is running counter to their positioning, and that's when things get interesting.  I expect pension funds, mom and pop investors overweight equities and who sold their bond funds in 2022, to jump back in when the coast is clear.  That would be when the Fed pauses rate hikes.  And that looks likely after a final 25 bps in March.  

Back to the stock market.  The 2021 stock slinging daytraders and meme stock crowd is back, this time jumping on the TSLA bandwagon again, along with a slew of other bubble stocks like ARKK, COIN, MSTR, etc.  They can't get enough of the action, and are pushing these stocks back to where they were in November, before the big plunge lower in all things tech related from late November to late December.  Now you are back to levels where the shorts are looking quite juicy for a lot of these former bubble boys.  I haven't put on any big positions in these yet, as I'm waiting for the FOMC and ECB meetings to be behind us before feeding the ducks.  

I sense there is some caution among investors and EVEN these gun slinging speculators ahead of the FOMC and ECB meetings this week.  They remember all the times last year when Powell came out hawkish as hell and hammered the markets.  So they are bracing for impact and selling some stocks ahead of time.  With Powell all but guaranteed to do 25 bps, his hawkish rhetoric won't have the same sting as when he went 75 bps and went full hawk.  It would be totally toothless for him to do 25 bps and then talk tough.  Its like a guy with a toy pea shooter acting like Mr. Tough Guy shooting plastic BB pellets into the crowd.  It just doesn't have much effect, no matter how tough he sounds.  

So I think these never say die bulls will have a sense of relief once this week's events are over as well as earnings season and ramp stocks back up again, past SPX 4100, creating that fake breakout above resistance that every paper napkin technician can see in the charts.  Once you get that move above 4100, you will truly see euphoria and be able to put on long term shorts.  I was expecting to put out the shorts in the spring, not expecting so much enthusiasm so quickly after the December washout of spec names, but here we are.  You have to play the hand that is dealt, and it looks like I'll have to put on the long term shorts earlier than I expect this year.  Got out of most of my underwater shorts yesterday, and will get out of the rest today.  Leaving dry powder for next week for the long term shorting campaign. 

Setting Up for FOMC/ECB

Its amazing how you can hear a mouse squeal when the Fed is in their quiet period.  Next week, we get the one two CB combo of Fed and ECB on back to back days.  With the Fed, you have Powell who has softened his tone lately but has mostly let his lieutenants run their mouth, because well, they just want to sound like inflation fighters to boost their careers.  I can't imagine Powell doing anything to placate the bulls, but I have a consensus view, so probably close to a nothingburger at the FOMC meeting, don't expect him to go full hawk like he did at J-Hole or the Sep. and Nov. meeting, expecting more mealy mouth language that's more noncommittal, except that he'll probably say rate hikes are not done, even with the step down to 25 bps.  Remember, Powell's ego and reputation is on the line. If he wimps out here and goes dovish when stocks are in rally mode, he will lose some credibility.  That said, he can't deny that inflation is coming down more quickly than many expected, even though the labor market remains tight.  

With the ECB, you have the hawkish Lagarde who is talking smack to STIR traders in the Eurozone who are long and fading her. You had a huge bond selloff post ECB meeting in December, so that's going to be on the minds of bond investors this time around.  After a big rally at the beginning of the year, kind of neutral here on the bond market, but if I had to make a play, I would choose the long side.  Longer term, unlike stocks which look a bit rich, bonds are at decent levels and have room to go higher.  

The price action in stocks has been strong after earnings reports that have been weak.  It appears that investors are feeling more bullish these days, and you are probably getting CTAs chasing the move higher, as the SPX trades above its 200 day MA and hit a 1 month high.  The last buyers will probably be vol control funds which are just waiting for the volatility to go down a bit more before they pile in.  That could be the last push higher before this bear market rally rolls over.  A realized vol chart from @NewRiverInvest for a SPX/UST balanced portfolio.  Still elevated, but if it drops a bit more, you will see funds getting deployed in BOTH stocks and bonds. 

The resilience of this stock market despite terrible fundamentals and tight monetary  conditions is a bit surprising.  The $5+ trillion Covid helicopter money drop is the gift that keeps on giving for financial markets.  Liquidity came in like a fire hose, and the meager QT is taking it out with a paper straw.  The only plausible bull case for a long term investment in SPX at these levels is if the Fed goes right back to their 2008 playbook and cuts to zero with alacrity and goes back to unlimited QE at the first sign of deep job losses and weak economic data.  But to get to that point, ironically the stock market would have to drop a lot in a hard landing to get the Fed's attention and make them overreact to the weakness.  A soft landing isn't the best case scenario for stocks, that will only take Fed funds rate down to 2.5-3% level.  A hard landing inducing the Fed to overreact with their liquidity bazooka gun is the bull case. 

Stuck in the red on my NDX and SPX short positions.  Not willing to make Custer's last stand with these, so will hold for a couple more days and look to exit early next week before the FOMC meeting.  There is a good probability that you will have a relief rally unless Powell goes full hawk (unlikely, but not zero probability).  I will not be playing the long side even though I think we're probably going to rally late next week.  The risk/reward is just not good enough (rug pull risk is too high here).  That relief rally + the return of the corporate buyback window in February could boost this market higher for the next few weeks.  As positioning has been getting more long among asset managers in SPX and NDX, the rally will probably be small (up to SPX 4150-4200), as you've already made a big move off the December lows. 

Cherry Bomb Market

There are markets where up trends last for a long time, and there are chop markets where up trends are brief and don't have staying power.  It feels like we're in one of those cherry bomb markets.  If you have ever lit a cherry bomb firecracker, you know that the fuse is very short.  So once you light the fuse, you have to run.  On the long side, you have can't stick around and wait for much higher prices to sell.  If you hold the bags for too long, they explode in your hand, like a short fuse cherry.  In the past, the bombs had much longer fuses, so bulls had plenty of time to stay invested, ride the trends higher, and get out comfortably without rushing.  This is a totally different.  It punishes the late seller, and the graceful selling windows are much smaller and narrower.  A much less forgiving market for longs. 

This uptrend off the October low has been choppy with deep pullbacks, with the market topping out as soon as investors got comfortable with whatever piece of bullish data or news that came out.  

Over the past 3 months, there have been 4 pullbacks after a good news pop as shown in the above chart.  The SPX didn't have staying power after each of those pops.  The investors who chased the rallies by buying on good news were punished.  The reason this keeps happening is because the big picture of tight liquidity conditions and earnings deterioration are still there.  In fact, we are getting closer and closer to the point in the cycle where leading indicators showing weakness start seeping into the coincident indicators and the hard data.  That's when the soft landing hopes dissipate and a re-valuation lower for equities is likely.  Maybe its because I'm a permabear, but I still don't understand how investors can get optimistic under these conditions.  

Its quite telling though that the optimists seem to be playing for short term move higher, not a long uptrend.  That means the active investors are looking to sell quickly and are not sticky investors, looking to hold for a long, big move higher.  Those are the worst owners of stocks.  They have low conviction, and sell quickly on a whim.  It appears those buyers of meme stocks, high beta tech, bitcoin, etc. are low conviction buyers looking for a quick hit and run play, hoping that the rally can last for a few more weeks so they can sell higher.  You don't see many new, highly convicted buy and hold investors jumping into US stocks.  Its all short term, technical based traders and investors that think they can jump in and out of the market and be nimble before the tide turns.  I don't like playing those games, because you have to deal with rug pull risk, which can come quickly and violently after bear market rallies.  

So what is the reason for the recent big rally in tech stocks and high beta names?  It appears to be a combination of being oversold, rally in bonds, and optimism that layoffs at the big tech companies will help to cut costs and boost profit margins.  Its almost as if all those workers were basically meaningless to the bottom line and were just dead weight.  I can't argue against that, but having fewer workers just means more work for those remaining, which isn't sustainable in the long run.  

Its not a good sign for equity investors to see oil creeping back over 80 and acting strong ahead of the Chinese re-opening.  The last thing this market needs is an uptrend in oil prices just as the higher interest rates really start kicking in to the real economy.  Nothing fundamental has changed from when the SPX was at 3800 in late December, and where it closed around 4020.  Its just been some price insensitive portfolio allocations getting jammed through at the start of the year along with neat excuses for the rally:  soft landing hopes (because yields are going lower while employment remains strong), weaker dollar, China re-opening, technical breakout above 200 day moving average, etc.  

Really specious reasoning out there which make the rallies more fleeting than if there were actual real fundamental changes going on that would signal that the worst is over.  Its just one of those listless periods where there are no strong drivers in the short term, so we chop around.  The hard data hasn't rolled over yet, so the soft landing hopes are still alive.  And bond yields are now much less volatile, as disinflation continues, so stock investors are finding comfort in that.  Expecting more of the same chop in the coming weeks, until the last gasp rally after the last rate hike in March.  From April onwards, I am expecting a 2nd leg down that will be brutal.  No need to think too far ahead, just try to ride the choppy waves in the meantime.  Staying on the short side of course. 

Remember, Its a Bear Market

I don't know what it was like in the 1970s during the high inflation period, but if I had to guess, this bear market looks similar to the 1973-1974 bear market, where SPX went down 49% from top to bottom in 21 months.  At the bottom in October, the SPX was down 27% from top to bottom in just over 9 months.  The bear market in 2000-2002, one which I actually experienced, with similar bubble characteristics, the SPX went down 50% from top to bottom in 28 months.  

SPX 1973-1974

SPX 2000-2002

Not saying that we're going to repeat those 2 previous brutal bear markets where the SPX was cut in half, but even a lesser bear market taking the market down a mediocre 35% from the top would take the SPX to around 3100.  

From both a technical and fundamental perspective, this is about as bearish of a market as I've seen since those dotcom bubble days.  Even in 2007, the SPX never got nearly as overvalued as it did at the end of 2021.  

Sometimes I think its just too obvious of a bearish setup, it must be a bear trap.  But then I look at the massive equity fund inflows for the last 2 years, and the ridiculous amounts of bullishness and bubble behavior in 2021 and it is a classic post bubble bear market here.  And the biggest and worst bear markets happen after bubbles. 

The first half of 2022 was a struggle to get rid of my bull market trading psychology built up over 13 years of a raging bull market.  It took time to embrace the bear market and adjust to the new reality that will be around for a while.  It was only after Powell went full hawk at Jackson Hole to fully realize that the SPX was now a short seller's market. 

For 2023, anytime the market even gets a little bit excited and optimistic about stocks, it is time to short.  There are so many underwater longs that are looking to get out on a big rally that any rallies that take the SPX towards 4000 or higher are great opportunities to layer on shorts.  There is a lot of overhead resistance.  The psychology of the US stock investor has changed.  They are no longer looking to chase momentum and look for home runs, they are just hanging on, hoping for a miracle soft landing and/or Fed to come to the rescue, expecting it to rocket the SPX higher.  Hope is not a strategy.  

The bearish turnaround in the market on Wednesday seems to have surprised a lot of bulls.  The PPI came in weaker than expected, economic data came in weak and boosted the bond market, and stocks liked it at first, but then sold off aggressively to close at the lows.  The stock/bond correlation is changing.  Bonds are strong, and receiving a lot of inflows.  Stocks are choppy, and losing their bid even when bonds are strong, so that high positive correlation of stocks and bonds moving together is breaking down in 2023.  We are now moving from an inflation focused regime to a growth focused regime.  Those regimes are dominated by negative correlations for stocks and bonds, as bonds like it when economic data is weaker than expected, but stocks don't, and vice versa when data is strong.  The bad economic data is good news for stocks regime is near its end. 

Expensive and Tight

These countertrend rallies in bear markets are always tempting to investors.  So much money has been lost, its only natural to expect a mean reversion, especially when the previous trend higher lasted for so long.  Investors have been conditioned to expect the US stock market to bounce back from downtrends, and do it quickly, going up aggressively, like what happened after every big pullback since 2008:  2011-2012, 2015-2016, 2018-2019, and 2020.  But during each of those selloffs, the Fed was on the long's side, pumping up the markets.  Valuations were on your side as the market was not overvalued at each of those previous bottoms.  This time around, you don't have the valuation buffer to support stocks, and you don't have the Fed backstopping the market.  These are probably the 2 most important factors in investing in stocks:  1. valuations  2. monetary policy.  

The trailing P/E for the SPX is 19.5, which is well above the average of 15.5.  

Those SPX earnings are driven by near record profit margins, which historically are mean reverting.  Given how much corporate tax rates have been cut, how much corporate lobbying is entrenched in Washington, its so good, it can't get much better  type of scenario.  Given the populist lean among current politicians, I doubt they give even more tax breaks and tax cuts to corporations.  The political tide is slowly shifting away from corporations.  Corporate welfare is losing favor, even among Republicans.

Now let's take a quick look at monetary policy, in particular, the shape of the yield curve.  Here's the 2-10 yield curve, at -65 bps, showing a massive inversion, signaling a Fed that is very tight.  Inverted yield curves are both signs of a pending economic slowdown and a Fed that is too tight.  Both negatives for equities.  

 

With cash yields so high, the bar for equity investments is raised, as the competition is now 4.5% T-Bills which are risk free and provide future optionality.  Under current monetary conditions of short term rates that are high, with QT working in the background, with no fiscal stimulus impulse for the coming year, those are brutal conditions for equity investors.  

Recently, I've noticed many touting the improving technicals for overseas markets, the falling bond yields, weaker dollar, and the breadth thrusts in the stock market, but those are minor short term positives going against major intermediate term negatives of long term downtrend, high valuations, and tight money. 

If you are buying after a 200 point SPX rally from 2 weeks ago, 400 points above the closing lows from last October, you are betting on this bear market to either be over, or for a bear market rally to extend to lengths that are uncommon.  The financial markets are a probability game.  The high probability scenario is for the bear market to continue, as you have rarely seen bear markets bottom with valuations so high, especially under tight monetary conditions.  And betting on a continuation of a bear market rally after its been over 3 months since the last mini panic bottom is pushing your luck.  

Those that get caught up in the day to day movements can get enamored with short term strength, extrapolating it into the future, and buying into the suddenly positive news stories that permeate after a bear market rally.  These mini buying frenzies are often led by speculative garbage (BBBY, CVNA, AMC, bitcoin, etc.) which get bid up by speculators looking for quick gains. 

Never lose the forest for the trees.  Stay with the long term trend and fade the short term countertrends, in both bull and bear markets.  Added to NDX and SPX shorts this week. 

Deer Hunting

Was in wait and see mode, relaxing, but they pulled me back in with that rally ahead of CPI.  Now that the number has come out, basically inline with consensus estimates, the market moves on to real fundamentals of earnings season and a dose of reality that falling inflation doesn't improve corporate earnings.  And an inline CPI number just means that the Fed will do 25 bps hikes for the next 2 meetings, which isn't exactly a bull catalyst.  

There is no point diving in to the CPI inflation underlying details, there are enough geeks out there who will do that and lose the forest for the trees.  What matters is what the market is thinking on inflation, and its no longer scared of it.  Its now quite sanguine and thinking that inflation will glide down to lower levels for several more months.  I don't disagree, but there is no more big positive catalyst for declining inflation.  The market has caught up to that disinflationary story line. 

Big picture, remember that monetary policy is really tight and Powell seems to be happy with that, and not willing to go for that soft landing by doing an abrupt dovish turn.  Powell still wants to be remembered as an inflation fighter, and he has room to act like a tough guy with nonfarm payrolls still coming in strong.  He wants to get rid of that money printer label, that Mr. Transitory label.  He's trying to rebrand himself as a hawk, and he'll try his best to fool the market into thinking that, and in the process, assure that the US stock market feels some serious pain before he pivots. 

I am sensing investors are about to make another mistake by getting bulled up on the China re-opening story, getting excited about emerging market and European stocks.  They fail to realize that China hasn't done a money spew like the US during Covid lockdowns.  There is some chunky stimulus to keep the property bubble from turning into a total disaster, but not enough to reinflate the bubble.  The bubble psychology in China for real estate is gone.  Its not coming back.  Not with the horrible fundamentals of oversupply with a shrinking working age population.  The long term story is the bursting of the Chinese real estate bubble, which is much more important than some temporary blip higher in services demand post zero Covid, which everyone loves to focus on.  It figures, considering how most investors' time frame these days is measured in days and weeks, not years. 

I wrote on Monday that I was looking at shorting NDX/SPX when SPX got towards the 3940-3980 range.  The market has gotten there and exceeded that level, and I've used the rally to put on a small short, with plans on adding more if we grind higher in the coming few days.  Expecting a range for the SPX between 3800 to 4000, with NDX lagging SPX in the first quarter.  There could be a slight overshoot beyond that range for a brief period, but expecting the majority of trade to happen in that range.  Not time yet to go elephant hunting, just hunting deer at the moment.  By spring time, it will be a different story and time to go for big game. 

A Fallow Period

Its the beginning of the year.  Everyone wants to predict what will happen in 2023.  But you can't force your views on the market.  People want to make the big call, for a big move, with time frames to match, like weak 1st half, strong 2nd half, etc.  You can't put a time frame for big moves during a period of range bound trading with little edge.  

Sometimes there just isn't much to do.  Or even to talk about.  Sure, I could talk about the big move on Friday in the bond market, and in stocks, on a relief rally that NFP didn't come in hotter on wages and jobs number, and due to a weak ISM services.  But I don't believe that storyline.  People won't tell you this, but over 90% of the explanatory power for Friday's moves were beginning of the year funds flows waiting for the NFP and ISM services to come out to pile into bonds and stocks (to a lesser extent) no matter what.  Its time sensitive and price insensitive money flows.  The kind of flows that moves markets.  Its of course a much better story to talk about a possible soft landing with wage growth weaker but jobs number strong (i.e. Goldilocks according to the media)  causing a surge of money to go to bonds and stocks.  That's not sustainable IMO. 

While the day to day movements are volatile, the week to week movements have been tame.  It almost seems as if the stock market has just became a 0DTE casino where bettors come in the morning and leave in the afternoon, win or lose.  Since I'm not smart enough to guess what the intraday movement will look like, I stay away from those daytrading games.  Before you had the HFTs dominating these markets with their front running and predatory algos, there were good daytrading opportunities even in index futures and big cap stocks.  But since around 2014-2015, its gotten tougher as the algos have gotten more advanced and the dumb money has been squeezed out of the short term game.  

It took a few years of flat to down results for daytrades for me to admit defeat in the intraday game.  I still dabble in single stocks for daytrades, but not SPX.  SPX and NDX are solely swing or position trades, which is where the sweet spot is for my style.  Yes, great daytrading opportunities made a brief comeback in single stocks in 2020 and 2021, but that's over.  We're definitely back to the same HFT dominated intraday flows which are tough to beat.  

For the Treasuries space, this is the fallow period.  A range bound market that doesn't get too bearish or too bullish, but is still dangerous to play because of the above average volatility that happens on a whim.  For example, the moves in the global bond markets were savage in December, when the market shot up on a cooler CPI, squeezing shorts, only to get hammered by a hawkish ECB and then a few days later by the BOJ loosening up yield curve control.  By any measure, the moves were overreactions, as the first week of 2023 has taken back most of the bond market moves happening in the last 2 weeks of December, without any meaningful changes, other than the calendar year.  If you were in the middle of the battle with long bond positions while the market was trading super weak, you were feeling some heat.  

For the index futures space, this is a much to do about nothing type of market.  Lots of day to day volatility, but not going too far on a week to week basis.  Definitely not the type of market that is great for longer time frames.  You aren't seeing extremes on either side, so its hard to put on a meaningful position with conviction.  

Here are the forces that are at play:  beginning of the month inflows into international stocks and bonds, lifting prices in those markets, while you see outflows from crowded, overvalued tech stocks from both retail and institutions.  They are not a sign of a trend change, just short term strategic flows coming from institutions that are putting cash to work, insensitive to price so they are moving markets.  Its not going to last much longer, as these type of flows are time sensitive and usually get done within the first 2 weeks of the year.  So at this point, its not really playable, except to fade it if it goes on for a few more days and gets extreme.  Some of the money being thrown at the emerging markets because of the China reopening theme is getting close to a short term extreme, near short term exhaustion points.  

Really, its a stretch to try to find good, high risk/reward opportunities at this juncture.  Things just feel too neutral.  In SPX/NDX, it feels like the crowd is leaning a bit bearish, but that's warranted given the weakness over the past month.  But even that bit of bearishness has gone away after the nonfarm payrolls/ISM services boosted sentiment.  The crowd is still not bullish enough to safely put on long term short positions.  Positioning is still leaning a bit too bearish after the heavy December outflows from equity/bond funds for me to want to put on equity shorts.  And I'm not even bothering to look for longs, as that's a dangerous game in this type of post bubble market that hasn't gone down to reasonable valuations.  There is still a lot of fat left in this bloated pig to shear off.  

As for Treasuries, with a Fed likely to raise at least 2 more times to 4.75-5.00%, possibly a bit higher, its not a great risk/reward trade at this point when 10 years are trading below 3.60%.  The curve is just too inverted (2s-10s at -70 bps) to expect a big rally in bonds without a Fed signal of a pause or a big shoe to drop, neither of which are likely to happen in the next 2 months.  So Treasuries are probably range bound here, trading in the range built up in December, just like the SPX.  Its a boring call, but everything feels neutral, and I don't expect a catalyst in the next 2 months to take this market out of this range bound trade.  Thinking SPX 3740 to 3980, UST 10 yr yield 3.40% to 3.90% until March.  Only interested in the short side for SPX/NDX around 3940-3980.  Interested in the long side if UST 10 yr is 3.90+%, small interest on the short side if US 10 yr is 3.40+%.  

This may be an exciting time for day traders due to the big intraday swings, but its a boring time for position traders.  Not pushing it here, letting the markets come to me, even if it means doing little for several weeks.  

By the way, if I'm not putting out posts in the coming weeks, its because there is not much to talk about and nothing to do.  When you don't have an edge, its best to just keep quiet.

Turn of the Year

Its not common to see bonds trade with more volatility than stocks but that's been the case for the past 2 weeks.  Ever since the BOJ tweaked their yield curve control levels, bonds have been in a free fall, exacerbated by fund managers looking to cut their bond losers and not wanting to show them in their year end portfolios.  The fear of hawkish central banks took over.  But as soon as it turned into 2023, its been nonstop buying in the bond market, especially Europe, which fell the steepest over the past 2 weeks on a hawkish ECB.  Its a battle between the disinflationary forces which are becoming more apparent and the stubborn hawkishness of the perpetually lagging central bankers. 

In the meantime, the stock indices have vacillated between weakness and strength, with that Santa Rally missing but no plunge into deeper negative, even with the weak bond market.  I hesitate to read too much into the price action in the last 2 weeks of 2022, and the first 2 trading days of 2023, but there are hints of a shift in investor psychology.  You are seeing the stock-bond positive correlation that's been prevalent in 2022 fade away as the focus moves from inflation to economic weakness.  In a high inflation environment, both stocks and bonds suffer as yields move higher.  But in a weak economic environment which is likely for 2023 and 2024, stocks suffer from lower corporate earnings while bonds benefit from weaker inflation due to weaker growth and an expectation of future rate cuts.  

Investors are still overweight equities and are still emotionally holding out hope for a recovery after a bad 2022, just because that's what's always happened since 2009.  The resilient nature of the SPX is what keeps investors hooked and hoping for a recovery out of the blue, as has happened so often the past 13 years.  But their intellectual side is telling them that stocks are still overvalued so they aren't very willing to add more.  They are underweight bonds after the last 2+ years of a steep bear market and are slow to embrace the better values found with the higher yields.  But their intellectual side is telling them that bonds are the go to asset class in a disinflationary, weak growth environment, even if it feels scary to fight the Fed, ECB, and BOJ who are still hawkish.  Lastly, investors are overweight cash as it's finally yielding a good return and stocks and bonds have been such poor performers in 2022.  They are comfortable holding cash.  Almost too comforting, which usually doesn't work out in the financial markets.  But the thing about cash is that it historically performs the weakest in the long term vs stocks and bonds, so its not something that investors will want to hold on forever.  

From my vantage point, 2022 was quite an unpredictable year because the Fed totally changed its behavior, turning into super hawks, and its something that took many by surprise.  Those trading based on pattern recognition and past historical data were hammered.  At the same time, as an institution, the Fed is the same political animal that follows what the politicians and market participants think.  As soon as the worry over inflation fades away in this disinflationary environment, as growth weakens and the economy enters a full blown recession, the words from politicians, economists, investors, etc. will be screaming policy error, begging for rate cuts, and putting immense pressure on Powell and the crew to deliver.  Its hard to imagine now, when they are still hawkish, saying they won't cut rates in 2023, when the unemployment rate is still very low, and the worries about inflation are still there, but fading.  But you get paid in the market when you can accurately predict change and make the proper bet that will pay off in such a scenario.  

The highest probability scenario in 2023 is the one where the economy gets much weaker than many expect, so weak that it will force the hand of the Fed, despite losing more credibility as they have to go back on their guidance of no rate cuts for 2023.  In that scenario, the Fed will probably start cutting sometime in the summer, perhaps July.  The stock market will have been plunging for several weeks due to an intransigent Powell who's trying to gain an inflation fighting reputation and admiration like Volcker, only to be making another policy mistake, keeping rates too high for too long and causing an economic mess.  

In this environment, being overweight bonds, underweight stocks, and holding some cash for optionality is the optimal portfolio mix.  But that's not how most investors are positioned.  Most retail investors are overweight big cap tech, with almost no fixed income exposure.  That's probably the worst portfolio for 2023, with already the first day of 2023 highlighting that fact.  Its a worse version of the post dotcom bubble period from 2000-2002, because this time, housing is much weaker, organic growth rates much lower, and productivity gains going in opposite directions from that period (up in 2000s, down in 2020s).  It feels like being long tech stocks now is akin to being long tech stocks in early 2002, looking cheaper after a big selloff the previous year, but still facing another big swoon in the coming year.  

In the first week of the year, I haven't made any big moves, holding some Treasuries, no real position in stocks, and waiting for the right time to add.  Looking to add more bond exposure (short end of the yield curve) and add some short tech stock exposure (hopefully after a bounce sometime this quarter) when the time looks ripe.  Both would be for longer term positions that could be held for a few months, so I see a lot of opportunity in those trades, something that you can ride for a big move.  Looking for the stock-bond correlation to turn negative with a vengeance as soon as the Fed finishes their last rate hike, mostly likely to happen after the March FOMC meeting.