Bond Market Fear and Loathing

The bond market has come unglued in the last few days.  This kind of bond volatility (to the downside) in a weakening economy must be taking out some leveraged players that we may hear about later.  As much as Treasury yields have moved recently, yields in Europe have been even more violent.  Treasuries have started pricing in the worst possible scenario for Fed tightening, and the massive losses in the past few days have infected the long end of the curve, as the short end led the selloff late last week, and this week, its been the long end taking the brunt of the punishment.  

Bond investors and stock investors are just different.  Those who buy bonds are conservative, and are looking to protect capital while collecting some yield.  They eschew risk, and are more easily unnerved when losses get big.  2022 has been a heart attack for bond investors, and I'm sure a lot of retired elderly parked out in bonds expecting their assets to be safe have gotten a rude awakening.  That's why you've had this big selloff when everyone realized that the Fed really has blinders on, hawkish blinders, raising rates relentlessly, economy be damned.  Bond investors have been taking more punishment than stock investors, as you can see by this chart:

Take a look at the 3 month performance of TLT, AAPL, and TSLA.  TSLA is up 19.7%, AAPL is up 6.7%, and TLT is down 9.6%.  

Stock investors have quite a different view of the current market than bond investors.  As much as I hear stock investors being bearish and pessimistic, they haven't sold much, while bond investors have been more quiet, but much more terrified of this market, selling down, as you can see in the fund flows for stock and bond funds.  

They are no longer piling into equity funds, like they did in 2021, but they haven't really sold much either. 

Based on relative valuations and the outflows that have already happened in bonds, I am getting quite bullish on the prospects for the bond market over the next 3-6 months.  At 10 year yields near 4%, you are turning the tables on the risk/reward for bonds vs stocks, making this the best time to be in bonds vs stocks since 2000.  I expect the inflation rate to be higher over the next 5 years than it was between 2000 and 2005, but the organic growth rate of the US is much lower than it was back then.  And the level of indebtedness is much greater now than back then, with a much more financialized economy that can't function well with higher rates.  So 4% in 2022 is akin to 6% in 2000.  

There is recency bias in the markets that has encouraged US stock investors to hold on when the markets go down, because it always goes back up.  Since the end of the bear market in 2009, deep losses in 2010, 2011, 2015/2016, 2018, and 2020 were all erased in less than 6 months, usually taking less than 3 months.  This has conditioned stock investors to just hang on and not sell, which has been the main reason they haven't budged despite sounding off about their bearishness in those sentiment surveys which have become nearly useless in 2022.  A bunch of fully invested bears.  2022 has been the first time in 13 years that you've actually had an established downtrend that has made lower lows and lower highs for more than 6 months. This is catching a lot of investors off-guard, way overexposed to risk parity, with not enough cash to buffer the volatility. 

Unlike stocks, there is not much of a recency bias in the bond market.  Bond investors are normally much more cautious and less sanguine about future bond returns.  They are just looking to get some yield while not risking too much money.  They don't expect ever higher prices and lower yields.  And with all the talk about inflation and how hawkish the central banks are, you are getting levels of pessimism that are quite extreme, and don't reflect the reality that leading indicators of inflation which are trending lower.  If you look at money supply growth and commodity markets, you can expect inflation to come down more than people expect in the first half of 2023.  That will coincide with the end of the Fed rate hiking cycle. Those are 2 potent bullish catalysts for bonds.  

The momentum is clearly bearish in the bond market, but the past few days since the FOMC meeting have been panicky selling, more than a big repricing of inflation or Fed rate hike expectations.  I am still holding a small bond position, while remaining short SPX/NDX.  Still see too many dip buyers who expect a short term rally, so rallies are likely to be quickly sold.  The fundamentals are much worse now than it was back in June at the same price levels.  And we are that much closer to the real economy entering a big slowdown.  

What the Bank of England did yesterday shows how much stress is accumulating from the plunging global bond markets.  Optimism from one off interventions are not bullish for stocks.  Only continuous interventions via QE programs can affect market pricing for the intermediate to long term.  Saving the market with these interventions without any change to their monetary policy will do nothing for the long term trajectory of the market.  They are just short squeeze events.  

More so than a strong dollar, a weak global bond market is more troublesome for stocks and the economy.  Until you see a strong sustained bounce in bonds, which doesn't look likely until at least the next CPI release, on October 13, stock rallies will be quickly sold as there will be nothing fundamental to latch on to for the bulls.  The bears are trading the fundamentals.  The bulls are trading the technicals (hoping for an oversold bounce).  

I think 4% 10 year yields should provide a short term floor for bonds, but there is so much damage going on in the bond market, bonds are trading like distressed assets.  There is potential for overshoots to the downside.  But once you get past the next couple of weeks, I think the sidelined buyers in fixed income will come back as the dust settles on the carnage, with good values left behind. 

No More Free Lunch

The 1980s to 2021 has been a great time to be a stock and bond investor.  Risk parity seemed like a free lunch of protecting downside while collecting coupons through bonds and getting dividends and capital gains through ever rising stock prices. The best of both worlds.  Downside protection through bonds and upside through stocks.  Both positive yielding.  That free lunch is over. 

Its been an amazing time to be a US stock investor for the past 13 years.  And its mainly because of one thing: profit margins.  The profit margins for S&P 500 companies has gone from a cycle peak of 7.5% in 2000, 9% in 2006, 11% in 2018, and 13% in 2021.  Those are fat profit margins.  

The rise in profit margins from the 1990s to 2021 coincides with a decrease in the cost of debt funding, as investment grade corporate bond yields have steadily gone lower, tracking the fall in 10 year Treasury yields.  

Notice how the recent sharp increase in investment grade bond yields coincides with the sharp drop in profit margins in 2022Q2.  

There are other factors that have contributed to the sharp drop in profit margins recently.  First, the revenue boost from massive fiscal and monetary stimulus has come and gone.  Second, the rise in commodity and housing inflation are net negatives for corporate profit margins, as discretionary spending gets reduced when the cost of necessities increase (food, energy, housing).  Less consumer spending on discretionary items hurt the S&P 500 as a whole.  The main beneficiary of commodity/housing inflation are a small portion of the SPX and are not well-represented in public financial markets (private market real estate investments).  

If you are a believer in secular commodity and housing inflation like I am, you have to believe that stocks will struggle in the coming years.  

I haven't even gotten to the cost of labor.  In a tight labor market where the working age population as a percent of total population is steadily shrinking, the productivity of the overall population decreases, as the growing elderly population are net consumers, and produce very little, while collecting Social Security and consuming subsidized medical services via Medicare.  This is a net drag on productive capacity in the US, while increasing federal outlays.  With fewer workers relative to the total population, you end up getting increases in the cost of services, as wages go up, a supply-demand phenomena exacerbated by huge federal budget deficits.  

Higher wages for the same productivity, or less, considering the growing trend of work from home (reduces productivity), and that hurts profit margins.  And that doesn't even get to globalization and labor arbitrage scraping the bottom of the barrel in China, where the excess labor coming from rural areas is near its end, and higher political cost of outsourcing to China as US-China relations continue to get worse.  

With the oligopolistic pricing power of many of the S&P 500 corporations, can't they just raise prices to maintain their profit margins?  Yes, they can, and that will exacerbate the inflationary pressures in the economy, and just guarantee that inflation stays high and the Fed keeps rates higher than they would otherwise.  In a labor and energy restrained world, inflation is the release valve, to relieve the pressure caused by a supply limited environment.  Also, at some point, raising prices on consumers is counter-productive as they will just either find alternatives or will be constrained from buying due to high energy/housing costs. 

Seeing how the US, UK, and other countries have reacted to high inflation, they've decided to fight fire with fire.  Basically handing out more money to the public either through stimmy checks or by capping prices on electricity bills/reducing gas taxes.  That's a recipe for a secular stagflation where central banks will either have to go back to financial repression and negative real rates to keep the economy going at the cost of high inflation or have positive real rates and kill the economy to keep inflation under control.  Its no longer a free lunch environment where cheap overseas labor and ever increasing oil and gas supplies allowed the Fed to print gobs of money without any inflationary consequences.  Under resource constraints, the Fed has to now weigh tradeoffs between lower inflation/lower growth or higher inflation/higher growth.  No more free lunch.  

Its been a sharp selloff after the FOMC meeting, much quicker than I thought would happen.  It just underlines the weakness in this market, where it gives you very little time to sell rallies and gives you plenty of time to buy weakness.  I remain short and not in a rush to cover.  Sure, the put/call ratios got very high on Friday and you are seeing some dislocations in the FX market.  But considering how weak the bond market is, I would expect the June lows to crack sometime soon and that will probably usher in some panic as we hit new 52 week lows in SPX and finally start flushing out some of those diamond hand retail investors who haven't budged in their equity allocations.  The low DIX reading on Friday (40.3%) after high readings for the past few weeks is the first sign of the retail investor cracking.  Will need to see several more days like that to have me believe that we can put in a tradeable bottom, where I will cover shorts. 

Ignore the Noise

There are so many wiseguys out there, they lose the forest for the trees.  Sometimes I am one of those wiseguys, but the macro situation is just so over the top bearish that you have to resist the urge to play the long side when you see these huge face ripper rallies happen from time to time during this bear market.  It is tempting to try to make money playing both sides, especially in a bear market when big moves happen quickly, and markets go up just as fast as they go down.  

But 2022 is the polar opposite of the 2021 market.  In 2020 and 2021, stocks spent very little time at the short term bottoms, as most of the bottoms were V bottoms with almost no consolidation near the lows.  It didn't give investors much time to buy the lows, which is very bullish.  So longs had a much wider margin for error, as they could take their time to sell, because most of the time, the markets were spending their time near the highs, so they didn't have to be precise when exiting their longs.  For the shorts, it was hell, as if they missed the occasional short term bottoms to cover, they were squeezed relentlessly as the markets grinded higher.  In 2022, you are getting repeated chances to buy short term lows, and the longs don't have a big margin for error.  The market is spending a lot less time at the short term highs, as longs are eager to sell any strength.  On the other hand, shorts have repeated chances to cover near the lows (sole exception was from mid July to mid August), giving them a much larger margin for error when exiting their positions. 

All this week, leading up to the FOMC meeting, I heard fast money traders and investors proclaiming that 75 bps was priced in, and that the market would have a relief rally after the FOMC announcement.  They probably won't admit it, but huge rallies in the March, May, and July FOMC meetings seeped into their brain, and they were subconsciously conditioned to believe that the market rallies on Fed days, even after big hikes.  Well, yesterday's selloff was the payback for investors being complacent about the FOMC meeting, even as Powell gave you a warning shot at Jackson Hole, that he was going to be as hawkish as possible.  I am sure yesterday's big selloff probably reset that conditioning and put in some doubt about the market outcome at the next FOMC meeting.  

One of the most important things that you can learn when playing the markets is that you will regularly lose.  Fear of losing, or giving back gains, is what leads to overtrading and trying to play every wiggle in the market, trying to buy low and sell high.  You have to have humility in this game, and realize that you can't predict all the ups and downs.  I am guilty of micro trading, trying to avoid drawdowns, but most of the time, it doesn't really add value.  

But you can predict some ups and downs, and that's when there is opportunity.  In trade selection.  Most of the time, there is no short term edge.  However, there are often longer term edges, which is less obvious because they play out over several weeks and months.   Having the luxury to play longer term time frames and be able to take drawdowns to ride the position to fruition, through the ups and downs is an edge.  One of the main reasons hedge funds underperform is because of month to month reporting, which shortens their time frames, making them unwilling to take short term pain for long term gain.  

I've been pondering how to play the upcoming economic downturn which many are underestimating.  Short SPX/NDX or long Treasuries/STIRs?  The trend obviously favors short equities, as that trade is working and it has fewer holes in the thesis, as it works when the Fed remains hawkish and inflation stays high.  But it is vulnerable to Fed pivot risk, which I believe is closer than most think (probably by November or December).  The long Treasuries/Eurodollars/SOFR trade has the obvious big hole of a Powell that is trying to be Volcker Jr., and panic puking of positions from those losing money in bonds if there is further weakness.  But the long bonds/STIRs trade will work great when the Fed pivots, and could explode higher when that happens.  Also, the positioning in bonds is light, which would make it easy for investors to increase their bond allocations from both cash and equities.  At the moment, I'm both short SPX/NDX and long Treasuries, with a bigger allocation to my shorts than my longs.  

In the coming weeks, if bonds continue to selloff and I see more signs of capitulation there, I will likely reduce my short equities position to increase my long Treasuries position.  At the moment, I prefer the short equities trade because of the uncertainty that's looming over the bond market, with regards to how far Powell will hike and how much pain he's willing to take before he cries uncle. 

Re-shorted yesterday pre-FOMC meeting, and will hold that short until I see some signs of panic, nowhere close to that yet.  The bond weakness tells me there is going to be a lot of pain ahead for the stock market.  Valuations are ridiculously high considering the financial conditions.  I know they say everyone is bearish, but ignore the crowd and focus on the fundamentals. 

Tightening the Noose

The lagged reaction function of the global central banks is wreaking havoc on historical patterns of the economic cycle and stock and bond market prices.  In a typical economic cycle, you see the central banks steadily raise interest rates after the recovery is well underway, with unemployment rate going down and inflation going up.  This allows for the economy to slow down more gradually.  This time, due to political reasons, Powell disseminated the lie of transitory inflation in order to keep rates low and ensure another term as Fed chair.  He had to fight off Lael Brainard for the spot so he put on a very dovish front in order to seal the nomination last fall.  That delay only exacerbated the bubbly animal spirits at the time and extended this high inflation period by several months.  

Remember, inflation acts with a lag, especially core inflation, so whatever fiscal and monetary policy enacted in 2021 will still have lasting effects well into 2022.  The unprecedented rise in M2 money supply in 2020, coming mainly from monetized stimmy checks, forgiveable PPP loans, giant child tax credits, and huge pork packages was the rocket fuel to feed the inflationary fire that's lasted for the past 20 months.  Forget about what the 15 minute macro experts say.  Inflation didn't come from Putin's war or from supply chain issues.  It came from a massive printing of money and enormous stimmy packages.  If you don't hand out free money to fuel record breaking demand for goods, you don't have supply chain problems.   

Just 5 months ago, the Fed funds rate was 0.25-0.5%.  Interest rate increases work quickly in the financial markets, but act much more slowly in the real economy.  The real economy will feel the brunt of the rate hikes in 2023, well after the top in bond yields.  This lag effect will be especially painful this time around, due to the speed of the rate hikes, going from 0 to 400 bps in 9 months (assuming market pricing is correct and the next 3 meetings have hikes of 75 bps-50bps-50bps).  Really the only way for the tighter monetary policy to quickly affect the real economy is by tightening financial conditions so much that you start seeing much lower stock prices and real credit stress,  which quickly leaks into the economy as corporations have to sell bonds at abnormally high yields to raise capital, and cost cutting becomes more urgent.  We're not quite there yet, but that's the direction we're heading.  And more quickly than people think.

I am already hearing anecdotes about corporations issuing high yield debt having a hard time getting deals done.  Fedex earnings warning was just the tip of the iceberg.  There will be more canaries in the coal mine, as higher rates, tighter monetary conditions, and much weaker global growth start to weigh on corporate earnings.  In this type of toxic environment, where the central banks are tightening the noose on the neck of the bulls, you have to throw out the 2009 to 2021 playbook.  Sentiment will be bearish, and you have to accept that as the norm now, as bearish sentiment is the default stance of market participants in this environment.  Bearish is the new neutral.  Neutral is the new bullish.  Only when things look really horrible, and after extreme price moves, can you lean on bearish sentiment as a tell for an imminent rally.  In the past, this kind of bearish talk among the investment community usually led to a big rally that lasted weeks, but these are not normal times.  75 bps for 3 straight meetings is NOT normal.

I covered yesterday after seeing some signs of dip buying and short covering, and to avoid the upward drift that is common a day or two ahead of the FOMC meeting.  Big selloffs going into the meeting often result in short covering rallies a day or two ahead of the event.  Once the event is over, the shorts usually come back to sell what they covered.  We've rallied big in the past 4 FOMC meetings.  That will be on the mind of the short sellers who are still short, and I expect some short covering from them heading into the meeting.  

Its a little bit of game theory, but this FOMC meeting should play out a bit differently than the others, just because Powell has put himself in a box by his hawkish words at Jackson Hole.  He almost has to come out and put on his most hawkish act, just so he doesn't look like a pivoting pansy again.  That could pour cold water on any expectations of him doing his usual dovish mealy mouth press conference, leading to a selloff during his press conference.  

The shorts I covered yesterday, I will probably put back on tomorrow ahead of the FOMC meeting.  I feel empty without having shorts on in this environment. 

Bonds are weak again today, I'm long a bit from late last week, and not too eager to add more right way.  After such huge losses in bonds this year, its going to take a while to consolidate at these higher yields before you get the change in trend.  There will have to be more overt signs of recession before you can get more investors selling equities and buying fixed income.  Equities have been the place to be for so long in the US, that its going to take some time to shake that BTFD psychology.  As that psychology changes, you will see retail equity holdings as a percentage of assets go down.  Its still near the highs of the past few years.  That will be the future supply that fuels the next leg down of this bear market.  The first leg down was fueled by hedge funds reducing equity exposure.  The next leg down will be retail reducing equity exposure. 

Overtightening Fears

The market teaches you a pattern and investors eventually adjust to it, and then the pattern changes again.  This year's lesson is that stocks and bonds can go down together, and that inflation was not transitory.  The Fed, always late to the game, finally realized that inflation wasn't going down and slowly reacted to the bond market signals in the spring which was pricing in many more hikes than the Fed was saying in their forward guidance.  If the bond AND stock market wasn't going down so much due to high inflation, you think Powell would have gone from 25 bps to 50 bps and eventually to 75 bps?  I doubt it.  The market was panicked about high CPI prints that kept beating expectations, and the Fed got the message, and reacted with bigger hikes and more hawkish talk.  

Fast forward to now.  The bond and stock market are both going down, but is it really because of high inflation?  The CPI number on Tuesday would have many believe that the market is going down again because inflation is way too high and not coming down fast enough.  But I think its for another reason.  The stock market is going down not because of inflation, which real-time reports show as slowing down, even housing.  The market is going down because they think Powell will now go unhinged, hell bent on trying to be Volcker Jr., and overtighten and make the recession even worse.  Its no longer inflation fears, its Fed overtightening fears.  A big difference. 

The whispers are beginning.  They aren't strong statements at the moment, but they will get louder and louder as time goes on.  Its the market's fear of a Fed policy error, this time, by being too hawkish and hiking rates too much.  I am already hearing some talk of a Fed policy error being discussed by those esteemed members of CNBC Fast Money.  I also heard a CEO come on CNBC saying that the Fed is hiking too fast, and should slow down, as the economy is weaker than most think.  

If you can sense when the Fed will pivot, you have the keys to the castle.  A Fed pivot at this point would just be to signal a pause, not even rate cuts.  Now that most market participants and analysts seem to have bought in to Powell's hawkish rhetoric, you are seeing some extreme pricing in the STIRs market.  The 2 biggest short term interest rate markets are now shared by Eurodollars and SOFR.  SOFR is a better representation of the Fed funds rate, as it removes bank credit risk.  

 

The SOFR futures are pricing in a Fed funds rate at 4.40% by March 2023 .  The current Fed funds rate is around 2.35%.  That's 205 bps of rate hikes priced over the next 6 months.  75 bps is basically guaranteed next week, so after the Fed goes to 3.00-3.25%, there is another 130 bps of hikes priced in.  During these big moves, when pricing starts looking irrational, its usually longs who are getting squeezed and having to dump their position to cut their losses.  Its mostly forced selling, as Eurodollars and SOFR longs are bleeding profusely.  

With Fed funds soon to be 3.00-3.25%, and some analysts and corporate CEOs on TV already saying that the Fed is going too fast, can you imagine what they will say if the Fed tries to take rates above 4%? 

If Powell tries to be Mr. Tough Guy, and hike to 4% and above, the stock market will revolt.  It probably revolts on the way there, not after you get there.  The market will give Powell a pass for 75 bps at this meeting, because its ready for it, and 3-3.25% is still a reasonable rate.  But if he tries to do 75 bps or more for the rest of the year, its going to be chaos out there. 

This much I can foresee:  if the SPX is making new yearly lows in the 3600s and below, stock investors will be complaining, loudly.  Especially if the economic data is coming in really weak.  And all the leading indicators are forecasting that scenario.  

Remember, the Fed follows the market, it doesn't lead the market.  But they usually act with a bit of a lag, which is where the opportunity arises.  I soon expect the equity market to really have a temper tantrum as short term cash will become quite an attractive alternative at above 3%, and especially at 4%+.  It will siphon more money out of equities and into cash, creating the conditions for a very weak stock market, and thus, a weak credit market, as the economy rapidly slows down.  Those are conditions when the Fed is cutting rates, not hiking rates.  I can't imagine Powell, who has a history of caving to the markets, trying to fight the credit and stock market by continuing to hike when things break. 

Things breaking will probably happening sometime within the next 2 months, a seasonally weak period after mid September when you have corporate buyback blackout period, thus fewer buyers, and also earnings coming up, which I expect to be gloomier than last quarter.  As time passes, the leading indicators will start showing up in the coincident indicators, and that's when the stock market gets really worried about a Fed that's too tight.  

Staying short here, not a huge position, so I'll let it ride and see how it goes into the traditionally weak Friday opex and post opex Monday.  Now that SPX has broken 3900, I don't see much technical support till you get towards 3800-3820.  Also with hawk Powell waiting on deck for Wednesday, I have a feeling there will be some more selling ahead of that event, and without options protection, the institutions will be likely do some selling today and early next week.  Bonds are getting interesting here, you are starting to see a slow motion capitulation in fixed income, especially in the short end of the curve.  Starting to slowly put on longs in Treasuries, with 10 year yields close to year highs at 3.50%.  I expect stocks and bond correlations to revert back to being negative in the coming months, as future equity weakness will force the Fed to pause rate hikes. 

Nothing Has Changed But Price

There was a change when the market went down from SPX 4300 to SPX 3900.  It was Powell reiterating what all the other Fed governors were saying, and that is that they will keep hiking to 3.75-4%, and/or until they break things.  They also went back to that dirty well again, forward guidance.  They couldn't resist flapping their gums and bringing out their cloudy crystal ball, to forecast that there will be no rate cuts in 2023.  And they repeated that mantra enough that the STIRs market took out almost 2 rate cuts in 2023, and are now pricing in only 40 bps of rate cuts after the peak in Fed funds rate in March 2023, which has also gone up to 4%, from 3.25% in early August.   

That is a huge move in the fixed income market, and during that time, the SPX has gone sideways, and is trading at the same levels as early August.  Is the stock market so strong that it can ignore the bond market and remain in its own world?  I don't think so.  Unlike before Q2 earnings in July, the setup for the Q3 earnings in October is much different.  This time, investors are much less worried about earnings revisions or weak guidance.  Just watching CNBC and you can see the lack of fear about earnings.  Also, the options market is much less hedged now than where it was back in June/July, which increases the likelihood of a left tail move, as investors don't have that much index put protection.  

What I am seeing since the bottom last week is the growing optimism about inflation having peaked and about a soft CPI number today, which explains the recent strength.  I see it as a combination of shorts covering ahead of the CPI, and longs getting more comfortable buying stocks, trying to play for a short term rally.  Also, the news coming out of Ukraine, with their recent success in gaining back territory from Russia has helped investor sentiment on the margin, with some hopes that the war will end sooner than originally thought. 

This short term greed, is not a big picture change in investors' views.  They all believe that the Fed is still going to keep hiking, and stay hawkish, regardless of the number, but they feel like it can't get any worse and all the "bad" news on Fed and ECB hawkishness is reflected in the market.  

Unlike during the rally from mid July to mid August, this latest rally isn't being joined by the bond market, and has a much flimsier foundation of peak inflation optimism, which would make more sense if the bond market was playing along with that view.  

Its a bit of an irrational rally, aided by the triple witching options expiration this coming Friday, which has created gamma squeezes that spillover into the indices. Just look at TSLA and AAPL, the 2 biggest options volume names in the market.  They have been outperforming the SPX since last Wednesday.  Add the time and IV decay of index puts that speeds up as you get closer to expiration, especially in a rising market, and you get a technical squeeze with no fundamental basis. 

This gamma squeeze is providing those with dry powder and a bearish bias an opportunity to put on shorts at good risk reward levels.  I have had a tendency to short too early after these bounces off of big selloffs, so I've been waiting and holding my fire.  The game is about learning from your past mistakes.  After the CPI release, especially if we get a soft number, I will be looking to aggressively put on short positions in both SPX and NDX, as well as some individual names that have short squeezed. 

Powell putting himself in a box again and trying to rekindle the spirit of Volcker just makes me more bearish on the market than a few weeks ago.  Monetary policy works with a lag, but after the September hike of 75 bps, short term cash will be able to collect over 3%, which is quite attractive for such a bad risk asset environment.  I expect a steady exodus out of equity funds (hasn't happened yet, still flatlining after big inflows from late 2020 to early 2022) and into cash and money market funds, earning over 3%, in the coming months.  The more hikes that Powell does, the more incentive there is for investors to sell equities and collect interest on their cash.  

Running with the Herd

Investing is hard.  Sometimes it favors the contrarians and the trend fighters.  Sometimes it favors the majority and the trend followers.  When there isn't a strong case for the market to go up or down, its probably better to be a trend fighter and play the ranges.  But when there is a strong case, usually its better to keep things simple, and just follow the herd, no matter how "crowded" the trade is.  Right now, there is a very strong bearish case for stocks.  

If you are a short seller, you have to pinch yourself to realize that its not a dream, but a reality.  Who would have thought at anytime before 2022 for the Fed AND the ECB to aggressively hike rates, at 75 bps increments, and do QT, while stocks are in a bear market?  Who would have guessed that it would be politically feasible for the central banks to torpedo BOTH the stock and bond markets in order to fight inflation?  Who would have thought that an energy crisis, that rivals that of the 1970s, to happen so quickly?  And all of this happening right after the biggest financial bubble in US history!  Into some of the weakest leading indicators of the economy since 2008. 

That combination of factors converging this year, and how bearish it is for stocks, is underappreciated by many portfolio managers.  Sure, most hedge funds are underweight their historical net exposure, but they are still about 50% net long.  And there has been a flood of money going into passive funds over the years, and the net inflows into equity funds, especially US equity, over the past 20 months is historic.  There have been minimal outflows from US equity funds during the carnage. 

I know a lot of people like to point out historical studies, statistics and data that mostly cover a bond bull market, with inflation that was relatively low, with central bank policy that favored stocks.  But there is nothing in US stock market history that matches the level of overvaluation, inflation, and corporate profit margins as the current time period.  Remember, corporate profit margins have historically been mean reverting, although they have trended higher since 2000, into nosebleed territory.  When you have globalization with labor arbitrage, low inflation as a result allowing for record low interest rates, a toothless antitrust policy that allows competition to be reduced through mergers and acquisitions, you have a recipe for fat profit margins.  

The tailwind from globalization is fading, as China's cheap labor has mostly been used up, and there are no other emerging markets that has the infrastructure or the skilled labor force to replicate it.  In the developed world, the labor force to total population ratio is shrinking, as demographics are aging, and that decreases productivity and increases wages and thus inflation.  

Add on top of this the lack of investment into energy (not unreliable, intermittent, and low efficiency solar/wind) that can actually power a grid reliably, you have supply constraints for further growth.  Economic growth requires more energy.  Its that simple.  Russia's war with the Western World just brought forward that crisis by a few years.  And the politicians are clueless, focusing on manipulating prices by putting on price caps, subsidizing electricity users, and doing everything but the right thing, which would be looking to increase nuclear power capacity as well as using more coal, while letting higher electricity prices do their thing, which is to kill marginal demand.   

These days, there are more doomsday predictors who are super bearish and usually they are completely wrong, but the situation is so bearish out there, that what they are predicting is somewhat reasonable.  It may take several months for the markets to get to where they predict it, but in this environment, its very possible.  

I don't feel comfortable when a lot of people are thinking the same way, but when there is such a strong case for one direction, you have to just run with the herd.  In most cases, its not a good time to short when investors are bearish, but there is a difference between investors feeling bearish and being positioned bearishly.  While it can definitely be argued that hedge funds and CTAs are positioned bearishly, they aren't the whole market.  There is a huge retail investor base that's still positioned heavily long stocks.  And in the options market, the investor community is very lightly hedged. 

Looking at the intermediate term, at these valuations, there is a lot of room to go lower.  SPX 3000 is not a crazy price target.  That would have been an all time high in 2018.  And the selling will come from retail, who are up to their eyeballs in US stocks.  When they eventually throw in the towel, you will see big outflows from equity funds, week after week, during this process.  Most of the wealth is held by the baby boomers, who will be looking to get into safer investments as they age, increasing demand for fixed income and reducing demand for stocks.  

Retail is hanging tough, and corporations still feel comfortable enough and have enough free cash flow to keep buying back stock.  But in the next 6 months, what the leading indicators show will start showing up in coincident indicators (employment, corporate earnings, etc.).  That's when corporations start cutting back their stock buybacks, and retail start selling their stocks.  That's when things really get ugly.  And that's going to happen even with a Fed pivot, which is all but guaranteed.  Don't forget that the final bottom of the bear market in summer/fall of 2002 and spring of 2009, came after the Fed had been cutting rates for years, not months.  Its going to take time for this process to play out.  

We are getting a relief rally after the ECB 75 bps hike and the Powell speech, which was hawkish as expected.  Now the market is looking forward to the CPI for next Tuesday, which most are expecting to show a continued decline in the inflation rate.  Since many are expecting the CPI to be a bull catalyst, its quite likely that you will squeeze some more shorts in the coming days and have a very short lived pop on the CPI data release.  If the SPX can get close to 4100 after the CPI is released, that is a very tempting spot to go short and ride it down into the seasonally weak post September opex time period, going from mid September to early October.  

A sustained equity bounce like you saw from mid June to mid August was possible due to a big down move in 10 year yields, with some hopes of a less hawkish Fed.  That lifeline has been thrown out the window for the time being, probably not coming until you see labor markets weaker and inflation going down for a couple more months.  Without a Fed pivot, and with leading indicators showing a big slowing of the global economy in the coming months, and the well advertised EU energy crisis that will be much feared ahead of the winter, you have all the ingredients for a grind lower.  Until the Fed cries uncle.  And that's probably going to require the SPX to make new yearly lows. 

Trading Regrets

There is the cliche that in order to be a good investor, you have to act without emotion, be like a machine.  It assumes that one can do that, which is very unlikely, even if you run a "system".  The development and tweaking of the system is ultimately discretionary, and, thus not pure.  So even for systematized strategies, human discretion and emotion are involved.  Even if you really wanted to take the emotion out of investing, you can't do it.  

Maybe its actually good to feel emotions when trading, to actually improve your decision making and learn from past mistakes.  There are those blind optimists who say that they live with no regrets.  But for most of us, we have regrets about the past, and its not a bad thing.  If you don't regret touching that hot stove, then you probably will be just as careless around that hot stove the next time.  I spoke with a trader in the past and asked whether he felt regret about selling his long term stock holdings after the initial bounce in April 2020, fearing that there would be more weakness.  He said no, the conditions were unprecedented and it seemed like a bear market rally at the time. 

That's completely different from how I felt after covering my short way too early for a small gain a few days after the market topped in mid August.  I felt regret almost immediately, realizing that I left a ton of money on the table, and ignored the signals from the options market, which were actually pointing to a lot of complacency in the face of the selloff.  

Losses are the best teacher, but huge missed opportunities are not far behind.  If you don't feel that disgust after exiting too early and taking a small profit when a big profit was just around the corner by holding a few more days, then you are probably going to keep exiting too early when having a small profit.  It works the other way as well, holding on too long (usually when holding a loss) and letting the trade go against you even more, changing the original exit plan to avoid taking that loss.  

Why do we do this to ourselves?  Why do we hate to take losses and love to take those small gains?  Its that reptilian brain that feeds off of dopamine hits, disregarding the long term or past history.  Gain = dopamine hit, and its not proportionate to the size of the gain, so small gains have almost as big of a dopamine hit as a large gain.  Thus encouraging suboptimal trading behavior.  

Loss aversion also feeds into this tendency, as traders book their gains quickly for fear that they will turn into losses, and avoid taking small losses, for hope that those small losses will turn into gains.  That's what a lot of these HFT algos run on, pushing the market in one direction as they know that most discretionary daytraders will be stuck on the losing side, and will eventually puke out their losers later in the day.  The video below is a classic example of loss aversion, during the January 21-22 2008 huge gap down (scarier than the March 2008 Bear Stearns liquidation). 

 Quite a few regrets about 2022, missing one of the great shorting opportunities in SPX, multiple chances at low risk entries on the short side, and missed most of them, and the one that I did catch, took profit way too early.  Not taking at least a small long position into the heart of the inflation fears in mid June, even though stocks were highly oversold and due for at least a short term bounce.  

Underlying most of these missed opportunities was a fear of getting short squeezed, and still having memories of the relentless dip buying and chasing in 2020 and 2021.  The bear market is more mature now, but there is still a lot of fat left on this pig.  Sometimes we make the game harder than it is.  Usually you have to put a big weight on positioning and some weight on what you hear repeatedly on CNBC, Bloomberg, Twitter (from a contrarian view), and that has interfered with the big picture view of a Fed that doesn't want to see financial conditions loosen (stocks and bonds going up) and is hell bent on tightening despite many signs of a slowing economy.  Worsening liquidity + overvalued stocks in a post bubble environment + Fed showing no signs of letting up on the brakes = a time to short aggressively.  Its simple logic, and a rare set of conditions which heavily favors the short sellers.  Let's not lose sight of that when making our decisions for the rest of the year.  

From Wednesday to Friday last week, I finally saw a change in options activity showing investor concern, as we no longer saw the heavy call buying and put selling on the dips, and instead saw call selling and put buying (not nearly enough to reverse the monster call buying and put selling from August 19 to August 30).  Its a sign that the steep drop is probably over, and that we're likely to see a few days of consolidation of the losses before the next downleg.  I will be looking to put on shorts during this consolidation phase, especially if there is a rally after the CPI report next Tuesday.  Expecting no significant rallies (more than 100 points) from these levels. 4000-4050 is probably about as high as it can get before its gets hammered back down by sellers.  

We have bonds giving up most of its post NFP gains overnight, and it looks like central bank fears are still quite high and should stay that way until we get to the FOMC meeting on Sep. 21.  

Terrible Backdrop for Stocks

This is just a terrible environment for stocks.  Its not just Powell with his appetite for destruction as he acts tough and gets egged on by financial media to be like Volcker on inflation.  While this is going on, you have an economy that is in a weak position to deal with all these rate hikes as the fiscal impulse is in contraction with nominal M2 money supply flat for the last 6 months, basically unheard of in the modern, post gold reserve era.  Add on top of that the negative wealth effects from stock and bond weakness, as well as much higher rents and food/energy/services costs and you have a consumer that is going to reduce consumption.  That will eventually feed into weaker manufacturing and services, and the inflation rate will go down with a lag of a few months.  

Stock valuations are based off of earnings and the multiple on those earnings.  Earnings are estimated based on the macro conditions.  The multiple depends on financial conditions, mostly the rate at which corporations can borrow.  These are the highest rates for borrowing for corporations looking to issue 5,10,20,30 year bonds since 2010.  Back then, the S&P was trading between 1000-1260.  Its basically 4 times that level now.  No, earnings haven't gone up 4 times.  The forward P/E ratio, which was estimated based off of post recessionary levels, were still just 12 times earnings.  Now, estimates based off of post fiscal boom levels, are trading at 16.8 times earnings.  Somewhat similar interest rate levels, except for short term rates being much higher now than back then, when it was hovering around 0. 

I can't think of a much worse time to be a stock investor after the biggest financial bubble in history just popped, and you still have valuations that are quite elevated with central banks trying to hammer the market anytime it rallies.  

If there is one thing to be learned this year, is that the longer time frame moves are based on macro fundamentals and liquidity, while short term moves are based a lot on positioning, either a wave of stop losses on the selloffs, or big time short covering on the rallies.  We had the short covering rally from mid June to mid August, now its back to the primary trend, which is down.  And I don't see why that trend would end, with the Fed hell bent on hiking to 3.5-4%, and then staying there for a while.  Sure, they'll eventually pivot to the dovish side, but after how much carnage? If there isn't much of a selloff, the Fed will just keep hiking until something breaks, or when the very lagged inflation numbers come down in the middle of 2023, as base effects bring it down sharply. 

I mentioned before that I preferred playing the coming weakness by going long bonds rather than shorting stocks, and that's true from a longer term view, in the short term, its probably better to just short stocks because the market has no appetite for taking on duration risk, and that's probably going to stay that way until the US economic numbers get much worse.  That could take 2-3 months.  In the meantime, stocks could keep getting hammered while bonds go nowhere, stuck between hawkish central banks talking tough and economic data that is weakening, but not falling apart enough to get them to pivot or talk more "gently".  

This market is really out to get counter trend traders.  Straight up and then straight down.  If you are trying to short tops and buy bottoms, its tough out there.  I am hoping for a 1-2 day relief bounce/short squeeze to give a good short entry but its not looking like its happening anytime soon.  And tough to just short the weakness, although it does seem so weak, almost as if the options data showing very little hedging over the past several weeks is coming to haunt the long only managers. Just watching, and waiting for a fat pitch.

Head First Into the Wall Again

We're back to the April to June playbook of selling everything on hawkish central banks.  There is a twist this time.  The economic data is significantly weaker and inflation is much better publicized now than back then.  That tells you the playbook is starting to get old, and the market won't be there to hand out free money to short sellers of both stocks and bonds like last time.  

In the short run, bonds can get pushed around by the central banks, but in the intermediate to long run, economic growth and inflation moves the market.  Its a more favorable environment now for bonds than it was a few months ago as now both growth and inflation are going down.  The level matters, but the direction is also important.  I get the sense that everyone is bearish on the European economy but think the US will come out of it with a "shallow" recession.  The crowd is too optimistic on the US (lowest M2 growth of the G20 this year), not considering the low organic growth rate for the US.  Some people are even saying the Inflation Reduction Act and the student debt cancellation will contribute to more growth and inflation, but that's small and spread out over a few years.  There is a big difference between giving someone $10K and reducing $10K from their pile of debt.  When you reduce the debt, they don't have the option to add $10K more in debt in order to spend it.  

Let's not forget that investors paid a lot of capital gains taxes this year, that's money they're not getting back when they lose back the gains.  That's contributing to the fiscal contraction vs 2021.  There is a bigger wealth effect from stocks and bonds than in the past.  The US economy has gotten more financialized, as a bigger portion of overall household assets are in stocks.  That negative wealth effect will remain unless there is a big run up higher in stocks again, which looks unlikely given the valuations, economy, and liquidity conditions.  

The CPI will remain high for several months mainly due to the lagged effects of owner equivalent rent calculations, but the reduction of pent up demand for services, negative wealth effect, tight liquidity working its way through the system, commodity weakness coming from zero Covid and housing bubble popping in China, and a stronger dollar will contribute to lower inflation in the next several months.  

In that kind of environment, inflation going down and economy getting much weaker, the Fed would be fighting both the stock and bond market in continuing to tighten, or even by just pausing at higher rates.  Contrary to what many think, the Fed wasn't the reason the stock market plunged.  It was inflation.  The market wasn't ready for inflation to get so high and remain there for so long, which prompted the selloff in the bond market, which then caused stocks to selloff.  In fact, the Fed has been following the market's orders in getting more serious about dealing with inflation, and that stopped the bleeding in June (along with short covering and put hedges being monetized by investors) as the Fed regained some credibility on that issue.  Once the Fed got the message, after that 75 bps hikes in June, and with oil prices going back down, the stock market soon bottomed, along with bonds.  

But this time, the stock market is not going down because of the inflation shock, its because its sniffing out a weakening economy and seeing that the Fed is still fighting the last war (inflation).  That's not good for the economic outlook, and earnings outlook for the next 12 months.  Yes, everyone still talks about inflation, but that's looking in the rear view mirror like the Fed.  Its the growth outlook that's going to be moving markets for the rest of the year.  And with Powell trying to be Mr. Hawk and the second coming of Volcker, that's only going to make things worse.  

Its really unbelievable how bad the central banks are at their jobs.  They keep making one error after another.  They overstay their welcome, especially on the easy money side, and that leads to future mistakes.  They tried to create more inflation by printing gobs of money from 2008 to 2021, and all they did was build a huge house of cards and a bloated stock market, along with a bunch of zombies addicted to low rates.  This time around, they blew it by being so slow to hike rates and stop QE, forcing them to panic hike and now they are fighting the last war and will be hiking and keeping rates high while the house of cards collapses.  And that will cause them to make the next mistake, cutting rates down to zero, and keeping rates too low again.  Running head on into a wall without a helmet, getting up, and then going in the opposite direction sprinting head first into the wall again. 

So what happens when stocks and bonds move on from inflation and start to focus more on the slowing growth?  In my view, stocks go down, bonds go up.  In the short term, they can go down together as they are afraid of a hawkish Fed and ECB, while inflation is still high, but its not going to last.  The leading indicators are pointing to 2008 like economic conditions for the next several months.  But unlike 2008 when the Fed was cutting to zero and soon embarking on QE to come to the rescue, its the opposite this time.  The Fed will be exacerbating the slowdown and make it that much worse.  

Once they realize their mistake, they will do a quick 180 and act like what they said a few months before never happened.  When does the Fed realize they've made another policy error and make a U turn?  Usually its when the stock vigilantes (selling off hard) or the reverse bond vigilantes (really inverting the yield curve) send the Fed a message by having a temper tantrum.  Its when the "experts" on CNBC and Bloomberg go from the Fed can't pivot now because inflation is too high, to the Fed is making a policy error by keeping rates too high because the economy is falling off a cliff.  They often coincide with economic data that is rapidly weakening, which is usually accompanied by a very weak stock market.  But these days, the stock market is so tied to low rates, that really bad economic data might not crush the stock market if the bond market rallies big and stock investors start anticipating a dovish pivot.  

But in any case, credit spreads will soon be blowing out as the economic weakness doesn't mix well with a hawkish Powell still conjuring up his inner Volcker, thinking this is a repeat of the 1970s.  

Got another weak Friday close, Monday morning big gap down in the works.  Similar amounts of SPX call buying and put selling on those big down Fridays.  Its a tricky time, as the futures speculators are massively short, but the options hedging investors are complacent and quickly monetizing their hedges or outright using index calls as stock replacements.  One force is bullish for stocks, once force is bearish.  Right now, the bearish forces are winning, and will probably keep winning due to where we are seasonally, a very weak period, along with where we are in the liquidity cycle, which is very tight.  

If the speculators weren't so short, I would have held my shorts like the Rock of Gibraltar, not moving an inch and holding it and holding it.  But just didn't feel comfortable holding a short position when speculators were up to their eyeballs in shorts.  But now that the speculators are not bleeding so profusely from the bear market rally, they are no longer the weak hands that they were when the SPX was above 4200 going towards 4300+.  The bears are on the right side, and those still short survived a heck of a short squeeze there in July and August.  

I'm looking to get short again, not at these levels, but if there is a little short covering post Jackson Hole, perhaps the SPX can get back up to 4150-4200 area.  That would be a spot to re-short.  I don't see the SPX being able to get back up to 4300, not with how unhedged investors are at the moment.  If I see a lot of hedging in the coming days, I can change my mind, but I doubt it.  It looks like the bear market rally is over, and we're on the other side of the hill looking to get back down to under 3800.  

Cyclical Disinflation Secular Inflation

We are on the downside of the cyclical inflation up move that started in April 2020 with negative oil prices and peaked in June 2022.  This cyclical inflation down cycle should not be confused with a return to the heyday of the Chinese offshoring / labor arbitrage era of the 2000s and 2010s.  That's not coming back unless India becomes China, and I just don't see that happening anytime within the next 10 years.

Supply and demand in the labor market is favoring workers for the first time since the 1970s.  Its a workers' market.  The aging population, with growing percent of the population retired, has kept labor force growth flat, even with population growth.  Corporations were able to fill the labor supply gap over the years by outsourcing production to China, but China's labor force is also flattening out, so that source of cheap excess labor has mostly been used up.  

A tight labor market may loosen up a bit with a deep recession, but we're not going back to the post 2008 labor market, when outsourcing to China was booming and demand for US workers was lower than supply.  Its the opposite now.  Especially for services, which can't be outsourced to China, and need a local population of workers.  That shortage of workers in services will increase their wages, which increases the cost of goods and services which are labor intensive, keeping inflation elevated.  Wage increases in the lower end of the income spectrum fuels inflation, as the bottom half of the income earners consume a huge portion of their income, unlike the rich who save and invest most of their income.  The buying power of the bottom half, boosted by higher wages, will fuel the inflationary fire as their consumption and ability to pay increasing rents keep the flame going.  

Its going to be a wage price spiral, with fiscal handouts like student debt forgiveness, gas tax holidays, and future stimmy checks and child tax credits spewing gasoline on the fire.  You have to rethink what the financial markets will be like in this secular high inflation environment.  

In a high inflation environment, bonds don't act as a good hedge for stock market volatility.  In fact, the correlation becomes more positive, so bonds act more like stocks.  And with high inflation, higher interest rates can be tolerated because everyone's cash flows increase.  Even retirees, who have cost of living adjustments baked into their Social Security payments, get bigger and bigger checks the higher inflation goes.  

But will the Fed actually take interest rates above the inflation rate, like it last did in the mid 2000s?  Highly unlikely.  There is just too much debt in the system to go back to positive real rates.  That's a fantasy now.  What blows up the system won't be allowed to happen.  Keeping interest rates above the rate of inflation will blow up the system in a zero growth rate environment.  And we are in a zero growth rate environment.  GDP numbers only will show positive readings due to the underreporting of inflation.  With accurate and real inflation numbers, organic GDP growth is around zero for the foreseeable future.  This is a function of no productivity (maybe slightly negative) growth, and very low population growth in the developed world, mostly in less productive elderly population.

In a secular high inflation environment, the go to play is to buy real assets:  real estate, commodities, and stocks that produce real assets.  The coming cyclical downturn and what I expect to be a deep recession will temporarily deflate these real assets and that's your opportunity.  I don't see a bright future for tech stocks, the thing that has been working the best over the past 13 years. 

We are in a precarious position now with cyclical and secular forces going in opposite directions, and in most cases, the cyclical forces win out in the short to intermediate term.  The next 3-4 months will show increasingly weaker economic data and that will likely help the bond market for the latter part of the year.  But that's not where the big money will be made over the next 5 years.  The big trade will be to invest in real assets and ride the inflationary wave back up, when the cyclical forces are no longer weighing down on the secular trend of higher inflation.  

Its tricky trying to time the cyclical moves, as the secular moves are longer term and easier to predict.  But I have a hard time going long commodities into a seasonally weak time period of the year as the economic data just starts to get really bad, with stocks still priced for a "softish" landing.  

On the current market, neutral on SPX at the moment, don't see much of an edge either way, would rather short rallies than buy dips as the seasonal equity weak period is coming up, which is early September to mid October.  Corporate stock buyback blackout period starts around mid to late September, so the bid coming from companies will be much lighter in a few weeks.  Also, angst over the coming winter in Europe with sky high gas and power prices, along with the continued strong dollar headwinds should keep investors from getting too bulled up.  On the other hand, the positioning data still shows hedge funds with huge futures short positions, and systematic funds with low equity exposure.  So a big plunge during this seasonal weak period is unlikely.  Thinking a move to SPX 3900 by October is possible.

Bonds really weakening over the past week, it looks like fear of a Fed overtightening and caution ahead of Jackson Hole.  This phase could last a few more weeks but the trend of higher and higher yields is unsustainable when the leading economic indicators are this bad.  So looking for a possible opportunity to get long bonds sometime in  September as the fear of an aggressive Fed gets more palpable. 

Fed is a Follower Not a Leader

Jackson Hole is now the event where Powell is supposedly going to put on his hawk costume and scare the markets into believing that he's going to be very aggressive hiking rates to control inflation.  I'm not holding my breath for that.  Powell has proven to be just another cookie cutter dovish Fed chair who seems more concerned about breaking something than about runaway inflation.  I know I am in the minority view, as most people now believe, unlike 6 months ago, that the Fed will keep hiking until the CPI comes way down, closer to the 2% level.  Balderdash.  

The Fed was only hiking big the past 3 meetings because the bond market was having a fit over the Fed sleeping at the wheel and not doing much about 8%+ inflation.  If the STIRs market wasn't aggressively pricing in hikes for 2022, and the stock market wasn't dropping big because it was afraid that the Fed was not doing enough to control inflation,  Powell would still likely be twiddling his thumbs.   The Fed are market slaves.  They are not thought leaders.  They are followers of the market.  

The Fed didn't raise rates 50 bps in May, 75 bps in June and July despite a falling stock market, it was because of a falling stock market, which was panicking over the Fed doing too little to fight inflation.  From what I read on Twitter and sell side research reports, it seems most are of the view that the Fed has to raise rates because year over year CPI is too high, even if inflation has peaked and month over month #s are going down sharply.  They ignored the fixed income market as rates went up earlier in the year, skeptical that Powell would go more than 25 bps a meeting, even as the bond market was screaming to the Fed to get on with the Fed hiking, and quickly.  Now they are ignoring the message from the bond market again, this time believing the Fed hawkish talk over what the bond market is saying.  

2s-10s are inverted 31 bps.  The STIRs market is pricing in a high in Fed funds rates in March 2023, and then 100 bps of cuts over the next 2 years into March 2025.  Its pricing in a long term neutral Fed funds rate of 2.5%.  It betting that whatever hikes that the Fed does from now on, will not be sustainable and will eventually be taken back starting from 2023.  The Fed is fighting back on this projection, saying they will keep rates restrictive and not cut so as to keep it at a higher "plateau" to fight inflation.  I don't buy it for a second. 

For the rest of 2022, the Fed projections and the STIRs pricing is similar, so there has been no temper tantrum in the stock market.  But if/when the bond market starts to price in rate cuts (wouldn't surprise me if the rate cut pricing gets pulled forwarded as the economy continues to weaken), and the Fed pauses at 3.5%+, the stock market will not be happy.  If the Fed deviates too far from market pricing, especially if it keeps rates higher than the bond market prices in, it will just exacerbate the yield curve inversion as the bond market prices in even more future economic weakness due to the tightness and the stock market will weaken as it starts projecting lower earnings coming from future economic weakness.  

After thinking about the markets and doing some reading, I've adjusted my strategy for the next few months.  My main view is that there will be a deep recession and I thought it would be best to play that by being short SPX or NDX.  But the cleaner and more direct expression of that view is to just get long Treasuries rather than short SPX or NDX.  With inflation having peaked and all leading indicators showing disinflation for the next several months, along with a rapidly slowing economy, I don't see a lasting scenario of bond market weakness + stock market weakness.  

And the advantage of being long bonds over being short stocks is that bonds will benefit greatly from a dovish pivot, while being short stocks could be quite risky when that pivot happens.  Considering how low net equity exposure is among systematic and CTA funds, there is a non negligible risk of stocks going up while the economic data comes in weaker as it tries to front run a dovish pivot. 

The bond market is making the initial steps in moving on from inflation to focus more on economic growth being the main variable for Fed policy going forward.  It started happening from mid June, as 10 year yields dropped from 3.48% to 2.52% as the economic numbers started coming in weaker (all except the NFP).  Now we've got a big pullback in Treasuries as the Fed tries to talk down the bond market with hawkish talk.  In the long run, the bond market always wins over the Fed.  The Fed can try to talk it down and keep rates higher than the market wants, but it eventually throws in the towel and pivots when credit markets starts to tighten up and stock markets have a temper tantrum. 

We are getting closer to the late 2018 stage of the Fed hiking cycle where each incremental rate hike and continued hawkish rhetoric starts to weigh on the stock market, and the bond market stops going down on hawkish Fed jawboning.  

We may have another few weeks of a choppy uptrend due to crowded short positioning but the stock market can't fight fundamentals forever.  During this economic interregnum, the stock market will feel like Goldilocks, as rates are coming down while the economy still seems resilient, the best of both worlds.  That doesn't last long, as it soon gives way to obvious signs of a recession and an increase in earnings warnings, which will fuel stock market weakness and bond market strength.  Soon enough, as SPX resumes its downtrend, the stock market will be demanding a dovish pivot, not skeptical of one as it is now.   

Covered some NDX shorts on Friday, to get to a more moderate position, and will be covering the rest today as I transition from being short equities to being long bonds.  Many are expecting a lot of hawkish talk from Powell at Jackson Hole, and the stock and bond markets have been pricing that in since late last week.  Now I very much see a possible sell the rumor, buy the news event at Jackson Hole.  This current bond selloff could last a few more weeks into mid September, as the stock market chops around, but eventually, I see a big bond rally waiting to happen later this year and into early 2023. 

Dollar Wrecking Ball

A move is always more meaningful when very few talk about it.  There was a lot of noise about a strong dollar when stocks were getting pummelled in June, but very little talk about it now after a huge rally.  But the dollar just won't quit.  Honey badger dollar doesn't care about a dovish Fed minutes.  Its getting stronger.  EURUSD is knocking on parity's door again as the dollar carry trade is growing wings, reaching levels that it last saw in the early 2000s. 

Add the stronger dollar with a weaker bond market and you have a double whammy of higher yields and a stronger currency, hurting overseas revenues for US multinationals.  I don't really put much weight on currencies unless they are extreme moves.  The dollar is getting quite strong against the EUR, JPY, emerging market currencies, etc.  Its another obstacle for the US stock market, along with monetary tightening and a rapidly slowing economy.  

Really the only thing that the bulls have going for them is positioning, which is still showing a decent short base, although hedge funds seem to have reduced their shorts and gotten their net exposure up to near neutral levels, the index futures positioning needs to follow for this to be a slam dunk setup.  We will find out a lot today at 3:30 PM ET when the COT data comes out covering up to 8/16, which encompasses the moves from SPX 4120 to 4300.  If we don't see a substantial reduction in spec short positions, that will be shocking, and will ring alarm bells and make me more cautious on the short side.  

I never feel comfortable holding a short position when the crowd has the same opinion.  Almost everything I hear on CNBC, Bloomberg, Twitter, podcasts, etc. emphasize that this is a bear market rally and that the Fed is not going to pivot anytime soon.  That makes me a bit nervous when the crowd has the same thoughts as I do, although I do differ on their thoughts on the Fed.  

In my view, the Fed will make a dovish pivot sooner than investors think, mainly because the US economy will get much weaker than most forecast.  The economic weakness should be much worse than 2001, although not as bad as 2008.  Its not going to be shallow and brief like most are expecting, as bad inflation (food, energy, rent) will be high and good inflation (asset prices) will be be low.  Basically bad for the rich and poor, and really only good for commodity producers.  Right, you have a cyclical commodity downturn, but it is still a secular bull market.  The long term supply problems have not been solved, and China will not stay with zero Covid forever.  

Still short, but looking to cover some on weakness today and Monday.  Don't see anyone mentioning month end pension fund rebalance, which is usually don't over a few days ahead of the last day of the month, and front run by traders who sniff out the flow ahead of time.  So expect stock selling and bond buying from pensions next week.  Plus today is options expiration, which has become a weak part of the month, along with the Monday after opex.  It used to be the week after opex having most of the weakness, but that has been front run by the investment community who are more savvy to gamma hedging flows, and now the weakness often starts a few days before opex.  

Economic Interregnum

The stock market does a great job of driving traders crazy.  I don't remember a time when a market going up so much was confounding so many as I do now.  Even during the spring of 2020, when there was a lot of nervousness, it didn't give the shorts much time to get short, as it was a huge V bottom.  There wasn't a lot of time spent near the lows.   This time was different.  The market gave shorts plenty of time (and rope) to hang themselves by chopping back and forth between 3750 to 3900 for about 4 weeks after the June bottom, before blasting off into hyperspace.  

Now you are in a market where most of the shorts are underwater, and in pain.  When traders are in pain, they make mistakes, and do things that they don't want to do, which is to close out their position based on their P&L, not based on logic or historical patterns.  That is what you have seen since the CPI report, as the SPX blasted higher from 4120 to 4320 in less than a week, a lot of that driven by short covering.  The prime broker data confirms that hedge funds have been aggressively covering shorts in the past week, but they haven't really been adding longs.  This brings up an interesting situation, after most of the short covering is finished.  

When everyone knows that we are in a bear market, and the fundamentals aren't improving, investors will not just blindly go long because everyone is bearish.  That's not how things work.  They will have positioning that is on a spectrum of bearish to neutral in this kind of environment.  It is extremely unlikely for them to get bullish positioning when the fundamentals are poor, even if the technicals and the charts look great.  They only get bullish when the economy is forecast to get stronger and/or the Fed is forecast to become dovish.  Neither is the case now.   

Right now, hedge funds are very close to neutral positioning based on last Friday's Morgan Stanley prime broker data (0.48 net exposure, historical avg. of low 50s).  There may be a little bit more short covering but hedge funds are mostly done buying here, barring a big fundamental change, which I actually think will be for the worse, not better.  

While I still hear more bearish arguments, now there is at least some talk about a soft landing.  That's because the leading indicators and the tightening financial conditions haven't worked their way through the economy, and earnings are still relatively unscathed.  That should change starting from Q3/Q4, when the weakness in leading indicators start showing up in coincident indicators.  It takes time for the weakness to flow through an economy, and we are in that interregnum where employment and inflation still show a hot economy but all the leading indicators and soft data show a sharp slowdown.  That interregnum should be over by Sep/October, at which time I expect there to be a big drop in stocks, ala January 2016.  Remember in December 2015, the Fed actually raised rates 25 bps to get off ZIRP for the first time in over 7 years.  So the Fed was actually not your friend in that time period too.

January 2016 was the only time I remember when stocks actually went down a lot when investors were quite bearish leading up to it.  Investors were quite bearish in December 2015 but positioning was neutral after a big rally in October and sideways chop in November/December.  I could see a similar move this time around.  I don't see investors getting bulled up in this market, the Fed is still tightening and the economic data will be coming in really weak in the coming months.  As long as positioning is close to neutral, you can get a big move down even while most are bearish.  The key is positioning.  In this market, positioning is everything.  Just getting positioning to near neutral is enough to reset the wheels for another big move lower. 

Looking to cover some shorts on a move down towards the SPX 4200-4220 area, in order to have some dry powder to add shorts if it goes even higher.  Put/call ratios have been low for the last 4 days, the bulls seem to be getting cocky here.  Opex week has been bearish lately, especially late in the week, and post opex Monday has historically been a weak day of the month. 

Pushing Them to the Limit

This is a different kind of torture for the underinvested:  seeing others make money (fully invested) while making nothing (in cash) or losing (being short).  Its not a fun place to be, its almost as bad as losing your ass with the crowd as the market plunges.  

The COT data on Friday is not good news for the shorts.  The speculator short positions grew even larger, these are massive short positions that will take weeks to unwind, so that is a big thorn in the side of the bears.  I am assuming that after the CPI number on Wednesday, you got a lot of short covering afterwards going into Friday, so the number should be quite a bit lower next week, but specs will still be quite short.  

The worrying part about the huge spec short position is that they are deep underwater, and close to the stop out point, which could usher in even more short covering in the days ahead.  This has nothing to do with fundamentals, but pure positioning and money flows, which favor the bulls here, despite a huge rally of over 600 SPX points in less than 2 months.  

There are 2 instances of large spec short positions while the market was ripping higher off an deeply oversold bottom, 2015 and 2020.  After a huge rip higher in October 2015, you had a 50 day consolidation from November to December 2015, during which shorts covered, before plunging again to new lows in January 2016.  In May 2020, after a huge rip higher, you didn't see shorts cover for several months as the market grinded and higher, grinding the shorts to dust and making new all time highs during the process.  

A sample size of 2 is not big enough to draw huge conclusions, but the liquidity conditions now are more similar to fall 2015 than spring 2020.  In December 2015, the Fed had its first rate hike in over 9 years, while in the spring of 2020, the Fed was embarking on bazooka QE while maintaining ZIRP.  The key will be to see how much short covering we get in the weeks ahead.  The more short covering you see in the COT data, the better the setup gets for the bears.  If however the bears remain stubbornly short like in 2020, then you could see a grind higher for much longer than most expect despite the poor liquidity conditions.  

If there is one thing I've learned over the years, its the importance of positioning in increasing or decreasing the probability of a trade.  The less popular my position is among the speculator community, the higher the win probability, especially for longer time frames.  

The bottom line is this:  everyone knows that the liquidity conditions are unfavorable for stocks, with Fed tightening into an economic slowdown, but the light positioning reflects this reality.  Everyone is focused on the Fed, and not focused enough on the economy, which is much weaker than the stock market is pricing in.  Will the economic weakness be big enough to overwhelm the light positioning and force retail investors (still high equity allocations historically) to dump their stocks as we see more earnings warnings in the coming month?  I give that a high probability of happening, but you probably need to see shorts cover first before you see that big move lower.  

The marginal buyer or seller is what moves the market.  There has been a lot of short covering this week, which has increased the net positioning of hedge funds, but the question is will they put on shorts again as the economy weakens or will they add to their low long exposure and cause a chase for performance as the market grinds higher?  It is a reflexive situation here.  I don't expect hedge funds to aggressively buy dips if the economy gets really weak, leading to mass earnings warnings, which likely leads to a retest of the June lows.  If the economy holds up for the next couple of months and Q3-Q4 earnings meet expectations, while the 10 year yield stays under 3%, you are likely to see a chase for performance and a grind higher to SPX 4600-4700.  

The difficulty in markets these days is that investors rightly focus on liquidity conditions when determining whether to get bullish or bearish, which makes everyone follow the same gameplan.  This leads to crowded positioning when the Fed is very loose (lot of bulls) and when the Fed is very tight (lot of bears).  Even 2 years ago, it wasn't like this, as the Fed was very loose, yet you still had a lot of bears.  Investors have learned their lesson over the years, and it is to not fight the Fed.  That leads to the widespread skepticism you are seeing about this so-called bear market rally.  It causes the market to trade in ways that seem irrational and manipulated, but its just because too many are leaning in one direction (short) and have to stop out of their positions as the losses get too big for comfort.  This is what has happened since the CPI release, and was the number 1 reason I waited till after the CPI came out before embarking on a short campaign, due to the crowded short positioning near the edge of getting stopped out.  

In the short term, the past few days squeeze higher looks like a blowoff top inducing massive short covering.  According to Goldman PB data, it was one of the fastest pace of short covers in the past decade:

This is one piece of news that finally shows that the pain has gotten too great for a lot of funds and they are cutting and running.  This is what I want to see more of to gain confidence on the short side.  Just a neutral level of positioning in this liquidity and valuation environment would present a high probability short setup for SPX and NDX shorts.  As of now, its a favorable risk/reward on the short side, but not high probability setup yet.  More data confirming lots of net buying (prime broker, COT, options) would generate a near can't miss shorting opportunity.   

Due to the speed of the up move and the heavier call buying activity in popular single name stocks (TSLA, AAPL, AMZN, MSFT), I put on a short NDX position on Friday with plans to add to it if I see more data coming in that's favorable for the bears.  

Its a tough time for bears as this is near ideal fundamental conditions for a big leg down, but its a crowded trade, and that makes the destination that much more difficult to arrive at as many shorts are in quite a bit of pain and at their wit's end, close to throwing in the towel, if they didn't late last week.  Hopefully, I won't be one of them!