Non Believers

Market participants will sometimes surprise you.  Usually when you are 6 weeks into a rally, making higher highs and higher lows, with a few face rippers, the crowd starts souring on put options and starts betting on upside through call options.  Well, that's just not happening.  As much as I want to believe that investors are believing in this rally and getting complacent, the numbers don't back it up.

The short term speculators (what most options volume is) are betting on downside during this rally.  The CBOE total put/call ratio was 1.05, which is quite high on a day that the SPX was up 2.6%, and the NDX up 4.2%.  It's rare.  And it makes me uncomfortable playing the short side at this moment.  

 

There has to be a lot of underlying strength and demand for stocks to rally so strongly while the short term options flow is acting as a headwind (call selling/put buying).  Usually, those OTM put options end up decaying to zero and dealers have to unwind their bearish hedges which results in net buying back of deltas, which pushes stocks up.  

So the Fed yesterday decided to back away from giving forward guidance, although Powell noted that the rate projections in June seemed reasonable for the rest of the year.  I didn't think he was more dovish or hawkish than expectations.  Just mealy mouth as usual.  No surprise there.  But its clear that he's not getting ahead of inflation.  He seems reluctant to push Fed funds rates higher than market pricing, which means we're unlikely to see 3.5% Fed funds or higher.  With a weakening economy, the bond market has turned the other way, reducing rate hike expectations since the June FOMC meeting, and now aggressively pricing in 2023 rate cuts.  

If there is one thing you can bet on with the Fed, and especially Powell, he will not try to fight the bond market.  He tried to do that for a brief period of time in late 2018 and he quickly caved in and made a dovish pivot.  I don't expect the bond market to relent in its pursuit for lower rates.  The economy is weak, the bond market sees it, everyone knows it.  

With Powell trying to go for a soft landing, the financial markets see an opening and are now going to push Powell until he caves.  They see he has no backbone when it comes to fighting inflation.  They are expecting a dovish pivot and will end up getting it, although probably only after you see stocks much lower and bonds much higher from here (by October?).   If both stocks and bonds start demanding a halt to the rate hikes and even demanding rate cuts, Powell will change his language and then deliver what the market wants.  That's just how he and the Fed works.  

In the markets, you have to trade what you think will happen, not what you want to see happen.  I'd like to see the Fed really hammer the financial markets to kill inflation but that's just not going to happen.  The high probability scenario is a Powell pivot in the fall, as stocks go lower on weaker earnings expectations and bonds go higher on weakening economic data.  Once he pivots in the fall, expect a surge higher in stocks, commodities, sticky high inflation, and a weaker dollar soon afterward.  Then Powell will really be in a bind as inflation stays high after his "pivot".  That's when you get the next leg lower in stocks that really demoralizes investors. 

Powell wants to be remembered as a great Fed chair like Paul Volcker, but he is just another Arthur Burns/Ben Bernanke clone, a money printer that has no backbone.  He is a politician first, central banker second.  Powell's DNA is like most politicians:  short term pleaser, not a long term thinker.  He will remembered as just another cookie cutter mediocre overly dovish Fed chairman when his reign is over.

Staying on the sidelines until I see signs that speculators are buying into the rally.  Maybe after all the big tech earnings are over this week, you'll finally get them to embrace it.  Will need to see real data to back it up. 

PMIs are Still High

The stock market cycle has run ahead of the economic cycle when it comes to pricing in an economic slowdown.  The stock market is actively front running economic weakness before it even arrives, which is confusing those that see the data and wonder why so many are afraid of a recession.  Let's look at the ISM Manufacturing Index for the last 2 proper bear markets, the 2000-2002 bear market, and 2007-2009 bear market.  

You can see that the ISM index bottomed in late 2001, but only after several months below 50 which is contraction.  The SPX didn't bottom till much later in summer of 2002 when the ISM rebounded back to above 50.  

In this recession, the ISM bottomed in late 2008, and spent several months below 50 before the SPX bottomed in March 2009.  

Here is where we are now.  Not even below 50 on ISM.  Its almost a given that it will go below 50 in the coming months, but even before it has, the SPX has already sold off over 25% from top to bottom.  That wasn't the case in either 2001 or 2008.  The stock market has become more forward looking than ever, and are more aligned with liquidity factors than in previous cycles.  Does that mean the bear market is over when the Fed pivots?  It depends on how much damage has been done when they do.  If they are pivoting with SPX between 3800-4000, then no, that's not likely to be the end of the bear market.  But if they pivot with SPX between 3000-3200, then I give it much higher odds that's the end of this bear market. 

Its a tricky market out there.  The bulls are not behaving like they normally would when you hit a one month high.  The put/call ratios have not been going down, but have stayed near the same levels as you saw for the earlier part of July.  Actually a bit more elevated than normal the past 2 days, even though pullbacks have been small.   I also keep an eye on the net deltas for the SPX, SPY, and QQQ.  When the net deltas are strongly negative, it tells you that investors are either selling calls or buying puts, or both.  For the last 3 days, the net deltas for the SPX, SPY, and QQQ options are very negative, as investors are not chasing this rally and are hedging for downside.  

CNBC Fast Money also seems to be less bullish now than they were on Friday, June 24, when the SPX rallied up to 3910 and then promptly sold off the following week.  Perhaps its the earnings jitters ahead of the big tech earnings announcements, with WMT's warning only increasing the caution among the crowd.  This doesn't feel like a great setup to be heavily short going into the FOMC meeting tomorrow.  I would like to see the bulls embrace this rally a bit more before putting on a big short position.  Maybe after the earnings are announced this week, and there are fewer walls of worry, there is a better setup to short.  But right now, I don't see much of an edge here to be short in the short term.   

The main factor that is giving me pause on holding short positions is the strength of the bond market.  Bonds are starting to get rebellious, not believing the Fed's word and starting to aggressively price rate cuts for 2023.  The Fed is usually bullied by the market, so there is a nontrivial risk that Powell caves to the bond market AGAIN and starts a dovish pivot early.  That would be the worst nightmare for the bears, as that's the linchpin for the bearish case, a Fed that is tightening financial conditions as the economy heads into recession.  If the Fed backs off their hawkish tone, you could see a continuation of this rally.  That's not my base case, I expect Powell to come out hawkish on Wednesday and focus on inflation being too high, but there is a small chance he goes mealy mouth and the market interprets that as him being dovish.  

After a nearly 6 week uptrend off the bottom, you would think that more investors would embrace this rally and start talking about higher SPX targets like 4050, 4100, 4200, but I'm not seeing too much of that on Twitter or CNBC, which is worrisome for a short seller.  I do believe that a definitive move above 4000 would change the minds of those on the sidelines and set the bull trap for later this year.  But I have to see the numbers to confirm that indeed the complacency has returned.  Currently, that's not the case.  

I covered my shorts on Friday and Monday, and waiting till later this week to see where the dust settles after all the big tech earnings, FOMC, and GDP number are behind us.

5 Year Making Moves

Bonds will soon be the new "hot" thing.  You can feel the strength underneath, the buyers waiting for a chance to get in.  Selloffs don't last even with a pumping stock market.  It was as if the whole fixed income community was waiting for the result of the ECB meeting, the first hike for the ECB since 2008, to buy.  Whether it was 25 bps or 50 bps, they were going to buy after the event had passed no matter what.  

Sure, you had higher jobless claims and a weaker Philly Fed report, but those aren't really important data points.  Bonds don't fear economic data anymore, now that gas/diesel prices are much lower than last month.  Bonds only fear stubborn central banks looking to continue to raise rates and QT. 

The collateral effect of bonds suddenly exploding up is higher stock prices.  All things equal, higher bond prices give comfort to stock investors as their bond holdings gives them a working hedge.  But there is a caveat.  The Fed needs to make a dovish pivot soon to keep the party going, otherwise stocks will go down as bonds are rallying.  Since 10 yr yields are now around 2.80%, if Powell keeps with the hawkish talk,  the curve really gets inverted and that will start breaking things.

The stock market grace period is almost over before it has a temper tantrum.  A 2 handle on Fed funds is a psychological meaningful.  That is actually a somewhat decent return on cash.  As economic data further deteriorates and signs of a weak economy become more pervasive, stocks and credit markets will have to go down meaningfully or Powell will stay on automatic pilot towards 3.50% and maybe higher.  That would spell eventual disaster for the stock market.  Counterintuitively, the quicker the stock market panics and credit spreads blow out, the less pain Powell will have to inflict on the economy. 

The market that I trust the most to reveal the truth about the economy is the commodity market.  More than the bond or stock market.  In a steady state supply situation that you have in copper, demand is setting prices.  

Copper is telling you manufacturing/construction demand is dropping fast.  More so than oil, copper gives you a better picture on capital expenditures and investment.  Oil is also weak recently, despite tight supply.  Just reinforcing the weak economy message.  Those celebrating lower oil prices need to realize that oil prices are going down because of lower demand and a weaker economy, which are negatives for the stock market, especially when the Fed is still taking away liquidity.  Sure oil going down will help to lower the CPI reading, but the nature of the owner equivalent rents calculation will keep those prices rising for a while.  

From the current politicized climate around inflation, Powell has gotten the message.  Inflation is the priority by a mile, and with employment numbers the most lagging of indicators, it won't show how bad the economy is for at least several more months, which gives Powell cover to stay on automatic pilot to 3.50%, unless the stock and credit markets start going down hard.  A gentle down move won't do it, it has to be enough to grab his attention, perhaps SPX down to 3300 or so, with credit spreads trading much wider.  

So the question is will the stock market just let Powell get to 3.50% without telling him to stop?  I doubt it.  3.5% Fed funds is not palatable with the current valuations in the stock market.  Not with the current economic weakness.  Remember in December 2018 when the Fed raised 25 bps to 2.5% and the market went into a rage and got him to make a dovish pivot? The economy is much worse now.  Much more wealth destruction and much higher inflation.  He's going to raise 75 bps to 2.5% next week and it feels like a relief after getting such a big CPI number.  The market is way too complacent on the rate hikes.  Just like in 2018 when the market was going up as Powell was raising 25 bps every quarter but then he reached the market's uncle point and the stock market went crazy and got the job done, as Powell pivoted a couple weeks later.   

 

My expectation is that the stock market is closing in on the temper tantrum point of no return, as you are starting to see extreme bull steepening, as the 5 year yields went down 30 bps over the past 24 hours!  While the 30 year only went down 15 bps during that time.  The 5 year is the most economically sensitive part of the curve, and is starting to raise its voice to the markets, telling you the economy is noticeably weakening.  This is the same thing you saw in November 2018, when the bull steepening started in earnest, led by the 5 year. 

Unlike 2018, the Fed is dealing with an inflation problem, and will have to see much more damage than he saw in December 2018 to make a dovish pivot.  The politics around inflation are totally different in 2022.  He can't look weak on inflation, so its got to get really bad before he signals a change.

Decided to go for the home run move by short NDX instead of going long Treasuries and paying the price.  Long bonds is always a safer play than shorting the stock indexes in a rapidly weakening economy.  At first, the stock market likes to see bond yields going lower, lowering the discount rate, while ignoring the real signal of future economic weakness.  I'm already gone down one fork in the road, and at these levels, the payoff on an NDX or SPX short are much greater than a long Treasuries position.  

With the stock market worried about weaker earnings guidance, there could be a bit more of a relief rally next week after the majority of tech earnings get announced, as more shorts cover and more fast money longs look to play a bear market rally, but that's probably the final hurrah before things get real in August and September. 

Eye on the Ball

The day to day fluctuations in a volatile market can obfuscate the bigger picture.  Its a terrible backdrop for equities.  But you can get big counter trend rallies which dazzle the crowd, and confuse and frustrate the bears.  As a bear, in a bear market, you have to keep your eye on the ball and brush off these rallies as part of doing business.  If markets always went down in a bear market, they would be done in a couple of months, and history shows that they average around a year, and longer when the previous bull market has been extended (13 years in this case).

Bear market rallies are famous for being face rippers, and we had another big one, the 3rd 2+% ripper since the June bottom, with the SPX going up 106 points.   That is the crack cocaine of bear markets.  The big one day rally.  It lures in the bottom pickers, who withstand the pain of bleeding out when they get the satisfaction of being long during one of these face rippers.  It feels exhilarating when they happen, like hitting 3 cherries in a line at the slots in Vegas.  It keeps them hopeful, that THIS is the turn, the big bounce that will take markets back to where it was 2 months ago, 3 months ago, etc.  

I've noticed a steady increase in speculation among the fast money crowd, as they are getting more aggressive chasing the highest beta names.  BTC going back above 23K has also gotten those speculators more excited.   This is all part of the package in a bear market, it looks like the world is going to end and then a few weeks later, people start getting FOMO when the market has a 3 day rally.  You get some echo rallies in a post bubble environment, where traders go back to the well, something that worked great 2 years ago, looking for an encore.  Take a look at GME, its flat on the year as the SPX has gotten pummeled.

The fundamentals have not changed.  They are just as bad as they were when the SPX was trading at 3750 last week.  There were fears that Russia would completely cut off gas to Europe, but news that they will be restarting gas flows through Nord Stream 1 set off a big rally in Eurostoxx yesterday.  And the chain effect of a higher euro, helping stocks in the US because the big fear these days is the strong dollar, which just obfuscates the real problem, an economy that is in a slow motion crash.  Yesterday is the type of "good" news bear market rally which usually don't last.  You saw a few of them in the fall of 2018, before the final capitulation in December.  You saw a bunch of them in 2008, and 2001. 

Watching CNBC and Bloomberg, it seems like the most common reason they cite to be bullish is because everyone is bearish.  Hardly heard a word on CNBC or Bloomberg about everyone being bullish in 2021 as a reason to be bearish.  

It just goes to show you how little there is in favor for the bulls.  Liquidity, leading economic indicators, valuations all favor the bear side.   Liquidity is the most important variable in the stock market.  US M2 money supply is going down!  That's unheard of.  The spigots are shut tight.  The stock market is on its own, into a rapidly slowing economy.  After a giant bubble.  The conditions are much worse than 2001-2002 (Fed was cutting aggressively), the last post bubble period.  And the SPX went down 50% in that bear market.  Its very possible that can happen again.  SPX 2400 is not a ridiculous price target, it takes the SPX back to where it was in 2017.  By comparison, the Eurostoxx 50 is now trading at levels that were seen in 1999, when the SPX was 1200.  Equity markets can go sideways for a long time, longer than people expect. 

It hasn't paid to be patient when entering short positions, and I expect that trend to continue.  When you get a big rally like yesterday up towards SPX resistance zone at 3900-3950, it is a chance to put on shorts.   I have initiated a short Nasdaq position and will add today and look to have a full position on before the end of July.  Also sold most of my energy longs, and positioning for a resumption of the downtrend in August and September. 

Crazy Pills

The economy.  Its going to get real in a matter of weeks to months.  Many think that we are already in a recession (like me), but that's still not a consensus view, considering how many rate hikes are priced into the STIRs market.  Its pricing in a peak of 3.55% Fed funds rate by Jan. 2023, or 185 bps more hikes by year end, which is 110 bps more after the near certain 75 bps at the July FOMC meeting.  

I find it hard to imagine a Powell led Fed hiking to above 3% while NFPs are printing around zero and credit spreads are blowing out as earnings disappoint in the latter part of the year.  This is a Fed that is nervous about keeping the markets in a cloud of uncertainty over whether its going to be 75 bps or 100 bps.  Look at that panicky piece they fed the Wall Street Journal about them hiking 75 bps in July while they are now in a quiet period.  Even during their quiet period, they can't shut up.  

Deep down inside, Powell is a market sycophant.  A pleaser.  A caver.  I don't think Powell wants to go back to the twilight zone like December 2018, when he tried to force another rate hike and got heavily criticized while the stock market revolted.  And this time, the economic backdrop is much worse with a worse inflation picture, weaker global economy, and a more overvalued stock market.  

Despite my view that Powell will eventually relent to the market, he's not going to do it when the SPX is trading 3800-3900.  Not when IG spreads are trading 90 bps.  He needs to see CPI come down for 2 straight months, and not by just small amounts, and he needs to see some pain in the stock market and corporate credit.  He's very comfortable with the economic conditions as they are right now, which means he'll go ahead and try to do what the market is pricing in, which is 3.5% Fed funds by year end, which would be an absolute hurricane to the financial markets if it goes through.  Its one thing to price it in for the future, its a whole another thing when investors can collect a risk free 3.5% in reverse repo in a crap economy while corporations have to pay up to issue short term paper.  At those rates, money will flood into cash and short term bonds out of equities. 

The market seems rather placid recently.  There are still a majority who don't think the US economy is in a recession, or going to be in recession soon.  Most think its due in 2023, or even later.  You can see their lack of fear in the options market.  The desire for put protection is going down, as the IVs on index puts are going down, down, down.  Dealers, who are usually heavily long index puts and short calls, have very neutral positioning, which is uncommon.  Meaning, customers are lacking their usual put protection, as they either monetized them in the recent downturn, and didn't replace them, or just got frustrated seeing OTM puts not payoff during a market selloff, and stopped buying them.  

This leaves the market more vulnerable to liquidations if there is a big selloff, as the Street is not well protected right now.  Yes, hedge funds have low net exposure, but I don't see them increasing their net exposure until you see a Powell pivot.  And I don't think they are in the mood or in the risk seeking position to try to anticipate it either.

Maybe I am just crazy for thinking that we are getting a good shorting opportunity this week into the renewed optimism from the longs after the "good" market reaction to a bad CPI report.  And the market is having a relief rally from the Fed's assurance that they won't go 100 bps next week, and do just 75 bps, as if that's ok.  It's a bizarre world out there.  If people would have told you in May at SPX 3900 that the CPI would be at 9.1% and the Fed would be raising 75 bps for the 2nd straight meeting, into an economic slowdown and upcoming earnings revisions, they wouldn't want to be anywhere near equities.  Now, at 3900, they want to be buyers to "play" for a bear market rally. 

Of course, you have the permabulls who say its all priced in, everyone is too bearish, and that there is a good chance for a soft landing and/or a dovish pivot soon. 

I hear a lot of talk about a bear market rally, and about all the bearish sentiment, but I look at what investors are saying on Twitter, Stocktwits, CNBC, Bloomberg, etc., and it seems like the action on Friday has made the crowd lean bullish again.  Many are looking for a rally this week, and have upside targets like 3900, 3950, even 4000 and above for the short term.  Admittedly, most of them think it will just be a bear market rally.  Which means that they are short term bullish, long term bearish.  That's another way of saying that they are long but holding a weak hand, looking to sell soon.  

When people tell you both their short term and long term view on the market, almost all of them are positioned with their short term view.  I would argue that the fast money is bullish, and either already long or looking to get long early this week, but sell quickly.  Which means that this rally off the CPI pullback will probably be brief.  Take a look at this survey from @hmeisler over the weekend:

Actually, this doesn't mean that the market will go down right away, the crowd is often right in the short term.  In a bull market, investors being very bullish doesn't tell you much.  But in a bear market, it tells you a lot.  Investors don't like to sell for a loss, especially retail investors, and most are still hanging on, expecting this to be another great buying opportunity like all the other corrections in the past 13 years.  This is not a good sign for the intermediate to long term outlook, as there aren't any big stimmy checks coming through that door, and their discretionary income is being squeezed by inflation, so less money for investing.  And they already have a heavy allocation to equities and a low allocation to bonds, which will make them even more nervous if the market keeps going lower. 

To be objective, there are 2 things that are a positive.  

1. Futures positioning in equity index futures among asset managers is very low, and have often coincided with bottoms over the last 7 years.  The counterpoint would be that they are always low after a 15-20% selloff.  And that is also true.  Correlation doesn't equal causation.  Dealers are long futures, so they are either hedging their short call and/or long put positions.  Which just confirms that the Street doesn't have on much put protection. 

2. Hedge fund / CTA positioning is light.  Hedge funds are notorious for being jumpy and being afraid to be on the wrong side of a trend.  I would argue that light hedge fund exposure is like lighter fluid, it can lead to explosive rallies if the fire can get ignited.  There needs to be a reason for the fire to start.  They are not getting back in because everyone is so-called bearish.  Its going to require something fundamental.  It will have to be a Powell pivot, and I don't see that coming until recession signs become more obvious and apparent to even the clueless politicians, who is the group that Powell aims to please.   

Getting a big gap up today.  Looking put on short Nasdaq positions and close out long energy positions this week.

Baseline Economic Realities

The hot CPI increases the probability of the Fed pushing this economy over the cliff.  This is not the same economy as 2000, or even 2008.  The population growth in the US, EU, and China, the 3 big economic zones, is near zero.  GDP growth = population growth + output per capita.  With an aging demographic in the developed world, output growth per capita will struggle to increase.  Decreasing immigration due to political reasons will also hurt population growth.  

The population growth in the US and China are barely above zero, and declining fast, and the EU has negative population growth which is also declining fast. 

Workers are the building blocks of an economy.  The labor shortages are often blamed on Covid, but its really due to a lack of population growth and an aging population.  Labor has gained a lot of bargaining power over corporations in the last 2 years.  That increases labor costs and also reduces productivity.  When you don't have to worry about getting fired, or can easily find another job if you do get canned, you don't feel as much pressure to perform on the job, and thus reducing productivity.  Work from home trends exacerbate this.  

So how does this tie into the current economic situation?  With offshoring to China maxed out and other emerging markets lacking the infrastructure to support a big offshoring boom, labor shortages will be a problem for corporations looking to grow.  And since the economy in the developed nations is 2/3 consumption, an aging demographic hurts the overall consumption levels, as you can see consumption peaks in the 40s and 50s, and declines into retirement and beyond.  

% Working Age population is stagnant or decreasing while the elderly population is exploding higher.  See 1995 and 2020 population pyramids to see the change.  It gets more extreme over the next 20 years.   In the EU and China, the trends are even stronger towards aging and increasing elderly.

In order to fill the void, just like Japan did starting from the 2000s, the US, EU, and China will have to run huge fiscal deficits to maintain positive growth rates, enough to keep the system stable, along with monetary stimulus to pay for all the spending necessary, as high interest rates are unsustainable with such huge debt/GDP ratios, as Japan has clearly shown.  

If the EU stubbornly sticks with its low budget deficit mandates for member countries, they will be stuck with permanent stagnation and zero growth, along with zero or negative rates.  Even if the EU stimulates, it has to be big deficits to make a difference,  otherwise growth will be zero.  

GDP growth in the US, EU, and China will come from inflation that is underestimated in the GDP deflator, as there is really no organic growth out there.  Everyone with half a brain knows that the US, and most countries, manipulate their inflation data to much lower levels than actual numbers.

CPI reported at 9.1%, is realistically around 15% using real pricing data.  Rents have been going up 15-20% annualized, and that's only showing up as 5.5% in owner equivalent rents, a manipulated measure that was developed by the US government to underestimate housing inflation.  Housing is 33% of the CPI.  Manipulating 33% of the CPI from 15% to 5.5% lowers the CPI reading by 3.2%.  Also throw in hedonic adjustments and substitution and CPI is probably underestimating current inflation by about 5%. 

So there is almost no population growth, output per capita is likely in decline, and you have an energy shortage, which limits growth as well.  Those are just background baseline economic fundamentals.  Add the variables that change frequently like asset prices, which affect economic activity.  With stocks down across the world, over 20% in most countries in 6 months, along with a drop in fixed income portfolios, negative wealth effect will seep into consumption.  Just a small drop in consumption is enough to take it to negative levels with such weak economic fundamentals.  Throw in higher energy prices and you have a consumer with much less discretionary income.

The bond market shocked by the Fed's hawkish tone since April, is slowly looking past the hot CPI readings and focusing on the next few months when lower commodity prices will push down inflation numbers, as well as the increasingly obvious signs that business spending, hiring, and consumer spending are all trending sharply lower.  Those looking in the rear view mirror and the high CPI number are missing the message.  Inflation has peaked.  The economy is getting closer to the breaking point and if Powell tries to put on his tough man Volcker act, he will only speed up the process of sending this bus hurtling over the cliff.  And then they'll have to panic pivot like January 2019.  Bonds are looking more and more attractive as the price action is getting more constructive after that June panic.  Lots of upside in bonds both leading into a dovish pivot and after the pivot. 

I am still a long term bull on commodities, but the bearish cyclical forces are too great to ignore in the short and intermediate term.  I will be looking to reduce energy exposure in the coming weeks and increasing bond exposure, and perhaps putting on a Nasdaq short if there is an irrational rally sometime this month.  We may have put in a short term bad news bottom yesterday, but it really is a perfect storm for stocks so rallies will be brief, if they do arrive.

Expressing a Deep Recession View

I can sense the bulls wanting to get more aggressively long, but only after they confirm that the financial world doesn't end after the CPI report comes out.  A bit hyperbolic, but there seems to be a substantial amount of risk capital waiting for the CPI on Wednesday to be behind them before going to work.  Also, to a lesser extent earnings reports later this month, especially tech.  

The buyers are still reluctant, as you can see in the price action, where the market can't stay at the local highs, and is constantly pulling back off highs and struggling to go north.  The fundamentals are about as bad I've ever seen, relatively to the valuations.  Even worse than the dotcom bubble bursting in 2001.  When was the last time you saw a Fed this aggressively looking to hike rates as the leading indicators are falling off a cliff and the layperson is searching for the words inflation and recession in big numbers on Google?  

With corporate bond yields much higher than they were over any period in the past 3 years, with a Fed determined to hike at least another 125 bps, maybe more (unlikely, IMO, but possible), you will end up with a Fed funds rate of at least 3.00% into an economy that is in recession, as the consumer is getting slammed by higher inflation and lower wealth due to stocks and bonds going down, as well as the possibility of layoffs looming around the corner.  You can feel the tension, in those search numbers, as they hope that stocks will rally to help offset the higher cost of living.  With a weakening economy, they will have a hard time getting wage increases to match inflation, if they can get wage increases at all in recessionary times.  

Its bad out there.  That can't be overstated enough.  With nonfarm payrolls still firmly positive, you are getting a chance to jump on the recession trade train before the latecomers come on board and really get it moving.  The 3 ways to play this recession trade is through 1) long bonds, 2) short stocks, or 3) short commodities.  

Let's go through each one.  

Long bonds.  This can mainly be played going long US Treasuries, long Eurodollars/SOFR futures in 2023, or German Bunds.  They will all work, but I prefer the US Treasuries trades, in the belly of the curve.   The belly of the curve are traditionally the most sensitive to economic conditions and move the most aggressively when it senses a recession, regardless of whether the Fed has made a dovish pivot or not.  For the Eurodollars/SOFR futures, in addition to economic conditions, you also have to take into account the Fed's reaction function to a weakening economy/inflation, which adds an extra variable.  As for the German Bunds, its probably the safest trade of the 3, as Europe is in a terrible spot and the ECB probably can raise at most 2 times and barely get to zero, while Bund are yielding 1.30% right now.  So very little room for Bund yields to go higher in this environment, but less upside than USTs as European yields are much lower.

Short stocks.  A variety of ways to play this, but the most generic one is to short one of the major indices.  Such as shorting Nasdaq 100, S&P 500, or Russell 2000.  I don't see much meat on the bone in the European or Asian indices so US stocks look like much better shorts here.  Also, US stocks have vastly more crowded positioning.  They are the favorites both in the US and abroad.  Just looking at the economic sensitivity and investor positioning, the Nasdaq 100 looks to be the most vulnerable, and it also has the most froth of the 3 indices.  People forget that the mega cap tech stocks are just as sensitive to economic conditions as oil and gas stocks, if not more so.  And even though the Nasdaq 100 has been a worse performer than SPX in 2022, it still looks like the mega cap tech names are still the most crowded trades among speculators and casual investors.  

Short commodities.  Don't think this is the best way to express a view on a big slowdown in the economy.  First, commodities have already come way down off the highs this year, and that makes it less attractive.  Second, the supply demand dynamics are much more favorable for a long term long position, not short position in most commodities, especially energy and agriculture.  Third, the bigger commodity markets are in backwardation, so its negative carry to hold a short position, and it adds up quickly with the steep backwardation of the curve in energy.   

Over the weekend, I was thinking that a short Nasdaq trade was the superior trade for expressing a view on a deep recession happening in the coming months, but there are compelling aspects to the long Treasuries trade (bonds have been going down for over 2 years), such as much more directly correlated to economic conditions, so a higher probability of the trade working if I am correct in my thesis, than a short Nasdaq trade.  Perhaps a combination of the two will work best, and add some diversification.  A Nasdaq short definitely has more potential profit, although I would say slightly lower probability of success than a long Treasuries trade.  

We are getting some pre-CPI jitters, just 48 hours away from the big number that sparked a huge selloff last month.  The crowd is nervous, my gut tells me they will be buyers of both stocks and bonds after the release, regardless of the number.  The stock rally probably doesn't last for more than a week, but the bond rally should have legs and go well into the autumn period.  

Post Bubble and Still Overvalued

We are in a post bubble world.  That is a heavy lead weight on the market for the next 6 months, or until we get down to pre-Covid bubble valuations, which is SPX between 3300-3400.  When you have the masses crowd into stocks at perhaps the worst time since 2000, you have a problem.  Households are overweight equities, getting nervous but aren't yet pushing the eject button.  Stocks widely held by increasingly weak hands that still haven't purged their holdings down to normal levels is the invisible hand that pushes down on stocks.  

For every buyer, there's a seller.  But one side is usually more eager than the other, and the eager side is the one pushing the market.  Despite the longest stretch below the 50 day moving average (almost 80 days, last above on April 21) since 2008, you haven't seen buyers eagerly push prices higher.  The market has been living under the 50 day moving average, as rallies don't have staying power and the market lingers near the lows.  That is classic post bubble price action, one way selling with only intermittent buying which fades after a few weeks, at most. 

Now on to the economy.  There is now recognition among investors that we're probably either in a recession, or about to enter one very soon.  Commodities getting crushed, including oil, and global bond yields screaming lower since the post CPI panic selling.  The bond market is right, and the stock market has its head stuck in the stand, hoping that a Powell pivot will come soon and rescue it.  

Forget about the leading indicators, all of which are forecasting a very weak economy in in the coming months.  You have a baseline of low economic growth in the OECD countries due to very low population growth + aging demographics (insufficient supply of working age labor), and productivity growth that's stagnant due to lack of breakthrough technological efficiencies. 

Add on top of that baseline a Fed that is not going to come to the market's rescue anytime soon, until they see inflation firmly going lower for a few months.  They will be late to pivot due to their lost credibility on controlling inflation.  Powell is a caver, and he will eventually relent under the constant pressure the bond market will put on him, but he also won't relent as easily as many expect, due to the political pressure from high inflation and his fear that inflation expectations will rise again as soon as he pivots.  

Given the asset price destruction so far this year (double barrel of stocks and bonds), that are hurting the wealthy, and the food, energy, and housing inflation that are hurting the poor, this economic slowdown is affecting a huge swath of the population, both US and global.  And both monetary and fiscal policy are no longer tailwinds for this market.  Basically a perfect storm.  

Let's look at copper and semiconductors.  Dr. Copper and Dr. Semi are giving out their diagnosis of the economy.  Its getting ugly.  Copper has started to plunge over the past month, and the semiconductors continue to underperform the SPX, even on rallies. 

 

Copper

SMH ETF vs SPX

Sure, there is probably a mild recession that is priced into the commodities market, but I'm not so sure its being priced in most of the stock market, as we are still close to bubble valuations on a price to sales basis.  

Notice how much higher the S&P 500 price to sales ratio got in this bubble compared to the dotcom bubble in 2000.  The P/E ratio didn't go as high, due to the ever increasing profit margins among S&P 500 companies, but are those profit margins sustainable when US corporate tax rates are near all time lows, the long term secular downtrend in yields seems to have finally turned (higher structural inflation), and the cost of labor rising amidst a shortage of workers due to an aging demographic (both domestic and off-shore) and low population growth?  

Earnings have gone higher through outsourcing labor to China, keeping labor costs low and increasing margins, while bond yields kept going lower due to the deflationary effects of shale oil and gas + cheap Chinese labor, reducing costs of capital.  But shale oil production looks to have peaked out, and Chinese working age population is no longer increasing.  They have a huge demographic cliff over the next 30 years. 

Can the oligopolies hold the center and keep making everyone poorer and making themselves richer as the politicians line their pockets via the corporate welfare lobbyists?  All the while their constituents get handed a few stimmy checks along the way to keep them from revolting, as the buying power of their dollars gets eroded away by oligopoly pricing exerted by huge corporations as well as the government excess and money spew which ensures an entrenched high inflation regime.  

Can the masses be continuously duped in a democracy that favors their oligopolistic overlords (corporations like AAPL, GOOG, MSFT, AMZN, etc.) over their quality of life?  

These are questions that will determine the fate of US corporate profit margins in the coming years.  My bias is towards a shrinking of profit margins as both the costs of capital (as corporate bond yields rise) and labor (fewer workers, more competition for skilled workers) rise more than revenue growth.  The only way for the margins to sustain at this high level is if politicians go batshit crazy and start handing out trillions to corporations, disguised as government pork projects or tax credits for this and that.  Its possible, you can never understimate the US politician for selling themselves out to corporations, but you probably need a crisis for them to have the pretext to do it, like Trump and Mnuchin did in 2020, and Biden did in 2021. 

They got to the last hiding place in this market, which was energy, while the SPX was in a bear market rally.  That is something I didn't expect, but I welcome this rally as it is starting to setup some great shorting opportunities for the next 3 months.  I am keeping my powder dry until after the CPI, as I expect a different reaction from the stock and bond markets this time around, regardless of how it comes out.  At this point, most investors can see that inflation has peaked, even if it won't be dropping as quickly as the Fed thinks.  After the CPI hurdle, hopefully the bulls will get excited and push the SPX and Nasdaq up to levels where the risk/reward for shorts are too good to pass up.  We'll see.  Last month, I was hoping for the same situation, and the market dumped post CPI.  This time, the setup definitely looks different as commodities have been getting crushed the last few weeks, which is probably enough of a sign for most that inflation isn't getting out of control. 

A Powell Pivot or More Energy

Fear.  What gets investors moving.  Its not about what I'm scared of, its about what the crowd is scared of.  If I am an investor in a stock, I'm worried about its long term earnings potential, total accumulated cash flow over the life of the company.  But that's not what the crowd is worried about.  Its worried about whether the stock will meet its earnings estimates, about what it will guide for the next quarter.  Its about whether recession will hurt its short term performance.  

You can't be self-centered in your thinking.  Unless you're brain is a replica of what the crowd is thinking (That brings on a whole different set of mental baggage that weighs on performance).  Through social media, you can observe in real-time, what a group of people are thinking.   If done well, observing the group and projecting their future behavior is an edge.  

Everyone seems to be scared of a recession, and the coming earnings reports showing weaker revenues and guidance.  I wouldn't say its priced in, but people are bracing for impact, which means you probably don't get that much selling during earnings season, but probably after its over, in late July, when investors breathe a sigh of relief and get complacent again.  

If I am investor in US stocks, my greatest fear is not recession, its 2 things: 1) the lack of money supply growth 2) the lack of supply growth in energy.  Both are flashing red.  

U.S. M2 Money Supply

Crude Oil & Condensates Production/Consumption

The money supply growth can easily be pushed higher by fiscal and monetary policy.  That's low hanging fruit for stocks, as more money in the system increases the price of everything.  But the energy supply.  Its not really growing.  Its stagnant, and even many of the energy bulls will put the blame for that on fiscal policy.  But is that really the case?  Are there a bunch of Ghawars awaiting to be drilled in "protected" locations that the Democrats won't give permits to? 

The public is way too optimistic about future energy supply growth, as if the past 50 years can be replicated over the next 50 years.  All the best locations have already been drilled.  Even the next best locations.  Now we are in the hard to get, expensive, high hanging fruit portion of the exploration cycle where lots of capex AND time is required to just maintain production levels, much less increase production.  The thing about the mediocre drilling locations is that it takes more money to produce, and you get much less production.  Its like real estate.  Location, location, location.  And there just aren't that many good locations left.  

So if energy supply growth isn't going to save this market, then it has to be money supply growth.  That happens with fiscal and monetary stimulus.  But Powell just turned hawkish a couple months ago, so he would look like a jackass if he went right towards a dovish pivot with inflation high, even if its decreasing from the peak.  He can't look like a jackass.  Its not about looking forward, its about his credibility, and even his legacy.  If he let's the inflation persist and tries to be balanced and worried about recession at the same time, he's going to look weak.  He's already viewed as a caver, and that's why so many are expecting a dovish pivot soon as the economic data comes in soft.  That's what the bond market is pricing in, as the Eurodollars curve is steeply inverted for 2023, pricing in multiple rate cuts.  They expect the economy to get bad, and they expect Powell to cave in to the markets and cut right after he hikes.  

Even though I agree with the majority that Powell will eventually cave in and give the market what it wants:  easy money, he's going to do it later than most of the fast money expects.  He has a tendency to always sound a bit dovish in his words, and that's going to work against him, because it will get investors' hopes up that he's about to pivot, even when he isn't planning on it.  I can picture a scenario in the autumn when he talks in his usual mealy mouth way, and the market misinterprets what he means and runs with the dovish pivot story, even before he's ready.  Its going to be a mess in the 2nd half, as the Fed is the only ones that can rescue this market.  Fiscal policy is toothless for the next 2 1/2 years, unless there is a full blown crisis that makes Republicans willing to help Biden with stimulus.  So basically, monetary policy will be the only game in town until late 2024.  

Without fiscal policy, monetary policy has to be super loose to get this market goosed higher.  At current valuations, you are not going to get a sustained rally unless you have both easy monetary and fiscal policy.  And since that's not happening, valuations have to come down, and is the reason the market is trading so heavy.  

This market has no lift.  Its got lead ankle weights.  It doesn't have that bullish energy that you are used to seeing from past bottoms (2009 to 2021).  The bulls have about a 2 week window during this intermediate term oversold period to make up some ground.  If they blow it, they are just setting up the market for even more serious damage in the coming months with no buffer.  No man's land now, but shorts will be a high probability play if there is a bounce in July.  There are many overweight equity longs looking to sell a bear market rally, so don't expect the bounce to last for long.