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.