Tuesday, November 29, 2022

Zooming Out

The markets have slowed down considerably since the big CPI rally.  There is a short term equilibrium in the market, and volatility has compressed.  Its during days like this where its good to take a look at the long term picture of various markets and stocks.  It only confirms that there was a big change that took place in 2022, that we had a big bubble pop, and given how big the previous trends have been, its a very significant change in the markets.  

Despite all the talk about investors, in particular hedge funds being very bearish, its good to take a look at the % of net worth in equities and bonds for US households.  

Households are very underweight bonds from a historical perspective, at the lowest levels in the past 40 years.  Contrast that with equities, which is near historical high levels.  The overweight in equities and underweight in bonds points to a high probability that equities will be underperforming bonds for the next several years. 

The SPX has appreciated a lot over the past 5 years, and even with the bear market in 2022, its still at elevated levels.  Earnings have improved, but a lot of that was the massive Covid stimulus in 2020 and 2021 pumping up the bottom line.  Without a continuous stream of stimulus, these earnings levels are unsustainable.  With a recognition that inflation is no longer something that is always transitory in nature, valuations have to reflect a Fed that will be more cautious going to ZIRP and QE.  They will go back to that well when things get really bad, but I don't expect Bernanke type policies which used QE frequently and freely even when the economy was stable and growing.  That should automatically lower the fair level P/E levels for the SPX, especially when we are basically in a zero real organic growth environment

Take a look at TSLA and AAPL, the faces of the everything bubble.  Still very extended technically from a long term view, and overvalued from a fundamental view.  Estimate of fair value in this new environment is $30 for TSLA and $80 for AAPL. 



Let's take a look at the bond market.  The 2 year yield is at the highest level since 2007, and holds long term value at these levels.  If you assume that the real growth rate (with neutral fiscal policy) for the US is close to 0, and inflation will be determined by fiscal policy (unlikely to have big stimulus for next 2 years), then long term fair value is probably close to 2%.  Of course, 2 year yields are priced off the forward curve of Fed funds rates for the next 2 years, but from a longer term view, these high rates are unsustainable when nominal GDP growth goes back towards 2%, which I expect in the coming years.  You can't hand out 4.5% risk free for very long when the nominal growth rate is 2%.  Secular stagnation never went away.  It was just papered over by massive fiscal and monetary stimulus in a big overreaction to a pandemic. 


I am sensing a shift in the market view on bonds since the CPI report came in lower than expectations.  The pentup demand for duration has been building up as investor outflows and Fed jumbo hikes scared fixed income investors.  Now that they see light at the end of the hiking cycle tunnel, that demand is slowly being unleashed.  Investors are now more willing to go out on the yield curve to lock in decent yields for the next few years.  Fundamentally, if you are expecting a recession, there is no better way to express that view than to be long bonds, especially the belly of the curve, which is the most sensitive to economic conditions.  The leading economic indicators are showing a drastic slowing in the economy for 2023:


This is looking very similar to early 2001, another post tech bubble environment, but I expect a worse outcome.  The LEI levels are similar, but Greenspan was aggressively cutting in 50 bps chunks during that time.  This time, Powell is aggressively hiking while the LEIs are in the same spot. What's even worse, is that the natural growth rate of the economy was much stronger in 2001 than it is now.  It was a younger demographic with stronger population growth and a strong increase in productivity due to rapidly increasing computing power and the growth of the internet.  So it should be a much worse recession than in 2001.  My base case is that the Fed has to cut rates down to 1% or below over the next 2 years to have any meaningful stimulative effect on the economy. 

The bull case that I am hearing is year end seasonality (very soft edge), strong consumer balance sheets (its getting weaker and weaker), and strong labor market (will get much weaker as recession hits).  Those are 3 temporary factors that will quickly dissipate in 2023.  So its hard to embrace the bull case, especially when there is still a big overweight in equities over bonds for US households, with much more inflows into equity funds than bond funds in 2022.  

Looks like I missed shorting the top of the rally last week, being too patient.  At SPX 3975, I see no short term edge shorting, so I will abstain.  If the market rallies back from here towards SPX 4040-4060 zone, I will put on NDX shorts looking for a 400-500 point pullback in the NDX.  Not going big game hunting yet, as I expect a narrow range over the next several weeks.  

On China: its a tempest in a teapot.  Human nature never changes, and the overreaction to social unrest will always be present.  Whether it be Zero Covid protests, BLM protests, French yellow vest protests, Greece austerity protests, etc., they don't affect the market.  They are an entertaining sideshow for news junkies that can't ignore the latest headlines and always have to put in there 5 minute expert take on the subject.  

What is exciting doesn't affect the financial markets for long (geopolitics, social unrest, etc.).  What is boring does (fiscal and monetary policy). 

9 comments:

Anonymous said...

Crwd down 20pct after market. Same likely to happen to zs, snow etc. Most overvalued names will decline another 50-75 pct over 2023. If u short anything, short tech hopefully after a rally

Market Owl said...

It appears that any tech rally will be limited from these levels. The cat is out of the bag, its becoming common knowledge now that tech earnings are going to be a wreck in 2023. Hope there is a sucker's rally to load up on tech shorts.

MM111 said...

Out of long. Damn what a move.

MM111 said...

4070. These moves becoming unhinged.

MM111 said...

Short here for whats its worth. Looks like we are breaking out however. Does not seem to be fading. Could run big now.

MM111 said...

135 s&p points round trip. Just a normal day I guess.

MM111 said...

Trapped at 4050. Do you think we will at least come back a bit MO or it looking bad for bear case now?

Market Owl said...

I think it comes back but not sure if it's going to happen this week. Still on the sidelines as Powell seems to be more neutral than hawkish now.

Market Owl said...

Putting on a small short here, will add if you get a pop higher on a weaker NFP on Friday. Very close to strong resistance here. The air is getting thin for the bulls, they are pushing their luck.