Late 1999, Late 2020 Flashback

Its getting bubbly out there.  Parabolic moves in heavily shorted names like UPST, CVNA, COIN.  A huge squeeze higher in Russell 2000, up over 20% in less than 45 days.  This is feeling like late 1999.  Like early 2021.  The difference this time versus the previous two times is the economy.  The economy in late 1999 was on fire.  Same with 2021.  Now?  You have the market not excited about earnings, but about the Fed.  That's a whole different type of euphoria, something that will have a shorter lifespan.  Also the fact that we had a bubble burst just 2 years earlier makes it much less likely this bubble will get as big or last as long.  People have short memories, but not that short. 

In 1999, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 1999 to early 2000.  

 

In 2020, you had the Russell 2000 lagging the SPX and NDX for the previous 18 months, and then went on a huge heater, massively outperforming the SPX from late 2020 to early 2021.

 

In late 2023, you are starting to see the Russell 2000, which has been lagging the SPX for the past 18 months, go on a huge rally, massively outperforming the SPX over the past 2 weeks.  

It is human nature to feel FOMO, when others around you are getting richer.  Investors and traders then try to catch up by playing more aggressively, going into riskier stocks with more beta, to get more bang for their buck.  It happened in late 1999/early 2000, in the later stages of the dotcom bubble.  It happened in late 2020/early 2021, at the peak of the SPAC/bitcoin/meme stock/everything bubble.  And it is happening again here.  

But can the economy stay strong enough to keep the animal spirits going, to keep the soft landing hopes alive?  That will be the question for the first quarter of 2024.  There are some who believe that the higher stock and bond prices will feed back into higher consumption by the wealthy, which will boost the economy in early 2024.  There is some merit to that thesis, but relying on the wealth effect as the main pillar of future consumption is not something I would put too much money on.  Plus, you have already front loaded so much of the Fed pivot rally in the past few weeks, that there isn't that much squeeze left to play for, unless things get really crazy.  And as I mentioned earlier, due to recency bias, and being burned the last time, I just don't see things getting as crazy as early 2021.  

One thing I do have conviction on is that Powell will cut way more than what the dot plot predicts for 2024.  But with 150 bps of cuts already priced into the SOFR curve, its not a great risk/reward at current levels.  You probably make money buying SOFR Dec. 2024 futures and hold them to expiration, but it could be a bumpy ride for the next few months.  I would have been much more confident betting on lower short term rates if Powell didn't signal a pivot, as that would have left a lot more potential in the trade.  As it is, its not a compelling trade at the moment.  

A factor that people are not thinking about enough is how the 2024 election and the looming Trump nomination will have on the Fed's reaction function.  The Fed will have an easy trigger finger on cuts in 2024 to try to help Biden (and hurt Trump).  I know there are still those who believe everything they hear from the Fed and believe they won't be political and will follow the data, but I'm cynical on how the Fed operates.  Their default position is to be on the side of easy money in the first place, so even a slight bit of motivation to keep Trump out of office will have them leaning towards more cuts than fewer.  Plus, with the stock market front running these rate cuts so aggressively with a big rally, I could picture a scenario where stocks actually go down after the rate cuts start.  This will hurt consumer sentiment as the election gets closer, which will encourage the Fed to be even looser and do more rate cuts.  I can imagine a snowball effect of the stock market being disappointed with just a few rate cuts and having a temper tantrum, inducing the Fed to cut even more.  

It's interesting that in 2022, even with surging inflation, everyone was so skeptical about the Fed hiking rates a lot after they signaled no rate cuts until 2024 just a year earlier.  After brainwashing investors and Wall Street with higher for longer for the past 12 months, now almost everyone seems skeptical about the Fed cutting rates a lot in 2024, even though Powell has already pivoted and started talking about cuts.  I see the current situation as a mirror image of 2022, with the Fed likely to surprise dovishly throughout 2024, steepening the yield curve in the process.  The economy is just not going to be as strong as 2023 due to the lower fiscal deficits on both the state and federal level, and with the resumption of student loans and the end of the employee retention fraud that many were taking advantage of.  Employment should get softer, as less bank credit and shrinking margins at small businesses will lead to job cuts.  

Short to intermediate term, its not an easy spot here for shorts or longs.  I put on a small short on Thursday and Friday in SPX and NDX, but those trades I intend to close out this week.  I may even play the long side for a quick trade ahead of the seasonally bullish last week of the year.  For longer term trades, I'm inclined to play small ball or just not swing until I see a fat pitch.  My best guess is that you will grind higher into the first rate cut in March, but not a huge amount of conviction.  Because things have been pulled forward so much, it wouldn't surprise me if we had a sharp pullback before March.  Its probably not a bad time to just park money in money market funds at 5% and wait for things to play out for the next couple of months.