Giffen Goods

The higher the prices, the more demand there is for stocks.  Stocks have turned into Giffen goods.  In particular, the Mag 7 and the other momentum favorites like LLY and COST.  They are like luxury items.   The buyers don't care about valuations.  They just care about making money, and believe that the current uptrend will continue into the future.  That is momentum investing.  The passive investors just put there money into index ETFs, target date funds, etc. and let it ride. 

This momentum game can go on for a long time but not forever.  Eventually, even luxury items like Mag 7 stocks get too expensive, and marginal buying has less effect on the stock price, and eventually when the trend breaks, the sellers come out of the woodwork.  That is what happened at the January 2018 top, February 2020 top, the January 2022 top, and the next top which I would guess happens sometime between now and year end.  Its hard to time tops, but you can get a general idea of when both valuations and positioning are extreme, and those are signals that usually result in a top within a few months. 

Dealers have been building up bigger and bigger short positions in SPX futures, amassing a larger short position than late 2021, and comparable to January 2018 and February 2020.  Those previous 3 cases were in the vicinity of significant tops that resulted in a big correction within weeks (Jan 2018, Feb 2020) to a few months (2nd half 2021).  

Large short positions for dealers means that they are hedging their books which are heavily short out of the money puts and long calls (both in and out of the money).  When institutional investors are heavily long the market, their demand for out of the money put protection increases, as well as the supply of out of the money calls, as covered calls is a popular strategy these days.  So dealers end up heavily long out of the money calls and short out of the money puts.  They hedge this by shorting futures.  

Also, you are seeing asset managers with very large net long positions in SPX futures, which is a quick and easy way for them to add net long exposure, without having to worry about picking the right stocks.  The COT data for SPX and Nasdaq futures are both showing asset managers holding large net long positions and dealers holding large net short positions.  The positioning is extreme, and sets up a ticking time bomb scenario for the SPX and NDX.  History shows that you get violent corrections off of these setups. 

As has been the case since mid May, the stock market has been going up on the strength of a small group of large cap tech stocks + a few large cap momentum stocks like LLY, COST, CMG, etc.  The majority of the stock market has not been participating in the run up from SPX 5300 to almost 5600 over the past 50 days.  This not only goes for the US stock market.  Foreign stocks markets have badly lagged the performance of the US, and are mostly trading below their early April highs.  While the SPX is up 6% from those early April highs.  The Russell 2000 trades horribly, as their fundamentals are fairly weak, and investors are not willing to push up the prices of so many value traps.  This reminds me a lot of the 1999 market when tech stocks were flying higher, but almost everything else was going sideways or down.  Only in the last gasp blow off top in spring of 2000 did you see small cap stocks catch up and squeeze higher, but that rally fizzled out immediately into a sharp correction.  The parallels between the internet bubble in the late 90s and 2000 are eerily similar to the AI bubble that we are witnessing now.  All the way down to the weak breadth in the market outside of the stocks in the bubble halo. 

Without even looking at the economic data, just by looking at the way the Russell 2000 is underperforming the broader market,  you can sense that the economy is weakening.  I don't need to see lagged, butchered, and badly manipulated BLS data to confirm what I'm seeing in the market.  Yet investors remain complacent because 1) they believe that the Fed will engineer a soft landing by cutting rates later this year 2) they are making money in their index funds and have been conditioned to buy and hold no matter what.  The 30% drop in early 2020 and the 9 month bear market in 2022 have taught investors that bear markets and sharp market drops will be brief, and that the SPX always comes back stronger, making new all time highs within either a few months or a couple of years!  

Not only do US investors believe this, foreign investors have been paying attention and seeing how much the SPX has outperformed their country's stock index since 2008, and are now believers in US stock market exceptionalism.  Foreign investors are like the dentists of the past.  They are the last to get the buy memo, and are often caught chasing strong markets right as they are about to top out.  

The ingredients for a long bear market are here.  Positioning can get more extreme, but not much more extreme.  You probably need one last bullish, euphoric move higher based on "good news", such as Trump getting elected, with investors front running potential tax cuts and whatever other fiscal stimulus that comes along with a Republican sweep of Congress and the White House.  Considering how unpopular Biden is, and how unhappy the population is with high inflation and a stagnating economy, its almost a lock at this point that Republicans sweep.  That could be the final euphoric top for this bull market before reality sets in and investors realize that even bigger budget deficits just mean more inflation and higher longer term rates, rather than a return to strong economic growth.  

Got short on Friday, which was too early, and I'm saving my short bullets for a bit higher of a move before adding.  I need to see either a extreme blowoff move higher to add or some confirmation that the upward momentum is petering out and sellers are starting to come back.  Its a hard way to make money, shorting such a strong uptrend.  But that's how some traders and investors are wired.  Perhaps a rally on the CPI number on Thursday could be the exquisite moment to add to shorts.