The Mental Game of Trading

Having an edge is the most important aspect of trading.  After that comes the mental game.  The mental game is an underrated aspect of trading.  This assumes that the trader has a long term edge.  If you don't have an edge, the mental game only prolongs the downward drift.  Important aspects of the mental game:  Discipline, Patience, Aggression, Risk Tolerance, Hope.  

Discipline

 “How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly." - Ernest Hemingway, The Sun Also Rises

The most important piece of the mental game.  In order to maximize lifetime gains, getting to the long run is the most important part.  The law of compounding is often mentioned in investing but usually ignored in trading.  Trading is just investing in shorter term time frames repeated over and over.  Long term investors usually avoid leverage, which allows them to survive and get to the long run.  Traders often use leverage which introduces blow up risk and prevents many from getting into the long run.  

Having discipline to not bet too big.  To not have FOMO and chase.  To not try to catch up and recover quickly (part of : to not bet too big).  Sizing positions correctly to avoid blowing up.  Just as in life, survival is the foundation.  

Patience

"You can beat a horse race, but you can't beat the races." - Jesse Livermore, Reminiscences of a Stock Operator

Traders are always watching the market.  That's like a gambler always watching the action in a casino.  It's tempting to put on trades.  Maintaining the same standards/requirements for entering trades is part of being patient.  A key aspect of patience is also recognizing when a market is good for your strategy and market bias.  A bearish biased trader needs to be pickier and more patient during a bull market and a strong uptrend.  A bullish biased traders needs to be pickier and more patient during a bear market.  For mean reversion traders, being more patient in markets with strong trends, for trend traders being more patient in range bound markets.  

Aggression

"It takes courage to be a pig." - George Soros / Stanley Druckenmiller

There will certain times when your strategy or style of trading will be well suited for the market environment.  You will notice this when you have many consecutive winners or a few big wins.  Its during these times that aggression improves performance.  Being more aggressive in entering trades.  Giving trades more time to reach their destination.  Having more aggressive price targets.  These are the times to follow the cliche: let winners run.  

Risk Tolerance

J. P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to the sleeping point.” - J.P. Morgan

Know your limitations.  Not everyone has the same risk tolerance.  Some traders will get depressed over a 10% drawdown, other traders will act like its almost nothing.  The simplest way to know your risk tolerance is sleep.  If the positions you take bothers your sleep, you have to size down.  Taking too much risk brings fear.  You can only function rationally and follow your plan when you aren't scared.  Scared money don't make money.  

Hope

"Losers average losers" - Paul Tudor Jones

Hope is what keeps us going.  What is a good thing in life, is not necessarily a good thing in trading.  Most people think of hope when things are going poorly.  When you are in a losing trade, hoping it gets back to even.  Or even worse, adding to the loser.  I add to losers and usually regret it.  Sometimes it works, which we remember, but usually it just makes the loss worse.  The time to hope is when your trading is "hot", not when its "cold".  But that's not natural, most people are wired to hope when things are bad, not when things are good.  

Nothing noteable in the SPX COT data as of last Tuesday.  Same goes for the put/call ratio and activity.  Did notice that commercial traders are accumulating a VIX net long position, which tends to happen near tops.  But SPX COT data is more important.  

Staying on the sidelines as SPX has recovered most of its losses from July 31-August 1.  It looks like it wants to grind higher before topping out.  Still keeping the view that this rally off the April bottom will take approximately 5 months to finish, so that would mean a top around early September.  Staying short some single stocks but mostly in cash.  A lot of potential energy being built up for a big down move, but some of that energy was released July 31-Aug 1.  This bull market is riding purely on technicals and momentum.  Most will agree that the fundamentals are not supporting such a big rally.  That's bubble psychology at work and it is fragile.  When the momentum dies out, it will get very volatile.

Being Desperate

“Most people overestimate what they can achieve in a year and underestimate what they can achieve in ten years.” - Bill Gates, Tony Robbins,.....

The market will seek out your weaknesses, find them, and test them.  One of those weaknesses is desperation.  Especially for full time traders.  When you have to make money, then you are trading from a weakened position.  Its easier to succeed when you want to make money, but don't need to make money.  

I've noticed that I've usually traded better when I've been winning than when I've been losing.  Its because losses affect your mindset differently than wins.  After losses, most traders, including myself, want to recover those losses quickly to get rid of the negative emotions that come from losing.  The bigger the loss, the stronger the urge to recover losses quickly.  This means trading from a desperate position, which is a position of weakness.  

After wins, most traders are not in a hurry to get into the next trade, because they already have a feeling of satisfaction from recent wins.  The bigger the wins, the stronger the feeling of satisfaction and the less urge to rush into the next trade.  This is trading from a position of strength, with no desperation.  

When you are not desperate, you don't take marginal or negative EV trades.  You don't sacrifice the optionality that cash provides by being stuck in those mediocre to bad trades.  When you have free cash, you have the option to take advantage of good opportunities that come along.  Just by not being a desperate trader, you can take advantage of more good opportunities because you aren't stuck in mediocre to bad trades.  

This is why I've noticed a streakiness to the results of not only my trading, but other peoples' trading.  The psychological aspect of this game is extremely important.  But since its so vague, and hard to quantify, it is underestimated and often ignored.  When I first started in this business, I gave little thought to psychology and emotions and mind control.  Its only after several years of experience and observation that you realize how psychology is such a huge part of the game.  

Becoming a full time trader is hard because of the need to make money.  Trying to make money in the markets is similar to trying to get a loan at the bank.  When you have enough money and don't need to make money, then it becomes easier to make money.  When you try to get a loan at the bank, its much easier to get a loan when you have collateral, i.e. real estate, to put up to get a loan.  If you have nothing, the bank doesn't want to lend to you.  If you have a lot, the bank will want to lend to you.  

If you really need to make money from trading, its hard to not  be desperate.  When you have lots of expenses, and no income except from trading, its nearly impossible to trick your mind into thinking from a position of strength when you are in a position of weakness.  Its why those that do make it as full time traders are mostly young traders, who don't have families, who have fewer expenses, and less to lose when blowing up.  The nothing to lose mentality actually can reduce the desperation of having to win.  And if you add risk management to that, then you have a chance to make it in the long run.  

Nothing noteworthy in the COT data or the put/call ratios last week.  Asset managers made small reductions in net long positions in index futures, and dealers reduced some of their net short positions.  Bond yields have stabilized around 4.5%, which is good news for risk asset holders.  It looks like we got the fear based bottom in both bonds and stocks in January after the hotter than expected NFP number along with the pre Trump inauguration jitters on tariffs.  

Last week began with tariff news at the start of the week, and ended with tariff news at the end of the weak.  These headlines ignite 1-2% moves, but they don't last.  The more often you get these headlines, and the more predictable they become, the less they will move the markets.  It appears a lot of selling was front run on Friday afternoon ahead of the potential announcement of reciprocal tariffs.  If tariffs are the worsㅅ thing that can happen to this market, then that's not really bad news.  Tariffs are easily taken off, and their effects are overrated.  Especially if you get all those tax cuts that Trump is looking for.  

Still holding a small long position, not looking to make any big moves here, in this narrowing range.  Although if I didn't have any position, would be taking a long position on any tariff fear induced dips this week.   

The Long Game

"Win or lose, everybody gets what they want out of the market." - Ed Seytoka

Everybody gets what they want out of the market.  Contrary to what they say, many people are looking to maximize thrills by betting huge and minimize the emotional toll of grinding through the ups and downs of winning and losing.  Trading is a game made for masochists.  Its not a game that will make you happy in the long run.  Being a trader is similar to being a drug addict.  It is hard to stop once you get into it.  It dulls the senses, making other non-trading experiences less interesting and fulfilling.  One of the greatest traders ever, Jesse Livermore, considered his life a failure and killed himself in the end.  

You get to choose whether you want to play a long game or a short game.  Those that want to play a long game will innately trade in a way to ensure their long term survival.  They can sense when they are in danger and betting too big, and reduce size and cut losses to live to fight another day.  Those that want to play a short game take huge risks and YOLO.  They are overconfident, but also know that they are living on the edge.  Its thrilling and exciting, but it doesn't last long.  They don't have the patience or the desire to play a long game.  

Why would anyone want to play a short game over a long game?  Its because of the emotional toll of trading.  The basic principle of this emotional toll is the pain of loss vs. the pleasure of gains.  It is widely known that the pain of a loss is felt greater than the pleasure of a gain.  Losing $10,000 will be much more painful than winning $10,000 is pleasurable.  Let's roughly estimate for gains and losses of equal amounts to be:   Pain of Loss = 2 x (Pleasure of Gain).  In order to emotionally break even, you have to have at least twice as many winners as losers (of the same size), or at least 67% winners to be emotionally "winning".  That is extremely difficult to do.  

Thus, to maximize the pleasure from trading, traders will often choose to incorporate a high winning percentage strategy, which means taking many small winners and letting losers run, in order to increase their winning percentage.  That's a formula to maximize long term emotional "gains", but not the formula to maximize long term financial gains.  Partially its because markets tend to follow trends more often then not, which means that letting losers run is a very bad strategy.  Its also because when you hold on to losers and cut your winners, the size of your losing trade becomes bigger relative to the size of your total account balance.  You end up taking bigger risks in the worse spots, and taking smaller risks in the better spots.  That is a long term loser of a strategy.  Yet, this is an emotionally appealing strategy from a reptilian brain wiring of win = good, loss = twice as bad point of view. 

A huge majority of human beings have this emotionally reptilian brain (including me).  It means that most of us are not emotionally designed for optimal trading.  We feel pleasure from taking winners.  We feel more pain from taking losses than from holding losers in the hopes that they turn into winners.  The longer we hold on to losers, the harder it is to take those losses, especially after all the mental capital that was spent holding on and hoping that the losing trade would come back and turn into a winner.  

A disciplined, winning trading strategy usually maximizes pain (lots of losses) and minimizes pleasure (larger, but much fewer wins).  That is why trading successfully is for masochists.  You have to enjoy the pain of taking losses, with the long term view that your short term emotional pain will lead to long term financial gain.  A lot of traders know this, but subconsciously cannot follow this strategy because its emotionally painful.  For those who are emotionally invested in their trading/investing accounts, being disciplined and taking lots of losses is self-induced torture.  That is why many choose to bet huge, to YOLO, to get away from the grind of this self-induced torture.  It is the strategy that maximizes long term emotional happiness, but also maximizes the probability of blowing up. 

You don't have control over where prices will go, but you do have control over how much you bet.  In my early days in the markets, I thought it was all about picking the right direction, whether it be up or down.  And while being a good forecaster and predictor is important, its less important than knowing how much to bet.  You can be the best predictor of prices in the world, but if you are bad at choosing bet size, you will either blow up or make very little.  

It is during losing streaks like the one that I am in right now that remind me of the importance of money management.  Its sucks to be in a deep drawdown but you can't allow your emotions to take over.  If you do, you'll try to find a quick way out of this painful spot by betting big, to make that quick comeback, to feel much better again.  That is dangerous.  That is the psyche that destroys trading accounts.  Been there, done that.  During losing streaks, it can feel like Chinese water torture.  Taking short cuts to try to relieve the pain of losing is lethal.  In order to win in the long run, you have to be a masochist.  You have to accept short term emotional pain as part of the process to achieve long term gains.  

The latest COT and options data shows no major changes, investors are dug into their heavy net long positioning, with lots of call activity and its working, so I would not expect anything to change until you start seeing bigger moves up and down.  This upward grind during a seasonally weak time period is a horrible market for my style of trading.  The nosebleed valuations make any long term longs a poor risk/reward trade.  It feels like insanity to be short this market.  But historically, these type of overvalued markets with investors heavily allocated to equities occur near market tops.  But market tops are usually a process that takes many months before the trend changes, so we have to patient, but persistent in looking for the big down move.  Its a tricky balance to maintain, but there will be great opportunities for those with a bearish bias in the next 12-18 months.  

The bond market weakness is partially reflecting election uncertainty and the fear of a potential big selloff like you saw in the past 2 elections.  The bond weakness is also showing the unfavorable supply/demand picture for Treasuries.  The giant fiscal deficit means lots of Treasury issuance, much of that having to be taken in by non-public investors.  Until the Fed restarts QE, bond investors face this hurdle of heavy supply.  This supports the long term bear thesis which is predicated on equity valuations being extremely high relative to bond valuations.  

Equities are at the bottom of the corporate capital structure, and face the most risk during economic downturns.  Therefore, earnings yields (inverse of the P/E ratio) should naturally be lower than long term corporate bond yields, due to the added risk of equities.  With long term investment grade corporate bond yields around 5%, the fair value for earnings yields should be above 5%.  Or put another way, the P/E ratio should be below 20 in this high government deficit, heavy Treasury supply market.  But with an estimated 2024 S&P 500 earnings of ~$250, the current P/E ratio based on 2024 earnings is approximately 23.4.  Based on this metric, the market is at least 15% overvalued. 

Still stuck short and not looking to hold beyond this week.  Post October opex week is a seasonally bearish time of year.  With many already assuming that Trump will win, there is plenty of room for the crowd to migrate towards a more neutral positioning ahead of the election.  The market is pricing in a quite optimistic scenario and assuming that you will have a post election rally after a Trump win.  So many assumptions for the base case optimism on the Street right now.  If even one of those assumptions comes under question over the next 2 weeks, you can have a quick dip lower (likely to be bought immediately).  The bears have one week, perhaps two weeks max, before the probabilities shift much more favorably to the bull side.  I will let the shorts play out this week and get out.  Its been a terrible ride for shorts, but this pain will set up a much more favorable environment for shorts with the tenacity and patience in 2025. 

Emotional Roller Coaster

They don't make it easy on the short side.  It has been a roller coaster ride since the island top made on July 16.  For shorts, in order to catch most of the down move from mid July to early August, you had to withstand an 80 point drawdown on day 4-5 of the selloff, and a 160 point drawdown on day 11-12 of the selloff.  That face ripper on July 31 on FOMC day truly tested the mettle of the bears.  It looked similar to a lot of the past V bottoms you've had over the past 15 years.  On that Wednesday, you had a lot of BTFD conditioned bulls shouting bottom on that day, and it shook the conviction of a lot of bears.  

I must admit, I was getting a bit nervous there, as the overshoot towards SPX 5560 made it look like a V bottom.  It was definitely not according to plan.  You can thank short term FOMO buyers and short term options flows for causing such a huge squeeze in the middle of the biggest down move this year.  Thankfully, that face ripper reversed quickly, because there were some doubts that were creeping in from past scars of being short after a V bottom. 

After a face ripper like that, it is natural to want to cover your short quickly afterwards on a selloff, to avoid that pain again.  Or if you were long, to just hang on during the ensuing selloff so that you can catch another whoosh higher.  

With all the spastic short term options trading these days, you get these ridiculous overshoots that can really test your nerves.  There are positives to the options flow.  If you are selective with entries, you can get great prices to enter either shorts or longs into the overshoot.  You saw that on Monday as the longs puked out their positions, which was reinforced by gamma and vanna forces in options as vols blew out.  Of course, you have to be ready to catch those overshoots by having pre-determined levels where you want to buy or sell. 

After the violent moves of the past several weeks, it shows how important psychology is in this game.  You had the relentless up move off the April bottom into the euphoric July top, where bulls were celebrating and shouting while the bears were getting crushed and despondent.  Then the sharp reversal which destroyed a lot of late to the party bulls and rewarded the timely bears who stuck with the fundamentals and data. 

The analysis is the easy part, going through the ups and downs when you have your own money on the line is the hard part.  The markets are much more a psychological test than an analytical one.  A slightly above average market forecaster who has a good psychological game will be a better trader and investor than an excellent market forecaster who is undisciplined, and falls for the temptations of locking in wins quickly and hanging on to the losers hoping they come back.  

In order to survive in this game, you have to be more like a gambler than a salaryman.   Gamblers enjoy the stress and tension of making a bet and riding the ups and downs.  Salarymen want regular wins, at regular intervals, and get stressed out experiencing the ups and downs of holding on to volatile positions.  The world of trading is not designed for the salaryman mentality.  No trader wants to be considered a gambler, but the financial markets are a glorified casino.  It fits those that are comfortable with volatility and risk.  Of course, too much risk is just asking to get blown up.  One has to ride that fine line between taking enough risk to get meaningful returns, while not taking too much risk which leads to blow ups.

There are many failed traders who go on to selling subscriptions to have a steady income and avoid getting a real job.  Psychologically, its much easier to sell subscriptions and have that be your main source of cash flow than it is to rely on speculation as your sole source of income.   Trading on the side as a part time pursuit with a full time job or with subscription revenue is not the same as having all your income based on trading.  That's why you see so many traders come and go on Twitter, but the sub sellers are always there.  Selling something. Trading as a profession has to be one of the lowest success rate endeavors out there.  They say 8 out of 10 businesses fail.  I would guess that more than 9 out of 10 traders fail. 

Speculating is stressful, and it lures traders to try to maximize emotional comfort.  This leads to overtrading and wanting to reduce risk quickly when winning.  Its human nature to want to hang on to losing trades, hoping they come back.  And its human nature to want to get out of winning trades, fearing that the gains will be given back, and to book a win.  Its not natural to hang on to winning trades, hoping for bigger gains.  That’s why I like to put on price targets for trades, in order to have a goal for the trade.  Its a psychological tool for staying in winning trades, to ride them out as planned.

When you are holding a big position, there is stress and tension that only gets relieved once that position is completely closed out.  The psychological temptation is always there to close out that winning position, to relieve the tension and reduce the stress, to give yourself the win.  That temptation is much weaker when holding a losing position.  While closing a loser relieves tension and reduces stress, you are also locking in a loss, admitting to losing, which most people naturally hate to do. 

Back to the market.  Monday was capitulation.  It came a couple of days faster than expected, but its hard to get both price and time correct.  At least the price targets were hit, and it went beyond expectations.  That is what happens when you have so many leaning on one side of the boat and it starts to tip over.  Panic ensues.  People will talk about the unwind of yen carry trades and CTAs and vol control funds dumping their positions, but it all comes down to speculators overexposed to the long side, with very little put protection, feeling intense heat as the market went against them in a hurry.  

A look at the COT data as of July 30, when the SPX closed at 5436, a 230 point drawdown from the top on July 16.  Normally, you would see a lot more positions being unwound by the asset managers and speculators, but that's not what happened.  Net longs remained elevated. And dealers remained very short.  

 

 

It will be interesting to see what this coming Friday's COT report shows, which will cover what happened during the selloff from Thursday to Monday.  It should show heavy reductions in the asset managers and small spec long positioning.  

On Monday, and to a lesser extent on Friday, we finally got the put buying that this market needed to at least start the bottoming process.  Given that its really only just starting, and there was so little put buying during the previous days of the selloff, I would expect it to continue througout the week.  

 

Given the massive move higher in vol, and the psychological damage of such a volatile drop, I don't think Monday was the day that we made a V bottom.  Based on previous vol explosions like August 2015 and February 2018, we should see a retest of Monday's lows in the next few days.  Those lows will probably hold, and you can have a 2-3 week rally which would suck in the bulls again, but they will have much less enthusiasm this time, meaning that I doubt you can get back near the July highs anytime soon.  

 

SPX February 2018

 

SPX August 2015

Covered all my shorts on Monday.  Did put on a small long position in SPX and NDX, looking for a gap up and a 1 day bounce.  Which is playing out.  I will likely close out this position today and may even put on a small short position, looking for another move lower this week to retest the Monday low zone around SPX 5120-5140.  After Monday's capitulation and liquidations, the market is now buyable for a trade, on weakness, and will favor a range trading strategy, rather than a bull or bear strategy.  There should be many opportunities on both sides for the next 2 months.  This is the time to make your points and be on your game.  These kind of trading markets don't last for long.  Take advantage of it while its here.

Its an Art Not a Science

The stock market is irrational.  Its based on numbers, but its not math or science.  There are no set rules.  There is no iron law in finance.  Its an art that people try to make into a science.  This isn't physics or math.  The closest thing that comes to mind is fashion.  There is no real logic when it comes to fashion.  Its based on feel, personal taste, emotion, societal trends, etc.  The thing about fashion is that it really doesn't matter how you feel about your clothes, its how others feel about your clothes.  That's the stock market.  It doesn't matter what you feel.  It matters what others are feeling.  

Having a quantitative mindset, it was bewildering to see how investors would get more excited about the stock market the higher it went.  The rationalization, the excuses, the reasons for the moves.  They are arbitrary but are quickly clamored onto like indisputable facts by the crowd.  There is no wisdom of crowds in the stock market.  That's BS.  Its the madness of crowds.  Its herd behavior coming from our primal instincts, that evolved over tens of thousands of years when survival was always the priority.  That way of thinking, the emotions and actions that all evolved when there was no stock market, when there was no crowd gambling on a huge scale.  

Trying to put logic or numbers into this game is like trying to put a square peg into a round hole.  Its an art, and it will always be art, even when AI or machines take over.  There is no science here.  The stock market is just a huge, glorified casino.  In fact, its less quantitative than a casino, where the odds are set.  In the market, the odds are unknown.  Its this mystery that keeps the hope alive, that provide fertile grounds for snake oil salesmen and subscription sellers.  The day that I start a substack to try to sell subscriptions is the day that I admit that I no longer can beat this game, and can only make money selling dreams rather than living the dream.  

Its an illogical game, but there are patterns to it.  Arbitrage has been sucked out of the market and there is very little alpha in that space. The main edge in markets is finding patterns and playing them over and over again.  Those patterns are derived from human psychology and they repeat.  Some patterns are long term, some are very short term.  But they repeat.  Successful speculation is about finding the patterns and anticipating the next move to come in the pattern.  There are seasonal patterns, patterns around events, etc.  Some patterns are higher probability than others.  And the probabilities change and are unknowable, but intuitively, you can sense what patterns are reliable and which ones are less so.  But to do so, you have to stop thinking about what's going on in your head.  But what's going on in the head of those moving the market.  

First order thinking is what you are thinking about the situation.  Second order thinking is what you are thinking about what others are thinking about the situation.  First order thinking doesn't help you much in this game.  Its second order thinking which is the foundation for market analysis.  No one cares about what I think.  No one cares about what you think.  I'm not the one who's going to drive the next move.  I want to know what the big money is thinking and what's their next move.  

The current bull run in stocks is puzzling from my view of how markets should be valued, but it really doesn't matter what I think.  If others are in a risk seeking mode, and past patterns of risk seeking behavior play out, we are not done with this uptrend.  That doesn't make me want to play this uptrend at the current time, even though the probability is high that the market will be higher 2 months from now.  Its the risk/reward thats not attractive here.  There is more downside risk in the short term than upside risk, even though its more likely to go up than down.  

These big bull runs, which we are currently on, tend to last 4 to 5 months before facing its first real test/correction.  Since this rally started at the end of October, that means a rally that likely lasts until late February to late March.  This also jives with the psychological importance of the Fed and the first rate cut, which looks like will happen at the March FOMC meeting.  Its a classic buy the rumor, sell the fact setup happening over several months.  This will be the framework with how I trade the market for the 1st quarter of 2024.  Its too early to think about shorting for longer than a couple of days, so I'd rather not play that game.  

No imminent trades at the moment, but I will be buying dips in SPX and Treasuries in January, as I expect the uptrend to continue into March. 

Avoiding Mistakes

The more you repeat mistakes, the more you realize that trading is not about making great trades, but more about avoiding the same mistakes that you made in the past.  Although I didn't make any money on SPX during the SIVB selloff and subsequent rebound, I'm glad I didn't lose money.  10 years ago, I probably would already be averaging up into an underwater SPX short as the market grinds higher from a panic bottom (post SIVB on March 13).  Throughout the years, one of the most consistent patterns in the stock market is the V bottom off of a short term panic.  It is why I always try to avoid shorting within 2 weeks of a panic, especially if the reason for the panic is overblown, which is usually the case. 

The long term negative implications of credit tightening was not the reason people were panic selling, they were panic selling because it was the fear of a systemic crisis and financial contagion.  The panic from financial contagion was a bit irrational, and overblown, in my view, as soon as you saw the Feds step in to backstop banks with the BTFP and through the discount window with "not QE" balance sheet expansion.  This is why I avoided the short side the past couple of weeks.  But the negative economic implications from the steady drift from bank deposits to money markets and less lending/tighter credit is for real, but its not as catchy of a headline or incites much panic.  

Cutting through what is short term fear mongering and media hype, and what is truly impactful requires a mix of common sense and macro homework.  Its not always obvious, but usually the scarier the headline, the more likely the issue is overblown and the market overreacted.  In particular, geopolitical headlines usually fall under this type of news, as its always scary, but rarely has a long term impact on the market.  A big geopolitical event like a Russian invasion of Ukraine is the exception, not the rule.  And even the effects of that have mostly faded away a year later, despite the ongoing war.  

The stock market usually doesn't reward the obvious.  This time, the obvious conclusion was to sell stocks because of a potential financial crisis.  Over the past few weeks, they kept saying this is not 2008, which is like saying to someone that just cut his finger, oh, that's not as bad as getting stabbed in the heart.  To even bring up 2008 showed you how scared some investors got 2 weeks ago.  I should have instinctively known to at least buy a little bit the day after SIVB went bankrupt, just for a trade.  But playing it conservatively, I waited for an even bigger dip that never came.  A market doesn't give you much time or repeated opportunities to buy the low is a sign of strength.  

Now that the dust has settled and the market has overcome another "hurdle", I'm sure you will get those who feel like the stock market is invincible, being able to shrug off such "bad" news, as fund managers overanalyze the situation and end up chasing stocks at high prices, to re-risk after they de-risked near the bottom.  That is what active management does for you.  Get you scared near the bottom, and aggressive near the top.  Every January, I heard these active managers talk about how this is the year for active managers, and yet they always underperform the SPX.  Don't trade like those active managers.  They underperform for a reason.  You have to do things that don't feel natural.  It goes against human evolution to break away from the herd and ignore the advice of so-called experts on CNBC. 

Since my last blog post, we have seen the SPX face rip for 100 points, ruining the week for a lot of bears.  Shorting is not an easy game.  Not when you have the Fed eager to bailout at the slightest sign of stress, pumping in $400B at the drop of a hat.  Yeah, they say its "not QE", but it sure had the same effect as QE, which was a huge rally after it went into effect.  The Fed has shown who they really are.  If they were true inflation fighters, they would have let creative destruction take place, let some two-bit banks fail, even at the risk of a short term banking panic.  That would have been a guaranteed inflation killer.  But instead, they took the easy road, which was to bail them out.  No surprise there.

I find it interesting that the vast majority don't believe that the Fed will cut rates this year, because of sticky inflation, yet they ignore the Fed's inflationary actions of bailing out the banks, as if that doesn't show you that the Fed put is still there.  They still think that Powell will keep rates higher for longer, even if the economy weakens.  Have they not learned from history?  Even the biggest hawk in the history of the Fed, Volcker, took rates down rapidly when the economy went into recession despite high inflation, although it was moderating when he did it.  And no, he didn't wait till inflation hit 2% to cut rates.  Those spewing nonsense out there have been completely brainwashed by Fed forward guidance.  If you repeat lies enough times, eventually people believe it.  Joseph Goebbels, the Nazi propagandist knew this human tendency very well.

If your bear thesis relies on the Fed remaining hawkish and higher for longer as the economic data deteriorates, you should rethink that thesis.  History is not on your side.  The main reason I have a bearish view on this market is because there are still too many that believe the US economy is strong, because of the tight job market.  Economic weakness, not Fed hawkishness is the bear catalyst.  Fed hawkishness as a reason to be bearish was a 2022 story.  2023 is about the economy entering a real recession for the first time in 15 years and earnings going down more than expectations.  Macro is hard to predict, and I've been early on predicting a recession, like many others, but the more time that passes at these high rates, the more damage that is being done to the economy.  And I still can't fathom an everything bubble like we had post Covid, being resolved with a soft landing.  Anything is possible, but post bubble environments are usually deadly for stocks, and for the economy. 

Market is getting a bit closer to my SPX 4150-4200 sell zone.  At this pace, it gets there by the end of next week.  Its been 14 trading days since the SIVB bottom on March 13.  Usually these bear market rallies fizzle out after about 20-25 trading days.  Considering that we didn't get a huge flush out like you saw in June 2022, I doubt this rally extends for 2 months like that June to August 2022 countertrend rally.  I give this rally another 2 weeks to go higher before it likely flattens out and starts getting choppy.  For some reason, I have a feeling this market tops out after the banks report earnings in the middle of April, signaling the all clear for the scarecrow fund managers that always have to wait for the uncertainty to clear out before putting their chips back in to play. 

Lizard Brain

Trading is such a mental game.  Its something I didn't really think about until the past few years when I realized I would have these long losing streaks and also long winning streaks.  It was because I was doing stupid things when I was losing money.  I would get desperate to quickly make back my losses.  Forcing trades.  Rushing to make it back.  In the process, I would take mediocre trades, get in too early.   I would dig the hole a little deeper.  It was a self-reinforcing cycle of losses leading to more losses.  A trading hamster wheel in hell. 

Only after a big win would I be able to stop that vicious losing cycle.  Why do we do this to ourselves?  Its that lizard brain that lingers after millions of years of human evolution that hates losing and wants to make that feeling go away, as soon as possible.  

Another remnant of that lizard brain is the desire to follow the herd.  It has less to do with getting more bullish when things go up and bearish when things go down, and more to do with following what others are doing.  Its like following the latest fashion trend, the latest fad.  Monkey see, monkey do.  Going on Twitter, watching CNBC and Bloomberg, and thinking that those guests and hosts know what they are talking about.  But its quite the opposite. In finance, those that know the most talk the least. 

How about that other thing we have in common with our ancient ancestors.  Recency bias.  How soon that we forget Powell's forward guidance in 2021, when he said he  wouldn't hike until 2024.  Now we believe his every word, taking it as gospel, that he will keep hiking the US economy into a depression!  I am old enough to remember when all the talk was about secular stagnation, deflation, and the worry that robots were taking away jobs.  Now we can't seem to find enough workers.

The financial markets are still stuck in that recency bias of believing that stocks always goes right back up.  Its that buy the dip mentality, the stocks for the long run crowd who believe that its their god given right to have 11% annualized returns, without a thought as to where that return will come from.  Valuations are an afterthought, its just about staying invested, dollar cost averaging, and investing for the long run.  A lot of bad habits and erroneous assumptions have been built based on the backs of the 2 biggest bull markets (1987 to 2000, 2009 to 2022) in recent history.  The stats nerds lap up every dip like its a lifetime buying opportunity, a guaranteed way to make money. 

Its that American Exceptionalism creeping in.  It assumes that the US will always be the best place to invest, the best currency, the cleanest dirty shirt, the best house in a bad neighborhood, etc.  All I see is a US that is becoming more of a bureaucratic country like Europe, that relies on fiscal policy to boost economic growth, with very little organic growth.  Productivity that is going down as the public sector gets bigger along with the ballooning budget deficits.  A country that has no vision, that just tries to throw money at problems with no scientific or logical plan for energy, healthcare, infrastructure, etc. 

Over the next 10 years, I can see a US stock market that goes sideways with 0% return, as the cost of both goods and services goes much higher, mainly from populist inflationary fiscal policy that aims to throw money at problems instead of looking for long term solutions to a lack of energy, labor, and productivity growth.  I can see financial repression coming back as negative real rates for US Treasuries are a fixture as the US government can't afford to enter a high debt, high interest rate, high inflation death spiral.  The Fed will eventually be forced to cut rates and restart QE to fund the massive budget deficits from an undisciplined and populist Congress that spends more and more but refuses to raise taxes to pay for it. 

Back to the current markets.  We are seeing both the Fed and the Treasury show early signs of caving.  On Friday, it was the Fed whisper at the WSJ hinting that the Fed will be looking at a smaller rate hike in December, followed by Yellen on Monday talking about Treasury buybacks and worries about liquidity.  Its funny they only worry about liquidity when bonds are going down (now), not when there is no liquidity when bond are going up (October 2014).  The stock market is running with the Fed/Treasury pivot hopes, while bonds are less sanguine about the prospects of the cavalry coming to the rescue.  

I have noticed a big shift in sentiment recently, as the bulls are coming out of their ratholes, thinking that the all clear is here, at least for the rest of the year, and they are getting bulled up again.  Even the permabears on CNBC Fast Money,  Dan Nathan and Guy Adami are pontificating on a bear market rally.  They may have a few weeks where the SPX stays above 3640, the lows from last week, but there is a lot of overhead supply and I can't picture this thing going much above 3900.  Just too many playing for a bear market rally without long term conviction, those who will be selling on strength, creating overhead supply.  Also, this market is running out of suckers who will chase stocks after a big rally.  They got smoked countless times this year, and they are quickly becoming an endangered species.  

Waiting for a short term rally in the bond market to pump the SPX higher a bit more, before I put on shorts.  SPX close to 3800 is a good short level, but want to wait for a bit higher for a lower risk short. 

Trading Regrets

There is the cliche that in order to be a good investor, you have to act without emotion, be like a machine.  It assumes that one can do that, which is very unlikely, even if you run a "system".  The development and tweaking of the system is ultimately discretionary, and, thus not pure.  So even for systematized strategies, human discretion and emotion are involved.  Even if you really wanted to take the emotion out of investing, you can't do it.  

Maybe its actually good to feel emotions when trading, to actually improve your decision making and learn from past mistakes.  There are those blind optimists who say that they live with no regrets.  But for most of us, we have regrets about the past, and its not a bad thing.  If you don't regret touching that hot stove, then you probably will be just as careless around that hot stove the next time.  I spoke with a trader in the past and asked whether he felt regret about selling his long term stock holdings after the initial bounce in April 2020, fearing that there would be more weakness.  He said no, the conditions were unprecedented and it seemed like a bear market rally at the time. 

That's completely different from how I felt after covering my short way too early for a small gain a few days after the market topped in mid August.  I felt regret almost immediately, realizing that I left a ton of money on the table, and ignored the signals from the options market, which were actually pointing to a lot of complacency in the face of the selloff.  

Losses are the best teacher, but huge missed opportunities are not far behind.  If you don't feel that disgust after exiting too early and taking a small profit when a big profit was just around the corner by holding a few more days, then you are probably going to keep exiting too early when having a small profit.  It works the other way as well, holding on too long (usually when holding a loss) and letting the trade go against you even more, changing the original exit plan to avoid taking that loss.  

Why do we do this to ourselves?  Why do we hate to take losses and love to take those small gains?  Its that reptilian brain that feeds off of dopamine hits, disregarding the long term or past history.  Gain = dopamine hit, and its not proportionate to the size of the gain, so small gains have almost as big of a dopamine hit as a large gain.  Thus encouraging suboptimal trading behavior.  

Loss aversion also feeds into this tendency, as traders book their gains quickly for fear that they will turn into losses, and avoid taking small losses, for hope that those small losses will turn into gains.  That's what a lot of these HFT algos run on, pushing the market in one direction as they know that most discretionary daytraders will be stuck on the losing side, and will eventually puke out their losers later in the day.  The video below is a classic example of loss aversion, during the January 21-22 2008 huge gap down (scarier than the March 2008 Bear Stearns liquidation). 

 Quite a few regrets about 2022, missing one of the great shorting opportunities in SPX, multiple chances at low risk entries on the short side, and missed most of them, and the one that I did catch, took profit way too early.  Not taking at least a small long position into the heart of the inflation fears in mid June, even though stocks were highly oversold and due for at least a short term bounce.  

Underlying most of these missed opportunities was a fear of getting short squeezed, and still having memories of the relentless dip buying and chasing in 2020 and 2021.  The bear market is more mature now, but there is still a lot of fat left on this pig.  Sometimes we make the game harder than it is.  Usually you have to put a big weight on positioning and some weight on what you hear repeatedly on CNBC, Bloomberg, Twitter (from a contrarian view), and that has interfered with the big picture view of a Fed that doesn't want to see financial conditions loosen (stocks and bonds going up) and is hell bent on tightening despite many signs of a slowing economy.  Worsening liquidity + overvalued stocks in a post bubble environment + Fed showing no signs of letting up on the brakes = a time to short aggressively.  Its simple logic, and a rare set of conditions which heavily favors the short sellers.  Let's not lose sight of that when making our decisions for the rest of the year.  

From Wednesday to Friday last week, I finally saw a change in options activity showing investor concern, as we no longer saw the heavy call buying and put selling on the dips, and instead saw call selling and put buying (not nearly enough to reverse the monster call buying and put selling from August 19 to August 30).  Its a sign that the steep drop is probably over, and that we're likely to see a few days of consolidation of the losses before the next downleg.  I will be looking to put on shorts during this consolidation phase, especially if there is a rally after the CPI report next Tuesday.  Expecting no significant rallies (more than 100 points) from these levels. 4000-4050 is probably about as high as it can get before its gets hammered back down by sellers.  

We have bonds giving up most of its post NFP gains overnight, and it looks like central bank fears are still quite high and should stay that way until we get to the FOMC meeting on Sep. 21.  

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.

Russia Risk and Psychology of War

Market participants are funny.  I am reading Russia takes from a lot of investors which doesn't make much sense.  A lot of people seem to think that Russia invasion of Ukraine is the biggest risk to the market, but they think that the risk is underpriced.  All people are talking about is Russia/Ukraine.   They are dominating the headlines.  And that's been the main reason we've had violent moves up and down over the last few days.  Its the main reason people have been buying puts.  Yet the Russia risk is underpriced?  

It gets back to the primal instincts of investors who are scared about war.  They equate human tragedy with stock market tragedy. 

Fed rate hikes seem trivial when compared to a war between Russia and Ukraine.  But Fed rate hikes are much more important to the stock market than war.  Its a much worse environment for stocks with a hawkish Fed and no war than a neutral Fed that can't hike aggressively with a war going on.  Investors tend to forget that this is a money game, not a news game.  Having bad news doesn't mean the stock market will be weak, and having good news doesn't mean the stock market will be strong.  But pumping a lot of money into the system usually means the stock market will go up.  And draining a lot of money from the system usually means the stock market will go down. 

Yet based on what I am seeing, investors are complacent about a hawkish Fed and think the Fed won't be able to hike much or meaningfully reduce their balance sheet but are scared that a Russia invasion would be a black swan.  Black swans don't happen when everyone is aware of it, with quite a few who are scared of it.  They happen when the event is either unknown or considered inconceivable.  

A lot of short term trading isn't about fundamentals but predicting whether a move is sustainable or unsustainable.  Fears based on war are not long term sustainable.  In the short term, the stock market can be inefficient and irrational, but in the long term, it finds its efficient, equilibrium level.  War doesn't hurt corporate earnings, in fact, it often helps corporate earnings for certain sectors (energy, materials, defense).  But you don't hear much about that, its just this instinctual fear about war that seeps into stock market.  

We have Fed minutes today, so I am sure that will get the nervous short term traders looking to sell or short ahead of the minutes release at 2:00 PM ET.  Stocks plunged on the last Fed minutes release in early January, so I'm sure not many are optimistic about what the Fed will have to say this time around.  Once we get past the Fed minutes, I don't see any more events that could be bear catalysts.  Except for World War 3!   

Got long SPX on Friday and Monday, looking for a bounce towards 4500 and higher by next week.  Lot of put volume in ETFs over the past few days, and investors seem to be leaning bearish and are getting more and more hedged.  I am just playing the range for now, don't expect any big moves in either direction.  If we can get back up to SPX 4550 and higher this month, I will consider a short position. 

Learning from Mistakes

2021 was a golden opportunity to be long US stocks for anyone who had a solid big picture view of how a bubble plays out.  Going into 2021, I was too enamored with not being caught long at the top of a massive bubble instead of recognizing that less than 1 year removed from the Covid "bear" market, it was highly unlikely a meaningful top would be made so quickly after such a huge flush out.  Even if you had a repeat of the brief Dec. 2018 to Feb. 2020 bottom to top cycle, that still gave you 14 months from the March 2020 lows, or until May 2021. 

The biggest clue that this bubble would be extended was how the Fed reacted to the growing bubble in 2021.  Powell remaining over the top dovish as the stock market kept going higher and higher and the economy was heating up was the most obvious sign that the bubble would get a lot bigger in 2021.  

February 2020 was the only meaningful top that was made while the Fed was not in a tightening mode, and it probably wouldn't have happened if not for a black swan event.  The only other instance of a big stock market drop without a tightening central bank was in the summer of 2011, when it was the tightening of the European financial system as sovereign yields for the PIIGS skyrocketed, a market driven tightening, not a central bank policy driven one.  A tightening nonetheless, the most important ingredient to form a meaningful stock market top. 

In hindsight, everything looks clear and obvious.  In the heat of the moment, in the middle of the battle, its never that easy.  Its much easier to make the right decisions as a Monday morning quarterback than trying to make the right reads while 300 pound linemen are trying to pummel you into the ground.   

The market was there offering loads of money and I was content with being short term focused and conservative, taking 5 dollar bills when I should have been collecting 100 dollar bills.  Finally in September/October, there was another golden opportunity, even though at the time, there was a lot of chop that made it "feel" scary to get long.  The disgust from my previous poor exits was enough motivation to make the right play.  The key was not getting in too early in buying the dip, which allowed me to hang on and not getting shaken out in late Sep./early Oct. as the market chopped violently from SPX 4300 to 4400.  

The first thing on my mind was to not sell if the trade went in my favor.  On my mind was those previous well-timed dip buys that didn't amount to much because I sold way too early, afraid of giving it back on another pullback.  This time, I gave the long trade plenty of time to work.  Even then, I sold a portion way too early, but thankfully, rode most of it to the 4650-4700 range.  The key was resisting the urge to microtrade, the bane of my existence, even as I thought that a quick 1 day pullback was imminent (it didn't happen until October 27).  Losing the arrogance of thinking that I was smart enough to time and predict every little move made me do nothing but just stay in the trade and let it play out.   

To this day, even after seeing the SPX go way higher after I sell so many times in my career, I still get that urge to sell after that quick profit on the initial portion of the V bounce.  It has to be the psychological crutch of aiming for steady, consistent moderate gains, instead of less common, but much bigger gains.  Even as I thought that I got rid of the salaryman mentality a long time ago, there is a seed deep inside my psyche that still wants to make consistent gains on my terms, instead of taking what the market gives me, whether it be big or small, plus or minus.  

There are zen like aspects to surfing the markets, if you try to force your will and style on the market, you limit yourself and close off the enormous potential that is out there.  Its like taking a boat out only to stay near the shore, content with catching little fish in quick daily trips, instead of going out into deep waters, looking for the big fish, going for the big catch in long multiday trips.  

I am all out of my SPX longs.  I could probably eek out a few more points but I just see too much call buying and complacency, as well as the upcoming options expiration and ensuing post-opex risk.  Also, the time window from the early October lows has played out, as we are 5 weeks from the blastoff point, and 6 weeks from the lows of early October.  Also the renewed weakness in Treasuries is another headwind.  Its a seasonally strong period, so not really interested in going short, but the risk/reward seems neutral to slightly favoring shorts.

Less Trading Longer Time Frames

As a beginner, trading only stocks, I envisioned taking on long term investments and holding for several months to years.  That lasted about a month, as watching the market everyday and not trading is very hard to do.  I traded more and more until I basically became a daytrader. 

I didn't know what I was doing, but I had a sense that it was easier to catch one big move than to catch several small moves.  In trading, 5 > 1+1+1+1+1.  On the path to catch several small moves, you often get something like this:  1+1+1-10.  Unless you have great discipline, which many don't, the more you trade, the more you leave yourself room for making a big mistake.  We are fallible, emotional, and prone to be undisciplined. 

Unless you are super disciplined and great at taking losses, small wins will eventually kill you in this game.  The market is like a series of heat seeking missiles.  It eventually finds your weakness and keeps attacking until you either change or throw in the towel.   I got hit with enough of those missiles over the years and gave up on daytrading, which was getting harder as the algos took over from the humans and made intraday patterns much less reliable.  Thus, I have reduced my trading, reducing my exposure to short term market moves by trading smaller and holding longer.  You don't get hit with as many missiles when you are smaller and further away.  The closer you play to the present, and the bigger you are, the more you are exposed to heat seeking predatory algos.

Even with the reduced trading, still probably trade way more than I should.  I could probably get rid of almost all of my short term trading and it probably wouldn't hurt the P&L at all.  Its mainly because a lot of those short term trades that end up as losers would have been big winners if I just waited for a better entry.  When you wait for the really good entries, you will end up missing quite a few good, but not great opportunities.  But most of the time, those great opportunties were actually good opportunities that became great opportunities due to the market overshooting due to algos and liquidations.  

If you are selective about trades, you will miss moves, and feel FOMO, but that's the only way to reduce your exposure to adverse market moves.  Buying or selling in the middle of the range sets you up to get chopped up by the algos that test your pain threshold by going to the top and bottom of the range. 

Back to the current market, the current rally is a classic FOMO rush after a pullback from a very long up trend, similar to March 2007, October 2014, and August-September 2019.  Investors experienced almost a nonstop rally for several months and have memories of the market making V bottom after V bottom, with higher highs and higher lows along the way.  The greed factor is still deeply embedded in the psyche of today's investors, as I've mentioned before with the post about sticky bulls, and how tenacious they have been even in the face of a downtrend that went on for over a month.  In these environments, after a dip, there is almost a reflexive reaction to buy no matter what when they see any sign that the market has bottomed.  I should have done nothing this week, but I tried to micromanage my position, reducing my profits by selling some on Monday, looking to buy back lower.  Of course, that never happened.  

Still holding my core long in SPX, and letting it ride.  Learned my lesson from the last few years of selling too early after these flush out bottoms, once you have a good position, doing nothing and hanging on for the ride is the best choice.  

Treasuries are starting to get to interesting levels, as 10 yr yields get closer to the year's highs at 1.75%.  Still waiting for a bit more weakness before possibly taking a swing at the long side.  But I don't see much potential for an explosive up move in bonds until after the first rate hike, which is priced to happen on September 2022.  There are already 2 rate hikes priced in for 2022 in the Eurodollars futures curve, and that's quite aggressive, considering how firmly the Fed has stated that they wouldn't hike rates while tapering.  And I don't expect a fast taper, just because of how they operate with an abundance of caution, taking their time when removing accomodation, but rushing when easing.  

10 yr yields are probably range bound until the first hike, between 1.40% to 1.75%. The power flattening over the past month has made the belly of the curve very attractively priced and with the most positive carry.  In a range bound market, collecting carry makes the difference between breaking even and making a decent gain.  Long side in Treasuries is getting more and more favorable, not only from a potential price appreciation, but also from the more positive carry from the higher yields.  

Caveman Discretionary Trading

In the beginning, it is about finding an edge, a setup that works over the long run, through multiple market cycles.  Backtesting that setup and also making sense of why there is that edge.  It is not some random thing that worked in the past that you just expect to keep working in the future.  There is an underlying bias or behavior among market participants that create the pattern. 

For example, a lot of retail traders are looking for a quick buck, a volatile small cap stock that is in play and going up on some hype press release from the company.  They see it going up and can't help themselves, they get FOMO and chase a stock that's already up a lot on nothing fundamental.  So they push the stock up to unsustainable levels.  Eventually it goes back down as they sell when the excitement fade away.  Some of these companies will take advantage of the higher price and volume generated by these traders and ram through a stock offering.  Even without an offering, the natural force is to the downside once the high volume frenzy calms down, usually within 2 days.  The classic pump and dump pattern.  

Finding an edge takes time and experience, but its only the first part of game.  The next part is discipline.  Discipline is mainly 2 things:  1) risk management.  2) trade selection.  Once you find your edge, keeping that edge is easier than keeping your discipline.  

For a lot of people, discipline is a function of results.  It is easier to maintain discipline when you are making money than when you are losing money.  There are a lot of trading cliches that are useless but the one about trading smaller after a big loss is useful, but psychologically difficult to implement.  That's due to our caveman roots.

After you have been winning, you feel good, and don't want to risk losing that good feeling by trading bigger, even though you can, with the same level of risk, because you now have more capital.  After you have been losing, you feel bad, and don't want to keep feeling bad.  So how do people cope with that feeling?  They trade bigger, even though they have less capital now, increasing the level of risk after losing.  That's revenge trading.  Taking less risk while winning, and taking more risk while losing. 

Revenge trading is what happens after you lose money on a trade and also lose your discipline.  It has been the bane of my existence.  If I never revenge traded in my career, I would have a lot more money right now.  And I don't think I'm the only one.  Its the caveman in us that is hard to contain.  The urge to double down.  This urge is especially strong in mean reversion traders.  That is the biggest edge that trend followers have over counter trend traders.  Trend followers have better risk management.  

The next aspect of discipline is trade selection.  Its much easier to maintain the same trade selection when you are winning than when you are losing.  When you are winning, you feel good, so you don't want to lose that feeling by making too many trades.  When you are losing, you feel bad, so you want to quickly get rid of that feeling, and become desperate to find the next trade to make back your losses, to get back to even.  So most end up loosening their trade criteria and get desperate trying to make their money back.  This can lead to a downward spiral of entering subpar setups which leads to more losses and more desperation.  It continues to feed on itself until you start making money again and even at that point, if you are still down a lot, you can still have that desperate mindset which makes it that much harder to get out of the hole.  

The flip side of compounding is losing so much that its almost impossible to come back.  If you start with 100, Losing 50% of your bankroll, and then making 50% back leaves you with 75, not 100.  Losing 90% of your bankroll and making 90% back leaves you with 19.  Excessive risk taking and volatility in your account is a negative drag on long term account growth.  I wrote about overbetting and  optimal bet size several years ago.   

That's why you can teach people the right setups to trade, and still the majority of them will screw it up because they lose their discipline.  

The bounce back from that overnight dip to 4350 in European hours on Thursday has gotten the SPX back to the pre-FOMC minutes break down level of 4440.  Call me old-fashioned, but the 15 minute chart looks like its begging for a retest of 4350 at a minimum in the coming days.  Definitely not shorting, as I refuse to short SPX until after the parabolic rally phase, but it seems odds favor the bears here.  Also, I find it interesting that you got the biggest equity inflows since March 24 last week, as the SPX was weakening from all time highs.  It looks like FOMO has finally caught up as the SPX kept grinding to new all time highs.  Those on the sidelines couldn't take it any longer and decided to pile into equities.  Seems somewhat ominous to me, but doesn't derail me from the BTFD strategy. 

If we do get back down to 4350 or even lower this week, I would be a buyer expecting Powell to be a cooing dove at Jackson Hole ahead of his reappointment decision, with Delta variant as a very convenient excuse. 

Similarly, I am a buyer of dips in Treasuries ahead of the 2/5/7 year auctions and Jackson Hole.  The power flattening over the past several days is consistent with tapering fears in the market, and everything in my gut tells me that Powell will be more dovish than expected on Friday. 

Mind Bender

Investors have a way of bending reality to back up their current position and outlook.  You heard all kinds of pseudo scientific rationalizations from economists about economic scarring, a term that was just made up to try to support their view that the economic recovery would be slow and prolonged.  I don't hear that anymore.  Also a new letter was used to describe the recovery, no V, no U, a K.  I don't see anything doing worse after the vaccine rollout, so that explanation should also be thrown in the garbage bin.  Now almost everyone is on board with the roaring inflation call, due to fiscal and monetary stimulus, and all that money printing.  The go to answer to explain stocks and bitcoin going up. 

Most investors believe that the main reason that we are seeing this huge bull market is because of monetary and fiscal stimulus.  I also hear a lot about the M2 money supply growth over the past year.  So let's look at the M2 money supply chart for the US and Euro zone for the past 5 years.  And compare the SPX vs the Dax over the past 5 years.  

M2 Money Supply 5 year chart

SPX (red/green bars) vs DAX 5 year chart

While the US is blowing everyone away in the money printing department over the past year, most of that occurred in March and April 2020, since then, the M2 money supply growth rate is similar for the US and the EU. 

And the often ignored aspect of the inflation fears is that it eventually leads to the Fed reacting to the market.  Expect the USD M2 money supply growth to slow down sharply if the Fed follows through with taper and interest rate increases like the market expects (1 rate hike priced in by Dec 2022, 3 rate hikes priced in by Dec 2023).   Under the market priced scenario, the US will once again fall behind Europe in M2 growth in 2022 and 2023, just like it did from 2017 to 2019, as shown in the M2 chart above.  

You don't hear too much about money printer goes brrrr when talking about the Euro area.  But Europe has printed just as much as the US over the last 5 years. 

The beginning of the end of most bull markets is an increase in interest rates.  That's not just for the Fed funds rate, but for interest rates across the curve. That is a market signal that money supply growth in the future will likely slow down as the Fed tightens monetary policy.  Right now, the Fed is not pushing back on the market pricing in 4 rate hikes by Dec 2023, just repeating their mantra that they need to see real data rather than forecasts before they change their stance.  We'll be seeing the hot data come out in the GDP numbers in the 2nd half of the year, and then what?  Powell will be running out of excuses to keep the easy money flowing. 

In most cases, the Fed follows the market.  It usually takes a few months for the hard heads and rear view mirror Fed governors to catch up, but they eventually do.  Everyone on Wall St. is forecasting a big jump in GDP over the next 12 months, so when the forecasts turn into real data, the Fed will be changing their language.  

That will be enough to change the current Wall St. paradigm of the Fed money printer goes brrr, weakening investor psychology just as the stock market is at the most overvalued levels in history.  Not a good combination.  

Longer term, I don't believe the Fed will be able to raise interest rates, mainly because of their reaction function vs SPX.  With the SPX going up so high and getting more and more fragile as it goes higher, it would get crushed during the prelude to the interest rate hiking cycle, which would be QE taper.  Not many share my view, the Eurodollars market certaintly doesn't, as the first rate hike has been brought forward to 2022, contrary to the dot plots showing the first rate hike in 2023.  

I can picture the following scenario in 2022, which is contrary to what both the stock and bond market are showing:  

1.  A hot economy that leads the Fed to start tapering in the beginning of 2022, but a stock market crash happening in the middle of 2022 which stops the Fed in its tracks, preventing the Fed from completing their QE taper, effectively reversing the market's rate hike forecast and opening the door to yield curve control.  A real taper tantrum, not the weak one we got in 2013. 

2.  Republicans winning either the House or Senate, or both in the 2022 midterm elections, assuring that there is no more fiscal stimulus until November 2024.  Economy weakens without the drug of fiscal stimulus.  

3.  A bear market starting in 2022, and continuing into 2024 due to a lack of fiscal stimulus, and the Fed going to yield curve control and back to full blown QE unable to stop the bear market.   

Current market doesn't entice my interest, so thinking about what happens in 2022 and beyond.   A dull market, grinding higher every day to new highs on low volume, in a seasonally bullish month.  No thank you. 

I am not a masochist, I've mostly avoided fighting this bull market.  However, we're getting closer to a point where it is worth a shot to put on a short for a sell in May and go away scenario.  Was thinking SPX 4150 to start the short campaign, but probably won't be willing to put on big size on the short side until its closer to 4200.  And this is just for a short term pullback (3-5%), nothing major like 10% on the downside. 

As crazy as 4200 is, this sucker probably goes even higher later in the year (4500?)  just because of the bubble dynamics and the infrastructure stimulus carrot still in front of us.  You probably need to see the infrastructure bills passed AND the Fed trial ballooning a taper before you see a halt to the uptrend.  That's likely not happening until September, at the earliest.