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. 

Bond Market Carnage

Stocks are trying to fight the Fed and the bond market and its struggling.  The pain is real in the bond market these days.  This is probably the weakest bond market in the last 50 years.  SOFR/Eurodollars are pricing in 5% Fed funds for March 2023.  That's another 190 bps of hikes in less than 5 months.  There are some cracks forming in the bond market, as you are getting indiscriminate selling in the long end of the curve.  The Treasury auctions over the past several weeks have been quite weak, a sign that foreign buyers are not in a buying mood and US domestic demand is just not there as investors are still piling more money into stocks than bonds.  

There are so many things going haywire outside of equities (USDJPY hit 151!), yet US stocks remain remarkably well bid, refusing to make new lows as Treasury yields make new highs.  A few days ago, Jim Bullard, the loudmouth at the Fed, showed some signs that hawkishness has reached its peak, as he put conditions on the Fed rate hike path after December.  Its not much, but its a small sign that the Fed is starting to get a bit nervous about the economy, without wanting to give the financial markets any hints of a Fed pivot.  

The bond market is now taking the Fed's hawkish rhetoric and running with it, seeing how far they can take yields higher until either the stock market starts sinking to new lows or the Fed take their foot off the brake.  It appears that the stock market will have to sink to new lows before the Fed really changes its rhetoric.  There are still too many dip buyers holding up the markets, which just means the bond market will have to keep pushing rates higher until the stock market gets the message.  At these level of yields, further bond market weakness will flow directly to the stock market.  These are dangerous levels, running straight towards the edge of the cliff, without a parachute.  

As I am writing this, we just got a WSJ article from the Fed whisperer, Nick Timiraos, who is hinting that the Fed could slow down to 50 bps rate hike at the December meeting.  It doesn't sound like much, but the STIRs market was pricing in a 5% Fed funds rate, so a slowdown to 50 bps or less in December would be a sign that the Fed is aware that things are on the edge of breaking.  You had Yellen come out with a word about Treasury market liquidity last Friday, and now Timiraos getting word that the Fed wants to slow things down a bit in December.  

This little sign from the Fed will not reverse the damage that has been done to the economy by signaling a year end Fed Funds rate well above 4%.  But it could be enough to prevent a UK gilts type of scenario from happening in the US Treasury market.  A less hawkish Fed in November and December, which is probably the most likely scenario, will be a short term positive for stocks, and both a short and medium term positive for bonds.  It could spark a 3-4 week bear market rally, but not something that lasts into 2023.  You have a return of stock buybacks in the end of October, with most earnings out of the way.  November and December are historically heavy stock buyback months.  However, there just hasn't been enough of a reset in retail positioning in stocks, or the usual outflows that you see around bear market bottoms.  So there is still a long ways to go.  

Missed the SPX short waiting for a bit higher levels to put on a position, so just waiting on the sidelines for a higher probability trade.  The volatility is just immense in this market, something that the VIX is underestimating.  Regularly seeing 2-3% intraday moves.  The SPX is trading more like the Hang Seng index than a steady blue chip index.  The longer the SPX lingers under 3750, the more likely the top of the next countertrend rally will be under 3900.  Its the opposite of what you had to do for 13 years.  Instead of buying the dip, its short the rip. 

G-Force

Interest rates are the gravitational pull on equities.  It is what keeps equity valuations grounded.  The current Fed funds rate, 3-3.25%, is about to go to 3.75-4% in 2 weeks.  And then you will probably get another hike at the December meeting, taking Fed funds over 4%.  This is what the equity market is fighting.  The higher the interest rates, the more incentive stock investors have to sell their stocks and put them in either cash or bonds.  To put things in perspective, you haven't seen this level of interest rates since early 2008, but at that time, the Fed was forecast to cut rates even further, unlike now, when its the exact opposite.  

Yet valuation measurements such as P/E and P/B are not anywhere close to early 2008 levels.  Its at levels far above those you normally see at bear market lows.  Valuation is one thing.  You also have to look at supply and demand.  With elevated equity allocations among households as a group, and with an aging population that will tilt towards more conservative investments as time passes, you will see a steady allocation shift from stocks to bonds over the next several years. Corporate earnings will go down in 2023, everyone knows that, and when earnings go down, corporations reduce stock buybacks.  Its that simple.  

Its fascinating to see how investors think after the popping of the biggest bubble in our lifetime.  Its no wonder the downtrend after bubbles lasts for so long, and has many countertrend rallies on the way down.  People can't shake recent history, all those years when BTFD worked great and when downtrends ended within a couple of months, at most.  So even if they say they are bearish, they are not positioned that way.  Because it hasn't paid to be positioned bearish for the last 13 years.  13 years is a long time to condition the mind.  Its human psychology at work, and it keeps repeating throughout history. 

You can't be super bullish on anything, including bonds, over the next several years.  If I had to choose a long term investment, it would be commodities, but I expect a very rough stretch over the next 3-6 months for anything commodity related as you haven't seen a purge in investor expectations yet in that space.  There are still too many that are sticking to their bullish energy thesis based on Russian sanctions, the war, the shortage of natural gas in Europe, etc.  But the macro environment is horrible for energy right now.  China is sticking with zero Covid in the middle of their deflating property bubble.  OPEC+ didn't cut production just to defend price, they are seeing the demand going down and they didn't want to get caught with their pants down when it gets even worse.  

As for short term investments, I would choose bonds over stocks easily.  Its not even close.  Despite the poor performance this year, at 10 year yields around 4%, they are definitely going to be able to provide a risk off hedge in 2023.  Further Fed hikes beyond this year is wishful thinking as the economy goes into the tank.  I don't understand all those who are so negative on the economy, yet also so negative on bonds.  Its as if they assume that Powell will just keep hiking no matter what, which is ridiculous.  He showed his true colors for years before he even got picked by Trump, who loves low interest rates.  Why do you think Trump picked him?  Because Mnuchin told him that he was a dove.   He's not the second coming of Volcker or Arthur Burns.  He's even worse.  He's more like the second coming of Ben Bernanke than any of those guys from the 1970s.   

I look at the SOFR curve, and its pricing in a Fed funds rate of 4.90% by March 2023.  I look at that and I realize the front end of the yield curve is the most mispriced right now.  In the front end of the yield curve, you don't really have to worry about falling demand from foreign investors or increasing supply from QT.  Its going to move with short term rate expectations.  I expect Fed funds rate to be either 4.1% or 4.35% after the December FOMC meeting.  That would imply 75 bps in November and either 25 or 50 bps in December.  After that, I think the economy will be too weak for the Fed to continue hikes.  If they do, they will seriously wreck things up that will force them to cut quickly.  The stock market is not going to hold up into year end if the Fed signals another 75 bps for December.  Its already struggling, and any remaining dip buyers will be totally spooked if the Fed tries to follow through with current STIRs market pricing.  

We got another face ripper on Monday, basically the worse situation for bears as it gapped up huge off an ugly Friday and just kept going higher, similar to Monday October 3.  That rally lasted until the close on Tuesday, and took the market up 200+ points.  This time, a similar move would take the market close to SPX 3800 again.  That would be a level I would eagerly short.  With bonds acting like this, I don't see much room to go higher than 3800.  I don't expect another move towards 3500 until you get more bulls trapped and sucked in with a counter trend rally into November, which could take SPX up to 3900.  So we are in the consolidation/countertrend rally phase, and it should last from 3 to 5 weeks, before the next sharp drop.  I don't see a long and strong bear market rally like August, the conditions are just completely different with how much weaker bonds are now than back then.  Also, Fed funds rate is much higher now so the competition from cash is much more compelling as an alternative to stocks. 

Another Classic Event Day

What a face ripper.  Yesterday took the face off the shorts with a dull knife from open to close.  Its the crack cocaine for investors, the intermittent face rippers that get paper napkin chartists excited about bullish hammers and the paper napkin statisticians excited about breadth thrusts.  It has no meaning for the destination of this bear market.  And it has only a small edge in predicting the short term path.  

It all goes back to investor positioning around event days.  With the fear and uncertainty of another possible big down day on a hot CPI number, you had the market selloff for 5 straight days into the CPI number.  Investors have short memories.  They remember the cliff dive drops from past CPI numbers this year, and they were proactive in taking down long equity exposure ahead of it.  When long exposure is light ahead of a big, bad feared event, the weak hands have mostly sold, so while you can get a knee jerk reaction down on bad data, as stop losses get hit and short term liquidations occur, it can't stay down because a lot of investors who were nervous already sold down their positions.  And there were quite a few who were waiting to buy after the CPI, so you had buyers waiting for the uncertainty to clear to go in.  It only helped the situation for the bulls when the gap down was so large that it felt like a short term capitulation that flushed out any remaining weak longs. 

And as the market started rallying, you got the short squeeze for those who put on daytrading shorts after the hot CPI release.  And don't forget all the put hedging that went on the past few days, to hedge the event risk.  All of that got unwound as dealers had to delta hedge their short put exposure by buying index futures as the market went higher.  And this is a negative gamma environment, so dealers exacerbate moves because they have to buy when it goes up and sell when it goes down.   

A day later, after the dust has settled, that hot CPI number doesn't really change anything.  The STIRS market was already pricing in nearly 100% odds of a 75 bps hike in Nov., and it remains that way.  It did price in much higher odds of a 75 bps hike in Dec., as well as a higher terminal Fed funds rate, up to 4.85%.  If you think the Fed will still remember this CPI number at their December FOMC meeting, or any meeting after that, I have a bridge that's for sale at a bargain price.  

And no, the Fed will not go 100 bps due to this number at their November meeting.   If they did, it would invert the yield curve like you wouldn't believe and crash the stock market so fast it would actually speed up their pivot, not slow it down.  

If you read the FOMC minutes, it was more neutral then the initial hawkish reaction in September.  Here is a quote from the minutes that tells you they are not completely oblivious to the damage going on:  “it would be important to calibrate the pace of further policy tightening with the aim of mitigating the risk of significant adverse effects.” 

The stock and credit markets are likely to have major convulsions before the CPI or NFP numbers get to levels that the Fed is comfortable with.  Then it will be up to Powell to make his call.  Cause an even bigger recession waiting for the CPI to get down close to 2% or cry uncle and make a U turn, making everyone at the Fed look like fools again for their shoddy forward guidance.  Looking at Fed history, I'll put my money on the side that he cries uncle and gives up on his Volcker Jr. act.  

It appears the bond vigilantes are back in some countries, with the UK being the latest addition.  U-turn on the mini-budget that caused a huge stir, sacking Kwarteng, the guy who came up with that mess, etc.  If the UK gilt market didn't selloff so hard, none of that would have happened.  Without QE, the bond market can put extreme pressure on politicians trying to pass budget buster legislation.  But that trend will not last for long.  The temptation to do QE to act as a quick fix is too great.  Its always much easier politically to have the central bank buy up the bonds that they issue to finance their huge deficits, keeping rates artificially low and letting the currency be the release valve.  More people will complain about losing money in their stock and bond portfolios than about a drop in the value of their home currency.  

Post CPI, the SPX has room to run up higher, as the biggest event for the month is over.  With all that de-risking you saw over the past few weeks, there is a decent amount of potential energy for a bounce.  You could definitely see a relief rally back up towards 3750-3800 by next week.  It would be another good short selling opportunity if it happens.  Neutral at the moment.  I would focus on retail favorites as the best short candidates in the next bear market rally.  Unlike hedge funds, retail investors are still highly overweight stocks and will eventually be underweight by the time you reach the bottom of this bear market. 

Repeating Lies

"If you tell a lie big enough and keep repeating it, people will eventually come to believe it."  - Joseph Goebbels, Nazi propagandist

Lies = Fed forward guidance.  The Fed is as united as they have ever been.  Its almost as if they met and said, "hey, we've got to talk hawkish to get inflation expectations down and financial conditions tighter, no matter what."  And they've repeated their hawkish rhetoric, all of them, over and over again, to the point that investors who are losing money are getting sick of hearing it.  For the few weeks where they backed off of forward guidance in the middle of the summer, they soon realized how insignificant they felt, how the market was going where it thought it should go (higher stocks and bonds), and they didn't like it.  So they went right back to doing forward guidance, but this time all in synchrony and on full blast.  

The Fed's forward guidance has such a terrible track record, that its puzzling to see the Fed governors complain about the STIRs market pricing in a rate cut in 2023, contrary to forward guidance for no cuts in 2023.  Frankly, I'm surprised the STIRs market is pricing in just one 25 bps rate cut for 2023, because the Fed has a history for terrible predictions about future policy, and they've tended to cut fast and big when they see the economy getting very weak.  And most signs are pointing to a very weak economy in 2023.

The Fed is fighting the bond market, and its winning, for now.  Whenever the curve is inverted this much, its because Fed policy is too tight.  But the bond market is an arbiter of truth (as long as the central banks don't do QE), and will eventually break the shackles of Fed forward guidance when the recessionary evidence starts mounting.  And it is starting to add up.  The weak ISM number last week, the big drop in job openings, and the various earnings warnings over the past few weeks.  There is a global recession happening, but the data that the Fed watches lags, so the Fed has cover to talk a hawkish game.  But not for long. 

All that consumer spending on goods in 2020 and 2021 means many pulled forward their purchases with the help of fiscal stimulus.  That fiscal stimulus is mostly gone, there is still a bit here and there, gas stimmies, electricity bill stimmies, etc, but those are minor compared to the big bazooka in 2020 and 2021.  Inflation has also done a good job of eating into consumers' purchasing power and excess savings, reducing demand.  M2 money supply growth is barely positive for 2022, which is a huge break from trend, when its averaged around 7-8% annually since 2000.   M2 supply growth feeds to inflation with a 12-18 month lag. 

With limited fiscal stimulus in 2022, and likely to be limited new fiscal stimulus in 2023 and 2024 with Washington gridlock, the biggest driver of inflation, excessive fiscal spending/tax cuts, will be absent.  Add to that, a Chinese economy that will be dealing with the popping of a huge property bubble and Europe that will be dealing with high electricity prices for the next few years (reducing discretionary spending), and you have the ingredients for a disinflationary wave.  Very few people are talking about this possibility.  Almost all I hear from the 5 minute macro experts is secular inflation, energy and commodity inflation due to supply concerns, a tight labor market, stagflation, etc.  I hear very few talk about a disinflationary cycle that lasts until 2024, due to the lack of a big fiscal stimulus wave and low population growth in the developed economies and China.  

The dirty little secret about inflation is that fiscal policy is more important than monetary policy in determining the inflation rate.  Powell can try to be Volcker Jr. as much as he wants, if the White House and Capitol Hill go on a deficit spending binge, inflation will go up, even with higher rates.  Just look at Argentina.  Last I checked, their interest rates were at 75% and their inflation is out of control.  In fact, over the long run, it can be argued that if you keep rates high, the interest income that flows from the Treasury to bond investors is a stimulus paid for by higher deficits. 

It is interesting that there are more people trying to play for a technical bounce in stocks than in bonds, even though the main catalyst for a bounce would be weaker economic data / lower inflation numbers, which usually benefits bonds more than stocks.  Really the only fundamental reason for buying stocks is to play for a Fed pivot based on peak hawkishness.  All of the leading indicators are showing earnings going down bigly in the next few quarters, so earnings will be a drag on stocks.  And valuations are still too high considering the higher risk free rate and dropping forward earnings estimates. On a pure valuation basis, stocks are expensive to bonds, but there have been more inflows into stocks than bond funds in 2022. 

There is a lot of talk about the Fed pivot, but there is no clear definition of it.  Its generally accepted that the Fed is a long ways from pivoting, or at least there needs to be a few weaker than expected CPI reports and nonfarm payroll numbers.  Unlike what most investors think at the moment, the bar has actually been lowered for a Fed pivot because the Fed funds rate is already 3-3.25%.  If the Fed funds rate was 1-1.25%, even some things breaking wouldn't get the Fed to pivot.  But at a Fed funds rate of over 4% by year end, which is almost guaranteed, it won't take much for the Fed to start talking less hawkish or gasp, even a bit dovish.  And I expect the economic data will start coming in much weaker which will also make it easier for the Fed to take their foot off the brake and stop and assess the damage. 

Covered the remaining shorts yesterday and now just long some Treasuries.  Don't want any short exposure going into the CPI number on Thursday, as I think a lot of the selling since Friday has been investor positioning ahead of the CPI.  This is a very different situation than before the CPI in September.  The SPX is down over 500 points from pre CPI levels in Sep., and bond yields are also much higher.   The hurdle to get the market to selloff on a hot CPI is much higher.  Neutral on stocks at the moment, but a bounce later in the week wouldn't surprise me. 

Spring Season for Bears

Shorting is not natural for most investors.  It presents a unique edge for those willing to go short just as easily as they are to go long.  During a bull market, that edge actually turns into a handicap, as those with a willingness to short don't put a short leash on that dog.  They short when the odds aren't completely favorable, or even during a raging bull market, when the market doesn't give short sellers any air.  But that handicap turns into an advantage in a bear market.  

My bearish tendencies has been a big handicap since 2008.  Its made me short in suboptimal spots, and more importantly, I missed a lot of good chances to get long and ride the bull trend.  And valuations weren't outrageous for the first few years of the bull market, yet I was still too cautious.  Huge opportunity costs along the way.  I did eventually adjust to playing the game in a QE world of excess reserves and TINA, but it was a rough road to get there.   

Shorting has been difficult for so long since the US stock market has spent most of its history in a long, strong bull market.  This has taught investors that shorting is hard, and a loser's game, as you can see from the miniscule amount of money in short only hedge funds vs long/short, macro, event driven, etc.  Its taken for granted that the stock market will always go up, cranking out average returns between 8-10% per year.  But that's a false assumption.  Just look at Europe, Japan, China, etc.  Stock markets that have been in sideways to down markets for several years to decades.  Investors in those regions have a much different view on stocks than those in the US.  It is no wonder that the equity valuation gap is the biggest its ever been between the US and Europe. 

At least the bulls and bears have one thing they can mostly agree on:  we are in a bear market.  The best way to profit in a bear market, especially an inflationary bear market, is to short stocks.  In non-inflationary bear markets, its actually much easier and safer to just buy bonds.  That's what's made this environment so nerve-wracking for investors.  They are used to having bonds provide a hedge against stock market weakness.  Its been a positive carry equity hedge for 40 years.  Shattering that hedge has big consequences forthe  risk appetite for investors.  Those consequences don't go away after a run of the mill bear market that ends in 9 months. 

But in a strong bear market, especially after it comes from a long, extended bull market that ends in a huge bubble, playing the short side becomes easier than playing the long side.  Its an uncommon time, in stock market history, but one that gives an edge to those who are willing to take on short positions and hold them for weeks.  There aren't too many speculators who are willing to do this.  Those that are have been burned numerous times over the years shorting in a downtrend, only to see it end prematurely due to easy Fed policy.  So you have a fairly small group now that are actively shorting the indices for longer term moves. 

If you a natural bear, you have to take advantage of this bear market because so many things are lined up in your favor.  Its rare to have the central banks actually on your side!  In a post-bubble, downtrending market.  Its so uncommon that its actually confused a lot of stock investors, making them feel bearish, but years of bull market conditioning make them reluctant to sell their stocks so far down from the highs.  Retail investors were brainwashed into buying stocks at the top in 2021, in the largest volumes since 2000, the total opposite of what they were thinking from 2008 to 2016, when they were reluctant to buy stocks after the 2008 carnage.  And they've only recently started to sell, and its been just a trickle.  They are heavily invested.  

The Fed pivot, the great hope of the bulls, will not be the savior that many think.  A Fed pivot would be good for bonds, but if the Fed pivoted with SPX where it is now, stocks will still be too overvalued given the fundamentals.  High interest rates are not the only problem for stocks.  Its a economy that can now only grow strongly on a nominal basis with a expansionary, populist fiscal policy.  A midterm election with Republicans taking the House (almost guaranteed) would be gridlock, so it will be almost impossible to pass pork stimulus in 2023-2024.  There is no more organic, secular growth in the US.  The internet was a once in a lifetime game changer.   Globalization and labor arbitrage on the scale that happened over the past 20 years will not be repeated.  There are no positive game changers coming in the near term horizon.  

We got OPEC+ cutting 2mb barrels of production at a time when oil is trading above $80/barrel.  OPEC+ is now using their price fixing skills to maximize revenues as much as possible without getting too much pushback and complaints from the rest of the world.   This is a negative for those hoping that inflation will come down quickly.  It also makes the Fed's job harder as it is now fighting both sticky inflation in housing/services as well as a potential rebound in energy prices due to OPEC price manipulation.  

I am a bit surprised that OPEC drew the line at $80/barrel but it seems like they see demand dropping a lot more than they are willing to admit.  The oil market is not as tight as all the energy bulls will have you believe.  Otherwise, OPEC would not need to do productions cuts.  Long term, I do expect oil prices to go a lot higher due to supply constraints, but cyclically, its not a bullish time for commodities.  

Bonds seem to have found a top in yields as the 4% 10 year yield area has lots of resistance, going back to 2009 and 2010, and is close enough to the terminal rate of this rate hiking cycle to attract fixed income buyers.  The stock market rally on Monday and Tuesday is largely based on the hopium of the Fed being less hawkish based on bad news like Credit Suisse, gilt market last week, and a disappointing ISM number.  But it looks like the stock market is running with that hopium a lot more than the bond market, which has given back most of its gains that it made earlier this week.  It once again reaffirms the belief that the stock bulls are still clinging to hopes of a "strong" bear market rally, like what you saw from June to August, while the bond bulls have mostly been extinguished and are reluctant to buy the hope of a Fed pivot until they actually see much weaker econ. data come through.  

Re-shorted what I covered on Friday into the rally on Tuesday.  Keeping it simple.  Covering on deep dips to free up cash to sell short term rips.  With nonfarm payrolls on Friday and CPI next Thursday, expecting investors to be reluctant to pay up going into those data points. 

The Elephant in the Room

If you are usually a bear, these are the times where you have to rack up your points, because bear markets don't come around often. And when they do, they usually don't last anywhere as long as bull markets.  Most investors are natural bulls, as they have faith in past stock market history continuing forever, believing that the last 100 years will repeat over the next 100 years, and that annual 8-10% stock market gains are a given.  Bears like me think that's preposterous, thinking that kind of future return is only possible in a high inflation environment that's tolerated by the central bank, politicians, and the masses.  That kind of optimism in the US stock market ignores what has happened in the stock markets in Asia and Europe in recent history, even during a falling rate environment.  

Those who are pessimistic about the market point to valuations, past bear markets, leading indicators, current economic trends, structually higher inflation from commodities, and a higher interest rate environment with a hawkish Fed as reasons to be bearish.  Those who are optimistic about the market point to bearish sentiment and the oversold technicals.  One side carries a lot more fundamental backing while the other side is expecting some greater fools will start chasing stocks again when there is a rally, creating a tradable bounce.  Anything can happen, but when the weight of the evidence overwhelmingly favors the sell side, then I just end up having conviction and better luck trading that side.  The buy side seems to be looking at the markets from a much shorter term time horizon, looking for a bear market rally, and that speaks volumes about how much conviction they have.  There are many that are looking to sell a bounce.  And I don't see too many who would be willing to chase prices higher for more than a few days.  So logically, the rallies should be short lived.  

This is not like the June lows, when there was still hopes of a quick, relatively painless Fed rate hiking cycle, as reflected by the big rally in bonds from mid June to early August.  Also there were still lots of hope for a soft landing.  This time, the Fed has been more concrete about their rate hike plans, and Powell has backed himself into a corner, and he would lose face, as well as some credibility if he didn't back up his tough talk with tough actions for at least another meeting or two.  And now, most expect a recession, unlike 3 months ago, so they won't be as many suckers with FOMO zealously chasing the market, as if the bear market is over.  

You are seeing more signs of stress in the FX and fixed income markets, as governments are resorting to interventions to keep things under control.  That's not a sign of a healthy environment.  And I don't think Credit Suisse is a big deal.  That's a red herring.  That's meaningless.  The elephant in the room is the Fed, and they are taking a huge dump on asset markets.  It is all that matters.  Even if they pivot, its not going to lift markets for long unless they start signaling cuts.  A pause and less hawkish talk will not be enough, especially if Fed funds is over 4%. 

Its an odd market.  Usually when you see such a sharp move down, basically straight down since the CPI release 3 weeks ago, you get more fear and a reluctance to buy the dip.  But its almost as if I see more fear from those short who are looking to lock in gains for fear of losing it back in a bear market rally.  Up until late Friday, I could sense the dip buying bulls looking at that double bottom on the charts, feeling confident that there would be a short term rally before further selling.  You could see it in the mediocre put/call ratios for a big down day on Thursday, and even more complacency on Friday on a small up day, with put/call ratio trading below 1 until the last 30 minute selloff.  

And the COT data confirms this, as speculators were heavy buyers while the SPX went from 3855 to 3647 from 9/20 to 9/27.  That's a pretty bearish combination, a sharp selloff and speculators buying into it. 

The lack of any counter trend rallies during the post CPI downtrend tells you a lot about the market.  Its not common to see such consistent selling, with almost no relief for the bulls.  The one big up day last week was immediately taken back the next day.  

One bullish sign, albeit small, is that you are finally seeing the generals get punished, as AAPL and TSLA are now selling off more than the market.  Its when investors start liquidating the winners that you are getting late in the selloff.  Its not an exact timing tool, but it does make me want to reduce shorts a bit, all else being equal. 

 Its been a while since we've had a nasty close.  Even on some big down days lately, there has been that closing hour mini ripper into the close, just to put a little seed of doubt into the short sellers, and give a bit of hope to the bulls.  It was probably daytrading short sellers who wanted cover and not take home shorts overnight.  

I actually covered half of my shorts near the Friday close just to have some more dry powder just in case the bulls try to run it up again this week, as fund flows in the new month could provide a bit of a bounce.  There are still too many looking for a bounce for me to want to cover all my shorts, although we are inching closer to my target of SPX 3520.  

We have a gap up in stocks and bonds off that weak close on Friday, as first day of the month automatic fund flows buoy the market.  This is inelastic money so its going to buy regardless, and there are still die hard bulls who blindly just plow money into stocks on a regular basis.   And now that the much feared September behind us, you have the optimists with renewed hopes of a better market.  With nonfarm payrolls and CPI coming up in the next several days, I don't expect buyers to aggressively chase the market higher.  If we get a rally today towards Friday's highs, I will probably put on those shorts again that I covered. 

Bond Market Fear and Loathing

The bond market has come unglued in the last few days.  This kind of bond volatility (to the downside) in a weakening economy must be taking out some leveraged players that we may hear about later.  As much as Treasury yields have moved recently, yields in Europe have been even more violent.  Treasuries have started pricing in the worst possible scenario for Fed tightening, and the massive losses in the past few days have infected the long end of the curve, as the short end led the selloff late last week, and this week, its been the long end taking the brunt of the punishment.  

Bond investors and stock investors are just different.  Those who buy bonds are conservative, and are looking to protect capital while collecting some yield.  They eschew risk, and are more easily unnerved when losses get big.  2022 has been a heart attack for bond investors, and I'm sure a lot of retired elderly parked out in bonds expecting their assets to be safe have gotten a rude awakening.  That's why you've had this big selloff when everyone realized that the Fed really has blinders on, hawkish blinders, raising rates relentlessly, economy be damned.  Bond investors have been taking more punishment than stock investors, as you can see by this chart:

Take a look at the 3 month performance of TLT, AAPL, and TSLA.  TSLA is up 19.7%, AAPL is up 6.7%, and TLT is down 9.6%.  

Stock investors have quite a different view of the current market than bond investors.  As much as I hear stock investors being bearish and pessimistic, they haven't sold much, while bond investors have been more quiet, but much more terrified of this market, selling down, as you can see in the fund flows for stock and bond funds.  

They are no longer piling into equity funds, like they did in 2021, but they haven't really sold much either. 

Based on relative valuations and the outflows that have already happened in bonds, I am getting quite bullish on the prospects for the bond market over the next 3-6 months.  At 10 year yields near 4%, you are turning the tables on the risk/reward for bonds vs stocks, making this the best time to be in bonds vs stocks since 2000.  I expect the inflation rate to be higher over the next 5 years than it was between 2000 and 2005, but the organic growth rate of the US is much lower than it was back then.  And the level of indebtedness is much greater now than back then, with a much more financialized economy that can't function well with higher rates.  So 4% in 2022 is akin to 6% in 2000.  

There is recency bias in the markets that has encouraged US stock investors to hold on when the markets go down, because it always goes back up.  Since the end of the bear market in 2009, deep losses in 2010, 2011, 2015/2016, 2018, and 2020 were all erased in less than 6 months, usually taking less than 3 months.  This has conditioned stock investors to just hang on and not sell, which has been the main reason they haven't budged despite sounding off about their bearishness in those sentiment surveys which have become nearly useless in 2022.  A bunch of fully invested bears.  2022 has been the first time in 13 years that you've actually had an established downtrend that has made lower lows and lower highs for more than 6 months. This is catching a lot of investors off-guard, way overexposed to risk parity, with not enough cash to buffer the volatility. 

Unlike stocks, there is not much of a recency bias in the bond market.  Bond investors are normally much more cautious and less sanguine about future bond returns.  They are just looking to get some yield while not risking too much money.  They don't expect ever higher prices and lower yields.  And with all the talk about inflation and how hawkish the central banks are, you are getting levels of pessimism that are quite extreme, and don't reflect the reality that leading indicators of inflation which are trending lower.  If you look at money supply growth and commodity markets, you can expect inflation to come down more than people expect in the first half of 2023.  That will coincide with the end of the Fed rate hiking cycle. Those are 2 potent bullish catalysts for bonds.  

The momentum is clearly bearish in the bond market, but the past few days since the FOMC meeting have been panicky selling, more than a big repricing of inflation or Fed rate hike expectations.  I am still holding a small bond position, while remaining short SPX/NDX.  Still see too many dip buyers who expect a short term rally, so rallies are likely to be quickly sold.  The fundamentals are much worse now than it was back in June at the same price levels.  And we are that much closer to the real economy entering a big slowdown.  

What the Bank of England did yesterday shows how much stress is accumulating from the plunging global bond markets.  Optimism from one off interventions are not bullish for stocks.  Only continuous interventions via QE programs can affect market pricing for the intermediate to long term.  Saving the market with these interventions without any change to their monetary policy will do nothing for the long term trajectory of the market.  They are just short squeeze events.  

More so than a strong dollar, a weak global bond market is more troublesome for stocks and the economy.  Until you see a strong sustained bounce in bonds, which doesn't look likely until at least the next CPI release, on October 13, stock rallies will be quickly sold as there will be nothing fundamental to latch on to for the bulls.  The bears are trading the fundamentals.  The bulls are trading the technicals (hoping for an oversold bounce).  

I think 4% 10 year yields should provide a short term floor for bonds, but there is so much damage going on in the bond market, bonds are trading like distressed assets.  There is potential for overshoots to the downside.  But once you get past the next couple of weeks, I think the sidelined buyers in fixed income will come back as the dust settles on the carnage, with good values left behind. 

No More Free Lunch

The 1980s to 2021 has been a great time to be a stock and bond investor.  Risk parity seemed like a free lunch of protecting downside while collecting coupons through bonds and getting dividends and capital gains through ever rising stock prices. The best of both worlds.  Downside protection through bonds and upside through stocks.  Both positive yielding.  That free lunch is over. 

Its been an amazing time to be a US stock investor for the past 13 years.  And its mainly because of one thing: profit margins.  The profit margins for S&P 500 companies has gone from a cycle peak of 7.5% in 2000, 9% in 2006, 11% in 2018, and 13% in 2021.  Those are fat profit margins.  

The rise in profit margins from the 1990s to 2021 coincides with a decrease in the cost of debt funding, as investment grade corporate bond yields have steadily gone lower, tracking the fall in 10 year Treasury yields.  

Notice how the recent sharp increase in investment grade bond yields coincides with the sharp drop in profit margins in 2022Q2.  

There are other factors that have contributed to the sharp drop in profit margins recently.  First, the revenue boost from massive fiscal and monetary stimulus has come and gone.  Second, the rise in commodity and housing inflation are net negatives for corporate profit margins, as discretionary spending gets reduced when the cost of necessities increase (food, energy, housing).  Less consumer spending on discretionary items hurt the S&P 500 as a whole.  The main beneficiary of commodity/housing inflation are a small portion of the SPX and are not well-represented in public financial markets (private market real estate investments).  

If you are a believer in secular commodity and housing inflation like I am, you have to believe that stocks will struggle in the coming years.  

I haven't even gotten to the cost of labor.  In a tight labor market where the working age population as a percent of total population is steadily shrinking, the productivity of the overall population decreases, as the growing elderly population are net consumers, and produce very little, while collecting Social Security and consuming subsidized medical services via Medicare.  This is a net drag on productive capacity in the US, while increasing federal outlays.  With fewer workers relative to the total population, you end up getting increases in the cost of services, as wages go up, a supply-demand phenomena exacerbated by huge federal budget deficits.  

Higher wages for the same productivity, or less, considering the growing trend of work from home (reduces productivity), and that hurts profit margins.  And that doesn't even get to globalization and labor arbitrage scraping the bottom of the barrel in China, where the excess labor coming from rural areas is near its end, and higher political cost of outsourcing to China as US-China relations continue to get worse.  

With the oligopolistic pricing power of many of the S&P 500 corporations, can't they just raise prices to maintain their profit margins?  Yes, they can, and that will exacerbate the inflationary pressures in the economy, and just guarantee that inflation stays high and the Fed keeps rates higher than they would otherwise.  In a labor and energy restrained world, inflation is the release valve, to relieve the pressure caused by a supply limited environment.  Also, at some point, raising prices on consumers is counter-productive as they will just either find alternatives or will be constrained from buying due to high energy/housing costs. 

Seeing how the US, UK, and other countries have reacted to high inflation, they've decided to fight fire with fire.  Basically handing out more money to the public either through stimmy checks or by capping prices on electricity bills/reducing gas taxes.  That's a recipe for a secular stagflation where central banks will either have to go back to financial repression and negative real rates to keep the economy going at the cost of high inflation or have positive real rates and kill the economy to keep inflation under control.  Its no longer a free lunch environment where cheap overseas labor and ever increasing oil and gas supplies allowed the Fed to print gobs of money without any inflationary consequences.  Under resource constraints, the Fed has to now weigh tradeoffs between lower inflation/lower growth or higher inflation/higher growth.  No more free lunch.  

Its been a sharp selloff after the FOMC meeting, much quicker than I thought would happen.  It just underlines the weakness in this market, where it gives you very little time to sell rallies and gives you plenty of time to buy weakness.  I remain short and not in a rush to cover.  Sure, the put/call ratios got very high on Friday and you are seeing some dislocations in the FX market.  But considering how weak the bond market is, I would expect the June lows to crack sometime soon and that will probably usher in some panic as we hit new 52 week lows in SPX and finally start flushing out some of those diamond hand retail investors who haven't budged in their equity allocations.  The low DIX reading on Friday (40.3%) after high readings for the past few weeks is the first sign of the retail investor cracking.  Will need to see several more days like that to have me believe that we can put in a tradeable bottom, where I will cover shorts. 

Ignore the Noise

There are so many wiseguys out there, they lose the forest for the trees.  Sometimes I am one of those wiseguys, but the macro situation is just so over the top bearish that you have to resist the urge to play the long side when you see these huge face ripper rallies happen from time to time during this bear market.  It is tempting to try to make money playing both sides, especially in a bear market when big moves happen quickly, and markets go up just as fast as they go down.  

But 2022 is the polar opposite of the 2021 market.  In 2020 and 2021, stocks spent very little time at the short term bottoms, as most of the bottoms were V bottoms with almost no consolidation near the lows.  It didn't give investors much time to buy the lows, which is very bullish.  So longs had a much wider margin for error, as they could take their time to sell, because most of the time, the markets were spending their time near the highs, so they didn't have to be precise when exiting their longs.  For the shorts, it was hell, as if they missed the occasional short term bottoms to cover, they were squeezed relentlessly as the markets grinded higher.  In 2022, you are getting repeated chances to buy short term lows, and the longs don't have a big margin for error.  The market is spending a lot less time at the short term highs, as longs are eager to sell any strength.  On the other hand, shorts have repeated chances to cover near the lows (sole exception was from mid July to mid August), giving them a much larger margin for error when exiting their positions. 

All this week, leading up to the FOMC meeting, I heard fast money traders and investors proclaiming that 75 bps was priced in, and that the market would have a relief rally after the FOMC announcement.  They probably won't admit it, but huge rallies in the March, May, and July FOMC meetings seeped into their brain, and they were subconsciously conditioned to believe that the market rallies on Fed days, even after big hikes.  Well, yesterday's selloff was the payback for investors being complacent about the FOMC meeting, even as Powell gave you a warning shot at Jackson Hole, that he was going to be as hawkish as possible.  I am sure yesterday's big selloff probably reset that conditioning and put in some doubt about the market outcome at the next FOMC meeting.  

One of the most important things that you can learn when playing the markets is that you will regularly lose.  Fear of losing, or giving back gains, is what leads to overtrading and trying to play every wiggle in the market, trying to buy low and sell high.  You have to have humility in this game, and realize that you can't predict all the ups and downs.  I am guilty of micro trading, trying to avoid drawdowns, but most of the time, it doesn't really add value.  

But you can predict some ups and downs, and that's when there is opportunity.  In trade selection.  Most of the time, there is no short term edge.  However, there are often longer term edges, which is less obvious because they play out over several weeks and months.   Having the luxury to play longer term time frames and be able to take drawdowns to ride the position to fruition, through the ups and downs is an edge.  One of the main reasons hedge funds underperform is because of month to month reporting, which shortens their time frames, making them unwilling to take short term pain for long term gain.  

I've been pondering how to play the upcoming economic downturn which many are underestimating.  Short SPX/NDX or long Treasuries/STIRs?  The trend obviously favors short equities, as that trade is working and it has fewer holes in the thesis, as it works when the Fed remains hawkish and inflation stays high.  But it is vulnerable to Fed pivot risk, which I believe is closer than most think (probably by November or December).  The long Treasuries/Eurodollars/SOFR trade has the obvious big hole of a Powell that is trying to be Volcker Jr., and panic puking of positions from those losing money in bonds if there is further weakness.  But the long bonds/STIRs trade will work great when the Fed pivots, and could explode higher when that happens.  Also, the positioning in bonds is light, which would make it easy for investors to increase their bond allocations from both cash and equities.  At the moment, I'm both short SPX/NDX and long Treasuries, with a bigger allocation to my shorts than my longs.  

In the coming weeks, if bonds continue to selloff and I see more signs of capitulation there, I will likely reduce my short equities position to increase my long Treasuries position.  At the moment, I prefer the short equities trade because of the uncertainty that's looming over the bond market, with regards to how far Powell will hike and how much pain he's willing to take before he cries uncle. 

Re-shorted yesterday pre-FOMC meeting, and will hold that short until I see some signs of panic, nowhere close to that yet.  The bond weakness tells me there is going to be a lot of pain ahead for the stock market.  Valuations are ridiculously high considering the financial conditions.  I know they say everyone is bearish, but ignore the crowd and focus on the fundamentals. 

Tightening the Noose

The lagged reaction function of the global central banks is wreaking havoc on historical patterns of the economic cycle and stock and bond market prices.  In a typical economic cycle, you see the central banks steadily raise interest rates after the recovery is well underway, with unemployment rate going down and inflation going up.  This allows for the economy to slow down more gradually.  This time, due to political reasons, Powell disseminated the lie of transitory inflation in order to keep rates low and ensure another term as Fed chair.  He had to fight off Lael Brainard for the spot so he put on a very dovish front in order to seal the nomination last fall.  That delay only exacerbated the bubbly animal spirits at the time and extended this high inflation period by several months.  

Remember, inflation acts with a lag, especially core inflation, so whatever fiscal and monetary policy enacted in 2021 will still have lasting effects well into 2022.  The unprecedented rise in M2 money supply in 2020, coming mainly from monetized stimmy checks, forgiveable PPP loans, giant child tax credits, and huge pork packages was the rocket fuel to feed the inflationary fire that's lasted for the past 20 months.  Forget about what the 15 minute macro experts say.  Inflation didn't come from Putin's war or from supply chain issues.  It came from a massive printing of money and enormous stimmy packages.  If you don't hand out free money to fuel record breaking demand for goods, you don't have supply chain problems.   

Just 5 months ago, the Fed funds rate was 0.25-0.5%.  Interest rate increases work quickly in the financial markets, but act much more slowly in the real economy.  The real economy will feel the brunt of the rate hikes in 2023, well after the top in bond yields.  This lag effect will be especially painful this time around, due to the speed of the rate hikes, going from 0 to 400 bps in 9 months (assuming market pricing is correct and the next 3 meetings have hikes of 75 bps-50bps-50bps).  Really the only way for the tighter monetary policy to quickly affect the real economy is by tightening financial conditions so much that you start seeing much lower stock prices and real credit stress,  which quickly leaks into the economy as corporations have to sell bonds at abnormally high yields to raise capital, and cost cutting becomes more urgent.  We're not quite there yet, but that's the direction we're heading.  And more quickly than people think.

I am already hearing anecdotes about corporations issuing high yield debt having a hard time getting deals done.  Fedex earnings warning was just the tip of the iceberg.  There will be more canaries in the coal mine, as higher rates, tighter monetary conditions, and much weaker global growth start to weigh on corporate earnings.  In this type of toxic environment, where the central banks are tightening the noose on the neck of the bulls, you have to throw out the 2009 to 2021 playbook.  Sentiment will be bearish, and you have to accept that as the norm now, as bearish sentiment is the default stance of market participants in this environment.  Bearish is the new neutral.  Neutral is the new bullish.  Only when things look really horrible, and after extreme price moves, can you lean on bearish sentiment as a tell for an imminent rally.  In the past, this kind of bearish talk among the investment community usually led to a big rally that lasted weeks, but these are not normal times.  75 bps for 3 straight meetings is NOT normal.

I covered yesterday after seeing some signs of dip buying and short covering, and to avoid the upward drift that is common a day or two ahead of the FOMC meeting.  Big selloffs going into the meeting often result in short covering rallies a day or two ahead of the event.  Once the event is over, the shorts usually come back to sell what they covered.  We've rallied big in the past 4 FOMC meetings.  That will be on the mind of the short sellers who are still short, and I expect some short covering from them heading into the meeting.  

Its a little bit of game theory, but this FOMC meeting should play out a bit differently than the others, just because Powell has put himself in a box by his hawkish words at Jackson Hole.  He almost has to come out and put on his most hawkish act, just so he doesn't look like a pivoting pansy again.  That could pour cold water on any expectations of him doing his usual dovish mealy mouth press conference, leading to a selloff during his press conference.  

The shorts I covered yesterday, I will probably put back on tomorrow ahead of the FOMC meeting.  I feel empty without having shorts on in this environment. 

Bonds are weak again today, I'm long a bit from late last week, and not too eager to add more right way.  After such huge losses in bonds this year, its going to take a while to consolidate at these higher yields before you get the change in trend.  There will have to be more overt signs of recession before you can get more investors selling equities and buying fixed income.  Equities have been the place to be for so long in the US, that its going to take some time to shake that BTFD psychology.  As that psychology changes, you will see retail equity holdings as a percentage of assets go down.  Its still near the highs of the past few years.  That will be the future supply that fuels the next leg down of this bear market.  The first leg down was fueled by hedge funds reducing equity exposure.  The next leg down will be retail reducing equity exposure. 

Overtightening Fears

The market teaches you a pattern and investors eventually adjust to it, and then the pattern changes again.  This year's lesson is that stocks and bonds can go down together, and that inflation was not transitory.  The Fed, always late to the game, finally realized that inflation wasn't going down and slowly reacted to the bond market signals in the spring which was pricing in many more hikes than the Fed was saying in their forward guidance.  If the bond AND stock market wasn't going down so much due to high inflation, you think Powell would have gone from 25 bps to 50 bps and eventually to 75 bps?  I doubt it.  The market was panicked about high CPI prints that kept beating expectations, and the Fed got the message, and reacted with bigger hikes and more hawkish talk.  

Fast forward to now.  The bond and stock market are both going down, but is it really because of high inflation?  The CPI number on Tuesday would have many believe that the market is going down again because inflation is way too high and not coming down fast enough.  But I think its for another reason.  The stock market is going down not because of inflation, which real-time reports show as slowing down, even housing.  The market is going down because they think Powell will now go unhinged, hell bent on trying to be Volcker Jr., and overtighten and make the recession even worse.  Its no longer inflation fears, its Fed overtightening fears.  A big difference. 

The whispers are beginning.  They aren't strong statements at the moment, but they will get louder and louder as time goes on.  Its the market's fear of a Fed policy error, this time, by being too hawkish and hiking rates too much.  I am already hearing some talk of a Fed policy error being discussed by those esteemed members of CNBC Fast Money.  I also heard a CEO come on CNBC saying that the Fed is hiking too fast, and should slow down, as the economy is weaker than most think.  

If you can sense when the Fed will pivot, you have the keys to the castle.  A Fed pivot at this point would just be to signal a pause, not even rate cuts.  Now that most market participants and analysts seem to have bought in to Powell's hawkish rhetoric, you are seeing some extreme pricing in the STIRs market.  The 2 biggest short term interest rate markets are now shared by Eurodollars and SOFR.  SOFR is a better representation of the Fed funds rate, as it removes bank credit risk.  

 

The SOFR futures are pricing in a Fed funds rate at 4.40% by March 2023 .  The current Fed funds rate is around 2.35%.  That's 205 bps of rate hikes priced over the next 6 months.  75 bps is basically guaranteed next week, so after the Fed goes to 3.00-3.25%, there is another 130 bps of hikes priced in.  During these big moves, when pricing starts looking irrational, its usually longs who are getting squeezed and having to dump their position to cut their losses.  Its mostly forced selling, as Eurodollars and SOFR longs are bleeding profusely.  

With Fed funds soon to be 3.00-3.25%, and some analysts and corporate CEOs on TV already saying that the Fed is going too fast, can you imagine what they will say if the Fed tries to take rates above 4%? 

If Powell tries to be Mr. Tough Guy, and hike to 4% and above, the stock market will revolt.  It probably revolts on the way there, not after you get there.  The market will give Powell a pass for 75 bps at this meeting, because its ready for it, and 3-3.25% is still a reasonable rate.  But if he tries to do 75 bps or more for the rest of the year, its going to be chaos out there. 

This much I can foresee:  if the SPX is making new yearly lows in the 3600s and below, stock investors will be complaining, loudly.  Especially if the economic data is coming in really weak.  And all the leading indicators are forecasting that scenario.  

Remember, the Fed follows the market, it doesn't lead the market.  But they usually act with a bit of a lag, which is where the opportunity arises.  I soon expect the equity market to really have a temper tantrum as short term cash will become quite an attractive alternative at above 3%, and especially at 4%+.  It will siphon more money out of equities and into cash, creating the conditions for a very weak stock market, and thus, a weak credit market, as the economy rapidly slows down.  Those are conditions when the Fed is cutting rates, not hiking rates.  I can't imagine Powell, who has a history of caving to the markets, trying to fight the credit and stock market by continuing to hike when things break. 

Things breaking will probably happening sometime within the next 2 months, a seasonally weak period after mid September when you have corporate buyback blackout period, thus fewer buyers, and also earnings coming up, which I expect to be gloomier than last quarter.  As time passes, the leading indicators will start showing up in the coincident indicators, and that's when the stock market gets really worried about a Fed that's too tight.  

Staying short here, not a huge position, so I'll let it ride and see how it goes into the traditionally weak Friday opex and post opex Monday.  Now that SPX has broken 3900, I don't see much technical support till you get towards 3800-3820.  Also with hawk Powell waiting on deck for Wednesday, I have a feeling there will be some more selling ahead of that event, and without options protection, the institutions will be likely do some selling today and early next week.  Bonds are getting interesting here, you are starting to see a slow motion capitulation in fixed income, especially in the short end of the curve.  Starting to slowly put on longs in Treasuries, with 10 year yields close to year highs at 3.50%.  I expect stocks and bond correlations to revert back to being negative in the coming months, as future equity weakness will force the Fed to pause rate hikes. 

Nothing Has Changed But Price

There was a change when the market went down from SPX 4300 to SPX 3900.  It was Powell reiterating what all the other Fed governors were saying, and that is that they will keep hiking to 3.75-4%, and/or until they break things.  They also went back to that dirty well again, forward guidance.  They couldn't resist flapping their gums and bringing out their cloudy crystal ball, to forecast that there will be no rate cuts in 2023.  And they repeated that mantra enough that the STIRs market took out almost 2 rate cuts in 2023, and are now pricing in only 40 bps of rate cuts after the peak in Fed funds rate in March 2023, which has also gone up to 4%, from 3.25% in early August.   

That is a huge move in the fixed income market, and during that time, the SPX has gone sideways, and is trading at the same levels as early August.  Is the stock market so strong that it can ignore the bond market and remain in its own world?  I don't think so.  Unlike before Q2 earnings in July, the setup for the Q3 earnings in October is much different.  This time, investors are much less worried about earnings revisions or weak guidance.  Just watching CNBC and you can see the lack of fear about earnings.  Also, the options market is much less hedged now than where it was back in June/July, which increases the likelihood of a left tail move, as investors don't have that much index put protection.  

What I am seeing since the bottom last week is the growing optimism about inflation having peaked and about a soft CPI number today, which explains the recent strength.  I see it as a combination of shorts covering ahead of the CPI, and longs getting more comfortable buying stocks, trying to play for a short term rally.  Also, the news coming out of Ukraine, with their recent success in gaining back territory from Russia has helped investor sentiment on the margin, with some hopes that the war will end sooner than originally thought. 

This short term greed, is not a big picture change in investors' views.  They all believe that the Fed is still going to keep hiking, and stay hawkish, regardless of the number, but they feel like it can't get any worse and all the "bad" news on Fed and ECB hawkishness is reflected in the market.  

Unlike during the rally from mid July to mid August, this latest rally isn't being joined by the bond market, and has a much flimsier foundation of peak inflation optimism, which would make more sense if the bond market was playing along with that view.  

Its a bit of an irrational rally, aided by the triple witching options expiration this coming Friday, which has created gamma squeezes that spillover into the indices. Just look at TSLA and AAPL, the 2 biggest options volume names in the market.  They have been outperforming the SPX since last Wednesday.  Add the time and IV decay of index puts that speeds up as you get closer to expiration, especially in a rising market, and you get a technical squeeze with no fundamental basis. 

This gamma squeeze is providing those with dry powder and a bearish bias an opportunity to put on shorts at good risk reward levels.  I have had a tendency to short too early after these bounces off of big selloffs, so I've been waiting and holding my fire.  The game is about learning from your past mistakes.  After the CPI release, especially if we get a soft number, I will be looking to aggressively put on short positions in both SPX and NDX, as well as some individual names that have short squeezed. 

Powell putting himself in a box again and trying to rekindle the spirit of Volcker just makes me more bearish on the market than a few weeks ago.  Monetary policy works with a lag, but after the September hike of 75 bps, short term cash will be able to collect over 3%, which is quite attractive for such a bad risk asset environment.  I expect a steady exodus out of equity funds (hasn't happened yet, still flatlining after big inflows from late 2020 to early 2022) and into cash and money market funds, earning over 3%, in the coming months.  The more hikes that Powell does, the more incentive there is for investors to sell equities and collect interest on their cash.  

Running with the Herd

Investing is hard.  Sometimes it favors the contrarians and the trend fighters.  Sometimes it favors the majority and the trend followers.  When there isn't a strong case for the market to go up or down, its probably better to be a trend fighter and play the ranges.  But when there is a strong case, usually its better to keep things simple, and just follow the herd, no matter how "crowded" the trade is.  Right now, there is a very strong bearish case for stocks.  

If you are a short seller, you have to pinch yourself to realize that its not a dream, but a reality.  Who would have thought at anytime before 2022 for the Fed AND the ECB to aggressively hike rates, at 75 bps increments, and do QT, while stocks are in a bear market?  Who would have guessed that it would be politically feasible for the central banks to torpedo BOTH the stock and bond markets in order to fight inflation?  Who would have thought that an energy crisis, that rivals that of the 1970s, to happen so quickly?  And all of this happening right after the biggest financial bubble in US history!  Into some of the weakest leading indicators of the economy since 2008. 

That combination of factors converging this year, and how bearish it is for stocks, is underappreciated by many portfolio managers.  Sure, most hedge funds are underweight their historical net exposure, but they are still about 50% net long.  And there has been a flood of money going into passive funds over the years, and the net inflows into equity funds, especially US equity, over the past 20 months is historic.  There have been minimal outflows from US equity funds during the carnage. 

I know a lot of people like to point out historical studies, statistics and data that mostly cover a bond bull market, with inflation that was relatively low, with central bank policy that favored stocks.  But there is nothing in US stock market history that matches the level of overvaluation, inflation, and corporate profit margins as the current time period.  Remember, corporate profit margins have historically been mean reverting, although they have trended higher since 2000, into nosebleed territory.  When you have globalization with labor arbitrage, low inflation as a result allowing for record low interest rates, a toothless antitrust policy that allows competition to be reduced through mergers and acquisitions, you have a recipe for fat profit margins.  

The tailwind from globalization is fading, as China's cheap labor has mostly been used up, and there are no other emerging markets that has the infrastructure or the skilled labor force to replicate it.  In the developed world, the labor force to total population ratio is shrinking, as demographics are aging, and that decreases productivity and increases wages and thus inflation.  

Add on top of this the lack of investment into energy (not unreliable, intermittent, and low efficiency solar/wind) that can actually power a grid reliably, you have supply constraints for further growth.  Economic growth requires more energy.  Its that simple.  Russia's war with the Western World just brought forward that crisis by a few years.  And the politicians are clueless, focusing on manipulating prices by putting on price caps, subsidizing electricity users, and doing everything but the right thing, which would be looking to increase nuclear power capacity as well as using more coal, while letting higher electricity prices do their thing, which is to kill marginal demand.   

These days, there are more doomsday predictors who are super bearish and usually they are completely wrong, but the situation is so bearish out there, that what they are predicting is somewhat reasonable.  It may take several months for the markets to get to where they predict it, but in this environment, its very possible.  

I don't feel comfortable when a lot of people are thinking the same way, but when there is such a strong case for one direction, you have to just run with the herd.  In most cases, its not a good time to short when investors are bearish, but there is a difference between investors feeling bearish and being positioned bearishly.  While it can definitely be argued that hedge funds and CTAs are positioned bearishly, they aren't the whole market.  There is a huge retail investor base that's still positioned heavily long stocks.  And in the options market, the investor community is very lightly hedged. 

Looking at the intermediate term, at these valuations, there is a lot of room to go lower.  SPX 3000 is not a crazy price target.  That would have been an all time high in 2018.  And the selling will come from retail, who are up to their eyeballs in US stocks.  When they eventually throw in the towel, you will see big outflows from equity funds, week after week, during this process.  Most of the wealth is held by the baby boomers, who will be looking to get into safer investments as they age, increasing demand for fixed income and reducing demand for stocks.  

Retail is hanging tough, and corporations still feel comfortable enough and have enough free cash flow to keep buying back stock.  But in the next 6 months, what the leading indicators show will start showing up in coincident indicators (employment, corporate earnings, etc.).  That's when corporations start cutting back their stock buybacks, and retail start selling their stocks.  That's when things really get ugly.  And that's going to happen even with a Fed pivot, which is all but guaranteed.  Don't forget that the final bottom of the bear market in summer/fall of 2002 and spring of 2009, came after the Fed had been cutting rates for years, not months.  Its going to take time for this process to play out.  

We are getting a relief rally after the ECB 75 bps hike and the Powell speech, which was hawkish as expected.  Now the market is looking forward to the CPI for next Tuesday, which most are expecting to show a continued decline in the inflation rate.  Since many are expecting the CPI to be a bull catalyst, its quite likely that you will squeeze some more shorts in the coming days and have a very short lived pop on the CPI data release.  If the SPX can get close to 4100 after the CPI is released, that is a very tempting spot to go short and ride it down into the seasonally weak post September opex time period, going from mid September to early October.  

A sustained equity bounce like you saw from mid June to mid August was possible due to a big down move in 10 year yields, with some hopes of a less hawkish Fed.  That lifeline has been thrown out the window for the time being, probably not coming until you see labor markets weaker and inflation going down for a couple more months.  Without a Fed pivot, and with leading indicators showing a big slowing of the global economy in the coming months, and the well advertised EU energy crisis that will be much feared ahead of the winter, you have all the ingredients for a grind lower.  Until the Fed cries uncle.  And that's probably going to require the SPX to make new yearly lows. 

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.