From Hawk to Dove

Last Sunday, when the BTFP facility was introduced to try to save the regional banks from bank runs, you had a big rally overnight which faded huge, with a 130 point swing from top to bottom before the cash open.  This time, you didn't get that big rally off the Credit Suisse bailout news, as you didn't have a "clean" bailout, as some bond holders ate giant losses in the process.  You had people on Twitter going on a tizzy over the lack of bailout for all bondholders as the equity still retained some value.  This will be forgotten about in 3 days but it got the bears excited for a moment.  The staying power of these headlines gets shorter and the effect gets weaker. 

When stocks struggle to go lower even as you continue to get bad news headlines about systematically important banks under stress, you know you are late in the selloff.  Its been over a month since the market topped out.  Most of the nervous stock holders have already sold at this point, and you will need to break technical levels at SPX 3800, and below to get stop loss selling and the fear necessary to get a swoon lower.  Given that the FOMC meeting is on Wednesday, the bears don't have much time left to drive this market down.  

In most cases, these scary news headlines are signs of a short term bad news bottom.  With the bond market rallying huge over the past week, you got some serious relief for the banks on the interest rate side, which cannot be ignored.  The regional banks will remain shaky until Powell cuts rates aggressively, mainly due to deposit flight for higher interest in money market funds.  But the money center banks should be fine in the short term, as they will be getting a lot of those deposits fleeing the smaller banks.  Beyond the next few weeks, without deep rate cuts, even the money center banks will be struggling.  They are too big to fail, so deposits are safe, but they also offer even lower rates than the regionals on savings, so they will also suffer deposit losses to higher yielding, risk-free instruments, especially as the public gets wiser on the huge interest rate differentials between bank savings and money markets.  

While the big bank headlines keep coming, the realized volatility has been dropping since the SIVB bomb first went.  This is typical price action when the market gets used to the daily negative news flow, and reacts less and less to each headline.  On a fundamental basis, I see more long term economic ramifications of these bank runs than systemic financial ones.  With the Fed and overseas governments willing and eager to backstop failing banks and to pump in liquidity without hesitation ($300B last week), you have taken away the short term systemic issues from panicked depositors/investors.  

The current issue worrying the market the most are the weakened bank balance sheets holding huge unrealized losses on their HTM portfolio, a problem that can be easily fixed with a hammer:  big rate cuts.  So its not going to be a long term problem.  Even deposits leaving the smaller banks can be covered by tapping the discount window or BTFP at market rates to avoid selling HTM bonds at a loss and the capital hit that comes with it.  The long term concern is the tighter credit and lending conditions that these bank runs have created.   They won't show up right away, so I am sure equity investors will forget about it over the next few weeks when the market calms down.  But these tighter conditions will be lasting, as the economic fundamentals are simultaneously deteriorating as excess savings are drawn down, and as housing slows even further.  Plus, you have the lagged effect of the 450 bps of rate hikes in the past 12 months, which the economy will feel more and more as the year goes on.  

I am optimistic in the short term as the market moves on from the banks to a potential end to rate hikes, which I expect soon.  As the stock market loves to do, it likes to front run future catalysts, and this time, it will be the much anticipated Fed pivot.  Paradoxically, the future economic weakness that these tightening bank lending and credit conditions create are what will allow the Fed to be more dovish and to end their rate hiking campaign sooner than most expected.  The stock market will have its usual Pavlovian response when the Fed is no longer hawkish and starts to signal a pause.  With the pivot in sight, the bond market will also add to the bullishness, as it won't be the weak link anymore which drags down equities.  I expect that bullish reflex response to push the SPX towards the YTD highs around 4150-4200, perhaps even a bit higher.  That's when things will get interesting.  That's when you can load up on a list of short names to ride down for the next wave down, which is usually the most brutal.  The one that comes after the Fed pivots towards future easing.  Below is an example in 2000-2001, showing price action after a Fed pause, signaling the end of a rate hiking cycle, and after the beginning of a cutting cycle.  

We are in a new phase of the bear market, the portion of the bear market when the economy notably slows down, but with that, comes lower bond yields which is initially embraced by the stock market as it looks forward to a Fed pivot.  These Fed pivot rallies are easier to short because they happen at the start of a recessionary environment of earnings declines and lower rates.  With all the angst over monster rate hikes and surging bond yields across the curve in 2022, it is only natural for the stock market to get excited about the end of this rate hiking cycle.  It is a trap.  There will be growing optimism in the coming weeks when the Fed heads are no longer talking 6% rates (Bullard, Kashkari, and other fair weather clowns), and instead have more balanced takes on future policy.  

I have low conviction on what Powell will do on Wednesday, but I am leaning towards 25 bps hike and dovish commentary that takes out talk of future rate hikes.  That will be taken positively by the Street, as a signal of a pause, and the end of this Fed rate hiking cycle.  Its possible Powell continues his hawk talk and leaves open the door for future rate hikes, which would NOT be taken well by the stock market, so I'm definitely not going to go into the meeting with bullish positions, but based on where we are in the monetary cycle, we are due for a Fed pivot rally very soon.  This should time up with seasonal equity strength from late March into late April, which is about as much of a rally as any bull should hope for.  At that point, it should be a free fire zone on the short side for stocks/ buying zone for bonds.  

One last note on the financials.  I expect financials underperformance on the next bear market rally.  Last week, you saw a lot of retail buying in the beaten up regional banks, a bad sign that speculators are playing for a bounce (chart of retail buying on the right).  They are the weakest hands and are guaranteed future sellers. 

Fundamentally, there are too many headwinds (mainly deposit flight to safer, higher yielding MMFs) and they are just not cheap enough to take on the possible go to zero risk.  They have become daytrader favorites, and they are exhibiting the classic daytrading intraday patterns.  Once the daytraders move on from the action, I expect these stocks to slowly drift lower over the next few months.

Same Old Fed

You thought the drug addict was clean after going to rehab, but its the same guy.  He's still going to chase that hit, always remembering the feeling of that first one.  Trying to relive those fun memories.  You thought it was a new Fed, no longer addicted to QE, focused on fighting inflation, thinking this was the 1970s.  Raising rates to sufficiently restrictive, and keeping them there, higher for longer.  No longer reaching for the money printer when things looked a bit shaky.  Sike.

Wall Street is a big psychological experiment in real-time.  You get to see how opinions and views evolve based on recent history and the current news flow.  Its hard-wired into most our reptilian brains over millions of years of evolution.  The extrapolation of recent history into the future.  Hearing the same thing over and over again from analysts and "experts" and eventually believing it.  

In early 2022, after repeated lies about transitory inflation and obnoxious forward guidance that stretched out to 3 years in the future (Fed hubris at its worst), you had knuckleheads in finance and banking that ate it up and extended duration to reach for yield in MBS and long bonds in a ZIRP environment.  SIVB was just another victim of believing in the Fed's forward guidance, thinking that they would keep rates at zero until 2024, while inflation was blooming in 2021.  

Powell was the drug dealer selling low rates, offering a 3 year guarantee, and reneging on that pledge after getting his nomination confirmed, just as heat from the public and politicians about inflation was boiling over.  Some of the B-team execs working at the regional banks took his word: hook, line, and sinker.  They didn't hedge duration risk, as that dampens profitability.  They didn't run a balanced book, running sky high duration assets against very short duration liabilities.  Thanks to the Fed from 2008 to 2021, who conditioned everyone that rates above zero were always temporary, and would be immediately brought back down to zero in a slowdown.  

Now you had a lot of traders and hedge funds that got blown out on the six sigma move in STIRs, as they bought into the higher for longer mantra, that Powell was going to hike to 6%, that inflation was sticky, jobs market was hot, and that the economy is strong.  All balderdash, but it was repeated over and over again, so people started believing.  They built up huge shorts in 2, 5, 10 year Treasuries.  Even though Fed forward guidance of higher for longer is about as believable as transitory inflation and zero rates until 2024 was 2 years ago, people bought into it.  When lies are repeated, eventually people believe it. 

People get used to zero interest rates.  For 13 years, its been zero, or near zero. That's why so many didn't even think about pulling out money from their banks' savings account earning next to nothing for higher yields in money markets and T-bills.  In the past, money markets and T-bills were offering zero as well.  But with this SIVB incident, the news has been plastered with stories about bank runs, making people actually think about what there money is doing in the bank.  Its earning next to nothing.  They are getting robbed of huge chunks of interest, while absorbing the risk of boneheaded risk managers at two-bit banks.  A raw deal. 

There are some out there screaming moral hazard about the bailouts, but they probably underestimate how much panic was brewing.   Judging by the outflows out of the regional banks into other banks and MMFs even with a bailout, it would have been an absolute deluge of money seeking safety, and it would probably have been the modern day version of the Panic of 1907.  That would kill inflation on the spot if they let Schumpeter's creative destruction take place, but you know they would never let that happen after the fallout they got from not bailing out Lehman in 2008.  

So after this heart attack among the regional banks, you have suddenly educated the masses about the dangers of having over $250K in a non money center bank.  Plus, to add insult to injury, some of them will finally realize that money markets are paying nearly 5% and its safer there than at these regionals.  And that they were just giving money away to these banks out of sheer ignorance for the past several months.  That is reason you had $121B flowing to the MMFs.  I expect those massive flows to continue out of bank deposits into money market funds and T-bills.  At this pace, it will make a serious dent into the deposit base of banks and force them to make up for it by either selling their AFS (available for sale) securities or hitting the discount window to pay out deposits and not have to dip into their HTM securities, which would force them to mark to market all of their HTM assets, crystallizing the loss on their book.  It will continue.  The seal has been broken.  Genie is out of the bottle.  

There is a chart going around showing the huge increase in the Fed balance sheet over the past week, an increase of $300B, about half of the QT done so far since 2022.  While its not QE, its not nothing either.  That is liquidity that the Fed has offered to banks instead of having that liquidity taken from the private sector.  It is one of the reasons that you had a strong rally this week in both stocks and bonds.  I expect that upward trend to continue unless Powell splashes cold water on the rally next Wednesday and hikes rates and signals more hikes by saying inflation is still too high, data dependent, and downplays what happened with the bank runs.  No strong lean on what he'll do next week, but I think he'll be more dovish than Lagarde yesterday, while still hiking 25 bps. 

Its a tricky environment, the economy is rapidly slowing but the lagging indicators which the Fed focuses on are still hot.  Credit will get tighter, but the Covid stimulus was so huge, that the US economy is hanging tough.  There are still a lot of excess savings.  And there is also the carrot of a Fed pivot coming sooner than people think, so its a dangerous time to short.  You will get that Fed pivot rally before the Fed cuts rates.  It will come when everyone realizes that the Fed is done hiking, and can now look forward to rate cuts, even if the Fed lies and says they are higher for longer after a pause.  That is the one whopper of a bull catalyst that could run the market up for several weeks.  But it would also be the easiest one to fade as the economy will be right at the starting line of a deep recession at that point.  

Currently holding some bonds, but mostly cash waiting for a good entry point to either add more bonds on a dip or short some of the retail names if they pop up on quasi QE delusions.  Stocks have been quite resilient this week, and it never reached levels where I was looking to buy dips.  Investors are still hardwired to buy stocks when they see the Fed and Treasury bailing out banks, thinking that the Fed is now on their side.  Its a hard habit to break.  It can only be broken with capitulation, and we're not even close. 

Band Aid on Humpty Dumpty

The volatility in stocks and bonds are off the hook.  130 point overnight range in SPX.  35 bps overnight range in 10 year yields.  They broke Humpty Dumpty and bandaids won't be enough to put it back together.  This haphazard bailout of depositors by providing par value loans on deep underwater hold to maturity (HTM) collateral is not going to placate the stock market for long.  Just out of the blue, Signature Bank was taken over by the FDIC without a warning on Sunday, just showing you how fragile the regional banks are.  They are loaded to the gills with underwater HTM collateral that no one wants except vulture hedge funds looking to pay 60 cents on the dollar.  And who's going to keep deposits at a crap regional bank collecting nearly zero interest when they can safely park their cash in money markets or T-bills at a brokerage firm and access cash same day via wire.  

The banks have a business model based on either dumb or lazy people who keep their money there collecting near zero interest when they could just buy a money market fund/ shorter term Treasury ETF through their stock broker.  These bank runs at regional banks should wake up a few of those lazy people into moving their funds to where they are better treated.

Backstopping the deposits prevents the bank runs, but it doesn't fix the root of the problem.  The banks are stuck with huge losses on their HTM collateral, and their deposits are moving out to places which offer much higher interest.  The banks either keeps rates low and let those deposits leave, or they substantially raise the interest on their deposits to keep the deposits that they do have, reducing profitability.  My bet is they try to wait it out, hoping this BTFP facility will keep their customers feeling safe, and hope that they are too dumb and lazy to move their cash to money markets or T-bills, to maintain their net interest margin.  

The broader economic implications of all this is tighter financial conditions, especially bank lending.  And with short term rates near 5%, there is little incentive for banks, especially regional banks to go out on the risk curve and lend in a slowing economy when they can just park their deposits in the RRP and earn the spread, which is huge because they are paying next to nothing on deposits.  And in case there is a bank run, they can quickly pay out without having to dip into their HTM pool and risk realizing losses for the whole portfolio and having to raise equity capital, which will be nearly impossible in this environment.  

The BTFP program is a small band aid put on the patient that is bleeding profusely from the shotgun wound that was buying long term MBS and Treasuries at ridiculously low yields when the Fed promised not to raise rates until 2024.  It was a combination of greed, incompetence, and belief in Fed forward guidance that has put these regional banks in a bind, hoping that their customers are blissfully unaware of the bank's precarious situation.  

The only lasting solution to the problem is rate cuts, and lots of them.  Fine tuning 50-100 bps will not get the job done.  The only way to get the whole yield curve lower to help out bank portfolios is to cut rates and signal more cuts in the future.  If Powell hikes in March and continues his hawk act, the stock market will revolt.  We could have a December 2018 scenario when Powell raised 25 bps to 2.5% and signaled automatic pilot for QT and didn't talk about a pause.  We know what happened after.  Stocks plunged for the next few days and Powell pivoted.  

This time, the economy is in a much worse spot as rates are double what they were in December 2018 with leading indicators much weaker.  Housing is weaker than 2018.  Global economy is weaker than 2018.  Inflation much higher.  If inflation doesn't come down as fast as the bond market is pricing, and the Fed still cuts, you may get huge steepening of the yield curve, like you saw in early to mid 2008, and not even get a move lower in long bond yields, which would not be good for mortgages or the banks' portfolios.  

So what is the Fed going to do here?  Will Powell think he stopped the bank runs and its all systems go on the fight against inflation with more 25 bps rate hikes?  As much as Powell wants to be the next Volcker, 2023 is not 1980.  The leverage built up in the system is much greater.  The US has become bailout nation as any little blowup is quickly defused with some random bazooka facility meant to keep Humpty Dumpty together.  In my view, Powell will fold like a cheap lawn chair.  His hawk act won't be taken well when you have banks blowing up.  Powell can resolve this either voluntarily (1) or involuntarily (2):  1)  Powell decides to cease and desist on his Volcker wannabe hiking campaign, and signals a pause, which will boost stocks for a few weeks and stanch the bleeding in the regional banks.   2)  Powell keeps the same message of higher for longer and the market forces his hand by plunging until he cries uncle.  

I am leaning towards 1) but either way, the market will get what it wants:  rate cuts. And these rate cuts will be warranted because the psychology around regional banks has completely changed, and now almost everyone is aware of how much duration risk these banks are carrying, along with deposit flight risk in a high interest rate environment.  Credit will get much tighter, lending standards will get stricter, and less money will flow to the economy.  This SIVB blowup has just kickstarted what was already a cycle that was going down, albeit slowly.  This has just sped things up and brought forward the recession timeline.  

Stocks are trading quite sanguine given the circumstances, with lighter hedge fund positioning in equities helping out here.  This reminds me of the end of the bull market in August 2007 when stocks were plunging as signs of stress in the banking system were percolating, and the Fed came in to cut the rate for the discount window, and followed up with a 50 bps rate cut in September.  The market embraced the Fed pivoting to rate cuts and rallied all the way from mid August to early October 2007.  

I can picture a similar situation when the Fed pivots and rallies on rate cut hopes.  But that rally probably lasts just a few weeks before investors realize they are buying right before a huge earnings recession in a fast slowing economy.  Historically, bear markets bottom after the Fed is well into its rate cutting cycle.  It could be different this time, as the markets are wiser in regards to how powerful Fed easing is towards financial markets.  But at these still rich equity market valuations, I lean towards history rhyming and market bottoming only after several rate cuts and a real capitulation in the stock market.   

We are in a different ballgame than 2022.  2022 was about inflation fears leading to rate shock fears.   2023 will be about credit tightening fears leading to recession fears.  The stock/bond correlation has flipped, and we're back to the same old negative correlation reflexive moves of stocks and bonds.  I expect that to be the case until you get a final big capitulation bottom in stocks.

Yesterday, we saw credit spreads blow out a bit, nothing crazy, but considering the sideways trading day in stocks, its a warning sign to be cautious trying to buy the dip here.  Also the MOVE index has hit a new high, above the 2020 Covid highs, so bond vol. is still in a raging bull market.  We have CPI today, and it seems the crowd is expecting another hot number.  But economic data is now a sideshow, so its not going to matter for long.  At current levels in SPX, not a compelling case for a buy or a sell.  I am a small buyer if we get one more flush lower below 3800.  I see a much better risk/reward buying Treasuries on any pullbacks.  The past few days have been an emphatic move that is signaling a bull curve steepening for the rest of the year.  

The Fed's power hiking cycle has finally broken something and that's usually when the Fed pivots.  If we do get a little bit more panic in the market, that could mark an intermediate term bottom IF Powell signals an end to rate hikes after March (even if he hikes 25 bps).  We could see a reflexive chase move higher on the Powell pivot and SPX could go towards 4200.  Which would be a great spot to put on long term shorts.  If Powell doesn't pivot next week, this market is not going to like it and it'll probably have to go much lower to get him to act.  In that case, we're going to see some savage moves.

SIVB Bomb

Things are starting to blow up.  The puppets are running as the bombs go off.  Silicon Valley Bank is the latest victim as the rapid pace of rate hikes is leading to some hairy consequences.  

The SIVB situation has shined a light on how fake those book values are in the banks.  Those hold to maturity (HTM) securities are not marked to market.  A lot of those securities were bought in 2020 and 2021 when 10 year yields ranged from 0.5% to 1.75%.  And when short term rates were hugging zero.  That is the asset side of the banks' balance sheets.  The banks are hanging on to huge unrealized losses on their assets.  Their liabilities are short term deposits, which they are currently paying way below market rates on.  Sure, a lot of the people holding them have balances that are small or are too dumb or lazy to seek higher yields on their cash.  But the smarter ones have started moving most of their deposits out of the banks into money markets, T-bills, and other short term cash alternatives.  QT will slowly suck out reserves, making deposits that much more valuable to banks going forward.  The banks' liabilities, deposits, are where they will have to increase the rates they pay out to keep them from moving out, reducing their net interest margin. 

People were ignoring this side effect of the Fed raising 450 bps in less than a year.  The effects of yield curve inversions have been slow to surface because of all the excess savings from the Covid stimulus and the massive Fed balance sheet.  But those are slowly being drawn down, just as the lagged effect of the rate hikes flow more and more into the real economy.  A poisonous brew that's getting a bit more toxic by the day. 

The yield curve inversion went parabolic this week with Powell's hawkish testimony, opening the door to a return to 50 bps hike in March.  The market has been taking the 2-10s curve inversion in stride, and you even saw articles about the economy being a "Godot" recession, as it seems that the recession is always 6 months away.  Investors got complacent on the potential economic weakness coming later this year. That complacency finally caught up to the market yesterday.  Until we got the SIVB news drop yesterday, the major worry was hot economic data that would force the Fed to hike 50 bps in March and maybe get to a 6% terminal.  Wall Street has such a short memory, little patience, and is so focused on the now, that it loses focus and overthinks as the path meanders towards the eventual destination that most agree on, which is a Fed engineered recession. 

The time lags between rate hikes and its effect on the economy have given equity bulls a false sense of invincibility, almost as if the economy is so strong, it can handle these high rates without a problem.  I even started hearing nonsense from Warren Mosler advocates about how raising interest rates is stimulative for the economy, as it increases interest payments from the government to the private sector.  This ignores all the non government borrowers who have to pay interest from their cash flows, not from printing more Treasuries.  Sure, the rich with big cash holdings will benefit from higher rates, but almost all of their marginal dollars aren't going to be spent on goods and services, but rather put towards stocks, bonds, or cash equivalents.  Those with the most propensity to spend their marginal dollars are the ones who are the most punished by higher interest rates.  Those people in the middle to bottom end of the income spectrum are the ones who are going to get squeezed by higher interest payments and less available credit as lending standards tighten.  You are already seeing that with a rise in auto delinquencies.  

Also don't forget that student debt payments have been suspended, and will resume once the Supreme Court decides on whether its legal or not for Biden to forgive that debt, or June 30, which ever comes earlier.  A ridiculously long suspension for no real  reason, other than thoughtless Covid pork jammed down peoples' throats who loved it. 

Here is a chart showing the lag effect and what the current economy is feeling based on the past rate hikes, assuming the following, from Michael Lebowitz's recent article on the Fed:  

 Rate hikes should affect the economy with the following lags:

• 25% First month
• 50% within three months
• 75% within nine months
• 85% within fifteen months
• 100% within two years

Using those assumptions, the overall economy is feeling like rates are at 2.44%, not 4.5%.  But its rising fast.  By the summer, the lagged effective Fed funds rate will be 3.5%.  Of course, this is a rough estimate, but it points to the speed of this rate hiking cycle, and how the tightening effects will be felt much more later this year than right now.  

It was fashionable to compare the current period to the 1970s, with the high inflation rates conjuring up that stagflationary and sticky inflation period.  But I see more similarities to 2001 and 2008 than 1973.  Its never the same recession.  With the government running huge budget deficits and reinvigorating a big chunk of household balance sheets with ridiculous amounts of money spew, you are not going to have anything as bad as 2008.  But the current situation looks worse than 2001.  Back then, the natural growth rate of the economy was higher, and you didn't exhaust monetary policy by staying at ZIRP and QEing for over a decade.  Greenspan cut rates from 6.50% to 1.00% from 2001 to 2003, even though the economy only had a mild recession, and housing was barely affected during that period.  That was hugely stimulative to the real estate sector, as households could refi to much lower interest rates, and the economy was strong from 2004 to 2006.  

This time, even if the Fed cuts from 5% to 0%, you aren't going to get the same stimulative effect.  Most homeowners won't refi even at ZIRP, because long term yields won't be going down below 1% like it did in 2020.  And you already have a huge chunk of outstanding corporate debt issued at much lower rates than today, unlike in 2001.  So a return to ZIRP won't drastically change the debt profile of corporations and won't have much of an effect on interest expense.  Don't forget, the early 2000s was when the internet exploded into mainstream use, and that was a huge productivity boost to the economy, a deflationary technology that has no parallels today.  You also had offshoring going into overdrive with China, keeping inflation low.  This time, there are no breakthrough productivity game changers in recent years to help keep inflation in check.  Offshoring is almost maxed out and its more likely to go in the other direction.  It will make it that much harder to keep inflation down, making it more difficult for the Fed to keep rates low. 

As soon as I write a post about the market being tamer we get a big move down with the SIVB bomb hitting the tape.  You always have to stay humble in this business, you will be wrong over and over again.  This negative correlation move with stocks diving and bonds squeezing higher was completely out of the blue, so quickly after Powell put 50 bps on the table.  But it reinforces my belief that unlike 2022, you are more likely to see stocks and bonds trade in opposite directions, like it did for most of the QE era.  In the end of a hiking cycle, bad economic data is still good for stocks, but that will only last for a couple months.  If you keep getting bad data, the focus will shift from inflation to growth, and that's when you really get the negative correlation moves in stocks and bonds.  That's probably happening this summer, and yesterday gave a sneak preview of things to come.  I don't recommend entering any short positions here as the bank contagion fears percolate ahead of the weekend, as I don't like to enter shorts when I see blood on the streets.  I also wouldn't be long either, at least until we get closer to the December lows around SPX 3800. Another 1 or 2 days of selloffs could get us to that level, where I would take a shot on the long side for a trade. 

From Altered Beast to Human

2023 is a much tamer animal than 2022.  If you want to make an analogy, 2022 was a wolf in the wild.  2023 is a kid in the backyard.  We got a throwback from 2022:  Hawk Powell.  If you heard that in 2022, it would have been absolute chaos.  This time, not so much.  Its not doing much damage to the long bond, which hardly moved down on the threat of a faster pace of rate hikes if data comes in hot this month.  But it crushed the short end of the yield curve, and now we have 2-10s curve inversion of 100 bps.  Something unthinkable a year ago.  

The power flattening of the curve, is telling you:  1) these high rates are not sustainable for very long and will cause economic weakness 2) there is a ton of liquidity in the bond market, as even QT and large Treasury issuance is unable to cause much of a selloff in the long end.  The relative tightness of credit spreads is also a signal of abundant liquidity.  The Fed's QT program is a joke.  MBS is hardly rolling off, as no one will re-fi in this environment, so the Fed is only reducing Treasuries in its balance sheet, and that is capped at $60B/month.  Don't forget back in the peak of the Covid money spew in spring 2020, the Fed were buying $75B/day of Treasuries.  Adding liquidity with a firehose, and taking it out with a straw.  Typical.  The Fed's balance sheet is still sky high, and bloated with low yielding coupon debt.  The Fed has essentially eaten the huge losses in MBS that private market would have had to bear in 2022.  This time, with the Fed's thumb all over the MBS market, there will be no mortgage crisis.  Its just likely to just be a classic slow bleed economic slowdown. 

If we just had normal liquidity conditions, it would be a toxic environment for stocks.  But we don't have normal liquidity conditions.  The budget deficit is high, the Fed balance sheet is still huge, and all that money pumped out in 2020 and 2021 is floating around in the financial markets, looking for a home.  Everything the government has done over the past several years has been stimulative:  tax cuts for corporations and middle/lower class in 2017, $5 trillion in Covid stimulus in 2020 and 2021, big fiscal budget increases the last 3 years, Inflation Reduction Act, student debt forgiveness, and most recently COLA inflation adjustments to Social Security, boosting handouts to the elderly.  No wonder the budget deficit hit 6% of GDP last year, even with huge capital gains and an overheating economy.  In the past, those budget deficits during boom times would be between 0-2% of GDP.  That's 5% more spending and less taxes which goes straight from the government's printing press to the pocketbooks of the masses.  If the government spending continues at this pace, those are the foundations of a sustained inflationary environment.  While it is very unlikely you will get much one-off spending bills in the next 2 years due to gridlock in Washington, it is likely you will get more pork stimulus starting from 2025 with a new President and/or a Democrat majority Congress.  

So as a short seller even though you have the Fed on your side (for a few more months), you are still fighting some strong forces on the other side, which is the ample accumulated liquidity.  In 2022, the vicious bond bear market and the rate shock was sufficient for the bears to overcome the big liquidity advantage that the bulls have.  This year, its a more even battle.  

Another reason for the resilience of the stock market:  volatility.  Volatility is down in both the stock and bond market.  Credit spreads are tighter than the 2nd half of 2022.  The uncertainty on the rate hike path for the Fed, despite yesterday's hawk Powell performance, is lowered from what you saw in 2022.  As a result, you get milder selloffs on bad news and the lowered volatility encourages dip buying.  When volatility is high, as it was in 2022, the demand for riskier assets such as equities and long duration bonds goes down.  But as the volatility in both the stock and bond market has died down in 2023, that suppressed demand for duration has come back even though the earnings fundamentals for stocks or long term inflation expectations for bonds haven't improved.  

What am I seeing in the COT reports and sell side CTA trackers is CTAs being much less short than they were in the fall of 2022.  Vol control funds and risk parity are steadily adding back long exposure to stocks, and to a lesser extent bonds, as both the VIX and MOVE index are lower than 2nd half 2022 levels.  Over the next few weeks, the vol control and risk parity funds should be done adding to their risk exposure.  At that point, you get a better set up on the short side as seasonality starts to turn worse with  tax refund season behind us and with a continued drawdown on excess savings from US consumers.  Its not going to be a sudden crisis situation like 2008, but more of a drawn out drip lower as the fiscal stimulus from 2020 and 2021 begin to wear off and credit conditions tightening with the higher rates.  

It is easy to forget about the Covid stimulus when all we hear about is the Fed and rising interest rates but the aftereffects are still reverberating.  $5 trillion dollar dropped from a helicopter into the economy distorts reality.  We are still not back to normal, no matter how fast the Fed wants to get inflation down.  One has to question why the Fed is not increasing the rolloff of the balance sheet, as the $60B/month of Treasuries has been woefully inadequate.  I guess Powell doesn't want to hurt too many of his friends in private equity by doing a power QT of say, $200B/month of Treasuries.  It can actually be argued that raising short term interest rates is just a stimulus for the rich holding a lot of cash, and just punishing those who have to borrow money.  If the Fed actually wanted to tighten financial conditions and reduce wealth inequality, he should stop hiking rates and instead increase the pace of QT with outright sales of long end Treasuries.  Of course, that will not happen, because there are no out of the box thinkers at the Fed and they still want to coddle the bond market while trying to kill consumer demand.  

Back to the markets.  We reached a short term bottom last Thursday, earlier than I expected, as this year's markets are not selling off that extra few days that really makes the longs question themselves, like what happened in 2022.  Short term traders need to recalibrate themselves to expect less on the downside, and expect more time spent at the top.  Until you get a noticeable shift down in the economy that leads to more layoffs and less sanguine consumers, you will continue with this low volatility, low energy market.  Compared to the 2013 to 2019 markets, this is not boring.  But compared to 2022, it is. 

I've noticed that the new mantra from the stock "experts" on TV is:  cash is not trash.  It is unusual and rare for the stock "experts" to tout cash as a good alternative. Considering their tendency to be late to a trend, it probably means that cash will be underperforming a stock and bond portfolio in the coming months.  If you see economic data cool off like the leading indicators are forecasting, that will provide support for the bond market which will provide support for the stock market, as the market will price in a less hawkish Fed and a return of the goldilocks/soft landing thesis.  Under that scenario, I could picture the 10 year going back down towards the bottom of its YTD range, to 3.50%, and the SPX to return to the top of its range, towards 4200.  

I have used the weakness yesterday to reduce my single stock shorts and add some bond exposure.  I see downside in fixed income as being limited, and thus downside in stocks as well.  The strength of the long end of the yield curve is a sign of underlying demand for bonds that won't go away easily.  The demand for duration is slowly coming back as the trauma from 2022 is further in the rear view mirror.  Those planning to decrease bond portfolio duration is at a 2 year low at 13%. 

With the overflowing liquidity out there, and at current price levels, buying bonds is a superior way of expressing a view of a weaker economy later this year than shorting the equity index.  Don't get caught up in 2022 mode of trading and investing.  This year has a different character to it.  It is tamer.  Those that can adjust to this new reality will outperform those that are still stuck on the 2022 playbook of shorting stocks and bonds.

Cash is Popular

After the weak close last Friday and the continued weakness in the bond market, I was looking for a capitulation this week to clear the decks and allow for a reflexive bounce that could last 3-5 trading days.  But the bears just couldn't get the job done and equities showed resilience, bouncing hard despite the 10 year yield breaking out above 4%, a new YTD high.  I would not read too much into one day's trading action, but it does fit in with my view that when volatility is shrinking in the stock and bond markets, it makes it tougher to shake out the bulls, as they are emboldened by the less treacherous environment, relative to 2022.  This is a mirage, as there just hasn't been enough time since the Fed really got aggressive with rate hikes (Jun-Jul 2022) to torpedo the economy.  Its not easy to time the turn of these economic cycles, but best estimate here is that it will be around summer time when the economic weakness becomes apparent and starts to spook the stock market.  Until then, equity vol will be subdued, with all the liquidity still sloshing around.  

These days, with T-bill yields above 5%, its been common to see analysts tout cash as the best thing to hold here, which is rare.  Usually these analysts and pundits that come out on TV are almost always bullish on stocks and rarely ever recommend cash.  In many ways, I agree, but anytime I hear something this consensus, it makes me think of scenarios where holding cash will lead to underperformance.  The most obvious thing I can think of would be if risk parity starts to perform strongly in the next few months.   

Holding cash is the anti-risk parity trade.  For asset managers, holding a lot of cash is like rooting for both stocks and bonds to go down.  It is a conservative way to express a bearish view.  It makes me re-think my original 2023 thesis of a huge downtrend starting in May and ending in July/August that takes the SPX towards 3200-3300 in a wave of capitulation selling.  It could take longer for the stock market to crack than I originally expected.  But I expect it to crack due to the high valuations and earnings pressure that will come in like a lion in the 2nd half of the year. 

Many are recommending cash because it yields 5% a year, but that averages out to less than 0.5% a month.  Not a great way to outperform.  It could get uncomfortable for those holding cash if inflation cools off in the next 3 months due to base effects and lagged effect of M2 deceleration, and it looks like a soft landing.  That would boost both stocks and bonds and leave behind cash holders earning 0.5% per month.  And anytime there is underperformance in the investment management community, they have a tendency to chase to catch up, which could take the SPX back towards 4200-4300 before enough supply comes out to stop the rally.  

Short term, it will be the bond market that ultimately decides the direction of the stock market.  The only thing that can sustain an equity rally is if the economic data cools down, starting with the nonfarm payrolls report on March 10, and CPI on March 13.  I am leaning towards the employment picture being weaker than consensus, as other labor market indicators are pointing to a less bullish picture.  But I've been wrong for the past few months, and the nonfarm payrolls is a horribly inaccurate number, so anything can happen.  Same view on the CPI, as the January effect will no longer be there and leading indicators still point towards disinflation.  

The equity put call ratios have been perking up over the past few days, there is some concern these days among the fast money traders out there.  That is as the SPX has bounced strongly off the SPX 3900-3920 support zone.  Bears used up a lot of their fuel taking the market lower over the past 2 weeks.  SPX is short term oversold.  I am not bullish, but I wouldn't be holding a lot of shorts either.  Still short individual stocks, which I might hedge with a long SPX position if there is another selloff next week towards that SPX 3900-3920 area.  April was horrible last year, but historically has been a very strong month for stocks as tax season and consumers spending or investing their tax refunds provide a short term boost to the economy and markets.  The big move lower in the SPX is looking like a Q2/Q3 story.  A stock market that chops around between SPX 3900 and 4150 without any big moves for the next 2 months is looking like the most likely scenario. 

Economic Balderdash

Something just doesn't feel right.  Almost everyone that comes out on CNBC/Bloomberg are telling me stocks are expensive, as global bond yields keep going higher, as central banks stay hawkish, yet SPX is trading around 4000, which would have been unthinkable just 3 years ago, and Eurostoxx is almost at an all time high.  You have the crowd last December being certain that recession is coming soon  to now almost certain that there is no recession in 2023 and that a soft landing is very possible. 

 

The global stock markets have been amazingly resilient in the face of the fastest tightening cycle in recent history.  The stock market is fighting the Fed, and holding up well.  So is the credit market.  The Fed keeps raising, yet credit spreads are much tighter than they were last fall.  

The easiest explanation for the high asset prices is the massive amounts of fiscal and monetary policy in 2020 and 2021.  It is the gift that keeps on giving.  It also explains the resilience of the global economy in the midst of a huge increase in interest rates all across the curve.  Everyone talks about the excess savings as a reason for the strength of the consumer.  But don't forget about the super low rates from early 2020 to early 2022.  They have made a lasting impact.  Households were able to buy or refi into very low rate mortgages.  Corporations were able to issue tons of debt at low rates.  Most corporations and households are holding low interest loans/bonds that will slowly roll over into much higher interest rate loans/bonds.  It is a gradual process.  Wall St. doesn't have any patience, so when they don't see an immediate recession, they jump to conclusions like soft landing/no landing.

Here is the Federal Reserve balance sheet: 

Despite all the QT fear peddling from the permabears, the Fed's balance sheet is still sky high.  Their QT program is painfully inadequate.  They have only reduced the balance sheet by $600B in the past 10 months, after adding $4800B from February 2020 to April 2022.  That is $4.2 trillion extra Treasuries and MBS that are on the Fed balance sheet and not in private hands, $4.2 trillion of ammo for private investors to buy financial assets with.  That is the elephant in the room the Fed doesn't talk about.  It is what is keeping a bid under stocks.  It is why the yield curve is so inverted.  There is just too much damn liquidity out there.  That is why it will take time to erode that bid for stocks as the economy gradually weakens. 

So if there is so much liquidity out there, why am I negative on the economy?  Its because of secular stagnation (demographics, lack of productivity, etc).  Without big time fiscal stimulus and very low interest rates, many businesses aren't viable in a zero population growth world.  In 2023 and 2024, you will see many businesses go out of business.  The last time you had 5% Fed funds rates was in 2007, and the global economy couldn't handle it.  There wasn't enough organic growth to sustain that level of rates.  People talk about the bursting of the housing bubble and the ensuing financial crisis in 2008 as the causes, but they don't talk much about the slowing organic growth of the developed world since the early 2000s, aging demographics, and slowing population growth rates.  That trend has only gathered momentum in the past 5 years, masked by big budget deficits and massive fiscal and monetary stimulus.  If the US government ran a balanced budget now, like it did in 2000, the US would be in the depths of a deep, deep recession.  The only growth you are seeing in the US is from government pork and entitlement spending.  If they just stay at current levels for the next few years, you will have zero growth.  

The inflationistas out there, which have grown in number quite a bit over the past year, are forgetting that the main cause of the huge rise in 2022 inflation was the 2020 and 2021 Covid bazooka stimulus that was the largest stimulus EVER in US history.  That was a one time bonanza for the financial markets and the economy, and it resulted in an inflationary surge with a 12 to 24 month lag.  The main cause of the inflation, a 40% rocket higher in M2 money supply from mid 2020 to end of 2021, is gone.  The M2 money supply is going in reverse, almost unheard of in US financial market history.  The monetary contraction starting from late 2021 and still ongoing will be the reason that inflation cools down in 2023 and 2024.  

All things being equal, inflation going lower in a high inflation environment is bullish for the financial markets, but this time, the cooling inflation will be accompanied by a big drop in economic growth with high interest rates.  Unlike the higher for longer crowd out there, I don't think the economy will hold up for long under this current high rate regime.  Do you really think the stock market will be happy with Powell sitting there, keeping short term interest rates above 5% for several months, while the economy deteriorates, like nothing is happening?  

If the Fed truly commits to its higher for longer rate regime, then they will have to do it in the face of a falling stock market, disinflation, rising credit spreads, and increasing unemployment.  Powell is not dogmatic.  He's from the Church of What's Happening Now.  He's not going to ignore incoming weak economic data just so that he can fulfill his forward guidance promise of higher for longer.  Just like he didn't fulfill his promise of rates at zero till 2024 in his forward guidance in 2021.  There is a high probability that the data will cause Powell to pivot later this year.  By that point, the stock market will probably be much lower than current levels, and it will have to be, in order to get Powell's attention.  If the stock market just meanders around 4000, give or take 200 SPX points, he's probably going to stay with high rates. 

Corporations will be sharply cutting back on investment, as the hurdle for productive use of debt in a 5% risk free rate world is much, much higher than it was when it was hugging zero.  If you can't make money borrowing money at 7,8,9%, why would you borrow at those rates?  If corporations cut back on debt issuance, that just means less investment, less stock buybacks, and less economic activity.  Businesses can't keep raising prices in perpetuity when the money supply isn't increasing.  The customers just won't have the money to buy the goods and services.  There has to be more money in circulation to keep inflation going.  

While I respect the price action in the bond market, as the sovereign bond market is trading extremely weak, I don't expect that to be a long term trend.  Short term, you have worries about econ. data continuing to come in hot, as the lag effect of higher rates has yet to really work its way through the economy.  The chart looks horrible for bonds.  It is also a seasonally weak period for bonds, as they tend to sell off in March and April.  

 

 

Longer term, bonds are a much better investment than stocks here.  I just don't believe high interest rates are sustainable for the developed world.  Its just a matter of when, not if the dam breaks and the economy buckles under the pressure.  The only way high interest rates can be sustained is if inflation sustains at a high level.  I don't think that's happening over the next 2 years.  Maybe starting from 2025 after you get either a Democratic president + both Houses with Democratic majority or a Republican president, then you create conditions for another fiscal bonanza as the populists take over and spew money everywhere.  But until then, fiscal policy just won't be loose enough to create the conditions for high inflation. 

Maintaining my equity shorts and just watching the SPX/NDX for now.  The stock selloff likely continues if the bond market stays weak.  CTAs, after getting long in January and February, started dumping SPX last week, so they are probably either flat or slightly short now.  Volatility is still relatively low so vol control funds are not selling here.  Don't have a lot of conviction on the indices, so just watching and waiting for a better spot.

Don't Call it a Comeback

"Don't call it a comeback.  I been here for years."

The retail trader is back.  Retail is aggressively buying stocks and crypto in 2023.  I am a bit skeptical about how they obtain data on retail investor flows, but everything I see points to them being generally correct.  The outperformance of daytrader favorites such as TSLA, bitcoin, meme stocks, etc. so far in 2023 are trademarks of retail investor inflows. 

Daily Net Inflows by Retail

 

Bitcoin vs SPY 6 mo. chart

Obviously retail investors are hooked on stocks.  2020 was the turning point for the stock market.  That is the year when the stock market went from being a casino occupied mostly by institutions to being a casino now being filled with both institutions and retail investors.  Individuals have found a new outlet for their gambling addiction:  the stock market.  Retail investors are the drivers of stocks like TSLA, even with its $600B+ market cap.  They are the ones that move around bitcoin.  This creates long term opportunities.  Retail are the least informed investors and the best fades over the long term.  

Fundamentals eventually determine the stock price.  Dislocations in retail dominant names can only last as long as the retail investors keeping pumping money into the same stocks.  Once they buy in, then the next step is not if, but when they sell.  As we saw with tech stocks and retail favorites like TSLA in December 2022, when retail investors start losing lots of money, they panic just as much, if not more than institutions on the way out.  

Retail investors have been buying into the soft landing/no landing thesis perpetuated by the institutions. Institutions have been coming back in and steadily increased net equity exposure this year, while retail has been piling back in and trying to relive their glory days in 2020 and 2021.  

In a bear market, the investor positioning among institutions rarely gets much above average, as the fundamentals are just not strong enough to change enough minds to have the majority all bulled up.  We are near a point where positioning will only get much more bullish if you see signs of earnings forecasts rebounding and inflation going down sharply to justify a pause and eventual rates cuts from the Fed.  That's a high hurdle, considering all the forward looking economic indicators and the lagged effect of higher interest rates working to slow down credit growth and thus economic growth.  

The options market is also showing signs of complacency, as the put/call ratios have been trending lower in 2023.  The 20 day moving average of the CBOE equity put/call ratio is back towards mid August 2022 levels.  That just happened to be when the SPX topped above 4300 and went down 800 points over the next 2 months.

 

If this is still a bear market, which I still believe, then you have limited upside from current levels, maybe a few percent at most in the SPX, and lots of downside.  A skewed risk/reward ratio in favor of shorts.  I was hesitant to go too heavy on the short side when I saw the lack of selling after bad inflation numbers and hot retail sales.  I missed the juicy short above SPX 4140.  Just too cautious and overthinking things as I was already short some high beta retail high flyers.  Given how much CTAs and systematics have added to the stock buying over the past few weeks, there is not much more ammo left on the bull side.  

The weakness in the bond market is the biggest barrier for a sustained stock market rally.  The bond market could of course reverse and start rallying, but looking at the charts and the distance from prior lows, its not looking great for bonds either.  The 10 year yield is at levels where the SPX was trading in the 3800s in late December.  Either the bond market is too low or the stock market is too high, or a combination of the two.  The divergence is getting extreme between stocks and bonds, and I wouldn't be surprised to see pension funds do a hefty rebalance out of stocks and into bonds going into the last few days of the month. 

Big picture, it looks like a topping process is ongoing in the SPX/NDX and the bottom could fall out at anytime.  There is serious rug pull risk here. 

Irrational Rally

This rally is even more confounding than the one you saw in July/August 2022 because at least back then, the bond market was rallying with the stock market.  This time, stocks are going up despite the bond market weakness and the additional Fed hikes priced into the yield curve.  Yes, its the soft landing hopes that are driving this rally. 

The market went from hard landing to soft landing in a hurry.  That strong nonfarm payrolls number really got investors believing in either a soft landing or a no landing!  Incredible how all the other economic indicators are immediately forgotten and investors latch on to the blowout jobs number.  That's classic Wall St. behavior.  What have you done for me lately thinking.  

One thing I've learned about shorting the SPX/NDX since the QE era began in 2008:  The rallies can go on much longer than you think possible.  Especially when investors are not totally bought in on the long side.  Sure, we've gone a long way since last October in adding bulls, in getting CTAs/vol control/systematic funds to add equity exposure.  But hedge funds still are below their average net equity exposure.  Here is a recent look at hedge fund positioning from Deutsche Bank:  

On CNBC/Bloomberg, I am still hearing some reluctance from institutional investors to embrace this rally, even as they say that the economy is unlikely to go into recession, as previously feared.  This is just another survey, which I put less weight in than positioning, but I was surprised to see these numbers after the equities rally so far this year:

It does make me want to wait for a more ideal spot to put on shorts, as the SPX could definitely grind higher until you see more overt signs of an economic slowdown, which probably will take a few more months.  During that time, who knows how far the chase for performance and trying to keep up with the indexes will do.  Its totally irrational, as extending the high rate regime by having non recessionary data for the next few months will just make the landing that much harder.  But so much of Wall St. is caught up in playing the short term game and not able to deal with underperformance or worse, big drawdowns.  So they have to often chase even though they know the fundamentals don't support the rally.  

Since they've reduced their shorts via massive short covering in the past few weeks, I don't expect much more juice left in the popular short names in the speculative tech.  That's where I've put on short positions.  I've stayed away from shorting the index until I see more of a blowoff top or signs that hedge funds are back to at least neutral positioning.  I like the risk/reward long term from shorting the SPX here, but with some single stock shorts, don't want to go all in by shorting indexes as well, until I see more signs of a top.  

Stocks shrugged off the higher than expected CPI number, while Treasuries went lower.  The price action does speak to the effect of puts losing value and being delta hedged by dealers, which is to buy back shorts.  Also this is opex week, so you get a lot of influence from options.  It feels a bit too neutral for my liking, so will wait and see.  

Retail Frenzy and Hedgie Caution

That nonfarm payrolls report is still having repercussions in the market.  The market has jumped from the immaculate disinflation to sticky inflation.  I am hearing talk about a strong job market, higher prices for used cars, strong new car sales, more optimism in real estate, etc.  I heard none of these things 2 weeks ago.  Its amazing how fast Wall St. jumps from one side of the fence to the other.  Now its clear that investors have come right back to the 2022 mindset of high inflation/good econ. data is bad news.  

However, that trend doesn't seem to have staying power.  Wall St. has no patience for things to play out.  If the economy doesn't immediately crater after rate hikes, then the economy is deemed to be impervious to rate hikes and very strong.  As the saying goes, monetary policy works with long and variable lags.  Most say the lags are anywhere from 12 to 18 months.  If that's the case, the bulk of the rate hikes happened after June, so that would be anywhere from June till next March for the full effect of the rate hikes to work their way into the  economy.  That monetary policy transmission takes time, its slow but the effects accumulate, like body punches in a boxing match.  One body blow usually won't knock anyone out, but they accumulate to weaken the opponent over the course of a match. 

The retail traders have regained confidence as the soft landing/no landing view gains popularity.  I am seeing some crazy action in pump and dumps the past couple of weeks.  Its almost as crazy as 2021, when you regularly saw multiple 100% daily gainers in a day.  But that confidence is missing from the hedgies, as they've been covering shorts and also reducing longs, pulling back on their gross exposure and not raising their nets, even with the growing economic optimism out there. 

Its a confusing time for macro based investors.  The leading indicators are telling you one thing, but there are bits of coincident data that remain strong, like employment, which gives out soft landing/no landing vibes to the public.  This seems to happen at the beginning of every downturn.  During this "Goldilocks" period, people play down the importance of the yield curve inversion, the accuracy of the leading indicators, and point to the strong jobs market as proof that the economy remains strong.  

The thinking out there is that there is still a lot of excess savings, and will keep the consumer spending for some time.  But average hourly earnings has been growing less than the CPI for the past 18 months, and we all know that the CPI underestimates inflation.  So consumers' buying power is probably the worse it has been for several years, as wage growth hasn't kept up with inflation.  

Logically, with government spending taking up a bigger percentage of GDP than in the past, the economy becomes less efficient.   Government waste and lost productivity manifests itself as inflation.  Government workers get paid more than their labor is worth, so the money that they get paid isn't made up for by increasing the productivity of the country, leading to more inflation, and less buying power for the private sector. Government spending to GDP ratio hit 37% in 2022, after reaching over 43% in 2020.  In the late 1990s/early 2000s, government spending to GDP was in the low 30s.  Government creep into the economy lowers productivity as their activity crowds out the more efficient private sector.  This is one of the trends that is a tailwind for higher inflation in the future.  While it doesn't have a big effect near term, over time, waste and inefficiency in the public sector gradually decreases the purchasing power of the dollar.  

While I am a believer in the secular inflation thesis, its going to be overwhelmed by cyclical forces.  In this part of the business cycle, you have disinflationary forces which are quite powerful, with high inventories, higher cost of capital forcing some businesses to close, negative wealth effect from housing and financial asset depreciation, and banks tightening credit standards and giving out fewer loans.  The recession callers at the end of last year weren't wrong.  But they jumped the gun by thinking that the Fed tightening would choke off the economy right away.  It may take a few more months than they thought.  

Noticing some interesting price action the past few days.  Even with the strong nonfarm payrolls report and a weak bond market, the bulls were aggressive, and pushing stocks up until yesterday.  Especially super speculative stocks that retail traders love to push around.  Greed is percolating out there.  You are seeing more optimism show up in the investor sentiment surveys, which are showing the highest levels of bullishness since early 2022.  It makes for a dangerous market to get long, with all these newfound bulls.  It makes it safer to short, but I would like to see less fear in the bond market in order to really get the bulls worked up and feeling invincible.  

Right now, there still seems to be a bit of apprehension among hedge fund managers, which still have relative low net exposure to equities.  Retail is almost all in, so that's a good sign to short the retail favorites.  But for the indices, its less clear cut.  I would like to see the hedgies increase their net exposure a bit more here.  The systematics and CTAs have been buying the past few weeks, so they are have used up most of their buying power.  Have been shorting retail driven stocks this week, but I will wait to short the SPX.  I missed a good down move yesterday but I think there will be at least one visit above 4200 before this bear market rally is done.  Gut feel tells me that this bear market rally will last longer than the one you saw from June to August of 2022.  So its going to be trickier to maintain a long term short this year.  Still think we see a big move lower eventually, but probably only after you suck in a few more bulls into the ring. 

Blowout Jobs

The higher for longer crowd got a boost when they saw the big nonfarm payrolls job number on Friday.  Instantly, you saw them sell everything, stocks and bonds, and with a delayed reaction, even commodities.  The nonfarm payrolls print just shows you how wild these BLS numbers are, how much they depend on the massaging of numbers, seasonal adjustments, population normalizing measures, etc.  The ADP number was much weaker, and the Challenger job cuts was higher, so this nonfarm payrolls number is totally out of whack from the other employment data, which shows some signs of weakening.  

The only real effect that the nonfarm payrolls report has on financial markets is how it affects monetary policy and I doubt this number will move the needle.  The Fed's number one goal is to reduce inflation, not to reduce jobs.  If reducing jobs is required to reduce inflation, then they're willing to force that situation, but if its not, they won't keep hiking if jobs are steady and if inflation continues lower at the current pace.  Powell is much more worried about wage inflation than the total number of jobs.  If wage inflation stays under control (trend is toward more lower paying service jobs and fewer higher paying tech/middle management jobs), as it has for the past few months, he's not going to kill the economy just because of strong NFP numbers.  The Fed's focus is still on inflation.  And based on base effects (energy was up huge from February to June 2022) and current high frequency data on rents, the year on year CPI numbers will be dropping dramatically unless oil prices surge back over $100 in the coming months.  This isn't a forecast for how inflation will be, its just simple math based on how CPI is calculated.  

It seems like I'm in the minority when it comes to betting on a big drop in inflation/even some deflation for 2023, here's a Twitter poll taken just recently:

In fact, I was quite surprised that so many bet on higher for longer, when the leading indicators are pointing to further decrease in inflation, as well as significant economic weakness.  Maybe this time is different, and the Covid stimulus is the inflationary gift that keeps on giving, but I have a hard time seeing high inflation and higher for longer when you have the housing market essentially frozen, with current listed home prices not reflective of where the actual market is, as sellers always are reluctant to lower prices at the beginning of a housing downturn.  Unlike the stock market, the lack of liquidity in real estate means bid and ask spreads widen at tops, as sellers are the only ones who list their prices.  There is only an ask price in house listings, there are no bid prices listed.  In the goods sector, inventories have built up bigly over the past 12 months, while demand is falling, a deflationary force that will play out in 2023 and feed into the CPI. 

In the heat of battle, its easy to go back to the last playbook and expect it to repeat.  The 2022 playbook was to sell bonds and stocks on strong economic data, and buy bonds and buy stocks on weak economic data.  I believe that playbook is on its last legs as the focus shifts from inflation to economic growth in the coming months.  When the focus turns towards growth, weak economic data will be considered a negative, as that just signals lower earnings in the future. 

The expectation here is that economic weakness for the next month or two will be taken as a positive, as investors still latch on to the last remaining bullish talking point: employment.  But when the economic weakness persists and the nonfarm payrolls numbers start to turn down, the talk among investors will shift from 1) the Fed needs to keep tightening, 2) the labor market is too tight, 3) inflation will be sticky, to: 1) the Fed is out of touch with the economy,  2) the economy is looking horrible, 3) when will the Fed come to the rescue?  It will happen sooner than people think, it always does. 

These outlier economic data prints (especially nonfarm payrolls) get investors so heated up and leaning towards one side, that it provides opportunity to take the other side, especially when the longer term trend is in the other direction.  The blowout jobs number is providing a good entry to get long bonds.  I was previously looking to enter SPX/NDX shorts, but I think I'll be able to get a better short entry point when the effects of this nonfarm payroll number wear off and everyone goes back to focusing on disinflation and a Fed that is almost done with the rate hiking cycle.  

These bear market rallies are seducive, and they suck in the technical traders who worship at the altar of price, and fund managers that have to keep up with the indexes, only to chew them out when the fundamentals come back to weigh on the market.  

After a huge rally in the SPX over the last month, the bar has gotten raised much higher for the economy.  Now you will need not only a continued disinflation to keep the Fed from overtightening, you will also need earnings to not go down much in order to justify all the recent optimism about a possible soft landing. 

A combination of long bonds and short stocks looks to be the ideal mix at these levels.  Based on how financial markets react, usually what happen is that bonds rally as it sniffs out economic weakness and future Fed loosening, and stocks react positively to that bond rally by rallying at the same time, but after a brief period of stocks and bonds going up together, the economic weakness becomes more pervasive and investors start worrying about recessionary impact on earnings, leading to weak stocks, and bonds going up even more as the feedback loop of weak stocks ---> weaker credit markets ----> weaker economy leads to a flight to safety.  

It appears we're still in the honeymoon phase with occasional flashbacks to the nightmare 2022 scenario of weak bonds/weak stocks (last Friday).  This honeymoon phase could last until the Fed finally says it is ready to pause its rate hikes, keeping the SPX above 4000, and then leading to one last relief rally, only to be met with the reality of an economy headed for a hard landing.  At that point, I expect a steady downtrend that lasts for months, and will be when you see retail start to throw in the towel on stocks that they bought up in January and February. 

Stupid Season

It must be that 6 month cycle working again.  Not many will remember this, but going into the earnings season in late July, ahead of the FOMC, the big worry was about bad earnings and a coming recession.  Fast forward 6 months.  The big worry was about weak earnings going into the new year, and a coming recession.  The market has climbed that wall of worry about downward earnings revisions, as all I heard in January was that earnings estimates for 2023 are too high from everyone that comes on CNBC or Bloomberg.  They were expecting earnings to disappoint and for stocks to go down.  Earnings disappointed, but stocks went up.  That is positioning at work.  People sell ahead of anticipated bad news, and buy ahead of anticipated good news.  No one is waiting for bad news to sell, when they know its coming.  That's the story for this earnings season.

Investors have not experienced this kind of chop market for a very long time.  You had smooth uptrends for most of the past 14 years, with every deep correction being over within a few months.  That is 14 years of investor conditioning to believe that the stock market always bounces back and eventually makes new all time highs.  Thus you get these fervent rallies when people think the market has bottomed, because it usually goes up for months on end.  

Its more than a year since the start of the bear market, and that belief in the stock market is still there.  I don't see the big outflows.   We've had 2 straight weeks of strong inflows into equity funds.  There is STILL a ton of speculation in shitcos, shitcoins, and meme stocks.  There are so many out there:  AMC, GME, CVNA, COIN, BYND, etc.  There is even an ETF that wraps up all of it in a nice little turd package known as ARKK.  All you need to do is look at the ARKK chart and you can tell that rampant speculation is picking back up.

The catalyst for all this movement?  Apparently it was because Powell didn't push back on the recent stock market rally and loosening of financial conditions by saying that financial conditions are tighter, and attempting to go for that soft landing.  Going for a soft landing = less likely to overtighten.  Powell is no longer looking for the market to feel pain to get inflation lower.  He thinks that inflation will go lower without much pain. It seems he has bought into the immaculate disinflation story that is getting quite popular these days.  That's why your seeing a strong rally in both stocks and bonds so far in 2023.  One rally looks sustainable.  The other looks to be running on hot air.  

Its hard to tell the difference between a mild economic slowdown and a deep recession at this point in the cycle.  We are just entering the fat cutting stage of the business cycle, as worker hours are reduced, layoffs announcements start up in a few bloated overstaffed sectors of the previous upturn.  Now is when investors and economists both get optimistic, as they see inflation coming down, growth slowing, but without the rise in unemployment.  This optimism is fueled by both the stock and bond markets going up, as it confirms their beliefs.  Fundamentally, the situation is worse than 6 months ago.  

July 28, 2022 (day after FOMC):  SPX 4072, 10 year 2.68%, Fed funds rate 2.33%

February 2, 2022 (day after FOMC): SPX 4179, 10 year 3.40%,  Fed funds rate 4.58%

The SPX is 100 points higher, the 10 year is 70 bps higher, and Fed funds is 225 bps higher.  The environment for the conservative investor is much more favorable, as he is getting 225 bps more on cash and 70 bps more on 10 year Treasuries than 6 months ago.  

The 2 main bear thesis are either:

1) Inflation will remain sticky, the Fed will keep their word, and not cut in 2023, and stay higher for longer, pulling down both stocks and bonds.  

2) Inflation goes down but the economy goes into a deep recession that hurts corporate profits and pulls down stocks but pushes up bonds.  

I am in camp number 2.  The disinflation is happening, but its not going to be immaculate.  This disinflation is happening mainly because demand is going down.  When the biggest asset in most people's portfolio, their house, is frozen, as transactions disappear in the face of higher mortgage rates and lack of demand at current prices, you will see sellers lower their offers.  That reverse wealth effect, combined with a bear market in stocks, is a toxic combination.  Don't forget that organic growth is meager now in the developed world, mainly due to low population growth and having squeezed all the economic growth possible from financial repression and low rates over the past 14 years. 

What you are seeing now is stupid season, when investors get enamored with the bullish side of the story, forgetting about the negatives.  These are the moments where you can take long term short positions.  Its what I've been waiting for while playing small.  Its getting very close to the time to go big on the short side.  I am not smart enough to pick the top, so I'll scale into the shorts, focusing more on heavily shorted and more speculative names at first, and then adding index shorts.  It is time to short the speculative, heavily shorted garbage, but I would wait a few days to short the SPX.  The strength in the bond market and the lower volatility means that you will see more inflows into risk assets as vol control and systematic funds add equity exposure.  It should mostly be played out by the end of next week.  

AAPL threw some cold water on this rally.  Rallies don't end on bad earnings reports.  The speculators are looking for blood.  Bear blood.  As I mentioned a few days ago, a strong rally after FOMC with Powell not going full hawk would make the bulls feel invincible.  That's where we are.  Its time to go to action on the short side, with any rally from here over the next couple of weeks likely to just be temporary, and all of it and more will be given back in the coming months.