Insanity

Sometimes you just have to shake your head.  It can feel like you are the one who's insane when everyone else is doing something else and making money at your expense.  That's what its felt like for the past 2 weeks.  I've been patient with the shorts, waiting for the bulls to regain their sanity, and they haven't.  Is it a new bull market, making me the one who's insane, or is it just a bear market rally, which is making the crowd insane.  We'll find out in the coming months.  

I'm not a Twitter trader, so I can admit to losing.  It's part of the game.  That being said, haven't seen that kind of mania in speculative stocks since last August, when I made the mistake of assuming that the market would linger near the rally highs around 4150-4300, covering shorts too early.  Of course, the market folded like a cheap lawn chair and went straight down for the next 45 days.  

On to the bond market.  2022 wasn't easy if you had any faith in the bond market, which I did and still do.  2023 should be quite a different story.  The coincident indicators are starting to show weakness, although employment remains stout, which keeps the soft landing crowd believing in stocks.  Leading indicators, however, are a horror show.  I'm noticing some interesting parallels between now and 2019 for the bond market, except this time, Powell is being stubbornly hawkish, not making a quick dovish pivot.  Here is a look at the leveraged funds position in 5 year and 10 year Treasuries back then and now:

5 year Treasury Futures COT Leveraged Funds Net Positions

10 year Treasury Futures COT Leveraged Funds Net Positions

Leveraged funds are hedge funds: a mix of CTAs, macro, and fixed income funds that use Treasury futures to either hedge their cash bonds or to make outright bets on rates.  They are trend followers, but they stick with the trend even when its going against them in the short term if the long term trend is still intact.  Of course, long term trends start from short term trends.  I believe we are at one of those inflection points in the bond market, as the long term trend has been down for over 2 years, since mid 2020 to late 2022.  But now, it looks like there is a battle going on, between the bulls and bears.  I lean on the bullish side as I am more bearish on the global economy than most, and less of a believer in the central banks' forward guidance, which changes quicker than people think.  

As you can see above, leveraged funds are putting on big short positions in both 5yr and 10 yr Treasuries, the shortest they've been since late 2019 in 10 yr Treasuries.  But the price action is running counter to their positioning, and that's when things get interesting.  I expect pension funds, mom and pop investors overweight equities and who sold their bond funds in 2022, to jump back in when the coast is clear.  That would be when the Fed pauses rate hikes.  And that looks likely after a final 25 bps in March.  

Back to the stock market.  The 2021 stock slinging daytraders and meme stock crowd is back, this time jumping on the TSLA bandwagon again, along with a slew of other bubble stocks like ARKK, COIN, MSTR, etc.  They can't get enough of the action, and are pushing these stocks back to where they were in November, before the big plunge lower in all things tech related from late November to late December.  Now you are back to levels where the shorts are looking quite juicy for a lot of these former bubble boys.  I haven't put on any big positions in these yet, as I'm waiting for the FOMC and ECB meetings to be behind us before feeding the ducks.  

I sense there is some caution among investors and EVEN these gun slinging speculators ahead of the FOMC and ECB meetings this week.  They remember all the times last year when Powell came out hawkish as hell and hammered the markets.  So they are bracing for impact and selling some stocks ahead of time.  With Powell all but guaranteed to do 25 bps, his hawkish rhetoric won't have the same sting as when he went 75 bps and went full hawk.  It would be totally toothless for him to do 25 bps and then talk tough.  Its like a guy with a toy pea shooter acting like Mr. Tough Guy shooting plastic BB pellets into the crowd.  It just doesn't have much effect, no matter how tough he sounds.  

So I think these never say die bulls will have a sense of relief once this week's events are over as well as earnings season and ramp stocks back up again, past SPX 4100, creating that fake breakout above resistance that every paper napkin technician can see in the charts.  Once you get that move above 4100, you will truly see euphoria and be able to put on long term shorts.  I was expecting to put out the shorts in the spring, not expecting so much enthusiasm so quickly after the December washout of spec names, but here we are.  You have to play the hand that is dealt, and it looks like I'll have to put on the long term shorts earlier than I expect this year.  Got out of most of my underwater shorts yesterday, and will get out of the rest today.  Leaving dry powder for next week for the long term shorting campaign. 

Setting Up for FOMC/ECB

Its amazing how you can hear a mouse squeal when the Fed is in their quiet period.  Next week, we get the one two CB combo of Fed and ECB on back to back days.  With the Fed, you have Powell who has softened his tone lately but has mostly let his lieutenants run their mouth, because well, they just want to sound like inflation fighters to boost their careers.  I can't imagine Powell doing anything to placate the bulls, but I have a consensus view, so probably close to a nothingburger at the FOMC meeting, don't expect him to go full hawk like he did at J-Hole or the Sep. and Nov. meeting, expecting more mealy mouth language that's more noncommittal, except that he'll probably say rate hikes are not done, even with the step down to 25 bps.  Remember, Powell's ego and reputation is on the line. If he wimps out here and goes dovish when stocks are in rally mode, he will lose some credibility.  That said, he can't deny that inflation is coming down more quickly than many expected, even though the labor market remains tight.  

With the ECB, you have the hawkish Lagarde who is talking smack to STIR traders in the Eurozone who are long and fading her. You had a huge bond selloff post ECB meeting in December, so that's going to be on the minds of bond investors this time around.  After a big rally at the beginning of the year, kind of neutral here on the bond market, but if I had to make a play, I would choose the long side.  Longer term, unlike stocks which look a bit rich, bonds are at decent levels and have room to go higher.  

The price action in stocks has been strong after earnings reports that have been weak.  It appears that investors are feeling more bullish these days, and you are probably getting CTAs chasing the move higher, as the SPX trades above its 200 day MA and hit a 1 month high.  The last buyers will probably be vol control funds which are just waiting for the volatility to go down a bit more before they pile in.  That could be the last push higher before this bear market rally rolls over.  A realized vol chart from @NewRiverInvest for a SPX/UST balanced portfolio.  Still elevated, but if it drops a bit more, you will see funds getting deployed in BOTH stocks and bonds. 

The resilience of this stock market despite terrible fundamentals and tight monetary  conditions is a bit surprising.  The $5+ trillion Covid helicopter money drop is the gift that keeps on giving for financial markets.  Liquidity came in like a fire hose, and the meager QT is taking it out with a paper straw.  The only plausible bull case for a long term investment in SPX at these levels is if the Fed goes right back to their 2008 playbook and cuts to zero with alacrity and goes back to unlimited QE at the first sign of deep job losses and weak economic data.  But to get to that point, ironically the stock market would have to drop a lot in a hard landing to get the Fed's attention and make them overreact to the weakness.  A soft landing isn't the best case scenario for stocks, that will only take Fed funds rate down to 2.5-3% level.  A hard landing inducing the Fed to overreact with their liquidity bazooka gun is the bull case. 

Stuck in the red on my NDX and SPX short positions.  Not willing to make Custer's last stand with these, so will hold for a couple more days and look to exit early next week before the FOMC meeting.  There is a good probability that you will have a relief rally unless Powell goes full hawk (unlikely, but not zero probability).  I will not be playing the long side even though I think we're probably going to rally late next week.  The risk/reward is just not good enough (rug pull risk is too high here).  That relief rally + the return of the corporate buyback window in February could boost this market higher for the next few weeks.  As positioning has been getting more long among asset managers in SPX and NDX, the rally will probably be small (up to SPX 4150-4200), as you've already made a big move off the December lows. 

Cherry Bomb Market

There are markets where up trends last for a long time, and there are chop markets where up trends are brief and don't have staying power.  It feels like we're in one of those cherry bomb markets.  If you have ever lit a cherry bomb firecracker, you know that the fuse is very short.  So once you light the fuse, you have to run.  On the long side, you have can't stick around and wait for much higher prices to sell.  If you hold the bags for too long, they explode in your hand, like a short fuse cherry.  In the past, the bombs had much longer fuses, so bulls had plenty of time to stay invested, ride the trends higher, and get out comfortably without rushing.  This is a totally different.  It punishes the late seller, and the graceful selling windows are much smaller and narrower.  A much less forgiving market for longs. 

This uptrend off the October low has been choppy with deep pullbacks, with the market topping out as soon as investors got comfortable with whatever piece of bullish data or news that came out.  

Over the past 3 months, there have been 4 pullbacks after a good news pop as shown in the above chart.  The SPX didn't have staying power after each of those pops.  The investors who chased the rallies by buying on good news were punished.  The reason this keeps happening is because the big picture of tight liquidity conditions and earnings deterioration are still there.  In fact, we are getting closer and closer to the point in the cycle where leading indicators showing weakness start seeping into the coincident indicators and the hard data.  That's when the soft landing hopes dissipate and a re-valuation lower for equities is likely.  Maybe its because I'm a permabear, but I still don't understand how investors can get optimistic under these conditions.  

Its quite telling though that the optimists seem to be playing for short term move higher, not a long uptrend.  That means the active investors are looking to sell quickly and are not sticky investors, looking to hold for a long, big move higher.  Those are the worst owners of stocks.  They have low conviction, and sell quickly on a whim.  It appears those buyers of meme stocks, high beta tech, bitcoin, etc. are low conviction buyers looking for a quick hit and run play, hoping that the rally can last for a few more weeks so they can sell higher.  You don't see many new, highly convicted buy and hold investors jumping into US stocks.  Its all short term, technical based traders and investors that think they can jump in and out of the market and be nimble before the tide turns.  I don't like playing those games, because you have to deal with rug pull risk, which can come quickly and violently after bear market rallies.  

So what is the reason for the recent big rally in tech stocks and high beta names?  It appears to be a combination of being oversold, rally in bonds, and optimism that layoffs at the big tech companies will help to cut costs and boost profit margins.  Its almost as if all those workers were basically meaningless to the bottom line and were just dead weight.  I can't argue against that, but having fewer workers just means more work for those remaining, which isn't sustainable in the long run.  

Its not a good sign for equity investors to see oil creeping back over 80 and acting strong ahead of the Chinese re-opening.  The last thing this market needs is an uptrend in oil prices just as the higher interest rates really start kicking in to the real economy.  Nothing fundamental has changed from when the SPX was at 3800 in late December, and where it closed around 4020.  Its just been some price insensitive portfolio allocations getting jammed through at the start of the year along with neat excuses for the rally:  soft landing hopes (because yields are going lower while employment remains strong), weaker dollar, China re-opening, technical breakout above 200 day moving average, etc.  

Really specious reasoning out there which make the rallies more fleeting than if there were actual real fundamental changes going on that would signal that the worst is over.  Its just one of those listless periods where there are no strong drivers in the short term, so we chop around.  The hard data hasn't rolled over yet, so the soft landing hopes are still alive.  And bond yields are now much less volatile, as disinflation continues, so stock investors are finding comfort in that.  Expecting more of the same chop in the coming weeks, until the last gasp rally after the last rate hike in March.  From April onwards, I am expecting a 2nd leg down that will be brutal.  No need to think too far ahead, just try to ride the choppy waves in the meantime.  Staying on the short side of course. 

Remember, Its a Bear Market

I don't know what it was like in the 1970s during the high inflation period, but if I had to guess, this bear market looks similar to the 1973-1974 bear market, where SPX went down 49% from top to bottom in 21 months.  At the bottom in October, the SPX was down 27% from top to bottom in just over 9 months.  The bear market in 2000-2002, one which I actually experienced, with similar bubble characteristics, the SPX went down 50% from top to bottom in 28 months.  

SPX 1973-1974

SPX 2000-2002

Not saying that we're going to repeat those 2 previous brutal bear markets where the SPX was cut in half, but even a lesser bear market taking the market down a mediocre 35% from the top would take the SPX to around 3100.  

From both a technical and fundamental perspective, this is about as bearish of a market as I've seen since those dotcom bubble days.  Even in 2007, the SPX never got nearly as overvalued as it did at the end of 2021.  

Sometimes I think its just too obvious of a bearish setup, it must be a bear trap.  But then I look at the massive equity fund inflows for the last 2 years, and the ridiculous amounts of bullishness and bubble behavior in 2021 and it is a classic post bubble bear market here.  And the biggest and worst bear markets happen after bubbles. 

The first half of 2022 was a struggle to get rid of my bull market trading psychology built up over 13 years of a raging bull market.  It took time to embrace the bear market and adjust to the new reality that will be around for a while.  It was only after Powell went full hawk at Jackson Hole to fully realize that the SPX was now a short seller's market. 

For 2023, anytime the market even gets a little bit excited and optimistic about stocks, it is time to short.  There are so many underwater longs that are looking to get out on a big rally that any rallies that take the SPX towards 4000 or higher are great opportunities to layer on shorts.  There is a lot of overhead resistance.  The psychology of the US stock investor has changed.  They are no longer looking to chase momentum and look for home runs, they are just hanging on, hoping for a miracle soft landing and/or Fed to come to the rescue, expecting it to rocket the SPX higher.  Hope is not a strategy.  

The bearish turnaround in the market on Wednesday seems to have surprised a lot of bulls.  The PPI came in weaker than expected, economic data came in weak and boosted the bond market, and stocks liked it at first, but then sold off aggressively to close at the lows.  The stock/bond correlation is changing.  Bonds are strong, and receiving a lot of inflows.  Stocks are choppy, and losing their bid even when bonds are strong, so that high positive correlation of stocks and bonds moving together is breaking down in 2023.  We are now moving from an inflation focused regime to a growth focused regime.  Those regimes are dominated by negative correlations for stocks and bonds, as bonds like it when economic data is weaker than expected, but stocks don't, and vice versa when data is strong.  The bad economic data is good news for stocks regime is near its end. 

Expensive and Tight

These countertrend rallies in bear markets are always tempting to investors.  So much money has been lost, its only natural to expect a mean reversion, especially when the previous trend higher lasted for so long.  Investors have been conditioned to expect the US stock market to bounce back from downtrends, and do it quickly, going up aggressively, like what happened after every big pullback since 2008:  2011-2012, 2015-2016, 2018-2019, and 2020.  But during each of those selloffs, the Fed was on the long's side, pumping up the markets.  Valuations were on your side as the market was not overvalued at each of those previous bottoms.  This time around, you don't have the valuation buffer to support stocks, and you don't have the Fed backstopping the market.  These are probably the 2 most important factors in investing in stocks:  1. valuations  2. monetary policy.  

The trailing P/E for the SPX is 19.5, which is well above the average of 15.5.  

Those SPX earnings are driven by near record profit margins, which historically are mean reverting.  Given how much corporate tax rates have been cut, how much corporate lobbying is entrenched in Washington, its so good, it can't get much better  type of scenario.  Given the populist lean among current politicians, I doubt they give even more tax breaks and tax cuts to corporations.  The political tide is slowly shifting away from corporations.  Corporate welfare is losing favor, even among Republicans.

Now let's take a quick look at monetary policy, in particular, the shape of the yield curve.  Here's the 2-10 yield curve, at -65 bps, showing a massive inversion, signaling a Fed that is very tight.  Inverted yield curves are both signs of a pending economic slowdown and a Fed that is too tight.  Both negatives for equities.  

 

With cash yields so high, the bar for equity investments is raised, as the competition is now 4.5% T-Bills which are risk free and provide future optionality.  Under current monetary conditions of short term rates that are high, with QT working in the background, with no fiscal stimulus impulse for the coming year, those are brutal conditions for equity investors.  

Recently, I've noticed many touting the improving technicals for overseas markets, the falling bond yields, weaker dollar, and the breadth thrusts in the stock market, but those are minor short term positives going against major intermediate term negatives of long term downtrend, high valuations, and tight money. 

If you are buying after a 200 point SPX rally from 2 weeks ago, 400 points above the closing lows from last October, you are betting on this bear market to either be over, or for a bear market rally to extend to lengths that are uncommon.  The financial markets are a probability game.  The high probability scenario is for the bear market to continue, as you have rarely seen bear markets bottom with valuations so high, especially under tight monetary conditions.  And betting on a continuation of a bear market rally after its been over 3 months since the last mini panic bottom is pushing your luck.  

Those that get caught up in the day to day movements can get enamored with short term strength, extrapolating it into the future, and buying into the suddenly positive news stories that permeate after a bear market rally.  These mini buying frenzies are often led by speculative garbage (BBBY, CVNA, AMC, bitcoin, etc.) which get bid up by speculators looking for quick gains. 

Never lose the forest for the trees.  Stay with the long term trend and fade the short term countertrends, in both bull and bear markets.  Added to NDX and SPX shorts this week. 

Deer Hunting

Was in wait and see mode, relaxing, but they pulled me back in with that rally ahead of CPI.  Now that the number has come out, basically inline with consensus estimates, the market moves on to real fundamentals of earnings season and a dose of reality that falling inflation doesn't improve corporate earnings.  And an inline CPI number just means that the Fed will do 25 bps hikes for the next 2 meetings, which isn't exactly a bull catalyst.  

There is no point diving in to the CPI inflation underlying details, there are enough geeks out there who will do that and lose the forest for the trees.  What matters is what the market is thinking on inflation, and its no longer scared of it.  Its now quite sanguine and thinking that inflation will glide down to lower levels for several more months.  I don't disagree, but there is no more big positive catalyst for declining inflation.  The market has caught up to that disinflationary story line. 

Big picture, remember that monetary policy is really tight and Powell seems to be happy with that, and not willing to go for that soft landing by doing an abrupt dovish turn.  Powell still wants to be remembered as an inflation fighter, and he has room to act like a tough guy with nonfarm payrolls still coming in strong.  He wants to get rid of that money printer label, that Mr. Transitory label.  He's trying to rebrand himself as a hawk, and he'll try his best to fool the market into thinking that, and in the process, assure that the US stock market feels some serious pain before he pivots. 

I am sensing investors are about to make another mistake by getting bulled up on the China re-opening story, getting excited about emerging market and European stocks.  They fail to realize that China hasn't done a money spew like the US during Covid lockdowns.  There is some chunky stimulus to keep the property bubble from turning into a total disaster, but not enough to reinflate the bubble.  The bubble psychology in China for real estate is gone.  Its not coming back.  Not with the horrible fundamentals of oversupply with a shrinking working age population.  The long term story is the bursting of the Chinese real estate bubble, which is much more important than some temporary blip higher in services demand post zero Covid, which everyone loves to focus on.  It figures, considering how most investors' time frame these days is measured in days and weeks, not years. 

I wrote on Monday that I was looking at shorting NDX/SPX when SPX got towards the 3940-3980 range.  The market has gotten there and exceeded that level, and I've used the rally to put on a small short, with plans on adding more if we grind higher in the coming few days.  Expecting a range for the SPX between 3800 to 4000, with NDX lagging SPX in the first quarter.  There could be a slight overshoot beyond that range for a brief period, but expecting the majority of trade to happen in that range.  Not time yet to go elephant hunting, just hunting deer at the moment.  By spring time, it will be a different story and time to go for big game. 

A Fallow Period

Its the beginning of the year.  Everyone wants to predict what will happen in 2023.  But you can't force your views on the market.  People want to make the big call, for a big move, with time frames to match, like weak 1st half, strong 2nd half, etc.  You can't put a time frame for big moves during a period of range bound trading with little edge.  

Sometimes there just isn't much to do.  Or even to talk about.  Sure, I could talk about the big move on Friday in the bond market, and in stocks, on a relief rally that NFP didn't come in hotter on wages and jobs number, and due to a weak ISM services.  But I don't believe that storyline.  People won't tell you this, but over 90% of the explanatory power for Friday's moves were beginning of the year funds flows waiting for the NFP and ISM services to come out to pile into bonds and stocks (to a lesser extent) no matter what.  Its time sensitive and price insensitive money flows.  The kind of flows that moves markets.  Its of course a much better story to talk about a possible soft landing with wage growth weaker but jobs number strong (i.e. Goldilocks according to the media)  causing a surge of money to go to bonds and stocks.  That's not sustainable IMO. 

While the day to day movements are volatile, the week to week movements have been tame.  It almost seems as if the stock market has just became a 0DTE casino where bettors come in the morning and leave in the afternoon, win or lose.  Since I'm not smart enough to guess what the intraday movement will look like, I stay away from those daytrading games.  Before you had the HFTs dominating these markets with their front running and predatory algos, there were good daytrading opportunities even in index futures and big cap stocks.  But since around 2014-2015, its gotten tougher as the algos have gotten more advanced and the dumb money has been squeezed out of the short term game.  

It took a few years of flat to down results for daytrades for me to admit defeat in the intraday game.  I still dabble in single stocks for daytrades, but not SPX.  SPX and NDX are solely swing or position trades, which is where the sweet spot is for my style.  Yes, great daytrading opportunities made a brief comeback in single stocks in 2020 and 2021, but that's over.  We're definitely back to the same HFT dominated intraday flows which are tough to beat.  

For the Treasuries space, this is the fallow period.  A range bound market that doesn't get too bearish or too bullish, but is still dangerous to play because of the above average volatility that happens on a whim.  For example, the moves in the global bond markets were savage in December, when the market shot up on a cooler CPI, squeezing shorts, only to get hammered by a hawkish ECB and then a few days later by the BOJ loosening up yield curve control.  By any measure, the moves were overreactions, as the first week of 2023 has taken back most of the bond market moves happening in the last 2 weeks of December, without any meaningful changes, other than the calendar year.  If you were in the middle of the battle with long bond positions while the market was trading super weak, you were feeling some heat.  

For the index futures space, this is a much to do about nothing type of market.  Lots of day to day volatility, but not going too far on a week to week basis.  Definitely not the type of market that is great for longer time frames.  You aren't seeing extremes on either side, so its hard to put on a meaningful position with conviction.  

Here are the forces that are at play:  beginning of the month inflows into international stocks and bonds, lifting prices in those markets, while you see outflows from crowded, overvalued tech stocks from both retail and institutions.  They are not a sign of a trend change, just short term strategic flows coming from institutions that are putting cash to work, insensitive to price so they are moving markets.  Its not going to last much longer, as these type of flows are time sensitive and usually get done within the first 2 weeks of the year.  So at this point, its not really playable, except to fade it if it goes on for a few more days and gets extreme.  Some of the money being thrown at the emerging markets because of the China reopening theme is getting close to a short term extreme, near short term exhaustion points.  

Really, its a stretch to try to find good, high risk/reward opportunities at this juncture.  Things just feel too neutral.  In SPX/NDX, it feels like the crowd is leaning a bit bearish, but that's warranted given the weakness over the past month.  But even that bit of bearishness has gone away after the nonfarm payrolls/ISM services boosted sentiment.  The crowd is still not bullish enough to safely put on long term short positions.  Positioning is still leaning a bit too bearish after the heavy December outflows from equity/bond funds for me to want to put on equity shorts.  And I'm not even bothering to look for longs, as that's a dangerous game in this type of post bubble market that hasn't gone down to reasonable valuations.  There is still a lot of fat left in this bloated pig to shear off.  

As for Treasuries, with a Fed likely to raise at least 2 more times to 4.75-5.00%, possibly a bit higher, its not a great risk/reward trade at this point when 10 years are trading below 3.60%.  The curve is just too inverted (2s-10s at -70 bps) to expect a big rally in bonds without a Fed signal of a pause or a big shoe to drop, neither of which are likely to happen in the next 2 months.  So Treasuries are probably range bound here, trading in the range built up in December, just like the SPX.  Its a boring call, but everything feels neutral, and I don't expect a catalyst in the next 2 months to take this market out of this range bound trade.  Thinking SPX 3740 to 3980, UST 10 yr yield 3.40% to 3.90% until March.  Only interested in the short side for SPX/NDX around 3940-3980.  Interested in the long side if UST 10 yr is 3.90+%, small interest on the short side if US 10 yr is 3.40+%.  

This may be an exciting time for day traders due to the big intraday swings, but its a boring time for position traders.  Not pushing it here, letting the markets come to me, even if it means doing little for several weeks.  

By the way, if I'm not putting out posts in the coming weeks, its because there is not much to talk about and nothing to do.  When you don't have an edge, its best to just keep quiet.

Turn of the Year

Its not common to see bonds trade with more volatility than stocks but that's been the case for the past 2 weeks.  Ever since the BOJ tweaked their yield curve control levels, bonds have been in a free fall, exacerbated by fund managers looking to cut their bond losers and not wanting to show them in their year end portfolios.  The fear of hawkish central banks took over.  But as soon as it turned into 2023, its been nonstop buying in the bond market, especially Europe, which fell the steepest over the past 2 weeks on a hawkish ECB.  Its a battle between the disinflationary forces which are becoming more apparent and the stubborn hawkishness of the perpetually lagging central bankers. 

In the meantime, the stock indices have vacillated between weakness and strength, with that Santa Rally missing but no plunge into deeper negative, even with the weak bond market.  I hesitate to read too much into the price action in the last 2 weeks of 2022, and the first 2 trading days of 2023, but there are hints of a shift in investor psychology.  You are seeing the stock-bond positive correlation that's been prevalent in 2022 fade away as the focus moves from inflation to economic weakness.  In a high inflation environment, both stocks and bonds suffer as yields move higher.  But in a weak economic environment which is likely for 2023 and 2024, stocks suffer from lower corporate earnings while bonds benefit from weaker inflation due to weaker growth and an expectation of future rate cuts.  

Investors are still overweight equities and are still emotionally holding out hope for a recovery after a bad 2022, just because that's what's always happened since 2009.  The resilient nature of the SPX is what keeps investors hooked and hoping for a recovery out of the blue, as has happened so often the past 13 years.  But their intellectual side is telling them that stocks are still overvalued so they aren't very willing to add more.  They are underweight bonds after the last 2+ years of a steep bear market and are slow to embrace the better values found with the higher yields.  But their intellectual side is telling them that bonds are the go to asset class in a disinflationary, weak growth environment, even if it feels scary to fight the Fed, ECB, and BOJ who are still hawkish.  Lastly, investors are overweight cash as it's finally yielding a good return and stocks and bonds have been such poor performers in 2022.  They are comfortable holding cash.  Almost too comforting, which usually doesn't work out in the financial markets.  But the thing about cash is that it historically performs the weakest in the long term vs stocks and bonds, so its not something that investors will want to hold on forever.  

From my vantage point, 2022 was quite an unpredictable year because the Fed totally changed its behavior, turning into super hawks, and its something that took many by surprise.  Those trading based on pattern recognition and past historical data were hammered.  At the same time, as an institution, the Fed is the same political animal that follows what the politicians and market participants think.  As soon as the worry over inflation fades away in this disinflationary environment, as growth weakens and the economy enters a full blown recession, the words from politicians, economists, investors, etc. will be screaming policy error, begging for rate cuts, and putting immense pressure on Powell and the crew to deliver.  Its hard to imagine now, when they are still hawkish, saying they won't cut rates in 2023, when the unemployment rate is still very low, and the worries about inflation are still there, but fading.  But you get paid in the market when you can accurately predict change and make the proper bet that will pay off in such a scenario.  

The highest probability scenario in 2023 is the one where the economy gets much weaker than many expect, so weak that it will force the hand of the Fed, despite losing more credibility as they have to go back on their guidance of no rate cuts for 2023.  In that scenario, the Fed will probably start cutting sometime in the summer, perhaps July.  The stock market will have been plunging for several weeks due to an intransigent Powell who's trying to gain an inflation fighting reputation and admiration like Volcker, only to be making another policy mistake, keeping rates too high for too long and causing an economic mess.  

In this environment, being overweight bonds, underweight stocks, and holding some cash for optionality is the optimal portfolio mix.  But that's not how most investors are positioned.  Most retail investors are overweight big cap tech, with almost no fixed income exposure.  That's probably the worst portfolio for 2023, with already the first day of 2023 highlighting that fact.  Its a worse version of the post dotcom bubble period from 2000-2002, because this time, housing is much weaker, organic growth rates much lower, and productivity gains going in opposite directions from that period (up in 2000s, down in 2020s).  It feels like being long tech stocks now is akin to being long tech stocks in early 2002, looking cheaper after a big selloff the previous year, but still facing another big swoon in the coming year.  

In the first week of the year, I haven't made any big moves, holding some Treasuries, no real position in stocks, and waiting for the right time to add.  Looking to add more bond exposure (short end of the yield curve) and add some short tech stock exposure (hopefully after a bounce sometime this quarter) when the time looks ripe.  Both would be for longer term positions that could be held for a few months, so I see a lot of opportunity in those trades, something that you can ride for a big move.  Looking for the stock-bond correlation to turn negative with a vengeance as soon as the Fed finishes their last rate hike, mostly likely to happen after the March FOMC meeting. 

Risk Management and Bet Sizing

Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1. - Warren Buffett

When I was young, I used to think more was better.  Big bets and big gains.  Trying to hit home runs.  Not focusing much on the downside, and the long run path.  It was always short term thinking, impatience.  Trying to make money quickly, without thinking about the long term implications of my strategy.  I've learned over the years at how flawed that strategy is.  Experience is a stern teacher in the market, especially for those that are stubborn and hesitant to change.  If you don't learn lessons from losing lots of money, you won't last in this business.

Managing risk is the most underrated aspect of trading and investing.  In a game where you will lose often, you have to be able to handle the ups and downs that come.  Being too conservative is much, much better than being too aggressive.  Those that are too conservative may not make a fortune but they stick around, survive, and have a chance to learn and get better.  And slowly accumulate.  Those that are too aggressive can have big runs but they can't dance around the raindrops and stay dry forever.  Those that push the limit don't survive and eventually have to get a real job.  

Being too conservative is a sign of fear.  That can be a good or bad thing.  It limits bet size which keeps you in the game.  But it also minimizes opportunities when more could have been made.  The financial markets don't attract too many of these types of people.  These types usually just put their money in equity index funds or bond funds.  Most of the types that are attracted to actually making their own investment decisions are usually too aggressive.  

The reason most traders fail is not because of bad stock picks or bad trading decisions.  Its because they bet too big and lose too much when they are wrong.  Traders usually think about how much they will make when they make a trade.  Not how much they could lose.  Its that eternal optimist in all of us where we cling to hopes and dreams.  Hoping and dreaming is a killer in the markets.   Even if you don't blow up trading too big, you will dramatically underperform a less risky trader.  Consider 2 traders:  

Trader A:  Makes or loses 50% of his account per trade.  Wins 60% of the time.  

Trader B:  Makes or loses 10% of his account per trade.  Wins 50% of the time.  

Who performs better over the long run?  

Let's do this exercise:  

Trader A and B both start with 100.  

Trader A:  wins 6 and loses 4.  100 -> 150 -> 75 -> 113 -> 169 -> 85 -> 128 -> 192 -> 96 -> 144 -> 72.  60% win rate but loses 28% after 10 trades.   

Trader B: wins 5 and loses 5.  100 - 90 - 99 - 89 - 98 - 108 - 97 - 87 - 96 - 106 - 95.  50% win rate but loses 5% after 10 trades. 

Imagine if both trader A and B both had the same win rates.  It would be an absolute disaster for trader A.  Even with a 10% higher win rate, trader A massively underperforms trader B.

Excessive volatility in the account balance is a huge drag on performance. 

Another big negative for traders that are too aggressive is that big bet sizes force unwanted decisions at bad times.  Forced selling is the worst way to sell (when long).  Forced buying is the worst way to buy (when short).  Proper bet size allows you to weather the storm, stay with trades through short term drawdowns to their ultimate destination.  It gives your trades time to work, which is half the battle.  Being forced to push the eject button because of short term market volatility destroys returns.  Closing out trades because you are wrong instead of because you are losing money is a big difference.  Its hard enough to make money playing on your own terms.  If you are forced to play on the market's terms, you will be chopped up and whipped around and left in tatters.  

There is a reason that Warren Buffett says the most important rule is never lose money.  He doesn't mean it literally, because that's an impossible task, but states that rule to emphasize the importance of limiting losses to growing wealth. 

The last week of the year, and for the past few trading days, you have seen tax loss selling and a cleaning up of portfolios for window dressing purposes.  That has led to weakness in tech stocks and bonds.  Its been a terrible year for most fund managers.  And amidst hopes for a Santa Claus rally, the firepower was lacking for buyers to push the market much higher.  I remain neutral on stocks, and did miss a potentially very profitable short a couple of weeks ago post CPI, but missed trades happen.  I overestimated the willingness of investors to chase stocks and make bad decisions while fundamentals remain terrible.  Although the price action is weak, I remain bullish on bonds as I expect the fundamentals of a weakening economy and falling inflation will supersede central banks' hawkish rhetoric.  

My New Year's resolution for 2023 is to trade less by betting smaller and having wider price targets.  By betting smaller, I will achieve 2 important things:  1) be less affected by short term price movements, leading to better decision making and less forced trades (stops/liquidations). 2) have a better quality of life with less stress.  

Here's to a great 2023.  Happy New Year.

When the Fed Pauses

We are very close to the end of the tightening cycle.  The LEIs and PMIs are both showing an economy that is at the beginning of an economic downturn.  While the labor market still hasn't cracked, its not as strong as the nonfarm payrolls have shown, due to inaccuracies and double counting part-time jobs held by one person.  The divergence between the household survey and the establishment survey is huge, which tells you that 2nd jobs have been a big part of the strength in the nonfarm payrolls number.  Also, the birth-death model underestimates job losses when the economy suddenly starts to weaken, as businesses unlikely to respond when they are about to go out of business or are out of business.  

Inflation is trending lower but people are still spooked by the trauma of higher than expected CPI prints for most of 2022.  On the housing side, the end of eviction moratoriums and the increase in supply in 2023 will ensure that rent inflation is subdued.  If layoffs blowup like I expect it to next year, a lot of Millenials will be moving back to their parents' basement rather than staying in an apartment.  The only fly in the ointment to my disinflation thesis for 2023 are commodities.  Commodity prices could go back up again as China comes back on to the market for their "reopening".  I don't think it will be as big as people expect, but the anticipation of it could boost energy prices in the first half of 2023.  But overall, even if oil prices go back up, the year over year comparisons will be favorable, so higher oil prices won't feed too much into the CPI.  

I know they say that Powell doesn't want to stop hiking and then start hiking again if inflation stays sticky, like they did in the 1970s, but he's deluding himself if he thinks this economy is anything like that of the 1970s.  You have to remember that in the early 1970s, the US went off the gold standard, and that ushered in an inflationary wave, exacerbated by the oil embargo.  You had a fast growing younger population, with a much higher demand for goods, while not having the mass globalization as you do now to be able to meet the demand.  The money supply was growing faster than it is now.  And there was much less household debt.  The household debt to gdp ratio is almost double that of the 1970s.  

Households cannot handle high interest rates when they hold so much more debt.  Not only that, the wages adjusted for inflation were much higher in the 1970s than they are now.  A lot of people are buying into the sticky inflation/deglobalization/1970s theme but the data just doesn't support it.  

I don't know what Powell is thinking, although many are saying that he wants to be revered like Paul Volcker.  But Volcker was just a person who was in the right place at the right time.  He wasn't the one who killed inflation.  Commodity deflation, productivity growth from technology leading to deflationary forces, and the dollar going on a massive appreciation cycle as it became the clear global reserve currency were the inflation killers.  

The bond market is the biggest beneficiary of a Fed that finishes its rate hiking cycle.  In the last 4 rate hiking cycles (1994, 1999-2000, 2004-2006, 2017-2018), 10 year yields fell rapidly after the last rate hike.  While stocks also did well right after the Fed finished hiking, the strength was temporary in 2 of 4 cases, as stocks dropped bigly in 2000-2002, and in 2007-2008.  But all 4 cases saw bond yields trend lower for years after the final hike.  

Here is what happened to 10 year yields after the last rate hike and during the subsequent pause in 1994, 2000, 2006, and 2018-2019.  

Here is what typically happens after the last rate hike by the Fed.  They never signal a future rate cut, they either signal more rate hikes which they can't execute due to economic weakness, or they signal that they will keep rates at current levels for an extended period.  They NEVER signal a rate cut right after their last rate hike.  So don't expect one.  Just expect the bond market to start rallying after the dark cloud of future rate hikes is lifted and the sunny skies of future rate cuts is on the horizon.  

People like to look in the rear view mirrow when forecasting, which is why you see a lot of fears of another bond market liquidity squeeze like you saw in September/October or hawkish central banks.  Central banks ALWAYS fight the last battle.  They have no foresight.  They are always in CYA mode (cover your ass), which means they take the politically safe route, which is to fight the last battle.  The last battle was inflation.  The next battle will be a deep recession.  I don't buy the shallow recession reasoning at all.  When you have secular stagnation and central banks still fighting the last battle and not coming to the rescue, you will get a deep recession and lots of job losses.  They are the firemen who always come an hour late, when the house is already burned down.  Expect the same result this time.  The house is burning now, and they are just adding more gasoline to the fire.  When they figure out their policy error, they'll act like nothing bad happened, they will just push their mistakes under the rug, and go back to what they always do: fight the last battle.  

Neutral on the stock market.  After this dip, leaning bullish on bonds.   The BOJ yield curve control tweak scared some weak hands, but it doesn't change anything.  Japan isn't really that relevant anymore in the big scheme of things, the big current account surpluses from their heyday are over.  The yield differentials are still huge so their won't be much repatriation unless they follow the ECB and get really aggressive.  Doubtful that happens before the global economy is in a deep recession, at which point they will stop whatever minor tightening they have done.  It appears that too many are jumping on the weak dollar bandwagon as the ECB and BOJ have suprised on the hawkish side.  Fundamentally, the dollar is still the cleanest dirty shirt out there.  Europe's energy policy is terrible.  Japan just isn't printing enough money to sustain big inflation numbers.  And after a big dip, I expect a return to a strong dollar in early 2023 as fundamentals reassert themselves. 

Cookie Cutter

First it was a hawkish Powell, then it was a hawkish Lagarde.  A very hawkish Lagarde who seems to be acting with a 3 month lag on Powell.  Apparently she didn't get the memo that inflation has peaked and is coming down.  Is she communicating by letter via sea mail with Powell and just received the letter in the mail about his hawkish Jackson Hole speech?  

Central banking is the embodiment of government work: easy, no accountability, and lots of incompetence.  No wonder you get such bad monetary policy.  The US had a demand side problem from too much fiscal stimulus and can fix it with demand side solutions.  That is why you are seeing some traction in fighting inflation with monetary tightening in the US.  But the EU has mostly a supply side problem(due to Russian gas cutoff and horrible energy policy) that they are trying to solve with demand side solutions.  Lagarde can't hike her way to more natural gas.  Raising rates to restrictive levels will just kill the economy and keep energy prices high.  The worst of both worlds.  Stagflation.  

These central bankers are such herd creatures.  They don't have an ounce of independent thought.  The only one sticking to their guns is the BOJ.  They are doing nothing.  Its comatose central banking 101.  Same old, same old.  These central bankers are straight out of a cookie factory.  Cookie cutter.  If you've heard one, you know what the next one will say.  They are always looking firmly in the rearview mirror and have no foresight.  They are constantly in CYA (cover your ass) mode.  They are basically politicians who no one can vote on.  

I wonder if Powell believes his own bullshit.  5%+ Fed funds rate and keeping them there for longer in 2023.  Does he think the US is the same economy that it was in the 1990s?  Or even the 1970s-1980s?  From the articles I read, he seems obsessed with being the next Volcker and being revered as an inflation fighter.  The US population in the 1970s was much younger and growing faster.  There was little globalization to keep wages in check.  There was no wage arbitrage.  Much less debt.  

Keeping rates above 5% for an extended time will guarantee a very weak housing market, and by extension, a deep recession.  Its not a matter of if, but when things blow up.  And we all know that when things blow up, the Fed will go back to their usual playbook of cutting in huge chunks, quickly, getting to the zero lower bound and then doing QE.  Same thing for the ECB.  By looking in the rear view mirror, they will ensure that the bond market will go back to the last regime of ZIRP and QE.  

High inflation isn't suddenly this new structural regime, its a function of massive money printing and handouts in 2020 and 2021.  Once again, the market is extrapolating a black swan event which caused inflation to spike as the new normal.  It is confusing cyclical with structural factors.  We have cyclically high inflation.  There is structurally low growth.  Structural low growth doesn't go away by having a crack up boom for 2 years.  The population is basically flatlining.  There is no productivity growth.  All future growth in the US, Europe, and East Asia will come from fiscal stimulus.  That's the only growth driver.  The developed economies have reached their end game in capitalism. Capitalism depends on continuous growth to function properly.  The inability to growth without fiscal largesse is a sign of secular stagnation.  

The Fed and ECB provided the 1-2 punch which is inflicting a lot of pain on the stock indices.  I didn't expect this reaction, but I also didn't go long.  It is days like Thursday which make me avoid the long side.  Going long in a bear market (unless after a deep pullback) is picking up quarters in front of a bulldozer.  Chasing strength in a bear market is asking the market to take your money.  Now that SPX has cracked wide open below 3900, I am staying on the sidelines.  I have levels where I am comfortable shorting, and at this juncture, not comfortable shorting under 3900.  That doesn't mean I won't get short if it goes under 3900, because that's exactly what I did in September.  I just need the right setup to do it.  And things aren't lined up yet.  With bond yields trending lower, its going to take a bit longer to build up the energy to make another sharp move lower like you saw from August 15 (SPX 4300) to September 30 (3600).  In investing, you don't have to swing.  You can wait for your pitch.  There are no called strikes, as Buffett says.  Its a time to wait.  No need to rush into a position with the low liquidity and usually boring environment of the final 2 weeks of the year. 

Recession Consensus

Almost everyone seems to realize that a recession is coming, but they are not selling stocks.  You are seeing some equity fund outflows after some inflows, but not a continuous trend of outflows.  They are also not buying bonds.  Instead, they are just adding to cash, and waiting.  If stock valuations were much lower and we weren't in a post-bubble environment, my natural inclination would be to lean bullish stocks.  But that's not the case.  Less than 12 months have passed since the top of the biggest bubble in US stock market history.  Stocks are still historically overvalued.  US stocks are considered a "good" asset class.  The big picture is very bearish.  Even without a potential recession and future earnings downgrades.   

If you zoom in and focus on light hedge fund/systematic positioning and somewhat bearish investor psychology, you can figure out a way to be bullish, but its a bit of a stretch.  I am not willing to undergo contrarian mental gymnastics to rationalize a bullish equity position in this environment.  Even if most people are expecting a tough 1st half of 2023 and a mild recession, which is the base case for most investors.  

As I have said in the past, overall, the institutional investor base is wiser than they were in the past.  They now put less focus on economic fundamentals and more focus on monetary and fiscal policy.  That's a better way to invest than to focus on the cyclical swings in the economy.   That is why studying past historical patterns of stock market behavior and reaction to monetary policy could lead to faulty conclusions.  In the past, earnings projections and current economic conditions had a much bigger impact on stock price movements than they do now.  Investors have wisened up.  They now view loose monetary policy with the corresponding weak economic conditions as an overall benefit to the stock market.  That's why you didn't get that big flush out of panicked investors selling on earnings disappointments that you saw in Q3 in October, because they are willing to look past the current downturn if monetary policy becomes more favorable.  

Yesterday's cooler than expected CPI number doesn't change much.  It may change your view if you thought that inflation was going to be stickier than expected.  But I've been of the view that disinflation is here and all the high frequency price data for housing, goods, and transportation costs are pointing to the same thing.  It was just a matter of time when the high frequency data would flow through to the CPI.  Since government data is lagging and often inaccurate, putting too much weight on is asking for trouble. There were so many ludicrous price targets from the sellside if the CPI was lower than expected or higher than expected, and with IVs juiced way too high, the market quickly faded after the initial spike higher.  I didn't expect a fade so big, otherwise I would have gotten short, but I suspected that it was not going to play out like it did after the November CPI.  With FOMC today, it seems like there is some leftover trauma from the past 2 cliff drops after the FOMC in September and November.  

Some may disagree with this view, but Powell is a natural dove.  He sounds mealy mouth and noncommittal if you listen to him.  That's what the Fed chair position does to people.  They get scared of spooking the markets.  So it took him some time to have the balls to spook the market to tighten financial conditions and raise rate expectations.  His Jackson Hole speech, and the past 2 FOMC meetings did that job.  With Fed funds rates projected to top out close to 5% in the spring of 2023, there is no need to act hawkish when the rate expectations are already so high.  It was a different story when the inflation data was not going down and the market was still pricing in a less hawkish Fed.  Who knows, maybe Powell flip flops from his November 30 speech and puts on his full hawk act again, but the economic data is trending much weaker now than it was 3 months ago when he went on a rampage.  The Angry Powell phase is over.  He may still try to sound tough, but he's lost his edge.  Even if he tries to fight the bond market this time, I don't expect it to gain much traction.  The data is showing weakness and with it, the more frequent recession calls for 2023.  

All the fund flows data for 2022 has shown a stubborn willingness to buy the dip in stocks and a fear that bonds will keep going lower.  After the first quarter where you saw hefty equity inflows, you went sideways with no meaningful net flows from April to November.  During that time, bond outflows accelerated and the household percentage of bond assets is historically low.  With an aging demographic and higher yields than almost anytime since 2008, bonds will attract inflows in 2023.  There is a notable sentiment shift from outright hate and fear to gradual acceptance.  It will take time from investors to fully get back on board the bond bus.   The supply/demand picture is not optimal with such huge budget deficits and QT for Treasuries, so I don't expect a huge rally from bonds right away.  But with the economic weakness and the secular stagnation thesis still very much alive, rates at these levels are not sustainable.  When the economy gets really weak and the shit hits the fan, they will cut big and fast.  The bond market is telling you as much.  Take a look at this inverted SOFR yield curve.  Its pricing in a drop to 2.75% Fed funds by 2025. 

Its almost the exact opposite of what investors were expecting in late 2021, with the SOFR curve quite steep, yet many expecting just gradual rate hikes for the next 2 years.  The bond market isn't always right, but it is more often right than Fed forecasts.  The Fed forecast of higher for longer is dubious.  Its what they say to try to tighten financial conditions, but it has no bearing on future monetary policy.  Forward guidance is just empty promises to try to trick the market to do its work for them.  Those who believe Fed forward guidance for 2023 are making the same mistake, the other way around as they did in 2021, when the Fed said lower for longer.  

Missed the short after the big gap up on the cool CPI, as my base case was shorting after the FOMC today.  It looks more apparent that there is a somewhat soft ceiling above SPX 4100 and soft support at SPX 3900.  Dare I say that we'll be range bound for the next month?  Its not flashy, but that's my projection.  If we get a rally after the FOMC that takes the SPX toward 4100, will enter shorts.  Although I am leaning towards a rally post FOMC, if there is no rally, I'll wait on the sidelines.  Definitely not interested in the long side.  This is still a hit and run market.  Seasonally, its not a favorable time for the bears.  I usually ignore seasonality, but the end of the year when liquidity is light is one of the few times that seasonal influences are strong.  Its not a market to bear down and take long term positions.  There are no great short term setups here.  Let the market come to you.

Sun Rises in the Bond Market

The positive correlation between stocks and bonds is weakening as the focus shifts from inflation to economic weakness.  The CPI report in November was the game changer.  It gave bond investors the green light to start buying as the fear of an inflationary price spiral and a possible UK like bond vigilante led squeeze higher in yields was put off the table.  As most bond fund managers have been afraid to add duration ahead of this freight train bear market, there was a lot of pent up demand that was building as 10 year yields broke the 2022 highs of 3.50% and squeezed mercilessly higher into late October, only to be saved by a nervous Fed using their loudspeaker, Nick Timiraos of the WSJ to calm down the market.  The day that Timiraos came to the rescue on October 21 was the top in 10 year yields at 4.33%.  

Since the CPI release with the softer than expected inflation print, bond investors have come out of their bunkers and looked at the charred landscape as 10 yr yields have gone from 1.51% at the start of 2022 to the mid 3s.  People forget in times of distress what they are buying and selling.  A 10 year Treasury note is pricing in the average of the Fed funds rate over the next 10 years + term premium.  It is a world where developed world population growth is approximately zero, and productivity is also around zero (maybe negative given the work from home trends, lack of meaningful technological advances, and increasing labor power = lazier workers).  Nominal GDP growth will be driven by inflation, not economic growth.  Expect a return to secular stagnation until the next big stimulus package (2025 story?).  2020-2021 was an anomaly.  You had a convenient excuse for politicians to go full bore populist and spew out tons of fiscal stimulus for individuals, state and local governments, and corporations.  

That is something that will happen again, but the stars have to align to get that kind of scale of coordinated, global fiscal pump priming.  The right mix of Republican and Democrat control of White House and Congress, either total control for one party or a Republican president.  Republicans will obstruct fiscal stimulus if there is a Democrat president in power, but not if its a Republican president.  And Democrats always believe in moar fiscal stimulus, no matter who the president is.  So in most cases, a Republican president leads to more fiscal stimulus than a Democrat president because its not common for Democrats to control both the White House and both Houses.  

Back to the bond market.  Its has been in a 26 month downtrend from August 2020 before it finally bottomed in October.  That is a LONG downtrend.  You have flushed out a lot of weak hands during that process, while offering much more attractive yields for long term investors.  Yields that are high enough where bonds can now provide a risk off hedge to equities once the rate hike cycle is done, which looks to be less than 3 months away.  Due to my pessimistic view on global growth, and even US growth, I lean towards the bullish side on bonds in most situations.  I definitely underestimated the inflationary effects of all that Covid stimulus but its looking like most of that has worked its way through the system.  With prices already having gone up a lot in 2021 and 2022, the base effects for inflation prints will favor disinflationary views over those who think inflation remains sticky in 2023.  The M2 money supply has been dropping steadily in 2022, which is rare to see.  I don't see a wage price spiral happening when the supply of money is no longer increasing and when the demand for workers is dropping as the economy gets weaker.  When the economy weakens, workers have to worry about potentially getting fired, which reduces their wage bargain power, and you have fewer workers switching firms, another source of wage growth.  

Lately, the yield curve has gone into a super inversion.  2-10s are trading -83 bps.  Look at the move in 1-10s, historically extreme:

Take a look at when the 1-10s spread went into negative territory, a sign that the Fed is overtightening and about to push the economy into a recession.  1989, 2000, 2007,2019.  They all resulted in sharp curve steepenings as the Fed aggressively cut rates in all 4 cases.  I expect a similar outcome this time around.  In fact, with the curve that much more inverted now, the curve steepening move will be vicious.  I am still seeing most fixed income analysts call for the Fed to keep rates high and not cut in 2023.  So betting on aggressive Fed rate cuts for the 2nd half of 2023 is both an out of consensus view, and also not priced into the SOFR futures curve as Dec 2023 is trading at 4.38%, which is only 52 bps lower than the 4.90% terminal rate pricing in Mar/June 2023.  The risk reward is quite good in the short end of the curve at current levels, although timing it will be important.  The roll up in yields is extreme at the short end of the curve, so the negative carry for being long 2s and short 10s is almost 40 bps/year.  That is a big chunk to pay out for a curve bet, but it should pay off big when the Fed enters a rate cutting cycle.

From the daily headlines, CNBC, and Bloomberg, slowly more are becoming aligned to the recession view, and that's part of the reason you are seeing the big rout in crude oil even as US inventories keep going lower and China loosens it Covid policies.  There has been heavy liquidation of long positions in Brent and WTI futures over the past couple of weeks.  With the curve going from backwardation to slight contango, systematic commodity traders are reducing longs and adding shorts. 

In trading, sometimes the market just induces you to take a position which you never thought about taking so soon.  The big drop in crude oil this week is piquing my interest.  Even with the short term cyclical headwinds and demand weakness that is sure to come down the pike, at a certain price, the risk reward turns positive for buyers.  We are probably already at that point, but I will wait for an even better level.  This is a seasonally weak time of year for crude oil, and there are still residual bagholders who still cling on to hopes of $100, $150, $200 oil.  There are plenty of barrel counters who are besides themselves trying to figure out why crude keeps going lower as crude inventory levels go lower, amidst China reopening hopes.  That has kept me away from the long side.  But I'm noticing that some of the permabulls are softening their bullish rhetoric.  Oil stocks have massively outperformed the commodity in 2022, so if I play for a long, it would be in oil itself, not oil stocks.  Something that is on the radar.  

Closed out part of the NDX short yesterday in the premarket, and will look to close out the rest today.  Finally got that big spike in put/call ratio to 1.17 yesterday, and noticed that the fear was building up watching CNBC.  After today, probably will not play the short side in NDX or SPX until after Christmas, as I see little edge shorting during a seasonally strong period of the year, and ahead of CPI and FOMC, which probably will result in a relief rally.  Even though I think SPX will go up next week after the big events are behind us, I will not play the long side.  The levels just aren't attractive and there is rug pull risk in the unlikely case that Powell puts back on his hawk costume or you get a hot CPI.  I will let others fight those battles.  Its still a swing trader's market in SPX.  If we get a big rally after the CPI and FOMC, then we can talk about taking longer term short positions later in the month.  Especially in tech.  Until then, letting the market come to my buy or sell levels to put on positions.  They need to induce me to take a position by getting to an extreme, because there is nothing that's really attractive at current levels.

Retail Getting Bagged

The post bubble environment is playing out and the winners and losers are becoming clear.  The winners:  energy, pharma, healthcare, utilities.  The losers: mega cap tech (GOOG, AMZN, META, TSLA) software, semiconductors, speculative tech (EVs, ARKK favorites).  The worse performing names:  AMZN, GOOG, TSLA, NVDA, ARKK, etc. are heavily owned by retail investors.  The best performing names are not:  XOM, OXY, MRK, LLY, XLV, etc.  

The stock market has managed to do what it always does:  punish the uninformed who come late to the party and crowd into the most popular and overvalued names.  Let's take a look at 2 of retail favorite ETFs:  TQQQ (3x leveraged Nasdaq 100) and ARKK, vs 2 of the best performing ETFs: XLE and XOP.  

Inflows into QQQ, TQQQ, and ARKK, and outflows from XLE and XOP.  Yet, the performance is the complete opposite of the investor flows.

While you've seen a big rally off the October lows for the SPX, you haven't much of a bounce in ARKK or even in TQQQ.  

The most overowned stock among retail, TSLA, is acting the weakest among the megacap tech names.  It still hasn't even been able to get back above the October lows, when the overall market bottomed.  Its quite clear that there is a drastic reduction in demand for concept stocks that are massively overvalued with weakening earnings outlooks.  About the worst combination you can get for a stock.  Would not be surprised to see TSLA perform even worse in 2023 than in 2022.  Look at the low institutional ownership, which means that retail ownership is huge, uncommon for a stock with a market cap so big. 

 The heavy participation of retail investors, who are still heavily invested (they got diamond hands!) is a classic symptom of a market that is saturated and likely heading lower.  From 2008 to mid 2020, retail investors stayed away from the stock market, as equity fund outflows were the norm.  Only in the past 2 years has that changed.  The millenials, probably the dumbest generation of investors, finally had enough of sitting on the sidelines and finally piled into the bubble stocks (FANG, EVs, ARKK, meme garbage) en masse in 2021 to catch up.  Not only that, they also piled into cryptos, looking to get rich quick.  The end result is a bubble that's now popped, with retail bagholders littering the landscape.  The wealth effect is real for these millenials.  They are the ones with the most propensity to consume yet have been hit with the biggest losses.  This is not going to help with household formation in the coming years.  Add to the much higher mortgage rates and house prices that still haven't come down much and you have a shit sandwich for the millenials.  

Last Wednesday, Powell dropped his hawk act and showed his true colors.  Its not easy putting on act all the time, especially when the incoming econ. data doesn't support it.  Powell either had to lie through his teeth to try to forward guide a much higher terminal rate to keep the stock market down, or just be honest and admit that looking at lagged data to keep hiking rates is asking for trouble.  Powell seems to be over the  hawk phase of his act, and finally telling people what he really thinks.  He's afraid of overtightening, and is still going for that soft landing.  Although its highly unlikely that there is a soft landing, he'll probably soften his tone for none other than political reasons.  

He is already feeling some heat from the Dems for being too hawkish, and he's a guy who tries to please politicians.  He's the farthest thing from Volcker, no matter how much he wants to be revered like him.  The sooner he drops his infatuation with being the next Volcker, the less pain the economy will feel in 2023 and 2024.  But its probably already too late.  This is nothing like the late 70s, early 80s.  The secular stagnation and debt dynamics are total opposites of that time period.  The yield curve inversion and the leading indicators have already baked in a mild recession.  I can't picture Powell getting ahead of the curve, and he'll probably just be reactionary as always and be late as a result, panic cutting in big chunks in the summer/fall of 2023 to try to stave off a huge rise in unemployment and a big economic slowdown.  

I put on a small short NDX position on Thursday, and am looking to add to the position on Monday.  The market seems to be struggling here as we approach that much talked about SPX 4100 level, which seems to be the target for a lot of short term bulls.  With CPI and FOMC, along with a bunch of central bank meetings next week, it would fit the pattern of a pullback ahead of the events, and then probably a rally after the events are behind us.  So looking for a pullback later this week.  Not sure about levels, but probably the best time to cover will be Thursday/Friday.