Waiting game

Since my last post the market rebounded but then sold off again pretty much putting it back to where it was a couple weeks ago. Sentiment conditions haven't changed much. Put/call ratio data and panic/euphoria model suggested too much exuberance while fund flows and AAII sentiment suggest too much pessimism. You also got the VIX north of 30 which is historically high and only gets notably higher during a waterfall type of downside move. I think what we got here is a market that has to wash out some of the exuberance as noted above which is likely ST in nature, but there's still quite a bit underlying pessimism out there which longer term is bullish.

Fears are rising due to the second wave of COVID which is clearly extending the timeline of when we are going back to a pre-COVID economy. It's also pretty much a certainty that we are going to be seeing a wave of bankruptcies in the industries related to travel&tourism (i.e. hotels, airlines) and commercial real estate in the coming months. Back in 2009 the bears were warning about a commercial real estate shoe to drop which didn't happen. This time around it seems likely this is going to indeed happen. 

Remember, it's only been about 4 months since the COVID bomb went off. It can take several months before the full effects of something like this is felt. When the dot com bubble burst in March 2000,  it took several months before the market started to  rollover in a major way. Go back and look at the chart of the SPX to see what I mean. The market had a sharp drop in March rebounded sharply and traded sideways the entire summer near the highs before rolling over in multi-year downward spiral starting in September.  When the housing bubble burst in 2006 it was only until August 2007 when we saw the first major crack in the market but that didn't stop the market from fully recovering from that dip and making an all time high by October 2007. The bears must have been suicidal. A year later though, the true turmoil started and we all know what happened. 

If COVID  is going to end up being the type of bomb that hit the economy much like the tech and housing bombs of yesteryear, you have to understand how early we may be in this. It takes time for such a bomb blast to fully reverberate though out the economy and it's the norm for the market to drop sharply and then recover sharply and stay stick for months after the first major sign of trouble, especially when this time around the monetary and fiscal responses have been swift and quite large. But look, how can government policies prevent bankruptcies in the aforementioned spaces if we are going to see a long lasting change in attitudes towards large gatherings, attitudes towards people in enclosed spaces and the avoidance/limiting of  business travel? And what about all of those missed rent and mortgage payments? They have to get paid back soon or else get defaulted on..seems like we will get more of the latter. Of course, authorities will come up with measures to try and counter act all this but there's only so much they can do...or is there? Lol. 

Anyhow, my point here is that if you are a bear and you're convinced that this has to end badly you need to have the right strategy and patience to able to capitalize on it. You need to realize that it can take a lot of time for all it to play out.  Going back to the housing bubble, there were bears who saw the writing on the wall in 2006 or 2007 but very few of them actually capitalized on it because they didn't have the patience and/or correct strategy. Most of the bearish traders you see now a days on twitter can't hold a position for more than a month yet alone a year. They watch the tape day by day, tick by tick which will make a month feel like an eternity. They use bear ETFs or short dated put options which is NOT the way to do it. 

The jury is still out in my book if COVID is indeed going to end up being the same type of catalyst that the tech bubble bust and housing bubble bust turned out to be, because those 2 were endogenous shocks whereas COVID is an exogenous shock. I mean, if an effective treatment/cure to COVID is found, then the bearish narratives go up in smoke and this time around, the authorities are being super aggressive in their responses whereas they were slower to react before. But until we get an effective treatment/cure we could end up seeing something that resembles a longer term malaise where when we look back we see that the market ended up going nowhere for a couple of years rather than a devastating 50% + drop.  I'm keeping an open mind to all possibilities and taking the pragmatic approach as opposed to a dogmatic one. Somehow I think there is an eventual bullish resolution to all this but not before we see some pain first. 

Portnoy top?

Markets pulled back very sharply on Thursday because there's growing evidence that a 2nd wave is hitting the US.  Secretary Mnuchin insists there will not be any more lockdowns because of this but so far the market is skittish. Was the market just looking for an excuse to sell off because it had gotten overbought? I think so. Although I don't think there will be any more lockdowns, a 2nd wave will at the very least  cause the delay of phase 3 of the re-opening which is where everything gets opened up again as it was pre-COVID.  As such, it's going to inhibit the ability for the economy to hit full potential. Has the market already discounted this? What exactly is the market's discounting ability anyways these days? It's looking more like a casino. I mentioned more than once about the growing cohort of retail traders who have apparently hijacked certain parts of the markets, the junk stocks like airlines in particular.

You may have heard of this trader called Dave Portnoy who has become famous for his rant about how he's better than Warren Buffet claiming he's all washed up. Portnoy is sports gambler turned stock trader who got into trading when he was no longer able to bet on sports. He has a quite a large following. Let me tell you this, I've seen people bash Buffet in late 1999/early 2000 when back then tech stocks were all the rage, and for a few months they got it right, but when the music stopped, they got badly humbled. This guy will no doubt get humbled, it's just a question of when. Could his exuberance signal a market top? It may very will indeed, at the very least for the junk stocks.

Here's another tell tale sign of a top in the junk stocks. Hertz is looking to issue $1 Billion in stock which will very likely end up being worthless. It's quite amazing that this idea was even proposed yet alone may end up happening. It would be insanity if this ends up actually going through.

AAII sentiment continues to be stubbornly bearish but fund flows did jump very notably, but that was before the big drop on Thursday.  As far as the general market goes, I would suspect that this correction has legs but It's going to be very tricky to capitalize on. I expect day to day volatility to be high and erratic with lots of squeeze action.

Additional thoughts

A realize that a lot of people out there, me included are stunned by this parabolic upside move in the market. The NASDAQ just made an all time high and it looks like that upfilled gap at about SPX 3350 is acting like a magnet destroying whatever bears are left along the way.  I get that the market is a  forward looking indicator, but it's very difficult to make the case that this move in the market is totally based on rational behavior.  You normally see such blow off moves during economic boom times not during times like this. In my opinion, there continues to be an element of woefully out of position investors/traders who drank too much of the doomer koolaid and are now being forced to cover or go long in combination with a speculative fever of newly minted millennial day traders. Remember back in mid May when the 3 bears Drukenmiller, Teper and Gundlach came out and bashed the market? They and all who listened to them have been  ran over and humbled and forced to cover shorts just adding more fuel to the fire. What I've been wrestling with myself to determine is just how legit this move is. Here's a breakdown of what I like about this advance and what I don't in terms of it being a sustainable move.

What I like:

• The underlying bearish/skeptical/skittish sentiment that's out there from both the "pros" and "retail" including a large portion of the amateur trading community which I like to call the permabear trading community because since 2009 the majority of traders out there have had a bearish bias towards the market. Although we may have seen a lot of the above give up or get blown out of bearish trades, they are not embracing the market at all. They just keep making sarcastic scoffing comments about the Fed and how everything is rigged and all it takes is the slightest of dips to get these losers excited about the downside. This is not unlike what I saw in 2009. Bearish/skeptical/skittish sentiment is the lifeblood of a bull run. Once everyone has embraced the market with most bears too afraid to bet against the market anymore, that's when the market is vulnerable for big trouble.
• Credit markets have dramatically settled down with investment grade bonds yields back to pre-crisis levels and junk bond yields on there way to that too. You can complain about the Fed intervention in these markets all you want, but it has worked and the Fed didn't have to do much heavy lifting, their verbal backstop was good enough. Maybe one day this all goes wrong and you can whine and complain all day about how the Fed is taking away "price discovery" and "free markets" but that's not going to do you any good. Either you embrace it or don't play. 
• The yield curve is normalizing. Although a rise in bond yields often puts the brakes on the market, yields are rising from ultra low levels and have plenty of room to unwind before they  become truly restrictive to the economy. A positive yield curve does wonders for the banks which have been battered for quite some time. It's also a signal of a healthier economy going forward.
• The large amount of cash on the sidelines via money market funds which is historically bullish. Once you have this much money on the sidelines and the market gains upside traction  to this degree and duration,  the market advance has had plenty of staying power. 

What I don't like

• The speculative action of junk stocks like HTZ. This stock is literally worthless and yet it has gone from $0.40 to $5.50. This is pure greater fool buying and short squeezing which means some of that behavior is most definitely occurring in general stock market too.  Believe it or not, it is not uncommon to see the worthless shares of bankrupt companies behave like this. I've seen it many times before. What it indicates is that in contrast to the permabear trading community, there is a growing cohort of naive permabull traders most of which are probably millennials who haven't experienced the massive pain of losses and therefore didn't become the embittered fucks that make up the generally older permabear trading community whom at one point in their life acted the same way as these naive millennials! Apparently, a lot of these traders are using Robin hood or other no commission brokers to make their trades. They are also buying equity call options hand over fist it would appear. For now these millennial traders are getting the better of the permabear trading community and even the pros but such action is indicative of speculative fever which is not sustainable. At some point you run out of bears to squeeze and longs to jump in and you get a collapse. But the speculative nature of these advances can go longer and higher than you thought was possible. Just look at run up of the bitcoin bubble before it burst.

• The gap and go nature of this bull run. This is simply not the type of normal behavior you see in a sustainable bull market. It is more indicative of forced buying from short,  panic buying and chasing. Again, such a run can last longer than you think possible but history shows that ultimately such runs get undone in a big way. 
• The parabolic shape of the rally. This again indicates an unsustainable panic buying situation. It's always difficult to know just how extended the parabolic move could go for but it's clear to me that it's getting late. That unfilled gap in the SPX could very well get filled first before it's over though.  
• There are plenty of unfilled gaps well below where the market is now. I'm not a believer that all gaps must get filled (they don't) but the fact that there's so many makes me believe that at least a few of them will. 

Conclusion

• You got to respect the upside momentum and there's a decent chance we see 3300-3350 before this ramp is over. Although the market is quite ST overbought now.
• When the inevitable correction happens, it will probably be a multi-month affair with at least 1 trap door moment. I will be watching closely to see how people react to it. If everyone runs for cover and the speculative excesses get washed way without too much damage that would be a good sign that the bull run has staying power. If instead people are eagerly buying the dip that would be a bad sign. 
• Despite some clear signs of froth there's still a bullish long term underpinning via high cash on the sidelines and a general distrust/ skitnessess  about the market. 
• If I was looking to make a longer term short bet I would need to see the following: AAII bulls/bears to hit 2:1 bulls vs bears, VIX sub 20, big spike in fund flows. Until then, I classify myself as agnostic. i.e. too late to buy, too early to short for longer term trades/investments. 
• Gun to my head: We get a minor dip and then rip higher one last time before we get a multi-month consolidation/correction.

The purpose of the market is to make fools of as many men as possible

There's a reason I made this the motto of my blog. How many times have we seen Mr. Market do this in the past 10+ years? It's incredible. First off, nobody, not even the giddiest of bulls could have predicted the market to be where it as to today. When I made my SPX 3000 call in mid April I wasn't nearly bullish enough and I'm not going to sit here and say that I called every wiggle correctly (pretty much impossible) and I was too bearish near the March low.  I didn't sense enough capitation at the time given the economic carnage that was taking place. Yes, there was indeed some signs of capitulation but I also saw what I believed was too much bottom fishing. Then what happened in April was that the sentiment conditions solidly improved. .Expectations for the economy and profits collapsed...and rightfully so. It was obvious what was coming...but that ironically is what did in the bears - it  was too obvious. As we got the oversold, stimulus bounce in early April, a lot of those bottom fishers sold into that big bounce while the permabear trading community, who came nowhere close to fully capitalizing on the March decline, aggressively built short positions and alas, the bullish wall of worry was rebuilt. But again not even the most bullish of bulls predicted the ferocity of this rally.  I read an article in early March which stated that a bear market which was caused by an exogenous shock resulted in an average decline of 35% in market and took 18 months on average before recovering all the losses. Well, we got the 35% decline but at this pace we'll be fully recovered in 5 months from the top as measured by the S&P!

The past is the past and what matters now if the future. So then what now? Well, coming into that gangbuster jobs report on Friday, although there were signs of froth in the options market and with NAAIM positioning who were 92% long , there was still a stubborn, cohort of stubborn bears out there reflected in AAII  sentiment and retail fund flows which have been negative for several weeks. This Friday report may have been a game changer for these bear holdouts. It may have have very well caused them to throw in the towel as we are finally getting "confirmation" of this rally with the data. I said in my last post that if you're waiting for more certainty to get back in the market, i.e. jobs, a cure, you're going to have to pay a higher price and that's exactly what happened. I'll be very interested in seeing what the sentiment data looks like Thursday. If we end up seeing a strong surge in fund flows and AAII bullish sentiment in the next couple of weeks, the market is going to be vulnerable as there will be no more "greater fools" to push it higher in the short-intermediate term at least. We're also seeing a notable spike in the 10 year yield which until now was a big holdout in calling for a top. I've said that tops are made when bond yields have had a notable rise as it signals economic optimism, the greater/longer the rise in yields the more significant the top.

At this point, I 'm just a spectator. I refuse to chase a parabolic run but it's too early to try to short it aside from 1-2 day hit and run trades which is not my style and I'm not in a position where I can be glued to my screen all day. However, that strong jobs number may actually be the bulls undoing (for awhile at least) if it ends up significantly ratcheting up expectations for next report and for economy in general.

As far as the economy goes, I can tell you that traffic in my area is pretty much back to normal levels. I believe that people are getting over COVID fears quicker than expected and that includes governments. People are realizing that this virus is not nearly as deadly as the media made it out to be and the solution to dealing with it is to isolate and protect the elderly and those with compromised immune systems as stats show these are people who are by in large representing the death count. The costs of a lock down in addition to serious economic fallout, leads to too much suffering including death and social unrest. I think most governments and people in general agree with this which is why if we get a second wave, there will be a reluctance to shut down again. Here in Ontario we are about to start Phase 2 of the economy re-opening even though the 7 day rolling average of daily cases is still above the target.

If we do get a second wave, which it appears we probably will as people are out and about again (accelerated by all the protesting), it could cause the market to get spooked serving as a catalyst for a correction as people fear another shutdown. Could this fear already be priced in the market to some degree? It's not like what I'm saying is something new. I think this fear is indeed priced in but to small degree right now. It's on the back burner but if it makes its way to front burner it would create angst even though it would ultimately end up been in vain in my view.

What else could cause this bull run to be derailed? We got to look at things that people aren't talking about much.  How about the fact that right now Joe Biden is presently a slight favorite to win the election when you look at betting odds? How about if we see inflation flare up as a result of all the fiscal stimulus being pumped into the system (notice I said fiscal stimulus, not QE which does not cause inflation)? Lastly, as I alluded to for several weeks, what if the pend up demand bounce we get fizzles out later this year as US government benefits stop at the end of July?

Let's look at bull case right now.  More fiscal stimulus is in pipeline which is going to come at a time when the economy is starting to open up and normalize as more and more people are getting over fears of COVID which has proven to have been overblown. This can end up creating the sort of V shaped recovery the market may be pricing in.  Although some people will continue to be skittish until there's a vaccine, the vast majority want to be able to live life as it was before willing to accept the risk of getting COVID using common sense preventative measures or simply just not caring about it at all. Speaking of vaccines, with the entire world in the race to develop one, it could end up coming a lot sooner than expected. If we get confirmation of a truly promising vaccine (not just fluff like what we've seen so far), it would be a huge nail in the bear's coffin. Despite signs of froth in some market indicators, there's still plenty of skeptical/cautious investors as evident by huge balances in money market funds and the underweight exposure of fund managers and although that may have shifted in the other direction on Friday, it usually takes several weeks if not months before these shifts swing too far in the opposite direction hence providing a longer term tail wind for the market.

There's certainly lots to consider here. I continue to take a pragmatic approach keeping an open mind to both bullish and bearish resolutions to all this. As already stated, I'm just going to be a spectator for now, as the market is simply too stretched and there's signs of ST froth. This risk/reward on the long side at this point in time is simply not good.  But as far a bull case goes longer term, the light at the end of tunnel is there which didn't appear to be there before and that to me stems from the notable shift in attitudes towards COVID such that there will not be anymore shutdowns even if there's a second wave. This is going to be critical if the bulls are to ultimately win.