Fed fatigue and seasonality

I meant to post sooner but I was busy and then I caught COVID. It was another crazy month. We went from a horrific September to a blissful October.  After my last post the market dipped back down as once again, any notion of a Fed pivot got shot down. As were were drifting near 52 week lows the notion of no fed pivot kept getting hammered into everyone's brains to the point where I was sensing that maybe we are getting to the point of Fed Fatigue i.e. an acceptance of no pivot. So if that's the case, I thought that maybe the market would get tired of going down over the same thing. The so called next shoe to drop according to the bears is for earnings to collapse and layoffs to spike. As earnings started rolling in that was simply not the case. Sure, there were some disappointments including some of the big tech names, but overall it has been a rather benign earnings season. Even though the tech giants AMZN, GOOG and MSFT had disappointing results and/or outlook banks and other companies have had good or OK results. This less than disastrous earnings season coupled with the so called bullish seasonality of the mid-term election cycle started the rally and when big tech earning disappointments last week couldn't take down the market, a lot of bears who positioned for the kill shit themselves and covered adding fuel to the fire. 

So now what? We have the widely expected 75 bps hike this coming week. Bears are counting on the Fed to piss all over this rally again, but this time around the set up is different as the market has not been rising on hopes of a Fed pivot and so even if the Fed reiterates this, it may not amount to much aside from a knee-jerk reaction. If the market fails to show any sustainable downside, it's going to embolden the bulls more and make the bearish shit themselves yet again. I could see the market ultimately going as high as SPX 4000-4100 on this latest rally. We'll see. The Bank of Canada hiked by only 50 bps last week which was taken by some as a pivot which is a bit of a stretch in my opinion. A true pivot is a clear indication that rates are going to at least stop rising in my opinion. People have been so desperate for a pivot that they are willing to count this less than expected hike as some sort of a quasi pivot; that perhaps the end of the rate hike cycle for Canada is getting close. I believe this too may have contributed to the positive market tone last week but not much.  

Despite all I've said, there's still problems with market action, namely, the fund flows continue to show FOMO. At the same time though, positioning from hedge funds and other measures like option activity shows bearish extremes that you see at major lows. I'm really struggling with these offsetting indicators. Therefore, I continue to believe that one be tactical. The tactical bullish call I made earlier this month is still in play although now the easy money has been made. If this rally ends up going to SPX 4000-4100 it will look a lot like a base-building bottoming scenario is in play. I would then expect more base building until March 2023. I'm clearly getting way ahead of myself but that's kind of how I see things unfolding IF the bull case is to play out.  By the way...Trader X once again mentioned earlier this month that it was not the time to start building long term positions.  Remember, he said the same thing in early July and in April 2000. Food for thought....

Critical Juncture

FYI most of this was written yesterday and an update to reflect today's action provided at the end. 

September was a brutal month with the SPX dropping 9%. Coming into Monday the market was in an acutely oversold condition with some notable extremes in pessimism. NAAIM for instance is at 13.6%. This is the lowest exposure since March 2020. DSI sentiment which is something I don't normally pay attention to unless it's an extreme  is currently single digits for both SPX and bonds. Over the weekend there was lots of chatter about an immanent major bank failure, Credit Suisse. in particular given the trading of their CDS swaps. The fear is that this will be the next Lehman moment. The US dollar strength has been a wrecking ball for global markets and you can just feel the global angst is reaching a crescendo. Surly the US Fed must now have some serious worries about this and are getting some pressure from foreign authorities to back down on their hawkish outlook

It looks like today's bounce is mainly a relief that the doomsday scenario did not pan out just yet, but obviously the market is still very much in a precarious position bouncing from a 52 week low. I've been saying  since July that if the bull case were to play out it would require base building. The other scenario obviously is the bear market still has a ways to go and it's quite conceivable this could be the case. Let's examine again the case for either side.  

Bull Case

We have seen multiple extremes in selling pressure and negative sentiment. Although there are some missing links, positioning shows extreme risk aversion that you typically see at major lows. The excesses of 2021 have been largely wiped out when you look at the unwinding of margin debt and the dearth of IPOs. Valuations although not historically cheap, are back to reasonable levels when you look at forward or trailing p/e.  The latest slide in the market has been largely self-inflicted by the Fed's unnecessary hawkish outlook which was been wrecking havoc on global financial markets given the parabolic rise in the US dollar. With pipeline inflation pressures collapsing and global stresses mounting, it gives the ability for the Fed to back down on their hawkishness at the very least. Doing so would bring much needed relief to the markets. Although earnings have been under pressure this year, they have not collapsed and since the main culprit of earnings pressure was inflation related, there will be relief when inflation pressures start subsiding which should happen soon although some sectors like retail might get hit because of inventory surpluses. The odds of Putin getting ousted are growing by day given the terrible results in the war and latest call for mobilization. The base case now is that we are in a recession and things are about to get worse. With expectations so low, it leaves the market ripe for an upward repricing. 

Bear Case

Although there are indicators showing extreme bearish sentiment and an unwinding of excesses, a very important holdout has been fund flows. We still have a long way to go to unwind all the inflows in 2021 which were still positive in the first couple of months of 2022. Fund flows were negative in September but only grudgingly so.  We have yet to have seen a 20+ billion weekly outflow.  AAII positioning also shows stubborn lack to capitulation with equity exposure at 63%. This should be at least in the mid 50's given all the damage. The crypto bubble has not been totally deflated as it still pretty much moves in lockstep with the Nasdaq. Bubble bursting typically result in 90%+ crashes. That implies BTC to $6000 as a long term target. Unlike in recent years, there is an alternative - TIAA.  Both short and long term GICs are providing rates not seen since 2000. We haven't felt the full impact of this interest rate shock as big hikes have only recently taken place and more is still to come and so even if we get a Fed pivot soon it will be too late. The yield curve inversion is quite entrenched and is set to go negative across all maturities if the Fed hikes another 75 bps in November. An inverted yield curve is a sign of immanent economic weakness, usually within the next 12 months. So even if we get a Fed pivot, at best it will result in only short to medium term relief. 

The Verdict

There's certainly enough evidence to suggest one be tactically bullish here, but nothing more. I'll repeat something that I've said a few times earlier in the year. For a bullish resolution to all this, we need to get to the point where the market sniffs out an end game to the rate hike cycle,  (i.e. the pivot) without there being too much damage to the economy. After the Fed's last meeting they poured cold water over any notion of a pivot coming any time soon however the subsequent market turmoil may have made them start to reconsider their hawkish plans. 

Update: 

The UN apparently has pleaded with the Fed to stop rate hikes given the havoc the strong US dollar is having on non-US economies. They confirmed the suspicions I had about the Fed coming under pressure from the global authorities to back down. Renewed Fed pivot hopes coupled with a still oversold market resulted in another strong bounce today. But even if we get a Fed pivot, will it be too late? And what kind of pivot, if any will it be? Any meaningful pivot would have to require the Fed to cancel any further hikes...at the very least one more hike and stopping. Bottom line is that the foundation for this bounce is shaky even though it has the potential to carry on longer. So long as we keep seeing crap like BTC, AMC, GME and BBBY surging every time the market is strong, it tells you that we haven't fully wrung out the excesses/stupidity of the prior cycle and so keep your guard up. More thoughts coming soon.