This rally feels different

We've had a pretty good run in the market for the past month and a half.  We had similar good rebounds twice before this year - one in the spring and one in the summer both of which obviously failed. This time around the rally feels different in some respects. First of all, everyone is calling it a bear market bounce and I don't see any "is this the bottom?" queries. Some sectors like financial and biotech are exhibiting the hallmarks of a bull market advance, namely a strong, relentless low vol  move and they have just broken above the August peak although barely. The other thing to note is how the Fed's latest attempts at jawboning the market down is not having the same amount of bite. Monday's decline was driven by comments from Bullard who's saying the Fed funds rate needs to go to 5-7% to fight inflation. With the 10 year yield trending down and comfortably below 4%, the bond market is giving the middle finger to this tough guy stance these Fed guys have.  The Fed's "we don't see any meaningful signs of inflation easing"  rhetoric is a farce. Maybe part of this talking down the market tactic has to do with the idiotic perception that the wealth effect of a stock market rally would add to inflation pressures. I nailed it when I compared the Feds to inspector Gadget. On Monday oil prices hit an  11 month low and went briefly NEGATIVE YTD  yet  "we don't see any meaningful signs of inflation easing". 5 Year break even rates have been down trending big time since April and currently stands  at 2.29% This is the market's average CPI expectation for the next 5 years. Historically, this has been an accurate measure of what the CPI actually ends up averaging over the next 5 years.. Yet "we don't see any meaningful signs of inflation easing". Idiots. 

Getting back to market action. Did you know that despite all the horrific macro developments in Europe all year,  European stocks are down only about 9-10% YTD? I don't hear ANYONE mentioning this. Whenever the market is quietly going against the narrative you ought to pay special attention. On October 20th I read a market pundit make this comment "don't expect anything but a bear market rally until the Fed pivots, inflation eases and war in Ukraine is over". The problem with acting on this belief is that by the time those things happen the market will probably be at or close to new all time highs.  The markets will anticipate, they will price in information. That doesn't mean it gets it right all the time, but that's what it does. The more you wait for certainty, the higher the price you will have to pay for it i.e. lower the returns you will get.  I mentioned something similar in the summer of 2020 as the pandemic was raging. And think about how the markets behaved earlier this year. Stocks and bonds sold off hard from Jan-March well before the Fed did its first rate hike. Markets will anticipate/price in things.  It will probably do the same going the other way. 

The market is going to face an important test. The last 2 times we had a run like this where it became ST/IT overbought it ultimately fell apart. Can the market consolidate this time and not totally fall apart? From a market action and sentiment/indicator perspective the chances of this look better than before. But what about the inverted yield curve and other ominous macro signs like rising layoffs which suggest immanent recession? They are surely a concern, but if the market can consolidate here before moving higher again, it would suggest that the market is expecting that any recession would be mild and better times lie ahead. How long could such a consolidation phase last for? Typically they take 1-3 months but it's very difficult to predict these types of wiggles in the market. The best we can do is use tactical indicators to help navigate. By the way, I have never seen such a unanimous call for a recession as I do now. This is not to say that since everyone is calling for one it won't happen, but rather that a recession is very likely priced into the market to some degree. If the market can consolidate and break out above August highs it would suggest that  he market is looking past any recession or that there won't be one at all. If it's the former, it would suggest the recession will be mild without any financial crisis. There's some good reasons to expect this to be the case. More on that in a future post. 

Bottom line is that the latest market action is encouraging  but by no means an all clear signal. Let's see how it handles the looming overbought condition. 

Crypto rant

Anyone reading this blog knows I've been a crypto skeptic for some time. This post I made in Feb 2021 says it all. This year we have seen the unravelling of crypto with the latest being the FTX fiasco.  Due to the lack of regulation, there's a ton of scams and leverage underpinning the entire crypto space which is coming to light. I doubt this unwinding is over.  BTC in its current form will end up going to 0 in the long run because it's fundamentally worthless - you can actually make the case that it has negative worth given the environmental damage it creates. Eventually people are going to wake up and question the lunacy of BTC.  How the fuck can people not see how utterly asinine and wasteful the process of  "mining"  bitcoin is? Even if you believe in the possibility of crypto having a value, clearly there must be a much better way to manage/maintain it than to waste an astronomical amount of energy like BTC does.  BTC is the top crypto by "market cap" simply because it the was first crypto invented, nothing more.  Regardless of the system that is used to maintain any crypto, they are worthless unless they are backed by something of actual value. You can't just simply create a "coin" out of thin air and it expect it hold any value aside from greater fool buying which eventually peters out. Mind you, this greater fool effect can go on for quite some time as it did for crypto, but now the jig is up because the last and biggest batch of fools - institutional money - joined in just before the last peak and subsequent crash. In order to revive crypto aside from short term bounces, you are going to need a fresh batch of  greater fools bigger than the last cohort of bag holders and that  probably doesn't exist. 

After the GFC many people had  resentment towards the Fed and governments given how it was handled which very much persists to this day. So, some person or group invented  BTC and basically said "we  have come up with an alternative currency free from any meddling by governments."  Such an idea could garner a cult-like appeal from anti-establishment sympathizers which it did. The other main appeal was the clever blockchain tech that underpinned BTC. Regardless of the appeal, BTC was able to capture the imaginations of people on an incredibly wide scale. It had more than a few crashes and recoveries along the way all of which led to new highs, but the only reason why BTC was able to recover to new highs was because it was able to recruit a fresh batch of greater fools larger than the previous batch. The last run to $60K was the result of the last and biggest batch of greater fools - institutional money. The collapse of FTX exposed some of these institutional investors such as the Ontario Teachers Pension Plan. How embarrassed and ashamed must they be? This latest fallout all but assures that institutional money will be sellers, not buyers from this point on. 

The bitcoin rise and fall is very similar to that of dot com stocks in mid-late 1990s.  When dot com stocks first started turning heads it was driven primarily by retail. The internet was hyped to be the next big thing set to revolutionize the world and the way to profit from this was to invest in dot com stocks. It didn't matter that most of these companies had no earnings or real business plan, the fact that they had dot com after their name was good enough as it  symbolized that they were part of the internet revolution.  Dot com was initially scoffed at and dismissed by the so called institutional investors,  but many under-estimated how long and how intense the frenzy was going to be. Some of these skeptical institutional folks shorted the dot com stocks only to get badly burned. By the time the bubble hit its peak the institutional money had capitulated and jumped on board because they simply couldn't afford to miss out anymore. Then, just like what happened with BTC and other crypto, they had to come up with rationalizations to buy. At the end of the day, it was FOMO and greed that did them.  The crytpo Superbowl commercials this year marked the pinnacle of the euphoria just like the dot com Superbowl commercials in 2000. Crypto will survive, but the days of  creating coins backed by nothing and expecting success are over. 

I can sympathize with the Fed haters and the notion of seeking an alternative to fiat currency. However, you can't just come up with a coin and say "hey everyone, let's start using this instead of the US dollar as an expression of our hatred of the system" and expect it to work long term. This type of  "expressionist"  investing also underpinned meme stocks.  Such a thing can't work long term without anything of true value underpinning it.  The only thing underpinning it is inflows from the herd.  The herd is fickle, it's unreliable, it has no obligation to be loyal and when the inflows stop and the price starts sagging, it's just a question of when not if, the heard is going to stop supporting it and move on.  But wait, aren't fiat currencies backed by nothing? No. There's a central authority that enforces it; that deems it to be legal tender and the only way to transact, pay taxes and settle debts in the country it represents (many countries also do business in US dollars). Therefore you are essentially FORCED to use fiat currency of the country you reside in or do business with, the same way you are forced to abide by the laws and regulations of that country.  Nobody is forced to use a crypto coin in any way.  The herd can easily move on from whatever coin is popular at the time to another coin or get turned off completely by crypto. A central authority on the other hand, is always going to be there enforcing that same fiat currency. Do authorities  abuse or misuse their powers? Of course; some more than others, but they provide stability and assurance which is critical. Central authorities also enforce laws and regulations which is obviously critical. Again, the system is not perfect but it's necessary to have a government enforcing certain things otherwise we would be  living in a jungle of chaos. And yes, I know there are plenty of countries in this world that have oppressive governments. It should be obvious that I'm referring to democratic governments and not regimes like North Korea.  

The argument that crypto's value is a reflection of the blockchain technology or anything along those lines is pure nonsense. Once again, this is expressionist investing.  Think about the Microsoft Excel program which creates spreadsheets (loosely analogous to blockchain which creates crypto). Cleary, the excel program has a worth as it creates spreadsheets which can be used to keep records, make calculations, ect., but what is the value of the spreadsheets it creates? Zero...with the exception of when it contains information that a person or entity may value, but even in such cases, it's the info not the  spreadsheet itself , that has the value. If Microsoft were to announce that all their excel programs would only be able to generate a combined lifetime total of 21 Million spreadsheets, would that then give these spreadsheets value? No. Because there are other companies that can generate unlimited spreadsheets. So you see, there's nothing special about a spreadsheet. 

Face ripper

We had an absolute face ripper of a rally last Thursday thanks to a better than expected CPI report. SPX up 5%, Naz up 7%. with no mercy to the bears as the market gapped up huge. Coming into the report the market was sagging and looking bleak. Given the last 2 disappointing monthly CPI reports expectations must have been quite low and bears were pressing. Lot's of folks talking about how good this report was and how it bodes well for the future but lots of folks were also talking about how bad last month's report was and how it boded ill. Suffice to say that one shouldn't get too excited or depressed about a single month's worth of data. I've been saying for a while that pipeline inflation pressures are collapsing in general, sure, some components will be stickier than others but overall it's clear that the trend for inflation is down. A great way to distill this is to track 5 year break even rates which has been hovering at around 2.5% for the past 4 months. I really like this indicator because it distills all the nuances of the CPI providing an outlook GOING FOWARD of what the average CPI will be for the next 5 years.  Meanwhile the bumbling, fumbling Fed keeps looking in the rear view mirror saying how they don't see inflation subsiding much. I suspect at some point in the next year or 2 there is going to be an overhaul in the Fed with respect to how they make forecasts as they will once again be made to look foolish. Mark my words. 

The market is just punishing everyone, whipsawing the shit out of both bulls and bears. Once again, read the motto of this blog and don't you ever forget it. So, is this latest rally yet another head fake? Most likely, but it could very well be part of a base building process if the bull case is playing out. I had given a target of SPX 4000-4100 for which we have hit the lower end of this range. The market could be forming a W type bottom, similar to what we saw in 2002 and 2011...obviously too early to know if that's the case as can only know in hindsight if that actually transpires. Take a look at the biotech index ETF BBH. The W bottom is much more pronounced here. This sector is one to keep on eye on as it's showing relative strength and not being talked about much.  Bears can easily make a good case that this is just another dead cat bounce but the fact that the market is now flat for the last 6 months is a big achievement given what has been an absolutely brutal macro backdrop. Keep an open mind. Nasdaq is showing early signs of decoupling from BTC. To me this is an important thing that needs to happen to suggest a true bottom is in. The market needs to shake itself off from the speculative crap of yesteryear. Meme stocks are another thing that needs to die but they are still showing correlation to the Nasdaq although they have been pounded quite hard and are not nearly getting the spot light as they once did. I'm going to make a post discussing crypto shortly. 

Let's talk indicators. Prior to this surge there were some indicators showing some extreme bearish sentiment, namely, put/call ratios and DSI. One surprising development was how AAII equity allocation declined to 61.5% and cash is at 2.5 year high at 22.5% in October which means AAII members sold into strength. At 61.5%, exposure is about as low as it was at the end of 2018, shortly after the market had decline 20% from the peak. This is a good contrarian development but I still think think this needs to come down a bit more. Other indicators were neutral such as NAAIM. Fund flows had reversed course flipping to negative for the week but only after having been positive for the 3 weeks prior. These latter 2 are now poised to jump to excessive optimism territory when next Thursday's readings come out assuming the market doesn't totally far apart by then. 

Let's talk more about positioning. Throughout 2022 the strongest case for the bears in regards to sentiment is positioning from investors. AAII allocation surveys have pointed out all year that  they are feeling very bearish but they haven't actually positioned their portfolios to reflect it,  having only grudgingly decreasing equity exposure. Market watchers are saying that we can't bottom until we see more capitulation. Well, here's another possibility that nobody is considering. What if the market hits a bottom and Investors sell into the strength early in the new bull market? As mentioned, AAII did sell into strength in October. If the market keeps rising and they keep selling they could  end up capitulating into strength rather than into weakness like everyone is expecting. It should be noted that AAII members also sold into July's rally but then bought back in August. And so here lies the problem of these kinds of sentiment indicators - they can flip flop and whipsaw you. What I've learned through out the years is that when a lot of market watchers are focusing on a particular indictor or strategy it will end up becoming less effective. 

Let's talk about the Ukraine war. When this war started about about 9 months ago, who could have predicted that Ukraine would been preforming so well and Russia so poorly? Nobody.  I have heard that Ukraine has obtained more stranded Russian weapons/equipment than what they are getting from NATO. Who could have predicted when the war broke out that that the price of oil and wheat would end up being being about the same as it was pre-war in November? Nobody, not even the most rose-coloured glasses wearing optimist. Oil was supposed to be at $200 by now. Granted, natural gas prices are notably higher but have come down substantially since September.  The bottom line is that so far the world has been able to cope and adjust to the loss of Russian and Ukrainian commodities. Sure, that could change, but then again it would appear that Russia is in terrible shape. In regards to the war they are  running out of ammo and troop moral must be rock bottom  and it was probably never good to start with. Meanwhile Ukraine is getting more supplies by the day and moral must be sky high after taking back Kherson. Russia is isolated from most of the world and have a poorly educated workforce to pick up the slack from all the skilled foreigners who have left and closed shop. It's seems like the walls are closing in on Putin quite fast, but perhaps that means he is going to do something desperate as a last ditch attempt to turn the tide. I don't know. But let's say the Russian regime as we know it collapses, Putin is ousted and Russia withdraws from Ukraine. That's gong to create another face ripper of a market rally and tank commodities. This is just me thinking out loud here. I won't be holding my breath for such a scenario to play out, but it sure looks like Russia's war effort is collapsing. We can't however get complacent because Putin is known for cranking up the brutality when things aren't going his way. The problem this time around though is that the Russian economy is isolated and crumbling and patience must be running thin. If he orders a nuclear strike, his generals may very well turn on him as they know the repercussions will be so severe including a fear for their own lives The Russian military authorities know they are absolutely no match for NATO, the US in particular. Once you play the nuclear card that gives license for NATO to do a full assault on Russia as they will do it the name of saving the world from a madman. 

Bottom line is that although this bounce is good and there's promising signs that inflation is showing deceleration in the rear view mirror CPI reports, it's way too early for bulls to declare any kind of victory. How can you tell when a new bull market has been born? It will most likely show up as via a relentless 2-3 month rally.