All eyes on Jackass Hole

Yes, I said Jackass Hole...more on that later. First off, so much for the yen carry trade meltdown. I thought the yen carry trade was such a big driver of US stocks for the past x number of years? Hyperbole just like I said. The market has recovered all the losses from a couple weeks ago and is closing in on the previous all time high. At the lows we saw excesses get purged as I had pointed out. Sentiment had been sufficiently reset for a solid low,  but now with this V shaped move, some excesses have quickly built up again. Put/call ratio these past few days have collapsed back to the complacent levels seen at the July peak. Apparently the CTAs are slated to be buyers over the next few weeks whatever the market does lol. There's guys are hilarious. They puked everything near the bottom and now buying it back 10% higher. AAII sentiment released this morning shows 2:1 bull to bear ratio, the same as where it was in mid July. NAAIM exposure which had dipped back to 56 last week is back up to 75% - not extreme but notably higher. So, all in all, the ST condition of the market is now stretched. However, having said that, there are some ST-medium term sentiment resets which still have ample room to unwind further. Fear/Greed index sits only at 54 for one. Hedge fund and mutual fund positioning had a significant unwind in tech stocks which is still in place.  I read an article on marketwatch which says tech stocks make up 16% of hedge funds portfolio. Compare that to the S&P 500 which has a 30% weight, it seems modest. Apples to oranges you might say. Fair enough, but what about this:  According to Goldman, US mutual funds are the most underweight tech stocks in 10 years. When the Mag 7 were getting hit a few weeks back, I saw a lot of chatter about how the AI bubble may have popped citing the same concerns I had listed in my July post.  That to me is a sign that such concerns will end up being premature at the least or wrong at the most. You see, when a bubble truly bursts you tend not to see major bubble-pop proclaiming come out until after major damage had been done i.e. 40-50% type damage. I had estimated in July that we could have up to another 9 months before the AI party would be over. As I had mentioned, the major thing missing to flag a major peak in AI is a flurry of IPOs. It would appear that the recent rout in tech was simply a reset from a very overbought condition. We shall see...

So, the main event at Jackass Hole is tomorrow. Expectations appear to be high for Powel to deliver a dovish message. The market is clearly expecting rate cuts to start in Sept which is pretty much a lock. So, what's the expectation? Are we primed for a sell the news reaction if Powel hints that only a 25 bps cut is in the cards? I know there's folks out there who want to hear that Powell is willing to consider 50 bp rate cut. The futures markets is currently pricing in only about a 30% chance of this happening but futures markets can be fickle. A couple of weeks ago I believe this percentage was around 80% but don't quote me on that. Given the ST overbought conditions of the market, ir would not surprise me to see a knee jerk decline post Jackass Hole, especially if Powell delivers only a mildly dovish tone.  

The obsession with the Fed dates back to at least 1998 when they did emergergy rate cuts in response to the LTCM debacle. Given all the crises that we've seen since then, the Fed has been viewed as this omnipotent force that pulls all the strings of the market. "Don't fight the Fed" is a mantra that's ingrained into everyone's psyche. Well, if you look at history there's times when this has turned out to be true and other times where is hasn't. 2023 was a great example of how fighting the Fed by being bullish was the right move as they were still hiking rates. 2001-2002 was another time when fighting the Fed was the right move by being bearish as they cut rates aggressively. Never blindly follow popular Wall Street adages. Context matters and markets are not meant to be so obvious otherwise we would see a far greater percentage of active managers beat the market. I clearly remember in Jan 2001 how CNBC was celebrating the Fed's first rate cut which was 50bps. They showed a statistic that the market was always higher 1 year following such a rate cut except for 1929. At that time I was a bear and I remember thinking "and what happened in 1929? It was the bursting of a stock market bubble, the same was this time!"

So, what is the context of rate cuts this time? I know there are some people hopeful about it but I also  see plenty of people showing an ominous chart of when rate cuts have started from elevated levels like this i.e. 2001 and 2008. Once again, people are just blindly adhering to analogs without taking context into consideration. The rate cuts in 2001 and 2008 were a response to a clear deterioration in the economy. This time around, the rate cuts are slated to be in response to clear deuteriation in the rate of inflation - an inflation episode which had been the result of a pandemic rather than structural issues. The economy, while having slowed is still healthy. Of course, this can certainly take a turn for the worse but as it stands now you can't argue that the US economy is showing deterioration comparable to that of early 2001 and early 2008. You can't argue that the consumers and/or businesses are as levered as they were back then either...not even close. You can't argue that credit spreads were blowing out as they were back then either. Again, I'm aware that things can change rather quickly but as it stands now, the situation we are in is not comparable to 2001 or 2008. The one thing you can argue is that valuations are historically high on some traditional measures, but that in of itself is not a predictor of major market peaks. But isn't the Fed behind the curve? Yes they are, but it doesn't matter as much as people are making it out to be. The bond market is doing some of the heavy lifting of the Fed already as long rates have declined notably in anticipation of lower short rates.  

Inflation subsided naturally, not because of the Fed. I've stated this ad nauseum for the past 2 years that this would be the case. As I predicted in my Inspector Gadget Fed post back in 2022, everyone is giving praise to the Fed for squashing inflation when in reality it was natural market forces that did the heavy lifting. In the US, rate hikes took place at a time when a lot of debt was termed out and generally speaking rate hikes can have conflicting effects on inflation because on the one hand it can crimp loan demand but on the other hand it can stifle supply as it raises the cost of capital, which in turn can raise the cost of goods and services and it also creates more money in the form of higher interest payments to savers. Since the inflation episode we had was largely due to a supply shock I would argue that hiking rates probably did more harm than good when it came of fighting inflation given its impact on supply side of the equation. I have argued that consumption is stable and generally inelastic and so hiking rates would have limited impact on it,. I was correct and yet it was the consumer that the Fed was targeting with their hikes. Deep down they were thinking "hopefully the rate hikes will create some unemployment which would cool off inflation".  A naive and hopeless notion, which did nothing to address the actual cause of the inflation which was the supply side shock. Anyhow I digress. 

Bottom line here is that this market is likely going to be in highly emotional state for the next few months given the inflection point in monetary policy. The narrative can easily go from "rate hikes are good" to "rate hikes are bad" to explain why the market is going up or down because everyone is so Fed obsessed. Add to the mix the election clown show that awaits us and the dreaded months of September and October. But at the end of the day, it's all about earnings.  Are earnings going to be in tact? That's what matters and that's the main question one should focus on. So long as they are slated to remain in tact or improve, everything else will be just noise, as scary as the action may get. I know that can be difficult to have faith in when you're actually in the midst of bad market action because I know I myself always can't help but have doubts. This is one reason why I do these posts as I can look back to see what my logical/intuitive brains was thinking when my emotional/privative brain starts flaring up. If the market starts declining from here, I bet you're gonna get lots of fretting about a dreaded double top.  Let's see how things play out....

Japanese contagion

No shortage of drama in the markets as of late. Adding to the growth scare I had discussed, we have seen a meltdown in the Japanese stock market, down 12% last night. Apparently this has been fueled by the unwind of the yen carry trade which will had spill over effects to global markets. The narrative basically goes like this: investors had been borrowing in Japanese Yen at 0% for years and had re-invested this money globally to take advantage of higher rates. This trade will work so long as the value of the Yen stays the same or declines. For the past 3 years the Yen has been in a steady decline and so this trade was a a huge money maker, but in the past 4 weeks the Yen has had a surge due to the BOJ raising rates from, get this,  0.1% to 0.25%. LOL!  But I believe that expectations for the US Fed to cut rates imminently after that weak July jobs number fueled the fire even further and may be the bigger factor. As crowded as this carry trade may have been, I have serious doubts that it was one of the main things underpinning the run in US stocks which is is a narrative that I'm seeing. Sure seems like the unwinding of this carry trade is a lot of hyperbole to me. And if this carry trade was being used to buy global assets, i.e. US assets, why is it that the Japanese stock market got hit the hardest? Beware taking market narratives at face value. 

The VIX tagged 65 this morning. Wow.  You got to back to the depths of the COVID panic to find a similar spike and before that, the depths of  the GFC. So far the markets have clawed back a lot of the initial morning losses but I won’t hold my breath . I mentioned the unwinding of the excesses in my previous post. Well, today should pretty much rinse out all the excesses. Fear greed hit 18, put/call ratio has surged and the VIX has moonshoted. The weak handed momo types are now flushed out for sure after today.  Lots of people crying for an emergency Fed rate cut. Not sure to make of that, as this. On one hand it could provide a psychological boost as most investors are monetarist zombies and Fed is indeed behind the curve right now. On the other hand, if this sell-off is being fueled by the carry trade unwind, cutting rates would make it theoretically put more pressure on the yen carry trade unwind as it would lower the value of the US dollar (at least initially). The solution IMO, would be for the BOJ announcing some sort to intervention or signal to calm the market.   

In my July post I mentioned that I believed we were late cycle in this bull run but not done yet. If I'm wrong about this and July was in fact the top, then there will likely be another rebound still left whereby the market retests the recent high or comes close to it. Coming into 2018 was a time which I had warned about the complacent condition of the market. The market had a sharp drop in February but then  eventually recovered all the losses by the summer, then the market eventually rolled over in the fall and made new lows by the end of the year. In August 2007 the market had shown the first major crack which ultimately led to the GFC. This is when Cramer famously has his "they know nothing" rant. But by October the market recovered all the losses and actually made an all time high before peaking for good. So, my point is that it's likely that if a major correction or bear market is in the cards, the market would likely still give you a better opportunity to exit as tops usually take a lot of time to form. In my opinion, we did not see enough conditions met for a major top and this current decline appears to be a correction, but as I said, I think we are late in the cycle and so I'm open minded to the possibility that I could be wrong and that we are in the process of forming a major top. 

Growth Scare

The market has taken quite a pounding late last week thanks to a "growth scare" that has now gripped the latest narrative with the latest news piece being the weaker than expected July jobs report.  Coming into the year we had expectations for 6 rate cuts which by end of April got revised to 1 or 0. At the time I had suggested the pendulum had swung too far given such low expectations. Now, not only is a rate cut a lock in September but the market is pricing in a 75% chance of a 50bps cut! What a manic depressive market.  The uptick in the unemployment rate has triggered a recession call as per the  SAHM rule and so now the "R word" is now back on the table further fueled by fears that the Fed is behind the curve. First of all, the uptick in the unemployment rate as of late is coming off all time historical lows, and at 4.3%, is still quite low. Higher labor force participation rates and to a smaller extent the impact of Hurricane Beryl are at least partially responsible for the uptick. If you look at announced monthly layoffs you will see that they have actually been declining and remain near historical lows and so it would be more alarming if the rise in unemployment was due to job cuts. So, yes, there has been less hiring for new jobs but there hasn't been a massive wave of layoffs either.  Anytime the SAHM rule had a successful recession call it was accompanied by a significant rise in layoffs. The leading indicator of layoffs is corporate profitability which is currently quite healthy. Absent a shock of some sort, economic growth should just ebb and flow.  One might argue that we may soon feel the effects of the Fed rate hike campaign and therefore the shock is immanent. The bears will say that it took longer than most expected but now we are about to get the reckoning. I just don't see the evidence of that. In Canada, yes, this is a valid concern as a massive wave of mortgage renewals are coming in the next 2 years, but in the US, debt was termed out by the majority of home owners and large corporations in 2020/21. There is stress in commercial estate market no doubt. Could that end up being a shock? Perhaps, but I have my doubts that this is a big enough problem to derail the economy....I will definitely need to look into this further. But so far as what the evidence says right now, recession fears are premature in my opinion. 

Let's discuss tactical. In my previous post I warned about the precarious positioning that was in place. The usual cadre of momentum chasing, sheep traders/investors were all in on the market by mid July. These weak handed folks were only long because they chase momentum and so once the tide turns these "savvy traders" will puke their positions en masse and this is what happened. On Friday, the VIX just about tagged 30 , fear greed index hit a low of 24, the put/call ratio  hit an intra-day high of 1.46 before settling down to 1.16. These are the types of things you see near a ST low. Given the extent of the excesses we had prior to the recent peak, it could take more time before the market can regain its footing, but there's enough evidence to suggest that most of or perhaps even all of the damage is done. The last time we had a VIX this high was during the depths of the 2023 "banking crisis". Last year at this time we had a similar situation with the market. Recession fears were palpable and the market didn't ultimately bottom until October. Maybe we see that again, maybe not. Beware of using analogs because they rarely work.

I got this chart from Twitter posted by Tier1 Alpha which stated "Our Systematic Positioning index, which tracks Vol Control, CTA, and Risk Parity strategies, just crashed to the lowest level since late 2023. So, with just a mild pullback of about 6% with the SPX still up 13% YTD, these folks are now at a YTD low in exposure. That's a significant reset. Yes, exposure has room to decline further but it has already declined by such a large amount, disproportionate to the 6% pullback in the market. I've read somewhere that CTAs are slated to continue selling a lot more for the next 2-3 weeks. If that's the case, it would suggest that a lower low could be in the cards or that the market would need time to consolidate even if the low has been made. It's just one indicator mind you, so don't hang your hat on this alone.

Let's forget about all the narratives for a moment. In any given year, the market has 5-6% corrections about 3.5 times on average, and a 10% correction 1 time on average. This is now the 2nd 5-6% correction for the year and the market is still up 13% YTD and so there's nothing out of the ordinary happening so far this year. Meanwhile the VIX spiked to 30, fear/greed hit 24 and CTA's are already running for the hills. Let's see when NAAIM and AAII sentiment stats get released on Thursday but so far the evidence from pure sentiment/positioning perspective suggests this is a bull market pullback which has had enough of a sentiment reset already to establish a bottom or be in the vicinity of one.