I’ve been thinking about oil this week for a number of reasons. We had the threats against oil shorts from the Saudis, suggesting they are looking at cutting oil. The US continues to drain its strategic petroleum reserve, and there is a limit to how much we can or will do that.
The chart from Ycharts.com above shows that we are still draining the SPR. In my opinion, the first major drain was strategic – to reduce the high cost of oil before for the 2022 midterm elections. The main reason to reduce the reserves now would be to gain revenue without issuing treasuries to buy time for the debt ceiling fight.
The idea is that oil will move higher once the SPR stops draining, which will potentially happen after the debt ceiling is resolved. Lets see how oil looks in the COTs and on the charts.
From the COT positioning, we can see that over the last month the speculative longs have been decreasing. This gives more room for upside as they can change their positions back to long given a catalyst, but these levels are well above the extremes we see with the 3/21 washout. How did that turn out? March 19 saw a low below $65 and the price climbed fast to peak above $83 by April 11.
The 5 year weekly chart shows us consolidating below the 50WMA and above the 200WMA on a current down-trend. It doesn’t look particularly bullish, I’d expect the bottoming process to take a bit longer here. How about the 1-year daily chart:
Right now we’re below a declining 200DMA and 50DMA, and we just failed a test of the 50 day moving average. The price has found very solid support at $65 in the past, and I’d expect that to hold, especially if we see a big drop in the speculative longs like in March. Note that the confirmation from the weekly COT’s – that speculative longs have washed out with a big drop – will come after the bottom like they did in March, but will come before the bulk of the next move higher. I like looking at price as a real-time indicator to find an entry point, and I’m tempted to try some longs once oil drops below $67.
As a small-time retail investor, the easiest way for me to bet long here would be to buy calls in USO. Here’s what that chart looks like:
Using the USO ETF as an oil proxy, I would look to enter a call position below at a USO price of $60, or wait and enter slightly above after seeing a big drop in speculative longs in the COT report. I would plan on selling them immediately on hitting the 200 DMA, currently around $68.50. Here are the contracts I’d be looking at, which expire July 21, 2023:
So the move I’d be expecting to ride would be $60 to $68.50. If I used these charts, it shows at-the-money calls at $3.60 or a few dollars out at $2.30. So if price hit $60, and I got a couple of $63 contracts at $2.30 each, nailed the move, and sold near expiration with a price at $68.50 then I would net $5.50 per contract for a 2.4x gain. Not really worth the risk as it quickly goes to zero if I miss the move. Perhaps a better way to play it would be to go a few months out.
At the money ($65) expiries on September 15 cost $5.22 and on October 20 they cost $6.20. I could aim for getting a contract that is well out of the money in October, lose 1 month duration, and sell it just in the money. This would mean waiting for that USO price to hit $60, buying an October contract at $68, and selling it in 1 month when USO hit $68.50. Here’s the potential move you’d be looking to get:
A current Oct 20 call that is $8 out of the money ($72 strike) costs $3.15.
A current Sept 15 call that is just in the money ($64 strike) costs $6.30.
Assuming you nailed the move, you would get a 2x gain. Slightly less than going short-dated, but you would be able to exit the trade without a complete loss if you were wrong. If you account for the fact that the rapid move higher you were looking for would increase the price of call options with duration, then you would get closer to that 2.4x return from the short-dated side with less risk, making this a superior trade.
After looking through this, I’d say its questionable that I’d bet on a sharp move higher in oil, but its worth watching. If call option spreads get cheaper as the USO price falls below $60, then it might be worth a shot. If prices go below $60, pull back above, and then I see the previous weeks speculative longs sharply lower then I will certainly look for an opportunity here.
Anyway, that’s the trade in a nutshell.
As far as everything else, I’m convinced we’re in a waiting period where the S&P 500 consolidates higher on weaker and weaker breadth until the labor market gets hit enough to spark an outflow from stock mutual funds into bond funds – which would cause a sharp move down in price. If the labor market doesn’t get hit, and this outflow from stock funds doesn’t happen, then I’d expect the S&P keeps consolidating until breadth starts to recover and then it breaks higher. There are times to go big and times to be patient, and we need to stay patient right now.
Here are my latest portfolio allocations. The only trade I did was selling new covered calls on LTBR. The previous ones expired worthless, and I noticed that 6-month calls just above the money were selling for a 15% premium. I’m hoping they expire in the money because I’d been thinking about selling that one for a while now anyway, but a 15% premium to sit on it 6 more months sounds like a great deal.
The S&P 500 has been consolidating in a fairly tight range between 4100 and 4200 since the beginning of April.
Here’s the equal weight S&P 500, ticker RSP. This looks like a descending channel, with the 50 day moving average falling below the 200 day moving average. Interesting that it is descending while the market-weight S&P 500 is climbing.
Here’s where all the money is crowding these days – AAPL and MSFT:
Here’s AAPL, recently hitting a 1-year high.
MSFT is well above its 1-year high:
The multi-year volatility of these mega-caps still amazes me. AAPL has a market cap of $2.76 Trillion, and within the last 2 years it fell below 130 (3) times and soared above 170 (4) times. 31% market swings in valuation mean a fluctuating valuation of $856 Billion. MSFT tends to trend more, with a market cap of $2.37 Trillion and rising from 250 to 350 then falling to 220 and rising back to 318. 220 to 318 is a 45% market swing for a fluctuating valuation of $1.06 Trillion.
It seems amazing that these two companies can be that volatile, but it makes sense considering that these companies are held in significant amounts in most exchange-traded funds. The S&P 500 trackers hold 14% of their assets in these two companies alone, and the NASDAQ trackers hold 26% of their assets in these two companies. These ETFs are designated as “passive,” which means that they don’t react directly to price. Their price reaction is to buy shares when money enters the fund in accordance to market cap.
Money has been flowing steadily into these passive index-tracking funds, especially recently as they are seen as “safe” because people feel they own the entire index. The higher the price of AAPL and MSFT rises, the more incremental dollars added go into purchasing their shares – and if flows into these funds reverse, then the higher price means more incremental dollars will be sold from AAPL and MSFT shares. What can make these flows reverse? A spike in layoffs would directly mean less money is going into 401k funds in weekly payrolls and could spook a number of investors holding these funds to consider a larger allocation to bonds. When flows reverse, these two stocks can fall quite rapidly, hence the high volatility over a two year period.
There’s not much more I can really say on markets except that we’re in a waiting game. The debt ceiling talks are totally irrelevant to the driving flows in markets today unless something happens that is serious enough to change them. Stock prices do not anticipate or to fundamentals, they simply flow with the prevailing winds which are still pushing the mega-caps higher.
High valuation metrics, like a P/E ratio near 30 for AAPL and near 35 for MSFT, and the danger of high exposure to China while Congress debates measures like this https://www.reuters.com/world/us/us-senate-draft-new-legislation-counter-china-2023-05-03/ simply mean that the price can drop quite considerably if the upward flows from stock buybacks and the passive investing trend are overwhelmed. On the other hand, there is a high short interest in the S&P 500, and if sellers are exhausted while passive flows and stock buybacks keep pushing then it could spark a massive short-covering rally. The only way to really play this is to expect volatility to be high and keep your exposure relatively low with instruments like puts when it looks like flows might shift downward and calls when they might shift upward. I’m biased to the downside here, but I could easily lose my AAPL puts and come out fine.
As for other stocks …
Cannabis is probably the most interesting as there had been another push for the all-important “Safe-Banking” legislation, but it looks like it has been once again derailed by Senate Majority Leader Chuck Schumer who tacked on a bunch of requirements that don’t have enough support to pass.
I still believe in the supply shortage story with many commodities, but commodities often react to the real economy more than stocks do and the trend is dis-inflationary to downright deflationary. Recent earnings have supported this with huge disappointments for Home Depot, Target, and Foot Locker while Walmart has been doing well with its focus on consumer staples. I haven’t heard about any significant new bankruptcies this week, but they do keep coming. Last week we had 7 big companies including Vice Media, Cox Operating, and Envision Healthcare, before that was First Republic Bank, and the pressure is still there. I’m still long a bunch of mining stocks with out-of-the-money covered calls sold on them to wait out this period of weakness.
That’s it for now. I recently added more Jan 2025 TLT calls. Here are my portfolio allocations:
With the debt ceiling coming up, stories of debt alarmism are shooting around like crazy. We’re back to seeing the ever-growing debt clock, along with fears of hyperinflation and questions of when foreigners will stop funding the US government by purchasing its debt. The famous Stanley Druckenmiller had a big speech arguing about how the US government needed to address its spending problem now by cutting 40% from its budget including almost all of our “entitlement” spending like Social Security.
One question that these debt alarmists always fail to ask is why foreigners are buying US debt. This seems odd, like blaming the entire 2008 global financial crisis on greedy subprime borrowers without ever asking who was lending so much on mortgages and why. The truth is, capital seeking a home will always find one. Take a look at China … they throw out their GDP targets, which are then achieved by local governments borrowing whatever it takes to get them there. They’ll invest in bullet trains, subway stations, property developments (even empty ones), property development companies – they’ll always find something.
Back to US debt – why are so many foreign entities buying it? Where are they getting the money?
This brings us to a critical issue that debt alarmists never seem to talk about – the trade deficit:
It’s amazing when you bring a historical perspective to our alarming debt problems. Debt to GDP was low during the period of sustained inflation, and recently CPI inflation problems were transitory, from the oil supply shocks of 2008 to the enormous shocks from the total economic disruptions of 2020-2021. If CPI inflation is driven primarily by debt today, then why wasn’t it a problem while Debt to GPD soared from 2009 thru 2012? The simple answer is that there are other factors at play.
Isn’t this debt growth unsustainable? Foreigners can’t buy our debt forever, can they?
If foreigners are getting the money to buy US assets from their trade surplus, then they can keep buying US debt and other assets as long as the trade surplus persists. In fact, they have to in order to keep it. Massive trade deficits mean that the US is supplying foreigners with massive amounts of US dollars – because Americans pay for goods in US dollars. If the rest of the world decides to convert these dollars into other currencies, then those currencies will rise in value relative to the dollar and the goods from those countries will be more expensive to US consumers.
Imagine you have a foreign government like China that decides it doesn’t want to accumulate any more US assets, but still wants to remain export competitive. Then one of two scenarios happens – either the Chinese currency begins to rise and the Chinese government intervenes to keep its exports competitive, or the Chinese government gives more support to state-operated-vehicles which produce exports and uses the dollars to accumulate Gold, Belt-and-road country debt, or other foreign assets. Those dollars are still accumulated by exports to the US, and they still can only come back by foreigners purchasing US assets such as debt, and the value of this US debt.
In short, foreign countries are fostering a permanent trade surplus with the US. As long as this persists, they will accumulate dollars which must be spent to purchase US assets. So why do they do it?
The US system has open capital markets with strong legal protections for foreign investors. Foreign countries that focus on supporting “export competitiveness” often have closed capital markets or more dubious legal structures. The leaders of powerful exporting firms are often very rich, quite happy to accumulate personal wealth in large Western countries, and they want to keep the status quo. At the same time, any disruption to their exporting machines leads to massive layoffs and protests from workers who live just above the subsistence level. It is extremely difficult for foreign export-oriented countries to change this system, so they keep exporting to the US and they keep buying US debt and other assets.
What happens if the US government decides to fight the deficit through spending cuts? The European Union actually did this during the early 2010’s. Here are some charts:
US GDP Growth for comparison:
Note that as the EU moved to a trade surplus from 2012 through 2019, and that trade surplus had to go somewhere. During that time, US GDP continued to grow as the US trade deficit remained large – so the US was able to help absorb the trade surplus of the EU as the system rebalanced.
If the US successfully cut its deficit, it would also crush the trade deficit by crushing domestic demand. However, the necessary GDP drop could be much lower as many foreign countries have policies in place which react to support their trade surpluses – policies which would lead to a soaring US dollar to help offset the drop in US demand with regard to their exports. Ultimately the system would have to find a new balance, which would involve a combination of rising US corporate and/or consumer debt, lower US demand, and higher unemployment in the US and even more in the large foreign exporters to the US.
So what should we do?
In my opinion, US government debt gets far too much focus and we should think about what our real goals are. Take a look at a chart of countries with debt-to-gdp ratios like this one:
When you look through these charts, you’ll notice right away that most of the popular destinations for people to want to move are on the left side, though not exclusively. There is a bit of a range here. The point is that Debt to GDP is not the most important thing to look for in a country, that many other factors are much more important such as high standards of living, personal freedoms, rule of law, and so on.
Perhaps we should consider these factors before plunging the country and the world into depression while cutting our social safety nets at a time of peak wealth inequality in a Quixotic charge against the Giant of US Government Debt.
Closing thoughts on markets
As for markets this week, they’re still in a painstakingly slow consolidation around 4100 in the S&P 500. Regional banks are still under stress as Jamie Dimon voices threats of banning short selling on banks and investigating anyone who would dare short a bank stock. No banks are fell to the FDIC this week, and breadth measures continue to diminish as Apple became more valuable than all the companies in the Russell 2000 combined.
I didn’t make any trades this week and the markets barely moved, so I’m not going to update my holdings today. One interesting thought though – stock market consolidation is a lot like tug-of-war: very little movement followed by a large move when the bullish or bearish forces collapse.
Conventional economics often ignores the effects of debt, but at high levels it can become quite powerful. Government deficits are inflationary, and if higher interest rates are paid with higher deficits then this can spiral out of control like it often does in emerging markets.
Example: A government with 200% debt to GDP raises interest rates to 20% to combat inflation. Most government debt is issued at short durations, and is very money-like in itself being used for payments on large transactions. This government must now pay 40% of GDP on interest expense alone. This involves heavy increases in money supply which causes hyperinflation. Emerging market nations such as Argentina understand this better than the IMF, but they ultimately have no choice but to accept their prescriptions.
Note that there are powerful anti-inflationary affects of forcing interest rates higher, such as causing a contraction in bank lending and offering better incentives for investors to hold the currency. However, these effects can be outweighed by debt just like atomic forces are outweighed inside a star.
Does this apply to the US?
Not yet. US Federal debt to GDP is 129%, so every interest rate hike does widen the deficits considerably. However, the powerful deflationary forces can be seen throughout the banking sector. Bank Failures:
Higher interest rates also affect corporate and consumer debt very differently than government debt, because these entities can’t just expand spending to cover the higher interest payments.
When commercial debt rolls over, a bank or banks have to agree to re-lend this debt. In some cases this just means higher interest rates which the company may or may not be able to afford. In other cases, the banks are simply not willing to finance the whole extent of the previous debt so the company has to come up with the difference or default on the loan. This is particularly relevant with asset-backed debt such as an office tower. If the value of the underlying assets drops considerably, or the interest coverage ratio plummets because income didn’t go up with interest rates, then banks won’t roll over the loans without a significant payment from the company, and the loan ends up in default.
Consumer debt is a bit different from corporate debt, in that it is often shielded from sharp rate increases and payment plans end with payoff rather than a planned refinancing date. As a result, interest rates alone don’t tend to spark consumer debt defaults – layoffs is the big driver. Higher interest rates do have a dampening effect on bank willingness to extend new credit however, so this does have a slowing effect. In other countries with high amounts of variable interest rate loans, rate hikes have a much bigger impact on consumers.
Where do things go from here?
There were a couple of interviews which really made me think about the current situation.
Chris Whalen gives his most condensed take here:
Chris describes the scenario where interest rates were thoroughly repressed in 2020 as US rates hit zero, European and Japanese rates went negative, and the Federal Reserve was buying up large amounts of mortgage-backed securities. Then massive fiscal stimulus put an incredible amount of deposits into the banking system, just as every mortgage borrower in the US was heavily incentivized to refinance at rock-bottom interest rates. Banks are in the business of lending their deposits, and they invested heavily, particularly in loans with low credit risk such as mortgage-backed securities and treasuries, but ultimately into any loans they could get their hands on as Powell was urging them on saying that interest rates will remain low for a very long time and they aren’t even thinking about thinking about raising rates. While some bankers were skeptical, like Jamie Dimon who kept JPM’s duration down around 3 years, many pushed the envelope like First Republic with a huge book of non-conforming mortgages on high end properties at 3% interest rates with no principle payments for 5 to 10 years.
When Powell raised rates at the fastest pace in history, going from 0% to 5% in just over a year, these banks were stuck with loans and securities that lost an enormous amount of market value. They can be held to maturity safely if they can keep deposits at 0% while slowly earning the 3 % to 4% yields on their longer duration debt, but a small amount of sales would push the equity value of the bank negative and throw them into FDIC receivership. Meanwhile, regular depositors are eying money market rates up to 5% and moving their savings while large depositors are worried about that $250k FDIC insurance limit if they don’t move their operations to one of the too-big-to-fail superbanks.
The Federal Reserve reacted by allowing large amounts of borrowing from the Federal Home Loan Bank, their traditional discount window, and a new facility called the Bank Term Funding Program. These programs all lend money secured by the bank’s loan and financial security assets, and the BTFP would even lend up to 100% par value on government-backed securities which is more than the current market value. This alleviates a spiraling crisis as banks can meet any deposit withdrawals using these programs without having to sell off their assets and incur big losses.
Although these government facilities stopped the immediate crisis, they only really delayed the problem. Why? Banks borrowing from these facilities are doing so around the Fed Funds Rate – so they are earning money from long-term loans at rates around 3-4% while paying around 5% interest to the federal reserve. They still face steep losses on any loans they sell, and their capital position is eroding over time.
The analogy that I like to use here is that the Federal Reserve is holding the regional banks under water while trying to prevent them from all drowning at once.
So why is Powell doing that? Is he trying to consolidate the banking system into a much smaller number of bigger banks that are easier to influence? To what end? That is where the second interview comes in:
Danielle describes Powell as an intelligent man with prior experience working at a hedge fund, who knows very well what he is doing. He understands that the job openings data is bogus, and that the economic indicators he touts are the most lagging for various reasons, but he will say whatever he needs to in order to keep interest rates as high as possible for as long as possible. He is on a mission that goes beyond simple CPI inflation, and he cites Paul Volker, who caused a major double-dip recession in 1980-1983, as his guiding light.
During the global financial crisis in 2008, the government decided to take much more regulatory control over the banking system to prevent them from causing the excesses that led to the GFC. However, most of the big players in banking at the time decided not to play ball. These bankers formed large hedge funds or shadow banks which would use enormous amounts of leverage while avoiding the new banking regulations. This activity was aided and abetted by low interest rate policies, an endless stream of QE operations, and the direct involvement of the Federal Reserve in the Repo markets.
The results of the high-leverage activities above were ballooning asset valuations leading up to the current “everything bubble” as stocks, bonds, and housing prices shot endlessly higher. This caused the asset-holding class to gain enormous wealth and hoard assets while ordinary citizens saw basic costs of living like rents shoot ever higher.
Here are a couple of charts which back that view, taken from Nick Gerli’s interview with Adam Taggart of Wealthion:
This chart shows more homes per capita in the US than at any point in the last 60 years in blue. The green line, homes per employed person, is above average but tends to spike when unemployment is high.
This chart is just as crazy, showing the tiny sliver of US homes for sale versus a much larger number of vacant homes and the total US single family homes at the bottom. An astounding 14% of homes are vacant! Why is that? Some are vacation homes, some are acquired by wealthy overseas investors who want a foothold in the country, but an ever-increasing number are investment homes, many of which are used for short-term rentals with services such as AirBnB.
Now back to Powell.
Jerome Powell knows how much pressure he is putting on anyone with excessive leverage right now, and that’s what he’s aiming to crush. He wants to see a wave of defaults which brings asset prices cascading down to the more reasonable levels we saw in the past.
Whether Powell’s cause is noble or not, it will have enormous effects on asset values going forward. The banking system is the tip of the iceberg here, and many of the entities that these policies are gunning for don’t have direct access to central bank financing. It is often said that central banks will hike until they break things, and things are breaking, but not quite enough to change policy.
Alternate Viewpoint leading to our current situation based on trade:
I recently finished Michael Pettis’s book “Trade Wars are Class Wars,” where he describes the effects of open trade with mercantilist policies. Here’s my quick-and-dirty overview of the situation.
Many countries in the world want to become wealthy, but they lack sufficient infrastructure and the competitive industries which require massive investment. They start subsidizing export-oriented businesses while suppressing their costs using a wide variety of methods, which essentially result in less income for wages and more income for the exporting industries. These policies helped Japan, then South Korea, then China grow at incredible rates while building first-rate infrastructure.
Unfortunately, it is very difficult for a country which embraces mercantilist policies to ease off and allow demand to increase domestically. The policies have fantastic initial results and provide excessive benefits to a class of powerful interests. Those who benefit are able to gain tremendous wealth by acquiring assets abroad at the expense of an increasingly underpaid workforce. Any attempts to re-balance the situation also lead to the immediate erosion of export competitiveness, which harms industries plagued with overcapacity. However, productive investments have all but dried up leaving ever more speculative projects and speculations such as the “ghost cities” scattered around Japan as well as China.
Germany has been a mercantilist powerhouse for many decades post WW2. After reunification, they doubled down on such policies to the extent that they had higher average income but lower median income than most of their neighbors. Before the GFC, their policies were coming under question, but post GFC their low government debt levels allowed them to impose their views and policies on much of the Eurozone. As a result, European bloc countries are strong net-exporters all while suppressing wages and demand back home.
Bring in the US. Clinton turned the country heavily towards “free trade” in the 1990’s with NAFTA, followed by Bush inviting China into the WTO and Obama moving to further trade pacts like the TPP. With a strong free-trade push combined with open capital markets featured by comparatively strong protections for foreign asset-holders and topped with the world’s reserve currency, the US became the dumping groud for trade surpluses worldwide as we outsourced the bulk of our manufacturing sectors and trade deficits soared. Wealth from trade surpluses abroad was increasingly re-invested in the US, shooting asset markets ever higher. Before the GFC, our financial sector got creative with new instruments like mortgage-backed securites to sell to an endless supply of foreign investors. After the GFC, the government-backed markets drew much more of the investment and foreign entities started holding US paper even at near-zero rates and then diversifying into US stock index funds, commercial real estate, and housing. Interest rates were rock bottom even as wages went nowhere and financial assets soared.
The viewpoint above for the increased value of US financial assets above all others makes a lot of sense to me, and it makes me think that Powell will ultimately fail in popping the US “everything bubble.”
I believe that we will continue to see bank defaults in coming months, along with more private sector funds we never heard of like Archegos in 2021 or Three Arrows Capital in 2022. The trickle of defaulted commercial real estate will continue as well, and banks will continue tightening credit to businesses as consumer demand remains constrained. I believe this will lead to a spike in unemployment which is impossible to ignore, just like the ones we saw after every other Fed tightening cycle, as many of the businesses which just recovered from the post-pandemic labor shortages lay off their newest employees again.
Then policital atmosphere will change dramatically as calls to replace Powell emerge and the Fed Funds rate goes down towards zero. As for fiscal stimulus, it could go any which way for a while as we enter an election year with a divided congress that will be frantically blaming the other side for all ills – as we see now with the debt ceiling. Regardless, they’ll eventually scramble for stimulus like in 2020 if they feel the need.
Ultimately, we have destroyed an enormous amount of supply capacity in the past few years with pandemic lockdowns, the rapid and permanent closure of nuclear plants and cancellation of oil and gas projects, the shuttering of large industrial capacity for fertilizer and aluminum and such, and the populist pressures we see throughout South America dropping mining capacity further. Once we saw the lagged measures of rapid inflation alongside pandemic re-opening, we started fighting it almost completely with demand-side measures.
Any attempts to bring back a normal level of growth will hit that supply wall even sooner until we finally make a real push to re-build supply capacity.
This is ultimately my thesis for a decade of outsized returns to commodities, and the reason why I’m piled into mining stocks. It takes many years and a lot of investment to develop a mine. For the past decade, this sector has been financially strained as the overcapacity from the boom through 2011 finally worked through. We’re approaching the time where prices will soar without new production, and current prices aren’t enough to incentivize that production. It will be a rough ride, and I sold a lot of covered calls expiring as late as January 2024 expecting a tough year in the sector, but it is a very small sector that can shoot up fast when investment money starts flowing in.
I’ll end it here. These are my current allocations. Note that I added a bit to my AAPL puts.
I didn’t do any trading this last week as we have been in a tight range this last month with shrinking volatility.
I’ve heard a number of very compelling bearish takes, these last few weeks, but more bullish takes have been coming out lately as well. A strict believer in fundamentals tends to pick a side – either focusing on the stories of tightening credit among regional banks, with First Republic close to failure, or pointing out the persistance of inflation, rebound in consumer spending, and still low unemployment numbers. A strict adherence to technicals requires shedding directional bias from these fundementals-based narratives and looking for signs of momentum change.
I admit that I am strongly biased to another big drop coming in markets because of the credit tightening story. Positive surprises in the data only means that the Fed is more likely to continue hiking rates because they don’t tend to stop until something breaks. Still, I could easily see the S&P 500 climbing higher from here as more money floods into the perceived safety of mega-cap stocks and/or index funds which heavily overweight the mega-cap stocks.
Here’s the S&P 500 equal-weighted vs the standard price-weighted S&P 500 in orange so you can see how big the flight to mega-caps has become:
The above has me worried that we are merely in the eye of a storm which hit markets in 2022. The S&P is recovering and volatility is shrinking. I fully expect the other side of the storm to hit at some point, but any bets on the bearish side just shrink in value as time marches on. Outside of the mega-caps, much of the market has been hit really hard and it is likely that some parts have already bottomed. So I’m sitting in a position where I’m fully allocated, margin is way too expensive to consider, and I just need to wait things out to see where they go.
Part of the reason I calculate out my holdings every week is so that I can see any significant moves.
In Hedges, my TLT calls gained significantly while my LEN & AAPL puts fell and the TSM puts stayed the same. The market for US treasuries rallies when credit tightens, yet we haven’t seen a plunge in employment or economic data that would cause significant selling.
My mining stocks involving gold, silver & copper have been falling this last week even as these metals remain relatively strong. Precious metals are near their long-term highs while copper has pulled back a bit but is still much higher than pre-pandemic levels.
Meanwhile, my Uranium miners have seen a decent bounce-back on Friday making solid gains for the week, though they are still down a lot year-on-year. Here’s the performance of Uranium miners vs the metal:
Last but not least, there was significant news in the US Cannabis sector, along with a significant jump in the stocks. Here’s the news clip:
The gist of it is that there is another push in both the congress and senate to pass SAFE Banking, which would enable US Cannabis companies to access the US Banking system and make it much easier for them to access capital markets. US States have been legalizing Cannabis for over a decade, but the federal laws regarding it never changed. Under Bush in the early 2000’s there were some high profile federal raids against Cannabis companies operating legally under California law. The Obama administration promised not to raid Cannabis companies operating legally in their states, but federal laws never changed. As more and more States legalized Cannabis sales in the following decade, multi-state operators emerged and listed on the Canadian stock exchange where US retail investors can invest through the OTC markets. However, these companies can’t directly list on a US exchange or use general US banking services (banks can be fined for working with them) and many investors are prohibited from owning them. There have been attempts to change this through legislation for years now, and we are seeing another one.
To me, this sector will serve as a long reminder of why professional traders like Tony Greer use tools like stop-losses to avoid riding a losing trade. As a stubborn retail investor I can keep riding this out, but there is no question that a guy like Greer who waits for the chart to show a decent bottoming and breakout – likely after the legislative change – will end up buying in at a much more favorable price than me if things work out and will simply avoid it if it never does. In a bull market you often see sharp gains after a pullback, which would have been great for a retail guy like me, but Greer actually bought in as well at these points so he would’ve gained there too – he just got stopped out when the trades didn’t work instead of riding it down for 2 years. Live and learn. Or not I suppose, because I’m still stubbornly holding this these stocks, I’m just not adding any more. Disciplined trading is not easy, and I’m not there yet.
I’ll leave off there. Here are my latest allocations:
It is very easy to get bearish right now. There are many stories out there about high end jobs getting trimmed, about banks cutting back on credit to the real economy, about the coming bust in Commercial Real Estate. These problems are very real, but that simply doesn’t mean a crash in the S&P 500 is imminent. Certain sectors of the market have been hit hard already, from speculative tech like ARKK invests in and the meme stonks to cyclical and financial stocks.
Russell 2000 looks like a much more muted peak this time
Put to call ratio looks relatively benign compared to recent years (from Ycharts)
On the other hand, the money in the stock market is still rotating more than its coming out, going more towards the big blue chips like AAPL and MSFT than anything else. Here are the top holdings of the S&P 500 tracker SPY:
In Stephanie Pomboy’s recent interview on Hedgeye, she said that she is actually holding a lot less puts than in past years because they just haven’t been working, so she’s sticking more with things like gold miners which should do well at the beginning of the next bull cycle as the Fed cuts rates back towards zero. I’m in a similar boat, also very nervous about holding too many puts, and sticking with longer durations in the puts I have.
My reasoning was that it effectively worked that way in past recessions, and that most of the money going into the stock markets week after week comes from payrolls with people letting their 401k’s do their thing. Layoffs and fears of layoffs mean that more people stop contributing to 401k’s and more employees decide to move towards the relative safety of bond funds over stock funds. Here’s where the labor market sits:
It looks like continuing claims have bottomed, but they haven’t spiked yet:
The working-age labor force participation rate, though well below its 1999 peak, is still sitting at its pre-pandemic highs:
I admit it still irks me that the recovery from the forced job losses of the pandemic is always referred to as a “red hot” labor market, but that’s beside the point … the labor market simply hasn’t broken yet so neither has the S&P 500 index.
I think what I’ll do is slowly accumulate more long-dated put positions, especially in the stocks where everyone is crowded today like AAPL, but I won’t jam into heavier positions or shorter-dated puts until I get more clarity about an S&P 500 collapse really being imminent.
The truth is that no matter how things seem in the economy, the S&P 500 does not reflect the underlying economy. It moves up and down on cash flows into US blue chip stocks and nothing more. We could hit all time highs again for a number of reasons, or do a long grind sideways like I expored last week here: https://johnonstocks.wordpress.com/2023/04/15/1947-long-grind/
Anyway, here’s where my portfolio weightings ended up. I didn’t do much trading this week – reduced SLVRF a bit and increased UROY a bit. Most of my stocks have covered calls on them where possible, as I don’t expect gold, silver, or uranium miners to moon in late 2023. I’m still on the deflationary side with my 401k in the safe bond fund choice – a 6.5 year duration which pays well now and will give great returns when the Fed cuts later on. At the same time, I really believe that we don’t have enough mining capacity for the next decade and that a lot of money will have to be invested in the sector at some point. I’m willing to wait that out, thinking of the post 2000 period as a proxy for a sector which has long-term bullish fundamentals following a decade of underinvestment.
I can’t help thinking of the markets today as being in the midst of the 2008 post Bear-Sterns rally which started in mid March, topped in mid May, fell to new 1yr lows by July, then fell off a cliff in September. We have the banking contraction going on right now, so a similar track is a possibility.
I also think of the long, grinding bear market post 2000. That combined all-time highs in tech with a Fed rate-hiking cycle.
Right now, the market looks markedly different than both of the above. Here are some charts:
One big and obvious difference between today’s market and the previous bear markets is the relationship with the 50 week and 200 week trendlines. In both 2000 and 2008, the S&P 500 quickly fell below the 50 week trendline, which then acted as resistance until after the market bottomed. The 200 week trendlines acted as initial support in both 200 and 2008, but was pierced within a year and never came back until long after those bear markets were over. The post 1990 Nikkei acted pretty similar to the post 2000 S&P 500 with heavy resistance at the 50 week MA for nearly 3 years.
Today’s market tested the 200 week MA last October, never quite reached it again, and is now consolidating over the 50 week MA. You can scroll back on the S&P 500 and see a number of similar patterns in past market corrections, but the vast majority re-test all time highs within a year. Currently, all-time highs are in late December 2021, which is 16 months ago.
The first market I see similar to that one is the fierce correction back in 1987:
As you can see, the movement of the 50 week and 200 week moving averages fits our current market pretty well. Still, 1987 was a sharp drop with a quick recovery whereas our current market has that grinding drop more reminiscent of the mid 2000’s.
Scrolling back, the 1981 Volcker bear didn’t recover the 50 week MA until the bear market was done in the midst of a monster rally. The declines in the 1970’s don’t quite seem to fit our pattern either. Here’s one that’s pretty close:
Another proxy that’s fairly close but a bit more sinister in 1947:
I’ll leave my search there – I actually really like this one. A lot of people have been talking about parallels with the 40’s, with the high levels of debt forcing rates low as inflation spikes and wages are muted.
As for my investment strategy now, I like having some hedges on the short side, and I added to them this week by joining Warren Buffet and a bunch of Senators that went bearish on TSM. All of my puts are long-dated though, as well as my TLT calls.
I also have covered calls sold on all the miners I can. Except DNN, which is kind of my lottery ticket Uranium stock where I’m holding a bunch of long-dated calls (half Jan 2024 and half Jan 2025).
It’s certainly a crazy market out there. Breadth is getting more bearish as the S&P 500 drives higher. More and more money is flowing towards “passive” ETF funds which almost all allocate enormous amounts to AAPL – and record share buybacks are here again as well. These leading stocks may be highly valuable at the moment, but with so much money crowding into fewer and fewer traded shares, they will become more and more volatile – to the upside as well as the downside. With the Fed tightening cycle gone mad, the credit reduction by regional banks, and the debt ceiling ahead, I certainly woundn’t want to be long those things right now.
I often hear the phrase “the stock market thinks” or “the stock market is pricing in”
People love to anthropomorphize everything. Stock markets are often depicted as both emotionally and fundamentally driven creatures driven by bulls and bears fighting it out on a pit like you see in the movie Trading Places. While it makes for exciting visuals, that isn’t how it works. Stock markets are driven by capital flows, many of which have little to do with underlying fundamentals.
The biggest flows are from employees with their 401k plans. Every week, a certain amount of money is allocated to the stock market along with payrolls, regardless of anything else. Typically, this creates a stock market that trends higher as unemployment trends lower until layoffs start to hit.
At that point, a few things happen: Employees start putting less money into their 401k’s in order to increase their emergency savings, employees lose their jobs and stop contributing to their 401k’s, after which they get the paperwork to move the accounts elsewhere and decide to move them out of stocks, and employees get nervous about the stock market and start moving their 401k’s toward bonds. These trends accelerate until the selling pressure stops as unemployment peaks out.
After unemployment peaks, you get a nice long bull cycle as the unemployment rate goes down, more people are hired and putting money into 401k’s, and more 401k money begins to shift back toward stocks. Here’s what this looks like on a chart:
As you can see, that 401k narrative fits pretty well up until our current cycle. This cycle is different from the past few in a number of unusual ways.
First, the stock market usually climbs as the federal reserve starts hiking rates and falls as the Fed starts cutting rates. In this cycle, the market peaked before the Fed started its first rate hike, then started to fall significantly as the Fed hiked rates at a much faster rate.
Second, the peak in unemployment and the bottom of stocks in 2020 happened in record time causing the NBER to declare the shortest recession ever. We went from lockdown layoffs en masse, to enormous fiscal stimulus, to a scramble to re-hire lost workers, causing a shock more like an EKG spike on a heart monitor than any kind of normal beat.
Third, the data is still more screwy than ever. We have signs of recession all over the place – including
yield curves inverted for more than a year and more steeply than ever
Weak transportation and manufacturing data
Weak retail sales, even at Cosco
Retail inventories swiftly climbed from Oct 2021-Aug 2022 and then stayed there rather than dropping
Significant layoff announcements from large corporations, particularly focused on office and technology employees
On the bullish side, the inflation rate has peaked but is coming down slowly, the unemployment rate is still very low, and the (highly questionable) job openings numbers have peaked but are much higher than we’ve seen in past decades.
Here are charts fitting a few of my notes above:
I’m still thinking that this enemployment rate is key. While the stock market is high, it’s mainly been driven by the top 10 stocks as money flowing into passive funds tends to pool there. AAPL for example is now the biggest stock in the S&P 500, making up 7.12% of the SPY S&P-tracking index fund and 12.33% of the QQQ Nasdaq-tracking index fund by itself. Despite being the largest company, making it unlikely to grow revenue in multiples, AAPL has a hefty P/E of 28 compared to the S&P 500 mean (avg value) of 16 and median (avg company) of 15.
Anyway, once unemployment spikes, it should spark a selloff from 401k funds as money is finally switched around out of stocks. With an enormous amount of that money piled into AAPL at sky-high prices, that stock can fall a lot quite quickly before it finds enough interested and capable buyers. I believe that’s beginning to happen, so I focused some puts there and even added one more on Thursday which expires in November.
Here’s AAPL’s chart:
It looks to me like AAPL is near the top of the descending channel on the weekly chart, and perhaps ready to break down from that ascending wedge on the daily chart.
Here’s my other focus for puts – LEN:
It looks to me like LEN is also near the dop of its weekly wedge while it is coming to the end of a wedge on the daily chart. To be honest though, I just couldn’t imagine why an enormous US homebuilder would be near its all-time highs after housing prices peaked and sales started to freeze up. These puts expire in January and I’m going to let them play out a bit, but I’m not planning on adding to them.
I’ll end with a chart of GDX:
The Gold Miner’s index GDX actually looks fairly bullish here. I wasn’t sure how to call it on the weekly – the descending channel with a false breakout is possible but ugly. On the daily chart it looks like an ascending channel which passed north of the tops of that bowl consolidation.
As for trading, it was actually quite a busy week. After finding out that I was getting charged a 14.25% interest rate on my margin which didn’t even offset tax gains, I was determined to get that cash balance positive. I sold off one of my gold miners (MGMLF), the portion of uranium miner BQSSF from my regular trading account, and some of my cannabis stock GTBIF. I also got more aggressive on selling covered calls on almost everything I could – gold, silver, and uranium. I did sell them all significantly out of the money in case they rip from here, as these mining stocks just haven’t seen the same level of gains we saw in both gold and silver. Still, hearing the strong narrative about the US Dollar being replaced – again – puts my guard up and makes me want to ease up a bit. This is the kind of narrative I’d expect to be trumpeting as gold and silver was sold to speculators before a significant smackdown. I’m bullish over the next few years, but I really don’t think these miners are going to make big moves until after the unemployment rate spikes and then peaks. My gut says they’ll probably go lower from here, and that they probably won’t take off until Q1 2024. Still, the moves in these things happen fast, so I plan to ride it through.
That’s all for now. Here are my latest allocations:
As an investor, every once in a while something surprises you and makes you feel like a complete idiot. Just yesterday, going through my accounts, I noticed an interest charge which seemed a bit high. At first I thought it must be quarterly, but its every month. It would seem that an asset-backed loan like margin should be fairly cheap, like a bit over fed funds, but it never occurred to me that it would be more expensive than many credit cards.
Even worse, this rate is not really tax deductible.
Basically, unless you are rich enough to own crazy expensive homes that charge you more than $13,850 in annual interest expenses, you are not itemizing your taxes and you won’t get a margin interest deduction.
Most people are in the bracket where 25% of additional income is taxed federally, and in a state like California there is another 10% tax for the state. Add in the flat payroll tax from social security/medicare/medicaid at 10% and the unemployment insurance at 6% and that leaves you with only 49% of your hard-earned income from actual work. Then theres the payroll tax your employer pays for you but you don’t see, sales taxes, etc – its infuriating. That’s beside the point though, most of that extra tax is only charged for actual labor not capital gains or interest, so that leaves you with a 35% tax rate on your short-term capital gains.
If you purchase anything on margin, then you have to make a gain of 14.25% x 1.35 = 19.25% just to pay the broker and the government and break even. That’s one heck of a hurdle rate.
Anyway, I’m going to get my margin back to zero quickly, and possibly cancel the margin account. I’ll set my credit cards to minimum payment for a while (they’re cheaper) and sell some things off.
I didn’t trade anything last week, its been choppy. I tried to sell more covered calls on mining shares but my price wasn’t hit.
Most people assume that the stock market reacts to fundamentals. This is a popular view, given the tendency of mainstream journalism to simply attribute the latest stock market move on a seemingly relevant news story. Inevitably, these views run into trouble as the stock market runs counter to expectations. You then see anger and judgement on financial twitter about the apparent lack of intelligence of investors or people in general.
I think everyone goes through that phase when they start investing. Many people never quite break out of it, because the prevailing narratives are all about fundamentals driving stock prices. A big eye opener for me was the stock market in late 2020. I was actually convinced in 2020 that if the bulk of the world went under lockdown, that had to be far worse for stocks than Trump tariffs, so we should fall below that level. Live and learn, right?
The current narrative that has been sticking is money printing and inflation. Everything is compared to the Fed’s balance sheet. Why did stocks turn higher AFTER the failures of Silvergate, Silicon Valley Bank, And Signature Bank? Why continue even higher after Credit Suisse fell? The most common narrative I see is that the Fed balance sheet went up. It doesn’t matter that the balance sheet was rising as record numbers of US regional banks were pulling money from the Fed discount window and their new lending mechanism, or that record amounts of US dollar swaps are being pulled by foreign central banks to backstop their banking sectors, the narrative simply says as the Fed’s balance sheet rises, so do stocks.
There are number of problems I have with this narrative. First of all, it doesn’t match the charts.
Second, the money printing narrative is all about excessive liquidity, so why would the stock market stay strong despite the large number of banks scrambling for liquidity to shore up their balance sheet losses from the recent record rate hikes?
Third, the federal reserve is not allowed to give away money like the US Treasury – they are only allowed to offer “reserves” for assets. When they take illiquid assets and offer more liquid bank reserves, it does increase liquidity. When they take highly liquid assets such as short-dated treasury bills and swap for slightly less liquid bank reserves, it does not increase liquidity.
So what does move markets? I’ll start by re-posting a chart from 2 weeks ago:
A few things I distinctly remember during that time were discussions on the Motley Fool boards about a “mutual fund puking” as money was being removed from stock funds and put into money markets or bond funds. I also remember a man at my work who had moved his 401k entirely to bonds and was determined to leave it there because stocks were just too risky.
Unfortunately, data on 401k allocations over time is extremely difficult to come by. Statistica has some charts that look like they might be helpful for $39/month, but that’s too high for me. The closest I came to a helpful chart was this one from the good old reliable FRED database:
So my final answer to what makes stock markets turn? Money flows. There are several different sources of money going into the US stock market. Here are a number of them:
Stock buybacks, are more prevalent in expansions. It just doesn’t look good to lay off a lot of people and then announce large share buybacks.
401k flows just routinely go in with payrolls. Every paycheck, regardless of any other considerations, money flows into 401ks and is allocated between stocks and bonds. The preferred allocation can change over time, and higher rates encourage higher allocation to bonds.
Foreign captial flows tend to rise when trade deficits are high, and trade surplus countries invest their excess dollars.
Foreign investment flows tend to rise when interest rate differentials are high, especially after accounting for currency hedges.
Actively managed funds are a relatively small portion of fund flows, but they can shift between maximum short positions and maximum long positions. This is the only portion of fund flows which directly act on fundamental data, and they are often overwhelmed by the other flows when they anticipate a drop that doesn’t happen. If these guys are near max short after news of a bank collapse hits, then there is simply no one left to sell and stocks can move sharply higher.
Any significant market crash, like the one in March 2020, happens when there is forced selling, typically due to margin calls. Once that force stops, the market has a reflexive rebound as many funds are left under-allocated and margin debts go back to a rising trend. I like looking at charts of margin data like you can find here, but there is no data point past January 2023 so I won’t bother posting it: https://ycharts.com/indicators/finra_margin_debt
That’s all for now – I’ll be keeping my eyes on that unemployment rate before I put significant money into more hedges like short-term market puts or TLT calls.
I actually did some trading last week, as I sold covered calls on a number of my precious metals mining stocks last Monday – focusing on a 6-9 month timeframe and strikes that are significantly out of the money. I still think these things are significantly undervalued, so I’m reluctant to sell them too cheaply. As for Uranium stocks, they went down a lot this week so I added more cheap Jan 2025 calls in DNN. This one has a fairly small market cap, an active options market, and a decent chance at a significant spike in coming years. It’s good to have at least one chance at an outsized win.