Disinflation and Soft Landing, "this time is different"
I share this article as a joke in my previous post titled "Soft Landing in the cards?"
I received questions from so many traders if I have turned bullish. And then it occurs to me that they did not even read the post. Well, we are in the era of fast-paced information, and the title is all that matters. Ain't no one got time to read!
Let's start off with some macro data.
There have been a lot of discussions about if Federal tightening will lead to a recession. Bulls often argue that rising rates do not necessarily mean a recession occurs. This is true. There were 4 times in history when the US did not enter recession even though there was a Fed hike. Bulls love to wave this flag like Christopher Columbus claiming new land. Herein lies a critical oversight. During those 4 periods, inflation was well managed.
The last rate hike was in 2015. The market stalled for a year and then continue to rally til 2020. During that period, CPI was well below 3.00%
S&P500 vs CPI (YoY)
What about periods where Fed tightening is taking place when inflation was sky high?
Yup. When Fed tightens to fight sky-high inflation, it ALWAYS triggers a recession to bring back the inflation down to the Fed's mandate level (2.0%)
The interesting thing is, each and every time, the Fed Chairman is always confident of a soft landing.
Back in Feb 2007, Bernanke declared victory as inflation was coming down and unemployment was low.
CPI vs Unemployment
CPI and unemployment spiked almost right after the soft landing was declared.
The fight against inflation in the 1970s is no stranger to anyone, much less to Fed Presidents. Paul Volker raises the FFR to 20% (!!) in order to tame inflation. This is not new to Fed Chairman like Benerke or Powell. Yet, it is very surprising to see how each chairman who faces the same scenario thinks they can achieve a soft landing. They always claim... this time it is different.
CPI vs Fed Fund Rate
Back to 2007 Berneke's example. Yes, it is the housing crisis that led to the market crash in 2008-2009. The housing bubble eventually pops in 2008, however, it was the Fed cutting rates too early that contributed to home pricing escalating to sky-high levels. In the latest FOMC, Powell showed more confidence in soft landing and mentioned the word "disinflation" 20 times. Since then, we have had the following economic data
MoM CPI was revised higher for Dec 2022 from negative 0.1% to positive 0.1%
Jan 2023's MoM CPI went back up by 0.5%
YoY PPI went was 6% compared to the consensus of 5.4%
MOM PPI went up by 0.7% instead of the consensus 0.4%
Unemployment went down to 3.4%, the lowest since 1969 (low unemployment equates to higher consumer spending equates to higher inflation )
MoM Retail sales went up 3% instead of the consensus 1.8%
Perhaps we are doomed to follow Berneke's path.
Why is the market rallying then?
If we look at the market on a larger time scale, it has been sideways for about 9 months. In the past 3 months (Nov 2022 to current), the sideway range is much tighter.
There was an attempt to break out of this huge range in Feb 2023 but it was shot down repeatedly. Note that the market has been sideways since FOMC where Jerome Powell gave the market green light to rally.
It is a common misconception for traders to look at macro data and expect stock market prices to follow immediately. We do see huge price volatility when data such as CPI or NFP are released but those are the work of algo and volatility traders. Price action can often remain irrational for a long period of time. This is because there are much more mechanisms in the stock market at play here. Short Squeeze and Gamma squeeze from the options market have a huge material impact on stocks.
Companies on the brink of bankruptcy like Carvana and Bed Bath Beyond rallied more than 300%. These companies are also one of the most shorted companies. Those that rallied the highest in 2023 were companies that were hammered the most in 2022.
And then we have Tesla.
213 million Tesla shares were traded on Friday. However, there were 4.9 million contracts were traded on the options market. This is equivalent to 490 million nominal Tesla shares traded on the derivatives market, more than twice the actual shares on the stock market! Most of the options contracts are short-dated, thus the buyers of these contracts are not committed for the long run.
This can often lead to stock prices remaining high for an irrationally long period. Impatient bears get repeatedly slaughtered by sudden up moves trying to pick the top, while the clueless bulls get sucked into the trap.
It breaks my heart to use cliche advice but, it must be done. The market can remain irrational longer than you can remain solvent.
What can we do as traders during these irrational and contradictory periods?
A good question. If we are short, we risk the squeeze to the upside. If we long, we may get trapped at the top. A catch-22. The solution is, why not both?
You can play both long AND short positions on carefully selected stocks. This strategy is called a Long/Short equity strategy. The purpose of having both long and short is to remain beta-neutral, while still profiting from the asymmetrical nature of our trades.
Sneak peek of slides from our course.
Sneak peek of slides from our course.
For example, even though we have a bearish view on the overall market, we entered Palantir in early Jan at 6.40 and took a profit at 8.3, for a 30% gain.
During this same period, we entered Netflix shorts and lost money on it.
If you study these two trades, you will notice
1) We gained 30% on PLTR profit but lost 15% on NFLX. This is a net gain of 15%
2) If the market were to head in the other direction, the potential profit on NFLX will be 23%, and the potential loss on PLTR will be 15%. This is still a net gain of 8% This is our actual profit on these 2 trades. Since we use options, we can exploit the asymmetrical nature even more
So either way, we will have net profit regardless of market direction. This is how we can profit by playing both long and short.
Currently, we are holding 4 Bullish positions and 3 Bearish positions on specific counters. If the market continues to irrationally head up, we simply book profit on our longs. If the market finally heads down, we will add a more bearish position to our portfolio. We have already prepared quite a number in our short watchlist.
Technical Analysis can act as a gatekeeper to prevent us from taking bad trades.
Both S&P 500 and the Nasdaq are still holding on to their support, hence there is no reason to short the market. It will be much safer to wait for the support breakdown before shifting our portfolio to a more bearish bias.
Conlusion 1) There is a huge disconnect between the Macro/Bond and the stock market
2) Stock market rally is primarily due to mechanical reasons such as short covering and unprecedented activity in the derivative market.
3) My personal view is that the market will head lower eventually but there is no reason to fight the price action. 4) A long/Short portfolio with a neutral bias is best for situations like this. It allows for some profit while still providing the optionality to pivot in either direction. ------------------------------------------------- Consider joining our Patreon for Trade Ideas, Weekly Outlook, and navigating the current stock market. https://www.patreon.com/nimbuscapital
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