A Crash Post Mortem

I had to come to a realization this week- that I have been flat wrong on the markets over the past few months. As so often happens these things are clear in retrospect. But in light of what has happened over the past several weeks I think the least I can do is figure out where I went wrong and what to do moving forward.

Over the past several months I had been looking for a market crash. All the signs were there- excessive optimism, P/E ratios that were completely off the charts and speculation going on with call options that was driving many stocks to stratospheric levels. It turns out the call for the market crash wasn’t off. The market crash did occur, but the reason I didn’t capitalize on it had entirely to do with how we define “the market”.

What do we mean when we say “the market”?

First of all, let’s take a step back. Many, many years ago in the late 19th century, stock trading was a difficult business. Many of the things we take for granted today- instant real-time quotes on any stock or commodity, the ability to view charts of historic prices and volume, put to call ratio and thousands of other data points simply didn’t exist. Traders were limited to viewing a few quotes on a slowly-moving ticker tape that was very often delayed. Of course everyone had this working against them so it didn’t necessarily provide a huge disadvantage to the individual trader. But at the same time it was very difficult to figure out what the overall market of stocks was doing on any given day at least without extensive amounts of work. You would have had to record prices throughout the day or at least closing prices, then compile them into an average, and track that average over time, by hand.

But, some very smart people realized the utility of being able to surmise at any point what the market was doing and set about doing this by creating stock market averages, such as the Dow Jones Industrial Average and the S&P 500. Later came equal-weighted indices like the Value Line Geometric Index. At a time when compiling these was a massive headache, they did so and published them in newspapers. In those days, the averages did a pretty good job of tracking the market and looking at an average gave you a pretty good idea of what markets overall were doing.

Now, let’s fast forward to today. You have many multiples more of stocks and ETFs, ETNs, and funds operating in many different industries. It seems as if the market has outgrown the averages. Granted many new averages have been created, but still and all most traders these days focus on three- the S&P 500, the Dow Jones Industrial Average, and the Nasdaq-100. There’s good reason for this as these averages not so coincidentally track the largest stocks by price and/or market capitalization.

But if you were to look at a chart of the S&P 500 not knowing anything else about the current state of the market and what individual issues have done over the past year, you would probably laugh if someone told you that we are in the midst of a crash. At best a decent-sized correction. After all, it is hovering just above levels it was at last October and is down all of 1.29% in the past six months!

Our definition of the market must evolve to account for the fact that there is very little correlation in the moves between the average stock and the parts that experienced the blow off tops that I wrote about a month or two ago.

The mistake I and so many others made was assuming that these blow-off tops would have large ramifications on the entire market of stocks. But that largely hasn’t materialized. The stocks that never really went up leaps and bounds like NVDA, FB, or NFLX did last summer and fall, have come down but nearly in the devastating manner that those stocks have.

But if we define the market as the parts that have caused the greatest concern- the ARK innovation type stocks and those that went up 50-80% in a span of a couple of months last year, we have experienced a crash. Crashes, by the way, historically last about 6-10 weeks. More on that later.

So what happened?

There were two key events that led to the blow-off top and ensuing crash in select parts of the market.

First, there was an acceleration of call-buying in a basket of extremely speculative names. As the call-buying continued and these stocks rose, dealer hedging resulted in gamma squeezes that drove stocks like NVDA up from an October 4th low of $197.32 to a high of $333.76 just seven weeks later- an increase of 69%! NVDA certainly wasn’t alone- many other stocks such as FB, NFLX and even AAPL and MSFT to an extent experienced similar blow-offs.

The second factor was the fed formally announcing the tapering of asset purchases accompanied by growing inflation concerns. It is no coincidence that these stocks peaked right around that time. It became clear that liquidity was going to get pulled back in the near future, and however gradually that might happen, growthy speculative stuff was not going to perform well.

I actually called the blow-off top and fed effects with great precision. But where I fell short was equating this with the overall market which really didn’t participate to the same extent to the upside or downside.

Where do we go from here?

When you are trying to form a picture of what the current state of the market is and where it is likely to go, it is so important to pull back your focus and widen the lens and keep a reasonable perspective based on all factors. It is very easy when you get scary intraday drawdowns in the Nasdaq-100 of 300-400 points like we did Thursday and Friday this week to buy into bearish scenarios such as the impact of the Russia/Ukraine conflict or rising rates or forthcoming draconian Fed measures to yank back liquidity and extrapolate that into a further crash, which is what many have done.

Marty Zweig wrote about the three factors necessary for a bear market. They are extreme deflation, ultrahigh P/E ratios, and an inverted yield curve. Not all three need to be present, any one could trigger a bear market but without at least one a bear market is extremely unlikely.

Clearly we don’t have extreme deflation, rather we have high inflation. We did have ultrahigh P/E ratios and I would argue we still do in many areas including the averages. Last but most importantly because this is the big one- we do not have an inverted yield curve. For all the fed fear and talk about rising rates, we are nowhere close to an inverted curve. In fact the areas of the market that would actually cause a recession- commercial paper rates, for example are up all of 25 basis points in the past three months. This is not a surprise because the fed hasn’t lifted a finger yet! And yet active market participants are fixated on treasury yields which fluctuate on a daily basis to every headline.

One must realize that the market has actually done just fine in a rising rate environment so long as rates are starting from a low base, which clearly they are. It is problematic that P/E’s still seem elevated but again, rates are so low higher P/E’s are to be expected.

As I mentioned previously, market crashes tend to last between 6-10 weeks. If we say this market crash began in earnest last November, let’s say smack in the middle, we are about eight to nine weeks out from the beginning. Given all factors I strongly believe that the worst part of this crash has happened although it has happened on a rolling basis- first NFLX, then FB, and on and on, individual stocks have been crashing. I attribute this largely to hope propping these stocks up in a very weak market for them, then any bad news causing a wave of selling with little appetite to step in and buy. This has caused extraordinary downdrafts in these stocks. But I think it really has very little cause for concern as it relates to the economy or even many of these companies. FB, for example seems like a very good opportunity, even if it goes lower. Especially if it goes lower. I think it is highly likely the worst is over and the selling this week was just a retest down to the January lows.

While I think it’s certainly possible that we go lower maybe with a dramatic red opening early next week, a major bounce is likely followed by a rangy trade. I wouldn’t get super optimistic about an immediate resumption of the bull market, but calls for a crash from here for the overall market seem extremely mis-timed.

One last clue that we are near a bottom- it is a common characteristic of markets that haven’t bottomed to have gigantic counter-trend rallies. We aren’t seeing that at all. Instead I’m seeing lots of fear and crash calls for a market that simply isn’t demonstrating anything that concerning from a fundamental or technical level. We haven’t even taken out the lows of January. The worst crashes hit complacent markets and we clearly don’t have that. They also hit the worst phases at the tail end in a span of a few days at lower prices and much higher volume. Again, we’re not seeing that. Volume over the past two sessions was actually extremely low. Finally, to reiterate this point, there is not much correlation between the overall market which while down, is acting fine, and individual issues that don’t seem to be able to find a bottom. The market is crashing in phases.

I believe the market seems to just need a jolt of optimism to trigger buying again. Not sure exactly when that will happen but we aren’t far off.

Best ideas to play this: short VIX, long S&P equal-weight as I don’t necessarily believe an appetite for the speculative stuff is likely to return.

What a wild week

This week was extraordinarily volatile with massive intraday swings of hundreds of points in the Nasdaq-100 pretty much every day. There were cross-currents of a hawkish fed mixed with great earnings from Microsoft and Apple. Apple’s results last night which were nothing short of extraordinary plus some dovish talk from Neal Kashkari caused a major relief rally today in the market. It looks like it will close at the high of the day with the Nasdaq-100 closing up around 433 points, or 3.17%!

This won’t come as a surprise, but I’m going to pour cold water on this rally and say we aren’t a bottom yet. Not even close. I still feel like we are in the early innings of a major decline. The timing of these things is always hard to work out but I don’t expect it to go on too long, maybe another couple of weeks.

Here’s what I see. Right now, Apple, Amazon, Alphabet and Microsoft are basically the market. Together they comprise about 20% of the S&P. Amazon has been extremely weak of late, but the other three have held up remarkably well given the volatility in the rest of the market. However I don’t think the market will bottom until everything participates in the downside to a large extent and we get some mean reversion in the weighted indices. Such a small number of stocks comprising so much market capitalization poses a pretty large risk to the economy because most passive investors are heavily invested in the S&P so, by extension, are heavily weighted to those four stocks. If those four stocks were to drop significantly, lots of people would see drastically diminished 401k balances which would make them feel less wealthy, spend less and have a negative impact on the economy. This is the wealth effect in action, or as George Soros might describe it as a reflexive relationship where the market prices have a direct impact on the earnings of the companies they represent.

If we look at a one-year chart of Apple, Microsoft, or Alphabet we will see a pattern familiar to markets right before they crash. A long, consolidating period (summer of 2021) followed by a near-vertical rally of 20-30% over the course of three months or so (October-December of 2021), followed by a relatively benign “normal” correction (early January through the beginning of this week), followed by a sharp reversal up recouping about half the decline (the latter half of this week and possibly continuing into next week) followed by a massive quick drop, climaxing over the course of about 1-2 weeks (TBD).

To me sentiment is still very risk-on and there are many talking heads calling Monday’s drop capitulation. It’s certainly possible, you never really know. Still, it’s very hard for me to understand with the monetary policy outlook for the next year or so that at current valuations, stocks are a buy. I firmly believe that Apple has achieved its permanent all-time high. That’s a controversial statement given that they just reported blow-out numbers. But, show me a company that is still growing that was the leading company of its day ten, twenty, or thirty years ago. Companies go through evolutions and lifecycles just like people and when they are at their peak, the only way is down. I truly believe Apple has peaked but the fundamentals haven’t. This is how markets work. Stock prices tend to peak while the outlook is still extremely favorable and there isn’t a bear case to be had. If they dropped when it was obvious, everyone would make a lot of money. Or nobody would. It doesn’t matter whether you’re in a bull market or a bear market- once the fundamentals align with the price action, there’s a good chance most of the opportunity has already been wrung out. That’s certainly how Apple feels at the moment. I feel certain this stock will be lower a year from now.

It’s not the only one. Microsoft’s chart looks similar and it’s price action post-earnings should be troubling to the bulls. After reporting massive earnings growth it could barely stay over $300 and failed multiple times this week before finally closing over $300 today after a very shaky gain. There just isn’t much momentum there.

At the market level, as discussed ad nauseam here, 3-4% rallies in a downtrend are a bearish signal and today’s ramp up into the close actually makes me feel better about this call, not worse.

Finally, as also mentioned here multiple times, sentiment is not close to bottoming yet. We are at what feels like an early phase where people who think they’re clever are looking for signs of capitulation. Things like the 1100 point drop in the Dow on Monday or the bear-bull survey that showed the lowest reading since the Covid crash. But that’s not real capitulation. You can’t summarize true sentiment from a survey or some widely-disseminated numbers. You can’t gauge it from oversold conditions. You have to put in the work to get to know multiple people who follow the market and gauge their reactions to it. So far I sense no real fear and a continued reluctance to accept the facts as they’re presented. Complete denial. Not even allowing for the possibility this market will go lower. People look at a large, quick drop like we’ve experienced over the past 3-4 weeks and believe the worst is over.

Another sign the denial is strong: on Tuesday after Monday’s massive drop, a Bloomberg article made the rounds citing a JP Morgan analyst who attributed Monday’s selling to retail investors panicking. The implication being that it was “dumb retail money” that was selling and then “smart institutional money” that came into buy the dip, taking such great deals off of poor retail’s hands. This type of straw-man story is very comforting to the bulls and further enforces their ill-informed idea that they are the smartest people in the room and on the same side of the trade as this mysterious institutional smart money. Never mind that most institutions fail to match the S&P’s performance nearly every year.

Real capitulation happens when everyone is terrified- bulls and bears and for very good reasons. Nobody wants to touch stocks because of the absolute devastation they’ve created. The pattern never fails. People are arrogant and believe that they are above everyone else past and present. People who panic-sold in previous panics near the bottom were stupid and irrational. This gives them the belief that they can easily spot fear in others and every drop is a great opportunity. They never stop to ask themselves why they didn’t think to buy on previous bottoms whether they be in 2010, 2018, or 2020. They get drawn in in the 8th inning of a bull run and then continue to buy as the market starts into a tailspin. What people fail to understand is that it is never apparent when a bear market is starting because the fundamentals haven’t emerged yet. People are simply taking risk off before the economy turns down. By the time the evidence is there, it’s too late. These people provide the opportunity in sell-offs.

As an aside, it brings me no joy to continue on and on about a bear market or crash. I’m not a doomsdayer normally and I consider myself an optimist. But a person who can’t accept facts as they are presented is doomed to fail in this business. If true capitulation were to be reached by my own measures, I would definitely switch to being a bull, but I just can’t in this market environment.

When the facts change...

So clearly I was wrong on my bottom call last week. I had reasoned that a drop would need to begin more gradually before getting into the crash/extreme correction phase. But once the markets crossed a certain point on Friday and then this morning, that analysis went out the window.

Fortunately the market staged one hell of a reversal into the close today and ended green after being down more than 700 points on the Nasdaq-100 and I used the opportunity to sell the SPY calls I bought on Thursday somehow only down about 25% despite the S&P being about 100 points lower. I don’t think we’ve touched bottom here. What a difference a few days makes.

Here’s why I think we have more pain in this selloff. If you look at previous crashes/deep corrections, a familiar pattern emerges. Volume picks up to ridiculous levels as selling accelerates, sentiment gets flushed, and the market way overshoots to the downside.

Volume today was enormous, as was it on Friday. But something about sentiment today makes me think we have further to go in this selloff. We are at the phase where people are joking and many are talking about capitulation and buyable dips. Markets don’t bottom when people recognize capitulation and say it’s time to buy. People spot what they think is capitulation, the market rallies, then drops much more as real capitulation occurs, chaos emerges and rumors start to circulate about margin calls and insolvency. Then panic sets in and you find a bottom. We aren’t there yet. Though deep and fast as this drop has been, it doesn’t seem to have created any real fear. There’s still tons of dip-buying.

Let’s look at the case of the 1929 market crash. On Monday, October 21st, the market dropped on near-record volume then staged a bit of a comeback towards the end of the day and the market rallied on Tuesday, accompanied by reassurances that all was well from some well-respected commentators. But then on Wednesday the selling returned and things got much worse from there.

I don’t think this is 1929. I don’t even think it’s anything more than a price and sentiment correction similar to 1962 given that there’s no damage in credit markets or economic warnings. But stocks like Tesla and Nvidia that had astronomical rises towards the end of the year need to come down more in my opinion. There still hasn’t been lasting damage to sentiment. If anything if we bottomed here it would only make people more bullish. I’d like to see a flush in a stock like Tesla of 50% or so. Sounds dramatic I know but so far we’ve only undone about three months worth of gains. Consider that Nvidia in October was around $200. Even after this correction it’s up 15% from those levels. We need to undo more like a year or two of gains, which for the QQQ’s would take us down to 240 or so. Nvidia to $120 or so.

I expect a decent market tomorrow as we await the Fed and some large earnings reports but I don’t think either can do anything other than pause the selling and if we get a rally tomorrow and the VIX drops I’d be willing to go for some short-dated very OTM puts on the QQQ’s again. I believe we are close to a bottom in time, as I think we would get this dramatic selloff sometime early next week, but I think we aren’t close in price. I’m looking for chaos, real fear and a massive overshoot to the downside before I’d be looking for a lasting reversal. People always underestimate how much damage can be done. I think there will come a point where a great buying opportunity will come but we haven’t reached it yet.

Going out on a limb

I very rarely do this and I’m certain I’ll regret it, but I’m going to go out on a limb and call a tactical bottom today. To be clear, I am not saying this is the bottom. Far from it. But my call for the past couple of weeks has been for what I’ve dubbed a “faux correction.”

What I mean by faux correction is an interim correction that people later think was the correction which allows them to get bulled up again when stocks start rallying and actually sustain it over a period of several weeks allowing them to get trapped for the real bear market, the assumption being that with the correction being so close in the rear view mirror, no way we will go back down again and that the fed news and such has been more than discounted.

There are a few reasons I’m calling this the bottom in the faux correction.

• The S&P hit my faux correction target level of 4470 today
• Sentiment seemed to hit a real short-term flush today, especially on the back of the Peloton news
• Earnings are starting and I suspect there will be a rush of money back into the market to position for them
• Even though the absolute level of the selloff didn’t seem like capitulation, peak to trough the NQ dropped more than 500 points!

Consequently I bought a handful of 5% OTM SPY calls towards the close. I think we could get a strong rally maybe tomorrow or early next week. I’d expect that rally to be both enormous and not believed (the hallmarks of a strong interim rally) and I’d look to pitch these after a day or two.

I believe the S&P could carry itself back up towards an ATH but stop just shy of it, maybe 2-3% below. I’m calling for a ~5% rally back, but not the vertical sort we got in December, more like a strong 2% pop (at which point I’d pitch my calls) then a more gradual ascent over the course of a few weeks which would peter out. It would really help sentiment get offsides if we get some strong earnings beats along the way. I think this would be necessary actually to get sentiment positioned very long stocks just in time for the real correction.

No, this is not the late 90's.

Lately I’ve seen so many comparisons of the current environment to the late 90’s and other cycles where the market rose in a higher rate environment and even after multiple rate hikes. The implication being that we are in something similar to 1997 or so right now and the market should rise another three years at least because we are just now talking about the Fed raising rates. I believe these comparisons to be ill-informed and I’ll explain why.

The late 90’s was a bona fide bubble. The focus of the market in those days was on this new emerging thing called the internet and all of its potential. Any person that could fog a mirror could take a company public and see its value ascend many multiples overnight. That boat lifted great companies with tons of potential right alongside crap that had no chance of ever making any money, as all bubbles do. Rates were totally in the background. All anyone was focused on was internet, software and hardware companies. So when Greenspan began talking about irrational exuberance and needing to curb it, it was like someone asking you to turn the music down at a party. But the focus is on the music.

In the current market environment there are surely some tiny pockets that look like bubbles- EV’s, crytpocurrencies, the meta verse to an extent. But that’s not the real story. In the current market environment the Fed is the story. Low rates are the story. They are the entire focus of the market. It’s all anyone who follows the market talks about. For the past two years the unfailing bull item has been low rates, low rates, low rates. Free money for all.

It’s curious to me then, that now that the Fed is talking about reducing liquidity and raising rates that people still think that this should have no effect on market psychology. If continued zero rates is bullish, then why is a departure from that not bearish? In other words, if you are bullish on stocks for more than a year with no real change to interest rates or the liquidity story, then why when a change to that story comes, why doesn’t the bull case change?

I believe that because low rates and continued liquidity injections are the reason for the market’s ascent over the past two years that when that story begins to change the character of the market will change. There is no real diversion to make rates a sideshow. We don’t have a new industry enriching millions of people and raising GDP. It’s all based on helicopter money.

The Crash Isn't Here. Yet.

The main reasons are:

1. Sentiment is extremely bearish
2. The move is not yet confirmed in high yield credit, equal weighted indices, the S&P or the DJIA. The only index in a (slight) downtrend is the Nasdaq 100, which I think will probably revert back onto a buy before the rest go to a sell

Why the sudden change after so much bearish rhetoric over the past several weeks/months?

Aside from the previous two points, the current setup to me seems very similar to the lead in to the 1962 crash. So, I’m still very bearish just not tactically at the current moment. I don’t think there’s a ton of upside, either.

In 1961, the market ran way up into the end of the year with a massive rally into the very end of the year. After that, the market began to drop in January of 1962. But it didn’t immediately crash. Instead it dropped for all of January, pretty substantially, but then had a decent pop throughout February and March before finally caving in in the spring.

In thinking about that entire move, it strikes me that a similar type of market could get people wildly offsides in the current market. In other words, the max pain trade.

So what I’m looking for is a decent drop over the next few weeks that could take the S&P down to around 4490 or so making sentiment extremely cautious. I think the market could then reverse back up and have a nice, sustained rally for as much as two months, restoring calm and I would expect the VIX to come back comfortably below 15. At that point the market could reverse back lower and then the real drop begin. Convinced the prior drop was the correction, this next drop would be viewed as a buying opportunity.

This is weirdly specific, but it’s actually describing a head and shoulders pattern on the S&P, which is what happened in 1962. Whatever the case, I see a pretty weak market and I’m not really making any moves at this point until I get a better read.

I just think there are too many expecting a massive drop without a whole lot of confirmation from the market. I too believe a big drop is coming, but the timing isn’t right for it, yet.

This indeed looks like a blow-off top.

It appears increasingly likely that from early October through the beginning to end of November (depending on which chart you look at) Tesla, Apple, Bitcoin, AMD, and Nvidia (and I’m sure several other high-risk names) put in blow-off tops. The rally that we saw from last Tuesday through this past Monday is now looking like a textbook bear-market rally.

Each of these stocks viewed as a microcosm look very similar to the markets of 1929, 1987, and 2000 right before they crashed. Even though I’ve been bearish on the indices I do believe that if these names collapse over the coming weeks it will almost certainly take the rest of the market down with it, given the concentration of cash in these names.

The market has been very top-heavy. I’ve been asking myself for over a year, what will finally put a bullet in the risk appetite that people have currently, and I am starting to think a collapse in these extremely speculative names could be just the recipe.

If history is any guide, by the way, I would expect the heavy selling to come over the next few weeks. In 1929, the crash phase lasted eight weeks. In 1987 it was about seven. 2000 was longer but the market was also much more elevated than it is now. I would expect all of these names to come down anywhere from 30-50% if a collapse occurs which I wouldn’t rule out.

Why am I acting so sure about a seemingly improbable event? Because of the nature of blow-off tops and the resulting collapse that almost always occurs. Also we are at the full on delusion phase of the Tesla bubble. The narrative from that camp has gone from hopeful to wildly insane. We need this correction to restore common sense and order to these markets though it will cost a lot of people massive gains.

From a price standpoint, a bull would have hoped for yesterday’s pause to resume to the upside but a premarket bid for all of these names quickly collapsed and now they are all pretty solidly red. The risk reward to shorting these right now is as good as I have seen it maybe ever.

Volmageddon Part II?

In the lead-up to the Volmageddon episode that took place on February 5th, 2018, there was a can’t-miss trade.

Let’s take a step back and rewind to the beginning of that lead-up.

In November of 2016, Donald Trump was elected President of the United States. This caught most everyone off-guard and the market was no exception. People didn’t know what to expect, but there was a real sense of worry about the future of the country. The market responded by going limit-down and several op-eds were published about how the market would crash and America was doomed.

But then something unexpected happened. The market reversed and one of the great bull runs of the modern era took hold. I don’t want to make this political but the reality is that most traders lean right politically due to the tax implications and free market ideals that Republicans (whether deserved or not) are known for. So there was this sort of tug of war going on between the left who were convinced that Trump was bad for America and by extension, the markets, and traders who were rightly convinced that he was great for the markets. If they could shove that in the liberals’ faces by making money off how wrong they were, all the better.

It was from this derision that the short vol trade was born. In the aftermath of the election and in the ensuing bull run, the VIX dropped to a historically low level and hovered down near 11 for months and people quickly embraced the Trump stock market and came piling into risky assets. Capitalizing on this, traders began shorting volatility, most notably through the UVXY. The other popular vehicles were shorting VXX and going long XIV, the inverse VIX ETN (which ended up largely causing Volmageddon).

Throughout 2017 this trade made many people very wealthy and more and more people began to pile into the short VIX trade.

But then one day in early February 2018, the impossible happened and all of those clever traders got their asses blown out by Mr. Market, as must always happen when any contingent gets too arrogant.

I live by a few maxims when it comes to the market and one is that nobody, and by that I mean nobody is infallible. Despite common lore, there is not a single man, woman, or child who is not acting on inside information who will stay on the right side of a trade in perpetuity or even the majority of the time. This is well documented throughout history, and yet people still believe in these mysterious market participants who have their fingers on the pulse of the market and never lose.

In the lead-up to Volmageddon there was a palpable arrogance among those who had been riding that trade and they were fully convinced of their genius. And for many months they were absolutely correct on the trade. But they got greedy and eventually blew out. Same old story. As it turns out bubbles crop up in lots of places, not just long stocks or real estate. You just have to recognize the signs.

I believe that we are at a similar point now in the market. But this time, instead of capitalizing on a perpetually low VIX by shorting VIX futures, they are capitalizing on a perpetually elevated VIX by shorting put options, namely the SPY and QQQ and a few high fliers like Tesla.

You see over the past year a similar trade has emerged where a contingent of market participants have convinced themselves of their own greatness and believe they have a sure-fire read on the market and that due to reflexivity the market will never go down due to all of the put buying. And for months and months the put buyers have been consistently shown to be on the wrong side of the trade. But as we should know by now, that can only go on for so long. Selling downside put protection is this cycle’s can’t miss trade and anyone buying downside put protection is viewed as a sucker and those selling it think they are Jesse Livermore Tudor Jones Icahn. This trade is getting long in the tooth and the put sellers are reaching a fever pitch of arrogance. Given the recent volatility and a sort of tipping point in arrogance towards this trade, I wonder if we aren’t in store for a similar blow-out.

Bear Market Rallies

They are of a different character than typical bull market rallies and have these traits in common:

• Gigantic in magnitude
• Late-cycle, early in a downtrend
• Extremely elevated sentiment (chest-pounding from bulls totally convinced we aren’t going lower- as an aside this is also true during bull markets, so it’s important to consider the other factors as well, but in a bear market rally the sentiment is of a different nature because it's born from an initial sense of fear and so it has a major "phew/relief/euphoric" flavor to it like you might feel after you survived your first skydive, except in this case you don't realize you haven't touched ground yet)

The rally we saw this week from Tuesday through Thursday that took the Nasdaq-100 up more than 5% is more evidence of a bear market than not. Yes, that’s right. Not buying this rally either. People often cite the 9-1 or double 8-2 up days as bullish indicators but I believe these only have relevance if you are in a solid uptrend in all indices and preferably early cycle with depressed sentiment. At the current stage of the cycle I believe they carry much less weight.

Bear market rallies occur because when bull markets end there is always a period of great uncertainty. Bears are unsure if it will culminate in a major slide while bulls hope it’s just a buyable dip. So there are these pockets of calm as the selling unfolds where a contingent of those bulls who didn’t see a sell-off coming and got trapped in the first one or two and hoped for a resumption of the bull market is now convinced it’s yet another buying opportunity. Then the selling stops for a day or two or three, and in this pocket of calm like the eye of a hurricane passing over, the bulls rush back in and drive prices up almost vertically.

The trapped bulls now have no impulse to get out and miss the continuation of the bull market and this massive rally only further reinforces the bulls’ bias towards the market. This is evidenced from the resurgence in bullish rhetoric and football spiking on the bears. Then a day or two later the selling inexplicably continues and the bulls get battered again. Rinse and repeat.

Eventually the bottom falls out and the market collapses and real fear, not the horse shit sentiment readings like the NAAIM and CNN Fear and Greed Index takes hold and nobody wants to touch risky assets. Then you may be closer to a bottom. We ain’t there yet. Not even close. There are just way too many permabulls convinced of their genius at this stage for me to buy it.

This market is very mixed despite all of the bullish rhetoric. Breadth has not returned and now money is extremely concentrated in a small basket of stocks which just happens to be what the S&P tracks and the S&P is what everyone follows so it has everyone masked from the extreme volatility happening beneath the surface.

Actually, that’s a bit disingenuous. There’s been a lot of commentary noting that underlying volatility, but most view it as bullish rather than worrisome because they think that the selling in those high beta stocks has likely bottomed and now everything will resume the uptrend. If the megacaps give way the entire market is going to come down and in a terrifying way. I don’t think anyone is really considering the amount of risk present right now given how heavily concentrated the average person’s wealth is in a few extremely expensive risk assets. I think we need a reminder that as iron-clad as Apple and Microsoft seem to be, they are risky assets. And despite the consensus view that they are cheap, they are not.

Let’s not overcomplicate this. My read on the market hasn’t changed. The recent weakness is all about the Fed. The market weakened significantly after the November FOMC and has not recovered. It got even weaker after the December meeting where a doubling of the taper was announced with rate hikes coming as soon as March. Every other narrative is a sideshow and while it’s possible we can regain some upside in the interim, I expect selling to resume soon. The constant spikes in price are a necessary ingredient of any lasting sell off.

Every market cycle is different and in this cycle I truly believe you need a resilient market during the slide to keep people in. In a way, if the market just sold off 20% it would be too easy because it would make everyone bearish at once and nobody would get drawn back in during the drop.

It seems easy to say that every dip over the past few years was a great buying opportunity. But the reality is that in Febrary of 2018, a 10% slide was enough to terrify people out of stocks. In December of 2018 it took a 20% drop over a few months. There is no such reluctance to buy risk assets currently so we know it’s going to take more than what we’ve seen to this point. The idea that we have a bottom because of what’s happened to the ARKK stocks is laughable. Yes, there is real fear in everyone else. You escaped unscathed, sir. As I like to point out regularly, real fear is achieved when everyone is terrified, bulls and bears, and for completely legitimate reasons.

The question you should always ask yourself if you’re trying to call a market top is, what is going to make people shun risk assets enough to miss out on the next bull market? When trying to spot a bottom you have to look for a complete reluctance to trust stocks or risk assets of any kind. You yourself as the oh so wise bear should feel some palpable nervousness too. No, you aren’t immune or better than anyone else and you too will probably be afraid to buy when an actual bottom is in. Best to just accept that reality. Cash goes from being trash to being the most valuable asset.

Narrative Shifts

One of the most remarkable things I’ve witnessed in some time is the shift in narrative that has occurred over the past month, although I’m not sure why I should be surprised.

Yesterday at 2:00pm the hugely-anticipated FOMC decision was released, followed by a press conference.

Now, to paint the full picture, let’s rewind to early November to the last FOMC meeting. At that meeting, the plan to begin tapering asset purchases was first announced. This was after growing pressure from economists and even increasingly market watchers who in the past had criticized any hawkish fed moves. The inflation numbers were too great and the idea of the fed continuing to pump billions of dollars a month into a red-hot economy was too much to ignore. The Fed up to that meeting had been as unambiguously doveish as any Fed in history.

In response to that announcement, small caps began to sell off and the VALUG officially hit a 4% week over week downtrend. Then on Thanksgiving night, news of the COVID Omicron variant hit and the market sold off hard. Even after it became apparent that the economy was not going to shut down again and that the Omnicron might actually be positive since it could be more transmissible but less deadly than the standard or Delta variants, the market continued down. This made it pretty apparent to me that the market weakness was mostly due to the November FOMC decision and the Omicron was just another weight added to the barbell for an already weak market.

Then in the days ahead of yesterday’s FOMC, reports began to circulate that the Fed might actually double its tapering rate and start rate hikes sooner, possibly as early as March (just a few months ago it was debated whether they would raise them at all in 2022 but that even if they did it was almost certainly not going to happen before Fall). A double-whammy for stocks, right?

Well…

With these rumors circulating of a more hawkish fed, selling indeed began to accelerate ahead of yesterday’s FOMC. But in the days leading up to the meeting, I began to read lots of commentary and opinions from clever market watchers who believed that with so much selling, the market had likely priced in any tapering and that the risk on decision day was actually to the upside.

Well, yesterday morning the market was pretty red and at 2:00pm Eastern when the minutes were released and the Fed did what the commentators had anticipated and formally announced a doubling of the rate of tapering and predicting three rate hikes the market initially began to sell off a bit and rates across the curve spiked higher. But the markets quickly reversed course and then stocks essentially went vertical into the close with the Nasdaq-100 staging a 500 point reversal!

As of now, it would seem to most that the permabulls have won another decisive battle.

But… (there’s always a but)

I came across the following article written in March of 2000 in the early stages of the dot-com bust: Wall St.: what rate hike?

I find the parallels between that article and the present environment interesting. Even though in March of 2000 the Fed was already in the midst of a tightening cycle and rates were much higher than they are now and that hike resulted in an inverted yield curve, I think the situations are similar in many ways.

When Greenspan announced that hike, the market rallied over 2% on the back of that news and as demonstrated in that CNN article, the narrative shifted to paint the rate hike as a positive and explaining the initial market reaction due to the hike being “priced-in.”

That move higher also demonstrated the thrust of bear market rallies. You see, bear market rallies fool everyone, bulls and bears, and that’s because they create the reality (yes, the reality, not the illusion), that the bull market is back on. It has to. Contrary to popular belief, market participants aren’t stupid or irrational. They won’t simply buy into a resurrection of the bull market if it’s not convincing. Bears won’t abandon their bearish theses and cover shorts if the rallies don’t seem to be extraordinarily powerful.

There are a few reasons I’m not buying yesterday’s rally, though:

1. There is simply no way the Fed doubling the pace of tapering and now planning three rate hikes in 2022, with the first coming as early as March is bullish.
2. Markets that rally 2% in the midst of a downtrend near ATH’s are more likely in a bear market than not.
3. To that point, we are still in a downtrend.
4. There has been very little damage to sentiment still.

What I find really interesting amidst this chaos though is how opinions change. Just a couple of months ago, even tapering was highly in question. Now with an accelerated taper and three hikes being announced, the market commentators are heralding this as bullish. It’s amazing what a combination of a bullish bias, long positions, and a couple hour’s worth of supportive price action can do to people’s sentiment. People are now totally convinced a hawkish fed is bullish and are calling for a Santa Claus rally into year end! I have to admit I never saw this coming.

I expect heavy selling to return soon, as early as today.

Risk is Rising

As I write this, the market is in the midst of a massive two-day rally. This seems to have emboldened the bulls even further and I would categorize this morning’s sentiment as full-on euphoria.

As I stated in my last post, in 1987, prior to the market’s October dive, it actually staged an enormous rally, which took it up almost 6% before beginning its nosedive. I continue to believe that there is a real chance that we are going to have extreme volatility in the coming few weeks.

As I’ve written about many times, you don’t typically see 600 point Dow and 280 point Nasdaq 100 rallies in healthy markets when sentiment is this elevated. It elevates sentiment to extreme levels and depletes cash levels even further in an already unhealthy market. Paradoxically, if I were a bull, I’d prefer to see less dip-buying and more chop. Instead, today’s rally seems to have attracted all of the bulls back with more confidence than ever, like moths to a flame. It’s safe to say that sentiment has sustained no damage since this correction began.

Most notably of all, all of the major indices and Value Line Geometric Index are still in downtrends. I still believe the risk of a market event soon is massive and today’s rally has actually done more to confirm it than detract.

In closing, just gonna drop this here: https://www.nytimes.com/1987/10/02/business/dow-soars-as-new-quarter-begins.html

Market Update

The QQQ made it’s last high on September 7th at a closing price of $382.11. Since then, it’s broken trend badly and although the selling to this point has been measured, I believe that it is likely to accelerate to the downside significantly before any bottom is going to be reached. The pattern of the QQQ’s over the past six months is particularly interesting to me because it is very similar to the lead-up to prior crashes.

In the May-June timeframe, the market had a smallish correction of around 8% that lasted a few weeks before entering what looked a lot like a blow-off top into early September. This is remarkably similar to the mega caps in 1987, when the DJIA topped on August 25th before beginning what looked like a benign correction before accelerating into the crash.

Here’s what’s interesting. In 1987, between August 25th and early October, the selling was relatively benign (the DJIA dropped about 8% between the August high and mid-September). Right before the crash, however, there was a massive rally that took the index back up to recoup roughly half of what it lost. To bulls hoping to spot a bottom that must have been a terrible trap! It wasn’t until days before the crash that the selling really accelerated. I’ve been turning this over in my mind for a few days now, and I now believe that if we get some extreme volatility and some sort of crash or deep correction, it’s likely to cap off a relatively benign correction like the one we are experiencing now.

Right at this moment I believe we are at a very precarious moment for the market and despite there being quite a bit of bearish commentary, few people are taking it seriously. I see a lot of complacency, dip-buying and perhaps most telling- people mocking those who are buying protection in the form of puts. That is, people continue to cite the put to call ratio as a given contrarian sentiment indicator but never stop to consider whether puts might actually not be a terrible buy. In short, people have completely disregarded the risk of a massive selloff. And that could be where the opportunity lies.

I believe that there is a very good chance that volatility is going to pick up dramatically in the next 2-3 weeks. This makes sense to me for two reasons. The first is that the past couple of weeks of gradual declines mixed with sharp recoveries keeps bulls from getting scared out of their positions and continually hoping for the bull market to resume. I still believe most bulls think we are in a “chop-fest” that will eventually resolve much higher into year-end. I think that the price action of recent weeks has been slow enough with enough upward rallies to provide hope that a sudden turn down would catch bulls completely offsides. Bulls also seem to be convinced that sentiment is overly bearish, citing things like the CNN Fear and Greed index and put-to-call ratios. I find this comical given where the market is currently. As an aside, I believe the CNN Fear and Greed index is the most overrated tool in existence, and even if it gave a meaningful reading, the mere fact that it is so widely observed would make it lose all relevance anyway.

The second reason is that historically, crashes have been pretty short-lived, lasting between 6-8 weeks from the top to the most violent bottom of the crash. In 1929 the top to the absolute bottom was ten weeks, but that includes two weeks where the market rallied strongly before falling to a new interim bottom. The crash phase really ended after about eight weeks. In 1987 it was about seven weeks. In 1962 it was about six weeks, depending on when you start the clock for the beginning of the crash (the market had been somewhat weak for several weeks ahead of the crash phase). Since the QQQ’s topped on September 7th, we are just shy of five weeks removed from the top. If (and it’s a big if), the market continues to weaken and eventually crash, history suggests that it would do so fairly suddenly in another 2-3 weeks. Granted this may be looking at the market too much like a train that I’m expecting to arrive at the same time as it did before, but you have to have some basis for your market view and given all the factors, this seems like a fairly decent setup for a sharp move down.

As for bears, I believe this could be painful as well. After all, bears have been waiting months and months for a massive sell-off and have gotten ripped apart in the process. At this point it seems completely reasonable that bears would want to wait for some heavy selling or bearish rhetoric from the fed to get aggressive. The problem is that as we all know, markets rarely give you a high sign when it’s a good time to get short. A sudden drop would catch a lot of bears off sides too, not giving them the chance to profit greatly from the crash that they’d been waiting for for so long.

As Michael Steinhardt once said- “to make money you’ve got to be willing to get in the way of danger.” I believe to profit from such a market event you’d have to cast your line now, while IV’s are relatively low and before the market makes a decisive move lower. By then put option prices will be prohibitively expensive and dangerous to trade.

Gauging Sentiment

There are two types of bulls. The first is the permabull. Permabulls are people who were drawn in at some point in the bull market. Most permabulls get drawn in very close to the end of a bull market. But the point is that sentiment-wise, permabulls are, well, always bullish. Because when you get drawn into a bull market and start making money, something funny happens. You can’t go back to being indifferent, let alone bearish. You’re a complete convert. Every piece of information is interpreted as a bull item and every dip is a buying opportunity. Upside price targets become more and more aggressive. And why not?

Palantir at $25? Why so conservative?! Why not $50 or $100 or $150? Did you see what every other growth stock did for the past year?! Sea Limited went up 10x!

And the thing is, this method works for a long time. It has to. If it didn’t, sentiment would never rise off of its lows. These are not the people you want to gauge for bullish sentiment because they’re always bullish.

There are those who believe that when too many permabulls show up and are making large sums of money by speculating that they are undeserving and stupid and will give it back. They try to time this and based on various pieces of anecdotal evidence decide to short the market. They usually get carried out in a casket.

This brings me to the second type of bull. That is the reluctant bull. A reluctant bull is someone who remained bearish for most of the rise, thinking the end was nigh because too much dumb money was sloshing around and speculation was rampant in assets that made absolutely no sense and people totally undeserving were making too much money. But the market stubbornly went higher and higher, the dumb money inexplicably being rewarded after blindly buying on every dip.

I do due diligence and have fancy degrees and know all sorts of technical indicators and valuation metrics! This type of rampant speculation is unprecedented! Why am I not the one making money?!

After enough bludgeoning by Mr. Market, the reluctant bull gradually caves in and becomes bullish. He doesn’t realize it, but it’s happening.

At first he covers his shorts. Then he eventually decides to stop shorting the market, telling himself he’ll get back in later when there’s a better setup. But the bullish evidence grows and grows. Now he doesn’t see why he shouldn’t at least participate for part of the ride. “At least I’ll get paid for waiting” he thinks. Or maybe he doesn’t go long but just gives up on the idea of trying to make money from shorting at all. He’s bullish, but he doesn’t realize it. But actions speak louder than words.

People love to say sell when there’s euphoria. Complete nonsense. That’s something those with the luxury of hindsight, picking apart prior bear markets like to think they can do in the present. It’s a complete fallacy that there’s ever going to be a time when 100% of people are wildly bullish and speculating. There are simply too many lessons from the past and scars from prior bear markets for everyone to become a bull. The reality is that there will always be those who are too clever to ever be bullish.

My advice: don’t pay attention to the CNN Fear and Greed Index or Put/Call Ratio or whatever sentiment gauge is being circulated to try and gauge sentiment. Pay attention to the reluctant bulls because when they capitulate the boat is truly one-sided and downside risk is great.

How to gauge this? I think the correct mix is complete arrogance amongst the permabulls (shit-talking, endless bullish chart posting, especially from people who had gone dormant for a number of weeks when things weren’t so rosy, etc.) along with the aforementioned abandonment of bearish positions from the reluctant bulls. In other words, when it is really hard to find people actually heavily positioned for a bear market.

Trading is harder than it seems.

As an aside, as I write this, there are those who I follow who were bearish on Bitcoin since they first heard of it who are now talking about “buyable dips.” Let’s see how this unfolds.

Aside part two: interestingly, this article showed up in my feed literally ten minutes after I posted this.

Feels Euphoric Out There This Morning

Lots of dunking on short sellers this morning. Massive run in megacap tech into earnings. Many posting enormous gains with extreme confidence. The proclamation that short-selling is dead.

I finally believe we are at a top. I think it’s time to get ready. Just need confirmation from the tape. Looking for a correction to begin sooner than later. A “buyable” correction, of course :).

Markets are Organisms

What the market is least prepared for, it will get. Expect the unexpected. When very few expect a correction, a correction will be sufficient to disrupt sentiment. When a correction is expected, a correction won’t do the job any more than a surprise party will surprise you when someone has told you that it’s going to happen. So the question becomes what will retrain the market? This is precisely what makes figuring where the markets are headed such a difficult task.

I believe that markets operate as a single organism comprised of billions of individual cells. Over time the organism experiences different episodes, some very traumatic. When these things happen, the organism is on especially high guard for a similar occurrence. Then, after enough time has passed, it let’s its guard down. The old cells have been replaced with younger, less experienced cells. This leaves the organism susceptible to new shocks, both to the upside and downside.

After a period of extreme volatility and bear markets many will expect new bear markets on every big advance only to be dismayed as the market keeps moving higher. This current market is even more challenging because things seem to happen in hyper-speed. But sometimes the simplest explanation is the best one and indeed I think we may be over complicating the current market. It’s likely not a new normal in which valuation has no place and businesses need not make more than they spend. This bull simply has further to run as more and more converts move from skeptical to bullish. It’s race is not yet run and the time for rampant bearishness isn’t upon us. Eventually though cash levels deplete, negative fundamental factors present themselves amid extreme sentiment, and the collapse begins.

To prove this out, think back on every significant correction and crash across every market over the past twenty years- the dot-com bubble, the real estate crash and great recession, volmageddon, the bear market and swift recovery in Q4 of 2018 into 2019- each one of these with minimal exception caught the market for the most part completely off sides. Of course with each there were a few lone voices calling for impending doom, but even many of these were permabears or gold bugs always looking for doom in every setup. But for the most part, the market was not expecting what came next.

In the current market I feel there is still just too much skepticism for a major crash to come right away, at least in the form most seem to expect one, and this is something I have been saying for a month or two now. Having been incorrectly bearish from August on, expecting a crash with every dip, in hindsight I was evidently way early. But now in recent weeks I have heard more and more calls for a crash and the end of this speculative episode once and for all, with many calling for a 10% correction or so in January which would present a buying opportunity.

Precisely because the market is so comfortable with this outcome, I believe that either any correction will not end with 10% downside followed by another massive rally to new highs, but finally be the correction that ushers in a lasting, painful bear market as virtually nobody seems to expect this as a possibility or, more likely, the market continues higher for a longer period of perhaps another 2-4 months before finally breaking down. It’s hard to say. I still lean very bearish due to the extreme positioning, speculation, and P/E ratios which I hear more and more pundits discounting as an outdated metric! But fighting the tape is recipe for disaster, so patience is the only play for now. However I still expect any significant crash to start gradually so I don’t believe it’s necessary to get aggressively positioned early as very few expect a drawn out bear market in any area possible given Fed policy. Plus, the fact that every correction of consequence of the last several years has been immediately bought up, leading to a complacency that is unrivaled in my memory. By complacency I mean a market that is ready to discount any correction as healthy and a buying opportunity. However there are many warning flags I’ve mentioned ad nauseam here- the ARK/retail feedback loop, excessive call buying, and absurd SPAC growth. I am content to follow the tape from here.

One last note- I do find the price action in megacap tech over the past few days to be interesting. After doing nothing since the end of August and frustrating the permabulls to no end and permabulls remaining convinced that they were right and the tape wrong while continuing to buy these stocks, seemingly out of the blue, the megacaps finally complied with their wishes and had an extraordinary rally over the past few days. This is interesting to me because as I talk about often, when dumb money consensus wants something to happen desperately, that thing seldom, if ever happens and even when it does it’s usually a very weak signal. I feel then, that this price action could be one last trap in a blow off top for the market to build even more confidence in the retail crowd. To explain the movement, Netflix had blowout earnings earlier this week and I feel that this rally is late money positioning for earnings and not much else. Megacap after earnings will be interesting to watch and will likely offer some clues as to what comes next.

Finally, a Decent Setup

I haven’t been trading at all for the past month or so, mostly because I simply haven’t spotted any setups that were remotely favorable. I know my style and it’s not chasing MOMO stocks or very short-term smallish movements. I tend to try to spot longer term trend changes, mostly tops that will begin lengthy or significant downtrends. Obviously given the current market trends it has been difficult to be overly bearish, so I’ve found myself in a sort of purgatory where I don’t want to chase anything on the long side, but am afraid to go short.

That changed today when I finally spotted a setup that fit my criteria. Now I just entered a very small trade today to test it out, so I have no idea if it will prove to be profitable or not, but I did want to take the time to explain the setup and why I found it to be favorable.

The stock in question is AMD. For many months, AMD has been a major public favorite and the move in it has not disappointed, having more than doubled in less than a year. This is a stock that I view as highly speculative because most who offer fundamental analysis have little actual understanding of the chip space and parrot the obvious bullish factors that everyone has known for many months. Last week, it broke up towards $100 and it looked as if it was on the verge of a massive breakout. But then it quickly reversed lower towards $95. Then earlier this week, news broke that Intel was going to replace its CEO. This caused Intel stock to immediately rip higher, and AMD to drop significantly.

The immediate, obvious reaction from the bulls was that it was stupid to sell AMD given that Intel was years behind and even if the new CEO was effective it would take years to turn the company around. Now, for what it’s worth, I actually agree with this. I think Intel has major, systemic problems that are going to be close to impossible to fix. But what I think doesn’t matter. While I’m long-term bearish on Intel, and I know that just a couple of years ago I would have fallen for this setup and quickly stepped in to buy up AMD on the dip, I now believe that you really have to carefully consider the opposite side of the trade and not immediately assume that your counter-party is a complete ignoramus who doesn’t have access to the same information you do. Of course they do. They have better information than you do. So then you must consider, in spite of all this, why are they selling? Or why aren’t more people buying? There must be a reason.

Over the past day or two, while AMD stock has continued to dip lower, the bulls have continued to confidently cite this price action as a major buying opportunity. It’s important to remember that sometimes stretched stocks are looking for a reason to sell off and don’t need a great one, any will do to disrupt the upward trend. I think that could be where AMD is. Most of the market is extremely bullish on it which makes the risk/reward to going long given the failed breakout and now continued weakness pretty bad, IMO, which makes the short setup pretty compelling.

As I continue to say, some of the best selloff catalysts are wolves in sheep’s clothing.

Blow-Off Rallies

I’ve read most of the well-known books about stock picking/trading/investing. The one I find myself going back to more than any other is Marty Zweig’s Winning on Wall Street.

My favorite part of the book is the introduction, in which Zweig recounts how he famously predicted the 1987 stock market crash. I think the information presented in those few pages is a timeless reminder of how the largest crashes in recent history have occurred and how similar conditions appear in the lead-ups. One particular part I always come back to when things seem extra frothy is the following:

What bothered me were the similarites to 1929, 1946, and 1962. The familiar pattern was gross overvaluation in P/E's and yields along with straight-up price movement which lacked a major correction for years and which had produced doubles or a lot more in the Dow. When these conditions had existed, I found that, late in bull markets, there was a major rally lasting several months which evolved out of a minor correction (the one which started in the fall of 1986 at 1755), another minor correction (spring of 1987 from 2404 to 2216), then a narrow smaller blowoff rally to the final high lasting 2-3 months (which peaked this time in August at 2722).

Those earlier markets then began what looked like "normal" corrections, but which soon cascaded into breaks. The key, and what upset me in September, was that as the smaller correction unfurled, the sentiment on Wall Street was "buy 'em."

I think that last part is particularly informative because indeed it has been my experience that the worst selloffs come as wolves in sheep’s clothing. Bull markets work people over time into an attitude of overconfidence, complacency, and the expectation that if anything at all were to sink the market, it would have to be something REALLY big like a terrorist attack or the Fed hiking rates 4% without warning.

This is folly. History shows us that in old bull markets when things really get extended, it takes very little to upset the market. The trouble for the bulls is that they have now formed a world view that people selling on such a small news item (Roger Babson in 1929, Kennedy’s comments regarding the steel industry in 1962, or the Fed hiking a single time in 1987) must be ill-informed and that they will be happy to take the idiot bears’ shares off their hands at such a bargain price. In these circumstances, stock prices no longer have any relation to fundamentals, they are just traded on a basis relative to prior highs. Amazon at anything under $3000 must be a bargain.

While reading the previous quote from Marty Zweig last week and observing the price action in the market over the past couple of weeks I have a strong suspicion that we are at the doorstep of a crash. In Zweig’s account, he cites the Dow. Everyone has their own opinions of the indices and their relevance. Mine is that the Dow was the index that mattered in a prior time. But in the past ten years or so, the Nasdaq has replaced it as the major indicator of the market’s strength. You can also use the S&P if you like (as most do), as it’s market cap weighting allocates most of its weighting to the same few primary constituents that carry most of the NASDAQ, hence the very close correlation in these over the past few years.

If you look at a chart of the past year, you can see that the crash of February/March of 2020 looks a lot more like a correction in the rear view, albeit a major one. Then in September through October we got another, smaller correction. After the election in November, the market began rallying violently with the small caps and average stocks carrying the slack that the mega cap tech names gave up after the September correction. Given the extreme exuberance among the Bitcoin, Tesla, growth stock and SPAC crowd, I have a feeling we are in this last, narrow 2-3 month blow-off rally Zweig referred to in his analysis.

In the summer of 1929, right before the markets made their final top, many stocks doubled in a period of just a few months after having experienced a small correction in March. $TSLA, $MSTR, $BTC, $ROKU, $PTON, $IPOC (or $IPOE or $IPOF or all of them) have doubled or more since the middle of November (less than two months)!

I believe the time is drawing near for a major crash that will likely hit tech stocks the hardest but won’t spare any sector. I also believe Bitcoin will crash if this happens, as has happened in every major correction we’ve had in the past few years.

One final point. A normal question to raise at this take would be “but what about stimulus and the Fed?” Those are obviously bullish factors, but only to a point. At some point equities become too stretched and positioning too aggressive. This is when markets are at their weakest, and to reiterate the earlier point, it takes very little to unseat the market. Once markets begin a downtrend at these levels, they can become panicky very quickly, in a reverse feedback loop.

We all know about stimulus. We all know about the Fed. And we are all trying to take each other’s money in the market. So at some point you have to part company with the common narrative that everything is bullish. I believe we’re at a point where pretty much anything could cause an initial break. One recent potential factor is interest rates which have started moving up recently and just crossed 1% yesterday. Interestingly, I heard Kevin O’Leary say just today on CNBC that it would require rates above 3% to impact equities. In the same introduction from Winning on Wall Street that I cited at the beginning of this post, Zweig wrote that leading up the the 1987 crash most were insistent that the Fed would have to hike rates at least three times for the market to take note. The first and only hike happened in August of 1987.

As I’ve written in my past couple of entries, what I’m looking for is a downward trend to begin on a seemingly innocuous catalyst. Nobody can say what this will be. But the tell-tale sign will be the bulls completely writing off the catalyst as a nothingburger while the market continues down. There will be rallies along the way to assuage the bulls’ concerns and allow them to get trapped further. I believe this setup will be an unbelievably favorable risk reward for near dated out of the money puts on most anything. In my prior post I talked about Intel and IBM which I still think would be great put plays due to their low IV. However I am becoming more and more enamored with the idea of ARKK, as that is as clear a bubble as I have seen in some time.

I’m sure I will have more to say on this over the next few weeks.

Market Outlook for 2021

All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment. More often, even a semblance of innovation is absent. In the 1920s, as we shall see, great holding companies were created. The owners, that is to say the stockholders, issued bonds and preferred stock in order to buy other stocks. As the latter appreciated in value- for a while- all the increase accrued to the owners. This was proclaimed one of the financial miracles of that age. It was, in fact, leverage in, at most, a slightly different guise.

-John Kenneth Galbraith, A Short History of Financial Euphoria

In late cycle bull markets you start to see strange things crop up. I was reading the above excerpt last night and couldn’t help but immediately think of the rise of ARK Invest and how Cathie Wood, the founder, is widely cited as a genius stock picker and tech visionary.

I subscribe to a few schools of thought when it comes to the market, maybe the most important being that when opportunity is present, many are drawn in, few survive, and even fewer thrive. It is a sad fact of life that there can only be a few true visionaries- Edison, Jobs, Ford, etc. When you start to see many people cited as genius visionaries at once, there’s a good chance there’s some willful delusion at play.

The reason I felt it appropriate to start this piece with that excerpt is that I think it serves as a strong reminder that when bubbles are in effect, people are willing to part with reason and things that they probably fundamentally understand about the world at some level. Cathie Wood is 65 years old. She founded ARK in 2014, roughly six years ago as I write this. ARK really seemed to hit its stride when Tesla’s stock started moving up. ARK continued to be perfectly positioned to ride the growth stock ascent. As ARK’s reputation (and the price of its stock holdings) rose, it launched more ETF’s. So what’s happening now is that you have investors buying stock in an ETF run by someone with a reputation as a visionary, which then uses said inflows to buy shares of high-flying growth stocks, which, after it being reported that ARK has initiated or increased its stake, rise as a result, further lifting the shares of ARK’s ETF’s in a virtuous feedback loop.

This has all the makings of a bubble within a bubble. One can hardly deny that there is at least massive correlation at play here where ARK’s success is closely tied to Tesla’s share price and the growth stock complex as well as investors’ seemingly insatiable appetite for risky stock issues. If you peruse any Twitter thread in which someone asks the question “what stocks are best to buy right now?” You will almost certainly see the majority of responses mention ARKK, the ARK Innovation ETF. It is consensus in the retail crowd that this is not only a smart investment, but should really be a cornerstone of any responsible portfolio. And this is not hyperbole. I read comments like this about once a week.

All the ingredients are here for a market top- overnight visionaries who’s star has risen with the market. Wood is not a lone exception, there are many others. One example being Chamath Palihapitya who has recently gotten fully involved with the SPAC craze, launching something like five or six SPAC’s in the past year. As the public has bought these up hand over fist, Chamath has become quite arrogant and unshy about promoting his own genius, despite not having much in the way of wins beyond a successful exit as an early employee at Facebook and selling shares to the public in businesses that at best, have yet to show sustained success at actually operating as a going concern.

Other problem signs- mega cap tech stocks look to have topped in early September prior to the correction that occurred around that time. Even though they certainly haven’t been in a down trend, their character has completely changed from leading the bull advance to simply treading water on low volume. I’ve seen many assume that this is a healthy consolidation, forming a nice long base that will resolve with a massive rally to the upside. And why shouldn’t they? The past five years have engrained in investor’s minds that every dip should be bought. I believe there is a very important time element in markets to wash away widespread fear and skepticism born in a lengthy painful bear market to setup for another. While we have had minute corrections from time to time, none have lasted more than a few months and in every case though doubts persisted early about how wise it was to buy the dip, history showed that if you had done so on any of those you’d be up significantly a few months later. I think we are at a point now where the bulls have enough confidence in their abilities and delusion about the lack of basic need for a company to earn more money than it spends to setup for a devastating bear market. The question is, what would that look like?

I have heard it consistently said that the market won’t really go down until the Fed tightens again which isn’t likely to be for at least a couple of years. The latter part of this I agree with. I do not, however agree with the premise that you can’t have a bear market emerge with a Fed as unambiguously accommodative as this one. The Fed’s positioning in 2019 and 2020 gave rise to a market that was completely unconcerned about Fed policy. This has led to extraordinarily stretched valuations, positioning, and sentiment. When these conditions occur what is required to bring about a devastating move lower becomes less and less significant. That’s why it’s all the more confounding when massive selloffs happen.

There’s an interesting common thread to every major crash of the past century- 1929, 1962, and 1987. Each began with pretty mild downward trends which quickly accelerated into crashes. I believe that the market has risen to a position of extreme weakness where it could easily lose its footing and start a similar move down and because of this anything at all can cause it.

Other warning signs I have been writing about since September- the number of secondary offerings spiking (similar to the launch of additional ARK ETF’s and SPAC’s) shows a public willing to by any old thing that moves. I believe this also explains the recent rally in Bitcoin. Maybe the most damning is the simple fact that so many have seen absurd returns by speculating in equities in recent months. And I’m not talking about 20% gains which the investing public would consider extremely boring today, but 300, 400, even 700% gains in eight or so months.

There is little doubt to me that in 2021 we will see a major correction in sentiment and price as always must happen when masses with little demonstrated talent suddenly believe themselves to have found a secret gift and should continue to make more money the same way.

Now to the question of when and how? I mean, who’s to say that even if the market does turn bearish that it isn’t a prolonged, soul-crushing bear market or just a sideways market? Why am I so convinced we will get a crash? It has to do with market levels including valuations, sentiment, and extreme levels of speculation. There have been few (perhaps no) instances where levels got so extended and we didn’t get a major crash. However, many think a correction will come in January. While this could certainly happen, I actually won’t be that surprised to see the market continue this sideways churn for another couple of months to really convince the market that no crash is coming and to not be invested is folly. I’d expect even more IPO’s along the way. More than anything I am looking for a sustained down trend in the market (I use the VALUG on a 4-5% weekly close to define the trend) that looks fairly normal and I would use that to initiate put positions.

My favorite short ideas are IBM, INTC, DIS and the QQQ’s (within the QQQ’s I’m most bearish on AMZN, MSFT, and CRM). IBM and INTC may seem like odd choices given that this market is defined by extreme speculation in growth stocks, and that given my prior statements I should short shares or buy puts in ARKK. But one thing I learned in the correction in February/March was that stocks exhibit relative weakness for a reason and it isn’t the stocks that rose the most in the bull advance that see the greatest setbacks when the market turns nor the most reluctance to buying on dips. When you are in a major bull market as we have been for the past year or so, stocks like IBM and INTC which have well-defined and understood fundamental problems get buoyed to much higher prices than they probably otherwise would. Additionally, these two stocks have some of the lowest implied volatility making the upside for put options in a crash event much greater than a stock like TSLA or AMZN where the IV is much higher. You can make good money in those as well but your timing has to be exactly right and you may be surprised to learn that you would’ve made even more being positioned in “boring” stocks. In the midst of a crash the high flyers with high IV’s can yield good results if you short counter-trend spikes as people rush in to buy on the dips, but overall these tend to be better tactical very short-term plays. DIS I’m bearish on for a variety of reasons I’ve written about over the past several months ad nauseam so I won’t recount them all here, but one additional factor at play now is the massive rise the stock has seen over the past month on very little fundamental news except for them proclaiming to have won the streaming wars. I’ll believe that when I see it.

One final point- I don’t believe as some do that we will see a prolonged rotation into small caps or financials with underperformance in megacap tech in 2021. The main reason I continue to point to the fact that megacap tech topped around Labor Day and has been fairly range-bound since is that these stocks defined the bull market of the past several years. I simply don’t believe that the market can have a major advance without them returning to a place of leadership. Small caps have underperformed for years for good reason- they are inferior businesses with inferior leadership. Megacap techs have fantastic fundamentals, ROC, the smartest leadership and the largest TAM’s. When they underperform it’s a major red flag to me. I believe bull markets are strongest when everything works on a relative scale with the best companies leading, particularly at the beginning of a new bull market that few have faith in. That is simply not where we are now. The investing public can make outsized returns for a while but basic laws of survival show that it can’t last and that when it’s going on it in and of itself is a sign something is out of balance.

The Markets in 2019

In the process of observing the markets and how they have moved on news over the past year combined with reading several books written over the past 30 years that captured what people knew (or thought they knew) at that time I have developed a sort of unconventional market outlook because I believe that the indicators that used to work no longer do, at least as well as they used to. That shouldn’t be too surprising in and of itself because markets evolve and learn to discount information and then look for the next thing that will tip them off to the future earnings of each company.

This is why cyclicals like Micron start falling when earnings are great and start rising when things are terrible. I’m going to bet that wasn’t always the case. I’d bet that cyclicals at one time actually fell when things started to actually get bad. Then people learned from this and realized that to make a gain you had to make your trade before things started to get bad so the smart money would start taking profits while things were still good. This confuses most observers because people assume that prices should coincide with earnings themselves. But what actually moves the price of the stock is people actually buying and selling it. So those people start dumping to lock in the gains and look to deploy the money elsewhere. Timing this is impossible and most people are very bad at it. In other words they love to buy when it seems there isn’t an end in sight and panic sell when things look like they are terrible and can only get worse.

Anyway, I think things have fundamentally changed in some areas and wanted to write them down to see how they hold up in the future.

An inverted yield curve no longer matters.

I think people get way too focused on the inverted yield curve as a recession predictor. I am certain that 50 years ago this would have been an amazing thing to watch if you were clever enough to have done so. But those who were made note of it and the inverted curve became public knowledge and went under a microscope.

I think people don’t really understand why the inverted curve matters and I would go so far as to say the inversion itself doesn’t even matter besides showing the relative move across different timelines. No two people even seem to agree about what constitutes an inverted curve- the 3 month Treasury Note to 10 year Treasury Bond? Or was it the 2 year to 10 year?

What does matter is the trend in short term lending instruments. I like to watch the three month commercial paper rates and think even then it’s just one input and has to be judged in the context of overall rates and how high they are on an absolute basis. Does it really matter if short term rates have been rising if they are sub 3%? That’s still extremely cheap and pretty much ensures that money will be flowing around the economy for a while and there will be no credit crunch.

The bond markets no longer have any predictive ability.

There is a pervasive idea that bond markets are smarter than equity markets at analyzing data and predicting changes in the economy. I believe that was definitely true at one point because the bond markets are actually making statements about how much it costs to borrow money across many time horizons. Performing research on fed statements and things that would influence the future costs of borrowing used to be fairly rigorous and most equity traders were more focused on earnings statements than fed statements. Bond traders conversely were far more interested in those in control of monetary policy and then that all would be distilled into the prices of bonds. That’s why equity markets would look to bond markets for predictions about the future price of equities.

But then along came the internet and Twitter and 24/7 market coverage combined with far more visibility into what the fed and ECB were doing. I believe this eroded any informational advantage the bond markets had. Now the bond markets and equity markets are looking at the exact same things but for some strange reason the equity markets still look to the bond markets to predict future earnings.

It’s like a student cheating on a test. He may figure with a high degree of certainty that if the smart kid chose “B” as the answer that’s probably the correct answer, but he has no idea why it is. If one day the teacher publishes the multiple choice answers ahead of time but starts grading on essay answers instead, suddenly knowing the correct multiple choice answers has no value and getting the correct responses by copying the smart kid doesn’t add any points to the cheating student’s GPA.

The next bear market will probably come while rates are still low.

This is less of a general market observation and more of a short term prediction for today, but because of the way that markets discount information and the fact that equity markets have now gotten to the point of fully discounting fed policy decisions, people will start dumping stock before the fed makes a monetary decision. I’m still bullish for now, but I do think that equity prices could start falling almost inexplicably while earnings are still good and fed policy is still dovish. While the former would certainly be nothing new, the latter definitely would be. Remember that moving ahead of markets is extraordinarily difficult, some might say impossible, due to the inherent biases we all have and the way we react to how others react to news. I think it’s still possible but you do have to be willing to sell when it seems things can only go higher if the markets start coming down while things seem great. I don’t think the next bear market will be preceded by a major crash, it will be more of a slow bleed down over many months as institutional investors start trimming way out in front of fed policy changes and rotating back into value investments, the same ones that people have hated for the past few years. To me this could happen if inflation were to start ticking up and the market starts anticipating data that would make the fed hawkish and taking profits then instead of after a fed decision.

An alternate theory is that we melt up and have a typical blow off the top euphoric market that ends up tumbling down. But since that’s happened pretty recently with the late 90’s bubble and more recently with the housing and bitcoin bubbles, the markets are more attuned to those setups making their actual occurrence less likely. It sounds obvious but its very difficult to sense euphoria in others when its actually happening and not get caught up in it yourself. The same is true for panic. That’s why I find it so absurd when I hear people call for “capitulation selloffs” when markets are trading down as if they actually believe they are more sensible than everyone else and also won’t be in a state of panic when that selloff actually comes.

You cannot outperform markets by doing the same thing that everyone else is doing or thinking the same thing that everyone else does. If most people are bullish that will probably work for a while since markets can trend in a direction for a while, but eventually most people won’t come out ahead because when things change they won’t correctly recognize it. I believe that trading is much more game theory than economic theory.

You will be okay if you remember these three rules:

• People are almost always wrong. Price action never is.
• Sentiment always follows price.
• Cut losses quickly.