What is the upside here?

Equity and other markets review (12.12.2022 - 16.12.2022)

General overview: Well, as it usually happens, just when you try not to be that short, the market tanks. But that is not the first time it happens to me and for sure not the last one. It’s part of the bussiness.

After getting well pumped up for a grand window dressing going into 2022 year end, Mr. Market shredded solid 3.37% off its body fat on Monday and Tuesday. Interestingly, it happened on no news. I guess it was just the realization of most of the participants in the last rally that they are walking on thin ice. Better get what you can while prices are still up. Heading into a CPI and FOMC week in less (long) exposure sounds quite reasonable to me, especially if you trust the signals about upcoming economic weakness in 2023 coming form long-term rates and oil.

Read the price action at your own peril, but those charts do not scream a walk in the part for demand and future growth expectation. Have the recent moves extende?Could very well be. Am I looking for a bounce? Indeed I am. But the informational value in them is that dark clouds are ahead of us.

PPI on Friday was a quick reminder that inflation might be not a slayed dragon but a hydra whose head had been chopped. More inflation than expected (consensus is that inflation is behind our backs for now) cannot be good for markets. But even if inflation is weak, too weak might not be good for equities either, as it means deteriorating demand at a faster rate.

So what is the upside potential here heading into 2023?

Low long positioning, seasonality and desire for bonuses are strong forces, but they might not be enough. A recent piece written by @donnelly_brent (must follow) shows that Santa rallies are basically non-existent in years, where the market is down from Jan to Nov.

Are equities particularly cheap? I do not think so. Are credit spreads quite high? I am sceptical of this too. Meanwhile, even big banks, the biggest sellers of hopium for a living, are now expecting rough time ahead.

Technically speaking, SPX is now in the middle of nowhere and failed to stay above the sma200d. With CPI and FOMC coming out, things are about to get volatile. I see the outcome skewed to the downside, but I have a proven record of bad results coming from trading binary events, so I will try to skip the upcoming ones and their impact on my PnL. I am only brave enough to try those when sitting on a good cushion of profit on the trade itself. Sadly, as of now this is not the case.

Sector overview and potential trades: Not surprisingly, oil equities were the largest losers last week. Rumors are that someone big is liquidating a position in oil, driving everything energy related down with it. Given how long everyone was on oil earlier this year, with calls from 200$ to 1000$, shakeouts like this one do occur. And if one goes a bit farther and sees how badly the cyclicality of the sector might effect returns if there is a recession, profit taking here is a must for those in the trade.

Stop and imagine for a second that you have been long oil/energy equities all year and are currently sitting on enormous gains on a relative basis. Suddenly, those profits start melting away at an increasing pace just before you get a fat bonus on the good trade all the while 2023 has huge uncertainty about the fundamentals of the trade. Why risk it? Take the money and start your Christmas sooner.

Realizing this makes me want to dip my toes in the commodity on the long side. Ideally, there will be final flush to the 65$ area which is a very good level from a technical point of view and also has the sma200 on the weekly timeframe to support it.

One thing to note is that while the front end is getting killed, some farther out contracts are doing better. A look at the Dec 23 futures shows that the Sept lows have not yet been breached. Following price action and positioning, I assume getting a long bet in the late 2023 (or even farther in time) futures is better.

SPR releases have been a major blow to oil’s price this year, but they are now behind our backs. Even better, demand from the administration to replenish very low inventory levels is around to corner.

In other news, the run-up in the other real economy sectors looks tired. The industrials have had a monster run but will not be spared if the narrative changes from a soft landing (currently priced in equities) to a recession.

I can easily see XLI going back to 96$ even without a change in narrative, it just advanced too much too fast. The materials and metals and mining are also looking like the next short term move is to the left right corner.

The review will be incomplete without point out what I hinted here last week about a big move coming in regional banks. KRE got absolutely slaughtered on Monday and so did XLF. No reason to expect anything good from regional banks heading into a recession given the inversion of the yield curve. Job and bonus cuts in big banks are not a good sign either.

For those who are long time readers of this substack and who followed a suggested long XLF short KRE trade at the end of September, I believe now is a perfect time to unwind it. The ratio has completely reverted and now I am tempted to play it on the short side, but lack a trigger to do so for now.

Lastly, VNQ has failed to impress despite the recent decrease in rates and looks to be breaking the support trendline from the lows. Fundamentals are known to everyone and have been discussed many times here, so I will skip on those this time.

Current positions: I am long IWM vs short SPY (1/2 position)

Last week I got rid of my short in PM when it refused to go below $101 several days in a row. It was a short term trade from overextended levels and it did what it was supposed to do.

I also got long IWM and shorted SPY with full risk on Monday for the reasons explained here. Unfortunately, the trade has been sucking wind since the get go as the market tanked so I decided to take off half of it on Friday. Even though it has not reached my 2.5% stop from entry, I did not like how it traded the whole week and knowing that volatility will increase I would rather take a smaller loss than planned then getting my face ripped or getting lucky from the binary outcomes of CPI and FOMC.

The other trades that I did were intraday and I plan to keep trading like this until both CPI and FOMC are over.

Conclusion: The week ahead has both important data and FOMC that could push the market in any direction. I believe the upside is limited but would not exclude the possibility of the market ripping. I have no edge in predicting such moves. Therefore, I would rather focus on intraday developments even though I am tempted to get short again as some charts are setting up very decently for such a move.