The rally in the SP500 was driven by a flush out of short positions and also the view that the Fed will soon be easing rates which are a bullish backdrop for stocks. The problem with this logic is the Fed has not indicated they will ease rates back in the near future as they fight stubbornly high inflation. Contrary to the market's belief the Fed will risk a recession by easing up on fighting inflation.
The Bull Argument for Stocks and the “Wrong” Logic
The bull argument for stocks has been based on a pivot from the Fed ceasing its rate hikes not only are they unlikely to pivot but the logic was wrong:
A “pivot” that would support higher stock prices would require two monetary policy changes. Dropping the Fed Funds rate toward the zero bound; Fed will not be doing this and Reversing “Quantitative Tightening” which again the Fed are not doing which would again provide liquidity. As the chart shows, periods of zero rates and monetary accommodation fuel asset prices higher. Periods of balance sheet contraction and higher rates lead to market selloffs so it looks like the bounce is corrective in nature…
Fed won't be Easing Rates to Zero!
TS Lombard "The Fed is far from done, but the market has already "eased "As a result, financial conditions are easier now than they were in June when fed funds were at 1.50-1.75%.” The Fed may reduce the size of hikes going forward but we will probably move up the 5% level before the terminal rate peaks and it won't be going to zero in the near future.
QT Balance Sheet Reduction Bearish Stocks
In terms of the Fed balance sheet, The Fed’s balance sheet reduction has been on autopilot since about midyear. In rounded figures, the Fed’s balance sheet should decline a little over $1 trillion next year. Keep in mind the huge stimulus done after COVID was the main reason stocks were able to double in value from COVID lows - this pillar of support has gone and wont be coming back in the near future.
Nordea Notes “The "nominal illusion" is disappearing, and we should enter a severe earnings recession. The Equity Risk Premium is way too low for such a scenario I expect marked new lows for equities during H1 2023.” (NORDEA)
Big Managed Money Selling
GS NY equity trading desk reports: "Our PB book was net sold for the 7th consecutive trading session yesterday and represented the largest net selling in 4 months driven by shorts relative to long sales: 7.5 to 1. HFs sold Financials for the 5th straight session, driven by short sales outpacing long buys 9 to 1. In cumulative $ terms, the recent net selling in US Financials is the largest over any 5 - day period in more than 5 years."
The last time the selling was this big (or bigger) was toward the end of August - just when the summer squeeze ended and SPX traded down 20% over the next 2 months...
Two charts below, the first from the Market Ear with the longer term chart and second from us on the levels of resistance and support – stocks have rallied to correct oversold and met resistance at the 4100.00 level. In our view, the SPX will continue to sell off down to support.