Just Sell Already!

I felt a bit like Happy Gilmore asking the ball why it didn't go home on Friday, but in this case it's the major indexes not finding their home at a lower, buyable level. I didn't feel angry though. I did give back a lot of profit on Friday because I didn't get out early enough, when I could sense the market wasn't behaving like it should in a meltdown. I made money on the day though, much more counting the entire week of trading. More importantly, I know the big trade is still in front of me.

What I feel even now is something more like resignation. Up until now, I've mostly enjoyed the decline and bulls getting their comeuppance. Friday was the moment I realized they might never sell. It's like watching a man walk on the train track. You feel a little worried when the train is far off. You expect he's going to jump off the track. Then you're yelling and screaming, maybe he's deaf? But then he looks at you and smiles. Friday was the moment when I realized many bulls won't ever get off the tracks.

Let's look at VIX from the 2000s bear market because I think that's our best template from the VIX data. The bear markets of 1973-1974 and even maybe 1929 are the more relevant setups for the geopolitical and macroeconomic backdrop, but there was no VIX then...

VIX peaks in the bull market! The 1998 high was the peak of the VIX and not even the 9/11 terror attacks could top it. There are some smaller peaks at capitulation points: the first sell-off wave in March 2000 ends in April, the bear market low in July 2002, the slightly higher low in March 2003 before the bull market really takes off.

Now here's the past 15 years:

The financial crisis produced a major VIX event because it was a financial crisis. It's a tautology, but when the crisis is the financial markets themselves, then extreme readings are going to be common. The coronaslam came close, but didn't beat 2008. All the other spikes came at the end of QE, a little after with yuan depreciation, and then Volmageddon and the 2018 correction during QT1. VIX is elevated again now with QT2 starting next month.

Takeaway: VIX can remain elevated during the bear market, but it's the bull markets that produce massive VIX spikes. A market needs to be caught off-guard for a VIX spike. All the sentiment and data showing bearishness is why VIX will stay suppressed during the bear market. It will be elevated and there will be capitulation points, but another massive spike will require an event or an escalation such as sovereign debt failures. We may well get them, I'd bet on it myself, but they aren't necessary.

So Much for Sentiment  

I don't find general sentiment too useful, haven't for many months. I am expecting a VIX spike and bull capitulation in some form, but I don't know when it arrives. Beyond that, I think it is more important to look at subject-matter sentiment. What trade is overdone? Inflation.

Supply chain problems do not equal inflation. Persistently high energy prices are not inflation in and of themselves. If there is a supply shock it can produce inflation if it is printed over. That's what happened in the 1970s and March 2020: the government and central bank panicked. They didn't let the economy suffer a recession. Result: high inflation. The mistake in the 1970s was they chickened out over and over until the early 1980s, then let a back-to-back brutal recession wring inflation out of the system.

Everyone thinks they know what the Fed will do now, and all assets are priced assuming a Fed policy turn is coming. Even down here at 3900 on the S&P 500, that is priced for a policy reversal. Bulls are still all in. Even many bears think the Fed will capitulate because of a recession.

I do think the Fed will capitulate, but the difference is I expect an extremely brutal conclusion first. They aren't going to act until they're reasonably certain inflation is done. Bulls who think a drop in interest rate is bullish are correct long-term, but very wrong for the short or intermediate-term.

I won't say energy is the place to short yet, but it is becoming a place to short. The volume profile shows support is about one-third below the current price of XLE.