At the close:

• New York Stock Exchange volume hit 467 million shares, 11% above its one-month average;
• Nasdaq volume hit 5.33 billion shares, 13% above its one-month average;
• Volatility Index: + 4.38% to 13.83
• NYSE Highs: 15 Lows: 52

• Nasdaq Highs: 42 Lows: 144

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I have a research call at 3:30 p.m. which will take about an hour.

If I am not back, thanks for reading my Diary.

Enjoy the evening.

Be safe.

With all the swings today - here is a look at large caps with the biggest % Range (day high v. day low). 

See both Advancers table and Decliners table.

Advancers

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Decliners

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RSP (equal weighted S&P) is -$1.02 or -0.65%, and IWM is -$2.00 (or -1.03%), while the S&P Index is down by only -0.44% and Nasdaq by -0.28%.

Adding to (XOM) , (OXY) and (CVX) .

After getting markets really excited on November 28th, 2023 when Fed Governor Chris Waller said "for several more months - I don't know how long that might be - three months, four months, five months - that we feel confident that inflation is really down and on its way, you could then start lowering the policy rate just because inflation is lower. It has nothing to do with trying to save the economy or recession," today he said that while inflation has further moderated, "concerns about the sustainability of these data trends requires changes in the path of policy to be carefully calibrated and not rushed."

There is that word again, 'sustainability' that I keep harping on. 

He is confident though "that the economy can continue along its current trajectory." When will 'sustainability' be achieved with inflation at 2%? "I think we are close, but I will need more information in the coming months confirming or (conceivably) challenging the notion that inflation is moving down sustainably toward our inflation goal." 

And with regards to financial conditions and how the markets started tightening in August, and then eased a few months later, "My view continues to be that, on net, financial conditions remain restrictive and continue to have the desired effect of being a drag on economic activity to put downward pressure on inflation." How he's defining "financial conditions" is thus unclear. Is it the S&P 500? Is it credit spreads? Is it just the cost of capital? 

And he repeated that he expects the Fed to cut rates this year, consistent with the 3 that the Fed dot plot revealed and the timing of the first one will "depend on the incoming data." As to the markets belief of 5-6 cuts this year and maybe the first one in March, Waller shot that down by saying with rates, "I believe it can and should be lowered methodically and carefully...I see no reason to move as quickly or cut as rapidly as in the past. The healthy state of the economy provides the flexibility to lower the nominal policy rate to keep the real policy rate at an appropriate level of tightness." 

Bottom line is, with today's info in hand, the Fed is intent on cutting 3 times this year and would only cut more if the economic situation deteriorated and the unemployment rate started heading towards 4.5-5% I believe. 

Treasury yields jumped to the highs of the morning in response and backed off a touch since. 

Intraday 2 yr yield

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Intraday 10 yr yield

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"Will be able to cut the policy rate this year as long as inflation doesn't rebound or stay high"

- Consistent with Fed policymaker projections for three 25-bps rate cuts in 2024

- Needs more info concerning inflation moving down to goal; timing and the number of cuts will be driven by incoming data

- More confident the US is close to sustainable 2% inflation, policy is set properly and on the right track

- No reason to move as quickly, to cut as rapidly as in the past; Policy path must be 'carefully calibrated, not rushed'

- Financial conditions remain restrictive; The setting of policy needs to proceed with more caution to avoid over-tightening

- I view risks to Fed's employment and inflation mandates as more closely balanced

- The slowdown in consumer spending appears tentative, we will find out more from Wednesday's retail sales data; December job reports was 'largely noise'

Bonds are getting hit to the day's lows after Fed's Waller comments. 

The ten year is now +10 bps. 

I stepped up my shorts into the market ramp from the lows.

* The yield on the 2-year Treasury note is 4.171% (+4 bps).

* The yield on the 10-year Treasury note is 4.003% (+6 bps).

* The yield on the long bond is 4.255% (+6 bps). 

A market headwind.

* At 10:30 am:

- NYSE volume 164M shares, 7% above its one-month average

- NASDAQ volume 1.61B shares, 7% below its one-month average

- VIX: + 2.57% to 13.59

Breadth

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Biggest Movers

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Heat Map

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S&P 500 Sectors

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The 10 yr yield dipped a touch below 4% after the disastrous January NY manufacturing index that printed -43.7 from -14.5 and well worse than the estimate of -5. This index dates back to 2001 and outside of Covid when it fell to -78.2, we've not seen a figure this weak, even during the '08-'09 recession when it touched -34.3. New orders plunged to -49.3 from -11.3 while backlogs were little changed at -24.2. Inventories continued to fall, at -7.4. Employment was -6.9 and that is the 5th month in the past 6 under zero and the workweek fell too. Delivery times remained negative but less so while prices paid jumped to a 3 month high but those received fell. 

The positive was the 6 month outlook which rose to 18.8 from 12.1 and that is a 3 month high. The outlook for new orders, backlogs, shipments and capital spending all rose m/o/m as they did too for employment and the workweek. Price expectations jumped with prices paid up 15 pts, the highest since February 2023 and expectations for prices received were higher too. 

Bottom line, I'm guessing that the Red Sea disruptions accounts for much of the dour confidence while the positive 6 month outlook reflects resolution soon. If it wasn't related to the Red Sea, which I doubt, the manufacturing recession deepened in January with hopes that maybe it can't get any worse and inventories will soon need to be restocked. The NY Fed does not in their press release give much color to the respondent answers and anecdotes behind them. 

NY Mfr'g

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Six month outlook for Prices Paid

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I shorted more (QQQ) at $408.43.

Selling some (GTBIF) at $13.18 after a big run to the upside.

From Peter:

In addition to the Hang Seng (where we own a few stocks, along with some in Macau) where my contrarian call, stated here multiple times, is that it outperforms the S&P 500 this year notwithstanding the rough start to the year (it's dirt cheap, China's economy will be less bad and KMT winning majority in parliament in Taiwan), I'm going to add cannabis stocks to the contrarian list for 2024.

This comes after documents were released Friday including an August 2023 letter to the DEA from the Health and Human Services (not previously publicly seen) saying "the FDA recommends that marijuana be placed in Schedule III of the Controlled Substance Act" from Schedule I and thus HHS also recommends the reclassification.

The DEA has the final say on this but the Washington Post talked to a former FDA deputy commissioner who "predicted DEA would follow HHS's recommendation. He noted that DEA, by law, must defer to the FDA's analysis on the science of marijuana's potential for medical use."

If the case, this should reduce the barriers to regular banking services and most importantly end the application of Section 280E of the IRS tax code which prohibits businesses from deducting normal business expenses from revenue associated with selling schedule I or II substances. The cash flow improvement if cannabis companies can deduct expenses like all other industries would be substantial. Lastly, this can bring in institutional investors if the stocks can be uplisted to the Nasdaq from the pink sheets and Canada. This group is cheap and just maybe the regulatory clouds clear soon.

While we don't own individual cannabis stocks for clients, I own Trulieve (TCNNF) and Medicine Man Technologies (SHWZ) personally.

Let's add the words 'firmly' and 'surely' to 'sustained' when gleaning what will satisfy Fed members with regards to inflation. Voting member Raphael Bostic said over the weekend that "Inflation must be firmly and surely getting back to our 2% target. It would be a bad outcome if we started to ease and inflation started to rise up and down like a see-saw. That would undermine people's confidence in where the economy is going." He also talked about what's going on in the Red Sea and the jump in shipping costs. "It will be very interesting to see to what extent the Middle east conflict and attacks on the container ships are starting to show up in the cost structure for businesses in my district." I'll add, if the Fed cuts 6 times this year it is because the unemployment rate is at 4.5-5%, not because inflation is lower from here.

If I had a dollar for everyone spiking the football on the end of inflation I'd be able to buy a lot more things but I'll say AGAIN, it is not the cyclical come down after the cyclical spike in inflation that matters, it is WHERE DOES INFLATION END UP ON A SUSTAINABLE BASIS that is most important.

Germany's economy contracted by .3% y/o/y in 2023 and by a similar amount in Q4 from Q3. It's semantics whether it's not a technical recession or not as there is essentially no growth. Germany's economy is particularly sensitive to exports (about 40% of economic activity) and its manufacturing base.

And what was the Bundesbank president Joachim Nagel's response when it comes to possible rate cuts? Speaking in Davos yesterday, "Maybe we can wait for the summer break or whatever but I don't want to speculate. I think it's too early to talk about cuts...This was often a mistake that was done in the past. I don't want to repeat this mistake. Inflation is a greedy beast."

Another ECB member, Robert Holzmann from Austria, doesn't expect any rate cuts in 2024. He in particular cited geopolitics, "The geopolitical threat has increased because what we saw until now by the Houthis. I think it's not the end, it might be the overture to something much more broad based, which will impact the Suez Canal and increase the prices there. We should not bank on the rate cut at all for 2024."

These comments yesterday from these two ECB members is why yields rose in Europe on Monday and combine that with the yield increase in Asia today helps to explain why the US 10 yr yield is back to 4.0% again.

The first trading day post Taiwan election saw the TAIEX up .2% but lower by 1.1% overnight because of broad Asian market weakness today. From the perspective of keeping things calm in the region, hopefully the KMT party getting the majority in the Parliament, picking up 14 seats to 52 vs the DPP gaining 10 to 51, will be enough for now.

Not having any different information than any of us have, and believing that Taiwan is happy with the status quo, I do not think China is going to resort to a military invasion to take Taiwan and will do all they can over the coming decade plus to do so instead via 'peaceful' means though via coercion, if at all. Taiwan semi's stock in particular was up .3% on Monday and down 1% on Tuesday.

The December Cass Freight index was released yesterday and it was up 2.1% m/o/m seasonally adjusted "as volumes fell less than normal in the holiday shortened month." The y/o/y drop was 7.2% after an 8.9% fall in November. The thing of course to watch from here are freight rates with what is going on in the Red Sea and how that will trickle down, first to air after sea and we'll see otherwise. In December, before all this started, inferred rates fell 2% m/o/m and by 18% y/o/y.

Bottom line from Cass, "US freight volumes have fallen for most of the past two years, similar to prior downcycles in both length and magnitude, except for the pandemic downturn." As FedEx said in its earnings call weeks ago, they think the destock has run its course but the restock has yet to start.

Let's now get to some notable earnings call comments from the big banks Friday:

JPM:

"The way we see it, the consumer is fine. All of the relevant metrics are now effectively normalized. And the question really, in light of the fact that cash buffers are now also normal, but that means that consumers have been spending more than they're taking in, is how that spending behavior adjusts as we go into the new year in a world where their cash buffers are less comfortable than they were."

"The net reserve build was primarily driven by loan growth in card and the deterioration in the outlook related to commercial real estate valuations in the Commercial Bank."

"Total debit and credit card spend was up 7% y/o/y, driven by strong account growth and consumer spend remained stable."

"Loans were down 1% q/o/q. C&I loans were down 2%, reflecting lower revolver utilization and muted demand for new loans as clients remained cautious. And CRE loans were flat as higher rates continued to have an impact on originations and payoff activity."

On the 2024 outlook, "Going through the drivers, the outlook assumes that rates follow the forward curve, which currently includes six cuts this year. On deposits, we expect balances to be very modestly down from current levels. While lower rates should decrease repricing pressure, we remain asset sensitive, and therefore the lower rates will decrease NII, resulting in more normal deposit margins. We expect strong loan growth in card to continue, but not at the same pace as 2023. Still, this should help offset some of the impact of lower rates. Outside of card, loan growth will likely remain muted."

BAC:

"The deposit outflows you've seen in consumer have largely been driven by the higher balance accounts who've moved their excess balances into the markets to seek higher yields. We captured those at our leading wealth platform."

"the consumers of Bank of America have had access to credit and are borrowing responsibly. The balance sheets are generally in good shape. And while impacted by higher rates, remember, many of them have fixed rate mortgages and remain employed. So they've shown great resilience."

"Net charge-offs reflect the continued trend in consumer and commercial charge-offs towards more normalized levels as well as higher commercial real estate office losses."

"you can see loan growth improved this quarter as we saw improvement in both credit card and commercial borrowing, offset by declines in commercial real estate and securities based lending. The commercial growth reflects good demand overall and was muted only at quarter end by companies paying down commercial balances as they finalized their yr end financial positions."

"if you look at our loan growth in the materials, it's been a pretty slow loan growth environment. And I think what's going on underneath it is, obviously, you've got the economic activity, offsetting that a little bit is lower revolver utilization. And you can start to see why with rates being much higher, it's a little more expensive to borrow a revolver."

By the way, "the hold to maturity book moved below $600 billion this quarter. It's now down $89 billion from its peak and it consists of about $122 billion in treasuries and about $465 billion in MBS along with a few billion others."

Their reserves assume a 5% unemployment rate by end of 2024 compared to the current 3.7%.

Well Fargo:

"Average loans increased modestly, with growth in the first half of the year, offsetting declines later in the year, reflecting weaker loan demand, as well as credit tightening actions. Average deposits were down, driven by consumer spending, as well as customers migrating to higher yielding alternatives."

"The financial health of our consumers remain strong. While average deposit balances per customer continue to decline from their peak, they remained above pre-pandemic levels as wage growth has more than offset increased spending. Having said that, there are cohorts of customers that are more stressed. Consumer spending remains strong. Credit card spend was up 15% for the year and was remarkably stable throughout the year with growth rates strong across all categories except fuel, which was impacted by lower gas prices."

Not surprisingly but still the case, "Discretionary spend growth slowed from a year ago, while non-discretionary spend was stable."

"As expected, net loan charge-offs increased up 17 bps from the third quarter to 53 bps of average loans driven by CRE office, credit card loans...As expected, losses started to materialize in our CRE office portfolio as market fundamentals remained weak. The losses were across a number of loans, spread across various markets, and were driven by borrower performance, lower appraisals, or the result of properties or loans being sold at a loss. We've substantially built reserves for this portfolio throughout 2023 as criticized and non-performing assets increased. And while we expect additional losses in the coming quarters, given market fundamentals and capital markets and liquidity challenges in this sector, the amounts will likely be uneven and episodic."

"Our allowance for credit losses increased slightly in the fourth quarter, driven by an increase for credit card and CRE loans, partially offset by a lower allowance for auto loans."

Of note in the auto lending sector, "The size of our auto portfolio has declined for 7 consecutive quarters, and balances were down 11% at the end of the fourth quarter compared to a year ago. Origination volume declined 34% y/o/y, reflecting credit tightening actions."

Citigroup (a cheap stock we own):

"2024 looks to be similar to 2023 in terms of the macro environment with moderating rates and inflation. We expect to see growth slowing globally, with the US well positioned to withstand a run of the mill recession should one materialize."

Back overseas, Japan said its December PPI was unchanged y/o/y vs a 3 tenths gain in November but that was 3 tenths more than anticipated. In response, the 10 yr inflation breakeven rose almost 2 bps to 1.21%, a one month high. Their 10 yr JGB yield was higher by 3 bps to .60%. The BoJ does meet next week and while no change to NIRP is expected, I do think it goes away at one of the next few meetings.

10 yr Inflation Breakeven in Japan

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The January German ZEW investor confidence index in their economy improved to 15.2 from 12.8 and above the estimate of 11.7. The Current Situation though remained in the doldrums at a deeply negative -77.3. Helping the expectations component were hopes for ECB rate cuts as "now more than half of the respondents assume that the ECB will make interest rate cuts in the first half of the year." Add in expectations for Fed cuts too.

Current Situation ZEW

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I reshorted (SPY) $478.33 and (QQQ) $408.81.

The post EPS reaction to financial EPS prints has been poor and are consistent with my cautionary remarks (and net short exposure) in my opener this morning.

At 8:04 am:

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At 8:43 am:

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Upside

- (HMST) +27% (to merge with FirstSun Capital Bancorp at $14.75/shr in all-stock deal; Announces $175M equity raise)
- (TAST) +13% (to be acquired by Burger King Company at $9.55/shr in $1.0B all-cash deal)
-BFRG +8.6% (declares issuance of Australian patent protecting novel prodrugs of Mebendazole and their use in treating cancer)
- (BEEM) +7.5% (receives $7.4M order from US Army for 88 off-grid EV ARC EV charging systems)
- (PGEN) +5.8% (European Commission grants orphan drug designation for PRGN-2012 for treatment of recurrent respiratory papillomatosi)
- (ANSS) +4.5% (confirms to be acquired by Synopsis in $35B cash-stock deal; Ansys shareholders to receive $197.00 in cash and 0.3450 shares of Synopsys common stock)
- (EGO) +2.1% (reports FY23 gold production)

Downside

- (ALLK) -54% (Phase 2 Lirentelimab trials in Atopic Dermatitis and Chronic Spontaneous Urticaria did not meet their primary endpoints; announces a restructuring to focus on development of AK006 including cutting 50% of jobs)
- (AXDX) -19% (files to sell 4.5M units)
- (APLD) -16% (earnings, guidance)
- (XPEV) -6.0% (Euro regulators considering imposing additional tariffs on Chinese automakers)
- (LI) -4.9% (Euro regulators considering imposing additional tariffs on Chinese automakers)
- (BIDU) -4.2% (downside momentum)
- (CPNG) -3.2% (CitiGroup Cuts CPNG to Neutral from Buy, price target: $17)
- (MNTS) -3.1% (announces $4.0M Registered Direct Offering priced at-the-market under Nasdaq rules)
- (BA) -2.5% (reportedly faces longer wait to resume MAX deliveries in China; Wells Fargo Cuts BA to Equal Weight from Overweight, price target: $225)
- (FIVE) -2.2% (Craig-Hallum Cuts FIVE to Hold from Buy, price target: $195)

From  Jefferies: 

GS FIRST LOOK

Beat on PE marks - core mixed

• GOOD - Comp, stake sales, flows IB, Credit
• Less Good - FICC, RWA growth
• Feedback mixed - call it close to 50/50 so far

• Comp looks good at +2% FY YoY and a ~mid-33% range ex provision (some others saying only in-line core - can assume severance was lighter? Tbd).
• BS stake sales $4B very solid
• Flows look good (but need more detail on this $51B #)
• IB beat and credit trajectory looks favorable

• FICC down -24% QoQ - inclusive of noted RWA growth
• With that RWA growth - comes the -30 bps CET1 decline
• Cant help but compare to JPM - with BS growth and in-line trading on a ~$16B+ RWA decline

• Bulls - IB beat/trend-line + strategic progress (BS stake sales)
• Bears - more focused on the FICC #, pushing back some on the comp beat

MS FIRST LOOK

A bit more controversial so far - both sides vocal

• GOOD - Fee-based NNA growth, NII less of a talking point
• Less Good - Margins, FICC/RWA growth, account growth
• Feedback pretty intense - call it 40/60 bull/bear (bulls coming alive some...)

• Fee based NNA growth up to the mid ~4% range vs last qtr mid 2% range
• Total NNA growth up to ~4% from last qtr ~3%
• NII small beat + sweep deposits up +$2B = less of a talking point for the win

• WM PT margin still under pressure - despite more stable NII (Bears also point to NII seasonality vs SCHW YTD MMF/broader 1Q headwinds)
• FICC soft - down -26% QoQ - with RWAs +$14B, leading to the -30 bps decline in CET1
• Account growth flattish - in both Direct and Workplace

• Bulls - NNAs better, NII non-event
• Bears - margins in focus, FICC vs RWA (not getting enough focus - JPM vs others?)

* I remain of the view that the market's upside reward is now likely dwarfed by the downside risk.

There is now a near-universal view -- after a rapid rise in the markets, especially of a Nasdaq-kind -- that stocks are headed higher over the near term and for the full 2024 year.

However, it is important to observe how wrong the confident consensus has been in each of the last two years:

* At the end of 2021, the herd was optimistic. 2022 was a disaster in both the fixed income and equity markets.

* With such a bad experience in 2022, the consensus ended the year wildly confident but this time bearish -- especially on mega tech. And that could not have been further off market as not only did the market rip higher, but tech materially led the way.

* Today the consensus, following the momentum built up in the last three months, is exceedingly bullish -- nary a bear can be found. This is consistent with market technician Helene Meisler's wonderful quote that "price has way of changing sentiment."

There is no more reason to expect the herd's optimistic market calls for 2024 to be closer to the mark than those of 2022 or 2023. While the "group stink" feeding these forecasts may not qualify as a leading contrary indicator of what we should expect this year, the upbeat consensus forecasts should definitely be taken with a grain of salt.

Count my hedge fund, Seabreeze, today, as we were at the beginning of 2023 -- when we were more upbeat than most -- to be outside the consensus, again. This time we are downbeat when almost everyone else is upbeat.

I see a vast array of unexpected political, geopolitical, economic and market surprises that could be on tap for the New Year.

Here are some of my principal concerns:

Equity Risk Premium: Despite the enormity of the drop in yields, the equity risk premium (the S&P earnings yield divided by the risk-free return) is still paper thin - and, historically this is a reasonable predictor of weak markets. The move higher in stocks in 2023 was mostly a valuation reset - and the specific move in the last two months has entirely been a reset of multiples as the 4Q2023 S&P EPS projections are down -6% from the beginning of the fourth quarter and 2024 S &P EPS forecasts are down by -1% to -2% in the same timeframe.

There is to me, a single-minded preoccupation with lower yields and disinflation. To me Treasury yields are still high relative to the lowly S&P dividend yield (at only 1.45%). Moreover, the S&P dividend yield compares unfavorably to the one-year Treasury bill yielding 4.80% and a three-month Treasury note yielding 5.40% - the gap between the S&P dividend yield and Treasuries is at a multi decade wide.

In other words, a reasonable risk free, nonvolatile, and equity-like return can be achieved in short term Treasuries today. If one goes out further to somewhat more risky credit, fixed income returns are in excess of historic equity returns. 

Fed Rate Cuts Are Typically Bearish: It is clear that the Fed's tightening cycle is over. But, as seen in the following chart, it is important to recognize that, over time, policy loosening and interest rate cuts are typically equity market unfriendly:

Geopolitical: As I have cautioned the world is no safer than it was three months ago, six months ago or one year ago. Arguably it is less safe. The Black Swans of Geopolitics are being largely ignored despite the danger being equal in my view to just before both World Wars. Indeed, the similarities to 1914 and 1938 are very scary. 

Political: Politically we are also in worse shape with an aging President leading the Democratic Party and a multiple times indicted ex-President (likely to represent the Republican Party) contributing to a toxic Washington that has never been more partisan and unequipped or unlikely to compromise in important legislative matters. 

Deficit/Debt: On that score the burgeoning U.S. and a $300 trillion global debt crisis are being ignored. Our nation's growing annual deficit and the accumulated debt load (of more than $34 trillion, +500% since 2000) will suppress economic growth:

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The rapidly expanding U.S. debt bill (observed above)- impacted by unprecedented political partisanship and our government's uncompromising policy - is being ignored by both parties as reflected in the expansive, unfocused and undisciplined fiscal policies maintained in the last decade. But, this is an obligation that must be paid.

With global debt growth accelerating at an alarming rate, markets are rallying on expectations of lower interest rates, lower inflation, and strong economic growth, a jigsaw puzzle whose pieces fundamentally don't fit together. Lower inflation and lower interest rates point to slowing economic growth and lower corporate profits which are inconsistent with forecasts for new stock market highs. But a foolish consistency is the hobgoblin of little minds in the ZIRP/QE era, and having crossed the Rubicon into that era, we can never cross back.

The world's debt load represents an existential threat to the global economy. That debt can never be repaid in constant dollars - it can only be addressed by defaults, inflation, and currency devaluation. The day of reckoning for this intensifying crisis is moving closer due to the exponential nature of debt. Investors who ignore this looming threat will suffer terrible consequences in the future; those who factor it into their investment decisions will better protect themselves and even prosper. But make no mistake about it - there is no way to avoid the debt crisis. Ignoring it is not an option and is the equivalent of financial suicide for anyone who sticks his or her head in the sand.

Economic And Corporate Profit Growth Expectations Are Inflated And Inflation Will Remain Sticky: As it relates to a consumer-driven domestic economy, the stacked or cumulative rise of well over 20% in prices since 2020 will likely weigh on both economic and corporate profit growth over the next several years. We are less concerned about a recession this year than an extended period of market unfriendly slugflation (sluggish economic growth and sticky inflation).

The likely future condition of slugflation could deliver a sustained period of higher interest rates than expected - providing both fundamental (debt rollover challenges) and valuation headwinds. (See Howard Marks' explanation of this "Sea Change" later on in our commentary.)

Meanwhile, back to the current situation in which the lingering period of curve inversion (in which short term interest rates have been above long-term interest rates since early 2023) represents a noteworthy valuation threat to equities - that has been dismissed by many. 

The last four times the Ten-Year Treasury note yield minus the Three-Month Treasury bill yield inverted, it led to the 1990s recession, the Dotcom Bust, the Global Financial Crisis and the 2020 Recession:

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Market Structure: The action in the last three months is proof positive that markets no longer move based on fundamental economic logic. Instead, they are driven by liquidity, flows, momentum and an extremely short-term oriented psychology which is reflected in the popularity of ODTE (zero days to expiration options) that today account for more than 60% of total options trading activity daily. Macro rules markets but not in the sense of traditional macroeconomics but the new macro-structure of markets. 

A Sea Change

Back last year, my friend Oaktree Capital's Howard Marks reflected upon an economic "sea change" he expected in the next decade. We agree with his thesis (which has bearing on our investing strategy and tactics), the upshot of which is:

- The period from 1980 through 2021 was generally one of declining and/or ultra- low interest rates.

- This had profound ramifications in many areas, including determining which investment strategies would be the winners and losers.

- That changed in 2022, when the Fed was forced to begin raising interest rates to combat inflation.

- We're unlikely to go back to such easy money conditions, other than temporarily in response to recessions.

- Therefore, the investment environment in the coming years will feature higher interest rates than those we saw in 2009-21.

- Different strategies will outperform in the period ahead, and thus a different asset allocation is called for.

Where I Erred

Since I have been directionally wrong over the last sixty days, I would be remiss (and it would be arrogant of us) if I didn't review why I have been wrong directionally and what I might have missed over the last sixty days:

* I underestimated the animal spirts and price momentum that accumulated during November and December.

* I underestimated the power of the herd - as the pressure to the upside intensified, so did FOMO (the fear of missing out).

* I underestimated the contribution that market structure would have in terms of intensifying the upside to equities - specifically, quant strategies that worship at the altar of price momentum catalyzed the market advance. Active managers came along for the ride. In essence, we live in a world where buyers live higher, and sellers live lower.

* The same applies to interest rates, as the momentum of yields to the downside accelerated, there was more and more buying (and lower yields) on fixed income products.

* I thought interest rates would decline but we underestimated the valuation reset higher in equities even in the face of weakening high frequency economic data.

* I overestimated the concerns that would accompany lower interest rates and did not anticipate the possibility that price earnings multiples would expand to the degree they did. 

Nonetheless, given the headwinds cited in this commentary, it is my strong (and non-consensus) conviction that the market's upside reward is now likely dwarfed by the downside risk. 

Summary

Christmas came early to Wall Street in 2023, but a New Year's Eve hangover may lie ahead.

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Currently the S&P Index is near a record high and "Goldilocks" thinking has been embraced by many market participants as a number of consequential market headwinds are being materially ignored.

I have often seen the acceptance of "Goldilocks" played out many times over the course of my investing career. But "Goldilocks" and a perfect outcome are rarely sustained for very long as ideal scenarios often fail to emerge.

More significantly one important effect of "Goldilocks" is that it leads to high investor expectations and room for potential disappointment and losses.

FT Unhedged recently expressed a similar view:

Yesterday's letter suggested that we think the market's current expectation of solid growth and six rate cuts seemed likely to be wrong in one direction or the other: either strong growth will limit the Fed to close to the three rate cuts it currently forecasts, or growth will be weak and there will be as many cuts as the market expects. In this sense, the market does look to be pricing in too much good news.

There are two important things to keep in mind with respect to market and economic forecasts: 

* There is often an inverse relationship between the degree of confidence with which a forecast is delivered and the ultimate accuracy of that forecast.

* Forecasts often say more about the forecaster than the object of the forecast. To borrow a phrase from William Butler Yeats' Among School Children - we often can't distinguish the dancer from the dance:

Labour is blossoming or dancing where
The body is not bruised to pleasure soul,
Nor beauty born out of its own despair,
Nor blear-eyed wisdom out of midnight oil.
O chestnut tree, great rooted blossomer,
Are you the leaf, the blossom or the bole?

O body swayed to music, O brightening glance, How can we know the dancer from the dance?

In a world filled with war, debt and political and geopolitical instability, general uncertainty of economic and profit outcomes and a "sea change" in interest rates -- bullish economic, corporate profit and market forecasts should be strenuously questioned. When those forecasts are almost uniformly bullish, as is the case today, they should be harshly interrogated. 

Importantly, the markets are likely underestimating the inflation risks and, therefore, probably overestimating the amount of cutting by the Federal Reserve that is going to take place. Specifically, it is my continued view that wage inflation will likely remain sticky:

Based on the likelihood that wage inflation will remain stubborn (and other factors), we believe inflation will be sticky (literally and figuratively) - and the disinflationary process will get harder from here relative to consensus expectations.

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Here are two analogs regarding the difficulty in taming inflation: 

* Eradicating inflation is like spilling a cup of coffee on your car's seats. Once it gets in the car seats it's awfully hard to clean up.

* Eradicating inflation is also like trying to diet and lose 20 lbs. The first ten are easy to lose, the next ten are far more difficult. (This might also help to explain why I have been taking Ozempic for the last thirteen months - and, in the process I have lost 50 lbs!) 

Regardless, as noted in the body of this letter, rate cuts historically have been bearish for equities.

Finally, valuations are extremely high with most historic metrics (price/book, price/earnings, enterprise/cash flow value, etc.) in over the 90%-tile:

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For now, I have a keen eye towards managing capital conservatively, structuring my hedge fund's (Seabreeze) portfolio defensively by positioning mainly in pairs trades and through opportunistic trading - with a net short bias.

Markets don't dictate my exposure - we are dispassionate in the investing process.

Despite the intensity of the market's current momentum to the upside and the emotional unleashing of animal spirits I manage money dispassionately based on the calculus of upside reward v downside risk with an eye towards "margin of safety."

I am disciplined, always seeking value: I don't chase strength solely in order to participate. 

It is my continued expectation that we will get a buying opportunity from lower levels sometime this year.

There will be no "Futures" column as I am out of the office at a breakfast/research meeting until 830 a.m.

This table is a valuable resource for momentum-based short-term traders:

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From JPMorgan:

US: Futs are lower to start the week as bond yields move higher by 6-7bps, in response to both Fed and ECB pushback to market expectations for rate cuts where the market is pricing ~70% chance for a rate cut in March. The USD spiked alongside the move in yields. Cmdtys are mixed with Ags and Energy higher and metals lower. Bank earnings continue today with GS/MS the bellwethers and Empire Mfg the macro data release. Tmrw's Retail Sales is the more impact data; combine with Beige Book and investors may get a clearer picture of the economy.

and...

EQUITY AND MACRO NARRATIVE: Coming into this year, we expected a choppy January that then gave way to more market upside given the strength of the economy, improving earnings, and a Fed who is done tightening. So far, this is playing out with the first week of the year seeing the SPX lose 1.5% and then gaining 1.8% last week. What's next? Positioning Intel flags the potential for a 5% pull back (full summary is below):

As we wrote last week, it appeared to us that we were at the end of the largest period of HF short covering by late Dec. In this context, we highlighted that the S&P 500 often experiences a ~5% drawdown over the next month and High SI stocks often fall 10-12%. So far, US High SI stocks (JPTASHTE Index) have fallen >10%, but the S&P 500 has held up well. So, is this time different? Possibly, but it's not clear we're out of the woods yet and we still think the SPX could fall.

· WHY STOCKS SHOULD SELL OFF - (i) Positioning / Statistical history - Positioning Intel goes through the rationale for a 5% in their note so will not rehash here; (ii) Fed Expectations are too dovish - calls for a March rate cut may prove premature, and we are seeing recent Fedspeak push back on these expectations, so we may see rates reprice higher, a negative for Equities; (iii) Seasonality - over the last 25 years, January has been up 12x and the average up-return is ~4% and the average down-return is ~4%; SPX is +29bps MTD so we could see a pullback aligned with Positioning Intel's analysis and historical outcomes; (iv) Earnings - with Tech expected to do the heavy lifting, it is possible that we see a series of disappointments ahead of MegaCap Tech earnings, the bulk of which occur between Jan 24 and Feb 2; (v) Flows - this could be a combination of dissipating retail demand, weak buyback bid, and a failure to see MMF flows moving into Equities. More generally, there is ample room for the market to get short, especially if we fail to burst through 4,800 in the SPX.

o TRADES - Long Defensives, Short Cyclicals, Short RTY. Consider commodity longs if inflation data ticks higher.

· WHY STOCKS SHOULD RALLY - (i) Growth Reboot - the US appears to be experiencing a rolling recession (asynchronous slow down across sectors) and we could see a rolling recovery take hold with growth data inflecting higher as soon as this week. If we continue to see growth without inflation this could result in a steeper yield curve, additive for Cyclicals and a broadening of the rally; (ii) The Fed - the combination of rate cuts and a slowing/halting of QT is a powerful tailwind and some clients think this could occur as soon as March though if short-term funding markets get gummed up, then the Fed would have to intervene with a form of QE which could occur sooner; (iii) Disinflation - while there are near-term price risks arising primarily from the Middle East, we may not see the brunt of the impact in the US, from a pricing perspective and with Core PCE tracking below 2% (more color in the next section) we may see another bearish argument removed, dovetailing with rate cut calls; (iv) Earnings - expectations fell over the course of 23Q4, from SPX EPS growth expectations falling from 8.1% to 2.4%, which may have overshot to the downside creating a low bar for expectations. Further, the AI revenue & earnings boost may be rekindled

o TRADES - Long Tech and Cyclicals. Can hedge using rate-sensitive sectors as well as Credit.

· US MKT INTEL VIEW - Cautious. The SPX appears to have a near-term ceiling at 4,800 unless there is new information. What could that be? The highest probability catalysts are rate cuts and/or materially stronger than expected earnings. For earnings, the areas to watch are the Cyclical sectors given the high expectations for Tech. Keep an eye on bond yields. As Mislav highlights in yesterday's strategy note, bond yields are likely to struggle to move lower from here without a decline in GDP growth, and could reprice higher; in either case they move from tailwind to headwind for stocks (his full note is here and summarized below). If we do see a near-term pullback, it will be interesting to see how low markets can go in this environment as many clients have expressed interest in buying below current levels. A 5% pullback would equate to 4,545 in the SPX.

o Longer-term, I think that the economy is on solid footing without any imminent stress points. The aggregate Consumer remains on solid footing and corporations with public debt remain historically strong. Given the low level of leverage in the broader system a credit crunch seems unlikely especially considering the speed with which the Fed and Treasury move to assuage last year's banking crisis. So, absent an exogenous shock the highest probability negative catalyst is a Fed that eases less than expected or potentially not at all.

o For investors aligned with the Bull Case, you may consider moving tactically towards market-neutral and/or buying downside protection (my derivatives colleagues highlight hedging activity with 1-week to 1-month tenor, among the more popular trades).

Wolf Street howls about Canada real estate prices.

Apple (AAPL) , the object of my disaffection (and short), is lower in premarket trading based on Chinese discounting.

How quickly the bullish cabal has forgotten about China, formerly the engine of global economic growth:

I have recently raised my net short exposure, in part by shorting a basket of high-beta large tech.

This morning I will deliver my explanation why in an updated market outlook for 2024.