SPX: How to Interpret today's CPI Reaction - What today's Auction tells us about where SPX is likely heading after FOMC
Why today's market auction for CPI is so important for what comes ahead.
Note: This strategy piece will serve as the mid-month December strategy update and will also be simultaneously posted in my Patreon Community. This note will focus a bit more on the mechanics behind understanding price action beyond what the typical retail investor can see and assess.
Understanding today’s market auction is absolutely critical to understand the psychology behind how much buying (and selling) interest there is at these current market levels.
My Bi-Weekly Research Dashboard will be updated by Friday December 16th. This note is sent out ahead of schedule due to Inflation/FOMC events.
Members & Friends,
It is incredibly important to understand the markets’ auction today given that it was CPI day. If you’re not familiar with market auction, I am referring to the constant tug of war between buyers and sellers and to find equilibrium among supply and demand.
What most of you witnessed today after the CPI release was the following:
The market was exceptionally strong pre-market
The market saw a substantial fade around noon time
The market somewhat bounced back in the final hours of trading
On a Daily Chart, what I circled in yellow below is today’s daily candle.
But if you really think about it, what does this candlestick actually tell us?
My opinion: Not too much.
And most retail investors look at that same exact chart that I showed you.
What does this mean? They’re looking at incomplete information.
In order for you to make use of this candlestick, it would be far more helpful to understand the auction behind the levels that comprise of this candlestick.
Given that today was CPI, a day where large institutional market participants are likely to make their move, that’s precisely what we’ll be discussing in this note.
Today’s market auction paints a picture of who is participating when. Those who understand today’s auction will understand how Big Money thinks about these levels (and where we likely go next).
Something important happened right at 830am today (when CPI was released). We’re going to talk about it below.
First, some conclusions I wish to share.
At these levels and higher, I’m actively using this window as an opportunity to reduce equity positioning as I expect us to enter a regime of “inflation volatility” once CPI enters the 6-7% region. More on this below.
I know I’ve said this multiple times, but I’ll say it so that new members know where I stand: I will not be doing any buying at all at SPX > 4100. Any price region from 4100-4400 is where I will be selling in tranches on a systematic basis. I will let others take equity risk at that level. I will be selling almost a large portion of my personal equity positions if we get to the top of this range (anything remotely close to 4400).
Now that this market has reached my targets, I shift my focus to the downward EPS revisions that are likely to come in the first half of 2023. I view any impulsive visit into the upper end of 4220-4370 as a tactical shorting opportunity at the index level for the most enterprising investors as previously discussed. The higher the better, obviously. Risk-averse investors can simply reduce. No need to short. If the index drifts higher to that region, stay far away from the short. Today’s Pre-Market CPI market action is an example of an “impulsive” move, in case you needed an example.
The only catalyst that can change my opinion is if the Russia-Ukraine war comes to an end (unlikely IMO as I write this note). The war is responsible for the terminally high Food Prices inside the Inflation CPI. No ending in war? No ending in structurally high Food Prices. It’s that simple.
As I have covered my thoughts on SPX and China in previous posts (on Substack and Patreon), I will be mindfully making this note more concise and more conclusion-driven given that we are in a market environment that requires more timely commentary.
Just so that we’re on the same page, I will provide a recap of opinions shared.
When pessimism was at its peak in mid-October and early November, I indicated that a change in political balance at the White House via the Midterms would potentially spark a rally that would catch bears off guard (feel free to read what I published at the time in Oct).
As we raced towards 4100 in late November, I guarded against the thinking that these levels would have much durability - and 4100 turned out to be a swing high before retracing back to 3900.
With CPI November coming in at 7.1%, the price action of SPX once again will entice investors who do not have strong beliefs in their core views that this could be “the one” that finally marks the death of the bear market. I do not think so, and will explain my thinking soon. Further market strength to the 4200 (or more region) does not stand on a strong foundation, and with all things, prices that are built on a weak foundation will eventually find its way lower.
In my past note on SPX, even though I am fundamentally negative on markets, I did not see an opening yet to short the market at 4100 or 4000. These past several days should be a clear example of why measuring risk/reward ahead of time is such a valuable planning tool. I stay convinced that a print close to the upper end of my previously given range 4220-4370 (the upper end especially) will be a level that I can cautiously say that shorting has over a 50% probability of working. In all markets, any probability over 50% is an edge, however small it may be. Remember, only impulsive moves to that region should be faded. Any grind/slow drift higher is a clear signal to stay away from any short-selling.
I now want to shift the attention of this note to my thoughts on today. And even though today is only one day, paying close attention to market auction on critical macro events will give us an informed understanding of what markets will do in the coming weeks.
Allow me to provide some context first.
On Price Action
Most retail investors have the ability to see Time & Sales and Level 2 data in their brokerage. But most retail investors are unable to see the historical volumetric data that a specific ticker has completed over time, across different timeframes.
This image here, is what most retail investors are largely using for investing/trading tools
If you’ve been following my work for a long time, you might have noticed that I like to produce forecasts of what may happen rather than provide a narrative of what has already happened.
As a recent example, our saying 4100 was likely to be a local top for the specific timeframe of the past 2 weeks. But that this level did not provide enough margin of safety to yet be short.
Part of the reason I have been able to assess key levels for the index and specific companies is my fundamental and macro assessment. But the other reason is that I’m able to see the market through a different lens compared to most folks because I also use the same tools that Desk Traders use at the Sales & Trading depts at investment banks. In addition to using candle stick charts, they primarily evaluate trading data using a methodology called Orderflow. Orderflow is an entirely separate discipline of trading away from fundamental analysis that I will not get into too deeply inside our Community here because it’s an extremely time-consuming endeavor to understand/master. But for the purposes of understanding today’s specific market auction, I will use it to explain CPI day today.
Back to why this matters with an example below.
CPI was released at 830 am Eastern on Tuesday December 13th.
What I witnessed at 830am was that the large green candle that spiked the index was conducted with meager volume. In fact, the last 5 minute candle from yesterday’s close on December 12th had a similarly sized volume as the 5 minute candle at 830am CPI release.
Today’s market auction exactly at 830 am when CPI released - Volume was light for such a big macro event. In other words, this big pre-market spike was likely done by a small group of participants. This partially explains why the pre-market spike could not be sustained throughout the day.
Now, the fact that yesterday’s closing candles had just as large volume footprints as the 830am CPI release candle is quite an observation.
This seriously implies that there are certain market participants that either “correctly guessed” that inflation would come in lower, or that they knew ahead of time.
I’m not going to speculate on which is likely to be true, but the level of games being played across actual trading volume and financial media homepages is astounding.
This morning as I observed volume at 830am being low (and the index spiking), I simultaneously saw CNBC headlines with photos of happy traders celebrating the 7.1% inflation print.
Not saying that 4100 is the absolute top of the next several trading regions, but it is suffice to say that the marketing to lure retail investors to become the liquidity for institutions at 4100 worked again (this time is the SECOND time in the matter of weeks).
Bottom line opinion is this: the market makers and big players are using any opportunity they can to stir up liquidity to reduce into more favorable prices.
I cannot prove this - this is ONLY my opinion based on the data I observe.
Up next, my assessment of inflation.
On Inflation
I have assessed the Inflation report. And I am objectively not impressed by the data, regardless of how the SPX moves in relation to the data point. I am seeing authors on Substack, folks on Twitter, and Youtubers talk about the inflation report as if it marks a structural change in the inflation story.
This couldn’t be further from the truth, in my opinion. My assessment on inflation is in relation to the market movement. From a purely economic perspective, yes inflation coming down is good. Yes, I agree.
But the way it’s coming down, specifically the components inside the index, is not something that I think Buyside investors are likely celebrating today (we can see it in the volume as I discussed above).
At the risk of sounding polarizing, I believe that we are soon entering a regime of “inflation volatility”. In previous strategy reports (see Sept-Nov in Dropbox), I discussed the fact that the journey from 8% CPI to 7% would be very straight forward. However, I believe that CPI is likely to have volatile characteristics once it enters the 6% region. Meaning that it will be harder to predict, and that just like a “feather falling from the sky” any additional wind can blow it in an upward direction.
In short, the easiest gains for CPI have now been made. As we enter the 6% region (especially the lower part of 6%), I would be very careful in hoping for and expecting a straight descent into the 5% region without inflation volatility first.
Markets are pricing in a straight-line direction for inflation. I simply do not see this to be true, and here’s why.
November’s CPI Data table below
Most of the progress from falling CPI in November was made in Used Cars and Energy. While this is encouraging, the U.S. consumer cares far more about the Food component of the CPI. We can see that Food at Home and Food away from Home barely budged. In fact, Food away from Home even increased month-over-month.
Shelter, which is a lagging indicator, will surely come down in the foreseeable future. But this will come during a time when unemployment starts ticking up, and consumers are unable to take advantage of lower rents or housing values.
Also, Washington is sending Ukraine more military assistance and advanced weapons to further aggressively fend off Russia. It is clear that this conflict is not ending anytime soon, and that will keep a baseline to defend prices for Oil and Food inputs such as Wheat (an important ingredient in Bread - and its contribution to CPI).
Consumers are being stretched very thin in this environment, and while the markets may (temporarily) celebrate this inflation, Consumers are not.
For shorter-term timeframes, sure you can trade the journey from 4050 to potentially 4200+. But in longer-term timeframes, the state of the Consumer’s story will win over because that represents fundamentals. And I struggle to find positive aspects from this perspective.
In other words, in the context of today’s environment, CPI at 7.1% is no reason to add long-term equity exposure as the risks continue to outweigh the rewards on the intermediate term (using SPX 4100 as a proxy).
Can a trade exist here to extend further into 4200-4300? Sure. But I believe any auction into that region to be on borrowed time.
As a reminder, you are welcome to do anything you wish to do - please do not let me stop you from buying if that is your desire. I’m simply telling you what I am doing and my personal views.
On the Outlook, on FOMC tomorrow
I expect the Fed tomorrow to come in with a 50BP hike. I also expect them to say that they are encouraged by recent inflation data and will consider pausing rates shortly.
However, the true key to evaluating markets in Q1 and Q2 of 2023 is NOT how many BPs left they will go but HOW long these high rates will stay in place. In other words, the Street will soon move onto figure out what is the unemployment rate % that will cause the Fed to finally react. I personally think that rate will be between 5-6%. So, a lot more pain for the real economy is in store.
To use a metaphor to describe the situation, I view monetary policy & interest rates like oxygen in the environment. Lower rates and easy money provide oxygen and that allows companies to borrow cheap money and use debt to fuel growth.
The opposite is also true. Higher rates and tighter policy will slow down growth expectations and drain the scarce oxygen from the environment. In science, not every species will make it in this landscape. In economics, not every company (in terms of their share price) will be able to survive easily in this environment. While they themselves might “survive”, their equity value may (continue to) get decimated.
For this reason, I don’t think it matters what the Fed says tomorrow. Their hiking campaign of 2022 will soon have its impact in 2023 as monetary policy works on a lagged effect.
If we don’t get anything more hawkish than expectations, I do think that Institutions will continue to try to push equity levels to the 4100, 4200, and perhaps 4300 SPX levels. We do have seasonality in our favor with the usual “Santa Claus” rally and perhaps the “January effect”.
Should this materialize, I expect media narratives to follow suit and get more optimistic as prices go up. We’ll see figures like Tom Lee, Jim Cramer, and Cathie Wood come out and discuss Bitcoin going up to 100K or 500K if BTC makes a “10% bounce” to 20K-25K. Or they might come out and say SPX will go to 5000 or new highs since the Fed has succeeded in taming inflation.
These are extremely dangerous words that will lure retail back again into a trade that is unlikely to succeed in this environment. The optimistic tone and rising markets could be a multi-week process that has the ability to convince even the most focused minds. It is during this period of time when Bears completely throw in the towel, and that is precisely when danger for Bulls will be at its highest.
And that is my personal ultimate signal to heavily, heavily reduce into this nonsensical narrative.
I understand that this note is not filled with optimism, and it contrasts with how holiday spirits should be. And I apologize for this in advance.
But privately here, I wish to sugar code nothing, and tell you my objective conclusions based on my observations. My aim is to be largely directionally correct (as much as possible, of course - some things are outside my control).
It is this same methodology that has gotten us on the right side of the trade almost on every major swing high or low, and I’m not going to be changing my methodology even if markets trade higher.
My aim is not to constantly be perma bearish or bullish. My aim is to help you assess what comes next as objectively and as scientifically as possible.
Last note - I know that many of you may want to know is there any opportunity out there then for stock selection?
Eye TSLA 130-145, a major weekly Demand Zone from November 2020. I’ve never talked about Tesla in our community up until now. But now’s the time to put it on your watchlist.
If TSLA gets to this level, given a 2 year timeframe, I believe you will be happy. But when I say 2 years, I mean 2 years. I do not mean 2 months.
If you cannot hold TSLA for 2 years, then don’t participate in this idea. If you do not believe in Elon Musk (or do not agree with his way of doing things), also do not participate in this idea.
Similar to the China trade, investing in these themes requires not just an assessment of the fundamentals but also a belief in what you’re investing in. If you only are in it for the price gains, I can assure you that volatility will shake you out.
I’m already building a position in Tesla given that we never know if 130-145 will ever trade. I believe the Tesla “millionaires” of 2020 and 2021 are going to capitulate soon (if they haven’t yet already). Currently, Tesla’s Weekly RSI is a 32 - very close to 30 (the oversold level)
In my view, 130-145 TSLA represents a tremendous opportunity to enter a first tranche position (See definition of Tranches in October Report) in a name that has incredibly strong fundamentals for those who missed the 2020-2021 parabolic run. I’ll guide on second tranches for TSLA if necessary but at the very least I do think any visit into this region (or earlier) will see a bounce materialize first. Stocks don’t go up or down in straight lines. At 130-145 (or before), I see a high probability of TSLA staging a bounce.
How sustainable will that bounce be? I’ll assess if/when we get to that region.
On China: My views on China remain exactly the same as my previous note. Nothing material has changed since my last note.
Stay safe in markets, and good luck to us all in the FOMC tomorrow.
-Larry