How the market could break up to a blow-off top

Preface: Explaining our market timing models 

 

I outlined the intermediate-term bearish market structure exhibited by the market last week and U stand by those remarks (see What market structure tells us about where we are in the cycle). While this is not my base case, I am starting to warm to the scenario of an upside breakout to a blow-off top, followed by a market collapse soon afterwards. As they say, don’t short a dull market.
 

Reasons to be bullish

The most compelling reason to be bullish is the behavior of corporate insiders. This group of “smart investors” has been timely at spotting tactical market bottoms in the past year, and net insider buying surprisingly appeared last week.
 

 

I interpret this to mean that, barring an unexpected negative surprise, downside risk in stocks is limited and risk/reward is skewed to the upside. 

What’s more the Citi Panic/Euphoria Model is back in the panic zone. While this model is not useful for short-term trades, it nevertheless highlights the burden that the bears face.
 

In addition, market fears of a regional banking meltdown is spiking. While there is no apparent fundamental resolution of those fears on the horizon, the tactical good news is the KRW Regional Banking Index is falling while exhibiting a positive RSI divergence, which is constructive.
 

Looking beneath the hood, seasonally adjusted deposits at small banks have stabilized after the Silicon Valley Bank debacle. The downward pressure on regional banking shares is fear based and not fundamentally driven.
 

The debt ceiling game of chicken

In early March 2021, a Morning Consult/Politico poll found that nearly half of Republicans said they had heard “a lot” about the news that the Seuss estate had decided to stop selling six books it deemed had offensive imagery. That was a bigger share than had heard a lot about the $1.9 trillion dollar stimulus package enacted into law that very week.

 

The result was a vivid marker of how much the Republican Party had changed over the Trump era. Just a dozen years earlier, a much smaller stimulus package sparked the Tea Party movement that helped propel Republicans to a landslide victory in the 2010 midterm election. But in 2021 the right was so consumed by the purported cancellation of Dr. Seuss that it could barely muster any outrage about big government spending.

Unspeakable default?

Treasury will make noises to scare Congress into action, but it understands the importance of avoiding default and will prioritize debt payments once it runs out of headroom. Prioritization can support the Treasury market indefinitely, and even if that support is withdrawn the Fed stands ready to act as dealer of last resort.

Wang explained:

When Treasury reaches the ceiling limit and also runs out of accounting tricks, then it will not have enough money to meet all its obligations. But it will still have enough money to meet some of the obligations. Prior Administrations have claimed technical impossibility or illegality in prioritizing payments, but that was largely to exert political pressure on Congress. A 2016 Congressional report (h/t @AnalystDC) reveals the Obama Administration was working with the NY Fed to prioritize debt payments and social security payments during the 2013 debt ceiling episode. This is essentially a compromise that maintains pressure on Congress while limiting the potentially significant financial and humanitarian costs. The same policy choice will very likely be made this time around.

Payment prioritization would also raise the level of pressure on lawmakers without significantly denting the economy in the short term.

 

The biggest losers of prioritization are those who usually receive large government expenditures: the medical and defense industry. Both of which are well funded industries that can handle a liquidity squeeze (and send lobbyists to hasten Congressional action).

Some analysts have raised the risk that financial clearinghouses such as futures exchanges who ask for the deposit of T-Bills as margin collateral may struggle with holding defaulted Treasury securities. Consequently, they may raise margin requirements and spark a credit crunch cascade. Wang has an answer for that eventuality:

The Fed has the tools and motivation to backstop any Treasury market dislocation. When the Treasury market liquidity disappeared last March, the Fed cranked up the printers and bought $1 trillion of Treasuries over just 3 weeks. In the same way, FOMC transcripts show the Fed is prepared to 1) provide liquidity against defaulted Treasuries in its repo operations, 2) offer to swap out defaulted Treasuries for “clean” Treasuries with its securities lending program, and 3) and fire up the printers to purchase defaulted Treasuries outright. At the end of the day the Treasury market will be strongly supported as it was last March. The Fed will be the Treasury dealer of last resort.

There are other gimmicky backstops, such as legislation that allows the Treasury to mint a$1-trillion platinum coin and deposit it at the Fed.
 

Debt ceiling aftermath

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account.  Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long SPXL