Shorting a Vulnerable Market
One of the most profitable beliefs about the stock market that I’ve adopted is that there exists a distinction between the real world company and the common shares of that company. I like to think of these two, distinct entities as being tethered, sometimes loosely, and sometimes strongly together.
At times when the tether between the company and its traded shares is too loose, the price of the shares can travel very far away from the actual value of the company. I think we are approaching a point in time when the tether between the shares and the company is stretched to the max on the upside. A snapback of price down to true value is quickly coming.
One of the more prominent metrics that most traders will be familiar with is the Schiller PE which has only been higher than the current level of 40x for several months in the year 2000 before the .com crash. It would be improper speculation to simply take this as a reason by itself to be bearish on the market. Proper speculation requires one to dig deeper and to look for a reason why the market would be vulnerable now.
I think that reason is that passive investing is about to see a big slowdown in inflows.
As tech companies work AI into their workflows, they are seeing just how many employees they need to keep the same level of output. Big corporations have been, for months now, burning through compute tokens as they let their employees run unconstrained with AI to see how much they can produce. The employees that can produce the most output, document it, and present it to management get to keep their jobs.
This has been going on since this Spring. As CFOs get back from the lazy days of summer, they will be planning their budgets for next year. The inflation that has caused all of us to figure out how to do the same with less is now biting corporations as well. The belt tightening always hits them last because they have so much money that they can resist the inflation for longer than individuals.
It’s these employees that are getting let go that will cause a slowdown in inflows to passive ETFs in retirement accounts; no more job, no more contributions every paycheck. Mike Green has been publicly vocal for 6 years now that passive investing has an outsized influence on the price of the index as it plows money indiscriminately into the largest market cap companies.
This is exactly why SpaceX needed to get a huge valuation on a tiny sliver of shares that are allowed to be traded and why the rules are being changed to allow these shares to be included in a large index like the S&P 500 far quicker than has customarily been allowed.
Wall Street needs these shares to get inclusion so the price will be supported. We’ve gotten to the point in this cycle where professionals on Wall Street are gaming the system right out in the open for all to see. Signals like this indicate we are very close to the end of the up cycle in asset prices.
Another cycle that seems to be coming to an end is the credit cycle. Michael Howell has been making the podcast rounds lately telling us that the 65 month credit cycle is due to peak imminently.
I’ve attempted to read his book, Capital Wars, but it’s far too complex in it’s entirety for me to fully grasp. All I need to know is that when excess reserves in the banking system fall below a certain dollar amount at the end of the credit cycle, we get a liquidity crisis, and asset prices fall. We know we are nearing the end of the credit cycle because the first warnings that private credit was in trouble came when Tricolor defaulted. Private credit funds have been gating their products for months now.
The combination of a slowing passive inflow and an ending credit cycle leave the market vulnerable. We saw the first hint of that this week with the FOMC decision to hold and the response in the market was a hard sell to the lows of the week. We’ve got expanding new 52 week lows as the market has been stuck in a range for 2.5 months. My bet is that this range resolves to the downside.
I think the market is vulnerable, and I see a low risk opportunity to short in a good, low risk location, with the added benefit of a potential autumn crash whose signs I’ve been watching for several weeks now.
Here’s my trade plan for shorting the SPY. I’ve left plenty of room for a logical stop for the usual coordinated market intervention by the Fed and BOJ that could spike the SPY up to $750. That gives about 2.5% of risk at current prices around $740, but the reward is two times that risk if the SPY can get down anywhere near the 200dma on a good sell move down.
That’s my plan on the large portion of a short position, but I do want to see if this $760 is the real top, so I’d like to keep a small short on unless and until $757 is breached on the upside. That’s not a great risk to reward if my profit target is $700 so I’ll keep that portion of the position to maximum 1/3rd (in other words, only $33 of every $100 bet would have the higher $757 stop).
There are more indications that this range could resolve to the downside like heavy volume on the last good sell move and weak volume on the subsequent rally to here. There are also increasingly more frequent volume increases on red days lately. All these elements combine to give me enough evidence to hypothesize that shares are moving to weak hands.
The odd part about being short the market is that my position really has zero to do with how well or how poorly I think the companies underlying the shares are doing. I’m very eager to short because I’ve grown increasingly bearish this summer, but that has everything to do with the share price and nothing to do with the company value that supports the share price.
While I’m eager to see some downside in the market, I’m even more eager to finally do some buying of cheap shares. I’ve been eyeing assets that have been underinvested relative to others, and I’ve singled out pipelines in earlier notes.
I’ve also got some preliminary research that shows underinvestment in the accommodation industry over the past decade. I’m waiting for the Airbnb, $ABNB, report on Aug 6 to see if their fundamental momentum is sustaining. If so, I expect the stock to close strongly above $150 and then it will be a buy on weakness.
I’ve got tons of cash, and I’m doing the work to find out what I want to buy after this correction. If I’m stopped out of my SPY short, I’ll have a plan for exactly what I want to buy to reverse course. While I’m growing increasingly bearish, I’ll let the market tell me if I’m right or wrong.
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By: Patrick G. Full-time independent trader in Atlanta, GA.
Patrick G is a full-time trader. Worked for a decade in a money management firm as a trader for high net-worth individuals.
He invested his and his family’s net worth into gold and mining stocks before the Covid money printing. Gold and commodity runs of the past 3 years allowed Patrick to trade full-time due to his gains.
Past performance does not guarantee future results. Trading involves significant risk of loss, and individual results vary. Positions mentioned are the author’s own, disclosed for transparency — not individual investment advice.
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