SPY ETF: I Closed The Short Positions (NYSEARCA:SPY)

I was publicly bearish on S&P 500 (NYSEARCA:SPY) since March 2022, with some tactical adjustments. The latest tactical adjustment was to play the market from the short side by selling naked call option on S&P 500 futures (SPX) with strikes at 4300. These options either expired worthless (Dec 22) or depreciated by 40-50% (Dec 23) since position initiation. I used the recent banking crisis to close these short positions.

First, I will explain my initial bearish thesis. Second, I will explain why closed the short bets, and my tactical plan for S&P 500 (SP500) going forward.

The initial short SPY thesis

As I previously explained in my articles (based on my research, part of which has been published in the Journal of Asset Management), the full bear markers have three phases. So, here is how I formed my bearish outlook for S&P 500:

Phase 1 selloff: the Fed-induced liquidity shock

I predicted that the Fed would be forced to aggressively increase interest rates to lower inflation, after making the major policy error by assuming that the post-pandemic inflationary spike would be transitory. This aggressive monetary policy tightening would cause the liquidity-based selloff and the burst of the bubbles: cryptocurrencies, meme stocks, big tech.

In this stage, the P/E valuation multiple contracts as the speculative positions are exited. In fact, the S&P 500 P/E ratio decreased from 37 to 21.

The Phase 1 selloff ends with the peak Fed hawkishness – or the expectations of the ending of the monetary policy tightening. What comes next?

Phase 2 selloff: Recession

The aggressive monetary policy tightening (Phase 2) generally causes a recession if the 10Y-3m curve inverts. Thus, the Phase 1 selloff transitions into the Phase 2 recessionary selloff.

During the recessionary selloff corporate earnings decrease and growth expectations get revised lower. The depth of the Phase 2 selloff depends on how deep and how long the recession is. The deeper and longer recessions cause deeper selloffs, while shallow and short recessions might not produce a selloff at all (if most of it has been priced-in during the Phase 1 selloff).

Thus, given the record inversion of the yield curve, I expected that the US economy would enter a deep and long recession, with S&P 500 earnings falling by 20%, which would put the S&P 500 at around the 2800 level, given the expected PE ratio of 16.

The recessionary selloff usually ends at the worst point of a recession, as the expectations of the new growth cycle increase, and usually with some kind of pro-growth fiscal/monetary stimulus policy mix.

Phase 3 selloff: Credit crunch

In extreme situations, as the economy enters a recession, the financial system can experience a severe credit crunch, usually due to overleverage, defaults and forced liquidations. This is the “Lehman moment” that requires a very strong policy response to defend the financial stability.

The current neutral thesis

My expectations were that the 2022 Fed-induced liquidity shock would case a recession in 2023, which justified the bearish view on S&P 500 – until Friday 10th, 2022, which was the beginning of the 2022 banking crisis with the SVB collapse.

On March 8th, the market predicted (based on Federal Funds futures) that the Fed would hike to 5.7% by October 2023, and possibly increase the pace of the monetary policy tightening to address the sticky services inflation. This supported the continuation of the Phase 1 selling, but more importantly ensured a very deep and long recession.

However, after the collapse of 3 US regional banks, the Federal Funds futures are currently pricing the 4.4% Federal Funds rate in October 2023, as the Chart below shows – the 1.3% Fed pivot from aggressive hiking to cutting.

In addition, the Fed might have to inject about $2 trillion in liquidity to protect the deposits at the vulnerable banks.

So, essentially, we skipped the Phase 2 and transitioned (at least temporarily) from Phase 1 directly to the policy response or the bottom of the Phase 3, which in-fact cause the bottom in stock prices.

Thus, at this point it does not make sense to be short the market. The only bullish thesis was that the Fed would pivot prematurely (before causing a recession), which would reinflate the previous tech bubble. This is in-fact becoming more likely now.

Going forward

I am transitioning from the bearish view to neutral, before assessing the next steps going forward.

S&P 500 has been in the range between 200wma and 100wma, which currently corresponds to the 3730-4200 levels.

The breakout above the 4200, with the fundamental support of the actual Fed pivot, and the assurance that the imminent recession has been avoided, is likely to push S&P 500 towards the 4800 level.

On the other hand, the Fed’s continuing focus on inflation would cause the repricing of the hawkish monetary policy expectations. Further, with some evidence of the weakening labor market, earnings downgrade, and the breakout below the 2730 level, S&P 500 would likely continue to drop towards the 2800 level.

At this point I am neutral, as more information is needed from the Fed next week. But, I am leaning more towards the bullish scenario.

SPY leadership

The ETF that tracks S&P 500 (SPY) is up by 1.37% YTD. The SPY sector performance analysis is important, since the bullish thesis is the re-inflation of the tech bubble.

In fact, in 2023 YTD, the SPY performance has been led by the Communication Services (XLC) and Technology (XLK) both up by around 13% YTD. The cyclical Consumer Discretionary Sector (XLY) is also up by 8.88%.

The SPY sector performance confirms that the bubble is reinflating, which supports the bullish thesis.