BROS - Friday's Selloff Can Extend Next Week You Should Buy

2023-12-31 22:18:24 ET

Summary

• The stock market uncharacteristically sold off on Friday, raising eyebrows in our community and looking for an explanation.
• Traders selling on the last trading day of the year for tax-propelled profit taking, as their trades will be confirmed in 2024.
• Several factors, including Q4 earnings reports, inflation, and the Fed's rate-cutting decisions, could impact the market to the downside in Q1 2024.
• After Q1 2024, I will be back to a bullish posture.

No this is not the big correction I have been modeling

The way I see it, there is still plenty of excitement over the narrative that no further rate raises are expected going forward. There is also even more excitement over the Fed beginning to lower rates in 2024. The accepted wisdom is that the first rate cut will be put through this March. Yet this Friday, with that same narrative still reigning and no macroeconomic changes, the stock market sold off, not enough to miss the record-breaking 9th week of rallying, the longest spree in the S&P 500 since 1985. Just enough weakness in the indexes to raise my and my community's collective eyebrows. Longer term, the momentum is so strong that the rally can continue well into January, and then deal with some turbulence in February and then a correction. That positive outlook will reassert itself again. Next week will likely shake off selling before this coming Friday. I would venture that the selling impulse will likely only be strong enough to overpower buying for the first two days of the week. It is no accident that they are the last 2 days of the Santa Claus Rally. These days can move sharply one way or another because of the low trading volume inherent after the New Year revelry.

So what caused the selling?

One of our members had a wonderful insight, traders selling on the last trading day of the year will have that trade confirmed on the first day of trading in 2024. According to Investopedia, In March 2017, the SEC shortened the trade settlement period to T+2, where T is the date of the trade, and on the second day, 2 business days from T the stock is actually delivered to the new owner. So that explains Friday's surge. Some traders pulled the ripcord on Friday and can claim the sale in 2024.

Most people are more comfortable waiting for January 2024 to enact their trades and take that profit. Most years it is tax-loss selling, traders and investors will sell in early December to have tax-loss deduction for a reduction in taxes. If they sell in early December, they can buy that stock back in early January if they wish and not come under wash sale regulations. Again, referencing the wonderful resources at Investopedia, a wash sale prohibits investors from selling a security at a loss, buying the same security again, and then realizing those tax losses through a reduction in capital gains taxes. The wash-sale period occurs within 30 days of the transaction—30 days before the sale and 30 days after. Just to be clear, selling the stock before 30 days will create a capital gains event.

However, what happens in a bullish year like 2023? Most investors and traders have fantastic gains and would want to wait to take profits as soon as possible and not have to pay taxes this April but instead pay that tax in April 2025. On Friday that high volume pulse of sellers savvy and gutsy enough to rely on “T+2” to overpower enthusiastic buyers on the last day of the year. It follows that the chances are strong that profit-laden equity owners will surge selling on Tuesday and Wednesday taking down the Nasdaq and S&P 500 indexes meaningfully.

So if the shocking selling this past Friday continues Tuesday, What’s next?

I have been writing for months that I expect a correction in Q1, though not right now. Right now there is too much positivity and let me be clear there is good news to be positive about this year overall. I just think back, just like many times in years past, we have pulled forward a ton of that positivity. This happens quite a lot, sentiment can surge creating super strong momentum, where the index runs up vertically. This creates a situation in which market participants require perfection from stocks. So what are the hurdles?

• The Fed will not be lowering rates in March, even if we see signs of a slowing market. Remember Powell relies on Federal Government statistical sources. These are very backward-looking data reveals. Powell was late to the rate-raising party, he will be late for the rate-lowering party too.

• We will get a very fresh look at the economy with Q4 earnings reports. Leaving aside the sandbagging that tech companies indulge in. Also leaving aside how a market looking for perfection will react to that. There will be earnings results by consumer-facing companies that could mimic the trouble FedEx ( FDX ) and NIKE ( NKE ) reported. A slumping consumer might have an outsized effect on stocks.

• Inflation doesn’t have an On/Off switch, we could have some turbulence in those numbers. Even just a little jump could set off a market that has room only for perfection.

• We have an FOMC meeting in March, at some point, the Fed will have to hint that March rate cuts are just too soon. That will not be a fun day. Besides lowering rates is a fraught exercise. Little is written about how lowering rates could cause a recession. If rates are falling, then why would a company borrow to invest in an opportunity now? Why not wait for the next lowering of rates?

• The same could be for consumer spending, if the mortgage rate drops (and it has been dropping on its own) to 6.15% why not wait for 5.9%? Some economists don’t expect housing sales to be truly ignited until mortgage rates hit 5%. That level is going to be quite a while, even as rates accelerate lower. If that happens, we are talking recession and that isn't good for stock either. This delay in consumer and business decisions could start an avalanche of deflation. The Fed knows how to deal with inflation, it’s easy just to raise rates. What the Fed and everyone else should be terrified of is deflation. Sure lower food costs are wonderful but if hiring stops because no one wants to invest in the future, which is scant consolation. We have disinflation already, why would the Fed want to promote deflation. Japan kicked off deflation 30 years ago, it only just now achieved inflation, and bullish stock market. Powell sees this and doesn't want that.

• It might be hard to remember but there was a time when the Fed was trying to push up inflation. It wasn’t that many years ago, the last thing the Fed wants to do is kick off zero inflation all over again. I guess what I am saying is that I am quite convinced that the Fed is going to resist lowering rates in the first half of the year. My base case is no earlier than Q4.

• If the Fed does fess up to a much slower rate-lowering regime than the current accepted wisdom then there is a good chance that the 10-year rate will actually go up not down in the coming months. That will hurt stocks too.

In conclusion, there are several ways that Q1 2024 will be temporarily inhospitable for the bulls. The good news is, this sell-off is really very temporary. The truth is, at some point even if it is Q1 2025 the Fed will be lowering rates. Rates will likely come lower after a very mild retreat in economic, or a bit of flatness in economic results. That means elevated PE levels on lower interest rates. Then all it takes is for modest profit growth to give us 9% to 12% growth on the indexes. The good news is that stock picking will outperform the indexes. That is if you are good at picking stocks. I will be in a very different place in Q2, that is back to my comfortable place as a bull.

What if you are wrong? It won’t be the first time. I usually get things wrong when it is a short-term call

The call is about macroeconomic conditions over the next 4 months or so. One way I could be wrong is that the current rally just plateaus and corrects over time instead of falling. That would mean that earnings come in very strongly as current analysts are predicting. I think analysts will be adjusting numbers on the companies they follow, after Q4 guidance so we can see soon enough. I think the analysts will be adjusting earnings outlooks a bit lower.

My trades

So if we saw the overall market action of the Nasdaq and the S&P 500 in the red on Friday, what did we do? I was very tactical; first I trimmed my trading account down to 47% cash. I took a lot of small profits and losses that normally I would not. Cash is going to be a priority going into Q1. That means a lot of fast money trading and keeping losses on a very tight leash, I am going to try and end the day with as close to 50% cash as I can for the next 8 weeks. I started initial positions with Long Puts on ProShares UltraPro QQQ ( TQQQ ), and Direxion Daily S&P500 Bull 3X Shares ( SPXL ). I also have individual Long Puts on NVIDIA ( NVDA ), and Uber ( UBER ) - before you send me hate mail just look at the charts, both are topped out at $500 and $62ish, respectively. I feel differently about Arm Holdings ( ARM ). While I respect and would love to be able to get long NVDA, and UBER again, I find ARM problematic. The PE is 442 times, and with a market cap of $77B, it is absolutely not growing fast enough to deserve a 442 PE. ARM projects revenue at $3.02B. SoftBank (SFTBY) (SFTBF) owns about 90% of ARM. I suspect they will be tempted to sell this extreme valuation 26 X revenue and 442 PE is an extremely high valuation for a stock growing at 27% in earnings. I want to also add that there are alternatives to ARM RISC chip designs. I am also Long Call on VIX futures out to March and April at the 13, 13.5, and 14 strikes. I of course believe that the market is way too complacent. What did I do on the long side? Well, we’ve been trading Celsius (CELH) getting long at 49-50 and closing out at 53.5 to 55. If you use options this can be very rewarding. I thought I could do the same with Dutch Bros ( BROS ) so far it isn’t working, I’m down 15% on the Long Calls. I am keeping a short leash on losses so it might not be in the line-up for very much longer.

What happens if we do have selling?

Well, I am likely to start closing out my Put positions first, and probably not get on the long side until the close of trading on Tuesday. I will allocate no more than 20% of my portfolio cash to new equity options positions. What will I be buying? I guess you’ll have to wait for my next article to drop on Wednesday. Either I will have all kinds of excuses for why the market didn’t sell off, or I will find a way to drop a humble brag somewhere…

Good luck and Happy New Year!

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