January 2023 Update

Is Santa Claus real?

In the September update, we said that Santa was coming back this year for a variety of reasons. After a bout of mostly dampened volatility starting October 7th, the S&P 500 has seen the largest 4 day rally since 2022. And, over the course of the following 8 weeks, the S&P500 climbed a staggering 17% and closed up ~26% YoY. Readers have been able to capitalize on this rally by taking advantage of cheaply priced options as it was described in the October update.

Broken Record

As the mainstream narrative turns to H4L (higher for longer), many question why 2022 and 2023 turned out so differently. We want to point back to the 1968-82 period where markets went nowhere for 14 years but was down 70% on an inflation adjusted basis. After suffering a -27% drawdown in 2022, we are now just 0.20% short of ATH on a nominal basis. In reality, if we factor in inflation, this top is really down about 11% from the ATH set in January 2022. So we shouldn’t be too quick to draw conclusions about what made 2023 significantly different from 2022. It is easy to lose sight of the secular by reading too much into the cyclical.

Recession fears and slowdown in inflation

As of the time of writing, there are currently 7 rate cuts priced in for 2024. Given that it is an election year, we expect more fiscal stimulus to keep the economy growing robustly so we will fade the recession fears. But that does not translate to rates not getting cut. We believe that it is possible for the 10Y to find a floor around 3.50% before a continued climb as large amounts of fiscal stimulus is inflationary at its core.

The Establishment (not in some conspiratorial way)

The Democrats and Republicans are much more afraid of Trump2.0 than they were of Trump1.0. Trump1.0 was a fake populist: he didn’t really mean the things he said. He staffed his cabinet full of Goldman Sachs executives and generals and that was very bullish for the market. Trump2.0 has been disappointed (to put it lightly) by all these members of his previous administration. Most turned on him, whether in writing books, giving interviews, or testifying in court. And one thing that US presidents do have constitutional power over is the management of federal employees. Trump2.0 will try to drain the swamp and this poses a real existential risk to the way the American government works. In terms of monetary policy, it means that no matter how hot the economy runs, the Fed will not raise rates, and if there is a recession, the Fed will cut a lot. So we lean bearish on the USD, while US equities can see significant upside over the next 12mo as markets realize that there will be no rate hike no matter what.

Tensions over Taiwan will be lowered in the next 1-3 years

Come January 13th 2024, the DPP’s William Lai is likely to win the election with 35% of the vote. With such low levels of support, they don’t have a popular mandate for independence or to even continue a close relationship with the US. Moreover, President Xi meeting Biden in SF is a big tip of the hat to the US. From an economic perspective, China is where the US was in 2009-2011. China is facing a private sector deleveraging moment, they’re in a balance sheet recession, facing their own secular stagnation. The consumption component of their GDP equation is going to be permanently impaired for the next 5, maybe 10 years. How long did it take the US to resolve their secular stagnation? 2009 to 2017-20 depending on how you see it. As long as that is true, China will hesitate to play ball.

Outlook for January 2024

If the US equity market is 40T in market cap and it is up 26%, we expect a reinvestment of about 10T come the new year. Not all of it will come in on January 1st but this reinvestment flow should provide bullish momentum into mid January and maybe into mid February. Since we expect a lot of supportive flows to disappear around mid Jan, we think a retracement is likely to occur at that point in time. As long as vol continues to go up with the market, a sharp reversal is likely to occur.

Trade: Long downside vol/gamma near mid Jan or around ATH levels.

• 10-20% OTM March puts is probably the play (does not mean we are expecting them to go ITM)