RIP Reflation?

Risk Model : 4/5 Beta up!

The Trump Dump

Investors sure have a short attention span. January's hopes of an immediate fiscal reflation have evaporated faster than a millennial's Snapchat.

The much ballyhooed Trump trade went like this: reflation-elation-frustration and last week... capitulation.

There is no doubt that Pres. Cheeto's election promises of regulatory removals, infrastructure spending and tax reforms created unrealistic expectations. This set up a major let-down as the facts could never live up the hype.

With the AHCA defeat as a catalyst, the resultant re-rotation to bonds, low-vol and especially growth stocks has been viciously abrupt and impossible to capture for most active managers.

What has now been presented to the investing public is a "second chance" opportunity to buy the reflation trade if they are brave enough - at an even lower relative valuation than last October.

As seen below, the speculative unwind was massive. Exhibit 'A' is the wholesale liquidation of longs in the crude square. I haven't seen a bigger whipsaw than this than the reversal at the time of Desert Storm in 1991. This time, thankfully, the demand fundamentals of are on far better footing and the inventory overhang is less onerous.

The Great Unwind

The Great Factor Whipsaw

The violent reversal in the Growth/Value factor ratio (shown below by the Growth/Value Russell ETFs) is one reason that active management has been challenged to consistently "beat"the market. The ten year growth stock bull market has been a function of the persistent slow growth, low interest rate environment. Apple, Amazon, Facebook and Google now account for over 25% of the QQQs. Value managers, Warren Buffet included, are despondently watching from the sidelines as passive money continues to chase large-cap growth, further crowding an already popular trade.

With a Trump victory, the promise of a lasting rotation into a rising rate, inflationary environment was a dangerous consensus, quickly priced into markets by late December. Within just a few weeks, on the back of major reset in the timeline for serious policy change, it has completely unravelled. Talk about jumping the gun!

Does this mean the reflation trade is dead?

We know the broader market is expensive - except for two areas, financials and resource. That's where significant upside in the market exists. The problem with this cyclical-value strategy is getting the timing right. Valuation without momentum is not a great strategy.

Currently, I am in a wait and see mode like most die-hard cyclical players after getting stopped-out in March. But an interesting clue may be at hand.

A massive breakout from a six year base in the Korean market is a serious positive. Korea is to the emerging markets what Germany is to the Eurozone- the engine of growth. If the commodity board can start to catch a bid on a rise in Asian economic growth we will be back in the reflation trade.

This week's political change in South Korea could serve to break the stalemate with the North and pave the way for a less corrupt and stagnant corporate culture. The market has sniffed this out and moved ahead of the events.

We certainly need more evidence than just a stock market rally. China is a bit of a wild card given the Shibor induced credit contraction now underway. Hopefully the PBC is just letting off steam now in preparation for goosing the economy ahead of this Fall's 19th National Congress.

The Risk Model is 4 out of 5, as the market has worked off an overbought condition and volatility and sentiment readings are placid. The missing component is the Copper/Gold ratio. Until Dr. Copper gets out of his funk, I'll be sitting on the sidelines... with a mitt full of blue tickets for resources.