Passing the Baton

Risk Model: 3 out of 5

A tepidly bullish reading with a disappointing print from last week's AAII Bull/Bear indicator. Momentum is stuck in a negative rut, with the RSI firmly below 50. The Vix and 200 day moving average are ok and the Copper/Gold ratio has re-accelerated nicely. The backdrop for a rally is there but there is no catalyst. Yellen's testimony tomorrow and the upcoming earnings season my change that.

Baton Pass Needed!

The long awaited final phase of the market cycle is tantalizingly close to unfolding. With multiple inter-market signals flashing last week, asset leadership is beginning to shift. Pro-growth policies combined with super easy money are about to finally yield results. However, the hand-off to a more cyclically oriented market is still in it's transition zone. We can see this in the lack of conviction from the AAII Bulls.

I like to call the AAII survey group the "Home Gamers", to steal from Jim Cramer. The survey results taken last week show an unusually high number of "Neutrals". Forty percent of members surveyed were in this group, compared to the long term median of thirty-one. Why is this?

At a major inflection point, the market does the thing that makes the most people wrong. If you have been bullish the last nine months, you probably have been happily nestled in the winning trades, Low Vol or large-cap Tech. When the market suddenly shifts, as it recently did this past quarter-end, you will be unwilling to give up without a fight. Investors naturally cling to their winners too long.

Global data continues to gradually improve and economic surprise is set to inflect positively as we lap easier comps. China is setting up for the next 5 year plan this fall after a snugging of policy. Eurozone bank bail-outs are gradually de-risking the system as credit sensitives lead that recovery. The Bund back-up has been orderly unlike the U.S. 2013 taper-tantrum panic.

A rising rate environment has begun to reassert itself, but we still have a long way to go. I will not be completely convinced until the U.S. 10 yr takes out the 2.65% level last seen in December's Trump-bump rate rally. The key variables for me continue to be the U.S./German 10 year spread and the 2s-10s curve shape. Both are confirming the pro-cyclical shift but I'd like to see more.

Unfortunately, the failure of Brent to hold $50 and a sharp drop in Gold, means the inflation trade is frustratingly problematic so this recent yield back-up is probably enough for now.

I covered my FAANG shorts last week, based on the violence of the downward move. There should be a bit of to-ing and fro-ing here as the entrenched leadership group cedes its dominance. I'm looking to re-enter my mega-cap Tech shorts post earnings though.

It will likely take more concerted efforts from the Risk-off crowd (are they still called bears?) before a durable and consistent leadership change asserts itself. A good, healthy Fall correction, combined with a Growth/Value rotation, would go a long way towards convincing the Home Gamers to join the cyclical party. They have run a great leg in this historically long market relay race. Time to pass the baton.

Till then, summer doldrums will dominate.

Below is a chart of the BMO low vol ETF (ZLB) relative to the XIU, a proxy for the TSX. This product has been very popular in their retail system over the past few years gather over $1B in assets. Notice how the relative performance broke down following the U.S. election, then regained it's strength in Q2.

A similar chart of the equivalent low vol U.S. ETF relative to the S&P shows that the downtrend has recently resumed, confirming a bearish trend.

With this compelling template from south of the border, I believe the Canadian low vol ETF products will soon begin to underperform the broader market. Check out the holdings on the BMO website for ZLB. It's easy to see that there isn't a cyclical or high beta name to be found. Now that the Bank of Canada has signaled it's intention to join the rate raising Federal Reserve, defensives and interest sensitives are highly vulnerable.

Given how crowded the low vol trade is, this is gonna hurt.