Head Fake
Last week's sharp, post-election rally, although impressive in terms of price restoration, didn't impress me much. The accompanying narrative was too feeble. Bulls trumpeted that the "post election rally was on!" It quickly became clear to me on seeing the low volume market move, last week's move was a head fake. As yesterday's give-back illustrated, the market's exuberant response to the election had the bulls jumping the gun.
In what alternate universe did investors believe an election that created gridlock was a good thing? This thinking was actually trotted out as a positive for stocks by the perma-bulls and MAGA cheerleaders during last week's post-election bounce. In reality, the next two years of polarized bickering is a headwind for risk takers, as endless House of Representative attacks on the Trump administration will preoccupy lawmakers. Gridlock is not always good for markets.
I'm still firmly in the camp of the bears. I believe global stock markets can't rally sustainably until two major issues are dealt with - the FED's rate hikes and the Trade War.
As for the FED, it has been confidently driving in the rearview mirror of the economic car. They will need hard evidence of data deterioration before changing course. Last week saw a strong print on the PPI that was preceded by equally solid employment measures. This week will see a CPI measure that is likely to be in line with recent strong readings, as it predates the weakness in oil.
The Fed has painted itself into a data dependent corner, seemingly hell bent on four more rate hikes. Chair Powell is apparently oblivious to the signals being given off from the weak stock market. He is calculating that the economy has a higher tolerance for rising rates than does the stock market, and he may be right - at least for now. I'm eager to hear what he has to say tomorrow. Any dovishly interpreted comments will immediately translate into stock upside, but what do I know about the contents of his speech? With the election behind us and a bit of distance between Trump's rate badgering and Powell's talk, it could present the FED chair the right forum to soften his rhetoric.
This year, risk asset got over their skis in terms of valuations, as the FAANG momentum trade took centre stage. I pointed this out in September, noting the equity risk premium had shrunk to a minuscule 2.0%. Bonds were poised to send stocks a message and Powell triggered the stock sell-off with his "far from normal" comments about neutral rates.
With the continuance of strong earnings this quarter (albeit with a heavier than normal dose of negative guidance), stock valuations have corrected sufficiently to again represent solid value. Absent a recession, the S&P should produce EPS of $165- for next year. This equates to a forward multiple of 16.5X, a fair level given 3% rates. We just need the confidence to believe in those forward projections, and for that we need to see the FED downshift to neutral.
Over to you Jerome.
Meanwhile, a healthy rotational move from Growth/Momentum to Quality/GARP is ongoing. The narrow advance of the past six months needs to broaden out. But it's tricky here given the specific risks in a decelerating economy. Yesterday investors discovered a worm in their Apple, with the downward revision in iPhone sales. The flagship stocks are under distribution.
Incentives to reallocate from the once impervious FAANG stocks are starting to multiply. This will exaggerate the choppiness of the bottoming process, but will ultimately be healthy for market breadth.
As for the deepest "Value" segments, Cyclicals, Energy and Financials, U.S. dollar strength continues to depress these groups. Let's wait until the Copper/Gold ratio signals a truce in the war on hard assets being waged by King Dollar. And with growth decelerating globally and a heavy handed FED, those waiting for a dollar reversal are still whistling dixie.
And speaking of truces, good luck handicapping this one. Trump and Xi meet later this month. The best we can hope for is a halt to escalating tensions with a cease fire agreement. That alone might be sufficient for a temporary rally in risk assets, prompted by a pullback in the dollar. But what level of confidence can one have in the Tweet-House policymaker to make nice with his sworn enemy, China, when he continually pokes sticks in the eyes of supposed friends like France? With the sounds of Remembrance Day bagpipes still ringing in our ears from Sunday's emotional commemorations, Trump has taken to Twitter this morning to denigrate his allies with a callous comment designed to extract funding for NATO.
I have no words.
So go ahead and trade from the long side this week if you want. The Trade Truce bounce is based on hope, and as we all know, hope is not a strategy. The Trump Administration can't even get on the same page with Mnuchin and Kudlow pitted against Lighthizer and Navarro. And Trump changes his mind from day to day depending on the spin Fox News puts on the issue.
Expect more head fakes. I'm still waiting for the necessary preconditions of a neutral FED and and resumption of global growth before getting structurally bullish. I want the deck to be stacked in my favour. We aren't there yet.
Risk Model : 2/5 - Risk Off
A recovery last week's bounce in the XIUs has restored a degree of calm in the model. But without a subdued VXV reading (3 month volatility) I can't be anything but a smash and grab trader here. The AAII Bull/Bear ratio has become a wind vane indicator, swinging with every weekly VIX move. Consequently I am upping the signal variable, the daily moving average, from 30 week to 50 week (see below). This will dampen the swings from sentiment, and thereby raising the bar for a positive signal.
Oil
Now that the market has realized there is plenty of $70 oil, we can start sifting though the ashes of the sector, as prices retreat to the mid 50s. I'm in no rush to buy though, given the above comments about global growth. The stocks are cheap, but value is not a catalyst. On the positive side, the deck is getting stacked in the favour of the bullish case. GE selling a stake in Baker Hughes after dropping 30+% is typical of a bottoming mentality. Sharpen your pencils on the XEG, the seasonality begins to bottom mid December. Could be the trade of 2019.
