Drone On

Last week, I talked about the need for a catalyst to create the long overdue correction. You would think last week's extrajudicial drone strike on a senior Iranian general would have fit the bill.

Somebody please tell the stock market.

Although it is drifting lower this morning after yesterday's positive reversal, there is a lack of conviction in the sell-off. Hardly a tradable market either way.

I guess this all makes sense when seen through the lens of U.S. domestic politics. To portray yourself as a strong leader in times of crisis, you actually need one. Replacing a proxy war with a real one seems to fit the bill. Now that the U.S./China tiff has receded temporarily, Donald Trump is trying a different approach in his efforts to deflect voter attention from his domestic failings. And a shooting war that targets real people istead of the global PMIs suits the Trumpster nicely.

That way, the economy isn't what gets stuffed into a body bag. It also keeps the stock market party going too. Too cynical for you? Wait til he takes the election rally stage again - you'll see.

Being of a certain age, I can vividly remember when the threat of Middle-East conflict regularly created bearish sell-offs. In the early 1980's, lead stories showing long lines at the pumps dominated the nightly news. Wall street was always hyper sensitive to a replay of the 1974 oil embargo. This week's feeble $3 jump in crude is testament to just how complacent traders have become - and with good reason.

Now that the fracking revolution has temporarily turned America into a net exporter, the collateral damage of higher oil prices on the U.S. economy is completely immunized. The U.S. economy is fully hedged. Bring on the $70 crude, says many a Texas Republican.

It also helps that most of the guys who remember those days are retired bloggers with too much time on their hands.

So under the heading of bad news is good news, the markets quickly stabilized yesterday, reflecting a measured market response to the attack. A 'flight to safety rally' in bonds created lower risk free rates, and TINA bids showed up instantly, as if on cue.

I hate this market. But it just won't give up.

Sideways is the new down, I guess.

One critically important thing did result from the crisis. The rotation to more cyclical and economically sensitive assets that has started to emerge recently, abruptly reversed. The Copper/Gold ratio was clobbered, the yield curve bullishly flattened and the Growth/Value ratio broke out decisively. Yesterday's reversal rally was dominated by the same tired leadership, Growth.

Now, we all know the last thing that a bull market does before it finishes going up, is that it makes a new high. Usually, a new high that is full of non-confirmations. Like poor volume. Let's go to the tape. Hmmm....

Growth ETF: 2017-2020

The volume confirmation necessary to support a move to new highs has been completely absent. The 2018 rally became vulnerable to a set-back when the Chaikin Money Flow indicator ( an indicator that measures the 'volume strength' of a given price move) is failing to confirm the new highs. Here we go again.

As well, the flows into mutual funds and ETFs (see below) have been pathetic recently. It's like a great party where everyone tries to leave early. Although sentiment improved after the trade deal was announced, nobody actually risked any cash. A new high based on a lack of selling should never be confused with a bull market.

S&P 500 & Equity Fund Flows - 2001-2019

Corporate buybacks are starting to wane after peaking early last year (below). The pressure from rising input costs, notably labour, is likely to curtail the aggressive balance sheet re-leveraging that has been partially responsible for the stock market resiliency. Now with an 18+ PE and a lack of demonstrable earnings growth, the stock market is well ahead of itself. Lacking any catalyst for increased risk taking, retail investors are unlikely to fill that gap.

Share Buybacks - S&P 500

So the case for a major correction is building, but is not likely to come from bad news. The mechanism for correction this bull market can only come from good news - news that leads to higher rates and a more hawkish tone from central banks. Today's positive surprise on the Non-Manufacturing ISM is more evidence that the economy is not the problem. The stimulative effects from last year's rate cuts are still in front of us. There is still a data valley that the market has to look over, but that's how it has always been after any significant reflation by central banks.

So I go back to my story of last week, "Get Real". The more likely environment for a correction one characterized by a lessening of geopolitical tensions combined with a ex-U.S. economic recovery, lead by China. That scenario is still on the table, should the events of the last week turn out to be contained to a regional event, however filled with human tragedy. The cold hearted economy should survive relatively unscathed.

Until we get a durable and co-ordinated economic expansion, the old bull market should continue to drone on.

Risk Model: 4/5 - Risk On

As I noted above, the weakening of copper prices combined with a flare-off move in gold prices has severely damaged this component of the model. The rotational move to hard assets was just getting going before being derailed by the Iranian crisis. Although the move higher by gold is justified, it needs to abate for the rotational trade to continue. Regaining the 50 DMA is now a priority.

Copper:Gold Ratio