Thought Bubble

Just saying it doesn't make it so. Or does it?

The trial balloons, floating around the virtual Jackson Hole convention hall like so many soapy bubbles, are starting to drive markets in a different direction. In his speech this Thursday, Jerome Powell is likely to announce a change in the Fed's tolerance for inflation. Such a seemingly small policy change from the guardian of the world's financial reserve currency may be enough to dramatically change market behavior. So far, it's working.

Inflation has been perceived as a nemesis for as long as I have been involved in financial markets. It was in the late 1970's that I felt the reality of inflation's wrath as a first time home buyer. From the time my wife and I decided to buy our first house to the actual closing, prices had escalated 30% and mortgage rates soared by 350 basis points. Fed Chairman Paul Volcker, finally had to choke the economy to a halt with rate hikes. Stocks sank and a recession quickly ensued.

I get why people of my age hate inflation.

For the current Fed Chair to now promote such a heretical policy seems astounding, and not a little bit desperate. But this is not 1979. The pandemic economy and it's attendant slack is like a string on which the monetary authorities globally have been pushing, with only marginal success so far. Housing has recovered, but travel, leisure and entertainment segments continue to lag. Demand is still weak and inflation is moribund.

The ability of the Fed to generate inflation is unfortunately not completely up to them. Fiscal stimulus, currently being punted back and forth in Washington's perennial political football game, needs to do it's part. The enormous unutilized pool of capital and labour will retard pricing power for many months to come. Technology continues to suppress prices by generating productivity enhancements. And a whole generation of investors are driving markets without any of the scar tissue of inflationary consequences to hold them back.

But here's the good news. Although expected inflation will move glacially, that is all that is needed to drive investment preferences. The bond markets, until yesterday, have been correctly pricing in a slowing in the economic backdrop. With the running out of the initial stimulus and the failed attempt at a second package, the bond markets rallied, testing earlier highs. But post their respective conventions, Democrats and Republicans alike will likely be eager to craft a stimulus package for use in their respective campaigns. Fiscal largess is now seen as a winning strategy - just ask Justin Trudeau and Boris Johnson. That too is inflation bullish.

I know what you are saying. How does a simple promise change everything? It doesn't change anything - except expectations. And sometimes that is all that is necessary for the market.

I'm anticipating the anticipations here - I know.

But that's what I do.

The post-Covid economy is drawing ever closer. Vaccine news flow is imminent. That will drive a very different set of expectations for markets in 2021. Stocks are about to look over the pandemic valley to a better future. And leadership will change quickly. Value stocks are now low-hanging fruit.

And what's the worst that can happen if you buy the value laggards? Another failed attempt a rotation, I guess. But when you have value stocks and cyclicals under performing by such a margin and so cheap, it seems like a good bet. It's a bit like increasing your bet in Blackjack when there are fewer face cards. You are less likely to bust. Wouldn't you buy just a little bit based on this chart?

Vanguard Value/Growth ETF Ratio

The psychological backdrop is favourable for a contrarian bet in favour of value and against growth. The capitulatory behaviour of the index construction team at Dow Jones is a prime example. Their removal of lagging value plays, Exxon, Raytheon and Pfizer for sexy growth plays, Salesforce, Amgen and Honeywell is a contrarian buy signal for the sleepy segments of the market. If the breadth of the market is to improve, a catch-up phase by the lagging sectors is a primary requirement.

And yesterday's reversals by Robinhood favs, AAPL and TSLA spoke volumes about the exhausted growth stocks. Just cutting the same pie into more slices doesn't make me want more of it. Sell the news.

August has seen more than its fair share of market inflection points, both positive and negative. My first experience was the famous low volume rally in August 1982. ( I seem like a historical fiction writer when I say that). Back then it was that same Paul Volcker, gingerly taking his foot off the monetary brake. It didn't seem like much at the time, but it changed everything. Markets never looked back, despite the calls for a retest.

So my thoughts today have all the substance behind them of a soap bubble. But that's sometimes what you need when you are cleaning up a mess like this. I'm calling for the rotation trade of the decade to start this week.

Risk Model: 3/5 - Risk On

The model has been correctly advising us to stay positive for some time now. The primary driver has been the persistently declining VXV - the volatility fear gauge. The drop is a function of the market's belief in a friendly Fed, combined with a gradually improving economy.

The AAII survey is now toying with a breakout after being the Grumpy Gus of the model for the entire rally. Importantly, if the rotation I talk about above is truly gonna take hold, we will need these guys to kick in to buy mode. They don't buy TSLA, so watch the XLF for a 'tell'. So far so good this week.

The Copper market has begun to respond to the improved growth expectations in China. Simultaneously the Gold market, overbought and extended, should continue to cool off as the real rate (inflation adjusted yields) bounces in step with rising long term Treasury yields. Bullish for value again!