TILT!
You have to love the old-school pinball machine as a metaphor for the stock market. In our MBA lounge at York Business School, we had a couple of machines that provided fun stress relief, and I got in my share of games between lectures. I got pretty good at the game, mainly by a highly physical approach involving shaking the board more than my classmates. And just as in stock investing, there is a bit of skill in the playing but a fair degree of frustrating randomness, too. But watch out if you risk too much by shaking the machine too much—it will shut down!
I have been bullish on risk assets lately based on the soft landing I saw in Q3. Current data show that U.S. GDP is running above 3%, dashing the hopes of the perma-bears betting on a much harder outcome. Meanwhile, the Fed slavishly slows short-rate expectations by shifting focus from inflation to unemployment metrics. But that's now the problem. The bulls are so convinced of a 'have-your-cake-and-eat-it-too' scenario for the U.S. economy that they are rocking the stock market like a pinball machine. Watch out - it could be ready to tilt!
The bond market is starting to notice. TLT, the flagship long-term bond ETF (nicknamed the"Tilt"), is getting smoked here, and stocks are now pausing before the election and the Big Tech earnings. After the Goldilocks scenario that brought them to new highs, they now show signs of topping out. Earnings reports have been sufficiently good, but that influence has been widely priced. Every time I see a Tesla rally, I get nervous. Musk's EV plaything is still a car company valued like a tech start-up, and he continues to damage a brand that is quickly becoming a pariah among non-MAGATs. And Trump supporters don't buy Evs!
Correlations this negative between the SPY and the TLT are dangerous risk-off periods, as we have seen in the past.
SPY and TLT Correlation
Expect the pain in the bond market to worsen if there is a "Trump trade" outcome next week. The inflationary consequences of higher tariffs and loose tax policies are hugely destabilising for fixed-income investors. To be fair, promises aren't policies, but the direction of travel for inflation and deficits is higher under any political scenario I see. With yields at 3.70% in September, I called the bond market a "crowded trade". Like a Trump rally, the crowd now seems to be heading for the exits this week. And with good reason, given the uncertainty.
Stock markets serve at the pleasure of the bond market. The structural connection between the risk-free asset and those that price off them cannot be broken. That hasn't kept this market from trying, though. As recently as August of this year, a temporary sell-off in markets due to the Japan carry trade unwinding was a shot across the bow of the good ship Bull Market. But it came from a weaker U.S. currency as Japan finally tightened monetary policy after years of yield curve control. Japanese bonds were the weak asset class. Japanese equities were trashed before the authorities reversed their rhetoric.
This time, the U.S. dollar is strengthening into the election, sucking in global investors into the S&P and cushioning the blow of higher bond yields. As well, U.S. economic performance sticks out like a sore thumb when compared to the rest of the world, except for India (which nobody is talking about but me). So the cleanest, dirty shirt continues to get the benefit of the doubt in the minds of global equity investors.
The pain threshold is hard to determine. It could be a round number like 4.5%. However, it could be higher due to a compression in the risk premium underway. I have previously flagged the case for stock earnings yields (inverse price-earnings ratios) to drop below their bond equivalent as they did in the late '70s. Unsurprisingly, this period also saw rising inflation and high deficits. In stock/bond valuations, attractiveness is a relative feature, not absolute. When inflation threatens fixed income as a store of value, stocks offer some degree of protection.
But it does feel like investors have been shaking the machine a bit too vigorously lately, especially now that Trump is gaining ground in the polls.
I sure hope this isn't the table we will have to play over the next 4 years:
TILT!!!
Risk Model: 0/5 - Risk Off
We rarely have this situation: an overbought stock market, elevated volatility levels, whipsaw bearish investor sentiment, and weak copper/strong gold. But here it is—a zero for 5 risk level. The messages of the VXV and Gold reflect a clear and present danger to this market from a Red wave. Hedges are now on their max settings.
With the most consequential U.S. election in history hanging by a knife edge, it's hard to be anything but anxious.
And with inflation ebbing globally, central bankers dovish and a transformational story in U.S. technology to distract us from the weakness in the economy, it's easy to be fooled into thinking everything is cool despite the negatives. The Fed, reading a three-month-old data set, continues to force-feed risk-taking, mostly from money market refugees, by lowering rates. Since stocks are ultimately a monetary phenomenon, it all fits. But that doesn't mean I want to go "all in", either.
Excuse me for sitting on a pile of cash right now, but unlike pinball, I don't like playing a game I have no control over. Sell.
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