Another One Bites the Dust

The bear market firing squad claimed another victim last week as the once-invincible Amazon was punished for perceived 'weak' results. Cost increases and labour unrest were putatively offered as the cause, but we really know that risk assets are still acting poorly and investors just need a 'reason' to sell. And this report reflected events prior to the impending rate hikes that will further damage consumer spending. My recent theory of a market rally based on stronger earnings seems, to be charitable, speculative. Mea Culpa.

Now that earnings reports have mostly come and gone, we lack a near-term catalyst. With markets limping towards the telegraphed increase in Fed-administered rates tomorrow, worried investors are scattering like cockroaches under a light. With sentiment at levels last seen during the massive uncertainties that followed the '20 declaration of a global pandemic and an existential financial implosion from the '08 credit crunch, we are now primed for a rally out of the gloom. But what will entice investors to re-engage with risk assets?

Valuation, although more supportive than the lofty levels of last year, the 18X forward level for the S&P500 is still generous by historical standards. To nobody's surprise, the bulk of the price damage has been in the non-earning tech sector where valuations are mostly an exercise in dart-throwing. Cathy Woods' ARK holdings look like the radioactive core of a melted nuclear reactor. But recent sell-down of inexpensive financials, once deemed to be beneficiaries of a rising rate environment, shows that cheap isn't enough. Chalk that up to multiplying recession fears that make forward earnings estimates look increasingly suspect.

The incoming inflation data are now critical to the bullish argument. There has rarely been a situation where the 'bad news is good news' theory is more appropriate to one's investment confidence. If we get any relief from the current price spiral, markets will breathe a sigh of relief as fears of a Fed-engineered hard landing will recede. Inflation dynamics are difficult to forecast, but at least we have the mechanical improvement of base effects directly ahead of us. Will that highly anticipated effect be enough to appease the inflationists?

Probably not, without a concomitant downshifts in demand, especially in the critically important domestic U.S. economy. American exceptionalism has never been more appropriate a descriptor of the current situation. Europe is in a war and China is behind the Covid curve, reluctant to bite the bullet by reversing their failing shut-down gambit and moribund property markets. As the soaring greenback has been demonstrating recently, the U.S. markets are being rewarded with a massive vote of confidence from risk-averse investors. The double-whammy of 'Zero Covid' China and Ukraine, and their effects on global supply, are immune to the limited Fed policy toolkit. That prevents me from declaring the bear market over until the weakening global economy begins to overwhelm the seemingly Teflon-coated U.S. consumer and a more subdued inflation outlook prevails.

We have the sentiment preconditions but not the catalyst for a relief rally. The more news like we got last week from the 'Bezos Behemoth' the better. Meanwhile, the bear market in bonds is shifting to the front end of the curve as the 10-year is bumping up against resistance at 3%. Any further upside to the long end seems to need an economic re-acceleration story that looks increasingly specious. I don't like bonds, but I think the 10-year bond is a buy here.

Interestingly, year-to-date, the Treasury ETF -TLT - has underperformed its high-yield counterpart - HYG (chart below). This would imply that inflation premiums are being restored to bonds but credit conditions remain supportive. This is what a soft landing looks like - à-la 1994. - as I argued a couple of weeks ago.

So once we get the inflation news we need to dial down the rampant Fed phobia, I look for a sharp recovery on which nimble traders can capitalize. It could come at any time now. For more patient investors, there are now plenty of good companies that have inflation-resistant cash flows and strong returns of capital to shareholders. Like a good doctor, I'm recommending an Apple a day to keep the bear market away.

Risk Model: 1/5 - Risk Off

No joy in Mudville here. The damaging effects of a spike in volatility combined with a weakening Copper/Gold ratio have added to the gloom. As I recently showed, the ratio of Spot to 3mo CBOE Volatility is in a zone usually associated with market lows. Like I said last week - they don't ring a bell at the bottom, but this measure is sounding a buy signal. A bit more patience than normal is also prudent but don't be shy to at least bottom-fish a few favourites here.