Bottom Fishing

When active investors look to allocate capital to risk assets there are three conditions that need to met: a degree of certainty, relative attractiveness and positive momentum. Currently, the equity market, after a dismal first three quarters, possesses only only one of those attributes - attractive valuation. The chart below, from Morningstar Financial,, is the DFC model of their U.S. coverage universe. We seem to have achieved trough valuation.

Morningstar U.S. Coverage Price/Fair Value

But for a true market turnaround, the two remaining elements need to reverse. Uncertainty and momentum often go hand-in-hand and are dependant on a supportive monetary policy for their existence. The elevated volatility and negative price action this year are primarily a function of the restrictive policies being pursued by Central Banks the world over. Until recently, they have all been aligned, taking their cue from Federal Reserve Chairman, Jay Powell. That is about to change.

For the U.K., caught in the grip of an inflationary spiral and weakening economic economic conditions, the situation became untenable. The changed leadership revealed new policies designed to address a crisis of confidence generated a flash crash in their currency and fixed income markets. As a result, the Bank of England was forced to relax their policy stance abruptly They blinked.

Down under, with an economy more reliant on Asia than the U.S. juggernaut, today's rate hike by the RBA unexpectedly undershot market expectations by 25 bps, reflecting their growing concern about the health of the housing market. They blinked too.

For the U.S. market, the data necessary for the Fed to similarly undershoot expectations is still being held in abeyance pending the release of 'bad' data. I have posited that 'bad news is good news' for a true market bottom to be made. A relaxation of the strident tone emanating from the Federal Reserve will go a long way to reducing uncertainty and could result in a resumption of positive momentum - thus fulfilling the remaining two preconditions for a true turnaround and the birth of a new market cycle. Good luck predicting that point in time exactly.

But the good news for long term investors is - you don't need to wait and worry. You just need to go fishing - bottom fishing.

Most bear markets (perhaps except 2020 one of the shortest on record) last less than a year. So here we sit three months from the anniversary of the prior market peak, with an undervalued, oversold market and the preconditions for a turnaround shaping up should weak data arrive.

The Fed has been late, tightening into declining leading indicators, as they become ever more confident by what they are seeing in their rear-view mirror of trailing inflation and employment data. Just as they were surprised by the onset of inflation, it makes sense that they will be similarly taken aback by it's decline over the next year. With the help of a soaring Greenback, they are ahead of the curve in my view and they don't even know it.

Investors who are still waiting for uncertainty to drop seem to want a light bulb to flash green before acting more aggressively. But there are already enough stocks to buy. Financials, especially lifecos for example, exhibit trough valuations, as rising bond yields and the end of peak lending conditions have combined to generate undue pessimism and hence undervaluation. In a year both those elements will have reversed. The future expectations of investors (remember what I preach) will inflect at some point and the cheapness of these equities will drive them higher. The bad news is 'priced in', especially with many dividend rich equities. So why not buy them now and wait?

This is not a 'call' for a bottom in the broad averages. Far from it. There is a earnings driven bear market yet to go though. Many stocks have yet to see ultimate lows as the inverted curve and sharp tightening in financial conditions work their evil magic on the economy. The volatility in currency, bond and commodity markets is a major generator of uncertainty and it isn't over yet.

I'm watching the copper/gold ratio to turn around in order to become more optimistic on economically sensitive equities. I don't see that for a few months yet. There is some seriously 'bad news' left to go for them. But that future low will involve fewer participants, thereby generating a breadth and volume 'non-con' typical of ultimate market bottoms .

So if you are waiting for a bell to ring I have news for you - it doesn't work like that. Just as I was early getting off the runaway growth stock mania last year, I'm willing to be early and more optimistic for quality stocks - those with fortress balance sheets, wide moats and non-cyclical business models. I postulated earlier this year that the economy would do better than the markets this year. I'm prepared to reverse that prediction for the next six to twelve months.

So if you have deep pockets and patience, what are you waiting for? Go fish.

Risk Model: 3/5 - Risk On

It appears as if the volatility event I was concerned about didn't happen. With twin catalysts - the spike in the U.S. dollar and the Nord Stream sabotage - the risk markets managed to survived their end-of-quarter shake-out by generating a fresh low, but with lower volatility than seen at June's bottom (chart below). I take that to mean an all-clear signal has been blown for now. A short term bounce has begun. The prerequisite data for a true Fed pivot has yet to arrive, especially on employment. Friday's NFP is key, but labour markets will be agonizingly slow to turn, given the structural declines we have experienced due to aging demographics and lingering Covid phobias.

Many unpriced risks still lurk in the background and anybody who says we are about to resume a true-blue bull market is playing with fire. Primary among these risks is the still-inverted yield curve. 'Nuff said.

The copper/gold indicator has yet to confirm any sort of economic recovery. The extremes of pessimism, level of technical 'oversoldness' and the build up of shorts and cash all argue for a bottom-fish environment that generates periodic buying of low-vol, quality equities. This supports the notion of a rolling-bottom for risk assets with outperformance from less economically sensitive sectors for now.

Copper/gold is still on a sell signal and a long way from healthy - hence my cautious approach to this market turnaround. With just a bit more work, copper could find its footing should the Fed pivot to a less restrictive stance over the coming months and generate a tradable low as it has done in prior periods. The resumption of positive growth could see copper return to favour, but it seems far too soon for that. More 'right shoulder' work is needed.