Breakaway

Readers will know I am a big fan of cycling, both as a participant and a viewer. I'm now glued to the Tour de France coverage (flobikes.com), closely following our top Canadian, Mike Woods. His gritty performance in Stage 14 earned him the coveted polka-dot jersey for best rider in the mountains. Although he lost it a day later, he remains only the second Canadian rider to wear 'dots' after Alex Steida accomplished the feat in 1986.

Team tactics of a Grand Tour bike race usually include a 'breakaway'. This is a common tactic used by many teams to establish a rider in an advanced group, usually 3 to 5 riders, who launch ahead early in the bunch and try to hang on ahead of the Peloton. This year's TDF has seen its fair share of breakaways some successful, some failing. Stage 4 was gripping, as an exhausted breakaway rider was caught and passed 150m from the finish line by veteran Mark Cavendish. It was a thrilling end to the race that left many participants exhausted.

I have a question about this market. Will anyone try a breakaway?

The search for a 'tradable top' for the stock market, so extended and now exhausted, continues. A series of mini-rotations from growth/interest-sensitive to value/cyclical sectors is creating an ever-rising index level that is forestalling the usual 3-7 % corrections that are typical of bull markets. But this has been anything but a typical bull market.

TINA and FOMO have more lives than a cat! A more substantial corrective phase has been put on hold due to a uber-dovish Fed. These rotational movements are similar to being in a peloton, where riders trade places at the front, allowing those behind to rest and recuperate. The finish line seems kilometers away.

Could we see a definitive breakaway from a stock group that will signal the end of the rally? That is an open question right now. I'm watching the U.S. banks closely. They have recently consolidated their gains from earlier this year, prompted by a surprising bond market rally that flattened the yield curve just as portfolio managers were positioning for the opposite. This morning they reported numbers that justified their year-to-date moves to new highs, but the tepid reaction of the share prices speaks to the market's cautious mood regarding the economic outlook.

The death knell of this market will be, as I have maintained since it started, an unanticipated reversal of the monetary conditions, the ones that have underwritten this astonishing rise in asset prices. For that to occur, we must first see the re-emergence of leadership from those equities that benefit from the cyclical upswing of economic expansion. As long as this tug-of-war between growth and value continues, the markets will stay bid.

This summer's upwardly biased drift has been a low-volatility nothing-burger of a market. No fireworks, just plodding progress higher. Other than a few notable casualties in the meme stock and crypto space, and a growing malaise in small-cap and emerging markets, most punters are complacently happy. If it ain't broke, don't fix it. I'm sitting it out but I'm not shorting it either.

The lagging banks' problem is that they are stuffed with deposits and starved for loans. The lack of loan growth is both temporary and structural. In the short run, massive financial backstopping by governments has negated the credit needs of consumers who would have maxed out their credit cards as in past recessions. Longer-term, their customers are now reluctant to borrow. Because of the specificity of the Covid shutdowns, many companies were not directly impacted. In fact, they benefitted from expanding cash flows that exceeded their reduced CAPEX, making loans (other than for stock buy-backs) unnecessary. Lending has suffered accordingly and banks are now overcapitalized. Coming out of a recession, I have never seen this level of financial solvency for the banking system. This time truly is different!

But fear not, the transition to a more tangible expansion with increased capital intensity is tantalizingly close. The half-empty car lots and sky-high used car prices say it all too well. Inventories are now at rock-bottom levels reflecting last year's unprecedented demand and supply shocks to the global system (see chart). Now that demand has raced ahead of supply, inflationary bottlenecks have shifted pricing power to producers from consumers. From semiconductors to semi-trucks, and everything in between, there is a shortage. For banks, that's a bullish portent of future loan growth.

Total Business: Inventory/Sales

So what if the market is fixated on "disappointing" second-quarter earnings that reflect a short-term peak for net interest margins and trading revenues? In a few short months, banks will be eying a loan growth environment that only comes along once a cycle. Corporations, eager to advance their sales fulfillment, are finally ramping up plans for spending on plant and equipment. And consumers, pivoting from their reliance on government stimulus cheques, are soon likely to return to their more normal 'spend-and-borrow' patterns of the past. Loan officers - enjoy your summer because you'll be busy come September.

So the peloton of stocks will stay bunched up a bit longer as investors focus more on their golf games than their portfolio gains. But come this fall, or perhaps sooner, I expect a 'bank breakaway' to shake the race up. They may not finish first in the end, but I'm watching for their attack to signal the next phase of the bull market.

Risk Model: 1/5 - Risk Off

The overbought readings from % Above 200 Dma and RSI have not allowed for a low-risk entry since Mid-May. Now we are seeing small cracks in the confidence (over-confidence?) in the bull case for risk. The AAII bullish levels have dropped below the signal line after rising to three-year highs in Q1 but remain elevated when viewed from a longer-term perspective (see chart). This is a smoothed moving average line that shows just how far the sentiment towards expected stock performance has traveled over the past year and a bit. Contrarians are taking this as evidence to be cautious here.

But from a positioning and flow standpoint, there has not been a huge move into equities and out of bonds since the Covid crisis began. The chart below courtesy of Fidelity, via David Morrison and Stuart Smith of Eight Capital, demonstrates how much farther we need to go to equilibrate the asset mix derisking that has taken place in portfolios. The blue bars are equity flows. The flows of funds into low-risk assets have dwarfed the equity equivalent. That is fuel for a massive shift should continue to sentiment shift towards equities. This bull market is far from over even if it does correct!

Mutual Fund and ETF Flows