Buy Sheep, Sell Deer

Was that it? Is it over just because Bill Ackman said so? Can we buy bonds now? Can the long-suffering Bondies finally get their mojo back? As my old friend Horst would say: "Buy sheep, und sell deer".

I don't know if 5% is the right number for defining a peak in bond yields, but it seems like a good place to start. If you recall the chart I presented in my "Getting Real" missive last month, it looks like there is at least a chance that real yields have gone up enough for the time being. I have massaged that chart below to depict it in a 'year over year' manner and it would appear that the expansion phase in real yields has peaked and is already on a downward trend.

U.S. 10Y Treasuries - Yr/Yr Change

Two things I noticed in this chart. One, the recent rise is one of the highest rates of change, but is not wildly so. There were years, 1984, 1995, & 2004, that were well over 2% expansion. Second, and most importantly, those peak rates of expansion came between recessions! Rapid expansions of the real rate of interest are a feature of a mid-cycle recovery environment, not a causal factor of imminent recessions. Maybe the soft landing scenario is still intact after all.

But the stock market is a dangerous place to be now. The economic backdrop is confusing and prone to extreme narrative swings. Geopolitics aside, the range of predictions is huge. Soft landing verbiage is now being challenged by renewed calls for a somewhat harder outcome, now that the rate structure has shifted so dramatically. The twin threats of higher-for-longer rates and possible global conflict have risk-takers running for cover. But I forecast an October low so I guess it's time to get busy and do some buying.

So what to buy? The easiest trade would be to buy the most beaten-down elements of the market. That points to Banks, Utilities, Pipelines, and Real Estate. This oscillation depicted below shows the relative prices of two groups - Utilities and Materials. It acts like an on/off switch for the economically sensitive vs defensive rotation. Utilities, and by extension Pipelines, are in the BUY zone. That fits with the hard landing story just fine. Materials look vulnerable to underperformance.

Utilities vs Materials ETFs

So what about the more economically sensitive components within interest sensitives, Banks and Real Estate? As long as the hard landing scenario remains on the table, those two groups should remain uninvestable. A trade -maybe - but those year-end rally fans out there should be careful not to fall in love. The recessionary forces of higher real rates and an inverted yield curve may have been blunted so far by dissaving and expansionary fiscal policy, but they are exacting a heavy toll on many small businesses and consumers. Discretionary spending is still decelerating. I'm still leaning toward a hard-landing scenario for now, despite the currently tight employment reports.

Any recovery in economically sensitive equities is not imminent unless we get a catalyst to break the Fed's inflation preoccupation. War in Israel isn't enough. Unless oil sees $120/bbl or higher on a larger regional conflict, energy isn't a worry. Gasoline prices in the U.S. are the same as forty years ago in real terms. Until the Fed sees enough of an employment decline to warrant easing, they will stay the course. Forget any chance of rotation for now - market leadership won't change without increased economic weakness that leads to easier money.

So my strategy is to buy a barbell. Buy the interest-sensitive 'defensives' on a valuation basis. They are the "sheep". You can probably buy the beaten-down Consumer Staples too. The Ozempic over-hype has left them for dead. Conversely, the "Magnificent Seven" play is starting to differentiate. Apple has a China problem, Tesla has a pricing problem, and Nvdia just has a valuation problem. These are the "deer" that should be sold.

That leaves Amazon and Microsoft. Google and Meta Their generative AI solutions and relative economic immunity are enough to keep them in leadership roles for now. They should trade up to the year-end bounce that is being made possible by the near-term peak in the 10-year. They are also among the strongest stocks technically and still have the relative earnings revisions necessary to keep their momentum. For now. Next year will be a different story.

October has lived up to its well-earned reputation as a bear-killer in the past and I see no difference this time. The S&P has survived the bond market rout relatively unscathed despite my fear-mongering about a repeat of the 1987 crash. Back then, the equity risk premium dropped sharply but bonds had been much higher in yield. Stocks only look 'overvalued' now when compared to the post-GFC environment of QE and financial repression by Central Banks. That era is over. An inflationary bias is 'a feature not a bug' of the next decade.

The recent cross-over may be just the beginning of stocks staying expensive to bonds. The 1980s were an environment when the inflation-hedging nature of nominal earnings awarded stocks with a valuation premium over fixed income and ERPs hovered around zero. Isn't that sort of what we have now?

S&P 500 Equity Risk Premium vs Bond Yield

Like a beachball underwater, yields have risen from the dead after being held down for years by the Fed and the ECB. Even moribund Japan is relaxing its grip on the long end of the curve. The post-GFC meddling by central banks has given way to a more volatile reaction function, sensitive to unpredictable cyclical forces. Inflation is back with a vengeance and labour unrest is palpable. This uncertainty has been exacerbated by political instability and societal polarization. Global constructs of cooperation and collaboration are breaking down daily. But Mr. Market is hanging in there for now.

Time to trade from the long side. I see some sheep just waiting to be bought.

Risk Model: 1/5 - Risk Off

The Model should be slow to react given the narrowness of the market rally that I see shaping up. If a wide swath of economically sensitive and financially deficient companies are left behind in any market bounce, the risk sentiment readings won't improve much. A bit of earnings optimism is at play this week but for a broad rally, we will need a signal that the December rate hike is off the table. Any hint of weakening data should be a salve for the wounded small caps and materials stocks as they respond to the possibility of an easier-than-expected Fed. I guessed right the last time when I said the Fed would raise the dot plot. I'm not so sure I can predict the timing of the next pivot. I guess we're all data-dependant now.

Just as the saying goes in commodity markets - the cure for high prices, is high prices. It can also be said of rising bond yields that the inflation problem is being solved by the bond market, not just the Fed. Real costs of debt have suddenly jumped onto the radar screens of many a company and the refinancing risk for companies has become a huge problem. This is a threat to any soft-landing story that may still be left rolling around in your head. Bonds have real value for the first time in years and that changes the game for many companies. Adjusting to the end of free money will have its costs.