Buy The Dip?

What dip?

After looking for a short-term correction for weeks now, I find myself nonplussed by the recent action in the market averages. This looks like another 'If you blink you miss it' pullback. At last night's close, we were a grand total of 3% off all-time highs. Really? That's all you got?

But the action is understandable given the lack of a dominant central narrative. The current policy set has generated an understandable sense of confusion. The shocking move of long-dated interest rates to six-month lows has generated a large red flag. Is the bond market saying that the Delta variant will cause the embryonic economic restart to fail? Is the Fed's QE program distorting the normal price discovery mechanism, thus fooling us into over-reacting to the message of lower yields? Has the risk preference of the investing public permanently been permanently lowered by a combination of demographics and investment PTSD from the multiple crises of the past 25 years? All three seem to be at work to frighten investors away.

Riding to the rescue is our favourite investor, 'TINA', who is already grabbing the blue 'buy' tickets today. But that also makes sense. Monetary conditions just got easier (lower rates) and stocks are a monetary phenomenon. So the Pavlovian dip buyers are out in force today. But which stocks do you buy?

What I think the market 'should' do is irrelevant. All I am trying to do is anticipate what other people are going to anticipate before they do it. It's a reversal of the Yogi Berra saying: If people want to come to the ballpark, you can't stop 'em. So the buyers are out in force this morning - sort of an early version of Tuesday at 11.

But if you look under the hood of this market, the best opportunities ahaven't been in timing the 'market', they are in timing the 'rotations' from quality/growth to cyclical/value styles. So let's see where we are in that context.

I have recently argued that the cyclical trade had gotten 'over its skis' recently. I sold my commodity stocks in May. Now , the concern over the path of the recovery due to the Delta surge, combined with a growing conviction that supply bottlenecks are transitory (Lumber I'm looking at you) has curbed that enthusiasm. That is the opportunity I see here.

Thinking two steps ahead has been the way to create excess profits, especially in this bull market. The 'porpoising' action of growth and value stocks is likely to continue for some time to come. Until the economic environment becomes dangerously overheated causing an unanticipated Fed tightening, there is ample room for cyclical stocks to trend higher. The 'second derivative' of economic growth expectations is the operant variable to watch. It should start to turn higher by the Fall after peaking in May.

So being a contrarian is helpful here. Last October, with 10 yr yields at 75 basis points, it paid to be an optimist and buy the reopening trade. In March with 10 yr yields at 175 basis points, it paid to worry and sell the value/cyclcal trade that had outperformed. Now with 10 yr yields at 120 basis points - a perfect 50% correction of the upsurge, it should pay to ...?

The charts of the Value/Growth ETF ratio and the Ten Year bond yield say it all. They are effectively the same chart.

Value vs Growth ETF Ratio

U.S. Treasury 10 Year Bond Yield

I believe the next phase of the reopening trade will start to develop over the next few weeks. The 2022 growth rate, although notionally lower than the base effect distorted 2021 levels, will be highly attractive for cyclical stocks. The technical sell-off in value stocks we have experienced is now setting us up for the next phase of the bull market. I have said there is plenty of $600 Lumber. $60 oil and $5.00 copper. That's the bad news for the momentum bulls, who are now pulling in their horns after chasing the commodity rally. The good news is that we are not going back to $250 lumber, $40 oil, or $3.00 copper, and that's enough to generate plenty of profitable growth for resource stocks. As we saw in the mid 1980's when oil prices stair-stepped from the $10-$20 range to the $25-$40 range, many companies were created to take advantage of the suddenly profitable cost/price environment. I believe a similar stair-step in commodity pricing has occurred.

I guess I am also saying sell the bond market. Despite the recently developed narrative that the bond market knows best, I don't buy that argument. The Fed distortion of both short-term and long-term rates cannot be understated. They are committed to staying behind the curve and that forces savers' hands to extend term. For risk-takers, this week's stock sell-off is likely the culmination of a knee-jerk de-risking after a dangerously overheated run-up that ran out of steam. Now, we should start the process of defining a base to support the next bull market phase. Don't be fooled by the lack of a generalized pull-back for all risk assets. It has already happened to the rotation trade.

Buy the dip!

Risk Model: 0/5 - Risk Off

The model is in a max risk-off position, but as we have seen this year, it isn't very effective at the macro level. An almost perennially overbought condition has not allowed for an entry point from the price variables. The AAII Sentiment measure has been slow to react. The Volatility environment has been very transitory and upswings are short duration in term.

The Copper/Gold ratio, more importantly, has aligned with the swings from growth to value.

Like the rotation trade and the path of yields, this ratio is a reflection of the shift in economic expectations. I am watching this ratio closely for confirmation that the yield/rotation/commodity trades once again align and present a buy signal. It should be soon.

Copper/Gold Ratio

The oversold market breadth condition presents favourable, low-risk area to start to accumulate. Stocks below their 50 dma is a good way to evaluate this (chart below). Small-Cap, Resource, and Financials are the most oversold sectors. The current pause in the economic growth rate is presenting a second chance to buy economically sensitive risk assets.

% of NYSE Above 50 DMA