Coiled Springs

When people want something badly enough, it's best not to argue with them. They often will do what they want, despite being fully aware of all the arguments to the contrary. In these circumstances, it's best to check your brain at the door and go with the flow.

Fund flows into risk assets have pushed markets higher since September's low. And it's little wonder, given how bad sentiment had become. Cash had built up to record levels and the commitment to equities had dropped accordingly. Now, with just a hint of a turndown in inflation, that extreme positioning is fuelling the rise in risk assets that is confounding the remaining bears out there.

The AAII sentiment indicator shown below is coiling like a spring. The upturn in the 30-week moving average marks an important inflection in people's market mood. Sort of a reverse Yogi Berra - if people want to go to the ballpark, you can't stop 'em.

AAII Bull/Bear Ratio

We could be on the cusp of a breakout in this chart should the upcoming Dec 2 U.S. NFP labour report show some degree of weakening. That will change the narrative of a hostile Federal reserve that is keeping financial conditions tight. That would be enough for investors to continue to get off the fence. But as we saw in July, investors will be risking jumping the gun. I have been recommending a bottom fishing strategy since October, but there is no rush here. The Fed may get off the brakes soon, but they won't necessarily get on the gas pedal for a while yet. Remember, the yield curve is highly inverted and the process of normalizing it will be painful for investors.

Not all risk assets will benefit from this gradual return of confidence. The damage done to long-duration financial assets, both bonds and stocks, has not been evenly distributed. Those assets that have benefitted from the financial repression of QE will have a hard time going forward. Starting with Crypto coins and Meme stocks, and extending to the richly valued Mega-caps, there is more downside to come. Investors will continue to be cautious as the scar tissue from their damaged confidence will heal slowly.

So some dry powder is warranted. But the narrative is ripe for a change. The early warning signals from the economy are encouraging as commodities are breaking, one by one. Oil is the latest crowded trade to unravel, showing signs of breaking now that the seasonals are working against it. But this is positively feeding back into a lowered 'fear of the Fed', and consequently, stocks are still rallying. Should investors perceive enough slowing in the broader economy to generate lower-than-expected terminal rates, the market will take off again.

Unfortunately, that will generate a quickly overbought market, given the current starting point. Market bottoms only become obvious in hindsight, often occurring in the midst of calls for "lower lows". But that's just my point. The market will do better than the economy going forward, surprising the crowd. More importantly, the volatility of the real economy will exceed the volatility of the market. In the short run, should be a good market for traders but a choppy ride for sure. In the long run, the market doesn't matter if you are disciplined and have been accumulating 'good' stocks lately. But that's how it has always worked.

I never bet against a market that has more buyers than sellers, and that's what we've got. Given the overwhelmingly negative news flow of the last year, many coiled springs lurk.

Risk Model: 4/5 - Risk On

Propelled by fund flows and aided by a weaker dollar, markets have been rising to the falling moving averages. I have shown below the VTI - Vanguard's Total Market ETF for illustration. The July bounce was rebuffed at the 40 wk moving average. I am expecting next week's data to make or break this rally.

An inflection point in investor expectations about inflation helped start this rally. If a similar effect on the labour front is seen after the NFP print a week from Friday - it's off to the races. Converseley, if the Fed interprets the data hawkishly, we will quickly revisit the lows. That should coincide with year-end effects such as window dressing and tax-loss selling, creating a choppy, volatile end to what has been a dramatic year. Hopefully, 2023 is more boring - I'm getting too old for this!

Vanguard Total Market ETF