Disaster Recovery

Yesterday I took this photo during our trip to see the Fort Meyers beach disaster site. Last September, Hurricane Ian blasted ashore there, destroying almost everything in its path. Buildings that had stood for years were reduced to rubble, leaving valuable possessions scattered among the debris. But be careful if you think there is easy money to be had by scavaging there. There were temporary police stations everywhere and a curfew is still being imposed. I even saw a sign on one destroyed home that read "You loot, we shoot". Indeed.

As we have seen this year, last year's market disaster is still a fresh memory for many. Whether it was low-risk fixed income, commodities, or equities, the sharp rise in administered rates blasted, hurricane-like, through the financial markets. Many investors experienced losses, with some losing everything on wrong-way bets on speculative leveraged positions. Like a one-story Florida beach home in a mega storm, they got destroyed.

But it's no wonder the markets have bounced hard into the new year. A lot of valuable items were left lying around in the rush to sell everything in Q4, 2022. And with a surprising set of positive surprises from the news flow - resilient labour markets, a China reopening, and the mild Europe weather - there was enough incentive to generate the brave bottom-fishing we have just witnessed.

Just as expectations for inflation peaked before the actual data last year, expectations of a recession may have already peaked. Notice I didn't say that the recession is now over. It may not have even started yet. But the unanimity of opinion regarding the eventuality of an economic decline was almost universal late last year. So it stands to reason that any evidence of a soft landing will be seized upon to validate the recent rally in risk assets.

But extrapolating this bounce to a sustainable rebound in economic activity that is sufficient to generate earnings growth later this year, as the market expects, is a dangerous construct. Believing that inflation levels will gently recede due to a mild recession, allowing the Fed to cut rates, is similarly a truly heroic narrative, and at odds with the generous valuations being afforded the S&P 500 above 4000.

Risk asset 'scavagers' have been looking for bargains lately. Their attention has increasingly been directed to beaten down discarded growth stocks that appear to be 'cheap'. Bitcoin has staged a comeback. Emerging markets and Chinese equities have also benefitted from the under-allocation of risk in many a portfolio. Investors just entered the 'hopium den' of the soft landing story. The leadership of this rally has come from the most shorted or under-owned segments. The ARKK portfolio (my favourite reverse indicator) has just had its best start to a year ever. But strength from junk assets and speculative stocks is not a recipe for a sustainable new bull market.

And be careful picking through this risk asset debris field. The Fed may be looking for you. If investors a caught looting the markets, they risk getting 'shot' by the frustrated owner of the property, Jerome Powell. A sudden and unwelcome easing in financial conditions has underpinned the bottom fishing witnessed in the early going of 2023, and he won't be happy if this keeps up much longer.

Like the now-vilified " transitory inflation " narrative of 2021, this current market bounce has been based on the specious argument that the Fed's job is almost over. However next week could see them push back on the current bout of market exuberance by restating their hawkish views and/or actions. Remember, they are rearview mirror drivers, and inflation isn't done yet - just ask the commodity markets that have jumped recently.

The 'immaculate disinflation' narrative is drawing investors to the market like a siren call. Be careful of the rocks ahead. Job cuts are multiplying in the disrupting growth companies. It could soon spread to the old economy, negating the argument of a 'soft' landing. 3M and Ford this morning are cases in point. Rosy earnings expectations are now becoming increasingly problematic for the bulls.

We all know the transfer coefficient between tight monetary policy and the economy has weakened because of structural changes in the ratio of goods to services. This is why I believe in the 'sticky' inflation view during the early stages of the recessionary cycle. But we can't see far enough into the future so we just trust that the data we are now seeing. To paraphrase a well know maxim, I believe monetary policy works with longer and with more variable lags. Yet here we have a Fed that is 'following the data' to derive policy change. Just as they kept easing into strength, they are now tightening into weakness. It is increasingly obvious that they don't really comprehend the effects of their actions and have used 'data dependency' as a crutch.

Weaker-than-forecast earnings and outlooks are now multiplying, portending a harder landing than has been currently expected. I believe the bond market has it right by its pricing of a steeply inverted forward view. Despite $400Bn of QT, yields have declined. That's not a sign of impending economic strength.

Sorry to say, but the first-half choppy positive environment that I described last week as a 'sentiment/positioning' rally is already looking frothy and tired. Investors seem to be scrounging around for discarded valuables in this market. Like looting a disaster site, that can be very dangerous.

Risk Model: 4/5 - Risk On

I'm getting the impression that the Model is going to get blindsided here. The low volatility and sudden optimism we have seen are behind the positive reading, but this could be a dangerous case of multicollinearity (a fancy word for group-think). A soft-landing vibe permeates both the AAII readings as well as the Copper/Gold rally. They are both a bit extended, leaving the market vulnerable here. I hate second-guessing the Model but I can't help myself sometimes.

AAII, the most lagging variable in the five-factor model is notoriously 'whippy' (see chart below). After a long period of decline, I'm not willing to trust the signal strength of a one-week bounce. This chart is the very definition of "choppy".

AAII Bull/Bear