Downbeat

Drummers often kick off a song with a downbeat. The rest of the band takes its cue and joins along, launching into the song. The role of the drummer is to carry the band along, providing the structure for the others to follow. In the stock market, banks are the drummers of the market band. Unfortunately for the economy and, by extension, risk assets, they are wildly out of sync at the moment.

The as-yet-unfinished regional banking crisis is a festering sore on the U.S. economy. The inability of banks to lend profitably is like a tourniquet on the pulse of the business cycle.

This tightening cycle is unique in one major dimension - speed, or lack thereof. The glacial pace is a function of the Fed's delayed, deer-in-headlights reaction to the post-covid rebound. Trapped by their misdiagnosis of 'transitory' inflation, and with a starting point of 0-25 bps, it's no wonder it's taken so long to slow the economy noticeably. But that could be changing

This morning's earnings chill from Home Depot marks a new phase for the rolling recession that started with the goods economy last year. Now we are seeing the smaller ticket items come under pressure as debt levels rise sharply, crimping demand. Finally, we are seeing cracks in the armor of this resilient economy.

The last pocket of strength, Travel & Leisure, are still in a growth spurt as aging Boomers, crawl out from their Covid caves and climb aboard various planes, trains, and automobiles. I'm heading for an Alaskan cruise next month, so I should know. Once that runs out of steam as a driver of the economy, the last deceleration in the services economy should reveal the "recession" that we have all been waiting for.

But notable in the Home Depot earnings was their claim that 'lumber deflation' caused part of the earnings miss. I believe this is telling us that inflation is now dead. A surreptitious deflation cycle has been brewing since last year, giving us an insightful lead indicator for the cycle. Commodities are the canary in the coal mine for the economy. And how's that oil trade working out for you today? Remember, gasoline peaked in Q2 last year. Especially for commodities, the cure for high prices is high prices. Trees, and apparently barrels of oil, do not grow to the sky!

Lumber Price

The lead indicators of the inflation scare have all dropped in unison. Our hapless friends at the Fed are studiously waiting for the data that will give them the cover they need to reverse their punitive policy course, and I think they are about to get it. With their gaze firmly in the review mirror, they will shortly declare victory over the now-waning inflation threat. Hurry up and get it over with, please.

I'm sticking with 'sell in May' theory for now, but that doesn't mean stocks will drop precipitously. The positioning of investor portfolios is already prepared for the worst. Rate hikes have finally done their job. The Fed is done and that's the most important thing to remember. The inverted curve is slowly unwinding and it looks like a trend break has occurred (chart below). In a perfect world, I can see the 10s and 2s crossing paths by late summer. That should be enough to soften the blow to the economy, especially for the all-important banking sector. With their valuations so compressed, anything less than a GFC repeat is already priced-in for that key group. The highest consensus trade revealed by the latest Bank Of America manager survey is "short the banks". I smell a trade here, but not just yet.

U.S. Treasuries Yield Curve Ratio: 10s - 2s

I view the next phase here as 'bad news is bad news' - until it isn't. Stocks always bottom 3-6 months before a recession ends. The final phase of the market correction is shaping up nicely as the weakness in earnings expands. The 'internal lows' of last Fall may not need to be broken or even tested. All it would take is a sharp pull-back in the mega-cap growth stocks to generate a correction that will scare out the last weak hands. The rest of the market is already in hunker-down mode and should provide a non-confirmation of that down move. I'm watching the AD lines and Small Caps relative strength for confirmation that we are setting the 'external low' for this cycle.

A mild recession is in the cards except for segments that are structurally challenged like CRE. A weak consumer will not be the focus as long as the Fed signals its willingness to pause and commit to a reversal of rate hikes next year. A restart of a new stock market cycle should begin soon after the next series of downward earnings revisions. Investors finally get what they have been waiting for - a downbeat.

Risk Model: 4/5 - Risk On

For now, I think we can safely ignore the Model unless you like watching hourly stock charts and have a quick trigger finger. Only the Copper/Gold ratio is negative, but I never go against that one! The other indicators could all turn south on a dime. The recent low volatility coma is masking the internal deterioration of the market. The Equal Weighted S&P is underperforming the Mega-cap heavy QQQs by a huge margin. Just like the time when Nortel soared above the clouds on pure hype back in 2000, this is not a market that is easy to 'beat'. That didn't end well, did it?