Dull Market

After a rollercoaster start to the year, equity investors have collectively thrown up their hands. The whipsaw price action, combined with a split-camp narrative on the economy has flummoxed even the most experienced observers, myself included. Investors have now given up on extreme scenarios and their implied "soar/plunge" price actions. Volatility, both implied and realized has collapsed, reflecting the lack of nervousness and cautious complacency. The result is a dull tape.

I never short a dull tape.

What about the fundamentals? At the margin, they have been better than feared. Inflation has clearly peaked and the surprisingly strong consumer/labour data support the soft landing scenario. Earnings have come in mixed, despite Morgan Stanley's Mike Wilson's prediction of disaster. Now even he's endorsing a risk-on stance due to "technical positives".

PE ratios are elevated, reflecting an 'over the valley' view of earnings. Soft-landing fever has broken out in a number of equity shops. China and Europe have dodged their respective bullets - covid shut-downs, and a cold winter - lessening the impediments for global risk-takers.

As I pointed out last year, some tightening in equity risk premia should be expected in the new inflationary environment. Earnings yields were actually below the 10y yields for most of my career so don't tell me that model is a constant. The monetary authorities' use of Zirp, and QE distorted that relationship over the past 20 years. Equities are an important inflation hedge, especially when the Fed is behind the curve and bonds are just now covering inflation. In the last year, fixed income has gone from 'uninvestable' to just plain expensive, given the recent reemergence of inflation. Call me back when they actually provide a real return above 2%.

The liquidity/sentiment indicators are similarly supportive. BofA survey data shows high levels of cash on the sidelines and a generally cautious outlook for stocks on the part of investors. After a brief burst, AAII sentiment sharply retreated. Most investors have pre-loaded a bearish stance that was deemed necessary by the Fed's attack on inflation. That was the reason for the October low.

Is this a bull market? Hardly. For that, the Fed has to be able to ease. Is the bear market over? Looks like it for now given the resilient tape. Should you lock in the new world of 5% fixed income? If that's all you need to earn I guess, but riskier asset returns could be higher. Does that mean you should go all in? That's never good advice.

Pick your poison, it's a trader's market for sure.

The inverted curve as an indicator is either being ignored by the momentum/repositioning buyers or it is a failed metric that has lost efficacy. I find it hard to believe the latter, but I'm not the market. The cushion provided by a structural shortage of labour and an aberrantly artificial starting point for interest rates, has generated this slow-motion recession and with it an equity short squeeze for the ages.

I repeat what I have said: "the model works with longer and more variable lags". I expect the inversion will slowly grind down risk-taking and economic performance, but it is taking longer than usual. Patience grasshopper.

This morning, Fed Chair Jay Powell has regurgitated a narrative that the market has already incorporated into its thinking - "we are committed to our 2% target". There is currently a short-term pull-back on the event that will likely be bought (buy the dip alert) as he confirms the market's thinking about the pace of rate hikes, even though those are higher than January's level. He's messaging a move in the dot plot expectations that the market already has priced in. The 10-year is hardly budging today.

The real fireworks will come on Friday with the employment data. A print outside of the expected range will move the risk needle. Unfortunately, if we get a number close to, or above expectations, the momentum merry-go-round will start up again as the soft-landers begin to 'party hard' once more. Buy Value.

If the upcoming data comes in weaker, reversing the outsized January spending and employment data, the terminal rate expectations will drop. That will prompt a bond rally that in turn generates one more leg in the stock market. The prospect of a mid-year 'mission accomplished' banner-raising will generate a level of certainty for equity investors that could embolden them and drag the last few bears off the sidelines. Buy Growth.

Either way, we get more upside to the market even if we don't want or need it.

But that's a tape I will want to short. At levels above 4300 on the S&P we will be back in the death zone for valuation. Valuation is not a short-term indicator however, and with a soft-landed economy seemly avoiding a deeper recession, the now-slumbering FOMO view will re-emerge from its dormant stage, pushing equity markets higher. The confidence that will flow from higher stock prices may even create a slight rebound in the consumer economy that will be interpreted as an all-clear signal.

That's a dangerous setup for an inflation-prone world. With a China rebound and a soft-landed U.S. economy, there will be a quick rebound in goods prices from a recovering global economy. I think the Fed will at that point have stopped short of its objective of 2% without realizing it. That raises the odds of a 1981-82 style stop-start of monetary policymaking and a 2024 emergence of a deeper bear market. But that's beyond the horizon on which market participants operate. Hence the upside bias to this 'bad news is good news' rally.

As a good friend of mine has said: "this is the most intellectually fascinating market in years, maybe ever" I couldn't agree more.

It may look like it now, but this is hardly a dull market.

Risk Model: 4/5 - Risk On

I love the symmetry of the AAII Bull/Bear ratio chart. Every pullback looks like a contrarian buy signal, despite the worries of the day.

AAII Bull/Bear Ratio

The soft landing crowd has got to be happy with this chart for obvious reasons.

Copper/Gold Ratio

The increasingly offside bears have not gotten what they want from this indicator. Only the talking heads on CNBC are exhibiting volatility these days. The 'SJIM' ETF is the way to play it.

Remember though, insurance is only expensive when you don't need it.

3 Mo VXV