Equal Measure

Skip, pause, or hike? What measures will the Fed take at their next meeting? There seems to be no consensus. And I can't blame the markets for being confused. With the broad averages poking up against, and in the case of the NASDAQ, at six-month highs, the betting seems to be for a 'pause'. That will be enough to continue the upside pain trade.

The data are helping to make the case for a Fed that has done enough. The second derivative of inflation is negative. The U.S. dollar is rising again. The commodity board is in full retreat. And more importantly, the banking system has ground to a halt as regional lending collapses, portending more slowing of demand.

All this is offset by the charades in Washington as politicians play pickleball with the debt ceiling bill. Investors have their heads down expecting the worst. The last time this topic dominated the headlines markets in 2011, a debt downgrade coincided with the impasse. The result was what I showed a couple of weeks back, instant pain for risk assets.

I don't expect a repeat of that externality. More likely, a debt ceiling resolution, however messy, should spark a catch-up phase for the underperforming segments of the market, especially banks. The front end of the yield curve, which is currently spiking higher on default risk, will abruptly reverse and provide a salve for the beleaguered banks. The back-end yields should rise from two sources. Risk-on traders will rotate back into equities from bonds and the Treasury will need to ramp up issuance. A flatter yield curve is coming into view and that's a big positive.

A debt ceiling deal will unleash the FOMO crowd once again. For that trade to have any durability, the Fed must be convinced that the economy is in full retreat. That is unlikely. The double-edged sword of a soft landing is the stickiness of inflation as pricing power is maintained by companies. This stagflation will sap earnings power for competitive industries such as retail and durables. But as we are seeing now, the wide-moated mega-cap tech plays have pricing power, especially with the disruptive AI arms race just now heating up.

As I have posited before, positioning and sentiment have been the primary source of demand for equities. Add to that the strong case for a narrowing of the equity risk premium due to the transition to a more inflation-prone economy. As we saw in the late Seventies, stocks are more highly valued against fixed-income assets as they have inflation pass-through attributes. That explains to me why stock prices are sticky too!

So the opportunity for a trade is shaping up nicely. The cyclicals and financials are priced for the worst. Flows have been one-sidedly negative except for the AI space. China's once-vaunted reopening play has all the appearance of a dead cat bounce, further dampening sentiment. They should start to stimulate soon, just as the soft landing scenario in the U.S. gains credence.

The Equal Weighted market, both S&P, and Nasdaq, are dramatically stretched to the downside (charts below) and could easily create the mean reversion I expect. The AI frenzy has generated most of the upside as eight or so stocks have produced 100% of the gains. When people say "the market" they really mean Apple, Nvidia, and Microsoft et al. Bears have been rightfully fussed about the lack of breadth lately. Turn that on its head and there's your opportunity.

Equal Weighted Relative - S&P 500

Equal Weighted ETF Relative - NASDAQ

This analysis only applies to the highly skewed U.S. major averages. In Canada, the chart below shows how a more balanced market in terms of tech stocks and cyclicals, gives a different picture. But if the rotation to economy sensitives is to occur, it should favour our market disproportionately. This trade into offense from defense is high risk. It is highly dependent on a U.S. debt deal that flattens the yield curve. Caveat Emptor!

Equal Weighted ETF Relative - TSX

When it comes to market expectations, the shift to a less pessimistic outlook on the economy, ie mild recession, combined with an overly-popular defensive investment posture is likely to provide at trade here. Oils, Metals, and Financials should be favoured for this shift. But it will only last as long as the Fed allows it to. If they get a sense that inflation is stickier than it first appears, They will be back on the brakes in no time.

But that's a story for later. For now, buy in equal measure!

Risk Model: 3/5 - Risk On

The main driver for equity markets has been the overly defensive positioning of investors. We (I include myself in this group) have been so bearish for so long that we are immune to good news. Hard to blame us though with bank failures, pandemics, wars, and a hawkish Fed. Look at how long this has taken to play out!! The ratio of investors who believe in the upside vs the downside (chart below) has formed a huge base and the longer the base the stronger the case! Now that's what I call a crowded trade! I don't like crowds.

AAII Bull/Bear Ratio

The highly volatile Copper/Gold ratio is depressed as it gets (chart below). I have started seeing more ads for gold and U.S. dollar bears have had free reign lately. I can see a reversal here as well as the sentiment seems stretched in favour of the gold bugs. Copper's underperformance is a function of tight money as we can see from the chart. The long decline in the bottom panel depicts the 10's minus 2's relationship which has resulted in the currently inverted yield curve. Reversing that relationship (the trend line has already broken thanks to the regional bank crisis) will create the conditions for an 'early cycle restart' condition in which the 'industrial' metal outperforms its 'flight to safety' compatriot. Stay tuned!

Copper/Gold Ratio & Yield Curve