Fact or Friction?

Friction is a force that seems strongest at the beginning of a move. When you first start to push something, it feels the hardest. Current inflation expectations are just like that, having been sharply elevated recently as the re-starting economy gains momentum. Temporary shortages are creating price pressures that have investors nervous. I believe these fears are more fiction than fact.

Only when the reopening of the economy is finally behind us - probably sometime in the late summer, early fall, - we will really know what inflation expectations are. Right now is not the time to measure them. Don't confuse the price of something temporarily in short supply with the long-run price that clears the market.

The bond market has it about right. Earlier this year, prompted by increased expectations of a post-Covid inflation surge, yields backed up abruptly. Recently, that trend has flattened. The message from the bond market is decidedly circumspect about the inflationary threat from the restart, and I tend to believe it.

With the hype meter on commodities at the red-line, portfolios are quickly being re-positioned to benefit from a hot economy. After a long bull run, the overvalued growth sectors - technology and consumer discretionary - have become a source of cash for that rotation. The rally of everything has finally gotten around to the commodity segments of the market. Hard assets have lived up to their name after years of being ignored.

The rush to restock after a long inventory purge in basic commodities has created a temporary imbalance between buyers and sellers. Now, hot commodity markets have attracted speculators, eager to front-run the actual recovery. The Wall Street cheerleaders are fanning the flames. Jeff Currie of Goldman Sachs and Francisco Blanch of BofA are promoting the "supercycle" theory for industrial metals. In time that will happen, but the latest jump in copper seems overdone in the short term. Actual demand from the widespread adoption of EV technologies is still nascent. Lumber and grain prices are similarly well ahead of long-term costs of replacement. And oil is not likely to experience a similar bull market, given the weak supply/demand dynamics of a de-carbonized future. It's quite telling that the Colonial Pipeline hack this week failed to ignite a significant rally.

Importantly, this particular type of inflation is currently not being impounded in the prices of fixed-income securities. It is a transfer of value from one segment of the economy to another. It isn't 'generalized'. After the huge amount of wealth that has been translated into high PE multiples on growth stocks, there is more than enough money to go around to fund the rotation from growth to value. The bathtub is full of water. Now it is sloshing from one side to the other.

As long as the Nasdaq underperforms, (Cathie Wood stocks especially), we have a choppy, internally correcting market. That is healthy - unless you are 'triple margin long' those names. Those who are, deserve what they are getting now. Nobody should be surprised, as the signs of speculative excess were obvious during the recent Reddit craze.

Crypto is likely the next segment of the speculative bubble that should feel the purge. How long before we see a shift from Bitcoin -'new-age gold' - back to the old-time original - GLD? Elon Musk, the modern-era Nero, fiddling on SNL while Tesla investors were getting burned, has it right. Dogecoin is a "hustle". He should know one when he sees one! I see more downside for the crypto space.

BITCOIN/GOLD Ratio

The inflation dichotomy I have outlined above will soon be revealed in the upcoming CPI and PPI data. This week's reports should serve to illustrate the differences in the inflation of physical inputs (PPI) and that of the broader economic measure, CPI. After adjusting for base effects, the CPI number should be relatively tame. Just because the input costs of the goods-producing segment of the market have risen, doesn't mean generalized inflation is coming. For that, we will need a sustained price pressure from the services segments of the economy, which is unlikely to materialize until we reach full employment sometime in 2023. Last week's poor employment data shows a re-opening that is still uneven. Most companies - like Amazon - have ample margin room to absorb short-term wage pressures. And the twin deflationary forces of relentless technological advancements and flattening demographics (even in China!) are still very much alive.

So before we jump on the 'sell-in-May' bandwagon here, consider the alternative. A sideways churn that redistributes equity value from last years' winners to the lagging segments is a more likely scenario. This is at the core of my call that the economy will do better than the market this year. Although markets have had a great head-start, I believe that the struggle within the various market sectors has just begun. Once this short-term gyration abates, (it may already have) the rally can get back up and running.

And that's a fact.

Risk Model: 4/5 - Risk On

Only the measured distance from the 200 dma is keeping the model from a bullish unanimity. The index used - the XUI - sits at 11%, just above the sell signal. But for the NASDAQ it is now at 6% and falling. Participation and support for the markets are not uniform, obviously.

An orderly bond market, a supportive Fed, and generally optimistic investors are factors that argue for the rotational correction scenario that I argued above. Huge cash balances that have built up due to lowered opportunities to spend, should start to support the market here. Not everybody is going to go on a post-Covid spending spree. They will continue to buy stocks.