False Start

When will they ever learn? When investors move in a herd-like manner, they open themselves up to self-inflicted damage. But when the starter's pistol is about to go off, you often get runners jumping the gun and a false start occurs. The Federal Reserve may soon raise the pistol to start the next bull market, but some market participants have already left the blocks.

In the early going of the year, with the help of seasonal effects - a post-tax-loss selling relief bounce is normal - hope often builds in January and we see a self-fulfilling rally. The prospective new year full of promise is a powerful intoxicant for the optimists among us. After a long year of frustration in 2022, the prospects of a less hawkish Fed have begun to incent investors to commit their fallow capital to risk assets. The bullish accelerant courtesy of China's flip-flop on Covid has juiced the rally like an injection of economic nitrous oxide. And the perennial value trap of European equities is again sucking in fans as a mild winter has reversed the dire economic scenarios of just weeks ago.

I'm not totally convinced, but I'm not the market. As a trader, all I have to do is guess correctly what others have in mind when they phone their brokers or click the green button on their screens before they do. So when you have such a negative unanimity and the narrative improves unexpectedly, the markets often send a false signal of 'all clear'. That was behind my call last week for a choppy upward bias to the first part of the new trading year. But a new bull market? Hardly.

There was a disturbingly high correlation for risk assets in this recent surge. High yield spreads tightened, despite the pervasive recession fears. Long-forgotten Emerging Markets have bounced hard. More surprisingly, it extended to the frothier components, such as meme stocks and Bitcoin. Gold similarly has benefitted from expectations of future monetary relaxation. But like the track & field example, when one runner jumps, the rest often follow.

Such strong positive correlations among assets are not comforting. Bonds have rallied on the back of diminished inflation expectations due to slower growth. This has supported equity valuations. Conversely, recession fears have declined on the back of the soft-landing narrative coming mainly from a China re-opening as well as nascent European optimism. Stocks have responded in a Pavlovian reactive way to these seemingly incongruent positives.

If the bullish inflation narrative is based on lowered expectations for economic strength, will corporate earnings not struggle to validate currently elevated stock prices? Conversely, if the China/Eurozone rebound is valid, will we not see a recovery in inflation expectations that leads to renewed Fed vigilance? Either way, the bear market bias should recommence by the middle of this year.

But for now, the itchy trigger fingers are dominating the tape. I'm less convinced of the rebound scenario, but the pandemic-related tightness of the U.S. labour markets and SPR-softened gasoline prices, support the soft-landing call for now. If the big drops in goods production reflected in this morning's Empire Manufacturing numbers spread to other regions, the expectations may revert to the recession camp. It's too early to tell as conflicting data is now the norm. The effects of monetary tightening may take longer to show than investors have the patience to wait for.

The U.S. dollar is also helping the bull case. When I think of the most unforecastable of the various risk markets, currency markets take the no. 1 position. They are herd driven, often with binary outcomes. The recent move in the Euro is a case in point. The abrupt reversal reflects the universality of the negative sentiment generated by the Ukraine war. A surprisingly warm winter has reversed these expectations and the herd has been now been caught short, hence the sharpness of the bounce. But can this trend hold up in the face of all the remaining uncertainties? I've never seen a durable recovery led by the sclerotic Eurozone economy.

My preferred scenario of a choppy upwardly-biased market still holds for now. But what part of 'choppy' don't you understand? Since we have built this rally on lower rate expectations, any whiff of upward movement in the risk-free rate or the benchmark Treasury markets will cause a sell-off. And with the roll-out of earnings releases offering bearish forecasts from the early-reporting banks, the risk of a quickly over-valued stock market could cap this rally in short order.

The Bank of America's Fund Manager Survey released today has depicted a pervasive consensus of caution. The respondents are under-exposed to equities and over-weight cash. Since the July bottom in the S&P, we have seen a series of positioning/sentiment-driven rallies, and this month's bounce is no different. This market action makes sense when you have opposing forces of diminished liquidity but a market full of cash-rich bearish participants who respond positively to 'less-bad-than-feared' news.

I will be busy this year if I want to call the market accurately. Conversely, you can probably ignore any short-term call for either a rally or a sell-off. There are too many cross-currents. I'm as guilty as anybody of trying to call every twist and turn. But the lags in monetary policy and the persistence of an inverted curve keep me still in the cautious camp, despite the rally we have seen.

I'm not gonna jump the gun.

Risk Model: 4/5 - Risk On

The slightly over-bought market is still not enough to signal a risk-off call. The collapse in Volatility - now at two-year lows - is notable. It may be reflecting a regime change to an environment that reflects the 'push-pull' of positive and negative forces. The choppy, trendless market that I expect is consistent with the transition of the market to a lower volatility environment from the high-vol phase we saw last year. It also validates the 'stock-pickers' market theory for the year ahead.

3 Month Vix

The AAII Sentiment indicator is bottoming after a tough year that saw investors lose confidence in the markets after a long bubble of ZIRP-supported speculative excesses. This indicator is also supportive of the notion that portfolios are tilted cautiously, as we saw in the B of A Manager report. It is fuel for the transitory bouts of equity inflows we have witnessed since last year.

We will not see a true bull market until the Fed has more evidence of actual economic duress and is compelled to actively ease in my view. The widely anticipated Fed pause, while refreshing, won't do the trick.

AAII Sentiment