Fearless

November's surprise rally in stocks has caught everyone napping. Like a pop star bursting on stage, risk assets have suddenly become fearless. I blame Taylor Swift.

The three charts below illustrate the evolution of the markets over the post-pandemic era. The sharp drop in bond yields this month has been quickly converted into a market rally, based on a sudden and unexpected bout of optimism. The evidence is everywhere. The so-called 'fear index' - the CBOE volatility index - is at all-time lows. Positioning measures reported by NAAIM - the active asset manager group - have reversed from extreme underweight and quickly reverted to 'normal. The retail investor is back, as a sharp reversal in sentiment is evident in the AAII Bull/Bear ratio.

CBOE Volatility Index

National Association of Active Investment Managers Exposure Index

American Association of Individual InvestorsBull/Bear Ratio

The fear of the Fed has been replaced with the fear of missing out on the stock market. It's like trying to get Taylor Swift tickets - you don't want to miss out. But like Taylor Swift herself, there isn't a lot behind the excitement. Sorry to get all 'old man yelling at clouds' on you, but the current state of music is depressing. And so is the fundamental support for this rally. Just like when a Swiftie song comes on my device, I can't get excited about something that is so lacking in substance.

When the consensus of higher rates (as personified by Jamie Dimon's headline-grabbing 7% call) was abruptly broken by weaker data and reduced fear of supply, the ensuing FOMO rally caught many by surprise. And fewer still participated in this bounce. The sharp drop in volume is shocking. Last week saw the lowest weekly reading in years.

S&P 500

Other evidence from the markets is not comforting either. The participation by the average stock is shown by the equal-weighted S&P vs the cap-weighted version that has a 29% composition slant towards mega-caps. No signs of a broadening of the market yet.

Equal Weighted vs Cap Weighted S&P500

Similarly, the value vs growth story hasn't changed either. Not a surprise, as the "value' in this market is centered on economically sensitive companies that are still disadvantaged by the Fed-induced deceleration of U.S. GDP. You don't need to diversify your portfolios when there are still only a handful of stocks that matter. It seems that many stocks have been dragged, kicking and screaming, higher in a suspiciously light volume bounce.

Value vs Growth

So now we have a wait-and-see pause in the stock and bond markets. Last week was the Thanksgiving turkey top. Now everyone is waiting on data that will either support or refute the hoped-for soft landing.

So enjoy the year-end run for the roses. There isn't a case to be made for stocks unless there is sufficient economic weakness for the Fed to validate this rally by lowering the administered rate structure. The problem with that argument is - it's already priced into financial markets, which have totally jumped the gun. The positive correlation of mega-cap growth stocks and bond prices that has been the hallmark of the post-Covid financial market is still driving the bus. I guess there isn't much difference between a Taylor Swift concert ticket and shares of NVDA - there aren't enough to go around.

This construct has generated an over-valued subset of mega-cap winners and a host of priced-for-disaster losers. But buying the left-behind components like banks and small caps because they represent cheaper alternatives still risks a downshift in earnings expectations, should the Fed stay on the brakes too long as I suspect they will.

Positive narratives based on the prospects of a soft-landed, immaculately deflated economy are now multiplying. Pundits are cheerleading the strong Black Friday/Cyber Monday numbers, leading to multiple calls for S&P 500 targets above 5,000. I even heard that the Kardashian IPO is being brought to market. Bears are in hibernation and the bulls are in charge again.

I fear that we have already reached a fearless state.

Risk Model: 3/5 - Risk On

The price variables are in an overbought state, while the sentiment measures are supportive. This fits a narrative of an illiquid market that was caught unawares by a sudden positive shift in sentiment.

Real Problems

The weakness in the U.S. dollar has translated into a number of calls for a break-out in the two non-fiat currencies gold and Bitcoin. Unfortunately for the tin-foil hat crew, there needs to be a lessening of the headwind that has held these alternatives back recently. The major flaw in the ointment is the absence of a lower 'real' rate structure. The recent decline in long yields has actually lagged the magnitude of inflation's deceleration, resulting in an actual increase in the real rate structure. With the Fed staying tight, for now, the rally in gold has to wait.

Federal Reserve Estimate of 10-Yr Real Rates