Game of Tones

When game theorists talk about 'signaling messages' sent between participants they talk about tone. The 'sending' player can improve his outcome by saying one thing while actually believing another. He may actually be sending an unfavourable message, but it is often perceived as positive. The 'receiver' will either choose to believe it or not. It's all about the tone.

Current low volatility and investor complacency reflect a growing belief in a decidedly positive outcome to the economic forecast. Our favourite monetary game player, Jerome Powell, seems to have convinced the market that he is on top of the situation. Having sent his positive messages about the transitory nature of inflation, markets are now comfortable that there will be no 2013 taper tantrum equivalency this time.

The few bearish commentaries, now starting to push back against this pollyanna view, are being ignored. The likes of perma-bear Paul Tudor Jones, and others, have opined that the inflation scare is real and persistent. We don't know for sure, but it doesn't matter. It only matters what Mr. Market thinks. Besides, the last time Jones was right about inflation, Ronald Regan was still a washed-up actor.

The re-rotation strategy is still working nicely, although at a less frenetic pace than in Q1. Growth stocks have been recouping their lost leadership ground for a few weeks now and led the late day bounce yesterday. Again we see the market making the most people wrong by taking the value trade down a notch just when economic data is peaking. It's the second derivative of data that generates expectation change and as readers will know, you need to anticipate anticipations to make money in the stock game.

The frictional effects on inflation from a robust economic rebound and an intransigent supply chain have already begun to wane. Lumber is down $500 from the highs set in April. Recently, while riding my bike, I have had to dodge large trucks piled high with freshly cut logs on our township roads. Those stands of relatively uneconomic red pine have stood idle for years waiting for a price that makes them profitable. The cure for high prices is always high prices. If inflation fears are 'transitory' so might be commodity price run-ups.

So while inflationists continue to cry wolf, the futures market is signaling a more benign outcome. This morning's report of a record PPI was met with a yawn on his morning's bond tape. Commodities have started to de-trend and backwardation is receding for many of the hard asset plays. The monthly survey of crowded trades done by Merrill Lynch is showing a huge build-up in commodity positioning. This should be a red flag to bullish punters on the CME and NY Merc.

China is doing its part as well by attempting to curb the rosy commodities markets, especially iron ore and copper. As raw material converters who sell finished goods, they stand to benefit from this correction, so they are desperate to see lower prices. When the last unit prices all the rest, the possibility of a sharp correction in the commodities market is now a distinct possibility. Shake-out time?

So record highs continue to confound those expecting a stock correction, me included. The change in messaging from the Fed this week won't be surprising. They will admit that they are finally willing to think about tapering. But we already know that from the hints they have given. But what if they are more right to be cautious than even they imagined? Could the economy suddenly weaken just when it is getting going? What if the Fed's QE message is actually more negative than it first appeared?

A loss of confidence in the smooth transition out of the pandemic will cause a disruption in the market. Until we get past the current reopening hype, we won't know for sure. But that point will soon be upon us, as the pandemic shut-downs fade into our memories and we face the new cycle head-on.

At that point, we may hear a different tone.

Risk Model: 2/5 - Risk Off

The overbought nature of the market averages is keeping the model cautious. The underlying story may be less supportive given that there is a loss of breadth recently. Stocks above the 50 day moving average have been trending down recently as market averages have trended upward. (chart below).

% Stocks Above 50 DMA, S&P 500

The message of copper/gold is more threatening to the bull case. The uptrend has broken hard now. Should the pullback in commodity prices get more dysfunctional, the confidence now being expressed in the markets for a stronger economy may be threatened. Unlike last year, the growth stock safety net might not break the fall this time.

Copper/Gold Ratio

Bond yields may be signaling a sharper economic deceleration in the short term than the complacent stock bulls have in their minds. The same survey that reported crowded commodities also revealed bond positions were at three-year lows. Now we have a growing gridlock in Washington that threatens the widely touted fiscal spending plans of the Biden Administration, just as the previous support programs start to roll off. The monetary-to-fiscal baton pass is about to get fumbled.

We could see a 1.3% Ten Year soon. Sell in June and wait for a swoon.