Hop, Skip & Slump

Call it a pause, a skip, or a pivot, last week the market moved higher on expectations of the end of tight money. Does that make it a bull market? By the highly arbitrary definition of 20% (who deemed that the standard?) the S&P500 has risen enough for that box to be checked. But we all know what's going on here. The Fed rate-hike battle with inflation has achieved its initial objectives. They are satisfied that the downward trajectory of inflation is enough for them to sit back and wait. And investors are jumping on the mega-cap growth stocks like a moving train, irrespective of the fact it left the station months ago.

The average stock has been left behind despite the feeble bounce in the banks and cyclicals. The basic traits of a bull phase - Fed easing that leads to economic expansion combined with a positive earnings revision cycle are nowhere to be seen. We didn't even get a recession, so how is a new credit cycle even a possibility? No wonder the breadth is lagging. This is not a new market cycle, just a counter-trend rally. One that is driving too much money into too few stocks.

But FOMO is now back in vogue. The average Joe and Josephines, sidelined for months by fear of recession, are now diving back into the risk pool just in time for summer. A jump in the AAII Bull/Bear ratio (chart below) of this magnitude is rare and has strong contrarian implications, especially given the narrowness of the advance. A similar bounce in February marked the short-term top. But as Reverse-Yogi said - "if people wanna come to the ballpark, you can't stop them".

There is evidence that the worst may be over for earnings expectations, but that speaks to the over-pessimistic projections of earlier this year. The Pavlovian response to the rapid rise of the Fed funds rate and the dire forecasts of the highly inverted curve generated that pessimism. The service economy has defied the forecast due to the unique circumstances provided by the post-pandemic stimulus cushion and structural labour market imbalances. A recession in the non-consumer segments such as white-collar, office-based workers is evident from the 50% office occupancy. But just try and hire a restaurant worker or an airline pilot at last year's wages and you're out of luck. LIV golfers aren't the only ones who got big raises this year.

That has implications for earnings going forward. A cost/profit squeeze is developing as we speak. Your airline fares are only going up at the same rate as a pilot's bank balance. Sorry shareholders, there's nothing left for you - and airline fares although higher than ever, actually dropped last month. Today's headline inflation is artificially depressed by base effects which have limited informational content. But itchy investors are happy to dust off their blue tickets after months of Fed phobia.

The rate structure is unlikely to normalize given the current data set. Decelerating inflation expectations are depressing the long end while the Fed is stubbornly holding firm in the front end as headline rates are still elevated. Something has to give. Investors are convinced of a positive outcome, but beware of the soft landing - it comes with a 4% sticky inflation message. Long bonds at 3.75% look expensive in that world and could face renewed selling pressure.

A hard landing, now slipping into a minority view, will be even more threatening should it arrive. Credit supply is shrinking rapidly as the upsidedown yield curve threatens bank solvency and regulators overreact to the SVB mess. Maybe the private credit markets are enough to sustain the cycle, but small businesses are well below the threshold of the Wall St. loansharks. The jury is out still.

So rate expectations, after the initial hop, have now focussed on 'the skip' this month. What follows is usually a slump. This one has been delayed by a year but it hasn't been banished for good. If labour keeps the upper hand over capital for much longer, profits will suffer and a pullback is likely. If companies respond with further price hikes later this year, the Fed will be forced to hit the brakes again.

Either way, we aren't out of the woods just yet, despite the bullish game of hopscotch the markets are playing.

Risk Model: 4/5 - Risk On

The model has played it perfectly this month. Only the CU/AU indicator is in the 'off' position. Should China actually get serious about its stimulus plan, that would generate a perfect 5 for 5 as copper would surge and the bar for a signal change is low. (chart). A soft landing for the economy, while not assured, is also a necessary precondition for this indicator to definitively turn. Don't bet the farm just yet.

Today would be a perfect day for a TUESAT11 short-term top. An inflation report sell-on-news is here! The expectations for a Perma-pause Fed have been priced-in and the next shiny coin trick for the market to focus on is nowhere to be seen. U.S. stocks are more overbought than anytime this year. With two weeks to go in the quarter, money managers will be window-dressing a bit longer, but come July - the profit-taking should get more serious.

APPLE has been downgraded due to a business slowdown in products and it's elevated valuation. (re-read last week for more). The AI frenzy has my contrarian sentiments itching. Tesla's charging-standard monopoly hype, while impressive, has little or no profit implications for the next 5 years. China's stimulus will need to be a little more than today's 10 bps rate cut to move the needle for me to be convinced.

But contrarians rejoice! The story is not over for Financials, Value, Small Cap, and Commodity Cyclicals. They are starting to act better, if only because they are so under-owned. Risk is concentrated in the Mega-Caps. The rest of the market is cheap and still oversold. A patient approach to investing in these left-behind stocks on weakness should offer rewards once the monetary cycle bottoms later this year. If investors seize on a soft landing narrative - the annual Growth/Value rotation could come relatively soon.