Inflated Expectations

As the scare stories about rising bond yields begin to recede from the front page this week, stock investors will soon be facing a new reality. The monetary and fiscal impulses emanating from central banks and legislatures worldwide are finite. Maybe the only true inflation threat is one of inflated expectations.

A stumbling roll-out of the Eurozone vaccine program, combined with the CDC's warning of a new wave of Covid, is tamping down the exuberance that surrounded the past few months of the 'rally of everything' bull market. Vaccine hesitancy and outright ignorance ( Miami, I looking at you) are slowing the drive towards a true Covid-free economy. The re-opening crazed market got well over its skis recently, responding to the initial vaccine success. In these spring snow conditions, replete with many bare patches, things can go wrong in a hurry.

Before I get accused of talking out of both sides of my mouth, I have previously argued that the market's expectations needed to move away from last year's emergency mode and begin to reprice fixed income for a recovery. As recently as December, this transition was not 'priced-in' to bond yields below 1%. Now, at 1.75% there is at least an acknowledgement that the economy will be better going forward. But are the inflationists with their dire forecasts correct in their fears?

Having lived through the inflationary '70s and suffered the effects directly, I can speak with some authority. Back then, prices of both goods and services rose with regularity and nobody even blinked. You just learned to live with it until your next annual salary review. The 10% raise you got made you feel whole again, but just. Inflation was fully embedded in the economy. This current scare, one that I have called for since December, is not that type of inflation. It took many iterations and years of negative real rates to create during the Seventies. The transitory nature of this inflation is obvious, created from the statistical lapping of last year's Covid shock. We may have reached a short-term peak in inflation expectations already even before the data are reported.

The commodity mini-bull market, now cresting, is a case in point. How many times do we need to hear Wall Street analysts call for $100 oil before they learn that there is still plenty of the $60 kind? If it were not for the shakey OPEC+ truce in competitive output hikes that surprised the market recently, we wouldn't even be talking about this. And recent copper markets have come off the boil, as speculative positions are quickly being liquidated in a bout of profit-taking after reaching three-year highs. Goldman Sachs' Jeff Currie is a great analyst, but the EV-related copper demand boom he is talking about is still years away.

CME Copper Positioning

So the Value trade that had just gotten started is now underperformed the broad market. This is only normal market action and should be taken as healthy. What is not healthy is the level of optimism about stock prices over the next six months. With a Fed that is happy to stay behind the curve, a new fiscal package on the table and an infrastructure deal brewing, investors can be excused for partying like a bunch of inebriated spring breakers. Does it get any better than this?

That's just the point. It doesn't. And we still have to deal with the fact that the markets are expecting to have their cake while eating it too. Although the Growth stocks have corrected quickly from a February peak, they still remain within 6% of all-time highs and 9% above the 200 dma. All this with a level of investor optimism that is measurably elevated and vulnerable to a sharp break. The chart below shows a smoothed 10-week look at bullish sentiment. It doesn't usually stay here for long. Stock market players are having their way with the bond market as the duration risk-purge in bonds seems to have only emboldened their preference for the reopening trade cyclical stocks. And this week's rebound bid to bonds from rebalancing pension funds has helped fuel a comeback of the 'buy the dip' mentality for Growth. Like an eight-year-old's soccer game, everybody wins!

AAII BULLISH SENTIMENT

So as a patient investor, one that can afford to wait for reality to catch up to the hype, I feel a bit of caution here is warranted. As we now mark the one-year anniversary of the bottom, the natural forces of gravity are working against us. Like the spinning plates on sticks that I referenced last week when the Fed stops spinning the cash, gravity will take over. The message of the Fed last week aside, their support of the economy is not infinite. Bad news on Covid remains good news for stocks for now. But the pull of gravity on the market's inflated expectations has already started.

Risk Model: 3/5 - Risk On

I hate this broken record model now. But it is what it is. The price variables are still uncomfortably extended but the fundamentals are supportive. The impasse being what it is, I just need to stay patient and wait for the overbought condition to work itself off - and sideways mini-rotation trades are the only way to play it for now. That seems like churning to me so I am sitting with a bit more cash after taking profits on the long copper, short bonds and long financials trades.

Hopefully, my earlier musings about a long VWAGY vs short TSLA trade actually spurred some of you to actually place that bet. It is well onside now. Despite ARK calling for a $3,000 target, based on Elon Musk becoming the next Henry Ford, I think TSLA has some downside yet. Amazon had only a hapless Sears as its disruption victim. Tesla has formidable foes like VW, Honda, GM with which to contend, not to mention the start-ups like Nikola. I'm calling Bunfight!