Inflection Point

The cure for high prices is usually higher prices. The market sends a signal and markets normally respond by increasing supply, thus solving the problem. In days gone by, and unfettered by constraints imposed by regulatory and environmental concerns, companies increased their capital spending in line with cash flows. Investors demanded growth in reserves at all costs, happy to send pensioner and mutual fund cash down the drill holes back then.

That ain't working so well now.

Investors have pivoted towards a return of capital model. They can't be seen supporting the expansion of 'dirty' industries as their ESG mandates curtail holdings of resource stocks. Our desire for a decarbonized future will come at an ever steepening price.

Capital spending is unlikely to catch up with the recovery in demand for environmental reasons and the market for resources will be stronger as a result. Despite the slowdown in the global economy off the sugar high of the Q2 reopening boom, the surging price for energy is exacerbating the sell-off in the bond market.

Weak bond prices reflect both the fear of the Fed taper and the tightness in commodities, most notably energy. The 'transitory' narrative of inflation is now at risk of wearing thin as supply constraints multiply. Chair Powell is delivering this message this morning thus fanning the flames of the bond rout. More serious supply constraints worldwide are prolonging the previously 'temporary' spike in prices that were initially driven by the reopening economy. Natural gas reserves have been depleted by low wind loads in Europe and lower hydropower production in China. Coal isn't a viable alternative given the pollution abatement policies, further boosting natgas demand.

As we see below, reinvestment levels are lagging well behind the price signal. As a proxy, rig counts in the U.S. shale regions, have yet to recover and remain at less than half the previous peak. Energy self-sufficiency in America is quickly becoming a fleeting memory.

As a result, the Growth/Value trade has reached another important inflection point. When bond yields were dropping during Q3, the Growth trade flourished. Not surprisingly for readers of this space, this 'bad news is good news' phase is coming to a close. In the short term, China's supply problems are seriously affecting global growth and in the U.S., direct Covid fiscal support programs are rolling off. These factors ensure that some slowing in demand for commodities will be with us for a while longer. But ultimately, it will be replaced by a robust self-sustaining economic recovery that is likely to drive market expectations as we enter 2022.

Effectively, the two charts below are the same thing. Inflation expectations are now free to influence bond yields now that the Fed has signaled its intention to exit the extraordinary support from QE. The higher inflation/interest rate environment is now looming large in investors' minds. Unsurprisingly, the high valuations awarded to the Growth are at risk of being repriced lower.

GROWTH vs VALUE ETF RATIO

U.S. 10 Yr BOND YIELDS

Will we see a more protracted correction in markets in response to the rapidly steepening yield curve?

The line in the sand for me will likely be a break of the recent U.S. ten-year bond yield highs. The 1.8% level (horizontal line above) is critical. The currently orderly, rotational sell-off could soon become unhinged. That is unlikely as the fiscal package political football is getting kicked back and forth in Washington. But should we get those issues behind us, there is a clear path to higher yields far into the future. For now, stock and bond prices are positively correlated, and that is hugely negative for investors. With renewed global expansion, that correlation will eventually reverse, but the transition is fraught.

My call to sell bonds and go to cash in equities last month has finally worked. As the quarter-end looms and with a decidedly opaque earnings season ahead, I am expecting more market choppiness here. The inter-market signals are lining up for a run into year-end for the value/cyclical trade, but I'm keeping my powder dry just in case. Inflection points are usually coincident with uncertain times. This one is no different. Relative strength during a correction is an important tell. But the absolute price levels are still a bit lofty for a market that has run so long and hard.

Inflection point detection is an art, not a science.

Risk Model: 2/5 - Risk Off

With this morning's renewed spike in volatility, the model is signaling more weakness ahead. The 200DMA signal, although still positive, is falling quickly and is likely to test the 95% level at some point during this correction.

As for sentiment, it looks like a split camp. Those who have been waiting for a lower market are now getting their wish for now, but flow of fund data are pointing to a rotational shift. Last week has seen the negative outflow from growth be largely offset by inflows for small-cap and value. A more generalized risk-off sentiment is demonstrated by the AAII chart below. It has yet to recover from the multiple threats posed by Delta Variant, China Evergrande, U.S. Government Shutdown fears. Add to that the renewed inflationary yield surge and Taper Tantrum fears and you can see the market has its work cut out for it to see a renewal of investor confidence. The quick run-up for the value stocks this week is likely to be quickly given back. Patience my fans.

AAII Bull/Bear Ratio