Jackson Pothole

This past weekend, I visited my friend and ex-partner at his summer home. The highlight was a wonderful bike ride along the shoreline of Lake Simcoe where I noted the high quality of the roads as compared with my Tiny Twp. haunts. My roads here are filled with potholes and are worse than ever after a couple of tough winters.

The problem with potholes is twofold. They really hurt if you hit them and are still dangerous if you swerve to avoid them. Seasoned bike enthusiasts know to rely on the lead rider to point out the potholes so they can be avoided. But that can present other risks as you veer around them.

This week sees the annual monetary conference in Wyoming that features a speech by Fed Chair Jerome Powell. I pointed out the potential Jackson Hole risks a couple of weeks ago, so you should not have been surprised by the market slump this week. This week's 'swerve' in the equity markets is a result.

Markets have gotten ahead of themselves as the June peak in inflation provided the narrative of a 'Fed pivot'. Bulls ran the show for the summer as they rushed to replenish their risk asset exposures that had been severely pared back due to the Fed tightening campaign. This Friday's Powell speech has been well telegraphed as a 'hawkish' event. That said, the short-lived market decline may actually have helped to avoid any pain associated with the widely-leaked bearish commentary. The 'Open Mouth Committee' has been hard at work this week preparing markets for his message.

Financial conditions (chart below), as defined by the monetary managers at the Fed, include stock prices as a key component. Recently, as a result of the bounce in equities off the June lows, these conditions have eased. Lower credit spreads also helped. The Fed has been eying these developments with a bit of consternation, as it wishes to exert tighter financial conditions to ratchet inflation lower. Blame meme traders if you want, but the summer buoyancy was an unwelcome development for the Fed.

So if the market avoids the sudden shock of a deep pothole in the form of a hawkish speech from Powell, will it be sideswiped by something else as it swerves? The bullish market view, still a minority opinion, may actually be extended by a counterintuitive rally once the highly telegraphed 'hawkish' remarks from the Fed chair are revealed. The soft landing scenario will be reinforced by a FOMO-fuel chase above recent highs.

It might be more perception than reality. But an extension of the rally, stoked by a recovering risk appetite, and force-fed by the current extended short interest positioning, is a distinct possibility.

But market riders, while swerving to avoid the Fed pothole, may ultimately veer into the path of an oncoming earnings recession that has yet to develop fully. The weakness in China, Europe, and elsewhere, combined with a super-strong U.S. Dollar are unappreciated risks to the pollyanna profit forecasts that have recently been reinforced by the better-than-feared, but lagging, Q2 numbers. As the forward-looking indicators of credit-sensitive sectors such as housing and autos combined with rising wages, imply the best case as a stagflationary environment. Earnings are now like an oncoming car heading towards the peloton of bulls who are currently in control of the narrative.

We actually need a U.S. recession to cleanse the system of excesses caused by the ultra-loose policies of the 2020-2021 time frame. Overvaluation of growth equities was the biggest of these, and that has mostly been achieved - just ask Cathie Wood. Fortunately, the job of purging those excesses has fallen where it should, on equity speculators, not on the financial system, as happened in 2008. Should the Fed need to become more hawkish than anticipated due to intransigent inflation expectations, it could be a different story.

Watch for the peak inflation argument to evaporate in the upcoming seasonal energy strength in front of the heating season. The Saudis were saber-rattling yesterday about the disconnect between the spot and futures in the oil market. They have a vested interest in seeing their party - the Trumpian Republicans - win the mid-terms. Mohammed bin Salman stiffed Biden in their last meeting, thwarting any hope of a windfall for the Democrats on cheaper energy. When the SPR giveaway ends, there won't be many sub-$100 barrels left, especially now that Europe is desperate for a replacement for Natgas, now trading at an oil equivalent of over $400/bbl.

Energy stocks have dug in their heels here and represent a good counter-weight in equity-only portfolios. Technology stocks are now pulling back from the over-reaction to the 'peak inflation' narrative, but are still most at risk from earnings hits due to global weakness and U.S. dollar strength. The bond market - especially in the lower-vol 'belly', represents another good alternative to risk assets as well. Yes, fans, as much as I hate to say it - I like bonds for now. Ugh - I hate myself.

Just dodging one pothole doesn't mean the road ahead is risk-free. Keep your heads up fellow market riders.

Risk Model: 5/5 - Risk On

Rarely does the model line up in unanimity as it has this week. The Copper/Gold ratio has been skated onside by a stronger U.S. dollar that served to thump my long gold position this week. (Ouch!) It also benefits from the reported lower inventory levels in the copper market. That is hardly encouraging for anyone looking for economic strength, however. It looks like an oversold bounce so far.

Copper/Gold

Lower volatility levels may also be giving a false signal after the recent option expiry and the end of the earnings season. Is this the quiet before the storm?

The AAII Bull/Bear ratio has risen from the June gloom but is still subdued relative to history. This reflects a market that lacks a strong consensus and may be consistent with a choppy, sideways period of consolidation after a sudden run-up. The interplay between the reversal of bearish positioning and still weakening fundamentals has been confusing to many. The market lows may already be in before we realize it. Remember - "the market does the thing that makes the most people wrong". Me included.

AAII Bull/Bear