Jumping the Gun

Now that the 'blink and you miss it' market correction is seemingly over, cashed-up investors are scrambling to get back in. FOMO has returned after a month off. TINA never left. We are jumping the gun surely, but it seems nobody wants to call a false start.

All the starting gates are now empty as virtually every scenario currently on the table has gotten off to the races. Those who have a rosy view of the potential for a Blue Wave victory in the U.S. election were buying cyclicals and small caps last week. The more moderate investor has begun nibbling at banks, as the previous pariahs of the stock market seem cheap and loan losses are more than 'priced in'. The go-go crowd, predictably, rushed back into big tech yesterday. Apple investors apparently just found out yesterday about the new 5G phone? Who knew?

Can all these scenarios be right simultaneously? Sure they can. Stocks are first and foremost a monetary phenomenon. When there is too much money chasing too few stocks, the market has a bias to the upside. There is a wall of liquidity, courtesy of our friends who run the global central banks, and it isn't just going into the economy. It is finding its way into asset prices.

Despite the lack of clarity about the outcome of the U.S. election, there is no doubt that a fiscal stimulus package is in the cards. Remember, stocks are the longest duration asset. Given the easy money environment that exists, stock prices can easily look over the economic effects of a second wave. The economy will continue to gradually dig out of the hole created in March, especially since the only thing that U.S. politicians are willing to shut is their eyes.

The credit markets have seen a huge increase in issuance as firms rushing to lock-in the generational lows in funding costs. This has effectively increased the financial leverage of corporations, thus allowing for enhanced return on equity - a fact that is not lost on the stock market. The economy, outside of travel, entertainment and other forms of in-person commerce, is recovering faster than expected. The surprisingly low levels of loan losses being reported by the U.S. banks speaks to that. And perhaps most importantly, a pervasive skepticism continues to prevail in the investor mindset.

A 'better than feared' outcome is all that is necessary for the market to continue its upward march. The only thing that can substantially derail things is a change in monetary policy that would tap the brakes on both the economy and the market. In that regard, recent Fed messaging about letting the economy run 'hot' is comforting. Jerome Powell is erring on the side of excess and markets have picked up on that.

Last week, I posted an issue that was cautiously optimistic about the long-suffering value trade. A more nuanced approach is now called for. 'Value' as a factor, has underperformed for a good reason. Just look at the energy sector for evidence of the secular nature of the decline of the non-technology economy. Technological advances that have embedded themselves into the very fabric of modern-day commerce are a permanent fixture. It is only fitting that growth stocks are represented disproportionately in current portfolio allocation. Whether it be in finance, consumer goods or transformative business behaviours, the imprint of tech disruption is everywhere. The scarcity of growth confers a high premium on those few companies at the forefront of this highly disruptive environment. Although stretched, they have yet to lose their scarcity value, especially since value stocks are still mired in a slow recovery rut.

But that doesn't excuse these companies and their related market valuations from the laws of gravity. Monopoly power has often brought with it searing scrutiny from jealous politicians. We blame Mark Zuckerberg personally for every bad thing we see on Facebook. Amazon is now a lightning rod for protests in communities suffering from their ubiquitous dominance over what used to the territory of local merchants. (Our Oakville neighbourhood has been the focus of anti-Amazon protests over its proposed fulfillment center). Apple is looking more and more like a bully in the fight over access to its dominant App Portal from the likes of Fortnite.

Economic disruption ruffles feathers. That is the biggest threat from a 'Blue Wave' Victory. The feeling of revenge is now stirring amongst the Democrats looking to ride this populist sentiment shift. Mom and Pop merchants, the poster children of the modern disrupted economy have garnered much sympathy. The Uber-cap stocks that have led this market to new highs are over-due for a rest and this issue could provide an excuse.

This brings up one of my favourite analogies about the market: the "Bathtub Theory". Back in the day, when your humble blogger toiled in the equity trenches of the Canadian Equity markets, this phrase somehow was attributed to me. I likened the Canadian market to a bathtub, water sloshing back and forth as investor attention shifted amongst the sub-groups in predictable waves of like and dislike. A captive market forced on Canadian pension funds by the regulator, combined with a strong parochial bias to institutional equity allocation back in those days, made these trades eminently exploitable for the nimble trader. It didn't matter what the fundamental differences were, with so few choices these mean reversion trades became a way to generate free alpha. Ahh, I miss those days.

Now that the water is sloshed up one side of the global market tub, a massive reversion trade has been set up for the global markets. Arbitraging the gap between growth and value is tempting. We do, however, need a more definitive catalyst than relative valuation attractiveness. Hence this morning's market 'message' following from the spectacular earnings 'beat' by JPM Morgan. The stock, having rallied recently, is pausing to assess the potential outcomes of the upcoming election. Uncertainty is still heightened, especially considering the unquantifiable effect of Donald Trump. Having 'beaten' COVID and seemingly reinvigorated, he has thrown doubts on the notion of a Blue Wave. With three weeks to go and polls being questioned, doubts over the outcome will escalate.

A pause in the proceedings would be welcome now, allowing for more base-building for the post-election rotation trade to unfold. There are multiple scenarios to consider, with the worst being a 'hung jury' Congress, with a concomitant outcome of fiscal gridlock.

Patience market sprinters, back to the starting line. But get ready to run!

Risk Model: 5/5 - Risk On

The model benefitted from the AAII survey turning positive. After fighting the trend for so long, and after seeing a correction, these conservative investors started to become more bullish, pushing the ratio above the moving average signal line. However, they are far from being outright bullish as a .89 reading would indicate. At least it's a sign of a bottoming in sentiment.

AAII BULL/BEAR RATIO

The vix index has seen a shift in term structure as the implied vols in the near term have been elevated. This would seem to be normal behaviour in advance of the binary election outcome.

3 Mo VIX/VIX