Labouring Market

Right on cue amid the release of jobs data, its the stock market that is suddenly starting to labour.

In the two weeks since my call to"sell the market," the prevailing narrative has abruptly shifted to the negative. The gradual deceleration in the once 'exceptional' U.S. economy is beginning to show in the data. Weaker-than-expected manufacturing reports and a pronounced decline in the economic surprise index have soured the previously bullish outlook. Weaker employment data are now expected to proliferate, causing a problem for the stock market. Bad news has suddenly become bad news.

Weaker data, previously a signal to investors to add risk, is now giving rise to sober second thoughts. The mechanism of weaker inflation data that gave rise to rate-cutting expectations has been a propellant for higher stock valuations. Combined with higher-than-expected earnings over the past two quarters, the case for a bull run to new highs has been solid. But weakening earnings from a decelerating economy now threatens the bull case.

This week's data are expected to confirm a slowing of the labour market. Even if the April slowdown in retail sales and new orders doesn't show up in this data, it surely will in May or June. Job quitting, often seen as a leading indicator of labour demand, has been heading lower for months and is now below pre-COVID levels. The Fed has kept its foot on the rate hike brakes long enough. Their 'review mirror' approach is suddenly causing the economy to head into a ditch, even if they haven't noticed it yet.

Fed Quits Rate

Stocks will bear the brunt. Speculative fever has crescendoed with a meme-stock flare-up from Gamestop. Sucking in the last few FOMO retail speculators is what a bull market does best just before it corrects. Cleansing this irrational behaviour will create a better environment for a more prudent and sustainable phase in the secular bull market. You Reddit here first.

I have steadfastly believed that any dis-inverting of the yield curve will reduce risk appetite. Restoring the 'normal' shape of 2-year yields below 10-year in the U.S. treasury market can only happen with pain. Now that the labour market is softening, the potential for higher 10-year yields has diminished. The likelihood of a sharp drop in 2-year yields is more plausible. Cue the negative estimate revisions.

But before we get uber-bearish, consider that the risk appetite has been highly concentrated in the mega-cap tech space. The left-behind segments, mainly small-cap and slow-growth sectors such as financials, still suffer from a long period of underperformance. Foreign markets are acting well now that the U.S. dollar has broken trend. They have performed poorly during the AI-fuelled growth stock mania that drove this last six-month run. There will be bargains in these segments if the correction becomes more widespread. More vulnerable are overpriced former growth darlings like Tesla that were swept up in the over-hyped Mag Seven fever.

The macro backdrop is changing quickly. The narrative ping-pong game that has driven investor's reaction function should start coalescing on the weaker side of the argument. Increased political uncertainty should reinforce the downwardly biased risk market environment.

It's a long way to the October low that I see as the true reset of the bull market. However, if we get the weaker data set I'm forecasting, a tradeable low in June is possible. Summer rallies are fun, but like ice in your glass on a hot day, they don't last long.

Risk appetite has maxed out just as the economy is starting to weaken. Expectations for higher stock prices are near-universal, and most bearish commentators have given up. The crowd may be bullish, but a crowded trade is a vulnerable one.

But I won't belabour that point.

Risk Model: 3/5 - Risk On

After last week's 5/5 reading, the drop this week is notable. Let's review the key elements.

Copper has reversed hard in the face of the weaker data this week, cancelling the risk-on signal of just 6 weeks ago. Speculative positions are being quickly unwound.

Copper/Gold

AAII data failed to confirm the restoration of a positive signal last week. A further shakeout seems necessary.

AAII Bull/Bear

Volatility is still subdued despite the weaker price action lately. Coming off such a low level, any sudden shock could result in a sharp rally in expected volatility, a risk-off signal.

3-Mo VIX

Weakness has shown up in the percentage of stocks above their 50d moving average, just as it did in the prior top-out in 2022.

S&P 500 - % stock above 50d MA