Naughty & Nice

Time for the annual recap of your humble blogger's prognostications and prevarications. Hey Elf, was I nice enough for ya?

More like a humble brag this year, as I got more right than wrong. But I sat out a huge rally too.

I guess I'll be keeping my day job - this one doesn't pay very well.

Besides, the hours seem pretty good, since I can't sleep past five o'clock anymore and there's not much else to do on Tuesday.

One year ago, the script called for the market to succumb to the Fed's tightening campaign that was likely to produce a serious recession. There were many calls for the highly valued growth stocks to endure a year of multiple compression. Not many saw any hope for a soft landing given the sharpness of the rate hikes and the inversion of the yield curve. The market bounce from the previous October low was viewed with suspicion. Calls for the S&P 500 to immediately decline were universal.

I wrote on January 10th:

Most people expect a first-half recession followed by an easing of monetary policy and a 2024 recovery. I propose the opposite: a near-term economic bounce based on lower inflation and higher spending by a resurgent consumer who benefits accordingly. This will be followed by a prolongation of Fed tightening into the secondary acceleration of prices later this summer. The lagged effects of higher for longer rates will depress risk asset valuations into the second half after a Q2 peak.

'Split Camp' Jan 10.

Bingo! Ok, the peak was in July, but the call for a soft landing and a hawkish Fed was there! Helped by a consumer with high savings and tight labour markets, the recession never arrived. The European energy crisis melted away like the snow in the mild winter. The quick reaction to the Silicon Valley Bank's demise diffused the effects of the crisis and gave the system a reprieve from higher rates.

I correctly anticipated that investors would respond to any signs of 'better than feared' earnings by deploying their cash despite the pessimism that had built over the previous year. I dubbed it 'the positioning/sentiment rally'.

Last year the economy did better than the stock market by only slightly decelerating. This year, despite all the economic threats but with gobs of unrisked cash, it seems that it could be the other way around!

'Words of Dove' Feb 2.

But I also pointed out the risks for the bond market priced for a hard landing that wasn't coming. To be fair I have always hated bonds, but I couldn't understand their usefulness in the new inflation-prone world.

 Now the soft-landing camp is in the ascendancy. There is a narrative change afoot, one that this market seems unprepared for especially the long bond. With Fed cuts pushed out in time by the short end, how long before the long-end players give up on their recession fairy tale?

'Just Do Over' Feb 7.

My caution did get the better of me as I argued for a 'sell in May and go away strategy. My bad. I based that call on the poor prospects for the broader market and the lack of positive economic momentum. Little did I know that the seeds of a mini-mania were being sown. The rise of the Magnificent Seven caught me totally off guard as I railed against the Growth hype. I decided to take the summer off, but the market didn't. I got out too soon.

My parting words were prophetic but of little concern to those still playing the market.

 The violence of the sell-off in the overpriced Growth sector could be significant as their rate sensitivity, now underappreciated and forgotten due to the current AI hype, reasserts itself as a valuation governor. Value stocks, while already priced for 'imperfection' will suffer a further earnings reset. That could be the low-risk entry point of the decade but save some dry powder for now as the market may get ugly.

Should current profligate trends persist, as we saw in the failed auction of 1987, there could be an ugly period ahead for the bondies. The soft landing we all hope for may not be as soft as you think, should inflation prove stickier than thought.

October low??

'The Pause that Depresses" June 20.

The ensuing summer rally saw a massive but narrow rally that I could only watch with envy. The AI craze lifted the multiples of the anointed tech beneficiaries and generated a huge concentration risk in the market. The Fed was a willing co-conspirator with its soft landing musings. Although the goods economy had deflated sufficiently both the wage and rent side of the inflation equation remained stubbornly high. Markets were vulnerable to monetary contraction despite the vilification of the inverted yield curve theory.

By August the market was ripe for a correction. Rising bond yields were matched by rising concerns about the debt bubble, and the Debt Ceiling debate in U.S. Congress didn't help. Stubborn inflation prompted the Fed to raise the hawkish tone. Then from Chair Powell in September, we heard the dreaded words 'Higher for longer". Cue the October low I had waited for.

As bond prices cratered, the contrarian in me was stirred. Remembering a long-forgotten time when bond markets actually dictated stock prices, I began to look for a positive turn in the markets.

I don't know if 5% is the right number for defining a peak in bond yields, but it seems like a good place to start.

'Buy Sheep, Sell Deer' Oct 24.

Then we got the sentiment sign I was looking for. Jamie Dimon was selling! Caught up in the most negative bond environment since the '80s and after 3 years of poor returns, the previously bullish CEO now turned seller. He cemented the turn in bonds by his capitulatory call of an imminent 7% yield. I love it when a plan comes together!

In the blog post of the year, I argued that the Fed was done hiking and the bond bottom was in. I was a buyer of Banks, Bonds, and defensive yielders with both hands. The Fed was again behind the curve and they knew it. It just remained a question of when not if they would relax their grip on the bond market. In a nod to the current pivot party, I postulated their move to a dovish messaging by stating:

They are waiting for a consensus to form around a new narrative that will allow them to climb down from their soft landing perch. Burned by bad forecasts, they are finding it impossible to proactively shift their stridently hawkish stance to a more supportive one. They are staying data-dependant. Kashkari even said that they suck at forecasting. I guess they are waiting for the crowd to move first. And we just saw a prime example of how ignorant that can be.

'The Ignorance of Crowds' Nov 7.

My subsequent posts during the rally were guilty of damning it with faint praise. I did worry that the Fed would stay on the brake for too long or that the yield curve wasn't flat enough. That turned out to be unfounded as last week we heard Powell acquiesce to the soft landing narrative, prompting this current pivot party. This bounce exhibited solid breadth and broad participation - something I had pointed out could happen:

It's perhaps given us a clue what a 2024 narrative could look like. There has been a noticeable rotation to the left-for-dead small-caps, hard assets, and financials, with a sharp drop in the Magnificent 7. It's all very hopeful to think about a broader market - one in which the banks participate fully. ( I long for the end of "no banks, no thanks"). But I fear we have much work to do before that happier time is sustainable.

'Sneak Peak' Dec 5.

But my concerns remain after the early Santa Claus rally we have just seen.

This leaves me with a sense of foreboding about January and the early part of 2024. Many owners of the narrow list of over-priced growth stocks are waiting for the new tax year before taking profits. And, any premature rotation to the underperformers of 2023 risks buying into the deceleration in cyclical earnings as employment wanes.

'Sneak Peak' Dec 5.

So here we sit with a market that nobody got completely right and now is almost too hot to handle after the face-ripping rally we just experienced. Bathtub theory indeed! More money than brains - Check. Misinterpretation of the Fed - Check. Premature celebration - probably. Bull markets are almost harder to take than bears sometimes.

If the immaculate disinflation story turns out to be a real thing, nobody will be more surprised than its main architects - the Fed. But that's what this market is now asking us to believe. And the definition of a bull market is more buyers than sellers - don't confuse it with brains.

The inflation battle is in the last mile - that's the trickiest part. It seems the Fed may be willing to accept a higher inflation target in the future but just don't ask them to admit it just yet. Any push-back from the dissidents on the Fed is being ignored for now. But I think a higher neutral rate will be necessary for the positive scenario to come out on top. Otherwise, the Fed and the bond market may take revenge once again.

So if last year's universal call for a recession was so wrong, could the widely-held Goldilocks consensus prediction be similarly at risk? You better believe it! The market has successfully "bullied the Fed", as Mohammed El Erian has said. I guess that's why the current crop of soft-landing optimists are called 'Bulls'. But saying something doesn't make it so.

Enjoy the holiday with good cheer. January could bring a few sober second thoughts.

APPLE

Any stock that purports to have a leadership role will need to show more accumulation than we have just seen in the latest rally in Apple. Notice the poor volume condition with the current rally. Similar to the last time it corrected. Anybody wanna buy a watch?

Risk Model: 4/5 - Risk On

With an overbought condition but without any fundamental sell signals, the Model stays with it for now. The view that the markets are frothy and have jumped the gun is popular. That doesn't mean it's wrong, but reflects a previously underinvested overly cautious participant that has been caught off-guard. Periods like this can last until the narrative of Goldilocks goes away. Watch for signals of a too-hot economy to force a rate back up. That should create the pull-back. Volatility protection is now as cheap as it gets.

AAII Bull/Bear

Volatility Index