Over Your Skis

Chalk up another victim of climate change. The ski industry is going the way of video rental and photo development as a viable business model. This year marks the third in a row that I have not been cross-country skiing at least once before January. I'd put my skis up on eBay, if only there wasn't thousands of pairs already for sale ahead of me.

And speaking of skis, the market is definitively over their collective ones with the 'jumping the gun' rally since talk of a Fed pivot began last month. We all know that the next move in policy rates will be lower so you might as well price in the positive effects before someone else does. Hence the FOMO/Short Covering rally to end the year. But, (there's always a but) is the pivot party already over?

The catch-up trade is already tired, as evidenced by the sharp underperformance of both small-cap and value trades this week. And the bond market is also ahead of itself. I've been short the 10-year since 3.8%, based on the imminent supply surge and the huge compression in real interest rates. The pendulum has swung too far from the depths of the October 'higher for longer' bond phobia. But this is just a short-term play for me. What about the year ahead?

To get a handle on this year, I took a look at the last validated 'soft landing experience' that occurred in the 1994-95 tightening cycle. I found some similarities to the current setup. But there were significant differences too. We shall see if those differences matter in short order as the markets develop, but for now, I'm cautiously optimistic about the outcome.

The biggest similarity I see is the level of investor pessimism that preceded the soft landing of 1995. The AAII Bull/Bear ratio looked eerily similar to the recent 2022-23 experience. In both instances, investors anticipated the negative effects of tighter monetary policy well in advance of their effects on the real economy and took evasive action. That explains the $6tn of unrisked cash on today's sidelines.

1994-95 Bull/Bear Ratio

2022-23 Bull/Bear Ratio

Similarities also include the volatility backdrop. Once the 'Mission Accomplished' banner was unfurled by Fed Chairman Alan Greenspan in early '95, the Vix levels dropped and stayed low for the duration of the rally well into 1995. Can Powell be far behind now that core inflation is ticking sub-3?

1994-95 VIX

2022-23 VIX

As to valuation, investors are looking through the earnings deceleration as they did back in 1995. Expanding PE ratios are the hallmark of all early-cycle market recoveries. These charts are almost identical!

1993-94 S&P500 PE Ratio

2022-23 S&P500 PE Ratio

Now for the differences.

Although dramatic flattening occurred, the yield curve never inverted in 1994, bouncing to a positive 30-40 bip range. Back then, the bond markets had never even heard of YCC or QE, now commonplace in the Central Bank policy toolkit. It was up to bond market participants to 'price-in' the inflationary threat posed by the post-recession recovery in 1993-94 and yields backed up sharply in the long end before the tightening.

This current cycle of tightening saw a new price agnostic player - the Fed -, who dampened the inflation premium during the Covid easing phase, and kept buying long-dated bonds and MBS right into the teeth of the recovery. - This had the effect of suppressing market signals and thereby letting the inflation genie out of the bottle. Add to that, the huge net real savings bulge from the fiscal support during Covid and it's no wonder bond yields are still barely positive in real terms. I still don't like bond valuations, despite my October yield peak call.

1994-95 Yield Curve

2022-23 Yield Curve

Another difference is the persistent weakness of the major commodity prices that has proceeded the Fed pivot. The copper-gold ratio has already been falling for almost two years now. In the 1994 example, it peaked almost coincidentally. Oil has similarly been much weaker than the 1994 example.

1994-95 Copper/Gold

2022-23 Copper/Gold

This could be due to the global desynchronization of the U.S. economy. The financial earthquake of China's property collapse is still producing aftershocks as we speak. It will be interesting to see if Emerging economies, ex China - Indonesia, India, Brazil - can offset this effect going into 2024 and beyond. Brazil is experiencing a multi-year breakout. With a new government, trade surpluses, growing oil production, and an easing Central Bank, it is a good bet for the year ahead.

Brazil Equity ETF

All in all, I see no reason for being a contrarian this year. Although we are over our skis a bit here, the risk this year will again be a call for recession that never comes - I call this condition Rosenbergitis. The soft landing will have some notable bumps, but those headlines will be idiosyncratic. Just ask Boeing about that. Systemic risk is highest when the Fed unexpectedly tightens the screws and people are caught napping á la Silicon Valley Bank. For that to happen again, we need to see something other than the declining inflation and decelerating growth forecast that early 2024 offers.

Inflation should bottom out in the first half of this year, so it's 2025 we should worry about. Add to that the quadrennial shit-show of a U.S. election, and there should be a pick of volatility in the back half of 2024.

So buying the dips and selling the rips may work this year. Stock picking and wider diffusion of return sources are likely to be the backdrops to a broadening of the tape this year. The Magnificent 7 is down to 5 with the sudden de-trending of TSLA and AAPL. There is more to life than mega-cap. Small caps, non-U.S., and Value, with a smattering of momentum technology stocks like NVDA, is my bet for the year ahead. And a 4200-4800 trading range looks likely.

Enjoy the risk asset slopes this year, even if there will be a bit of mud on your skis.

Risk Model 5/5 -Risk On

Going 5 for 5 is a bit rare for the Model and I'm even fudging the Copper/Gold Ratio today. It's right on the signal line so it could flip later today. But it needs to do a lot of work to convince investors to stop buying NVDA and go long FCX as they did in 2020 and 2022. Jes' sayin'.

Relative Performance: FCX vs NVDA

The consensus thinking about China's weak economy is keeping investors away from what is a growing opportunity in the rest of the emerging market space. As I showed with Brazil, there is life beyond China if you would only look for it!

Emerging Market ETFs - Ratio of ex-China vs including-China