Polkaroo

The popular TVO children's program from long ago - Polka Dot Door - was a favourite of my kids. The 'shtick' of the show was an appearance of the male host, in a costume that can only be described as a hallucinogenic giraffe. The same host would return later in the show to exclaim 'The Polkaroo was here and I missed him again!"

Last week was another Polkaroo moment - the market bottomed and I missed it again!

The risk of writing a weekly blog and hitting the 'send button' came back to bite me last week. In a classic "Tuesday at 11" turnaround (chart below), the fears that had driven investors to the sidelines and kept me cautious in September were brushed aside and the markets turned sharply higher. The spectacular earnings from JP Morgan, Bank of American, Goldman Sachs caught the market napping. Higher commodity prices, notably energy, also garnered the attention of the suddenly bullish market players. The selling dried up in key Growth stocks. Bitcoin caught a bid on the news of the approval of a new ETF. Without my predicted 'test' of the 200-day moving average, the correction was suddenly over as risk appetite abruptly reversed.

DJIA

What happened? Why the new optimism?

Is it that the growth rate of the economy is about to implode?

Not from what the 2 Yr yield is saying (chart below).

U.S. 2 YR Treasury Yield

Is global growth set to improve despite the bursting of the China property bubble?

Maybe, given that Dr. Copper as it broke free of a six-month consolidation.

Copper

Was it the imminent melt-down of the uber-valued concept stocks and a rotation to Value?

Not from what Netflix and Tesla are saying.

TSLA

NFLX

Despite the wall of worries that dominates the recent narrative, we have to get used to the basic fact that there is still too much money chasing too few stocks and there will be for some time to come. The sentiment surveys - both AAII and Bank of American Manager Survey are showing an abundance of caution and higher levels of cash. The buyer's strike that culminated with the September sell-off was enough to reset investor comfort levels that the current stagflation fears are now survivable. Inflows into the market resumed last week, with over $3bn going into the key SPY and QQQ funds. The market does 'what makes the most people wrong' yet again.

As long as the uptake of liquidity by the real world lags the provision of that liquidity from Central Banks, the markets will continue to have more buyers than sellers. Stock prices are a monetary phenomenon. The stock market is the plug variable in a system that continues to repress risk. Despite all the fears and bearish hopes- TINA lives!

We know that the current social experiment by the loose perma-dove Fed has to come to a head at some point. The switch from an inflation phobia to an employment focus by Chairman Powell is driving the risk tolerance of investors to a dangerously complacent level. As we saw during the late 1970s, staying too loose for too long will ultimately end in tears. Meanwhile, the game of monetary 'chicken' that Powell is attempting by continuing to profess that "tapering is not tightening" and 'inflation is transitory' is luring investors back. FOMO lives!

What are now the consensus trades that we should worry about? The biggest one is the massive under-allocation to bonds by active investors. Last week saw a decided flattening in the U.S. Treasury curve as the rate hike scenario was accelerated - despite the calming message from the Fed. Investors are sourcing the cash for further investment in stocks from bond sales. Animal spirits are being stirred up by a narrative that encourages increasing risk appetite, force-fed by accommodative Central Bank. We have avoided a 'Taper Tantrum 2.0' for now, but should the anti-bond sentiment get disorderly, it won't be pretty in fixed-income land.

The next hurdle for the markets is the post-taper, stronger global growth 2022 mid-cycle environment. After being delayed by the Delta variant, the renewed investment next year will drive the economy higher. This should continue to fan the flames of anti-bond sentiment, further driving divergence in stock and bond returns. The 'supply chain issue' clogging up GDP progress is actually a potential growth accelerant for next year as increased capital investment attempts to improve production and delivery systems.

So it's a more heterogenous rally, but get used to it. Stock selection continues to play a critical role. According to Morgan Stanley, over 80% of S&P stocks have experienced a greater than 10% draw-down this year - while the aggregate market has yet to drop more than 5%! Given the liquidity backdrop and the flows out of fixed income, that is not surprising. 'Buying the dip' continues to be rewarded. The bull will be hard to play but even harder to fade.

He's still here, so don't miss him again.

Risk Model: 3/5 - Risk On

The resumption of the bull last week was predicted by the model and I should never have doubted it! One of the lags in a key confirmation from the AAII survey, due out on Thursdays. That variable in the model should kick into 'buy' mode should the current market optimism get reflected in the survey.

Copper has vaulted on a supply chain squeeze at the LME generating a decisively bullish CU/AU ratio signal. Despite the potential of a China slowdown, the energy price surge is generating a fear that metals production curtailments won't keep up with the gradually improving demand picture. Gold continues to suffer from a rising interest rate headwind but could positively surprise should the U.S dollar rally start to wane. I'd buy this dip as a hedge against the current market complacency.

Volatility is the linchpin variable currently and in this regard dominates my market view. The failure of the VXV to meaningfully expand is a comforting sign. Only the RSI signal is definitively negative, as the surprise rally has quickly generated an overbought sell signal.