Revenge is Sweet

These past two weeks have given us a glimpse of what the next bull market will look like. But the aggressive investor crowd are confused. They have been brought up on disruption stories and messianic leader-driven concept stocks, and have no clue what is going on here. Long-suffering conservative investors are about to enjoy a renaissance. The Revenge of the Nerds is back! The 'Nerds' in this case are investors who 'Never Enjoyed Reddit-Driven Stocks'. Count me as one of them.

The last 10 years, since the onset of QE and ZIRP fomented a falsehood that investments didn't need to generate near-term profits for their inherent validation. All the sins of omission or commission on the part of these growth stocks were forgiven in a bull market fuelled by hope over reason. Of course, there were notable successes such as Tesla and Amazon. But now their days as market leaders are over. The crowding effect of the few winners gaining all the investment flows generated historic overvaluations that are now unwinding.

Investors, who for months have been cowering in the risk-market corner clutching their T-bills, are now buying the dip with renewed vigor. Equity positioning is the main reason equities have been rallying. In a blink, the over-sold markets of September have quickly been replaced by an equally overbought October. But it is what they are buying that has caught my attention. Small Caps, Dow Stocks, and Value outperformed. And I don't think that will change anytime soon.

The chart below is illustrative of this. Growth stocks are underperforming Value by a wide margin. After an era of easy money and poor relative returns on Value-oriented strategies, the top for Growth is 'in'. We should spend the next few years returning to trend and perhaps over-shooting. Newly-adopted tight financial conditions from policymakers, exacerbated by the supply-constrained goods economy, portend persistent headwinds for mega-cap, long-duration equities, as interest rates stay elevated due to stubbornly high inflation. I have drawn an uptrend to indicate the secular uptrend in growth over value during the QE Era. I'm not convinced that it will hold as the QT era unfolds over the next few years.

Russell Growth vs Value

Similarly, Small-Cap has begun to emerge from a bottom pattern. Propelled by a durable economic performance from the U.S. economy and supported by the tight labour markets, the smaller domestically oriented companies continue to chug along, despite some notable exceptions. The post-tightening prospects for these cheap equities are tantalizingly bright.

Russell SmallCap vs LargeCap

This is not to say that the market is out of the woods just yet. You rarely see a market so willing to jump the gun as this one. We saw it in July, as the anticipated earnings rollover was tenuous and unevenly distributed. This earnings season is similarly shaping up to be 'less bad than feared'. As a result, cash-rich portfolio managers and private investors have enthusiastically embraced the notion that the 'Step-Down Fed' (re-read last week) should prompt a Pavlovian buy-the-dip mentality.

The Fed may need to pause at some point, but at what cost? The data is not universally negative as of yet. Just the sentiment was. I think we need more bad news in order to get a sustained easing of financial conditions necessary for a durable bull market. The rally in risk assets by itself has partially countered the efforts of the Fed to combat inflation expectations. Chair Powell is not amused, stock bulls.

Markets hate uncertainty. The well-scripted transparency of the Fed's tightening policy has given the average investor confidence that they 'know' the future path for rates. So, prompted by the fixed-income rally that has acted as a relief valve for risk-taking, stocks are being chased higher. Add to the positive optionality of a China restart (note the 5% HSI bounce today) and "risk-on" is the new default condition for investors.

Although I saw this coming, it doesn't make me complacent about the risks. As I postulated last week, the true bull market of our future depends on a level of economic pain that has yet to be fully embraced by market participants.

The mortgage securities market is a complete mess with MBS spreads at crisis levels. A hard landing in real estate is inevitable. Resets are about to hit homeowners with nose-bleed level rates relative to their pollyanna expectations of just six months ago. This is why the 'long and variable lags' expression about monetary policy was coined in the first place. As we have seen in China, the first signs of duress will come from the shadow banking segment of the industry. The tide of cheap credit has gone out and there is a naked swimmer out there somewhere. It just takes time to find him.

Similarly, the consumer discretionary segment is now slowing dramatically - see $AMZN and $NFLX. It may soft-land as many expect, but I'm calling for the Grinch to steal Christmas, especially if crude prices jump higher in a post -SPR supply crunch rally. I know I'm on record as calling for the opposite but given the global uncertainties, prices could stay elevated for longer than the weaker seasonality would dictate.

As for the Copper market, it is also a pick 'em call here. There is a level of shortage building in the out months of the futures curve that offsets the weakness of the current supply/demand balance as the global economy cools. The CEO of copper giant Freeport gave a bullish longer-term outlook in his recent LME week speech that caught my attention. If one looks over the current valley of the current Fed-induced slowdown, copper looks much higher than current levels.

This is also supportive of a return to a less 'growthy' stock selection tilt as we transition from the momentum mania market to one of higher for longer interest rates and higher input costs for the post-carbon economy later this decade. Goldman Sachs' Jeff Currie with his secular commodity call may have been temporarily hijacked by the pernicious Fed attack on inflation, but I do believe it had an intrinsic validity, nonetheless.

So enjoy the current rally if you must. It will peter out in time. October, lived up to its reputation as the 'bear killer', prompting a seasonal pivot point once again. But isn't the current bounce nothing more than a reflection of how pessimists got too far over their skis? The AAII Sentiment Survey has never been so scared of a market in its 35-year history from a moving average basis. The Iraq War, Tech Bubble, GFC and Covid were less damaging to optimism than the end of easy money has been. It says a lot about the postulation of stocks being primarily a 'monetary phenomenon' in my view.

AAII Bull/Bear Ratio - 30wk ma

I await the post-election U.S. mid-terms environment with a bit of trepidation, especially if the Democrats surprise the consensus and retain control of the Senate. Their espoused anti-Fed, anti-oil, and anti-wealth policies are anti-risk-taking, to say the least. A hung jury outcome will be neutral for stocks, as always, but that outcome is a dangerous consensus view as we rally here.

The case for investing is strong. The case for momentum chasing is not. Although revenge is sweet, it is a meal best consumed slowly.

Risk Model: 4/5 - Risk On

Helped by a lower 3-month VIX and a bounce in Copper/Gold, the model has 'played' this rally nicely. Now that the RSI is quickly approaching overbought levels, I am reluctant to go all-in for risk-taking at this juncture. It is still just a technical bounce until such time as monetary conditions can be eased with consistency. In 1994, the last true 'soft landing', that process took about six months from the end of tightening before the confidence in the economic outlook coalesced around a rebound and a fresh bull run began. This Fed hasn't even blessed us with a hint that they are done jamming on their brakes, let alone reversing their stance. Risk on for a trade if you want but don't get wedded to a view just yet.