Revisionist History

Investors have entered the 13th month of the bull market still searching for a market peak that seems ever more elusive. I have just one word for the bears. Revisions. They're really, really good.

One of the main preconditions for a correction, overvaluation, is obviously in place. Asset prices have been jammed higher by the Fed, hell-bent on financial repression. Both administered rates and, through the magic of TINA, the equity risk premium, have compressed, forcing up valuation to generational highs. Unfortunately, especially for the long-suffering bears, that isn't enough. Stocks are composed of three elements: risk-free rate, risk premium and expected earnings. The actions by the Fed have taken care of the first two. The third element, earnings, is all that stands between investors and a meaningful pullback.

We will shortly be faced with a deluge of earnings reports and/or guidance that should be universally positive. And markets have acted well in advance. The internal correction in markets since last fall has averted a more coordinated drop. Value took up the baton dropped by the high flyers in February. And judging by the chart below, there is good news yet to come on that front. Earnings revisions are always a precursor to the better than expected reports soon to be reported by the more cyclical side of the economy. Just as the analysts were behind on reducing earnings last year as the pandemic worsened, they are now playing catch-up to the rapid recovery of the corporate reports due in a few weeks.

Earnings Revisions

But will the blow-out earnings due to be reported be enough to keep the markets elevated? Or are we on the cusp of a sell-the-news top? Like the bettors who had Gonzaga last night, it could be lunch bag letdown time. Still fits well with my 'sell in May' view. But let's just wait and see.

Tesla, a good test case, reported some key numbers yesterday. Not earnings, of course, that is too old school for the likes of star manager Cathy Wood and her followers (Arkolites?). They reported vehicle deliveries that were about 10% ahead of expectations for the quarter. Wedbush Securities analyst and Elon Musk fanboy, Dan Ives, called it a "drop-the-mic" number and promptly raised his bull case target to $1,300. The stock responded by initially breaching the $700 level before failing to hold it and fading badly into the close. I don't call that 'great tape'.

With the markets jammed up against the top rail of the channel defined by the tops of the last decade, I believe that we have priced in most of the good news. The chart analysis below, courtesy of former superstar stock salesman (and one-time John Bolton look-alike before he shaved his moustache), Bill Verner, shows the limiting effects of a clearly defined channel for the S&P500.

S&P 500: 2009-2021

It remains to be seen what path markets take going forward, as we bump up against the guardrail defined by the last decade of price action. Is it a sharp pullback to the midrange like the 2010 experience, or a bump-a-long topping like 2014-15? The market's reaction function to the earnings, about to be reported, will tell the tale.

The weak bond market, last month's sentiment shocker, seems to have settled into a range between 1.60% to 1.75%. These levels look unthreatening to a market about to get a positive earnings boost. The 2Yr yield is similarly well behaved, lingering below 20 bps. As the "transitory" inflation data roll out over the next few weeks, the markets will inevitably be sensitive to Fed policy communication. I think they will err on the side of caution. Nothing to see here.

Fund flows last week showed a preference for defence. Utility and short-term bond funds received inflows from investors fearing a correction. I'm watching for pre-earnings jitters that could develop over the next few weeks. This week's AAII sentiment survey could give us a clue. I'm thinking a plurality of investors is looking for a pull-back.

The amount of de-risking and low positioning in the cyclical side of the markets argue for a choppy sideways corrective phase that frustrates the cautious crowd. The message of the market so far this year is still one of stock selection, not market timing. If those are the cards we are dealt, those are the cards we play. Absent a melt-up from a FOMO risk-on chase, I don't have enough of a reason to short this market, especially given the collapse in the VIX.

But that view, like all expectations, is also subject to revision.

Risk Model: 3/5 - Risk On

Having been stuck in the 'on' position for weeks now, I applaud the model for not trading in and out of a market that just keeps going. Further investigation (the chart below) is necessary for navigating the daily swings, should anyone be tempted to do so. Stock pickers can go back to doing what they do. Ignore the following guesswork.

The porpoising action of the past six months has revealed a relationship between fund flows (defined by the Chaikin Money Flow) and the subsequent price action. The obvious conclusion is one of caution now. There needs to be a strong volume uptick in response to the earnings season, or a pull-back of some magnitude, as we saw in February, could ensue.