Safety Sucks

The repetitive patterns that we count on are once again on full display. Good news. A typical seasonal October low is in the making! Now that the narrative of 'higher for longer' has become entrenched, risk is being shed like a summer wardrobe. We all saw it coming and thought it would satisfy our desire to punish the mega-cap leadership. Think again.

Unfortunately, this is a correction that is punishing the left-behind and underperforming segments in a cruel blow to the more risk-averse among us. Defense, in the form of utilities and high dividend payers, is perversely the most vulnerable segment, driven by the sudden repricing of long-term bonds. Thanks to a Federal Reserve that continues to drive in a rearview mirror, we haven't seen the last of rate hikes. Having fully bought into the soft-landing theory, they are remaining vigilant. Loretta Mester, a FOMC voter, posited one more hike in a speech just yesterday. Just holding short rates at current levels would generate bond weakness due to forward duration convergence. Bonds suck.

As measured by the ratio of Value vs. Growth performance the news isn't looking great for cheap stocks either. An almost two-decade-long downtrend of this ratio has taken $1.25 and turned it into less than 60 cents! Remember, the Value ETF has both defensive and cyclical stocks as its main constituents. Both have suffered disproportionately during this tightening phase. The bottoming phase for the Value trade has taken much longer than anyone expected but a possible pattern of downside exhaustion is gradually appearing after last year's aborted reversal in market leadership.

Value vs. Growth ETF Ratio

So what kind of correction punishes the most conservative investor? I invite you to keep all expletives to yourself. I have enough of my own.

It's no fun being a retired guy looking for a safe and secure retirement with a major allocation to fixed-income and dividend stocks. But it made no sense to take any economic sensitivity risks given the inverted yield curve. And the Growth trade seems wildly expensive. Deeper cyclical segments of Value have also been punished by a combination of slowing global demand and a strong U.S. dollar. Add to the decelerating G7 economies the China real-estate implosion that has sucked dry any speculative flows into commodities.

That has left investors with a singular default option - buy the winners - Apple, Amazon Nvdia, Google, Meta, Tesla, and Microsoft. And that's what 'they' did yesterday. Higher rates actually benefit these free cash flow machines as they continue to pad their immaculate balance sheets. So fight the tape if you want, but the leadership of this market will remain intact until the Fed is in an easing mode. That easing mode by definition can only follow a liquidity or economic event that would first generate a further liquidation of the Value trade. A Catch-22 if I've ever seen one.

Let's play the optimist for a bit here. If the Fed is wrong and inflation comes down without having to hike rates again, maybe we can see them cut a couple of times and re-normalize the curve. Their projections of 3.8% by year-end are likely to be under-shot if crude oil weakness persists. Other commodities have been weakened by a soaring dollar and the China slow-down. What makes crude strong is the seasonal rebuild for winter that typically peaks and declines into November. I see that as a catalyst for a Fed pivot as early as Q1 '24 especially if the current labour cost push fails to generate meaningful consumer price hikes.

Crude Oil Seasonal Pattern

The current bond phobia is reaching a frenzy. Calls for the return of the vigilantes are rising to a fever pitch. Pessimism has been heightened into this week's 10-year auction as supply is rising from all sides of the equation. China is reported to be selling U.S. reserves. The Fed itself is not replenishing its bloated balance sheet. X searches of the term "bond yields" are second only to "Taylor Swift". A counter-trend rally in bond prices is likely now. Note how the CMF volume is showing non-confirmation of today's price level and the RSI is oversold.

TLT - Bond ETF

So what will it take to generate the broadening out of the narrow cyclical bull market? We should see enough data over the next few weeks to make a stab at rotating toward the economically sensitive parts of the market that have been so badly punished. Hard landing data would generate further weakness in cyclicals and banks but could cause a Fed pivot that could bottom those stocks that have already 'priced-in' the recession. Soft landing data, as we got this morning, will perpetuate the growth outperformance as they are best positioned to withstand the higher-for-longer environment.

The Fed seems to be erring on the side of being too tight for too long. Just as they underestimated inflation on the way up, they seem to be keen to stay on top of inflation as we decelerate. They want to be sure they have licked the problem. In doing so, they risk generating a hard landing that we didn't really need, but it is what it is. The JOLTS data this morning indicated a strong environment for workers in the U.S. There seems to be no end in sight to the resilient economy that resulted from the over-stimulated environment of 2022. That pushes us further into Q4 or Q1 '24 before we bottom the Value trade.

For now, the safety trade still sucks.

Risk Model: 2/5 - Risk Off

The rarely invoked 200-day rule, while still positive, is heading south (currently 4% below) as the XIU falls well below that long-term benchmark. The rule goes into 'sell' mode when it breaches 95% of the 200-day moving average and is only operative during the worst bear markets or during severe corrections. Stay tuned this week for such an occurrence. Also, the 200 dma is likely to start trending down should the October weakness persist.

XIU

Copper/Gold has been schizophrenic. A sharp sell-off in Gold has generated a whippy sideways pattern. Not a surprise given the economic cross-currents during at tightening phase that refuses to definitively break the economy down. Perhaps this is a soft-landing/hard-landing head fake that awaits a more definitive breaking of the pattern that is just ahead.

Copper/Gold Ratio