Sell The News

Why do markets always sell the news?

Bitcoin, NVDA, and the Japanese Yen have all sold off this week after what seemed like positive news. Each for a different reason, but all are down sharply from their highs. But when it comes to risky assets, it's always been this way. Markets remain undefeated in their battle against investors who chase trends. They punish the late-comers mercilessly, confounding their expectations and confiscating their profits. It's why I love them, and simultaneously fear them.

These sudden reversals may portend even bigger things in the next few weeks. The rally since last October has been based on two supporting premises. The first driver of this rally, and one I flagged in early November, was the impending 'pivot' of the Federal Reserve from a tightening to a neutral bias on the peaking of inflation expectations. The second one was removing the word 'recession' from the narrative and replacing it with the now-consensus 'soft landing'. The markets have embraced it as it provided surprisingly strong earnings revisions. Both the pivot and the soft landing are valid supports of the bullish case for risk assets.

But now they are the 'news' that investors can sell. And the environment for a pull-back or correction is ripe. Bullishness, although not extreme, is in risky territory, and often means reverts suddenly.

AAII Bull/Bear Ratio

As to the all-important inflation narrative, the risk is to the upside. A resilient U.S. consumer and strong capital investment are boosting goods and services demand. With a fixed supply curve for many goods and a labour squeeze, prices are sticky. The Fed's wiggle room to produce lower rates has quickly evaporated. Inflation has bottomed at 3% and will go no lower in my view. The chart below, a long-forgotten Fed indicator known as 16% Trimmed-Mean CPI, is instructive. It smooths the data by trimming the 'tail' readings from volatile one-month moves. It looks to have already made its low last summer. If it was a stock, I'd be a buyer.

FED Trimmed CPI

As for the earnings surge, the expansion of valuation has already 'priced that in' to equities, especially in the stronger momentum areas of this narrow market advance. Looks pretty rich to me, but it isn't a good forward return indicator by itself. I'm just saying the earnings news has been good, but you sure have paid for it!

S&P 500 Price/Earnings

So what's a market to do when the unexpected becomes the consensus? Sell the news! The next set of expectations that will drive a new narrative is what matters most. In a broadening bull market, the rotations are often fast and furious. After a huge run-up, AI now stands for 'All In'. - who's left to buy? The AI expectations wave has hit the shore and is now beginning to recede. You gotta go where the puck will be, not where it is. Last week, Copper jumped out of the penalty box and scored a short-handed goal on team NVDA.

Admittedly, I have been a bit more cautious about the markets for two reasons. Firstly, I'm getting older. The obvious consequence is ( besides more bathroom visits ) increased conservatism and higher risk aversion. That's why I never opine when asked, as I was this week, to give personal risk-taking strategies. Everyone's circumstance is unique and I don't have the qualifications to advise them. You are your own Risk Control Board.

The second reason for caution is more pedantic but no less important to the narrative. With the stronger-for-longer economy, the R* discount rate has ratcheted higher and now threatens the equity market from a macro valuation standpoint. Capitulating bears and FOMO have been active this year so far, oblivious to the fact that the Federal Reserve meeting should again push out the dot plot into late this year. Bond yields are entering their third year of an uptrend, as the rush for duration extension has been more than met by record supply. I am reminded of what a veteran bond told me once back in the mid-80s - "the bond crop never fails"!

U.S. 10 Year Yield

I'm throwing the flag on this market for excessive celebration after a touchdown (even if it was a soft landing). But it's only a 15-yard penalty, not the end of the game.

Markets have been undergoing a quarter-end window dress that prevents many institutions from making abrupt moves, even if it is warranted. I'm looking for a correction in this market, but it might take a turn of the calendar to do it. But using a time-honoured technical rule, I'm also looking for a rotation to market segments that exhibit good relative strength during just such a downdraft. Those will be leadership stocks in the next advance.

We got a glimpse of 'where the money's going' this past week. Last week, I flagged the upside potential for the energy and materials segments that had been left for dead by the Magnificent Seven mania. Copper finally broke above an ascending wedge on an unexpected supply curtailment directive in China. It may seem a bit premature with the weak demand dynamics in the all-important Chinese economy. But there is life beyond China for the red metal. Traders may be overly concerned by the real estate debacle there, and are missing the growth stories from the likes of Brazil, Mexico, India, and other Ex-China EMs. Long copper, short Tesla still works for me.

Copper Price

So the bull market isn't ending, it just needs to stop reading its press and start sellin' the news.

Risk Model: 3/5 - Risk On

The swapping of positions by two of our Model components is instructive. Copper/Gold rallied hard on the China news yet at the same time, the $VXV rose above its signal line, indicating a rising demand for protection on the part of investors. We will have to wait til the Thursday print for the AAII Bull/Bear indicator. A sudden drop as I outlined above could cement the case for risk-off.

I expect a return of volatility at some point this year. I can't believe that the U.S. market, as well supported as it seems to be by rising earnings expectations and cash coming in from off the sidelines, can go another year without some hiccups. The declining trend of volatility seems to be now entering an accumulation phase, and just like a stock, could be setting up a new uptrend at some point this year. I can't think of any catalysts but maybe this guy can:

3 Month Volatility Index - CBOE