September or Meh?

I apologize in advance for the lack of conviction in this week's post but sometimes it just feels like it doesn't much matter what I say - nobody seems to care. Sitting here on the first trading day of a new month, taking in the various commentaries rehashing the litany of fears, woes, and existential threats to holders of risk assets, I've got to ask myself, why should I care?

Call it complacency, call it inertia, but there just isn't a fat pitch that justifies a big swing. I'm waiting for now. Just like everyone else.

Go 'full-on bearish' and you are fighting the most telegraphed prepared-for bear market I have ever seen. People seem resigned to the inevitability that the economy will deteriorate steadily over the next year - and earnings-sensitive assets, both stocks, and credit should suffer. Sentiment, commitment levels, and cash levels are at extremes. Speculation has again faded badly as Bitcoin and GME head lower after their failed summer revival show. Bet365 has replaced Robinhood as the millennial's favourite site.

But get up your nerve to call the bottom, arguing all the negatives are impounded at today's prices, and you risk having your ass handed to you by a Federal Reserve that is on an as-yet-unfinished mission. They have raised rear-view mirror navigation to a new art. A revisiting of 3.5% on tens won't make investors' lives very easy. Remember I argued if the curve 'un-inverts' - either way - it will hurt risk assets. Seems like higher long-end yields are the odds-on fav bet there.

Although the summer rally seemed a fool's errand, the recent pullback has been relatively shallow so far. Stocks got some mixed messaging with the release of positive U.S. data on employment, bolstering the case for a soft landing. The perennially resilient U.S. consumer has been let off the hook by declining gasoline prices. I think that's a bogus read. Mortgage rates have eaten into shelter costs recently and employment is a lagging indicator. The path ahead for their domestic economy is as clear as mud. Ex-North America, the story is incontrovertibly negative.

For energy, it's an even tougher call to make now that demand destruction, especially in Europe, is vying with supply curtailments for a price-signaling narrative that traders can get behind. Efforts to stop Russian crude from leaking out to Asia have so far failed. Opec+ is doing its best to hold the line but has yet to fully convince the markets.

For currency players, the cognitive dissonance of a monetary tightening cycle in the face of global deceleration has them herding into an ever-crowded U.S. dollar trade. Nobody is calling for a yen rally now that Kuroda has lashed himself to the wheel of lower rates. Sterling acts like the second coming of a Soros bear raid is imminent. Can they all be right? I smell a short squeeze coming at some point, but not just yet.

Credit is halfway between the QE tights and the recessionary wides, evidence of a split-camp mentality for the corporate debt cycle. The market has been orderly and corporate funding efforts have been uneventful. It's a far cry from 2008, but the curve is still inverted - a bearish sign.

Given the above, why should I care?

As the active investor knows, there is always a risk that a random event upsets their view and they must make a decision. Either they react (the facts changed and so must I) or become entrenched (the market is WRONG!). But neutral is always an option. You don't always have to position yourself in the tails. Passive may be boring, but it has its merits.

I have been waiting for the earnings downgrade cycle to show up. It seems closer at hand now. When economically immune mega-caps like Apple and Microsoft represent such a high proportion of the most widely followed index and Energy has been a fish swimming upstream, it has been hard to tell if the earnings environment is actually deteriorating. But this quarter should be the 'reveal' that I have been waiting for.

As for Apple and similar global companies, I don't like their chances when the U.S. dollar is rising and their product cycles are long in the tooth. As for smaller capitalization stocks, they are weakening as costs outpace their revenue growth. Interest-sensitive stocks are caught between the rock and hard place of higher rates and an inverted curve that makes cash king. Energy stocks may have already seen their best days.

All this reinforces the bear case that the likes of Morgan Stanley's Mike Wilson have posited. But the switch will flip if the Fed gets cold feet on its inflation fight and dovishly pivots due to a sudden shift in the inflation narrative. Watch for commodities to resume their downside for a tell. Energy is also a crowded and consensus 'long'. Any crack there and most risk-off bearish bets will get covered.

You won't catch the first ten percentage points of the market rally if that happens.

So timing the bottom seems like a mug's game. If you ask me, this feels more like Meh than September.

Risk Model: 2/5 - Risk Off

I second-guessed the model last week and it worked! I didn't think AAII Sentiment, VXV and Copper/Gold would hold up and they are all reversing sharply now. My "don't fight the Fed" thinking seemed well founded. The summer bear market rally reversal has taught many that harsh lesson yet again. BBBY squeezers - I'm looking at you!

The chart below shows the ratio between spot VIX and the 3-mo VXV. Risk-off events usually culminate with a sharp rise in this indicator. If we get a spike this month or next it could signal a bear market capitulation has occurred. The circle is the Covid crisis spike demonstrated just such an event. There is a large basing pattern in recent months that could easily result in another low-risk entry point just ahead.

A fat pitch! Send it in!

VIX as a ratio of VXV

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