Silent Night

All is calm. All is bright.

There is a noticeable lack of concern in financial markets going into the Christmas season. Traders are starting to prepare for the holidays by 'squaring positions' and trading volumes are slowing accordingly. Volatility is ebbing and fear is almost a forgotten word in the popular financial media.

The pre-holiday shopping and festive preparations have been scaled down this year as we deal with the second wave of COVID. But that hasn't dampened the spirits of investors, judging by the sentiment surveys. Whether it is the recent rush into the re-opening trade, the last gasp of Tesla into its index inclusion or the hype surrounding Airbnb & DoorDash, there seems to be no lack of confidence in a better, brighter future. The consensus for a smooth transition phase from the acrimonious Trumpian era to a harmonious political kumbaya is now gaining credence as the fiscal sausage-making in Washington gathers momentum. And expectations for The FED to announce maturity extensions of their QE program next week has calmed the bond market nerves sufficiently, following the sudden vaccine-induced yield surge of recent weeks. The approvals of vaccines are now like sugar plums visions dancing in the dreams of investors the world over.

Sorry Santa, like the Christmas season, I don't expect these expectations to last much longer.

Initially, the roll-out of the vaccine programs will be bumpy and protracted, leading to a slower than hoped recovery and extended financial duress. More threatening, the re-opening trade south of the border is now being short-circuited by a vicious counter-attack from the virus, unhindered by a lack of any coherent curve-bending policy responses. And the quiescent bond market is being hoodwinked into believing that QE is the antidote to all financial market ills. With inflation expectations now rising and Treasury issuance more than three times the level of announced QE, it's easy to envision a rough patch in the bond market, leading to a market set-back of significance. And with the year-end FOMO trade in full swing, this should be a classic sell-the-news intermediate market-top when the first vaccinations start. Option activity is currently dangerously bullish.

These worries should be, from a market perspective, temporary and survivable. The stability that we currently see stems from the bad-news is good-news bull market mantra that has dominated this year. The 'Powell Put' hedges my January 700 TSLA calls!

So dear pundit, what other lumps of financial coal are likely to discover in our market stocking? They will take the form of bond certificates, in my view.

Once we get over this false-start recovery phase and the vaccine takes full effect we will ultimately get higher rates, as we always have had in past recoveries. The long end of the bond market will see it first, so I'm watching it like a hawk. Tens-twos went out to new highs this week, despite all the 'second wave' news. The consensus of a 2021 year-end 10 Yr bond yield currently sits at 1.2%. Really? Inflation will likely print above 3% in March!

The next few months will see the ending of the case for 'lower for longer yields' as a credible valuation support mantra. The case for a rising stock market in the first stages of any recovery I can remember has always been based on hope, and this time is no different. Bull markets begin in pain and economic deterioration. There are always investors left at the starting gate, vainly waiting for a sign that things are getting better before committing to the new market cycle. Unfortunately, the market doesn't wait for them to get aboard the train before chugging out of the station.

Conversely, the market always has a significant corrective phase precisely at the moment that the actual recovery begins to broaden out. This puts the johnny-come-lately crowd on their back foot again, as markets respond poorly to the 'good news' of restoration of economic normalcy. it is this perversity that I really love about the stock market. It always does the thing that makes the most people wrong!

Why does this always happen? Two words - human nature. And the Federal Reserve governors are looking all-to human right now.

I have been watching the pronouncements coming from Fed officials recently and have noticed a decided preoccupation with the short-term. The lack of a second phase of fiscal stimulus (only in America by the way - Canada is still blasting the stimulus fire hose) is seemingly a preoccupation with many Fed officials. They are hell-bent on overstimulating the economy after re-reading the Bernanke playbook from the post-GFC experience. It is human nature to fear a repeat of the tepid and tentative approach that almost failed to revive the 2009-12 post-crisis economy. They seem determined to keep the spigots open long after the evidence of success is on the tape.

The consequence of all this will be a sharp and damaging resurgence of temporary but extreme inflationary forces. That should take some parts of the market by surprise. I say some parts, but I really mean bonds and by extension expensive growth stocks. The rush to the exits should be a painful lesson for the Newby momentum trading crowd. I expect they won't even get the chance to sell, given the technical weakness in Robinhood's trading platform that has already been exposed.

It's been a widow-maker trade to short the bond market for virtually 40 years, so I know this is potentially the worst call of my career. I have already written about the end of the secular bull market in bonds once before. Go back and re-read my January 2018 piece "No Mr. Bond - I Expect You To Die"

It was a good call for 10 months, but ultimately came viciously undone by the U.S. - China trade war and this year's pandemic black swan event.

This trade (expressed by my long position in TBT) could be challenged by any signs of economic slowing or from exogenous market gyrations that drive risk-off panics. But absent those near-term threats, the more likely scenario is for a successful and robust recovery next year that leads to expectations of a reversal of Fed easing bias. Reported inflation will spike as we lap 2020. More important, a COVID-free future will generate animal spirits as we rush to make up for experiences lost over the last 12 months. Voila - rising bond yields and a market correction! The rush to the exits will be abrupt and painful.

There will be some excellent trading opportunities over the next few months as these various scenarios play out. Buy-and-hold strategies will be challenged. Stock picking and trading should be rewarding again in what I envision as a broadly topping trading range. And not all market segments respond poorly to rising rates. The commodity markets, although short-term ahead of themselves (read last week), will benefit from a combination of successful reflation of the economy as well as the current debasement activities of fiat currencies by central banks.

I expect that we should get ready for some January fireworks. The silence you are now hearing will shortly be broken.

Risk Model: 3/5 - Risk On

In a repeat of last week, we have price variables overbought and the fundamentals supportive. People see economic recovery coming and are complacently bullish. As I have argued above, that is not how you make money in the stock market. I expect the VXV indicator to have it's annual January blow out sale, but the sidelines seem like a good place for now.