Some Like it Hot

The bull market of everything has shrugged off yet another challenge this morning. Bond yields are suddenly rising but the equity buying stampede is seemingly unfazed. The bull case for stocks, based on low rates and rising economic growth has become an unassailable consensus in early 2021. The cooks at the Federal Reserve monetary kitchen have kept the money-pot boiling for a while now and investors, like a frog, are feeling warm and cozy. This teflon-coated market is warming up and investors are loving it.

The frothy activity in the meme stocks or the exploding volume in the options market doesn't seem to have made a dent in investor confidence yet. You actually need to have froth like that to draw attention to a rising market. It's now the conservative investor, after reaching for yield in an era of financial repression, who is suddenly getting fleeced. Apple issued bonds last week that are now down a quick 4%. Austria issued a 100 years bond that has fallen 25% in a matter of weeks. Conservative investors are jealous. Just try telling clients that your portfolio is underperforming a bunch of chat-driven retail traders with 6 months of experience.

Investment losses often produce behavioural change. Having already lost their coupon this year, the reaction of some investors is likely a reversal of their previously held caution. The 'safety' of fixed income seems like a head fake now. It has only taken a few weeks of poor returns to turn their thoughts to the alternative - stocks.

Inflation talk has recently trended higher, propelled by the looming prospects of a vaccinated population with pent-up demand, colliding with a supply-constrained economy. Add to this, we have the inflationary and mistimed fiscal stimulus now being concocted in Washington - in my view 'too much - too late'. Then there is the statistical certainty of a surge in the 'annualized' data from last years' weakness adding fuel to the inflationary fire. A sobering gut-check has arrived for the bond market.

This explains why we are seeing investors again pile into the stock market. The seasonality of fixed income investment flows is usually front-end loaded, meaning the best issuance environment has now come and gone. But can't we still make money this year? Stocks offer inflation protection - don't they?

If we have learned anything about the behaviour of investors over the past 12 years since the Great Financial Crisis, it is that they are resilient. This is why the widely expected market correction, overly anticipated since the late October lows, has been forestalled time and time again. Monetary conditions are still supportive of risk asset prices, for now.

So what needs to change for the party to take a much-needed breather? I go back to the gambling analogy, wait for the cards to turn in your favour. We will have a valuation problem on our hands if yields rise substantially from here. The equity risk premium, a measure of the expected earnings yield minus the 10 yr bond yield, is narrowing quickly. But it probably should. Valuation is a very poor timing tool for the market direction in the short term.

There was a time (the 1980s) when the earnings yield on stocks was chronically below bonds due to the lingering effects of inflation expectations stemming from the '70s. This was partly to blame for the 1987 crash. Bonds were 'cheap' to stocks because they were perceived to suffer the loss of purchasing power should double-digit inflation return. It never did.

Similarly, bonds were shunned in the late 1990s due to the promise of the revolutionary technology known as the internet. Equities were again expensive to bonds (earnings yields below bond yields) by the time the tech bubble fully formed in early 2000. With the strong earnings we have already seen so far this year, the risk premium on a forward basis hasn't dropped much, even though stocks have risen and bond yields seem headed to pre-pandemic levels. Stocks still offer a premium of 3.00%.

Will we see the repeat of history as equities ignore the risk of rising rates and the premium shrinks to zero? Ultimately, yes. This would be a reasonable response to the Fed policy of artificially suppressing yields. But don't forget, it will occur from both directions and could be quicker than market participants believe.

The narrative surrounding this market seems to be relatively optimistic. "Rates will not choke off the market rally". With a friendly Fed and so much labour 'slack', the current rate increase seems transitory anyway. The pace of rate increases is the key variable to watch now. If the vaccination roll-out goes faster than expected, look for a disorderly rise and a stock market reaction.

For now, we seem to be enjoying the warmth of a gradually rising temperature in our investment pot. Bond yields will have to get back to the boiling point before the 'risk-off' switch gets thrown. We aren't anywhere close to that yet. But we have started turning up the heat now.

Risk Model: 3/5 - Risk On

The quick snap back in markets following the Gamestock headlines has been impressive. As I said last week, the earnings news was far more important than the Reddit controversy. AAII Investors agreed by quickly returning to their bullish view (below). Fund flows were strong as reported by ETF.com, favouring mid-cap equities, while high yield - $HYG and gold - $GLD were sources of cash.

AAII Bull/Bear Ratio

Volatility discussions dominated the weekend technical analysis blogs as the widely followed "VIX" Index approached the 20 level. The "VIX", erroneously called the "Fear Index", is seemingly blowing an 'all clear' signal for some investors. I say erroneously because the VIX actually can rise from too little fear, as it is now doing. Because the VIX measures implied volatility of both PUTS and CALLS, the index has been elevated by the strong participation by retail investors in the single-stock call options market lately. The ease of entry into the market offered by apps such as Robinhood has allowed novice retail investors the chance to get-rich-quick by playing out of the money call options on their favourite stocks. For just a few dollars, these newby stock players get in the 'game' cheaply. Unfortunately, the other side of the trade, the major investment houses like Goldman and Morgan Stanley, know this. By jacking up the price when writing these options, they are boosting the VIX and keeping it elevated. It is also affecting the 3month VXV, pushing it towards the sell signal at the 100 day line (below). This could be a catalyst for a much-needed risk reset. Stay tuned.

3 Month VXV