Storm Watch

The 2022 NOAA hurricane forecast issued earlier this year gave a dire prediction of higher than average named storms for the season. So far there hasn't been a single one. So much for trying to predict the future. This is the meteorological equivalent of the Fed's "transitory inflation" policy error that damaged the credibility of their so-called experts. As a long-time forecaster myself, I feel their pain.

Not falling into group-think is the hallmark of successful investing. It isn't what the market thinks now that matters when trying to anticipate the next move. It's what people are gonna think once we get there that is important.

Measures of investor and consumer sentiment this year showed a level of pessimism that reached apocalyptic extremes. The reports such as AAII bull/bear sentiment and the University of Michigan plunged to recessionary lows (chart below). Being a cautious bear earlier this year. I was on the right side of that trade.

If you were somehow privy to the recently weaker economic numbers two months ago, wouldn't your response be to sell risk assets as fast as you could? Well, that was what the June lows were all about. People expected the worst and adjusted their risk tolerances accordingly. Fast forward to mid-August and the less-bad than expected earnings and the evidence of peak inflation were all you needed to know in order to reverse the downward market momentum. A classic 'bad news is good news' rally has extended into a second month. Again, you heard it here first, as I have been calling for just such a bounce.

But the currently weak data seem to belie the optimism expressed in the recent market move. The odd juxtaposition of weaker housing, auto, and investment data with a continued strong job market has confused investors recently. The bullish camp sees a soft landing in these data. Bearish interpretations of the economy are centered on the weakening consumer durables numbers to bolster their case for a harder bumpy outcome.

The plug variable in this raging debate is the positioning of portfolios going into the bounce. Once the markets peaked in late January, investors aggressively dumped risk assets to prepare for the worst outcomes implied by the aggressive Fed pivot to tightening. By mid-June they had gotten to their risk-based 'happy place' and were hunkered down for the bad data that is now being printed.

But like their hapless NOAA forecasting equivalents, the economic storms anticipated by bearish investors weren't nearly as damaging as expected. Hence the soft landing that is now being 'priced-in' to the equity market. Gasoline demand numbers are being cited most often as evidence of the slowdown theory. Driving data has been only a bit softer than expected and not nearly reflective of a recession. The runoff of speculative gasoline and crude positions in June indicates the lack of concern over energy prices and hence inflation expectations.

So why is the bond market forecasting a recession that the stock market has now dismissed? The yield curve has a perfect record in forecasting recessions over recent history. Anyone managing money for more than 10 years will attest to that. When 10s are below 2s, I can't be anything but bearish. But I've been surprised that, despite the inversion, risk appetite has dramatically improved in the equity markets.

Leads and lags are to blame. The inflation that we have experienced is a reflection of loose policy over 18 months ago. By that reasoning, the negative effects of the current tight policy won't crescendo until next year. The case for a soft landing shouldn't be based on current data, as the bulls have argued. You need to convince me that the better-than-feared Home Depot and Walmart numbers reported this morning can be sustained for the next twelve months in the face of a highly inverted curve. Fat chance.

My fears for the 2023 slowdown have only increased as the pollyanna profit forecasts have rolled out. Labour costs will soon eat into profits just as the higher interest costs replace energy as the source of constrained consumer spending. And if China stimulates further, their increased call on crude should reignite that source of cost increases for corporate America. Inflation is a sticky substance. It should take a few more hikes to quell the surge in prices, especially the cost-push kind. Labour costs have only begun to catch up. As just one example, Ontario teachers have proposed an 11% bump in their current contract talks. That should put a dent in job growth.

So don't let the current fair weather fool you. An economic storm is still brewing, and investors need to put up the storm shutters as soon as possible. Just because you haven't seen a hurricane yet doesn't mean they can't happen.

Risk Model: 3/5 - Risk On

With an RSI of over 70 and pushing up on the falling 200 dma, the markets have reached an important inflection point. The sellers have disappeared in the face of the budding soft-landing narrative. But the buyers never actually showed up. Notice the chart below that shows that volume accumulation (CMF -top panel) in the recent 10-week run has been weaker than the corresponding price move. The lows of early June were made on much heavier selling. ETF Fund flow data for the $SPY this year showed a $26Bn outflow in the period leading to June's bottom. Inflows since then have been a mere $8Bn. Optimists may say there is still dry powder. Pessimists will say it's a lack of conviction. You decide.

SPY and Volume Accumulation