Summer Breeze

As any sailor knows, the shifty and light breezes of a hot summer day are hard to navigate. Just as you set a course the wind often dies unexpectedly, making it hard to make any progress. Skippers need to accept these frustratingly short legs to any tack or they might as well head to port via the iron jib. Summer markets are often no different.

A quick survey of the markets this morning has me in a better mood. As a full-blooded contrarian, I like the level of capitulation in sentiment and surge in pessimism that has dominated the narrative lately. Depending on the measure, (University of Michigan survey, Bloomberg poll, etc.) there is universal acceptance of the inevitability of a hard landing. The seeds of a countertrend rally are often germinated by such verbiage. It won't take much to generate a bottom-fish mentality given this backdrop.

Investors are eagerly grasping at any hint of 'peak' inflation. Commodity prices, ex-oil, recently came down due partly to China's Covid shut-downs and partly from the liquidation of 'spec' positions. I have been flagging the demise of >$4 copper for weeks and we finally got it. Last week, oil joined the downside party, albeit temporarily. But forget about the why, traders didn't need much prompting to cover their shorts, as I did last week. But is this really the "bottom" or just the shifty zephyr of an ephemeral summer breeze?

Did the Fed suddenly regain the confidence of market participants? Has Powell gotten ahead of the curve? Has the demand destruction due to tightening financial conditions done the job? More importantly, are markets fully prepped for this outcome?

Hardly. Our hapless friends at the Federal Reserve are still two 75bp hikes away from the market's forecast, let alone getting 'ahead'. Earnings expectations have hardly budged despite the macro headwinds. The Bottom-Up consensus chart (below) doesn't seem to show any hint of a recession. And now that the oversold market is bouncing on perceived 'good news' out of China, the traders are now trying to catch this falling knife of risk assets, basing their decisions on the weakest of empirical indicators - hope. Lisa Shalett of Morgan Stanley has called bottom-up analysts and their lack of hubris, "deer in headlights", and I agree. The full effects of higher capital, materials, and most importantly labour costs are not impounded in their numbers yet. Negative revisions are coming soon.

S&P 500 2023 Earnings Expectations

Chart: J Aitkens, TD Securities

Bear market rallies are notoriously fickle, often evaporating with the slimmest hint of worry. Investor confidence is fragile now that the terms 'TINA' and 'FOMO' have been retired from the investor lexicon.

Bond yields are stiff competition for the first time in years, despite the fact that 'real' yields are barely positive. And now that era of QE is mercifully over, and the Treasury auctions are not going smoothly, bond yields can readily spike on any perceived 'positive' news, choking off any upward thrust for equities. 'Good' news is still not welcome in this blogger's mind.

The lessening of pessimism should not be confused with a resumption of the bull run that ended with the Fed's Volkerian pivot earlier this year. They have a lot of unfinished business still to negotiate. Wages are a lagging indicator for the corporate crowd, who are scrambling to keep staffing levels high enough in the post-pandemic rebound. But it's one thing to offer people overtime bonuses for a temporary capacity bump. It's quite another to permanently hire more from a dwindling pool of candidates. Compensation costs are now the Achilles heel of corporate profitability and the price hikes that have so far covered up this weakness are going to be harder and harder to implement.

Earnings season kicks off shortly after the Quarter-end position squaring runs its course this week. I will be looking at the evidence and fact rather than just hoping for a shift in the economic winds. So enjoy the soft breezes of positive markets on your back. Just don't expect them to carry you very far.

Risk Markets: 3/5 - Risk On

AAII Bull/Bear levels were as low as I've ever seen them last week. This level of negative sentiment combined with a failure of Volatility to match the highs of the 2020 panic is an unreserved contrarian buy signal. But both measures are far from giving a consistent message of comfort for risk-taking. The pattern of higher lows for the $VXV is a disturbing trend despite the notional 'buy' signal (crossing below the 100 dma). The Model has now reversed sharply on this temporary bounce from oversold levels. But can the Model be believed by longer-term investors?

Well, it is not even a relevant question. Quant models by definition don't think, they just act. There is a Risk-On signal from our model, this week and I'm not surprised. That isn't inconsistent with my message above, just a confirmation that we can easily generate a summer rally given the technical setup. True recovery awaits a Fed that has finished its work and a positive estimate revision tailwind. Neither precondition prevails at present.

AAII Bull/Bear Ratio

3Mo CBOE Volatility