Taking a Bath

I know when I'm licked. There is more money than brains right now. I realize the market always has the final say, but it doesn't make it comfortable all the same. But my job is to try and get out in front of the changing expectations of others and identify emerging macro trends. Being cautious now, could I be at risk of missing the next move? Who knows? I never claimed this was easy!

But that's what it should feel like when trying to parse the recent move in stocks. The metaphor I like to use is the "bathtub theory". I coined that years ago in an era of captive capital in the Canadian pension business. There was a time when the Canadian government had a limit on the amount of money that pensions could invest in 'non-Canadian' assets. Set at an onerous 10% in the pre-1994 era, it meant that there was always too much money chasing too few stocks in the relatively small Canadian market. Add to that, there was a stark bifurcation between resource and non-resource companies represented in the index.

In the TSE 300, as it was once known, like an investment bathtub with the tap of rising pension obligations turned up high and the choices for investment limited, money was trapped. Canadian equity managers gave little thought to the valuations, it was just a matter of relative momentum. If oil prices rose, the market would be led by resource stocks, if they fell, it was back to the staples like Imasco, Molsons, and the banks. Little thought was given to diversification. The cash just sloshed back and forth.

Are we at that point in the U.S. market? Is there too much cash on the sidelines as a result of the prolonged Fed tightening and its threat to the economy? Is that cash now at risk of sloshing back into the market from its comfy 5% yield home in money market funds? The expectations of multiple rate cuts next year are creating a huge reinvestment risk for the hordes of conservative investors who cashed out of the market and never came back. Estimates of unrisked cash in the U.S. approach $6Tn now and there aren't enough NVDAs and METAs to go around it seems.

The deceleration of the real economy is preventing a fundamental bull case for small-caps, cyclical, and value stocks for now. They are relatively cheap, but cheap for a reason. Earnings are still being revised downward for many of them. That's why the Magnificent Seven exist. The market is shoving all its cash into the few quality stocks whose cash generation is still rising and share counts still falling.

What could incent investors to into those economically sensitive areas that have underperformed? I see a real risk of investors moving en mass into the market as they "look over the valley". Stocks could rise well in advance of an actual reacceleration in economic growth. It's the bathtub theory, writ large!

As I postulated last week, the market is giving us a peek at what that could look like. Smallcaps, emerging markets, and value over growth were all winning themes last week. Even gold and Bitcoin have had rallies of consequence. Only the pure economic harbingers, Oil and Copper have been left behind.

A sign of hope has flashed in the form of the quick pullback in gold and Bitcoin this week. The threat of hawkish talk from Chair Powell in tomorrow's press conference scared off the bulls. But talk is cheap. He may be about to deliver his expected "hawkish pause" message, but I don't believe he can do it credibly. As the labour market cools and inflation continues to ebb, the scope for easier money should support these assets. I like the look of the hard asset and cyclical charts. Copper/Gold, my preferred measure of this area, is a forming long base that counts much higher. All that is missing is an easier Fed - in fact, not in prospect.

But the prospect of looser money could create a self-fulfilling prophecy and money may start to slosh

Copper/Gold

January looks very much like a time to look for the long-awaited rotation based on a 'landed' economy, however soft or hard. The remaining stickiness in inflation is mainly coming from the shelter component which has lagged behind the declines already seen elsewhere. "Supercore' inflation, which removes this effect, is still above the comfort level at 3.9%, so the market needs to chillax here after getting ahead of itself. Powell can't be pleased with the sudden loosening of financial conditions recently so expect a negative tone tomorrow. I'm not sure the market will respond to any negatives that lack policy substance. October's low looks like a solid pivot point now, given all that water that built up in the money market end of the tub.

But I do feel the water is poised to start sloshing back soon.

Risk Model: 4/5 - Risk On

Just an over-bought RSI has the model from being unanimously bullish. The failure of the volatility component to flash any kind of caution is notable, as is the modest drop in the AAII sentiment indicator.

The market feels like it wants to move higher into the new year. Getting the leadership right, as always, is the key to outperforming. Just ask the Federal Liberals about that!