Test for Echo

Now that U.S. politicians have decided not to decide to fund the government, markets bounced off their lows last week. In a case of too much money chasing too few stocks, it is an echo of last year's TINA-driven market that whipsawed the bears so decisively. The mere hint of a deal to postpone the fiscal reckoning was enough to bring out the 'buy the dippers'.

Unfortunately, this echo, like a yell into a canyon, is growing fainter with each iteration.

As evidence, the breadth and volume, and momentum confirmation were sorely lacking, as the following charts show.

NYSE Advance-Decline Weekly

NYSE: Volume & Momentum (CMF, PPO)

With quarterly earnings season now upon us, and with the continuing political 'Squid Game' being played in Washington, investors will be hard-pressed to commit funds to this market with any degree of confidence. The leading groups, Energy and Financials, reflect the rotational shift in the market. Both are perceived to be immune to the supply-side pressures that are driving the 'Stagflation" narrative currently gaining adherents among investors. The energy-driven rise in inflation expectations, albeit a temporary event, is mirrored by the steepening yield curve.

It is now incumbent on these leadership groups to generate sustained investor confidence. Industrials and Cyclical Consumer stocks, each directly affected by multiple supply shortages, have diverged from their 'Value' brethren, creating a more heterogeneous rally than was seen during the Q2 rotation trade. This is reflected in the flattening out in the broad market that is illustrated in the NYSE chart above. We are lacking participation, which, in a bull market, is unhealthy. Small caps have been left behind yet again.

Can a market based on a shortage scenario be a sustainable investment thesis? Hardly plausible, in my view. If this year's chip shortage and commodity drawdowns persist, global growth disappointments will be a major headline headache for the bulls. Revisions to earnings have already plateaued and rolled off after rising abruptly when the Q2 re-opening hype-meter redlined. Cooler heads are now prevailing on earnings expectations, as the following chart demonstrates.

Chart ; Courtesy J Aitkens

A durable restart to the bull market, in my view, will have to be based on a broad-based recovery in the global economy. That is antithetical to the current 'stagflation/shortage' based narrative that has driven the recent surge in energy and the back-up in bond yields. And what if the bond market becomes disorderly? This week will see the U.S. Treasury issue another $60+ Billion in long-dated bonds. Currently being backstopped by the FED, it could be the last refunding that goes well. Should investors get cold feet when a wack of debt gets issued in a post QE era, it might not go so smoothly, unless the inflation phobia abates.

A test of the lows set last week is necessary to give me the confidence to fully commit to this market. If the bounce led by Energy is indicative of the future leadership of the equity markets, I'm not a fan. I don't believe that inflation is sustainable when it is largely reflecting ultimately temporary pandemic induced curtailment of supply. The long-term supply story driven by ESG cap-ex curtailments will drive shortages that are still over the horizon, not this year or next. I still stand by my statement - "there is plenty of $60 oil". Just not this week or next. If you have been lucky enough to be in the oil/gas trade - take profits.

Let's hold off chasing a narrow group of leaders for now. Durable bottoms often involve a test. As the echoes generated by the cries of 'there is no alternative' die down this week, and earnings season becomes a 'sell on news' event, we might just have such a test. Banks are rolling over into the news already. The echos are growing fainter.

Risk Model: 3/5 - Risk On

In a not-so-surprising development, the Model has flashed a buy signal. This reflects the comfort offered from the recent price correction as well as a Copper/Gold ratio that has been bouncing on either side of the signal line for months now (chart below). We have seen this latter indicator suddenly reverse multiple times over the past six months and then just as rapidly fail. I'm a 'show-me' on this one until it definitively breaks above the high-water mark set earlier in May.

Investor optimism is still at a low ebb, and the pull-back in volatility, while encouraging, has further to go to cement the bottom. If earnings season generates a slew of downward guidance warnings, we should see a test of the recent lows. The path to higher markets, although likely into 2022, continues to look choppy. Don't chase last week's leaders. Sustained advances will be hard to maintain in this environment.

As for oil, the long-term downtrend line (chart below) provides daunting resistance. If the calls for $100 a barrel are to be achieved, it will take a major surge in global growth that I don't see coming. The seasonal peak from inventory re-stocking is at its greatest between now and early December. A January thaw in energy prices is now my preferred scenario.