WAM SCAM

The Fed meeting this week should see a renewed commitment to their favourite mantra - 'lower for longer'. When it comes to longer-dated Treasuries they only wish it were true. I smell a Royal Scam.

They will be unveiling their new monetary strategy tomorrow, signalling a targeting of longer-dated maturities in the QE asset purchase program. The increase in the Weighted Average Maturity - WAM - is designed to keep the liquidity flowing to a faltering recovery. For now, the market seems to be buying it, but I am not sure they can keep up the illusion for much longer.

I see a few problems with the 'have your cake and eat it too' scenario that has driven markets to new all-time highs recently. Answer me this. If we are supposed to see a strong economic rebound later this year as a result of the roll-out of an effective vaccine, why do we need rates so low?

Even if the Fed continues to buy what they have announced, the U.S. Treasury will have issue more bonds - NET OF QE - than any time in history. The bond crop never fails, but this year is surely a bumper crop indeed.

Other buyers of bonds will need to pick up the slack. But that dear readers is the problem.

Banks will cease to hoard government bonds as more profitable lending activities result from the recovering economy. Individuals will stop pouring record amounts into bond funds as they recover their risk appetite post-COVID. And foreign buyers may stand aside from the next few auctions as the advantage of higher coupons available in the U.S. market are now being offset by currency related losses.

The history of reflation is there for all to see. And this could prove problematic over the next few quarters. The usual pattern of a 200 basis point increase in the yield curve is playing out in the early stages. But as we see below, it can gather steam quickly once the recovery takes hold.

U.S. Treasuries: 10yrs-2yrs

But isn't this what we want for the stock market - a strong recovery in the economy, leading to higher inflation expectations and 'normal' interest rates? Whoa there, be careful what you wish for!

The 2020 rally in equities has been mostly on the back of higher multiples on earnings that will struggle to match expectations due to the second wave of the pandemic. But let's assume the earnings do come through as expected (except for TSLA who will guide down shortly).

Given a normal risk premium on equities of 350-400 basis points and forward consensus earnings of $170 on the S&P 500, the fair value range is currently 3400-3700. That's about where we have been since September. But this is predicated on a sub 1% ten-year bond yield. Just moving that yield up 75 bps - a sub-par recovery based on history - drops fair value to 2800-3400.

Instant correction!

And the most vulnerable segments of the market will be Tech/Growth due to the leveraged valuation effects of declining multiples.

Oh and by the way, the most crowded overweight consensus trade this year, according to BofA investor survey is Tech. Bitcoin and short USD were a distant second and third. My short for this upcoming year is the go-go ETF run by supernova star manager Cathie Wood of ARK Innovations symbol ARKK. Live by the sword...

So scam away Fed, I feel a correction setting up.

Risk Model: 3/5 - Risk On

No change from last week as the overbought condition pauses for the model to catch up. The volatility gauge is showing signs of perking up. I would like to see the AAII Bull/Bear ratio (below) settle back before getting more constructive, but the fact that they awoke from a record-long slumber is ultimately bullish for risk markets.

Suspiciously, the S&P 500 has become locked in a tight range just prior to the massive rebalance due to the inclusion of TSLA. I'm watching vol closely for signs of either trouble or one last Santa rally into the year-end. Once the calendar turns over, I think we could be in for some tax-deferred selling as the 2020 gains have been pretty spectacular.

AAII BULL/BEAR RATIO