After Burn

I sincerely hope you can read this after yesterday's partial eclipse in the southern region of our fair province. A quick peek skyward yesterday afternoon was all it took to experience severe retinal trauma. But then who among us hasn't been tempted to do a bit of sun gazing. I mean, it's soooo tempting to take just a quick look at the sun as it dips behind a cloud or majestically sinks to the horizon at sunset.

But if you have gotten this far in the blog you probably didn't stare skyward yesterday. Trump actually did it on camera, but he's already blind to most things anyway. No matter how much we are warned, it is hard to avoid the temptation. Human nature is like that.

Large cap tech stocks are confounding us by refusing to correct significantly as the rest of the market subsides. They are like the sun, and investors can't help but look at them, beaming up at them from their portfolio reports.

We know they are expensive. They are hated by hedge funds. The strategists and value managers continually are underexposed to them. We are told by the talking heads and permabears not to buy them. We all remember Pets.com don't we?! Then why do they refuse to go down?

I believe that, because they are some of the heaviest weighted stocks in the index, they become overvalued by default. The majority of funds getting inflows are passively managed mega-cap index funds. Go back and look at the June 25th blog. There, I showed a chart of the huge differential in fund flows between active and passive managers. That will convince you that we are witnessing a dogtail-chasing market that will not stop until it reaches a consensus of euphoric proportions.

The fomo (fear of missing out) by closet indexers and benchmark relative institutional funds only adds to this self sustaining leadership. Remember when Nortel was 35% of the TSX? You had to own it to beat the market.

The problem with indexing is in its cap weighting structure. But that is biggest opportunity for active management - underweighting the crowded trade. Only a bear market can reveal the weakness in the passive strategies. Future leadership only is revealed by relative strength in a correction.

So, when do we correct this asset bubble?

This week's chart of the long term ratio of AAII Bulls to Bears should help answer that question.

You can easily see how bullish investors were the last time markets were so richly valued. Surprisingly, that market optimism remained after the Tech Bubble burst, being replaced by the U.S. housing bubble. Not so in this market. People are not that bullish.

But don't forget this survey only samples the "Home Gamers", who by definition are not passive investors. The AAII membership is composed of D.I.Y. investors. They don't use index funds. They are also the ones who were burned in the 2008 drubbing and they have never fully regained their confidence in markets. Hence the 'bull market in pessimism' that I have described regularly.

The overvaluation of FANG stocks is actually widely accepted by the active investing public. It has actually helped to perpetuate the bull market by keeping a cash hoard on the sidelines. Therefore, dips are bought aggressively and immediately.

So I believe that the current market cycle will persist until active investors get a lot more bullish about stocks. Unfortunately they are continually being tempted to look into the investment solar flares of large cap Tech with each re-rally of the NASDAQ.

So, as the passive sungazers bask in the financially warming glow of a market that is two standard deviations above valuation trend, we are left hoping for a mean reversion that eclipses their complacency. But I fear it needs to get hotter first.

Risk Model: 2/5 (risk off)

The surge in the VIX, and a fall in the Bull/Bear ratio, related to the ongoing White House melt-down, kicked me out of the market last week. The upcoming Jackson Hole conference and the looming government shutdown risk haven't helped sentiment either. Earnings are now a spent force and valuation warnings from pundits have multiplied. Oil continues to grovel lower, damping any inflation talk but the short side is getting crowded.

On the positive side, copper has continued leading industrial metals validating the synchronized global expansion. Gold continues to be rejected at $1300 despite the weak U.S. dollar. Bitcoin has double topped and is now correcting. I expect the August slowdown to give way to a tradable bounce as the broader market gets oversold. Percent of stocks below the 50 day is getting close to a buy zone. The Treasury curve is low and stable, with a comfortable 90 bps of steepness. There are bargains beneath the Fang facade.

Canadian Dollar

Following from the surprise second quarter strength and a subtle shift in the B of C's body language, the C$ has returned to above the PPP level of 78 cents. (OECD est.) But the forward looking data isn't encouraging.

The plurality of negatives includes, a new anti-investment B.C. government, weak energy and grain prices for the west, collapsing GTA house prices, high cost power and minimum wage hikes in Ontario, and the profligate Federal Liberals running up the deficit. But, yikes, there's more.

European lumber imports into the U.S. have quintupled due to the recently imposed duties. With NAFTA in limbo, Magna's management is openly questioning it's commitment to Ontario as a production hub due to higher wage costs and housing shortages. I've read that, due to the currency, lobster prices are down 25% in New Brunswick and boats are tying up... seriously! What's next, European poutine imports soar under CETA?

Under the cover of a rising Euro and Yen, the overly hated Loonie has recently enjoyed a strong short covering rally aided by an global anti-Greenback tailwind. That effect seems to be waning. Unless commodity prices quickly bail us out, look out for falling Loons.