Naughty and Nice

In April, I introduced Tues@11 to an unsuspecting audience. I thought it would be fun to offer my investment views and attendant thoughts on how I navigate financial markets. Since that time, I have had the opportunity to offer my thoughts on a weekly basis. The discipline of the weekly blog has helped me stay focussed on the progression of the current bull market. How have I been doing? On which side of Santa's list do I belong?

Initially, I commented on the relative performance of Growth and Value stocks (see below). I was looking for a durable 'rotation' to value stocks and a leadership change that was evidence of the late cycle phase of the bull cycle. I even call the market a 'House of Cards' in late May. That view was proven to be premature and at odds with inter-market signals. Naughty.

Russell Growth vs Value:

With the bond market supported by the QE effects of central bankers and the demographically motivated perma-bid to fixed income funds, the rotation to a more cyclically dominated market was frustratingly elusive. In May I postulated that the long end of the bond market was more 'anchored' that in past cycles and that the Fed would be frustrated in raising rates too aggressively for fears that the curve would prematurely invert. That threat remains the highest risk that investors could be facing in the coming year. Repeated Fed caution has been a key ingredient in prolonging the rally in momentum stocks. Nice.

Thankfully I was guided by the behaviour of the risk model and after the mild 'correction' in June, and the summer commodity rally, I was prompted to cover my 'Fang" shorts and go with the momentum trade. The lack of inflation and resultant lower for longer bond yields has prevented a meaningful rotation from growth to cyclical value leadership. I dismissed the negatives of valuation and debt build ups, while maintaining a consistent long bias to the market. Nice.

August saw a mini rotation into Financial stocks and the risk of a seasonal correction faded with the improved sentiment about the economy and the tax reform hype. The hoped-for September/October correction came and went with only a sideways move that proved to be un-tradable. I also called for a 'fade' of the energy rally after the OPEC induced run-up. As yet, the downside in oil has been mitigated by temporary pipeline outages but oil stocks are underperforming the crude futures and the long liquidation is continuing. To my mind, the C$ sell-off I flagged in July is not yet over.

The November Junk bond sell-off was a low risk entry for the run to the year end and I noted the various data non-confirmations that supported that view. Nice call. But, I also discussed the potential for a bond market blow-up that could result from the structural imbalances in demand for long dated bonds that seemed similar to that experienced in the late seventies. Still waiting for that call to pan out.

Last month, I discussed the reason Quant based investment strategies have struggled to add value unless they included momentum based drivers. My Mike Archibald cartoon got a lot of mileage. Naughty indeed!

Recently, after flagging a potential sell-off prompted by a mis-reporting of the Mueller investigation, (Naughty-I got that wrong, just like ABC news), I questioned the validity of any rotation out of the momentum trade without a corroboration from the bond market. This is the key to staying with the trend. Inter-market action must always confirm the trend change or it should be questioned.

Overall not a bad set of calls. Given that this is one of the strongest bull markets in history however, it has been easy to sail with such a strong tailwind. Never confuse a bull market with brains.

The Santa rally has come early, fuelled by a imminent tax bill, and this most recent market melt-up has created a potential air pocket. As we enter 2018, there increasing calls for Dow 30,000 and S&P 3,000. The sentiment turn is starting to show up in fund flows, with bond funds finally losing assets to equity based funds. We seem to be entering a potentially euphoric phase of the U.S. market. The risks are now beginning to be weighted towards a sharp correction, perhaps as early as January.

Bonds have had their usual strong seasonal bid this year, but things will look very different as we enter 2018. The Fed will be keen to dampen the risk appetite that has been unleashed by the recent run in asset prices. Irrational exuberance is alive and well and Jay Powell will be temped to manage that macro risk in his first year as Chairman of the Fed. Also, watch for continued government intervention and regulation of the cryptocurrency markets.

The Fed's attempts to 'normalize' policy continue to bump up against the secular downward pressure on longer dated bond yields. The U.S. rate curve is flattening at an accelerating pace, creating increasing pressure on longer dated bond valuations. The Eurozone is running hotter than at any time since the financial crisis. Any potential hawkish tone from the ECB could start to weigh on Bund yields causing pressure on the U.S.-Euro carry trade. The potential for a sharp sell-off in bonds has never been higher. Should that produce a sympathetic sell-off for stocks, the long awaited rotation into 'inflation proof' cyclicals could ensue.

But there are major risks to this bullish market view.

China remains a huge negative wild card. Shanghai is one of the worst performing of all the major markets since the People's Conference in October. The currently under-reported credit crunch there, combined with any escalation in regional geopolitical tensions, is a real threat. I talked about the potential for a 'kitchen sink' phase for the Chinese economy in my October 'Ji Whizz' blog. The Chinese yield curve has now inverted.

Chinese Yield Curve

As usual, the U.S. centric news flow is creating a false sense of security about global growth. The euphoria surrounding the tax-bill is misplaced and this second 'Trump Bump', like the first, is unlikely to last. Talk about a Christmas sugar high! Tax relief is unlikely to offset rate hikes over the next few years. With Obamacare gone, the increase in health care costs will offset most of the tax goodies for many in the middle class. Corporations are unlikely to do more than increase dividends and buy-backs with the reparation of capital. Global growth is likely to peak next year, given both China, and the removal of monetary accommodation. The potential for a 2019 growth slowdown could start to get priced in by mid next year. A correction is long overdue. The two year now yields as much as the S&P 500.

While still looking for a second quarter peak, I am still (nervously) long the market. And as yet, there is no negative signal from the Risk Model. Remember the Pat Taylor rule: "keep buying util the last day of the bull". As I have discussed, valuation is a plug variable in the stock market equation and the momentum we are currently experiencing will be difficult to reverse. However, I can now be convinced that the "bull market in pessimism" that has accompanied this epic 8 year long rally in global risk assets may finally be over. The healthy scepticism that was once supportive of the market seems to be fading. I am reminded of Warren Buffet's maxim to be nervous when others are greedy. Bitcoin is proof that speculation and greed will always accompany a bull market.

I am starting to look for candidates in my long-dormant short margin account. I'm already short bonds.

Risk Model* : 4/5 Risk On

The huge bounce in AAII sentiment (bulls up 8 to 45%) has kicked the model in high gear. The Copper/Gold ratio broke out to a 15 month high and has been a consistent positive signal. Vix is dormant and the XIU is not at risk versus the 200 dma.

The only negative is the RSI, at an overbought 74 level. It has stayed overbought for 8 weeks, reflecting the low volatility environment.

* for a full description of the Model go to the blog in the April 27 archive.