Loco-motion

This has been a 'crazy' week so far. When the Chairman of the most powerful government agency is ripped by the President for being "loco", I can honestly say I've seen it all. The good news is that we can now stop obsessing about the un-correctable market. Its time now to get down to the tough work of finding the next leadership theme for the ongoing bull market. I called for a garden variety correction. We're getting it. Get ready to assume long positions for the next phase of the bull.

Wait a minute. How do I know that the bull is still alive? What evidence do I look for to give me confidence that the market will mount a come-back?

The yield curve is the tell - it steepened. This means to me "buy the dip". If this was the true ending to what will be the longest bull market in history, we would have inverted the curve by now.

Equities are always and everywhere a monetary phenomenon. They operate at the pleasure of the monetary forces that shape risk markets. When risk assets get over their skis in valuation terms we should look for the markets to square themselves. That is now happening big time. The analogy I'm using is 1987.

I said last week that equities had the deck stacked against them relative to fixed income in valuation terms. Powell's message that he was not at neutral yet was a wake-up call for the bulls.

Trump's ranting aside, I don't believe the FED will respond to the market gyrations in anything but a few soothing comments. It fears looking like it is bending to political pressure. The market, in my view, has been ignoring the FED for too long. It was the market that had gone 'loco'. It had gotten so used to seeing them walk back their dot plots and inflation forecasts for years that it ignored the obvious risks right in front of it. But unlike 2009, the FED "Put" is currently still well out of the money. Powell is effectively saying that its up to the market to pick itself and dust itself off.

For those, Like Jim Cramer who have called this a mistake, - stop talking your book! He and his perma-bull, Trump apologist crowd had it coming to them, as I warned in my Sept 18 entry "E Hubris Unum".

And the bond market, I pointed out in Sept 25th's "A Little Patience", had started to create valuation headwinds as the risk premium on U.S. equities had declined to a critical low point. Faced with strong data and a bearish interpretation of Chair Powell's most recent comments, bond yields finally broke out of their artificially low range. The 'squeeze play' is now over and yield curve has, thankfully, bearishly steepened, forestalling inversion. It was the speed of the yield move that spooked the complacent bulls into a knee-jerk selling mode.

Equity Hubris has finally peaked.

The September end to the tax-advantaged pension funding that came in the recent tax bill is notable. I believe it helped prop up the bond market as pension funds pre-funded all of their 2018 costs with expensive bonds. As well, the carry trade from foreign investors waned as hedging cost rose throughout the last quarter. With this week's impending Treasury refunding looming, bids were suddenly pulled in the face of the supply. The threat of a Chinese boycott of the auction was also a bearish factor. I vividly remember the fear of a Japanese bond boycott (August 1987) that provided a similar catalyst to correct equity valuation excesses. This week's sell-off is, so far, a thankfully milder version.

So, like umbrellas on a Florida beach, Bonds are now left to twist in the wind and find their own level. This was the mini black swan catalyst I had been looking for.

So what are the positive factors that counter the read-through of this bearish sell-off? Credit spreads were well behaved. Although gold caught a bid and bond yields have backed off their highs, the safe haven bid has been muted. Copper/ Gold has pulled back but not dramatically. Compared to the Volatility fire sale in February, the VIX spike to the low 20s has been textbook and looks to be peaking. The basic economic indicators are still strong. Markets were orderly from a liquidity standpoint. We are at the 200 Day ma on the S&P 500 already. Yesterday was a 90% down day - a level usually associated with a capitulation low.

So a short, sharp correction (the hallmark of a bull market) is now occurring and its time to figure out what to buy.

Financials should be the best bet here. The balance sheets and valuations are compelling. They had priced in an ever-flattening curve and the weak loan growth. Those factors are likely to turn into tailwinds in the next few months. Post the mid term elections, the stimulative fiscal factors should reassert themselves leading to a true late cycle environment that is supportive of value over growth.

The other thing to watch is the EEM. Should there be a recovery in risk appetite in the emerging markets, lead by China, it could usher in a further support for a true late cycle set-up.

The bad news of tariffs is out and the once the election-induced rhetoric dies down in November, rapprochement between the U.S. and China could be on the table. The global economy could re-synchronize.

Monetary authorities in China are unwinding a tightening bias that has been in place since the fall of 2017. Portfolio managers are salivating with the relative cheapness of non-US equities. Now that the U.S. growth/momentum fever has broken, they can start nibbling without FOMO.

This week, a garden variety seasonal correction has produced an environment for a textbook rotational leadership change that the market has needed for months. I'm starting to nibble on the banks first, with commodity cyclicals now in my gunsights for a seasonal run into Q2 next year. But wait for the U.S. dollar to weaken on a FED pause before getting all hard asset happy. Short term, housing and auto data are fading badly, setting up just such a narrative. A pause in QT is in the cards now.

When they're yellin' you should be sellin' and when they're cryin' you should be buyin'!

Just don't go loco.

Risk Model: 1/5 - Risk Off

As I expected the AAII Bull/Bear ratio collapsed this week following the spike in volatility. The failure of the Tuesday at 11 pivot point this week caused me reverse my thinking on an early bounce on Wednesday. Two days later, the market is now getting quickly oversold, but the indicators will take a few weeks to repair themselves. There is no rush to buy anything but a few banks here. Lets wait til next Tuesday at 11.