Pushing On A Strain

Yesterday's stock market rally that caught everyone off-guard made complete sense to me in hindsight. Too bad it didn't wait for Tuesday at 11 to occur, but it has its origins in the same psychology. The economic effects of the Corona virus are still to be completely understood or defined, but the market didn't wait to price them in. Last week's sharp decline in stocks and concomitant bond rally saw to that.

And since markets work on expectations, not historical data, any hint of solution to the health crisis created a shift in expectations that quickly translated into a buying panic. The rally was premised on rate cuts from central banks, combined with a growing sense that fiscal easing is coming from the G7. Expectations raced ahead of reality, and now the second sober thought is prevailing. Market bottoms often feel this way.

A sharp pull-back to the uptrend line of stock/bond relative performance had, by yesterday morning, successfully corrected the overbought condition in stocks, while simultaneously creating one in bonds. This triggered a bottom in the stock market that left commentators struggling to explain what happened.

Here's my take.

Since these two assets are increasingly seen as fungible yield vehicles, the effects of rebalancing are powerful automatic stabilizers for markets. Asset allocation timing models kicked in hard yesterday, creating a reflex rally of major proportions. The upward sloping trend line (show below) continues define the path of relative performance between bonds and stocks since the GFC. The uptrend is a function of the relentless quest for yield.

The corrections of this relative line back to trend have been a function of economic weakness. Yield seeking investors have defined the course of asset returns for 10 years now. I don't see that trend breaking unless monetary policy is held too tight for too long and equities enter a structural bear market. Unfortunately, there is now risk of exactly that occurrence.

SPY vs TLT

While the initial panic phase may be over, the grim reality of a world with increased economic supply and demand shocks is staring us in the face. Nobody can tell how long this will last and how much damage will be caused by the shut downs. So while the risk markets fight it out, I believe a prudent course of 'non-action' is warranted.

The sentiment lows may have been seen, but the market lows still need to be tested. I don't believe we are likely to see the same type of rally as in Q1 2019 after the Fed pivot. There is too much earnings damage yet to be revealed and the yield curve remains dangerously inverted.

The Fed reaction of a 50 basis point reduction in administered rates is being taken poorly by markets.Their cut is mostly a response to the sharply inverted curve. They don't want to make the same mistake as in 2018 by trying to tell investors what to do. The market is now the de facto Fed Chairman.

And the bigger fear that markets have yet to face is the effectiveness of monetary easing in this unique set of circumstances. There is, as yet, little evidence that lower interest rates can prevent the virus related downturn in economic activity from spreading. The economic aphorism 'pushing on a string' has now been replaced by a new one ....'pushing on a strain', a viral one.

Those who attempt to catch a falling knife here are just guessing. The risk model (discussed below) is far from giving the all clear signal. The sidelines seem like a great place to hang out for now.

Risk Model: 1/5 - Risk Off

As copper desperately hangs on to the critically important $2.50 level, gold this morning has resumed its assault on the 2011 highs. Will the floor traders don 'Gold $2,000' hats to replace the now useless 'Dow 30,000' ones?

The 3 month Vix at 30 is far above its 'all clear' level and the failed rally attempt today will most likely produce a 'risk off' reading for the AAII Sentiment for the second week in a row.

I'd like to see a greater than 5% drop below the 200 day moving average before committing funds to the markets. This element of the model has always flashed risk-off before the bull market resumed. A 2850 level on the S&P 500 would be a minimum prerequisite before getting bullish again.