Failure to Launch

The UAE's Mars mission vanity project is the latest example of more money than brains. Showcasing their technological expertise and timed to celebrate the desert nation's 50th anniversary, it went off just as planned. Sounds a bit like the stock market to me. It's going straight up. Too bad we can't say that about the U.S. economy.

Last week saw a mixed reaction to the start of earnings season with the majority of the results coming from the financial sector. Although the numbers were not worse than feared, the markets more or less ignored them because of fears that the economy was set to decelerate over the next few months as a result of a second shutdown.

Seasoned investors, wary of the over-hyped growth stocks and gun shy from the outside reversals in the majority of NASDAQ stocks last week, were hungry for a rotation into the lagging sectors. Initially I was too, but the second sober thoughts engendered by the worsening Covid news tempered my enthusiasm. Tail between my legs, I cancelled orders in the financials and went sailing last Tuesday. (At 11 of course).

As I said last week, the bad news is now like an elixir to the growth bulls, many of whom are laughing at the bearish value players cowering in their home offices with huge cash positions and no confidence to use them. Mark Cuban' tweeted that his 19 year old daughter is pumping him for stock picks for her Robinhood account. That has him worried - and so am I.

My reasoning is simple. Crowded and overvalued stocks that result from self-reinforcing groupthink are always doomed to failure when the narrative changes (re-read last week for more on that). So the failure to launch on the part of lagging areas of the market - mainly financials, small cap and deep cyclicals is prolonging an already stretched market run.

The ratio of Russell's Growth and Value ETFs are shown below. The bubble in 2000/2001 unwound viciously after the internet hype machine fell apart, bottoming in 2007. Fast forward to today's action and the growth stock revenge is almost complete.

A move this abrupt is hard to fade and even harder to short. It's even worse in the growth starved Canadian market. If you don't own Shopify, a stock that only looks cheap when valued in Bitcoin, you can't beat the market. But I do remember telling clients and consultants in 2000 that sometimes you shouldn't want to do so. How much Nortel can you own when it's 35% of the index?

This is another one of those crazy markets that just defies logic. But it can last much longer than you think. What killed the internet bubble wasn't valuation per se. It took an inverted yield curve to finally prick the bubble. It's not something that looks likely in today's financially repressed world.

But a 10 year yield dropping to zero, combined with record high market valuations would do it. Instant correction - if not renewed bear.

Zero yield bonds you say? It is still possible. Let me explain.

The fiscal-cliff hissy fit that is shaping up in Washington this week, combined with growth-sapping business shutdowns now being revisited on an economy experiencing an out-of-control pandemic, could be the catalyst for that seemingly far fetched event.

What seems to be holding bond yields up is the reversal of the huge flight-to-quality flows of March, exacerbated by huge Treasury issuance with record auctions. Expectations for a orderly re-opening combined with virus cure have raised hopes of a successful reflation, reversing the bond inflows and forcing money into stocks. The Phase 1 data of virus development is also helping levitate markets like a magician's wand. Viruses don't pause for final drug approvals before raging out of control, but it doesn't seem to matter to the bulls.

The scenario of a much worse economy, combined with a deadlocked congress, isn't that far fetched. Does anyone remember September 2008 and the TARP debates? The gap to fill between Dems and the GOP is now 2 Tn$ - that's serious cabbage. There's not a lot of political will to move off their positions either.

What incentive do they have to come to an agreement when Biden's polling numbers are positively correlated with the new Covid case rate? I'm only kidding of course, but a scenario of a less than effective fiscal package - one that placates the Senate - won't help the restart much either. The economy will downshift in either scenario of deal, or no deal.

And of those of you who think that elevated treasury issuance is an impediment to lower yields - do the arithmetic. Just selling 15% of your top six holdings in order to lock in the gains since the March lows will free up a trillion dollars in no time. (chart below). Total market cap of U.S stocks is now $35T. There's lots of flight-to-quality firepower in the tank.

There'll be a bun-fight for Treasuries if a correction happens.

With first wave of stimulus over and the second one in doubt, I'm giving this scenario better than even odds. It's one nobody expects. Kinda why I like it.

Oh by the way, value stocks are looking more like value traps.

They won't hold up either if bond yield start to break down. It's the economy stupid - again. Credit markets are similarly vulnerable, having been masked by the Fed to prevent a viral loss of confidence on the part of yield-starved investors.

Watch this chart ( ratio of the bond ETF to the stock ETF) for a 'tell' that the much talked about second wave is actually a bond rally and not an Covid infection surge.

If bonds re-accelerate due to a failure-to-launch economy, it's not gonna be pretty for anyone.

Risk Model: 3/5 - Risk On

As my old buddy Pat Taylor used to say, "keep buying until the last day of the bull!" I suppose I should still be long Amazon in this melt-up but I have never been able to pick tops of these types of moves. Especially this one.

What does it tell you that the TSX is 3% above the 200 dma while at the same time QQQ's are at 27%?? The model can't seem to pick up the excesses of the growth mania. Otherwise it would be fighting the tape just like me.

Volatility watchers saw the Vix drop below the 200 dma yesterday. The longer dated version isn't as optimistic. History shows that market corrections are predated by rising relative levels of the 3month and spot Vix measures (chart below). It's getting late in the game. Enjoy the summer rally. Fall corrections are the strongest seasonality I know.