Bump in the Road

The market has finally hit its first speed bump of the year.

Speaking as an avid cyclist, a bump on the road is just a part of the journey. It comes with the territory. Risks include perhaps a blown tube or a speed wobble that slows progress. With clip-in pedals, you can even 'bunny hop' over them. But it doesn't mean the end of the road has been reached. It just delays the trip a little.

Today, we will hear Federal Reserve Chairman Jerome Powell's defense of his characterization of inflation as a "bumpy" process. After the recent spate of strong data, especially yesterday's Retail Sales print, this hapless Fed's pronouncements on inflation progress are looking like a repeat of the failed"transitory' messaging of 2021. They keep repeating the mantra of data dependence. Data dependency is a dangerous construct when you cede the management of the U.S. economy to backward-looking and randomly volatile data. But its all they got it seems.

Now that the Fed has abrogated its responsibility to make any proactive decisions, it is up to the market to make up its own forecast. The recent stock slump that began as post-quarter profit-taking is now at risk of snow-balling into a full-on correction of 10%. All bull markets experience these periods of second sober thought without changing their upward trajectory. But it hurts all the same.

I'm in the 'no cut' camp for rates, at least on the near-term outlook. The smooth downward trajectory of inflation and growth has suddenly turned choppy and upwardly biased. The "go around" I spoke of last week is unfolding as we speak. It shows up in the recent uptick in the GDPNow data (chart below). And as the market is reacting. As Jack Nicholson famously said - "you can't handle the truth!!" The good news from the economy is bad news for much of the market now.

Atlanta Fed GDPNow

Looking past the short-term turbulence, I see a transition in the market to a better balance in leadership once the correction runs its course. The current earnings season should continue the process of back-filling the valuation excesses built up during the Magnificent Seven mini-bubble that has now thankfully crested. Rotation to more economically sensitive stocks should continue.

Thankfully, the bond blow-up hasn't created issues as they did last year in the Regional Banks. Fixed income is becoming a compelling alternative, especially for the risk-averse. TINA has been laid to rest with levels above 4.5% for 10-year Treasuries. There now is an alternative! However, investors in fixed income are seemingly in no hurry to add more duration given the stubborn upside bias to the data. In addition, supply has been rising, especially in the Treasuries segment. Yes, this year's bond crop is a bumper harvest, but the salubrious conditions for issuance may not last into the second half of the year. With the stickiness in the CPI outlook, bondies risk becoming "trans-fixed income" investors as they wait for inflation to abate decisively.

But there is reason to maintain hope in the equity markets, as companies seem to be adjusting to the regime change in interest rates and inflation. That transition will exact some pain though. Certain parts of the economy will continue to suffer and experience default risks. It is no wonder that the Regional banks and small-cap equities have again lagged in the recent rally to all-time highs. They are the most interest-sensitive and over-levered segments. I'm on credit watch now.

The U.S. exceptionalism that propelled the S&P 500 to a record high was based on a now-failed premise of 'having your cake and eating it too". The market began at a starting point of 7 expected cuts and a benign soft landing. Now the narrative has changed on both fronts. As I pointed out last week, the economy has recently re-accelerated from the immaculate soft landing that was once thought impossible but has become consensus. But it's a case of 'be careful what you wish for'.

This growth spurt, so helpful to the earnings outlook, will come at the cost of a much higher interest rate floor. Although harmful to valuations, it supports a secular shift to a pro-equity bias to asset preference on the part of investors. The era of positive spreads in the equity risk premium to bonds is over. As we saw in the 1980s, an inflationary bias to the economy incents investors to accept a higher valuation for equities given their inflation pass-through abilities that bonds lack. PE ratios will be consistently higher than you think they should be this cycle.

The implications of this on asset mix in the average investor portfolios will have long-lasting effects. With supportive financial conditions, mostly through the strong stock market and tight credit spreads, the consumer spending surprises will continue to support the upward earnings trajectory that will be increasingly necessary to combat higher-for-longer rates. This will be especially true if the correction is as short and sharp as I anticipate.

But for now, watch the bump.

Risk Model: 2/5 - Risk Off

Congrats to the Model for nailing the call last week. I said that Jerome Powell had some more flying to do before the plane landed, and did the crosswinds sure blow last week! The stronger data and a risk-off scare from the Middle East helped reanimate the VXV to new highs for the year. A decline in the AAII Sentiment will likely reinforce this risk-off tone on Thursday's data release. I don't expect any buy signal this week, but it is a lagging model as we should know by now. Look for something close to a 1:1 ratio on AAII Bull/Bear for a buy point.

AAII BULL/BEAR

As for the Copper/Gold ratio, there is no risk-on corroboration from that indicator. Perhaps the scare factor of a hot war in the Middle East was too much for Copper to overcome despite its positive action in light of the Chinese GDP upside surprise. Calmer conditions geopolitically are required to break the pattern. Seasonality remains bullish for cyclical inflation beneficiaries like Copper.

As for Copper outright, it remains my biggest conviction trade for the year and a way to play the secular shift from financial assets to hard assets for the coming decade. I think I spotted the 'reverse indicator' bottom on October 21st (circled on the chart) when the Economist printed the following article:

"Why it is time to retire Dr Copper

The red metal no longer tells investors much about the global economy"

A Tuesday at 11 turn-around today would probably help the bond market more than the stocks as rebalancing flows and the dearth of Treasury issuance over the next few weeks should help stabilize the shattered confidence in the bond pits. A strong U.S. dollar also supports the demand side for Treasuries. I'd buy the dip in $TLTs here. Sell some $GLD to fund it.

As for stocks, they will bottom on the sound of cannons and peak on the sound of trumpets as they always do. Israel's response to the Iraqi drone attack should mark the low in sentiment should it be anything less than the measured limited-variety attack that is expected.

I still hold out hope for another rally into the May-June seasonal top. Yes, hope is a strategy for this old bold trader!