Cracks Appearing

There are cracks appearing in the U.S. economy. When you turn on the CNBC or Bloomberg financial channels, you get the same story on oil prices. They continue to use the oil futures markets to describe the costs to consumers of energy. But you don't put crude oil into your car - it's gasoline and diesel that run your car. And I'm sorry, EV fans - less than 2% of miles driven in the U.S. are fuelled by electrons.

Trump's on-again, off-again war in the Middle East is causing macro strategists to pull their hair out. There is no way to handicap this amount of schizoid policy flip-flopping from the White House. But with additional damage to refineries in Russia from Ukrainian precision drone attacks and low refined product inventories, depleted by the first Iranian shocks in May, there is no more wiggle room for gasoline prices to fall this year. Even with a quick resolution to the Iran impasse, higher-for-longer costs to consumers are inevitable.

The chart below shows the relationship between product prices and crude prices, and what the headlines miss. The 3-2-1 crack spread (insert joke here) is the theoretical difference between the cost of 3 barrels of crude that convert into 2 barrels of gasoline and 1 barrel of diesel. The soaring spread between product prices and crude prices is the real issue for consumer spending and inflation expectations.

Crack Spreads

Reaction from investors has been relatively muted as there is a firm expectation of another Trump 'TACO' on Iran. That may well be correct, but the lasting effects of this year's product price shock will be felt well into the fourth quarter. Lower consumer spending and higher interest rates for longer is now the base case. This will further push out the broadening of the stock market into those companies exposed to the bottom half of the 'K' shaped consumer behaviour that has characterized the past year.

As I described last week, the stock market is experiencing a choppy sideways 'internal' correction. The broader averages are not what to watch here. Sector rotations have been vicious lately, so only the most nimble traders are benefiting. NVIDIA has done nothing for over a year, SpaceX is below issue, and Marathon Petroleum is at an all-time high. Who had that call in January when all you heard about was AI?

And quietly, the best widow-and-orphan trade has been in the Financial sector. The all-time highs for Canadian banks haven't gone unnoticed by Bay Street veterans, who have long had a love-hate relationship with this key sector. Their fortress-capital position and oligopoly status have led to a huge multiple expansion lately. Perhaps the hype over AI's benefits to their cost structure is to blame, but when the Canadian markets offer so little in terms of growth, they are the default option most people turn to.

With the barrage of earnings over the next week as support, the US market should experience even more internal volatility than usual. With valuations well ahead of expectations, a sell-the-news environment looks likely. But as we saw with the large U.S. banks, the selling was quickly and easily absorbed by the massive amounts of cash on the sidelines. The market is still in a powerful bullish phase. Investors have been mostly wary of the tech-fuelled run-up this year, but today they are buying the chip dip. Don't forget - FOMO is still a powerful force in this bull market.

Even within the tech sector, returns have been highly dispersed. On a year-to-date basis, Apple is up, Meta is flat, and Microsoft is down hard. A stock selection theme has replaced the rally-of-everything momentum trade that peaked in Q1. Active managers should benefit - that is, if there are any left after the past two decades of passive investment supremacy. Selfishly, I recommend Greg Taylor (gtaylor@penderfund.com), but you might expect no less from his mentor.

Until the Fed actually raise policy rates, we can expect a series of violent swings in sentiment to cause sharp rallies and reversals in this market. Heterogeneity is here to stay after such a long bull run. Geopolitical uncertainty isn't going to make it easier as we approach the U.S. midterms. And, just when we had forgotten them, tariffs are making a comeback in the Trumpian policy playbook. They won't move the needle on the macro front, however. I mean, 50% tarriff on hockey sticks? Really, Trump, is that the best you can come up with?

So there are definitely some cracks developing in this tired, old bull market. And the thrashing about that is going on underneath the surface doesn't make it any easier. The Fed will issue a series of threats about the persistence of inflation over the next few days in advance of their meeting, but this is nothing more than the "open mouth" committee at work. The real Open Market Committee is all that matters, and I don't think a rate hike is in the cards just yet.

Rising rates are the only thing that will derail the markets, especially now that the spectacular earnings being reported have back-filled valuations so quickly. I'm seeing a lot of valuation-based "sell the market' commentaries lately, but only the Fed can truly cause a secular bear market in my view. But the cracks now appearing in the market often occur near short-term bull-market peaks. A correction in the Fall would also be seasonally appropriate.

I still recommend you take a crack at the long side if we get it.

Risk Model - 5/5 - Risk On

Although it might reverse quickly, AAII Sentiment has swung into bull territory while the short-term setback in tech stocks has offered an entry point. At the same time, the Copper/Gold ratio has extended its bullish run. All the while, Index volatility has receded nicely. A short-term rally into the Fed meeting is likely. I expect them to talk loudly and carry a small stick, so those who are short on the short end will get killed.

Also watch for the U.S. dollar. Crowded bearish $CADUSD positioning has built up over the past few months. A C$ rally would catch the bears napping now that the non-extension of CUSMA and Trump's new tariffs are on the table. A rally into the September Canadian Investment Summit is a good bet here.