Sea Fog

The fog of war has finally descended on Wall Street.

After a narrowly based snap-back, markets are poised to contract once again as the second sober thoughts of higher-for-longer oil prices dampen economic hopes and, by extension, risk appetite. The stalemate over the Strait of Hormuz is less a Black Swan event than a 'known unknown'. And investors have seen oil price spikes driven by geopolitical factors before. With Trump as its progenitor this time, I see it more like an Orange Swan event that leads to a TACO resolution. At some point, investors will look through this, but for now, it is a risk-off generator.

Prompted by a stellar start to earnings season and with AI mania in the semiconductor chip sector driving FOMO, markets became rapidly overbought. The narrative I had posited in January of an expanding, broad-based rally fed by stronger economic growth has actually unfolded nicely. That suddenly pulled back as market leadership returned to Big Tech. The chart below shows Value has sharply pulled back relative to Growth.

Relative Performance: Value/Growth

Another factor bet that made sense in an economic growth spurt was Small Cap. The chart below shows the recent relative performance of small companies. The "V" shape rally mimics the Value/Growth relative performance shown above. Is a similar check-back in the cards, given the sudden reacceleration in oil prices?

Relative Performance: Small/Large Cap

But as any seasoned sailor will tell you, if you have a trusty radar, you still can proceed in foggy conditions. Here is the problem - my scope is picking up a false signal. The recent rally in chips and tech is bogus. The expected strong earnings this week in Big Tech are a classic 'sell on news' event. Today's Wall Street Journal reporting on the internal weakness at OpenAI is an "emperor has no clothes" revelation. The AI stock bubble is now bursting.

The Growth trade is vulnerable to a compression in risk premium as the second phase of AI adoption unfolds. A shakeout in software stocks like Oracle, CoreWeave, and Microsoft has already revealed the downside of disruptive AI capabilities to legacy industries. Now the industry's flagship company, OpenAI, is under pressure to deliver on the starry-eyed promises of the past year and a half. Who had a revenue problem at the leading private AI company on their bingo card this year? The WSJ's 'hit piece' today is maybe just an excuse to cash in some hot money trades, but the April rally is now over.

My strategy here would be to hold some dry powder for a further pull-back. The small backup in longer-term yields on higher-for-longer oil prices is also a convenient excuse for the profit-taking in Growth. The spectre of a stagflationary oil shock will crimp Industrial stocks as well. But I'm getting ready to buy them on any weakness.

The economic picture has been shrouded in fog from the Middle East turmoil. But this is the opportunity to re-up your bets on an economic recovery once that fog lifts. The UAE's announcement today that it intends to leave OPEC suggests that oil above $100 is unsustainable and speculative. We know the next big move in crude is down; the only question is when.

A stimulative energy cost reset is somewhere out there, lurking in the fog. You just need to use a good radar to see it.

Risk Model: 5/5 - Risk On

The moderation that started last week had a positive effect on price-related variables - RSI and 200 DMA are less overbought. The bounce in Bullishness evident in the AAII survey supported the rally in sentiment. Copper is surpassing gold, even with the risk of stagflation. Finally, the subdued levels of VXV have eased traders' concerns. Everything looks good from the model, despite being slightly late to the party. As long as longer-term interest rates stay below last year's highs, the bull market is likely to continue.

Just a thought on the Airline business. Capital discipline and pricing power have created a durable environment of profitability for this highly cyclical sector. As we see in the U.S. airline industry, it is a case of haves and have-nots, with the likes of Southwest and JetBlue struggling while Delta and United prosper. Similarly, Air Canada has carved out a strong position, especially in the International arena. With Carney steering the Canadian economy out of the Trump ditch and a new CEO soon at the helm, I expect Air Canada to regain investor credibility. The stock has been rangebound since the COVID shock and has recently come under low-volume selling pressure. Look for a breakout as soon as oil prices settle down and the Canadian economy revs up later this year.

Air Canada