The Sky is Falling

So, as a good contrarian would do, I'm buying.

One could be excused for not paying attention to the market this year. With your Social Media feeds crammed full of political news, it has been hard to pay full attention to the bull run that started in April. However, "Independence Day" marked the low point for the cycle of economic deceleration caused by previous Fed rate hikes. The massive investor sentiment hit that resulted is still in repair mode. A couple of scary headlines this morning warned of an impending correction.

The narrative Plinko game continued this past week. While the Fed was trying to cast doubt on the prospects for further rate cuts, the market continued to chase AI stocks higher. Not wanting to be short going into earnings was a powerful driver of investor behaviour. Market breadth suffered as a result. Narrow markets can be detrimental to one's financial health. However, this frustratingly narrow market is about to broaden. However, it first needs to pull back.

Palatir is the poster child of the AI mania. Trading at 100 times sales and 700 times earnings, it is, shall we say, a bit dear. However, recalling Microsoft's first five years as an expensive company, many growth managers have at least dipped their toes in this AI software leadership candidate. But many have missed it. Now ominously, the technical picture is getting a bit ragged here. The volume-based indicators are lagging significantly behind the new highs for this stock (chart below). A five-wave pattern seems to have run out of headroom for this tech darling. Today's 'sell-on-news' price action was all too predictable.

Palantir

But what does it mean for the overall market? I believe we are in the early stages of a major rotation from the AI-crazed, narrow bull market of the past few years, which could lead to the next cyclical bull phase in 2026 and beyond. Previously bullet-proof Meta also wiffed last week as well. And now that Mega-cap Tech is tapping the bond markets for cash, equity investors are starting to worry.

In every cycle I have seen, the Fed calls the shots. Markets respond to the Fed in a predictable pattern. The first area to see leadership in a typical cycle is a strong balance sheet and quality stocks. Investors need time to recover from a shock and regain their appetite for risk. The 'U' shape of the AAII Sentiment Survey bears this out (chart below). The first stocks to recover are non-cyclical growth, as we have seen in the AI tech space this year. It makes sense that low-quality, small-cap and economically sensitive stocks have lagged this year, especially with the negative externality of tariffs.

AAII Sentiment

But surely as spring follows winter, the recovery starts to broaden out. Fed easing typically takes effect with a lag of between 9 months and a year. Banks are the highest quality cyclicals, and they are the canary in the coal mine of rotation. They initiate the cyclical leadership rotation. I have seen this every cycle in the past, and this one is no different. U.S. banks should now begin to turn in relative terms after the recent positive reaction to solid earnings reports last week and the topping out of the Tech mega-caps. A perfect example of this is the two-year relative high in JHPM vs. Meta (chart below).

JPM vs META

Without the Magnificent Seven, the markets would be in their usual early-stage recovery mode. More importantly, they would appear much cheaper and less overbought than they currently look to be. The many examples of early-stage recovery are evident in non-U.S. market action. European and Canadian bank stocks have been leading the recoveries in their markets. I expect the U.S. market will exhibit this pattern early next year.

Europe: Financials vs Market

Canada: Financials vs Market

So it may be a choppy period of post-earnings profit-taking for some of the tired leadership names that have dominated the tape this year. Should that translate into a broader drop in the more cyclical stocks, I would accumulate on that weakness.

Is the sky really falling? I don't know, but Chicken Little was eventually right, too. When the sky is falling, I like to buy sky.

Risk Model: 3/5 - Risk On

Risk on, but just barely. The RSI is falling below 50, and the VXV has spiked again. Are the prospects of the Supreme Court reversing the tariff legality, combined with Republican intransigence over the shutdown, causing the protective elements of risk aversion to dominate? A reversal for companies like PLTR and META is a sure sign of investor skittishness. Perhaps my 'buy-the-dip' call is a bit early, but, as I outlined above, it's what you buy that matters.

The economic all-clear will need a more definitive bottom in the Copper/Gold ratio as well. I think it's coming, but let's wait till Q1 before getting too bullish on the deeper cyclicals. This chart has failed before, but that was during a harsher monetary regime.