Transit Story

Kevin Warsh, the newly installed Federal Reserve Chairman, has inherited a problem not of his making. The Orange Menace's war with Iran was meant to deflect from more mundane issues, such as those contained in a certain set of DOJ files. Unfortunately for Mr. Trump, resulting higher oil prices quickly fed into inflation expectations, threatening the global economy and distorting the fixed-income markets. Only one week into his new role, and he's dropped his new Fed boss directly into hot water.

I don't mean to say that the Straits of Hormuz are all that warm, but the inflationary implications of closing that critical waterway have already boiled over. And that isn't helping the freshly minted Fed chief in his quest to steer the massive monetary ship now at his command. Transiting these narrow inflationary straits will require the utmost skill and seamanship.

But what is this so-called "inflation" everyone is talking about? Is it a real problem for the world economy, or just a blip on marine radar screens? Approaching new highs recently, the stock market has made its opinion clear. Inflation expectations have risen in the near term but are far from being unanchored. To the financial markets, the energy price Inflation is a "nothing burger."

So how is one to make sense of all this fuss about nothing? As always, dear Tuesat11 reader, it's about expectations. More precisely, 'expecting the expectations of others' - as the patron saint of this blog famously implied in this quote:

"we devote our intelligences to anticipating what average opinion expects the average opinion to be"

J.M. Keynes

In other words, you have to guess 'what other people are thinking that other people are thinking.' No wonder this game is hard!

Stocks are blithely 'looking through' the headline-grabbing energy price shock and expecting the cessation of the Iran conflict at some point to lead to lower prices. I said as much a few weeks ago when I advised going long the market on the "sound of cannons." I correctly anticipated the average opinion of the average opinion - if that makes any sense!

It is, therefore, incumbent on me to offer the corollary view now. We are getting fully close to the second part of Rothschild's metaphor, where one must 'sell on the sound of trumpets." But not just yet.

That brings us back to Mr. Warsh. He may see the oil price inflation as "transitory." Will he then respond with a dovish policy shift to placate his meddling political overlord? Will he give Trump the rate cut he so desperately wants?

Or will he stay on hold? By showing uncharacteristic prescience, he could anticipate the stimulative effects of lower rates and energy costs on consumer behaviour, which risks triggering an economic surge and an accompanying inflation threat down the road. Yeah ... and I've got some waterfront property on the Persian Gulf for sale for you.

So with the dichotomy of record-high stock prices and record-low consumer optimism staring back at us from the financial news landing pages, it's time to make a call to JMK for advice. I expect that, shortly, investors will expect others to expect that others will expect good news. Lower oil prices should lead people to believe that the economy will recover quickly from this episode of high prices. The consumer will recover.

It follows from his model of stock market behaviour that we should expect investors to shift their focus, at some point, away from the narrow leadership provided by AI and toward the economic beneficiaries of lower rates. Round up the usual suspects: Small and Mid Caps, Housing and Autos, Airlines, Consumer Discretionary, and Non-energy Resources.

Now that the bond markets have bumped their heads on a 5% ceiling and nothing broke, the stock bulls have regained their seemingly impervious bravado. Instead of getting any tough love from higher administered rates from the Fed, the markets should soon respond to the salve of continuously cheap money and therefore broaden, soaring ever higher on the benign neglect from a complicit central bank.

All that's left now is for the bandleader to cue the trumpets by admitting his embarrassment and implementing his new TACO strategy: Trump Always Capitulates Officially.

Cue the rally - it has already started, by the way. Stocks have, against all odds, navigated the minefield and broken through the blockade. How's that for a transit story?

Risk Model: 2/5 - Risk Off

The lagging model has kicked into bear mode due to the RSI and 200 DMA crossing overbought territory. But most of the index-level readings have been skewed by the narrow chase higher in the Canadian Banks and by MegaTech in the S&P500. A broad-based phase is pending now.

AAII Bull/Bear data, which could conceivably positively reverse the signal this week, will be released on Thursday

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Copper/Gold remains bullish, reflecting the dominance of positive copper news amid the AI buildout. Despite the elevated level of spec positions, the shallow pull-back in base metals prices may be all we get if the optimistic scenario soon dominates the economic narrative.

The 3 Month VXV is now below 20 - all is well with the 'fear gauge." That says a lot about the investment climate we are facing. Despite the news, stocks only care about earnings rising and rates staying low. The rest is noise.

The rotation to economy-sensitive sectors should be short and sweet. The SmallCap sector (relative performance shown below) has experienced a sharp retreat, as I flagged a few weeks ago when the Hormuz-Newz broke. The dry powder I have been sitting on should start to be deployed shortly into this and other stocks punished by the energy shock.

Small Cap Relative Performance