Vacation Cancelled

Come back from the cottage and get on your computers. It's correction time.

Bulls: We are in a technology renaissance that will drive a productivity-induced explosion of profitability. Sustainable FEMO (fabulous earnings momentum). Roaring 20s are here again!

Bears: Bond yields are soaring on an orgy of private and public debt creation during an inflationary backdrop. The Fed is rudderless and politically compromised. We have nothing but valuation downside risk to stocks.

Pick your narrative and place your bets. I've heard both arguments lately. So, how do you position your risk assets? Where is the line in the sand? What is the catalyst?

There is already a catalyst. It's that nobody is willing to acknowledge it. Cue the boiling frog metaphor. Markets have ignored the rise in competitive yields all year. But now the temperature has reached the boiling point. I've been a reluctant bull for most of this year. I have joined the bear camp this week.

As in any bull market, confirmation bias arises as stocks keep going higher despite the negatives. It's euphemistically known as "climbing the wall of worry". It's not that those worries don't matter. It's that people don't believe that others will act as if they matter. These people are called Bulls. Bulls don't stop and ask questions. They just put their heads down and charge ahead.

Bears hide in the bushes. They often run away from strange noises. Bears will sometimes 'bluff charge' but don't follow through on their threats. But when they do attack, it gets painful real quick.

If you have been reading this blog for the past few months, I have been sounding the alarm over rising rates and their potential effect on stock valuations. The time to prepare for a correction is before you realize you are in one. Most drawdowns are two-thirds over before you realize it's happening.

To demonstrate the effect of rate increases on stocks in this cycle, the chart below shows the correlation between stocks and bonds (bottom panel). You can see the decline into a negative correlation - stocks continue to rise as bond prices fall - precedes the sell-off in equities.

S&P ETF (SPY); Treasury Bond ETF (TLT) Correlation

The time is ripe for a pull-back of consequence. The August Bank of America Fund Manager Survey shows record-low levels of cash held in institutional portfolios. The average manager is behind the markets and has been chasing performance all year as the AI boom narrative has experienced violent swings. Hyperscalers (read Mag 7) corrected, and Semis soared. Other underowned segments, like energy, sprang to life. They are all-in, performance-chasing, and have no buffer against a declining market.

And in the AAII sentiment survey, the individual investor has been held back by the headlines from Washington and elsewhere. The record levels of money market cash tell a story of investors satisfied with 5% yields and with diminished risk appetites as they grow old. In my backtesting of AAII sentiment in the Risk Model - see below - I found that this group is a confirming variable for risk-taking. Markets need their participation to go higher. Unlike two years ago, they seem reluctant to "pull the trigger" recently, which isn't good for stock prices.

AAII Bull/Bear Ratio

So with the Institutions fully invested and the 'home gamers' sitting this one out, who is left to buy this market? Good question.

The much-anticipated 'broadening out' of the market has also stalled out. The theory was that the economy would benefit from the massive AI spend and that all boats would rise. But now that the expectations have run ahead of reality on the pace of data center buildouts - mostly due to power constraints and NIMBYism, the benefits are less than hoped. All while stubborn inflationary and affordability issues slow consumer spending. Is anybody buying Walmart stock this year? Don't think so.

I expect another test of the lows before any sustained upswing in market breadth.

Equal-Weighted ETF (RSP) vs Index (SPY)

Walmart

The recent earnings season exceeded all expectations, thus creating the melt-up we have just seen. Now the hard part begins. Two critical issues are facing markets in the Fall - the post-Jackson Hole Federal Reserve meetings and the Midterms. If you want catalysts, there are a couple right there.

Market timing is a difficult game to play. But, like in blackjack, when the deck is tilted against you, like it is for the market bulls, you just might want to take something off the table.

Unless you just want to stay on vacation.

Risk Model: 1/5 - Risk Off

Notice how the recent run-up in the TSX has rolled over into declining participation (CMF -money flow index, third panel). Nobody came to this latest party. A test of the 200-day moving average would be painful (down 10%+) but would improve long-term market health.

TSX Composite ETF (XIU)

Copper is likely to give back much of its summer rally as a weakening economy and reversal of AI-related bullish sentiment could trigger the liquidation of large speculative long positions that have built up this year. I don't like the implications of the hard break against the gold market.

Copper/Gold

Copper Speculative Positions