Updated July 17, 2023
Raymond Micaletti, Ph.D.
Equity markets bounced back last week after the prior week’s selloff, driven in large part by cooler than expected inflation readings.
Risk assets rejoiced at the news. Silver rallied 7.9% while emerging markets and the Nasdaq both rallied 3% post-CPI. The U.S. dollar, meanwhile, wasn’t as jubilant, breaking below its April low.
Our thesis has been (and remains) that we are in a secular bear market driven by high inflation—a secular regime that will last at least a decade and be inflamed by the sovereign debt bubble, de-dollarization, and de-globalization.
Thus, it is reasonable to ask how last week’s inflation prints fit into that thesis?
On the one hand, we hear highly esteemed voices argue that real-time inflation is much lower than the latest CPI print, and that 2-year real rates are reaching their highest levels in 14 years (indicating exceptionally low 2-year inflation expectations).
On the other hand, macro analyst Luke Gromen, in his latest weekly report, notes that interest expense on U.S. government debt is approaching $1 trillion, and when added to entitlement spending now exceeds U.S. government tax receipts (which are down 20% year-over-year despite full employment(!), which highlights just how critical rising asset prices and the attendant capital gains taxes are to U.S. government solvency).
In other words, the U.S. government needs a weaker dollar and higher inflation in order to remain nominally solvent. The Fed can sacrifice the U.S. dollar or bankrupt the government. Those appear to be the only two options. The Fed’s response to the bank crisis earlier this year suggests it will sacrifice the dollar (which is down 4% since mid-March).
A weaker dollar, should the dollar continue down that path, would lead to higher commodities prices and higher commodities prices would lead to higher inflation expectations.
If the dollar counterintuitively were to strengthen (and from a trading perspective, it’s not out of the question that last week’s breakdown might turn out to be a false breakdown), risk assets and tax receipts would likely suffer, deficits would balloon even further, and the Fed would most likely have to step in and monetize the debt, thereby reigniting inflation.
Not to mention the fact that geopolitical rivals are actively trying to squeeze the U.S. economically (by lessening their need for dollars).
Thus, to us, it appears all paths lead to inflation over the intermediate- and longer-term.
With respect to energy commodities, investor positioning is still bearish, but it is now the least bearish it has been in 8 weeks. Is a change afoot?
Broad commodities are up 4.5% so far in July (quietly outperforming the Nasdaq). And retail sentiment in commodities is approaching levels that suggest renewed inflationary pressures.
In addition, according to Jeff Currie of Goldman Sachs:
"The OPEC+ production cuts are beginning to bite. We're starting to see the supply side have an impact on prices. These price caps don't make economic sense. Once you hit them, you start to lose supply. The supply situation becomes relatively scarce."
Meanwhile, the Biden administration has announced it will purchase 12 million barrels of crude oil by the end of August to begin refilling the Strategic Petroleum Reserve (SPR).
One might argue the only reason inflation came down in recent months is because of the SPR drain. So now that the SPR dynamic is reversing into the teeth of OPEC+ production cuts…
We wouldn’t write off inflation just yet.
With respect to stocks, the action since March 10 in mega-cap tech stocks has been historic. No need to rehash all the stats, but one thing we were curious about and decided to compute was how AAPL’s recent Sharpe ratio compares with history. (If you look at its chart, it’s essentially a straight line higher since March 10).
It turns out that AAPL’s rolling 6-month Sharpe ratio of daily returns hit 4.28 on July 6. Since AAPL’s IPO on December 12, 1980, only 73 of 10,374 trading days have had a rolling 6-month Sharpe ratio greater than 4.28, putting it at the 99.3 percentile. Incredible.
Part of the recent tech frenzy could be related to retail traders buying call options on mega-cap tech names. Such purchases require option dealers to buy the underlying stocks in greater and greater quantities as those stocks rise, leading to what is known as a “gamma squeeze.”
We saw similar action in the Nasdaq in August 2020, when the Nasdaq rose 14% in 3 weeks. It then fell 12% in September (giving back all its gains). But it eventually stabilized and resumed its uptrend.
Perhaps we will see a similar dynamic this year–i.e., a short-term pullback and then a resumption of the uptrend?
Short-term technical conditions are exceptionally stretched and overbought, with key indicators at levels that have historically coincided with interim market peaks. Further, the Nasdaq is nearing the upper reaches of the channel it has traded in the last several months, just as we approach mega-cap tech earnings in two weeks.
In light of those conditions, a 5%-10% decline seems within the realm of possibility.
But momentum has been so strong, it’s reasonable to expect the momentum to resume should the Nasdaq sell off in the near-term.
If the Nasdaq were to continue higher without a reasonable, healthy pullback, however, a bigger selloff would likely loom in the future (especially with valuations where they are and institutions now selling the Nasdaq–the opposite of what they were doing in January).
Making the picture even murkier is that certain measures of equity relative sentiment appear as though they may turn bearish in a couple weeks (on account of institutions selling equities as retail investors buy).
Bearish relative sentiment versus bullish price momentum tends to end in a stalemate, with equities going sideways (but going “sideways” may entail a face-ripping blowoff top that collapses back on itself to where it launched).
Then again, recall crude oil positioning is becoming less bearish. If it turns bullish, that tends to be a tailwind for equities (because it suggests growth is increasing).
Then again, retail sentiment in commodities is starting to enter inflationary territory, which tends to lead to headwinds for equities.
Then again, seasonality is strong for equities in the third year of a presidential term.
As one can see, we are faced with several conflicting cross-currents.
How will things play out?
The Bull Case
The bull case remains largely unchanged from last week:
Still-bullish relative sentiment despite trending bearish
The market may be sniffing out the U.S. government’s need for inflation given the fiscal situation and viewing stocks as inflation hedges (credit to Warren B. Mosler via Luke Gromen for this idea)–this might also explain why gold has held up reasonably well despite real rates having risen substantially in recent months.
The Bear Case
The bear case also remains largely unchanged from last week:
Unsustainable mega-cap tech valuations
Bearish technical divergences
Even bullish Nasdaq momentum studies suggest a double-digit drawdown over the period of the study
The crowd has abandoned put protection and the tech trade is becoming crowded
We can’t recall a time of less certainty over the past 18 months when it comes to market direction (and market direction is always fraught with uncertainty).
In early 2022, institutions were overwhelmingly bearish–equities fell. Starting in late June/early July, they became bullish equities, and although the ride was bumpy at first, equities have risen.
Now, institutions are in somewhat of an in-between state. They are no longer buying equities, yet their overall positioning across equities, bonds, currencies, and commodities remains in a bullish configuration–but that configuration could very well shift bearish in the next couple weeks.
Momentum is strong and not to be trifled with–it can withstand institutional selling for a period of time as retail traders get cajoled back into the market and led to their eventual slaughter.
Seasonality is strong over the remainder of the year and we’re heading into a presidential election cycle.
With this much uncertainty, we tend to view things in terms of potential scenarios.
One scenario would see the market continuing higher in the near-term. If so, this rise would likely be halted during the week of mega-cap tech earnings (July 24-28) at or near the top of the trend channel stocks have been trading in this year.
We believe mega-cap tech earnings will be a sell the news event–if equities continue higher from here without a pullback–whether they are good or bad.
If bad, well then, the recent rise obviously got ahead of itself and new buyers would likely be scarce.
If good, we may get a flood of buy volume from retail traders that almost certainly would be met with an equal or greater flood of sell volume from institutions. A pullback would likely ensue.
A second scenario would be that equities run out of steam here and pull back in a meaningful way (3%-5% for the S&P, greater than 5% for the Nasdaq) before the FOMC meeting and tech earnings two weeks from now.
In that scenario, assuming no exogenous shocks, we would expect the market to stabilize eventually and resume its uptrend.
In general, we believe the market won’t top until the relative positioning between institutions and retail becomes extreme in the bearish direction, and while positioning is moving that way, it’s simply not there yet.
Allio Portfolio Updates
No changes to Allio’s core or tactical portfolios last week.
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