Inflection point?

The reaction to news this week has one thinking that maybe we are at an inflection point. It could be too soon for that.

This week may go down as one of those weeks we look back on at the end of the year and talk about how it changed everything. We discussed last week in “Somethings Gotta Give”, how important the coming two weeks were because of the economic and earnings data, information that could embolden either the bulls or the bears.

On Wednesday morning, I wrote on LinkedIn what I would be watching for:

“A quick scan of some of the bigger drivers of CPI that affect most of us every day shows that we probably shouldn't expect CPI lower today. Food prices as measured by ag futures have fallen but this has not shown up in the grocery stores of yet. That is in purple. Daily average gasoline prices in orange are coming off the boil but still quite elevated. Finally, rental prices nationally in blue have not even started to come lower. As people are backing out of buying a home, that means many will continue to rent. Anecdotally, I hear of how tight the rental mkt is in Chicago, which is surprising to me because many are trying to get out of the city. Rents are still tight though.

We will know in an hour so there is no reason to speculate. I don't want to downplay this number though as it does set a tone. I think it will be more important to look at the drivers of CPI to get a sense of how much it might change next month. Also, now that the mkt might be expecting a much higher than expected number, will a moderately higher number lead to a relief rally? As with most data, I think the market reaction to news is more important than the news itself. This is what I will be watching today.”

Why do I care about the reaction to the news, more than the news itself? In some ways this goes back to the great debate between the advocates of the Efficient Markets Hypothesis vs. the advocates of Behavioral Finance. These discussions happen frequently. I am not going to go into detail but encourage you to listen to the two Nobel Prize winners who were instrumental in each of these, both from one of my alma maters - University of Chicago. Eugene Fama of EMH fame and Richard Thaler of Behavioral Finance fame are friends and discussed if markets are efficient. You can find it here.

Suffice to say, we get a sense of what news and how much of it is priced in when we look at the reaction to the news and not just the headline information. I wrote about this on Friday on LinkedIn.

“Chart of the Day - the reaction. If you are a poker player you know that everyone at the table has a tell. The mkts have a tell as well. It is impossible for us to know what every person is thinking, however, we can read the price action of the mkts, the reaction to the news, to get a sense of where the softer side may be, to get a sense of when too many people might be on the same side of the boating & looking over. In "Reminiscences of a Stock Operator", it is said that when Jessie Livermore was given a tip to buy a stock, he would immediately go out & sell it to see what the price reaction was. If the mkt could hold up in the face of his sell, he knew there was a legitimate bull trend. If it could not, it probably meant he was the last person getting into the trade. Never a good place to be.

In my Stay Vigilant blog & on LI earlier this week, I discussed how important this wk was for news, as much for the reaction as the headline. Let's take a look.

Chart 1 - Pres Biden in the Middle East this wk among other things to speak to the Saudis about more oil. Oil was weak heading into this meeting & hit a bottom during it but has bounced more than $5 off the lows.

Chart 2 - Treasury bonds. Many had started buying in anticipation of the recession. We got a historic CPI print on Wed that hit bonds. Then another from PPI on Thurs. The bond mkt has recovered from both shots better than Rocky against Drago. Have we seen the lows in bonds?

Chart 3 - speaking of bonds, Italian bonds were hit when PM Draghi resigned. They have recovered as his resignation has been denied. Widening spreads in Europe is a big bear thesis now. Could they start to narrow?

Charts 4-7 - earnings. This wk we got earnings from JPM, MS & DAL. The news wasnt good as it wasnt expected to be. The stocks sold off but have started to recover a fair bit. The last chart is MU from a couple weeks ago. The news & guidance was bad & the stock was hit hard but has recovered it all. When stocks cant stay down on bad news, maybe too many expect it.

Chart 8 - the summary of earnings reaction to the news. With 30 of the 500 having reported, earnings growth is -8%. We knew it would be negative. The aggregate reaction of stocks that have reported to this negative news? Flat. When stocks can't go down ...

Chart 9 - e-mini S&P. The mkt has had a ton thrown at it this week. Negative earnings. 100 bps in July now now an 83% chance. Negative geopolitics. It is down 3% as I write this but if I was a bear, & could have predicted a week where I got historically bad inflation numbers, more aggressive Fed hikes AND subsequent cuts priced in, topped off with really bad earnings, I know I would have expected a more down wk particularly as we had rallied 6+% on air before. We must respect price action.”

As we can see, the reaction to news this week was much better than many would have expected. If we add to this that other banks such as Citi, WFC, USB etc. came out later and put up good numbers, we shouldn’t be surprised at the more positive than expected end of the week. When all is said and done, people had gotten bearish, maybe too bearish.

I spoke about the lack of optimism that I see on Thursday:

“Chart of the Day - optimism. Been following a lot more social media of late in trying to assess which are the right platforms for me. One theme I tend to come across as I read the various people discussing the markets & the economy is this notion that there is still too much optimism out there. I have never been accused of being overly optimistic. Maybe it is because I began on a trading floor where one learns to manage risk tightly & try to anticipate everything that can go wrong. While I recognize that investors can be too optimistic at times, I certainly don't see it right now. I have too many charts to show this as I wanted to look from a variety of angles, so I put them in a document.

Chart 1 - are people optimistic? Ask them. Univ of Michigan & Conf Board did. You can see the results. In the case of U of M, it is worse than 2008.

Chart 2 - small biz. They employ the most people. Their optimism index is approaching 2008 & their outlook index is lower than 2008.

Chart 3 - AAII bulls less bears. Individual investors. At 2008 levels & more bearish than the 2001-2002 tech bubble & 9/11.

Chart 4 - complacency in options? If you look at implied vs. realized you will see it is right on the mean of the last 2 yrs.

Chart 5 - Small caps vs. large caps or EM vs. US. The cyclical parts of the market. Both are at the lowest levels in 5 years.

Chart 6 - cyclical sectors have held up better this yr because of energy. If you look at the last 6 weeks, energy & materials have been crushed. Energy is further off its 52 wk high than technology now.

Chart 7 - The NY Fed has its own investor survey of the expectation for stocks prices vs. actual. It is the lowest in a decade.

Chart 8 - BAML global fund mgr survey. They use a variety of indicators to determine global sentiment. Longest data series. It reads extreme bearish.

Chart 9 - CNN Fear & Greed. They use a variety of mkt indicators to measure the fear or greed in mkts. It reads extreme bearishness.

We have had the worst start to stocks AND bonds in 50 years. Risk parity is off to its worst start ever. 60-40 portfolios do not work. So I ask all of you. Are you optimistic? Is there a measure of optimism I am missing? The argument goes that even though we are getting bad economic news we all saw coming, because there is too much optimism in mkts, we need to go down another 20-40%. Do you agree?”

I later added to this post with some other examples of indicators that I think suggest people are getting too bearish right now.

I spoke about Italian bonds (BTPs) before but look at the spread to German bonds (Bunds). It is not historically wide but it is more than 1 standard deviation from its mean over the last 8 years. The ECB meets this week and one of the topics is whether it should buy more Italian BTPs to support the market. You think the Draghi resignation was maybe politics to sway that decision?

Another example is the Asian Dollar Index, which I use as a proxy for all emerging markets foreign exchange or EMFX. This is a really bad time for emerging and frontier market investors. We have recently seen the collapse of the government in Sri Lanka (a major geopolitical asset by the way) and may potentially be seeing the same in Laos. In emerging markets, stocks, bonds and FX are all highly correlated because money moves in or out. It is not very nuanced. Right now, it is moving out.

Finally, look at crypto. We know of all of the bankruptcies and implosions this year - Terra/LUNA, Celsisus, 3 Arrows Capital etc. Institutional investors are reducing their exposure:

However, look at Bitcoin (other coins are similar) the last several days. It has re-taken 20k and is looking higher as I write this. I spoke at a DeFi conference this week. It was a full event. Investors are still doing their homework and digging into the topic. This doesn’t mean there will be a V-shaped bottom. It does suggest that the asset class is here to stay though. This crypto price action (using Bitcoin as the example here) is taking equities with it as crypto has become a good leading indicator of risk sentiment globally.

I am not here suggesting the 2022 bottom is in and everyone needs to get invested. Far from it. This week is a very busy week for earnings and we have a Fed meeting coming up on July 27. There is still quite a bit that can move markets and influence decisions. Just this week, after the CPI and PPI data, the market initially priced in that the Fed would go 100 bps at their next meeting. This has since largely backed off, particularly on Jamie Dimon (JP Morgan CEO) comments on the economy. However, even as the market was pricing in larger rate hikes this summer, it was pricing in more rate cuts in 2023. The thought is that the Fed would act more severely to squelch inflation and this brought in more recession risk later. The rate cuts further out have largely stuck.

It is still early in earnings season. If you want an excellent article to prepare you for earnings season, I encourage you to read “Summer Bummer” by Mr. Blonde (also a great follow on Twitter). Mr. Blonde writes a Substack blog called “Stuck in the Middle” which I encourage you to read. You can find “Summer Bummer” here

Earnings are coming lower, but again, how much is anticipated. Next week I will go into more on earnings as we will have more data. For now, I will show you the recap from the US where sales are in line and earnings are slightly better than expected, though not as big of beats as we normally see.

Earnings have been a more downbeat story in Europe so far:

I know this is already way too long. However, I want to leave you with two more charts. With the CPI news this week, there is the discussion of stagflation and the 70s. Last week I spoke about what type of recession we may have. Could it look like 81-83? Well, Mr. Risk, a long time friend, turned my attention to the post WWII era. I am embarrassed I didn’t consider this. In my classes I had told my students that the fiscal and monetary stimulus we saw in 2020 was unlike any other US period except WWII. Why shouldn’t we then look at CPI and the SPX in the post WWII era? What you can see is that the market sold off before the big spike in inflation, just like this year. Once inflation peaked, stocks then went sideways for a while as policy worked through the economy. Eventually, this laid the ground work for a rally in stocks as inflation was brought under relative control.

Again, this doesn’t mean stocks go straight up. Inflation hasn’t peaked yet. If I overlay where we are now with that period, it does suggest we could see some more downside but then go sideways.

As I have said before, history doesn’t repeat but it rhymes. A sideways market that allows us to work off excesses may be exactly what the doctor ordered. Risky assets may be inflecting, but in the event it is to work off too much pessimism, it would be short-lived. There is still a lot of negative news on the economy. However, much like as the DeFi investors were doing at the IDX DeFi summit, it is the right time to do your homework on what you want your portfolio to look like so you can begin to position for that.

Sorry for the long one this week.

Stay Vigilant