Face ripper

We had an absolute face ripper of a rally last Thursday thanks to a better than expected CPI report. SPX up 5%, Naz up 7%. with no mercy to the bears as the market gapped up huge. Coming into the report the market was sagging and looking bleak. Given the last 2 disappointing monthly CPI reports expectations must have been quite low and bears were pressing. Lot's of folks talking about how good this report was and how it bodes well for the future but lots of folks were also talking about how bad last month's report was and how it boded ill. Suffice to say that one shouldn't get too excited or depressed about a single month's worth of data. I've been saying for a while that pipeline inflation pressures are collapsing in general, sure, some components will be stickier than others but overall it's clear that the trend for inflation is down. A great way to distill this is to track 5 year break even rates which has been hovering at around 2.5% for the past 4 months. I really like this indicator because it distills all the nuances of the CPI providing an outlook GOING FOWARD of what the average CPI will be for the next 5 years.  Meanwhile the bumbling, fumbling Fed keeps looking in the rear view mirror saying how they don't see inflation subsiding much. I suspect at some point in the next year or 2 there is going to be an overhaul in the Fed with respect to how they make forecasts as they will once again be made to look foolish. Mark my words. 

The market is just punishing everyone, whipsawing the shit out of both bulls and bears. Once again, read the motto of this blog and don't you ever forget it. So, is this latest rally yet another head fake? Most likely, but it could very well be part of a base building process if the bull case is playing out. I had given a target of SPX 4000-4100 for which we have hit the lower end of this range. The market could be forming a W type bottom, similar to what we saw in 2002 and 2011...obviously too early to know if that's the case as can only know in hindsight if that actually transpires. Take a look at the biotech index ETF BBH. The W bottom is much more pronounced here. This sector is one to keep on eye on as it's showing relative strength and not being talked about much.  Bears can easily make a good case that this is just another dead cat bounce but the fact that the market is now flat for the last 6 months is a big achievement given what has been an absolutely brutal macro backdrop. Keep an open mind. Nasdaq is showing early signs of decoupling from BTC. To me this is an important thing that needs to happen to suggest a true bottom is in. The market needs to shake itself off from the speculative crap of yesteryear. Meme stocks are another thing that needs to die but they are still showing correlation to the Nasdaq although they have been pounded quite hard and are not nearly getting the spot light as they once did. I'm going to make a post discussing crypto shortly. 

Let's talk indicators. Prior to this surge there were some indicators showing some extreme bearish sentiment, namely, put/call ratios and DSI. One surprising development was how AAII equity allocation declined to 61.5% and cash is at 2.5 year high at 22.5% in October which means AAII members sold into strength. At 61.5%, exposure is about as low as it was at the end of 2018, shortly after the market had decline 20% from the peak. This is a good contrarian development but I still think think this needs to come down a bit more. Other indicators were neutral such as NAAIM. Fund flows had reversed course flipping to negative for the week but only after having been positive for the 3 weeks prior. These latter 2 are now poised to jump to excessive optimism territory when next Thursday's readings come out assuming the market doesn't totally far apart by then. 

Let's talk more about positioning. Throughout 2022 the strongest case for the bears in regards to sentiment is positioning from investors. AAII allocation surveys have pointed out all year that  they are feeling very bearish but they haven't actually positioned their portfolios to reflect it,  having only grudgingly decreasing equity exposure. Market watchers are saying that we can't bottom until we see more capitulation. Well, here's another possibility that nobody is considering. What if the market hits a bottom and Investors sell into the strength early in the new bull market? As mentioned, AAII did sell into strength in October. If the market keeps rising and they keep selling they could  end up capitulating into strength rather than into weakness like everyone is expecting. It should be noted that AAII members also sold into July's rally but then bought back in August. And so here lies the problem of these kinds of sentiment indicators - they can flip flop and whipsaw you. What I've learned through out the years is that when a lot of market watchers are focusing on a particular indictor or strategy it will end up becoming less effective. 

Let's talk about the Ukraine war. When this war started about about 9 months ago, who could have predicted that Ukraine would been preforming so well and Russia so poorly? Nobody.  I have heard that Ukraine has obtained more stranded Russian weapons/equipment than what they are getting from NATO. Who could have predicted when the war broke out that that the price of oil and wheat would end up being being about the same as it was pre-war in November? Nobody, not even the most rose-coloured glasses wearing optimist. Oil was supposed to be at $200 by now. Granted, natural gas prices are notably higher but have come down substantially since September.  The bottom line is that so far the world has been able to cope and adjust to the loss of Russian and Ukrainian commodities. Sure, that could change, but then again it would appear that Russia is in terrible shape. In regards to the war they are  running out of ammo and troop moral must be rock bottom  and it was probably never good to start with. Meanwhile Ukraine is getting more supplies by the day and moral must be sky high after taking back Kherson. Russia is isolated from most of the world and have a poorly educated workforce to pick up the slack from all the skilled foreigners who have left and closed shop. It's seems like the walls are closing in on Putin quite fast, but perhaps that means he is going to do something desperate as a last ditch attempt to turn the tide. I don't know. But let's say the Russian regime as we know it collapses, Putin is ousted and Russia withdraws from Ukraine. That's gong to create another face ripper of a market rally and tank commodities. This is just me thinking out loud here. I won't be holding my breath for such a scenario to play out, but it sure looks like Russia's war effort is collapsing. We can't however get complacent because Putin is known for cranking up the brutality when things aren't going his way. The problem this time around though is that the Russian economy is isolated and crumbling and patience must be running thin. If he orders a nuclear strike, his generals may very well turn on him as they know the repercussions will be so severe including a fear for their own lives The Russian military authorities know they are absolutely no match for NATO, the US in particular. Once you play the nuclear card that gives license for NATO to do a full assault on Russia as they will do it the name of saving the world from a madman. 

Bottom line is that although this bounce is good and there's promising signs that inflation is showing deceleration in the rear view mirror CPI reports, it's way too early for bulls to declare any kind of victory. How can you tell when a new bull market has been born? It will most likely show up as via a relentless 2-3 month rally.