We've seen the market snap back since my last post up about 4% from the lowest point of this decline despite oil rocketing up 11% to $111 on Friday after Trump's state of union address the night prior. I found this oil price reaction strange because Trump didn't exactly say anything new or that surprising. The market opened up down 1.5% but by the end the day clawed back to even. This must have been infuriating to the bears. I can just hear them yell "how the fuck can the market be flat with oil soaring like this?" If I was short, I would be very worried of this action. The market is acting like a beach ball being held under water....more on this later.
Although Trump says that the straight of Hormuz is Asia and Europe's problem and that they are the ones who should sort it out, the US military build up suggests that they are planning to pry open the straight by force as I had mentioned in the prior post. Although the US doesn't heavily rely on energy supply from the straight, the impact of the high global pricing of energy is felt by everyone and if there's one thing we know about Trump is that he wants low energy prices...that has always been his mantra. If we don't do anything and just allow Iran and its proxies to be able to attack energy supply lines like this with impunity they will hold the world hostage anytime they want something. Yes, the US started this war and Iran is retaliating but now they learned something from this and would be inclined to use this tactic going forward. Iran is actually allowing some ships to pass so long as they pay a toll which means they are profiting from this situation, yet another "why didn't we think of this before" epiphany for them. The bottom line is that when it comes to war, diplomacy is not going to work. Only force works. Only when enough force has been applied does diplomacy eventually work as the nation who is all but defeated has no choice to accept it, especially a brutal regime like Iran. So long as the straight of Hormuz is in Iran's control, this war is likely not going to end with diplomacy. Last week a coalition of 40 Nations discussed diplomatic and economic strategies to open the straight, in other words. sanctions. This is probably not going to amount to much. Iran has been sanctioned to the wazoo for decades already. Macron says miliary force must not used to open the straight. Good luck with that. Why would Iran give up their biggest leverage in this war? But sure, go ahead and try to see if Iran will be "diplomatic"...just don't hold your breath.
Let's get back to the markets. As of now with this latest little rebound, the market is only down about 5.5% from the all time high earlier this year. This is pretty incredible considering that oil prices have doubled in 3 months and 20% of the world's oil and gas supply has been cut off in addition to other things. There's 2 ways to look at this...either the market is in denial or the market is looking across the valley and sees this as temporary. Most evidence suggests the latter in my opinion. Oil futures for delivery in August and December are trading at $82.50 and $72 respectively. This is a massive discount to spot which indicates the market is pricing in much lower prices in the not too distant future...I know there's more to it than this but this is likely the main reason for this pricing. More often than not, steep differences in futures prices to spot like this signal the spot price is unsustainable and destined to go the other way. I pointed out this disparity last post, but now the situation is even more extreme because the longer dated futures are trading LOWER than they were 2 weeks ago despite the fact that spot prices are higher. Some people would argue that this is complacency, that this indicates denial. History suggests otherwise.
Another thing to look at is the 5 year break even inflation rate implied by TIPs. I've quoted this indicator before as far back as late 2022 to suggest that the market was pricing in much lower future CPI inflation going forward from that time which hardly anyone believed. Well, it turned out that the market was indeed correct. While the TIPs market under estimated the actual inflation realized, it was directionally correct when spreads started falling significantly in late 2022 just like how it was directionally correct in mid 2021 when it was ramping signaling an inflation surge forthcoming while the US and CDN Feds had their dicks in hand saying "lower rates for much longer". So what's the 5-year breakeven spread saying now? While it has up ticked since the war broke out, it's currently at 2.56% which is near the higher end of the range it's been for the past 3 years and has not made a higher high despite oil making one on Friday. What this means is that the market is not expecting inflation to dramatically surge otherwise it would have definitively broken out to new 52 week highs. The same message can be seen in the 2 year TIPs market, in fact, it's at 2.27% and near the mid point of its 3 year range which is an even stronger signal that the market does not expect significant inflation pressures forthcoming in the near term. Once again, the skeptic would argue that the TIPs market is being complacent but history shows that the TIPs market tends to get it right....not necessarily right in the average CPI it implied (which can be off by 1-1.5%), but the direction of the CPI trend.
I mentioned last post how some sentiment indicators have already hit extremes. Here's some more evidence of that
I would say that the sentiment reset overall is not extreme as it was last year at this time, but it's defiantly notable and enough to suggest that a bottom is in or close. AAII sentiment and II sentiment are now at pessimistic levels commensurate with some prior market lows. AAII bearish sentiment has averaged about 50% for the past 4 weeks, while the slower moving II bull to bear ratio is currently at 1.12 which is quite low. Ideally, I'd like to see it at 1 or less (which can happen this week), but at 1.12, that's already a big reset especially for a market that is off only 5.5% from the high. At the market high, the ratio was 4. So, sentiment has rapidly cooled. Can it get cooler? Of course, but it has cooled off enough for the market to resume its uptrend should the proper catalyst(s) slow up. Another thing I have noticed is how the put/call ratio has been at or near 1 throughout this recent pop in the market. That shows you folks are shorting/hedging aggressively into strength which usually means the rally has legs to go higher still. Ideally, I'd like to have seen NAAIM exposure be lower as it's currently at 68, but I know from experience, not every indicator is going to perfectly line up.
The market has had plenty of time now to price in the situation in Iran. It has taken limited damage given what seems to be a very serious situation with the Straight closure which gives me the analogous feeling of a beach ball that is being held under the water...you can push it down but not much and once that artificial pressure is released, the beach ball pops up violently. I realize I could end up looking like a total clown making this claim, but this is how I feel about the market at this point. Always remember the motto of this blog. How would the market create the most amount of fools right now? By going down another 5-10% or going up 5-10% making new all time highs? It would seems the latter is a near impossibility at this point....and that's why you should be prepared for it. I feel squeamish making this post...let's see how it turns out.
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