The market has cooled off since my last post as I expected. The main narrative as to why is because of hotter than expected inflation numbers which was also something I said to look out for. With the market having been overbought with ST sentiment indicators in nosebleed territory it was no surprise to me that the market has since pulled back. I'm not going to get into to weeds too much about why inflation numbers came in hot. One explanation was that due to unusually warm weather created a surge in spending that would have not otherwise happened. I don't care if that's the case or not. Making a big fuss over one's month's worth of data is not wise. I will take my cue from the 5 year breakeven CPI rate currently at 2.47% which is still suggesting disinflation lies ahead. If we start to see this trending up then I will become concerned that inflation is not going to come down sufficiently in the near future.
So far we have seen a significant retreat in the tactical indicators which had redlined. NAIIM exposure dropped back to 57%. This was coming into Thursday and so it's likely that number got even lower since. The bullish pop in AAII sentiment from a couple weeks ago got sharply reversed and bears are once again are notably outnumbering bulls about 1.8 to 1. Fund flows, which were flat going into this decline, showed a moderate outflow. Put/call ratios are also turning up sharply. If the bull thesis is in tact, we should have seen the bulk of the decline for this pullback and the market will consolidate and turn back up at some point in March. I would caution on being too cute with market wiggles though. The shorter the time frame, the more randomness plays a factor.
Due to the hot inflation numbers, expectations for higher terminal Fed funds rate has increased and the "higher for longer" narrative got strengthened. But notice how the market's reaction to higher interest rates is becoming more muted since the fall while any hint of interest rate expectations being revised lower is met with a much stronger positive response. That's because this "higher for longer" narrative has been already been drilled into everyone's brain for so long. I hate to use the words "priced in" because these words were often said in vain last year by bulls, so perhaps "hawkish Fed fatigue" is better.
I'm always trying to get a sense of what expectations are because I adhere to the motto of this blog. I've read the bullish and bearish arguments and the latter tends to seems to be the most convincing in general, especially now given the macro backdrop. But you always have to keep in mind that the market is a forward looking discounting mechanism. Bears are pointing out how earnings are set to decline this year, hence the market is poised to go down, yet they fail to mention that the market has already had a significant decline. They fail to acknowledge the forward looking nature of the market and that history shows that the market can go up strongly when earnings have been trending down and down strongly when earnings have been trending up. Yes, there are also times when the market goes up or down in the same direction as earnings as well. Markets, like most women, are not straight forward. If they were every trader would be rich. They can act a certain way in response to a certain set of circumstances one day but then react in the complete opposite way with the same set of circumstances the next day leaving men scratching their heads
Look at how the market declined in the first half of 2022. By mid June, the Fed funds rate was still at 1.50-1.75% yet the market had dropped over 20%. Now the Fed funds rate is 4.5- 4.75% yet the market has been up as much as 13% since then. Of course, time will tell if all of this is simply a counter trend rally that will fail or if the market is looking ahead to better times, but to ignore the forward looking/discounting nature of the market is a huge blunder and in my opinion, there's enough evidence to suggest that you at least respect that the bull case can play out.
Despite what the bears are trying to convince you about, it's undeniable that there is a large cohort of fund managers and traders who are underexposed to equites because of interest rate and recession fears. This is indicative of low expectations and represents a powder keg of buying power should the aforementioned, widely held fears were to abate making the market vulnerable to a melt-up scenario.
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