As summer draws to a close, the market makes yet new highs on lighter and lighter volumes. To everyone's dismay it is not the entire market that is up, but just a handful of stocks. Every day that passes by, that leadership narrows even further to just one to two stocks claiming new highs. Is August indicative of the start of a new underlying fundamental trend or is there something more ominous that awaits us after everyone returns in September?
On Thursday, Federal Reserve Chairman Powell released his statement at the Jackson Hole virtual conference that caused quite a stir and confusion in the markets. One of the most supporting factors for the market has been the over eager Fed coming to its rescue, pumping the market with endless liquidity and buying all sorts of high yield and junk assets. Their promise of keeping rates lower for longer, perhaps even for the next 3-5 years, has convinced investors all around that the cost of capital will remain low, or almost non-existent. Their aim is to provide a floor for equity markets long enough, such that the overall economy slowly recovers post the pandemic and no longer needs the Fed's help. But this has not benefited all sectors. Given the structural and cyclical weakness in the global economy, most value or cyclically sensitive stocks have underperformed. Some are trading at two year lows! It is mostly the Technology stocks that have benefited, and the large cap ones, that have solid balance sheets and have decent 25%+ earnings growth. As rates remain low, these companies can borrow even more money at minimal rates to then reinvest in their own company or buy back their stock. Multiples no longer matter as these stocks rerate every single day. The stock price run in these stocks is all attributed to massive P/E expansion. But when is enough, enough? When does this parabolic rise stop? It is hard to say, because until yields start rising or rates, there seems to be no end to Technology buying.
From the July Fed FOMC minutes and even during the Jackson Hole commentary, the market initially took delight in the fact that rates were to remain low and inflation would be allowed to overshoot their 2% target, implying the Fed would keep printing its way out of this recession. The Dollar fell immediately on this and Gold and Silver spiked higher, the same theme as over the past few months. However, there was another comment released that said "inflation shoot over 2% would be moderate", suggesting that perhaps the Fed is keeping a close eye on its inflation measures and that it is not going to just let it fly. This immediately saw the Dollar reverse its fall and close up on the day, knocking Gold and Silver lower with US 10-year bond yields ticking higher above 0.71%.
The Dollar has fallen about 10% vs. some developed market currencies like the Euro and Sterling. The latter is most confusing given Brexit is going to happen without anything resembling a deal. Everyone is ready to give up on the Dollar and calls for its global reserve currency status demise are heard. Be that as it may, that is a much longer-term call. The true question is, is there even another currency that can replace the Dollar? Not really. Until then we will see mini cycles of risk on and risk off as the Dollar appreciates and depreciates within each economic cycle.
Positioning is very stretched right now as everyone is short the Dollar and long U.S. Bonds. From a pure contrarian point of view, risk reward does not bode well to be in that camp, for the near term is very sensitive to any sort of unwinds. We are heading into the key November elections, and the race is close, the market has yet to price in some election risk along with the lack of a fiscal stimulus bill. The Fed is wishful for not wanting inflation to overshoot much above 2%, but once the can of worms is open, it will be hard to control, at least not without raising rates aggressively to tame the beast. It seems the Fed is more concerned with deflation than inflation. Either way the market is at risk of facing stagflation or deflation, neither good for equity markets or cyclically sensitive assets in general.
September is always a tricky month and put protection is at its lows leaving the market open to quick downside surprises. Maybe it is best to see how it develops before being caught up in the FOMO train, especially given all the risks that are brewing in the background.