Wednesday, November 1, 2017

This Week's Message: Mispricing, Ms. Yellen, and a Certain Something

Interesting day yesterday. The U.S. stock market began with a nice broad-based rally which ultimately fizzled into a, broadly-speaking, mediocre session that saw the Nasdaq give up all of its morning gains, and some, while energy stocks advanced an impressive 1.13%, followed by our global natural resources (read commodity producers) ETF, up .87% and materials +.49%. Utilities and telecom came in last with .56% and .79% declines respectively.

Given that yesterday's economic data, like so much of the data of late, came in unambiguously strong, the above makes some sense; cyclical stuff (save for tech) doing well, defensive (economically defensive) stuff not. However, what made yesterday particularly interesting is that gold and bonds -- those defensive asset classes -- actually rallied quite hard.

Now, if we're correct in our view of what's presently moving bonds and gold, yesterday's action -- at first blush -- made absolutely zero sense. Our view being that gold is presently trading in negatively correlated fashion to the prospects for higher interest rates -- and the same for bonds. So, again, with yesterday's data releases coming in really good, what gives? Are we incorrect in our assumptions?

Well, while after 33 years of doing this stuff yours truly is very open (to say the least) to the possibility that our thesis is off the mark, I'm not there just yet. In fact, far from it. My best guess is that yesterday's odd action -- which also featured a lower U.S. dollar -- reflects traders' views of what a Jerome Powell Fed (he'll get the official nod today) is going to look like. Clearly, as we've been reporting herein, he's the most dovish on President Trump's shortlist, save for the current Fed chair (Janet Yellen).

The funny thing is, while, again, he'd be the easiest on monetary policy among the candidates, we don't believe that Powell would be at all easier than Ms. Yellen. In fact, we see him as the next "best" thing to a Yellen reappointment, with one caveat, he's very open to lightening the regulatory grip on banks; a place Yellen is adamantly unwilling to go. In theory, deregulating the banking sector would boost economic activity, which, at this juncture, is the stuff of higher interest rates/stronger dollar. So we're thinking gold and bonds are experiencing what will likely be deemed a mispricing in the not too distant future, especially if this keeps up. Time will tell...

So why do we spend our time getting into such weeds? Well, intermarket relationships are important things to keep watch over. Experienced, and thoughtful, investors/advisers analyze how different asset classes interact with one another. Such analyses can offer important clues as to the sustainability of certain trends and/or the prospects for trend reversals as relationships begin to break down. 

For example, here's a look at how gold and copper have related to one another (via the gold-to-copper ratio) over the past 5 years:     click to enlarge...

That's presently a very economically bullish chart you got there. I.e., a rising copper price indicates rising global industrial production, while a stable to lower gold price suggests generally good things about the state of the global economy. The chart -- which shows the gold-to-copper ratio contracting (copper gaining ground vs gold) -- confirms our presently bullish view of global economic affairs, and helps validate our presently growthy approach to our equity sector weightings.

To add fuel to those bullish flames, the entries to our October 2017 trends file, on balance, paint a relatively rosy picture as well (we'll copy and paste all of the titles at the end of this post). Plus, 74% of the 72 economic and market data points we monitor at the beginning of each week are exhibiting positive trends, while just 5% are trending negatively, with the remaining 21% receiving our neutral score. That's about as bullish as it gets, and, mind you, it absolutely can't last forever -- which is why we monitor things so closely.

Lastly, you may have noticed that many of our recent Quotes of the Day have focused on investor psychology; specifically, the mistakes most investors make. Reason being, we think it's of paramount importance that we remind our clients of the reality of financial markets -- particularly given the fact that the recent stretch has been one of the least volatile on record. You see, another intermarket relationship worth monitoring would be the one between the S&P 500 Index and the CBOE Volatility Index (VIX).

Here's an historical look at the VIX-to-S&P 500 ratio:     click to enlarge...

While the present setup suggests that volatility should (like gold and bonds) indeed underperform, we think this is a bit much, and we're concerned that recency bias may infect our clients' thinking. I.e., when one becomes accustomed to a certain something, particularly a pleasant certain something, one can feel an intense sense of shock when that certain something morphs into a certain something else. Bottom line, the present certain something -- historically low volatility -- doesn't jibe with market history, even bull market history. So, don't be too dismayed when volatility picks up a bit, it's actually the norm.

Have a great weekend!

October 2017 Current Trends File (shoot me an email if you'd like to see the contents underneath any of the following titles):    click to enlarge...

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