Euphoric Markets Set Their Own Narrative – How Dangerous is That?

Blain’s Morning Porridge 13th June 2023:  Euphoric Markets Set Their Own Narrative – How Dangerous is That?

“Only Napoleon did more than I have done, but I am definitely taller.”

US Stocks are back in bull territory, but how dangerous are Euphoric Markets determined to follow an upside narrative – no matter what the underlying reality? Markets are not clever, just voting machines reflecting how smart participants are.

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Apparently, we are back in a bull market when it comes to US stocks: 20% higher than the 2022 October low – and at 8 months it was also the longest bear market since 1948. No wonder everyone has got their buying boots on. Positive Sentiment has been turned up to 11!

Bah, Humbug I say…

Today’s US Consumer Price Inflation (CPI) number should be a critical moment – but the market already made up its mind:

• If inflation comes in weak or on target (4%) then it will swiftly be acclaimed as proof positive the Fed can start to ease/taper (whatever the current buzz word is), therefore boosting the market.
• If it comes in stronger (ie stickier) then the market will say the Fed should wait for more data, “skip” an interest rate hike this month (as Fed commentators have suggested) and wait to see what the next number says. The market will rally because everyone buys into the narrative inflation is falling, rates will be cut and this is now a raging Bull market.

Doh..

The market narrative is simple. Argue with a strongly established market narrative at your peril. It says: there will be no recession. The US economy is resilient. Inflation will be beaten and will swiftly fall back to the 2% Fed Target range. Sales will recover. There is nothing to worry about. These are not the droids you are looking for…. This is a bull market.. (Repeat till you believe it.)

The market had plenty to be scared of through the first half of 2023 – a series of swift sentiment/twitter-sphere driven bank collapses, the threat of a debt-ceiling government closure and the end of all things as the treasury market threatened to disappear in a puff of logic. All of these crisis points proved resolvable. A classic example of my mantra: “Things are never as bad as we fear, but seldom as good as we hope.”

The market survived, it bounced back, and now it wants to party.

Even if inflation continues to look frightening, the stock barkers will argue investors should favour stocks over bonds – 10-year bond yields in the US at 3.75% are still in negative real yield territory – therefore an exceptionally bad return choice when “we’re in a bull equity market..”  (Repeat till you believe it.) Therefore, goes the chant.. much better returns can be garnered from the unlimited upside of stock prices..

(Yeah, but… the beauty of bonds is you usually get your capital back…. Don’t confuse my thinking by asking about hi-yield junk bonds… there will be a reckoning some day!)

I am not a uber-bear.

I am a realist – although I accept I sound like a grumpy old man. I do believe the Western economies are going to avoid recession and there is upside… But I also think the markets are getting a bit carried away. In markets like this you can’t beat the narrative. You really can’t argue with a market that has already decided what numbers it’s going to listen to, and how it’s going to digest the information.

The market is not smart or clever – all it is a voting machine reflecting what every participant is thinking. If these participants lack knowledge or experience – then there is a potential problem. (If you want to trade their mistakes – and why not – follow the sentiment, and be ready to leap off before it cracks.) When the market believes the bear market is over, and they are about to miss a massive bull market, then FOMO takes over and its buy, buy, buy..

Sentiment is not necessarily logical. Markets should be data determined…. But this market is mood driven with the core belief that rates are going lower driving it higher.

I wonder how long the mood can be sustained? More than a few US investment banks are putting out warnings about how difficult markets will get in H2 2022 as the fizz recedes and real economic reality impacts the market.

I’m not expecting a deep US recession – I get the arguments and US economic resilience, and reckon the Federal Reserve has a better handle on rates vs inflation than the market commentariat gives them credit for. However, I do see issues across all the consumer-led Western Economies in terms of a slowly rolling series of storm fronts coming over in terms of issues such as falling consumer discretionary spending impacting company earnings, accommodation affordability/crashing home prices denting prices, sticky for longer inflation, and a rising tide of political populism on the back of unhappy voters.

In equity markets pricing themselves for perfection, bad news is oft ignored.

I am not expecting a massive reversal of the mood – maybe just some hangovers as folk wake up to a new reality. Rates probably are closer to the top than bottom, but Inflation is Not Dead. Across every sector there are still significant supply chain wrinkles delaying deliveries and pushing up prices. Companies are trying to keep earnings on track by cutting costs and raising prices. Workers are pressuring for wage hikes. If inflation remains sticky for longer – and yesterday I was writing about how this is likely to be the case in the UK – it will keep rates higher for longer.

Faster inflation for longer could/will eventually dent the current euphoric mood in markets. Rather than a swift taper of rates when inflation returns to the Fed‘s 2% target, what happens if CPI remains stubbornly high?

On the other hand, projections from analytics agencies, like the IMF, say US inflation will drop to 2.3% next year, and remain within a crotchet of 2% for the rest of the decade. Maybe my question should not be how much damage will it do the market if inflation does not fall, but how much the market will rally (and overprice itself) if inflation and rates do meet the market’s expectations? Wow.. that could be truly dangerous overheating territory….

Until then it’s broadly joy unlimited across the stock market – led, as we are all aware but fantabulous expectations investors have of the 7 big tech names. Time to broaden your buy list I am told – Big Tech is finally dragging other stocks higher in their wake.

I am not anti bull-markets, just very suspicious of them.

There is one bigger issue to consider – the degree to which stocks remain overpriced on the back of the decade of easy interest rates and QE, and how much that changed the way markets are vulnerable to over-speculation. Most folk active in markets today learnt their trade in ultra-low rate environments. Low rates fuelled speculation and all the hype and nonsense that drove insane valuations and collapses like Theranos and We-Work, SPACS, Crypto, NFTs and lots of other improbable ideas.. Easy money fuels speculation. I wonder if that has made today’s markets less sensible?

The stock market correction from last year – the bear market – removed some of the frothy noise from the market, but not speculative hype – and I can’t help but wonder if that’s still in the market driving seat.

Instead of joining the party, I will sit in my ivory tower and ponder the reality of the data and wonder when the market might start to pay more attention to the real stuff. Jobless claims, corporate defaults, and earnings outlooks.

Meanwhile… maybe one sign things are changing.

Yesterday I posted a somewhat negative comment on Tesla on blog about how its market cap set to rise. I acknowledged Tesla’s an excellent EV maker, but in the face of competition, the non-delivery of autodriving, falling discretionary spending, and it being a child of the speculative age, I reckon its lustre trading at 5 times the multiple of other auto firms is unsustainable.

Brace, brace, brace….

In the good old days, I would have been remorselessly trolled for such a comment, videos of me would be photo-shopped as a clown for not believing Tesla’s price would go stratospheric, but this time, no one came back to criticise… only to agree. (Fair enough, but its just posted a record 12 days of stock price gains..)

Interestingly, a new narrative is emerging to support Tesla – that its’ charging stations have become the defacto EV infrastructure across the US, therefore giving Tesla a pole position in EV sales. It reminds me of the post World War 1 aviation market when Airplane inventors the Wright Brothers gave up making planes to focus on engines instead…

Five Things to Read This Morning:

WSJ                 Jerome Powell’s Big Problem Just Got Even More Complicated

BBerg              China Central Bank Surprises With Cut to Spur Economy

BBerg              ECB Inches Nearer to the Interest Rate Summit

FT                    Normalisation, not recession

Times              Silvio Berlusconi, Italy’s scandalous celebrity PM: Obituary

Follow up to last’s week story on Golf:

FT                    “For money alone”: Scotland’s home of golf takes swing at Saudi Arabian ambitions

PODCAST

Macrovoices    Bill Blain: Inflation, Central Banks, BRICS, Geopolitics, Alternative Assets and More!

Out of time, and off to take clients out for the day….

Bill Blain

Strategist – Shard Capital