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Rally on! Admittedly, as of this writing on Friday, October 22, we didn’t close at new highs, but we did manage to bounce back from that horrible 5% decline earlier in October that admittedly no one seemed that worried about even when it was happening. BTFD worked again, and the prognosticators’ calls are out for another 7-10% upside into year end.

It’s not my intention to peddle fear. I merely think the market has become numbed to problems. When people see no worries, I get worried. From a short-term perspective, this doesn’t seem like a great time to buy. While we saw some hedging as the market went down, that totally disappeared on this rally. Implied Volatility (forward-looking volatility expectation) is now at a discount to Realized Volatility, as people seem positive nothing bad can happen. VIX (market volatility index) is back near the lows. In short, we’re well positioned to get hit by an unexpected problem, as few are is positioned for it. That doesn’t mean it happens, but the risks are there and they’re not getting attention.

Source: Bloomberg

Longer term, there are worries that don’t seem priced in, probably because we haven’t experienced lasting problems for quite a while. Earnings thus far have basically been a non-factor. Some have been good, some not-so-good, and some where people care more about the story than something so base as cash flows. Could some bad reports create problems out there? Possible, but so far, so good.

Federal government issues seem more worrisome. I know people refuse to get worried, again, because nothing bad has happened in quite a while, but getting this Frankenstein’s monster of two stimulus packages and a debt ceiling raise doesn’t seem easy. It’s difficult for me to see how all this happens without reconciliation, and ultimately someone will have to compromise. That’s a recipe for brinksmanship, and potentially disaster. There had been hopes that an agreement would be reached at the end of October, both to help the Virginia governor race and handle the roll-off of the old highway bill. That seems nigh impossible at this point. While I think a deal gets done, I wonder if it will be less grandiose than expected.

As to the Fed side, that particular provider of eternal liquidity, there seems cause for particular concern for the next few months. It seems very likely that they will announce a taper in early November. As seems to be pointed out a lot lately, a taper is just a slowdown in the rate of growth. That said, if you believe the market is a discounting machine, when does a taper become a problem? When the taper is announced? When it starts? When the debt ceiling is raised and the Treasury rebuilds their balance sheet, thereby likely making liquidity go negative, will that be a problem for the market? All these things are basically certain to happen, likely in the next three months. Considering how much Fed liquidity has been viewed as the main factor of this market boom, I think it makes sense to pay attention. As to when it matters, I think liquidity has already had an impact. Gone are the halcyon days where the crappier the company, the more its price goes up.

The slowdown in economic growth has been ignored. I don’t pay a great deal of attention to the Atlanta Fed’s GDP model, as I think it over-weights more recent data, but I would note that their model moved from 6+% growth for Q3 to less than 1%. I doubt their current estimate is correct, but I wouldn’t be surprised if the number is more like 3%, vs. the 6% that had been expected. More importantly, I think the direction is right. If they’re talking about near 0% growth in Q3, does the trend imply negative growth in Q4? So, what do you buy in this situation? Let’s go through some popular ideas.

Focusing on commodities has been quite popular, with energy and industrial commodities doing quite well. With industrial commodities, I have a really hard time getting too excited right now, with US growth looking like it’s slowing down and China clearly slowing. China is a huge buyer of industrial commodities, and if they’re likely to slow purchases, it’s hard to get too excited going forward. Numera Analytics points out that while these commodities rallied, there was weakening demand. It’s been a great ride, but right now I think there’s a reason so many of these industrial miners are closer to 52-week lows than highs.

What about energy? Again, if global growth is slowing, it’s hard to get excited about demand. Natural gas in Europe seems like one place that looks troubled, and you can certainly see plenty of fear factor stories out there. That said, we had the same basic scenario and stories in 2010, and everyone survived just fine. Could there be continued, largely supply-side, problems? Sure, but the downside risks in energy stocks seem pretty high (see what happened to those industrial miners above.) Commodities soar and crash, and are occasionally widow-makers. Right now seems like a tough time to get excited, but if we start seeing more positive data, maybe there’s still more puffs out of this cigarette.

Speaking of positive economic data, another popular idea of late seems to be the reopening theme (again), presumably due to hopes for a post-Delta-variant economic boost as restrictions ease again. My problem with that is this would only be an echo boom, as we already reopened, so in general you can’t expect too much out of it. There’s also not much real evidence for it. To be fair, I can point to some. For instance, manufacturing in South Korea and Vietnam has been picking up, and there are signs that bottlenecks are easing. Q3 data is also likely to be weak enough to be fairly easy to improve upon, lending credibility to a rebound. That said, between a lack of solid confirmation and so many of these stocks moving up so much of late, it’s hard for me to figure out what can reasonably be bought right now. I think it makes more sense to wait and watch for more data. You also have to ask how long any echo boom could last. Full disclosure: I thought we could get a two-week bounce, and now I’d say we’re on week four, so what do I know. That said, a lot of reopening names haven’t been impressive of late, like cruise lines and airlines.

Overall for the longer term, I think the problems only get harder. It’s hard to see how federal stimulus and Fed support doesn’t at least slow from here. I think that represents a problem. Profit margins in the broad market actually soared with Covid, but now seem likely to pull back. The gap between fundamental buyers and current prices strikes me as even bigger than it was in 2000. Eventually that should matter. It always does.

Source: Hussman Funds

 My concern is that we’re poking around a potential inflection point, here. You could just sit back, own the market, and wait for the trend to change. Honestly, there’s not really anything wrong with that. Could you lose a chunk of money quickly? Sure, but you’ve also done pretty well so far. My only concern with that is the attitude that recent experience tells us what the future will be. Growth stocks aren’t always the best idea. We’ve already seen this, really. Something like TSLA (Tesla) may have continued to work, but ZM (Zoom) hasn’t, just to name one of many failed growth stocks from the last year. Somebody got to buy that at twice the current price, and that 2000-like scenario seems likely to repeat for other stocks.

Given all that, is there anything you want to own? I do think there are still reasonable values in largely defensive names. For instance, Unilever (UL) hasn’t performed well, but they recently announced they’re raising prices at a fast clip. A cheap stock with pricing power and a durable business strikes me as a good idea in this environment. I’d prefer that over figuring out where the next options gamma-squeeze is coming from. You may not make a bunch of money quickly from UL, but it’s hard to see how you can lose too much, either.

Over the past year, I’ve been happy to buy selected tech stocks, and happy to buy selected industrials. I’m not opposed to buying growth, or anything else, really, but I try to do it so that the potential reward is better than the risk. Right now, it seems to me that the best risk/reward is focused in more defensive areas, particularly for the longer term.

Eventually we’re going to slow down from these big numbers we’ve seen, both in growth and inflation. Honestly, I think it’s already happening, but I also think you can have a fair debate about that. Whether it’s happening now or later, we can adjust based on what comes. Another reason for caution is that while the indexes have been broadly steady, under the surface it is a lot more exciting, whether it be Tesla going up 60% over the last five months or Zoom going down 50% over the last year. With moves like that reasonably common, I don’t think the current price of anything is overly meaningful. It can change, and if we’re really seeing a regime change in the market, that change could be dramatic.

I think it’s fair to say there’s been a lot of speculation in the market over the last two years. While that paid off handsomely for a while, many of those popular names are well off the highs. It’s become a much tougher game, and with all the potential problems right now, I’d like to see fewer risks before I got more aggressive. At the same time, I do think there are intelligent places to invest right now. For now, boring seems good.

Again, it’s not my intention to peddle fear. I merely think the market has become numbed to problems. The watchmen are gone. People hardly seem to care what they own, as long as it goes up. Risk management seems to have become a quaint idea in a land where more risk is always better, and markets always bounce. It hasn’t really paid to think too much. Could that change?