How to trade the YOLO and FOMO market

As an example, Bitcoin prices have soared. Historically, Bitcoin has been correlated with the relative performance of the ARK Innovation ETF (ARKK), which is a bellwether for speculative growth stocks. This time, ARKK hasn’t risen as much. Is this a positive or negative divergence?
 

 

At the same time, the price momentum factor, which measures the propensity of momentum stocks to keep rising, has been strong. The accompanying chart shows the relative performance of different price momentum ETFs, which have been universally positive.
 

 

Worried about bad breadth? New 52-week highs-52-week Lows (bottom two panels) have been positive throughout the rally off the October bottom.
 

 

I stand by my assertion that the AI-related bull has a lot longer to run (see The Path to Magnificent Exuberance). I also guesstimated that if the current episode corresponds to the dot-com bubble, this would be 1997 or 1998. As a reminder, there were plenty of hiccups during that period, including the Asian Crisis and the Long-Term Capital Management blow-up.

Here are some of today’s potential potholes along the way.
 

 

Event-driven tail-risks

Let’s begin with the biggest event-driven tail-risk that hasn’t been discounted by the market, the Russo-Ukraine War is not going well for the Ukrainians.

This War on the Rocks podcast discusses the problems. While the general consensus in the West is that the 2024 campaign is likely to be another stalemate, a stalemate may be the best-case scenario. Ukraine is desperately short of artillery ammunition. Its ground forces are exhausted. The median age of the Ukrainian infantryman is between 40 and 45. Ukraine badly needs some form of conscription, but its meeting political opposition. It’s also unclear whether the army were to receive the hundreds of thousands in new recruits, if it has the resources to properly train them. The military leadership has been replaced, and confidence is eroding in the direction of the war.

In the wake of the Russian victory at Andiivka, Russian forces have used their raw advantage in numbers and ammunition to probe along the line. Ukraine never fortified its frontline the way the Russians did, and it’s entirely possible that Russia could achieve a breakthrough this summer. Such an outcome could cause further anxiety in the Ukrainian population and spark another refugee crisis that the EU will struggle to handle. French President Macron recently floated the idea of deploying troops to Ukraine, a move that many other European NATO allies have rejected.

Keep an eye on the relative performance of neighbouring Poland as a real-time indicator of geopolitical tensions. Downside breaks could be a signal for a disorderly risk-off episode.
 

 

Another possible tail-risk that could cause a reversal of risk appetite is the disorderly failure of one or more U.S. regional banks. New York Community Bancorp skidded badly on Friday when it disclosed it found deficiencies in its internal controls. The regional banking stocks are testing a key relative support level (bottom panel) and a decisive breach could be a signal of panic.
 

 

Most of the problematic regional banking exposure has been concentrated in office real estate. So far, office REITs are not showing signs of significant distress.
 

 

 

The risk of transitory disinflation

Here are some macro risks that the market seems to be impervious to. The most significant is the risk of transitory disinflation, which would delay or possibly even reverse the possibility of rate cuts from the Fed.

There are four main components to inflation. Commodity price inflation has been tame. Goods inflation has been decelerating the fastest, aided by the normalization of supply chain bottlenecks. Rents have been falling, which will eventually feed into Owners Equivalent Rents, Core services inflation, or services ex-housing, has been stubbornly strong.

The PCE report released last Thursday tells the story of an uptick in core PCE to 0.4% (blue bars). The monthly rise in core PCE reversed a trend of falling or stable core PCE readings over the past few months. Equally disturbing is the surge in supercore, or core services ex-housing (red bars).
 

 

Another unsettling development is a trend in the reversal of goods disinflation. New orders from the ISM Manufacturing Survey have been edging up, and new orders have been correlated with prices paid, which is an input to goods inflation. This development feeds into the transitory disinflation narrative risk that I have highlighted in the past.
 

 

For completeness, here is the chart for ISM nonmanufacturing, which shows that the service sector to be in expansion and indicates upward price pressures.
 

 

As a consequence, market expectations of a March or May rate cut have completely evaporated. The consensus is now a June rate cut, with three cuts in 2024, which now matches the Fed’s dot plot.
 

 

The equity market appears to have totally ignored the higher-for-longer interest rate scenario. Has it been fully discounted? The 2-year Treasury yield has been edging up and so has the USD. A strong USD has historically been negative for stock prices and risk appetite.
 

 

 

Short-term tactical risks

You can tell that excesses are building when strategists and analysts try to rationalize extremes. In response to concerns about index concentration, Bloomberg featured a chart of the index concentration in selected markets. But index concentration in the smaller national markets is no surprise as there aren’t many investable names. The S&P 500 is, and always has been, a far more diversified index, and U.S. index concentration is far more anomalous by historical standards.
 

 

To be sure, index concentration creates volatility risk. An analysis of the consensus EPS revisions of the Magnificent Seven shows that fundamental earnings momentum is becoming even more concentrated.
 

 

From a tactical perspective, standard indicators of risk appetite appear healthy and they are confirming the stock market advance.

 

On the other hand, the currency markets beg to differ. The Australian Dollar/Japanese Yen cross, which is an indicator of global risk appetite, has gone nowhere since November.
 

 

In conclusion, a YOLO and FOMO mania has gripped stock market psychology and it’s unclear when the mindset will reverse. Numerous warnings are appearing and the market can correct at any time. I am long-term bullish on stocks, but remain cautious near term. Despite my cautious short-term outlook, traders are advised against taking a short position until some tangible signs of a bearish reversal appear.

My inner investor is bullishly positioned. The Trend Asset Allocation Model correctly turned bullish last July and performance has been excellent (see track record here). My inner trader is on the sidelines. Maybe the only way the market falls is he turns bullish (just kidding)!