The Three Most Important Words in Investing

Posted by Cam Hui -
Mid-week market update: As expected, the Fed stayed on hold today and took a wait-and-see attitude on the timing of rate cuts. While economic data has softened recently, as evidenced by the decline in the U.S. Economic Surprise Index, the Fed is still waiting for clarity on the effects of tariffs on inflation to make monetary policy decision. Even the dot plot represents nothing more than guesses that are subject to change.

 

In other words, the Fed has uttered the three most important words in investing: “I don’t know.”

 

 

Indeed, investors are facing uncertainty and binary event risk relating to the trade war, monetary policy, and the Israeli-Iran conflict. How can mere mortals like us pretend to forecast the future?

 

In circumstances like these, it’s better to say, “I don’t know.”

 

 

Technical Confusion

From a technical perspective, the picture is confusing.

 

In the short-term, Seth Golden pointed out that SPY has a very high level of call options outstanding that expires Friday at 600: “Implication is unwinding of long positions associated w/those calls represents risk to bulls if SPY below 600 into Friday expiry.” On the other hand, a price above 600 will force market makers to delta hedge and buy the index. SPY closed today at 597.25. Short-term direction is on a knife edge.

 

 

Market cap leadership isn’t providing any definitive clues on direction. NASDAQ 100 stocks are still the leadership, but momentum is waning. While the relative of mid- and small-caps are starting to bottom and turn up, evidence of transition isn’t definitive.

 

 

The relative performance of defensive sectors look like they are trying to bottom, which has bearish implications for stock prices. In the absence of upward breaks in the relative returns of these sectors, it’s too early to become overly cautious.

 

 

Small trader sentiment looks frothy. Goldman’s Social Media Index levels are in the stratosphere.

 

 

The S&P 500 is rising against a backdrop of a negative 5-day RSI divergence, which is a bearish warning. On the other hand, the VIX Index is near the upper band of its Bollinger Band, which is a signal of high anxiety consistent with elevated geopolitical risk that contrarian analysis would call a buy signal.

 

 

 

Wars Are Roach Motels

In the meantime, the market is beset by event risk. Israel and Iran are trading bombs and missiles. Mohamed El-Erian recently outlined the issues facing investors in a way that’s beyond the headlines of the latest salvos:

 

  • Slower Global Growth as mounting geopolitical uncertainty dampens business investment and consumer confidence.
  • Inflationary Pressures in the context of uncertainty about shipping lanes and, more broadly, global supply chain vulnerabilities.
  • Reduced Policy Flexibility for some countries, including the UK, as central banks face harder choices between fighting inflation and supporting growth, and fiscal space tightens.
  • Further Gradual Erosion of the Global Order, including America’s role at the core of the trade and payments systems.

 

From a geopolitical perspective, wars are like roach motels. They are easy to get into, but hard to get out of. While a country’s leadership may make the military calculation that it can win the war, but winning the peace may be another matter. (As an example, the U.S. lost the Vietnam war but eventually won the peace, as the U.S. is one of Vietnam’s best friends on the geopolitical stage.)

 

In the short run, much depends on Trump’s decision on whether to enter the war on the side of Israel, which would spike the geopolitical risk premium in global financial markets. The Economist recently outlined Trump’s aversion to war, and his aversion to forcing regime change, in particular:
There are two pillars to Mr Trump’s dislike of regime change, suggests Elliott Abrams, a veteran of several Republican administrations who served as special envoy to Venezuela and Iran during the first Trump presidency. First, Mr Trump is responding to policy failures in Afghanistan and Iraq. Second, Mr Abrams believes that Mr Trump is influenced by Henry Kissinger and other cold war practitioners of realpolitik. According to that school of statecraft: “all of these countries, Iran, Russia, China, North Korea, are black boxes and they have a person at the top, and you must negotiate with that person.” Mr Abrams calls this a “club of leaders” view, which attaches little significance to ordinary citizens’ wishes. In this worldview: “We deal with people who’ve risen to the top of the greasy pole no matter how they got there: by winning elections, by murdering people. It doesn’t matter.”
A NY Times article describe how he had a change of heart in supporting Israeli attacks on Iran based on an argument from the Israelis: “If you want diplomacy to succeed you have to prepare for a strike, so there is real force behind the negotiations.”

 

U.S. participation in Israeli attacks would split the Republican Party. The BBC reported that MAGA “America First” Republicans, like Tucker Carlson,  Marjorie Taylor Greene, and Steve Bannon openly criticized any decision to get involved in a Mideast war. That said, there was broad support for supplying weapons to Israeli: “The survey by Gray House found that 79% of respondents would back the US providing offensive weapons for Israel to strike Iranian military targets. Some 89% were concerned about Iran obtaining atomic bombs.”

 

On the other hand, there is broad opposition on direct American military involvement.

 

 

What Trump decides will affect the short-term outlook. A Reuters report revealed while Trump called for Iran’s unconditional surrender, his honest desire is for “a ‘real end’ to the nuclear dispute with Iran and indicated he may send senior American officials to meet with the Islamic Republic”.