I noted yesterday in The Lead-Lag Report, on InvestorPlace, and on X, formerly Twitter, that all my signals flipped risk-on. My risk rotation signals are short-term in nature and use various intermarket relationships to determine near-term conditions favoring lower stock market volatility (risk-on) or higher stock market volatility (risk-off). I wrote yesterday arguing that small-caps were the key, and despite all kinds of eye-rolling from those not following along, it turns out I’ve been right. Small-caps, as of this writing, are melting everyone’s face off, and seemingly everyone is cheering inflation coming in softer than expected.
Here’s the thing. While the initial reaction is positive, the implications are actually very negative beyond this surge.
I remain blown away how few understand this. Interest rates act with a lag on the stock market and the economy. Whatever data we are seeing now on inflation is not from the last Fed hike. On the contrary — it’s from whatever Fed hikes happened at the start of the year. Just like the regional bank crisis was driven by rate hikes in mid 2022, the slowdown in inflation now is because of actions the Fed took at the start of 2023.
October CPI Report: Don’t Fall for the Hype
This is incredibly important. We have not yet seen the impact of the Fed’s last round of hikes, which means, as I noted a couple of days ago here on InvestorPlace, the Fed overtightened. If inflation were to fall precipitously now, we actually risk a situation where the Fed created an outright deflation dynamic. Why? Because demand pull and cost push inflation are breaking. This reaction by the stock market is likely short-lived as a result.
Having said that, yes — clearly its tradeable, but this is ultimately a question more of duration of how long the move will last. The interesting thing about the reaction today is that while small-cap companies are significantly surging, from a sector perspective, utilities, the most defensive sector of all, are leading. Long-duration Treasurys are surging. I get it — that’s because they are proxies for each other and this is a move based on falling inflation. But what if it’s not? What if it’s actually defensive repositioning into a major rally? At this point in seasonality, utilities should not be this strong. This alone makes me question just how sustainable this move really is.
I still believe a corporate credit event is out there. The market may be doing what it always does — making fools of bulls and bears alike.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
