Pulling it all together

 The last few weeks I have embarked on showing you the three stages to my investment process - the three body problem - in which I look at the Fundamental and Behavioral drivers of the financial markets and what Catalysts may be out there to change investors minds. 

In order to remind you of the summary of the data, let's go quickly back through the data. In the Fundamental section we look at the strength of the economy and the liquidity that is still in the financial system. The economic trend continues to be strong. Yes, everyone expects the US economy to cool off this year. It has been running at historically strong levels. This should be expected. We identified a few potential problems areas, with inventories building and with weaknesses overseas, namely in China. Since we discussed this, we have seen companies such as Lululemon and Peloton both discuss the excess inventory and the steps they needed to take going forward. In fact, the forward outlook from many companies reporting strong earnings has not been great. However, this does not suggest a recession is imminent. The yield curve has been flattening but is not inverted. Only an inversion would forecast a recession, and it is not yet doing so. Even when it does, there is a lag. Yes, the Fed has come out as more hawkish than expected in the minutes from the December meeting and now in the January press conference. However, this is hawkish from historically easy conditions. So let's pump the brakes a bit. Yes things are cooling off. However, we are a far cry from a recession. The Fundamental trend is still Positive. 

The behavioral aspect was negative when we looked a couple weeks ago and, if anything, has gotten more negative. Daily charts have broken and now it looks more like a 'sell-the-rally' than a 'buy-the-dip' market. Near term, many oversold indicators are suggesting we have sold off too much too quickly. But the investor mindset has taken a body shot.  On the positive, the margin of safety that as not present in the market before is quickly fixing itself. In a little over a year, the forward P/E of the market has fallen from 27x to under 20x. The EV/EBITDA has fallen from 17x to 13x. Still a little expensive on both front, but with historically low interest rates, arguably on the cheap side. This doesn't mean we should all jump in and buy-buy-buy. It does mean there is a lot more margin of safety. That said, there has been damage done to investor psyche. We have seen increased hedging demand and some panic setting into the options market. Equity fund flows and M&A still suggest there might be some overconfidence in the market still. In sum, though, I would say the Behavioral part of the process still leans Negative. 

What changes minds? The economic data has continued to come in softer than expected in aggregate. Growth is slowing and inflation is persistent. Plenty of calls for economic cycle peak if not outright stagflation.  Earnings data have come in positive but only marginally better than expected. The price reaction to the news has been negative so investors are unimpressed. This is a combination of the diminishing returns to the positive surprises - each quarter the surprises have been less and less - as well as the conference call feedback. Finally, geopolitics were not too bad when we looked before but since then the problems in the Ukraine with Russia and NATO have only gotten a lot worse. Thus, each part of this category is Negative. 

Pulling it all together, the Fundamental trend is positive, but weakening, the Behavioral aspects of the market are negative, and the changes at the margin are also negative. This creates a negative environment for risky assets. Yes, near term we can see an oversold move higher as we have gotten a little too negative, but as I said, we should be in a sell-the-rallies mode. Look to add convexity to your portfolio on any pullback in the cost in insurance, which has gotten pretty expensive. We are in a year this year in which we sill see a lot of volatility. 

Stay Vigilant