The Pain Trade is Up

By David Nelson, CFA

The Pain Trade – Definition by Investopedia

The tendency of markets to deliver the maximum amount of punishment to the most investors from time to time. A pain trade occurs when a popular asset class or widely followed investing strategy takes an unexpected turn that catches most investors flat-footed.

Background

It’s nearly 8 years since the end of the financial crisis and the Fed’s next move seems as important today as it was then. The broadcast and print media have a myopic view of Janet & Co. And why shouldn’t they? Investors seem to hang on every word. Will they move in June? Will they wait till July? The focus on monetary policy often trumps economic and earnings data both positive and negative. We’ve taken one step toward normalization and the market temper tantrum that followed seemed to push off any thoughts of another hike at least until year’s end.

Of course, that was prior to the FOMC minutes released earlier this month. It took 48 hours but investors soon embraced the possibility of a hike believing rates are rising for the right reasons. The S&P 500 (SPX) rallied in the back of the month but was unable to sustain a break above the all-important 2100. At least in the days that followed 10 year yields rose right along with the market, a good sign potentially pointing to better economic trends ahead. This of course wasn’t lost on the financial sector as a steeper yield curve would do wonders for the bottom line dependent on net interest margins. However, for the financial sector to benefit long term the US Treasury yield curve chart below has to change. Today’s yield curve looks little different than it did a month ago. If the short end rises from higher rates we need to see the long end follow confirming the Fed’s confidence the economy is improving.

Fed Signals

The charts below show Fed probability of a hike before and after the FOMC minutes on May 18th. The odds quickly changed pointing to hikes just around the corner and at least for the last couple of weeks that perception seems to include sentiment that it’s happening for the right reasons. Despite recent commentary from Fed officials and Chair Yellen herself July seems like the more likely next move. The Brexit vote takes place later this month, after the June 15th FOMC rate decision. I believe they will push to July to see how the vote plays out in the capital markets.

Fed Probability May 17th

Fed Probability May 18th

Earnings are the life’s blood of stocks and will be key to the next leg of the bull market. Yes, it’s true that CEO’s have squandered $Billions propping up earnings with stock buybacks that no longer seem capable of holding up shares in the face of lagging sales. (Click here for last week’s post on Stock Buybacks & Earnings)

But eventually even CEO’s will get the message to increase R&D & CAPEX because investors frustrated with stalled performance will demand organic sales growth which only comes from new products and new customers.

Last week’s commentary still holds. The market can’t break out until earnings do. However, it’s important to remember that stocks are a discounting mechanism. Less a report card of the past and more a prediction of the future. Price performance often leads fundamentals. If we get a meaningful push higher it’s imperative that earnings confirm the move. It’s unlikely we can get much in the way of multiple expansion and the argument can certainly be made that multiples are due for a correction in the face of rising rates. However, despite these concerns investors need to prepare for the very real possibility of a market that breaks to the upside in the weeks ahead. In the short run, “price is truth” or at least the “perception of truth” which can take on a life of its own. The caveat is that it has to happen sooner than later. The longer we trade sideways bias will shift to the downside.

Wall Street Bears

The street is certainly leaning in the direction that there is little upside ahead. Two of my favorite Wall Street Strategists Goldman’s David Kostin and Merrill’s Savita Subramanian see at best flat returns till year’s end. They’re not alone. Even if we ignore the perma bears who scream the “sky is falling” from sunrise to sunset it would be foolish to ignore the challenges mentioned above.

However, as Fast Money & CNBC regular Josh Brown in a recent post points out; most of Wall Street is in the bear camp and retail investor bullishness is now under 24% pouring money into fixed income stretching for yield. With little evidence of euphoria and most convinced the markets will fail once again, conditions are ripe to catch investors off sides.

I’m not oblivious to the headwinds investors’ face which has been well documented. The rising dollar, financial engineering of returns, multiple compression from rising rates and a polarizing election cycle all weigh on investor sentiment. Even the NYSE Bullish Percent Index is currently a negative signal. Never the less here we are just below all-time highs once again.

Even a little good news would be enough to light the match sending stocks higher. With so few believers and Wall Street on the sidelines the “Pain Trade is Up.”