Like a good boy scout be prepared

Inflation expectations have been the name of the game for investors as banks and commodity stocks have rallied at the start of the year, and longer dated bond yields have been rising. Bill Gross, the acclaimed bond market guru, added fuel to the speculation as he claimed on Thursday that the 25-year bull market in bonds is at an end. In his view some long-term trend lines have been broken. The price of gold, which can often trade with an inverse correlation to bond yields, has also been rising. As gold is a negative yielding asset, this means as bond yields rise, bonds become more attractive and gold less. Currently the price of gold seems to be driven higher by the flight to commodities.

Friday should provide further indications into any inflation pressures that may be building, alongside the start of the reporting season for the banks sector, and we will see if the recent rally will be underpinned or undermined. We may have received some insight into Friday’s inflation data on Thursday from the release of December’s Producer Price report. Producer prices unexpectedly fell in December, the first time in 18 months. This report follows on from news on Wednesday that import prices also moderated in December. Later today we get the December inflation rate along with retail sales. The possibility that inflationary pressures are still not building in the US despite an improving economy and tight labour markets, will on the one hand encourage investors to believe that goldilocks porridge is still just right.

We may not be at the point of euphoria, but are investors reaching a point of complacency? Some technical indicators such as market breadth combined with a strong fundamental back drop could be encouraging this complacency. Other technical indicators are suggesting the rally is becoming a little stretched. Barron’s reported that the Relative Strength Index is at the highest level recorded since the 1970’s. Not having a market correction of 5% since 2016 is bound to make investors more complacent.

Markets can stay overbought for a while and the complacency remain, however as Barron’s points out, the problem comes when an external shock from an unexpected source occurs. The impact of shaking investors out of that complacency can lead to a rapid correction. The resultant over-reaction, for those who are prepared and have a steady hand, is where the opportunity will lie.

Posted on January 11, 2018 .