The market is dreamin’

November was a screamer of a month for nearly all markets.

But don’t be fooled. This isn’t the start of a new bull market. In this wire, I’ll explain why.

First, let’s have a look at the numbers…

The ASX200 increased 4.52% in November. Property trusts and healthcare both jumped 11%. Gold stocks added more than 7%. The industrial sector rose 6.6%, while info tech increased 7.3%. The consumer discretionary sector added 4.7%. The Small Ordinaires increased 6.9%.

These are the sectors that suffered some of the biggest falls in October. November – obviously – was the bounce back.

Tellingly, economically sensitive sectors like energy, resources and financials all underperformed. Not what you’d expect for a new bull market, is it?

The ASX200 Energy index fell a large 7.4% for the month (after outperforming in September and October). Resource stocks added just 1.75%, while the bank index increased 4.1% for the month.

In the US, the S&P500 jumped 8.9%. The NASDAQ surged 10.7%, while the Dow Jones industrials rose 8.8%.

Even bonds got in on the action. The popular US Treasury ETF, TLT, jumped 9.6%.

Just about the only major asset down in price was the US dollar index (-3%) and oil (brent crude down 5.3%).

What’s going on? Why the November celebration?

MarketWatch explains:

‘Soaring stocks, falling Treasury yields, sliding crude-oil prices, a weaker U.S. dollar and tighter credit spreads caused the Goldman Sachs Group U.S. financial conditions index to fall by nearly a percentage point last month, it is biggest monthly drop in at least four decades.’

The fastest monthly loosening in financial conditions in 40 years! Wow…

US investors are now betting on FOUR to FIVE interest rate cuts next year.

Financial conditions have gone from tight to loose in the space of a month.

How could this happen?

Well, the first thing to understand is that it is a bit of a myth that the Fed controls interest rates. They control the Fed funds rate, which other market-based rates trade off. But they don’t have any control over those rates.

Their greatest form of control comes via communication, which is also known as ‘jawboning’.

They spent most of 2023 convincing the market that interest rates would remain higher for longer. The market spent most of 2023 ignoring them.

But in September/October, the Fed’s jawboning efforts finally got the upper hand. The 10-year US Treasury bond breached 5%. Real yields hit their highest level since before the GFC. Financial conditions were tight!

But all it took to undo the hard work was a slightly better-than-expected inflation number for October. That data point came out in early November. The market was ready to rally anyway, given the heavy selling in October.

Now, the rally has taken on a life of its own. In the space of a month, the market has gone from oversold to overbought. Investment sentiment has gone from overly bearish to overly bullish. The CNN Fear and Greed index has gone from extreme fear to greed.

Why the sudden change?

The market thinks the inflation fight is over and done with. It thinks the economy is slowing. But not so much that it will lead to recession. It’s going into a soft-landing phase and the Fed will be able to cut rates next year. In a word, Goldiocks!

What is the market pricing in?

Whether you believe this scenario or not doesn’t matter. What matters is what the market is pricing in, and whether that outcome is a reasonable probability.

Let’s consider the facts…

The market thinks the Fed will cut rates at least four times next year as inflation comes down. But analysts expect S&P500 earnings per share to increase by over 11% next year.

How it achieves this with inflation and nominal growth slowing sharply is beyond me. Moreover, the market trades on a price-to-earnings multiple of 18.7 times these optimistic earnings forecasts.

So, if you’re looking at things from a probabilistic perspective, the market is dreaming. It’s a Goldilocks scenario that doesn’t take the Fed’s ‘reaction function’ into account. What do I mean by that?

Do you really think the Fed is going to cut rates four times next year in anything other than a recessionary scenario? It’s spent all of 2023 telling the market it’s keeping rates higher for longer. It made a huge error fueling inflation in 2020/21. It’s not going to risk stoking inflation again but cutting rates in a benign economy.

The core CPI figure for October was 4%, down from 4.1% the prior month. That’s not in rate cutting territory. The Fed’s preferred measure, the core PCE (personal consumption expenditure) came in at 3.5% for October, down from 3.7% in September.

Falling inflation is good for markets, don’t get me wrong. But in a Goldilocks economy, inflation won’t come down fast enough for the Fed to cut as much as the market thinks it will.

And with the huge easing of financial conditions in November, do you think the Fed isn’t going to push back against current expectations?

Granted, they haven’t done so yet. In fact, you could argue the Fed has fueled the market’s belief by NOT pushing back yet.

But here’s the dilemma. Goldilocks growth means sticky inflation. Which means the Fed won’t cut. More likely, it will try to jawbone markets into tightening financial conditions again.

The only scenario where the Fed cuts four times or more next year is in a recession. And in that case, you can throw 11% earnings growth out the window. You can also forget about a bullish nearly 19 times multiple on those lower earnings.

Finally, consider that inflation is a lagging indicator. By the time it gets back to the Fed’s target of 2%, it will mean a considerable slowdown in nominal GDP growth has already occurred. Again, that’s not good for earnings growth.

So, yeah, we’re in a strong seasonal time for markets. Santa Claus rally and all that. And traders and funds managers want to try to squeeze a better bonus out of 2023 by fueling this rally.

But it doesn’t stand up to scrutiny.

In my view, early 2024 will see bullish hopes dashed. This rally will exhaust itself to the upside. Sentiment will top out. And then the selling will kick in again.

My preferred course of action is to ignore ‘the market’. There are plenty of good value opportunities lurking beneath the hood. Gold stocks look good. And last month, I recommended a financial services play yielding nearly 8%.

The key is to look for opportunities ignored by the market. You want to find stocks that have a bleak outlook in the price and bet that things might not be so bad.

And on the flip side, you should ignore scenarios where a rosy future is already in the price. Buying when optimism and good times are already priced in can get you into trouble in this kind of market.

Good luck!

*This article originally appeared in The Insider, a free service for all Fat Tail Investment Research members. To sign up to the Fat Tail Daily for free, go here.