Market Forecast For The Week of October 4, 2021

FORECAST: The S&P 500 rallies modestly early this week to around 4440 then falls again as the consolidation of this summer’s bull run continues for two more weeks. The foundational elements of the bull run remain, namely liquidity, strong profit growth, mild geopolitical risks and TINA, so following this consolidation period I expect a return to this summer’s highs around 4545.

Liquidity is virtualy unchanged for the present as the Fed taper won’t be halfway done until next year, but a mild debate has emerged between inflation cassandras and the mainstream that follows the Fed’s logic of transient supply-induced inflation. The cassandras largely apply old monetarist formulas that consider inflation to be simply a monetary phenomenon, despite little ability to predict a key variable in these formulas (the velocity of money). The behavioral explanation of inflation (considering real-world supply and demand dynamics) suggests inflation is transient unless most of the major economic trends of the past 20 years reverse. The cassandras have won some battles of late and consequently real rates are rising and attracting money to the US and out of Europe, Japan and many EMs. But inflation expectations still haven’t broken out of their trading range and I predict they will subside soon, allowing interest rates to fall back to earlier summer levels, igniting another bull run in equities.

The bulls have valuations on their side along with low rates that make bonds unattractive. With profit growth still on track for nearly 22% this year and 7-8% next year, strong growth means valuations are fair even though they are relatively high historically. By my estimate roughly half of the top 100 stocks in the S&P 500 are undervalued and the balance modestly overvalued. Since valuations are fair the market is now weighing the risk that the vaccination rate will remain under 60% as winter approaches and another wave of COVID surges, this time with possibly worse variants than delta. This fear is enough to force consolidation, and I expect the market to remain in a trading range for the next two weeks. Subsequently the bull market will resume since the odds are still positive that the worst of COVID is over. Public and private sector mandates are nearly certain to force a majority of the unvaccinated to get vaccinated, so there is still a strong likelihood we reach a high level of immunity assuming worse variants don’t emerge. Barring news of a surging variants or a major geopolitical shock (e.g., out of North Korea) expect one more leg down in the current consolidation and then run back to old highs.

Financial risk remains a concern since last week saw shortages in the dollar among international banks and consequently a rise in the cross-currency basis. And cross-border bank claims are high (the most recent BIS data shows an increase in Q1 2021 of $646 billion, partly due to seasonal factors but still high, although due to comparisons with Q2 2020 it registered as a slight decline of -0.6% year on year), indicating contagion risk is a concern. EM debt repayment remains murky for badly run nations (e.g., Turkey, Argentina) but moderate global growth is buoying export confidence in major EMs. Fortunately there has been no major chatter regarding concentration risk or counterparty risk at large financial institutions.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), Apple (AAPL), Gibraltar Industries (ROCK), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE) and a hedged position in the S&P 500 (UPRO and SPXU).