Wow! Skynet Is I Control!!!!!

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By: Kent Engelke | Capitol Securities

My initial title of this morning’s comments was, “The ISM Nonmanufacturing Index surged to its greatest level since 2005.” Obviously that is a meaningless headline.

Yesterday’s volatility was intense. The Dow fell almost 1600 points in a matter of minutes, Treasury bond prices surged and fear really started to mount. Just as quickly as the selling in equities accelerated and bond prices surged, the tide was reversed. The averages retraced about twenty five percent of its losses and the Treasury gave back half of its gains. In six trading days, the Dow has fallen about 2300 points and is now negative for the year.

I have written at length about the dangers of ETF/passive investing, the massive domination of algorithmic traders, creating a grossly imbalanced environment where the vast majority of investing decisions are made by momentum lacking any geopolitical, macroeconomic or security analysis.

In many ways, the current market structure is unsustainable, utilizing genoism thinking to justify valuations. Rationality will ultimately be restored. Are we in the infancy of this process, a process that includes the transition of monies back to Main Street from Wall Street?

The transition will have bumps. Ultimately society measures their economic wellbeing by its ability to get a job, get a raise and the value of their homes, not by the increase in the equity averages. All three of the above were absent during the past ten years and we are now perhaps returning back to Main Street America at the expense of averages.

I reiterate I am macroeconomic bullish and equity average bearish. I also reiterate in this unfolding scenario, security analysis will be paramount as well as a macroeconomic and geopolitical thesis. This is the inverse of the last ten years.

Speaking of data and a cause for yesterday’s volatility, the ISM non-manufacturing index is indicating the economy is surging as it January reading smashed even the most optimistic forecast rising to the highest levels since 2005. This index measures activity in about 90% of the economy.

The rise was driven mainly by a surge in new orders, perhaps early evidence that tax cuts are boosting demand. The employment index also rose to a record high, consistent with private payrolls rising by a barely believable 350,000. The prices paid component of the ISM is also continuing its upward trend.

Wow!

In my view, if the momentum continues at this pace, I think the Fed will be forced to increase rates at least four times this year. If this does occur, I think index valuations will continue to be challenged.

The Dow should open sharply lower with some suggesting the 18-month long trade of shorting volatility and going long momentum is quickly unraveling. Some are suggesting that in some cases losses are approaching 70%.

I must write the selloff is not economic weakness induced, but rather the result of stronger than expected growth that could impact monetary policy assumptions, assumptions that many of these algorithmic trading models are based upon. As noted a gazillion times, approximately 90% of equity trading is now done electronically and there are now more indices and ETFs than listed securities. Does anyone really know how they are constructed?

The 10-year is flat at a 2.71% yield. This week is the US Treasury auction. How strong is demand? The answer to that question can be the catalyst for the next direction of the equity averages.

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