Expert REVEALS strategy to stay nimble in market

Key Concepts

• Capitulation: A market event where investors sell assets in a panic, leading to a sharp price decline.
• Declining Volume: A metric indicating the number of shares traded on a declining market.
• Curvature: A term used to describe the shape of a financial curve, often related to interest rates or yield curves.
• Mosaic: A strategy of looking at multiple indicators or data points to form a comprehensive view.
• Three "I"s: Inflation, Interest Rates, and Investment Banking.
• Yield Curve Steepening: A situation where the difference between long-term and short-term interest rates increases.
• Fixed Income: Investments that provide a fixed stream of income, such as bonds.
• Valuations: The process of determining the current worth of an asset or company.
• AI (Artificial Intelligence): A technology driving significant investment and infrastructure build-out.
• Capex (Capital Expenditure): Funds used by a company to acquire, upgrade, and maintain physical assets.
• OPEC: The Organization of the Petroleum Exporting Countries, a cartel of oil-producing nations.
• West Texas Intermediate (WTI): A benchmark grade of crude oil used in the United States.
• Brent Crude: A major global oil benchmark.
• Fiscal Tailwinds: Government policies that support economic growth.
• Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions.

Market Rebound and Capitulation Metrics

The speaker expresses surprise at the market's rebound, noting it's the third time a quick recovery has occurred against expectations. They highlight a potential shift in measuring capitulation, moving beyond percentage decline to consider volume. Specifically, a chart showing declining volume on the New York Stock Exchange is presented. The speaker points out that the highest spikes in declining volume, indicated by spikes above a red line, have historically preceded massive rebounds. Yesterday's declining volume on the NYSE was the highest ever, suggesting this might be a new indicator of capitulation and explaining the rapid reversal observed today.

The Three "I"s: A Framework for Investment Strategy

The discussion shifts to a framework presented by Daryl Krocken, Chief Investment Officer for Wealth and Investment Management at Wells Fargo, focusing on three key factors: Inflation, Interest Rates, and Investment Banking.

1. Inflation

• Current State: Inflation has been "sticky" at around 3% for over four years.
• Fed Target Discrepancy: The speaker expresses a personal belief that the 2% inflation target is unrealistic and that a higher inflation rate might be more appropriate. They note that the Federal Reserve is unlikely to admit this.
• Projection: Inflation is expected to remain elevated and potentially push into 2026.
• Historical Pattern: Inflation has a history of rapid increases, sharp declines, consolidation, and then often a resurgence. The current period of consolidation is seen as potentially surprising.
• Impact on Rally: While inflation might benefit certain sectors, it's not considered an impediment to a broad market rally.

2. Interest Rates

• Fed Rate Cuts: Expectations are for one more Fed rate cut by December and two more into next year, bringing the Fed funds rate down to 3% to 3.25%.
• Yield Curve Steepening: A high-conviction idea for the next year is the steepening of the yield curve. This can occur if long-term rates rise while short-term rates remain stable, or if short-term rates fall more significantly while long-term rates stay anchored.
• Implications for Fixed Income: Yield curve steepening implies opportunities for "roll down" in fixed income portfolios, where investors can benefit from the difference between higher-yielding longer-term bonds and lower-yielding shorter-term bonds as they mature.
• Fixed Income Performance: Broad fixed income indices have performed well, with the speaker noting seven and a half percent returns this year, marking the first consistently positive returns since 2020.

3. Investment Banking

• 2026 Outlook: Investment banking activity is expected to pick up in 2026, following an "air pocket" in 2025. This is driven by increased M&A (Mergers and Acquisitions) and capital market activity.

Action Plan: Trimming and Redeploying Capital

The recommended action plan involves "trimming" certain sectors and redeploying capital into others.

• Trimming Technology and Communication Services:

  • Reasoning: Valuations in technology were considered overextended.
  • Methodology: A formula based on valuations was used. Technology was moved from a "favorable" to a "neutral" weighting in portfolios around October 30th, shortly before the NASDAQ peaked on October 29th.
  • Timing: This adjustment was made after the summer months and into early fall, when valuations were deemed excessive.

• Favoring Financials:

  • Multivariant Story: Financials benefit from several factors.
  • Yield Curve Steepness: As discussed, this favors financial institutions.
  • Credit Quality: Credit portfolios are described as "pristine," and capital ratios remain high.
  • Investment Banking Boost: The anticipated pickup in investment banking activity in 2026 is a positive for the sector.

• Liking Industrials and Utilities:

  • Industrials: Seen as a "horizontal play" to the AI trend, benefiting from the build-out and investment required for AI infrastructure.
  • Choke Point: The speaker identifies energy and industrial companies as potential choke points in fulfilling technology capex demands, meaning their capacity to build at the required pace is crucial.

Commodity Outlook: Gold and Oil

• Gold: The speaker is looking for gold to help sustain the current rally.
• Oil (West Texas Intermediate - WTI):
  • Current Price: Around $64 (WTI is slightly cheaper than Brent).
  • Projected Increase: An 8-9% increase is anticipated, reaching approximately $70.
  • Supply Dynamics: OPEC has been increasing supply, and the US has also been pushing out production. This supply is not expected to decrease significantly in the first half of the year.
  • Economic Activity: The speaker believes that greater economic activity in 2026 will also contribute to pushing oil prices up, even if supply and demand dynamics alone don't fully account for it.

Economic Outlook and Corporate Profits

• Bullishness for 2026: The speaker is "quite bullish" into 2026.
• Driving Factors:
  • Fiscal Tailwinds: Government policies are expected to support economic growth.
  • Monetary Policy Direction: While the exact timing and magnitude of Fed cuts are debatable, the general direction is towards easing financial conditions.
  • Corporate Profits: Corporate profits are described as "off the charts," indicating strong business performance.
• Overall Economy: These factors are leading to expectations of a "good economy" in the following year.
• Margins: Corporate margins are also noted as being "phenomenal."

Conclusion

The market's recent rebound, potentially signaled by a new measure of capitulation based on declining volume, has surprised the speaker. A strategic framework focusing on inflation, interest rates, and investment banking suggests a nuanced approach. While technology is being trimmed due to valuation concerns, sectors like financials, industrials, and utilities are favored. The outlook for 2026 is bullish, supported by fiscal tailwinds, easing monetary policy, strong corporate profits, and a projected increase in oil prices. The key takeaway is a cautious optimism, with a focus on redeploying capital into areas poised for growth driven by technological advancements and favorable economic conditions.