You've Got One Job

It never ceases to amaze me the many ways people find to make driving a car even more dangerous than it is inherently. Some look straight into their laps texting War and Peace while going 75 miles an hour on the interstate. Others eat a five course meal.

Hey, Gordon Ramsay! “Ten and two o’clock” is for your hands, not your knees!

Last week, I was behind a lady who approached a four-way stop sign as she was applying her morning makeup. Her car crept into the intersection until she actually stopped right in the middle of it. She had been completely oblivious while she put on her face. That is, until I gave her a polite “you’ve got one job to do, and that’s to drive” honk.

This incident reminded me of what happens when investors ignore the data and instead pay more attention to media narrative, friends at cocktail parties and nut jobs on TV with more sound effects than financial market acumen. This commentary, my friends, is your “you’ve got one job to do” honk.

One Above All Others

There has been one critical development in markets over the last three months — just one. Do you know what it is?

It’s not any of the 19 things Trump has done since being in office that have ignited chants for impeachment.

It’s not that everyone and their mother believes that every segment of the U.S. stock market is overvalued.

And no, it wasn’t even the June 9 “rout” of technology stocks (which in fact left the QQQs only 2% shy of freshly minted all-time highs).

The most critical development has been the slowing of inflation.

Miss Cleo was right

On April 10, I published “The Great One,” a commentary in which I channeled my inner Miss Cleo and foretold the coming rollover in U.S. inflation. I suggested that you either short silver or avoid it altogether. Since that commentary, the annual pace of headline CPI has slowed for three consecutive months, and silver has declined 10%, peaking three days after my commentary was published.

No, I don’t have a crystal ball, but the inflation math was simple. When crude oil doubles in price, as it did at the beginning of 2016, it’s going to have a positive influence on inflation numbers. Likewise, when oil trades sideways, as it did from October 2016 until late April 2017, that will also impact the pace of inflation, but to the downside.

The data told me that the most likely direction for inflation in the coming months was lower.

Great Expectations

Last week we received May’s inflation numbers, which showed the slowing of headline CPI for the third successive month. The media declared that this was the third time CPI had “missed” expectations, that no one saw this coming and that it shifts the Fed’s entire policy trajectory.

As for the first part, there is nothing I disdain more than economists’ consensus forecasts. What could possibly go wrong when 16 people forecast something as complex as the global economy and then take an average of their guesstimates? Yet, Wall Street and most investors judge the merits of an economic data point entirely on whether it “met, missed or exceeded” expectations. I can promise you that there is no more fruitless evaluation of economic data.

As for how slowing inflation impacts the Fed’s plan, a whole lot can happen between now and the next “live” Fed meeting. It’s a waste of time trying to predict what the Fed may do months from now based on inflation data that is already a month old.

However, what’s not a waste of time is understanding what slowing inflation means for asset class performance and how to position your portfolio accordingly.

The playbook for a slowing inflation environment is simple: you avoid (or opportunistically short) the energy sector and, as Dennis Gartman puts it, “things that if dropped on your foot shall hurt.” Based on several qualitative and quantitative aspects of markets, I know most investors aren’t yet hip to what the inflation rollover means for asset class performance.

The Blindside

So far this year, investors have plowed $348MM into the SPDR S&P Oil and Gas Exploration ETF (XOP), $207MM into the VanEck Vectors Oil Services ETF (OIH) and $980MM into the Energy Select Sector SPDR ETF (XLE).

Not only that, but investors have redeemed only $26M worth of the iShares Silver Trust (SLV), which accounts for less than 0.5% of assets in that particular ETF.

All these markets have been careening off a cliff since December, with the exception of SLV, which held on until mid-April before making its plunge to lower levels.

Now, I could understand taking a shot on these markets as inflation continued to accelerate in January and February. But investors are plowing money into these ETFs right now, while inflation is actively slowing!

Since I published my commentary on April 10, investors have added $276MM to XOP, $92MM to OIH, $133MM to XLE and $194MM to SLV!

There is no nice way to put this. These people are getting crushed.

During this period of ETF inflows, all four ETFs have declined: XOP is down 17%, OIH is down 19%, and XLE and SLV are both down 7%.

Talk about doing the exact wrong thing at the exact wrong time. This is the investing equivalent of creeping past a stop sign into middle of a busy intersection while applying your eyeliner.

The Bottom Line

When you are behind the wheel, you have one job and that’s to drive. Do the rest of us on the road a favor and put down the iPhone, the eyeliner and the double cheeseburger combo meal.

When you are making investment decisions, you have one job and that’s to stay data dependent, process driven and risk conscious.

The data indicates inflation will continue to slow in the months ahead. The process says avoid (or short) anything energy related or “things that if dropped on your foot shall hurt.” And risk consciousness says you don’t add money to markets that are in crash mode until their Fundamental Gravity has shifted from bearish to bullish.