@theMarket: 'Valuations Don't Matter'

Over the last few weeks, the above statement has been appearing on financial channels, in newsletters, and on many trading desks. That runs counter to everything taught in business schools and the financial world at large. Has the stock market truly become a trillion-dollar casino, or is there something else going on?

 

As readers are aware, the Trump administration has pushed back the implementation date of reciprocal tariffs until Aug. 1. In the meantime, the White House is sending a flurry of form letters to various countries, listing what will happen if they do not make a deal with the U.S. before that date.

 

A new risk on the tariff front is that Donald Trump showed his willingness to step beyond the economic frontier in his tariff war. Unlike many countries, Brazil has a trade deficit with the U.S. That means Brazilians buy more from us than we buy from them.

 

This time, he is using tariffs to insert himself into a country's domestic political affairs. He threatens to slap a 50 percent tariff on Brazil unless Brazilian authorities drop charges against former President Jair Bolsonaro, a right-wing populist leader. Bolsonaro is accused of attempting an alleged coup and trying to poison the sitting president, Lula da Silva.

 

How does this square with his speech to the Arab Islamic American Summit in May, in which he said:

 

"America is a sovereign nation, and our first priority is always the safety and security of our citizens. We are not here to lecture — we are not here to tell other people how to live, what to do, who to be, or how to worship. Instead, we are here to offer partnership — based on shared interests and values — to pursue a better future for us all."

 

The markets are divided on whether this upsurge in tariff rhetoric is just another TACO trade, an escalation, or whether the president will finally put our money where his mouth is. In the meantime, we are getting the usual "a deal any day now" promises from his staff. Judging from this week's market reactions, Donald is the "boy who cried wolf" too often, but there may be something else afoot that explains the market's resilience.

 

 The answer lies in the flow of funds that propel markets in one direction or another, depending on a variety of variables. Readers need to understand that professionals and institutions place their bets on which way the markets are going, like the rest of us, but they also hedge those bets. For professionals, volatility (often a polite term for downside risk) is an extremely important concept that, if not properly hedged, could result in significant portfolio losses and possibly jeopardize your job.

 

Over the decades, an entire industry of funds, known as Volatility Control Funds (VCF), has emerged around the concept of volatility. It is a strategy designed to go long or short based on volatility levels often embedded in portfolios, protecting them from extreme market fluctuations. Class over.

 

For the last few months, the imposition of tariffs has been high on the markets' list of potential volatility events. Witness the stock markets' reaction to President Trump's April 2 announcement of reciprocal tariffs. The "Trump dump" took four days, and the S&P 500 Index fell about 12 percent while the Dow dropped 11 percent. On April 9, Trump announced a 90-day pause, and markets recovered.

 

Since then, VCF funds have been hedging the potential downside to their portfolios by shorting markets to the tune of billions of dollars, ahead of the new July 9 deadline. The higher the markets climbed, the more money was invested in protecting those gains. Last week, President Trump postponed again, this time to August 1.

 

As a result, VCFs must extend their tariff playbook to August. In the meantime, they need to buy back the millions of stocks they shorted over the last 90 days and bring their equity positioning back to neutral. Estimates are that we were looking at $45 billion or more in mechanical demand for equities. This flow of funds is happening regardless of the present valuation of the stock market. It doesn't happen all at once, but at worst, it has kept a floor under stocks this week.

 

In the meantime, we have some important data scheduled for next week. The Consumer Price Index for June is scheduled for release on Tuesday. It will mark a turn in the recent downward trend of the inflation rate. That should come as no surprise to you since I have been warning readers of this turn of events for months.

 

Wall Street analysts have finally twigged to the possibility that the CPI will be higher than expected. Many economists have rushed to ratchet up their expectations for a higher CPI over the last week or two. Many now have higher numbers than my own. In any case, that event poses some risk to the market. It should push bond yields higher along with the dollar.

 

The cryptocurrency markets had a good week. Bitcoin followed the stock market and made a new high at $118,000. Ethereum is also on a tear, as is Solano. I see Bitcoin trading at $145,000 this year. Gold is still trading within a range, but I remain bullish on the precious metals as long as stagflation remains the name of the economic game.

 

 The markets overall have hung in there. The selling pressure in the first half of the week that I had expected was more than matched by the buying demand from the VCTs. As for other potential market movers, I do not expect an interest rate cut by the Fed when they meet at the end of July, so that leaves the inflation data next week, as well as Donald Trump and his tariff threats. My CPI number is plus-2.5 percent while the Street is now at plus-2.6 percent. A hot number could hurt stocks for sure and, if so, send markets down a percent or two.

 

As for President Trump, he remains a wild card. One of the best trading strategies this year has been to buy stocks when they fall because of his tariff threats. Every day this week, he threatened one country or another with higher tariffs. The latest was Canada. He also said he will levy a 50 percent tariff on foreign copper imports. The point is that since markets are at an all-time high, he feels he has room to rattle his tariff stick at the world.

 

As I have advised readers many times over, ignore the noise coming out of Washington. Instead, focus on stocks and sectors that will do well in a stagflation environment domestically, and move more money into overseas markets.

 

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