Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
- Ultimate market timing model: Sell equities
- Trend Model signal: Neutral
- Trading model: Bearish
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
Subscribers can access the latest signal in real-time here.
A holding pattern
After several weeks of back-and-forth, the stock market remains in a range-bound holding pattern. A breakout or breakdown may be depending on upcoming news in the form of Q2 earnings season, and the resolution of negotiations in Congress over a second round of fiscal stimulus.
How will the headlines develop over the next couple of months? Will the narrative be an out-of-control pandemic, no or inadequate fiscal stimulus, an economic disaster, and skyrocketing bankruptcies; or will it be a vaccine by late 2020, renewed fiscal stimulus, and an economic revival in 2021? Long-dated implied option volatility and the SKEW Index, which measures the price of tail-risk hedge, are telling the story of mildly elevated risk, but there are no signs of outright panic,
Waiting for earnings season
How far has the market discounted a slowdown as we approach Q2 earnings season? FactSet reported that forward 12-month EPS is rising, indicating positive fundamental momentum. On the other hand, the forward P/E is highly elevated at 22.0, indicating valuation risk.
High frequency economic data from Tracktherecovery.org shows that consumer spending peaked out and began to retreat mid-June, followed by stabilization in late June and early July.
Chase card spending shows a similar pattern of flattening sales.
More worrisome is the health of small businesses, which peaked out in the same time frame, but saw no signs of stabilization. Instead, the number of open small businesses are plunging.
Much of the progress in reopening depends on the pandemic, and the news isn’t good. The COVID Tracking Project reported that case counts are skyrocketing. As expected, hospitalizations lag the new case count, and fatalities are turning up as they lag hospitalizations.
At its peak, New York reported 595 new cases per million on April 15. Arizona (580) and Louisiana (568) are nearing that figure. As the case counts surge, other states are likely to follow. This is what Dr. Anthony Fauci meant when he said that we are in the middle of the first wave, not the second, as the lagging regions catch up with Washington State, New York, and New Jersey. Fear is rising, and expect consumer sentiment to get worse before it gets better.
Back on Wall Street, a more detailed analysis of quarterly estimate revisions shows that the Street dramatically cut Q2 estimates last week, raised H2 estimates, and cut 2021 estimates. The lack of H2 downgrades indicates that consensus estimates have not fully incorporated the downdraft seen in the high frequency data.
Discounting a mild slowdown
Real-time market signals are telling the story of a mild slowdown. I am seeing numerous signs of minor negative divergences, or warning flags but no outright sell signals. As an example, the relative performance of the equal-weighted consumer discretionary stocks to equal-weighted consumer staples is rolling over. (The indicator uses equal-weighted indices in order to minimize the massive weight of Amazon in the consumer discretionary sector). This rollover is a minor negative divergence and a sign of waning equity risk appetite.
Similar minor negative divergences can be seen in the credit markets. The relative price performance of high yield (junk) bonds and leveraged debt to their respective duration equivalent Treasures are also signs of reduced credit market risk appetite. More worrisome is the behavior of the 10-year Treasury yield, which tested and bounced off support last Friday. A violation of support would be a potential trigger for the risk-off trade.
Waiting for Washington
In addition to Q2 earnings season, there are two developments of importance to investors in the month of July. First, the deadline for filing income taxes is coming up on July 15. Historically, the stock market experiences brief weakness as taxpayers scramble for liquidity around the tax deadline date.
More importantly, the $600 CARES Act individual weekly payments expires on July 31, and there are no signs that the Democrats and Republicans have come to any agreement for another round of fiscal stimulus. Despite the better than expected June Employment Report, permanent job loss has spiked to recessionary levels. Notwithstanding the debate about whether additional support represents a disincentive to work, or a necessary or essential support for people, the macro outlook appears dire without a second round of fiscal stimulus.
The Payroll Protection Program (PPP) was not the best designed rescue package. You can’t really fault the drafters of the CARES Act. It was battlefield surgery, and battlefield surgery is imperfect. PPP is paying companies to artificially lower the unemployment rate, and now the media and politicians are bickering over the interpretation of the results. The focus is now over who received the loans, e.g. the aha! moment for the libertarian Ayn Rand Institute, and who is deserving of them. These details miss the big picture of the urgency of a second round of stimulus, without which the economy could enter a death spiral.
What about the Fed? Can’t the Fed step in and play a role? This NY Times account of the Fed’s troubled Main Street lending program which had little take-up from small and medium business borrowers is a cautionary tale of dysfunctional bickering bureaucratic institutions.
The central bank and the Treasury, which is providing money to cover any loans that go bad, spent months devising the program, negotiating over credit risk and vetting terms. Many officials within the Fed wanted to create a program that businesses would actually use, but some at Treasury saw the program as more of an absolute backstop for firms that were out of options. Steven Mnuchin, the Treasury secretary, has resisted taking on too much risk, saying at one point that he did not want to lose money on the programs as a base case.
What has emerged after three months, two overhauls and more than 2,000 comments filed with the Fed is a program that seems to be incapable of pleasing much of anyone.
The latest update from CNBC indicates that the Trump administration favors a reduced and targeted fiscal stimulus package.
As the end of July draws closer, tens of millions of Americans are set to lose the $600 a week in federal unemployment benefits meant to tide them over during the coronavirus pandemic. Though some lawmakers have suggested the benefits could be extended, they likely will not be as generous in the next stimulus package, according to Treasury Secretary Steve Mnuchin.
In the next stimulus package, the Trump administration wants to cap the benefits so that workers don’t receive more in unemployment than they did at their jobs, Mnuchin said Thursday on CNBC. With the extra $600 per week, an estimated two-thirds of displaced workers are eligible for benefits in excess of their normal wages, according to a recent paper from the National Bureau of Economic Research.
This means extended unemployment insurance, but at a lower $200-$300 level; another $600 style stimulus payment, also at a lower level; some state and local government aid; and some small business aid. Whether House Democrats can agree to such a package is anyone’s guess, as both sides will undoubtedly be jockeying for political advantage this close to an election.
As Congress grapples with what will be in the next relief package, CNBC reported that almost 32% of households missed their July housing payments, and eviction moratoriums are either set to expire or have expired about now. Tens of millions of households are facing an imminent income cliff.
The idea of creating incentives for people to return to work in the face of weak demand, or to force people to work in the face of a local pandemic wave will be disastrous health policy and further tank the economy. Congress has 10 legislative days left before households go over the income cliff. No pressure at all.
The week ahead
Looking to the week ahead, I continue to have a slight bearish bias. II sentiment has normalized, and readings have returned to levels just before the COVID Crash, which makes the market vulnerable to a downdraft.
The Citigroup Panic/Euphoria Model remains in euphoric territory, which is intermediate-term bearish but tells us nothing about the short run market outlook.
The NYSE Summation Index (NYSI) has rolled over from an overbought reading after bouncing from a deeply oversold condition in March. This is a rare condition that has occurred only three times in the last 20 years, and the market has weakened in two of the three. Even in the one episode in 2019 when stocks continued to advance, the index paused and pulled back briefly before resuming its advance.
Here is a close-up look at the relationship between the NYSI and S&P 500.
Let Q2 earnings season begin!
Disclosure: Long SPXU (daylight hours only)