The anatomy of a failed breadth thrust

Many technical analysts turned excited in late August when the percentage of S&P 500 stocks above their 50 dma surged from below 5% to over 90%. Historically, such breadth and momentum thrusts have signaled a fresh bull market with a track record of 100% accuracy.


Since then, the percentage of stocks above their 50 dma retreated all the way back down to 5%. The breadth thrust fizzled. Here’s why.



Don’t ignore the Fed

The historical record of another breadth thrust model, the Zweig Breadth Thrust, tells the story. ZBT buy signals are extremely rare. There have been six out-of-sample ZBT buy signals since Marty Zweig outlined this signal in 1985. The stock market was higher 12-months later in all cases. In two of the cases, the market didn’t immediately surge after the buy signal. These periods coincided with periods of a rising Fed Funds rate, just as we have today.



Today, Fed policy is extremely tight. Here is what we know from the last FOMC meeting:
  • The Fed is anticipating “ongoing increases” in the Fed Funds rate, and expects higher for longer: “Restoring price stability will likely require maintaining a restrictive policy stance for quite some time”.
  • Median expectations for the Fed Funds rate is 4.4% by year-end and 4.6% by the end of 2023.
  • The Fed will keep at it “until the job is done”.
Ignore the Fed at your own peril.



Better news on inflation

That said, inflation pressures are moderating all around the world, as measured by the Inflation Surprise Indexes, notwithstanding the hotter than expected August PCE print.



Remember the supply chain bottlenecks? Global shipping rates are all collapsing, which should be good news for inflation.



The problem is the jobs market is still strong, as evidenced by falling initial jobless claims after topping out in late July. The Fed has made it clear that unemployment has to rise for inflation to fall.




Will something break?

I’ve pointed out before that the other hope for a central bank pivot is a financial crisis (see Why a financial crisis could be the bulls’ best hope). Last week’s BoE intervention in the gilt market was a stark example that the UK had come very close to a consequential financial accident with likely domestic and international spillover effects. 


In very simple terms, here is what happened. The WSJ reported that liability-driven investment funds (LDI) are leveraged, and that’s when trouble began.


The LDI strategy is meant to help pensions more efficiently manage their assets to ensure they can pay future retirees. Pensions use an LDI manager, who buys interest-rate swaps and other financial instruments to hedge against the risk that falling interest rates and rising inflation will increase their future obligations. 


The LDI strategies also widely use leverage to try to close the gap between what they own and their future pension promises. “A LDI manager might buy £100 of interest rate exposure using £30 to £40 of the fund’s assets,” said Jon Hatchett, a partner at consulting firm Hymans Robertson. 


That freed up assets to try to close pension-fund deficits but it increased the strain on the funds during the market turmoil, Mr. Hatchett said. “Those moves decimated the value of the assets backing the LDI portfolio,” he said. 


The strategy was encouraged by U.K. regulators to help funds manage interest-rate risks. A guide from the pensions regulator said the strategy typically offers “an improved balance between investment risk and return but it does introduce additional risks.”
The LDI strategy is very popular in the UK and employs leverage as much as seven to one.
The widespread adoption of LDI has been accompanied by higher levels of risk taking, according to the U.K. pensions regulator. Its 2019 survey of 137 big U.K. pension schemes found 45%, or almost half, had increased their use of leverage in the last five years. The maximum leverage allowed by the pensions ranged up to seven times, the survey found.
Pension funds hold gilts, but they repo the gilts out. They hedge with interest rate swaps by receiving fixed and paying variable rates. When the market reacted badly to the new government’s mini-budget, the gilt market fell and a doom loop began. As the value of gilts, or collateral, fell the pension received margin calls. What’s more, as rates move higher, they had to post variable margin on their interest rate swaps. A significant number of UK pension funds were at risk of becoming insolvent  In response, the BoE said it would purchase gilts on “whatever scale is necessary” for a limited time to prevent an “unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy”.


The problem doesn’t stop there. European banks have extensive exposure to the UK. It’s unclear the degree of contagion risk exposure had the BoE not stepped in on an emergency basis. The European Systemic Risk Board (ESRB) just issued a general warning about tail-risk in the Eurozone, “Risks to financial stability may materialise simultaneously, thereby interacting with each other and amplifying each other’s impact”. It identified three issues:
  • Rising debt levels and recession risk: The deterioration in the macroeconomic outlook combined with the tightening of financing conditions implies a renewed rise in balance sheet stress for non-financial corporations (NFCs) and households, especially in sectors and Member States that are most affected by rapidly increasing energy prices. These developments weigh on the debt-servicing capacity of NFCs and households.
  • Systemic financial risk: Risks to financial stability stemming from a sharp fall in asset prices remain severe. This has the potential to trigger large mark-to-market losses, which, in turn, may amplify market volatility and cause liquidity strains.
  • Rising credit risk: The deterioration in macroeconomic prospects weighs on asset quality and the profitability outlook of credit institutions
European credit risk is rising. High yield spreads have widened to levels seen during the COVID Crash.




King Dollar = Godzilla

The accumulated problems presented by Fed hawkishness are also present in Asia. In the movies, Godzilla emerges from the sea and wreaks havoc on Tokyo. Godzilla’s real name today is King Dollar. The Fed’s tight monetary policy has forced up the USD. By contrast, the BoJ has chosen to swim against the global monetary tide by staying dovish, which has cratered the JPY and effectively imported inflation from America. The Yen is back to levels not seen since the 90’s.



Over in China, it was the story of another day, another intervention by global central bank authorities. The strong USD pushed the onshore Chinese yuan to the psychologically 7.25 level before retreating, a level last seen during the GFC. The PBOC warned against speculative trading against the yuan and asked state-owned banks to be prepared to sell dollars in order to stabilize the currency. The yuan depreciation raises the risk of capital outflows. As a reminder, when China faced a balance of payment pressures in 2015, the PBOC sold U.S. assets to support the exchange rate and U.S. stock and bond prices came under pressure. 


FT Alphaville reported that Barclays analysts warned about the systemic risks posed by CNY depreciation:
While this is not a ‘systemic crisis’ moment, it is a worrying sign for the global macro outlook. After all, China is the single most important trading economy in the world. If the CNY is on a path to sustained depreciation, that is big news for every other exporter; most other countries will have to follow to keep themselves competitive. And yet, many of these countries are already facing high inflation and the need to defend their currencies from further depreciation. As important, the overnight move might be a sign that the PBoC is now comfortable with further weakness. A few days ago, it seemed like the Chinese central bank was planning to push back against further USD strength. If China is now changing tack, there is considerable room to go. In some ways, the recent CNY weakness is just the currency playing catchup to the weakness in every other currency against the dollar. We estimate that if the CNY were to go back to Q1 2021 levels on the CFETs basket, it would need to depreciate to 7.5 against the USD.



In short, an RMB depreciation would be catastrophic for Asia and create systemic problems for the region and for the global trading system. Other Asian central banks are also feeling the heat. As the sign of another pivot, the Bank of Korea took bids in the bond market as it became the latest central bank to intervene and resume bond buying to curb rising yields.


Something is going to break soon, we just don’t know what, but it will likely be outside US borders. For the moment, the level of US financial stress is low. Historically, recessions haven’t ended without the St. Louis Fed Financial Stress Index rising above zero.




Investment implications

Based on this analysis, I can think of two possible scenarios for US equities. The first is a multiple bottom scenario like 2002-2003. The S&P 500 first bottomed by experiencing a breadth wipeout, as measured by the percentage of stocks above their 50 dma, in July rallies and suffered a second breadth wipeout in October. The market then recovers but chops around but doesn’t really get the all-clear signal until the following May. The timing of this pattern is consistent with a recession in 2023 that ends late in the year. Since markets look forward by 6-12 months, a market bottom by next spring or summer is to be expected. 


While history doesn’t repeat itself but rhymes, this scenario doesn’t preclude the market from going lower before it makes a final bottom (see How to estimate S&P 500 downside risk). The S&P 500 is currently trading at a forward P/E of 15.3. History shows that there were two periods when the 10-year Treasury was trading at similar yield levels. The first was 2002-2003 when the market bottomed, and 2007-2011, which was the period just before and after the GFC. There are some key differences. The 2002-2003 episode was during a period when yields were falling, while the GFC episode featured yield volatility. Yields are rising today. Nevertheless, we can see that the S&P 500 forward P/E ratio traded in a range of 15-17 during the 2002-2003 period and 13-15 during GFC, if we exclude the panicked valuation during the 2008-2009 bottom. Assuming a 20% cut to forward earnings estimates and a 13-17 range as a target P/E multiple, this translates to a peak-to-trough drawdown of 30-50%, which is a typical loss experienced in recessionary bear markets.



The second scenario is that something breaks and the world experiences a financial crisis with sufficient contagion risk that global central bankers are forced to pivot monetary and save the system. In that case, the seasonal mid-term election year pattern might be a better template for the path going forward.



Take your pick, but don’t forget to practice prudent risk management in the process.


17 thoughts on “The anatomy of a failed breadth thrust

  1. Lessons learned and the inevitability of being wrong.

    What the Breadth Thrust indicator and Marty Zweig indicator teaches us (me) is that in the stock market there is nothing that is a sure thing (sometimes inside information which is illegal can be wrong). Therefore, it is imperative that we use stops. Not mental stops but paper stops that are in the market. When we put on a trade that is the time when we have the maximum confidence of our decision and it is the easiest time to do it. I am not stating something new better traders like Paul Tudor Jones, Mark Fisher, Larry Benedict all stress the same thing in the Market Wizards Book. There are exceptions however i.e. Bank of England “whatever it takes rule”.

    Unfortunately, for us mortals we don’t have unlimited money. Therefore stops are the only choice. Also, trailing stops to protect our profits. What this Bear Market has taught us is that there is nothing sacrosanct. Ring Central which is high quality growth stock has gone down from $450 to $40. OUCH!!! That hurts.

  2. I think your two scenarios make a lot of sense Cam. I also think that the playbook, at least for the investor, might be the same. If the former, a recession occurs and earnings go down, which theoretically beats back inflation to the point where the Fed pivots. In the latter, something breaks and the Fed similar to BoE has to pivot. I’m thinking in the former you might look to anticipate the pivot, in the latter you can only react. Or you can react to either, maybe missing the very initial gains but capturing plenty of whatever upside forms from there. Watch, wait and gather cash seems to be the most prudent investment strategy.

    1. Readers who have followed Cam’s recommendations have bypassed most of the bear market. So there’s little reason to take on risk right now.

      (a) Cash is one option.
      (b) In place of cash, consider 1-year T-bills and/or 1-year CDs, both yielding >4% right now.
      (c) If the bear continues for another year, you will have earned 4% risk-free.
      (d) If/when Cam’s model turns bullish, sell the bonds/CDs in the secondary market and reinvest in the stock market.

      At the very least, your portfolio will be +4% higher in a year. Nothing wrong with that.

  3. I think what scares the Fed is not so much inflation and it’s effect on us, but the effect on debt. If inflation is entrenched, then yields go up, and although we can copy the BOJ and buy all the government debt, corporations and households cannot.
    The debt won’t go away, this is the problem, and to work. off this debt will take years, which would also mean less spending etc.
    Are they just waiting for a good excuse to pivot?
    A mirror on the long supply chains and relying on far away sources, will other countries take a hard look at relying on the dollar?
    If the cost of servicing the Federal debt hits 1 trillion a year and social security COLAs go way up, how does that work?

    1. Some average numbers from various studies I have seen about the additional burden of servicing gov debts, based on current backdrop and as a crude approximation, is each 0.75% FFR increase would add about $2T over ten years. So we are looking at $8T for next 10 years. Sure it is not linear, and it will be bigger.

  4. A look at Credit Suisse credit default swaps adds credibility to the financial crisis scenario. While I don’t have additional insight, we have seen this movie before and the resemblance to 2008 is still striking. Investors and asset managers should be aware of the risk and I would very much understand continued risk aversion until we get more clarity on the situation, the results of a Credit Suisse strategy review are due Oct 27.

      1. Seen those reports as well. Even without a major bank collapsing, the looming energy crisis itself could be potentially enough to delay the current tightening path of the ECB at least. It is very foreseeable that European governments will be trying to fight rising energy costs with fiscal policy “bazookas” – already doing so. Not sure how much safety European government bonds will be providing and which banks will be caught off-guard.

  5. If you are a student of market price action and market internals, you should have spotted what happened on Friday and how it is similar to only a hand full of instances over the last 10 years in the SPX. The criteria is that market has to have >1.5% daily loss, > 7% 2 week loss and NYSE new 52 week high minus low (market internal) that was more than 30% higher than previous close. This is a clear divergence of lower price to higher market breadth. These are the following instances, all except one was within 1 to 3 days of the bottom:
    Going back 10 years,

    12/19/2018 , 2506.96
    12/21/2018 , 2416.58
    12/24/2018 , 2351.10
    03/03/2020 , 3003.37 * only 2 to 7 days away from the 50 or 200 day MA
    03/20/2020 , 2304.92
    09/30/2022 , 3585.62

    3/3/20 could be discounted because it was the beginning of a sharp sell off that was only 2 to 7 days away from dropping below its 50 or 200 day MA.

    As an exercise, go and check those dates and see what day of the week they were and see if the following Monday was the market low (and reversal). There were only two others plus this past Friday if it should follow those patterns.

    1. I take these studies with a grain of salt because it’s easy to torture the data until it talks

      1. Thank you Cam but I assure you that no data was harmed in this simple divergence analysis. It is interesting how some traders were readily accepting 6/17/22 as the bottom when no such breadth divergence was observed, but now a divergence has been seen and on Friday JPM has put in its massive put spread collar to hedge the market until end of December, that few can believe a short term bottom could be had at this point. It may not be bottom for long but it could be a short term bottom for days or weeks up to November.

    2. This turned out to be a reasonable strategy with 13 trades in 15 years that goes back to 2007, 10 winning and 2 losing, one even, profit factor 7.36. It returned net 41.47% including 8 trades during the 2008 and 2009 bear market which had the only two losing trades, one in 2008 and one in 2009 that contributed to total of 6.5% losses. The rules are simple as stated above, buy the next trading day close (such as this coming Monday close) when previous daily loss is >1.5% and two week loss is >7% and NYSE new high minus low showed a 30% higher divergence to price. Do not take the trade if it has already risen too close to the 200 day MA in the last 5 trading days – which almost never happens under these conditions unless SPX fell off a cliff like it did in early March 2020. Exit on close of the 3rd trading day is the backtested result. However in 2018 and 2020 the long trade kept going, well, that is history. The stop for this trade is if the daily NYSE new 52wk Hi-Lo dropped more than 75% (i.e., large loss in market breadth), exit.

      Please do your own due diligence and understand the strategy before trading.

      1. This is actually a 100% profitable strategy with no losses but fewer trades over 15 years of SPX if it is followed as described. The use of the code:

        rateofchange(c data2,1)<30
        instead of the correct value of -30 was for the purpose of testing the worst case scenario and exit strategy. Just wanted to correct the description for the picture linked. One additional filter was that any signal within 2 % of the 200 DMA was ignored as this is a bottom spotting strategy.

      2. For completeness of this strategy and this trade, the following chart is included. Following a large drop in breadth on 10/5/22 which was sufficient to trigger the exit (see above NYSE 52wk HiLo diff dropped >75%).

  6. Inflation is the north star for the Fed. In the more traditional approach, Fed raises rates to choke off demand sufficiently to cause a recession. Question is how long and deep the recession needs to be to get to the point where inflation is snuffed out and Fed pivots? All the while there is heightened risk that something breaks. In such a scenario of Fed Pivot due to financial crisis, it might resolve the immediate crisis but would it bring inflation down?
    My personal sense is that we may be entering a secular bear market, not a bear market in a secular bull market. Is that too pessimistic a view?
    How should an investor be positioned for such a scenario?

    1. If inflation stays in the system because the fed is forced to pivot before the job is done, then we might be in for a extended period where things go up and down and in the end are flat. I’m not 100% sure of that, so my strategy is to take part of our funds and put them into tactical asset allocation strategies, which is something I would not have done over the past ten years because of its active nature. Theoretically this approach would limit losses while getting on board for more of the gains. We’ll see, so far it’s been good in 2022. I still keep a more traditional strategy as part of the portfolio as well, where essentially allocations are based on current valuation and earnings outlook.

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