There is an adage on Wall Street that investors shouldn’t fight the Fed (or central banks in general), but the devil is in the details.
Callum Thomas of Topdown Charts that global central banks are engaged in a broad-based easing campaign. The limited sample of the history of such episodes (annotations are mine) show stocks rose on two of the four occasions (blue lines) and fell in the other two (grey lines). This begs the question of whether pivots to widespread rate cuts are equity bullish.
My analysis of the latest circumstances is a qualified “yes”, but investors should be aware of the risks.
Don’t fight momentum
My Trend Asset Allocation Model turned cautious from bullish to neutral in July (see China Slowdown = Reduce Risk). I am upgrading the signal back to bullish, and it’s attributable to the exhibition of price momentum by global equity markets.
As a reminder, my Trend Asset Allocation Model applies trend following principles to global equity and commodity markets.
Willie Delwiche of HiMount Research recently pointed out that over 50% of MSCI All-Country World Index (ACWI) markets have reached 52-week highs, a feat last achieved in 2018. That’s price momentum.
The momentum effect can be seen in the U.S., which is the largest market by capitalization. The NYSE McClellan Summation Index (NYSI) surged to over 1000, which is a momentum buy signal. In the last 20 years, the stock market was up a year later in virtually all cases. The two exceptions were unusual macro events. One was in 2011 in the wake of the Greek Crisis and a budget impasse in Washington, and the other was the COVID Crash in 2020. That said, about one-third of such signals saw the S&P 500 pull back briefly after the buy signal (pink lines).
As for the excitement over the announcement of Chinese stimulus, I take the view that Chinese equities are not investable, but they can be traded.
While the stock market in most countries reflect the state of their economies, the same isn’t true for China. The accompanying chart shows the 20-year return history of major regional ETFs, all measured in USD. While Europe and Japan have risen steadily since the GFC low, China has been roughly flat despite showing significant GDP growth over the same period.
Gavekal pointed out that China has shown a history of stimulus-fueled rallies, and they tend to last about 9-12 months. The rallies can be traded, but don’t overstay the party.
My Trend Asset Allocation Model also uses commodity prices as inputs, mainly because they represent better signals of global and Chinese economic activity than Chinese equities. I turned cautious in July because of falling commodity prices, but now they have caught bids. While their price trends are still flat, they are now “less bad” and can be classified as “neutral”.
Key risks
The key risk to my bullish call on stocks is a wobble on the growth outlook. This can take several forms.
Equity valuation is a long-term concern. Even if investors adopt the benign view that there is no recession in sight even as global central banks ease monetary policy, the S&P 500 has never started an easing cycle at such elevated forward P/E valuations. The best-case scenario under these circumstances may be to expect subpar long-term returns for the S&P 500.
From an earnings perspective, the growth in forward 12-month EPS estimates is stalling as we approach Q3 earnings season. Keep an eye on how earnings estimates evolve, as this could be an ominous sign of negative fundamental momentum.
John Butters at FactSet raised this concern by noting that Q3 estimates had fallen by -3.9% going to earnings season, compared to an average drop of -3.3%.
In addition, the Fed is shifting its attention to its full employment mandate. The market breathed a sigh of relief when the September Payroll Report came in ahead of expectations. But leading indicators or employment, such as temporary jobs and the quits/layoffs ratio, are declining.
The September report response rate was unusually low, indicating that the figures could be subject to significant revisions.
To be sure, concerns over softening growth may be overdone. The Citigroup Economic Surprise Index, which measures whether economic indicators are beating or missing expectations, has risen from negative to positive. This suggests that there may be greater price risk to bonds than to stocks.
From a tactical perspective, the threat of a Q4 retail disruption was defused by an tentative deal that takes the prospective of an immediate East Coast port strike off the table. However, the greater threat to supply chains may be the devastation wreaked by Hurricane Helene to Spruce Pine, North Carolina, which is the sole global mine high-quality quartz used for semiconductor manufacturing. The mines are flooded in the wake of the storm, and there is no visibility on when production will restart.
Finally, history shows that the two major failures of the NYSI buy signal were connected with unexpected external macro events in 2011 and 2020. Another may be on the horizon.
As tensions mount in the Middle East, Israel is contemplating attacking Iranian oil infrastructure. When Biden was asked by the press whether he supports an attack, his response was informative, “We’re discussing that. I think that would be a little… anyway.” Investors can infer that if discussions are at the level all the way up to the U.S. President, an Israeli strike is one of the options on the table, and the risks are very real. Iran has threatened to retaliate against oil infrastructure in the Gulf in response. While this is not my base case scenario, emergence of geopolitical tail-risk that causes another energy crisis isn’t in many investors’ models and could act to sink global growth. I will publish a more detailed discussion on this topic tomorrow.
Cautiously bullish
In conclusion, the combination of easier monetary policy by most global central banks and strong price momentum is equity bullish. However, investors should be aware of the risks to the growth outlook.
Global institutions are underweight risk and they may be forced to play catch-up should price momentum persist, which is long-term bullish
On the other hand, fast money risk appetite is elevated, which makes stock prices vulnerable to short-term setbacks that can happen at any time.
One thing that bothers me about all of this is the fact that since 2009 market have been going higher and higher. This means that for the last 15 years if you have some kind of thrust, or the $NYSI >1000, of course the odds are greater than prices 1 year later are higher. There was a high in late 2006 just before the GFC. A year later prices were a little higher before everything came crashing down.
What happened to the yield curve inversion/uninversion? Perhaps it is because the sovereigns are all having debt crises and the FIAT Effect is overwhelming pricing of assets.
$$HYIOAS is also very low which is reassuring although it can change fast.
Not sure what’s going on but something ain’t right.
Cam has a very good write-up here. Yes the employment data are increasingly suspect. The revision variance is getting larger. The JOLTS numbers are even more unreliable. In the era of social networks companies are putting out more and more ghost positions. And they are more reluctant to share data.
Here we are talking about soft landing thanks to flooding of money into the civilian sectors. This is a large cushion effect. So obviously the bond market will not behave like the old days. And a rethinking of 60/40 is warranted. No matter what happens the PE ratio of the markets will go up as time goes by. It has two dimensions. First is the devaluation of USD. The second is the ever higher productivity. The inefficiencies of the corporate are gradually being wrung out, thru whatever means available and necessary. It is a ruthless process but it goes on and no one can stop it. It is the result of total financialization of US economy. Every layer has been put into place and tightly compressed and fully exploited. It is now so rigid, just like those scar tissues in your body, that renders restructure impossible because many layers are rent-seeking in nature.
Needless to say life is going to be very expensive for a lot of people. What are they going to do? I don’t know. I just saw the pricing of a few simple plumbing jobs. For example installing a simple pressure regulating valve in the water line costs about $2-2.5K. It looks like we are going to be living like in Zimbabwe.