A long-term sell signal?

I warned last week about a possible long-term sell signal from my market timing indicator, but I wasn’t willing to front run my models as the month hadn’t ended yet. Now it’s happened. A long-term sell signal has been triggered.

As a reminder, this long-term timing indicator buys when the monthly MACD (bottom panel) turns positive and sells when the 14-month RSI of the NYSE Composite (top panel) flashes a negative divergence. Now that the month of January is over. The S&P 500 rose to a marginal closing high on a monthly basis, but the 14-month RSI is exhibiting a lower high, which qualifies as a sell signal.

 

No model is perfect and this sell signal should be regarded as a warning and not actionable trading advice. I interpret this signal as the warning of a possible major market top in Q1 or Q2. From a tactical perspective, I am inclined to monitor other indicators on different investing dimensions for signs of a tactical tipping point that the bears are taking control of the tape.
 

 

Market breadth warnings

The most worrisome technical development is the lack of breadth participation in the latest advance. Even as the S&P 500 reached another all-time high, none of the Advance-Decline Lines have been able to exceed their previous highs that were set in late November. But A-D Line divergences can persist for months before the market’s actual high. This represents just another warning and not a tactical sell signal.
 

 

Rather than just measuring market breadth on an aggregate stock basis, SentimenTrader measured breadth on a sector basis and found that the latest advance was very restricted, which tended to lead to high levels of uncertainty and subpar returns.
 

 

While many investors have compared the current era to the dot-com bubble, which was composed mainly of unprofitable companies with strong growth outlooks, the current instance of breadth deterioration is more reminiscent of the Nifty Fifty top. That era was dominated by the leadership of a few large-cap profitable and fast-growing companies. The top was preceded by breadth divergences, which ultimately resolved with a major bear market.
 

 

The bond market’s verdict

Mark Hulbert recently documented the off-the-charts level of valuation for U.S. equities. But valuation metrics tend to predict long-term 10-year returns and are ineffective over shorter 1-year horizons.
 

 

With valuations so stretched, investors should pay attention to the bond market, which could be in the driver’s seat of equity returns. The bond market’s risk appetite can be decomposed to several components.
 

The first component is the term premium, or the compensation investors demand to extend the maturity of a bond. Right now, term premiums have risen to a new cycle high, but there are no signs of panic or a stampede for the exits.
 

Another way of thinking about the term premium is to view it through the inflation expectations lens. The accompanying chart shows the relative performance of TIPs against a long-dated zero-coupon Treasury bond. The inflation factor recently staged an upside breakout to a fresh high, but pulled back below resistance. Is this the case of a glass half-full or half-empty?
 

 

The last signal from the bond market is the pricing of high leverage equities, as measured by effective junk bond yields, which are estimated using the blue and red lines in the accompanying chart. Currently, junk bond funding costs are slightly elevated but remain in the middle of a range, indicating few levels of anxiety.
 

 

 

Policy wildcards

Finally, I am monitoring the effects of Trump’s new policy directions which are largely unknown at this point.

Two key questions come to mind. I discussed the outsized effects of Trump’s deportation policy last week (see Two Key Risks to the Bull That No One Is Talking About). Will the scale of the deportations be as significant as promised or will they be largely be cosmetic in nature?

Finally, how will Trump wield the tariff tool? Specifically, what will the relationship be with China?
 

The early indications show that Trump is using tariffs as a blunt negotiation tool against allies to extract concessions unrelated to trade (see Denmark/Greenland, Panama, Mexico and Canada). He appears to have signaled his willingness to make a deal with China based on his TikTok decision, and his threat to impose tariffs on semiconductors made in Taiwan, which has significant geopolitical implications that go well beyond trade.

As for the announced tariffs of 25% on Canada and Mexico, I believe they were imposed to virtue signal and likely to be reversed in the near future as their costs are too high for all parties involved. The headline reasoning for the tariffs is the amount of fentanyl crossing U.S. borders. The accompanying chart shows the history of fentanyl seizures. The amount seized at the Canadian border in 2024? Only 43 pounds.
 

 

A recent Bank of Canada study which modeled the effects of a 25% tariff on Canada projected a -6% growth effect on GDP, which amounts to a deep recession. Trade within the USMCA bloc in 2020 accounted for 29% of Canadian GDP, 40% of Mexican GDP and 10% of U.S. GDP. Undoubtedly the effects of a 25% tariff on Mexican goods would be the same order of magnitude or worse. Slowdowns of that magnitude in Canada and Mexico would crater the U.S. growth outlook expectations and probably plunge the U.S. economy into recession as well, which is an outcome that Trump is unlikely to want to risk if his intention is to virtue signal.

Canada’s Globe and Mail reported about a different study by the Canadian Chamber of Commerce’s Business Data Lab which estimated Canadian GDP would fall -2.6% and U.S. GDP by -1.6%. In addition, many U.S. companies with cross-border supply chains will be affected, which will result in significant U.S. job losses.  Expect the stock market vigilantes to force a further face-saving backtrack in the near future.

The following chart summarizes the market’s reaction to Trump’s tariff threat. The USD initially rose strong on the fear of large-scale tariff imposition, based on the expectation that the currencies of America’s trading partners would devalue to offset the effects of tariffs. The USD later retreated when Trump’s tariff threat turned out to be worse than his bite. The volatility in the currency markets is occurring against signals of weak global cyclical strength, as measured by the base metals to gold ratio (black line) and copper to gold ratio (red line). The combination of USD strength and weak global cyclical demand is not conducive to the price of risk assets like equities.
 

 

The lack of strength from global cyclical indicators is reflected in the latest PMI surveys from China. Activity is steady, but shows no signs of acceleration or deceleration. As China forms one of the three triumvirates of global growth, the lack of a Chinese cyclical recovery matters for equity prices.

 

In the absence of clarity on trade, John Authers highlighted analysis from China Beige Book, which concluded that Beijing is not inclined to stimulate its economy, even if it has the capacity to do so [emphasis added]:

Our data indicate Beijing feels little pressure to unleash historic levels of stimulus spending, even if it’s capable of doing so. Current accommodating words and inactions from Trump on tariffs reinforce that view.

In conclusion, breadth indicators are flashing early cautionary signals for U.S. equities, but these signals can often be early in calling a major market top. A review of other indicators on different investing dimensions are either benign or cautious. I interpret this as the warning of a possible major market top in Q1 or Q2. Investors should monitor risk appetite indicators for tactical signs to turn cautious.