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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Too far, too fast?
Has the bull run gotten ahead of itself? The S&P 500 was up 14.5% for the first half. In addition, Ryan Detrick observed that the Zweig Breadth Thrust signal of early November showed very strong returns. It was a buy signal I also highlighted (see Zweig Breadth Thrust: From caution to YOLO). The S&P 500 was up 19.0% in the six months since the buy signal, and the market was up 3.5% since then. Combined, investors would be up nearly 22.5% since the buy signal, which is just under the 12-month average and median return.
In light of these strong returns, how much gas is left in the bulls’ gas tank? Is this the case of the market going up too much, too fast?
Warning signs
A number of warning signs are appearing. An enormous divergence has appeared as consumer survey expectations of business sentiment is weak, but stock market return expectations are strong.
As well, household stock allocations have reached an all-time high, which is contrarian bearish.
From a valuation perspective, the equity risk premium is low, indicating that investors should expect subpar long-term returns.
Tactically, the most concerning development has been the violations of both absolute and relative rising trend lines by semiconductor stocks, which were the market leaders.
Wait for the trend break
Another warning sign is the suppression of market volatility, as measured by the low value of the VIX Index. While some may see this as an accident waiting to happen, there is no obvious trigger.
Instead, I interpret the warnings as a market in need of a breather. The S&P 500 remains in a well-defined uptrend. While it would not be unexpected to see stock prices correct, I see no signs of any trend break that signals a major bearish episode.
I also pointed out last week that the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) flashed a buy signal when its 14-day RSI recycled from oversold to neutral. The market has been bifurcated between the narrow leadership AI-related plays and the rest of the market. I interpret the ITBM buy signal as the rest of the market is showing signs of positive price momentum after becoming oversold, which is a constructive sign.
In conclusion, the stock market advance in 2024 has been impressive, but prices can continue to rise. Market internals have become frothy and overbought in the AI-related leadership, but the rest of the market is showing signs of recovery that’s indicative of a leadership rotation. My base-case scenario calls for some near-term choppiness, followed by further gains into year-end.
While some of the technical warnings may be disturbing, they are not signs of an immediate major market top. Analysis from SentimenTrader put this into some context, the accompanying chart shows the spread between the percentage of S&P 500 stocks above their 200 dma and percentage of NASDAQ above their 200 dma (bottom panel). High spreads of 30% or more have signaled broad market tops in the past, but the tops can take some time to develop. Keep an eye on this development, but there is no immediate need to panic.
Debate Postscript: I am not fond of political bias in my investment analysis, but the consensus is that Biden performed very badly in the presidential debate last week and the odds of a Trump win have spiked in the betting markets. I reiterate my analysis from last week:
I project that a Biden win would be bearish for bond prices and mildly bullish for stock prices. A Trump win would be bond and USD bearish and gold bullish. The path of equity prices under a Trump Administration is too difficult to forecast as it depends on too many variables.
The first half of 2024 was very good to U.S. equity investors. The S&P 500 was up 14.5% excluding dividends for that period. As stock market investors look forward to the second half, the first order of business will be the Q2 earnings reports, and there are a number of unanswered questions.
The bulls will argue that forward 12-month EPS estimate revisions have been strong, which should be positive for stock prices. The bears will argue that top-down macro reports have largely missed expectations, which foreshadows a period of earnings disappointment and negative guidance. Moreover, valuations are becoming stretched, which will be a headwind for stock prices.
Who is right? Here is a preview of the Q2 earnings season.
A strong bottom-up outlook
Let’s start with the good news. As we look ahead to Q2 earnings season, FactSet reported that S&P 500 forward 12-month EPS revisions are strongly positive, which is a bullish sign of positive fundamental momentum.
On a bottom-up basis, Street analysts are expecting above-average EPS growth of 11.2% for 2024 and 12.7% for 2025.
A K-shaped recovery
On the other hand, Peter Atwater, author of The Confidence Map, has argued that the U.S. economy is undergoing a K-shaped recovery:
The haves suddenly had much more which, in turn, fostered an extraordinary wealth effect. For luxury in all its forms – fashion, travel, cars, real estate… – the post-COVID economy has been a golden era, sending companies like LVMH to the top of the charts.
Meanwhile, those at the bottom have not only been left behind as financial assets have soared, but with interest rates rising, they have paid a higher and higher price to stay afloat. Since 2021, food prices have risen by more than 20%, automobile loan rates have all but doubled, and today, U.S. banks charge over 25% on most credit card balances.
The net result is that behind a supposedly strong and resilient single U.S. economy, there are two: one where those at the top spend like there is no tomorrow, and one where those at the bottom struggle to make it through today.
The Transcript has documented anecdotal evidence of the K-shaped recovery from earnings calls:
“We’re seeing pretty consistent behavior with the upper-income consumers – they’re continuing to buy as they normally have.” – Casey’s General Stores CEO Darren Rebelez
“I think what we believe that we’re seeing is a little bit of impact on almost like a bifurcated economy. I think most people in this room feel pretty good about the economy, feel pretty good about what’s going on, but I think that…if you’re out there more in a working class at the lower end of the economy, you’re having to make choices every day about how to meet your mortgage, how to pay higher insurance costs, how to keep food on the table in a much higher cost environment… And so, they’re having to make tougher choices” – Phillips 66 CEO Mark Lashier
“…if you’re in the lower end of the income spectrum in the U.S., you’re under pressure from inflation…And you can see that pressure coming through — saw that pressure coming through in QSR restaurants and a number of areas where footfall or basket size was under pressure and, of course, consequent behaviors looking for affordability.” – Coca-Cola CEO James Quincey
Consumer-driven companies have responded by prioritizing a focus on volume growth by lowering prices. McDonald’s has famously brought back its $5 menu, along with a number of its competitors. General Mills revealed during its earnings calls that it’s increasing the practice of couponing in order to pursue volume growth.
From a top-down perspective, the Citigroup Economic Surprise Index (ESI), which measures whether top-down economic releases are beating or missing expectations, has weakened to levels last seen in 2022. This is indicative of a deceleration in the economic growth outlook that stands in direct contradiction to the sunny bottom-up earnings expectations of Street analysts. The silver lining to this dark cloud is that ESI has shown a rough correlation to bond yields, and lower yields would put upward pressure on stock prices.
The anecdotal evidence of lower price pressure is good news on inflation for the Fed. The market is now expecting two quarter-point rate cuts this year, with the first at the September FOMC meeting and the second at the December meeting.
Elevated valuation
Another concern for equity prices is valuation. The S&P 500 is trading at a forward P/E of 21.0, which is above its 5-year average of 19.2 and 10-year average of 17.8. These levels are above historical norms. It’s also a warning for investors who follow the Rule of 20, which stipulates that the stock market is overvalued if the sum of the P/E multiple and inflation rate is above 20.
On the other hand, I found a surprising result from my monthly screen of LBO candidates, (for an explanation of my LBO research see How To Buy A Company If You Have No Money).
In my first publication in late May, I screened non-financials within the S&P 1500 looking for LBO candidates, or stocks an investor could buy with no money down. Last month, I found no stocks fitting that criteria and 22 stocks which you could buy with 30% down.
The latest update of my screen revealed three stocks that an investor could buy with no money down and 25 stocks in total that you could buy with 30% down or less. This is a somewhat surprising result in light of the strong gains exhibited by the S&P 500 in June. I attribute this to the valuation bifurcation between large-cap technology stocks and small- and mid-cap stocks. Evidence of deep value is emerging among SMID cap stocks.
In conclusion, investors are facing a number of challenges as they approach Q2 earnings season. While bottom-up EPS estimate revisions are strong, top-down economic releases have been weak. As well, forward P/E valuations are elevated, which can create headwinds for stock prices.
I interpret these conditions as the characteristics of a mid-cycle expansion. Fundamental momentum, in the form of EPS expectations, drive the short-term trend and tells you whether you are likely to fall out of the window. Valuation, which matters in the long term but has little effect in the short term, tells you how far down the window you could fall. As long as momentum is positive, U.S. equities can continue to rise.
Mid-week market update: The S&P 500 has become an index of behemoth NVIDIA and everything else. The all-time high experienced by the S&P 500 in mid-June was largely attributable to the price action of NVIDIA. The rest of the market, as measured by the equal-weighted S&P 500, has been trading sideways for several months and never exceed the highs reached in late March.
Will the S&P 500 continue to rise, or is it destined to correct in the short run? The answer is “yes”. Here are the risks and opportunities.
The bear case
The bear case is easy to make. Semiconductor stocks, which have led the latest advance, are exhibiting signs of a loss in price momentum on both an absolute and relative basis.
If the semiconductors falter, can the rest of the market pick up the leadership baton? Don’t be so sure. The relative performance of cyclical stocks have been weak across the board, indicating a loss of macro momentum.
Speaking of momentum, different measures of the momentum factor, which measures whether stocks that are outperforming continue to outperform, has been flat to weak.
Sentiment, as measured by the put/call ratio, is low and appears frothy. Similar readings were indicative of short-term tops in the past.
I interpret these conditions as a stock market that’s vulnerable to a setback.
The bull case
On the other hand, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) recently flashed a tactical buy signal with its 14-day RSI reverted from oversold to neutral. This is a sign that the non-NVIDIA part of the market is starting to recover its price momentum from an oversold condition.
As well, the equal-weighted ratio of consumer discretionary to S&P 500 stocks is turning up, indicating positive risk appetite, which is a bullish sign.
So where does that leave us? I believe that technology stocks, and semiconductors in particular, are showing signs of bullish exhaustion and vulnerable to market weakness. On the other hand, the rest of the market is starting to rebound from weak oversold levels, which could put a floor on stock prices. It’s unclear whether the bulls or bears will prevail in the short run. My base case scenario calls for a period of near-term choppiness.
Tactically, investors could see some short-term volatility. The S&P 500 is consolidating after an upper Bollinger Band ride and anything can happen in the coming days. Thursday night will be the Presidential debate, followed by the PCE report Friday morning, which could be another source of market turbulence.
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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
A case of bad breadth
Anxiety has been increasing among the technical analysis community over the blatant instances of narrow market leadership and negative breadth divergence. Even as the S&P 500 rose to new all-time highs, the Advance-Decline Line, regardless of how it is measured, is exhibiting a series of negative divergences.
Even though these breadth divergences are concerning, they are not necessarily bearish signals. Here’s why.
Persistent divergences
Here is a monthly chart of the NYSE, S&P 500 and S&P 600 Advance-Decline Lines for a long-term perspective. The most notable negative divergence began in 1998 but the S&P 500 didn’t peak until March 2000, a span of two years. A shorter lead-lag relationship can be seen at the 2007 top and the 2021 top. In the two latter cases, the negative A-D Line divergences persisted for several months among both large and small caps.
We can see a similar pattern of a persistent warning signal from the BoA Global Manager Survey, which showed that institutions had cash at historically low levels, which should be contrarian bearish. In all cases, cash didn’t outperform until the condition persisted for several months.
In other words, breadth divergences are conditional warnings and they are not automatic and actionable sell signals.
A question of leadership
Technical analysts have largely focused on the narrowing leadership of the market. This 10-year chart shows that the relative performances of the equal-weighted S&P 500 and Russell 2000 have been abysmal. Even as the S&P 500 rose to all-time highs, relative breadth indicators were nosediving to all-time lows.
The flip side of the narrow leadership coin is the persistent strength in megacap technology stocks. The NYSE FANG Plus Index staged an upside breakout from a multi-year cup and handle formation in Q4 2023. Both absolute and relative performance is strong.
Even if you are cautious, do you want to stand in front of this runaway train with no obvious bearish catalyst? This analysis highlights the importance of of Bob Farrell’s Rule 4: Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
Waiting for the sell signal
In summary, the market advance is highly extended and stock prices can pull back at any time. However, turning tactically bearish here would be tempting fate by spitting into the wind.
I would prefer to wait for a trading sell signal. One possible candidate is an excessively low put/call ratio, indicating a crowded long, which is contrarian bearish.
Other sentiment models are also flashing warning signs. Marketwatch reported that PMorgan analyst Nikolaos Panigirtzoglou found that short interest on SPY and QQQ had evaporated and fallen to a new low.
Bear in mind, however, that sentiment is a condition model that can warn of an extreme condition, but it can’t be relied upon as a tactical sell signal.
On the other hand, while the S&P 500 appears extended, what’s the downside risk if the NYSE McClellan Oscillator (NYMO) and the NASDAQ McClellan Oscillator are near oversold?
As well, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) just flashed a tactical buy signal when its 14-day RSI recycled from oversold to neutral.
The week ahead
Looking to the week ahead, stock prices will be facing some liquidity headwind. The U.S. Treasury will have $211 billion in notes for sale. ON RRP is likely to rise as RRP rates are higher the then 1-month T-Bill rate, which would drain liquidity from the banking system.
Initial S&P 500 support can be found at the gap at 5370-5400, which represents a downside potential of less than -2%. The challenge for the bulls is to hold the line at that level. That’s when investors will find out whether the pullback will be deep or shallow.
In conclusion, while the conventional bearish view of negative breadth divergences is bearish, it isn’t necessarily correct. The bearish consequences of a negative breadth divergence can take over a year to be realized. Instead, they are warnings of bearish conditions than actionable tactical sell signals. I interpret current market conditions as highly extended that can pull back at any time, but investors should also recognize that the situation could resolve itself in a benign manner.
I am reiterating my bullish outlook on gold. The yellow metal staged an upside breakout from a cup and handle pattern in March. As well, the long-term inflation expectations of ETF (RINF) has been in a steady uptrend. The only question is how far and how fast can gold run?
The future may be bright as gold prices respond to unexpected inflation. The non-partisan Congressional Budget Office (CBO) recently updated its projection of the U.S. fiscal path by raising its FY 2024 estimate of the deficit from $1.5 trillion to $1.9 trillion, driven by emergency spending on foreign assistance to Israel, Ukraine and Taiwan, as well as student loan relief. The long-term picture also deteriorated, the deficit rises to $2.8 trillion by 2034 and debt is expected to grow to 122% of GDP by 2034.
For investors, much of its intermediate-term outlook depends on the outcome of the U.S. November elections and the trajectory of White House policies.
The path to fiscal dominance
The CBO report makes for sobering reading. Not only did the expected FY 2024 budget deficit rise by 27%, projected debt/GDP in 2034 was revised up from 116% to 122%.
It would be trite to say that the fiscal deficit is running out of control. Net interest outlays are expected to dwarf the primary deficit, or actual spending.
This makes for interesting policy choices for legislators and the Fed. Interest expense now exceeds the defense budget. Historian Niall Ferguson warned that the U.S. is starting to look like the late stages of the Soviet Union:
A chronic “soft budget constraint” in the public sector, which was a key weakness of the Soviet system? I see a version of that in the U.S. deficits forecast by the Congressional Budget Office to exceed 5 percent of GDP for the foreseeable future, and to rise inexorably to 8.5 percent by 2054.
The U.S. is on the path to fiscal dominance. It cannot resolve its fiscal challenges without resorting to some form of financial repression. In all likelihood, the Fed will own greater portion of Treasury debt in order to keep interest expense under control.
All eyes on the November election
In the intermediate term, the path of the deficit will depend on the occupant of the White House in 2025. While the Democrats and Republicans have different fiscal priorities, both are expected to expand the deficit. The only question is by how much.
As the Biden Administration is already well-known, investors should have some reasonable expectations of Biden’s economic policy. More industrial policy, such as the IRA and CHIPS Act, more military assistance for Ukraine and Taiwan, more social policy relief, such as student loan relief, and higher taxes for high income earners. Expect the deficit to expand at roughly the pace projected by the CBO under a second Biden term.
If Trump were to win in November, one sure bet would be the extension of the Trump tax cuts that are set to expire in 2025, whose effects were not scored by the CBO as they weren’t legislated. There will be more trade friction. Trump has proposed substituting tariffs revenue and eliminating the income tax.
I have many questions about this proposal. While Trump was vocal about eliminating income tax, he was silent on the payroll tax. Does that mean the payroll tax stays? Tariffs are levied on goods but not services. If a U.S. pharmaceutical or technology company minimizes its tax burden by funneling its profits to an Irish subsidiary which holds the bulk of the company’s intellectual property, would that be subject to tariffs and how does raising tariffs help onshore jobs to the U.S. in such instances? Income taxes are progressive by design, tax rates rise as your income rises, while tariffs, which is a consumption tax, is regressive. Since tariffs amount to a flat tax, tax rates fall as income rises and the burden of taxation falls mainly on lower income taxpayers. The regressive nature of such a regime would be exacerbated if Trump were to eliminate income taxes but not payroll taxes. Such an approach tilts the playing field toward suppliers of capital at the expense of the suppliers of labour.
Another major policy difference between Biden and Trump is immigration. A study from Barclays documented the immigration surge and estimates about 75% of job gains are filled by immigrants. The flood of immigrants has acted to restrain wage gains.
CBO director Phill Swagel analyzed the effects of the immigration surge and projects that lowers the deficit by $0.9 trillion for the 2024–2034 period.
In our baseline budget projections, which account for the immigrants in the surge and their children, the increase in immigration lowers deficits by a net total of $0.9 trillion over the 2024–2034 period. Specifically, revenues will be higher by $1.2 trillion over that period, in our estimation, and spending for mandatory programs and net outlays for interest on the federal debt will be higher by a total of $0.3 trillion as a result of the immigration surge.
One of the planks in Trump’s platform is to restrict immigration. These studies conclude that his policies will put upward pressure on the deficit and inflation.
In all cases, Trump proposals are inflationary. Viewed in isolation, extending the Trump tax cuts set to expire in 2025 would spike the deficit. While the elimination of income taxes could spark an investment and growth boom, which would rattle the bond market, raising tariffs puts upward pressure on consumer goods, which would also spike inflation.
I project that a Biden win would be bearish for bond prices and mildly bullish for stock prices. A Trump win would be bond and USD bearish and gold bullish. The path of equity prices under a Trump Administration is too difficult to forecast as it depends on too many variables.
Electoral expectations
How should investors position themselves ahead of the U.S. election?
The results of the election may hinge on turnout. A NY Times analysis of presidential polls found that Biden has an advantage among engaged voters while Trump leads among less engaged voters. In other words, Biden leads among survey polls while Trump leads in registered voter surveys.
I have long held the belief that market prices have informational content. Here are a few ways of handicapping the election. First of all, RealClearPolitics’ board of betting odds shows Trump in a clear lead, though the liquidity in the betting markets is thin.
As Trump has a history of being a hawk on trade policy, Bloomberg columnist John Authers has proposed that investors monitor the stock price of FedEx, the global transportation logistics giant who would benefit from rising global trade.
The accompanying chart shows the price of FedEx, along with its relative performance against an equal-weighted S&P 500 benchmark, which was chosen to mitigate the recent dominance of large-cap technology stocks. FedEx is mired at the lower end of its relative performance band, which is an indication that the market may be expecting headwinds for global trade.
For completeness, here is FedEx rival UPS, who is showing a similar pattern of underperformance.
Another group of losers under a Trump Administration would be the stock markets of NAFTA partners Mexico and Canada. Here is a chart of MSCI Mexico (in USD). Its relative performance is shown against the MSCI All-Country World Ex-U.S. Index in order to mitigate the recent strong leadership effects of U.S. technology stocks. Mexican stocks skidded in the wake of its own election, so some of the weak relative returns can be ignored.
Here is MSCI Canada, which has also been weakening on a relative basis.
In conclusion, the latest CBO fiscal update raises the odds of upside inflation surprises in the coming years, which would be bullish for gold. The intermediate-term outlook for inflation will largely depend on the outcome of the November election. I project that a Biden win would be bearish for bond prices and mildly bullish for stock prices. A Trump win would be bond and USD bearish and gold bullish. The path of equity prices under a Trump Administration is too difficult to forecast as it depends on too many variables. A survey of market-based indicators suggests that the electoral momentum is toward Trump and away from Biden.
Mid-week market update: I am publishing this earlier than usual as the U.S. markets are closed for the Juneteenth holiday.
The S&P 500 has gone on another upper Bollinger Band ride, accompanied by a severely overbought reading on the 5-day RSI, which is over 90%. Overbought conditions are often not bearish, but a manifestation of strong price momentum, otherwise known as a “good overbought” signal. That’s bullish, right?
Here is what’s different this time. The overbought condition occurred along with signs of weak breadth, as evidenced by a series of negative net highs-lows on both the NYSE and the NASDAQ even as the index made new all-time highs.
Negative divergences
Signs of poor breadth are confirmed by negative divergences from risk appetite indicators. Even as the S&P 500 advanced to new all-time highs, equity risk appetite, as measured by the relative performance of high beta to low volatility stocks (dotted red line), have been trading sideways since mid-April. A similar pattern can also be seen in the relative price returns of junk bond to their duration-equivalent Treasuries. What’s worrisome is both indicators weakened in the last week even as the S&P 500 rose.
Poor breadth is also triggering a Hindenburg Omen cluster for NASDAQ stocks, which is an indication of a highly bifurcated market that’s losing price momentum. There have been 15 clusters in the last 10 years. Nine of them resolved bearishly and six did not.
As well, the put/call ratio is nearing a crowded long condition, which is contrarian bearish.
Tech’s narrow leadership
I have documented the narrow leadership of large cap technology and the trend continues.
On the other hand, it’s difficult to see much equity price downside if Treasury yields are weak. The 2-year yield is testing support while the 10 and 30 year yields have violated support.
My base case calls for a 60% chance of a 5-10% downdraft, and a 40% chance of a sideways consolidation. Those aren’t sufficiently compelling odds for my inner trader to step off the sidelines and short the market.
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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Time for cheap protection?
Last week, I suggested that the stock market was susceptible to a setback (see A Time For Tactical Caution). Even though the pullback never appeared, I reiterate my cautious view, though I am not outright bearish.
In light of the market’s vulnerable position, it may be time to exploit the low VIX and buy some cheap downside protection in the form of protective put options. The S&P 500 achieved a fresh all-time high while exhibiting a negative 5-week RSI divergence. As well, the VVIX/VIX ratio is showing a negative divergence. Such episodes have tended to resolve bearishly in the past. As well, the VIX Index is low and testing its lower boundary at 12, indicating low option premium and cheap cost of downside protection.
Narrowing breadth
One of my concerns is that breadth has been narrowing instead of broadening as it often does during a bull market. Even as the S&P 500 reached an all-time high, market breadth is narrowing and not broadening out.
To illustrate my point, here is the relative performance of growth sectors. Only technology stocks are showing signs of leadership.
The relative performance of value and cyclical sectors are nosediving.
For completeness, here is the relative performance of defensive sectors, which are all lagging. Even Utilities, which recently gained a bid on the promise of AI data centre demand, rolled over in June.
In other words, only a single sector, technology, is exhibiting signs of market leadership. The other 10 sectors are lagging the S&P 500. The narrow leadership is occurring against a backdrop of a technology sector forward P/E of 30.5, which was last seen in May 2002.
The narrowness of market leadership can also be seen from a market cap viewpoint. Not only is the small cap Russell 2000 underperforming the S&P 500, but also small cap NASDAQ stocks (QQQJ) are exhibiting a similar pattern of underperformance against the NASDAQ 100.
As breadth divergences can last for a considerable time, these conditions aren’t necessarily fatal to the bull run. Instead, it should be interpreted as a signal for caution.
Silver linings
Here is the silver lining in the dark cloud for the bulls. The market’s risk-on tone has been supported by a retreat in Treasury yields across the board that have shown a pattern of support violation.
Already, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) is on the verge of a buy signal setup. The 14-day RSI of ITBM has reached an oversold reading and a buy signal occurs when it recycles from oversold to neutral.
In conclusion, a series of negative breadth divergences is signaling caution for the stock market advance. However, breadth divergence can persist for a long time and these divergences should be regarded as cautionary conditions and not outright sell signals. Investors should take steps to mitigate their long exposure using risk control techniques, such as the use of trailing stops, or take advantage of the low VIX to buy cheap downside put protection.
Remember that equity investors tend to enjoy strong returns in the absence of recession, which dents returns, or war and revolution, which can result in a permanent loss of capital. With those caveats in mind, the market gods are presenting patient investors with three gifts from the three economic blocs in the world: the U.S., Europe, and China.
Powell’s dilemma
The “dot plot” published in the aftermath of the June FOMC meeting was starkly hawkish. Four members, likely Fed Governors Bowman and Waller, along with Barkin of the Richmond Fed and Bostic of the Atlanta Fed, projected no rate cuts in 2024. There is a significant minority on the FOMC who are opposed to a rate cut this year.
It should also be acknowledged that inflation is decelerating even as the Fed Funds rates stays steady, which has the effect of a de facto tightening of monetary policy as the real Fed Funds rate rises.
The lower-than-expected CPI and PPI readings in May served to underline this point. With both CPI and PPI reported, estimating the May core PCE, the Fed’s preferred inflation metric, becomes easier. The Cleveland Fed’s inflation nowcast is now calling for a May core PCE of 0.1%.
That’s why all FOMC members a projecting rate cuts in the future. The question is one of timing. While we are seeing are welcome signs of tame inflation, the market has seen similar episodes in the last half of 2023. That’s why the FOMC hawks don’t appear convinced.
In the wake of soft inflation reports, the market is pricing in two rate cuts this year. One in September, followed by a second in December.
Here is Powell’s political problem. The Fed will have difficulty cutting rates ahead of an election in the face of entrenched opposition within the FOMC without appearing to be helping the incumbent President. He can’t afford to have any dissents on a rate cut decision at the September meeting.
Powell’s challenge was to communicate an explicit process for a rate cut or pause at the September meeting while avoiding any discussion of his political problem, which he failed to do at the post-FOMC meeting press conference. All he could manage was to repeat the mantra that the test for any cut is greater confidence in lower inflation or unexpected weakness in the jobs market. Even then, he declined to specify numeric benchmarks for inflation or employment, other than to say that the Fed is looking at a spectrum of data.
Such an approach to communications policy is a recipe for failure. Unless we see a string of very soft inflation readings between now and the September meeting or a collapse in employment, the market is likely to be disappointed.That’s the opportunity setup for investors. The macro backdrop of continued strong growth looks like either a soft landing or even no landing. As long as EPS estimates continue to rise, stock prices should advance even in the face of a pause in rate cuts. Remember that recessions are bull market killers, and there are no signs of recession on the horizon.
That’s the first gift from the market gods for patient investors. A pullback from a delayed rate cut is on the way, and it’s a buying opportunity.
Macron’s gambit
Across the Atlantic, financial markets were rattled when French President Macron unexpectedly dissolved the National Assembly and called an early election in the wake of strong gains by Marine Le Pen’s far right Rassemblement National (RN) in European parliamentary elections.
The timing of the election calls was unfortunate. S&P recently downgraded French debt on May 31 and spreads against German Bunds are blowing out. Bloomberg columnist John Authers highlighted a growing risk to the eurozone’s financial system. The Greek Crisis was a problem that Europe could survive. France and Germany are the two pillars of Europe and France is too big to save.
Now comes the terrifying part. The Greek crisis was brought to a head when the radical leftist Alexis Tsipras became prime minister in 2014. A French legislature headed by the forces of Marine Le Pen might play the same role at a time when French indebtedness has made the risk of crisis much greater… there’s the risk that most scares investors — that the Rassemblement does get to form a government, and then provokes a crisis within the eurozone that the euro could not survive. That remains unlikely. But ultimately, Europe confronts a low-probability extreme event. These are just the things that markets can’t deal with. Judging how to respond is their nightmare.
What was Macron thinking? Has his political gambit backfired? An early poll shows the far right in the lead, the left in second and Macron’s party in third place. As a reminder, the French electoral system is based on runoffs. If any candidate doesn’t achieve a simple majority in an election, the top two candidates go head-to-head in a second round runoff.
However, the polling results are highly preliminary. Macron’s surprise announcement set off a scramble to set candidate lists and form political alliances. The parties on the left acted first by forming a Nouveau Front Populaire to field a slate of candidates, though the coalition appeared slightly shaky as the Socialists were opposed to the alliance.
The right disintegrated in the wake of the election call. First, the president of Les Républicains Éric Ciotti announced on TV an alliance with Le Pen’s RN, only to be publicly fired and repudiated by the party’s executive. It’s unclear at this point the status of Les Républicains, the party of Chirac and Sarkozy.
The far right also splintered. Jean-Marie Le Pen’s granddaughter Marion Maréchal, who allied with Éric Zemmour’s Reconquête instead of her aunt Marine Le Pen’s party in the last election, announced on live TV that she would join her aunt’s RN. The announcement came as a complete surprise to Zemmour, who denounced it as the “world record of betrayals”. Chaos ensued.
If Macron’s strategy was to the far right, his election call is starting to look Jupiterian. Further disarray on the right could cause the markets to sigh in relief. However, his decision may come at a price of a left-wing resurgence that destroys his own centre-right coalition.From a technical perspective, the financial mini-panic may be nearing a crescendo. The Euro STOXX 50 skidded on Friday to test a key support level. Keep an eye on whether support holds.
No doubt there will be more drama ahead in the coming days, but this looks like the buying opportunity that accompanies the usual episode of European Crisis Theatre and a second gift from the market gods for patient investors.
The PBOC surprise
The third gift from the market gods appeared when the PBOC announced that it had suspended gold purchases. Gold prices skidded about $20 on the news and it’s testing a support level of $2300.
I have been long-term bullish on gold. The metal staged an upside cup-and-handle breakout at $2100 and it hasn’t looked back ever since. Moreover, the gold/S&P 500 ratio is forming a constructive saucer-shaped multi-year bottom that should see it outperform equities in the coming years.
Tactically, I had been concerned about the short-term extended nature of the advance in gold and gold miners but the PBOC news could be a catalyst for some welcome weakness. The gold miner ETF (GDX) had become overbought on the percentage bullish on P&F indicator and it was exhibiting a series of negative RSI divergences. Past episodes have tended to resolve in pullbacks that have turned out to be buying opportunities.
In conclusion, market conditions are setting up for buying opportunities in three markets. U.S. equities will probably weaken on disappointment over the timing of rate cuts. European stocks corrected over political turmoil in France that’s likely to be temporary. China’s announcement that its central bank had suspended gold buying looks like an entry point in the near future.
Mid-week market update: The option market was pricing in a daily equity market swing of 1.6% ahead of today’s events, namely the May CPI report and the FOMC decision. Even though the S&P 500 gained strongly today, the move could be said to be disappointing in volatility terms.
The bullish tone was set this morning by the softer than expected CPI report. Stocks gained but didn’t react much to the FOMC decision, despite the hawkish tone of the Summary of Economic Projections. Bond prices held above a key resistance level, and the USD weakened, indicating a risk-on tone.
The market is fighting the Fed, should you?
A soft inflation report
The May CPI report was much softer than expected. May core CPI (blue bars) came in at 0.16%, which was cooler than the forecast consensus of 0.3%. Supercore services (red bars) was also weak. These are all welcome signs of moderating inflation readings. The one caveat is this is only one data point and don’t necessarily represent a sufficient trend for the Fed to be confident about cutting rates.
As I’ve pointed out before, the Citi Inflation Surprise Index has been coming down for most major economies. It was therefore no surprise that other central banks, such as Switzerland, Sweden, the ECB, and Canada, have initiated rate cut cycles.
How the Fed is different
In many ways, the U.S. is different and it has shown an unusual degree of strength when compared to other economies. The Fed’s Summary of Economic Projections (SEP) published today contained several hawkish surprises.
Upward revisions in the dot plot of year-end Fed Funds projections;
Expected rate cuts reduced from three to one;
An upward revision to the long-term Fed Funds equilibrium rate.
Fed Chair Powell was asked during the press conference a number of questions that he tried very hard not to answer. The projected 2024 GDP growth rate and the unemployment rate are unchanged from March, why did the inflation forecast rise? Can you reconcile the median projection of one rate cut of one this year against no projected changes in growth or unemployment?
What Powell couldn’t say was the “dot plot” showed four participants are projecting no rate cuts in 2024. There is a significant minority of hawks in the FOMC who are adamant against rate cuts. Powell has a problem of cutting rates before the election without the move being politically motivated. He can’t afford to have any dissents. Nevertheless, the market is expecting two rate cuts this year. One in September and one in December.
I think that the market is likely to be disappointed in light of Powell’s political bind.
A vulnerable stock market
This leaves the stock market vulnerable to a short-term setback. The S&P 500 spiked above its upper Bollinger Band in the wake of this morning’s CPI print. In the past, such events have been followed either by an upper Bollinger Band ride or the sideways consolidation of a few days before making the next tactical directional move. What’s different this time compared to past upper BB spikes is relative breadth is narrowing.
It’s not unusual to see directional market moves on FOMC decision day reverse themselves the next day. Tomorrow’s PPI report could be a negative catalyst. While I am not an advocate for shorting this market, you should also be aware that stocks can pull back at any time.
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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
The bull isn’t done
Make no mistake, I am intermediate-term bullish on U.S. equities. The monthly MACD buy signal remains in force and there are no signs of any negative divergence that signals a major market top.
Beneath the hood, however, disturbing signs of that not all is well in the short run. Here are bull and bear cases.
The bull case
Let’s start with the bull case for stocks. It is said that there is nothing more bullish than a stock market that makes new highs. The current bull is still young by historical standards and should have much further to run.
Sentiment readings are supportive of more gains. The latest NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, retreated from an excessively bullish reading to a neutral level.
The 10 dma of the CBOE put/call ratio rose steadily even as the S&P 500 rallied, which is a sign of skepticism of the market advance – another contrarian bullish signal.
Bearish cautionary signals
On the other hand, cautionary signs are appearing beneath the surface. The price momentum factor has gone nowhere. I distinguish between the concept of market momentum, which is the propensity of a stock market that’s rising to continue rising, and the price momentum factor, which measures whether stocks that are beating the market continue to beat the market.
The accompanying chart shows the relative performance of different price momentum ETFs. Each defines momentum in a slightly different way and each rebalances its portfolio at different times. In all cases, the price momentum factor is turning down, indicating leadership uncertainty.
One of the most important “tells” of market direction is the relative performance of defensive sectors. If they outperform, it means that the bears are gaining control of the tape. The jury is still out on that score, but it is disturbing for the bull case that the relative performance of three of the four defensive sectors are bottoming and trading sideways even as the S&P 500 reaches all-time highs.
Equally concerning is the relative performance of most cyclical industries. With the exception of semiconductors, cyclicals have rolled over when measured against the S&P 500.
Jason Goepfert of SentimenTrader observed that the NASDAQ Composite made a record high even as 52-week lows exceeded 52-week highs. While the sample size is relatively small (n=10), the market has tended to resolve such conditions in a bearish manner. In light of the importance of NASDAQ growth stocks in the weight, this will pose severe near-term headwinds for the S&P 500.
Equally ominous is the appearance of a cluster of Hindenburg Omen signals for the NASDAQ. Single Hindenburg Omen signals tend to be insignificant, but clusters of omens have tended to precede downdrafts.
In addition, every formulation of the Advance-Decline Line is exhibiting negative divergences against the S&P 500.
None of these conditions are automatic sell signals as there are no bearish triggers. I was asked by several readers in the wake of my last post with bullish overtones if I was long the market in my trading account (see A well-telegraphed market advance). My answer isI interpret current conditions as a weak bull pushing price upward, but the market is fragile and can pull back at any time. My base case calls for stock prices to grind upward, albeit in a choppy manner over the next few weeks.
Is good economic news good news for equities or bad news? We know how to interpret macro news for the bond market. The Citi Economic Surprise Index (ESI), which measures whether top-down economic releases are beating or missing expectations, has been a bit weak. Historically, a weak ESI has meant lower bond yields.
What does it mean for equities? Investors saw a string of weaker-than-expected macro prints last week, starting with an anemic ISM PMI on Monday, followed by a miss on job openings in JOLTS Tuesday and another miss on ADP employment Wednesday. In each of those cases, bond prices rallied and equities initially weakened, followed by price recoveries later in the day.
I interpret events from the perspective of three trading desks: bonds, commodities and equities.
The bond market reaction
Let’s start with the view from the bond desk.
The Bank of Canada did it, and so did the European Central Bank. Both announced quarter-point rate cuts last week — when will the Fed follow suit?
Up until Friday’s May Jobs report, Treasury yields fell across the entire yield curve in response to the trend in weaker-than-expected economic data. The 2-year yield bounced off a key technical support level, while longer-term yields tested support.
The closely watched employment picture is showing mixed signals. Fed Chair Jerome Powell has cited the number of job openings per available worker as an indicator of labour market tightness. The April JOLTS report shows that this metric has normalized back to pre-pandemic levels.
Even though the headline nonfarm payroll establishment survey and average hourly earnings release surprised to the upside, the noisy household survey was deeply negative and the unemployment rate actually rose. As well, the quits to layoffs ratio, which is a leading indicator of nonfarm payroll employment, has flatlined since last summer, with the caveat that this is a noisy data series.
The jobs market may be much weaker than the headlines show. Bloomberg Chief U.S. economist Anna Wong argued that the Establishment survey is overstating employment by about 100,000 because of errors in the birth-death adjustment from the Quarterly Census of Employment and Wages (QCEW), which is reported with a significant delay.
How should investors interpret this data? For now, the consensus view is mildly dovish. Fed Funds market expectations calls for the first cut expected at the September FOMC meeting and almost a coin flip as to whether we will see a second cut at the December meeting.
The commodity market reaction
The view from the commodity desk is one of economic weakness.
Commodity prices have been either trading sideways or in decline, depending on what index you use. The headline commodity indices, which tend to be heavily weighted in energy because of their higher liquidity, have been falling in the wake of last week’s OPEC+ decision to gradually allow the potential return of OPEC barrels to production. The cyclically sensitive copper/gold and base metals/gold ratios are also pulling back after a surge during the April–May period.
Precious metal investors were blindsided when the PBOC announced that it had stopped buying gold after an 18-month stretch of accumulation.
However, investors may want to take the commodity desk’s view of cyclical weakness with a grain of salt. Commodity prices are undergoing a period of negative seasonality, which should end about mid or late July.
The equity market reaction
By contrast, the view from the equity desk is bullish.
From a fundamental perspective, global EPS estimate revisions have turned positive, with the sole exception of China.
Analysis from John Butters of FactSet confirms this view. S&P 500 EPS estimate revisions have been strong.
Moreover, references to the term “recession” on earnings calls are fading.
The market’s price momentum has been strong. Ryan Detrick pointed out that the historical evidence indicates that strong price gains tend to beget more price gains.
Growth deceleration or disinflation?
In summary, the bond and commodity markets are signaling weakness while equity markets are signaling growth. How should you reconcile these disparate views?
I think investors should distinguish between economic growth deceleration, which would stand in direct contrast to bottom-up Street expectations of rising EPS estimates, and disinflation. A growth deceleration would pose headwinds to equity price gains, while disinflation would be a positive factor. That’s how you determine if good economic news is good news or bad news for equity prices.
As the economic indicators stand today, job openings have come down without a significant rise in unemployment. That’s what the fabled soft landing looks like, and it should be equity bullish.
Mid-week market update: The S&P 500 has risen to a new all-time high, and this move was well-telegraphed. I wrote on the weekend and characterized conditions “half-hearted buy signals that indicate low downside risk”.
The S&P 500 subsequently staged an upside breakout from a bull flag to a fresh all-time high.
The move was even more impressive on the S&P 500 hourly chart. The index staged a furious last hour ramp on Friday on no news. The market retraced about half of the advance on Monday on an intra-day basis on concerns over a weak ISM report, but reversed upwards to close the day in the green. It saw a similar pattern of weakness and reversal Tuesday in reaction to an anemic jobs openings print from the JOLTS report. And on Wednesday the S&P 500 blasted off to a new all-time high.
Bullish confirmation
The upside breakout was confirmed by cross-asset return patterns. Treasury bond prices broke out of a minor resistance level. The USD, which has been inversely correlated to stock prices, was rejected at resistance. Oil prices weakened in reaction to this week’s OPEC decision, which should be positive for the headline inflation outlook.
The relative performance of equal-weighted consumer discretionary stocks, which is a cyclical indicator, has turned up. If history is any guide, this is the start of a significant advance.
That said, I am a little concerned that breadth isn’t broadening out.
However, NYSE 52-week highs-lows have turned positive, indicating bullish momentum.
In conclusion, these are all risk on signals, though Friday’s Jobs Report could be a source of volatility.
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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
A failed breadth thrust?
Is the Triple 70 breadth thrust that triggered on May 6 in trouble? As a reminder, a Triple 70 breadth thrust occurs when the percentage of NYSE advances exceed 70% for three consecutive days, which is a bullish momentum signal. If history is any guide, Rob Hanna’s study of such events has seen strong bullish momentum follow through.
On the other hand, the short-term warning signs have been appearing everywhere. Even as the S&P 500 advanced to new all-time highs, the 5-week RSI flashed a negative divergence, and so did the VVIX/VIX ratio.
Is this evidence of a failed breadth thrust? How should investors react to the simultaneous appearance of bullish price momentum signals like a breadth thrust and the risk of dips from negative technical divergences?
Warning signals
The warning signs were plain to see. I highlighted the excessive bullishness of the put/call ratio last week.
Moreover, the daily S&P 500 chart was flashing warning signs. It’s not unusual for the index to consolidate sideways for a few days after reaching its upper Bollinger Band before making the next directional move. The latest move was foreshadowed by a bearish recycle of the stochastic from overbought to neutral. However, the market did show a constructive reversal candle on Friday, which needs to be confirmed by bullish follow through next week.
Limited downside risk
In light of the short-term warning signs, how far can the market pull back?
The bulls can be consoled by the fact that the market is already showing near oversold readings, indicating a relatively shallow pullback. Of the five components of my Bottom Spotting Model, one, the NYSE McClellan Oscillator (NYMO), flashed a buy signal when it reached an oversold condition last week. A number of other indicators are close to buy signals. The VIX Index is nearing the top of its Bollinger Band, and the intermediate-term overbought/oversold indicator is also near an oversold condition. Historically, the market is close to a bottom when two or more components of the Bottom Spotting Model trigger buy signals.
The Zweig Breadth Thrust Indicator, which is reported with a delay, came within a hair of an oversold condition last week, and its real-time estimate did become oversold, though that does not count as an “official” oversold reading. In the past, the market has bottomed soon after similar episodes.
As well, one of the important indicators of equity risk appetite, which was bearish last week, is turning up. The relative performance of equal-weighted consumer discretionary may be bottoming, which is a constructive sign.
While these are not definitive market bottom signals, I interpret these as half-hearted buy signals that indicate low downside risk.
Key risk
Even though I believe any pullback should be shallow, the key risk to my bullish outlook is the reaction of the bond market. Last week’s blizzard of Treasury supply was not well received and caused some indigestion among buyers.
Notwithstanding the softer-than-expected core PCE report that depressed bond yields, auction supply is expected to rise and peak in June. This will put additional pressure on yields in the new month and present a key test for risk appetite. {Corrected chart below)
In conclusion, I believe the bullish implication of Triple 70 Breadth Thrust triggered on May 6 is still alive. The U.S. equity market has just hit a temporary air pocket and should experience a shallow pullback. The key risk is how the bond market reacts to a continuing flood of issuance in June, which could put upward pressure on yields and downward pressure on risk appetite.
The closely watched April PCE moderated as expected. Headline PCE came in 0.3%, in line with expectations, while core PCE was 0.2% (blue bars), which was softer than expectations. Supercore PCE, or services ex-energy and housing, also decelerated (red bars). This latest print represents useful progress, but won’t significantly move the needle on Fed policy.
The worrisome development is the global trend of transitory disinflation. The Citi Inflation Surprise Index, which measures whether incoming inflation data is beating or missing expectations, is bottoming in most countries and rising again. If this continues, any expectations of ongoing rate cuts are likely to be pulled back.
Now that 2024 is nearly half over, it’s time to peer into 2025 to see the upside and downside factors that are expected to affect inflation and the Fed’s interest rate trajectory. The three main factors to consider are changes in immigration policy and how they affect employment; the evolution in productivity; and the possible political effects of the election on inflation.
Immigration and labour supply
Immigration has become an increasingly touchy subject in the 2024 election. What’s surprising is the degree of agreement about not only restricting illegal immigration, but also the willingness to shrink the pool of unauthorized workers.
The Fed has weighed in on this touchy topic. When asked about the labour market, Fed Chair Jerome Powell said during the December post-FOMC press conference that, “The labor force participation rate has moved up since last year, particularly for individuals aged 25 to 54 years, and immigration has returned to pre-pandemic levels. Nominal wage growth appears to be easing, and job vacancies have declined.”
In particular, the prime age (25–54) labour force participation rate (red line, right scale) has recovered quicker post-pandemic than the overall participation rate (blue line, left scale). Powell hinted that immigration may serve some role in supplying more workers and curbing wage growth. “Does labor force participation have much more to run? It might. Immigration could help, but it may be that, at some point—at some point, you will run out of supply-side help, and then it gets down to demand, and it gets harder.”
So what happens if there is a border bill that either restricts unauthorized immigration or implements a mass deportation of illegal workers? I looked at the data to test the hypothesis that unauthorized immigration is expanding the labour supply more than normal.
Unauthorized workers mostly toil in low-skilled and low-wage jobs. From a policy standpoint, few are worried about the Canadian who sneaks across the U.S.-Canada border to work at a six-figure job as a project manager at GE. The Atlanta Feds’ Wage Growth Tracker shows that workers with high school education (green line) has usually lagged overall wage growth (blue line), but the rate of wage increase has exceeded the median in the post-pandemic era. If there is an excess supply of unauthorized workers during that period, they should be depressing wage growth, which is not evident in the data.
Here’s another way of analyzing wage growth in greater detail. The accompanying chart shows the average hourly earnings of production and non-supervisory workers (black line), of retail trade workers (red line) and of leisure and hospitality workers (blue line), all normalized to 100 in January 2019, which is about a year before the onset of the pandemic.
While low-wage workers are concentrated in retail and leisure and hospitality, retail employment tends to require a higher skill level and have a language requirement for client-facing positions compared to leisure and hospitality workers. As the chart shows, average hourly earnings for retail workers have lagged the overall average in the post-pandemic era, while leisure and hospitality average hourly earnings have been stronger. As unauthorized workers tend to cluster more among leisure and hospitality, excess supply in this group should show up as depressed wages not higher ones.
Now imagine that in the 2025 post-election world the White House and Congress come to an agreement on an immigration bill. Regardless of whether the bill just restricts the supply of illegal immigrants or takes active steps to deport them, it will worsen labour supply at the low-wage end of the market, tighten the jobs market and create upward pressures on inflation.
The market is currently discounting one rate cut in 2024, which is expected to occur at the September FOMC meeting. All else being equal, any immigration bill to restrict labour supply in an already tight jobs market may resolve itself in no rate cuts and possibly rate hikes in 2025.
The productivity wildcard
Productivity is the cure for inflation. Better productivity is an offset to higher growth and wages. Analysis from the non-partisan Congressional Budget Office (top left chart) dramatically shows how productivity matters and how it affects not only inflation, but also the degree of fiscal room the government will have in the future.
The question of how productivity evolves has been a puzzle for Fed policy makers as productivity gains have been noisy. Powell discussed this policy dilemma at the May post-FOMC press conference: “We saw a year of very high productivity growth in 2023, and we saw a year of, I think, negative productivity growth in 2022. So I think it’s hard to draw from the data.”
As the accompanying chart shows, changes in productivity (blue line) are very noisy. It’s not unusual to see a leap in productivity when the economy revives from a recession. Economic output rebounds, but the number of workers is still low, which shows up as higher output per worker, or a productivity improvement. Productivity fell and went negative after the initial leap in the post-pandemic era, and it has risen again. What’s different this time is the prime age participation rate is also rising, indicating that productivity gains are not the result of fewer workers, which is a constructive development.
There are several schools of thought on productivity. The conventional view is that changes in productivity are noisy and Fed policy makers can’t reliably depend on productivity gains to moderate inflationary pressures.
A more constructive view is that the adoption of AI will drive powerful productivity gains in the coming years. There are numerous anecdotes of productivity gains through AI. One example can be found in this paper from the world of investing that found “machine learning models not only generate significantly more accurate and informative out-of-sample forecasts than the state-of-the-art models in the literature but also perform better compared to analysts’ consensus forecasts”.
On the other hand, the excitement over AI and large language models sounds remarkably like the hype over self-driving cars about 10 years ago. AI can get you 90–95% of the way, but the last 5% or 10% represents a last-mile problem that’s very difficult to solve. The St. Louis Fed published a paper that projected the pace of AI adoption to be similar to that of PC adoption, which is a cycle with an elongated pace of productivity gains.A more nuanced view is that PPP and inflation-adjusted productivity have been gaining steadily on a global basis, aside from Japan and Italy. The only difference is the strength of the USD.
Election effects
While it’s always difficult to predict electoral outcomes and it could be argued that polls aren’t very meaningful until the campaign begins in earnest in September, current market expectations of aggregated betting odds has Trump leading Biden despite his felony convictions last week.
With that in mind, Bloomberg reported that Deutsche Bank economists project that Trump’s proposed tariffs are expected to raise headline PCE by 1.2% and core PCE by 1.4%. This will force the Fed’s hand to pivot to raising rates.
In addition, investors will have to be prepared for the second-order effects of trade policy and Fed policy. If Trump, who is a self-professed “debt and low interest rate” guy, tries to politicize or change either the Fed Chair or the make-up of the Fed Board of Governors in order to force lower rates, expect USD weakness, accelerating inflation and possibly stagflationary growth.
In conclusion, I peered into 2025 to see how U.S. inflation may evolve with specific focus on changes in immigration policy and how they affect employment, the evolution in productivity and the possible political effects of the election on inflation. Upward pressures on inflation will come from changes in immigration policy and a Trump win. Productivity gains are uncertain and AI-driven gains are likely to take a long time to be realized.
Such an environment is typical of a mid- or late-cycle expansion. It is bond price unfriendly, and neutral or positive for stock prices, depending how the nominal growth outlook evolves.
Mid-week market update: I pointed out on the weekend that it’s not unusual for the S&P 500 to consolidate sideways after reaching its upper Bollinger Band before the market makes its next major directional move. There have been five other similar instances in the last six months. What’s a little unusual about the current episode is the length of the consolidation.
Even though the S&P 500 remains in its narrow consolidation range, the odds point to a shallow correction, as the daily stochastic has recycled from overbought to neutral, which is a sell signal. Initial SPY support can be found at 520-525, and secondary support at 505-510, based on volume by price analysis.
Narrowing leadership
Here’s what is bothering me. Even as the S&P 500 advanced, leadership was narrowing and it wasn’t broadening out.
Market leadership had become AI and NVIDIA and virtually nothing else. The technical condition of the Semiconductor Index as a proxy for AI plays appears precarious. On an absolute basis (top panel), the index staged an upside breakout and it’s pulling back to test its breakout turned support level. On a relative basis (bottom panel), it was rejected at an intersection of relative resistance levels, which is concerning.
I am also seeing a number of bearish cross-asset signals. Yesterday’s poor Treasury auction didn’t help risk appetite. The 7-10 year Treasury ETF (IEF) broke a key support level today. The USD is strengthening and testing a key resistance level, and oil prices are rallying. These are all signs that point to a risk-off environment.
A crowded long
In addition, analysis from the Leuthold Group showed that “commercial hedgers” in the S&P 500 e-minis, who are generally regarded as the “smart money”, have a short position similar to levels before the last major correction in early 2022. An interpretation of flip side of this coin is a crowded long by the “dumb money”, which would be contrarian bearish.
A modest correction
SentimenTrader is calling for a modest correction after last week’s downside break, which was the day my inner trader took profits in his long S&P 500 positions.
I agree with the modest correction call. Two of the five bottom spotting indicators in my Bottom Spotting Model are close to a buy signal. It wouldn’t take much of a market downdraft for the VIX Index to spike above its upper Bollinger Band, and the NYSE McClellan Oscillator (NYMO) is very close to an oversold reading.
Perhaps the PCE report could provide a catalyst on direction. Either way, don’t panic and get ready to buy the dip.
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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Bearish Capitulation
Morgan Stanley’s strategist Mike Wilson has been one of the more prominent bears left standing and he capitulated last week. Now that Wilson has reluctantly turned bullish, is it time to turn contrarian bearish on stocks?
I can think of two scenarios for the U.S. equity market. The bulls will argue that the market structure of the S&P 500 shows the index has outrun the bullish channel, as defined by the solid lines, and ascended to a steeper channel, as defined by the dotted lines. The advance has been characterized by a series of “good overbought” RSI signals. The bullish scenario opens up a short-term objective of 5500 before the rally is done.
The bears will argue that the combination of the “buy the rumour, sell the news” market reaction to the strong NVIDIA report and the negative divergence on the 5-week RSI is a signal of an exhaustive advance.
Bull or bear? Here are the signposts to an intermediate-term market top.
What could derail the bull?
I’ve made the point before that the U.S. economy is undergoing a mid-cycle expansion (see Relax, It’s Just A Mid-Cycle Expansion). In order for the equity bull to continue, it needs stable interest rates, continued economic growth and rising earnings.
Let’s begin with the issue of interest rates. The market took a risk-off tone after the release of the FOMC minutes, which had a hawkish tone and put the possibility of rate hikes on the table. Expectations shifted from two rate cuts this year to just one, and the timing of the first cut was pushed out from September to November. Despite all the hand wringing, the expected direction of interest rates is down.
The path of interest rates depends on inflation. Keep in mind that the world is undergoing a disinflationary cycle. The only debate is how quickly inflation is decelerating. Joe Wiesenthal highlighted how CPI has been trending down around the world.
Moreover, much of U.S. inflation is attributable to shelter. Harmonized core CPI from BLS and harmonized core PCE, as estimated by Moody’s, which exclude the shelter component of inflation, is already at the Fed’s 2% target.
In other words, equity bulls shouldn’t overly worry about the interest rate threat to stock prices.
Turning to the growth question, one of the best real-time signals of global growth are commodity prices. And they are not signaling a growth slowdown. Instead, they are trending up. The cyclically sensitive copper/gold ratio has become extended and it’s pulling back. The more broadly based base metals/gold ratio is flat to up.
Q1 earnings season is mostly over. The EPS beat rate was slightly above the historical average while the sales beat rate was below. The more important development is the continued strength in forward EPS estimates, which is a bottom-up sign of fundamental momentum.
An intermediate-term market top will not be in sight until the fundamentals shift that derail any of those factors, either in the form of rising rates or a downward shift in growth expectations.
Tactically cautious
That said, some tactical caution may be warranted in the short run.
Sentiment, as measured by the pub/call ratio, reached the froth zone. In the past, such conditions have made the market vulnerable to pullbacks. There were 17 other similar signals in the last 10 years. The market fell in 11 instances and six were resolved in a benign manner.
Equally concerning for the bull case is the inability of consumer discretionary stocks to outperform, which is a warning of falling risk appetite.
As well, the usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) flashed a sell signal when the 14-day RSI of ITBM recycled from overbought to neutral. The recent trend in breadth deterioration, as evidenced by the poor S&P 500 and Russell 2000 reaction to the blockbuster NVIDIA earnings blowout, is both a disturbing exhibition of market psychology and contributed to the decline in RSI.
On the other hand, traders are advised to be cautious about shorting this market as the NYSE McClellan Oscillator has already reached an oversold level. Even though the market is vulnerable to a setback, downside risk could be limited at these levels.
In conclusion, I am not overly concerned about the capitulation of a prominent bear on an intermediate-term basis. Stock prices are advancing on stable interest rates and continued economic and earnings growth. However, the stock market is showing some signs of bullishness exhaustion and it’s vulnerable to a short-term pullback.
Perhaps you remember the late-night television commercials selling tapes and courses on how to buy real estate with no money down. One memorable character from the early 1990s ran infomercials featuring him on a yacht surrounded by bikini-clad women to emphasize how he, a Vietnamese refugee, had made a fortune from nothing. You could do the same thing if you bought his course.
The Wall Street equivalent of buying a company with no money down is the leveraged buyout, or LBO. The LBO was made possible by the popularization of junk bond, or high yield bond, financings, which was a financial innovation from the 1980s.
Even though the LBO has gone mostly out of usage, it may be time to revisit LBO targets now that high yield spreads are narrowing. I screened non-financial stocks in the S&P 1500 for LBO candidates and came up with a number of interesting insights.
It turns out that LBO candidates are relatively rare. They may be the modern deep value equivalent of Ben Graham’s formulation of stocks trading below net-net working capital or current assets minus all debt.
Introducing the LBO model
How do you identify an LBO candidate?
First, you eliminate financial companies from consideration because these companies already have highly leveraged balance sheets and you can’t LBO a bank or insurance company. The way you LBO a company is to pay equity holders with the company’s own money.
How do you do that? Here is the formula I used to identify LBO candidates?
LBO value = Cash + Extra borrowing power
Where
Extra borrowing power = Allowable borrowing power – Existing debt – Leasehold obligations
To calculate allowing borrowing power, I calculated the 5-year standard deviation of EBITDA margin divided by median EBITDA margin as a measure of the underlying volatility of the business. I then divided the results into deciles. The most volatile decile was assigned an allowable EBITDA interest coverage of six and least volatile an allowable interest coverage of two. From that:
Given the current high yield spread against Treasuries, the financing rate is about 8%.
Model characteristics
Before diving into the companies identified by the LBO model, it’s worthwhile considering the factor characteristics of the model.
One of the key questions is what EBITDA measure do you plug into the model? I tried three: The last reported EBITDA, a normalized EBITDA based on the median EBITDA margin as applied to last reported sales; and a forward 12-month EBITDA derived from Wall Street’s consensus forward 12-month EPS estimates.
The results were surprising. When measured by the ratio of LBO/Stock Price, a scatter plot of the results of LBO/Price from the last reported EBITDA and LBO/Price from normalized EBITDA were highly correlated.
As it doesn’t make a lot of investment sense to focus on last reported EBITDA as an input to a model because it represents stale data, I compared LBO to price for normalized EBITDA to forward 12-month EBITDA. The results were still highly correlated but not as correlated as the previous analysis (more on this later).
You would think that the LBO model would be correlated to the EV/EBITDA ratio. While there is tight dispersion to the scatter plot, the correlation was relatively low. This can be explained by the single dimensional characteristic of the EBITDA/EV ratio against the multi-dimensional nature of the LBO model, which incorporates margin variability and balance sheet cash in its analysis. In other words, EV/EBITDA is not a shorthand for LBO analysis.
In the end, I decided to employ both normalized EBITDA and forward 12-month EBITDA as inputs to the LBO model as a way to identify a range of possible LBO target values. I found that stocks which trade at LBO value are rare, but there were sufficiently interesting investment candidates if the LBO/Price criteria is relaxed to 0.7, or buying a company with 30% down or less.
I found additional insights from a scatter plot of stocks with LBO/Price of 0.7 on either the normalized EBITDA or forward 12-month EBITDA models. There were a considerable number of companies that scored well on normalized EBITDA, but didn’t score well on forward 12-month EBITDA. That’s because the forward outlook is weaker than the company’s history. These are the deep value recovery candidates.
With that preface, let’s look at a few LBO candidates identified by the LBO screen of LBO/Price of 0.7 or more.
LBO candidate examples
Tapestry, the luxury goods producer retailing under the Coach, Kate Spade and Stuart Weitzman brands is an example of a partial LBO. The company raised cash to finance a takeover of its rival luxury group Capri Holdings but was rebuffed by regulators. Now it has a $32/share cash hoard burning a hole in its pocket.
What will happen next? In theory, a corporate raider could swoop in and attempt an LBO. Instead, management could pay out a $32 special dividend. How do you feel about a $41 stock with a possible $32 dividend trading at a forward P/E of 9.4?
Asking for a (deep value investor) friend.
Speaking of deep value, here is a recovery candidate in a hated industry. Peabody Energy is a coal stock with a wide LBO target range. With the stock at about $24, the LBO target based on forward 12-month EBITDA is only $13, using a conservative allowable interest coverage ratio of 6. By contrast, the LBO target using normalized EBITDA is $23, which is very close to the current stock price.
Peabody Energy is an example of a deep value recovery candidate. If margins were to revert to its historical median level, the cash generative power of the company is strong, even though it is operating in an industry in decline.
In total, my LBO screen identified 22 LBO candidates with an LBO/Price ratio of 0.7 or more. The low number of stocks that fit this criteria may be reflective of an elevated stock market valuation. I will be monitoring the number of stocks that pass this screen in the future and report on the results on a regular basis. For the full list of stocks that pass my LBO screen, please contact Ed Pennock at ed@pennockideahub.com or +1 647 287-6800. This is a specialized institutional level report with institutional pricing of USD 1,000 for a single one-time report, or USD 6,000 annually for monthly reports.
In conclusion, I built an LBO model to identify possible LBO candidates among the S&P 1500. I found that stocks which qualify under an LBO criteria are relatively rare. This may be a modern day deep value equivalent of the Ben Graham net-net working capital model, whose candidates are usually micro-caps and not very invetable. Despite the LBO moniker, the model is a deep value one that spots companies with clean balance sheets with earnings above the of their debt capital and thematically similar to the Economic Value Added concept pioneered by Stern Stuart.
Many of the stocks identified by the LBO screen are blemished, each in a different way. A deep value screen like the LBO screen should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk that will be difficult to diversify away.
This was a summary of some specialized research that I undertook that I would normally not publish in these pages. We return to our regular programming tomorrow.
Mid-week market update: After the market reaches its upper Bollinger Band, it isn’t unusual at all for it to consolidate sideways and drift for a few days before making the next move. As the chart below shows, this has happened four other times (grey shaded boxes) in the last six months. The latest episode is the fifth.
The market rose in two of the four episodes and fell in the other two, so there are no apparent clues to future short-term market direction. That said, I have heard concerns about the VIX Index declining below the 12 level, which is historically low. But the VIX did not fall below its lower Bollinger Band, which would be an overbought signal for the market.
The most important difference between now and past instances is the pending earnings report from AI bellwether NVIDIA. As a reminder, the last time NVIDIA reported earnings, not only did the stock pop, the upside gap took the S&P 500 with it and the market didn’t look back for weeks.
A sideways consolidation
Not only is the S&P 500 trading sideways, factor returns are also exhibiting a consolidation pattern. While breadth has been positive during this latest advance to all-time highs in the S&P 500 and other major indices, breadth hasn’t broadened out. Neither large-caps nor small-caps have been able to gain a decisive upper hand in leadership.
The sideways drift can also be seen in style returns. U.S. value and growth have traded leadership since February, and international value and growth have trade sideways for the last month.
So where does that leave us? Waiting for a catalyst like NVIDIA.
Bullish anticipation
Going into the earnings report, bullish anticipation is building. The Semiconductor Index rose above absolute and relative resistance. The upside breakout is impressive in the context of its violating of a rising trend line in early April and subsequent sideways consolidation and correction.
As it turns out, NVIDIA’s earnings beat Street expectations. As I write this, the stock is up about 2% in after hours trading. As the option market was pricing in a 6% move in either direction, this represents vastly diminished volatility. compared to expectations.
For what it’s worth, investors will see the minutes of the FOMC meeting tomorrow (Thursday). Jeffrey Hirsch at Trader’s Almanac observed that the Thursday is the most bullish day before the Memorial Day long weekend.
Both my inner investor and inner trader are bullishly positioned. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
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 email alerts is 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: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 10-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
A Trend Model review
Over the course of several discussions with readers, it was apparent that some didn’t understand the Trend Asset Allocation Model, otherwise known as the Trend Model. This is a model that applies trend-following principles to a variety of global markets and commodities to form a composite signal.
While a history of out-of-sample weekly signals are available dating back to 2013, there is no actual portfolio return track record. However, a simulated strategy of using the out-of-sample signals to either overweight or underweight the S&P 500 by 20% around a 60% S&P 500 ETF (SPY) and 40% 7-10 year Treasury ETF (IEF) would have yielded significantly better returns with 60/40 like risk.
This week I review the model’s internals to reveal why I am bullish on equities.
A trip around the world
The Trend Model uses a variety of global equities as its input. So let’s take a quick trip around the world.
Starting with the U.S., the Dow, S&P 500 and NASDAQ Composite achieved all-time highs last week, which trend-following models interpret as a bullish signal.
Across the Atlantic, both the Euro STOXX 50 and FTSE 100 have reached all-time highs, which is another bullish trend-following signal.
The Asian markets present a mixed picture. China and Hong Kong are recovering from recent lows. Beijing’s latest initiatives to rescue its troubled property market should put a bid under Chinese and Hong Kong equities. Japan made a new recovery all-time high in local currency terms, but the Yen has been weak and its market is still relatively weak for foreign investors. Taiwan has been strong, thanks to its exposure to the semiconductor industry, but Korea and Australia have mostly traded sideways for the past few months.
The mixed picture in Asia can be better seen on a relative return basis. When compared to the MSCI All-Country World Index (ACWI), China and Hong Kong are just starting to recover from relative downtrends. Japan is weak in USD terms, and the other Asian markets are trading sideways on a relative basis.
Commodity strength = Economic expansion
In addition to monitoring global equity markets, the Trend Model also uses commodity price signals as a signal of trends in the global economy.
A quick overview of the commodity markets show that commodities are showing moderate strength and they are trading above key moving averages. The cyclically sensitive copper/gold ratio has surged because of a squeeze in the copper price, but the more diversified base metals/gold ratio has been trading sideways.
A global economy in expansion
In summary, we have:
New all-time highs in U.S. equities;
New all-time highs in European equities;
A mixed picture in Asia; and
Moderate strength in commodity prices.
Putting it all together, this is a picture of an expanding global economy, which should be bullish for risk appetite.
Moreover, sentiment indicators are turning bullish, but readings are not excessive. As an examples, the latest BoA Global Fund Manager Survey shows that the equity weights of global institutions are rising, but conditions cannot be described as a crowded long, which would be contrarian bearish.
As well, the relative performance of IPOs shows a definite lack of investor enthusiasm for risk, which is contrarian bullish. The market’s animal spirits are still dormant.
That’s why the Trend Model is bullish on equities.
The week ahead
Looking to the week ahead, the major sources of possible volatility is the NVIDIA earnings report on Wednesday and the FOMC minutes on Thursday.
The NVIDIA report will undoubtedly have a major say in how the semiconductor stocks and the S&P 500 trades. The Semiconductor Index is at a crossroad as it tests overhead absolute and relative resistance.
My inner trader is staying with the bullish momentum trend and he is long the market. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
The Dow, S&P 500 and NASDAQ Composite all achieved new all-time highs last week. It is said that there is nothing more bullish than a stock making a new high. This is not a time for caution. Higher stock prices are ahead.
Here are the reasons why I am bullish.
Bullish Technicals
Let’s begin with a technical assessment of the stock market. The market printed a “triple 70 breadth thrust” during the May 2–6 time frame, in which the percentage of NYSE advancing stocks exceeded 70% for three consecutive days. The advance sparked a likely “good overbought” condition on RSI, which is a signal of a sustained rally.
Rob Hanna at Quantifiable Edges studied the effects of triple 70 breadth thrusts and found that the price momentum effects tended to be long lasting.
The upside breakout to all-time highs was accompanied by strong breadth. The S&P 500, NYSE and S&P 400 Advance-Decline Lines also showed all-time highs, which confirms the strength of the rally. The only exception was the small-cap S&P 600 Advance-Decline Line that was just short of a new high.
Progress on disinflation
From a top-down macro perspective, the market received some welcome news on inflation last week. April CPI came in slightly weaker than expected. Core CPI (blue bars) softened and so did services ex-shelter (red bars). Owners’ Equivalent Rent (green bars) also continued their expected pace of deceleration.
From a bottom-up perspective, FactSet report that citations of “inflation” have plunged.
The tame CPI report sparked a bond market rally and cemented market expectations of two rate cuts this year, with the first to occur in September. Even before the CPI report, dovish comments from Fed officials that took a rate hike off the table was helpful to risk appetite.
Valuation Tailwinds
The CPI report inspired bond market rally created some tailwinds on equity valuation. The forward S&P 500 forward P/E has been elevated at 20.7, which ahead of its 5-year average of 19.1 and 10-year average of 17.8.
While the longer term trend of valuation divergence between P/E and yields that began in 2022 is concern, in the short-term, falling yields have given some room for P/E expansion, which is a positive.
In addition, forward EPS estimates have been rising strongly in the wake of Q1 earnings season, which is nearly complete. This development lends support to high stock prices in the form of positive fundamental momentum.
Moreover, company guidance has been dramatically improving compared to late 2023 and early 2024.
A welcome growth revival
Lastly, strategist Jim Paulsen made the point that monetary velocity is a form of monetary productivity. In that sense, the U.S. is undergoing a major revivals in monetary productivity, which is helpful for growth and stock prices.
In conclusion, stock prices have achieved fresh all-time highs and they are rising for the following reasons, which indicate sustainable progress on disinflation and economic growth:
Strong technical picture;
Progress on disinflation and dovish comments from Fed officials; and
Continuing signs of growth.
All these factors are combining to be supportive of high stock prices ahead. While I have no specific target in mind, the measured upside objective from a point and figure analysis of the S&P 500 is an astounding 7469. As is the case with point and figure charting, the time frame for achieving such an objective is unknown.
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