Will the Fed crash the stock market?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Breaks at key support

A week ago, I wrote that I was bullish on the equity outlook, but the S&P 500 appeared to be extended short-term and the Powell testimony and Jobs Report could be sources of volatility (see China: Global bullish catalyst?). I was right on the volatility as Powell sounded a hawkish tone and the SVB crisis didn’t help matters. The S&P 500 violated its key support levels at the 50 dma and 200 dma. In addition, the equal-weighted S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 all blew through the bottom of descending channels.

 

 

Is this the End? Here are the bull and bear cases.

 

 

Bull case

In response to Powell’s remarks, Fed Funds futures is now discounting a 50 basis point move at the March 20 FOMC meeting and a terminal rate of 550-575 basis points. The 2-year Treasury yield spike above 5%, which is a high for this cycle before pulling back. These conditions should be very challenging for stock prices, but the S&P 500 only fell -3.1% from Friday to Thursday, which is the day before the Jobs Report. Is that all the Fed can do to dent the stock market?

 

Meanwhile equity risk appetite indicators are exhibiting positive divergences.

 

 

From a long-term perspective, the analysis of the 50 and 200 dma of the equity call/put ratio shows that sentiment is recovering from an excessively condition. The crossover of the 50 and 200 dma is a constructive sign that signals the start of a new bull leg in stocks.

 

 

 

The bear case

Here is the bear case. The Fed’s hawkish tone put a bid under the USD, which has been inversely correlated to equity prices. The USD Index has been range bound but it may be about to stage a major technical breakout, which would be negative for risk appetite.

 

 

Stock prices may also be facing headwinds from liquidity conditions. Fed liquidity is showing a negative correlation to the S&P 500. The lack of liquidity is a potential a headwind for the bulls, though the sudden banking crisis could compel the Fed to inject funds into the banking system.

 

 

From a technical perspective, the NYSE McClellan Summation Index (NYSI) is recycling from an overbought condition, but the stochastic hasn’t reached an oversold reading yet, which suggests further downside potential in the next few weeks.     

 

 

As well, different versions of the Advance-Decline Line are breaking below support, which is an ominous near-term development. Market breadth has sustained considerable technical damage. Unless stock prices can immediately reverse those losses, they may need a period of basing before they can rally higher.

 

 

 

The verdict

What’s the verdict? The S&P 500 has been consolidating sideways since it staged an upside breakout through a falling trend line in January. The upside breakout was constructive for stock prices, but until the consolidation period resolves itself either to the upside or the downside, it’s difficult to be definitive about direction. While I am constructive on stock prices, some caution needs to be warranted here.

 

 

Tactically, the market is poised for a relief rally. Three of the four components of my Bottom Spotting Model have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band, which is an oversold market reading, the NYSE McClellan Oscillator is oversold, and TRIN spiked above 2 on Thursday, indicating price-insensitive selling, which is a characteristic of a margin clerk driven liquidation. Only the term structure of the VIX Index hasn’t inverted on a closing basis, though it did invert several times during the day on Friday.

 

 

Subscribers received an alert Friday that my inner trader had initiated a long position in the S&P 500 and he had bought into the panic. 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 headline volatility event next week will be the CPI report. The FOMC meeting will be in the following week on March 20. Brace for further choppiness.

 

 

Disclosure: Long SPXL
 

Double-dip recession of 1980-82 = False dawn of 2023?

Posted by Cam Hui -
One of these cyclical indicators is not like the others. While many cyclical industries are in relative uptrends, which is a technical signal of economic expansion, the 2s10s yield curve is deeply inverted and shows few signs of steepening. This is one of those occasions when the stock market and bond markets disagree.

 

 

Which market is right? Maybe they both are.

 

 

What’s Fed thinking?

Let’s start with the economy and the Fed’s reaction function. Fed Chair Jerome Powell and other Fed officials have been repeating the mantra that the Fed will continue its inflation fight until the job is done and inflation is at 2%.

 

Here’s a quick snapshot of the economy. The Atlanta Fed’s GDPNow estimate of 2.6% is signaling a strong expansion.

 

 

In addition, the US Economic Surprise Index has been rising, indicating economic data is surprising to the upside.

 

 

As the Fed has indicated it’s focused on the jobs market and wage growth in its inflation fight, here are some metrics to consider. Initial jobless claims have been flattening out and show uneven signs of rising even after all the monetary tightening.

 

 

Average hourly earnings, unit labor costs, and the employment cost index are all decelerating, but readings remain elevated. While recent signs of disinflation are welcome, services inflation has been sticky on the way down and the journey from 4-5% to 2% inflation could be much harder than anyone thinks.

 

 

That’s because, in light of the Fed’s hyper focus on wage and services inflation, Steno Research argues that China’s credit impulse leads ISM services price. That makes China’s recent stimulative policies bad news for inflation in H2 2023.

 

 

As well, San Francisco Fed President Mary Daly warned that reshoring could raise the demand for labor and push up inflationary pressures:
 

If firms decide to reshore some or all of their foreign production facilities, costs and prices are likely to continue to rise. My conversations with business leaders suggest that some of this is already happening…a trend toward less global competition could mean more inflation in the goods sector and more pressure on overall inflation going forward.

Moreover, the combination of a decline in the labor force participation rate and low immigration is restricting labor supply and putting upward pressure on wages.
Another potential factor affecting future inflation is the ongoing domestic labor shortage. Labor force participation fell precipitously during the pandemic and has been slow to recover, especially among workers aged 55 years and older. These developments exacerbate the already significant downward drag on participation related to population aging. Absent a substantial pickup in the share of working-age adults looking to be employed or a large change in immigration flows, labor force participation will continue to decline and worker shortages will persist, pushing up wages and ultimately prices, at least in the near and medium term.
She concluded that “further policy tightening, maintained for a longer time, will likely be necessary”.

 

Even more worrisome is a Kansas City Fed study that linked tight labor markets to rent inflation. With the Fed focused on services inflation, rents have been a major component of CPI and especially services inflation.

 

 

The study found that tight labor markets affect rent inflation because of “greater demand for rental units afforded by job gains and wage growth”.
Rent inflation responds more to labor market conditions compared with other components of inflation. We attribute this link between labor market tightness and rent inflation to greater demand for rental units afforded by job gains and wage growth. Although online measures of asking rents currently suggest official measures of rent inflation will decline, we caution that rent inflation is likely to remain above pre-pandemic levels so long as the labor market remains tight.
As a consequence, Fed Chair Jerome Powell sounded a hawkish tone during his Congressional testimony and put a 50 bps rate hike on the table for the next FOMC meeting.

 

 

What’s bond market thinking?

Here’s one way of squaring the circle of disagreement between the stock and bond markets. The accompanying chart shows two cyclical indicators, the 2s10s yield curve and the copper/gold ratio. The historical evidence shows that the 2s10s yield curve normalizes about 1-3 before a recovery in the copper/gold ratio. 

 

Fast forward to 2023. As investors have already observed from stock market internals, cyclical industries are roaring ahead, just like the copper/gold ratio. This presents a problem for the Fed. How can it control inflation when readings at still elevated and, if current signs of an expansion are correct, it would lead to further inflationary pressures? The answer is more monetary tightening that’s beyond market expectations. Current conditions are reminiscent of the double-dip recession of 1980-1982, when the Fed reversed its accommodative policy and tightened to extremely painful levels. Instead of a double-dip, current recovery expectations are likely to be a false dawn.

 

Bond market expectations are already reflecting the false dawn scenario. The 2-year Treasury yield, which can be thought of as a proxy for market expectations of the terminal Fed Funds rate, is making a new high for the cycle. Historically, peaks in the 2-year rate have been either coincident or led peaks in the Fed Funds rate, though the signal has shown a hit-and-miss record on stock market timing. Bottom line, the peak in the 2-year rate is ahead of us, which raises the uncertainty of any Fed Funds forecast.

 

 

 

Will the Fed break something?

In the past, Fed tightening cycles always breaks something. Nothing has broken yet in the current cycle, but the behavior of bank stocks is concerning. Banks tend to borrow short and lend long, and therefore the shape of the yield curve affects profitability. It’s no surprise that the relative performance of banks is correlated to the yield curve, but the recent violation of relative support by bank stocks and the SVB Financial Group and Silvergate Capital debacles could be the signal of rising stress in the banking system.

 

 

These circumstances lead me to believe that the combination of a cyclical rebound and elevated inflation rates raises the odds of a double-dip recession. While history doesn’t repeat itself but rhymes, the 1980-1982 experience may be a useful template to think about the stock market. In that case, current market conditions puts is at about Q2 or Q3 1980. Brace for volatility.

 

 

In addition, the 2s10s yield curve is also pointing toward a false dawn recovery. In the past, yield curve normalization leads the copper/gold ratio, which is a key cyclical indicator, by 1-3 years. The 2s10s yield curve hasn’t even begun to normalize in any signification fashion yet but the copper/gold ratio has turned up. This “false dawn” pattern is highly reminiscent of the 1980-1982 experience.

 

 

In conclusion, current equity market expectations of a cyclical recovery is simply unrealistic in light of the Fed’s focus on 2% inflation. Any signs of growth will be met with tighter monetary policy that will have the effect of pushing the economy into recession. While history doesn’t repeat itself but rhymes, the current situation is highly reminiscent of double-dip recession of 1980-1982. While the technical conditions are still constructive for stock prices, investors are advised to be prepared to revise their risk profile as conditions may change later this year.
 

China: Global bullish catalyst?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

America the weak?

This chart of the Euro STOXX 50, MSCI China, and S&P 500 (all in USD) tells a story of differing relative strength. The Euro STOXX 50 has been flat since early February the best relative performer. MSCI China has been correcting, but turned up last week when Hong Kong announced that it was eliminating its COVID mask mandate. In addition, China’s PMI data came in better than expected, indicating expansion. The S&P 500 topped out mid-February and its bottom lagged both Europe and China.
 

 

Let’s briefly review the performance and backdrop of each region.

 

 

US: Fed-induced headwinds

Good news is bad news in America. January core durable goods rose 0.7% from -0.4% in December (consensus 0.1%). January pending home sales surged by 8.1% (1.0% expected). Q4 unit labor costs rose 3.7% (1.6% expected), which is a signal of wage pressures. However, the Institute of Supply Management (ISM) Manufacturing PMI rose slightly from 47.4 to 47.7 but missed expectations (vs. 48.0 consensus).

 

Fed Funds futures are discounting three consecutive quarter-point rate hikes, followed by a plateau until early 2024. Past expectations of any rate drops in late 2023 are gone. Powell’s Congressional testimony Tuesday and Wednesday should bring further clarity to Fed Funds expectations and be a source of potential market volatility.

 

 

From a bottom-up perspective, the results of Q4 earnings season landed with a thud. The Street is cutting forward 12-month EPS across all market cap bands.

 

 

It’s not a pretty picture.

 

 

Europe: Still the leader

On the other hand, a relative performance analysis shows that eurozone equities have been the leaders since the October bottom. Most notably, standouts were France and Greece (yes, that Greece).

 

 

Since the October bottom, industrial and financial stocks have shown the greatest relative strength in Europe, which are signals of cyclical strength. Bloomberg reported that the “EU Seeks Trade Deal With US to Unlock EV Benefits” and it’s seeking to clinch the outline of an accord that could allow US consumers get IRA tax credit for EU vehicles. Such news could provide a boost to the European auto sector and further improve sentiment for European equities.

 

 

 

China: From re-opening to recovery?

The bull case for China may be evolving from an re-opening story to a recovery story. A Bloomberg article indicated that China’s reopening trade may be unraveling: “Hedge funds who piled into the rally late last year are rapidly trimming risk. Key stock benchmarks in Hong Kong have fallen more than 10% from their January peaks. Bond outflows have resumed.” Alibaba, which is an approximate proxy for hedge fund exposure to China, recently became oversold based on its 14-day RSI. Oversold conditions in the last year have resolved in price rebounds.

 

 

 

A different Bloomberg article tells a story of renewed optimism: “China’s Upcoming Congress Spurs Optimism on Mainland Stocks” as “investors say NPC meeting to deliver bigger windfall onshore”. Hong Kong and Chinese equities surged last week when John Lee, the city’s the chief executive, announced eliminated mask mandates.

 

An analysis of my China re-opening indicators tells a mixed story. On one hand, the pullback in Chinese equities and the equity markets of China’s major Asian partners is very real. While the USD-denominated performance of the Japanese market has moved sideways against the MSCI All-Country World Index (ACWI), other Asian markets have violated either rising relative trend lines or relative support, indicating market expectations of weakness and underperformance.

 

 

On the other hand, a review of the relative performance of key sectors within the Chinese market leads to a more constructive conclusion. Material stocks are still turning up relative to MSCI China, which is a market signal of strong commodity and materials demand from Chinese infrastructure investment. As well, the real estate and financial sectors are also exhibiting signs of relative turnarounds, which are signals that Beijing’s policies to support the property market are having their effect. However, consumer discretionary and internet stocks, which are dominated by giants like Alibaba and Tencent, whose businesses are sensitive to consumer spending, are still lagging.

 

 

This update of the China market internals tells a mixed, but constructive picture. While the initial market enthusiasm over the re-opening story has faded, underlying indicators of a cyclical rebound from market and sentiment indicators are still positive. 

 

 

The geopolitical tail risk is a Chinese decision to supply arms to Russia. While it has sent non-lethal aid such as helmets and dual-use items such as aircraft parts in the past, sending weapons such as artillery shells to bolster Russia’s depleted stocks would be a game-changer in Sino-Western relations. It risks the imposition of sanctions and could crater the Chinese economy. Goodbye re-opening. Goodbye recovery.

 

However, if the current trend were to continue, the market should see more concrete signs of a cyclical rebound by Q2. The bull case for China appears to be evolving from a re-opening story, which became overbought and faded, to a longer-lived recovery story.

 

With Europe still the global leaders and China and Asia showing signs of a bullish turnaround, US equities are likely to be laggards for the remainder of this year.

 

 

The week ahead

Look into the week ahead, the S&P 500 regained its 50 dma but it looks extended on the hourly chart. The 5-hour RSI has exceeded 90, which is a level that has led to short-term pullbacks in the last three months. Before you jump on the bulls’ train, Powell’s Congressional testimony Tuesday and Wednesday and Friday’s Jobs Report could be sources of volatility.

 

 

My inner investor remains bullishly positioned. Subscribers received an email alert on Friday that my inner trader had taken profits on his long S&P 500 position. He is standing aside for better opportunities. In all likelihood, we will see some weakness in the coming week. Keep an eye on whether positive or negative divergences develop should the index retreat and re-test its early March lows.

 

Publication note:  I am scheduled for a cataract operation on my eye Monday. There will be no mid-week market update next week as I expect to be out for the week. I will try to publish at least an abbreviated note next weekend, but that will be dependent on the progress of my recovery.

 

A tale of two bubbles

Posted by Cam Hui -
It was the best of times. It was the worst of times. The S&P 500 (SPX) remains in a well-defined uptrend, but the NASDAQ 100 (NDX), which represents large-cap growth, violated an uptrend that stretches back to the GFC. The relative performance of the NASDAQ 100 to the S&P 500 shows a similar trend break that’s somewhat reminiscent of the Tech Bubble top of 2000. Moreover, the recent relative performance of speculative growth stocks, as measured by ARK Investment ETF (ARKK), is similar to the post-2000 Bubble bust.

 

 

 

Growth poised for a recovery?

Is this the bottom for growth stocks? The dark line in the lower panel depicts the relative performance of the NDX to the SPX, normalized to the price action in the last 12 months. The shaded regions show periods when the NDX has been oversold relative to SPX and reached an area of relative support. With the exception of the 2000-2002, relative oversold periods at relative support have been good times to buy NDX for superior relative performance.

 

 

NDX is now recycling off oversold. Does this mean that the worst is over for growth stocks?

 

 

This time is different

History doesn’t repeat itself but rhymes. Not all growth stock bubbles are the same. At the 2000 top, the NASDAQ 100 was full of companies with unprofitable companies with insane valuations. Fast forward to 2023, large-cap growth stocks are mostly profitable, cash generative, and have strong competitive positions. By contrast, the performance of speculative growth stocks as proxied by ARK Investment ETF (ARKK) far more resembles the behavior of growth stocks in the post-bubble bust of 2000-2002.

 

To be sure, large-cap growth is richly valued and have come to represent about 40% of S&P 500 weight. Consider, for example, that the S&P 500 trades at a forward P/E premium of 3-4 points compared to the mid-cap S&P 400 and small-cap S&P 600. Moreover, the history of forward P/E by market cap shows that the large-cap premium wasn’t evident until 2020, the onset of the pandemic.

 

 

 

A question of leadership

The dominance of FANG+ large-cap growth in the S&P 500 begs another question. US equities have been leading non-US since the GFC. Much of the outperformance is attributable to the superior fundamentals and earnings growth from FANG+ names. Now that the NASDAQ 100 has violated its uptrend, can US equities continue to lead?

 

US equities also trade at a considerable premium forward P/E to the rest of the world. Unlike the P/E history of US forward P/E by market cap, the US valuation premium had been relatively modest until about 2016, when it began to widen against the rest of the world.

 

The question of future market leadership can be distilled as, “Are the FANG+ stocks gone ex-growth in their earnings outlook?”
 

On one hand, the recent scramble over natural language AI is a sign that competitive barriers are crumbling, as evidenced by investor concerns over the AI threat to Google in search. Facebook’s uneven pivot to the Megaverse is another example that the growth trajectory for social media may be decelerating. Netflix’s initiatives to limit password sharing is another sign that the company is reaching the limits of subscriber growth. By contrast, Apple’s research initiatives for non-invasive blood glucose monitoring opens up an enormous medical device opportunity for the Apple Watch.

 

In all likelihood, faltering large-cap growth is putting US global equity leadership on borrowed time. Investors should keep an eye on the evolution of relative performance. Should the S&P 500 violated any relative uptrend compared to either EAFE or EM, it will be a definitive signal to decisively rotate into non-US equities for better performance in the next cycle.

 

 

 

Publication note: I am scheduled for a cataract operation on my eye Monday. There will be no mid-week market update as I expect to be out for the week. I will try to publish at least an abbreviated note next weekend, but that will be dependent on the progress of my recovery.

 

Why I am constructive on the stock market

Posted by Cam Hui -
Mid-week market update: As the S&P 500 consolidates just below its 50 dma, here are some considerations that make me constructive on the stock market. The index is exhibiting an oversold condition on the percentage of stocks above their 20 dma and a minor positive divergence on the 5-day 

 

 

 

Bullish factors

The analysis of market breadth yields a mixed, but nuanced picture. The percentage of stocks above their 50 dma has fallen below the 50-60 range, which is concerning. The question is whether this metric will fall to an oversold condition, as it did last April and last September, or recover as it did in early January. The net 52-week highs-lows indicator gives investors some clues. During the declines in April and September, net highs-lows were deeply negative, indicating breadth deterioration. By contrast, the January rally was signaled by a positive net highs-lows. This indicator remains weakly positive, even for NASDAQ stocks today, which makes me constructive on the direction for stock prices.

 

 

Other market internals are also signaling limited downside risk. Even as the S&P 500 traded sideways, the relative performance of defensive sectors are weakening, which is an indication that the bears are losing control of the tape.

 

 

Moreover, my equity risk appetite indicators are also flashing positive divergences.

 

 

From a longer term perspective, the (bullish) trend is your friend. Seth Golden pointed out that the S&P 500 has spent 18 days above its 200 dma. If history is any guide, the index hasn’t made a new low and it’s been higher on a three, six, and 12 month horizon.

 

 

 

Liquidity headwinds

I don’t want to give the impression that the stock market is about to take off like a rocket. Fed liquidity has been flat this year while stocks have risen. The lack of liquidity in the banking system will be a headwind for stock prices.

 

 

In conclusion, barring any unexpected shocks, US equities are likely to move upward over the next few weeks in a choppy fashion. My inner investors is bullishly positioned, and my inner trader is tactically long the S&P 500. 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.

 

Publication note:
I am scheduled for a cataract operation on my eye Monday. There will be no mid-week market update next week as I expect to be out for the week. I will try to publish at least an abbreviated note next weekend, but that will be dependent on the progress of my recovery.

 

 

Disclosure: Long SPXL

 

Is this the next FANG-style market darling?

Posted by Cam Hui -
I don’t comment about individual stocks very often, but I came upon this chart. It has been steadily rising for the last few years and it has been quietly beating its sector peers. Could this be the next Amazon or Apple?

 

 

 

Relative strength study

My conclusion is based on a study I did in 2012. I found that investors should buy the relative strength winners when the market is in a bull trend, as defined by the Trend Asset Allocation Model.
 


 

During the Tech Bubble, the leadership were the TMT (Tech-Media-Telecom) stocks. After the bubble burst, it was real estate – until it wasn’t. Every bull cycle has its market darlings.

 

 

Intrigued? The mystery chart turns out to be LVMH, the luxury goods maker (all charts are in USD). I was inspired to look at it after a Ones and Tooze podcast which revealed that LVMH’s CEO Bernard Arnault had pushed Elon Musk aside to be the world’s wealthiest man.
As Elon Musk’s fortune dwindles to a mere $190 billion, a new oligarch has been crowned the richest person in the world: Bernard Arnault of France. On the episode this week, Cameron and Adam discuss how Arnault made his money and what his empire tells us about his home country. 

 

 

If this is the start of a new bull cycle, LVMH is a strong candidate to be the next market darling. I have made the case before for Europe becoming the next market leader. The leadership of LVMH is supportive of that case.

 

Here are some other large cap European stocks that could be leadership candidates. Linde, which is an industrial gas and engineering company. The stock achieved a relative breakout (bottom panel) but it’s testing resistance on the absolute (USD) price chart (top panel).

 

 

Allianz could be intriguing as European financial stocks have begun a recovery.

 

 

Here is the sector ETF EUFN.

 

 

Bottom line. When US investors think about the new leadership, think outside the box and think about Europe.

 

Decision time for bull and bears

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Testing key support

As the S&P 500 tests critical support level, as defined by the falling trend line, it’s technical decision time for both bulls and bears. While a rally off support levels is the more likely outcome, a break of support opens the door to considerable downside risk to the 200 wma at about 3715. On the other hand, a relief rally is likely to be capped at resistance at about 4180.

 

 

 

The bull and bear cases

Here are the bull and bear cases. The bull case consists mainly of an oversold condition. While oversold markets can become more oversold, the NYSE McClellan Oscillator had already become very stretched to the downside. Markets usually don’t crash from such levels.

 

 

From a longer term perspective, the price momentum factor, as measured in different ways, is turning up. These readings are consistent with conditions seen in the last two major market bottoms.

 

 

On the other hand, both the equal-weighted S&P 500, the S&P 400, and the Russell 2000 have broken support, indicating overall weakness beneath the hood.

 

 

Different versions of the Advance-Decline Line have all violated their uptrends, which is a signal that the bulls have lost control of the tape. Even if you aren’t bearish, this argues for a period of sideways consolidation and choppiness.

 

 

 

The China wildcard

I have pointed out before that it’s impossible to make a call on risk appetite if you don’t pay attention to the China re-opening narrative. The report card on the China re-opening trade contains both good news and bad news.

 

The bad news is the market is losing faith in the trade. The relative performance of the Chinese equity market and her major Asian trading partners shows that, with the exception of Japan, all the other markets have violated key relative uptrends. At the very least, a period of sideways consolidation will be necessary before regional markets can consistently outperform again.

 

 

On the other hand, the analysis of sector relative performance within China tells a more constructive story. Consumer stocks are still lagging. Consumer discretionary and internet, which consist of consumer sensitive companies like Alibaba and Tencent, are in minor relative downtrends. By contrast, the cyclically sensitive materials sector has turned up. So have the highly leveraged real estate stocks and the real estate sensitive financials, which reflect Beijing’s initiatives to support the property sector.

 

 

While these developments are constructive for the Chinese re-opening trade, a possible tail risk has appeared. In a more ominous development, China and Russia affirmed their deep ties, with Beijing’s top diplomat describing the relationship as “solid as a mountain” during talks in Moscow. The WSJ reported that “US Considers Release of Intelligence on China’s Potential Arms Transfer to Russia”. Nothing has been decided, but Secretary of State Blinken stated that China is almost certainly supplying non-lethal dual-use goods. If China were to take the next step and provide weapons in support of the Russo-Ukraine war, it risks sanctions from Europe and the US, who are its major customers, and reverse any positive effects of the re-opening trade for investors in a catastrophic manner.

 

 

The week ahead

Looking to the week ahead, the S&P 500 is testing its 50 dma while exhibiting positive divergences on its 5-day RSI and VIX Index, which has recycled below its upper Bollinger Band after spike above. I interpret these as tactical buy signals.

 

 

The odds favor a relief rally of unknown duration and magnitude. The usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) is oversold on its 14-day RSI, which is a bullish setup. The buy signal will be triggered when the ITBM RSI recycles from oversold to neutral.

 

 

From strictly a technical perspective, investors and traders should make a directional call based on how the market behaves after the relief rally. My inner trader remains positioned bullishly. 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.

 

 

Disclosure: Long SPXL

 

Fight the tape, or the Fed?

Posted by Cam Hui -
In addition to the hot January PCE print, the other surprise of last week was the upbeat flash PMI from S&P Global Market Intelligence (formerly IHS Markit) showing upside surprises from the G4 industrialized countries. Increasingly, the market narrative is shifting from a growth slowdown to no recession and continued growth. The markets are behaving the same way, as they turn to discounting a growth revival, led by a successful China reopening.

 

 

At the same time, last week’s release of the February FOMC minutes warned, “Participants observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2%, which was likely to take some time.”

 

What should you do? Fight the tape, or fight the Fed?

 

 

Hard, soft, or no landing?

Ever since the Federal Reserve began to tighten monetary policy and show its determination to bring inflation back to its 2% target, economists and strategists have debated whether the US economy would experience a hard landing, soft landing, or, more recently, no landing.
 

First, let’s define some terms. The chart below shows the history of the US unemployment rate with peaks and valleys labelled (blue line), core inflation (red line), and recession periods shaded. We would define a hard landing as a recessionary period when the unemployment rate rose more than 3% and soft landings otherwise. The 1990 and the 2000-2002 periods qualify as soft landings, though unemployment rose further after the recession ended. The 2022 COVID Crash would have been the hardest landing comparable to the Great Depression were it not for the unprecedented level of fiscal and monetary response by Congress and the Federal Reserve.

 

 

A no-landing scenario implies that unemployment doesn’t rise much, growth doesn’t decline much, but inflation remains elevated. Increasingly, market action is shifting towards that view as cyclical industries with the exception of oil and gas are outperforming the market. The recent results of the BoA Global Fund Manager Survey showed recession fears peaked in November 2022 and have fallen sharply.

 

 

The current economic cycle is somewhat unusual compared to past cycles. Manufacturing and goods inflation have weakened, but services inflation remains strong. In particular, the labor market is tight and unemployment is low, as Fed Chair Powell pointed out in his February post-FOMC press conference.
 

However, US economic growth is beating expectations. The January Jobs Report saw half a million new jobs, retail sales grow a whopping 3%, and the January stronger-than-expected PCE report are all supportive of the no-landing narrative. However, a no-landing growth pattern where inflation remains elevated will force the Fed to raise rates even further, which risks an eventual hard landing.

 

Current market expectations calls for three more consecutive quarter-point rate hikes, followed by a plateau and no rate cut in late 2023. With the caveat that the last FOMC occurred before the blockbuster January Jobs Report and strong retail sales print, the minutes showed that “almost all” participants agreed to a 25 basis point rate hike, and only “a few participants stated that they favored raising the target range for the federal funds rate 50 basis points at this meeting or that they could have supported raising the target by that amount”. In a victory for the doves, it seems that Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard, who called for a 50 basis point hike at the next meeting, have little support within the FOMC.

 

 

 

Recession to the left, recession to the right

Despite the rosy numbers, forward looking indicators point to a recession ahead. New Deal democrat, who maintains a set of coincident, short-leading, and long-leading economic indicators with zero, six, and 12 month time horizons respectively,  believes the economy is on the verge of entering a recession, but positive developments in leading indicators point to better times ahead.
There are two trends percolating under the surface. One trend is the continued slow decaying of growth in the coincident indicators. The other is the slow move towards turning neutral or positive among some of the long and even short leading indicators.
 

No forecast at this point, but I am beginning to suspect that, while there will be a recession, it will be relatively short and relatively mild.

Unrelated to any of New Deal democrat’s analysis, the results of the quarterly loan officer’s survey is disturbing inasmuch as it’s signaling a credit crunch. A net 44.8% of banks are tightening credit for large and middle-market firms and the results for small-market firms, which are not shown, are similar. While the history for this series is limited, readings above 40% have either led to, or coincided, with a recession.
 

 

Even if the economy were to avoid a recession, continued growth and elevated inflation are likely to see the Fed react with even a tighter monetary policy and higher interest rates. Such a scenario is reminiscent of the double-dip recession of 1980-1982, when the Volcker Fed initially cut rates in 1980, only to raise them again to very painful levels until something broke. In this case, it was the Mexican  Peso Crisis that threatened the solvency of the US banking system.
 

 

 

What’s holding up the market?

In light of the dubious macro outlook, what’s holding up the market. Marketwatch reported that Morgan Stanley’s Mike Wilson pointed to rising liquidity as an explanation for the risk-on character of the market, and compared the current situation to climbers on Mount Everest.

Either by choice or out of necessity investors have followed stock prices to dizzying heights once again as liquidity (bottled oxygen) allows them to climb into a region where they know they shouldn’t go and cannot live very long. They climb in pursuit of the ultimate topping out of greed, assuming they will be able to descend without catastrophic consequences. But the oxygen eventually runs out and those who ignore the risks get hurt.

Wilson went on to warn about the elevated valuation of the stock market. Indeed, the S&P 500 forward P/E is exhibiting a strong negative divergence compared to the 10-year real rate.

 

 

On the other hand, Fed liquidity has been fairly stable despite the Fed’s quantitative tightening program. That’s because the Treasury Department is drawing down the Treasury General Account (TGA) held at the Fed and supplying the banking system with liquidity as part of its “extraordinary measures” to mitigate the effects of the debt ceiling. Treasury Secretary Janet Yellen has estimated that the government will run out of money in June, while the Congressional Budget Office’s estimate is between July and September.

 

 

From a global perspective, FT Alphaville reported that Apollo chief economist Torsten Sløk pointed out that the BoJ’s liquidity injections as part of its yield curve control program is overwhelming the Fed’s QT.

 

 

That’s not all. The PBoC is another major supplier of liquidity to the global financial system (see Fed paper What Happens in China Does Not Stay in China). Recent evidence shows that the PBoC has been ramping up liquidity, which has the effect of holding up the price of risky assets.

 

 

 

Investment conclusions

In light of these cross-currents, what should investors do? Should they fight the tape, or fight the Fed, along with elevated valuation risk?

 

I believe that the answer lies with investment time horizon. In the short run, liquidity controls the tape. In the long run, valuation and interest rates matter to returns. For now, European stock and cyclical industries are the leadership. Enjoy the ride and take shelter if their leadership falters.

 

 

Party now, pay later.

 

Oversold, but wait for the re-test

Posted by Cam Hui -
Mid-week market update: The Zweig Breadth Thrust buy signal is a rare price momentum signal that’s been triggered only six times since Marty Zweig wrote the book that outlined his signal. The stock market has risen every time 12 months after the buy signals. It requires the Zweig Breath Thrust Indicator (ZBT) to rise from an oversold to an overbought condition within 10 trading days, which is indeed an rare occurrence.

 

While the ZBT buy signal is extremely rare, the ZBT Indicator can serve as a useful short-term trading indicator when it is oversold. In the past, this has served to indicate favorable risk-reward long entry points, which seems to be the situation today.

 

 

Tactical bottom signals

In addition, two of the four components of my Bottom Spotting Model have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band, and the NYSE McClellan Oscillator is oversold. In the past, two or more simultaneous buy signals have also been decent long entry points.
 

 

 

Reasons to be cautious

Even though the equity market may be due for a bounce, I have some doubts as to whether the current circumstances represent a durable bottom. Option sentiment, as represented by the 10 dma of the put/call ratio, isn’t fearful yet.

 

 

As well, while the term structure of the VIX is exhibiting some signs of rising anxiety, it isn’t showing signs of panic either.

 

 

The relative performance of defensive sectors are starting to bottom and they are trying to turn up, which is an ominous sign for the bulls. Investors need to keep an eye on how these sectors perform in the coming days.

 

 

 

What to watch

Here is what I am watching. The S&P 500 is short-term oversold on a number of key indicators. The 5-day RSI is oversold, the percentage of S&P 500 above their 20 dma is near or at oversold territory, the index is at the bottom of its Bollinger Band and it’s testing its 50 dma.

 

 

In all likelihood, we are going to see only a 2-4 day bounce, but watch for the re-test after the relief rally. In the past, durable bottoms have been signaled by positive divergences shown by the 5-day RSI and the percentage of stocks above their 20 dma.

 

Subscribers received an alert that my trading account had tactically entered a long position in the S&P 500. 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.

 

 

Disclosure: Long SPXL

 

Could EM weakness unravel the equity bull case?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Three golden crosses

Here’s why I am bullish on the outlook for equities. A review of the performance of the major regions shows that all regions have achieved golden crosses, which occurs when the 50 dma rises above the 200 dma to indicate an uptrend. MSCI EAFE is in the lead, followed by the S&P 500, while MSCI Emerging Markets is lagging and it’s violated its 50 dma.

 

 

While strong global breadth is constructive for the equity outlook, the nagging question is, “Could EM weakness unravel the bullish narrative?”

 

 

Too far, too fast?

A review of global relative return unpacks the story of EM weakness. While developed markets are largely performing well, emerging markets (bottom panel) are running into some trouble. Since China accounts for about one-third of the weight in the EM index, dis-aggregating China from the rest of EM makes some sense. In particular, EM ex-China has fallen to fresh relative lows, which is an ominous sign of relative performance. In other words, China is holding up EM performance, but there are signs that its returns are becoming wobbly.

 

 

The latest BoA Global Fund Manager Survey also reveals some troubling sentiment conditions. Global institutional investors had been stampeding into EM equities, which is contrarian bearish.

 

 

Drilling down further, the EM stampede appears to be China related. “Long China stocks” is now perceived to be the most crowded trade.

 

 

 

A China reopening report card

There was considerable investor excitement in January over the prospect of China reopening its economy after its zero COVID policy about-face. Here is how the China reopening trade is progressing, based on relative performance real-time market-based data.

 

About a month ago, I evaluated the China reopening trade based on several sector relative performance milestones (see Time to revisit the question: How investable is China?).

 

Materials: A successful re-opening would translate into a cyclical rebound, which raises commodity demand and would be reflected in strength in materials stocks.
Consumer Discretionary and Internet: A successful re-opening would translate into increased consumer spending and a better outlook for consumer discretionary and internet stocks, which comprises consumer sensitive companies like Alibaba and Tencent.
Real estate and Financials: One of China’s long-term challenges is the resolution of its debt-induced property bubble. Beijing recently relaxed its “three red lines” criteria, which was designed to rein in rampant property speculation. Can Beijing mitigate the tail-risk of a collapse in its real estate sector?

 

Here is what’s happened since the publication of that report. 

 

 

The good news is a constructive long-term relative return patterns of Chinese material stocks. I compared the relationship of Chinese Materials to both Global Materials and MSCI China separately and found that the market is discounting a cyclical rebound in Chinese investments. As China has historically represented dominant for many commodities, rising Chinese infrastructure investment will be bullish for commodities and the equity materials sector. Chinese materials stocks are exhibiting relative rebounds against MSCI China, indicating the market is discounting rising demand, and against global materials stocks, which is another positive sign as rising Chinese materials demand would affect Chinese materials producers first before global producers.

 

 

In addition, the fears of another COVID wave of infection that could overwhelm the healthcare system in rural China from Lunar New Year travel have not materialized. A podcast by the Economist revealed much of rural China had already experienced its COVID wave last December.

 

On the other hand, consumer discretionary relative performance has been flat to down. The WSJ reported that consumers are hoarding cash and not borrowing. This is a market signal that China’s consumer spending is not on course for a full recovery and consumer confidence is not recovering. The unwillingness to take on debt is a consequence of the reluctance to buy property. This translates into the relative underperformance of real estate and financial stocks (see chart above showing the flat to negative relative performance of consumer discretionary, internet, real estate, and financial stocks against MSCI China).

 

The evolution of China’s bank credit tells the story. The household sector can’t drive consumption if consumer credit growth is decelerating. Much of household credit growth goes into real estate, and the real estate sector remain in the doldrums.

 

 

Here is how I interpret these readings. While China is undoubtedly reopening and there will be a cyclical rebound effect, as evidenced by the surge in China’s Economic Surprise Index, the equity markets have discounted much of the reopening narrative.

 

 

 

The analysis of the relative performance of China’s equity market and the markets of her major Asian trading partners shows that technical breakdowns of relative uptrends everywhere. The China reopening story is coming back down to earth. In all likelihood, this will resolve in choppy sideways consolidation patterns as the cyclical opening effects will create headwinds for bears.

 

 

The longer term outlook for China is more troubling. The Financial Times reported that Singapore’s GIC, which is the world’s fifth larges sovereign wealth fund, is putting the brakes on private investment in China. GIC is a well-respected institution with deep experience in China, and this pivot sends an ominous signal for China’s long-term investment outlook.

 

 

A healthy pullback

The cyclical reopening rebound is still intact and tradable. While it may become a drag on EM equity performance, it is unlikely to derail the equity bullish impulse that just began in 2023. Market internals of US cyclical industries are mostly in relative uptrends, which is supportive of a cyclical equity bull thesis. The current episode of global equity market weakness looks like a healthy pullback.

 

 

From a longer term perspective, the copper/gold and semiconductor/S&P 500 ratios serve as useful cyclical indicators and they are correlated to the stock/bond ratio, which is a risk appetite indicator. Both the copper/gold and semiconductor/S&P 500 ratios are confirming the current risk-on environment. This isn’t just a bear market rally, but the start of a fresh bull market.

 

 

In the short-term, other equity risk appetite indicators are exhibiting a positive divergence to the S&P 500.

 

 

Lastly, Mark Hulbert observed that NASDAQ market timer sentiment has retreated dramatically since the recent short-term market peak, which is constructive.

It’s remarkable that the market timers aren’t more upbeat. At its peak earlier this month, the Nasdaq Composite was up more than 20% from its late-2022 low, thereby satisfying the semiofficial criterion for what constitutes a new bull market. It’s only modestly below that threshold level now. Yet the market timing community is in a meh mood, and that’s bullish—relative to what we’d normally expect in the wake of a rally as strong as the one recently.

 

 

 

 

None of this means that the correction is over right now. Sentiment conditions, such as the 10 dma of the put/call ratio, are not signaling panic just yet.

 

 

The current global risk-off tone can be attributed to the series of strong US data, such as the jobs report and inflation readings, which, along with hawkish tones from non-voting FOMC members, have sparked a USD rally and equity weakness. Realistically, can anyone expect the blockbuster January jobs report to be followed by another 500K jobs gain in February (see Was the January Jobs Report a data blip?) or the strong January retail sales print to be followed by another?

 

 

The main risk occurs later in the year, when China’s reopening is evident and puts upward pressure on global demand and boosts inflation. The market is expecting the Fed Funds to fall in late 2023, which will be difficult if inflation gets a second wind.

 

 

My inner investor remains constructive on the equity outlook and he will be accumulating long positions. My inner trader is standing aside for clearer signs of a tactical opportunity.
 

Is there an inflation threat in your future?

Posted by Cam Hui -

On Valentine’s Day, the European Central Bank tweeted a poem to underscore its commitment to fighting inflation.
 

 

The ECB tweet is also indicative of the tight monetary policy undertaken by most major central banks. Only two central banks, the BoJ and the PBoC, are meaningful suppliers of global liquidity. The rest are raising interest rates and engaged in quantitative tightening. While the Fed may be on the verge of a pause, last week’s hot PPI report and slightly stronger than expected CPI print has raised doubts about a dovish pivot.
 

Inflation is becoming a threat again.
 

 

Interpreting the US inflation reports

US inflation figures came in hotter than expected. The monthly changes in headline and core CPI were in line with expectations, but annual changes of headline and core CPI were both 0.1% above market consensus. By contrast, monthly core PPI came in at 0.5%, which was well ahead of the 0.3% forecast, and December was revised upward from 0.1% to 0.3%.
 

 

Notwithstanding the stronger than expected PPI report, the longer term trend shows that headline CPI retreated from over 8% to 5-6%. While the deceleration is constructive, both headline (red bars) and core (blue bars) are stabilizing at those levels. It’s less clear how inflation readings can fall to 2% without further significant monetary tightening.
 

 

The San Francisco Fed undertook a study of cyclical and acyclical components of PCE, the Fed’s preferred inflation metric. While it’s clear that acyclical inflation has fallen, largely because of the normalization of supply chain constraints, cyclical inflation is stubbornly high and rising.
 

 

The analysis of sticky price and flexible price CPI tells the same story. Core flexible price CPI, which reflects the rise and fall of pandemic shock goods like used cars, have fallen dramatically. On the other hand, sticky price CPI is stuck at about the 6% level.
 

 

This begs the question of what happens if China reopens successfully and global demand surges. What happens to the inflation picture then?
 

 

The monetary policy response

In the wake of the January CPI report, Fed Funds futures began discounting a higher terminal rate and two consecutive quarter-point rate hikes, followed by easing in late 2023.
 

 

Will that level of monetary tightening be enough? The February FOMC statement committed to “a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time”. What does “sufficiently restrictive” mean? The February FOMC statement made it clear that the Fed is laser focused on the labor market and central to the “sufficiently restrictive” definition.

Despite the slowdown in growth, the labor market remains extremely tight, with the unemployment rate at a 50-year low, job vacancies still very high, and wage growth elevated. Job gains have been robust, with employment rising by an average of 247,000 jobs per month over the last three months. Although the pace of job gains has slowed over the course of the past year and nominal wage growth has shown some signs of easing, the labor market continues to be out of balance. Labor demand substantially exceeds the supply of available workers, and the labor force participation rate has changed little from a year ago. 

Both Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard made the case for half-point rate hikes in speeches last week. Former Fed economist John Roberts analyzed what stronger growth and higher inflation could mean for the Fed’s Summary of Economic Projections, otherwise known as the “dot plot”.

While the main focus of the analysis is the ongoing strength in the economy, I also modify my December SEP matching exercise to take account of the incoming data on inflation, which suggest a somewhat more optimistic outlook than the FOMC assumed in December. As I discuss in more detail below, I raise the path for the federal funds rate by enough to ensure that inflation is close to the FOMC’s objective by 2025.

He concluded that unemployment rises at the end of 2023 to 4.2% (vs. SEP median projection of 4.6%), core PCE at 3.5% (SEP median projection 3.1%), and the Fed Funds rate rises to 5.6% by Q3, which is higher than market terminal rate expectations.
 

 

Roberts’ study raises two key questions:

  • In light of the Fed’s focus on the labor market, does an unemployment rate of 4.2%, which is 0.4% lower than the December SEP projection, satisfy the “sufficiently restrictive” criteria?
  • How will the Fed respond to the global inflationary effects of higher China demand in the case of a successful reopening?

In short, it’s relatively easy to get inflation from 6% to 4%. Getting it down to the 2% target could be much tougher than anyone expects. The Congressional Budget Office is now projecting that inflation won’t reach 2% until 2027.
 

 

A seismic shift at the BoJ?

Across the Pacific in Japan, a seismic shift may be occurring at the BoJ. After decades of fiscal and monetary intervention, core CPI began rising in mid-2022 and has reached the 4% level.
 

 

The BoJ has been the lone holdout among G7 central banks by staying dovish while others have become hawkish. Rising inflation has begun to pressure the JPY exchange rate and the its bond market. The BoJ already gave in to market pressures and widened its yield curve control (YCC) level for the 10-year JGB from 0.25% to 0.50%. 
 

Looking ahead, current BoJ head Kuroda is stepping down after two consecutive 5-year terms in which he authored an unprecedented easy credit and monetary policy to boost inflation. Kuroda is expected to be replaced by Kazuo Ueda, an academic whose views are largely not known to the public.
 

The current market consensus is the choice of Ueda by Prime Minister Kishida as a way to differentiate the government’s policies from the “Abenomics” strategy of near-zero interest rates and massive asset purchases by the central bank meant to combat stagnation. At best, Ueda will continue Kuroda’s easy monetary policy. The more likely path is a minor hawkish pivot in which the BoJ gradually pulls back from its YCC and eventually raises interest rates. 
 

The BoJ and the People’s Bank of China (PBoC) are the two major central banks that are main suppliers of liquidity to the global financial system. For some perspective, the magnitude of the BoJ’s QE program is overwhelming the Fed’s QT program. The BoJ will likely reverse its ultra-loose credit policies in the next few years, creating headwinds for global risk appetite. In addition, the near-term path of US monetary policy is likely to be more hawkish than market expectations. The factors all serve to create headwinds for bond prices and risky assets in the medium term. Unless the growth outlook significantly improves, this will be a bearish environment for stock prices.
 

 

My base case scenario calls for a bullish recovery in H1 2023 for stocks, based on the cyclical effects of China reopening, followed by a dip in H2, triggered by a more hawkish monetary response to rising inflation (see The risk of transitory disinflation). The contrarian view is based on the Economist magazine cover indicator, which suggests that inflation will fall rapidly from here.
 

 

Sound the tactical all-clear

Posted by Cam Hui -

Mid-week market update: Last week, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) flashed a tactical sell signal when its 14-day RSI recycled from overbought to neutral.
 

 

It’s time to sound the tactical all-clear in the aftermath of the sell signal.
 

 

Bottoming signals

One reader alerted me that my bottoming model flashed a buy signal early this week when the VIX Index rise above its upper Bollinger Band and the NYSE McClellan Oscillator became oversold. In the past, buy signals from two or more indicators in close proximity to each other is enough for a buy signal.
 

 

A review of the equity averages across market cap bands shows that the S&P 500 briefly dipped below support and recovered, with the equal-weighted S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 all held above support. These are all constructive signs for the market.
 

 

As well, the relative performance of all of the defensive sectors are not behaving well.
 

 

Tactically, these are all indicators that the bears have lost control of the tape, but it doesn’t necessarily mean that the bulls are fully in the driver’s seat. The long Treasury bond has violated support and it’s breaking down, and so are non-US sovereigns. Rising bond yields (and falling bond prices) are likely to weigh on the equity outlook in the near-term.
 

 

My base case calls for an uneven and choppy intermediate term upward path for stock prices.
 

Cautious signs of a bullish revival

Posted by Cam Hui -

Preface: Explaining our market timing models

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Bearish

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.

Can’t have a bull market without the bulls

Ever since I turned bullish on equities (see What the bull case looks like), I am seeing signs of a revival in sentiment. Contrarian sentiment analysis is useful, but if you believe this is the start of a new bull, sentiment needs to steadily improve. You can’t have a bull market without a steady revival of bullish sentiment. Indeed, the 4-week moving average of AAII bulls-bears and the NAAIM Exposure Index, which measure the sentiment of RIAs managing individual client funds, have bottomed turned up.

Similarly, the TD Ameritrade IMX, which measures the equity exposure of the firm’s clients, have also been making a bottom.

As well, Bloomberg reported money managers have cut their bearish equity exposures and they are now positioned more in line with historic norms. Readings are not extreme. The stock market can rise further if there are positive catalysts.

Willie Delwiche pointed out that recoveries after a prolonged bout of bearishness, which he measured as the number of weeks AAII bulls were below AAII bears, tend to be bullish.

Bullish rebound

Other signs of a bullish revival can be seen in factor analysis and the technical structure of the market. A review of four major factors reveals the following:

  • Underlying strength in small caps.
  • A revival of value against growth, notwithstanding the recent growth rebound.
  • High quality dominance in H2 2022, followed by a reversal in 2023.
  • Uneven returns to price momentum.

Recessionary market bottoms are often characterized by a dash for junk, which are the characteristics seen in small cap strength and low quality rally of 2023. The value/growth reversal appears to be a secular change in leadership that can be seen when market leadership changes from bull to bear.

Cross Border Capital pointed out that the global liquidity cycle is bottoming. Rising liquidity should be positive for stock prices.

In addition, the broadly based Wilshire 5000 is on the verge of flashing a long-term buy signal. In the past, this model has served well to delineate bull and bear markets. A bullish signal occurs when the MACD histogram turns from negative to positive, which should occur within the next few months should the market advance continue. A sell signal occurs when the 14-month RSI exhibits a negative divergence.

Key risks

The bull case faces several risks. The first is valuation. The S&P 500 forward P/E is elevated by historical standards. That doesn’t mean the market can’t advance from current levels, but a gain of 15-20% would put valuation into extreme bubbly territory.

Other risks can be characterized as tail risks, which are relatively low probability events with high impact. The Economist highlighted Pakistan as a sovereign default candidate. A Pakistani default has the potential to ripple through the Chinese financial system because of the debts incurred from the Belt and Road Initiative. Such a default could cause a disorderly unwind that unduly affects China’s financial system.

Moreover, Zeynep Tufekci highlighted bird flu as another pandemic threat to global health in a NY Times OpEd. First, mammal to mammal transmission has been documented in the latest bird flu variant.

Alarmingly, it was recently reported that a mutant H5N1 strain was not only infecting minks at a fur farm in Spain but also most likely spreading among them, unprecedented among mammals. Even worse, the mink’s upper respiratory tract is exceptionally well suited to act as a conduit to humans, Thomas Peacock, a virologist who has studied avian influenza, told me.

More importantly, the latest H5N1 bird flu strain exposes vulnerabilities in the vaccine supply chain. Vaccines production depend mainly on egg production, but the hens that lay the eggs could be devastated by (you guessed it) bird flu.

Worryingly, all but one of the approved vaccines are produced by incubating each dose in an egg. The U.S. government keeps hundreds of thousands of chickens in secret farms with bodyguards. (It’s true!) But the bodyguards are presumably there to fend off terror attacks, not a virus. Relying on chickens to produce vaccines against a virus that has a 90 percent to 100 percent fatality rate among poultry has the makings of the most unfunny which-came-first, the-chicken-or-the-egg riddle.

The only company with an F.D.A.-approved non-egg-based H5N1 vaccine expects to be able to produce 150 million doses within six months of the declaration of a pandemic. But there are seven billion people in the world.

Short-term vulnerable

In the short-term, the market appears to be extended. The 14-day RSI reached an overbought level and retreated last week. Such events have usually resolved in either pullbacks or sideways consolidations in the past.

As well, the 10 dma of the put/call ratio has normalized from panic levels to readings indicating growing bullishness. While this doesn’t mean that the market will crash from here, it is a cautionary signal and a sign of rising headwinds for stock prices.

Another short-term risk factor can be seen in the development of Fed liquidity, which consists of quantitative tightening, less changes in the TGA and RRP. Fed liquidity has been highly correlated with the S&P 500 and a negative divergence is appearing between the two.

In conclusion, the signs of a bullish revival are becoming more evident in both the sentiment and technical data. However, valuation risk is elevated. The market is also extended in the short run and may be in need of a corrective or consolidation period.

My inner investor is bullishly positioned. My inner trader is tactically short the market in anticipation of near-term weakness. The usual caveats 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.

Disclosure: Long SPXU

Why you should fade the NASDAQ surge

Posted by Cam Hui -
The recent market rally has been led by a resurgence in large-cap NASDAQ stocks. This leadership has become overly extended, as evidenced by the rising divergence between their relative performance and the 10-year Treasury yield. A detailed factor and sector performance analysis reveals an underlying trend in favor of cyclical exposure.

 

 

 

Growth leadership

Make no mistake, the latest rally is a bullish revival. The only question is the nature of the leadership. A review of relative performance shows defensive sectors to all in relative downtrends, with the exception of real estate, indicating that the bulls have control of the tape.

 

 

The relative performance of growth sectors have all rebounded strongly in 2023.

 

 

By contrast, value sector leadership have faded, with the exception of the cyclically sensitive equal-weighted consumer discretionary stocks.

 

 

Signs of cyclical strength

A review of the value/growth relationship by market cap tells a different story. While growth has been dominant against value among large caps in 2023, they were largely flat among small caps. In other words, the growth rebound has been concentrated in a narrow leadership of just a few FANG+ names.

 

 

A more detailed analysis shows a picture of underlying strength among cyclical stocks. The relative performance of key selected cyclical industries are strong.

 

 

A review of the difference in relative performance between large and small cap industrial stocks tells a similar story. While large cap industrial relative returns sagged in 2023, the small cap industrial stocks remain in a relative uptrend.

 

 

A similar pattern of small cap relative strength can be seen in the materials sector.

 

 

Consumer discretionary is another cyclically sensitive sector. In this case, both large and small caps are exhibiting positive relative strength.

 

 

In conclusion, the recent rebound in the US equity market has been led by a narrow leadership of large-cap growth stocks. The relative breadth of NASDAQ 100 stocks (bottom two panels) are weak. A more detailed analysis shows underlying strength in cyclical sectors and industries, which is where investors should concentrate their exposure.

 

 

 

Making sense of the S&P 500 golden cross

Posted by Cam Hui -

Mid-week market update: In case you missed it, the S&P 500 experienced a “golden cross” this week, when the 50 dma rose above the 200 dma. This is generally regarded as a bullish development among the technical analysis crowd as an indication that the price trend has turned upward.
 

 

How should traders and investors interpret the golden cross signal?
 

 

Good news, bad news

Rob Hanna at Quantifiable Edges analyzed past golden cross buy signals and he had some good news and bad news for investors. The signal was generally positive for stock prices and beat a buy and hold benchmark, but drawdowns can be quite substantial.

While drawdowns have been mostly fairly moderate since the mid-50s, prior to that there were some very large drawdowns to endure. The 2020 drawdown was the biggest since the 40s.  Despite some fairly sizable drawdowns, the Golden Cross would have beaten “Buy and Hold” handily. Over the time period measured, the SPX had a compound annual growth rate (CAGR) of 5.57%. Simply incorporating a Golden Cross filter would have raised the CAGR to 7.25%. It is a bullish long-term trend indication.  But it is not a bulletproof long signal.

 

 

 

Bullish, with a chance of pullback

This leaves us with an intermediate-term bullish outlook, but with a substantial chance of a pullback in the near term. The usually reliable 14-day RSI of the S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) recycled from an overbought to a neutral condition yesterday, which is a tactical sell signal and an indication of a loss of momentu.
 

 

The market is getting a little frothy, and a pullback would not be unusual. How frothy? FactSet reported that the Q4 earnings beat rate was 70%, which was short of the 5-year average of 77% and 10-year average of 73%. The sales beat rate was 61%, compared to the 5-year average of 69% and 10-year average of 63%. Nevertheless, Bespoke observed, “Over the last three months, stocks that have reported have seen a median one-day gain of 0.86% on their earnings reaction days.”
 

 

 

Estimating downside risk

What’s the near term downside risk for the S&P 500 from here? The S&P 500 staged upside breakouts through double resistance, and a logical support level is the falling trend line at the 3920-3930 level. That represents a peak-to-trough downside potential of -5%, which is not bad in the context of an intermediate uptrend. As the equal-weighted S&P 500, S&P 400, and Russell 2000 all broke resistance, watch for them to pull back to test the breakout turned support.
 

 

In conclusion, the golden cross signal should be an intermediate term bullish signal for stock prices. However, the market is extended and the risk of a near-term pullback is high. The most likely peak-to-trough downside risk for the S&P 500 is about -5%.
 

Subscribers received an email alert this morning that my trading account had initiated a short position in the S&P 500. This is only a tactical short and I believe the intermediate trend is still up. The usual disclaims 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.

 

 

Disclosure: Long SPXU
 

Was the January Jobs Report a data blip?

Posted by Cam Hui -

I’ve been trying to make sense of the blowout January Jobs Report. BLS reported a Nonfarm Payroll gain of 517,000, which was an off-the-charts surprise compared to market expectations of 185,000. Whenever large surprises occur, it makes me think that the report represents a data blip.
 

For some perspective, the 517,000 gain represents an enormous surge in the seasonally adjusted NFP report (blue). The non-seasonally adjusted figure (red) shows that January usually sees large layoffs, and job losses were lower than normal.
 

 

Here are the bull and bear cases for employment and the labor market.

 

 

The bull case

Some signs of improvement can be seen in the more volatile household survey. The establishment survey (blue) is the headline jobs figure that is the main focus. The household survey (red) is a smaller sample survey and the results are more volatile. Nevertheless, the household survey showed signs of improvement in December, which continued into January. By that metric, the January upside blowout shouldn’t have been a major surprise.

 

 

In addition, initial jobless claims (blue) have been trending down, which is an indication of labor market strength. On the other hand, continuing claims have been edging up. In other words, people are losing jobs at a slower pace, but those who lost jobs are encountering more difficulty finding new ones.

 

 

Some of the raw data shows a mixed picture. The non-seasonally adjusted establishment survey (blue) shows fewer job losses compared to the last two instances in January. However, the non-seasonally adjusted household survey (red) shows more job losses compared to January 2022 but more job losses compared to January 2021. This suggests that either there is a problem with the seasonality adjustment, a data blip with the volatile household survey data, or a weather-related issue that’s affecting employment.

 

 

New Deal democrat argued that the level of January layoffs was extraordinarily low and the odds of a downdraft in February employment is high.

In conclusion, here’s what we have: in a very tight labor market, in the aggregate employers were reluctant to lay off seasonal hires in January, electing to keep them on payroll. This translated into blockbuster job gains on a seasonal basis. But we have to wait for February’s report to see whether this is a sign of renewed strength in the jobs market, or whether employers have less need to hire new workers as a result. In other words, will January’s strength continue in a month where actual hiring, not layoffs, are expected.

 

 

The bear case

The bear case depends on trends. Even though headline employment gains were strong in January, compensation gains have been soft and they haven’t kept pace with job gains. The employment cost index (blue) is released quarterly and includes both wages and benefits. ECI gains have been decelerating. Similarly, the average hourly earnings for nonsupervisory employees (red), which is less distorted by year-end bonuses of management workers, have also seen the rate of change plunge.

 

 

In addition, the Philadelphia Fed published a study showing Q2 job gains were only 10,500 compared to 1.1 million reported by the establishment survey. The study was based on Quarterly Census of Employment and Wages (QCEW) data of unemployment insurance premiums of workers. The survey is very comprehensive and covers virtually all employers that pay insurance premiums, compared to the sampling technique used by the establishment and household job surveys. 

 

 

Unfortunately, QCEW data is not reported on a timely basis and the latest report we have is Q2. Nevertheless, the Philadelphia Fed study leads to the conclusion that investors should put more weight on the household survey (red line, December 2021 = 100), which shows flat jobs growth for most of 2022, with a re-acceleration that began in December even as the establishment survey (blue line) raced ahead.

 

 

What does this all mean? My base case calls for a downward reversion in future job reports. If the household survey is right, employment was flat for most of 2022, though it revived late in the year. It also means that the labor market is not as tight as the Fed believes, though we will have to wait until February to see how much momentum there is in job gains.

 

Has the market reached escape velocity?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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 market gods smile on the bulls

Last week was a very data-heavy week, filled with macro events and earnings reports from several megacap growth stocks. I was expecting volatility as anything could have happened. Instead, the market gods smiled on the bulls as most of the events resolved in bullish fashions. Inflation (Employment Cost Index) was tame. Employment (JOLTS, ADP, and NFP) were either weak or exhibited weak internals. The Fed raised rates by an expected quarter-point. Powell tried, but failed to put on a hawkish face. The positive market reaction to META overwhelmed to negative reactions to AAPL, AMZN, and GOOGL earnings results.

 

As a consequence, all of the market averages staged convincing upside breakouts through resistance.

 

 

Is this a sign of a market liftoff that signals a new bull?

 

 

Bullish signals

The latest rally was accompanied by strong breadth, as measured by new highs-lows on the NYSE and NASDAQ. Past bear market rallies saw advances stall whenever net new highs turned positive. Not this time.

 

 

Rob Anderson of Ned Davis Research defined breadth as the number of sectors trading above their 200 dma. Past instances of strong advances have been good buying opportunities.

 

 

The Economist recently published a magazine cover questioning the viability of the Goldman Sachs business model. If history is any guide, these covers have been terrific contrarian signals. I interpret this as a bullish signal not only for GS, but the entire high-beta broker-dealer industry.

 

 

 

Estimating upside potential

I can anticipate the next question: How far can stock prices rise? 

 

The S&P 500 is trading at a forward P/E of 18.4, which is just below its 5-year average of 18.5 and above its 10-year average of 17.2. A market driven by speculative fever could see the forward P/E spike to 21-22, which represents an upside potential of 15% to 20%.

 

 

 

Key risks

Needless to say, valuation risks are growing. Q4 earnings season results have been subpar and the E in the forward P/E is falling. 

 

 

In addition, the rally in US markets may be a counter-trend relative performance rally. US equities had been lagging for several months. A relative rebound was to be expected but its sustainability is an open question.

 

 

The performance of risk assets like equities has been inversely correlated to the USD. The USD Index weakened to test a key support level. While the greenback weakened after the FOMC decision and press conference, it strengthened against the EUR and GBP in the wake of the ECB and BoE rate decisions on Thursday. Equity bulls are hoping that the USD can break support, which is another open question.

 

 

The NYSE Summation Index (NYSI) has spike to above 1000, which is an overbought condition. Historically, oversold conditions of under -1000 (pink lines) have been strong indicators of tradable bottoms, but overbought conditions (grey lines) be resolved in different ways. They can either signal short-term tops or pauses, or the start of a major bull. Of the 17 instances in the last 20 years, 10 have either ended in pullbacks and consolidations, and 7 in continued advance. Is this a plain vanille overbought condition, or a “good overbought” reading that signals a sustained bull?

 

 

In conclusion, the S&P 500 advance appears extended and it can pull back at any time. While the intermediate-term trend looks bullish, don’t be surprised to see a period of pullback and consolidation before stock prices can rise in a sustainable manner.

 

A risk of transitory disinflation

Posted by Cam Hui -

The main event last week for US investors was the FOMC decision. As expected, the Fed raised rates by a quarter-point and underlined that “ongoing increases in the target range will be appropriate”. Powell went on to clarify that “ongoing increases” translated to a “couple” of rate hikes, which would put the terminal rate at 5.00% to 5.25%, a level that was just above market expectations. He went on to signal that the Fed does not expect to cut rates this year. Moreover, he stressed, “We will stay the course until the job is done”.
 

Those statements appeared hawkish, until he allowed, “We can now say for the first time that the disinflationary process has started”. In addition, he characterized financial conditions as tight when it was obvious that markets had been taking on a risk-on tone since October. 

 

As a consequence, the Fed’s hawkish warnings fell on deaf ears. Asset prices went into a risk-on mode in response to Powell’s statements during the press conference. The market consensus terminal rate stayed at just below 5% and expectations of rate cuts at the end of 2023 changed from one to two. It took a strong surprise from the January Jobs Report to push the terminal rate above 5%, though easing expectations was pushed forward into mid-year.

 

 

To be sure, inflationary pressures are softening in a constructive way, but the risk of transitory disinflation is rising.

 

 

Inflation is decelerating

Powell was correct in observing that the “disinflationary process has started”. Inflation rates, however they’re measured, have been decelerating since mid-2022.

 

 

Goods inflation has been falling as supply chain bottlenecks normalized. This effect is can be seen in the slump in manufacturing indicators such as PMI and ISM, though the service side of the economy has been much more robust. Powell made several references to the “services ex-shelter” components, which are mainly linked to the labor market and wages, of inflation that are worrisome. Even then, compensation pressure, as measured by the Employment Cost Index and Average Hourly Earnings for nonsupervisory workers (which largely excludes bonuses), has been trending down.

 

 

On the other hand, leading indicators of employment such as temporary jobs and the quits/layoffs rate have also been noisy. They had been falling until the positive shock seen in the January Jobs Report, which saw a rebound in temporary employment.

 

 

In addition, Variant Perception pointed out that consumer expectations of inflation are falling fast.

 

 

 

A dove in hawk’s clothing?

There was some surprise and confusion when Powell characterized financial conditions as tightening very significantly in the last 12 months. It was an opportunity for the Fed Chair to push back against the risk-on rally that began in October, but he declined.

 

 

Powell’s comments are consistent with a recent Lael Brainard speech given on January 19, 2023. The Fed appears to interpret financial conditions indices differently when real rates are rising significantly. This was an important signal that the Fed is prepared to allow the stock and credit markets to rip.
Financial conditions have tightened considerably over the last year as the Federal Reserve and foreign central banks have tightened policy. Real yields have risen significantly across the curve over the past year: 2-year yields on Treasury Inflation-Protected Securities (TIPS) have risen more than 4-1/2 percentage points to 2.1 percent, and 10-year TIPS yields have risen more than 2-1/4 percentage points to 1.2 percent. Short-term real interest rates have moved into decidedly positive territory. Mortgage rates have doubled.
From a technical internals perspective, market leadership had been signaling a cyclical rebound since the rally off the October lows. Cyclical industries, with the exception of oil and gas, have been outperforming. Even transportation, which had been the laggards, joined the party.

 

 

 

The China reopening boost

The cyclical rebound theme is also evident in the China reopening narrative. Chris Williamson, Chief Economist at S&P Global Markit Intelligence, observed that “Global factory downturn shows signs of easing as China re-opens”.

 

 

Indeed, China’s Manufacturing and Non-Manufacturing PMIs have rebounded.

 

 

Hopes of a China reopening rebound can be seen in the relative performance of the Chinese materials sector.

 

 

A review of the relative performance of the stock markets of China and her major Asian trading partners shows that while the China and Hong Kong markets have pulled back after an initial surge, the performance of semiconductor-sensitive Korean and Taiwan markets are in relative uptrends, and the mining sensitive Australian market has staged a relative breakout and pullback.

 

 

In short, the combination of excitement over China’s reopening and the dovish pivot by the Fed is sparking a risk-on rally in risky assets. My Trend Asset Allocation Model turned bullish last week. The performance of my model portfolio based on the real-time signals of this model that varies asset allocation by 20% over/under a 60% S&P 500 and 40% 7-10 Year Treasuries has been excellent (see link for full discussion of methodology). The model portfolio is ahead of the benchmark for all 1, 3, 5 year time horizons and since inception in December 2013. In addition, it is exhibiting equity-like returns with 60/40 balanced fund like risk.

 

 

 

Key risks: Heads I win, tails you lose

There are two key risks to the China reopening narrative: Its failure and its success. 

 

What if the China reopening trade fizzles? While the hopes for a cyclical rebound is evident in equity market action, there is little confirmation from the commodity markets. Commodity prices, regardless of how they’re measured, have been moving sideways and are not showing the same risk-on pattern seen in equity markets. Similarly, the cyclically sensitive copper/gold and base metals/gold ratios are also range-bound and are not exhibiting signs of surges in demand.

 

 

What if the reopening scenario succeeds? Bloomberg Economics modeled the effects of a successful China reopening and forecasts that China’s GDP will accelerate from 3% to 5.8% in 2023. It could also elevate global CPI to the 5% level in Q2, which would complicate the Fed’s plans to pause rate hikes.

 

 

Instead of cutting rates, the Fed would interpret this as transitory disinflation and respond by raising rates. Such an inflationary resurgence would be an unwelcome surprise for risky assets. The closest analogy is the double-dip recession of 1980-82. The Fed had tightened in early 1980 and the yield curve had become deeply inverted. The inversion reversed itself in mid-1980, but the Fed began to tighten again in July and sent the economy into a second recession. During that period, the stock market rallied for eight months in 1980, topped, and went into a prolonged bear market for almost two years.

 

 

The moral of this story is, be careful what you wish for. The disinflation you see today may be transitory and you will pay for it later in the year. Powell has made it clear that he wants to avoid the Volcker era when the Fed was forced to raise rates to very painful levels to control inflation and inflation expectations. He would prefer to err on the side of overtightening and remedy with rate cuts in the case of a slowdown rather than undertighten and allow inflation to run out of control.

 

Powell, whose previous career was in finance, summarized the difference between the jobs of Fed officials and market participants during the post-FOMC press conference.
It’s our job to restore price stability and achieve 2% inflation. Market participants have a very different job… It’s a great job. In fact, I did that job for years, in one form or another. But we have to deliver.
It’s a message that all market participants should keep in mind.

 

Beware of the initial reaction on FOMC days

Posted by Cam Hui -

Mid-week market update: The stock market reacted with a risk-on tone to the FOMC decision. The S&P 500 has staged an upside breakout through the 4100 level. While I am cautiously intermediate-term bullish, be warned that the initial reaction to FOMC decisions are often reversed the following day.
 

 

Keep in mind that this is a weekly chart. The week isn’t over.

 

 

Be prepared for consolidation

Investors are faced with a data-rich week this week, each of which is a potential source of volatility. In the US, we have seen softer than expected consumer confidence, a deceleration, and missed expectations in the Employment Cost Index, constructive conditions from the JOLTS report, inasmuch as the quit/layoffs rate is falling and the ratio has led NFP employment. The main event was the FOMC decision.

 

 

In addition, META reported earnings after the close today, with AAPL, AMZN, and GOOGL tomorrow. As well, there is the January Employment Report print Friday morning. In Europe, we have seen a mixed picture in the eurozone inflation reports, with CPI softer than expected by core HICP coming hot. Investors will also see the ECB and BoE rate decisions tomorrow.

 

While the data has mainly been risk positive so far, keep in mind that they can’t be relied upon to stay that way and the market is overbought while exhibiting negative divergences.

 

 

In other words, be prepared for a period of consolidation after the upside breakout through the falling trend line.
 

 

Fedspeak risk

During the post-FOMC press conference, Fed Chair Powell acknowledged that most inflation and labor market indicators are softening, which is constructive development. But he also tried very hard to push back against the notion that the Fed is going to pivot to a less hawkish path in the near future. In particular, the statement about ongoing increases (plural) is a hint that the Fed intends to raise the Fed Funds rate to above 5%, which is higher than current market expectations.
The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.
If the Fed is dissatisfied with the exuberance of the market reaction, watch for Fed speakers in the coming days to reinforce the notion of a higher-than-expected terminal rate and a low probability of rate cuts later this year.

 

To be sure, today’s upside breakouts were confirmed by other indices, which is a positive sign. However, the advance may be extended. While I am not inclined to be short, I would also caution against chasing the rally. Wait for a pullback before buying.

 

 

What the bull case looks like

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model 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 [upgrade]
  • Trend Model signal: Bullish [upgrade]
  • Trading model: Neutral [upgrade]

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Positive or negative divergence?

Several readers pointed out to me that while the short-term breadth indicators like the percentage of S&P 500 above their 20 and 50 dma are exhibiting negative divergences, the longer-term percentage of S&P 500 above their 200 dma has been far more resilient. In fact, the strength of the percentage above 200 dma is a signal of underlying strength.

 

 

Is the market showing positive or negative divergences?

 

 

The bull case

While I have been cautious on the market, here is the bull case. Rob Anderson of Ned Davis Research pointed out that the percentage of stocks above their 200 dma rose above 61%, which is an indication of broad market strength, which is historically bullish.

 

 

Bespoke drilled down further by sector and found that the percentage of stocks above their 200 dma is strong among cyclical sectors and weak among defensive sectors, which is another bullish signal.
 

 

Across the Atlantic, European value sectors are also exhibiting signs of relative strength, with industrials and financials in the lead.

 

 

 

A Trend Model upgrade

In connection with my other publication this week (see FOMC preview: How and why the Fed could pivot) and these technical readings, I am upgrading the Trend Asset Allocation Model from neutral to bullish. The caveat is most of the strength is likely to be found outside the US, in Europe, and in emerging markets.

 

 

An analysis of the iMGP DBi Managed Futures Strategy ETF as a proxy for trend following systematic CTAs shows that the fund is significantly short interest rate futures, short the S&P 500, and have minor long positions in EAFE and emerging market equities. As trend following programs like this CTA and my Trend Asset Allocation Model are designed to be slow to enter and exit positions in order to take advantage of long-term trends, I interpret these readings as the bull trend has more room to run.

 

 

The Trend Model upgrade also means that the Ultimate Market Timing Model is now bullish, with the caveat that the S&P 500 may have to re-revisit the old October lows.

 

 

A rising tide lifts all boats, but…

Don’t get me wrong, US equities are likely to be dragged upwards by the global bull wave especially when the S&P 500 has decisively staged an upside breakout through a falling trend line.

 

 

In the short-term, the S&P 500 is encountering overhead resistance. However, the equal-weighted S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 have all staged upside breakouts. How the US market behaves this coming week with the FOMC decision Wednesday, the January Payroll Report Friday, and a significant portion of the S&P 500 reporting results could be decisive.

 

 

That said, US equity investors are warned of elevated downside risk compared to non-US markets. The US is trading at a significant valuation premium compared to other markets around the world.

 

 

Moreover, the elevated forward P/E ratio is based on an assumption of a soft landing. Consensus estimates indicate that EPS deterioration should end in Q1 and earnings should return to growth in Q2. As earnings estimates are being revised downwards across almost all time horizons, the risk is the earnings recession extends into Q2 and beyond.

 

 

The big picture is Q4 earnings season results have been subpar. Sales and EPS beat rates are below historical averages even as Street analysts downgrade forward EPS estimates.

 

 

This report began with the divergence between short and long-term indicators. I interpret these readings as the S&P 500 may need a period of consolidation or pullback within a longer-term bull trend. The best opportunities are to be found within cyclical stocks and in non-US regions.