Page 11 – Humble Student of the Markets

Risk budgeting ahead of NVIDIA’s earnings report

Posted by Cam Hui - August 28, 2024

Mid-week market update: Several readers asked me for comments going into NVIDIA’s earnings report Wednesday night, so I thought I would publish my mid-week update a little earlier than usual.

Bottom line, I have no idea about NVIDIA’s fundamentals. You can study the chart pattern, but event-driven market moves are “roll the dice” moments. Instead of trying to focus on what how stock and the market will move after the earnings report, my inclination is to focus on portfolio risk during these binary events. How is your portfolio positioned relative to your risk budget?

Even though I can offer no insights on market direction, here are some thoughts on risk from the option market.

Estimating risk

Here is a snapshot of NVIDIA’s options that expire this Friday from the CBOE website. The implied volatility (IV column) of at-the-money options is between 1.47 and 1.48. For the uninitiated, you convert from an annual to a daily volatility by dividing the annual implied volatility by the square root of 252, which is roughly the number of trading days in a calendar year. That implies a one-day standard deviation move of 9.3%, which would occur about two-thirds of the time, and a two standard move of 18.6%, which would occur about 95% of the time. That’s quite the range to be rolling the dice on.

In addition to the NVIDIA earnings report Wednesday night, the other major market moving event is the PCE report on Friday morning. We can estimate market expectations of volatility of these events based on option pricing.

Here is the option pricing for SPY options that expire Thursday night, which would be one trading day after the NVIDIA report, and Friday, which would be one trading day after the PCE report. The market is discounting a one-day SPY volatility of 1.0% on Thursday, and volatility declines to 0.9% on Friday. Translated, the market is expecting a decline in volatility of 0.1% after the PCE report compared to the NVIDIA report.

That’s an example of how to risk budget.

Bullish sentiment?

Here’s a sentiment insight from the option market. The accompanying chart compares the 10-minute bars of the S&P 500 on Tuesday (top panel) and the 9-day VIX (bottom panel). From about 2pm onward, the index was flat to slightly down, and so was VXST, which is somewhat unusual as the stock market tends to be inversely correlated to volatility. I interpret this as a slightly bullish sentiment bias going into the NVIDIA earnings report. Keep an eye on how this relationship evolves Wednesday as a way of measuring overall market sentiment.

My inner investor is neutrally positioned at roughly the investment policy stock/bond target mix. My inner trader has stepped to the sidelines ahead of this potential market moving event.

Bullish momentum vs. bearish seasonality

Posted by Cam Hui - August 25, 2024

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 (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Neutral (Last changed from “bullish” on 20-Aug-2024)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.

Subscribers can access the latest signal in real time here.

Negative seasonality ahead

Now that the rally off the early August low appears to be stalling, what are the odds of a re-test of the August lows?

The accompanying chart from Jeffrey Hirsch of Almanac Trader shows that the stock market pattern in 2024 has closely followed the historical election year seasonal pattern. We are about to enter a period of negative seasonality until late October. Is this a sign the S&P 500 could weaken back to its early August low?

Here are the bull and bear cases.

Momentum, momentum!

The short-term bull case rests on price momentum. The market came within a hair of a Zweig Breadth Thrust buy signal. As a reminder, the ZBT buy signal triggers when the ZBT Indicator surges from oversold to overbought within 10 trading days. Historically, such displays of strong price momentum tend to persist for at least a year.

The ZBT Indicator plunged to a near oversold condition on the day of the August panic. It reached an overbought condition last Monday, which was exactly 10 trading days later. It was a breadth thrust, just not a Zweig Breadth Thrust. Breadth thrusts deserve some respect.

Along with the impressive display of strong price momentum, sentiment readings are not stretched and could rise further. The CNN Business Fear & Greed Index has only recovered to neutral. Frothy markets don’t look like this.

The short-term bear case

The short-term bear case rests on a combination of overbought conditions and a series of negative divergences.

If the market is exhibiting strong price momentum, it’s not showing up at the stock or sector level. The accompanying chart shows the relative performance of the top five sectors in the index comprising 75% of index weight. If overall momentum is so strong, where’s the relative momentum at the sector level? The market can’t meaningfully rise without strong relative performance from a majority of these major sectors.

The sectors that are possibly showing signs of emerging leadership are the defensive sectors. They appear to be trying to make rounded bottoms (blue lines). While the evidence isn’t definitive, some of them began to turn up in relative strength slightly before the S&P 500 began to stall (red lines).

In addition, the NYSE McClellan Oscillator reached an overbought condition and recycled downwards, which is usually interpreted as a short-term sell signal.

What to watch

Short-term bullish or bearish? I believe the jury is still out on that score. Here is what I am watching.
How will breadth evolve? Even as the S&P 500 stalled just below the resistance level defined by its all-time high, the equal-weighted S&P 500 broke out to an all-time high, indicating that the average stock in the index is dragging the index upwards. That’s bullish, right?

Not necessarily. The small-cap Russell 2000 is well below its all-time high and its lack of momentum is disappointing. I am waiting for greater clarity to see how breadth indicators evolve.

Other risk appetite indicators are giving off mixed signals. Even though credit market risk appetite (green line) is holding up well, equity risk appetite (red dotted line) is flashing a negative divergence.

More ominously, Bitcoin prices continue to track the relative performance of the ARK Investment ETF (ARKK), which is an indicator of speculative growth stocks. Bitcoin can also be thought of as a liquidity proxy and its downtrend is bad news for the bull camp.

Over at the bond market, yields fell when Fed Chair Powell stated in his speech Friday that it was time to cut interest rates: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

It was a dovish speech. Powell opened the door to half-point rate cuts by raising concerns about the cooling jobs market: “We do not seek or welcome further cooling in labor market conditions.” In particular, there were no coded signals of gradualism in the pace of cuts as “gradual”, “gradualism”, “measured (pace)” were notably absent from his speech.

I have many questions. The market is discounting a 1% decline in rates until year-end and a half-point cut at one of the three remaining FOMC meetings between now and December. Notwithstanding Powell’s dovish tone, can he even manage a September rate cut without any dissents?

Are market expectations overly ambitious? Both the 10-year and 2-year rates are testing key support zones. Is this as good as it gets? Bond bulls need to push yields below the support zones to sustain a risk-on rally.

In summary, I can think of two scenarios for the short-term path of stock prices. The market could continue to rise, supported by positive momentum and a neutral sentiment backdrop. On the other hand, overbought readings and a lack of leadership could resolve in the typical pattern of seasonal weakness. I am waiting for greater clarity as to how market internals develop in the coming days. Even if stock prices were to pull back, it doesn’t mean that the market is on the verge of a major top. My most cautious case calls for a period of consolidation and correction until late October, followed by a rally into year-end.

Gold: Fakeout or generational buying opportunity?

Posted by Cam Hui - August 24, 2024

I highlighted the accompanying chart before. Gold staged an upside breakout at 2100 out of a cup and handle pattern. It recently rose above 2500 to an all-time high. In addition, the cup and handle breakout of 2024 is highly reminiscent of a similar breakout in 2005. Not only did the gold price stage upside breakouts, but also the gold/S&P 500 ratio made a rounded saucer shaped bottom (bottom panel) that resolved in over a decade of positive relative performance.

In December 2023, I studied the factors driving gold strength and concluded that they “should be bullish for the price of risky assets” (see The Market Meaning of a Gold Breakout). In June 2024, I focused on the inflationary pressures behind fiscal dominance and looked forward to the November election. I concluded that gold prices should benefit regardless of who wins the White House, but a Trump win would be especially inflationary (see Why the November Election Matters to Gold).

Now that gold has reached another all-time high at 2500, will history repeat itself? Is this another generational buying opportunity or a bull trap fakeout?

Reasons for caution

Let’s begin with the reasons for caution. Conventional drivers of gold prices have lagged the yellow metal and they are forming negative divergences that warn of excessive frothiness.

Gold has traditionally been inversely correlated to the USD. But USD weakness (inverted chart scale) doesn’t explain why gold is at an all-time high. As well, gold is thought of as a hedge against inflation. However, the price of TIPS, or inflation-linked Treasury bonds, made a lower high even as gold breached 2500. A similar negative divergence can be seen in RINF, the inflation expectations ETF linked to the price of the FTSE 30-year TIPS Index.

Should investors be worried about these technical warnings of possible weakness?

New bullish factors

The bull case can be summarized this way. Even as the conventional factors affecting the gold price have stumbled, other factors have emerged to support demand for gold.

In particular, gold prices have soared because of central bank buying for geopolitical reasons. Central bankers saw the effects of how America could weaponize the banking system by denying access to SWIFT after the onset of the Russo-Ukraine War. The most prominent central buyers of gold were Russia and China as they sought to diversify their holdings away from USD assets in the event of a geopolitical conflict.

For some perspective on the magnitude of fund flows, central bank buying has strongly supported gold prices in the last few years.

Aside from PBOC demand for gold, Chinese households have also been buying. I pointed out in the past the softness of the Chinese economy (see China Slowdown = Reduce Risk). The Chinese yuan is overvalued, but the PBOC dare not allow it to weaken too quickly as it has the potential to start a capital flight stampede. The downward pressure has shown up in Chinese private demand for gold. Reuters reported that Chinese buyers are back after a brief two-month hiatus:

Several Chinese banks have been given new gold import quotas from the central bank, anticipating revived demand despite record high prices, four sources with knowledge of the matter told Reuters.

The new quotas, aimed at helping the People’s Bank of China (PBOC) control how much bullion enters the world’s leading consumer of the precious metal, were granted in August after a two-month pause largely due to slower physical demand in the wake of a bullish market.

In addition to central bank and Chinese private demand, the conventional drivers of gold are also tactically turning up. Central banks are cutting rates as inflation falls, which has the effect of reducing real rates, which is supportive of higher gold prices.

In addition, estimates of global liquidity are turning up, which is reflationary and supportive of higher gold prices.

Too frothy?

As a consequence, western investors of the gold ETF (GLD) have returned to the party. This can be judged bullishly as either as the start of a momentum stampede or in a contrarian bearish fashion as the dumb retail money piling in.

There is no question that gold is extended in the short term. SentimenTrader observed, “It’s rare to see sentiment toward gold more optimistic than other major markets. April 2020 is the only time in the past decade when sentiment toward gold was higher than that toward stocks, bonds, and crude oil.”

On the other hand, my analysis of gold sentiment has a more nuanced view. The bears will argue that the percentage bullish on point and figure of gold mining stocks (GDX) is above 80% (bottom panel), which is in the overbought zone and a sign of a frothy market. The bulls will argue that the gold miner to gold ratio is only in the middle of its three-year range. More importantly, junior gold mining stocks (GDXJ) are near the bottom of their range against the senior miners (GDX), which is hardly a sign of excessive speculation.

Here is my view. The upside breakout in gold prices has more room to run, though the market is extended and could pull back at any time.

For some perspective, a point and figure analysis of the daily gold chart using a 1% box and 3-box reversal shows a measured objective of 2826, which is a rough indication of the upside potential over a 12–18-month time frame.

A long-term point and figure analysis of monthly prices using a 5% box and 3-box reversal shows a measured objective of 4406, which is a rough indication of the upside potential on a multi-year time frame.

An almost Zweig Breadth Thrust buy signal

Posted by Cam Hui - August 21, 2024

Mid-week market update: The market almost flashed a Zweig Breadth Thrust buy signal this week, though there is some dispute over the calculations. As a reminder, a ZBT buy signal is triggered when the market rises from oversold to overbought within 10 trading days. According to StockCharts, the market never reached the oversold condition on August 2, the day of the market panic, but did become overbought on Monday, which was exactly 10 trading days later.

However, Ryan Detrick observed that there is a considerable difference in advancing and declining stocks on August 2 between StockCharts and NDR. According to NDR, the ZBT buy signal was triggered on Monday. Ed Clissold of NDR admitted that data issues may cloud the picture. The use of all securities traded, common stock only, or a “transaction only” dataset could account for the difference.

In the interests of conservatism, I will call it a near miss, but the market action can still be characterized a a breadth thrust, just not a ZBT. Generally speaking, breadth thrusts are characterized by strong price momentum that persist for months. Though the market often pauses to take a breather after the initial buy signal. The accompanying chart shows eight instances when both the ZBT Indicator and the NYSE McClellan Oscillator were overbought. Six (pink) of the eight saw the market pause afterwards.

In the absence of major macro news, this week’s stock market action can be described dominated by technicals and waiting for Fed Chair Powell’s Jackson Hole speech scheduled Friday.

A Jackson Hole preview

The market will be waiting for bated breath to hear what hints Powell might drop on the future trajectory of interest rate policy. As the Jackson Hole symposium is supposed to be a discussion of policy approaches, Powell’s speech will likely be short on specifics. With inflation falling, I would expect him to start discussing the balance of risks. Watch for comments on the Fed’s full employment mandate.

The Fed has described the employment market as “balanced”, but the latest New York Fed Labour Market survey shows increasing anxiety about job loss and a corresponding decline in workers expecting to move to a new employer, particularly among workers aged 45 and under.

Equally important for Fed policy makers is the latest BLS revisions to the NFP establishment survey. It revised down by -818,000 jobs over the 12 months ended March, which translates to an average reduction in monthly payroll gains of 68K a month and the biggest revisions since 2009. Bloomberg’s U.S. chief economist Anna Wong pointed out that the Q1 QCEW county data implies an even bigger revision of -958,000. These figures are consistent with the FOMC minutes that the “vast majority” of members “observed that, if the data continued to come in about as expected, it would likely be appropriate to ease policy at the next meeting”,

Stock market reaction

What does that mean for the short-term outlook for stock prices?

Some of it will depend on how the market reacts to Powell’s speech. Will it be disappointed by the lack of specifics? How much is priced in? According to the CME FedWatch Tool, the market is expecting a half-point cut some time this year which sounds overly ambitious.

Marketwatch reported that Nicholas Colas of DataTrek studied the market reaction to past Jackson Hole speeches by the Fed Chair, and it tended to have a bullish bias,

However, averages can vary greatly. Specific to this year, the market is just starting to consolidate sideways after a breadth thrust, and it faces possible uncertainty ahead as it looks forward to the election in November.

From a technical perspective, the S&P 500 appears to be pausing its advance as it approaches its all-time high resistance with a possible significant market moving event Friday morning. This is a time to exercise some caution and reduce overall portfolio risk.

4 reasons why you should be tactically bullish

Posted by Cam Hui - August 18, 2024

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)

Subscribers can access the latest signal in real time here.

A “good overbought” advance?

The rebound off the August 5 panic bottom has shown an astounding level of price momentum. The S&P 500 printed a William O’Neil Follow Through Day, which is an indication of strong positive price momentum with a 1.7% advance on higher volume than the previous day. It went on to break out through its 50 dma and a falling trend line by gapping up through those levels. The next test to exceed the bearish engulfing pattern on August 1.

The market appears to be on its way to start a “good overbought” advance. Here are some other reasons why this rally could continue.

Strong momentum

The stock market is exhibiting evidence of strong price momentum. The market came within a hair of a buy signal. As a reminder, the ZBT buy signal flashes a buy signal when it recycles from oversold to overbought within 10 trading days.

The Zweig Breadth Thrust Indicator plunged to a near oversold condition on the day of the August panic. Last Friday was day 9 of the almost breadth thrust window, and the indicator is near overbought.
Call it an almost, or incomplete, breadth thrust.

A sentiment reset

Investor sentiment has reset in the wake of the market panic. Analysis by Deutsche Bank shows investors’ aggregate allocation to stocks is now in the 31st percentile and underweight, compared to the 97th percentile of the historical range three short weeks ago.

Similarly, the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual client funds, has fallen below its 26-week Bollinger Band. This has been a virtually foolproof tactical buy signal.

The 10 dma of the CBOE put/call ratio spike above its 1 standard deviation Bollinger Band, which indicates fear and a contrarian buy signal.

VIX spikes are bullish

There have been numerous studies showing that VIX spikes are contrarian bullish. The VIX Index touched 65 on the day of the market panic on August 5 and fell below 20 soon afterward. A study of VIX action that fall from above 40 to below 20 shows strong positive returns, though one-year returns were below average.

Positive internals

Technical internals are flashing bullish signals. The equal-weighted relative performance of the consumer discretionary stocks and global consumer discretionary to global consumer staples are turning up, which are indications of positive risk appetite and cyclical buy signals.

Breadth indicators are confirming the market advance. Both the S&P 500 and NYSE Advance-Decline Lines have made fresh all-time highs.

What about leadership?

I continue to favour a tilt away from Magnificent Seven leadership for this next bull phase. Magnificent Seven has led profit growth for several quarters, but the other 493 stocks in the S&P 500 are projected to deliver their first profit growth since Q4 2022.

In addition, small-cap indices are breaking out of their trading range, which is a constructive sign that they are out of the penalty box and poised for further gains.

In conclusion, the stock market is poised for continued strength. I can think of at least four reasons to be tactically bullish on stocks: price momentum; a sentiment reset from bullish to caution, which is contrarian bullish; the historical bullish record of VIX spikes; and positive and supportive internals. I continue to favour non-Magnificent Seven leadership for the next bull phase.

In normal circumstances, my inner trader would have exited his long positions by now as technical conditions have normalized from an oversold extreme to neutral. However, the strength of price momentum has convinced him to hold on until readings become overbought. 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.

Disclaimer: Long TNA

Back to the soft landing

Posted by Cam Hui - August 17, 2024

The latest BoA Global Manager Survey is a dramatic illustration of market anxiety. In July, 18% of respondents believed that a U.S. recession was the biggest tail risk. That figure surged to 39% in the August survey, which was taken August 2–8 right at the height of the market panic.

During the market panic, the market went from pricing in a soft landing to rising odds of a hard landing. About two weeks later, the consensus has shifted back to a soft landing, which should be friendly to risk assets.

Here is my macro assessment of the U.S. economy in the aftermath of the growth scare.

Back to Goldilocks

The backdrop for the U.S. economy can be best described as a combination of decelerating inflation and moderating growth. Notwithstanding the recent growth scare which sparked an unwind of leveraged positions, that “not too hot, not too cold” Goldilocks trend remains intact.

The July CPI and PPI reports showed the disinflationary trend is continuing. Now that the components of CPI and PPI are known, it’s relatively easy to estimate PCE, which is the Fed’s preferred inflation metric. These latest set of readings should allow the Fed to start shifting its focus from its price stability mandate to its full employment mandate and cut rates. Unless the August Payroll Report shows a dramatic fall in employment, expect a quarter-point cut at the September FOMC meeting.

As for growth, the Atlanta Fed’s nowcast of Q3 GDP stands at 2.0%, which is hardly recessionary.

More importantly for equity investors, forward 12-month EPS estimates are still rising.

Investors may recall the roots of the growth scare. It began with a higher-than-expected initial jobless claims print, followed by a disappointing July Payroll Report. Since then, both initial and continuing claims have moderated.

Since the onset of the growth scare, a number of data points have appeared that are supportive of continuing growth. As an example, the Cass Freight Index, which measures the North American freight market, ticked up after four months of weakness.

Small business confidence increased, which is an important barometer of the economy as small businesses have little bargaining power. Both the soft and hard data components rose. To be sure, the surge in soft confidence may be attributable to (then) optimism about Trump’s electoral prospects in the wake of his assassination attempt. Nevertheless, I find it constructive that both components showed increases.

The Transcript, which monitors earnings calls, summarized the state of the U.S. economy as undergoing moderating growth:

The stock market was the elephant in the room on earnings calls last week. After the recent volatility, many analysts were asking CEOs if they had seen a change in the environment and whether a recession was forthcoming. Most CEOs said that there has not been a change, but some were slightly more cautious. Even though there hasn’t been a change, consumers are still fatigued and segments that had been strong, like travel and restaurants, are reporting more softness. The industrial economy has already been in a recession for 4-5 quarters. But with interest rates likely to come down, that may be closer to the end than the beginning.

Putting it all together, we have an economy that’s showing decelerating, but not recessionary, growth, and the start of a rate cutting cycle. Even though forward P/E valuations are somewhat elevated compared to historical norms, this should not be a concern as interest rates fall and EPS growth continues.

Key risks

There are two key risks to the Goldilocks bullish scenario. The first is the continuing growth malaise in China, which is exporting deflation to the rest of the world. Despite its efforts at target stimulus, credit growth has stagnated.

Chinese economic weakness can be seen in the slump in iron ore prices, which looks like it has more room to run.

Another key risk to consider is rising geopolitical tensions that could spike energy costs. Russia, a major energy exporter, is already engaged in a war. Iran is on the verge of retaliating against Israel for two assassinations that could spark a regional conflict and disrupt the oil market. The oil market has barely reacted to these potential risks and the 52-week rate of change is negative, which is positive for U.S. consumer confidence. But consumer confidence could take a hit if oil prices spike, which could spark another round of growth scares and rattle financial markets.

The bulls are gaining back control of the tape

Posted by Cam Hui - August 14, 2024

Mid-week market update: I wrote on the weekend that investors should watch for signs of an O’Neill follow through day for bullish confirmation of the rebound.

A follow through day can occur as soon as day 4 (last Friday) of a rally. It’s defined as the index rising 1% or more on higher volume than the previous day. The most powerful follow through days occur between day 4 and day 7 of the rebound.

We got the follow through day on day 6 yesterday when the S&P 500 rose 1.6% on higher volume. This is an indication that the bulls are seizing control of the tape. Even as the S&P 500 tests overhead resistance at the 50 dma, the follow through day raises the odds that the market will break up.

In addition, Helene Meisler ran a poll on the weekend. While she found that most respondents were bullish, there was a slight plurality of opinion that the market would weaken and possibly re-test the old lows. The follow through day, which is a sign of strong price momentum reversal, significantly reduces that risk.

Technical recovery

I am seeing other signs of technical recovery. Breadth is coming back. NYSE new highs-lows is positive, NASDAQ new highs-lows is negative but turning up.

Risk appetite indicators are also turning up after a sudden fright.

Repricing risk

Even though the backdrop is equity bullish, here are a key reason for some choppiness ahead.

Yesterday’s softer than expected PPI report sparked a strong risk-on response by the markets. Today’s benign CPI report cements the odds of a September rate cut. Now that we have both CPI and PPI, we have a fairly good idea of what PCE will look like. The Cleveland Fed’s nowcast for July core PCE now stands at 0.13%. These readings gives the Fed cover to pivot to risk control mode and turn to the “balance of risks” as a reason to cut rates.

While a September rate cut is fully expected, the market is pricing in a near coin flip as to whether the cut will be a quarter-point or half-point. At a minimum, it’s expecting a half-point cut some time this year.

There are hawks on the FOMC who are resisting the notion of a September cut at all, and the expectations of a half-point cut is probably overly ambitious. As Powell herds the Committee members towards a rate cut, watch for Fed speakers to take a half-point off the table. The Jackson Hole meeting could well be the catalyst for such a re-pricing.

My inner trader remains long small caps. 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.

Disclaimer: Long TNA

What will lead the anticipated market rebound?

Posted by Cam Hui - August 11, 2024

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)

Subscribers can access the latest signal in real time here.

Poised for a rebound

Numerous historical studies of volatility spikes have concluded that such episodes are good buying opportunities for stocks.

The accompanying chart shows just one example of what happens when the VIX Index surges above 45 and recycles below 30. The market has been higher every single time. The only question is whether the market re-tests its old lows.

If stock prices are poised for a rebound, the next question is the nature of the leadership of the ensuing rally.

The crowded trade reset

Let’s first begin with a review of the market backdrop.

Admittedly, psychology had become a little too giddy and was due for a reset. The Euphoriameter from Callum Thomas of Topdown Charts shows that sentiment had become a little too frothy and the recent market setback can be considered to be an opportunity for a welcome reset.

Longer term, growth stocks have been on a tear against value stocks since the GFC. The trend may have become excessive. The divergence between U.S. growth and value and EAFE growth and value became evident with the onset of AI investing mania in early 2023.

The recent risk-off episode may be the signal of a reset of the growth and value relationship.

The rotation continues

The accompanying chart shows the relative performance of the value and cyclical sectors of the S&P 500. All turned up when the S&P 500 topped out in early July.

By contrast, here is the relative performance of growth sectors. Only Communication Services have been flat against the S&P 500 in the past year. Technology and Consumer Discretionary, which are dominated by heavyweights Amazon and Tesla, turned down when the market topped in July.

In particular, the absolute and relative performance of technology stocks has been weak, and so is their relative breadth indicators (bottom two panels).

Growth stocks, as represented by the NASDAQ 100, aren’t sufficiently washed out to form a relative bottom (black line).

By contrast, a bottom-up review of deep value stocks is presenting greater buying opportunities. My Leveraged Buyout screen of non-financial stocks in the S&P 1500 (see How to buy a company with no money) revealed 38 candidates that pass the screen of buying the company with no more than 30% of the stock price and borrowing the rest, compared to 25 candidates at the end of July and 25 at the end of June.
The biggest surprise on the LBO list was the Tech Bubble favourite Cisco Systems, which is trading at a forward P/E of 12.7.

Small-cap stocks also look intriguing. If we use the relative performance of high yield (junk) bonds to their duration-equivalent Treasuries (black line) as a proxy for risk appetite, the small-cap/large-cap ratio (red line) began to diverge from high yield in early 2019 and recently fell to 20-year lows.

Tactically, small-cap indices have retreated back to their absolute and relative trading ranges after failed upside breakouts. Upside breakouts would be confirmations of renewed leadership by these stocks. I remain constructive.

Welcome signs of normalization

Since the recent volatility storm originated in the derivatives market, I am seeing welcome signs of normalization in the option market that lays the foundation for a stock market rebound in the week ahead.
The VVIX, which is the volatility of the VIX, has begun falling in line with the decline in the VIX. I interpret this as falling expectations of higher future volatility.

In conjunction with a falling VVIX, the term structure of the VIX has also normalized from inversion, indicating receding fear levels.

The SKEW Index, which measures the relative cost of tail hedges, rose above its 200 dma even as stock prices rebounded. Rising cost of downside protection in the face of market strength is a useful contrarian signal.

As always, there are no guarantees in trading, but these are constructive signs that the bulls are taking control of the tape. Look for an O’Neil Follow Through Day in the coming week for bullish confirmation. A follow through day can occur as soon as day 4 (last Friday) of a rally. It’s defined as the index rising 1% or more on higher volume than the previous day. The most powerful follow through days occur between day 4 and day 7 of the rebound.

In conclusion, the market is poised for renewed strength. A review of market leadership shows weakness by technology and other large-cap growth stocks. I believe the rotation from growth to value and from large caps to small caps will continue and these stocks will be the new leadership in the next leg up.

My inner trader continues to hold a long position in small caps. 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 TNA

Assessing the damage: Not just the carry trade

Posted by Cam Hui - August 10, 2024

After strengthening rapidly, the Japanese Yen (bottom panel) has stabilized has stabilized in the 140-150 range. The 10-year Treasury-JGB spread also stabilized and found support. So did the Nikkei Average after suffering the greatest one-day decline since the Crash of 1987. The Bank of Japan sounded a dovish tone when deputy governor Shinichi Uchida said that the Bank would “refrain from hiking interest rates when the markets are unstable”. In addition, Bloomberg reported that “JPMorgan says three quarters of global carry trades now unwound”.

Is it all over? It’s time to assess the damage from the latest fright by diagnosing what sparked the sell-off.
Even though many market observers focused on the currency carry trade as the source of the mini-panic, I argue that the carry trade unwind was only a symptom of what’s plaguing the markets.

A complacency unwind

Joe Wiesenthal and Tracy Alloway at Bloomberg conducted a series of podcasts that explain the roots of the latest panic. It wasn’t just the unwind of the leveraged Yen carry trade, it was an unwind of a series of trades based on the complacency that the markets were going to stay in a low-volatility stable environment.

Here is a recent interview with Charlie McElligott, cross-asset macro strategist at Nomura, who pointed out that complacency manifested itself in the form of investors piling into a series of volatility selling products to enhance income. Things weren’t going to end well, it was just a question of when.

A different interview in January 2024 with Kris Sidial, Co-CIO of Ambrus Group, about the return of the short volatility trade and how investors forgot the lessons of Volmageddon told a similar story of complacency.

A separate interview in June 2024 with Michael Purves, CEO and founder of Tallbacken Capital Advisors, and Josh Silva, managing partner and CIO at Passaic Partners, on how the dispersion trade is another manifestation of complacency. The dispersion trade consists of investors using equity options to bet on the relative volatility between single stocks and stock indexes. For example, someone might buy volatility in a basket of individual stocks using single stock options while simultaneously shorting volatility in an index like S&P 500 is going to stay relatively low. This works if individual stock volatility is high while index volatility stays low and boring, which it was, until it wasn’t.

All of these derivative trades, including the carry trade, depend on a low volatility market environment. These trades saw a violent reversal when the market consensus suddenly shifted from a U.S. soft landing to pricing in the possibility of a hard landing.

In the space of a few days, initial jobless claims unexpectedly rose to a one-year high. A weaker-than-expected July Payroll report pushed the unemployment rate from 4.1% to 4.3%, which triggers the Sahm Rule as a recession indicator. Moreover, the Bank of Japan took a hawkish pivot by raising rates and tapering its quantitative tightening program. As Joe Wiesenthal put it:

In that moment that the “things are calm and will stay that way” bets get into trouble. So you have the collapsing yen carry trades. And you have the exploding VIX demolishing the short-volatility trades. And you have rising correlations busting dispersion trades. And of course any kind of long stock bets are implicitly short volatility trades, and you get this plunge in the hottest names in the market (like Nvidia and other MAG 7 companies).

In other words, it wasn’t just the carry trade that caused the panic.

Volatility spike = Panic bottom

Here is the good news. The accompanying chart shows the hourly swings in the S&P 500 since 2002. Episodes of hourly swings of +/- 2.5% coincided with market bottoms. The only question is timing and whether the stock market sees a short-term bottom or continues to fall after the initial volatility spike.
There appears to be two categories of bottoms. Sudden panics, usually from unexpected reversals of crowded positions, reverse themselves quickly. Longer term declines occur when the roots of the decline are macro or fundamentally driven, such as the GFC in 2008, the eurozone crisis of 2011, and the COVID Crash of 2020. In all cases, stock prices were higher a year later.

The latest panic appears to be in the first category. Stock prices are poised for a recovery.

Three of the five components of my Bottom Spotting Model flashed buy signals in the last week. The VIX Index spiked above its upper Bollinger Band, which is an oversold signal; the term structure of the VIX inverted, indicating fear; and the NYSE McClellan Oscillator fell to an oversold condition. In the past, the market has bottomed whenever two or more components triggered buy signals.

IPO stocks are turning up on a relative basis, which is a sign of the revival of the market’s animal spirits.

In addition, forward 12-month EPS estimates are still rising. This is a sign of positive fundamental momentum that’s supportive of higher stock prices. Hard landings don’t look like this.

Key risk

For traders, the key risk to the benign V-shaped recovery scenario is a Long-Term Capital Management (LTCM) style hedge fund blowup that threatens the stability of the financial systems. Even if the latest volatility spike caused a hedge fund to unravel, rest assured that central bankers have a well-worn playbook for dealing with financial crises. Flood the system with liquidity, and find one or more partners. Under such a scenario, expect a rally off the initial low, and a re-test of the old low about a month later.

Here is what I am watching. If stresses are appearing in the financial system, it should show up in credit yield spreads. So far, credit spreads have widened, but they haven’t spiked. The financial system doesn’t appear to be in crisis.

Market psychology is jittery, which is a recipe for higher volatility. As an illustration, the 2.3% rally of the S&P 500 in response to a noisy high frequency data release such as initial jobless claims shows the jittery nature of market psychology. While the initial claims report was modestly constructive, continuing claims show a gentle upward path. How will the market react next week if it encounters a disappointing economic report, or if Iran retaliates against Israel?

In conclusion, the recent disorderly risk-off episode can be attributed to the unwind of a series of trades that depend on a low-volatility and complacent environment. Historically, such unwinds have resolved in volatility spikes and higher equity returns soon afterwards. The current environment is supportive of a quick market recovery, though the risk of a LTCM-style blowup could see a longer and more complex market bottom.

In the wake of Biden’s subpar debate performance and the assassination attempt on Trump, the prediction markets’ odds of a Trump victory in November have substantially risen. Equally important is Wall Street’s reaction, which has investors sitting up to take notice of the implications of a second Trump Administration in 2025.

Despite the real-time information from the betting markets, financial markets haven’t fully discounted the possibility of a Trump win. Here’s how you can take advantage of that arbitrage opportunity.

Trump 2.0 macro effects

Donald Trump sat down with Bloomberg Businessweek for a wide ranging interview. Here are the key points, covering the Fed, trade and tax policy.

Starting with the Fed, Trump said that he would allow Fed Chair Jerome Powell to serve out his term, which ends in May 2026, but “if I thought he was doing the right thing”. The Financial Times also reported that Trump warned the Fed to avoid cutting interest rates before the election. While the headline that he wouldn’t fire Powell was designed to calm markets, the qualification of “doing the right thing” and attempts to strong arm current monetary policy could create instability.

These comments puts the Fed in a difficult position. The markets is putting the odds of a September rate cut as a virtual certainty in the wake of softer-than-expected inflation data. The September cut would be followed by further cuts in November and December. Fed officials will need to push back against that dovish interpretation if they don’t want to surprise the markets.

On trade, Trump called for new China tariffs at a rate of between 60% and 100%, and would impose a 10% tariff on imports from other countries. A new economics paper modeled the effects of a 10% across the board tariffs on imports and 60% on China. It concluded “across-the-board tariffs do not protect manufacturing jobs because the cost of imported intermediate goods increases, raising costs in manufacturing production” and “the world economy can adjust to U.S. trade wars, diverting trade around the U.S.”

Goldman Sachs chief economist Jan Hatzius stated at the ECB’s Sintra conference that a 10% tariff could spark trade war retaliation which raises the U.S. inflation by 1.1% and forces the Fed to into five quarter-point rate hikes.

In addition, Trump’s threat to restrict immigration and deport undocumented workers will act as a supply shock to the labour market. This will put additional upward pressure on wages and push inflation upwards.

On taxes, Trump told Bloomberg that he aims to cut corporate taxes to 15%, though he admitted that objective may be overly challenging and he would accept a 20% rate “for its simplicity. He will also extend the 2017 Tax Cuts and Jobs Act.

On one hand, this should provide a fiscal boost to the economy. On the other hand, it will add to the fiscal deficit. A study of the effects of 2017 legislation found that the reduced corporate tax rates did increase domestic investment by 20% and investment by foreign firms substantially. However, the tax cuts did not pay for themselves and raised the deficit by an extra $100 billion per year.

In short, Trump’s plans are inflationary. A WSJ survey of economists found that 56% believed inflation would be higher under another Trump term than under a Biden term. In particular, any attempt to interfere with Federal Reserve independence could send financial shockwaves around the world in light of the reserve currency status of the USD.

On the other hand, Trump voiced his desire for a lower USD in the interview.

I think manufacturing is a big deal, and everybody that runs for office says you’ll never manufacture again. We have currency problems, as you know. Currency. When I was president, I fought very strongly and hard with President Xi and with Shinzo Abe… So we have a big currency problem because the depth of the currency now in terms of strong dollar/weak yen, weak yuan, is massive.

A government that strong arms the Fed to lower rates in the face of inflationary pressures would have the unwelcome effect of tanking the greenback as confidence on its status is eroded.

Discounting Trump 2.0

While the Bloomberg Businessweek interview and details from the Republican platform reveal the intentions of a Trump Administration, investors need to understand the new administration’s actual plan of action.

The easiest policy to implement would be the extension of the 2017 tax cuts. The BoA Global Fund Manager Survey found that the policy areas most affected by a Trump win would be trade, followed by immigration.

Global managers also believe that a sweep, which would likely be a Republican seep in light of the electoral outlook, would be inflationary that resolves in higher bond yields.

What about the stock market? Reasonable people can disagree on the growth outlook under Trump 2.0, but it is undeniable that investors face more challenging valuations today compared to Trump 1.0. When Trump first took office, the S&P 500 was trading at a forward P/E of 16, compared to over 21 today. Stock prices could face additional headwinds if bond yields were to rise, which would also put downward pressure on valuation.

How is the market reacting to all this?

It’s been a bit of a mixed bag. The accompanying charts show the performance of different Trump market factors. Each of the charts is designed that a rising line denotes rising odds of a Trump win. The trade-related factors, such as the relative performance of companies with domestic revenue, and logistics shipping giants FedEx and UPS, show little reaction. By contrast, the yield curve and gold prices are signaling higher inflationary expectations.

The Republican platform has promised a policy of “drill, baby, drill” of energy independence, which should benefit energy stocks. The energy sector has lagged the market and it would be a prime beneficiary should Trump win the White House.

Another Trump trade that should perform well is financial stocks, which should benefit from deregulation and lower taxes. Watch for few barriers to consolidation in the banking sector, which should benefit regional banks. The sector recently staged a convincing upside breakout on an absolute basis, but remains range-bound relative to the S&P 500 (second panel), though relative breadth appears constructive (bottom two panels).

By contrast, the technology sector may be at risk under a Trump White House. Trump expressed his skepticism about defending Taiwan against China in the Bloomberg Businessweek interview: “I mean, how stupid are we? They took all of our chip business. They’re immensely wealthy. I don’t think we’re any different from an insurance policy. Why are we doing this?”

The shares of TSMC skidded -3.6% after those remarks. The Semiconductor Index, which has been an AI bellwether, is testing a key area of absolute support (top panel) and violated relative support (bottom panel).

In conclusion, the betting odds on a Trump victory in November have risen substantially, but the markets haven’t fully discounted such an outcome. Investors who want to position for Trump 2.0 should seek long inflation exposure (long gold/short bonds) and short globalization (long domestic producers/short transportation and logistics). Regardless of the growth outlook, equity returns may be more challenging as Trump 2.0 will see the S&P 500 at more lofty multiples than the P/E ratio of Trump 1.0. At a sector level, look for better performance in energy and financials, while technology may be under some pressure.

Estimating risk

Bullish sentiment?

Negative seasonality ahead

Momentum, momentum!

The short-term bear case

What to watch

Reasons for caution

New bullish factors

Too frothy?

A Jackson Hole preview

Stock market reaction

A “good overbought” advance?

Strong momentum

A sentiment reset

VIX spikes are bullish

Positive internals

What about leadership?

Back to Goldilocks

Key risks

Technical recovery

Repricing risk

Poised for a rebound

The crowded trade reset

The rotation continues

Welcome signs of normalization

A complacency unwind

Volatility spike = Panic bottom

Key risk

Insufficient fear

Downside catalyst

A leveraged position unwind

Spotting the panic crescendo

Watch the Yen

What’s the downside risk?

Nearing a bottom

A question of leadership

What’s bothering markets?

Too little, too late?

A soft landing

Mag 7 weakness

Broad market strength

Farrell’s Rule 2 in action

The currency market unwind

Stocks are oversold

Buy small caps for the bounce

Key risk

Market-based signals

Inadequate rebalancing

Investment implications

A market bottom signal

Trust the Great Rotation

Remember the Great Rotation?

Here comes the Great Rotation

A crowded long

The bull case

The bear case

Investment implications

Trump 2.0 macro effects

Discounting Trump 2.0