We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 20-Nov-2023)
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.
Don’t overstay the party
Two weeks ago, I set out a number of bearish trigger warnings for investors (see How Far Can This Market Run?). Two signals have been triggered.
The NYSE McClellan Summation Index saw its weekly stochastic (bottom panel) edge into overbought territory. The NASDAQ McClellan Summation Index, which is not pictured, also reached a similar reading.
Don’t panic. These readings are only bearish set-ups and not immediate take-profit signals. Current conditions are consistent with a rally into year-end and possibly early January, but it is a warning not to overstay the party.
Still bullish
I remain tactically bullish. Other indicators that I outlined two weeks ago are not flashing sell signals. Neither the CBOE put/call ratio nor the equity-only put/call ratio has reached the froth zone, which I define as the bottom of the one-standard deviation around their 200 dma.
I also highlighted cryptocurrencies as a system liquidity indicator, which has also been correlated with the relative performance of speculative growth stocks such as the ARK Innovation ETF (ARKK). Both these indicators are still flashing green.
The market is also showing signs of broadening breadth, which is another constructive sign.
Low VIX = Complacency warning?
Other analysts have raised alarms over the low level of the VIX Index. Not only is option volatility low, but also interest in buying cheap put protection has been virtually non-existent. Is this a sign of complacency?
Don’t worry. Analysis by Mark Ungewitter shows that VIX readings below 14 have historically been bullish for equities.
Even though the VIX Index has been relatively low by historical standards, the VVIX, which is the volatility of the VIX< has been elevated. I interpret this to be an early warning sign.
An analysis of the VVIX/VIX ratio (bottom panel) is revealing. My main takeaways from this analysis are:
Peaks in the VVIX/VIX ratio lead past tops in the S&P 500.
S&P 500 tops are usually proceeded by negative divergences in the VVIX/VIX ratio.
Our interpretation of this graph is this that is a sell signal set-up, but it’s too early to turn bearish just yet.
Don’t fight bullish seasonality
In conclusion, technical indicators are flashing very preliminary warning signs of an impending market top, but it’s too early for traders to take action. Price momentum is still positive and other bearish tripwires have not turned bearish yet. I are inclined to trust the seasonal pattern of December market strength. Historically, the first half of the month tends to be choppy and flat while the second half has been bullish.
Enjoy the party, but don’t overstay the festivities.
Both my inner investor and my inner trader are bullishly positioned. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Gold bulls became very excited when gold prices tested overhead resistance at the 2000–2100 level. In the past, such tests had been met with selling pressure, but technical analysts would interpret a definitive breakout at these levels as opening the door to significant upside.
Moreover, the bottom panel of the accompanying chart shows that the gold to S&P 500 ratio has been making a multi-year bottom, which argues for the start of a cycle that favours hard assets like gold and commodities over paper assets like stocks and bonds. Before you get too excited, such bottoms can take some time to develop and a hard asset bull market may not appear for several years.
In addition, the long-term bull case for commodities and hard assets is underscored by a regime of chronic underinvestment in capital expenditures in commodity extraction industries.
I am no gold bug and I have no strong opinion on the direction for gold prices. I am more interested in the cross-asset implications of this gold rally.
What’s driving gold prices?
What’s driving gold prices? Historically, gold has been inversely correlated to the USD Index. However, the relationship began to diverge in late 2014 and diverged further in 2021. If history is any guide, gold prices should be a lot weaker than it is today.
In addition, gold is positively correlated to the price of inflation-indexed bonds (TIPS) and inversely correlated to TIPS yields. A similar bearish divergence appeared in late 2022. To be sure, similar negative divergences showed up in 2006 when gold prices began to rally and the divergence didn’t close until 2013–2016.
The bond and TIPS market received a boost when Fed Governor Christopher Waller gave a dovish update to his assessment of the economy. In a previous speech on October 18, 2023 (see Something’s Got to Give), Waller highlighted a divergence in the economy and a question for Fed officials. Economic growth seems to be accelerating while inflation is slowing. Either inflation reaccelerates, which would force the Fed to adopt a tighter monetary policy, or the economic slows, which allows a more dovish path [emphasis added].
The data in the past few months has been overwhelmingly positive for both of the FOMC’s goals of maximum employment and stable prices. Economic activity and the labor market have been strong, with what looks like growth well above trend and unemployment near a 50-year low. Meanwhile, there has been continued, gradual progress in lowering inflation, and moderation in wage growth. This is great news, and while I tend to be an optimist, things are looking a little too good to be true, so it makes me think that something’s gotta give. Either growth moderates, fostering conditions that support continued progress toward our 2 percent inflation objective, or growth doesn’t, possibly undermining that progress. But which is going to give—the real side of the economy or the nominal side?
Waller’s latest update (see Something Appears to Be Giving) observed that “something appears to be giving, and it’s the pace of the economy”. Waller has been seen as a hawk and this speech was a signal that there is little appetite for further rate hikes. In a subsequent Q&A, Waller addressed the issue of rate cuts: “If you see this [lower] inflation continuing for several more months, I don’t know how long that might be—three months? four months? five months? You could then start lowering the policy rate because inflation’s lower.”
In other words, if monthly core PCE continues to print at 0.2% for 3–5 months, the Fed would start to cut rates as it’s becoming evident that inflation is moving toward its 2% target.
Fed Chair Jerome Powell also underlined Waller’s signal that the Fed is done raising rates in a speech made last Friday.
The strong actions we have taken have moved our policy rate well into restrictive territory, meaning that tight monetary policy is putting downward pressure on economic activity and inflation…Having come so far so quickly, the FOMC is moving forward carefully, as the risks of under- and over-tightening are becoming more balanced.
Though he tried to push back against the market expectations of rate cuts:
It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.
The market sided with Waller and dismissed Powell’s warning by discounting rate cuts that begin in March.
The conditions set out by Governor Waller are similar to remarks by Goldman Sachs strategist Jan Hatzius in a Bloomberg podcast:
We have a proof of concept that we can bring down inflation and rebalance the labour market without having to crush the economy and put the economy into recession and I think we’ve seen that clearly in 2023.
Fed watcher Tim Duy was more blunt in his assessment of the direction of monetary policy:
If the Fed has already restored price stability, nominal rates need to come down, both quickly and deeply. If the run rate of inflation is just over 2% now, it’s reasonable to believe that inflation a year ahead should be 2%. But not if real rates stay above 3%. If real rates stay above 3%, the Fed will undershoot its inflation target.
Falling rates would put downward pressure on real yields and boost gold prices. Such an environment would also be bullish for the price of risk assets such as stocks. In the past, gold and stocks have moved in opposite directions as gold has acted as a risk-off asset, a dovish Fed would be bullish for both stocks and gold. All else being equal, lower U.S. rates would put downward pressure on the USD, which has been inversely correlated to gold and stock prices.
Chinese gold demand
While falling real rates as a driver for gold prices are bullish for equities, a more neutral factor for risk asset prices might be Chinese physical demand. The New York Times recently published an article, “Gold Bars and Tokyo Apartments: How Money Is Flowing Out of China”, which highlighted Chinese physical demand for gold.
In some cases, Chinese are improvising to get around China’s strict government controls on transferring money overseas. They have bought gold bars small enough to be scattered unobtrusively through carry-on luggage, as well as large stacks of foreign currency.
To assess the seriousness of Asian physical demand, I studied the spread between the London AM and PM gold fixes as an apples-to-apples measure of Asian demand. The AM fix occurs roughly at the end of the Asian trading day, and the PM fix is more reflective of the gold market at the end of European trading day. All else being equal, the spread should be a random walk. However, a persistently negative spread would indicate strong Asian demand, which includes both China and India, as India has traditionally been strong buyers of physical gold.
An analysis of the London AM-PM gold spread in the last two years shows some seasonal demand in Q2 and at year-end, but no persistent buying from Asia as postulated by the New York Times article. As a consequence, we can reject the hypothesis that significant Asian demand is boosting gold prices.
Rotate Into early cycle stocks
From a technical perspective, the U.S. equity market appears to be undergoing a rotation into early-cycle leadership of financials and other interest-sensitive stocks. In theory, leadership would rotate into mid-cyclical industries such as retailing and advertising as it becomes evident that the economy is expanding. Eventually, inflation-sensitive commodity producers would lead as inflation becomes a problem.
The accompanying chart shows an upside breakout by financial stocks and a constructive saucer-shaped relative bottom by the sector. In addition, the relative breadth indicators (bottom two panels) are equally supportive of further gains by these stocks.
Even though I highlighted the long-term potential of hard asset plays in the next market cycle, it’s too early to make a significant commitment to cyclicals and commodity producers. The gold/CRB and gold/oil ratios favour gold. In addition, the cyclically sensitive copper/gold ratio hasn’t turned up yet, indicating the absence of cyclical reflation as an investment theme.
In summary, I have been more interested in the drivers of gold strength than trying to forecast gold itself. My analysis indicates that gold is rising on expectations of falling real rates, which also depresses the USD. These factors should be bullish for the price of risky assets. Specifically, I would focus on financials and other early market cycle groups.
Mid-week market update: I recently pointed out that the S&P 500 was becoming overbought and poised for a consolidation or pullback. The 14-day RSI had reached the overbought zone and the percentage of S&P 500 stocks above their 20 dma exceeded 90%. The market tried to rally today, but failed. Is this the correction?
Corrections can occur in price or time. The market could pull back (price) or the market could consolidate sideways (time).
The case for a sideways consolidation
I am inclined to believe that we are experiencing a sideways consolidation, or a correction in time. In a strong bull market, dip buyers can be disappointed as prices may not correct in accordance with conventional technical analysis techniques. This may be one of those cases. The accompanying chart shows the S&P 500 using one-hour ticks. For much of this year, the market has pulled back whenever the 14-hour RSI reached 90 (red vertical lines) and corrective episodes have reached a minimum of 50. The market achieved that objective yesterday and today even though the percentage above 20 dma remains elevated.
Buy signals everywhere
I am seeing buy signals everywhere. Bloomberg reported a surge of insider buying, though readings are not as strong as the 2020 COVID panic bottom.
As of Monday, almost 900 corporate insiders have purchased their own stock in November, more than double the previous month. While the number of sellers also rose, the pace of increases was smaller. As a result, the buy-sell ratio jumped to 0.54, the highest level since May.
The buying impetus pales next to March 2020, when insider buyers outnumbered sellers by a ratio of 2-to-1 at the exact bottom of the pandemic crash. Still, the bullish stance is a departure from July, when stocks climbed and insiders rushed to dump stocks. That exit proved prescient as the S&P 500 sank 10% over the following three months
Moreover, stock prices are supported by corporate buybacks.
After refraining from buybacks earlier this year, American firms are now embracing them. Repurchases among BofA’s clients have stayed above seasonal levels for three weeks in a row, including one in which a record $4.8 billion was bought, according to data compiled by the firm’s strategists including Jill Carey Hall and Savita Subramanian.
Corporate buybacks will likely be running at $5 billion a day until the market enters an earnings-related blackout on Dec. 8, according to Scott Rubner, a managing director at Goldman, who has studied the flow of funds for two decades. Once the blackout window opens, the flow may drop by 35%, he estimates.
Dean Christians at SentimenTrader highlighted a trading system based on Goldman’s Financial Conditions Index just flashed a buy signal.
Charlie McElligott at Nomura believes that in the absence of a central bank surprise, risk assets likely to grind higher into year-end.
Tactically, Friday December 1 could be subject to bearish seasonality, according to Jeffrey Hirsch. If you’re waiting for an opportunity to buy the dip, this might be it.
My inner trader remains bullishly positioned. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 20-Nov-2023)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
A cup and handle breakout
Much has been made about a nascent cup and handle pattern in the S&P 500 and the NASDAQ 100, which would have strong bullish implications if either index were to stage upside breakouts. While investors wait for those breakouts, here is a cup and handle that has staged a definitive upside breakout on both an absolute basis and relative to the S&P 500. It was made by the NYSE FANG+ Index, which represents megacap growth stocks.
In light of the strong price momentum exhibited by the stock market in the wake of the Zweig Breadth Thrust buy signal, I believe these are strong indications that investors and traders should embrace a market melt-up scenario into year-end and possibly beyond.
Learn to love Magnificent Seven
There have been warnings about excessive herding into the Magnificent Seven, or the seven largest megacap growth stocks in the S&P 500. FT Alphaville highlighted a report by Goldman Sachs that hedge fund concentration in the Magnificent Seven is in the 99th percentile. Instead of fading these stocks, I argue that investors and traders should stay with price momentum and buy the Magnificent Seven as a beta chase into year-end is likely to cause a melt-up in these names for the following reasons.
First, contrary to popular belief, hedge funds are underweight the Magnificent Seven, not overweight. The FT Alphaville article reported that these stocks account for “13 per cent of the aggregate hedge fund long portfolio, twice their weight at the start of 2023”, but went on to acknowledge that this exposure only represents half of the index weight in the Russell 3000. In other words, a fund that bought the S&P 500 index would be overweight the Magnificent Seven when compared to the aggregated bottom-up hedge fund holdings in these stocks.
What overcrowding?
Are you worried about valuation? An analysis of the Magnificent Seven’s forward P/E ratio shows that it’s only roughly at the average for the time frame starting in 2015.
Worried about excessive concentration in the S&P 500? FT Alphaville editor Robin Wigglesworth looked up the 1976 prospectus for the First Index Investment Trust (now Vanguard 500). He found that the top five companies in 1976 “accounted for over 21% of S&P 500, and top 10 were 28.3%. Not far off today’s 23.5% and 32%, respectively.”
Using the NASDAQ 100 as a proxy for megacap growth, the NASDAQ 100 to S&P 500 ratio (black line) is not overly extended by historical standards. Growth stocks have more room to run.
More breadth thrusts
In addition to the Zweig Breadth Thrust that I have documented in past publications, the S&P 500 gained over 9.5% since the October bottom. Call it what you want, a breadth thrust or just strong price momentum. A rose by any other name. Since 1990, there were 15 similar episodes and 11 of them signaled the start of new bull phases.
Jay Kaeppel of SentimenTrader also pointed out that the percentage of major S&P 500 sectors above their 200 dma rose above 30% from below, which is a sector-level breadth thrust. If history is any guide, the market should see strong returns over the next six months.
Supportive macro backdrop
Worried about macro conditions? Don’t be.
Citations of “inflation” during earnings calls have been falling for nearly two years, indicating that inflation is coming under control and confirms market expectations of a rate hike pause.
In addition, citations of “recession” on earnings calls topped out six quarters ago and they have been falling sharply.
Supportive sentiment
As well, sentiment readings aren’t overly stretched. The accompanying chart shows the 10 dma of the CBOE put/call ratio and the equity put/call ratio (blue lines) around their 1 standard deviation 200 dma Bollinger Bands. Both indicators are in neutral and neither are showing any signs of excess froth.
The 2019 ZBT template
The V-shaped rebound off the October bottom generated a Zweig Breadth Thrust buy signal in early November. That buy signal is highly reminiscent of the ZBT signal in early 2019, which saw the market also form a V-shaped price surge off the Christmas Eve bottom of 2018.
While history doesn’t repeat itself but rhymes, the 2019 experience could be a useful template for expectations of market performance in the current circumstances. If we use the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) as a tactical trading signal, we can see that the S&P 500 ran up for seven weeks and returned 8.5% from the date of the ZBT buy signal until ITBM flashed a trading sell signal when its 14-day RSI recycled from overbought to neutral. The S&P 500 went on to show a total return of 28.8% a year after the ZBT buy signal.
If we were to use the 2019 experience as a guide, the equivalent ITBM sell signal would occur seven weeks after the ZBT buy signal on December 24 and the S&P 500 would reach a level of 4730. As December 24 is in the middle of the seasonally strong period for stock prices, my base-case scenario calls for a tactical rally into early January, followed by a period of consolidation or pullback.
Too early to buy small caps
One concern raised by some technicians is the lack of breadth participation. The equal-weighted S&P 500 and the Russell 2000 are lagging the S&P 500 in the current rally. I don’t believe that should be a significant worry in the short run as the fast money engages in a FOMO beta chase into year-end.
As smaller stocks have lagged in a strong year for the S&P 500, I would expect there would be more losers among these stocks that would be subject to tax-loss selling pressure into year-end. Tactically, nimble traders could rotate from megacap growth to small caps during the second or third week of December in order to take profits in the Magnificent Seven names and position for an anticipated year-end and January small-cap rebound once tax-loss selling season is over.
Buy the dip!
Tactically, the market may be due for a brief pause in the advance. Both the 14-day RSI and the percentage of S&P 500 stocks above their 20 dma are extended, which is likely to resolve in a brief pullback or consolidation. Don’t worry, the S&P 500 continues to rise on a series of “good overbought” 5-day RSI conditions. Any weakness would be a welcome opportunity to buy the dip.
In summary, I would not go as far as to call the current circumstance a generational buying opportunity, but a rare and obvious “fat pitch” that comes along only once or twice per decade. Most of my models have been designed to minimize risk and not maximize return. As an example, my very successful Trend Asset Allocation Model was designed to eliminate significant drawdowns by sidestepping prolonged equity bear markets. The accompanying chart shows the performance of a model portfolio based on a rule varying by 20% in equity weight against a 60/40 benchmark using out-of-sample Trend Model signals.
The current episode of strong breadth thrust off the market bottom in late October is a rare and clear and extraordinary trading signal of a major market bottom. I believe investors should, at a minimum, embrace the likely melt-uTp into year-end and re-evaluate market conditions in January.
My inner investor is bullishly positioned and so is my inner trader. 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.
Much has happened since my last global market review. Investors saw a bond market tantrum, followed by a down yield reversal and a risk-on rally in asset prices. Willie Delwiche at Hi Mount Research put the equity price surge into perspective when he observed that 94% of global markets in the MSCI All-Country World Index (ACWI) had exceeded their 50 dma. This is a sign of strong global breadth that shouldn’t be ignored.
Drilling down, let’s take a quick trip around the world to spot investing opportunities.
U.S. growth has been dominant
Starting with the U.S., as it represents about 60% of capitalization within ACWI, growth has become the dominant leadership. Two of the three growth sectors in the S&P 500 have exhibited strong relative strength. I am inclined to stay with the current U.S. growth leadership until the December to early January time frame as hedge funds and other investors will likely be engaged in a beta chase for returns into year-end.
The growth investing style isn’t just dominant in the U.S., but in the non-U.S. developed markets as well. Growth began its outperformance against value stocks both within and outside the U.S. in early October.
By contrast, here is the relative performance of U.S. value and cyclical sectors, which can be best described as pedestrian.
For completeness, here is the relative performance of defensive sectors in the S&P 500. It is not surprising that these sectors are showing no signs of leadership in the face of a strong equity rally.
Emerging Non-U.S. leadership
Turning our focus outside the U.S., the accompanying chart of the relative performance of different regions is revealing. While U.S. equities are leading, their outperformance is starting to flatten out. The two regions that show promise as emerging leadership are Europe (middle panel, black line) and emerging markets ex-China (bottom panel, black line). Both are exhibiting saucer-shaped bases which are set-ups for possible new leadership.
European relative performance is more advanced. An analysis of relative returns of selected eurozone markets shows relative strength by France, Italy and Greece (yes, that Greece).
Across the English Channel, U.K. markets are showing signs of relative weakness. Large-cap U.K. stocks have been highly correlated to energy due to the heavy energy weight in the large-cap British market. Small caps, which are more reflective of the U.K. economy, are still weak.
Asia and Emerging Markets
Pivoting to Asia, the relative performance of the equity markets of China and her major Asian trading partners can be best described as unexciting.
However, the chart of the major emerging markets ex-China is starting to reveal some opportunities. While China’s relative performance (top panel, dotted red line) has been in a relative downtrend, EM ex-China (top panel, black line) is starting to flatten out and possibly turn up. The analysis of the top four countries in the index, which make up 68.6% of index weight, shows that the sources of relative strength are appearing in all countries except South Korea.
In conclusion, here are my main takeaways from my review of global leadership:
Global equities are surging, led by growth stocks. I am inclined to stay with the current leadership until year-end as hedge funds are likely to engage in a beta chase for performance.
U.S. stocks are still the leaders, especially the megacap growth stocks.
Set-ups for a new leadership are emerging in Europe and EM ex-China. I am inclined to wait until early 2024 to re-evaluate the evolution of leadership before making any decisions on rotation. Historically, Q1 in an election year tends to be choppy and move sideways.
Mid-week market update: The “three white soldiers” candlestick pattern is made up of three long white candles, and typically occurs after a falling price trend. It is indicative of strong price momentum after a price reversal. This pattern is evident in the weekly S&P 500 chart shown below. Usually, the market consolidates sideways after the “three white soldiers”, but the market has continued to advance on the back of the strength of the recent breadth thrust signals. As well, the index faces initial resistance at about 4600, which should be overwhelmed in light of a combination of strong price momentum and the lack of volume resistance (see side bars).
This is a timely gift to all investors and traders who observe U.S. Thanksgiving.
Risk on!
The NASDAQ 100 ETF QQQ is exhibiting a similar “three white soldiers” bullish pattern, which I interpret to indicate megacap growth leadership in the latest advance.
Risk appetite indicators are all flashing green and confirming the market advance. Risk on!
Small cap laggards
Do you know what’s not exhibiting strong price momentum? It’s small cap stocks. Take a look at the Russell 2000, where the “three white soldiers” are not evident.
Market breadth is not broadening out in this rally, as evidenced by the relative downtrend of the equal-weighted S&P 500, which gives higher weight to the smaller companies in the index, and the Russell 2000. In the short run, this should not be a concern (see my previous analysis in Will narrow leadership unravel the ZBT buy signal?).
My inner investor has an overweight position in equities. My inner trader has jumped on the bull train in anticipation of a strong rally into year-end. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 14-Nov-2023)
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.
An extraordinary price surge
The S&P 500 rally off the bottom in late October has been extraordinary. It resolved itself in a Zweig Breadth Thrust buy signal and four price gaps that likely won’t be filled. Classical chartists would characterize them as breakaway gaps indicating strong price momentum.
How far can this rally run?
Breakaway gaps
For some context on the price momentum that generated four consecutive price gaps in a short period, Jason Goepfert of SentimenTrader made a study of such events. While the sample size is relatively small (n=9), past returns of four unfilled price gaps showed very bullish results.
Price momentum can be thought of as “the stock market will continue to rally once it’s started rising”, while the price momentum factor is “stocks that outperform will continue to outperform”, regardless of market direction. Not only is the market’s price momentum strong, but the renewed performance of the price momentum factor also underscores the strength of this rally. The accompanying chart shows the relative performance of different price momentum factor ETFs, which have begun to beat the market in the last month.
Estimating upside potential
Under these circumstances, how should investors estimate upside potential? At what point should they take profits?
The point and figure chart offers some perspective from a longer-term point of view. Using different box sizes, the point and figure chart of the S&P 500 shows measured objectives in the 5300 range, which represents an upside potential of roughly 18%.
The point and figure chart of the NASDAQ Composite shows an even more impressive measured objective representing upside potential of over 20%.
Using the same technique, the upside potential for the Russell 2000, which is lagging the S&P 500, is similar to the S&P 500 at about 17%.
Unfortunately, the one drawback of point and figure charting is it’s silent on time horizon. While measured objectives are useful, it’s difficult to form realistic expectations of how long it will take to achieve those price objectives.
Sell signal triggers
For traders with shorter time horizons, I can offer a few indicators that can trigger a “take profit” warning.
The accompanying weekly chart shows the NYSE McClellan Summation Index (NYSI, middle panel). NYSI rebounded from a near oversold condition. If history is any guide, the rally will start to peter out when the stochastic (bottom panel) becomes overbought.
Here is the NASDAQ McClellan Summation Index (NASI). NASI reached an extreme oversold condition of under -1000 and bounced. Such severely oversold episodes have marked major market bottoms in the past, and the rally hasn’t ended until the stochastic becomes overbought. The NASI rebound from such an oversold extreme consequently results in my belief that megacap growth stocks will lead to the upside in this rally.
From a sentiment perspective, keep an eye on the equity put/call ratio, which is still elevated indicating skepticism about the rally. Current readings are still contrarian bullish. At a minimum, wait for the ratio to fall decisively below its 200 dma before taking profits.
Lastly, cryptocurrencies such as Bitcoin can be thought of as proxies for financial system liquidity. Historically, Bitcoin prices have been correlated with the relative performance of speculative stocks such the ARK Innovation ETF. If Bitcoin appears to top out, consider battening down the hatches and adopt a risk-off position.
Key risk
The near-term risk to the equity rally is interest rate expectations have run too far and too fast. The 10-year Treasury yield had been in a steadily uptrend and pulled back after peaking in October.
The market is pricing in no more rate hikes and four cuts in 2024, with the first one in May. Those expectations appear to be overly ambitious and prone to disappointment.
In conclusion, the U.S. equity rally off the bottom in late October is characterized by strong price momentum and shows a high degree of upside potential. In all likelihood, the market will follow its seasonal pattern of a year-end seasonal rally. Point and figure charting signifies measured objectives indicating percentage gains in the high teens or low 20s. I also offer a series of sell signal triggers that indicating possible inflection points in risk/reward potential.
The markets took a risk-on tone in the wake of a softer-than-expected CPI report, followed by a tame PPI report and strong retail sales print. Even before these reports, Mohamed El-Erian issued a warning about the goldilocks scenario of lower oil prices and falling bond yields.
Is market psychology in a “bad news is good news” mode that’s discounting weakness ahead? To answer that question, one useful way of seeing the world is through the lens of last week’s meeting between Joe Biden and Xi Jinping on the sidelines of the APEC Summit in San Francisco. The U.S. and China met to stabilize their relationship, but each is coming to the table with deep wounds, which are useful in evaluating potential weakness that could affect the global economy. The actual progress made at the meeting was modest, but it’s less important inasmuch as what it revealed about the vulnerabilities of each economy to the growth risks highlighted by El-Erian.
A wounded America
Biden goes into the meeting with a wounded America. Moody’s put the U.S. on credit watch for a possible downgrade, citing large fiscal deficits, fiscal paralysis and the headwinds from higher rates affecting debt service ability. Moreover, consumer confidence has been weakening.
While Congress managed to cobble together a Continuing Resolution that avoids a government shutdown, the legislation did not include any aid for Israel or Ukraine, which is an indication of the Biden administration’s foreign policy weakness.
Biden faces an election battle against Trump in a year, and he is trailing in a number of polls. New Deal democrat (NDD) unpacked some of the economic reasons. Notwithstanding the ideological differences, the electoral choice is between Candidate A, the incumbent, and Candidate B, the past President. NDD observed that people fared better under Trump:
Real wages for non-supervisory workers, increased 3.3% between January 2017 and the end of 2019. Meanwhile the unemployment rate fell from 4.7% to 3.5%.
And that wasn’t just something ho-hum. In the case of real wages, they were the highest since the end of the 1970s. The unemployment rate was the lowest since the end of the 1960s.
By contrast, here is the current snapshot of Biden’s economic record:
The unemployment rate has varied between 3.4% and 3.9% in the past year, about even with Trump’s best year – but not better. More importantly, while real wages for non-supervisory workers are up 2.2% since right before the pandemic hit, measured from when Biden came into office they are actually down -1.5%.
NDD went on to highlight the difficulty that households are experiencing under Biden, by comparing average hourly earnings (nominal, not real) for non-supervisory workers (in red) to house prices (dark blue) and mortgage payments (light blue). All of these values are set to 100 as of January 2021, so you can see what has happened during Biden’s administration.”
NDD observed, “Is it any wonder younger workers who would like to buy their first home, or upgrade to a bigger home, would be upset?”
A wounded China
Xi Jinping arrived in the San Francisco APEC summit while heading an economy that’s also wounded, albeit in a different fashion.
Foreign Direct Investment (FDI) has collapsed. To be sure, the negative FDI print isn’t as bad as it sounds. It’s attributable to foreign companies repatriating profits overseas instead of re-investing the funds into their Chinese operation. Nevertheless, it does reflect a growing lack of confidence by foreigners.
The Chinese property sector is a disaster. Not only that, but also consumer confidence is sluggish, indicating household sector weakness.
The latest trade figures indicate exports weakness across the board and generalized import weakness.
The verdict on U.S. growth
I began with a rhetorical question on growth risks from Mohamed El-Erian. Within that context, what’s the verdict?
The review of U.S. growth vulnerability indicates that recession risks are low. Biden political problems relate to his economic performance relative to Trump. In fact, from the Fed’s dual mandate of price stability and full employment, the Powell Fed is very close to achieving its objective of a Goldilocks not-too-hot-not-too-cold soft landing.
The disinflation trend is becoming more evident. Investors saw softer-than-expected CPI and PPI reports last week. As a consequence, market expectations have shifted to no more rate hikes and rate cuts that begin in May 2024.
The rate cut expectations are based on softening inflation. Here is Chair Powell at the July post-FOMC press conference [emphasis added]:
So if we see inflation coming down credibly, sustainably, then we don’t need to be at a restrictive level anymore. We can, you know, we can move back to a—to a neutral level and then below a neutral level at a certain point. I think we would, you know, we would—we, of course, would be very careful about that. We’d really want to be sure that inflation is coming down in a sustainable level. And it’s hard to make—I’m not going to try to make a numerical assessment of when and where that would be. But that’s the way I would think about it, is you’d start—you’d stop raising long before you got to 2 percent inflation, and you’d start cutting before you got to 2 percent inflation, too, because we don’t see ourselves getting to 2 percent inflation until—you know, all the way back to 2—until 2025 or so.
The scenario outlined by Powell appears to be playing out. Inflation, as measured by core PCE (red line), has been falling. If the nominal Fed Funds rate stays unchanged and inflation falls, the real Fed Funds rate (blue line) will keep rising, which represents an implicit tightening of monetary policy. At some point, the Fed will decide that policy is sufficiently restrictive to cut rates so the real Fed Funds rate stays flat, thus it doesn’t overtighten.
The Fed is also making progress on the full employment side of its mandate. The job market is softening from extremely tight conditions. Leading indicators of employment, such as temporary job growth and the quits to layoffs ratio, have been falling. Combined with the recent strong productivity report, the combination of a cooling jobs market and strong productivity lays the foundation for non-inflationary growth.
The verdict on China growth
What about China? In my opinion, the greatest threat to global growth is a China slowdown.
In the faces of these risks, green shoots are appearing. The IMF announced that it had upgraded its China GDP growth projections by 0.4% for 2023 and 2024. The IMF now projects Chinese GDP to grow at 5.4% in 2023 and 4.6% in 2024.
The Citi China Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been rising. This is a welcome indication of economic momentum.
Another welcome geopolitical development appeared in Taiwan ahead of its elections in January. Opposition parties KMT and TPP have agreed to put forward a joint presidential ticket to challenge the DPP, which advocates for an independent Taiwan. The DPP, which is the current ruling party, is likely to lose control of the legislature, and the announcement of the joint ticket dramatically reduces the chance of a DPP victory, which will lessen some of the geopolitical tensions in the Taiwan Straits.
Analyzing China is always a challenge because of the undependability of its statistics. Free market prices can offer a more reliable window on the state of the Chinese economy. China is a voracious consumer of commodities. An analysis of commodity prices shows that they are trading sideways, but much of the weakness can be attributable to falling energy prices. The cyclically sensitive copper/gold and base metals/gold ratios are turning up. I interpret these conditions as a cautiously bullish signal on China
The ratio of global consumer discretionary to consumer staple stocks, which is an indicator of global risk appetite, is exhibiting a positive divergence compared to the MSCI All-Country World Ex-U.S. Index. This is another market-based bullish signal for the global economy.
Lastly, Willie Delwiche pointed out that the percentage of global markets above their 50 dma is over 70%, which represents a tailwind for equities.
In summary, the Biden-Xi meeting in San Franciso exposed the growth risks and vulnerabilities of each country’s economy. In particular, the recent bond market rally and falling oil prices could be a signal of a growth slump. A review of the U.S. and Chinese economies shows that slowdown risks are low. Consequently, investors should embrace the recent risk-on tone in the markets.
Mid-week market update: Until yesterday’s market melt-up, it seemed that individual investors were fighting the rally, which is a contrarian bullish sign. I noticed it on the weekend when the level of engagement on my bearish tweets were an order of magnitude higher than my bullish ones. In addition, the New York Fed’s recent consumer expectations survey was having trouble finding equity bulls.
Also take a look at the equity put/call ratio (CPCE), which is more indicative of retail investor sentiment as their trading tends to be more focused on individual stocks. The 10 dma of CPCE is consistent with levels seen during the spike late last year and higher than it was at the height of the COVID Crash.
By contrast, the latest BoA Global Fund Manager Survey of global institutions showed a growing willingness to take risk. The most notable change in sentiment was the stampede into the bond market.
This risk-on attitude has dragged equity sentiment with it, as respondents have shifted from underweight to a minor overweight position in equities, but levels aren’t extreme.
For a non-contrarian viewpoint, I also found it constructive that insiders had been buying this rally, though insider purchases (blue line) have been lower than insider sales (red line), which would be a buy signal.
The combination of skeptical high turnover retail sentiment, slowly
improving institutional sentiment, and constructive insider activity is intermediate term bullish and supportive of a year-end rally and probably beyond.
Breadth is improving
Remember the concerns about poor breadth? Yesterday’s rally saw a stampede into small cap stocks. Both the equal-weighted S&P 500 and the small cap Russell 2000 have begun to outperform the S&P 500. This is a chart investors need to keep an eye on to see if the rally broadens out.
Yesterday’s rally was a short-covering rally. Bespoke reported that the most shorted decile of stocks within the S&P 500 gained 5.0% while the least shorted gained only 1.4%.
Short-term extended
Tactically, the stock market looks extended in the short-term. The 14-hour RSI reached an extreme overbought condition of 80. Similar conditions this year has seen the S&P 500 form a trading top and pull back until RSI falls to a minimum level of 50. A logical support zone would be the recent gap at 4425-4450.
Subscribers received an email alert yesterday hat my inner trader had taken profits in his long S&P 500 position, which he entered on October 27 and represents a close-to-close gain of 9.2%. He expects to re-enter on the long side once the market cools off in the coming days. Stay tuned.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 27-Oct-2023)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
A narrow advance
The recent Zweig Breadth Thrust signal should have been unconditionally bullish. This is a rare signal that has only been generated eight times since Marty Zweig first wrote about it in 1986. The stock market has been up 6 and 12 months later after every single signal. In some cases, stocks continue to rise like a runaway freight train. In three instances, which include the buy signal generated in late March, the market rose but pulled back several months later to re-test the buy signal level.
What category will the latest buy signal fall in?
One short-term blemish to the latest buy signal is the problem of narrow leadership. Breadth, as measured by the ratio of S&P 500 to equal-weighted S&P 500 and net new highs, has been abysmal in the latest post-buy signal advance. Leadership has been mainly concentrated in the megacap growth stocks and small and mid-caps haven’t participated in market strength in the same way.
Will narrow leadership and bad breadth sink the latest ZBT buy signal?
A FANG+ market
Indeed, the NYSE FANG+ Index representing megacap growth stocks staged a relative breakout and has been rising steadily against the equal-weighted S&P 500 (bottom panel).
Further analysis of growth sectors within the S&P 500 shows that technology stocks have staged an upside relative breakout and communication services stocks are in a steady relative uptrend. Only the consumer discretionary sector, which is dominated by heavyweights Amazon and Tesla, has been market performers.
A bad breadth study
Conventional technical analysis focuses on breadth to measure the health of a rally. Using the analogy of an army, investors would like to see a broad-based advance if all the troops (all stocks) are advancing together. A narrow advance consisting of only the generals (large-cap heavyweights) while the troops don’t move is said to be a sign of trouble.
I studied the validity of that analytical framework by observing market history. The accompanying chart shows the relative performance of large caps (S&P 100), small caps (S&P 500), and in an apple-to-apples comparison, the relative performance of equal-weighted S&P 500 to the float-weighted S&P 500.
Going back to 1995, there were cases of negative breadth divergences in 1998–2000, 2006–2008, 2018–2019 and today. In each case, it can take two years or more of negative divergences before the market topped out.
The current market advance is led by the heavyweight megacap growth stocks in the NASDAQ 100. The accompanying chart shows the relative performance of the NASDAQ 100 (red line) and the normalized price momentum of the NASDAQ 100 (black line). Shaded grey zones indicate areas of relative support which would have been good times to overweight NASDAQ 100 stocks.
Where are we today? The megacap growth stocks have risen off their relative lows, but their relative advance is not overly extended (black line). Moreover, the relative performance of the NASDAQ 100 (red line) is only testing a relative resistance level. Our interpretation is that megacap growth stocks are elevated on a relative basis, but there are no signs of froth and their advances can go much further.
Poised for a FOMO rally
Sentiment indicators are also supportive of an advance into year-end and beyond. Hedge funds had de-risked to a crowded short just before the ZBT buy signal and they are scrambling to cover their short positions. A recent JPMorgan client survey indicates that the FOMO surge is just starting.
The CNN Business Fear & Greed Index has recovered from levels indicating extreme fear, but readings aren’t even past the neutral 50 level and they aren’t indicating greed.
Option-based sentiment is telling a similar story. The CBOE put/call ratio has normalized from levels indicating panic, but readings don’t indicate complacency.
A breadth warning that works
Do you feel better about the bad breadth problem now?
Instead, here is a long-term breadth waning signal that works. The accompanying chart shows the rolling 52-week average of the difference between the percentage of S&P 100 stocks that are bullish on P&F charts and the percentage of S&P 500 stocks that are bullish on P&F charts. Major market peaks occur when this indicator rolls over from a high level, which is not the case today.
An upside breakout
Looking to the week ahead, the hourly S&P 500 chart shows that its 14-hour RSI reached an overbought extreme reading of 80 and pulled back. Past instances of similar overbought conditions ended when RSI fell to 50 or less. The market reached this level last Thursday and decisively reversed upward by simultaneously rallying above a falling trend line and the 4380-4400 resistance zone. If the history of Zweig Breadth Thrusts is any guide, stock prices should continue to advance, with the next resistance zone at 4500-4540.
Lastly, before anyone freaks out over the late breaking news that Moody’s had downgraded the rating for U.S. debt from stable to negative, remember this April 2020 analysis from Jason Goepfert of StntimenTrader about past downgrades.
In conclusion, the market action in the wake of the recent Zweig Breadth Thrust buy signal has been characterized by narrow leadership and poor breadth. A historical analysis of market breadth shows that it can take two or more years of negative breadth divergences before a market tops out. Today’s market conditions indicate that the current megacap growth leadership is not extended and can rise much further, indicating more upside potential for both the overall stock market and megacap growth stocks.
My inner trader continues to be 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.
The S&P 500 exhibited a surprise price reversal on the weekly chart. After violating an uptrend line that stretches back to the COVID Crash bottom which scared the living daylights out of a lot of investors, the index staged an upside reversal while the weekly stochastic recycled from oversold to neutral, which has been a useful buy signal in the past.
In addition to this obvious bullish price reversal on the weekly chart, here are five other risk reversal factors that you may have missed.
A credit reversal
Not very long ago, the market consensus was a U.S. recession is just around the corner. Historically recessions are equity bull market killers.
One characteristic of a recession is a credit crunch. The Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) showed some surprising results. Banks tightening credit standards for corporate loans (blue line, inverted scale) reversed a tightening trend and eased. This indicator has been highly correlated with real GDP growth (red line).
Recession, what recession?
A term premium reversal
Also not very long ago, the market was highly concerned about a rising term premium, or the price demanded by investors to hold long-dated bond maturities. Numerous Fed speakers acknowledged that a rising term premium was tightening financial conditions, which lessened the necessity for the Fed to raise rates. The latest Quarterly Refunding Announcement revealed a lower level than expected supply of Treasury bonds and sparked a bond market rally. The term premium fell as a consequence of lower yields.
Does that mean the Fed will have to raise rates to compensate for a falling term premium? Not necessarily. Improvements in productivity gives the Fed more wiggle room as better productivity is conducive to non-inflationary growth.
In fact, BoA pointed out that productivity improvements have enabled real revenue per worker to near all-time highs.
An earnings expectations reversal
From a fundamental perspective, market expectations of an earnings recession and recovery are almost upon us. FactSet reports that consensus EPS estimates for the S&P 500 calls for quarterly EPS to trough in Q4 and recover starting in Q1. As markets are forward-looking and usually look ahead 6–12 months, any weakness has already been discounted.
Indeed, the Q3 GDP growth came in at a sizzling 4.9%, the Atlanta Fed’s Q4 GDPNow has slowed to 2.1%.
Nevertheless, S&P 500 consensus forward 12-month EPS are continuing to rise, indicating bullish fundamental momentum.
An emerging market risk reversal
I have highlighted how the S&P 500 has been inversely correlated to the USD in the past. The USD Index, which is heavily influenced by the weakness in the euro and the Japanese yen for idiosyncratic reasons, is testing a key support level. However, the more sensitive emerging market currencies (bottom panel) have already rallied above a key resistance level, which has bullish implications for risk appetite.
Callum Thomas of Topdown Charts also pointed out that EM breadth is surging, which is an early sign of improving global risk appetite.
A geopolitical risk appetite reversal
Finally, remember the surprise Hamas attack on Israel and the market fears of what may happen when Israel responded? Since then, while Hezbollah and Iran have used tough rhetoric, they pulled back from participating in the war and the risk of conflict enlargement has receded. As a consequence, the geopolitical risk premium has narrowed. Israeli stocks have begun to recover and oil prices have receded. This is emphatically not a call to buy the Israeli market, only an illustration of how the geopolitical risk premium has narrowed.
In conclusion, we’re old enough to remember how the market was panicked about a U.S. recession and a rising term premium in the Treasury market. Since then, a series of positive technical, macro and fundamental reversals has occurred to alleviate those concerns. These reversals of an extremely bearish psychology are bullish for risk assets.
Mid-week market update: I have written extensively about the Zweig Breadth Thrust and its bullish implications in the past few days. In case you haven’t seen the numerous historical return studies floating around on the internet, here is one from Ryan Detrick of Carson Group.
In almost instance, the market cools off for a few days after the ZBT buy signal. Is it time for a temporary ZBT price reset?
The historical evidence
Here is a survey of the out-of-sample ZBT buy signals since 1986. The first one was in 2004, which is marked by the vertical line. The bullish news is the S&P 500 only saw a one-day consolidation after the buy signal. The bad news is the market rallied but weakened to test and eventually undercut the buy signal level within 2-3 months.
The 2009 ZBT signal saw a two-day pullback and a sideways consolidation for about two weeks.
The market traded sideways for four days after the 2011 signal and went on to re-test and undercut the buy signal level within two months.
The market action after the 2013 buy signal can be best described as a runaway freight train, though it did consolidate sideways with a slight upward bias in the first week after the buy signal.
The 2015 buy signal failed badly. The market traded sideways for a week but weakened within three months and fell well below the buy signal level. That said, the S&P 500 was positive both 6 and 12 months after the buy signal.
The market rose after the 2019 buy signal and never looked back. This was another runaway freight train experience.
The ZBT buy signal of March 31, 2023 saw the market consolidate sideways for almost two months. While it did see high prices, the S&P 500 eventually corrected back to buy signal levels until it flashed the most recent buy signal.
Regardless of stocks reacted after the ZBT signal, the historical evidence shows that any pullback during the immediate consolidation period has been minor at worse.
The challenges ahead
Investors and traders face different time horizons and different challenges. For investors, the ZBT is an extremely bullish signal with strong historical returns and success rates. Don’t miss this buying opportunity and remember the words of technical analyst Walter Deemer.
While I am intermediate-term bullish, here are the tactical challenges ahead for bulls and bears. The daily S&P 500 chart shows that the S&P 500 is struggling to overcome gap resistance at the 2380-2400 level. The 5-day RSI only reached the 80 level but this indicator has been higher this year. Arguably, a breadth thrust should carry the RSI reading higher. On the other hand, breadth (bottom two panels) have been poor. Leadership is narrow and breadth hasn’t broadened out, which argues for a short-term price reset.
In conclusion, a rare bullish ZBT signal has been triggered. Goldman Sachs Prime Brokerage data shows that trend-following CTAs are in a crowded short in equities and their positioning is even more extreme than the readings seen at the COVID Crash bottom. A decisive upside breakout through the 4400 level could spark a short-covering melt-up stampede.
On the other hand, the U.S. House of Representatives is expected next week to consider how to address the expiring Continuing Resolution (CR) that will determine whether the government will undergo a shutdown. My political crystal ball is broken and I have no idea how any CR would resolve itself, only that events in Israel and Ukraine is expected to put tremendous pressure on lawmakers. This could be a source of uncertainty and volatility in the coming week.
My inner investor is bullishly positioned, and my inner trader is choosing to look through any possible downdraft and he is staying long the market. 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.
I would like to address the feedback from my recent publication, Nine reasons why this rally has legs. Some readers questioned my change in tone in the interpretation of the Zweig Breadth Thrust buy signal.
As a reminder, the ZBT is a price momentum signal. It is triggered when breadth indicators rise from oversold to overbought within 10 trading days. Breadth thrust price momentum signals usually resolve in a surge. The market triggered a ZBT buy signal on March 31, 2023 and my reaction was cautious (see Why I am fading the latest breadth thrust). This time, the tone is far more bullish and I am inclined to adopt a YOLO (You Only Live Once) to portfolio positioning.
I wrote in early April that I was cautious, but not outright bearish. I was mostly correct. Instead of a price surge, the S&P 500 traded sideways for two months after the buy signal, rallied and topped out in late July, and pulled back to the approximate level of the buy signal in late October.
Here’s what’s different about the latest signal compared to March.
A history of ZBT signals
The accompanying chart shows the out-of-sample history of ZBT signal when Marty Zweig outlined his breadth thrust signal methodology in 1986.
Excluding the latest buy signal, there have only been seven out-of-sample ZBT buy signals since 1986. The S&P 500 was higher a year later in all instances. Four of the buy signals were accompanied by runaway freight train-style price surges, but the market traded sideways and re-tested the buy signal entry points in three cases.
Here’s what made the “failures” different.
The “failures” occurred against a backdrop of tightening monetary policy, as measured by a rising Fed Funds rate.
Most of the “successful” signals came out of V-shaped panic bottoms, though the one in 2013 did not, and the 2015 “failure” was a V-shaped bottom that was later re-tested later.
What’s different this time
It is against this framework that we can observe the Fed Funds rate continued to rise after the March ZBT signal. Today, investors can be more confident that the rate hike cycle is over. Fed Chair Powell signaled that the Fed is done raising rates at the last post-FOMC press conference, though he left the door open to more hikes should inflationary pressures persist.
In addition, successful ZBT buy signals generally occurred after a V-shaped panic bottom. An analysis of SentimenTrader’s Fear & Greed Index shows that sentiment is far more extreme and panicked today compared to the March ZBT buy signal.
Key risk
While I am far more bullish on equities in the wake of the latest ZBT buy signal compared to the March signal, the one key risk to the bullish scenario is valuation. The accompanying chart shows past ZBT buy signals in the last 10 years as marked by red vertical lines. The current stock/bond valuation of an S&P 500 forward P/E of 17.8 compared to a 10-year Treasury yield of 4.57% is less attractive when compared to past buy signals. Arguably, it’s difficult to envisage a new equity bull that starts at these lofty levels. In effect, the bulls are depending on the combination of price momentum and a less restrictive monetary policy and benign liquidity environment sparking the market’s animal spirits to push stock prices higher.
In conclusion, I am far more bullish on the equity outlook in the aftermath of the latest ZBT buy signal compared to the one in late March. The key differences between the two signals are a less hawkish monetary policy outlook and the presence of a market panic that sparked V-shaped rebound in the latest episode. However, investors face the risk of heightened valuation headwinds to this bullish forecast.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 27-Oct-2023)
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.
This rally has legs
Last week, I outlined bullish and bearish scenarios and estimated their odds at 70% and 30%, respectively. The bulls won.
A relief rally was more or less inevitable. Once the S&P 500 violated a rising trend line that began at the COVID Crash bottom, it scared the daylights out of the bulls and caused a panic. The weekly slow stochastic touched 10, which has marked either important bottoms or tactical bottoms in the past.
I believe the combination of a severely oversold condition, washed out sentiment and the lifting of market concerns will spark a durable rally into year-end. I can think of nine reasons why this rally has legs. The reading of 10 on the weekly slow stochastics is just the first.
Supportive sentiment
Sentiment models are supportive of a durable rebound. The weekly AAII sentiment survey showed that the percentage of bears came in at 50% and bull-bear spread at -26%. Pay attention to the level of bearish sentiment. Similar readings have marked either short-term bottoms or prolonged bear markets in the past. AAII sentiment is a condition indicator and not an actionable trading signal. Nevertheless, it does inform investors that survey respondents are panicked.
The AAII Survey describes retail trader sentiment. Goldman Sachs prime brokerage, which offers a window into hedge fund sentiment, reported that the equity exposure long/short funds are the most defensively positioned in 11 years. Moreover, the CTA trend-following hedge funds are likely maximum short equity futures in light of recent market action, and further gains would trigger a buying stampede to reverse from short to long.
The other side of the sentiment coin is insider activity. While most extreme sentiment signals should be faded, extreme bullish insider sentiment is a buy signal. Not only have insiders bought the latest dip, they also continued to buy even after the market began to rally, which is another sign of a durable advance.
Falling macro uncertainty
Another factor supportive of a bullish scenario is the recent reduction in macro uncertainty. In the last few weeks, market psychology had become unsettled over the prospect of excessive Treasury supply putting upward pressure on yields. Indeed, the 10-year Treasury yield briefly traded above 5%, which rattled investors.
The U.S. Treasury’s Quarterly Refunding Announcement alleviated many of those concerns. Borrowing was lower than expected. In addition, Treasury announced that debt issuance would be tilted toward more short-term debt than expected, which alleviated many of the concerns over bond supply.
As a consequence, bond yields fell dramatically. The move was probably inevitable as yields have roughly tracked real-time indicators of economic strength, as measured by the Citigroup Economic Surprise Index. Yields had been rising in the past few months even as ESI flattened out. A convergence between the two was more or less inevitable once the fears of excess supply became alleviated.
Coming into last week, an air of uncertainty also hung over the FOMC decision. While a November pause was widely expected, it was less clear whether the hiking cycle was over. To no one’s surprise, the Fed left rates unchanged and kept the door open to another rate hike. WSJ reporter Nick Timiraos reported that Fed Chair Powell telegraphed that the Fed was not eager to hike rates.
At Fed officials’ September meeting, most projected one more rate increase this year, but some have spoken in recent weeks as though they aren’t eager to hike again unless hotter-than-expected economic data force their hand.
Powell echoed that sentiment on Wednesday by repeatedly highlighting how much inflation has fallen, rather than emphasizing the economy’s recent strength.
Indeed, there are signs that both inflation and the jobs market are cooling. Q3 S&P 500 earnings calls show a decline in references to “labour shortage” and increases in “job cuts”.
Q3 real GDP growth came in at a very hot 4.9%, which raised worries about excessive growth leading to inflation. Those concerns may be misplaced. The latest Q3 productivity report showed a 5.9% jump in output and a 4.7% surge in productivity. These readings should alleviate many of the concerns over wage inflation and excessive growth.
The October Jobs Report came in slightly softer than expected. Headline employment rose 150,000 against an expected 180,000, though the more volatile household survey showed a loss of -348,000 jobs. The participation rate stayed steady and the unemployment rate edged up to 3.9% from 3.8%. More importantly, the rate of change in average hourly earnings is decelerating, indicating moderation in wage growth.
These are very market friendly reports. The combination of slightly soft employment, tame wage growth and strong productivity paints a picture disinflationary growth. If continued, it should allow the Fed to stay on hold and possibly cut rates next year.
A Zweig Breadth Thrust buy signal
Last but not least, the market flashed a rare Zweig Breadth Thrust buy signal Friday when price momentum surged, as measured by market breadth indicators rising from an oversold to overbought condition within 10 trading days. The latest signal only took five days to achieve the momentum surge, which is unusual even for a breadth thrust.
ZBT buy signals are extremely rare. Not counting the latest, there have only been seven out-of-sample buy signals since Marty Zweig outlined this system in 1986. The S&P 500 has been up after a year after every signal. There were, however, three instances of failed momentum when the market pulled back after the initial buy signal. Those “failures” occurred against a backdrop of rising rates, which may not be the case this time if consensus market expectations are correct.
The “ZBT failures” occurred against a backdrop of rising rates, which may not be the case this time if consensus market expectations are correct. Historically, peaks in the 2-year Treasury yield have coincided with peaks in the Fed Funds rate, but investors won’t know if the 2-year yield has actually peaked until after the fact.
In the short run, the stock advance may be due for a breather. It isn’t unusual for the market to pause and consolidate for a few days after a ZBT buy signal. The S&P 500 has risen very quickly and become overbought on the 5-day RSI and the NYSE McClellan Oscillator. It is now approaching overhead resistance at 4380-4400, which is also the site of an unfilled gap from September 20.
Finally, if the market were to pull back next week, the S&P 500 could be forming an inverse head and shoulders pattern. Keep in mind, however, that head and shoulders formations are incomplete until the neckline breaks, so this scenario is highly speculative.
Putting all together, I have enumerated reasons why the market is due for a relief rally, but what makes the rally sustainable? The stock market reached an extreme oversold condition and recycled to signal a relief rally is underway. Every oversold rally begins with short covering, but needs more buying fuel to keep going. Evidence of insider buying, even after the onset of the rally, provides bottom-up fundamental support to further gains. In addition, psychological relief from macro uncertainty also provides top-down bullish fuel for a sustainable advance, culminating in a breadth thrust, which is a technical condition indicating a FOMO buying stampede.
My inner trader was fortunate enough to have bought in just before the onset of the price surge. Under normal circumstances, he was ready to take profits last Friday as the market had become extremely overbought – until evidence of the ZBT came to light. He decided to look through likely short-term turbulence next week in anticipation of greater gains. Your decision process will vary depending on your risk appetite and pain threshold. 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.
There was some consternation among equity bulls when the S&P 500 violated its 200 dma as it could have been the signal of a major bearish episode.
Technical analysts offered some relief when they pointed out that it’s the slope of the 200 dma that matters. The historical evidence shows violations of the 200 dma when the moving average is just a correction in an uptrend. However, an index that’s trading below a falling 200 dma is a warning flag that a bear market is under way. The arrows in the accompanying chart show the occasions when the S&P 500 fell below a falling 200 dma. Often these signals occurred when the index violated a rising moving average, which later turned down, marked by the red arrows.
The bulls may have felt vindicated when the S&P 500 regained its 200 dma late last week. This episode is a lesson for investors to regard similar circumstances as a buying opportunity. But that’s not the entire story as the market is becoming increasingly bifurcated.
This chart shows the S&P 500, NASDAQ 100, Dow Jones Industrials Average, the mid-cap S&P 400 and the small-cap Russell 2000 with their respective moving averages. The good news is the S&P 500 and the Dow regained their 200 dma. While the S&P 500 moving average has been rising, the same isn’t true for the Dow. The NASDAQ 100 is holding above its 200 dma. The bad news is the S&P 400 and the Russell 2000 are below falling moving averages. The strength of the S&P 500 has been held up by megcap growth stocks. In the absence of the effects of megcap growth, the other major U.S. equity averages are signaling bear markets.
How you position yourself in light of this bifurcation in market internals depends on your time horizon and whether you are a momentum or value investor.
The 200 dma study
Beyond the eye test of the rising and falling 200 dma, I conducted a study of what happens if you bought the market when it violated its 200 dma during rising and falling moving average episodes. The study began in 1990 and ended in November 2023, and it was conducted using the following assumptions:
Returns were capital returns and don’t include re-invested dividends.
The study was based on non-overlapping periods, defined as the first instance when an index was both below its 200 dma and the moving average was rising or falling in the last 21 trading days.
The sample sizes varied, but they were large enough to draw conclusion. Here is how the S&P 500 behaved during 200 dma episodes when the moving average was rising and falling, as measured by the percentage of occasions when the index was positive or negative over different time horizons. These results confirm our eye test that violations of a rising 200 dma can be regarded as just a correction within an uptrend, especially over shorter time horizons. The differential starts to dissipate over six months and completely disappears after 12 months.
Similarly, here are the results the NASDAQ 100.
The results of this trading system when applied to the Dow show a more dramatic drop-off in percentage positive differential beyond six months.
In addition to a focus on percentage of occasions when the index was positive, I also studied the average returns under the conditions when the index was both under its 200 amd and the moving average was rising compared to when it was falling. The accompanying chart shows the return differentials of strategies of buying the index under the two different conditions. Return differentials top out at about six months and more or less disappear after 12 months.
Investment implications
What does this mean for investors? How you react and position yourself depends on your time horizon and whether you focus on price momentum or value.
The results of the 200 dma study indicate that growth stocks are undergoing a correction within an uptrend. At a minimum, an analysis of the NASDAQ McClellan Summation Index (NASI) shows that the NASDAQ 100 is severely oversold and poised for a tactical relief rally.
The picture for mid and small caps, which don’t benefit from the megacap growth bull trend, is a different matter. The mid-cap S&P 400 and small-cap S&P 600 have fallen to a long-term relative support zone. The lower-quality Russell 2000, which contains more unprofitable companies than the S&P 600, has violated a key relative support level and shows no signs of a bottom.
The takeaways from this analysis indicate that high-quality mid and small caps are at support, but may need a period of sideways consolidation before a relative bull can begin. This is consistent with the results of the 200 dma that indicate the market action during the first six months of the violation of a falling 200 dma can be sloppy. I would also like to see some stabilization in the relative performance of the lower-quality Russell 2000 before turning bullish on mid and small caps.
Tactically, the poor performance of these groups will put short-term downward pressure from year-end tax-loss selling, followed by a Santa Claus rally in late 2023 and early 2024. But don’t be fooled by any signs of short-term market strength. These stocks need a period of consolidation before they can meaningfully turn up.
From a valuation perspective, the mid-cap S&P 400 and small-cap S&P 600 are trading at a substantial forward P/E ratio discount to the large-cap S&P 500, which is dominated by the megacap growth stocks. Mid and small caps are trading at valuations similar to the levels last seen during the GFC of 2008–2009 and the U.S. government shutdown impasse and Greek Crisis of 2011. These stocks are value stocks, but recent market action calls for some patience before they can become the next leadership.
In summary, U.S. equity averages recently violated their 200 dma but a historical study found that violations are benign as long as the moving average is rising. However, the rising dma is only evident in the megacap growth-dominated S&P 500. Mid and small caps are becoming value candidates, but recent market action calls for some patience before they can become the next leadership. How you position yourself will depend on your time horizon and whether you are a momentum or value investor.
Mid-week market update: I told you so. As I recently pointed out, psychology had become too stressed to the downside, which opened the door to a relief rally. The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, fell sharply last week and below its 26-week Bollinger Band. Historically, theses signals have resolved in a tactical rally in stock prices.
Sometimes the anticipation can be worse than the event itself. Coming into the weekend, the market was focused on three sources of possible stress: geopolitical tensions from the Israel-Hamas war, excess supply putting upward pressure on Treasury yields, and Fed policy. Here’s how those fears have resolved themselves.
The sum of all fears
When the market opened on Monday, Israel’s Incursion into Gaza had begun, but the conflict hadn’t spread, which could have sent oil prices soaring.
The U.S. Treasury announced it would be borrowing less than expected, followed by today’s announcement that debt issuance would be more skewed to the short end of the yield curve than expected, which alleviated pressure on bond yields.
Finally, the Fed announced that it would keep rates on hold, but left the door open to further rate hikes, which is a monetary policy stance that’s largely in line with market expectations.
Ripe for a rally
Market psychology had become so stretched that stocks were ripe for a rally. Charlie McElligott of Nomura published a note indicating that positioning had turned into a crowded short:
We have exhausted selling, both systematic and fundamental, while downside hedges too are deep in-the-money [and] at risk of being taken-down and monetized, which could set off some reversal flow.
An analysis of volume by price showed that SPY had reached a support level. It was therefore no surprise that the market would rebound.
Moreover, insider purchases were exceeding sales, which is another tactical buy signal.
I told you so.
My inner trader initiated a long position in the S&P 500 last Friday and he expects further gains, though the advance may be bumpy. Jeff Hirsch at Almanac Trader pointed that November seasonality tends to see gains early in the month, followed by a period of consolidation, and a further advance in late November. In light of the recent market action, that road map sounds about right.
The usual disclaimers are application to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 27-Oct-2023)
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.
Oversold markets can become more oversold
This stock market is oversold on a whole host of indicators. Consider, for example, the Zweig Breadth Thrust Indicator. A Zweig Breadth Thrust buy signal occurs when the ZBT Indicator surges from an oversold to overbought condition within 10 trading days. In the last 10 years, there have been four such buy signals (red dotted lines) and numerous oversold conditions (grey lines).
Here’s what we know. In all cases, the market has been higher 12 months later after a buy signal, though they didn’t always rise in a straight line. In all cases, the market has staged a relief rally when the ZBT Indicator has become oversold, but oversold markets can become more oversold.
A case can be that this is one of those occasions the market could become more oversold and experience a deeper drawdown.
The bear case
The most disturbing pattern is the lack of breadth support exhibited by this market. The accompanying chart shows the percentage of S&P 500 above their 200 dma. Whenever this indicator reached 30%, it has almost invariably fallen further. I interpret this as a sign of bearish momentum caused by poor breadth.
Evidence of poor breadth can be graphically illustrated by the following chart of different U.S. equity indices by market cap. The strongest is the Dow at the top. Market weakness becomes more and more evident as we go down by market cap bands, until the small-cap Russell 2000 at the very bottom. Even if the market were to stage a relief rally, one pre-condition for a durable rally would be a broadening of market leadership.
As well, none of the components in my Bottom Spotting Model are flashing a buy signal right now, though the VIX Index did surge above its upper Bollinger Band and the NYSE McClellan Oscillator did become oversold earlier last week. These conditions as the components of this model have come off levels of extreme stress even as stock prices retreated.
I interpret these readings as the market hasn’t fully discounted several key risks.
The geopolitical risk of an enlargement of the Israel-Gaza conflict.
Renewed upward pressure on Treasury yields, which would pressure equity valuation.
The risk of a disorderly unwind in the credit markets owing to the stress caused by monetary tightening.
An equally disturbing pattern can be seen in some sentiment indicators. The Fear & Greed Index improved even as stock prices declined, indicating growing bullishness, which is contrarian bearish. This argues for a final drop and wash-out before the market can form a durable bottom.
The bull case
While readings from the Fear & Greed Index are worrisome, two sentiment indicators with strong track records have flashed buy signals.
The first is the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds. The NAAIM Exposure Index fell below its 26-week lower Bollinger Band last week. Such conditions have marked either short- or intermediate-term bottoms in the entire history of this indicator.
Another reliable sentiment indicator is the action of corporate insiders, though this is not a contrarian signal. The market has bottomed whenever insider purchases (blue line) exceeded insider sales (red line), which just occurred late last week.
While I believe seasonality factors are only of secondary importance in technical analysis, the combination of an oversold market and bullish sentiment signals are more important and constructive signs for the stock market.
Technical analyst Wayne Whaley found that the case for an end-of-year rally remains intact, especially when the August–October period has been negative.
However, any upward march in stock prices in November and December may not occur in a straight line. The S&P 500 cycle composite from NDR is projecting a November advance, followed by a low in late November/early December, and higher highs in late December and January
Q3 earnings season has been a qualified success. Forward 12-month EPS estimates are rising, the EPS beat rate is slightly above average, and the S&P 500 forward P/E ratio is below its 5- and 10-year averages. The only blemish is the subpar sales beat rate
In conclusion, the S&P 500 is at a key technical crossroad as it tests support at 4100. While the market is oversold, it isn’t as oversold as it was during the sell-offs in 2022, which opens the door to further potential weakness. However, sentiment readings are turning and pointing to a near-term bottom. To be sure, oversold markets can become more oversold as the market faces several key risks, I judge the odds of a year-end rally at 70% and further weakness at 30%. If a relief rally fails to materialize and the index fails to regain the trend line, or if market breadth does not broaden out, stock prices could see a panic sell-off into much lower levels.
Subscribers received an email alert Friday that my inner trader had initiated a long position in the S&P 500. While sentiment indicators are signaling a strong buy signal, technical indicators are signaling caution. Should Wednesday’s combination of the Quarterly Refunding Announcement and FOMC decision fail to provide a bullish catalyst. I expect to exit my tactical trading position and the Trend Model will be downgraded from bullish to neutral. 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.
Has the Fed managed to achieve a soft landing? If so, Jerome Powell will go down in Federal Reserve history as a legend, and one of the greatest Fed Chairs who occupied that position.
There is some cause for optimism. The latest flash PMIs show that U.S. and China manufacturing PMI on the rebound, though the eurozone is weak, and U.S. services PMI turning up.
Not only that, the U.S. is outperforming the other major economic blocs since the COVID Crisis.
Winning the inflation fight
Moreover, the Fed and other central banks are winning the inflation fight. Inflation, however it’s measured, is decelerating.
Leading indicators of inflation, such as PMI output prices, are pointing to further deceleration in CPI.
As a consequence, the global monetary cycle is turning. Most global central banks have signaled pauses in rate hikes, including the Fed and ECB, and 31% have begun to cut rates.
China turns to stimulus
Across the Pacific, China is turning to stimulus. After Xi Jinping visited the PBOC for the first time since he took power, Beijing announced that it will RMB 1 trillion in bonds in the fourth quarter “to support the rebuilding of disaster-hit areas”, which is an unusual announcement as China rarely adjusts its budget mid-year. It could be argued that this round of fiscal stimulus is designed to spur economic growth, to offset the negative growth in government spending this year.
These developments should be bullish for the global growth outlook. The U.S. looks strong as Q3 real GDP growth came in at a better-than-expected 4.9%. China is stimulating. While Europe is weak, its export outlook is levered to China.
Investment implications
The appearance of U.S. economic strength and weakness in the rest of the world has resolved in U.S. equity leadership. That’s not surprising as investors bought growth in a growth-starved world. The onset of Chinese stimulus is likely to resolve in better performance in non-U.S. equities.
U.S. megacap growth stock leadership may be starting to stumble. The market reaction to earnings reports in this group have skewed negative. While leadership is poised to rotate away from megacaps, investors should wait for confirmation in the form of a break in the relative trend, which is still range-bound (bottom panel).
Keep an eye on commodities and the cyclically sensitive copper/gold and base/metal gold ratios. A new round of China stimulus would be evident in commodity demand and spark a global cyclical rebound.
An analysis of P/B versus ROE by country reveals that the U.S. market is a major outlier that’s very expensive. As growth returns to China and Europe, ROEs should improve in the other regions and boost the returns in the rest of the world.
Key risks
This bullish scenario of a U.S. soft landing and China stimulus faces a number of key risks.
The main risk of a disorderly unwind in the credit market. Already, Treasury yields have soared, and a Bloomberg article pointed out that the local currency yields of emerging market bonds are now below the 10-year Treasury. The surge in Treasury yields may be attributable to a supply-demand imbalance. Issuance has risen and important buyers have stepped away. The Fed is no longer buying and foreign central bank demand has been flat. This leaves domestic buyers to absorb the new supply. The Quarterly Refunding Announcement of Treasury issuance on November 1 will bring further clarity to this question.
As well, both the U.S. household and corporate sectors face the challenge of tightening credit conditions against a backdrop of rising interest rates. Similar readings have resolved in recessions in the past, which would derail the hopes of a soft landing.
That said, there are few signs of distress in the credit market. The relative performance of high yield to Treasuries is exhibiting a positive divergence against the S&P 500.
Another risk is too strong economic growth which causes further monetary policy tightening. Fed Chair Jerome Powell made that point in a speech to the Economic Club of New York [emphasis added]:
Still, the record suggests that a sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions…
We are attentive to recent data showing the resilience of economic growth and demand for labor. Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.
What does the Fed judge to be “persistently above-trend growth”? Investors should gains some clarity on that question in the post-FOMC meeting press conference.
In conclusion, the U.S. economy appears to be undergoing a soft landing. The global economy may be boosted by a new round of Chinese stimulus. Investors can position for this scenario by rotating away from U.S. megacap growth equities to non-U.S. markets. However, the risk of a credit event and overly strong U.S. growth may derail that bullish scenario. The coming week, which will see the U.S. Treasury Quarterly Refunding Announcement, the FOMC meeting rate decision, and the October Jobs Report could go a long way to resolving those risks.
Mid-week market update: There was a lot of angst last week about how Treasury market, whose yields had been rising steadily, was the main driver of risk appetite. When I saw this cartoon circulating, I thought that it marked the top in yields as a contrarian indicator. Indeed, the bond market rallied when Bill Ackman announced that he had closed his bond short and Bill Gross declared that a recession was in sight and investors should buy bonds.
An equity rally ahead?
While stocks did briefly advance this week, the S&P 500 was sideswiped by disappointments over the earnings results from META and GOOGL, though MSFT beat and was rewarded with a positive reaction. This kind of volatility is to be expected during earnings season. Even though the market is probing its recent lows, it’s exhibiting a series of positive RSI divergences, which is constructive. The likely peak in the 10-year yield will also provide a tailwind for stock prices.
In addition, the stock market is very stretched to the downside, as evidenced by oversold condition shown by the Zweig Breadth Thrust Indicator.
Nevertheless, this market makes me uneasy about being overly bullish.
Not scared enough
Even though the stars appear for a relief rally and possibly a rally into year-end, which is my base case, I am approaching this market with some caution. Although bond market sentiment reached a crowded short level and bond prices were ready to rally, equity market sentiment looks too bullish. As the S&P 500 tests the 4200 level, the put/call ratio hasn’t spiked, indicating complacency.
Helene Meisler conducted an (unscientific) Twitter/X poll on the weekend and found that most respondents are expecting a year-end rally. In other words, equity sentiment hasn’t capitulated yet.
This leaves us with an oversold market ready to bounce, but the risk is any bounce could be very brief. We may need a final flush before the market can rally into year-end.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 11-Oct-2023)
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.
Valuation pressures
Technical analyst Helene Meisler aptly characterized this market last Thursday as “Stocks want to go to the party. But the bonds won’t get in the car.” I agree.
The equity market appears to be enjoying fundamental and technical tailwinds, but rising Treasury yields are pressuring both stock and bond prices. Indeed, the difference between the S&P 500 forward earnings yield and 10-year Treasury yield hasn’t been this low since 2002.
Will these valuation pressures sink stock prices? What about the bond market?
A bond market tantrum
The U.S. Treasury is throwing a tantrum. How much of one? The 10-year yield of Greece (yes, that Greece), which is just returning to an investment grade credit, is trading lower that the 10-year Treasury.
A number of explanations have been advanced for rising bond yields. None of them are especially satisfying.
The evidence for the excess supply argument for the surge in yields is uneven. While the 30-year auction two weeks ago had dismal results, the 20-year auction the following week was well-received.
What about the narrative of rising yields owing to a stronger economy? The Citigroup Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is positive but decelerating while yields have surged.
The market became excited last week with the release of the TIC report which showed that China was selling its U.S. holdings. Analysts seized upon this as the reason for the upward pressure on Treasury yields.
The “China is selling story” is less bearish that it sounds. While the narrative of a modest Chinese reduction in Treasury bonds and Agencies is true, Council for Foreign Relations senior fellow Brad Setser found that China’s overall USD holdings after accounting for direct and indirect custodial accounts were broadly stable. Maturing Treasuries were rolled into T-Bills and bank accounts, which is far less ominous from a geopolitical viewpoint.
Fed Chair Jerome Powell’s speech last Thursday took a slight dovish tone and should be supportive of lower yields. Powell opened his speech to the Economic Club of New York on a constructive tone.
Incoming data over recent months show ongoing progress toward both of our dual mandate goals—maximum employment and stable prices.
After characterizing the jobs market as “tight” for many months and focusing on core services ex-housing inflation, which is the Fed’s code about wages pressuring the price of services, Powell seemed to switch his tone on wages.
Indicators of wage growth show a gradual decline toward levels that would be consistent with 2 percent inflation over time.
He also gave a nod to higher bond yields and their effects on monetary policy. Translation: The market is tightening monetary conditions for the Fed. This is as clear a signal a central banker can give that there will be no more rate hikes, at least in the near term.
Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening. We remain attentive to these developments because persistent changes in financial conditions can have implications for the path of monetary policy.
From a technical perspective, Treasury prices look washed-out and appear to be ready to bottom. The 20+ Year Treasury ETF (TLT) fell to multi-year lows on enormous volume last week while exhibiting positive divergences on the 14-day RSI and money flow indicator.
Stocks ready to party
Over in the stock market, equities are ready to party. Even though valuation appears to be under some pressure, the reaction from Q3 earnings season is encouraging and estimate revisions are exhibiting positive fundamental momentum.
Jurrien Timmer at Fidelity pointed out that the global earnings cycle is turning up, which is another sign of positive fundamental momentum.
From a technical perspective, the VIX Index has spiked above its upper Bollinger Band, which is a signal of an oversold market as the S&P 500 tests support at its 200 dma.
The analysis of the weekly S&P 500 chart is equally revealing. The index is testing a long-term uptrend that stretches back to the 2020 bottom as its 5-week RSI has become oversold.
Goldman Sachs’ prime brokerage arm reported that hedge fund positioning is extremely defensive, which is contrarian bullish. While stocks may decline a little further from here, they don’t crash when technical and sentiment conditions are this extreme.
In conclusion, surging yields have not only cratered bond prices, but also created severe valuation headwinds for stock prices. A fundamental and technical review of the U.S. Treasury market shows that bond prices are poised for a rally. The fundamental and technical picture for U.S. equities is even brighter as fundamental momentum and oversold conditions point to a strong rebound.
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