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.
Publication note: There will be no mid-week market update next week. Regular service will resume the weekend of December 30. Happy Holidays.
A temporary blip
It appears that the best explanation for Wednesday’s sudden market downdraft was same-day option related activity (0DTE) that forced market makers to hedge by selling equities. From a longer-term context, analysis from Bespoke indicates that similar hiccups in strong bull trends haven’t done damage.
With that in mind, here are the issues to consider as we look ahead into 2024 on differing time horizons.
Short-term outlook
Starting with the short-term outlook, the year-end rally appears to be intact. First, let’s address the issue of Wednesday’s sudden market downdraft on no news, which was accomplished on a TRIN reading of above 3. Such episodes are indicative of price-insensitive selling, this time by option market-makers to hedge an influx of 0DTE put buying in an illiquid market. The past history of TRIN spikes in the last two years have usually resolved with quick price recoveries.
In the short run, I have been focused on equity hedge fund performance and the necessity of HF managers to preserve and enhance returns ahead of their December 31 incentive fee calculation dates. Equity HF returns, as proxied by the market-neutral ETF BTAL, has shown itself to have the following factor bets:
Negative beta;
Long quality and profitability;
Long large caps and short small caps; and
Long Magnificent Seven and short everything else.
As the accompanying chart shows, BTAL has been losing ground since early November and the FOMC meeting set off a sudden downdraft in returns. This will necessitate a beta chase during a historically illiquid period for funds that haven’t closed their books in order to preserve performance bonuses.
Small cap stocks are staging upside breakouts from multi-month bases during a seasonally positive period for these stocks. Further progress will confirm the bullish prognosis for these stocks, which could spark a FOMO stampede.
In addition, I have highlighted the closely linked relationship between Bitcoin prices and the relative performance of ARK Innovation ETF (ARKK). Bitcoin is also a real-time proxy for financial system liquidity and it’s still rising, indicating strong market animal spirit activity.
Even though I am a cryptocurrency skeptic, Bitcoin may have more room to rally. Jurrien Timmer at Fidelity has a fair-value estimate for Bitcoin, consisting of a _/- 2.5% real yield, and Bitcoin prices are just moving into that range.
In short, the underpinnings of the Santa Claus rally appears to be intact.
The challenges of 2024
Looking ahead into 2024, investors and traders are hearing calls to take profits in response to the strong equity rally from the October low. Bloomberg reported that Morgan Stanley’s Portfolio Solutions Group, along with others, is turning cautious on the market:
“We’ve been overweight in equities all year,” said Jim Caron at Morgan Stanley’s Portfolio Solutions Group. “We are starting to think about reducing that and moving towards neutral. We haven’t done it yet but that’s probably our next step. And why that is, everything we thought about in late October, November has actually already come through.”
Marketwatch reported that uber bull Ed Yardeni has also turned temporarily cautious:
Proceed cautiously, warns our call of the day from Yardeni Research’s chief investment strategist, Ed Yardeni, who earlier this month predicted the S&P 500 could reach 6,000 in two years.
“Is everybody (too) happy?” Yardeni asks in an update to clients on Thursday. “Most pundits concluded that the market was overbought and due for a correction. We agree, which is why we haven’t raised our longstanding year-end target of 4,600.”
The strategist said one possible trigger for the selloff was a sign that the Israel-Gaza war is turning more regional, after the U.S. announced a security operation in the Red Sea involving the U.K., Canada, France, Spain and other nations, to protect ships from a wave of Houthi attacks.
Despite these calls to take profits, keep in mind that the BoA Global Manager Survey don’t show the fingerprints of a major market top. While the risk levels of global institutions are normalizing, readings are not a crowded long and equity weights can rise much further before they reach a crowded long condition, which would be contrarian bearish.
Soft landing ahead
Here is the big picture from a macro perspective. The market is discounting Fed rate cuts that begin in Q1 2024. While recessionistas and bears have pushed back against the bullish Fed rate cut narrative on the basis that rate cuts will only occur in response to slower economic growth and a possible recession, numerous Fed speakers have underlined the message the Fed can cut rates if inflation were to fall. Analysis from Goldman Sachs shows how stock prices respond to the first rate in the case of recessions (blue line) and soft landings (gold line).
A soft landing appears to be in the cards. The Atlanta Fed’s GDPNow nowcast of Q4 GDP growth is 2.8%, which is nowhere near recession territory.
November’s monthly core PCE came in at 0.06%, which was well below the consensus estimate of 0.2%. Fed Governor Waller had implied that the Fed would start to consider cutting rates if core PCE came in at 0.2% for several months. Regardless of whether these string of readings qualify under the “several” criteria, the November PCE report will cement the market’s conviction of rate cuts that begin in March.
Key risks
My sunny outlook doesn’t come with some risks. The FedEx earnings report contained a recession warning: “U.S. package volume was down 3.5% in the November quarter, on a down 15.1% year-ago comp. In other words, the two-year volume trend is deeply negative, and worse than last quarter. So much for improving box demand…”
In addition, the stock market has been supported by strong financial liquidity. One key announcement to watch is the Quarterly Refunding Announcement in late January in which the U.S. Treasury announces its planned issuance. Despite the ballooning federal deficit and strong financing requirements, Treasury has been issuing far more bills than coupon bearing paper. The less than expected coupon supply supported bond prices, which in turn supported equity valuations. Moreover, more T-Bill issuance has reduced the levels of reverse repos at the Fed, which has the effect of boosting liquidity to the banking system. The short-term fate of the Treasury and stock markets will hang in the balance at the next QRA.
In conclusion, I end 2023 short-term bullish on equities. The market may see some choppiness in the new year as bullish year-end hedge funds flows dry up, and from calls for profit taking. The macro outlook is constructive and investors should see a decent year for equity returns.
Both my inner investor and inner trader are bullishly positioned. My inner traders anticipates that he will start to take profits in early 2024. 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.
Mid-week market update: The recent stock market rally has been astounding. Sentiment readings on the Fear & Greed Index surged from extreme fear in October to extreme greed in less than two months. While extremely fearful sentiment can be useful buy signals, extreme bullish sentiments are condition indicators and inexact sell signals. This leads to the tactical conclusion that it’s too late for investment-oriented accounts to be adding risk. Bulls should wait for a likely pullback for a lower-risk entry point.
Publication note: There will only be one publication this weekend showing the model readings with a brief commentary. There will be no mid-week market update next week barring unforeseen volatility. The regular publication schedule will resume the weekend of January 30.
Respect the breadth thrust
Even though the market appears to be overbought, investors should keep in mind that these conditions are appearing against a breadth thrust backdrop. Consider how the percentage of S&P 500 stocks above their 50 dma surged from below 10% to over 90% this week. Such overbought conditions can be interpreted two ways. First, these are instances of strong price momentum that signal bull markets. On the other hand, they have also resolved in short-term pullbacks that can be good buying opportunities.
The 10-year history of the Zweig Breadth Thrust Indicator (bottom panel) tells a similar story. As a reminder, a ZBT buy signal is triggered when the ZBT Indicator rises from oversold to overbought within 10 trading days, which is a rare occurrence. That said, the market has flashed a cluster of ZBT Indicator overbought conditions and past instances were indicators of strong market momentum. In other words, these are “good overbought” signals.
This market advance has been accompanied by broadening breadth. Willie Delwiche pointed out that the percentage of industry groups making 13-week highs is at its highest since June 2020, which is another sign of price momentum and broadening participation.
Santa rally ahead
The official “Santa Claus Rally” season is the last five days of the year, or December 22, and ends on the second day of the new year and it is seasonally positive for equities.
Wednesday’s downdraft in prices reset the 14-hour RSI of the S&P 500 to its target of below 50 after breaching the 90 level. If the recent past is any guide, this should represent a welcome entry point for nimble traders to position for a potential Santa Claus rally.
Small-cap stocks, which have been the laggards in 2023, have tended to outperform during that period, and small caps are attempting breakouts through resistance. Upside breakouts during this seasonally strong period could signal even more upside potential.
Tactically, I believe small caps, and especially low-quality small caps, have the potential for strong gains during the Santa Claus rally period. I recently highlighted the reversal of the crowded equity hedge fund trade of long Magnificent Seven and short small caps and low-quality names. Keep an eye on the behaviour of the equity market-neutral ETF BTAL as a proxy for equity hedge fund factor exposure. Even though many hedge funds have closed down their trading books for the holiday season, their incentive fees are determined at the end of the year. If they haven’t flattened their books, further reversals of the small-cap and low-quality factors will force traders to chase these names in a short-covering rally. The price response of these stocks would be especially exaggerated during a period of low liquidity.
Too early to short
I have had discussions with traders who have shown some eagerness to short this overbought market. My advice is to wait for the sell signal before entering a short position. You don’t want to be caught short during a seasonally strong period.
Option sentiment models are nearing a sell signal, but they’re not there yet. The 10 dma of the CBOE put/call ratio and the equity-only put/call ratio are still above their one-standard deviation Bollinger Bands. A breakdown through these levels would be signals of imminent market weakness. Just not yet.
In conclusion, the stock market is overbought and sentiment models are reaching bullish extremes. However, price momentum is strong, indicating long-term bullish outlooks. Similar overbought conditions have resolved with short-term pullbacks. Investors who are under-invested should wait for weakness for a better long entry point.
Both my inner investor and inner trader are bullishly positioned. The usual disclaimers apply to my trading positions:
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 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.
One sentiment indicator that’s of concern is the put/call ratio. Both the CBOE put/call and the equity-only put/call ratios are approaching the bottom of their one-standard deviation Bollinger Bands, or the froth zone. Past instances, which are marked by vertical pink lines, have tended to resolve in pullbacks.
Price momentum has been strong as stock prices surged in response to the FOMC announcement. It’s starting to look like a frothy Christmas this year.
Bearish tripwires
Let’s review the other bearish tripwires that I set out two weeks ago. The weekly stochastic (bottom panel) of the NYSE McClellan Summation Index (NYSI) is wildly overbought. Fortunately, there is no sign of a downward recycle yet. Should momentum continue to be strong, stock prices can advance for a few weeks more, but investors and traders should monitor market internals for signs of weakness.
Bitcoin prices and speculative stocks, as measured by the ARK Innovation ETF (ARKK), are correlated to each other. Bitcoin suffered a brief setback last week, but the market’s speculative juices are still flowing.
Bitcoin prices are also correlated to overall market liquidity.
This wasn’t part of my suite of bearish tripwires. But for what it’s worth, the Citi Panic/Euphoria Model is nowhere near euphoric territory that indicates a major market top.
Still bullish
While some indicators are raising cautionary signals, I believe the seasonal rally has more room to run. The S&P 500 just staged an upside breakout from a cup and handle pattern, which has strong bullish implications.
A review of the Commitment of Traders report shows that leveraged long speculators, which are mostly drawdown sensitive hedge funds, are not surprisingly short S&P 500 futures and they are continuing to fight this rally. The combination of strong momentum and year-end seasonality will cause pain and should force them to cover and drive prices up further.
Small caps have a tendency to outperform this time of year. The rally is exhibiting broadening market breadth, which is an indication of better participation by smaller stocks. This is another sign that strong seasonality is taking hold.
Blowoff top ahead?
It’s difficult to know how far this rally can run but current conditions may be setting up for a blowoff top at year-end or January. A point and figure analysis of the S&P 500 using a short time horizon of 30-minute ticks, 0.25% box size and 3-box reversal shows an upside measured objective of 4949. Broader parameters yield upside measured objectives in the 5800–6000 range.
Just remember that we are entering a period of strong seasonality for the S&P 500.
A possible Gamestop style risk scramble
In addition, equity market-neutral and equity long/short hedge funds were shocked last week when their funds experienced severe drawdowns in the aftermath of the FOMC announcement. Using the market-neutral ETF BTAL as a proxy for hedge fund exposures, we can see that BTAL was caught offside in probable crowded trades in several correlated factors:
Profitability and high quality: As measured by the return spread between the S&P 500 and Russell 1000 because S&P has a stricter profitability index criteria than FTSE/Russell;
Size: As measured by the return spread between the S&P 500 and Russell 2000; and
Magnificent Seven over “junk stocks”: As measured by the return spread between the Russell 1000 Growth Index and the Russell 2000 Value Index.
All of these factors started turning down in early November in lockstep with BTAL performance. The downturn accelerated after the FOMC announcement when market participants began to buy low-quality small caps in a beta and short covering scramble in anticipation of a Fed-induced risk-on rebound. The returns to these factor exposures stabilized on Friday and so did BTAL returns.
Hedge funds may have been buying Russell 2000 call options as a hedge, which fed into the bullish feedback loop in the small cap index. The scramble for high beta hedges opens the door to a Gamestop-style parabolic price run in small caps and other correlated low-quality factors.
Will the short covering in these factors continue? I believe that this may be the start of a Gamestop style short covering rally. Hedge funds were caught offside in a crowded trade when low-quality names began to rally. The combination of risk manager mandated de-risking during a period of low liquidity have the potential to move prices further than anyone expects and such a rally would raise frothy sentiment to extreme levels. Just keep in mind that Bob Farrell’s Rule #4 is applicable to factor returns too: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
In conclusion, the U.S. stock market appears to be undergoing a seasonal rally into year-end and January. Warning signs of froth are starting to appear and traders should exercise caution. I believe stock prices may advance further into a possible blowoff top.
In particular, the market may be poised for a Gamestop style short covering rally in low-quality stocks. Hedge funds were caught offside in a crowded short when low-quality names began to rally. Bob Farrell’s Rule #4 is applicable to factor returns too: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
Both my inner investor and inner trader are bullishly positioned. The usual disclaimers apply to my trading positions:
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
The Fed has clearly pivoted. It indicated at its December FOMC meeting that, for all intents and purposes, it was done hiking and the “dot plot” is projecting three quarter-point rate cuts in 2024 against a soft landing backdrop. Fed Chair Jerome Powell was given ample opportunity to push back against the dovish narrative. Instead, he embraced it. He shrugged off concerns about easing financial conditions. He didn’t express concern about above trend growth in the economy. When asked about the “last mile” problem of reducing inflation to the Fed’s 2% target, he said, “We kind of assume it will get harder from here, but so far it hasn’t.”
The Fed pivot set off a bull steepener in the bond market, where yields fell (and bond prices rose) while the yield curve steepened. The historical evidence shows that the relative performance of bank stocks is correlated to the shape of the yield curve. There was some interruption of this relationship in 2016–2018 when the shares of banks surged when Trump was elected on the expectations of bank tax cuts, and another rally when tax cuts were passed in 2017. Otherwise, the relative performance of banks has been sensitive to the yield curve as they tend to borrow short and lend long. As a consequence, a steepening yield curve is bullish for lending margins.
The Fed pivot is the catalyst for my high conviction call to buy U.S. financials for potential outperformance.
Inevitable dovishness
The Fed’s dovish pivot was inevitable. Conditions are ripe for a bond market rally. Monetary conditions are tight, as measured by the Fed Funds rate (red line) above core CPI (blue line). The combination of falling CPI and the start of an easing cycle has historically been conducive to falling Treasury yields.
The current disinflationary environment should put downward pressure on real yields, which is correlated to the USD.
Putting it all together, falling real yields, or rising TIPS prices, will create tailwinds for the S&P 500.
In addition, equities should receive an additional boost from rising EPS estimates. Rising estimates will boost valuation by increasing the E in the forward P/E ratio. Falling yields will also enable P/E expansion as bonds become less competitive with stocks.
A focus of financials
The financial sector had been showing signs of renewed leadership even before the Fed pivot. Financial stocks staged a decisive upside breakout in late November and relative performance had been making a saucer-shaped bottom. Relative breadth indicators were also improving.
The steepening yield curve, which improves banking profitability, should also allay fears about regional banks, whose prices have recovered sharply. Another constructive sign is that the relative performance of this group never broke relative support even at the height of the SVB crisis.
This sector is also hated. Goldman Sachs prime brokerage reported, “HFs sold U.S. Financials at the fastest pace in a month, driven by long sales. The sector now makes up 10.1% of overall U.S. Net Exposure, which is at the lowest level since March ’20.”
Keep an eye on the large-cap growth stocks as represented by the NASDAQ 100 (NDX). Even though the upside breakout by the NDX has been impressive, its relative performance is losing momentum and relative breadth (bottom panel) is weak. Should we see a convincing rotation from growth to value, financial stocks should benefit as they are the largest sector among value stocks. Perhaps as the ultimate contrarian signal, robo-advisor Wealthfront just announced it is updating its “Smart Beta service” and that it will “no longer use the ‘value’ factor in our service, as research suggests it is no longer as effective as it once was”.
In conclusion, I am making U.S. financials a high conviction buy idea for the following reasons:
Positive macro backdrop from falling yields and steepening yield curve;
Mid-week market update: The Fed delivered a dovish pause today. In addition, Powell was given opportunities to push back with bearish scenarios, such as raising concerns over the recent risk-on rally as a sign that financial conditions are loosening, or the elevated levels of super-core inflation, but he declined to do so. It is becoming more and more evident that the rate hike cycle is over. The market is looking forward to rate cuts and it’s discounting cuts to begin in March and five quarter-point cuts in 2024.
Here is a framework for thinking about the Fed’s monetary policy.
A soft landing
The Summary of Economic Projections (SEP) is projecting the unemployment rate to rise to 4.1% next year and GDP growth. In other words, a soft landing. The SEP is also projecting a Fed Funds rate of 4.6% in 2024, down from 5.1% in its September. This translates to three rate cuts next year. Moreover, it’s projecting four more rate cuts in 2025, but let’s not get ahead of ourselves.
Treasury Secretary and former Fed Chair Janet Yellen is calling for rate cuts next year in a CNBC interview: “As inflation moves down, it’s in a way natural that interest rates should come down somewhat because real interest rates would otherwise increase, which can tend to tighten financial conditions.” Already, core PCE has undershot the Fed’s year-end target from September.
This is all good news for the markets.
A positive reaction
The market has reacted positively. The S&P 500 has staged an upside breakout of a cup and handle pattern with resistance in the 4600-4630 zone.
Bond prices are also rallying after testing their 10 dma.
What more do you need to know? Get ready for the year-end rally as we approach a period of bullish seasonality. 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.
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 healthy consolidation
The S&P 500 staged a late Friday breakout above 4600 out of a narrow consolidation range. The accompanying hourly chart shows that whenever the 14-hour RSI reaches an overbought extreme of 90 or more, it has retreated to a minimum level of 50, which it has in the latest episode. In light of the powerful momentum exhibited by the Zweig Breadth Thrust buy signal in early November, the market has met the conditions for another bull run in the near future.
I continue to believe that stocks are poised for a rally into year-end. My analysis of market internals shows that the market’s animal spirits are still alive.
Bullish liquidity sparks animal spirits
Liquidity conditions are supportive of a risk-on tone in asset prices. One quick real-time proxy of liquidity is Bitcoin and other cryptocurrency prices.
Bitcoin prices are also correlated to the relative performance of speculative growth stocks, as measured by the ARK Innovation ETF (ARKK). Current conditions reflect a flood of liquidity and tailwinds for high beta animal spirits’ stocks represented by ARKK.
Supportive positioning
In addition, a recent interview with derivatives analyst Cem Carson also paints the potential for a melt-up into year-end and beyond. Here are the main points from the interview transcript, which is well worth reading in its entirety.
A flood of yield-enhancing structured products and ETFs that use buy-write strategies of buying an underlying index and selling call options for extra income have served to suppress implied volatility, which creates a price bullish environment.
The surge in 0DTE option trading, or options that expire the same day, allow banks issuing these structured products to hedge their risk cheaply. 0DTE option trading also suppresses implied volatility.
These circumstances create an unstable equilibrium, but don’t worry about short-term instability.
Current positioning of structured products, along with year-end re-positioning, imply strong positive flows into equity-linked products until at least January 3, or possibly January 17, which is VIX expiration.
A separate research note from Charlie McElligott at Nomura is also calling for a year-end melt-up:
That infamous call spread buyer made the jump into Dec 29th 4800/4820 ES and Jan. 5th 4800/4820 CS. Such a jump in short period likely elicit Spot up/Vol up reaction with folks forced to chase into Right Tail
No bull market without bulls
Another supportive factor is a surge of insider buying. This group of “smart investors” have historically been prescient in their market timing.
The inverse of insider activity is AAII sentiment. AAII sentiment is starting to become excessively bullish, but that’s not necessarily contrarian bearish. History shows that elevated AAII bull-bear spreads have not been actionable sell signals.in the past. In other words, you can’t have a bull market without the bulls.
Supportive intermarket signals
Intermarket signals are also flashing green. The S&P 500 has been inversely correlated with the USD, which has weakened below a resistance level. Emerging market currencies (bottom panel) already showed the way in early November by breaking up above a key resistance level.
Both equity and credit market risk appetite indicators are also strong and confirm the strength in equity prices.
Event risks ahead
The key event risks to this bullish scenario are the CPI report next Tuesday and FOMC meeting next Wednesday.
Inflation appears to be trending in the right direction. Core PCE came in at 0.2% in October. Market expectations for the November CPI print is 0.2%, while the Cleveland Fed nowcast is 0.33%. But anything can happen.
Keep an eye on bond prices, as they were the initial catalyst for the equity rally. Depending on how tight you want to set trading risk controls, the 10 dma (blue line) would be the first line in the sand, and the 20 dma (red line) would be the second.
Prepare for year-end seasonality
In conclusion, the combination of strong price momentum, supportive market positioning and intermarket factors argue for a rally into year-end. However, the CPI report and FOMC meeting next week could derail the bullish scenario and become the source of market volatility. Historically, positive year-end seasonality in a pre-election year starts about mid-month, which begins just after the FOMC meeting.
I am bullish but I am prepared for anything. The S&P 500 staged a marginal upside breakout from a cup and handle pattern with bullish implications, but we’ll have to see whether the breakout holds next week.
Both my inner investor and inner trader are bullishly positioned. The usual disclaimers are applicable 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 Zweig Breadth Thrust buy signal in early November sparked a price surge and a price momentum chase. Already, the S&P 500 made a late-day charge above 4600 for a new recovery high.
The price momentum factor is defined as stocks that beat the market continue to beat the market. The red line in the accompanying chart shows the difference between the one-month price momentum ETF (FDMO) and the six-month price momentum ETF (MTUM). One-month momentum has rocketed upward against six-month momentum, which is an indication that under-invested funds are scrambling to buy beta and momentum in order to catch up on performance.
In all likelihood, the momentum chase will last until year-end as fast money accounts continue to chase returns into year-end. The key question for investors is what happens after the chase?
All systems green
From a top-down macro perspective, all systems are green for a soft landing and Fed rate cuts in Q1 or Q2.
Let’s take a look at the major indicators on the Fed’s dashboard, starting with the jobs market. The November Payroll Report showed an improving economy. Headline nonfarm payroll came in at 199,000 and slightly beat expectations of 180,000 but those figures were distorted by the return of UAW workers after the strike. Average weekly hours edged up to 34.4 from 34.3, which was a welcome surprise of economic strength. The unemployment rate dropped from 3.9% to 3.7%, which puts to rest Sahm Rule recessionary signals.
However, leading indicators of the jobs market are softening. Temporary employment is rolling over, and the quits/layoffs ratio from JOLTS is also falling, albeit in an uneven fashion.
Labour market productivity has been strong. This leaves more room for non-inflationary economic growth.
The improvement in productivity should lay to rest concerns about the pace of change in average hourly earning, which is decelerating but not as fast as core CPI.
Equally important is the recovery in monetary velocity. Recall that monetary theory posits GDP = MV, where M=money supply and V=monetary velocity. Even as M2 growth (red line) has fallen dramatically, M2 velocity (blue line) has been recovering to support GDP growth.
These readings cement the market’s expectations of no more rate hikes and possible rate cuts that begin in May 2024 as the Fed’s way to reduce real interest rates in the face of falling inflation.
The bulls’ challenge
While I expect that a momentum and beta chase will push upward pressure on stock prices into year-end and possibly early January, here is the challenge for the bulls.
In light of the strong macro backdrop, earnings estimates have to keep rising.
From a technical perspective, a constructive sign is the re-emergence of a positive monthly MACD for the broadly based NYSE Composite. If the signal holds until month end, such readings have historically signaled the start of long and sustainable bull runs. Keep in mind, however, that this is the only long-term buy signal and this doesn’t mean that prices advance in a straight line after the signal.
A useful development would be continual broadening breadth away from the narrow leadership of the Magnificent Seven.
Keep an eye on how the internals of value and growth rotation is progressing. It’s not enough to monitor U.S. large-cap value and growth, which is dominated by the outsized effects of the Magnificent Seven, but other value and growth relationships. Even as large-cap growth has been dominant for much of this year, mid-cap growth and value have been flat since June and small-cap value has been outperforming small-cap growth in the second half of 2023. In addition, developed market value has been turning up against its growth counterparts (top panel, red line). An ultimate test of broadening breadth and market rotation is whether small-cap value can continue to beat large-cap growth (bottom pane).
Lastly, the recent scramble for risk assets coincided with a bond market rally sparked by a tamer-than-expected Quarterly Refunding Announcement (QRA) from the U.S. Treasury. Treasury is expected to issue even more debt in Q1 2024 than in Q4 2023 and break above the bond supply of the COVID era. The next QRA will be on January 31, 2024. Mark that on your calendar as a source of volatility and possible catalyst for a bearish reversal.
In conclusion, the market appears to be setting up for a beta and momentum price melt-up into year-end. The question is what happens afterwards. Top-down macro indicators are supportive of a soft landing. From a technical perspective, the bulls need to broaden market leadership and allow the market to sustainably advance.
Mid-week market update: Another day, another sideways consolidation price action in the S&P 500, which is typical of seasonal pattern in the first half of December. Beneath the surface, I am seeing numerous signs that the market is still poised for the year-end rally. Supportive sentiment First of all, sentiment models […]
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: 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.
Disclosure: Long SPXL
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