Page 14 – Humble Student of the Markets

Zweig Breadth Thrust: From caution to YOLO

Posted by Cam Hui - November 6, 2023

I would like to address the feedback from my recent publication, Nine reasons why this rally has legs. Some readers questioned my change in tone in the interpretation of the Zweig Breadth Thrust buy signal.

As a reminder, the ZBT is a price momentum signal. It is triggered when breadth indicators rise from oversold to overbought within 10 trading days. Breadth thrust price momentum signals usually resolve in a surge. The market triggered a ZBT buy signal on March 31, 2023 and my reaction was cautious (see Why I am fading the latest breadth thrust). This time, the tone is far more bullish and I am inclined to adopt a YOLO (You Only Live Once) to portfolio positioning.

I wrote in early April that I was cautious, but not outright bearish. I was mostly correct. Instead of a price surge, the S&P 500 traded sideways for two months after the buy signal, rallied and topped out in late July, and pulled back to the approximate level of the buy signal in late October.

Here’s what’s different about the latest signal compared to March.

A history of ZBT signals

The accompanying chart shows the out-of-sample history of ZBT signal when Marty Zweig outlined his breadth thrust signal methodology in 1986.

Excluding the latest buy signal, there have only been seven out-of-sample ZBT buy signals since 1986. The S&P 500 was higher a year later in all instances. Four of the buy signals were accompanied by runaway freight train-style price surges, but the market traded sideways and re-tested the buy signal entry points in three cases.

Here’s what made the “failures” different.

The “failures” occurred against a backdrop of tightening monetary policy, as measured by a rising Fed Funds rate.
Most of the “successful” signals came out of V-shaped panic bottoms, though the one in 2013 did not, and the 2015 “failure” was a V-shaped bottom that was later re-tested later.

What’s different this time

It is against this framework that we can observe the Fed Funds rate continued to rise after the March ZBT signal. Today, investors can be more confident that the rate hike cycle is over. Fed Chair Powell signaled that the Fed is done raising rates at the last post-FOMC press conference, though he left the door open to more hikes should inflationary pressures persist.

In addition, successful ZBT buy signals generally occurred after a V-shaped panic bottom. An analysis of SentimenTrader’s Fear & Greed Index shows that sentiment is far more extreme and panicked today compared to the March ZBT buy signal.

Key risk

While I am far more bullish on equities in the wake of the latest ZBT buy signal compared to the March signal, the one key risk to the bullish scenario is valuation. The accompanying chart shows past ZBT buy signals in the last 10 years as marked by red vertical lines. The current stock/bond valuation of an S&P 500 forward P/E of 17.8 compared to a 10-year Treasury yield of 4.57% is less attractive when compared to past buy signals. Arguably, it’s difficult to envisage a new equity bull that starts at these lofty levels. In effect, the bulls are depending on the combination of price momentum and a less restrictive monetary policy and benign liquidity environment sparking the market’s animal spirits to push stock prices higher.

In conclusion, I am far more bullish on the equity outlook in the aftermath of the latest ZBT buy signal compared to the one in late March. The key differences between the two signals are a less hawkish monetary policy outlook and the presence of a market panic that sparked V-shaped rebound in the latest episode. However, investors face the risk of heightened valuation headwinds to this bullish forecast.

Nine reason why this rally has legs

Posted by Cam Hui - November 5, 2023

Preface: Explaining our market timing models

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

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 27-Oct-2023)

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

Subscribers can access the latest signal in real time here.

This rally has legs

Last week, I outlined bullish and bearish scenarios and estimated their odds at 70% and 30%, respectively. The bulls won.

A relief rally was more or less inevitable. Once the S&P 500 violated a rising trend line that began at the COVID Crash bottom, it scared the daylights out of the bulls and caused a panic. The weekly slow stochastic touched 10, which has marked either important bottoms or tactical bottoms in the past.

I believe the combination of a severely oversold condition, washed out sentiment and the lifting of market concerns will spark a durable rally into year-end. I can think of nine reasons why this rally has legs. The reading of 10 on the weekly slow stochastics is just the first.

Supportive sentiment

Sentiment models are supportive of a durable rebound. The weekly AAII sentiment survey showed that the percentage of bears came in at 50% and bull-bear spread at -26%. Pay attention to the level of bearish sentiment. Similar readings have marked either short-term bottoms or prolonged bear markets in the past. AAII sentiment is a condition indicator and not an actionable trading signal. Nevertheless, it does inform investors that survey respondents are panicked.

The AAII Survey describes retail trader sentiment. Goldman Sachs prime brokerage, which offers a window into hedge fund sentiment, reported that the equity exposure long/short funds are the most defensively positioned in 11 years. Moreover, the CTA trend-following hedge funds are likely maximum short equity futures in light of recent market action, and further gains would trigger a buying stampede to reverse from short to long.

The other side of the sentiment coin is insider activity. While most extreme sentiment signals should be faded, extreme bullish insider sentiment is a buy signal. Not only have insiders bought the latest dip, they also continued to buy even after the market began to rally, which is another sign of a durable advance.

Falling macro uncertainty

Another factor supportive of a bullish scenario is the recent reduction in macro uncertainty. In the last few weeks, market psychology had become unsettled over the prospect of excessive Treasury supply putting upward pressure on yields. Indeed, the 10-year Treasury yield briefly traded above 5%, which rattled investors.

The U.S. Treasury’s Quarterly Refunding Announcement alleviated many of those concerns. Borrowing was lower than expected. In addition, Treasury announced that debt issuance would be tilted toward more short-term debt than expected, which alleviated many of the concerns over bond supply.

As a consequence, bond yields fell dramatically. The move was probably inevitable as yields have roughly tracked real-time indicators of economic strength, as measured by the Citigroup Economic Surprise Index. Yields had been rising in the past few months even as ESI flattened out. A convergence between the two was more or less inevitable once the fears of excess supply became alleviated.

Coming into last week, an air of uncertainty also hung over the FOMC decision. While a November pause was widely expected, it was less clear whether the hiking cycle was over. To no one’s surprise, the Fed left rates unchanged and kept the door open to another rate hike. WSJ reporter Nick Timiraos reported that Fed Chair Powell telegraphed that the Fed was not eager to hike rates.

At Fed officials’ September meeting, most projected one more rate increase this year, but some have spoken in recent weeks as though they aren’t eager to hike again unless hotter-than-expected economic data force their hand.

Powell echoed that sentiment on Wednesday by repeatedly highlighting how much inflation has fallen, rather than emphasizing the economy’s recent strength.

Indeed, there are signs that both inflation and the jobs market are cooling. Q3 S&P 500 earnings calls show a decline in references to “labour shortage” and increases in “job cuts”.

Q3 real GDP growth came in at a very hot 4.9%, which raised worries about excessive growth leading to inflation. Those concerns may be misplaced. The latest Q3 productivity report showed a 5.9% jump in output and a 4.7% surge in productivity. These readings should alleviate many of the concerns over wage inflation and excessive growth.

The October Jobs Report came in slightly softer than expected. Headline employment rose 150,000 against an expected 180,000, though the more volatile household survey showed a loss of -348,000 jobs. The participation rate stayed steady and the unemployment rate edged up to 3.9% from 3.8%. More importantly, the rate of change in average hourly earnings is decelerating, indicating moderation in wage growth.

These are very market friendly reports. The combination of slightly soft employment, tame wage growth and strong productivity paints a picture disinflationary growth. If continued, it should allow the Fed to stay on hold and possibly cut rates next year.

A Zweig Breadth Thrust buy signal

Last but not least, the market flashed a rare Zweig Breadth Thrust buy signal Friday when price momentum surged, as measured by market breadth indicators rising from an oversold to overbought condition within 10 trading days. The latest signal only took five days to achieve the momentum surge, which is unusual even for a breadth thrust.

ZBT buy signals are extremely rare. Not counting the latest, there have only been seven out-of-sample buy signals since Marty Zweig outlined this system in 1986. The S&P 500 has been up after a year after every signal. There were, however, three instances of failed momentum when the market pulled back after the initial buy signal. Those “failures” occurred against a backdrop of rising rates, which may not be the case this time if consensus market expectations are correct.

The “ZBT failures” occurred against a backdrop of rising rates, which may not be the case this time if consensus market expectations are correct. Historically, peaks in the 2-year Treasury yield have coincided with peaks in the Fed Funds rate, but investors won’t know if the 2-year yield has actually peaked until after the fact.

In the short run, the stock advance may be due for a breather. It isn’t unusual for the market to pause and consolidate for a few days after a ZBT buy signal. The S&P 500 has risen very quickly and become overbought on the 5-day RSI and the NYSE McClellan Oscillator. It is now approaching overhead resistance at 4380-4400, which is also the site of an unfilled gap from September 20.

Finally, if the market were to pull back next week, the S&P 500 could be forming an inverse head and shoulders pattern. Keep in mind, however, that head and shoulders formations are incomplete until the neckline breaks, so this scenario is highly speculative.

Putting all together, I have enumerated reasons why the market is due for a relief rally, but what makes the rally sustainable? The stock market reached an extreme oversold condition and recycled to signal a relief rally is underway. Every oversold rally begins with short covering, but needs more buying fuel to keep going. Evidence of insider buying, even after the onset of the rally, provides bottom-up fundamental support to further gains. In addition, psychological relief from macro uncertainty also provides top-down bullish fuel for a sustainable advance, culminating in a breadth thrust, which is a technical condition indicating a FOMO buying stampede.

My inner trader was fortunate enough to have bought in just before the onset of the price surge. Under normal circumstances, he was ready to take profits last Friday as the market had become extremely overbought – until evidence of the ZBT came to light. He decided to look through likely short-term turbulence next week in anticipation of greater gains. Your decision process will vary depending on your risk appetite and pain threshold. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long SPXL

How the U.S. could be in both a bull and bear market

Posted by Cam Hui - November 4, 2023

There was some consternation among equity bulls when the S&P 500 violated its 200 dma as it could have been the signal of a major bearish episode.

Technical analysts offered some relief when they pointed out that it’s the slope of the 200 dma that matters. The historical evidence shows violations of the 200 dma when the moving average is just a correction in an uptrend. However, an index that’s trading below a falling 200 dma is a warning flag that a bear market is under way. The arrows in the accompanying chart show the occasions when the S&P 500 fell below a falling 200 dma. Often these signals occurred when the index violated a rising moving average, which later turned down, marked by the red arrows.

The bulls may have felt vindicated when the S&P 500 regained its 200 dma late last week. This episode is a lesson for investors to regard similar circumstances as a buying opportunity. But that’s not the entire story as the market is becoming increasingly bifurcated.

This chart shows the S&P 500, NASDAQ 100, Dow Jones Industrials Average, the mid-cap S&P 400 and the small-cap Russell 2000 with their respective moving averages. The good news is the S&P 500 and the Dow regained their 200 dma. While the S&P 500 moving average has been rising, the same isn’t true for the Dow. The NASDAQ 100 is holding above its 200 dma. The bad news is the S&P 400 and the Russell 2000 are below falling moving averages. The strength of the S&P 500 has been held up by megcap growth stocks. In the absence of the effects of megcap growth, the other major U.S. equity averages are signaling bear markets.

How you position yourself in light of this bifurcation in market internals depends on your time horizon and whether you are a momentum or value investor.

The 200 dma study

Beyond the eye test of the rising and falling 200 dma, I conducted a study of what happens if you bought the market when it violated its 200 dma during rising and falling moving average episodes. The study began in 1990 and ended in November 2023, and it was conducted using the following assumptions:

Returns were capital returns and don’t include re-invested dividends.
The study was based on non-overlapping periods, defined as the first instance when an index was both below its 200 dma and the moving average was rising or falling in the last 21 trading days.

The sample sizes varied, but they were large enough to draw conclusion. Here is how the S&P 500 behaved during 200 dma episodes when the moving average was rising and falling, as measured by the percentage of occasions when the index was positive or negative over different time horizons. These results confirm our eye test that violations of a rising 200 dma can be regarded as just a correction within an uptrend, especially over shorter time horizons. The differential starts to dissipate over six months and completely disappears after 12 months.

Similarly, here are the results the NASDAQ 100.

The results of this trading system when applied to the Dow show a more dramatic drop-off in percentage positive differential beyond six months.

In addition to a focus on percentage of occasions when the index was positive, I also studied the average returns under the conditions when the index was both under its 200 amd and the moving average was rising compared to when it was falling. The accompanying chart shows the return differentials of strategies of buying the index under the two different conditions. Return differentials top out at about six months and more or less disappear after 12 months.

Investment implications

What does this mean for investors? How you react and position yourself depends on your time horizon and whether you focus on price momentum or value.

The results of the 200 dma study indicate that growth stocks are undergoing a correction within an uptrend. At a minimum, an analysis of the NASDAQ McClellan Summation Index (NASI) shows that the NASDAQ 100 is severely oversold and poised for a tactical relief rally.

The picture for mid and small caps, which don’t benefit from the megacap growth bull trend, is a different matter. The mid-cap S&P 400 and small-cap S&P 600 have fallen to a long-term relative support zone. The lower-quality Russell 2000, which contains more unprofitable companies than the S&P 600, has violated a key relative support level and shows no signs of a bottom.

The takeaways from this analysis indicate that high-quality mid and small caps are at support, but may need a period of sideways consolidation before a relative bull can begin. This is consistent with the results of the 200 dma that indicate the market action during the first six months of the violation of a falling 200 dma can be sloppy. I would also like to see some stabilization in the relative performance of the lower-quality Russell 2000 before turning bullish on mid and small caps.

Tactically, the poor performance of these groups will put short-term downward pressure from year-end tax-loss selling, followed by a Santa Claus rally in late 2023 and early 2024. But don’t be fooled by any signs of short-term market strength. These stocks need a period of consolidation before they can meaningfully turn up.

From a valuation perspective, the mid-cap S&P 400 and small-cap S&P 600 are trading at a substantial forward P/E ratio discount to the large-cap S&P 500, which is dominated by the megacap growth stocks. Mid and small caps are trading at valuations similar to the levels last seen during the GFC of 2008–2009 and the U.S. government shutdown impasse and Greek Crisis of 2011. These stocks are value stocks, but recent market action calls for some patience before they can become the next leadership.

In summary, U.S. equity averages recently violated their 200 dma but a historical study found that violations are benign as long as the moving average is rising. However, the rising dma is only evident in the megacap growth-dominated S&P 500. Mid and small caps are becoming value candidates, but recent market action calls for some patience before they can become the next leadership. How you position yourself will depend on your time horizon and whether you are a momentum or value investor.

The anticipation can be worse than the pain

Posted by Cam Hui - November 1, 2023

Mid-week market update: I told you so. As I recently pointed out, psychology had become too stressed to the downside, which opened the door to a relief rally. The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, fell sharply last week and below its 26-week Bollinger Band. Historically, theses signals have resolved in a tactical rally in stock prices.

Sometimes the anticipation can be worse than the event itself. Coming into the weekend, the market was focused on three sources of possible stress: geopolitical tensions from the Israel-Hamas war, excess supply putting upward pressure on Treasury yields, and Fed policy. Here’s how those fears have resolved themselves.

The sum of all fears

When the market opened on Monday, Israel’s Incursion into Gaza had begun, but the conflict hadn’t spread, which could have sent oil prices soaring.

The U.S. Treasury announced it would be borrowing less than expected, followed by today’s announcement that debt issuance would be more skewed to the short end of the yield curve than expected, which alleviated pressure on bond yields.

Finally, the Fed announced that it would keep rates on hold, but left the door open to further rate hikes, which is a monetary policy stance that’s largely in line with market expectations.

Ripe for a rally

Market psychology had become so stretched that stocks were ripe for a rally. Charlie McElligott of Nomura published a note indicating that positioning had turned into a crowded short:

We have exhausted selling, both systematic and fundamental, while downside hedges too are deep in-the-money [and] at risk of being taken-down and monetized, which could set off some reversal flow.

An analysis of volume by price showed that SPY had reached a support level. It was therefore no surprise that the market would rebound.

Moreover, insider purchases were exceeding sales, which is another tactical buy signal.

I told you so.

My inner trader initiated a long position in the S&P 500 last Friday and he expects further gains, though the advance may be bumpy. Jeff Hirsch at Almanac Trader pointed that November seasonality tends to see gains early in the month, followed by a period of consolidation, and a further advance in late November. In light of the recent market action, that road map sounds about right.

The usual disclaimers are application to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long SPXL

Could this be the start of a major bearish episode?

Posted by Cam Hui - October 29, 2023

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 27-Oct-2023)

Subscribers can access the latest signal in real time here.

Oversold markets can become more oversold

This stock market is oversold on a whole host of indicators. Consider, for example, the Zweig Breadth Thrust Indicator. A Zweig Breadth Thrust buy signal occurs when the ZBT Indicator surges from an oversold to overbought condition within 10 trading days. In the last 10 years, there have been four such buy signals (red dotted lines) and numerous oversold conditions (grey lines).

Here’s what we know. In all cases, the market has been higher 12 months later after a buy signal, though they didn’t always rise in a straight line. In all cases, the market has staged a relief rally when the ZBT Indicator has become oversold, but oversold markets can become more oversold.

A case can be that this is one of those occasions the market could become more oversold and experience a deeper drawdown.

The bear case

The most disturbing pattern is the lack of breadth support exhibited by this market. The accompanying chart shows the percentage of S&P 500 above their 200 dma. Whenever this indicator reached 30%, it has almost invariably fallen further. I interpret this as a sign of bearish momentum caused by poor breadth.

Evidence of poor breadth can be graphically illustrated by the following chart of different U.S. equity indices by market cap. The strongest is the Dow at the top. Market weakness becomes more and more evident as we go down by market cap bands, until the small-cap Russell 2000 at the very bottom. Even if the market were to stage a relief rally, one pre-condition for a durable rally would be a broadening of market leadership.

As well, none of the components in my Bottom Spotting Model are flashing a buy signal right now, though the VIX Index did surge above its upper Bollinger Band and the NYSE McClellan Oscillator did become oversold earlier last week. These conditions as the components of this model have come off levels of extreme stress even as stock prices retreated.

I interpret these readings as the market hasn’t fully discounted several key risks.

The geopolitical risk of an enlargement of the Israel-Gaza conflict.
Renewed upward pressure on Treasury yields, which would pressure equity valuation.
The risk of a disorderly unwind in the credit markets owing to the stress caused by monetary tightening.

An equally disturbing pattern can be seen in some sentiment indicators. The Fear & Greed Index improved even as stock prices declined, indicating growing bullishness, which is contrarian bearish. This argues for a final drop and wash-out before the market can form a durable bottom.

The bull case

While readings from the Fear & Greed Index are worrisome, two sentiment indicators with strong track records have flashed buy signals.

The first is the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds. The NAAIM Exposure Index fell below its 26-week lower Bollinger Band last week. Such conditions have marked either short- or intermediate-term bottoms in the entire history of this indicator.

Another reliable sentiment indicator is the action of corporate insiders, though this is not a contrarian signal. The market has bottomed whenever insider purchases (blue line) exceeded insider sales (red line), which just occurred late last week.

While I believe seasonality factors are only of secondary importance in technical analysis, the combination of an oversold market and bullish sentiment signals are more important and constructive signs for the stock market.

Technical analyst Wayne Whaley found that the case for an end-of-year rally remains intact, especially when the August–October period has been negative.

However, any upward march in stock prices in November and December may not occur in a straight line. The S&P 500 cycle composite from NDR is projecting a November advance, followed by a low in late November/early December, and higher highs in late December and January

Q3 earnings season has been a qualified success. Forward 12-month EPS estimates are rising, the EPS beat rate is slightly above average, and the S&P 500 forward P/E ratio is below its 5- and 10-year averages. The only blemish is the subpar sales beat rate

In conclusion, the S&P 500 is at a key technical crossroad as it tests support at 4100. While the market is oversold, it isn’t as oversold as it was during the sell-offs in 2022, which opens the door to further potential weakness. However, sentiment readings are turning and pointing to a near-term bottom. To be sure, oversold markets can become more oversold as the market faces several key risks, I judge the odds of a year-end rally at 70% and further weakness at 30%. If a relief rally fails to materialize and the index fails to regain the trend line, or if market breadth does not broaden out, stock prices could see a panic sell-off into much lower levels.

Subscribers received an email alert Friday that my inner trader had initiated a long position in the S&P 500. While sentiment indicators are signaling a strong buy signal, technical indicators are signaling caution. Should Wednesday’s combination of the Quarterly Refunding Announcement and FOMC decision fail to provide a bullish catalyst. I expect to exit my tactical trading position and the Trend Model will be downgraded from bullish to neutral. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long SPXL

What a soft landing looks like

Posted by Cam Hui - October 28, 2023

Has the Fed managed to achieve a soft landing? If so, Jerome Powell will go down in Federal Reserve history as a legend, and one of the greatest Fed Chairs who occupied that position.

There is some cause for optimism. The latest flash PMIs show that U.S. and China manufacturing PMI on the rebound, though the eurozone is weak, and U.S. services PMI turning up.

Not only that, the U.S. is outperforming the other major economic blocs since the COVID Crisis.

Winning the inflation fight

Moreover, the Fed and other central banks are winning the inflation fight. Inflation, however it’s measured, is decelerating.

Leading indicators of inflation, such as PMI output prices, are pointing to further deceleration in CPI.

As a consequence, the global monetary cycle is turning. Most global central banks have signaled pauses in rate hikes, including the Fed and ECB, and 31% have begun to cut rates.

China turns to stimulus

Across the Pacific, China is turning to stimulus. After Xi Jinping visited the PBOC for the first time since he took power, Beijing announced that it will RMB 1 trillion in bonds in the fourth quarter “to support the rebuilding of disaster-hit areas”, which is an unusual announcement as China rarely adjusts its budget mid-year. It could be argued that this round of fiscal stimulus is designed to spur economic growth, to offset the negative growth in government spending this year.

These developments should be bullish for the global growth outlook. The U.S. looks strong as Q3 real GDP growth came in at a better-than-expected 4.9%. China is stimulating. While Europe is weak, its export outlook is levered to China.

Investment implications

The appearance of U.S. economic strength and weakness in the rest of the world has resolved in U.S. equity leadership. That’s not surprising as investors bought growth in a growth-starved world. The onset of Chinese stimulus is likely to resolve in better performance in non-U.S. equities.

U.S. megacap growth stock leadership may be starting to stumble. The market reaction to earnings reports in this group have skewed negative. While leadership is poised to rotate away from megacaps, investors should wait for confirmation in the form of a break in the relative trend, which is still range-bound (bottom panel).

Keep an eye on commodities and the cyclically sensitive copper/gold and base/metal gold ratios. A new round of China stimulus would be evident in commodity demand and spark a global cyclical rebound.

An analysis of P/B versus ROE by country reveals that the U.S. market is a major outlier that’s very expensive. As growth returns to China and Europe, ROEs should improve in the other regions and boost the returns in the rest of the world.

Key risks

This bullish scenario of a U.S. soft landing and China stimulus faces a number of key risks.

The main risk of a disorderly unwind in the credit market. Already, Treasury yields have soared, and a Bloomberg article pointed out that the local currency yields of emerging market bonds are now below the 10-year Treasury. The surge in Treasury yields may be attributable to a supply-demand imbalance. Issuance has risen and important buyers have stepped away. The Fed is no longer buying and foreign central bank demand has been flat. This leaves domestic buyers to absorb the new supply. The Quarterly Refunding Announcement of Treasury issuance on November 1 will bring further clarity to this question.

As well, both the U.S. household and corporate sectors face the challenge of tightening credit conditions against a backdrop of rising interest rates. Similar readings have resolved in recessions in the past, which would derail the hopes of a soft landing.

That said, there are few signs of distress in the credit market. The relative performance of high yield to Treasuries is exhibiting a positive divergence against the S&P 500.

Another risk is too strong economic growth which causes further monetary policy tightening. Fed Chair Jerome Powell made that point in a speech to the Economic Club of New York [emphasis added]:

Still, the record suggests that a sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions…

We are attentive to recent data showing the resilience of economic growth and demand for labor. Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.

What does the Fed judge to be “persistently above-trend growth”? Investors should gains some clarity on that question in the post-FOMC meeting press conference.

In conclusion, the U.S. economy appears to be undergoing a soft landing. The global economy may be boosted by a new round of Chinese stimulus. Investors can position for this scenario by rotating away from U.S. megacap growth equities to non-U.S. markets. However, the risk of a credit event and overly strong U.S. growth may derail that bullish scenario. The coming week, which will see the U.S. Treasury Quarterly Refunding Announcement, the FOMC meeting rate decision, and the October Jobs Report could go a long way to resolving those risks.

A better tone from the Treasury market

Posted by Cam Hui - October 25, 2023

Mid-week market update: There was a lot of angst last week about how Treasury market, whose yields had been rising steadily, was the main driver of risk appetite. When I saw this cartoon circulating, I thought that it marked the top in yields as a contrarian indicator. Indeed, the bond market rallied when Bill Ackman announced that he had closed his bond short and Bill Gross declared that a recession was in sight and investors should buy bonds.

An equity rally ahead?

While stocks did briefly advance this week, the S&P 500 was sideswiped by disappointments over the earnings results from META and GOOGL, though MSFT beat and was rewarded with a positive reaction. This kind of volatility is to be expected during earnings season. Even though the market is probing its recent lows, it’s exhibiting a series of positive RSI divergences, which is constructive. The likely peak in the 10-year yield will also provide a tailwind for stock prices.

In addition, the stock market is very stretched to the downside, as evidenced by oversold condition shown by the Zweig Breadth Thrust Indicator.

Nevertheless, this market makes me uneasy about being overly bullish.

Not scared enough

Even though the stars appear for a relief rally and possibly a rally into year-end, which is my base case, I am approaching this market with some caution. Although bond market sentiment reached a crowded short level and bond prices were ready to rally, equity market sentiment looks too bullish. As the S&P 500 tests the 4200 level, the put/call ratio hasn’t spiked, indicating complacency.

Helene Meisler conducted an (unscientific) Twitter/X poll on the weekend and found that most respondents are expecting a year-end rally. In other words, equity sentiment hasn’t capitulated yet.

This leaves us with an oversold market ready to bounce, but the risk is any bounce could be very brief. We may need a final flush before the market can rally into year-end.

Stocks want to go to the party, but bonds won’t go in the car

Posted by Cam Hui - October 22, 2023

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 11-Oct-2023)

Subscribers can access the latest signal in real time here.

Valuation pressures

Technical analyst Helene Meisler aptly characterized this market last Thursday as “Stocks want to go to the party. But the bonds won’t get in the car.” I agree.

The equity market appears to be enjoying fundamental and technical tailwinds, but rising Treasury yields are pressuring both stock and bond prices. Indeed, the difference between the S&P 500 forward earnings yield and 10-year Treasury yield hasn’t been this low since 2002.

Will these valuation pressures sink stock prices? What about the bond market?

A bond market tantrum

The U.S. Treasury is throwing a tantrum. How much of one? The 10-year yield of Greece (yes, that Greece), which is just returning to an investment grade credit, is trading lower that the 10-year Treasury.

A number of explanations have been advanced for rising bond yields. None of them are especially satisfying.

The evidence for the excess supply argument for the surge in yields is uneven. While the 30-year auction two weeks ago had dismal results, the 20-year auction the following week was well-received.

What about the narrative of rising yields owing to a stronger economy? The Citigroup Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is positive but decelerating while yields have surged.

The market became excited last week with the release of the TIC report which showed that China was selling its U.S. holdings. Analysts seized upon this as the reason for the upward pressure on Treasury yields.

The “China is selling story” is less bearish that it sounds. While the narrative of a modest Chinese reduction in Treasury bonds and Agencies is true, Council for Foreign Relations senior fellow Brad Setser found that China’s overall USD holdings after accounting for direct and indirect custodial accounts were broadly stable. Maturing Treasuries were rolled into T-Bills and bank accounts, which is far less ominous from a geopolitical viewpoint.

Fed Chair Jerome Powell’s speech last Thursday took a slight dovish tone and should be supportive of lower yields. Powell opened his speech to the Economic Club of New York on a constructive tone.

Incoming data over recent months show ongoing progress toward both of our dual mandate goals—maximum employment and stable prices.

After characterizing the jobs market as “tight” for many months and focusing on core services ex-housing inflation, which is the Fed’s code about wages pressuring the price of services, Powell seemed to switch his tone on wages.

Indicators of wage growth show a gradual decline toward levels that would be consistent with 2 percent inflation over time.

He also gave a nod to higher bond yields and their effects on monetary policy. Translation: The market is tightening monetary conditions for the Fed. This is as clear a signal a central banker can give that there will be no more rate hikes, at least in the near term.

Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening. We remain attentive to these developments because persistent changes in financial conditions can have implications for the path of monetary policy.

From a technical perspective, Treasury prices look washed-out and appear to be ready to bottom. The 20+ Year Treasury ETF (TLT) fell to multi-year lows on enormous volume last week while exhibiting positive divergences on the 14-day RSI and money flow indicator.

Stocks ready to party

Over in the stock market, equities are ready to party. Even though valuation appears to be under some pressure, the reaction from Q3 earnings season is encouraging and estimate revisions are exhibiting positive fundamental momentum.

Jurrien Timmer at Fidelity pointed out that the global earnings cycle is turning up, which is another sign of positive fundamental momentum.

From a technical perspective, the VIX Index has spiked above its upper Bollinger Band, which is a signal of an oversold market as the S&P 500 tests support at its 200 dma.

The analysis of the weekly S&P 500 chart is equally revealing. The index is testing a long-term uptrend that stretches back to the 2020 bottom as its 5-week RSI has become oversold.

Goldman Sachs’ prime brokerage arm reported that hedge fund positioning is extremely defensive, which is contrarian bullish. While stocks may decline a little further from here, they don’t crash when technical and sentiment conditions are this extreme.

In conclusion, surging yields have not only cratered bond prices, but also created severe valuation headwinds for stock prices. A fundamental and technical review of the U.S. Treasury market shows that bond prices are poised for a rally. The fundamental and technical picture for U.S. equities is even brighter as fundamental momentum and oversold conditions point to a strong rebound.

Why you should fade the war hysteria

Posted by Cam Hui - October 21, 2023

Oil prices have jumped over $6 a barrel since the Hamas attack on Israel as a geopolitical risk premium became embedded in the oil price. The surprise attack brought up memories of the Yom Kippur War 50 years ago, in which the armies of Egypt and Syria launched a simultaneous surprise attack on Yom Kippur in 1973 that left Israel fighting for its existence. In the wake of that war, the Arab-producing states launched an oil embargo on the West which devastated growth. It’s no wonder oil prices popped this time.

I think investors should fade market’s war fears. Here’s why.

SitRep: Not a repeat of 1973

Let’s begin with a sober evaluation of the military situation report, or SitRep. While the Hamas attack was a surprise and well-organized, it’s not a repeat of the Yom Kippur War of 1973. Then, two large conventional armies with (then) new weaponry in the form of Soviet-supplied Sagger anti-tank missiles under Surface-to-Air Missile (SAM) umbrellas, which largely negated the effects of Israeli air superiority, launched a devastating attack on Israeli forces. Then, Israel faced an existential crisis as its forces could have been driven into the sea.

Today, the Hamas-led attack overwhelmed surprised defenders and overran settlements bordering Gaza. Terrorism is the wrong word to describe the attack, a better word is barbarism, in the medieval manner of how Mongol hordes of Genghis Kahn sacked the cities they conquered and put the population to the sword. The events of 2023 can better be described as a 9/11 moment, which is an experience burned into the psyche of Israelis.

For some perspective on force structure, this UTV article describes Israel with “169,500 active military personnel in the army, navy and paramilitary”. Recent reports indicate that the government has mobilized 300,000 reservists. While the exact Hamas force strength is unclear, the article quotes a 2021 write-up in the Times of Israel that “quoted an unnamed senior Israeli commander as saying Hamas had an army of 30,000 men”. Israel has stated that it plans to invade Gaza to eliminate every vestige of Hamas. While not all Israeli forces will be deployed there, Israeli forces outnumber Hamas by roughly 15-to-1, plus it has the advantage of superior technology. That’s why this is not 1973.

This War on the Rocks podcast described the urban warfare challenges of the Israeli military response in entering Gaza. The battle for Mosul by U.S. and Coalition forces is a comparable example. That attack took months to plan and the operation took months to execute. Any Israeli incursion into Gaza is unlikely to be quick or antiseptic. Axios reported that former Israeli prime minister and now new member of the new Israeli unity government Benny Ganz “told Biden the effort to dismantle Hamas could take years”.

The Biden Administration has pressed the Israeli government to formulate a plan for its Gaza incursion. The objective shouldn’t just to be eradicate Hamas or the ability of Hamas to launch attacks into Israel, but what happens afterward. Hamas is the governing authority in Gaza, what happens afterward if its leadership has been eliminated? While Israel has stated that it doesn’t intend to re-occupy Gaza, the Israeli government hasn’t formulated an exit strategy for its forces.

All very good questions. The current response as reported by Axios is “they aren’t there yet and for now are focused on the counteroffensive to the Oct. 7 attack by Hamas that ignited the war”. The eyes of the world are on Israel and its future relationships with her neighbours hinge on the answers.

For investors in U.S. equities, history shows that negative reactions from conflicts should be faded.

The market reaction

It is an unfortunate fact of life that markets are insensitive to human suffering. Instead, Mr. Market focuses on factors like growth and interest rates. While the tail-risk of another Arab Oil Embargo and subsequent recession is always present, the market has largely shrugged off geopolitical risk.

Take oil prices as an example. While the spot price has increased, the more relevant long-term price is the strip price used by oil producers to hedge production. For the uninitiated, the strip price for oil is based on a series of oil price contracts into the future. As an example, a 12-month strip is 1/12th of the front month future price, plus 1/12th of the next month futures price, and so on until all 12 months are summed.

Strip contrasts trade OTC, but investors can see an indicative price based on the futures contract, which can be illiquid past the front month. The chart of the 36-month strip oil price shows that it hasn’t even breached its recent high.

Similarly, these accompanying charts of the relative performance of energy equities and oil and gas industries show that none have rallied to new relative highs. I interpret this to mean that the market’s judgment of geopolitical risk is relatively low.

That’s because there are several firewalls to the supply disruptions of oil. First, the U.S. has turned a blind eye to the sale of Iranian crude to China. While that technically represents a sanctions violation, Iranian supply of oil to China represents a relief valve that Chinese demand doesn’t overwhelm global demand.

As well, the U.S. has concluded an agreement with Venezuela for a partial lifting of sanctions for a commitment for the Maduro government to adhere to fair and free elections next year. Venezuelan crude represents another source of global supply.

Remember that Saudi Arabia and Russia agreed to cut supply in order to boost the oil price? Should the unthinkable happen and the Straits of Hormuz is closed, Saudi Arabia has spare production capacity should hostilities break out.

Relax, fade the war fears.

Regional markets

The performance of regional markets is a different matter. Moody’s reported that Israel’s labour force is 4.5 million people. The government has mobilized 300,000 reserves and this an able-bodied demographic that is largely employed and in the labour force. The mobilization takes over 6% of the working population out of the workforce, which will be a drag on growth and strain government finances.

Using the battle for Mosul as a template, the battle for Gaza is likely to take months, and an exit strategy hasn’t been fully articulated by the government. It’s unclear how long the drag on growth will last.

It is therefore no surprise that MSCI Israel (in USD) has dropped dramatically. As many Israeli companies are listed on NASDAQ, a comparison with junior NASDAQ stocks (QQQJ) is appropriate, as well as MSCI All-Country World Index (ACWI). No matter how it’s measured, MSCI Israel has violated key relative support levels. Avoid, at least some clarity on a plan for reserve force demobilization. Axios reported that Israeli authorities expect the Gazan incursion to be a long-lasting affair:

There was one consistent message President Biden heard from nearly all the Israeli officials he met in Tel Aviv: The war in Gaza will take time — and will test Israel’s support from its allies, Israeli and U.S. officials say.

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 22-Sep-2023)

Subscribers can access the latest signal in real time here.

Poised for a rebound

There are numerous signs that the U.S. stock market is oversold, washed out and poised for a FOMO (Fear of Missing Out) rebound. The latest indicator is the CNN Fear & Greed Index, which is beginning to recover from levels seen at the market lows of October 2022 and March 2023.

The stock market has experienced a technical wipeout. Jay Kaeppel at SentimenTrader found that whenever the percentage of S&P 500 stocks fell below 15% (it reached as low as 8.6% last Tuesday), forward returns have been strong, with the exception of the 2008 experience.

Seasonal indicators are also pointing to a market rally. Combined with the deeply oversold nature of the market, the odds favour an imminent “rip your face off” rally to alleviate the oversold condition.

A leadership review

Should the market experience a relief rally, what vehicles could an investor use to position to maximize potential return under such a scenario?

Let’s consider how different groups have performed. The megacap growth stocks, as measured by the NYSE FANG+ Index, remain range-bound relative to the S&P 500. They have, however, recovered from the bottom of the range to the middle, which may be indicative that these growth stocks were regarded as safe-havens during periods of stress.

Defensives sectors have also performed poorly on a relative basis, largely because utilities and REITs are interest-sensitive sectors that didn’t respond well to the surge in bond yields.

The relative returns of cyclically sensitive value sectors were mixed. Most were either flat with the index, though energy turned up but weakened when oil prices retreated.

The hidden surprise

The surprising flat relative returns of cyclically sensitive sectors highlighted a hidden investment theme. If these sectors, which should lag during bearish episodes, are flat with the market, does that mean they will perform well during a risk-on period?

In particular, consider how gold has behaved since 2021. Gold has shown an inverse historical relationship to the USD. When the USD started to rally in early 2021, gold should have fallen. Instead, the price of bullion was mainly flat over this period.

In the short-term, the surprise attack by Hamas on Israel is likely to raise geopolitical tensions and be positive for gold. Look out further, what happens if real bond yields, which have been the principal driver of higher nominal yields, turn down?

Gold mining stocks offer a similar favourable risk-reward ratio. The gold mining to gold ratio is trading at a relative support zone, indicating excessive bearish sentiment. Similarly, the percentage of stocks bullish on point and figure charts is nearing 10%, which is another washed-out area. As well, gold miners to S&P 500 are testing a key relative support level.

From a long-term perspective, the gold to S&P 500 ratio appears to be making a bottom that should favour gold and inflation hedge vehicles over U.S. equities.

An analysis that zooms out from gold to the materials sector also shows a constructive picture. While the relative performance of materials stocks has been flat, relative breadth indicators (bottom two panels) are exhibiting underlying strength. This sector should outperform in a risk-on rebound.

No review of gold and materials without a word on the energy sector. Energy stocks retreated when oil prices weakened, but the recent events in Israel is likely to derail the Saudi-Israeli dialogue and increase the geopolitical premium on oil prices. Longer term, the transition to renewable energy creates significant disincentives for oil producers to invest in new production, which will put a floor on oil prices over the next few years. Oil has become the new tobacco.

The technical outlook for energy is mixed. The recent downdraft incurred technical damage and any rebound in oil prices could be short-lived, depending on how events in the Middle East unfold. While I am long-term bullish on the sector, I am inclined to wait on the sidelines as event risk is too high.

Unanswered questions

You can tell a lot about market psychology by the way the market reacts to news. The S&P 500 took a reflex risk-off tone on the blowout jobs report, but turned around and rallied to a gain of 1.8% on the day. Earlier in the week, the market had been exhibiting a series of positive divergence on its 5-day RSI, which was a setup for the relief rally.

However, the eruption of war in the Middle East raises a number of unanswered questions for the trajectory of risk appetite:

The early knee-jerk reaction on extremely thin CFD market has been a minor risk-off event. Will the risk-off tone continue?
As wear breaks out, what will be the main beneficiary of safe haven flows, gold or USD assets?
If flows move into the USD, will that alleviate the upward pressure on Treasury yields?

My Bottom Spotting Model flashed a buy signal about two weeks ago, and the signal was sparked by the extreme oversold nature of the stock market. The market’s risk-on reaction to the NFP beat Friday was a signal that the rebound had begun,

While my Bottom Spotting Model is based mainly on oversold indicators, the usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) is based on the use of price momentum off an oversold condition. The 14-day RSI of ITBM is oversold and starting to turn up, which is a buy signal setup and a buy signal occurs when RSI recycles from oversold to neutral. Another open question is whether the stock market shrugs off the events in the Middle East and advance and spark an ITBM buy signal.

In conclusion, the stock market is oversold, washed out and poised for a FOMO relief rally. My review of sector relative performance leads me to believe that the leadership in a rebound will be led by the cyclically sensitive materials stocks. In particular, gold and gold stocks have defied their inverse correlation to USD strength and could be strong beneficiaries under a relief rally scenario.

My inner trader continues to be bullishly positioned in the S&P 500. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long SPXL

A history of ZBT signals

What’s different this time

Key risk

This rally has legs

Supportive sentiment

Falling macro uncertainty

A Zweig Breadth Thrust buy signal

The 200 dma study

Investment implications

The sum of all fears

Ripe for a rally

Oversold markets can become more oversold

The bear case

The bull case

Winning the inflation fight

China turns to stimulus

Investment implications

Key risks

An equity rally ahead?

Not scared enough

Valuation pressures

A bond market tantrum

Stocks ready to party

SitRep: Not a repeat of 1973

The market reaction

Regional markets

Bond market tantrum

More room to recover

Rebound from a panic bottom

Supportive market structure

Supportive risk appetite indicators

Supportive sentiment

Key risks

The week ahead

A matter of psychology

Higher for longer?

A durable rebound

Still intermediate bullish

Poised for a rebound

A leadership review

The hidden surprise

Unanswered questions

Good news on inflation and employment

A rising term premium

The bull and bear cases

Credit event ahead?

How oversold?

How much downside risk from here?

Sufficiently oversold?

A correction in an uptrend

A question of breadth

Trend Asset Allocation Model still bullish

Addressing the bear case

Compounding oversold

The bear case

VIX as fear gauge

Can support hold?

The bear case