What to watch for in a pivotal earnings season

Posted by Cam Hui -
The Q2 earnings reporting season could be a pivotal one. Earnings reports and subsequent corporate guidance are likely to give investors greater clarity on whether the economy is softening into a slowdown or undergoing a soft landing and recovery. The preliminary picture is a fragile recovery. Forward guidance for Q2 has improved from Q1. Negative pre-announcements have fallen and positive ones have risen.

 

The key question is whether this represents a data blip or the real signs of recovery. This matters because stock prices are facing substantial valuation risk. The S&P 500 is trading at a forward P/E of 19.3, which is higher than its 5-year average of 18.6 and 10-year average of 17.4, along with an elevated 10-year Treasury yield when compared to its 10- and 20-year history. The asset allocation case for equities has changed from TINA (There Is No Alternative) when rates were near zero to TARA (There Are Reasonable Alternatives) today. Any earnings disappointment could see stocks face substantial downside risk.
 

 

 

Here’s what I am watching.
 

 

The margins question

In a recession, margins come under pressure. How will margin estimates evolve during Q2 earnings season? FactSet reported that analysts expect year-over-year EPS growth to fall -7.1% during Q2 and revenue to fall only -0.4%, indicating margin compression. Q2 is already history. The key question is margin estimates for Q3 and Q4. In particular, the profitability in small-cap stocks appears ominous. About one-third of the Russell 2000 is unprofitable and the trend is rising.

 

 

However, there are some hopeful signs from the NFIB small business survey. The survey is useful because small businesses have little bargaining power and they are sensitive barometers of the economy. The bad news is small business sales expectations are under pressure.
 

 

The good news is that earnings expectations are recovering, albeit in a choppy way. These are early clues of margin expansion.

 

 

 

A bifurcated market

The U.S. equity market has become highly bifurcated. The advance has been led by a handful of megacap growth stocks. Even as the S&P 500 staged an upside breakout to new recovery highs, the equal-weighted index, which is indicative of the average stock, has gone sideways and only testing a resistance zone. Keep an eye on the earnings results for megacap techs, as they could set the tone for the market. Big Tech companies began to announce layoffs in late 2022. Will there be more downsizing announcements, or will the reduction in staff sufficient to move the needle to boost operating margins?

 

 

 

What about the American consumer and the rest of the market? The early indications are mixed. PepisCo results are a case in point. Organic revenue was up 14% YTD, while volumes were flat to down. The company has pursued a price over volume strategy, which is indicative of strong branding and unwelcome signs of “greedflation”.

 

 

High frequency indicators of retail sales are weakening. The weekly reported Redbook Index, which measures same-store sales of large general merchandise retailers, saw its YoY growth go negative last week. While this is just one data point, it is nevertheless an indication of softness in consumer spending.

 

 

 
On the other hand, travel stocks have been rising strongly, which is an indication of strong consumer spending. Delta Airlines, which may be a bellwether for the group, reported last week. It beat both sales and earnings expectations and guided higher.
 
 

 
 

Lastly, don’t forget China as key indicator of the global economy. China reported a stronger-than-expected trade surplus, but internals were weak. Chinese exports tanked, indicating global weakness, and imports softened, though they fell less than exports.

 

Much like many other countries, S&P Global reported that Chinese manufacturing PMI was weaker than services PMI. The Chinese consumer could be an important source of global demand. Keep an eye on the earnings reports from the operators of Macau casinos and European luxury goods makers.
 

 

 

 

What about the recession?

What about the recession, which is becoming the most anticipated recession in history. While opinion appears to be evenly divided between the recession and soft landing camps, an economic downturn has the potential to sideswipe expectations of earnings and margin growth. 

 

So far, the manufacturing side of the U.S. economy has been weak and arguably recession, but the consumer has been resilient. What has held up the economy is the strength in employment.
The jobs market may be about to crack. New Deal democrat has been tracking the evolution of initial jobless claims. He found that year-over-year increases of the 4-week average of initial jobless claims of over 12.5% tended to be recession signals. We’ve seen five consecutive readings of growth over that benchmark. While NDD isn’t ready to make a recession call just yet (see Initial Claims Move Closer to Red Flag Recessionary Warning), these readings don’t look like data blips and are starting to look ominous.

 

 

The soft June CPI report sparked a rally in stock and bond markets. Both headline and core CPI came in below Street expectations, but much depends on the Fed’s reaction function. A quarter-point increase in the Fed Funds rate is baked in at the July FOMC meeting, but much depends on what the Fed is watching and placing the greater weight on its decision-making process. Supercore CPI, which is a metric often cited by Chairman Powell, showed signs of collapse.

 

 

On the other hand, average hourly earnings is running at an annualized 4.7% rate and it’s showing few signs of deceleration.

 

 

The inflation fight narrative is changing to the last-mile problem. It may be easy to get inflation down to 4%, but it will be far more difficult to push it down from 4% to the Fed’s 2% target. This raises the risk of a Fed policy overtightening mistake and craters the economy into recession.

 

In conclusion, the upcoming Q2 earnings reporting season could be pivotal for investors. The direction of the economy and the earnings outlook could go either way. There are many questions but no answers. I have offered some signposts to watch for clues to future market direction.

 

Tech leadership stumbles, what will pick up the pace?

Posted by Cam Hui -
 Mid-week market update: It finally happened. The NASDAQ 100 is being re-weighted in order to address “concentration risk” (full details here). It was a belated decision in response to narrow market leadership, but the problem seems to have moderated on its own. Large-cap technology stocks, which had been on a tear, stalled against the S&P 500. Moreover, sector relative breadth (bottom two panels) are deteriorating.
 

 

It may be time to look for new leadership.
 

 

Broadening breadth

Breadth indicators are starting to broaden out. The ratio of equal-weighted to float-weighted S&P 500 and NASDAQ 100 bottomed out in the last month.
 

 

Here are some ideas for sources of outperformance with the caveat that they mostly depend on a soft landing, which is still in doubt . I pointed out on the weekend that travel related stocks have been surging. The hotels, airlines, and cruise ETF (CRUZ) staged absolute and relative breakouts. Keep an eye on the Delta Airlines earnings report tomorrow (Thursday) as a possible bellwether for the group.
 

 

 

Another sector that is poised to become market leaders are energy stocks. The sector is exhibiting a saucer-shaped bottoming pattern both on an absolute and relative basis. Relative breadth (bottom two panels) is improving, which is bullish.
 

 

A similar relative improvement in energy stocks can also be seen in Europe, which is a helpful confirmation of sector strength. Drilling down, the relative bottoming pattern is more pronounced in oil exploration stocks. The high beta oil service companies is even showing more relative strength. I interpret these patterns as indicators that energy strength is broad based and poised for outperformance.
 
 

 

Another group that may see positive relative performances are small=caps. Small=cap stocks are exhibiting a similar saucer-shaped bottoming pattern, both on an absolute and relative basis, though they have not staged upside breakouts yet.
 

 

The NFIB June Small Business Survey provides some hopeful signs for small-caps. Small business optimism has ticked up, which is constructive.
 

 

 
Small business earnings appeared to have bottomed. If they are representative of small-cap trends, this should be a positive fundamental tailwind.

 

 

Market stall or “good overbought”?

As for the S&P 500, the index surged to a new recovery high in response to a softer than expected CPI report. The 5-day RSI is overbought. The bullish interpretation is this could be the start of a series of “good overbought” advances. The bearish interpretation is we are seeing ominous negative RSI divergences.
 

 

Even though my personal opinion leans bearis, I am unwilling to put on a short position as long as price momentum is positive. Technical interpretations aside, how this really plays out will depend on earnings season, which is just starting. Stay tuned.

 

The mystery in the NFP report

Posted by Cam Hui -
 I’ve been thinking about the nonfarm payroll report that was reported on Friday. Employment has been gradually slipping from a 5 and 8 handle to about 200K today. The June headline payroll report came in at 209K, which was under consensus expectations. The big surprise was the decline in the unemployment rate.
 

 

 

Explaining the unemployment rate decline

The payroll report was weak. Private sector jobs only grew by 149K and a substantial amount of growth was accounted for by government jobs. In this case, why did the unemployment rate rise?
 

One clue to the mystery is the divergence in labour force participation rates (LFPR). Prime age LFPR has been rising steadily while 55+ LFPR has been weak.

 

 

In other words, the Baby Boomers have been retiring in great numbers, and that’s pushing up the unemployment rate. Speaking from experience, it’s difficult form someone over 50 to find a job. Many of my peers have found self-employment as a solution instead.

 

 

This matters because I have been tracking the steady rise in initial jobless claims, which has historically led the unemployment rate and the Sahm Rule, which is a recession indicator. The 4-week average of initial jobless claims have been in the red zone for four consecutive weeks. While that’s not a definitive recession signal, it is nevertheless an ominous warning should conditions persist. The decrease in the June unemployment rate is at odds with the general weak tone of the report.

 

 

In light of the substantial weight of the Boomers in the population, perhaps a useful metric is to analyze the difference between the unemployment rate (blue line) and the U-6 unemployment rate (red line, right scale), which includes discouraged workers. The differential (black line) has historically bottomed and turned up ahead of recessions, which may be happening now and was in evidence in the June Jobs Report.

 

 

That’s a warning to keep in mind.
 

Bond rout = Stock rout?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Neutral (Last changed from “bearish” on 15-Jun-2023)

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

Subscribers can access the latest signal in real time here.

 

 

Trading the island reversal

The S&P 500 hit an air pocket last week as it was rattled by the rout in bond prices. As the index weakened, SPY formed a textbook island reversal with a measured objective of about 435, which represents a fairly shallow pullback. However, the VIX spiked above its upper Bollinger Band, which is an oversold condition that could be indicative of a short-term bottom.

 

 

Notwithstanding the market’s short-term volatility, what’s the intermediate-term prognosis? Can the bulls hold support at that initial support level?

 

 

An ominous rate spike

The recent spike in interest rates looks ominous. The 2-year Treasury yield is a proxy for the market’s expectations of the direction of the Fed Funds rate. In the past, peaks in the 2-year rate have been coincident or led peaks in the Fed Funds rate. Last week’s rate spike may be a signal that the bond market expects more Fed tightening than generally expected.

 

 

 

 

An unexpected rotation

Turning to the stock market, the AI frenzy appears to be petering out. Google searches for “AI” and “ChatGPT” peaked in late April and they’ve begun to tail off ever since.
 

 

From a technical perspective, the relative performance of the NASDAQ 100 normalized against a rolling past 52-week window, reached an overbought extreme and retreated (bottom panel). There were eight similar episodes since 1997. The NASDAQ 100 continued to advance in half of the cases (shown in grey) and corrected in the other half (pink). Looking ahead a year, the index rose in most cases. I conclude that the current stall should be characterized as a pause that refreshes.

 

 

As large-cap technology stalled, new leadership has appeared from an unusual quarter –transportation stocks. The Dow Jones Transports have been on a tear compared to the Dow Jones Industrials Average. Even as the Transports test resistance while tracing out a possible inverse head and shoulders pattern, the Industrials are weaker by contrast.

 

 

A similar pattern can be seen in the travel-related stocks comprising airlines, hotels and cruise lines. This group has staged a decisive upside breakout on an absolute basis (top panel) and on and a relative basis (bottom panel). The strength in these stocks should be comforting to the soft landing narrative as it represents a signal of consumer resilience.

 

 

 

Weak cyclicals = Caution

Before the bulls become overly excited, the analysis of value and cyclical sectors tells a different story. The relative performance of these sectors is weak, except for industrial stocks, whose strength is mainly attributable to the transportation stocks.

 

 

In particular, the financial stocks, which will kick off Q2 earnings season, are still weak and their relative performance has been closely correlated with the shape of the yield curve as the recent downdraft in bond prices hasn’t materially affected that dynamic. Regional banks have fallen back to test a long-term relative support level (bottom panel), which is concerning.

 

 

As well, the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator just flashed a sell signal when its 14-day RSI recycled from overbought to neutral. To be sure, it’s difficult to interpret that signal as the VIX Index is already above its upper Bollinger Band, which is an oversold reading for the stock market.
 

 

 

The AAII bull-bear sentiment spread is elevated by historical standards, which is contrarian bearish.

 

 

In conclusion, these conditions argue for a corrective period or consolidation before equity bulls can regain their mojo. Traders should look for either a panic and sentiment washout or more evidence of oversold conditions before tactically turning bullish.

 

Why our Ultimate Market Timing Model is cautious

Posted by Cam Hui -
 I recently had a discussion with a reader about my Ultimate Market Timing Model (UMTM). The UMTM is an extremely low turnover model that flashes signals once every few years and is designed to limit the extremes of the downside tail-risk of owning equities. When extreme downside risk is minimized, investors can afford to take greater equity risk. Instead of, say, a conventional 60% stocks/40% bonds asset mix, an investor could be more aggressive and move to a 70/30 or even 80/20 asset mix and revert to a more defensive posture such as a 40/60 or 30/70 asset mix under risk-off conditions.
In that context, the reader asked why the UMTM flashed a buy signal in February and flipped back to sell in March, even as the S&P 500 rallied to a new recovery high.

 

 

As it turns out, the UMTM was whipsawed by a trend-following model, which is an unfortunate feature of trend-following strategies. To explain further, let’s unpack the details of the model, which is based on a blend of trend-following strategies and a macro overlay.
 

 

 

The pros and cons of trend following

Let’s begin with the trend-following component. The study shown in the accompanying chart shows what happens when an investor applies a 200-dma filter to the S&P 500 as a proof of concept of trend-following strategies. A number of simplifying assumptions were made to the study:

  • Buy the S&P 500 when the index is above its 200 dma.
  • Hold cash when it’s below the 200 dma.
  • Trades are executed the day after a signal is triggered at the closing price.
  • There are no transaction costs.
  • There are no dividends.
  • Holding cash earnings 0%.

 

 

 

The study was conducted based on daily price data from January 1, 1995 to June 30, 2023, and the cumulative wealth lines were normalized at 100 on the start date in January 1995. I can make the following observations, which is applicable to virtually all trend-following strategies.

  • Trend following underperformed the buy-and-hold benchmark, but…
  • Trend following was able to sidestep the worst of the secular bear market drawdowns.

 

As a proof of concept, my Trend Asset Allocation Model, which is separate from the UMTM, has been extremely successful. The model applies trend-following techniques to a variety of global equity indices and commodity prices to reach a composite signal. I have been running this model since 2014. When I apply the out-of-sample signals to a simple asset allocation of varying equity and bond weights by 20% around a 60/40 asset mix, the results are impressive. The Trend Asset Allocation Model achieved almost equity-like returns with balanced fund-like risk. Moreover, the model beat its 60/40 benchmark in seven out of nine years. Even when it lagged its benchmark, the underperformance was relatively minor.
 

 

 

 

The macro overlay

From an operational viewpoint, trend-following strategies have a disadvantage of experiencing whipsaws, when the model issues frequent buy and hold signals when the index encounters volatility around the moving average.

 

How can investors achieve the downside protection of trend-following models while avoiding the disadvantage of whipsaws? Enter the macro overlay.
 

 

A study of market history shows that recessions are bull market killers. If an investor could forecast recessions, he could sidestep recessionary equity bear markets. In addition, recessionary bear markets tend to bottom after the recession has begun.
 

 

 

 

In light of those two observations, we can construct an Ultimate Market Timing Model using the following rules:

  • If recession risk is low, stay long equities.
  • If recession risk is high, buy equities only when the Trend Asset Allocation Model is flashing a buy signal for equities.

Even with these rules, the UMTM isn’t perfect. This model would have been bullish into the Crash of 1987, and it experienced a signal whipsaw during the February and March of this year.
 

 

Where are we now?

What are the models saying now? Recession risk is high, and the Trend Asset Allocation Model is on a neutral signal, which translates into a risk-off or sell signal for the Ultimate Market Timing Model.
Recession signals are mixed. The latest FOMC minutes shows that the Fed’s staff economists expect “a mild recession starting later this year”, though they “saw the possibility of the economy continuing to grow slowly and avoiding a downturn as almost as likely as the mild-recession baseline.”

 

The manufacturing part of the U.S. economy is extremely weak. Jeroen Blokland pointed out that a tanking ISM Manufacturing survey has historically been a recession signal.
 

 

On the other hand, the service part of the economy has been resilient. ISM Services and different components of the survey are above 50, which indicates expansion.
 

 

 

 

While Street expectations of a H2 2023 recessions are widespread, they have receded a bit. The key to the recession question is employment – and the labour market is showing mixed signals.
 

 

On one hand, the 4-week average of initial jobless claims has risen over 12.5% year-over-year for four consecutive weeks. If it persists, this would be a recessionary signal that the labour market is rolling over, which would weaken the demand for services and be the last Nail in the recession coffin.
 

 

 

 

In addition, the recent Supreme Court defeat of Biden’s student loan forgiveness initiative represents a fiscal contraction hitting household balance sheets, especially for the young. This will reduce consumer demand for goods and services.

 

 

 

On the other hand, the May JOLTS survey told a good-news bad-news story about the jobs market. The good news is job openings are falling (blue line), which is an indication that labour market tightness is softening, which reduces inflation pressure. But the quits/layoffs ratio (red line) rose for a second consecutive month. While this data series is noisy, it is a signal that employment is strong.

 

 

Looking ahead to the July FOMC meeting, a quarter-point rate hike is locked in in the absence of an extremely weak June jobs report, which it wasn’t. Headline payroll grew slower than expected at 209K, compared to market expectations of 225K, and the unemployment rate fell from 3.7% to 3.6%. However, average hourly earnings rose stronger than expected and the U6 unemployment rate, which includes under-employed and discouraged workers, rose from 6.7% to 6.9%.

 

 

Where does that leave us?

 

I can see two scenarios, neither of which is equity bullish. The first is a mild recession, which is consistent with the Fed’s staff forecast. In that case, equity investors will have to adjust to and discount a sudden series of downward EPS revisions. As we approach earnings reporting season, forward EPS revisions are still rising, but barely. This would be a jolt to the recent trend of rising forward EPS estimates, which is potentially a challenge in elevated valuations by historical standards. The mild recession scenario is likely to be equity negative while bond positive.
 

 

 

 

The other more ominous scenario is the false soft landing which turns into stagflationary growth. The economy avoids a recession, but inflation remains elevated, which forces the Fed to tighten further than market expectations. The recent trend in de-globalization is likely to depress productivity, barring an AI-driven productivity surge. This will be both equity and bond negative.
 

 

In plain English, these scenarios explain why the Ultimate Market Timing Model remains cautious on equities.

 

A geopolitical stress test?

Posted by Cam Hui -
Mid-week market update: Geopolitical risks are rising and it remains to be seen how the market reacts to geopolitical stress. On the weekend, I made the following tweet.

 

 

Those fears are becoming more real. Ukrainian President Zelensky stated in a tweet, “Now we have information from our intelligence that the Russian military has placed objects resembling explosives on the roof of several power units of the Zaporizhzhia nuclear power plant.”
 

 

Even if there are explosives and they are triggered, the effect is unlikely to be equivalent to a tactical nuclear weapon. In all likelihood, the worst case scenario would be a Fukushima nuclear accident and not a Chernobyl style disaster. So far, global markets are soft but cannot be described as showing a strong reaction to this risk. 

 

 
Here is how the S&P 500 behaved in the wake of the earthquake and subsequent tsunami that devastated the Fukushima nuclear plant on March 11, 2011. The market tanked but recovered quickly, though 2011 also marked a budget ceiling drama in Washington and a Greek Crisis in Europe later in the year.
 
 

 

You can tell a lot about market psychology by the way it reacts to news – and we’ve seen more than a fair share of bad news today. China’s imposition of export controls on critical elements gallium and germanium hit the semiconductor stocks, but the NASDAQ 100 remains resilient. The release of the FOMC minutes revealed no big surprises. The Committee is divided and a quarter-point rate hike at the next meeting seems all but certain, barring an extremely soft NFP report Friday. Fed Funds expectations are largely unchanged following the release of the minutes.
 

 

These conditions argue for stock advance to continue. On the other hand, the S&P 500 is flashing a series of negative divergences.
 

 

As well, the put/call ratio continues to fall, which is an indication of complacency.
 

 

In conclusion, the stock market  faces a series of events in the short run, namely developments in the Russo-Ukraine War and the Jobs Report on Friday. Wait for how those sources of volatility resolve themselves before making a judgment on market direction.
 

A Q2 global market review

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Neutral (Last changed from “bearish” on 15-Jun-2023)

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

Subscribers can access the latest signal in real time here.

 

 

A global market review

Now that the first half of 2023 is in the rear view mirror, let’s review how global equity markets performed. Here are the quick takeaways from a preliminary analysis of relative returns.

  • U.S. equities were the leaders in Q2.
  • Japan is becoming the new stealth leader, while Europe is pulling back.
  • China and other emerging markets were weak on a relative basis.

 

 

Hwever, there were more subtle indications if we drill into the details by region.
 

 

Faltering U.S. leadership?

Starting with the U.S., there may be early indications that U.S. leadership may be
starting to stall. Large-cap growth stocks, as represented by the NASDAQ 100, had been on a tear for all of 2023 and their relative returns had become disconnected from the 10-year Treasury yield. More recently, the relative performance of growth stocks has flattened out against the S&P 500, which could be a sign of a loss in momentum.
 

 

 

As growth stocks have begun to stumble, value stocks haven’t taken up the mantle of leadership, which is a worrisome sign that breadth isn’t broadening out. While industrials have begun to turn up, other sectors continue to lag. More importantly, the heavyweight financial sector isn’t showing signs of relative strength. Without growth or value leadership, there’s isn’t much that leads U.S. stocks upward.
 

 

 

The view from Asia

Moving across the Pacific, this macro comment from The Transcript, which monitors earnings calls, caught my eye:

 

China is experiencing a consumer recovery but foreign investors are reducing their exposure to the country. Mainland Chinese tourists are starting to travel abroad, with great impact on neighboring countries. The demand for semiconductors weakened from late 2022 enabling automakers to get the chips they need to ramp up production.

 

This bottom-up view is contrary to the consensus narrative of Chinese economic weakness. If the Chinese consumer revival plays out, it could be the spark for a rebound in Chinese sensitive equities around the world. For now, the relative performance of Asian equities are all flat to down except for Japan, which broke out of a long base and pulled back.

 

 

 

A bullish set-up in Europe

As we shift our focus to Europe, the Euro STOXX 50 staged an upside relative breakout in early 2023. While it has pulled back, the index has constructively stayed above its breakout level. If the China cyclical rebound narrative holds, European equities should benefit as a variety of European companies have strong exposure to Chinese exports.

 

 

Looking across the English Channel, U.K. equities may be showing signs of a bullish set-up. Large-cap U.K. stocks historically have been correlated to the relative returns of energy stocks, mainly because of their large energy weight. More recently, U.K. stocks have been flat while the energy sector has weakened, which is a positive divergence. Moreover, the relative performance of small-cap U.K. stocks, which are more reflective of the British economy, are bottoming out against their large-cap counterparts, which is a constructive sign. I interpret this as a bullish set-up for the U.K., but not a buy signal.

 

 

No discussion of Europe would be complete without highlighting the geopolitical risks of the Russo-Ukraine War. MSCI Poland has functioned well as an indicator of geopolitical risk, and Polish stocks have been in steady absolute and relative uptrends. However, a recent tweet indicates a heightened risk of deliberate sabotage at Europe’s largest nuclear plant.
 

 

 

In conclusion, a review of the relative performance of global equities shows preliminary signs of faltering U.S. leadership. Japan is slowly gaining and showing signs of revival. Anecdotal bottom-up indications of a Chinese cyclical rebound could spark a rally in China-sensitive stocks around the world, which will benefit China’s Asian trading partners, as well as many European companies that export to China.

 

Is the Bidenomics electoral focus a contrarian economic indicator?

Posted by Cam Hui -
In many ways, politicians are worse than magazine covers as contrarian indicators. Magazine editors focus on an economic issue when it moves from page 20 to page 1 in the public’s mind. By that time, it’s been largely discounted by the market. Politicians are worse. They follow the trends raised by magazine editors and are even more reactive.
 

 

It was therefore of great interest that President Joe Biden kicked off his re-election by running on his economic record, which he called “Bidenomics”, which is composed of a grab bag of his past legislative initiatives such as infrastructure, renewable energy and semiconductors. The main theme is a focus on an economic revival for the middle class by emphasizing the addition of 1.3 million jobs and the achievement of a historically low unemployment rate.
 

 

The Bidenomics focus raises a contrarian risk that the President is touting his economic record just when recession odds are elevated. Consensus expectations for a recession from a variety of surveys of economic forecasts call for a recession to begin in H2 2023.
 

 

 

 

Did Biden just top tick the economy?
 

 

 

The effects of monetary tightening

A new Fed paper, “Distressed Firms and the Large Effects of Monetary Policy Tightenings”, offers some clues to the timing of a downturn. The paper found that a combination of high financial distress significantly exacerbates the effects of tight monetary policy:

Our results suggest that in the current environment characterized by a high share of firms in distress, a restrictive monetary policy stance may contribute to a marked slowdown in investment and employment in the near term.

 

 

 

 

 
The Fed researchers concluded that the worse effects may be seen in 2023 and 2024:

Do our results suggest that the monetary policy tightening engineered since 2022 might have substantial effects on investment and employment given the high share of firms currently in distress relative to previous tightening cycles? While answering this question is difficult, back of the envelope calculations indicate that the effects may be large….With the share of distressed firms currently standing at around 37 percent, our estimates suggest that the recent policy tightening is likely to have effects on investment, employment, and aggregate activity that are stronger than in most tightening episodes since the late 1970s. The effects in our analysis peak around 1 or 2 years after the shock, suggesting that these effects might be most noticeable in 2023 and 2024.

Indeed, stress levels are rising. Even though the latest Fed stress tests show that the 23 banks all passed with flying colours, market signals are indicating distress. The relative performance of the Regional Banking Index shows that it is testing an important relative support level (bottom panel). Regional banks have a higher exposure to the troubled office commercial real estate exposure than the big money centre banks, which is a concern.

 

 

The labour market is also showing signs of stress. New Deal democrat recently highlighted the Sahm Rule, which he caked “a rule of thumb started by [former Fed] economist Claudia Sahm, stating that the economy is in a recession when the three-month average of the unemployment rate rises 0.5% from its low of the previous 12 months.” He found that the Sahm Rule, which is based on the unemployment rate, is at best a nowcast of the economy, but the more weekly reports of initial jobless claims tend to lead unemployment and the Sahm Rule. The latest readings of the 4-week average of initial jobless claims shows three consecutive weeks of unemployment rate forecasts consistent with a recessionary reading.
 

 

 

 

The initial jobless claims data series is noisy and New Deal democrat would prefer to see two consecutive months of year-over-year increases in claims above 12.5%. So far, we have only seen three consecutive weeks. While these readings are not definitive evidence of a recession, they do signal upward pressure on the unemployment rate, which will be reported on Friday.
 

 

 

 

 

Recession, what recession?

On the other hand, recent data has been coming in stronger than expected. The S&P 500 recently rose 20% from its October low, and the 20% mark is an informal way of defining a new bull market.
As well, the Conference Board reported that its Consumer Confidence Index rose to an 18-month high.

 

 

 

The devil is in the details and some of these indicators are too correlated with each other to signal new information. Consumer confidence is highly influenced by stock prices (strong), housing prices (strong), the unemployment rate (low) and inflation (elevated). The Conference Board’s Expectations Index rose to 79.3, but has been below 80, which is the level associated with a recession within the next year, since February 2022.
 

 

Moreover, analysis from JPM Asset Management found that consumer sentiment is a contrarian indicator for stock prices. Forward 12-month equity returns tend to be strong when confidence is low and weak when confidence is high.
 

Consumer savings from the pandemic stimulus are mostly exhausted and the savings rate is depressed.
 

 

 

The Fed has strongly signaled its intention to raise rates at its next FOMC meeting and to hold them at elevated levels for some time. While core PCE came in slightly softer than expectations, the big picture is that inflation metrics are still sticky and should keep Fed policy on a tightening path. This is not a recipe for strong economic growth.
 

 

 

 

The earnings season acid test

For equity investors, the recession question will be decided by the earnings report acid test. Forward 12-month EPS has been rising. The upcoming Q2 earning season has the potential to alter the trajectory of earnings estimates.
 

 

The stakes are high. An analysis of the stock market shows a bifurcated market. The Dow, which represents the “old economy”, has been trading flat while the NASDAQ 100, which represents the “new economy”, has been surging. A similar pattern was seen during the Tech Bubble of late 1990s. Moreover, both period show similar patterns of small-cap underperformance and inverted yield curves, which is a recession signal.

 

 

The S&P 500 is trading at a forward P/E ratio of 18.9, which is elevated by historical standards, and so are 10-year Treasury yields, which is creating competition for stocks. The last time the 10-year Treasury yield was at similar levels was during the 2008–2010 period, when the forward P/E of the S&P 500 traded in the 12–16 range.
 

 

 

 

n conclusion, President Joe Biden’s focus on his economic record based on Bidenomics may be a contrarian economic signal in the current environment of elevated recession risk. While indicators show a mixed picture, equity risk is high. Investors should find better clarity from the results and guidance from Q2 earnings season.

 

A test of support at S&P 4320

Posted by Cam Hui -
 Mid-week market update: The S&P 500 daily stochastic recycled from overbought to neutral last week and stock prices pulled back. Initial support can be found at about 4320, with secondary support at about 4200, which is also the approximate level of the 50 dma.
Can 4320 hold?

 

 

Signs of weakness

I am seeing signs of short-term weakness. The usually reliable S&P 500 Intermediate Breadth Momentum Oscillator flashed a sell signal when its 14-day RSI recycled from overbought to neutral.
Technology leadership appears to be stalling. The relative performance of the sector has started to flatten out and relative breadth indicators are weakening, which are not good signs.
Market breadth isn’t broadening out in a significant way. The ratio of equal-weighted to float-weighted indices for the S&P 500 and NASDAQ 100 remain in downtrends. While the S&P 500 ratio may be trying to bottom, the NASDAQ 100 is showing few signs that it’s turning up.
The lack of breadth in the recent rally is disturbing. Goldman strategist David Kostin pointed out that narrow rallies are usually followed by sharper drawdowns than normal, especially now when the market internals of technology, which is the leading sector, is weakening.

Taken together, these point to further weakness in the coming days. However, the recent resilience of stock prices should also be respected. I am inclined to give a two-thirds chance that a floor can be found for the S&P 500 at 4320, which is not that far away. 

 In other words, it’s too late for traders to sell, but too soon to buy in light of the risks.

A focus on AI and technology stocks

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Neutral (Last changed from “bearish” on 15-Jun-2023)

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

Subscribers can access the latest signal in real time here.

 

 

AI mania

These days, it’s difficult to turn on financial TV without mention of artificial intelligence and technology stocks. Indeed, popular AI-related plays like NVDIA and C3.AI have been on a tear.
 

 

 

 

How sustainable is the move? Let’s examine the technical and fundamental underpinnings.

 

Time for a breather

The technical condition of the NASDAQ 100, which serves as a proxy for the AI and technology mania, looks extended in the short term. The relative performance of the NASDAQ 100 had been closely correlated to the 10-year Treasury yield, but a divergence has appeared (second panel). As well, relative breadth is showing signs of deterioration (bottom two panels). These are signs that tech stock may be due for a breather.
 

 

 

Here is the good news. Technology leadership is evident net of the market cap effect. The top panel depicts the relative performance of large-cap technology to the S&P 500 (black line) and small-cap technology to the Russell 2000 (green line). Both are beating their respective benchmarks in a similar fashion. The bottom panel shows the relative performance of the Russell 2000 to the S&P 500 as an indication of the size effect (black line) and the relative performance of small- to large-cap technology (green line). Even though small-cap technology is outpacing the Russell 2000, the relative performance of small-cap to large-cap technology is similar to the overall market size effect. This is an indication of sector leadership resilience, net of the market cap effect.
 

 

 

However, the price momentum factor hasn’t performed well, which is a bit of a puzzle. The price momentum factor, which measures whether stocks that have outperformed continue to outperform, is usually dominant during market frenzies. The following chart shows the relative returns of? different versions of momentum ETFs against the S&P 500 and none of them are showing signs of strength. One reader pointed out that the popular MTUM ETF rebalances its holdings once every six months while FDMO (bottom panel) rebalances more quickly every three months. Even then, the relative performance of FDMO can’t be described as exciting.
 

 

It’s possible that the AI and technology frenzy is only in its early stages and needs time to develop.

 

 

Fundamental opportunities and risks

No doubt, AI has the potential to be a radically disruptive technology, much like the internet was in the 1990s. Microsoft CEO Satya Nadella offered some perspective on how AI has transformed Microsoft’s workflows today:

So inside Microsoft, the means of production of software is changing. It’s a radical shift in the core workflow inside Microsoft and how we evangelize our output—and how it changes every school, every organization, and every household. A lot of knowledge work is drudgery, like email triage. Now, I don’t know how I would ever live without an AI copilot in my Outlook. Responding to an email is not just an English language composition, it can also be a customer support ticket. It interrogates my customer support system and brings back the relevant information. This moment is like when PCs first showed up at work. This feels like that to me, across the length and breadth of our products

Notwithstanding any hype about “pie in the sky” technologies that could be here in the future, the BoA Global Fund Manager Survey found respondents mostly believe the widespread adoption of AI in the next two years will boost profits.

 

What could stop the AI freight train in its tracks?

 

Soon after the release of ChatGPT, over 1,000 technology leaders and researchers signed an open letter to calling for “a pause in giant AI experiments”. The letter warned that AI researchers are “locked in an out-of-control race to develop and deploy ever more powerful digital minds that no one — not even their creators — can understand, predict or reliably control.” Signatories include luminaries such as Elon Musk and Apple co-founder Steve Wozniak. Soon after the open letter was published, the Association for Advancement of Artificial Intelligence released its own letter warning of the risks of AI.

 

These warnings are reminiscent of the Robert Oppenheimer warnings about the Bomb. Oppenheimer was a key figure in the Manhattan Project that developed the atomic bomb, and he later came out and voiced his regrets.

 

What are the risks of AI? The criticisms can be long and tortuous, but there are two categories of risks.
 

The first is AI is an extremely powerful technology, much like the Bomb. One risk is a malevolent actor deploys it in a destructive way. One obvious use is pattern recognition and neural networks to create new pathogens for biological weapons. China already combines a vast surveillance network with facial recognition to keep tabs on Chinese residents. If you don’t consider government surveillance malevolent, what if it’s done by a private network of data brokers? Even before the use of AI, the business model of Facebook, Google and Amazon is to know everything there is about you in order to sell you more things. The combination of AI pattern recognition and vast computing power makes that prospect even more intrusive. What if the data wasn’t controlled by giant corporations, but networks of unregulated data brokers who sell your information? 

 

Here’s another example. Current versions of chatbots were trained on carefully curated data sets of vast size. AI researchers have grappled with the “data pollution” problem of what happens when bad training data alters chatbot results in unexpected ways. One early visible example of the “data pollution” problem was made evident when Microsoft released a chatbot but had to shut it down because users trained it to become a neo-Nazi.
 

 

The other risk is called the fictional Skynet problem, also known as the “alignment problem” in academic circles. The problem is no one will be able to control an AI system that learns because the objectives programmed into the system may have unintended consequences.
 

 

There are always a few bugs in the system. Consider the number of operating system updates you may have seen from your software provider. Some were patches to simple bugs, others were in response to>zero-day security holes. Nothing is perfect.
 

 

For investors, risks will become apparent once the lawyers get involved. There is a well-defined body of law on liability if a dog attacks someone and causes harm. But what happens if the “dog” is a self-learning AI neural network? Who bears the liability? Is it the “dog” owner? Is it the “dog” breeder or software provider? The “dog” trainer, or the people who trained the system?
 

 

These are all good questions, and the issues raised beg for regulation. As the law catches up with these issues, the insurance industry will begin to price these risks and they will become apparent in the deployment of these technologies. But that day is still several years in the future.
 

 

Another investor risk a recession, when credit dries up. As an analogy, Bloomberg published an article, “Beyond Meat Wannabes Are Failing as Hype and Money Fade”. The article detailed how a “shakeout in a once-hot sector is widening as funding dries up”. Just like AI, fake meat is a promising technology and industry, albeit on a smaller scale. Should we see a recession or credit squeeze, the cost of capital for unprofitable start-ups will rise to unsustainable levels, which may crater the promise of AI technology.
 

 

The week ahead

Looking to the week ahead, the stock market is facing further downside risk as signs of excessive bullishness are evident.

 

The S&P 500 reached an overbought extreme on the 5-week RSI and pulled back. Past instances of similar overbought readings have seen the market stall. Initial support is at 4320, and a secondary support zone can be found at about 4200. As well, the VIX Index fell to a multi-year low, which is a sign of complacency.  
 

 

 

Sentiment readings are becoming a little giddy The Citi Panic/Euphoria Model is euphoric and at the levels last seen at the February top.
 

 

 

Similarly, the AAII bull-bear spread, which measures individual investor sentiment, and the NAAIM Exposure Index, which measures the attitudes of RIAs who manage individual investor accounts, are elevated.
 

 

 

As well, the put/call ratio has reached levels seen at recent tops and shows no signs of fear, which is a worrisome sign.
 

 

Lastly, liquidity has been highly correlated with stock prices and the historical evidence shows that it is coincident or slightly leads the S&P 500. The latest reading shows a contraction in liquidity and a growing divergence between liquidity and stocks.
 

 

In conclusion, the adoption of AI promises to be highly disruptive and has potential to improve profitability of companies that adopt the technology. It faces regulatory hurdles and risk-pricing challenges as insurance companies learn to price AI risk, but those problems are a few years away. In the near term, the technology rally appears extended and may need a breather.
 

 

Tactically, the S&P 500 may face short-term headwinds as sentiment readings are complacent as the market pulls back from an overbought condition.

 

Is the Fed deliberately engineering a recession?

Posted by Cam Hui -
 Fed Chair Jerome Powell struck a hawkish tone at the Semiannual Monetary Policy Report to the Congress last week, “The process of getting inflation back down to 2 percent has a long way to go”. While the Federal Open Market Committee (FOMC) decided to pause its pace of rate hikes at the latest meeting, he signaled further rate hikes in the near future. “Nearly all FOMC participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year.”
 

 

The word “nearly” is an understatement. The “dot plot” shows only two out of 18 dots project the Fed Funds rate to remain constant at current levels by the end of 2023. Nine project a half-point rate hike, and three project even more rate hikes by year-end. None expect rate cuts.
 

 

 

 

 
At the same time, Powell acknowledged during his testimony that shelter costs are lagging components of CPI and PCE. Leading indicators of shelter are falling, which is good news on inflation.
Why is the Fed ignoring leading indicators of inflation, which are falling, while focusing on lagging conventional inflation metrics, which are stable? Is it deliberately trying to engineer a recession?
 

 

 

Signs of cooling

There are numerous signs of economic cooling and disinflation if you know where to look.
Here is CPI Servies Ex-Rent of Shelter, which is a closely watched metric that’s decelerating quickly.

 

 

Producer prices, which have no wage or shelter component, are also dropping precipitously. May core PPI for finished goods (blue line) came in at 5.0% and core PPI for final demand (red line) printed a 2-handle at 2.8%.
 

 

 

 
What about the Fed’s characterization of the labour market as “tight” as a reason for concern for inflation? A near real-time recession indicator was proposed by (then) Fed economist Claudia Sahm. The “Sahm Rule” recession signal is based on surges in the unemployment rate.
 

 

 

Analysis by New Deal democrat found that initial jobless claims lead the unemployment rate. The chart shows the 4-week average of initial claims (red line) and Sahm Rule signals (blue line, above 0 is recession signal). The chart excludes the spike in unemployment during the pandemic, which distorts the scale of the chart and makes it unreadable.
 

 

 

Here is a close-up of initial jobless claims and the Sahm Rule. Initial claims have been rising strongly and we have seen two consecutive weeks where they have beached the recession signal zone. Initial jobless claims is a useful indicator as it’s reported weekly, but it’s also highly noisy and two weeks isn’t enough to make a definitive call that a recession is on the way. The longer-term history also shows that there have been false positives in the past, and we would like to see some persistence in initial claims before making a recession call. Nevertheless, this is a warning flag that the employment market is weakening to be of concern. The title of New Deal democrat’s latest blog post on the subject was enough to tell the story, “Initial claims: yellow caution flag turns more orange”.
 

 

 

 

There are other signs that labour tightness is easing. The JOLTS report shows that job openings (blue line) are topping out while the quits/layoffs ratio is falling in an uneven manner. The only caveat is JOLTS reported with a delay and the latest data point is in April,

 

 

 

The most recent Philadelphia Fed survey also revealed important signs of a reduction in the tightness in the jobs market. When businesses were asked when the labour market was improving (for them), the percentage who replied “improved” outnumbered the number who replied “worsened” by 29.4% to 17.6%.
 

 

 

 

 

The FOMC analytical framework

To understand the reasoning behind the Fed’s reaction function, you have to understand the FOMC’s analytical framework. The bout of monetary easing left the real Fed Funds rate deeply negative, and the FOMC reacted by raising it to a positive in to? squeeze inflation and inflationary expectations out of the system. Today, the real Fed Funds rate based on headline CPI is positive (blue line) and negative using core CPI (red line). That’s barely in restrictive territory.
 

 

 

 

The Fed’s wants falling inflation to do the heavy lifting. As the inflation falls but the nominal Fed Funds rate stays constant, the real Fed Funds rate rises as a form of monetary tightening. Should inflation rise, the nominal Fed Funds rate will also have to rise in lockstep. Here’s the problem, monthly core CPI and PCE have been stuck in the 4–5% range for several months. 

 

 

 

There is another source of inflation that the Fed may be worried about. That’s the so-called “greedflation”, where companies sacrifice sales growth for price increases. Analysis from the Economic Policy Institute found that corporate profits replaced unit labour costs as the largest component to unit price growth for the post-pandemic period from Q2 2020 to Q4 2021.
 

 

 

Yardeni Research also reported that forward estimates of corporate margins are rising, which is another indication that greedflation may be taking hold.

< 

 

In the wake of unwelcome inflation surprises in Australia and Canada, whose central banks reversed rate pauses to raise rates, members of the FOMC became sufficiently alarmed that they collectively raised their consensus GDP growth forecast for 2023, lowered the unemployment rate forecast and raised their inflation forecast. More importantly, the downgrade of the year-end unemployment rate from 4.5% in March to 4.1% in June means that the Sahm Rule warning for a recession will not be triggered. By contrast, the May forecast from the Fed’s staff economists has been calling for a recession to start in H2 2023.
 

 

 

 

In short, the members of the Committee believe inflation risks are rising and recession risks are receding. It’s safe to adopt a more hawkish monetary policy. No one wants to be another Arthur Burns. Better to err on the side of over-tightening and pay the price of a recession than to allow inflation to run out of control.

 


Bloomberg reported that Chicago Fed President Austan Goolsbee characterized the June pause decision to be a “close call”. Viewed in this context, the skip in June was a compromise decision to satisfy both the doves and hawks on the FOMC. When Powell was asked by WSJ reporter Nick Timiraos why the FOMC decided to skip a rate hike in June but signal a July rate hikes when there was much new data other than an employment and CPI report between meetings, he equivocated and didn’t have a very good answer.
NICK TIMIRAOS. I know you said July is live with only one June employment, with only the June Employment and the CPI report for June due to be released before the July meeting. You get the ECI, after you get the senior loan officer survey, after you get some bank earnings at the end of next month. What incremental information will the Committee be using to inform their judgment on whether this is, in fact, a skip or a longer pause?
CHAIR POWELL. Well, I think you’re adding that to the data that we’ve seen since the last meeting, too. You know, we since we chose to maintain rates at this meeting, it’ll really be a three-month period of data that we can look at. I think it’s a full quarter, and I think you can, you can draw more conclusions from that than you come from any six in a six week period. We’ll look at those things. We’ll also look at the evolving risk picture. We’ll look at what’s happening in the financial sector. We’ll look at all the data, the evolving outlook, and we’ll make a decision.
The only reasonable explanation was the June decision was a compromise and the Fed would raise rates in July, barring any extraordinary events.
In conclusion, I rhetorically asked whether the Fed is deliberately trying to engineer a recession. The answer is a qualified no. The Fed is primarily focused on coincidental and lagging indicators of inflation, which have been sticky, while forward-looking indicators are cooling. The Fed policy mindset is to err on the side of being too tight as policy makers want to avoid the 1970s Arthur Burns blunder of giving up on the inflation fight too early. This is leading to an increased risk of recession which many models indicate is on the horizon. It’s also consistent with the 1980–1982 double-dip recession scenario that I outlined 

 

In light of this week’s cover of The Economist with the title, “The Trouble with Sticky Inflation”, this might be the perfect contrarian magazine cover buy signal for Treasury bonds, which have been stuck in a trading range.

 

 

An overdue pullback?

Posted by Cam Hui -
Mid-week market update: The S&P 500 reached an overbought extreme on the 5-week RSI after nearing the top of an ascending channel and it appears to be in the process of pulling back. In the past, such extreme RSI conditions has seen the market rally stall. There is a strong support zone at about 4200, though it’s an open question whether the index will reach those levels.

 

 

 

Bearish factors

Market breadth, as measured by the performance of an equal-weighted index to a float-weighted index as an apples-to-apples comparison, is still not broadening out. I interpret this to be an intermediate concern.

 

 

Another short-term factor to consider is quarterly re-balancing flows. Stocks have risen strongly compared to bonds, Watch for institutional balanced funds to re-allocate by selling equity holdings and buying bonds to keep their asset allocation at mandated targets.

 

 

 

No signs of a liquidity catastrophe

One factor I had highlighted in the past is proving to be benign. The U.S. Treasury is replenishing its Treasury General Account levels by selling Treasury bills and other paper. It is expected that the TGA account could rise by $1 trillion in the next three months. Fears have arisen that the TGA reset could draw significant liquidity from the financial system and create headwinds for the price of risk assets. Based on data published last Thursday, increases in TGA has been offset by flows out of the Fed’s reverse repo account, which is supplying liquidity to the banking system. So far, so good, but it’s only one week of data so bulls should celebrate just yet.

 

 

I expect the stock market to see a downward bias into this week and quarter-end. After that, it’s all up to the market gods.

 

How to trade a split personality market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Neutral (Last changed from “bearish” on 15-Jun-2023)

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

Subscribers can access the latest signal in real time here.

 

 

A bifurcated market

In the past few weeks, I have heard different variations of a similar message from professional investors when asked about their portfolios: “We recognize that the AI transformation is very real and AI-related plays could soar, we are staying with defensively oriented names in our client portfolios.”

 

Translated: We are afraid of being left behind in an AI bubble, so we have a part of the portfolio in those names. The core portfolio consists of high-quality value stocks.
Indeed, the stock market has become bifurcated.

 

The accompanying chart tells the story of bifurcation by style and quality. There are different ways of 

 

measuring quality. One simple way is to compare the performance of S&P and Russell indices in the same market cap range. S&P has a much stricter index inclusion criteria than the FTSE/Russell indices, which creates a quality spread as the Russell Index will have a higher proportion of unprofitable companies.
As the top panel of the chart shows, growth has outperformed value in 2023. Within the value universe (second panel), the high-quality factor is dominant. By contrast, low-quality is dominant within the growth universe (bottom panel).

 

 

 

That’s the essence of the split personality the stock market is exhibiting. Investors appear to be chasing speculative growth while holding high-quality value stocks in a barbell portfolio.
 

 

This time isn’t different

From a fundamental perspective, it makes perfect sense that AI will be disruptive to the way we work in the coming years, much like how the internet disrupt life in the late 1990s. The only question is how the AI stocks are priced and their upside potential.  

 

  
Large-cap technology stocks are already showing signs of extreme froth. These stocks, which are made up of the technology and communication services sectors plus Amazon and Tesla, comprise about 42% of the weight of the S&P 500. The ratio of the NASDAQ 100 to the Value Line Geometric Index, which represents the “average” listed stock, is at an all-time high and far exceeds the peak set in 2000 at the height of the internet bubble. If you think that comparison is too extreme, consider the NASDAQ 100 to Russell 2000 ratio, which set a new cycle high and hasn’t achieved these levels since late 2000.
 

 

 

These ratios are indications that tech valuations are already stretched compared to the rest of the stock market. If you don’t think the market is frothy, FT Alphaville (free registration required) reported that a company called Asset Entities is offering a forthcoming set of AI chatbot digital NFTs.
 

By contrast, the relative performance of cyclically sensitive value sectors are weak and all are in relative downtrends. (Consumer discretionary stocks were excluded from this analysis because of the significant weights of Amazon and Tesla, which are regarded as growth stocks).
 

 

 

 

Trading growth

The textbook approach to trading high-octane growth stocks is to employ a high turnover price momentum strategy. Buy the stocks that are rising. If they falter, sell them and go on to the next momentum candidate. While that should work well in theory, price momentum hasn’t been a dominant factor in recent price performance. There are several momentum ETFs available, and none of them are showing any signs of outperformance, which is a worrisome sign that the latest AI frenzy is faltering.

 

 

In a glass half-full or half-empty debate, bulls can argue that while the NASDAQ 100 to S&P 500 ratio looks stretched, the price momentum of the ratio (bottom panel) has barely started rising. If an AI frenzy is real, it’s barely started when compared to the 1990’s experience.
 

 

Growth and momentum investors should consider an important macro risk factor. My quality analysis shows that low-quality is dominant within the growth universe, which is reminiscent of the froth experienced the late-stage bull environment in 1999, when virtually every internet startup projected that it would be EBIDA positive within two years, indicating that they weren’t profitable then. When the economy fell into recession, the resulting credit crunch wiped away an entire universe of internet startups that were burning cash and needed continuing new financings to stay solvent. Should the economy experience a downturn today, the same effect is likely to devastate unprofitable tech startups, no matter how promising their technology might be.

 

Fast forward to 2023. While Q2 isn’t quite over just yet, the basket of unprofitable technology stocks tracked by Goldman Sachs is exhibiting its second consecutive quarter of double-digit gains. The last time this happened was during the tech run in 2020.
 

 

 

Recession risk is elevated. As a reminder, Bloomberg recently reported a warning from JPMorgan strategists based on the divergence between equity and bond market expectations:

“Bond markets are still pricing in a sustained period of elevated macroeconomic uncertainty, even if there has been some modest decline over the past three months,” strategists including Nikolaos Panigirtzoglou and Mika Inkinen wrote in a note. “By contrast, equity markets look ‘priced for perfection’ with the S&P now above a fair value estimate looking through the rise in macroeconomic volatility since the pandemic.”

 

 

Value opportunities

On the other hand, if you are a value investor who isn’t convinced of the NASDAQ and technology hype, where can you hide and find opportunities? The accompanying chart of regional relative returns tells the story. The U.S. equity market violated a rising trend line and it is consolidating sideways. By contrast, Japanese equities staged an upside relative breakout from a long base, indicating strong upside potential. Tactically, Japanese equities are seeing strong fund flows and the Nikkei Average just rose to multi-decade recovery high. Investors may want to wait for a pullback before committing to a full position.
 

Eurozone equities also staged an upside breakout and they have pulled back but remain above the breakout level turned relative support. I pointed out in my recent publication (see A global market review: Risks and opportunities) that Chinese sector rotation is signaling a cyclical rebound in spite of the dire headlines. European exports are highly sensitive to the Chinese economy and should benefit from Chinese economic strength.
 

 

 

 
Here are two specific examples of European sensitivity to the Chinese economy, though they don’t necessarily buy recommendations without further due diligence.
BASF is a classic example of a German industrial with high sensitivity to China. The share prices of BASF (in USD) closely tracked Dow Chemical, another commodity chemical company, before the onset of the Russo-Ukraine War. Even though BASF has significant operations in China, the conflict devastated the margins of the company’s European operations because of the high cost of natural gas feedstock. However, the bottom panel shows that the BASF/Dow Chemical ratio has been recovering and it has been in a slow but steady relative uptrend ever since.
 

 

 

;
LVMH is another European company with strong sensitivity to the Chinese economy, as its outlook for the sales of its luxury goods depend a great deal on the high-end Chinese consumer. The shares have pulled back and the relative return pattern in the bottom two panels is showing violations of rising relative trend lines and tests of relative support, which are signs of technical caution.
 

 

 

 

However, an analysis of insider activity shows an astounding level of insider buying on weakness (green dot = buy, red dot = sales). Hermès, another European luxury goods producer whose charts are not shown, has a similar technical price chart pattern and positive, though less enthusiastic, pattern of insider buying.
 

 

 

In conclusion, the U.S. equity market is becoming very bifurcated. Leadership is composed of a handful of frothy growth names while value and cyclicals are laggards and signaling recessionary conditions. Investors who want to trade growth stocks can use the price momentum factor. Investors who are seeking better opportunity should consider Japan and Eurozone equities.

 

How economic myopia is leading investors astray

Posted by Cam Hui -
I found this recent CNBC interview with former Obama CEA Chair Jason Furman on June 6 rather disturbing. Furman expressed the opinion that the Fed would need to raise rates by 50 basis points before the rate hike cycle is complete, though he believed that it would skip a hike at the June FOMC meeting. 

 

 

 

While headline inflation had been falling, core CPI hadn’t made any progress for several months, which is causing concern for the Fed.

 

This prompted a discussion of the level of unemployment needed to slow inflation to acceptable levels, which Furman estimated at 4.5–5.0% (which incidentally would trigger a Sahm Rule recession alert). The question arose, “Is such a level of unemployment politically palatable?”

 

Furman equivocated by saying that’s why you have a Fed that’s insulated from political pressure, but that was the wrong answer. Both the question and the reply demonstrated a level of economic myopia that’s sure to lead investors astray.
 

 

An elongated cycle

I believe the conventional framework of thinking about the economic and stock market recovery from the 2020 lows as the start of an economic and market cycle is misguided. It has led to a debate over a long-anticipated recession which hasn’t arrived. 

 

Instead, this is an elongated cycle because of the unusual policy response to the pandemic. What Furman should have said was, “A 4.5–5.0% unemployment rate is far better than a 20% unemployment had we not implemented stimulus measures in response to the pandemic. We were looking at another Great Depression had the fiscal and monetary authorities not acted. Now we are paying the price.”
 

 

When the pandemic came out of nowhere in 2020, the global economy came to a sudden stop. China took the unprecedented step of shutting down its economy and the ripple effects were felt worldwide. Airlines stopped flying. Cruise lines stopped sailing. Restaurant sales plummeted and so did services employment.
The human costs didn’t just stop there. There was no cure or treatment. Medical practitioners followed the SARS playbook of quarantine, isolation, keeping the patient comfortable and hoping for the best. Does anyone remember the devastating effects on northern Italy, which was the wealthiest and most industrialized part of the country? When the virus first reached American stores in Washington State, the medical system couldn’t cope with the onslaught. And who could forget the bodies piling up in New York City when the morgues were overwhelmed.
 

 

 

Had major global authorities not acted, the sudden economic stop would have amounted to a slowdown of Great Depression proportions. Instead, we saw an unprecedented level of fiscal and monetary stimulus. While the programs could have been better designed with full hindsight, it was imperfect battlefield surgery designed to keep the patient alive.

 

The global economy is not paying the price of those stimulus programs in the form of unwelcome inflation. A better framework for analyzing the current cycle isn’t to view the recovery from 2020 as part of a cycle, but the start of the pandemic, recovery and monetary tightening as an unusual elongated cycle.
History doesn’t repeat itself, but rhymes. The closest analogy for the current circumstances is the double-dip recession of 1980–1980. As the accompanying chart shows, the 2-year Treasury yield, which is a proxy for rate expectations, first peaked in early 1980 and dipped. It was followed by monetary tightening that began later that year and ended with painfully high interest rates that wrung inflationary expectations out of the system. The stock market experienced an initial dip in early 1980, rallied and topped in 1981. The bear market didn’t end until August 1982, when the Mexican Peso Crisis caused the Fed to relent and ease. Investors were afforded the opportunity to buy the market at a single-digit P/E and the August 1982 low turned out to be a generational low.
 

 

 

 

The 2020–2023 cycle

Fast forward 40 years. The government and the Fed eased dramatically in the wake of the pandemic. The stock market fell but recovered, but the massive stimulus brought an unwelcome acceleration of inflation. The Fed responded with an aggressive tightening.

 

While headline inflation has subsided, core inflation, whether it’s measured using CPI or PCE, has been stubbornly sticky. Sticky inflation is a trend that was observed around the world. The Reserve Bank of Australia surprised markets by raising rates by a quarter-point and cited strong inflationary trends. The Bank of Canada followed suit a week later with a similar action and message. The U.K. surprised markets last week with stronger-than-expected wage growth, which raised expectations of further tightening.
 

That said, the progress on the inflation fight may be better than expected. Much of the stickiness in inflation rates can be attributed to the shelter component, which is a lagging indicator. Core sticky price CPI less shelter has been coming down, which is a positive sign.  However, Fed Chair Jerome Powell stated at the June FOMC press conference that the risks to inflation are to the upside. Moreover, core inflation has been flat, indicating that the Fed is focused on core inflation as a key metric over leading indicators such as core sticky CPI less shelter.
 

 

 

The Fed is also focused on its super-core inflation indicator, which is composed mostly of wages. The Atlanta Fed’s wage growth tracker shows the picture of a hot labour market. Median wage growth is moderating but it’s still very high at 6.3%. Job switchers are receiving raises of an astounding 7.5%, though the JOLTS report shows that quits are falling, which should lessen the overall effects of job switching.
 

 

Needless to say, the Fed’s job isn’t done yet. Current market expectations call for one more quarter-point rate hike in the Fed Funds rate at the July meeting, and no rate cuts until early 2024.
 

 

 

 

The soft landing mirage

The Fed’s main challenge is getting inflation down to 2%, or near 2%. Monetary policy is a blunt tool, and it’s virtually certain to induce a recession. Even though the FOMC’s official view is to navigate the economy to a soft landing, the Fed’s own staff economists are forecasting a recession to begin in Q4 2022. In the history of 13 rate hike cycles since 1955, there have only been three soft landings. In all probability, the current hiking cycle isn’t complete yet.
 

 

The soft landing narrative promoted by equity bulls doesn’t make sense. Earnings estimates are starting to rise again, but if growth were to revive it would add to inflationary pressures in an environment of elevated inflation. The Fed’s reaction would be to tighten further. That’s equity bullish?
 

 

 

The tightening cycle is global and we are seeing its effects. Jeroen Blockland recently highlighted a close correlation between Chinese producer prices and global EPS. If the relationship were to hold, an earnings recession is just around the corner.

 

 

In conclusion, investors have become overly myopic about the nature of the latest economic cycle, which should be viewed as an elongated recovery from the 2020 pandemic that’s likely to lead to a double-dip recession in the manner of 1980–1982.

 

A very hawkish skip

Posted by Cam Hui -
Mid-week market update: It’s not easy to make a market comment on an FOMC day. Let’s start by analyzing the Fed’s projections. The latest Summary of Economic Projections (SEP) shows a stronger economy and tigher monetary policy in response to the revised projections.

 

The Fed revised up its GDP projections for this year by 0.6% and revised down the unemployment rate by 0.4%. While headline PCE inflation is expected to fade by -0.1%, the more important core PCE was revised up by 0.3%. As a consequence, the target Fed Funds rate projection rose by 0.5% for 2023, with further upside revisions for 2024 and 2025.

 

 

During the press conference, Powell reiterated several times that the July meeting is “live”, meaning that they could raise rates at that meeting, and the risks to inflation is tilted to the upside. Equally important, Powell said that there were no plans to adjust the RRP rate in response to the Treasury’s expected $1 trillion issuance (see How the Treasury refresh may not be catastrophic), which is a sign that the Fed may not be able to act in a timely manner should Treasury issuance drain liquidity from the banking system and threaten the price of risk assets.
 

As a result, the market is now expecting a quarter-point rate hike at the July meeting and no cuts this year. Note that those expectations fall short of the Fed guidance of a cumulative 50 basis points for 2023.

 

 

 

An extended advance

Turning to the stock market, the S&P 500  initially sold off in response to the Fed decision, but recovered to roughly flat by the end of the day. Zooming out to the weekly chart for a longer-term perspective, the index blew past a key Fibonacci retracement level that served as resistance. However, the 5-week RSI has reached levels that have signaled market stalls and pullbacks in the past.

 

I have been looking for signs that the advance is broadening out beyond a handful of market leaders, but that doesn’t seem to be the case. An apples-to-apples comparison of the equal-weighted index to the float-weighted index for the S&P 500 and NASDAQ 100 shows that the equal-weighted indices continue to undeperform. This is a sign that the largest weights in each of the respective indices are doing the heavy liftin in the rally. In other words, breadth is still narrow.

 

 

This week is June option expiry (OpEx), and Jeff Hirsch observed that June Opex returns tend to be volatile.While the win rate is positive (24 up and 17 down), returns have been uneven. Average returns are negative while median returns are negative. However, the following week has shown a negative bias.

 

 

My inner trader is maintaining his short position in the S&P 500. I received some inquiries from readers about how I set my stop loss positions and I want to address that question. I disclose the entry and exit points of my trading to disclose possible conflict. Between those entry and exit signals can be gradients of positions. I could either add or subtract from my short (in this case) in accordance with my risk and profit assessments. I don’t disclose those changes because they depend on my personal risk profile. My return expectations are not the same as yours. My pain threshold are not the same as yours. My tax situation is definitely the same as yours. That’s why the disclosure of those adjustments are entirely inappropriate. Any reader who decides to act on my entry and exit disclosures should set their own risk parameters and set their own stop loss levels. I can’t do that for you. If I did, I would be offering a fund that sets out risk levels.
 

That’s a long-winded way of reiterating the importance of reading and understanding the disclaimers about my trading positions.
 

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

 

 

Disclosure: Long SPXU
 

How the Treasury refresh may not be catastrophic

Posted by Cam Hui -

Preface: Explaining our market timing models

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

 

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

 

 

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

 

 

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Bearish (Last changed from “neutral” on 02-Jun-2023)

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

Subscribers can access the latest signal in real time here.

 

 

A liquidity catastrophe?

Even before the resolution of the debt ceiling impasse, analysts had been warning about the consequences of a post-deal hangover.
 

 

It was said that the U.S. Treasury market would see a flood of new issuance which would draw liquidity from the financial system. Such a loss of liquidity would create significant headwinds for the prices of risk assets. Since the conclusion of the debt ceiling deal, the warnings have become a cacophony. Estimates vary, but consensus market expectations call for the issuance of about $1 trillion in Treasury paper over the next three months.
 


 

I have warned before about the liquidity impact of new Treasury issuance and I am certainly cognizant of the risks. However, there is a narrow path for a benign resolution of the reset of the U.S. Treasury’s cash balances without significantly affecting the price of risk assets.

 

 

A financial plumbing primer

There are three main ways to affect U.S. financial system liquidity. The first is changes in the Fed’s balance sheet, which is slowly falling because of the steady pace of quantitative tightening. The second is changes in the Treasury General Account (TGA), which is the U.S. Treasury’s “bank account” held at the Fed. As the debt ceiling approached, Treasury took extraordinary steps to avoid default by drawing down TGA balances, which injected liquidity into the banking system by spending the cash. The third is the Reverse Repurchase Agreement operations (RRP), which the New York Fed describes in the following way:
The Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York (New York Fed) is responsible for conducting open market operations under the authorization and direction of the Federal Open Market Committee (FOMC).

 

A reverse repurchase agreement conducted by the Desk, also called a “reverse repo” or “RRP,” is a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction.
Most RRP transactions are overnight RRPs (ON RRP). The Richmond Fed explained the reasoning behind the RRP facility this way:

The Federal Reserve’s Overnight Reverse Repo (ON RRP) facility provides a floor to implement its interest rate target (i.e., the federal funds rate) in abundant reserve environments. (For an explanation of repo markets, see the 2020 article, The Repo Market Is Changing (and What Is a Repo, Anyway?)

The idea is that the ON RRP facility gives participants in the short-term funding market the risk-free overnight option of lending to the Fed at the guaranteed ON RRP rate. Thus, other lending rates — like the fed funds rate — will be above the ON RRP rate.1 Figure 1 illustrates how the short-term funding network functions in the U.S.

 

 

A funny thing happened to RRP balances as they exploded in March 2021:

In the original design, ON RRP was a backstop, as market participants should lend to banks or others (via federal funds, repo, wholesale deposits, commercial papers, etc.) before lending to the Fed.2. This was the case during the early stage of the pandemic: The daily usage of ON RRP averaged $8.7 billion from March 2020 to March 2021.

 

However, ON RRP usage steadily increased after March 2021 and reached an unprecedented $1.6 trillion in September 2021. This hints at an excess supply of nonbank savings that is not intermediated by banks or absorbed by Treasuries, which has ultimately flowed into the ON RRP facility. The Fed becoming the borrower-of-last-resort has prompted concerns about how the U.S. banking system is functioning during the pandemic. Concerns include, for example, bank capital regulation being too tight or the Fed’s actions creating asset dislocation.

At about the same time, TGA balances (blue line) fell dramatically, though that’s not the only reason for the surge in RRP levels (red line). The Richmond Fed offered the factors as reasons why RRP rose so dramatically:

  1. The escalated supply of funds due to the saving glut in the shadow banking sector.
  2. The reduction in the supply of Treasury bills (due to TGA drawdown) that used to absorb non-bank savings.
  3. The dislocation and uptake of banks’ balance sheet capacity due to quantitative easing.
  4. The reduction in banks’ ability to expand balance sheets due to capital regulation.
  5. The reduction in the profit margin of banks’ intermediation due to the interest rate policy.

 

 

Here is how the TGA account reset could be relatively benign for risk assets. Even though TGA is expected to rise by about $1 trillion over the next three months, RRP balances are well above that level. What’s not known is how much of the funds invested in the RRP facility would migrate over to Treasury’s new issuance. A shift from RRP to TGA would have no liquidity effect, whereas a direct investment into Treasury paper from other funding sources would draw liquidity from the U.S. financial system.

 

That’s the narrow path to a benign outcome. At this point in time, we have no way of knowing how much RRP balances will flow into new Treasury paper. Equity bulls and bears will be waiting with bated breath for the results.

 

Keep an eye on the spread between the Treasury Bill rate and the RRP rate, which is currently pegged at 5.05% to maintain a floor on the Fed Funds rate. While the spread is positive right now, which may  incentivize institutions to park their funds in Treasury Bills, the RRP rate will have to rise by 25 basis point in lockstep with the Fed Funds target should the Fed raise rates at either the June or July FOMC meeting.

 

 

June swoon still in play

Turning to the technical conditions of the stock market, conditions are setting up for a pause and pullback and a June swoon scenario is still in play.
From a technical perspective, the S&P 500 is testing overhead resistance while the NYSE McClellan Oscillator reached an overbought condition and pulled back.
 

 

 

There has been much discussion about the poor breadth exhibited by the market. Here is a glass=half-full and half-empty analysis. Notwithstanding the minor 5-day RSI divergence, the S&P 500 is testing the highs set last August. Note the breadth readings in the three indicators in the bottom three panels. In two of the three, namely percentage of S&P 500 bullish on P&F and percentage of the S&P 500 above their 50 dma, current readings are lower than they were in August and those two indicators are showing signs of deterioration. On the other hand, the the percentage of S&P 500 above their 200 dma is higher today than the August reading, though that indicator peaked in February and it is also deteriorating. I interpret these conditions as long-term constructive for stock prices, but as a sign of short-term caution.
 

 

Sentiment readings are turning giddy. The weekly AAII bull-bear spread has reached levels similar to readings achieved just before the market top in late 2021. While sentiment can’t be described as euphoric, current conditions call for a measure of caution.
 

 

Similarly, the CBOE put/call ratio has fallen to levels consistent with complacent conditions based on recent readings. Longer term, however, they have only normalized to pre-pandemic levels. I interpret these conditions as the market needs a pullback and consolidation, but they don’t forecast a crash.
 

 

Last week’s market stall saw a surge in the small-cap Russell 2000. Sentiment has become so frothy that the Russell 2000 ETF (IWM) call volumes spiked to an off-the-charts level.
 

 

 

Putting it all together, current technical and sentiment conditions indicate that near term risk and reward is tilted to the downside. The magnitude of the pullback may be a function of how much of the funds from the RRP facility flows into TGA without affecting overall financial system liquidity. The coming week will see a crucial U.S. CPI report and interest rate decisions from the ECB, the Fed, and the BoJ, which could be sources of volatility.

 

My inner investor remains neutrally positioned. My inner trader is short 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.

 

 

Disclaimer: Long SPXU

 

Can AI stocks lead the market to a new bull?

Posted by Cam Hui -

 

I have had a number of discussions with investors and the question keeps coming up. Can the AI frenzy, which appears to be in its early stages, carry the stock market to a new bull?
 

 

The AI frenzy begins

A narrative is emerging that AI will become a highly disruptive force, much like the internet was in the 1990s. Indeed, the emergence of natural language processing like ChatGPT has the potential to transform the nature of work in the coming years.

 

A gold rush is developing. NVDIA has become the poster child for selling the picks and
shovels of AI, much like Cisco and Oracle were during the internet gold rush. As one analyst aptly put it, “There is a war in AI, and NVDIA is the only arms dealer in town.”
 

 

But market breadth has become extremely narrow, worse than it was during the internet bubble. Can an AI gold rush propel the stock market to a net bull?
 

 

I think that may be the wrong question to ask.
 

 

Combining momentum and trend following

I base my conclusions on a study by a number of academics at the Bayes Business School at the City University of London. The study is entitled, “The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation”.

 

To make a long story short, the researchers found that investors can achieve superior risk-adjusted returns by combining price momentum with trend-following models. The strategy can be summarized as, “In a bull market, buy the hot stocks of the day”. Buy the flavour of the day. It doesn’t matter if they’re biotech, uranium, social media or AI stocks. 

 

The caveat is price momentum — a strategy of piling into winners — which works only with a trend-following filter. In a neutral or negative trend (bear) market, momentum doesn’t work very well.
My own research that uses sectors instead of individual stocks as a momentum strategy also confirms these results. Pile into the winners in an uptrend. Avoid momentum in a neutral or downtrend.
That’s why the question of whether am AI frenzy can carry the stock market to a new bull is the wrong question to ask. The right question is whether the stock market can achieve a bull trend and propel AI stocks to an internet-style bubble. For that to happen, a technical bull market where the index rises 20% from its low isn’t enough. Market leadership needs to broaden out.
 

 

One measure of the breadth of participation is the Advance-Decline Line. As the S&P 500 tests overhead resistance, different versions of the A-D Line are well below their highs. I would like to see these indicators strengthen further as signals of broadening participation.
 

 

Also don’t forget the venerable Dow Jones Industrials Average. Both the Dow and the Transportation Average are also well below their old highs.
 

 

 

An alterative explanation

If breadth were not to broaden in a definitive fashion, here is an alternative explanation of the current market structure. Recall Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of names”.

 

An analysis of the relative returns of value and growth shows that growth stocks have dominated value in 2023. While the dominance continues within large-cap stocks, value has begun to regain relative strength within small caps. In other words, value/growth dominance is beginning to show signs of cracking.
 

 

The analysis of quality within value and growth is equally revealing. There are many ways of measuring company quality. One simple way is to measure the relative performance of the S&P and Russell indices. S&P has a much stricter profitability inclusion criteria than the FTSE/Russell indices. Consequently, the companies in the S&P indices are more profitable and have fewer money-losing companies than the stocks in the Russell indices.

 

While growth outperformed value, what we can observe is the more profitable S&P 500 value stocks tunderperformed but performed better than he less profitable and lower-quality Russell 1000 stocks (top panel). The middle panel shows that high-quality value beat low-quality value, but the bottom panel shows the low-quality growth stocks outperformed high-quality growth stocks.
 

 

In other words, the market structure is being dominated by a group of low-quality growth, while high quality is still dominant within the value universe.
 

Low-quality growth dominance and high-quality value? That should like a frothy market poised for a recession – which is the alternative and conventional explanation for the current market structure.
 

 

Investment conclusions

We began this publication with the rhetoric of whether AI frenzy, which appears to be in its early stages, carry the stock market to a new bull. Academic studies indicate that the right question is to determine whether we are in an equity bull so that AI stocks can take advantage of the bull trend. For that to happen, breadth participation needs to broaden out considerably.

 

The other and more conventional explanation of the current market structure is that this is a frothy market dominated by growth, while quality stocks are outperforming within the value universe. This is suggestive of an unhealthy and unsustainable theme-driven advance against a backdrop of a market that’s positioning for a recession.

 

The good news and bad news

Posted by Cam Hui -
Mid-week market update: Subscribers received an email alert last Friday that I had issued a tactical sell signal for the stock market. The VIX Index had fallen below its lower Bollinger Band, which is often a signal of a short-term top. Since then, the index has been trading sideways while the 5-day RSI slowly descended and flashed a minor negative divergence.

 

 

 

Here is the good news and the bad news.

 

 

The good news

The good news is the VIX has fallen below 15, which is a bull market signal.

 

 

As well, BoA reported that private client equity flows are reaching capitulation selling levels, which is contrarian bullish.

 

 

 

The bad news

Here is the bad news. Tactical sell signals are piling up. The 5-day correlation of the S&P 500 and the VVIX, which is the volatility of the VIX, has spiked. Such conditions tend to be bearish for stocks in the short run, especially when the NYSE McClellan Oscillator is positive.

 

 

Nautilus Research also found that the first time the VIX Index falls to 14 after being above 20, which occurred yesterday, the S&P 500 faces headwinds on a one-week and one-month time horizon.

 

 

Where does that leave us? The odds favor a short-term pullback in the context of a longer term bull, but much will depend on how the $1 trillion Treasury issuance will resolve itself in the coming weeks and months. My inner trader remains short the market. 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 SPXU

 

Why the Saudi output cut could be a bullish catalyst for energy stocks

Posted by Cam Hui -
The Saudis made a surprise unilateral cut of 1 mbpd at the OPEC+ meeting on the weekend. The NY Times reported that the Kingdom was forced to make the move as a matter of fiscal necessity:

Saudi Arabia is in “whatever it takes mode,” Helima Croft, head of global commodity strategy at RBC Global Markets, wrote in an investor note this morning. That the country is “willing to shoulder it alone adds to the credibility of the cut and signals real barrels coming off the market.”
 

Analysts calculate that Brent needs to stay above $80 in order for Saudi Arabia to keep its budget balanced and to finance the ambitious infrastructure program backed by the country’s crown prince, Mohammed bin Salman.

Oil prices initially popped in reaction to the cut, but pulled back over the course of the day.

 

 

 

Here’s what the cut may mean for energy stocks.

 

 

A constructive pattern

I noticed the unusual pattern that the energy sector was a leading sector in the China RRG chart on the weekend (see Global market review: Risks and opportunities). As a reminder, the charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotate to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

 

 

I check the U.S. RRG chart and found energy in the bottom left lagging quadrant, but if the counterclockwise rotation pattern holds, it is on the verge of an upgrade into the top left improving quadrant.
 

 

The RRG chart for Europe shows that energy is already in the improving quadrant.

 

 

An analysis of the U.S. energy ETF (XLE) shows that it is testing a falling trend line. Even though felative breadth (bottom two panels) are negative, they are showing signs of steady improvement.

 

 

Here is the higher beta oil services ETF (OIH), which has already rallied through the falling trend line and exhibiting a potential bottoming pattern.

 

 

In conclusion, the energy sector has been showing the setup for a buy signal based on improving relative strength and relative breadth. The Saudi output cut may be just be the catalyst for further strength in energy stocks.

 

Global market review: Risks and opportunities

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 
 

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

 

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Bearish (Last changed from “neutral” on 02-Jun-2023)

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

Subscribers can access the latest signal in real time here.

 

 

A quick trip around the world

Now that the U.S. debt ceiling drama is over, it’s time to take a quick trip around the world to review the state of global equity leadership.

 

The relative performance of different major regions against the MSCI All-Country World Index (ACWI) shows a surge in the U.S. market. Europe has pulled back and Japan is steadily advancing against ACWI. Within emerging markets, heavyweight China is weak and EM ex-China is steady against ACWI.

 

 

 

 

Fragile U.S. leadership

Even though the U.S. equity market has rallied strongly, its leadership can only be characterized as fragile. The U.S. market has been held up by a handful of AI-related stocks.

 

Even as the S&P 500 broke out through the 4180-4200 resistance zone, breadth and momentum indicators are flashing negative divergences.

 

 

Analysis from John Authers shows that technology outperformance against the S&P 500 sparked by the AI frenzy is comparable to the NASDAQ Bubble of the late 1990s. If this is truly the start of another bubble, it has the potential to go much further.
 

 

 

Tactically, the lifting of the debt ceiling will be a catalyst for the U.S. Treasury by borrowing to reverse its drawdown of the Treasury General Account, which is its “checking account” at the Fed. This will drain liquidity from the financial system. The net effect could amount to quantitative tightening on steroids. The open question is whether the Fed will act to cushion the effects of the liquidity drain after seeing the effects of the recent regional banking crisis.

 

 

 

Historically, changes in liquidity have been closely correlated with stock prices. The forecast liquidity drain could be the spark for a risk-off period with U.S. equities at the epicenter. Another intermediate-term headwind is contained in the debt ceiling bill, as the spending cuts contained to the bill amount to a greater fiscal drag on the economy.
 

 

 

Constructive Asia

The relative performance of major Asian markets shows a mixed bag. China-related markets of China and Hong Kong are underperforming ACWI. Japan is on the verge of a relative breakout from a long base and could be a source of leadership should it show further strength. Taiwan and Korea have ticked up, but the strength is attributable to the AI frenzy in the U.S. that has sent semiconductor stocks surging. India is flat against ACWI.

 

 

 

The market took a fright when Chinese Manufacturing PMI shrank for a second straight month in May from 49.2 to 48.8, though Non-Manufacturing PMI remained in expansion territory despite dropping from 56.4 to 54.5. However, Caixin Manufacturing PMI, which measures a sample of smaller firms, unexpectedly rose from 49.5 to 50.9, indicating expansion.

 

 

 

A look beneath the surface of sector leadership shows that the industrial economy is in good shape. The primary tool for our analysis is the Relative Rotation Graph, or RRG chart, which is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotate to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
 

The RRG chart of China sectors shows some surprising results. The top right leading quadrant consists of energy, financials, industrials and utilities. The presence of cyclical sectors such as energy and industrials are signals of strength not weakness as indicated by official Manufacturing PMI.

 

  

 

The Chinese technology sector deserves a special mention. We had suggested that the actions taken at the recent G7 meeting were a signal of a deepening rift between China and the West (see How the G7 meeting exposes the risks for 2024). 

 

Since the publication of that report, relations between China and the U.S. and Europe have deteriorated. China declined an American proposal for U.S. Defense Secretary Austin to meet with his Chinese counterpart Li Shangfu at the Shangri-La Dialogue security forum in Singapore.

 

In addition, China has sanctioned Micron Technology and barred its semiconductor components for national security reasons. Even though Western powers raised concerns about how to de-risk their economies from Chinese influence for security reasons, China has rejected the “de-risk” language and perceived initiatives as the ban on the export of advanced semiconductor manufacturing equipment to China as a way of hobbling Chinese technological advancement. Instead, Beijing has labeled de-risking initiative as a decoupling effort and encouraged the development of semiconductor technology to catch up with the West as a matter of industrial policy.

 

 
In the past, China has gone through several industrial policy cycles. The story is the same. Beijing exhorts its economy to invest in industry X. Local cadres rush to foster start-ups in that industry, which creates a boom in the stocks involved in industry X and eventually over-investment and white elephants. The latest semiconductor development imperative is likely to end the same way, but with a difference. This time, foreigners may not be able to benefit from the boom phase as semiconductors will be deemed to be sensitive and not open to foreign investment.

 

 

A buying opportunity in Europe

Turning to Europe, which had been the global leadership. The Euro STOXX 50 staged an upside relative breakout in early 2023. While it has pulled back, it remains above the breakout level, which is constructive. Several countries also remain above their relative breakout levels, which we interpret as a buying opportunity. As European exports are sensitive to Chinese growth, and our analysis of Chinese growth internals are constructive, I believe the current pause in European strength should be bought.

 

 

In conclusion, here are the takeaways from our quick trip around the world:

  • U.S. equities have surged, but the leadership is narrow and may not be sustainable. Treasury will be borrowing extensively after the debt ceiling is lifted and drain liquidity from the financial system, which will create headwinds for equities.
  • Japan appears to be on the verge of a relative breakout that could see it become a global leader.
  • The apparent weakness in China may not be as dire as the headlines indicate.
  • Europe has pulled back, but it remains the global leaders and should be bought.

 

 

The week ahead

Looking to the week ahead, current market conditions are starting to look like the blow-off top scenario that I outlined three weeks ago (see How the market could break out to a blow-off top). Subscribers received an email alert on Friday that my inner trader had initiated a short position in the S&P 500. In addition to the intermediate-term headwinds from the TGA reset, the VIX Index had fallen below its lower Bollinger Band, which is usually a sign of a short-term top.

 

 

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 SPXU