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In conclusion, these are all risk on signals, though Friday’s Jobs Report could be a source of volatility.
Preface: Explaining our market timing models
The latest signals of each model are as follows:
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
On the other hand, the short-term warning signs have been appearing everywhere. Even as the S&P 500 advanced to new all-time highs, the 5-week RSI flashed a negative divergence, and so did the VVIX/VIX ratio.
Is this evidence of a failed breadth thrust? How should investors react to the simultaneous appearance of bullish price momentum signals like a breadth thrust and the risk of dips from negative technical divergences?
The warning signs were plain to see. I highlighted the excessive bullishness of the put/call ratio last week.
Moreover, the daily S&P 500 chart was flashing warning signs. It’s not unusual for the index to consolidate sideways for a few days after reaching its upper Bollinger Band before making the next directional move. The latest move was foreshadowed by a bearish recycle of the stochastic from overbought to neutral. However, the market did show a constructive reversal candle on Friday, which needs to be confirmed by bullish follow through next week.
The Zweig Breadth Thrust Indicator, which is reported with a delay, came within a hair of an oversold condition last week, and its real-time estimate did become oversold, though that does not count as an “official” oversold reading. In the past, the market has bottomed soon after similar episodes.
As well, one of the important indicators of equity risk appetite, which was bearish last week, is turning up. The relative performance of equal-weighted consumer discretionary may be bottoming, which is a constructive sign.
Notwithstanding the softer-than-expected core PCE report that depressed bond yields, auction supply is expected to rise and peak in June. This will put additional pressure on yields in the new month and present a key test for risk appetite. {Corrected chart below)
In conclusion, I believe the bullish implication of Triple 70 Breadth Thrust triggered on May 6 is still alive. The U.S. equity market has just hit a temporary air pocket and should experience a shallow pullback. The key risk is how the bond market reacts to a continuing flood of issuance in June, which could put upward pressure on yields and downward pressure on risk appetite.
The closely watched April PCE moderated as expected. Headline PCE came in 0.3%, in line with expectations, while core PCE was 0.2% (blue bars), which was softer than expectations. Supercore PCE, or services ex-energy and housing, also decelerated (red bars). This latest print represents useful progress, but won’t significantly move the needle on Fed policy.
The worrisome development is the global trend of transitory disinflation. The Citi Inflation Surprise Index, which measures whether incoming inflation data is beating or missing expectations, is bottoming in most countries and rising again. If this continues, any expectations of ongoing rate cuts are likely to be pulled back.
Now that 2024 is nearly half over, it’s time to peer into 2025 to see the upside and downside factors that are expected to affect inflation and the Fed’s interest rate trajectory. The three main factors to consider are changes in immigration policy and how they affect employment; the evolution in productivity; and the possible political effects of the election on inflation.
Immigration has become an increasingly touchy subject in the 2024 election. What’s surprising is the degree of agreement about not only restricting illegal immigration, but also the willingness to shrink the pool of unauthorized workers.
So what happens if there is a border bill that either restricts unauthorized immigration or implements a mass deportation of illegal workers? I looked at the data to test the hypothesis that unauthorized immigration is expanding the labour supply more than normal.
Here’s another way of analyzing wage growth in greater detail. The accompanying chart shows the average hourly earnings of production and non-supervisory workers (black line), of retail trade workers (red line) and of leisure and hospitality workers (blue line), all normalized to 100 in January 2019, which is about a year before the onset of the pandemic.
Now imagine that in the 2025 post-election world the White House and Congress come to an agreement on an immigration bill. Regardless of whether the bill just restricts the supply of illegal immigrants or takes active steps to deport them, it will worsen labour supply at the low-wage end of the market, tighten the jobs market and create upward pressures on inflation.
The market is currently discounting one rate cut in 2024, which is expected to occur at the September FOMC meeting. All else being equal, any immigration bill to restrict labour supply in an already tight jobs market may resolve itself in no rate cuts and possibly rate hikes in 2025.
Productivity is the cure for inflation. Better productivity is an offset to higher growth and wages. Analysis from the non-partisan Congressional Budget Office (top left chart) dramatically shows how productivity matters and how it affects not only inflation, but also the degree of fiscal room the government will have in the future.
The question of how productivity evolves has been a puzzle for Fed policy makers as productivity gains have been noisy. Powell discussed this policy dilemma at the May post-FOMC press conference: “We saw a year of very high productivity growth in 2023, and we saw a year of, I think, negative productivity growth in 2022. So I think it’s hard to draw from the data.”
There are several schools of thought on productivity. The conventional view is that changes in productivity are noisy and Fed policy makers can’t reliably depend on productivity gains to moderate inflationary pressures.
While it’s always difficult to predict electoral outcomes and it could be argued that polls aren’t very meaningful until the campaign begins in earnest in September, current market expectations of aggregated betting odds has Trump leading Biden despite his felony convictions last week.
With that in mind, Bloomberg reported that Deutsche Bank economists project that Trump’s proposed tariffs are expected to raise headline PCE by 1.2% and core PCE by 1.4%. This will force the Fed’s hand to pivot to raising rates.
Preface: Explaining our market timing models
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:
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Morgan Stanley’s strategist Mike Wilson has been one of the more prominent bears left standing and he capitulated last week. Now that Wilson has reluctantly turned bullish, is it time to turn contrarian bearish on stocks?
Bull or bear? Here are the signposts to an intermediate-term market top.
I’ve made the point before that the U.S. economy is undergoing a mid-cycle expansion (see Relax, It’s Just A Mid-Cycle Expansion). In order for the equity bull to continue, it needs stable interest rates, continued economic growth and rising earnings.
The path of interest rates depends on inflation. Keep in mind that the world is undergoing a disinflationary cycle. The only debate is how quickly inflation is decelerating. Joe Wiesenthal highlighted how CPI has been trending down around the world.
Moreover, much of U.S. inflation is attributable to shelter. Harmonized core CPI from BLS and harmonized core PCE, as estimated by Moody’s, which exclude the shelter component of inflation, is already at the Fed’s 2% target.
In other words, equity bulls shouldn’t overly worry about the interest rate threat to stock prices.
Q1 earnings season is mostly over. The EPS beat rate was slightly above the historical average while the sales beat rate was below. The more important development is the continued strength in forward EPS estimates, which is a bottom-up sign of fundamental momentum.
An intermediate-term market top will not be in sight until the fundamentals shift that derail any of those factors, either in the form of rising rates or a downward shift in growth expectations.
That said, some tactical caution may be warranted in the short run.
Equally concerning for the bull case is the inability of consumer discretionary stocks to outperform, which is a warning of falling risk appetite.
As well, the usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) flashed a sell signal when the 14-day RSI of ITBM recycled from overbought to neutral. The recent trend in breadth deterioration, as evidenced by the poor S&P 500 and Russell 2000 reaction to the blockbuster NVIDIA earnings blowout, is both a disturbing exhibition of market psychology and contributed to the decline in RSI.
In conclusion, I am not overly concerned about the capitulation of a prominent bear on an intermediate-term basis. Stock prices are advancing on stable interest rates and continued economic and earnings growth. However, the stock market is showing some signs of bullishness exhaustion and it’s vulnerable to a short-term pullback.
It turns out that LBO candidates are relatively rare. They may be the modern deep value equivalent of Ben Graham’s formulation of stocks trading below net-net working capital or current assets minus all debt.
How do you identify an LBO candidate?
Before diving into the companies identified by the LBO model, it’s worthwhile considering the factor characteristics of the model.
As it doesn’t make a lot of investment sense to focus on last reported EBITDA as an input to a model because it represents stale data, I compared LBO to price for normalized EBITDA to forward 12-month EBITDA. The results were still highly correlated but not as correlated as the previous analysis (more on this later).
You would think that the LBO model would be correlated to the EV/EBITDA ratio. While there is tight dispersion to the scatter plot, the correlation was relatively low. This can be explained by the single dimensional characteristic of the EBITDA/EV ratio against the multi-dimensional nature of the LBO model, which incorporates margin variability and balance sheet cash in its analysis. In other words, EV/EBITDA is not a shorthand for LBO analysis.
In the end, I decided to employ both normalized EBITDA and forward 12-month EBITDA as inputs to the LBO model as a way to identify a range of possible LBO target values. I found that stocks which trade at LBO value are rare, but there were sufficiently interesting investment candidates if the LBO/Price criteria is relaxed to 0.7, or buying a company with 30% down or less.
With that preface, let’s look at a few LBO candidates identified by the LBO screen of LBO/Price of 0.7 or more.
Tapestry, the luxury goods producer retailing under the Coach, Kate Spade and Stuart Weitzman brands is an example of a partial LBO. The company raised cash to finance a takeover of its rival luxury group Capri Holdings but was rebuffed by regulators. Now it has a $32/share cash hoard burning a hole in its pocket.
Speaking of deep value, here is a recovery candidate in a hated industry. Peabody Energy is a coal stock with a wide LBO target range. With the stock at about $24, the LBO target based on forward 12-month EBITDA is only $13, using a conservative allowable interest coverage ratio of 6. By contrast, the LBO target using normalized EBITDA is $23, which is very close to the current stock price.
In total, my LBO screen identified 22 LBO candidates with an LBO/Price ratio of 0.7 or more. The low number of stocks that fit this criteria may be reflective of an elevated stock market valuation. I will be monitoring the number of stocks that pass this screen in the future and report on the results on a regular basis. For the full list of stocks that pass my LBO screen, please contact Ed Pennock at ed@pennockideahub.com or +1 647 287-6800. This is a specialized institutional level report with institutional pricing of USD 1,000 for a single one-time report, or USD 6,000 annually for monthly reports.
This was a summary of some specialized research that I undertook that I would normally not publish in these pages. We return to our regular programming tomorrow.
As it turns out, NVIDIA’s earnings beat Street expectations. As I write this, the stock is up about 2% in after hours trading. As the option market was pricing in a 6% move in either direction, this represents vastly diminished volatility. compared to expectations.
For what it’s worth, investors will see the minutes of the FOMC meeting tomorrow (Thursday). Jeffrey Hirsch at Trader’s Almanac observed that the Thursday is the most bullish day before the Memorial Day long weekend.
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.
Preface: Explaining our market timing models
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:
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
This week I review the model’s internals to reveal why I am bullish on equities.
The Trend Model uses a variety of global equities as its input. So let’s take a quick trip around the world.
Starting with the U.S., the Dow, S&P 500 and NASDAQ Composite achieved all-time highs last week, which trend-following models interpret as a bullish signal.
Across the Atlantic, both the Euro STOXX 50 and FTSE 100 have reached all-time highs, which is another bullish trend-following signal.
The Asian markets present a mixed picture. China and Hong Kong are recovering from recent lows. Beijing’s latest initiatives to rescue its troubled property market should put a bid under Chinese and Hong Kong equities. Japan made a new recovery all-time high in local currency terms, but the Yen has been weak and its market is still relatively weak for foreign investors. Taiwan has been strong, thanks to its exposure to the semiconductor industry, but Korea and Australia have mostly traded sideways for the past few months.
The mixed picture in Asia can be better seen on a relative return basis. When compared to the MSCI All-Country World Index (ACWI), China and Hong Kong are just starting to recover from relative downtrends. Japan is weak in USD terms, and the other Asian markets are trading sideways on a relative basis.
In addition to monitoring global equity markets, the Trend Model also uses commodity price signals as a signal of trends in the global economy.
In summary, we have:
Putting it all together, this is a picture of an expanding global economy, which should be bullish for risk appetite.
As well, the relative performance of IPOs shows a definite lack of investor enthusiasm for risk, which is contrarian bullish. The market’s animal spirits are still dormant.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
The Dow, S&P 500 and NASDAQ Composite all achieved new all-time highs last week. It is said that there is nothing more bullish than a stock making a new high. This is not a time for caution. Higher stock prices are ahead.
Here are the reasons why I am bullish.
Let’s begin with a technical assessment of the stock market. The market printed a “triple 70 breadth thrust” during the May 2–6 time frame, in which the percentage of NYSE advancing stocks exceeded 70% for three consecutive days. The advance sparked a likely “good overbought” condition on RSI, which is a signal of a sustained rally.
Rob Hanna at Quantifiable Edges studied the effects of triple 70 breadth thrusts and found that the price momentum effects tended to be long lasting.
The upside breakout to all-time highs was accompanied by strong breadth. The S&P 500, NYSE and S&P 400 Advance-Decline Lines also showed all-time highs, which confirms the strength of the rally. The only exception was the small-cap S&P 600 Advance-Decline Line that was just short of a new high.
From a top-down macro perspective, the market received some welcome news on inflation last week. April CPI came in slightly weaker than expected. Core CPI (blue bars) softened and so did services ex-shelter (red bars). Owners’ Equivalent Rent (green bars) also continued their expected pace of deceleration.
From a bottom-up perspective, FactSet report that citations of “inflation” have plunged.
The tame CPI report sparked a bond market rally and cemented market expectations of two rate cuts this year, with the first to occur in September. Even before the CPI report, dovish comments from Fed officials that took a rate hike off the table was helpful to risk appetite.
In addition, forward EPS estimates have been rising strongly in the wake of Q1 earnings season, which is nearly complete. This development lends support to high stock prices in the form of positive fundamental momentum.
Moreover, company guidance has been dramatically improving compared to late 2023 and early 2024.
In conclusion, stock prices have achieved fresh all-time highs and they are rising for the following reasons, which indicate sustainable progress on disinflation and economic growth:
All these factors are combining to be supportive of high stock prices ahead. While I have no specific target in mind, the measured upside objective from a point and figure analysis of the S&P 500 is an astounding 7469. As is the case with point and figure charting, the time frame for achieving such an objective is unknown.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
Preface: Explaining our market timing models
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:
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
The S&P 500 violated a rising trend line in early April and corrected. It appears to have formed a V-shaped bottom and it is resuming its advance by clearing a resistance and volume congestion zone. It’s also exhibiting a series of “good overbought” conditions on the 5-day RSI. The “good overbought” rally will be confirmed if and when the 14-day RSI becomes overbought and stays overbought.
Market internals are pointing to another sustained upleg in stock prices. Here are four other reasons why.
The market printed a Triple 70 breadth thrust last week, defined as three consecutive days of NYSE advancing issues of 70% or more. Historically, such events tend to be signals of strong price momentum that are long lasting.
The advance has been accompanied by renewed strong breadth. Net highs-lows have turned positive for both NYSE and NASDAQ stocks, which is a sign of underlying strength.
In addition, the Advance-Decline Line is also showing signs of good breadth. Even though the S&P 500 is below its all-time high, most versions of the A-D Line have reached their previous highs, with the exception of the small-cap S&P 600 A-D Line.
One of the headwinds posed by stock prices has been rising yields and USD strength, as the USD has been inversely correlated to stock prices. Yields have been retreating across the entire yield curve but remain above their upside breakout levels. The USD Index is similarly weakening and nearing a key resistance turned support level. Stock prices have the potential to undergo a parabolic advance should Treasury yields and the USD break support.
Sentiment, as measured by the Fear & Greed Index, is supportive of a further advance. Readings are only starting to rise from a mild fearful condition and they are nowhere near greed levels, which indicate a frothy market.
From a sentiment modeling perspective, the relative performance of equal-weighted consumer discretionary stocks, which takes out the effects of heavyweights like Amazon and Tesla, has been a terrific contrarian indicator. Relative weakness in this sector has been strong S&P 500 buy signals, and they are now testing a key relative support zone.
In support of this contrarian bullish thesis, references to the “low end consumer” have surged in earnings calls..
The bull case isn’t without risks. A review of the relative performance of defensive sectors shows that three of the four have rallied out of relative downtrends and they are either consolidating or starting to rise (Utilities). Leadership by defensive sectors would be an unwelcome development for the bulls.
In conclusion, a review of technical and sentiment conditions shows that stock prices are setting up for a sustained advance. The combination of strong momentum, good breadth and skeptical sentiment points to higher stock prices. Key risks are evidence of a disturbing relative strength by defensive sectors and an upcoming CPI report that could upend the bullish narrative.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
I believe AI stocks are overhyped short term but underhyped long term. Here’s why.
The exuberance over AI can be exemplified by the market reaction to the earnings of two AI ecosystem stocks, Palantir (PLTR) and Cloudflare (NET), both of which reported double beats on earnings and revenue. Reports of segmented results were strong. In Palantir’s case, the company even raised guidance, but the stock fell because guidance failed to exceed the whisper numbers. In Cloudflare’s case, the market sold off because the company failed to raise guidance.
From a fundamental perspective, signs are appearing that the narrative is turning from the upside to the downside of AI adoption. The CNBC article, “AI engineers report burnout and rushed rollouts as ‘rat race’ to stay competitive hits tech industry”, tells the story of AI development for the sake of appeasing investors instead of actual productive development. The key points are:
At the Berkshire Hathaway annual general meeting, Warren Buffett was asked about AI, his response focused mainly on the downside of AI:
Fairly recently, I saw an image in front of my screen. It was me, and it was my voice and wearing the kind of clothes I wear. My wife or my daughter wouldn’t have been able to detect any difference. And it was delivering a message that in no way it came from me.When you think about the potential for scamming people… Scamming has always been part of the American scene. If I was interested in investing in scamming— it’s going to be the growth industry of all time.
From a technical perspective, momentum in AI stocks is flagging. I identified 29 stocks exhibiting strong price momentum in January (see At Least 29 Reasons to be Bullish), most of which were technology stocks. Most, like this chart of NVIDIA, are either consolidating sideways or pulled back like Palantir and Cloudflare.
By contrast, market leadership has shifted to cyclical names, like Costco, which broke out of a multi-year base and rallied to fresh highs.
The homebuilding stocks are exhibiting a similar pattern of market strength.
GE, which is an important cyclically sensitive industrial stock, has been on an absolute tear.
In other words, leadership has shifted from AI-related technology to value and cyclical stocks. But from a long-term perspective, the AI bull isn’t over. Here is the percentage of NASDAQ 100 stocks bullish on point and figure, which recently bottomed out at below 25% and rebounded. In the last 10 years, such episodes have always seen the NASDAQ 100 stage a relief rally. However, the initial rally was often fleeting and followed by a lower low.
Another source of warning of near-term NASDAQ weakness can be found in the relative volume of NASDAQ/NYSE volume, which is weakening.
Even though AI stocks appear to be overhyped in the short run and prone to a hangover, investors are advised to be patient on the long-term potential of AI. A St. Louis Fed study compared the pace of AI adoption to other technologies. It concluded that “early evidence on the diffusion of AI seems to suggest a pattern similar to those of personal computers and cloud computing”. In other words, it will be a long cycle. Investors need to be patient about the pace of AI benefits.
In conclusion, I believe AI is overhyped in the short run and underhyped in the long run. Recent instances of earnings report reactions of stocks in the AI ecosystem indicate excessive frothiness and even AI bellwethers like NVDIA have begun to consolidate sideways. A St. Louis Fed study of the pace of technology adoption suggests that AI adoption will undergo a long cycle like the PC, so investors need to be patient.
This matters because the relative performance of junk bonds is correlated to equity prices because junk bond performance is an indicator of risk appetite. Right now, junk bond relative performance (green line) is exhibiting a minor positive divergence against the S&P 500. The risk is the spread widens and junk bond relative performance tanks and sparks a risk-off stampede.
Preface: Explaining our market timing models
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:
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
What are the key drivers of stock prices? There are some factors to keep an eye on:
The accompanying chart shows the market progress of the first two factors. The 7-10 year Treasury ETF (IEF) is staged an upside breakout of a narrow range that began in mid-February. The USD, which is tied to interest rate differentials in the short run, has also break down out of a similar trading range. These are constructive signs that the interest rate environment is benign. Geopolitical risk indicators like oil and gold prices are in retreat, which are signals of a narrowing risk premium on the market.
The good news is the Fed hasn’t taken a hawkish pivot. At the May post-FOMC press conference, Jerome Powell pushed back against the odds of a rate hike:
JEANNA SMIALEK. Thanks for taking our question, Chair Powell. I wonder, obviously Michelle Bowman has been saying that there is a risk that rates may need to increase further, although it’s not her baseline outlook, I wonder if you see that as a risk as well, and if so, what change in conditions would merit considering raising rates at this point?
CHAIR POWELL. So I think it’s unlikely that the next policy rate move will be a hike. I’d say it’s unlikely. You know, our policy focus is really what I just mentioned, which is how long to keep policy restrictive. You ask what would it take, I think we’d need to see persuasive evidence that our policy stance is not sufficiently restrictive to bring inflation sustainably down to 2 percent over time. That’s not what we think we’re seeing, as I mentioned, but something like that is what it would take. We’d look at the totality of the data and answer that question that would include inflation, inflation expectations, and all the other data too.
JEANNA SMIALEK. Would that be a reacceleration in inflation?
CHAIR POWELL. Well, I think again, the test, what I’m saying is, if we were to come to that conclusion that policy weren’t tight enough to achieve that. So it would be the totality of all the things we’d be looking at. It could be expectations, it could be a combination of things, but if we reach that conclusion and we don’t see evidence supporting that conclusion, that’s what it would take I think for us to take that step.
The market remains on edge because of an acceleration in wage rates. The Employment Cost Index (ECI), which measures both wages and benefits, came in at 1.2% for Q1, which was higher than the expected 1.0%. Q1 unit labour costs also came in at a hot 4.7%, ahead of an expected 3.6%. The April Jobs Report shows a welcome cooling in the labour market. The headline employment was softer than expected at 175,000 and, more importantly, average hourly earnings also missed Street expectations.
In addition, the New York Fed’s Multivariate Core Trend Inflation, which is an indicator of inflation persistence, fell to 2.6% in March.
In reaction to the softer than expected April Jobs Report, the market is discounting two rate cuts in 2024, with the first occurring at the September FOMC meeting.
With Q1 earnings season in full swing, earnings reports have generally been better than expected. The EPS beat rate is 77%, which is equal to the 5-year average of 77% and ahead of the 10-year average of 74%. More importantly, forward 12-month EPS estimates are rising.
This means that the recent market downdraft was driven by P/E compression and not earnings fundamentals, which have been improving. As the forward-looking inflation outlook seems to be decelerating and the Fed is not hawkish, this should lead to a stabilization in P/E ratios and possible P/E expansion, which would be positive for stock prices.
There is even more bullish macro news. Recession Alert found that the net percentage of 39 OECD countries with rising leading economic indices (LEIs) and the net percentage of 39 central banks that are easing rates are powerful leading indicators of U.S. stock prices with a 7-10 month lead at an r-squared of 0.57.
In the short run, the technical structure of the market is pointing to healing, which is a signal that the correction may be coming to an end.
Risk appetite indicators present a mixed but slightly bullish picture. The ratio of high beta to low volatility stocks is tracking the S&P 500, but high yield bond relative performance has been flashing a minor positive divergence.
Lastly, investors shouldn’t be overly worried about the negative seasonality effects of “sell in May and go away”. Callum Thomas at Topdown Charts found a distinct difference between May–October seasonality during bull and bear markets. Notwithstanding the bullish reasons that I have already cited for higher stock prices, as long as the S&P 500 stays above its 200 dma, you can consider this to be a bull market.
The one short-term blemish to the bullish outlook is a continued deterioration in banking system liquidity, which could put a lid on any stock price rally and possibly even spark a re-test of the recent lows.
The S&P 500 faces an important short-term test in the coming week. The index rallied to test its 50 dma resistance and it’s in a heavy resistance zone. The bulls need to see some upside follow through. Stay tuned.
In conclusion, a review of the main short-term drivers of stock prices, namely interest rates, geopolitical risk and the earnings outlook, are all pointing to higher stock prices. As well, short-term technical indicators such as breadth and momentum are also bullish. The key risk to this bullish outlook is a continued deterioration in banking system liquidity that could pose headwinds to stock prices.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
Does that mean you should continue to bet on growth investing or are value stocks about to have their day? Here an analytical framework to think about the value/growth paradigm.
Michael Mauboussin recently published an article that’s a master class on valuation techniques, focusing mainly on the P/E and EV/EBITDA multiples. One of the key points that he made is that not all EV/EBITDA multiples are the same. Investors need to distinguish between the EBIT and the DA in EBITDA. That’s because the DA in EBITDA is a proxy for the maintenance capital needed to maintain a company’s business. All else being equal, you should prefer a lower DA because it offers a higher free cash flow to investors.
In plain English, these results mean that, all else being equal, asset-light companies with lower DA should trade at a higher multiple than asset-heavy companies. It just happens that in the last 20 years, the asset-light companies have been the growth stocks. They tended to be platform companies that engage in little or no manufacturing and rely mainly on intellectual capital to generate cash flow.
Mauboussin advised investors to focus on the DA in EBITDA in order to maximize the FCF available to investors. There is an additional detail in analyzing EBIT. Ian Hartnett of Absolute Strategy Research pointed out that EBIT margins tend to be higher in large-cap companies.
Putting it all together, the secret of past investing success has been an exposure to large-cap growth for its innovation and intellectual property, as well as its strong margins because of scale.
In the short run, however, value has outperformed growth across all market cap bands and internationally. That’s because the market consensus has pivoted from a soft landing to a no landing scenario of continued economic growth, even as inflation stays elevated and the Fed maintains its higher-for-longer interest rate policy.
Under the current circumstances, what should the equity investor do?
Callum Thomas pointed out that non-U.S. markets have a much higher cyclical exposure compared to the U.S., so it makes sense to raise non-U.S. exposure.
I prefer Europe and Japan, in that order, for cyclical exposure while avoiding emerging markets. European stocks have been in a choppy relative uptrend since last October, and should benefit from a global cyclical rebound. Japanese stocks recently achieved fresh all-time highs in local currency terms, but uncertainty over BOJ policy has weakened the Japanese Yen, which makes Japanese equity exposure problematic for unhedged foreign investors. The relative hawkishness of Fed policy is likely to put a bid on the USD, and USD strength presents significant risks to emerging market exposure, which I would avoid.
While I am advocating a tactical overweight position in cyclicals and value stocks, how can investors time the turn back to growth?
More sophisticated investors with detailed quantitative tools can look for signs of changes in price and fundamental momentum, as measured by EPS estimate revision, to spot shifts in investment regime changes. If estimate revisions for value stocks begin to falter, and revisions for growth stocks are stock, that would be a signal to pivot from value to growth.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
Preface: Explaining our market timing models
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:
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
In discussions with investors, I have been asked if Are Big Tech has formed a bottom. Big Tech had been the leadership in the U.S. equity market. It’s an important group as it forms roughly 40% of the weight of the S&P 500. The NYSE FANG Plus Index staged an upside breakout out of a cup and handle pattern with long-term bullish implications. The index then pulled back and it’s bouncing off a relative support zone (bottom panel).
Is it time to tiptoe back into these stocks? What are the implications for the overall market in light of the outsized weight of Big Tech in the S&P 500?
The chart of QQQ, or the NASDAQ 100 ETF, tells a similar but more detailed story as the analysis of the NYSE FANG Plus Index. QQQ bounced off a relative support level. However, indicators of relative breadth (bottom two panels) haven’t decisively turned up just yet.
An analysis of the 12-month normalized relative performance of the NASDAQ 100 shows that it is nearing the oversold zone. I interpret to mean that investment-oriented accounts should be accumulating Big Tech, but there is more downside potential.
Relative volume of the NASDAQ to NYSE, which tends to be either coincident or lead the NASDAQ 100, is turning down, which is another warning that Big Tech may be in need of one final flush.
I conclude from this analysis that Big Tech is showing signs of healing but may be vulnerable to further downside, which may be relatively minimal.
As for the rest of the stock market, the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator (ITBM) is on the verge of a buy signal, which is triggered when its 14-day RSI recycles from oversold to neutral.
About half of the Regional Banking Index has reported earnings results, and the index is holding above relative support. This is another constructive sign that a potential trouble spot has dodged a bullet.
While these are constructive signs that the stock market may have limited downside risk, Ryan Detrick pointed out that the market has historically shown some choppiness after a five-month winning streak ends. With the caveat that the sample size in this study is small (n=7), this does suggest that a re-test of the recent lows may be ahead.
Notwithstanding the questions about market direction, one key question is, value or growth? Big Tech, or large-cap growth stocks, had been the market leadership for much of 2023 and early 2024. They have since stumbled but show possible bottoming behaviour. Value stocks have begun to turn up since February and the relative performance is evident across all U.S. market cap bands and internationally.
My inclination is to follow the adage, “The trend is your friend”. Overweight value, but take a partial position in growth as it’s showing signs of a potential relative bottom.
In addition, value sectors, which tend have greater cyclical exposure, are all behaving well relative to the S&P 500.
Watch for rate-driven volatility from the QRA, which will disclose the U.S. Treasury’s plan of issuance of bill and bond supply, and the FOMC meeting. Treasury yields are rising. The 2-year yield has already reached 5%. While the Fed isn’t expected to cut rates at the May meeting, the it may disclose plans to reduce the pace of its balance sheet runoff, or quantitative tightening, which could be a bullish development.
In conclusion, Big Tech has been lagging the market since February and the relative performance reset is nearing an end. The overall stock market is undergoing a bottoming process. Investment-oriented accounts should be accumulating positions at these levels, but should be prepared for some near-term choppiness. Tactically, I am inclined to overweight value over growth stocks for short-term performance.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
Investors should fade stagflation fears and embrace the “no landing” scenario. These conditions should be good news for risk assets. It’s what a mid-cycle expansion looks like.
This idealized depiction of a business cycle would classify the current phase as a “stage 4” market. I interpret this as a mid-cycle expansion when the economy is enjoying bullish fundamental and technical momentum.
Here is an example of fundamental momentum. The recent market correction on a peak-to-trough basis was -5.5% for the S&P 500. Investors should consider this episode as a buying opportunity as the price decline was attributed entirely to P/E contraction. Forward 12-month EPS estimates are continuing to rise.
The economy is healthy. One of the key earnings reports that I monitor is the VISA double beat on both sales and earnings as the company reported “resilient consumer spending”. Moreover, fundamental momentum is expected to broaden. Earnings growth for the non-megacap Big Tech companies are forecast to outpace Big Tech by year-end.
From a technical perspective, the positive readings from the monthly MACD histogram of the NYSE Composite underline the strength of the equity bull phase. Historically, positive MACD crossovers have signaled momentum-driven bull markets that have been long lasting.
Friday’s March PCE report didn’t really move the needle of expectations in the wake of Thursday’s GDP report. The market is now only discounting a single rate cut in 2024, which is expected to occur at the September FOMC meeting.
Despite all the hand wringing over the last-mile inflation problem, my base case calls for continued progress toward the Fed’s 2% inflation objective. One of the most troublesome elements of inflation is shelter, and it is well known that Owners’ Equivalent Rent is a lagging indicator of shelter inflation. The Cleveland Fed’s New Tenant Repeat Rent Index (blue line) shows that rent growth has slowed to well below 2%.
That said, there is theory and there is practice. While the idealized version of the economic cycle is a useful analytical framework, the past history of 20 years shows that similar episodes of “strong stocks, strong commodities, and weak bonds” have resolved in mid-cycle accidents (red circles) whose causes were often independent of the economic cycle.
The most obvious spark is the tail-risk of an Asian competitive devaluation. Starting in Japan, the USDJPY exchange rate has been weakening, which was exacerbated by last week’s lack of action by the BoJ. Yen weakness has occurred despite a rise in the 10-year JGB yield owing to a widening spread between the Treasury-JGB that’s attracting Japanese investors abroad.
The pressures that yen weakness is putting on China and the effects of PBOC intervention are becoming more evident. In the last month, the onshore yuan (white line) has been weakening while the offshore yuan (blue line) has been roughly flat, but in a choppy manner. This pattern may be a sign that the PBOC is leaning against the market to avoid yuan weakness. The risk is a sudden and wholesale devaluation of the Chinese yuan, which would reverberate all over Asia.
Brad Setser at the Council on Foreign Relations also found that the onshore yuan has been bumping against the lower end of its policy band, which is another sign of downward pressure.
Another sign of downward pressure on the Chinese yuan from capital flight is the stampede by Chinese investors into gold.
The risk, therefore, isn’t just Japanese yen weakness, but yen weakness that pressures China to devalue the Chinese yuan in one sudden stroke. Such a shock would trigger an emerging market stampede of competitive devaluation and spark a risk-off tone to financial markets.
In conclusion, the U.S. economy is undergoing a mid-cycle expansion, which is characterized by a combination of fundamental and technical momentum. As long as the economy stays resilient, earnings estimates rise and inflation doesn’t accelerate, stock prices can advance without rate cuts. The risk of a cyclical bear that begins at these levels is minimal.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
Preface: Explaining our market timing models
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.
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
What’s bothering the stock market? Stock prices have had to contend with a trifecta of woes:
One helpful sign for the bulls is that the gold mining stocks, which represent the safety trade, are showing signs of bullish exhaustion. RSI is rolling over and percentage bullish is overbought. (Disclosure: I remain long GDX, but I am scaling back my exposure.)
As well, the percentage of stocks above their 50 dma exhibited a breadth thrust by surging from an extreme oversold to overbought extreme. Such episodes have always resolved in a pullback in the indicator to below 50% (see circles), which was accomplished last week. We interpret this as a sufficient condition for a market bottom, though there are no guarantees as oversold markets can become even more oversold.
One constructive short-term development are the bullish divergences, as measured by improvement in breadth, even as the S&P 500 weakened and the 5-day RSI reached an oversold extreme.
The stock market is due for a bounce.
Here’s where the market stands today. The S&P 500 is extremely oversold, as evidenced by the low reading on the stochastic. A relief rally can happen at any time. It breached initial support at the 50 dma and is testing support at about the 5000 level, which is the price gap from February.
The key question is how stock prices behave after the bounce. Will the market weaken further or have we seen a durable bottom? (Please note that the levels shown in the lines are stylized and they are not forecasts).
Here are some nagging doubts. While short-term sentiment models are bearish, which is contrarian bullish, longer-term sentiment remains elevated. The monthly BoA Global Fund Manager Survey, which was taken before the market downdraft began, is the most bullish since January 2022, though readings are not extreme.
Even the weekly AAII sentiment survey is still net bullish and respondents aren’t showing signs of panic yet.
In addition, banking system liquidity is weak, which poses a headwind to stock prices.
Another key question is: “Where is the insider buying?”
As investors and traders wait for the inevitable bounce, here is what to watch. The following analysis is based on the assumption that geopolitical risk eventually recedes and all-out war doesn’t break out in the Middle East.
In particular, three of the Magnificent Seven are expected to report earnings next week. Tesla will report earnings on Tuesday, and Alphabet and Microsoft on Thursday. Don’t forget that Friday morning will see the all-important PCE report, which is the Fed’s key inflation metric. Brace for volatility.
Both my inner investor and inner trader are bullishly positioned. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL