Trust (the bull), but verify (there’s no recession)

Posted by Cam Hui -
 It’s finally happened. The monthly MACD of the NYSE Composite turned positive at the end of July. This has been a reliable long-term buy signal in the past. The sell rule in this model is a negative 14-month divergences.

 

 

In the words of Ronald Reagan when he was negotiating an arms control treaty with the Soviets, “Trust, but verify.” I am inclined to trust the bull, but it’s equally important to verify that a recession won’t sideswipe any potential equity advance.
 

 

Reasons to be bullish

Equity market internals are looking more constructive as leadership is broadening out from the narrow megacap technology leadership. The performance of large-cap growth sectors has begun to go sideways, but the S&P 500 remains in an uptrend.
 

 

As growth leadership stalled, the relative performance of the cyclically sensitive value sectors have begun to turn up.
 

 

A similar pattern can be seen in the relative returns of small-cap value sectors, which are not burdened by the performance of megacap growth stocks in comparing performance. The relative uptrend in small-cap industrial stocks is particularly impressive.
 

 

These charts are supportive of the bullish soft landing and cyclical rebound scenario.
 

 

Reasons to be skeptical

One maxim of good investing is to look for reasons to be skeptical of your investment posture as a way of avoiding confirmation bias. Here’s what’s keeping me awake at night. The possibility of a credit event that derails the bull (see Could A Credit Event Derail the Equity Bull?) and weakness in employment that plunges the economy into recession.

 

The latest Senior Loan Officer Opinion Survey (SLOOS) highlights my concerns. Banks are tightening lending standards, The Fed’s July SLOOS reported tighter credit conditions across the board and weak consumer loan demand.
Regarding loans to businesses, survey respondents reported, on balance, tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the second quarter. Meanwhile, banks reported tighter standards and weaker demand for all commercial real estate (CRE) loan categories.

 

For loans to households, banks reported that lending standards tightened across all categories of residential real estate (RRE) loans, especially for RRE loans other than government-sponsored enterprise (GSE)-eligible and government loans. Meanwhile, demand weakened for all RRE loan categories. In addition, banks reported tighter standards and weaker demand for home equity lines of credit (HELOCs). Furthermore, standards tightened for all consumer loan categories; demand weakened for auto and other consumer loans, while it remained basically unchanged for credit card loans.

 

 
Historically, tighter credit has translated into widening credit spreads and greater risk aversion, which is bearish for stock prices. This time, credit spreads have narrowed and exhibited a worrisome negative divergence.

 

 

 

The employment puzzle

The Fed announced after its July FOMC meeting that it was raising rates by a quarter-point and the Committee would be watching incoming data in order to make further decisions about the direction of monetary policy. Fed Chair Powell was repeatedly asked about the Fed’s reaction function to data, but he deflected all questions and declined to give further forward guidance, other than to say that upside and downside risks were relatively balanced.

I’d say it this way, it’s really a question of how do you balance the two risks, the risk of doing too much or doing too little? And, you know, I would say that we’re coming to a place where there really are risks on both sides. It’s hard to say exactly whether they’re in balance or not. But as our stances become more restrictive and inflation moderates, we do increasingly face that risk. But, you know, we need to see that inflation is durably down that far.”

Moreover, he revealed that Fed staff had revised their base case to a soft landing from a mild recession in H2 2023. 

 

While the debate has raged between the recession and soft-landing camps, there is nevertheless an area of agreement – unemployment will rise. Consider the June Summary of Economic Projections, which summarizes the opinions of FOMC members who are expecting a soft landing. At the same time, the unemployment rate is expected to rise from (then) 3.6% to 4.1% in December and 4.5% by the end of 2024. Such a rise in unemployment would amount to recessionary conditions by the standards of the Sahm Rule.

 

 

While I recognize that inflation rates are decelerating, it’s difficult to see how inflation can reach the Fed’s 2% target without labour market adjustment. Powell said during the press conference that the labour market is still too tight. A Dallas Fed study pointed out that businesses are expecting wage growth in the 4–5% range in 2023, which is still too high for the Fed’s comfort.

 

 

The labour market is cooling, but it’s not cool enough. The latest JOLTS report shows that both the job openings/hires and quits/layoffs ratios are falling, which is a sign of a cooling jobs market. However, levels are still above pre-pandemic levels. There are still 1.6 job openings for each person hired, indicating wage pressure. But more drops in vacancies will mean higher unemployment and a slowing economy.
 

 

It’s difficult to see how inflation can reach 2% without a modest rise in unemployment, such as 4.5%, which translates into a mild recession. The only other narrow path is if the participation rate rises sharply, or if businesses pause their hiring, which is an implausible scenario.
The July Jobs Report serves as window of this problem. Headline employment growth and average weekly hours were softer than expected, indicating decelerating economic growth. But average hourly earnings was higher than expectations, indicating wage pressure.

 

 

While Fed Chair Powell deflected questions about the Fed’s reaction function, the former Obama CEA Chair outlined his estimate in a recent tweet (UR=unemployment rate), which he claims to be roughly consistent with the reaction embedded in the last SEP.

 

With core PCE at 4.1% and the unemployment rate at 3.6%, the Fed will have to carefully monitor incoming data. However, Furman warned, “The next month or two of inflation are likely to be soft so won’t raise rates in September. I think it will rear its head again at some point so expect another hike later in the year or early next year.”
 

 

Current market expectations call for the Fed to pause and begin cutting rates in H1 2024, but there may be more tightening ahead.
 

In summary, investors are faced with another situation where the technical and macro indicators disagree. The price charts are screaming “cyclical recovery and new bull”, while macro indicators are calling for caution. Investors are advised to trust the bull, but verify there’s no potential credit event or recession ahead.

 

A test of bullish conviction

Posted by Cam Hui -
Mid-week market update: I wrote on the weekend that my monthly MACD model was “On the verge of a long-term buy signal”. The good news is the stock market rose enough on Monday, which was the last day of July, to eke out a buy signal condition.

 

 

 
The bad news is the market is very extended and vulnerable to market weakness. And if this is the start of a pullback, it could be a test of market psychology and bullish conviction.
 

 

Short-term bearish

Here are some reasons why traders should be short-term cautious about the stock market. Bloomberg reported that stock vs. bond sentiment is at a record high, which is contrarian bearish for stocks.
Stock-bond sentiment

 

Ryan Detrick pointed out that whenever the percentage of S&P 500 stocks above their 50 dma reaches 90%, the following year tends to be bullish.

 

 

Unfortunately, this metric neared the 90% and pulled back. Missed it by *that* much!

 

 

 

A downside break?

The S&P 500 has been advancing while exhibiting a series of negative RSI divergences. This is a risky condition and a downside break is bound to happen sooner or later. Initial support can be found at about the rapidly rising 50 dma, which is in the 4400-4450 zone. If initial support fails, strong support can be found at about 4200. That said, today’s stock market downdraft spiked the VIX Index above its upper Bollinger Band, which is a sign of an oversold condition.
 

 

 

Subscribers received an alert this morning that the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator flashed a tactical sell signal last night when its 14-day RSI recycled from overbought to neutral.

 

 

The downside break may finally be here. but there is also a possibility that today’s weakness could be a one-day wonder. We will need to monitor how the market reacts in the next few days to render a decision. There will be lots of sources of volatility in the next few days,,such as reports from Apple and Amazon after the close on Thursday. In addition, the July Jobs Report due Friday could also be a source of near-term volatility. Be prepared. Anything can happen.
 

My inner investor is opportunistically accumulating stocks in order reach an overweight position in equities. 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.

 

 

Disclosure: Long SPXU

 

On the verge of a long-term buy signal

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: Buy equities (Upgrade)
  • Trend Model signal: Bullish (Upgrade)
  • 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 likely buy signal ahead

Regular readers know that I apply the monthly MACD crossover as a way of determining long-term buy signals. The model works this way:

  • Buy when the monthly MACD histogram changes from negative to positive.
  • Sell the market exhibits a negative 14-month RSI divergence.

The month isn’t over yet, but when this model is applied to the broadly based NYSE Composite, it is on the verge of a buy signal, with the caveat that it’s never a good idea to front-run model readings. Significant market strength on Monday, which is the month-end, could tip the model reading into buy territory. Otherwise, the model should flash a buy signal in August barring a major pullback.
 

 

This model has performed well on an out-of-sample basis. It was timely in flashing a sell signal in late 2018. It bought back into the market in 2019 and sold just as the market topped in early 2020. It turned bullish again in late 2020 and became bearish in early 2022.
 

The history of past buy signals has usually indicated relatively long-lived bull runs with only minor drawdown risk.
 

 

A Trend Model upgrade

Independent of the MACD crossover model, the Trend Asset Allocation Model has finally turned bullish after staying at a neutral reading since March. As a reminder, the Trend Model has been running on an out-of-sample basis since December 2013. A hypothetical strategy of over or under-weighting equities by 20% against a 60/40 benchmark using out-of-sample signals would have yielded almost equity-like returns with 60/40 like risk. The Ultimate Market Timing Model has also flipped to bullish as a result of the risk-on signal from the Trend Model.

 

As for the internals of the Trend Model, here are some constructive signs that I would highlight. First, market leadership is broadening out after megacap technology stocks began to falter.

 

 

The relative performance of most cyclical industries is turning up, which is the equity market’s signal that a soft landing is ahead.

 

 

 

Commodity prices are showing signs of recovery. More importantly, industrial commodity prices are turning up, which are signals of probable global cyclical strength.

 

 

 

Across the Atlantic, the Euro STOXX 50 has broken out to a new high. The UK’s FTSE 100 is holding above both its 50 and 200 dma.

 

 

 

 

Short-term cautious

While the intermediate trend appears bullish, stock prices can pull back 5–10% at any time in the short term. The market is technically extended and sentiment is extremely frothy.

 

Even though breadth has begun to broaden, readings are still not confirming the strength in the S&P 500. To be sure, the S&P 500 has made a new recovery high, but the equal-weighted S&P 500, the md-cap S&P 400 and the small-cap Russell 2000 are struggling below key resistance levels.

 

 

 

Sentiment also looks a little giddy. ETF flows indicate a FOMO buying stampede. While this is not an immediate actionable sell signal, it is nevertheless an indication that the market can pull back at any time.

 

 

The National Association of Active Investment Managers (NAAIM) conducts a weekly survey of RIAs who manage individual investors’ funds. The replies allow for extreme opinions, from levered short, exposure of less than -100%, to levered long. The latest results show an average NAAIM Exposure of 100%, or a levered long. 

 

The survey also discloses the minimum, maximum, first, middle and bottom quartile exposures. The latest readings show a minimum exposure of 31%. In other words, the most bearish respondent is bullish, and this is the third consecutive week that the minimum exposure has been positive. An analysis of the history of NAAIM data shows only four instances of three consecutive positive readings, which is too small a sample size. However, a study of two consecutive positive readings showed 21 instances of two consecutive positive readings. The average one-week forward S&P 500 return in those cases was -0.2%, compared to 0.2% in all instances. The four-week forward return was -0.3%, compared to 0.5% in all cases.

 

 

The reports from Q2 earnings season were mixed. With 51% of the S&P 500 reported, the EPS expectations beat rate is above the 5-year average but the sales beat rate is below. One constructive development is the resumption of upward revisions in forward 12-month EPS estimates.

 

 

As a consequence of the mixed beat rates, the price response to positive EPS surprises have been wobbly.
 

 

In conclusion, my Trend Asset Allocation Model has turned bullish, which is a signal for long-term investors to raise their equity allocations. However, the short-term outlook is less certain and the market can correct at any time.

 

From a big picture perspective, hers’s how I reconcile bullish and bearish outlooks in different time frames. The percentage of S&P 500 stocks above their 200 dma has risen strongly to above the 75% level (top panel, red line), which is a sign of positive price momentum. But momentum isn’t strong enough to take the indicator to over 90%, which is a “good overbought” condition that was a signal of sustained market advances in the past. This “in between” level of between 75% and 90% has shown a hit-and-miss record. The market has continued to rise at times and shown choppy in a sideways patterns during other periods.

 

 

I conclude from this analysis that the intermediate-term risk/reward is bullish for equity prices, but not so bullish to signal a hyper-aggressive posture. If history is any guide, stock prices should rise steadily from current levels. While garden variety 5-10% corrections are to be expected, the tail-risk of a drawdown of over 20% is greatly diminished. Nevertheless, investors should be aware of the key risks of a credit event should the economy weaken into recession, stagflation risk should the Fed fail to bring inflation under control, and decoupling risk if Sino-American relations deteriorate further in the 2024 election year.

 

My inner investor is beginning to shift his equity allocation from a neutral to an overweight position. My inner trader is on the sidelines. The market is too overbought and extended to take action without a downside break. He’s waiting for the proverbial fat pitch to take a position.

 

Could a credit event derail the equity bull?

Posted by Cam Hui -
Is the soft landing here? Wall Street strategists have been racing to reduce their recession odds in the last week. More importantly, Fed Chair Powell revealed during the post-FOMC meeting press conference that Fed staff had upgraded its forecast from a mild recession in H2 2023 to no recession.
 
In the past few weeks, the stock market has become increasingly exuberant, but the bond market remains nervous. The VIX Index, which is the option implied volatility of stocks, has been steadily falling, indicating the expectation of lower risk. On the other hand, the MOVE Index, which is the bond market’s equivalent of VIX, is still elevated.

 

 

I interpret these readings as the stock market is discounting a soft landing, while the bond market is still concerned about a recession. In addition, the Bank of Japan’s decision to ease its yield curve control program has rattled the bond market. Equity bulls run the risk of a credit event which could spark a bear market. Here is my assessment of that risk.
 

 

Tightening credit = Rising defaults

Most U.S. banks have reported Q2 earnings results. Virtually all are tightening lending criteria and raising loan loss provisions in anticipation of an economic slowdown. The Senior Loan Officer Survey due out on July 31 will undoubtedly confirm these conditions.

 

Moody’s pointed out that a default cycle has just started. The only question is how severe the downturn will be.

 

 

U.S. household finances are increasingly stressed. While surplus cash levels are elevated in many industrialized countries in the post-pandemic era, Americans have mostly depleted their savings.

 

 
 

On the corporate side, commercial and industrial loan growth has been abysmal in 2023. In addition, the FT reported that the $1.4-trillion risky corporate loan market has been hit by $136 billion in downgrades, which has only been exceeded by the pandemic shock of 2020.

 

 

To be sure, the potential damage in the corporate sector may be mitigated by the timely decision by CFOs to take advantage of the Fed’s recent low-interest era to borrow long-term at very low rates. While balance sheets may become strained as the low-interest borrowings mature, that’s mainly a problem for tomorrow.

 

 

Don’t worry, be happy

So far, the market is reacting to these potential sources of stress by whistling the song, “Don’t Worry, Be Happy”. Credit markets don’t look very worried. Yield spreads are narrowing and not showing signs of anxiety.

 

 

Over in the stock market, financial stocks are turning up against the S&P 500. Relative breadth indicators are also showing signs of improvement (bottom two panels).

 

 

 
From a global perspective, the only signs of financial stress are appearing in China. U.S. large-cap financials are bottoming relative to the S&P 500, and so are the troubled regional banks. European financials are even in better shape as they have been in a relative uptrend that began in March. The only blemish is China, which is dealing with its real estate problems. Since virtually all of the loans are made in RMB, problems in China are likely to stay in China and global contagion risk is relatively low.

 

 

Even office REITs, which has been a trouble spot in commercial real estate, is trying to make relative bottoms.
 

 

 

Sound the All-Clear?

With the exception of a warning from the elevated level of the MOVE Index, market signals are unabashed bullish. Does that mean it’s time to sound the all-clear?

 

Not so fast. It’s difficult to forecast recessions and credit events that accompany recessions. Consider this transcript of the staff briefing of economic conditions from the FOMC meeting of October 2007, two months before onset of the NBER dated recession.
There can be little denying that, almost across the board, the readings on economic activity have been stronger than our expectations in September… All told, third-quarter growth in consumption looks stronger than we had expected, and spending appears to be headed into the fourth quarter with a bit more momentum.
At present, it is difficult to find evidence in high-frequency indicators that the economy is in the process of turning down.

The only warning came from the Senior Loan Officers Opinion Survey as an indication of credit conditions:

In terms of credit provision, the Senior Loan Officer Opinion Survey revealed a sharp jump in the fraction of banks reporting tighter terms and standards on loans to businesses and households, a development consistent with the restraint on spending that we have built into our forecast. Consumer sentiment remains depressed relative to overall economic conditions, perhaps because of worries about financial developments.

How much weight should investors put on today’s shift in opinion by the Fed’s staff forecast from mild recession to soft landing and the downward revisions of Wall Street strategists of recession risk?
 

What about the message of the market? Technical analysts tell us that price reigns supreme and it’s the best forecast of the future. Let’s consider how the markets behaved in the Mother of Credit Events, the GFC.

 

Let’s begin with the failure of Bear Stearns in March 2009. By that time, the problems with subprime mortgages were well known and the NBER recession had already started. The relative performance of financial stocks made a relative bottom after the Bear Stearns implosion and so did the relative performance of high yield or junk bonds (bottom panel). The S&P 500 rallied for two months after that event.

 

Financial and regional bank stocks went on and made a V-shaped relative bottom in July 2008 and the S&P rallied again. Was it time to sound the all-clear?
 

Lehman Brothers went on to fail in September and the roof caved in on stock prices. The S&P 500 made an initial bottom in November, rallied and made a final bottom in March 2008.

 

 

 
In short, neither the relative performance of financial stocks nor the behaviour of the credit market discounted the seriousness of the GFC. Price reigns supreme in technical analysis, but the technique doesn’t work all the time.
 

Here is a more recent example of how technical analysis was unable to discount the risk of a well-known and well-telegraphed event, the start of the Russo-Ukraine War.

 

The accompanying chart shows the share prices of BASF and Dow Chemical, two major commodity chemical companies that use natural gas as feedstock for their products. BASF is headquartered in Europe and Dow in the U.S. The bottom panel shows the relative price relationship between the two companies. Until the onset of the Russo-Ukraine War, the two stocks had traded in a relatively narrow range.
Everything changed on February 24, 2022, when Russia invaded Ukraine. The war sent the price of European gas soaring and the margins of BASF collapsed because of soaring natural gas prices.

 

 

 
Where was the market warning? Why didn’t it anticipate and begin to discount the effects of the invasion? It was no surprise. Evidence of Russian troops massing at the border was evident in late 2021, and the Biden Administration had adopted a policy of the open disclosure of its intelligence of Russian troop concentration as a way of warning the world.

 

 

Possible choppiness ahead

Where does that leave us? For the final word, I refer to the work of New Deal democrat, who uses a methodology of coincident, short-leading and long-leading indicators to forecast the economy. This discipline is especially attractive as it shows a picture that potential growth can evolve over different time frames. His latest update is calling for a mild recession:

  • The U.S. economy is showing signs of a slowdown turning into a shallow recession, with weak consumer spending and negative long-leading indicators.
  • But short-leading indicators have improved, driven by stock prices and a weak U.S. dollar, suggesting the slowdown may be temporary.
  • One scenario suggested by the order of the indicators is an economy that wobbles back and forth between data that shows slow growth versus shallow contraction.

The last point about the wobble between the soft landing and recession narrative is important. If we are in such an environment, investors should be prepared for possible choppiness and the risk of a credit event that could derail the bullish narrative. In addition, investors should be aware of the possible risks from further ruptures in the Sino-American relationship as anti-Chinese rhetoric heats up ahead of the 2024 election (see How the G7 meeting exposes the risks for 2024).

 

If you want to be bullish, I wouldn’t argue with you. Just be careful.

 

Coming up. Stay tuned tomorrow for “On the verge of a long-term buy signal”.

 

It’s not just about the Fed

Posted by Cam Hui -
Mid-week market update: The market reaction to the FOMC decision was mostly a yawn. The Fed raised rates by a quarter-point, which was expected, and Powell refused to commit to further hikes while repeating his data dependency mantra.  As a consequence, the S&P 500 was mostly unchanged from before the decision to after the close. However, the 2-year Treasury yield, which is a proxy for Fed Funds expectations, did ease a little. Fed Funds expectations were mostly unchanged, other than the first easing was pulled from the May 2024 FOMC meeting to March.

 

 

The market faces far more sources of volatility than just the Fed.
 

 

How the stock and bond market disagree

The stock and bond markets have been in disagreement. While the S&P 500 has moved steadily upward in the past few weeks, which indicates growing optimism about a soft landing, the bond market has been range-bound, indicating continuing concerns over inflation, the growth outlook, and Fed policy. Even as technicians analyze charts to discern the message of the market, the stock and bond market disagreement will be a source of risk and volatility. One source of near-term risk is the negative 5-day RSI divergence exhibited by the S&P 500 as it advanced.

 

 

 

Sources of volatility

We are proceeding through Q3 earnings season, with a number of prominent heavyweights reporting this week. Be prepared for choppiness as individual companies report results.

 

 

From a broader perspective, I continue to be concerned about the odds of a slowdown. The signs of a slowdown are beginning to be seen in a deterioration in forward 12-month margins.

 

 

Looking ahead, we have interest rate decisions from the ECB and the BOJ this week. As well, investors will see an update to the inflation picture from PCE, which is the Fed’s preferred inflation metric, and the quarterly Employment Cost Index, which measures total compensation. While Fed Chair Powell declined to comment on any single union contract, the Fed is likely to see the recent UPS-Teamsters agreement as an indication of continuing strong wage pressures. In addition, gasoline prices have been rising, which will put upward pressure on headline inflation.

 

 

Bottom line, the stock market is being buffeted by many sources of volatility while equities are priced for a soft landing. This represents a condition that’s makes equities vulnerable to a correction in the short run. Longer-term, the outlook depends on whether you are in the soft landing camp or the recession camp.

 

A new cyclical bull?

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.

 

 

The momentum buy signal

Technical buy signals are coming out of the woodwork, supported by strong price momentum and signs of broadening market breadth.

 

Ryan Detrick pointed out that the S&P 500 is on the verge of a five-month win streak of consecutive positive returns. Historically, market strength begets more strength.
 
 

 

I can sympathize. My slower-moving Trend Asset Allocation Model, which monitors a blend of global equity and commodity markets, is on the verge of a buy signal. While I am not inclined to front-run model readings, nor am I inclined to second guess model readings too much, I have some doubts. Here are the bull and bear cases.

 

 

A risk-on stampede

The signs of a risk-on stampede are forming. Credit market risk appetite indicators are confirming the advance in the S&P 500.

 

 

The folks at SentimenTrader are turning bullish. As one of many examples, Dean Christians observed that “the percentage of cyclical sub-industry groups up more than 40% from their respective 1-year lows”. This is an important signal from the markets that a cyclical recovery may have begun.

 

 

Commodity prices are also recovering, though the lack of bullish confirmation from the cyclically sensitive copper/gold and base metals/gold ratios is a little disconcerting.
 

 

 

A crowded long

In the short run, however, sentiment has become excessively bullish. Such crowded long conditions argue for caution.

 

 

The Bob Farrell AAII Sentiment Indicator, which is AAII bulls . (AAII bears + AAII neutral/2), is up sharply (red line in chart).
 

 

The retail investor was all bulled up going into earnings season. While the market response hasn’t been bad, warnings from cyclically sensitive companies like Fastenal and Rio Tinto are cautionary flags. In addition, banks reported that they are preparing for a recession by tightening lending standards. Tightening credit in the face of a possible slowdown is not only negative for consumer spending, it also runs the risk of setting off an unforeseen credit event that rattles risk appetite.

 

 

The early results from Q2 earnings season have been mildly disappointing. The EPS and sales beat rates are below historical norms and EPS estimate revisions are stalling. This is all happening against a backdrop of elevated forward P/E multiples. To be sure, only 18% of the S&P 500 have reported results. We should see greater clarity next week when about half of the weight of the S&P 500 report results.

 

 

With the relative performance of cyclical industries mostly in uptrends, recent earnings reports have seen many cyclicals exhibit pullbacks. Is this just a hiccup or something more serious?

 

 

 

A regime change judgment call

Where does that leave us? While the intermediate-term outlooks appears uncertain, the market looks like it’s poised for a short-term correction or consolidation.

 

 

The key question for investors is whether they should buy the anticipated dip. If this is the start of a new cyclical bull, excessively bullish sentiment doesn’t necessarily have to be contrarian bearish. There have been several instances in recent history when the S&P 500 has continued to advance while the AAII bull-bear was highly elevated, which can be characterized as “good overbought” conditions.

 

 

Similarly, an analysis of the CBOE equity-only call/put ratio (top panel) shows that bullish crossovers of the 50 and 200 dma of the ratio can signal secular bull trends. The last buy signal occurred in February 2023.

 

 

On the other hand, the macro risk is that the market is repeating the double-dip recession of 1980–1982. Just as stock prices recovered after the initial dip in 1980, the Volcker Fed squeezed the economy with painfully high interest rates. The economy suffered a second setback and didn’t recover until 1982. Under that scenario, we are roughly in Q1 or Q2 1981, which is just before the short rate peak.

 

 

Ultimately, the bull and bear decision amounts to a judgment call on regime change. Is the economy emerging out of recession or is there a slowdown waiting around the corner to sideswipe stock prices and market expectations?

 

My answer is one of the more valuable and honest ones in investing, “I don’t know.” While stock prices are vulnerable to a setback in the short run, the intermediate-term outlook depends on the newsflow on earnings, the market reaction, the Fed decision and other factors, such as evolution of expectations of Chinese stimulus in the coming weeks.

 

The risks to the disinflation and soft-landing bull case

Posted by Cam Hui -
Ever since the softer-than-expected June CPI report, the Wall Street narrative has pivoted toward disinflation and a soft landing. The disinflationary trend had been building for some time and inflation has been surprising to the downside around the world.

 

 

 As a consequence, the markets have taken a risk-on tone in anticipation of less hawkish tones from major central banks. Nevertheless, I would like to sound a word of warning of the risks in the disinflation and soft-landing scenario. Investing isn’t easy, and seemingly bullish scenarios could easily shift at a moment’s notice.
 

 

 

The risk of catastrophic success

The first risk is the risk of catastrophic success. The June core CPI came in at 4.9%. What if it were to fall, say, another 1% by year-end?
 

 

Consider what the consensus expectations are for the Fed Funds rate. A quarter-point rate increase is baked-in for the July FOMC meeting. The market expects no more hikes and probable cuts in early to mid-2024.

 

 

From a policy perspective, the Fed’s tightening policy relies on falling inflation to do most of the heavy lifting. If it were to hold rates steady for several months and the inflation rate falls, the real Fed Funds rate rises, which amounts to a de facto tightening. If core CPI declines 1% by year-end, the real Fed Funds rate would rise to about 1.5%. Can the economy cope with real rates at that level without going into recession?

 

 

 

What about the stock market? The S&P 500 forward P/E and the long Treasury yield have exhibited a strong inverse relationship over the last 10 years but they have shown a divergence recently. Much of the rise in stock prices from the October 2022 lows is attributable to P/E expansion, which is typical of a new bull. The market’s forward P/E of 19.5 is already elevated by historical standards and above its 5- and 10-year averages. Can the stock market cope with a similarly elevated Treasury yield? TARA (There Are Real Alternatives) is back in play.
 

 

 

The last mile inflation problem

While some strategists have turned bullish in response to falling inflation, others have worried about the so-called last-mile inflation problem. One prominent macro voice in the last-mile camp is Bridgewater Co-CIO Bob Prince, who voiced his concerns in an FT interview.

“Inflation has come down but it is still too high, and it is probably going to level out where it is — we’re likely to be stuck around this level of inflation,” Prince said. “The big risk right now is that you get a bounce in energy prices when wages are still strong”, which could drive a rebound in inflation, he added.

Prince believes the Fed’s policy levers are too blunt to achieve its objectives.

“Current levels of spending are being financed by income, not a credit expansion,” Prince said. “So inflation is really hard to bring down.”

In a separate Bloomberg podcast that was taped before the FT interview, Bridgewater co-CIO Greg Jensen echoed Prince’s remarks and laid out a scenario of disappointing growth and upside surprises in inflation. Such an environment would be unfriendly to both stocks and bonds.

 

While inflation has shown a welcome trend of deceleration, internals point to either a flattening or acceleration in the near future. Much of the decline in the headline CPI rate is attributable to falling gasoline prices. As the accompanying chart shows, the 52-week rate of change in gasoline prices is starting to become less negative while the 13-week rate of change has been flat for most of 2023. Gas prices made a first bottom in September 2022 and a second bottom in December. Even if prices were to stay flat, base effects will see energy prices start to flatten out or accelerate by year-end.

 

 

Another key component of the inflation rate is shelter. Apartment List tracks rents, which leads the Owners Equivalent Rent component of CPI. The Apartment List Rent Index has been falling on a year-over-year basis, which is a positive sign for disinflation.

 

 

However, the analysis of monthly changes in the same data series shows that deflationary effects of rents are behind us and rents have been rising for several consecutive months. All else being equal, base effects will see the shelter component of inflation stabilize and rise again in the near future.
 

 

 

What about the recession?

A third risk is the risk of an imminent recession. New Deal democrat, who monitors the economy using the discipline of coincident, short-leading and long-leading indicators, recently pushed back against the soft-landing narrative in his weekly update. The bad news is a recession appears imminent. The good news is any slowdown should be relatively shallow.

  • The high-frequency weekly indicators suggest that a recession is imminent, with all three primary systems indicating a near-term economic downturn.
  • Consumer spending and tax withholding are of particular importance; both consumer spending measures (Redbook and OpenTable) were negative this week, and if tax withholding turns negative as well it would signal the start of a contraction.
  • However, the continued improvement in the short-leading indicators suggests that any recession is likely to be either short or not very deep.

Since the publication of that note, the weekly Redbook series printed a second consecutive year-over-year reading indicating a weakening consumer.

 

 

 
NDD has argued that consumer spending leads employment. However, initial jobless claims improved last week and the year-over-year increase in the 4-week average fell below the 12.5% recession warning mark after five consecutive weeks of recessionary warning conditions. This is a noisy data series. Is this a data blip?

 

 

In summary, nothing in investing is easy. While the disinflation and soft-landing narrative is the dominant one, sentiment could change very quickly. While I am necessarily dismissing the bullish implications of the disinflation and soft-landing scenario, investors should be aware of the risks, which are the implications of catastrophic success, the last-mile inflation problem and the risk of a recession.

 

Scenes from Q2 earnings season

Posted by Cam Hui -
Mid-week market update: I wrote on the weekend that Q2 earnings season is potentially pivotal for the stock market (see What to watch for in a pivotal earnings season). Going into reporting season, the consensus is calling for a rebound in earning, though the recovery is expected to be stronger in large and mid-caps compared to small-caps.

 

 

The very early report card shows relatively upbeat results, though there are some blemishes of concern.

 

 

Early report card

In reality, this isn’t quite an early report card and not a mid-term, but the results of a quiz. The big banks reported and the sector has performed well, indicating that the reports were generally well received. Underneath the hood, however, some details of the reports are a little disconcerting.

 

As examples, both JPM and C are preparing for a sharp rise in unemployment. Here is a key quote from JPM’s Bob Michele, via Bloomberg:

Based on all the stress we’re seeing in the system, we’re pretty confident we’re going to see that sharp rise in unemployment. .. It’s going to feel like a soft landing until you actually hit recession.

Here is a similar quote from Citigroup’s CFO:

We’ve got a base case, an upside, a downside. Our current reserves are based on the mix of those 3 macroeconomic scenarios. It reflects about a 5.1% unemployment rate on a weighted basis over the 8 quarters, and it’s roughly flat to what it was last quarter.

 

As a reminder, the current unemployment rate is 3.6%. An unemployment rate of over 5% is a sharp rise and recessionary. If banks are preparing for such an environment, they will tighten lending conditions, which leads to a credit squeeze. FactSet reported that banks are raising Q2 loan loss provisions.
 

 
 

 
 

The NY Fed reported that the rejection rate for auto loans is at a decade highh. Credit card rejection rates are rising, though they’re not at their peak yet.

 

 

Equally disturbing is the report from cyclical bellwether Fastenal, which is warning of a slowdown in demand in H2 2023.

 

 

As well, global mining giant Rio Tinto warned on its outlook: “China’s economic recovery has fallen short of initial market expectations, as the property market downturn continues to weigh on the economy and consumers remain cautious despite monetary policy easing…Manufacturing data in advanced economies showed a further slowdown and recessionary risks remain.”

 

 

What resilient consumer?

I wrote on the weekend that I was monitoring the results from luxury goods makers for indications of the Chinese consumer. Burberry and Richemont reported, and the general tone is strength in China and Asia, but weakness in Americas, which is contrary to top-down reports of a resilient American consumer. If high-end luxury goods market is faltering in the U.S., what does that say about consumption and how the Fed’s tightening is affecting the wealth effect?

 

New Deal democrat monitors real retail sales closely, as it leads employment by several months. June real retails sales came in flat and it’s -3.1% below its 2021 peak.

 

 

 

Vulnerable to a pullback

The latest BoA Global Fund Manager Survey highlighted a dispersion in sentiment. While retail investors are bullishly positioned, institutional managers are relatively cautious but recovering from extreme levels of bearishness. Technically, these readings look like a market that’s poised for a pullback within the context of a long-term uptrend. Individual investors are too bullish, which argues for a pause or correction. Institutional money moves glacially, but when it moves, the tide may seem never-ending.

 

 

Despite the institutional cautiousness, don’t expect the AI mania to continue in the short run from big money support. The FT reported that many large U.S. investment funds are at or near their diversification constraints that block them from buying more large-cap tech stocks. Many mutual funds are running into strict regulatory limits that determine whether a fund can be categorized as diversified.

 

 

There is also this tactical warning from Nomura’s derivatives analyst Charlie McElligott.

 

 

In the short run, the market is vulnerable to a pullback. I just don’t know what the catalyst might be. The intermediate term depends on the results and guidance from earnings season and the Fed’s policy direction, which we’ll find out more about next week.

 

The soft landing vs. slowdown debate

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 fragile consensus

It’s remarkable how swiftly the consensus narrative can change. Two weeks ago, the 2-year Treasury yield spike above 5% when the ADP Non-farm Employment report came in at a blowout 497K, which was well ahead of expectations of 228K. The news prompted speculation that the Fed would have to tighten more than expected and send the economy into recession.
 

Last week, the softer-than-expected CPI report abruptly shifted the tone of the consensus to a soft landing and sparked a risk-on rally in risk assets and yields retreated. This matters because the 2-year Treasury yield is a proxy for market expectations of the Fed Funds rate. Past peaks in the 2-year rate have either been coincidental or led peaks in Fed Funds.
 

 

The current environment illustrates the fragile nature of the market consensus. If the narrative can flip from bear to bull in a week, it may not take much for it to flip back. The market is at a critical juncture. Team Soft Landing is locked in a cage match with Team Slowdown. Who wins?
 

 

Team Soft Landing

Here is the case for a soft landing. From a top-down perspective, the U.S. Economic Surprise Index, which measures whether economic indicators are beating or missing expectations, is rising, which is a sign of economic recovery.
 

 

 

The relative returns of selected key cyclical industries are either bottoming or rising.
 

 

Even commodity prices have caught a bid.
 

 

 

Team Slowdown

The case for a slowdown relies on leading indicators of economic weakness. The historical record shows that initial jobless claims leads the unemployment rate, and the Sahm Rule, which is a heuristic coined by former Fed economist Claudis Sahm, uses increases in the unemployment rate to spot a recession. Here is a chart of the Sahm Rule (blue line, above 0 is a recession flag) and the 4-week average of initial jobless claims (red line) before the distorting pandemic-related data spike.

 

 

Here is a close-up of recent data. We’ve seen five consecutive weeks of warnings of a Sahm Rule recession signal. While these readings don’t represent a definitive recession call, it nevertheless is a sobering warning.
 

 

While the soft CPI report is a helpful step in the right direction, it doesn’t move the Fed’s monetary policy needle. We’ve seen these kinds of false starts in the past and the FOMC needs to see more convincing signs that inflation is under control before shifting its policy stance.
 

 

 

The Fed doesn’t want to repeat the stop-start inflation fighting mistakes of the 1970s by declaring victory on inflation too early, only to see inflation run away again. This attitude raises the risk of a policy mistake that overtightens and pushes the economy into recession.

In addition, the growth, value and quality factor return internals of the stock market argue for caution. One way of measuring quality is by profitability. S&P has a stricter index inclusion criterion than FTSE/Russell, which means that S&P stock indices have more profitable companies that Russell ones, which creates a quality bias.
 

The top panel of the chart shows that while large-cap growth has beaten value in 2023, high quality has performed better. The bottom two panels show that within the value universe, high-quality value outperformed, while within the growth universe low-quality growth was dominant. The combination of low-quality growth and high-quality value leadership tells the story of a frothy market that argues for a tilt toward high-quality value, which is not the characteristic seen during an economic recovery.
 

 

 

 

A frothy market

Other signs of froth can be found in sentiment indicators. The put/call ratio is showing signs of complacency by recent historical standards, though it could be argued that it’s only normalizing to pre-pandemic level readings.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, is nearing a bullish extreme.
 

 

Tactically, the percentage bullish indicator is in overbought territory. Similar readings in the last two years have resolved in market pullbacks. Overbought markets can become more overbought, but will this time be different?
 

 

In conclusion, Team Soft Landing and Team Slowdown are engaged in a cage match. Incoming data in the coming weeks will decide the winner. In the short run, the market is overbought and posed for a period of consolidation or correction.
 

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.

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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.