An overdue pullback?

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

 

 

 

Bearish factors

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

 

 

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

 

 

 

No signs of a liquidity catastrophe

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

 

 

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

 

How to trade a split personality market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

 

The latest signals of each model are as follows:

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

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

Subscribers can access the latest signal in real time here.

 

 

A bifurcated market

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

 

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

 

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

 

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

 

 

 

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

 

This time isn’t different

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

 

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

 

 

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

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

 

 

 

Trading growth

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

 

 

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

 

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

 

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

 

 

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

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

 

 

Value opportunities

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

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

 

 

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

 

 

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

 

 

 

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

 

 

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

 

How economic myopia is leading investors astray

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

 

 

 

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

 

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

 

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

 

An elongated cycle

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

 

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

 

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

 

 

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

 

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

 

 

 

The 2020–2023 cycle

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

 

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

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

 

 

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

 

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

 

 

 

The soft landing mirage

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

 

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

 

 

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

 

 

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

 

A very hawkish skip

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

 

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

 

 

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

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

 

 

 

An extended advance

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

 

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

 

 

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

 

 

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

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

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

 

 

Disclosure: Long SPXU
 

How the Treasury refresh may not be catastrophic

Posted by Cam Hui -

Preface: Explaining our market timing models

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

 

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

 

 

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

 

 

 

 

The latest signals of each model are as follows:

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

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

Subscribers can access the latest signal in real time here.

 

 

A liquidity catastrophe?

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

 

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


 

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

 

 

A financial plumbing primer

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

 

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

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

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

 

 

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

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

 

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

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

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

 

 

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

 

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

 

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

 

 

June swoon still in play

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

 

 

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

 

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

 

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

 

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

 

 

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

 

My inner investor remains neutrally positioned. My inner trader is short the S&P 500. The usual disclaimers apply to my trading positions:

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

 

 

Disclaimer: Long SPXU

 

Can AI stocks lead the market to a new bull?

Posted by Cam Hui -

 

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

 

The AI frenzy begins

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

 

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

 

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

 

I think that may be the wrong question to ask.
 

 

Combining momentum and trend following

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

 

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

 

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

 

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

 

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

 

 

An alterative explanation

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

 

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

 

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

 

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

 

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

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

 

Investment conclusions

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

 

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

 

The good news and bad news

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

 

 

 

Here is the good news and the bad news.

 

 

The good news

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

 

 

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

 

 

 

The bad news

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

 

 

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

 

 

Where does that leave us? The odds favor a short-term pullback in the context of a longer term bull, but much will depend on how the $1 trillion Treasury issuance will resolve itself in the coming weeks and months. My inner trader remains short the market. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account.  Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXU

 

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

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

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

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

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

 

 

 

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

 

 

A constructive pattern

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

Global market review: Risks and opportunities

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 
 

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

 

 

 

The latest signals of each model are as follows:

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

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

Subscribers can access the latest signal in real time here.

 

 

A quick trip around the world

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

 

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

 

 

 

 

Fragile U.S. leadership

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

 

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

 

 

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

 

 

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

 

 

 

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

 

 

Constructive Asia

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

 

 

 

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

 

 

 

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

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

 

  

 

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

 

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

 

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

 

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

 

 

A buying opportunity in Europe

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

 

 

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

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

 

 

The week ahead

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

 

 

The usual disclaimers apply to my trading positions.

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

 

 

Disclosure: Long SPXU
 

A different kind of Fed pivot?

Posted by Cam Hui -
 Now that the debt ceiling drama is over, investors’ eyes are turning toward the Fed and the trajectory of monetary policy. The current Fed tightening cycle is one of the most aggressive in memory. After a series of staccato rate hikes, the Fed hinted that it was ready to pause. However, the recent stronger-than-expected April PCE may have changed the narrative from a pause to another rate hike.
Will the Fed pause its rate hikes, skip a hike but continue later, or just raise rates at the June FOMC meeting?

Setting expectations

Fed communications have become far more transparent since the days of the Greenspan Fed. The market interpreted May FOMC meeting statement as a hint at a pause in the rate hike cycle:

In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

This was in direct contrast to the “additional firming” language from the March FOMC meeting statement:

The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

The release of the May FOMC meeting minutes revealed a divided Fed, with a tilt toward a pause. On one hand, “some participants commented that, based on their expectations that progress in returning inflation to 2 percent could continue to be unacceptably slow, additional policy firming would likely be warranted”. On the other hand, “several participants noted that if the economy evolved along the lines of their current outlooks, then further policy firming after this meeting may not be necessary”. “Some” is fewer than “several”, right?

Governor Christopher Waller, who is regarded as a hawk, opened the door to a “skip” in the rate hike cycle in a May 24 speech. He concluded:

I do not expect the data coming in over the next couple of months will make it clear that we have reached the terminal rate. And I do not support stopping rate hikes unless we get clear evidence that inflation is moving down towards our 2 percent objective. But whether we should hike or skip at the June meeting will depend on how the data come in over the next three weeks.

On the other hand, Governor Philip Jefferson, who’s nominated to be Vice Chair and whose views are closer to those of Fed Chair Jerome Powell, said in a separate speech that that hinted at the idea of skipping a rate increase.

A decision to hold our policy rate constant at a coming meeting should not be interpreted to mean that we have reached the peak rate for this cycle. Indeed, skipping a rate hike at a coming meeting would allow the Committee to see more data before making decisions about the extent of additional policy firming.

Arguably, the progress toward lower inflation has been “unacceptably slow”. The April PCE print showed an unwelcome upward surprise in core PCE. In particular, the closely watched super-core PCE, which measures services ex-food and energy and housing, saw the strongest uptick since the start of 2023.

All eyes on the labor market

What will the Fed do? Fed Chair Jerome Powell has acknowledged that goods inflation has been falling, but services inflation remains stubbornly high. He has repeatedly focused on services ex-food, energy and shelter, or “super-core” inflation, as a key metric to watch.

The main component of “super-core” is labor compensation, which means that the Fed will be intensely focused on the jobs market. Two key reports released last week gave updates on the state of the U.S. labor market.
The April Job Openings and Labor Turnover Survey (JOLTS) showed that job openings rose, which is a sign of a resilient labor market. The job openings to hires (blue line) edged up, indicating there were more jobs than applicants, and voluntary quits to layoffs rose (red line). The latter indicator has shown itself to be a noisy but useful leading indicator of the jobs market. While the latest April reading indicated strength, it has been trending downward as a signal of impending labor market weakness.
The May Jobs Report, on the other hand, was a bit of a head scratcher as the report contained good news for both doves and hawks. Headline nonfarm payroll blew past expectations of 180,000–339,000 jobs. The April figure was revised up from 253,000 to 294,000. These figures point to a strong jobs market.
On the other hand, the unemployment rate rose from 3.4% to 3.7%. In addition, MoM average hourly earnings missed expectations at 0.3% and April was revised down from 0.5% to 0.4%, which indicate a weak labor market. As well, average weekly hours fell from 34.4 to 34.3 as a signal of economic weakness.

More crucially, the average hourly earnings of non-supervisory workers, which is less noisy as it excludes the bonuses of managerial workers, showed an unwelcome acceleration.

Notwithstanding the results of the May Jobs Report, the Atlanta Fed’s Wage Growth tracker, which measures median wage growth rather than average hourly earnings, has shown an unwelcome level of stickiness at 6.1%.

As a consequence, Fed Funds futures are now expecting a pause at the June FOMC meeting, followed by a quarter-point rate hike at the July meeting and rate cuts that begin in November.

What’s the Fed’s reaction function?

At the end of the day, making a call on Fed policy is a call on the Fed’s reaction function.

In the short run, the Powell Fed has shown itself to hate surprising markets. Fed Governor and nominated Vice-Chair Philip Jefferson’s speech of a hint at a June pause cemented expectations that rates would stay steady at the June meeting. But incoming data pushed expectations of a quarter-point hike out to July. If the consensus on the FOMC were to shift to a June rate hike, watch for Fed officials to give speeches to guide expectations in that direction.
In the longer run, the Fed tightening cycle has two phases. The first is to raise nominal rates to a level that real rates become positive. That phase has largely been accomplished. The second phase depends on rising real rates. The combination of steady nominal rates and cooling inflation is expected to do most of the heavy lifting to tighten monetary policy. If inflation doesn’t cool, nominal rates will have to rise further.
The JOLTS report hasn’t been helpful as a sign that super-core inflation is cooling. The job openings to hires ratio ticked up, and so did the quits to layoffs ratio. The unexpected acceleration in the hourly earnings of non-supervisory workers also did not help matters. The Atlanta Fed’s wage growth tracker is showing stickiness in wage growth. All these signs point to a labor market that remains extremely tight.
While monthly annualized inflation data can be noisy, May monthly core PCE (blue bars) and the Dallas Fed trimmed mean PCE (red bars) — both tell the story of an unexpected upside inflation surprise. While inflation has generally been trending down, the current episode is reminiscent of the December–January period when core PCE rose for two consecutive months before resuming its decline.
In conclusion, the Fed remains data dependent. Incoming data indicates a further quarter-point rate hike in the near future, either at the June or July FOMC meeting. Further rate hikes may be necessary to contain inflation and the Fed is not afraid to cause a recession in pursuit of its price stability mandate. In fact, the FOMC minutes indicate that Fed staff is forecasting a recession to begin in Q4 2023.

All else being equal, further Fed rate hikes will put a bid under the USD, which tends to be negative for risk assets such as equities. In the short run, a negative divergence has been growing between the greenback and the S&P 500. In all likelihood this will create a headwind for equity prices.

We have a debt ceiling deal, where’s the relief rally?

Posted by Cam Hui -
Mid-week market update: Is this a case of buy the rumor and sell the news? We’ve had the news of a debt ceiling deal and it appears that the bill will have enough votes to pass the House today. But where’s the relief rally?
The S&P 500 continues to struggle with resistance at the 4180-4200 level. A decisive upside breakout would see the next resistance at 4300-4310, but the relief rally seems to be fizzling,
All is not lost for the bulls. Hedge fund position is bullish. Systematic hedge funds have been buying and there is room for positions to rise should a FOMO stampede develop. Discretionary hedge funds are very short and they may be forced to cover should stock prices advance.
The relative performance of defensive sectors is extremely weak, indicating that bulls still have control of the tape.
As well, regional banks have stabilized at a relative support level. That’s one tail-risk off the table.

Bear case

On the other hand, breadth is extremely weak. Even as the S&P 500 rose to a new recovery high, the equal-weighted S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 are all weak.
When the debt ceiling bill becomes law, expect Treasury to replenish the levels of the Treasury General Account (TGA), which is the checking account held at the Fed. At last report, TGA was a minuscule $62 billion. This will drain liquidity from the financial markets and create headwinds for the price of risk assets like stocks.
If history is any guide, TGA levels always rebound after an increase in the debt ceiling. The magnitude of increase depends on the magnitude of the drawdowns leading up to the event. As current TGA levels are extremely low, expect TGA to rise significantly in the near future.
Before the bears become overly excited, be aware that bad breadth cuts both ways. The percentage of S&P 500 stocks above their 20 dma and the NYSE McClellan Oscillator are all nearing oversold levels. This suggest that the immediate downside support can be found at the 50 dma of the S&P 500, which is about the 4100 area.
In other words, don’t expect the market to crash from these levels.

Don’t learn the wrong lesson from 2011

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
  • Trend Model signal: Neutral
  • Trading model: Neutral

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 History Lesson from 2011

The last time the U.S. faced a serious debt ceiling impasse was 2011. The S&P 500 skidded -8.2% in the weeks leading up to x-date, or the estimated day that the U.S. Treasury would run out of funds. Both sides came to an agreement two days before x-date, and the market fell further after the deal.

 

While history doesn’t repeat itself but rhymes, we fear that some analysts have learned the wrong lesson from 2011. The post-deal market weakness was mainly attributable to the Greek Crisis in which the very existence of the euro currency was threatened. It’s unclear how much of that sell-off can be traced to a “buy the rumour, sell the news” reaction to a debt ceiling deal.

 

 

This time is indeed different. Here’s why.

 

 

What’s different

Here is what’s different this time compared to 2011. In 2011, the eurozone was experiencing an existential crisis. Today, the Euro STOXX 50 has staged a relative breakout and most European markets have also done the same.

 

 

As well, the Fed and the U.S. Treasury now have contingency plans in place to stabilize markets in the event of a default (see How the market could break up to a blow-off top). While a default will still be disruptive, it may not immediately turn out to be like falling off a cliff, but taking a significant stumble.

 

 

What’s the same

Here’s what’s the same as 2011. Sentiment readings are very similar. Institutional risk appetite, as measured by the monthly BoA Global Fund Manager Survey, is very similar to the levels seen during the 2011 Greek Crisis. 

 

 

Retail sentiment, as measured by the weekly AAII survey, shows a slightly greater level of net bullishness, but otherwise conditions are broadly similar.

 

 

If U.S. lawmakers step back from the brink, the Treasury Department’s response to the lifting of the debt ceiling should be the same. Expect Treasury to flood the market with paper, which would drain liquidity from the financial system. Historically, equity prices have been correlated with liquidity conditions.

 

 

In the event the debt ceiling is raised, Treasury is expected to issue a flood of new paper. In addition, it will reverse the drawdown of the Treasury General Account (TGA), which is its account held at the Fed. Both measures will have the effect of reducing liquidity.

 

 

In conclusion, I continue to be surprised by how well stock prices have held up in the face of the combination of a banking crisis and U.S. default fears, suggesting that market participants are too bearish, which is contrarian bullish.  A definitive breach of S&P 500 resistance at 4180-4200 could see the index surge to the next resistance level at 4300-4310.

 

 

A study of the last debt ceiling crisis in 2011 leads me to believe that, in the event of a default, risky asset prices will initially crater in a disorderly fashion but stabilize soon afterward. Should the White House and Republican lawmakers come to a debt ceiling deal, expect a reflex risk-on rally, followed by a decline as liquidity conditions create headwinds for stock prices.

 

Back to a focus on technicals

Posted by Cam Hui -
 As at the time of writing, the White House and the Republican-led House haven’t come to a debt ceiling deal yet, though both sides are getting closer to a deal. But you only die once, and focusing on the fear of a catastrophe isn’t very useful. Hedging only works if there is someone you can collect from on your hedge, and obsessing over a U.S. default only gets you so far. Instead, I will focus on getting back to the technical structure of the market by assuming that all parties agree to step back from the brink.

 

From a longer-term perspective, the narrow leadership of the S&P 500 is disturbing. Remember Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names”. As the S&P 500 tests its 50 dma, the equal-weighted S&P 500, the mid-cap S&P 400 and the small-cap Russell 2000 have already violated their 50 dma.

 

 

How much does bad breadth matter?

 

 

The bull case

With apologies to Bob Farrell, narrow leadership may not really matter all that much. Dean Christians of Sundial Capital documented past instances of narrow leadership, and the stock market didn’t fall apart in those cases.

 

 

Still, there are good fundamental reasons for the boom in large-cap tech, namely Artificial Intelligence (AI). AI has the potential to disrupt the way we work, and it could be just as disruptive as the internet was in the 1990s.

 

 

During the internet bubble, the shares prices of companies like Cisco and Oracle soared because they supplied the backbone of the internet. Today, NVDIA could be the Cisco and Oracle of the AI era. This Bloomberg podcast with Bernstein semiconductor analyst Stacy Rasgon explains NVDIA’s competitive position, which I summarize below.

 

NVDIA specializes in the production of Graphics Processing Units (GPUs). GPUs are powerful parallel processors capable of making large-scale calculations of mathematical matrices for linear algebra applications. To explain linear algebra, recall the problem of solving simultaneous equations back in high school. A typical example might be the following set, where you are asked to solve for x and y:

 

3x + y = 16
x – y = 0

 

Without going into a lot of detail, the solution is x=4 and y=4. This example involves two variables and two equations. To find a solution for a set of simultaneous equations of n variables, you need n equations (in most cases). GPUs happen to be very good at doing those kinds of matrix calculations. Initially, GPUs were used mainly for graphics applications in computer gaming. Instead of two variables and two equations, imagine thousands of data points, each representing a pixel, that need to be refreshed quickly. That was how NVIDIA made its mark.

 

Researchers went on to discover that GPUs are also useful for AI applications in computing repeated very large matrix calculations. That was the second stage of NVIDIA’s growth path. In addition to supplying high-performance GPUs, NVIDIA also created a suite of software applications to make it easier for users to make matrix calculations. That became NVIDIA’s competitive advantage, giving it a technological lead over its competitors.

 

If you understand and buy into the disruptive nature of AI, you understand the parallels of NVIDIA with the Ciscos and Oracles of the internet craze of the 1990s. To reinforce our point, NVIDIA’s blowout earnings report cements its status as the new AI darling.

 

 

 

The bear case

Here is the bear case. Every market cycle has its manias. The tricky question is how far each bubble inflates before it pops. Jurrien Timmer at Fidelity documented how the gap between the trailing P/E ratio of the top 50 stocks and the bottom 450 of the S&P 500 is only exceeded by the Nifty Fifty era and the NASDAQ Bubble. This doesn’t mean that valuations can’t become more extended, only that they are becoming very stretched.

 

 

An analysis of the rest of the market reveals some troubling signs of a cyclical downturn. The relative performance of cyclical industries are all in relative downtrends, with the exception of homebuilding. From a bottom-up perspective, the market is telling a story of an imminent economic downturn or recession, which is an environment that’s not friendly to equity returns.

 

 

A similar chart of global risk appetite comes to a similar conclusion of negative divergences. Cyclical commodity indicators such as the copper/gold and base metals/gold ratios are falling, while the relative performance of global consumer discretionary to consumer staples are flat to down. By contrast, the stock/bond ratio is rising.

 

 

Moreover, Ed Clissold of NDR pointed out that the investment environment has changed from TINA (There Is No Alternative to stocks) to TARA (There Are Reasonable Alternatives) as the yields on fixed income instruments are becoming more compelling.

 

 

In conclusion, the White House and the Republican-led House haven’t come to a debt ceiling deal as at the time of writing. Assuming that both sides come to some sort of accommodation, a review of the market’s technical structure reveals serious negative divergences characterized by bubbly narrow leadership and weakening cyclical indicators. While this doesn’t mean that the stock market is about to crash, it does indicate that investors should be prepared for reduced long-term return expectations from U.S. equities.

 

Ignore the noise and focus on the main event

Posted by Cam Hui -

Mid-week market update: Have you ever seen any technician publish the short-term analysis of the stock market just before a key event with a binary outcome, such as an FOMC decision, NFP report, or CPI report? How much confidence would you place in such a forecast?
 

As we await the outcome of the debt ceiling negotiations in Washington, the market is left to guessing the direction of stock prices. Analysts wind up focusing on indicators that have little or no value, such as the size of (former) Fed Chair Alan Greenspan’s briefcase. While negotiations are at an apparent impasse, we are left to guessing how much of the statements from each side is real and how much is bluff., or even the exact timing of X-date, or the day the U.S. Treasury runs out of money It’s highly likely a deal will be reached and the U.S. will not default on its debts, at this point it’s all noise as the S&P 500 remains in a trading band.

 

 

While we don’t know whether there will be a deal, some analysis of sentiment can yield some clues as to the degree of market reaction once the results of the binary event is known.

 

 

How short is the market?

I have seen sentiment analysis indicating that market participants are very short the equity market, which is contrarian bullish. While negotiations not strictly true.

 

To be sure, the TD Ameritrade Investor Movement Index, which measures the aggregate positioning of Td Ameritrade’s retail clients. They are very cautious by historical standards.

 

 

Hedge funds are a different matter. Discretionary HFs are very short the market, but systematic funds,  which are mostly trend following CTAs, are net long and have room to buy more. 

 

 

Aggregate put option open interest is highest since 2011, the date of the last debt ceiling crisis, indicating high levels of fear.

 

 

At the same time, regional banking stocks, which was at the epicenter of the last market crisis, have begun to stabilize and turn up.

 

 

I interpret these conditions as a bullish setup. Should we see a debt ceiling deal, which is highly likely, stock prices have the potential to rocket upwards on such an outcome. A debt default would obviously be catastrophic for the global system, but sentiment indicator may serve to put a soft floor on stock prices should a debt ceiling deal fail to materialize.

 

 

European bull of 2023 = FANG bull of 2008?

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
  • Trend Model signal: Neutral
  • Trading model: Neutral

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.

 

 

Dissecting the sources of European strength

As investors wait for the resolution of the debt ceiling talks, I would like to pivot away from the U.S. market and focus on the sources of underlying European strength. As regular readers are aware, we have been bullish on European equities for some time (see The market leaders hiding in plain sight).
 

Here is the major reason we are bullish. The Euro STOXX 50 staged a relative breakout from a long base in early 2023. France has been the leader among the major core and peripheral European countries, along with Italy and Greece. However, Germany has been the laggard, testing a key relative resistance level.

 

 

I analyzed the sources of European equity strength and show why the latest move is sustainable. The possibility exists that this could be the start of a major bull leg in Europe, much like how the U.S. FANGs led global markets in 2008.
 

 

Emerging leadership

One surprising source of European strength has been financial stocks. European financials have been on a tear relative to U.S. financials (top panel). This doesn’t mean that they were immune to banking crisis fears. It’s just that European financials managed to hold a key relative support zone, while U.S. financials, and U.S. regional banks in particular, weakened.
 

 

 

The relative strength of this sector compared to the U.S. has resulted in strong relative performance of markets with high bank weights such as Italy and Greece.
 

The other strong market in Europe is France. Looking beneath the hood, it is the luxury goods companies that have led French equities upward. Shares of companies like Hermès and LVMH have risen strongly, thanks to spending by the high-end Chinese consumer. Here is Hermès, which has outperformed global consumer discretionary stocks and the MSCI All-Country World Index (ACWI).

 

 

LVMH has a similar technical pattern.

 

 

I interpret these technical patterns as the market signaling a cyclical recovery from a downturn in Europe, while the U.S. slips into recession.
 

 

Special cases to watch

Here are two special cases that investors should watch. Poland has been a major staging ground for Western aid to Ukraine since the start of the Russo-Ukraine War. MSCI Poland recently rallied to a new recovery high and it has been performing well against both Euro STOXX 50 and ACWI. This is a bullish indication of fading geopolitical risk premium and possibly in anticipation of a successful Ukrainian counter-offensive this spring and summer.
 

 

 

No discussion of Europe is incomplete with the U.K. History shows that the relative performance of large-cap U.K. stocks was highly correlated to the relative performance of energy stocks, mainly because of the significant weights of energy in the large-cap U.K. index. The two began to decouple in 2021 and seriously bifurcate in early 2022, reflecting increasing nervousness over the British economy. This was confirmed by the relative underperformance of U.K. small-cap stocks that began in late 2021.
 

More recently, energy stocks lagged ACWI in 2023 while U.K. large-caps were flat. As well, small-cap relative performance has bottomed against large caps. This is may be an early sign that the U.K. market is bottoming and this is a bullish set-up, though not an actual buy signal, for U.K. equities.
 

 

 

The strength in the UK economy is coming from a surprising source. The Economist featured an article highlighting the outperformance of the British service sector, while its goods sector lagged.

 

 

In conclusion, European stocks staged a relative upside breakout against global stocks from multi-year bases, which makes us bullish on the region. An analysis of the region shows that different sources of underlying strength are sustainable into the future. The possibility exists that this could be the start of a major bull leg in Europe, much like how the U.S. FANGs led global markets in 2008.

 

How the G7 meeting exposes the risks for 2024

Posted by Cam Hui -
Two weeks ago I highlighted how history shows that the stock market only bottomed after recessions have begun (see How to spot the stock market bottom) and a recession is likely on the way in H2 2023. If that is the case, U.S. equities should bottom at some point this year and a recovery should be in full swing by 2024. 

 

 

However, the agenda of G7 Summit in Hiroshima highlights the geopolitical risks to the 2024 recovery and the threat to global growth in 2024 and beyond.
 

 

 

 

 

The G7 summit agenda

The G7 leaders of Canada, France, Germany, Italy, Japan, the U.K. and the U.S. will be meeting in Hiroshima, Japan on May 19–21. The White House issued a statement that said the agenda will be the war in Ukraine, global food and climate crises, and “securing inclusive and resilient economic growth”. They will also discuss how they can “deepen their cooperation on critical and emerging technologies, high-quality infrastructure, global health, climate change, maritime domain awareness, and other issues.”
 

 

In particular, the Russo-Ukraine war will be a focus of the summit. As the meeting is in Asia, there will undoubtedly be discussions on the geopolitics of managing the relationship with China. The summit communique is expected to address the problem of “Chinese economic coercion”. After the G7, President Joe Biden was scheduled to fly to Australia for a meeting of the Quad, consisting of Australia, India, Japan, and the U.S., which is an informal group focused on regional security but structured as a bulwark against China’s military ambitions in Asia and the Pacific. But Biden was forced to cut short his trip and skip the Quad meeting and return to Washington to focus on the debt ceiling crisis. Nevertheless, the point is clear. China’s adversarial relationship with the West is coming into focus and it will increasingly be a focus for America and her allies.
 

 

Keep in mind that the U.S. will hold an election in 2024. Both sides of the aisle agree that China is an adversary and Sino-American relations are becoming more and more chilly. The recent balloon incident is just one of many sources of friction. Directly unrelated to America, Canada recently expelled a Chinese diplomat for interference in the Canadian political process and China expelled a Canadian diplomat in a tit-for-tat retaliation. Both Democrats and Republicans will be positioning themselves on how tough they are on China, and sanctions such as the restrictions on the export of high-end semiconductors are likely to increase in the coming year.
 

 

To be sure, investors were encouraged when U.S. National Advisor Jake Sullivan met with senior Chinese diplomat Wang Yi in Vienna to try and defuse tensions. Chinese official media Global Times described the dialogue as “candid, in-depth, substantive and constructive”. The good news is the lines of communication are still open. The bad news is the U.S. is headed into a political cycle next year that’s potentially toxic for the Sino-American relationship.
 

 

From Trade War to Cold War 2.0?

U.S. National Security Advisor Jake Sullivan recently made a speech at the Brookings Institute outlining the Biden Administration’s international economic agenda (link to full transcript). Here are some of the key points he made with respect to American policy on China.

  • The U.S. has a robust trade relationship with China. We are not looking for confrontation. We need mature and open lines of communication even as we compete.
  • The U.S. is not trying to constrain China’s growth. Its development and that of others is good for the world and stability. But, and this is a big “but”, the U.S. is protecting its critical technologies and its allies are doing the same with targeted measures.
  • The U.S. is converging with Europe on derisking but not decoupling.

This is all high-sounding rhetoric, but this is a dual strategy of the combination of a de facto technological blockade of China for national security reasons while trying to reap the benefits of low-tech trade such as the exports of agricultural products and basic materials. In other words, it will be a Cold War 2.0 but not the Soviet-style détente kind of Cold War, but an active effort to confront China in a variety of dimensions.

 

To reinforce my point, U.S. Treasury Secretary Janet Yellen prioritized national security concerns over economic relationships with China in a speech on April 20, 2024.

We will secure our national security interests and those of our allies and partners, and we will protect human rights. We will clearly communicate to the PRC our concerns about its behavior. And we will not hesitate to defend our vital interests…We will not compromise on these concerns, even when they force trade-offs with our economic interests.

Tensions are rising. The EU has also proposed imposing sanctions on a number of Chinese companies selling dual-use goods to Russia that can be used for both civilian and military purposes. Viewed in such a context, the implicit message from scheduling a meeting of the Quad after the G7 summit takes on a heightened level of importance.

 

The Cold War 2.0 animosity isn’t just one-sided. The Economist documented how the release of a new “Top Gun” style film in China called Born to Fly has demonized America and normalized the idea of war with the U.S. The plot line focuses on a brash young test pilot in a group of test pilots that’s reminiscent of the American Top Gun films. Because the technological blockade of the West has left China’s military severely handicapped, the test pilots’ task is to test China’s latest generation of fighter jets in order to catch up with an unnamed and aggressive adversary, which is clearly the U.S. in the film. While Born to Fly depicts a China that’s under siege, a similar jingoistic and militaristic film released in 2017, Wolf Warrior 2, painted a very different picture of an internationalist China that’s respectful of international norms. The plot of the 2017 film involves a Chinese commando who rescues Chinese medical workers and civilians from a civil conflict in an unknown African country. In a key scene, a Chinese warship is itching to fire missiles against the villains but was forced to wait for clearance from the UNSC before it could fire.

 

As well, China’s new anti-spy campaign that caught a number of foreign consulting firms in its national security dragnet must have had a chilling effect on Western firms doing business in China. The Beijing government last month passed a new counter-espionage law that expanded the list of activities that could be considered spying. The recent life sentence handed to a 78-year-old American citizen living in Hong Kong for spying is certain to be another irritant between the two countries.
 

 

The Trump Administration imposed a series of tariffs on China. When Biden occupied the White House, most of the tariffs have remained in place. Now Biden has gone further to restrict the export of key technologies to China. The Sino-American relationship has deteriorated from a simple trade war to a sanctions war. An election is coming in 2024. Both Democrats and Republicans generally agree that China is more of an adversary than a trade partner. At worst, more sanctions or over-eagerness by U.S. lawmakers to demonstrate support for Taiwan will encourage the decoupling of China from the global economy, the near-shoring of production and the formation of two distinct trade blocs in the world.

 

Stephen Roach, in a Project Syndicate essay, outlined what he believes to be “The Economic Costs of America’s Conflict’ with China”. Roach highlighted an IMF study which “estimates that the formation of a U.S. bloc and a China bloc could reduce global output by as much as 2% over the longer term” and “America will account for a significant share of foregone output”. Roach also pointed out the results of an ECB study which concluded that “geostrategic conflict could boost inflation by as much as 5% in the short run and around 1% over the longer term. Collateral effects on monetary policy and financial stability would follow”.

 

In other words, stagflation.
 

 

Investment implications

The decoupling scenario that I have outlined is highly speculative and difficult to chart without knowing the level of friction that may exist between China and the West, as well as the degree of retaliation each side may undertake. Also, the timing of any sanctions or counter-sanctions is impossible to predict this early in the political cycle. It’s entirely possible that while the effects of Cold War 2.0 come into view in 2024 the effects aren’t felt until 2025 and beyond.

 

That said, the current picture of global market leadership shows European equities in the lead, while Asia and emerging markets are trading sideways with global stocks, and the U.S. is showing signs that it is starting to roll over on a relative basis.
 

 

 

How might the decoupling of the world into China and U.S. trade blocs and the stagflation scenario play out? While it’s difficult to predict specifics, here are some milestones to watch for:

  • New leadership from emerging market countries, especially commodity-producing countries that China pivots to for inputs, such as Brazil and Indonesia.
  • A loss of European equity leadership. China is a very large customer of European exports, Germany in particular.

 

 

 

Watch for a possible repeat of the stagflation 1970s in U.S. equities. U.S. stocks traded sideways in a broad trading range for that decade and dismal bond market returns owing to inflationary pressures. The valuation of the S&P 500 is elevated and Shiller CAPE modeled 10-year return is about 5%. With the 10-year Treasury yield at about 3.5%, the equity risk premium is a miniscule 1.5%, which is hardly enough for investors to assume equity risk.

 

 

 
What are the chances of a Cold War 2.0 scenario? It’s far too early to guess at this point, but the political backdrop in Washington suggests that the odds will rise in 2024.
 

 

Here is what I am watching for signs of decoupling and Chinese retaliation to any U.S. measures. FDI into China has collapsed. Is this the start of a trend or a temporary aberration?

 

 

How will U.S. soybean prices react, especially if China shifts demand to Brazil? Remember the depressed level of soybean prices during the Trump trade war era?
 

 

 

 
As well, keep an eye on rare earth mining stocks. As much of the rare earths are sourced from China, the imposition of Chinese export controls would have a chilling effect on the semiconductor industry, among others, and crater global trade. It would also set off a scramble for rare earth mining capacity outside of China. Don’t forget to disentangle the returns of rare earth mining stocks from the global materials sector, which is currently in a relative downtrend (bottom panel).

 

 

 

In conclusion, the agenda of the G7 and the subsequent but cancelled meeting of the Quad in Australia highlight the rising risk of a new Cold War 2.0 that decouples China from the West. Tensions are likely to rise in 2024 as U.S. electoral politics will encourage both sides to show how tough they are on China. Under such a scenario, the global economy would be split into a China bloc and a U.S. bloc that resolves in global stagflation, with the U.S. bearing the brunt of the growth reduction.

 

Being bearish is too obvious

Posted by Cam Hui -
Mid-week market update: I am publishing this before the market close on Wednesday because I have an appointment just before the close so many of the charts won’t have Wednesday’s closing prices. The market structure continues to be bearish, and I continue to believe that the intermediate-term trend is down. Nevertheless, it’s too obvious to be bearish, so I’m resisting that urge.

 

Case in point. Market breadth looks terrible. Even as the S&P 500 remains in a narrow trading range, there are negative divergences everywhere I look.

 

Bespoke pointed out that leadership has become so narrow that the market capitalization of Apple now exceeds the entire market cap of the Russell 2000.

 

 

Callum Thomas reported that the latest S&P Global survey of U.S. managers shows excessive levels of cautiousness. He went on to observe that, if history is any guide, these readings should not be interpreted in a contrarian fashion.

 

 

For what it’s worth, the latest BAML Global Fund Manager Survey shows a similar level of risk aversion.

 

 

 

What’s the pain trade?

Technical conditions argue for cautious positioning, which I agree with on an intermediate-term basis. The key question for investors is, “If the bear case is so obvious, why aren’t stock prices falling?”

 

That’s because the pain trade is up, at least in the short run. Here’s why.

 

The principal fears that overhang the market are the banking crisis and the debt ceiling impasse. In case you hadn’t noticed, regional banking stocks are finally stabilizing. The KBW Regional Banking Index found some footing at long-term relative support (bottom panel).

 

 

The short-term chart also shows that the index is finding support and attempting to turn up.

 

 

With all the bad news, you would think that insiders would be selling. Instead, we are seeing signs of sporadic net insider buying (blue line above red line). This group of “smart investors” have been tactically prescient in the past year in timing short-term bottoms.

 

 

 
Much of the bad news is already in. To be bearish, traders would be betting on the Apocalypse. As for the debt ceiling negotiations, we are in the “trade talks are going very well” phase of waiting for market news. Treasury Secretary Janet Yellen recently reaffirmed her previous estimate of X-Date, the day that the government cannot meet all of its financial obligations, to be as early as June 1. In all likelihood, Washington lawmakers will come to an agreement before the deadline and spark a relief rally in the S&P 500.

 

My inner trader continues to be bullishly positioned anticipation of the relief rally. The usual disclaimers apply to my trading positions.

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

 

 

Disclosure: Long SPXL

 

How the market could break up to a blow-off top

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
  • Trend Model signal: Neutral
  • Trading model: Bullish

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 tight trading range

The S&P 500 has been mired in two trading ranges for several weeks. The smaller range is defined by 4050–4180 (grey zone), and the larger one is defined by 3800–4180. Neither the bulls nor the bears have been able to break through.

 

 

I outlined the intermediate-term bearish market structure exhibited by the market last week and U stand by those remarks (see What market structure tells us about where we are in the cycle). While this is not my base case, I am starting to warm to the scenario of an upside breakout to a blow-off top, followed by a market collapse soon afterwards. As they say, don’t short a dull market.
 

 

Reasons to be bullish

The most compelling reason to be bullish is the behavior of corporate insiders. This group of “smart investors” has been timely at spotting tactical market bottoms in the past year, and net insider buying surprisingly appeared last week.
 

 

I interpret this to mean that, barring an unexpected negative surprise, downside risk in stocks is limited and risk/reward is skewed to the upside. 

 

What’s more the Citi Panic/Euphoria Model is back in the panic zone. While this model is not useful for short-term trades, it nevertheless highlights the burden that the bears face.
 

 

In addition, market fears of a regional banking meltdown is spiking. While there is no apparent fundamental resolution of those fears on the horizon, the tactical good news is the KRW Regional Banking Index is falling while exhibiting a positive RSI divergence, which is constructive.
 

 

Looking beneath the hood, seasonally adjusted deposits at small banks have stabilized after the Silicon Valley Bank debacle. The downward pressure on regional banking shares is fear based and not fundamentally driven.
 

 

 

The debt ceiling game of chicken

What could spark a buying stampede? How about a debt ceiling deal or a limited fallout from a Treasury default?

 

Washington politicians will undoubtedly posture for the cameras and reach a deal to raise the debt ceiling just before X-date, or the projected day that the U.S. government runs out of money. Nate Silver, writing in the NY Times on January 30, 2023, revealed that Republican voters care more about cultural issues like Dr. Seuss than fiscal matters like the budget, which is an indirect indication of how much political capital Republican lawmakers are willing to expend in the debt ceiling fight:
In early March 2021, a Morning Consult/Politico poll found that nearly half of Republicans said they had heard “a lot” about the news that the Seuss estate had decided to stop selling six books it deemed had offensive imagery. That was a bigger share than had heard a lot about the $1.9 trillion dollar stimulus package enacted into law that very week.

 

The result was a vivid marker of how much the Republican Party had changed over the Trump era. Just a dozen years earlier, a much smaller stimulus package sparked the Tea Party movement that helped propel Republicans to a landslide victory in the 2010 midterm election. But in 2021 the right was so consumed by the purported cancellation of Dr. Seuss that it could barely muster any outrage about big government spending.
Both the Republicans and the White House are still talking and staff is working out the details of different proposals. In all likelihood, we will see a last-minute deal.

 

 

Unspeakable default?

What if there is no deal and the U.S. government defaults?

 

I am indebted to former New York Fed trader Joseph Wang who writes under the name, “the Fed Guy”. Wang published the details of a contingency plan hatched in 2021 by the Fed and Treasury in case of a debt-ceiling default. The plan was pieced together from past FOMC transcripts and Congressional subpoenas. Despite statements that software systems are not set up to prioritize payments to different parties, Wang concluded that Treasury is prepared to prioritize:

Treasury will make noises to scare Congress into action, but it understands the importance of avoiding default and will prioritize debt payments once it runs out of headroom. Prioritization can support the Treasury market indefinitely, and even if that support is withdrawn the Fed stands ready to act as dealer of last resort.

Wang explained:

When Treasury reaches the ceiling limit and also runs out of accounting tricks, then it will not have enough money to meet all its obligations. But it will still have enough money to meet some of the obligations. Prior Administrations have claimed technical impossibility or illegality in prioritizing payments, but that was largely to exert political pressure on Congress. A 2016 Congressional report (h/t @AnalystDC) reveals the Obama Administration was working with the NY Fed to prioritize debt payments and social security payments during the 2013 debt ceiling episode. This is essentially a compromise that maintains pressure on Congress while limiting the potentially significant financial and humanitarian costs. The same policy choice will very likely be made this time around.

Payment prioritization would also raise the level of pressure on lawmakers without significantly denting the economy in the short term.

 

The biggest losers of prioritization are those who usually receive large government expenditures: the medical and defense industry. Both of which are well funded industries that can handle a liquidity squeeze (and send lobbyists to hasten Congressional action).

Some analysts have raised the risk that financial clearinghouses such as futures exchanges who ask for the deposit of T-Bills as margin collateral may struggle with holding defaulted Treasury securities. Consequently, they may raise margin requirements and spark a credit crunch cascade. Wang has an answer for that eventuality:

The Fed has the tools and motivation to backstop any Treasury market dislocation. When the Treasury market liquidity disappeared last March, the Fed cranked up the printers and bought $1 trillion of Treasuries over just 3 weeks. In the same way, FOMC transcripts show the Fed is prepared to 1) provide liquidity against defaulted Treasuries in its repo operations, 2) offer to swap out defaulted Treasuries for “clean” Treasuries with its securities lending program, and 3) and fire up the printers to purchase defaulted Treasuries outright. At the end of the day the Treasury market will be strongly supported as it was last March. The Fed will be the Treasury dealer of last resort.

Do you feel better now? The Fed and Treasury have the market’s back. A debt ceiling breach won’t be a catastrophe.
To be sure, these measures by Treasury and the Fed are the technical equivalent of going nuclear, which institutions would like to avoid. It may not come to that, even if there is no last-minute deal.

 

There are other steps the Administration could take. For example, President Joe Biden revealed that there has been some tentative consideration of invoking the 14th Amendment, even without a debt ceiling hike. Section 4 of the 14th Amendment states: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.” In other words, any law, such as debt ceiling legislation, is unconstitutional because it can force a government default.

 

There are other gimmicky backstops, such as legislation that allows the Treasury to mint a$1-trillion platinum coin and deposit it at the Fed.
 

Reuters reported that “U.S. equity funds faced outflows worth $5.7 billion, which was their seventh consecutive week of outflows” and the sales were attributable to jitters over the debt ceiling. The stock market has been trading in a tight range for the last seven weeks. If that’s the worst that debt ceiling fears can do to stock prices, what happens if both sides come to an agreement?
 

 

 

 

Debt ceiling aftermath

After all the growing angst that’s in the market over the debt ceiling, any development that sidesteps all the worst effects of going over the debt ceiling cliff, such as a last-minute deal, constitutional workaround, or Fed and Treasury contingency plans to stabilize markets, would be welcome by the markets with a risk-on FOMO buying stampede. That’s how a blow-off top might happen.

 

What would happen next? I already outlined the bearish nature of market structure last week. In addition, raising the debt ceiling would have a perverse effect of draining liquidity from the financial system, which would be bearish for risk assets. When it became evident that the ceiling was about to be breached, Treasury resorted to extraordinary measures and accounting tricks to pay the bills and keep government running. Accounting tricks include deferring the payment of funds into government employee pension plans and drawing down the Treasury General Account (TGA), which is the equivalent of the “bank account” that Treasury has at the Fed. When the government disburses funds from TGA, it has the effect of injecting funds into the financial system, which increases liquidity. When the debt ceiling is raised, TGA balances are raised and the process goes into reverse. Liquidity is drained, which creates headwinds for the price of risk assets.

 

 

If the stock market were to melt-up, the loss of liquidity could be the catalyst for a meltdown.

 

In conclusion, I continue to believe the path of least resistance for stock prices in the intermediate term is down. However, the odds of an upside breakout and a blow-off top are rising, followed by a collapse in the stock market. I would estimate the chances of the breakout and melt-up scenario at about one in three.

 

My inner trader remains tactically long the S&P 500. The usual disclaimers apply to my trading positions:

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

 

 

Disclosure: Long SPXL

 

A pause isn’t a pivot

Posted by Cam Hui -

Now that the market has had over a week to absorb the implications of the last Fed rate decision and incoming data since the meeting, here is where we stand.
 

The Fed made an important change in its statement that hinted it was preparing to pause interest rate increases. Even though the Fed raised rates by 25 basis points at the May meeting, it made an important change in its language from the March meeting, which stated:

The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

The May meeting statement allowed for a pause in rate hikes, with the usual nod to data dependency.

The Committee will closely monitor incoming information and assess the implications for monetary policy. In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time,

Since the conclusion of the May meeting, the April Jobs Report came in mixed. While the headline increase in non-farm payroll employment was ahead of expectations, the figures for the previous two months were dramatically revised downward. The April CPI report came in slightly softer than expected. Headline YoY fell from 5.0% to 4.9%, which was below market expectations, while core CPI was unchanged from the previous month at 5.5%. As well, PPI came in softer than expected. Overall, inflation has been slowly decelerating. The target Fed Funds rate of 5.00–5.25% is now above the core PCE rate of 4.2%. Historically, the Fed has kept the Fed Funds rate above its preferred inflation metric of core PCE whenever inflation has been above its 2% target.
 

 

Is it time for a pause? Under what conditions would the Fed pivot to cutting rates?
 

 

How hawkish is the Fed?

Before everyone becomes overly excited about the prospect of a pause in rate hikes, the first question to consider is whether monetary policy is sufficiently restrictive. While some Fed speakers, such as Cleveland Fed President Loretta Mester, who is considered to be a hawk, has said that she considers the Fed to be sufficiently restrictive when the Fed Funds rate is above the inflation rate, Fed Chair Jerome Powell equivocated at the May post-FOMC press conference when asked if he considered the latest Fed Funds target is sufficiently restrictive.

That’s going to be an ongoing assessment. We’re going to need data to accumulate on that. Not an assessment that we’ve made that would mean we think we’ve reached that point. And I just think it’s not possible to say that with confidence now. But, nonetheless, you will know that the summary of economic projections from the March meeting showed that in – at that point in time, that the median participant thought that this was – this was the appropriate level of the ultimate high-level of rates. We don’t know that. We’ll revisit that at the June meeting. And that’s – you know, we’re just going to have to — before we really declare that, I think we’re going to have to see data accumulating and – and, you know, make that – as I mentioned, it’s an ongoing assessment.

On the other hand, Powell did allow that monetary policy is tight and he estimates inflation to be at 3% when the latest core PCE reading is 4.2% [emphasis added]:

I think that policy is tight. I think real rates are probably — that you can calculate in many different ways. But one way is to look at the nominal rate and then subtract a reasonable estimate of let’s say one-year inflation, which might be 3 percent. So you’ve got 2 percent real rates. That’s meaningfully above what most people would — many people, anyway, would assess, as, you know, the neutral rate.

(Did he say a reasonable estimate of one-year inflation is 3%?) The key question for investors is whether current conditions are sufficient for the Fed to pause. In addition, when does the pause turn into a pivot to lower rates? Fed Funds futures are now discounting rate pauses for the next two meetings, with a series of consecutive quarter-point cuts that begin at the September meeting.
 

 

 

Did the Fed break something?

Arguably, the only reason for the Fed to cut is a marked deterioration in economic growth and a possible recession. It is also said that the Fed usually keeps raising rates until something breaks. Did the Fed break something this cycle that the damage warrants a pivot to rate cuts?
 

The quarterly Senior Loan Officer Opinion Survey (SLOOS), which was released after the FOMC meeting, shows a heightened level of recession risk. Banks are tightening lending standards in a variety of categories for businesses and consumers, which is a signal of a credit crunch. Similar episodes have resolved in economic recessions in the past.
 

 

The performance of regional banking has become an increasing concern to the market. The KBW Regional Banking Index violated a key support zone and an important Fibonacci retracement level (top panel). The bulls’ only hope is the index can hold at a relative support level that stretches back to 2020 (bottom panel).
 

 

Moreover, commercial real estate could be an additional source of stress for regional banks, which have high levels of exposure to the sector. In particular, office real estate is a concern as many workers have not returned since the pandemic, and office space occupancy is down substantially. As an illustration, the accompanying chart shows the relative performance of three large office REITs relative to the S&P 500 and to the Vanguard REIT ETF. As the chart shows, office REITs not only have underperformed the S&P 500, they have also substantially lagged other REITs as well.
 

 

In addition, business inventories have historically been closely correlated with core PCE inflation. Dramatic declines in business inventories have been disinflationary, but such episodes have also coincided with recessions. Will the U.S. economy fall into recession this time?
 

 

 

Scenes from small business America

The monthly NFIB small business survey is useful because small businesses have little bargaining power and they are sensitive barometers of the U.S. economy. The results of the April survey broadly reflect our assessment of economic conditions.
 

First, small business confidence is collapsing. While researchers make seasonal adjustments to their data, NFIB does not make political adjustments to its Optimism Index as it tends to be higher during Republican Administrations and lower when a Democrat is in the White House. Nevertheless, the recent trend of falling confidence is instructive.
 

 

Small business employment is softening from red hot to just hot, which is consistent with what we are seeing in labor market surveys like JOLTS and NFP. This should be comforting to Fed officials as the jobs market is going in the right direction for them.
 

 

Good news and bad news: The good news is inflation is falling. The bad news is the closely waged services inflation component, which consists mainly of wages, is sticky. A comparison of the Prices and Employment readings shows that prices are falling faster than compensation. In other words, wages are sticky.
 

 

As well, credit conditions are deteriorating, which is consistent with the recent SLOOS report.

 

Putting this all together, we have a picture of decelerating inflation and slowing economic growth, but sticky wages that prevent the Fed from meaningfully easing unless there is a catastrophe.
 

Fed Chair Jerome Powell pushed back against that view at the May post-FOMC press conference: “We on the committee have a view that inflation is going to come down not so quickly, that it’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates and we won’t cut rates.”
 

In conclusion, the Fed may pause rate hikes, but it’s unlikely to ease until it’s too late and a crisis erupts. Expect a recession in H2 2023. Such an environment should be supportive of Treasury prices, but create headwinds for stock and commodity prices.
 

 

Still stuck in a trading range

Posted by Cam Hui -
Mid-week market update: The S&P 500 remains mired in a trading range, and neither the bulls nor the bears can gain the upper hand.

 

 

 

Here are the bullish and bearish reasons why the market can’t break out of that range.

 

 

Bull case

Part of the bull case rests on excessively bearish sentiment. The Barron’s Big Money survey of U.S. institutional investors shows a crowded short reading, which is contrarian bullish.

 

 

As well, consider hedge fund positioning. Discretionary funds (dark blue line) are also in a crowded short, but systematic (light green line) funds, which are mainly the trend followers, have been buying the market and they are roughly neutral. Any bullish catalyst could spark a FOMO buying stampede.

 

 

While excessively bearish sentiment can put a floor on stock prices, an unexpected bullish factor has appeared – insiders. Insiders have been tactically very good at timing short-term market bottoms in the past year, and the latest readings show net insider buying, which is a buy signal.
 

 

 

Bear case

I extensively discussed the intermediate-term bearish factors that overhang the stock market so I won’t repeat myself (see What market structure tells us about where we are in the cycle). All of the points that I made in my last publication are still valid.

 

In the short run, regional banking shares can’t seem to stabilize themselves, indicating that the slow motion banking crisis remains a problem in the eyes of investors. The KBW Regional Banking Index violated a long-term support zone, with no Fibonacci retracement support underneath the index. The only hope that bulls can hope for is the group holds relative support at the 2020 lows (bottom panel).

 

 

So where does that leave us?The market stuck in a tug-of-war between the bulls and bears with neither side gaining the upper hand. I believe that the odds are starting to favor an upside breakout of resistance at about 4180 in the coming weeks, sparked by a positive surprise such as a debt ceiling deal, followed by a blowout top and bearish collapse.

 

My inner investor is neutrally positioned at about the equity and bond weights specified by his investment policy statement. My inner trader is tactically long the S&P 500. He will evaluate his position should the S&P 500 test resistance at 4180. The usual disclaimers apply to my trading positions.

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

 

 

Disclosure: Long SPXL