Page 19 – Humble Student of the Markets

How far can the relief rally run?

Posted by Cam Hui - August 23, 2023

Mid-week market update: I have been calling for a relief rally, followed by a deeper correction (see Why I am both bullish and bearish). The relief rally seems to have arrived as the S&P 500 breached the upper trend line of a falling channel while exhibiting improvements in new 52-week high breadth.

How far can the rally run?

Lessons from recent history

Here are some lessons from recent history to consider in setting minimum rally objectives. The NYSE McClellan Oscillator (NYMO) reached an extreme oversold reading last week when it neared the -100 level. The last three times NYMO reached -100, it always staged a relief rally. Each time, the reflex rally retraced at least 50% of the decline. As well, the VIX Index fell to its 20 dma.

What does that mean in the current instance? A 50% retracement of the decline translates to roughly 4470, which is just above the 50 dma of the S&P 500 at 4460. The VIX Index just stands above its 20 dma. In other words, there’s a bit of possible upside left when setting a minimum upside objective.

Sources of volatility

Two key events are sources of near-term volatility. The main event after the close today is the earnings report from Nvdia, which beat expectations. The stock is trading at 44 times sales and option traders went into the report positioned for a bullish outcome.

Investors will also be closely watching Jerome Powell’s speech at Jackson Hole Friday morning for any hints of shifts in monetary policy. Former Fed economist Claudia Sahm believes that the speech will be big yawner.

Powell will strive to be as boring as humanly possible in his speech. He will repeat, some of it word for word, what he said at the last FOMC meeting or last FOMC minutes—which are released three weeks after every meeting…

There’s a good reason not to get creative. Powell, as Chair, speaks for the FOMC, not himself. There are two major data releases—employment and CPI inflation—before the next vote in September. Why box the FOMC in when you don’t have to? His speech will be short; we will learn nothing from him if all goes well.

If Sahm is right, a non-speech from Powell could spark a risk-on stampede. The bond market had taken fright at the stronger than expected growth figures coming from economic statistics. A boring speech could calm markets and spur bond prices to rise and better valuation support for stock prices.

My inner trader is still long the S&P 500, but he is edging towards the exit. The usual caveats 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

Why I am both bullish and bearish

Posted by Cam Hui - August 20, 2023

Preface: Explaining our market timing models

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

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

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

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 16-Aug-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.

Bullish and bearish on different time horizons

As the S&P 500 violated its 50 dma but reached an oversold condition on the percentage of stocks above their 20 dma, I am bullish and bearish on stocks, depending on the time frame.

Due for a Relief Rally: The market is due for a bounce (1–2-week horizon).
A Deeper Correction: There may be unfinished business to the downside once the relief rally is complete (3–6-week horizon).
Long-term Bullish: The technical structure of market action points to a longer-term bull trend.

Relief rally ahead

Let’s start with the shortest time frame. The market is sufficiently panicked and oversold that the odds favour a short-term relief rally.

The CBOE put/call ratio spiked last week, which is a sign of panic and contrarian bullish.

Two of the four components of my Bottom Spotting Model flashed buy signals last week. Historically, such conditions have signaled strong risk/reward long entry points for traders. The VIX Index spiked above its upper Bollinger Band, indicating panic, and the NYSE McClellan Oscillator (NYMO) fell below -50, which is an oversold condition.

The extreme level of the NYMO is especially notable. The indicator closed at -97.7 on Thursday, which is within a hair of the -100 mark. I went back to June 1998 and studied past instances when NYMO fell below -100, which is a rare event as there were only 20 non-overlapping instances when this happened. Median S&P 500 returns were strong after such signals and peaked eight trading days after the signal.

To be sure, last Thursday’s NYMO level does not constitute an NYMO signal based on a -100 threshold. But relaxing the test from -100 to -95 yields expands the sample size from 20 to 24 and the return patterns are very similar. I show the study based on a -100 threshold purely because it’s a round number. Regardless of whether the reading was -97.7 or -100, the market was very oversold.

The market is near a tactical buy signal. A bounce is about to begin soon.

A deeper correction

While the U.S. equity market appears washed out, oversold and poised for a rebound, the stall in large-cap technology stocks, and AI-related plays in particular, constitutes significant headwinds for the overall stock market. The relative performance of the NASDAQ 100 has historically been inversely correlated to the 10-year Treasury yield, which makes sense because growth stocks have higher duration than the broad market and are therefore more sensitive to changes in interest rates. The NASDAQ 100 began to diverge from the interest rate factor until recently when it violated a key relative support level. Notwithstanding the fact that bond yields are experiencing upward pressure today, the broad market would face substantial headwinds should the NASDAQ 100 close even half the gap shown on the chart. That’s because large-cap growth stocks, which consist of technology, communication services, and Amazon and Tesla within the consumer discretionary sector, represent over 40% of S&P 500 index weight.

Make no mistake, the AI party is over. One of the most sensitive AI industries is semiconductors, which violated a relative trend line, indicating a loss of momentum.

Here’s another way of visualizing the AI frenzy. Most of the AI-related plays are listed in the U.S. The accompanying chart shows the relative performance of U.S. large-cap value and growth (black line), which has bottomed and only begun to turn up. By contrast, non-U.S. developed market value and growth relative returns (red dotted line) has been soaring since early June.

The combination of faltering NASDAQ 100 and the outsized weight of large-cap growth within the S&P 500 argues for a deeper pullback once any reflex rally runs its course.

Long-term bullish

Even though I am concerned about a deeper correction, here’s why I am still long-term bullish. Such corrective action isn’t unusual after the stock market exhibits strong initial price momentum. The accompanying chart shows the history of the S&P 500 and the percentage of stocks above their 50 dma. Historically, a close 90% above their 50 dma after a 20% reading has generally resolved bullishly for stock prices. But the market often pulls back after the 90% reading, sometimes all the way back to the 20% level.

One mitigating factor that supports the bull case is the relative strength exhibited by cyclical industries. The relative performance of key cyclicals appears constructive, with the exception of semiconductors and transportation stocks. Even then, semiconductors remain in a relative uptrend, and these stocks have shown a stair-step upward pattern in the recent relative advance.

The bull case for transportation stocks is supported by the inverse head and shoulders pattern of the Dow Jones Transportation Average, which is still holding its breakout by its fingernails.

For a big picture long-term perspective, here is the weekly point and figure chart of the S&P 500 with a 2% box size and a three-box reversal. This doesn’t look like a price pattern that the bulls should be worried about.

Lastly, take a look at the trajectories of Bitcoin and the ARK Innovation ETF (ARKK) as indicators of the market’s animal spirits and the speculative cycle. Both bottomed out in late 2022 and their rebounds are intact.

In conclusion, I am bullish and bearish on stocks depending on the time frame. The market is poised for a short-term rebound, but the durability of the rebound is in serious doubt. However, the long-term trend of the market is still bullish. Investors and traders should tailor their trading decisions depending on their own investment horizons and risk preferences.

My inner investor is bullish and he has been opportunistically accumulating positions on weakness. My inner trader initiated a long position in the S&P 500 last Wednesday and he has been averaging in on the long side. The usual disclaimers apply to my trading positions.

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

Disclosure: Long SPXL

What are the contagion effects of a China slowdown?

Posted by Cam Hui - August 19, 2023

Periodically, the market is rattled by a “China is slowing” narrative. As the accuracy of official Chinese statistics can be doubtful, the real-time market reaction indicates nervousness, but no panic. The performance of the equity markets of China and her major trading partners relative to MSCI All-Country World Index (ACWI) shows that their trends are all flat to down.

How concerned should investors be about a China slowdown and its contagion effects?

Assessing the damage

The economic news out of China is certainly concerning. Bloomberg columnist John Authers pointed out that the six-month average of Chinese growth rates in different categories have been significantly decelerating.

The bad news just keeps on coming. Large Chinese shadow bank Zhongzhi and its affiliate Zhongrong missed payments on several investment products as a result of China’s property slump. The move sparked rare protests in Beijing.

The PBOC unexpectedly announced a cut in the medium-term lending rate by 15 basis points, which unsettled markets. What does the PBOC know that the rest of us don’t?
The offshore yuan, or USDCNH rate, has been weakening and briefly breached the 7.35 level. The yuan exchange rate was not helped by the ultra-dovish policies of the BoJ, which weakened the Japanese Yen and created competitive devaluation pressures in Asia.

Not as bad as it sounds

It may not be as bad as it sounds. In a recent podcast, Leland Miller of China Beige Book, which monitors the Chinese economy from a bottom-up basis, argued that the market has over-reacted to the prospect of the Chinese slowdown. There are two elements of the China slowdown story, a cyclical and a structural element. Miller believes that Chinese cyclical growth is better than the market believes, though he allowed that the structural elements are creating long-term headwinds.

Consider, as an example, Fathom Consulting’s China Momentum Indicator, which tracks Chinese GDP in a noisy fashion. The bad news is that China is indeed slowing. The good news is growth momentum is exhibiting a series of higher lows.

Beijing’s announcement that it would stop reporting the youth unemployment rate, which is at about 20% and a record high, illustrates the long-term structural challenges facing the Chinese economy. This NY Times article about China’s skyrocketing youth unemployment provides some context. Young educated graduates simply can’t find jobs, which has led to the “lying flat” movement, or the refusal to pursue a career, or consider leaving the country. In response, Xi Jinping advised the young to “eat bitterness” or to learn to endure hardships.

The youth unemployment problem seems curious in light of China’s aging demographics. Birth rates have been dropping and recently fell below the death rate. Why can’t the young find employment in an economy with aging population, which should give rise to strong employment demand?

The answer is a skills mismatch. There are plenty of low-paying jobs, but a lessened demand for the skilled workers that the Chinese education system is churning out. The NY Times article reported that “a 11.6 million college graduates are entering the work force this year, and one in five young people is unemployed”. The skills mismatch and youth unemployment problem illustrates China’s long-term challenge of transforming its economy from relying on low-cost labour as a source of competitive advantage to higher value-added production, which requires more skilled and educated workers.

In the long run, China faces a competitive imperative to migrate up the value chain. Chinese wage rates are already being undercut by its Asian neighbours such as Vietnam and it’s losing its edge in cheap labour costs. As well, the Party has tried to assert greater control over businesses, which as scared away foreign investment. As a consequence of these factors, Foreign Direct Investment has collapsed.

The market reaction

The market fallout from China slowdown fears has been limited. The primary tool for my 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 shows some surprising results. The top half of the chart is occupied by real estate and consumer discretionary stocks, which should be sources of trouble in a slowing economy.

A more detailed analysis of the relative performance of these key sectors shows that consumer discretionary stocks have bottomed and they are turning up. Real estate, which has been hit by the news of the troubles at Country Garden, is trying to form a constructive relative bottom pattern.

Outside China, the U.S. is the major region whose equities are insulated from China. The relative performance of the S&P 500 has shown a consistent negative correlation to the relative performance of MSCI China. By contrast, Europe is more exposed to Chinese growth, but the correlative of relative performance of European equities to China is still relatively low.

To be sure, not all global equity markets are uncorrelated to Chinese growth. If China catches sneezes, expect Asian markets to catch a cold. As well, the relative performance of the markets of countries that are resource producers are all flat to down.

In conclusion, the market narrative is raising concerns about a China slowdown. A review shows that the verdict from the market is the fears are overdone, though China faces long-term growth challenges. The equity markets of U.S. and Europe are largely insulated from any China slowdown, though those of Asia and resource-producing countries are more exposed.

Poised for a rebound

Posted by Cam Hui - August 16, 2023

Mid-week market update: The S&P 500 became extremely stretched in mid-June when its 14-week RSI exceeded the 90 level. The last two times this happened, the market eventually pulled back and the initial decline was arrested with RSI reached a neutral reading of 50. That 50 target was reached this week, which I interpret as the market is setting up for a relief rally.

A bounce ahead

There are other signs that stock prices are poised to bounce. Subscribers received an email alert this morning that my inner trader had initiated a long position in the S&P 500. The NYSE McClellan Oscillator (NYMO) had reached a sufficiently oversold condition that the odds favour a tactical long position.

In addition, the Zweig Breadth Thrust Indicator became oversold as of last night’s close. In the past, such oversold conditions usually resolved in relief rallies.

Here’s another constructive sign of possible bearish exhaustion. The market was rattled by a Fitch warning that it was going to downgrade the credit ratings of several U.S. banks including JPM. While I understand that financials aren’t all banks, the relative performance of U.S. financials bounced back today. Moreover, the relative performance of European and Chinese financials appear healthy, which is an indication of a lack of contagion risk.

This week is option expiry week. Jeffrey Hirsh pointed out that August OpEx weeks tend to have a bearish bias – and that includes OpEx day on Friday. However, stocks tend to bounce back the following week. As a consequence of the historical sloppy trading pattern of August OpEx, my inner trader decided to average into his long position over the next 2-3 days.

A contrarian magazine cover indicator

While my inner trader is positioning for a relief rally, he has few elusions about the durability of any possible rebound. the most recent Money Week cover provides a sobering contrarian magazine cover indicator that the market may need to fall further before the correction is over.

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

Will NASDAQ weakness unravel the bull?

Posted by Cam Hui - August 13, 2023

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bearish” on 03-Aug-2023)

A weak NASDAQ

Call the Market Police! The NASDAQ Composite has fallen for two consecutive weeks and violated a rising trend line. It seems that the AI-fueled party is over.

The key question is whether this pullback unravels the equity bull case.

The AI party is over

The accompanying chart tells the story of an AI-fueled party for NASDAQ stocks. The relative performance of the NASDAQ 100 (black line) had historically been inversely correlated with the 10-year Treasury yield (red dotted line). That makes sense as NASDAQ stocks, which have growth characteristics, are high-duration vehicles and therefore more sensitive to interest rate changes. The relationship diverged in early 2023 when the market was gripped by an AI frenzy. In addition, the relative performance of the NASDAQ 100 was also correlated to the relative performance of EM Internet and eCommerce stocks (EMQQ, bottom panel). EMQQ similarly did not participate in the AI-fueled rally in 2023. More recently, the NASDAQ 100 violated a key relative support level, indicating probable further weakness ahead.

Semiconductor stocks, which led the AI charge to the upside, have now violated an important relative support level.

This analysis of the NASDAQ 100 tells the story of breadth deterioration. The bottom two panels show that NASDAQ 100 relative breadth indicators have been corroding. To be sure, the relative percentage of stocks bullish on P&F chart has reached oversold levels, though the differences in percentages in stocks above their 50 dma have not.

A rolling correction

The weakness in NASDAQ and AI-related stocks doesn’t necessarily mean that the bears have control of the tape. The top five sectors of the S&P 500 comprise 73% of index weight, and it would be difficult for the index to meaningfully rally or decline without the participation of a majority. An analysis of the relative performance of these sectors shows uneven and un-synchronized relative strength. The growth sectors, technology, communication services and consumer discretionary, of which nearly half is made up of heavyweight growth stocks Amazon and Tesla, are either flat to down against the S&P 500. By contrast, the other two sectors, healthcare and financials, are starting to exhibit improvements in relative strength.

This looks like a rolling correction where one group weakens and others rise to take up the baton of fresh leadership.

The growth and value divide is more evident as we go down market cap bands. While large-cap growth and value relative performance have stalled since June, value outperformance can be seen more clearly in mid-caps and very clearly in small caps.

These results are supportive of the rolling correction thesis. In addition, the relative performance of defensive sectors is not strong, indicating that the bears haven’t taken control of the tape.

Bearish impulse stalling

Sentiment has normalized from bullish extremes, which I interpret as bearish momentum is stalling. The latest AAII weekly survey shows that %Bears at historically low levels, though the bull-bear spread remains elevated.

Similarly, the 10 dma of the CBOE put/call ratio has nearly returned to its 200 dma.

However, that doesn’t mean that stocks are ready to bottom. None of the four components of my Bottom Spotting Model have flashed buy signals. The four components are:

VIX Index above its upper Bollinger Band.
An inversion of the term structure of the VIX.
The NYSE McClellan Oscillator (NYMO) falls below -50, which is an oversold condition.
TRIN above 2, indicating price-insensitive selling, or a “margin clerk” liquidation.

Historically, the market has shown good risk/reward long entry points whenever at least two of the components have flashed buy signals.

In summary, the weakness of large-cap NASDAQ growth stocks, which comprise over 40% of S&P 500, is a drag on the S&P 500. However, the market appears to be undergoing a rolling correction, which should limit severe downside risk for stock prices. Even though the market appears oversold in the short run, the corrective period is probably incomplete and investors face further downside risk. Initial S&P 500 support can be found at the 50 dma at about 4440 and secondary support at about 4200.

The TARA risk from Japan

Posted by Cam Hui - August 12, 2023

Strategists coined the term TINA (There Is No Alternative) for describing equities as an asset class during the low-interest rate era. Now that rates have risen, there is a new acronym, TARA (There Are Reasonable Alternatives). Today, U.S. faces a TARA challenge from elevated Treasury yields.

The forward P/E ratio of the S&P 500 had been tracking the inverse of the 30-year Treasury yield in the last 10 years until early 2023 when they diverged. The forward P/E and Treasury yields rose together, which made bonds more attractive. That’s the TARA valuation threat to U.S. equities.

On top of that, there’s another emerging TARA valuation threat – and it’s coming from Japan.

So long, YCC

The source of the threat isn’t primarily from Japanese equities, but a change in policy at the Bank of Japan (BOJ). For years and years, the BOJ had kept rates artificially low in order to boost the Japanese economy. More recently, the BOJ was the only major central bank to maintain a dovish monetary policy when other central banks were raising rates. This ultra=stimulative policy encouraged Japanese savers to invest their funds abroad. As a consequence, Japan had long been a net supplier of liquidity to the rest of the world.
When BOJ governor Kuroda retired and Ueda took the reins at the BOJ, policy began to shift. The BOJ had a policy in place of capping the 10-year JGB yield at 0.50%, known as yield curve control (YCC). It recently signaled that it was prepared to be more flexible on YCC and expand the allowable range up to 1.0%. The JGB yield spiked in response to the announcement, but fell back when the BOJ intervened to slow its rise. Nevertheless, the psychological damage was done and the yield rose above the 0.5% mark. Global bond markets were briefly rattled by the change in BOJ policy, as the threat of a liquidity withdrawal could be unsettling to yields. (For the same of completeness, the bottom panel of the chart shows the relative performance of MSCI Japan on a currency hedged and unhedged basis, which shows that Japanese stocks may be gaining momentum on a currency hedged basis.)

The BOJ’s YCC policy tweak has reverberated around the world and pushed up yields. While the upward pressure can be observed in the nominal 10-year Treasury yield, what’s more damaging is the effects on the 5×5 year forward expected inflation rate, which rose to a new cycle high. This increase has made the Fed’s job more difficult in the face of an apparent upward pressure in inflationary expectations.

The recent Fitch downgrade of U.S. Treasury’s credit rating also didn’t help matters. Both the BOJ’s actions and the Fitch downgrade have put upward pressure on Treasury yields, all else being equal. In addition, the U.S. fiscal position is deteriorating.

While the increases in the absolute level of outstanding debt appears alarming, net interest expense normalized as a percentage of revenues and GDP are less alarming, but nevertheless concerning. The non-partisan Congressional Budget Office estimates that net interest expense will consume over 20% of government revenues by 2033.

The fallout for equity investors is upward pressure on long rates, and the TARA valuation threat. Tactically, last week’s boost to Treasury issuance also put a damper on Treasury bond sentiment, which creates headwinds for equity risk appetite.

Disinflation a mitigating factor

The major mitigating factor to the bear case is falling inflation. Both headline and core CPI prints have been soft, both on an absolute basis and relative to expectations. Even though the downward trend is constructive, the readings aren’t at the Fed’s 2% target just yet.

Moreover, researchers at the San Francisco Fed published a paper which argues that shelter inflation, which is a significant part of CPI, is rapidly decelerating and will slide into deflation by mid 2024.

Keep an eye on the difference between CPI, a proxy for selling prices, and PPI, a proxy for inputs. The current positive gap translates to better operating margins for manufacturers, all else being equal. This represents a silver lining for equity investors in the current disinflationary environment.

The one risk to the moderating inflation picture is energy prices. The tailwinds from falling energy prices are gone. The July CPI report showed a monthly increase of 0.3% in energy commodities, 0.2% rise in gasoline, and an astounding 3.0% surge in fuel oil.

If oil prices start to rise again, the Fed could shift its focus from a decelerating core rate back to a re-accelerating headline CPI.

In conclusion, Japan has long been a supplier of liquidity to the global financial system. The BOJ’s tweak to its YCC policy poses a threat to that paradigm and has the potential to significantly push up global bond yields. Such a change would also threaten equity risk appetite. So far, any damage from the shift in BOJ policy has been minor, but investors should monitor the effects of this policy shift as a source of risk.

Buy or sell this resilient stock market?

Posted by Cam Hui - August 9, 2023

Mid-week market update: I have been calling for a period of consolidation and pullback and that phase of the market seems to have arrived. As the S&P 500 weakened and the VIX Index spiked above its upper Bollinger Band, indicating a short-term oversold condition, this stock market has been remarkably resilient. The 5-day RSI traced out a positive divergence, and the NYSE net new highs remained positive during this episode.

Does this mean the correction is over?

One more flush ahead

I would argue that there is at least one more flush ahead for the market. I outlined a number of criteria for a market bottom last weekend (see How to spot the correction bottom). One of them was to see what happened when the S&P 500 Intermediate Breadth Momentum Oscillator (ITBM) flashed a sell signal when its 14-day RSI normalized from an oversold condition against a backdrop of an extreme overbought condition for the stock market, as measured by the percentage of stocks with P&F buy signals turned down from the 80% level. The study published on the weekend considered a five-year period, which yielded a very limited sample. I went back 20 years and the accompanying chart shows the 20-year period of this signal. Here are my main takeaways:

These sell signals were extremely powerful tactical sell signals, which are marked by vertical lines. All except one were successful (dotted blue line).
Market declines stopped when the 14-day RSI of ITBM (top panel) and the NYSE McClellan Oscillator (NYMO, bottom panel) reached oversold levels.

As these conditions haven’t happened yet, market history indicate another downleg to stock prices.

Put it another way, here are the four components of my Bottom Spotting Model. Only one component, the VIX Index has flashed a buy signal by spiking above its upper Bollinger Band. Historically, this Bottom Spotting Model has been effective at calling short-term bottoms when two or more components flashed buy signals.

In the short run, however, this market has been very resilient. When news broke yesterday that Italy imposed a surprise windfall tax on banks, which the government later backtracked on, and Moody’s downgraded a number of U.S. banks, the relative performance of financial stocks held up and remain in relative uptrends.

I conclude from this market action that the market is correcting, but may be undergoing a reflex rally. We probably haven’t seen the bottom of this corrective phase and the market needs one more flush and panic before it’s all over.

How to spot the correction bottom

Posted by Cam Hui - August 6, 2023

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bearish” on 03-Aug-2023)

Subscribers can access the latest signal in real time here.

A correction in an uptrend

I have been warning for several weeks that U.S. equities appeared extended even as stock prices advanced. Even though the intermediate trend was bullish, the market could pull back at any time.

It seems to have finally happened. The S&P 500 stalled and turned down on the news that Fitch had downgraded U.S. government debt. The ratings downgrade shouldn’t have been a risk-off trigger. U.S. Treasury paper is regarded as the default-free and risk-free asset. No one buys Treasuries based on a credit rating. In fact, the market reaction to the ratings downgrade was a steepening of the yield curve. Short Treasury yields fell while longer-term yields rose. If the market was truly rattled by the change in credit rating, yields should have risen across the board.

Instead, I believe the stock market had risen too far and too fast. The Fitch downgrade was just an excuse to sell and the pullback was overdue. You can tell a lot about the psychology of the market by the way it responds to news. FactSet reported that, with 84% of the S&P 500 having reported earnings, the market isn’t rewarding the shares of companies that beat EPS expectations.

Where’s the correction bottom?

No signs of panic

So far, the pullback has only begun, and there are few signs of panic that mark buying opportunities. The Fear & Greed Index is still at a greedy reading.

The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, rose last week, indicating increasing bullishness. Readings are above 100, which is a levered long position. I interpret this as a frothy market in need of a period of consolidation or correction.

Tactically, VIX Index term structure is not inverted, which would be a sign of fear.

The CBOE put/call ratio, has begun to normalize from an overly complacent reading. If this is a major correction, the 10 dma of the put/call ratio may have to return to its 200 dma before a durable bottom can be made. However, investors can find other signs of a short-term bottom in the absence of the major correction scenario.

Bottom spotting

The usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) flashed a sell signal last week when its 14-day RSI recycled from overbought to neutral. What makes this episode stand out is the sell signal occurred against a backdrop of the percentage of S&P 500 stocks bullish on P&F charts turned down from above 80% to neutral, indicating a sell signal from a severely extended condition.

There were only four other episodes in the last five years. In all of them, the market decline didn’t stop until the NYSE McCellan Oscillator (bottom panel) reached an oversold condition. As well, the 14-day RSI of ITBM (top panel) reached an oversold reading in three of the four occasions, and the last one was close. In the case of the major downdraft that began with the sell signal of August 2022, indicators reached an initial oversold reading and the market bounced before resuming its decline into its ultimate low.

In addition, the 5-week RSI of the S&P 500 reached an overbought extreme in June. The last two times this happened the decline wasn’t arrested until RSI reached a neutral reading of 50, which could be as low as the S&P 500’s long-term support at about 4200.

However, the pullback may not necessarily be that severe. The 5-day RSI of the S&P 500 is already oversold. Initial support can be found at the 50 dma at about 4400, with secondary support at 4200. If that support breaks, look for a test of the 200 at about 4100.

Still constructive

Despite the short-term dominance bearish price momentum, I am still constructive on the stock market. Market leadership has broadened out from the narrow leadership of megacap technology stocks, which is helpful to the bull case.

The relative performance of key cyclical industries is either bottoming or in a relative uptrend, both are signals of a bullish cyclical rebound.

Finally, keep an eye on the Dow Jones Transportation Average, which exhibited an inverse head and shoulders breakout. If this is indeed just a short-term correction, the index should hold above its breakout level.

In conclusion, the stock market had been undergoing an unsustainable advance and a corrective period has probably started. I believe this is just a pullback within the context of an intermediate uptrend. I offer several clues on how to spot the corrective bottom.

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

Posted by Cam Hui - August 5, 2023

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

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

Reasons to be bullish

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

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

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

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

Reasons to be skeptical

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

The latest Senior Loan Officer Opinion Survey (SLOOS) highlights my concerns. Banks are tightening lending standards, The Fed’s July SLOOS reported tighter credit conditions across the board and weak consumer loan demand.

Regarding loans to businesses, survey respondents reported, on balance, tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the second quarter. Meanwhile, banks reported tighter standards and weaker demand for all commercial real estate (CRE) loan categories.

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

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

The employment puzzle

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

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

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

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

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

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

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

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

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

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

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

A test of bullish conviction

Posted by Cam Hui - August 2, 2023

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

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

Short-term bearish

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

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

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

A downside break?

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

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

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

My inner investor is opportunistically accumulating stocks in order reach an overweight position in equities. My inner trader is short the S&P 500. The usual disclaimers apply to my trading positions.

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

Disclosure: Long SPXU

On the verge of a long-term buy signal

Posted by Cam Hui - July 30, 2023

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Upgrade)
Trend Model signal: Bullish (Upgrade)
Trading model: Neutral (Last changed from “bearish” on 15-Jun-2023)*

Subscribers can access the latest signal in real time here.

A likely buy signal ahead

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

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

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

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

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

A Trend Model upgrade

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

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

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

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

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

Short-term cautious

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

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

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

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

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

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

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

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

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

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

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

Could a credit event derail the equity bull?

Posted by Cam Hui - July 29, 2023

Is the soft landing here? Wall Street strategists have been racing to reduce their recession odds in the last week. More importantly, Fed Chair Powell revealed during the post-FOMC meeting press conference that Fed staff had upgraded its forecast from a mild recession in H2 2023 to no recession.

In the past few weeks, the stock market has become increasingly exuberant, but the bond market remains nervous. The VIX Index, which is the option implied volatility of stocks, has been steadily falling, indicating the expectation of lower risk. On the other hand, the MOVE Index, which is the bond market’s equivalent of VIX, is still elevated.

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

Tightening credit = Rising defaults

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

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

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

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

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

Don’t worry, be happy

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

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

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

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

Sound the All-Clear?

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

Not so fast. It’s difficult to forecast recessions and credit events that accompany recessions. Consider this transcript of the staff briefing of economic conditions from the FOMC meeting of October 2007, two months before onset of the NBER dated recession.

There can be little denying that, almost across the board, the readings on economic activity have been stronger than our expectations in September… All told, third-quarter growth in consumption looks stronger than we had expected, and spending appears to be headed into the fourth quarter with a bit more momentum.

At present, it is difficult to find evidence in high-frequency indicators that the economy is in the process of turning down.

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

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

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

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

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

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

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

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

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

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

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

Possible choppiness ahead

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

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

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

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

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

It’s not just about the Fed

Posted by Cam Hui - July 26, 2023

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

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

How the stock and bond market disagree

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

Sources of volatility

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

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

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

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

A new cyclical bull?

Posted by Cam Hui - July 23, 2023

Preface: Explaining our market timing models

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)

Subscribers can access the latest signal in real time here.

The momentum buy signal

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

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

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

A risk-on stampede

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

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

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

A crowded long

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

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

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

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

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

A regime change judgment call

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

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

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

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

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

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

The risks to the disinflation and soft-landing bull case

Posted by Cam Hui - July 22, 2023

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

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

The risk of catastrophic success

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

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

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

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

The last mile inflation problem

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

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

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

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

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

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

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

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

What about the recession?

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

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

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

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

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

Scenes from Q2 earnings season

Posted by Cam Hui - July 19, 2023

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

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

Early report card

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

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

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

Here is a similar quote from Citigroup’s CFO:

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

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

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

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

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

What resilient consumer?

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

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

Vulnerable to a pullback

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

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

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

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

The soft landing vs. slowdown debate

Posted by Cam Hui - July 16, 2023

Preface: Explaining our market timing models

The latest signals of each model are as follows:

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A fragile consensus

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

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

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

Team Soft Landing

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

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

Even commodity prices have caught a bid.

Team Slowdown

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

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

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

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

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

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

A frothy market

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

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

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

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

What to watch for in a pivotal earnings season

Posted by Cam Hui - July 15, 2023

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

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

Here’s what I am watching.

The margins question

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

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

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

A bifurcated market

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

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

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

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

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

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

What about the recession?

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

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

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

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

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

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

Tech leadership stumbles, what will pick up the pace?

Posted by Cam Hui - July 12, 2023

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

It may be time to look for new leadership.

Broadening breadth

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

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

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

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

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

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

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

Market stall or “good overbought”?

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

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

The mystery in the NFP report

Posted by Cam Hui - July 10, 2023

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

Explaining the unemployment rate decline

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

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

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

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

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

That’s a warning to keep in mind.