What market structure tells us about where we are in the cycle

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

 

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

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Bullish

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

Subscribers can access the latest signal in real time here.

 

 

Sell in May?

It’s that time of the year again. As April turns into May, market prognosticators everywhere ponder the wisdom of the “sell in May and go away” adage. In reality, history shows that the six months that begin in May only experienced subpar returns and it isn’t actually bearish. In fact, the May to October period has shown relatively strong returns since 2009.

 

 

Rather than obsess over the implications of May seasonality, a more practical focus is the analysis of market structure and what it’s telling us about where we are in the cycle.
 

 

 

The big picture

Let’s begin by stepping back and analyzing the “big four” factors used by Fama and French to explain equity returns, namely price momentum, quality, size, and value and growth. The accompanying chart shows the returns of these four factors in the last 10 years. Here are the main takeaways:

  • Price momentum peaked in early 2021 and has been falling ever since.
  • Quality troughed in 2022 and began to rise in a choppy manner.
  • Returns to size (small caps) dropped sharply in 2023 as large caps outperformed.
  • Value bottomed against growth in early 2022, but fell in 2023 as FANG+ recovered.

 


 

 

 

Putting it all together, analysis of the “big four” factors tells a story of a late-cycle market, characterized by large-cap leadership with a bias for high-quality stocks. The emergence of megacap FANG+ stocks as leadership is also an indication of a slowing growth environment. When growth is scarce, investors gravitate toward high-quality growth stocks.

 

A glance at the relative performance of cyclical industries confirms the slowing growth narrative. With the exception of homebuilders, all other cyclical industries are in relative downtrends.

 

 

The past behaviour of the 2s10s yield curve is instructive from a top-down perspective. While an inverted yield curve does serve as a warning, the S&P 500 tended to top out when the yield curve began to steepen after an inversion event.

 

 

The recent banking regional banking crisis is an equally concerning market signal. Past instances of violations of relative support for bank stocks have marked major market tops, especially if bank relative performance is plummeting as it is today.

 

 

 

Narrow leadership

A comparison of the S&P 500, which is float-weighted, the equal-weighted S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 shows how leadership has become concentrated in the largest stocks. All of the other indices are weaker than the S&P 500 at a key support level last week.
 

 

 

It’s not unusual for the market leaders to be concentrated in a handful of stocks. What is disturbing is the growing lack of fundamental support. Rob Anderson of Ned Davis Research documented how FANG+ share “of the S&P 500 has risen back above 22%, while its percentage of earnings has barely budged at 16%”.

 

 

In summary, market structure analysis shows a late-cycle market with leadership concentrated in a few high-quality growth stocks whose outperformance is driven more by P/E expansion than fundamental strength. This is the picture of a market top. New bull markets simply don’t start this way.
 

 

The week ahead

While we are cautious about the intermediate-term outlook, the tactical picture turned bullish. Two of the four components of my bottom spotting model have flashed buy signals. The VIX Index closed above its upper Bollinger Band and the NYSE McClellan Oscillator fell below -50, both of which indicate oversold conditions. In the past, two or more simultaneous buy signals from the bottom spotting model components have tended to mark entry points for the S&P 500 on the long side with strong risk/reward ratios.
 

 

According to FactSet, the results from Q1 earnings season have been very strong. With 85% of the S&P 500 having reported results, 79% of companies beat EPS expectations compared to a 5-year average of 77%, and 75% of companies beat sales expectations, compared to a 5-year average of 69%. Consequently, forward 12-month EPS estimates have been rising.

 

Q1 earnings season has not been the catastrophe that we had somewhat expected. While forward P/E valuations are somewhat extended, the strength in Q1 results is supportive of higher stock prices in the short run. The key caveat is a report by Sam Ro of a Warren Buffett commentary at the recent Berkshire Hathaway meeting, “In the general economy, the feedback we get is that perhaps the majority of our businesses will actually report earnings this year lower than last year”.

 

 

Keep an eye on the regional banking stocks, which have become the focus of the latest pullback scare. The bears will point out that the KBW Regional Banking Index violated a long-term support zone and blew past an important Fibonacci support retracement level with no support in sight (top panel). The bulls’ only hope is the group finds footing at or near relative support (bottom panel). Until these stocks find their footing, the path of least resistance for the market will be down.
 

 

 

While the short-term buy signal from the Bottom Spotting Model is tactically constructive, the bulls shouldn’t overstay their welcome. The S&P 500 bounced off short-term support last Thursday while exhibiting a positive RSI divergence, but it’s still in a trading range. Expect stiff resistance at about 4180,
 

 

 

In conclusion, what investors face is an oversold market poised for a tactical rally within the context of an intermediate downtrend. Investment-oriented accounts should be cautious and use market strength to de-risk. Be aware that the S&P 500 remains in a trading range and there is still resistance at about 4180, which is only 1.1% from Friday’s closing level.

 

My inner trader reversed from short to long the S&P 500 late last week. He expects that he will either sell or start to scale out of his position should the index reach the resistance level of 4180. The usual disclaimers apply to my trading positions.

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

 

 

Disclosure: Long SPXL

 

How to spot the stock market bottom

Posted by Cam Hui -
Is the U.S. economy headed into recession? The signs are all there.

 

Even though a recession isn’t part of the Fed’s official forecast, Fed Chair Jerome Powell conceded during the May post-FOMC press conference that the Fed’s staff economists were calling for a mild recession. Carl Quintanilla of CNBC also reported that the overwhelming consensus from a JPMorgan investor survey was for a recession to begin in H2 2023.

 

Here’s why the recession question matters. The historical record shows that the stock market only bottomed after recessions have begun (shaded areas are recessions). If the economy does enter a recession, chances are, investors haven’t seen the bottom of the current bear market yet. That doesn’t mean, however, that NBER has to declare a recession before the stock market bottoms as NBER tends to be glacial in its evaluation of economic data and slow to react. 

 

 

 

If a recession is ahead, here are some ways to spot the market bottom.
 

 

PMI signals

One clue for timing a stock market bottom can be found in the Purchasing Managers’ Indices (PMIs), which are diffusion indices designed to measure whether business conditions are undergoing expansion or contraction. Historically, stock prices haven’t bottomed until ISM Manufacturing PMI has bottomed.

 

 

That makes sense from a fundamental perspective. Manufacturing PMI readings have historically led gross margins, which drive earnings and stock prices.
 

 

 

However, this has been an unusual cycle because of the effects of the COVID-19 disruptions. The pandemic initially created a supply shock and supply chain disruption in goods. As supply chains normalized, manufacturing sector activity slowed, which manifested itself in persistently falling manufacturing PMI readings that are below 50, indicating contraction.

 

 

By contrast, non-manufacturing, or services, PMI initially cratered with the pandemic shock, but it recovered and ISM non-manufacturing PMI has been flashing a series of above 50 readings, which indicate expansion.

 

 

This begs the question of whether the deterioration in manufacturing PMI could be sending false positive signals about a recession if the manufacturing and services economies are so bifurcated.
 

 

Labor market signals

Indeed, the Fed has acknowledged that goods inflation is decelerating and shifted its focus to the services economy and the jobs market in particular.

 

The labor market can offer some clues on the timing of a stock market bottom. I studied investor risk appetite using the monthly AAII asset allocation survey, which is a long data series that asks what investors are doing with their money rather than the weekly survey that asks what they think about the market. The AAII asset allocation survey also offers a way of normalizing risk appetite by measuring household allocations to equities through different economic cycles beginning in 1987. I then compared the equity allocation to the year-over changes in non-farm payroll employment over the study period. Here are the main takeaways from the analysis:
  • Equity allocations tend to lead year-over-year changes in NFP, which is another way of saying stock prices are leading indicators and employment is a lagging indicator.
  • Recessionary equity bears don’t end until year-over-year changes in NFP turn negative.
  • The non-recessionary soft landing of 1995 ended with a year-over-year NFP change of 1.6%; the current reading of 2.6% is well above that level, indicating that stocks may be far from a bottom.
  • Despite the recent retreat, equity allocations are still elevated and above their historical average, indicating possible relative downside risk when compared to cash and bonds.

 

 

Fed Chair Jerome Powell allowed during the May post-FOMC press conference that “supply and demand in the labour market are coming back into better balance” but still characterized the jobs market as “very tight”. Nevertheless, there are signs that it is slowing. From an anecdotal perspective, mentions of “job cuts” (orange line) compared to the “unemployment rate” (white line) during company earnings calls have reversed positions. Job cut references have been rising while unemployment rate references have stayed relatively stable in the past few months.
 

 

In addition, leading indicators of employment are weakening. Temporary jobs and the quits/layoffs ratio from the JOLTS report have historically led NFP employment. The March JOLTS report showed a continuing plunge in quits/layoffs (red line) while temporary jobs have been slowly falling over the past few months.

 

The April Employment Report showed a strong upside surprise in the headline payroll report and in average hourly earnings. However, temporary jobs continued to decline, which is an ominous sign for the future of employment.

 

 

 

 

Insider signals

While economic indicators like manufacturing PMI and employment figures can yield some clues to the timing of a stock market bottom, the magnitude of equity downside risk is difficult to estimate because I have no idea how deep a possible recession might be. However, investors can find some clues from insider trading signals.

 

In the past year, net insider buying (blue line above the red line) has been a good tactical indicator of low-risk entry points into the stock market.
 

 

 

Every market cycle is different. Insiders were early to buy the market during the 2008 market crash.

 

 

 

The pattern of insider activity during the 2011 market bottom was more timely. As a reminder, 2011 was also when that the U.S. Treasury came within two days of running out of funds and defaulting on its debt before lawmakers crafted a deal to raise the debt ceiling. However, that period also coincided with the Greek Crisis which threatened to tear apart the eurozone.

 

 

Insiders were also early to buy in October 2019. When the market bottomed in December, they also stepped up and bought. The main takeaway from insider activity is that it can be a useful guide to spotting tactical bottoms, but every cycle is different and net insider buying is no assurance that fundamentals won’t deteriorate further to depress prices.

 

 

In conclusion, a recession is likely on the horizon and historically stocks don’t bottom until the economy enters a downturn. Investors can monitor macro indicators like PMI and employment statistics, as well as alternative signals like insider trading to spot the ultimate market bottom.
 

It’ll feel like a tightening every meeting

Posted by Cam Hui -
Mid-week market update: As expected, The Fed raised rates by a quarter-point and hinted that it will pause rate hikes at the next meeting, but underlined its conviction that it will not cut this year. Fed Funds expectations are largely unchanged after the meeting. The market is expecting a pause and cuts later this year.

 

 

The gulf between the market’s expectations and the Fed’s messaging isn’t closing. As we proceed into summer and early fall, every meeting that the Fed doesn’t cut and maintains its higher for longer narrative will amount to a tightening of expectations for the market. And that’s not equity bullish.

 

 

Why the Fed will or won’t pivot

Former Fed economist Claudia Sahm recently explained the three reasons why the Fed won’t pivot to rate cuts this year:

 

  •     No one wants to be Arthur Burns.
  •     Current Fed officials experienced the 1970s and early 1980s firsthand.
  •     Inflation is persistent and won’t slow fast enough to declare victory this year.
    • Here is the one reason why the Fed might cut. A recession that highlights the Fed’s dual mandate of price stability, which it is mainly focused on today, and full employment (and financial stability). 

     

    While the disconnect between the fixed income market and the Fed’s message is problematic, the disconnect that the stock market has with the macro picture is even worse. The bond market is discounting a recession that forces the Fed to cut rates later this year. The stock market is discounting a soft landing. Under a soft landing scenario, meaningful rate cuts are unrealistic. If rates were to fall and there is a recessionary hard landing, the economic contraction will put downward pressure on sales and margins, which is bearish for stock prices. 

     

    In effect, stock market bulls are wrong either way. If there is a soft landing, rates will stay high and P/E ratios, which are already historically elevated, will have little room for expansion. By contrast, the equity bull case under a hard landing that’s attributable to falling rates is equivalent to dancing on your front lawn as your house burns down because you got to collect on your insurance.

     

     

    Banking crisis not over

    When SVB collapse, I wrote that one of the pre-conditions for a resumption of the bull phase is stabilization in regional bank stocks. On the day that JPMorgan bought First Republic Bank, the KBW violated a long-term support level and regional banking shares are continuing to weaken. While the Fed has made noises about supplying liquidity to the system to ensure banking stability, regional banks have not found a bottom yet.

     

     

    Much depends on the perception of Fed policy. That’s because banks, in general, are borrowing short and lending long. The persistent inversion of the yield curve is hurting bank profitability, large or small.

     

     

    My inner trader is maintaining is short position in the S&P 500. The usual disclaimers about my trading positions apply.

    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

     

    My case for a correction

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

     

    The latest signals of each model are as follows:
    • Ultimate market timing model: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Bearish

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

    Subscribers can access the latest signal in real time here.

     

     

    A possible stall

    The stock market was choppy on earnings season-induced volatility last week, but a case is being formed for a correction. Even as the S&P 500 tested overhead resistance Friday, it exhibited several negative divergences, which is a signal that the market rally is poised for a stall.

     

     

    Here are the bull and bear cases.
     

     

    The bear case

    The bear case is the easier one to make.

     

    One troubling bottom-up sign came from the earnings report of Coca-Cola and PepsiCo, both of which reported that they were successfully pursuing price over volume strategies of increasing prices while sacrificing volume growth. While such a strategy increased margins at the company level, it is troubling at the macro level as they are signals of consumer acceptance of higher prices. By implication, inflation may be more difficult to tame than the Fed expects.

     

    In addition, the banking crisis may not be over. The earnings report from First Republic Bank was a shocker. Even though the bank beat earnings expectations, it reported that deposits fell an astonishing 41% in the first quarter. Regulators have not intervened in hopes that the other banks will hash out a deal to ensure that First Republic doesn’t collapse. In response, the KBW Regional Banking Index is teetering at a key support zone.

     

     

    Despite concerns over the banking system, the latest figures show that liquidity is still being withdrawn. In the past, liquidity has either been coincident or slightly led the S&P 500.

     

     

     

    Equally worrisome is the narrow leadership exhibited by last week’s market advance. Big Tech took the spotlight and earnings results were strong. The accompanying chart of the S&P 500, the NASDAQ 100 compared to the equal-weighted versions of the same indices, illustrates the outsized influence of megacap stocks, and megacap FANG+ names in particular. For the uninitiated, cap-weighted indices give more weight to the price action of the largest stocks while their equal-weighted counterparts emphasize the price movement of smaller names.

     

     

    Other indicators, such as equity risk appetite factors, are signaling negative divergences.

     

     

     

    Similarly, credit market risk appetite is also not confirming the S&P 500 advance.

     

     

     

     

    The bull case

    The file on the bull case is thinner but nevertheless valid.

     

    First, the latest downdraft in regional banking shares should not be treated as an alarm, but a welcome buying opportunity. The KBW Regional Banking Index is exhibiting a series of positive RSI divergences, indicating a loss of downside momentum. Such instances of weakness should be bought and not sold.

     

    From a fundamental perspective, bank regulators have a well-worn playbook on what to do in the case of a banking crisis, and they should be well positioned to act should matters get out of hand. The epicentre of the latest crisis are the small and mid-sized banks, which are within the Fed’s regulatory reach, unlike past crises such as LTCM in 1988, which was a hedge fund problem, and Bear Stearns and Lehman Brothers in 2008, which were broker-dealers, none of which were the kind of organizations that the Fed had a mandate to rescue. More importantly, new reports indicate that the FDIC is preparing to put First Republic Bank under receivership and it has asked other banks, including JPMorgan, and PNC for their bids for First Republic.

     

     

     

    From a longer-term perspective, the NYSE McClellan Summation Index is turning up and its stochastic recently recycled from oversold to neutral, which is a buy signal. 

     

     

    In addition, the closely watched Q1 earnings season hasn’t been no earnings catastrophe. FactSet reported that with 53% of S&P 500 companies reporting actual results, 79% of S&P 500 companies reported positive EPS surprises, compared to a 5-year average of 77%, and 74% of S&P 500 companies reported positive revenue surprises, compared to a 5-year average of 69%. These results are not disasters.

     

     

    The debt ceiling wild card

    No analysis of the markets today would be complete without a discussion of the debt ceiling game of chicken in Washington. Estimates of X date, or the date that the U.S. Treasury runs out of money, varies between early June and August. Much depends on 2023 tax receipts, which have been weak compared to 2022.

     

    The accompanying chart shows the S&P 500, the price performance of junk bonds compared to their equivalent-duration Treasuries and the 3-month T-Bill yield in 2011, which was the last episode of debt ceiling havoc. The budget was passed on April 15, 2011, but the debt ceiling was approaching soon after its passage. Treasury estimated an X date of August 2, and after much negotiation the debt ceiling was raised on July 31, two days before the estimated X date. The eventual peak-to-trough S&P 500 drawdown over that episode was -8.2%. However, the 2011 incident is not a perfect comparison as that period coincided with a Greek Crisis that threatened the break-up of the euro currency.

     

     

     

    Historically, the U.S. Treasury has drawn down its account at the Fed (TGA) as part of its extraordinary measures to avoid running out of money as a debt ceiling approached; 2023 is no different. As Treasury draws down and spends its cash, it has the effect of injecting liquidity into the banking system, which creates a tailwind for equity prices. As soon as the debt ceiling is raised, TGA balances will gradually rise and liquidity is withdrawn, which is bearish for stocks.
     

     

    In conclusion, the technical backdrop may be setting up for pullback in the S&P 500. Strong support can be found at the 3770–3800 zone should the market weaken. The bear case consists of renewed doubts over banking system stability, narrow leadership and negative divergences from risk appetite indicators. The bull case consists of positive divergences in the regional banking index, a bullish recycle in NYSI and a relatively benign earnings season.
     

    My inner investor is neutrally positioned between stocks and bonds at about his investment policy target. My inner trader is nervously maintaining his S&P 500 short position. The key market moving event will be the FOMC decision next week. The Fed is expected to raise rates by a quarter-point but possibly hint at a pause at the next meeting, which could be interpreted as bullish, but also signal a higher for longer regime, which would be bearish. How this plays out, I have no idea.

     

    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

     

    The final Fed rate hike?

    Posted by Cam Hui -
    The main events in the coming week will be the interest rate decisions by Federal Reserve on Wednesday and the ECB on Thursday. Both are widely expected to raise rates. However, market expectations for the trajectory of the U.S. Fed Funds rate is a 25-basis-point hike at the May meeting, a pause, and rate cuts later in the year. By contrast the ECB is expected to continue hiking.

     

    On the other hand, the ECB path is more hawkish and its rate hike cycle does not appear to be complete. The governing council is reportedly split between a 25-basis point and a 50-basis point hike at the May meeting. ECB board member Isabel Schnabel told Politico in an interview that underlying inflation, which filters out volatile food and energy prices, shows very strong momentum and it was not clear that it would peak “very soon”. Belgium’s central bank head and ECB setting governing council member Pierre Wunsch told the Financial Times in an interview: “We are waiting for wage growth and core inflation to go down, along with headline inflation, before we can arrive at the point where we can pause.”

     

     

    The Fed hates to surprise markets. A 25-basis-point rate hike is a virtual certainty. Unless it doesn’t plan to pause increases after the May meeting, it will signal its intention next week, subject to the usual caveats about data dependency. The challenge for investors is how to position themselves should the Fed pause.
     

     

    Due for a pause

    A pause should be no surprise. This has been the fastest and steepest rate hike cycle, ever. As monetary policy operates with a lag, it makes sense to pause tightening in order to measure its effects, now that monetary tightening is no longer accommodative.

     

     

    Numerous signs are appearing that the Fed is tightening into a slowdown. Bespoke Investment Group pointed out that U.S. leading indicators have declined for 12 straight months.

     

     

    Cyclical indicators, such as the copper/gold and base metals/gold ratios, and risk appetite indicators like the relative performance of global consumer discretionary to global consumer staple stocks, are signaling a risk-off environment.

     

     

     

    The New York Fed’s yield curve-based recession model is also pointing to a hard landing ahead.

     

     

     

     

    What happens next?

    What happens next? I studied the capital market reaction when the Fed stopped raising rates. There have been nine distinct episodes since 1980 when the Fed stopped raising rates. Here are how the different markets responded to the final rate hike. The charts show the median and the maximum and minimum rates of return for different asset classes after each of the final rate hikes, with the starting point indexed at 100 in the case of stock market indices, and at zero in the case of yields and yield spreads.

     

    The S&P 500 showed considerable variation in returns over the study period, but the median market response (solid dark line) shows that the index was flat to down about two months after the initial Fed decision, followed by gains afterwards. However, there was a distinct difference between the cases when the Fed stopped raising rates when the yield curve was inverted and when it was not. With the caveat that we are looking at a small sample size, S&P 500 returns when the yield curve was normally inverted (red line) underperformed the median and instances when the yield curve was upward sloping (blue line).

     

     

     

    By contrast, I found little difference between the response of the 10-year Treasury yield and yield curve regimes in our study. The median 10-year Treasury yield tended to edge up after the initial Fed decision, followed by a steady decline.
     

     

     

    There were, however, two outliers that were partly omitted from the historical study as they may give readers the wrong impression of the maximum or minimum in the analysis. The first was the rate hike of December 1980.

     

    This instance was unusual inasmuch as it occurred during the double-dip recession of 1980–1982 and during the tight money era of the Volcker Fed. The 10-year Treasury yield rose for much of the next 12 months. The period was excluded from the Treasury yield study but it was included in the S&P 500 study.

     

     

     

    The second outlier was the final rate hike of September 1987, when the Fed raised rates multiple times on an inter-meeting basis to defend the USD. The rest, as they say, is history. This was excluded from the S&P 500 study as it may create an outsized expectation of downside equity risk.
     

     

     

     

     

    The silver lining

    In conclusion, the Fed appears to be tightening into a slowdown. If history is any guide, the S&P 500 is likely to exhibit subpar performance in the coming year, while 10-year Treasury yields decline and bond prices should see some gains.

     

    The one silver lining to this apparent dire scenario is the world is unlikely to fall into a synchronized global recession. In particular, China is stimulating its economy. It already made an about-face away from its zero-COVID policy early this year, and the PBoC is pivoting toward a more stimulative monetary policy.

     

     

    Fathom Consulting’s estimate of Chinese GDP is already on the rebound, and if earnings results from luxury goods producer LVMH is any guide, Chinese consumers are going on a spending spree.

     

     

    I reiterate my view that equity investors should find better bargains outside the U.S. (see The market leaders hiding in plain sight). European equities have staged a relative breakout. Asian equities are consolidating sideways and investors should monitor them for signs of upside relative breakouts.

     

     

    Market correction signals

    Posted by Cam Hui -

    Mid-week market update: Subscribers received an alert on Monday that my trading model had turned bearish. Despite the positive reaction to the Microsoft earnings report, which is holding up the NASDAQ today, there are plenty of signs beneath the surface that the stock market is weakening.   The failure of the S&P 500 to hold […]

    To access this post, you must purchase Monthly subscription.

    Making sense of the Mona Lisa market

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

     
    The latest signals of each model are as follows:
    • Ultimate market timing model: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Neutral

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

    Subscribers can access the latest signal in real time here.

     

     

    The Mona Lisa market

    The Economist aptly characterized the current circumstances like the Mona Lisa:

    What is the Mona Lisa doing? At first glance the subject of the world’s most famous painting seems to be smiling. Look again and her smile fades. When it next reappears, it is a different sort of smile. Leonardo da Vinci achieved this ambiguous effect with the use of sfumato, where he blurred the lines around Mona Lisa’s face. No matter how many times you look, you are unsure quite what is happening.

     

    The post-pandemic economy is like the Mona Lisa. Each time you look, you see something different. After chaos in the banking industry, many analysts are now convinced that the world economy is heading for a “hard-landing” recession. Few seem to expect a “no-landing” scenario, in which the economy remains untroubled by rising interest rates—a fashionable opinion just weeks ago, and one which itself supplanted a common view late last year that a mild recession was certain.

     

    Even though the stock market isn’t the economy, it’s also beset by a series of cross-currents that are difficult to interpret, much like the Mona Lisa.

     

    Starting with earnings season, which is in full swing. It began with a series of strong reports from large banks, but one key test came last week when about 50% of regional banks, which were at the epicentre of the latest banking crisis, reported. Equity bulls breathed a sigh of relief when the KBW Regional Banking Index held technical support.

     

     

     

    Even though the regional banks held support, the bulls face a series of obstacles to overcome, and it isn’t clear at all whether they’ll succeed.
     

     

    Credit crunch ahead

    The banking crisis has sparked concerns about a credit crunch as banks re-calibrate their loan books in light of the heightened stress in the financial system. Reuters reported that New York Fed President John Williams sounded a word of warning about the effects of tightening credit.

     

    “Conditions in the banking sector have stabilized, and the banking system is sound and resilient,” Williams said. But he added the troubles will likely make credit more expensive and harder to get, which will in turn will depress growth.

     

    “It is still too early to gauge the magnitude and duration of these effects, and I will be closely monitoring the evolution of credit conditions and their potential effects on the economy,” Williams said.

     

    The good news is any credit crunch could do the Fed’s work in tightening monetary policy and a more accommodative interest path may be possible. In a CNN interview, Treasury Secretary and former Fed Chair Janet Yellen addressed the “tightening of lending standards in the banking system” and the tightening “could be a substitute for further pricing, further interest rate hikes that the Fed needs to make”. The credit cycle is indeed turning. The Fed’s survey of senior loan officers shows a significant tightening of lending standards since COVID Crash.
     

     

    Evidence of tightening credit is confirmed by the NFIB small business survey.

     

     

    Tightening credit is how recessions start.

     

     

    The challenges of earning season

    FactSet reported that with 16% of the S&P 500 having reported earnings results, 76% of companies have beaten EPS estimates, which is slightly below the 5-year average of 77%, and the sales beat rate is 63%, compared to the 5-year average of 69%. It’s still early in earnings season and challenges are ahead. Historically, the trajectory of ISM Manufacturing PMI has been correlated with the earnings beat rate. ISM has been tanking. Will the beat rate follow?

     

     

     

    The debt ceiling and De-Dollarization

    In addition, concerns over the resolution of the debt ceiling are rising. The price of credit default swaps has soared to levels last seen in 2011.

     

     

    The debt ceiling debate has brought the deficit hawks out and raised the fears of de-dollarization, or the loss of the USD as the status of a global reserve currency. We are here to put those fears to rest.
    Intertwined with de-dollarization fears are geopolitical concerns and the rise of the Chinese yuan as a reserve currency. But one key characteristic of a reserve currency is that there must be plenty of it sloshing the global financial system. In order for that to happen, the issuing country needs to run a persistent trade deficit like the U.S. Instead, China has been running trade surpluses, which creates headwinds for spreading its currency around the world.
     

     

    The Swiss Franc (CHF) is a favorite of the hard money crowd, but it can’t be a viable major reserve currency. There just aren’t enough CHFs around. Gold is the same story. Consider that the U.S. is one of the largest holders of gold in its reserves. Imagine if the U.S. Treasury sold off every ounce of gold in its inventory. At the current market price of about $2,000, it would net roughly $300 billion, which doesn’t’ even cover a single year’s fiscal deficit. The aggregate market capitalization of all gold mining companies ranks somewhere between the market cap of Proctor & Gamble and ExxonMobil. In other words, gold stocks are a round error when compared to the total size of global equities.
     

    Brad Setser has been a master in tracking balance of payment flows and he finds no evidence of de-dollarization in China’s foreign currency reserves. Remember that when a Chinese exporter sells something to a U.S. customer, it receives USD in return. The Chinese producer then has to decide what to do with those dollars, which shows up in balance of payment flows. In practice, most of it ends up invested us Treasury and Agency paper.
     

     

    Setser also found that there is no evidence of de-dollarization from non-China sources.

     

     

    Instead, the USD Index has repeatedly successfully tested support and held ground. A rally in the greenback could prove to be negative for stock prices as the USD and the S&P 500 have shown themselves to be inversely correlated to each other.

     

     

     

    A liquidity retreat

    Tactically, the market is likely to seem some headwinds in the week ahead. The stock market has been supported by liquidity injections as a reaction to the banking crisis. Now that the panic is over, the Fed is withdrawing liquidity from the financial system, which is likely to create headwinds for stock prices.

     

     

    Another proxy for system liquidity are crypto-currency prices, which are in retreat.

     

     

    In conclusion, the market is behaving like the enigmatic Mona Lisa as it is beset by a series of cross-currents that investors may not even be aware of:

    • The uncertainties stemming from Q1 earnings season.
    • The possible effects of a credit crunch on the economy and the Fed’s reaction.
    • The concerns over a potential debt ceiling impasse.
    • The de-dollarization narrative, and the effects on the USD, which has shown itself to be inversely correlated to the S&P 500.

    For now, these cross-currents are serving to create volatility as neither bulls nor bears have been able to gain the upper hand. Expect a range-bound choppy market until a trend emerges.

     

    Why I’m not overly bullish or bearish

    Posted by Cam Hui -
    As the S&P 500 stalls at overhead resistance while exhibiting negative divergences, here are some reasons why you shouldn’t be overly bullish or bearish on U.S. equities.

     

     

     

    The Bear Case

    The bear case for stocks is based mainly on macro and fundamental conditions. A recession is on the horizon in H2 2023, and recessions are bull market killers. New Deal Democrat, who maintains a set of coincident, short-leading, and long-leading indicators, has been documenting the slow deterioration of economic momentum, which first started in the long-leading indicators designed to spot economic weakness 12 months ahead. The weakness spread to short-leading indicators, which have a six-month time horizon, and they are finally appearing in the coincident indicators. His latest update shows that of his 14 long-leading indicators, one is positive, three neutral and 10 are negative. Among his short-leading indicators, the score is four positive, four neutral and six negative. The coincident indicator dashboard shows two positive, three neutral and five negative. He concluded:

    The “Recession Warning” which began at the end of November for this year remains, as all three of my primary systems remain consistent with a near-term recession.

     


     

    In addition to the economic recession, don’t forget about the likely earnings recession. BoA found that estimate revisions have been deteriorating across the board.

     

     

    These signals, along with the deterioration in small business optimism, are pointing to a hard landing in the near future.

     

     

     

    Possible Sentiment Support

    On the other hand, most of the recessionary conditions may already be discounted. Carl Quintanilla of CNBC reported that a recent JPMorgan survey of investors shows that a recession that begins in H2 2023 is already the consensus call.
     

     

    In addition, Lisa Abramowicz at Bloomberg reported that, according to the April BoA Global Fund Manager Survey, global managers’ allocation to equities relative to bonds has dropped to its lowest level since 2009.

     

     

    As well, hedge funds have built up record shorts in S&P 500 futures, which should be contrarian bullish.

     

     

     

    Sentiment Doubts

    On the other hand, bearish futures positioning has been no guarantee of higher stock prices. In fact, an analysis of the recent record shows that investors should bet with and not against significant long or short positions in hedge fund positions in S&P 500 futures.

     

     

    The crowded short sentiment readings from surveys and S&P 500 futures have not been confirmed by other sentiment models. The NAAIM Exposure Index, which measures the sentiment of RIAs who invest individual investors’ accounts, is in neutral territory and readings are nowhere near a buy signal.

     

     

    The recent behavior of the VIX Index and high yield bond relative performance are also pointing to a risk-on sentiment backdrop.

     

     

     

    Similarly, the put/call ratio is also in neutral and shows few signs of excessive fear or greed. Readings have normalized to levels last seen before the pandemic.

     

     

     

    In short, some of the sentiment models supportive of a bullish outcome are suspect. The history of a crowded short in S&P 500 futures has shown itself to be not very useful as a contrarian indicator. In addition, sentiment surveys are less useful than models that show how investors are committing their funds. And option market sentiment, such as the put/call ratio and the VIX Index, are showing neutral or risk-on readings that contradict the extreme cautiousness of institutional sentiment surveys.
     

     

     

    Historical Templates to Consider

    So where does that leave us? It’s possible that both the bulls and bears are right. A recession is probably in the cards, but most of the deterioration may have already been discounted, though European equities appear to be in a better position than the U.S. 

     

    This suggests a scenario where neither bulls nor bears gain the upper hand. Recession and earnings fears constrain the upside potential to stock prices and cautious sentiment serves to put a floor on them.
     

     

     

    I offer the 2001 experience as a possible template for the trajectory of today’s market. Recall that the stock market peaked in March 2000 when the NASDAQ Bubble burst and stocks went into a long multi-year bear market. The 9/11 shock was a jolt to market psychology. At that time, the Fed was already easing monetary policy. The market rebounded quickly soon afterwards, only to see negative fundamentals re-assert themselves. The stock market then chopped around for about a year before making a final bottom about a year later.

     

     

    The 1980–1982 experience is another market template to consider. The most commonly quoted index then was the Dow and not the S&P 500. The market made an initial bottom in March 1980 and proceeded to rally as rates fell. The rally ran into stiff headwinds in early 1981 as the Volcker Fed tightened monetary policy to extremely painful levels. The bear market resumed in mid-1981 and didn’t bottom until the Mexican Peso Crisis threatened the stability of the U.S. banking system, which forced the Fed to ease. 

     

     

    Fast forward to 2023. The Fed and other major central banks were near the end of their tightening cycles when they were hit with a banking crisis, which was sparked by the failure of Silicon Valley Bank but spread to the systemically important Credit Suisse. The crisis passed and the banking system appears to have stabilized, but valuations are still challenging.  The S&P 500 trades at a forward P/E of 18.2, which is elevated by historical standards especially in light of continuing negative earnings revisions that put upward pressure on the P/E ratio.

     

     

    If today’s market were to follow the 1980–1982 or the 2001 templates, expect stock prices to rebound and trade in a choppy and volatile range until the full effects of the likely recession is known. Bear in mind that these experiences are only templates for the market. Don’t expect the market to necessarily undercut the recent lows, or expect the timing of the banking crisis low and the final low to be the same as past periods.

     

    Word of warning for equity bulls

    Posted by Cam Hui -
    Mid-week market update: I am publishing this note slightly early today as I have an appointment just after the market close and the prices on the charts will not be today’s closing prices. As the S&P 500 struggles with overhead resistance, I would like to offer some words of warning for equity bulls. The VIX Index has returned to levels not seen since November 2021, before the market topped out. Is that a sign of complacency, or normalization?

     

     

    As a reminder, November 2021 was just before the onset of the omicron variant, and the retirement of the transitory language by the Federal Reserve. While this doesn’t mean that the market will necessarily fall immediately, it does indicate a possible precarious backdrop and an accident waiting to happen.

     

    As well, cross-asset volatility has dropped to a 14-month low.

     

     

     


     

    Negative divergences

    From a technical perspective, the S&P 500 is struggling with a resistance zone, but the 5-day RSI and NYSE McClellan Oscillator (NYMO) are exhibiting short-term negative divergences. Even though the percentage bullish and percent of S&P 500 above their 50 dma are positive in the same short-term time frame (dotted arrows), they are also showing negative divergences when compared to the peak in early February (solid arrows).

     

     

    Similarly, equity risk appetite indicators are also exhibiting negative divergences.

     

     

    So are credit market risk appetite indicators.

     

     


     

    The debt ceiling landmine

    In addition, market anxiety over the debt ceiling is already rising as Treasury approaches its X date when it has exhausted its extraordinary measures. 

     

     

     

    Ironically, one of the extraordinary measures is supporting stock prices. That’s because Treasury is drawing down its account (TGA) at the Fed – sort of like taking cash out of your bank and spending it. This has the effect of injecting liquidity into the financial system, which supports the price of risky assets.

     

     

    The vast majority of respondents of the BoA Fund Manager Survey expects that the debt ceiling will eventually be resolved, and that is certainly the market consensus. Once the debt ceiling is lifted, the US government will start to borrow again. Debt issuance will have the effect of soaking up liquidity. Moreover, the U.S. Treasury will undoubtedly try to build up its TGA balance, which also withdraws liquidity from the system. These measures will create headwinds for stock prices.

     

     


     

    Don’t expect a crash

    Putting it all together none of my analysis means that the market is about to crash. It’s only been about a month since the failure at Silicon Valley Bank sparked a banking crisis. Stock prices have rebounded strongly, but the market suffered considerable technical damage from that mini-panic. Expect a period of sideways choppiness and  consolidation before stocks can sustainably rally (see Assessing the technical damage).

     

    Fortunately, regional bank stocks, which was at the epicentre of the panic, are holding support and exhibiting a series positive RSI divergences, which is a positive sign.

     

     

    My base case continues to be a period of back-and-forth choppiness during earnings season. Market direction won’t be resolved until the S&P 500 achieves either an upside breakout or downside breakdown.

     

    The market leaders hiding in plain sight

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

     

     

    The latest signals of each model are as follows:
    • Ultimate market timing model: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Neutral

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

    Subscribers can access the latest signal in real time here.

     

     

    A mystery chart

    As investors search for evidence of market leadership, here is a mystery chart of constructive patterns of a closely related group. The chart shows patterns of either upside breakouts or pending breakouts out of long multi-year bases.

     

     

     

    Can you guess what they are?
     

     

    Faltering U.S. leadership

    U.S. equities have been the market leaders since the GFC, but that may be changing. The S&P 500 appears to be undergoing a topping pattern after violating a relative uptrend. The topping patterns are more evident in the relative performance of the NASDAQ 100 and the small-cap Russell 2000. The NASDAQ 100 topped out earlier on a relative basis and the Russell 2000 is flat to down when compared to MSCI All-Country World Index (ACWI).
     

     

    I have repeatedly pointed out the premium forward P/E valuation of U.S. equities. Where can investors find better value and momentum in other parts of the world?
     

     

     

    Hello Europe!

    Back to our mystery chart. It’s the relative performance of MSCI Eurozone and selected major core and peripheral countries in the eurozone. With the exception of Germany, all countries have staged upside relative breakouts from long bases, indicating strong upside potential.

     

     

    What about the U.K., which is the cheapest major region by forward P/E. While U.K. equities are exhibiting a similar multi-year relative base and breakout pattern to other eurozone markets, some caution is warranted.
     

     

    While the technical pattern of the relative returns of large-cap U.K. stocks (dark solid line) appears to be constructive, history shows that their relative performance have been closely correlated to energy stocks (red dotted line). Here’s where trouble begins. Large-cap U.K. stocks are negatively diverging from the energy sector, indicating a country-level drag. Moreover, the relative performance of small-cap U.K. equities, which are more sensitive to the British economy, are lagging large caps.

     

     

    Avoid.
     

     

    Unexciting Asia

    As we move across time zones, the relative performance of Asian markets can best be described as unexciting. Asian markets are flat to down compared to ACWI. The charitable characterization is that they will need more time to base before they can break out.
     

     

    In the short run, Asian equities may see a boost from Chinese stimulus. Total Social Financing in China has been elevated in the last three months, indicating efforts by Beijing to boost the economy. Keep an eye on the relative performance of China and Hong Kong. Can they stage relative breakouts?
     

     

     

    The week ahead

    The market action of the S&P 500 last week showed the jittery and headline sensitive nature of market sentiment. The market was flat and marked time on Monday and Tuesday in wait of the closely watched CPI report. When CPI came in slightly softer than expected, prices rallied but retreated later on disappointment over the release of the FOMC minutes. The market then rallied Thursday when PPI came in lower than expected.

     

    In the short run, liquidity conditions are stabilizing, but keep an eye on the debt ceiling impasse in Washington. The U.S. Treasury has been drawing down the TGA of funds held at the Fed as part of its extraordinary measures to keep the government running, which injects liquidity into the banking system. A resolution of the debt ceiling impasse will see an accumulation in TGA and more bond and bill sales, which reduces system liquidity.
     

     

     

    That said, hedges are in a crowded short in S&P 500 futures, which will provide buying support and a floor on stock prices in the event of bad news. In the best case, it could spark a FOMO buying panic in the event of good news.

     

     

    The S&P 500 is testing overhead resistance while exhibiting negative divergences in the 5-day RSI and the NYSE McClellan Oscillator, which are both overbought. Until we see a definitive breakout, the base case remains a choppy range-bound market.

     

     

     

    In conclusion, the long-term structure of global markets is seeing a loss of leadership by U.S. equities and emerging new leadership in Europe. The short-run outlook will depend on the results of earnings season, but my base case remains a choppy and range-bound market.

     

    How to position for the coming growth slowdown

    Posted by Cam Hui -
    The International Monetary Fund published its latest World Economic Outlook. It cut its global GDP growth estimate by 0.1% from 2.9% in January to 2.8%. More ominously, it issued a warning about a growing risk of recession in the advanced economies from financial instability risk from bank failures: “A hard landing — particularly for advanced economies — has become a much larger risk”
     

     

     

     

    In light of the risks of a substantial slowdown, how should investors position themselves?
     

     

     

    Signs of a U.S. Slowdown

    In the U.S., signs of a slowdown are appearing everywhere. The March CPI report came in a little on the soft side, but decelerating inflation is a two-edged sword. The New York Fed’s Underlying Inflation Gauge shows slowing inflation, but sharp declines are consistent with a recession or economic slowdown.
     

     

    Even though the Fed’s official position is a soft landing, the New York Fed’s yield curve-based recession probability estimate has spiked substantially.

     

     

    The NFIB monthly survey of small business sentiment is revealing, though the readings have to be interpreted carefully as small business owners tend to be small-c conservatives whose sentiment rise when a Republican is in the White House and falls when a Democrat occupies the Oval Office. Nevertheless, the survey is useful as small businesses lack bargaining power and they are therefore sensitive barometers of economic conditions.
     

     

    The latest sentiment figures show optimism has fallen substantially to COVID Crash levels.

     

     

    Even before the onset of the banking crisis, small businesses reported tightening credit conditions. 

     

     

    Moreover, hiring plans are softening. 

     

     

    As we approach Q1 earnings season, FactSet reported an elevated level of negative earnings guidance…

     

    <

     

    …and a depressed level of positive guidance.

     

     

    Putting it all together, this spells an economic slowdown ahead.

     

    Real-time Market Warnings

    In addition, I am seeing real-time signs of a slowdown from market data.

     

    Gold acts as a risk-off asset and performs well when stress levels are high. By contrast, the copper/gold ratio is a cyclically sensitive indicator and rises when market expectations of economic growth rise. The accompanying chart depicts past periods when the copper/gold is rising, which coincided with a falling gold/CRB Index ratio. @here are we today? Gold is rising relative to the CRB, indicating a risk-off environment, and the copper/gold is flat to down, indicating a period of softness in the economy.

     

     

    During periods of economic stress, investors favour high-quality stocks at the expense of high-flying unprofitable companies. We measure the quality factor in several ways. One way is profitability. Standard & Poors has a higher profitability inclusion criterion for its indices than the FTSE/Russell indices. Therefore, the return spread between similar S&P and Russell indices could be a measure of profitability quality. 

     

    As the accompanying chart shows, investors have been accumulating both large- and small-cap quality stocks, which is a signal of a risk-off condition for the economy and stock market.
     

     

     

     

     

    Investment Implications

    We began this publication with the rhetorical question of how investors should position themselves in light of the risks of a substantial economic slowdown. The coming environment is ideal for a 60/40-style balanced portfolio of equities and fixed income instruments.

     

    Last year was difficult for the traditional 60/40 portfolio as both stock and bond prices fell together, but the relationship and correlation between the two asset classes have begun to normalize in 2023 (bottom panel). The accompanying chart shows the stock/bond correlation in the bottom panel and the shaded areas represent past major bear markets. It was only the double-dip recession of 1980–1982 during the tight Volcker money era that stocks and bonds exhibited positive correlation. Much like the Volcker era, the correlation is falling and the historical diversification effects of the two asset classes are re-asserting themselves.
     

     

     

     

    While reasonable people can debate about the near-term trajectory of Federal Reserve monetary policy, there is little doubt that global central bankers are nearing the end of their tightening cycle. Historically, peaks in the 30-year Treasury yield have either been coincident or led peaks in the Fed Funds rate – and falling bond yields are bullish for bond prices. By contrast, peaks in the 30-year Treasury yield have shown a spotty record of calling equity market tops or bottoms.

     

     

     

    The 30-year yield appears to have already peaked, which should be bullish for the bond price outlook. If history is any guide, the outlook for stocks is less certain.
    In conclusion, the risk of a substantial economic slowdown is rising based on our review of macro, fundamental, and real-time market factors. Investors should position themselves by holding a diversified portfolio of stocks and bonds to protect themselves from possible future asset price volatility.

     

    Does inflation matter to stocks anymore?

    Posted by Cam Hui -
    Mid-week market update: The S&P 500 roared out of the gate this morning on a slightly softer than expected CPI print. Robin Brooks observed that super-core CPI (core services  ex-housing and healthcare, light blue bars) have been decelerating.

     

     

    Unfortunately for equity bulls, the gains faded over the course of the day.

     

    Callie Cox pointed out that stock market volatility has been falling on CPI days when compared to FOMC and NFP days.

     

     

    Does inflation matter to stocks anymore?

     

     

    Differing technical patterns

    What would prefer to hold in the current environment? The 7-10 year Treasury ETF (IEF), which is their upside breakout?

     

     

    Or would you prefer the S&P 500, which unsuccessfully test a overhead resistance level while exhibiting a negative RSI divergence and overbought on the % of stocks above their 20 dma?
     

     

    A review of market breadth, as measured by capitalization bands, tells a story of narrow leadership by the large-cap S&P 500. While the S&P 500 is range-bound, market strength deteriorates as you go down market capitalization groupings, starting with the equal-weighted S&P 500, which reduces the dominance of the megacaps, to the mid-cap S&P 400, and finally the small=cap Russell 2000.

     

     

    A review of the relative returns of the top five sectors of the S&P 500, which comprise over 70% of index weight, shows few signs of sustained leadership. Technology relative strength is rolling over. The defensively oriented healthcare sector is starting to turn up. Financial and industrial stocks may be trying to bottom, and consumer discretionary is flat against the index.

     

     

    None of this means that it’s time to be outright bearish, but disappointing performance in the face of good news is a cautionary flag. I reiterate my belief that the stock market is in a choppy range-bound pattern. Investors should wait for either a bullish or bearish catalyst before taking a directional view on stock prices.

     

    Why I am fading the breadth thrust

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

     

    The latest signals of each model are as follows:

    • Ultimate market timing model: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Neutral

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

    Subscribers can access the latest signal in real time here.

     

     

    About that breadth thrust

    I have had several discussions with investors over the meaning of the recent Zweig Breadth Thrust (see Interpreting the Zweig Breadth Thrust Buy Signal). A ZBT is a rare condition that occurs when the market moves from an oversold to an overbought condition within 10 trading days. There have been seven out-of-sample signals since Marty Zweig wrote his book, Winning on Wall Street. The stock market was higher a year later in every instance, though it did pause and pull back on two occasions, which occurred against Fed tightening cycles. I think that the latest signal will resolve in a pullback.

     

     

     

    What’s a Breadth Thrust?

    I have found that too many investors regard technical indicators and their buy and sell signals as black boxes. To address that issue, let’s consider the investment theme behind a breadth thrust. A breadth thrust involves the following conditions:

    • Usually an oversold market where sentiment becomes washed out.
    • A sudden violent market recovery and buying stampede with broad participation.
    • The momentum from the buying stampede eventually pushes prices higher and usually marks the start of a new bull phase.

    Let’s apply those three criteria to the current ZBT buy signal. Arguably, the recent banking crisis jitters created an oversold and washed-out sentiment. But broad participation? The accompanying chart shows the relative performance of the five sectors in the S&P 500 by weight. The sectors comprise over 70% of index weight. Technology was the sole market leader. The other four were either flat or lagged the market. Broad participation doesn’t look like this.

     

     

    I would also point out that the Fed tightening cycle isn’t complete. Cleveland Fed President Loretta Mester explained in greater detail why the Fed has much more work to do to tame inflation. She said that the Fed should raise the Fed Funds rate above 5% this year and hold it at restrictive levels, which she defined as the inflation rate, for some time to quell inflation. 

     

    The market is discounting a rate plateau just below the 5% level specified by Mester and rate cuts that begin mid-year, which is contrary to the message from Mester and other Fed speakers. As a reminder, Fed Chair Jerome Powell stated during the last FOMC press conference that rate cuts in 2023 are not part of the Fed’s baseline.

     

     

    If a breadth thrust is the signal of a new equity bull phase, valuation would be a concern. I pointed out last week that the current signal would be the highest forward P/E in the out-of-sample history of ZBT buy signals. It would also be the highest P/E compared to the 10-year Treasury yield, or equity risk premium, in the out-of-sample history. Investors who buy here wouldn’t be depending on valuation support, but betting on the start of a new investment bubble.

     

     

    Breadth thrust signals aren’t perfect. Technical analyst Walter Deemer highlighted the simultaneous combination of a Whaley Breadth Thrust and Breakaway Momentum in mid-January. The buying stampede was sparked by the bullish prospect of China re-opening its economy after a reversal of its zero-COVID policy. While the S&P 500 did rally shortly after the two signals, it pulled back after investor disillusionment with the China re-opening trade. Similarly, the latest ZBT signal was sparked by a recovery off the banking crisis low, but the KBW Regional Banking Index has since retreated to test its previous lows, which is not a good sign.

     

     

    Other analysts have analyzed breadth thrusts and arrived at similar conclusions. Tom McClellan analyzed the history of ZBT buy signals all the way back to 1928 and concluded that they only had about a 50-50 chance of success, though he defined failures as the market not immediately rising to new highs.
     

    Brett Steenbarger quantified the short-term effects of breadth thrust and he was not impressed.

    I went back to 2006 and identified all market occasions in which more than 90% of SPX stocks were above their 3, 5, and 10-day moving averages at the same time. Interestingly, out of well over 4,000 market days, this only occurred on 42 occasions.  Over the next five trading sessions, the market was down by an average of -.26%, compared with a gain of +.18% for the remainder of the sample.  No particular edge here, even going out 20 days.  Returns over a next 20-day period were volatile, with 17 of the 42 occasions rising or falling by over 5%.

     

     

    Not Bearish

    My skepticism of the effectiveness of the latest ZBT doesn’t mean that we are outright bearish on stock prices. Rob Anderson at Ned Davis Research pointed out that the Coppock Curve flashed a buy signal for the S&P 500 at the end of March by turning up.

     

     

    While the Coppeck Curve is flashing a buy signal, other short-term factors are not as bullish. The Fed is draining liquidity (blue line) after stabilizing the banking system. Eagle eye readers will also have noticed that Bitcoin, which is a partial proxy for short-term system liquidity, went nowhere last week.

     

     

    As the Fed drains liquidity from the banking system, regional bank stocks struggled to hold their long-term support. Coincidence?

     

     

    Here’s the good news. The market structure of the S&P 500 indicates that it’s undergoing a bottoming process. The percentage of S&P 500 stocks above their 50 dma is moderating. My base case calls for breadth to recover in a choppy manner for the next few months.

     

     

    In the short run, the market is range-bound. Wait for greater clarity for either an upside breakout or downside breakdown before taking a view on market direction.

     

     

    A fire and ice challenge to risk assets

    Posted by Cam Hui -
     In case you missed it, the 10-year Treasury yield fell and broke a technical support level even as the 3-month T-Bill yield rose. This left the 10-year to 3-month yield spread inverted further, which has historically been a strong recession signal.
     

     

     

    The 10-year and 3-month Treasury yield spread has inverted before every recession. If history is any guide, a slowdown is just around the corner.

     

     

     

    The stock market and other risk assets are facing a fire and ice challenge. Fire in the form of still overly hot inflation readings and ice in the form of a deteriorating economy.
     

     

     

    The Fire Threat

    The fire threat of too-hot inflation was outlined by Cleveland Fed President Loretta Mester, who explained in greater detail of why the Fed has much more work to do to tame inflation. She said that the Fed should raise the Fed Funds rate above 5% this year and hold it at restrictive levels, which she defined as the inflation rate, for some time to quell inflation. The Fed remains data-dependent and the path of monetary policy depends on how quickly price pressures ease.
     

     

     

     

    The seriousness of the global inflation fight was reinforced when the Reserve Bank of New Zealand (RBNZ) unexpectedly raised rates by 50 basis points. Despite New Zealand’s small size, the RBNZ was a leader in the latest tightening cycle and the recent aggressive move could be interpreted as a signal that a pivot to an easier monetary policy may not be as close as the market thinks.
     

    Mester’s remarks stand in stark contrast to the Fed Funds market expectations of a near-term plateau that peaks just below 5%, followed by a series of rate cuts that begin in mid-2023.

     

     

    Former Fed economist Claudia Sahm explained the difference in the Fed’s and the market’s thinking this way. The Fed expects inflation to be sticky.

    The Fed thinks that inflation, especially ‘super core,’ will be very persistent, and bringing it down will require high rates for some time. It also does not expect a recession.

    On the other hand, the market expects a recession:

    Markets also expect a recession, possibly a severe one. The thinking is that the Fed will not stand by and do nothing as the economy tanks. Inflation should soften in a recession, giving the Fed cover to cut some.

    Sahm thinks that we will see a recession.

    The Fed will not cut. And there will be a recession starting in the second half.

     

     

    The Ice Threat

    The ice threat can be neatly summarized by the U.S. Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations. ESI recently peaked at a high level and began to roll over, indicating a loss of economic momentum. 

     

     

    Looking ahead to Q1 earnings season, forward 12-month sales estimates have been flat to up while forward EPS has been falling in an uneven manner, indicating margin compression. This is not an environment that’s conducive to strong equity returns.

     

     

    Q1 earnings season will kick off with reports from large banks. Even though financial stocks have stabilized after the banking crisis, their relative performance continues to struggle, and so has their relative breadth conditions (bottom two panels). How will the market react to the reports from the banks?

     

     

    As well, market internals of the relative performance of cyclical industries are weakening. Even the semiconductors, which had been the last holdout among the leaders, recently violated a rising relative trend line, indicating a loss of cyclical momentum.
     

     

    By contrast, defensive sectors are either staging relative breakouts or on the verge of relative breakouts, indicating that the bears are trying to seize control of the tape.

     

     

    In the current environment, investors have been piling into large-cap quality as a refuge. We measure the quality factor in several ways. One way is profitability. Standard & Poors has a higher profitability inclusion criterion for its indices than the FTSE/Russell indices. Therefore, the return spread between similar S&P and Russell indices could be a measure of profitability quality. In addition, the dotted line (middle panel) shows the relative performance of a quality ETF against the S&P 500. As the accompanying chart shows, investors panicked into large-cap quality in March, but the return to small-cap quality was flat during the same period.

     

     

     

    Remember China Re-opening?

    One of the last hopes for the cyclical bull case was the China re-opening narrative. The market greeted the prospect of China re-opening its economy after abandoning its zero-COVID policy with great fanfare in January. Since then, the China re-opening trade has gone nowhere. The relative performance of China and the stock markets of its major Asian trading partners have either gone sideways or down.

     

     

    What about China’s domestic economy? The accompanying chart shows the relative performance of selected cyclical sectors compared to MSCI China. Here are my main takeaways:

    • Material stocks, which are sensitive to commodity demand, mainly from infrastructure spending, are lagging after showing a brief burst of strength.
    • Consumer sensitive sectors such as consumer discretionary and internet stocks, which contain heavyweight consumer spending sensitive Alibaba and Tencent, have gone nowhere on a relative basis since the re-opening announcement.
    • The real estate sector, which is the most vulnerable part of the Chinese economy because of the collapse in prices and major developers like China Evergrande, along with the financial sector, have been steady against MSCI China. This is an indication that the authorities have stabilized the property market and the tail-risk of a disorderly breakdown has been diminished.

     

     

     

    The Bearish Tripwire

    So far, these signals are only bearish warnings and not outright bearish signals. We would watch for a technical break in NASDAQ 100 leadership as a sign that the bulls have lost control of the tape to the bears. As well, keep an eye on the relative performance of European equities, which are still in a relative trading range. An upside relative breakout or downside breakdown out of the range could be a useful signal of how leadership could develop in the next market cycle.
     

     

     

    A NFP preview

    Posted by Cam Hui -
    Mid-week market update:  I know that we mostly focus on the outlook for the stock market in these pages, but investors should cast their eyes on the bond market once in a while, as they might learn something. Bond prices staged an upside breakout, which is a signal of economic weakness.

     

     

    As the next major economic data point is the March Employment Report due Friday morning, this is a good time to review the jobs market outlook, which is probably more important  to the bond market than the stock market.

     

     

    Signs of weakness

    There are many signs that the jobs market is weakening. The February JOLTS report showed a decline in job openings that was beyond market expectations.

     

     

    Leading indicators, such as temp jobs (blue line) and the quits/layoffs ratio (red line), were not as calamitous. Nevertheless, the quits/layoffs ratio from the JOLTS report shows a noisy decline, indicating job market weakness.

     

     

    Mike McDonough, the Chief Economist at Bloomberg Financial Products, observed that mentions of “job cuts” art now starting to exceed “job shortages” on company earnings calls, which are signs of labor market softness.

     

     

    As well, ISM Manufacturing PMI fell and badly missed expectations. Moreover, ISM Manufacturing Employment showed similar signs of weakness.

     

     

     

    Soft, but not that soft

    While the jobs market is showing signs of softness, it’s not a disaster. ISM Non-Manufacturing Employment rose, though it missed expectations.

     

     

    Initial jobless claims (blue line) have been remarkably resilient. For some context on the strength of the economy, initial claims normalized for population (red line) made an all-time line before the onset of the pandemic and readings remain low by historical standards. (The figures are shown in log scale in order to minimize the distortions caused by the pandemic jobless spike).

     

     

    Here is a close-up of initial claims data, which is stable but exhibiting minor signs of weakness.

     

    <

     

     

    In conclusion, the March Employment Report this Friday will probably elicit a market reaction, but unfortunately the markets won’t be open until Monday. Expect minor signs of weakness, but not that weak. If I am right, bond prices should rally, but what happens to stock prices will be an open question. The S&P 500 pulled back after testing resistance amidst an overbought condition. Likely support can be found at the 50 dma at about 4027.

     

     

    Interpreting the Zweig Breadth Thrust buy signal

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

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

     

     

    The latest signals of each model are as follows:
    • Ultimate market timing model: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Neutral*/li>

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

    Subscribers can access the latest signal in real time here.

     

     

    A ZBT buy signal

    The market flashed an extremely rare Zweig Breadth Thrust buy signal late Friday. Without going into a lot of detail, the ZBT buy signal is triggered when the market surges from an oversold to an overbought reading within 10 trading days, which it managed to achieve on Friday.

     

     

     

    How should investors interpret this buy signal? At first glance, it appears to be an excitingly bullish development, or a “what’s the credit limit on my VISA card” buy, but I have doubts.

     

     

    Analyzing the ZBT

    There have only been six out-of-sample ZBT buy signals since Marty Zweig wrote the book, Winning on Wall Street, that outlined the details of this technique in 1986. In all cases, the stock market
    was higher a year later. In four of the six instances, the market kept rising after the signal and never looked back. The two “failure”, which saw the S&P 500 pull back after the buy signal. Will this market immediately launch itself to new highs or will the rally fizzle like it did in 2004 and in 2016?

     

     

    What category does the current episode belong? I can observed that most ZBT buy signals were seen in V-shaped rebounds after the market tanked and sharply recovered, While there was a relief rally in the aftermath of the banking crisis, the current episode can hardly be described as a V-shaped recovery.

     

    The unsuccessful buy signals occurred when the Fed was undergoing a tightening cycle. What’s different this time is we are near the end of the tightening cycle, which doesn’t quite fit the “fizzle” template. The market is discounting nearly a 50-50 chance of a quarter-point rate hike at the May FOMC meeting and rate cuts by mid-year. Is the Fed still tightening? The market is unsure on that score, but the latest Fed rhetoric is still of the “there is  more work to do” variety.

     

     

    What about valuation? The accompanying chart shows the S&P 500 forward P/E at the time of the six out-of-sample ZBT buy signals, along with the 10-year Treasury yield as an indication of the relative attractiveness of stocks compared to bonds. I can make the following observations:

     

    • Most ZBT buy signals occurred when the forward P/E dropped suddenly and then recovered (a V-shaped rebound), which is not the case today,
    • The S&P 500 current forward P/E of 18.1 is higher than any of the other P/Es seen during past ZBT buy signals.
    • Past buy signals were triggered in environments of more
      attractive cheaper valuations of stocks compared to bonds. Even
      though forward P/E of the other ZBT buy signals were lower than what it
      is today, the other buy signals occurred in environments when the
      10-year Treasury was lower than it is today, with one exception.
    • In the one exception in 2004 when the 10-year Treasury yield was higher, the S&P 500 forward P/E was still lower than it is today. Even then, the 2004 buy signal fizzled by trading sideways for several months before rising to fresh highs. The price action can be seen as a P/E de-rating before rising again.

     

     

    In short, the latest ZBT breadth thrust signal has been triggered when the stock market is the most expensive in history compared to other buy signals. The combination of a lack of valuation support and uncertainty over Fed policy leads me to believe that the immediate upside to the latest buy signal is likely to be limited. While the S&P 500 will probably be higher a year from now, the more likely path for stock prices is a pullback in a choppy setting before the market can reach fresh highs.

     

    Technicians need to be prepared to be disappointed.

     

     

    Home on the range

    Despite the rally experienced by the U.S. equities and the ZBT buy signal, the S&P 500 remains in a trading range. Initial support can be found at the falling trend line at about 3800, with secondary support at the 200 wma at about 3750. Initial resistance is at about 4080, which the index broke through, and secondary resistance at 4150. With the market already overbought, as measured by the NYSE McClellan Oscillator, expect choppiness and turbulence until the index can break out, either to the upside or downside.

     

     

     

    Uncertainty from bond and factor analysis

    Other assets confirm the range-bound nature of this market. As an example, the bond market is unhelpful in determining the trend in risk appetite as bond prices are also range-bound. The 7-10 Year Treasury ETF (IEF) staged a failed upside breakout and retreated back into a range between 94.50 and 100. The International Sovereign Bond ETF (IGOV), which is priced in USD and has a similar duration, or interest rate sensitivity, as IEF, is lagging IEF. The poor relative performance of IGOV is surprising as the USD has been weak for most of March, which should provide a boost to IGOV returns.

     

     

    The analysis of the commonly used four Fama-French equity return risk factors, which are price momentum, quality, size and value and growth, also offer few clues to market direction. One possible hint can be seen in the recent positive but choppy returns to quality, which is often a characteristic found during past equity bears.

     

     

    The banking crisis also has both bullish and bearish implications. On one hand, it is constructive that regional banking stocks have stabilized. 

     

     

    On the other hand, the emergency liquidity injections are starting to be drained from the banking system in the wake of the crisis, and lower liquidity tends to be bearish for risk assets.

     

     

    Mixed Sector Internals

    An analysis of the returns of style and sector internals also show a mixed picture. While it’s true that investors have gravitated toward large-cap growth during the recent banking crisis, most of the outperformance can be found in technology. The other two growth sectors show little signs of leadership.

     

     

    By contrast, the relative performance of value sectors, which are cyclically sensitive, have been challenging.

     

     

    If large-cap technology is leading the market and value is lagging during a period of financial stress, does this mean it’s time to turn bearish?
     

    The answer is no. The relative performance of defensive sectors presents a mixed picture of market leadership. Of the four defensive sectors, one (consumer staples) is in relative uptrend, one (real estate) is in a relative downtrend and the other two are range-bound when compared to the S&P 500. These are not signs that the bears have seized control of the tape.
     

     

    In conclusion, I believe that despite the potential excitement generated by the ZBT buy signal, the U.S. equity market remains in a holding pattern. Investors should wait for more definitive signs of market direction from either factor returns or market internals before turning overly bullish or bearish. Investors will see the March Jobs Report next week, followed by the start of Q1 earnings season, which may provide better guidance to near-term market direction.
     

     

    What USD weakness may mean for asset returns

    Posted by Cam Hui -
    An unusual anomaly arose during the latest banking crisis when a long-standing historical relationship broke apart. When bank stocks skidded in response to the problems that first appeared at Silicon Valley Bank, the 2-year Treasury yield fell dramatically, indicating a rush for the safety of Treasury assets. What was unusual this time was the weakness in the USD. The greenback has rallied during past financial scares and crises as investors piled into the safety of the USD and Treasury paper. This time, Treasuries did reflect a flight to safety, but not the USD. As the USD has been inversely correlated to the S&P 500, and the dollar can’t advance even with the macro tailwind of a banking crisis, what does this mean for asset returns?

     

     

     

    The long-term picture

    Let’s start with the long-term view. The 20-year chart of the USD shows that it has retreated to test a support zone that stretches back to 2015. If it were to break support – the next support level can be found at just under 90 – it would spark a secular bear phase and the dollar could face considerable downside potential compared to current levels.

     

     

    What would a break of support mean for asset prices in the next market cycle? While correlation isn’t causation, the relative performance of the S&P 500 against MSCI EAFE has been highly correlated to the USD Index. Will dollar weakness mean better relative returns for non-U.S. equities?   

     

     

    To be sure, the relative forward P/E valuation of different regions argue against U.S. equities.

     

     

    If the USD were to fall into a secular bear phase, one asset that is likely to benefit is gold, which has historically been inversely correlated to the dollar. Gold prices staged an upside breakout from a multi-year base in 2020. If the greenback were to weaken further here, it would represent further tailwinds for the yellow metal.

     

     

    The measured upside on a monthly point and figure chart of gold is $2,779, though that represents a multi-year target and it’s unlikely to be reached in the immediate future.

     

     

     

    A cyclical Warning

    One word of warning. There is one negatively correlated asset to the USD that is flashing a cyclical warning. In addition to gold, commodity prices have also been historically inversely correlated to the dollar. But the two assets started to diverge in mid-2021.

     

     

     

    I attribute this to a sign of global cyclical weakness. The decline in the cyclically sensitive copper/gold and base metals/gold ratios is a sign of economic weakness. Economic weakness is also foreshadowing a reduction in risk appetite, as measured by the stock/bond ratio.

     

     

    A similar relationship can be found between the copper/gold ratio and the 10-year Treasury yield. Weakness in cyclical indicators like copper/gold point to lower bond yields and a probable recession ahead.

     

     

    In conclusion, the USD Index is on the verge of breaking long-term support. If it does, it would have multiple implications for asset class returns:

    • Bullish: Non-U.S. compared to U.S. equities.
    • Bullish: Gold.
    • Bearish: Near-term economic outlook. Commodity prices are sounding a warning that a recession is likely ahead, which would be bullish for Treasuries and bearish for cyclically sensitive assets like commodities.

     

    How greedy should you be during this rally?

    Posted by Cam Hui -
    Mid-week market update: There is an adage on Wall Street, “Bulls, make money, bears make money, hogs just get slaughtered.” I issued a tactical buy signal to subscribers on the weekend based on my usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM). ITBM flashed a buy signal as of the close on Friday when its 14-day RSI recycled from oversold to neutral.

     

     

     

    Now that the stock market is rallying, how greedy should you be? One guideline to consider is, after an ITBM buy signal, the percentage of S&P 500 above their 20 dma generally reaches at least 60%, if not more, before the rally peters out. (Note one-day data delay on % above 20 dma).

     

     

    Still range-bound

    This will be a relatively brief note as the technical structure of the stock market is mainly unchanged since my last update on the weekend. The S&P 500 is still range-bound. Support can be found at the falling trend line at about 3800. Initial upside resistance is at about 4080, with secondary resistance at about 4150. 

     

     

    Before you get too bullish, let’s takeone step at a time. The daily chart of the S&P 500 shows that the index is just testing its 50 dma level, and there is a resistance zone just above the 50 dma. Net NYSE highs-lows have barely turned positive. While that is constructive, it’s no reason to throw caution to the wind and get all bulled up. Tactically, long exit triggers to consider are 1) percentage of S&P 500 above their 20 dma above 60% (almost), or 2) the VIX Index reaches to bottom ot its Bollinger Band (not yet).

     

     

     

    Inflation will set the tone

    Keep in mind that we will see the report of February PCE, which is the Fed’s preferred inflation metric, Friday morning and the report will be a potential source of volatility and it will set the tone for the market next week. 

     

    The Cleveland Fed’s Inflation Nowcast tool is in line with consensus cover PCE expectations of 0.4% month/month and 4.7% year/year.

     

     

    S&P Global (formerly IHS Markit) reported that G4 goods inflation has been falling, but services inflation, which is a metric that the Fed is watching closely, was stubbornly strong in March.

     

     

    My inner trader remains tactically long the S&P 500, but he is inclined to either reduce or exit his position tomorrow (Thursday) ahead of the PCE report, especially if the market exhibits any bullish follow-through. The usual disclaimers apply to my trading positions.

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

     

     

    Disclosure: Long SPXL

     

    A Fed Put of a different kind

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

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

     

     

    The latest signals of each model are as follows:
    • Ultimate market timing model: Sell equities [downgrade]
    • Trend Model signal: Neutral [downgrade]
    • Trading model: Neutral

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

    Subscribers can access the latest signal in real time here.
     

     

    Market stabilization

    Last week, I suggested that one of the key conditions for a sustainable rally is for the KBW Regional Banking Index (KRX) to hold long-term support despite Friday’s market jitters over the stability of Deutsche Bank. While KRX has held support, it disappointed the bulls by refusing to rally off the bottom.  We interpret this to mean that market sentiment over the banking crisis has stabilized.

     

     

    The Fed Put has been activated, but it’s a put of a different kind. Investors can return to more mundane matters such as technical and fundamental analysis.
     

     

    Wobbly signs of cyclical strength

    As a framework of analysis, you need to understand that investors rushed into large-cap growth stocks as safe havens during the banking crisis. Since large-cap growth comprise about 40% of S&P 500 weight, any relative performance analysis using the S&P 500 is distorted by the significant weight of growth stocks.

     

     

    Before the banking crisis, cyclical industries had been in relative uptrends. The same relative performance analysis of the cyclicals reveals a series of broken relative uptrends, with the single exception of semiconductors.
     

     

     

    The relative performance analysis of the same cyclical industries against the equal-weighted S&P 500, which reduces the outsized weights of large-cap growth stocks, shows a series of similar patterns of weakness.

     

     

    The wobbly message from the relative performance of cyclicals is confirmed by a cautionary signal from the softening commodity prices, which should be performing well in light of USD weakness, and weakness in the cyclically sensitive base metal/gold and copper/gold ratios.

     

     

     

    Macro and fundamental headwinds

    In effect, market conditions have deteriorated since the banking crisis. Not only are cyclical stocks losing momentum, but macro and fundamental analysis called for caution.
     

     

    The most significant macro headwind was presented by Fed Chair Jerome Powell during the latest post-FOMC press conference. Even though the latest quarter-point hike was interpreted as a dovish hike by the markets, Powell pushed back against market expectations that the Fed would cut rates in 2023 as it was not in the Fed’s baseline. Nevertheless, Fed Funds futures are pricing in a series of rate cuts starting mid-year.
     

     

    Do you really want to fight the Fed?
     

    In addition, equity valuations is still challenging. The S&P 500 is trading at a forward P/E of 17.2. The last time the 10-year yield was at these levels, the forward  P/E was considerably lower, though they were at similar levels in 2003.

     

     

    When you consider that Street analysts have been downgrading earnings estimates, the forward P/E ratio could be higher even if pries were unchanged. This makes valuation even more challenging for investors.
     

    Equally disturbing is the stock market’s poor breadth. Even as the S&P 500 struggles at its 50 and 200 dma, different versions of Advance-Decline Lines are testing support and not showing any signs of strength.

     

     

     

    What kind of Fed Put?

    I interpret current conditions as Powell Fed has conveyed that there is a limited Fed Put in the market. The Fed will act to support the banking system, or a Bank Put, but it will do little to support the overall stock market, or a Market Put.

     

    Here’s what the Fed Put looks like. The chart of the financial sector looks ugly, but a bottom may be near. It’s exhibiting a positive 5-day RSI divergence and relative breadth indicators are improving (bottom two panels).

     

     

    As long as market concerns over the banking system are in place, expect a range-bound choppy market, bounded by about 3800-3830 on the downside and about 4080 to the upside. If 3800-3830 support breaks, the next major support can be found at the 200 wma at about 3740.

     

     

    As a consequence of these conditions, the Trend Asset Allocation Model reading has been downgraded from bullish to neutral. The Ultimate Market Timing Model is also downgraded to sell as there is a possible recession on the horizon, and recessions are bad news for stocks.My inner investor will start to de-risk and realign his portfolio from an equity overweight to a neutral weight consistent with long-term investment policy weights.

     

     

    The week ahead

    Tactically, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator flashed a buy signal Friday when its 14-day RSI recycled from oversold to neutral on Friday. In the past three years, this model has had 26 buy signals. Of the 26, 22 of them resolved bullishly and four resolved bearishly. My inner trader plans on entering a small long position on Monday/ However, I wouldn’t characterize it as a high confidence trading call in light of the volatile and choppy backdrop.

     

     

    Helene Meisler’s weekly sentiment poll readings were cautiously bullish. Respondents have been mostly right about short-term market direction, which makes my inner trader  somewhat optimistic.

     

     

     

     

    My inner trader plans on entering a long position on Monday. The usual disclaims 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.

     

    Why the dot-plot doesn’t matter

    Posted by Cam Hui -
    It was a closely watched FOMC meeting. The Fed raised rates by a quarter-point, which was widely anticipated, and signaled that it would likely raise another quarter-point before it’s done. It was interpreted as a dovish hike. The Fed also  published a Summary of Economic Projections (SEP), also known as the “dot plot”. In the end, the “dot plot” wasn’t very relevant for two reasons. It was stale by the time it was published, and there was a high degree of uncertainty around the projections.

     

     

    During these times of uncertainty, what matters more is the Fed’s reaction function to financial crises. To address that issue, I have conducted an event study of how the Fed has reacted to shocks and crises in the past in order to estimate the Powell Fed’s reaction function.

     

     

    1987 Crash

    Starting with the Crash of 1987, the accompanying chart shows the S&P 500 as a measure of risk appetite, the yield on 2-year and 3-month Treasury paper as measures of market expectations of changes in policy, the Fed Funds rate, and the 3-month growth in M2 money supply indications of changes in monetary policy.
     

    In response to the greatest market crash since 1929, the Fed embarked on a course of monetary easing as Treasury yields and the Fed Funds rate fell and bottomed within and bottomed within a month of the crash. M2 growth similarly surged and stabilized at about the same pace as the other indicators.
     

     

     

    LTCM implosion, 1998

    Policy response to the Asian Crisis of 1997 was more complicated and matters didn’t come to a head until the Russia Crisis and the failure of Long-Term Capital Management (LTCM) in 1998. After Russia defaulted in August 1998, Treasury yields fell first and policy action, as measured by the Fed Funds rate and M2 growth, followed about a month later. LTCM, which was a secretive hedge fund founded in 1994 by Joh Meriwether, the former head of bond trading as Salomon Brothers, and included Nobel laureates Myron Scholes and Bob Merton, had initially been initially been very successful with strong returns by identifying small pricing differences and exploiting with high degrees of leverage. The fund began to suffer difficult drawdowns in 1998, starting with -7% in May, -10% in June, and –18% in July. The Russia default and subsequent financial crisis widened the pricing differences LTCM expected to converge and the fund was down -44% in August. The fund collapsed -83% in September as excessive financial leverage magnified the losses to a total of $4.5 billion, which threatened the financial system’s stability. The Fed engineered a recapitalization of LTCM on 23 September 1998 by a Consortium of 14 financial institutions after the fund collapsed and declared bankruptcy.
     

    Treasury yields, which are a proxy for market expectations, bottomed in October, about a month after the LTCM bankruptcy. As measured by the Fed Funds rate, policy rates bottomed in December, and M2 growth, as a measure of monetary stimulus, peaked in late November.
     

     

     

    9/11, 2001

    The 9/11 attack on the Twin Towers in New York was an exogenous geopolitical event. and not a crisis rooted in the financial system. The stock market had been in a bear market for over a year when the dot-com bubble burst in March 2000. Interest rates had already been declining, but the Fed reacted to 0/11 by boosting liquidity into the banking system, as evidenced by the surge in M2 growth. As the financial effects of the shock wore off, monetary stimulus was withdrawn and normalized by December. Stock prices rebounded, but topped out in early January and resumed their bear trend, which ended in late 2002.

     

     

     

     

    GFC, 2008

    The crash that marked the Global Financial Crisis (GFC) of 2008 was a slow and draw-out affair. The S&P 500 topped out in 2007. Bear Stearns failed in March 2008, but the markets shrugged off the event as it didn’t pose any systemic risk. It wasn’t until the Lehman Brothers collapse in September that it sparked an institutional bank run and a crisis of confidence among broker-dealers. That’s when the Fed swung into action. Treasury yields fell and the Fed Funds eased to the zero-bound. M2 growth surged.  Stimulus measures peaked in December. Even though the three-month rate of m2 growth peaked at that time, the 12-month growth rate continued to rise until February 2009.
     

     

     

    COVID Crash, 2020

    The COVID Crash was another event whose roots were not in the financial system, but whose effects had real-world economic implications. After the COVID-19 pandemic began to spread, China responded by shutting down its economy to combat the virus. The Chinese shutdown, along with outbreaks in the rest of the world, threatened the global economy with a slowdown of Great Depression proportions. Fiscal and moneary authorities around the world responded with unprecedented levels of stimulus. Interest rates dropped to near zero, and M2 growth surged over a three-month time span

     

     

     

    What’s next?

    Fast forward to 2023, what can investors expect?

     

    It is said that history doesn’t repeat itself but rhymes. This was a limited event study that focused on the reaction of the Fed to financial crises and other shocks. In all cases, the Fed took action to stabilize the system once it became apparent that a failure threatened financial stability. Once stability returned, the Fed withdrew stimulus measures 2-3 months after the event. If history is any guide, the Fed should normalize and withdraw liquidity enhancing measures by about May or June.

     

    If that’s the template, here are some real-time indicators to watch. First, anxiety over the banking system needs to stabilize. The KBW Regional Banking Index is testing a key support zone. A violation would signal further bank system jitters and invite further policy support.

     

     

    Watch for signs that the Fed is withdrawing liquidity support, which would be bearish for equities. Fed liquidity can be measured by changes in its balance sheet  – changes in the Treasury General Account – changes in Reverse Repo Purchase agreements.

     

     

    While the Fed liquidity indicator is reported weekly, the price of Bitcoin and other crypto-currencies can be used as a quick approximation of system liquidity.

     

     

     

    Also don’t forget the USD. The USD is a risk-off asset and it’s inversely correlated to the S&P 500. The USD will eventually break out of its trading range, but in which direction?

     

     

    Once policy support is withdrawn, equity investors will have to focus on such mundane matters as interest rates and the earnings outlook. While most of the instances in the five historical studies saw stock prices roar to new highs, this time may be different. Fed Chair Jerome Powell pushed back at his press conference twice against the notion that the Fed will cut rates in 2023 as it’s not in the Fed’s baseline. Nevertheless, market expectations are calling for a series of cuts that begin mid-year. Either the market or the Fed is very wrong, and it’s usually not wise to fight the Fed.

     

     

    In addition, the yield curve is starting to steepen after becoming deeply inverted. A steepening yield curve after an inversion usually foreshadows recession, and recessions are not negative for stock prices.

     

     

    Putting it all together, the banking crisis pattern of 2023 more resembles the 9/11 shock. The stock market was already in a bear market, and interest rates rose after the effects of the shock wore off. Expect a similar pattern of a short-term stock market recovery, followed by further weakness as market fundamentals reassert themselves. This is consistent with my “party now, pay later” theme of a near-term rally, follow by weakness later this year