A cyclical rebound mirage?

Posted by Cam Hui -

I highlighted a widening gulf between the technical and macro outlook in August (see “Price leads fundamentals”, or “Don’t fight the Fed”?). At the time, the technical indicators were wildly bullish because of strong price momentum, while the macro outlook was cautious. The macro view eventually won out.
 

A similar divide may be appearing again, albeit not as wide. Technical internals has been pointing to a shift in leadership to value and cyclical sectors, indicating the emergence of cyclical green shoots. Further analysis of technical internals, as well as the macro picture, indicate that hope of a cyclical rebound may be an illusion.

 

 

Here’s why.

 

 

Technical deterioration

Here are some signs of technical deterioration to ponder. If the market is discounting a cyclical revival, why have the relative performance of defensive sectors been in minor uptrends since the S&P 500 rallied off its October low. Should defensive sectors be losing ground on a relative basis under such circumstances?

 

 

Further analysis of the relative performances of individual sectors reveals inconsistencies. Historically, the relative returns of Financials have been correlated to the shape of the yield curve. Banks tend to borrow short and lend long. A steepening yield curve enhances profitability while a flattening yield curve reduces profitability. As the yield curve flattens, this leads to a negative divergence in the relative strength of Financials. As well, the relative breadth of the sector (bottom two panels) have been flat to down, which is not a positive sign for sector leadership.

 

 

The Industrials sector enjoyed a strong recent rally and the sector appears a bit extended. Relative breadth is also weakening, which is another warning sign.

 

 

Energy stocks staged upside absolute and relative breakouts, which are positive signs, but relative breadth has been weakening since mid-October.

 

 

I interpret these charts as the market having second thoughts on the prospect that a cyclical rebound is just around the corner. The US value/growth rebound can be explained mainly by weakness in large-cap growth stocks. Developed international value/growth, as represented by the EAFE Index, has been trading sideways since early September.

 

 

 

Recession ahead

From a top-down macro perspective, the idea of a bottom and cyclical rebound doesn’t make sense. Signs of an impending recession are everywhere. The November FOMC minutes indicate that “the staff…viewed the possibility that the economy would enter a recession sometime over the next year as almost as likely as the baseline”. New Deal democrat, who maintains a set of coincident, short-leading, and long-leading indicators, is warning about a recession in H1 2023.
  • A significant majority of the short leading indicators, as codified by both the Conference Board and previously by Prof. Geoffrey Moore, have all declined from their peaks.
  • This decline has been long enough and strong enough, per past experiences with the onset of recession, to justify a warning that a recession is more likely than not to begin in the next 6 months.
The Conference Board’s Leading Economic Indicators Index just fell into recession territory.

 

 

The NDR Index of Coincident Economic Indicators is also flashing a recession signal.

 

 

 

Valuation and earnings risk

Notwithstanding the risk of deteriorating fundamentals from a recession, the S&P 500 is slightly overpriced based on current earnings estimates. The index is trading at a forward P/E of 17.5, based on bottom-up derived EPS estimates. The last time the 10-year Treasury yield was at similar levels, the market was trading at a P/E range of 13-15, though it fell to a high single-digit multiple during the 2008 panic.

 

 

Bottom-up EPS estimates are only starting to fall, but the decline is nowhere near the 15-20% peak-to-trough basis seen in a garden variety recession. According to FactSet, consensus bottom-up derived S&P 500 EPS estimates for 2023 is $232. Bloomberg reported that the average Wall Street strategist estimate is $215, with a high of $232 from Jefferies and a low of $185 from Morgan Stanley. It’s not unusual to see top-down estimates diverge from bottom-up estimates at major economic turning points. Strategists can estimate the economic impact from their top-down models, while individual company analysts have to wait for company guidance to change their estimates. This is a signal that bottom-up aggregated estimates have much further to fall. The combination of an elevated forward P/E ratio with the prospect for further cuts in earnings outlook is an indication that a valuation air pocket is ahead for equity investors.

 

 

 

The bull case

Even though the economic and valuation outlook appears dire, here is the bull case, or at least some mitigating circumstances indicating that any downturn should be mild.

 

The first is a high level of household savings in developed economies.

 

 

A Federal Reserve study confirmed the findings of high savings. While low income households are stressed, middle and high income consumer balance sheets are in good shape.
 

 

I would warn, however, that while elevated levels of household savings could act to cushion the effects of a recession, the magnitude of the effect could be relatively minimal. Consider, for example, how the housing market has become the economic cycle. As mortgage rates have surged, strong levels of savings will have a relatively minor effect on the deterioration of housing affordability. As a consequence, housing permits, which lead housing starts, have plummeted.

 

 

As property prices have risen dramatically around the world, housing affordability has been a problem in many countries.

 

 

Another factor that has raised hopes on Wall Street is the China reopening narrative. It is said that China is undergoing a process of relaxing its Zero COVID policy. As well, Beijing unveiled a 16-point plan to stabilize its property market.

 

Despite all of the hopes about a COVID policy relaxation, the barriers to a full reopening are considerable. China has taken a different course to address the pandemic compared to the rest of the world as it continues to pursue the lockdown as a primary tool of disease control. Vaccination rates are relatively low compared to other Asian countries, especially among the vulnerable elderly population. A relaxation of COVID restrictions will also require a significant expansion of hospital and ICU capacity, which is not at all evident. The recent steps at relaxation have predictably collapsed. China’s daily case count reached an all-time high and the city of Beijing has relapsed back into the strictest level of quarantine.

 

 

Equally concerning is a Bloomberg report that the Street consensus has shifted to turn bullish on China. The China reopening narrative is extremely vulnerable to disappointment.

 

 

On the property front, I am monitoring the Premia China USD Property Bond ETF (3001.HK). The ETF measures the USD-denominated bonds of Chinese property developers, whose price slide has begun to stabilize, but it’s not showing signs of a strong recovery.

 

 

There is one green shoot and right-tailed risk on the horizon that hasn’t been discounted by the markets. The protests in Iran have become more serious and widespread. Tehran has shifted from a counter-protest approach to a counter-insurgency approach, which is an indication that the regime feels it is increasingly threatened. The IRGC has been deployed instead of regular police and it is resorting to deadly force in some instances. 

 

While this is not my base case, a collapse of the Iranian regime would have dramatic geopolitical and financial consequences for the region and the world. It would deprive Russia of a key arms supplier and create more pressure on the Kremlin to sue for peace. As well, a less belligerent government in Tehran would allow Iranian oil to flow more freely and put downward pressure on energy prices, which would be a welcome relief for global central bankers concerned about inflation, and act as an enormous risk-on catalyst for asset prices. Indeed, oil prices have begun to moderate, even without the collapse of the Tehran regime, which I would characterize as a green shoot.

 

 

In conclusion, a more detailed analysis of market internals indicates that hopes of a cyclical rebound are beginning to fade. Macro and valuation risk are weighing on equity prices and downside risk remains. As the expectations of a recession are becoming consensus, investors may be better served in a greater allocation to Treasury bonds than stocks over the coming months.

 

 

 

Things are breaking beneath the surface

Posted by Cam Hui -

Mid-week market update: I thought that I would publish an early mid-week market update in light of the shortened US Thanksgiving trading week. As the S&P 500 consolidates in a narrow range between 3900 and 4000, things are breaking beneath the surface.
 

Let’s begin the analysis at the extreme risk part of the market. As the crypto world teeters, Bitcoin is weakening, Coinbase shares (COIN) have broken support, and the Bitcoin to Greyscale Bitcoin Trust (GBTC) ratio erode, indicating a widening NAV discount.

 

 

I haven’t conducted a full analysis of Coinbase, but consider the market’s signals on the company. Its debt is trading at nearly 50c on the dollar. If the entire edifice were to collapse, will the common shareholders receive anything in liquidation?

 

 

Then we have the cult favorite, Tesla. TSLA broke neckline support on a head and shoulders formation on the monthly chart. The measured downside objective is *gasp* about $20.

 

 

Another warning can be found in the relative performance of defensive sectors. Even as the S&P 500 rallied off the October bottom, defensive sectors were all in relative uptrends during that period.

 

 

Finally, the VIX Index just breached the bottom of its Bollinger Band, which is usually an indication of an overbought stock market. Past occurrences have foreshadowed market stalls in the last six months. 

 

 

I recognize that Thanksgiving Week is normally thought of as a period of positive seasonality for stock prices. But analysis from Jeff Hirsch shows that the seasonality win rate on Tuesday and Wednesday has been positive, upside potential was been relatively weak.

 

 

In the short run, the key trigger for market direction may be the release of the FOMC minutes tomorrow. Stay cautious.

 

 

Disclosure: Long SPXU

 

Sentiment whipsaws are masking the bear trend

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 risk-on stampede?

I pointed out in the past that risk appetite in 2022 can largely be attributable to changes in the USD. The S&P 500 has shown a close inverse correlation to the greenback. Now that the USD has decisively violated trend line support, does that mean that it’s time for investors to stampede into a risk-on trade?

 

 

What are the fundamentals that explain the technical breakdown in the USD? Has the Fed signaled that it is about to out-dove the European Central Bank and other major central banks, which would narrow interest rate differentials and weaken the dollar? Will other central banks out-hawk the Fed?

 

 

A positioning whipsaw

The risk-on rally since the soft October CPI report can mainly be attributable to the combination of a positive surprise and a crowded short, which led to a price whipsaw based on excessive positioning.

 

Respondents in the latest BoA Global Fund Manager Survey agreed that the most crowded trade for the fifth consecutive month is a USD long, which is a risk-off position.

 

 

The survey also showed a crowded underweight in equity positioning, with the caveat that respondents were correctly cautious the last time sentiment reached similar lows during the 2008 bear market.

 

 

The holdings report of the DBMF active ETF provides a useful window into the positioning of managed futures commodity trading advisers or CTAs. DBMF is short Treasuries and rates, long the USD, and roughly flat equities. It was therefore no surprise that a soft CPI report sparked a risk-on stampede in bond prices.

 

 

The bond price surge is probably on its last legs. Garfield Reynolds, Chief Rates Correspondent for Bloomberg News in Asia, observed that the market reaction to St. Louis Fed President Jim Bullard’s remarks that the Fed Funds policy rate needs to reach at least 5% put an abrupt end to the bond  buying stampede as bond market volatility turns up.
A look at the action for implied volatility gauges underscores the potential for further wild moves. The classic MOVE Index, based on one-month volatility, tumbled to well below the three-month gauge and has since rebounded. The last two times that happened, in August and June, both indexes soared to fresh highs. Get ready for a wild year-end, because it looks like the bond market is gearing up for one.  

 

 

 

A stall ahead?

The equity market’s technical internals indicate that the rally is losing momentum. The S&P 500 advance stalled at the key Fibonacci retracement level of 4000 with a spinning top candlestick on the weekly chart, indicating a possible inflection point. This is the perfect spot for the bears to become more active.

 

 

The NYSE McClellan Oscillator recycled from an overbought condition, which is an ominous sign that price momentum is rolling over.

 

 

The 5-day correlation between the S&P 500 and VVIX, which is the volatility of the VIX, spiked while NYMO is positive. There were 26 such signals in the last five years, of which 18 resolved bearishly and eight bullishly.

 

 

Sentiment isn’t excessively bearishly anymore. The Fear & Greed Index has evolved from an extreme fear reading to greed.

 

 

Similarly, the NAAIM Exposure Index, which measures the sentiment of RIAs managing retail investor funds, has steadily recovered from a bearish extreme.

 

 

 

Negative seasonality

The stock market will also face short and intermediate-term seasonal headwinds. While US Thanksgiving week has a record of positive seasonality, Mark Hulbert pointed out that the 2022 FIFA World Cup begins on November 20 and stock returns tend to be weak during the tournament.

 

 

Looking into 2023, conventional seasonality analysis shows that stock prices tend to be strong during the third year of a Presidential cycle. However, Jeroen Blokland pointed out that the US economy has never experienced a recession during the third year of a Presidential term. 2023 will be the likely exception, which will create headwinds for stock prices in the first half of next year.

 

 

In conclusion, the recent risk-on episode is attributable to the combination of excessively bearish sentiment and a positive inflation surprise. Most of the effects of the buying stampede have likely dissipated. Technical conditions are weak and the bear market is poised to resume.

 

Subscribers received an alert on Thursday that my inner trader had re-entered a short position in the S&P 500.

 

 

Disclosure: Long SPXU

 

The Fed cratered stock-bond diversification, what’s next?

Posted by Cam Hui -

The performance of balanced funds has become especially challenging in 2022. In most recessionary equity bear markets, falling stock prices were offset by rising bond prices or falling bond yields. The fixed income component of a balanced fund portfolio has usually acted as a counterweight to equities.
 

 

Not so in 2022. You would have to go back to the double-dip recession of 1980-1982 to see a prolonged period of positive correlation between stock and bond prices. That era was characterized by the hawkish Volcker Fed, which was determined to keep raising rates in order to squeeze inflationary expectations out of the economy. Fast forward to 2022, the Powell Fed appears to be on a similar path. What does that mean for investors?

 

 

Here are the challenges for stock, bond and balanced fund investors as we peer into 2023.

 

 

50 doesn’t mean an easy Fed

The October CPI and PPI reports were welcome news for investors. Both came in lower than expectated and the soft CPI report sparked a risk-on melt-up. In addition, Jason Furman had previously observed that the shelter component of CPI is a lagging indicator. When he swapped spot rents instead of the BLS shelter metric, he found that core CPI with spot rents rose at a 2.8% annual rate over the last three months, compared to a 5.8% for actual core CPI.

 

 

Before everyone gets too excited, a parade of Fed speakers cautioned that while the October CPI print was a welcome development, it wasn’t enough to move the needle on monetary policy. Moreover, while Fed speakers were telegraphing that a 50 bps increase in the Fed Funds rate is likely at the December FOMC meeting, a slower pace of rate hike doesn’t translate to an easier policy. The terminal rate will remain the same.

 

As one of many examples, here is Fed Governor Christopher Waller in a speech on November 16, 2022.
I cannot emphasize enough that one report does not make a trend. It is way too early to conclude that inflation is headed sustainably down. In 2021, monthly core CPI inflation fell during the summer—it fell from 0.9 percent in April 2021 to 0.2 percent in August 2021 before accelerating back to 0.6 percent and 0.5 percent in October and November of that year. More recently, monthly core CPI inflation fell from 0.7 percent in June 2022 to 0.3 percent in July, only to rebound to 0.6 percent the next two months. We’ve seen this movie before, so it is too early to know if it will have a different ending this time.
Waller cautioned that monetary policy “is barely in restrictive territory today” and while he supports a 50 bps hike at the next meeting, it doesn’t mean that the Fed is pivoting to an easier monetary policy.

I am going to take a considerable risk here and employ an airplane simile to illustrate how I think of our past policy actions and where we are going. When an airplane is taking off, the pilot fires the engines as much as possible to get off the ground. The goal is to get to cruising altitude quickly, so the initial ascent is steep. But as the plane gets closer to cruising altitude, the pilot slows the rate of ascent, while continuing to climb. The final cruising altitude will depend on many factors, most notably details about the weather. Turbulence may force you to a higher or lower altitude, but you adjust as you go to have a smooth ride.

St. Louis Fed President James Bullard went further when he discussed what he considered to be a “sufficiently restrictive” policy rate in a recent presentation. Using a different range of assumptions, Bullard projected a range of 5-7% for the Fed Funds rate using the Taylor Rule. To be sure, Bullard’s projections can be regarded as an outlier as most Fed speakers have discussed a Fed Funds terminal of about 5%, which is roughly current market expectations. Bullard’s analysis nevertheless an indication that the Fed could far more hawkish than what is being priced in.

 

 

In short, the Fed recognizes that it is tightening into a recession, much like the Volcker Fed did nearly 40 years ago. The 2s10s yield curve is deeply inverted and it hasn’t been this inverted since 1981 during the Volcker tight money era. The Powell Fed’s fear is stopping tightening too soon and in so doing spark a more persistent level of inflation. It is signaling that it is willing to assume the risk of a recession in order to get inflation under control.

 

 

 

The challenge for equity investors

Here is the challenge for equity investors. The last time the 10-year Treasury yield was at similar levels was 2008-2009, which was a recessionary period. The forward P/E fell as low as 10, but a more realistic range was 12-16. The S&P 500 is currently trading at a forward P/E of 17.2, which is slightly above that historical range.

 

 

More worrisome is the downside potential in forward EPS estimates. A recession is on the way, but the earnings recession is only just starting. Estimates typically fall 15-20% in a recession, but they are only down -3.8% on a peak-to-trough basis. They fell about -20% during the COVID Crash.
 

 

The recent risk-on episode in reaction to the soft CPI print was ironically unhelpful to the intermediate outlook for stock prices. That’s because market rallies have the effect of causing the Fed to raise rates even further in order to tighten financial conditions.

 

 

 

Investment implications

In conclusion, equity prices look pricey by historical standards. Analysis from Absolute Strategy Research going back to 1910 shows that the bond/stock yield ratio is extremely stretched by historical standards. Investors will find better risk/reward in the bond market than the stock market.

 

 

The good news is that the inflection point may be just around the corner. Historically, peaks in the 30-year Treasury yield have either been coincident or led Fed pivots and equity market bottoms, though the lead times have been highly variable. As well, the positive correlation between stock and bond prices in 2022 should translate into a strong return recovery for balanced funds. The two-edged sword of positive asset price correlation works both ways.

 

 

Investors who are compelled to be exposed to US equities by mandate may wish to consider small-cap stocks, whose forward P/E valuations are far more compelling than the S&P 500.

 

 

Market leadership appears to be undergoing a long-term shift which should see a prolonged period of better relative performance for value stocks and small-caps.
 

 

 

Time to jump on the year-end rally bandwagon?

Posted by Cam Hui -

Mid-week market update: The stock market surged last week in reaction to the soft CPI reading. It got better news this week when PPI came in lower than expected. As well, China unveiled a 16-point package to try and stabilize its cratering property market and softened some of its Zero COVID policies. Berkshire Hathaway unveiled a new long position in TSMC, which light a fire under  semiconductor stocks, though Micron’s warning this morning unwound some of the rally.
 

As a consequence, the Investors Intelligence survey showed that the bull-bear spread turned positive. Increasingly, I am seeing discussions about positioning for a year-end rally.

 

 

Should you jump on the year-end rally bandwagon?

 

 

A year of the Grinch

While the year-end rally is becoming the consensus view, I beg to differ. Beneath the hood, signs of technical deterioration are appearing that are causing some concern. 2022 is likely to be a year of the Grinch for equity investors, instead of Santa Claus.

 

Despite all of the good news, the S&P 500 is struggling to overcome resistance at the 4000 level. Should it stage an upside breakout, the next major resistance level is at about 4120 at the falling trend line resistance.

 

 

The NYSE McClellan Oscillator (NYMO) is exhibiting a negative divergence while overbought. While this is not a precise market timing indicator, it is nevertheless an ominous development.

 

 

The NYSE McClellan Summation Index (NYSI) recycled from an extreme oversold condition of under -1000. Past rallies have usually taken NYSI back to positive – and it’s nearly there. The one exception was the bear market rally of 2008 when NYSI rose to -200 before weakening. The current reading is above the -200 minimum level, indicating that stock prices could fall at any time during this bear market rally.

 

 

The 10 dma of the CBOE put/call ratio has fallen to levels that indicate complacency is setting in, which is contrarian bearish.

 

 

 

A short covering rally

The violent price surge off the CPI report can mainly be attributable to short covering. SocGen found that last Thursday’s big winners have been the worst losers in 2022. 

 

 

In addition, anecdotal evidence indicates that a number of long/short equity hedge fund strategies were recently shut down. This necessitated a massive bout of short covering, as evidenced by the reversal in all flavors of the price momentum factor. In order for the rally to continue, the bulls need to exhibit further momentum. In this context, the failure of the S&P 500 at 4000 is disappointing.

 

 

 

Seasonality headwinds?

Investors are probably familiar with the analysis of mid-term election year seasonality, which states that the stock market tends to enjoy a bullish tailwind into year-end. Callum Thomas at TopDown Charts analyzed mid-term election year seasonality by bull and bear markets and found that the S&P 500 tends to decline into year-end during bear markets.

 

 

The moral of this story is, “Beware the facile analysis of seasonality”. The weakness during bear markets makes sense, as stock prices will be pressured by tax-loss selling as December approaches.

 

In conclusion, don’t be fooled by the talk of a year-end rally. The market rally is poised to stall in the near future. Even though I don’t have an actionable sell signal for traders, investors should stay cautious.

 

 

Soft CPI is helpful, but it’s still a bear 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 and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.
 

 

Curb your enthusiasm

Does the soft October CPI report mark the start of a fresh bull? Not so fast!

 

To be sure, the report was positive in many ways. Most of the strength in core CPI was in services and Owners’ Equivalent Rent (OER) in particular. Rents are a lagging component of CPI and it has been weakening. Eventually, it will show up in actual CPI metrics. In the meantime, monthly core CPI ex-OER continues to show a trend of deceleration.

 

 

Mark Hulbert advised investors to curb their enthusiasm. He pointed out that the stock market’s outsized one-day return in response to the softer than expected CPI report is an indication that the bear market is still alive and well.
Despite Thursday’s explosive rally in stocks, it’s likely we’re still mired in a bear market.

 

In fact, the magnitude of the surge itself suggests the bear is still alive and well.

 

Consider all trading days since the Nasdaq Composite Index was created in 1971 in which it gained — as it did Thursday — more than 6%. Twenty of 26 of those days prior to Thursday occurred during a bear market, or 77% of the time, according to Ned Davis Research.
Indeed, Rob Hanna at Quantifable Edges found that market returns after a one-day 5% gain tend to be bearish and volatile.

 

 

 

CPI: Not as good as it looks

Equity bulls should be warned that the positive CPI surprise wasn’t as good as it looks. BLS made a technical adjustment to the way it calculates medical insurance for the month of October.

In October 2022, the retained earnings calculation began including premium and benefit expenditures for Medicare Part D. Previously, these Medicare Part D expenditures were not included.

The adjustment made the medical care services component of CPI plunge -0.6% for October and accounted for -0.05% of the -0.2% surprise. This adjustment will not be reflected in PCE, which is the Fed’s preferred inflation metric. For more details, see this WSJ article from October 25, 2022.

 

 

Even though housing is weakening, softness in housing component of inflation won’t be seen for some time in CPI, RSM found that housing prices lag inflation rates by about 18 months. Inflation will stay elevated for most of 2023 and won’t decline until early 2024.
 

 

 

Bull or bear?

From a technical perspective, investors could view the market’s strength through a bullish or bearish lens. The bullish interpretation is the S&P 500 staged an upside breakout from an inverted head and shoulders neckline at 3900, with an upside measured objective of 4300. The bearish view is the market is overbought on the percentage of S&P 500 stocks above their 20 dma and the advance is about to stall.

 

 

I am inclined to believe that risk/reward is unfavorable based on Hanna’s analysis and other factors. Now that the S&P 500 has staged an upside breakout at 3900 and reached the Fibonacci resistance level of about 4000. It will encounter strong resistance at the falling trend line at about 4130. In other words, upside potential is limited.

 

 

 

Negative divergences

I am also seeing warning signs of negative divergences from equity risk appetite factors. The equal-weighted ratio of consumer discretionary to staple stocks has been lagging behind the S&P 500.

 

 

Credit market appetite is also flashing warning signals. Even as the S&P 500 staged an upside breakout through 3900, the relative performance of high-yield bonds relative to their duration-equivalent Treasuries lagged and failed to confirm the breakout.

 

 

 

Waiting for the next shoe to drop

Now that most of the mid-term election drama is past and the Republicans have narrow control of the House, the next probable speed bump is a debt ceiling battle. Oxford Economics observed that the Treasury will likely reach its debt limit in December and a debt ceiling increase is required. While it’s technically possible a debt ceiling bill could be passed in the lame duck session while the Democrats have control of both chambers of Congress, it requires the cooperation of the Republicans in the Senate, which is unlikely. Depending on the makeup of the new Republican House caucus, investors could see debt ceiling drama very soon. The recent UK experience shows that markets were unforgiving of fiscal uncertainty.

 

 

Even in the absence of a debt ceiling showdown, the stock market is likely to face headwinds into year-end. Fed reserve balances (blue line) have shown a close correlation with the S&P 500, and they have been fairly steady in the past few weeks. The Treasury’s General Account (red line, inverted scale) is likely ramp into year-end ahead of the debt ceiling, which will drain reserves from the system and have an adverse effect on stock prices. Add to that the high probability of tax loss selling in a year when stocks are down, the market will face considerable pressures.

 

 

The Goldman Sachs Financial Conditions Index eased considerably in the wake of the risk-on episode. In reaction to the CPI report, the market is now anticipating a 50 bps hike in the December Fed Funds rate and a change in the terminal rate from 500-525 bps to 475-500 bps. While a 50 bps hike is plausible, the reduction in the terminal rate is less likely. As a reminder, here is how Powell responded to the news in the last post-FOMC press conference that the markets had gone risk-on after the last FOMC meeting.

CHAIR POWELL. We’re not targeting any one or two particular things. Our message should be, what I’m trying to do is make sure that our message is clear, which is that we think we have a ways to go, we have some ground to cover with interest rates before we get to, before we get to that level of interest rates that we think is sufficiently restrictive. And putting that in the statement and identifying that as a goal is an important step.

 

 

In addition, the market has only begun to respond to the deterioration in economic conditions. The recent NFIB survey is revealing, as small businesses have little bargaining power and they are therefore sensitive barometers of the economy. Small business earnings growth is tanking, but S&P 500 earnings growth is only decelerating. An earnings recession is just around the corner, and it hasn’t been fully discounted by the market yet.

 

 

In conclusion, while the soft CPI report is intermediate-term positive for risk assets, equities face a number of important hurdles before a new bull market can begin. I believe that stocks are undergoing a bear market rally. The S&P 500 will encounter strong resistance at about 4130.

 

Who’s swimming naked as the tide goes out?

Posted by Cam Hui -
Warren Buffett famously said that when the tide goes out, you find out who has been swimming naked. Now that the Fed is tightening financial conditions and the tide is going out, I undertake an analysis to find out what countries and sectors have been swimming naked, and who has been opportunistically swimming with the tide.

 

 

 

A global perspective

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

 

 

A few themes emerge from this analysis:
  • Laggards: China and most Asian economies, such as Hong Kong, Taiwan, and South Korea. The latter two are seeing the fallouts from the Biden semiconductor export controls.
  • Cyclical leaders: Resource extraction economies such as Australia, Canada, and Brazil, which is a heavyweight in Latin America. The Eurozone is also emerging as new leaders.
  • New growth leaders: India and Mexico are becoming the new growth leaders within emerging markets. India is benefiting from a rebound in growth after a period of COVID-related stagnation. Mexico is being bought as the winner from the near-shoring boom as manufacturers diversify their operations away from China.
  • The S&P 500 has lost its past leadership position as most large-cap growth stocks have reported disappointing earnings. Large-cap growth accounts for about one-third of the S&P 500, which is a disproportionate weight compared to other regional and country indices.
In particular, the market is indicating concerns about China’s growth outlook. The Financial Times reported that in addition to its struggles with a property bubble implosion and a series of rolling zero-COVID lockdowns, it faces the challenge of slowing consumer demand from the US and Europe. There have been a number of risk-on rallies in China on rumors that Beijing may relax its zero-COVID policies. The market got all excited Friday when China eased quarantine measures for visitors by two days. Bloomberg reported that Shehzad Qazi of China Beige Book offered the following guide to interpreting stories of a zero-COVID policy pivot: Watch for:
  • A real vaccination push, especially among the elderly and potentially involving mandates.
  • The concerted introduction of mRNA shots.
  • Improved hospital capacity, including downgrading COVID to an illness you don’t necessarily have to be hospitalized for.
  • Easing of the border regime.
  • Backing away from lockdowns and other Zero-COVID mitigation measures.
  • A change in political rhetoric.
None of these steps are evident. Until then, fade any zero COVID relaxation rumors.

 

 

Sector analysis

I also conducted sector analysis on US and European sectors to find commonalities. Asian markets were excluded from this analysis as the markets are too disparate to conduct sector analysis. Here is the RRG chart for the US using equal-weighted sectors as a way of mitigating the effects of large-cap growth stocks to better capture the sector effects.

 

 

Here is the RRG chart for Europe.

 

 

Here are the common themes.
  • Laggards: Technology is suffering. Interest-sensitive sectors such as real estate and utilities are also lagging.
  • Cyclical leaders: Financials, industrials, and energy, though energy looks a little extended and may stall in the short term. Materials are also showing up as emerging leaders.

 

 

A cyclical recovery ahead

Here is my interpretation of these results. The equity market is detecting a global cyclical recovery. The rotation begins in Europe, then the US, and finally with China with differing lags. As an example, I have highlighted the BASF/Dow Chemical pair before. Both are large-cap commodity chemical producers. BASF is headquartered in Europe while Dow is in the US. The two stocks tracked each other closely until the onset of the Russo-Ukraine war. BASF tanked because of rising energy input costs but recently staged an upside relative breakout indicating a relative and cyclical recovery (bottom panel).

 

 

The bullish outlook in Europe is supported by a more expansive fiscal impulse. The European Commission released a proposed reformed European fiscal framework which allows for greater flexibility in achieving EU objectives such as green spending, a focus on medium-term debt sustainability, and an end to unrealistic debt brakes. Bloomberg also reported that Germany plans to more than double 2023 net debt to €45 billion.

 

In addition, Poland is a sensitive barometer of geopolitical risk as the country borders Ukraine and it is used as a base for aid into Ukraine. MSCI Poland has staged relative breakouts against both the Euro STOXX 50 and MSCI All-Country World Index (bottom two panels).

 

 

The tail risk of nuclear war in Europe is also falling. SCMP reported that Xi Jinping sent a clear message to Russia during German chancellor Olaf Scholz’s visit to China: “Nuclear wars must not be fought, in order to prevent a nuclear crisis in Eurasia”. Indeed, Russia has recently toned down its threat of tactical nuclear weapons. Alexander Shevchenko, a Russian UN delegate, stated, “Russia’s nuclear doctrine is purely defensive and cannot be interpreted in a broad way”.

 

 

Key risks

The key risks to the cyclical leadership scenario is a commitment to cyclical sectors is contrary to the hawkish monetary backdrop of major central banks. Recent risk appetite has been one macro trade. Liquidity is inversely correlated to the USD in 2022.

 

 

The USD is inversely correlated to the S&P 500.

 

 

While the softer than expected CPI report helped Fed Funds expectations, the market still expects to Fed to hike by 1% or more before it reaches its terminal rate.

 

 

The Fed is tightening into a recession, but the earnings recession is only starting and Q4 negative earnings guidance is above average. Such an environment is not usually conducive to overweight in cyclical stocks.

 

 

 

Squaring the circle

I can offer two templates for resolving the conundrum of the technical picture arguing for cyclical exposure while macro analysis calls for caution. The bearish template is the NASDAQ top that began in 2000. 

 

There are a lot of similarities between 2000 and today. While Buffett’s metaphor about finding naked swimmers when the tide goes out is relevant, the degree of nakedness matters to downside risk. Recessions act to correct the excesses of the previous cycle. The NASDAQ Bubble was characterized by overvaluation, but financial leverage was relatively minimal, just like today.

 

A review of market history from that era shows that the Dow, which was relatively free of technology stocks, traded sideways in 2000 while the NASDAQ 100 tanked. The Dow didn’t really fall until the 9/11 attack in 2001. The Oil Index (XOI), which is a proxy for resource extraction sectors, was flat to up during this period. That said, all indices did make an ultimate low in 2002 and recovered in 2003. History repeats itself but rhymes. The recession of that period was a multi-year downturn, which is unlikely to be repeated today.

 

 

The more bullish explanation is market strategist Russell Napier‘s capex boom scenario. He believes that central banks won’t be able to bring inflation down to 2%, but will settle for a 4-6% range because too much tightening will create financial instability problems. The fiscal authorities will intervene in the banking system by issuing guarantees for selected sectors of the economy, which amounts to a form of financial repression. However, he is not calling for stagflation.
That’s utter nonsense. They see high inflation and a slowing economy and think that’s stagflation. This is wrong. Stagflation is the combination of high inflation and high unemployment. That’s not what we have today, as we have record low unemployment. You get stagflation after years of badly misallocated capital, which tends to happen when the government interferes for too long in the allocation of capital.
While stagflation will eventually be the end game, the initial response will be a capex boom, which would be hugely bullish for cyclical sectors.
First comes the seemingly benign part, which is driven by a boom in capital investment and high growth in nominal GDP. Many people will like that. Only much later, when we get high inflation and high unemployment, when the scale of misallocated capital manifests itself in a high misery index, will people vote to change the system again. In 1979 and 1980 they voted for Thatcher and Reagan, and they accepted the hard monetary policy of Paul Volcker. But there is a journey to be travelled to get to that point. 
It’s possible that the old macro relationships are already diverging and breaking up, indicating a regime shift. The USD is no longer inversely correlated to the Fed’s balance sheet, as the USD has broken rising trend line support, which is bullish for risk appetite.

 

 

Why the risk-off tone? Isn’t divided government bullish?

Posted by Cam Hui -

Mid-week market update: Why have the markets gone risk-off? Isn’t divided government supposed to be equity bullish?
 

While the exact results of the mid-term elections aren’t known just yet, polling models and PredictIt odds, which represent consensus expectations, show a narrow Republican majority in the House and a probable Democrat control of the Senate.

 

 

This result should be equity positive for several reasons:
  • A tighter fiscal policy which makes the Fed’s job easier and raises the odds of a more dovish path for monetary policy.
  • A narrow Republican majority reduces the tail risk of a disorderly debt ceiling impasse. The recent UK experience showed that the market has little patience for fiscal uncertainty.
While the political overtones of the election are mildly bullish, I can think of some other reasons for the risk-off tone in the markets.

 

 

Crypto implosion

The FTX crypto implosion dragged down the most extreme forms of risk appetite. Crypto prices are correlated with the performance of speculative growth, as measured by the relative performance of ARKK. The recent problems with FTX likely had some contagion effects on the speculative growth factor.

 

 

 

Risk divergence

An unusual condition occurred yesterday to flash a tactical sell signal. The 5-day correlation between the S&P 500 and VVIX, which is the volatility of the VIX Index, spiked when the NYSE McClellan Oscillator was not oversold. There were 25 such signals in the last five years. 18 of them resolved bearishly and 7 bullishly. I interpret the heightened correlation as a divergence between stock prices, or risk appetite, and risk measures such as VVIX. History shows that the risk indicator is usually correct in these cases.

 

 

As well, investors have to be aware that the Cleveland Fed’s inflation nowcast is slightly above consensus expectations for tomorrow’s CPI print. Here are the market expectations.

 

 

Here is the Cleveland Fed’s inflation nowcast. A hot CPI would be bearish for risk appetite.

 

 

Subscribers received an email alert this morning that my trading account was initiating a short position in the S&P 500. If I am right on the short-term outlook, the 14-day RSI of the S&P 500 Intermediate-Term Breadth Momentum Oscillator should recycle from an overbought condition to neutral. In the past, this has been a reliable tactical sell signal for the market.

 

 

Stay tuned.

 

 

Disclosure: Long SPXU

 

The hidden story of investor capitulation

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 and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.
 

 

Resilient retail sentiment?

AAII conducts two surveys, and they are different from each other. The weekly AAII survey asks respondents how they feel about the markets. The monthly survey asks them what they’re doing with their money. The latest monthly asset allocation survey shows that while equity weights have fallen, they are nowhere near the capitulation levels seen at the bottom of the 1990, 2003, and 2008 bear markets. It has led to the conclusion that retail investors haven’t thrown in the towel, which opens the door to further downside potential in stock prices.

 

 

A BoA survey of its private client equity allocations tells a similar story of falling weightings, but readings are nowhere near panic levels.

 

I beg to differ. The poor performance of the bond market in 2022 has masked the story of retail capitulation.

 

 

A 60/40 failure

The standard 60/40 portfolio consisting of 60% stocks and 40% bonds was an abysmal failure in 2022. Bond prices are supposed to provide a counterweight to stock prices. When one rises, the other falls. That’s the story of diversification. In the last three recessionary bear markets, stock and bond prices have moved inversely to each other. In 2022, they fell in concert with each other.

 

 

Had bonds risen as stocks fell in 2022, the pure price effects would have resulted in a lower equity allocation. It’s impossible to estimate the FOMO effect of investor psychology but had bond prices risen as stock prices fell, it’s likely investors would have shifted more funds from stocks to bonds and reduced equity allocations further. Using the BoA data as an illustration, I estimate the equity allocation based on price changes only to be about 57%, which would be slightly above the historical average.

 

 

The TD Ameritrade Investor Movement Index (IMX) is another survey that measures retail sentiment using actual fund flows rather than a sentiment survey. The latest reading shows that sentiment is depressed and just above the capitulation lows seen during the 2011 Greek Crisis and the 2020 COVID Crash. In short, retail sentiment is very depressed but not totally panicked just yet.

 

 

As well, data from Longview Economics shows the first significant instance of closure of Schwab accounts since the COVID Crash.

 

 

When we combine the retail sentiment readings with institutional sentiment surveys, this is what capitulation looks like.

 

 

In addition, Mark Hulbert highlighted possible upside potential in equity prices based on Robert Shiller’s U.S. Buy-on-Dips Confidence Index, which “is based on a monthly survey in which investors are asked to guess the market’s direction the day after a 3% market decline.
This past summer the index got lower than 7% of all other monthly readings since Shiller began this survey in the 1990s. While that in itself is low enough to impress contrarians, it’s also encouraging that the index hasn’t jumped more since then. The normal pattern is for bullishness to jump whenever the market begins to rally. But the index currently stands at just the 20th percentile of the historical distribution.

 

In fact, the latest reading is even lower than the one registered in March 2020, at the bottom of the waterfall decline that accompanied the initial lockdowns of the COVID-19 pandemic. But as for the summer of 2022, you have to go back to late 2018 and early 2019 to find another time when the Buy-on-Dips Confidence Index was lower than where it stands now. Those months coincided with the bottom of the 19%+ correction (bear market) caused by the Fed’s late 2018 rate-hike cycle.

 

 

Hulbert found that there was statistical significance in Shiller’s survey and documented its historical performance.

 

 

As an aside, several readers have asked me about the readings of the Trend Asset Allocation Model. I previously stated that the actual reading had been bearish, but I was reluctant to downgrade it because an allocation into the poorly performing bond market would not add any return to a portfolio in the current environment. I have re-evaluated the model and I can report that readings have improved to a bona fide actual neutral condition because of strength in non-US equities and commodity prices.

 

 

A new bear leg?

Despite the overwhelming evidence of sentiment support, the market may be starting a tactical bear leg. The NYSE McClellan Oscillator (NYMO) recycled from an overbought condition to neutral, which is a sell signal.

 

 

The 10 dma of the equity-only put/call ratio touched its 200 dma and bounced upwards, indicating that it is beginning to recycle from greed to fear.

 

 

However, I am not inclined to make a tactical sell call until price momentum has definitively turned. The 14-day RSI of the S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) is still overbought and hasn’t reverted to neutral yet, which has proven to be a very reliable sell signal in the past.

 

 

Commodity prices surged late in the week, and the cyclically sensitive copper/gold and base metals gold ratios also spiked on the expectations that China may relax its zero COVID policy and reopen its economy.

 

 

Ultimately, the bull and bear debate may have to be settled by the new small-cap leadership. The Russell 2000 has staged a relative breakout out of a broad base (bottom panel) while exhibiting a double bottom pattern (top panel). The key test will be whether the index can overcome falling trend line resistance, or weaken to test support one more time.

 

 

Traders should wait for further clarity before opening a position in this uncertain and volatile climate.

 

 

The week ahead

Two events next week are potential sources of additional market volatility. The first is the US midterm elections. Current polling indicates that the Republicans are likely to retake control of the House, but the Senate is too close to call. While markets may reflexively rally on the expectations that a divided government is bullish, equity investors may be better served if the Republicans control both the House and Senate as a divided Congress raises the disorderly tail risk of a debt default.

 

Republican House Leader Kevin McCarthy has vowed to spark a debt ceiling confrontation with the Biden Administration if McCarthy doesn’t get his priorities of rolling back social programs passed. Marketwatch reported that Republican Senators have gone as far as calling for social security cuts, which would be a political line in the sand that is sure to spark a fierce battle. The debt ceiling could be breached as soon as February. As a reminder, the market behaved badly during the last major debt ceiling impasse in 2011, though the Greek Crisis was occurring in Europe at about the same time. Nevertheless, the recent UK experience demonstrated that the markets don’t react well to fiscal uncertainty. If the Republicans were to control both the House and Senate, it would be much more difficult for them to deflect responsibility for a Treasury default, which makes a debt ceiling crisis less likely.

 

 

Investors will also have to recognize that the current version of the GOP is not as business-friendly as past versions. Axios reported that Kevin McCarthy is clashing with the leadership of the Chamber of Commerce, which is a highly unusual development in light of the historically friendly relationship between the Republicans and business interests.

 

House GOP Leader Kevin McCarthy is telling U.S. Chamber of Commerce board members and state leaders the organization must undertake a complete leadership change and replace current president and CEO Suzanne Clark, Axios has learned.
The next source of volatility is the closely watched CPI report on Thursday. The consensus expects headline CPI to rise by 0.7% and core CPI to rise by 0.5% sequentially.

 

 

The Cleveland Fed’s inflation nowcast calls for a headline CPI of 0.76% and core CPI of 0.54%, which are slightly ahead of expectations. Don’t be surprised if CPI comes in hot next week, which would be equity bearish.
 

 

In addition, the FIFA World Cup tournament begins the following week, on November 20. Mark Hulbert pointed out that equity markets tend to perform poorly during World Cup tournaments.
This research traces to a study two decades ago entitled “Sports Sentiment and Stock Returns,” conducted by finance professors Alex Edmans of the London Business School; Diego Garcia of the University of Colorado Boulder, and Oyvind Norli of the Norwegian School of Management. 

 

The professors analyzed stock market behavior following more than 1,100 soccer matches back to 1973. They found that, on average after a given country’s soccer team lost in the World Cup, its stock market the next day produced a return significantly below average. The professors did not find a correspondingly positive effect for the stock markets of countries whose teams won.

 

The logical consequence of this asymmetry is that the global stock market tends to be a below-average performer during the World Cup tournament. That is precisely what was confirmed by a follow-on study entitled “Exploitable Predictable Irrationality: The FIFA World Cup Effect on the U.S. Stock Market,” by Guy Kaplanski of the Bar-Ilan University in Israel and Haim Levy of the Hebrew University of Jerusalem.

 

 

In conclusion, my market analysis is a good news and bad news story. The good news is that retail sentiment is more washed out than generally believed. The combination of extremely bearish retail and institutional sentiment are likely to put a floor on stock prices should bearish catalysts appear. The bad news is the stock market faces a number of short-term challenges in November. Uncertainty over the midterm election and a possible fiscal fallout, a likely hot CPI report, and bearish World Cup seasonality will create headwinds for stock prices, especially when last week’s analysis showed that equity investors are positioned for a cyclical rebound (see What is the market anticipating ahead of the FOMC meeting?).

 

Peering into 2023: A bear market roadmap

Posted by Cam Hui -
In the wake of the November FOMC meeting, Fed Chair Jerome Powell summarized Fed policy very clearly with two statements: “We will stay the course until the job is done”. He added, “It is very premature to think about pausing (rate hikes)”.

 

It was a hawkish message, though Fed Funds expectations were largely unchanged after the meeting and press conference.

 

 

Stock prices reacted by skidding badly. The S&P 500 ended the day -2.5%. The Fed has made it clear that it wants to tighten monetary conditions by engineering an equity bear market. How far can the bear market run? Here is a roadmap.

 

 

Where are we in the equity cycle?

Where are we in the equity cycle? This helpful analysis from Michael Cembalest of JPMorgan Asset Management provides some clues. Stock prices are forward-looking, and they have bottomed before GDP, payroll, or reported earnings in past recessions.

 

 

While stocks have bottomed before reported earnings, the historical evidence also indicates that stock prices move roughly coincidentally with forward 12-month EPS estimates, which are falling.

 

 

 

Assessing the economic outlook

Where are we in the economic cycle? New Deal democrat uses a discipline of analyzing the economy using coincident indicators, short leading indicators that look forward six months, and long leading indicators that look forward 12 months. His latest update makes for grim reading. 2 of his long leading indicators are positive and 12 are negative. The short leading indicators are a little better. 3 are positive, 5 neutral, and 6 negative. Reading between the lines, a recession is likely to begin in either Q4 2022 or Q1 2023.
All three timeframes of indicators remain negative, and there was further deterioration in the long leading index, as the 10 year minus 3 month Treasury yield inverted; and also railroads in the coincident data. Consumer spending remains weakly positive, and now staffing also has weakened significantly.
What about the inflation outlook, which will strongly influence Fed policy? While reported inflation is still hot, forward-looking inflation indicators are cooling. Goods inflation, as measured by ISM prices paid, is pointing to an imminent deceleration.

 

 

What about the services inflation? J.W. Mason observed that roughly two-thirds of excess CPI over the Fed’s 2% target is attributable to shelter.

 

 

The Owners’ Equivalent Rent component of shelter inflation is deflating. Apartment List reported that October effective asking rents fell -0.7% sequentially, though they are still up 5.7% on an annual basis. This was the third deepest decline in its history, which was only exceeded by the COVID era of April and May 2020.

 

 

There is also good news on wages. Small businesses are especially sensitive barometers of the business cycle because of their lack of bargaining power, and some small business indicators are pointing to slowdowns. Wage growth, as measured by NFIB wage pressures, is nosediving. NFIB wage intentions has historically led the Atlanta Fed’s wage tracker by about three months.

 

 

As further evidence of an economic slowdown, Bloomberg reported that about 37% of small businesses were unable to fully pay their rent in in October.

 

 

A resilient consumer

While forward-looking indicators are pointing to an economic slowdown, the Fed’s main focus on CPI and PCE inflation isn’t slowing. In fact, bottom-up reports from companies tell the story of a resilient consumer. Real retail sales adjusted by population has historically peaked before past recessions, but consumer spending has slowed, but not collapsed despite strong monetary tightening. 

 

 

The strength in consumer spending can be attributed to the flood of fiscal stimulus during the COVID pandemic era. Jason Furman observed that households saved about $2.2 trillion of pandemic stimulus. but they’ve only spent about $0.7 trillion. This may mean that the Fed will have to tighten even further before “the job is done”.

 

 

Employment will be a key determinant of Fed policy. Initial jobless claims normalized by population has been rising, but readings are nowhere near levels seen during past recessions. 

 

 

The stronger than expected October Employment Report also underlines the continued tightness in the jobs market. In addition, leading indicators of Non-Farm Payroll, such as temporary jobs and the quits/layoffs ratio from the JOLTS report, are still strong.

 

 

That said, the more volatile household survey differed from the establishment survey by showing a decline in jobs. As well, average hourly earnings are decelerating, which should provide relief to Fed officials concerned about a wage-price spiral,

 

 

 

An orderly or disorderly pivot?

In summary, the Fed is determined to slow the economy and the economy is slowing into a recession that will likely begin in Q4 2022 or Q1 2023. Forward-looking indicators of inflation are falling, though reported inflation indicators will remain strong for a few more months. The consumer is still resilient, which means that the Fed will stay hawkish until unemployment spikes.

 

There are two ways this tightening cycle could end. The first is an orderly slowdown which allows the Fed to stabilize interest rates and ease gradually. The other is a disorderly slowdown and financial crisis that forces global central bankers to act.

 

The initial sentences from FOMC press conferences offer clues of when the Fed might actually pivot and ease. Here is an excerpt from the May 2022 press conference when the Fed began to raise rates.
Inflation is much too high, and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses. The economy and the country have been through a lot over the past two years and have proved resilient. It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit all.

 

From the standpoint of our Congressional mandate to promote maximum employment and price stability, the current picture is plain to see: The labor market is extremely tight, and inflation is much too high. Against this backdrop, today the FOMC raised its policy interest rate by ½ percentage point and anticipates that ongoing increases in the target rate for the federal funds rate will be appropriate. 
Powell repeated the “inflation is much too high” and “the hardship it causes American families” mantras at the June 2022 press conference.
I will begin with one overarching message: We at the Fed understand the hardship that high inflation is causing. We are strongly committed to bringing inflation back down, and we’re moving expeditiously to do so. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses. 
He moved away from the “I feel your pain” message but the focus on the inflation message was clear at the July 2022 press conference.

My colleagues and I are strongly committed to bringing inflation back down, and we’re moving expeditiously to do so. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses…

Skip ahead to the November 2022 press conference, and the message remains the same.

My colleagues and I are strongly committed to bringing inflation back down to our 2 percent goal. We have both the tools that we need and the resolve it will take to restore price stability on behalf of American families and businesses. 

While growth has slowed, the Fed is focused on the employment picture.
Despite the slowdown in growth, the labor market remains extremely tight, with the unemployment rate at a 50-year low, job vacancies still very high, and wage growth elevated. Job gains have been robust, with employment rising by an average of 289,000 jobs per month over August and September. Although job vacancies have moved below their highs and the pace of job gains has slowed from earlier in the year, the labor market continues to be out of balance, with demand substantially exceeding the supply of available workers. The labor force participation rate is little changed since the beginning of the year. 
Until the focus of the opening statement of the FOMC press conference changes from an inflation focus, the Fed will not pivot and ease.

 

The one exception to the orderly pivot scenario is a financial crisis. A recent BIS bulletin raised concerns about USD strength and global financial stability.
  • A sequence of major shocks to the global economy has led to substantial exchange rate adjustments, notably a strengthening of the US dollar against most currencies, reflecting cross-country  differences in shock exposure and in the pace of monetary tightening.
  • Given the central role of the US dollar as an invoicing currency, a dollar appreciation tends to raise foreign import prices. Unlike in the past, recent dollar appreciation has coincided with a surge in commodity prices, compounding the impact on inflation. Dollar appreciation has also been associated with a tightening of global financial conditions.
  • FX intervention may help mitigate dislocations arising from exchange rate swings, but is likely to be effective only if it is part of a consistent macroeconomic policy stance that ensures macro-financial stability. In particular, a coherent fiscal-monetary mix is essential to avoid disruptive exchange rate movements that may arise from fears of fiscal dominance.

 

 

Callum Thomas of Topdown Charts observed that the central banks of smaller and emerging market countries have begun to pivot to easing, as they can be sensitive barometers of monetary policy. Within the developed markets, the RBA has hiked rates consecutively by less than expected quarter-points, and the Bank of Canada also raised rates by a half-point, which was less than the expected three-quarters, and cited financial stability concerns in its statement. Norges Bank slowed its rate hike to 25 bps despite upside inflation surprises, which was less than expected.

 

 

A Fed pivot is on the horizon. The only questions are timing and the trigger.
 

 

Investment implications

Here is what all this means for equity investors. Financial markets are forward-looking. If the economy enters a recession in Q4 or Q1, the most likely historical outcome shows that it will emerge within about six months. This puts the timing of an ultimate market bottom in Q4 or Q1.

 

As for the level of stock prices. the last time the 2-year Treasury yield was at these levels, the S&P 500 was trading at a forward P/E of 14 to 16. The S&P 500 is trading at a forward P/E of 16.1. Assuming a typical 15-20% cut to forward earnings estimates in a recession, this puts the downside potential at 2600 to 3200.

 

 

Historically, equities have struggled in the first year of fast tightening cycles, which this is. Stocks are likely to find a bottom when it begins to discount an improvement in the macro picture.

 

 

Do the bulls have anything left in the tank for their charge?

Posted by Cam Hui -

Mid-week market update: It’s always difficult to make tactical trading calls on FOMC meeting day. The S&P 500 approached the latest meeting with the 5-day RSI near overbought territory. The experience in 2022 of overbought or near overbought conditions on meeting days (March and July, n=2) has seen stock prices continue to advance. Can it continue? Do the bulls have anything left in the tank for their charge?
 

 

 

Low expectations

Market psychology coming into the meeting was tactically cautious. The short-term term structure of the VIX is deeply inverted (bottom panel), indicating fear.

 

 

Short-term dated option volume has been surging, which makes the short-term term structure of 9-day to 1-month VIX more relevant in determining option sentiment.

 

 

As well, inverse leveraged ETF activity has also exploded, which is contrarian bullish.

 

 

 

Is the rally done?

Strictly from a technical perspective, the S&P 500 traced out an inverse head and shoulders pattern. The index pulled back below the breakout level. The 14-day RSI hadn’t reached an overbought condition, which is the level where the last rally failed. On the other hand, the percentage of S&P 500 above their 20 dma neared the 90% level, which is an overbought extreme and defined the last tactical top.

 

 

It could be argued that the latest rally still has some momentum. The NYSE McClellan Summation Index (NYSI) rallied off an extremely oversold condition of -1000. If history is any guide, rallies haven’t stalled until NYSI turned positive. The lowest level this indicator reached before a rally ended was -200 in 2008, which is far from the current reading of -575.

 

 

On the other hand, the 5 dma of the percentage of S&P 500 bullish on P&F also reached an oversold extreme, and it recovered to approach the minimum level of 67% when rallies stalled.

 

 

So where does that leave us? The market is nearing a number of key “take profit” technical tripwires with the prospect of high volatility in the coming week. Investors are facing a series of event risks with binary outcomes in the coming days in the form of the October Jobs Report on Friday, mid-term elections next Tuesday, and the CPI report next Thursday. Despite today’s downdraft, Fed Funds expectations were largely unchange as a result of the FOMC announcement.

 

 

Subscribers received an email alert yesterday that my trading model had turned neutral and my inner trader had taken profits in his long S&P 500 positions. While anything can happen and there could be some further upside in the major equity indices, prudence dictates that risk reduction is in order.

 

How to trade the Fed Whisperer rally

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 and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.
 

 

Still a single macro trade

How should investors interpret the recent risk-on episode? It’s all still one big macro trade. The S&P 500 continues to be inversely correlated to the USD Index, which is mainly driven by the expectations of a less hawkish Fed. The USD Index helpfully broke down through a minor rising trend line, which is a positive sign for risk appetite.

 

 

I call it the Fed Whisperer rally (h/t Walter Deemer).

 

 

Earnings, earnings!

There is no question that earnings matter and the stock market faced headwinds from disappointing earnings results from large-cap technology giants. While the Street has questioned the long-term viability of META’s business model, the challenges faced by the other FANG+ names are cyclical in nature. The primary driver of large-cap growth stock relative performance continues to be the 10-year Treasury yield.

 

 

That said, the NASDAQ TRIN spiked above 2 on Thursday, which was before the Apple and Amazon earnings reports. This is an indication of blind panic selling in large-cap growth stocks.

 

 

Setting aside the problems of Big Tech, earnings results weren’t all bad. Investors saw strong positive results from the cyclical generals, such as General Motors and General Electric, as well as other cyclically sensitive industrial stocks, all of which reported results last week.

 

 

 

Mid and small-cap leadership

Here are some possible positives that are likely not fully discounted by investors. Even as the S&P 500 rally began to stall under the weight of tech earnings, small and mid-cap stocks were undergoing a stealth advance. The midcap S&P 400 is already in a choppy relative uptrend against the S&P 500. The small-cap S&P 600 achieved a relative breakout, while the Russell 2000 is testing a key relative resistance zone.

 

 

In other words, market breadth is stronger than it appears on the surface.

 

 

Fading geopolitical risk

Here are some other things that could go right. I have written before about the signs of fading geopolitical risk, as measured by the relative breakout achieved by MSCI Poland.

 

 

While this is not my base case, unrest in Iran sparked by a backlash against restrictions against women could topple the government in Tehran, which would be energy bearish but risk appetite bullish. The Economist summarized the protests in Iran this way:

 

Dictatorships tend to fall the way Ernest Hemingway said people go bankrupt: gradually, then suddenly. The omens can be obvious with hindsight. In 1978 Iran’s corrupt, brutal, unpopular regime was besieged by protesters and led by a sick old shah. The next year it was swept away. Today Iranian protesters are again calling for the overthrow of a corrupt, brutal regime; this time led by a sick old ayatollah, Ali Khamenei. As Ray Takeyh, a veteran Iran-watcher, put it, “History…is surely rhyming on the streets of Tehran.”

 

Pessimists caution that mass protests have rocked Iran’s theocracy before, notably in 2009 and 2019, and the regime has always snuffed them out by shooting, torturing and censoring. Yet there are reasons to think that this time may be different; that the foundations of the Islamic Republic really are wobbling.

 

The challenge for the regime is whether the security forces would obey orders to use deadly force on women, or whether entrenched interests would acquiece to such harsh levels of oppression.
Yet however much the mullahs may want to crush these unruly women, they cannot be sure that the security forces would obey an order to shoot them in the street, or that the fury that would follow mass femicide could be contained.

 

Previously, when faced with protests, the regime has called on its supporters to stage counter-demonstrations. This time, hardly any have shown up. And several grandees who might in the past have condemned the protests or voiced support for the regime have conspicuously failed to do so. For now, Iran’s generals say they back Mr Khamenei. But it is unclear how far they will go to support an out-of-touch 83-year-old who wants to install his second-rate son as his successor. When protests in Egypt got out of hand in 2011, the top brass elbowed aside the unpopular president (who was also grooming his son as his heir) and allowed a brief flowering of democracy before eventually seizing power. In Iran, as in Egypt, the top brass have vast, grubby business interests to protect. If they sense the supreme leader is sinking, they have no incentive to go down with him.
Moreover, the collapse of the Iranian government would deprive Russia of an ally and arms supplier, which would pressure the Kremlin to end the Russo-Ukraine war, which would be another bullish development.

 

 

The week ahead

In the wake of a slowing core PCE print of 0.5%, which was in line with expectations, compared to a downward revision of 0.5% from 0.6% in August, I reiterate Jim Paulson’s analysis of S&P 500 returns when inflation is decelerating (see How inflation is a game changer for portfolios).

 

 

Tactically, the current rally may have further upside potential. The market is anticipating a 75 bps hike at the November FOMC meeting, followed by two consecutive 50 bps hikes at the next two meetings, and a terminal rate of 475-500 bps, which is already the base case scenario.

 

San Francisco Fed President Mary Daly has said she could support slowing rate hikes to 50 and 25 bps hikes at subsequent FOMC meetings. If the Fed were to signal such a dovish path, it would spark a further risk-on rally. The probabilities are asymmetric. At worst, the Fed will behave in line with expectations and at best it will spark a risk-on episode.

 

 

Credit Suisse pointed out that the dovish central bank surprises have recently outnumbered hawkish ones. Will the Fed continue that trend next week?

 

 

Here’s where Fed watching gets a little tricky. What ultimately matters to the market isn’t whether the Fed slows to a 50 bps hike at the December FOMC meeting, but the level of the terminal rate. Investors are seeing some very different messages from the rates market. The 2-year Treasury yield (black line), which can be a proxy for market expectations of the terminal rate, has been trending up but recently pulled back to 4.4%. The 5-year breakeven rate (red line) has trended downwards and recently steadied. Arguably, this rate signal is overly noisy because it’s based on the TIPS market, which has been dominated by the Fed and may produce a false market signal. The 5×5 year rate (blue line) has traded sideways for all of this year. Which market signal should investors believe?

 

 

In the meantime, the equity bull party is in full swing. The S&P 500 regained its 50 dma on Friday, which gives it a shot at its inverse head and shoulders measured objective of about 4120, which is also the site of its 200 dma.

 

Bullish traders should enjoy the party, but be aware that event risk is rising.

 

 

Disclosure: Long SPXL

 

What is the market anticipating ahead of the FOMC meeting?

Posted by Cam Hui -

Ahead, of the upcoming FOMC, meeting, what is the market discounting? I conduct a factor and sector review for some answers. Starting with a multi-cap review of value and growth, value stocks have been outperforming growth stocks within large caps since early August, but this has not been confirmed by mid and small caps. The value and growth relationship has been mostly trendless since June.

 

 

 

Sector review

Here is a deeper dive into the value and growth framework. The relative performances of the growth sectors relative to the S&P 500 are weak. Communication services has been in a relative downtrend for about a year (thank you, META). Technology topped out on a relative basis in August, and consumer discretionary, which is dominated by the heavyweights AMZN and TSLA, has been weakening since mid-September. 

 

 

The value sectors are showing some signs of life. Financial, industrial, and energy stocks have been in relative uptrends since August, while materials and the equal-weighted consumer discretionary sector, which reduces the effects of AMZN and TSLA, have moved sideways.

 

 

For completeness, most of the defensive sectors, with the exception of healthcare, are trading flat to down relative to the S&P 500.

 

 

 

Signs of a cyclical rebound

A deeper dive into some of the sectors reveals signs of a cyclical revival. The top panel of the following chart shows the relative performance of large and small cap industrials relative to their respective benchmarks (black=large cap industrials to S&P 500, green=small cap industrials to Russell 2000). The bottom panel shows the relative performance of small and large caps (black) and small cap industrials to large cap industrials (green). Both panels show that small cap industrials are showing better relative strength, which confirms the signs of cyclical strength.

 

 

While large cap material stocks have mostly been trading sideways relative to the S&P 500, small cap materials have been beating their small cap benchmarks. This is another sign of a cyclical rebound.

 

 

From a global perspective, the cyclical rebound theme is confirmed by the BASF/Dow Chemical pair. Both are large cap commodity chemical companies, with BASF headquartered in Europe and Dow in the US. Both stocks tracked each other closely until the start of the Russo-Ukraine war, when BASF tanked on a relative basis because of higher European energy costs. The BASF/Dow pair achieved a relative breakout, indicating a cyclical revival in Europe despite a Reuters report that BASF needs to permanently curtail some of its European operations because of high energy costs.

 

 

Joe Wiesenthal at Bloomberg pointed out that, beneath the surface of weak PMI readings, the industrial sector is mostly showing signs of strength.

 

 

By contrast, small cap financial stocks are not showing the same degree of outperformance as their large cap counterparts.

 

 

 

Why the bond market matters

The relative performance of financial stocks has been correlated to the shape of the yield curve. While the 2s10s yield has moved sideways since early August, large cap financials have outperformed. Large cap financials are anticipating a steepening of the yield curve, which is the bond market’s signal of a cyclical rebound, while small cap financials have not.

 

 

The bond market also matters from a cross-asset perspective. The poor relative performance of large cap growth, as measured by the NASDAQ 100, is inversely correlated to the 10-year Treasury yield. What the Fed does in the upcoming meeting and in future meetings matters.

 

 

 

Waiting for the Fed

How is the Fed likely to react? While the Fed is likely to raise rates by 75 bps at the November meeting, a debate is raging about the pace of future rate hikes. Fed Governor Lael Brainard and San Francisco Fed President Mary Daly have cast their lot with “Team Decelerate” (rate hikes). The Bank of Canada surprised the markets last week by raising by 50 bps instead of the anticipated 75 and cited financial stability concerns in its statement. Will this be the start of a trend of central bankers tempering their rate hikes?

 

Here are some of the data points that Fed officials are watching. Financial conditions have tightened, but monetary policy operates with a lag. Is it time to slow down the pace of the rate hikes and monitor the effects of past monetary tightening?

 

 

Since Brainard and Daly made their “Team Decelerate” pivot, the market reacted by edging up inflation expectations, though they retreated slightly later. This raises the risk of inflation expectations becoming unanchored.

 

 

Yield spreads shows a mixed picture. US high yield spreads have narrowed while emerging market spreads have widened, indicating a rising risk of global financial instability from growing offshore USD stress.

 

 

The closely watched September core PCE release, which is the Fed’s preferred inflation metric, came in at 0.5%, which was in line with expectations. Moreover, the August figure was revised down from 0.6% to 0.5%. The Dallas Fed’s Trimmed Mean PCE also showed similar signs of deceleration.

 

 

As well, the Q3 Employment Cost Index came in at 1.2%, which was also in line with expectations, and represents a slowdown from 1.3% in Q2. As a reminder, Fed Chair Jerome Powell explained one of the reasons why he pivoted to a tighter policy was because of the strong ECI at the December 2021 FOMC press conference.

So coming to your real question, we got the ECI reading on the eve of the November meeting—it was the Friday before the November meeting—and it was very high, 5.7 percent reading for the employment compensation index for the third quarter, not annualized, for the third quarter, just before the meeting. And I thought for a second there whether we—whether we should increase our taper, [We] decided to go ahead with what we had—what we had “socialized.” Then, right after that, we got the next Friday after the meeting, two days after the meeting, we got a very strong employment report and, you know, revisions to prior readings and, and no increase in labor supply. And the Friday after that, we got the CPI, which was a very hot, high reading. And I, honestly, at that point, really decided that I thought we needed to—we needed to look at, at speeding up the taper. And we went to work on that. So that’s, that’s really what happened. It was essentially higher inflation and faster—turns out much faster progress in the labor market.

 

 

These releases should keep the Fed on a path to the more dovish policy that was telegraphed just before the media blackout.

 

 

Not all pivots are the same

In conclusion, the market is starting to discount a cyclical rebound, but much depends on Fed policy. Even if the Fed were to signal an imminent pause in rate hikes, that’s not necessarily very equity bullish. Rob Anderson at Ned Davis Research observed that not all Fed pivots are created equal. Rate cuts and QE announcements are the most bullish, while rate pauses and the end of tightening cycles have resolved with below average gains in the S&P 500.

 

 

 

How far can this rally run?

Posted by Cam Hui -

Mid-week market update: How far and long can this rally run? Here is one way of determining upside potential. The S&P 500 staged an upside breakout through an inverse head and shoulders pattern, with a measured objective of about 4120, which is the approximate level of the 200 dma.

 

 

The inverse head and shoulders breakout is even more evident using the Russell 2000, which staged an upside breakout through its 50 dma.

 

 

 

The bull case

Here are some reasons why that this rally has a lot further to run. The NYSE McClellan Summation Index (NYSI) just recycled from an extreme condition of below -1000, which has always sparked a relief rally in the past. As well, rallies usually haven’t stalled until returned to the zero neutral line. The only exception occurred in July 2008, when the rally petered out with NYSI at -200.

 

 

The S&P 500 has been inversely correlated to the USD for all of this year. The USD Index has been weakening and just violated a minor rising trend line, though the longer term uptrend remains intact. At a minimum, this argues for a period of consolidation for the USD and therefore stock prices instead of a stock market decline back to test the old lows.

 

 

 

What to watch

It’s always more difficult to call tops than bottoms, but here are some other signposts that I am watching from a short-term tactical viewpoint. The NYSE McClellan Oscillator (NYMO) reached an overbought condition yesterday. The last two bear market rallies of 2022 saw NYMO trace out negative divergences before finally topping, and tops were accompanied by either near-overbought or overbought conditions on the 14-day RSI. We’re quite there yet.

 

 

The three to one-month term structure of the VIX is upward-sloping, but the one-month to nine-day term structure is inverted. As more and more option players have migrated to short-term options, the shorter-term structure is still indicative of fear, which is contrarian bullish.

 

 

The two bear market rallies of 2022 saw the 10 dma of the equity put/call ratio fall below the 200 dma. While readings are close, the cautionary signal hasn’t been triggered yet.

 

 

That said, ITBM flashed a well-time buy signal last week, by its 14-day is nearing an overbought condition, which would be a warning that the rally could stall at any time.

 

 

Stay tuned. In addition to the volatility induced by earnings season, investors will have to look forward to the uncertainty of the FOMC meeting next week.

 

 

Disclosure: Long SPXL

 

Five constructive signs of a short-term bottom

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 and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real-time here.
 

 

Testing support

As the S&P 500 tests a key support level just above its 200-week moving average and while exhibiting a series of positive RSI divergences, I am seeing five constructive signs that the market may be forming a short-term bottom.

 

 

 

Supportive breadth

The first is better underlying breadth. Even when the S&P 500 struggled at a key support level, the mid- and small-cap S&P 400 and Russell 2000 held support in more solid manners.

 

 

 

A momentum rebound

Friday’s strong gains on high volume qualified as a Follow-Through Day, as specified by William O’Neil, which is a sign of strong price momentum.
A follow-through day occurs during a market correction when a major index closes significantly higher than the previous day, and in greater volume. It happens Day 4 or later of an attempted rally. Leading up to a follow-through day, an attempted rally takes place during a downtrend when a major index closes with a gain. The rally attempt continues intact as long as the index doesn’t make a new low.

 

Follow-through day variables include: an index closing sufficiently above 1% on increased volume, positive behavior of leading stocks, and improved market action regarding support vs. resistance levels. The most powerful follow-through days often happen Day 4 through Day 7 of an attempted rally.

 

 

From a longer term perspective, the 10 dma of the NYSE McClellan Oscillator recycled from an extreme oversold level, indicating price momentum turnarounds. There have been eight instances of this signal since 1998. All of them coincided with strong short-term market rebounds.

 

 

 

Signs of a cyclical bottom

As the global economy weakens, a recession call has become the consensus view. Ned Davis Research’s global recession model shows a 98% chance of a global recession. 

 

 

Similarly, the BoA Global Fund Manager Survey shows that economic weakness has become the overwhelming consensus.
 

 

In light of this bearish macro backdrop, expectations for Q3 earnings season have been diminished. While it’s still early, the EPS beat rate is below average while the sales beat rate is above average. In short, the preliminary verdict on Q3 earnings season is better than some of the dire expectations when the reporting period began.

 

 

The cyclically sensitive copper/gold and base metals/gold ratios have been flat to up since July, which is also inconsistent with the expectation of global weakness.

 

 

 

Europe FIFO

I speculated in late August about the spillover effects of European weakness (see Will Europe drag us into a global recession?). At the time, the EU was beset by high energy prices because of the Russo-Ukraine war and fears of de-industrialization loomed. Even today, the BoA Global Fund Manager Survey shows that the Eurozone is the second lowest regional underweight behind the UK.

 

 

At the time, I set out two bullish tripwires based on the first-in-first-out principle. Europe was the first to enter a recession, and if signs emerged that it was beginning to emerge out of a slowdown, that would be a positive sign for risk appetite. Both of those tripwires have been triggered.

 

The first was the BASF and Dow Chemical pair trade. Both companies are giant chemical companies whose stock prices had historically tracked each other closely. BASF dramatically lagged against Dow when the war began, but now it has staged a relative breakout out of a base.

 

 

In addition, MSCI Poland has staged a relative breakout out of a downtrend against the MSCI All-Country World Index (ACWI), with both vehicles measured in USD terms. I interpret this to mean that geopolitical risk is fading in Europe.

 

 

First in, first out. These are the signs of green shoots of global risk appetite.

 

 

Sentiment still washed out

Lastly, sentiment models are still washed out, which is contrarian bullish. Investors Intelligence sentiment is showing more bears than bulls, which is an unusual and excessively bearish condition.

 

 

The latest AAII weekly survey still shows far too many bears. Both the bull-bear spread and bearish percentage are consistent with major market bottoms. While stock prices can weaken further from these sentiment levels, bearish investors would have to be betting on a major financial crisis like the Lehman Crisis in order to realize more downside.

 

 

In conclusion, a combination of factors, namely positive breadth, improving price momentum, signs of cyclical strength, European turnaround, and excessively bullish sentiment, are serving to signal a possible tactical bottom and put a floor on stock prices. 

 

However, investors should recognize that the current environment has been dominated by a single macro trade, the inverse correlation of the S&P 500 with the USD, which is a two-edged sword. Should interest rate expectations rise further to boost the dollar, it would represent a significant headwind for stock prices. On the other hand, now that Fed speakers are in a blackout period ahead of the November FOMC meeting and the last comments were less hawkish than expectations, the price momentum of that commentary has the potential to spark a risk-on stampede without interruption or contradiction from Fed officials.

 

 

 

Disclosure: Long SPXL

 

How inflation is a game changer for portfolios

Posted by Cam Hui -

In light of the dismal performance in the first nine months of a 60/40 portfolio in 2022, it’s time to ask, “What’s changed and what adjustments should investors make to their portfolios?”
 

 

The answer is inflation, and it’s a game changer. The correlation between stocks and bond increasingly rise as inflation rises. In a low-inflation environment, the correlation is slightly negative, indicating moderate diversification effects. In a high-inflation environment, stock and bond returns becomes correlated, which was demonstrated in the bear market of 2022.
 

 

 

The inflation picture

The global inflation picture looks dire. Inflation rates are surging all around the world/

 

In response, central banks around the world have raced to hike interest rates and raised the risk of a global recession.

 

While the current inflation acceleration is cyclical in nature, the long-term secular trend is worrisome. A BIS study found a link between age demographics and inflation: “A larger share of young and old in the population is associated with higher inflation.”

 

 

As the population of advanced economies ages, inflation pressures from demographics will present a challenge for policy makers in the coming decades.

 

 

 

The Fed’s response

Notwithstanding the long-term problems of inflation, the Fed has made it clear that bringing inflation back to its 2% target is its primary focus. The September Summary of Economic Projections (SEP) is a succinct outline of its economic projections and expected policy response.

 

The changes in projections from the June SEP to September SEP highlight the broad outline of the Fed’s thinking:
  • Recession ahead: 2022 GDP growth was dramatically downgraded from 1.7% to 0.2%, but it’s projected to bounce back to 1.2% in 2023. Reading between the lines, that projection doesn’t sound plausible at unemployment is projected to rise in 2023 and so are interest rates. In other words, the Fed is expecting a recession, but it’s published a soft landing scenario for political reasons.
  • Decelerating inflation: Core PCE inflation is projected to peak in 2022 at 4.5% and decelerate to 3.1% in 2023 and 2.3% in 2024, which is near the Fed’s 2% target.
  • A rates plateau: The median Fed Funds rate ends 2022 at 4.4%, plateaus in 2023 at 4.6%, and gradually falls afterward.

 

 

Reuters reported that the theme of frontloading rate hikes is consistent with what was voiced by St. Louis Fed President James Bullard:

A “hotter-than-expected” September inflation report doesn’t necessarily mean the Federal Reserve needs to raise interest rates higher than officials projected at their most recent policy meeting, St. Louis Fed President James Bullard said on Friday, though it does warrant continued “frontloading” through larger hikes of three-quarters of a percentage point…

 

After delivering a fourth straight 75-basis-point hike at its policy meeting next month, Bullard said “if it was today, I’d go ahead with” a hike of the same magnitude in December, though he added it was “too early to prejudge” what to do at that final meeting of the year.

 

If the Fed follows through with two more 75-basis-point hikes this year, its policy rate would end 2022 in a range of 4.50%-4.75%.
San Francisco Fed President Mary Daly said Friday, just ahead of the media blackout ahead of the FOMC meeting, that she wants to avoid putting the economy into an unforced downturn by overtightening, “I want to make sure we don’t overtighten just much as I want to make sure we don’t undertighten.” She added that the SEP Fed Funds rate forecast, which amounted to a 75 bps hike in November and followed by 50 bps in December, was a “good projection” and argued for rate hikes to slow to a 50 or 25 bps pace after the November meeting.

 

Current market expectations calls for a terminal rate of under 5% in 2023, with easing to begin late in the year. This is consistent with the Fed’s stated course that it will pause but not ease prematurely because of the fears of a policy error that ignites a 1970’s style inflationary spiral.

 

 

 

Good news on inflation

Despite all of the angst about broadening inflation dynamics, an analysis of the underlying trend indicates that inflation is peaking and will decelerate in the near future.

 

A disaggregation of PCE inflation trends shows that the inflation shock is mainly attributable to COVID-19 and the Russo-Ukraine War. Moreover, much of the supply-driven inflation is starting to diminish and roll over.

 

 

As for the hot September CPI report that came in ahead of expectations and rattled markets, the overshoot can be attributable to Owners’ Equivalent Rent (OER), which is a large weight in CPI. An analysis of core CPI ex-OER shows a clear trend of deceleration.

 

 

OER is a lagging indicator, which is a problem for Fed policy makers. Paul Krugman pointed out that an analysis from Goldman Sachs found that average alternative metrics of rental rates show that rents are rising at about 3% and decelerating, compared to the accelerating September BLS OER rate of 6.8%.

 

 

Jason Furman substituted Zillow’s new rent data into core CPI and found a similar trend of deceleration, though the alternative core CPI measure shows greater volatility.

 

 

As for the Fed’s fears of a 1970’s style wage-price spiral, relax. Wage increases are starting to top out. While job switchers are enjoying better raises than job stayers, which is an indication of a tight labor market, the rate of increase for both switchers and stayers is rolling over.

 

 

Moreover, an IMF study concluded that wage-price spirals are rare.

 

 

None of this means that the Fed should pivot from tightening to easing, but it does mean that inflationary pressures are starting to ease and an interest rate pause should be closer than the market expects. I would argue that the Fed is fighting the wrong war by targeting wage inflation. The main enemy during the inflationary 1970’s was the enormous power they wielded by unions and the Fed was correct in breaking the wage-price spiral then. The policy problem today should be the ability of companies to raise their prices in response to inflationary pressures. Pretax margins fell during the 1970’s when inflation rose. Today, margins are rising in lockstep with inflation as corporations have been able to pass through price increases.

 

 

 

It’s become all one trade

Here is what all this means for investors. The intense market focus on Fed policy has translated into a single one-factor Fed policy factor trade.

 

The Fed’s balance sheet (blue line) is inversely correlated to real 10-year Treasury yields (red line).

 

 

The Fed’s balance sheet (blue line) is also inversely correlated to the trade-weighted dollar (red line, inverted scale) as Fed tightening has driven up the USD and exported inflation abroad. 

 

 

Finally, the S&P 500 (red line) is highly correlated to the Fed’s balance sheet (blue line). By extension, it has become all the same factor trade – liquidity, real yields, the USD, and stock prices.

 

 

Here is a chart of the USD Index since 1980 along with its 20-month Bollinger Band and the S&P 500. Past overbought episodes of the USD have occurred during periods of positive correlation with the S&P 500. The current period is highly unusual inasmuch as it is occurring during a period of S&P 500 weakness for the reasons already cited. The greenback is very extended and fault lines are appearing around the world. Japan and China have intervened to stabilize their currencies, and the UK has experienced funding stress. Either an inflation or crisis driven pivot should occur in the near future.

 

 

 

Investment implications

I began this publication by rhetorically asking the question of how investors should adjust their portfolios in response to high inflation. The analysis from JPM Asset Management outlines how asset classes perform in different inflation environments.

 

 

Jim Paulson at Leuthold Group further analyzed the S&P 500 during rising and falling inflation under high, medium, and low inflation regimes. If my analysis of decelerating inflation is correct, the S&P 500 is about to undergo a period of strong returns in the coming months.

 

 

In conclusion, rising inflation has played havoc with 60/40 portfolios as bond prices haven’t provided a counterweight to falling stock prices. A study reveals that underlying inflation trends are decelerating. which should be positive to risk appetite expectations. The inflation and market pivot is just around the corner and it may be closer than the market expects.

 

Liftoff?

Posted by Cam Hui -

Mid-week market update: Recent discussions with readers made me realize that many investors may have become so numb to the endless bearish stock market impulses that they don’t realize how oversold the stock market is. I have highlighted in the past the chart of the NYSE McClellan Summation Index (NYSI) to demonstrate that a reading of under -1000 is rare and historically led to tactical rebounds.
 

 

But that’s not the full story. Here is the NASI, which is the NASDAQ version of NYSI. Readings of -1000 are a bit more frequent, but they have led to tactical rebounds with the single exception of the episode in late 2000.

 

 

The S&P 500 weekly Williams %R, which is another overbought/oversold oscillator, recently recycled from a deeply oversold reading of -100. While this indicator has shown itself to be an inexact trading signal, it also signaled a deeply oversold condition that has usually resolved in tactical rebounds.

 

 

The 5 dma of the percentage of the S&P 500 with bullish patterns on point and figure charts recently fell below 15% before recovering. While historically these signals were slightly early, they have nevertheless indicated a positive risk/reward ratio for bullish positions in the past.

 

 

The percentage of NASDAQ stocks above their 200 dma fell below 10% and recovered. These are all signs of a deeply oversold market by any historical measure.

 

 

The percentage of S&P 500 stocks above their 50 dma experienced a breadth wipeout in June by falling below the 5% level but recovered to over 90% in a brief period. In the past, such breadth thrusts have always signaled the start of a fresh bull leg – except that the latest buy signal failed and the indicator retreated below 5%. The closest template of current conditions may be the 2008-2009 period. While this indicator did not fail by flashing a buy signal and weaken during that period, it did flash a positive divergence by exhibiting a higher low. So did the percentage of the S&P 500 above their 20 dma. I interpret this to be a constructive sign for the bulls.

 

 

 

Bearish sentiment

Sentiment models have also been very bearish, which is contrarian bullish. The latest BoA Global Fund Manager Survey shows that respondents are extremely overweight cash and underweight equities. Fund managers have built the highest cash levels since April 2001.

 

 

The New York Post featured the losses in the average 401k account this year as a contrarian newspaper cover indicator.

 

 

Futures positioning is very short financial assets.

 

 

The lack of risk appetite is confirmed by Goldman Sachs prime brokerage, which reported net equity positioning at fresh lows.

 

 

 

The bullish catalyst

The market just needed a catalyst for a risk-on liftoff. From a technical perspective, the usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) just flashed a buy signal when its 14-day RSI recycled from an oversold condition to neutral. There have been 26 such signals in the last five years and 22 have resolved bullishly. The current buy signal is reminiscent of the September 2021 period when the RSI indicator weakened from neutral back to oversold soon after the buy signal. The final buy signal eventually succeeded and the index rallied about 10% on a trough-to-peak basis, which would come to about 3940 on the S&P 500.

 

 

From a fundamental and macro perspective, the bullish catalyst could be attributable to two possible factors. The most obvious is the British government’s about-face on its fiscal plan, which sparked a relief rally in the gilt market and Sterling. 

 

Less noticed but equally important is the prospect of better liquidity in the Treasury market. In the wake of concerns expressed by Treasury Secretary Janet Yellen about diminished Treasury market liquidity, Reuters reported that the US Treasury asked banks if it should buy back Treasuries to improve UST market liquidity. Joseph Wang, otherwise known as the Fed Guy, explains:
Treasury buybacks would be a powerful tool that could ease potential disruptions arising from quantitative tightening. The Treasury hinted in their latest refunding minutes of potential buybacks, which is when Treasury issues new debt to repurchase old debt. Buybacks can be used to boost Treasury market liquidity, but more importantly also allow Treasury to rapidly modify its debt profile. By issuing bills to purchase coupons, Treasury could strengthen the market in the face of rising issuance and potentially structural inflation. An increase in bill issuance would also facilitate a smooth QT by moving liquidity out of the RRP and into the banking sector.
Better UST liquidity would be a step to offset the bearish factors posed by the Fed’s QT program.

 

 

Key risks

Investors face a number of key risks to any risk-on rally.
  • Fed hawkishness: Jenna Smialek of the NY Times report that a pause is not on the Fed’s current trajectory and a 75 bps hike is baked-in at the November meeting. However, this degree of hawkishness has already been discounted by the market. The real question, which no one can answer, is the terminal rate and how long the Fed intends to hold rates at that level.
Federal Reserve officials have coalesced around a plan to raise interest rates by three-quarters of a point next month as policymakers grow alarmed by the staying power of rapid price increases — and increasingly worried that inflation is now feeding on itself.

 

Such concerns could also prompt the Fed to raise rates at least slightly higher next year than previously forecast as officials face two huge choices at their coming meetings: when to slow rapid rate increases and when to stop them altogether.
  • The uncertainties posed by Q3 earnings season: Despite widespread concerns about earnings deterioration, earnings report risks are symmetrical. Indeed, Bianco Research’s corporate guidance index, which measures the rate of positive to negative earnings guidance, is positive for Q3.

 

 

  • Financial instability in Japan: The USD wrecking ball is wreaking havoc in Japan. The 10-year JGB is edging above the BOJ’s 25 bps yield curve control mark, and the JPY is weakening to new post-1990 lows. 

 

 

  • Geopolitical risk: China recently advised its citizens to leave Ukraine. Other countries that recently either closed their embassies or urged their citizens to evacuate from Ukraine include Belarus, Kazakhstan, Kyrgyzstan, Serbia, Tajikistan, Turkmenistan, and Uzbekistan. All these countries are either Russian allies, or closely aligned with Russia. Do these countries know something the rest of the world don’t know?
  • Chinese retaliation in the semiconductor war: The Biden White House recently imposed a set of semiconductor export controls on China that are expected to hobble China’s science and technology ambitions. For a detailed explanation, listen to this podcast with Kevin Wolf, former Assistant Secretary of Commerce for Export Administration. While the announcement has cratered semiconductor stocks, Beijing hasn’t announced retaliation measures and it’s unclear how wide-ranging or the magnitude of the retaliation will be.

 

In conclusion, these violent market swings tend to be bear market characteristics and my base case scenario for this latest advance is a bear market rally. 

 

 

How far can the rally run? Assuming that this is a sustained bear market rally and not a two-day wonder, a 10% rebound would take the S&P 500 to about 3940, while the first Fibonacci retracement level is about 3990. The rally will encounter strong resistance at about 4140, which is the intersection of the falling trend line and the 50% retracement level.

 

 

 

Disclosure: Long SPXL

 

How bears turn into bulls

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 and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real-time here.
 

 

A failed reversal

Last week, I highlighted a possible bullish reversal candlestick on the weekly chart, but warned that the reversal needs to be confirmed by the next candle. This week, the S&P 500 weakened and failed to confirm the reversal candle, though the market is still exhibiting a positive 5-week RSI divergence and it is still testing support at the 200 week moving average. 

 

 

Regardless, I am seeing helpful signs of leadership rotation. During bear markets, the old market leaders fade and new leadership emerges to lead the new bull cycle. The change in leadership is a constructive market internal that is indicative of a bottoming process.

 

 

Ready to rally

Sentiment readings indicate that the market is washed out and poised to rally. The Investors Intelligence bull-bear spread had fallen to levels last seen during the GFC.

 

 

The TD-Ameritrade Investors Movement Index, which measures the positioning of that firm’s customers, fell to historically low levels, which is contrarian bullish.

 

 

The NDR Crowd Sentiment Poll has fallen to levels last seen at the 2008 low, which should put a floor on stock prices. The market just needs a catalyst to begin an advance.

 

 

 

A change in leadership

The US equity market has seen a definite shift in leadership. Changes in market leadership can be a sign that a bear market is turning into a fresh bull. As the old bull and old leaders falter, new blood and new leaders take up the baton. Large-cap growth FANG+ names, which had been the leaders since before the onset of the COVID pandemic, have seen their relative strength completely roll over.

 

 

A more detailed analysis of the relative performance of the three major growth sectors shows that they are all struggling.

 

 

Tactically, FANG+ prices may be experiencing headwinds because of SNB selling. Detailed disclosures of changes in the SNB balance sheet shows that most of the equity sales are concentrated in large-cap US growth stocks.

 

 

By contrast, the relative performance of cyclical value sectors are more positive.

 

 

A detailed relative performance analysis of selected cyclical industries shows:
  • A relative breakout by infrastructure stocks;
  • Broker-dealers have been in a relative uptrend since early July, though the group hasn’t achieved a relative breakout yet;
  • Homebuilding stocks, which should be in the gutter with the tanking housing market, is in a relative uptrend;
  • Retailers are forming a saucer-shaped relative bottom;
  • The laggards are transportation and semiconductor stocks.

 

 

 

Valuation support

It’s possible that the market has seen the lows for the cycle. The S&P 500 is trading at a forward P/E of 15.4, but the forward P/E is about 12 on an ex-FAAMG basis, which is arguably cheap by historical standards.

 

 

An ex-FAAMG forward P/E of 12 is in the vicinity of mid- and small-cap P/E ratios.

 

 

Indeed, the small-cap Russell 2000 and S&P 600 have been strengthening against the S&P 500 since May in an uneven manner and attempting a relative breakout.

 

 

 

Bear market rally ahead

My base case scenario calls for a bear market rally for several reasons. The market has been extremely oversold, as measured by the NYSE McClellan Summation Index. Past readings of under -1000 have seen stock prices rally, even in the bear markets of 2002 and 2008.

 

 

However, the rotation from growth to value isn’t entirely convincing. While large-cap value has turned up against large-cap growth, mid- and small-cap value and growth aren’t confirming the rebound.

 

 

In conclusion, the stock market is poised to undergo a bear market rally.  Sentiment and technical conditions continue to be supportive of a short-term bottom. Beneath the hood, the market is undergoing a change in market leadership, which can be indicative of a long-term bottom process as the old leaders falter and the new leaders take up the baton.

 

 

Disclosure: Long SPXL

 

Why the pivot may be closer than you think

Posted by Cam Hui -

Richard Nixon’s Treasury Secretary John Connally famously said in 1971, “The dollar is our currency, but it is your problem”. Nixon’s actions at the time closed the gold window, imposed a number of tariffs, and drove the USD down in the aftermath of the collapse of the Bretton Woods Agreement of fixed exchange rates.
 

Fast forward to 2022, and the situation is different. The Federal Reserve is one of the most hawkish of advanced economy central banks, and its interest rate policy. The Fed’s actions are exporting disinflation abroad and forcing major trading partners to engage in a series of competitive tightening to defend their own currencies. 

 

 

While US financial conditions are still relatively stable, financial cracks are appearing abroad and USD strength has become a wrecking ball wreaking havoc around the world. In spite of the hot September CPI print, the Fed’s pivot may be closer than the market expects.

 

 

A global wrecking ball

Let’s begin with the good news. A strong USD (orange line, inverted scale) is disinflationary. Historically, USD strength leads global inflation by eight months.

 

 

Here is the bad news, financial stress has been correlated with USD strength. The Chicago Fed National Financial Conditions Index (black line) is just under zero today. In the past, strength in this index, which indicates stress, has preceded recessions. While most recessions have seen this index turn positive, it did peak at just below zero during the late 1990s.

 

 

The Chicago Fed National Financial Conditions Index just covers the US, whose conditions are relatively tame. The IMF’s newly published Global Financial Stability Report found higher stress levels in the Euro area and emerging market countries ex-China.

 

 

Offshore USD liquidity is drying up, which can be seen in the cross-currency swap market. While levels are elevated, they are not at crisis levels yet. Liquidity problems are particularly concerning as Treasury Secretary Janet Yellen stated, “We are worried about a loss of adequate liquidity in the [Treasury] market”.
 

 

 

Self-inflicted wounds

Europeans central bankers appear to have a propensity for self-inflicted wounds. The BoE apparent indecision on whether to support the gilt market confused markets. Last Tuesday, BoE Governor Andrew Bailey told pension fund managers to finish rebalancing their positions by Friday when it will end its emergency support program to support the gilt market: “And my message to the funds involved and all the firms involved managing those funds: You’ve got three days left now. You’ve got to get this done.”

 

The gilt market was instantly thrown into turmoil until on Wednesday, the FT reported:
The Bank of England has signalled privately to bankers that it could extend its emergency bond-buying programme past Friday’s deadline, according to people briefed on the discussions, even as governor Andrew Bailey warned pension funds that they “have three days left” before the support ends.
A few hours later, the story changed to:
A sell-off in UK government bonds accelerated on Wednesday, sending long-term borrowing costs higher after the Bank of England reiterated its plans to halt its emergency gilt-buying scheme as scheduled on Friday. The central bank said on Wednesday morning that it “has made clear from the outset, its temporary and targeted purchases of gilts will end on 14 October”.
In addition, there is an accounting quirk at the BoE that makes its intervention vulnerable to a pro-cyclical factors. There are two sources of losses. The first will be losses on its asset purchases holdings (AFP) as the interest rate on bank reserves exceeds the coupon yield on the asset purchases. As well, the BoE will realize losses on its balance sheet in light of the Bank’s intention to sell gilts as part of its QT program. Unlike other central banks such as the Federal Reserve, which can record losses as deferred assets and amortize them over many years from the Fed’s monetary income and lower transfers to Treasury, the BoE directly bills HM Treasury for these losses immediately. These losses will force the UK government to sell gilts to finance these losses at a time when the budget is under severe pressure and raise political pressure on BoE leadership. 

 

An analysis by Chris Marsh estimates that this fiscal indemnity under differing scenarios will cost £20 to £30 billion per year for the next few years, which is an enormous burden for the government.
To put this indemnity in context, the abolition in the top rate of tax (of 45p) was projected to have an impact of about GBP2bn per year in the steady state. The BOE indemnity will be GBP20-30bn per year for the next two years and potentially much more later.

 

The primary deficit from the March 2022 OBR forecast was projected for 2022/23 at GBP27bn and for 2023/24 at GBP13bn.

 

 

The ECB tried to top the BoE for a self-inflicted wound on Thursday when Reuters reported that it is considering a change to its TLTRO program because it has become overly generous to banks.
European Central Bank policymakers are closing in on a deal to change rules governing trillions of euros worth of loans to banks in a move that will shave tens of billions of euros off in potential banking profits, sources close to the discussion said.

 

Euro zone banks sit on 2.1 trillion euros ($2.04 trillion) of cash handed out by the ECB at ultra-low, sometimes even negative interest rates, in the hopes that doing so would help kick-start the economy.

 

But after a string of unexpectedly quick and big rate hikes banks can now simply park this cash back at the ECB, earning a risk-free profit, irking policymakers who see it as gaming the system.

The intention of the policy change is to “hurt banks”.

“We are very close and a decision is going to come soon,” one of the sources, who asked not to be named, said on the sidelines of the International Monetary Fund and World Bank annual meetings in Washington. “The ultimate design is going to hurt banks, and that is very much our intention.”
Wait, what? Hurt a fragile banking system in an economy that’s in a recession? Instead, a desire to “hurt banks” will have the pro-cyclical effect of exacerbating the banking system’s downside risk. On the scale of policy errors, this has the potential to rival the BoE’s on-again, off-again statements of support for the gilt market.

 

In short, enormous stresses are appearing in European central banking. Rate hike cycles end abruptly when something breaks, and something may break soon in Europe.

 

 

Earnings stress

Back on Wall Street, the dollar wrecking ball could wreak havoc on earnings growth. Historically, a strong USD has been correlated with negative earnings growth. While the very early results from Q3 earnings season have been encouraging, earnings growth will face macro headwinds longer term. Watch for earnings calls that include the phrase “but on a constant currency basis, we…”.

 

 

 

The party line on Fed policy

Current Fed policy is hawkish and it will remain especially hawkish in light of the hot September CPI report. The September FOMC minutes reveals the key points of the Fed’s thinking.

 

Inflation is stubbornly high.

Participants observed that inflation remained unacceptably high and well above the Committee’s longer-run goal of 2 percent. Participants commented that recent inflation data generally had come in above expectations and that, correspondingly, inflation was declining more slowly than they had previously been anticipating.

Inflation risks are skewed to the upside.
Participants agreed that the uncertainty associated with their economic outlooks was high and that risks to their inflation outlook were weighted to the upside. Some participants noted rising labor tensions, a new round of global energy price increases, further disruptions in supply chains, and a larger-than-expected pass-through of wage increases into price increases as potential shocks that, if they materialized, could compound an already challenging inflation problem. A number of participants commented that a wage–price spiral had not yet developed but cited its possible emergence as a risk.
The good news is inflation expectations are well anchored, but the Fed is concerned that elevated inflation rates will boost inflation expectations.
In assessing inflation expectations, participants noted that longer-term expectations appeared to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters as well as measures obtained from financial markets. Participants remarked that the Committee’s affirmation of its strong commitment to its price-stability objective, together with its forceful policy actions, had likely helped keep longer-run inflation expectations anchored. Some stressed that a more prolonged period of elevated inflation would increase the risk of inflation expectations becoming unanchored, making it much more costly to bring inflation down.
Saying the quiet part out loud, monetary policy needs to deflate the jobs market to fight inflation.
Participants judged that a softening in the labor market would be needed to ease upward pressures on wages and prices. Participants expected that the transition toward a softer labor market would be accompanied by an increase in the unemployment rate. Several commented that they considered it likely that the transition would occur primarily through reduced job vacancies and slower job creation.

 

 

A Brainard pivot?

By contrast, Fed Vice Chair Lael Brainard may on leading the charge for caution in raising rates. Brainard is part of the powerful triumvirate at the Fed consisting of the Chair, Jerome Powell, the Vice Chair, and the President of the New York Fed, John Williams. Brainard had been on the Fed Board since 2014, and much of her work focused on global linkages and their effects on financial stability. In a speech she made entitled “Global Financial Stability Considerations for Monetary Policy in a High-Inflation Environment” on September 30, 2022, she focused on the international linkages of monetary policy and referred to the word “spillovers” nine different times.
We meet regularly not only with monetary policy officials from different countries, but also with fiscal and financial stability officials in a variety of international settings, which helps us to take into account cross-border spillovers and financial vulnerabilities in our respective forecasts, risk scenarios, and policy deliberations.
While the Fed’s north star is still its price stability mandate and bringing inflation back to its 2% target, she acknowledged that monetary policy works with a lag. At some point, it will be appropriate to proceed “deliberately and in a data-dependent manner”, otherwise known as a pause.
We also recognize that risks may become more two sided at some point. Uncertainty is currently high, and there are a range of estimates around the appropriate destination of the target range for the cycle. Proceeding deliberately and in a data-dependent manner will enable us to learn how economic activity and inflation are adjusting to the cumulative tightening and to update our assessments of the level of the policy rate that will need to be maintained for some time to bring inflation back to 2 percent.
Brainard made a separate speech, “Restoring Price Stability in an Uncertain Economic Environment”, on October 10, 2022 that was full of references to reasons why inflation is moderating but warned that monetary policy operates with lags.
We are starting to see the effects [of monetary tightening] in some areas, but it will take some time for the cumulative tightening to transmit throughout the economy and to bring inflation down.
She once again referred to the “combined effect of concurrent global tightening”, “spillovers”, and called for “moving forward deliberately and in a data-dependent manner” as a way of warning against over-tightening. In particular, she did not include the Fed party line about the risks of prematurely pulling back on tightening.

 

In the wake of the higher than expected CPI report, Fed Funds expectations have changed dramatically.
  • A 75 bps hike in November has become a virtual certainty.
  • The market now expects a 75 bps hike in December instead of 50 bps.
  • The terminal rate rose to 475-500 bps, up 25 bps.

 

 

Those expectations may be overly hawkish in light of Brainard’s remarks. In particular, there has been a lot of hand-wringing over the shelter component of CPI, which comprises 32% of headline CPI weight and 40% of core CPI. A BLS research paper found that the CPI rent index lags a full year behind rents paid by new tenants. Redfin reported that rent increases are decelerating rapidly, supporting concerns about the Fed’s focus on a lagging indicator which will lead it to over-tighten.

 

 

Further analysis of core CPI ex-Owners Equivalent Rent shows a clear trend of deceleration in this “core+ CPI”.

 

 

In conclusion, the Fed’s tight monetary policy is creating spillover effects all over the world by boosting the USD. The recent cover of Barron’s may be the contrarian magazine cover signal that the era of the USD wrecking ball is over. 

 

 

Market conditions may be on the verge of triggering a pause in the global hiking cycle. Possible contagions from uncertainties in the gilt market and euro area bonds, lack of liquidity in the onshore and offshore USD market will increase financial stability concerns for central bankers. A monetary policy pivot may be far closer than the market expects. 

 

Do divergences matter anymore?

Posted by Cam Hui -

Mid-week market update: The stock market has been exhibiting a series of positive breadth and momentum divergences as the S&P 500 weakened, but the recent main driver of risk appetite has been the fixed income and currency markets.
 

Do divergences matter anymore?

 

 

External drivers

The divergences matter less inasmuch as the stocks in the S&P 500 are all moving together, indicating that equities are being driven by either extreme emotion and external macro forces. In this case, the external drivers are mainly the bond and currency markets.

 

 

 

You’ve got three days

The market was thrown into turmoil yesterday when BoE Governor Andrew Bailey told pension fund managers to finish rebalancing their positions by Friday when the Banks ends its emergency support program for the country’s fragile bond market, “And my message to the funds involved and all the firms involved managing those funds: You’ve got three days left now. You’ve got to get this done.” The market was instantly thrown into turmoil, though the FT reported that the Bank walked back the sudden stop in BoE support, but left participants confused. The yield on the 10-year gilt surged to levels last seen during the GFC.

 

 

The MOVE Index, which measures the volatility of the Treasury market, has also surged to GFC levels, though the anxiety can largely be attributable to the Fed’s tightening trajectory.

 

 

 

Cross-asset signals

Even then, I am seeing a number of cross-asset signals that may be conducive to a better risk appetite. 

 

I have heard from some readers expressing concern about the breach of support by TLT, the long bond Treasury ETF, other ETFs representing the shorter end of the Treasury yield curve held support during the latest bond market downdraft, which may be a constructive sign for risk appetite.

 

 

The S&P 500 has been inversely correlated to oil prices and the USD. Oil prices have been flat even as stock prices fell, and the USD Index is exhibiting a slight positive divergence against the S&P 500, which is another positive sign for risk appetite.

 

 

 

Poised for a bear market rally

I interpret these conditions as the stock market is washed out and poised for a rally. The NYSE McClellan Summation Index (NYSI) has fallen below -1000. Stock prices have historically rebounded when NYSI reached these levels. Even during the bear markets of 2002 and 2008, the market rebounded before weakening again.

 

 

The VIX Index is nearing or reaching the minimum level of 34, which has signaled near-term bottoms in the past year.

 

 

As well, the term structure of the VIX is inverted, indicating widespread fear.

 

 

Analysis from SentimenTrader shows that the Fear & Greed Index exhibited a positive divergence. The last time this happened was the Christmas Eve Panic of 2018, and the market rallied hard afterwards.

 

 

You can tell a lot about market psychology by the way it responds to news. PPI came in hot this morning, and stock prices have been roughly flat on the day instead of tanking as they did after the NFP report, indicating that risk appetite is becoming numb to bad news. Much will depend on the CPI report tomorrow morning. 

 

The Cleveland Fed’s inflation nowcast is calling for a monthly headline CPI of 0.3% and core CPI of 0.5%, compared to consensus expectations of a headline of 0.2% and a core of 0.5%. 

 

 

Ahead of the CPI report, SPY option open interest is skewed very bearish, which may mean that we need a very hot CPI print for stock prices to tank. If the report comes in at or below expectations, it could spark a strong risk-on bounce tomorrow.

 

 

 

Disclosure: Long SPXL