Mr. Bond, I expected you to die

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 rejection and a breakout from resistance

Last week, I highlighted the key technical tests that the S&P 500 was about to undergo as it breached its 200 dma and it was nearing a falling trend line. Ultimately, the stock market failed at resistance and pulled back to a key support level. Long Treasury prices, which had been highly correlated with stock prices in 2023, underwent a similar technical test but staged an upside breakout. 

 

 

The stock/bond ratio is now weakening. Anyone who expected Mr. Bond to die in the face of hawkish Fed policy must be disappointed.

 

 

A change in tone

The change in tone in the Treasury market can be attributed to several factors. One is growing evidence in the jobs market. Initial jobless claims are rising, albeit slowing, from their April trough.

 

 

Unit labor costs, which were reported last week, decelerated and came in softer than expected. It was a welcome antidote to the upside surprise exhibited by average hourly earnings in the November Non-Farm Payroll report.

 

 

Before you get overly excited, the Atlanta Fed’s wage growth tracker showed that wage growth for job switchers rose from 7.6% in October to 8.1% in November while the overall wage growth rate stayed constant at 6.4%, indicating continued tightness in the labor market.

 

 

Oil prices broke a key technical support level, which was a surprise in light of the expected strength in demand from the China reopening narrative.

 

 

As well, used car prices continue to weaken, which is positive for disinflation.

 

 

Moreover, the Bank of Canada’s dovish rate hike raised hopes of a possible pause in the global rate hike cycle. The BoC increased rates by 50 basis points, but signaled a possible pause in its statement: “Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance”.

 

 

Asset market implications

The divergence between Treasury and equity prices has bearish implications for risk assets. Much of the recent market relationships can’t be relied on anymore.

 

As an example, the relative performance of large-cap growth stocks has been inversely correlated to Treasury yields because of the long-duration characteristic of growth stocks. As the bond market begins to discount a growth slowdown and probable recession, don’t expect growth to outperform under these circumstances.

 

 

Indeed, both the absolute and relative performance of technology stocks are struggling, and relative breadth indicators (bottom two panels) are also lagging behind the S&P 500.

 

 

Despite the Treasury market rally, investors should be cautious about high-yield credits. While the relative performance of junk bonds is tracking the performance of the S&P 500, leveraged loans (red dotted line) are flashing warning signs of rising credit risk.

 

 

 

The week ahead

Looking to the week ahead, investors will be watching the November CPI report on Tuesday and the FOMC decision Wednesday. The Cleveland Fed’s inflation nowcast of 0.47% and 0.51% for headline and core CPI respectively are ahead of consensus expectations of 0.3% and 0.4%. The risk of a hot negative surprise is elevated and the market reaction to the PPI print on Friday was a potential preview of the market reaction.

 

 

The market is discounting a 50 basis point hike in December, a terminal rate that’s just over 5%, and rate cuts in mid 2023. Keep an eye on expected inflation, and the unemployment rate that will be published in the December Summary of Economic Projections after the FOMC meeting. While the inflation rate will determine the pace of rate hikes, the Fed’s perception of the labor market will determine the timing of rate cuts.

 

 

I have argued the lack of recovery in the labor force participation rate by older workers translates into a higher natural unemployment rate, which will keep the job market tight. Market expectations of rate cuts in mid 2023 would be unrealistic under such a scenario. The prospect of a prolonged tight Fed as the labor market stays tight would be bullish for bonds but bearish for stocks.

 

 

In conclusion, the Treasury bond market is turning up while the stock market is turning down, which is a condition that hasn’t been seen for much of this year. I believe that this market action is the market’s signal of weaker economic growth, which should be bond bullish and equity bearish. However, much of the short-term outlook will depend on next week’s CPI report and FOMC meeting.

 

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

 

 

Disclosure: Long SPXU

 

The stealth change in market leadership you may have missed

Posted by Cam Hui -

It’s time to conduct one of my periodic market leadership reviews. The review will be done through different viewpoints, starting from the top from an asset lens, a global equity lens, and finally through a factor, or style, lens.
 

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. All of the RRG analysis is conducted in USD and therefore includes all currency effects in the returns.
 

The benchmark for the asset RRG analysis is the Vanguard Balanced Index Fund (VBINX). It shows leadership by virtually all equities except China. Non-US bonds are in the improving quadrant. EM equities are only in the improving quadrant, dragged down by China in the lagging quadrant, which also contains US large-cap growth and Treasuries.

 

 

Here are my main takeaways from this analysis:

  • The market is discounting a global recovery as equities are generally leading the rotation.
  • The recovery is more advanced in non-US markets, as evidenced by the superior performance of non-US bonds over Treasuries.
  • China is a laggard and dragging down the performance of emerging market equities.
  • US large-cap growth is dragging down the performance of US equities, as shown by the poor performance of the NASDAQ 100 compared to the S&P 500.
In addition, the bond market is starting to discount a pause and possible pivot in the Fed Funds rate. Past peaks in the 30-year Treasury yield have either been coincident or led peaks and pauses in the Fed Funds rate. However, the timing record for the stock market for these signals has been spotty.

 

 

Tactically, the uptrend shown by both the iShares 20 year+ Treasury ETF (TLT) and iShares International Treasury Bond ETF, as evidenced by the price above the 10 dma, which is above the 20 dma, and above the 50 dma, are constructive signs that uptrends are in place and global bond prices have turned.

 

 

 

Global equity rotation themes

Viewing global equities on a region and major country basis, the following themes stand out:
  • Europe is a clear leader, along resource sensitive countries like Australia and Canada. 
  • Mexico is also a market leader, probably because it is a beneficiary of the near-shoring of production to the NAFTA bloc. On the other hand, Brazil has also become a major drag on Latin American stocks.
  • China and Hong Kong are major drags on emerging markets, though other Asian markets such as Japan, Korea, and Taiwan are in the improving quadrant. 
  • The US market is losing steam, as large-cap growth stocks have lagged.

 

 

The break in US equity performance is not a surprise. US equities have been trading at a premium P/E to the rest of the world for about a decade. The strong performance was attributable to the fundamental dominance of FANG+ stocks, which are now in retreat.

 

 

The lag in performance of US large-cap stocks can also be seen in the chart of regional relative performance. The NASDAQ 100 peaked in August relative to MSCI All-Country World Index (ACWI) and the S&P 500 peaked in early November. Consistent with the more detailed RRG chart of region and country rotation, European equities have been on a tear since September, while Japan, China, and EM have gone nowhere in the past few months.

 

 

 

US factor rotation themes

An analysis of the US factor rotation chart tells a story of the devastation of growth stocks and the emergence of value stocks. Growth factors are in the bottom half of the chart, indicating weakness, while the top half is dominated by value factors of different descriptions.

 

 

I would warn, however, that the apparent superior relative performance of value stocks is more attributable to the poor performance of FANG+ stocks. While US value has outpaced growth since September, EAFE value has gone nowhere against growth during the same time period.

 

 

In addition, many of the value sectors, which have a high degree of cyclical exposure, appear to be extended in the short run and they are prone to a relative pullback.

 

 

More disturbing is the relative performance of defensive sectors, which have been in relative uptrends since August despite the market advancing during that period.

 

 

That said, the relative performance pattern of small-cap value sectors appears to be constructive.

 

 

 

Investment conclusions

In conclusion, bond markets are discounting a global growth slowdown. Different regions of global equities are in various phases of recovery. I reiterate my conviction to overweight Europe on a FIFO basis of entering and exiting recession. European equities are attractively priced on a forward P/E basis and FactSet reported that forward 12-month EPS for MSCI Europe has risen to a new cycle high.

 

 

Callum Thomas also reported that EU equity positioning is still extremely defensive and the cyclical bull trade has only barely begun.

 

 

China and Asia still needs time to consolidate and digest their relative gains after the recent China reopening rally. 

 

 

The next shoe in the reopening drama is about to drop. China’s National Health Commission announced 10  measures that amount to a pivot from zero-COVID containment to mitigation. Bloomberg reported that China faces the risk that infection rates will rise rapidly, along with underreporting risk as testing requirements are eased.

With requirements for frequent lab testing dialed back significantly, anecdotal evidence suggests undetected cases are on the rise. Some health experts are predicting actual infections will far surpass the official tally.

The Financial Times also reported China is bracing for COVID outbreaks among medical staff and migrant workers. 

 

Q1 growth is likely to be challenging for China. Already, China’s Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is falling. A spike in COVID infections will be a further drag to the economy. Expect some bumpiness in the coming months.

 

 

Investors who are focused on the US market by mandate are advised to focus on value and quality factors. Mid and small-cap stocks are more attractive on a valuation basis compared to large-caps.

 

 

The US market appears to be undergoing a secular rotation from growth to value and from large-caps to small-cap leadership.

 

 

Tactically, a strategy of buying Treasuries and non-US stocks could have considerable upside potential. An analysis of the holdings of the iM DBi Managed Futures ETF (DBMF), which is a proxy for CTA futures programs, shows that the fund is short bonds and roughly neutral on equity positioning. Should bonds and non-US equities rip, buying potential from CTAs could drive prices quite a bit higher.

 

 

Making sense of the market’s risk reversal

Posted by Cam Hui -

Mid-week market update: So much for the S&P 500 testing the 200 dma and falling trend line resistance. The index reached its resistance zones late last week and pulled back to test a key support level.
 

 

What’s puzzling is the lack of a fundamental driver for the market weakness. While I have been cautious, this kind of market action even surprised me.

 

 

Fear of recession

A narrative has crept up this week that the market is pivoting from a fear of rate hikes to a fear of recession. As stock prices weakened, bond prices rallied, which broke the 2022 pattern of the synchronization of stock and bond prices. This could be interpreted as the bond market discounting a growth slowdown while the stock market is anticipating an earnings slowdown.

 

Take a look at how commodity prices and the Treasury yield curve have behaved. Commodities took a nosedive this week in the face of the China reopening news, which I interpret to mean that the market is expecting slower global growth. Indeed, last night’s reports of China’s imports and exports missed expectations, which is a signal of weak global demand. In addition, different yield curve spreads have been inverting, indicating that the bond market expects slowing growth. The 10s30s yield curve (bottom panel) is nearly inverted. In the last two sell-offs this year, the stock market didn’t bottom until the 10s30s started to turn up, which means that we could be early in this latest pullback episode.

 

 

 

A reliable sell signal

The usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) flashed a sell signal last night when its 14-day RSI recycled from overbought to neutral. There have been 21 such signals in the past five years, the market fell on 16 occasions (pink vertical lines) and advanced on five (grey lines). 

 

 

How do the bears know when to cover their shorts? I can offer two guidelines. In the past, trigger points to unwind bearish exposures occur whenever either the 14-day RSI of ITBM falls into oversold territory, or when the Zweig Breadth Thrust Indicator becomes oversold. The market has overshot these signals before, but most of the losses have been seen when these buy-cover signals have occurred. 

 

As for timing, successful ITBM sell signals typically have lasted 10-14 days until the buy-cover signal. This would put us right near the end of the tax-loss selling period just before Christmas and just in time for the Santa Claus rally (via Mark Hulbert). 
The several-day period beginning after Christmas does exhibit abnormal strength. According to the Stock Traders Almanac, this genuine Santa Claus rally period lasts from the first trading session after Christmas and continues through the second trading session of the New Year. The Dow over this period has risen in 77% of the years since the index was created in 1896, and produced an average gain of 1.5%. Across all other periods of equal length over the last 126 years, the Dow has risen 56% of the time and produced an average gain of just 0.2%. These differences are statistically significant.
In the meantime, investors will have to look forward to the CPI report next Tuesday, followed by the FOMC decision Wednesday, which will be sources of volatility.

 

My inner investor remains roughly neutrally positioned at the asset allocations specified by investment policy. My inner trader remains short. He is enjoying the latest round of market weakness but keeping an eye out for the exit.

 

 

Disclosure: Long SPXU

 

Second time lucky, or Fooled me once?

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.
 

 

Here we go again

Here we go again. A previous “can’t miss” breadth thrust indicator of a new bull market just flashed a buy signal. The percentage of S&P 500 above their 50 dma rose from below 5%, which is an oversold extreme, to over 90%, an overbought extreme. Such a breadth had been a buy signal with a 100% success rate until this year. This indicator flashed a buy signal in August, which failed badly and it recycled back to below 5%.

 

 

Is this latest buy signal a case of second-time lucky, or fooled me once, shame on you, fooled me twice, shame on me?

 

 

The bull case

The equity bull case rests strictly on historical studies of price momentum. While there are many variations of the bullish resolutions of breadth thrusts and price momentum, I offer the following examples.

 

Ryan Detrick pointed out that the S&P 500 just put in two back-to-back gains of 5% or more. These examples of strong price momentum have tended to resolve bullishly.

 

 

Steve Deppe observed that the S&P 500 ended November with a monthly close with a trailing 2-month return of 10% or more and negative trailing 6-month returns. Such instances of strong momentum after a bear trend have also tended to be bullish.

 

 

Jonathan Harrier published a historical study that defended the bullish conclusion of the breadth thrust signal based on the percentage of S&P 500 stocks above their 50 dma. All were higher six and 12 months later.

 

 

The devil is in the details. When the first buy signal from the breadth thrust signal appeared in August, I pointed out that while the technical and price momentum outlook was positive, the macro outlook was negative. Moreover, the Zweig Breadth Thrust, which was the rare granddaddy of breadth thrust signals, only flashed six buy signals in the out-of-sample period since Marty Zweig published his book in 1986. While the S&P 500 was higher 12 months later in all cases, the market sputtered immediately after the buy signal in two instances during periods when the Fed was raising rates.

 

 

The lesson here is that while technical analysis does add value, top-down macro analysis also matters. In the current case of the breadth thrust buy signal, what would the investor be discounting if he were to buy the market?

 

 

What are the bulls discounting?

One positive macro development is a softening of inflation indicators. However, analysis from Goldman Sachs found that an inflation peak is only equity bullish if it’s not followed by a recession. If you’re bullish, you’re betting on a soft landing.

 

 

New Deal democrat, who maintains a modeling discipline of keeping coincident, short leading, and long leading indicators, has some bad news. Starting with his analysis of ISM data:
Going back almost 75 years, the new orders index has always fallen below 50 within 6 months before a recession. Recessions have typically started once the overall index falls below 50, and usually below 48.

 

Which means that today’s report for November comes very close to meeting all of the above criteria. The overall index declined below 50 for the first time since May 2020, at 49.0. The new orders subindex declined -2 to 47.2, the 5th time in the past 6 months that it has been below 50, and only 0.1 above its September low of 47.1:

 

 

Even though the November Jobs Report was stronger than expected, his analysis of the high-frequency initial jobless claims data is coming close to a recession signal:
In the past, if the 4 week average is more than 5% higher YoY for any significant period of time, and less reliably, if the slightly lagging continuing claims are higher YoY, a recession is almost always close at hand:

 

The first marker could be met by January 1. The second marker could be met by February.

 

 

From a global perspective, the South Korean economy is a sensitive bellwether of global growth. South Korea’s October industrial production fell -3.5%, which was the biggest decline since April 2020. In addition, the SCMP reported that:
  • Shipments to China have fallen for six consecutive months, but November’s decline was the sharpest since mid-2009
  • South Korean shipments worldwide fell by 14% to US$51.91 billion last month compared to November 2021

 

 

 

What did Powell say?

The market adopted a risk-on tone after Fed Chair Jerome Powell’s speech at Brookings Institution last week (also see video of the speech and Q&A). Market participants appeared to have focused on Powell’s confirmation that the Fed will temper its December rate hike to 50 basis points and he did not want to overtighten. 

 

There were several points that the bulls may have missed. First, Powell revealed that the natural rate of unemployment, or Non-Accelerating Inflation Rate of Unemployment (NAIRU), has risen strongly since the pandemic, and the labor force participation rate (LFPR) has not fully recovered. The weakness in LFPR was mainly attributable to early retirement as older workers left the workforce and to a lesser extent a slower growth in the working population, and lower rates of immigration. Powell observed that older workers have not retired and they are unlikely to return. 

 

This sets up a jobs market dynamic of a higher NAIRU and a persistent tighter labor market. While the Fed may be correct to slow the pace of its rate hikes, it will be more difficult to cut interest rates if NAIRU is still elevated and the job market stays tight. The market is expecting a Fed Funds plateau to begin in early 2023 and next summer or fall. An elevated NARIU makes that scenario less likely.

 

 

In the Q&A discussion about the r*, or the natural rate of interest, Powell revealed that the Fed is monitoring how the market responds to monetary policy to measure whether how the tightness of monetary policy. He also stated in his speech that “ongoing rate increases will be appropriate in order to attain a policy stance that is sufficiently restrictive to move inflation down to 2 percent over time”. 

 

The Chicago Fed National Conditions Index has been easing and financial conditions eased further in the aftermath of Powell’s speech. Did the Fed Chair overdo the dovish tilt? Did he inadvertently ease financial conditions with his speech? (Asking for a friend).

 

 

In summary, Fed policy in 2023 can be summarized as raise and hold. In the current circumstances, the odds of rate cuts later in the year are relatively low, which is contrary to market expectations.

 

 

 

The bear case

Notwithstanding the macro case to be cautious on stocks, here are the technical and sentiment bear cases. Insider activity has seen a recent surge of selling.

 

 

Jay Kaeppel at SentimenTrader found that similar past episodes have been short-term bearish but longer-term bullish for stock prices.

 

 

Don’t forget that the Fed’s quantitative tightening program is still operating in the background. Liquidity conditions are starting to roll over, and they have been strongly correlated to the S&P 500.

 

 

The S&P 500 is testing key resistance levels, as defined by its 200 dma and falling trend line, while it is overbought on the percentage of stocks above their 20 dma. The market has been behaving in an unusual way. It failed to rally significantly on Thursday after the tame PCE report and it rallied to nearly even after the stronger than expected Jobs Report on Friday. Do you feel lucky?

 

 

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

 

 

Disclosure: Long SPXU

 

How the World Cup almost unraveled China

Posted by Cam Hui -
The Chinese authorities were stuck between a rock and a hard place. On one hand, COVID caseloads were skyrocketing; on the other hand, after two years of a series of on-again-off-again of lockdowns, it was unsurprising that Chinese citizens, many of them young, got a case of cabin fever and protested the government’s COVID policies in a series of nationwide demonstrations. A podcast from the Economist argued that the combination of strict lockdowns and ubiquitous government monitoring led to widespread dissatisfaction.

 

Two incidents were believed to be the final straws that were the catalysts for the unrest. The first was an apartment fire in the city of Urumqi in western Xinjiang, where 10 people died, in which fire exits were locked because of COVID restrictions that trapped occupants inside, and COVID barriers prevented firefighters from reaching the building. In addition, broadcasts of the World Cup showed numerous unmasked spectators in the stands, which ran counter to the government’s narrative that China was controlling the pandemic much better than the West.
 

 

Protests are relatively common in China, but it’s rare to see them erupt spontaneously and in different cities. While the authorities appear to have the protests under control, it could be argued that broadcasts of the World Cup were a spark that almost unraveled China.

 

 

The evolution of China’s COVID policies

About a year ago, a patient in Wuhan was diagnosed with an affliction known as a novel coronavirus. The outbreak spread and medical staff and researchers didn’t really know how to react. There was no known cure. The only treatment at the time was isolation and, if necessary, intubation. The fatality rates were horrendous. As the pandemic spread out of China, the West was overwhelmed. Who could forget the devastation in northern Italy, which was the richest and most industrialized part of the country, and when it first cases landed in America in Washington State? China reacted by putting the entire country into quarantine and voluntarily shutting down its economy. The measures worked, and they allowed China to return to some semblance of normality.
 

Fast forward to 2022, vaccines are widely available and served to control the effects of the pandemic. However, Chinese vaccines are less effective than the mRNA vaccines in the West and vaccination rates are low among the vulnerable elderly. The authorities reacted with the same-old draconian tactic of lockdown and quarantine to control the pandemic. Despite these steps, caseloads are skyrocketing.

 

As a consequence of the lockdowns and restrictions, dissatisfaction bubbled up and protests appeared. While protests are not unusual in China, the grievances were usually localized, such as peasants objecting to having their land taken away by corrupt officials or protests over environmental issues. These protests are unusual inasmuch as they are nationwide and in objection to a specific Xi Jinping policy initiative. At the extreme, the dissent became overtly political and some even called for Xi Jinping to step down or for the CCP to cede power. 

 

 

The economic fallout

Moreover, the economic effects are worsening. China’s PMI came in below expectations and in contraction territory. 

 

 

Lockdowns are intensifying and they cover nearly 60% of GDP.

 

 

Bloomberg reported that the virus is rapidly spreading and affecting production, with over half of firms reporting a case among their employees this month.
About 53% of companies surveyed by China Beige Book said they’d had a case in their workforce this month. That was more than double the 24% who reported a case in October and the highest level in data back through January last year, according to the report. 
It is no surprise that household confidence skidded badly.

 

 

The low level of household confidence has exposed the fault lines in the all-important real estate market and cratered the finances of the over-leveraged property development companies.

 

 

 

The policy response

In response to the protests, which are reportedly ongoing, the authorities have opted for a three-pronged approach.
  • Adopt a more conciliatory tone;
  • Reinforced the police presence on the streets; and
  • Use the State’s ubiquitous monitoring apparatus to discourage individual dissidents.
Jiang Jiang, a reporter at China’s official media Xinhua, recently recounted an official article, “‘People first’ is not ‘Covid control first'”. While the title sounds conciliatory, it explains the dilemmas that the authorities face in addressing the protesters’ grievances.

 

 

Here are some key excerpts. The initial tone is conciliatory.

Epidemic prevention and control is to prevent the virus, not to prevent people; there is no such thing as “epidemic prevention first” but “people first”. No matter what kind of prevention and control measures are taken, they should be aimed at returning society to normal ASAP and getting life back on track as soon as possible. All options are “bridges” and “boats” to this goal, not simply to restrict people, regardless of the cost of blind brute force. 

But later the account addressed the issue of the unmasked spectators at the World Cup and outlined the tradeoffs.
During this period, the World Cup in Qatar is in full swing. The crowd in audience didn’t wear masks, look at the scene of the revelry, everything seems to be no different from before the epidemic. Some people ask: “Many countries in the world now have everything as usual.
Up to now, there are 636 million new confirmed cases and over 6.6 million cumulative deaths worldwide, with 230,000 new confirmed cases and 428 deaths in a recent day. Among them, Japan, which has 126 million people, sees 98,000 new confirmed cases per day; South Korea has a population of more than 50 million people. It sees 47,000 new confirmed cases per day.
Simply put, China doesn’t have the medical capacity to open up 
Regarding medical resources, this year China has 6.7 medical beds per 1,000 population, compared with 12.65 in South Korea, 12.63 in Japan and 7.82 in Germany in 2020. In 2020, China has 4.5 ICU beds per 100,000 people, Germany 28.2, the U.S. 21.6, France 16.4 and Japan 13.8, a global average of 10. Earlier this year, covid critically ill patients occupied 32.7% of the total ICU capacity in the U.S., and about 7 ICU beds per 100,000 people were crowded by covid critically ill patients, the number of which has exceeded the total number of ICU beds per 100,000 people in China. As of the end of 2021, China’s population aged 60 & above reached 267 million, & the population of children exceeded 250 million, so the size of “the elderly and the children” group is huge.
Opening up would be a medical disaster for China.
According to the latest data from Singapore, the mortality rate of infection among the elderly aged 60-69, 70-79 and 80 years old and above with vaccine protection is 0.014%, 0.064% and 0.54% respectively; the mortality rate of infection among the elderly in the three age groups without vaccine protection is 0.19%, 0.29% and 2.5% respectively. And the three age groups of elderly people who have not completed vaccination in China are about 22.64 million, 16.16 million and 14 million respectively.If we completely lift all the restrictions now, according to the estimated mortality rate of infection in Singapore, the number of deaths in our country will reach about 600,000 for the elderly over 60 years old only.
In support of the 600,000 fatality projection, a separate analysis from The Economist concluded that a disorderly reopening could lead to 680,000 deaths.

The Economist has modelled the likely progress of China’s current outbreak. If it is allowed to proceed unchecked, even assuming all patients who need intensive care receive it (which they would not), some 680,000 people are likely to die.

Jiang Jiang concluded with some comments of his own [emphasis added]:
The piece focused on the expression of empathy with the public under epidemic prevention & control (which might explain why it enjoys some popularity now), explained the logic behind the current “Dynamic Zero-Covid” policy and listed many wrong actions of the local governments in implementing the policy. No signal can be seen from the article that China will change the overall policy soon, though the article mentioned the “iteration” and “optimization” of the policies. To me, it is a message to the public that the central government is aware of the various problems including “some interest groups 利益群体” behind the epidemic (though it was published by a local account), but it is not realistic to change the policy entirely now due to the reasons I highlighted in the last thread/
Despite the conciliatory tone from the authorities, no full de facto opening up is in the cards in China this winter. However, there may be some localized semi-loosening. Local authorities are allowing positive cases and close contacts to quarantine at home under certain conditions. As well, China is expected to reduce the frequency of mass testing and regular PCR tests, But any full exit from China’s zero-COVID policies will be a long process and dependent on how it manages increases in case counts, which are skyrocketing right now.

 

 

Investment implications

How should investors think about the current protests in China? How risk appetite reacts to events such as the unrest in China depends on how they are perceived. Will it be viewed as political instability, financial or economic instability, or will be shrugged off as business as usual? While history doesn’t repeat itself but rhymes, here are some historical templates to consider. 

 

The widespread nature of the unrest is reminiscent of the Tiananmen Crisis of 1989, though the level of dissent does not appear to be as deep as it was then. Chinese markets were highly immature at that time, and even Deng Xiaopeng’s Southern Tour, in which he pivoted to a more capitalistic friendly policy, would not occur until three years later in 1992. One of Xi Jinping’s first policy speeches as a new leader 10 years ago was about how the Soviet Union betrayed a fatal weakness in dealing with perestroika in the 1985-91 era. The current protests are a direct challenge to Xi and cannot be allowed to succeed. If other methods fail, watch for harsh means of repression. However, I believe a Tiananmen-style crackdown is unlikely. The more recent Hong Kong protests, which were far more serious and conducted without much censorship, were slowly smoldered by the authorities. Today, China’s surveillance state and its use of technology have become far more developed.

 

In 1989, Hong Kong’s Hang Seng Index, which was the best proxy for China, skidded -27.0% in the two months ending in June and recovered strongly for the rest of the year. By contrast, other major market indices hardly reacted at all to the political turmoil in China. In the spirit of the adage “buy to the sound of cannons, sell to the sound of trumpets”, 1989 was an illustration that political instability fears are generally good buying opportunities.

 

 

By contrast, an example of the financial and political instability scenario can be seen during the COVID Crash of 2020. The COVID-19 pandemic spread unchecked around the world. Had it not for the quick response of global fiscal and monetary authorities, the global economy could have collapsed into another Great Depression. Global equities were far more correlated than they were in 1989.

 

 

The combination of the Chinese authorities’ more conciliatory tone and harsh police measures may have served to keep a lid on the dissent. The markets took a risk-on tone in the hopes of the relaxation of zero-COVID measures, which may be fleeting. MSCI China has staged an upside relative breakout from a falling trend line, and so have a number of stock markets of China’s key Asian trading partners. From a technical perspective, China and China-sensitive markets may need some time to trade sideways and consolidate their relative gains. 

 

 

Investors are faced with the dilemma of missing out on the end of the zero-COVID bandwagon FOMO rally, while managing the reality that zero-COVID will not end immediately, nor are there any signs of a recovery in the Chinese economy. As well, they should be prepared for more near-term volatility, but keep in mind the outcomes from the 1989 and 2020 tail-risk scenarios.

 

“50 bps in December”, or “Stay the course until the job is done”

Posted by Cam Hui -

Mid-week market update: In the long awaited Powell speech, the Fed Chair signaled, “It makes sense to moderate the pace of our rate increases…[and] the time for moderating the pace of rate increases may come as soon as the December meeting”. The market reacted with a risk-on tone and began to discount a series of rate cuts in Q3 2023.
 

 

Every Fed speaker this week has said that the Fed isn’t going to cut rates. Powell concluded his speech with:

 

It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.
The change from 75 bps to 50 bps has long been anticipated. Is the risk-on reaction appropriate in this instance? Should investors buy “the 50 bps in December”, or sell the “stay the course until the job is done” nattative?

 

 

Analyzing Powell’s speech

Powell covered the topics of inflation and the labor market. On inflation, he found the October inflation data to be encouraging, but “it will take substantially more evidence to give comfort that inflation is actually declining. By any standard, inflation remains much too high.” Powell observed that goods inflation is falling. The housing services component is accelerating, though he acknowledged that it is a lagging indicator. Core services less housing has been flat, which is a function of the labor market.

 

 

However, the labor market is still too tight, and “a significant and persistent labor supply shortfall opened up during the pandemic—a shortfall that appears unlikely to fully close anytime soon”. He added, “A moderation of labor demand growth will be required to restore balance to the labor market.”

 

Wage growth has also begun to decline, “but the declines are very modest so far relative to earlier increases and still leave wage growth well above levels consistent with 2 percent inflation over time. To be clear, strong wage growth is a good thing. But for wage growth to be sustainable, it needs to be consistent with 2 percent inflation.”

 

 

While he confirmed market expectations that the Fed will raise rates by 50 bps at the December meeting, he cautioned that “Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.”

 

In other words, don’t expect rate cuts anytime soon. In fact, there was no discussion of easing in his speech.

 

 

Other warnings

There are other warning signs. In addition to Powell’s speech, Vice Chair Lael Brainard made a speech to the BIS that highlighted the risk central bankers could face more inflationary volatility from climate change, demographics, and deglobalization.
In addition, to the extent that the lower elasticity of supply we have seen recently could become more common due to challenges such as demographics, deglobalization, and climate change, it could herald a shift to an environment characterized by more volatile inflation compared with the preceding few decades.
While bond market based measures of inflation expectations have been relatively stable, other metrics present a more disturbing picture.

 

 

The Central Bank Research Association is maintaining an experimental inflation expectations indicator, or indirect consumer expectations (ICIE), based on research from the Cleveland Fed.
Surveys often measure consumers’ inflation expectations by asking directly about prices in general or overall inflation, concepts that may not be well-defined for some individuals. In this Commentary, we propose a new, indirect way of measuring consumer inflation expectations: Given consumers’ expectations about developments in prices of goods and services during the next 12 months, we ask them how their incomes would have to change to make them equally well-off relative to their current situation such that they could buy the same amount of goods and services as they can today.
The good news is ICIE is in retreat. The bad news is the absolute reading of 7.56% is very high compared to conventional surveys.

 

 

In conclusion, the knee-jerk risk-on reaction of the market to the Powell speech seems unwarranted. The Fed will stay the course until the job is done.

 

 

Market technicals

From a technical perspective, the S&P 500 is testing key resistance at the 200 dma and the descending trend line while the NYSE McClellan Oscillator flashes a series of negative divergences.

 

 

As well, equity risk appetite indicators peaked in mid-November. Equally disturbing is the violation of relative support by the highly speculative ARK Investment ETF.

 

 

Despite the recent show of market strength, defensive sectors are all in relative uptrends.

 

 

I am inclined to stay cautious. My inner trader is holding to his short position and he has a stop placed just above the descending trend line. 

 

 

Disclosure: Long SPXU

 

Waiting for clarity from the Nov 30 Powell speech

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.
 

 

Marginally more dovish

Fed policy is still moving markets. The release of the November FOMC minutes confirmed what Fed officials had been telegraphing in the past few weeks, namely that “a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate”. However, “the target range for the federal funds rate…had become more important …than the pace of further increases in the target range”. Fed Funds expectations turned marginally more dovish in the wake of the release and the S&P 500 rallied. 

 

 

Despite the market’s excitement about the slowing in the pace of rate hikes, Fed Chair Powell sounded a more hawkish tone and said during the November FOMC press conference that he’s “never thought of [a series of milder inflation readings] as the appropriate test for slowing the pace of increases or for identifying the appropriately restrictive level”. Fed Chair Jerome Powell is scheduled to speak at the Brookings Institution on November 30 on the economy and labor markets, just two days before the  start of the blackout window for Fed speeches ahead of the December FOMC meeting. That speech is likely to set the tone for the markets for the coming weeks.

 

 

Why QT and liquidity matters

As well, investors may have forgotten about the FOMC’s decision to “continue the process of reducing the Federal Reserve’s securities holdings, as described in the Plans for Reducing the Size of the Federal Reserve’s Balance Sheet that the Committee issued in May”, otherwise known as quantitative tightening (QT). While correlation isn’t causation, the size of the Fed’s balance sheet has closely tracked the S&P 500 in the post-COVID Crash era. That’s because liquidity matters to stock prices.

 

 

Despite the ongoing quantitative tightening program that’s reduced the size of the Fed’s balance sheet, liquidity conditions have improved because of changes in reverse repos and rundowns in the Treasury General Account. Liquidity conditions are highly correlated to the S&P 500, but the conditions that boosted liquidity should be temporary.

 

 

Indeed, Cross Border Capital has argued that the Fed liquidity is exhibiting a staircase pattern, and it’s correlated to the S&P 500. 

 

 

Analysis from Pictet Asset Management shows that the S&P 500 is trading at a premium to liquidity-implied fair value.

 

 

Moreover, non-US M2 growth has been plunging precipitously, which creates headwinds for equity prices..

 

 

A recent OECD simulation found that when all countries hike rates in concert, the impact on inflation is less while the negative effect on inflation is higher. These factors may act to keep the Fed more hawkish than what the market expects.

 

 

 

Waiting for Powell

That’s why Powell’s upcoming speech could set the tone for asset prices. Fed policy has affected Treasury yields and the USD, and the S&P 500 has been inversely correlated to the USD for all of 2022. 

 

 

You can tell a lot about the psychology of a market by seeing how it reacts to news. The S&P 500 rose only 0.6% after the release of the FOMC minutes. The index is nearing two key resistance levels, its 200 dma at about 4060, and its falling trend line at about 4080-4100 while exhibiting overbought conditions, as measured by the VIX Index recently breached its lower Bollinger Band and the percentage of S&P 500 stocks above their 50 dma is within a hair of 90%. As well, the NYSE McClellan Oscillator (NYMO) flashes negative divergence through a series of lower highs and lower lows. I interpret these conditions as the market advance is poised to stall.

 

 

While there is undoubtedly a dovish contingent within the FOMC, the message from recent Fed speakers has emphasized the risk of under-tightening and allow inflation to get out of control. Powell has sounded a more hawkish tone than other members in the past. his speech sets up a potential pivotal turn for risk appetite into the end of 2022.

 

The subject of Powell’s speech is the economy and labor markets. I expect that he will reiterate his determination to maintain a tight monetary policy until there is “clear and convincing evidence” that inflation is falling. As well, he will also focus on the labor market, which is still tight, and probably cite low unemployment and strong wage growth as hurdles for pausing interest rate increases. As a reminder, the Chicago Fed National Financial Index is slightly lower, or looser, than the readings at the time of Powell’s Jackson Hole speech that cratered the S&P 500 -3.4% in one day. 

 

 

In addition to the Powell speech, which is on Wednesday at 1:30 pm ET, the market will see a number of key inflation and labor market data points that could be sources of volatility, namely the PCE report and JOLTS report on Wednesday and the Non-Farm Payroll report Friday.

 

 

Disclosure: Long SPXU

 

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.