Back to a focus on technicals

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

 

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

 

 

How much does bad breadth matter?

 

 

The bull case

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

 

 

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

 

 

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

 

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

 

3x + y = 16
x – y = 0

 

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

 

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

 

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

 

 

 

The bear case

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

 

 

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

 

 

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

 

 

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

 

 

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

 

Ignore the noise and focus on the main event

Posted by Cam Hui -

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

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

 

 

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

 

 

How short is the market?

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

European bull of 2023 = FANG bull of 2008?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

 

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

 

 

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

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

Subscribers can access the latest signal in real time here.

 

 

Dissecting the sources of European strength

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

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

 

 

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

 

Emerging leadership

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

 

 

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

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

 

 

LVMH has a similar technical pattern.

 

 

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

 

Special cases to watch

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

 

 

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

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

 

 

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

 

 

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

 

How the G7 meeting exposes the risks for 2024

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

 

 

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

 

 

 

 

The G7 summit agenda

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

 

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

 

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

 

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

 

From Trade War to Cold War 2.0?

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

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

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

 

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

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

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

 

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

 

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

 

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

 

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

 

In other words, stagflation.
 

 

Investment implications

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

 

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

 

 

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

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

 

 

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

 

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

 

Being bearish is too obvious

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

 

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

 

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

 

 

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

 

 

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

 

 

 

What’s the pain trade?

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

 

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

 

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

 

 

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

 

 

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

 

 

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

 

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

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

 

 

Disclosure: Long SPXL

 

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

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

 

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

 

 

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

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

Subscribers can access the latest signal in real time here.

 

 

A tight trading range

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

 

 

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

 

Reasons to be bullish

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

 

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

 

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

 

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

 

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

 

 

The debt ceiling game of chicken

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

 

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

 

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

 

 

Unspeakable default?

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

 

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

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

Wang explained:

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

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

 

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

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

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

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

 

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

 

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

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

 

 

 

Debt ceiling aftermath

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

 

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

 

 

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

 

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

 

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

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

 

 

Disclosure: Long SPXL

 

A pause isn’t a pivot

Posted by Cam Hui -

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

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

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

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

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

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

 

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

 

How hawkish is the Fed?

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

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

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

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

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

 

 

Did the Fed break something?

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

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

 

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

 

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

 

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

 

 

Scenes from small business America

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

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

 

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

 

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

 

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

 

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

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

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

 

Still stuck in a trading range

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

 

 

 

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

 

 

Bull case

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

 

 

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

 

 

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

 

 

Bear case

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

 

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

 

 

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

 

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

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

 

 

Disclosure: Long SPXL

 

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

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

 

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

 

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

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

Subscribers can access the latest signal in real time here.

 

 

Sell in May?

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

 

 

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

 

 

The big picture

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

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

 


 

 

 

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

 

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

 

 

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

 

 

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

 

 

 

Narrow leadership

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

 

 

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

 

 

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

 

The week ahead

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

 

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

 

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

 

 

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

 

 

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

 

 

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

 

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

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

 

 

Disclosure: Long SPXL

 

How to spot the stock market bottom

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

 

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

 

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

 

 

 

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

 

PMI signals

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

 

 

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

 

 

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

 

 

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

 

 

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

 

Labor market signals

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

 

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

 

 

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

 

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

 

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

 

 

 

 

Insider signals

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

 

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

 

 

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

 

 

 

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

 

 

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

 

 

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

It’ll feel like a tightening every meeting

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

 

 

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

 

 

Why the Fed will or won’t pivot

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

 

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

     

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

     

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

     

     

    Banking crisis not over

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

     

     

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

     

     

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

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

     

     

    Disclosure: Long SPXU

     

    My case for a correction

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

     

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

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

    Subscribers can access the latest signal in real time here.

     

     

    A possible stall

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

     

     

    Here are the bull and bear cases.
     

     

    The bear case

    The bear case is the easier one to make.

     

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

     

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

     

     

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

     

     

     

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

     

     

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

     

     

     

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

     

     

     

     

    The bull case

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

     

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

     

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

     

     

     

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

     

     

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

     

     

    The debt ceiling wild card

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

     

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

     

     

     

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

     

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

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

     

    The usual disclaimers apply to my trading positions.

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

     

     

    Disclosure: Long SPXU

     

    The final Fed rate hike?

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

     

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

     

     

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

     

    Due for a pause

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

     

     

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

     

     

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

     

     

     

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

     

     

     

     

    What happens next?

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

     

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

     

     

     

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

     

     

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

     

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

     

     

     

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

     

     

     

     

    The silver lining

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

     

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

     

     

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

     

     

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

     

     

    Market correction signals

    Posted by Cam Hui -

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

    To access this post, you must purchase Monthly subscription.

    Making sense of the Mona Lisa market

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

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

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

    Subscribers can access the latest signal in real time here.

     

     

    The Mona Lisa market

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

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

     

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

     

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

     

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

     

     

     

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

     

    Credit crunch ahead

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

     

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

     

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

     

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

     

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

     

     

    Tightening credit is how recessions start.

     

     

    The challenges of earning season

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

     

     

     

    The debt ceiling and De-Dollarization

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

     

     

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

     

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

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

     

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

     

     

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

     

     

     

    A liquidity retreat

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

     

     

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

     

     

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

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

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

     

    Why I’m not overly bullish or bearish

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

     

     

     

    The Bear Case

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

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

     


     

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

     

     

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

     

     

     

    Possible Sentiment Support

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

     

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

     

     

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

     

     

     

    Sentiment Doubts

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

     

     

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

     

     

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

     

     

     

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

     

     

     

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

     

     

    Historical Templates to Consider

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

     

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

     

     

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

     

     

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

     

     

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

     

     

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

     

    Word of warning for equity bulls

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

     

     

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

     

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

     

     

     


     

    Negative divergences

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

     

     

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

     

     

    So are credit market risk appetite indicators.

     

     


     

    The debt ceiling landmine

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

     

     

     

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

     

     

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

     

     


     

    Don’t expect a crash

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

     

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

     

     

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

     

    The market leaders hiding in plain sight

    Posted by Cam Hui -

    Preface: Explaining our market timing models 

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

     

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

     

     

     

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

     

     

     

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

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

    Subscribers can access the latest signal in real time here.

     

     

    A mystery chart

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

     

     

     

    Can you guess what they are?
     

     

    Faltering U.S. leadership

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

     

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

     

     

    Hello Europe!

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

     

     

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

     

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

     

     

    Avoid.
     

     

    Unexciting Asia

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

     

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

     

     

    The week ahead

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

     

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

     

     

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

     

     

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

     

     

     

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

     

    How to position for the coming growth slowdown

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

     

     

     

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

     

     

    Signs of a U.S. Slowdown

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

     

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

     

     

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

     

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

     

     

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

     

     

    Moreover, hiring plans are softening. 

     

     

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

     

    <

     

    …and a depressed level of positive guidance.

     

     

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

     

    Real-time Market Warnings

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

     

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

     

     

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

     

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

     

     

     

     

    Investment Implications

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

     

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

     

     

     

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

     

     

     

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

     

    Does inflation matter to stocks anymore?

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

     

     

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

     

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

     

     

    Does inflation matter to stocks anymore?

     

     

    Differing technical patterns

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

     

     

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

     

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

     

     

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

     

     

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