How I learned to stop worrying and love the bond market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.
 

 

An inverted yield curve

James Carville, who was Bill Clinton’s political strategist, famously said, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

 

If the bond market were to intimidate everybody, what’s it saying? The accompanying chart shows the spread between the 2-year and 10-year Treasury yield, which is currently inverted. If history is any guide, inverted yield curves are bad news for stock prices.

 

 

Some analysts have quibbled with the use of the 2s10s yield curve as a recession forecaster. The spread between the 10-year and 3-month T-Bill has been a more accurate gauge. Market expectations call for a 75 bps rate hike at the September FOMC meeting, which will either invert the 3m10y curve or close to it. 

 

I conducted a study of sensitivity analysis of asset class returns. I first compiled monthly asset prices in USD and calculated the returns based on whether the yield curve was steepening, flattening or inverting, or neutral. The steepening or inverting categorizations were based on whether movements in the yield curve were one standard deviation above or below the monthly average for the period. Asset returns were then placed into three buckets, steepening, neutral, or inverting. The results shown in the table are the annualized median returns of the asset classes, which are in USD with the exception of fixed income assets, which are expressed in changes in yields and in local currency.

 

The results of the study are clear. Inverting yield curves, which is the current regime, is challenging for equities across all geographies and for commodities. Equities and commodities perform best when the yield curve is steepening. By contrast, bond yields tend to fall (and prices rise) when the yield curve is inverting but face headwinds when the yield curve steepens.

 

 

 

A fear of higher rates

The current environment argues for an overweight position in bonds, but the market isn’t behaving as expected. Yields are rising because the market is afraid of the Fed’s hawkishness.

 

Signs are emerging of a global slowdown. The cyclically sensitive copper/gold ratio is pointing to a weakening economy. Historically, the copper/gold ratio has been highly correlated to the 10-year Treasury yield, but a divergence is appearing between the two.

 

 

Similarly, a gap is appearing between the 10-year Treasury yield and oil prices. I interpret these conditions as the market being more afraid of what the Fed might do to interest rates than being afraid of recession, which normally depresses bond yields.

 

 

Indeed, commodity prices are under pressure, which is a sign of global economic weakness. Energy prices have held up better because of supply shortages caused by the Russo-Ukraine war.

 

 

 

Bond bullish

All of these factors argue for a bullish outlook for bond prices, especially when hedge fund sentiment on bonds is extremely bearish.

 

 

Historically, a falling copper/gold and the more broadly diversified base metals/gold ratios has historically been bearish for equity risk appetite.

 

 

However, equity investors can find some outperformance in high-quality long-duration stocks such as NASDAQ 100 large-cap growth names.

 

 

 

Key risks

There are two key risks to the bond bull scenario. The first is a more hawkish than expected Fed. A paper presented at the Brookings Papers on Economic Activity argues that the Fed will push unemployment significantly higher in order to hit its 2% inflation target. 
According to the paper, whether the Fed can achieve its objectives depends on whether it is possible to slow demand in such a way that vacancies decrease but unemployment doesn’t rise (returning the V/U ratio to its pre-pandemic norm) and on whether consumers and businesses start to expect that high inflation will continue for the longer term, and thus plan for it. Under optimistic assumptions for both the V/U ratio and long-term inflation expectations (and assuming the Fed’s 4.1 percent unemployment projection proves correct), the paper projects the Fed will bring core inflation down close to its target by the end of 2024. However, under the most pessimistic assumptions for both the V/U ratio and inflation expectations, core inflation rises to about 8.8 percent if unemployment moves up only to 4.1 percent.

 

 

A soft landing is possible but highly unlikely. The Fed will have to be more aggressive and tighten policy. While this will eventually be bond price bullish, in the short run it will raise interest rate expectations, which is bond market bearish.

 

Keep an eye on the August CPI report, which is due Tuesday. Consensus expectations call for a monthly increase of -0.1% in headline CPI and a 0.4% increase in core CPI, which are tamer than the Cleveland Fed’s inflation nowcast.

 

 

Fed Governor Christopher Waller gave a speech Friday just before the FOMC blackout window affirming the Fed’s commitment to stay the course in its inflation fight because the “consequences of being fooled by a temporary softening in inflation could be even greater now”. Translation: Expect high rates for longer.

To sum up, while I welcome promising news about inflation, I don’t yet see convincing evidence that it is moving meaningfully and persistently down along a trajectory to reach our 2 percent target. I keep in mind that a year ago we saw similarly promising evidence of inflation moderating for several months before it jumped up to a high and then very high level. Those earlier inflation readings probably delayed our pivot to tightening monetary policy by a few months. The consequences of being fooled by a temporary softening in inflation could be even greater now if another misjudgment damages the Fed’s credibility. So, until I see a meaningful and persistent moderation of the rise in core prices, I will support taking significant further steps to tighten monetary policy.

The other risk is a sudden policy pivot in response to crisis conditions, which changes the narrative from recessionary conditions to renewed growth, and would see the yield curve steepen, bond yields rise, and cyclical stocks outperform. The risk of such a scenario may already be underway in Europe  (see Assessing “Big Short” Michael Burry’s crash warning).

 

 

S&P 500 stall ahead?

As for the stock market, I have suggested in the past week that equities were due for a relief rally and it appeared more or less on schedule (see Saved by Fibonacci). However, the rally may be about to stall after the S&P 500 regained its 50 dma on Friday. The VIX Index has recycled from above its upper Bollinger Band to its 20 dma. The market advance has stalled in 8 out of 9 cases in the past year when this happened (pink=stall, grey=rally). If the bulls were to decisively take control of the tape, the index needs to breach the next major resistance level at the falling trend line, which also happens to coincide with the 200 dma at about 4275.

 

 

The NYSE McClellan Oscillator (NYMO) has recovered from below -1000 to almost the neutral level. While the market can rise further, any bullish trading edge from the oversold signal is past. I pointed out last week that there were 9 instances in the past 10 years when NYMO has recovered from a -1000 reading. The market went on to weaken in 8 out of the 9 cases (see How to trade the failed breadth thrust).

 

 

The relative performance of defensive sectors appear constructive. If the bottom four charts were stocks, a case could be made for buying their dips.

 

 

In the short run, breadth indicators are at an overbought extreme, which indicates the market is due for a pause and pullback.

 

 

Even though the market is tactically poised for some weakness, I am reluctant to short into strength as the 14-day RSI of the S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) is turning up and it wouldn’t take too much further strength for this model to flash a buy signal. As the ITBM has been an extremely reliable trading model, shorting just ahead of a possible buy signal is probably not a good idea. My inner trader is staying on the sidelines for now.

 

 

As well, SentimenTrader shared his surprise at the capitalization weighted outsized institutional put/call ratio, indicating excessive institutional bearishness. At a minimum, such bearishness would put a floor on stock prices should they weaken.

 

 

In conclusion, cross-asset signals from the commodity market indicate that bond prices are poised to rise, which should provide a tailwind for large-cap NASDAQ stocks. The key risks are continued market fears of rising rates from hawkish Fed rhetoric, and a possible sudden policy reversal in response to crisis conditions, which changes the narrative from recessionary conditions to renewed growth.

 

 

Disclosure: Long ZROZ

 

Assessing “Big Short” Michael Burry’s crash warning

Posted by Cam Hui -

A number of readers asked me to comment on Michael Burry’s forecast of a crash, according to a report from Business Insider.

Doomsday is finally here, he hinted in a since-deleted tweet this week.

 

The fund manager of “The Big Short” fame shared a screenshot of a S&P 500 chart, showing the benchmark stock-market index has tumbled 18% from its December peak, despite several blistering rallies this year.

 

“And yet I keep getting asked ‘wen crash?'” he tweeted, poking fun at some of his followers’ poor spelling, and underlining his view that the market collapse is underway.

 

Burry suggested in May that the S&P 500 could drop as low as 1,900 points, or another 53%, over the next few years, based on how past crashes have played out. Moreover, he has dismissed the rebounds in stocks this year as bear-market rallies or “dead cat bounces” — temporary reprieves along the road to inevitable disaster.

 

 

The S&P 500 has a downside potential of 1900? How plausible is that scenario?

 

 

Conventional technical analysis

While technical analysts style themselves as contrarians, the analysis of Ari Wald more or less represents the mainstream view among chartists (as reported by J.C. Parets), In short, the stock market is undergoing a bottom process that should see higher prices by next year.
Looking at the last 21 bear cycles, 12 of them bottomed in a mid-term year, and six of those bottoms occurred between June and October: 1962, 1966, 1974, 1982, 1990, and 2002. We expect 2022 to be added to this list,

 

 

For a more nuanced perspective, Marketwatch reported that the equity outlook depends on whether the economy sinks into recession.
“Recession fears are the most likely trigger of a retest of the June lows,” said Ed Clissold, chief U.S. strategist at Ned Davis Research, in an Aug. 31 note. “From a seasonality perspective, a retest could come in the next several weeks.”

 

Whether any “retest” of the stock market’s lows is brief may depend on the ability of the U.S. to avoid a recession, according to Ned Davis.

 

“The average non-recession bear lasts about seven months and has declined 25% (-18% over the past half century), putting the January – June drop in line with the typical case,” Clissold wrote in the Ned Davis note. “Conversely, the average recession bear has lasted about a year (17 months over the past 50 years) and declined a mean of 35%.”
 

 

The S&P 500 fell -23.5% peak-to-trough in 2022, which is consistent with a non-recessionary bear market. However, if the US economy were to see a recession in 2023, which is likely, downside risk could be higher.

 

 

Valuation risk

From a fundamental perspective, the S&P 500 suffers from a lack of valuation support. The index is trading at a forward P/E ratio of 16.8, which is below its 5 and 10-year historical averages. However, the last time the 10-year Treasury yield was anywhere near current levels, the forward P/E fell below 14.

 

 

All else being equal, a forward P/E of 14 would translate into a downside S&P 500 target of 3320. The Transcript, which monitors earnings calls, recently highlighted a trend among bottom-up repors of weakness that points to earnings deterioration and EPS downgrades from Wall Street analysts.

Still, we’ve recently been noticing that there is a negative divergence between macroeconomic and microeconomic commentary. Many companies are seeing signs that could indicate that we are in the early stages of deceleration. These signs include bloated retail inventories, lower-income consumers trading down, falling used car prices, the pace of hiring slowing down, and weak consumer electronics sales, to name but a few.

Assuming that earnings estimates fall by -25% in a bad recession and applying a forward P/E of 14, the S&P 500 could fall to 2490. A level of 1900 on the S&P 500, based on Burry’s maximum downside risk, would mean a forward P/E of 8.0 to 10.7, which would be highly unlikely gifts from the market gods. 
 

While the fundamental forecasts of downside risk could see considerable downside risk to the S&P 500, I concluded from this analysis that Burry’s fo€1recast of doom is overblown.

 

 

So bad it’s good

There is a third way of threading the needle between the relatively sanguine outlook of technical analysts and the more bearish outlook of fundamental analysis.

 

Last week I suggested that a financial crisis could be the bulls’ best hope, it appears that we are on the verge of another Lehman moment, but in Europe. Eurozone banks are the counterparties to $1.5 trillion in margin calls and the Financial Times reported that European power producers face €1 trillion in margin calls. As an example, Credit Suisse credit default swaps are approaching levels last seen at the last Lehman Crisis. This could be nothing, but it’s difficult to tell what other banks are vulnerable to in their derivative exposure.

 

 

The energy shock is shutting down most of Europe’s businesses. In a joint letter, over 40 CEOs of European metal groups warn of an “existential threat” to the industry due to sky-high gas and electricity prices. The group warned that “50% of the EU’s aluminium and zinc capacity has already been forced offline due to the power crisis”.

 

As expected, the ECB raised rates by 0.75% last week and it’s tightening into a recession. Moreover, it has to manage the widening yield spread between German and Italian paper.

 

 

The IMF published a paper calling for deficit rules that force high-debt countries to balance their budgets within 3-5 years, along with a more integrated fiscal policy to guard against sudden economic shocks.

 

Here is the good news. The Russo-Ukraine war is turning against the Russians. According to the NY Times, the Russians are buying artillery shells and rockets from North Korea, which is a sign that Russian industrial production is breaking down because of sanctions. Moscow announced that it was fully cutting off Nord Stream 1 gas flow to the EU. The market responded with a brief price spike, followed by renewed losses after a peak in late August. 

 

 

If you had asked a European economist six months ago about their worst-case scenario, it would have a Russian gas embargo and recession. We are there. The Kiel Institute is forecasting German GDP growth at 1.4% for 2022, -0.7% for 2023, and 1.7% for 2024. Is this as bad as it gets? The best part is that the market has stopped responding to bad news. 

 

 

The Nord Stream 1 cut-off now looks more like an act of desperation. It’s a sign that Putin is losing leverage over the EU. Andreas Steno Larsen pointed out that Russia will find it very difficult to pivot its gas sales to Asia because of a lack of pipeline capacity.

 

 

To be sure, European industrial production has cratered, but the USD price performance of commodity chemical giants BASF and Dow Chemical is revealing. The two stocks had tracked each other closely until the Russian invasion in February when BASF skidded against DOW. Even with all the bad news, BASF may be bottoming on a relative basis and it is starting to turn up (bottom panel).

 

 

In short, the market is becoming immune to bad news. If and when the war is over, energy prices will fall and risk assets will rip. I suggested in the past that investors should monitor the performance of European equities on a FIFO basis (see Will Europe drag us into a global recession?). A review of global regional relative performance shows that US equity markets remain the leaders, Europe continues to lag, and other markets are flat against global equity markets. 

 

 

If and when European stocks begins to bottom on a relative basis, that could be the risk-on signal for global equities. Also, keep an eye on the role of Turkey in the war. Erdogan is facing an election on April and 80% inflation, he has strong incentives to try and negotiate peace.

 

 

Squaring the circle

In conclusion, Michael Burry’s wildly bearish projection of S&P 1900 seems implausible. However, the S&P 500 faces strong valuation and macro headwinds in the near future. On the other hand,  conventional technical analysis view calls for market weakness and a bottom during the September-October time frame.

 

While S&P 500 valuations are still slightly challenging, they can be described as being at fair value or slightly overvalued. Stock prices could still rise based on positive macro developments. The bullish catalyst could emanate from Europe, as the authorities unleash a fiscal impulse to counteract its recession and possible financial crisis. The new UK Prime Minister Liz Truss announced a price cap on household energy bills, though protection for businesses will be more limited. Other European capitals will undoubtedly follow suit with similar protection schemes in the near future.

An “energy price guarantee” will limit average annual household bills to £2,500 over the next two years. The price guarantee will apply to the unit cost of energy so the amount any household pays will vary depending on how much gas and electricity they use.

The UK fuel subsidy of is estimated to be in the order of £170 billion, which roughly equals the annual NHS budget and over 5% of GDP. The scale of the fiscal intervention is reminiscent of the shock-and-awe response to the COVID Crash. In addition, the stabilization and recovery of BASF against Dow Chemical is a sign that European markets may be bottoming.

 

Here is how I square the circle between the fundamental and macro challenge to US equity prices and the more sanguine outlook by technical analysts. The market will undergo the ultimate litmus test in the coming days.

 

Take the 1962 experience as an example. The stock market topped out in early 1962 and crashed in the so-called Kennedy Slide. The Cuban Missile Crisis followed after a brief market recovery, but the market never undercut its lows despite the fears of total nuclear annihilation. While I am in no way suggesting that the world is headed towards a nuclear war, this 1962 experience is an example of how the markets bottomed (such as it did in June of this year), staged a relief rally, and, according to many chartists, weaken to possibly re-test its lows. If the lows hold, it could be the sign that a new bull has begun, with the probable catalyst of a resolution of Europe’s recession.

 

 

Saved by Fibonacci

Posted by Cam Hui -

Mid-week market update: I suggested on the weekend that the stock market was oversold and poised for a short-term rally (see How to trade the failed breadth thrust). The rally seems to have arrived.
 

The weakness in the S&P 500 has been stunning as it sliced through multiple levels of support like a hot knife through butter. The decline was halted at the last remaining support was the 61.8% Fibonacci retracement level, which also coincided with a volume support zone. 

 

 

Saved by Fibonacci! The logical initial upside resistance is the 50 dma at 4020 on the S&P 500, or 401.25 on SPY.

 

 

Positive divergences

The relief rally was bound to happen. The market was extremely oversold and a number of positive divergences had begun to appear. None of the divergences, by themselves, were strong reasons for the market to rally. Taken together, it was enough for stock prices to bounce.

 

Consider, as an example, that stocks had been inversely correlated with oil price for most of this year. Oil prices have fallen and a yawning gap is appearing between WTI oil and the S&P 500.

 

 

Credit market risk appetite is also perking up. The price of junk bonds against duration-adjusted Treasuries (green line) and leveraged loans (dotted red line) are exhibiting positive divergences (with the caveat that the Fed won’t be overly pleased if credit conditions continue to ease).

 

 

Equity risk appetite factors are also starting to look constructive. While the high beta to low volatility ratio has followed the S&P 500 (dotted red line), the equal-weighted consumer discretionary to staples ratio  (black line) bottomed during the latest stock market downdraft.

 

 

Lastly, the usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) flashed a sell signal when its 14-day RSI recycled from overbought to neutral. The RSI signal has now reached 20, which is also a fairly reliable “take profits” signal (top panel). In addition, the NYSE McClellan Oscillator (NYMO) reached -100, which is an oversold extreme (bottom panel).

 

 

 

Intermediate term bearish

Make no mistake, any relief rally should be sold. As I pointed out on the weekend (see How to trade the failed breadth thrust), “there were nine NYMO extreme oversold episodes in the last 10 years. Eight of the nine resolved in further declines after bounces.”

 

Here are some reasons for concern. I had been watching for insiders to start buying as the market weakened. Instead, they were selling the latest rally.

 

 

Sentiment isn’t panicked enough to signal a bottom yet. The 10 dma of the CBOE put/call ratio has been rising, but levels are not elevated enough to signal a capitulation bottom.

 

 

Finally, Helene Meisler published a column yesterday which concluded, “Expect an oversold rally to develop this coming week, but the intermediate-term indicators say after that we should come down again”. I agree 100%.

 

In the near term, the calendar has been filled with investor conferences after the Labor Day weekend. In particular, keep an eye on any guidance from large-cap tech companies that may move the market, in addition to the Apple iPhone event. The market may either rally or tank, depending on the tone from management in the coming days.

 

 

 

How to trade the failed breadth thrust

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.
 

 

Faltering momentum

Technical analysts recently became excited when the percentage of S&P 500 stocks above their 50 dma surged from below 5% at the June low to over 90% in mid-August. In the past, such strong price momentum has always signaled the start of a new equity bull.

 

 

Since then, the S&P 500 fizzled at its 200 dma. Markets further took a risk-off tone when the Fed and other central bankers signaled their determination to raise interest rates and warned about pain ahead. The reversal has been so dramatic that the percentage of S&P 500 stocks above their 20 dma has retreated to under 10%.

 

If it’s any consolation, the intermediate technical outlook is still bullish for equities.

 

 

Buy signal still intact

Rob Hanna at Quantifiable Edges studied the history of failed breadth thrusts. He found that historical returns are strong even in cases when the market suffered an initial drop.

 

 

Jason Goepfert at SentimenTrader studied historical analogs to the recent breadth thrust market action and concluded:
  • The 50-day rally off the June low is comparable to other long-term bottoms.
  • A price analog shows that the highest-correlated 50-day patterns all showed one-year gains.
  • Shorter-term returns were inconsistent, with several giving back most or all of the initial rally.
  • The highest-correlated rallies tended to peak where we did now but showed long-term gains.

 

 

 

Lessons from market history

Some lessons from market history are revealing. A study of past market bottoms since 2000 shows that recovery from a breadth wipeout (bottom panel), as measured by the percentage of S&P 500 stocks above their 50 dma rising from below 5% to over 90%, has always been bullish. Other market bottoms have been characterized by low-quality rallies, a rebound in the cyclically sensitive copper/gold ratio, and strength in the consumer discretionary to consumer staples ratio as an indicator of risk appetite. In addition to the recent breadth thrust, all three of those factors are confirming the latest bullish impulse.

 

 

What about the Fed? A key risk to the bull case is the Fed’s “whatever it takes” determination to bring inflation back to its 2% target. A study of the Zweig Breadth Thrust tells the story of the interaction of breadth thrusts and Fed policy. There have been only six ZBT buy signals since Marty Zweig wrote about his model in 1986. The market has been higher a year later in all instances. In two cases, the market chopped around and re-tested its lows during periods when the Fed was raising rates. While it’s difficult to make any definitive forecasts based a study where n=2, the re-tests occurred 2-4 months after the initial ZBT buy signal.

 

 

Fast forward to 2022, the 30-year long Treasury bond could be giving investors a message. In the past, the peak in the long 30-year Treasury yield has been either coincident or slightly led the peak in the Fed Funds rate. The long bond yield appears to be trying to top out. Past episodes have tended to be bullish for risk assets such as equities.

 

 

Former Fed economist Claudia Sahm outlined how inflation could resolve itself in a relatively benign manner. Economic weakness in Europe and China helps the US to bring down inflation.

Who benefits from Europe going into recession? We do. The United States, as the largest economy in the world, the largest producer of oil and natural gas, and with one of the strongest recoveries, should be able to weather the storm in Europe. Their hardship will sharply lower their demand and help bring our inflation down.

She added:

Yes, the lockdowns and production stoppages in China will reduce the available goods for us to buy. But remember, inflation comes down with more supply and/or less demand. We are not the only ones who buy electronics and cars. If demand in the European Union, the second-largest economy, China, third-largest, and others, slows dramatically, that’s less competition for goods and less inflation for us.

USD strength is importing disinflation and exporting inflation to America’s trading partners.

The stronger dollar pushes down our inflation. Imports are cheaper now for us from basically everywhere. Usually, the “pass-through” of import prices to the overall CPI is considered small. But import prices are falling markedly—both with the stronger dollar and easing supply chain disruptions—and will show up to some degree. Moreover, new research from the New York Fed by Mary Amiti, Sebastian Heise, Fatih Karahan, and Ayşegül Şahin suggests that the import price “pass-through” in the United States has been larger since the pandemic began.

 

 

Short-term pain ahead

Tactically, equity bulls are likely to face further pain. The market is very oversold, but fear levels are inconsistent with major market bottoms.

 

The NYSE and NASDAQ McClellan Oscillators (NYMO and NAMO) are exhibiting deep oversold readings, which could see the market bounce, but any rally is unlikely to be unsustainable.

 

 

That’s because sentiment indicators did not reach washout and capitulation levels. Investors Intelligence sentiment has recovered from a crowded short condition and readings are only mildly bearish.

 

 

A 10-year history of the CBOE put/call ratio and equity put/call ratio shows a pattern of slowly rising put/call ratios until readings reach a crescendo. I conclude from this that the market needs to either re-test or stage a near re-test of the June lows.

 

 

The term structure of the VIX isn’t even inverted, which would be an indication of panic.

 

 

The VIX Index appears to be exhibiting a 50-day cycle, and the projected peak for the VIX is above 34 on September 20, 2022, which coincidentally is one day before the next FOMC meeting. Stay tuned.

 

 

To underscore my point about the unsustainability of a bounce, here are all the instances in the past 10 years when NYMO became as oversold as it did recently. 

 

There were four cases during the 2012-2013 period. None of them exhibited extreme fear as measured by the inversion of the VIX curve. All relief rallies resolved with lower lows soon afterwards.

 

 

There was one instance of an oversold NYMO in 2015. The VIX curve inverted. The market staged a relief rally but came back to re-test the old low.

 

 

There were four episodes during the 2018-2020 period. The VIX curve inverted in all cases, indicating panic. Only the Christmas Eve Panic of 2018 resolved in a V-shape bottom. All others, including the COVID Crash, saw the market decline soon after a rally. 

 

In summary, there were nine NYMO extreme oversold episodes in the last 10 years. Eight of the nine resolved in further declines after bounces.

 

 

In conclusion, the bullish implications of the breadth thrust are still alive. If history is any guide, stock prices should be higher by next summer after some short-term sloppiness. The key risk to this forecast is the Fed will continue to tighten into a recession and deliberately tank stock prices to fight inflation.

 

Why a financial crisis could be the bulls’ best hope

Posted by Cam Hui -

I pointed out two weeks ago the strong disagreement between technical analysts, who were bullish because of strong price momentum, and macro investors, who were bearish because of concerns over hawkish central bank policy and a slowing growth outlook (see “Price leads fundamentals”, or “Don’t fight the Fed”?). In the wake of the market reaction to the Fed’s Jackson Hole symposium, it seems that macro investors have won the argument, at least for the time being.
 

In Fed Chair Powell’s speech, he underlined that tight monetary policy will “bring some pain to households and businesses” but vowed to “keep at it until the job is done”, which was a signal that there will be no dovish pivot until inflation is beaten. The only exception to that rule is a financial crisis. Historically, equity markets haven’t bottomed until the St. Louis Fed Financial Stress Index has risen to positive. While the index has begun to turn up from a very low level, stress levels are still very tame, indicating that financial crisis risk is still relatively low.

 

 

 

The hawks at Jackson Hole

The speeches at Jackson Hole were, on the whole, brutally hawkish. Powell’s speech, which contained 47 instances of the word “inflation”, began with a stark warning about the effects of Fed policy:

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Powell went on to outline the extent of the Fed’s hawkishness: “With inflation running far above 2% and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.” He went on to discuss how inflation expectations ran out of control during the 1970’s.

During the 1970s, as inflation climbed, the anticipation of high inflation became entrenched in the economic decisionmaking of households and businesses. The more inflation rose, the more people came to expect it to remain high, and they built that belief into wage and pricing decisions.

A San Francisco Fed study found that “wage inflation is sensitive to movements in household short-run inflation expectations but not to those over longer horizons”. The latest ADP report shows that job stayers saw annual wage gains of 7.6%, while job switchers saw gains 16.1%. Fed officials will undoubtedly be closely monitoring wage gains and short-term inflation expectations. Powell concluded, “We must keep at it until the job is done.”

 

That was just the appetizer. A closely watched speech by Isabel Schnabel, who is a Member of the ECB Executive Board, was equally hawkish. She acknowledged that supply shocks are mainly responsible for the latest bout of inflation, which is beyond the control of central banks. Nevertheless, she laid out a case for tight monetary policy as a response.
  • Uncertainty about inflation persistence requires a forceful policy response.
  • Risks of a de-anchoring of inflation expectations are rising.
  • Central banks are facing a higher sacrifice ratio when high inflation has become fundamentally entrenched in expectations.
Schnabel echoed Powell’s sentiments about the risks of allowing inflation and inflation expectations to run out of control.
Both the likelihood and the cost of current high inflation becoming entrenched in expectations are uncomfortably high. In this environment, central banks need to act forcefully. They need to lean with determination against the risk of people starting to doubt the long-term stability of our fiat currencies.

 

Regaining and preserving trust requires us to bring inflation back to target quickly. The longer inflation stays high, the greater the risk that the public will lose confidence in our determination and ability to preserve purchasing power.
I don’t want to sound like a broken record, but Gita Gopinath, First Deputy Managing Director of the IMF, sang from the same songbook in her remarks: “Central banks must act decisively to ensure inflation expectations are anchored”.

 

As well, an important financial market plumbing paper by Acharya et al about the effects of quantitative tightening concluded that the effects of QT are not a mirror image of QE. Instead, “the shrinkage of the central bank balance sheet is not likely to be an entirely benign process” as QT effects are non-linear.
During quantitative tightening, the banking sector may not shrink the claims it has written on liquidity at the same pace that the central bank withdraws reserves. This may lead to tightened liquidity conditions and the greater possibility of episodes of systemic liquidity stress.
The paper’s discussant, Wenxin Du, pointed out that the Acharya paper found that “no robust relationship between aggregate reserves and the price of liquidity”, as measured by the spread between the effective Fed Funds rate (EFFR) and interest on reserve balance rate (IOR). However, there is a strong relationship between liquidity and reserves in foreign entities (FBOs) instead of US banks. When QT drains liquidity from the financial system, it raises the risk of emerging market instability.

 

 

For investors, the key takeaway from Jackson Hole is hawkish Fed and other major central bank policy for as far as the eye can see.

 

Subsequent to the Jackson Hole symposium, Minneapolis Fed President Neel Kashkari astonishingly admitted in a Bloomberg podcast that the Fed wants stock prices to fall: “I certainly was not excited to see the stock market rallying after our last Federal Open Market Committee meeting, because I know how committed we all are to getting inflation down. And I somehow think the markets were misunderstanding that.” Kashkari went on to underscore the Fed’s seriousness in its inflation fight by stating that “a commitment of returning inflation to 2%” is a form of forward guidance.

 

In other words, if you’re an equity bull, you are fighting the Fed.

 

 

Signposts to watch

In light of the hawkish rhetoric from Fed officials, the next important signpost is the Summary of Economic Projections, which is scheduled to be published after the September FOMC meeting on September 21, 2022. Watch for how the neutral rate evolves, which stood at 2.5% in June. As well, watch for how much over and overshoot of the neutral the Fed is willing to tolerate based on its projections for 2022, 2023, and 2024.

 

 

At the extreme, the Taylor Rule prescribed Fed Funds rate under “normal assumptions” is 11.4%, indicating that there is enormous upside potential in rates should the Fed turn really, really hawkish. To underline that point, Cleveland Fed President Loretta Mester expressed a preference “to move the Fed Funds rate up to somewhat above 4% by early next year and hold it there.” She added, “I do not anticipate the Fed cutting the Fed Funds rate target next year”.

 

 

 

Investment implications

What does all this mean for investors? Needless to say, most projections are equity bearish. CEO confidence has fallen to levels which makes a recession unavoidable. Historically, recessions have always resolved in bear markets.

 

 

Rob Anderson of Ned Davis Research found that high inflation and below potential growth is a bad combination for equity returns.

 

 

There are few historical instances when the Fed deliberately tightened into a recession. Walter Deemer invoked the 1969 template.

 

 

The other is the Volcker Fed of the early 1980’s. Even Volcker pivoted when the Mexican Peso Crisis threatened the stability of the US banking system.

 

 

There is one narrow path for the bulls. Central bankers could wrong about the inflation outlook. Inflation surprises have generally been moderating all over the world. 

 

 

Markets are forward-looking and yield curves are inverting, indicating slower economic growth ahead. In the past, the peak in the long 30-year Treasury yield has been either coincident or slightly led the peak in the Fed Funds rate. While the signal hasn’t been perfect, those episodes have tended to be bullish for risk assets such as equities, and the long bond yield may peaking today.

 

 

The August Employment Report came in slightly above expectations, with payrolls rising at 315,000 (300,000 expected) and significantly decelerating from the July rate of 526,000, Both average hourly earnings and average weekly hours were worse than expectations, which indicate a gradually weakening economy. This report is consistent with the Fed’s desire to cool growth and inflation.
 

 

Whatever it takes, or…

In reference to the euro, then ECB president Mario Draghi uttered the phrase “whatever it takes” in 2012.  Today, central bankers have taken a “whatever it takes” position to fight inflation at the Federal Reserve’s Jackson Hole symposium.

 

If you believe the Fed and other central bankers, monetary policy is hawkish as far as the eye can see. However, there are two non-linear and narrow paths forward for equity bulls. One is a financial crisis that forces central bankers to pivot to an easier policy to preserve financial stability. The other is the central bankers have misjudged the inflation outlook and markets are right. If long Treasury yields fall in a convincing fashion, it could be the signal for a market-led dovish pivot.

 

I recognize the tone of this publication is very bearish. Tomorrow, I’ll discuss the bull case from a technical analysis perspective. Don’t slit your wrists just yet.

 

Jackson Hole turbocharges the FOMC market cycle

Posted by Cam Hui -

Mid-week market update: The stock market has mostly followed an FOMC cycle where prices decline into an FOMC meeting and rallied afterward. While the Jackson Hole symposium wasn’t an FOMC meeting, it nevertheless seems to have sparked market weakness. 
 

 

After the S&P 500 stalled and pulled back at its 200 dma, I thought that it might experience a minor setback The market action is pointing to a deeper downside as every rally attempt this week has been met with selling. Both the VIX and S&P 500 appear to be undergoing Bollinger Band rides: An upper BB ride for the VIX and a lower BB ride for the S&P 500. 

 

 

Cautionary signals everywhere

I am seeing cautionary signals everywhere. The market printed several high downside volume days of over 80%, which is consistent with past S&P 500 lower BB rides.

 

 

Rob Anderson of Ned Davis Research revealed that their short-term VIX indicator has flashed a sell signal.

 

 

I pointed out before that the VIX Index appears to exhibit a 50-day cycle, which bottomed out on August 17. If the cycle analysis is correct, the VIX is on its way to a target zone of over 34. This market drop is not anywhere near done.

 

 

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

 

If we apply the RRG technique to the top-weighted stocks in the S&P 500, we can see that only two stocks, BRK.B and JPM, are in the top half of the chart, which indicate potential leadership. The rest, which are large-cap FANG+ names, are in the bottom half indicating relative deterioration. It’s difficult to see how the index could meaningfully advance under such conditions.

 

 

 

Bottoming tripwires

I am not going to estimate a numerical downside target for the S&P 500, but I can point to several bottoming tripwires.

 

One way is to watch for the VIX Index to rise up to its target zone which begins at 34 (see above chart).

 

Another way is to monitor the S&P 500 Intermediate Breadth Oscillator Momentum Indicator. Historically, corrective impulses haven’t ended until the 14-day RSI on ITBM has fallen to 20 or less.

 

 

Another way is to watch insider activity. Should strong net insider buying appear (the blue line rising above the red line), that would be a signal that downside risk is becoming limited.

 

 

Tactically, the S&P 500 is extremely oversold and could stage a brief rally at any time, but the path of least resistance is still down. My inner trader remains short the market and he is enjoying the ride. He is watching for the tripwires to take profits and cover shorts.

 

 

Disclosure: Long SPXU

 

Six reasons why this was just a bear market rally

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

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

 

Something for everyone

During the recent bull and bear debate, Nautilus Research provided some historical analogs for both bulls and bears. Depending on what camp you are in, Nautilus had a market template for you.

 

 

I have been in the bear camp ever since this rally began (see Lessons from a study of past major bottoms). As the S&P 500 rally stalled and pulled back at the 200 dma, here are six reasons why the advance was likely a bear market rally and not the signal that a new bull had begun.

 

 

A short covering rally

The rally off the June low was mainly a short covering rally as sentiment and positioning were stretched at historic extremes. While the S&P 500 has risen 15% from its June low, the Goldman Sachs Basket of most shorted stock basket was up over 45% at its peak and the performance of the basket has dramatically pulled back. While short covering rallies can be bullish indicators of positive price momentum, the market needs additional catalysts to push prices higher once the fast money has covered its short positions.

 

 

 

Flagging momentum

When the S&P 500 was rejected at its 200 dma resistance, momentum began to turn down. The 14-day RSI recycled from an overbought condition, which is a tactical sell signal. The index has reached its first Fibonacci retracement level and may see some near term strength early next week.

 

 

A similar pattern can be seen in the weekly chart as the 5-week RSI recycled from an overbought reading.

 

 

 

Unchanged leadership

New bull markets are generally characterized by a change in leadership. Investors have seen no signs of the emergence of any new leadership. In fact, the same old large-cap growth leadership is still leading the way as the relative performance of the NASDAQ 100 remains sensitive to the 10-year Treasury yield.

 

 

On the other hand, speculative growth stocks have cratered and its price pattern is following the script of growth stocks in the aftermath of the dot-com bust.

 

 

The script hasn’t fully played out yet. A new bull won’t emerge until new leadership appears.

 

 

Deteriorating fundamentals

In all likelihood, the US economy is headed into a recession by Q1 2023. Earnings estimates are falling. Jeff Weginer at WisdomTree observed that S&P 500 EPS growth is inversely correlated to credit conditions, as measured by the loan officer survey. Once earnings estimates decline, valuation support for stock prices will weaken.

 

 

 

A hawkish Fed

The Federal Reserve has made it clear that its north star is fighting inflation. In his Jackson Hole speech, Powell affirmed the Fed’s “responsibility to deliver price stability is unconditional”. He admitted that monetary is a crude tool because it can only affect demand and not supply, but he implicitly accept that the economy could fall into recession as the Fed tightens monetary policy.

It is also true, in my view, that the current high inflation in the United States is the product of strong demand and constrained supply, and that the Fed’s tools work principally on aggregate demand. None of this diminishes the Federal Reserve’s responsibility to carry out our assigned task of achieving price stability. There is clearly a job to do in moderating demand to better align with supply. We are committed to doing that job.

He acknowledged that higher rates will cause some pain, but invoked the short-term pain for long-term gain mantra. In other words, the Fed will tolerate a recession in order to control inflation.

While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Powell warned, “We must keep at it until the job is done”.
History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting. The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.
With the inflation rate running close to a 40-year high and the unemployment rate at half-century lows, the Fed will stay hawkish for a considerable period. Ryan Detrick highlighted analysis from Strategas that in the past eight cycles, the Fed kept raising rates until the Fed Funds rate exceeded CPI. 

 

 

Even if we use the most optimistic assumptions by substituting core CPI for headline CPI and assumethat the transitory nature of goods inflation subsides, core CPI is likely to decelerate to only about 4% by early 2023. But sticky price CPI is stubbornly high and accelerating. This indicates that the Fed Funds rate will continue to rise to 4% or more before the Fed is done, which is well above current market expectations.

 

 

 

Negative seasonality

Tactically, a number of seasonality studies indicate that September is a poor month for stock returns. September is especially negative during midterm election years.

 

 

Mark Hulbert also found that history shows September to be a particularly negative month. He could find no explanation and chalked it up to a market mystery.

 

 

As well, the Fed is scheduled to double the pace of its quantitative tightening to $95 billion per month starting in September. Investors should be prepared for the possible negative effects of a withdrawal of liquidity from the financial system.

 

In conclusion, while there appear to be some superficial reasons to support the case for the start of a bull market, an analysis of market internals, valuation, and monetary policy backdrop indicates that the bear market isn’t over. Investors should watch for a re-test of the June lows and make a decision then about downside risk based on sentiment, technical conditions, and insider behavior.

 

 

Disclosure: Long SPXU

 

Will Europe drag us into a global recession?

Posted by Cam Hui -

It’s finally happened, the euro fell below par against the US Dollar. The weakness can be attributable to a combination of Fed hawkishness and European economic weakness.
 

 

Europe is almost certainly in a recession. Consumer confidence has skidded to levels last seen during the Eurozone Crisis of 2011-2012. The questions are whether the region will drag the rest of the global economy down and the implications for asset returns.

 

 

 

Bears in Europe

European equity market performance looks grim. The relative performance of the MSCI Eurozone is testing a key relative support level. The region’s laggards are Germany, which has become the sick man of Europe, and Italy, which is burdened by concerns over yield spreads and the political uncertainty of the upcoming election on September 25, 2022. Polling indicates that a right-wing coalition consisting of Fratelli d’Italia, which has its roots in the fascism of Benito Mussolini, Lega, and Forza Italia are poised to seize control of power. Not only would the new government be anti-Europe, and anti-immigrant, but it is also expected to be more Moscow friendly, which would weaken the EU consensus in support of Ukraine in the war against Russia. The outperforming country is Greece (yes, that Greece) as it appears to be trying to carve out a relative bottom against the MSCI All-Country World Index (ACWI).

 

 

Across the English Channel, large-cap UK stocks have held up well, but that’s because of its heavy energy weight. The relative performance of large-cap UK stocks has been highly correlated to the relative performance of energy stocks. By contrast, small-cap UK stocks, which are more reflective of the performance of the British economy, are exhibiting relative lows against ACWI.

 

 

 

Energy crisis

Russia has weaponized its natural gas exports in the wake of the Russo-Ukraine war. Investors are seeing almost daily headlines about how gas prices have surged to another high. For some context, on a per barrel of oil equivalent basis, wholesale electricity prices in most European countries are over $1,000 oil. The 1974 Arab Oil Embargo cratered the American economy. Will the Russian gas curtailment be any different for Europe?

 

 

This chart of the showing the difference in USD performance of BASF and Dow Chemical tells the story of the burden being carried by European heavy industry.

 

 

It was no surprise that Eurozone flash PMI fell into contraction territory.

 

 

While core HICP came in at 5.1%, which was slightly ahead of an expected 5.0%, German PPI rose an astounding 37.2%. These inflation readings will handcuff the ECB and force it to tighten into a slowdown.

 

 

The good news is that most European countries are on track to reach their targeted 80% gas storage capacity by October 1, and a considerable number already have. Europe won’t freeze this winter, though it may have to shut down some industrial activities. The feat was accomplished through a combination of Russia’s slowness to curtail gas exports and a pivot towards gas from other sources.

 

 

Here’s the bad news. A Bloomberg Odd Lots podcast with Bloomberg Opinion Columnist Javier Blas and Singapore-based hedge fund manager Alex Turnbull reveals that Europe achieved its natural gas position by outbidding others for LNG cargo. While Europe won’t freeze this winter, Europe’s gas shortages were exported to EM economies like Pakistan, Bangladesh, and India, which would affect industrial output in those countries. As well, while Europe may emerge from the coming winter relatively unscathed, gas storage will be depleted in the spring and it will face supply problems next summer and winter.

 

 

The geopolitical wildcard

Much of Europe’s economic outlook depends on how the Russo-Ukraine war evolves in the coming months. Putin issued a decree last week ordering that the Russian defense ministry raise its budget and plan for an increase of 137,000 troops. This is a signal that he is planning for a long war.

 

EU support for Ukraine has been strong but a little uneven. Ukraine has received strong support from the US, UK, former Warsaw Pact states, and Baltic countries like Sweden and Finland, the principal axis of the EU, France and Germany, have lagged in military support. Surprisingly, a recent poll shows a vast majority of Germans want to continue to support Ukraine in the war, even if this entails income losses due to high energy prices. In fact, three politicians, from SPD, FDP, and Greens have written a Der Spiegel op-ed calling for more weapons for Ukraine. As long as the conflict persists, this will undoubtedly affect the security of Europe’s Russian energy supply.
 

 

Currently, the market’s perception of geopolitical risk is still rising, and the relative performance of MSCI Poland continues to weaken.

 

 

Looking longer term, continued Western support is likely to translate into a Ukrainian victory. However, investors have to be prepared for any possible geopolitical consequences of a Russian defeat. Just as Russia experienced political upheaval soon after the defeat of the Russian fleet at the Battle of Tsushima Strait in 1905, Russia is likely not to be the same within five years. The West will need to better manage Moscow’s decline in a better way than the collapse of the Soviet Union. Russian culture has few institutions in place to support democracy, property rights, and the rule of law and any collapse could be disorderly. European businesses and investors will also have to be prepared for any blowback from such an event.

 

 

Limited contagion effects

In conclusion, developed market flash PMIs are exhibiting a synchronized decline, led by Europe. The contagion effects of a European slowdown appear to be limited to selected EM economies through the globalization of natural gas prices.

 

 

European equities are lagging badly on a relative basis, but the relative performance of the other regions are largely unaffected by European weakness. Investors are advised to avoid Europe, but monitor the region based on the first-in-first-out principle. If European stocks begin to recover and outperform, it could be the bullish signal of global recovery.

 

 

Short covering rally is over, now waiting for Powell

Posted by Cam Hui -

Mid-week market update: According to Goldman Sachs, systematic hedge fund positioning has reversed from a crowded short to a crowded long. Readings are similar to the levels seen at the market top in late March. 
 

 

The S&P 500 stalled at 200 dma resistance. In light of this analysis of HF positioning, the bulls are unlikely to regain control of the tape in the near term. The key question for traders is, “How will the Powell speech Friday move the markets?”

 

 

A change in tone

The tone of the market has definitely changed. The bears have begun to seize control of the tape after a goal-line stand at the 200 dma. The relative performance of defensive sectors tells the story. Healthcare and consumer staples tested relative support and bounced. The other two defensive sectors never deteriorated to relative support levels.

 

 

Equity risk appetite factors are flashing negative divergences. In particular, the relative performance of speculative growth stocks, as measured by ARKK, was rejected at relative resistance.

 

 

 

A possible pause?

Subscribers received an alert on August 12, 2022 that my inner trader had shorted the S&P 500 when the correlative between the S&P 500 and VVIX, which is the volatility of the VIX, had spiked. The signal was slightly early by two days. The trade’s drawdown wasn’t overly onerous, but it has turned out to be a good decision so far.

 

 

The slower moving but usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator flashed a sell signal this week. The signal was unusual inasmuch as it occurred when the NYSE McClellan Oscillator was already in oversold territory, which is a cautionary sign that downside potential may be limited.

 

 

I interpret these conditions as downside momentum is in need of a pause. Fed Chair Jerome Powell is scheduled to speak at the Fed’s Jackson Hole symposium on Friday at 10 ET. However, market positioning is already tilted towards a hawkish tone. Fed Funds futures are now discounting a 75 bps hike in September, instead of an expected 50 bps last week. The terminal rate is now 375-400 bps, which is 25 bps more than last week. 

 

 

Jon Turek at Cheap Convexity rhethorically asked

The most important theme for this week and really going into the September FOMC is how does the Fed dropdown from 75 to 50bps without it being perceived as an ease on financial conditions (FCIs)? Jackson Hole is the start of this journey, the beginning of, “we want to go to 50bps, but we are not done in this fight.”

The answer can be found in the level of interest rates and not the rapidity of the increases.

The Fed wants to transition to a world where the hawkishness comes from the level of the funds rate not the size of the interest rate hike.

While Powell will probably push back against a dovish pivot, the risk is his speech may be less hawkish than market expectations, which would spark a relief rally.

 

 

Sell the rips

While I continue to believe that the market is likely to work its way lower and test Fibonacci support at about 4050 and 3970, the S&P 500 is short-term oversold and it’s due for a pause in the manner of the mid-April consolidation. Powell’s Jackson Hole speech Friday could be the catalyst for a brief bullish reversal.

 

 

If this downdraft does weaken further to test the June lows, keep an eye on insider activity. In the past, insider buying (blue line) exceeded selling (red line) when the stock prices fell to key support levels. Should that occur, it would be an intermediate-term buy signal for stocks.

 

 

 

Disclosure: Long SPXU

 

A Jackson Hole preview: Are expectations finally rational?

Posted by Cam Hui -

The Federal Reserve’s annual Jackson Hole symposium is being held this week on August 25-27. Fed officials have fanned out across the land to deliver the message that market expectations of a dovish pivot are misplaced. The question for investors is, “Are market expectations finally rational?”
 

The CME’s Fedwatch tool shows the market expects two consecutive 50 bps hikes in September and November, followed by a 25 bps hike and a plateau into mid-2023.

 

 

Is the market still misreading the Fed? How will Powell steer expectations?

 

 

The Fed’s inflation challenge

The Fed has made it clear that its primary focus is getting inflation down to its 2% target. While it would like to avoid a recession, a recession may be necessary to achieve its task. Let’s see what challenges lie ahead.

 

Starting with inflation, the June core PCE stands at 4.8%. July PCE will be reported Friday and the market expects that it will decelerate to 4.7%. An analysis of the components of PCE is revealing.

 

The accompanying chart shows the evolution of the components of PCE, with the components shown on the left scale and core PCE on the right scale. Durable goods PCE (red line) peaked in April 2021 and it has decelerated considerably since as supply chain bottlenecks have eased to 2.7% in June. However, services PCE and non-durable goods PCE remain stubbornly high at over 9%. 

 

 

The Fed’s June Summary of Economic Projections (SEP) shows that it expects core PCE to fall to 4.3% by December 2022. The decline will largely be attributable to the easing of transitory supply chain induced inflation. Getting core PCE down to the 4% zone will be easy. The path from 4% to 2% core PCE will be much harder.

 

The good news is inflation expectations are not running out of control, which will make the Fed’s job easier.

 

 

For a different perspective, The Transcript, which monitors earnings reports, offered a bottom-up view of inflation and its effects on the economy:
 

Inflation and rising interest rates have put a lot of pressure on the economy but overall consumers have remained remarkably resilient. Still, we are finding areas of concern building in many sectors. Consumer electronics and used cars are two areas where demand is ebbing. Middle-income consumers may be starting to trade down.

 

 

Tight labor market

The Fed’s inflation fighting job is complicated by a hot labor market. As an indication of the tightness of the labor market, job switchers enjoyed a 6.7% median wage increase compared to 4.9% for stayers.

 

 

As well, the labor force participation rate (LFPR) hasn’t recovered to pre-pandemic levels, which is worrisome. An analysis of LFPR by education reveals that it’s the less educated and presumably lower paid workers who are missing from the workforce.

 

 

An Atlanta Fed study of the decomposition of the changes in the LFPR between Q4 2019 to Q4 2021 shows that most of the decline is attributable to behavioral factors.

 

 

If the behavioral factors were to hypothetically all disappear tomorrow, prime age LFPR would be above pre-pandemic levels.

 

 

All of these factors combine to make the Fed’s job of fighting inflation harder. All else being equal, it needs to tighten further to raise the unemployment rate to head off the risk of a wage-price spiral.

 

 

A hawkish path ahead

So where does that leave us? Here’s what we know. The good news is inflation expectations are well-anchored. The bad news is the reduction in transitory inflation will bring the inflation rate down to about the 4% level, but the path from 4% to 2% will be far more difficult. As well, the labor market is hot and the risk of a wage-price spiral is rising. 

 

I interpret these conditions as meaning the Fed will continue to pursue a hawkish policy. The title of the discussion at Jackson Hole is “Reassessing Constraints on the Economy and Policy”. Global central banks remain in tightening mode. Don’t expect the Fed to execute a dovish pivot in the near future.

 

 

Just a flesh wound, or a deeper cut?

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

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

 

A stall at resistance

The S&P 500 stalled as it approached overhead resistance after recycling from an overbought condition on the weekly chart.

 

 

The key question for investors, much like the famous scene of King Arthur’s encounter with the Black Knight in Monty Python’s Holy Grail, “Is this just a flesh wound, or a deeper cut?”

 

 

 

Just a flesh wound

Let’s begin with the bull case. Investors can be excited about the powerful momentum unleashed by the recent breadth thrust. The percentage of stocks above their 50 dma surged from below 5% to over 90%. If history is any guide, such an episode should resolve bullishly.

 

 

As a consequence, the S&P 500 Advance-Decline Line made a fresh all-time high. All other versions of A-D Lines are also showing signs of strength.

 

 

The bulls will argue that the market may be due for a breather, but any pause is likely to be in the form of sideways consolidation in light of the strong momentum underlying the market.

 

 

A deeper cut

However, I would argue that the more likely scenario is a deeper pullback for several reasons.

 

While I am respectful of the bullish implications of the breadth thrust, the underlying market internals are different compared to the last breadth thrust, which saw the market surge after the COVID Crash of 2020. 

 

Consider the behavior of the relative performance of defensive sectors. Even as the market surged off the June bottom, all of the defensive sectors held relative support, indicating that the bears haven’t fully lost control of the tape. The NYSE McClellan Oscillator (NYMO, top panel) signaled that a period of weakness had begun by recycling off an overbought condition, much like it did in March and June. By contrast, the breadth thrusts in June 2020 saw defensive sectors violate relative support, and a similar violation of relative support occurred when NYMO recycled off an overbought condition in November 2020.

 

 

Other indicators are signaling warning signs. Equity risk appetite, as measured by the ratio of equal-weighted consumer discretionary to staples, and high beta to low volatility stocks, is exhibiting negative divergences to the S&P 500.

 

 

Semiconductor stocks were rejected at trend line resistance. Moreover, the bottom panel shows that the group weakened through a relative downtrend, which is a signal of cyclical weakness in an important technology industry.

 

 

The S&P 500 has been inversely correlated with oil prices this year. So far, the two have moved together.

 

 

Andrew Thrasher observed that oil prices also closely track the crack refining spread. As the crack spread widens, this has bullish implications for oil and bearish implications for equities.

 

 

One of the global canaries in the equity coal mine are UK stocks. The UK July CPI came in at 10.1%, which is a double-digit level that was last seen when Margaret Thatcher occupied 10 Downing Street. The BOE has vowed to pursue an aggressive hawkish policy and a recession is certain. UK stocks are therefore a useful barometer of global risk appetite. The FTSE 100 is composed of too many global companies and the index also has a strong energy tilt. The performance of the midcap FTSE 250 is more reflective of the British economy, and this index has failed to breach resistance. The bears are still in control of that tape.

 

 

 

A contrarian magazine cover buy signal?

The latest cover of Barron’s could be seized by the bulls as a contrarian magazine cover indicator. The fear of recession has become sufficiently mainstream. It’s time to be buying stocks.

 

 

While this is only one data snapshot, a review of order flow from Fidelity customers dispels the notion that investors are fearful of a recession. In the wake of Friday’s -1.3% drop in the S&P 500, retail traders were heavily buying speculative and high-beta favorites, such as Tesla, AMC, Gamestop Amazon, AMD, Nvida, Shopify, and Meta. They were also buying the triple leveraged QQQ and selling the triple leveraged inverse QQQ ETF.

 

 

 

Downside risk

It’s difficult to know in advance the downside risk posed by a pullback, but we can make some educated guesses. Initial support for the S&P 500 can be found at 4160, with further support at the first Fibonacci retracement of 4060, and at the 50% retracement at 3980. Much depends on the newsflow, which is impossible to predict. The Fed’s Jackson Hole symposium, “Reassessing Constraints on the Economy and Policy”, is next week on August 25-27, and it could be a source of volatilty.

 

 

In conclusion, the S&P 500 has paused its advance after a breadth thrust, but not all breadth thrusts are the same. While most breadth thrusts have strong bullish implications, a variety of market internals indicates that the pause is likely to resolve in a deeper pullback rather than a more benign sideways consolidation.

 

 

Disclosure: Long SPXU
 

 

“Price leads fundamentals”, or “Don’t fight the Fed”?

Posted by Cam Hui -

Wall Street is full of adages. Technical analysts are fond of, “Price leads fundaments” as a way of dismissing macro and fundamental analysis. But traders are also warned, “Don’t fight the Fed”. 
 

A vast gulf is appearing between bullish technicals and macro concerns. The bulls, who are mainly technicians, point to strong price momentum, which may be interpreted as discounting a soft landing for the economy. The bears can be found in macro and valuation, as equity markets are complacent about tight monetary policy and slowing growth. 

Who’s right? Should you believe that price is leading fundamentals, or stay cautious and not fight the Fed?
 

 

In the 1993 Berkshire Hathaway shareholder’s letter, Warren Buffett famously quoted Ben Graham:

 

In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.
Where you stand on the bull and bear question depends on your time horizon. Do you focus on the voting machine or the weighing machine?

 

 

The bull and bear cases

The bull and bear cases can be summarized by two charts I showed last week. The percentage of S&P 500 stocks above their 50 dma fell below 5% in June, a breadth wipeout, and quickly recovered to over 90%. These breadth thrusts are historically impressive and they have always signaled the start of a fresh bull market.

 

 

On the other hand, past market downdrafts have never ended until the St. Louis Fed Stress Index has tightened enough to into positive territory. Financial conditions are easing in the face of a Federal Reserve determined to tighten monetary policy. The bear market isn’t over yet.

 

 

Both models have shown an accuracy of 100%, but they can’t both be right.

 

 

A sentiment rebound

The roots of the breadth thrust begin with a sentiment and positioning wipeout. The BoA Global Fund Manager Survey shows that institutional manager risk appetite had reached a bearish extreme that even exceeded the levels seen at the height of the GFC. The recent softer than expected CPI print sparked a reversal and a stampede to add risk.  Prime brokerage data also confirmed that hedge funds had reached a crowded short and reacted to market strength by rapidly covering short positions. 

 

 

A breadth thrust was born. Rob Hanna at Quantifiable Edges documented the historical record of similar breadth thrusts, and the implications are very bullish for equity returns. The S&P 500 was higher in all cases three, six, and 12 months later.

 

 

I would warn, however, that sentiment reversals are not necessarily actionable trading signals. Managers were early in 2008 when they reversed and began to buy, but the market didn’t bottom until several months later.

 

 

 

Macro bears

The bear case consists of two major concerns. The market has totally misunderstood the Fed, which continues to raise interest rates and has no intention of cutting them until inflation is under control. In addition, earnings estimates have only begun to fall and they haven’t fully discounted the probable recession that’s just ahead.

 

Former New York Fed President Bill Dudley said in a CNBC interview that the markets are misunderstanding what the Fed is up to. Interest rates will be higher and longer, which is contrary to market expectations of a plateau and rate cuts in 2023. 

 

 

Consider the inflation picture. Dudley stated that underlying inflation is 4-6% and the Fed has a lot more to do in raising rates. The need to be confident that inflation will return to 2%. Dudley dismissed the recent deceleration by attributing the softness to transitory inflation. If your intention is to ignore transitory inflation on the way up, you also need to ignore it on the way down. 

 

Recall that the Fed turned hawkish when the components of CPI began to broaden out, as measured by the Sticky Price CPI and Trimmed-Mean CPI. Both of these metrics remain elevated even as core CPI rolled over.

 

 

The July FOMC minutes betrayed a hawkish tilt as there is a “significant risk” that inflation would stay elevated.

 

Participants judged that a significant risk facing the Committee was that elevated inflation could become entrenched if the public began to question the Committee’s resolve to adjust the stance of policy sufficiently. If this risk materialized, it would complicate the task of returning inflation to 2 percent and could raise substantially the economic costs of doing so. 

While Fed officials did acknowledge that the Fed could tighten more than necessary, the risk was not described as “significant”.

 

Many participants remarked that, in view of the constantly changing nature of the economic environment and the existence of long and variable lags in monetary policy’s effect on the economy, there was also a risk that the Committee could tighten the stance of policy by more than necessary to restore price stability. 

In short, the Fed is a long way from easing. Callum Thomas at Topdown Charts pointed out that the global monetary policy cycle is still tilted towards tightening. With the exception of China and Turkey, global central banks have not even begun to ease yet.

 

 

As the Fed tightens monetary conditions, a recession is looming. The Conference Board’s Leading Economic Indicator has fallen for five consecutive months. It has never done that other than ahead of a recession.

 

 

New Deal democrat, who monitors the economy using a set of coincident, short leading, and long leading indicators have been warning about a likely recession that begins in Q1 2023 and it will likely continue until Q2 2023.
  • The long leading indicators are those which have a lengthy track record of accurately forecasting a peak in economic activity 12 or more months out.
  • A majority turned negative as of Q1’s reports this spring, prompting a “Recession Watch” beginning Q1 of 2023.
  • With Q2’s updates now in hand, there isn’t a single positive long leading indicator left.
  • The negative forecast thus remains in effect through Q2 of next year.
  • While they have not turned back positive, two of the indicators *may* have put in their worst readings one month ago, and bear watching for signs of a positive turn.
Since markets are inherently forward-looking, the June panic could be attributed to the market discounting a recession that begins early next year, and the subsequent recovery is anticipating a recovery soon after.

 

However, earnings estimates are only just beginning to roll over. However, the S&P 500 is losing valuation support. Forward P/E is already 18, and as estimates decline, the P/E ratio becomes even more challenging. After the recent short-covering rally, the market lacks a catalyst to push stock prices higher.

 

 

 

Voting or weighing machine?

Where does that leave us? Short-term price momentum implies the start of a new bull market, but macro conditions argue for caution.

 

Marketwatch reported that Dan Suzuki of Richard Bernstein Advisors urged investors to “curb your FOMO”.

 

“Many investors insist on buying early so that they ‘can be there at the bottom.’ Yet history suggests that it’s better to be late than early,” wrote Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors.

 

Whether mid-June marked the bottom will only be clear in hindsight. RBA’s Suzuki said an analysis of performance around past bear-market troughs shows that being fully in the market at the bottom isn’t as important as many investors might think.

 

Suzuki explained:

 

In a refresh of our previously published analysis, we analyzed the returns for the full 18-month period encompassing the six months before and the 12-months after each market bottom. We then compared the hypothetical returns of an investor who owned 100% stocks for the entire period (“6 months early”) with one who held 100% cash until six months after the market bottom, then shifted to 100% stocks (“6 months late”).

 

The chart below reflects the findings, which showed that in seven of the last ten bear markets, it was better to be late than early.

 

“Not only does this tend to improve returns while drastically reducing downside potential, but this approach also gives one more time to assess incoming fundamental data. Because if it’s not based on fundamentals, it’s just guessing,” Suzuki wrote.

 

 

In other words, it pays to be patient. The recent rally off the June low was very impressive, but the market lacks a catalyst to push prices higher. Fed easing and earnings improvements are several quarters in the future. A study of past major bear market bottoms and factor responses suggest two possibilities.

 

The benign outcome will see the market undergo some choppiness for several months in the manner of the 2010 and 2011 bottom. The more bearish scenario calls for a second leg down in the manner of the post-9/11 rally as the full effects of the recession reach culmination.

 

 

In all cases, the market is due for a pause. The S&P 500 recently stalled as it tested its 200 dma. I will be watching how the macro backdrop and technical internals evolve during the coming pullback for greater clarity as to which is the more likely scenario.

 

Overhead resistance test = Possible weakness ahead

Posted by Cam Hui -

Mid-week market update; The S&P 500 has undergone a powerful rally off June’s bottom, but it’s now approaching technical resistance in the form of a 200 dma and a falling trend line. In addition, the market is overbought as measured by the 5 and 14-day RSIs, much in the manner of early November 2021.
 

 

Even if you are intermediate-term bullish, the convergence of these factors argues that it’s time for a tactical pause and possible pullback.
 

 

Volatility warning

Last week, I highlighted a market warning and tactical sell signal when the 5-day correlation of the S&P 500 and VVIX, which is the volatility of the VIX, spiked. Historically, this model has shown a strong track record (pink=successful sell signals, grey=unsuccessful signals).

 

 

Andrew Thrasher observed a similar effect. When the 14-day correlation between VIX and VVIX fall below zero, which is an indication that the two indices are moving in different directions, the market has more often than not seen volatility spikes.

 

 

Further analysis reveals that the VIX Index appears to have a 50-day cycle and volatility may be at the bottom of an inflection point. While cycle analysis can be uncertain and unreliable, the negative correlation of VIX and VVIX further builds the case for a turn in volatility.

 

 

 

Negative seasonality

Speaking of cycles, Jeff Hirsch at Almanac Trader pointed out that seasonality is about to turn negative for the S&P 500.

 

 

 

A FOMO stampede

When the market turned risk-on after June’s bottom, the advance was supported by a sentiment wipeout. The latest BoA Global Fund Manager Survey shows that managers have begun to rebuild their equity positions, albeit from very low levels.

 

 

That should be bullish, right? The Fund Manager Survey is an inexact timing tool. The survey showed that managers turned bullish in October 2008, but history shows that the market didn’t bottom out until five months later.

 

 

Goldman Sachs Prime Brokerage reported that the current rally stands as the third largest short covering event in the last 10 years.

 

 

Macro Charts pointed out that the option deltas on QQQ have reversed from a crowded short position to a crowded long position. The fast-money crowd has already engaged in a FOMO buying stampede.

 

 

None of this means that the market can’t rise from here. In the short run, however, the market is overdue for a pause and pullback.

 

 

Disclosure: Long SPXU

 

A warning from a market leadership review

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

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

 

Dovish pivot?

The stock market has taken on a giddy tone in the wake of the tamer than expected inflation reports. The S&P 500 has staged an upside breakout through a key 50% Fibonacci retracement level, which according to some chartists, could be the signal for the all-clear and a resumption of the bull market.

 

 

Marketwatch reported that technical analyst Jonathan Krinsky interpreted the upside breakout with guarded optimism:

 

“Since 1950 there has never been a bear market rally that exceeded the 50% retracement and then gone on to make new cycle lows,” said Jonathan Krinsky, chief market technician at BTIG, in a note earlier this month…

 

Krinsky, meanwhile, cautioned that previous 50% retracements in 1974, 2004, and 2009 all saw decent shakeouts shortly after clearing that threshold.

 

“Further, as the market has cheered ‘peak inflation’, we are now seeing a quiet resurgence in many commodities, and bonds continue to weaken,” he wrote Thursday.

 

My review of market internals shows narrowing leadership which is a warning that the current rally is unsustainable.

 

 

A leadership review

My market leadership review begins at the global level, which shows strong US leadership and flat to falling relative strength in all other regions. Europe and China are lagging the MSCI All-Country World Index (ACWI). Japan is trading sideways, and EM xChina appears to be trying to bottom on a relative basis.

 

 

A more detailed analysis of EM xChina shows that two of the top three countries in the index are in relative downtrends and only one, India, is in a relative uptrend.

 

 

In other words, the US and India are holding up the world.

 

 

Narrow US leadership

Relative performance analysis of the top five sectors of the S&P 500 also shows narrow leadership. The top five sectors comprise over 70% of index weight and it would be difficult for the S&P 500 to rise or fall without the participation of a majority. Sector relative performance shows that technology and consumer discretionary stocks are leading the market up in the last two months, with healthcare and communication services the laggards. Financial stocks are flat to down compared to the index. However, the equal-weighted consumer discretionary sector, which lessens the effects of the heavyweights AMZN and TSLA, has been flat against the index. In short, the leadership in the S&P 500 amounts to technology and large-cap NASDAQ 100 names like AMZN and TSLA.

 

 

A review of the relative performance of defensive sectors is equally revealing. Two defensive sectors, healthcare and consumer staples, are holding relative support and the other two, real estate and utilities, are trading in a sideways range. The relative strength shown by these sectors is an indication that the bears haven’t fully lost control of the tape.

 

 

In summary, the global market advance is being led by a handful of US technology stocks and, to a lesser extent, India. The narrowness of breadth amounts to a warning to investors.

 

 

Other warnings

Other warnings about stock market strength are emerging. Even as the WSJ declared that a new bull market had begun for the NASDAQ Composite when it rallied 20% from June’s bottom, Mark Hulbert disagreed and sounded a word of caution.
 

On the contrary, there have been a number of occasions during past bear markets in which the Nasdaq Composite index rallied by far more than 20%. There were three such rallies during the bear market that accompanied the bursting of the late 1990s internet bubble, for example. The most explosive of them occurred between early April and late May of 2001, during which this benchmark rallied more than 40%. I doubt that any investor who lived through the bursting of the internet bubble would look back and consider that rally to have been a new bull market.

 

It’s not just the volatile Nasdaq that has the ability to rally explosively during bear markets. The same is true for the more sedate, blue-chip dominated Dow Jones Industrial Average. There are three bear markets in the calendar maintained by Ned Davis Research in which the Dow also rallied more than 20%. The most spectacular of those rallies occurred over a five-week stretch in late 1931, when the Dow gained 35.1%. That rally occurred during some of the darkest days of the Great Depression, and once again I doubt any market historian would consider it to have been a bull market.

 

John Butters at FactSet pointed out that S&P 500 earnings growth is becoming challenging. Q2 earnings growth was actually negative if the energy sector is excluded. Viewed in this context, the recent expansion in the S&P 500 forward P/E ratio raises valuation risk for the market.

 

The Energy sector is also the largest contributor to earnings growth for the S&P 500 for Q2 2022. The sector is reporting an aggregate year-over-year increase in earnings of $47.7 billion, while the S&P 500 overall is reporting an aggregate year-over-year increase in earnings of $31.1 billion. In fact, if the Energy sector is excluded, the S&P 500 would be reporting a year-over-year decline in earnings of 3.7% rather than a year-over-year increase in earnings of 6.7%.

 

 

Equity risk appetite factors are showing growing negative divergences. The relative performance of equal-weighted consumer discretionary to consumer staples is already lagging the S&P 500, and the gap with the high beta to low volatility baskets is starting to grow.  Speculative growth stocks, as measured by ARK Innovation ETF, is still struggling with relative resistance and hasn’t achieved an upside relative breakout. View in isolation, these divergences are not actionable sell signals, but they are concerning when viewed in conjunction with the other warnings.

 

 

Subscribers received an email alert Friday that the VVIX, which is the volatility of the VIX Index, had flashed a short-term sell signal. In the past, a spike in the 5-day correlation between the S&P 500 and VVIX tended to resolve bearishly. There were 21 similar signals in the past five years. The market was flat or up in six cases (grey vertical lines) and fell in 15 (pink vertical lines).

 

 

My inner investor remains neutrally positioned at the asset weights specified by his investment policy. My inner trader just went short the market based on the spike in correlation between the S&P 500 and VVIX. Historically, the results of the sell signal should be known almost immediately and the trade will be stopped out if the market continues to advance in next few days. Good traders play the odds, but they also practise risk control.
 

Disclosure: Long SPXU

 

Lessons from a study of past major market bottoms

Posted by Cam Hui -

The mood has changed on Wall Street. The WSJ declared last week that the NASDAQ is back in a bull market.
 

 

The number of “new bull market” stories have skyrocketed in recent days. Suddenly, chartists on my social media feed are full of “if this index rises to X, or this indicator gets to Y, we have a new bull market”.

 


 

I am skeptical of single-variable models. Instead, I offer a study of past major bear market bottoms using factor and macro analysis to see how current circumstances fit with the fresh bull story.

 

 

A factor analytical framework

Strictly from a quantitative and technical analysis framework, here is where the market stands today using the following uncorrelated factors to spot a bottom:
  • Quality Factor: Major market bottoms often see a low-quality rebound as the washed-out stocks and half-dead companies surge and act like out-of-the-money call options. The quality factor is measured using the Russell 1000 to S&P 500 ratio. Both indices are nearly the same as they are both cap weighted, but S&P has stricter profitability inclusion criteria for its indices compared to FTSE/Russell, therefore the performance of the ratio shows a large cap quality effect.
  • Cyclical Factor: Major market bottoms usually experience a cyclical rebound, as measured by the copper/gold ratio.
  • Risk Appetite Factor: One indicator of risk appetite and equity beta is the performance of consumer discretionary to consumer staple stocks.
  • Price Momentum Factor: New bull markets sometimes exhibits strong price momentum after a major market bottom. I measure this factor using a variation of the “bear killer” model created by Dean Christians of SentimenTrader. The model flashes a buy signal on the first instance of the percentage of S&P 500 stocks above their 50 dma to spike above 90% after an initial decline of -20% in the S&P 500. 
The status of the factors today presents a mixed picture. The S&P 500 has rebounded, but it has yet to challenge a major falling trend line.

 

 

The copper/gold ratio has been mostly flat, while low-quality has experienced a mild rebound. The cyclical factor, as measured by the consumer discretionary to staples ratio, has rebounded. The market saw a breadth wipeout in mid-June and the “bear killer” factor recovered strongly and it reached the critical 90% level to flash a buy signal.

 

 

A history of market bottoms

A study of past market history shows eight major market bottoms since the market top in 2000. There were three bear market bottoms caused by recessions and five that were not, which we will call cyclical bears.

 

 

Here are some commonalities of recession bear markets, which are marked in pink on the chart. Both the low-quality factor and bear killer models registered buy signals, though the elapsed time from the breadth wipeout to the buy signal was a bit prolonged in the 2003 case. The signals from the other two factors were more hit-and-miss. They flashed buy signals in some cases and not in others.

 

I don’t plan to analyze every bottom episode in detail, but the factor conditions today bear an uncanny resemblance to the bottom in 2001, though 2001 was an unexpected geopolitical shock from the 9/11 attack. The stock market had been in a bear phase in 2001 when 9/11 hit and the S&P 500 rebounded sharply to rally through a fall trend line. Much like today, neither low-quality nor the cyclical factor showed much of a bullish response, but the risk appetite factor was bullish. After rallying through the falling trend line, the market went on to trade sideways for eight months before weakening again to test the old lows. I am not fond of market analogs and this is not a forecast, but the 2001 experience opens the door to the market consolidating sideways for months after rallying through a falling trend line.

 

 

The jury is out on a V-shaped bottom. There were three V-shaped bottoms and five bottoms where the market chopped around after making an initial low. Of the three shaped bottoms, two were successful and the market never looked back (2016 and 2020) and one was unsuccessful (2001). The 2016 bottom was characterized by a “bear killer” price momentum buy signal and the 2020 bottom was boosted by an unprecedented level of fiscal of monetary support which also led to a “bear killer” buy signal.

 

 

The Fed’s reaction function

History doesn’t repeat itself but rhymes. Historical studies can only offer some guidelines to the market outlook. Notwithstanding the results of the historical factor studies, what really matters is the Fed’s response function. Does it react to the forward-looking indicators of inflation, which are trending down, or will the Fed err on the side of caution in its inflation fight and drive the economy into recession?

 

The bullish narrative is that inflation surprise has been trending down all over the world, indicating an easing of inflationary pressures.

 

 

On the other hand, the Fed has repeatedly said that it is concerned about inflationary expectations becoming unanchored. The conventional way of controlling inflationary expectations and preventing a wage-price spiral is by cooling the jobs market. The Atlanta Fed’s Wage Growth Tracker shows that job switchers are enjoying much better wage growth than job stayers, indicating a tight labor market. The Fed’s job of tightening monetary policy is nowhere near done.

 

 

One key transmission mechanisms of tight monetary policy is through tightening financial conditions, as evidenced by yield spreads. Can anyone honestly say that the Fed’s job is done and it’s time to ease financial conditions, as yield spreads have done recently? 

 

 

In the past, major stock market downdrafts have been accompanied by the St. Louis Fed Stress Index rising above zero. This will be the only exception if the market has indeed bottomed and it implies that the Fed is nearly done tightening.

 

 

In the wake of the tamer than expected CPI report, the Fed sent out two well-known doves to deliver hawkish messages. Bloomberg reported that Minneapolis Fed President Neel Kashkari stated: 

The idea that we’re going to start cutting rates early next year, when inflation is very likely to be well in excess of our target – I think it’s just unrealistic…I think a much more likely scenario is we will raise rates to some point and then we will sit there until we get convinced that inflation is well on its way back down to 2% before I would think about easing back on interest rates.

The Financial Times reported that San Francisco Fed President Mary Daly that it’s too early to declare victory on inflation:
“There’s good news on the month-to-month data that consumers and business are getting some relief, but inflation remains far too high and not near our price stability goal,” Daly said on Wednesday, after the latest consumer price index report showed no increase between June and July and a slower annual inflation rate of 8.5 per cent.

 

Still, “core” prices — which strip out volatile items such as energy and food — climbed higher, led by an uptick in services inflation that Daly said showed little sign of moderating.

 

“This is why we don’t want to declare victory on inflation coming down,” she said. “We’re not near done yet.”
She continued:
“We have a lot of work to do. I just don’t want to do it so reactively that we find ourselves spoiling the labour market,” Daly said. She pushed back on rising investor expectations that the Fed will abruptly turn to cutting rates next year. “If we tip the economy over and [people] lose jobs, then we haven’t really made them better off.”

 

 

Market positioning

The Fed’s job of tightening monetary policy and financial conditions is complicated by the animal spirits of some market participants and capitulation by others. Numerous institutional surveys and data point to a high degree of risk aversion by institutional investors and hedge funds. The latest S&P Investment Manager Index shows that risk appetite is low and a bearish outlook on near-term US equities. Both Goldman Sachs and Morgan Stanley prime brokerage have also reported low levels and falling levels of risk exposure among hedge funds.

 

 

On the other hand, the retail Reddit YOLO stock traders are back and pumping up the shares of meme stocks.

 

 

As well, households have bought $5.9 trillion in equities over the past two years through Q1 2022. Historically, the past three major market bottoms have occurred after substantial household investor selling.

 

 

Marketwatch also reported that Citi’s global strategist Robert Buckland sounded a note of warning that sell-side analysts were becoming overly giddy, which is a worrisome sign in the face of a possible recession.
“Our index of global sell-side recommendations is back to peak bullishness levels reached in 2000 and 2007, after which global equities halved,” noted a team led by chief global equity strategist, Robert Buckland.

 

“Analysts are net buyers of every sector in every region, but then they usually are,” he said, noting specific concentration on U.S. and emerging markets. “They are still bullish on cyclical sectors suggesting few fears of oncoming global recession.”

 

In any case, that “analyst herding” has triggered a red flag in Citi’s bear market checklist, which has eased to 6 from a potential 18 flags. Note, this particular flag gave a false sell signal in 2012, when global stocks were flat for the following 12 months. But still, what happened in 2000 and 2007 makes it worth noting they say.
Institutions and hedge funds have thrown in the towel but retail investors and sell-side analysts are still partying. Sure, stock prices can squeeze higher from here, but do durable market bottoms look like this?

 

 

A narrow soft landing window

Much depends on whether the economy can avoid a recession. In a speech on May 30, 2022, Fed Governor Christopher Waller outlined a narrow window to achieve a soft landing without substantial damage to the jobs market. Waller highlighted the Beveridge Curve, which shows an inverse relationship between unemployment and the job vacancy rate. Waller noted a distinct anomaly between the Beveridge Curve data point in January 2019, which was before the onset of the pandemic, and the (then) latest data, March 2022.

These two dots suggest that the vacancy rate can be reduced substantially, from the current level to the January 2019 level, while still leaving the level of vacancies consistent with a strong labor market and with a low level of unemployment, such as we had in 2019.

 

 

What if the economy were to lower job vacancies by better matching jobs to job seekers? Waller asserted that “Matching efficiency represents factors that can increase (or decrease) job findings without changes in labor market tightness” and better matching as the pandemic era jobs rigidities fade can show the way.
The March 2022 observation lies at the top of the curve and is labeled point A. If there is cooling in aggregate demand spurred by monetary policy tightening that tempers labor demand, then vacancies should fall substantially. Suppose they decrease from the current level of 7 percent to 4.6 percent, the rate prevailing in January 2019, when the labor market was still quite strong. Then we should travel down the curve from point A to point B. The unemployment rate will increase, but only somewhat because labor demand is still strong—just not as strong—and because when the labor market is very tight, as it is now, vacancies generate relatively few hires. Indeed, hires per vacancy are currently at historically low levels. Thus, reducing vacancies from an extremely high level to a lower (but still strong) level has a relatively limited effect on hiring and on unemployment.

 

 

Former IMF Chief Economist Olivier Blanchard and former US Treasury Secretary Lawrence Summers pushed back against Waller’s narrative in a paper. They concluded that after every previous peak in job vacancies, unemployment rose as the vacancy rates fell. In other words, higher levels of vacancies will lead to a rise in unemployment.

 

 

Waller and Fed economist Andrew Figura responded with another paper and argued that the effects of the pandemic-related shutdown were so unprecedented that this time could indeed be different. In any case, the data should resolve the Beveridge Curve debate in the coming months. If Waller is right and the curve is steep, job vacancies should fall without substantial damage to the unemployment rate. On the other hand, if the historical evidence cited by Blanchard et al is right, tighter monetary policy will cause the unemployment rate to rise. An economic slowdown and probable recession will follow.

 

 

A likely re-test

Where does that leave us? I believe the most likely outcome will see the major market averages weaken and re-test of the June lows in the coming months. Much depends on the Fed’s reaction function. The market has already discounted a dovish pivot and any surprise is likely to be a hawkish one. 

 

Despite the “bear killer” price momentum model flashing a buy signal, I still have my reservations. A study of the record of another price momentum model, the Zweig Breadth Thrust buy signal, is instructive. The model is a price momentum model that showed only six buy out-of-sample buy signals since Marty Zweig wrote about it in 1986. While the market was up a year later in all cases, the two “failures” in 2004 and 2015 occurred when the S&P 500 didn’t immediately rise further and traded sideways. The macro backdrop was an environment of the Fed tightening monetary policy, which corresponds to the conditions today. The monetary policy backdrop is especially important in light of the previous analysis showing that past periods of major market downdrafts has always seen the St. Louis Fed Financial Stress Index rise above zero, which it hasn’t done yet.

 

 

For the contrary view, I turn to Walter Deemer‘s canary in the coal mine using the UK stock market as a risk appetite barometer: “The Bank of England hiked their inflation rate-peak forecast to 13%. It also now expects the economy to be in recession for more than four quarters starting this fall. These are far dire forecasts than three months ago.” If UK equities can shrug off the grim outlook, it would have bullish implications for global risk appetite.

 

I point out that the FTSE 100 consists of global companies, it is heavily weighted in resource and energy stocks and it’s not reflective of the UK economy. The midcap FTSE 250 is a better barometer of market expectations for the UK. So far, the FTSE 250 looks like it’s trying to form a bottom, but investors will have to wait for better price action before turning overly bullish as it’s failed to achieve the same kind of upside breakout seen in the S&P 500.

 

 

 

A useful step, but where`s the clear and convincing evidence?

Posted by Cam Hui -

Mid-week market update: The markets took on a risk-on tone in the wake of the softer than expected CPI report. It was a useful first step and a possible sign that inflation is peaking, but I am still waiting for the “clear and convincing evidence” that inflation is under control before getting overly excited about the stock market. Managing monetary policy is like steering a supertanker. Changes happen very slowly and market sentiment may be getting ahead of itself.
 

 

 

A constructive CPI report

The good news is all CPI metrics came in below expectations. The bad news is both median CPI and sticky price CPI are above core CPI, indicating persistent inflationary pressures. Fed Chair Jerome Powell has stated that he is looking for “clear and convincing evidence” that inflation is moving towards the Fed’s 2% objective. This was a constructive first step, but hardly “clear and convincing evidence” of deceleration.

 

 

As a reminder, the Fed has already penciled in a deceleration in inflation pressures by year-end in its June Summary of Economic Projections (SEP). However, the SEP, which Powell said is still the valid forecast at the last FOMC press conference, has a 3.4% median Fed Funds rate at year-end.

 

 

Getting inflation down to the 4% level will be a useful first step, but can inflation fall to the Fed’s 2% target? According to the Atlanta Fed, wage growth is showing signs of acceleration.

 

 

Maybe it`s me, but isn`t weird that the markets are giddy over a 8.5% inflation print?

 

 

An ambitious market reaction

The bond market responded by steepening the Treasury yield curve as short rates fell dramatically, but the long-end response was muted and the 30-year rate marginally rose. Fed Funds futures are now discounting a 50 bps hike at the September meeting (from 75 bps) and rate cuts by next June. Those expectations may be overly ambitious in light of Powell’s “clear and convincing evidence” criteria.

 

 

The S&P 500 and Russell 2000 staged upside breakouts through resistance, though the midcap S&P 400 is still testing resistance. However, the VIX Index has fallen below its lower Bollinger Band, which would be a signal of an overbought condition.

 

 

Meanwhile, NDR’s Daily Trading Sentiment Composite has moved into a crowded long reading, which is contrarian bearish.

 

 

In short, the markets are front-running the Fed and playing with fire. Financial conditions are loosening and not tightening, which is contrary to the Fed’s current intentions. While the consensus may be shifting about the Fed’s actions next year, there is no disagreement that the Fed’s next step is to tighten monetary policy.

 

When the animal spirits run, it’s unclear how far the markets can advance. Enjoy the party, but this is a rally that should be sold into and not bought. 

 

We will see the PPI report tomorrow. Expect a wild ride in the coming days.

 

The overlooked reason why the market is so strong

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

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

 

Defying gravity

Why is the stock market holding up so well? What happened to all the warnings from the Fed? One speaker after another warned that the Fed is nowhere near a dovish pivot. CNN reported that former New York Fed President Bill Dudley issued a similar warning that rising stock prices translate into even more rate hikes:

 

Dudley added that another rate hike of three-quarters of a percentage point is still “potentially in play,” depending on how the economy evolves. He expects the Fed will need to raise interest rates to 4% or higher — up from 2.5% today…

 

Dudley warned that the uptick in the stock market may be counterproductive because it translates to easier financial conditions. And that’s exactly the opposite of what the Fed wants as it tries to tame inflation.

 

“Ironically,” Dudley said, “the big rally in financial markets increases pressure on the Fed to do more.”
Wall Street shrugged off the Fed’s warnings and Friday’s hot jobs report. The S&P 500 is testing a key resistance level, and the NASDAQ 100 blew past resistance and it is now approaching a key falling trend line.

 

 

 

Why is the market defying gravity?

 

 

The bear case

The bear case is easy to make. I have already outlined the warnings from Fed officials. Despite the strong rally off the June bottom, net NYSE and NASDAQ new highs have not turned convincingly positive.

 

 

NASDAQ 100 stocks have been the leaders in the latest advance, but on balance volume, which measures net accumulation and distribution, is exhibiting a negative divergence.

 

 

John Authers at Bloomberg reported that Jason Goepfert of SentimenTrader is warning his Dumb Money Indicator is flashing a sell signal.

 

This threshold generally serves as a good delineator between healthy and unhealthy markets. During persistent bull markets, the model consistently levitates above 60%. When it stays below 60% consistently, sentiment is poor and periods of recovery tend to bring in sellers.”

 

The chart above shows that Dumb Money Confidence loosely tracks the S&P 500. When the market is going well, the dumb money gets more bullish and vice versa. The last couple of times it significantly rose, it quickly peaked and equities turned as well. That implies that the next down leg is imminent. So far this year, as the chart below shows, Dumb Money Confidence has continued to tend to chase the S&P, and the 60% barrier has twice acted as a point at which the market turns down (bringing traders’ confidence with it):

 

 

Earnings estimates are falling

In addition, forward 12-month EPS are falling and the forward P/E valuation is no longer compelling. Q2 earnings season is subpar as measured by EPS beats but slightly above average on sales beats. Perhaps one reason why the market has acted well is forward guidance is better than average.

 

 

Nevertheless, it’s disconcerting to see negative EPS revisions across all time horizons.

 

 

 

The bull case

Here is the bull case. Hedge funds are still pressing their short bets in S&P 500 futures and positioning rivals the COVID Crash bottom levels of 2020. The crowded short reading should act to put a floor on prices should the market weaken.

 

 

Price momentum (bottom panel) is very strong. Past episodes of strong momentum in the last 20 years have resolved bullishly. The only exception was last March (pink vertical line) when the 5-week RSI failed to reach an overbought condition. Keep an eye on this indicator, if RSI were to become overbought a new bull is confirmed.

 

 

All the talk of sentiment and momentum aside, the overlooked reason for price strength is the market may be sniffing out disinflation. The S&P 500 has been inversely correlated with oil prices, and WTI fell below $90 last week, which is a level not seen since the Russia-Ukraine war began.

 

 

Tactically, the S&P 500 is following the FOMC pattern of 2022, when the market rallied in the wake of an FOMC meeting. In the past, the peak has occurred 1-2 weeks after the meeting. If history is any guide, that should put the timing of the peak about now.

 

 

My base case scenario continues to call for a re-test of the June lows, but I allow that there is about a one-third chance the market is undergoing a V-shaped bottom. The coming days should bring more clarity from the market. 

 

Stay tuned.

 

Why this isn’t your father’s recession (and how to profit from it)

Posted by Cam Hui -

There is a growing acceptance among investors that the global economy is sliding into recession. S&P Global, which was formerly known as IHS Markit, reported:
 

The global manufacturing PMI survey’s Output Index, which acts as a reliable advance indicator of actual worldwide output trends several months ahead of comparable official data (see chart 2), signaled stalled production in July. The stagnation signals a faltering of the global production rebound seen in June from two months of contraction in April and May.

 

The conventional view suggests a synchronized global recession. The more nuanced view is the world is undergoing a rolling recession, which offers more opportunities for investors.

 

 

A rolling recession

A more detailed analysis of the new orders component of manufacturing PMI shows that not all regions are the same. In particular, new orders in the eurozone have been the worst, while Asia ex-Japan and China have performed the best. In other words, it’s a rolling recession as economic weakness rolls from one region to the next. Investors should position themselves accordingly.

 

 

With that preface, I will examine the outlooks for the three major global trade blocs, Europe, China, and the US.

 

 

Eurozone: Recession leader

Staring in Europe, the eurozone manufacturing PMI has turned sharply lower, indicating an almost inevitable recession.

 

 

The weakness is also reflected in the Citigroup Eurozone Economic Surprise Index, which measures whether economic indicators are beating or missing expectations.

 

 

There are two explanations for economic weakness in the eurozone, as shown by the eurozone trade balance. The more obvious reason is rising energy costs as a result of the Russia-Ukraine war. But the trade balance in the non-energy sector has been plunging as well. The reason is weakness in China.

 

 

 

A slump in China

An analysis of the Chinese economy reveals a broad picture of softness. Its trade balance with Germany and Korea, which export capital equipment to China, is in deficit, indicating weakness in manufacturing and exports. 

 

 

China is beset by the triple whammy of property market troubles, falling consumer confidence, and a lack of stimulus. Shehzad Qazi of China Beige Book International, which monitors the Chinese economy on a bottom-up basis, stated in a CNBC interview that he is seeing widespread weakness and the country’s manufacturing, services, and retail sectors are all struggling.
 

Evergrande failed to deliver a promised US$300 billion restructuring plan last week, which caused further loss of confidence in China’s property sector. Developers are facing a liquidity crunch and high leverage ratios. Half-built and incomplete projects are leading to a mortgage boycott groundswell, which is feeding into a negative feedback loop as suppliers to property developers are in turn facing liquidity problems. Bloomberg reported that Chinese banks may face up to $350 billion in loan losses from the property crisis – and that figure doesn’t include the non-bank financing that developers tapped from the shadow banking system.

 

 

As Chinese developers encounter a cash crunch, the overdue accounts of their suppliers are growing, which is creating a domino effect and negative feedback loop for the economy.

 

 

In addition, China’s zero-COVID lockdowns have shaken consumer confidence, which is also leading to the malaise in the labor market as employers are hesitant to hire in an uncertain and weak environment. Shehzad Qazi of China Beige Book International recently testified before the U.S.-China Economic and Security Review Commission. He had a sobering outlook for China’s zero-COVID policy and forecasted that it’s here to stay for some time.
 

At this point it can be reasonably assumed, that China’s zero-COVID policy is here to stay until the country has access to mRNA vaccines with high efficacy rates and is also able to vaccinate a vast majority of its population, especially the elderly. This pushes any lifting of zero-COVID as it is implemented today well into 2023 if not beyond.

 

This then suggests that the Chinese economy will remain under pressure for the foreseeable
future as new virus outbreaks emerge and lockdowns go into effect, especially in more economically developed regions. Furthermore, it paints an especially concerning picture for the services and retail sectors of the Chinese economy which have suffered the most from lockdowns. This, of course, has long-term consequences as it will only push any rebalancing to a consumption-driven economy further into the future.

 

 

In the past, Beijing has stepped in with new stimulus whenever the economic outlook has skidded this badly. However, the July Politburo meeting offered little relief. Officials affirmed that the zero-COVID policy takes priority over growth imperatives. Policy makers indicated that they will stay their current course and not look to ramp up policy support. 

 

Current economic operations are facing some prominent contradictions and problems. We should maintain strategic concentration and firmly do our own work.
Officials made it clear that COVID policy tops the agenda as pandemic containment is the pre-condition to stable economic growth: “When an outbreak occurs, we must immediately and strictly prevent and control it.” In short, senior officials offered no new ideas for economic management in the second half of the year and no initiative that hasn’t already been telegraphed:
  • Boosting infrastructure investment through special purpose bonds issued by provincial authorities and supplemented by policy bank credit.
  • A continued focus on risk, which further limits stimulus programs.
  • An acknowledgment that there is a need to ensure housing is delivered in reaction to recent mortgage boycotts.
The WSJ reports that tension is growing between the central government and regional authorities. Regional governments are becoming increasingly growth constrained and their finances are shaky as the source of funds has been land sales in the past. As Bejing increases its focus on risk control, it is creating a credit crunch for local governments.
 

China’s property market slowdown and strains from the country’s zero-Covid-19 campaign are putting new pressure on local governments’ finances, forcing some to rein in spending, adding another drag on China’s weakened economy.

 

Local governments, which shoulder much of the expense for education, healthcare and other services in China, were already struggling with high debt loads and unsustainable expenses as 2022 began.

 

Now the strains are getting worse. Cities must fund costly mass Covid testing programs imposed by Beijing to try to keep Covid-19 caseloads near zero. They are also being asked by Beijing to support stimulus meant to revive growth, including tens of billions of dollars’ worth of railways and other infrastructure projects.

 

Is China in a recession? It’s a close call. The Fathom China Momentum Indicator has fallen to 0.2%, indicating extremely grim growth conditions.

 

 

While the initial read of the manufacturing PMI of Asia ex-Japan and China was one of the bright spots, investors shouldn’t interpret that in an overly positive way. When China sneezes, the rest of the region catches a cold. Already, the manufacturing PMI of cyclical bellwether South Korea slumped into contraction territory in July.

 

 

Recession in America?

Across the Pacific, America isn’t in recession despite two consecutive quarters of negative GDP print. Ryan Detrick pointed out that NBER, which is the committee that is the ultimate arbiter of recessions, focuses on six metrics: nonfarm payrolls, household survey, real personal income (less transfers), real PCE, industrial production, and real manufacturing. Five of the six are positive on a YTD basis, indicating there is no recession. That’s the good news.

 

The bad news is the economy is weak and sliding into recession. New Deal democrat, who maintains a disciplined process of recession forecasting with a set of coincident, short-leading, and long-leading indicators, recently conceded that a recession in Q1 is almost a certainty.
 

The long leading forecast continued to be negative, despite even more resilient corporate profits. My “Recession Watch” start time of Q1 of next year continues. The short term forecast also remains negative, as initial jobless claims and the regional Fed new orders indexes continue to trend more or to remain negative.
NDD did leave the door open for a soft landing:

 

Hopes for a “soft landing” must rely on the possibility that gas prices will decline further enough fast enough to make a big dent in inflation, assisting consumer spending, and perhaps making the Fed pause, as otherwise all the signs point to recession soon, with only the start time – and the intensity – open to discussion.
Joe Wiesenthal at Bloomberg also cited some encouraging signs of a soft landing.
  • Housing may already be stabilizing a little bit after the initial mortgage-rate shock
  • Yesterday we got an ISM Services reading showing an unexpected gain in July
  • June durable-goods orders also came in better than expected
  • ISM Manufacturing index came in better than expected as well. And not only that, there was a major drop in the prices paid index.
  • Gas prices have fallen for 50 straight days.
  • Earnings have been decent, not amazing, but no widespread signs that the bottom is falling out of demand. Yesterday, Booking Holdings, the online travel company, warned of some softness out there, but it noted that North America was holding up the best of all regions.
However, the Fed has embarked on a concerted push to convince the markets that it is not on the verge of a dovish pivot. It flooded the speaker circuit with a variety of interviews and speeches by Fed regional presidents, beginning with Minneapolis Fed President Neel Kashkari, who is regarded as a dove. In a NY Times interview, Kashkari said officials are a long way from backing off the inflation fight. San Francisco Fed President Mary Daly, another dove, told a Reuters Twitter Space that the neutral rate won’t be reached until about 3.1%. And it will need to be restrictive. St. Louis Fed President James Bullard, a hawk, said he favored a Fed Funds rate of 3.75-4.00% by the end of 2022.

 

The strong July Jobs Report cemented the expectations of a hawkish Fed. Non-Farm Payroll came in at 528K (250K expected). Average hourly earnings rose 0.5% for the month (0.3% expected), and the unemployment rate fell from 3.6% to 3.5% (3.6% expected). These figures are all above expectations indicating a strong economy and room for the Fed to take more aggressive steps to tighten monetary policy.

 

My base case calls for the US to enter a recession in early 2023.

 

 

Investment implications

What does this all mean for investors? The conventional recession trade is to buy USD assets, with Treasury assets as the safe haven. A better way might be to buy JPY assets. The BoJ has bucked the global trend with a continued easy monetary policy while all other major central banks have tightened, which has caused incredible weakness in the JPY. If the world goes into recession, global central banks will be moving towards BoJ policy and not the other way around. This form of reverse policy convergence will put strong upward pressure on the JPY exchange rate.

 

For investors with equity holdings, regional rotation will be the name of the game. Investors will have to consider the tension between valuation and price momentum. The accompanying chart shows the relative performance of regional markets relative to the MSCI All-Country World Index (ACWI). The US is the market leader, and the NASDAQ 100 has been the standout since early June. Japan has gone sideways while Europe, China, and other EM have been weak.

 

 

Valuation, as measured by forward P/E, tells a different story. The US is the outlier and highly valued relative to the other markets, whose forward P/E ratios are all clustered together.

 

 

Here is how I would approach rotation among the global regions.
  • Overweight the US: It’s not in a recession yet and it’s the relative strength leadership. But don’t be overly complacent. Analysis from Ned Davis Research indicates that if a recession is on the horizon, the market is likely to re-test the June lows.

 

  • Wait for Europe to turn: There is a reason why some markets are cheap. Europe is probably already in recession, but the markets may have already discounted the region’s anemic growth outlook. However, European equities present strong upside potential. Wait for a turn in relative strength and rotate from the US to Europe. The relative performance of MSCI Poland (bottom two panels) may serve as a useful barometer of geopolitical risk, which could be a buy signal for the region if risk premium fades.

 

  • Avoid China and Asia: China is the wildcard. Investors should wait for greater policy clarity from Beijing before committing funds to the region.

 

What’s “Black Swan” in Chinese?

Posted by Cam Hui -

Mid-week market update: Here we go again. Just when you thought world events were under control, House Speaker Nancy Pelosi’s visit to Taiwan raised the geopolitical risk premium.
 

 

And just as I predicted on the weekend (see In what world is fighting the Fed a good idea?), we’ve had a cacophony of Fed officials pushing back on market expectations of an imminent pause in rate hikes. Bond yields spiked in response.

 

Here is what I am watching.

 

 

A measured response

As the world watched Pelosi’s aircraft approach Taiwan, former Global Times editor Hu Xijin suggested that China would intercept her plane and force it to land elsewhere, which would have caused an international incident. Fortunately, the intercept never occurred. While the Chinese registered their protests over the Pelosi visit and promised a forceful response, the response was highly measured and World War III didn’t begin.

 

Instead, China announced a number of trade sanctions and a series of military exercises, with life-fire exclusion zones around the island of Taiwan reminiscent of the Third Taiwan Strait Crisis. It was a signal that China could effectively blockade Taiwan without an actual invasion. The good news for investors is the markets shrugged off the Third Taiwan Crisis in 1996, the bad news is that crisis didn’t occur when the Chinese and global economy were undergoing a soft patch which makes markets vulnerable to risk-off episodes.

 

 

It appears that both the Pentagon and PLA have been in close contact with each other during the current episode, which reduces the risk of a mistake that could unnecessarily spiral into unintended hostilities. For investors, this is good news as a hot war would disrupt semiconductor production that would snarl supply chains all over the world.

 

 

A failed H&S breakdown

On the monetary policy front, a flood of Fed officials pushed back against market expectations of a dovish pivot. The tables below show how Fed Funds expectations have changed, before the FOMC meeting, just after the meeting, and where they are today. After the meeting, the market began to discount a brief peak in the Fed Funds rate that begins in late 2022, with easing to begin by March 2023. After yesterday’s and today’s Fed speakers:
  • The market now expects a 75 bp hike at the September FOMC meeting, instead of 50 bp;
  • Peak Fed Funds had risen 25 bp to 350-375 bp; and
  • Expected easing returned to June 2023, which was the same as expectations before the July FOMC meeting. 

 

 

I previously highlighted a possible head and shoulders breakdown in Treasury yields. While the 10-year Treasury yield did break the neckline, yesterday’s Fed guidance pushed yields back above the neckline. For chartists, there is nothing worse than a failed breakout or breakdown.

 

 

Bond bulls have one last chance this week in the form of the July Jobs Report. The June JOLTS report shows that both job openings and quits fell, indicating labor market weakness.

 

 

Initial jobless claims also show a pattern of softness in the labor market.

 

 

The market consensus calls for NFP to come in at 250K, down from 372K in June. NFP has printed four consecutive upside surprises so far. A fifth positive surprise would put the final nail on the coffin of the bond bulls, a miss would be consistent with the recent pattern of economic weakness.

 

 

What’s holding up equities?

I observed on the weekend that the S&P 500 had been going on an upper Bollinger Band ride, which may be continuing. However, the index is in the process of testing a key 50% retracement resistance level.

 

 

What’s holding up the market?

 

One clue is a less bad earnings season. With 320 components of the S&P 500 reported, the EPS beat rate is 75% (5-year average 77%) and the sales beat rate is 66% (5-year average 69%). While beat rates are below par, they appear to be less than expected going into Q2 earnings season. The good news is earnings results validated that the economy isn’t in a recession. The bad news is forward 12-month EPS estimates are falling, which is a worrisome development.

 

 

FactSet’s earnings update, based on last Thursday’s data, showed that analysts were downgrading EPS estimates for every quarter except for Q2, which makes valuation more challenging.

 

 

The combination of nearby overhead resistance and growing valuation challenges leads me to believe that the S&P 500 is likely to undergo some choppiness in the coming weeks. The market underwent a breadth wipeout in mid-June and recovered. I am waiting for the percentage of S&P 500 stocks to rise above 90% to sound the all-clear, which hasn’t happened yet. There have been seven similar episodes in the last 20 years. The shortest period between the breadth wipeout and the all-clear signal was two months (2019) and the longest was nine months (2003). The market made a V-shaped bottom on two occasions and re-tested the old lows on the other five. The re-tests were all accomplished with positive 14-day RSI divergences.

 

 

The odds favor a re-test. That’s why my base case scenario calls for a period of sideways consolidation and choppiness. The market is short-term overbought. Wait for the pullback.

 

My inner investor is neutrally positioned. My inner trader is on the sidelines as he waits for a better opportunity.

 

How a war of conquest has become a contest of pain

Posted by Cam Hui -

I received considerable feedback from readers in response to my publication, Bearishness, begone!. They expressed concern over the terrifying spike in European natural gas prices. In response to the EU’s support for Ukraine, Russia has weaponized its energy exports. Gazprom has already reduced Nord Stream 1 gas flows to 20% of capacity. What happens this winter? What are the consequences for the region’s economy? How will the ECB cope in light of inflationary pressures from rising energy prices?
 

 

The root of the surge in energy prices is the Russia-Ukraine war. In response to the aforementioned questions, I discuss:
  • The state of the battlefield and its outlook;
  • The hybrid war beyond the battlefield; and
  • The contest of pain between Russia and the West.

 

 

A battle of exhaustion

The relative position of each side ultimately depends on what happens on the battlefield. The Russia-Ukraine war, which was originally conceived by Moscow as a quick Blitzkrieg to conquer Ukraine, has turned into a World War I style battle of exhaustion. After a failed assault on Kyiv, Moscow pivoted to focusing on taking ground in the Donbas by concentrating its troops in that region. While Russian forces has had some success, the advances were minuscule World War I style victories. The Pentagon put the Russian victories into context by stating that, in the space of about four months, Russian advances amounted to 4-10 miles, or 7-16 km, while suffering grievous losses of personnel.

 

The NY Times reported that American intelligence estimates Russian losses to be more than 75,000 dead and wounded. Britain’s MI6 concurs with that assessment. The loss estimate is astounding when you consider that the initial Russian invasion force was about 180,000 troops, not all of which were combat formations.

 

Russia has tried to replace the losses in a number of ways, such as mandatory conscription in the breakaway Republics, the use of mercenaries such as the Wagner Group and Chechens, and the formation of new brigades by offering lavish signing bonuses and salaries in the more isolated and poorer regions of Russia. There are several challenges in forming new units. First, how well will they be trained and who will train them? Most of the officer corp has already been committed to the front lines. There are unconfirmed reports that some soldiers are being rushed into combat with as little as 1-4 weeks of training, which is just enough to train someone to handle a weapon. Artillery troops are rumored to have as little as 2-3 days of training. (see Twitter thread)

 

As well, what equipment will the new troops have? There are reports that the Russians are resorting to 70’s era tanks and fighting vehicles for the new troops. At best, the new troops can hold ground but they will be hard pressed to effectively conduct offensive operations.

 

Ukrainian losses are more difficult to compile, but they are considerable. In a War on the Rocks podcast, Michael Kofman of CNA’s Russia team said that Ukraine concentrated its best and most experienced troops in the Donbas region, which it defended well. It can only muster about five experienced brigades for a counterattack. The rest of Ukraine’s forces are mostly territorial army units with little experience and can only hold ground. Trapped Ion compiled a list of Ukrainian brigades and concluded, “There truly is no ‘reserve’ army. At best, there are a few brigades that can be used for offensive action and rotation. Ukraine is throwing in what they got. There has already been a ton of rotation and many units are absolutely mauled…I truly believe Ukraine only has enough reserves for one major counteroffensive.”

 

 

Ukraine’s Kherson offensive

Here is my assessment of the battlefield. The long-range artillery provided by the US and other NATO countries has turned the tide. The Ukrainians have used them effectively attack the weakest physical support systems of the Russian forces, namely communications networks, logistic supply routes, artillery, and command posts. The Russian offensive advantage rests on massive artillery barrages and, with the loss of the supply depots and ammunition, the artillery strikes have greatly diminished.

 

The Russian Donbas offensive is stalled. The Ukrainians are preparing for a counterattack in the south with a focus on the Kherson region. Kherson is important for a number of reasons. The city lies just west of the Dnipro River and it’s a Black Sea port. Retaking Kherson will show that Ukraine can show some success on the battlefield, and thwart Russia’s stated plan to annex the region by holding a September referendum. More importantly, Kherson Oblast controls Crimea’s water supply.

 

In the battle for Kherson, Ukrainian artillery has taken out two major bridges across the Dnipro river, which leaves the Russian army on the west side of the river isolated. While Russians have laid a pontoon bridge adjacent to the destroyed rail crossing, supplies are only trickling in. Russian forces are being starved of food, ammunition, and fuel.

 

 

Phillips O’Brien, professor of strategic studies at St. Andrews University, assesses that the Russian offensive is stalled because of a lack of artillery ammunition from Ukraine’s effective use of long-range artillery to interdict ammunition supply. Ukrainian forces are making probing attacks against the isolated Russian forces west of the Dnipro:

 

The Ukrainians seem to be carving the Kherson front into separate districts for the Russians, which will have huge difficulties supporting each other. This is why they have been cutting the bridges over the Dnipr river, but also the rivers dividing the areas on the west bank. Having made these areas non-supporting, and also reduced Russian ranged fires, they are now probing it for weaknesses without taking massive risks. Its not glamorous, but its smart. They seem to be sending small units to find weak points. So while the Ukrainians seem to be advancing in Kherson about as slowly as the Russians advanced in the Donbas, they are doing is far more intelligently. 1) they are not risking suffering major losses. 2) They are doing it not just by blasting the land in front of them that they want to take (making their plans obvious) but by severely hampering Russian abilities to fight back through the logistics and command/control attacks.

If Ukraine is successful in its Kherson counteroffensive, it will be a major victory for Kyiv, both on the battlefield and strategically. Make no mistake, the Kherson counterattack may be the last attack by Ukrainian forces. Both sides are exhausted. The war is resolving into a World War I style stalemate.

 

 

The hybrid war

Some defense analysts are already forecasting a frozen conflict in the manner of the Donbas in 2014, as well as the ones in Tranistria, Nagorno-Karabakh, South Ossetia, Abkhazia, and Crimea. However, the war extends well beyond the actual battlefield. The West has already imposed a series of sanctions on Russia. Russia, in return, is using energy and food as weapons against the West.

 

In particular, the EU faces the prospect of a Russian gas cutoff, a cold winter, and a recession. I already pointed out that the European Commission has estimated that a full cutoff of Russian gas during an average winter could reduce the EU’s GDP by 0.6-1% if no action is taken in advance to conserve energy. In a cold winter, a cutoff without preparation could lower GDP by an average of 0.9-1.5%. The IMF also modeled the effects of a Russian gas cutoff. Its effects would depend on two assumptions: “An integrated-market approach that assumes gas can get where it is needed, and prices adjust…[or] a fragmented-market approach that is best used when the gas cannot go where needed no matter how much prices rise.” The magnitude of effects of the IMF model are broadly similar to the European Commission’s model.

 

 

However, , a research paper by Sonnenfeld et al at Yale found that sanctions are crippling the Russian economy. The risk/reward for Europe is asymmetric. Russia is more dependent on Europe for natural gas exports than vice versa.

 

 

Russia faces steep challenges executing a “pivot to Asia” in commodity exports.

 

 

Russian imports have largely collapsed, and the country faces stark challenges securing crucial inputs, parts and technology from hesitant trade partners.

 

 

Russian domestic production has come to a complete standstill because of sanctions. Reports that Russia is in discussion to buy Iranian UAVs, or drones, is testament to Russian industrial capability.

 

 

Inflation is rising, especially in sectors dependent on foreign inputs.

 

 

In short, the Russian economy is collapsing.

 

 

Even the foreign reserve account is falling in spite of the spike in energy prices.

 

 

In summary, while a gas embargo will cost the EU up to -1.5% of GDP growth, which will be painful, the Russian economy is undergoing a post-Soviet-style collapse. The scenario of a frozen conflict by military analysts, while theoretically possible, is unlikely. The war has become a contest of which side is willing to bear more pain. If Russia has to continue to endure sanctions and an economic collapse, Putin faces the rising risk of political instability because of the tanking economy. This analysis by Kamil Galeev of Russian losses indicates that the Russian military is mainly recruiting in the less populated and poorer regions. It also explains why Putin has labeled the conflict a “special military operation” instead of a war. A war would triggers mobilization and conscription, and there would be far more casualties among the Moscow and St. Petersberg elite, which would be politically expensive. His only hope is to engineer sufficient pain in the West and to try to influence upcoming elections, such as in Italy and the US midterms, to effect changes in government policy that are more friendly to Moscow.

 

 

Which side can bear more pain? When both sides eventually reach the negotiation table, which will hold the better hand? The recent cover of The Economist may hold some clues as a contrarian magazine cover indicator. I recently observed that stock prices are inversely correlated to oil prices. If the war is resolved and energy prices slide, the stock market could rocket upwards.

 

 

Stay tuned.