In what world is fighting the Fed a good idea?

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 (upgrade)
  • 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.
 

 

A dovish tone?

There were few substantial surprises from last week’s FOMC decision. However, the market interpreted Powell’s statements as slightly dovish. As a consequence, Fed Funds futures began to discount a pause in late 2022 and easing by March 2023, which is a significant change from the expectations before the meeting announcement.

 

 

Fed Chair Jerome Powell referred to the June Summary of Economic Projections, or dot plot, in the post-FOMC press conference as “probably the best estimate of where the Committee’s thinking is still”. The Daily Shot pointed out that the market is massively fighting against the dot plot, which is “a trajectory that looks too dovish, given the broad and entrenched inflationary pressures”.
 

 

In case you missed it, Powell slammed the door on a dovish pivot during the press conference, even if the economy were to fall into recession.

 

STEVE LIESMAN. The question was whether you see a recession coming and how you might or might not change policy. 

 

CHAIR POWELL. So, we’re going to be– again, we’re going to be focused on getting inflation back down. And we– as I’ve said on other occasions, price stability is really the bedrock of the economy. And nothing works in the economy without price stability. 
The Fed appears to already be starting a campaign to correct market perceptions. The NY Times reported that Minneapolis Fed President Neel Kashkari pushed back on market expectations of a dovish Fed pivot.

 

Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, suggested on Friday that markets had gotten ahead of themselves in anticipating that the central bank — which has been raising interest rates swiftly this year — would soon begin to back off.

 

“I’m surprised by markets’ interpretation,” Mr. Kashkari said in an interview. “The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”

 

“I don’t know what the bond market is looking at in reaching that conclusion,” Mr. Kashkari said, adding that the bar would be “very, very high” to lower rates.

 

In what world does anyone think that massively fighting the Fed is a good idea?

 

 

The bull case

To be sure, a bull case can be made. From a technical perspective, the bulls will argue that the S&P 500 is going on an upper Bollinger Band ride, with the 5-day RSI exhibiting a series of “good overbought” readings, with initial resistance at the 4150-4170 zone. However, the VIX Index closed Friday below its Bollinger Band, indicating an overbought market condition and flashed the warning the sign of a possible short-term top.

 

 

Price momentum is strong and it’s hard to argue with success. Ed Clissold at Ned Davis Research pointed out that the market flashed two breadth thrust signal last week and such instances have tended to resolve in bullish manners. The first saw 10-day advances/10-day declines rose above 1.9.

 

 

The second saw the percentage of S&P 500 stocks at 20-day highs rise to 55%.

 

 

Sentiment readings are normalizing after a period of bearish excess. The Investors Intelligence bull-bear spread turned positive after several weeks in negative territory. Such conditions are typically signs that a sustained relief rally is underway.

 

 

 

The bear case

From an intermediate-term perspective, the most worrisome aspect of the current market advance is the lack of retail capitulation. While institutional and hedge fund sentiment is washed out, (see  Revealed, the secret lives of corporate insiders), retail investors are still moderately bullish on equities. 

 

Mark Hulbert, who has been a long time tracker of newsletter sentiment, also believes that the market needs a final washout. He advised in a recent Marketwatch column, “Be on the lookout for the final two stages of bear market grief — depression and acceptance — before a major new bull market can begin.”

 

A recent BoA survey of private clients reveals that while equity allocations have retreated from all-time highs, readings are nowhere near panic levels.

 

 

A survey of Schwab client cash shows that while cash levels have risen, readings are also far from levels seen at past major market lows. 

 

 

The breadth thrusts recorded last week were accomplished with less than impressive up volume, which barely exceeded 80% on one of the days. Shouldn’t breadth thrusts, which are buying panics, be occurring on better enthusiasm? On Balance Volume, which measures accumulation and distribution, is indicating a lack of participation on this rally, or distribution, similar to the failed rally in March. As well, while net new highs (bottom two panels) are trending up, the lack of net new highs is another sign of poor breadth. While OBV divergences and negative breadth are not immediate and actionable sell signals, they nevertheless are warning of an unsustainable advance.

 

 

Market seasonality could also provide some headwinds for equity returns. Jay Kaeppel at SentimenTrader observed that the S&P 500 Index has registered a net loss for the months of August and September during midterm election years.

 

 

Tactically, Jeff Hirsch at Almanac Trader pointed out that “the first eight or nine trading days [of August] have historically been weak with the major indexes shedding around 0.4% to 1.2%”, followed by some up-and-down volatility for the remainder of the month.

 

 

As well, House Speak Nancy Pelosi’s scheduled trip to Taiwan in early August has the potential to raise geopolitical tensions and spark an unwelcome risk-off event.

 

 

Clues from cross-asset analysis

Where does that leave us? This is an occasion where cross-asset, or inter-market, analysis can provide some clues. Here is what I am watching as indicators of risk appetite.

 

The 10-year and 30-year Treasury yields may be in the process of forming a head and shoulders pattern, but as good chartists know, such formations are incomplete until the neckline definitively breaks. If they both break in convincing manners, bond prices will rip.

 

 

As well, oil prices have also shown a strong long-term correlation to the 10-year Treasury yield. If bond yields break, look for confirmation from oil prices.

 

 

In the current environment of hyper-sensitivity over headline inflation, the S&P 500 has exhibited an inverse correlation to energy prices but they are currently exhibiting a minor negative divergence.
 

 

In conclusion, asset markets have gone risk-on in the wake of the FOMC meeting, but the market may be getting ahead of itself. The stock price advance has begun to take on a FOMO tone and could run further, but risk levels are rising. The Treasury and energy markets could be the guide to changes in risk appetite. If geopolitical tensions don’t fade and oil prices stay elevated, it will be difficult for stock prices to rise, bond yields to decline, and, by implication, for the Fed to pause or reverse its tight monetary policy.

 

Bearishness begone!

Posted by Cam Hui -

The returns of my Trend Asset Allocation Model have been strong. Based on an “out of sample” record of signals from 2013 and a simulated portfolio that varies up to +/- 20% from a 60/40 benchmark, the model portfolio has managed to achieve equity-like returns with 60/40-like risk. Performance has also been consistently positive in the shorter time frames (to July 26, 2022).

  • 1 year: Model portfolio -8.1% vs. 60/40 -9.8%
  • 2 years: Model portfolio 7.1% vs. 60/40 4.2%
  • 3 years: Model portfolio 10.2% vs. 60/40 7.1%
  • 5 years: Model portfolio 10.9% vs. 60/40 7.8%

 

 

The Trend Model turned neutral from bullish in January 2022 and turned bearish in March. Amidst all the gloom about a global recession, it’s time to become more constructive on equities. The signal has been upgraded to neutral from bearish.
 

Here’s why.

 

 

A trip around the world

I turned more constructive on equities in late June based on conventional technical analysis techniques (see Why last week may have been THE BOTTOM), but trend-following models are not designed to spot exact tops and bottoms, only trends. They will always be late to buy and late to sell. That’s a feature, not a bug.

 

My Trend Asset Allocation Model applies trend-following techniques to a variety of equity and commodity markets around the world to form a composite score to determine whether the global economy is reflating or deflating. A reflating economy is equity bullish and a deflating economy is bearish. With that preface in mind, let’s take a quick tour around to world to see how market perceptions have changed.

 

Starting with commodity prices, the energy-heavy Invesco-DB Commodity Index is holding between its 50 and 200 dma, which is a neutral signal, while the equal-weighted index is below both, a bearish signal. The cyclically sensitive copper/gold and base metal/gold ratios are in downtrends, which are deflationary signals. I interpret these conditions to be generally deflationary and negative for global growth. Commodities represent the weakest component of the Trend Model.

 

 

Over in the US equity markets, the S&P 500 has managed to regain its 50 dma while trading below its falling 200 dma. A falling moving average such as the 200 dma is usually interpreted as a bear trend, though the rally above the 50 dma is a constructive sign.

 

 

Across the Atlantic, the Euro STOXX 50 has regained its 50 dma but is trading below its 200 dma. The energy and resource-heavy FTSE 100 is above both its 50 and 200 dma, though the FTSE 250, which is more representative of the UK domestic outlook, is above its 50 dma but below its 200 dma. These are surprising results in light of the strains placed on Europe’s economy by skyrocketing energy prices as a result of the Russia-Ukraine war.

 

 

Asian equities are a bit of a mixed bag. None are in major downtrends, with some above their 50 dma and some below.

 

 

The relative underperformance of Asia can be attributed to the slump in Chinese growth, which can be also seen in the weakness in the commodity complex as Chinese infrastructure and property development has been the primary driver of commodity demand for the last two decades.

 

 

 

Neutral ≠ Buy

Before you become overly bullish, keep in mind that a neutral score isn’t a buy signal. This long-term monthly chart of the broadly based Wilshire 5000 has produced some useful buy and sell signals in the past. Buy signals are generated when the monthly MACD turns positive (bottom panel) and sell signals are shown by negative 14-month RSI divergences (top panel). The market is far from a buy signal on this model.

 

 

According to Jurrien Timmer at Fidelity, the valuation case for a resumption of an equity bull depends on a macro Goldilocks scenario of a Fed halt at the neutral rate, falling inflation, and positive earnings growth.

 

 

As a reminder, former New York Fed President Bill Dudley wrote a Bloomberg Op-Ed on April 6, 2022, which concluded that the Fed needs to hurt the stock and bond markets in order to bring inflation under control.

 

As [Jerome Powell] put it in his March press conference: “Policy works through financial conditions. That’s how it reaches the real economy.”

 

He’s right. In contrast to many other countries, the U.S. economy doesn’t respond directly to the level of short-term interest rates. Most home borrowers aren’t effected, because they have long-term, fixed-rate mortgages. And, again in contrast to many other countries, many U.S. households do hold a significant amount of their wealth in equities. As a result, they’re sensitive to financial conditions: Equity prices influence how wealthy they feel, and how willing they are to spend rather than save.
Dudley added:

 

Investors should pay closer attention to what Powell has said: Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.

 

If stock prices were to rise significantly, the Fed would view that as a loosening of financial conditions and it would have to respond with a tighter monetary policy. In other words, the Fed wants the stock market to fall. In addition, inflation expectations have begun to edge up. If it continues, it would be a disturbing sign for policy makers.

 

 

 

Key risks

For investors, a neutral ranking translates to upside potential is roughly balanced with downside risk. Since equities historically outperform bonds in the long run, it makes sense to hold a higher commitment to equities compared to bonds in a portfolio, all else being equal. But that doesn’t mean there are no downside risks.

 

There are two key risks to the equity outlook, namely China and Europe. Bloomberg reported that the mortgage boycott is significantly denting the banking system.

 

In the ongoing property crisis, people in cities from pottery-making hub Jingdezhen to Shanghai are withholding payments on mortgages for homes that developers, including Evergrande, have yet to finish. The amounts are huge. The wildcat boycott on loans is worth as much as 2 trillion yuan ($296 billion) to lenders, which have relied on mortgages as their safest source of revenue as Covid lockdowns stifle growth.

As a result, Chinese consumer confidence has plummeted.

 

 

As the Chinese financial system is largely closed, contagion risk should be relatively limited. However, the downturn in China is leaking globally through the trade channel. Both Korea and Germany have exhibited rare trade deficits as Chinese capital goods imports have tanked.

 

 

The other major risk to the global macro outlook is the effects of the Russia-Ukraine war on Europe. While progress is largely stalled on the battlefield, the battleground has shifted to hybrid war as Russia has weaponized energy and grains. Europeans are paying the equivalent of $400 oil as gas prices surged in Europe after Russia cut flows from the Nord Stream 1 pipeline to just 20% of normal capacity after flows resumed after scheduled maintenance. Soaring energy prices have stoked a cost of living crisis and boosted costs for industry, threatening to push the region into recession. 

 

The WSJ reported 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.

 

 

The one wildcard is Chinese LNG demand. Chinese LNG importers have not been buying in the spot market for the winter in anticipation that Beijing’s zero-COVID policy will continue to cut demand. A rebound in Chinese LNG demand has the potential to devastate the global gas market.

 

 

Already, Asian LNG prices have surged as other regional buyers compete for scarce supply.

 

 

In conclusion, the balance of equity risk has begun to normalize. Signals from global commodity and equity markets showing that the upside potential and downside risk of owning equities have become more balanced. However, downside risks remain in the form of a China slowdown and further risks from the Russia-Ukraine war. 

 

From a technical perspective, the S&P 500 staged an upside breakout through a falling channel, which is a constructive development. However, the market is likely to need a period of basing and consolidation. Expect some short-term choppiness before stock prices can recover to new highs.

 

 

Be patient.

 

Cutting through the noise: Why today’s Fed decision doesn’t matter

Posted by Cam Hui -

Mid-week market update: It’s always difficult to make a stock market comment on FOMC announcement day. Equity prices can exhibit strong reversals after the announcement and press conference. As well, it’s also not unusual for the move to reverse itself the next day.
 

It’s not clear whether the 2023 FOMC pattern of weakness into the meeting and a rally afterward will appear again, mainly because the market had been rallying into the July meeting, which is a different pattern than all of the other meetings this year.

 

 

I am very conflicted about the short-term direction of stock prices.

 

 

The bull and bear cases

You can tell a lot about the character of a market by the way it reacts to the news. Let’s begin with the reaction to Q2 earnings season. As of last night, 116 of the companies in the S&P 500 have reported. The EPS beat rate was 74% (5-year average of 79%) and the sales beat rate was 65% (5-year average 69%). 

 

While results have been below average, last night’s market reaction was unusual. Both MSFT and GOOG, which are two heavyweights that comprise an aggregate of 9.6% of S&P 500 index weight, missed on both the top and bottom line. Instead of skidding in the after hours, both stocks rallied. Market strength in the face of bad news should be bullish.

 

On the other hand, the usually reliable S&P 500 Intermediate Breadth Oscillator (ITBM) is overbought on its 14-day RSI. Market weakness that pushes RSI into neutral is a sell signal, which has been correct about two-thirds of the time.

 

 

The NYSE McClellan Oscillator (NYMO) and the NASDAQ McClellan Oscillator (NASI) have already recycled from overbought conditions, which is a warning signal.

 

 

You see why I am conflicted. There’s a better way to cut through the noise.

 

 

Peak inflation

It’s FOMC day and all eyes are on inflation and Fed policy. Inflation isn’t just a US problem, it’s global and global central bankers are tightening monetary policy in response.

 

 

The good news is inflation pressures appear to be peaking. Inflation surprise is flat to down in most major countries except for Canada.

 

 

The narrative is turning from the fear of rising rates to recession. /Tomorrow’s GDP print is expected to be negative, and the cacophony of calls for a recession has already begun based on two consecutive quarters of negative GDP growth. Recession has become such a consensus call that Jim Cramer did a CNBC show on the three flavors of recession. 

 

Indeed, the commodity markets are signaling a downturn. Historically, the cyclically sensitive copper/gold ratio has been strongly correlated to the 10-year Treasury yield. The copper/gold ratio is falling, which should put downward pressure on yields.

 

 

Tactically, the 10-year Treasury yield is tracing out a possible head and shoulders top, with the chartist’s caveat that H&S patterns are incomplete until the neckline breaks.

 

 

Instead of trying to guess the direction of the stock market, a better way of cutting through the noise is a commitment to the Treasury market. The longer the maturity, the better.

 

 

Disclosure: Long ZROZ

 

FOMC preview: 75 or 100 is the wrong question

Posted by Cam Hui -

Anticipation is building over the FOMC decision, which is scheduled for this coming Wednesday. Leading up to the meeting, there had been growing speculation over whether the Fed would hike by 75 or 100 bps. Market expectations had been oscillating wildly, but it has now settled into a consensus of 75 bps, followed by a pause in late 2022 and rate cuts that begin in mid-2023.
 

 

In my opinion, 75 or 100 bps is the wrong question to ask.

 

 

Better questions to ask

The better questions for investors are:
  • What’s the terminal rate?
  • How long will the Fed pause?
  • Most of all: Is the Fed willing to tolerate a recession?
As inflation indicators have been coming hot, or ahead of expectations, the Fed will undoubtedly employ tough hawkish language in its FOMC statement and subsequent press conference. A recent speech by Fed governor Christopher Waller summarizes the Fed’s tough stance:

 

Congress did not say “Your goal is price stability unless inflation is caused by supply shocks, in which case you are off the hook.” We want to reduce excessive inflation, whatever the source, in part because whether it comes from supply or demand, high inflation can push up longer-run inflation expectations and thus affect spending and pricing decisions in the near term.
There are signs that inflation may be peaking. Both core CPI and core PCE, which is the Fed’s preferred policy metric, are rolling over. Investors will be scrutinizing the PCE announcement Friday. Market expectations call for stabilization in core PCE at 4.7%.

 

 

As well, inflation expectations are also under control.

 

 

Supply chain bottlenecks are beginning to ease, as evidenced by falling industrial prices in the G4.

 

 

Mentions of “shortage” in the Fed’s Beige Book have been trending down, indicating lower supply chain inflationary pressures.

 

 

While all of these signs are constructive, the WSJ recently asked, “There Are Signs Inflation May Have Peaked, but Can It Come Down Fast Enough?” It’s a valid question. Ethan Harris at BoA pointed out that the market expects inflation to fall considerably over the next 12 to 24 months, but that isn’t how inflation (which is inertial) has historically behaved. What if inflation doesn’t tank? Are rate cut expectations all that realistic?

 

 

 

The policy conundrum

A recent speech by Hyun Song Shin, Economic Adviser and Head of Research of the BIS, argued for front-loaded rate hikes because they were historically more likely to result in soft landings.

 

 

There are many ways of poking holes in the BIS study, mostly because the study period was concentrated in the inflationary 1970’s. A separate paper by Luca Fornaro and Federica Romei argues that current policy has undesired recessionary effects from a global perspective.

 

During periods of global stagflation, central banks may tighten too much. The reason is that interest rate increases trigger exchange rate appreciations and trade deficits. While these two factors contain domestic inflation, they have the side effect of exporting inflation abroad. So when a central bank hikes, other central banks hike back to sustain their exchange rate and reduce imported inflation. As a result of this “competitive appreciations game”, interest rates end up being too high, and economic activity too low, compared to what would be optimal from a global perspective. There are thus gains from international monetary cooperation in times of high inflation.

In other words, while front-loading rate hikes may raise the odds of a soft landing, globally synchronized rate hikes have undesired recessionary effects. In all cases, it sounds like market expectations of rate cuts by mid-2023 are overly optimistic. Even if the economy were to plunge into recession, inflationary pressures may still be evident and not under control.

 

 

When does the Fed blink?

There is one exception to the anti-inflation fighting rule. The event that forces central bankers to spring into action and ease monetary policy is a financial crisis. It is said that the Fed will raise rates until something breaks. US corporate and household balance sheets are in strong positions this cycle and it’s unlikely anything will break, which argues for a continued hawkish Fed.

 

 

On the other hand, emerging market defaults have spiked to fresh highs, according to ASR Ltd., EM countries have been the canaries in the global financial coal mine in past cycles. However, ASR observed that contagion risk has been limited so far, “Default risk is mostly limited to smaller, less well-connected countries, limiting the spillover to the global economy. Turkey is the major exception.”

 

 

Nevertheless, hard currency EM debt issuance has now turned negative, which is a sign of a global credit crunch.

 

 

As the US PMI plunges into recession territory and the fragility of EMs becoming evident. While financial crises are by their nature discontinuous events and difficult to predict with any certainty, the markets are expecting a disorderly event by mid-2023. Will the Fed blink then?

 

 

 

Investment implications

Putting it all together, here is what this all means for investors. Economic data like Philly Fed, ISM, and PMI are all likely to be weak for the next few months. If there is even any hint of disinflationary tendencies, bond prices will rip, and yields tank.

 

 

In the past, peaks in long Treasury yields have preceded pauses in Fed Funds rate hikes by a few months. At a minimum, the market expectations of a pause by late 2022 should be correct. Keep an eye on the PCE report Friday.

 

 

Tactically, Rob Hanna at Quantifiable Edges observed that FOMC days tend to be equity bullish if stocks decline into meeting days while confidence into meeting days has been disappointing.

 

 

A powerful new bull? Don’t be fooled!

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: Bearish
  • 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.
 

 

A bullish reversal

In the past month, I have been constructive on US equities in the face of growing doubts about the macro and fundamental environment. our cautious optimism had been met with skepticism. Now that the S&P 500 has rallied above a falling channel and regained its 50 dma, the tone on our social media feed has turned more bullish.

 

 

While it’s nice to feel some vindication, investors shouldn’t make the complete about-face from bear to bull just yet.

 

 

A turn in sentiment

The narrative is changing. The latest BoA Global Fund Manager Survey shows institutional risk positioning at a historical extreme, which led to a stampede of contrarian bullish calls.

 

 

Sentiment model readings have begun to normalize. The AAII bull-bear spread has recycled from a bearish extreme reading to -12.6, which is in the neutral zone.

 

 

Similarly, the Investors Intelligence bull-bear spread has risen to zero from negative for the first time in 12 weeks. There are now an equal number of bulls and bears.

 

 

Market breadth is improving. The percentage of S&P 500 stocks above their 50 dma has risen to just under 60% from a bearish extreme of 2.6% at the June low. While net new highs are still negative, the trend has been steadily rising.

 

 

Does that mean the bulls have seized control of the tape?

 

 

A bear market rally?

While I am open to the possibility that this is the beginning of a new bull leg, some caution is warranted. Keep in mind that the current rally has mainly been driven by short covering.

 

 

Don’t forget that the NASDAQ 100 underwent several powerful bear market rallies during the 2000-2002 period before it finally bottomed. Many of those episodes featured strong overbought readings which could have been signs of “good overbought” advances.

 

 

 

Key risks

Here are some of the risks that are keeping me awake at night. The Conference Board’s Leading Economic Index (LEI) fell -3.7% annualized in the last six months. Going back to 1960 a recession has always occurred when the LEI reached this level.

 

 

The Philly Fed’s Manufacturing Business Outlook Survey is painting a picture of tanking economic activity as the FOMC meets next week and hikes into a weakening economy.

 

 

Initial jobless claims have bottomed and they are rising. This is a sign of a weakening jobs market, just as the Fed adopts an aggressive tightening policy.

 

 

 

European risks

Across the Atlantic, Europe has been buffeted by a combination of war and a heatwave that underscores the EU’s vulnerability to climate change.

 

Germans breathed a brief sigh of relief when the Nord Stream 1 gas pipeline restarted after a scheduled shutdown for maintenance. Initial flow rates have begun at 30% of capacity, but as the history of gas supplies shows, Putin has weaponized energy in retaliation for EU sanctions in the aftermath of the war.

 

In response, the European Commission proposed a plan to reduce natural gas consumption by 15% through rationing, but it appears to be in very serious trouble. Spain, Greece and Portugal have rejected it. Others, such as Italy and Poland, have raised deep reservations.

 

 

Even as Germany reluctantly pivoted to the use of coal as a substitute for gas as an energy source, the heatwave has lowered river levels. Water levels on the Rhine are the lowest for the time of year for over a quarter of a century. This restricts freight traffic and is an indication of the stress for coal and nuclear power plants which rely on river water for cooling.

 

 

The monetary authorities aren’t helping matters. The ECB just raised rates by 50 bps and rolled out a Transmission Protection Instrument (TPI) to control “fragmentation”, or peripheral spreads blowing out. TPI “would be conducted such that they cause no persistent impact on the overall Eurosystem balance sheet and hence on the monetary policy stance”. In other words, it’s an Operations Twist where the ECB buys peripheral paper at the expense of core debt. Christine Lagarde has in effect traded support for the periphery for a more hawkish rate hike. It remains to be seen how this policy will play out, especially when the Mario Draghi’s government lost support in Italy and an election may have to be called. 

 

 

Just like the U.S., eurozone monetary tightening is occurring just when the economy is slowing. Eurozone July Flash PMI fell from 52.0 to 49.4, indicating contraction. The last time the ECB hiked into falling PMI readings was 2011 and monetary policy was reversed as rates eventually turned negative. It will be difficult for the ECB to repeat that performance in the face of global inflationary pressures.

 

 

 

Emerging market risks

It is said that central banks tend to raise rates until something breaks. The canaries in the global coal mine are the emerging market economies, and EM countries are breaking.

 

In the past few weeks, the government in Sri Lanka fell because of protests over a collapsing economy. Pakistan is teetering. Inflation sparked riots have appeared in Panama, Malawi, and Uraguay. EM debt defaults have spiked to historically high levels. Turkey announced that it brokered a deal between Russia and Ukraine to ship grain through the Black Sea. Hopefully, the agreement should alleviate some of the pressures on food supplies and on inflation.

 

 

China, the EM elephant, is seeing weakness in its property market.

 

 

As a sign of desperation, some property developers are accepting produce, such as garlic, watermelons, wheat and barley as down payments from farmers on new apartments. Some homebuyers have gone on strike and refused to pay the mortgage on incomplete projects where the developers have stopped work. Contagion risk is rising as some suppliers have also joined the boycott until the developers pay them. Beijing is considering declaring a mortgage grace period for buyers to alleviate pressure, but it remains to be seen whether how much of the stress leaks into the Chinese banking system. This matters because China’s property market may be the largest asset class in the world.

 

 

 

Bottom calls everywhere

Despite the negative macro backdrop, there is still hope for the bulls. That’s because markets are inherently forward-looking and price behavior is a key factor in the equity market’s outlook.

 

Indeed, bottom calls are all coming out of the woodwork. Jason Goepfert of SentimenTrader recently pointed to an indicator with a perfect track record, though the sample size is small.

 

 

I have two ways of resolving the question of whether the latest advance represents a bear market rally, or the start of a V-shaped recovery. One is fundamental and the other technical.

 

Jurrien Timmer at Fidelity showed this chart of changes in the P/E ratio (pink) compared to forecast earnings growth (cyan) and rhetorically asked:

 

Are we witnessing the beginning of an earnings contraction, or is the rate of growth merely slowing? The answer will determine whether the current 25% drawdown will be the end of this valuation reset, or the start of a full-fledged recession bear market.

 

 

While it’s still early in Q2 earnings season, the preliminary results show that both EPS and sales growth beat rates are coming in at below historical averages. Investors will find out if the Street aggressively downgrades EPS forecasts in the coming weeks.

 

From a technical perspective, the market experienced a breadth wipeout when the percentage of S&P 500 stocks above their 50 dma fell below 5% and recovered to above 20%. There have been seven similar episodes in the last 20 years and all have marked major market bottoms. However, the market went on to weaken and re-test the old lows in five of the seven episodes. Only two were V-shaped bottoms. The rest saw positive 14-day RSI divergences on the re-tests.

 

 

I am inclined to play the odds. My base case scenario calls for a failed rally, followed by a re-test of the lows. However, we remain open to the possibility of a V-shaped bottom, but the bulls need to demonstrate strong positive price momentum to convince me. Dean Christians at SentimenTrader offered his “bear killer” model, where he looks for 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. This model has not flashed a buy signal yet.

 

 

In conclusion, the tone of stock market action has become more constructive and investor sentiment is turning from bearish to bullish. While I am turning more bullish on stocks longer term, the jury is still out as to whether the latest advance is the start of a V-shaped bottom. Fundamentally, I am monitoring the evolution of earnings estimates as Q2 earnings season progresses. As well, durable advances are accompanied by strong price momentum, which the bulls haven’t demonstrated yet.

 

Revealed, the secret lives of corporate insiders

Posted by Cam Hui -

Why are stocks rallying? Maybe it’s because for much of this year, corporate insiders have been stepping up to buy dips in the stock market. The purchases have occurred in the face of growing recession risk and apparent challenging valuations.
 

 

What does this group of “smart investors” know that we ordinary mortals don’t? An analysis of valuation and the technical backdrop reveals some pockets of value in the US equity market.

 

 

A challenging environment

This has become an increasingly challenging environment to be taking risk. The latest BoA Global Fund Manager Survey found that a recession is now the overwhelming consensus view among institutional investors.

 

 

The Citigroup G10 Economic Surprise Index, which measures whether economic releases are beating or missing expectations, is nosediving.

 

 

As the Fed and other major central banks tighten monetary policy, yield spreads are widening, indicating tightening financial conditions.

 

 

Treasury settlement fails have increased to levels last seen during the GFC, indicating a severely compromised bond market liquidity. High yield spreads are especially sensitive to bond market liquidity, which has the potential to set off a doom loop in the credit markets.

 

 

The S&P 500 is trading at a forward P/E of 16.7, which is below its 5 and 10-year averages. However, the E in the forward P/E ratio is at risk of compressing as we progress through Q2 earnings season.

 

 

The latest update from earnings season indicates that both the EPS and sales beat rates are below historical averages, which raises the risk of earnings downgrades. Historically, stock prices have struggled whenever forward EPS has either flattened or fallen.

 

 

Why on earth would corporate insiders be buying the dips?

 

 

A valuation analysis

For some clues, I use the Morningstar fair value analysis tool to calculate valuation. While it doesn’t represent the Holy Grail of valuation analysis, it is a consistent metric for comparing value over time and across different parts of the stock market. A preliminary analysis of the Morningstar stock universe shows that the market appears to be cheap, but it doesn’t represent screaming value compared to past major market bottoms in 2009, 2011, and 2020.

 

 

The intent of this analysis isn’t to exhaustively enumerate all the ways the Morningstar fair value tool measures different pockets of the market. Here are some highlights.

 

An analysis by sector shows several standouts. Technology stocks are more undervalued compared to the overall universe and they haven’t been this attractive since the GFC.

 

 

Communication services are at an “off the charts” undervaluation reading.

 

 

By contrast, the consumer defensive stocks that investors have bought for their low-beta characteristics, are slightly overvalued.

 

 

The other sectors, which consist of basic materials, consumer cyclicals, financial services, real estate, healthcare, utilities, energy, and industrials, don’t show as extreme in over and undervaluation. However, wide-moat companies, or high-quality companies with strong competitive positions, also show a high degree of undervaluation that was only exceeded by 2009.

 

 

 

A technical view

The Morningstar fair value analysis is consistent with SentimenTrader’s observation of heavy insider buying in NASDAQ 100 names. These stocks are concentrated in the technology and communication services sectors and they tend to be high-quality with strong competitive positions and cash flows.

 

 

The relative performance of the NASDAQ 100 to the S&P 500 is trading in a relative support zone that hasn’t been exceeded since the dot-com bubble bust. I would add the NASDAQ 100 is very different compared to the 2000-2003 period. Today’s companies have far stronger cash flows and competitive positions compared to their predecessors.

 

 

The technical position of technology stocks shows that the sector is bottoming on both an absolute and relative to the S&P 500. As well, the sector is enjoying strong positive relative breadth (bottom two panels).

 

 

The technical position of communication services stocks is not as strong, but they do show a similar bottom pattern and improving relative breadth.

 

 

 

Good reasons to be bullish

In conclusion, corporate insiders have good reasons to be bullish. Valuations are reasonable and there are pockets of value in the stock market concentrated in the large-cap NASDAQ 100 names. Here are selected large-cap stocks that have shown insider buying in the last six months: CHTR, INTC, MSFT, NFLX, and PYPL. This is not a complete list and it is only a quantitative screen. You are advised to perform your own due diligence.

 

From a technical perspective, the bull case for equities is institutions and hedge funds have all sold and the only sellers left are retail investors. The BoA Global Fund Manager Survey shows that risk appetite is lower than Lehman Crisis and GFC Crash levels.

 

 

Equity futures positioning tells a similar story of a historic crowded short reading.

 

 

Retail positioning is cautious, but it has room to capitulate further.

 

 

As I pointed out about a month ago (see Why last week may have been THE BOTTOM), the mid-June breadth wipeouts are setups for a durable market bottom. While there is no guarantee that the major market indices won’t retreat and re-test the old lows, risk/reward has become increasingly bullish for equities. 

 

Buy the dip.

 

An FOMC market nosedive ahead?

Posted by Cam Hui -

Mid-week market update: I recently identified a 2022 market formation where the S&P 500 declines into an FOMC meeting and rallies afterward. The key question for investors is whether the same pattern will repeat itself for the July meeting. If so, the market should top out about now.
 

 

Here are the bull and bear cases.

 

 

The bear case

Let’s begin with the bear case, which represents the base case scenario. Here are some catalysts that could spark a risk-off episode.

 

Anxiety over European energy supplies are rising. The NY Times reported that the EU has asked member states to start rationing natural gas in anticipation of a Russian gas cutoff in retaliation for European support of Ukraine. The positions on both sides are becoming dug in. A recent German poll which asked whether respondents would keep supporting Ukraine despite higher energy prices was a resounding “yes”, except for the supporters of the far-right AfD. 

 

 

Higher energy prices, which have the dual effect of pressuring inflation and pushing the economy into recession, puts the ECB in a difficult position. Tumbling cyclically copper prices in the face of rising European gas prices illustrates the economic impact of the Russia-Ukraine war. Even worse, water levels on the Rhine have fallen to levels that make it difficult to transport coal, which is the emergency alternative fuel, to power plants. As well, the latest drama from Italy indicates that the Draghi government is unlikely to survive, which presents challenges for the ECB as it tries to control peripheral bond spreads as it tightens monetary policy. The ECB’s interest rate decision tomorrow could be a source of market turbulence.

 

 

Over on this side of the Atlantic, Q2 earnings season has been weaker than usual. According to the Earnings Scout, both the EPS and sales beat rates are below historical averages. With 12% of companies reported, the EPS beat rate is 75% (vs. the 5-year average of 81%) and the sales beat rate is 69% (vs. the 5-year average of 77%).

 

 

As market participants look ahead to the FOMC meeting next week, monetary tightening is raising the stress in the financial system. Liquidity is worsening, as evidenced by a rate of failed bond trade settlements that was last seen during the GFC. In particular, junk bond risk premium is especially sensitive to liquidity conditions. A bond market blowup would not be conducive to risk appetite.

 

 

 

The bull case

Here is the bull case. USD strength has created havoc in fragile EM economies. Dollar positioning is at a crowded long and could reverse soon.

 

 

As well, the latest BoA Global Fund Manager Survey shows that cash levels are at historically low levels, and so are equity allocations.

 

 

The FT reported that Ukraine and Russia are nearing a possible deal to transport grain through the Black Sea, which would be a huge positive surprise that alleviates inflation pressure.

 

Ukraine and Russia are close to agreeing a deal to secure the safe passage of millions of tonnes of grain through the Black Sea but remain at odds over how to ensure the security of the ports and ships along the crucial export route, according to people familiar with the UN-led negotiations.

 

The four-party agreement, which is also being mediated by Turkey, would end a months-long Russian blockade of Ukraine’s Black Sea ports that has cut off the export route for one of the world’s leading grain producers and threatened a global food crisis.

 

 

Bull or bear?

Where does that leave us? Tactically, the SKEW Index, which measures the market pricing of tail-risk is historically low at about 120. The market hasn’t crashed with SKEW at these levels. I interpret this to mean that even if the stock market were to weaken, downside risk should be relatively low.

 

 

From a technical perspective, the S&P 500 has staged an upside breakout through a falling trend line and its 50 dma. If the breakout holds, it would be a signal of a possible inflection point and a new bull leg in the market. On the other hand, the VIX Index is nearing the bottom of its Bollinger Band, which is an overbought condition for the market.

 

 

The next few days will be a test for both bulls and bears. Should the FOMC pattern of market weakness continue into next week, investors and traders should consider that to be a low-risk entry point for long equity positions.

 

Three catalysts that could spark a “rip your face off” 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: Bearish
  • 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.
 

 

A resilient market

The US stock market has been surprisingly resilient in the face of bad news. The pattern has been the same on Wednesday and Thursday. Futures opened the day deeply negative, first on a hot CPI print Wednesday and a hot PPI print and earnings disappointment Thursday, but rallied over the day to erase most, if not all of the previous losses. The banks, which kicked off Q2 earnings season, have mostly been disappointing, but it only took one positive surprise to spark Friday’s relief rally.

 

 

A market that does not react to bad news is a sign of bearish exhaustion. Here are some other catalysts that could spark an unexpected “rip your face off” rally and change the narrative from bearish to bullish.

 

 

Supportive factors

Here are some supportive factors that won’t be the cause of rallies, but could put a floor on stock prices.

 

Gary N. Smith, who is the Fletcher Jones Professor of Economics at Pomona College, wrote in Marketwatch that the stock market enjoys strong valuation support. Using a dividend discount model to value the market, he concluded that there is a 4% chance investors will be overpaying with the S&P 500 at 3902.62.

 

 

SentimenTrader has been pounding the table for several weeks about strong insider buying of technology stocks. The 20 dma of insider buying of the NASDAQ 100 is at the highest level since 2011, indicating a bullish risk/reward setup.

 

 

The WSJ reported that sentiment is becoming increasingly bearish, which is contrarian bullish.

 

Asset managers and hedge funds recently stepped up bearish bets against U.S. stocks to the highest level since 2016, when fears about a global slowdown were on the rise. That is according to a JPMorgan Chase & Co. analysis of futures tracking major stock indexes.

 

The average active investor has steadily pared her stock exposure this year and dropped equity allocations to one of the lowest levels since the start of the pandemic, according to a survey by the National Association of Active Investment Managers, which primarily polled registered investment advisers…

 

Estimates from Deutsche Bank show that investors have steadily decreased their exposure to stocks to some of the lowest levels of the past 12 years. That includes slashed positioning among systematic funds that make buying and selling decisions based on levels of volatility in the markets and other metrics. Meanwhile, bullish bets in the options market among traders big and small recently fell to the lowest level since April 2020.

 

 

 

A cyclical surprise?

While the factors outlined so far will not spark rallies by themselves, here are some catalysts that might.

 

Earnings season is upon us. Forward 12-month EPS estimates are flattening out as recession fears have grown. The coming weeks will be an acid test for both bulls and bears.

 

 

Despite the gloomy outlook, an important cyclically sensitive non-US bellwether reported earnings last week that may be a cause for bullish celebration. TSMC raised its sales outlook while warning that it will delay some capital spending. Positive guidance from a growth cyclical semiconductor company like TSMC is welcome relief amidst all of the macro gloom about a global recession. Semiconductor stocks are trying to turn up in relative strength, which could be a signal for a better cyclical outlook (bottom panel).

 

 

Jefferies recently highlighted a historical pattern that semiconductor stocks led the interest cycle by about six months. If these stocks are indeed starting to turn, the rate inflection point should soon follow. Keep an eye on the earnings reports of semiconductors in the coming weeks. A pattern of strong guidance could change the narrative and spark a strong market rally.

 

 

Mary Daly, President of the San Francisco Fed, pointed out that this is a very fast tightening cycle. If the semiconductor equity cycle has indeed turned, it’s possible that the lead times will be more compressed than historical experience for that reason.

 

 

 

Falling energy prices?

One macro overhang for the growth outlook is the supply-demand imbalance in a number of key energy and food commodities owing to the Russia-Ukraine war. It is well known that some countries like China and India have been buying Russian energy products, but it is less known that Russian oil has been leaking into the Middle East. As an example, Saudi Arabia has been importing cheap Russian fuel oil to feed power stations and free up the kingdom’s own crude for export. While such developments do little to help Ukraine, it does keep the energy market well supplied and serves to alleviate some of the inflationary pressures that concern global central bankers. As inflation decelerates, central bankers could pivot to a less hawkish monetary policy, which would be bullish for risky assets.

 

 

While Europe’s energy shortage is gas and not oil, the latest cover of the Economist may serve as a useful contrarian magazine cover indicator.

 

 

As a reminder, this is what happened the last time the magazine published cover indicating panic over energy prices.

 

 

 

Falling food prices?

Finally, the most important possible surprise could come from the grains market. The FT reported that Ukraine, Russia, Turkey, and the UN are negotiating and the parties have made “very substantial progress” on a plan to avert a global food crisis by securing the safe passage of millions of tonnes of grain through the Black Sea. António Guterres, UN Secretary-General, expressed hopes that a final deal could be reached as soon as next week. 

 

This development could be hyper-bullish for two reasons. Food and energy have been pressuring inflation upwards, and a Black Sea deal which allows the safe passage of Russian and Ukrainian grain has the potential to spark strong disinflationary pressures that change the entire inflation expectations narrative. As well, it would alleviate the political pressures on many emerging markets and developed economies and reduce the geopolitical risk premium of risky assets. 

 

Jerome Powell made it clear at the last post-FOMC press conference that the Fed is shifting its focus from core inflation to headline inflation. Relief in food and energy prices will be a welcome development for not only the Fed, but also other central bankers.

Headline inflation is important for expectations. People—the public’s expectations, why would they be distinguishing between core inflation and headline inflation? Core inflation is something we think about because it is a better predictor of future inflation. But headline inflation is what people experience. 

 

 

In conclusion, the stock market appears to be highly resilient in the face of bad news. A number of factors, such as valuation and insider activity, are putting a floor on stock prices. Three catalysts, such as the unexpected turnaround in the cyclically sensitive semiconductors, a better-supplied oil market, and a possible deal on Black Sea grain exports, have the potential to change the macro narrative from bearish to bullish and spark a “rip your face off” rally. While none of these factors are specifically actionable, investors should be aware of possible asymmetry of risks and behave accordingly.

 

How the Fed is acting like a bull in the china shop

Posted by Cam Hui -

The June CPI and PPI reports both came in higher than expectations. The good news is core CPI is decelerating. The bad news is both core sticky price CPI and Owners’ Equivalent Rent, which is about one-third of core CPI, are rising rapidly. 

 

These readings confirm the market’s expectations that the Fed will continue to tighten until something breaks. In effect, the Fed is behaving like the proverbial bull in a china shop.

 

 

Brave words

It is said that no battle plan survives contact with the enemy. The Fed’s current battle plan against inflation is to be “resolute”. A recent WSJ article telegraphed the Fed’s concerns about a repeat of the 70’s era of “stop and go” inflation.

 

Fed officials are eager to see inflation pressures diminish soon so that they won’t have to raise interest rates above 4% or 5%. But they are also using terms such as “fortitude,” “resolute” and “bumpy road” to show they are alert to the risks of stubborn inflation.

 

“This kind of worry that there’s going to be a stop-and-go policy by the committee like what happened in the ’70s—that’s just not going to happen in my view,” Fed governor Christopher Waller said during a webinar with private-sector economists last week.

 

Officials are concerned that inflation psychology is shifting in a way that will lead businesses and consumers to continue to accept higher prices. To prevent those expectations from becoming self-fulfilling, the Fed is using words and actions now that it hopes will shock the public out of believing inflation will stay high.

 

 

Brave words indeed. The key question is whether the plan will survive contact with the enemy. That enemy’s name is financial stability. History shows that even Paul Volcker relented when faced with a Mexican Peso crisis that left the US banking system teetering on the brink of insolvency.

 

 

Will this time be different? 

 

The conventional policy view is, that in the wake of the hot inflation reports, there is no off-ramp to aggressive rate hikes. By contrast, the market has shifted from a straight-line acceleration of rate hikes to pulling forward expected hikes in 2022, a plateau in early 2023, and rate cuts by the middle of next year. In other words, something is going to break – and soon.

 

 

Rising EM instability

Here is what`s breaking in the global financial markets. Riots engulfed Sri Lanka as it faced a foreign currency crisis. Protests over rising food and fuel prices caused the government to fall. Protests were also seen in the Albania capital of Tirana last week over inflationary pressures.

 

The USD is surging as investors piled into the greenback as a safe haven, which is pressuring fragile EM economies. A rising greenback imports disinflation because the cost of imports are lower while exporting inflation to America’s trading partners by raising their costs.

 

 

A Bloomberg article identified El Salvador, Ghana, Egypt, Tunisia, and Pakistan as particularly vulnerable to defaults. The WSJ echoed similar warnings and also identified Lebanon and Zambia as “already in the grip of crises”. In addition, Fitch downgraded Turkey’s rating another notch.to B, which is five levels below investment grade.

 

The FT reported that EM debt outflows is having its worst year on record. This is a classic recipe for an EM debt crisis.

 

 

 

Rising European instability

The outlook for Europe isn`t very much better. Inflation is rising everywhere.

 

 

The Nord Stream 1 gas pipeline is down for scheduled maintenance and fears are rising in European capitals that Russia will take the opportunity to shut flows in retaliation for the EU’s support of Ukraine in the war. 

 

 

To be sure, Robin Brooks of IIF pointed out that a gas cut-off is a two-edged sword. While there have been studies of the effects of a Russian gas embargo, what`s lost in the analysis are its asymmetric effects on Russia vs. Germany and Europe.

 

What’s missing from Germany’s debate on an energy embargo is just how asymmetric an embargo would be. Russia is a gas station. If you embargo energy, that shuts down the gas station and GDP will collapse. Germany will get hit, but much less.

 

 

The relative performance of BASF and Dow Chemical, which are both measured in USD, shows the growing disparity between energy costs. The relative performance of the two stocks (bottom panel) had been relatively steady until the war began. BASF tanked against DOW when the war began and it is lagging further. If Russia does fully embargo gas to Europe, drastic rationing measures will be taken and priority will be given to households over industrial users and the BASF to Dow performance spread will further deteriorate.

 

 

From a big picture perspective, the markets are signaling renewed concerns over the Russia-Ukraine war. The performance of MSCI Poland, which is a proxy for the geopolitical risk premium, has violated a relative support level against the Euro STOXX 50 and against the MSCI All-Country World Index (ACWI).
 

 

This combination of events has put the ECB in a difficult position of tightening into a possible downturn. EURUSD reached parity for the first time in two decades and the USD is at 40-year highs against the GBP. The ECB is expected to announce its interest rate decision next week. Christine Lagarde has given guidance for a 25 bps hike, though pressure for 50 bps is building.

 

 

 

China instability

China is also facing growing risks of instability. China’s Q2 GDP growth came in weaker than expected as quarterly GDP growth turned negative at -2.6%. Trade surplus figures were a bit of a mixed bag. The good news is China’s trade surplus soared to a record US$97.9 billion in June as exports grew by 17.9%, though export strength is likely to fade as the Fed tightens monetary policy in order to destroy demand. The bad news is imports only grew by 1% owing to weak consumer demand, signaling weakness in the household sector. 

 

 

Meanwhile, the Chinese high yield bond market is continuing to collapse even amid a rebound in PMIs and fiscal front-loading signaling a warning to the property market. More and more home buyers have joined a mortgage boycott on stalled projects, which is unsettling investor sentiment. As another sign of growing financial stress, protesters seeking frozen funds in four rural banks in Zhengzhou clashed with police. 

 

 

A recent PBOC survey found that household income expectations and investment intention were at an all-time low while saving intentions were at an all-time high. Moreover, the latest Omicron-led wave of outbreaks and ensuing containment measures have delivered a huge blow to their incomes, casting a shadow over the health of the Chinese economy and potentially restraining authorities’ ability to inject stimulus via public spending.

 

The FT reported that “Western investors pumped a record amount into Chinese equity ETFs in June”. The foreign stampede into Chinese equities has the potential to be a disaster in the making.

 

 

 

A game of chicken?

In conclusion, the Fed is well aware that it is risking a recession with its tight monetary policy, but its main and only focus is fighting inflation. While the US economy remains resilient, as both corporate and household balance sheets are strong by historical standards, the same cannot be said of many other countries.

 

 

Even as Fed speakers assert their determination to bring down inflation, the market is signaling growing stress. The combination of a falling 10-year Treasury yield, which is an indication of falling growth expectations, and rising HY spreads, which is a sign of tightening credit conditions, is a possible lethal combination for financial stability.

 

 

It is therefore not surprising that in the wake of the hot CPI and PPI reports, Fed Funds futures is expecting the Fed to pull forward rate hikes but the terminal rate remains the same at 350-375 bps and rate cuts by mid-2023.
  • July meeting expectations changes from a near certain 75 bps to about a one-third chance of a 100 bps move;
  • A 75 bps hike at the September meeting;
  • The target rate at the November meeting remains unchanged; 
  • A terminal rate of 350-375 bps is achieved at the December meeting; and
  • Rate cuts by mid-2023.

 

 

 

How to trade the hot CPI report

Posted by Cam Hui -

Mid-week market update: So much for the Cleveland Fed inflation nowcast which was calling for a tame CPI surprise. The market reacted to the hot CPI print this morning by adopting a risk-off tone, though it recovered later in the day.
 

For equity investors, keep in mind that the intermediate-term structure of the S&P 500 is a falling channel within the context of a positive RSI divergence.
 

 

Here is how I interpret the stock market’s outlook.

 

 

A hot CPI report

CPI came in higher than expected. The bad news is core CPI is accelerating upwards, which will keep the Fed on a hawkish path. The good news is average hourly earnings is decelerating, indicating the lack of a wage-price spiral.

 

 

Here is how Fed Funds futures reacted in the wake of the CPI report:
  • The base case for the July FOMC meeting remains a 75 bps hike, though there is a significant probability that it will be 100 bps.
  • The September rate hike increased from 50 bps to 75 bps.
  • The terminal rate remains at 350-375 bps, and the market expects the Fed to pause in November instead of December.

 

 

 

Still constructive on equities

I remain constructive on the intermediate-term equity outlook. The S&P 500 is successfully testing a key support level in the face of bad news, which is a positive sign.

 

 

The relative performance of defensive sectors has been moving sideways, except for healthcare, during a period when the S&P 500 has been weak. This positive divergence is another reason why I am constructive on stocks.

 

 

Ed Clissold at NDR pointed out that the “Combination High-Low Logic Index” has moved into a zone when the S&P 500 has risen at a 21% pace per annum. Norm Fosback explained the Logic Index in this way:

Under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows – bot not both. As the Logic index is the lesser of the two percentages, high readings are therefore difficult to achieve.

 


 

In spite of the excitement over inflation, the Inflation Beneficiaries ETF (INFL) hasn’t performed well, either on an absolute or relative basis.

 

 

 

Earnings seasons challenges

The next key test will be Q2 earnings season, which begins tomorrow as the banks report. Jurrien Timmer at Fidelity observed that global earnings growth is decelerating, though the US is decelerating the least.

 

 

Expect greater volatility in the coming weeks as we proceed through earnings season. I am inclined to buy the dips as the market doesn’t seem to be reacting very negatively to bad news. Earnings season will be the acid test for the markets.

 

 

China blinked, but can it save the world again?

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: Bearish
  • 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.
 

 

Beijing blinked

It’s always the darkest before the dawn. Just as it seemed that the world was about to collapse into a synchronized global recession, Beijing announced that it’s considering allowing the sale of 1.5T yuan (USD 220B) in local government bonds earlier than planned to fund infrastructure projects.

 

 

Commodities rallied on the news but China related equity markets greeted the announcement with a yawn. Can China rescue the global economy once again?

 

 

China’s policy challenges

The jury is still out on that question. In the past, Asian markets have moved in lockstep with China’s ups and downs. This time, it has become more bifurcated. While China and Hong Kong have turned up in relative strength even before the announcement, Japan has roughly matched the performance of the MSCI All-Country World Index (ACWI). Semiconductor-sensitive South Korea and Taiwan are weak, and so is resource-heavy Australia.

 

 

While the stimulus program is a positive step, China’s challenge is to balance the needs of its zero COVID policy against the need for a growth revival. To be sure, injecting 1.5 trillion yuan into the Chinese economy will create a flood of liquidity into the financial system, but how much of the stimulus will be financialized, and how much will actually get into the Main Street economy?

 

 

Beware of the FOMC cycle

It’s difficult to instantly assess the impact of a policy shift. China’s stimulus could have a real lasting effect on global liquidity, or it could be a fake-out. US investors need to be mindful of the FOMC market cycle that’s played out in 2022. The market has shown a tendency to peak about one to two weeks before an FOMC meeting and decline into the meeting, followed by a rally. As the next meeting is scheduled for July 26-27, the timing of a peak could begin as soon as the coming week. (Note that the arrows shown in the accompanying chart are purely stylized and do not connote any price targets).

 

 

The stock market may have further short-term upside potential. One of the key indicators that the Fed will be watching is the June CPI report due Wednesday. Consensus expectations calls for a monthly headline CPI of 1.1% and core CPI of 0.6%. The Cleveland Fed’s inflation nowcast shows a headline CPI of 0.97% and core CPI of 0.49%, which is a setup for a tame inflation surprise and potentially bullish for risky assets.

 

 

For now, the S&P 500 remains in a falling channel on the weekly chart. Until it can stage an upside breakout, the bears are still in control of the tape.

 

 

 

Timing the short-term peak

The S&P 500 is testing resistance in the 3900-3920 zone, with secondary at the 50 dma at about 3970. Momentum may stall here, but the bulls have a shot at rallying the market further as indicators are not overbought yet.

 

 

Here are some of the indications that I am monitoring in order to time a short-term peak. The NYSE McClellan Oscillator (NYMO) recycled from an oversold condition and flashed a buy signal. An overbought reading, or a near overbought reading, would be a sign to take some profits.

 

 

Similarly, the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator (ITBM) also flashed a buy signal at about the same time. The buy signal is based on a recycle of ITBM’s 14-day RSI from oversold to neutral. I am waiting for an overbought condition for a sell signal.

 

 

 

Still a crowded short

Despite my short-term caution, sentiment models are still pointing to the market forming an intermediate-term bottom. AAII sentiment remains at a crowded short, which is contrarian bullish.

 

 

While AAII sentiment is an investor survey, the TD-Ameritrade Investor Movement Index (IMX) measures the client positions of the firm. The latest monthly readings have continue to plunge and sentiment is approaching COVID Crash lows.

 

 

Macro Charts also pointed out that aggregate equity futures positioning by asset managers and hedge funds is at a record low.

 

 

In conclusion, I continue to believe the stock market is in the process of making an intermediate-term bottom. The panic from mid-June likely established a major support level for a bottom for this cycle (see Why last week may have been THE BOTTOM). While a V-shaped recovery is always a possibility, the odds favor a re-test of the old lows in the coming weeks. The China stimulus news was the catalyst for a relief rally of unknown magnitude. The bears aren’t done yet, and the FOMC cycle may not be done either.

 

What if the market bottomed and no one realized it?

Posted by Cam Hui -

It’s stunning how market psychology has changed. In the space of a few months, we’ve swung from “everyone is bullish” to “everyone is bearish”. These results from the BoA Global Fund Manager Survey were done in early June and sentiment has likely deteriorated since then.
 

 

The good news is the market is becoming numb to bad news. What if the stock market bottomed and no one actually realized it?

 

 

The bears throw a party

The bears are throwing a party and there’s no shortage of bad news. From a global perspective, ASR’s New Orders PMI 12-month diffusion indicator, which is composed of 24 country PMIs, is cratering.

 

 

In the US, the yield curve has flattened and the 2s10s spread has slightly inverted, which is usually interpreted as a recession warning.

 

 

The June Jobs Report solidified the Fed’s tightening path. Non-Farm Payroll came in ahead of expectations at 372K jobs, and average hourly earnings printed a slight beat at 5.1%. This is a picture of a strong labor market. More ominously was the Diffusion Index. While the diffusion index for total private jobs stayed steady, manufacturing showed some signs of weakness.

 

 

Other leading indicators of the jobs market is showing signs of deterioration. Temporary jobs and the quits/layoffs rate from the JOLTS report have led Non-Farm Payroll, and both indicators are rolling over. This, along with the Diffusion Index, is pointing to the conclusion that the Fed is tightening into a slowdown.

 

 

I recently pointed out that as the macro backdrop deteriorates, the Q2 earnings season will be the acid test for the equity market. As investors await the start of earnings season, FactSet reported that the rate of negative guidance has been steadily rising, though levels are nowhere near all-time highs.

 

 

Across the Atlantic, Germany’s vaunted trade surplus has swung into deficit and dragged the eurozone down with it. The chief culprit has been the high cost of energy in the wake of the Russia-Ukraine war. 

 

 

The French nationalization of electric utility EDF and the German bailout of Uniper are signs of the stresses appearing in Europe’s energy market. European electricity prices are potentially reaching a credit level event, especially if a bank or hedge fund is caught on the wrong side of electricity price hedges.

 

 

The credit default swaps of Credit Suisse skyrocketed last week, though the cause is unrelated to electricity hedging. For the uninitiated, CDS contracts are insurance policies that pay out if a borrower were to default on its debt. Arguably, this could be filed under “it’s so bad it’s good”. Central banks tighten until something breaks that threatens financial stability. Skyrocketing CDS rates are warning signs of cracks appearing in the system.

 

 

Over in Asia, Fathom Consulting makes the case that China is already in recession, though activity indicators are not as severe as what was seen during the first COVID Crisis.

 

 

Keep an eye on commodity prices, which is also tells the tale of a sputtering Chinese economy. Beijing is considering a sale 1.5 trillion yuan (USD 220B) of local government bonds in the second half of this year to fund infrastructure projects. The success or failure of the latest stimulus program will be reflected in commodities.

 

 

 

Where’s the panic?

As the flood of bearish news continues, investors would expect the markets to take a risk-on tone. But market psychology is becoming increasingly numb to bad news.

 

For example, consider Fed Funds futures, which is discounting a series of rate hikes into year-end, followed by a pause in early 2023 and rate cuts by next summer. If markets look forward 6-12 months, are they anticipating the recession or the prospect of Fed easing?

 

 

The 30-year Treasury yield may be peaking. Historically, peaks in the long bond yield has coincided or slightly preceded Fed rate cycle pauses. These readings are consistent with the expectation of a plateau in the Fed Funds rate in early 2023.

 

 

Even as recession fears spike, corporate insiders are stepping up and buying whenever the S&P 500 has weakened. While insider activity isn’t a precise market timing indicator, this group of “smart investors” are signaling that they are willing to look over any recessionary valley.

 

 

I previous made the point that the Q2 earnings season could be the acid test for equity prices. As negative guidance rises and growth slows, analysts are likely to cut their earnings estimates, which makes the forward P/E less attractive. While it’s difficult to anticipate how forward 12-month EPS estimates will evolve in the coming weeks, investors can see the relationship between the 10-year Treasury yield and trailing 12-month reported P/E ratio. S&P 500 trailing P/E is roughly in the same range as the last two times the 10-year Treasury yield was at these levels. Downside potential may be limited, especially if the economy either achieves a soft landing or experience a mild recession.

 

 

Technical analysis offers some clues about how market psychology has evolved. The percentage of S&P 500 above their 50 dma fell below 5% in mid-June, indicating a panicked extreme, and recycled back above 20%. There have been seven similar episodes in the last 20 years. The market made a V-shaped bottom on two of these occasions. In the other five, these oversold and recoveries were the signs of an initial bottom, followed by a re-test of the old lows within a few months. Only one (2008) saw a significant undercut of the initial low. All of the re-tests were marked by positive RSI divergences. These conditions are consistent with my past observation of a panic low in stock prices (see Why last week may ahve been THE BOTTOM). The odds favor a rally and re-test of the lows, though the historical record indicates that a V-shaped bottom has a probability of about 30%.

 

 

The rally and re-test scenario is consistent with the midterm election year seasonal pattern of a strong July followed by weakness and a low in September.

 

 

 

Trend Model

Finally, some readers have asked why the Trend Asset Allocation Model remains in a bearish signal if my analysis has become more constructive on the stock market. The Trend Asset Allocation Model is a model based on the application of trend-following principles on a variety of global stock markets and commodity prices, most of which are in downtrends. Trend following models are designed to spot durable trends and they are by design late at major tops and bottoms. Even if I am right about a market bottom, I don’t expect the Trend Model to turn more positive until a turnaround is more established. That’s a feature, not a bug.

 

This model has beaten a 60/40 benchmark during this latest bear episode, even though stock and bond prices have fallen together (detailed track record here).

 

 

In conclusion, market psychology has taken a sudden shift from bullish to bearish as recession risks have surged, but the stock market has become increasingly numb to bad news. I interpret this to mean that equities are undergoing a bottoming process. Downside risk is limited and upside potential is high, though investors should be prepared for some short-term bumpiness.

 

Numb to bad news

Posted by Cam Hui -

Mid-week market update: You can tell a lot about the tone of a stock market by the way it reacts to news. The 2s10s yield curve just inverted again, which has been a sign of an impending recession. If history is any guide, yield curve inversions have marked major market tops. The exceptions, shown as pink lines, are the instances when the yield curve just missed an inversion and economic growth continued.
 

 

Why hasn’t the S&P 500 tanked? The answer seems to be it has become numb to the flood of bad news.

 

 

Washed out

Here’s another example. Micron Technology issued an ugly warning last week. Revenue and earnings guidance was an order of magnitude below consensus expectations.

 

 

In more normal times, the stock could have been down 50%. Instead, it fell -3% and it recovered all of the losses this week.

 

 

The market’s response on the extreme end of the risk scale is equally illuminating. As more news of platform blowups and withdrawal suspensions emerged from Crypto-Land, Bitcoin should be tanking and trading in the single-thousand level, if not even lower. Instead, it has steadied at around 20,000. As well, the ARK Innovation ETF (ARKK) is exhibiting positive relative strength and beginning to outperform the S&P 500.

 

 

Goldman’s sector valuation found that defensive sectors were all in the upper half of relative valuations, which is a sign that the risk-off trade is becoming increasingly crowded.

 

 

The market is washed-out and risk appetite is returning.

 

 

Upside potential

If the market is undergoing a relief rally, what’s the upside potential? A number of low sample size studies offer some clues.

 

Yesterday’s market action was particularly impressive. The S&P 500 opened up -2% but managed to recover and claw its way to a slightly positive close. Steve Deppe conducted a study that found some impressive forward returns but warned that the sample size was small (n=7).

 

 

Rob Hanna at Quantifable Edges studied markets with -15% returns in the first half of the year..These markets also experienced strong positive forward returns, though the sample size is even smaller (n=5) and some of the episodes went back to the 1930’s.

 

 

He warned that the results after H1 years that fell between -10% and -15% were uneven.

 

 

I conclude from this that historical experiences can only offer a rough guide because of the low sample size of the studies. While market psychology is washed-out and the market is undergoing a relief rally, traders should exercise some caution and refrain from becoming overly greedy. The S&P 500 will see resistance in the 3900-3940 zone. Above that is secondary resistance offered by the 50 dma. If the index reaches those levels, traders should take some profits.

 

 

As the trader’s adage goes, “Bulls make money, bears make money, pigs just get slaughtered.”

 

When does the pain end?

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: Bearish
  • 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.
 

 

Here we go again

June was awful month and 2022 was even worse for investors. The S&P 500 has been falling all year, though it constructively ended the week with a continuing positive 5-week RSI divergence, indicating waning downside momentum.

 

 

Where’s the bottom? 

 

 

A history of pain

The historical studies give a good sense of the carnage. There have only been seven other occasions since 1946 when the S&P 500 has fallen -15% or more. If history is any guide, the market rebounded in the next three, six, and 12 months.

 

 

The first half was also ugly, with similarly positive results for the remainder of the year.

 

 

Not only did stocks perform badly, but also the 10-year Treasury hasn’t had such a rough time since 1788, which was the year before George Washington first became President.

 

 

Even my Trend Asset Allocation Model was substantially in the red, though it did beat its benchmark. The model portfolio one-month return was -3.7% vs. -4.3% for a 60/40 benchmark. The one-year return was -7.5%, vs. -9.0% for the 60/40 benchmark (full details here).

 

 

 

A nadir in confidence?

Do these historical studies mean that the markets are poised for a rebound? Here are some clues.

 

A recent Deutsche Bank survey found that “90% expect the next US recession by the end of 2023 or before, with 20% anticipating one this year. That is up from 37% and 2% in January, respectively, and 78% and 13% last month.” A recession is now the overwhelming consensus.

 

 

Households are similarly pessimistic. Bottoms in consumer confidence has historically resolved in strong equity price returns. The key question for investors is whether confidence can turn up in the near future.

 

 

Consumer confidence has shown a strong inverse relationship with oil prices since the mid-90’s (WTI price is inverted).

 

 

Crude oil prices are looking a little toppy, but can they drop in light of the supply difficulties caused by the Russia-Ukraine war? The New York Fed produces a weekly oil price dynamics report, which decomposes the different elements of oil prices. Supply dynamics (red) are tight, but demand (blue) is falling. The gold region, or residual, can be best thought of as speculative investor demand, which is also falling. Consequently, oil prices have encountered difficulty advancing in the face of falling supply. 

 

 

Already, growth expectations are skidding. As the growth outlook slows, the combination of slower demand and waning speculative activity will be bearish factors in oil prices. As energy costs ease, consumer confidence should begin to recover.

 

 

 

Sentiment support

Sentiment and technical conditions point to a washout. Jason Goepfert at SentimenTrader found that 5-week market volatility is at its highest since 1928, which has caused sentiment to tank. Over the past 80 years, similar instability coincided with the ends of bear markets. The catch is such conditions don’t always pinpoint the precise bottom.

 

 

SentimenTrader also has built a proprietary Risk On/Off Indicator, which combines 21 unique components into a weight-of-the-evidence approach to assess market conditions. It just fell to zero for only the sixth time in the last 20 years.
 

 

 

Valuation signals

As well, JPMorgan Asset Management found that the percentage of companies trading at below cash and short-term investments has risen to a fresh high. Before becoming overly excited, keep in mind that these companies are from the CRSP universe, which contains many micro-cap stocks that are not investable for liquidity reasons. Nevertheless, this is a useful signal that the stock market is becoming very cheap.

 

 

 

No Fed Put

The bears will argue that this time is different. While the market is becoming stressed and sentiment looks washed out, global central bankers have affirmed their commitment to fighting inflation. Better take a little pain now than have to take a lot more pain later if inflation expectations become unanchored. In other words, there’s no Fed put.

 

Financial conditions are becoming stressed, but readings are hardly at crisis levels and the unemployment rate is 3.6%.

 

 

It is said that the Fed will raise rates until something breaks, nothing in the U.S. is at imminent risk of breaking. Across the Atlantic, the situation looks a little more precarious. The German utility Uniper announced that it was withdrawing guidance as the company relies on Russian Gas for 50% of its supply. Uniper is losing €30M a day from buying missing gas volumes at spot prices. The situation was resolved when the German government indicated that it stood ready to support the company with a bailout. There’s nowhere to hide. Not even utilities are safe.

 

The Uniper situation highlights the EU’s fragile position. Gazprom is scheduled to shut down the Nordstream 1 pipeline July 11–21 for planned maintenance. The concern is that Moscow will take the opportunity to permanently shut gas supplies to the EU in retaliation for supporting Ukraine in the war. Notwithstanding the effects of tighter monetary policy, a shutdown will have the double whammy effect of cratering European growth.

 

Does this meet the criteria of something breaking?

 

 

Seasonal tailwinds

Where does that leave us? 

 

While I am somewhat skeptical of seasonal patterns, the NDR Cycle Composite takes three historical cycles made up of the one-year, Presidential, and 10-year decennial cycles. It has been almost perfect in 2022. It’s pointing to a strong stock market rally in the second half.

 

 

While I am not brushing aside the downside risks to growth, investors have to play the odds in these times of apparent market panic. The market is very worried about falling growth and an inflation rate that’s slow to decelerate. Few have considered a scenario of a combination of small improvements in supply and demand destruction from higher rates is just enough to soft-land the economy. The rise of recession hysteria has meant that risk/reward is becoming tilted to the upside for equity investors.

 

The seven reasons why this cycle is different

Posted by Cam Hui -

One of the key risks to the stock market is earnings expectations. As recession risk rises, it has been unusual to see forward 12-month EPS estimates continue to rise. The latest update finally shows that earnings expectations are beginning to stall. S&P 500 estimates are flat for the week, up a miniscule 0.01, while small-cap S&P 600 estimates are down over -1% in the week.
 

 

Why haven’t stock prices skidded further? Here are some reasons why this cycle is different from others.

 

 

Recession fears overdone

Here is the bull case. Recession fears are overdone and a slowdown may already be discounted by the markets. Global web searches for the term “recession” has spiked to levels consistent with the COVID Crash and the GFC.

 

 

Economic deterioration is attributable to three factors. 
  • Household consumption has shifted from goods to services. While the shift is not recessionary, it does resulted in a dramatic change in indicators like manufacturing PMI.
  • Inflationary pressures from higher prices have resolved in volume destruction, but no demand destruction, which would be recessionary.
  • Monetary policy is working to dampen growth expectations.
LinkedIn chief economist Gary Berger pointed out that the economy may not be as bad as many people feared. While most investors and economists focus on GDP, which is derived from spending data, GDI, which is calculated from income data, is not that bad. Q1 GDI expanded at the trend growth rate of 2%.

 

 

Berger’s observation that income-derived data points to continued expansion is consistent with Ben Carlson‘s conclusion that consumers are prepared for a recession. Household balance sheets are strong and any recession should be mild as leverage is low in the system.

 

 

 

Inflation pressures are easing

Remember the transitory inflation narrative? It’s actually happening. Container freight rates have peaked, which is a signal that supply chain bottlenecks are easing.

 

 

The latest release of PCE shows monthly core PCE at 0.3% for May and annual core PCE at 4.7%, both of which were below market expectations. The good news is PCE and core PCE are decelerating on an annual basis. The bad news is the progress in monthly core PCE has been stalled at 0.3% and the base effects of high inflation will dissipate by July. These readings will be encouraging for Fed officials, but they aren’t likely to be convincing enough for a pivot to an easier monetary policy.

 

 

 

Effective monetary policy

The positive effects of tighter monetary policy are appearing. Inflationary expectations are well-anchored and falling. Central bankers will think twice when they consider tighter policy to overshoot their neutral rate targets.

 

 

The current cycle looks like a rapid rate hike cycle. The market focus has shifted to whether the Fed will hike 0.50% or 0.75% at the next FOMC meeting to the terminal rate and the timetable for easing policy. Fed funds futures are now expecting a terminal rate of 3.25% to 3.50%, which is down 0.50% from 3.75% to 4.00% after the hot May CPI print. The market expects the Fed to reverse course and ease in mid-2023. In other words, it’s expecting a recession. While this is consistent with the Fed’s SEP projection of a Fed Funds rate of 3.4% at the end of 2022, the Fed expects further tightening in 2023.

 

 

Financial markets are inherently forward-looking. If they discount events 6-12 months ahead of time, any recession is already priced in and the stock market’s strength is anticipating a Fed pivot towards easing.

 

 

Value signals

Finally, value signals are appearing in the stock market. Insiders have been buying the dips whenever the market has weakened, which could put a floor on stock prices.

 

 

As well, value investor Howard Marks, whose newsletter is admired by Warren Buffett, was profiled in the Financial Times and said, “Time is ripe to snap up bargains”. He revealed that he is “starting to behave aggressively”.

 

 

You ain’t seen nothing yet

Here is the bear case. A global recession is looming. NDR’s Global Recession Probability Model is now at 89.3%. It has never moved above 90% without a global slowdown either being in place or happening soon.

 

 

Central bankers are engineering a recession. Even as they focus on fighting inflation, PMI data indicates that they are tightening into a slowdown.

 

 

Commodity prices are also signaling a slowdown. Both the liquidity-weighted headline commodity indices, which are heavily weighted in energy, and the equal-weighted indices are breaking down. The all-important copper/gold and base metal/gold ratios are falling, indicating cyclical weakness.

 

 

In particular, the copper/gold and base metal/gold ratios have shown a strong history of being a good risk appetite indicator.

 

 

 

More downside risk

If you thought that the market has already fully discounted a slowdown, think again. S&P 500 forward 12-month estimates are just starting to wobble. Historically, EPS falls -17% during recessions. The coming days could see both P/E compression and a falling E.

 

 

As an example, Micron’s earnings and Q4 guidance was astonishingly bad. That said, the market reacted positively on Friday to GM’s negative guidance.

 

 

The WSJ also reported that stocks normally don’t bottom until the Fed eases:
If history is any guide, the selloff might still be in its early stages. 

 

Investors have often blamed the Federal Reserve for market routs. It turns out the Fed has often had a hand in market turnarounds, too. Going back to 1950, the S&P 500 has sold off at least 15% on 17 occasions, according to research from Vickie Chang, a global markets strategist at Goldman Sachs Group Inc. On 11 of those 17 occasions, the stock market managed to bottom out only around the time the Fed shifted toward loosening monetary policy again. 
In other words, brace for more downside risk.

 

 

China weakness

Furthermore, don’t bother waiting for Chinese stimulus to pull the global economy out of its slump. The Chinese economy is exhibiting signs of weakness with few signs of recovery. CNBC reported that China Beige Book found widespread weakness in the wake of the zero-COVID lockdowns.
Chinese businesses ranging from services to manufacturing reported a slowdown in the second quarter from the first, reflecting the prolonged impact of Covid controls.

 

That’s according to the U.S.-based China Beige Book, which claims to have conducted more than 4,300 interviews in China in late April and the month ended June 15.

 

“While most high-profile lockdowns were relaxed in May, June data do not show the powerhouse bounce-back most expected,” according to a report released Tuesday. The analysis found few signs that government stimulus was having much of an effect yet.
Sales and profit margins are slumping.

 

 

Credit growth is still weak, indicating a lack of stimulus.

 

 

The SCMP reported that Q1 migrant worker wages were flat year on year in real terms, which is a signal of anemic household demand. Other anecdotal evidence points to weakness in both the property market and household sector. If you were waiting for another round of stimulus to boost infrastructure spending, forget it!

 

 

 

A rapid tightening cycle

Here is how I resolve the bull and bear cases. This has been an extraordinarily rapid rate hike cycle. Mary Daly of the San Francisco Fed pointed out that financial conditions have tightened very quickly compared to past cycles. It is therefore no surprise that the market is discounting Fed easing in 2023.

 

 

The economy is in uncharted waters in light of the speed and intensity of the current tightening cycle. Conventional cycle analysis argues for more equity downside in light of the earnings adjustments should a recession materialize. Willie Delwiche at All Star Charts has proposed a 2008 style template for the stock market.

 

 

I think his conclusions are overly alarmist. Even if a recession were to occur, its effects on employment and spending should be relatively mild, like in 1990, when the S&P 500 peak-to-trough drawdown was -20%. The bulls will argue the market has already discounted the downturn and it’s now looking ahead to the easing cycle. 

 

The acid test for market psychology will be Q2 earnings season. How will earnings and guidance come in? More importantly, how will the market react to the news? More immediately, the June Employment Report will serve as another guidepost for the trajectory of monetary policy.

 

Stay tuned.

 

Trading the FOMC pattern

Posted by Cam Hui -

Mid-week market update: Even though the sample size is small (n=4), the stock market seems to be repeating the FOMC meeting pattern of 2022. The pattern consists of weakness into an FOMC meeting and a rally afterward. The post-meeting rally in May fizzled out quickly but the others were more sustainable. 
 

 

The S&P 500 is now testing support after breaking out. If the market were to rally, gap resistance can be found at 3980-4020. Is there any more life left in the current rally? Will the market decline into the next FOMC meeting scheduled for July 26-27?

 

 

Sentiment support

While it is true that the market retreated from a short-term overbought condition and prices would weaken further from current levels, excessively bearish sentiment will act to put a floor on prices. II sentiment improved this week but remains at a bearish extreme.

 

 

A recent survey of JPM Macro Quantitative conference attendees revealed a bearish bias.

 

 

Macro Charts pointed out that aggregate futures positioning is at a record low.

 

 

Outside of a cataclysmic event such as California getting hit with the BIG ONE and sliding into the sea, markets simply don’t crash with sentiment at such extremes.

 

 

Timing the peak

While there are no guarantees, if the market were to follow the FOMC pattern, watch for a peak about 10 days before the next FOMC meeting, which takes us to mid-July. Tactically, I would stay bullish and watch for an overbought condition in the NYSE McClellan Oscillator.

 

 

My inner investor is still cautiously positioned but he will nibble away at positions should the market weaken. My inner trader is on the sidelines. It’s too late to buy but too early to short.

 

Q2 earnings season = Market abyss?

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: Bearish
  • 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.
 

 

Nagging doubts

Despite my constructive views on the direction of the stock market, some nagging doubts remain. Even as top-down strategist reduce their S&P 500 EPS estimates, bottom-up estimates, as measured by forward 12-month EPS, have been rising steadily for both large and small caps.

 

As we approach Q2 earnings season, the risk of a flood of negative guidance that pushes down consensus estimates is high, which would spark a risk-off episode.

 

 

Still a crowded short

Sentiment models are supportive of higher prices. I recognize that there are problems with the AAII weekly sentiment survey, such as low sample size and differing survey respondents that vary from week to week. Nevertheless, the latest AAII weekly survey shows that the bull-bear spread has only been exceeded twice in its history, the 1990 bear market and the GFC Crash. The percentage of bears also shows a similar result. These levels are astonishing when you consider the Crash of 1987 is part of the historical period.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investor funds, is also highly negative. This index has flashed an almost sure-fire buy signal whenever it fell below its 26-week Bollinger Band. While the latest readings weren’t below the 26-week BB, they did equal the level five weeks ago when this index produced a buy signal.

 

 

The correlation of stocks within the S&P 500 has spiked. This is another contrarian bullish signal which indicates herding and excessive fear.

 

 

 

Technically bullish

From an intermediate-term basis, the weekly S&P 500 exhibited a positive RSI divergence when it fell to fresh lows two weeks ago on high volume, which should lead to higher prices.

 

 

Market breadth is also constructive. NYSE 52-week highs-lows failed to make a new low when the S&P 500 made a low for the year, while NASDAQ 52-week highs-lows exhibited a positive divergence.

 

 

The S&P 500 Intermediate Term Breadth Oscillator saw its 14-day RSI recycle from an oversold condition. This has been a fairly reliable tactical buy signal in the past.

 

 

 

Price leads fundamentals

Jurrien Timmer of Fidelity offered a highly insightful chart that put the risk of negative EPS revisions into context. The chart compares the percentage of S&P 500 stocks above their 200 dma (blue line, bottom panel) to EPS revisions (gold line, bottom panel). The history of major market downdrafts shows that declines in market breadth almost always led changes in fundamentals. The only exception occurred in 2015 (red box), when the decline in earnings was attributable to falling oil prices. (Annotations are mine).

 

 

In conclusion, the intermediate-term bull case remains intact. Both sentiment and technical conditions are still supportive of high stock prices. While investors may face the risk of earnings downgrades as we approach Q2 earnings season, much of the fundamental weakness may already have been discounted.

 

Bullish omens from the factor gods

Posted by Cam Hui -

Recession fears are rising everywhere, both on Wall Street and in Washington. Fed eonomist Michael T. Kiley formulated a recession model based on unemployment rates. The probability of a recession over the next four quarters is now over 50%, but the economy has never avoided a recession when readings were this high.
 

 

The New York Fed’s DSGE model, which does not represent its official forecast, puts the chances of a hard landing at 80%. There are numerous other examples. That’s just two of them. 

 

Recessions are supposed to be negative for stocks, right? Yes, most of the time. Even as recession anxiety rises, the omens from the sector and factor gods are telling a different story for the stock market.

 

 

Macro downgrades

The macro downgrades shouldn’t be a surprise. The US Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations, has been tanking. 

 

 

Wall Street strategists are scrambling to cut top-down earnings estimates. As an example, Ian Harnett of ASR penned an op-ed in the Financial Times that indicated the risk to equities isn’t interest rates, but earnings.

 

The current data signal a synchronised slowdown around the world. Rather than uninterrupted earnings per share growth, our models point to an earnings recession in the year ahead. We expect US earnings to fall by an 10 to 15 per cent over that time. 

 

Perhaps even more impressive is that the consensus EPS forecast for the Euro Stoxx index companies is signalling increasing earnings expectations despite the war in Ukraine and a cost of living crisis that is likely to raise costs and reduce demand for corporates. Our “top-down” forecasts suggest that eurozone EPS could fall by an annualised 20 per cent in the year ahead.

 

 

A recessionary slowdown is now becoming the consensus call.

 

 

Bad news is good news

Ironically, bad news is becoming good news for risky assets. Jerome Powell stated in the last post-FOMC press conference that the Fed is increasingly focused on headline inflation rather than core inflation as a guide to monetary policy. It sounds like the political press to control inflation is heating up.

 

People, the public’s expectations, why would they be distinguishing between core inflation and headline inflation. Core inflation is something we think about because it is a better predictor of future inflation. But headline inflation is what people experience, they don’t know what core is. 
Here’s the good news. Energy and food prices are falling. The point and figure chart of crude oil violated a key uptrend.

 

 

Wheat prices peaked in May and they have been weakening since. 

 

 

These developments are welcome news for policy makers. It’s an indication that inflation pressures are beginning to top out. Moreover, falling grain prices serve to alleviate hunger in much of the world as the Russia-Ukraine war has restricted global cereal exports. 

 

 

In response, bond yields have begun to fall in response to expectations of slower growth.

 

 

Improved risk appetite

A review of sector and factor returns in the US equity market was highly revealing of changes in market psychology. Even as the S&P 500 fell to fresh lows in June, the relative performance of defensive sectors failed to make relative highs, with the exception of healthcare.

 

 

Growth stocks are starting to show some signs of life. The relative performance of growth sectors are all trying to bottom even as the S&P 500 probed new lows for the year.

 

 

The relative performance of value sectors tells a different story. Resource extraction sectors such as energy and materials have fallen hard against the S&P 500, while the relative performances of other value sectors have traded sideways. The cyclically sensitive equal-weighted consumer discretionary sector is in a well-defined relative downtrend.

 

 

The returns to the quality factor have been unexciting, which is a surprise as quality stocks tend to outperform during periods of economic stress.

 

 

From a market cap perspective, the mega-cap S&P 100 and NASDAQ 100 have suddenly surged relative to the S&P 500, while mid and small-cap stocks have trended sideways to down.

 

 

I interpret these conditions as signs of bearish exhaustion. As bond yields decline in anticipation of slower growth, high-duration plays such as large-cap quality growth are making a comeback. It’s difficult to forecast how the intersection of likely falling earnings estimates and declining yields will play out for equity prices, but the market reaction has been constructive so far.

 

 

Fading geopolitical risk

Another piece of good news for equity investors is a fading geopolitical risk premium. Despite the shock of the Russia-Ukraine war and the risks it poses to the European economy and global hunger, the market appears to have digested much of the risk.

 

Consider Poland, which is located on Ukraine’s western flank. The performance of MSCI Poland has stabilized, on an absolute basis and relative to European and global equities (all returns are in USD).

 

 

Turkey is on the southern flank of the conflict. Despite well-publicized problems with inflation and a falling currency, MSCI Turkey has performed well in a difficult environment and it’s in a relative uptrend compared to Europe and global stocks.

 

 

The onset of the Russia-Ukraine war has led some analysts to voice concerns about a Chinese invasion of Taiwan. While MSCI Taiwan recently broke support on an absolute basis, it’s performing well when compared to EM xChina and global stocks.

 

 

In case you missed it, my recent market bottom call has been highly controversial (see Why last week may have been THE BOTTOM). Even though a recession has become the consensus view among strategists, the market is not reacting to the negative news. A review of sector and factor returns shows a constructive return of risk appetite. While it’s impossible to know if another shock could spark another risk-off episode, the long-term risk/return outlook for equities is becoming more attractive at these levels.

 

The key risk to watch is whether the BOJ can continue to buck the trend with an easing policy even as global central bankers tighten. JPYUSD has fallen dramatically, which raises the risk of a currency war in Asia. Already, Chinese sovereign bonds are now yielding less that Treasuries, which is putting pressure on China to devalue. Other Asian currencies, such as INR< PHP, and KRW have also weakened, which are worrisome developments.

 

Unpacking my market bottom call

Posted by Cam Hui -

Mid-week market update: My last publication (see Why last week may have been THE BOTTOM) certainly caused some contraversy. Why I am making no promises the future, I turned cautiously bullish on February 25, 2008, just a week before the generational March 2009 bottom (see Phoenix rising?). 
 

In that post, I postulated that the market was sufficiently washed out that it was time to dip your toe into the water with speculative Phoenix stocks, low-priced stocks that had fallen dramatically and saw significant insider buying. The good news is the timing of the call was nearly perfect, it came a week before the ultimate low. The bad news is the S&P 500 fell another -8% before the market finally bottomed.

 

 

Nobody’s perfect.

 

 

Still washed-out

You can tell a lot about market psychology by the way it responds to news. The WSJ reported what everyone already knew, that Fed Chair Jerome Powell Says Higher Interest Rates Could Cause a Recession:
 

Federal Reserve Chairman Jerome Powell said the central bank’s battle against inflation could lead it to raise interest rates high enough to cause an economic downturn.

 

“It’s certainly a possibility,” Mr. Powell said Wednesday during the first of two days of congressional hearings. “We are not trying to provoke and do not think we will need to provoke a recession, but we do think it’s absolutely essential” to bring down inflation, which is running at a 40-year high.
In response, the S&P 500 opened in the red early in the morning as overseas markets were weak overnight, but closed roughly flat on the day. That’s how wash-out markets behave.

 

Sentiment models are contrarian bullish and supportive of an advance. The bull-bear spread in Investor Intelligence sentiment printed another low this week, and readings were only exceeded by the levels seen during the GFC. II bears, however, were only comparable to the 2011 low.

 

 

Morgan Stanley’s prime brokerage arm reported that net leverage of long/short hedge funds fell to levels last seen during the GFC.

 

 

Is sentiment sufficiently panicked to signal a major market bottom?

 

 

Buy signal, or just a setup?

I honestly don’t know. Mark Ungewitter observed that past breadth wipeouts, as measured by the % of S&P 500 above their 50 dma, tend more to be buy signal setups than actual buy signals.

 

 

 

Bull and bear cases

The bull case, as outlined by Ryan Detrick, is the S&P 500 has tended to perform well after two back-to-back -5% weeks.

 

 

As we approach Q2 earnings season, the bear case is while bottom-up EPS estimates are still rising, strategists are cutting their top-down estimates. This could be a key inflection point in the cycle where top-down analysts see an economic slowdown ahead, but bottom-up company analysts won’t revise their estimates downwards until they speak to company management. If Q2 earnings disappoint or if guidance is weak, watch for mass earnings downgrades.

 

 

 

Relief rally ahead

The odds favor a short-term rally. Rob Hanna at Quantifiable Edges reported that his Quantifiable Edges Capitulative Breadth Indicator (CBI) spiked to 11 on Friday. Readings above 10 have historically resolved in a bullish manner, at least in the short run.

 

 

It’s possible that last week marked the first market bottom that will be retested sometime in the coming weeks. History doesn’t repeat, but rhymes. We have not seen the positive divergences that characterize bear market bottoms yet. The March 2009 bottom was signaled by positive breadth divergences and sparked a rare Zweig Breadth Thrust buy signal. The market never looked back after that.

 

 

If the relief rally were to continue, initial resistance can be found at the first gap at 3830-3900, secondary resistance at the next gap at 3975-4010, and a strong resistance zone at 4080-4200. If the rally were to fail, watch for a test of support and possible positive technical divergences.

 

 

My inner investor is still cautiously positioned, but he dipped his toe into the water. My inner trader is standing aside until volatility calms and a trend begins to manifest itself.

 

Why last week may have been THE BOTTOM

Posted by Cam Hui -

I am not always right and financial markets are facing many uncertainties, but last week’s market action may have marked the bottom of this market cycle.
 

It isn’t just the extreme level of the BoA Bull & Bear Indicator. though that is one piece of the puzzle. This indicator turned prematurely bullish by falling below 2 in March, but readings have declined to the extraordinarily low level of 0.
 

 

Marketwatch reported that the index last reached 0 only on a handful of occasions: in August 2002, July 2008, September 2011, September 2015, January 2016, and March 2020.

 

 

 

Extreme technical wipeouts

Many technical conditions are at levels seen at past major market lows.
  • NYSE 52-week lows reached levels last seen during the GFC bear market. Readings were higher than the COVID Crash, the 2011 Greek Crisis, and the 2002 post-NASDAQ Bubble low.
  • The ratio of S&P 500 stocks above their 50 dma to S&P 500 stocks above their 150 dma, which is an intermediate-term oscillator, reach levels last seen during the COVID Crash, the 2011 Greek Crisis, the GFC, and the 2002 lows.

 

 

Other breadth indicators are also signaling oversold extremes seen at major market bottoms.

 

 

I previously highlighted the “good overbought” condition exhibited by the market based on the percentage of S&P 500 stocks above their 200 dma rising above 90% in mid-2020 after the COVID Crash (top panel, shaded areas). Such “good overbought” readings are indicators of strong price momentum that allow stock prices to advance steadily. Momentum faltered in mid-2021, which was an early sign of a market top. Past episodes have resolved in market bottoms when the percentage of S&P 500 above their 50 dma falls below 20% (bottom panel). This indicator reached 2% last week, which is an extreme level indicative of stock market panic. As well, the percentage of S&P 500 above their 200 dma fell to 12.8% last week, which is another extreme reading.

 

 

The BoA Global Fund Manager Survey showed that institutional managers have de-risked to levels comparable to the GFC.

 

 

From a technical and sentiment perspective, these are all signs of the blinding fear and capitulation seen at major market bottoms. The only glaring exception was 2008, but 2008 saw a major financial crisis that shook the global banking system. This is not 2008. Today, we have coordinated global central bank tightening that raises recession risk, but no signs of a financial collapse. Arguably, the crypto craze served a useful purpose inasmuch it channeled many of the excesses into non-systematically important parts of the economy.

 

 

Valuation support

I recently wrote that the S&P 500 forward P/E is 15.2, which represents roughly fair value (see The Fed braces for a harder landing), but markets often overshoot fair value when it panics. However, other pockets of the stock market appear to offer compelling value.

 

The S&P 600 is trading at a forward P/E of 11, which is a level last seen during the GFC. The S&P 600 represents a better way of measuring valuation for small-cap stocks than the Russell 2000. The S&P 600 has far fewer unprofitable small caps than the Russell 2000 because of the stricter profitability inclusion criteria of S&P. Consistent with my observations about the number of NYSE 52-week lows, these readings exceed the market bottoms seen during the COVID Crash, the 2011 Greek Crisis, and the 2002 post-NASDAQ Bubble lows.

 

 

Tobias Carlisle of Acquirer Funds recently screened for companies trading below a trailing EV/EBIT ratio of 3 in the Russell 3000. He found 905, which is an all-time high.

 

 

Another indirect signal of value in the stock market is insider buying. Insiders tend not to be short-term traders in their own stocks. They prefer to focus on capitalizing on the lower long-term capital gain tax rate by holding their positions for a year or more. It is therefore constructive that this group of “smart investors” believe that the valuation of their companies relative to publicly available fundamentals are compelling enough that purchases outnumbered sales during the latest downdrafts.

 

 

 

A gift horse?

In short, both technical and valuation conditions indicate that the market gods are offering a gift to equity investors. But should investors look the gift horse in the mouth, just as the defenders of Troy should have?

 

The key risk to the market bottom narrative is a recession that sends earnings estimates skidding. FactSet reports that bottom-up forward 12-month EPS estimates are still rising in the face of an above average level of negative earnings guidance.

 

More S&P 500 companies have issued negative EPS guidance for Q2 2022 compared to recent quarters as well. At this point in time, 103 companies in the index have issued EPS guidance for Q2 2022, Of these 103 companies, 72 have issued negative EPS guidance and 31 have issued positive EPS guidance. This is the highest number of S&P 500 companies issuing negative EPS guidance for a quarter since Q4 2019 (73). The percentage of companies issuing negative EPS guidance for Q2 2022 is 70% (72 out of 103), which is above the 5-year average of 60% and above the 10-year average of 67%.

 

 

Furthermore, the number of buy ratings remains highly elevated.

 

 

Recession risk is rising. New Deal democrat, who maintains a discipline by monitoring a series of coincident, short-leading, and long-leading indicators, has documented the deterioration of his long-leading indicators for several months. His latest update shows that the weakness is spreading to his short-leading indicators, which are designed to spot economic weakness six months ahead, indicating a possible downturn that begins in Q1.

 

The Wall Street Journal conducts a regular poll of economists to determine the probability of recession within 12 months. The latest reading is 44%, which is a level seen during or on the brink of actual recessions.

 

 

Recessions are normally thought of as two consecutive quarters of negative real GDP growth. Q1 real GDP was already negative, though the figures are distorted by inventory adjustments and final demand told a stronger story. The Atlanta Fed’s Q2 nowcast is now zero, which raises the risk of two consecutive quarters of negative GDP growth.

 

 

For the record, the National Bureau of Economic Research (NBER) is the official dater of recessions. It defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months” and focuses on “three criteria—depth, diffusion, and duration”. This is a slightly more complicated metric that the simple two consecutive quarters of negative real GDP growth.

 

 

Wait for the retest

I resolve the bull and bear debate this way. The base case scenario is a double or triple bottom. Extreme oversold conditions were observed during past market panics in 2002, 2008, and 2011. The S&P 500 rallied and went on to retest the old lows several weeks or months later.

 

The lack of earnings downgrades is troubling in the face of growing recession risk. While the market recently went bonkers over the hot CPI print, a little-noticed effect of CPI is it tends to lag PCE, which is the Fed’s preferred inflation metric. That’s because the higher weight of shelter in CPI and rents and property prices, which affect rent, are lagging indicators. Historically, headline CPI-PCE (blue line) has risen strongly ahead of recessions. Both headline and core PCE appear to be topping out, which may foreshadow less aggressive Fed tightening.

 

 

Here is a closer look at core PCE, which peaked in February. The combination of strong CPI and tame PPI has led to a tamer May core PCE estimate.

 

 

How will the market react if earnings estimates decline while the Fed pivots to an easier monetary policy? There are too many moving parts to tell how this all plays out. 

 

If there is a recession, it should be mild because of a lack of excessive leverage. In the mild recessions of 1990 and 2000-2002, forward EPS estimates fell by 10-15%. Keep in mind, however, that actual earnings didn’t fall in the 1970’s in nominal terms. It’s therefore possible during the current episode of elevated inflation that EPS estimates stay flat while interest rates decline.

 

One possible template for current market and economic conditions is the double-dip recession. GDP growth turns negative in Q2, which raises concerns that the economy has entered a recession, though it doesn’t get confirmed by NBER. Earnings estimates continue to rise, inflation begins to ease and so do Fed Funds expectations. The stock market rallies, only to meet the actual recession which begins in early 2023, which is the time frame forecast by many top-down models.

 

Double-dip recessions are rare. The last one occurred in 1980-81. The Dow first bottomed in April 1980 and rallied into early 1981 by breaking through the psychologically important 1,000 mark. It began a bear market that ended in August 1982 when the Fed eased in response to the Mexican Peso Crisis which threatened the US banking system.

 

 

In conclusion, technical and valuation conditions are consistent with past major panic lows. The key risk is a lack of earnings downgrades in the face of growing recession risk.

 

Despite the strong technical evidence of a panic bottom, I am taking a more nuanced view. My base case scenario calls for a double or multiple bottoms in stock prices and a possible double-dip recession. History doesn’t repeat itself, but rhymes. Q2 earnings season will prove to be a key test for market expectations. Stay tuned.