The bears gain the upper hand

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.
 

 

Breaking support

So much for the breadth thrust. After surging off a test off the lows in late May after exhibiting strong price momentum known as breadth thrusts, the S&P 500 consolidated sideways for about a week. The index decisively broke down through a narrow trading range Thursday with a 93% downside volume day, which negated the bullish implications of the previous breadth thrust signal. The index is now testing support as defined by the May lows.

 

 

While it would be very easy to turn bearish, sentiment and market internals suggest relatively low downside risk.

 

 

Reasons to be bullish

Here are some reasons to be constructive about the stock market outlook. From a technical perspective, Mark Ungewitter pointed out that 90% downside volume following 90% upside volume doesn’t guarantee further drawdowns/

 

 

Sentiment models are showing signs of fear, which is contrarian bullish. The correlation of stocks with each other (yellow line) is rising, indicating herding behavior typically seen when the market panics.

 

 

Consumer sentiment has tanked. Historically, these readings have been a good long-term entry point for stocks.

 

 

The weekly AAII bull-bear spread fell back to -25%, which is a contrarian buy signal.

 

 

Here’s another anomaly to ponder. There has been a lot of anxiety over the housing sector as mortgage rates rose. This is a cyclically sensitive sector that’s a recession bellwether. So why are homebuilding stocks outperforming?

 

 

 

Neutral indicators

A number of indicators are flashing mixed signals, such as market breadth. On one hand, net 52-week highs-lows turned positive when the market rallied but turned negative as the market weakened. On the other hand, the percentage of S&P 500 stocks above their 50 dma fell has reached a deeply oversold condition.

 

 

Another set of mixed signals can be found in credit market risk appetite. The relative price performance of junk bonds compared to their duration-equivalent Treasuries tanked and negated the minor positive divergence shown by this asset class. However, the relative performance of leveraged loans are still exhibiting a positive divergence from the S&P 500.

 

 

The term structure of the VIX is also showing some mixed signals. While the 1-month and 3-month term structure of the VIX is still upward sloping, indicating complacency, the 9-day to 1-month ratio inverted even as the S&P 500 consolidated sideways, indicating rising fear.

 

 

 

A reliable sell signal

To be sure, the S&P 500 intermediate breadth momentum oscillator (ITBM) has seen its 14-day RSI recycle from an overbought condition to neutral, which is a sell signal. This is a worrisome sign as this has been a very reliable trading model in the past.

 

 

 

Limited downside risk

In the short run, the market is very oversold. Readings are as oversold during the COVID Crash and subsequent recovery in 2020. In each of the cases, the S&P 500 staged a short-term rally even if the market went on to weaken further.

 

 

Rob Hanna at Quantifiable Edges found that whenever the S&P 500 fell -2.5% or more on a Friday, the subsequent return over the next two days were strong. Using that template, investors should see a recovery early in the week, followed by the uncertainty of the FOMC announcement on Wednesday.

 

 

In conclusion, my survey of sentiment and technical indicators show most are either bullish or neutral. I interpret this as crash risk is low and downside potential is limited. As the S&P 500 tests its May lows again, keep an eye on insider activity. Should insider buying rise above selling, it will be another signal that the support defined by the recent lows is likely to hold.

 

 

 

In search of the bullish catalyst

Posted by Cam Hui -

I have pointed out before that the last time the 10-year Treasury yield was at these levels, the S&P 500 was trading at a forward P/E of 14-16. The current forward P/E is 16.8, which is slightly above that range. In order for stock prices to rise, at least one of two things has to happen. Either the discount rate has to fall, which expands P/E ratios, or earnings have to rise.

 

 

Since global central bankers are engaged in a tightening cycle, the prospect of falling rates is off the table. In that case, what’s the outlook for earnings?

 

 

Excessive optimism

The Daily Shot recently featured an analysis of S&P 500 consensus forward 12-month sales and EPS estimates. While both are rising, the rate of increase in forward EPS is steeper than sales, indicating margin expansion. While top-down strategists are starting to reduce their S&P 500 EPS estimates, bottom-up analysts are still raising. This analysis begs the question of whether Wall Street analysts are being excessively optimistic about the outlook for individual companies.

 

 

Ian Hartnett of Absolute Strategy Research pointed out that CEO confidence is plunging. Conditions are consistent with past earnings recessions. JPMorgan CEO Jamie Dimon recently warned about an impending hurricane:

 

I said there’s storm clouds, they’re big storm clouds, they’re — it’s a hurricane It’s, we — right now it’s kind of sunny, things are doing fine, everyone thinks the Fed can handle this. That hurricane is right out there down the road coming our way. We just don’t know if it’s a minor one or Superstorm Sandy or — yes, Sandy or Andrew, or something like that.

 

 

Staying with the storm analogy, there is a silver lining in the dark clouds. Despite the plunge in CEO confidence, insiders stepped up their buying when the S&P 500 tested its May lows. These is a constructive sign from a group of “smart investors” that the outlook isn’t necessarily disastrous.

 

 

 

Main Street turns grumpy

The dour mood is becoming evident on Main Street. An Economist/YouGov poll found a majority of Republicans and a plurality of Democrats believe the economy is in an economic recession.

 

 

As a reminder, recessions are officially determined by NBER Business Cycle Dating Committee, based on a definition that “emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months”. Even if you use the definition of two consecutive quarters of negative GDP growth, it’s difficult to square the recession view with the unemployment rate at 3.6%, though initial jobless claims have bottomed and begun to rise.

 

 

I interpret these conditions to mean that most people don’t know the specific definition of “recession”. They are probably using the term to describe their general feeling about the economy. In particular, inflation is biting into household budgets. The Economist/YouGov poll found that gasoline prices are becoming a problem for most people.

 

 

These conditions lend support to the Fed’s determination to maintain a tight monetary policy to fight inflation, especially in the wake of the hot May CPI report. These kinds of survey results can easily spark a wage-price spiral where the Fed loses control of inflationary expectations.

 

 

Recession ahead?

With the Fed intent on raising rates to fight inflation, what are the odds of a recession? 

 

From a central banker’s perspective, real M2 money growth had been rising at a 3-4% rate until the COVID Crisis pushed liquidity well above trend. The Fed’s challenge is to return real M2 to trend growth, either hold real M2 growth flat until 2025 or sharply reducq liquidity over the next 12-18 months, which would be highly recessionary.

 

 

Here is the latest update from New Deal democrat, who monitors the health of the economy with a series of coincident, short-leading, and long-leading indicators. Among the long-leading indicators, which are designed to spot economic weakness a year ahead, four had positive components, two neutral, and eight negative. The score for the short-leading indicators was more balanced at 6-1-7, while the coincident indicator score was 2-5-4.
 

We have an objectively weak, and weakening, economy. At this point, I would suggest especially watching the consumer coincident indicators – restaurant reservations (one of the first, and easiest things for consumes to cut), and Redbook consumer spending. If these turn significantly negative, then trouble is very close. But I continue to think, based on the timing of the turn in the long leading indicators, that the danger of an outright downturn is next year rather than this.
The outlook for 2023 is extremely wobbly. As the Fed raises rates in order to destroy demand, it’s difficult to see how the economy can sidestep a recession in Q1 or Q2.

 

Here’s the good news. Investors are often afflicted with recency bias. When they think “recession”, they think either 2008, which was the Great Financial Crisis, or 2020, which was rescued by unprecedented levels of fiscal and monetary stimulus that are unlikely to be repeated.

 

This time is different. The US economy is faced with minimal financial crisis risk. Corporate balance sheets are strong.

 

 

Household debt ratios are also under control.

 

 

Instead, the economy is faced with a plain vanilla inventory recession. In the absence of excessive leverage, any slowdown will see greater resilience. A reasonable template would be the post-NASDAQ peak recession. While equity prices cratered because of excess valuation, the rise in the unemployment rate was relatively tame by historical standards.

 

That doesn’t mean, however, that a financial crisis is off the table. Notwithstanding the usual risk of a currency crisis from a strong USD that sparks either an EM crisis or excessive JPY weakness that sets off a round of competitive currency devaluation in Asia, the risk from the developed economies come from countries with property market bubbles, namely Sweden, Canada, Australia, Norway, and New Zealand (SCANNZ), where housing prices have surged far more than rents and incomes to create affordability problems.

 

 

 

Investment implications

In conclusion, the equity market is currently suffering from a non-recessionary slump. Valuations are slightly above fair value and bottom-up EPS estimates are rising. In order for prices to advance, one of two things need to happen. Either earnings need to continue growing, or the cost of capital, otherwise known as interest rates, need to fall.

 

Earnings can only grow if the economy avoids a recession, which is a difficult task in light of the Fed’s tightening bias. If the 10-year Treasury yield were to decline, it would be the bond market’s signal of a weakening economy, which is negative for the earnings outlook.

 

I have made the point before that valuations don’t matter much in a bull market, but define downside risk in a bear market. This is a difficult economic environment for US equity investors. It’s time to consider non-US markets, whose forward P/E ratios are well below the S&P 500, as a way to mitigate downside risk and enhance upside potential when the turn actually arrives. 

 

 

Just be aware of SCANNZ markets as a source of tail-risk.

 

Waiting for the breakout (or breakdown)

Posted by Cam Hui -

Mid-week market update: As the S&P 500 consolidates its gains in a narrow range after its surge last week, it has been a frustrating time for both bulls and bears. 
 

 

As investors wait for either the breakout or breakdown from the range, here are the bull and bear cases.

 

 

A mixed sentiment picture

First, sentiment presents a mixed picture. A variety of (unscientific) Twitter polls lead to wildly different conclusions.

 

Helene Meisler’s weekend poll saw the consensus change from wildly bullish to slightly bearish. The last time a slightly bearish reading followed a string of bullish readings occurred in December when the market topped out. That’s bearish, right?

 

 

Not so fast. Callum Thomas also conducts a weekend Twitter poll. Respondents were bearish, which is contrarian bullish.

 

 

Charlie Bilello recently asked if the recent rally is a dead cat bounce or the real thing, and the consensus is “dead cat bounce”, indicating excessive bearishness.

 

 

My head hurts from thinking about sentiment. Poll results are wildly different and it’s difficult to make any definitive conclusions.

 

 

A butterfly flaps its wings in Beijing

The most bullish development may not be immediately evident to American investors. China’s technology sector has been experiencing a broad-based rally on strong volume, indicating institutional participation. Authorities approved about 60 new video games and eased a crackdown on the sector which began last year. A report earlier this week that regulators were looking to end a probe into Didi Global Inc. also helped sentiment.

 

At the same time, SentimenTrader also reported strong insider buying among NASDAQ 100 stocks.

 

 

From a technical perspective, the relative performance of the NASDAQ 100 to the S&P 500 and Chinese internet stocks to MSCI China have turned up. These developments are supportive of a bullish impulse led by the technology sector.

 

 

Longer term, both the NASDAQ 100 and EM internet and e-commerce stocks are very oversold and due for a turnaround.

 

 

Even ARK Innovation (ARKK) is performing well, both on an absolute and relative basis.

 

 

The NYSE McClellan Oscillator (NYMO) recently became wildly overbought and recycled from its overbought reading. Past experiences has shown that while the market has paused its advance in the past, downside risk has been relatively low and stock prices have continued to advance in most instances of a similar nature.

 

 

 

The challenges ahead

Looking ahead, the bulls face some challenges, starting with tomorrow’s ECB decision, Friday’s CPI report and next week’s FOMC meeting could be sources of volatility.

 

The ECB is expected to turn hawkish in the face of strong inflationary pressures. It will signal an end to asset purchase and a commitment to raise rates in the near future.

 

 

On Friday investors will get the all-important CPI report, which will be watched closely by the Fed ahead of the FOMC meeting next week. While core CPI is expected to decelerate, volatile components such as used car prices aren’t cooperating. The latest Manheim report saw prices edge up. Owners’ Equivalent Rent, which is a significant component of CPI, is expected to firm as well.

 

 

Looking ahead to the FOMC announcement, half-point hikes are already baked into expectations for the next two meetings. The key question for investors is how expectations move for the September meeting. While the market is pricing in another half-point increase in September, the probability estimate is far less certain.

 

 

Vice-Chair Lael Brainard stated in a CNBC interview, “It’s very hard to see the case for a pause.  We’ve still got a lot of work to do to get inflation down to our 2% target.” In light of the strength in the April JOLTS and May Jobs Report, the Fed appears to be prepared for an even more hawkish pivot.

 

So where does that leave us?

 

My inner investor remains defensively positioned. My inner trader is bullish but he has trimmed his long positions. While he is hopeful that the S&P 500 can stage an upside breakout, his risk control discipline calls for him to exit his longs should the market break down from the recent trading range.

 

 

Disclosure: Long SPXL

 

Take some chips off the table

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: Bullish

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

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

 

Nearing upside targets

I recently outlined several ways of estimating the upside potential of the current market rally. A number of tripwires have been triggered or nearly triggered. While the market may strengthen further, it’s time to take some chips off the table.

 

Firstly, the S&P 500 is nearing initial resistance at the combination of the first Fibonacci resistance level and descending trend line at about 4200.

 

 

As well, the S&P 500 Intermediate Term Breadth Oscillator recycled from an oversold to an overbought condition. While overbought markets can become more overbought, it would be prudent to be reducing some risk at these levels.

 

 

While these represent cautionary signals, some other indicators are still bullish.

 

 

Bullish signals

I also suggested watching for penetration of the VIX Index below its lower Bollinger Band as a sign of an overbought extreme, which hasn’t happened yet.

 

 

Another sell signal that hasn’t been triggered is a rise in the NAAIM Exposure Index, which measures the sentiment of RIAs, from below its 26-week Bollinger Band to the 26-week moving average. The NAAIM Exposure Index barely budged in the latest week.

 

 

Similarly, other sentiment indicators like the 10 dma of the put/call ratio has begun to normalize from an extreme fear reading that was last seen during the COVID Crash. However, the 10 dma hasn’t returned to a neutral condition as defined by the 200 dma.

 

 

On the other hand, the AAII weekly sentiment survey jumped to a bull-bear spread of -5, which is a neutral condition.

 

 

 

Constructive indicators

While the following are not actionable trading signals, there are nevertheless constructive for the bull case. Breadth is improving as. NYSE net highs-lows finally printed a series of positive readings.

 

 

As well, credit market risk appetite is flashing positive divergences. The performance of high yield and leveraged loans relative to their duration-equivalent Treasuries is outpacing the S&P 500.

 

 

The BoA Bull & Bear Indicator, which is primarily a contrarian sentiment model, fell from 0.6 to 0.4 last week. This is an indicator with an intermediate time frame and not a short-term tactical timing indicator. It fell below 2 and prematurely generated a buy signal on March 23, 2022 near the tail end of the March rebound. Readings are now the lowest since June 2020.

 

 

 

The easy money has been made

I interpret these conditions as the initial rebound is nearly over and the market is due for a pause, but stocks could work their way higher in a choppy manner over the next few weeks. Intermediate indicators such as the NAAIM Exposure Index, the CBOE put/call ratio, and the BoA Bull & Bear Indicator point to further upside potential.

 

However, the latest risk-on episode has the markings of a bear market rally. Price momentum is strong, but it’s not overwhelming. If history is any guide, past episodes where the five-day rate of change exceeds 10% have marked durable bottoms (grey vertical lines). If we change the threshold to 7% (pink lines), the results can be hit and miss. While the market has roared ahead in some cases, it also weakened after a brief rally. In light of the hawkish monetary backdrop, caution is warranted.

 

 

Finally, a bullish setup is appearing in the gold mining stocks (GDX), which has bearish equity market implications. The gold miners are oversold on the percentage bullish on P&F indicator (bottom panel), but exhibiting positive relative strength against gold. As well, the junior golds (GDXJ) are also showing positive relative performance against the seniors (GDX). The combination of an oversold internals combined with improving internals is potentially bullish for this group. Gold stocks are bottoming, which I interpret as potentially bearish for the overall equity market because of their negative beta characteristics.

 

 

My inner investor is cautiously positioned. My inner trader remains long the market, but he is starting to edge his way towards the exit. How your trading account behaves will be a function of your risk and reward profile. Be bullish, but reduce your risk.

 

 

Disclosure: Long SPXL

 

Buy or fade the breadth thrust?

Posted by Cam Hui -

The recent price surge in late May off the bottom produced a flurry of excitement among technical analysts. Extreme price momentum is known as a breadth thrust in chartist circles. Depending on the magnitude of the breadth thrust, they are often signals of new bull markets.
 

Marty Zweig detailed what became known as the Zweig Breadth Thrust buy signal in his book, Winning on Wall Street, which was first published in 1986. A ZBT buy signal is generated when NYSE breadth moves from an oversold extreme to an overbought extreme within 10 trading days. ZBT signals are very rare. The book described 14 signals since 1945. The average gain following these 14 Thrusts was 24.6% within 11 months.

 

The market surge in late May just missed generating a ZBT. The market achieved the breadth thrust in 11 days, not 10. Since then, a number of chartists have analyzed these “just missed” signals and concluded that they are nearly just as good as the classic ZBT buy signal. As an example, Recession Alert observed:

All but 2 of the 13 signals in the above chart provided positive gains averaging 8.4% some 6 month out, which is equivalent to a 84.6% accuracy. If you relaxed the positive outcome holding period from 6 months to 12 months, then only the 2001 signal provided a negative outcome, increasing the accuracy to 92%. In fact, an examination of an actuarial table of the SP-500 gains for various holding periods after each ZBT-A signal yields some more interesting results.

 

 

Does that mean it’s time to sound the all-clear and buy stocks?

 

 

Meet the Fed

Not so fast. An out-of-sample analysis of the classic ZBT shows that these signals are indeed very rare. There have been only six signals since the publication of Zweig’s book in 1986. In all cases, the S&P 500 was higher a year later, but there were two cases of failed momentum – when the market chopped sideways and retested the old lows before rising.

 

While the sample size is extremely small (n=2), the cases of momentum failures coincided with the Fed tightening policy. The successful ZBT signals occurred during periods when the Fed Funds rates was either stable, falling, or the Fed was about to embark on an easing cycle.

 

 

Breadth thrust bulls, meet the Fed.

 

 

Clear and convincing

Global central banks are undergoing a tightening cycle. The market expectations of the Fed Funds rate indicate a virtual certainty of half-point rate hikes at the next two FOMC meetings, with a split decision between a quarter-point or half-point hike at the September meeting.

 

 

What’s the criteria for the Fed to pause its breakneck pace of half-point rate hikes? At the WSJ Future of Everything Festival, Fed Chair Jerome Powell stated, “What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that.” He went on to use the “clear and convincing” language three times in the interview.

 

What does “clear and convincing” mean? Powell was originally trained as a lawyer, and “clear and convincing” is a legal standard of proof that it requires that the evidence be substantially more probable to be true, It rests between the “preponderance of evidence” standard, which requires only “more likely than not” and the strict “beyond a reasonable doubt” standard.

 

Core PCE, which is the Fed’s preferred inflation metric, has been moderating. We have seen three consecutive months of core PCE prints at the 0.3% level, which is consistent with the Fed’s year-end projection of 4.1%/ Average hourly earnings have also moderated. Does that constitute “clear and convincing” evidence? Here is how Powell responded:

We all read—of course, everyone reads—the inflation reports very carefully and looks for details that look positive and that kind of thing. But truthfully, this is not a time for tremendously nuanced readings of inflation. We need to see inflation coming down in a convincing way. That’s what we need to see. And until we see that, we’re going to keep going. We’re not going to assume that we’ve made it until we see that. And we’re not seeing that right now.

 

 

In other words, don’t expect a dovish pause in the near future. Fed governor Christopher Waller echoed Powell’s view with an even more hawkish tone in a recent speech delivered at the Institute for Monetary and Financial Stability in Frankfurt:

I support tightening policy by another 50 basis points for several meetings. In particular, I am not taking 50 basis-point hikes off the table until I see inflation coming down closer to our 2 percent target. And, by the end of this year, I support having the policy rate at a level above neutral so that it is reducing demand for products and labor, bringing it more in line with supply and thus helping rein in inflation.

A lot of data will be coming in between now and the September FOMC meeting. While a dovish pivot is possible, don’t expect a pause in rate hikes at the September meeting. At best, the Fed will moderate its pace to a quarter-point increase.

 

 

A counterproductive rally

While many technical analysts have viewed the recent breadth thrust in a bullish light, the recent risk-on tone is acting to encourage the Fed to be even more hawkish. That’s because monetary policy works through tightening financial conditions. While the Chicago Fed’s National Financial Conditions Index has tightened, it is not extreme by historical standards.

 

 

The recent risk-on tone of the markets, of which the near ZBT is a symptom, acted to ease financial conditions. As an example, the iShares Interest Rate Hedged High Yield ETF (HYGH), which measures the relative performance of junk bonds compared to Treasuries, rallied so hard in late May that it left two price gaps. The strength in HYGH and the S&P 500 effectively unwound some of the Fed’s tightening policy. All else being equal, the market reaction will encourage an even more aggressive monetary policy.

 

 

In all likelihood, global central banks will keep raising rates until something breaks. Nouriel Roubini is calling for a hard landing in a Project Syndicate essay:
Because stagflationary shocks both reduce growth and increase inflation, they confront central banks with a dilemma. If their highest priority is to fight inflation and prevent a dangerous de-anchoring of inflation expectations (a wage-price spiral), they must phase out their unconventional expansionary policies and raise policy rates at a pace that would likely cause a hard landing. But if their top priority is to sustain growth and employment, they would need to normalize policy more slowly and risk unhinging inflation expectations, setting the stage for persistent above-target inflation.

 

A soft-landing scenario therefore looks like wishful thinking. By now, the increase in inflation is persistent enough that only a serious policy tightening can bring it back within the target range. Taking previous high-inflation episodes as the baseline, I put the probability of a hard landing within two years at more than 60%.
Well-known emerging markets investor Jay Newman wrote in an FT Op-Ed that global central bank tightening will spark a series of EM crises:

We are on the brink of an epidemic of emerging market defaults, the scale and scope of which will rival the debt crisis of the 1980s. Rate increases by Western central banks, fallout from the COVID pandemic, surging food and fuel prices resulting from the economic fallout of the war between Russia and Ukraine, mismanagement, and outright corruption all are contributing factors.

Cracks are already appearing. Sri Lanka’s economy is teetering and Pakistan’s foreign exchange reserves have fallen below $10 billion, which has prompted the government to seek help from the IMF.

 

 

Investment implications

In conclusion, traders should fade the recent episode of positive equity price momentum. While breadth thrust signals are bullish over a one-year time horizon, past signals have fizzled and the market has retested the old lows when the Fed is undergoing a hiking cycle.

 

Long-term investors can begin to accumulate positions at current levels with the awareness that they may see some lower prices over the next few months. The recent cluster of insider buying at the May lows is a constructive sign that downside risk may be limited (see A bull’s view of the rebound). Focus on high-quality stocks in equity portfolios during the current period of economic uncertainty.

 

The quality factor can be measured in a number of ways. S&P has a stricter profitability index inclusion criteria than FTSE/Russell, and S&P’s large and small-cap indices have beaten their Russell counterparts. As well, Pacer has a series of cash cow ETFs consisting of companies with strong cash-generative qualities (COWZ and GCOW). Both have outperformed their benchmarks in 2022.

 

 

 

A bull’s view of the rebound

Posted by Cam Hui -

Mid-week market update: As the stock market rebounded from a deeply oversold condition last week, a consensus is building that this is a bear market rally, and I am in that camp. A Google Trends search for “bear market rally” has spike to all-time highs.
 

 

The contrarian conclusions are either the rally will carry much further than anyone expects, or the recent bottom represented the actual low for the current market cycle. With that thought in mind, what should the bullish investor be buying?
 

 

The insider’s view

The bullish analytical framework begins with insider activity, which saw buys (blue line) outnumber sells (red line) during the last episode of market weakness. 

 

 

For further detail, JPMorgan analyzed insider activity by sector and found:

 

  • Buying activity in industrials, consumer discretionary, healthcare, technology, communication services, and real estate.
  • Selling activity in Energy and Utilities..
  • All other sectors have either marginal buy or neutral readings.

 

 

 

An emerging theme

A theme is emerging from insider activity analysis. Insiders are buying the growth stock losers and selling the winners.

 

Take a look at the relative performance of technology stocks. Relative performance appears to be bottoming out, and so are the relative breadth indicator (bottom two panels).

 

 

Communication services shows a similar pattern of bottoming relative performance and improvements in relative breadth.

 

 

The consumer discretionary sector is dominated by two growth large-caps (AMZN and TSLA). The sector formed a V-shaped relative bottom. While relative breadth is showing some signs of improvement, the signs of a turnaround is not as distinctive as in the previous two growth sectors.

 

 

Industrial stocks, which are not classified as growth but cyclical value, are exhibiting a choppy relative uptrend and some signs of relative breadth improvement.

 

 

Healthcare stocks have been in a relative uptrend for all of 2022, though insiders are buying during the latest period of relative weakness. Relative breadth has improved during the latest market rebound.

 

 

The technical outlier among the sectors exhibiting strong insider buying is real estate. While the sector is exhibiting a relative uptrend, relative breadth is poor.

 

 

By contrast, here are the two sectors experiencing insider selling. Energy stocks have been on a tear, both on an absolute and relative to the S&P 500. However, there may be warning signs that relative breadth may be rolling over.

 

 

The utilities sector remains in a minor relative uptrend, but minor signs of breadth deterioration are also starting to appear.

 

 

 

Insiders are bottom fishing

In conclusion, a technical sector review shows that insiders are buying the beaten-up growth sectors, along with healthcare and industrials. They are selling energy and utilities, which may be a sign that some defensive stock valuation has gotten out of hand.

 

 

In the meantime, there are numerous studies that point to further market strength based on the strong price momentum shown by the market last week. As an example, Rob Hanna at Quantifiable Edges analyzed instances when the market exhibited three consecutive days of at least 70% of upside volume. The market tended to consolidate its gains for the next 1-2 weeks, but risk/return was extremely positive after 70-90 trading days.

 

 

I will address the bear case in a later post.

 

 

Disclosure: Long SPXL

 

How far can this rally run?

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: Bullish

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

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

 

A bullish turnaround

The S&P 500 turned up last week after a test of the May lows while exhibiting a 5-day RSI divergence. The rally was convincing as the index rallied through a falling trend line and the daily MACD indicator turned positive.

 

 

One of the most anticipated relief rallies is here. How far can the stock market run?

 

 

Buy signals everywhere

Last week’s market action sparked buy signals everywhere. NYSE breadth on Wednesday was an 83% volume upside day, Thursday was an 87% upside day, and Friday was another 87% upside day. Two consecutive 80% upside days are unusual. Three consecutive ones are extremely rare. A study by Paul Desmond of Lowry’s Reports found that back-to-back 80% upside days were breadth thrust signals indicating “the completion of the major reversal pattern[s]”.

 

On occasion, back-to-back 80% Upside Days (such as August 1 and August 2, 1996) have occurred instead of a single 90% Upside Day to signal the completion of the major reversal pattern. Back-to-back 80% Upside Days are relatively rare except for these reversals from a major market low. 

The historical record shows that while three consecutive 80% upside days tended to be bullish, there were exceptions. Stock prices topped out after such a signal in 1981 and fell to a lower low in 2008. In other case, the market consolidated sideways.
 

 

Nevertheless, price momentum has become very strong. The NYSE McClellan Oscillator has reached levels consistent with a “good overbought” advance, indicating further upside potential.

 

 

Credit market risk appetite is also starting to show some life. The relative performances of high yield and leveraged loans relative to their duration-equivalent Treasury prices are exhibiting some minor positive divergences from the S&P 500.

 

 

AAII weekly sentiment is still excessively bearish, which is contrarian bullish.

 

 

Sentiment models are supportive of further gains. Last week, we saw bear claws on the cover of Barron’s. This week, Bloomberg BusinessWeek’s cover is another contrarian magazine cover indicator that’s supportive of the bull case. 

 

 

From a global perspective, the percentage of countries above their 50 dma rose from zero the previous week to 10% last week, indicating a recycle off an oversold extreme.

 

 

The performance of MSCI Poland is turning up, which is a sign that geopolitical risk is fading.

 

 

 

When should traders sell?

What’s the upside potential of this rally? The most straightforward way of estimating upside potential is to find potential areas of resistance. Arguably, the S&P 500 is already testing a resistance zone. Further resistance can be found at the first Fibonacci retracement level of about 4185, with secondary resistance at the 50 dma at about 4280, which also roughly corresponds to the area at the falling trend line..

 

 

Another way of estimating upside potential is to monitor the evolution of trading signals. The NAAIM Exposure Index, which measures the sentiment of RIAs, flashed two consecutive buy signals by falling below its 26-week Bollinger Band. This indicator has been excellent at calling short-term bottoms. Upside momentum often fades when NAAIM rises to its 26-week moving average.

 

 

Also, keep an eye on the VIX. Trading tops often form when the VIX Index falls below its Bollinger Band.

 

 

 

Intermediate-term bearish

Despite last week’s show of strength by the bulls, my base case scenario calls for a bear market rally within a bear trend. The relative performances of defensive sectors are still in uptrends, indicating that the bears still have control of the tape.

 

 

Enjoy the rally, but don’t overstay the party.

 

 

Disclosure: Long SPXL

 

Green shoots = Time to bottom fish?

Posted by Cam Hui -

Now that the S&P 500 has started to turn up after bouncing off a head & shoulders downside target. Green shoots are starting to appear for the bulls, is it time for investors to buy stocks and bottom fish?

 

 

 

Rising recession fears

Let’s begin with why the market weakened. Recession fears were rising.

 

As an example, consider the recent changes in the signals from the fixed income markets. For most of 2022, both the 3-month and 10-year Treasury yields rose in lockstep as the market discounted an increasingly hawkish Fed. In early May, the 10-year yield began to fall even as 3-month yields continued to advance.  This is an indication that the bond market is now shifting from fears of Fed tightening to fears of an economic slowdown.

 

 

A Google Trends analysis of searches for “recession” has exceeded the highs during the GFC, but just short of the COVID Crash. By contrast, searches for “inflation” is at an all-time high. Main Street is clearly worried about both inflation, which would cause the Fed to tighten monetary policy, and recession.

 

 

The Citigroup Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, fell below zero, which is an indication of economic deterioration.
 

 

 

Green shoots

On the other hand, green shoots are starting to appear, if you know where to look. Inflation looks like it’s coming under control, which should allow the Fed to take a less hawkish path. The latest FOMC minutes indicate that two half-point hikes are baked in for the next two FOMC meetings, but the Fed would re-evaluate the situation at the September meeting.

 

Most participants judged that 50 basis point increases in the target range would likely be appropriate at the next couple of meetings…Participants judged that it was important to move expeditiously to a more neutral monetary policy stance. They also noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.

The minutes also indicate that the staff forecast for core PCE has risen from 4.0% to 4.3% by the end of 2022. The median core PCE forecast of FOMC members, which is the Fed board of governors and regional presidents, is 4.1%, according to the Summary of Economic Projections published in March. Both core PCE and trimmed mean PCE have been at or under those levels for three consecutive months. These readings are already quite tame by the Fed’s own standards and more prints at these levels in the next few months would allow the Fed to become less hawkish.

 

 

In addition, the New York Fed conducts a survey of consumer expectations and found that the median consumer expects inflation to fade over the next few years. Inflation expectations are well anchored and not running wild.

 

 

There is also some possible good news in equity valuation. The S&P 500 is trading at a forward P/E of 17.1, which is slightly above its 10-year average of 16.9. When the 10-year yield was trading at similar levels, the market traded at a forward P/E of 14-15.

 

 

While current valuations still appear to be a little rich by historical standards, much depends on the evolution of the E in the P/E ratio. If the economy were to weaken into recession, earnings would decline and put further pressure on equity valuation. Instead, corporate guidance has been positive, despite recent headlines from selected retailers and technology stocks.

 

 

Marketwatch reported that insiders have been stepping up their buying of company stock. The ratio of insider buys to sells has spiked.

 

 

Leuthold Group’s analysis of big block insider activity is also flashing a buy signal.

 

Leuthold Group Chief Investment Officer Doug Ramsey prefers to gauge insiders by measuring big transactions of either 100,000 shares or $1 million. He subtracts buys from sells to find “net sells” as a percentage of issues traded on the NYSE. This fell below 1% May 20, boosting this measure to “maximum bullish,” he says.

 

These readings are consistent with my own observation that insider buys (blue line) have recently exceeded insider sales (red line).

 

 

It’s impossible to say whether this constitutes the bottom of the current stock market pullback. Insider activity has its limitations as a market timing signal. At a minimum, these conditions should be a signal for a short-term rally. The pattern of insider buying in 2008 is an example of the limitations of insider activity as an investment signal. Insiders were early in buying in March and July. The market staged minor rallies after those instances but weakened further later in the year. Insiders went on to buy aggressively from October 2008 to March 2009. While they were on the whole correct, these signals were inexact market-timing indicators.

 

 

If the recent episode of stock market strength is a bear market rally, a template of current insider activity might be the 2015-16 period. Insiders flashed buy signals in July and August 2015 and the market staged minor rallies. Stock prices consolidated sideways in a choppy pattern and insider buys exceeded sales during the January and February 2016, which turned out to be the ultimate bottom.

 

 

 

Not out of the woods

While these green shoots are helpful signs, investors are not out of the woods and I am not ready to declare the May lows as the bottom for the current bear cycle. 

 

Inflation surprise is still rising globally. While the trend in the US (red line) is decelerating, inflation is still running hot in most other countries, which will force central banks to tighten globally. As well, China is expected to experience a prolonged slowdown due to its zero-COVID policy. Can American Exceptionalism serve as a shield against a global slowdown?

 

 

While the recent rally is constructive, the Fed is still removing accommodation and quantitative tightening begins on June 1. Historically, equity returns during QT are lower than QE periods with greater volatility.

 

 

For the recession question, I present the CNN Business Op-Ed by Lakshman Achuthan and Anirvan Banerji of the respected forecasting firm ECRI advising Americans to prepare for a recession. As well, New Deal democrat, who maintains a disciplined process of monitoring coincident, short-leading, and long-leading indicators, is calling for a possible recession that begins in Q2 2023 and he has gone on recession watch. Markets are forward looking. Current forward P/E valuations are implying a soft landing. Should a recession develop, stock prices should weaken to a bottom no later than Q3 2022, which is six months before the onset of the recession. 

 

In conclusion, my base case scenario is this is a bear market rally and the March lows are not the lows of the bear cycle. The alternative scenario is the US economy achieves a soft landing and sidesteps a recession next year. If the market doesn’t weaken to a new low by early Q4 2022, the bottom is in for this cycle. I assign a 60-70% probability to the bear market rally and recession scenario and a 30-40% chance of a soft landing.

 

Have the bulls seized control of the tape?

Posted by Cam Hui -

Mid-week market update: After weeks of documenting how oversold and washed out the stock market is, the S&P 500 staged a marginal upside breakout through a falling channel while exhibiting a series of positive 5-day RSI divergences. Equally constructive is the behavior of net new highs, which turned positive today.
 

 

Have the bulls seized control of the tape?

 

 

More signs of a sentiment washout

There have been more signs of a sentiment washout. SentimenTrader pointed out that small option traders (read: retail speculators) have been buying put protection at a level only exceeded by the COVID Crash.

 

 

Marketwatch reported that Kevin Muir at the Macro Tourist documented panic among hedge fund giants as a contrarian bullish sign. Bill Ackman sent out a tweet that Muir interpreted as a contrarian bullish signal: “Bill might be a brilliant investor, but the last thing you should do is trade off his emotional tirades. They are better fades than signals.”

 

 

In addition, Muir also highlighted George Soros’s Davos warning that “civilization may not survive” Russia’s war in Ukraine, with climate change taking a back seat.

 

Cam here: I have an acquaintance who worked at a hedge fund and he was on the same Bloomberg message stream as Soros and Druckenmiller during the GFC. After observing the messages that went back and forth, his conclusion was no one knew what was going on during periods of crisis.

 

As well, don’t forget the cover of last weekend’s Barron’s as a contrarian magazine cover indicator.

 

 

 

A fragile market

Despite the constructive signs of a rally through a downtrend, S&P 500 bulls aren’t quite out of the woods yet. The negative reaction to SNAP’s negative earnings report which cratered the social media stocks is an example of a fragile market that’s subject to a high degree of volatility. It remains to be seen whether NVDA’s decline from its weak guidance after the close will be a contagion on the general market tomorrw. We also have the PCE report Friday morning that will be a source of volatility.

 

My inner investor is cautiously positioned, but my inner trader remains bullish. The S&P 500 Intermediate-Term Breadth Oscillator recently flashed a buy signal by recycling from an oversold reading on RSI to neutral. The historical success rate of this buy signal has been very good (grey=bullish outcome, pink=bearish).

 

 

Assuming this rally continues, my inner trader will seek to exit his long position when RSI nears an overbought condition.

 

 

Disclosure: Long SPXL

 

Washed out enough?

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: Bullish

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

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

 

Different fears for different folks

Is the market sufficiently fearful yet? There is no single sentiment indicator. The market consists of different constituents and different types of investors can be bullish or bearish at any single point in time. While conventional surveys such as Investors Intelligence shows continued levels of extreme bearishness, other indicators can tell different stories.

 

 

The NAAIM Exposure Index, which measured the sentiment of RIAs investing individual investor funds, fell below its 26-week Bollinger Band for a second consecutive week, which has shown an uncanny accuracy as a buy signal during the history of the index since 2006.

 

 

Institutional sentiment, as measured by the latest BoA Global Fund Manager Survey, reveals positioning is at a defensive extreme that’s only exceeded at the height of the Great Financial Crisis.

 

 

The Financial Times reported that hedge funds have dramatically reduced their leverage and exposure in response to the recent equity market weakness.
 

The sharp pullback has prompted funds that trade with Goldman, Morgan Stanley and JPMorgan Chase, three of the largest prime brokers on Wall Street, to dial back their positions over the past week, according to client reports seen by the Financial Times…

 

Goldman on Thursday reported five consecutive days of declines in gross leverage — a measure of a fund’s overall exposure to stock-price moves — among its US long-short equity hedge fund clients, the largest reduction since it began tracking the figures in 2016.

 

At Morgan Stanley, the gross leverage of its US long-short hedge fund clients — which attempt to profit on stocks rising or falling — this week fell to its lowest level since April 2020 and was just 15 per cent above a low hit in March of that year, when the pandemic pushed the US into recession. It noted that those hedge funds were again selling stocks but had also added to their short trades, bets that could pay off if a stock or index falls in value.

 

Executives working in JPMorgan’s prime brokerage unit, which reported similar findings, said there were signs that the US stock market could be close to finding a bottom, but they warned that funds still had room to cut their exposure to the market.
While II sentiment, RIAs, institutions, and hedge funds have been cutting equity exposure, retail investors are still exhibiting a strong risk appetite. A snapshot of Fidelity’s customer trading activity shows that retail is actively buying the high-octane names in the market.

 

 

Four out of five ain’t bad.

 

 

Poised for a rally

I continue to believe the market is due for a relief rally even under a major bear market scenario. The market is very oversold on breadth indicators and it rallied in similar circumstances during the bear markets of 2000-02 and 2007-09.

 

 

While breadth indicators appear very oversold from a long-term perspective, all versions of Advance-Decline Lines are exhibiting positive divergences, which is tactically constructive.

 

 

The S&P 500 intermediate-term breadth momentum oscillator just flashed a buy signal when its 14-day RSI recycled from an oversold condition to neutral. In the last five years, 20 buy signals have resolved bullishly (grey lines) and four were bearish.

 

 

Speculative growth stocks such as ARKK, which led the downdraft, are holding up remarkably well both on an absolute and relative basis. This is a sign of a renewed equity risk appetite.

 

 

An analysis of the top five sectors of the S&P 500, which comprise over three-quarters of index weight, shows a constructive picture. Technology and financial stocks have stabilized relative to the S&P 500, and communication services, which had been hard hit, has found a bid. It would be difficult for the index to either rise or fall without a majority of the top five sectors, and this technical assessment argues for stabilization.

 

 

For the final word, the latest issue of Barron’s has bear claws on the cover as the example of another possible contrarian magazine cover indicator.

 

 

In conclusion, a review of different sentiment metrics indicates an atmosphere of heightened fear. While the intermediate path of least resistance for equity prices is still down, I continue to believe the risk/reward is tilted to the upside in the short run. 

 

 

Disclosure: Long SPXL

 

From FOMO to GIDOT (Glad I Don’t Own That)

Posted by Cam Hui -

Legendary investor John Templeton once said:

Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Where are we in the market cycle? From a long-term perspective, the S&P 500 is wildly oversold on the monthly MACD histogram, but the 14-month RSI has retreated to a neutral reading. Market psychology has shifted from FOMO (Fear of Missing Out) to GIDOT (Glad I Don’t Own That).

 

 

Much depends on the Fed, interest rates, and the earnings outlook.

 

 

A determined Fed

The behavior of the stock and bond markets has seen a shift in tone over the past few weeks. The S&P 500 fell for much of 2022 and the 10-year Treasury yield has been rising in lockstep, indicating bond market concern over Fed hawkishness. In the last two weeks, bond yields peaked even as stocks weakened and the 2s10s yield curve flattened. Market psychology has changed from a fear of rising rates to the fear of an economic slowdown, which is the second phase previous specified in my publication, A 2022 inflation investing tantrum roadmap.

 

 

Much depends on where the Fed is in its hiking cycle. Fed Chair Jerome Powell made a series of recent media appearances. In a WSJ interview, Powell reiterated the Fed’s determination to fight inflation, “Restoring price stability is an unconditional need. It is something we have to do. There could be some pain involved.”

 

In a Marketplace interview, Powell underlined the message that “the process of getting inflation down to 2% will also include some pain”. More importantly, he considered the risk of elevated inflation more important than the risk of a recession. 

 

I think it’s a very challenging environment to make monetary policy. And we certainly, our goal, of course, is to get inflation back down to 2% without having the economy go into recession, or, to put it this way, with the labor market remaining fairly strong. That’s what we’re trying to achieve. I think the one thing we really cannot do is to fail to restore price stability, though. Nothing in the economy works, the economy doesn’t work for anybody without price stability. We went through periods in our history where inflation was quite high. This was back in the ‘70s, and I was old enough to remember. I’m old enough to remember that very well. And we really, we can’t fail to restore price stability.
In other words, the Fed is willing to drive the economy into recession in order to wring inflation and inflation expectations out of the system. A soft landing would be nice, but it’s not necessarily the objective.

 

So a soft landing is, is really just getting back to 2% inflation while keeping the labor market strong. And it’s quite challenging to accomplish that right now, for a couple of reasons. One is just that unemployment is very, very low, the labor market’s extremely tight, and inflation is very high. 
Much will depend on wages.

 

For example, in the labor market, there’s more demand for workers than there are people to take the jobs, right now, by a substantial margin. And, because of that, wages are moving up at levels that are unsustainably high and not consistent with low inflation. And so what we need to do is we need to get demand down, give supply a chance to recover and get those to align.
Powell gave a nod to events outside the Fed’s control, such as the inflationary pressures caused by the Russia-Ukraine war and China’s COVID lockdowns in his WSJ interview.

 

Still, the Fed as recently as January had expected inflation to diminish this spring as supply-chain bottlenecks improved. Russia’s invasion of Ukraine in late February and rolling Covid-related lockdowns in China created new sources of inflationary pressure.

 

“That is going to make it harder for inflation to come down, so it has added a degree of difficulty to what was already a challenging market,” said Mr. Powell.

 

 

A monetary policy report card

Let’s take a look at an interim monetary policy report card. Two consecutive half-point rate hikes are baked into expectations in accordance with Fed communications. While the market is leaning towards a third half-point hike at the September FOMC meeting, the probability is less certain.

 

 

Here are some of the metrics the Fed is considering. Wage growth is soaring, though the less educated and lower paid workers are receiving the most. The distribution of the gains is constructive as this represents catchup from years of lagging growth.

 

 

New Deal democrat has been calling for a slower jobs market because real retail sales leads employment. While that hasn’t shown up in the monthly Non-Farm Payroll report just yet, initial jobless claims are bottoming, indicating a cooling jobs market.

 

 

Even though the transitory word has been erased from the Fed’s vocabulary, inflation, as measured by core PCE, is cooling. Both core PCE and the trimmed-mean PCE have been decelerating in the past three months and annual PCE should fall as large readings drop off in the next three months. All else being equal, core PCE is currently running at an annualized rate of 3.0-3.5%, which is below the Fed’s SEP projections of 4.1% by December 2022.

 

 

Monetary policy is doing its job of tightening financial conditions, though readings are not at past crisis high levels. Various Fed speakers have made it clear that there is no Fed Put in the stock market. What the Fed cares about is the proper functioning of credit markets and excessive Wall Street turbulence doesn’t leak over to Main Street.

 

 

As well, inflation expectations have improved, which makes the Fed’s job easier.

 

 

 

The stock market’s reaction

Here is the stock market’s view. The S&P 500 is trading at a forward P/E of 16.4, which is below its 10-year average of 16.9. In the past 10-year, similar levels of the 10-year Treasury yield has seen the forward P/E in the 14-15 range, with a panic low of 13.5. This translates to an average downside risk of 10-15%, though it could fall as much as -25% if the market panics.

 

 

In effect, the market is discounting a soft landing, which is consistent with Jurrien Timmer‘s choppy market scenario of 1994, 2015-16, and 2018. That’s the rosy scenario.

 

 

Here is the ominous scenario. The Misery Index, which is the sum of CPI and unemployment rate, is rising in the US and Europe.

 

 

Eurozone consumer confidence is at levels consistent with recession sin the past.

 

 

The European economy will further be pressured by the additional imposition of sanctions on Russia. In addition, food shortages will become an additional source of global instability as summer progresses. The Russia-Ukraine war has closed Ukrainian grain exports through the Black Sea. In Asia, China’s wheat crop is expected to be very poor because of a delayed planting and the heat wave in India has sapped grain production. Moreover, Europe is expected to experience a dry summer and create drought-like conditions in wheat growing regions like France.

 

 

The outlook for North America isn’t much better. The UKMO model calls for dry conditions over most of the cereal growing regions in central and northern US and southern Canada this summer.

 

 

As well, Europe and North America is expected to see a hot summer, which would boost air conditioning usage and natural gas demand and add to inflationary pressures.

 

 

 

Recession ahead?

For investors, much will depend on whether the Fed is at peak hawkishness and if the economy falls into recession. The best-case scenario will see inflation peaking out this summer, a cooling of wage pressures, and no further supply chain disruptions. The S&P 500 forward P/E valuation of 16.4 is adequate.

 

The risk is the economic outlook slows further and Wall Street cuts earnings estimates. While forward 12-month EPS estimates haven’t fallen so far, a recessionary scenario will see analysts cut EPS estimates, which has caused past turbulence in the past.

 

 

The dismal financial performance of Target and Walmart shows the lingering effects of the COVID Crash and recovery. Both retailers reported that sales were up, but profits were down and inventory rose. The inventory increase is partly a result of the over-ordering effect because of COVID supply chain disruptions. As bottleneck pressures eased, deliveries rose, which boosted inventories and reduced margins.

 

Ben Carlson pointed out that recession bear markets are far more vicious than non-recessionary bears. If the economy were to sidestep a recession, investors may have seen the worst of the equity decline, but there could be substantially more downside risk if the economy were to collapse into recession. That said, any recession should be relatively mild, as both household and corporate balance sheets are strong. Deep downturns are attributable to the combination of economic weakness and excessive leverage, which is not evident in the US, though it can be found in some non-US economies. So far, the S&P 500 is down -20% in 4.5 months, or about 135 days.

 

 

In conclusion, the US equity outlook depends on the economic outlook. P/E multiples are adequate if the economy sidesteps a recession, but the risks are skewed to the downside. If the Fed becomes more hawkish, the economy collapses into recession, or if further supply chain disruptions pressures inflation, downside risk could be considerably higher.

 

Is the bounce over?

Posted by Cam Hui -

Mid-week market update: One of the concerns I had after last Friday’s market turnaround was that a bounce had become the consensus view. Virtually every technical analyst was calling for a bear market rally, followed by further weakness. It sounded too easy. Either the bounce was going to fail, or the market was going to roar to new highs.
 

The market followed through Friday’s strength with a 2% gain in the S&P 500 yesterday (Tuesday), but managed to give it all back and more today. The hourly S&P 500 chart exhibited a possible upside breakout through an inverse head and shoulders pattern, which was thwarted by today’s weakness. While there is nothing worse than a failed breakout, it could be argued that the market is in the process of forming the last shoulder of the formation. 

 

 

In light of today’s market action, is the bounce over?

 

 

The bull case

Here are the bull and bear cases for the bounce. Technical analysts were fretting about a lack of capitulation in the market last week. RecessionALERT revealed that ll of its multi-factor S&P 500 models were past their 90th percentiles, which is a highly unusual condition because the uncorrelated nature of the components.

 

 

The latest BoA Global Fund Manager Survey also gave some clues about the institutional mood. If this wasn’t a capitulation, then it was a high degree of worry. Cash levels were at levels consistent with past panics and major market bottoms.

 

 

Portfolios were positioned for stagflation. Overweight cash and commodities; underweight stocks and bonds. Within equity portfolios, managers were rotating into defensive sectors in order to lower their equity beta.

 

 

The behavior of equity factors is also revealing. Low quality junk stocks should be leading the rally in a bounce off a deeply oversold condition. This is precisely the scenario as the lower quality Russell 1000 large cap index is leading the high quality S&P 500.

 

 

Similarly, the speculative growth ARK Innovation ETF (ARKK) has held up remarkably well both on an absolute and relative basis in today’s market pullback.

 

 

 

The bear case

Last week’s market downdraft was headlined by the implosion of the LUNA stablecoin, weakness in Crypto-Land is likely to affect overall market risk appetite (see The crypto contagion risk to the stock market). Beneath the surface, the problems in crypto are not resolved. In fact, confidence continues to deteriorate even as Bitcoin struggles to hold support at about 30,000.

 

 

Tether, the largest stablecoin, broke the buck and never recovered. This is like a money market fund trading below par owing to credit problems in its portfolio. Confidence wanes and investors rush to pull out their funds.

 

 

Funds are flowing out of Tether. This is what a bank run looks like. 

 

 

In offshore Crypto-Land, there is no lender of last resort that comes to the resue. Equally worrisome is the refusal of Tether management to document how its stablecoin assets are backed on a 1-1 basis to the USD.

 

 

The bulls can argue that since ARKK is outperforming, the stock market is decoupling from the crypto market. The bears will argue that the crypto implosion is just starting and its effects will affect global risk appetite.

 

 

The short-term outlook

Here is how I resolve the short-term outlook. Other than a few CTAs, hedge funds had an abysmal Q1 and April performance was also disappointing. Many hedge funds have Q+30 day or Q+45 day redemption windows. We just passed the Q+45 day window and managers have already received their redemption notices. The recent market weakness may be reflective of the redemption pressures, which should abate in the near term.

 

 

In conclusion, this is a relief rally in a bear market. Bear markets are volatile and experience short and sharp rallies. I am encouraged by the appearance of a sudden surge of insider buying. A similar episode put a temporary floor on the market in January.

 

 

My inner investor is cautiously positioned. My inner trader has been accumulating long positions on weakness.

 

 

Disclosure: Long SPXL

 

The crypto contagion risk to the stock market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A crypto bank run

I had voiced my reservations about the cryptocurrency ecosystem in the past (see The brewing Lehman Crisis in Crypto-Land) and the risks manifested themselves in the last week. To briefly recap the problem, cryptocurrencies are mainly traded in the offshore market. A crypto trader can exchange USD for crypto, but banks do not allow direct access to crypto exchanges, with some exceptions. The crypto trader can exchange his USD for a stablecoin, which is a token that is theoretically backed 1 for 1 to the USD. He then exchanges his stablecoin to buy cryptocurrencies and back when he sells. When he wants USD in his account, he instructs the stablecoin provider to convert his stablecoin into USD, which is deposited to his onshore USD account.

 

The important piece of the crypto ecosystem plumbing is confidence in the stablecoin system. Stablecoins are supposed to be like money market funds, they shouldn’t be trading below par. Last week, the TerraUSD stablecoin, also known as UST, broke its USD peg and sparked a crisis of confidence. Within the space of a few days, the value of LUNA had evaporated to zero. Crypto traders began a virtual bank run on stablecoins. Tether, the largest stablecoin, broke its peg last week, While prices have partly recovered and stabilized, Tether is still trading slightly below 1.

 

 

The crypto bank run set off a stampede of selling in cryptocurrencies and other speculative risk assets. 

 

 

The big question for investors is whether the crypto meltdown will have a long-lasting effect on global risk appetite and risk aversion leak into the equity market. Was the Crypto meltdown last week the new LTCM moment for asset markets?

 

 

Tightening until something breaks?

One way to explain the crypto crash is the tightening of financial conditions because of central bank monetary policy. Cross Border Capital has documented the collapse in global liquidity, which would have been even worse without the BoJ.

 

 

The retreat in crypto values can be attributable to the financial system wringing out some of the speculative excesses from the last boom. Simply put, crypto assets went up a lot and they’re now retracing their gains.

 

In the past, the Fed has halted its tightening policy when something breaks, such as the Russia Crisis which sank LTCM. Does this mean that the Fed will come to the rescue of crypto investors? Probably not. Remember the underlying reasoning behind cryptocurrencies is they exist outside the fiat currency system. If you crash, you’re on your own, unless the crash threatens the fiat banking system. The Fed won’t act unless credit spreads blow out, which hasn’t happened. Financial conditions have tightened, though not a lot by historical standards.

 

 

Nevertheless, the high level of correlation between cryptocurrencies and the relative performance of speculative growth stocks, as exemplified by ARKK, is a measure of risk appetite. Last week’s stabilization of ARKK on high volume is a constructive sign for short-term risk appetite. The worst of the crash may be behind us.

 

 

 

Waiting for capitulation

Still, market analysts have voiced concerns about a lack of capitulation in the market. While technical internals are oversold, the signs of panic and capitulation that mark tradable bottoms have not been present.

 

The term structure of the VIX at the 1-month and 3-month level hasn’t inverted, indicating fear.

 

 

As well, some analysts observed that ARKK was seeing substantial inflows even as the ETF tanked. However, Jason Goepfert pointed out that ARKK experienced a surge in short sales and the inflows could be explained by unit creation to accommodate short sellers.

 

 

Here’s a sign of capitulation. The NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investor funds, fell below its 26-week Bollinger Band last week. Historically, this has been a buy signal with an excellent track record with strongly bullish risk/reward implications.

 

 

SentimenTrader also pointed out that Lipper also reported that investors redeemed $44 billion from equity funds and $39 billion from bond funds in the last six weeks. This is a very unusual condition that only happened four times in the last 20 years, usually at stock market panic bottoms.

 

 

 

An oversold market

The stock market is oversold by a variety of indicators. One of the most effective trading signals is the Zweig Breadth Thrust Indicator, which has a strong record of marking short-term bottoms in the last five years. Friday’s rebound starts the clock at day 1. The market has 10 trading days to reach an overbought condition for a ZBT buy signal, but don’t hold your breath.

 

 

Jonathan Harrier observed that the S&P 500 was down six weeks in a row. There have only been 20 such events since 1950 and the market made it to a seventh consecutive decline on only five occasions. These instances of bearish market action appear exhaustive and they have historically resolved bullishly.

 

 

I highlighted the S&P 500 head and shoulders breakdown last week. The pattern showed a measured downside target of about 3830, which is roughly the same region as the Fibonacci retracement level of about 3800. As the 3800-3830 zone is well known to chart watchers, in all likelihood the index will either never reach there or blow past those levels in a downdraft.

 

 

Friday’s strong market rebound represents a hopeful sign for the bulls. The NYSE McClellan Oscillator flashed a buy signal by recycling from an oversold condition, with past buy signals of the last two years shown as vertical lines on the chart.

 

 

As well, Rob Hanna at Quantfiable Edges found that Friday rebounds after a 21-day low tend to be far more sustainable over multiple timeframes compared to turnarounds on other weekdays.

 

 

In the short run, the VIX Index will have to violate the rising trend line for the bulls to prevail. 

 

 

Keep an eye on cryptocurrencies, which are experiencing some volatility this weekend. Despite Friday’s strong recovery, cryptos may be the tail that wags the stock market dog.

 

 

 

Portfolio positioning changes

Even though I believe the market is poised for a multi-week relief rally, the combination of deteriorating global equity and commodity prices is a cause for long-term concern. 

 

One disturbing development is the continual decline in bottom-up aggregated EPS estimates. The latest update of S&P 500 consensus EPS estimates from FactSet shows that the Street has reduced EPS estimates for the next three quarters of 2022 for a second week in a row. 

 

 

New Deal democrat, who maintains a set of coincident, short leading, and long leading indicators, is still on the fence about a recesion call, though “a recession may be in the offing beginning in Q2 of 2023”. There is sufficient evidence for a global slowdown for a sell signal on the Ultimate Market Timing Model. As a reminder, this model issues a sell signal whenever both the Trend Asset Allocation Model is risk-off and a recession is at hand. Investors should sell into the anticipated rally to raise cash and wait for the all-clear to re-enter the market.

 

The weakness in commodity prices is also a signal to unwind many of the long commodity and short cyclical pair trades I suggested in the past. 

 

 

Of the four regional long producer-short importer country pairs and only the long Indonesia and short Vietnam pair has performed well. The other three have faltered and it’s time to close this factor exposure.

 

 

From a US perspective, only the quality pairs of long S&P and short Russell indices and the defensive pair of long consumer staples and short discretionary are performing well. The rest, which are long commodity and short cyclical pairs, are rolling over and should be unwound.

 

 

The performance of these pairs underscores the underlying factors that are driving the market. Even the commodity and inflation hedge plays have lost their leadership status. Only high quality and defensive factors remain dominant. I interpret these conditions to mean that while the market may be poised for a relief rally, the bears are still in control of the tape.

 

Investors should also unwind the long gold and short gold miners pair. The relationship is nearing a short-term resistance level in a very short time that it’s time to take some profits.

 

 

In conclusion, signs of possible stabilization in crypto assets and speculative growth stocks are pointing to an imminent equity relief rally. Factor analysis shows that the bears are still in control. Investment-oriented accounts should be cautiously positioned and sell into market strength. Traders can try to position for a relief rally, but don’t overstay the party.

 

 

Maintaining risk control

Finally, I would like to add a word about the trading model and positioning. My inner trader was too early in entering his long position and he held his position even as the market fell, and some readers raised the question of a sufficient risk control discipline. 

 

Not every trade works. While the current drawdown may be painful, it leads to a useful lesson about the formulation of a risk control discipline.

 

Portfolio construction consists two decisions. Deciding on what to buy and sell and how much to buy and sell. A strategy of going all-in on a trade signal and all-out on an exit signal will yield different result than a discipline of scaling in and out of positions. I publish long and short positions to disclose possible conflicts. I don’t publish how I scale in and out of positions because it assumes that we have a similar risk profile.

 

I know nothing about you. I don’t know your risk preferences. Your pain threshold isn’t my pain threshold. I don’t know your tax situation, or even what jurisdiction you live in. If you try to mirror incremental changes in long and short positions is mirroring my risk profile, which is probably not the same as yours. 

 

That’s why this isn’t investment advice. Otherwise, I would be offering a fund, with all the appropriate risk disclosures so that you can decide on whether it’s appropriate for you.

 

 

Disclosure: Long SPXL

 

The commodity canary in the coalmine is falling over

Posted by Cam Hui -
One of the main elements of my Trend Asset Allocation Model is commodity prices as a real-time indicator of global growth. As well, John Authers recently wrote, “The commodity market is a real-time attempt to assimilate geopolitical developments, growth fears, and shocks to supply and demand, so it’s an important place to look for the next few weeks.” So far, commodities have been elevated even as the global economy showed signs of slowing. The divergence is attributable to supply shocks.

 

 

We all know the recent story of supply shocks. The COVID-19 pandemic disrupted global supply chains and caused both a supply shock. As the virus first emerged in China, Beijing responded by shutting down the economy and its industrial capacity came to a virtual halt. Just as the world began to recover from the COVID Crash, the Russia-Ukraine war sparked another supply shock, this time in energy and agricultural products. 
 

Despite the supply pressures, commodity prices have finally started to fall. In particular, the cyclically sensitive industrial metals have rolled over.

 

 

Here is what it all means.

 

 

Supply chain disruptions

The supply chain effects of COVID Crash are well known, so I won’t repeat the story. What’s new is the less publicized story of how the Russia-Ukraine war is sparking another supply shock.

 

This map of the Russian military control of Ukraine tells the story of how Russia is strangling the Ukrainian economy. Before the war began, Ukraine exported most of its goods through its Black Sea and Sea of Azov ports, such as Izmail, Odesa, Kherson, and Mariupol. Now that most of those ports are under Russian control and the Russian navy is blockading access to Odesa, Ukraine’s export capacity is greatly diminished. While Ukraine can still ship products by rail, rail capacity is a fraction of its port capacity. Moreover, the cost of rail freight is about three times higher than maritime shipping and Ukrainian rail gauges are different than European rail gauges, which creates logistical problems at the border.

 

 

In addition to being an important source of agricultural exports to the world, Ukraine produces about half of the world’s neon, which is an important input for semiconductor manufacturing. The neon plants are located in Mariupol, which has been flattened by the war, and Odesa, which has stopped production. Even if hostilities ends tomorrow and the Odesa plant resumed production, it needs a means of export. That’s why Ukraine’s maritime access matters.

 

Turning to energy, the Russia-Ukraine war has disrupted energy supplies, mainly to Europe. The EU is on the verge of banning Russian oil imports by year-end. In addition, Russian gas exports to Europe through Ukraine are being shut off. That’s because Ukraine’s gas grid operator said it can’t receive gas at Sokhranivka because of a lack of control, but Gazprom refused to move shipments to Sudzha, though there are other routes for Russian gas to reach Europe.

 

 

The energy shock won’t just affect Europe, its effects are global. Recently, there have been dire warnings from various quarters about tight refined product markets, such as diesel, jet fuel, and US East Coast diesel. This all adds up to higher prices and a slowing economy.

 

 

As well, there is the supply chain disruption from China’s zero-COVID lockdown policy. The low rate of vaccination, especially among the elderly, opens China to the risk of another wave of COVID related deaths unless Beijing significantly alters course on its pandemic policies.

 

 

 

The central bank response

Here is the worrisome central bank response. Minneapolis Fed President Neel Kashkari recently stated in a speech that the Fed is willing destroy demand and drive the economy into recession if supply chain difficulties don’t ease.

 

If supply constraints unwind quickly, we might only need to take policy back to neutral or go modestly above it to bring inflation back down. If they don’t unwind quickly or if the economy really is in a higher-pressure equilibrium, then we will likely have to push long-term real rates to a contractionary stance to bring supply and demand into balance. The incoming data over the next several months should provide some clarity on these questions.

Kashkari’s views are consistent with an influential 1997 paper by Bernanke, Gertler, and Watson, “Systematic Monetary Policy and the Effects of Oil Price Shocks”, which concluded that energy price shocks on their own don’t lead to recessions, but slowdowns are attributable to the central bank’s tight monetary policy in response to higher inflation.

 

 

 

Interpreting commodity weakness

Here is how commodity prices stand today. Broad-based commodity indices, which have heavy energy weights, are in faltering uptrends. Equal-weighted commodities are displaying a sideways pattern and violated their 50 dma. The copper/gold and base metals/gold ratios have fallen dramatically in the past two months, indicating cyclical weakness.

 

 

Putting it all together, what we have is a Federal Reserve that’s tightening into widespread evidence of a slowing economy. Not only have global equity prices fallen, but cyclically sensitive commodity markets, which had been held up by supply shortages, are cracking. Robin Brooks at IIF stated that the world is on the verge of a recession. Setting aside base effects, 2022 global growth is effectively zero.

 

 

 

Silver linings

Even though the outlook appears dire, there are two silver linings in the dark clouds of recession that are on the horizon. First, peace may be at hand in the Russia-Ukraine conflict. Russian ally and Belarus’ President Alexander Lukashenko admitted in an AP interview that the Russian offensive had stalled and he was calling for negotiations.
 

The 67-year-old president struck a calm and more measured tone in the nearly 90-minute interview than in previous media appearances in which he hectored the West over sanctions and lashed out at journalists.

 

“We categorically do not accept any war. We have done and are doing everything now so that there isn’t a war. Thanks to yours truly, me that is, negotiations between Ukraine and Russia have begun,” he said.
Moreover, Russian President Putin did not escalate the war as expected on Russia’s Victory Day on May 9. Russian advances in the Donbas, which was the new reduced objective of the war, have been minimal and a Ukrainian counteroffensive had pushed Russian troops back to the border near Kharkiv. Russia lacks the means to escalate by mobilization, as it has neither the training facilities nor trainers to train new troops. Moreover, it lacks means to equip the troops with such things as tanks and fighting vehicles because of the effects of sanctions on its weapons production capacity.

 

This sets up incentives for Putin to call for a ceasefire and negotiations, which has the potential to spark a risk-on rally. Stay tuned.

 

As well, the Treasury market is finally behaving as expected and long yields are falling in anticipation of a weakening economic outlook. In the past, peaks in the 30-year yield have led to turns in the Fed’s tightening policy by 1-6 months. Despite the Fed’s hawkish rhetoric, a pivot from a restrictive monetary policy could be closer than you think.

 

 

In conclusion, weakness in commodity and equity prices is signaling a global slowdown and possible recession. Conventional wisdom would call for cautiousness in portfolio positioning. However, investors should be prepared for good news, either in the form of a cessation in Russia-Ukraine hostilities, or a turn in the Fed’s tightening policy.

 

A market bottom checklist update

Posted by Cam Hui -

Mid-week market update: For several weeks, sentiment surveys such as AAII and Investors Intelligence have signaled extreme levels of bearishness seen at past market bottoms. However, some observers have played down the sentiment surveys because indications of positioning are inconsistent with extreme fear. As an example, funds are still pouring into the Cathie Wood’s Ark Investment ETFs even as the speculative growth vehicles tank. That’s not the sort of behavior seen at washout bottoms. On the other hand, I have received a flood of emails and other messages of concern about the stock market indicating growing fear and panic.
 

 

To resolve the dilemma, my publication “How to spot a market bottom” published on March 19, 2022 offered a useful checklist that I’ll go through.

 

 

Market bottom checklist

The checklist consisted of:
  • Insider activity;
  • Market positioning in futures; and
  • Oversold and breadth indicators.
Let’s go through them, one at a time. Recent insider activity showed a brief flash of more buying (blue line) than selling (red line), which is constructive. We saw a similar episode during the short-term bottom in January. 

 

 

As a reminder, insiders were buying hand over fist during the GFC market bottom.

 

We also saw clusters of much stronger insider buying during the Greek Crisis of 2011.
 

 

Insiders similarly stepped up their buying during the COVID Crash.
 

 

The takeaway from insider activity is these “smart investors” do not signal tactical trading bottoms, but intermediate and long-term market bottoms. While current activity is mildly constructive, we aren’t quite there yet.

 

 

Futures positioning

As for futures positioning, the latest Commitment of Traders report, which was published last Friday based on the data from the previous Tuesday (May 3, 2022) shows that large speculators held a minor long position in S&P 500 e-minis, but the momentum was negative. However, futures positioning have tended to lag major market bottoms owing to the lagging nature of trend following CTA programs.

 

 

The COT picture for the NASDAQ 100 futures shows a similar minor long position and historically lagging positioning signals.

 

 

 

Oversold enough?

From a technical perspective, the good news is one of the main technical indicators shows that the market has reached the minimum threshold for an intermediate bottom. 
I have highlighted the “good overbought” advance from the March 2020 bottom before. This was evidenced by the percentage of S&P 500 stocks above their 200 dma rising to 90% and remaining there. The overbought condition recycled in mid-2021 (top panel). Historically, such declines don’t end until the percentage of stocks above their 50 dma fall below 20% (bottom panel).
The percentage of S&P 500 stocks below their 50 dma fell below 20%, which is the minimum criteria for a bottom. At this point, investors have to make a decision as to whether the current market downdraft represents a minor pullback or a major bear market. If it’s a minor downdraft, the bottom is in. In a major bear market, this indicator has fallen to as low as 5%, though the current sub-20% reading could be a setup for a relief rally, followed by further losses.

 

 

The NYSE McClellan Summation Index (NYSI) has signaled major market bottoms when it fell to -1000 or less. The NYSI is far from that reading, but the market has bottomed at current levels in 2011 and 2015-16.

 

 

Other breadth indicators which weren’t part of the checklist are sufficiently oversold to signal a possible bottom.

 

 

 

A rally within a downtrend

I interpret these conditions as the market is setting up for an imminent relief rally within the context of an intermediate downtrend. I recently pointed out that S&P 500 valuations are not attractive enough for a major market bottom (see Profit opportunities in the coming global recession). 

 

On the other hand, I was surprised that the stock market didn’t immediately tank on the hot April CPI report this morning. While core PCE and core CPI are decelerating, the pace of deceleration is uneven. The long-awaited decline in durable goods CPI is finally evident (see used cars), but services CPI is stubbornly strong, paced by an acceleration to a 0.5% MoM increase in heavyweight Owners Equivalent Rent from 0.4% the previous month, and an astounding 18.6% MoM rise in airfares. These conditions allows the Fed to stay on its hawkish tightening path, but stock prices didn’t immediately respond. By contrast, the 2-year Treasury yield rose, which is a proxy for the market’s estimate of the Fed Funds terminal rate, while longer dated Treasury yields fell, indicating the expectations of a slowing economy.

 

 

In the meantime, the NYSE McClellan Oscillator (NYMO) is oversold, where the vertical lines on the chart are buy signals when NYMO recycles from oversold to neutral.

 

 

The Zweig Breadth Thrust Indicator is also in oversold territory. Major bear legs simply don’t start in such extreme conditions.

 

 

My inner investor is cautiously positioned. My inner trader has a few nicks on his hands from trying to catch falling knives, but he is positioned for a counter trend rally. 

 

 

Disclosure: Long SPXL

 

Making sense of the H&S breakdown

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: Buy equities
  • Trend Model signal: Bearish
  • Trading model: Bullish

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

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

 

Head and shoulders intact

The head and shoulders breakdown of the S&P 500 remains intact. The index surged to test neckline resistance last week when Powell took a three-quarter rate hike off the table, but the bears regained the upper hand the next day.

 

 

How much should you trust the head and shoulders breakdown and its downside measured objective of about 3830? The 5-week RSI is already oversold. How much more downside is left?

 

Here are the bull and bear cases.

 

 

Bull case

Let’s start with the bull case. This may sound like beating a dead horse, but AAII weekly sentiment is still very bearish, which is contrarian bullish. The survey cutoff was on Tuesday, which was the day before the FOMC ramp. While bullishness had risen and bearishness retreated, the bull-bear spread is still flashing a buy signal at -26. Bearish sentiment is still historically high at 52.9.

 

 

The CBOE put/call ratio is elevated, which is a sign of heightened fear. The put/call ratio remained above 1 at 1.05 on the day of the FOMC market surge, indicating skepticism of the advance.

 

 

Thursday’s bearish turnaround after Wednesday’s surge was enough for CNBC to broadcast a “Markets in Turmoil” special program, which has been regarded as a contrarian bullish signal.

 

 

Charlie Bilello helpfully compiled the instances of “Markets in Turmoil” programs since 2010 and he found that the one-year forward returns had a perfect track record, though he added that the period was “limited to a buy-the-dip bull run where corrections have been short-lived”. Based on Bilello’s data set, I made a shorter-term study of the strategy, with the caveat that there was a large cluster starting from February 24, 2020, that didn’t end until June 4, 2020. There were a total of 97 signals during the study period but only 14 non-overlapping signals. Based on the first occurrence of a “Markets in Turmoil” program, the sweet spot for buying the S&P 500 is about 4-5 days, with a median outperformance of 1.2% to 1.3%. The chart below depicts the profit curve if you had held the S&P 500 for five days after the signal.

 

 

Even though market breadth was negative, the market exhibited breadth improvements as a series of higher lows and higher highs.

 

 

 

Bear case

The bears will argue that there is plenty to be concerned about. Even though breadth shows signs of improvement, readings are not oversold enough to indicate a long-term market bottom.

 

 

Other breadth indicators, such as the Advance-Decline Lines are weak. A survey of different versions of A-D Lines shows that most of them are in downtrends.

 

 

Even though sentiment appears excessively bearish, the term structure of the VIX Index isn’t inverted, indicating fear and panic haven’t fully appeared just yet.

 

 

Equally disturbing is the behavior of insiders. Mark Hulbert observed that this group of “smart investors” are selling into the downdraft.
 

In April, insiders aggressively picked up the pace of selling. Nejat Seyhun, a finance professor at the University of Michigan and one of academia’s leading experts on interpreting the behavior of insiders, says this is perhaps the most bearish thing insiders can do. That’s because they normally are contrarians, selling more as the market rises and increasing the pace of buying as the market declines.

 

When insiders sell into a market decline, Seyhun reasons, it means they don’t believe their companies’ shares will be significantly higher any time soon.
Lastly, if you think that Jerome Powell’s remark that the Fed isn’t considering a three-quarter point rate hike is dovish, it’s not. The Fed is keeping to a measured pace of tightening. The knee-jerk market reaction overlooked the announcement that the Fed is conducting quantitative tightening (QT) and reducing its balance sheet. An analysis of returns during QE and QT shows that while QT is not necessarily negative for the stock market, volatility is considerably higher compared to QE periods.
 

 

 

Catch a falling knife?

So where does that leave us? The bull and bear debate is really a debate of differing time horizons. The bullish factors are mainly short-term in nature, while bearish factors tend to be more intermediate term. My base case scenario calls for a short-term bottom and a bear market rally of unknown magnitude, followed by a greater decline into an ultimate low in the coming months.

 

The S&P 500 is undergoing a third possible double bottom as its exhibits a positive RSI divergence this year. Should a rally materialize, the initial upside objective would be a test of the falling trend line in the 4300-4350 zone, with secondary resistance at the 50 dma of about 4370. 

 

 

Key dates to watch in the coming week are the Russia Victory Day on May 9 for signs of a possible escalation, and the CPI report on May 11 for signs of expectations changes in the trajectory of monetary policy. Stay tuned.

 

 

Disclosure: Long SPXL

 

Profit opportunities in the coming global recession

Posted by Cam Hui -

Welcome to the coming global recession. We can debate all day about the global growth outlook, but consider this: Global Manufacturing PMI has fallen to 48.5, indicating contraction. It’s the first negative reading since the COVID Crash of 2020.
 

 

The signs of deceleration have been confirmed by the G10 Economic Surprise Index, which measures whether economic reports are beating or missing expectations.

 

 

Even in a recession, there is opportunity for equity investors. This week, I analyze the economic and equity outlooks for the three major trading blocs, the US, Europe, and Asia.

 

To make a long story short, I conclude that a survey of the world economic outlook shows the increased risk of a global recession. An analysis of the global regions indicates the US is no longer a safe haven in downturns. Relative valuations of non-US markets have converged and the best opportunity is appearing in non-German eurozone. Asia may be constructive but it is subject to China lockdown risk and possible fallout from India’s heatwave.

 

 

Price performance and valuation

Let’s begin with global equity performance. The relative performance of the major regions relative to the MSCI All-Country World Index (ACWI) shows that US outperformance has stalled and all of the other regions are beginning to catch some bids. Europe is recovering after the Russian invasion of Ukraine. Japan is trying to bottom. The emerging markets are all trying to bottom.

 

 

From a valuation perspective, the US stands out in exhibiting a premium forward P/E ratio. The forward P/Es of all of the other major regions are all converging to a narrow range.

 

 

Commodity prices also offer a cautionary message. While most headline commodity indices are strong, their strength can be attributable to the heavy weighting in energy, which has risen because of the Russia-Ukraine war. Equal-weighted commodity indices have been trading sideways and they are testing their 50 dma. Just as disturbing is the behavior of the cyclically sensitive copper/gold and more broadly based base metals/gold ratios, which have been falling.

 

 

Here’s what this all means.

 

 

America: Safe haven no more?

The major reason US equities were trading at a premium P/E valuation is their growth characteristics. The FANG+ stocks are large-cap dominant companies with strong competitive positions and cash flows. When the global growth outlook faltered as the COVID pandemic ripped through the world, investors piled into US equities as a safe haven. According to the BoA Global Fund Manager Survey, the US is the region with the greatest overweight position.

 

 

Fast forward to Q2 2022. The US economy looks far more wobbly today. The April ISM print shows that economic growth is decelerating. ISM Manufacturing fell to 55.4. New orders fell and employment dropped sharply.

 

 

New Deal democrat, who maintains a series of coincident, short-leading, and long-leading indicators, is beginning to ponder the prospect of a recession in Q2 2023 in his last update. He now has more negative components in his long-leading indicators, which look ahead a year, than positives.

 

There was deterioration across all three timeframes this week. The coincident nowcast is only weakly positive, the short term forecast is neutral, and the long leading forecast, for this first time since before the pandemic, has turned negative.

 

It is important to emphasize that while the high frequency indicators give early warning of changes, they are also somewhat noisy. Some of the negative trends might reverse (e.g., financial conditions, which showed tightening for the first time), and some positive trends (like corporate earnings beats) may amplify…

 

To sum up: the outlook for the rest of 2022 remains a weak positive economy, while for the first time, the outlook for 2023 beginning in Q2 may include a recession. From here on, we look to see if the negativity persists in the long leading indicators, and begins to spread into the short leading indicators.
The S&P 500 is trading at a forward P/E ratio of 17.6. The 10-year experience of the 10-year Treasury yield at above 3% indicates that forward P/E should be about 14-15, indicating a downside potential of about -20%.

 

 

The S&P 500 has even more downside risk than -20%. The market is in the part of the cycle in which estimate revisions are has begun to decelerate and P/E ratios are undergoing compression. In the past, the S&P 500 has struggled when EPS revisions were flat to down.

 

 

This is the first week of decline in forward 12-month EPS estimates. While it could be just a data blip, a detailed analysis of the weekly quarterly EPS revisions shows a disturbing trend. Q1 2022 EPS estimates were revised upwards, mostly because 79% of reporting S&P 500 companies have beat estimates. However, the Street substantially cut estimates for the next three quarters and Q2 2023. The only exception was a minor upward revision for Q1 2023.

 

 

Not such a safe haven anymore.

 

 

Asia: A recovery mirage?

Looking across the Pacific to Asia, the relative performance of Asian markets can be characterized as constructive. All of the major Asian regional markets are in the process of making relative bottoms. India is in a minor relative uptrend.

 

 

The apparent strength could be a mirage. That’s because of the unknown effects of China’s spreading lockdowns because of its zero-COVID policy. April’s manufacturing PMI has nosedived. 

 

 

As China is a major global manufacturing hub, a Chinese slowdown will cause a renewal of supply chain bottlenecks around the world. The WSJ reported that the average time to receive production materials rose to 100 days in April because of the lockdowns.

 

The Institute for Supply Management said its index of U.S. manufacturing activity in April hit its lowest level since July 2020, and the average time to receive production materials increased to 100 days in April, its longest span ever. In the survey, 15% of panelists expressed concern about the ability of partners in Asia to reliably make deliveries in the summer months, up from 5% in March.
If you thought manufacturing PMI was weak, the weakness in China’s services PMI illustrates the damage of the lockdowns are doing to the economy.

 

 

Barron’s reported that China Beige Book, which compiles bottom-up statistics for China, revealed “severe pressures” for the Chinese economy not reflected by official statistics.
 

There is no sugarcoating the economic situation in China. Lockdowns to fight Covid-19 whose effects aren’t yet reflected in official data are already causing “severe pressure,” according to a survey of more than 1,000 firms conducted in the last week of April by China Beige Book and released on Monday. Almost a quarter of the companies reported virus outbreaks among employees, up from 20% in March.

 

Growth in revenue and profits in manufacturing, retail, and services already is slowing. Even more troubling: Hiring took its first big hit since the initial Covid outbreak in 2020 as companies took on fewer staff and wages dropped. Companies also demonstrated little appetite for credit. Both borrowing and bond sales dropped, according to the China Beige Book, a troubling sign for investors waiting for easier access to credit to help stem the slowdown.

As well, OPEC indicated that China is facing the biggest demand shock since early 2020 because of its lockdowns.
 

Over in India, Bloomberg reported that the country is experiencing the worst heatwave in 122 years. This has resulted in power cuts owing to a coal shortage and high coal and oil prices have pressured inflation. The heatwave has also damaged crops and added to the global food shortage as India is considering restricting wheat exports.
 

 

Europe: First in, first out?

Turning to Europe, the economic outlook looks like a mess, but European equities present opportunities because the region may be the first to undergo a recession, and it could the first one out of one. 
 

The BOE raise rates by a quarter-point last week and presented a dire forecast for the UK economy. It sees the second largest drop in living standards since 1964, with inflation peaking at 10.2% in Q4. Unemployment will rise and GDP growth will fall -1% by Q4. While large cap UK stocks are showing some relative strength because of their large energy and mining exposure, small caps, which are more reflective of the British economy, is lagging.
 

 

Across the English Channel, the April Eurozone manufacturing PMI is falling, which is not a surprise because of weakened Chinese demand.
 

 

The bright spot was services PMI, which rose “amid falling COVID-19 case numbers and an associated relaxation of health restrictions”.
 

 

The relative performance of eurozone countries was a surprise. Relative performance was better in all countries other than Germany, which is struggling with the severe political pressure over a possible ban on Russian energy imports. 

 

 

Non-German eurozone equities represent an opportunity for investors, especially when the BoA Global Fund Manager Survey indicates it’s a very hated regions.

 

 

What about the Russia-Ukraine war? I use the Polish equity market as a proxy for geopolitical risk. The relative performance of Poland is still weak, indicating an elevated level of geopolitical risk premium. Poland has violated relative support against the Euro STOXX 50 and it is testing a key relative support level against ACWI. Avoid it for now.

 

 

In conclusion, a survey of the world economic outlook shows the increased risk of a global recession. An analysis of the global regions indicates the US is no longer a safe haven in downturns. Relative valuations of non-US markets have converged and the best opportunity is appearing in non-German eurozone. Asia may be constructive but it is subject to China lockdown risk and possible fallout from India’s heatwave.

 

FOMC reaction: I told you so

Posted by Cam Hui -

Mid-week market update: Happy Price Stability Day to you!
 

Ahead of the FOMC meeting, I had been pounding the table that market expectations were unrealistically hawkish. The market was discounting strong rate hikes well beyond the Fed’s stated median neutral rate of 2.4%, according to the March Summary of Economic Projections.
 

 

Combine the market’s hawkish expectations with a continued sense of panic in Investors Intelligence sentiment where bearishness jumped to a two-year high. What did you expect would happen?

 

 

The Fed came through with an expected half-point rate increase, quantitative tightening to begin on June 1 at $47.5 billion per month and rising to $95 billion after three months. These actions were entirely in line with expectations. More importantly, Powell pushed back on a 75 bps hike and it is not something the Committee is considering.

 

 

Inflation may have peaked

Here is what the picture is on inflation. Core PCE, which is the Fed’s favorite inflation metric, has been falling in the past two months. So has the Dallas Fed’s Trimmed Mean PCE. The high PCE prints will begin to drop off over the next few months, which makes the YoY comparisons tamer. At the current monthly rate, core PCE is running at 3.0-3.5% on an annualized basis, which is below the SEP projection of 4.1%. This makes the Fed’s job of pivoting to a less hawkish policy easier, though the Employment Cost Index remains stubbornly high. Investors should keep an eye on Average Hourly Earnings in Friday’s Jobs Report.

 

 

In addition, 5×5 inflation expectations is in retreat. While they are still elevated, readings are below the highs of the last cycle. While the Fed will undoubtedly remain vigilant, this will also allow Fed officials more room to make a dovish pivot.

 

 

Powell acknowledged in the press conference that inflation has decelerated, but a one-month data point is not enough to change policy. The FOMC is watching for trends in inflation, though Powell allowed that there is no evidence of a wage-price spiral.

 

 

Upside potential

In light of the excessively bearish sentiment, it was no surprise that the market took on a risk-on tone when Powell took a three-quarter point rate hike off the table. The question is how far the market can rally from here.

 

The S&P 500 surged today to test resistance at the 4300 level and the next logical resistance level is the 50 dma at about 4375. Moreover, the VIX Index retreated from above the upper Bollinger Band to its 20 dma. The market gas often paused its advance under such conditions. The key test is whether the market can exhibit bullish follow-through tomorrow, or whether it will consolidate sideways.

 

 

My inner trader is highly conflicted. Generally, he is inclined to exit long positions when the VIX recycles back to its 20 dma, but it’s difficult to see how such record levels of bearishness can unwind itself in a single day. Stay tuned for tomorrow’s market action and Friday’s Jobs Report.

 

 

Disclosure: Long SPXL

 

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A sentiment preview of FOMC week

Posted by Cam Hui -

Since the publication of my weekend trading update (see Will the Fed rally or tank markets?), a number of additional sentiment readings have come to light that may be relevant to traders and investors. The historic almost off-the-chart levels of bearishness of the AAII weekly sentiment survey has been known for several days, but there’s more.
 

 

The Callum Thomas (unscientific) weekly Twitter sentiment poll is at levels highly reminiscent of the COVID Crash lows.

 

 

In addition, the Goldman Sachs Sentiment Indicator has fallen to -2.2, which is another bearish extreme.

 

 

Historically, forward S&P 500 returns after such readings have been strong, with the important caveat that none of those instances occurred during fast Fed tightening cycles.

 

 

The markets are so jittery before Monday’s open that CNBC took the unusual step to broadcast a morning “Markets in Turmoil” banner (link here). In the past, such episodes have been done after the market close and the episodes were contrarian bullish signals.

 

 

Looking ahead past Wednesday’s FOMC meeting, Friday will see the publication of the April Jobs Report. While I have no strong views on the NFP print, Friday will mark the weekly option expiration where an unusual level of put buying has occurred. To be sure, many of the positions were opened weeks ago, but such an unusual skew is contrarian bullish. All else being equal (and unless the puts are rolled forward), the imminent expiration of the put options will force market makers to buy the underlying stocks owing to gamma decay as Friday draws closer.

 

 

Finally, investors will face the falling tail risk of Russian escalation. There had been considerable speculation that Putin was aiming to declare a limited victory in Ukraine by May 9, the day commemorating the Soviet victory over Nazi Germany. The latest assessment indicates that the Russians have only made minor gains at considerable cost on the battlefield. Russian forces are close to exhaustion and no victory is in sight. 

 

In such an event, observers had speculated that Putin would announce a general mobilization and draft of personnel and escalate the war, which would have unsettled markets. I had been skeptical of the general mobilization scenario for a couple of reasons. First, the Russians have committed about three-quarters of their standing ground forces to Ukraine. The latest intake of 100K conscripts is already short of trainers. How will the Russian forces be able to accommodate more troops? As well, the fighting in Ukraine has taken a toll on equipment and recent estimates indicate that the war has destroyed two years of Russian tank production. Western sanctions and the lack of semiconductors have put a halt to Russian military equipment production. As well, much of the inventory of tanks and other vehicles is too old, rusty, and not usable. Some tanks reported even lack engines. What would the new troops in a general mobilization be equipped with? Would they fight by throwing rocks?

 

A recent talk show on Russian state media gave no hint of any preparation for a general mobilization, which reduces the tail-risk of Russian escalation.

 

 

An oversold market

In short, the market is oversold and sentiment is discounting the direst scenarios. Any hint of better news would spark a rip-your-face-off risk-on rally. Steve Deppe studied what happened when the S&P 500 went on a four-week losing streak of -5% or more. At a minimum, expect a one-week bounce even if the fundamental and macro backdrop is bearish.

 

 

Any market weakness should be regarded as a gift from the market gods.

 

 

Disclosure: Long SPXL

 

Will the Fed rally or tank markets next week?

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 price. 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 bsoe 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: Buy equities
  • Trend Model signal: Bearish
  • Trading model: Bullish

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

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

 

Another test of the 2022 lows

Here we go again. The S&P 500 tested its 2022 lows on Friday while exhibiting a positive 5-day RSI divergence. Selected sentiment readings are at off-the-charts levels. Both the bond and stock markets are poised for a relief rally, and the FOMC meeting Wednesday could be the catalyst.

 

 

 

A historic sentiment extreme

I recently expressed doubts over the weekly AAII sentiment survey readings, but the latest survey results now finally confirmed a contrarian bullish conclusion. For the third consecutive week, the bull-bear spread remains below -20. Not only has bullish sentiment collapsed in the latest week, but also bearish sentiment spiked to a nearly off-the-charts reading, indicating unbridled panic. Both the bull-bear spread and bearish sentiment have not been this bearish other than the bear market low in 1990 and the generational equity market low in February 2009.

 

 

In addition, equity fund flows have tanked to levels last seen during the 2020 COVID Crash, the 2011 Greek Crisis, the 2008 Lehman Crisis, and other major market panic lows.

 

 

At a minimum, this is a setup for a tactical stock market rally, though I remain unconvinced that investors have seen the actual low for this market cycle. As we look ahead to the FOMC meeting in the coming week, the market is also setting up for a bond market rally with important implications for stock market leadership.

 

 

Stocks vs. bonds

Stock and bond prices have undergone the unusual condition of falling together in 2022. Both stock and bond sentiment are exhibiting excessively bearish readings. A review of the technical and sentiment backdrop leads me to believe that bond prices have greater intermediate upside potential than stocks.

 

 

Let’s begin with the equity market outlook. While the AAII sentiment readings appear contrarian bullish, other sentiment models are not confirming similar extremes. The CNN Business Fear & Greed Index is fearful, but conditions are not at panic-driven lows seen in the recent past.

 

 

Similarly, the NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investor funds, retreated last week. While readings are below average, indicating minor levels of bearishness, they are nowhere near conditions seen in past washout lows.

 

 

To be sure, all four components of my bottom spotting model flashed buy signals within a few days of each other last week.

 

 

From an intermediate-term perspective, the S&P 500 has definitively violated neckline of a head and shoulders pattern. This suggests that any relief rally will encounter overhead resistance at about 4310.

 

 

From a long-term technical perspective, the percentage of S&P 500 stocks above their 200 dma reached a “good overbought” condition of over 90% in 2020 and recycled below in mid-2021 (top panel). Historically, such declines don’t end until the percentage of S&P 500 above their 50 dma fall to 20% or less (bottom panel). Investors have yet to see that capitulation low.

 

 

From a valuation perspective, the S&P 500 is trading at a forward P/E of 18.1, which is constructive. I pointed out recent (see US equity investors are playing with fire) that the last two times the 10-year Treasury yield traded at current levels, the forward P/E ranged from 13.5 to 16, which represents further downside potential from current levels.

 

 

In addition, we have not seen the clusters of insider buying that exceed sales that usually mark major market bottoms.

 

 

As a reminder, this is the pattern of insider activity during the COVID Crash bottom.

 

 

 

What about bonds?

Turning to the bond market, Ed Clissold of Ned Davis Research observed that bond market sentiment is excessively bearish.

 

 

The blogger Macro Charts also confirmed that the 10-year Treasury Note’s Daily Sentiment Index is at a bearish extreme, though DSI can be an inexact timing indicator.

 

 

As the market looks ahead to the May FOMC meeting, investors are faced with the unusual condition where the Fed Funds rate has barely budged but the 2-year Treasury yield has skyrocketed in anticipation of a fast tightening cycle.

 

 

The market is anticipating a half-point hike in May, followed by a three-quarter point hike in June, and a half-point hike in July, which represent extremely hawkish expectations. In all likelihood, a three-quarter point hike in July may be overly aggressive and any hint of a steady course of half-point moves would be enough to spark a bond market rally.

 

 

 

Watching for confirmation

From a technical perspective, the 7-10 Year Treasury ETF (IEF) appears to be trying to form a bottom, but we have seen similar false starts in the recent past. 

 

 

Here is what I am watching. If the bond market were to stage a rally from bearish sentiment extremes, watch for confirmation from changes in equity market leadership from inflation hedge groups to interest-sensitive issues.

 

 

In addition, falling bond yields would translate into better relative performance for high duration quality large-cap growth stocks such as the NASDAQ 100.

 

 

In conclusion, extremes in bearish sentiment in both stocks and bonds are setting up for tactical rallies in both asset classes. Short-term stock market readings are extremely oversold and major downdrafts simply don’t begin under such conditions. My base case scenario calls for better intermediate upside potential from the bond market. The upcoming FOMC meeting is a potential catalyst for the rally.

 

 

Strap in and brace yourself.

 

 

Disclosure: Long SPXL