Seven reasons why traders should grit their teeth and buy

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

 

 

So much for the BoE

The market took a risk-off to begin last week until the BoE announced a surprise intervention to buy gilts with maturities of 20 years or more “on whatever scale is necessary” in order to stabilize markets. Global markets rallied for all of one day and the S&P 500 weakened for the rest of the week. So much for BoE intervention.

 

As the S&P 500 violated support on Friday, the midcap S&P 400 and the smallcap Russell 2000 did not confirm by holding their respective support levels. Should you believe the breakdown?

 

 

Here are seven reasons why traders should grit their teeths and buy stocks.

 

 

Buy signals everywhere

I am seeing short-term buy signals everywhere. Investors Intelligence bull-bear spread has turned negative again, which have tended to signal good long entry points. Bullish sentiment has fallen to lows not seen since 2016. 

 

 

The AAII bull-bear remained roughly unchanged at an extreme bearish reading for a second consecutive week.

 

 

Bloomberg reported that four out of five components of Sanford Bernstein’s Composite Sentiment Indicator, volatility, put/call ratio, investor survey and equity fund flow data, have reached negative extremes. 

 

 

The Zweig Breadth Thrust Indicator reached an extreme oversold level comparable to the levels last seen during the COVID Crash. Readings recycled to neutral on the day of the BoE intervention but returned to oversold the next day. While there is no guarantee that oversold markets can become more oversold, the odds indicate a favorable risk/reward for bullish positions.

 

 

Rob Hanna of Quantifiable Edges reported that his Capitulative Breadth Indicator (CBI) reached 13 last Tuesday. Historically, readings above 10 have been strong buy signals.

 

 

As the S&P 500 probed its lows last week, improvements in breadth appeared beneath the surface. Net NYSE and NASDAQ highs-lows turned up even as the market weakened, which is a constructive sign for equities.

 

 

Best of all, insiders are buying as the market fell. 

 

 

 

Bullish, but beware of tail-risk

In conclusion, market omens are lining up for a strong relief rally. While the intermediate-term trend is still down after a bounce, traders should be prepared for a rip-your-face-off rally that could happen at any time. The Trend Asset Allocation Model has finally turned risk-off. In light of the likely relief rally and the poor performance of the bond market which has not been diversifying for equity holdings this year, I am putting the signal change on hold. I will re-evaluate market conditions in two weeks and make a decision on the model signal.

 

To be sure, tail-risk is still present. The Guardian reported that Ukrainian intelligence believes the threat of Russian use of tactical nukes are “very high”.
 

In an interview, Ukraine’s military intelligence put the threat of Russia using tactical weapons against Ukraine at “very high”. A nuclear weapon is about 100 times more powerful than the type of rockets Russia has used against Ukraine so far, said Vadym Skibitsky, Ukraine’s deputy intelligence chief.

 

“They will likely target places along the frontlines with lots of [army] personal and equipment, key command centres and critical infrastructure,” said Skibitsky, about Russia’s use of tactical nuclear weapons. “In order to stop them we need not just more anti-aircraft systems, but anti-rocket systems.

 

“But everything will depend on how the situation develops on the battlefield.”
In that case, the 1962 Kennedy Slide and Cuban Missile Crisis market template could come into play. As a reminder, the market tanked in early 1962, rallied, and fell again into a second low that coincided with the Cuban Missile Crisis. But the Cuban Missile Crisis low did not undercut the initial low.

 

 

 

Disclosure: Long SPXL

 

The anatomy of a failed breadth thrust

Posted by Cam Hui -

Many technical analysts turned excited in late August when the percentage of S&P 500 stocks above their 50 dma surged from below 5% to over 90%. Historically, such breadth and momentum thrusts have signaled a fresh bull market with a track record of 100% accuracy.
 

 

Since then, the percentage of stocks above their 50 dma retreated all the way back down to 5%. The breadth thrust fizzled. Here’s why.

 

 

Don’t ignore the Fed

The historical record of another breadth thrust model, the Zweig Breadth Thrust, tells the story. ZBT buy signals are extremely rare. There have been six out-of-sample ZBT buy signals since Marty Zweig outlined this signal in 1985. The stock market was higher 12-months later in all cases. In two of the cases, the market didn’t immediately surge after the buy signal. These periods coincided with periods of a rising Fed Funds rate, just as we have today.

 

 

Today, Fed policy is extremely tight. Here is what we know from the last FOMC meeting:
  • The Fed is anticipating “ongoing increases” in the Fed Funds rate, and expects higher for longer: “Restoring price stability will likely require maintaining a restrictive policy stance for quite some time”.
  • Median expectations for the Fed Funds rate is 4.4% by year-end and 4.6% by the end of 2023.
  • The Fed will keep at it “until the job is done”.
Ignore the Fed at your own peril.

 

 

Better news on inflation

That said, inflation pressures are moderating all around the world, as measured by the Inflation Surprise Indexes, notwithstanding the hotter than expected August PCE print.

 

 

Remember the supply chain bottlenecks? Global shipping rates are all collapsing, which should be good news for inflation.

 

 

The problem is the jobs market is still strong, as evidenced by falling initial jobless claims after topping out in late July. The Fed has made it clear that unemployment has to rise for inflation to fall.

 

 

 

Will something break?

I’ve pointed out before that the other hope for a central bank pivot is a financial crisis (see Why a financial crisis could be the bulls’ best hope). Last week’s BoE intervention in the gilt market was a stark example that the UK had come very close to a consequential financial accident with likely domestic and international spillover effects. 

 

In very simple terms, here is what happened. The WSJ reported that liability-driven investment funds (LDI) are leveraged, and that’s when trouble began.

 

The LDI strategy is meant to help pensions more efficiently manage their assets to ensure they can pay future retirees. Pensions use an LDI manager, who buys interest-rate swaps and other financial instruments to hedge against the risk that falling interest rates and rising inflation will increase their future obligations. 

 

The LDI strategies also widely use leverage to try to close the gap between what they own and their future pension promises. “A LDI manager might buy £100 of interest rate exposure using £30 to £40 of the fund’s assets,” said Jon Hatchett, a partner at consulting firm Hymans Robertson. 

 

That freed up assets to try to close pension-fund deficits but it increased the strain on the funds during the market turmoil, Mr. Hatchett said. “Those moves decimated the value of the assets backing the LDI portfolio,” he said. 

 

The strategy was encouraged by U.K. regulators to help funds manage interest-rate risks. A guide from the pensions regulator said the strategy typically offers “an improved balance between investment risk and return but it does introduce additional risks.”
The LDI strategy is very popular in the UK and employs leverage as much as seven to one.
The widespread adoption of LDI has been accompanied by higher levels of risk taking, according to the U.K. pensions regulator. Its 2019 survey of 137 big U.K. pension schemes found 45%, or almost half, had increased their use of leverage in the last five years. The maximum leverage allowed by the pensions ranged up to seven times, the survey found.
Pension funds hold gilts, but they repo the gilts out. They hedge with interest rate swaps by receiving fixed and paying variable rates. When the market reacted badly to the new government’s mini-budget, the gilt market fell and a doom loop began. As the value of gilts, or collateral, fell the pension received margin calls. What’s more, as rates move higher, they had to post variable margin on their interest rate swaps. A significant number of UK pension funds were at risk of becoming insolvent  In response, the BoE said it would purchase gilts on “whatever scale is necessary” for a limited time to prevent an “unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy”.

 

The problem doesn’t stop there. European banks have extensive exposure to the UK. It’s unclear the degree of contagion risk exposure had the BoE not stepped in on an emergency basis. The European Systemic Risk Board (ESRB) just issued a general warning about tail-risk in the Eurozone, “Risks to financial stability may materialise simultaneously, thereby interacting with each other and amplifying each other’s impact”. It identified three issues:
  • Rising debt levels and recession risk: The deterioration in the macroeconomic outlook combined with the tightening of financing conditions implies a renewed rise in balance sheet stress for non-financial corporations (NFCs) and households, especially in sectors and Member States that are most affected by rapidly increasing energy prices. These developments weigh on the debt-servicing capacity of NFCs and households.
  • Systemic financial risk: Risks to financial stability stemming from a sharp fall in asset prices remain severe. This has the potential to trigger large mark-to-market losses, which, in turn, may amplify market volatility and cause liquidity strains.
  • Rising credit risk: The deterioration in macroeconomic prospects weighs on asset quality and the profitability outlook of credit institutions
European credit risk is rising. High yield spreads have widened to levels seen during the COVID Crash.

 

 

 

King Dollar = Godzilla

The accumulated problems presented by Fed hawkishness are also present in Asia. In the movies, Godzilla emerges from the sea and wreaks havoc on Tokyo. Godzilla’s real name today is King Dollar. The Fed’s tight monetary policy has forced up the USD. By contrast, the BoJ has chosen to swim against the global monetary tide by staying dovish, which has cratered the JPY and effectively imported inflation from America. The Yen is back to levels not seen since the 90’s.

 

 

Over in China, it was the story of another day, another intervention by global central bank authorities. The strong USD pushed the onshore Chinese yuan to the psychologically 7.25 level before retreating, a level last seen during the GFC. The PBOC warned against speculative trading against the yuan and asked state-owned banks to be prepared to sell dollars in order to stabilize the currency. The yuan depreciation raises the risk of capital outflows. As a reminder, when China faced a balance of payment pressures in 2015, the PBOC sold U.S. assets to support the exchange rate and U.S. stock and bond prices came under pressure. 

 

FT Alphaville reported that Barclays analysts warned about the systemic risks posed by CNY depreciation:
While this is not a ‘systemic crisis’ moment, it is a worrying sign for the global macro outlook. After all, China is the single most important trading economy in the world. If the CNY is on a path to sustained depreciation, that is big news for every other exporter; most other countries will have to follow to keep themselves competitive. And yet, many of these countries are already facing high inflation and the need to defend their currencies from further depreciation. As important, the overnight move might be a sign that the PBoC is now comfortable with further weakness. A few days ago, it seemed like the Chinese central bank was planning to push back against further USD strength. If China is now changing tack, there is considerable room to go. In some ways, the recent CNY weakness is just the currency playing catchup to the weakness in every other currency against the dollar. We estimate that if the CNY were to go back to Q1 2021 levels on the CFETs basket, it would need to depreciate to 7.5 against the USD.

 

 

In short, an RMB depreciation would be catastrophic for Asia and create systemic problems for the region and for the global trading system. Other Asian central banks are also feeling the heat. As the sign of another pivot, the Bank of Korea took bids in the bond market as it became the latest central bank to intervene and resume bond buying to curb rising yields.

 

Something is going to break soon, we just don’t know what, but it will likely be outside US borders. For the moment, the level of US financial stress is low. Historically, recessions haven’t ended without the St. Louis Fed Financial Stress Index rising above zero.

 

 

 

Investment implications

Based on this analysis, I can think of two possible scenarios for US equities. The first is a multiple bottom scenario like 2002-2003. The S&P 500 first bottomed by experiencing a breadth wipeout, as measured by the percentage of stocks above their 50 dma, in July rallies and suffered a second breadth wipeout in October. The market then recovers but chops around but doesn’t really get the all-clear signal until the following May. The timing of this pattern is consistent with a recession in 2023 that ends late in the year. Since markets look forward by 6-12 months, a market bottom by next spring or summer is to be expected. 

 

While history doesn’t repeat itself but rhymes, this scenario doesn’t preclude the market from going lower before it makes a final bottom (see How to estimate S&P 500 downside risk). The S&P 500 is currently trading at a forward P/E of 15.3. History shows that there were two periods when the 10-year Treasury was trading at similar yield levels. The first was 2002-2003 when the market bottomed, and 2007-2011, which was the period just before and after the GFC. There are some key differences. The 2002-2003 episode was during a period when yields were falling, while the GFC episode featured yield volatility. Yields are rising today. Nevertheless, we can see that the S&P 500 forward P/E ratio traded in a range of 15-17 during the 2002-2003 period and 13-15 during GFC, if we exclude the panicked valuation during the 2008-2009 bottom. Assuming a 20% cut to forward earnings estimates and a 13-17 range as a target P/E multiple, this translates to a peak-to-trough drawdown of 30-50%, which is a typical loss experienced in recessionary bear markets.

 

 

The second scenario is that something breaks and the world experiences a financial crisis with sufficient contagion risk that global central bankers are forced to pivot monetary and save the system. In that case, the seasonal mid-term election year pattern might be a better template for the path going forward.

 

 

Take your pick, but don’t forget to practice prudent risk management in the process.

 

The BOE rescues the markets

Posted by Cam Hui -

Mid-week market update: Before going to bed last night, I check the overnight market and saw that S&P 500 futures were down as much as -1% and thought, “Here we go again!” I woke to see that the BOE had committed to buying Gilts “on whatever scale is necessary” which sparked a risk-on stampede.

The market was ready to be rescued, it just needed the bullish catalyst. One of the signs of an oversold stock market is the VIX Index rising above its upper Bollinger Band, and the VIX had gone on an upper BB ride for nearly a week. Tactically, the bullish impulse has historically petered out when the VIX reaches its 20 dma.

Ready to rally

The market was washed out and it was ready to rally. All four of my bottom spotting indicators had flashed buy singals in the past week.

  • The VIX above its upper BB, indicating an oversold market;
  • An inverted VIX structure, indicating fear;
  • The NYSE McClellan Oscillator was wildly oversold; and
  • TRIN spiked above 2, indicating panic-driven selling.

For some context on how badly price momentum got wiped out in the last downdraft, the % of S&P 500 stocks above their 200 dma fell to 10%, which is rare and has occurred four times in the last 20 years and marked major bear markets.

As well, the VIX Index had reached the bottom of its target zone yesterday, which was a sufficient condition for a short-term bottom.

When markets panic like this, it’s difficult to trade the bottom as markets can be volatile and extremely headline sensitive. Trading guru Brett Steenbarger recently discussed wildly oversold stock markets and came to the following conclusion:

Positive average returns don’t mitigate the need for sound risk management.  If central banks need to see significantly weaker economies to crush inflation, then stock markets can be expected to anticipate that weakness.  The average individual investor is long stocks and long bonds.  Both positions are getting crushed and could see real disaster if central banks need to continue to administer harsh medicine.

In all likelihood, the BOE decision was the catalyst for a relief rally. As well, CNBC reported that San Francisco Fed President Mary Daly struck a less hawkish tone in a speech today. My inner trader is long the market and he will exit his position once the VIX reaches its 20 dma, but as Steenbarger pointed out, sound risk management is a key to trading these volatile markets.

Disclosure: Long SPXL

How to estimate S&P 500 downside risk

Posted by Cam Hui -

As we approach Q3 earnings season, the Street cut the bottom-up S&P 500 forward 12-month EPS estimates by an estimated -0.41% as recession anxiety begins to rise. The good news is the market is trading at a forward P/E of 15.8, which is below its 5- and 10-year averages.
 

 

In light of the heightened recession risk, what’s an appropriate valuation for the S&P 500? What’s the downside risk from here?

 

 

What’s the “right” valuation?

Forward P/E ratios don’t exist in a vacuum. Stocks have to compete with other asset classes, such as risk-free Treasuries, for investment funds. With that in mind, I went back to 1995 and looked at the last time the 10-year Treasury yield traded at the current levels.

 

There were two periods when the 10-year Treasury was trading at similar yield levels. The first was 2002-2003 when the market bottomed, and 2007-2011, which was the period just before and after the GFC. There are some key differences. The 2002-2003 episode was during a period when yields were falling, while the GFC episode featured yield volatility. Yields are rising today.

 

Nevertheless, we can see that the S&P 500 forward P/E ratio traded in a range of 15-17 during the 2002-2003 period and 13-15 during GFC, if we exclude the panicked valuation during the 2008-2009 bottom.

 

 

Here is where we stand today. FactSet reported that the S&P 500 forward P/E as of last Thursday’s close was 15.8, or a forward 12-month EPS of 237.85. Negative earnings growth varies considerably during recessions. The average decline since 2001 is -22%, which is a slightly optimistic estimate since the sample includes 2007, which was just the start of the recession, and 2015, which was a growth recession.

 

 

If we pencil in a -20% decline in forward EPS estimates and apply the 15-17 2002-2003 multiple range to the S&P 500, we get a downside potential of 12% to 22% from Friday night’s closing prices. Applying the 13-15 multiple range of the GFC experience, the downside potential is 22% to 33%.

 

What if there is no recession? Assuming that earnings estimates don’t change, the range is a downside potential of -16% and upside potential of 10%.

 

In conclusion, rising yields are putting pressure on S&P 500 valuations. If investors were to assume an average recession, the downside potential could be as high as 33% from current levels and a peak-to-trough range of -33% to -48%, which would take the S&P 500 to either the top of the pre-pandemic peak or the levels of the 2018 Christmas Eve panic. On the other hand, the market is roughly fairly valued if the economy were to sidestep a downturn.

 

 

The right and wrong way to throw in the towel

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A crowded short

In the wake of the post-FOMC meeting downdraft, three of the four components of my bottom spotting models flashed buy signals. 
  • The VIX Index has spiked above its upper Bollinger Band, which is an oversold condition for the market, 
  • Yhe NYSE McClellan Oscillator had become wildly oversold, and 
  • TRIN spiked above 2, indicating price insensitive panic selling. 

In the past, buy signal counts above two have indicated bullish risk/reward conditions for stock prices.

 

 

Other sentiment models are also pointing to crowded short conditions. In many ways, traders had already thrown in the towel even before the FOMC meeting, which is likely to put a floor on stock prices. But there is a right way and a wrong way to throw in the towel.

 

 

Too many bears

Numerous signs have appeared of a sentiment washout. The BoA Global Fund Manager Survey, which was conducted September 2-8, 2022, showed equity positioning at a record low.

 

 

The AAII weekly sentiment survey showed that the bull-bear spread and bearish sentiment readings were only exceeded at the 1990 and 2008 market lows. Bearishness today is even worse when compared to the aftermath of the 1987 market crash.

 

 

I recognize that the AAII survey is flawed because of a small sample size and a varying composition of respondents, but Ryan Detrick compiled the historical returns of the S&P 500 after AAII bears exceeded 60%. The instances were rare (n=4), but subsequent returns were strong across all time horizons.

 

 

In addition, S&P 500 futures net positioning is very bearish and has reached levels only seen during the downturns of 2008, 2011, 2015, and 2020.

 

 

In a report published on September 20, 2022, which was before the FOMC meeting, Mark Hulbert observed that his Hulbert Nasdaq Newsletter Sentiment Index dipped in the bottom decile of sentiment readings.

 

 

 

The wrong way to throw in the towel

Despite the apparent signs of excessive bearishness, Hulbert had a warning for investors.
A new bear-market low is likely still in the cards for U.S. stocks, for two contrarian-related reasons:

 

First, at no point in the current bear market has there been the deep pessimism and despair that frequently accompanies major bottoms — what many refer to as capitulation, or throwing in the towel.

 

Second, whenever even moderate pessimism has emerged, it has been short-lived; investors instead have been eager to jump on the bullish bandwagon at the mere whiff of a possible rally.
Jurrien Timmer at Fidelity pointed out that for all the talk about excessive bearishness, fund flows aren’t showing signs of capitulation. That said, the latest fund flow reports indicate that investors pulled money from all asset classes and money market fund assets swelled, but that may be only a blip and not evidence of protracted panic.

 

 

Equally disturbing is the lack of insider buying. A monitor of insider activity shows that insider buying (blue line) hasn’t exceeded insider selling (red line) as it did during incidents of market weakness this year.

 

 

Option sentiment presents a mixed picture. On one hand, the VIX Index remains below the target zone of 33-36 where the market has bottomed in the past. On the other hand, put/call ratios have spiked to fresh highs and the 10 dma of both the CBOE put/call ratio and equity-only put/call ratio are consistent with levels reached at the June bottom.

 

 

 

Sell the rips

I interpret these readings in two ways. The signs of excessive bearishness are short-term in nature, which is likely to put a floor on stock prices as they weaken. In other words, the market is poised for a relief rally.

 

On the other hand, the bearish factors are more intermediate-term in nature. Barring a bullish macro or fundamental catalyst, the path of least resistance is still down after any counter-trend bounce (see yesterday’s publication What the Fed and FedEx are telling the markets).

 

Technical analysts virtually all turned universally bullish after the strong momentum thrust off the June low when the percentage of S&P 500 stocks above their 50 dma surged from below 5% to over 90%. Since then, price momentum has fizzled and readings have returned to oversold again, indicating a failed breadth thrust.

 

 

Willie Delwiche also pointed out that global breadth, as measured by the percentage of individual markets above their 200 dma, is low at 17%. The moral of this story is not to over-rely on sentiment or any single model. Wait for confirmation from other uncorrelated models before making an investment decision.

 

 

In conclusion, sentiment readings and technical conditions are sufficiently washed out that a relief equity rally can happen at any time. However, the intermediate-term direction is still down. Prepare for the bounce, but don’t forget to sell the rips.

 

 

 

Disclosure: Long SPXL

 

What the Fed and FedEx are telling the markets

Posted by Cam Hui -

Both the Fed and FedEx had messages of recession for the markets. Fed Chair Jerome Powell said that the Fed would raise rates until there was clear and convincing signs that inflation was headed toward its 2% target, and its projections amounted to a recession that begins either late this year or early next year. FedEx warned about a slowdown in global shipping volumes and recessionary conditions.
 

As we approach Q3 earnings season, an interesting divergence is appearing in the derivative markets. While the SKEW, which measures the price of option tail-risk, is low for the S&P 500, the SKEW for individual stocks has been elevated. This reflects rising anxiety about possible blow-ups in individual stocks as earnings season approaches.

 

 

Still, a review of the risks shows that not all is at it seems below the surface.

 

 

The Fed’s hawkish message

The latest Summary of Economy Projections (SEP) was highly revealing of Fed policy. The Fed had sharply reduced its GDP growth projection for 2022 and raised its Fed Funds projections for 2022 and 2023. The median expected Fed Funds rate is now 4.4% for December 2022 and 4.6% for December 2023, which was ahead of market expectations. In other words, the message is “higher for longer”.

 

 

Even though the Fed can’t be seen to call for a recession, a recession is implicit in the Fed’s forecast. How can GDP growth slow to 0.2% by December 2022 and rise to 1.2% by December 2023 when the Fed is raising rates and keeping them elevated for all of next year? Moreover, former Obama CEA Chair Jason Furman pointed out that the Fed’s unemployment forecast would trigger the Sahm Rule recession tripwire.

 

 

The market reflexively went risk-off in the wake of the FOMC meeting as it began to discount a recession. New Deal democrat, who maintains a discipline of using coincident, short-leading, and long-leading indicators to forecast economic growth, isn’t now pondering whether there will be a recession, but how deep it will be.

Suddenly there are a lot of things for me to write about; including not just if there will be a recession, but also how deep and how long it might be. The longer the Fed goes on raising rates, the more I think it may turn into a bad, deep recession.

Alfonso Peccatiello, who writes as Macro Alf, went back 100 years and looked at all 16 U.S. recessions during that time. In all 11 episodes when we entered a recession with inflation above 3%, the resulting sharp economic slowdown did bring inflation down.  On average it took 16.2 months to slow CPI from peak back to 2%. The peak-to-trough reduction in CPI was -6.8%. Based on his projections, this recession should end in late 2023.

 

 

 

The FedEx warning

In addition, FedEx CEO Raj Subramaniam recently issued a warning about a global slowdown:
Global volumes declined as macroeconomic trends significantly worsened later in the quarter, both internationally and in the U.S — We’re seeing that volume declined in every segment around the world, and so you know, we’ve just started our second quarter. The weekly numbers are not looking so good, so we just assume at this point that the economic conditions are not really good. We are a reflection of everybody else’s business, especially the high-value economy in the world.
The slowdown is especially evident in China, but global container shipping rates have been falling since late 2021 and the collapse began to accelerate at the end of Q1 2022.

 

 

However, not all is gloom and doom. Demand has shifted from goods, which affects shipping companies like FedEx, to services. Bank of America CEO Brian Moynihan revealed in an earnings call that the American consumer is still spending.

In the month of August 2022, consumers spent 10% more than they spent in August 2021 — customers are spending more. They have – the amount of money and accounts is not going down. It’s been relatively flat — They’re spending it at a good clip. Their capacity to borrow. All credit cards are still enough to where they were in the pandemic. Our home equity loans are still down and you look across the industry capacity to borrow. So the consumer is in very good shape. And you sort of say, why is that true in the discussions with various people, it’s pretty simple. They’re getting employed.

VISA President Ryan McInerney agrees with that assessment:
So I think the best way to describe consumer spending right now is stable, and that’s what we see in our numbers. There’s been some shifts in the way consumers are spending, what they’re buying, and where they’re spending. But, overall spending has been remarkably stable, both in the United States here and for the most part around the world.
VISA CFO Vasant Prabhu explained that the weakness in FedEx results can be explained by a shift in demand from goods to services:
If you look across categories, as you might expect, people have switched from, as they say, buying things to doing things. And sort of buying goods, people are into experiences. Travel is booming as you might know from having flown yesterday. Hotels, airlines, and entertainment is doing well, restaurants are doing well. There’s no obvious difference between high-end consumers and lower-end consumers. They may be buying different things, but nominal levels of spending have stayed quite stable, and that’s largely true around the world.
We can see the shifts in demand in different categories of PCE. While Services PCE (blue line) has been remarkably stable, durables goods PCE (red line) has been extremely volatile during the pandemic and post-pandemic period, and nondurable goods PCE (green line) less volatile. The FedEx warning is reflective of the sudden downdraft observed in durable goods PCE, or the “transitory inflation” effect. The disaggregation of PCE components also shows the Fed’s dilemma. PCE inflation rates remain stubbornly elevated, which may prompt Fed officials to over-tighten and send the economy into a deep recession.

 

 

 

A dismal earnings outlook

This analysis indicates that investors will need to be prepared for volatility from different parts of the market. While services companies are more likely to meet or beat Street expectations, companies involved in goods production and their transportation are prone to disappointment.

 

The outlook for long-term corporate profitability is even worse. Fed research Michael Smolyansky published a note which concluded that much of the increase in net margins can be explained by falling interest expenses and lower tax rates, which are unlikely to continue. 
Over the past two decades, the corporate profits of stock market listed firms have been substantially boosted by declining interest rate expenses and lower corporate tax rates. This note’s key finding is that the reduction in interest and tax expenses is responsible for a full one-third of all profit growth for S&P 500 nonfinancial firms over the prior two-decade period. I argue that the boost to corporate profits from lower interest and tax expenses is unlikely to continue, indicating notably lower profit growth, and thus stock returns, in the future.

 

 

In the short-term, the latest update from FactSet shows weekly EPS revisions falling across all time frames, which is bearish sign for equity fundamentals.

 

 

 

Investment implications

Putting this all together, these developments have ominous implications for equity market returns. The Fed is tightening policy, which is negative for equity valuation. A recession is on the horizon, which is bearish for the earnings outlook. Q3 earnings season could see some bifurcation as the goods-producing sector faces challenging conditions while services remain strong.

 

A non-linear thinker may conclude that while the equity market outlook may be bearish short-term, market history shows that the Fed always pivots in the face of a financial crisis. While US corporate and household balance sheets are strong, the same can’t be said overseas. Europe is already in recession, and China is probably in a recession. I am monitoring the stock market performance of regional markets for signs of a bottom and turnaround. In particular, Europe is extremely vulnerable to a financial crisis that would prompt global central bankers to ride to the rescue and ease policy.

 

 

 

Higher for longer

Posted by Cam Hui -

Mid-week market update: The Fed has spoken. As expected, it hike interest rates 75 bps. In its Summary of Economy Projections (SEP), it sharply lowered GDP growth for this year and it raised the Fed Funds projection to 4.4% for this year and 4.6% next year, which are both ahead of market expectations. In other words, higher for longer (though it did signal rate cuts in 2024).

 

Fed Funds futures reacted by extending the already elevated Funds Funds rates for next year, but it did show some skepticism of the Fed’s SEP by expecting rate cuts by September 2023.

 

 

 

The FOMC pattern broken?

The 2022 S&P 500 FOMC pattern of weakening into an FOMC meeting and rallying afterward appears to be broken. However, the market may be oversold enough to bounce. the 5-day RSI was already oversold coming into the meeting, indicating limited downside potential.

 

 

II sentiment shows more bears than bulls, which is conducive to market strength.

 

 

Two of the four components of my market bottoming model are already flashing a buy signal. The NYSE McClellan Oscillator was oversold coming into the meeting. Today’s estimated TRIN reading spike above 2 to 2.3, indicating panic selling and another buy signal.

 

 

The other two components are also very close to buy signals. The VIX Index briefly spiked above its upper Bollinger Band today and the term structure of the VIX also briefly inverted. In the past, two out of four components flashing buy signals have been indicators of positive risk/reward for long positions.

 

Subscribers received an alert yesterday that my trading account had tactically bought S&P 500 exposure. My inner trader is maintaining the long position in light of these buy signals in anticipation of a turnaround in the next two days.

 

 

Putin’s gambit

The other development to be aware of is the news of Russia’s partial mobilization. Putin appeared on Russian television and announced a partial mobilization of 300,000 reservists. While the measure was short of a full draft, it was also designed to keep soldiers with contracts that expire in the Russian Army. Moreover, he announced annexation referendums in the Russian occupied parts of Donetsk, Luhansk, Kherson, and Zaporizhzhia regions of Ukraine, which would make attacks in these regions an attack on Russia. It was a way of rattling the nuclear saber.

 

Take a deep breath. The risk of nuclear war remains low. The Ukrainians had already attacked parts of Crimea, which was considered Russian soil, and crossed Putin’s red line with no reaction. The market agrees. The relative performance of MSCI Poland edged down on the news and it remains in relative downtrends against the Euro STOXX 50 and ACWI. However, there is no sign of panic.

 

 

I interpret these developments as signs of Russian recognition that it needs to bolster the ranks of the Army for a fight over the winter. While the nuclear threat is always present, the risk of crossing that threshold is still low.

 

 

Disclosure: Long SPXL

 

A flock of hawks circle Wall Street

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

Subscribers can access the latest signal in real time here.
 

 

Waiting for the FOMC

As investors look ahead to the FOMC meeting next week, rates are rising and the 2s10s yield curve is inverting further. The 10-year to 3-month spread is not inverted yet, but it likely will once the Fed raises rates.

 

 

It’s difficult to make definitive bull or bear views on equities and bonds as there is much policy uncertainty. Here is what I am watching:
  • The Fed has given the obligatory nod to a “soft landing” but what’s the body language about a possible recession?
  • The Fed has said higher for longer, but how much longer?
  • What are its inflation projections for 2022, 2023, and 2024 in the Summary of Economic Projections (SEP)?
  • How far does the dot plot get revised up, and what is the terminal rate?

 

 

The small business barometer

As we are in the blackout period for Fed officials ahead of the FOMC meeting, investors are left to speculate on the likely direction of Fed policy. Here are some clues from the most recent NFIB small business survey. The survey is especially useful since small businesses are sensitive economic barometers because they lack bargaining power. The NFIB survey had some good news on inflation. The pace of price increases is rapidly decelerating, which is good news.

 

 

The bad news is that small business optimism edged up, which is a curious reading during a midterm election year. Small business owners tend to tilt small-c conservative and Republican. Normally, small business optimism is depressed when the Democrats control the White House and both the Senate and House. The small increase in optimism is a signal that the economy is robust in the face of recession fears which leaves room for the Fed to raise rates without too many recession worries.

 

 

 

Signs of technical weakness

What does that mean for the stock market? Technical indicators all suggest that the path of least resistance is down, at least for the short term. First, we are seeing trend line violations across all market cap bands.

 

 

As the S&P 500 broke down to a lower low, breadth indicators have confirmed the weakness by also showing lower lows.

 

 

The NYSE McClellan Summation Index (NYSI) has been falling and stochastics are not oversold yet, indicating further downside potential in the near term.

 

 

The NYSE McClellan Oscillator rebounded from an extreme oversold reading and it is weakening again, which is an indication that the market could fall further if the bears control the tape.

 

 

Equally disturbing is the lack of insider buying as stock prices weakened.

 

 

 

Beware of reversals

Ahead of a possible market-moving event like an FOMC meeting, it’s difficult to make a call on market direction beyond the event. Investors and traders risk falling into a possible price reversal trap. The stock market has followed an FOMC pattern in 2022, where stock prices fall and bottom just ahead of the FOMC meeting and rally afterward, which is an indication that positioning becomes overly hawkish and bearish and snaps back.

 

 

Ryan Detrick calculated the daily seasonality for the S&P 500, and we are entering a period of negative seasonality and reversal that roughly coincides with the FOMC meeting cycle.

 

 

The market saw a big drop in stock prices in reaction to the hot CPI print. SentimenTrader observed that every single stock in the NASDAQ 100 fell that day, which is rare. A historical study shows that the median one-week return is 0.3%, but the median two-week return is 4.1%. Unless the market melts up on Monday, the first week will be negative, but if history is any guide, the following week should be strongly positive.

 

 

In conclusion, it’s difficult to make definitive calls on market direction ahead of an FOMC meeting. Price momentum is negative in the wake of the hot CPI report and I would expect it to continue into the date of the meeting. However, investors need to be prepared for a possible reversal should sentiment and positioning become excessively bearish and hawkish.

 

A pending major market bottom? It sounds too easy!

Posted by Cam Hui -

Is the universe unfolding as it should? Most technical and sentiment indicators argue for a near-term double bottom in the S&P 500. The June bottom was the initial capitulation bottom. The market rallied and it is poised to weaken and re-test the old lows in the near future. That’s when the new bull begins.
 

 

The new bull narrative sounds far too easy. Macro and fundamental factors argue for further downside potential. The Powell Fed is in a “whatever it takes” mode to tame inflation. The 2-year Treasury yield has been climbing relentlessly, which is an indication of rising market expectations of a terminal Fed Funds rate. Forward P/E valuations are becoming increasingly challenging even as the E in the P/E ratio declines ahead of a likely recession. If support at the June low doesn’t hold, SPY faces a possible air pocket and a rapid fall to the 260-320 support zone, which represents considerable downside risk from current levels.

 

 

The bull case

The bull case is easy to make. The percentage of S&P 500 stocks above their 50 dma fell below 5% at the June low, which was the signal for a price momentum wipeout (pink vertical lines). The indicator flashed a buy signal by quickly rebounding to over 90% (grey vertical lines). The stock market has continued to rise after every single buy signal in the last 20 years.

 

 

With the S&P 500 about to undergo the typically weak September seasonality in a mid-term election year, investors are faced with a potential buying opportunity in the coming weeks that could yield a bonanza by year-end and beyond.

 

 

The latest BoA Global Fund Manager Survey showed that global equity allocation fell to an all-time low, indicating widespread panic, which is contrarian bullish. These excessively bearish sentiment conditions should act to put a floor on stock prices if the market were to weaken during its period of negative seasonality.

 

 

Putting it all together, the market is poised for a major market bottom in the coming weeks. What more could anyone ask for?

 

 

Fundamental and macro doubts

It sounds just too easy and the Federal Reserve begs to differ. Marketwatch reported that Anatole Kaletsky of Gavekal warned that the Fed’s inflation fight isn’t over and the Fed won’t respond if the economy falls into recession.
Anatole Kaletsky, the chairman and chief economist of Gavekal, calculates that even if price increases come to a complete standstill right now, core inflation would still be 4.3% in December, and the headline rate at 6.2%. If core inflation continues to rise at the 0.56% rate as it did in August, it will hit 6.6% in December — and if inflation rises at the same rate recorded by the median CPI over the last three months, that core number will reach 7.2% by December.

 

“Many investors expect the U.S. economy to plunge into a deep recession and the Fed to respond by panicking and abandoning its inflation target. Both things may happen eventually, but neither is remotely plausible within the next six months or so,” he says.

 

After all, the most recent data on U.S. activity actually has been strengthening. “With inflation and labor market reports still pointing clearly to overheating, the Fed will have no excuse to hint at pausing, never mind at future easing,” says Kaletsky.

 

He forecasts the fed funds rate will be 4.5% by Christmas, that core inflation will be around 6.5% and the U.S. economy will still show no evidence of recession.
Fed Funds futures are now pricing in a peak Fed Funds rate of 4.42% in March 2023 and rates remaining above 4% for the bulk of next year. These hawkish higher for longer expectations don’t appear to be fully priced into stock prices.

 

 

As we approach Q3 earnings season, the market faces possible disappointment in the form of earnings disappointments as Q3 earnings estimates have been declining.

 

 

The earnings picture becomes even worse if the energy sector is excluded. Yardeni Research Inc. suggests that sector analysts are likely to cut profit margin estimates further during Q3 earning season. “Analysts remain mostly bullish on S&P 500 revenues in part because they go up along with inflation. Furthermore, very few industries (such as the S&P 500 Homebuilding) are showing signs of falling into a recession currently.” With the exception of energy and real estate, sector margins have been falling, which is going to create valuation and growth headwinds for equity prices.

 

 

The latest economic update from New Deal democrat, who maintains a set of coincident indicators, short-leading indicators with a 6-month horizon, and long-leading indicators with a 12-month horizon, is effectively pointing to a slowdown that begins in early 2023 and a recession by next summer.
The long leading forecast continues to be very negative. The short term forecast is only slightly negative. The nowcast turned slightly positive last week, but back to neutral this week, as tax withholding turned decisively negative (I’ll withhold judgment on the potential broader implications of that until the August 31-September 1 anomaly is out of the 20 day mix).
In a separate post analyzing aggregate payrolls, he warned:
Although the decline in gas prices in the past 3 months has been very helpful, the consumer remains in a really dicey situation. Any further deterioration is likely to signal either that a recession is nearly imminent, or that one has already begun.
As well, last week’s warning from FedEx could be seen as a wake-up call for investors. The company announced that it is closing 90 locations, five corporate offices, and parking aircraft all due to macroeconomic headwinds: “Macroeconomic trends significantly worsened later in the quarter… given the speed at which conditions shifted… we are aggressively accelerating cost reduction efforts.” The company went on to suspend earnings guidance because of ongoing uncertainty.

 

In short, the combination of higher interest rates, falling earnings expectations, and a probable 2023 recession makes the new bull scenario unlikely. 

 

 

Bearish charts

Not all technicians are bullish. Martin Pring is one of the few technical analysts who has a more cautious interpretation of the market and believes that US equity prices could see further downside in the context of inter-market analysis.

 

 

Arguably, the June bottom was not a capitulation bottom. The accompanying chart shows the one-hour swings of the S&P 500 since 2001. The hourly swings at the June bottom barely reached the 2.5% level, which is a marginal reading, though similar conditions could be found at the 2018 Christmas Eve bottom.

 

 

Let’s have some fun with point and figure charting. Here is a monthly S&P 500 point and figure chart with a 5% box and a one box reversal. The index has retreated to a rising trend line and a breach could signal serious trouble.

 

 

Here is the same chart with a two box reversal. The measured target is 3258, which is in the top half of the support zone outlined earlier in the weekly SPY chart.

 

 

 

Resolving the bull-bear debate

Here is how I resolve the bull and bear debate. The BoA Global Fund Manager Survey is a global survey and the underweight position in equities is more reflective of the economic anxieties outside the US. The relative performance of the different regions shows that the US is the clear leader. Europe is underperforming and the other regions are roughly flat relative to the MSCI All-Country World Index (ACWI).

 

 

The two main non-US trading blocs, Europe and Asia are in serious economic trouble. For some context, my analysis presents some of the effects in the form of a percentage of GDP.

 

It’s no surprise that Europe is tanking. Energy costs are soaring and the scale of the energy shock dwarfs past global shocks. A Bloomberg article documented how the ripple effects are shutting seemingly unrelated industries such as brewing and tomato farming. Britain has announced household energy subsidies that amount to 5% of GDP. EU price support is not far behind and estimates are in the range of 5-10% of GDP. BlackRock estimates that the EU energy burden, which is not its price support, is 11.7% of GDP.

 

 

Over in Asia, China isn’t faring much better. China’s COVID lockdowns are bringing the economy to a screeching halt. Goldman Sachs estimated that Chinese cities representing 35% of GDP are subject to lockdown.

 

 

At the same time, the Chinese property market is imploding. A Bloomberg podcast with Bloomberg Economics chief economist Tom Orlik outlined the scale of the mortgage strike by buyers of incomplete projects. It typically takes about three years for property development to reach completion. Bloomberg Economics found the normal three-year completion rate is 80%, but that figure recently fell to 50% because property developers found themselves squeezed by a lack of financing. The mortgage strike problem is now about 1.4% of GDP. If left unchecked, it will balloon to 4% of GDP by 2024.

 

 

How both the bulls and bears are right

Putting it all together, here is how both the bulls and bears could be right. I believe investors need to consider the level of equity sentiment by region. The market is far more concerned about economic weakness outside the US than within the US. The outperformance of US equities is an indication that the market regards the US stock market as a safe haven. In particular, the surveyed exposure to eurozone equities is at a record low, indicating extreme fear.

 

 

I recently suggested that Europe is probably already in a recession (see Will Europe drag us into a global recession?) and monitor European equities based on a first-in-first-out principle. Once European risk appetite begins to emerge from its doldrums, that could be the signal for a risk-on revival.

 

In many ways, Europe is starting to turn. European gas prices have peaked and they are in retreat, indicating that Russia is losing leverage over the EU. While Ukraine has seen some successes on the battlefield, the Russo-Ukraine war is by no means over. Here is what I am watching.

 

The performance of MSCI Poland is a useful barometer of geopolitical risk premium. The index is still in a downtrend relative to the Euro STOXX 50 and ACWI. Wait for a definitive sign of relative breakouts before sounding the all-clear.

 

 

Both BASF and Dow Chemical are commodity chemical producers based on two sides of the Atlantic. BASF (in USD) skidded against Dow in February with the onset of the war, but its relative performance is tracing out a relative bottom against Dow and it is testing a key resistance level. Wait for the relative breakout.

 

 

If and when they occur, relative breakouts in these two barometers will be a buy signal for global risk appetite. As investors piled into US assets for their safe haven quality during this downturn, expect US equities to lag as investors rotate into higher octane and higher beta equities. S&P 500 stocks have the potential to lag in the new bull phase. Jurrien Timmer at Fidelity has suggested the 1940’s as a template for the S&P 500, when stock prices fell -26% and then moved sideways as P/E ratios gradually fell.

 

 

Investors who are constrained to the US should consider mid- and small-cap equities, whose forward P/E ratios are far less demanding than the large-cap S&P 500.

 

 

In conclusion, the bulls could be right in their timing and analysis, and at the same time, the bears could also be right because of their macro and valuation concerns. The key difference is geography. Most of the growth concerns and opportunities are outside the US, while large-cap US equity valuations are elevated because of their perceived safe haven status in a period of slow global growth.

 

 

Fed: Do you believe us now?

Posted by Cam Hui -

Mid-week market update: Yesterday’s hot CPI report finally convinced the market that the Fed is serious. For weeks one Fed official after another gave the same message: We will raise rates to about 4% and hold them there while we evaluate the inflation picture. We don’t want a repeat of the 1970s when the Fed prematurely eased while inflation pressures were still strong.
 

Former Fed Vice Chair Richard Clarida said in a CNBC interview,  “I think they’re going to 4% hell or high water, if I had to put it into two boxes. They are data-dependent, but that’s why they’re going to 4%. Inflation is way too high.”

 

The market is now discounting a 75 bps move next week with about a 25% chance of a 100 bps. The terminal rate is rose to 400-425 bps from 375-400 bps before the CPI report.

 

 

 

Not unexpected

While the intensity of yesterday’s slide was a surprise, a stock market slide was not unexpected. I pointed out that the market was vulnerable to a setback. The VIX Index had recycled from above its Bollinger Band, which is an oversold signal for the market, to its 20 dma. Such events have typically resolved in a stall in rallies. As well, yesterday’s sell-off left an island reversal top, which is also an ominous technical sign.

 

 

I also alerted readers that the Cleveland Fed’s August inflation nowcast was above consensus expectations. Ahead of the CPI report, my social media feed was filled with chatter about how soft the print was going to be, indicating excessive sentiment for a dovish pivot and risk-on rally. 

 

 

Ed Clissold of Ned Davis Research found that, historically, the DJIA struggles but is marginally positive whenever headline CPI is higher than core CPI, which is the case today. 

 

 

 

More downside potential

Traders were undoubtedly disappointed by the CPI report and the overly bullish positioning led to a -4.3% skid in the S&P 500. While the TRIN spike was a sign of a selling stampede, none of my other tactical bottom indicators are flashing buy signals. I interpret this to mean that there is unfinished business to the downside. The market’s inability to stage any meaningful reflex rebound after yesterday’s massive down day is disturbing.

 

 

Nautilus Research pointed out that there is a 50-day VIX cycle, with the scheduled top on Monday, September 19, 2022, which is just before the start of the two-day FOMC meeting.

 

 

This is consistent with the FOMC cycle that I’ve noticed in 2022. The market has tended to weaken and bottom either just ahead or coincident with FOMC meeting day.

 

 

My inner investor remains neutrally weighted at roughly the weights specified by investment policy. My inner trader remains hesitant about taking a position. The usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) just flashed a buy signal when its 14-day RSI recycled from an oversold condition. In light of the bullish headwinds that I just outlined, the risk of a buy signal failure in the manner of the model choppiness during the August-September 2020 period (circled) is a strong possibility.

 

 

My inner trader concludes that the prudent course of action is to stay on the sidelines. It’s probably too late to sell but too early to buy.

 

How I learned to stop worrying and love the bond market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

Subscribers can access the latest signal in real time here.
 

 

An inverted yield curve

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

 

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

 

 

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

 

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

 

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

 

 

 

A fear of higher rates

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

 

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

 

 

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

 

 

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

 

 

 

Bond bullish

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

 

 

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

 

 

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

 

 

 

Key risks

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

 

 

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

 

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

 

 

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

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

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

 

 

S&P 500 stall ahead?

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long ZROZ

 

Assessing “Big Short” Michael Burry’s crash warning

Posted by Cam Hui -

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

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

 

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

 

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

 

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

 

 

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

 

 

Conventional technical analysis

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

 

 

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

 

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

 

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

 

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

 

 

Valuation risk

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

 

 

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

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

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

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

 

 

So bad it’s good

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

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Squaring the circle

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

 

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

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

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

 

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

 

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

 

 

Saved by Fibonacci

Posted by Cam Hui -

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

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

 

 

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

 

 

Positive divergences

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Intermediate term bearish

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

 

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

 

 

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

 

 

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

 

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

 

 

 

How to trade the failed breadth thrust

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

Subscribers can access the latest signal in real time here.
 

 

Faltering momentum

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

 

 

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

 

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

 

 

Buy signal still intact

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

 

 

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

 

 

 

Lessons from market history

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

 

 

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

 

 

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

 

 

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

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

She added:

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

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

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

 

 

Short-term pain ahead

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

 

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

 

 

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

 

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

 

 

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

 

Why a financial crisis could be the bulls’ best hope

Posted by Cam Hui -

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

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

 

 

 

The hawks at Jackson Hole

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

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

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

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

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

 

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

 

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

 

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

 

 

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

 

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

 

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

 

 

Signposts to watch

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

 

 

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

 

 

 

Investment implications

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

Whatever it takes, or…

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

 

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

 

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

 

Jackson Hole turbocharges the FOMC market cycle

Posted by Cam Hui -

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

 

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

 

 

Cautionary signals everywhere

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

 

 

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

 

 

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

 

 

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

 

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

 

 

 

Bottoming tripwires

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

 

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

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXU

 

Six reasons why this was just a bear market rally

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Something for everyone

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

 

 

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

 

 

A short covering rally

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

 

 

 

Flagging momentum

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

 

 

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

 

 

 

Unchanged leadership

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

 

 

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

 

 

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

 

 

Deteriorating fundamentals

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

 

 

 

A hawkish Fed

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

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

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

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

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

 

 

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

 

 

 

Negative seasonality

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

 

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXU

 

Will Europe drag us into a global recession?

Posted by Cam Hui -

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

 

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

 

 

 

Bears in Europe

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

 

 

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

 

 

 

Energy crisis

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

The geopolitical wildcard

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

 

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

 

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

 

 

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

 

 

Limited contagion effects

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

 

 

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

 

 

Short covering rally is over, now waiting for Powell

Posted by Cam Hui -

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

 

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

 

 

A change in tone

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

 

 

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

 

 

 

A possible pause?

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

 

 

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

 

 

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

 

 

Jon Turek at Cheap Convexity rhethorically asked

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

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

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

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

 

 

Sell the rips

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

 

 

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

 

 

 

Disclosure: Long SPXU

 

A Jackson Hole preview: Are expectations finally rational?

Posted by Cam Hui -

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

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

 

 

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

 

 

The Fed’s inflation challenge

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

 

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

 

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

 

 

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

 

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

 

 

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

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

 

 

Tight labor market

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

A hawkish path ahead

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

 

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