Imagining War and Peace

Posted by Cam Hui -

The Russia-Ukraine war has dealt an unexpected shock to the global economy and markets. Even as the world began an uneven recovery from the COVID Crash of 2020 and inflation pressures began to rise, the war has spiked geopolitical risk premiums and exacerbated supply chain difficulties and added more inflationary pressures. From an economic perspective, rising inflation and inflation expectations are forcing central bankers to react with more hawkish monetary policies, which raise recession risk.
 

It’s not a pretty picture. Now that we know what war looks like, let’s engage in some scenario planning. Imagine peace. How would the global economy and markets react?

 

 

 

The price of war

Let’s begin with the current situation report. About a month into the invasion, the Russian offensive has largely stalled. The Ukrainians have made a number of localized successful counter-attacks but the Russians are making steady progress in wearing down the besieged defenders in the southern port of Mariupol. Russian forces are digging in defensively and bombarding Ukrainian cities. This may turn out to be a protracted conflict.

 

The key question is how long can Russia can sustain a war?

 

Joachim Klement, writing at the CFA Institute’s blog, analyzed Russia’s current account and economy. He concluded:
 

The conclusion of all these calculations is simple: As long as Russia can continue to export oil and gas, it can finance the revenue shortfalls generated by the sanctions for a long time. But the economic toll will be enormous: GDP will drop nearly 10% over the next 12 months alone and may not stop there.

 

But if Russia loses its oil and gas revenues, it will run out of money within one to two years.

 

 

While that analysis is correct from a top-down macro perspective, anecdotal reports indicate that sanctions are biting. Fortune cited a Ukrainian military social media release, whose information is unconfirmed by other sources, that Russian tank production has ground to a halt because of a parts shortage.

The country’s primary armored vehicle manufacturer appears to have run out of parts to make and repair tanks, according to a Facebook post by the General Staff of the Armed Forces of Ukraine.
 

Citing “available information,” it reported state-owned company Uralvagonzavod, which builds tanks such as the T-72B3, has had to temporarily cease production in Nizhny Tagil.

The Russian offensive has depleted its troop strength. The latest NATO estimate indicates that the Russian Army has lost 30-40K men, which includes killed, wounded, missing in action, and taken prisoner. It is, therefore, no surprise that Moscow has mobilized reserves, recruited Syrian fighters, and called for a draft. Anecdotal accounts from social media from Russian mothers’ groups indicate heightened anxiety among the middle-class of the draft for their teenage sons. There were also reports of shortages of staples like sanitary napkins and, more importantly, insulin.
 

In addition, Russia’s latest reported weekly CPI was up 1.93%, which puts CPI up an astounding 132% for the period of the war.
 

On the other hand, Russia has substantial leverage in terms of its exports as it is the substantial source of some key global commodities.
 

 

Both Russia and Ukraine are major exporters of grains, which threatens the global food supply. In particular, African countries are especially dependent on Russian and Ukrainian wheat, which increases the risk of global famine. The last episode of food insecurity coincided with Arab Spring. This raises the risk of geopolitical instability.

 

 

The West announced additional Russian sanctions last week. The EU held further discussions of cutting dependence on Russian gas, though Reuters reported that German chancellor Olaf Scholz pushed back on the idea.
 

“Yes, we will end this dependency – as soon as possible. But to do this from one day to the next would mean plunging our country and the whole of Europe into a recession,” Scholz told the Bundestag lower house of parliament.

 

“Hundreds of thousands of jobs would be in danger. Whole branches of industry would be on the brink,” he said. “Sanctions should not hurt European states harder than the Russian leadership.”

A recent paper co-authored by a distinguished group of economists working both inside and outside Germany projected the effects of a sudden cutoff of Russian gas to Germany, based on the scenario that Germany loses 30% of natural gas supply and 8% of its primary energy supply. 
 

Purely in the spirit of being conservative, we therefore postulate a worst-case scenario that doubles the number without input-output linkages from 1.5% to 3% or €1,200 per year per German citizen. This number is an order of magnitude higher than the 0.2-0.3% or €80-120 implied by the Baqaee-Farhi model. We should emphasize that this is an extreme scenario and we consider economic losses as predicted by the Baqaee-Farhi model to be the more likely outcome

Bear in mind that this is a worst-case scenario where there are no substitutes for Russian gas. A GDP shock of 1.5% to 3.0% is similar in magnitude to the COVID shock. It’s painful but manageable. While Berlin may balk at the price of a complete cutoff of Russian gas, Scholz could change his mind under a scenario of Russian escalation to the use of WMDs, especially if they’re on a civilian population.
 

In short, Ukraine and the West are engaged in a contest of pain with Russia. Pressures are building for a settlement. Will anyone blink?
 

 

What would peace look like?

The details of any peace agreement are beyond the scope of this analysis, but imagine that peace suddenly descended in Ukraine. What are the economic and market ramifications of this best-case scenario?
 

An analysis from the European Central Bank outlined a heatmap of supply chain pressures in the US and eurozone. Even before the war, supply chain bottlenecks were evident in a variety of sectors.
 

 

Supply chain problems aren’t going away even if peace broke out. As an example, Ukraine has two plants that are about 50% of the global source of neon, a key component in semiconductor manufacturing. One is in Mariupol, which has been flattened by Russian bombing. The other is in Odessa, which is under threat, but it has shut down production. In addition, Ukrainian farmers are unlikely to plant their spring crop, especially in fields that may be strewn with landmines. At best, Ukrainian grain production won’t return to full production in the next few years.
 

Energy prices are likely to remain elevated in energy sanctions remain in place. A recent Dallas Fed survey of oil patch operators was highly revealing. While most respondents replied that an $80 to $90 WTI price is enough to spur new investment, a full 29% replied that their investment decisions are not oil price dependent.
 

 

That’s because of increasing investor pressure to maintain capital discipline. There is also anecdotal evidence of a scarcity of capital in the oil patch at any price owing to the growing trend of ESG investment mandates.
 

 

Where does that leave Fed policy? That depends on how transitory the inflation effects of the war are. As an example, Cullen Roche pointed out that global container freight rates have flattened out.
 

 

If they were to stay flat, the annualized rate of change would begin to fall in Q2, which alleviates inflation pressure.
 

 

Notwithstanding the effects of the war, inflation should begin to fall from a combination of the transitory effects and monetary tightening. The wildcard is the degree and magnitude of the supply shocks from the war, and how they affect inflation and inflation expectations. The 5×5 forward inflation expectation is currently at the top of its range. An upside break would be a signal for the Fed to adopt an even more hawkish monetary policy.
 

 

The market is already expecting consecutive half-point rate hikes at the next two FOMC meetings, a total of 2.25% rate increases in 2022 and topping out in early 2023 at 2.50% to 2.75%. The disruption from the war could make things worse and force the Fed to engineer a recession in order to control inflation.
 

 

 

Recession odds are rising

In conclusion, a best-case scenario of a sudden peace agreement would leave the global economy exposed to additional supply chain aftershocks from the Russia-Ukraine war. I agree with John Authers, who wrote that all the good scenarios are gone. The markets are forward-looking and they are discounting a rising risk of recession, even though recession models are not calling for a recession just yet. 
 

Bill McBride at Calculated Risk who relies mainly on housing market indicators for his recession calls, said that he isn’t even on recession watch yet. New Deal democrat, who monitors a series of coincident, short-leading, and long-leading indicators, characterized the economy as a weakening cycle overlaid with the negative effects of an exogenous shock from the war.
 

There are two separate dynamics operating on the economic indicators. One dynamic is a typical cyclical one of the Fed reacting to high inflation and low unemployment by raising rates, now that it has been convinced that inflation has not been “transitory.” The second dynamic is Russia’s invasion of Ukraine, and the world’s reaction to it.
 

The first dynamic is primarily acting on the long leading indicators. Thus we see bond yields rising, and yield spreads tightening. In fact, several portions of the yield curve inverted Thursday and at least intraday Friday (most notably the 5 minus 3 year spread which briefly turned negative Friday, before closing ever so slightly positive). This dynamic is also why mortgage rates are negative, and at least partially why credit conditions have tightened.
 

As a result, the long leading forecast has turned neutral. A recession is possible one year from now, but not that likely yet…
 

The global economic reverberations of the Russian invasion of Ukraine, and the reactions to it, by way of sanctions, global oil supply, and also by businesses severing ties with Russia, is an exogenous event, just as the pandemic was in 2020. And just as with the pandemic in 2020, it could cause a recession without the normal procession of cyclical effects through the economy. But it is “transitory” in the sense that if and when the conflict resolves, the normal cyclical procession will reassert itself. Those cyclical processes, the other side of the pincer, continue to point towards a stall roughly at the beginning of next year.

I reiterate my views from my February publication, A 2022 inflation tantrum investing roadmap, except for an upgrade to a market weight position in resource extraction sectors for their inflation hedge characteristics. This is a bear market. Investment-oriented accounts should be cautiously positioned. 
  • Overweight defensive sectors.
  • Overweight quality stocks.
  • Neutral weight resource extraction sectors such as energy and mining (upgrade).
  • Neutral weight high-quality growth, which should be the next market leadership.
  • Underweight value and cyclical stocks, such as financials, industrials, and non-FANG+ consumer discretionary.

 

The breadth thrust controversy

Posted by Cam Hui -

Mid-week market update: The strength of the rally off the mid-March lows has been breathtaking. Ed Clissold of NDR Research pointed out that the market experienced several breadth thrust buy signals. The % of stocks above their 10 dma surged from under 10% to above 90% in a short time, which is historically bullish. He also observed that their version of the Zweig Breadth Thrust model using a common stock only universe also flashed a buy signal last Friday.
 

 

That’s where the controversy begins.

 

 

An uncertain breadth thrust

Much depends on what you call a “breadth thrust”. The term refers to a burst of positive price momentum over a short period, usually defined as a move from an oversold to overbought condition within 5-10 trading days.

 

An analysis of the % of S&P 500 above their 10 dma is not confirming the NDR buy signal. The market fell under 10% on this metric on February 24, 2022, and rose above 90% last week, which is not within a 10-day trading window. In all likelihood, NDR uses a different sample universe, such as NYSE issues, but this analysis casts some doubt on the breadth thrust conclusion.

 

 

Similarly, the classic Zweig Breadth Thrust indicator using all NYSE-listed issues rose above its oversold condition on February 24, 2022, and it has not reached an overbought condition.

 

 

Strike two.

 

 

Occam’s razor

In light of these closely competing narratives, what should we make of these breadth thrust claims? Steve Deppe put it best when he threw up his hands when he analyzed historical analogs. One was wildly bullish, the other bearish.

 

 

I prefer the Occam’s Razor approach of using the simplest explanation instead of more complex and convoluted analysis. The rally off the mid-March bottom was a short-covering rally driven mainly by the fast money crowd that was overly short the market. Sentiment was in a crowded short condition going into the FOMC meeting. Even though the Fed was hawkish as expected, it wasn’t enough. Buy the rumor, sell the news.

 

Even though sentiment surveys were at bearish extremes, the analysis of equity positioning showed that investors were cautious but readings were not at capitulation lows.

 

 

My base case scenario is the advance off the mid-March lows is a bear market rally, which tends to br short but vicious.

 

 

 

A stall ahead

The rally appears to be stalling. Both the NYMO and NAMO have reached overbought conditions. There were seven instances when this happened in the last three years and five of them resolved with market stalls. The only exceptions occurred when the market surged off the March 2020 bottom.

 

 

I had highlighted evidence of a bottom by the widespread incidence of bullish island reversals in washed-out pockets of the market. Here is ARK Innovation (ARKK), which exhibited an island reversal but the rally seems to have stalled.

 

 

The Euro STOXX 50 ETF (FEZ) is exhibiting a similar pattern of island reversal and stalled rally/

 

 

So is MSCI China.

 

 

My crystal ball is a little cloudy and I am not sure about the direction of the next major market move. I do know that bullish momentum is fading. Subscribers received an alert yesterday that my inner trader had closed out his long position and stepped to the sidelines.

 

The balance of risks is tilting to the downside. Jerome Powell’s testimony on Monday was very hawkish and the market is now discounting half-point hikes at the next two FOMC meetings. 

 

 

The Russian offensive has stalled and the Ukrainians have made some successful local counter-attacks. The risk of escalation remains high, which could spook the market.

 

My inner investor believes this is a time for prudence. My inner trader doesn’t have an edge and so he is stepping aside in wait for a better opportunity.

 

 

Trading the relief 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 price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can bsoe found here.

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bearish (downgrade)
  • 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 relief rally

A week ago, I highlighted an observation by Bill Luby that a recycle of the VIX Index below 30 after a prolonged period above that level is historically bullish. Now that the VIX has fallen below 30, how far can the rally run?

 

 

The S&P 500 tested support while exhibiting a series of positive RSI and rallied on the hopes of a Russia-Ukraine peace accord. The advance continued even in the face of a hawkish FOMC message. The index violated a falling trend line, which is a positive development.

 

 

Despite the strong historical statistics, don’t be too bullish. The relief rally looks like a bear market rally within a downtrend.

 

 

Time to turn cautious

My Trend Asset Allocation Model has downgraded its signal from neutral to bearish. It’s time to acknowledge that this is a bear market. The model applies trend following principles to global stock and commodity prices to create a composite signal. The model is pointing to recessionary, or near recessionary conditions. 

 

The Ultimate Market Timing Model remains bullish. As a reminder, this model only turns bearish when the trend model is bearish, which it is, and my Recession Watch indicators flash the warning sign of a recession, which it hasn’t yet.  The combination of the two is rare, which explains the low level of model turnover. This is confirmed by the latest update from New Deal democrat, who maintains a set of coincident, short-leading, and long-leading indicators. He reported that his long-leading indicators have moved into neutral, with the caveat that war-related disruptions could plunge the economy into recession [emphasis added].

 

There are two separate dynamics operating on the economic indicators. One dynamic is a typical cyclical one of the Fed reacting to high inflation and low unemployment by raising rates, now that it has been convinced that inflation has not been “transitory.” The second dynamic is Russia’s invasion of Ukraine, and the world’s reaction to it.

 

The first dynamic is primarily acting on the long leading indicators. Thus we see bond yields rising, and yield spreads tightening. In fact, several portions of the yield curve inverted Thursday and at least intraday Friday (most notably the 5 minus 3 year spread which briefly turned negative Friday, before closing ever so slightly positive). This dynamic is also why mortgage rates are negative, and at least partially why credit conditions have tightened.

 

As a result, the long leading forecast has turned neutral. A recession is possible one year from now, but not that likely yet…

 

The global economic reverberations of the Russian invasion of Ukraine, and the reactions to it, by way of sanctions, global oil supply, and also by businesses severing ties with Russia, is an exogenous event, just as the pandemic was in 2020. And just as with the pandemic in 2020, it could cause a recession without the normal procession of cyclical effects through the economy. But it is “transitory” in the sense that if and when the conflict resolves, the normal cyclical procession will reassert itself. Those cyclical processes, the other side of the pincer, continue to point towards a stall roughly at the beginning of next year.
In the US, the S&P 500 has exhibited a dark cross, where the 50 dma falls below its 200 dma. Moreover, the broadly-based Value Line Geometric Index is in a well-defined downtrend and violated support.

 

 

Across the Atlantic, the Euro STOXX 50 has taken the brunt of the Russia-Ukraine war fears. Even though the FTSE 100 is acting a bit better, the mid-cap FTSE 250, which is more sensitive to the UK economy, is in a downtrend.

 

 

In Asia, China and Hong Kong have tanked, though a recent announcement of market-friendly measures has sparked a turnaround. Nevertheless, the market structure of the major Asian markets are all screaming “downtrend”.

 

 

Commodity prices are strong, but I pointed out last week (see Not your father’s commodity bull) that price strength is attributable to supply shortages and not excess demand. Such conditions are not reflective of strong cyclical strength but will resolve in demand destruction, which is bearish for the global economy. Indeed, the cyclically sensitive copper/gold ratio confirms this assessment by trading sideways.

 

 

 

A bear market rally

Bull markets don’t go straight up and bear markets don’t go straight down. Short-term sentiment is supportive of a bear market rally, which can be brief but vicious. The AAII bull-bear spread remains at a buy signal, which is tactically bullish.

 

 

 

A key technical test

Last week’s bounce presents a key technical test for the S&P 500. Since December, the S&P 500 has reacted to oversold conditions with sharp 2-4 day rallies, followed by further weakness to either test the previous lows or more new lows. The main differences this time are the violation of the falling downtrend line and the positive RSI divergence. Much will depend on whether the market can follow through with more strength in the coming week.

 

 

The market is also enjoying a momentum tailwind. The S&P 500 exhibited four consecutive days when it was up 1% or more last week. Such episodes are rare but they have historically resolved with a bullish bias, though the sample size is very small (n=4).

 

 

The bullish island reversals exhibited by both the Euro STOXX 50 (FEZ) and MSCI China (MCHI) are additional inter-market signs that a strong bear market rally is underway.

 

 

In the short run, the part of the US market with the most upside potential is large-cap growth. Macro Charts pointed out that the NASDAQ 100 is exhibiting a strong breadth thrust after a deeply oversold condition, which is very bullish.

 

 

I agree with the bullish assessment on the NASDAQ 100. The index violated a falling downtrend after exhibiting a series of positive RSI divergences. Relative breadth against the S&P 500 has been strong (bottom panel), indicating positive underlying relative strength. Watch for overhead resistance at the 50%  Fibonacci retracement level as a possible profit target, but recognize that there is also a risk of momentum failure.

 

 

Even ARK Innovation (ARKK), which represents speculative growth stocks, underwent a bullish island reversal, though its downtrend remains intact. If the rally continues, watch how the ETF performs near its trend line resistance.

 

 

In conclusion, the stock market is undergoing a relief rally in the context of an intermediate-term downtrend. It’s difficult to know exactly how far the rally can run. Investment-oriented accounts should take advantage of market strength to rebalance to a position of minimum risk. Traders who are long should use a stop-loss to define their risk.

 

 

Disclosure: Long TQQQ

 

How to spot a market bottom

Posted by Cam Hui -

Did the stock market make a meaningful bottom last week? Financial markets had been taking a risk-off tone coming into the week, but when the Powell Fed was slightly more hawkish than expected, the market rallied. 
 

The S&P 500 was -14.6% peak-to-trough on an intraday basis in 2022. Ed Clissold of Ned Davis Research pointed out that the characteristics of cyclical bears and recession bears have been very different. Cyclical bears that don’t involve a recession tend to be shorter in length and less severe in magnitude compared to recession bears, though “most non-recession bears include a recession scare”.
 

 

Here are some ways of spotting a durable market bottom.

 

 

The Fed’s rosy scenario

If we were to cut through all the noise, it’s the Fed cycle that mainly dominates the stock market. The Powell Fed turned hawkish, as expected, at the March FOMC meeting. However, a number of unusual forecasts from its Summary of Economic Projections (SEP) caught my eye.

 

First, the “dot plot”, or expected Fed Funds rate, jumped from 0.9% to 1.9% by December 2022, which was roughly consistent with market expectations. The expected Fed Funds rate in 2023 and 2024 will overshoot its longer-run target, indicating an extra tight monetary policy. Core PCE inflation was revised up from 2.6% to 4.3% for 2022, indicating a hot inflationary environment, though Powell indicated in the press conference that he still expects inflation to moderate in the second half of 2022.

 

Here is the anomaly. Despite all of the tightening, the forecast GDP growth rate is still relatively strong at 2.8% for 2022 and 2.2% for 2023. Moreover, the unemployment rate forecast was unchanged at 3.5% in 2022 and 2023. The Fed expects a strong labor market and no recession. 

 

 

This sounds like an unrealistic rosy scenario. If the Fed continues to anchor the long end of the Treasury yield curve with its guidance on the neutral policy rate, the yield curve will invert before the end of 2022. Inverted yield curves have been strong predictors of recessions. The Fed’s rosy scenario is leading monetary policy of tightening until something breaks.

 

 

If a recession is ahead, the downside risk to equity prices will be a lot more than the -14.6% peak-to-trough drawdown experienced recently. What could rescue the stock market from a recession bear?

 

The answer is financial instability, otherwise known as something breaking. Conventional measures of financial stress are rising, though readings are nowhere near crisis levels. Keep an eye on emerging market spreads (red line), which is raising a cautionary flag.

 

 

A key risk is the Russia-Ukraine war spikes food prices. The last time food prices rose sharply, it created political instability in the form of the Arab Spring in emerging and frontier markets. While that scenario may fraught with risk on paper, many EM countries are commodity exporters that benefit from higher commodity prices, especially in Latin America. Even in Africa, many countries have partial natural hedges. The UN defines a country as commodity-dependent if it is more than 60% of its physical exports are commodities, and 83% of Africa is in that category.

 

 

The elephant in the emerging market room is China, which is a voracious importer of commodities. The key question is its pandemic management policy in the face of its zero-COVID policy. While the recent market-friendly pivot is helpful for financial stability, those policies will do nothing if the Chinese economy slows and snarls global supply chains because of ongoing pandemic lockdowns.

 

 

 

Market positioning

While an analysis of Fed policy may point to a recession bear, the risk-on rally in the face of a hawkish Fed last week may be a reflection of excessively bearish positioning. The BoA Global Fund Manager Survey shows that respondents are all-in on their recessionary outlook. As well, a recent CNBC poll of Fed watchers saw a 33% chance of a recession within the next 12-months.

 

 

Consequently, manager risk appetite has plunged.

 

 

Mark Hulbert also pointed out that short-selling is virtually nonexistent, which is potentially bullish.

 

 

On the other hand, insider buying is also nowhere to be found, though there was a brief episode of insider buys exceeding sales at the January low.

 

 

As a reminder, here is what insider activity looked like during the GFC market bottom. There were strong clusters of insider purchases that exceeded sales.

 

 

Here is the history of insider activity during the recent COVID Crash bottom.

 

 

As well, S&P 500 futures positioning is not signaling a capitulation bottom. Historically, hedge funds have been in crowded shorts in S&P 500 futures at past major market bottoms. Readings are still net long and hedge funds aren’t panicked just yet.
 

 

 

Insufficiently oversold

From a technical perspective, the market is insufficiently oversold for a major market bottom. I have highlighted the “good overbought” advance from the March 2020 bottom before. This was evidenced by the percentage of S&P 500 stocks above their 200 dma rising to 90% and remaining there. The overbought condition recycled in mid-2021 (top panel). Historically, such declines don’t end until the percentage of stocks above their 50 dma fall below 20% (bottom panel). The recent market weakness reached 25% and recovered. This analysis indicates further downside risk ahead.

 

 

In addition, the NYSE McClellan Summation Index (NYSI) has signaled major bottoms whenever it fell to -1000 or less. This indicator isn’t perfect as it was early to flash buy signals in 2008. Nevertheless, readings of -1000 have shown a strong track record of calling bottoms in the past.
 

 

 

Recession ahead?

Where does that leave us? I am about two-thirds of the way down the path to the recession camp, though my models are not calling for a recession just yet and I don’t like to front-run model readings. The path of Fed policy seems to be to tighten until something breaks. An inverted yield curve is almost inevitable at this point and other economic indicators are deteriorating.

 

Regardless of whether there will be a recession, analysis from Ned Davis Research indicated that stocks struggle during the first year of a fast tightening cycle. In the current circumstances, both the “dot plot” and market expectations are indicating a fast tightening cycle.

 

 

I am downgrading the reading of my Trend Asset Allocation Model from neutral to negative. Investment-oriented accounts should shift to a maximum defensive posture. 

 

 

This is a bear market. The current episode of stock market strength is a bear market rally. Don’t be fooled. Sell into strength.

 

 

Great (bearish) expectations

Posted by Cam Hui -

Mid-week market update: The bears have exhibited great expectations for risk assets. Ed Clissold of Ned Davis Research observed that the NDR Crowd Sentiment has been at a sub-30 reading, which is historically bullish. However, he pointed out that momentum is negative and hedged with “sentiment is extremes differ cycle to cycle, so it’s best to wait for sentiment to begin to reverse”.
 

 

 

Bearish sentiment

Sentiment indicators have indeed been extreme for some time. Investors Intelligence bears exceeded bulls for the third week. Such conditions have historically marked short-term bottoms in the past.

 

 

The latest BoA Global Fund Manager survey also shows that managers have gone extremely risk-off, which should be contrarian bullish.

 

 

 

Fed expectations

Chartists can analyze all the sentiment and technical charts they want, but the inescapable reality is the market is nervous over the course of Fed policy and the inflationary effects of the supply chain disruptions of the Russia-Ukraine war. If you can predict those outcomes, you can predict the market.

 

Here is how interest rate expectations have evolved. Coming into the FOMC meeting, Fed Funds futures was discounting a quarter-point rate hike at the March meeting, a half-point rate hike at the May meeting, and a total of 1.75% for 2022.

 

 

The Fed raised rates by a quarter-point, as expected and acknowledged the uncertainty posed by the Russia-Ukraine war in its FOMC statement.

 

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.
In its Summary of Economic Projections (SEP), it revised the 2022 expected core PCE inflation from 2.6% in December to 4.3%. The Fed had been expecting that inflation would fall in 2022 and this upward revision is reflective of the Russia-Ukraine war inflationary disruptions but leaves it wiggle room to turn less hawkish if inflationary pressures ease. The median Fed Funds target at the end of 2022 is now 1.9%, which is consistent with market expectations. In addition, Fed Funds is expected to overshoot the long-run neutral rate in 2023 and 2024.

 

 

In the wake of the FOMC meeting and the Powell press conference, expectations have turned even more hawkish and now expects a total of 2.0% in rate hikes by December.

 

 

Even though the SEP reduced the expected GDP growth rate in 2022, Powell asserted that the economy is strong and recession risks are not especially elevated. The risk is the Fed is tightening into a recession. Indeed is already reporting some softness in the jobs market. Job postings have topped out and begun to roll over. Looking under the hood, the weakness in jobs postings is evident in low-wage jobs, while middle and high-wage job postings have been steady.

 

 

As well, retail sales missed expectations this morning. Real retail sales per capita appear to be rolling over, and this indicator is one of my Recession Watch long-leading indicators.

 

 

While these readings are highly preliminary, this is what an economy that’s peaking out looks like. The  market reacted by collapsing the 2s10s yield curve from 30 bps to 25 bps. I interpret these developments constructively as it is setting Fed policy and expectations to be as hawkish as it can possibly get. The stock market’s ability to hold its gains in the wake of the FOMC meeting is also positive.
 

 

Peace in our time?

The market’s recovery yesterday and today can be partly attributed to hopeful signs that a breakthrough may be near with the Russia-Ukraine negotiations. The geopolitical risk premium is fading, but some underlying worries remain and they are especially evident in China. 

 

Both gold and oil prices have made the round-trip from their recent price spikes, indicating war fears are receding.

 

 

I have remarked in the past that the S&P 500 has held up remarkably well even though it had to contend with a hawkish Fed, a surge in global inflation, and the Russia-Ukraine war. Here’s why. The returns of different regions relative to the MSCI All-Country World Index (ACWI) tell the story. The US stock market has been a relative safe haven during the war. Just take a look at the drop in the relative performance of Europe and subsequent recovery (middle panel) and you can see the volatility and jitters of investors. Emerging markets ex-China has held up well (bottom panel), which is explained by the composition of some EM markets are commodity exporters that have benefited in the price surge while others were hurt by geopolitical and global inflation fears.

 

 

China, on the other hand, is a different story. The Chinese economy has been burdened by the real estate debacle and now the massive COVID lockdowns. Notwithstanding the recent announcement of support measures by Beijing, the relative performance of Asian markets has been equally challenging with the exception of resource-rich Australia.

 

 

China’s pro-market pledges overnight were obviously helpful to the market as Asian markets affected a risk-on reversal. But none of that matters if China were to help Russia in the war. The West will be forced to sanction China into the ground. Beijing knows this. If the war drags on, China, the US, and the EU will be playing a high-stakes game of chicken.

 

 

The news from the front

In short, the short-term fate of risk appetite depends on how the war evolves. The Russian advance has been stalled for days, though they have made some progress in the south. The Russian military continues to be constrained by logistical problems. This map of Ukraine shows a group of almost equidistant road-linked thrusts stretching from Russia and Belarus into Ukraine illustrates the Russian Army’s supply-constrained advance. This War on the Rocks analysis indicated the average Russian unit has a truck lift to take it to 90 miles (140km) from the closest large supply dump (see below). You would have to double the trucks on hand to get to 180 miles. The only exception is the black arrow on the map, where the Russians appeared to have doubled their transportation allocation in order to reach the eastern edge of Kyiv.

 

 

A Twitter thread by retired Australian Major General Mick Ryan summarizes the situation. The Russian Plan A was a lightning thrust to take over Kyiv and the government within a couple of days, which didn’t work. The Russians turned to Plan B, which “features lots more firepower, as well as destruction of smaller cities to set an example for Kyiv”. 

 

Plan B has not worked out either. They have slowly gained ground, but at massive cost in personnel & equipment. At the same time, rear area security has suffered. This is obviously a trade off by the Russians so they can push forward as much combat power as possible.

 

But rear area security is a significant mission, and normally absorbs thousands of troops (infantry, air defence, cavalry, engineers, etc). Because the Russians have incompetently executed this mission, there have been constant ambushes against logistics convoys.

 

These ambushes on logistics convoys are another source of attrition in personnel, supplies and equipment to add to combat losses, and (if it is to be believed) combat refusals and desertions from Russian troops.
The Russians have now committed all of their pre-positioned invasion force, and Plan B is making only slow progress. Ryan concluded:

The Russian campaign, if it has not already, is about to culminate. US doctrine defines this as (for offense) “the point at which continuing the attack is no longer possible and the force must consider reverting to a defensive posture or attempting an operational pause.”

They are now mobilizing more reserves, which are of lower troop quality, and recruiting mercenaries from Syria as part of Plan C.

Plan C might be described as: hold current gains, long range firepower on cities, foreign fighters as cannon fodder, destroy as much infrastructure and manufacturing capacity as possible, expand the war to the west to deter foreign volunteers & aid providers.

While that represents Ryan’s assessment of the facts on the ground, it may serve both sides to reach a peace agreement in order to halt hostilities and the pain on both sides. The Financial Times reported that “Ukraine and Russia have made significant progress on a tentative 15-point peace plan including a ceasefire and Russian withdrawal if Kyiv declares neutrality and accepts limits on its armed forces, according to three people involved in the talks.” However, Ukrainian officials downplayed the reports of progress as “more positive tone from Russia was more about Moscow wanting sanctions pressure eased, calling it a “smoke curtain.”
 

We are now at the “the trade talks are going very well” phase of the market. Much is at stake. The disintegration of the European economy and global supply chain disruptions could continue, which will lead to inflationary pressures that force the Fed to tighten until the economy falls into a recession. In addition, there is the Beijing wildcard. Will China actively support Russia with supplies for its war and risk sanctions, which would tank its economy?
 

Stay tuned. War-related developments cannot be predicted by any charting or sentiment indicators. The market is recovering from a deeply oversold condition, but the environment remains volatile and there will undoubtedly be opportunities for both bulls and bears ahead.
 

 

Disclosure: Long TQQQ

 

Beware the Ides of March

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

 

No lack of volatility

This stock market certainly does not lack volatility. The VIX Index underwent a recent series of upper Bollinger Band rides (shaded zones) while exhibiting positive RSI and MACD divergences. 

 

 

The next known source of volatility starts on March 15, the Ides of March, as the FOMC convenes for its regularly scheduled meeting. 

 

 

Fearful sentiment

Sentiment models remain in the fear zone this week. The AAII bull-bear spread is under -20, which constitutes a buy signal indicating a high level of anxiety.

 

 

The Investors Intelligence bull-bear spread is also negative, which is another contrarian bullish signal.

 

 

Keep an eye on the VIX Index. The VIX closed Friday at 30.75, which makes 10 consecutive days above 30. Bill Luby at VIX and More observed that a recycle below 30 is historically bullish, though the buy signal hasn’t been triggered yet.

 

 

 

Can Europe show the way?

You can tell a lot about market psychology by the way it reacts to the news. European stocks, which are the most sensitive to Russia-Ukraine war news, traced out a bullish island reversal on high volume last week when hopes rose that a ceasefire to evacuate civilians would be declared. The market retreated when ceasefire negotiations fell apart, but the island pattern remained intact.

 

 

Gold has acted as a risk-off asset during this crisis and GLD printed a bearish island reversal last week. I interpret this as an encouraging sign for the bulls.

 

 

 

The news from the front

I may be clutching at straws, but there are some glimmers of hope from the developments in the war. An Estonian journalist recounted a discussion with an Estonian military analyst in a Twitter thread. The conclusion: “The danger is far from over but there is reason for a very cautious optimism. Russian advance has clearly stalled.”
Since last [Saturday] it’s been relatively stable on the fronts. There is an expectation of a reforming of RU units and a new line of attack, but so far little evidence of it. “If Russia doesn’t achieve a remarkable advance by end of week, difficult to see how it should come at all.”

 

The [southern] line of attack has split in 2, one advancing twd  Mykolaiv, the other to Kryvyi Rih. This is serious risk to RU forces as the supply lines, which we already know are crap, will be dragged even longer. “This leaves the Ukrainians plenty of chance to ‘beat them to pieces’.

 

The question is if Moscow today forces Lukashenko to send in the troops from Belarus, but BY troops’ motivation is even lower than that of RU. “The Western-Ukrainian national & anti-Russian environment would be extra hostile towards them.”

 

The idea of bringing in Syrian fighter is extra desperate. “One thing is to fight in the narrow streets of Arabian cities. It’s something else in Kyiv or Kharkiv where the boulevards are 100m wide.” Also refers to cold climate and low morale of Syrians.

 

About possible mobilization in RU. That was on the agenda last Friday in Fed Council and duma but allegedly high-ranking military re-convinced Putin. “Reserve units have no training, they even don’t have enough uniforms for them.”

 

“They’ve included very few reservists in Zapad exercises. Of the few thousand they usually include, the officers complain about them “messing up” the exercise.”

 

Fatigue of RU units “massive”.  A third has been replaced, but incoming units have even worse quality. Another third has been destroyed, killed or wounded. Re-formation of units doesn’t have a good impact on combat capability.

 

Ukraine’s counter-offensive has so far been small-scale but when RU stalls, they have resources to start pressing. First aim would be to drive RU out of country in the North (Kyiv and Kharkiv). It will be more difficult to gain back ground in South, also because of terrain. “In steppe you will be an open target from air.”

 

Regarding Russia’s shortage of missiles. “Putin was told he had 10,000 missiles. In fact, he had 1,000. It’s peculiar he didn’t remember how he was lying to his own bosses as a young KGB officer. Such lying is common in the culture.”
In addition, Fortune reported that two hardcore pro-Putin guests, Karen Shaknazarov and Semyon Bagdasarov, appeared on a Russian prime time TV talk show and acknowledged the impact of sanctions, military failures, and called for an end to the invasion. This is a pre-taped TV show and is usually carefully orchestrated. Their remarks sound like the Russian elite showing their dissatisfaction with the war and looking for an exit ramp.
The first criticism came from Karen Shakhnazarov, a filmmaker and a usually reliable state pundit who had previously signed a letter in support of Putin’s annexation of Crimea. But on Solovyov’s show, Shakhnazarov said, “I have a hard time imagining taking cities such as Kyiv. I can’t imagine how that would look,” and noted that Putin’s invasion risked isolating Russia.

 

He called for an end to the conflict, the Telegraph reported, saying, “If this picture starts to transform into an absolute humanitarian disaster, even our close allies like China and India will be forced to distance themselves from us.”

 

He added, “This public opinion, with which they’re saturating the entire world, can play out badly for us…Ending this operation will stabilize things within the country.”

 

Later during the broadcast, Semyon Bagdasarov, a Russian member of parliament, also criticized the invasion of Ukraine, and likened it to Afghanistan, an embarrassing military blunder for Russia that some analysts believe was a catalyst for the fall of the Soviet Union.

 

“Do we need to get into another Afghanistan, but even worse?” Bagdasarov asked, adding that in Ukraine, “there are more people, and they’re more advanced in their weapon handling.”

 

“We don’t need that. Enough already,” he said.
Shakhnazarov added that the Russian army has achieved its goals. Donbas is “liberated”. NATO only benefits from the protracted conflict. He called for an end to the operation. In other words, declare victory and go home.

 

These developments are encouraging. We have seen that even the hint of a ceasefire has sparked strong equity rallies. The news of a deal would be the catalyst for a melt-up. However, the risk is a stall in the Russian advance could provoke further escalation, such as the use of chemical weapons, in the war. Such a development could spook the markets even more.

 

 

Fed policy expectations

As the FOMC prepares to meet in the coming week, Fed Funds futures expectations have turned even more hawkish. The market now expects the equivalent of seven quarter-point rate hikes by December.

 

Have market expectations become too hawkish? In light of the stock market’s inability to fall further in the face of bad news, is sentiment washed out?

 

These are all good questions. This cycle is very different from the working experience of most investment managers. Reported inflation has spiked to a 40-year high, pressures are global, and inflationary expectations are also rising. On top of that, the supply shock from the Russia-Ukraine war is creating a high level of uncertainty. The stock market has held up remarkably well in light of these risks.

 

Traders will have to weigh the constructive signals from technical and sentiment indicators against the risk of further escalation in the war. Investors should remain cautiously positioned, as the Fed cycle will dominate intermediate-term equity price trends. Traders can play the odds and tilt bullish, but be mindful of the risks and size positions accordingly.

 

 

Disclosure: Long TQQQ

 

Not your father’s commodity bull

Posted by Cam Hui -

Some chartists have recently become excited over the commodity outlook. Setting aside the headline-driven rise in oil prices, the long-term chart of industrial metals like copper looks bullish. Copper is tracing out a cup-and-handle pattern breakout that targets strong gains in the years ahead. Moreover, the one-and the two-year rate of change, which is designed to look through the effects of the COVID Crash, are elevated but not out of line with past bull phases.
 

 

The point and figure chart of copper appears equally impressive. The measured target on a point and figure breakout is an astounding 9.50, which is over a double from current prices.

 

 

Is this the start of a new commodity bull? I would argue that this is not your father’s commodity bull market.

 

 

Bullish chart patterns

The chart patterns of commodity-related equity sectors look equally impressive. Energy stocks are already in both absolute and relative uptrends.

 

 

Global mining stocks are testing resistance while forming a saucer-shaped base, and they have already staged a relative breakout when compared to the MSCI All-Country World Index (ACWI).

 

 

The agribusiness industry has also staged an upside breakout from a long base, and the relative breakout is also evident.

 

 

 

Demand destruction ahead

While I love a commodity bull story, there’s a difference between a healthy bull and a destructive one. We are headed for the latter. Commodity bull markets are caused by a supply/demand imbalance. A healthy bull stems from demand outstripping supply. 

 

On the other hand, a destructive bull is caused by a shock of supply withdrawal. If supply can’t come online quick enough, prices must then rise to the point of reducing demand.  That’s a destructive bull market because it’s unsustainable. Prices spike and then crash as consumers pull back on demand.

 

Here is what a supply shock looks like. The relative performance of cyclical industries tells the story. The relative returns of oil and gas extraction and mining stocks have suddenly spiked, but the relative returns of other cyclical industries are range bound. In a healthy bull, strong cyclical demand should be lifting all boats. Instead, this is a picture of a supply shock related to the Russia-Ukraine war.

 

 

A long-term analysis of the CRB Index shows that it staged an upside breakout through a falling trend line (dotted line) but it is approaching a key resistance level. The one and two-year rates of change are highly extended by historical standards.

 

 

The commodity price spike is also causing dislocations in the financial markets. Nickel prices soared to as much as $100,000 per tonne on the LME before the exchange suspended trading last week. Chinese tycoon Xiang Guangda, who controls the world’s largest nickel producer, Tsingshan Holding Group, had built a large short position in nickel futures and is rumored to have incurred losses of as much as $2 billion at the price peak of $100,000. The company later secured a bank lifeline and prices stabilized in Shanghai, though the LME nickel market remains suspended.

 

 

Imagine the panic if this had happened in wheat or corn and the hedger was a Russian or Ukrainian producer that couldn’t meet its margin calls.

 

 

A hawkish Fed

The commodity price spike puts the Fed in an uncomfortable position. The February CPI print was in line with market expectations, but headline CPI reached a 40-year high and it is expected to rise further owing to the strength in energy and food prices. As a consequence, Fed Funds futures have turned even more hawkish. The market now expects rate hikes totaling 1.75% by the December FOMC meeting.

 

 

The silver lining is that energy intensity has fallen dramatically since the Arab Oil Embargo price shock of the 1970’s. Energy expenditures as a percentage of PCE (blue line) and gasoline prices to average hourly earnings as a measure of affordability (red line) have both risen but levels are not extreme compared to their own histories.
 

 

However, inflation expectations are rising and they are at risk of becoming unanchored. Jerome Powell is on record as willing to drive the economy into recession in a Volcker-like manner. Is a recession ahead? When will the Fed stop?

 

 

Even Paul Volcker was cognizant of financial stability risk – and the first task of central bankers is to be financial firefighters. Don’t forget that the Volcker Fed eased policy in response to the Mexican Peso Crisis in August 1982.

 

The accompanying chart is a history lesson of that era. The DJIA, which was the market benchmark of that period, topped out in 1981 as the Fed tightened policy and raised rates. The share price of Citigroup, which is representative of the banking group, topped out with the Dow and began a slow descent as financial conditions deteriorated. Cyclical indicators such as the platinum-gold spread, which was relevant because both metals had precious metal components but platinum also had an industrial use in automotive catalytic converters, topped in early 1980 and fell negative. When Mexico announced that it couldn’t meet its debt obligations and devalued the Peso, financial stress spiked and threatened the stability of the US banking system. The Fed responded by easing policy and that incident marked the beginning of a long equity bull.

 

 

Fast forward to 2022. How far is the system from a Mexican Peso Crisis moment? To be sure, yield spreads are rising as financial stress increases, but readings are nowhere near crisis levels. Don’t expect the Powell Put to be activated under the current conditions.

 

 

 

An unexpected supply shock

In summary, the latest spike in commodity prices should be interpreted as an exhaustive move instead of the start of a new bull cycle. It is a supply shock that should resolve with demand destructive in the coming months, which implies a slowdown in economic activity. The yield curve is flattening quickly, indicating market expectations of an economic slowdown.

 

 

I had highlighted last September a different source of stagflation risk. Former Fed economist Claudia Sahm (of Sahm Rule fame) observed that the risk is “supply chain disruptions became more frequent as climate change disasters become more commonplace”. Little did I expect the supply chain disruption would come from a war. As an illustration, a recent Financial Times article reported that Volkswagen warned that the economic damage from the war could be even worse than the pandemic.

 

Much will depend on how the war develops and the evolution, the effects of the accompanying sanctions, and how governments react to shortages.

 

In conclusion, the recent strength in commodity prices is exhaustive and not the start of a secular bull trend. Treat any narrative of a new commodity bull or super cycle with caution. To the extent that investors hold or overweight energy and mining stocks, consider rotating into long duration Treasury bonds in anticipation of a bond market rally as the economy slows.

 

 

A double bottom?

Posted by Cam Hui -

Mid-week market update: The S&P 500 put in a potential double bottom when it tested its recent lows while exhibiting a positive RSI divergence. Stock prices rallied on the news of a ceasefire in order to allow civilians to evacuate.
 

 

Is this a durable bottom?

 

 

News from the front

The market has been extremely war headline sensitive and it’s impossible to discuss risk appetite without discussing the war. While I am no military analyst, here is a summary of what is known from open intelligence (OSINT) sources.

 

Here is the good news. Both sides are talking and there is some movement in position. Initially, the Russians had demanded total surrender and regime change when the invasion began. Early this week, the Kremlin softened their position to:
  • A constitutional change that Ukraine would not join any blocs, i.e. EU or NATO;
  • Ukraine recognizes the breakaway regions become independent republics; and
  • Ukraine cedes Crimea to Russia.
Zelensky responded with a willingness to negotiate on the status of the breakaway regions and conceded that NATO is not ready to accept Ukraine as a member but sought security guarantees for a settlement. AP also reported that Russia says negotiations with officials from Kyiv to resolve the conflict in Ukraine were making headway and underscored that Russian troops were not working to topple the Ukrainian government.

 

While there is still a large gulf between the two sides, a narrowing of positions is constructive.

 

As for the war, both sides are facing different pressures. Russian forces have significantly underperformed expectations and the Ukrainians have put up strong resistance. Moreover, Ukraine has been winning the information war by highlighting Russian failures and losses, though Russia recently stepped up its information campaign by claiming that Ukraine was developing a dirty bomb and the US had a dangerous bio lab on Ukrainian soil.

 

 

The Russian advance has been largely stalled in the past few days owing to supply and logistical constraints. However, Russian forces have made slow but methodical progress in their advance and changed to a strategy of pummelling cities with artillery and airpower without regard for civilian casualties. In the north, the Russian goal is the encirclement of Kyiv in order to lay siege to the city. In the south, Mariupol is surrounded and isolated. Its eventual fall will free up Russian forces to pivot north in a pincer movement to cut off Ukrainian defenders in the Donbas region. A negative surprise is on the horizon and the southern and eastern front could collapse in the coming days.

 

On the other hand, this is the first large-scale offensive undertaken by the Russian Army since World War II. For some perspective on distances, the Russia-Ukraine border is roughly equivalent to the US-Canadian border from the Pacific Ocean to Wisconsin. The Russian Achilles Heel is supply logistics and Ukrainian forces have been successful in disrupting Russian supply lines. A commentary by Alex Vershinin, written in November 2021, focused on the Russian Army’s supply constraints as envisaged by NATO planners in case of an attack into NATO territories such as Poland or the Baltic States. Simply put, Russian forces are tied to their railroads for supply support:

Russian forces are tied to railroad from factory to army depot and to combined arms army and, where possible, to the division/brigade level. No other European nation uses railroads to the extent that the Russian army does. Part of the reason is that Russia is so vast — over 6,000 miles from one end to the other. The rub is that Russian railroads are a wider gauge than the rest of Europe. Only former Soviet nations and Finland still use the Russian standard — this includes the Baltic states.

Russian forces have a much smaller logistical tail compared to western forces.

Russian army logistics forces are not designed for a large-scale ground offensive far from their railroads. Inside maneuver units, Russian sustainment units are a size lower than their Western counterparts. Only brigades have an equivalent logistics capability, but it’s not an exact comparison. Russian formations have only three-quarters the number of combat vehicles as their U.S. counterparts but almost three times as much artillery.

The Russians don’t have enough trucks, and Ukrainians have been ambushing supply truck convoys.

The Russian army does not have enough trucks to meet its logistic requirement more than 90 miles beyond supply dumps. To reach a 180-mile range, the Russian army would have to double truck allocation to 400 trucks for each of the material-technical support brigades. To gain familiarity with Russian logistic requirements and lift resources, a useful starting point is the Russian combined arms army. They all have different force structures, but on paper, each combined army is assigned a material-technical support brigade. Each material-technical support brigade has two truck battalions with a total of 150 general cargo trucks with 50 trailers and 260 specialized trucks per brigade. The Russian army makes heavy use of tube and rocket artillery fire, and rocket ammunition is very bulky. Although each army is different, there are usually 56 to 90 multiple launch rocket system launchers in an army. Replenishing each launcher takes up the entire bed of the truck. If the combined arms army fired a single volley, it would require 56 to 90 trucks just to replenish rocket ammunition. That is about a half of a dry cargo truck force in the material-technical support brigade just to replace one volley of rockets. There is also between six to nine tube artillery battalions, nine air defense artillery battalions, 12 mechanized and recon battalions, three to five tank battalions, mortars, anti-tank missiles, and small arms ammunition — not to mention, food, engineering, medical supplies, and so on. Those requirements are harder to estimate, but the potential resupply requirements are substantial. The Russian army force needs a lot of trucks just for ammunition and dry cargo replenishment.
 

For fuel and water sustainment, each material-technical support brigade has a tactical pipeline battalion. These have lower throughput than their Western equivalents but can be emplaced within three to four days of occupying new terrain. Until then, fuel trucks are required for operational resupply. 

The UK estimates that the war costs the Kremlin about £1 billion a day, which is a strain in light of the severe sanctions imposed by the West. The latest briefing from the Pentagon indicates that the Russians have committed roughly all of the forces arrayed at the beginning of the invasion, which is about 190K troops, which amounts to roughly 55% of all available ground troops. This compares to about 24% of US ground force commitment for the invasion of Iraq during Gulf War II. Retired Australian Major General Mick Ryan wrote:

In military operations, casualties and fatigue, as well as equipment losses, wear and tear, will decrease force strength over time. Rotation of forces is necessary for any missions of even medium length duration. Humans can only fight for so long before becoming non-effective.

While Kyiv is at risk of encirclement, current Russian force strength in the north is insufficient to create an effective cordon around the city. Most military analysts estimate that it would take about half of all  Russia’s invading forces to encircle Kyiv, which would be a stretch in light of military operations in the rest of Ukraine. Add to that the necessity of force rotation, the Russian High Command faces a problem. On the other hand, Ukrainians are receiving western aid in the form of anti-tank missiles and other weaponry, as well as a reported 40K foreign volunteers to help defend Ukraine. It’s a race against time to see if Ukrainian forces can hold out before Kyiv is besieged.
 

In summary, the Ukrainians are exposed militarily but the Russians are close to exhaustion and vulnerable to supply disruptions. If there is no settlement, this could be a long war that could last years. Western sanctions are certain to bite well before then and the Kremlin will face both military and domestic political problems.
 

Both sides have strong incentives to settle.
 

 

Short-term equity outlook

What does this mean for the stock market? One hint can be found in the price action of European stocks, which are the most sensitive to the Russia-Ukraine war. The Euro STOXX 50 ETF (FEZ) traced out a bullish island reversal similar to the ones seen in November 2020, July 2021, October 2021, and December 2021. The odds are that the latest reversal will also resolve in a bullish manner, which should positive for all risk assets.
 

 

Jeff Hirsch at Almanac Trader pointed out that the market has tended to weaken early in March and find a bottom around the sixth trading day of the month, which is today. The subsequent trend has been choppy but exhibited a bullish bias until the end of the month. 
 

 

That sounds about right. Tomorrow morning’s CPI release and next week’s FOMC meeting promises to be sources of potential volatility.
 

In conclusion, stock prices have likely reached a short-term bottom, but the coming weeks could still be treacherous. My inner investor remains cautious, but my inner trader is still long risk.
 

 

Disclosure: Long TQQQ

 

Panicked enough for a relief 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 price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can bsoe found here.

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

 

Scared enough?

Are you scared enough? The market is extremely jittery. News last week of a Russian attack that started a fire at a Ukrainian power plant sparked a risk-off episode. Further sober analysis revealed that the incident was under control and there was no radiation leak. Worries about the incident sparking a second Chernobyl disaster are overblown.

 

Two weeks ago, the AAII weekly sentiment survey showed the bull-bear spread had fallen to -30, but it rebounded last week to -11. Readings of -30 are rare and they have only been lower during the bear markets of 1990 and 2008 (shown in pink). These levels weren’t even seen in the wake of the Crash of 1987. In all cases, they signaled short-term bottoms.

 

 

The key question for investors is whether current conditions represent a durable market bottom, or just a bear market rally.

 

 

Rising fear = Bullish confirmation

The AAII buy signal is confirmed by readings from other sentiment models. The NAAIM Exposure Index, which measures the sentiment of RIAs, fell below its 26-week Bollinger Band. In the history of the NAAIM data series, such extreme conditions have been useful signals that downside risk is limited short-term and risk/reward is tilted to the upside. These buy signals, however, are not indications of a durable intermediate-term bottom, as evidenced by their behavior during the GFC bear market.

 

 

I could write about the elevated level of the VIX Index as an indication of market anxiety. Instead, I would point out that the MOVE Index, which measures the implied volatility of the bond market, is also high. For some context, a reading of 120 on MOVE implies a daily change of 7.5 bps every day for the next 30 days.

 

 

As well, does this cover from the Economist represent the peak of war hysteria, which would be a contrarian magazine cover indicator? Asking for a friend (see Wars are equity bullish, but there’s a catch).

 

 

Lastly, Mark Hulbert recently published a Marketwatch article, “The end (of the stock market correction) may be near”.
 

The end of the stock market’s correction may be near.

 

That’s because I just received an email from a prominent money manager declaring that “buy and hold is dead.” Like the first robin of spring heralding warmer weather around the corner, emails such as this one are a contrarian signal that the tide is about to turn.

 

That’s because the relative popularities of market timing and buying-and-holding follow a fairly predictable cycle. Buying and holding will be at its most popular at market tops and least popular at bottoms. Just the reverse will be the case for market timing.

 

 

A bear market rally

Sentiment model readings aside, I would argue that the intermediate-term trend is still down, but the stock market is poised for a bear market rally. I had highlighted the sell signal flashed by the negative RSI divergence by the Wilshire 3000. Such signals have led to significant drawdowns in the past.

 

 

I also pointed out in the past the S&P 500 underwent a “good overbought” rally off the March 2020 bottom, as shown by the percentage of stocks above their 200 dma rising to 90% on a persistent basis (top panel). The momentum of that advance faded in mid-2021 when the indicator fell below 90%. There have been four similar episodes of “good overbought” rallies in the last 20 years. All of them did not end until the percentage of stocks above their 50 dma fell below 20% (bottom panel). That condition has not occurred yet.

 

 

Here’s another reason why I am bearish. The Russian ETF RSX is trading at $5.65. Notwithstanding the fact that the Ruble has crashed, the underlying stocks in Moscow are halted, though the ETF holds GDRs which do trade in London, the last reported NAV is $0.89! There’s still too much bullishness.

 

 

 

Poised for a rally

In the short run, the S&P 500 is poised for a counter-trend relief rally. The stock/bond ratio exhibited a series of positive RSI divergences, which is constructive.

 

 

Fundamental momentum is supportive of an advance and, at a minimum, should put a floor on stock prices. Forward 12-month EPS estimates are still rising and there is no signs of earnings estimates declines that have accompanied past market downdrafts.

 

 

In conclusion, the stock market is poised for a counter-trend relief rally in the context of an intermediate-term downtrend. Investment-oriented accounts should stay cautious and take advantage of any market strength to reduce equity weights. Traders can position for the rally, which is often brief but violent in bear markets.

 

 

Disclosure: Long TQQQ
 

An energy and geopolitical recession?

Posted by Cam Hui -

Much has happened in the space of a week. In the wake of Russia’s Ukrainian invasion, the West has responded with a series of tough sanctions designed to tank the Russian economy. Energy and other commodity prices have soared and this is shaping up to be another energy and geopolitical crisis. The last three episodes resolved in recessions, which are equity bull market killers. Fourth time lucky?

  • The 1973 Arab Oil Embargo
  • The 1979 Iranian Revolution
  • The 1990 Gulf War
  • The 2022 Russia-Ukraine Energy Shock (?)
The backdrop sounds dire. Nouriel Roubini recently warned of stagflation in a Project Syndicate essay. An analysis from Oxford Economics shows that the shocks will hit the Russian economy, but Europe will not be spared. The US is expected to see the least negative impact from the Russia-Ukraine energy shock.

 

 

As the Fed embarks on its tightening cycle, it faces a nightmare stagflation scenario of higher energy and commodity prices pressuring inflation and falling economic growth. 

 

 

How sanctions hurt Russia

In response to the Russian invasion, the West collectively agreed to exclude major Russian banks from SWIFT. More importantly, the Russian central bank, Bank of Russia (BoR), will be blocked from its assets held in the West.

 

Zoltan Pozsar, a money market analyst at Credit Suisse, warned that “supply chains are payment chains in reverse” and explained these sanctions matter to the global financial system in a recent research note.

Today we’ll say that all global payments go through SWIFT (including payments for commodities) and so exclusions from SWIFT will lead to missed payments everywhere again: the virus froze the flow of goods and services that led to missed payments, and war has led to exclusions from SWIFT that will lead to missed payments again. But by design, and not without a risk of retaliation: if a freeze in activity can lead to missed payments, an inability to receive payments through SWIFT can freeze the flow of goods, services, and commodities like gas or neon in kind.

In the double-entry accounting world, someone’s asset is someone else’s liability. Freezing or blocking access to Russian assets can create a problem on the other ledger on the balance sheet. Let’s unpack the effects.

 

The BoR reported that it has $630 billion in FX reserves as of February 18, 2022. The report is no longer available on the BoR website but a screenshot was saved by Matthew Klein at Barron’s. 

 

 

The asset mix breakdowns show 23.3% in gold and 12.8% in RMB, which totals 36.1% that’s out of the reach of sanctions. In practice, Treasury Secretary Janet Yellen recently announced that roughly half of BoR assets were immobilized. Regardless of implementation details, Western sanctions have turned Russia’s vaunted FX reserves into a financial Maginot Line. 

 

 

 

How sanctions hurt the West

While blocking BoR assets and cutting Russian bank access to SWIFT may sound good in theory for policy makers to tanks the Ruble and sparks hyperinflation in Russia, the West will nevertheless have to deal with a number of unintended consequences. 

 

The most important consideration is the possible loan losses and losses from the possible Russian nationalization of banking subsidiaries. According to the latest BIS figures dated September 2021, the four largest countries most exposed to Russia are France ($23.6 billion), Italy ($23.2 billion), Austria ($17.1 billion), and the US ($14.5 billion). Austria’s exposure is mostly accounted for by Sberbank Europe, which leaves the French and Italian banks with high exposures to Russian assets. CNBC reported that Citi flagged $5.4 billion of exposure to Russia, which represents 0.3% of its assets, though it’s unclear how much of that was in its subsidiary Citibank Russia. Is it any wonder why financial stocks are skidding?

 

 

As for Russian energy exports, the US Treasury has issued guidance to exempt this category from sanctions. That said, sanctions on the export of oil field service equipment to Russia will hobble production capacity in the long run.

Treasury remains committed to permitting energy-related payments — ranging from production to consumption for a wide array of energy sources — involving specified sanctioned Russian banks. To help protect Americans, partners, and allies from higher energy prices that would drive more resources to Russia, Treasury swiftly issued and updated Russia-related guidance to allow U.S. financial institutions to continue processing these transactions and underscore that such activity is not prohibited by sanctions.

 

 

The Fed’s dilemma

For investors, the Fed cycle is still the center of all attention. In the face of the conflict, the Fed faces a dilemma. Fed Chair Jerome Powell made the following points in his Congressional testimony last week:
  • The labor market is extremely tight.
  • Inflation increased sharply last year and is now running well above the Fed’s longer-run objective of 2%.
  • The Fed continues to expect inflation to decline over the course of the year as supply constraints ease and demand moderates.
  • The near-term effects on the U.S. economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain.
  • The process of removing policy accommodation in current circumstances will involve both increases in the target range of the federal funds rate and reduction in the size of the Federal Reserve’s balance sheet.
Here is the Fed’s dilemma. Economic growth is skidding. The Atlanta Fed’s GDPNow nowcast of Q1 growth is 0.0%.

 

 

The yield curve is flattening, indicating expectations of slowing economic growth.

 

 

On the other hand, commodity prices are surging, which puts upward pressure on inflation. Fitch warned that higher prices can have a self-reinforcing effect on inflation. While the Fed expects inflation pressures to fall as supply chain bottlenecks ease this year, higher commodity prices will make the projection of a core PCE rate of 2.6% by year-end difficult to achieve.
Inflation is a dynamic process and can be self-reinforcing. Energy price shocks related to geopolitical events exacerbate risks. Various scenarios could see inflation stay high through 2022. If core inflation were to remain high or increase further and inflation expectations started to become de-anchored from targets, this could prompt swift moves from central banks.
These conditions are laying the foundation for a stagflationary environment. Growth is slowing, but inflation pressures are still strong. Conventional thinking dictates that the Fed continues to tighten and drive the economy into recession in order to meet its price stability mandate.
 

That seems to be the path the Fed is on. In his Congressional testimony, Powell set a course for raising rates. While the Fed projects inflation to cool off this year, persistent higher commodity prices poses a problem for monetary policy. Powell concluded, “We will use our policy tools as appropriate to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and a strong labor market.”

 

Powell also voiced concerns about how commodity price increases would feed an inflation spiral during his Senate testimony: “Commodity prices have moved up, energy prices in particular. That’s going to work its way through the U.S. economy. We’re going to see upward pressure on inflation, at least for awhile. We don’t know how long that will be sustained for.”

 

To reinforce his inflation concerns, Powell underlined the point that he is willing to drive the economy into recession to control inflation (see link to video). 

 

 

Keep an eye on inflationary expectations. The 5×5 inflationary expectations are well anchored for now. Should they become unanchored, Cleveland Fed President Loretta Mester stated in an interview that the Fed may have to raise rates to above the neutral rate, which she defined as between 2.0% and 2.5%. 

 

 

 

Rising stagflation fears

The financial markets are already beginning to discount stagflation risk. When the stock market weakened in late January, insider buying briefly ticked up, which was a constructive sign for equities. But when the market weakened again to test the January lows as geopolitical risk rose, insiders did not step up to buy. In effect, insiders are discounting a significant growth slowdown.

 

 

Bloomberg Economics sketched out three scenarios of how this crisis could resolve itself. Much depends on how energy and commodity supply disruptions play out. In all cases, the impact of the sanctions is the worst in Russia, moderate in Europe, and the least for the US. The best-case scenario, in which oil and gas keep flowing and markets calm down, sees a tanking Russian economy, a European slowdown, and a steady Fed tightening cycle. The worst-case resolves in 1970’s style stagflation and a synchronized global recession. There are no bullish outcomes.

 

 

Although the outlook appears dire, keep in mind that not all oil price spikes have led to recessions. The accompanying chart shows the two-year rate of change in oil prices (bottom panel), which was chosen to smooth out pandemic related disruptions. Since 1983, there were six price spikes when the rate of change rose above 100% and only three of them resolved with recessions.

 

 

Ed Clissold at Ned Davis Research pointed out that past geopolitical-related oil spikes have tended to be transitory in nature. If history is any guide, commodity price inflation anxiety will peak and begin to fade in about two months.

 

 

In conclusion, the Russia-Ukraine war is unsettling for the risk appetite and asset price outlook. It only accelerates the scenario I outlined several weeks ago (see A 2022 inflation tantrum investing roadmap). The market phases are defined as:
  1. Equity downtrend;
  2. Rising expectations of slowing growth or recession;
  3. Fed easing and recovery.
The market is somewhere in a transition period from phase 1 to 2. Tactically, the market is oversold and it could rally at any time. All it takes is the whisper of a negotiation breakthrough. Investors need to keep in mind that the Fed cycle remains the dominant driving force in stock prices. In the current environment, use rallies to reduce equity weights and overweight defensive sectors in their equity portfolios and slowly increase their weights in high-quality large-cap growth as duration plays in anticipation of falling bond yields and a flattening yield curve.

 

 

As an indication of the quality growth characteristic of large-cap growth stocks, forward estimates of the technology sector’s are still rising. This makes them a refuge for investors as economic growth slows.

 

 

 

Disclosure: Long TQQQ
 

A key test at neckline support

Posted by Cam Hui -

Mid-week market update: Will the S&P 500 hold support or will it break? The index is once again testing the neckline of a potential head and shoulders pattern while exhibiting a minor positive RSI divergence.
 

 

Here are the bull and bear cases.

 

 

Sentimental bulls

Short-term sentiment models look stretched to the downside, which is contrarian bullish. The bull-bear spread from the AAII weekly survey is at levels that have seen short-term bounces. Readings have only been exceeded to the downside during the GFC and the bear market of 1990. Similar readings were seen during the bear market low in 2002. Investors weren’t even as panicked during the Crash of 1987.

 

 

The latest update of Investors Intelligence sentiment shows a spike in bearish readings which resulted in the bull-bear spread turning negative. These are the kinds of conditions that have signaled previous bottoms.

 

 

 

Sentimental bears

Does that mean it’s time to buy? Not so fast, says Mark Hulbert. His survey of NASDAQ market timing newsletters is not sufficiently bearish for a durable bottom.

 

Many market timers became more bullish during this period, with the HNNSI rising 57 percentage points. Though it has fallen back in recent sessions, it currently stands well above its late January low — at minus 29.7% versus minus 67.2%. The current reading puts the HNNSI at the 15th percentile of the historical distribution, above the 10th percentile which is the upper edge of the zone that in previous columns I have considered to represent excessive bearishness. (See the chart below.)

 

It’s amazing that the HNNSI is higher today than a month ago. Imagine being told in late January that the coming month would experience Russia’s invasion of Ukraine, Russia putting its nuclear forces on high alert, oil prices soaring to an eight-year high and U.S. inflation spiking to a 40-year high. I for one would have guessed that the HNNSI would fall even further — not jump more than 30 percentage points.

 


 

As well, the AAII monthly asset allocation survey reveals a bifurcated result. While the weekly survey is a sentiment survey that asks respondents about their views on the stock market, the monthly asset allocation survey asks what they are doing with their money. The allocation survey shows that equity weights have come down, but weightings are still elevated and there are no signs of panic that were seen at previous major market bottoms.
 

 

 

A bear market rally ahead

So where does that leave us? The market structure of technical deterioration is signaling the start of a bear market. That said, short-term conditions are sufficiently oversold and washed out that a bear market relief rally can happen at any time. Such rallies are usually short but intense in magnitude. The market is volatile because of its geopolitical risk premium and any hint of a ceasefire could send stock prices rocketing upwards.

 

Indeed, two of the four components of the Bottom Spotting Model flashed buy signals yesterday. The VIX Index rose above its upper Bollinger Band, indicating an oversold condition, and the term structure of the VIX inverted, indicating fear.

 

 

Investment-oriented accounts should continue to be cautious. My inner investor is positioned at a neutral asset allocation weight as specified by his investment objectives. 

 

The S&P 500 rallied and unsucessfully tested a resistance level today. My inner trader remains positioned for a tactical market rally. Should the market follow through on today’s bullish impulse, he is looking for the VIX Index to decline back to its 20 dma before taking partial or full profits.

 

 

 

Disclosure: Long TQQQ

 

I’ll never complain about a lack of panic again

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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 reversal bottom

Last week, I lamented that the stock market appeared to be fearful, but not panicked. Be careful what you wish for, you might just get it.

 

On Wednesday, the S&P 500 violated a key neckline support level of an apparent head and shoulder pattern. On Thursday, the Russian Army crossed into Ukrainian territory and conducted what Putin called a “special military operation”. Global markets adopted a risk-off tone and S&P 500 futures were down -2.5% overnight. The index opened deeply in the red but recovered strongly on the day on high volume to form a classic reversal bottom.

 

 

If war is what it took, I’ll never ask the market gods for panic again.

 

 

Supportive internals

Market internals are supportive of a bullish reversal. Even though the large-cap S&P 500 briefly violated support, the mid-cap S&P 400 and small-cap S&P 600 both held support, which is a constructive development.

 

 

On an intra-day basis, three of the four components of my Bottom Spotting Model had flashed buy signals, only to see one of the models reverse itself as the VIX Index closed below its upper Bollinger Band.

 

 

 

Supportive sentiment

Even before the shooting began, sentiment models were supportive of a short-term bottom. The AAII bull-bear spread had fallen to -30, which is consistent with signs of panic bottoms.

 

 

II sentiment tells a similar contrarian bullish story. The bull-bear spread had fallen to just above zero and bearish sentiment had spiked to levels that were indicative of panic.

 

 

As well, Macro Charts pointed out that the traded value of put options had spiked and the traded value of call options had plunged.

 

 

 

Selected industries of interest

Here are some indutries to consider in the current heightened geopolitical risk environment.

 

Ukraine is the breadbasket of Europe and the war is likely to curtail production. Instead of buying an agricultural products ETF, I prefer to focus on companies that support the agricultural industry (MOO). The ETF is holding above absolute support and recently staged an upside breakout through relative resistance.

 

 

Another obvious industry is that benefits in the current environment is aerospace and defense, which broke up through a relative downtrend and exhibiting positive relative strength.

 

 

Finally, cyber security stocks represent a group that has been overlooked in the current environment but they are starting to catch a bid. They violated an important relative support level but recently recovered above relative support turned resistance. This is an industry that could show significant potential for outperformance.

 

 

In conclusion, a short-term bottom is probably in, but it’s difficult to predict short-term market fluctuations in the current circumstances. The situation on the ground in Ukraine is highly fluid and a jittery market is highly sensitive to headline risk. 

 

Investors could focus on agriculture (MOO), aerospace and defense (ITA), and cyber security (HACK) for outperformance opportunities in the current elevated geopolitical risk environment.

 

 

Disclosure: Long TQQQ

 

Wars are equity bullish, but there’s a catch…

Posted by Cam Hui -

Four weeks ago, I suggested that investors buy to the sound of cannons. Now that the cannons have sounded, is that still a good idea?
 

Yes, but there’s a catch. A detailed list of past crises from Ed Clissold of Ned Davis Research reveals that stock prices usually rebound strongly after sudden shocks such as war. On average, the DJIA is up 4.2% after a month and 15.3% a year later.

 

 

Here’s the catch. Consider the following: Jeremy Siegel observed that stocks return about 7% real per annum. Supposing your distant ancestors had invested $100 in equities or equivalent at the time of Augustus Caesar and held the investment for the last 2000 years. Your family would be so obscenely rich that it could have rescued the entire global financial system during the GFC with the proceeds of less than one day’s interest. 

 

The key caveat to event studies such as the effects of war and historical analysis of long-term returns is they suffer from survivorship bias. A past study from Credit Suisse of cumulative real returns illustrates the risk from the permanent loss of capital from war and rebellion. Simply put, a lot of people died in very nasty ways and they never lived long enough to enjoy the use of their assets.

 

Exhibit A is Germany, which was extensively involved in both World Wars.

 

 

China and Russia are even more extreme examples of the permanent loss of capital. Had you been living in those countries, the last thing on your mind would have been the value of your investment portfolio. If you were lucky, you escaped with your life.

 

 

 

The inflation fallout

How do these studies apply to the current circumstances? As NATO has repeatedly asserted that it will not militarily intervene and send troops into Ukraine, the tail-risk of a global catastrophe is off the table. Investors can rely on the plain vanilla analysis of how markets reacted in past conflicts.

 

Nevertheless, there are several important fallouts from the current war. As the West rolls out sanctions on Russia, an article in the Economist outlined Moscow’s possible retaliatory steps that could dent the global economic outlook.

Such tougher sanctions would have several drawbacks for the West. They might prompt economic retaliation from Russia, in the form of cyber-warfare or restrictions on the sale of gas to Europe. They would impose direct costs on Western economies. Russia remains the eu’s fifth-largest trading partner, for instance. European banks have $56bn-worth of claims on Russian residents. Cutting Russia off from swift could cause instability in the financial system. And energy bills in Europe would probably rise further. Furthermore, to be truly effective the West would also need to ensure that the sanctions are globally enforced: that means either persuading or coercing Asian countries, including China and India, to abide by them, perhaps by threatening secondary sanctions on them if they refuse. Without this any stronger sanctions regime would be a leaky bucket.

The most obvious problem for investors is soaring energy prices which puts upward pressure on inflation. As Russian troops crossed the line of control, Brent prices spiked to over $100, which will both raise inflation and dent economic growth.

 

Less noticed by the Street is the importance of Ukraine as the breadbasket of Europe. Ukraine is the top global producer of sunflower seed and a major producer of corn, barley, and wheat.

 

 

In short, the war will spark an inflation problem. How will the fiscal and monetary authorities respond?

 

 

Rally around the flag?

It depends on the jurisdiction. The EU had long been a collection of bickering countries, but its response has been remarkably united. The German decision to suspend approval of the Nordstream 2 pipeline was a demonstration that it was willing to bear substantial pain. 

 

Count on a strong fiscal response where Berlin exempts military spending and energy diversification initiatives from eurozone deficit targets. While this is highly speculative, the war will accelerate Europe’s transition to green energy, which is a bullish factor for capital spending and investment in the region. The ECB should cooperate and decline to offset any fiscal expansion with monetary tightening. Peripheral country bond spreads will narrow. We saw this movie before in 2014.

 

The situation across the Atlantic is another matter. It is unclear how much of a rally around the flag effect the US will see in light of the divisions in the American electorate. While both Democrats and Republicans called for the government to support Ukraine, a division is appearing between the supporters of the two parties about the degree of support. A recent YouGov poll sponsored by The Economist reveals an elevated level of opposition to different degrees of military aid and support to Ukraine and divisions between Democrats and Republicans about these issues.

 

 

These divisions in the electorate make a fiscal response, either to offset the inflationary effects of war or increased military spending, less likely. Any rally around the flag effect in America is likely to be far more muted than in Europe. The fiscal drag is projected to be negative and the war is unlikely to move the needle significantly.

 

 

As for the Fed, it continues to be worried about inflationary pressures. Fed Governors Michelle Bowman and Christopher Waller recently suggested a half-point rate hike could be on the table at the March FOMC meeting. The market continues to discount seven quarter-point rate hikes this year.

 

 

In the meantime, the 2s10s yield curve continues to flatten, indicating expectations of a growth slowdown.

 

 

 

Investment implications

In conclusion, buy the war dip is the order of the day in the absence of risk of a total loss of capital from war and rebellion. Take note, however, that macro conditions still dominate in the long run. The Afghanistan War began in 2001 shortly after 9/11, which was in the middle of a recession. While stock prices rebounded, they continued to decline after an initial rebound as economic conditions deteriorated.

 

 

The S&P 500 forward P/E has declined to a more reasonable 18.5, which slightly below the 5-year average of 18.6 but above the 10-year average of 16.7.

 

 

I continue to favor large-cap high-quality growth stocks in the NASDAQ 100, which have become extremely oversold on a normalized historical basis. As economic growth becomes scarce, expect investors to bid up the prices of cash generative growth stocks.

 

 

While the primary focus of my analysis is on regions, countries, sectors, and factors, investors may wish to consider the top half of the RRG chart for FANG+ stocks for inclusion in their portfolios.

 

 

I expect the market will recover from the war scare in a short time, but I reiterate my views from my recent publication (A 2022 inflation tantrum investing roadmap). The Fed is undergoing a tightening cycle. Stock prices will not bottom until the inflation outlook improves and the Fed stops removing monetary accommodation.

 

Buy the market panic for a tactical rebound, but don’t overstay your welcome.

 

 

Disclosure: Long TQQQ
 

Knife catching at a time of war

Posted by Cam Hui -

Mid-week market update: Trying to spot a bottom here is like trying to catch a falling knife – and at a time of war. Here is what I am watching in order to navigate the turmoil.
 

It’s official. We are entering the Biden administration’s “trade talks are going very well with China” phase of market psychology where asset prices respond to every headline in the Russia-Ukraine conflict. Since it’s virtually impossible to predict what’s ahead on the geopolitical front, traders can only focus on technical internals and how stock prices respond to news.
 

Virtually every chartist can see the developing head and shoulders pattern in the S&P 500, but that’s not the entire story and investors should look for signs of confirmation from other indicators.

 

 

 

Becoming oversold

I wrote on Sunday that the market was Fearful but not panicked, now the market is showing signs of becoming both oversold and panic is starting to set in.

 

The Zweig Breadth Thrust Indicator has now reached an oversold condition, which is a constructive sign that the market may be nearing a short-term bottom.

 

 

Another constructive sign is the S&P 500 testing a key support level while exhibiting positive RSI divergences.

 

 

As well, the term structure of the VIX is inverted, indicating strong fear.

 

 

Oversold and panicked markets can become more oversold and panicked. So how can we spot a bottom?

 

 

Cross-asset clues

Here is what I am watching in my cross-asset, or inter-market, analysis.

 

Is the risk-on/risk-off move being confirmed in the safe havens and related plays? As an example, gold, which is a classic safe haven vehicle, is making new highs while exhibiting positive confirmation from RSI indicators. Score one for risk-off.

 

 

The USD is another classic safe-haven play during times of stress. By contrast, the euro is especially vulnerable in the current geopolitical environment. Both are trading sideways.

 

 

Oil prices have been a beneficiary of the geopolitical turmoil. WTI crude recently violated a rising uptrend, indicating its bull move is becoming exhaustive.

 

 

Another sign that the market may be bottoming is the behavior of small-cap stocks. Even as the current Russia-Ukraine episode has clobbered risk assets, small caps are starting to bottom and outperform relative to the S&P 500. Rank that as constructive.

 

 

In conclusion, the weight of the evidence is pointing to the stock market undergoing a bottoming process. While it is poised for a relief rally, headlines will undoubtedly contribute to near-term volatility. Traders who choose to take positions in this market will have to monitor how it reacts to news in order to decide whether a bottom is truly in place.

 

The next test is likely to occur within the next 48-72 hours, when Russian forces cross the line of control into Ukrainian territory. Watch the market reaction.

 

Fearful, but not panicked

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

 

The drumbeats of war

From a purely fundamental perspective, the US equity outlook is mildly bullish. However, rising geopolitical risk premium is unsettling risk appetite. Sentiment surveys such as AAII have fallen into the fear zone. In the past, such readings have resolved in relief rallies.

 

 

While fear levels are elevated, the market is neither panicked nor oversold, which is an indication that there may still be unfinished business to the downside once the market bounce is over.

 

 

Constructive fundamentals

Developments last week have been constructive for equity fundamentals. The release of the January FOMC minutes was a bit anti-climactic. The Fed indicated that it would raise interest rates and it would normalize the balance sheet, but there was no hawkish bombshell as advocated by hawks such as St. Louis Fed President James Bullard. In the wake of the publication of the minutes, Fed Funds futures walked back its expectations for a half-point rate hike at the March FOMC meeting, but it still expects six quarter-point rate hikes in 2022. 

 

 

The other bullish factor for stock prices is the evolution of earnings expectations. Q4 earnings season is nearly over. Both the EPS and sales beat rates are above average and forward EPS estimates are still rising. Fundamental momentum remains strong.

 

 

 

A looming conflict

However, the rising risk of a Russia-Ukraine conflict has left the market nervous. Brent crude prices are in severe backwardation, where the front month price is much higher than the futures price indicating short-term jitters. Readings exceed the levels seen at the first Gulf War, indicating fears of Russian energy supply disruptions.

 

 

Another factor that could keep geopolitical tensions elevated is falling EU electricity prices despite the strength in natural gas. The price decline is attributable to a strong wind season. Falling electricity prices reduces the short-term leverage that Russia has over the EU.

 

 

Historically, shocks involving limited war have had a minor impact on stock prices. Bloomberg identified 18 war-linked events since 1940. The S&P 500 fell -1.5% on the event date and the average total drawdown was -5.4%. If we exclude incidents during recessions, the averages were -1.3% and -4.3%.
 

 

NATO has asserted that it will not send troops into Ukraine. If a conflict were to break out, the equity market impact should be relatively modest based on this historical study. 

 

 

 

Where’s the panic?

Despite the jittery nature of market psychology, the market is neither panicked nor oversold, which is disconcerting. None of the four components of my Bottom Spotting Model have been triggered. The components consist of:
  • VIX Index: Watch for a spike above the upper Bollinger Band.
  • VIX term structure: Watch for inversion.
  • NYSE McClellan Oscillator: Watch for an oversold condition.
  • TRIN: Watch for a reading above 2, indicating involuntary “margin clerk” liquidation.

 

 

The best-case scenario will see a relief rally that tests 50 dma resistance once geopolitical tensions fade. The worst-case scenario is a break of neckline support at about 4300-4330 of a possible head and shoulders pattern, with a measured downside objective of about 3800.

 

Tactically, the market could rally early next week as it is mildly oversold. However, it may need another day of weakness to spark a washout low.

 

Peak Fed tightening anxiety?

Posted by Cam Hui -
The past week saw rising anxiety about a flattening yield curve rise to a crescendo. The 2s10s spread narrowed to as low as 40 bps before recovering and ending the week at 46 bps. Coincidentally, the BoA Global Fund Manager Survey showed an overwhelming majority of respondents hold believe the yield curve will flatten.

 

 

Even though it hasn’t inverted yet, an inverted yield curve has signaled recessions in the past. This raises two key questions for investors.
  1. What’s the near-term outlook for inflation?
  2. Is the Fed willing to drive the economy into a recession in order to fight inflation?

 

 

The Fed’s dilemma

Let’s begin with the good news. The 5×5 inflation expectations (blue line) remains tame, even as current inflation indicators such as core CPI (red line) skyrocket seemingly out of control.

 

 

The bad news is that global central banks are tightening into a slowdown. Global manufacturing PMIs are falling. The percentage of OECD countries with rising leading indicators is tanking.

 

 

Similar evidence of economic deceleration can be found in the US from a variety of sources. This is just one example.

 

 

Against a backdrop of an elevated reading in the monetary policy component of the Economic Uncertainty Index, how does the Fed resolve this dilemma?

 

 

 

The view from Oregon

Well-known Fed watcher Tim Duy of SGH Macro Advisors and the University of Oregon conducted a Bloomberg podcast interview and provided some answers. The podcast lasts about an hour and well listening to in its entirety, but the main points are summarized below.

 

Duy believes the Fed is deeply behind the inflation-fighting curve and unknowingly made a policy error. He characterized the COVID shock as a snowstorm and not a persistent loss of demand. Policy makers did not understand the situation at the time and responded with a full suite of fiscal and monetary stimulus. 

 

As the snowstorm passed, the economy experienced a fairly rapid recovery. Arguably, quantitative easing was not necessary past mid-2020 because financial markets were already functioning well by then. In short, the Fed’s policy error was to pile on too much monetary stimulus. The Fed should have begun to tighten in 2020 as a monetary offset against fiscal expansion.

 

Hindsight is always 20-20. In retrospect, it would have been politically very difficult for the Fed to withdraw stimulus in 2020 in the midst of a COVID shock, especially when no vaccines or treatments were in sight.

 

As the economy stabilized and vaccines began to become available, successive COVID waves saw less and less economic impact. The economy experienced a strong jobs market recovery, it led to growing inflationary pressures that the Fed was late to spot.

 

As a consequence, Duy believes inflationary pressures have embedded in psychology. The Fed needs to get rates up to neutral quickly, which amounts to about 150bp by year-end. 

 

The challenge is to break a nascent psychology that’s leading to an inflationary spiral. Companies have shown that customers are willing to accept price increases in response to rising input costs. This is leading to more and more inflationary pressures. 

 

The traditional way of breaking an inflationary spiral is through the wage growth mechanism. Historically, wage growth expectations are very sticky. Unless the Fed can guide expectations back down, it will have no choice but to induce a recession to crater wage expectations.

 

The optimal outcome is a series of rate hikes, followed by a moderation of inflation back to 2%, and a tight jobs market.

 

What about the Fed Put? Duy said that any Fed Put exists mainly for the credit markets, not the stock market. The Fed doesn’t care very much if stock prices fall unless it’s a 1987-style crash. It will act should credit spreads blow out, or if liquidity in the banking or financial system seizes up as it did during the GFC or the Russia Crisis.

 

 

Inflation hysteria

Tim Duy is a seasoned Fed watcher with a strong track record. But I believe Duy may be suffering from a case of inflation hysteria that has gripped the markets in the past few weeks.

 

Ned Davis Research has a 22 component Inflation Timing Model and it just rolled over into neutral. Historically, neutral readings have been constructive for equity returns.

 

 

While anecdotal evidence indicates that companies have been able to pass on price increases, which is contributing to inflationary pressures, that effect may be a bit of an exaggeration. FactSet reported that near 75% of S&P 500 cited “inflation” on earnings calls, which is a worrisome development.

 

 

However, net margin expectations are in retreat sequentially by fiscal quarter and fiscal year, indicating that some companies are experiencing difficulty passing on price increases, which is a positive for the inflation outlook. 

Given the high number of S&P 500 companies that have cited “inflation” on Q4 earnings calls, have net profit margin expectations for the S&P 500 for Q1 2022 and CY 2022 been revised? The current net profit margin estimate of 12.3% for Q1 2022 is slightly below the estimate of 12.4% on December 31, while the current net profit margin estimate of 12.7% for CY 2022 is slightly below estimate of 12.8% on December 31.

While the conventional approach to the economic policy of breaking the inflationary spiral is through the wage link, another way is to break the operating margin link if companies cannot pass on price increases. While large-cap S&P 500 is showing some minor margin pressure, small businesses are experiencing much greater margin pressure, which is a positive development for the inflation outlook. The January NFIB Small Business Survey shows that prices are skyrocketing.

 

 

Even as prices rose, earnings have been in a downtrend, indicating margin pressure.

 

 

A CNBC report indicated that small businesses lack bargaining power with suppliers and customers, which is squeezing margins.

 

“They are getting squeezed by supply chain disruptions and inflation and workforce shortages and already had to reinvent themselves a few times over in the past few years, and are running out of options,” said Kevin Kuhlmann, who leads the NFIB’s government relations team. “They are continuing to adapt … but you can only increase prices so much before you might see a loss,” he said. 

 

 

A slowdown, but no recession

While I am not inclined to front-run model readings, New Deal democrat, who monitors a series of coincident, short-leading, and long-leading indicators is calling for an economic slowdown in 2022, but no recession.

 

The long leading forecast remains weakly positive. Mortgage rates in particular are now a negative for the housing market. Yields on bonds from 1 year duration out through the intermediate maturities have continued to increase, anticipating Fed rate increases, as the Miller score has been suggesting for months…

 

The expansion is decelerating, and will continue to do so. In context, what is really happening is that a white hot economic Boom is ending, and a more normal, somewhat patchy, expansion will continue for a while. When the leading indicators that I have tracked consistently for over 15 years signal a downturn, I will not hesitate to tell you so. Now is not yet.
Subsequent to the publication of that analysis, NDD concluded that the trend in retail sales is foreshadowing a job market slowdown in the coming months. Despite January’s positive surprise, real retail sales have not exceeded the high from last April.

 

Retail sales, one of my favorite “real” economic indicators, rose sharply in January, up +3.8% for the month before inflation. After inflation, “real” retail sales were still up +3.1% for the month, although they are still down -2.2% from last April’s peak: 

 

 

Note that these comparisons almost certainly will turn negative in March. Probably more important is that, as shown in the first graph above, they have been essentially flat since last April. That’s not recessionary, but it’s not good either.

 

In short, this report remains consistent with a slowdown in the consumer sector of the economy.

 

Next, let’s turn to employment, because real retail sales are also a good short leading indicator for jobs…That’s because demand for goods and services leads for the need to hire employees to fill that demand.  The exceptions have been right after the 2001 and 2008 recessions, when it took jobs longer to catch up, as shown in the graph below, which takes us up to February 2020.

 

 

The signs are lining up for inflation pressures and employment growth cool off in the next few months. It will take the pressure off the Fed to tighten.

 

In addition, the flattening yield curve may not as strong a signal of recession odds in the current circumstances. The conventional metric for measuring the yield curve is the 2s10s, or the yield spread between a 10-year and 2-year Treasury note. Historically, an inversion in the 2s10s has been a strong indicator of a pending recession. This time may be different. In the past, a flattening 2s10s has been confirmed by a flattening spread between the 10-year Treasury yield and the 3-month T-Bill. This time, the two series have diverged. This can be explained by a strong rise in the 2-year Treasury yield that was not followed by the 3-month T-Bill. 

 

 

The divergence can be explained by market expectations that the Fed will raise rates, which has put upward pressure on the 2-year while the 3-month rate, which represents current policy, remains low. This is a divergence to keep an eye on. It may be a signal that the market tightening consensus has gotten ahead of itself and the odds of a recession may not be as high as believed.

 

Inflationary pressures will begin to ease in the next few months and so will the trajectory of monetary policy.
 

 

Be cautious and prepare for opportunities

Investing in the current economic environment of uncertainty will be challenging. I reiterate my recommendation to be cautious in equity positioning with an overweight on defensive sectors and high quality stocks (see A 2022 inflation tantrum investment roadmap). 

 

The bearish impulse of the current market cycle isn’t over. The S&P 500 surged off the March 2020 bottom by exhibiting a series of “good overbought” conditions as defined by over 90% of S&P 500 stocks over their 200 dma. The “good overbought” advance petered itself out in mid-2021. While the jury is still out on whether the market will consolidate sideways as it did in 2004 and 2014, or undergo a major downdraft as it did in 2010 and 2011, similar episodes have not ended until the percentage of S&P 500 above their 50 dma dipped below 20% (bottom panel).

 

 

Investment-oriented accounts should also begin to accumulate positions in large-cap high quality growth stocks. When the narrative pivots from strong inflation to slowing GDP, FANG+ stocks are likely to catch a bid as investors pile into quality growth in as growth becomes scares. Growth stocks, and in particular technology stocks, are becoming washed-out. The latest BoA Global Fund Manager Survey shows that respondents have stampeded out of the tech sector while believing that long US technology is the most crowded trade.

 

 

 

Don’t forget about the intermediate-term trend

Posted by Cam Hui -

Mid-week market update: I wrote on Monday (see Everything but the kitchen sink) that market sentiment was overly stretched on the downside, “If you are short here, you need a catastrophe within the next 10 days, otherwise, you run the risk of a rip-your-face-off relief rally.”
 

The relief rally appeared right on cue on Turnaround Tuesday and prices stabilized today in the wake of the release of the FOMC minutes. Before the bulls get too excited, don’t forget that the intermediate trend is still down. The Value Line Geometric Index, which measures the performance of the average stock, broke a long-term support level and is tracing out a falling channel.

 

 

Mike Howell at Crossborder Capital also pointed out that global liquidity is drying up. Changes in global liquidity is historically correlated with asset prices, such as stocks, bonds, gold, property, and so on.

 

 

 

Positive seasonality

Tactically, the market may still see an upward bias as it rebounds from an oversold extreme. If seasonal patterns hold, the market should be positive for the rest of this week and then correct and bottom in early March.

 

 

This week is also option expiry week. Historically, February OpEx has exhibited a bullish pattern.

 

 

 

Short and long-term sentiment

Short and long-term sentiment models present a mixed picture. Short-term sentiment, such as Callum Thomas’ (unscientific) Twitter poll, shows bearish extremes.

 

 

By contrast, longer term models such as the Citi Panic-Euphoria Model is in neutral territory. There is lots of downside before a long-term washout low can be declared.

 

 

 

Technical damage

Broadly speaking, the stock market has sustained too much technical damage for it to roar back to test the old highs. The S&P 500 may be forming a head and shoulders formation, but H&S patterns are incomplete until the neckline breaks.

 

 

I expect the S&P 500 to encounter resistance at the 50 dma, which also coincides with last week’s highs. My base case scenario calls for a continuation of the choppy range-bound market that has frustrated both bulls and bears this year. Nevertheless, I do find it constructive that the S&P 500 has managed to find its footing and hold above its January lows in the face of potentially catastrophic news.

 

 

My inner investor is neutrally positioned at roughly the target asset allocation weights specified by his investment policy. My inner trader is standing aside. There is no need to take excessive exposure in the face of wild volatility.

 

Everything but the kitchen sink

Posted by Cam Hui -

I must admit, the bears are trying their best. They’ve thrown everything but the kitchen sink at the stock market: The prospect of a half-point rate hike, an inter-meeting hike, and the looming risk of an armed Russia-Ukraine conflict.
 

 

Despite all the bad news, the S&P 500 is holding above its January lows. What’s next, an asteroid from outer space?

 

 

Depressed sentiment

Short-term sentiment is certainly depressed. Two (unscientific) weekend Twitter polls tell the story. Helene Meisler’s weekly poll readings show a high level bearishness.

 

 

Callum Thomas’ weekend poll tells a similar story.

 

 

 

How far will the Fed go?

St. Louis Fed President James Bullard appeared in a CNBC interview this morning in which he defended his views and did not walk any of hawkishness back. Over the weekend, San Franciso Fed President May Daly called for Fed actions “measured in our pace and importantly, data-dependent”. Kansas City Fed President Esther George dismissed the idea of an inter-meeting rate hike.

 

In response to the contradictory messages from Fed speakers, the market turned even more hawkish. Fed Funds futures are now discounting six rate hikes in 2022 for a total of 1.75%, up from five rate hikes for a total of 1.50% on Friday. Expectations for a half-point move at the March meeting remain intact.

 

 

The key question for investors is whether the Fed will push back against the notion of such a steep interest rate path and, in particular, a half-point move in March. There will be lots of Fed speakers in the coming weeks and we should get more clarity on that question.

 

 

Ukrainian offensive: Now or never

The newsflow from the Russia-Ukraine situation is chaotic and confusing. I am not a military expert and I don’t even play one on TV. However, the window for an armed conflict is closing quickly for two reasons.

 

Reports emerged in late January that the Russians had moved medical units near the Ukrainian border. More alarmingly, blood supplies were also being deployed to the frontlines in anticipation of possible casualties. According to the American Red Cross, the shelf life of whole blood is 21-35 days, depending on blood type. The shelf life of red cells is up to 42 days. Frozen blood plasma is good for up to a year. Based on that report and assuming that the Russian High Command is planning for a quick two-week offensive, the window for a full attack closes in late February before their initial blood supply runs out, though undoubtedly they can get more if the conflict continues.

 

As well, Russian forces will have to contend with the dreaded Rasputitsa, the season when the spring thaw turns the region into mud, which dramatically slowed the German offensive from 1942 onwards as tanks got stuck and supply lines shortened. CNN reported that the region is experiencing a mild winter and above-average temperatures.
 

Social media videos from several areas where Russian forces are deployed — some posted by soldiers themselves — show soft and flooded ground, and plenty of mud.

 

Data from Copernicus, the EU’s Earth Observation program, shows that much of eastern Europe experienced well-above-average temperatures in January. Ukraine saw temperatures between 1 to 3 degrees Celsius higher than the average of the past 30 years, one of many changes that the climate crisis has brought this region.

 

Copernicus also notes that in January, “eastern Europe was predominantly wetter than average” and the soil in Ukraine was wetter than normal. The combination means less frost and more mud.
For the Russian military, it’s now or never for an offensive.

 

The open question for investors is what has already been discounted in the market. An article in The Economist speculated that a limited offensive to recognize and annex the breakaway regions of Donetsk and Luhansk as independent republics might be a cause for relief that a full-blown conflict did not emerge.
 

If Russia were to formally recognise the two self-proclaimed republics, as independent entities, or even station its troops and military infrastructure there, it would amount to something not far short of annexation, since the “republics” would be full of newly minted Russian citizens, and be unable to stand on their own feet without substantial help from Moscow.

 

Ukraine and the West would object loudly to the redrawing of international borders by force. But the move would also lower tensions, because the immediate excuse for an Russian invasion was always likely to be a “provocation”, allegedly by Ukraine, in Donetsk or Luhansk. Even as it protested, the government in Kyiv might therefore heave a sigh of relief, and so would the rest of the world. The danger, however, is that Russia may not stop at that.
The NY Times reported this morning that tensions had ratcheted down a little. The path for negotiation is still open. If military action remains on hold until early March, any Russian offensive will have to take place under less than ideal conditions.
 

Speaking in what appeared to be a carefully scripted televised meeting with President Vladimir V. Putin of Russia, Foreign Minister Sergey V. Lavrov said that he supported continuing negotiations with the West on the “security guarantees” Russia has been demanding of the United States and NATO.

 

“I believe that our possibilities are far from exhausted,” Mr. Lavrov said, referring to Russia’s negotiations with the West. “I would propose continuing and intensifying them.”

 

Mr. Putin responded simply: “Good.”

 

The televised meeting was a signal that Russia might continue using the threat of an invasion of Ukraine to try to squeeze diplomatic concessions from the West, rather than resorting to immediate military action.

I interpret current conditions as constructive for risk assets, though event risk remains high. If you are short here, you need a catastrophe within the next 10 days, otherwise, you run the risk of a rip-your-face-off relief rally.
 

Three questions to ask as fear spikes

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

 

Another 200 dma test

In the wake of the drama that played out in the stock market last week, the S&P 500 weakened to test the 200 dma. Is this just a re-test of the January lows or the start of a new bear leg?

 

 

To answer that question, I step outside the realm of pure technical analysis and pose three questions for both bulls and bears.
  1. What will happen to earnings and earnings expectations in the wake of the hot January CPI report that spooked the market?
  2. Fed Funds futures are now discounting a half-point liftoff at the March FOMC meeting. Some analysts have even speculated that the Fed may raise by a quarter-point in a surprise inter-meeting move. Will the Fed acquiesce or push back against those expectations?
  3. If stock prices were to weaken further, how will insiders react?

 

 

Earnings do the heavy lifting

In the wake of increasingly hawkish expectations for Fed policy, bond yields have risen and the yield curve has flattened. Rising yields have consequently put downward pressure on the S&P 500 forward P/E ratio, which has become more reasonable by historical standards.

 

 

The historical experience shows that when the Fed first begins to raise rates as the economy strengthens, P/E ratios compress but stock prices can continue to rise. But earnings expectations will have to do all of the heavy lifting. So far, forward 12-month EPS are still rising and Q4 earnings season results have been moderately positive.

 

 

 

Fed expectations

In reaction to the strong January CPI report, Fed Funds futures are now pricing in a half-point rate hike by the March FOMC meeting.

 

 

Leading up to last week’s CPI report, a total of five Fed speakers pushed back on the need for a half-point rate hike in March. Will the Fed push back against the sudden change in expectations? Fed communication policy, which began under the Yellen and possibly even the Bernanke Fed, has shown that it doesn’t like to surprise markets. If future Fedspeak is silent on this subject, it will be a signal that policy makers have decided to acquiesce to the consensus and raise by a half-point in March. On the other hand, Fed speakers could reiterate their go-slow tightening policy in order to dial back market expectations.

 

The instant reaction is somewhat constructive for risk assets. St. Louis Fed President James Bullard, a well-known hawk, stated that he supports a full point rate increase by the July FOMC meeting. However, CNBC reported a number of other regional Fed Presidents have pushed back against Bullard’s hawkish view. 

 

Atlanta Fed President Raphael Bostic told CNBC Thursday after the inflation report, “My views have not changed” for three or four rate hikes this year, likely beginning with a 25-basis point hike. That was the same view he gave CNBC on Wednesday before the inflation report…

 

Richmond Fed President Tom Barkin said in a speech that “I’d have to be convinced” of the need for a 50-basis-point rate hike, saying there may be a time for that, but it did not appear to be now.

 

San Francisco Fed President Mary Daly said after the inflation report a 50-basis-point hike is “not my preference.”
Stay tuned for more Fedspeak next week. In addition to the schedule shown below, Jerome Powell and Lael Brainard will appear before the Senate for more confirmation hearings.

 

 

 

Will insiders buy?

As forward P/E ratios fall, valuations have become more attractive. While we can argue about valuation until everyone is blue in the face, a more objective test is the behavior of insiders, who are regarded as “smart investors”. When the market hit an air pocket in early January, insiders exhibited net buying activity, which is a bullish signal. The signal faded as stock prices rallied.

 

 

A key test is whether insiders will step up and buy if stock prices decline again, which would be a constructive signal for equity prices. A word of warning – insider activity is an inexact market timing indicator. Instead, investors should look for clusters of insider buying as a signal that a long-term bottom is forming, as it did during the GFC.

 

 

Insiders were also timely in their purchases during the Greek Crisis of 2011, though the timing wasn’t absolutely precise. In both 2008 and 2011, insider buying rose, which is a more bullish signal than the pattern of insider selling (red line) falling below insider buying (blue line) exhibited recently.

 

 

 

Elevated fear levels

In the short run, some sentiment indicators are showing signs of a fear spike. Macro Charts pointed out that put optiion buying is high, which is contrarian bullish.

 

 

Other option sentiment indicators, such as the term structure of the VIX, hadn’t inverted indicating elevated fear, though readings had briefly undergone inversions Friday afternoon before the close.

 

 

Just because fear levels are elevated doesn’t mean they can’t go higher. Much of the anxiety is attributable to the White House announcement that a Russian invasion of Ukraine is imminent and could begin as soon as Wednesday. Over a dozen countries have told their citizens to leave Ukraine.

 

I am indebted to Helene Meisler who highlighted the market action during the Iraqi invasion of Kuwait in 1990 as a possible template for the circumstances today. As a reminder, here is a brief history of what happened in 1990 (via Wikipedia). The dispute began in the wake of the Iran-Iraq war, which left Iraq heavily in debt to Kuwait and strained Iraqi finances. A further fissure appeared when Iraq called for oil price increases to alleviate its cash flow problems, which Kuwait opposed.

 

Iraq began massing troops on the Kuwaiti border. On July 25, 1990, Saddam Hussein met with American ambassador April Glaspie to discuss the troop buildup, who told him Washington “inspired by the friendship and not by confrontation, does not have an opinion” on the disagreement between Kuwait and Iraq, stating “we have no opinion on the Arab–Arab conflicts”. When questioned later, Glaspie’s response was “we didn’t think he would go that far” meaning invade and annex the whole country”.

 

The invasion began on August 2, 1990, and Iraqi forces soon overran Kuwait. The S&P 500 began a decline that didn’t bottom out until two months later. Oil prices rose for the next two months, but oil equities, as proxied by XOM, peaked about the time of the invasion.

 

 

Here are some key differences between 1990 and 2022. The markets were taken off guard by the invasion. Although Iraqi forces had massed on the border, there was still doubt that hostilities would break out. Market expectations are much different today.

 

Consider the 2014 experience and the market reaction to the Russian invasion of the Crimean Peninsula. The market had already taken a tumble and did not weaken further as Russian forces crossed the border. 

 

 

Fast forward to 2022. The Biden administration has adopted a strategy of declassifying  and publicizing intelligence about Russian preparations in a manner that’s far more extensive than the public disclosures in 2014. How much of that is already reflected in the markets?

 

History doesn’t repeat itself, but rhymes. I interpret current conditions as a state of high anxiety over a possible conflict. If geopolitical tensions fade, risk asset prices should rally, particularly when it appears that other Fed officials are pushing back against Bullard’s hawkish views. On the other hand, should a hot war break out, stock prices may see a short and sharp downturn, followed by recovery (see my previous publication Buy to the sound of cannons).

 

In conclusion, the S&P 500 is undergoing another test of its 200 dma and some open questions remain. So far, the preliminary answers appear to be tactically constructive for equity prices.

 

A 2022 inflation tantrum investing roadmap

Posted by Cam Hui -

In the wake of the hot January CPI print, I have had a number of discussions with readers about the most advantageous way of positioning an equity portfolio in a rising rate environment. The most obvious strategy is to use an allocation similar to the Rising Rates ETF (EQRR) is to tilt towards value and cyclical stocks.
 

 

Beneath the surface, however, such an approach carries considerable risks owing to growing negative divergences. Instead, I present a framework for managing the inflation tantrum of 2022.

 

 

Rising inflation concerns

The main investor concern today is the prospect of higher interest rates. Not only has the Fed revealed a tightening bias, but also the European Central Bank recently made a similar pivot. The economy is on fire and there is plenty of room for the Fed to raise rates. Job postings are strong and the data underscores Jerome Powell’s comment during the January FOMC press conference about a tight labor market.

 

I think there’s quite a bit of room to raise interest rates without threatening the labor market. This is, by so many measures, a historically tight labor market. Record levels of job openings, of quits. Wages are moving up at the highest pace they have in decades. If you look at surveys of workers, they find jobs plentiful. Look at surveys of companies—they find workers scarce. And all of those readings are at levels, really, that we haven’t seen in a long time—and, in some cases, ever. So this is a very, very strong labor market, and my strong sense is that we can—we can—we can move rates up without,
without having to, you know, severely undermine it.

 

 

Moreover, consumers are spending again. These are the signs of a robust recovery that allows the Fed to tighten without worrying about tanking the economy.

 

 

While concerns over inflation and monetary policy are very valid today, there is no need to panic. Hockey legend Wayne Gretzky famously said that he skates to where the puck is going to be, not where it’s been. Here is where I believe the puck is headed.

 

 

How to position today

The most obvious way to address current market worries is to position for rising inflation and rising rates. The main overweight positions in EQRR are value and cyclical sectors. But a more detailed analysis of the relative performance of value sectors reveals a number of shortcomings to this approach.
  • Most of the value sectors are in relative downtrends compared to the S&P 500, except for financials and energy.
  • The relative performance of financials is showing a negative divergence to the 2s10s yield curve. Historically, financials perform better in a steepening yield curve environment because banks borrow short and lend long. A flattening yield curve is normally a headwind for this sector.
  • The superior relative performance of energy stocks is attributable to rising oil and gas prices from geopolitical risk over Russia-Ukraine tensions. Exposure to this sector amounts to a bet on war breaking out.

 

 

In short, exposure to value sectors carries considerable risk. Investors are betting that the relationship between the yield curve and financials has decoupled. As well, energy prices will remain elevated or a Ukrainian war will break out.

 

A better way to position equity portfolios in the current environment is overexposures to defensive sectors and high-quality stocks. Three of the four defensive sectors have been in relative uptrends, which began in December and before the onset of the latest market pullback.

 

 

There are many ways of defining the quality factor. SPHQ is an S&P 500 quality factor ETF that calculates quality based on the fundamental measures of “return on equity, accruals ratio, and financial leverage ratio”. Another way of defining quality is profitability. S&P has a higher profitability inclusion criteria for index components than Russell and the relative performance of similar large and small-cap indices from the two providers shows the effects of the profitability factor. However it’s defined, the quality factor began to outperform in late 2021.

 

 

Investors can also observe the effects of the quality factor when viewed through the value and growth lens. While value stocks have recently led growth stocks mainly for the reasons mentioned previously in the discussion of value, high-quality value has beaten low-quality value and high-quality growth has led o low-quality and speculative growth.

 

 

 

Someday soon

In the wake of the latest hot CPI report, Fed Funds futures are discounting a half-point rate hike in March, five rate hikes in 2022 for a total of 1.5%. These expectations go beyond St. Louis Fed President James Bullard’s call for a full-point hike by the July FOMC meeting.

 

 

As a consequence, the yield curve has been flattening as short rates rise. So far, the bond market has exhibited a bear flattener in which both short and long rates rise but long rates rise less than short rates. 

 

 

Someday soon, long rates will stop rising and begin to decline. The transition will be difficult to time precisely, but that should happen as the market prices in a Fed policy error and the rising risk of a hard landing. Historically, the 10-year Treasury yield has been roughly correlated with the Economic Surprise Index (ESI), which has been falling. As the Fed tightens and ESI declines further, indicating a weakening economy, bond yield should close the gap and begin to fall.

 

 

Historically, the relative performance of large-cap growth stocks, as measured by the NASDAQ 100, is inversely correlated to the 10-year Treasury yield. Falling long rates will see market leadership rotate from defensive sectors to growth stocks.

 

 

 

Recovery phase

The next phase of market leadership can be described as the recovery phase. As the economy slows and inflationary pressures ease, the Fed will shift to a more accommodative monetary policy. That will be the signal for investors to rotate to value and cyclical stocks. For the time being, these industries are mostly weak to trading sideways relative to the S&P 500, with the exception of oil and gas stocks because of geopolitical tensions.

 

 

While it’s difficult to precisely forecast the turning points, investors should begin to overweight large-cap growth when 10 and 30 Treasury yields start to decline, which I expect will happen during Q1 or Q2. The recovery phase should begin when inflationary pressures begin to roll over.

 

 

Much of the inflation pressure can be attributed to shortages from supply chain bottlenecks. A recent snapshot of 28 exchanged-traded commodities shows that almost 20 of them are in backwardation, where the front month price is higher than the second month. Backwardation is an indication of a short-term shortage but history shows that such spikes don’t last very long.

 

 

Here is another sign that the inflection point is just around the corner. While the 5s30s nominal yield curve is flattening (red line), the 5s30s breakeven yield curve has already inverted (blue line). Even though nominal headline CPI is 7.5%, long-term inflation expectations are falling. Don’t be surprised if the Fed pivots back to a more accommodative monetary policy in H2 2022 as inflationary expectations remain well-anchored.

 

 

In conclusion, the current market environment is tricky to navigate and investors will be faced with considerable volatility in 2022. As it’s difficult to precisely time turning points, I suggest investors adopt the following positioning for their portfolios today.
  • Overweight defensive sectors.
  • Overweight quality stocks.
  • Neutral weight high-quality growth, which should be the next market leadership.
  • Underweight value and cyclical stocks.