The dirty little secret of Q4 earnings season

Posted by Cam Hui -

You can tell a lot about the character of a market by the way it reacts to the news. Bespoke reported a downbeat market reaction to earnings and sales beats, which is disappointing, “The 163 companies that have beaten both top and bottom line estimates this earnings season have averaged a one-day decline of 0.23% on their earnings reaction days.”
 

 

While this may seem like the dirty little secret of Q4 earnings season, there’s another one that buried that you may not be aware of.

 

 

A difficult market

While the tone of the market has been difficult in the past few weeks, negative market reactions to positive surprises aren’t necessarily bearish signals. 

 

FactSet reported that the market is punishing stocks with both positive and negative earnings surprises. At first glance, that sounds bearish. However, the slope of the earnings reaction (dotted red line) is positively sloping, indicating that positive surprises are still being rewarded. Earnings beats are still outperforming earnings misses. It’s the overall market conditions that are challenging.

 

 

 

Mid-cycle expansion challenges

The market’s risk-off tone can be mainly attributed to two factors, fears over a Russia-Ukraine confrontation and a hawkish pivot by the Federal Reserve. The geopolitical risk premium seems to be facing, as measured by a stabilization in the Ruble exchange rate.

 

 

So has the relative performance of Russian stocks to the EURO STOXX 50.

 

 

However, the market reacted to the Fed’s hawkish pivot by flattening the 2s10s and 5s30s yield curves, indicating expectations of slower economic growth.

 

 

As a consequence, the S&P 500 forward P/E ratio fell…

 

 

…even as forward 12-month EPS estimates continued to rise.

 

 

P/E ratio compression during a period that the Fed shifts from easy to tight money is a normal characteristic of a mid-cycle expansion. Investors deflate P/E ratios because of the expectation of higher interest rates. In order for stock prices to advance, earnings growth will have to do the heavy lifting to overcome falling P/Es.

 

So far, the results are not encouraging. While it’s important to consider the earnings beat and miss rate, the magnitude of the beat and miss rates have been subpar. While FactSet reported that the Q4 earnings beat rate is above its 5-year average, the magnitude of the beats is lower.

 

At this point in time, more companies are beating EPS estimates than average, but they are beating estimates by a smaller margin than average…Overall, 33% of the companies in the S&P 500 have reported actual results for Q4 2021 to date. Of these companies, 77% have reported actual EPS above estimates, which is above the 5-year average of 76%. In aggregate, companies are reporting earnings that are 4.0% above estimates, which is below the 5-year average of 8.6%.
That’s the true dirty little secret of Q4 earnings season. Even though earnings beats are above average, the magnitude of the beats have been subpar.

 

About one-third of the S&P 500 has reported earnings so far and individual stocks have been the source of significant daily volatility. Earnings season continues and significant FANG+ names such as GOOGL, FB, and AMZN report this week. 

 

 

Stay tuned and keep an open mind.

 

Trading the Panic

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.
 

 

Fear rising

The stock market action last week is an example of a classic panic. Not only is the market oversold, but also extreme fear is showing up in sentiment readings. The weekly AAII survey has flashed a contrarian buy signal for a second consecutive week. Not only is the bull-bear spread at an extreme seen only two other times in the last 10 years, but also bearish sentiment is the fourth highest on record in the same period.

 

 

While survey-based sentiment models can be useful, they can have only limited utility because the surveys ask respondents their opinions and not what they are actually doing with their money. Option market sentiment, which is based on actual fund flows, is also showing signs of high anxiety. The term structure of the VIX inverted last week, indicating high levels of fear.

 

 

The Bollinger Band of the VIX Index also spiked above 90. Past episodes have marked either bottoms or preceded short-term bottoms.

 

 

As well, SentimenTrader observed that small trader put option buying is off the charts, which is contrarian bullish.

 

 

 

An oversold extreme

The market is oversold, but you probably already knew that. The Zweig Breadth Thrust Indicator fell to an oversold level last week. As a reminder, a ZBT buy signal requires the ZBT Indicator to rise from an oversold to overbought condition within 10 trading days. ZBT buy signals are rare. There was only one buy signal in the last five years and three in the last 10 years. By contrast, there were 13 ZBT oversold conditions in the last five years and 29 in the last 10 years. Virtually all ZBT oversold conditions resolved in short-term rallies.

 

 

 

Constructive breadth

Even breadth indicators are becoming more constructive. Net NYSE and NASDAQ 52-week highs-lows bottomed out last Monday and turned less negative.

 

 

Similarly, the relative performance of the equal-weighted S&P 500 to the S&P 500 is turning up. The average stock in the index is outperforming the index itself, which is another sign of breadth improvement.

 

 

 

Insiders are buying

Another data point supportive of a bottom is the appearance of insider buying. The latest reports show that insider buys are outnumbering insider sells, which is a positive development by this group of “smart investors”.

 

 

However, insiders are not perfect at timing market bottoms. However, a cluster of persistent insider buying is a signal that a durable bottom is forming. As an example, consider the insider trading pattern during the Great Financial Crisis.

 

 

Insiders also stepped up to buy in 2011 at the height of the Greek Crisis.

 

 

Insiders were equally timely in their purchases during the COVID Crash of 2020.
 

 

While the latest whiff of insider buying is constructive, they cannot be regarded as a full fledged buy signal until buying becomes more persistent.

 

 

Echoes of 2008

This level of daily market volatility is almost unprecedented. Bloomberg reported that the only parallel is October 2008.

Twice in two days, S&P 500 has erased a gains of roughly 2% to close the session lower. Such a streak of big back-to-back downside reversals has occurred only once before in Bloomberg’s four decades’ worth of data: October 2008. Equally big swings rocked the market on Monday and Tuesday.

Consider the differences between then and now from the viewpoint of my bottom spotting model. Currently, three of the four components of the model have flashed buy signals. The only missing element is the lack of a TRIN spike indicating price-insensitive margin clerk selling.

 

 

Here are the readings from October 2008. The S&P 500 was experiencing extreme levels of daily volatility. In early October, the VIX Index rose above its upper Bollinger Band and recycled, just as it did now. The term structure of the VIX was deeply inverted starting in mid-September and the high fear level lasted until December, which is different from today. The NYSE McClellan Oscillator reached an oversold condition, just like today. TRIN experienced several spikes above 2, which are indicative of price-insensitive margin clerk liquidation, which has not happened today.

 

 

The key difference is the macro backdrop. The financial system was undergoing an institutional bank run. The stability of the global financial system was at risk. The banking system was at the edge of an Apocalyptic cliff.

 

Fast forward to 2021, the Fed has signaled a regime shift from an easy monetary policy to a tightening policy. Further, the markets are rocked by fears of a Russia-Ukraine military conflict. These are the same scale of Apocalyptic fears that the markets faced in 2008. At worse, today’s events represent normal equity risk, which should resolve in a 10-15% pullback.

 

In conclusion, the US equity market is undergoing the classic signs of a panic bottom and it is poised for a relief rally. While it’s difficult to pinpoint the exact point of a bottom and Friday’s one-day strength does not make a trend, the ability of the S&P 500 to hold above support on the 30 minute chart is constructive.

 

 

 

Disclosure: Long SPXL

 

Buy to the sound of cannons

Posted by Cam Hui -

As global markets have been jittery on the prospect of military conflict in Ukraine, Ben Carlson showed a table of the regular nature of US stock market drawdowns, which is a feature of equity risk.
 

 

I am also reminded of the quip by British banker Nathan Rothchild, “Buy to the sound of cannons, sell to the sound of trumpets.” As well, the trader Art Cashin also related his experience with the Cuban Missile Crisis as a young man (via Barry Ritholz):
 

Anyway, it was the Cuban Missile Crisis and there were rumors that Russia had launched rockets and the Dow took a dive near the bell.

 

I cleaned up my desk and raced to the Moosehead, as animated as only an 18 year-old can be. Jack was already there and as I burst through the door, I shouted: “Jack! Jack, there was a strong rumor that the missiles were flying and I tried to sell the market but failed.”

 

Jack said “Calm down kid! First buy me a drink and then sit down and listen to me.” I ordered the drink and meekly sat down.

 

Jack said – “Look kid, if you hear the missiles are flying, you buy them. You don’t sell them.”

 

“You buy them?” I said, somewhat puzzled.

 

“Sure you buy them!” said Jack. “Cause if you’re wrong, the trade will never clear. We’ll all be dead.”

 

That’s a lesson you won’t learn in the Wharton School.

Both Rothchild’s thinking and Cashin’s story are lessons in market psychology and the occasional asymmetric nature of asset returns. With the angst over the FOMC decision out of the way, let’s consider what might happen if war were to actually break out.
 

 

A hot war, or stealth war?

The framework of a discussion of a Russia-Ukraine war is based on Russia’s political objectives, the military situation, and NATO’s response, and, most importantly for investors, the economic fallout.
 

As Russian troops mass on Ukraine’s borders, the biggest unknown is Putin’s political objective in an invasion. Is he aiming for limited military objectives, or does he want to topple the Ukrainian government altogether?
 

In a limited hot war involving actual hostilities, Russia could take the breakaway and separatist regions of Luhansk and Donbas. A more ambitious plan would be to secure a “land bridge” to the annexed Crimea, which involves seizing territory between the Sea of Azov to the Dnieper River.
 

 

Moscow could decide to destabilize the current Ukrainian government using covert operatives to spark another Orange Revolution, this time to install a Russia-friendly regime. If that’s the objective, why mass 125,000 troops on the border? A full hot war could see the siege and fall of Kyiv to Russian forces.
 

Each plan carries its own risks. A limited incursion would still leave a West-leaning government in Kyiv in power. While Russia is likely to win a full military campaign that ends with the takeover of Ukraine, its losses could be considerable and see soldiers return home in body bags, which should not be popular. If it were to install a Moscow-friendly government in Kyiv, will the government remain stable if Russian troops go home? The Russian Army could be bogged down in a bloody guerilla conflict with no end in sight. 
 

 

The economic fallout

The West has threatened severe sanctions if Russia were to invade. A recent background press conference by senior US officials outlined the measures being contemplated.
 

That means the gradualism of the past is out, and this time we’ll start at the top of the escalation ladder and stay there.  We’ve made efforts to signal this intention very clearly.  And I would say the deepening selloff in Russian markets, its borrowing costs, the value of its currency, market-implied default risk reflect the severity of the economic consequences we can and will impose on the Russian economy in the event of a further invasion.
 

In addition to financial sanctions, which have immediate and visible effect on the day they’re implemented, we’re also prepared to impose novel export controls that would deal Putin a weak strategic hand over the medium term. 

Specifically, the White House is threatening the use of technology export sanctions that crippled Huawei in the past.

In the case of export controls, what we’re talking about are sophisticated technologies that we design and produce that are essential inputs to Russia’s strategic ambitions. 
 

So, you can think of these export controls as trade restrictions in the service of broader U.S. national security interests.  We use them to prohibit the export of products from the U.S. to Russia and, potentially, certain foreign-made products that fall under U.S. export regulations. 

The nightmare scenario for the West is Russia’s use of natural gas as a weapon. Russian gas exports account for about one-third of the EU’s gas use and the European economy could collapse if the taps were to be turned off. The White House is working with other global gas suppliers to fill the gap.

 

We’re working with countries and companies around the world to ensure the security of supply and to mitigate against price shocks affecting both the American people and the global economy…

 

We’ve been working to identify additional volumes of non-Russian natural gas from various areas of the world — from North Africa and the Middle East to Asia and the United States.
 

Correspondingly, we’re in discussions with major natural gas producers around the globe to understand their capacity and willingness to temporarily surge natural gas output and to allocate these volumes to European buyers.

The Economist summarized Europe’s gas supply situation and concluded that Europe has become more energy resilient owing to a number of measures: Changes to contracts that allow the re-export and redirection of gas supplies; the supply of LNG, which saw an armada of LNG carriers redirected to Europe as supplies tightened recently; gas held in storage; and a supply of “cushion gas”, which is an extra supply of gas that regulators demanded to held in storage caverns.
 

Mr Stoppard [of IHS Markit] helpfully simplifies things. Russian gas exports to Europe currently amount to about 230m cubic metres per day (cm/d). He reckons surplus regasification capacity could make up for about 50m cm/d. Boosting coal and nuclear power, for example by restarting recently mothballed plants or increasing load factors at underutilised ones, could add the equivalent of another 40m cm/d. That still leaves a shortfall of 140m cm/d. He calculates that if weather remains normal then the amount of stored gas (not including cushion gas) would cover the remaining 140m cm/d shortfall for four and a half months. “This is a price crisis more than a physical supply crisis,” he concludes.

In other words, demand can be met from physical supplies, it’s only money.
 

 

The fiscal put

One of the headwinds to growth in 2022 is the falling fiscal impulse, which has already turned negative. In the US, it appears that Biden’s Build Back Better legislation is collapsing, which Moody’s estimates would subtract 0.75% from GDP growth this year. In addition, the Republicans are likely to regain control of Congress in November, which will put a screeching halt to most of Biden’s spending plans.
 

 

In Europe, France and Germany are at loggerheads over the fiscal impulse. France, which took over the rotating EU Presidency, favors fiscal expansion while the new German finance minister is a fiscal hawk. Across the English Channel, the UK raised taxes by about 2% of GDP in 2021. China and Japan are the only major countries that are engaged in any stimulus.
 

If a hot war were to break out, political reservations about fiscal responsibility will fly out the window. Expect fiscal expansion to support growth. Don’t be surprised to see EU government fuel subsidies to gain approval, financed by the European Central Bank. A similar bipartisan consensus is likely to emerge in Washington on defense-related spending, though it’s unclear whether the Fed would pivot to an easier monetary policy.

 

 

Investment implications

There are two industries that are likely beneficiaries of a hot war. This is emphatically not a recommendation to trade in any of these securities, only to point out the opportunities and risks in these industries and sectors.

 

The most obvious is Aerospace and Defense, which have begun to bottom out relative to the S&P 500 but haven’t fully discounted the prospect of increased defense spending.

 

 

The other are cyber security companies. Any Russian offensive is likely to involve cyber attacks in order to cripple command and control systems and infrastructure. These stocks haven’t responded to the threat of war.

 

 

However, energy stocks have surged in response to Russia-Ukraine tensions. They appear extremely extended and their 5-day RSI is exhibiting a negative divergence. This sector is at risk of a severe pullback should tensions fade.

 

 

In conclusion, investors need to consider two scenarios when forecasting asset returns. If a hot war were to breakout, wars are intermediate-term bullish owing to an accommodative fiscal and probable monetary responses as long as they don’t involve the complete collapse of civil society or nuclear annihilation. Remember Rothchild’s words: “Buy to the sound of cannons…” 

 

If, on the other hand, war fears fade and peace breaks out, the market will be faced with the more conventional challenges of central banks tightening monetary policy during a mid-cycle expansion. In that case, expect the market to be choppy and range-bound after an initial relief rally. “Sell to the sound of trumpets.”

 

Even though the drums of war are beating, an invasion doesn’t appear to be imminent. Representatives from Russia, Ukraine, Germany, and France met in Paris last Wednesday. The meeting broke up with an interim understanding that the ceasefire in eastern Ukraine under the Minsk Agreement would be upheld by all parties. They further agreed to meet again in two weeks’ time in Berlin. While this is a classic “kick the can down the road” development, it is nevertheless a constructive one. The Russian troops massed on the Ukrainian border can’t remain there forever. Some were redeployed from as far as the Korean border. Moreover, the area will thaw in March and turn the ground into an impassable mud and bog. If all sides are still talking in mid-February, the odds of an invasion recedes significantly as the window for a campaign will become extremely narrow.

 

In all cases, investors and traders should fade the war fears and take advantage of any price weakness to buy risky assets.

 

Seeking sanity in a mad market

Posted by Cam Hui -

Mid-week market update: The stock market has been extremely oversold for the past few days, but one element had been missing for the short-term, namely a sentiment capitulation and wash-out, which may have finally appeared. The latest Business Week cover may be the classic contrarian magazine cover indicator of a developing bottom.
 

 

 

Oversold signals everywhere

As well, I am seeing oversold signals everywhere. Two of my four bottom spotting models have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band and the NYSE McClellan Oscillator (NYMO) reached an oversold extreme. While the term structure of the VIX did not invert on a closing basis, they did invert intra-day both on Monday and Tuesday. Moreover, the 5-day RSI of the S&P 500 reached oversold levels last seen during the COVID Crash of 2020.

 

 

The NASDAQ 100 is especially washed out. QQQ short volume has spiked to unprecedented levels.

 

 

The normalized 52-week NDX/SPX ratio has fallen into a relative support zone that has historically defined buying opportunities for large-cap growth stocks with the exception of the 2000 dot-com crash.

 

 

Risk appetite is poised for a comeback, though the longevity of any relief rally remains an open question.

 

 

Main Street, or Wall Street?

Coming into the FOMC meeting, the Fed was caught between the desires of Main Street, which has been increasingly concerned with inflation, and Wall Street, which was hoping for a more dovish message. The Fed threw its lot with Main Street as Jerome Powell stated that “inflation risks are to the upside in my view” and the Fed’s balance sheet is “substantially larger than it needs to be”.

 

Inflation concerns were so widespread on Main Street that it became a major issue on Glassdoor, a website built mainly for employees and potential employees to rate employers. Most of the concerns amount to “my pay raise isn’t keeping up with inflation”.

 

 

The cacophony of inflation complaints prompted President Biden to pressure the Federal Reserve to “do something” in order to bolster the Democrats’ faltering position in the mid-term elections. While the Fed has its own reasons to tighten monetary policy, the combination of broadening inflation pressures and emerging signs of full employment prompted its hawkish pivot.

 

Despite Powell’s equity unfriendly message, the stock market reacted in a constructive fashion by holding above Monday’s panic lows and the VIX recycled below its upper BB.

 

 

In conclusion, stock prices are overly stretched on the downside and a relief rally is more or less inevitable, though its longevity is questionable. While my inner trader remains tactically bullish, he is monitoring the evolution of internals should the bounce materialize. My inner investor has de-risked from an aggressive position to an asset allocation that is consistent with his long-term policy mix.

 

 

Disclosure: Long SPXL

 

What’s the market pricing in?

Posted by Cam Hui -

As the stock market looks forward to another exciting week of volatility, the technical damage suffered by the market is quite severe. Nevertheless, investors need to take a deep breath and ask, “What’s the market pricing in?”
 

 

The three major factors I consider in my analysis are:
  • Earnings and valuation;
  • Fed policy; and
  • Geopolitical risk.

 

 

A valuation reset?

As we proceed through Q4 earnings season, the market hasn’t mostly reacted well to earnings announcements, headlined by the -20% air pocket suffered by Netflix. Nevertheless, the macro summary from The Transcript, which monitors earnings calls, is relatively benign.

 

Omicron continues to sweep through the US and it’s causing some disruptions, but consumer spending continues to be strong. Inflation is also strong and inflation expectations are rising. The Fed is expected to raise rates four times this year and that is spooking investors.

Forward earnings estimates have been steadily rising across all market cap bands.

 

 

As stock prices pulled back, stock prices are undergoing a valuation reset. While all eyes have been on the large-cap S&P 500, the valuation reset has been evident in mid and small-cap stocks, 

 

I can make two observations from this analysis. Valuation resets are a feature and not a bug of mid-cycle expansions (see How small caps are foreshadowing the 2022 market). As well, the forward P/E for the S&P 400 and S&P 600 are arguably quite attractive relative to their own history. 

 

 

Goldman Sachs studied the history of S&P 500 forward P/E ratio around the time of the first Fed rate hike. It found that forward P/E is typically flat ahead of the first rate hike and then falls afterwards. Equity price gains are dependent on the evolution of forward EPS estimates, which have been rising so far.

 

 

While major earnings misses like the one suffered by Netflix have received the headlines, FactSet reported that the 5-year average EPS beat rate is 76% and the average sales beat rate is 68%. As more companies report in the coming weeks, the market will react on a daily basis to reports and there should be more better reactions than the Netflix debacle.

 

 

In light of the recent market weakness, earnings expectations may have become too low/

 

 

How hawkish will the Fed be?

A potential major market event will be the FOMC meeting on Wednesday. While no interest rate changes are expected, both the FOMC statement and Powell’s subsequent press conference remarks will be closely scrutinized to the direction of Fed policy. (The Bank of Canada will also announce its interest rate decision Wednesday and it is expected to chart a more hawkish course by raising rates, but that won’t be the same global market-moving implications as the Fed announcement.)

 

Recent Fedspeak has made it clear that there are no doves left on the FOMC. How hawkish will the Fed be? 

 

Market expectations for the rate hike path is already very hawkish. Fed Funds futures are discounting five rate hikes this year, with liftoff in March.
 

 

Bloomberg recently conducted a survey of economists and here’s what they said. While no rate announcement is expected at the January meeting, most expect a signal of a rate hike. Respondents were split between the language of whether the Fed would explicitly signal a March rate hike or a rate hike “soon”.

 

 

As for the Fed’s balance sheet, survey respondents expect quantitative tightening to begin in the April to June period.

 

Economists expect the runoff of maturing securities to commence this year, with 29% looking for a start from April to June and 40% expecting July to September. The median economist estimate looked for monthly reductions between $40 billion and $59.9 billion. The runoff would bring the size of the balance sheet down to $8.5 trillion at the end of this year and $7.6 trillion at the end of 2023, still far above pre-pandemic levels.

 

 

In short, market expectations are already very hawkish. While the Fed is set on a course of tightening monetary policy, it may have to exceed hawkish expectations to spark a further risk-off episode. Morgan Stanley recently highlighted analysis which showed 10 year real yields are up by over 50 bps in the last three weeks, while 10-year breakevens are down by more than 25 bps. This is an event that has only happened before at or near major market bottoms, in October 2008, March 2009, June 2013, and March 2020.

 

 

 

The drumbeats of war?

The headlines from Ukraine are alarming. The White House warned that an invasion could happen at any time, but there will be dire consequences for Russia if it undertakes military action. The US ordered the evacuation of families of embassy staff from the Kyiv mission. The UK has also withdrawn some embassy staff. Germany will help embassy staff family leave Ukraine.

 

British intelligence accused the Russians of hatching a plot to install Ukrainian parliamentarian Yevgeniy Murayev to be the leader of a Russian-friendly government in Kyiv. Russia has accused Ukraine of building up forces on the border of Donbas, a separtist region, and called the threat of a Ukrainian invasion very high. The US is considering sending troops to eastern Europe and various other NATO members are mobiling and sending military assets to the region.

 

 

Even as the drumbeats of war sound, the tail-risk of an immediate invasion may be receding. While the Blinken-Lavrov meeting in Geneva broke up last Friday with no breakthrough, both sides agreed to continue a dialogue next week and there is the possibility of a direct Biden-Putin meeting in February. As well, the back channels are active on all fronts. Reuters reported that political advisers from Russia, Ukraine, France, and Germany will hold talks on Ukraine in Paris on January 25. If they’re talking, there will be no invasion, at least for now.

 

Moreover, a Bloomberg article speculated that the Beijing Olympics may restrain Putin’s maneuvering room in an invasion.

 

As the U.S. and Europe mount increasingly frantic efforts to deter Russia from any invasion of Ukraine, it’s Chinese President Xi Jinping who may have the biggest influence on Vladimir Putin’s timetable.
The Russian president has said he will join Xi at the opening ceremony Feb. 4 of the Beijing Winter Olympics, where the Chinese leader has lavished billions of dollars to showcase his nation’s superpower status to the world.

 

The last thing Xi needs is for Putin to overshadow China’s big moment by triggering a global security crisis with the U.S. and Europe. That’s especially the case given Xi is looking to bolster his prestige at home as he seeks endorsement for an unprecedented third term later this year. 

 

Xi called Putin an “old friend” when they chatted in mid December, while the Russian leader hailed what he said was a “responsible joint approach to solving urgent global issues.” 

 

But kicking off an invasion of Ukraine in the middle of Xi’s Olympic moment would throw a wrench into such warmth, and risk drawing China into the diplomatic fray. It’s possible Xi asked Putin in their recent call not to invade Ukraine during the Games, according to one diplomat in Beijing who asked not to be identified talking about such scenarios. Putin has repeatedly denied he currently intends to attack Ukraine. 
While an immediate invasion is always possible, the more likely time frame is mid or late February. The closing date of the Beijing games is February 20.
 

Putin and China have been here before. Russia’s 2008 war with Georgia erupted on the day of the opening ceremony of the Beijing Summer Olympics, to the chagrin of Chinese leaders, prompting Putin to fly home to direct military operations.

 

Days after Putin hosted the closing ceremony of the 2014 Winter Olympics in Sochi, on which he’d spent a record $50 billion to stage the Games, Russian forces began their operation to annex Crimea from Ukraine.  
During moment of crisis, even developments that appear to kick the can down the road, such as a Biden-Putin meeting in February or the staging of an Olympic games that delay the onset of conflict, can spark a risk-on episode. Today’s market action where everything is falling except for safe haven assets has the hallmark of a panic liquidation event. The term structure of the VIX has fully inverted, which is another indication of high anxiety.

 

 

In conclusion, the balance of short-term risks is tilted to the upside. Expectations have been ratcheted down too much and the chances of positive surprises from earnings season, Fed policy, and Ukrainian developments appear to be higher than what’s in the price. Being bearish here amounts to betting on outcomes of catastrophic proportions. While that’s not impossible, the odds of rip your face off rally in light of the market’s severely oversold condition are high.

 

However, intermediate-term challenges remain. Technical conditions are deteriorating and the macro backdrop of a mid-cycle expansion will be headwinds for risk assets. I continue to expect stock prices to chart a choppy to down course for the first half of 2022. The recent lows set by the S&P 500 may not be the ultimate low of the latest downdraft.

 

 

Disclosure: Long SPXL

 

Buy the dip, or sell the dead cat bounce?

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.
 

 

Estimating downside risk

Last week, I highlighted a sell signal from the intermediate-term breadth momentum oscillator (ITBM). The 14-day RSI of ITBM had recycled from an overbought condition, which was a sell signal for the stock market. In the past, ITBM sell signals have resolved with 5-10% drawdowns and the market bottomed with the ITBM RSI fell to an oversold or near oversold condition.

 

 

The S&P 500 fell -5.8% since the sell signal and RSI is oversold. Does this indicate a short-term bottom, or is this the start of a major bear leg?

 

 

The bull case

Here are the bull and bear cases. The market is oversold and due for a relief rally. The percentage of S&P 500 stocks above their 10-day moving averages (dma) has reached levels consistent with short-term bottoms.

 

 

As well, the Zweig Breadth Thrust Indicator has fallen into oversold territory (grey bars). As a reminder, a ZBT buy signal occurs when the indicator rises from an oversold to overbought condition within 10 trading days. These signals are extremely rare (red dotted line) and I am not anticipating such a buy signal. Nevertheless, a ZBT Indicator oversold condition has usually marked short-term bottoms in the past.

 

 

Two of the four components of my bottom spotting model have flashed buy signals. In the past, such episodes have signaled tradable bottoms with reasonable accuracy. The VIX Index spiked above its upper Bollinger Band, indicating oversold conditions, and the NYSE McClellan Oscillator (NYMO) has also fallen to oversold levels. Only the term structure of the VIX hasn’t inverted and TRIN hasn’t risen above 2, which are indicators of short-term panic.

 

 

While market-based sentiment indicators such as the VIX term structure and TRIN have not signaled fear, survey-based indicators have. Mark Hulbert revealed that his newsletter sample of NASDAQ market timers had become sufficiently bearish to flash a contrarian buy signal. Sentiment is more bearish than it was at the March 2020 bottom.

 

 

Indeed, the normalized ratio of the NASDAQ 100 to S&P 500 has reached historically important oversold conditions that NASDAQ stocks are likely to see low relative downside risk at current levels.

 

 

That said, Hulbert also his regular sample of market timers are not bearish enough to be in the lowest decile reading to flash a contrarian buy signal, though readings are close.

 

 

Similarly, the latest AAII weekly survey shows a spike in bearish sentiment and a bull-bear spread of -25.7. In the past, bull-bear sentiment spreads below -20 have marked low-risk long entry zones for equity investors.

 

 

 

The bear case

While sentiment models are showing a retreat in bullishness, some models indicate a stubborn lack of bearishness. This could be interpreted as the market due for a short-term bounce, but a durable bottom isn’t in sight just yet.

 

For example, the Investors Intelligence survey shows the bull-bear spread in retreat, but a lack of a spike in bearishness. This could be interpreted as an oversold market, but the absence of panic and washout translates to greater intermediate-term downside risk.

 

 

Helene Meisler conducts a weekly unscieintific poll every weekend. To my surprise, the bulls slightly edged the bears despite last week’s carnage in stock prices. Sentiment may still be too complacent and traders are not panicked enough yet.

 

 

Similarly, while the VIX Index had risen above its upper Bollinger Band, indicating an oversold market, the width of the Bollinger Band remains relatively narrow and not wide enough to be consistent with intermediate-term bottoms.

 

 

Other market internals are also problematic. Indicators of equity risk appetite are exhibiting negative divergences, which is disturbing for the bulls.

 

 

The relative performances of defensive sectors are all forming saucer-shaped bottoms, indicating that the bears have gained control of the tape.

 

 

 

What to watch

How can we resolve this bull and bear debate? First, recognize that the market is stretched to the downside and a short-term relief rally can happen at any time. Much will depend on how the market behaves after the bounce.

 

Here is what I am watching. The percentage of S&P 500 stocks has fallen through the 50-60% zone that defines up and downtrends. If the market were to rally, can this indicator regain the 60% level?

 

 

Support and breadth indicators can also be useful guides. The S&P 500 is testing its 200 dma, which should act as a support level. As well, the weakness in the S&P 500 is overstating index weakness. The equal-weighted S&P 500, which represents the average stock in the index, has been outperforming its float-weighted counterpart since early December, which is constructive.

 

 

In conclusion, the stock market is sufficiently oversold that a relief rally is likely in the short run. However, stock prices remain vulnerable to intermediate-term downside risk. Subscribers received an email alert that my inner trader had bought an S&P 500 position as a short-term trade.

 

Traders and investors should monitor the development of market internals should the rally materialize. The FOMC meeting in the coming week could prove to be a catalyst for volatility and greater clarity on market direction.

 

 

Disclosure: Long SPXL

 

Rethinking the Hindenburg Omen

Posted by Cam Hui -

The ominously named Hindenburg Omen was developed by Jim Miekka to spot major stock market tops. Unfortunately, it has also had a history of crying wolf too many times with false positives. Its inconsistency prompted one commentary to call it a warning to avoid traveling by blimp.
 

David Keller recently penned an article that analyzed the Hindenburg Omen in detail. He called it a breadth indicator with three specific components:
  1. The stock market has to be in an established uptrend;
  2. An expansion in both new 52-week highs and lows that indicate indecision; and
  3. The market exhibits a price momentum break.
Keller further explained, “A valid Hindenburg Omen signal needs to have multiple signals within a 30-day window to actually register a valid bearish indication.”

 

A chart of the Hindenburg Omen is shown below. The indicator is displayed in the lower panel and a valid signal has a value of 3. History shows that there were 11 such warnings in the last 10 years. Six saw declines (shown in pink). The market continued to advance or the Omen was too late in warning of declines in four instances (grey). One resolved in a sideways choppy market (grey/pink). While these results are marginally useful, this indicator’s sell signals don’t inspire a high level of confidence.

 

 

The Hindenburg Omen has recently flashed a series of sell signals. How should investors react?

 

 

A condition indicator

I conducted a more detailed analysis of the history of this indicator going back to the 1990’s and found that it spotted most major market declines ahead of time, such as the dot-com top in 1999 and 2000 and the market top in 2007 and subsequent Great Financial Crisis in 2008. The only one it missed was the Long-Term Capital Management Russia Crisis meltdown.

 

 

I conclude that this is an indicator with a spotty success record with a strong left return tail. Despite the record of false positives, it has warned of almost every major past bearish episode. I call this a condition indicator that is a signal of potential large downside risk but needs confirmation from other indicators for investors to turn cautious.

 

As a reminder, I recently pointed out that the Wilshire 5000 and its negative monthly RSI divergence flashed a sell signal. While the Wilshire 5000 sell signal can take anywhere from two months to over a year to resolve bearishly, the combination of these bearish warnings should raise the level of cautiousness for investors.

 

 

 

A Trend Model downgrade

In addition, my Trend Asset Allocation Model has been downgraded from bullish to neutral. As a reminder, the Trend Model is based on a composite of global stock and commodity markets. It has a history of out-of-sample signals since 2013. A model portfolio that varies 20% in weight from a 60/40 benchmark has shown a record of equity-like returns with balanced fund-like risk.

 

 

Investors should interpret the downgrade as a signal to de-risk from an aggressive to a neutral position. It is not the Apocalypse.

 

Let’s take a look. In the US, the S&P 500 has violated its 50-day moving average (dma) and testing its 200 dma. Both the S&P 500 and NASDAQ 100 have begun to lag global stocks, as measured by the MSCI All-Country World Index (ACWI).

 

 

In Europe, the Euro STOXX 50 is struggling to hold its 50 dma. The FTSE 100 has held up well, mainly because of its heavier weighting in energy and financial stocks, which have outperformed. The mid-cap FTSE 250, which is more reflective of the British economy, has violated both the 50 and 200 dma.

 

 

Asian markets, on the other hand, are showing signs of stabilization after a period of poor performance. Both China and Hong Kong have begun to turn up relative to ACWI. The PBoC has begun to ease, though it’s still an open question whether the change in policy will stimulate the Chinese economy or just stabilize the growth downturn from the property developer implosion. Monetary policy will not be able to address the growth challenges posed by China’s zero COVID policy of locking down areas whenever an infection is found. Other Asian markets are also exhibiting constructive signs of forming relative bottoms.

 

 

Commodity prices present a mixed picture. On one hand, they are strong and broke out to new recovery highs. On the other hand, the cyclically sensitive copper/gold ratio has been trading sideways for about a year, indicating neither strong economic strength nor weakness.

 

 

These readings support the Trend Asset Allocation Model’s shift to de-risk, but markets are not a complete disaster.

 

 

Cognitive dissonance

Two recent institutional investor surveys are highlighting a case of cognitive dissonance, the need for caution and the potential of a rush for the exits should risks materialize. The BoA Global Fund Manager Survey found that respondents were piling into value and cyclical sectors.

 

 

The IHS Markit Survey of Managers found a similar preference for cyclical exposure.

 

 

Here is where the cognitive dissonance comes in. The BoA Fund Manager Survey shows that the biggest tail-risk is a hawkish central bank. Why on earth would you stampede into cyclical stocks if you are worried about the Fed raising rates?

 

 

I pointed out before that equity investors face an elevated level of risk with value and cyclical stocks in the current environment (see Fade the value rebound). The market should gain greater clarity on this question after the January FOMC meeting next week. Notwithstanding the geopolitical risk of a Russia-Ukraine conflict, the FOMC meeting could represent an inflection point in risk appetite.

 

In conclusion, I am seeing signs of technical deterioration from a variety of sources, such as the Hindenburg Omen, a long-term Wilshire 5000 sell signal, and a Trend Asset Allocation Model downgrade. At a minimum, investment-oriented accounts should de-risk their portfolios and shift to a neutral equity weighting position consistent with their benchmark targets.

 

 

Painful enough for a bounce?

Posted by Cam Hui -

Mid-week market update: After this week’s brutal sell-offs, the stock market is oversold enough for a bounce. The VIX Index has risen above its upper Bollinger Band, which is an oversold market condition and short-term buy signal.
 

 

If the market action in the past year is any guide, the potential for the S&P 500 is the 4720-4750 zone.

 

 

Relief rally ahead

There are other signs that the market is due for a relief rally. The CBOE put/call ratio spiked to 1 or more in the last two days. These have been good indicators that risk/reward is tilted to the upside in the short run. In the past 18 months, the bullish resolutions of these buy signals (grey bars) have greatly outnumbered the bearish resolutions (pink bars).

 

 

Remember the carnage in the NASDAQ? The ratio of NASDAQ 100 to S&P 500 has become sufficiently oversold that the NDX is due for some better performance.

 

 

 

Not out of the woods yet

Despite the signs that the market is about to undergo a bounce, psychology may not be sufficiently washed out yet. Even as the put/call ratio rose to panic levels, the term structure of the VIX Index is showing a mixed picture. The 9-day to 1-month VIX inverted yesterday, indicating fear, but the 1-month to 3-month ratio remained upward sloping. These readings are not consistent with a durable bottom.

 

 

Similarly, the Fear & Greed Index is on the greedy side of neutral territory. Panic bottoms don’t look like this.

 

 

I had highlighted the sell signal from the intermediate-term breadth momentum oscillator. In the past, declines from this signal have ranged between 5% and 10%. The latest downdraft in the S&P 500 has only been -3.8% since the initiation of the sell signal. The bear leg from this signal may not be over.

 

 

Breadth indicators remain wobbly. All Advance-Decline Lines have broken down below their upside breakout levels, indicating broad-based weakness.

 

 

 

Opportunity and risk

In the short run, the market backdrop is more balanced between opportunity and risk. The effects of the Omicron wave appear to be peaking. Case counts in the UK, US, and Canada are starting to roll over, which is good news.

 

 

Q4 earnings season is proceeding. The market will experience both upside and downside volatility as individual companies report. The good news is forward EPS estimates are rising across all market cap bands.

 

 

On the other hand, Russia-Ukraine tensions are not abating. Russian troops are massing on the Ukrainian border in Belarus. The White House has warned that an attack could happen “on short notice”. US Secretary of State Anthony Blinken is scheduled to meet with Russian Foreign Minister Sergey Lavrov on Friday in Geneva. Neither side has indicated any hope of breakthroughs. The markets are understandably on edge and the tail-risk of an invasion could materialize at any time.

 

 

Don’t forget that the FOMC meeting is next week. Hawkish expectations are rising. The market expects four quarter-point rate hikes this year. Some strategists have even called for a half-point hike in March. Watch for signals about a reduction in the size of the Fed’s balance sheet from either the FOMC statement or from Powell during the press conference.
 

 

Subscribers received an alert this morning that my inner trader had closed his short position and stepped to the sidelines. He believes that the intermediate-term outlook is bearish and he will wait for a rally to re-enter his short position. While the market is oversold, the magnitude of downside risk far outweigh any short-term upside potential.

 

Reversals everywhere

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: Bullish
  • Trading model: Bearish

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

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

 

Fun with Japanese candlesticks

Last week’s market action in the S&P 500 was a classic lesson in the usefulness of Japanese candlesticks. I wrote last weekend that the market was oversold and due for a rebound. The S&P 500 cooperated on Monday by exhibiting a hammer candle, in which the market tanks but rallied to a level equal to or above the open. Hammer candles are indications of capitulation selling and a possible short-term bottom, but the pattern needs to be confirmed by continued strength the next day. The bottom was confirmed Tuesday when the index advanced and regained the 50 dma.

 

The second candlestick lesson came on Wednesday, when the S&P 500 showed a doji, when the open and closing levels are about the same. Doji candles are signs of indecision and possible reversals but must be confirmed the next day. The S&P 500 duly weakened Thursday and stabilized Friday ahead of the long weekend. All of this is occurring as the S&P 500 forms a triangle, which suggests that a big move is just around the corner.

 

 

In short, it was a master class in trading Japanese candlestick patterns. Not all candlesticks resolve in textbook manners, but they did last week.

 

 

Reasons to be bearish

Now that the bearish reversal is in place, the path of least resistance is down. The intermediate-term breadth momentum oscillator (ITBM) flashed a sell signal when its 14-day RSI recycled from overbought to neutral. In the past, these sell signals have been effective about three-quarters of the time.

 

 

My cautious outlook is supported by negative divergences in equity risk appetite indicators. In particular, speculative risk appetite for high-beta story growth stocks is tanking (bottom panel), which is bearish.

 

 

Breadth indicators are wobbly again. The NYSE Advance-Decline Line has been unable to regain its upside breakout level. Net NYSE highs-lows are negative again. The percentage of S&P 500 stocks above their 50 dma has deteriorated to the critical 50-60% zone that separates bullish and bearish trends.

 

 

Determining downside risk is always a difficult exercise. In the past, ITBM sell signals have resolved with pullbacks in the 5-10% range. In this case, a test of the 200 dma, which stands at about 4420 and represents about a 7% drawdown, is a reasonable guesstimate. However, the sell signal presented by the negative 14-month RSI divergence of the Wilshire 5000 has typically ended with corrections of up to 20%.

 

 

 

The earning season wildcard

A 20% pullback would involve a major bearish catalyst. A possible source of volatility is the Q4 earnings season. So far, consensus EPS estimates have been steadily rising.

 

 

With December headline CPI at 7.0% and headline PPI at 9.7%, one of the key questions for investors is whether companies can pass through increased costs. 

 

 

What about the effect of the Omicron wave? As an example, Bloomberg reported that lululemon revealed Omicron had dented its sales. Was LULU an exception or the start of a trend?

 

The company best known for its yoga pants said that it started the holiday season strongly. But then it suffered from several effects of omicron, including staffing shortages and reduced operating hours in certain locations. Even before the latest variant, consumer-facing companies were grappling with supply-chain snarl ups and not having enough workers. If these pressures continue, Lululemon won’t be the last to highlight the consequences. 

 

So far, companies with strong brands, such as Nike Inc., and with scale, such as Walmart Inc. and Target Corp., have been able to withstand the supply-chain challenges, while weaker firms have struggled to stay afloat. Last week, Bed Bath & Beyond Inc., which is in the midst of a turnaround plan, cut its sales and profit forecast.
Expectations are elevated, but companies have tended to manage expectations so they’ll surprise Street estimates. The very preliminary results are disconcerting. Four large financials reported Friday morning. JPMorgan beat on earnings and sales expecations. Blackrock beat on earnings but slightly missed on sales. Citigroup missed on both. Wells Fargo beat on both. Of the four stocks, only Wells Fargo advanced.

 

 

The geopolitical wildcard

The other major source of market risk is geopolitical instability over Ukraine. US-Russia talks on the issue broke up with the Russian side characterizing the discussions at a “dead end”. Russian troops have been massing on the Ukrainian border and the muddy season is ending soon. The window for an invasion will open as soon as the ground firms.

 

A discussion of whether an invasion is justified is beyond my pay grade, but Adam Tooze of Columbia University recently outlined the challenges the West faces with Russia. Simply put, economic sanctions are not a very useful levers for two reasons. First, Russia has a strong foreign exchange reserve position.
 

Hovering between $400 and $600 billion they are amongst the largest in the world, after those of China, Japan and Switzerland.

 

This is what gives Putin his freedom of strategic maneuver. Crucially, foreign exchange reserves give the regime the capacity to withstand sanctions on the rest of the economy. They can be used to slow a run on the rouble. They can also be used to offset any currency mismatch on private sector balance sheets. As large as a government’s foreign exchange reserves may be, it will be of little help if private debts are in foreign currency. Russia’s private dollar liabilities were painfully exposed in 2008 and 2014, but have since been restructured and restrained.

 

 

As well, Russia is too big to effectively sanction. More importantly, it will continue to accumulate reserves as long as oil prices stay above $44 a barrel.

 

Russia is a strategic petrostate in a double sense. It is too big a part of global energy markets to permit Iran-style sanctions against Russian energy sales. Russia accounts for about 40 percent of Europe’s gas imports. Comprehensive sanctions would be too destabilizing to global energy markets and that would blow back on the United States in a significant way. China could not standby and allow it to happen. Furthermore, Moscow, unlike some major oil and gas exporters, has proven capable of accumulating a substantial share of the fossil fuel proceeds…

 

Putin’s regime has managed this whilst operating a conservative fiscal and monetary policy. Currently, the Russian budget is set to balance at an oil price of only $44. That enables the accumulation of considerable reserves.
Even as the Ukrainian story occupies the front page, an equally important geopolitical development that is on back pages is the recent crisis in Kazakhstan. From the Kremlin’s point of view, Kazakhstan represents a vital Russian interest for a number of reasons. First, it has an enormous border with the Russian Federation. About 20% of the population are ethnic Russian and political instability will create a refugee crisis for Russia. As well, several Soviet-era space launch sites that are still being used by Russia are located in Kazakhstan and the country is a major producer of uranium.

 

 

While Kazakhstan’s independence from the Soviet Union was relatively smooth economically, it has been ranked as one of the top countries for corruption. It is, therefore, no surprise that NGOs such as George Soro’s Open Society Foundation and the US-based National Endowment for Democracy (NED) funded democracy movements in the country. However, the NED has the unfortunate history of being spun out of the CIA during the Reagan years because it was felt that the CIA should not be seen as directly supporting pro-democracy movements in other countries. In the past, the NED has supported “color revolutions” in former Soviet republics, which has cast suspicion on the organization, especially to a former KGB officer like Vladimir Putin.

 

The Russians recently sent about 2,000 paratroopers to stabilize the situation in Kazakhstan when mass protests erupted over fuel price increases and the troops began withdrawing last week after accomplishing their mission. Nevertheless, Putin could view the Kazakh protests as covert American intervention in a former Soviet republic that is of vital interest to Moscow, which raises the temperature of the Ukraine situation.

 

I don’t want to over emphasize Russia’s role in the world. Russian GDP is roughly the same size as Italy’s. However, geopolitical tail-risk is probably higher than the market is discounting and an invasion could spark a major risk-off episode in the markets.

 

In conclusion, the tone of the market is turning bearish. Technical internals are deteriorating and my base case scenario calls for a 5-10% pullback in the coming weeks. A downdraft of 20% represents an outlier case but would need a major bearish catalyst such as severe earnings disappointments or the emergence of geopolitical risk.

 

 

Disclosure: Long SPXU

 

Fade the value rebound

Posted by Cam Hui -

In the past week, several readers have asked whether it’s too late to be buying financials, value, and other cyclical stocks. In reply, I highlighted the recent Mark Hulbert column, “Value stocks now are beating growth by 10 points, but the easy money might be behind us”, namely that the value/growth reversal may not necessarily have legs.
 

I analyzed value’s relative strength back to 1926, courtesy of data from Dartmouth College professor Ken French. On average, a given month’s relative strength persisted for just one month. With holding periods lasting two or more months, value’s performance against growth was only randomly related to what came before…

 

So if you’re keeping score for these three instances in which value beat growth by as much as it has recently, there’s one case in which value relative strength continued, one in which it reversed itself, and one in which there was no trend one way or the other. Good luck extrapolating that into the future.

 

 

Here are some other reasons to fade the value rebound.

 

 

Value’s cyclical beta

First, it’s important to understand how the beta of value stocks to interest rates. The returns of the Rising Rates ETF (EQRR) is highly correlated to the 10-year Treasury yield, both on an absolute basis and relative to the S&P 500. The sector weights of EQRR are also coincidentally concentrated in sectors considered to be cyclically sensitive and value-oriented.

 

 

As well, consider how value stocks are positioned within the S&P 500. Growth sectors, which consist of technology, communication services, and Amazon and Tesla, which are two large-cap stocks within the consumer discretionary sector, make up 44.9% of the S&P 500 index weight. By contrast, value sectors, which are financials, industrials, consumer discretionary ex-AMZN and TSLA, energy, and materials, are only 30.8% of index weight. While value stocks are generally cheaper than growth stocks on a variety of valuation metrics, value stocks are also highly concentrated in cyclical sectors and industries.

 

 

With the index weight analysis in mind, the relative weight difference between growth and value also means that any sudden or large scale rotation from growth to value will produce a sudden spike in relative performance, which is what happened recently.
 

Longer-term, however, there are two key drivers of value and growth stock relative performance, bond yields and the yield curve, and the cyclical outlook for the economy.

 

 

The Fed turns hawkish

Let’s begin with the interest rate outlook. The Federal Reserve has been active in its communication strategy in telegraphing its next move. Monetary policy has pivoted from an accommodative to a tightening stance. Fed Funds futures are now discounting four quarter-point rate hikes in 2022, which is a distinct change from six months ago when expectations called for a possible rate hike at the end of 2022.

 

 

In addition to its restrictive views on interest rate policy, the Fed is also turning hawkish on the withdrawal of balance sheet stimulus. Fed Chair Jerome Powell stated during his Senate re-confirmation hearings last week that while no firm decision has been made on the Fed`s balance sheet, otherwise known as quantitative tightening (QT), “At some point, perhaps later this year, we will start to allow the balance sheet to run off.”

 

Passive QT may sound benign, but it really isn’t. Passive QT calls for allowing securities to mature without reinvesting the proceeds while refraining from active selling the Fed’s holdings. However, its effects of are different from the last passive QT round after the GFC. Alfonso Peccatiello pointed out that the structure of the Fed’s balance sheet is highly concentrated in shorter maturities. A strategy of pure passive QT would see over $1 trillion roll off the Fed’s balance sheet in 2022 and a total of $2 trillion in the 2022 and 2023. That’s a lot of tightening.

 

 

The bond market has reacted to the Fed’s increasingly restrictive bias. Bond yields pulled back after the initial spike. More importantly, the 2s10s yield curve flattened after an initial steepening reaction and the 5s30s have been flattening for about a month. The flattening yield curve is an expectation of slower economic growth.

 

 

Nevertheless, the Fed is facing growing pressures to be more hawkish in the face of rising inflation. A chorus of former Fed officials called for a stronger tightening response. The WSJ reported that former Fed governor Laurence Meyers believes the Fed is at risk of being behind the inflation-fighting curve.

 

It isn’t so much inflation today that’s the problem. What they want to make sure is that they haven’t let the situation get out of hand, where once the supply-based inflation has come down, demand-based inflation tells them they should have gone sooner or faster.

Former New York Fed President Bill Dudley wrote in a Bloomberg Op-Ed that the Fed’s latest economic projections amount to a dovish “fantasy” that inflation can return to 2% with rates gently rising up to 2% over the same three-year timeframe. The Fed may need to raise rates four times this year.

 

Former Fed governor Frederic Mishkin expressed his opinion in the Financial Times that the Fed misjudged demand last year and poorly executed its new flexible average inflation targeting framework.

 

There are no doves left on the FOMC. Even über-dove San Francisco Fed President Mary Daly expressed support last week for a March rate hike. Charles (“don’t hike until you see the whites of inflation’s eyes”) Evans of the Chicago Fed raised concerns about price stability and stated, “Because inflation has stayed higher and longer we have to take action quicker than I thought.”

 

Here is why this matters to value stocks. The relative performance of financial stocks is especially sensitive to the shape of the yield curve. A steepening curve, which is the bond markets signal of a strong economy, is positive for the sector because banks borrow short and lend long. A steepening yield curve is positive for lending margins. Conversely, a flattening yield curve is negative for financial stocks. The Fed’s hawkish pivot on both rate hikes and its balance sheet indicates it has entered a tightening cycle, which is negative for the growth outlook. A tightening cycle is designed to cool off economic growth, which should result in a flattening yield curve, not a steepening one.

 

 

 

The cyclical outlook

Notwithstanding the effects of a tightening cycle, what about the organic cyclical outlook, which is also important to value stocks?

 

The Citigroup US Economic Surprise Index, which measures whether economic data is beating or missing expectations, has rolled over after recovering from a negative reading in Q4.

 

 

Cyclically sensitive industries are not showing any signs of relative strength except for energy stocks. Most cyclical industries are trading sideways relative to the S&P 500. Is this what market leadership looks like?

 

 

Looking globally, the relative performance of the stock markets of the major energy- producing countries has been correlated to oil prices, but they are also trading sideways to down relative to the MSCI All-Country World Index. 

 

 

Moreover, the cyclically sensitive copper/gold ratio has been trading sideways, which is another signal of lackluster economic growth.

 

 

The final nail in the coffin of the cyclical trade comes from Barron’s in the form of the contrarian magazine cover indicator. Barron’s turned bullish on commodities.

 

 

 

Focus on quality

If equity investors were to fade the value rebound, how should they be positioned?

 

In addition to an underweight position in value and cyclical sectors, investors should focus on the quality in their equity portfolios. There are many ways to define quality, one simple way is profitability. Standard & Poors has a stricter index profitability inclusion criteria for stocks than Russell. Comparing S&P and Russell indices, the large-cap quality factor began to outperform in late 2021 and a similar measure rose coincidentally for small-cap stocks.

 

 

Even within the growth and value universes, quality matters. The S&P growth and value indices started to beat their Russell counterparts in November (bottom two panels). In addition, there was a minor divergence between the Russell 1000 Value to Growth ratio and the S&P 500 Value to Growth ratios, indicating that high-quality growth stocks performed better during the value rebound (top panel).

 

 

In summary, the economy is transitioning to a mid-cycle phase of its expansion. Economic and earnings growth momentum are fading after the initial V-shaped recovery in stock prices. Short rate pressures are rising, but cyclical relative strength, as measured by the commodity/stock (CRB/S&P 500) ratio, is flat. Similar episodes in 1994, 2004, and 2010 resolved themselves with sideways and choppy stock markets. Investors should not expect superior performance from value and cyclical sectors. Instead, focus on stocks with quality growth characteristics and defensive names.

 

 

 

A buy signal AND a sell signal

Posted by Cam Hui -

Mid-week market update: In my update last weekend (see Waiting for the sell signal), I observed that the S&P 500 was oversold and due for a relief rally. The market cooperated by printing a hammer candle on Monday, which is a capitulative reversal indicator, and confirmed the reversal with a bullish follow through on Tuesday by recapturing the 50-day moving average. The index finished the move today with a doji candle, which indicates possible indecision.
 

 

That was the buy signal. There was also a sell signal.

 

 

Time to sell?

On the weekend, I also highlighted a possible deterioration in the intermediate breadth momentum oscillator (ITBM). I was waiting for the 14-day RSI of ITBM to recycle from overbought to neutral as a sell signal for the market. 

 

I got the signal on Tuesday. The chart below shows ITBM sell signals in grey for bullish outcomes and in red for bearish outcomes. The sell signals have been correct about three-quarters of the time. 

 

 

In addition, Ed Clissold of Ned Davis Research pointed out that NDR Trading Composite Sentiment is still in neutral. Trader sentiment isn’t washed out yet and there is more room on the downside for stock prices.

 

 

Similarly, all the components of my market bottom model are also neutral. If the stock market were to experience a downdraft, there is lots of downside potential before a bottom can be reached.

 

 

Jason Goepfert at SentimenTrader observed that defensive sector breadth is exhibiting an off-the-charts level of internal momentum. 

 

 

He did add a caveat that these conditions are not necessarily bearish.

 

It’s assumed that if investors are so hyper-focused on defensive stocks, it’s a bad omen for the broader market. Not to be. While the S&P 500 didn’t exactly go gangbusters after these signs of long-term internal momentum in the defensive sectors, it still showed above-average returns. 
I interpret these readings as the bears are seizing control of the tape. The combination of neutral sentiment and a loss of intermediate momentum raises the odds of an air pocket for equity prices in the near term. Subscribers received an email alert today that my inner trader had initiated a short position in the S&P 500.

 

 

Disclosure: Long SPXU

 

Waiting for the sell signal

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 be found here.

 

 

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

 

 

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

 

No sell signal yet

The S&P 500 took fright last week when the December FOMC minutes revealed a hawkish pivot and the stock market sold off. While I have become more cautious in the past few weeks, technical indicators have not flashed any intermediate-term sell signals just yet.

 

As an example, the NYSE McClellan Summation Index (NYSI) is only recycling from an oversold condition. In the last 20 years, few instances have resolved in a bearish manner (red vertical lines) and most have seen the market advance (black lines).

 

 

The market is increasingly vulnerable to a setback, but there is no need to become overly bearish just yet. Traders should wait for a sell signal first.

 

 

A vulnerable market

As an illustration of the market’s vulnerability, Mark Hulbert reported that newsletter writer sentiment remain stubbornly bullish despite last week’s air pocket, which is contrarian bearish.

 

 

The December Jobs Report provided a picture of an economy at full employment and gave the Fed another reason to tighten rates. The unemployment rate fell to 3.9%, compared to a pre-pandemic level of 3.5%, the Fed’s SEP forecast of 4.3% for 2021, 3.5% for 2022, and a long run unemployment rate of 4.0%. The U6 unemployment rate, which includes discouraged workers, fell to 7.3% compared to a pre-pandemic level of 6.9%. Average hourly earnings was also strong, indicating strong wage pressures.

 

 

For an intermediate-term technical perspective of the market’s outlook, consider the evolution of price momentum. The S&P 500 has enjoyed a remarkable run since the March 2020 bottom. The percentage of S&P 500 stocks above their 200 day moving averages (dma) rose to over 90%. Past episodes (shaded areas) saw the market advance as internals flashed a series of “good overbought” conditions. Momentum began to fade in mid-2021 when the percentage of stocks above their 200 dma deteriorated below the 90% level. If history is to be any guide, this should resolve in a relatively benign manner. Cyclical indicators such as the ratio of consumer discretionary to staple stocks and the copper/gold ratio are trading sideways, indicating little macro stress. Investors should therefore expect a return to an environment of normal equity risk of 10% drawdowns. However, all of these episodes of fading price momentum have not ended until the percentage of S&P 500 stocks above their 50 dma have fallen to 20% or less (bottom panel).

 

 

I am waiting for the next shoe to drop.

 

 

 

Remarkable resilience

To be sure, market internals have begun to deteriorate and the bulls are losing control of the tape but the market remains resilient. The S&P 500 achieved new highs while flashing negative RSI divergences. What is remarkable, however, is the strength in breadth. While breadth internals were negative a month ago, they have recovered since. NYSE highs-lows have risen from negative to positive. In addition, the percentage of S&P 500 stocks above their 50 dma is showing strength and well above the 50-60% zone that indicates short-term weakness.

 

 

Tactically, I am monitoring the intermediate-term breadth momentum oscillator (ITBM) for a sell signal. The 14-day RSI of ITBM is still in the overbought zone and a recycle back to neutral would constitute a sell signal. There have been 20 sell signals in the last five years, The market fell in 14 cases (red lines) and rose in six (grey lines), which is a remarkable record for this indicator. If and when this indicator flashes a sell signal, there will be plenty of downside opportunities left for short sellers to profit from.

 

 

My Trend Asset Allocation Model remains at a risk-on reading for now. As a reminder, trend following models are not designed to spot the exact market top or bottom but to identify the trend. The trend remains weakly bullish. While I am not inclined to front-run model readings, I expect it will be downgraded to neutral in the coming weeks.

 

 

A bounce first?

The stock market may be due for a relief rally before an intermediate-term sell signal. The S&P 500 reached an oversold level on its 5-day RSI as it tested its 50 dma on Friday.

 

 

The recently beaten up growth stocks may be due for a bounce as well. The trailing 12-month return of NASDAQ 100 to S&P 500 is nearing a relative support zone that has seen the NASDAQ 100 rally strongly.

 

 

The health of any possible bounce will depend on the evolution of market internals. I will monitoring them for signs of either positive or negative divergences.

 

 

Bearish tripwires

What does this mean for market participants? Investment-oriented accounts should take the opportunity to sell into strength and de-risk portfolios by reducing equity weights and rotating from high-beta into low-beta stocks. Traders should not turn bearish prematurely and wait for a sell signal first.

 

What could turn the market tone even more bearish?

 

Both Jerome Powell and Lael Brainard are expected to testify before the Senate next week in their confirmation hearings as Fed Chair and Vice Chair. While both are experienced central bankers who are unlikely to unintentionally let slip market moving remarks, anything is possible.

 

As well, all eyes will be on the CPI report due on Wednesday. Any hint of a hot inflation pressure will give the hawks on the FOMC more reasons to tighten. The current consensus expects a core YoY CPI of 5.4% and headline CPI of 7.0%, which are high bars for the inflation rate to clear.

 

In addition, the Omicron variant is running wild throughout the world. Researchers at Columbia University are projecting a rapid surge of US cases that peak between the first and third week of January. US case count is expected to peak at between three and eight million. This has the potential bring the economy to a screeching halt.

 

 

A wildcard is the news that French researchers have identified a new COVID variant B.1.640.2, dubbed IHU because it was found by a team from Méditerranée Infection University Hospital Institute (IHU) in Marseilles.

 

Not much is known about IHU. It was found in a vaccinated male patient who returned to France from Cameroon, developed mild symptoms, and it spread to 11 others. It’s far too early to panic over IHU. It’s unclear whether it’s more virulent or deadly than Omicron. In fact, it may be relatively benign as its identification predates Omicron. IHU was first sequenced on November 4, almost three weeks before Omicron was identified and sequenced.

 

While IHU may not be cause for panic, the real tragedy can be found in the November JOLTS report. Healthcare workers have been quitting in droves and at a higher rate than the overall quits rate, which has already skyrocketed. Healthcare workers are leaving just when we desperately need them and leaves us increasingly vulnerable to the emergence of new variants.

 

 

In closing, the market has become increasingly vulnerable to more setbacks. Equity risk appetite indicators (top panel) began diverging from the S&P 500 in early December. As a measure of extreme risk appetite, the bottom panel shows the relative performance of speculative growth stocks, as proxied by ARK Innovation ETF (ARKK) and the Social Sentiment ETF (BUZZ) against small-cap value stocks, which severely lagged the S&P 500 in 2021. These extreme risk appetite indicators are still falling, indicating further weakness in sentiment and internals. The bears are seizing control of the tape.

 

 

Long-term investors should position themselves cautiously by reducing equity weights. Traders, on the other hand, should not be overly eager to turn bearish. Wait for the tactical sell signal first.

 

2022 = Twenty-Twenty, Too?

Posted by Cam Hui -

As 2021 drew to a close, the broadly based Wilshire 5000 flashed a particularly long-term sell signal in the form of a negative 14-month RSI divergence. The last time this happened was in August 2018 (see Market top ahead? My inner investor turns cautious). Stock prices continued to rise for another two months before it hit an air pocket. In the past, a bearish event can take as long as a year. What does this mean for stocks in 2022?
 

 

The bond market may fare better in the coming year. The Barclays Aggregate Index unusually fell last year and it has never exhibited two consecutive years of negative returns (warning: n=3).
 

 

What does this mean for asset prices? Will 2022 be equity bearish and volatile and become Twenty-Twenty Too?

 

 

A bond tantrum

The latest source of market angst was sparked by the release of the December FOMC minutes. Further bad news came with the release of December Jobs Report, which had all the signs of full employment that allowed the Fed to raise rates. Even San Francisco President Mary Daly, who is viewed as a dove, believes the economy is nearing full employment and was in favor of raising rates: “I’m of the mind that we might need to, likely will need to, raise interest rates … in order to keep the economy in balance”.

 

The Treasury market threw a tantrum last week when both the 10 year Treasury yield broke up through resisance and the 30 year Treasury yield surged above its falling channel. In addition, the 2s10s yield curve steepened, indicating that the market expects better economic growth as the Fed “gently” tightens monetary policy. On the other hand, the 5s30s had the opposite gentle flattening reaction to the FOMC minutes.

 

 

A similar minor divergence is appearing between the Economic Surprise Index, which is stalling, and the 10-year Treasury yield, which is rising.
 

 

I interpret this to mean that investors should fade the bond market’s rising yields. The combination of a hawkish Fed and a loss of economic momentum is a recipe for slower growth and lower rates.

 

 

Defensive stocks take the lead

The stock market’s internals are also telling a similar story of caution. An analysis of the changing leadership of different parts of the stock market was highly revealing. 

 

Starting with the defensive sectors, their relative performance is showing signs of emerging leadership. All are forming saucer-shaped relative bottoms against the S&P 500, indicating that the bears are wrestling control of the tape away from the bulls.

 

 

The leadership pattern of value and cyclical sectors looks a little better. In particular, the relative performance of financial stocks is the most correlated to the shape of the yield curve, mainly because banks borrow short and lend long. A steepening yield curve, therefore, enhances banking profitability. The other value and cyclical sectors are all exhibiting sideways basing patterns, though there have been some short-term recoveries, such as the one shown by energy stocks.

 

 

A more detailed look at the relative performance of cyclically sensitive industries tells a different story. Most have been trading sideways against the market and show no definitive signs of strong leadership.

 

 

From a global perspective, even though commodity prices are holding up well, the relative performance of the equity markets of resource producing countries to the MSCI All-Country World Index (ACWI) are all flat to down. This is additional confirmation that cyclical exposure is to be avoided.

 

 

What about growth stocks? They look downright ugly. Growth sectors are either rolling over or in decline on a relative basis.

 

 

In short, stock market internals are turning risk-off. This is consistent with a hawkish interpretation of Fed policy. The market is already discounting three quarter-point rate hikes this year and a discussion of quantitative tightening, or a reduction in the size of the Fed’s balance sheet, may not be very far behind.

 

 

Investment implications

Here is what this means for investors. Position for slower growth, at least for the first half of 2022. This means:

 

  • A flattening yield curve and long bond duration, or maturity, 
  • Long USD in response to a hawkish Fed;
  • Long defensive sectors of the equity market; and
  • Long large-cap growth stocks as duration plays for their interest rate sensitivity.
Equity investors should also brace for greater volatility. The S&P 500 exhibited a drawdown of only -5.2% in 2021, which is well below average. The S&P 500 rose over 10% for the last three consecutive years, which is an unusual condition. Even on those occasions, which saw the market advance in four out of five instances since 1928, the average drawdown in the fourth year was -13.5% and the lowest was -6.8%.

 

 

To be sure, a flattening yield curve is a signal of slower economic growth. In all likelihood, COVID-19 fueled inflation pressures will begin to fade about mid-year, which will allow the Fed to reverse course on monetary tightening. Prepare for a dovish and cyclical pivot in the summer or autumn. This scenario is consistent with the historical mid-term election year pattern of a choppy market for the first nine months, followed by a rally into year-end.

 

 

 

Why I am cautious

Posted by Cam Hui -

Mid-week market update: As 2022 opens, I have become increasingly cautious about the stock market. The put/call ratio (CPC) is a bit low, indicating rising complacency. Past instances of a combination of a rapidly falling CPC and low CPC have seen the market struggle to advance. While this is not immediately bearish, it is a flag for caution.
 

 

Here are some other reasons why I am cautious.

 

 

Bearish triggers

The current sentiment backdrop can be best described as a “this will not end well” story. Such conditions can persist for months and the stock market can continue to consolidate or even advance if there is no bearish trigger. Here are some possible bearish triggers to consider.

 

Nouriel Roubini worried about the combination of monetary policy normalization and a litany of risks that could unsettle markets in a Project Syndicate essay.

 

As long as central banks were in unconventional policy mode, the party could keep going. But the asset and credit bubbles may deflate in 2022 when policy normalization starts. Moreover, inflation, slower growth, and geopolitical and systemic risks could create the conditions for a market correction in 2022. Come what may, investors are likely to remain on the edge of their seats for most of the year.
Indeed, the FOMC minutes conveyed a hawkish tone, beginning with a faster pace of rate hikes, followed by quantitative tightening, or a reduction in the Fed’s balance sheet [emphasis added].

 

Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures. These participants noted, however, that a measured approach to tightening policy would help enable the Committee to assess incoming data and be in position to react to the full range of plausible economic outcomes.

In particular, the quantitative tightening debate is now on the table at the FOMC.

 

Some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process, especially in light of abundant liquidity in money markets and elevated usage of the ON RRP facility.

Conditions are ripe for a less accommodative monetary policy. The November JOLTS report printed a record level of quits. Moreover, the hires to quits rate have been steady, indicating that people are not quitting to leave the labor force, but to another job. These are the signs of a strong labor market.

 

 

While data history is limited, both temp employment (blue line) and the quits/layoffs ratio (red line) have led non-farm payroll employment (black line). The latest JOLTS report showed that a soaring quits/layoffs ratio. The Fed will interpret these conditions as signals of an economy nearing full employment.

 

 

 

The popping speculative growth bubble

In addition, the popping of the speculative growth stock bubble could be the source of tail risk for the market. Bridgewater outlined the risks in a recent research note.
 

As the Fed has shifted toward tapering and a slowing in the flood of liquidity has begun to get priced in, we are seeing cracks emerge in the bubbliest segments of the market.

 

As we have noted before, the unprecedented flood of liquidity following COVID has caused our bubble measures to flash red in certain pockets of global markets. We have studied bubbles and built measures of whether economies or individual markets are in them. By our measures, there are likely bubbles in emerging technology stocks, SPACs, cryptocurrencies, NFTs, collectibles, etc. These bubbles have been particularly pronounced in the US, where households piled savings into the markets as their incomes were supported by massive government checks, their spending was curtailed by the lockdown, and lower-cost trading driven by competition and technology made investing (and speculation) easier than ever before.

 

 

Of the several key risks that Bridgewater outlined, there are two that I am most concerned about:

  • Forced retail liquidation effect: “If the bubble turns, retail traders, especially those who have used leverage either directly or via options, may be forced to liquidate other positions, widening the breadth of the sell-off.”
  • Cash generative large-cap growth stocks are not immune to a popped bubble. “These [startup] companies, as well as the broader venture capital ecosystem, have important implications for the earnings of the most important companies in the S&P 500. As shown below, early stage companies deploy a significant share of their cash on things like cloud services and online advertising, which then ends up being revenue for the US tech giants… customer acquisition (Facebook, Google) and cloud providers (Amazon, Microsoft), these companies end up earning significant profits from startup spending.”

 

 

 

Santa Claus has left the building

In conclusion, I don’t mean to imply that the market is about to crash, but the stock market is vulnerable to a setback. I don’t know if today’s risk-off reaction to the release of the FOMC minutes is the bearish trigger. 
 

Subscribers received an alert that my inner trader sold all his long positions yesterday and stepped to the sidelines, citing event risks such as the release of the FOMC minutes today and Friday’s NFP report. If this is the start of a major bear leg, my inner trader is waiting for the sell signal and believes there will be sufficient time to profit accordingly in a falling market.
 

A “penny wise, pound foolish” application of the Trend Model

Posted by Cam Hui -

I received a number of responses to the post on the 2021 report card on my investment models. While most were complimentary, one reader asked me for a more aggressive formulation of the Trend Asset Allocation Model. 
 

As a reminder, the signals of the Trend Model are out-of-sample signals, but there are no portfolio returns to publish, mainly because I don’t know anything about you. I know nothing about your return targets, your risk tolerance and pain thresholds, your tax situation, or even the jurisdiction you are in. If I offered an actual portfolio, it would be a formal prospectus document outlining what to expect.

 

Instead, the backtested returns are based on a specific formula for constructing a balanced fund portfolio based on Trend Model scores and reasonable risk assumptions of an average investor with a 60% stock/40% bond asset allocation.

  • Risk-on: 80% SPY (S&P 500), 20% IEF (7-10 Treasuries)
  • Neutral: 60% SPY, 40% IEF
  • Risk-off: 40% SPY, 60% IEF
An advisor or portfolio manager could then change the equity allocation by 20% depending on the Trend Model score without Compliance tapping him on the shoulder.

 

The historical backtest of the Trend Model using this portfolio construction technique yielded excellent results. An investor using this approach could achieve equity-like returns while bearing balanced fund-like risk. Needless to say, this backtest is just a proof of concept. Every investor is different and your mileage will vary.

 

 

A reader then asked me to backtest a more aggressive approach to portfolio construction. Instead of a 60% SPY and 40% IEF benchmark, he suggested a 100% equity position, based on 60% SPY and 40% defensive equity substitute for bonds. The defensive portfolio consists of an equal-weighted portfolio of XLV (Healthcare), XLP (Consumer Staples), XLU (Utilities), and XLRE (Real Estate).

 

The results turned out to be a case of “penny wise, pound foolish”.

 

 

The value of diversification

I re-ran the backtest using the same signals but with different portfolio construction rules. In my results, I dubbed the 60% SPY and 40% defensive equity portfolio the “Hybrid 60/40” and the portfolio constructed using the Trend Model using the defensive equity portfolio component the “All Equity Model”.

 

 

The good news is the Trend Asset Allocation Model worked as expected.
  • The All Equity Model had the best returns. It beat the Hybrid 60/40 and the 100% SPY benchmark over the study period.
  • The All Equity Model outperformed the Hybrid 60/40 benchmark, indicating that it was able to distinguish between risk-on and risk-off episodes.
The bad news is there are major caveats to the results.
  • The outperformance exhibited by the Original Model was far better than the All Equity Model. The Original Model beat its benchmark by 4.2% over the study period compared to 1.6% alpha by the All Equity Model. Moreover, the Original Model’s outperformance was far more consistent than the outperformance of the All Equity Model against its benchmark.
  • The All Equity Model exhibited equity-like maximum drawdowns. Even though returns were better, the maximum drawdown for the All Equity Model was similar to the S&P 500 benchmark.
  • The Original Model had better risk-adjusted returns. Even though the All Equity Model had better returns, an investor using the Original Model could achieve a similar return level by employing modest leverage with lower risk, as measured by either standard deviation or maximum drawdown.
The last point illustrates the value of stock-bond diversification. The Original Model used a combination of stocks (S&P 500) and bonds (7-10 year Treasuries) as portfolio building blocks. Stocks and bonds are less correlated to each other than the S&P 500 and a portfolio of defensive stocks, mainly because the latter are stocks and therefore more correlated to the S&P 500. Applying a market timing model to less correlated assets is more valuable than applying the same timing model to correlated assets.

 

In conclusion, this exercise was a lesson in the value of diversification. Applying a market timing model which works to less correlated assets will add more value than applying the same timing model to correlated assets.

 

The moral of this story? Pay attention to diversification when constructing a portfolio. Even though you may have a tool such as the Trend Asset Allocation Model that works, using it improperly can lead to a “penny wise, pound foolish” result.

 

Don’t overstay the party

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 be found here.

 

 

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

 

 

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

 

Edge towards the exit

Happy New Year! I hope you are enjoying the seasonal rally, but don’t get overly complacent about the party that the bulls are throwing. Sufficient warning signs are appearing that it’s time to edge towards the exit.

 

Exhibit A is the relative performance of the top five sectors of the S&P 500. These sectors comprise over three-quarters of index weight and it would be impossible for the S&P 500 to rise or fall without the leadership of a majority of sectors. As the accompanying chart shows, none of the sectors are in a relative uptrend. The most bullish pattern is technology, which is trading sideways compared to the S&P 500.

 

 

Once the seasonal strength fades, what happens to the market?

 

 

Warnings everywhere

Despite the recent market strength, warnings are appearing under the hood. The most disturbing development is the long-term sell signal shown by a negative 14-month RSI divergence as the Wilshire 5000 rose to an all-time high. In the past, the MACD histogram rising from negative to positive has been a very good buy signal, and negative 14-month RSI divergences have been reasonable cautionary signals. The last negative divergence occurred in August 2018 (see Major top ahead? My inner investor turns cautious). This is a long-term signal and a market top may not be apparent for some time. The stock market continued to rise for another two months before it hit an air pocket. In the past, the lag can be as much as a year.

 

 

Other market internals are flashing intermediate-term warnings. Equity risk appetite, as measured by the relative performance of equal-weighted consumer discretionary to consumer staples, and the relative performance of high beta to low volatility stocks, are not confirming the fresh highs set by the S&P 500.

 

 

The relative performance of defensive sectors is also raising concerns. The relative returns of these sectors surged and became overextended when the S&P 500 hit an air pocket in mid-December. They have pulled back but their relative performance is improving again. This is a sign that the bears haven’t lost control of the tape.

 

 

A closer look at selected defensive sectors tells the story of lurking bears. Consumer Staples, which is a classic defensive sector, rose to fresh all-time highs and its performance compared to the S&P 500 is forming a saucer bottom. Relative breadth (bottom two panels) is also showing signs of improvement.

 

 

Healthcare is showing a similar pattern of new highs, a bottom in relative performance, and improving relative breadth.

 

 

I could go on, but you get the idea.

 

 

Temporary bullish tailwinds

In the short run, asset prices have also been supported by fresh liquidity from the Federal Reserve. According to the New York Fed, the Fed balance sheet rose by almost $140 billion month-to-date to December 21.

 

 

Wait, what? Isn’t the Fed supposed to be tapering its QE program? Didn’t the FOMC announce that it was reducing its asset purchases from $120 billion to $105 billion per month? Is this some sort of nefarious Deep State plot?

 

Actually, the Fed’s balance sheet faces substantial maturities between December 15 and December 31. The $140 billion in purchases was intended to offset the maturity of assets rolling off the balance sheet before year-end.

 

 

Nevertheless, the purchase of nearly $140 billion by the Fed temporarily injected a substantial amount of liquidity into the system, which should have had a bullish effect on asset prices. This effect will fade in January.

 

 

Wait for the sell signal

I interpret these conditions as the stock market is poised to weaken. Investment-oriented accounts should begin to de-risk now. Returning to the party metaphor, the celebrations are getting out of hand and the neighbors have called the police. It’s time to gather friends and relatives and prepare to leave.

 

I had highlighted an uncanny buy signal in mid-December. The NAAIM Exposure Index, which measures the sentiment of RIAs, had fallen below its 26-week lower Bollinger Band. Virtually all past episodes have been strong tactical buy signals with minimal S&P 500 downside risk. The last buy signal worked out perfectly. In the past, the return of the NAAIM Exposure Index back to its 26-week moving average (wma) has been a good spot to lighten long positions as the bullish momentum begins to fade, which it did last week. Readings have risen higher in the past, but risk/reward becomes less attractive at the 26 wma.

 

 

While investors should begin to lighten equity positions, traders may want to stay at the party for one more round. There may be further upside in January. Historically, the beginning of the year sees strong seasonal flows.

 

 

Tactically, S&P 500 intermediate breadth momentum reached an overbought reading. But selling now may be premature. Historically, a better sell signal occurs when this indicator recycles from overbought back to neutral.

 

 

In conclusion, investment-oriented accounts should begin to de-risk their portfolios by reducing their equity weights and lowering the beta of their equity portfolios. Short-term traders may want to stay at the bulls’ party a little longer and wait for a sell signal to turn bearish.

 

 

Disclosure: Long SPXL

 

>

Don’t fight the (hawkish) Fed

Posted by Cam Hui -
As the S&P 500 rises to fresh all-time highs, an important risk is lurking in the form of a more hawkish Fed. Inflation is running hot. When the Fed was officially in the transitory camp earlier this year, inflation pressures were concentrated in only a few components such as used cars. Today, price increases are broadening and even core sticky price CPI (red line) is rising strongly. As a consequence, the Fed made its hawkish pivot and signaled that it is on pace to end its QE program by March 2022, even though inflation expectations (black line) remain well-anchored.

 

 

The market is now discounting three rate hikes in 2022, with lift-off to begin in March. Here is how the Fed turned hawkish.

 

 

 

A no-surprise Federal Reserve

Former Fed economist Claudia Sahm wrote that the Fed doesn’t like to surprise markets. She outlined the steps it takes to prepare the markets for policy shifts [edited for brevity].
 

Ok, so what does “laying the groundwork” mean? Top Fed officials start ‘dropping hints’ into their speeches, emphasizing the change in economic conditions that warrant the shift. It can be confusing with five Board members and twelve Reserve Bank Presidents who are constantly talking publicly. Here’s my cheat sheet.

 

Order of importance:
  1. Fed Chair (Jay Powell)
  2. Vice-Chair of the Board (Rich Clarida)
  3. Federal Reserve Bank President of New York (John Williams)
A unique feature of the Powell Fed is there’s another key official to watch:

 

Board member, Lael Brainard.

 

Jay elevated Lael to “Troika,” which traditionally includes the Chair and the three roles above. So currently, it’s more of a “Quad” setting the agenda. I would put Brainard’s importance in messaging between Clarida and Williams (2.5).

As inflation pressures rise, the only thing that holds the Fed back from raising rates is its full employment mandate. Powell stated at the December post-FOMC press conference that “the economy has been making rapid progress toward maximum employment”. In short, the labor market is healing on many dimensions.
 

Amid improving labor market conditions and very strong demand for workers, the economy has been making rapid progress toward maximum employment. Job gains have been solid in recent months, averaging 378,000 per month over the last three months. The unemployment rate has declined substantially, falling six tenths of a percentage point since our last meeting and reaching 4.2 percent in November. The recent improvements in labor market conditions have narrowed the differences in employment across groups, especially for workers at the lower end of the wage distribution, as well as for African Americans and Hispanics. Labor force participation showed a welcome rise in November but remains subdued, in part reflecting the aging of the population and retirements. In addition, some who otherwise would be seeking work report that they are out of the labor force because of factors related to the pandemic, including caregiving needs and ongoing concerns about the virus. At the same time, employers are having difficulties filling job openings, and wages are rising at their fastest pace in many years. How long the labor shortages will persist is unclear, particularly if additional waves of the virus occur. Looking ahead, FOMC participants project the labor market to continue to improve, 

Here is why the full employment mandate matters. The December SEP projects the 2021 unemployment rate at 4.3%, falling to 3.5% in 2022 and remaining there for two years. The November unemployment rate is already 4.2%. Already, initial jobless claims normalized to population are at an all-time low.
 

 

Powell couldn’t quite bring himself to say the economy is at full employment during the press conference. Instead, he pivoted to that the jobs market is “not going back to the same economy” new era as a way of justifying the hawkish turn in policy.
 

You know, the thing is, we’re not going back to the same economy we had in February of 2020. And I think early on, that was the sense was that that’s where we were headed. The post-pandemic labor market and the economy, in general, will be different. And the maximum level of employment that’s consistent with price stability evolves over time within a business cycle and over a longer period, in part reflecting evolution of the factors that affect labor supply, including those related to the pandemic. So I would say, look, we’re at 4.2 percent now and it’s been — the unemployment rate has been dropping very quickly. So we’re already in the vicinity of 4 percent. The way in which the — The important metric that has been disappointing really has been labor force participation, of course, where we had widely thought, I had certainly thought that last fall as unemployment insurance ran off as vaccinations increased, that schools reopened, that we would see a significant surge, if you will, or at least a surge in labor force participation. So we’ve begun to see some improvement. We certainly welcome the 2/10 improvement that we got in the November report. But, I do think that it’s — it feels likely now that the return to higher participation is going to take longer. And, in fact, that’s been the pattern in past cycles that labor force participation is — tend to recover in the wake of a strong recovery in unemployment, which is what we’re getting right now. So, you — It could well have been if this cycle was different because of the short nature of it and a very strong — the number of job openings, for example, you would have thought that that would have pulled people back in. But, really, it’s the pandemic, it’s a range of factors. But the reality is, we don’t have a strong labor force participation recovery yet and we may not have it for some time. At the same time, we have to make policy now. And inflation is well above target. So this is something we need to take into account.

Consistent with Claudia Sahm’s thesis that the Fed doesn’t like to surprise markets, Fedspeak is now turning even more hawkish. Governor Christopher Waller recent speech that echoed Powell’s remarks about “meeting the FOMC’s maximum-employment goal”.
 

The economy is set to continue growing very strongly through at least the first half of next year, and I expect employment to keep growing. With the unemployment rate at 4.2 percent in November, I believe we are very close to meeting the FOMC’s maximum-employment goal. For inflation, as I said earlier, the next few months will be crucial in determining whether price increases will begin to moderate, as I still expect in my baseline outlook. However, I will be closely watching indicators of inflation expectations for signs that consumers and investors have come to expect high inflation well into the future, a development that could signal that the moderation in inflation I expect will not be coming soon. 

Waller went further and called for rate hikes to begin in March, shortly followed by a reduction in the Fed’s balance sheet, or quantitative tightening. 
 

In addition, San Francisco Fed President Mary Daly, who is widely considered to be a dove, stated in a NY Times interview that she supports the increased pace of QE taper and could be open to a March rates liftoff.
 

Ms. Daly said she supported ending bond buying quickly so that officials were in a position to begin raising interest rates. A higher Fed policy rate would percolate through the economy, lifting the costs of mortgages, car loans and even credit cards and cooling off consumer and business demand. That would eventually tamp down inflation, while also likely slowing job growth.
 

Ms. Daly said it was too early to know when the first rate increase would be warranted, but suggested she could be open to having the Fed begin raising rates as soon as March.

If the Fed were to continue on this signaling path, watch for more important Fed speakers to turn hawkish in the coming weeks.
 

 

Still data dependent

Despite the hawkish path, the Fed remains data dependent. Policy makers will be closely watching the December Jobs Report due out Friday and the JOLTS report the following week. 
 

The key metrics to watch are the prime-age labor force participation rate (LFPR) and employment to population rate (EPOP). Both haven’t recovered to pre-pandemic levels, but Powell “feels likely now that the return to higher participation is going to take longer”.
 

 

As well, temporary jobs and the quits/layoffs ratio have historically led Non-Farm Payroll and both indicators are flattening out.
 

 

The quits rate will also be closely watched in the JOLTS report. While the historically high quits rate has been dubbed the Great Resignation, the surge has been concentrated in lowly paid leisure and hospitality, and retail industries. In a tight jobs market, participants are quitting and upgrading to better paying positions.

 

 

 

Dovish factors to consider

Even though the Fed is set on a hawkish path, here are some developments that could shift policy in a more dovish direction. The rapid transmission of the Omicron variant could cause a sudden collapse in global economic activity, as demonstrated by the recent widespread flight cancellations due to the infections of flight crews. The announcement from Centers for Disease Control and Prevention to reduce the recommended isolation and quarantine times should alleviate some of the pressure, but the economic effects of these measures remain to be seen.

 

 

In the meantime, the WSJ reported that economists are reducing their GDP growth forecasts because of the effects of the Omicron variant.

 

 

Improvements in the Citigroup Economic Surprise Index, which measures whether economic data is beating or missing expectations, have also begun to stall.

 

 

Similarly, the growth rate of ECRI’s Weekly Leading Index is rolling over.

 

 

As well, a sudden deceleration in fiscal impulse could also dent the growth outlook. In the wake of Senator Joe Manchin’s withdrawal of support of Biden’s Build Back Better fiscal stimulus plan, expected fiscal spending is will be weaker in 2022. Barron’s reported that Goldman cut projected GDP growth. Other strategists won’t be far behind. While Fed officials are mainly focused on their dual mandate of price stability and full employment, they are not completely blind to the effects of fiscal policy.

 

“We had already expected a negative fiscal impulse in 2022 as a result of the fading support from Covid-relief legislation enacted in 2020 and 2021, and without Build Back Better enactment, this fiscal impulse will become somewhat more negative than expected,” a team led by chief economist Jan Hatzius said in a note Sunday. 

 

 

Be cautious (for now)

In conclusion, the Fed doesn’t like to surprise markets and is poised to reinforce its hawkishness in its communication strategy in the coming weeks. The yield curve is already flattening, which is the bond market’s signal that it expects slower economic growth ahead. A flattening yield curve also reflects fears of a policy error. The Fed may be over-tightening and will have to reverse course later.

 

 

FANG+ stocks are the new defensive positioning under such a scenario. In a growth starved world, investors will bid up the prices of cash generative growth companies. The relative performance of the NASDAQ 100 has exhibited a rough inverse correlation with the 10-year Treasury yield.

 

 

However, the expected large-cap growth leadership should begin to fade when inflation pressures begin to abate. Keep an eye on the evolution core PCE as 2022 progresses. The Fed has penciled in a 2022 core PCE inflation rate of 2.6% in its Summary of Economic Projections. If inflation pressures begin to fade and monthly changes in core PCE fall to 0.2% for several months, the Fed would interpret this as a signal that inflation is under control and shift to a more dovish stance. Under such a scenario, the yield curve would begin to steepen again, indicating a better growth outlook, and equity leadership should rotate from large-cap growth into value and cyclical stocks.

 

 

Riding the seasonal bull

Posted by Cam Hui -

Mid-week market update: The Santa Claus rally, which begins just after Christmas and ends on the second day of the new year, began with a bang. The S&P 500 surged 1.4% on Monday to kick off the Santa rally and managed to make another marginal closing high today. The bullish impulse has been relentless.
 

Marketwatch documented a small sample study (n=8) indicating that Santa rallies that began with an advance of 1% or more tended to be strong.
 

 

I pointed out that the S&P 500 staged an upside breakout from an inverse head and shoulders pattern with a measured objective of about 4920 (see The anatomy of a Santa rally) but cautioned that the 4920 target may be overly ambitious. In light of Monday’s surge, 4920 may not be totally out of reach.

 

 

 

A different kind of rally

That said, the internals of this seasonal rally is a little unusual. In the past, low-quality stocks and small caps have led the way. This year, low-quality leadership has mostly fizzled.

 

 

As well, the Russell 2000 remains stuck in a trading range after a failed upside breakout. However, the higher quality S&P 600 is testing resistance and could break up through resistance. Even within small caps, high quality is winning.

 

 

I had also anticipated that the beaten-up speculative growth stocks would rebound after tax-loss selling petered out. There has been no evidence of such a rebound this year.

 

 

I interpret these developments as an indication that the Santa rally is only seasonal in nature and price momentum would start to fade in January.

 

In the meantime, enjoy the ride for a few more days.

 

 

Disclosure: Long SPXL

 

A 2021 report card

Posted by Cam Hui -

The year 2021 is nearly complete and it’s time to issue a report card for my three investment models. Going in order of short to long time horizons, these are:

  • The Trading Model;
  • Trend Asset Allocation Model; and
  • The Ultimate Market Timing Model.
All showed strong results.

 

 

The Trading Model

The weakest result came from the trading model, which was strongly positive but lagged the S&P 500. This was still a solid result as it is arguably an absolute return strategy that should be benchmarked to cash rather than the stock market.

 

After a dismal 2020 in which the model incorrectly shorted the market as stocks rallied, the trading model clawed its way back in 2021. Based on the methodology outlined in My Inner Trader, the trading model returned 19.7% in 2021, assuming no trading costs and dividends. While this was impressive, it nevertheless lagged the S&P 500 capital-only return of 27.6% to December 27, 2021.

 

 

After a difficult 2020, I made an adjustment to the trading model. After realizing most of the past losses were from short positions, I made a decision to forego shorting in 2021 as long as the intermediate trend is up. I expect that 2022 will be more challenging, as the intermediate trend will turn choppy, which will call for some short positions, which will offer both opportunity and risk.

 

 

Trend Asset Allocation Model

The Trend Asset Allocation Model also had a strong year. Using the switching methodology outlined here, the model portfolio showed a total return of 23.7% compared to a 60% SPY/40% IEF benchmark of 16.5%. 
As a reminder, model portfolio returns were backtested based on specified asset allocation rules, but the signals were produced out-of-sample. Past individual year returns during the out-of-sample period also showed a consistent pattern of outperformance.
  • 2020: Model 20.6% vs. 60/40 14.2%
  • 2019: Model 22.3% vs. 60/40 22.6%
  • 2018: Model 1.9% vs. 60/40 -2.7%
  • 2017: Model 17.4% vs. 60/40 13.8%
  • 2016: Model 13.9% vs. 60/40 7.9%
  • 2015: Model 2.5% vs. 60/40 1.4%
  • 2014: Model 14.2% vs. 60/40 12.2%

 

 

The Trend Asset Allocation Model was designed for individual investors and portfolio managers whose objective is to achieve equity-like returns with balanced fund-like risk on a long-term basis. For advisors and portfolio managers who adhere to Investor Policy Statements for individual clients, the Trend Model is a useful tool to achieve superior returns while maintaining the risk profile demanded by each firm’s Compliance department. The idea is to begin with a 60/40 benchmark and either over or underweight equities by 20% depending on model readings. 

 

This model achieved its objective again in 2021.

 

 

The Ultimate Market Timing Nodel

While the Trend Asset Allocation Model usually flashes several signals a year, the Ultimate Market Timing Model only flashes a signal once every few years. 

 

This model combines the risk control elements of trend following models with an economic overlay. Trend following models using moving averages can spot falling markets, but they have the disadvantage of flashing false-positive signals that whipsaw portfolios in and out of positions. By recognizing that recessions are bull market killers, the Ultimate Market Timing Model will only de-risk when the economic model (see my Recesion Watch indicators) warn of a recession and Trend Asset Allocation Model issue a sell signal. It re-enters the market after a recession signal only when the Trend Model returns from bearish to neutral.

 

This model exited the market in the wake of the COVID shock of 2020 and re-entered the market in Q3 2020. It remained 100% long in 2021 and reaped a 27.6% return to the S&P 500.

 

 

This model is designed for investors who don’t want to trade but are willing to bear normal equity risk of 10-20% drawdowns. An investor using this model can then enjoy the benefits of higher long-term equity returns while avoiding the negative returns from major bear markets.

 

In conclusion, I began Humble Student of the Markets to help readers achieve better returns. Unlike most other services, I have not shied away from reporting my results. After a difficult 2020, the models all exhibited strong returns in 2021 and I continue to refine my investment process as needed.

 

The process is working and I hope to report similarly positive results a year from now.

 

 

The anatomy of a Santa 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 be found here.

 

 

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

 

 

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

 

Has Santa come to town?

Will the real Santa Claus rally, which begins on Monday and lasts until the second trading day of January, now begin in earnest? 

 

I pointed out last week (see A breakout to S&P 4920?) that the S&P 500 was potentially forming an inverse head and shoulders pattern, but head and shoulders patterns are incomplete until the neckline breaks. The market staged a marginal upside breakout through resistance on Thursday. The measured objective of the inverse H&S breakout is about 4920, but that level may be overly ambitious. If the Santa rally has truly begun, one of the tactical indicators that he has returned to the North Pole is whether the VIX Index falls below its lower Bollinger Band, which is an overbought signal to take trading profits.

 

 

Here is what else I am watching.

 

 

Santa rally internals

In my last post (see Was the Grinch in the house?), I outlined some possible characteristics of a year-end market advance. One is the snapback of beaten-up stocks as tax-loss selling season ends. One possible group for a relief rally is speculative growth stocks, which have begun to bottom out relative to both the S&P 500 and NASDAQ 100 in December but tailed off in the last week. Will they pop in the coming week and early January?

 

 

Another hated group is small-cap stocks. While most investors use the Russell 2000 as a small-cap benchmark, which is still stuck in the middle of its trading range, the higher quality S&P 600 is nearing resistance. An upside breakout by the S&P 600 would be a positive sign for the bulls. 

 

However, the market tends to be led by low-quality stocks this time of year. If the seasonal rally is indeed underway, watch for the Russell 2000 to outperform the S&P 600.

 

 

Indeed, an analysis of the quality factor shows that low quality is dominant in both large and small-caps.

 

 

 

How durable is the advance?

If Santa does come to town, how durable is the advance?

 

The relative performance of the top five sectors is revealing. These sectors account for over three-quarters of S&P 500 weight and it would be impossible for the index to significantly rise or fall without the participation of a majority. An analysis of the top five sectors shows that three, technology, consumer discretionary, and communication services, exhibited temporary relative strength that appear to be more of a counter-trend nature. I interpret this to be an early warning for traders not to overstay the party.

 

 

Risk appetite internals are equally troubling. Equity risk appetite indicators are flashing negative breadth divergences.

 

 

Credit market risk appetite shows a mixed picture. While the relative price performance of junk (high yield) bonds compared to their duration-equivalent Treasuries have confirmed the S&P 500 advance, emerging market bonds have not. As the Fed begins its rate hike cycle, fragile EM economies will be the canaries in the global financial system coal mine and the relative performance of EM bonds is not encouraging.

 

 

 

Don`t be prematurely bearish

Before traders turn prematurely bearish, keep in mind that the market staged a rally from an oversold condition and sentiment washout. The NYSE McClellan Summation Index (NYSI) remains oversold on the weekly chart.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs, fell below its 26-week lower Bollinger Band two weeks ago. This model has had a remarkable record of spotting short-term bottoms. Tactically, I am inclined to wait for NAAIM to return to the 26-week moving average. This has historically taken between 2-5 weeks from the time of the buy signal, which puts the time horizon for exiting a tactical long position about the middle of January.

 

 

Analysis by Martin Pring [gated at StockCharts] is also supportive of a 2-4 week rally. Pring pointed out that the KST for the put/call ratio had rolled over. (KST is a momentum oscillator that’s “a weighted average of four different rate-of-change values that have been smoothed”.)

 

Last week, [KST] had started to go flat. Now, it has experienced a decisive peak, which indicates that traders have started to become more optimistic. The arrows show that such action has consistently been followed by a 2-to-4-week rally or more.
This indicator flashed 10 buy signals in the last five years. Of the 10, the S&P 500 rose in seven instances (blue lines), fell in two (red lines), and fell immediately before rising again in one (black line).

 

 

A simple analysis of option sentiment also shows that bearishness has come off the boil but readings are still high. The equity-only put/call ratio has fallen, indicating a retreat in bearishness, but the 10 dma remains elevated. In short, intermediate-term sentiment models are beginning to recycle back to neutral, but conditions are nowhere near crowded long conditions that warrant caution.

 

 

As well, seasonal patterns are supportive of a bullish outcome. The S&P 500 has been tracking its seasonal pattern remarkably well in 2021. If it were to continue, watch for a short-term top about the second week of January.

 

 

 

What if Santa doesn`t call?

Mark Hulbert recently demonstrated that the odds have historically favored a market advance after Christmas and for the first two days of the new year. However, there is still the possibility that the Santa Claus rally doesn’t materialize.

 

 

Short-term breadth is very extended and a pause and pullback would be no surprise in the early part of next week.

 

 

Ryan Detrick of LPL Financial showed the history of returns if the Santa rally fails. While the sample size is small (n=5), the implications for January and the rest of the year are not encouraging.

 

 

In conclusion, the market is poised for a year-end rally with an S&P 500 measured objective of 4920. The key risks are faltering market internals and overbought short-term breadth. If the market were to stage a seasonal advance, historical odds point to a trading top in mid-January.

 

 

Disclosure: Long SPXL