A breakout to S&P 4920?

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.
 

Publication schedule next week: There will be no regular strategy publiction next Saturday owing to the seasonal holidays. I will publish a tactical trading comment next Sunday.
 

 

A potential inverse H&S

A potential inverse head and shoulders pattern is forming in the S&P 500? The measured upside objective is roughly 4920. Despite the volatility from Friday’s quadruple witching, the S&P 500 held support at its 50 dma.

 

 

The bulls shouldn’t break out the champagne just yet. Strictly speaking, head and shoulders patterns are incomplete until the neckline breaks. If the index can stage an upside breakout above resistance, then traders can declare a risk-on tone to the market. On the other hand, if the S&P 500 were to undercut the “head” at about 4500 and invalidate the inverse head and shoulders pattern, things could get very ugly.

 

Here are bull and bear cases.

 

 

The bull case: Fearful sentiment

The bull case rests on a recovery from an oversold condition and washed out sentiment. The 14-day RSI of the  DecisionPoint Intermediate-Term Breadth Momentum Oscillator recently recycled off an oversold condition. In the last five years, there have been 23 such signals and 70% of them have resolved bullishly. Do you want to play the odds?

 

 

As well, the NAAIM Exposure Index, which measures the sentiment of RIAs, plunged to 52% last week, which is below its lower 26-week Bollinger Band. Since the inception of this index, this signal has virtually been a foolproof buy signal for equities.

 

 

Still not convinced that the market is near a washout bottom? Macro Charts pointed out that option order flow conditions have reached a crowded short reading, which is contrarian bullish.

 

 

 

The bear case: Weak internals

The bears will argue that breadth has deteriorated sharply. The S&P 500 tested resistance while exhibiting negative 5 and 14 day RSI divergences. The NYSE Advance-Decline Line retreated below its breakout level, which is another sign of weakening breadth; net NYSE and NASDAQ highs-lows are negative; and the percentage of S&P 500 and NASDAQ 100 stocks above their 50 day moving averages are exhibiting a series of lower highs and lower lows.

 

 

As a counterpoint to the poor breadth readings, Washington Service reports that insider buying has spiked and buying levels are the highest since the March 2020 market bottom. As well, insider selling is below this year’s average. If poor breadth is an indication of broad market weakness, then why are insiders, who are thought of as the “smart money”, buying?
 

 

Nevertheless, defensive sectors are staging upside relative breakouts across the board. This is another indication that the bears are seizing control of the tape.

 

 

Moreover, equity risk appetite has plunged, indicating a sharp deterioration of market internals.

 

 

These conditions call for short-term bullishness and intermediate-term caution. Sentiment is too bearish. In particular, the NAAIM Exposure Index has an impeccable short-term market timing for buy signals.

 

Be bullish and enjoy some holiday cheer. But don’t overstay the party as the calendar rolls into January.

 

 

Disclosure: Long SPXL

 

A recession in 2023?

Posted by Cam Hui -

The Fed has spoken by pivoting to a more hawkish trajectory for monetary policy. The FOMC announced that it is doubling the scale of its QE taper, which puts the program on track to end in March. The December median dot-plots show that Fed officials expect three quarter-point rate hikes in 2022 and three quarter-point rate hikes in 2023.
 

 

The 10-year Treasury yield is about 1.4% today. All else being equal, the Fed’s dot-plot puts monetary policy on track to invert the yield curve some time in 2023. Historically, inverted yield curves precede recessions and recessions are bull market killers.

 

 

Is the Fed on course to raise rates until the economy breaks?

 

 

The market reaction

Much depends on how the bond market interprets the Fed’s monetary policy pivot. Consider the following three scenarios for the 10-year Treasury yield, which currently stands at about 1.4%.
  1. Using the 2s10s as a benchmark for the yield curve and assuming that the 2-year yield moves in lockstep with the Fed Funds rate, the 2s10s would flatten and invert in late 2022 or early 2023.
  2. The 10-year yield has been falling in anticipation of the Fed’s hawkish pivot, which is a bond market signal that it expects a slowing economy. If the 10-year yield continues to fall, inversion would occur in H2 2022. 
  3. If the 10-year yield rises, which would be a signal that the market expects the Fed to get inflation under control and sparks a second wind in economic growth and earnings estimates continue to rise, it would be bullish for the equity outlook.
What happens next? Here is what I am watching.

 

What happens to the yield curve? Recent history shows that inverted yield curves have either slightly preceded or been coincidental with stock market tops. Arguably, the minor inversion in 2019 was a false positive as the 2020 recession was attributable to the pandemic, which is an exogenous event.

 

 

While the dynamics of the British economy is unique owing to the fallout from Brexit, the UK yield curve is inverted from 20 years onward. Is the UK the canary in the coalmine or a special case? Will the inversion spread across the developed markets?

 

 

Monitor the growth outlook. Accelerating growth translates to rising EPS estimates, which is equity bullish. So far, the Economic Surprise Index, which measures whether economic data is beating or missing expectations, is rising.

 

 

S&P 500 forward EPS estimates have also been strong, indicating positive fundamental momentum.

 

 

Rate increases are designed to cool off an overheated economy and control inflation. What happens to inflation expectations? 5×5 inflation expectations have been falling, which is positive for the Fed’s inflation-fighting credibility. Will it continue?

 

 

The latest release of global flash PMIs indicate that inflationary pressures look decidedly *ahem* transitory. Supplier delays are rolling over, which should alleviate some of the pandemic-related price pressures.

 

 

In addition, the newly listed Inflation Beneficiaries ETF (INFL) provides the equity market’s view of inflation. The absolute performance of INFL roughly tracks the relative performance of TIPs against their duration-equivalent Treasuries. The relative performance of INFL to the S&P 500 has been falling, which confirms the market signal from 5×5 inflation expectations. Will the trend continue?

 

 

If the Fed raises interest rates until something in the financial system to break, the most sensitive barometers of financial stress are high yield and emerging market bonds. Bloomberg reported that Ken Rogoff warned that EM countries are especially vulnerable to rising rates.

 

“Developing economies are just an accident waiting to happen,” the Harvard University economics professor said on Bloomberg TV on Wednesday, before the Fed’s policy decision. “There are already a lot of problems in what we call the frontier emerging markets.”

 

A full percentage-point of Fed rate increases next year could shut some countries out of markets, further straining already vulnerable fiscal situations. He pointed to Egypt, Pakistan and Ghana as nations already battling large debt obligations, narrower market access and, in some cases, double-digit inflation…

 

Emerging markets are “very sensitive to the hiking-more-quickly scenario,” Rogoff said. “Many, many countries that have access right now, suddenly wouldn’t. That would really be catastrophic.”
Keep an eye on HY and EM spreads. Widening spreads would be bad news for the growth outlook.

 

 

 

A question of credibility

Much depends on the market’s view of the Fed’s inflation-fighting credibility. Here is the FOMC’s Summary of Economic Projections (SEP). 

 

 

While the initial reaction to the publication of the SEP is to focus on its Fed Funds projections or the dot plot, two other forecasts are equally important. The Fed forecasts that core PCE, which is its preferred inflation indicator, falls from 4.4% in 2021 to 2.7% in 2023. While Jerome Powell has abandoned the term “transitory”, the SEP is projecting an outlook consistent with the now-banned term. Moreover, the December FOMC statement contained a nearly identical sentence as the previous month’s and attributing inflationary pressures to the pandemic and reopening factors is another way of saying “transitory” without using the word.

 

Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.
As well, the SEP forecast calls for the unemployment rate to fall from 4.3% in 2021 to 3.5% in 2022 and remain at that level until 2024. The long-term unemployment rate, however, is 4.0%. In other words, the Fed is signaling that it is willing to run the economy a little “hot” and tolerate some inflation pressure to achieve full employment.

 

Both of these forecasts are growth-friendly and equity bullish. For equity investors, I sketch out two possible paths. A hawkish reaction, which would be signaled by a flattening yield curve, translates into slowing growth. Under those conditions, investors flock to quality large-cap growth stocks when growth is scarce. Moreover, the forward P/E spreads of FANG+ stocks against the S&P 500 have fallen since September and valuation premiums are not overly demanding.

 

 

However, investors are best served by avoiding speculative growth stocks as psychology has turned and their bubble seems to have burst. Speculative growth-related ETFs such as ARKK and BUZZ are lagging both the S&P 500 and the high-quality large-cap NASDAQ 100.

 

 

A dovish reaction, or a steepening yield curve, is friendly to value and cyclical stocks. In the current environment, however, a bifurcated market has appeared between large, mid and small-cap value and growth return patterns. The recent dominance of large-cap FANG+ names has meant that growth has been outperforming value among large caps. However, value stocks, which are also concentrated in cyclical sectors, are beating their growth counterparts among mid and small-caps. The bottom panel shows the relative performance of small-cap value against large-cap growth. Based on a head-to-head comparison, large-cap growth remains dominant.

 

 

How should investors position themselves? My Trend Asset Allocation Model remains bullishly positioned in equities. However, I have made the case in the past that the economy and market are transitioning from an early cycle recovery to a mid-cycle expansion. During such periods, rising rates put downward pressure on P/E ratios, which is offset by rising EPS estimates. If history is any guide, stock prices tend to move sideways as the Fed starts to raise rates, but we are still several months from liftoff and the market could continue to advance until then. Remain bullish on equities until the market signals a downside trend break, which hasn’t happened yet.

 

 

Owing to the uncertainty of the market’s reaction to the Fed’s policy pivot, equity investors should adopt a barbell position of large-cap quality growth and small-cap cyclical value. A scenario of slowing growth should see large-cap growth stocks outperform, while signs of accelerating growth should benefit high-beta small-cap stocks.

 

Heightened fear + FOMC meeting = ?

Posted by Cam Hui -

Mid-week market update: I don`t have very much to add beyond yesterday`s commentary (see Hawkish expectations). Ahead of the FOMC announcement as of the Tuesday night close, fear levels were elevated.
 

 

The market`s retreat left it oversold or mildly oversold, such as the NYSE McClellan Summation Index (NYSI).

 

 

Both the NYSE and NASDAQ McClellan Oscillators (NYMO and NAMO) were approaching oversold readings.

 

 

As I pointed out yesterday, anxiety was in the air as the market was discounting a Fed policy error of overtightening. Arguably, the recent pullback is in line with the historical seasonal pattern of mid-December weakness before a year-end rally.

 

 

Here comes the oversold bounce. Tactically, I remain cautiously bullish and I will be monitoring the evolution of the market`s internals and psychology as prices rise before pronouncing judgment on the durability of this rally.

 

 

Disclosure: Long SPXL

 

Hawkish expectations

Posted by Cam Hui -

Ahead of tomorrow’s FOMC decision, market expectations are turning bearish. Even as the S&P 500 consolidated sideways, defensive sectors are all starting to show signs of life by rallying through relative performance downtrends.
 

 

 

Hawkish fears

A CNBC poll found that the consensus expects the Fed to double its taper, which would end QE by March, and three rate hikes each in 2022 and 2023. 
 

The CNBC Fed Survey finds that respondents expect the Fed to double the pace of the taper to $30 billion at its December meeting, which would roughly end the $120 billion in monthly asset purchases by March. The 31 respondents, including economists, strategists and money managers, then see the Fed embarking on a series of rate hikes, with about three forecast in each of the next two years. The funds rate is expected to climb to 1.50% by the end of 2023 from its range near zero today.

Psychology has turned cautious. A Bloomberg survey found that respondents are more worried about a Fed policy error of over-tightening than inflation.
 

 

The BoA Global Fund Manager Survey showed a similar result.
 

 

Positioning has turned defensive in response.

 

 

 

Too bearish?

Are expectations too hawkish and psychology too bearish? A quick Twitter poll by Helene Meisler today shows that the bull-bear spread has turned decidedly negative after a bull-bear spread of +15 on her weekend poll.
 

 

Fear levels are elevated, as measured by the put/call ratio, even as the S&P 500 is less than 1% from its all-time highs.
 

 

Short-term breadth has come off the boil and it is approaching oversold levels.
 

 

This is option expiry week (OpEx) and December OpEx has historically been bullish for stocks. However, the short-term outlook is clouded by the Fed decision wildcard.
 

 

In conclusion, major bear markets don’t begin when psychology is this bearish. Recall that when the November CPI print was in line with market expectations last Friday, the S&P 500 rallied to an all-time high. Even if you believe that the bull trend is rolling over, wait for a relief rally before initiating short positions.
 

 

Disclosure: Long SPXL
 

The Fed’s inflation problem

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.
 

 

A data and political problem

The S&P 500 experienced an air pocket in late November, sparked by a combination of the news of the emergence of the Omicron virus variant and the Fed’s hawkish surprise. Since then, the Omicron news has been mostly benign. While the new variant is more transmissible, its effects appear to be less severe. Pfizer and BioNTech reported that lab tests showed that a third dose of its vaccine protected against the Omicron variant. A two-dose regime was less effective but still prevents severe illness. With the Omicron threat off the table, the market staged a strong relief rally.

 

The second threat of a hawkish Fed still remains. As investors look ahead to the FOMC meeting next week, the Fed faces both a data and political inflation problem. The data problem is that inflation surprise is surging all around the world.

 

 

The closely watched November CPI report came in in line with market expectations, which was a relief for the equity markets. The S&P 500 responded by rallying to a marginal new all-time high. The Dow and the Transports are holding their previous breakouts.

 

 

Despite the market’s relief, there may be further upside pressure on CPI in the coming months. While airfares, used cars, and energy prices are noisy, volatile, and transitory components that have boosted CPI, Owners’ Equivalent Rent (OER) is a large weight in CPI and its outlook is concerning.

 

 

While OER (red line) has been relatively tame, it has historically lagged housing prices by about 12 months. If history is any guide, OER should start to rise next summer, a year after housing prices began their upward climb.

 

 

While the Fed is in theory independent from Congress and the White House, it nevertheless faces a political problem of rising inflation. This can be summarized by the recent plunge in consumer sentiment. For years, consumer sentiment (blue line) and the unemployment rate (red line, inverted) tracked each other closely. Their recent divergence is an indication that households are becoming less concerned about employment than other economic factors, especially when initial jobless claims printed a half-century low last week. The latest University of Michigan survey tells the story of a dramatic shift in consumer focus.

 

When directly asked whether inflation or unemployment was the more serious problem facing the nation, 76% selected inflation while just 21% selected unemployment (the balance reported the problems were equal or they couldn’t choose). The dominance of inflation over unemployment was true for all income, age, education, region, and political subgroups. 

It can also be explained by the Misery Index, which is the sum of the unemployment rate and inflation (black line, inverted). In the post-COVID Crash era, the Misery Index and consumer sentiment track each other more closely, indicating that households are increasingly concerned about inflation.

 

 

These political pressures undoubtedly played a role in the Fed’s recent hawkish pivot. In the wake of Jerome Powell’s Senate testimony, the market is now anticipating that the Fed will announce doubling the pace of its QE taper. At the new anticipated pace, the Fed’s asset purchases will end in March, which allows the Fed the flexibility to begin raising rates at the May FOMC meeting.

 

While investors will be closely watching the pace of the taper, another key indicator to monitor is the dot-plot and the long-term neutral Fed Funds rate. Former New York Fed President Bill Dudley wrote in a Bloomberg Op-Ed that he expects three rate hikes in 2022 and the long-term neutral rate should be as high as 2.5%.

 

For 2022, I expect a median forecast of 0.8%. This would signal three 0.25-percentage-point increases next year – not so many as to require a rate hike in March, but enough to be consistent with the faster taper and the unemployment and inflation outlook.

 

For 2023, I expect officials to project four more rate hikes, taking the median target rate to 1.8% a year earlier than in the September projections. Such gradual, consistent tightening makes sense once the Fed gets started. But policymakers aren’t likely to anticipate moving more quickly as long as they project inflation to remain below 2.5%.

 

For 2024, I expect the projected target rate to reach the 2.5% level judged as neutral. Anything less seems hard to justify, given that the economy will have been running beyond full employment and above the Fed’s 2% inflation target for several years.
If the Fed were to follow the trajectory laid out by Dudley, the yield curve would flatten and invert by late 2022 or early 2023, which would be an early signal of a recession – and recessions are bull market killers.

 

 

Reasons to be bullish

From a technical perspective, the combination of Omicron news and November CPI print represents a short-term bullish dynamic for stock prices.

 

The bulls can point to the strong rebound after a series of severely oversold market conditions and panicked sentiment readings. All components of my market bottom models flashed buy signals at the height of the market weakness when the S&P 500 tested its 50 day moving average.

 

 

The pullback weakened sentiment readings dramatically. Investors Intelligence bullish sentiment weakened and bearish sentiment edged up. The bull-bear spread tanked.

 

 

Similarly, the Citi Panic-Euphoria Model has come off the boil. While readings are still in euphoria territory, they are nowhere as extended as they have been in the past year.

 

 

In many ways, the relief rally was no surprise. Historically, the S&P 500 has shown strong returns whenever the VIX Index spiked above 30, indicating fear.

 

 

The ensuring rally exhibited strong price momentum. A recent backtest of similar momentum readings showed strong returns. Recently, 80% of S&P 500 stocks were at 5-day highs and the 50 dma was above the 200 dma. There have been only 29 similar instances in the last 30 years. History shows that the market was up an average of 14.3% a year later with a 90% success rate. Average drawdown was only -6.1%.

 

 

Notwithstanding those momentum results, the market is undergoing a possible setup for a rare Zweig Breadth Thrust buy signal. ZBT buy signals occur when market breadth surges from an oversold to an overbought condition with 10 trading days. The last day in the window is Wednesday or the day of the FOMC meeting.

 

 

 

Seasonality

Another consideration to keep in mind is seasonality. Seasonality is only of secondary importance as prices are affected by other factors and seasonality charts only show average returns without any recognition of wide historical variations. This year, the market tracked the seasonal pattern well until Thanksgiving. On average, the market begins to weaken now and begins a Christmas rally about mid-December.

 

 

In conclusion, the stock market has shrugged off both the Omicron scare and the Fed’s hawkish pivot scare. My base case scenario calls for further gains until year-end, though traders should be prepared for some FOMC related volatility next week.

 

 

Disclosure: Long SPXL

 

China gets rich AND old, but…

Posted by Cam Hui -

China has a well-known demographic problem: its working population is aging quickly. For years, many analysts have rhetorically asked whether China can get rich before it gets old. 
 

 

We have the answer. A recent McKinsey study found that China has beaten the US to become the richest nation. McKinsey found that China’s wealth rose from $7 trillion in 2000 to an astounding $120 trillion in 2020. By contrast, the US doubled its wealth to $90 trillion during the same period.

 

Be careful what you wish for. China becoming rich just as it begins to age is like the dog that caught the car but doesn’t know what to do next.

 

 

Unbalanced wealth

Here is the downside to being rich. The Financial Times pointed out that being rich in China is no picnic.

 

Among the 72 billionaires, 15 were murdered, 17 committed suicide, seven died from accidents, 14 were executed according to the law and 19 died from diseases.

As well, the growth in wealth was highly uneven and concentrated in real estate. China watcher Michael Pettis observed “the last time a country’s total wealth exceeded that of the US was in Japan around 1990. Its share of global GDP at the time was roughly the same as China’s today, and it was experiencing an even greater real estate bubble.”

 

 

Can China escape Japan’s fate?

 

 

The middle-income trap

China may be facing the classic middle-income trap problem of development. Few countries have successfully made the migration from middle-income to high-income countries. Most have been small, such as South Korea and Taiwan, or levered their positions as trading, capital, and technology hubs to leap to advanced economy status, such as Hong Kong, Singapore, Cyprus, and Ireland.

 

 

The World Bank explained the challenges of growth for middle-income countries this way:

 

Middle-income countries may face particular challenges because growth strategies that were successful while they were poor no longer suit their circumstances. For example, the reallocation of labor from agriculture to industry is a key driver of growth in low-income economies. But as this process matures, the gains from reallocating surplus labor begin to evaporate, wages begin to rise, and decreasing marginal returns to investment set in, implying a need for a new source of growth. Middle-income countries that become “trapped” fail to sustain total factor productivity (TFP) growth. By contrast, “escapees” find new sources of TFP growth (Daude and Fernández-Arias 2010). Indeed, 85 percent of growth slowdowns at the middle-income levels can be explained by TFP slowdowns (Eichengreen, Park, and Shin 2013). 

The World Bank hit the nail on the head with its formulation of TFP growth as the key to avoiding the middle-income trap. China faces two main challenges in maintaining growth. First, its GDP growth at any cost model has incentivized provincial cadres to focus on unproductive credit-driven real estate growth. The teetering finances of China Evergrande and other property developers have exposed the limits of this growth model.
 

As well, it faces the more conventional problem of migrating up the value-added chain as “the gains from reallocating surplus labor…evaporate”, as per the World Bank. Indeed, the SCMP reported that vice-premier Liu He penned a long article in China’s Daily about Beijing’s plan to avoid the middle-income trap by relying on technological innovation.
 

“Since the end of World War II, there are many countries that have started the industrialisation process and even briefly stepped over the threshold of being a high-income country,” Liu wrote. “Yet only very few countries, such as South Korea, Singapore and Israel, have truly leapt over the middle-income trap.”
 

To become an advanced economy, China has to shift its growth model from a strategy “driven by inputs” to an approach “driven by technological innovation” – a process that is still in progress, according to Liu.
 

Liu’s article, which argues for China to embrace “high-quality” growth and lays out ways to achieve that goal, is consistent with the World Bank and the State Council’s joint report a decade earlier. Worries about the sustainability of China’s growth persists, and the role of innovation in solving that problem is highlighted.

What does “high quality” growth mean? First, it means avoiding low-quality growth such as credit-fueled growth based on investment in unproductive real estate. Moreover, it means a pivot to high value-added technology services from low labor cost manufacturing. 
 

Yukon Huang and Jacob Feldgoise pointed out in an SCMP Op-Ed that virtually all countries have experienced declines in manufacturing. Taking the US as an example, the process of de-industrialization was accompanied by a surge in knowledge-intensive industries, which represented a bright spot in America’s growth path as shown by this Brookings study. As China attempts to move up the value-added chain, they argue that a Sino-American trade agreement for knowledge-intensive services would substantially benefit both sides. Whether there is sufficient political will in Washington and Beijing to complete such an agreement is an open question.
 

 

 

China’s report card

If that is the growth path laid out by Beijing, how is China doing?
 

Let’s start with real estate. The authorities have managed to stabilize the percentage of real estate investment in the economy and they are trying to slowly deleverage the industry.

 

 

China recently cut its reserve ratio by 0.50%, which has been interpreted as an attempt to stabilize the financial system in the wake of the Evergrande default and the fragile finances of other property developers. Bloomberg reported the Poliburo’s concerns have pivoted to potential instability.

 

“The tone has turned much more dovish,” Macquarie Group Ltd. analysts led by Larry Hu wrote in a Monday note. “For the first time, the Politburo meeting uses the phrase ‘stability is the top priority.’ In other words, top leaders are deeply concerned about the risk of potential instability.”

 

 

The key question is whether RRR cut affects the real economy or just asset prices. A discouraging sign comes from bond issuance data, which is rising in all sectors except for services. In the short term, however, strength in real estate and construction financings indicates an easing in financial conditions. As Beijing looks ahead to the Winter Olympics and the 20th Party Congress in 2022, the authorities are easing but for political reasons.

 

 

As a way of addressing the distrust of China’s official economic statistics, I rely on market-based indicators to measure the health of the Chinese economy. A month ago, weakness in commodity prices were signaling weakness in Chinese growth (see Commodity weakness = Global slowdown?).

 

The latest update shows that China is stabilizing. While the relative performances of MSCI China and Hong Kong to the MSCI All-Country World Index (ACWI) are still falling, the relative performances of the stock markets of China’s other major Asian trading are either bottoming or starting to turn up. I interpret this to tactically mean that the worst of the fears of a China downturn is over. For investors, this translates an ungrade from an underweight position to a neutral weight in China and other Asian markets.

 

 

In conclusion, China faces many long-term challenges. In the short run, excess credit-fueled investment in real estate is raising alarms about instability. Longer-term, the economy needs to successfully pivot from reliance on low-cost labor as a source of export-driven growth to higher value-added knowledge industries. Tactically, real-time market-based data shows that China’s economy is stabilizing, which translates to a neutral weight in China and other Asian countries.

 

 

Omi-what?

Posted by Cam Hui -

Mid-week market update: The most recent stock market downdraft was sparked by the news of a new virus variant that was initially identified in South Africa and the Fed’s hawkish pivot. As evidence emerged that Omicron is more transmissible but less deadly, the market staged an enormous rip-your-face-off short-covering rally. Today, Pfizer and BioNTech reported that lab tests showed that a third dose of its vaccine protected against the Omnicron variant. A two-dose regime was less effective but still prevents severe illness. Here we are, the S&P 500 is within 1% of its all-time high again.
 

Omi-what?

 

 

In the wake of the relief rally, the bulls still face the challenge presented by next week’s FOMC meeting. The risk of a hawkish Fed still looms. 

 

Here are the short-term bull and bear cases from a chartist’s perspective.

 

 

The bull case

One positive sign from the market’s exhibition of positive price momentum is the Dow traced out a bullish island reversal pattern, which is defined by the index falling through a downside gap and then reversing through an upside gap. The measured minimum upside target is roughly its all-time high.

 

 

The Omicron/Powell downdraft saw two down days on significant volume which is indicative of strong selling pressure. It began on Black Friday, which had 90.1% of NYSE volume on the downside. It was followed on Monday with a 89.4% downside day (red down arrows). According to Lowry’s, closely spaced downside days can be ominous if not quickly negated by a 90% upside day or two consecutive 80% upside days. Fortunately for the bulls, the market flashed two 80% upside days on Monday (80.0%) and Tuesday (85%, marked by blue up arrows).

 

 

In addition, the market flashed a possible setup for a rare Zweig Breadth Thrust buy signal on December 2, 2021. A ZBT buy signal is triggered when the ZBT Indicator moves from an oversold condition to an overbought reading of 0.615 or more within 10 trading days. In all likelihood, the ZBT buy signal setup will fail. A buy signal would be unabashedly bullish for stocks, but a failure should not be interpreted in a bearish manner.

 

There have been six ZBT buy signals since 2004. The S&P 500 was higher in all cases after a year. The two “momentum failures” saw the market correct before prices rose. The rest continued to rally after the buy signal into further highs.

 

 

The end of the 10-day window is next Wednesday, which coincides with the announcement of the FOMC decision. Brace for possible fireworks.

 

 

The bear case

While the bulls have staged an impressive show of positive price momentum, the bears may still be able to make a goal-line stand and turn the tide. The bulls can argue that the large-cap S&P 500 and mid-cap S&P 400 have held above their breakout levels. The bears can argue that the high-beta small-cap S&P 600 is struggling below resistance after a failed breakout.

 

 

Equity risk appetite indicators are exhibiting a minor negative divergence. Keep an eye on this should these indicators deteriorate further.
 

 

As well, the risk of a hawkish Fed hasn’t disappeared. Fed Funds futures are anticipating three quarter-point rate hikes in 2022, with liftoff at the May FOMC meeting. Since the Fed has signaled that it will not raise rates until the QE taper is complete, all eyes will be on the pace of the taper and the expected pace of 2022 rate increases in the dot-plot next week.

 

 

There is a severe disagreement between stock and bond market option markets. While the VIX Index has fallen dramatically as equities rallied, MOVE, which is the bond market’s VIX equivalent, has risen and remains highly elevated.

 

 

In conclusion, the S&P 500 is undergoing a high-level consolidation as it works off an overbought condition. 

 

 

Much depends on the FOMC decision next week and how much tightening has been priced into the market. My inner trader remains bullish but he is becoming more cautious. Traders should properly size their positions in light of the increasing market.

 

 

Disclosure: Long SPXL

 

About that crypto crash…

Posted by Cam Hui -

Risk-off came to the crypto world on the weekend as all cryptocurrencies took a sudden tumble. Bitcoin fell as much as 20%. Prices slightly recovered and steadied, but all major coins suffered significant losses.
 

 

How should investors analyze the crypto crash and what does it mean for equity investors and other risk assets.

 

 

Asset return profile

Will there be any fallout from the crypto crash? A MAN Institute study of cryptocurrency asset returns found that cryptos are uncorrelated with other asset classes.

 

 

While overall correlations are low, the researchers also found higher correlations during periods of equity drawdowns.

 

In the 6% of instances where the equity market sold off 5% or more over a one month period:
  • The average performance of Bitcoin was -13%;
  • Bitcoin registered a negative return 86% of the time
  • The left tail correlation was 0.3. 

 

 

Although these statistical studies are interesting, they don’t tell the entire story.

 

 

Profile of a crypto investor

To fully analyze the possible fallout of crypto volatility, it’s important to first understand the demographic profile of a crypto investor. A recent Pew Research survey found that “16% of Americans say they have ever invested in, traded or used cryptocurrency”. A closer examination found that crypto investors and traders are mostly young and male. 43% of men ages 18 to 29 are or have been crypto participants. The next largest demographic group are men ages 30 to 49.

 

 

 

Crypto bros ~ YOLO speculators

While they don’t exactly overlap 1 to 1, the young and male demographic is highly similar to the “get rich quick” and “you only live once” (YOLO) psychology Robinhood traders. It is therefore not surprising to see the high correlation between the price of Bitcoin as a proxy for the crypto complex and the relative performance of the ARK Innovation ETF.

 

 

Similarly, the performance of meme stocks as measured by BUZZ is also highly correlated. From a factor perspective, this is all the same trade. Investors should also distinguish between speculative growth and large-cap high-quality growth, as measured by the NASDAQ 100. Speculative growth is breaking down against both the S&P 500 and NASDAQ 100 FANG+ stocks, which are cash generative and enjoy strong competitive positions.

 

 

A sentiment-driven explanation of last weekend’s crypto crash is Crypto.com’s purchase of naming rights to the now “Staples Center” in Los Angeles. A macro explanation is a deceleration in global liquidity, as measured by changes in M2 money supply, which has shown a rough but uneven correlation with Bitcoin prices. The recent hawkish pivot by central bankers around the world is likely to put downward pressure on crypto assets. Add to the mix the 5x and 10x leverage available to crypto traders in offshore markets, downside volatility episodes such as the one this weekend is not a surprise. If leveraged crypto traders need to sell other assets to meet margin calls, the most correlated assets are speculative growth equities, as evidenced by the poor performance of ARKK today.

 

 

 

A Christmas present under the tree?

I suggested yesterday that small-cap stocks are beaten up and could see further selling pressure during the tax-loss selling season, followed by a rebound in late December and January (see In search of the next bearish catalyst). An even more speculative play for traders would be speculative growth stocks, as represented by ARKK and BUZZ, later this year. If leveraged crypto traders are forced to liquidate their stocks to meet margin calls, expect further selling pressure in the coming days, followed by a rebound soon afterward.

 

For small-cap investors, this means the lower quality Russell 2000 should lag the higher quality S&P 600 in the first half of December, followed by a relative relief rally.

 

 

 

In search of the next bearish catalyst

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.
 

 

Another leg down?

Here is some good news and bad news. The good news is that the S&P 500 tested its 50-day moving average (dma) while exhibiting a positive 5-day RSI divergence. That’s bullish, right?

 

 

The bad news is the same pattern occurred during the COVID Crash of 2020. Even though RSI showed a series of higher lows and higher highs, the market continued to fall after a brief relief rally.

 

The moral of this story is that RSI divergences can be more persistent than you expect. Will history repeat itself? Will the market experience another leg down?

 

 

Similarities and differences

Here is what is similar and different between 2020 and today.The market is severely oversold today. All of my market bottom models have flashed buy signals in the past week. But oversold markets can become even more oversold, which is exactly what happened during the COVID Crash of 2020.

 

 

As the market became oversold in 2020, selling was sparked by further bad news. Global markets were suddenly faced with an exogenous shock. A pandemic had gripped the world. While initial models had penciled in a SARS-like outcome, the reality was actually far worse. There were no treatments. China reacted by shutting down its economy. The global economy was collapsing.

 

Here is what’s different today. The markets were surprised by the appearance of a new variant and a hawkish pivot from the Federal Reserve. The markets are already oversold. What’s the next shoe to drop that could spark another down leg?

 

Omicron running out of control? The latest mRNA technology allows pharmaceutical companies to re-program vaccines quickly. In the worst case, a new vaccine could be available within 3-4 months, depending on testing and the regulatory approval process.

 

Government shutdown? House and Senate leaders came to an agreement to continue to fund the US government until February. Crisis averted.

 

A hawkish Fed? The yield curve flattened in the wake of the November Jobs report, indicating that the market believes economic growth is decelerating and a probable Fed policy mistake.

 

 

I know I am tempting fate by asking this question. What’s the worst thing that could happen? The market is already oversold. Oversold markets become more oversold from existential bearish catalysts such as a Russia Crisis, a Lehman collapse that threatens the global financial system, or an unexpected pandemic that shuts down the global economy. What else could go wrong?

 

Otherwise, this market weakness is just a temporary panic and a buying opportunity.

 

 

Poised for a rally

Last week, I observed that the market was oversold, but upon further investigation, sentiment was still complacent. Most traders expected the market to rally after the Black Friday downdraft.

 

This week, the market became even more oversold. Ed Clissold of Ned Davis Research observed that 7.0% of S&P 500 stocks were above their 10 dma, which is below the 7.7% oversold threshold level. Forward returns have historically been strong after similar signals.

 

 

More importantly, evidence of panic is appearing in the markets. The markets are extremely jittery. The Bollinger Band of the VIX Index has spiked above 90. While similar readings have not marked exact market bottoms in the past, they do indicate a heightened state of anxiety.

 

 

The put/call ratio has risen to levels consistent with fear.

 

 

As well, insider buying is starting to look constructive, though this indicator is an inexact market timing tool.

 

 

Another constructive sign is selling pressure may be abating on NYSE stocks. NYSE new lows peaked on November 30, just before the S&P 500 tested its 50 dma. However, NASDAQ new lows are still expanding, which is still bearish. Viewed through a style lens, this is bullish for value (NYSE) over growth (NASDAQ).

 

 

In short, the stock market is sufficiently oversold and washed out that a meaningful relief rally is imminent.

 

 

Looking for opportunity

Under a relief rally scenario, where are the greatest opportunities?

 

The most straightforward way to benefit would be to buy S&P 500 exposure in anticipation of a rebound. A most speculative way to participate would be small-cap stocks. Small-caps are washed out and hated. The small-cap indices staged a failed upside breakout and they are approaching the bottom of their trading range that has been in place for most of this year. Watch for additional selling pressure in the next few weeks as investors harvest tax losses for 2021. Buy them in anticipation of a year-end relief rally into early January.

 

 

Mark Hulbert recently cited a study showing that December tax-loss sale candidates usually turn into January winners. This Santa Claus effect begins just after Christmas and lasts into the new year.

 

 

Notwithstanding the tax-loss selling scenario, portfolio manager Steve Deppe conducted a historical study of the Russell 2000 when the index reached an all-time high weekly close followed by a three-week losing streak. While the sample size is small (n=8), the index has never closed lower a month later.

 

 

In conclusion, the stock market is oversold and there are signs of capitulation. Barring another major negative shock, the market is poised for a relief rally into year-end and possibly January. Small-caps are washed out and could prove to be a worthwhile speculative buy as a way of taking advantage of the Santa Claus rally seasonal pattern.

 

 

Disclosure: Long SPXL

 

Assessing the damage

Posted by Cam Hui -

Stock markets were recently sideswiped by the dual threat of a new Omicron strain of COVID-19 and Jerome Powell’s hawkish pivot. Global markets adopted a risk-on tone and the S&P 500 pulled back to test its 50-day moving average.
 

 

This week, I assess the damage that these developments have done to the investment climate from several perspectives:

 

  • Fundamental and macro;
  • Omicron and Federal Reserve monetary policy; and
  • Technical analysis.

 

 

Fundamental momentum still positive

Let’s start with the good news. Recessions are bull market killers and there is no recession in sight. New Deal democrat maintains a dashboard of coincident, short-leading, and long-leading indicators. His latest update concluded that the “underlying indicators for the economy in all timeframes remain generally positive”.

 

 

Fundamental momentum is still strong. Forward 12-month EPS estimates for both large and small-cap stocks are still rising.

 

 

CEO confidence is on fire. So is the employment and capital spending outlook.

 

 

 

Omicron and the Fed

There is much we don’t know about the Omicron variant of the virus. Some very preliminary data indicate that it is spreading more quickly than previous variants. The data from South Africa’s Gauteng province, which includes Johannesburg, indicates that Omicron related caseloads are rising faster than Delta. Early anecdotal evidence also suggests that infections are mild as hospitalization rates are similar or lower than other waves. On the other hand, early reports indicate that the current generation of vaccines are not as protective against Omicron infection, though they are still effective against serious illness.

 

 

There are two ways of interpreting this preliminary data. A benign scenario of a fast spreading but less deadly virus is equity bullish. Lockdowns measures would be minimal and there would be few supply chain disruptions. As well, a lower mortality wave would have the additional benefit of endowing the infected with some natural immunity. Such an outcome would be bullish for the cyclical and value stocks and beneficial to high-beta small-caps.

 

The cautious view came from the Fed’s Jerome Powell, whose testimony to Congress was initially interpreted by the markets as dovish but turned out to be hawkish [emphasis added]:

 

The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation. Greater concerns about the virus could reduce people’s willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions.
Here is the reasoning behind’s Powell’s phrase, “time to retire the word transitory”.  The Fed recently rolled out its Flexible Average Inflation Targeting framework (FAIT) as a way of addressing criticism that it was chronically undershooting its inflation target. FAIT also served as a way of allowing the Fed to pay more attention to its full employment mandate. 

 

The Fed’s response to the pandemic was a test of FAIT. The downturn in 2020 was highly unusual inasmuch as demand for goods rose while demand for services fell. At the same time, the global economy shut down in response to the pandemic and sparked a supply shock in goods production. As a consequence, durable goods PCE shot up while services PCE was relatively tame. Over time, supply chain bottlenecks should ease and inflation should fall, which was the reasoning behind the “transitory” narrative.

 

 

The emergence of Omicron poses “increased uncertainty for inflation”. Further COVID-19 disruptions to the supply chain mean that the inflation spike is more enduring and less transitory. In effect, the Fed risks being caught behind the inflation-fighting curve by allowing inflation expectations to rise and become unanchored. In other words, the Fed’s nightmare scenario is stagflation caused by slow growth from COVID-19 induced bottlenecks and rising inflation expectations. 

 

 

Stalling price momentum

Even though fundamental momentum remains positive, the combination of the Omicron news and the Fed’s hawkish pivot has turned price momentum negative. The S&P 500 had been held up during most of 2021 by the presence of positive price momentum, but momentum has turned. My momentum indicator, defined as the percentage of S&P 500 stocks above their 50 dma to percentage above 150 dma, rose above 1 and recycled below 0.9. Historically, this has been an intermediate-term cautionary signal to de-risk equity portfolios.

 

 

A longer time horizon price momentum model focuses on the percentage of stocks above their 200 dma. In the last 20 years, there has only been five episodes when this indicator reached 90% and stayed there, indicating a “good overbought” market advance (grey shaded periods). This indicator has also stalled and recycled downwards. Even though macro indicators, such as the copper/gold ratio and the equal-weighted consumer discretionary/staples ratios, appear benign, past stalls have not ended until the percentage of stocks above their 50 dma has reached the oversold levels of 20.

 

 

 

Investment implications

What does this mean for the stock market? The intermediate-term outlook depends on the path of the Omicron wave and the Fed’s reaction function. Ned Davis Research found that stock prices especially struggle if the Fed undergoes a fast tightening cycle. 

 

 

What will the Fed do? Powell testified the FOMC will consider speeding up the taper of its QE program at the December meeting, but nothing is set in stone. Expect the Fed to pivot to the narrative that “tapering does not mean rate hike”. The Fed will remain data-dependent and its reaction function will depend on progress towards economic recovery and the wildcard posed by the Omicron variant.

 

It is appropriate, I think, for us to discuss at our next meeting, which is in a couple of weeks, whether it will be appropriate to wrap up our purchases a few months earlier. In those two weeks we are going to get more data and learn more about the new variant.

Investor reaction function will also be dependent on time horizon. I have been calling for a sloppy range-bound market in H1 2022 (see How small caps are foreshadowing the 2022 market and Time for a mid-cycle swoon?). The latest risk-off episode is probably just a shot off the bow of equity investors.
 

Under these conditions, investment-oriented accounts should practice some scenario planning and risk mitigation. In the coming months, gradually de-risk portfolios by reducing equity risk and raising fixed-income allocations. My Trend Asset Allocation Model remains at a risk-on signal. The model is based on trend following principles and it will not buy in at the bottom and sell at the top. While I am not inclined to front-run model readings, I expect the Trend Model signal will be downgraded from risk-on to neutral in the next few weeks.
 

I would favor a barbell portfolio of FANG+ growth and small-cap value stocks as a way of risk mitigation and scenario analysis. If the Fed’s stagflation fears were to materialize, high-quality FANG+ stocks will outperform in a growth-scarce world. Make sure to focus on quality growth names with strong cash flows and competitive positions. Speculative growth stocks, such as meme stocks and unprofitable but promising growth companies such as the ones held by ARKK, are underperforming.
 

 

On the other hand, if the benign scenario of the Omicron wave is correct, high-beta and cyclically sensitive small-cap value stocks would have the greatest leverage to a recovery.
 

Positioning for short-term traders is a different matter. The market is wildly oversold and there are numerous short-term studies that call for a relief rally. Instead of de-risking, traders should be buying the dip.
 

As one of many examples, 95% of S&P 500 stocks closed down on November 30, 2021. There were 19 similar episodes in the last 10 years and the S&P 500 was higher within 20 trading days every time.
 

 

In conclusion, I have been calling for a transition from an early cycle market to a mid-cycle market marked by more choppiness. The recent air pocket encountered by global stock markets may just be the prelude to such a scenario. Investment-oriented accounts should gradually de-risk portfolios by reducing equity weights and adding fixed income positions. Focus on a barbell portfolio of FANG+ growth and small-cap value stocks as a way of risk mitigation.
 

Traders, on the other hand, are faced with a market that is extremely oversold. The short-term risk/reward is tilted to the upside. Buy the dip in anticipation of gains over the next few weeks.
 

Do you believe in Santa Claus?

Posted by Cam Hui -

Mid-week market update: Last Friday’s Omicron surprise left a lot of bulls off-guard when the markets suddenly went risk-off on the news of a new variant emerging from South Africa. Stocks became oversold and I observed that “To be bearish here means you are betting on another COVID Crash.” (see COVID Crash 2.0?). Even as the market staged a relief rally Monday, my alarm grew when it appeared that the consensus opinion was the bottom was in. It was a sign of excessive complacency.
 

Stock prices were sideswiped Tuesday by the news that existing vaccines may be of limited utility against Omicron and Powell’s hawkish turn. At a Senate hearing, Powell called for the retirement of the “transitory” term as a way to describe inflation, “It’s probably a good time to retire that word and explain more clearly what we mean.” As well, Powell stated that it was time for the FOMC to consider accelerating the pace of QE taper at its December meeting. The S&P 500 tanked and undercut its lows set on Friday.

 

Can the market still manage a year-end Santa Claus rally? Ryan Detrick of LPL Financial argues that history is still on the bulls’ side.

When the S&P 500 is up >20% for the year going into December, the final month of the year is actually stronger than normal.

 

What about you? Do you believe in Santa?

 

 

The bear case

The bear case is easy to make. Much technical damage has been done by the market action in the past week. Even though the S&P 500 stages an initial test of its 50 dma, the Dow fell below its 50 dma several days ago and violated its 200 dma today.

 

 

Equally disconcerting is the downward trajectory of NYSE highs-lows and NASDAQ highs-lows. The deteriorating in the NASDAQ is especially concerning as NASDAQ stocks have been the market leaders.

 

 

Even as the market became oversold, there has been a lack of panic in many quarters. The equity-only put/call ratio rose to only 0.48 on Tuesday, but the reading was below Friday’s level and well below panic levels seen in recent short-term bottoms.

 

 

Moreover, sentiment remains jittery. The market tried to stage a relief rally today, only to be derailed by the news that the Omicron variant had landed on American shores.

 

 

The bull case

The bulls will argue that the recent market action was only a hiccup. The relative performance of defensive sectors are all in downtrends, indicating that the bears haven’t seized control of the tape.

 

 

All four of my bottoming models had flashed oversold signals. In addition, TRIN spiked above 2 Tuesday, which is an indication of market clerk liquidation and price-insensitive selling that often marks short-term bottoms.

 

 

 

Waiting for the rebound

What’s the verdict? Bull or bear?

 

The jury is still out on that score. The market is obviously very oversold. Today’s market action indicates that stock prices are poised for a relief rally. Any trader who initiates short positions at current levels risks getting his head ripped off.

 

I am waiting to see how the market behaves in the next few days to pass judgment. The S&P 500 should find downside support at the current level, which is its 50 dma, and could encounter overhead resistance at its 20 dma at about 4660.

 

 

 

Stay tuned.

 

 

Disclosure: Long SPXL

 

COVID Crash 2.0?

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.
 

 

COVID panic!

Global markets took a risk-off tone on Friday when news of a heavily mutated coronavirus variant labeled B.1.1.529, or Omicron, emerged from Southern Africa. Nature reports that South African scientists recently identified a new strain.
 

Researchers in South Africa are racing to track the concerning rise of a new variant of the coronavirus that causes COVID-19. The variant harbours a large number of mutations found in other variants, including Delta, and it seems to be spreading quickly across South Africa.

 

A top priority is to follow the variant more closely as it spreads: it was first identified in Botswana this month and has turned up in travellers to Hong Kong from South Africa. Scientists are also trying to understand the variant’s properties, such as whether it can evade immune responses triggered by vaccines and whether it causes more or less severe disease than other variants do.

 

“We’re flying at warp speed,” says Penny Moore, a virologist at the University of Witwatersrand in Johannesburg, whose lab is gauging the variant’s potential to dodge immunity from vaccines and previous infections. There are anecdotal reports of reinfections and cases in vaccinated individuals, but “at this stage it’s too early to tell anything,” Moore adds.

 

“There’s a lot we don’t understand about this variant,” Richard Lessells, an infectious disease physician at the University of KwaZulu-Natal in Durban, South Africa, said at a press briefing organized by South Africa’s health department on 25 November. “The mutation profile gives us concern, but now we need to do the work to understand the significance of this variant and what it means for the response to the pandemic.”

 

 

When COVID-19 first came out of nowhere in early 2020, the global economy shut down and the markets crashed. Could we be seeing the start of COVID Crash 2.0?

 

 

2020 parallels

There are some parallels to the 2020 experience. The stock market was already exhibiting technical stress even before the onset of COVID-19.

 

The standard technique for calculating a Bollinger Band (BB) is to put a two standard deviation band around a 20-day moving average (dma). As a demonstration of how strong the recent advance has been, the S&P 500 approached the top of the 200 dma BB and stalled. In the last five years, there have been six episodes of 200 dma BB rides. In five of the instances, the top was signaled by a negative RSI divergence, which is the case today. Half of them resolved with significant downdrafts (circled in red) and the other half ended with a sideways consolidation.

 

 

If the latest round of market weakness is a just plain vanilla pullback, the latest stall is likely to be benign. That’s because the market saw an initial bottom when the NYSE McClellan Oscillator (NYMO) has already reached an oversold level. The caveat is oversold markets can become more oversold. During the COVID Crash, market internals blew past oversold conditions to reach extreme levels very quickly.

 

In fact, three of the four components of my bottoming models have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band, NYMO is oversold, and so is the 5-day RSI. Only the term structure of the VIX hasn’t inverted, but it’s very close. However, the COVID Crash was an exception to the rule for these buy signals,

 

 

Another breadth indicator, the percentage of advancing-declining volumes, fell to an oversold extreme on Friday. This has usually led to short-term bounces. To be bearish here means you are betting on another COVID Crash.

 

 

 

2020 differences

Here are some key differences between today and 2020. Global healthcare systems were completely unprepared when COVID-19 first appeared in early 2020. China reacted by completely shutting down its economy. Hospitals in northern Italy, which is the wealthiest part of the country in a G-7 nation, were overwhelmed and the death rates were horrific. There were no treatments available. The only solution was a lockdown in order to reduce the transmission rates (remember “flatten the curve”) in order to buy time for researchers to find vaccines and treatments.

 

Fast forward to 2021. Vaccines and treatments are available. Any lockdowns are likely to be relatively temporary. However, there are some key unanswered questions about the new Omicron variant.

 

  • How transmissible is it compared to other COVID-19 strains? Higher transmission rates mean greater virulence and ability to spread through the population.
  • Are its symptoms more severe than previous variants?
  • How effective are current vaccines and treatments against Omicron?
  • If current vaccines and treatments are ineffective, which is a big if, mRNA technology allows researchers to react quickly to new variants. How quickly can a new vaccine be tested and approved?
Equally important is the policy reaction. Prior to the emergence of Omicron, Fedspeak had turned hawkish. Two Fed governors and San Francisco Fed President Mary Daly, who is considered to be a dove, all supported a faster taper of QE purchases. In addition, Reuters reported that when Biden announced the re-nomination of Jerome Powell as Fed Chair and Lael Brainard as Vice-Chair, both turned their focus to inflation.

 

“We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials, like food, housing and transportation,” Powell said in comments alongside Biden and Brainard. “We will use our tools both to support the economy – a strong labor market – and to prevent higher inflation from becoming entrenched.”

 

Brainard added she too was committed to putting working Americans at the centre of her agenda. “This means getting inflation down at a time when people are focused on their jobs and how far their paychecks will go,” Brainard said.

 

The November FOMC minutes, which were released last Wednesday, also contained some surprises. It seems that the Fed is reacting to market pressures on inflation, even though the official view remains in the transitory camp.

 

Participants generally saw the current elevated level of inflation as largely reflecting factors that were likely to be transitory but judged that inflation pressures could take longer to subside than they had previously assessed.

 

Last week’s hawkish Fedspeak was confirmed by the minutes, which is signaling an acceleration in the pace of taper.

 

Some participants suggested that reducing the pace of net asset purchases by more than $15 billion each month could be warranted so that the Committee would be in a better position to make adjustments to the target range for the federal funds rate….
In the wake of the Omicron news, the WSJ reported a dramatic shift in Fed Funds expectations.

 

Federal funds futures, a proxy for market expectations of interest rate changes, shifted downward Friday, with the market anticipating that the Federal Reserve will keep interest rates low for longer. CME Group data showed the majority of investors are now pricing in two or three, quarter percentage-point rate increases by the end of 2022, compared with three or four on Wednesday. Equivalent measures of interest-rate expectations for the eurozone and the U.K. also shifted downward.

 

 

Market anomalies

As the markets reacted to the news of the new variant on Friday, some market anomalies have appeared signaling that the latest risk-off episode is a buying opportunity rather than COVID Crash 2.0. Friday’s market action is indicative of an irrational panic rather than reasoned reaction to events.

 

Treasury yields understandably fell dramatically during this risk-off episode. But if the B.1.1.529 is truly a threat to the global economy, expect the Fed to downgrade its hawkish views in light of the downside threats to growth. If that’s the case, why did the yield curve initially experience a parallel shift downwards in the 2-10 year range (though it did flatten later in the day)?

 

 

A survey of case counts shows that the situation had deteriorated badly in Europe compared to other regions. When global markets took a risk-off tone, why did EURUSD surge? The USD is normally a safe haven during periods of crisis. Instead, the greenback weakened.

 

 

 

Sentiment vs. data

Notwithstanding the latest panic, high frequency economic data had been improving. The Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been rising.

 

 

Similarly, the San Francisco Fed’s daily news sentiment index, which tracks the tone of economic news, has recovered after a brief dip.

 

 

In 2021, every variant sell-off has turned out to be a buying opportunity. The latest sell-off is likely to be another. 

 

Take a deep breath and relax. The latest mRNA technology is well-positioned to react to new variants  should current vaccines and treatments fail. Central bankers are poised to ease should growth disappoint. The latest risk-off episode represents a washout panic and a probable near-term bottom. 

 

Buy the dip.

 

 

Disclosure: Long SPXL

 

How small caps are foreshadowing the 2022 market

Posted by Cam Hui -

Small-cap stocks have lagged their large-cap counterparts in 2021. Even as the S&P 500 steadily rose to fresh highs this year, the Russell 2000 and S&P 600 finally staged upside breakouts in November out of a multi-month trading range, but they have struggled to hold those breakouts. Small-cap relative performance peaked in March, but they have sagged and been flat to down relative to the S&P 500. In an equally disturbing development for the bulls, the S&P 600 Advance-Decline Line did not confirm the upside breakout by failing to rise to new highs in November.
 

 

Here is how I believe small-cap performance is foreshadowing the S&P 500 in 2022, but probably not in the way that you are thinking.

 

 

A mid-cycle market

In the past few months, I have been making the case that the US economic expansion is changing from early cycle to mid-cycle (see Time for a mid-cycle swoon? and Where are we in the market cycle?). Mid-cycle expansions are characterized by tightening monetary policy which leads to P/E multiple contractions. Stock prices are driven by earnings growth, which are still positive.

 

There have been three such mid-cycle episodes since 1990 that could serve as templates for 2022, namely 1994, 2004, and 2010. Common characteristics were:
  • Upward pressure on 3-month T-Bill rates, indicating tighter monetary policy;
  • Flat to rising commodity prices, indicating signs of continued global expansion; and
  • Flat to choppy stock prices in H1, followed by market strength in the latter part of the year. None of the episodes resolved in major bear markets.

 

 

From a chartist’s perspective, these episodes had both similarities and differences. In all cases, the stock market had surged off major bottoms and exhibited strong positive price momentum, as shown by prolonged periods when the percentage of stocks above their 200-day moving averages (dma) had risen and stayed above 90%. The key difference was what happened when the price momentum faded. In 2004 and 2014, risk appetite indicators such as the cyclically sensitive copper/gold ratio and the consumer discretionary/staple ratios were flat. In those cases, the stock market response was a soft landing in the form of a period of sideways consolidation. By contrast, risk appetite indicators fell in 2010 (and in 2011), and stock prices corrected sharply.

 

 

As I look ahead to 2022, risk appetite indicators are flat to up. This suggests a soft landing ahead, or some choppiness and sideways consolidation for the S&P 500, but no major bearish episode, followed by market strength later in the year.

 

 

The small-cap template

Here is how small-cap performance in 2021 could foreshadow S&P 500 performance in 2022. First, the valuation framework for analysis is the S&P 600 rather than the more widely used Russell 2000. That’s because S&P has a much stricter profitability inclusion criteria than Russell. This difference has resulted in a higher weight of zombie companies, or companies whose cash flow can’t cover their interest payments, in the Russell 2000 compared to the S&P 600. As the economy emerges from the recession of 2020, it was no surprise that the zombie-laden Russell 2000 beat the S&P 600 because zombie stocks behave like out-of-the-money call options and exhibit a high degree of leverage. As the expansion matures, the higher quality S&P 600 should begin to outperform.

 

 

With that preface, the development of forward EPS estimates for both the S&P 500 and S&P 600 are similar. Both have risen strongly in the wake of the COVID Crash.

 

 

However, the patterns in forward P/E ratios are very different. While the S&P 500 forward P/E has been flat to slightly down during the recovery period, the S&P 600 forward P/E has fallen dramatically and P/E valuation levels appear quite reasonable compared to its recent history.

 

 

This brings me back to the point about what happens during a mid-cycle expansion. Interest rates rise, which puts downward pressure on P/E multiples. Earnings growth will have to do the heavy lifting in order to maintain stock price levels. In the past, this has resolved in a period of sideways consolidation, much in the manner that small-cap stocks behaved in 2021. Small caps eventually overcame the problem of P/E compression and staged an upside breakout. Expect a similar pattern for the S&P 500 in 2022. I would caution, however, that this analysis is not a forecast that the S&P 500 will match the exact pattern of small-cap stocks in 2021, only that small-cap performance serves as a template for the S&P 500 in the coming year.

 

 

Interpreting negative breadth divergence

I would like to address the concern raised by many technicians over the recent negative breadth divergence exhibited by stock market internals. The NYSE A-D Line failed to hold its breakout. Net new highs have turned negative for both the NYSE and NASDAQ. As well, the percentage of stocks above their 50 dma have struggled to maintain their strength.

 

 

The poor breadth is attributable to the lagging performance of smaller stocks, which is particularly evident by comparing the equal-weighted NASDAQ 100 to the cap-weighted NASDAQ 100.

 

 

A similar, but less pronounced effect, can be seen in the S&P 500.

 

 

Contrary to popular belief, a Mark Hulbert study found that small-cap returns have little or no effect on the S&P 500. In fact, Hulbert found that the overall market doesn’t perform when small-cap stocks are the leaders.

 

 

The combination of more attractive small-cap relative valuations and the coming transition to mid-cycle market all point to a period of struggle for the large-cap S&P 500. 

 

All is not lost for the bulls. A separate analysis by Hulbert of insider trading activity by Nejat Seyhun found that insider buying is consistent with a stock market with slightly below average returns.

 

Their current posture translates into an expected U.S. stock market return over the next 12 months that’s only moderately below the historical average.

 

 

This series of analysis is consistent with my scenario of a sideways first half and a rally in the second half of 2022.

 

In conclusion, investors should expect a period of choppy sideways action in H1 2022 for the S&P 500, followed by further strength in H2. Within the US, small-cap valuations appear more attractive on a relative basis. As well, investors should focus on high-quality stocks in the coming year. If the small-cap history of 2021 is any guide, the quality factor should outperform in 2022.

 

 

 

Trading the seasonal 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

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.
 

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.
 

Author’s note: There will be no mid-week market update next week because of the holiday-shortened week.
 

 

Melt-up risk control

The good news is the S&P 500 is testing resistance and less than 1% from its all-time high. Moreover, the recent sideways consolidation has elevated the VIX Index to near its upper Bollinger Band. An upside breakout of the Bollinger Band would constitute an oversold reading for the stock market that carries with it the prospect of more price gains. The market is presenting investors with an unusual condition of a breakout test while exhibiting a near oversold condition.

 

 

The bad news is a number of negative divergences have appeared warning of near-term weakness ahead. Even though a melt-up into year-end remains my base case, investors need to practice some risk control in case the advance unravels.

 

 

A case of bad breadth

The most glaring problem for the bulls is the narrowness of the market strength last week and this is particularly evident among NASDAQ stocks. The market has been held up by a few large-cap growth stocks. Even as the NASDAQ 100 advanced, every breadth indicator has shown negative divergences.

 

 

Small-cap indices recently staged an upside breakout but pulled back to test the breakout level. The bulls need to defend these levels, otherwise decisive violations of support could signal a bull trap.

 

 

One silver lining in the bad breadth narrative is the NYSE McClellan Oscillator has fallen to an oversold condition. With the exception of the COVID Crash, such readings have been bullish signals in the past two years.

 

 

 

Momentum still positive

As another way of practicing risk control, I present a momentum indicator that can warn of a downdraft should the melt-up fail. I found this momentum indicator to be more effective, timely and generates fewer false signals than similar models such as MACD crossovers and negative RSI divergences.

 

The accompanying chart shows the ratio of S&P 500 stocks above their 50-day moving average (dma) to S&P 500 stocks above their 150 dma. When the line rises strongly, it is an indication of strong underlying momentum. When it falls, it is signaling weakening momentum. A sell signal is generated when the momentum indicator first rises above 1 and recycles below 0.9. While no model is perfect, this indicator has warned of market downdrafts after strong rallies.

 

 

 

Where are we now? The market is on a buy (rose above 1), but it hasn’t fallen below 0.9 yet. For the time being, I am inclined to give the bull case the benefit of the doubt until this model flashes a sell signal.

 

Similarly, the SPY/IEF ratio upside breakout is still holding and it remains in a relative uptrend. Risk appetite is still positive, though it is testing trend line support and needs to be monitored.

 

 

In addition to positive technical momentum, the S&P 500 is also experiencing positive fundamental momentum. FactSet reported that Street analysts revised their aggregated bottom-up quarterly S&P 500 EPS upwards across all time horizons.

 

 

 

Positive seasonality

The bulls should totally give up. As Americans prepare to tuck into their Thanksgiving turkey next week, Jeff Hirsch at Almanac Trader pointed out that the market is entering a period of positive seasonality. This summary of Hirsch’s findings shows that stock prices on Monday and Tuesday of the week before Thanksgiving have historically been flat, but Wednesday and Friday of Thanksgiving week have exhibited a bullish bias. However, the period from Thanksgiving to year-end has also been bullish. However, the strength of the rally has been more restrained since 1987 compared to early periods.

 

 

Here is a chart in graphical form, with the caveat that seasonal tendencies are only averages and there can be wide dispersion around average returns.

 

 

 

Climbing a Wall of Worry

Even as equity prices benefit from the tailwind of positive seasonality, sentiment readings are not stretched. The market can rise further as it is climbing the proverbial Wall of Worry.

 

The latest update of weekly AAII sentiment shows a retreat in the bull-bear spread as the market consolidated sideways. This is an indication of skittishness among retail traders during a seasonally strong period.

 

 

The Investors Intelligence Survey tells a similar story of an elevated level of bearishness. I am not ready to turn cautious until the bears capitulate and turn bullish.

 

 

In conclusion, the base case scenario is another year-end rally while enjoying the tailwinds of positive momentum, bullish seasonality, and supportive sentiment conditions. Investors should monitor the market for a loss of momentum, and a decisive violation of small-cap support, which would be cautionary signals to de-risk portfolios.

 

 

Disclosure: Long SPXL

 

What’s wrong with value stocks?

Posted by Cam Hui -

What’s wrong with value stocks? The accompanying chart shows the relative performance of the Russell 1000 Value to Russell 1000 Growth Index ratio (bottom panel, solid line) and the closely correlated S&P 600 to NASDAQ 100 (bottom panel, dotted line). When the dot-com mania peaked in 2000, value stocks initially rocketed upward relative to growth stocks. The relative ascent began to moderate in 2001 but continued for several years.
 

Fast forward to 2020. The growth style had been dominant for 5-7 years and value/growth relative performance had become extremely stretched. Value recovered in 2020 but fell back in 2021. 

 

 

History doesn’t repeat, but is it even rhyming this time? What’s wrong with the value style? 

 

 

Unbalanced return profiles

First, factor returns have been distorted by the outsized performance of a handful of stocks. Analysis by S&P Global found that a small number of stocks perform extremely well and raise the average index return significantly above the median.

 

 

One prominent heavyweight that has performed well and distorted factor returns is Tesla (TSLA), which has crept into the top 10 stocks by S&P 500 index weight.

 

 

As an example of how TSLA has distorted factor return calculations, the accompanying chart shows the relative performance of the Russell 1000 Value to Russell 1000 Growth ratio (black line), which TSLA has influenced, and the relative performance of banks to software stocks (dotted red line), which has no TSLA. The two lines tracked each other well for some time, until they began to diverge.

 

 

Similarly, a comparison of the Russell 1000 Value to Growth ratio and the Russell 2000 Value to Growth ratio shows that small-cap value has performed better than large-cap value. The bottom panel shows that the size effect within value is outperforming the simple size effect as measured by the Russell 2000 to S&P 500 ratio.

 

 

While this analysis of the value/growth ratio shows that a pure value factor has performed better, its recovery remains disappointing. On the other hand, the superior performance of growth stocks is not as widespread. The relative performance of speculative growth, as measured by the relative performance of BUZZ, which are mainly meme stocks, and Cathie Wood’s ARK Innovation ETF, are flat to slightly down YTD.

 

 

 

Macro uncertainty

The lack of a value stock recovery can partly be explained by macro cross-currents. An analysis of the relative performance of cyclically sensitive value sectors shows that most are trading sideways this year. In particular, the relative returns of financial stocks are highly correlated to the shape of the 2s10s yield curve. As banks tend to borrow short and lend long, a steepening yield curve boosts profitability while a flattening yield curve squeezes lending margins. The same influence can be said of the other cyclically sensitive sectors. A steepening yield curve is the bond market’s signal of improving growth and a flattening yield curve indicates a growth deceleration. Since the yield curve has been flattening, value and cyclical stocks are facing macro headwinds.

 

 

The market consensus is shifting towards stagflation. Economists are downgrading their GDP forecasts while boosting their inflation forecasts. It is therefore no surprise that growth stocks are getting a second wind. When growth becomes scarce, investors gravitate toward growth stocks.

 

 

This macro consensus scenario may be short-lived. The Economic Surprise Index, which measures whether economic reports are beating or missing expectations, is rising. This should put upward pressure on bond yields. At a minimum, stronger growth should steepen the yield curve, which would benefit value stocks.

 

 

In addition, there are early signs that supply chain bottlenecks are easing. The semiconductor shortage is unwinding and auto production is showing preliminary signs of a rebound, This will alleviate some of the inflationary pressure in the coming months and lead to a reversal of the stagflation expectations.

 

 

 

Bull case for growth stocks

While the bull case for value stocks is based on cyclical factors, which appear to be turning up, the bull case for growth stock rests on solid secular factors. At first glance, the evaluation spread as measured by EV/sales, is at bubbly dot-com peak levels.

 

 

The relative P/E ratios, which stretched, are tamer than the EV/sales spreads suggest. That’s because large-cap growth stocks today have better margins and earnings than those of the dot-com era. The FANG+ companies tend to be cash generative and enjoy strong competitive positions.

 

 

An indirect way of observing the characteristics of large-cap growth stocks is through an ESG (Environmental, Social Governance) lens. ESG stocks have historically shown a growth tilt. That’s because it’s much easier for a growth company like Microsoft to qualifying under an ESG filter than a value company like Exxon Mobil.

 

 

Further analysis of ESG stocks reveals that they are asset-light companies which are more profitable, exhibit higher ROE and have fewer employees than the index. 

 

 

 

Value or Growth?

In conclusion, value stocks have faced a few headwinds in 2021. Large-cap factor calculations were distorted by the strong performance of heavyweight Tesla, whose share price has risen strongly to affect factor returns. In addition, the growing belief in stagflation characterized by slowing growth and rising inflation has boosted growth stocks at the expense of the value style.

 

However, an analysis of stock price momentum shows that this factor has mainly trades sideways in the last six months, indicating a lack of style dominance.

 

 

I believe investors should adopt a balanced approach by holding both value and growth stocks in their portfolios. Tactically, value should start to enjoy a revival in H1 2022 as inflation expectations ease and growth expectations rise. However, there are considerable macro risks to this scenario and investors should practice risk mitigation with commitments to large-cap growth stocks.

 

Consolidating for a rally

Posted by Cam Hui -

Mid-week market update: My trading view remains unchanged. The market is consolidating for a rally into year-end (see The seasonal rally is intact). Initial S&P 500 support on the hourly chart is at about 4680, and secondary support is at 4630-4640. If the S&P 500 breaks out to an all-time high, we’re off to the races.
 

 

 

Uptrend intact

Here are some bullish data points to keep in mind. The recent Dow Theory buy signal indicates a bullish primary trend.
 

 

As well, the relative performance of defensive sectors to the S&P 500 are not showing any signs of strength. The bears are not showing any signs of life.

 

 

Breadth indicators are positive. The NYSE Advance-Decline Line broke out to a fresh high. Net NYSE and NASDAQ highs-lows made a recent high before the market retreated. The percentage of NYSE stocks above their 50 dma broke resistance, though the NASDAQ counterpart is still lagging.

 

 

Equity risk appetite is confirming the strength in the S&P 500 and there are no negative divergences.

 

 

Finally, semiconductor stocks represented one of my bullish tripwires. These growth-cyclicals staged an upside relative breakout through a range and they are now testing another relative resistance level.

 

 

In conclusion, the market is trading sideways but internals remains bullish. My inner trader is keeping an eye on 4680 initial support and 4630-4640 secondary support as ways to control downside risk. He remains bullishly positioned.

 

 

Disclosure: Long SPXL

 

The inflation challenge

Posted by Cam Hui -

Inflation fears have been rising in the wake of the hot October CPI report. Barry Ritholz, the CEO of Ritholz Wealth Management, recently issued an open challenge to the inflationistas.
 

 

Which side of that bet would you take?

 

 

Rising inflation concerns

Inflation concerns are becoming widespread. FactSet reported the highest number of companies citing “inflation” on their earnings calls in 10 years.

 

 

While virtually all sectors saw rising “inflation” citations in their earnings calls, the one silver lining for the consumer is inflation pressures were tame in consumer staples and utilities.

 

 

 

A glass half full, or half-empty?

There has been a growing cacophony of voices calling for tighter monetary as fears that the Fed is behind the inflation-fighting curve grows. The accompanying chart depicts the heart of Ritholz’s inflation challenge. The blue line shows the 2-year Treasury yield less core CPI, which has been plunging owing to the surge in reported inflation. Readings have fallen to levels not seen since 1980 when Paul Volcker really applied the monetary brakes to wring inflationary expectations out of the system. The red line shows 2-year Treasury yields less the 5×5 inflation expectations, which is negative but turning up. One uses a backward-looking inflation metric and the other uses a forward-looking indicator. Which should Fed policy makers pay the most attention to?

 

 

If the inflationistas are right, how much should the Fed tighten? Former New York Fed President Bill Dudley penned a Bloomberg Op-Ed highlighting the risks. The later the Fed waits to tighten policy, the higher the risk that such a policy path could lead to recession. The potential peak policy rate in this cycle may be as high as 3-4%, which would well ahead of market expectations. Even a 3% Fed Funds rate would mean an inverted yield curve, which usually foreshadows a recession.

 

For what it’s worth, the Taylor Rule under different assumptions calls for a Fed Funds target of between 5.0% and 5.8%, which is substantially higher.

 

 

 

BIS: Mostly a bottleneck problem

What’s the answer on the inflation bet? The Bank of International Settlements recently published a research note which concluded that supply chain bottlenecks accounted for 2.8% of the recent inflationary spike in the US and 1.3% in the euro area [emphasis added]:
 

The mechanical effect on CPI inflation from the price increases for bottleneck-affected items has been notable in recent months. If energy and motor vehicle prices in the United States and the euro area had grown since March 2021 at their average rate between 2010 and 2019, year-on-year inflation would have been 2.8 and 1.3 percentage points lower, respectively…That said, once relative prices have adjusted sufficiently to align supply and demand, these effects should ease. Some price trends could even go into reverse as bottlenecks and precautionary hoarding behaviour wane. The mechanical effect on CPI could well turn disinflationary during this second phase.
The pandemic caused both a supply and demand shock to goods and services. Goods demand shot up while services demand cratered. Over time, increased investment in the goods sector should alleviate most of the bottlenecks and the inflation shock is forecasted to dissipate after three or four quarters.

 

 

The BIS expects inflation to fade in the coming months. Moreover, a Bloomberg article highlighted the degree of fiscal drag on the horizon, which will also have a deflationary impact.

 

 

 

Investment implications

What does this mean for investors? For equity investors, the inflation spike has been good for profits, according to the WSJ.

 

Companies are paying higher wages, spending more for materials and absorbing record freight costs, pushing up economic inflation gauges. They are also reporting some of their best profitability in years.

 

Executives are seizing a once in a generation opportunity to raise prices to match and in some cases outpace their own higher expenses, after decades of grinding down costs and prices…

 

Nearly two out of three of the biggest U.S. publicly traded companies have reported fatter profit margins so far this year than they did over the same stretch of 2019, before the Covid-19 outbreak, data from FactSet show. Nearly 100 of these giants have booked 2021 profit margins—the share of each dollar of sales a company can pocket—that are at least 50% above 2019 levels.
As long as inflation expectations are rising, that should be bullish for equities. The key is timing the inflection point. I am monitoring gold and the price of TIPs. Any weakness will be a signal to de-risk portfolios.

 

 

Conversely, the recent BoA Global Fund Manager Survey shows a record level of bearishness in bonds.

 

 

In conclusion, the recent inflation surge is temporary. It’s difficult to time the exact top in inflationary expectations, but any loss of momentum in gold and TIPs prices should be regarded as a signal for investors to reposition portfolios away from equities into bonds.

 

 

The seasonal rally is intact

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.
 

 

The most wonderful time of the year?

Jurrien Timmer at Fidelity observed that the S&P 500 is roughly following the pattern of a seasonal rally into year-end and beyond. In light of last week’s market weakness, what’s the health of the seasonal rally in 2021?

 

 

However, traders who rely on seasonality should be cautious as Ryan Detrick pointed out the middle of November can be choppy.

 

 

 

Bull trend still intact

Let’s start with the big picture. The bull trend remains intact. The market staged upside breakouts through resistance to all-time highs across all market cap bands. All indices are holding above their breakout levels, which is bullish.

 

 

Both the Dow and the Transports broke out to new highs. Those breakouts are also holding.

 

 

Market internals, such as indicators of equity risk appetite, are confirming the stock market’s newfound strength.

 

 

As well, defensive sectors are all in relative downtrends.

 

 

 

A brief setback

The market did flash a brief warning last week when the S&P 500’s 5-day correlation with the VIX and VVIX, which is the volatility of the VIX, spiked. Past instances has seen stock prices either weaken or consolidate.

 

 

On the other hand, the VIX Index rose above its upper Bollinger Band as the S&P 500 weakened. Such episodes have been signs of an oversold market indicating positive risk/reward for long positions.

 

 

The pullback appears to be over, or on its last legs. However, this doesn`t preclude the possibility of the market weakening to re-test the old lows if seasonality calls for some choppiness.

 

 

Supportive sentiment

Sentiment models are supportive of further gains in light of the backdrop of strong price momentum. The latest update of AAII weekly sentiment shows rising bullish sentiment and retreating bearish sentiment. However, the bull-bear spread is not extreme enough to warrant caution. In the past, bearish sentiment of 20% or less has been a useful but inconsistent warning sign, but bearish readings have not reached those levels yet.

 

 

The TD-Ameritrade IMX, which measures the positioning of that firm’s clients, fell even as the S&P 500 rose to fresh highs. This is a classic sign of the market climbing the proverbial Wall of Worry.

 

 

Sentiment is by no means frothy. The combination of positive seasonality, strong price momentum, and skeptical sentiment indicates that there is more upside potential.

 

 

All systems go

In conclusion, the upside breakouts of the major market indices are holding. The measured upside objective of the S&P 500 on a point and figure chart varies between 5220 and 5450, depending on how the box size and reversal parameters are set.

 

 

All systems are go for the seasonal rally.

 

 

Disclosure: Long SPXL

Commodity weakness = Global slowdown?

Posted by Cam Hui -

My Trend Asset Allocation Model has performed well by beating a 60/40 benchmark on an out-of-sample basis in the last few years. The early version of the Trend Model relied exclusively on commodity prices for signals of global reflation and deflation. While the inputs have changed to include global equity prices, this nevertheless raises some concerns for equity investors.
 

 

Commodity prices are weakening, which could be a signal of global economic deceleration. In particular, the cyclically sensitive industrial metals are losing momentum and showing signs of violating a rising trend line.

 

 

 

Commodity warnings

Even as the equity averages in the major developed world rallied to fresh all-time highs, a negative divergence is appearing in the commodity markets. Commodity averages, whether they are energy-heavy liquidity weighted or equal-weighted, have failed to confirm equity market strength. Equally disturbing is the weakness in the cyclically sensitive copper/gold ratio and the more diversified base metals/gold ratio.

 

 

Commodity weakness may not be over. Recession Alert highlighted an eight-month lead-lag relationship between countries with rising leading economic indicators (LEI) and the CRB Index. If the past is any guide, the recent loss in momentum in LEIs is foreshadowing a major top in commodity prices.

 

 

 

Silver linings

In more normal times, an imminent top in commodity prices would have me concerned about the health of the global economy. But this is an unusual economic cycle characterized by the stresses of supply chain bottlenecks.

 

There is no recession on the horizon. New Deal democrat, who monitors the US economy using coincident, short-leading, and long-leading indicators, declared that all three time horizons are positive. In fact, the nascent weakness in commodity prices represents a silver lining.

 

For the second week in a row oil has declined, joining shipping costs and all commodities, not just industrial metals, in retreating from highs. Gas prices should follow suit within the next few weeks. Note that the BDI has fallen by more than -50% from a peak just one month ago. This suggests that the supply chain bottleneck has passed its peak. If so, one would expect the huge increases in house and car prices to begin to abate soon.

Indeed, easing commodity prices are likely to put a lid on the inflation hysteria that emerged after the hot October CPI print. Producer prices (red line) have led CPI upwards in recent months and any commodity price weakness will cool off CPI in the near future.
 

 

 

China weakness contained

As China is such a voracious consumer of commodities, I believe commodity weakness is mainly reflective of a slowdown in China whose effects have so far been contained in Asia  The relative performance of the stock markets of China and her major Asian trading partners tells the story. All are in relative downtrends compared to the MSCI All-Country World Index (ACWI). Several have broken relative support. Japan rallied on the news of a change in the prime minister, but gave up all of its gains soon afterward.
 

 

Within the global materials sector, Chinese material stocks have plunged relative to their global counterparts in recent weeks, indicating greater weakness within the Middle Kingdom in that sector.
 

 

On the other hand, the Chinese consumer doesn’t seem to be hurting very much. Alibaba reported a record 540.3 billion yuan in Singles Day sales this year. Moreover, European luxury goods maker LVMH, which derives a substantial amount of its sales in China, is performing in line with other consumer discretionary stocks.
 

 

Markets in Europe and the US have mostly shrugged off any weakness coming from China. In the US, the relative performance of key cyclical sectors and industries appears constructive. Some are staging relative breakouts (semiconductors and transportation), others are range-bound (homebuilders, energy, mining), and one is bottoming (industrials).
 

 

In Europe, cyclical sectors like industrials and financials are not showing signs of relative weakness. However, basic materials are in a relative downtrend, which is unsurprising in light of a loss of commodity price momentum.
 

 

 

A decoupled China

In conclusion, weak commodity prices are signaling a slowdown in the Chinese economy. Although China Evergrande’s debt woes has not resulted in a Lehman 2.0 event in China, its debt problems have spread to other property developers. Yields on China’s USD junk bonds are soaring and the slowdown is manifesting itself in falling commodity demand.
 

 

However, we are seeing few contagion effects and there are some silvering linings to commodity price weakness. First, it should lead to better inflation prints in the coming months and alleviate some of the inflation hysteria gripping the markets. As well, falling commodity prices translate to lower input prices for manufacturers, which should improve operating markets and boost profitability.
 

Commodity and China weakness only represents a minor pothole in global growth. Topdown Charts recently pointed out that 90% of countries saw their October PMIs in expansion even as China weakened. This is what China decoupling and weakness containment looks like.

October PMI data was particularly encouraging last week. The data show that the proportion of countries with a PMI above 50 reached 90%. Most countries are seeing significant economic growth as the world fights off the final wave of COVID-19 (knock on wood).

 

 

Bullish and bearish signals from volatility

Posted by Cam Hui -

Mid-week market update: Volatility indexes are flashing a number of signals of interest. In the past few weeks, a yawning gap has opened out between MOVE, which measures bond volatility, and VIX, which measures equity volatility. The divergence has begun to close in the last couple of days as the VIX has risen and the spread has narrowed.
 

 

Another cautionary signal from vol is appearing in the form of an increased 5-day correlation between the S&P 500 and VIX, and VVIX, which is the volatility of the VIX. In the past, spikes in correlation has seen stocks either pause their advance or pull back. In particular, high correlations with VVIX have been more effective as short-term warnings than VIX correlations.

 

 

Does that mean the S&P 500 is at risk of a significant downdraft? Not so fast. A third volatility indicator suggests that downside risk is limited. Even as the S&P 500 weakened, the VIX Index has spiked above its upper Bollinger Band (BB), which is an oversold reading for the market. In the past, such events have marked indicating positive risk/reward for the bulls over a 3-5 day time horizon.

 

 

The stock market is roughly following its seasonal pattern. If the past is any guide, stock prices should pause its advance about now, which would be followed by a resumption of a rally into year-end.

 

 

In other words, the seasonal melt-up that I have been calling for remains intact.

 

 

Opportunities in gold

On a different topic, the October CPI print came in hot this morning. Both headline and core CPI came in well ahead of expectations. The strong CPI report highlights a tactical opportunity in gold and gold mining stocks. Gold, which is viewed as an inflation hedge vehicle, staged a decisive upside breakout through resistance today and its strength had already been signaled by the rally in TIPs prices.

 

 

In addition, the gold miners have also staged an upside liftoff from a support zone. The improvement had been signaled by a bottom in the percentage bullish indicator, which had recycled from an oversold condition. Gold miner strength has also been confirmed by the miner/gold ratio and the high-beta junior/senior gold ratio (GDXJ/GDX).

 

 

 

Disclosure: Long SPXL