China blinked, but can it save the world again?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Beijing blinked

It’s always the darkest before the dawn. Just as it seemed that the world was about to collapse into a synchronized global recession, Beijing announced that it’s considering allowing the sale of 1.5T yuan (USD 220B) in local government bonds earlier than planned to fund infrastructure projects.

 

 

Commodities rallied on the news but China related equity markets greeted the announcement with a yawn. Can China rescue the global economy once again?

 

 

China’s policy challenges

The jury is still out on that question. In the past, Asian markets have moved in lockstep with China’s ups and downs. This time, it has become more bifurcated. While China and Hong Kong have turned up in relative strength even before the announcement, Japan has roughly matched the performance of the MSCI All-Country World Index (ACWI). Semiconductor-sensitive South Korea and Taiwan are weak, and so is resource-heavy Australia.

 

 

While the stimulus program is a positive step, China’s challenge is to balance the needs of its zero COVID policy against the need for a growth revival. To be sure, injecting 1.5 trillion yuan into the Chinese economy will create a flood of liquidity into the financial system, but how much of the stimulus will be financialized, and how much will actually get into the Main Street economy?

 

 

Beware of the FOMC cycle

It’s difficult to instantly assess the impact of a policy shift. China’s stimulus could have a real lasting effect on global liquidity, or it could be a fake-out. US investors need to be mindful of the FOMC market cycle that’s played out in 2022. The market has shown a tendency to peak about one to two weeks before an FOMC meeting and decline into the meeting, followed by a rally. As the next meeting is scheduled for July 26-27, the timing of a peak could begin as soon as the coming week. (Note that the arrows shown in the accompanying chart are purely stylized and do not connote any price targets).

 

 

The stock market may have further short-term upside potential. One of the key indicators that the Fed will be watching is the June CPI report due Wednesday. Consensus expectations calls for a monthly headline CPI of 1.1% and core CPI of 0.6%. The Cleveland Fed’s inflation nowcast shows a headline CPI of 0.97% and core CPI of 0.49%, which is a setup for a tame inflation surprise and potentially bullish for risky assets.

 

 

For now, the S&P 500 remains in a falling channel on the weekly chart. Until it can stage an upside breakout, the bears are still in control of the tape.

 

 

 

Timing the short-term peak

The S&P 500 is testing resistance in the 3900-3920 zone, with secondary at the 50 dma at about 3970. Momentum may stall here, but the bulls have a shot at rallying the market further as indicators are not overbought yet.

 

 

Here are some of the indications that I am monitoring in order to time a short-term peak. The NYSE McClellan Oscillator (NYMO) recycled from an oversold condition and flashed a buy signal. An overbought reading, or a near overbought reading, would be a sign to take some profits.

 

 

Similarly, the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator (ITBM) also flashed a buy signal at about the same time. The buy signal is based on a recycle of ITBM’s 14-day RSI from oversold to neutral. I am waiting for an overbought condition for a sell signal.

 

 

 

Still a crowded short

Despite my short-term caution, sentiment models are still pointing to the market forming an intermediate-term bottom. AAII sentiment remains at a crowded short, which is contrarian bullish.

 

 

While AAII sentiment is an investor survey, the TD-Ameritrade Investor Movement Index (IMX) measures the client positions of the firm. The latest monthly readings have continue to plunge and sentiment is approaching COVID Crash lows.

 

 

Macro Charts also pointed out that aggregate equity futures positioning by asset managers and hedge funds is at a record low.

 

 

In conclusion, I continue to believe the stock market is in the process of making an intermediate-term bottom. The panic from mid-June likely established a major support level for a bottom for this cycle (see Why last week may have been THE BOTTOM). While a V-shaped recovery is always a possibility, the odds favor a re-test of the old lows in the coming weeks. The China stimulus news was the catalyst for a relief rally of unknown magnitude. The bears aren’t done yet, and the FOMC cycle may not be done either.

 

What if the market bottomed and no one realized it?

Posted by Cam Hui -

It’s stunning how market psychology has changed. In the space of a few months, we’ve swung from “everyone is bullish” to “everyone is bearish”. These results from the BoA Global Fund Manager Survey were done in early June and sentiment has likely deteriorated since then.
 

 

The good news is the market is becoming numb to bad news. What if the stock market bottomed and no one actually realized it?

 

 

The bears throw a party

The bears are throwing a party and there’s no shortage of bad news. From a global perspective, ASR’s New Orders PMI 12-month diffusion indicator, which is composed of 24 country PMIs, is cratering.

 

 

In the US, the yield curve has flattened and the 2s10s spread has slightly inverted, which is usually interpreted as a recession warning.

 

 

The June Jobs Report solidified the Fed’s tightening path. Non-Farm Payroll came in ahead of expectations at 372K jobs, and average hourly earnings printed a slight beat at 5.1%. This is a picture of a strong labor market. More ominously was the Diffusion Index. While the diffusion index for total private jobs stayed steady, manufacturing showed some signs of weakness.

 

 

Other leading indicators of the jobs market is showing signs of deterioration. Temporary jobs and the quits/layoffs rate from the JOLTS report have led Non-Farm Payroll, and both indicators are rolling over. This, along with the Diffusion Index, is pointing to the conclusion that the Fed is tightening into a slowdown.

 

 

I recently pointed out that as the macro backdrop deteriorates, the Q2 earnings season will be the acid test for the equity market. As investors await the start of earnings season, FactSet reported that the rate of negative guidance has been steadily rising, though levels are nowhere near all-time highs.

 

 

Across the Atlantic, Germany’s vaunted trade surplus has swung into deficit and dragged the eurozone down with it. The chief culprit has been the high cost of energy in the wake of the Russia-Ukraine war. 

 

 

The French nationalization of electric utility EDF and the German bailout of Uniper are signs of the stresses appearing in Europe’s energy market. European electricity prices are potentially reaching a credit level event, especially if a bank or hedge fund is caught on the wrong side of electricity price hedges.

 

 

The credit default swaps of Credit Suisse skyrocketed last week, though the cause is unrelated to electricity hedging. For the uninitiated, CDS contracts are insurance policies that pay out if a borrower were to default on its debt. Arguably, this could be filed under “it’s so bad it’s good”. Central banks tighten until something breaks that threatens financial stability. Skyrocketing CDS rates are warning signs of cracks appearing in the system.

 

 

Over in Asia, Fathom Consulting makes the case that China is already in recession, though activity indicators are not as severe as what was seen during the first COVID Crisis.

 

 

Keep an eye on commodity prices, which is also tells the tale of a sputtering Chinese economy. Beijing is considering a sale 1.5 trillion yuan (USD 220B) of local government bonds in the second half of this year to fund infrastructure projects. The success or failure of the latest stimulus program will be reflected in commodities.

 

 

 

Where’s the panic?

As the flood of bearish news continues, investors would expect the markets to take a risk-on tone. But market psychology is becoming increasingly numb to bad news.

 

For example, consider Fed Funds futures, which is discounting a series of rate hikes into year-end, followed by a pause in early 2023 and rate cuts by next summer. If markets look forward 6-12 months, are they anticipating the recession or the prospect of Fed easing?

 

 

The 30-year Treasury yield may be peaking. Historically, peaks in the long bond yield has coincided or slightly preceded Fed rate cycle pauses. These readings are consistent with the expectation of a plateau in the Fed Funds rate in early 2023.

 

 

Even as recession fears spike, corporate insiders are stepping up and buying whenever the S&P 500 has weakened. While insider activity isn’t a precise market timing indicator, this group of “smart investors” are signaling that they are willing to look over any recessionary valley.

 

 

I previous made the point that the Q2 earnings season could be the acid test for equity prices. As negative guidance rises and growth slows, analysts are likely to cut their earnings estimates, which makes the forward P/E less attractive. While it’s difficult to anticipate how forward 12-month EPS estimates will evolve in the coming weeks, investors can see the relationship between the 10-year Treasury yield and trailing 12-month reported P/E ratio. S&P 500 trailing P/E is roughly in the same range as the last two times the 10-year Treasury yield was at these levels. Downside potential may be limited, especially if the economy either achieves a soft landing or experience a mild recession.

 

 

Technical analysis offers some clues about how market psychology has evolved. The percentage of S&P 500 above their 50 dma fell below 5% in mid-June, indicating a panicked extreme, and recycled back above 20%. There have been seven similar episodes in the last 20 years. The market made a V-shaped bottom on two of these occasions. In the other five, these oversold and recoveries were the signs of an initial bottom, followed by a re-test of the old lows within a few months. Only one (2008) saw a significant undercut of the initial low. All of the re-tests were marked by positive RSI divergences. These conditions are consistent with my past observation of a panic low in stock prices (see Why last week may ahve been THE BOTTOM). The odds favor a rally and re-test of the lows, though the historical record indicates that a V-shaped bottom has a probability of about 30%.

 

 

The rally and re-test scenario is consistent with the midterm election year seasonal pattern of a strong July followed by weakness and a low in September.

 

 

 

Trend Model

Finally, some readers have asked why the Trend Asset Allocation Model remains in a bearish signal if my analysis has become more constructive on the stock market. The Trend Asset Allocation Model is a model based on the application of trend-following principles on a variety of global stock markets and commodity prices, most of which are in downtrends. Trend following models are designed to spot durable trends and they are by design late at major tops and bottoms. Even if I am right about a market bottom, I don’t expect the Trend Model to turn more positive until a turnaround is more established. That’s a feature, not a bug.

 

This model has beaten a 60/40 benchmark during this latest bear episode, even though stock and bond prices have fallen together (detailed track record here).

 

 

In conclusion, market psychology has taken a sudden shift from bullish to bearish as recession risks have surged, but the stock market has become increasingly numb to bad news. I interpret this to mean that equities are undergoing a bottoming process. Downside risk is limited and upside potential is high, though investors should be prepared for some short-term bumpiness.

 

Numb to bad news

Posted by Cam Hui -

Mid-week market update: You can tell a lot about the tone of a stock market by the way it reacts to news. The 2s10s yield curve just inverted again, which has been a sign of an impending recession. If history is any guide, yield curve inversions have marked major market tops. The exceptions, shown as pink lines, are the instances when the yield curve just missed an inversion and economic growth continued.
 

 

Why hasn’t the S&P 500 tanked? The answer seems to be it has become numb to the flood of bad news.

 

 

Washed out

Here’s another example. Micron Technology issued an ugly warning last week. Revenue and earnings guidance was an order of magnitude below consensus expectations.

 

 

In more normal times, the stock could have been down 50%. Instead, it fell -3% and it recovered all of the losses this week.

 

 

The market’s response on the extreme end of the risk scale is equally illuminating. As more news of platform blowups and withdrawal suspensions emerged from Crypto-Land, Bitcoin should be tanking and trading in the single-thousand level, if not even lower. Instead, it has steadied at around 20,000. As well, the ARK Innovation ETF (ARKK) is exhibiting positive relative strength and beginning to outperform the S&P 500.

 

 

Goldman’s sector valuation found that defensive sectors were all in the upper half of relative valuations, which is a sign that the risk-off trade is becoming increasingly crowded.

 

 

The market is washed-out and risk appetite is returning.

 

 

Upside potential

If the market is undergoing a relief rally, what’s the upside potential? A number of low sample size studies offer some clues.

 

Yesterday’s market action was particularly impressive. The S&P 500 opened up -2% but managed to recover and claw its way to a slightly positive close. Steve Deppe conducted a study that found some impressive forward returns but warned that the sample size was small (n=7).

 

 

Rob Hanna at Quantifable Edges studied markets with -15% returns in the first half of the year..These markets also experienced strong positive forward returns, though the sample size is even smaller (n=5) and some of the episodes went back to the 1930’s.

 

 

He warned that the results after H1 years that fell between -10% and -15% were uneven.

 

 

I conclude from this that historical experiences can only offer a rough guide because of the low sample size of the studies. While market psychology is washed-out and the market is undergoing a relief rally, traders should exercise some caution and refrain from becoming overly greedy. The S&P 500 will see resistance in the 3900-3940 zone. Above that is secondary resistance offered by the 50 dma. If the index reaches those levels, traders should take some profits.

 

 

As the trader’s adage goes, “Bulls make money, bears make money, pigs just get slaughtered.”

 

When does the pain end?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Here we go again

June was awful month and 2022 was even worse for investors. The S&P 500 has been falling all year, though it constructively ended the week with a continuing positive 5-week RSI divergence, indicating waning downside momentum.

 

 

Where’s the bottom? 

 

 

A history of pain

The historical studies give a good sense of the carnage. There have only been seven other occasions since 1946 when the S&P 500 has fallen -15% or more. If history is any guide, the market rebounded in the next three, six, and 12 months.

 

 

The first half was also ugly, with similarly positive results for the remainder of the year.

 

 

Not only did stocks perform badly, but also the 10-year Treasury hasn’t had such a rough time since 1788, which was the year before George Washington first became President.

 

 

Even my Trend Asset Allocation Model was substantially in the red, though it did beat its benchmark. The model portfolio one-month return was -3.7% vs. -4.3% for a 60/40 benchmark. The one-year return was -7.5%, vs. -9.0% for the 60/40 benchmark (full details here).

 

 

 

A nadir in confidence?

Do these historical studies mean that the markets are poised for a rebound? Here are some clues.

 

A recent Deutsche Bank survey found that “90% expect the next US recession by the end of 2023 or before, with 20% anticipating one this year. That is up from 37% and 2% in January, respectively, and 78% and 13% last month.” A recession is now the overwhelming consensus.

 

 

Households are similarly pessimistic. Bottoms in consumer confidence has historically resolved in strong equity price returns. The key question for investors is whether confidence can turn up in the near future.

 

 

Consumer confidence has shown a strong inverse relationship with oil prices since the mid-90’s (WTI price is inverted).

 

 

Crude oil prices are looking a little toppy, but can they drop in light of the supply difficulties caused by the Russia-Ukraine war? The New York Fed produces a weekly oil price dynamics report, which decomposes the different elements of oil prices. Supply dynamics (red) are tight, but demand (blue) is falling. The gold region, or residual, can be best thought of as speculative investor demand, which is also falling. Consequently, oil prices have encountered difficulty advancing in the face of falling supply. 

 

 

Already, growth expectations are skidding. As the growth outlook slows, the combination of slower demand and waning speculative activity will be bearish factors in oil prices. As energy costs ease, consumer confidence should begin to recover.

 

 

 

Sentiment support

Sentiment and technical conditions point to a washout. Jason Goepfert at SentimenTrader found that 5-week market volatility is at its highest since 1928, which has caused sentiment to tank. Over the past 80 years, similar instability coincided with the ends of bear markets. The catch is such conditions don’t always pinpoint the precise bottom.

 

 

SentimenTrader also has built a proprietary Risk On/Off Indicator, which combines 21 unique components into a weight-of-the-evidence approach to assess market conditions. It just fell to zero for only the sixth time in the last 20 years.
 

 

 

Valuation signals

As well, JPMorgan Asset Management found that the percentage of companies trading at below cash and short-term investments has risen to a fresh high. Before becoming overly excited, keep in mind that these companies are from the CRSP universe, which contains many micro-cap stocks that are not investable for liquidity reasons. Nevertheless, this is a useful signal that the stock market is becoming very cheap.

 

 

 

No Fed Put

The bears will argue that this time is different. While the market is becoming stressed and sentiment looks washed out, global central bankers have affirmed their commitment to fighting inflation. Better take a little pain now than have to take a lot more pain later if inflation expectations become unanchored. In other words, there’s no Fed put.

 

Financial conditions are becoming stressed, but readings are hardly at crisis levels and the unemployment rate is 3.6%.

 

 

It is said that the Fed will raise rates until something breaks, nothing in the U.S. is at imminent risk of breaking. Across the Atlantic, the situation looks a little more precarious. The German utility Uniper announced that it was withdrawing guidance as the company relies on Russian Gas for 50% of its supply. Uniper is losing €30M a day from buying missing gas volumes at spot prices. The situation was resolved when the German government indicated that it stood ready to support the company with a bailout. There’s nowhere to hide. Not even utilities are safe.

 

The Uniper situation highlights the EU’s fragile position. Gazprom is scheduled to shut down the Nordstream 1 pipeline July 11–21 for planned maintenance. The concern is that Moscow will take the opportunity to permanently shut gas supplies to the EU in retaliation for supporting Ukraine in the war. Notwithstanding the effects of tighter monetary policy, a shutdown will have the double whammy effect of cratering European growth.

 

Does this meet the criteria of something breaking?

 

 

Seasonal tailwinds

Where does that leave us? 

 

While I am somewhat skeptical of seasonal patterns, the NDR Cycle Composite takes three historical cycles made up of the one-year, Presidential, and 10-year decennial cycles. It has been almost perfect in 2022. It’s pointing to a strong stock market rally in the second half.

 

 

While I am not brushing aside the downside risks to growth, investors have to play the odds in these times of apparent market panic. The market is very worried about falling growth and an inflation rate that’s slow to decelerate. Few have considered a scenario of a combination of small improvements in supply and demand destruction from higher rates is just enough to soft-land the economy. The rise of recession hysteria has meant that risk/reward is becoming tilted to the upside for equity investors.

 

The seven reasons why this cycle is different

Posted by Cam Hui -

One of the key risks to the stock market is earnings expectations. As recession risk rises, it has been unusual to see forward 12-month EPS estimates continue to rise. The latest update finally shows that earnings expectations are beginning to stall. S&P 500 estimates are flat for the week, up a miniscule 0.01, while small-cap S&P 600 estimates are down over -1% in the week.
 

 

Why haven’t stock prices skidded further? Here are some reasons why this cycle is different from others.

 

 

Recession fears overdone

Here is the bull case. Recession fears are overdone and a slowdown may already be discounted by the markets. Global web searches for the term “recession” has spiked to levels consistent with the COVID Crash and the GFC.

 

 

Economic deterioration is attributable to three factors. 
  • Household consumption has shifted from goods to services. While the shift is not recessionary, it does resulted in a dramatic change in indicators like manufacturing PMI.
  • Inflationary pressures from higher prices have resolved in volume destruction, but no demand destruction, which would be recessionary.
  • Monetary policy is working to dampen growth expectations.
LinkedIn chief economist Gary Berger pointed out that the economy may not be as bad as many people feared. While most investors and economists focus on GDP, which is derived from spending data, GDI, which is calculated from income data, is not that bad. Q1 GDI expanded at the trend growth rate of 2%.

 

 

Berger’s observation that income-derived data points to continued expansion is consistent with Ben Carlson‘s conclusion that consumers are prepared for a recession. Household balance sheets are strong and any recession should be mild as leverage is low in the system.

 

 

 

Inflation pressures are easing

Remember the transitory inflation narrative? It’s actually happening. Container freight rates have peaked, which is a signal that supply chain bottlenecks are easing.

 

 

The latest release of PCE shows monthly core PCE at 0.3% for May and annual core PCE at 4.7%, both of which were below market expectations. The good news is PCE and core PCE are decelerating on an annual basis. The bad news is the progress in monthly core PCE has been stalled at 0.3% and the base effects of high inflation will dissipate by July. These readings will be encouraging for Fed officials, but they aren’t likely to be convincing enough for a pivot to an easier monetary policy.

 

 

 

Effective monetary policy

The positive effects of tighter monetary policy are appearing. Inflationary expectations are well-anchored and falling. Central bankers will think twice when they consider tighter policy to overshoot their neutral rate targets.

 

 

The current cycle looks like a rapid rate hike cycle. The market focus has shifted to whether the Fed will hike 0.50% or 0.75% at the next FOMC meeting to the terminal rate and the timetable for easing policy. Fed funds futures are now expecting a terminal rate of 3.25% to 3.50%, which is down 0.50% from 3.75% to 4.00% after the hot May CPI print. The market expects the Fed to reverse course and ease in mid-2023. In other words, it’s expecting a recession. While this is consistent with the Fed’s SEP projection of a Fed Funds rate of 3.4% at the end of 2022, the Fed expects further tightening in 2023.

 

 

Financial markets are inherently forward-looking. If they discount events 6-12 months ahead of time, any recession is already priced in and the stock market’s strength is anticipating a Fed pivot towards easing.

 

 

Value signals

Finally, value signals are appearing in the stock market. Insiders have been buying the dips whenever the market has weakened, which could put a floor on stock prices.

 

 

As well, value investor Howard Marks, whose newsletter is admired by Warren Buffett, was profiled in the Financial Times and said, “Time is ripe to snap up bargains”. He revealed that he is “starting to behave aggressively”.

 

 

You ain’t seen nothing yet

Here is the bear case. A global recession is looming. NDR’s Global Recession Probability Model is now at 89.3%. It has never moved above 90% without a global slowdown either being in place or happening soon.

 

 

Central bankers are engineering a recession. Even as they focus on fighting inflation, PMI data indicates that they are tightening into a slowdown.

 

 

Commodity prices are also signaling a slowdown. Both the liquidity-weighted headline commodity indices, which are heavily weighted in energy, and the equal-weighted indices are breaking down. The all-important copper/gold and base metal/gold ratios are falling, indicating cyclical weakness.

 

 

In particular, the copper/gold and base metal/gold ratios have shown a strong history of being a good risk appetite indicator.

 

 

 

More downside risk

If you thought that the market has already fully discounted a slowdown, think again. S&P 500 forward 12-month estimates are just starting to wobble. Historically, EPS falls -17% during recessions. The coming days could see both P/E compression and a falling E.

 

 

As an example, Micron’s earnings and Q4 guidance was astonishingly bad. That said, the market reacted positively on Friday to GM’s negative guidance.

 

 

The WSJ also reported that stocks normally don’t bottom until the Fed eases:
If history is any guide, the selloff might still be in its early stages. 

 

Investors have often blamed the Federal Reserve for market routs. It turns out the Fed has often had a hand in market turnarounds, too. Going back to 1950, the S&P 500 has sold off at least 15% on 17 occasions, according to research from Vickie Chang, a global markets strategist at Goldman Sachs Group Inc. On 11 of those 17 occasions, the stock market managed to bottom out only around the time the Fed shifted toward loosening monetary policy again. 
In other words, brace for more downside risk.

 

 

China weakness

Furthermore, don’t bother waiting for Chinese stimulus to pull the global economy out of its slump. The Chinese economy is exhibiting signs of weakness with few signs of recovery. CNBC reported that China Beige Book found widespread weakness in the wake of the zero-COVID lockdowns.
Chinese businesses ranging from services to manufacturing reported a slowdown in the second quarter from the first, reflecting the prolonged impact of Covid controls.

 

That’s according to the U.S.-based China Beige Book, which claims to have conducted more than 4,300 interviews in China in late April and the month ended June 15.

 

“While most high-profile lockdowns were relaxed in May, June data do not show the powerhouse bounce-back most expected,” according to a report released Tuesday. The analysis found few signs that government stimulus was having much of an effect yet.
Sales and profit margins are slumping.

 

 

Credit growth is still weak, indicating a lack of stimulus.

 

 

The SCMP reported that Q1 migrant worker wages were flat year on year in real terms, which is a signal of anemic household demand. Other anecdotal evidence points to weakness in both the property market and household sector. If you were waiting for another round of stimulus to boost infrastructure spending, forget it!

 

 

 

A rapid tightening cycle

Here is how I resolve the bull and bear cases. This has been an extraordinarily rapid rate hike cycle. Mary Daly of the San Francisco Fed pointed out that financial conditions have tightened very quickly compared to past cycles. It is therefore no surprise that the market is discounting Fed easing in 2023.

 

 

The economy is in uncharted waters in light of the speed and intensity of the current tightening cycle. Conventional cycle analysis argues for more equity downside in light of the earnings adjustments should a recession materialize. Willie Delwiche at All Star Charts has proposed a 2008 style template for the stock market.

 

 

I think his conclusions are overly alarmist. Even if a recession were to occur, its effects on employment and spending should be relatively mild, like in 1990, when the S&P 500 peak-to-trough drawdown was -20%. The bulls will argue the market has already discounted the downturn and it’s now looking ahead to the easing cycle. 

 

The acid test for market psychology will be Q2 earnings season. How will earnings and guidance come in? More importantly, how will the market react to the news? More immediately, the June Employment Report will serve as another guidepost for the trajectory of monetary policy.

 

Stay tuned.

 

Trading the FOMC pattern

Posted by Cam Hui -

Mid-week market update: Even though the sample size is small (n=4), the stock market seems to be repeating the FOMC meeting pattern of 2022. The pattern consists of weakness into an FOMC meeting and a rally afterward. The post-meeting rally in May fizzled out quickly but the others were more sustainable. 
 

 

The S&P 500 is now testing support after breaking out. If the market were to rally, gap resistance can be found at 3980-4020. Is there any more life left in the current rally? Will the market decline into the next FOMC meeting scheduled for July 26-27?

 

 

Sentiment support

While it is true that the market retreated from a short-term overbought condition and prices would weaken further from current levels, excessively bearish sentiment will act to put a floor on prices. II sentiment improved this week but remains at a bearish extreme.

 

 

A recent survey of JPM Macro Quantitative conference attendees revealed a bearish bias.

 

 

Macro Charts pointed out that aggregate futures positioning is at a record low.

 

 

Outside of a cataclysmic event such as California getting hit with the BIG ONE and sliding into the sea, markets simply don’t crash with sentiment at such extremes.

 

 

Timing the peak

While there are no guarantees, if the market were to follow the FOMC pattern, watch for a peak about 10 days before the next FOMC meeting, which takes us to mid-July. Tactically, I would stay bullish and watch for an overbought condition in the NYSE McClellan Oscillator.

 

 

My inner investor is still cautiously positioned but he will nibble away at positions should the market weaken. My inner trader is on the sidelines. It’s too late to buy but too early to short.

 

Q2 earnings season = Market abyss?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Nagging doubts

Despite my constructive views on the direction of the stock market, some nagging doubts remain. Even as top-down strategist reduce their S&P 500 EPS estimates, bottom-up estimates, as measured by forward 12-month EPS, have been rising steadily for both large and small caps.

 

As we approach Q2 earnings season, the risk of a flood of negative guidance that pushes down consensus estimates is high, which would spark a risk-off episode.

 

 

Still a crowded short

Sentiment models are supportive of higher prices. I recognize that there are problems with the AAII weekly sentiment survey, such as low sample size and differing survey respondents that vary from week to week. Nevertheless, the latest AAII weekly survey shows that the bull-bear spread has only been exceeded twice in its history, the 1990 bear market and the GFC Crash. The percentage of bears also shows a similar result. These levels are astonishing when you consider the Crash of 1987 is part of the historical period.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investor funds, is also highly negative. This index has flashed an almost sure-fire buy signal whenever it fell below its 26-week Bollinger Band. While the latest readings weren’t below the 26-week BB, they did equal the level five weeks ago when this index produced a buy signal.

 

 

The correlation of stocks within the S&P 500 has spiked. This is another contrarian bullish signal which indicates herding and excessive fear.

 

 

 

Technically bullish

From an intermediate-term basis, the weekly S&P 500 exhibited a positive RSI divergence when it fell to fresh lows two weeks ago on high volume, which should lead to higher prices.

 

 

Market breadth is also constructive. NYSE 52-week highs-lows failed to make a new low when the S&P 500 made a low for the year, while NASDAQ 52-week highs-lows exhibited a positive divergence.

 

 

The S&P 500 Intermediate Term Breadth Oscillator saw its 14-day RSI recycle from an oversold condition. This has been a fairly reliable tactical buy signal in the past.

 

 

 

Price leads fundamentals

Jurrien Timmer of Fidelity offered a highly insightful chart that put the risk of negative EPS revisions into context. The chart compares the percentage of S&P 500 stocks above their 200 dma (blue line, bottom panel) to EPS revisions (gold line, bottom panel). The history of major market downdrafts shows that declines in market breadth almost always led changes in fundamentals. The only exception occurred in 2015 (red box), when the decline in earnings was attributable to falling oil prices. (Annotations are mine).

 

 

In conclusion, the intermediate-term bull case remains intact. Both sentiment and technical conditions are still supportive of high stock prices. While investors may face the risk of earnings downgrades as we approach Q2 earnings season, much of the fundamental weakness may already have been discounted.

 

Bullish omens from the factor gods

Posted by Cam Hui -

Recession fears are rising everywhere, both on Wall Street and in Washington. Fed eonomist Michael T. Kiley formulated a recession model based on unemployment rates. The probability of a recession over the next four quarters is now over 50%, but the economy has never avoided a recession when readings were this high.
 

 

The New York Fed’s DSGE model, which does not represent its official forecast, puts the chances of a hard landing at 80%. There are numerous other examples. That’s just two of them. 

 

Recessions are supposed to be negative for stocks, right? Yes, most of the time. Even as recession anxiety rises, the omens from the sector and factor gods are telling a different story for the stock market.

 

 

Macro downgrades

The macro downgrades shouldn’t be a surprise. The US Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations, has been tanking. 

 

 

Wall Street strategists are scrambling to cut top-down earnings estimates. As an example, Ian Harnett of ASR penned an op-ed in the Financial Times that indicated the risk to equities isn’t interest rates, but earnings.

 

The current data signal a synchronised slowdown around the world. Rather than uninterrupted earnings per share growth, our models point to an earnings recession in the year ahead. We expect US earnings to fall by an 10 to 15 per cent over that time. 

 

Perhaps even more impressive is that the consensus EPS forecast for the Euro Stoxx index companies is signalling increasing earnings expectations despite the war in Ukraine and a cost of living crisis that is likely to raise costs and reduce demand for corporates. Our “top-down” forecasts suggest that eurozone EPS could fall by an annualised 20 per cent in the year ahead.

 

 

A recessionary slowdown is now becoming the consensus call.

 

 

Bad news is good news

Ironically, bad news is becoming good news for risky assets. Jerome Powell stated in the last post-FOMC press conference that the Fed is increasingly focused on headline inflation rather than core inflation as a guide to monetary policy. It sounds like the political press to control inflation is heating up.

 

People, the public’s expectations, why would they be distinguishing between core inflation and headline inflation. Core inflation is something we think about because it is a better predictor of future inflation. But headline inflation is what people experience, they don’t know what core is. 
Here’s the good news. Energy and food prices are falling. The point and figure chart of crude oil violated a key uptrend.

 

 

Wheat prices peaked in May and they have been weakening since. 

 

 

These developments are welcome news for policy makers. It’s an indication that inflation pressures are beginning to top out. Moreover, falling grain prices serve to alleviate hunger in much of the world as the Russia-Ukraine war has restricted global cereal exports. 

 

 

In response, bond yields have begun to fall in response to expectations of slower growth.

 

 

Improved risk appetite

A review of sector and factor returns in the US equity market was highly revealing of changes in market psychology. Even as the S&P 500 fell to fresh lows in June, the relative performance of defensive sectors failed to make relative highs, with the exception of healthcare.

 

 

Growth stocks are starting to show some signs of life. The relative performance of growth sectors are all trying to bottom even as the S&P 500 probed new lows for the year.

 

 

The relative performance of value sectors tells a different story. Resource extraction sectors such as energy and materials have fallen hard against the S&P 500, while the relative performances of other value sectors have traded sideways. The cyclically sensitive equal-weighted consumer discretionary sector is in a well-defined relative downtrend.

 

 

The returns to the quality factor have been unexciting, which is a surprise as quality stocks tend to outperform during periods of economic stress.

 

 

From a market cap perspective, the mega-cap S&P 100 and NASDAQ 100 have suddenly surged relative to the S&P 500, while mid and small-cap stocks have trended sideways to down.

 

 

I interpret these conditions as signs of bearish exhaustion. As bond yields decline in anticipation of slower growth, high-duration plays such as large-cap quality growth are making a comeback. It’s difficult to forecast how the intersection of likely falling earnings estimates and declining yields will play out for equity prices, but the market reaction has been constructive so far.

 

 

Fading geopolitical risk

Another piece of good news for equity investors is a fading geopolitical risk premium. Despite the shock of the Russia-Ukraine war and the risks it poses to the European economy and global hunger, the market appears to have digested much of the risk.

 

Consider Poland, which is located on Ukraine’s western flank. The performance of MSCI Poland has stabilized, on an absolute basis and relative to European and global equities (all returns are in USD).

 

 

Turkey is on the southern flank of the conflict. Despite well-publicized problems with inflation and a falling currency, MSCI Turkey has performed well in a difficult environment and it’s in a relative uptrend compared to Europe and global stocks.

 

 

The onset of the Russia-Ukraine war has led some analysts to voice concerns about a Chinese invasion of Taiwan. While MSCI Taiwan recently broke support on an absolute basis, it’s performing well when compared to EM xChina and global stocks.

 

 

In case you missed it, my recent market bottom call has been highly controversial (see Why last week may have been THE BOTTOM). Even though a recession has become the consensus view among strategists, the market is not reacting to the negative news. A review of sector and factor returns shows a constructive return of risk appetite. While it’s impossible to know if another shock could spark another risk-off episode, the long-term risk/return outlook for equities is becoming more attractive at these levels.

 

The key risk to watch is whether the BOJ can continue to buck the trend with an easing policy even as global central bankers tighten. JPYUSD has fallen dramatically, which raises the risk of a currency war in Asia. Already, Chinese sovereign bonds are now yielding less that Treasuries, which is putting pressure on China to devalue. Other Asian currencies, such as INR< PHP, and KRW have also weakened, which are worrisome developments.

 

Unpacking my market bottom call

Posted by Cam Hui -

Mid-week market update: My last publication (see Why last week may have been THE BOTTOM) certainly caused some contraversy. Why I am making no promises the future, I turned cautiously bullish on February 25, 2008, just a week before the generational March 2009 bottom (see Phoenix rising?). 
 

In that post, I postulated that the market was sufficiently washed out that it was time to dip your toe into the water with speculative Phoenix stocks, low-priced stocks that had fallen dramatically and saw significant insider buying. The good news is the timing of the call was nearly perfect, it came a week before the ultimate low. The bad news is the S&P 500 fell another -8% before the market finally bottomed.

 

 

Nobody’s perfect.

 

 

Still washed-out

You can tell a lot about market psychology by the way it responds to news. The WSJ reported what everyone already knew, that Fed Chair Jerome Powell Says Higher Interest Rates Could Cause a Recession:
 

Federal Reserve Chairman Jerome Powell said the central bank’s battle against inflation could lead it to raise interest rates high enough to cause an economic downturn.

 

“It’s certainly a possibility,” Mr. Powell said Wednesday during the first of two days of congressional hearings. “We are not trying to provoke and do not think we will need to provoke a recession, but we do think it’s absolutely essential” to bring down inflation, which is running at a 40-year high.
In response, the S&P 500 opened in the red early in the morning as overseas markets were weak overnight, but closed roughly flat on the day. That’s how wash-out markets behave.

 

Sentiment models are contrarian bullish and supportive of an advance. The bull-bear spread in Investor Intelligence sentiment printed another low this week, and readings were only exceeded by the levels seen during the GFC. II bears, however, were only comparable to the 2011 low.

 

 

Morgan Stanley’s prime brokerage arm reported that net leverage of long/short hedge funds fell to levels last seen during the GFC.

 

 

Is sentiment sufficiently panicked to signal a major market bottom?

 

 

Buy signal, or just a setup?

I honestly don’t know. Mark Ungewitter observed that past breadth wipeouts, as measured by the % of S&P 500 above their 50 dma, tend more to be buy signal setups than actual buy signals.

 

 

 

Bull and bear cases

The bull case, as outlined by Ryan Detrick, is the S&P 500 has tended to perform well after two back-to-back -5% weeks.

 

 

As we approach Q2 earnings season, the bear case is while bottom-up EPS estimates are still rising, strategists are cutting their top-down estimates. This could be a key inflection point in the cycle where top-down analysts see an economic slowdown ahead, but bottom-up company analysts won’t revise their estimates downwards until they speak to company management. If Q2 earnings disappoint or if guidance is weak, watch for mass earnings downgrades.

 

 

 

Relief rally ahead

The odds favor a short-term rally. Rob Hanna at Quantifiable Edges reported that his Quantifiable Edges Capitulative Breadth Indicator (CBI) spiked to 11 on Friday. Readings above 10 have historically resolved in a bullish manner, at least in the short run.

 

 

It’s possible that last week marked the first market bottom that will be retested sometime in the coming weeks. History doesn’t repeat, but rhymes. We have not seen the positive divergences that characterize bear market bottoms yet. The March 2009 bottom was signaled by positive breadth divergences and sparked a rare Zweig Breadth Thrust buy signal. The market never looked back after that.

 

 

If the relief rally were to continue, initial resistance can be found at the first gap at 3830-3900, secondary resistance at the next gap at 3975-4010, and a strong resistance zone at 4080-4200. If the rally were to fail, watch for a test of support and possible positive technical divergences.

 

 

My inner investor is still cautiously positioned, but he dipped his toe into the water. My inner trader is standing aside until volatility calms and a trend begins to manifest itself.

 

Why last week may have been THE BOTTOM

Posted by Cam Hui -

I am not always right and financial markets are facing many uncertainties, but last week’s market action may have marked the bottom of this market cycle.
 

It isn’t just the extreme level of the BoA Bull & Bear Indicator. though that is one piece of the puzzle. This indicator turned prematurely bullish by falling below 2 in March, but readings have declined to the extraordinarily low level of 0.
 

 

Marketwatch reported that the index last reached 0 only on a handful of occasions: in August 2002, July 2008, September 2011, September 2015, January 2016, and March 2020.

 

 

 

Extreme technical wipeouts

Many technical conditions are at levels seen at past major market lows.
  • NYSE 52-week lows reached levels last seen during the GFC bear market. Readings were higher than the COVID Crash, the 2011 Greek Crisis, and the 2002 post-NASDAQ Bubble low.
  • The ratio of S&P 500 stocks above their 50 dma to S&P 500 stocks above their 150 dma, which is an intermediate-term oscillator, reach levels last seen during the COVID Crash, the 2011 Greek Crisis, the GFC, and the 2002 lows.

 

 

Other breadth indicators are also signaling oversold extremes seen at major market bottoms.

 

 

I previously highlighted the “good overbought” condition exhibited by the market based on the percentage of S&P 500 stocks above their 200 dma rising above 90% in mid-2020 after the COVID Crash (top panel, shaded areas). Such “good overbought” readings are indicators of strong price momentum that allow stock prices to advance steadily. Momentum faltered in mid-2021, which was an early sign of a market top. Past episodes have resolved in market bottoms when the percentage of S&P 500 above their 50 dma falls below 20% (bottom panel). This indicator reached 2% last week, which is an extreme level indicative of stock market panic. As well, the percentage of S&P 500 above their 200 dma fell to 12.8% last week, which is another extreme reading.

 

 

The BoA Global Fund Manager Survey showed that institutional managers have de-risked to levels comparable to the GFC.

 

 

From a technical and sentiment perspective, these are all signs of the blinding fear and capitulation seen at major market bottoms. The only glaring exception was 2008, but 2008 saw a major financial crisis that shook the global banking system. This is not 2008. Today, we have coordinated global central bank tightening that raises recession risk, but no signs of a financial collapse. Arguably, the crypto craze served a useful purpose inasmuch it channeled many of the excesses into non-systematically important parts of the economy.

 

 

Valuation support

I recently wrote that the S&P 500 forward P/E is 15.2, which represents roughly fair value (see The Fed braces for a harder landing), but markets often overshoot fair value when it panics. However, other pockets of the stock market appear to offer compelling value.

 

The S&P 600 is trading at a forward P/E of 11, which is a level last seen during the GFC. The S&P 600 represents a better way of measuring valuation for small-cap stocks than the Russell 2000. The S&P 600 has far fewer unprofitable small caps than the Russell 2000 because of the stricter profitability inclusion criteria of S&P. Consistent with my observations about the number of NYSE 52-week lows, these readings exceed the market bottoms seen during the COVID Crash, the 2011 Greek Crisis, and the 2002 post-NASDAQ Bubble lows.

 

 

Tobias Carlisle of Acquirer Funds recently screened for companies trading below a trailing EV/EBIT ratio of 3 in the Russell 3000. He found 905, which is an all-time high.

 

 

Another indirect signal of value in the stock market is insider buying. Insiders tend not to be short-term traders in their own stocks. They prefer to focus on capitalizing on the lower long-term capital gain tax rate by holding their positions for a year or more. It is therefore constructive that this group of “smart investors” believe that the valuation of their companies relative to publicly available fundamentals are compelling enough that purchases outnumbered sales during the latest downdrafts.

 

 

 

A gift horse?

In short, both technical and valuation conditions indicate that the market gods are offering a gift to equity investors. But should investors look the gift horse in the mouth, just as the defenders of Troy should have?

 

The key risk to the market bottom narrative is a recession that sends earnings estimates skidding. FactSet reports that bottom-up forward 12-month EPS estimates are still rising in the face of an above average level of negative earnings guidance.

 

More S&P 500 companies have issued negative EPS guidance for Q2 2022 compared to recent quarters as well. At this point in time, 103 companies in the index have issued EPS guidance for Q2 2022, Of these 103 companies, 72 have issued negative EPS guidance and 31 have issued positive EPS guidance. This is the highest number of S&P 500 companies issuing negative EPS guidance for a quarter since Q4 2019 (73). The percentage of companies issuing negative EPS guidance for Q2 2022 is 70% (72 out of 103), which is above the 5-year average of 60% and above the 10-year average of 67%.

 

 

Furthermore, the number of buy ratings remains highly elevated.

 

 

Recession risk is rising. New Deal democrat, who maintains a discipline by monitoring a series of coincident, short-leading, and long-leading indicators, has documented the deterioration of his long-leading indicators for several months. His latest update shows that the weakness is spreading to his short-leading indicators, which are designed to spot economic weakness six months ahead, indicating a possible downturn that begins in Q1.

 

The Wall Street Journal conducts a regular poll of economists to determine the probability of recession within 12 months. The latest reading is 44%, which is a level seen during or on the brink of actual recessions.

 

 

Recessions are normally thought of as two consecutive quarters of negative real GDP growth. Q1 real GDP was already negative, though the figures are distorted by inventory adjustments and final demand told a stronger story. The Atlanta Fed’s Q2 nowcast is now zero, which raises the risk of two consecutive quarters of negative GDP growth.

 

 

For the record, the National Bureau of Economic Research (NBER) is the official dater of recessions. It defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months” and focuses on “three criteria—depth, diffusion, and duration”. This is a slightly more complicated metric that the simple two consecutive quarters of negative real GDP growth.

 

 

Wait for the retest

I resolve the bull and bear debate this way. The base case scenario is a double or triple bottom. Extreme oversold conditions were observed during past market panics in 2002, 2008, and 2011. The S&P 500 rallied and went on to retest the old lows several weeks or months later.

 

The lack of earnings downgrades is troubling in the face of growing recession risk. While the market recently went bonkers over the hot CPI print, a little-noticed effect of CPI is it tends to lag PCE, which is the Fed’s preferred inflation metric. That’s because the higher weight of shelter in CPI and rents and property prices, which affect rent, are lagging indicators. Historically, headline CPI-PCE (blue line) has risen strongly ahead of recessions. Both headline and core PCE appear to be topping out, which may foreshadow less aggressive Fed tightening.

 

 

Here is a closer look at core PCE, which peaked in February. The combination of strong CPI and tame PPI has led to a tamer May core PCE estimate.

 

 

How will the market react if earnings estimates decline while the Fed pivots to an easier monetary policy? There are too many moving parts to tell how this all plays out. 

 

If there is a recession, it should be mild because of a lack of excessive leverage. In the mild recessions of 1990 and 2000-2002, forward EPS estimates fell by 10-15%. Keep in mind, however, that actual earnings didn’t fall in the 1970’s in nominal terms. It’s therefore possible during the current episode of elevated inflation that EPS estimates stay flat while interest rates decline.

 

One possible template for current market and economic conditions is the double-dip recession. GDP growth turns negative in Q2, which raises concerns that the economy has entered a recession, though it doesn’t get confirmed by NBER. Earnings estimates continue to rise, inflation begins to ease and so do Fed Funds expectations. The stock market rallies, only to meet the actual recession which begins in early 2023, which is the time frame forecast by many top-down models.

 

Double-dip recessions are rare. The last one occurred in 1980-81. The Dow first bottomed in April 1980 and rallied into early 1981 by breaking through the psychologically important 1,000 mark. It began a bear market that ended in August 1982 when the Fed eased in response to the Mexican Peso Crisis which threatened the US banking system.

 

 

In conclusion, technical and valuation conditions are consistent with past major panic lows. The key risk is a lack of earnings downgrades in the face of growing recession risk.

 

Despite the strong technical evidence of a panic bottom, I am taking a more nuanced view. My base case scenario calls for a double or multiple bottoms in stock prices and a possible double-dip recession. History doesn’t repeat itself, but rhymes. Q2 earnings season will prove to be a key test for market expectations. Stay tuned.

 

A butterfly flaps its wings in Zurich

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A disorderly unwind

Just when you thought it was safe to go back into the water after an FOMC meeting that turned out to be more dovish than expectations, the Swiss National Bank unexpectedly raise rates by a half-point after holding it at -0.75% for almost a decade and sent global asset prices reeling.

 

 

Here’s why the SNB’s actions mattered. The rate hike was a reversal of a long-held policy of the SNB, which had been trying to hold the CHFEUR exchange rate down in order to bolster Swiss competitiveness. CHFEUR spiked nearly 2% on the news. The daily move far exceeded anything in its seven years of Swiss interest rate stability.

 

 

The outsized move in the CHFEUR exchange rate made Value-at-Risk (VAR) models go haywire. For readers unfamiliar with these models, they estimate risk based on the past history of volatility. When actual volatility spiked, risk managers tapped traders on the shoulders and told them to reduce the size of their books. Almost instantly, global markets sold off in a price insensitive liquidation stampede.

 

It was a textbook example of non-linear dynamics. A metaphorical butterfly flapped its wings in Zurich and the global financial markets shuddered.

 

 

Capitulation watch

Price insensitive selling is a classic sign of capitulation. Here are some other ways of watching for an oversold extreme and washout.

 

The ratio of the percentage of S&P 500 above their dma to the percentage of S&P 500 above their 150 dma reached 20%. These are market crash levels last seen in 2002, 2008, 2011, and 2020. All saw short-term snapback rallies. Moreover, NYSE 52-week lows haven’t spike to these levels other than the 2008 crash in the last 20 years.

 

 

The AAII weekly bull-bear spread deteriorated to another crowded short extreme reading again. Other than a recent episode, bearish sentiment hasn’t been this high since 2011.

 

 

Other signs of washout and capitulation on Thursday include:
  • Reports of the second biggest sell program in a year and the fourth biggest of all time.
  • Reports of no-bid markets in high yield bonds.
  • A 93% downside volume day on the NYSE.
  • The S&P 500 saw over 90% of its issues decline on Thursday and that was the fifth episode in seven days. This has never happened in the history of the index since 1928, according to SentimenTrader.
  • A panicky Drudge Report headline on Thursday as a contrarian sentiment indicator.

 

 

Be patient

For investors who are willing to be patient, the rewards can be high. Mark Hulbert found that if you bought the S&P 500 after it first fell -20%, which occurred last Monday, the average one-year gain since World War II was 22.7%.

 

 

A more detailed analysis by Jonathan Harrier identified 11 similar events since 1950. While returns were strong, investors also endured significant drawdown risk.

 

 

For the last word, I leave you with Stan Druckenmiller, who recently spoke at the Sohn Conference:

 

This is my 45th consecutive year as a Chief Investment Officer. In 45 years I’ve never seen a constellation where there’s no historical analogue. I probably have more humility in terms of my views going forward than I’ve ever had.

In conclusion, this volatility too, shall pass. Hopefully, the markets can return to a more normal state next week.

 

 

The Fed braces for a harder landing

Posted by Cam Hui -

Even before the FOMC meeting and in a survey period that ended on June 10, 2022, which was the day of the hot May CPI print, the respondents to the BoA Global Fund Manager Survey showed a high degree of anxiety about a recession.
 

 

Here is the bad news. At the post-FOMC meeting press conference, Fed Chair Jerome Powell pointedly responded to a question with, “We are not trying to induce a recession”. Despite the “softish landing” rhetoric, it is becoming clear that the Fed is trying to induce a recession.

 

Volcker 2.0

Sometimes investors can find the most interesting clues on Fed policy intentions in speeches and statements, but the Fed hit the market with a sledgehammer with its communications policy at the June FOMC meeting. The new “dot plot” projects the Fed Funds peaking in 2023 and falling afterward. That pattern is consistent with a recession in 2023, followed by easing in 2024. By contrast, Fed Funds futures (grey line) expects a peak in 2022 and an easing in 2023, which pulls ahead of the implied probability of a recession into this year.

 

 

In addition, the most revealing sentence of the FOMC statement was: “The Committee is strongly committed to returning inflation to its 2 percent objective”, indicating that the Fed is bent on taming inflation without regard to recession risk.

 

As well, Powell was asked during the post-FOMC press whether the Fed will focus on headline or core inflation in managing monetary policy. The surprising answer was “headline inflation”.

 

But all over the world, you are seeing these effects. And so — and we’re seeing them here, gas prices at, you know, all-time highs and things like that. That’s not — that’s not something we can do something about. So that is really — and by the way, headline inflation, headline inflation is important for expectations. People have — the public’s expectations; why would they be distinguishing between core inflation and headline inflation?

 

Core inflation is something we think about because it is a better predictor of future inflation. But headline inflation is what people experienced. They don’t know what core is; why would they? They have no reason to. So, that’s — expectations are very much at risk due to high headline inflation.
While core inflation is easier for central bankers to model, headline inflation fluctuates more with the volatile food and energy components, which are dependent on the resolution of the Russia-Ukraine war. Energy prices have spiked because of energy supply disruptions, and so have food prices. An influential 1997 paper by Bernanke Gertler, and Watson concluded that while recessions have followed surging oil prices, oil price increases alone weren’t the explanation. It was the Fed’s reaction to rising energy prices that caused recessions. If the Bernanke paper is correct and the Fed is focused on oil prices, which is a factor beyond its control, this is an instance of Volcker 2.0 that will induce a recession.

 

Here’s another ominous sign of Fed policy. Jerome Powell stated at the WSJ Future of Everything Festival, “What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that.” He went on to use the “clear and convincing” language three times in the interview. It is well-known that monetary policy operates with a lag. If the Fed is waiting for “clear and convincing” evidence that inflation is falling, it will by definition overtighten.

 

Here is how the monthly headline and core PCE, which are the Fed’s preferred inflation metrics, are shaping up. An estimate of May core PCE based the combination of the CPI and PPI reports is 0.39%. That’s not “clear and convincing” evidence of deceleration.

 

 

Even within the Fed, some unease is appearing. A Fed research paper by David Ratner and Jae Sim offers the alternative hypothesis that the effects of the Volcker shock are exagerrated. Inflation of the 1970’s was addressed through the degradation of the union movement rather than monetary policy.

 

Is the Phillips curve dead? If so, who killed it? Conventional wisdom has it that the sound monetary policy since the 1980s not only conquered the Great Inflation, but also buried the Phillips curve itself. This paper provides an alternative explanation: labor market policies that have eroded worker bargaining power might have been the source of the demise of the Phillips curve. We develop what we call the “Kaleckian Phillips curve”, the slope of which is determined by the bargaining power of trade unions. We show that a nearly 90 percent reduction in inflation volatility is possible even without any changes in monetary policy when the economy transitions from equal shares of power between workers and firms to a new balance in which firms dominate. In addition, we show that the decline of trade union power reduces the share of monopoly rents appropriated by workers, and thus helps explain the secular decline of labor share, and the rise of profit share. We provide time series and cross sectional evidence.

I leave the discussion of policy choice up to you. The political ramifications of the conclusions is above my pay grade.

 

 

Good news

Here is the good news. Inflation is already decelerating. Callum Thomas of Topdown Charts pointed out that the leading indicators of growth, namely the backlog and order components of PMI, have been in a descending trend for several months. This should eventually lead to falling prices. 

 

 

The economy is slowing and demand destruction is occurring, especially in the cyclically sensitive housing market. Consider these observations of mortgage specialist Louis Barnes after the hot May CPI print:

 

The CPI news this morning was so awful that it changed the bond market’s view of Fed trajectory, and the weakest sector broke. In bond jargon, MBS went “no-bid.” No buyers for MBS. Then a few posted prices beyond borrower demand, not wanting to buy except at penalty prices. Overnight the retail consequence has been a leap from roughly 5.50% to 6.00% for low-fee 30-fixed loans…

 

Another marker of MBS distress: the 10-year T-note had held 3.00% since April, the important top in 2012 and 2018. Trading 3.05% yesterday, now 3.20% — retail mortgages jumped triple that amount. The 10s/mortgages spread today is almost 300bps and double the 10s’ yield. Inconceivable. The Fed telltale 2-year T-note had held 2.70% since April, 2.85% yesterday, today 3.05% adding only one more .25% hike to the 2-cast, which is not enough to explain MBS overnight.

 

 

The earnings puzzle

Here is the market consensus. Both stock and bond prices are falling together. In other words, the market is expecting slower growth (stocks) but inflation will stay elevated (bonds). At a minimum, the bond market should begin to rally soon. Keep in mind that rates fell across the board in the wake of the FOMC meeting, which may be a sign that the Fed is ahead of the curve, not behind it.

 

 

I have made the point before that the last time the 10-year Treasury yield was at similar levels, the S&P 500’s forward P/E ratio was trading in the 14-16 range. It is now 15.3, which represents fair value. The key question is how far earnings estimates fall should the economy experience a recession. Forward EPS estimates are still rising, so far.

 

 

Why aren’t earnings estimates falling? Doesn’t Wall Street realize there’s a slowdown on the horizon? A more detailed analysis of forward 12-month EPS estimates by sector shows that most of the gains are in the energy sector. However, most other sectors are still seeing positive estimate revisions.

 

 

Here is the process by which most Wall Street analysts estimate earnings for their companies. In additional to independent research, such as channel checks, company estimates depend on corporate guidance. If guidance is still strong, analysts are unlikely to go out on a limb and downgrade their estimates. As analysts and companies engage in the guidance dance, it’s always possible that corporate management is shading the truth and telling a more bullish story than the company’s underlying fundamentals.

 

What they are unlikely to lie about is how they manage their own finances. The most constructive news for equity investors is insiders are turning more confident. This group of “smart investors” is buying the recent dip. Either the group doesn’t seem to believe the recession narrative, or it believes that slowdown fears are overblown and valuations are becoming compelling.

 

 

To be sure, insider activity is an inexact market timing indicator. Insiders were overly eager to buy in 2008.

 

 

In a more “normal” bear market like 2018, insider activity can be useful signals.
 

 

Recessions serve to unwind the excesses from the previous cycle. The good news is there is little evidence of too many excesses. A lot of the speculative money has gone into crypto. While the right tail of crypto returns were spectacular during the bull phase, any possible collapse is less likely to threaten global financial stability as crypto has largely existed in an offshore and unregulated market. This makes the left tail of the unwind less risky to asset prices.

 

Even if investors were to see a recession induced bear market, it shouldn’t last too much longer. My base case scenario calls for a slowdown to begin either in Q1 or Q2 2023. Historically, recessions last about 6-9 months. As markets look forward about 6-12 months, and the stock market peaked in January, this puts the timing end of the bear market between now and late Q3.

 

In conclusion, the Fed appears intent on tightening policy to fight inflation. It is focused on headline inflation, which is expected to remain stubbornly high as the Russia-Ukraine war keeps energy prices elevated. It’s difficult to see how the US economy can sidestep a recession.

 

The good news is the S&P 500 is at or near fair value, as long as earnings don’t significantly deteriorate. Renewed insider buying as the market reached its recent lows is another sign that downside risk may be low.

 

How the FOMC meeting script played out

Posted by Cam Hui -

Mid-week market update: Can the stock market follow the script for past FOMC meetings in 2022? In each of the cases this year, the market weakened ahead of the meeting and rallied afterwards. The only deviation from the script occurred at the May FOMC meeting, when stock prices fell to new lows after a post-meeting reflex rally. 
 

 

Fast forward to the June meeting. The S&P 500 skidded in accordance to the script and stocks rallied today, though there are two unfilled gaps above.

 

 

The setup

Here is how market conditions were setting up coming into the FOMC announcement. 

 

The consensus last week was the Fed would raise rates by 50 bps in June and July, and wait for more data before making a decision at the September meeting. In the wake of a hot CPI report, expectations shifted to a virtual certainty of a 75 bps rate hike in June, followed by another 75 bps in July and consecutive 50 bps hikes for the next three meetings. The expected terminal rate is 4.00% to 4.25%, which would be reached in February.

 

 

Over at the stock market, three of the four components of my Bottom Spotting Model flashed buy signals on Monday. The only exception was the shape of the VIX curve, which came within a hair of inversion. Most notably, TRIN spike to an off-the-charts reading, indicating price-insensitive selling that’s indicative of a margin clerk driven liquidation event (see A liquidation panic).

 

 

 

The evolution of inflation

Lost in all of the inflation hysteria was a tamer than expected PPI report. In the wake of the better than expected PPI print, WSJ reporter Nick Timiraos observed that JPMorgan estimates that core PCE will decelerate to 4.7% in May.

 

 

This puts core PCE, which is the Fed’s preferred inflation metric, on a decelerating path.

 

 

Here is the all-important revised Summary of Economic Projections, which is more dovish than market expectations. Key highlights:
  • All growth projections were revised down and inflation projections were revised up.
  • The median projected Fed Funds rate at year-end is 3.4%, compared to market expectations of 3.75% to 4.00% coming into the meeting. 
  • The median long-run neutral rate edged up from 2.4% to 2.5%. The Fed expects the Fed Funds rate to be above the neutral rate for the next two years.
  • The projected median core PCE at year-end is 4.3%, compared to the JPM May forecast of 4.7%. If the pace of inflation deceleration continues, core PCE should reach easily the 4.3%.

 

 

If the SEP projections are to be believed, the Fed is setting itself a low bar to pivot to a more dovish policy.

 

 

Insiders are buying

I recently wrote that investors should monitor insider activity as the S&P 500 tests its May lows (see The bears gain the upper hand). Though it’s only one data point, insider buying exceeded selling as the market panicked this week.

 

 

 

The market reaction

The market reacted to the FOMC statement and Powell’s press conference by adopting a risk-on tone.  Treasuries exhibited a bull steepener. The 2-year Treasury yield fell by 20 bps. The 2s10s yield curve, which was nearly flat at the height of the panic early this week, steepened to 13 bps. The USD fell. Stock prices rebounded.

 

Tomorrow is another day and the market may pivot to a different take, but I interpret the Fed’s statement, SEP, and Powell’s remarks as slightly more dovish than market expectations. 

 

Fed Funds futures reacted dovishly:
  • A 75 bp move in July was unchanged.
  • Expectations of three consecutive 50 bps hikes had changed to two, followed by two consecutive 25 bp hikes.
  • The terminal rate has fallen by a quarter-point from 4.00% to 4.25% to 3.75% to 4.00%.

 

 

Tactically, this looks like a bullish outcome for risky assets. The stock market is an an oversold extreme and a relief rally would not be unusual reaction. 

 

As alwasy, I remain data dependent.

 

A liquidation panic

Posted by Cam Hui -

I know that Friday’s CPI print was ugly, but it seems to have sparked a “correlations converging to 1” liquidation panic where everything is getting sold today. The good news is such panics usually don’t last long.
 

Several readers highlighted analysis from Rob Hanna of Quantifiable Edges of a rare Inverse Zweig Breadth Thrust. Although the sample size is small (n=10 since 1926), the bearish implications of the study are clear.
 

 

Take a deep breath. Notwithstanding the fact that negative ZBTs were not part of Marty Zweig’s work as detailed in Winning on Wall Street, this study is nearing “torturing the data until it talks” territory. While positive ZBTs are rare buy signals, there have been six instances since the publication of Zweig’s book in 1986. Can you really trust the results of a study when the last instance of a negative ZBT was in 1943?

 

 

Panic in the air

Two weekend (unscientific) Twitter polls are testament to the sense of panic. Callum Thomas has been conducting a weekly poll since 2016, and readings are at an all-time low. The weekly reading of equity bearishness has exceeded the levels seen during the COVID Crash, though the four-week average is not.

 

 

Helene Meisler conducts a similar weekend poll and the results are net bearish by -20%. In the limited time she has conducted this poll, there were only a few instances when readings reach these levels:

 

3/11/22
7/16/21
1/15/21
6/26/20
5/15/20

 

 

While the sample size is small (n=5), four of the five samples saw the S&P 500 immediately rebound the following week. In the single exception where the market showed a red candle, investors saw a Turnaround Tuesday rally that led to higher prices for the remainder of the week.

 

 

Purely as an anecdotal observation, the respondents in Meisler’s poll seem to have a shorter time horizon than in Thomas’ poll.

 

 

Some silver linings

I don’t want to imply that this is “the bottom”, as the US equity market still faces some valuation challenges (see In search of the bullish catalyst). but some silver linings are starting to appear in a series of dark clouds.

 

Let’s begin with the long-term technical perspective. I have highlighted the point that the % above the 200 dma reached over 90% as the market recovered from the COVID Crash in 2020, which created a “good overbought” advance (top panel). The “good overbought” condition petered out in Q2 2021. In the past, the market has bottomed this indicator reached 15%. It’s now about 20%. It’s getting close. Such pullbacks have also ended when the % above their 50 dma (bottom panel) fell below 20% and this indicator has fallen as far as a sub-5% reading in the past. It’s now there.

 

In short, technical conditions are consistent with long-term bottoms, though the market still lacks valuation support.

 

 

In the short run, the crypto space tanked on the weekend when Celsius halted redemptions and transfers. Not only did the episode spark fears that this was another instance of fraud or Ponzi scheme implosion, but it also had real liquidity implications. Some crypto investors who had their holdings at Celsius faced with margin calls had the choice of either liquidating their positions or adding USDs into an institution that was not allowing withdrawals. The silver lining is the performance of cryptocurrencies has been highly correlated with the relative performance of speculative growth stocks, as proxied by ARKK. But is that a positive divergence I see?

 

 

 

Waiting for the Fed

One development that investors are watching is the FOMC announcement on Wednesday, and the event may provide some relief for risky assets. In the wake of the hot CPI print, the market is now discounting a 30% chance of a 75 bps hike on Wednesday. As well, it’s discounting a series of rate hikes with the terminal rate at 3.75% to 4.00% in early 2023.

 

 

I believe those expectations are far too hawkish. On the question of what the Fed will do this month, just remember the Fed is a bureaucracy and an institution. It’s not some trader sitting in front of several screens trading the market and it doesn’t pivot policy based on a single data point. A 50 bps increase is far more likely, though 75 bps hikes are plausible this year.

 

On the other hand, the terminal rate of nearly 4% may be overly aggressive with the level of the 2-year Treasury yield at 3.3%. In the past, the 2-year yield has served for another estimate for the terminal Fed Funds rate. In effect, the market is discounting a 3.75% to 4.00% Fed Funds rate next year and a 3.3% in 2024, indicating Fed easing and therefore a recession.

 

The bears gain the upper hand

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Breaking support

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

 

 

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

 

 

Reasons to be bullish

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Neutral indicators

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

 

 

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

 

 

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

 

 

 

A reliable sell signal

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

 

 

 

Limited downside risk

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

 

 

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

 

 

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

 

 

 

In search of the bullish catalyst

Posted by Cam Hui -

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

 

 

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

 

 

Excessive optimism

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

 

 

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

 

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

 

 

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

 

 

 

Main Street turns grumpy

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

 

 

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

 

 

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

 

 

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

 

 

Recession ahead?

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

 

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

 

 

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

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

 

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

 

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

 

 

Household debt ratios are also under control.

 

 

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

 

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

 

 

 

Investment implications

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

 

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

 

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

 

 

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

 

Waiting for the breakout (or breakdown)

Posted by Cam Hui -

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

 

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

 

 

A mixed sentiment picture

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

 

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

 

 

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

 

 

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

 

 

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

 

 

A butterfly flaps its wings in Beijing

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

The challenges ahead

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

 

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

 

 

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

 

 

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

 

 

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

 

So where does that leave us?

 

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

 

 

Disclosure: Long SPXL

 

Take some chips off the table

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Nearing upside targets

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

 

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

 

 

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

 

 

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

 

 

Bullish signals

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

 

 

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

 

 

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

 

 

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

 

 

 

Constructive indicators

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

 

 

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

 

 

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

 

 

 

The easy money has been made

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

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

Buy or fade the breadth thrust?

Posted by Cam Hui -

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

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

 

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

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

 

 

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

 

 

Meet the Fed

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

 

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

 

 

Breadth thrust bulls, meet the Fed.

 

 

Clear and convincing

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

 

 

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

 

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

 

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

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

 

 

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

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

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

 

 

A counterproductive rally

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

 

 

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

 

 

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

 

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

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

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

 

 

Investment implications

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

 

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

 

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

 

 

 

A bull’s view of the rebound

Posted by Cam Hui -

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

 

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

 

The insider’s view

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

 

 

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

 

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

 

 

 

An emerging theme

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Insiders are bottom fishing

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

 

 

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

 

 

I will address the bear case in a later post.

 

 

Disclosure: Long SPXL