How far can this rally run?

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.
 

 

A bullish turnaround

The S&P 500 turned up last week after a test of the May lows while exhibiting a 5-day RSI divergence. The rally was convincing as the index rallied through a falling trend line and the daily MACD indicator turned positive.

 

 

One of the most anticipated relief rallies is here. How far can the stock market run?

 

 

Buy signals everywhere

Last week’s market action sparked buy signals everywhere. NYSE breadth on Wednesday was an 83% volume upside day, Thursday was an 87% upside day, and Friday was another 87% upside day. Two consecutive 80% upside days are unusual. Three consecutive ones are extremely rare. A study by Paul Desmond of Lowry’s Reports found that back-to-back 80% upside days were breadth thrust signals indicating “the completion of the major reversal pattern[s]”.

 

On occasion, back-to-back 80% Upside Days (such as August 1 and August 2, 1996) have occurred instead of a single 90% Upside Day to signal the completion of the major reversal pattern. Back-to-back 80% Upside Days are relatively rare except for these reversals from a major market low. 

The historical record shows that while three consecutive 80% upside days tended to be bullish, there were exceptions. Stock prices topped out after such a signal in 1981 and fell to a lower low in 2008. In other case, the market consolidated sideways.
 

 

Nevertheless, price momentum has become very strong. The NYSE McClellan Oscillator has reached levels consistent with a “good overbought” advance, indicating further upside potential.

 

 

Credit market risk appetite is also starting to show some life. The relative performances of high yield and leveraged loans relative to their duration-equivalent Treasury prices are exhibiting some minor positive divergences from the S&P 500.

 

 

AAII weekly sentiment is still excessively bearish, which is contrarian bullish.

 

 

Sentiment models are supportive of further gains. Last week, we saw bear claws on the cover of Barron’s. This week, Bloomberg BusinessWeek’s cover is another contrarian magazine cover indicator that’s supportive of the bull case. 

 

 

From a global perspective, the percentage of countries above their 50 dma rose from zero the previous week to 10% last week, indicating a recycle off an oversold extreme.

 

 

The performance of MSCI Poland is turning up, which is a sign that geopolitical risk is fading.

 

 

 

When should traders sell?

What’s the upside potential of this rally? The most straightforward way of estimating upside potential is to find potential areas of resistance. Arguably, the S&P 500 is already testing a resistance zone. Further resistance can be found at the first Fibonacci retracement level of about 4185, with secondary resistance at the 50 dma at about 4280, which also roughly corresponds to the area at the falling trend line..

 

 

Another way of estimating upside potential is to monitor the evolution of trading signals. The NAAIM Exposure Index, which measures the sentiment of RIAs, flashed two consecutive buy signals by falling below its 26-week Bollinger Band. This indicator has been excellent at calling short-term bottoms. Upside momentum often fades when NAAIM rises to its 26-week moving average.

 

 

Also, keep an eye on the VIX. Trading tops often form when the VIX Index falls below its Bollinger Band.

 

 

 

Intermediate-term bearish

Despite last week’s show of strength by the bulls, my base case scenario calls for a bear market rally within a bear trend. The relative performances of defensive sectors are still in uptrends, indicating that the bears still have control of the tape.

 

 

Enjoy the rally, but don’t overstay the party.

 

 

Disclosure: Long SPXL

 

Green shoots = Time to bottom fish?

Posted by Cam Hui -

Now that the S&P 500 has started to turn up after bouncing off a head & shoulders downside target. Green shoots are starting to appear for the bulls, is it time for investors to buy stocks and bottom fish?

 

 

 

Rising recession fears

Let’s begin with why the market weakened. Recession fears were rising.

 

As an example, consider the recent changes in the signals from the fixed income markets. For most of 2022, both the 3-month and 10-year Treasury yields rose in lockstep as the market discounted an increasingly hawkish Fed. In early May, the 10-year yield began to fall even as 3-month yields continued to advance.  This is an indication that the bond market is now shifting from fears of Fed tightening to fears of an economic slowdown.

 

 

A Google Trends analysis of searches for “recession” has exceeded the highs during the GFC, but just short of the COVID Crash. By contrast, searches for “inflation” is at an all-time high. Main Street is clearly worried about both inflation, which would cause the Fed to tighten monetary policy, and recession.

 

 

The Citigroup Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, fell below zero, which is an indication of economic deterioration.
 

 

 

Green shoots

On the other hand, green shoots are starting to appear, if you know where to look. Inflation looks like it’s coming under control, which should allow the Fed to take a less hawkish path. The latest FOMC minutes indicate that two half-point hikes are baked in for the next two FOMC meetings, but the Fed would re-evaluate the situation at the September meeting.

 

Most participants judged that 50 basis point increases in the target range would likely be appropriate at the next couple of meetings…Participants judged that it was important to move expeditiously to a more neutral monetary policy stance. They also noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.

The minutes also indicate that the staff forecast for core PCE has risen from 4.0% to 4.3% by the end of 2022. The median core PCE forecast of FOMC members, which is the Fed board of governors and regional presidents, is 4.1%, according to the Summary of Economic Projections published in March. Both core PCE and trimmed mean PCE have been at or under those levels for three consecutive months. These readings are already quite tame by the Fed’s own standards and more prints at these levels in the next few months would allow the Fed to become less hawkish.

 

 

In addition, the New York Fed conducts a survey of consumer expectations and found that the median consumer expects inflation to fade over the next few years. Inflation expectations are well anchored and not running wild.

 

 

There is also some possible good news in equity valuation. The S&P 500 is trading at a forward P/E of 17.1, which is slightly above its 10-year average of 16.9. When the 10-year yield was trading at similar levels, the market traded at a forward P/E of 14-15.

 

 

While current valuations still appear to be a little rich by historical standards, much depends on the evolution of the E in the P/E ratio. If the economy were to weaken into recession, earnings would decline and put further pressure on equity valuation. Instead, corporate guidance has been positive, despite recent headlines from selected retailers and technology stocks.

 

 

Marketwatch reported that insiders have been stepping up their buying of company stock. The ratio of insider buys to sells has spiked.

 

 

Leuthold Group’s analysis of big block insider activity is also flashing a buy signal.

 

Leuthold Group Chief Investment Officer Doug Ramsey prefers to gauge insiders by measuring big transactions of either 100,000 shares or $1 million. He subtracts buys from sells to find “net sells” as a percentage of issues traded on the NYSE. This fell below 1% May 20, boosting this measure to “maximum bullish,” he says.

 

These readings are consistent with my own observation that insider buys (blue line) have recently exceeded insider sales (red line).

 

 

It’s impossible to say whether this constitutes the bottom of the current stock market pullback. Insider activity has its limitations as a market timing signal. At a minimum, these conditions should be a signal for a short-term rally. The pattern of insider buying in 2008 is an example of the limitations of insider activity as an investment signal. Insiders were early in buying in March and July. The market staged minor rallies after those instances but weakened further later in the year. Insiders went on to buy aggressively from October 2008 to March 2009. While they were on the whole correct, these signals were inexact market-timing indicators.

 

 

If the recent episode of stock market strength is a bear market rally, a template of current insider activity might be the 2015-16 period. Insiders flashed buy signals in July and August 2015 and the market staged minor rallies. Stock prices consolidated sideways in a choppy pattern and insider buys exceeded sales during the January and February 2016, which turned out to be the ultimate bottom.

 

 

 

Not out of the woods

While these green shoots are helpful signs, investors are not out of the woods and I am not ready to declare the May lows as the bottom for the current bear cycle. 

 

Inflation surprise is still rising globally. While the trend in the US (red line) is decelerating, inflation is still running hot in most other countries, which will force central banks to tighten globally. As well, China is expected to experience a prolonged slowdown due to its zero-COVID policy. Can American Exceptionalism serve as a shield against a global slowdown?

 

 

While the recent rally is constructive, the Fed is still removing accommodation and quantitative tightening begins on June 1. Historically, equity returns during QT are lower than QE periods with greater volatility.

 

 

For the recession question, I present the CNN Business Op-Ed by Lakshman Achuthan and Anirvan Banerji of the respected forecasting firm ECRI advising Americans to prepare for a recession. As well, New Deal democrat, who maintains a disciplined process of monitoring coincident, short-leading, and long-leading indicators, is calling for a possible recession that begins in Q2 2023 and he has gone on recession watch. Markets are forward looking. Current forward P/E valuations are implying a soft landing. Should a recession develop, stock prices should weaken to a bottom no later than Q3 2022, which is six months before the onset of the recession. 

 

In conclusion, my base case scenario is this is a bear market rally and the March lows are not the lows of the bear cycle. The alternative scenario is the US economy achieves a soft landing and sidesteps a recession next year. If the market doesn’t weaken to a new low by early Q4 2022, the bottom is in for this cycle. I assign a 60-70% probability to the bear market rally and recession scenario and a 30-40% chance of a soft landing.

 

Have the bulls seized control of the tape?

Posted by Cam Hui -

Mid-week market update: After weeks of documenting how oversold and washed out the stock market is, the S&P 500 staged a marginal upside breakout through a falling channel while exhibiting a series of positive 5-day RSI divergences. Equally constructive is the behavior of net new highs, which turned positive today.
 

 

Have the bulls seized control of the tape?

 

 

More signs of a sentiment washout

There have been more signs of a sentiment washout. SentimenTrader pointed out that small option traders (read: retail speculators) have been buying put protection at a level only exceeded by the COVID Crash.

 

 

Marketwatch reported that Kevin Muir at the Macro Tourist documented panic among hedge fund giants as a contrarian bullish sign. Bill Ackman sent out a tweet that Muir interpreted as a contrarian bullish signal: “Bill might be a brilliant investor, but the last thing you should do is trade off his emotional tirades. They are better fades than signals.”

 

 

In addition, Muir also highlighted George Soros’s Davos warning that “civilization may not survive” Russia’s war in Ukraine, with climate change taking a back seat.

 

Cam here: I have an acquaintance who worked at a hedge fund and he was on the same Bloomberg message stream as Soros and Druckenmiller during the GFC. After observing the messages that went back and forth, his conclusion was no one knew what was going on during periods of crisis.

 

As well, don’t forget the cover of last weekend’s Barron’s as a contrarian magazine cover indicator.

 

 

 

A fragile market

Despite the constructive signs of a rally through a downtrend, S&P 500 bulls aren’t quite out of the woods yet. The negative reaction to SNAP’s negative earnings report which cratered the social media stocks is an example of a fragile market that’s subject to a high degree of volatility. It remains to be seen whether NVDA’s decline from its weak guidance after the close will be a contagion on the general market tomorrw. We also have the PCE report Friday morning that will be a source of volatility.

 

My inner investor is cautiously positioned, but my inner trader remains bullish. The S&P 500 Intermediate-Term Breadth Oscillator recently flashed a buy signal by recycling from an oversold reading on RSI to neutral. The historical success rate of this buy signal has been very good (grey=bullish outcome, pink=bearish).

 

 

Assuming this rally continues, my inner trader will seek to exit his long position when RSI nears an overbought condition.

 

 

Disclosure: Long SPXL

 

Washed out enough?

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.
 

 

Different fears for different folks

Is the market sufficiently fearful yet? There is no single sentiment indicator. The market consists of different constituents and different types of investors can be bullish or bearish at any single point in time. While conventional surveys such as Investors Intelligence shows continued levels of extreme bearishness, other indicators can tell different stories.

 

 

The NAAIM Exposure Index, which measured the sentiment of RIAs investing individual investor funds, fell below its 26-week Bollinger Band for a second consecutive week, which has shown an uncanny accuracy as a buy signal during the history of the index since 2006.

 

 

Institutional sentiment, as measured by the latest BoA Global Fund Manager Survey, reveals positioning is at a defensive extreme that’s only exceeded at the height of the Great Financial Crisis.

 

 

The Financial Times reported that hedge funds have dramatically reduced their leverage and exposure in response to the recent equity market weakness.
 

The sharp pullback has prompted funds that trade with Goldman, Morgan Stanley and JPMorgan Chase, three of the largest prime brokers on Wall Street, to dial back their positions over the past week, according to client reports seen by the Financial Times…

 

Goldman on Thursday reported five consecutive days of declines in gross leverage — a measure of a fund’s overall exposure to stock-price moves — among its US long-short equity hedge fund clients, the largest reduction since it began tracking the figures in 2016.

 

At Morgan Stanley, the gross leverage of its US long-short hedge fund clients — which attempt to profit on stocks rising or falling — this week fell to its lowest level since April 2020 and was just 15 per cent above a low hit in March of that year, when the pandemic pushed the US into recession. It noted that those hedge funds were again selling stocks but had also added to their short trades, bets that could pay off if a stock or index falls in value.

 

Executives working in JPMorgan’s prime brokerage unit, which reported similar findings, said there were signs that the US stock market could be close to finding a bottom, but they warned that funds still had room to cut their exposure to the market.
While II sentiment, RIAs, institutions, and hedge funds have been cutting equity exposure, retail investors are still exhibiting a strong risk appetite. A snapshot of Fidelity’s customer trading activity shows that retail is actively buying the high-octane names in the market.

 

 

Four out of five ain’t bad.

 

 

Poised for a rally

I continue to believe the market is due for a relief rally even under a major bear market scenario. The market is very oversold on breadth indicators and it rallied in similar circumstances during the bear markets of 2000-02 and 2007-09.

 

 

While breadth indicators appear very oversold from a long-term perspective, all versions of Advance-Decline Lines are exhibiting positive divergences, which is tactically constructive.

 

 

The S&P 500 intermediate-term breadth momentum oscillator just flashed a buy signal when its 14-day RSI recycled from an oversold condition to neutral. In the last five years, 20 buy signals have resolved bullishly (grey lines) and four were bearish.

 

 

Speculative growth stocks such as ARKK, which led the downdraft, are holding up remarkably well both on an absolute and relative basis. This is a sign of a renewed equity risk appetite.

 

 

An analysis of the top five sectors of the S&P 500, which comprise over three-quarters of index weight, shows a constructive picture. Technology and financial stocks have stabilized relative to the S&P 500, and communication services, which had been hard hit, has found a bid. It would be difficult for the index to either rise or fall without a majority of the top five sectors, and this technical assessment argues for stabilization.

 

 

For the final word, the latest issue of Barron’s has bear claws on the cover as the example of another possible contrarian magazine cover indicator.

 

 

In conclusion, a review of different sentiment metrics indicates an atmosphere of heightened fear. While the intermediate path of least resistance for equity prices is still down, I continue to believe the risk/reward is tilted to the upside in the short run. 

 

 

Disclosure: Long SPXL

 

From FOMO to GIDOT (Glad I Don’t Own That)

Posted by Cam Hui -

Legendary investor John Templeton once said:

Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Where are we in the market cycle? From a long-term perspective, the S&P 500 is wildly oversold on the monthly MACD histogram, but the 14-month RSI has retreated to a neutral reading. Market psychology has shifted from FOMO (Fear of Missing Out) to GIDOT (Glad I Don’t Own That).

 

 

Much depends on the Fed, interest rates, and the earnings outlook.

 

 

A determined Fed

The behavior of the stock and bond markets has seen a shift in tone over the past few weeks. The S&P 500 fell for much of 2022 and the 10-year Treasury yield has been rising in lockstep, indicating bond market concern over Fed hawkishness. In the last two weeks, bond yields peaked even as stocks weakened and the 2s10s yield curve flattened. Market psychology has changed from a fear of rising rates to the fear of an economic slowdown, which is the second phase previous specified in my publication, A 2022 inflation investing tantrum roadmap.

 

 

Much depends on where the Fed is in its hiking cycle. Fed Chair Jerome Powell made a series of recent media appearances. In a WSJ interview, Powell reiterated the Fed’s determination to fight inflation, “Restoring price stability is an unconditional need. It is something we have to do. There could be some pain involved.”

 

In a Marketplace interview, Powell underlined the message that “the process of getting inflation down to 2% will also include some pain”. More importantly, he considered the risk of elevated inflation more important than the risk of a recession. 

 

I think it’s a very challenging environment to make monetary policy. And we certainly, our goal, of course, is to get inflation back down to 2% without having the economy go into recession, or, to put it this way, with the labor market remaining fairly strong. That’s what we’re trying to achieve. I think the one thing we really cannot do is to fail to restore price stability, though. Nothing in the economy works, the economy doesn’t work for anybody without price stability. We went through periods in our history where inflation was quite high. This was back in the ‘70s, and I was old enough to remember. I’m old enough to remember that very well. And we really, we can’t fail to restore price stability.
In other words, the Fed is willing to drive the economy into recession in order to wring inflation and inflation expectations out of the system. A soft landing would be nice, but it’s not necessarily the objective.

 

So a soft landing is, is really just getting back to 2% inflation while keeping the labor market strong. And it’s quite challenging to accomplish that right now, for a couple of reasons. One is just that unemployment is very, very low, the labor market’s extremely tight, and inflation is very high. 
Much will depend on wages.

 

For example, in the labor market, there’s more demand for workers than there are people to take the jobs, right now, by a substantial margin. And, because of that, wages are moving up at levels that are unsustainably high and not consistent with low inflation. And so what we need to do is we need to get demand down, give supply a chance to recover and get those to align.
Powell gave a nod to events outside the Fed’s control, such as the inflationary pressures caused by the Russia-Ukraine war and China’s COVID lockdowns in his WSJ interview.

 

Still, the Fed as recently as January had expected inflation to diminish this spring as supply-chain bottlenecks improved. Russia’s invasion of Ukraine in late February and rolling Covid-related lockdowns in China created new sources of inflationary pressure.

 

“That is going to make it harder for inflation to come down, so it has added a degree of difficulty to what was already a challenging market,” said Mr. Powell.

 

 

A monetary policy report card

Let’s take a look at an interim monetary policy report card. Two consecutive half-point rate hikes are baked into expectations in accordance with Fed communications. While the market is leaning towards a third half-point hike at the September FOMC meeting, the probability is less certain.

 

 

Here are some of the metrics the Fed is considering. Wage growth is soaring, though the less educated and lower paid workers are receiving the most. The distribution of the gains is constructive as this represents catchup from years of lagging growth.

 

 

New Deal democrat has been calling for a slower jobs market because real retail sales leads employment. While that hasn’t shown up in the monthly Non-Farm Payroll report just yet, initial jobless claims are bottoming, indicating a cooling jobs market.

 

 

Even though the transitory word has been erased from the Fed’s vocabulary, inflation, as measured by core PCE, is cooling. Both core PCE and the trimmed-mean PCE have been decelerating in the past three months and annual PCE should fall as large readings drop off in the next three months. All else being equal, core PCE is currently running at an annualized rate of 3.0-3.5%, which is below the Fed’s SEP projections of 4.1% by December 2022.

 

 

Monetary policy is doing its job of tightening financial conditions, though readings are not at past crisis high levels. Various Fed speakers have made it clear that there is no Fed Put in the stock market. What the Fed cares about is the proper functioning of credit markets and excessive Wall Street turbulence doesn’t leak over to Main Street.

 

 

As well, inflation expectations have improved, which makes the Fed’s job easier.

 

 

 

The stock market’s reaction

Here is the stock market’s view. The S&P 500 is trading at a forward P/E of 16.4, which is below its 10-year average of 16.9. In the past 10-year, similar levels of the 10-year Treasury yield has seen the forward P/E in the 14-15 range, with a panic low of 13.5. This translates to an average downside risk of 10-15%, though it could fall as much as -25% if the market panics.

 

 

In effect, the market is discounting a soft landing, which is consistent with Jurrien Timmer‘s choppy market scenario of 1994, 2015-16, and 2018. That’s the rosy scenario.

 

 

Here is the ominous scenario. The Misery Index, which is the sum of CPI and unemployment rate, is rising in the US and Europe.

 

 

Eurozone consumer confidence is at levels consistent with recession sin the past.

 

 

The European economy will further be pressured by the additional imposition of sanctions on Russia. In addition, food shortages will become an additional source of global instability as summer progresses. The Russia-Ukraine war has closed Ukrainian grain exports through the Black Sea. In Asia, China’s wheat crop is expected to be very poor because of a delayed planting and the heat wave in India has sapped grain production. Moreover, Europe is expected to experience a dry summer and create drought-like conditions in wheat growing regions like France.

 

 

The outlook for North America isn’t much better. The UKMO model calls for dry conditions over most of the cereal growing regions in central and northern US and southern Canada this summer.

 

 

As well, Europe and North America is expected to see a hot summer, which would boost air conditioning usage and natural gas demand and add to inflationary pressures.

 

 

 

Recession ahead?

For investors, much will depend on whether the Fed is at peak hawkishness and if the economy falls into recession. The best-case scenario will see inflation peaking out this summer, a cooling of wage pressures, and no further supply chain disruptions. The S&P 500 forward P/E valuation of 16.4 is adequate.

 

The risk is the economic outlook slows further and Wall Street cuts earnings estimates. While forward 12-month EPS estimates haven’t fallen so far, a recessionary scenario will see analysts cut EPS estimates, which has caused past turbulence in the past.

 

 

The dismal financial performance of Target and Walmart shows the lingering effects of the COVID Crash and recovery. Both retailers reported that sales were up, but profits were down and inventory rose. The inventory increase is partly a result of the over-ordering effect because of COVID supply chain disruptions. As bottleneck pressures eased, deliveries rose, which boosted inventories and reduced margins.

 

Ben Carlson pointed out that recession bear markets are far more vicious than non-recessionary bears. If the economy were to sidestep a recession, investors may have seen the worst of the equity decline, but there could be substantially more downside risk if the economy were to collapse into recession. That said, any recession should be relatively mild, as both household and corporate balance sheets are strong. Deep downturns are attributable to the combination of economic weakness and excessive leverage, which is not evident in the US, though it can be found in some non-US economies. So far, the S&P 500 is down -20% in 4.5 months, or about 135 days.

 

 

In conclusion, the US equity outlook depends on the economic outlook. P/E multiples are adequate if the economy sidesteps a recession, but the risks are skewed to the downside. If the Fed becomes more hawkish, the economy collapses into recession, or if further supply chain disruptions pressures inflation, downside risk could be considerably higher.

 

Is the bounce over?

Posted by Cam Hui -

Mid-week market update: One of the concerns I had after last Friday’s market turnaround was that a bounce had become the consensus view. Virtually every technical analyst was calling for a bear market rally, followed by further weakness. It sounded too easy. Either the bounce was going to fail, or the market was going to roar to new highs.
 

The market followed through Friday’s strength with a 2% gain in the S&P 500 yesterday (Tuesday), but managed to give it all back and more today. The hourly S&P 500 chart exhibited a possible upside breakout through an inverse head and shoulders pattern, which was thwarted by today’s weakness. While there is nothing worse than a failed breakout, it could be argued that the market is in the process of forming the last shoulder of the formation. 

 

 

In light of today’s market action, is the bounce over?

 

 

The bull case

Here are the bull and bear cases for the bounce. Technical analysts were fretting about a lack of capitulation in the market last week. RecessionALERT revealed that ll of its multi-factor S&P 500 models were past their 90th percentiles, which is a highly unusual condition because the uncorrelated nature of the components.

 

 

The latest BoA Global Fund Manager Survey also gave some clues about the institutional mood. If this wasn’t a capitulation, then it was a high degree of worry. Cash levels were at levels consistent with past panics and major market bottoms.

 

 

Portfolios were positioned for stagflation. Overweight cash and commodities; underweight stocks and bonds. Within equity portfolios, managers were rotating into defensive sectors in order to lower their equity beta.

 

 

The behavior of equity factors is also revealing. Low quality junk stocks should be leading the rally in a bounce off a deeply oversold condition. This is precisely the scenario as the lower quality Russell 1000 large cap index is leading the high quality S&P 500.

 

 

Similarly, the speculative growth ARK Innovation ETF (ARKK) has held up remarkably well both on an absolute and relative basis in today’s market pullback.

 

 

 

The bear case

Last week’s market downdraft was headlined by the implosion of the LUNA stablecoin, weakness in Crypto-Land is likely to affect overall market risk appetite (see The crypto contagion risk to the stock market). Beneath the surface, the problems in crypto are not resolved. In fact, confidence continues to deteriorate even as Bitcoin struggles to hold support at about 30,000.

 

 

Tether, the largest stablecoin, broke the buck and never recovered. This is like a money market fund trading below par owing to credit problems in its portfolio. Confidence wanes and investors rush to pull out their funds.

 

 

Funds are flowing out of Tether. This is what a bank run looks like. 

 

 

In offshore Crypto-Land, there is no lender of last resort that comes to the resue. Equally worrisome is the refusal of Tether management to document how its stablecoin assets are backed on a 1-1 basis to the USD.

 

 

The bulls can argue that since ARKK is outperforming, the stock market is decoupling from the crypto market. The bears will argue that the crypto implosion is just starting and its effects will affect global risk appetite.

 

 

The short-term outlook

Here is how I resolve the short-term outlook. Other than a few CTAs, hedge funds had an abysmal Q1 and April performance was also disappointing. Many hedge funds have Q+30 day or Q+45 day redemption windows. We just passed the Q+45 day window and managers have already received their redemption notices. The recent market weakness may be reflective of the redemption pressures, which should abate in the near term.

 

 

In conclusion, this is a relief rally in a bear market. Bear markets are volatile and experience short and sharp rallies. I am encouraged by the appearance of a sudden surge of insider buying. A similar episode put a temporary floor on the market in January.

 

 

My inner investor is cautiously positioned. My inner trader has been accumulating long positions on weakness.

 

 

Disclosure: Long SPXL

 

The crypto contagion risk to the stock market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

 

A crypto bank run

I had voiced my reservations about the cryptocurrency ecosystem in the past (see The brewing Lehman Crisis in Crypto-Land) and the risks manifested themselves in the last week. To briefly recap the problem, cryptocurrencies are mainly traded in the offshore market. A crypto trader can exchange USD for crypto, but banks do not allow direct access to crypto exchanges, with some exceptions. The crypto trader can exchange his USD for a stablecoin, which is a token that is theoretically backed 1 for 1 to the USD. He then exchanges his stablecoin to buy cryptocurrencies and back when he sells. When he wants USD in his account, he instructs the stablecoin provider to convert his stablecoin into USD, which is deposited to his onshore USD account.

 

The important piece of the crypto ecosystem plumbing is confidence in the stablecoin system. Stablecoins are supposed to be like money market funds, they shouldn’t be trading below par. Last week, the TerraUSD stablecoin, also known as UST, broke its USD peg and sparked a crisis of confidence. Within the space of a few days, the value of LUNA had evaporated to zero. Crypto traders began a virtual bank run on stablecoins. Tether, the largest stablecoin, broke its peg last week, While prices have partly recovered and stabilized, Tether is still trading slightly below 1.

 

 

The crypto bank run set off a stampede of selling in cryptocurrencies and other speculative risk assets. 

 

 

The big question for investors is whether the crypto meltdown will have a long-lasting effect on global risk appetite and risk aversion leak into the equity market. Was the Crypto meltdown last week the new LTCM moment for asset markets?

 

 

Tightening until something breaks?

One way to explain the crypto crash is the tightening of financial conditions because of central bank monetary policy. Cross Border Capital has documented the collapse in global liquidity, which would have been even worse without the BoJ.

 

 

The retreat in crypto values can be attributable to the financial system wringing out some of the speculative excesses from the last boom. Simply put, crypto assets went up a lot and they’re now retracing their gains.

 

In the past, the Fed has halted its tightening policy when something breaks, such as the Russia Crisis which sank LTCM. Does this mean that the Fed will come to the rescue of crypto investors? Probably not. Remember the underlying reasoning behind cryptocurrencies is they exist outside the fiat currency system. If you crash, you’re on your own, unless the crash threatens the fiat banking system. The Fed won’t act unless credit spreads blow out, which hasn’t happened. Financial conditions have tightened, though not a lot by historical standards.

 

 

Nevertheless, the high level of correlation between cryptocurrencies and the relative performance of speculative growth stocks, as exemplified by ARKK, is a measure of risk appetite. Last week’s stabilization of ARKK on high volume is a constructive sign for short-term risk appetite. The worst of the crash may be behind us.

 

 

 

Waiting for capitulation

Still, market analysts have voiced concerns about a lack of capitulation in the market. While technical internals are oversold, the signs of panic and capitulation that mark tradable bottoms have not been present.

 

The term structure of the VIX at the 1-month and 3-month level hasn’t inverted, indicating fear.

 

 

As well, some analysts observed that ARKK was seeing substantial inflows even as the ETF tanked. However, Jason Goepfert pointed out that ARKK experienced a surge in short sales and the inflows could be explained by unit creation to accommodate short sellers.

 

 

Here’s a sign of capitulation. The NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investor funds, fell below its 26-week Bollinger Band last week. Historically, this has been a buy signal with an excellent track record with strongly bullish risk/reward implications.

 

 

SentimenTrader also pointed out that Lipper also reported that investors redeemed $44 billion from equity funds and $39 billion from bond funds in the last six weeks. This is a very unusual condition that only happened four times in the last 20 years, usually at stock market panic bottoms.

 

 

 

An oversold market

The stock market is oversold by a variety of indicators. One of the most effective trading signals is the Zweig Breadth Thrust Indicator, which has a strong record of marking short-term bottoms in the last five years. Friday’s rebound starts the clock at day 1. The market has 10 trading days to reach an overbought condition for a ZBT buy signal, but don’t hold your breath.

 

 

Jonathan Harrier observed that the S&P 500 was down six weeks in a row. There have only been 20 such events since 1950 and the market made it to a seventh consecutive decline on only five occasions. These instances of bearish market action appear exhaustive and they have historically resolved bullishly.

 

 

I highlighted the S&P 500 head and shoulders breakdown last week. The pattern showed a measured downside target of about 3830, which is roughly the same region as the Fibonacci retracement level of about 3800. As the 3800-3830 zone is well known to chart watchers, in all likelihood the index will either never reach there or blow past those levels in a downdraft.

 

 

Friday’s strong market rebound represents a hopeful sign for the bulls. The NYSE McClellan Oscillator flashed a buy signal by recycling from an oversold condition, with past buy signals of the last two years shown as vertical lines on the chart.

 

 

As well, Rob Hanna at Quantfiable Edges found that Friday rebounds after a 21-day low tend to be far more sustainable over multiple timeframes compared to turnarounds on other weekdays.

 

 

In the short run, the VIX Index will have to violate the rising trend line for the bulls to prevail. 

 

 

Keep an eye on cryptocurrencies, which are experiencing some volatility this weekend. Despite Friday’s strong recovery, cryptos may be the tail that wags the stock market dog.

 

 

 

Portfolio positioning changes

Even though I believe the market is poised for a multi-week relief rally, the combination of deteriorating global equity and commodity prices is a cause for long-term concern. 

 

One disturbing development is the continual decline in bottom-up aggregated EPS estimates. The latest update of S&P 500 consensus EPS estimates from FactSet shows that the Street has reduced EPS estimates for the next three quarters of 2022 for a second week in a row. 

 

 

New Deal democrat, who maintains a set of coincident, short leading, and long leading indicators, is still on the fence about a recesion call, though “a recession may be in the offing beginning in Q2 of 2023”. There is sufficient evidence for a global slowdown for a sell signal on the Ultimate Market Timing Model. As a reminder, this model issues a sell signal whenever both the Trend Asset Allocation Model is risk-off and a recession is at hand. Investors should sell into the anticipated rally to raise cash and wait for the all-clear to re-enter the market.

 

The weakness in commodity prices is also a signal to unwind many of the long commodity and short cyclical pair trades I suggested in the past. 

 

 

Of the four regional long producer-short importer country pairs and only the long Indonesia and short Vietnam pair has performed well. The other three have faltered and it’s time to close this factor exposure.

 

 

From a US perspective, only the quality pairs of long S&P and short Russell indices and the defensive pair of long consumer staples and short discretionary are performing well. The rest, which are long commodity and short cyclical pairs, are rolling over and should be unwound.

 

 

The performance of these pairs underscores the underlying factors that are driving the market. Even the commodity and inflation hedge plays have lost their leadership status. Only high quality and defensive factors remain dominant. I interpret these conditions to mean that while the market may be poised for a relief rally, the bears are still in control of the tape.

 

Investors should also unwind the long gold and short gold miners pair. The relationship is nearing a short-term resistance level in a very short time that it’s time to take some profits.

 

 

In conclusion, signs of possible stabilization in crypto assets and speculative growth stocks are pointing to an imminent equity relief rally. Factor analysis shows that the bears are still in control. Investment-oriented accounts should be cautiously positioned and sell into market strength. Traders can try to position for a relief rally, but don’t overstay the party.

 

 

Maintaining risk control

Finally, I would like to add a word about the trading model and positioning. My inner trader was too early in entering his long position and he held his position even as the market fell, and some readers raised the question of a sufficient risk control discipline. 

 

Not every trade works. While the current drawdown may be painful, it leads to a useful lesson about the formulation of a risk control discipline.

 

Portfolio construction consists two decisions. Deciding on what to buy and sell and how much to buy and sell. A strategy of going all-in on a trade signal and all-out on an exit signal will yield different result than a discipline of scaling in and out of positions. I publish long and short positions to disclose possible conflicts. I don’t publish how I scale in and out of positions because it assumes that we have a similar risk profile.

 

I know nothing about you. I don’t know your risk preferences. Your pain threshold isn’t my pain threshold. I don’t know your tax situation, or even what jurisdiction you live in. If you try to mirror incremental changes in long and short positions is mirroring my risk profile, which is probably not the same as yours. 

 

That’s why this isn’t investment advice. Otherwise, I would be offering a fund, with all the appropriate risk disclosures so that you can decide on whether it’s appropriate for you.

 

 

Disclosure: Long SPXL

 

The commodity canary in the coalmine is falling over

Posted by Cam Hui -
One of the main elements of my Trend Asset Allocation Model is commodity prices as a real-time indicator of global growth. As well, John Authers recently wrote, “The commodity market is a real-time attempt to assimilate geopolitical developments, growth fears, and shocks to supply and demand, so it’s an important place to look for the next few weeks.” So far, commodities have been elevated even as the global economy showed signs of slowing. The divergence is attributable to supply shocks.

 

 

We all know the recent story of supply shocks. The COVID-19 pandemic disrupted global supply chains and caused both a supply shock. As the virus first emerged in China, Beijing responded by shutting down the economy and its industrial capacity came to a virtual halt. Just as the world began to recover from the COVID Crash, the Russia-Ukraine war sparked another supply shock, this time in energy and agricultural products. 
 

Despite the supply pressures, commodity prices have finally started to fall. In particular, the cyclically sensitive industrial metals have rolled over.

 

 

Here is what it all means.

 

 

Supply chain disruptions

The supply chain effects of COVID Crash are well known, so I won’t repeat the story. What’s new is the less publicized story of how the Russia-Ukraine war is sparking another supply shock.

 

This map of the Russian military control of Ukraine tells the story of how Russia is strangling the Ukrainian economy. Before the war began, Ukraine exported most of its goods through its Black Sea and Sea of Azov ports, such as Izmail, Odesa, Kherson, and Mariupol. Now that most of those ports are under Russian control and the Russian navy is blockading access to Odesa, Ukraine’s export capacity is greatly diminished. While Ukraine can still ship products by rail, rail capacity is a fraction of its port capacity. Moreover, the cost of rail freight is about three times higher than maritime shipping and Ukrainian rail gauges are different than European rail gauges, which creates logistical problems at the border.

 

 

In addition to being an important source of agricultural exports to the world, Ukraine produces about half of the world’s neon, which is an important input for semiconductor manufacturing. The neon plants are located in Mariupol, which has been flattened by the war, and Odesa, which has stopped production. Even if hostilities ends tomorrow and the Odesa plant resumed production, it needs a means of export. That’s why Ukraine’s maritime access matters.

 

Turning to energy, the Russia-Ukraine war has disrupted energy supplies, mainly to Europe. The EU is on the verge of banning Russian oil imports by year-end. In addition, Russian gas exports to Europe through Ukraine are being shut off. That’s because Ukraine’s gas grid operator said it can’t receive gas at Sokhranivka because of a lack of control, but Gazprom refused to move shipments to Sudzha, though there are other routes for Russian gas to reach Europe.

 

 

The energy shock won’t just affect Europe, its effects are global. Recently, there have been dire warnings from various quarters about tight refined product markets, such as diesel, jet fuel, and US East Coast diesel. This all adds up to higher prices and a slowing economy.

 

 

As well, there is the supply chain disruption from China’s zero-COVID lockdown policy. The low rate of vaccination, especially among the elderly, opens China to the risk of another wave of COVID related deaths unless Beijing significantly alters course on its pandemic policies.

 

 

 

The central bank response

Here is the worrisome central bank response. Minneapolis Fed President Neel Kashkari recently stated in a speech that the Fed is willing destroy demand and drive the economy into recession if supply chain difficulties don’t ease.

 

If supply constraints unwind quickly, we might only need to take policy back to neutral or go modestly above it to bring inflation back down. If they don’t unwind quickly or if the economy really is in a higher-pressure equilibrium, then we will likely have to push long-term real rates to a contractionary stance to bring supply and demand into balance. The incoming data over the next several months should provide some clarity on these questions.

Kashkari’s views are consistent with an influential 1997 paper by Bernanke, Gertler, and Watson, “Systematic Monetary Policy and the Effects of Oil Price Shocks”, which concluded that energy price shocks on their own don’t lead to recessions, but slowdowns are attributable to the central bank’s tight monetary policy in response to higher inflation.

 

 

 

Interpreting commodity weakness

Here is how commodity prices stand today. Broad-based commodity indices, which have heavy energy weights, are in faltering uptrends. Equal-weighted commodities are displaying a sideways pattern and violated their 50 dma. The copper/gold and base metals/gold ratios have fallen dramatically in the past two months, indicating cyclical weakness.

 

 

Putting it all together, what we have is a Federal Reserve that’s tightening into widespread evidence of a slowing economy. Not only have global equity prices fallen, but cyclically sensitive commodity markets, which had been held up by supply shortages, are cracking. Robin Brooks at IIF stated that the world is on the verge of a recession. Setting aside base effects, 2022 global growth is effectively zero.

 

 

 

Silver linings

Even though the outlook appears dire, there are two silver linings in the dark clouds of recession that are on the horizon. First, peace may be at hand in the Russia-Ukraine conflict. Russian ally and Belarus’ President Alexander Lukashenko admitted in an AP interview that the Russian offensive had stalled and he was calling for negotiations.
 

The 67-year-old president struck a calm and more measured tone in the nearly 90-minute interview than in previous media appearances in which he hectored the West over sanctions and lashed out at journalists.

 

“We categorically do not accept any war. We have done and are doing everything now so that there isn’t a war. Thanks to yours truly, me that is, negotiations between Ukraine and Russia have begun,” he said.
Moreover, Russian President Putin did not escalate the war as expected on Russia’s Victory Day on May 9. Russian advances in the Donbas, which was the new reduced objective of the war, have been minimal and a Ukrainian counteroffensive had pushed Russian troops back to the border near Kharkiv. Russia lacks the means to escalate by mobilization, as it has neither the training facilities nor trainers to train new troops. Moreover, it lacks means to equip the troops with such things as tanks and fighting vehicles because of the effects of sanctions on its weapons production capacity.

 

This sets up incentives for Putin to call for a ceasefire and negotiations, which has the potential to spark a risk-on rally. Stay tuned.

 

As well, the Treasury market is finally behaving as expected and long yields are falling in anticipation of a weakening economic outlook. In the past, peaks in the 30-year yield have led to turns in the Fed’s tightening policy by 1-6 months. Despite the Fed’s hawkish rhetoric, a pivot from a restrictive monetary policy could be closer than you think.

 

 

In conclusion, weakness in commodity and equity prices is signaling a global slowdown and possible recession. Conventional wisdom would call for cautiousness in portfolio positioning. However, investors should be prepared for good news, either in the form of a cessation in Russia-Ukraine hostilities, or a turn in the Fed’s tightening policy.

 

A market bottom checklist update

Posted by Cam Hui -

Mid-week market update: For several weeks, sentiment surveys such as AAII and Investors Intelligence have signaled extreme levels of bearishness seen at past market bottoms. However, some observers have played down the sentiment surveys because indications of positioning are inconsistent with extreme fear. As an example, funds are still pouring into the Cathie Wood’s Ark Investment ETFs even as the speculative growth vehicles tank. That’s not the sort of behavior seen at washout bottoms. On the other hand, I have received a flood of emails and other messages of concern about the stock market indicating growing fear and panic.
 

 

To resolve the dilemma, my publication “How to spot a market bottom” published on March 19, 2022 offered a useful checklist that I’ll go through.

 

 

Market bottom checklist

The checklist consisted of:
  • Insider activity;
  • Market positioning in futures; and
  • Oversold and breadth indicators.
Let’s go through them, one at a time. Recent insider activity showed a brief flash of more buying (blue line) than selling (red line), which is constructive. We saw a similar episode during the short-term bottom in January. 

 

 

As a reminder, insiders were buying hand over fist during the GFC market bottom.

 

We also saw clusters of much stronger insider buying during the Greek Crisis of 2011.
 

 

Insiders similarly stepped up their buying during the COVID Crash.
 

 

The takeaway from insider activity is these “smart investors” do not signal tactical trading bottoms, but intermediate and long-term market bottoms. While current activity is mildly constructive, we aren’t quite there yet.

 

 

Futures positioning

As for futures positioning, the latest Commitment of Traders report, which was published last Friday based on the data from the previous Tuesday (May 3, 2022) shows that large speculators held a minor long position in S&P 500 e-minis, but the momentum was negative. However, futures positioning have tended to lag major market bottoms owing to the lagging nature of trend following CTA programs.

 

 

The COT picture for the NASDAQ 100 futures shows a similar minor long position and historically lagging positioning signals.

 

 

 

Oversold enough?

From a technical perspective, the good news is one of the main technical indicators shows that the market has reached the minimum threshold for an intermediate bottom. 
I have highlighted the “good overbought” advance from the March 2020 bottom before. This was evidenced by the percentage of S&P 500 stocks above their 200 dma rising to 90% and remaining there. The overbought condition recycled in mid-2021 (top panel). Historically, such declines don’t end until the percentage of stocks above their 50 dma fall below 20% (bottom panel).
The percentage of S&P 500 stocks below their 50 dma fell below 20%, which is the minimum criteria for a bottom. At this point, investors have to make a decision as to whether the current market downdraft represents a minor pullback or a major bear market. If it’s a minor downdraft, the bottom is in. In a major bear market, this indicator has fallen to as low as 5%, though the current sub-20% reading could be a setup for a relief rally, followed by further losses.

 

 

The NYSE McClellan Summation Index (NYSI) has signaled major market bottoms when it fell to -1000 or less. The NYSI is far from that reading, but the market has bottomed at current levels in 2011 and 2015-16.

 

 

Other breadth indicators which weren’t part of the checklist are sufficiently oversold to signal a possible bottom.

 

 

 

A rally within a downtrend

I interpret these conditions as the market is setting up for an imminent relief rally within the context of an intermediate downtrend. I recently pointed out that S&P 500 valuations are not attractive enough for a major market bottom (see Profit opportunities in the coming global recession). 

 

On the other hand, I was surprised that the stock market didn’t immediately tank on the hot April CPI report this morning. While core PCE and core CPI are decelerating, the pace of deceleration is uneven. The long-awaited decline in durable goods CPI is finally evident (see used cars), but services CPI is stubbornly strong, paced by an acceleration to a 0.5% MoM increase in heavyweight Owners Equivalent Rent from 0.4% the previous month, and an astounding 18.6% MoM rise in airfares. These conditions allows the Fed to stay on its hawkish tightening path, but stock prices didn’t immediately respond. By contrast, the 2-year Treasury yield rose, which is a proxy for the market’s estimate of the Fed Funds terminal rate, while longer dated Treasury yields fell, indicating the expectations of a slowing economy.

 

 

In the meantime, the NYSE McClellan Oscillator (NYMO) is oversold, where the vertical lines on the chart are buy signals when NYMO recycles from oversold to neutral.

 

 

The Zweig Breadth Thrust Indicator is also in oversold territory. Major bear legs simply don’t start in such extreme conditions.

 

 

My inner investor is cautiously positioned. My inner trader has a few nicks on his hands from trying to catch falling knives, but he is positioned for a counter trend rally. 

 

 

Disclosure: Long SPXL

 

Making sense of the H&S breakdown

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: Buy 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.
 

 

Head and shoulders intact

The head and shoulders breakdown of the S&P 500 remains intact. The index surged to test neckline resistance last week when Powell took a three-quarter rate hike off the table, but the bears regained the upper hand the next day.

 

 

How much should you trust the head and shoulders breakdown and its downside measured objective of about 3830? The 5-week RSI is already oversold. How much more downside is left?

 

Here are the bull and bear cases.

 

 

Bull case

Let’s start with the bull case. This may sound like beating a dead horse, but AAII weekly sentiment is still very bearish, which is contrarian bullish. The survey cutoff was on Tuesday, which was the day before the FOMC ramp. While bullishness had risen and bearishness retreated, the bull-bear spread is still flashing a buy signal at -26. Bearish sentiment is still historically high at 52.9.

 

 

The CBOE put/call ratio is elevated, which is a sign of heightened fear. The put/call ratio remained above 1 at 1.05 on the day of the FOMC market surge, indicating skepticism of the advance.

 

 

Thursday’s bearish turnaround after Wednesday’s surge was enough for CNBC to broadcast a “Markets in Turmoil” special program, which has been regarded as a contrarian bullish signal.

 

 

Charlie Bilello helpfully compiled the instances of “Markets in Turmoil” programs since 2010 and he found that the one-year forward returns had a perfect track record, though he added that the period was “limited to a buy-the-dip bull run where corrections have been short-lived”. Based on Bilello’s data set, I made a shorter-term study of the strategy, with the caveat that there was a large cluster starting from February 24, 2020, that didn’t end until June 4, 2020. There were a total of 97 signals during the study period but only 14 non-overlapping signals. Based on the first occurrence of a “Markets in Turmoil” program, the sweet spot for buying the S&P 500 is about 4-5 days, with a median outperformance of 1.2% to 1.3%. The chart below depicts the profit curve if you had held the S&P 500 for five days after the signal.

 

 

Even though market breadth was negative, the market exhibited breadth improvements as a series of higher lows and higher highs.

 

 

 

Bear case

The bears will argue that there is plenty to be concerned about. Even though breadth shows signs of improvement, readings are not oversold enough to indicate a long-term market bottom.

 

 

Other breadth indicators, such as the Advance-Decline Lines are weak. A survey of different versions of A-D Lines shows that most of them are in downtrends.

 

 

Even though sentiment appears excessively bearish, the term structure of the VIX Index isn’t inverted, indicating fear and panic haven’t fully appeared just yet.

 

 

Equally disturbing is the behavior of insiders. Mark Hulbert observed that this group of “smart investors” are selling into the downdraft.
 

In April, insiders aggressively picked up the pace of selling. Nejat Seyhun, a finance professor at the University of Michigan and one of academia’s leading experts on interpreting the behavior of insiders, says this is perhaps the most bearish thing insiders can do. That’s because they normally are contrarians, selling more as the market rises and increasing the pace of buying as the market declines.

 

When insiders sell into a market decline, Seyhun reasons, it means they don’t believe their companies’ shares will be significantly higher any time soon.
Lastly, if you think that Jerome Powell’s remark that the Fed isn’t considering a three-quarter point rate hike is dovish, it’s not. The Fed is keeping to a measured pace of tightening. The knee-jerk market reaction overlooked the announcement that the Fed is conducting quantitative tightening (QT) and reducing its balance sheet. An analysis of returns during QE and QT shows that while QT is not necessarily negative for the stock market, volatility is considerably higher compared to QE periods.
 

 

 

Catch a falling knife?

So where does that leave us? The bull and bear debate is really a debate of differing time horizons. The bullish factors are mainly short-term in nature, while bearish factors tend to be more intermediate term. My base case scenario calls for a short-term bottom and a bear market rally of unknown magnitude, followed by a greater decline into an ultimate low in the coming months.

 

The S&P 500 is undergoing a third possible double bottom as its exhibits a positive RSI divergence this year. Should a rally materialize, the initial upside objective would be a test of the falling trend line in the 4300-4350 zone, with secondary resistance at the 50 dma of about 4370. 

 

 

Key dates to watch in the coming week are the Russia Victory Day on May 9 for signs of a possible escalation, and the CPI report on May 11 for signs of expectations changes in the trajectory of monetary policy. Stay tuned.

 

 

Disclosure: Long SPXL

 

Profit opportunities in the coming global recession

Posted by Cam Hui -

Welcome to the coming global recession. We can debate all day about the global growth outlook, but consider this: Global Manufacturing PMI has fallen to 48.5, indicating contraction. It’s the first negative reading since the COVID Crash of 2020.
 

 

The signs of deceleration have been confirmed by the G10 Economic Surprise Index, which measures whether economic reports are beating or missing expectations.

 

 

Even in a recession, there is opportunity for equity investors. This week, I analyze the economic and equity outlooks for the three major trading blocs, the US, Europe, and Asia.

 

To make a long story short, I conclude that a survey of the world economic outlook shows the increased risk of a global recession. An analysis of the global regions indicates the US is no longer a safe haven in downturns. Relative valuations of non-US markets have converged and the best opportunity is appearing in non-German eurozone. Asia may be constructive but it is subject to China lockdown risk and possible fallout from India’s heatwave.

 

 

Price performance and valuation

Let’s begin with global equity performance. The relative performance of the major regions relative to the MSCI All-Country World Index (ACWI) shows that US outperformance has stalled and all of the other regions are beginning to catch some bids. Europe is recovering after the Russian invasion of Ukraine. Japan is trying to bottom. The emerging markets are all trying to bottom.

 

 

From a valuation perspective, the US stands out in exhibiting a premium forward P/E ratio. The forward P/Es of all of the other major regions are all converging to a narrow range.

 

 

Commodity prices also offer a cautionary message. While most headline commodity indices are strong, their strength can be attributable to the heavy weighting in energy, which has risen because of the Russia-Ukraine war. Equal-weighted commodity indices have been trading sideways and they are testing their 50 dma. Just as disturbing is the behavior of the cyclically sensitive copper/gold and more broadly based base metals/gold ratios, which have been falling.

 

 

Here’s what this all means.

 

 

America: Safe haven no more?

The major reason US equities were trading at a premium P/E valuation is their growth characteristics. The FANG+ stocks are large-cap dominant companies with strong competitive positions and cash flows. When the global growth outlook faltered as the COVID pandemic ripped through the world, investors piled into US equities as a safe haven. According to the BoA Global Fund Manager Survey, the US is the region with the greatest overweight position.

 

 

Fast forward to Q2 2022. The US economy looks far more wobbly today. The April ISM print shows that economic growth is decelerating. ISM Manufacturing fell to 55.4. New orders fell and employment dropped sharply.

 

 

New Deal democrat, who maintains a series of coincident, short-leading, and long-leading indicators, is beginning to ponder the prospect of a recession in Q2 2023 in his last update. He now has more negative components in his long-leading indicators, which look ahead a year, than positives.

 

There was deterioration across all three timeframes this week. The coincident nowcast is only weakly positive, the short term forecast is neutral, and the long leading forecast, for this first time since before the pandemic, has turned negative.

 

It is important to emphasize that while the high frequency indicators give early warning of changes, they are also somewhat noisy. Some of the negative trends might reverse (e.g., financial conditions, which showed tightening for the first time), and some positive trends (like corporate earnings beats) may amplify…

 

To sum up: the outlook for the rest of 2022 remains a weak positive economy, while for the first time, the outlook for 2023 beginning in Q2 may include a recession. From here on, we look to see if the negativity persists in the long leading indicators, and begins to spread into the short leading indicators.
The S&P 500 is trading at a forward P/E ratio of 17.6. The 10-year experience of the 10-year Treasury yield at above 3% indicates that forward P/E should be about 14-15, indicating a downside potential of about -20%.

 

 

The S&P 500 has even more downside risk than -20%. The market is in the part of the cycle in which estimate revisions are has begun to decelerate and P/E ratios are undergoing compression. In the past, the S&P 500 has struggled when EPS revisions were flat to down.

 

 

This is the first week of decline in forward 12-month EPS estimates. While it could be just a data blip, a detailed analysis of the weekly quarterly EPS revisions shows a disturbing trend. Q1 2022 EPS estimates were revised upwards, mostly because 79% of reporting S&P 500 companies have beat estimates. However, the Street substantially cut estimates for the next three quarters and Q2 2023. The only exception was a minor upward revision for Q1 2023.

 

 

Not such a safe haven anymore.

 

 

Asia: A recovery mirage?

Looking across the Pacific to Asia, the relative performance of Asian markets can be characterized as constructive. All of the major Asian regional markets are in the process of making relative bottoms. India is in a minor relative uptrend.

 

 

The apparent strength could be a mirage. That’s because of the unknown effects of China’s spreading lockdowns because of its zero-COVID policy. April’s manufacturing PMI has nosedived. 

 

 

As China is a major global manufacturing hub, a Chinese slowdown will cause a renewal of supply chain bottlenecks around the world. The WSJ reported that the average time to receive production materials rose to 100 days in April because of the lockdowns.

 

The Institute for Supply Management said its index of U.S. manufacturing activity in April hit its lowest level since July 2020, and the average time to receive production materials increased to 100 days in April, its longest span ever. In the survey, 15% of panelists expressed concern about the ability of partners in Asia to reliably make deliveries in the summer months, up from 5% in March.
If you thought manufacturing PMI was weak, the weakness in China’s services PMI illustrates the damage of the lockdowns are doing to the economy.

 

 

Barron’s reported that China Beige Book, which compiles bottom-up statistics for China, revealed “severe pressures” for the Chinese economy not reflected by official statistics.
 

There is no sugarcoating the economic situation in China. Lockdowns to fight Covid-19 whose effects aren’t yet reflected in official data are already causing “severe pressure,” according to a survey of more than 1,000 firms conducted in the last week of April by China Beige Book and released on Monday. Almost a quarter of the companies reported virus outbreaks among employees, up from 20% in March.

 

Growth in revenue and profits in manufacturing, retail, and services already is slowing. Even more troubling: Hiring took its first big hit since the initial Covid outbreak in 2020 as companies took on fewer staff and wages dropped. Companies also demonstrated little appetite for credit. Both borrowing and bond sales dropped, according to the China Beige Book, a troubling sign for investors waiting for easier access to credit to help stem the slowdown.

As well, OPEC indicated that China is facing the biggest demand shock since early 2020 because of its lockdowns.
 

Over in India, Bloomberg reported that the country is experiencing the worst heatwave in 122 years. This has resulted in power cuts owing to a coal shortage and high coal and oil prices have pressured inflation. The heatwave has also damaged crops and added to the global food shortage as India is considering restricting wheat exports.
 

 

Europe: First in, first out?

Turning to Europe, the economic outlook looks like a mess, but European equities present opportunities because the region may be the first to undergo a recession, and it could the first one out of one. 
 

The BOE raise rates by a quarter-point last week and presented a dire forecast for the UK economy. It sees the second largest drop in living standards since 1964, with inflation peaking at 10.2% in Q4. Unemployment will rise and GDP growth will fall -1% by Q4. While large cap UK stocks are showing some relative strength because of their large energy and mining exposure, small caps, which are more reflective of the British economy, is lagging.
 

 

Across the English Channel, the April Eurozone manufacturing PMI is falling, which is not a surprise because of weakened Chinese demand.
 

 

The bright spot was services PMI, which rose “amid falling COVID-19 case numbers and an associated relaxation of health restrictions”.
 

 

The relative performance of eurozone countries was a surprise. Relative performance was better in all countries other than Germany, which is struggling with the severe political pressure over a possible ban on Russian energy imports. 

 

 

Non-German eurozone equities represent an opportunity for investors, especially when the BoA Global Fund Manager Survey indicates it’s a very hated regions.

 

 

What about the Russia-Ukraine war? I use the Polish equity market as a proxy for geopolitical risk. The relative performance of Poland is still weak, indicating an elevated level of geopolitical risk premium. Poland has violated relative support against the Euro STOXX 50 and it is testing a key relative support level against ACWI. Avoid it for now.

 

 

In conclusion, a survey of the world economic outlook shows the increased risk of a global recession. An analysis of the global regions indicates the US is no longer a safe haven in downturns. Relative valuations of non-US markets have converged and the best opportunity is appearing in non-German eurozone. Asia may be constructive but it is subject to China lockdown risk and possible fallout from India’s heatwave.

 

FOMC reaction: I told you so

Posted by Cam Hui -

Mid-week market update: Happy Price Stability Day to you!
 

Ahead of the FOMC meeting, I had been pounding the table that market expectations were unrealistically hawkish. The market was discounting strong rate hikes well beyond the Fed’s stated median neutral rate of 2.4%, according to the March Summary of Economic Projections.
 

 

Combine the market’s hawkish expectations with a continued sense of panic in Investors Intelligence sentiment where bearishness jumped to a two-year high. What did you expect would happen?

 

 

The Fed came through with an expected half-point rate increase, quantitative tightening to begin on June 1 at $47.5 billion per month and rising to $95 billion after three months. These actions were entirely in line with expectations. More importantly, Powell pushed back on a 75 bps hike and it is not something the Committee is considering.

 

 

Inflation may have peaked

Here is what the picture is on inflation. Core PCE, which is the Fed’s favorite inflation metric, has been falling in the past two months. So has the Dallas Fed’s Trimmed Mean PCE. The high PCE prints will begin to drop off over the next few months, which makes the YoY comparisons tamer. At the current monthly rate, core PCE is running at 3.0-3.5% on an annualized basis, which is below the SEP projection of 4.1%. This makes the Fed’s job of pivoting to a less hawkish policy easier, though the Employment Cost Index remains stubbornly high. Investors should keep an eye on Average Hourly Earnings in Friday’s Jobs Report.

 

 

In addition, 5×5 inflation expectations is in retreat. While they are still elevated, readings are below the highs of the last cycle. While the Fed will undoubtedly remain vigilant, this will also allow Fed officials more room to make a dovish pivot.

 

 

Powell acknowledged in the press conference that inflation has decelerated, but a one-month data point is not enough to change policy. The FOMC is watching for trends in inflation, though Powell allowed that there is no evidence of a wage-price spiral.

 

 

Upside potential

In light of the excessively bearish sentiment, it was no surprise that the market took on a risk-on tone when Powell took a three-quarter point rate hike off the table. The question is how far the market can rally from here.

 

The S&P 500 surged today to test resistance at the 4300 level and the next logical resistance level is the 50 dma at about 4375. Moreover, the VIX Index retreated from above the upper Bollinger Band to its 20 dma. The market gas often paused its advance under such conditions. The key test is whether the market can exhibit bullish follow-through tomorrow, or whether it will consolidate sideways.

 

 

My inner trader is highly conflicted. Generally, he is inclined to exit long positions when the VIX recycles back to its 20 dma, but it’s difficult to see how such record levels of bearishness can unwind itself in a single day. Stay tuned for tomorrow’s market action and Friday’s Jobs Report.

 

 

Disclosure: Long SPXL

 

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A sentiment preview of FOMC week

Posted by Cam Hui -

Since the publication of my weekend trading update (see Will the Fed rally or tank markets?), a number of additional sentiment readings have come to light that may be relevant to traders and investors. The historic almost off-the-chart levels of bearishness of the AAII weekly sentiment survey has been known for several days, but there’s more.
 

 

The Callum Thomas (unscientific) weekly Twitter sentiment poll is at levels highly reminiscent of the COVID Crash lows.

 

 

In addition, the Goldman Sachs Sentiment Indicator has fallen to -2.2, which is another bearish extreme.

 

 

Historically, forward S&P 500 returns after such readings have been strong, with the important caveat that none of those instances occurred during fast Fed tightening cycles.

 

 

The markets are so jittery before Monday’s open that CNBC took the unusual step to broadcast a morning “Markets in Turmoil” banner (link here). In the past, such episodes have been done after the market close and the episodes were contrarian bullish signals.

 

 

Looking ahead past Wednesday’s FOMC meeting, Friday will see the publication of the April Jobs Report. While I have no strong views on the NFP print, Friday will mark the weekly option expiration where an unusual level of put buying has occurred. To be sure, many of the positions were opened weeks ago, but such an unusual skew is contrarian bullish. All else being equal (and unless the puts are rolled forward), the imminent expiration of the put options will force market makers to buy the underlying stocks owing to gamma decay as Friday draws closer.

 

 

Finally, investors will face the falling tail risk of Russian escalation. There had been considerable speculation that Putin was aiming to declare a limited victory in Ukraine by May 9, the day commemorating the Soviet victory over Nazi Germany. The latest assessment indicates that the Russians have only made minor gains at considerable cost on the battlefield. Russian forces are close to exhaustion and no victory is in sight. 

 

In such an event, observers had speculated that Putin would announce a general mobilization and draft of personnel and escalate the war, which would have unsettled markets. I had been skeptical of the general mobilization scenario for a couple of reasons. First, the Russians have committed about three-quarters of their standing ground forces to Ukraine. The latest intake of 100K conscripts is already short of trainers. How will the Russian forces be able to accommodate more troops? As well, the fighting in Ukraine has taken a toll on equipment and recent estimates indicate that the war has destroyed two years of Russian tank production. Western sanctions and the lack of semiconductors have put a halt to Russian military equipment production. As well, much of the inventory of tanks and other vehicles is too old, rusty, and not usable. Some tanks reported even lack engines. What would the new troops in a general mobilization be equipped with? Would they fight by throwing rocks?

 

A recent talk show on Russian state media gave no hint of any preparation for a general mobilization, which reduces the tail-risk of Russian escalation.

 

 

An oversold market

In short, the market is oversold and sentiment is discounting the direst scenarios. Any hint of better news would spark a rip-your-face-off risk-on rally. Steve Deppe studied what happened when the S&P 500 went on a four-week losing streak of -5% or more. At a minimum, expect a one-week bounce even if the fundamental and macro backdrop is bearish.

 

 

Any market weakness should be regarded as a gift from the market gods.

 

 

Disclosure: Long SPXL

 

Will the Fed rally or tank markets next week?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Another test of the 2022 lows

Here we go again. The S&P 500 tested its 2022 lows on Friday while exhibiting a positive 5-day RSI divergence. Selected sentiment readings are at off-the-charts levels. Both the bond and stock markets are poised for a relief rally, and the FOMC meeting Wednesday could be the catalyst.

 

 

 

A historic sentiment extreme

I recently expressed doubts over the weekly AAII sentiment survey readings, but the latest survey results now finally confirmed a contrarian bullish conclusion. For the third consecutive week, the bull-bear spread remains below -20. Not only has bullish sentiment collapsed in the latest week, but also bearish sentiment spiked to a nearly off-the-charts reading, indicating unbridled panic. Both the bull-bear spread and bearish sentiment have not been this bearish other than the bear market low in 1990 and the generational equity market low in February 2009.

 

 

In addition, equity fund flows have tanked to levels last seen during the 2020 COVID Crash, the 2011 Greek Crisis, the 2008 Lehman Crisis, and other major market panic lows.

 

 

At a minimum, this is a setup for a tactical stock market rally, though I remain unconvinced that investors have seen the actual low for this market cycle. As we look ahead to the FOMC meeting in the coming week, the market is also setting up for a bond market rally with important implications for stock market leadership.

 

 

Stocks vs. bonds

Stock and bond prices have undergone the unusual condition of falling together in 2022. Both stock and bond sentiment are exhibiting excessively bearish readings. A review of the technical and sentiment backdrop leads me to believe that bond prices have greater intermediate upside potential than stocks.

 

 

Let’s begin with the equity market outlook. While the AAII sentiment readings appear contrarian bullish, other sentiment models are not confirming similar extremes. The CNN Business Fear & Greed Index is fearful, but conditions are not at panic-driven lows seen in the recent past.

 

 

Similarly, the NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investor funds, retreated last week. While readings are below average, indicating minor levels of bearishness, they are nowhere near conditions seen in past washout lows.

 

 

To be sure, all four components of my bottom spotting model flashed buy signals within a few days of each other last week.

 

 

From an intermediate-term perspective, the S&P 500 has definitively violated neckline of a head and shoulders pattern. This suggests that any relief rally will encounter overhead resistance at about 4310.

 

 

From a long-term technical perspective, the percentage of S&P 500 stocks above their 200 dma reached a “good overbought” condition of over 90% in 2020 and recycled below in mid-2021 (top panel). Historically, such declines don’t end until the percentage of S&P 500 above their 50 dma fall to 20% or less (bottom panel). Investors have yet to see that capitulation low.

 

 

From a valuation perspective, the S&P 500 is trading at a forward P/E of 18.1, which is constructive. I pointed out recent (see US equity investors are playing with fire) that the last two times the 10-year Treasury yield traded at current levels, the forward P/E ranged from 13.5 to 16, which represents further downside potential from current levels.

 

 

In addition, we have not seen the clusters of insider buying that exceed sales that usually mark major market bottoms.

 

 

As a reminder, this is the pattern of insider activity during the COVID Crash bottom.

 

 

 

What about bonds?

Turning to the bond market, Ed Clissold of Ned Davis Research observed that bond market sentiment is excessively bearish.

 

 

The blogger Macro Charts also confirmed that the 10-year Treasury Note’s Daily Sentiment Index is at a bearish extreme, though DSI can be an inexact timing indicator.

 

 

As the market looks ahead to the May FOMC meeting, investors are faced with the unusual condition where the Fed Funds rate has barely budged but the 2-year Treasury yield has skyrocketed in anticipation of a fast tightening cycle.

 

 

The market is anticipating a half-point hike in May, followed by a three-quarter point hike in June, and a half-point hike in July, which represent extremely hawkish expectations. In all likelihood, a three-quarter point hike in July may be overly aggressive and any hint of a steady course of half-point moves would be enough to spark a bond market rally.

 

 

 

Watching for confirmation

From a technical perspective, the 7-10 Year Treasury ETF (IEF) appears to be trying to form a bottom, but we have seen similar false starts in the recent past. 

 

 

Here is what I am watching. If the bond market were to stage a rally from bearish sentiment extremes, watch for confirmation from changes in equity market leadership from inflation hedge groups to interest-sensitive issues.

 

 

In addition, falling bond yields would translate into better relative performance for high duration quality large-cap growth stocks such as the NASDAQ 100.

 

 

In conclusion, extremes in bearish sentiment in both stocks and bonds are setting up for tactical rallies in both asset classes. Short-term stock market readings are extremely oversold and major downdrafts simply don’t begin under such conditions. My base case scenario calls for better intermediate upside potential from the bond market. The upcoming FOMC meeting is a potential catalyst for the rally.

 

 

Strap in and brace yourself.

 

 

Disclosure: Long SPXL

 

Peak hawkishness = Risk-on?

Posted by Cam Hui -

The Economist is becoming known as a source of the contrarian magazine cover indicator. As the world holds its collective breath for the FOMC decision next week, the recent cover of the magazine begs a number of important questions for investors.

  • How far beyond the inflation-fighting curve is the Fed?
  • What are the likely policy implications?
  • Is this a case of peak hawkish expectations for the market and what does that mean for asset prices?

 

 

 

A “whatever it takes” moment

Let’s begin with the Fed’s policy path. Not only has the Fed taken a hawkish pivot, but also so have most central bankers around the world. John Authers reported that Deutsche Bank currency strategist George Saravelos summarized the recent IMF/World Bank meetings as a “whatever it takes” moment on inflation for global central bankers.

 

The IMF/World Bank meetings are rarely market-moving events. But this year they were: It was the “whatever it takes” moment for global central bankers on inflation. As the week progressed, the messaging got progressively more hawkish. Take President Lagarde [of the European Central Bank] who said little at the start of the week, only to conclude by Friday that an early end to QE was likely. Take Governor Ingves of Sweden – an outspoken dove until a few weeks ago — who threw “low for long” out of the window. Governor Macklem of Canada probably summarized the outcome of the mingling best: “There is a growing sense… central bankers need to ensure that control (on) inflation is realized.”
In a CNBC panel discussion that featured Fed Chair Jerome Powell, IMF Managing Director Kristalina Georgieva, ECB President Christine Lagarde, G20 host Indonesia Finance Minister Sri Mulyani Indrawati, and Barbados Prime Minister Mia Mottley, Powell reiterated his mantra that the Fed is focused mainly on price stability. Fed officials had expected inflation would peak in the wake of the pandemic, but they are now waiting for real evidence of deceleration before acting and the Fed is no longer waiting for help from the supply side to bring down inflation. In the face of supply shocks from the pandemic and the war, Powell acknowledged that monetary policy can do little to affect supply, but the Fed is raising rates to reduce demand through two policy levers. The jobs market is too hot, and the Fed would like to see the unemployment rise. Powell also gave an indirect nod to Bill Dudley’s thesis in his Bloomberg Op-Ed that monetary policy affects financial conditions whose effects are transmitted to the actual economy. Translation: the Fed would like the stock and bond markets to fall. As a reminder, here is what Dudley wrote:

 

Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.
From a monetary policy perspective, here is how the Fed is thinking about inflation. Researchers at the San Francisco Fed decomposed the components of core PCE that are COVID-sensitive and insensitive. As the analysis shows, inflation pressures would be under control without the pandemic. Most of the inflation pressures stem from COVID-sensitive elements of core PCE.

 

 

In light of this analysis, Fed officials had hoped that once the pandemic-related supply chain disruptions begin the fade, the inflation surge would be transitory and decelerate back to the Fed’s 2% target again. A recent New York Fed study on the breadth and persistence of inflation has thrown many of those assumptions out the window. Here are the key conclusions:

 

We find that the large ups and downs in inflation over the course of 2020 were largely the result of transitory shocks, often sector-specific. In contrast, sometime in the fall of 2021, inflation dynamics became dominated by the trend component, which is persistent and largely common across sectors.
To make a long story short, Fed researchers found that inflation pressures rose strongly at a sector level in the fall of 2021, which was much sooner than many analysts had expected. Moreover, the statistical isolation of common components shows that inflation broadened much earlier than consensus.

 

 

In other words, don’t expect inflation to ease in a transitory fashion when momentum is so strong. That’s why Fed officials have taken a decidedly hawkish pivot.

 

 

Dire warnings

In response to the Fed’s hawkish path, recession warnings have begun to come out of the woodwork.  Wall Street forecasts vary greatly. The most bearish is the call for a hard landing by the team at Deutsche Bank. Fannie Mae issued a forecast for a mild recession in the second half of 2023, which is an important marker as the organization is intensely focused on the highly sensitive housing sector.

 

Our updated forecast includes an expectation of a modest recession in the latter half of 2023 as we see a contraction in economic activity as the most likely path to meet the Federal Reserve’s inflation objective given the current rate of wage growth and inflation. Since our last forecast, monetary policy guidance has shifted in a hawkish direction, and markets have responded with rapid increases in interest rates, signaling a belief that brisker tightening is likely to occur. While a “soft landing” for the economy is possible, which is where inflation subsides without economic contraction, historically such an outcome is an exception, not the norm. With the most recent inflation readings at levels not seen since the early 1980s and wage growth exceeding that which is consistent with a 2-percent inflation objective, we believe the odds of a soft landing are even lower. Returning to the Fed’s policy target, therefore, likely necessitates economic growth slowing sufficiently to lead to a rise in the unemployment rate, which would cool wage and price pressures.
Other housing focused forecasters, such as Logan Mohtashami, have been more on the fence. Mohtashami outlined his concerns in a recent podcast. Housing starts numbers have been distorted by supply chain problems and he is monitoring new home sales instead. Mortgage rates have been rising, which has put pressure on new home buyers because some can’t qualify for purchases at the higher rate. This has left builders scrambling to replace the buyers who have abandoned purchases. If new home sales fall, a decline in housing construction will follow, which leads to a cyclical downturn.

 

The latest release of the March new home sales was weak and missed expectations. This may be the start of a stall, which could be dire for the economy. However, this data series is volatile and prone to revisions. Therefore I would like to wait at least a month for confirmation of weakness.

 

 

Another disconcerting data point can be found in the spread between the forecasted new orders and current new orders components of the Philly Fed manufacturing survey. While readings may not necessarily be recessionary, they do warn of a slowdown ahead.

 

 

For the last word, I turn to New Deal democrat, who maintains a set of coincident, short-leading, and long-leading indicators. He recently wrote about the parallels between the situation in 1948 and today. The economy went into a recession without a yield curve inversion, though it did follow a familiar boom-bust cycle.

 

Our current situation shows many similarities: the Fed has been on the sidelines, while both wages and prices have increased sharply. While there has been no yield curve inversion, the increase in real consumer spending has stopped. And this may be taking a toll on corporate profits, although we won’t know – at least in terms of the official GDP report – for another month.
 

But there are several differences as well. Most importantly, the important leading sector of the housing market has not yet turned down, and there is no sign of cooling demand showing up in commodity or producer prices. Additionally, much of the inflation is from outright supply chain disruptions (viz., at the moment the COVID-caused bottleneck in the port of Shanghai), rather than just increased demand.

 

Of course, the Fed could yet step in and raise interest rates enough to persistently invert the yield curve. Failing that, the housing market and a sharp pullback in commodity prices are the surest signs of the “bust” part of the old-fashioned Boom and Bust cycle, a la 1948.
We’ve had some additional data since the publication of that note. Real M2 growth has slowed sufficiently to signal a recession, though real M1 growth remains neutral. More importantly, Q1 proprietors’ income, which is an early look at corporate profits, held up reasonably well. NDD concluded that “the picture continues to deteriorate”. I interpret this to mean that the economy is wobbly, but it would be too early to call a recession based on NDD’s set of long-leading indicators that look ahead 12 months.

 

 

Rising systemic risk

One of the risks of Fed hiking cycles is the systemic risk of a disorderly deleveraging event or financial crisis. Financial stability risk within the US should be relatively low. In the wake of the COVID Crash, household and corporate balance sheets improved because of the massive fiscal and monetary stimulus. Leverage ratios fell and the risk of a financial crisis should be low because the economy has already deleveraged.

 

 

That said, the risk is outside the US. The Fed has embarked on a more aggressive tightening program than other major central banks. The eurozone economy is extremely weak in the face of the war. Despite the threat of rising inflation, the ECB is expected to take an easier monetary policy in its tightening cycle. Over in Asia, the BoJ is stubbornly clinging to its yield curve control regime and the PBoC is eyeing an easing cycle. Consequently, the USD is appreciating against all major currencies. This has led to the unusual condition where inflation is rising alongside the USD, which is creating risk for fragile emerging markets.

 

 

In other words, when the Fed raises rates, it’s raising them for the rest of the world. IMF head Kristalina Georgieva warned in the CNBC panel discussion that a 50 basis point hike by the Fed doesn’t just mean that fragile EM economies have to take on the burden of a similar hike, but the prospect of hot money fund flows out to dollar assets as a safe haven. This exacerbates the risk of sovereign debt defaults. Moreover, the stampede into King Dollar raises the risk of a dollar shortage in the offshore USD markets, which also raises the risk of a discontinuous deleveraging event.

 

 

Hawkish expectations

Ahead of the May FOMC meeting, hawkish expectations are high. Even though the Fed Funds rate has barely budged, the 2-year Treasury yield, which is a proxy for the market expectations of the neutral Fed Funds rate, has soared.

 

 

What’s the neutral rate? Currently, the market is discounting a half-point hike in May, a three-quarter point rate hike at the June meeting, followed by another half-point hike in July. The December projection of a Fed Funds rate of 275-300 bps is past the Fed’s published median neutral rate of 2.4%, as outlined by the Summary of Economic Projections.

 

 

Consider Friday’s report of March core PCE, which came in at 0.3%, which was equal to market expectations. In the next three months, high core PCE rates will roll off and the annual rate will decline. Based on current figures, core PCE is running at around 4% per annum, which is roughly equal to the Fed’s projected core PCE rate of 4.1% at year-end, according to its Summary of Economic Projections. This reduces pressure on the Fed to be aggressive in its tightening policy.
 

 

This is sounding like the market has overshot the Fed’s policy path. The Economist cover may prove to be another classic contrarian magazine indicator for a bond market rally, with the FOMC meeting as a possible trigger for a reset of expectations. Arguably, USD strength will weaken inflation and growth and contribute to a gentler rate hike cycle.

 

For much of 2022, stock and bond prices have fallen in an unusual synchronized manner. A more dovish Fed rate hike policy could send both stocks and bonds up together.

 

 

Stay tuned. Tomorrow, I will write about how to tactically position for the potential rally ahead.

 

The bulls attempt a goal line stand

Posted by Cam Hui -

Mid-week market update: As the S&P 500 tests the lows for 2022, the question for investors and traders is whether support will hold. The analysis of the large-cap S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 presents a mixed picture. While large and mid-caps appear to be holding support, small-caps look wobbly.
 

 

A violation of support would open up considerable downside potential and this is the equivalent of the bulls’ goal-line stand. Will they be successful?

 

 

An oversold extreme

Notwithstanding the market nervousness over individual large-cap tech stock earnings, there is ample evidence that a short-term bottom is forming. The market was very oversold based on yesterday’s apparent panicked market action.

 

 

Three of the four components of my bottom spotting models flashed buy signals Tuesday, which is a signal that a bounce is on the horizon. The VIX Index has maintained its position above its upper Bollinger Band, the term structure of the VIX is inverted, and the NYSE McClellan Oscillator reached -65.7, which is an oversold condition.

 

 

The Zweig Breadth Thrust Indicator confirmed the market’s oversold condition by exhibiting an oversold reading as well.

 

 

Breadth indicators, while negative, appear helpful for the bulls. Even as the S&P 500 tests support, breadth indicators are showing positive divergences, which is constructive.

 

 

Market Charts observed that over 30% of S&P 500 stocks are now trading below their lower Bollinger band. A backtest of these conditions in the last 10 years shows that the index was up an average of 2.79% after 20 trading days with a 86% positive return success rate.

 

 

 

The bears are still in control

Before you get all excited, you should regard any relief rally as a counter-trend move in a downtrend. The bears are still in control of the tape, as evidenced by the relative uptrend exhibited by defensive sectors. While some sectors, such as consumer staples and real estate, appear a little extended and due for a pause, this chart shows that the intermediate trend is still down.

 

 

Jeff Hirsch at Trader’s Almanac also pointed out that we are entering the weak spot of the four-year election cycle. This is a time for investors to be extra cautious with their equity commitments.

 

 

In short, traders should prepare for a relief rally, but don’t overstay the party. My inner trader is tactically long the market. He doesn’t have a specific upside target for the S&P 500, but he is waiting for the VIX Index to return to its 20 dma from its position above the upper BB as a take profit signal.

 

 

 

Disclosure: Long SPXL

 

Pairs Monitor: Correlations converging to 1?

Posted by Cam Hui -

I recently suggested a number of long/short pair trades as a way of achieving performance in an uncertain and choppy market. Inflation hedge vehicles have begun to underperform, and the subsequent performance of the pairs is revealing of the factors driving the current market environment.
 

The four regional pairs were based on a theme of long producer and short importers in order to gain exposure to an inflationary environment. Three of the four have rolled over (horizontal lines indicate the pair price levels on the date of publication).

 

 

Of the US-centric pairs, the defensive pairs with exposure to quality (long S&P and short Russell and long consumer staples and short discretionary) have performed reasonably well. but the long inflation hedge and short cyclical pairs have turned down.

 

 

The last pair, long gold and short gold miners, is a mean-reverting pair that has exhibited strong positive performance.

 

 

 

Inflation factor analysis

How can investors interpret these changes in factor exposures? In particular, why are the inflation hedge vehicles skidding? An analysis of global inflation hedge sectors such as energy, mining, agribusiness, and real estate reveals that all are in relative uptrends compared to ACWI with one exception. Global mining has tanked, though these stocks have been very choppy in the past.

 

 

Weakness in inflation hedge vehicles should be interpreted as investor fear of central bankers tightening the global economy into recession. If that’s the case, the 10-year Treasury yield should be falling – and it did not decline until today.

 

An alternative explanation for the recent weakness in inflation factor exposure is the rising fears in the stock market. When stocks all fall in a panic, asset and factor correlations converge to 1.

 

 

An oversold market

I recently wrote that the market had unfinished business to the downside (see Sentiment: This time is different). Much of the unfinished business may be temporarily complete when global markets turned deep red to open the new week when Asian markets sold off on the fears of a Beijing lockdown.

 

At least two of the components of my bottom spotting model either flash buy signals or flashed outright buy signals Friday, which is an indication that the short-term risk/reward is tilted to the upside. The VIX Index has already risen above its upper Bollinger Band, which indicates an oversold market. The NYSE McClellan Oscillator was already very near an oversold level. TRIN reached 1.96 on Friday, which is very close to the 2.0 level that’s a signal of a margin clerk driven liquidation market. Monday’s late day recovery after a day of weakness cements the thesis of a short-term bottom.

 

 

Traders shouldn’t mistake any relief rally for an intermediate-term market bottom. For some perspective, the CBOE put/call ratio spiked to levels on Friday that were last seen during the March 2020 panic bottom, but readings could be a one-day data blip. The 10-day moving average is nowhere near March 2020 levels. In addition, the percentage of S&P 500 bullish on point and figure charts cannot be interpreted as even oversold.

 

 

The key caveat is Q1 earnings season is in full swing and several mega-cap technology companies are scheduled to report this week. Be prepared for further volatility.

 

 

In conclusion, I am inclined to give the long inflation hedge pairs trades the benefit of the doubt. In all likelihood, they are being sold along with other equity positions in a panic liquidation where all correlations converge to 1. The market is oversold and a relief rally is on the horizon. Wait for the rally to see if the inflation hedge factors are still weakening before making a judgment.

 

 

Disclosure: Long SPXL, SLY. Short IWM.

 

Sentiment: This time is different

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

 

About that AAII sentiment…

It’s confirmed. The AAII weekly sentiment data was not a blip. While bullish sentiment advanced slightly from the previous week, it remains weak and the bull-bear spread is still below -20, which is a contrarian buy signal. While bullish sentiment did crater, bearish sentiment did not spike to levels indicating panic.

 

 

A similar set of circumstances was found in the Investors Intelligence survey. The %bulls skidded badly, but %bears fell too, though not as much as %bulls. The bull-bear spread consequently turned negative, which is interpreted as a contrarian buy signal.

 

 

While conventional sentiment analysis would conclude that these represent tactical buy signals, I beg to differ. This time is different, and here’s why.

 

 

Conflicting sentiment signals

Even though the AAII and II sentiment surveys show strong buy signals, a number of other sentiment models tell a different story.

 

The NAAIM Exposure Index, which is a survey of RIAs who manage individual investor funds, is neutral. As a reminder, a breach of the lower 26-week Bollinger Band of the NAAIM Exposure Index has been an excellent buy signal (vertical lines).

 

 

A detailed analysis of the NAAIM data shows the survey exposures at the first, middle, and third quartile breaks, as well as the maximum and minimum equity exposures. The minimum exposure of 16% means that there were no respondents who were short the market as they were several weeks ago. These results are inconsistent with a picture of investors who are panicked over the stock market’s outlook.

 

 

A similar lack of fear can be found in the options market. If investors are afraid of a sudden drop in stock prices, they tend to buy put option protection and drive up the price of puts compared to calls. The SKEW Index measures the relative pricing of out-of-the-money calls to puts. A high SKEW indicates the perception of high tail-risk while a low SKEW indicates complacency. Current readings are neutral to low. More importantly, the 10-day change in SKEW recently fell by -10%. Historically, such episodes have been reasonably good trading sell signals. In the last five years, there were 18 such signals. 11 resolved in a bearish manner (pink vertical lines) and seven bullishly (grey lines).

 

 

 

The bears are in control

Tactically, the bears are in control of the tape. Defensive sectors are all in relative uptrends.

 

 

Equity risk appetite factors are exhibiting negative divergences against the S&P 500. In particular, speculative growth stocks, as represented by the ARK Innovation ETF, broke a relative support level after holding up well for about a month.

 

 

SentimenTrader highlighted the spike in both new highs and lows and concluded that such a conditions has always resolved in a bear market. His observation is similar to one of the underlying elements of the Hindenburg Omen, where both new highs and new lows rise together indicating a bifurcated market (see Another Omen warning).

 

 

As well, Cross Border Capital pointed out that Fed liquidity injections had dropped dramatically last week, though the drop may be a data blip. Historically, the S&P 500 has been highly correlated with market liquidity.

 

 

If the decline in Fed liquidity injections is concerning, the more ominous sign is that quantitative tightening has only started. The Fed’s balance sheet fell a measly $10 billion in the week, which amounts to a roundoff error in a balance sheet of $8.97 trillion.

 

 

 

An oversold market

In conclusion, I interpret the AAII and II sentiment readings as the bulls have capitulated but the bears haven’t and there is unfinished business to the downside. Despite my intermediate bearish outlook, the market weakness late in the week left the stock market oversold, though sentiment indicators are still mixed. The VIX Index spiked above its upper Bollinger Band, which is a sign of a short-term oversold condition. As recent history shows, oversold markets can become even more oversold.

 

 

As well, the Zweig Breadth Thrust Indicator reached an oversold level on Friday. As a reminder, Zweig Breadth Thrust buy signals are triggered when the ZBT Indicator moves from oversold to overbought in 10 trading days. Such conditions are rare and I am not holding my breath for the signal. Nevertheless, it does indicate that prices are stretched to the downside.

 

 

Investment-oriented accounts should be positioned cautiously and take advantage of rallies to raise cash. Trading accounts should be aware that the market is short-term oversold and poised for a relief rally in the context of a downtrend.

 

How to time the recession stock market bottom

Posted by Cam Hui -

Recession fears have arrived on Main Street. From a statistical perspective, Google searches for “recession” have spiked.
 

 

From an anecdotal perspective, recession talk has emerged as the talk of the party.

 

 

These conditions beg three crucial questions for investors:
  • Will there be a recession?
  • If so, how much of the slowdown is in the market?
  • When will the recessionary stock market bottom?

 

 

Will there be a recession?

It’s difficult to call with many degrees of certainty whether there will be a recession in the next year. Recession modeling depends on several difficult to forecast moving parts, namely inflation, the supply chain effects of the war and war-related sanctions, as well as the Chinese zero-COVID lockdown, and Fed policy.

 

As an example, the latest Philly Fed survey saw both employment and prices paid move higher. The Fed’s challenge is to suppress inflation without excessively suppressing job growth.

 

 

Some analysts I respect have pulled back their recession forecasts. New Deal democrat, who maintains a series of long leading, short leading, and coincident indicators is calling for a slowdown in late 2022 and early 2023, but no outright recession. He recently voiced concerns about the surge in mortgage rates that will slow housing, which is an important cyclical industry. His initial forecast called for a possible recession just based on a downturn in housing.

 

Because of the effect on monthly interest payments, as discussed above, I suspect it will be worse. And that would almost certainly have enough impact on the economy next year to put us close to if not in a recession, all by itself.
In the wake of the housing starts report, his housing starts commentary noted the strength in housing permits but relative weakness in housing starts because of “a unique divergence between permits and starts, as supply shortages resulted in a delay in actually building houses that had been approved”. The pent-up demand caused him to amend his forecast to downgrade the economic drag of housing starts on the economy:

 

In the coming months, I still expect to see a substantial decline in permits. Ordinarily that would be a major negative long leading indicator. But actual construction starts are likely to continue to show strength until the near record backlog has been cleared. Since starts are the actual, hard economic activity, this indicates that housing is still going to make a positive to the economy looking out ahead 12 months.

 

In fairness, this is an amendment to what I wrote yesterday. Then I noted that there was no “pent-up demand” or “demographic tailwind” present anymore. That is true; but the backlog in construction due to supply shortages will delay any actual downturn affecting economic activity. 

 

Former Fed economist Claudia Sahm (of Sahm Rule fame) recently outlined her base case for a mild recession next year:

 

With what we know now, my most likely scenario (60%) is a mild recession next year, something like the 2001 recession in severity when the unemployment rate rose two percentage points. We could also easily see a 2-handle on unemployment (under 3 percent) sometime this year. I don’t care what hawks say; that would be amazing. (Note, to complete my forecast: 30% on no recession; 10% on a severe one.)
In the wake of the soft CPI report, she downgraded the probability of a mild recession to 30%.
 

I wrote in my Sahm Rule post that a mild recession next year was my “most likely” (as in at least 50%) forecast. After a restless night of sleep—yes, I have macro nightmares, I deleted it. Chances are not that high.

 

After the CPI release I downgraded my “mild recession” to 30% chance. 

As Keynes famously said, “When the facts change, I change my mind. What do you do, sir?” While there are many moving parts to my economic forecast, my base case calls for a slowdown to begin in either Q4 2022 or Q1 2023. As to whether the economy weakens into outright recession, as defined by two consecutive quarters of negative GDP growth, the jury is out on that.
 

That said. Fed Chair Jerome Powell reinforced his hawkish views at an IMF hosted discussion with ECB President Christine Lagarde, as reported by the WSJ. First, he affirmed that a half-point rate hike is a done deal at the May FOMC meeting and to expect more half-point moves at subsequent meetings.
 

“It is appropriate in my view to be moving a little more quickly” to raise interest rates than the Fed has in the recent past, Mr. Powell said Thursday. “I also think there’s something in the idea of front-end-loading” the removal of stimulus, he said.

As for the trade-off between recession and fighting inflation, he gave a nod to trying to engineer a soft landing, but gave a higher priority to its price stability mandate.
 

The Fed is trying to engineer a so-called soft landing in which it slows growth enough to bring down inflation, but not so aggressively that the economy falls into a recession. “I don’t think you’ll hear anyone at the Fed say that that’s straightforward or easy. It’s going to be very challenging,” Mr. Powell said.
 

Mr. Powell said the Fed is focused above all else on bringing down inflation. “Economies don’t work without price stability,” he said.

To underline the Fed’s inflation fighting commitment, Powell went on to extol Paul Volcker’s efforts in controlling inflationary expectations.
 

“Chair Volcker understood that expectations for inflation play a significant role in its persistence,” said Mr. Powell. “He therefore had to fight on two fronts: slaying, as he called it, the ‘inflationary dragon’ and dismantling the public’s belief that elevated inflation was an unfortunate, but immutable, fact of life.”
 

Mr. Volcker “knew that in order to tame inflation and heal the economy, he had to stay the course,” Mr. Powell said.

 

 

Discounting recession risk

How much recession risk is priced in? I would argue that while recession fears are rising, the market hasn’t fully discounted recession risk at all. The BoA Global Fund Manager Survey showed that while global institutions are all-in on slowdown risk, portfolio positioning can only be described as neutral and not risk-off.
 

 

I also highlighted a possible equity valuation shortfall last week (see US equity investors are playing with fire). Based on current consensus S&P 500 EPS estimates and bond yields, the downside valuation risk is -10% to -30%. In the case of a recession, earnings estimates would decline further and raise downside risk, though the fall in earnings would be partly offset by falling yields.

 

 

 

When should you buy?

So where does that leave us? Current data indicates that the economy will experience a slowdown by late Q4 or early Q1, though an outright recession is in doubt. However, the Fed Funds futures market is discounting a very hawkish Fed of a half-point rate hike in May, followed by a three-quarter point hike in June, a half-point hike in July, and moderating to a series of quarter-point hikes.
 

 

If the Fed’s actions are remotely near what the market expects, it’s difficult to see how the economy won’t avoid a recession. In that case, let’s assume that a recession begins in Q1 and lasts two quarters. As the stock market looks ahead 6-12 months, expect a market bottom some time in Q3 or Q4. This scenario is also consistent with the mid-term election year seasonal pattern of a market bottom in early October.
 

 

I also offer two rough guideposts to a market bottom. The first is insider activity. If the stock market were to weaken further, watch for insider buying (blue line) to overwhelm insider selling (red line). While this is an inexact market timing indicator, it does show periods when this group of “smart investors” believe that the long-term risk-reward of owning stocks is favorable.
 

 

Another way of spotting a long-term bottom is to watch when the awareness of a recession is well-known by using the Sahm Rule: “If the unemployment rate—the average of the current month and the prior two—is 0.5 percentage points above its lowest value during the previous twelve months, then we are in a recession.” Add to equity allocations when the Sahm Rule indicates a recession (blue line) and when confirmed by a falling 10-year Treasury yield. Like the insider trading rule, the Sahm Rule buy signal will not spot the exact bottom, but it will indicate low-risk entry points for long-term equity investors.
 

 

Neither model has flashed buy signals. In the alternative, if the S&P 500 continues to rise from current levels into late Q3 or early Q4, all bets are off. I will have to revisit my assumptions about a recession, economic slowdown, bear market, and equity valuation risk.
 

Cyclicals catch a bid, but…

Posted by Cam Hui -

Mid-week market update: Cyclical industries have caught a bid in the last week. That’s not a big surprise as they have been badly clobbered relative to the market. Transportation stocks exhibited impressive strength as they regained relative support turned resistance level. However, the relative performance of all of the other industries was either below relative support or in a relative downtrend (retailers). The cyclically sensitive copper/gold ratio also rebounded, but in the context of a broad sideways pattern (bottom panel).
 

 

Don’t be fooled. Fade the rally.

 

A cyclical rebound is inconsistent with the current macro backdrop of tight monetary policy.  As a reminder, former New York Fed President recently wrote a Bloomberg Op-Ed that said the quiet part out loud. The Fed wants monetary conditions to tighten by forcing the stock market to fall.

Investors should pay closer attention to what Powell has said: Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.

With inflationary pressures running hot, the S&P 500 is about -7% from its all-time highs. Credit spreads have widened a little, but stress levels are still low. Expect the Fed to tighten further and which will snuff out any cyclical rebound.
 

 

Jurrien Timmer at Fidelity observed that while fixed income markets have tightened, equity markets have not, as measured by earnings yield.

 

 

San Francisco Fed President Mary Daly, who is widely considered to be a dove, confirmed the Fed’s hawkishness in a speech today, “The case for a 50 basis-point adjustment is now complete.” She added, “I see an expeditious march to neutral by the end of the year as a prudent path”. While she did not specify where she believed the neutral rate is, the median rate specified in the Fed’s SEP is 2.4%.

 

 

Explaining the rally

In short, the macro backdrop argues for further stock market weakness. The recent market advance can be attributed to a combination of seasonality and negative sentiment. 
 

AAII bullish sentiment collapsed last week and readings fell to levels not seen since the Greek Crisis of 2011. These conditions were confirmed by the latest release of the Investors Intelligence survey, which also saw a similar decline in the bull-bear spread.
 

That’s contrarian bullish, right?
 

 

While the bull-bear spread retreated to negative, which should be interpreted as a buy signal, the sentiment backdrop appears flimsy beneath the surface. That’s because both bulls and bearish sentiment fell. Just like last week’s AAII survey, bullish sentiment collapsed faster than bearish sentiment. Respondents aren’t becoming actively more bearish, which would be positive for stock prices, they became more uncertain, which does not lead to the same solid contrarian bullish conclusion.
 

From a top-down macro viewpoint, cyclical sentiment had become excessive bearish. The Atlanta Fed’s GDPNow nowcast of Q1 GDP fell into negative territory in late February, which pulled down the economic growth outlook. It has since rebounded to 1.3%.
 

 

Post-Tax Day positive seasonality is providing a temporary tailwind for the bulls.
 

 

 

Exercise caution

Investors should exercise some caution as we progress through Q1 earnings season. Notwithstanding the Netflix disaster, S&P 500 large-cap forecast margins are fine, but S&P 600 small-cap margins appear wobbly.
 

 

Meanwhile, equity risk appetite factors are still weak and do not confirm the market rally.
 

 

As well, market breadth has been hardly inspiring. With the exception of the S&P 500 Advance-Decline Line, the other versions of A-D Lines are either deteriorating or trading sideways. 
 

 

The S&P 500 will encounter overhead resistance at its 200 dma at about 4500 and upside potential is limited. Stay defensively positioned.