Page 3 – Humble Student of the Markets

Tips on navigating the post-inauguration rally

Posted by Cam Hui - January 26, 2025

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 (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
Trading model: Neutral (Last changed from “bullish” on 17-Jan-2025)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent and on BlueSky at @humblestudent.bsky.social. 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.

Time for a pause?

January is almost over, and the S&P 500 staged an upside breakout to an all-time high last week, which Jeffrey Hirsch found is consistent with market seasonality. If the seasonal patterns found by Almanac Trader were to continue, stock prices are likely to be flat to down in February.

The rally left the market overbought, as measured by the NYSE McClellan Oscillator (NYMO). This is not necessarily bearish. Of the nine instances in the last three years when it reached 70 or more, stock prices retreated on three occasions and either advanced or consolidated sideways in the other six.

Supportive sentiment

In addition, short-term sentiment readings are not excessively bullish. The AAII weekly bull-bear spread is positive at 14, but don’t represent a crowded long. These readings leave the bulls more room to run should the backdrop prove to be favourable.

Bloomberg reported that positioning is light and institutions are skeptical of the rally:

Barring any negative surprise, my base-case scenario calls for some near-term choppiness and, at worse, a shallow pullback to the 50 dma, which represents downside risk of only 2% on the S&P 500.

A case of bad breadth

While the short-term outlook for stock prices appear looks like it’s flat to up, I have some concerns about the intermediate-term trend. That’s because of the growing negative breadth divergences. Even as the S&P 500 broke out to an all-time high, none of the Advance-Decline Lines confirmed with a fresh high.

Breadth divergences can be measured in other ways beside the A-D Line. A rapid decline in the percentage of S&P 500 stocks above their 200 dma can be signals of a substantial decline.

To be sure, negative breadth divergences are warnings and not immediate sell everything signals. Negative breadth divergences can take months to resolve before the bears take control of the tape.

Near-term consolidation ahead

My base-case scenario calls for some near-term consolidation or shallow pullback. An analysis of the relative performance of the top five sectors by weight in the S&P 500 shows no strong co-ordinated bullish or bearish trends. As these sectors represent about 70% of index weight, the index needs broad-based participation for the S&P 500 to either rise or fall.

In conclusion, the S&P 500 is short-term overbought after breaking out to an all-time high and needs time to digest its gains. I expect this will resolve in a period of sideways consolidation or shallow pullback, though the combination of the uncertainty of Q4 earnings season reports, with 37% of S&P 500 expected to report, and the upcoming FOMC and ECB rate decisions could induce some volatility. However, I have substantial concerns over growing signs of negative breadth divergences, which could be signals of a cycle top in either Q1 or Q2.

Two key risks to the bull that no one is talking about

Posted by Cam Hui - January 25, 2025

The S&P 500 has been in a steady uptrend for over two years and it just staged an upside breakout to an all-time high. It may seem counterintuitive to be discussing the risks of a major market top, but I am seeing some early warnings that few analysts are paying attention to.

The roots of its own demise

While I am not inclined to front run model readings, if the S&P 500 were to end January at a closing high, it would represent the roots of a bullish demise.

The accompanying chart shows a long-term buy and sell discipline that has served us well over the years. Here is how it works. A buy signal is triggered when the monthly MACD of the NYSE Composite (bottom panel) turns positive (dotted blue vertical lines). A sell signal is triggered when the 14-month RSI (top panel) flashes a negative divergence when the market makes a new high. If the S&P 500 were to close the month at current levels, it would represent a new monthly high, while the 14-month RSI is making a lower high, or a sell signal.

While it is said that there is nothing more bullish than a stock or index making a fresh all-time high, this might be an exception to that adage. In this case, weak RSI momentum is setting up the bulls with the roots of their own demise.

The weakness in NYSE Composite RSI is reflective of the weak breadth exhibited by the stock market. Even as the S&P 500 tests overhead resistance at its all-time high, no version of the Advance-Decline Line is nearing a fresh high.

It could be argued that my long-term model readings, which are based on the NYSE Composite, are misleading as the S&P 500 has been outperforming the NYSE Composite because of the strength of the Magnificent Seven. A similar monthly analysis based on the S&P 500 also shows a less pronounced but still negative RSI divergence.

To be sure, negative RSI divergences and negative breadth divergences are not immediate sell everything and rush into cash signals. Instead, they are warnings of faltering momentum, but these readings are warning of a potential Q1 or Q2 market top. The caveat is this is a monthly model and investors need to monitor how the market closes at the end of January.

MarketWatch recently also reported another long-term warning with no immediate bearish trigger. Ed Yardeni found that foreigners, who have a terrible market timing record, are piling into U.S. equities at a record pace.

The deportation growth threat

Markets turned risk-on after Trump’s inauguration, largely because many of the potential headwinds to growth did not immediately materialize. While Trump did sign a flurry of executive orders, most of them were either symbolic, cultural or only had economic effects that didn’t unsettle markets, such as the reversal of DEI initiatives, renaming the Gulf of Mexico and the withdrawal from the Paris Accords.
Trump didn’t immediately slap tariffs on China, though he did threaten Canada and Mexico with 25% tariffs and China with 10% by February 1, which the market interpreted as bluster. It seems that Trump 2.0 learned from the lessons of Trump 1.0 and the chaos of the Muslim ban when Trump first took office in 2017. The new Trump Administration is being more measured in the implementation of its campaign promises.

One of Trump’s signature initiatives is on deportation as he vowed in his inaugural address to send “millions and millions of criminal aliens back to the places from which they came.” The Peterson Institute estimated the effects of Trump’s major electoral promises in a study. It modeled the effects on GDP and inflation of light (1.3 million people) and severe deportation (8.3 million) over a four-year window, as well as the effects of different tariff rates and the revocation of Fed independence. The magnitude of the effects on growth and inflation of deportation is substantially higher than either tariffs or the revocation of Fed independence.

A different study by the Brookings Institute projected less alarming effects on growth, though there are different approaches to the two studies. The Peterson study projected the effects over four years and analyzed pure deportations, while the Brookings study modeled the effects in 2025 and focused on net migration, which includes the natural effect of legal immigration plus the negative effects of deportations.

The Brookings study, which assumed an extreme scenario of a mass deportation of over one million people in 2025 is reminiscent of the Eisenhower deportations of 1954, modeled a one-year GDP growth shock of -0.4%. To make an apples-to-apples comparison to the Peterson study, its assumption of the removal of 1.3 million illegals caused a negative GDP growth shock of -3.8% over four years, which averages to just under -1% a year.

Any way you look at it, there will be a negative growth surprise from mass deportation. Economists can make various assumptions in modeling but won’t know until it actually happens.

So far, the Trump Administration is taking more disciplined measured steps to implement its campaign promises. The House just passed the Laken Riley Act, which will deport illegal immigrants charged, but not necessarily convicted, with certain crimes. The Act is certain to be signed into law by Trump, though it’s unclear whether it will survive a court challenge because it denies due process to deportees. While there were stories of scheduled immigration raids in sanctuary cities like Chicago and San Diego, the raids have been put on hold, though there were a raid reported in Boston. In short, the extent and scale of deportation efforts remains to be seen. If the measured pace of Trump 2.0 continues, investors will see more substantial signs of deportation by Q2 or Q3. This is consistent with the scenario of a cyclical stock market top in Q1 or Q2 signaled by negative breadth divergences, as markets tend to be forward-looking.

So far, two industries that depend on undocumented worker labour, homebuilding and restaurants, have lagged the S&P 500 but price action shows increasing concern but no panic.

In conclusion, nascent signs of a major market top are appearing even as the S&P 500 tests its all-time high. A growing negative breadth divergence and a potential growth shock of mass deportations could sideswipe stock prices. The scenario of a major market top in Q1 or Q2 2025 is building. The caveat is these are very early and preliminary warning signs of risk that should be monitored before taking action.

The Trump Put lives!

Posted by Cam Hui - January 22, 2025

Mid-week market update: Trump promised a flurry of executive orders to implement his campaign promises on the first day he took office. Amidst the flurry, the market breathed a sigh of relief as there were no major risk-off catalysts. The market is apolitical and it doesn’t care about the reversal of DEI policies, or whether a mountain in Alaska is named Denali or McKinley. Although there were threats of 25% tariffs on Canada and Mexico, and a 10% tariff on China, both to be put in place on February 1st, there were no instant tariffs that would have rattled markets.

Trump showed during his first term that he cared about the stock market. As he begins his second term, the Trump Put seems to be alive again.

As a consequence, the S&P 500 is testing its all-time high at about 6100. Even though readings are overbought, this could be a “good overbought” advance that takes the market to new highs, with upside potential at the dotted resistance line measuring at about 6300 by the end of January. On the other hand, it’s disconcerting to see a breadth indicator such as the percentage above the 20 dma (bottom panel) fall on a day the market is testing its all-time high.

Here are the bull and bear cases.

Sentiment isn’t stretched

An analysis of institutional sentiment, as measured by BAML Global Fund Manager Survey, shows that respondents are bullish, but conditions aren’t extreme. Stocks could continue to rally from here.

Trump’s decision on the TikTok ban was even more encouraging for the bulls. As a reminder, Congress passed a law forcing TikTok’s Chinese parent ByteDance to either shut down or divest TikTok by last Sunday. The bill was signed into law by Biden and upheld by the Supreme Court in a 9-0 decision. Trump, who originally opposed TikTok’s U.S. presence, changed his mind and signed an executive order delaying the ban for 75 days. More importantly, he left the door open for TikTok to continue to operate if the U.S. government could take a 50% stake in the company.

Combined with the absence of immediate tariffs on China, the TikTok decision was a signal to the Chinese government that Trump was willing to make a deal. The less threaten tone against China also raises the odds of a China growth recovery, which is the BAML Fund Manager Survey’s biggest possible bullish surprise.

Weakening breadth

I had been encouraged by evidence of broadening breadth in the market, but today’s test of key resistance is being accomplished on narrow breadth. While breadth divergences can last for months before stock prices take a stumble, this is an unwelcome development for the bulls.

Another concern is the bond market, whose rally had underpinned the latest risk-on episode. Bond prices are stalling at resistance, which is another warning sign.

A complacent market

So where does that leave us? While the Trump Put is probably in place, traders can’t rely on it as unexpected policy announcements and individual company’s results during Q4 earnings season could induce volatility at any time. In the meantime, the market looks complacent. The accompanying chart shows the implied volatility (IV) of near-the-money SPY options that expire on January 31, 2025. The top panel shows the closing IV readings as of January 17, 2025, the Friday before Trump’s inauguration, and the bottom panel shows the latest figures. IVs are flat to down, indicating complacency in an environment of uncertainty.

In conclusion, the S&P 500 could rally above resistance at 6100 and end the month significantly higher, but I am inclined to be cautious and fade any upside breakout. Uncertainty is high and the market is an accident waiting to happen. At the same time, my inner trader isn’t inclined to actively take a short position in the face of possible rampage of the animal spirits.

What a changing of the guard means for stocks

Posted by Cam Hui - January 19, 2025

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
Trading model: Neutral (Last changed from “bullish” on 17-Jan-2025)

Subscribers can access the latest signal in real time here.

A bond market reversal

Last week, I highlighted the risk-off tone caused by the bond market tantrum that was under way. As the week progress, softer-than-expected PPI and CPI reports calmed the bond market vigilantes and yields retreated.

The reversal occurred just in time for the changing of the guard at the White House.

In search of policy clarity

While the rally in bond prices (and decline in yields) was constructive, it left Fed Funds policy expectations unchanged. The market continues to expect just one rate cut in 2025, with the first one occurring mid-year. In effect, the bond rally amounted to a reduction of the tail-risk of a Fed pivot to either stopping rate cuts or even raising rates in response to runaway inflation.

As Trump takes office, expectations had been building for his policies. But volatility risk will stay high until investors see some actual clarity and concrete actions by the new administration.

Treasury Secretary designate Scott Bessent offered some guidance on Trump’s economic policies when he testified at his Senate confirmation hearing. Bessent confirmed that Trump will impose tariffs, though the implementation timeline is unclear. There are three reasons for tariffs. The first is to remedy unfair trade; the second is to raise revenue for Treasury; and the third is a tool to negotiate with other countries, such as Trump’s threat to impose 25% tariffs on Canada and Mexico if they didn’t address U.S. border issues.

In addition, Bessent affirmed that the Trump Administration is committed to the extension of the TCJA tax cuts and called it “the single most important economic issue of the day”.Now that the market is starting to see some policy clarity, what will the upcoming changing of the guard bring?

How far can the rally run?

Let’s assess how equity market conditions have evolved. I was pounding the table that the market was oversold and poised for a relief rally. The relief rally began last week and it was sparked by the bond market rally.

Conditions aren’t oversold anymore. The S&P 500 is broke through overhead resistance at its 50-dma and falling trend line (dotted line). Moreover, some indicators, like the NYSE McClellan Oscillator, have reached an overbought extreme. Other indicators, such as the percentage of S&P 500 above their 20 dma, have exceeded my minimum upside target of 65%.

Can the market rally further?

Certainly. The S&P 500 rose 1% Friday, which qualifies as an IBD follow-through day, indicating positive momentum. However, Friday’s rally was slightly unconvincing as it was accomplished with a doji candle, signaling indecision and possible trend reversal. The next upside target for the S&P 500 is its all-time high at about 6100. Additional resistance can be found at the rising trend line (dotted red line) at about 6300.

Before the bulls become overly excited, let’s take it one step at a time.

Where’s the fear?

I have been concerned about the lack of extreme fear during this latest oversold episode.

The stock market was extremely oversold in December, but option sentiment showed no evidence of a fear spike in the put/call ratio that was in evidence at recent tactical bottoms.

The AAII weekly sentiment survey is showing similar readings of elevated concern, but no panic.

No compelling buy signals

The lack of fear during this latest oversold episode is an argument that the relief rally is likely to fizzle sooner rather than later.

To be sure, technical conditions are constructive but there are no compelling buy signals. Breadth is broadening out, which is helpful to the bull case.

A review of insider activity did not show strong insider buying in the December downdraft, when insider buying (blue line) exceeded insider selling (red line). While the lack of insider buying isn’t necessarily bearish, it does give support to the case that the relief rally may not be sustainable.

As well, risk appetite indicators present a mixed picture. The relative performance of junk bonds is bullish, while the relative performance of high beta to low volatility stocks yields a neutral signal.

The lack of small-cap strength during a period of seasonal strength for smal-cap stocks is equally concerning.

Lastly, the negative divergence in the extreme animal spirits tail of the market is disconcerting. Bitcoin is rallying based on the cryptocurrency friendly policies of the Trump Administration.. Bitcoin prices had been correlated with the relative performance of speculative growth stocks, as measured by the ARK Investment ETF. In the current instance, speculative growth is exhibiting a series lower lows and lower highs.

In conclusion, much of the gains from the relief rally that I called for are likely in the rear-view mirror. The lack of extreme fear during this latest oversold episode makes me question the longevity of the rally. In light of the uncertainties posed by the changing of the political guard in the U.S., the prudent course of action for traders is to step aside and wait for greater clarity before taking further action.

In the coming week, the market is likely to focus on the new directions of the new Trump Administration. The downside risk of Trump’s signature electoral promises, such as the negative growth from tariffs and deportations, can be implemented immediately with executive orders, while the upside potential of his pro-growth policies, such as the tax cut extension and deregulation, need legislative approval that depend on a razor-thin House majority.

As we saw with the H-1B decision, some Trump constituents are likely to be disappointed, and the potential for market disappointment is elevated.

Trump 2025 market = Reagan 1981?

Posted by Cam Hui - January 18, 2025

There are many remarkable similarities between the 1980–1981 stock market pattern and today. Ronald Reagan was elected in November 1980 amidst a wave of partisan enthusiasm and ushered in a revolution, much like Trump. Reagan entered office with a foreign policy win, which was the release of the American hostages held by Iran. Trump enters office ahead of the Israel-Hamas ceasefire that will see the release of hostages.

The S&P 500 topped out for the market cycle in late November just after Reagan won the election, though the Dow, which was the more widely quoted market index of the day, made a second high in April 1981. The NYSE Advance-Decline Line topped out in September 1980 and telegraphed the market’s technical deterioration.

There are many eerie similarities. Today’s stock market is struggling to regain its highs after a rally after Trump’s electoral win. The Advance-Decline Lines are also weak and technical analysts have expressed concerns about negative breadth divergences. The key difference is the Volcker Fed raised interest rates to punishingly high levels during Reagan’s era, while today’s Fed is pursuing a policy of monetary easing. The 2-year Treasury rate, which is a proxy for Fed Funds expectations, rose steadily and didn’t top out until August 1981.

Cyclical bullishness

The latest NFIB survey of small business owners, who tend to be mostly small small-c conservative, illustrates the surge of economic optimism among Trump supporters after his election victory. Soft optimism, which is reflective of expectations, has soared, while the hard data was steady.

The Republican enthusiasm over the promise of Trump’s pro-growth policies saw cyclical industries outperform.

However, the bond market has pushed up yields in anticipation of higher inflation under Trump. As a consequence, the high duration NASDAQ 100 growth stocks, which are more interest rate sensitive, have begun to lag the market.

The rotation amounts to a form of rolling correction. An analysis of the relative performance of the top five sectors by weight shows that large-cap growth sectors account for nearly half of S&P 500 weight, while the other components in the index, such as financial and healthcare stocks have taken up the mantles of leadership.

Challenges to the cyclical bull case

The key question for investors is the sustainability of the cyclical leadership. If the cyclical rebound, which is reflationary, is sustainable, the stock market should break from the Reagan era 1980–1981 pattern and advance to fresh highs. If it fails, the 1981 pattern is in play and investors have to consider that the market is in the process of making an intermediate-term high for the current expansion cycle.
Here are the challenges to the cyclical and reflationary bullish scenario.

Commodity prices have surged, but that’s mainly attributable to rising energy prices from the imposition of additional sanctions on Russian oil. Beneath the surface, the cyclically sensitive copper/gold and more broadly based base metals/gold ratios are flat, indicating a lack of global cyclical strength (bottom panel).

Similarly, the cyclically sensitive industrial metals have staged a minor rally but the trend is flat to down. Does global cyclical reflation look like this?

Much like the 1980–1981 episode, Advance-Decline Lines are weak. Even though the S&P 500 regained its 50 dma, all of the other A-D Lines are below theirs. However, the breadth divergences today are only minor and don’t represent a cause for alarm just yet.

The stock market became extremely oversold in December, but option sentiment showed no evidence of a fear spike in the put/call ratio that was in evidence at recent tactical bottoms. Other sentiment indicators, such as the AAII weekly survey, show a similar lack of alarm. Unless stock prices skid and market sentiment pivots to panic, the latest attempt at a relief rally is likely to fizzle and the narrative of a cyclical rebound is likely to evaporate. In the alternative, the bulls need to muster a strong breadth thrust and inter-market signs of global cyclical strength, such as industrial metal strength, for a convincing reflationary bull move.

In conclusion, history doesn’t repeat itself but rhymes. The current market pattern is eerily similar to the 1980–1981 period when Ronald Reagan first won when the market made an intermediate-term top. Reagan entered the White House amidst a wave of partisan enthusiasm but the stock market ran into technical and economic headwinds.

In 1980, the market faced the challenge of a highly hawkish Federal Reserve. In 2025, the market faces the challenge of elevated valuation and expectations. We reiterate our belief that, in the absence of a recession, stock prices are unlikely to experience a major bear market. But unless the market exhibits convincing signs of cyclical strength, investors may have to brace for subpar returns in 2025.

What an actual bond market catastrophe looks like

Posted by Cam Hui - January 15, 2025

Mid-week market update: Is the bond market tantrum over?

Here is the good news. In the wake of tame PPI and CPI reports this week, the 30-year Treasury yield retreated while in a resistance zone (top panel). In addition, there is nothing worse than a failed breakout. The second panel shows the inflation factor trade, consisting of long TIPS and short long-dated zero coupon Treasuries, which staged an upside breakout and reversed itself.

The worse of the yield spike fears may have passed. But that was nothing. As a lesson. Here is an actual case of what a potential bond market catastrophe from uncontrolled debt growth looks like.

Russia under stress

Consider Russia. An analysis of Russian finances at Navigating Russia shows how the Russian economy is straining under growing stress. On the surface, Russia’s defense expenditures appear to be well under control, but that’s not the entire story. The Kremlin has forced Russian banks to lend to defense industries at below market rates.

Russian corporate credit growth has surged as a consequence, and much of it will be bad debt financed at below market rates.

Most the credit increase is attributable to the war.

The payment for the off-budget financing is coming due. As with bad debts, somebody pays. As Russian interest rates have soared, the burden has fallen to the real companies in the Russian economy, such as Gazprom, which is additionally suffering from a loss of revenue from sanctions and a partial cutoff of Russian gas to Europe.

To be sure, the day of reckoning hasn’t arrived for Russia just yet. The Ruble skidded against the Dollar in late December, but strengthened to a USDRUB of 102.80.

See? Even Russia’s bond market tantrum seems to be abating.

The U.S. bond market

Over in the U.S., Robin Brooks has argued that it suffers from bond market tantrums owing to inflation from year-end price adjustment seasonality.

Now that both CPI and PPI are reported, it’s relatively easy to estimate PCE, which is the Fed’s preferred inflation metric, as the components of CPI and PPI are inputs into PCE. It’s just the weights are different.

The Cleveland Fed’s inflation nowcast estimates December core PCE to be 0.19%, which should allow the Fed to continue on its interest rate glide path. Whew!

The relief rally continues

Over in the stock market, equity prices are continuing their relief rally from an oversold condition. I advised readers to “trust the models” on the weekend (see What’s rattling the stock market?). With the exceptions of major systemic catastrophes like the GFC and the COVID Crash, stock prices have bounced from similar oversold readings in the past, and this is nothing like the GFC or the COVID-19 pandemic.

In addition, Rob Hanna at Quantifiable Edges revealed that his Capitulative Breadth Indicator (CBI) reached 10 on the Friday. A trading strategy based on buying the S&P 500 when it reached 10 was historically profitable – with the exception of the COVID Crash.

Under normal circumstances, the rally should continue for at least another week. However, investors will have to contend with the uncertain market reaction of the new Administration’s policies when Trump takes office on Monday.

My inner trader remains long the S&P 500. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

A focus on financials

Posted by Cam Hui - January 13, 2025

The Q4 earnings reporting season kicks off Wednesday with reports from major banks and financial companies. This is a good opportunity to review the outlook for the financial sector.

What election rally?

Let’s begin with the bad news. The post-election gains for financial stocks have completely evaporated (top panel). The good news is the sector remains in a relative uptrend (bottom panel). The outperformance of this sector is one reason I am bullish on financial stocks.

My bullish bias is global. Even as U.S. financials remain in a choppy relative uptrend, European financials have been outperforming its region in the last year.

The fundamental outlook

Looking past the technical picture, FactSet reports that the sector is expected to see blowout earnings growth in Q4, followed by deceleration into Q2 and re-aceleration in Q3 and Q4 2025.

One little noticed development that’s relevant to the banking sector happened at the Fed. Federal Reserve Vice Chair for Supervision Michael Barr, the Fed’s top banking regulator, announced that he would resign as vice chair but remain as a Fed governor for the remainder of his term which ends in January 2032. The decision heads off a battle between the Trump White House and the Fed on bank regulation, but the retention of Barr’s governorship draws a line in the sand on the issue of monetary policy independence.

Powell made the case in a 2018 speech that the Fed independence on regulatory matters is important, but the argument isn’t as strong as the case for independence on monetary policy.

This is a long way of saying that investors should expect further deregulation of the banking industry, which should boost the future earnings outlook and provide a tailwind for financial sector outperformance.

What’s rattling the stock market?

Posted by Cam Hui - January 12, 2025

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
Trading model: Bullish (Last changed from “neutral” on 19-Dec-2024)

Subscribers can access the latest signal in real time here.

Is the honeymoon over?

What’s rattling the stock market? The S&P 500 has been mired in a trading range that began in early November. It sold off in mid-December and flashed an extremely oversold reading on December 20. Subsequent rally attempts have failed and the index is testing its December lows. A definitive breakdown opens the door to a decline to the 200 dma at 5573.

Four weeks ago, I published an article entitled “The Public Embraces the Trump Honeymoon”. Under ordinary circumstances, a relief rally should be well underway by now. Is the honeymoon over? How patient should investors be with the bull case?

In search of a bearish catalyst

The stock market’s inability to rally argues that the market is concerned about another underlying risk factor that could lead to a deeper drawdown. If that’s the case, what’s the bearish catalyst?

For the time being, the decline in bond prices is driving the decline in stock prices. It’s possible that stock prices are responding to a deceleration in economic growth. The Citi Economic Surprise Index, which measures whether economic data is beating or missing expectations, has been falling. Such conditions should see bond yields decline, which would boost bond prices. Instead, bond yields have risen. That’s another head scratcher.

Another possible explanation for the risk-off tone is central banks are losing control of the bond market. Yields on the long end of the yield curve have been rising despite the general tone of monetary easing by central banks around the world.It’s just not Treasury yields. Yields in Europe have also risen and the carnage in U.K. gilts has been particularly acute. As well, Treasury yields soared Friday in reaction to the stronger-than-expected U.S. December Jobs Report.

The term premium, which measures how much investors demand to extend maturity, has been rising. In particular, the 10-year term premium (blue line) has risen faster than the 5-year term premium (red line) by reaching a high not seen in over a decade. By contrast, the 5-year term premium is not as acute by historical comparison.

Are these conditions reflective of rising inflation fears? The inflation factor trade of long inflation expectations and short the zero-coupon long Treasury has staged a dramatic breakout. The good news is it hasn’t exceeded the levels seen in October 2023.

Bond market sentiment shows elevated concerns about inflation, but readings are not stretched by historical standards.

None of this explains the stock market’s inability to rally from a deeply oversold condition.

One final possible explanation is the markets are concerned about the downside risk posed by the new Trump Administration. While the markets rallied in anticipation of Trump’s pro-growth policies and the promise of tax cuts, investors also have to contend with the bearish implications of a trade war, as well as the uncertainties of relations with allies such as Canada, Mexico, Greenland and Denmark, and Panama. And markets hate uncertainty.

It’s possible that the market is waiting for greater clarity.

Trust the models

In the end, I am inclined to trust the models in my tool kit that have shown a history of strong results from past buy signals.

One such model is my Bottom Spotting Model, which has shown a history of spotting tactical trading bottoms in the last five years. In the past, this model has triggered buy signals whenever two or more of the five components flashed buy signals. The five components are:

The VIX Index spiking above its upper Bollinger Band.
The VIX term structure inverts, which is an indication of fear.
The NYSE McClellan Oscillator becomes oversold.
TRIN spikes above 2, which is a sign of a “margin clerk” market indicating price-insensitive selling.
The intermediate-term overbought/oversold indicator of the ratio of stocks above their 50 dma to stocks above their 150 dma falls below 0.5, which is an oversold extreme.

The five-year record of this model shows that there have been several occasions (circled) when the market weakened to test its previous lows. Outside of the COVID Crash (shown in pink) and one instance in 2022 (red arrow), the market has rallied after such signals.

Another model with a strong track record is the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual clients’ funds. The NAAIM Exposure Index flashes a tactical buy signal whenever it falls to the bottom of its 26-week Bollinger Band. Failures of these buy signals are few, and the study period includes episodes such as the GFC in 2008, the Greek Crisis in 2011 and COVID Crash in 2020.

What has this index doing now? It flashed a buy signal two weeks ago and the latest reading stabilized, indicating moderating fear.

In conclusion, markets have taken on a risk-off tone with few satisfactory bearish explanations. It’s possible that the combination of rising inflation fears and concerns about the lack of clarity over Trump’s policies is sparking the market’s cautious tone. I remain tactically constructive, as technical models with strong historical track records whose study periods include major catastrophic episodes argue that risk and reward are bullishly skewed. At worse, the current backdrop is a bond market tantrum and nothing like the GFC or COVID Crash. Other historical studies such from portfolio manager Steve Deppe and SentimenTrader also point to bullish market rebounds. Investors will see Q4 earnings season begin next week, as well as the CPI and PPI reports. A weaker than expected inflation report has the potential to dramtically change the bond market bearish narrative.

The key risk to the bullish assessment is Friday’s violation of support, if sustained, opens the door to a decline to the 200 dma at 5573. Bear in mind, however, the decline is occurring against a backdrop of positive divergences, as measured by the 5-day RSI and percentage of S&P 500 above their 20 dma.

By contrast, the violation of support by the Russell 2000 is less clear and definitive, though it is exhibiting positive divergences in a similar fashion.

From a technical perspective, the current risk-off episode looks like a plain vanilla bond market tantrum. The 30-year Treasury yield is encountering a resistance zone within the context of a rounded top formation.

This latest panic should dissipate soon.

My inner trader remains in his long S&P 500 position, but risk control will dictate the trigger of a stop-loss should price weakness continue. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

A preview of the Sino-American Trade War 2.0

Posted by Cam Hui - January 11, 2025

China’s leadership was caught off-guard in 2016 because few people expected Trump to win the election. This time, Beijing has had plenty of warning, and it is far better prepared for Trade War 2.0.

The key difference is the divergence in the path of economic growth, as signaled by the bond market. Chinese 10-year yields have plunged below 2%, which is a sign of a dramatic slowdown. By contrast, U.S. 10-year Treasury yields have risen, which reflects concerns over a heightened fiscal deficit and rising inflation.

In the face of economic weakness, China seems to be preparing for Trade War 2.0 on a different dimension of belligerence. China has embraced von Clausewitz’s famous quote on war: “War is merely the continuation of politics by other means.”

Investors should prepare for greater newsflow volatility and rising geopolitical risk in the months ahead.

A teetering economy?

Bloomberg reported that the markets are sounding the alarm over the Chinese growth outlook. China’s 30-year bond yields have plunged to all-time lows and they are now below Japan’s 30-year JGBs, which is causing concern over the Japanification of China and a possible Lost Decade.

The combination of a weak economy and the threat of Trump tariffs has dramatically weakened the Chinese yuan. The weakness in the currency against the USD is likely to exacerbate trade tensions in the coming months.

China’s pre-emptive response

In the face of growing economic weakness, Beijing has chosen to respond in other dimensions of conflict in a “wolf warrior” in a pre-emptive fashion. Here is what China has done in the recent past:

Chinese intelligence hacked the U.S. Treasury Department (NY Times). Intruders accessed Treasury user workstations and stole unclassified documents.
Chinese hackers have compromised major U.S. infrastructure, such as ports and power grids in anticipation of an invasion of Taiwan (WSJ).
China conducted a massive naval exercise off the Taiwan coast in early December (Reuters). The scale of the exercise was the largest in decades. News outlets reported that 90–100 ships were deployed across the Western Pacific.
The PLA Navy and China Coast Guard jointly carried out an exercise similar to a naval blockade in the Miyako Strait in December (Japan News).
China marked Mao’s birthday in late December by launching a new generation of amphibious assault ship in late December (Naval News).
China is building a fleet of naval barges to support amphibious landings (Naval News). The barges are reminiscent of the Mulberry Harbours used to support the D-Day landings and were used to help supply troops after they established a beachhead. This is an ominous sign that China is quietly preparing for an invasion of Taiwan. It’s only a matter of time.
Taiwan asked South Korea to help investigate a Chinese-owned ship suspected of cutting a subsea cable off its northern coast (Financial Times).
China banned exports of “dual-use items” related to gallium, germanium, antimony and superhard materials to the U.S. (Reuters).

I could go on, but you get the idea. Only the last measure, the banning of selected rare earth exports, was a trade response. The others were in the intelligence and military dimensions.

Investment implications

As we count down to Trump’s inauguration, we don’t know the specifics of Trump’s tariff measures, but the investment landscape is becoming clear. Here are the main investment implications of the Sino-American Trade War 2.0.

Chinese equities are uninvestable. Even though the S&P 500 has outperformed the rest of the world since the GFC, the accompanying chart shows that Chinese stocks (in USD terms) have traded sideways over the same period, while Europe and Japan have climbed. This does not mean that traders can’t profit from swings in Chinese stocks, it’s just that the Chinese market is an unattractive asset class over the long run.

Consider de-dollarization and gold as investment themes. Broad-based sanctions on Russia since the onset of the Russo-Ukrainian War taught America’s adversaries that they should diversify away from the USD as a reserve currency. While the process will take decades, investors can see the effects on the price of gold. Not only has gold broken out to all-time highs in USD terms, it also reached all-time highs in all currencies. Most notably, it has been strong against the Swiss Franc (CHF), which is regarded as a “hard currency”, and the Chinese yuan (CNY), which is reflective of Chinese private and central bank demand.

The strength in the gold price is occurring in the face of outflows in GLD, the popular gold ETF, which is reflective of Western investor skepticism about the sustainability of a gold bull.

I further underline my view that investors should prepare for greater volatility in the coming months. Bloomberg reported that a “Trader Who Made Billions in 2008 Returns to Bet on Market Swings”. Steve Diggle, who made $3 billion in 2007–2008, is seeking to raise up to $250 million for an upcoming volatility trading fund. Diggle cited “potential flash points are the stretched valuations of U.S. stocks, the country’s prime office market glut, elevated federal debt and tight credit spreads.” While Diggle’s sources of potential volatility do not include China, investors need to consider geopolitical risk as a fat-tailed risk in over the next four years.

While risk levels are heightened, investors should also be prepared that the Sino-American trade dispute is resolved in a relatively benign manner. Noah Smith wrote an opinion column, “How we’ll know if Trump is going to sell America out to China”. While both sides of the aisle in Washington now regard China as an adversary, Trump has been known to backtrack on his tough stance on China, such as the reversal of his views on a bill to require the divestment of TikTok by its Chinese parent ByteDance.

The key decision to watch, according to Smith, is whether Trump trades away the export controls on advanced semiconductor technology. The semiconductor ban worked to hobble Chinese artificial intelligence research. A reversal of the export controls would considerably turn down the temperature of trade friction.

In conclusion, an economically weakened China is preparing for Trump’s tariff war with an array of assertive measures in the intelligence, military and trade dimensions that may not be fully be discounted by the market. I continue to believe Chinese equities are an uninvestable asset class, though traders could profit from swings in that market. Investors should consider gold as a de-dollarization play, and possible commitments into tail-risk volatility.

A tale of two markets

Posted by Cam Hui - January 8, 2025

Mid-week market update: When we last left the stock market on the weekend, the bulls were given a homework assignment (see A failed Santa rally, what now?).

The S&P 500 and Russell 2000 had to stage upside breakout through the falling dotted trend line. While the S&P 500 briefly broke out, it retreated yesterday through the trend line. The Russell 2000 never came close to a breakout.
The S&P 500 and Russell 2000 had to break out of their sideways range. Not yet.
Small caps should outperform, indicating broadening breadth and better participation in an advance. The bad news is the small cap Russell 2000 is lagging. The good news is the equal-weighted S&P 500 is holding up well on a relative basis, and small caps outperformed yesterday during the market decline.

Tuesday’s equity pullback was attributable to the rise of the bond market vigilantes, who pushed bond yields up and rattled overall risk appetite. On the other hand, the stock market’s own technical internals are supportive of an advance.

In other words, it’s a tale of two markets.

The return of the vigilantes

The bond market vigilantes are back. The extremely sensitive inflation factor trade of going long the bond market’s inflation expectations ETF (RINF) and short the long-dated Treasury bond (ZROZ) shows that inflation expectations are breaking out.

Unsurprisingly, the term premium, which measures what the market demands for extending time to maturity, has risen to the highest level seen in a decade.

The rise of the bond market vigilantes were not just restricted to the U.S. John Authers documented how yields were rising in Europe as well.

A puzzling reaction

Rising bond yields were puzzling inasmuch as November JOLTS signaled a weak labour market. While job openings were higher than market expectations, job openings represent a noisy indicator of labour market tightness because companies often advertise non-existent jobs to fill their resume banks. The more important quits to layoffs ratio, which has led nonfarm payroll employment, weakened. Investors should get a better read on the jobs market when the December Payroll report is released Friday.

The weaker than expected JOLTS internals should have seen bond yields
fall and bond prices rise. Instead, yields rose as inflation
expectations surged. From a technical perspective, the 7-10 year Treasury ETF IEF, which represents the belly of the yield curve, experienced a positive RSI divergence.

The RSI divergence is less obvious in the long end of the curve, as represented by TLT.

These technical conditions should be supportive of a bullish outcome for risk appetite.

Constructive equity technical conditions

Over in the equity market, technical conditions are also supportive of the bull case. I am seeing similar patterns of positive RSI divergences in equity indices, which should limit downside risk.

Breadth is negative but gradually improving even as the S&P 500 tests a key support level. I interpret this as a constructive positive divergence.

One worrisome development can be found in option sentiment. The put/call ratio has been remarkably low during the latest market decline, which is a signal of complacency.

My inner trader is giving the bull case the benefit of the doubt, but he could re-evaluate his position if the market were to break short-term support in the coming days. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

A failed Santa rally, now what?

Posted by Cam Hui - January 5, 2025

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
Trading model: Bullish (Last changed from “neutral” on 19-Dec-2024)

Subscribers can access the latest signal in real time here.

Santa has left for the year…

As I pointed out last week, the Santa Claus rally window is the last four days of the year and the first two days of the new year, and it’s one of the seasonally bullish periods of the year. History shows that a failed Santa rally often leads to subpar returns for the remainder of the year. The first day of the window was December 24 and the last day was January 3.

Santa has failed to call this year. The S&P 500 and the Dow closed above their respective Santa rally levels, though the Russell 2000 was marginally positive.

If adage about the Santa Claus rally is to be believed, the odds favour a subpar year in 2025 for the S&P 500: “If Santa should fail to call, the bears may come to Broad and Wall”.

Poised for a rebound

Before you turn overly bearish, you have to consider the short- and medium-term outlook. In the short term, the market remains highly oversold and poised for a rebound.

Even as the S&P 500 tests its recent lows, it’s flashing a series of positive divergences, as measured by its 5-day RSI, NYSE McClellan Oscillator, and NASDAQ McClellan Oscillator.

The latest bullish data point comes from the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual client funds. A buy signal is issued whenever NAAIM falls below the lower 26-week Bollinger Band. The latest reading shows the index within a hair of that threshold, which I interpret to be close enough for a buy signal.

This indicator has shown a near 100% historical success rate in its track record. I interpret these conditions as the path of resistance for stock prices is up, at least in the near term.

The bull’s challenge

The key to the intermediate health of the bull market is its behaviour during the anticipated rebound. Walter Deemer recently voiced concerns that current technical conditions resemble the Nifty Fifty market top in 1972. This isn’t the dot-com bubble, when most of the bubble companies had no earnings. The AI-related stocks today have earnings and exhibit strong growth, much like the Nifty Fifty.

The warning in 1972, just as today, is showing up in the form of negative breadth divergences. Advance-Decline Lines, however they are measured, are all weaker than the S&P 500.

There are, however, some rays of hope.

The smaller stocks within the S&P 500, as well as the small-cap Russell 2000, are showing early signs of relative strength, which are indications of broadening breadth. If this trend were to continue during the anticipated rebound, that would give the bulls some hope that the top isn’t in yet.

Another constructive sign is the positive divergence exhibited by the junk bond market. The relative performance of junk bonds to their duration-equivalent Treasuries has reached a new high, even as the S&P 500 remains below its all-time high.

In conclusion, the Santa Claus rally didn’t come for stock investors this year. Perhaps he misread the calendar and confused it with the Julian calendar of the Ukrainian and Russian Orthodox Churches, which celebrates Christmas on January 7, though Ukraine switched its Christmas to December 25 to divorce itself from Russian traditions because of the war.

I believe investors need to consider short- and intermediate-term market conditions separately. Current market weakness has left the market poised for a reflex rally. The key to the intermediate-term outlook is the market’s behaviour during the anticipated rebound. Can breadth broaden out and more stocks participate on the upside?

Here are some questions to consider as the likely rebound develops in the coming days as ways to measure the health of the bull market:

Can the S&P 500 and Russell 2000 break out through the (dotted) falling trend lines?
How will each index behave if they reach the top of their respective trading ranges?
Can the small cap Russell 2000 outperform, which would be a constructive sign of broadening breadth?

Stay tuned.

My inner trader continues to hold a long position in the S&P 500. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

Trump’s messy governing challenges

Posted by Cam Hui - January 4, 2025

The year started with a bang. Investor hopes were high on the expectation of the implementation of Trump’s pro-business and pro-growth policies, but stock prices struggled and ended last week in the red.

According to FactSet, the bottom-up aggregated S&P 500 target price for year-end 2025 is 6,678.18. But in the last 20 years, bottom-up analysts have historically overestimated the S&P 500 year-end price by 6.9%. Applying the 6.9% discount we would arrive at an adjusted target of 6,084.19, which represents a price gain of 5.7% for the year.

The FactSet adjusted estimate is roughly in line with my expectation of low single-digit gains. Along the way, however, I expect a higher degree of market volatility during the year as the Trump 2.0 Administration takes office and faces the challenges of governing.

Here’s why.

The challenges of governing

Donald Trump was elected as a disrupter. Washington needed to be disrupted, and Trump was the man to do it. However, the details of disruptions were less clear. In many ways, we can draw an analogy with Brexit. Brexit was seen as a new order for Britons, though there was no consensus on the actual details of Brexit implementation. The reality of Brexit turned out to fall short of the expectations of most Brexiteers.

In the same fashion, Trump will have to face the challenges of governing.

The recent dispute within the Republican Party over the H-1B visa is an illustration of the hard choices of governing. For readers who are unfamiliar with the H-1B visa, employers apply for H-1B work permits for overseas skilled workers, but those workers are severely restricted from leaving their employers once they landed on U.S. soil. Employers argued that there was a lack of trained U.S. personnel to fill open positions. Trump’s electorate base argued that the H-1B undercut American workers. The truth was somewhere in between. There is a lack of qualified skilled workers at a price, and H-1B visas helped employers, which are mostly technology companies, to improve their margins with lower labour costs.

In the end, Trump sided with the employers.

Legislative challenges

As Trump takes office on January 20, here are some of the challenges facing him.

The most immediate challenge was the election of a Speaker of the House. The current speaker, Mike Johnson, faced a number of challenges to his position. The Republicans hold a 219–215 majority. Rep. Thomas Massie (R-Ky) has actively opposed Johnson, which means that one more Republican defection would sink Johnson’s leadership. In the end, Johnson won the speaker’s gavel on the first ballot after some extensive negotiation. This was a test that turned out to be bullish for the Republican legislative agenda, but the risk of a Party revolt was extensive.

The next urgent issue facing the government is the debt ceiling. Trump had hoped that the last-minute continuing resolution deal in December to avoid a government shutdown would extend or eliminate the debt ceiling, but his hopes were dashed. On December 27, Treasury Secretary Janet Yellen wrote to Congress and warned, “Treasury currently expects to reach the new limit between Jan. 14 and Jan. 23, at which time it will be necessary for Treasury to start taking extraordinary measures.”

In the short run, Treasury’s “extraordinary measures” are equity bullish, as it draws down the funds in the Treasury General Account held at the Fed. This has the effect of writing cheques and injecting liquidity into the banking system, which is bullish. If the debt ceiling dispute isn’t resolved in reasonably short order, the market will start to price in the tail-risk catastrophe of a U.S. Treasury default.

Bessent’s Challenges

As well, incoming Treasury Secretary Scott Bessent faces the challenge of re-financing about 30% of the $28 trillion of the Treasury’s outstanding debt. The Yellen Treasury adopted the position of issuing a greater mix of short-term T-Bills, which are effectively floating rate paper, compared to fixed-rate coupon paying Treasury Notes and Bonds. As rates have risen over the past few years, the reliance on short-term financing has increased the Treasury’s interest burden.

Bessent has promised to remedy the situation by borrowing longer term. But the issuance of long-term debt has the short-term effect of draining liquidity from the banking system. To explain, imagine an investor has the option of investing in short-term paper, which he can draw on relatively quickly, or lock up his money in a long bond, which is less liquid and comes with price risk. As a result, a greater pool of short-term Treasury paper encourages higher banking system liquidity, which is equity positive.

A Bloomberg article, “Treasury’s Elite Bond Dealers Will Struggle to Handle $50 Trillion Debt”, outlined the extent of the challenges facing the new Treasury Secretary. One stark example occurred last September, when Citadel Securities announced in September that it declined to join the group of Treasury primary dealers, which makes a market and bids on newly issued Treasury securities. Bloomberg reported that heavy issuance was putting strains on primary dealer operations:

Macro headwinds

Trump’s policy challenges could have the effect of distracting the incoming administration from implementing its equity friendly policies of tax cuts and deregulation. In addition, stock prices face a number of macro challenges in the year ahead.

First, disinflationary progress appears to be stalling. The inflation expectations factor, as measured by a long TIPS ETF and short long zero-coupon Treasury ETF, is breaking out to new recovery highs. The Fed may soon face a difficult decision of either accepting a higher 3% inflation rate or raising interest rates.

At the same time, economic growth may be stalling as the U.S. Economic Surprise Index has declined in the past few months. While these readings are not recessionary, they do raise the risk of either stagflation or recession scares later in the year. Decelerating economic growth rates also translate into falling earnings growth rates, which is equity bearish.

These macro risks are occurring against a backdrop of an elevated forward P/E ratio. The S&P 500 is priced for perfection, or near perfection.

In conclusion, I reiterate my belief that in the absence of a recession the S&P 500 should register low single-digit gains for 2025. However, the emergence of policy implementation risk by the incoming Trump Administration makes me believe the market will experience several volatility shocks during the year. Be prepared for a choppy but mildly positive year for stock prices in 2025.

So much for December seasonality

Posted by Cam Hui - January 1, 2025

Mid-week market update: I reiterate my belief that while seasonality is informative of climate, it is not a forecast of the weather ahead. 2024 was a difficult year based on seasonal patterns, as depicted by Jeffrey Hirsch of Almanac Trader.

Instead, the stock market was weak in the second half of December and small caps leadership did not emerge during that period. That said, the S&P 500 ended to year right at trend line support and the NASDAQ 100 ended the year at 50 dma support.

Positive divergences

I can find several silver linings in the dark cloud of market correction. First, the market achieved a severely oversold condition reminiscent of the October 2023 bottom and the COVID Crash. While a V-shaped recovery did not appear as expected, subsequent weakness revealed a series of positive divergences as the S&P 500 tested its recent lows, such as this one from the Fear & Greed Index.

As well, small cap relative performance started to turn up in the last few days, which is a constructive development indicating broadening breadth.

We can see the a similar effect in the value and growth relationship. Value rebounded against growth across all market bands in late December.

Historical studies

I hate to bring up historical studies of similar episodes because of their small sample sizes. Wayne Whaley highlighted that 2024 was the worst last week of December since 1937. He found that there weren’t many cases of a double digit year finishing with a 1% last week loss. In those four cases, the following week in January was resolved in strong rebounds, though January returns were lacklustre.

Ryan Detrick found only five cases of three consecutive down days to end the year. In all cases, the market rebounded strongly 100% of the time.

It’s difficult to forecast what 2025 will look like for investors. However, I am reasonably constructive that the stock market is poised for a short-term rebound. The S&P 500 Intermediate-Term Breadth Momentum Oscillator is on a buy signal setup, and the buy signal will trigger once its 14-day RSI recycles from oversold to neutral. As well, the percentage of S&P 500 above its 20 dma remains highly oversold. While oversold markets can become more oversold, I haven’t seen any fundamental catalyst to spark another downleg. I therefore conclude that the odds favour an upside move in the near future.

My inner trader is holding on to his long S&P 500 position. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

Contrarian bargains among Santa’s discards

Posted by Cam Hui - December 29, 2024

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
Trading model: Bullish (Last changed from “neutral” on 19-Dec-2024)

Subscribers can access the latest signal in real time here.

If Santa should fail to call…

The Santa Claus rally window is the last four days of the year and the first two days of the new year, and it’s one of the seasonally bullish periods of the year. History shows that a failed Santa rally often leads to subpar returns for the remainder of the year. The first day of the window was December 24. So far, the market has performed well this year.

There is an adage among traders: “If Santa should fail to call, the bears may come to Broad and Wall”. If the advance continues, the risk of a major bear market in 2025 is diminished though.

So far, the question of whether Santa Claus will appear this year is a toss-up. It is constructive that Friday’s S&P 500 decline bounced off the 50 dma. While the S&P 500 closed marginally below the December 23 close, which is the Santa Claus rally starting level, both the Dow and Russell 2000 closed above their respective Santa rally levels.

Narrow leadership

Nevertheless, the rebound should continue as the advance began from deeply oversold conditions. In the past, such rallies didn’t stall until most of the overbought/oversold indicators reached overbought levels.

What’s unusual about the initial rebound is the narrow leadership. Market breadth isn’t broadening out during the relief rally.

The animal spirits don’t seem to be participating. The performance of IPO stocks, which is an indicator of speculative activity, is lagging the market.

Contrarian opportunities for the bulls

These conditions set up two possible outcomes. Either the rally fails and the market corrects in January or leadership rotates to the lagging groups of the market. With that in mind, here are some selected contrarian opportunities for bulls or investors who want some equity exposure. These highlighted opportunities trade at single-digit forward P/E ratios, which is rare in an environment when the S&P 500 trades at a forward P/E of 22. As well, each of these stocks exhibited weakness in December, which may be attributable to year-end tax loss selling and sets up the potential for a January rebound.

I produce a monthly LBO screen of non-financial stocks within the S&P 1500. For a full description of my methodology, please see my original publication, How To Buy A Company If You Have No Money. As a reminder, I calculate a LBO price target range based on two techniques to estimate cash flows: based on normalized EBITDA margins as applied to current sales and EBITDA based on consensus forward 12-month EPS.

I found 35 stocks that qualify under my LBO criteria of 30% down which is an increase from 29 last month. Funding costs have been steady. The increase can be attributed to the combination of the underperformance of small-cap stocks, which have lagged large caps even within the technology sector, and the underperformance of energy stocks, which are appearing on my LBO screen in increasing numbers.

I highlight three selected opportunities among the possible LBO candidates, with the caveat that a deep value screen like the LBO should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk which will be difficult to diversify away.

Centene hit a 52-week low in December and passed my LBO screen on the basis of low volatility of its margins, which allow for higher debt levels, single-digit forward P/E and sizeable cash position.

Lear Corp. could be attractive for contrarian value investors. It appears on my LBO screen based on its strong cash position and steady margins. In addition, its single-digit forward P/E ratio adds to its value as a potential bargain.

Another recurring theme that I found among the LBO stocks is energy. Consider Peabody Energy. This coal stock shows a relatively large cash position and strong cash flow. Peabody Energy is a deep value recovery candidate that’s trading near the top of its LBO range.

The relative attractiveness of the energy sector is underlined by the continued accumulation of Occidental Petroleum by Warren Buffett’s Berkshire Hathaway. Occidental’s stock price is now at or below Buffett’s original purchase levels.

Are you prepared to be contrarian?

In conclusion, the stock market is likely to advance during the Santa Claus rally window, which began on December 24 and ends January 3. But the rally is attributed to an oversold bounce and marked by narrow leadership. Either the rebound fizzles in January or broadens into lagging issues. I identified selected contrarian value opportunities for bulls among Santa’s discards for potential outperformance into January and beyond.

As a reminder, a deep value screen like the LBO should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk which will be difficult to diversify away.

My inner trader continues to hold a long position in the S&P 500. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

Estimating downside risk

Posted by Cam Hui - December 28, 2024

I have warned about excessive valuation before (see 2025 Outlook: Cautious But Not Bearish). The S&P 500 is trading at a forward P/E of 22, which is elevated by historical standards. On one hand, valuation isn’t highly predictive of returns over a one-year horizon. On the other hand, elevated P/E ratios lead to lower returns over a five-year time horizon.

In other words, valuations don’t matter until they matter. As investors look ahead into 2025 against a backdrop of a high P/E market, one key question is: “What’s the downside risk in the event of a bear market?”

A giddy backdrop

Callum Thomas of Topdown Charts highlighted the frothy nature of the market today. IBES is known for its compilation of analyst earnings estimates. In addition to the well-known consensus FY1 and FY2 EPS estimates, IBES also publishes a long-term EPS growth estimate. As the accompanying chart shows, long-term growth estimates have reached the giddy levels similar to the dot-com bubble top.

The combination of elevated P/E valuation and extremes in earnings growth expectations makes the U.S. equity market vulnerable to a setback.

Sources of vulnerability

What could make stock prices fall? What if the Magnificent Seven growth were to slow?

To be sure, the stock market is rationally exuberant owing to the earnings growth of the Magnificent Seven compared to the rest of the 493 stocks in the S&P 500 (see Equity Return Expectations Under an Alien Invasion). On the other hand, this makes the market highly vulnerable to Magnificent Seven earnings disappointment. At a minimum, the gap in earnings growth expectations between the Magnificent Seven and the S&P 493 is expected narrow in 2025.

In addition, the stock market isn’t cheap even outside of the Magnificent Seven. Combined P/E ratios are equally elevated outside of TMT (Technology-Media-Telecom).

From a top-down perspective, the emerging divergence between the U.S. Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, and the 10-year Treasury yield is worrisome.

The divergence is especially concerning as the inflation expectation trade is heating up.

If inflation expectations rise and push up yields, it would put downward pressure on P/E ratios.

Estimating downside risk

As the Magnificent Seven is a source of major vulnerability for the S&P 500, here is one way of estimating downside risk. An analysis of the limited history of changes in peak and trough P/E ratios shows that the median tech P/Es fell from 29.5 to 13.1, which is over 50%, though that doesn’t represent actual price risk because earnings will rise during the bear market. Nevertheless, a ballpark estimate of price risk in technology stocks should the AI bubble burst would be about 50%.

As the Magnificent Seven represents about 32% of the weight of the S&P 500, this translates into about 15% downside risk for the overall index. The 15% downside is a minimum estimate, as the S&P 493 would likely decline as well. Assuming a lower beta in the S&P 493 during a price decline, we estimate bear market downside risk at 20–30% for the S&P 500.

Watching for bearish triggers

Despite my valuation concerns, I see no immediate bearish triggers for stock prices. High yield funding proxies, such as the junk bond spread plus a five-year Treasury yield, and actual junk bond yield levels (blue and red lines) are not showing signs of excessive funding stress. I consider junk bond funding a sensitive canary in the coalmine of equity fund costs, which needs to be closely monitored.

I am also keeping an eye on the Advance-Decline Line, which is showing a minor negative divergence against the S&P 500. Historically, A-D Line divergence have lasted for months before major tops of the market.

In conclusion, the U.S. equity is highly vulnerable because of overvaluation and excessive growth expectations, but valuation is not very predictive of returns over a one-year time horizon. I estimate downside risk on the S&P 500 in the 20–30% range in the event of a major bear market. Despite my concerns, I see no immediate bearish triggers for investors to adopt defensive positioning in their portfolios.

The darker meaning of the Hindenburg Omen

Posted by Cam Hui - December 22, 2024

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
Trading model: Bullish (Last changed from “neutral” on 19-Dec-2024)*

Subscribers can access the latest signal in real time here.

An unusual omen

I recently highlighted the trigger of the ominously named Hindenburg Omen, which describes the condition of a highly bifurcated market undergoing a downside break (see A Hindenburg Omen in an Oversold Market). While Hindenburg Omens often resolve in corrective market action, the current episode occurred against the backdrop of an extremely oversold market with readings reminiscent of the Christmas Eve Panic of 2018, the COVD Crash of 2020, and the October bottom of 2022.

A tactical buy signal

Indeed, four of the five components of my Bottom Spotting Model triggered buy signals. In the past, two or more buy signals have resolved in near-term bottoms and relief rallies.

The tactical buy signal was confirmed by Rob Hanna of Quantifiable Edges, who revealed a buy signal on his Capitulative Breadth Indicator.

The stock market is poised for a significant relief rally.

Not out of the woods

Nevertheless, market internals are marred by a problem of poor breadth. Even the bounce has been led by large-cap growth stocks, and the rest of the market isn’t showing much enthusiasm.

Jason Goepfert of SentimenTrader found the current conditions disturbing. He studied cases when the “S&P 500 is within spitting distance of a high yet fewer than 39% of its stocks are even above their 50-day moving averages”. The closest template he found was in 1972, when the market staged a relief rally, but topped out a few months later, which turned out to be the top of the Nifty Fifty era.

The 1972 template represents the dark side of the Hindenburg Omen.

What to watch

Will history repeat itself? Will it rhyme?

Here is what to keep an eye on. Breadth has been deteriorating, which is a worrisome development. All Advance-Decline Lines have broken down below their 50 dma. Can they recover back to their highs when the inevitable relief rally appears?

Negative A-D Line divergences are nothing to worry about in the short run. However, they can be warnings of long-term cyclical tops. In the past, A-D Line divergences have persisted for months before the S&P 500 made the ultimate top.

Another sign to watch for is a negative RSI divergence in my long-term timing model based on the monthly chart of the NYSE Composite. Watch for a negative 14- month RSI divergence should the index make a new high.

In the short run, I am tactically bullish. In addition to the buy signals triggered by my Bottom Spotting Model, the relative performance of defensive sectors is not showing any leadership, which is an indication that the bears haven’t seized control of the tape.

I would also monitor the relative performance of small cap stocks. The Russell 2000 halted its decline at relative support (bottom panel). A small cap revival during this seasonally positive period would be tactically bullish and could serve to alleviate some of the breadth concerns about a potential long-term market top.

In conclusion, current market conditions are characterized by a strong S&P 500 that’s near its all-time high and weak breadth. The closest template to these circumstances is August 1972, which is just before the final Nifty Fifty top. As the market undergoes its inevitable bounce due to oversold conditions, investors should monitor technical conditions for negative divergences, which could be the signal for a long-term cyclical top.

Subscribers received an alert on Thursday that my inner trader had initiated a long S&P 500 position. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

Time for a pause?

Supportive sentiment

A case of bad breadth

Near-term consolidation ahead

The roots of its own demise

The deportation growth threat

Sentiment isn’t stretched

Weakening breadth

A complacent market

A bond market reversal

In search of policy clarity

How far can the rally run?

Where’s the fear?

No compelling buy signals

Cyclical bullishness

Challenges to the cyclical bull case

Russia under stress

The U.S. bond market

The relief rally continues

What election rally?

The fundamental outlook

Is the honeymoon over?

In search of a bearish catalyst

Trust the models

A teetering economy?

China’s pre-emptive response

Investment implications

The return of the vigilantes

A puzzling reaction

Constructive equity technical conditions

Santa has left for the year…

Poised for a rebound

The bull’s challenge

The challenges of governing

Legislative challenges

Bessent’s Challenges

Macro headwinds

Positive divergences

Historical studies

If Santa should fail to call…

Narrow leadership

Contrarian opportunities for the bulls

A giddy backdrop

Sources of vulnerability

Estimating downside risk

Watching for bearish triggers

An unusual omen

A tactical buy signal

Not out of the woods

What to watch

Is ET here?

Conventional thinking

The catastrophic scenario

A benign scenario

Deceptive assumptions

The limitations of the Hindenburg Omens

The FOMC decision

Stubborn inflation

The last-mile inflation problem

A small-cap honeymoon?

Constructive for a year-end rally

High expectations

Things you don’t see at market bottoms