Why I am cautious

Posted by Cam Hui -

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

 

Here are some other reasons why I am cautious.

 

 

Bearish triggers

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

 

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

 

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

 

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

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

 

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

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

 

 

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

 

 

 

The popping speculative growth bubble

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

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

 

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

 

 

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

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

 

 

 

Santa Claus has left the building

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

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

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

Posted by Cam Hui -

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

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

 

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

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

 

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

 

 

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

 

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

 

 

The value of diversification

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

 

 

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

 

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

 

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

 

Don’t overstay the party

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Edge towards the exit

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

 

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

 

 

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

 

 

Warnings everywhere

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

I could go on, but you get the idea.

 

 

Temporary bullish tailwinds

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

 

 

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

 

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

 

 

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

 

 

Wait for the sell signal

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

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Don’t fight the (hawkish) Fed

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

 

 

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

 

 

 

A no-surprise Federal Reserve

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

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

 

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

 

Board member, Lael Brainard.

 

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

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

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

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

 

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

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

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

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

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

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

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

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

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

 

Still data dependent

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

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

 

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

 

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

 

 

 

Dovish factors to consider

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

 

Be cautious (for now)

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

 

 

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

 

 

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

 

 

Riding the seasonal bull

Posted by Cam Hui -

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

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

 

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

 

 

 

A different kind of rally

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

 

 

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

 

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXL

 

A 2021 report card

Posted by Cam Hui -

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

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

 

 

The Trading Model

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

 

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

 

 

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

 

 

Trend Asset Allocation Model

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

 

 

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

 

This model achieved its objective again in 2021.

 

 

The Ultimate Market Timing Nodel

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

 

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

 

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

 

 

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

 

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

 

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

 

 

The anatomy of a Santa rally

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Has Santa come to town?

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

 

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

 

 

Here is what else I am watching.

 

 

Santa rally internals

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

 

 

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

 

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

 

 

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

 

 

 

How durable is the advance?

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

 

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

 

 

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

 

 

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

 

 

 

Don`t be prematurely bearish

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

 

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

 

What if Santa doesn`t call?

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

Was the Grinch in the house?

Posted by Cam Hui -

Mid-week market update: I am publishing this note one day early ahead of my holiday hiatus. Regular service will return Sunday with a trading note.
 

In the Dr. Seuss children’s story, “How the Grinch Stole Christmas”, the Grinch is a grouchy character who conspired to steal all the Christmas presents from the nearby village. He later has a change of heart and returns all the gifts and participates in the villagers’ Christmas celebrations. 

 

Was the Grinch in the house? It certainly seemed that wau. The Grinch arrived last week in the form of a market pullback accompanied by weak breadth and negative momentum, capped by Omicron shutdown fears and disappointment over delays of Biden’s Build Back Better fiscal stimulus program.

 

 

Even though the Grinch has stolen the presents, we may be nearing the end of the story. The market printed a Turnaround Tuesday and the S&P 500 regained its 50 dma.

 

 

Positive seasonality

Ryan Detrick compiled the likelihood each trading day finishes in the green. We are approaching a seasonally bullish period that ends in early January.

 

 

Rob Hanna at Quantifiable Edges published a “three nights before Christmas” study, which begins after the close today. He found that the optimal holding window ends on day 8, which is January 3, 2022.

 

 

The tax-loss selling activity window is closing this week. The “official” Santa Claus rally window begins in the last five tradings of the year and ends on the second trading day of the new year and the stock market was positive 34 out of the last 45 sessions (75.6%). There are a number of badly beaten-up stocks that should see a rebound next week and in early January. I offer some suggestions.

 

 

A possible short squeeze

Breadth readings were oversold based on Monday’s market action. It was therefore not surprising to see prices turn up today. The real question is, “How durable is the rally?”

 

 

JP Morgan strategist Marko Kolanovic thinks the rally has legs. He recently published a bullish note calling for a short squeeze.

 

Positioning of systematic and discretionary investors has already declined significantly to the bottom third of the historical distribution (~30-35th percentile). CTAs are fully short small cap and many international indices, while S&P 500 positions are not under pressure given the ~25% one-year appreciation of the cap-weighted benchmark. Volatility targeting and risk parity funds started adding exposure, given muted realized volatility and correlation and internally offsetting large stock moves. There will also be buying of equities into month- and quarter-end – particularly for international, SMID, and cyclical benchmarks that are impacted the most. In short, this is not a setup similar to 4Q2018 from a fundamental or technical angle. Yet, there is aggressive shorting, likely in a hope of declines in retail equity position and cryptocurrency holdings – while in fact both of these markets and retail investors have shown resilience in the past weeks. One should note that large short positions likely need to be closed before (the seasonally strong) January, which is likely to see a small-cap, value and cyclical rally. And given that market liquidity is dwindling, the impact of closing shorts may be bigger than the impact of opening them, when liquidity conditions were better.

 

 

Plunging SKEW = bullish

The SKEW Index measures perceived tail-risk by quantifying the price of out-of-the-money call and put options in the S&P 500. The index usually varies between 100 and 150. A high SKEW level indicates a high cost of tail-risk protection and vice versa for a low reading. In effect, the index is a proxy for sentiment and volatility.
 

Many analysts have unsuccessfully used SKEW as a contrarian trading indicator by buying when SKEW is high and selling when SKEW is low. Instead, I introduce a trading model based on the change in SKEW. Whenever the 10-day change in SKEW falls -10% or more, it has been an effective buy signal for the S&P 500. Rapid declines in SKEW indicate alleviation of market anxiety, sort of like a rapid fall in the VIX Index. It can induce market makers to adjust their hedges, usually by buying the index, much like the way the Robinhood crowd created a price momentum effect with massive buying of individual stocks and forcing market makers to hedge by buying the underlying.
 

The chart below shows the five-year record of this short-term trading model, where bullish resolutions are shown in grey and bearish ones shown in pink. Buy signals have been successful roughly two-thirds of the time, and it just flashed a buy signal.
 

 

The SKEW model buy signal is timely in light of seasonal effects and consistent with Kolanovic’s call for a short squeeze rally.
 

 

Rebound candidates

With that preface in mind, here are some short-covering candidates that could benefit as a tax loss selling season ends and a rebound begins. Small-cap stocks have traded sideways for most of 2021. They recently exhibited a failed breakout and they are much hated.
 

 

Even though prices have been flat, forward EPS rose steadily in 2021, which makes their forward P/E valuation less demanding.
 

 

On the other side of the value/growth spectrum, speculative growth stocks have been clobbered recently while high-quality growth FANG+ names have been the leadership. Trading in these stocks has been the province of small individual investors and recent losses could be the catalyst for tax-loss selling. The ETFs ARKK and BUZZ appear to be good barometers of the speculative growth factor. Watch for a short-term rebound.

 

 

With the caveat that this is emphatically not a buy recommendation, I am monitoring Nuvei Corp (NVEI) as an example of the shares of a company with speculative characteristics whose price has skidded. NVEI is a payment processor that went public in September 2020. It was the recent target of activist short-seller Spruce Point, which issued a highly unflattering report about the company.  Surprisingly, Andrew Left at Citron Research, which is another activist short-seller, came to NVEI’s defense (story details here). Subsequent to those events, a number of Street analysts brushed off Spruce Point’s allegations and reaffirmed their buy rankings on the stock. If my scenario of a short-covering and tax-loss rebound were to transpire, the price of NVEI should stage a strong relief rally.

 

 

 

Buy the junk!

Generally speaking, year-end rallies have been dominated by low-quality leadership. The chart below shows the relative performance of the large-cap quality factor (middle panel) and the small-cap quality factor, as measured by the relative returns of the S&P 600 against the Russell 2000. S&P has a much stricter index profitability inclusion criteria than Russell and therefore the S&P 600 has a quality tilt compared to the Russell 2000. 

 

Historically, low-quality stocks have performed well when the stock market advanced at year-end. With the exception of instances when the S&P 500 fell during the year-end period, which are shown by the pink vertical lines, there have been far more low-quality leadership episodes (blue arrows) than high-quality leadership (red arrows).

 

 

Keep in mind, however, that the year-end and early January rallies are short-term trading calls. Don’t overstay the party. 

 

 

Disclosure: Long SPXL

 

A breakout to S&P 4920?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

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

 

A potential inverse H&S

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

 

 

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

 

Here are bull and bear cases.

 

 

The bull case: Fearful sentiment

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

 

 

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

 

 

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

 

 

 

The bear case: Weak internals

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

 

 

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

 

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

 

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXL

 

A recession in 2023?

Posted by Cam Hui -

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

 

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

 

 

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

 

 

The market reaction

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

 

 

A question of credibility

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

 

 

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

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

Heightened fear + FOMC meeting = ?

Posted by Cam Hui -

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

Hawkish expectations

Posted by Cam Hui -

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

 

 

Hawkish fears

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

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

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

 

The BoA Global Fund Manager Survey showed a similar result.
 

 

Positioning has turned defensive in response.

 

 

 

Too bearish?

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

 

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

 

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

 

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

 

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

 

Disclosure: Long SPXL
 

The Fed’s inflation problem

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A data and political problem

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

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

 

 

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

 

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

 

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

 

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

 

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

 

 

Reasons to be bullish

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Seasonality

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

 

 

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

 

 

Disclosure: Long SPXL

 

China gets rich AND old, but…

Posted by Cam Hui -

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

 

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

 

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

 

 

Unbalanced wealth

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

 

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

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

 

 

Can China escape Japan’s fate?

 

 

The middle-income trap

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

 

 

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

 

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

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

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

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

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

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

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

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

 

 

China’s report card

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

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

 

 

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

 

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

 

 

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

 

 

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

 

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

 

 

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

 

 

Omi-what?

Posted by Cam Hui -

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

Omi-what?

 

 

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

 

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

 

 

The bull case

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

 

 

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

 

 

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

 

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

 

 

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

 

 

The bear case

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

About that crypto crash…

Posted by Cam Hui -

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

 

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

 

 

Asset return profile

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

 

 

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

 

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

 

 

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

 

 

Profile of a crypto investor

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

 

 

 

Crypto bros ~ YOLO speculators

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

 

 

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

 

 

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

 

 

 

A Christmas present under the tree?

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

 

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

 

 

 

In search of the next bearish catalyst

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Another leg down?

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

 

 

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

 

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

 

 

Similarities and differences

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

 

 

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

 

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

 

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

 

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

 

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

 

 

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

 

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

 

 

Poised for a rally

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Looking for opportunity

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

Assessing the damage

Posted by Cam Hui -

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

 

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

 

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

 

 

Fundamental momentum still positive

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

 

 

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

 

 

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

 

 

 

Omicron and the Fed

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

 

 

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

 

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

 

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

 

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

 

 

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

 

 

Stalling price momentum

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

 

 

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

 

 

 

Investment implications

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

 

 

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

 

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

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

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

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

 

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

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

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

 

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

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

Do you believe in Santa Claus?

Posted by Cam Hui -

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

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

 

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

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

 

What about you? Do you believe in Santa?

 

 

The bear case

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

 

 

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

 

 

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

 

 

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

 

 

The bull case

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

 

 

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

 

 

 

Waiting for the rebound

What’s the verdict? Bull or bear?

 

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

 

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

 

 

 

Stay tuned.

 

 

Disclosure: Long SPXL

 

COVID Crash 2.0?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

COVID panic!

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

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

 

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

 

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

 

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

 

 

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

 

 

2020 parallels

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

 

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

 

 

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

 

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

 

 

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

 

 

 

2020 differences

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

Market anomalies

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

 

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

 

 

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

 

 

 

Sentiment vs. data

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

 

 

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

 

 

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

 

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

 

Buy the dip.

 

 

Disclosure: Long SPXL