The canaries in a bifurcated coalmine

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A bifurcated market

As the S&P 500 struggles to hold its 50 dma, an unusual condition is occurring in the US equity market. The intermediate-term technical outlook is decidedly bearish, but the survey sentiment has reached a crowded short condition, which is contrarian bullish. This week, I offer some canaries in the coalmine as a way to resolve the wildly differing views of the market.

 

 

 

Crowded short sentiment

I was shocked to see a complete collapse in the weekly AAII bullish sentiment which took the bull-bear spread to -32.6, a reading last seen in 2011 at the height of the Greek Crisis. While bearish sentiment did not surge to 2011 levels, they are nevertheless elevated.

 

 

A similar sentiment extreme was also evident in the Investors Intelligence survey, which did see a historically high level of bearishness.

 

 

The level of bearishness was also confirmed by the CNBC All-American Survey, which found that 28% of respondents who invested in the stock market believe that it’s a good time to invest in stocks, compared to 48% who don’t. These readings have deteriorated since the last time the survey was conducted in December.

 

 

One drawback of survey-based sentiment is it asks respondents what they think and does not indicate what they’re doing with their money. Option-based sentiment, which measures dollars-and-cents sentiment, is nowhere near a bearish extreme. The term structure of the VIX is far from inverted, which indicates fear.

 

 

I was also surprised by the results of Helene Meisler’s (unscientific) weekly Twitter sentiment poll, which came in at zero net bull-bear reading. Survey sentiment has usually turned bearish when stock prices turn soft in the previous week. I interpret these conditions as the market has further room to fall.

 

 

 

Technical caution

The most worrisome development is bearishness of intermediate-term market internals. The usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) recently flashed a sell signal. The ITBM’s sell signals were correct about two-thirds of the time in the last five years (red=bearish outcomes, grey=bullish).

 

 

In addition, a warning was also sounded by the Hindenburg Omen. The Hindenburg Omen depends on three conditions:
  1. An established uptrend;
  2. Elevated new highs and new lows, indicating indecision; and
  3. A bearish momentum break.
The Omen does not turn bearish until we see a cluster of signals within a short period of time, which has not happened yet.

 

 

 

The canaries in the coalmine

How should investors and traders react to these widely differing market interpretations? I rely on the pairs trades that I identified in the past two weeks, which I call my canaries in the market coalmine. 

 

As a reminder, the pairs have a number of factor exposures to be aware of:
  • Long price momentum;
  • Long commodity producers and short either importers at a country level or cyclicals at an industry level; and
  • Slight negative beta, which may be a product of the price momentum factor.
Here is a report card of the country and regional pairs identified two weeks ago (see How the commodity tail wags the stock market dog), where the horizontal lines indicate the publication date price levels. Three of the four pairs are profitable and the remaining unprofitable pair, long Brazil/short frontier markets, remains in a relative uptrend. I see no reason to exit any of these positions.

 

 

Last week’s factor and industry pairs show more of a mixed result (see Secrets of stable returns in a chaotic bear market). While most are in relative uptrends, some are consolidating sideways. I also see no reason to exit of these positions – yet.

 

 

As long as the majority of these pairs remain in relative uptrends, my bearish outlook remains intact. Nevertheless, survey sentiment readings present a risk for short-term bear market rallies.

 

 

An ESG mean-reverting pair

As all of the pairs introduced have a positive price momentum exposure, I am introducing a new pair trade with a mean-reverting feature which has the added bonus of allowing investors to passively beat the gold mining index on a long-term basis. Moreover, the approach should be compliant on most ESG metrics.

 

Making a directional call on gold prices has been difficult. In the past, gold was highly correlated with TIPS but they have each gone in their own direction in the past year. The divergence can be partly explained by the rise in a geopolitical risk premium. Investors can find a better way to profit by trading a gold/gold mining stock pair.

 

 

To explain, a gold mine can be modeled as a series of annual call options with the strike price set at the cost of production. To estimate the value of the mine, just multiply the value of the option by the projected ounces of production and sum the value of the options over the expected life of the mine, and adding in an inflation factor to production costs every year. An investor can model the value of a gold mining company by summing the value of its mines. As most gold miners tend to be mainly financed with equity, valuation is relatively simple using this technique. 

 

There are some limitations to this modeling approach. It will not capture the upside potential from new discoveries. On the other hand, it will sidestep the risk of labor strife and production problems such as mine fires and floods. Moreover, an investment approach that owns either physical or paper gold compared to the messiness of owning gold mines should be ESG compliant.

 

I produced a research report in 2006 in a previous life using this technique that compared the value of the gold mining index to the model value and the fit was remarkably good. The report is available here (see page 6).

 

Here is the problem for the gold miners. Cash costs for the gold mining industry were $261/ounce. They have skyrocketed since then as old deposits became depleted and they were replaced by new mines with higher costs. Imagine if you bought a long-term call option with an exercise price of X, but discovered that, some time later, X had risen without your knowledge. The value of your call option would have fallen in response. That’s the long-term problem with owning gold mining stocks.

 

The chart below shows the long GLD/short GDX pair. The pair is trading at a support zone that stretches back to 2016. While the ratio has been lower in the distant past, the lower values can be explained in the context of a much lower cash cost regime, which can be modeled as a lower strike price.

 

 

This is a mean-reverting pair trade worthy of consideration. In addition, investors can take advantage of this relationship to outperform any gold mining stock index over the long term.

 

In conclusion, intermediate-term technical indicators remain bearish but survey-based sentiment indicates crowded short conditions, which is contrarian bullish. As long as my pairs trading factors remain in uptrends, I am inclined to remain cautious on the equity outlook.

 

As a consequence, my inner investor is cautiously positioned and underweight equities relative to benchmark. Subscribers received an email alert on Thursday that my inner trader had covered his short position and stepped to the sidelines until there is greater clarity on the short-term outlook.

 

 

Disclosure: Long SLY/Short IWM
 

US equity investors are playing with fire

Posted by Cam Hui -

In bull markets, valuation generally doesn`t matter very much unless it reaches a nosebleed extreme, such as the NASDAQ Bubble. In bear markets, valuation defines the downside risk in equity prices.
 

As the Powell Fed has signaled it is dead set on a hawkish policy that does not preclude inducing a recession, valuation will matter soon. The 10-year Treasury yield stands at 2.8% and the S&P 500 forward P/E is 19.0. The last time the 10-year reached these levels was 2028 when the forward P/E traded mostly in a range of 15-16 but bottomed at a panic low of 13.6. The previous episode of a similar 10-year yield was in H2 2013 when the forward P/E was in the range of 13.5-15. 

 

 

All else being equal, this implies downside risk of -15% to -30% for the S&P 500. That’s why US equity investors are playing with fire.

 

 

The Fed’s inflation obsession

Inflation and inflationary expectations are why the Fed has turned so hawkish. The March core CPI report came in at 0.3%, which is well below Street expectations of 0.5%. The bad news is that services CPI has been accelerating for several months. As goods inflation ease from a combination of base effects and the easing of COVID-related supply chain shortages, consumers have shifted spending from goods to services. An acceleration in services CPI is an unwelcome development for Fed officials.

 

The Fed is well aware of these changes. New York Fed President John Williams stated in a Bloomberg interview: “We are seeing signs that consumers are shifting their pattern from goods to services … It is a pattern I expect to continue, and it is an important part of the story as we watch consumers move back to more normal patterns of spending.”

 

 

While core CPI was weaker than expected, PPI came in hot and well ahead of expectations at an astonishing 11.2%. The key question is how well companies will be able pass on these rising input costs to their customers, the effects of the pass-through on corporate margins, and the leakage effects of higher commodity prices on CPI.

 

 

While inflation will eventually come under control, the risk for the Powell Fed is that inflationary expectations become unanchored. Already, they have reached a new high for the current expansion, though levels are consistent with readings seen in past cycles.

 

 

As a consequence, the market is now discounting consecutive half-point rate at the next three FOMC meetings, followed by a staccato series of quarter-point every meeting until February 2023. Fed Funds are expected to reach the Fed’s long run neutral rate of 2.4% by the November meeting and well exceed the Fed’s projected peak rate of 2.8%, according to the Summary of Economic Projections.

 

 

 

More valuation headwinds

In a rising rates environment, earnings growth and estimate revisions are left to do the heavy lifting for equity prices. So far, forward 12-month EPS estimate revisions are still rising, which is a positive.

 

 

However, there is more to earnings growth than meets the eye. Jurrien Timmer at Fidelity pointed out that S&P 500 Q1 EPS growth is reported to be 5.1% but all of the gains are attributable to higher oil and gas prices. Q1 EPS growth falls to -0.1% if the energy sector (3.9% of S&P 500 weight) is excluded.

 

 

 

A slowing economy

Q1 earnings season could be a problem. Corporate guidance has turned negative. While EPS beat rates could still be positive as management plays the beat the Street expectations game, the challenge is to maintain a positive tone when discussing the outlook for the remainder of 2022.

 

 

As well, top-down indicators point to a slowing economy, which may also create headwinds for earnings expectations for the remainder of 2022. The Citigroup Economic Surprise Index, which measures whether high-frequency economic releases are beating or missing expectations, could be starting to stall.

 

 

Job postings on Indeed have plateaued and begun to roll over. When will the deceleration in job gains begin to show up in the Non-Farm Payroll reports?

 

 

As well, the slight miss in the March retail sales report shouldn’t have been a surprise. Weakness had been foreshadowed by the Chicago Fed Advance Retail Trade Summary (CARTS).

 

In the fourth week of March, the Weekly Index of Retail Trade decreased 0.1% on a seasonally adjusted basis after remaining unchanged in the previous week. For the month of March, retail & food services sales excluding motor vehicles & parts (ex. auto) are projected to decrease 2.9% from February on a seasonally adjusted basis and to decrease 4.2% when adjusted for inflation.

 

 

From a global perspective, China’s zero-COVID induced lockdowns are concerns for global growth. Gavekal reported that in its survey of the top 100 Chinese cities, all but 13 have imposed some form of quarantine restriction, from no restrictions (level 0) to full lockdown (level 4). More importantly, lockdown intensity is increasing.

 

 

High frequency data shows a slowdown in the Chinese economy and the world faces two China shocks. The first is from falling demand from its zero COVID policy, and the second is from a supply shock owing to a slowdown in Chinese production. Neither are growth-friendly and neither will be positive for the corporate earnings.

 

 

 

Defying gravity?

How long can US equity prices defy valuation risk? One hint can be found in the latest BoA Global Fund Manager Survey, which found that global institutions regard the US as a safe haven. In the short run, positive fund flows can partially support the S&P 500.

 

 

Before the bulls get too excited, the same survey found that managers believe S&P 500 downside risk is greater than upside potential. As a frame of reference, the survey was conducted April 1 to 7, when the S&P 500 traded in a range of 4500-4540.

 

 

In conclusion, the S&P 500 is facing the twin macro risks of a hawkish Fed and deteriorating fundamentals. Based on the current 10-year yield of 2.8% and the current earnings outlook, the historical downside risk is between -10% and -30%. Arguably, the 10-year yield should be much higher in light of recent core CPI readings, which would have even greater dire consequences for equity valuation.

 

 

 

Another Omen warning

Posted by Cam Hui -

Mid-week market update: In case you missed it, the market recently flashed a Hindenburg Omen last week. The criteria for the Omen was succinctly explained by David Keller as:

  • The market is in an established uptrend;
  • A sharp expansion in both new highs and new lows, indicating indecision; and
  • A momentum break.

 

 

To be sure, Hindenburg Omens aren’t bearish until we see a cluster of Omen signals within a short period. Since last week’s Omen was a singular event, we should only treat it as a warning and not an actionable signal.

 

Instead of a sharp expansion in individual stock new highs and lows, Willie Delwiche observed a sharp bifurcation in new highs and lows by industry, which is not surprising in light of the current backdrop of weak economic growth expectations and strong commodity strength. While such an instance does not have the other criteria of the Hindenburg Omen, historically such episodes have shown a negative price bias on a 4-week horizon.

 

 

 

Bullish or bearish sentiment?

Sentiment models show a mixed picture. While survey data is not at a bearish extreme, positioning data indicates a crowded short. The latest BoA Global Fund Manager Survey shows that institutional managers are extremely pessimistic about global growth (light blue line), their equity positioning is cautious but not at a panic extreme. Watch what they do, not just what they say.

 

 

Similarly, Mark Hulbert found that the Hulbert Newsletter Stock Sentiment Index (HSNSI) is turning cautious, but nowhere near a crowded short reading indicative of a durable market bottom.

 

 

On the other hand, a report from Morgan Stanley Prime Brokerage found that hedge fund net leverage had fallen to the second percentile on a one-year lookback and a seventh percentile since 2010. If the large fast-money crowd is already that bearish, selling will have to come from different sources to drive stock prices down.

 

 

As well, the BoA Bull & Bear Indicator, which is a contrarian model mainly on sentiment-like signals, is very close to a buy signal at 2.1.
 


 

 

Bearish internals

I interpret these readings as intermediate-term bearish, but the market may be due for a short-term pause. The usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator flashed a sell signal on Monday, indicating the path of least resistance is down.

 

 

My inner investor is cautiously positioned. My inner trader initiated a short position last week and he expects to hold it until the NYSE McClellan Oscillator reaches an oversold condition.

 

Stay with the bearish momentum, but beware of bullish reversals.

 

 

Disclosure: Long SPXU

 

Secrets of stable returns in a chaotic bear market

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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 bear market

The signs are becoming clear. This is an equity bear market. Global central banks are engaged in a coordinated round of tightening. Fed Governor Lael Brainard put on the table the prospect of quantitative tightening, or a reduction of the Fed balance sheet, in a speech last week. This was confirmed by the release of the March FOMC minutes which revealed the Fed is targeting $95 billion in balance sheet reduction per month. Cue the fears about the effects of falling liquidity on stock prices.

 

 

In addition, the hopes that the bulls had for a momentum-driven rally fizzled in late March. The S&P 500, S&P 400, and S&P 600 all stalled at resistance and have all since pulled back.

 

 

Here are some ways that traders and investors can find stable and risk-controlled returns in a chaotic bear market.

 

 

Brace for turbulence

The S&P 500 intermediate-term breadth momentum oscillator (ITBM) is on the verge of a trading sell signal when its RSI recycled from overbought to neutral. There were 21 sell signals in the last five years. 14 resolved in a bearish manner and seven were bullish. Unless the market stages a gargantuan rally, count on a sell signal on Monday.

 

 

Historically, ITBM sell signals are better at calling direction than magnitude. In all likelihood, the latest downdraft is likely to be relatively shallow. The NYSE McClellan Oscillator (NYMO) is falling quickly and nearing an oversold condition. A recycle from oversold to neutral has been an effective buy signal in the past.

 

 

As well, the AAII weekly bull-bear spread has already fallen to -16.7%. Further deterioration in sentiment will push this model to a contrarian buy signal.

 

 

However, long-term sentiment models are contrarian bearish. The Citigroup Panic-Euphoria Model recently edged into euphoric territory.

 

 

The BoA Sell-Side Indicator, which measures the positioning of Street strategists, has been slowly falling, but readings are still elevated and much closer to a contrarian sell signal than buy signal.

 

 

 

Achieving stable risk-controlled return

My working hypothesis for the near-term outlook is a choppy market, but the S&P 500 is unlikely to breach its 2022 lows. While traders may profit from short-term bearish exposures, risk will need to be managed carefully. Bear market rallies can be vicious and short-sellers run the risk of getting their faces ripped off.

 

It is in this chaotic environment that I suggest pairs trading as a more risk-controlled way of finding better returns. There are two ways of approaching pairs. Traders can simply buy the bullish half of the pair and short an equal dollar amount of the bearish half. Long-only investors whose returns are measured against a benchmark should consider overweighting the bullish half of the pair while underweighting the bearish half.

 

Here are some pairs to consider. 

 

 

A focus on quality

During periods of economic stress, investors are advised to be tilted towards high-quality stocks. There are several ways of measuring quality. One simple way is profitability, which can be seen by the return differential between the S&P and Russell stock indices. S&P has stricter profitability index inclusion criteria than Russell. We can see this effect by observing the cumulative return spreads of large caps (long S&P 500/short Russell 1000) and small caps (long S&P 600/short Russell 2000).

 

 

 

Long defensive/short cyclical exposure

My recent publication (see The 9 reasons you should be bearish) reviewed the relative performance of a variety of sectors and industries. Positive relative strength was evident in inflation hedge groups and defensive sectors, while cyclical and growth stocks exhibited negative relative strength. Based on this theme, consider these pairs.

 

Long Healthcare (XLV) and short Communication Services (XLC): The technical pattern of this pair is clear. The pair is in a well-defined uptrend, and so is XLV, which is a defensive sector. XLC is in a well-defined downtrend.

 

 

Long equal-weighted consumer staples (RHS) and short equal-weighted consumer discretionary (RCD): I chose the equal-weighted ETFs because the cap-weighted consumer discretionary sector is dominated by Amazon and Tesla. The equal-weighted versions are more reflective of the underlying fundamentals of the economy. Just like the XLV/XLC pair, RHS is in strong and staged an upside breakout while RCD is in a well-defined downtrend.

 

 

 

Long inflation hedge/short cyclical exposure

The long inflation hedge theme is a little tricky because of the possible bearish reversal exhibited by Brent oil prices. For this reason, I prefer to avoid the energy sector and focus on mining and agricultural products, whose technical patterns did not exhibit monthly tombstone candlestick patterns.

 

 

Long global mining (PICK) and short regional banks (KRE): The pair is in a well-defined uptrend and so is PICK. Regional banks (KRE) are likely to weaken further as the Fed tightens and financial conditions worsen. Moreover, regional banks are likely to be more exposed to financial stress than their larger counterparts.

 

 

Long global mining (PICK) and short broker-dealers (IAI): Much like the above PICK/KRE pair, this is a long inflation hedge and short market beta and cyclical play. Broker-dealers (IAI) are sensitive to financial conditions and they tend to underperform during periods of financial stress.

 

 

Long agribusiness (MOO) and short homebuilders (XHB): This is an attempt at theme diversification of long inflation hedge and short cyclical exposure. Agricultural production will continue to be affected by the Russia-Ukraine war, regardless of its outcome. The homebuilding business faces headwinds from Fed tightening and higher mortgage rates. That said, this pair is a little extended and may be due for a short-term reversal should the bond market, which is oversold, stage a rally and alleviate some of the pressures on homebuilding stocks.

 

 

 

Regional pairs

I also identified several selected global regional pairs last week, based on a theme of long producers and short importers (see How the commodity tail wags the stock market dog). These regional pairs continue to be well worth considering.

 

 

I will update all of the pairs outlined in this publication on a periodic basis. Feedback and expressions of interest are appreciated so I know how much resources to devote to the regular update to this strategy.

 

My inner investor remains cautiously positioned. Subscribers received an email update on Friday that my inner trader had initiated a short position in the S&P 500.

 

 

Disclosure: Long SPXU

 

The 9 reasons why you should be bearish

Posted by Cam Hui -

Take a look at this mystery chart. Is that a bullish or bearish pattern? This chart is just the start of my nine reasons to be bearish on risk assets. My analysis is mainly based on real-time pricing signals from the market and relies less on fundamental or macro analysis. 
 

 

This is a time for investors to be cautious and think more about risk than return. That said, I offer one silver lining in all the dark clouds. There is one (sort of) reason to be bullish.

 

 

A failed geopolitical risk rally

Sometimes it’s useful to view a chart upside down. The mystery chart is MSCI Poland in USD, which I use as a proxy for geopolitical risk. The Polish market bottomed out in early March as Russia-Ukraine war fears peaked. Unfortunately, the rebound had no legs and began to fade in April. The relative performance of Poland to the Euro STOXX 50 (bottom panel) also shows an ominous pattern of lower lows and lower highs.

 

 

The relative performance of major eurozone equity markets to the MSCI All-Country World Index (ACWI) is similarly discouraging. In particular, relative weakness is more evident in core eurozone than the periphery, which is negative for the region’s economic and market outlook.

 

 

Much of the weakness is attributable to the size of the energy shock that Europe has to endure. The EU’s energy burden as a share of GDP spiked to 9.1%, which is a level not seen since the late 70’s and early 80’s. Across the Atlantic, the effects of higher US energy costs are mild by comparison.

 

 

 

A failed rate hedge

The second reason why I am cautious on the markets is the inability of hedges to work, which is a signal that the plumbing of the markets is broken somewhere. The Rising Rates ETF (EQRR) is supposed to hedge against rising rates. To be sure, yields have risen across the board and EQRR has held its own on an absolute basis. However, the bottom panel shows that the relative performance of EQRR is rolling over, which I interpret as a sign that factor returns are behaving in unexpected ways.

 

 

 

Cyclicals breaking down

If we look under the hood of the EQRR portfolio, we can see that it has a large weight in financial stocks, followed by resource extraction sectors and other cyclicals. While commodities and resource extraction stocks have performed well, other cyclical industries have been tanking.

 

This relative performance analysis of cyclical industries tells the story. While infrastructure stocks are holding their own relative to the S&P 500, all of the other industries are either breaking down or in a relative downtrend. This is an unambiguous message from the market that’s screaming “cyclical slowdown”.

 

 

The relative performance of homebuilding stocks is indicative of the headwinds faced by cyclical stocks. Historically, the relative performance of this industry has been inversely correlated with mortgage rates. As interest rates rise, this highly cyclical industry faces some tough challenges. As well, the relative weakness in homebuilding has been confirmed by lumber prices.

 

 

 

A Dow Theory sell signal

The poor performance of the Dow Jones Transportation Average is equally worrisome as a sign of cyclical weakness. Not only have the Transports plunged in just a few days, they have also breached a relative support level compared to the Dow Jones Industrials Average.

 

 

Mark Hulbert reported that Manuel Blay issued a sell signal on February 22.
 

According to Manuel Blay, editor of TheDowTheory.com, is that the stock market is punishing U.S. firms that rely on international supply chains. He points out that U.S. companies that are “more local [and] less outsourced” recently have significantly outperformed.

 

For the record, I note that Blay doesn’t base his market timing advice on the Dow Jones Transportation Average alone. Consistent with his interpretation of the Dow Theory, the oldest market timing system that remains in widespread use today, he instead focuses on both the Dow Transports and the Dow Jones Industrial Average. On that basis, Blay issued a “sell” signal on Feb. 22 of this year.

 

 

Defensive leadership

On the other hand, defensive sectors are all in relative uptrends.

 

 

For the sake of completeness, the relative performance of the major growth sectors is also weak.

 

 

 

No help from China

Other than the defensive sectors, the part of the market that’s showing leadership is commodity-related resource extraction industries. This is an indication that the market is undergoing a late-cycle phase led by inflation hedge vehicles.

 

 

The blemish to the late-cycle expansion narrative is China. China is a voracious consumer of raw materials and Beijing has undertaken some steps to stimulate its economy. However, the relative performance of Chinese material stocks is weak, indicating a lack of Chinese demand. Investors shouldn’t expect China to rescue the global economy.

 

 

 

Weak equity risk appetite

In addition, equity risk appetite indicators, as measured by the relative performance of high beta to low volatility stocks and the equal-weighted relative performance of consumer discretionary to staples, are weak and flashing minor negative divergences to the S&P 500.

 

 

 

Hawkish central bankers

Lastly, central bankers are turning hawkish everywhere.

 

 

In addition, former New York Fed President Bill Dudley wrote a Bloomberg Op-Ed which concluded that the Fed needs to hurt the stock and bond markets in order to bring inflation under control.

As [Jerome Powell] put it in his March press conference: “Policy works through financial conditions. That’s how it reaches the real economy.”
 

He’s right. In contrast to many other countries, the U.S. economy doesn’t respond directly to the level of short-term interest rates. Most home borrowers aren’t effected, because they have long-term, fixed-rate mortgages. And, again in contrast to many other countries, many U.S. households do hold a significant amount of their wealth in equities. As a result, they’re sensitive to financial conditions: Equity prices influence how wealthy they feel, and how willing they are to spend rather than save.

Dudley concluded:

 

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

Financial conditions are far from showing signs of stress. Yield spreads widened but they recently narrowed again, indicating loose financial conditions. If Dudley is right, the Fed will need to tighten a lot more to break the markets.

 

 

 

Good news on inflation?

If Dudley is focused on inflation, some good news on inflation may be on the way. That’s the silver lining in all the dark bearish clouds. As the market openly worries about a repeat of the 1970’s, an analysis of different measures of CPI shows that sticky price CPI is tame while flexible price CPI has surged. By comparison, both were rising uncontrollably during the inflationary 1970’s.

 

 

The woes of the truckers and transportation stocks may be an indication that flexible price CPI is ready to retreat. China to US shipping volume is falling, indicating an easing in COVID-induced supply chain disruptions.

 

 

The drop in transportation volume is a manifestation of the bullwhip effect. When supply chain disruptions hit a market, the initial reaction is to horde inventory and over-order, which creates a ripple effect down the supply chain. As new supply appears, participants are caught with excess inventory and evaporating orders because their customers had over-ordered. This creates a boom-bust volatility effect in the supply chain as disruptions go down the supply chain. 

 

This bullwhip effect can also be observed in the components of the March ISM Manufacturing report. The spread between new orders and production has fallen dramatically, indicating easing supply chain pressures.

 

 

Fed policy makers recognize these inflation dynamics. Goods inflation is expected to decline. The dual challenges are the additional supply chain disruption effects of the Russia-Ukraine war and the evolution of services inflation as consumers shift spending from goods to services as the pandemic eases. 

 

 

Brent crude printed a tombstone candle for the month of March, which may be indicative of a top. The price reversal needs to be confirmed by the next candle (in April), which is playing out so far. This is another sign that much of the war-related commodity price surge has peaked, which could feed into a welcome inflation surprise in the near future.

 

 

Job posting growth on Indeed are starting to stall, which may be a sign that the red-hot labor market is cooling.

 

 

The key indicators to watch in the coming months are non-farm payroll for signs of changes in job market pressures and the interaction between wages and inflation. Also, keep an eye on the evolution of inflation. The Fed is projecting a core PCE rate of 4.1% by December. Will inflation overshoot or undershoot that estimate?

 

 

The US Inflation Surprise Index is positive but decelerating. The CPI report on Tuesday will be a key test for the markets.

 

 

In conclusion, a review of a variety of market-based signals lead to the conclusion that risk asset prices are headed lower. The combination of hawkish central bank policy tightening into a cyclical downturn is the recipe for an equity bear market. The only hope for the bulls is better news on inflation which will slow the pace of accommodative policy removal and change the economy’s flight path into a soft landing.

 

Momentum, Schmomentum!

Posted by Cam Hui -

Mid-week market update: There had been some recent buzz around the positive effects of price momentum on stock prices (see The breadth thrust controversy). In particular, Ed Clissold at NDR highlighted several breadth thrust buy signals, which are based on the positive effects of price momentum. Since then, the equity rally has fizzled and the major market indices across all market cap bands are struggling just below key resistance levels. More importantly, today’s weakness left the S&P 500 just below its 200 dma.
 

 

Momentum, Schmomentum!

 

 

What bad breadth looks like

Here are some reasons to be concerned. Technical analysts like to talk about breadth. An analysis of different flavors of Advance-Decline Lines shows that the S&P 500 A-D Line has been holding up well, with the others having been far weaker. This is what bad breadth looks like.

 

 

From a fundamental perspective, forward margins for the S&P 500 are rising while forward margins for the mid-cap S&P 400 and small-cap S&P 600 are wobbly. In other words, large cap stocks are holding up well while the rest of the market is deteriorating beneath the surface.

 

 

 

Failed momentum

Here is why this matters from a price momentum perspective. Regular readers know that I monitor the Zweig Breadth Thrust indicator, which is based on NYSE internals, on a regular basis. A ZBT buy signal is generated when the indicator moves from an oversold to an overbought condition within 10 trading days. ZBT buy signals are very rare, but they can be highly effective signs of the bullish effects of price momentum.

 

I also developed a similar ZBT indicator based only on S&P 500 components (bottom panel). The S&P 500 ZBT indicator is less effective and often produces false signals. In the last five years, there were 12 instances when the S&P 500 ZBT indicator became overbought without a classic ZBT overbought signal. The market resolved in a bearish manner in eight, or two-thirds, of those cases.

 

 

Current conditions are starting to look like the case of failed momentum. Instances of failed momentum rallies are rare. I constructed a momentum indicator based on the ratio of % of S&P 500 stocks above their 50 dma to % above their 150 dma (bottom panel). I defined a strong momentum condition when the indicator reached 1.25. In almost all cases, market rallies didn’t fade until the 5-week RSI reached an overbought condition. You have to go back to early 2008, which is the start of the GFC bear market, to find a similar case of momentum failure (red arrow). 

 

 

While I am not implying that the market is about to undergo a 2008 waterfall decline, the circumstances are nevertheless ominous.

 

 

No sell signal yet

Despite the disturbing internals, I see no actionable sell signal just yet. It’s just a bearish setup. Notwithstanding the false breakdown, the head and shoulders pattern may still be in play, but good chartists know that a head and shoulders formation is incomplete until the neckline breaks.

 

 

I continue to monitor the S&P 500 intermediate-term breadth oscillator (ITBM) for a sell signal, based on a recycle of its RSI from overbought to neutral.

 

 

Keep an open mind about the anticipated sell signal. ITBM sell signals are highly effective on direction but not on the magnitude of the move. Any decline could be halted at the head and shoulders neckline support. 

 

While my inner trader leaning bearish, he is not ready to pull the trigger and go short. One day at a time.

 

How the commodity tail wags the stock market dog

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

How strong is the commodity bull?

How far can the inflation trade run? A long-term chart of the conventional inflation hedge gold shows a bullish cup and saucer pattern with strong upside potential.

 

 

By contrast, the CRB Index approaching resistance appears overbought and extended.

 

 

Here’s why this matters. An analysis by KKR concluded that the US economy is in a late cycle expansion, which is a period of decelerating equity returns. As the Fed raises rates to choke off inflation pressures, the inflation-sensitive commodity bull will fade and take the stock market down with it as economic growth decelerates.

 

 

 

In effect, we have a case of the commodity tail wagging the stock market dog.

 

 

Inflation hedge leadership

A review of inflation vehicle leadership shows that inflation hedge leadership is mostly intact. The relative performances of energy, mining, and agribusiness are in relative uptrends, though the relative return pattern of real estate is more choppy.

 

 

The relative performances of the stock markets of resource-producing countries are mostly in uptrends while undergoing high-level consolidations.

 

 

In particular, the Russia-Ukraine war has exposed the vulnerability of Asian markets, which tend to be major commodity importers.

 

 

One way of measuring the strength of the global inflation and commodity trade is the long producer/short importer pair. The following chart shows the relative performance of selected country and region pairs.
  • Long Australia and short Japan.
  • Long Canada, which is an energy exporter, and short eurozone.
  • Long Brazil, a grain exporter, and short frontier markets, which are mostly food importers.
  • Long Indonesia and short Vietnam as the example of a regional Asian pair.

 

In all cases, these pairs are in strong relative uptrends. The commodity trade is still alive and kicking.

 

 

Bond market rally ahead?

Over at the fixed income markets, bond yields have been surging but they appear to be stalling. The 2s10s yield curve has inverted, which is a decelerating economy. At some point, bond yields should fall in anticipation of slower growth. Indeed, the 10-year Treasury yield seems to have stalled after skyrocketing in 2022.

 

 

Long Treasury prices look like they are bottoming after exhibiting a positive RSI divergence.

 

 

Similarly, the stock/bond pair looks extended after showing a negative RSI divergence.

 

 

These are all signs that the bond market is setting up for a rally, and stock prices may be due for a period of relative weakness.

 

 

What to watch

The S&P 500 staged an upside breakout last week but pulled below resistance turned support, indicating a failed breakout. However, the market did print a hammer candle, which is a potential bullish reversal that will need to be confirmed by Monday’s market action.

 

 

I continue to monitor the S&P 500 intermediate breadth oscillator for a recycle from an overbought condition to neutral, which would be a sell signal.

 

 

Longer-term, I am watching the long producer/short importer pairs. Widespread breakdowns in these pairs would be a sign of a transition from a late-cycle market regime to a contractionary phase. Until then, investors can consider the pairs as sources of performance – with a well-defined risk control process.

 

What matters more, the war or the Fed?

Posted by Cam Hui -
An unusual divergence has appeared between the VIX Index and MOVE, which measures the implied volatility of the bond market. While MOVE has spiked, VIX has fallen. 

 

 

The difference in the two indicators can be explained by two forces that affect markets today, namely geopolitical risk and macro risk as defined by the Fed cycle. The decline in the VIX and equity rally reflects a compression in geopolitical risk premium in light of constructive Russia-Ukraine discussions, while the elevated nature of the MOVE Index reflects the market’s concerns about the Fed’s tightening cycle.

 

I pointed out a month ago that Wars are equity bullish, but there’s a catch. History shows that stock markets have recovered from sudden geopolitical shocks, with the exception that the war or insurrection results in a permanent loss of capital. It is therefore no surprise that stock prices advanced as the Russia-Ukraine risk premium faded. 
 

Here is a framework to consider. In the short-term, geopolitical risk will continue to dominate market volatility. Longer-term, it is the Fed cycle that matters to stock prices.

 

 

Recession or stagflation?

While the Russia-Ukraine risk is starting to fade, it hasn’t entirely gone away and it will continue to be a source of volatility. While the news of a Ukrainian offer of neutrality with security guarantees is constructive, Russian media such as the Moscow Times downplayed the offer as a breakthrough in negotiations.
 

The Kremlin on Wednesday welcomed Ukraine’s proposals at peace talks but played down progress at the negotiations after more than a month of war.

 

Russia’s chief negotiator Vladimir Medinsky said following three-hour talks in Istanbul on Tuesday that Moscow will study Kyiv’s proposals — which include an offer of neutrality in exchange for security guarantees — and report them to President Vladimir Putin. 

 

“The positive thing is that the Ukrainian side has at least begun to concretely formulate and put on paper its proposals,” Putin’s spokesman Dmitry Peskov told reporters the next day.

 

But he played down expectations that the latest round of talks — the first in eight days of fighting — would yield tangible results.
Longer-term, the key question for equity investors is the evolution of the Fed cycle. There are two schools of thought. The recession school believes that the Fed will keep raising rates until something breaks and the economy goes into recession. The stagflation school believes the Fed is so far behind the curve that Fed actions will only slow the economy without any meaningful effect on inflation.
 

The recession vs. stagflation call will be the key macro call for equity investors for the coming year. Under a recessionary scenario, investors should be cautious with overweight positions in defensive sectors and market weight high-quality growth stocks in anticipation that the market bids up growth in a growth-scarce environment. Under a stagflation regime, investors should overweight hard asset plays such as energy, mining, agriculture,  and real estate as inflation hedges.

 

 

 

A inverted 2s10s yield curve

There seems to be a disagreement between the Fed’s perception of its policy effects and the market’s perception. The 2s10s yield curve has inverted and heightened investor anxiety about a recession in 2023. 

 

 

In response to the heightened level anxiety, the Fed published a paper, “(Don’t Fear) The Yield Curve, Reprise”, in order to push aback against the concerns. The paper concluded that the 2s10s yield curve is not a good predictor of recessions. Instead, the near-term forward spread, which is the spread between the 18-month and 3-month Treasury rate, is a much better forecasting tool.

 

It is not valid to interpret inverted term spreads as independent measures of impending recession. They largely reflect the expectations of market participants. Among various terms spreads to consider, the 2-10 spread offers a particularly muddled view. Especially in the present circumstances when the 2-10 spread is very much out of step with the near-term forward spread, which offers a much more precise view of market expectations over the next year and a half, it is difficult to concoct a reason to be concerned about the flattening of the 2-10 spread. In contrast, if and when the near-term spread does contract, we know that investors will then be expecting a cessation in monetary policy tightening. While such a shift in expectations could well be precipitated by future concerns about a recession, that need not be the case. A more benign cause would be a marked easing in inflation and inflation expectations that allow for a cessation of policy firming.

The following chart shows the different techniques of measuring the yield curve. The blue line depicts the 2s10s yield curve.  As FRED does not have an 18-month Treasury rate, I approximated the 18-month rate by interpolating the 1-year and 2-year rates. While the approach isn’t perfect, it serves as a reasonable approximation of the 18-month to 3-month spread (red line). In addition, the green line shows the 10-year to 3-month Treasury spread. 

 

 

While the 2s10s yield curve is inverted, the other yield curves are still strongly upward sloping. The difference can be explained by the shape of the short end of the yield curve, which is still quite steep.

 

 

Callum Thomas also pointed out that the 2s10s yield curve has been highly correlated to the expectations – current situation components of the Conference Board Consumer Confidence Index. This observation is consistent with the view that the 2-year Treasury yield contains an expectational component that’s signaling an economic slowdown. As well, the flattening yield curve prompted New Deal democrat to concede that, as far as recession conditions go, “The Camel’s Nose is in the Tent”.
 

 

For a contrary perspective, Kansas City Fed President Esther George, who is regarded as a monetary policy hawk, recently voiced her concerns about the flattening yield curve from a financial stability perspective:
My concern about an inverted yield curve does not reflect its intensely debated value as a predictor of recession. Rather, my view is that an inverted curve has implications for financial stability with incentives for reach-for-yield behavior. An inverted yield curve also pressures traditional bank lending models that rely on net interest margins, or the spread between borrowing short and lending long. Community banks in particular rely on net interest margins to maintain their profitability, with rural areas especially dependent on community banks. 
She went on to concede that “a soft landing is possible but not guaranteed” and “less favorable outcomes are certainly possible”.

 

 

Tightening into a slowdown?

Another disagreement between the Fed and the market is whether the Fed is engineering a recession by tightening into a slowdown. Jerome Powell’s comments at the March 2022 FOMC press conference made it clear that Fed officials believe the economy is strong and it is able to withstand a withdrawal of monetary accommodation.

 

Powell characterized the job market as “extremely tight”. He voiced concerns about inflation and the disruptive effects of the Russia-Ukraine war on commodity prices.
 

Inflation remains well above our longer-run goal of 2 percent. Aggregate demand is strong, and bottlenecks and supply constraints are limiting how quickly production can respond. These supply disruptions have been larger and longer lasting than anticipated, exacerbated by waves of the virus here and abroad, and price pressures have spread to a broader range of goods and services. Additionally, higher energy prices are driving up overall inflation. The surge in prices of crude oil and other commodities that resulted from Russia’s invasion of Ukraine will put additional upward pressure on near-term inflation here at home. 

Indeed, the latest Markit PMI report is pointing to growth acceleration, not a slowdown, as well as strong inflation pressures.

Price pressures remained a significant theme in March, as costs increased at one of the fastest rates on record. Firms stated that further hikes in raw material, fuel and energy costs drove inflation, but also highlighted that the war in Ukraine and China’s lockcdowns were exacerbating supply chain strain.

 

 

The Citigroup Economic Surprise Index, which measures whether economic reports are beating or missing expectations, is similarly strong.
 

 

Regardless of which side of the debate you are on, a recessionary slowdown will see employment tank. While there has been some anecdotal evidence of softness in the jobs market, the employment situation remains strong.

 

 

 

TINA no more?

For equity investors, rising rates are pressuring valuation. When the Fed pushed rates to ultra-low levels in response to the COVID Crisis, equity investors could point to the TINA (There Is No Alternative to stocks) narrative. Now that rates are rising, is this a case of TINA no more?

 

The S&P 500 trades at a forward P/E of 19.5, which is above its 5 and 10-year averages. The forward P/E ratio peaked in 2020 and fell dramatically in 2022, which is consistent with a rising yield environment. However, recent market strength boosted the P/E ratio, which is pressuring valuation.

 

 

In such an environment, stock prices have to rely on earnings growth for all of the heavy lifting in the face of competition from higher rates. For now, forward EPS estimates are continuing to rise.

 

 

Here are valuation bull and bear cases. George Pearkes at Bespoke pointed out that profit margins are soaring despite all the hand wringing about wage pressures.

 

 

The bears will argue that while the current snapshot shows a strong economy, forward looking indicators such as the ECRI Weekly Leading Indicator are tanking. While readings aren’t at recessionary levels, they do point to a slowdown. Earnings growth expectations should decelerate accordingly.

 

 

As well, the combination of rising stock prices and rising 10-year Treasury yields has severely compressed the implied equity risk premium, defined as the forward earnings to price ratio minus the 10-year rate.

 

 

 

The market’s message

It’s time to settle the argument. Which school of thought will win in the end, recession or stagflation?
 

I conclude that current conditions indicate a late-cycle expansion consistent with a stagflation thesis. Forward looking indicators, however, point to a slowdown and possible recession ahead.

 

Timing the turn will be a tricky task for investors, but I have a simpler heuristic. The recent 2s10s flattening episode has been a bear flattener, where yields have risen, which is bearish for bond prices, while the 2s10s spread has turned negative. Instead, I prefer to focus on the longer end of the yield curve. Independent of the pace of Fed tightening and the anticipated pace of monetary policy, a falling 10-year yield is the bond market’s signal of economic weakness. If the 10-year yield begins to decline significantly, such as the violation of the 10-week moving average, that will be a signal for investors to embrace the recession scenario.

 

 

As well, an analysis of the relative performance of global resource groups shows that energy, mining, and agribusiness, which are sensitive to war-related supply chain disruptions, are undergoing high-level consolidations after upside relative breakouts. I interpret this to mean that stagflation pressures are steadying, but they haven’t completely faded.

 

 

In conclusion, the markets are being battered by geopolitical risk in the short term, which is stagflationary, and a Fed tightening cycle in the long term. The key risk for investors is whether the Fed will tighten into a recession, or if inflation expectations have taken hold and the economy has shifted into a stagflation era. The question is important because each scenario calls for different ways of positioning equity portfolios.

 

Current conditions call for a commitment to the stagflation trade, with an overweight position in late-cycle hard assets plays such as energy, materials, agriculture, and real estate. But investors shouldn’t overstay the party. The Fed tightening cycle should begin to squeeze inflation and growth expectations in the near future.

 

The key indicator of the regime shift will be bond yields. If bond yields were to decisively decline, it would be a market signal of slower growth and recessionary conditions on the horizon.

 

Sell to the sound of trumpets?

Posted by Cam Hui -

Mid-week market update: Before the war began, I wrote that investors should Buy to the sound of cannons. Historically, investors have been rewarded by buying sudden geopolitically related downdrafts. The corollary is “sell to the sound of trumpets”, or news of peace.
 

US equity indices across all market cap bands staged upside breakouts through resistance yesterday and they pulled back today to test the breakout levels.

 

 

Is peace at hand? Are the trumpets sounding?

 

 

Falling geopolitical risk

The market rallied yesterday on the hopeful news of Russia-Ukraine negotiations. The Ukrainians made a proposal of neutrality under the following conditions:
  • Ukraine would be neutral and agree not to join alliances like NATO or have foreign troops on its soil, but would have security guarantees in terms similar to NATO’s Article 5, which states that an attack on any NATO member would be interpreted as an attack on all.
  • Russia would not object to Ukraine joining the EU.
  • There would be a t5-year consultation period on the status of Crimea and the Donbas breakaway republics.
  • The proposals would be subject to ratification by a referendum in Ukraine.
The Russians stated that they would scale back military operations around the cities of Kyiv and Chernihiv. However, a read of Russian media indicated a less constructive view, where the Kremlin downplayed the odds of a breakthrough and featured the profile of s soldier “cleaning up” Mariupol along Chechen comrades. 

 

Left unsaid is the issue of reparations, if any, for the rebuilding of Ukrainian cities. As well, Biden’s recent outbursk, “For God’s sake, this man [Putin] cannot remain in power” will be an impediment to a deal.

 

The response to the negotiations news is an instructive window on market psychology. Russia-Ukraine war-sensitive instruments experienced island reversals. The Euro STOXX 500 and MSCI Poland printed bullish reversals, while gold showed a bearish reversal. Equity markets staged upside breakouts through resistance in the manner of US markets, but gold prices did not break support.

 

 

I interpret this to mean that geopolitical risk is fading, but could flare up again at any time.

 

 

Strong momentum, weak breadth

Market internals are characterized by strong price momentum but weak breadth. 

 

Bullish price momentum has been strong. In the last 10 years, such episodes have carried stock prices higher and, at a minimum, have not topped until the 5-week RSI has become overbought.

 

 

On the other hand, breadth indicators are unusually weak for a momentum-driven advance. The percentage of S&P 500 bullish on P&F has not reached the 80% level that’s consistent with a “good overbought” rally. Net NYSE and NASDAQ highs-lows have also been weak. Readings finally turned positive yesterday (Tuesday) after a prolonged period of net negatives.

 

 

Bloomberg’s Dani Burger highlighted a recent BoA cautionary note based on the divergence between the VIX Index and MOVE Index, which measures bond market implied volatility. The last time this happened, the S&P 500 took a tumble.

 

 

In conclusion, stock prices can run higher in the short term as momentum has become dominant, but negative breadth divergences are concerns. If momentum falters, the S&P 500 intermediate-term breadth momentum oscillator should be able to flash a sell signal. 

 

 

But not yet.

 

A breather, or a stall?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A sentiment reset

The stock market staged a relief rally, sparked by excessively bearish sentiment readings. The weekly AAII bull-bear spread had fallen into buy signal territory. Not surprisingly, the stock market bounced. The latest AAII readings have begun to normalize into neutral territory.

 

 

An analysis of Investors Intelligence tells a similar story. The bull-bear spread has begun to revert from negative, which is historically a tactical buy signal, to zero.

 

 

Can the bullish impulse continue? Here are bull and bear cases.

 

 

Strong momentum

The stock market exhibited strong positive momentum in the latest rally. Numerous historical studies, such as this one from Jonathan Harrier, indicate that forward returns after such events were extremely strong. The blogger Macro Charts also posted a study with similar bullish conclusions based on NASDAQ 100 returns.

 

 

I outlined the reasons why I believe this is a bear market and to be intermediate-term cautious last week (see Trading the Relief Rally). While bear market rallies are normally short and vicious, Real Money columnist Helene Meisler documented instances when bear market rallies can be long lasting. She cited the example of the 9/11 market bottom in 2001, the subsequent advance in 2002, followed by a second low in July 2002.

 

 

She also highlighted the multi-month bear market rally in 2008 before the market fell to a final panic low.

 

 

 

Can momentum win the day?

The key question for traders is whether price momentum can prevail and win the day. Friday’s release of the Commitment of Traders report showed that large speculators, or hedge funds, sold the rally. (As a reminder, the CoT report shows positions from Tuesday to Tuesday and it is released Friday afternoon). While CoT data leads to a contrarian bullish conclusion, the S&P 500 exhibited a negative RSI momentum divergence, which is bearish. 

 

 

What stood out in the CoT report was the heavy sales in S&P 500 futures, as large speculator positions moved from substantially net long to net short.

 

 

Net sales were observed across the board. Large speculators sold NASDAQ 100 futures…

 

 

…And they sold Russell 2000 futures, though the magnitude of the sales was not as large as the ones seen in S&P 500 futures.

 

 

Macro
Charts pointed out that this level of sales has a record of being contrarian bullish.

 

 

 

A weak overbought market

The bull and bear debate comes down to the strength of the momentum signal. The market is short-term overbought. Both the NYSE and NASDAQ McClellan Oscillators reached overbought conditions last week, which are cautionary signals.

 

 

While the market is overbought, it is not showing a strong “good overbought” condition that is characteristic of a momentum-driven advance. The percentage of S&P 500 bullish on point and figure charts stalled at about the 70% level, which is shy of the 80% threshold for a “good overbought” reading. As well, both NYSE and NASDAQ net 52-week highs-lows are weak, which is also indicative of weak momentum.

 

 

As well, equity risk appetite, as measured by the equal-weighted consumer discretionary to staples ratio and the high beta to low volatility stock ratio, is exhibiting negative divergences against the S&P 500.

 

 

If price momentum were to falter, that would be the setup for a sell signal. The S&P 500 Intermediate-Term Breadth Oscillator reached an overbought condition last week. A sell signal is generated when it recycles back to neutral. In the past five years, there were 21 such signals; 14 of them resolved in a bearish manner (pink lines) and 7 bullishly (grey lines). These episodes include strong rallies off V-shaped bottoms in 2019 and 2020.

 

 

A sell signal may be imminent. Do you want to play those odds of this model if momentum were to weaken?

 

In conclusion, the market is extended in the short run and rally may be starting to show signs of exhaustion. While momentum is strong strong and it would be too soon for traders to take bearish positions, I am seeing the set-up for a sell signal, which should appear soon.

 

 

Imagining War and Peace

Posted by Cam Hui -

The Russia-Ukraine war has dealt an unexpected shock to the global economy and markets. Even as the world began an uneven recovery from the COVID Crash of 2020 and inflation pressures began to rise, the war has spiked geopolitical risk premiums and exacerbated supply chain difficulties and added more inflationary pressures. From an economic perspective, rising inflation and inflation expectations are forcing central bankers to react with more hawkish monetary policies, which raise recession risk.
 

It’s not a pretty picture. Now that we know what war looks like, let’s engage in some scenario planning. Imagine peace. How would the global economy and markets react?

 

 

 

The price of war

Let’s begin with the current situation report. About a month into the invasion, the Russian offensive has largely stalled. The Ukrainians have made a number of localized successful counter-attacks but the Russians are making steady progress in wearing down the besieged defenders in the southern port of Mariupol. Russian forces are digging in defensively and bombarding Ukrainian cities. This may turn out to be a protracted conflict.

 

The key question is how long can Russia can sustain a war?

 

Joachim Klement, writing at the CFA Institute’s blog, analyzed Russia’s current account and economy. He concluded:
 

The conclusion of all these calculations is simple: As long as Russia can continue to export oil and gas, it can finance the revenue shortfalls generated by the sanctions for a long time. But the economic toll will be enormous: GDP will drop nearly 10% over the next 12 months alone and may not stop there.

 

But if Russia loses its oil and gas revenues, it will run out of money within one to two years.

 

 

While that analysis is correct from a top-down macro perspective, anecdotal reports indicate that sanctions are biting. Fortune cited a Ukrainian military social media release, whose information is unconfirmed by other sources, that Russian tank production has ground to a halt because of a parts shortage.

The country’s primary armored vehicle manufacturer appears to have run out of parts to make and repair tanks, according to a Facebook post by the General Staff of the Armed Forces of Ukraine.
 

Citing “available information,” it reported state-owned company Uralvagonzavod, which builds tanks such as the T-72B3, has had to temporarily cease production in Nizhny Tagil.

The Russian offensive has depleted its troop strength. The latest NATO estimate indicates that the Russian Army has lost 30-40K men, which includes killed, wounded, missing in action, and taken prisoner. It is, therefore, no surprise that Moscow has mobilized reserves, recruited Syrian fighters, and called for a draft. Anecdotal accounts from social media from Russian mothers’ groups indicate heightened anxiety among the middle-class of the draft for their teenage sons. There were also reports of shortages of staples like sanitary napkins and, more importantly, insulin.
 

In addition, Russia’s latest reported weekly CPI was up 1.93%, which puts CPI up an astounding 132% for the period of the war.
 

On the other hand, Russia has substantial leverage in terms of its exports as it is the substantial source of some key global commodities.
 

 

Both Russia and Ukraine are major exporters of grains, which threatens the global food supply. In particular, African countries are especially dependent on Russian and Ukrainian wheat, which increases the risk of global famine. The last episode of food insecurity coincided with Arab Spring. This raises the risk of geopolitical instability.

 

 

The West announced additional Russian sanctions last week. The EU held further discussions of cutting dependence on Russian gas, though Reuters reported that German chancellor Olaf Scholz pushed back on the idea.
 

“Yes, we will end this dependency – as soon as possible. But to do this from one day to the next would mean plunging our country and the whole of Europe into a recession,” Scholz told the Bundestag lower house of parliament.

 

“Hundreds of thousands of jobs would be in danger. Whole branches of industry would be on the brink,” he said. “Sanctions should not hurt European states harder than the Russian leadership.”

A recent paper co-authored by a distinguished group of economists working both inside and outside Germany projected the effects of a sudden cutoff of Russian gas to Germany, based on the scenario that Germany loses 30% of natural gas supply and 8% of its primary energy supply. 
 

Purely in the spirit of being conservative, we therefore postulate a worst-case scenario that doubles the number without input-output linkages from 1.5% to 3% or €1,200 per year per German citizen. This number is an order of magnitude higher than the 0.2-0.3% or €80-120 implied by the Baqaee-Farhi model. We should emphasize that this is an extreme scenario and we consider economic losses as predicted by the Baqaee-Farhi model to be the more likely outcome

Bear in mind that this is a worst-case scenario where there are no substitutes for Russian gas. A GDP shock of 1.5% to 3.0% is similar in magnitude to the COVID shock. It’s painful but manageable. While Berlin may balk at the price of a complete cutoff of Russian gas, Scholz could change his mind under a scenario of Russian escalation to the use of WMDs, especially if they’re on a civilian population.
 

In short, Ukraine and the West are engaged in a contest of pain with Russia. Pressures are building for a settlement. Will anyone blink?
 

 

What would peace look like?

The details of any peace agreement are beyond the scope of this analysis, but imagine that peace suddenly descended in Ukraine. What are the economic and market ramifications of this best-case scenario?
 

An analysis from the European Central Bank outlined a heatmap of supply chain pressures in the US and eurozone. Even before the war, supply chain bottlenecks were evident in a variety of sectors.
 

 

Supply chain problems aren’t going away even if peace broke out. As an example, Ukraine has two plants that are about 50% of the global source of neon, a key component in semiconductor manufacturing. One is in Mariupol, which has been flattened by Russian bombing. The other is in Odessa, which is under threat, but it has shut down production. In addition, Ukrainian farmers are unlikely to plant their spring crop, especially in fields that may be strewn with landmines. At best, Ukrainian grain production won’t return to full production in the next few years.
 

Energy prices are likely to remain elevated in energy sanctions remain in place. A recent Dallas Fed survey of oil patch operators was highly revealing. While most respondents replied that an $80 to $90 WTI price is enough to spur new investment, a full 29% replied that their investment decisions are not oil price dependent.
 

 

That’s because of increasing investor pressure to maintain capital discipline. There is also anecdotal evidence of a scarcity of capital in the oil patch at any price owing to the growing trend of ESG investment mandates.
 

 

Where does that leave Fed policy? That depends on how transitory the inflation effects of the war are. As an example, Cullen Roche pointed out that global container freight rates have flattened out.
 

 

If they were to stay flat, the annualized rate of change would begin to fall in Q2, which alleviates inflation pressure.
 

 

Notwithstanding the effects of the war, inflation should begin to fall from a combination of the transitory effects and monetary tightening. The wildcard is the degree and magnitude of the supply shocks from the war, and how they affect inflation and inflation expectations. The 5×5 forward inflation expectation is currently at the top of its range. An upside break would be a signal for the Fed to adopt an even more hawkish monetary policy.
 

 

The market is already expecting consecutive half-point rate hikes at the next two FOMC meetings, a total of 2.25% rate increases in 2022 and topping out in early 2023 at 2.50% to 2.75%. The disruption from the war could make things worse and force the Fed to engineer a recession in order to control inflation.
 

 

 

Recession odds are rising

In conclusion, a best-case scenario of a sudden peace agreement would leave the global economy exposed to additional supply chain aftershocks from the Russia-Ukraine war. I agree with John Authers, who wrote that all the good scenarios are gone. The markets are forward-looking and they are discounting a rising risk of recession, even though recession models are not calling for a recession just yet. 
 

Bill McBride at Calculated Risk who relies mainly on housing market indicators for his recession calls, said that he isn’t even on recession watch yet. New Deal democrat, who monitors a series of coincident, short-leading, and long-leading indicators, characterized the economy as a weakening cycle overlaid with the negative effects of an exogenous shock from the war.
 

There are two separate dynamics operating on the economic indicators. One dynamic is a typical cyclical one of the Fed reacting to high inflation and low unemployment by raising rates, now that it has been convinced that inflation has not been “transitory.” The second dynamic is Russia’s invasion of Ukraine, and the world’s reaction to it.
 

The first dynamic is primarily acting on the long leading indicators. Thus we see bond yields rising, and yield spreads tightening. In fact, several portions of the yield curve inverted Thursday and at least intraday Friday (most notably the 5 minus 3 year spread which briefly turned negative Friday, before closing ever so slightly positive). This dynamic is also why mortgage rates are negative, and at least partially why credit conditions have tightened.
 

As a result, the long leading forecast has turned neutral. A recession is possible one year from now, but not that likely yet…
 

The global economic reverberations of the Russian invasion of Ukraine, and the reactions to it, by way of sanctions, global oil supply, and also by businesses severing ties with Russia, is an exogenous event, just as the pandemic was in 2020. And just as with the pandemic in 2020, it could cause a recession without the normal procession of cyclical effects through the economy. But it is “transitory” in the sense that if and when the conflict resolves, the normal cyclical procession will reassert itself. Those cyclical processes, the other side of the pincer, continue to point towards a stall roughly at the beginning of next year.

I reiterate my views from my February publication, A 2022 inflation tantrum investing roadmap, except for an upgrade to a market weight position in resource extraction sectors for their inflation hedge characteristics. This is a bear market. Investment-oriented accounts should be cautiously positioned. 
  • Overweight defensive sectors.
  • Overweight quality stocks.
  • Neutral weight resource extraction sectors such as energy and mining (upgrade).
  • Neutral weight high-quality growth, which should be the next market leadership.
  • Underweight value and cyclical stocks, such as financials, industrials, and non-FANG+ consumer discretionary.

 

The breadth thrust controversy

Posted by Cam Hui -

Mid-week market update: The strength of the rally off the mid-March lows has been breathtaking. Ed Clissold of NDR Research pointed out that the market experienced several breadth thrust buy signals. The % of stocks above their 10 dma surged from under 10% to above 90% in a short time, which is historically bullish. He also observed that their version of the Zweig Breadth Thrust model using a common stock only universe also flashed a buy signal last Friday.
 

 

That’s where the controversy begins.

 

 

An uncertain breadth thrust

Much depends on what you call a “breadth thrust”. The term refers to a burst of positive price momentum over a short period, usually defined as a move from an oversold to overbought condition within 5-10 trading days.

 

An analysis of the % of S&P 500 above their 10 dma is not confirming the NDR buy signal. The market fell under 10% on this metric on February 24, 2022, and rose above 90% last week, which is not within a 10-day trading window. In all likelihood, NDR uses a different sample universe, such as NYSE issues, but this analysis casts some doubt on the breadth thrust conclusion.

 

 

Similarly, the classic Zweig Breadth Thrust indicator using all NYSE-listed issues rose above its oversold condition on February 24, 2022, and it has not reached an overbought condition.

 

 

Strike two.

 

 

Occam’s razor

In light of these closely competing narratives, what should we make of these breadth thrust claims? Steve Deppe put it best when he threw up his hands when he analyzed historical analogs. One was wildly bullish, the other bearish.

 

 

I prefer the Occam’s Razor approach of using the simplest explanation instead of more complex and convoluted analysis. The rally off the mid-March bottom was a short-covering rally driven mainly by the fast money crowd that was overly short the market. Sentiment was in a crowded short condition going into the FOMC meeting. Even though the Fed was hawkish as expected, it wasn’t enough. Buy the rumor, sell the news.

 

Even though sentiment surveys were at bearish extremes, the analysis of equity positioning showed that investors were cautious but readings were not at capitulation lows.

 

 

My base case scenario is the advance off the mid-March lows is a bear market rally, which tends to br short but vicious.

 

 

 

A stall ahead

The rally appears to be stalling. Both the NYMO and NAMO have reached overbought conditions. There were seven instances when this happened in the last three years and five of them resolved with market stalls. The only exceptions occurred when the market surged off the March 2020 bottom.

 

 

I had highlighted evidence of a bottom by the widespread incidence of bullish island reversals in washed-out pockets of the market. Here is ARK Innovation (ARKK), which exhibited an island reversal but the rally seems to have stalled.

 

 

The Euro STOXX 50 ETF (FEZ) is exhibiting a similar pattern of island reversal and stalled rally/

 

 

So is MSCI China.

 

 

My crystal ball is a little cloudy and I am not sure about the direction of the next major market move. I do know that bullish momentum is fading. Subscribers received an alert yesterday that my inner trader had closed out his long position and stepped to the sidelines.

 

The balance of risks is tilting to the downside. Jerome Powell’s testimony on Monday was very hawkish and the market is now discounting half-point hikes at the next two FOMC meetings. 

 

 

The Russian offensive has stalled and the Ukrainians have made some successful local counter-attacks. The risk of escalation remains high, which could spook the market.

 

My inner investor believes this is a time for prudence. My inner trader doesn’t have an edge and so he is stepping aside in wait for a better opportunity.

 

 

Trading the relief 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 bsoe found here.

 

 

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

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bearish (downgrade)
  • 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 relief rally

A week ago, I highlighted an observation by Bill Luby that a recycle of the VIX Index below 30 after a prolonged period above that level is historically bullish. Now that the VIX has fallen below 30, how far can the rally run?

 

 

The S&P 500 tested support while exhibiting a series of positive RSI and rallied on the hopes of a Russia-Ukraine peace accord. The advance continued even in the face of a hawkish FOMC message. The index violated a falling trend line, which is a positive development.

 

 

Despite the strong historical statistics, don’t be too bullish. The relief rally looks like a bear market rally within a downtrend.

 

 

Time to turn cautious

My Trend Asset Allocation Model has downgraded its signal from neutral to bearish. It’s time to acknowledge that this is a bear market. The model applies trend following principles to global stock and commodity prices to create a composite signal. The model is pointing to recessionary, or near recessionary conditions. 

 

The Ultimate Market Timing Model remains bullish. As a reminder, this model only turns bearish when the trend model is bearish, which it is, and my Recession Watch indicators flash the warning sign of a recession, which it hasn’t yet.  The combination of the two is rare, which explains the low level of model turnover. This is confirmed by the latest update from New Deal democrat, who maintains a set of coincident, short-leading, and long-leading indicators. He reported that his long-leading indicators have moved into neutral, with the caveat that war-related disruptions could plunge the economy into recession [emphasis added].

 

There are two separate dynamics operating on the economic indicators. One dynamic is a typical cyclical one of the Fed reacting to high inflation and low unemployment by raising rates, now that it has been convinced that inflation has not been “transitory.” The second dynamic is Russia’s invasion of Ukraine, and the world’s reaction to it.

 

The first dynamic is primarily acting on the long leading indicators. Thus we see bond yields rising, and yield spreads tightening. In fact, several portions of the yield curve inverted Thursday and at least intraday Friday (most notably the 5 minus 3 year spread which briefly turned negative Friday, before closing ever so slightly positive). This dynamic is also why mortgage rates are negative, and at least partially why credit conditions have tightened.

 

As a result, the long leading forecast has turned neutral. A recession is possible one year from now, but not that likely yet…

 

The global economic reverberations of the Russian invasion of Ukraine, and the reactions to it, by way of sanctions, global oil supply, and also by businesses severing ties with Russia, is an exogenous event, just as the pandemic was in 2020. And just as with the pandemic in 2020, it could cause a recession without the normal procession of cyclical effects through the economy. But it is “transitory” in the sense that if and when the conflict resolves, the normal cyclical procession will reassert itself. Those cyclical processes, the other side of the pincer, continue to point towards a stall roughly at the beginning of next year.
In the US, the S&P 500 has exhibited a dark cross, where the 50 dma falls below its 200 dma. Moreover, the broadly-based Value Line Geometric Index is in a well-defined downtrend and violated support.

 

 

Across the Atlantic, the Euro STOXX 50 has taken the brunt of the Russia-Ukraine war fears. Even though the FTSE 100 is acting a bit better, the mid-cap FTSE 250, which is more sensitive to the UK economy, is in a downtrend.

 

 

In Asia, China and Hong Kong have tanked, though a recent announcement of market-friendly measures has sparked a turnaround. Nevertheless, the market structure of the major Asian markets are all screaming “downtrend”.

 

 

Commodity prices are strong, but I pointed out last week (see Not your father’s commodity bull) that price strength is attributable to supply shortages and not excess demand. Such conditions are not reflective of strong cyclical strength but will resolve in demand destruction, which is bearish for the global economy. Indeed, the cyclically sensitive copper/gold ratio confirms this assessment by trading sideways.

 

 

 

A bear market rally

Bull markets don’t go straight up and bear markets don’t go straight down. Short-term sentiment is supportive of a bear market rally, which can be brief but vicious. The AAII bull-bear spread remains at a buy signal, which is tactically bullish.

 

 

 

A key technical test

Last week’s bounce presents a key technical test for the S&P 500. Since December, the S&P 500 has reacted to oversold conditions with sharp 2-4 day rallies, followed by further weakness to either test the previous lows or more new lows. The main differences this time are the violation of the falling downtrend line and the positive RSI divergence. Much will depend on whether the market can follow through with more strength in the coming week.

 

 

The market is also enjoying a momentum tailwind. The S&P 500 exhibited four consecutive days when it was up 1% or more last week. Such episodes are rare but they have historically resolved with a bullish bias, though the sample size is very small (n=4).

 

 

The bullish island reversals exhibited by both the Euro STOXX 50 (FEZ) and MSCI China (MCHI) are additional inter-market signs that a strong bear market rally is underway.

 

 

In the short run, the part of the US market with the most upside potential is large-cap growth. Macro Charts pointed out that the NASDAQ 100 is exhibiting a strong breadth thrust after a deeply oversold condition, which is very bullish.

 

 

I agree with the bullish assessment on the NASDAQ 100. The index violated a falling downtrend after exhibiting a series of positive RSI divergences. Relative breadth against the S&P 500 has been strong (bottom panel), indicating positive underlying relative strength. Watch for overhead resistance at the 50%  Fibonacci retracement level as a possible profit target, but recognize that there is also a risk of momentum failure.

 

 

Even ARK Innovation (ARKK), which represents speculative growth stocks, underwent a bullish island reversal, though its downtrend remains intact. If the rally continues, watch how the ETF performs near its trend line resistance.

 

 

In conclusion, the stock market is undergoing a relief rally in the context of an intermediate-term downtrend. It’s difficult to know exactly how far the rally can run. Investment-oriented accounts should take advantage of market strength to rebalance to a position of minimum risk. Traders who are long should use a stop-loss to define their risk.

 

 

Disclosure: Long TQQQ

 

How to spot a market bottom

Posted by Cam Hui -

Did the stock market make a meaningful bottom last week? Financial markets had been taking a risk-off tone coming into the week, but when the Powell Fed was slightly more hawkish than expected, the market rallied. 
 

The S&P 500 was -14.6% peak-to-trough on an intraday basis in 2022. Ed Clissold of Ned Davis Research pointed out that the characteristics of cyclical bears and recession bears have been very different. Cyclical bears that don’t involve a recession tend to be shorter in length and less severe in magnitude compared to recession bears, though “most non-recession bears include a recession scare”.
 

 

Here are some ways of spotting a durable market bottom.

 

 

The Fed’s rosy scenario

If we were to cut through all the noise, it’s the Fed cycle that mainly dominates the stock market. The Powell Fed turned hawkish, as expected, at the March FOMC meeting. However, a number of unusual forecasts from its Summary of Economic Projections (SEP) caught my eye.

 

First, the “dot plot”, or expected Fed Funds rate, jumped from 0.9% to 1.9% by December 2022, which was roughly consistent with market expectations. The expected Fed Funds rate in 2023 and 2024 will overshoot its longer-run target, indicating an extra tight monetary policy. Core PCE inflation was revised up from 2.6% to 4.3% for 2022, indicating a hot inflationary environment, though Powell indicated in the press conference that he still expects inflation to moderate in the second half of 2022.

 

Here is the anomaly. Despite all of the tightening, the forecast GDP growth rate is still relatively strong at 2.8% for 2022 and 2.2% for 2023. Moreover, the unemployment rate forecast was unchanged at 3.5% in 2022 and 2023. The Fed expects a strong labor market and no recession. 

 

 

This sounds like an unrealistic rosy scenario. If the Fed continues to anchor the long end of the Treasury yield curve with its guidance on the neutral policy rate, the yield curve will invert before the end of 2022. Inverted yield curves have been strong predictors of recessions. The Fed’s rosy scenario is leading monetary policy of tightening until something breaks.

 

 

If a recession is ahead, the downside risk to equity prices will be a lot more than the -14.6% peak-to-trough drawdown experienced recently. What could rescue the stock market from a recession bear?

 

The answer is financial instability, otherwise known as something breaking. Conventional measures of financial stress are rising, though readings are nowhere near crisis levels. Keep an eye on emerging market spreads (red line), which is raising a cautionary flag.

 

 

A key risk is the Russia-Ukraine war spikes food prices. The last time food prices rose sharply, it created political instability in the form of the Arab Spring in emerging and frontier markets. While that scenario may fraught with risk on paper, many EM countries are commodity exporters that benefit from higher commodity prices, especially in Latin America. Even in Africa, many countries have partial natural hedges. The UN defines a country as commodity-dependent if it is more than 60% of its physical exports are commodities, and 83% of Africa is in that category.

 

 

The elephant in the emerging market room is China, which is a voracious importer of commodities. The key question is its pandemic management policy in the face of its zero-COVID policy. While the recent market-friendly pivot is helpful for financial stability, those policies will do nothing if the Chinese economy slows and snarls global supply chains because of ongoing pandemic lockdowns.

 

 

 

Market positioning

While an analysis of Fed policy may point to a recession bear, the risk-on rally in the face of a hawkish Fed last week may be a reflection of excessively bearish positioning. The BoA Global Fund Manager Survey shows that respondents are all-in on their recessionary outlook. As well, a recent CNBC poll of Fed watchers saw a 33% chance of a recession within the next 12-months.

 

 

Consequently, manager risk appetite has plunged.

 

 

Mark Hulbert also pointed out that short-selling is virtually nonexistent, which is potentially bullish.

 

 

On the other hand, insider buying is also nowhere to be found, though there was a brief episode of insider buys exceeding sales at the January low.

 

 

As a reminder, here is what insider activity looked like during the GFC market bottom. There were strong clusters of insider purchases that exceeded sales.

 

 

Here is the history of insider activity during the recent COVID Crash bottom.

 

 

As well, S&P 500 futures positioning is not signaling a capitulation bottom. Historically, hedge funds have been in crowded shorts in S&P 500 futures at past major market bottoms. Readings are still net long and hedge funds aren’t panicked just yet.
 

 

 

Insufficiently oversold

From a technical perspective, the market is insufficiently oversold for a major market bottom. I have highlighted the “good overbought” advance from the March 2020 bottom before. This was evidenced by the percentage of S&P 500 stocks above their 200 dma rising to 90% and remaining there. The overbought condition recycled in mid-2021 (top panel). Historically, such declines don’t end until the percentage of stocks above their 50 dma fall below 20% (bottom panel). The recent market weakness reached 25% and recovered. This analysis indicates further downside risk ahead.

 

 

In addition, the NYSE McClellan Summation Index (NYSI) has signaled major bottoms whenever it fell to -1000 or less. This indicator isn’t perfect as it was early to flash buy signals in 2008. Nevertheless, readings of -1000 have shown a strong track record of calling bottoms in the past.
 

 

 

Recession ahead?

Where does that leave us? I am about two-thirds of the way down the path to the recession camp, though my models are not calling for a recession just yet and I don’t like to front-run model readings. The path of Fed policy seems to be to tighten until something breaks. An inverted yield curve is almost inevitable at this point and other economic indicators are deteriorating.

 

Regardless of whether there will be a recession, analysis from Ned Davis Research indicated that stocks struggle during the first year of a fast tightening cycle. In the current circumstances, both the “dot plot” and market expectations are indicating a fast tightening cycle.

 

 

I am downgrading the reading of my Trend Asset Allocation Model from neutral to negative. Investment-oriented accounts should shift to a maximum defensive posture. 

 

 

This is a bear market. The current episode of stock market strength is a bear market rally. Don’t be fooled. Sell into strength.

 

 

Great (bearish) expectations

Posted by Cam Hui -

Mid-week market update: The bears have exhibited great expectations for risk assets. Ed Clissold of Ned Davis Research observed that the NDR Crowd Sentiment has been at a sub-30 reading, which is historically bullish. However, he pointed out that momentum is negative and hedged with “sentiment is extremes differ cycle to cycle, so it’s best to wait for sentiment to begin to reverse”.
 

 

 

Bearish sentiment

Sentiment indicators have indeed been extreme for some time. Investors Intelligence bears exceeded bulls for the third week. Such conditions have historically marked short-term bottoms in the past.

 

 

The latest BoA Global Fund Manager survey also shows that managers have gone extremely risk-off, which should be contrarian bullish.

 

 

 

Fed expectations

Chartists can analyze all the sentiment and technical charts they want, but the inescapable reality is the market is nervous over the course of Fed policy and the inflationary effects of the supply chain disruptions of the Russia-Ukraine war. If you can predict those outcomes, you can predict the market.

 

Here is how interest rate expectations have evolved. Coming into the FOMC meeting, Fed Funds futures was discounting a quarter-point rate hike at the March meeting, a half-point rate hike at the May meeting, and a total of 1.75% for 2022.

 

 

The Fed raised rates by a quarter-point, as expected and acknowledged the uncertainty posed by the Russia-Ukraine war in its FOMC statement.

 

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.
In its Summary of Economic Projections (SEP), it revised the 2022 expected core PCE inflation from 2.6% in December to 4.3%. The Fed had been expecting that inflation would fall in 2022 and this upward revision is reflective of the Russia-Ukraine war inflationary disruptions but leaves it wiggle room to turn less hawkish if inflationary pressures ease. The median Fed Funds target at the end of 2022 is now 1.9%, which is consistent with market expectations. In addition, Fed Funds is expected to overshoot the long-run neutral rate in 2023 and 2024.

 

 

In the wake of the FOMC meeting and the Powell press conference, expectations have turned even more hawkish and now expects a total of 2.0% in rate hikes by December.

 

 

Even though the SEP reduced the expected GDP growth rate in 2022, Powell asserted that the economy is strong and recession risks are not especially elevated. The risk is the Fed is tightening into a recession. Indeed is already reporting some softness in the jobs market. Job postings have topped out and begun to roll over. Looking under the hood, the weakness in jobs postings is evident in low-wage jobs, while middle and high-wage job postings have been steady.

 

 

As well, retail sales missed expectations this morning. Real retail sales per capita appear to be rolling over, and this indicator is one of my Recession Watch long-leading indicators.

 

 

While these readings are highly preliminary, this is what an economy that’s peaking out looks like. The  market reacted by collapsing the 2s10s yield curve from 30 bps to 25 bps. I interpret these developments constructively as it is setting Fed policy and expectations to be as hawkish as it can possibly get. The stock market’s ability to hold its gains in the wake of the FOMC meeting is also positive.
 

 

Peace in our time?

The market’s recovery yesterday and today can be partly attributed to hopeful signs that a breakthrough may be near with the Russia-Ukraine negotiations. The geopolitical risk premium is fading, but some underlying worries remain and they are especially evident in China. 

 

Both gold and oil prices have made the round-trip from their recent price spikes, indicating war fears are receding.

 

 

I have remarked in the past that the S&P 500 has held up remarkably well even though it had to contend with a hawkish Fed, a surge in global inflation, and the Russia-Ukraine war. Here’s why. The returns of different regions relative to the MSCI All-Country World Index (ACWI) tell the story. The US stock market has been a relative safe haven during the war. Just take a look at the drop in the relative performance of Europe and subsequent recovery (middle panel) and you can see the volatility and jitters of investors. Emerging markets ex-China has held up well (bottom panel), which is explained by the composition of some EM markets are commodity exporters that have benefited in the price surge while others were hurt by geopolitical and global inflation fears.

 

 

China, on the other hand, is a different story. The Chinese economy has been burdened by the real estate debacle and now the massive COVID lockdowns. Notwithstanding the recent announcement of support measures by Beijing, the relative performance of Asian markets has been equally challenging with the exception of resource-rich Australia.

 

 

China’s pro-market pledges overnight were obviously helpful to the market as Asian markets affected a risk-on reversal. But none of that matters if China were to help Russia in the war. The West will be forced to sanction China into the ground. Beijing knows this. If the war drags on, China, the US, and the EU will be playing a high-stakes game of chicken.

 

 

The news from the front

In short, the short-term fate of risk appetite depends on how the war evolves. The Russian advance has been stalled for days, though they have made some progress in the south. The Russian military continues to be constrained by logistical problems. This map of Ukraine shows a group of almost equidistant road-linked thrusts stretching from Russia and Belarus into Ukraine illustrates the Russian Army’s supply-constrained advance. This War on the Rocks analysis indicated the average Russian unit has a truck lift to take it to 90 miles (140km) from the closest large supply dump (see below). You would have to double the trucks on hand to get to 180 miles. The only exception is the black arrow on the map, where the Russians appeared to have doubled their transportation allocation in order to reach the eastern edge of Kyiv.

 

 

A Twitter thread by retired Australian Major General Mick Ryan summarizes the situation. The Russian Plan A was a lightning thrust to take over Kyiv and the government within a couple of days, which didn’t work. The Russians turned to Plan B, which “features lots more firepower, as well as destruction of smaller cities to set an example for Kyiv”. 

 

Plan B has not worked out either. They have slowly gained ground, but at massive cost in personnel & equipment. At the same time, rear area security has suffered. This is obviously a trade off by the Russians so they can push forward as much combat power as possible.

 

But rear area security is a significant mission, and normally absorbs thousands of troops (infantry, air defence, cavalry, engineers, etc). Because the Russians have incompetently executed this mission, there have been constant ambushes against logistics convoys.

 

These ambushes on logistics convoys are another source of attrition in personnel, supplies and equipment to add to combat losses, and (if it is to be believed) combat refusals and desertions from Russian troops.
The Russians have now committed all of their pre-positioned invasion force, and Plan B is making only slow progress. Ryan concluded:

The Russian campaign, if it has not already, is about to culminate. US doctrine defines this as (for offense) “the point at which continuing the attack is no longer possible and the force must consider reverting to a defensive posture or attempting an operational pause.”

They are now mobilizing more reserves, which are of lower troop quality, and recruiting mercenaries from Syria as part of Plan C.

Plan C might be described as: hold current gains, long range firepower on cities, foreign fighters as cannon fodder, destroy as much infrastructure and manufacturing capacity as possible, expand the war to the west to deter foreign volunteers & aid providers.

While that represents Ryan’s assessment of the facts on the ground, it may serve both sides to reach a peace agreement in order to halt hostilities and the pain on both sides. The Financial Times reported that “Ukraine and Russia have made significant progress on a tentative 15-point peace plan including a ceasefire and Russian withdrawal if Kyiv declares neutrality and accepts limits on its armed forces, according to three people involved in the talks.” However, Ukrainian officials downplayed the reports of progress as “more positive tone from Russia was more about Moscow wanting sanctions pressure eased, calling it a “smoke curtain.”
 

We are now at the “the trade talks are going very well” phase of the market. Much is at stake. The disintegration of the European economy and global supply chain disruptions could continue, which will lead to inflationary pressures that force the Fed to tighten until the economy falls into a recession. In addition, there is the Beijing wildcard. Will China actively support Russia with supplies for its war and risk sanctions, which would tank its economy?
 

Stay tuned. War-related developments cannot be predicted by any charting or sentiment indicators. The market is recovering from a deeply oversold condition, but the environment remains volatile and there will undoubtedly be opportunities for both bulls and bears ahead.
 

 

Disclosure: Long TQQQ

 

Beware the Ides of March

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

 

No lack of volatility

This stock market certainly does not lack volatility. The VIX Index underwent a recent series of upper Bollinger Band rides (shaded zones) while exhibiting positive RSI and MACD divergences. 

 

 

The next known source of volatility starts on March 15, the Ides of March, as the FOMC convenes for its regularly scheduled meeting. 

 

 

Fearful sentiment

Sentiment models remain in the fear zone this week. The AAII bull-bear spread is under -20, which constitutes a buy signal indicating a high level of anxiety.

 

 

The Investors Intelligence bull-bear spread is also negative, which is another contrarian bullish signal.

 

 

Keep an eye on the VIX Index. The VIX closed Friday at 30.75, which makes 10 consecutive days above 30. Bill Luby at VIX and More observed that a recycle below 30 is historically bullish, though the buy signal hasn’t been triggered yet.

 

 

 

Can Europe show the way?

You can tell a lot about market psychology by the way it reacts to the news. European stocks, which are the most sensitive to Russia-Ukraine war news, traced out a bullish island reversal on high volume last week when hopes rose that a ceasefire to evacuate civilians would be declared. The market retreated when ceasefire negotiations fell apart, but the island pattern remained intact.

 

 

Gold has acted as a risk-off asset during this crisis and GLD printed a bearish island reversal last week. I interpret this as an encouraging sign for the bulls.

 

 

 

The news from the front

I may be clutching at straws, but there are some glimmers of hope from the developments in the war. An Estonian journalist recounted a discussion with an Estonian military analyst in a Twitter thread. The conclusion: “The danger is far from over but there is reason for a very cautious optimism. Russian advance has clearly stalled.”
Since last [Saturday] it’s been relatively stable on the fronts. There is an expectation of a reforming of RU units and a new line of attack, but so far little evidence of it. “If Russia doesn’t achieve a remarkable advance by end of week, difficult to see how it should come at all.”

 

The [southern] line of attack has split in 2, one advancing twd  Mykolaiv, the other to Kryvyi Rih. This is serious risk to RU forces as the supply lines, which we already know are crap, will be dragged even longer. “This leaves the Ukrainians plenty of chance to ‘beat them to pieces’.

 

The question is if Moscow today forces Lukashenko to send in the troops from Belarus, but BY troops’ motivation is even lower than that of RU. “The Western-Ukrainian national & anti-Russian environment would be extra hostile towards them.”

 

The idea of bringing in Syrian fighter is extra desperate. “One thing is to fight in the narrow streets of Arabian cities. It’s something else in Kyiv or Kharkiv where the boulevards are 100m wide.” Also refers to cold climate and low morale of Syrians.

 

About possible mobilization in RU. That was on the agenda last Friday in Fed Council and duma but allegedly high-ranking military re-convinced Putin. “Reserve units have no training, they even don’t have enough uniforms for them.”

 

“They’ve included very few reservists in Zapad exercises. Of the few thousand they usually include, the officers complain about them “messing up” the exercise.”

 

Fatigue of RU units “massive”.  A third has been replaced, but incoming units have even worse quality. Another third has been destroyed, killed or wounded. Re-formation of units doesn’t have a good impact on combat capability.

 

Ukraine’s counter-offensive has so far been small-scale but when RU stalls, they have resources to start pressing. First aim would be to drive RU out of country in the North (Kyiv and Kharkiv). It will be more difficult to gain back ground in South, also because of terrain. “In steppe you will be an open target from air.”

 

Regarding Russia’s shortage of missiles. “Putin was told he had 10,000 missiles. In fact, he had 1,000. It’s peculiar he didn’t remember how he was lying to his own bosses as a young KGB officer. Such lying is common in the culture.”
In addition, Fortune reported that two hardcore pro-Putin guests, Karen Shaknazarov and Semyon Bagdasarov, appeared on a Russian prime time TV talk show and acknowledged the impact of sanctions, military failures, and called for an end to the invasion. This is a pre-taped TV show and is usually carefully orchestrated. Their remarks sound like the Russian elite showing their dissatisfaction with the war and looking for an exit ramp.
The first criticism came from Karen Shakhnazarov, a filmmaker and a usually reliable state pundit who had previously signed a letter in support of Putin’s annexation of Crimea. But on Solovyov’s show, Shakhnazarov said, “I have a hard time imagining taking cities such as Kyiv. I can’t imagine how that would look,” and noted that Putin’s invasion risked isolating Russia.

 

He called for an end to the conflict, the Telegraph reported, saying, “If this picture starts to transform into an absolute humanitarian disaster, even our close allies like China and India will be forced to distance themselves from us.”

 

He added, “This public opinion, with which they’re saturating the entire world, can play out badly for us…Ending this operation will stabilize things within the country.”

 

Later during the broadcast, Semyon Bagdasarov, a Russian member of parliament, also criticized the invasion of Ukraine, and likened it to Afghanistan, an embarrassing military blunder for Russia that some analysts believe was a catalyst for the fall of the Soviet Union.

 

“Do we need to get into another Afghanistan, but even worse?” Bagdasarov asked, adding that in Ukraine, “there are more people, and they’re more advanced in their weapon handling.”

 

“We don’t need that. Enough already,” he said.
Shakhnazarov added that the Russian army has achieved its goals. Donbas is “liberated”. NATO only benefits from the protracted conflict. He called for an end to the operation. In other words, declare victory and go home.

 

These developments are encouraging. We have seen that even the hint of a ceasefire has sparked strong equity rallies. The news of a deal would be the catalyst for a melt-up. However, the risk is a stall in the Russian advance could provoke further escalation, such as the use of chemical weapons, in the war. Such a development could spook the markets even more.

 

 

Fed policy expectations

As the FOMC prepares to meet in the coming week, Fed Funds futures expectations have turned even more hawkish. The market now expects the equivalent of seven quarter-point rate hikes by December.

 

Have market expectations become too hawkish? In light of the stock market’s inability to fall further in the face of bad news, is sentiment washed out?

 

These are all good questions. This cycle is very different from the working experience of most investment managers. Reported inflation has spiked to a 40-year high, pressures are global, and inflationary expectations are also rising. On top of that, the supply shock from the Russia-Ukraine war is creating a high level of uncertainty. The stock market has held up remarkably well in light of these risks.

 

Traders will have to weigh the constructive signals from technical and sentiment indicators against the risk of further escalation in the war. Investors should remain cautiously positioned, as the Fed cycle will dominate intermediate-term equity price trends. Traders can play the odds and tilt bullish, but be mindful of the risks and size positions accordingly.

 

 

Disclosure: Long TQQQ

 

Not your father’s commodity bull

Posted by Cam Hui -

Some chartists have recently become excited over the commodity outlook. Setting aside the headline-driven rise in oil prices, the long-term chart of industrial metals like copper looks bullish. Copper is tracing out a cup-and-handle pattern breakout that targets strong gains in the years ahead. Moreover, the one-and the two-year rate of change, which is designed to look through the effects of the COVID Crash, are elevated but not out of line with past bull phases.
 

 

The point and figure chart of copper appears equally impressive. The measured target on a point and figure breakout is an astounding 9.50, which is over a double from current prices.

 

 

Is this the start of a new commodity bull? I would argue that this is not your father’s commodity bull market.

 

 

Bullish chart patterns

The chart patterns of commodity-related equity sectors look equally impressive. Energy stocks are already in both absolute and relative uptrends.

 

 

Global mining stocks are testing resistance while forming a saucer-shaped base, and they have already staged a relative breakout when compared to the MSCI All-Country World Index (ACWI).

 

 

The agribusiness industry has also staged an upside breakout from a long base, and the relative breakout is also evident.

 

 

 

Demand destruction ahead

While I love a commodity bull story, there’s a difference between a healthy bull and a destructive one. We are headed for the latter. Commodity bull markets are caused by a supply/demand imbalance. A healthy bull stems from demand outstripping supply. 

 

On the other hand, a destructive bull is caused by a shock of supply withdrawal. If supply can’t come online quick enough, prices must then rise to the point of reducing demand.  That’s a destructive bull market because it’s unsustainable. Prices spike and then crash as consumers pull back on demand.

 

Here is what a supply shock looks like. The relative performance of cyclical industries tells the story. The relative returns of oil and gas extraction and mining stocks have suddenly spiked, but the relative returns of other cyclical industries are range bound. In a healthy bull, strong cyclical demand should be lifting all boats. Instead, this is a picture of a supply shock related to the Russia-Ukraine war.

 

 

A long-term analysis of the CRB Index shows that it staged an upside breakout through a falling trend line (dotted line) but it is approaching a key resistance level. The one and two-year rates of change are highly extended by historical standards.

 

 

The commodity price spike is also causing dislocations in the financial markets. Nickel prices soared to as much as $100,000 per tonne on the LME before the exchange suspended trading last week. Chinese tycoon Xiang Guangda, who controls the world’s largest nickel producer, Tsingshan Holding Group, had built a large short position in nickel futures and is rumored to have incurred losses of as much as $2 billion at the price peak of $100,000. The company later secured a bank lifeline and prices stabilized in Shanghai, though the LME nickel market remains suspended.

 

 

Imagine the panic if this had happened in wheat or corn and the hedger was a Russian or Ukrainian producer that couldn’t meet its margin calls.

 

 

A hawkish Fed

The commodity price spike puts the Fed in an uncomfortable position. The February CPI print was in line with market expectations, but headline CPI reached a 40-year high and it is expected to rise further owing to the strength in energy and food prices. As a consequence, Fed Funds futures have turned even more hawkish. The market now expects rate hikes totaling 1.75% by the December FOMC meeting.

 

 

The silver lining is that energy intensity has fallen dramatically since the Arab Oil Embargo price shock of the 1970’s. Energy expenditures as a percentage of PCE (blue line) and gasoline prices to average hourly earnings as a measure of affordability (red line) have both risen but levels are not extreme compared to their own histories.
 

 

However, inflation expectations are rising and they are at risk of becoming unanchored. Jerome Powell is on record as willing to drive the economy into recession in a Volcker-like manner. Is a recession ahead? When will the Fed stop?

 

 

Even Paul Volcker was cognizant of financial stability risk – and the first task of central bankers is to be financial firefighters. Don’t forget that the Volcker Fed eased policy in response to the Mexican Peso Crisis in August 1982.

 

The accompanying chart is a history lesson of that era. The DJIA, which was the market benchmark of that period, topped out in 1981 as the Fed tightened policy and raised rates. The share price of Citigroup, which is representative of the banking group, topped out with the Dow and began a slow descent as financial conditions deteriorated. Cyclical indicators such as the platinum-gold spread, which was relevant because both metals had precious metal components but platinum also had an industrial use in automotive catalytic converters, topped in early 1980 and fell negative. When Mexico announced that it couldn’t meet its debt obligations and devalued the Peso, financial stress spiked and threatened the stability of the US banking system. The Fed responded by easing policy and that incident marked the beginning of a long equity bull.

 

 

Fast forward to 2022. How far is the system from a Mexican Peso Crisis moment? To be sure, yield spreads are rising as financial stress increases, but readings are nowhere near crisis levels. Don’t expect the Powell Put to be activated under the current conditions.

 

 

 

An unexpected supply shock

In summary, the latest spike in commodity prices should be interpreted as an exhaustive move instead of the start of a new bull cycle. It is a supply shock that should resolve with demand destructive in the coming months, which implies a slowdown in economic activity. The yield curve is flattening quickly, indicating market expectations of an economic slowdown.

 

 

I had highlighted last September a different source of stagflation risk. Former Fed economist Claudia Sahm (of Sahm Rule fame) observed that the risk is “supply chain disruptions became more frequent as climate change disasters become more commonplace”. Little did I expect the supply chain disruption would come from a war. As an illustration, a recent Financial Times article reported that Volkswagen warned that the economic damage from the war could be even worse than the pandemic.

 

Much will depend on how the war develops and the evolution, the effects of the accompanying sanctions, and how governments react to shortages.

 

In conclusion, the recent strength in commodity prices is exhaustive and not the start of a secular bull trend. Treat any narrative of a new commodity bull or super cycle with caution. To the extent that investors hold or overweight energy and mining stocks, consider rotating into long duration Treasury bonds in anticipation of a bond market rally as the economy slows.

 

 

A double bottom?

Posted by Cam Hui -

Mid-week market update: The S&P 500 put in a potential double bottom when it tested its recent lows while exhibiting a positive RSI divergence. Stock prices rallied on the news of a ceasefire in order to allow civilians to evacuate.
 

 

Is this a durable bottom?

 

 

News from the front

The market has been extremely war headline sensitive and it’s impossible to discuss risk appetite without discussing the war. While I am no military analyst, here is a summary of what is known from open intelligence (OSINT) sources.

 

Here is the good news. Both sides are talking and there is some movement in position. Initially, the Russians had demanded total surrender and regime change when the invasion began. Early this week, the Kremlin softened their position to:
  • A constitutional change that Ukraine would not join any blocs, i.e. EU or NATO;
  • Ukraine recognizes the breakaway regions become independent republics; and
  • Ukraine cedes Crimea to Russia.
Zelensky responded with a willingness to negotiate on the status of the breakaway regions and conceded that NATO is not ready to accept Ukraine as a member but sought security guarantees for a settlement. AP also reported that Russia says negotiations with officials from Kyiv to resolve the conflict in Ukraine were making headway and underscored that Russian troops were not working to topple the Ukrainian government.

 

While there is still a large gulf between the two sides, a narrowing of positions is constructive.

 

As for the war, both sides are facing different pressures. Russian forces have significantly underperformed expectations and the Ukrainians have put up strong resistance. Moreover, Ukraine has been winning the information war by highlighting Russian failures and losses, though Russia recently stepped up its information campaign by claiming that Ukraine was developing a dirty bomb and the US had a dangerous bio lab on Ukrainian soil.

 

 

The Russian advance has been largely stalled in the past few days owing to supply and logistical constraints. However, Russian forces have made slow but methodical progress in their advance and changed to a strategy of pummelling cities with artillery and airpower without regard for civilian casualties. In the north, the Russian goal is the encirclement of Kyiv in order to lay siege to the city. In the south, Mariupol is surrounded and isolated. Its eventual fall will free up Russian forces to pivot north in a pincer movement to cut off Ukrainian defenders in the Donbas region. A negative surprise is on the horizon and the southern and eastern front could collapse in the coming days.

 

On the other hand, this is the first large-scale offensive undertaken by the Russian Army since World War II. For some perspective on distances, the Russia-Ukraine border is roughly equivalent to the US-Canadian border from the Pacific Ocean to Wisconsin. The Russian Achilles Heel is supply logistics and Ukrainian forces have been successful in disrupting Russian supply lines. A commentary by Alex Vershinin, written in November 2021, focused on the Russian Army’s supply constraints as envisaged by NATO planners in case of an attack into NATO territories such as Poland or the Baltic States. Simply put, Russian forces are tied to their railroads for supply support:

Russian forces are tied to railroad from factory to army depot and to combined arms army and, where possible, to the division/brigade level. No other European nation uses railroads to the extent that the Russian army does. Part of the reason is that Russia is so vast — over 6,000 miles from one end to the other. The rub is that Russian railroads are a wider gauge than the rest of Europe. Only former Soviet nations and Finland still use the Russian standard — this includes the Baltic states.

Russian forces have a much smaller logistical tail compared to western forces.

Russian army logistics forces are not designed for a large-scale ground offensive far from their railroads. Inside maneuver units, Russian sustainment units are a size lower than their Western counterparts. Only brigades have an equivalent logistics capability, but it’s not an exact comparison. Russian formations have only three-quarters the number of combat vehicles as their U.S. counterparts but almost three times as much artillery.

The Russians don’t have enough trucks, and Ukrainians have been ambushing supply truck convoys.

The Russian army does not have enough trucks to meet its logistic requirement more than 90 miles beyond supply dumps. To reach a 180-mile range, the Russian army would have to double truck allocation to 400 trucks for each of the material-technical support brigades. To gain familiarity with Russian logistic requirements and lift resources, a useful starting point is the Russian combined arms army. They all have different force structures, but on paper, each combined army is assigned a material-technical support brigade. Each material-technical support brigade has two truck battalions with a total of 150 general cargo trucks with 50 trailers and 260 specialized trucks per brigade. The Russian army makes heavy use of tube and rocket artillery fire, and rocket ammunition is very bulky. Although each army is different, there are usually 56 to 90 multiple launch rocket system launchers in an army. Replenishing each launcher takes up the entire bed of the truck. If the combined arms army fired a single volley, it would require 56 to 90 trucks just to replenish rocket ammunition. That is about a half of a dry cargo truck force in the material-technical support brigade just to replace one volley of rockets. There is also between six to nine tube artillery battalions, nine air defense artillery battalions, 12 mechanized and recon battalions, three to five tank battalions, mortars, anti-tank missiles, and small arms ammunition — not to mention, food, engineering, medical supplies, and so on. Those requirements are harder to estimate, but the potential resupply requirements are substantial. The Russian army force needs a lot of trucks just for ammunition and dry cargo replenishment.
 

For fuel and water sustainment, each material-technical support brigade has a tactical pipeline battalion. These have lower throughput than their Western equivalents but can be emplaced within three to four days of occupying new terrain. Until then, fuel trucks are required for operational resupply. 

The UK estimates that the war costs the Kremlin about £1 billion a day, which is a strain in light of the severe sanctions imposed by the West. The latest briefing from the Pentagon indicates that the Russians have committed roughly all of the forces arrayed at the beginning of the invasion, which is about 190K troops, which amounts to roughly 55% of all available ground troops. This compares to about 24% of US ground force commitment for the invasion of Iraq during Gulf War II. Retired Australian Major General Mick Ryan wrote:

In military operations, casualties and fatigue, as well as equipment losses, wear and tear, will decrease force strength over time. Rotation of forces is necessary for any missions of even medium length duration. Humans can only fight for so long before becoming non-effective.

While Kyiv is at risk of encirclement, current Russian force strength in the north is insufficient to create an effective cordon around the city. Most military analysts estimate that it would take about half of all  Russia’s invading forces to encircle Kyiv, which would be a stretch in light of military operations in the rest of Ukraine. Add to that the necessity of force rotation, the Russian High Command faces a problem. On the other hand, Ukrainians are receiving western aid in the form of anti-tank missiles and other weaponry, as well as a reported 40K foreign volunteers to help defend Ukraine. It’s a race against time to see if Ukrainian forces can hold out before Kyiv is besieged.
 

In summary, the Ukrainians are exposed militarily but the Russians are close to exhaustion and vulnerable to supply disruptions. If there is no settlement, this could be a long war that could last years. Western sanctions are certain to bite well before then and the Kremlin will face both military and domestic political problems.
 

Both sides have strong incentives to settle.
 

 

Short-term equity outlook

What does this mean for the stock market? One hint can be found in the price action of European stocks, which are the most sensitive to the Russia-Ukraine war. The Euro STOXX 50 ETF (FEZ) traced out a bullish island reversal similar to the ones seen in November 2020, July 2021, October 2021, and December 2021. The odds are that the latest reversal will also resolve in a bullish manner, which should positive for all risk assets.
 

 

Jeff Hirsch at Almanac Trader pointed out that the market has tended to weaken early in March and find a bottom around the sixth trading day of the month, which is today. The subsequent trend has been choppy but exhibited a bullish bias until the end of the month. 
 

 

That sounds about right. Tomorrow morning’s CPI release and next week’s FOMC meeting promises to be sources of potential volatility.
 

In conclusion, stock prices have likely reached a short-term bottom, but the coming weeks could still be treacherous. My inner investor remains cautious, but my inner trader is still long risk.
 

 

Disclosure: Long TQQQ

 

Panicked enough for a relief 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 bsoe found here.

 

 

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

 

 

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

 

Scared enough?

Are you scared enough? The market is extremely jittery. News last week of a Russian attack that started a fire at a Ukrainian power plant sparked a risk-off episode. Further sober analysis revealed that the incident was under control and there was no radiation leak. Worries about the incident sparking a second Chernobyl disaster are overblown.

 

Two weeks ago, the AAII weekly sentiment survey showed the bull-bear spread had fallen to -30, but it rebounded last week to -11. Readings of -30 are rare and they have only been lower during the bear markets of 1990 and 2008 (shown in pink). These levels weren’t even seen in the wake of the Crash of 1987. In all cases, they signaled short-term bottoms.

 

 

The key question for investors is whether current conditions represent a durable market bottom, or just a bear market rally.

 

 

Rising fear = Bullish confirmation

The AAII buy signal is confirmed by readings from other sentiment models. The NAAIM Exposure Index, which measures the sentiment of RIAs, fell below its 26-week Bollinger Band. In the history of the NAAIM data series, such extreme conditions have been useful signals that downside risk is limited short-term and risk/reward is tilted to the upside. These buy signals, however, are not indications of a durable intermediate-term bottom, as evidenced by their behavior during the GFC bear market.

 

 

I could write about the elevated level of the VIX Index as an indication of market anxiety. Instead, I would point out that the MOVE Index, which measures the implied volatility of the bond market, is also high. For some context, a reading of 120 on MOVE implies a daily change of 7.5 bps every day for the next 30 days.

 

 

As well, does this cover from the Economist represent the peak of war hysteria, which would be a contrarian magazine cover indicator? Asking for a friend (see Wars are equity bullish, but there’s a catch).

 

 

Lastly, Mark Hulbert recently published a Marketwatch article, “The end (of the stock market correction) may be near”.
 

The end of the stock market’s correction may be near.

 

That’s because I just received an email from a prominent money manager declaring that “buy and hold is dead.” Like the first robin of spring heralding warmer weather around the corner, emails such as this one are a contrarian signal that the tide is about to turn.

 

That’s because the relative popularities of market timing and buying-and-holding follow a fairly predictable cycle. Buying and holding will be at its most popular at market tops and least popular at bottoms. Just the reverse will be the case for market timing.

 

 

A bear market rally

Sentiment model readings aside, I would argue that the intermediate-term trend is still down, but the stock market is poised for a bear market rally. I had highlighted the sell signal flashed by the negative RSI divergence by the Wilshire 3000. Such signals have led to significant drawdowns in the past.

 

 

I also pointed out in the past the S&P 500 underwent a “good overbought” rally off the March 2020 bottom, as shown by the percentage of stocks above their 200 dma rising to 90% on a persistent basis (top panel). The momentum of that advance faded in mid-2021 when the indicator fell below 90%. There have been four similar episodes of “good overbought” rallies in the last 20 years. All of them did not end until the percentage of stocks above their 50 dma fell below 20% (bottom panel). That condition has not occurred yet.

 

 

Here’s another reason why I am bearish. The Russian ETF RSX is trading at $5.65. Notwithstanding the fact that the Ruble has crashed, the underlying stocks in Moscow are halted, though the ETF holds GDRs which do trade in London, the last reported NAV is $0.89! There’s still too much bullishness.

 

 

 

Poised for a rally

In the short run, the S&P 500 is poised for a counter-trend relief rally. The stock/bond ratio exhibited a series of positive RSI divergences, which is constructive.

 

 

Fundamental momentum is supportive of an advance and, at a minimum, should put a floor on stock prices. Forward 12-month EPS estimates are still rising and there is no signs of earnings estimates declines that have accompanied past market downdrafts.

 

 

In conclusion, the stock market is poised for a counter-trend relief rally in the context of an intermediate-term downtrend. Investment-oriented accounts should stay cautious and take advantage of any market strength to reduce equity weights. Traders can position for the rally, which is often brief but violent in bear markets.

 

 

Disclosure: Long TQQQ
 

An energy and geopolitical recession?

Posted by Cam Hui -

Much has happened in the space of a week. In the wake of Russia’s Ukrainian invasion, the West has responded with a series of tough sanctions designed to tank the Russian economy. Energy and other commodity prices have soared and this is shaping up to be another energy and geopolitical crisis. The last three episodes resolved in recessions, which are equity bull market killers. Fourth time lucky?

  • The 1973 Arab Oil Embargo
  • The 1979 Iranian Revolution
  • The 1990 Gulf War
  • The 2022 Russia-Ukraine Energy Shock (?)
The backdrop sounds dire. Nouriel Roubini recently warned of stagflation in a Project Syndicate essay. An analysis from Oxford Economics shows that the shocks will hit the Russian economy, but Europe will not be spared. The US is expected to see the least negative impact from the Russia-Ukraine energy shock.

 

 

As the Fed embarks on its tightening cycle, it faces a nightmare stagflation scenario of higher energy and commodity prices pressuring inflation and falling economic growth. 

 

 

How sanctions hurt Russia

In response to the Russian invasion, the West collectively agreed to exclude major Russian banks from SWIFT. More importantly, the Russian central bank, Bank of Russia (BoR), will be blocked from its assets held in the West.

 

Zoltan Pozsar, a money market analyst at Credit Suisse, warned that “supply chains are payment chains in reverse” and explained these sanctions matter to the global financial system in a recent research note.

Today we’ll say that all global payments go through SWIFT (including payments for commodities) and so exclusions from SWIFT will lead to missed payments everywhere again: the virus froze the flow of goods and services that led to missed payments, and war has led to exclusions from SWIFT that will lead to missed payments again. But by design, and not without a risk of retaliation: if a freeze in activity can lead to missed payments, an inability to receive payments through SWIFT can freeze the flow of goods, services, and commodities like gas or neon in kind.

In the double-entry accounting world, someone’s asset is someone else’s liability. Freezing or blocking access to Russian assets can create a problem on the other ledger on the balance sheet. Let’s unpack the effects.

 

The BoR reported that it has $630 billion in FX reserves as of February 18, 2022. The report is no longer available on the BoR website but a screenshot was saved by Matthew Klein at Barron’s. 

 

 

The asset mix breakdowns show 23.3% in gold and 12.8% in RMB, which totals 36.1% that’s out of the reach of sanctions. In practice, Treasury Secretary Janet Yellen recently announced that roughly half of BoR assets were immobilized. Regardless of implementation details, Western sanctions have turned Russia’s vaunted FX reserves into a financial Maginot Line. 

 

 

 

How sanctions hurt the West

While blocking BoR assets and cutting Russian bank access to SWIFT may sound good in theory for policy makers to tanks the Ruble and sparks hyperinflation in Russia, the West will nevertheless have to deal with a number of unintended consequences. 

 

The most important consideration is the possible loan losses and losses from the possible Russian nationalization of banking subsidiaries. According to the latest BIS figures dated September 2021, the four largest countries most exposed to Russia are France ($23.6 billion), Italy ($23.2 billion), Austria ($17.1 billion), and the US ($14.5 billion). Austria’s exposure is mostly accounted for by Sberbank Europe, which leaves the French and Italian banks with high exposures to Russian assets. CNBC reported that Citi flagged $5.4 billion of exposure to Russia, which represents 0.3% of its assets, though it’s unclear how much of that was in its subsidiary Citibank Russia. Is it any wonder why financial stocks are skidding?

 

 

As for Russian energy exports, the US Treasury has issued guidance to exempt this category from sanctions. That said, sanctions on the export of oil field service equipment to Russia will hobble production capacity in the long run.

Treasury remains committed to permitting energy-related payments — ranging from production to consumption for a wide array of energy sources — involving specified sanctioned Russian banks. To help protect Americans, partners, and allies from higher energy prices that would drive more resources to Russia, Treasury swiftly issued and updated Russia-related guidance to allow U.S. financial institutions to continue processing these transactions and underscore that such activity is not prohibited by sanctions.

 

 

The Fed’s dilemma

For investors, the Fed cycle is still the center of all attention. In the face of the conflict, the Fed faces a dilemma. Fed Chair Jerome Powell made the following points in his Congressional testimony last week:
  • The labor market is extremely tight.
  • Inflation increased sharply last year and is now running well above the Fed’s longer-run objective of 2%.
  • The Fed continues to expect inflation to decline over the course of the year as supply constraints ease and demand moderates.
  • The near-term effects on the U.S. economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain.
  • The process of removing policy accommodation in current circumstances will involve both increases in the target range of the federal funds rate and reduction in the size of the Federal Reserve’s balance sheet.
Here is the Fed’s dilemma. Economic growth is skidding. The Atlanta Fed’s GDPNow nowcast of Q1 growth is 0.0%.

 

 

The yield curve is flattening, indicating expectations of slowing economic growth.

 

 

On the other hand, commodity prices are surging, which puts upward pressure on inflation. Fitch warned that higher prices can have a self-reinforcing effect on inflation. While the Fed expects inflation pressures to fall as supply chain bottlenecks ease this year, higher commodity prices will make the projection of a core PCE rate of 2.6% by year-end difficult to achieve.
Inflation is a dynamic process and can be self-reinforcing. Energy price shocks related to geopolitical events exacerbate risks. Various scenarios could see inflation stay high through 2022. If core inflation were to remain high or increase further and inflation expectations started to become de-anchored from targets, this could prompt swift moves from central banks.
These conditions are laying the foundation for a stagflationary environment. Growth is slowing, but inflation pressures are still strong. Conventional thinking dictates that the Fed continues to tighten and drive the economy into recession in order to meet its price stability mandate.
 

That seems to be the path the Fed is on. In his Congressional testimony, Powell set a course for raising rates. While the Fed projects inflation to cool off this year, persistent higher commodity prices poses a problem for monetary policy. Powell concluded, “We will use our policy tools as appropriate to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and a strong labor market.”

 

Powell also voiced concerns about how commodity price increases would feed an inflation spiral during his Senate testimony: “Commodity prices have moved up, energy prices in particular. That’s going to work its way through the U.S. economy. We’re going to see upward pressure on inflation, at least for awhile. We don’t know how long that will be sustained for.”

 

To reinforce his inflation concerns, Powell underlined the point that he is willing to drive the economy into recession to control inflation (see link to video). 

 

 

Keep an eye on inflationary expectations. The 5×5 inflationary expectations are well anchored for now. Should they become unanchored, Cleveland Fed President Loretta Mester stated in an interview that the Fed may have to raise rates to above the neutral rate, which she defined as between 2.0% and 2.5%. 

 

 

 

Rising stagflation fears

The financial markets are already beginning to discount stagflation risk. When the stock market weakened in late January, insider buying briefly ticked up, which was a constructive sign for equities. But when the market weakened again to test the January lows as geopolitical risk rose, insiders did not step up to buy. In effect, insiders are discounting a significant growth slowdown.

 

 

Bloomberg Economics sketched out three scenarios of how this crisis could resolve itself. Much depends on how energy and commodity supply disruptions play out. In all cases, the impact of the sanctions is the worst in Russia, moderate in Europe, and the least for the US. The best-case scenario, in which oil and gas keep flowing and markets calm down, sees a tanking Russian economy, a European slowdown, and a steady Fed tightening cycle. The worst-case resolves in 1970’s style stagflation and a synchronized global recession. There are no bullish outcomes.

 

 

Although the outlook appears dire, keep in mind that not all oil price spikes have led to recessions. The accompanying chart shows the two-year rate of change in oil prices (bottom panel), which was chosen to smooth out pandemic related disruptions. Since 1983, there were six price spikes when the rate of change rose above 100% and only three of them resolved with recessions.

 

 

Ed Clissold at Ned Davis Research pointed out that past geopolitical-related oil spikes have tended to be transitory in nature. If history is any guide, commodity price inflation anxiety will peak and begin to fade in about two months.

 

 

In conclusion, the Russia-Ukraine war is unsettling for the risk appetite and asset price outlook. It only accelerates the scenario I outlined several weeks ago (see A 2022 inflation tantrum investing roadmap). The market phases are defined as:
  1. Equity downtrend;
  2. Rising expectations of slowing growth or recession;
  3. Fed easing and recovery.
The market is somewhere in a transition period from phase 1 to 2. Tactically, the market is oversold and it could rally at any time. All it takes is the whisper of a negotiation breakthrough. Investors need to keep in mind that the Fed cycle remains the dominant driving force in stock prices. In the current environment, use rallies to reduce equity weights and overweight defensive sectors in their equity portfolios and slowly increase their weights in high-quality large-cap growth as duration plays in anticipation of falling bond yields and a flattening yield curve.

 

 

As an indication of the quality growth characteristic of large-cap growth stocks, forward estimates of the technology sector’s are still rising. This makes them a refuge for investors as economic growth slows.

 

 

 

Disclosure: Long TQQQ