A key test at neckline support

Posted by Cam Hui -

Mid-week market update: Will the S&P 500 hold support or will it break? The index is once again testing the neckline of a potential head and shoulders pattern while exhibiting a minor positive RSI divergence.
 

 

Here are the bull and bear cases.

 

 

Sentimental bulls

Short-term sentiment models look stretched to the downside, which is contrarian bullish. The bull-bear spread from the AAII weekly survey is at levels that have seen short-term bounces. Readings have only been exceeded to the downside during the GFC and the bear market of 1990. Similar readings were seen during the bear market low in 2002. Investors weren’t even as panicked during the Crash of 1987.

 

 

The latest update of Investors Intelligence sentiment shows a spike in bearish readings which resulted in the bull-bear spread turning negative. These are the kinds of conditions that have signaled previous bottoms.

 

 

 

Sentimental bears

Does that mean it’s time to buy? Not so fast, says Mark Hulbert. His survey of NASDAQ market timing newsletters is not sufficiently bearish for a durable bottom.

 

Many market timers became more bullish during this period, with the HNNSI rising 57 percentage points. Though it has fallen back in recent sessions, it currently stands well above its late January low — at minus 29.7% versus minus 67.2%. The current reading puts the HNNSI at the 15th percentile of the historical distribution, above the 10th percentile which is the upper edge of the zone that in previous columns I have considered to represent excessive bearishness. (See the chart below.)

 

It’s amazing that the HNNSI is higher today than a month ago. Imagine being told in late January that the coming month would experience Russia’s invasion of Ukraine, Russia putting its nuclear forces on high alert, oil prices soaring to an eight-year high and U.S. inflation spiking to a 40-year high. I for one would have guessed that the HNNSI would fall even further — not jump more than 30 percentage points.

 


 

As well, the AAII monthly asset allocation survey reveals a bifurcated result. While the weekly survey is a sentiment survey that asks respondents about their views on the stock market, the monthly asset allocation survey asks what they are doing with their money. The allocation survey shows that equity weights have come down, but weightings are still elevated and there are no signs of panic that were seen at previous major market bottoms.
 

 

 

A bear market rally ahead

So where does that leave us? The market structure of technical deterioration is signaling the start of a bear market. That said, short-term conditions are sufficiently oversold and washed out that a bear market relief rally can happen at any time. Such rallies are usually short but intense in magnitude. The market is volatile because of its geopolitical risk premium and any hint of a ceasefire could send stock prices rocketing upwards.

 

Indeed, two of the four components of the Bottom Spotting Model flashed buy signals yesterday. The VIX Index rose above its upper Bollinger Band, indicating an oversold condition, and the term structure of the VIX inverted, indicating fear.

 

 

Investment-oriented accounts should continue to be cautious. My inner investor is positioned at a neutral asset allocation weight as specified by his investment objectives. 

 

The S&P 500 rallied and unsucessfully tested a resistance level today. My inner trader remains positioned for a tactical market rally. Should the market follow through on today’s bullish impulse, he is looking for the VIX Index to decline back to its 20 dma before taking partial or full profits.

 

 

 

Disclosure: Long TQQQ

 

I’ll never complain about a lack of panic again

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity 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.
 

 

A reversal bottom

Last week, I lamented that the stock market appeared to be fearful, but not panicked. Be careful what you wish for, you might just get it.

 

On Wednesday, the S&P 500 violated a key neckline support level of an apparent head and shoulder pattern. On Thursday, the Russian Army crossed into Ukrainian territory and conducted what Putin called a “special military operation”. Global markets adopted a risk-off tone and S&P 500 futures were down -2.5% overnight. The index opened deeply in the red but recovered strongly on the day on high volume to form a classic reversal bottom.

 

 

If war is what it took, I’ll never ask the market gods for panic again.

 

 

Supportive internals

Market internals are supportive of a bullish reversal. Even though the large-cap S&P 500 briefly violated support, the mid-cap S&P 400 and small-cap S&P 600 both held support, which is a constructive development.

 

 

On an intra-day basis, three of the four components of my Bottom Spotting Model had flashed buy signals, only to see one of the models reverse itself as the VIX Index closed below its upper Bollinger Band.

 

 

 

Supportive sentiment

Even before the shooting began, sentiment models were supportive of a short-term bottom. The AAII bull-bear spread had fallen to -30, which is consistent with signs of panic bottoms.

 

 

II sentiment tells a similar contrarian bullish story. The bull-bear spread had fallen to just above zero and bearish sentiment had spiked to levels that were indicative of panic.

 

 

As well, Macro Charts pointed out that the traded value of put options had spiked and the traded value of call options had plunged.

 

 

 

Selected industries of interest

Here are some indutries to consider in the current heightened geopolitical risk environment.

 

Ukraine is the breadbasket of Europe and the war is likely to curtail production. Instead of buying an agricultural products ETF, I prefer to focus on companies that support the agricultural industry (MOO). The ETF is holding above absolute support and recently staged an upside breakout through relative resistance.

 

 

Another obvious industry is that benefits in the current environment is aerospace and defense, which broke up through a relative downtrend and exhibiting positive relative strength.

 

 

Finally, cyber security stocks represent a group that has been overlooked in the current environment but they are starting to catch a bid. They violated an important relative support level but recently recovered above relative support turned resistance. This is an industry that could show significant potential for outperformance.

 

 

In conclusion, a short-term bottom is probably in, but it’s difficult to predict short-term market fluctuations in the current circumstances. The situation on the ground in Ukraine is highly fluid and a jittery market is highly sensitive to headline risk. 

 

Investors could focus on agriculture (MOO), aerospace and defense (ITA), and cyber security (HACK) for outperformance opportunities in the current elevated geopolitical risk environment.

 

 

Disclosure: Long TQQQ

 

Wars are equity bullish, but there’s a catch…

Posted by Cam Hui -

Four weeks ago, I suggested that investors buy to the sound of cannons. Now that the cannons have sounded, is that still a good idea?
 

Yes, but there’s a catch. A detailed list of past crises from Ed Clissold of Ned Davis Research reveals that stock prices usually rebound strongly after sudden shocks such as war. On average, the DJIA is up 4.2% after a month and 15.3% a year later.

 

 

Here’s the catch. Consider the following: Jeremy Siegel observed that stocks return about 7% real per annum. Supposing your distant ancestors had invested $100 in equities or equivalent at the time of Augustus Caesar and held the investment for the last 2000 years. Your family would be so obscenely rich that it could have rescued the entire global financial system during the GFC with the proceeds of less than one day’s interest. 

 

The key caveat to event studies such as the effects of war and historical analysis of long-term returns is they suffer from survivorship bias. A past study from Credit Suisse of cumulative real returns illustrates the risk from the permanent loss of capital from war and rebellion. Simply put, a lot of people died in very nasty ways and they never lived long enough to enjoy the use of their assets.

 

Exhibit A is Germany, which was extensively involved in both World Wars.

 

 

China and Russia are even more extreme examples of the permanent loss of capital. Had you been living in those countries, the last thing on your mind would have been the value of your investment portfolio. If you were lucky, you escaped with your life.

 

 

 

The inflation fallout

How do these studies apply to the current circumstances? As NATO has repeatedly asserted that it will not militarily intervene and send troops into Ukraine, the tail-risk of a global catastrophe is off the table. Investors can rely on the plain vanilla analysis of how markets reacted in past conflicts.

 

Nevertheless, there are several important fallouts from the current war. As the West rolls out sanctions on Russia, an article in the Economist outlined Moscow’s possible retaliatory steps that could dent the global economic outlook.

Such tougher sanctions would have several drawbacks for the West. They might prompt economic retaliation from Russia, in the form of cyber-warfare or restrictions on the sale of gas to Europe. They would impose direct costs on Western economies. Russia remains the eu’s fifth-largest trading partner, for instance. European banks have $56bn-worth of claims on Russian residents. Cutting Russia off from swift could cause instability in the financial system. And energy bills in Europe would probably rise further. Furthermore, to be truly effective the West would also need to ensure that the sanctions are globally enforced: that means either persuading or coercing Asian countries, including China and India, to abide by them, perhaps by threatening secondary sanctions on them if they refuse. Without this any stronger sanctions regime would be a leaky bucket.

The most obvious problem for investors is soaring energy prices which puts upward pressure on inflation. As Russian troops crossed the line of control, Brent prices spiked to over $100, which will both raise inflation and dent economic growth.

 

Less noticed by the Street is the importance of Ukraine as the breadbasket of Europe. Ukraine is the top global producer of sunflower seed and a major producer of corn, barley, and wheat.

 

 

In short, the war will spark an inflation problem. How will the fiscal and monetary authorities respond?

 

 

Rally around the flag?

It depends on the jurisdiction. The EU had long been a collection of bickering countries, but its response has been remarkably united. The German decision to suspend approval of the Nordstream 2 pipeline was a demonstration that it was willing to bear substantial pain. 

 

Count on a strong fiscal response where Berlin exempts military spending and energy diversification initiatives from eurozone deficit targets. While this is highly speculative, the war will accelerate Europe’s transition to green energy, which is a bullish factor for capital spending and investment in the region. The ECB should cooperate and decline to offset any fiscal expansion with monetary tightening. Peripheral country bond spreads will narrow. We saw this movie before in 2014.

 

The situation across the Atlantic is another matter. It is unclear how much of a rally around the flag effect the US will see in light of the divisions in the American electorate. While both Democrats and Republicans called for the government to support Ukraine, a division is appearing between the supporters of the two parties about the degree of support. A recent YouGov poll sponsored by The Economist reveals an elevated level of opposition to different degrees of military aid and support to Ukraine and divisions between Democrats and Republicans about these issues.

 

 

These divisions in the electorate make a fiscal response, either to offset the inflationary effects of war or increased military spending, less likely. Any rally around the flag effect in America is likely to be far more muted than in Europe. The fiscal drag is projected to be negative and the war is unlikely to move the needle significantly.

 

 

As for the Fed, it continues to be worried about inflationary pressures. Fed Governors Michelle Bowman and Christopher Waller recently suggested a half-point rate hike could be on the table at the March FOMC meeting. The market continues to discount seven quarter-point rate hikes this year.

 

 

In the meantime, the 2s10s yield curve continues to flatten, indicating expectations of a growth slowdown.

 

 

 

Investment implications

In conclusion, buy the war dip is the order of the day in the absence of risk of a total loss of capital from war and rebellion. Take note, however, that macro conditions still dominate in the long run. The Afghanistan War began in 2001 shortly after 9/11, which was in the middle of a recession. While stock prices rebounded, they continued to decline after an initial rebound as economic conditions deteriorated.

 

 

The S&P 500 forward P/E has declined to a more reasonable 18.5, which slightly below the 5-year average of 18.6 but above the 10-year average of 16.7.

 

 

I continue to favor large-cap high-quality growth stocks in the NASDAQ 100, which have become extremely oversold on a normalized historical basis. As economic growth becomes scarce, expect investors to bid up the prices of cash generative growth stocks.

 

 

While the primary focus of my analysis is on regions, countries, sectors, and factors, investors may wish to consider the top half of the RRG chart for FANG+ stocks for inclusion in their portfolios.

 

 

I expect the market will recover from the war scare in a short time, but I reiterate my views from my recent publication (A 2022 inflation tantrum investing roadmap). The Fed is undergoing a tightening cycle. Stock prices will not bottom until the inflation outlook improves and the Fed stops removing monetary accommodation.

 

Buy the market panic for a tactical rebound, but don’t overstay your welcome.

 

 

Disclosure: Long TQQQ
 

Knife catching at a time of war

Posted by Cam Hui -

Mid-week market update: Trying to spot a bottom here is like trying to catch a falling knife – and at a time of war. Here is what I am watching in order to navigate the turmoil.
 

It’s official. We are entering the Biden administration’s “trade talks are going very well with China” phase of market psychology where asset prices respond to every headline in the Russia-Ukraine conflict. Since it’s virtually impossible to predict what’s ahead on the geopolitical front, traders can only focus on technical internals and how stock prices respond to news.
 

Virtually every chartist can see the developing head and shoulders pattern in the S&P 500, but that’s not the entire story and investors should look for signs of confirmation from other indicators.

 

 

 

Becoming oversold

I wrote on Sunday that the market was Fearful but not panicked, now the market is showing signs of becoming both oversold and panic is starting to set in.

 

The Zweig Breadth Thrust Indicator has now reached an oversold condition, which is a constructive sign that the market may be nearing a short-term bottom.

 

 

Another constructive sign is the S&P 500 testing a key support level while exhibiting positive RSI divergences.

 

 

As well, the term structure of the VIX is inverted, indicating strong fear.

 

 

Oversold and panicked markets can become more oversold and panicked. So how can we spot a bottom?

 

 

Cross-asset clues

Here is what I am watching in my cross-asset, or inter-market, analysis.

 

Is the risk-on/risk-off move being confirmed in the safe havens and related plays? As an example, gold, which is a classic safe haven vehicle, is making new highs while exhibiting positive confirmation from RSI indicators. Score one for risk-off.

 

 

The USD is another classic safe-haven play during times of stress. By contrast, the euro is especially vulnerable in the current geopolitical environment. Both are trading sideways.

 

 

Oil prices have been a beneficiary of the geopolitical turmoil. WTI crude recently violated a rising uptrend, indicating its bull move is becoming exhaustive.

 

 

Another sign that the market may be bottoming is the behavior of small-cap stocks. Even as the current Russia-Ukraine episode has clobbered risk assets, small caps are starting to bottom and outperform relative to the S&P 500. Rank that as constructive.

 

 

In conclusion, the weight of the evidence is pointing to the stock market undergoing a bottoming process. While it is poised for a relief rally, headlines will undoubtedly contribute to near-term volatility. Traders who choose to take positions in this market will have to monitor how it reacts to news in order to decide whether a bottom is truly in place.

 

The next test is likely to occur within the next 48-72 hours, when Russian forces cross the line of control into Ukrainian territory. Watch the market reaction.

 

Fearful, but not panicked

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: 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.
 

 

The drumbeats of war

From a purely fundamental perspective, the US equity outlook is mildly bullish. However, rising geopolitical risk premium is unsettling risk appetite. Sentiment surveys such as AAII have fallen into the fear zone. In the past, such readings have resolved in relief rallies.

 

 

While fear levels are elevated, the market is neither panicked nor oversold, which is an indication that there may still be unfinished business to the downside once the market bounce is over.

 

 

Constructive fundamentals

Developments last week have been constructive for equity fundamentals. The release of the January FOMC minutes was a bit anti-climactic. The Fed indicated that it would raise interest rates and it would normalize the balance sheet, but there was no hawkish bombshell as advocated by hawks such as St. Louis Fed President James Bullard. In the wake of the publication of the minutes, Fed Funds futures walked back its expectations for a half-point rate hike at the March FOMC meeting, but it still expects six quarter-point rate hikes in 2022. 

 

 

The other bullish factor for stock prices is the evolution of earnings expectations. Q4 earnings season is nearly over. Both the EPS and sales beat rates are above average and forward EPS estimates are still rising. Fundamental momentum remains strong.

 

 

 

A looming conflict

However, the rising risk of a Russia-Ukraine conflict has left the market nervous. Brent crude prices are in severe backwardation, where the front month price is much higher than the futures price indicating short-term jitters. Readings exceed the levels seen at the first Gulf War, indicating fears of Russian energy supply disruptions.

 

 

Another factor that could keep geopolitical tensions elevated is falling EU electricity prices despite the strength in natural gas. The price decline is attributable to a strong wind season. Falling electricity prices reduces the short-term leverage that Russia has over the EU.

 

 

Historically, shocks involving limited war have had a minor impact on stock prices. Bloomberg identified 18 war-linked events since 1940. The S&P 500 fell -1.5% on the event date and the average total drawdown was -5.4%. If we exclude incidents during recessions, the averages were -1.3% and -4.3%.
 

 

NATO has asserted that it will not send troops into Ukraine. If a conflict were to break out, the equity market impact should be relatively modest based on this historical study. 

 

 

 

Where’s the panic?

Despite the jittery nature of market psychology, the market is neither panicked nor oversold, which is disconcerting. None of the four components of my Bottom Spotting Model have been triggered. The components consist of:
  • VIX Index: Watch for a spike above the upper Bollinger Band.
  • VIX term structure: Watch for inversion.
  • NYSE McClellan Oscillator: Watch for an oversold condition.
  • TRIN: Watch for a reading above 2, indicating involuntary “margin clerk” liquidation.

 

 

The best-case scenario will see a relief rally that tests 50 dma resistance once geopolitical tensions fade. The worst-case scenario is a break of neckline support at about 4300-4330 of a possible head and shoulders pattern, with a measured downside objective of about 3800.

 

Tactically, the market could rally early next week as it is mildly oversold. However, it may need another day of weakness to spark a washout low.

 

Peak Fed tightening anxiety?

Posted by Cam Hui -
The past week saw rising anxiety about a flattening yield curve rise to a crescendo. The 2s10s spread narrowed to as low as 40 bps before recovering and ending the week at 46 bps. Coincidentally, the BoA Global Fund Manager Survey showed an overwhelming majority of respondents hold believe the yield curve will flatten.

 

 

Even though it hasn’t inverted yet, an inverted yield curve has signaled recessions in the past. This raises two key questions for investors.
  1. What’s the near-term outlook for inflation?
  2. Is the Fed willing to drive the economy into a recession in order to fight inflation?

 

 

The Fed’s dilemma

Let’s begin with the good news. The 5×5 inflation expectations (blue line) remains tame, even as current inflation indicators such as core CPI (red line) skyrocket seemingly out of control.

 

 

The bad news is that global central banks are tightening into a slowdown. Global manufacturing PMIs are falling. The percentage of OECD countries with rising leading indicators is tanking.

 

 

Similar evidence of economic deceleration can be found in the US from a variety of sources. This is just one example.

 

 

Against a backdrop of an elevated reading in the monetary policy component of the Economic Uncertainty Index, how does the Fed resolve this dilemma?

 

 

 

The view from Oregon

Well-known Fed watcher Tim Duy of SGH Macro Advisors and the University of Oregon conducted a Bloomberg podcast interview and provided some answers. The podcast lasts about an hour and well listening to in its entirety, but the main points are summarized below.

 

Duy believes the Fed is deeply behind the inflation-fighting curve and unknowingly made a policy error. He characterized the COVID shock as a snowstorm and not a persistent loss of demand. Policy makers did not understand the situation at the time and responded with a full suite of fiscal and monetary stimulus. 

 

As the snowstorm passed, the economy experienced a fairly rapid recovery. Arguably, quantitative easing was not necessary past mid-2020 because financial markets were already functioning well by then. In short, the Fed’s policy error was to pile on too much monetary stimulus. The Fed should have begun to tighten in 2020 as a monetary offset against fiscal expansion.

 

Hindsight is always 20-20. In retrospect, it would have been politically very difficult for the Fed to withdraw stimulus in 2020 in the midst of a COVID shock, especially when no vaccines or treatments were in sight.

 

As the economy stabilized and vaccines began to become available, successive COVID waves saw less and less economic impact. The economy experienced a strong jobs market recovery, it led to growing inflationary pressures that the Fed was late to spot.

 

As a consequence, Duy believes inflationary pressures have embedded in psychology. The Fed needs to get rates up to neutral quickly, which amounts to about 150bp by year-end. 

 

The challenge is to break a nascent psychology that’s leading to an inflationary spiral. Companies have shown that customers are willing to accept price increases in response to rising input costs. This is leading to more and more inflationary pressures. 

 

The traditional way of breaking an inflationary spiral is through the wage growth mechanism. Historically, wage growth expectations are very sticky. Unless the Fed can guide expectations back down, it will have no choice but to induce a recession to crater wage expectations.

 

The optimal outcome is a series of rate hikes, followed by a moderation of inflation back to 2%, and a tight jobs market.

 

What about the Fed Put? Duy said that any Fed Put exists mainly for the credit markets, not the stock market. The Fed doesn’t care very much if stock prices fall unless it’s a 1987-style crash. It will act should credit spreads blow out, or if liquidity in the banking or financial system seizes up as it did during the GFC or the Russia Crisis.

 

 

Inflation hysteria

Tim Duy is a seasoned Fed watcher with a strong track record. But I believe Duy may be suffering from a case of inflation hysteria that has gripped the markets in the past few weeks.

 

Ned Davis Research has a 22 component Inflation Timing Model and it just rolled over into neutral. Historically, neutral readings have been constructive for equity returns.

 

 

While anecdotal evidence indicates that companies have been able to pass on price increases, which is contributing to inflationary pressures, that effect may be a bit of an exaggeration. FactSet reported that near 75% of S&P 500 cited “inflation” on earnings calls, which is a worrisome development.

 

 

However, net margin expectations are in retreat sequentially by fiscal quarter and fiscal year, indicating that some companies are experiencing difficulty passing on price increases, which is a positive for the inflation outlook. 

Given the high number of S&P 500 companies that have cited “inflation” on Q4 earnings calls, have net profit margin expectations for the S&P 500 for Q1 2022 and CY 2022 been revised? The current net profit margin estimate of 12.3% for Q1 2022 is slightly below the estimate of 12.4% on December 31, while the current net profit margin estimate of 12.7% for CY 2022 is slightly below estimate of 12.8% on December 31.

While the conventional approach to the economic policy of breaking the inflationary spiral is through the wage link, another way is to break the operating margin link if companies cannot pass on price increases. While large-cap S&P 500 is showing some minor margin pressure, small businesses are experiencing much greater margin pressure, which is a positive development for the inflation outlook. The January NFIB Small Business Survey shows that prices are skyrocketing.

 

 

Even as prices rose, earnings have been in a downtrend, indicating margin pressure.

 

 

A CNBC report indicated that small businesses lack bargaining power with suppliers and customers, which is squeezing margins.

 

“They are getting squeezed by supply chain disruptions and inflation and workforce shortages and already had to reinvent themselves a few times over in the past few years, and are running out of options,” said Kevin Kuhlmann, who leads the NFIB’s government relations team. “They are continuing to adapt … but you can only increase prices so much before you might see a loss,” he said. 

 

 

A slowdown, but no recession

While I am not inclined to front-run model readings, New Deal democrat, who monitors a series of coincident, short-leading, and long-leading indicators is calling for an economic slowdown in 2022, but no recession.

 

The long leading forecast remains weakly positive. Mortgage rates in particular are now a negative for the housing market. Yields on bonds from 1 year duration out through the intermediate maturities have continued to increase, anticipating Fed rate increases, as the Miller score has been suggesting for months…

 

The expansion is decelerating, and will continue to do so. In context, what is really happening is that a white hot economic Boom is ending, and a more normal, somewhat patchy, expansion will continue for a while. When the leading indicators that I have tracked consistently for over 15 years signal a downturn, I will not hesitate to tell you so. Now is not yet.
Subsequent to the publication of that analysis, NDD concluded that the trend in retail sales is foreshadowing a job market slowdown in the coming months. Despite January’s positive surprise, real retail sales have not exceeded the high from last April.

 

Retail sales, one of my favorite “real” economic indicators, rose sharply in January, up +3.8% for the month before inflation. After inflation, “real” retail sales were still up +3.1% for the month, although they are still down -2.2% from last April’s peak: 

 

 

Note that these comparisons almost certainly will turn negative in March. Probably more important is that, as shown in the first graph above, they have been essentially flat since last April. That’s not recessionary, but it’s not good either.

 

In short, this report remains consistent with a slowdown in the consumer sector of the economy.

 

Next, let’s turn to employment, because real retail sales are also a good short leading indicator for jobs…That’s because demand for goods and services leads for the need to hire employees to fill that demand.  The exceptions have been right after the 2001 and 2008 recessions, when it took jobs longer to catch up, as shown in the graph below, which takes us up to February 2020.

 

 

The signs are lining up for inflation pressures and employment growth cool off in the next few months. It will take the pressure off the Fed to tighten.

 

In addition, the flattening yield curve may not as strong a signal of recession odds in the current circumstances. The conventional metric for measuring the yield curve is the 2s10s, or the yield spread between a 10-year and 2-year Treasury note. Historically, an inversion in the 2s10s has been a strong indicator of a pending recession. This time may be different. In the past, a flattening 2s10s has been confirmed by a flattening spread between the 10-year Treasury yield and the 3-month T-Bill. This time, the two series have diverged. This can be explained by a strong rise in the 2-year Treasury yield that was not followed by the 3-month T-Bill. 

 

 

The divergence can be explained by market expectations that the Fed will raise rates, which has put upward pressure on the 2-year while the 3-month rate, which represents current policy, remains low. This is a divergence to keep an eye on. It may be a signal that the market tightening consensus has gotten ahead of itself and the odds of a recession may not be as high as believed.

 

Inflationary pressures will begin to ease in the next few months and so will the trajectory of monetary policy.
 

 

Be cautious and prepare for opportunities

Investing in the current economic environment of uncertainty will be challenging. I reiterate my recommendation to be cautious in equity positioning with an overweight on defensive sectors and high quality stocks (see A 2022 inflation tantrum investment roadmap). 

 

The bearish impulse of the current market cycle isn’t over. The S&P 500 surged off the March 2020 bottom by exhibiting a series of “good overbought” conditions as defined by over 90% of S&P 500 stocks over their 200 dma. The “good overbought” advance petered itself out in mid-2021. While the jury is still out on whether the market will consolidate sideways as it did in 2004 and 2014, or undergo a major downdraft as it did in 2010 and 2011, similar episodes have not ended until the percentage of S&P 500 above their 50 dma dipped below 20% (bottom panel).

 

 

Investment-oriented accounts should also begin to accumulate positions in large-cap high quality growth stocks. When the narrative pivots from strong inflation to slowing GDP, FANG+ stocks are likely to catch a bid as investors pile into quality growth in as growth becomes scares. Growth stocks, and in particular technology stocks, are becoming washed-out. The latest BoA Global Fund Manager Survey shows that respondents have stampeded out of the tech sector while believing that long US technology is the most crowded trade.

 

 

 

Don’t forget about the intermediate-term trend

Posted by Cam Hui -

Mid-week market update: I wrote on Monday (see Everything but the kitchen sink) that market sentiment was overly stretched on the downside, “If you are short here, you need a catastrophe within the next 10 days, otherwise, you run the risk of a rip-your-face-off relief rally.”
 

The relief rally appeared right on cue on Turnaround Tuesday and prices stabilized today in the wake of the release of the FOMC minutes. Before the bulls get too excited, don’t forget that the intermediate trend is still down. The Value Line Geometric Index, which measures the performance of the average stock, broke a long-term support level and is tracing out a falling channel.

 

 

Mike Howell at Crossborder Capital also pointed out that global liquidity is drying up. Changes in global liquidity is historically correlated with asset prices, such as stocks, bonds, gold, property, and so on.

 

 

 

Positive seasonality

Tactically, the market may still see an upward bias as it rebounds from an oversold extreme. If seasonal patterns hold, the market should be positive for the rest of this week and then correct and bottom in early March.

 

 

This week is also option expiry week. Historically, February OpEx has exhibited a bullish pattern.

 

 

 

Short and long-term sentiment

Short and long-term sentiment models present a mixed picture. Short-term sentiment, such as Callum Thomas’ (unscientific) Twitter poll, shows bearish extremes.

 

 

By contrast, longer term models such as the Citi Panic-Euphoria Model is in neutral territory. There is lots of downside before a long-term washout low can be declared.

 

 

 

Technical damage

Broadly speaking, the stock market has sustained too much technical damage for it to roar back to test the old highs. The S&P 500 may be forming a head and shoulders formation, but H&S patterns are incomplete until the neckline breaks.

 

 

I expect the S&P 500 to encounter resistance at the 50 dma, which also coincides with last week’s highs. My base case scenario calls for a continuation of the choppy range-bound market that has frustrated both bulls and bears this year. Nevertheless, I do find it constructive that the S&P 500 has managed to find its footing and hold above its January lows in the face of potentially catastrophic news.

 

 

My inner investor is neutrally positioned at roughly the target asset allocation weights specified by his investment policy. My inner trader is standing aside. There is no need to take excessive exposure in the face of wild volatility.

 

Everything but the kitchen sink

Posted by Cam Hui -

I must admit, the bears are trying their best. They’ve thrown everything but the kitchen sink at the stock market: The prospect of a half-point rate hike, an inter-meeting hike, and the looming risk of an armed Russia-Ukraine conflict.
 

 

Despite all the bad news, the S&P 500 is holding above its January lows. What’s next, an asteroid from outer space?

 

 

Depressed sentiment

Short-term sentiment is certainly depressed. Two (unscientific) weekend Twitter polls tell the story. Helene Meisler’s weekly poll readings show a high level bearishness.

 

 

Callum Thomas’ weekend poll tells a similar story.

 

 

 

How far will the Fed go?

St. Louis Fed President James Bullard appeared in a CNBC interview this morning in which he defended his views and did not walk any of hawkishness back. Over the weekend, San Franciso Fed President May Daly called for Fed actions “measured in our pace and importantly, data-dependent”. Kansas City Fed President Esther George dismissed the idea of an inter-meeting rate hike.

 

In response to the contradictory messages from Fed speakers, the market turned even more hawkish. Fed Funds futures are now discounting six rate hikes in 2022 for a total of 1.75%, up from five rate hikes for a total of 1.50% on Friday. Expectations for a half-point move at the March meeting remain intact.

 

 

The key question for investors is whether the Fed will push back against the notion of such a steep interest rate path and, in particular, a half-point move in March. There will be lots of Fed speakers in the coming weeks and we should get more clarity on that question.

 

 

Ukrainian offensive: Now or never

The newsflow from the Russia-Ukraine situation is chaotic and confusing. I am not a military expert and I don’t even play one on TV. However, the window for an armed conflict is closing quickly for two reasons.

 

Reports emerged in late January that the Russians had moved medical units near the Ukrainian border. More alarmingly, blood supplies were also being deployed to the frontlines in anticipation of possible casualties. According to the American Red Cross, the shelf life of whole blood is 21-35 days, depending on blood type. The shelf life of red cells is up to 42 days. Frozen blood plasma is good for up to a year. Based on that report and assuming that the Russian High Command is planning for a quick two-week offensive, the window for a full attack closes in late February before their initial blood supply runs out, though undoubtedly they can get more if the conflict continues.

 

As well, Russian forces will have to contend with the dreaded Rasputitsa, the season when the spring thaw turns the region into mud, which dramatically slowed the German offensive from 1942 onwards as tanks got stuck and supply lines shortened. CNN reported that the region is experiencing a mild winter and above-average temperatures.
 

Social media videos from several areas where Russian forces are deployed — some posted by soldiers themselves — show soft and flooded ground, and plenty of mud.

 

Data from Copernicus, the EU’s Earth Observation program, shows that much of eastern Europe experienced well-above-average temperatures in January. Ukraine saw temperatures between 1 to 3 degrees Celsius higher than the average of the past 30 years, one of many changes that the climate crisis has brought this region.

 

Copernicus also notes that in January, “eastern Europe was predominantly wetter than average” and the soil in Ukraine was wetter than normal. The combination means less frost and more mud.
For the Russian military, it’s now or never for an offensive.

 

The open question for investors is what has already been discounted in the market. An article in The Economist speculated that a limited offensive to recognize and annex the breakaway regions of Donetsk and Luhansk as independent republics might be a cause for relief that a full-blown conflict did not emerge.
 

If Russia were to formally recognise the two self-proclaimed republics, as independent entities, or even station its troops and military infrastructure there, it would amount to something not far short of annexation, since the “republics” would be full of newly minted Russian citizens, and be unable to stand on their own feet without substantial help from Moscow.

 

Ukraine and the West would object loudly to the redrawing of international borders by force. But the move would also lower tensions, because the immediate excuse for an Russian invasion was always likely to be a “provocation”, allegedly by Ukraine, in Donetsk or Luhansk. Even as it protested, the government in Kyiv might therefore heave a sigh of relief, and so would the rest of the world. The danger, however, is that Russia may not stop at that.
The NY Times reported this morning that tensions had ratcheted down a little. The path for negotiation is still open. If military action remains on hold until early March, any Russian offensive will have to take place under less than ideal conditions.
 

Speaking in what appeared to be a carefully scripted televised meeting with President Vladimir V. Putin of Russia, Foreign Minister Sergey V. Lavrov said that he supported continuing negotiations with the West on the “security guarantees” Russia has been demanding of the United States and NATO.

 

“I believe that our possibilities are far from exhausted,” Mr. Lavrov said, referring to Russia’s negotiations with the West. “I would propose continuing and intensifying them.”

 

Mr. Putin responded simply: “Good.”

 

The televised meeting was a signal that Russia might continue using the threat of an invasion of Ukraine to try to squeeze diplomatic concessions from the West, rather than resorting to immediate military action.

I interpret current conditions as constructive for risk assets, though event risk remains high. If you are short here, you need a catastrophe within the next 10 days, otherwise, you run the risk of a rip-your-face-off relief rally.
 

Three questions to ask as fear spikes

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: 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.
 

 

Another 200 dma test

In the wake of the drama that played out in the stock market last week, the S&P 500 weakened to test the 200 dma. Is this just a re-test of the January lows or the start of a new bear leg?

 

 

To answer that question, I step outside the realm of pure technical analysis and pose three questions for both bulls and bears.
  1. What will happen to earnings and earnings expectations in the wake of the hot January CPI report that spooked the market?
  2. Fed Funds futures are now discounting a half-point liftoff at the March FOMC meeting. Some analysts have even speculated that the Fed may raise by a quarter-point in a surprise inter-meeting move. Will the Fed acquiesce or push back against those expectations?
  3. If stock prices were to weaken further, how will insiders react?

 

 

Earnings do the heavy lifting

In the wake of increasingly hawkish expectations for Fed policy, bond yields have risen and the yield curve has flattened. Rising yields have consequently put downward pressure on the S&P 500 forward P/E ratio, which has become more reasonable by historical standards.

 

 

The historical experience shows that when the Fed first begins to raise rates as the economy strengthens, P/E ratios compress but stock prices can continue to rise. But earnings expectations will have to do all of the heavy lifting. So far, forward 12-month EPS are still rising and Q4 earnings season results have been moderately positive.

 

 

 

Fed expectations

In reaction to the strong January CPI report, Fed Funds futures are now pricing in a half-point rate hike by the March FOMC meeting.

 

 

Leading up to last week’s CPI report, a total of five Fed speakers pushed back on the need for a half-point rate hike in March. Will the Fed push back against the sudden change in expectations? Fed communication policy, which began under the Yellen and possibly even the Bernanke Fed, has shown that it doesn’t like to surprise markets. If future Fedspeak is silent on this subject, it will be a signal that policy makers have decided to acquiesce to the consensus and raise by a half-point in March. On the other hand, Fed speakers could reiterate their go-slow tightening policy in order to dial back market expectations.

 

The instant reaction is somewhat constructive for risk assets. St. Louis Fed President James Bullard, a well-known hawk, stated that he supports a full point rate increase by the July FOMC meeting. However, CNBC reported a number of other regional Fed Presidents have pushed back against Bullard’s hawkish view. 

 

Atlanta Fed President Raphael Bostic told CNBC Thursday after the inflation report, “My views have not changed” for three or four rate hikes this year, likely beginning with a 25-basis point hike. That was the same view he gave CNBC on Wednesday before the inflation report…

 

Richmond Fed President Tom Barkin said in a speech that “I’d have to be convinced” of the need for a 50-basis-point rate hike, saying there may be a time for that, but it did not appear to be now.

 

San Francisco Fed President Mary Daly said after the inflation report a 50-basis-point hike is “not my preference.”
Stay tuned for more Fedspeak next week. In addition to the schedule shown below, Jerome Powell and Lael Brainard will appear before the Senate for more confirmation hearings.

 

 

 

Will insiders buy?

As forward P/E ratios fall, valuations have become more attractive. While we can argue about valuation until everyone is blue in the face, a more objective test is the behavior of insiders, who are regarded as “smart investors”. When the market hit an air pocket in early January, insiders exhibited net buying activity, which is a bullish signal. The signal faded as stock prices rallied.

 

 

A key test is whether insiders will step up and buy if stock prices decline again, which would be a constructive signal for equity prices. A word of warning – insider activity is an inexact market timing indicator. Instead, investors should look for clusters of insider buying as a signal that a long-term bottom is forming, as it did during the GFC.

 

 

Insiders were also timely in their purchases during the Greek Crisis of 2011, though the timing wasn’t absolutely precise. In both 2008 and 2011, insider buying rose, which is a more bullish signal than the pattern of insider selling (red line) falling below insider buying (blue line) exhibited recently.

 

 

 

Elevated fear levels

In the short run, some sentiment indicators are showing signs of a fear spike. Macro Charts pointed out that put optiion buying is high, which is contrarian bullish.

 

 

Other option sentiment indicators, such as the term structure of the VIX, hadn’t inverted indicating elevated fear, though readings had briefly undergone inversions Friday afternoon before the close.

 

 

Just because fear levels are elevated doesn’t mean they can’t go higher. Much of the anxiety is attributable to the White House announcement that a Russian invasion of Ukraine is imminent and could begin as soon as Wednesday. Over a dozen countries have told their citizens to leave Ukraine.

 

I am indebted to Helene Meisler who highlighted the market action during the Iraqi invasion of Kuwait in 1990 as a possible template for the circumstances today. As a reminder, here is a brief history of what happened in 1990 (via Wikipedia). The dispute began in the wake of the Iran-Iraq war, which left Iraq heavily in debt to Kuwait and strained Iraqi finances. A further fissure appeared when Iraq called for oil price increases to alleviate its cash flow problems, which Kuwait opposed.

 

Iraq began massing troops on the Kuwaiti border. On July 25, 1990, Saddam Hussein met with American ambassador April Glaspie to discuss the troop buildup, who told him Washington “inspired by the friendship and not by confrontation, does not have an opinion” on the disagreement between Kuwait and Iraq, stating “we have no opinion on the Arab–Arab conflicts”. When questioned later, Glaspie’s response was “we didn’t think he would go that far” meaning invade and annex the whole country”.

 

The invasion began on August 2, 1990, and Iraqi forces soon overran Kuwait. The S&P 500 began a decline that didn’t bottom out until two months later. Oil prices rose for the next two months, but oil equities, as proxied by XOM, peaked about the time of the invasion.

 

 

Here are some key differences between 1990 and 2022. The markets were taken off guard by the invasion. Although Iraqi forces had massed on the border, there was still doubt that hostilities would break out. Market expectations are much different today.

 

Consider the 2014 experience and the market reaction to the Russian invasion of the Crimean Peninsula. The market had already taken a tumble and did not weaken further as Russian forces crossed the border. 

 

 

Fast forward to 2022. The Biden administration has adopted a strategy of declassifying  and publicizing intelligence about Russian preparations in a manner that’s far more extensive than the public disclosures in 2014. How much of that is already reflected in the markets?

 

History doesn’t repeat itself, but rhymes. I interpret current conditions as a state of high anxiety over a possible conflict. If geopolitical tensions fade, risk asset prices should rally, particularly when it appears that other Fed officials are pushing back against Bullard’s hawkish views. On the other hand, should a hot war break out, stock prices may see a short and sharp downturn, followed by recovery (see my previous publication Buy to the sound of cannons).

 

In conclusion, the S&P 500 is undergoing another test of its 200 dma and some open questions remain. So far, the preliminary answers appear to be tactically constructive for equity prices.

 

A 2022 inflation tantrum investing roadmap

Posted by Cam Hui -

In the wake of the hot January CPI print, I have had a number of discussions with readers about the most advantageous way of positioning an equity portfolio in a rising rate environment. The most obvious strategy is to use an allocation similar to the Rising Rates ETF (EQRR) is to tilt towards value and cyclical stocks.
 

 

Beneath the surface, however, such an approach carries considerable risks owing to growing negative divergences. Instead, I present a framework for managing the inflation tantrum of 2022.

 

 

Rising inflation concerns

The main investor concern today is the prospect of higher interest rates. Not only has the Fed revealed a tightening bias, but also the European Central Bank recently made a similar pivot. The economy is on fire and there is plenty of room for the Fed to raise rates. Job postings are strong and the data underscores Jerome Powell’s comment during the January FOMC press conference about a tight labor market.

 

I think there’s quite a bit of room to raise interest rates without threatening the labor market. This is, by so many measures, a historically tight labor market. Record levels of job openings, of quits. Wages are moving up at the highest pace they have in decades. If you look at surveys of workers, they find jobs plentiful. Look at surveys of companies—they find workers scarce. And all of those readings are at levels, really, that we haven’t seen in a long time—and, in some cases, ever. So this is a very, very strong labor market, and my strong sense is that we can—we can—we can move rates up without,
without having to, you know, severely undermine it.

 

 

Moreover, consumers are spending again. These are the signs of a robust recovery that allows the Fed to tighten without worrying about tanking the economy.

 

 

While concerns over inflation and monetary policy are very valid today, there is no need to panic. Hockey legend Wayne Gretzky famously said that he skates to where the puck is going to be, not where it’s been. Here is where I believe the puck is headed.

 

 

How to position today

The most obvious way to address current market worries is to position for rising inflation and rising rates. The main overweight positions in EQRR are value and cyclical sectors. But a more detailed analysis of the relative performance of value sectors reveals a number of shortcomings to this approach.
  • Most of the value sectors are in relative downtrends compared to the S&P 500, except for financials and energy.
  • The relative performance of financials is showing a negative divergence to the 2s10s yield curve. Historically, financials perform better in a steepening yield curve environment because banks borrow short and lend long. A flattening yield curve is normally a headwind for this sector.
  • The superior relative performance of energy stocks is attributable to rising oil and gas prices from geopolitical risk over Russia-Ukraine tensions. Exposure to this sector amounts to a bet on war breaking out.

 

 

In short, exposure to value sectors carries considerable risk. Investors are betting that the relationship between the yield curve and financials has decoupled. As well, energy prices will remain elevated or a Ukrainian war will break out.

 

A better way to position equity portfolios in the current environment is overexposures to defensive sectors and high-quality stocks. Three of the four defensive sectors have been in relative uptrends, which began in December and before the onset of the latest market pullback.

 

 

There are many ways of defining the quality factor. SPHQ is an S&P 500 quality factor ETF that calculates quality based on the fundamental measures of “return on equity, accruals ratio, and financial leverage ratio”. Another way of defining quality is profitability. S&P has a higher profitability inclusion criteria for index components than Russell and the relative performance of similar large and small-cap indices from the two providers shows the effects of the profitability factor. However it’s defined, the quality factor began to outperform in late 2021.

 

 

Investors can also observe the effects of the quality factor when viewed through the value and growth lens. While value stocks have recently led growth stocks mainly for the reasons mentioned previously in the discussion of value, high-quality value has beaten low-quality value and high-quality growth has led o low-quality and speculative growth.

 

 

 

Someday soon

In the wake of the latest hot CPI report, Fed Funds futures are discounting a half-point rate hike in March, five rate hikes in 2022 for a total of 1.5%. These expectations go beyond St. Louis Fed President James Bullard’s call for a full-point hike by the July FOMC meeting.

 

 

As a consequence, the yield curve has been flattening as short rates rise. So far, the bond market has exhibited a bear flattener in which both short and long rates rise but long rates rise less than short rates. 

 

 

Someday soon, long rates will stop rising and begin to decline. The transition will be difficult to time precisely, but that should happen as the market prices in a Fed policy error and the rising risk of a hard landing. Historically, the 10-year Treasury yield has been roughly correlated with the Economic Surprise Index (ESI), which has been falling. As the Fed tightens and ESI declines further, indicating a weakening economy, bond yield should close the gap and begin to fall.

 

 

Historically, the relative performance of large-cap growth stocks, as measured by the NASDAQ 100, is inversely correlated to the 10-year Treasury yield. Falling long rates will see market leadership rotate from defensive sectors to growth stocks.

 

 

 

Recovery phase

The next phase of market leadership can be described as the recovery phase. As the economy slows and inflationary pressures ease, the Fed will shift to a more accommodative monetary policy. That will be the signal for investors to rotate to value and cyclical stocks. For the time being, these industries are mostly weak to trading sideways relative to the S&P 500, with the exception of oil and gas stocks because of geopolitical tensions.

 

 

While it’s difficult to precisely forecast the turning points, investors should begin to overweight large-cap growth when 10 and 30 Treasury yields start to decline, which I expect will happen during Q1 or Q2. The recovery phase should begin when inflationary pressures begin to roll over.

 

 

Much of the inflation pressure can be attributed to shortages from supply chain bottlenecks. A recent snapshot of 28 exchanged-traded commodities shows that almost 20 of them are in backwardation, where the front month price is higher than the second month. Backwardation is an indication of a short-term shortage but history shows that such spikes don’t last very long.

 

 

Here is another sign that the inflection point is just around the corner. While the 5s30s nominal yield curve is flattening (red line), the 5s30s breakeven yield curve has already inverted (blue line). Even though nominal headline CPI is 7.5%, long-term inflation expectations are falling. Don’t be surprised if the Fed pivots back to a more accommodative monetary policy in H2 2022 as inflationary expectations remain well-anchored.

 

 

In conclusion, the current market environment is tricky to navigate and investors will be faced with considerable volatility in 2022. As it’s difficult to precisely time turning points, I suggest investors adopt the following positioning for their portfolios today.
  • Overweight defensive sectors.
  • Overweight quality stocks.
  • Neutral weight high-quality growth, which should be the next market leadership.
  • Underweight value and cyclical stocks.

 

In the eyes of the beholder

Posted by Cam Hui -

Mid-week market update: Technical analysis can be highly interpretative. Consider, for example, the bull or bear flag, which is a continuation pattern. For the uninitiated, a bull flag is a pullback within a bull trend and the trend is deemed to have continued when the stock or index stages an upside breakout from the flag. The reverse holds for a bear flag.
 

With that brief explanation in mind, did the S&P 500 just break out of a bull flag, or is it still tracing out bear flag?

 

 

Bullishness and bearishness are in the eyes of the beholder.

 

 

Waiting for a sentiment reset

The principal reason for the bull case is the lack of a sentiment reset. Sentiment remains overly bearish. Jeff Hirsch at Alamanac Trader recently wrote, “Sentiment looks like it’s getting negative enough to support a rally”. He cited the skyrocketing put/call ratio and the overall bearish tone from Investors Intelligence as the reasoning for his bullishness.

 

 

Jason Goepfert at SentimenTrader wrote that “Investors are hedging like it’s a repeat of the pandemic”. Small investor put buying had recently skyrocketed.

 

 

Indeed, the 10 dma of the equity put/call ratio is highly elevated and readings haven’t been this high since the days of the COVID Crash and recovery.

 

 

Similarly, JPMorgan’s strategist Mislav Matejka recently pointed out that the VIX Index had risen by over 50% of its 1-month moving average on January 25, 2022. The indicator has proven to be 100% accurate outside of recessions over the last three decades.

 

 

 

Intermediate-term bearish

On the other hand, Goldman Sachs bull/bear indicator is at or near bear market territory. This is an intermediate-term bearish signal.

 

 

Tactically, tomorrow’s CPI report could be a bearish trigger. In a briefing today, White House Press Secretary Jen Psaki warned of “a high yearly inflation reading in tomorrow’s data”,

 

To be sure, the BLS annual CPI basket revision could be a source of volatility. The changes are based on consumer expenditure data from 2019-2020, which raised the weight of goods and reduced the weight of services. As an example, during the pandemic, households mostly avoided restaurants, which depressed the weight of the “food away from home” basket (service), and ate at home, which boosted the weight of “food at home” basket (goods). Consensus estimates peg the changes as boosting annual headline CPI by 0.2%.

 

The most worrisome factor for investors is a hot Owners Equivalent Rent (OEF) print, which comprises roughly 40% of core CPI. While OER has been relatively stable, leading indications from housing prices are likely to put upward pressure on OER, core CPI, and spook the financial markets in the near future.

 

 

 

Bull flag, bear flag

How should traders interpret current conditions? Did the S&P 500 trace out a bull flag breakout or is it still in a bear flag pattern?

 

Instead of fretting over bull and bear flags, I interpret the S&P 500 as being caught between 50 dma resistance and 200 dma support. The analysis of other major market averages presents a mixed picture. While the Dow has staged an upside breakout through its 50 dma, both mid and small-cap indices are below their respective 50 and 200 dma. Moreover, they have either undergone or about to undergo bearish dark crosses of these moving averages.

 

 

My inner investor is neutrally positioned at about his investment policy stock and bond targets. Subscribes received an email alert that my inner trader had taken profits in his long S&P 500 position and stepped to the sidelines ahead of tomorrow’s CPI report. He may be inclined to re-enter on the long side should the market experience a bearish shock from a hot CPI print.

 

4 reasons to be bullish, 4 to be bearish

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.
 

 

A dead cat bounce?

Now that the stock market has staged a relief rally, can it be characterized as just a dead cat bounce, or is it a more durable move? Arguably, the downdraft that began in January violated an uptrend. It would be difficult to believe that a market can recover to its previous highs that quickly after such technical damage.

 

 

Here are four reasons to be bullish and four to be bearish.

 

 

The bull case

Here are some reasons to be bullish. The S&P 500 intermediate-term breadth momentum oscillator just flashed a buy signal. Its RSI indicator just recycled from an oversold reading to neutral. These signals have shown a 72% success rate in the last five years.

 

 

Cyclical indicators like commodity prices and the base metals/gold ratio are strong, though the copper/gold ratio has been trading sideways. Commodity price strength isn’t attributable just to energy. The equal-weighted commodity index has made new recovery highs. This is an important cross-asset, or intermarket, relationship that should at least put a floor on stock prices.

 

 

Credit risk appetite has also been acting well. Both the junk bond and leveraged loan markets are showing few signs of stress.

 

 

Finally, sentiment readings are still depressed. Macro Charts pointed out that S&P 500 futures speculators cut their long exposure by the fastest rate in history. Even when normalized by market cap, the selling stampede is consistent with past short-term bottoms.

 

 

SentimenTrader also observed that leveraged Rydex bear assets skyrocketed to an off-the-charts reading last week. Major bear legs simply don’t start with sentiment readings at such extremes.

 

 

 

The bear case

Here is the bear case. Three of the four defensive sectors are in relative uptrends and the uptrends began before the market weakened. This is a signal that the bears still have control of the tape.

 

 

I had highlighted in the past the long-term sell signal from the negative RSI divergence of the monthly Wilshire 5000 chart. The most recent peak-to-trough drawdown was about -10%. Was that enough? If the Wilshire 5000 were to close at these levels today, MACD would turn negative (bottom panel). In the past, this has sometimes been a sign that the decline is nearly over or the start of a deeper drawdown. In all cases, it has not marked the market bottom.

 

 

How far can the market fall? This analysis of past strong advances yields some clues. The S&P 500 staged a massive rally from the March 2020 lows and the percentage of stocks above their 200 dma reached the 90% level, which represents a “good overbought” rally (shaded regions, top panel). Momentum then cooled and the percentage above their 200 dma recycled below the 90% level. There have been four other similar episodes other than the current one in the last 20 years. Two resolved in sideways markets, characterized by sideways movement in cyclical and risk appetite indicators, namely the copper/gold ratio and the equal-weighted consumer discretionary to staples ratio. And two resolved with deeper pullbacks when the cyclical and risk appetite indicators fell. 

 

 

The current episode presents a mixed picture. While the copper/gold ratio has traded sideways, indicating a benign environment with normal equity risk, the equal-weighted consumer discretionary to staples ratio has fallen, indicating plunging equity risk appetite. In all past cases, pullbacks ended when the percentage of stocks above their 50 dma fell to 20% or less, which hasn’t happened yet (bottom panel). Notwithstanding the debate over the magnitude of any potential stock market weakness, the bears phase isn’t over yet.

 

This chart also shows how momentum has turned. People usually analyze the equity put/call as a contrarian short-term indicator, but it can also be a long-term indicator of retail sentiment and the animal spirits of the market. During a durable advance, retail investors often pile into single-stock call options to speculate on the market. The top panel shows the 50 dma of the equity call/put ratio (red line) and the 200 dma (black line). In a strong uptrend, equity call/put ratios rise, indicating strong retail participation and momentum. The equity call/put ratio began topping out in mid-2021 and they are now rolled over. The animal spirits are gone, which removes a source of equity demand.

 

 

The retreat in animal spirits is particularly bearish for speculative growth stocks. ETFs such as Cathie Wood’s ARKK are likely to be vulnerable to setbacks. The market won’t bottom until the relative performance of ARKK bottoms.

 

 

 

Bull or bear?

So where does that leave us? Who is right, the bulls or bears?

 

Actually, they both are. Bullish factors tend to have shorter time horizons, which are weeks, compared to those of bearish factors, which are 3–6 months. I interpret these conditions as the market can tactically rally further, but the intermediate-term outlook is still bearish. The current rally is a bear market rally. Expect further choppiness and volatility for the next few months with little upward progress in the major equity averages. Depending on the evolution of technical, macro, and fundamental conditions, stock prices could see further downside and undercut the recent lows.

 

Investment-oriented accounts are advised to maintain a neutral position in line with the asset allocation targets specified by investment policy. Traders could try to capitalize on further potential gains, but purely from a tactical perspective. If the seasonal pattern is any guide, the S&P 500 should be choppy for another week and rally into a mid-month peak.

 

 

Earnings season reporting continues and the market will undoubtedly be volatile and respond to the headline reports of the day. In addition, the CPI report on Thursday will also be a source of uncertainty.

 

 

 

Disclosure: Long SPXL

 

Can the Fed engineer a soft landing?

Posted by Cam Hui -
Stock market pullbacks happen. The normal equity risk of pullbacks is the price investors pay for better long-term performance. But a recent analysis by Oxford Economics found that the average S&P 500 pullback during non-recessionary periods is -15.4% and -36% during recessions.

 

 

Here is why this matters for equity investors. The recent peak-to-trough drawdown for the S&P 500 was about -10%. If there is no recession, the downside risk is relatively limited. However, Fed Funds futures expect five quarter-point rate hikes in 2022, with some strategists calling for as many as seven. The current rate of expected tightening will push the 2s10s yield curve to invert in late 2022 or early 2023, which would be a recession signal. Markets look ahead 6-18 months. A 2023 recession translates into an equity bear market in 2022. Suddenly, the recent -10% S&P 500 decline could become a prelude to a vicious bear market.

 

Ominously, the path of the stock market is following the pattern of 1982. In 1982, the economy was in recession. CPI was 7% and the Fed had been hiking aggressively. It was a mid-term election year and the second year of the Presidential Cycle. The market experienced a down January and saw a bearish turn-of-year barometer (TOY) signal. 

 

 

The key difference between today and 1982 is the recession question. With all of the G7 central banks except for the BoJ turning hawkish, can the Fed rescue the stock market from the 1982 analogue by engineering a soft landing?

 

 

The Fed’s inflation challenge

It is an understatement that the Fed is extremely focused on inflation. In particular, Jerome Powell’s language in the wake of the January FOMC meeting was revealing. He declined every off-ramp offered from the Fed’s hawkish path. Instead, he said there was “quite a bit of room to increase rates without hurting the labor market.” Moreover, he pointed out that balance-sheet reduction could be quicker than in 2015 in light of the economy’s strength now, though no decision had been made 
  • Job market conditions “are consistent with maximum employment”, which leaves the Fed to focus on its price stability mandate. Moreover, the “labor market’s going to be strong for some time”.
  • Powell was hawkish on the inflation outlook, “I’d be inclined to raise my own estimate of 2022 core PCE inflation” [since the publication of the December SEP estimates].
  • The Fed would not commit to any particular path of rate increases. It could raise rates at every meeting. In addition, rate hikes could be as much as a half-point instead of the widely expected quarter-point.
  • When questioned about the volatility in financial markets, Powell lowered the strike price on the Powell Put and later added that “asset prices are somewhat elevated”.
In reaction to Powell’s press conference remarks, financial markets took a sudden risk-off turn. In the following week, six of the 12 regional Fed Presidents spoke, all with the message that while the Fed is on a tightening cycle. However, they walked back some of Powell’s hawkishness by emphasizing a path of gradual tightening and the Fed’s data dependence.

 

In short, the Fed hates surprising the markets and officials may have decided that the market’s sudden risk-off tone was overdone. Had expectations ramped up to a half-point boost in the Fed Funds rate at the March meeting, the FOMC would have been put in the uncomfortable position of either surprising the market with a dovish quarter-point increase or following the market up with a half point. Subsequent Fedspeak may have been an effort to dampen overly hawkish expectations. The hawkish Kansas City Fed President Esther George said “unexpected adjustments” are not in anyone’s interest and the dovish San Francisco Fed President Mary Daly underscored the need not to be disruptive. 

 

 

How the Powell Fed has evolved

While the Fed has taken a hawkish turn, its projections and policy direction has shown a remarkable amount of flexibility. This gives investors hope that the Fed could pivot back to a more dovish view in the future should conditions warrant it.

 

The WSJ recently document the evolution of Powell’s thinking. Consider that, a year ago, Powell was dovish on the prospect of inflationary pressures.

He even said that higher price pressures, after years of weakness, could be a good thing. “We welcome slightly higher inflation, somewhat higher inflation” to compensate for the years when inflation had fallen short of the Fed’s 2% goal. He added, “The kind of troubling inflation that people like me grew up with seems far away and unlikely.”

Inflation concerns had started to creep in by the June FOMC meeting.

But by the June meeting, Mr. Powell sounded more concerned about inflation. He acknowledged that “inflation has increased notably in recent months,” and the supply problems driving it were proving bigger and more persistent than expected. He flagged uncertainty about what would happen as well.

Powell was still on Team Transitory in the fall.
By the fall, Mr. Powell still stuck to his view that inflation would moderate, but acknowledged the costs of what was happening.

 

“The level of inflation we have right now is not at all consistent with price stability,” Mr. Powell said after the Nov. 2-3 FOMC meeting. “We understand the difficulties that high inflation poses for individuals and families, particularly those with limited means to absorb higher prices for essentials such as food and transportation,” he added.
By the December FOMC meeting, inflation pressures broadened out from just a few categories. As a consequence, policy took a hawkish turn.
By the final FOMC meeting of 2021, the inflation outlook drove a notable change in the Fed policy outlook. Officials accelerated the drawdown of their bond-buying stimulus effort, in part to help open up space in 2022 for rate rises. The Dec. 14-15 FOMC press conference was dominated by questions on price pressures.
How quickly could the Fed pivot back?

 

 

Key risks

The key risk to the Fed’s hawkish policy is that it is tightening into an economic growth deceleration. The Economic Surprise Index, which measures whether economic indicators are beating or missing expectations, has rolled over. 

 

 

It is unclear how much the significant beat in the January Employment Report moves the needle. The White House had issued a warning that it would likely be disappointing owing to the Omicron variant and a quirk of the survey techniques. John Authers of Bloomberg reported that “a number of Fed governors have already staked out a position that the January unemployment numbers will be bad, and that it doesn’t matter for the future of monetary policy”.

 

Notwithstanding the January Jobs Report beat, economic weakness isn’t just confined to the US. Global GDP growth estimates are being downgraded everywhere.

 

 

The Fed is now caught between the Scylla of inflationary pressures and the Charybdis of slowing growth. This spells policy error and possible recession if the Fed cannot react in time.

 

It is no surprise that the bond market has reacted with a flattening yield curve even as bond yields rose. As a reminder, an inverted yield curve is usually a recession signal.

 

 

When questioned about the flattening yield curve at the January press conference, Powell dodged the question.
JEAN YUNG. Thanks, Michelle. Chair Powell, some investors are expecting the yield curve could flatten or even invert after rate hikes begin. Would that worry you, and how important is that risk in the Fed’s consideration for adjusting policy? 

 

CHAIR POWELL. So we do monitor the slope of the yield curve, but we don’t control the slope of the yield curve. Many flat — many factors influence longer-term interest rates. But it is something that we watch, and you will know that from — when we had this issue a few years ago. And we take it into account along with many other financial conditions as we try to assess the implications of all those conditions for the economic outlook. So that’s one thing I would say. Another is, currently, you’ve got a slope. If you think about 2s to 10s, 2-year Treasury to 10-year Treasury, I think that’s around 75 basis points. That’s well within the range of a normal yield curve slope. So it’s something we’re monitoring. We don’t think of it as — I don’t think of it as some kind of an iron law. But we do look at it and try to understand the implications and what it’s telling us. And it’s one of many things that we monitor.
Even as the yield curve flattens, which is a short-term forecast of slowing growth, the gap between the market’s and the Fed’s projected terminal rate is equally revealing. The market implied terminal rate of just under 2% is well under the SEP long-term median of 2.5%, indicating that the market believes the Fed will have to reverse course and lower rates as it realizes it had committed a policy error by over-tightening.

 

When questioned about the risk of over-tightening and the need for a course correction, Powell signaled that the Fed may be handcuffed by its Flexible Average Inflation Targeting framework and overly slow to react in the embrace of its backward-looking data dependency.
MICHAEL MCKEE. If I could — if I could follow up, does the danger of tightening too much as policy works its way into the economy with a lag mean that you should go back to being more forecast dependent in making decisions rather than the state dependency you’ve been using as a framework for the last year and a half or so? 

 

CHAIR POWELL. State dependency was particularly around the thought that if we saw a very strong labor market, we would wait to see actual inflation, actual inflation before we tightened. And so that was a very state-dependent thought because, for a long time, we’ve been tightening on the expectation of high inflation, which never appeared. And that was the case for a number of years. So in this particular situation, we will be clearly monitoring incoming data as well as the evolving outlook.

 

 

Important indicators to watch

So where does that leave us? Consensus Fed Funds forecasts have been badly wrong in the past. The key question for investors is whether it is willing to push the economy into a recession to bring down inflation, or will it stop in time to achieve a soft landing?
 

 

While the consensus calls for five quarter-point rate hikes, bank projections of 2022 rate hikes are all over the place. The most dovish is Barclays with three, while the most hawkish is BoA with seven, followed by Nomura with five, but with a half-point hike in March.

 

 

I am mostly watching how inflationary pressures develop in the coming months. Inflation pressures are rising globally, with the eurozone being the worst. The good news for the Fed is that inflation surprise is tame in the US. 

 

 

The latest release of PMI data from IHS Markit shows a mixed picture. The good news is supply chain pressures are easing, which should alleviate some of the inflation pressures.

 

 

However, the inflation front presented some good news and bad news. Input price inflation is softening, but finished goods inflation has edged up.

 

 

Analysis from Pictet indicates that inflation pressures may be overblown. While core PCE appears highly elevated at 4.9%, it falls to a far tamer 2.4% after adjusting for COVID sensitive items and base effects.

 

 

Keep an eye on the evolution of core PCE and CPI. Especially pay attention to owners’ equivalent rent, which accounts for one-quarter of CPI weight, has been relatively tame. If Team Transitory is correct, inflationary pressure should ease by summer. If core PCE can print 0.2% for a few consecutive months, the Fed may respond by taking its foot off the tightening brake.

 

 

Even though it will be difficult to time the inflection point, it may sneak up much quicker than anyone thinks based on this week’s cover of The Economist as a contrarian indicator.

 

 

 

Investment implications

For equity investors, the current environment is tricky to navigate. Analysis from Ned Davis Research shows that stock market returns vary depending on the speed of the tightening cycle. The current cycle is expected to be fast and investors should expect a choppy and volatile market.

 

 

My base case scenario calls for a soft landing, which I assign a 60% probability, though the risk of a policy error and over-tightening is high. Notwithstanding any geopolitical risk from Ukraine, Fed policy uncertainty will translate into choppy markets for the first half of 2022.

 

As long as the Fed adopts a hawkish tone, growth expectations will be under pressure and the yield curve will flatten. This environment should be favorable to large-cap high-quality growth as duration plays and unfavorable to value stocks for their cyclical exposure. However, recent surveys show that institutions are overly exposed to cyclicals (see Rethinking the Hindenburg Omen). Combined with the oversold condition of the NASDAQ 100, which is a proxy for large-cap high-quality growth, FANG+ names should outperform under these conditions.

 

 

From a technical perspective, the outlook for the hard-hit NASDAQ stocks, which have begun to rebound, look promising. While the sample size is extremely low (n=5), SentimenTrader observed that similar episodes had resolved bullishly. 
 

 

For investors concerned about the recent downdraft exhibited by Meta (FB), don’t be fooled by recency bias. Of the large-cap growth stocks that reported during Q4 earnings season, four (Apple, Microsoft, Alphabet, and Amazon) saw positive market reactions while two (Netflix and Meta) saw negative ones. While the sample size is small, the results were better than just a coin toss, though the daily volatility has been hair-raising.
 

As the economy slows, watch for the turn in inflationary pressures. If core PCE can fall to 0.2% on a monthly basis for two or more months, it should allow the Fed to gradually ease policy. This would be the signal to take great risk in portfolios and to rotate from growth into value stocks for their cyclical exposure.

 

Panic and bounce, what’s next?

Posted by Cam Hui -

Mid-week market update: How far can the market rally run? The S&P 500 weakened in January and bottomed last week. It has mounted a strong relief rally, but it is testomg a key Fibonacci retracement level at about 4590 and a resistance zone at 4600-4630.
 

 

Is this the start of a V-shaped market recovery, or will the market weaken to retest the old lows?

 

 

Sentimental buy signals

The relief rally had to happen sooner or later. The market was deeply oversold on numerous technical indicators. Sentiment models finally showed signs of capitulation selling and the rebound was on.

 

NDR’s Daily Trading Sentiment Composite had become deeply pessimistic, indicating a washout low was near.

 

 

As well, equity fund flows had dried up, which is another contrarian buy signal.

 

 

The market appears to be climbing the proverbial Wall of Worry. Even as the S&P 500 roared up 1.9% on Monday, the put/call ratio remained elevated at over 1. It finally retreated to 0.95 Tuesday after a 0.7% advance.

 

 

 

The bear case

However, investors should sound the all-clear just yet. From a longer-term perspective on the weekly chart, much technical damage has been done when the index violated a long-term rising trend line. Strong resistance can be found at about the 4720-4730 level.

 

 

Tactically, I previously pointed out that the daily S&P 500 chart shows the index is facing overhead resistance at a key Fibonacci retracement level of 4590, with a further resistance zone at 4600-4620. In addition, the NYSE McClellan Oscillator is approaching an overbought reading, which would be a cautionary signal.

 

 

On the other hand, the RSI of the S&P 500 intermediate-term breadth oscillator is on the verge of recycling from oversold to neutral, which would be a buy signal. Buy signals in the last five years have resolved bullishly with a 72% success rate.

 

 

How will all this play out? I honestly don’t know.

 

My inner investor is neutrally positioned in accordance with the recent downgrade of the Trend Asset Allocation Model’s signal from bullish to neutral. He expects further volatility and choppiness in the coming weeks and months.

 

My inner trader is nervously long the market and enjoying the ride. He is carefully monitoring how the market behaves during this relief rally and whether it can overcome or fail at nearby resistance.

 

 

Disclosure: Long SPXL

 

The dirty little secret of Q4 earnings season

Posted by Cam Hui -

You can tell a lot about the character of a market by the way it reacts to the news. Bespoke reported a downbeat market reaction to earnings and sales beats, which is disappointing, “The 163 companies that have beaten both top and bottom line estimates this earnings season have averaged a one-day decline of 0.23% on their earnings reaction days.”
 

 

While this may seem like the dirty little secret of Q4 earnings season, there’s another one that buried that you may not be aware of.

 

 

A difficult market

While the tone of the market has been difficult in the past few weeks, negative market reactions to positive surprises aren’t necessarily bearish signals. 

 

FactSet reported that the market is punishing stocks with both positive and negative earnings surprises. At first glance, that sounds bearish. However, the slope of the earnings reaction (dotted red line) is positively sloping, indicating that positive surprises are still being rewarded. Earnings beats are still outperforming earnings misses. It’s the overall market conditions that are challenging.

 

 

 

Mid-cycle expansion challenges

The market’s risk-off tone can be mainly attributed to two factors, fears over a Russia-Ukraine confrontation and a hawkish pivot by the Federal Reserve. The geopolitical risk premium seems to be facing, as measured by a stabilization in the Ruble exchange rate.

 

 

So has the relative performance of Russian stocks to the EURO STOXX 50.

 

 

However, the market reacted to the Fed’s hawkish pivot by flattening the 2s10s and 5s30s yield curves, indicating expectations of slower economic growth.

 

 

As a consequence, the S&P 500 forward P/E ratio fell…

 

 

…even as forward 12-month EPS estimates continued to rise.

 

 

P/E ratio compression during a period that the Fed shifts from easy to tight money is a normal characteristic of a mid-cycle expansion. Investors deflate P/E ratios because of the expectation of higher interest rates. In order for stock prices to advance, earnings growth will have to do the heavy lifting to overcome falling P/Es.

 

So far, the results are not encouraging. While it’s important to consider the earnings beat and miss rate, the magnitude of the beat and miss rates have been subpar. While FactSet reported that the Q4 earnings beat rate is above its 5-year average, the magnitude of the beats is lower.

 

At this point in time, more companies are beating EPS estimates than average, but they are beating estimates by a smaller margin than average…Overall, 33% of the companies in the S&P 500 have reported actual results for Q4 2021 to date. Of these companies, 77% have reported actual EPS above estimates, which is above the 5-year average of 76%. In aggregate, companies are reporting earnings that are 4.0% above estimates, which is below the 5-year average of 8.6%.
That’s the true dirty little secret of Q4 earnings season. Even though earnings beats are above average, the magnitude of the beats have been subpar.

 

About one-third of the S&P 500 has reported earnings so far and individual stocks have been the source of significant daily volatility. Earnings season continues and significant FANG+ names such as GOOGL, FB, and AMZN report this week. 

 

 

Stay tuned and keep an open mind.

 

Trading the Panic

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.
 

 

Fear rising

The stock market action last week is an example of a classic panic. Not only is the market oversold, but also extreme fear is showing up in sentiment readings. The weekly AAII survey has flashed a contrarian buy signal for a second consecutive week. Not only is the bull-bear spread at an extreme seen only two other times in the last 10 years, but also bearish sentiment is the fourth highest on record in the same period.

 

 

While survey-based sentiment models can be useful, they can have only limited utility because the surveys ask respondents their opinions and not what they are actually doing with their money. Option market sentiment, which is based on actual fund flows, is also showing signs of high anxiety. The term structure of the VIX inverted last week, indicating high levels of fear.

 

 

The Bollinger Band of the VIX Index also spiked above 90. Past episodes have marked either bottoms or preceded short-term bottoms.

 

 

As well, SentimenTrader observed that small trader put option buying is off the charts, which is contrarian bullish.

 

 

 

An oversold extreme

The market is oversold, but you probably already knew that. The Zweig Breadth Thrust Indicator fell to an oversold level last week. As a reminder, a ZBT buy signal requires the ZBT Indicator to rise from an oversold to overbought condition within 10 trading days. ZBT buy signals are rare. There was only one buy signal in the last five years and three in the last 10 years. By contrast, there were 13 ZBT oversold conditions in the last five years and 29 in the last 10 years. Virtually all ZBT oversold conditions resolved in short-term rallies.

 

 

 

Constructive breadth

Even breadth indicators are becoming more constructive. Net NYSE and NASDAQ 52-week highs-lows bottomed out last Monday and turned less negative.

 

 

Similarly, the relative performance of the equal-weighted S&P 500 to the S&P 500 is turning up. The average stock in the index is outperforming the index itself, which is another sign of breadth improvement.

 

 

 

Insiders are buying

Another data point supportive of a bottom is the appearance of insider buying. The latest reports show that insider buys are outnumbering insider sells, which is a positive development by this group of “smart investors”.

 

 

However, insiders are not perfect at timing market bottoms. However, a cluster of persistent insider buying is a signal that a durable bottom is forming. As an example, consider the insider trading pattern during the Great Financial Crisis.

 

 

Insiders also stepped up to buy in 2011 at the height of the Greek Crisis.

 

 

Insiders were equally timely in their purchases during the COVID Crash of 2020.
 

 

While the latest whiff of insider buying is constructive, they cannot be regarded as a full fledged buy signal until buying becomes more persistent.

 

 

Echoes of 2008

This level of daily market volatility is almost unprecedented. Bloomberg reported that the only parallel is October 2008.

Twice in two days, S&P 500 has erased a gains of roughly 2% to close the session lower. Such a streak of big back-to-back downside reversals has occurred only once before in Bloomberg’s four decades’ worth of data: October 2008. Equally big swings rocked the market on Monday and Tuesday.

Consider the differences between then and now from the viewpoint of my bottom spotting model. Currently, three of the four components of the model have flashed buy signals. The only missing element is the lack of a TRIN spike indicating price-insensitive margin clerk selling.

 

 

Here are the readings from October 2008. The S&P 500 was experiencing extreme levels of daily volatility. In early October, the VIX Index rose above its upper Bollinger Band and recycled, just as it did now. The term structure of the VIX was deeply inverted starting in mid-September and the high fear level lasted until December, which is different from today. The NYSE McClellan Oscillator reached an oversold condition, just like today. TRIN experienced several spikes above 2, which are indicative of price-insensitive margin clerk liquidation, which has not happened today.

 

 

The key difference is the macro backdrop. The financial system was undergoing an institutional bank run. The stability of the global financial system was at risk. The banking system was at the edge of an Apocalyptic cliff.

 

Fast forward to 2021, the Fed has signaled a regime shift from an easy monetary policy to a tightening policy. Further, the markets are rocked by fears of a Russia-Ukraine military conflict. These are the same scale of Apocalyptic fears that the markets faced in 2008. At worse, today’s events represent normal equity risk, which should resolve in a 10-15% pullback.

 

In conclusion, the US equity market is undergoing the classic signs of a panic bottom and it is poised for a relief rally. While it’s difficult to pinpoint the exact point of a bottom and Friday’s one-day strength does not make a trend, the ability of the S&P 500 to hold above support on the 30 minute chart is constructive.

 

 

 

Disclosure: Long SPXL

 

Buy to the sound of cannons

Posted by Cam Hui -

As global markets have been jittery on the prospect of military conflict in Ukraine, Ben Carlson showed a table of the regular nature of US stock market drawdowns, which is a feature of equity risk.
 

 

I am also reminded of the quip by British banker Nathan Rothchild, “Buy to the sound of cannons, sell to the sound of trumpets.” As well, the trader Art Cashin also related his experience with the Cuban Missile Crisis as a young man (via Barry Ritholz):
 

Anyway, it was the Cuban Missile Crisis and there were rumors that Russia had launched rockets and the Dow took a dive near the bell.

 

I cleaned up my desk and raced to the Moosehead, as animated as only an 18 year-old can be. Jack was already there and as I burst through the door, I shouted: “Jack! Jack, there was a strong rumor that the missiles were flying and I tried to sell the market but failed.”

 

Jack said “Calm down kid! First buy me a drink and then sit down and listen to me.” I ordered the drink and meekly sat down.

 

Jack said – “Look kid, if you hear the missiles are flying, you buy them. You don’t sell them.”

 

“You buy them?” I said, somewhat puzzled.

 

“Sure you buy them!” said Jack. “Cause if you’re wrong, the trade will never clear. We’ll all be dead.”

 

That’s a lesson you won’t learn in the Wharton School.

Both Rothchild’s thinking and Cashin’s story are lessons in market psychology and the occasional asymmetric nature of asset returns. With the angst over the FOMC decision out of the way, let’s consider what might happen if war were to actually break out.
 

 

A hot war, or stealth war?

The framework of a discussion of a Russia-Ukraine war is based on Russia’s political objectives, the military situation, and NATO’s response, and, most importantly for investors, the economic fallout.
 

As Russian troops mass on Ukraine’s borders, the biggest unknown is Putin’s political objective in an invasion. Is he aiming for limited military objectives, or does he want to topple the Ukrainian government altogether?
 

In a limited hot war involving actual hostilities, Russia could take the breakaway and separatist regions of Luhansk and Donbas. A more ambitious plan would be to secure a “land bridge” to the annexed Crimea, which involves seizing territory between the Sea of Azov to the Dnieper River.
 

 

Moscow could decide to destabilize the current Ukrainian government using covert operatives to spark another Orange Revolution, this time to install a Russia-friendly regime. If that’s the objective, why mass 125,000 troops on the border? A full hot war could see the siege and fall of Kyiv to Russian forces.
 

Each plan carries its own risks. A limited incursion would still leave a West-leaning government in Kyiv in power. While Russia is likely to win a full military campaign that ends with the takeover of Ukraine, its losses could be considerable and see soldiers return home in body bags, which should not be popular. If it were to install a Moscow-friendly government in Kyiv, will the government remain stable if Russian troops go home? The Russian Army could be bogged down in a bloody guerilla conflict with no end in sight. 
 

 

The economic fallout

The West has threatened severe sanctions if Russia were to invade. A recent background press conference by senior US officials outlined the measures being contemplated.
 

That means the gradualism of the past is out, and this time we’ll start at the top of the escalation ladder and stay there.  We’ve made efforts to signal this intention very clearly.  And I would say the deepening selloff in Russian markets, its borrowing costs, the value of its currency, market-implied default risk reflect the severity of the economic consequences we can and will impose on the Russian economy in the event of a further invasion.
 

In addition to financial sanctions, which have immediate and visible effect on the day they’re implemented, we’re also prepared to impose novel export controls that would deal Putin a weak strategic hand over the medium term. 

Specifically, the White House is threatening the use of technology export sanctions that crippled Huawei in the past.

In the case of export controls, what we’re talking about are sophisticated technologies that we design and produce that are essential inputs to Russia’s strategic ambitions. 
 

So, you can think of these export controls as trade restrictions in the service of broader U.S. national security interests.  We use them to prohibit the export of products from the U.S. to Russia and, potentially, certain foreign-made products that fall under U.S. export regulations. 

The nightmare scenario for the West is Russia’s use of natural gas as a weapon. Russian gas exports account for about one-third of the EU’s gas use and the European economy could collapse if the taps were to be turned off. The White House is working with other global gas suppliers to fill the gap.

 

We’re working with countries and companies around the world to ensure the security of supply and to mitigate against price shocks affecting both the American people and the global economy…

 

We’ve been working to identify additional volumes of non-Russian natural gas from various areas of the world — from North Africa and the Middle East to Asia and the United States.
 

Correspondingly, we’re in discussions with major natural gas producers around the globe to understand their capacity and willingness to temporarily surge natural gas output and to allocate these volumes to European buyers.

The Economist summarized Europe’s gas supply situation and concluded that Europe has become more energy resilient owing to a number of measures: Changes to contracts that allow the re-export and redirection of gas supplies; the supply of LNG, which saw an armada of LNG carriers redirected to Europe as supplies tightened recently; gas held in storage; and a supply of “cushion gas”, which is an extra supply of gas that regulators demanded to held in storage caverns.
 

Mr Stoppard [of IHS Markit] helpfully simplifies things. Russian gas exports to Europe currently amount to about 230m cubic metres per day (cm/d). He reckons surplus regasification capacity could make up for about 50m cm/d. Boosting coal and nuclear power, for example by restarting recently mothballed plants or increasing load factors at underutilised ones, could add the equivalent of another 40m cm/d. That still leaves a shortfall of 140m cm/d. He calculates that if weather remains normal then the amount of stored gas (not including cushion gas) would cover the remaining 140m cm/d shortfall for four and a half months. “This is a price crisis more than a physical supply crisis,” he concludes.

In other words, demand can be met from physical supplies, it’s only money.
 

 

The fiscal put

One of the headwinds to growth in 2022 is the falling fiscal impulse, which has already turned negative. In the US, it appears that Biden’s Build Back Better legislation is collapsing, which Moody’s estimates would subtract 0.75% from GDP growth this year. In addition, the Republicans are likely to regain control of Congress in November, which will put a screeching halt to most of Biden’s spending plans.
 

 

In Europe, France and Germany are at loggerheads over the fiscal impulse. France, which took over the rotating EU Presidency, favors fiscal expansion while the new German finance minister is a fiscal hawk. Across the English Channel, the UK raised taxes by about 2% of GDP in 2021. China and Japan are the only major countries that are engaged in any stimulus.
 

If a hot war were to break out, political reservations about fiscal responsibility will fly out the window. Expect fiscal expansion to support growth. Don’t be surprised to see EU government fuel subsidies to gain approval, financed by the European Central Bank. A similar bipartisan consensus is likely to emerge in Washington on defense-related spending, though it’s unclear whether the Fed would pivot to an easier monetary policy.

 

 

Investment implications

There are two industries that are likely beneficiaries of a hot war. This is emphatically not a recommendation to trade in any of these securities, only to point out the opportunities and risks in these industries and sectors.

 

The most obvious is Aerospace and Defense, which have begun to bottom out relative to the S&P 500 but haven’t fully discounted the prospect of increased defense spending.

 

 

The other are cyber security companies. Any Russian offensive is likely to involve cyber attacks in order to cripple command and control systems and infrastructure. These stocks haven’t responded to the threat of war.

 

 

However, energy stocks have surged in response to Russia-Ukraine tensions. They appear extremely extended and their 5-day RSI is exhibiting a negative divergence. This sector is at risk of a severe pullback should tensions fade.

 

 

In conclusion, investors need to consider two scenarios when forecasting asset returns. If a hot war were to breakout, wars are intermediate-term bullish owing to an accommodative fiscal and probable monetary responses as long as they don’t involve the complete collapse of civil society or nuclear annihilation. Remember Rothchild’s words: “Buy to the sound of cannons…” 

 

If, on the other hand, war fears fade and peace breaks out, the market will be faced with the more conventional challenges of central banks tightening monetary policy during a mid-cycle expansion. In that case, expect the market to be choppy and range-bound after an initial relief rally. “Sell to the sound of trumpets.”

 

Even though the drums of war are beating, an invasion doesn’t appear to be imminent. Representatives from Russia, Ukraine, Germany, and France met in Paris last Wednesday. The meeting broke up with an interim understanding that the ceasefire in eastern Ukraine under the Minsk Agreement would be upheld by all parties. They further agreed to meet again in two weeks’ time in Berlin. While this is a classic “kick the can down the road” development, it is nevertheless a constructive one. The Russian troops massed on the Ukrainian border can’t remain there forever. Some were redeployed from as far as the Korean border. Moreover, the area will thaw in March and turn the ground into an impassable mud and bog. If all sides are still talking in mid-February, the odds of an invasion recedes significantly as the window for a campaign will become extremely narrow.

 

In all cases, investors and traders should fade the war fears and take advantage of any price weakness to buy risky assets.

 

Seeking sanity in a mad market

Posted by Cam Hui -

Mid-week market update: The stock market has been extremely oversold for the past few days, but one element had been missing for the short-term, namely a sentiment capitulation and wash-out, which may have finally appeared. The latest Business Week cover may be the classic contrarian magazine cover indicator of a developing bottom.
 

 

 

Oversold signals everywhere

As well, I am seeing oversold signals everywhere. Two of my four bottom spotting models have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band and the NYSE McClellan Oscillator (NYMO) reached an oversold extreme. While the term structure of the VIX did not invert on a closing basis, they did invert intra-day both on Monday and Tuesday. Moreover, the 5-day RSI of the S&P 500 reached oversold levels last seen during the COVID Crash of 2020.

 

 

The NASDAQ 100 is especially washed out. QQQ short volume has spiked to unprecedented levels.

 

 

The normalized 52-week NDX/SPX ratio has fallen into a relative support zone that has historically defined buying opportunities for large-cap growth stocks with the exception of the 2000 dot-com crash.

 

 

Risk appetite is poised for a comeback, though the longevity of any relief rally remains an open question.

 

 

Main Street, or Wall Street?

Coming into the FOMC meeting, the Fed was caught between the desires of Main Street, which has been increasingly concerned with inflation, and Wall Street, which was hoping for a more dovish message. The Fed threw its lot with Main Street as Jerome Powell stated that “inflation risks are to the upside in my view” and the Fed’s balance sheet is “substantially larger than it needs to be”.

 

Inflation concerns were so widespread on Main Street that it became a major issue on Glassdoor, a website built mainly for employees and potential employees to rate employers. Most of the concerns amount to “my pay raise isn’t keeping up with inflation”.

 

 

The cacophony of inflation complaints prompted President Biden to pressure the Federal Reserve to “do something” in order to bolster the Democrats’ faltering position in the mid-term elections. While the Fed has its own reasons to tighten monetary policy, the combination of broadening inflation pressures and emerging signs of full employment prompted its hawkish pivot.

 

Despite Powell’s equity unfriendly message, the stock market reacted in a constructive fashion by holding above Monday’s panic lows and the VIX recycled below its upper BB.

 

 

In conclusion, stock prices are overly stretched on the downside and a relief rally is more or less inevitable, though its longevity is questionable. While my inner trader remains tactically bullish, he is monitoring the evolution of internals should the bounce materialize. My inner investor has de-risked from an aggressive position to an asset allocation that is consistent with his long-term policy mix.

 

 

Disclosure: Long SPXL

 

What’s the market pricing in?

Posted by Cam Hui -

As the stock market looks forward to another exciting week of volatility, the technical damage suffered by the market is quite severe. Nevertheless, investors need to take a deep breath and ask, “What’s the market pricing in?”
 

 

The three major factors I consider in my analysis are:
  • Earnings and valuation;
  • Fed policy; and
  • Geopolitical risk.

 

 

A valuation reset?

As we proceed through Q4 earnings season, the market hasn’t mostly reacted well to earnings announcements, headlined by the -20% air pocket suffered by Netflix. Nevertheless, the macro summary from The Transcript, which monitors earnings calls, is relatively benign.

 

Omicron continues to sweep through the US and it’s causing some disruptions, but consumer spending continues to be strong. Inflation is also strong and inflation expectations are rising. The Fed is expected to raise rates four times this year and that is spooking investors.

Forward earnings estimates have been steadily rising across all market cap bands.

 

 

As stock prices pulled back, stock prices are undergoing a valuation reset. While all eyes have been on the large-cap S&P 500, the valuation reset has been evident in mid and small-cap stocks, 

 

I can make two observations from this analysis. Valuation resets are a feature and not a bug of mid-cycle expansions (see How small caps are foreshadowing the 2022 market). As well, the forward P/E for the S&P 400 and S&P 600 are arguably quite attractive relative to their own history. 

 

 

Goldman Sachs studied the history of S&P 500 forward P/E ratio around the time of the first Fed rate hike. It found that forward P/E is typically flat ahead of the first rate hike and then falls afterwards. Equity price gains are dependent on the evolution of forward EPS estimates, which have been rising so far.

 

 

While major earnings misses like the one suffered by Netflix have received the headlines, FactSet reported that the 5-year average EPS beat rate is 76% and the average sales beat rate is 68%. As more companies report in the coming weeks, the market will react on a daily basis to reports and there should be more better reactions than the Netflix debacle.

 

 

In light of the recent market weakness, earnings expectations may have become too low/

 

 

How hawkish will the Fed be?

A potential major market event will be the FOMC meeting on Wednesday. While no interest rate changes are expected, both the FOMC statement and Powell’s subsequent press conference remarks will be closely scrutinized to the direction of Fed policy. (The Bank of Canada will also announce its interest rate decision Wednesday and it is expected to chart a more hawkish course by raising rates, but that won’t be the same global market-moving implications as the Fed announcement.)

 

Recent Fedspeak has made it clear that there are no doves left on the FOMC. How hawkish will the Fed be? 

 

Market expectations for the rate hike path is already very hawkish. Fed Funds futures are discounting five rate hikes this year, with liftoff in March.
 

 

Bloomberg recently conducted a survey of economists and here’s what they said. While no rate announcement is expected at the January meeting, most expect a signal of a rate hike. Respondents were split between the language of whether the Fed would explicitly signal a March rate hike or a rate hike “soon”.

 

 

As for the Fed’s balance sheet, survey respondents expect quantitative tightening to begin in the April to June period.

 

Economists expect the runoff of maturing securities to commence this year, with 29% looking for a start from April to June and 40% expecting July to September. The median economist estimate looked for monthly reductions between $40 billion and $59.9 billion. The runoff would bring the size of the balance sheet down to $8.5 trillion at the end of this year and $7.6 trillion at the end of 2023, still far above pre-pandemic levels.

 

 

In short, market expectations are already very hawkish. While the Fed is set on a course of tightening monetary policy, it may have to exceed hawkish expectations to spark a further risk-off episode. Morgan Stanley recently highlighted analysis which showed 10 year real yields are up by over 50 bps in the last three weeks, while 10-year breakevens are down by more than 25 bps. This is an event that has only happened before at or near major market bottoms, in October 2008, March 2009, June 2013, and March 2020.

 

 

 

The drumbeats of war?

The headlines from Ukraine are alarming. The White House warned that an invasion could happen at any time, but there will be dire consequences for Russia if it undertakes military action. The US ordered the evacuation of families of embassy staff from the Kyiv mission. The UK has also withdrawn some embassy staff. Germany will help embassy staff family leave Ukraine.

 

British intelligence accused the Russians of hatching a plot to install Ukrainian parliamentarian Yevgeniy Murayev to be the leader of a Russian-friendly government in Kyiv. Russia has accused Ukraine of building up forces on the border of Donbas, a separtist region, and called the threat of a Ukrainian invasion very high. The US is considering sending troops to eastern Europe and various other NATO members are mobiling and sending military assets to the region.

 

 

Even as the drumbeats of war sound, the tail-risk of an immediate invasion may be receding. While the Blinken-Lavrov meeting in Geneva broke up last Friday with no breakthrough, both sides agreed to continue a dialogue next week and there is the possibility of a direct Biden-Putin meeting in February. As well, the back channels are active on all fronts. Reuters reported that political advisers from Russia, Ukraine, France, and Germany will hold talks on Ukraine in Paris on January 25. If they’re talking, there will be no invasion, at least for now.

 

Moreover, a Bloomberg article speculated that the Beijing Olympics may restrain Putin’s maneuvering room in an invasion.

 

As the U.S. and Europe mount increasingly frantic efforts to deter Russia from any invasion of Ukraine, it’s Chinese President Xi Jinping who may have the biggest influence on Vladimir Putin’s timetable.
The Russian president has said he will join Xi at the opening ceremony Feb. 4 of the Beijing Winter Olympics, where the Chinese leader has lavished billions of dollars to showcase his nation’s superpower status to the world.

 

The last thing Xi needs is for Putin to overshadow China’s big moment by triggering a global security crisis with the U.S. and Europe. That’s especially the case given Xi is looking to bolster his prestige at home as he seeks endorsement for an unprecedented third term later this year. 

 

Xi called Putin an “old friend” when they chatted in mid December, while the Russian leader hailed what he said was a “responsible joint approach to solving urgent global issues.” 

 

But kicking off an invasion of Ukraine in the middle of Xi’s Olympic moment would throw a wrench into such warmth, and risk drawing China into the diplomatic fray. It’s possible Xi asked Putin in their recent call not to invade Ukraine during the Games, according to one diplomat in Beijing who asked not to be identified talking about such scenarios. Putin has repeatedly denied he currently intends to attack Ukraine. 
While an immediate invasion is always possible, the more likely time frame is mid or late February. The closing date of the Beijing games is February 20.
 

Putin and China have been here before. Russia’s 2008 war with Georgia erupted on the day of the opening ceremony of the Beijing Summer Olympics, to the chagrin of Chinese leaders, prompting Putin to fly home to direct military operations.

 

Days after Putin hosted the closing ceremony of the 2014 Winter Olympics in Sochi, on which he’d spent a record $50 billion to stage the Games, Russian forces began their operation to annex Crimea from Ukraine.  
During moment of crisis, even developments that appear to kick the can down the road, such as a Biden-Putin meeting in February or the staging of an Olympic games that delay the onset of conflict, can spark a risk-on episode. Today’s market action where everything is falling except for safe haven assets has the hallmark of a panic liquidation event. The term structure of the VIX has fully inverted, which is another indication of high anxiety.

 

 

In conclusion, the balance of short-term risks is tilted to the upside. Expectations have been ratcheted down too much and the chances of positive surprises from earnings season, Fed policy, and Ukrainian developments appear to be higher than what’s in the price. Being bearish here amounts to betting on outcomes of catastrophic proportions. While that’s not impossible, the odds of rip your face off rally in light of the market’s severely oversold condition are high.

 

However, intermediate-term challenges remain. Technical conditions are deteriorating and the macro backdrop of a mid-cycle expansion will be headwinds for risk assets. I continue to expect stock prices to chart a choppy to down course for the first half of 2022. The recent lows set by the S&P 500 may not be the ultimate low of the latest downdraft.

 

 

Disclosure: Long SPXL

 

Buy the dip, or sell the dead cat bounce?

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.
 

 

Estimating downside risk

Last week, I highlighted a sell signal from the intermediate-term breadth momentum oscillator (ITBM). The 14-day RSI of ITBM had recycled from an overbought condition, which was a sell signal for the stock market. In the past, ITBM sell signals have resolved with 5-10% drawdowns and the market bottomed with the ITBM RSI fell to an oversold or near oversold condition.

 

 

The S&P 500 fell -5.8% since the sell signal and RSI is oversold. Does this indicate a short-term bottom, or is this the start of a major bear leg?

 

 

The bull case

Here are the bull and bear cases. The market is oversold and due for a relief rally. The percentage of S&P 500 stocks above their 10-day moving averages (dma) has reached levels consistent with short-term bottoms.

 

 

As well, the Zweig Breadth Thrust Indicator has fallen into oversold territory (grey bars). As a reminder, a ZBT buy signal occurs when the indicator rises from an oversold to overbought condition within 10 trading days. These signals are extremely rare (red dotted line) and I am not anticipating such a buy signal. Nevertheless, a ZBT Indicator oversold condition has usually marked short-term bottoms in the past.

 

 

Two of the four components of my bottom spotting model have flashed buy signals. In the past, such episodes have signaled tradable bottoms with reasonable accuracy. The VIX Index spiked above its upper Bollinger Band, indicating oversold conditions, and the NYSE McClellan Oscillator (NYMO) has also fallen to oversold levels. Only the term structure of the VIX hasn’t inverted and TRIN hasn’t risen above 2, which are indicators of short-term panic.

 

 

While market-based sentiment indicators such as the VIX term structure and TRIN have not signaled fear, survey-based indicators have. Mark Hulbert revealed that his newsletter sample of NASDAQ market timers had become sufficiently bearish to flash a contrarian buy signal. Sentiment is more bearish than it was at the March 2020 bottom.

 

 

Indeed, the normalized ratio of the NASDAQ 100 to S&P 500 has reached historically important oversold conditions that NASDAQ stocks are likely to see low relative downside risk at current levels.

 

 

That said, Hulbert also his regular sample of market timers are not bearish enough to be in the lowest decile reading to flash a contrarian buy signal, though readings are close.

 

 

Similarly, the latest AAII weekly survey shows a spike in bearish sentiment and a bull-bear spread of -25.7. In the past, bull-bear sentiment spreads below -20 have marked low-risk long entry zones for equity investors.

 

 

 

The bear case

While sentiment models are showing a retreat in bullishness, some models indicate a stubborn lack of bearishness. This could be interpreted as the market due for a short-term bounce, but a durable bottom isn’t in sight just yet.

 

For example, the Investors Intelligence survey shows the bull-bear spread in retreat, but a lack of a spike in bearishness. This could be interpreted as an oversold market, but the absence of panic and washout translates to greater intermediate-term downside risk.

 

 

Helene Meisler conducts a weekly unscieintific poll every weekend. To my surprise, the bulls slightly edged the bears despite last week’s carnage in stock prices. Sentiment may still be too complacent and traders are not panicked enough yet.

 

 

Similarly, while the VIX Index had risen above its upper Bollinger Band, indicating an oversold market, the width of the Bollinger Band remains relatively narrow and not wide enough to be consistent with intermediate-term bottoms.

 

 

Other market internals are also problematic. Indicators of equity risk appetite are exhibiting negative divergences, which is disturbing for the bulls.

 

 

The relative performances of defensive sectors are all forming saucer-shaped bottoms, indicating that the bears have gained control of the tape.

 

 

 

What to watch

How can we resolve this bull and bear debate? First, recognize that the market is stretched to the downside and a short-term relief rally can happen at any time. Much will depend on how the market behaves after the bounce.

 

Here is what I am watching. The percentage of S&P 500 stocks has fallen through the 50-60% zone that defines up and downtrends. If the market were to rally, can this indicator regain the 60% level?

 

 

Support and breadth indicators can also be useful guides. The S&P 500 is testing its 200 dma, which should act as a support level. As well, the weakness in the S&P 500 is overstating index weakness. The equal-weighted S&P 500, which represents the average stock in the index, has been outperforming its float-weighted counterpart since early December, which is constructive.

 

 

In conclusion, the stock market is sufficiently oversold that a relief rally is likely in the short run. However, stock prices remain vulnerable to intermediate-term downside risk. Subscribers received an email alert that my inner trader had bought an S&P 500 position as a short-term trade.

 

Traders and investors should monitor the development of market internals should the rally materialize. The FOMC meeting in the coming week could prove to be a catalyst for volatility and greater clarity on market direction.

 

 

Disclosure: Long SPXL