How small caps are foreshadowing the 2022 market

Posted by Cam Hui -

Small-cap stocks have lagged their large-cap counterparts in 2021. Even as the S&P 500 steadily rose to fresh highs this year, the Russell 2000 and S&P 600 finally staged upside breakouts in November out of a multi-month trading range, but they have struggled to hold those breakouts. Small-cap relative performance peaked in March, but they have sagged and been flat to down relative to the S&P 500. In an equally disturbing development for the bulls, the S&P 600 Advance-Decline Line did not confirm the upside breakout by failing to rise to new highs in November.
 

 

Here is how I believe small-cap performance is foreshadowing the S&P 500 in 2022, but probably not in the way that you are thinking.

 

 

A mid-cycle market

In the past few months, I have been making the case that the US economic expansion is changing from early cycle to mid-cycle (see Time for a mid-cycle swoon? and Where are we in the market cycle?). Mid-cycle expansions are characterized by tightening monetary policy which leads to P/E multiple contractions. Stock prices are driven by earnings growth, which are still positive.

 

There have been three such mid-cycle episodes since 1990 that could serve as templates for 2022, namely 1994, 2004, and 2010. Common characteristics were:
  • Upward pressure on 3-month T-Bill rates, indicating tighter monetary policy;
  • Flat to rising commodity prices, indicating signs of continued global expansion; and
  • Flat to choppy stock prices in H1, followed by market strength in the latter part of the year. None of the episodes resolved in major bear markets.

 

 

From a chartist’s perspective, these episodes had both similarities and differences. In all cases, the stock market had surged off major bottoms and exhibited strong positive price momentum, as shown by prolonged periods when the percentage of stocks above their 200-day moving averages (dma) had risen and stayed above 90%. The key difference was what happened when the price momentum faded. In 2004 and 2014, risk appetite indicators such as the cyclically sensitive copper/gold ratio and the consumer discretionary/staple ratios were flat. In those cases, the stock market response was a soft landing in the form of a period of sideways consolidation. By contrast, risk appetite indicators fell in 2010 (and in 2011), and stock prices corrected sharply.

 

 

As I look ahead to 2022, risk appetite indicators are flat to up. This suggests a soft landing ahead, or some choppiness and sideways consolidation for the S&P 500, but no major bearish episode, followed by market strength later in the year.

 

 

The small-cap template

Here is how small-cap performance in 2021 could foreshadow S&P 500 performance in 2022. First, the valuation framework for analysis is the S&P 600 rather than the more widely used Russell 2000. That’s because S&P has a much stricter profitability inclusion criteria than Russell. This difference has resulted in a higher weight of zombie companies, or companies whose cash flow can’t cover their interest payments, in the Russell 2000 compared to the S&P 600. As the economy emerges from the recession of 2020, it was no surprise that the zombie-laden Russell 2000 beat the S&P 600 because zombie stocks behave like out-of-the-money call options and exhibit a high degree of leverage. As the expansion matures, the higher quality S&P 600 should begin to outperform.

 

 

With that preface, the development of forward EPS estimates for both the S&P 500 and S&P 600 are similar. Both have risen strongly in the wake of the COVID Crash.

 

 

However, the patterns in forward P/E ratios are very different. While the S&P 500 forward P/E has been flat to slightly down during the recovery period, the S&P 600 forward P/E has fallen dramatically and P/E valuation levels appear quite reasonable compared to its recent history.

 

 

This brings me back to the point about what happens during a mid-cycle expansion. Interest rates rise, which puts downward pressure on P/E multiples. Earnings growth will have to do the heavy lifting in order to maintain stock price levels. In the past, this has resolved in a period of sideways consolidation, much in the manner that small-cap stocks behaved in 2021. Small caps eventually overcame the problem of P/E compression and staged an upside breakout. Expect a similar pattern for the S&P 500 in 2022. I would caution, however, that this analysis is not a forecast that the S&P 500 will match the exact pattern of small-cap stocks in 2021, only that small-cap performance serves as a template for the S&P 500 in the coming year.

 

 

Interpreting negative breadth divergence

I would like to address the concern raised by many technicians over the recent negative breadth divergence exhibited by stock market internals. The NYSE A-D Line failed to hold its breakout. Net new highs have turned negative for both the NYSE and NASDAQ. As well, the percentage of stocks above their 50 dma have struggled to maintain their strength.

 

 

The poor breadth is attributable to the lagging performance of smaller stocks, which is particularly evident by comparing the equal-weighted NASDAQ 100 to the cap-weighted NASDAQ 100.

 

 

A similar, but less pronounced effect, can be seen in the S&P 500.

 

 

Contrary to popular belief, a Mark Hulbert study found that small-cap returns have little or no effect on the S&P 500. In fact, Hulbert found that the overall market doesn’t perform when small-cap stocks are the leaders.

 

 

The combination of more attractive small-cap relative valuations and the coming transition to mid-cycle market all point to a period of struggle for the large-cap S&P 500. 

 

All is not lost for the bulls. A separate analysis by Hulbert of insider trading activity by Nejat Seyhun found that insider buying is consistent with a stock market with slightly below average returns.

 

Their current posture translates into an expected U.S. stock market return over the next 12 months that’s only moderately below the historical average.

 

 

This series of analysis is consistent with my scenario of a sideways first half and a rally in the second half of 2022.

 

In conclusion, investors should expect a period of choppy sideways action in H1 2022 for the S&P 500, followed by further strength in H2. Within the US, small-cap valuations appear more attractive on a relative basis. As well, investors should focus on high-quality stocks in the coming year. If the small-cap history of 2021 is any guide, the quality factor should outperform in 2022.

 

 

 

Trading the seasonal rally

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.
 

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.
 

Author’s note: There will be no mid-week market update next week because of the holiday-shortened week.
 

 

Melt-up risk control

The good news is the S&P 500 is testing resistance and less than 1% from its all-time high. Moreover, the recent sideways consolidation has elevated the VIX Index to near its upper Bollinger Band. An upside breakout of the Bollinger Band would constitute an oversold reading for the stock market that carries with it the prospect of more price gains. The market is presenting investors with an unusual condition of a breakout test while exhibiting a near oversold condition.

 

 

The bad news is a number of negative divergences have appeared warning of near-term weakness ahead. Even though a melt-up into year-end remains my base case, investors need to practice some risk control in case the advance unravels.

 

 

A case of bad breadth

The most glaring problem for the bulls is the narrowness of the market strength last week and this is particularly evident among NASDAQ stocks. The market has been held up by a few large-cap growth stocks. Even as the NASDAQ 100 advanced, every breadth indicator has shown negative divergences.

 

 

Small-cap indices recently staged an upside breakout but pulled back to test the breakout level. The bulls need to defend these levels, otherwise decisive violations of support could signal a bull trap.

 

 

One silver lining in the bad breadth narrative is the NYSE McClellan Oscillator has fallen to an oversold condition. With the exception of the COVID Crash, such readings have been bullish signals in the past two years.

 

 

 

Momentum still positive

As another way of practicing risk control, I present a momentum indicator that can warn of a downdraft should the melt-up fail. I found this momentum indicator to be more effective, timely and generates fewer false signals than similar models such as MACD crossovers and negative RSI divergences.

 

The accompanying chart shows the ratio of S&P 500 stocks above their 50-day moving average (dma) to S&P 500 stocks above their 150 dma. When the line rises strongly, it is an indication of strong underlying momentum. When it falls, it is signaling weakening momentum. A sell signal is generated when the momentum indicator first rises above 1 and recycles below 0.9. While no model is perfect, this indicator has warned of market downdrafts after strong rallies.

 

 

 

Where are we now? The market is on a buy (rose above 1), but it hasn’t fallen below 0.9 yet. For the time being, I am inclined to give the bull case the benefit of the doubt until this model flashes a sell signal.

 

Similarly, the SPY/IEF ratio upside breakout is still holding and it remains in a relative uptrend. Risk appetite is still positive, though it is testing trend line support and needs to be monitored.

 

 

In addition to positive technical momentum, the S&P 500 is also experiencing positive fundamental momentum. FactSet reported that Street analysts revised their aggregated bottom-up quarterly S&P 500 EPS upwards across all time horizons.

 

 

 

Positive seasonality

The bulls should totally give up. As Americans prepare to tuck into their Thanksgiving turkey next week, Jeff Hirsch at Almanac Trader pointed out that the market is entering a period of positive seasonality. This summary of Hirsch’s findings shows that stock prices on Monday and Tuesday of the week before Thanksgiving have historically been flat, but Wednesday and Friday of Thanksgiving week have exhibited a bullish bias. However, the period from Thanksgiving to year-end has also been bullish. However, the strength of the rally has been more restrained since 1987 compared to early periods.

 

 

Here is a chart in graphical form, with the caveat that seasonal tendencies are only averages and there can be wide dispersion around average returns.

 

 

 

Climbing a Wall of Worry

Even as equity prices benefit from the tailwind of positive seasonality, sentiment readings are not stretched. The market can rise further as it is climbing the proverbial Wall of Worry.

 

The latest update of weekly AAII sentiment shows a retreat in the bull-bear spread as the market consolidated sideways. This is an indication of skittishness among retail traders during a seasonally strong period.

 

 

The Investors Intelligence Survey tells a similar story of an elevated level of bearishness. I am not ready to turn cautious until the bears capitulate and turn bullish.

 

 

In conclusion, the base case scenario is another year-end rally while enjoying the tailwinds of positive momentum, bullish seasonality, and supportive sentiment conditions. Investors should monitor the market for a loss of momentum, and a decisive violation of small-cap support, which would be cautionary signals to de-risk portfolios.

 

 

Disclosure: Long SPXL

 

What’s wrong with value stocks?

Posted by Cam Hui -

What’s wrong with value stocks? The accompanying chart shows the relative performance of the Russell 1000 Value to Russell 1000 Growth Index ratio (bottom panel, solid line) and the closely correlated S&P 600 to NASDAQ 100 (bottom panel, dotted line). When the dot-com mania peaked in 2000, value stocks initially rocketed upward relative to growth stocks. The relative ascent began to moderate in 2001 but continued for several years.
 

Fast forward to 2020. The growth style had been dominant for 5-7 years and value/growth relative performance had become extremely stretched. Value recovered in 2020 but fell back in 2021. 

 

 

History doesn’t repeat, but is it even rhyming this time? What’s wrong with the value style? 

 

 

Unbalanced return profiles

First, factor returns have been distorted by the outsized performance of a handful of stocks. Analysis by S&P Global found that a small number of stocks perform extremely well and raise the average index return significantly above the median.

 

 

One prominent heavyweight that has performed well and distorted factor returns is Tesla (TSLA), which has crept into the top 10 stocks by S&P 500 index weight.

 

 

As an example of how TSLA has distorted factor return calculations, the accompanying chart shows the relative performance of the Russell 1000 Value to Russell 1000 Growth ratio (black line), which TSLA has influenced, and the relative performance of banks to software stocks (dotted red line), which has no TSLA. The two lines tracked each other well for some time, until they began to diverge.

 

 

Similarly, a comparison of the Russell 1000 Value to Growth ratio and the Russell 2000 Value to Growth ratio shows that small-cap value has performed better than large-cap value. The bottom panel shows that the size effect within value is outperforming the simple size effect as measured by the Russell 2000 to S&P 500 ratio.

 

 

While this analysis of the value/growth ratio shows that a pure value factor has performed better, its recovery remains disappointing. On the other hand, the superior performance of growth stocks is not as widespread. The relative performance of speculative growth, as measured by the relative performance of BUZZ, which are mainly meme stocks, and Cathie Wood’s ARK Innovation ETF, are flat to slightly down YTD.

 

 

 

Macro uncertainty

The lack of a value stock recovery can partly be explained by macro cross-currents. An analysis of the relative performance of cyclically sensitive value sectors shows that most are trading sideways this year. In particular, the relative returns of financial stocks are highly correlated to the shape of the 2s10s yield curve. As banks tend to borrow short and lend long, a steepening yield curve boosts profitability while a flattening yield curve squeezes lending margins. The same influence can be said of the other cyclically sensitive sectors. A steepening yield curve is the bond market’s signal of improving growth and a flattening yield curve indicates a growth deceleration. Since the yield curve has been flattening, value and cyclical stocks are facing macro headwinds.

 

 

The market consensus is shifting towards stagflation. Economists are downgrading their GDP forecasts while boosting their inflation forecasts. It is therefore no surprise that growth stocks are getting a second wind. When growth becomes scarce, investors gravitate toward growth stocks.

 

 

This macro consensus scenario may be short-lived. The Economic Surprise Index, which measures whether economic reports are beating or missing expectations, is rising. This should put upward pressure on bond yields. At a minimum, stronger growth should steepen the yield curve, which would benefit value stocks.

 

 

In addition, there are early signs that supply chain bottlenecks are easing. The semiconductor shortage is unwinding and auto production is showing preliminary signs of a rebound, This will alleviate some of the inflationary pressure in the coming months and lead to a reversal of the stagflation expectations.

 

 

 

Bull case for growth stocks

While the bull case for value stocks is based on cyclical factors, which appear to be turning up, the bull case for growth stock rests on solid secular factors. At first glance, the evaluation spread as measured by EV/sales, is at bubbly dot-com peak levels.

 

 

The relative P/E ratios, which stretched, are tamer than the EV/sales spreads suggest. That’s because large-cap growth stocks today have better margins and earnings than those of the dot-com era. The FANG+ companies tend to be cash generative and enjoy strong competitive positions.

 

 

An indirect way of observing the characteristics of large-cap growth stocks is through an ESG (Environmental, Social Governance) lens. ESG stocks have historically shown a growth tilt. That’s because it’s much easier for a growth company like Microsoft to qualifying under an ESG filter than a value company like Exxon Mobil.

 

 

Further analysis of ESG stocks reveals that they are asset-light companies which are more profitable, exhibit higher ROE and have fewer employees than the index. 

 

 

 

Value or Growth?

In conclusion, value stocks have faced a few headwinds in 2021. Large-cap factor calculations were distorted by the strong performance of heavyweight Tesla, whose share price has risen strongly to affect factor returns. In addition, the growing belief in stagflation characterized by slowing growth and rising inflation has boosted growth stocks at the expense of the value style.

 

However, an analysis of stock price momentum shows that this factor has mainly trades sideways in the last six months, indicating a lack of style dominance.

 

 

I believe investors should adopt a balanced approach by holding both value and growth stocks in their portfolios. Tactically, value should start to enjoy a revival in H1 2022 as inflation expectations ease and growth expectations rise. However, there are considerable macro risks to this scenario and investors should practice risk mitigation with commitments to large-cap growth stocks.

 

Consolidating for a rally

Posted by Cam Hui -

Mid-week market update: My trading view remains unchanged. The market is consolidating for a rally into year-end (see The seasonal rally is intact). Initial S&P 500 support on the hourly chart is at about 4680, and secondary support is at 4630-4640. If the S&P 500 breaks out to an all-time high, we’re off to the races.
 

 

 

Uptrend intact

Here are some bullish data points to keep in mind. The recent Dow Theory buy signal indicates a bullish primary trend.
 

 

As well, the relative performance of defensive sectors to the S&P 500 are not showing any signs of strength. The bears are not showing any signs of life.

 

 

Breadth indicators are positive. The NYSE Advance-Decline Line broke out to a fresh high. Net NYSE and NASDAQ highs-lows made a recent high before the market retreated. The percentage of NYSE stocks above their 50 dma broke resistance, though the NASDAQ counterpart is still lagging.

 

 

Equity risk appetite is confirming the strength in the S&P 500 and there are no negative divergences.

 

 

Finally, semiconductor stocks represented one of my bullish tripwires. These growth-cyclicals staged an upside relative breakout through a range and they are now testing another relative resistance level.

 

 

In conclusion, the market is trading sideways but internals remains bullish. My inner trader is keeping an eye on 4680 initial support and 4630-4640 secondary support as ways to control downside risk. He remains bullishly positioned.

 

 

Disclosure: Long SPXL

 

The inflation challenge

Posted by Cam Hui -

Inflation fears have been rising in the wake of the hot October CPI report. Barry Ritholz, the CEO of Ritholz Wealth Management, recently issued an open challenge to the inflationistas.
 

 

Which side of that bet would you take?

 

 

Rising inflation concerns

Inflation concerns are becoming widespread. FactSet reported the highest number of companies citing “inflation” on their earnings calls in 10 years.

 

 

While virtually all sectors saw rising “inflation” citations in their earnings calls, the one silver lining for the consumer is inflation pressures were tame in consumer staples and utilities.

 

 

 

A glass half full, or half-empty?

There has been a growing cacophony of voices calling for tighter monetary as fears that the Fed is behind the inflation-fighting curve grows. The accompanying chart depicts the heart of Ritholz’s inflation challenge. The blue line shows the 2-year Treasury yield less core CPI, which has been plunging owing to the surge in reported inflation. Readings have fallen to levels not seen since 1980 when Paul Volcker really applied the monetary brakes to wring inflationary expectations out of the system. The red line shows 2-year Treasury yields less the 5×5 inflation expectations, which is negative but turning up. One uses a backward-looking inflation metric and the other uses a forward-looking indicator. Which should Fed policy makers pay the most attention to?

 

 

If the inflationistas are right, how much should the Fed tighten? Former New York Fed President Bill Dudley penned a Bloomberg Op-Ed highlighting the risks. The later the Fed waits to tighten policy, the higher the risk that such a policy path could lead to recession. The potential peak policy rate in this cycle may be as high as 3-4%, which would well ahead of market expectations. Even a 3% Fed Funds rate would mean an inverted yield curve, which usually foreshadows a recession.

 

For what it’s worth, the Taylor Rule under different assumptions calls for a Fed Funds target of between 5.0% and 5.8%, which is substantially higher.

 

 

 

BIS: Mostly a bottleneck problem

What’s the answer on the inflation bet? The Bank of International Settlements recently published a research note which concluded that supply chain bottlenecks accounted for 2.8% of the recent inflationary spike in the US and 1.3% in the euro area [emphasis added]:
 

The mechanical effect on CPI inflation from the price increases for bottleneck-affected items has been notable in recent months. If energy and motor vehicle prices in the United States and the euro area had grown since March 2021 at their average rate between 2010 and 2019, year-on-year inflation would have been 2.8 and 1.3 percentage points lower, respectively…That said, once relative prices have adjusted sufficiently to align supply and demand, these effects should ease. Some price trends could even go into reverse as bottlenecks and precautionary hoarding behaviour wane. The mechanical effect on CPI could well turn disinflationary during this second phase.
The pandemic caused both a supply and demand shock to goods and services. Goods demand shot up while services demand cratered. Over time, increased investment in the goods sector should alleviate most of the bottlenecks and the inflation shock is forecasted to dissipate after three or four quarters.

 

 

The BIS expects inflation to fade in the coming months. Moreover, a Bloomberg article highlighted the degree of fiscal drag on the horizon, which will also have a deflationary impact.

 

 

 

Investment implications

What does this mean for investors? For equity investors, the inflation spike has been good for profits, according to the WSJ.

 

Companies are paying higher wages, spending more for materials and absorbing record freight costs, pushing up economic inflation gauges. They are also reporting some of their best profitability in years.

 

Executives are seizing a once in a generation opportunity to raise prices to match and in some cases outpace their own higher expenses, after decades of grinding down costs and prices…

 

Nearly two out of three of the biggest U.S. publicly traded companies have reported fatter profit margins so far this year than they did over the same stretch of 2019, before the Covid-19 outbreak, data from FactSet show. Nearly 100 of these giants have booked 2021 profit margins—the share of each dollar of sales a company can pocket—that are at least 50% above 2019 levels.
As long as inflation expectations are rising, that should be bullish for equities. The key is timing the inflection point. I am monitoring gold and the price of TIPs. Any weakness will be a signal to de-risk portfolios.

 

 

Conversely, the recent BoA Global Fund Manager Survey shows a record level of bearishness in bonds.

 

 

In conclusion, the recent inflation surge is temporary. It’s difficult to time the exact top in inflationary expectations, but any loss of momentum in gold and TIPs prices should be regarded as a signal for investors to reposition portfolios away from equities into bonds.

 

 

The seasonal rally is intact

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The most wonderful time of the year?

Jurrien Timmer at Fidelity observed that the S&P 500 is roughly following the pattern of a seasonal rally into year-end and beyond. In light of last week’s market weakness, what’s the health of the seasonal rally in 2021?

 

 

However, traders who rely on seasonality should be cautious as Ryan Detrick pointed out the middle of November can be choppy.

 

 

 

Bull trend still intact

Let’s start with the big picture. The bull trend remains intact. The market staged upside breakouts through resistance to all-time highs across all market cap bands. All indices are holding above their breakout levels, which is bullish.

 

 

Both the Dow and the Transports broke out to new highs. Those breakouts are also holding.

 

 

Market internals, such as indicators of equity risk appetite, are confirming the stock market’s newfound strength.

 

 

As well, defensive sectors are all in relative downtrends.

 

 

 

A brief setback

The market did flash a brief warning last week when the S&P 500’s 5-day correlation with the VIX and VVIX, which is the volatility of the VIX, spiked. Past instances has seen stock prices either weaken or consolidate.

 

 

On the other hand, the VIX Index rose above its upper Bollinger Band as the S&P 500 weakened. Such episodes have been signs of an oversold market indicating positive risk/reward for long positions.

 

 

The pullback appears to be over, or on its last legs. However, this doesn`t preclude the possibility of the market weakening to re-test the old lows if seasonality calls for some choppiness.

 

 

Supportive sentiment

Sentiment models are supportive of further gains in light of the backdrop of strong price momentum. The latest update of AAII weekly sentiment shows rising bullish sentiment and retreating bearish sentiment. However, the bull-bear spread is not extreme enough to warrant caution. In the past, bearish sentiment of 20% or less has been a useful but inconsistent warning sign, but bearish readings have not reached those levels yet.

 

 

The TD-Ameritrade IMX, which measures the positioning of that firm’s clients, fell even as the S&P 500 rose to fresh highs. This is a classic sign of the market climbing the proverbial Wall of Worry.

 

 

Sentiment is by no means frothy. The combination of positive seasonality, strong price momentum, and skeptical sentiment indicates that there is more upside potential.

 

 

All systems go

In conclusion, the upside breakouts of the major market indices are holding. The measured upside objective of the S&P 500 on a point and figure chart varies between 5220 and 5450, depending on how the box size and reversal parameters are set.

 

 

All systems are go for the seasonal rally.

 

 

Disclosure: Long SPXL

Commodity weakness = Global slowdown?

Posted by Cam Hui -

My Trend Asset Allocation Model has performed well by beating a 60/40 benchmark on an out-of-sample basis in the last few years. The early version of the Trend Model relied exclusively on commodity prices for signals of global reflation and deflation. While the inputs have changed to include global equity prices, this nevertheless raises some concerns for equity investors.
 

 

Commodity prices are weakening, which could be a signal of global economic deceleration. In particular, the cyclically sensitive industrial metals are losing momentum and showing signs of violating a rising trend line.

 

 

 

Commodity warnings

Even as the equity averages in the major developed world rallied to fresh all-time highs, a negative divergence is appearing in the commodity markets. Commodity averages, whether they are energy-heavy liquidity weighted or equal-weighted, have failed to confirm equity market strength. Equally disturbing is the weakness in the cyclically sensitive copper/gold ratio and the more diversified base metals/gold ratio.

 

 

Commodity weakness may not be over. Recession Alert highlighted an eight-month lead-lag relationship between countries with rising leading economic indicators (LEI) and the CRB Index. If the past is any guide, the recent loss in momentum in LEIs is foreshadowing a major top in commodity prices.

 

 

 

Silver linings

In more normal times, an imminent top in commodity prices would have me concerned about the health of the global economy. But this is an unusual economic cycle characterized by the stresses of supply chain bottlenecks.

 

There is no recession on the horizon. New Deal democrat, who monitors the US economy using coincident, short-leading, and long-leading indicators, declared that all three time horizons are positive. In fact, the nascent weakness in commodity prices represents a silver lining.

 

For the second week in a row oil has declined, joining shipping costs and all commodities, not just industrial metals, in retreating from highs. Gas prices should follow suit within the next few weeks. Note that the BDI has fallen by more than -50% from a peak just one month ago. This suggests that the supply chain bottleneck has passed its peak. If so, one would expect the huge increases in house and car prices to begin to abate soon.

Indeed, easing commodity prices are likely to put a lid on the inflation hysteria that emerged after the hot October CPI print. Producer prices (red line) have led CPI upwards in recent months and any commodity price weakness will cool off CPI in the near future.
 

 

 

China weakness contained

As China is such a voracious consumer of commodities, I believe commodity weakness is mainly reflective of a slowdown in China whose effects have so far been contained in Asia  The relative performance of the stock markets of China and her major Asian trading partners tells the story. All are in relative downtrends compared to the MSCI All-Country World Index (ACWI). Several have broken relative support. Japan rallied on the news of a change in the prime minister, but gave up all of its gains soon afterward.
 

 

Within the global materials sector, Chinese material stocks have plunged relative to their global counterparts in recent weeks, indicating greater weakness within the Middle Kingdom in that sector.
 

 

On the other hand, the Chinese consumer doesn’t seem to be hurting very much. Alibaba reported a record 540.3 billion yuan in Singles Day sales this year. Moreover, European luxury goods maker LVMH, which derives a substantial amount of its sales in China, is performing in line with other consumer discretionary stocks.
 

 

Markets in Europe and the US have mostly shrugged off any weakness coming from China. In the US, the relative performance of key cyclical sectors and industries appears constructive. Some are staging relative breakouts (semiconductors and transportation), others are range-bound (homebuilders, energy, mining), and one is bottoming (industrials).
 

 

In Europe, cyclical sectors like industrials and financials are not showing signs of relative weakness. However, basic materials are in a relative downtrend, which is unsurprising in light of a loss of commodity price momentum.
 

 

 

A decoupled China

In conclusion, weak commodity prices are signaling a slowdown in the Chinese economy. Although China Evergrande’s debt woes has not resulted in a Lehman 2.0 event in China, its debt problems have spread to other property developers. Yields on China’s USD junk bonds are soaring and the slowdown is manifesting itself in falling commodity demand.
 

 

However, we are seeing few contagion effects and there are some silvering linings to commodity price weakness. First, it should lead to better inflation prints in the coming months and alleviate some of the inflation hysteria gripping the markets. As well, falling commodity prices translate to lower input prices for manufacturers, which should improve operating markets and boost profitability.
 

Commodity and China weakness only represents a minor pothole in global growth. Topdown Charts recently pointed out that 90% of countries saw their October PMIs in expansion even as China weakened. This is what China decoupling and weakness containment looks like.

October PMI data was particularly encouraging last week. The data show that the proportion of countries with a PMI above 50 reached 90%. Most countries are seeing significant economic growth as the world fights off the final wave of COVID-19 (knock on wood).

 

 

Bullish and bearish signals from volatility

Posted by Cam Hui -

Mid-week market update: Volatility indexes are flashing a number of signals of interest. In the past few weeks, a yawning gap has opened out between MOVE, which measures bond volatility, and VIX, which measures equity volatility. The divergence has begun to close in the last couple of days as the VIX has risen and the spread has narrowed.
 

 

Another cautionary signal from vol is appearing in the form of an increased 5-day correlation between the S&P 500 and VIX, and VVIX, which is the volatility of the VIX. In the past, spikes in correlation has seen stocks either pause their advance or pull back. In particular, high correlations with VVIX have been more effective as short-term warnings than VIX correlations.

 

 

Does that mean the S&P 500 is at risk of a significant downdraft? Not so fast. A third volatility indicator suggests that downside risk is limited. Even as the S&P 500 weakened, the VIX Index has spiked above its upper Bollinger Band (BB), which is an oversold reading for the market. In the past, such events have marked indicating positive risk/reward for the bulls over a 3-5 day time horizon.

 

 

The stock market is roughly following its seasonal pattern. If the past is any guide, stock prices should pause its advance about now, which would be followed by a resumption of a rally into year-end.

 

 

In other words, the seasonal melt-up that I have been calling for remains intact.

 

 

Opportunities in gold

On a different topic, the October CPI print came in hot this morning. Both headline and core CPI came in well ahead of expectations. The strong CPI report highlights a tactical opportunity in gold and gold mining stocks. Gold, which is viewed as an inflation hedge vehicle, staged a decisive upside breakout through resistance today and its strength had already been signaled by the rally in TIPs prices.

 

 

In addition, the gold miners have also staged an upside liftoff from a support zone. The improvement had been signaled by a bottom in the percentage bullish indicator, which had recycled from an oversold condition. Gold miner strength has also been confirmed by the miner/gold ratio and the high-beta junior/senior gold ratio (GDXJ/GDX).

 

 

 

Disclosure: Long SPXL

 

A question of leadership

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Nagging questions of leadership

It is said that the most bullish thing a market could do is to make fresh highs. An even more bullish development is to see the market break out to fresh highs across all spectrums. Indeed, the large-cap S&P 500, mid-cap S&P 400, small-cap S&P 600, and the NASDAQ Composite has achieved all-time highs.

 

 

However, discussions with several readers revealed nagging questions about the quality of the leadership in this advance.

 

 

A broad advance?

Conventional breadth analysis leads to a bullish conclusion of a broad advance. The Advance-Decline Lines of the S&P 500, NYSE, and S&P 400 have all made all-time highs. Only the NASDAQ and S&P 600 A-D Lines are lagging. The standard interpretation is that most of the troops are advancing with the generals, which is bullish.

 

 

However, a review of the relative performance of the top five sectors reveals a less exciting story. As a reminder, the top five sectors make up about three-quarters of S&P 500 weight and it would be virtually impossible for the index to meaningfully rise or fall without their broad participation. The analysis of the top five sectors shows that technology stocks are in a minor relative uptrend and the cap-weight consumer discretionary sector is surging. However, the relative performance of the equal-weighted consumer discretionary sector, which reflects the breadth of the sector, is much weaker. More disturbing is the relative weakness of communication services, healthcare, and financials. The lack of relative strength in financial stocks is disconcerting in light of the Fed’s dovish taper announcement, which should be bullish for the sector.

 

 

A more detailed analysis of large-cap strength shows that the recent advance was attributable to only a handful of stocks. A comparison of the relative strength of consumer discretionary to consumer staple stocks, which is often used as an equity risk appetite indicator, shows that most of the strength can be explained by the gargantuan gains of a single stock, Tesla (TSLA). The equal-weight relative performance of the two sectors (bottom panel), while positive, is less clear-cut bullish.

 

 

The recent upside breakout of the Dow Transports to all-time highs can be interpreted as a Dow Theory buy signal. However, the strength in that index is attributable to a surge in the price of Avis (CAR). This is another sign of a single stock pulling up an indicator or index.

 

 

Similarly, while the strength in the NASDAQ 100 appears bullish, the relative performance of the equal-weighted to cap-weighted NASDAQ 100 has been tanking, which is another sign of narrowing leadership.

 

 

 

Resolving the doubts

How can investors square the question? Is the leadership broad or narrow and what does it mean for the durability of the current market rally? Both statements can be true. 
  • The stock market is rising with broad participation; and
  • Within large caps, the indices are being pulled up by a handful of speculative names.
I interpret these conditions to mean that the stock market can continue to advance, but investors need to be cautious about excess enthusiasm for soaring single stock stories. This environment has distorted factor returns. In particular, the Fed’s recent dovish taper should be bullish for value and cyclical stocks at the expense of growth. Instead, growth has dominated, but that’s because of a handful of stocks.

 

 

Under these circumstances, I am inclined to adopt a balanced approach to leadership of both value and growth with a possible small value tilt.

 

 

Trading the melt-up

Putting the concerns about leadership quality aside, confirmations are emerging that the stock market is undergoing a melt-up. The S&P 500 has reached the upper Bollinger Band defined by its 200 dma, which is a telltale sign of a market melt-up. In the past five years, there have been six other instances when this has happened. In five of the six, the market topped out when the 14-day RSI flashed a negative divergence. This is a FOMO stampede. Stay long and buy the dip.

 

 

The measured objective from a point and figure chart is 5220, which represents an upside potential of 11% from Friday’s closing price.

 

 

In the short-term, however, the market is very overbought and the advance could pause at any time. The 5-day RSI is at an extreme, and the 14-day RSI has risen above 70 where advances have temporarily stalled in the last year. One possible trigger of volatility could be the CPI print on Wednesday.

 

 

You can tell a lot about the psychology of a market by how it reacts to news. The House of Representatives passed the Infrastructure Bill late Friday, sending it to Biden’s desk for signature. Keep an eye on infrastructure stocks (PAVE) on Monday. Will they be rising in relief that the legislative impasse is over, or will investors sell the news?

 

 

In conclusion, the stock market is following the script for a melt-up into year-end. However, market leadership may be changing as selected speculative issues are leading in a massive way. Investors should be positioned bullishly, but adopt a more balanced approach between value and growth.

 

 

Disclosure: Long SPXL
 

A Dow Theory buy signal, but…

Posted by Cam Hui -

Jack Schannep at DowTheory.com described a classic Dow Theory buy signal this way:
 

The classic Buy signal is developed as follows: After the low point of a primary downtrend in a Bear market is established, a secondary uptrend (this is the most often debated part of the Theory) bounce will occur. After that, a pullback on one of the averages must exceed 3%, according to Robert Rhea in his 1930’s The Dow Theory,  must then, ideally, hold above the prior lows on both the Industrial and the Transportation Averages. Finally, a breakout above the previous rally high by both, constitutes a BUY Signal for the developing Bull market.

 

The chart represents how the Dow Jones Industrial Average and the Transportation Average might look under the most usual BUY signal (B-1):

 

 

Both the Dow and the Transports made all-time highs last week, aided by a surge in the shares of Avis. The technical pattern is consistent with the description of a Dow Theory buy signal.

 

 

While the Dow Theory buy signal is bullish for stock prices, a number of key risks are lurking as I look forward to 2022.

 

 

Bullish confirmations

Let’s start with the good news. There are plenty of bullish confirmations. In the short term, Ryan Detrick pointed out that strong momentum, defined as the S&P 500 up 20% or more in the year, tends to resolve bullishly for November and December. While the same size is small (n=8), the remaining two months have been 100% positive.

 

 

The market is also exhibiting signs of strong breadth. A review of different Advance-Decline Lines shows that the S&P 500, NYSE, and S&P 400 A-D Lines have broken out to all-time highs. Only the NASDAQ and S&P 600 A-D Lines are lagging.

 

 

Broad equal-weighted market indices, such as the Value Line Geometric Index, have also achieved fresh highs.

 

 

I had written in the past that one of my bullish tripwires is an upside breakout of small-cap stocks out of their trading range. Both the Russell 2000 and S&P 600 broke out last week.

 

 

My other key bullish tripwire is an upside relative breakout by semiconductors. While these stocks have staged upside absolute breakouts, they only recently broke out of a relative trading range. This is a signal from a group of growth cyclicals that a global recovery is underway.

 

 

Sentiment readings are also supportive of further gains. The latest Investors Intelligence shows a recovery in the number of bulls, but my former Merrill Lynch colleague Fred Meissner pointed out that the number of bears also rose. I interpret this combination of skepticism in the face of strong momentum as the market climbing the proverbial Wall of Worry. This rally has room to run.

 

 

From a fundamental and macro perspective, the signs of a recovery are continuing. The Citigroup Economic Surprise Index, which measures whether economic releases are beating or missing expectations, is rising. In particular, the October Employment Report was a Goldilocks “not too hot, not too cold” report. Job gains were slightly ahead of expectations and the figures from previous months were revised upward. Moreover, gains in average hourly earnings were in line with expectations, which alleviated concerns about excessive wage inflation.

 

 

The Q3 earnings season has been solid. Both EPS and sales beat rates are above average and forward 12-month EPS revisions are rising. In addition to positive price momentum, positive EPS revisions are indications of fundamental momentum that is supportive of further gains.

 

 

 

Beware of 2022 headwinds

Here is the bad news. While I am slightly early to be writing about the outlook for 2022 in early November, the bad news is that market bulls won’t find next year’s stock market to be as easy.

 

Consider how quarterly estimate revisions have evolved in the last four years. Historically, analysts have been overly optimistic about their EPS estimates. Initial estimates tend to be high and they are gradually revised downward until the report date and that is why I have monitored forward 12-month estimates as a way of normalizing this effect. The pace of the pandemic recovery was a surprise to the Street, but the rate of upward quarterly revisions rose as the strength of the recovery became evident. The pace of upward revisions has decelerated for the last two quarters and revisions are likely to return to the more normal pattern of negative revisions for the Q4 earnings season. This development shouldn’t necessarily be interpreted as bearish, but the removal of a bullish tailwind for the EPS outlook.

 

 

The S&P 500 forward P/E ratio has been slowly falling in the past few months. P/E compression often occurs as the expansion matures from the initial rebound to mid-cycle. The challenge for equity bulls is the E in the P/E ratio has to rise faster than the decline in the P/E ratio.

 

 

The easy money has been made. The S&P 500 has returned to trend EPS growth. While this doesn’t mean that earnings can’t temporarily grow above trend, the recovery tailwind has dissipated.

 

 

Moreover, the relative performance of non-US markets is starting to raise warning flags. The accompanying chart depicts the relative performance of different regions compared to the MSCI All-Country World Index (ACWI). US stocks are leading the way (top panel). The major developed markets are going sideways (middle panel). The most disturbing development is the poor relative performance of emerging markets (bottom panel). Relative weakness in high-beta EM equities sets up a possible disappointment in the global economic recovery.

 

 

 

A late-cycle bull

In conclusion, I reiterate my view that the stock market is in a late-phase bull cycle, though that does not mean the economy is in the late-cycle phase of an expansion (see Where are we in the market cycle?). 

 

My base case scenario calls for a stock market rally into year-end led by reflation stocks. We are entering a period of positive seasonality and the market has been tracking the seasonal pattern relatively well in 2021. Expect a growth deceleration soon afterward, a rotation into growth, and a possible correction in Q1, but no bear market.

 

A no-surprise Federal Reserve

Posted by Cam Hui -

Mid-week market update: I told you so. Earlier in the week, I wrote that the market had become overly hawkish about interest rate expectations (see Hawkish expectations). Leading up to the November FOMC meeting, the Fed had signaled that a QE taper is about to begin and, if everything goes along with projections, the first rate hike would occur in late 2022.
 

Fed watcher Tim Duy added (before the meeting) that the Fed had unveiled its spanking new FAIT framework and it was unlikely to abandon it so quickly.

 

The Fed doesn’t want to drop the new framework at the first sign of trouble. The issue of full employment still obstructs the path to rate hikes. If the Fed were to pull tapering forward, the implication would be either the Fed is abandoning its new shiny new framework or that it has redefined full employment. Remember, there is institutional inertia at play here…The new framework sets the Fed apart from its central banking peers that are quickly pivoting in a hawkish direction. Indeed, the new framework is intended to prevent such a pivot, which means that if the Fed were to move in the BoC/BoE/RBA/RBNZ direction, it would amount to abandoning the new framework.

We got a dovish taper, which is what I expected. The 2-year Treasury yield eased in reaction to the FOMC decision and the yield curve steepened.
 

 

As well, ECB head Christine Lagarde said today that conditions for rate hikes are unlikely to be met next year. As a consequence, German 2-year rates also fell.
 

 

 

Rising bond yields

The steepening yield curve is a cyclical signal and the rising rates ETF (EQRR) rose in response.

 

 

The heaviest components of EQRR are mainly value sectors. Value stocks are turning up against growth, and small-caps in particular. The value/growth relationship is correlated to the steepness of the yield curve.

 

 

 

Small caps break out

One of my bullish tripwires has been an upside breakout by high-beta small-cap stocks. While the popularly charted IWM on StockCharts broke out a few days ago, the ticker is a total return series and includes dividends. The capital return only ticker _IWM only staged an upside breakout today, and the breakout was confirmed by the S&P 600.

 

 

Depending on the parameters are set, the upside objective for IWM is between 265 and 273 on the point and figure chart, which represents an upside potential of 11% to 14%.

 

 

 

Year-end rally underway

The year-end rally that I had forecasted appears to be underway. Some sentiment indicators, such as the Fear & Greed Index, have become overbought. However, this index is not useful as a trading indicator. In fact, such readings could be interpreted as signals of positive momentum consistent with year-end meltups in the past.

 

 

Risk on!

 

 

Disclosure: Long SPXL

 

Hawkish expectations

Posted by Cam Hui -

Short-term rates are freaking out. 2-year yields are rising based on the expectation of a tightening bias by global central bankers.
 

 

The market should gain greater clarity on central bank intentions soon. Both the Fed and the BoE will announce their interest rate decisions this week and the BLS will report Non-Farm Payroll Friday.

 

 

How hawkish?

How hawkish could be Fed turn? Since the market has already discounted an aggressive policy, what does it need to beat expectations?

 

Let’s look at the data. Core PCE, which is the Fed’s favorite inflation indicator, came in below expectations as it was flat in September compared to August. Most of the inflation was attributable to durable goods PCE. The strength in durables PCE is mainly attributable to supply chain bottlenecks, illustrated by the inverse correlation between it and the plunging domestic auto inventories (black line, right scale). This is what transitory inflation pressures look like. Falling auto inventory is a symptom of the semiconductor shortage. 

 

 

How transitory? The CNBC interview with Intel CEO Pat Gelsinger provides a window on supply chain pressures. The shortages are peaking now and they should start to ease, but don’t expect normalization until 2023.

 

Gelsinger said that…he didn’t expect the semiconductor shortage to end until 2023.

 

“We’re in the worst of it now, every quarter next year we’ll get incrementally better, but they’re not going to have supply-demand balance until 2023,” Gelsinger said.
As a window on commodity inflation, the IEA forecasts the oil market will return to surplus by H2 2022. 

 

 

In other words, inflation pressures are peaking now and they should begin to diminish, but normalization will not occur until mid or late 2022.

 

Even as demand-pull inflation pressures peak, cost-push wage pressures are rising. The Q3 employment cost index (ECI) came in hot, led by wages (red line).

 

 

A breakdown of ECI by industry shows that most of the gains were in low-paid groups such as retail and leisure and hospitality. This is consistent with the Fed’s stated objective to reduce inequality. 

 

 

Will these indications of transitory inflation and falling inequality be enough for the Fed to stay the course, or pull forward its projected rate liftoff from late 2022 to the market’s expectation of June 2022, and a second rate hike in September? Don’t count on it. A recent Bloomberg survey of economist shows that they expect inflation to be under control by 2023.
 

 

 

Focus on productivity

To settle the debate, Ed Yardeni hit the nail on the head when he said that the single variable affecting the Fed’s decision process is productivity growth.

 

Productivity growth is the key swing variable” in determining whether this decade looks like the Roaring 1920s or the inflationary 1970s, says Ed Yardeni, president of Yardeni Research. “If productivity growth doesn’t improve as we expect, then upward wage pressures would cause a wage-price spiral similar to what happened during the 1970s.”

As I pointed out on the weekend, the global economy is experiencing tight labor markets (see Making sense of the Great Resignation). Analysis from the BCG Henderson Institute found that tight labor markets tend to spur productivity growth as companies substitute technology and capital for labor. This should usher in an economic boom in the coming years.
 

 

The market has become overly hawkish. The odds are the Fed will disappoint with a dovish tone. Keep an eye on Friday’s NFP report. Unless the jobs report comes in very strong, or if the gains in average hourly earnings exceed expectations, the doves should continue to have the upper hand.

 

 

Waiting for the FOMC

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

 

An asset rotation review

A review of the asset returns on an RRG chart and found a possible inflection point for both equity market leadership and bond prices. As a reminder, I use the Relative Rotation Graphs, or RRG charts, as the primary tool for the analysis of sector and style leadership. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

 

 

Here are the main takeaways from the analysis of daily asset returns using a 60/40 US stock/bond mix as a benchmark for USD investors.
  • The S&P 500 is in the leading quadrant and shows no signs of weakness. The market is on track for a rally into year-end. The open question is whether value or growth stocks will lead the charge.
  • EAFE, or developed market international stocks, is in the improving quadrant, but price momentum is weakish.
  • MSCI China is also in the leading quadrant, but it is showing some signs of weakness. Investors are returning to Chinese equities but face considerable risks.
  • EM xChina has fallen into the lagging quadrant.
  • Bond prices are in the lagging quadrant but showing signs of improvement. In particular, long Treasuries (TLT) is on the verge on rising into the improving quadrant. Much depends on the language from the FOMC meeting in the coming week.

 

 

Global equity market review

The accompanying chart of the relative returns of different regions compared to the MSCI All-Country World Index (ACWI) is a snapshot of global market leadership. The S&P 500 is strong and staged a relative upside breakout to all-time highs. The two main regions in the EAFE markets are Europe and Japan. European stocks are going nowhere. Japanese stocks surged in anticipation of a change in political leadership but gave all the gains back afterward. China is the heavyweight in EM and it appears to be trying to make a relative bottom. By contrast, EM xChina is weak.

 

 

 

U-S-A! U-S-A!

In the US, strong momentum is supportive of further gains and so are sentiment model conditions. All Star Charts found an unusual agreement between AAII and Investors Intelligence sentiment readings have led to further price gains.

 

Both surveys now show bulls in the 40’s and bears in the 20’s. Our sentiment chart of the week shows that when we’ve seen this degree of agreement between these surveys in the past, stocks have tended to do pretty well.

 

Similarly, SentimenTrader observed that the NAAIM Exposure Index, which measures the sentiment of RIA advisors, has moved to a levered long condition. Similar past episodes have resolved in a bullish manner.

 

 

In addition, Q3 earnings season has been strong. Both EPS and sales beat rates are above average and EPS estimate revisions are rising. This is evidence of fundamental momentum that is supportive of more gains.

 

 

In the short-term, the S&P 500 is in a holding pattern after ending an upper Bollinger Band ride which has resolved with either a sideways consolidation or pullback. More ominously, it is exhibiting a negative 5-day RSI divergence. Nevertheless, I remain intermediate-term bullish on US equities.

 

 

 

Emerging markets are weak

While the outlook for international developed market equities is unexciting, the emerging markets outlook much depends on China. China is the heavyweight in EM indices and foreign investor sentiment has changed from an un-investable to a constructive view. Bloomberg summarized the issues well in an article, “Bulls Return to China’s Markets Just as Risks Start to Multiply”.

 

On one hand, valuations are becoming more attractive.

 

 

On the other hand, investors face considerable risks.

 

Unlike the rest of the world, China is sticking with plans to eliminate local transmission of Covid-19, even as it battles with sporadic outbreaks. The economy is showing signs of a further slowdown with car and housing sales dropping this month, and a number of economists have lowered their growth forecasts for this year and next.  

 

China is reluctant to stimulate the economy because of a determination to deleverage the housing market and reduce financial risk. The policy has exacerbated the crisis at Evergrande and other indebted developers, with at least four missing dollar debt payments this month. Distressed property firms, which make up about one-third of China’s record dollar bond defaults this year, face a bigger test in January — when maturities more than double from October, according to Citigroup Inc.

 

The other emerging market countries offer few exciting opportunities from a technical perspective. Of the top three weights in EM xChina that make up about 60% of the index, Taiwan and South Korea are not showing any leadership qualities. The third, India, is exhibiting a choppy and uncertain uptrend relative to ACWI.
 

 

 

Waiting for the FOMC

The RRG chart highlighted a possible bullish setup for bond prices. First, sentiment is at a bearish extreme. The BoA Global Fund Manager Survey revealed that respondents were at a record underweight position in bonds.

 

 

Moreover, the high duration 30-year Treasury yield is reversing its recent surge.

 

 

Further declines in yields would be bullish for bond prices, but much depends on the language coming from the Fed in the wake of its November FOMC meeting and subsequent press conference. In the wake of a hawkish surprise from the Bank of Canada last week, the market began to price in an aggressive tightening cycle by global central banks as yield curves around the world flattened. 

 

 

The flattening yield curve has two components. On one hand, rising 2-year yields is a signal that the market expects hawkish pivots from central bankers. On the other hand, falling long bond yields reflect an expectation of slower growth. The market is in effect saying that any early tightening represents a policy mistake and central bankers will have to reverse course and ease policy in the near future.

 

That’s where the Fed comes in. It has signaled in the past that a QE taper at the November meeting is baked-in and it expects the taper to end in mid-June. The CME’s Fedwatch Tool shows that the market is discounting rate liftoff at the June FOMC meeting, right when the QE taper is expected to be terminated. If that is indeed the scenario, expect language that accelerates the taper schedule so that it ends before June.

 

 

Will policy makers turn hawkish in reaction to market expectations and rising inflation pressures to pull the tightening schedule forward, or will it stay the course, which would be a dovish outcome?

 

A dovish tone is likely to lead to a steepening yield curve as 2-year yields ease and 10 and 30-year yields rise. In that case, kiss the prospect of a bond market rally goodbye. A hawkish tone would result in a further flattening of the yield curve and a bond market rally. 

 

What will the Fed do? History shows market expectations have been overly hawkish.

 

 

The Fed’s tone will also matter to equity market leadership. The value/growth relationship has been correlated to shape of the yield curve. A dovish Fed would be value bullish and a hawkish tone would be growth bullish.

 

 

What say you, Jerome Powell?

 

 

Making sense of the Great Resignation

Posted by Cam Hui -

An unusual labor market shift has occurred since the onset of the pandemic. Employers everywhere are complaining about a lack of quality employees. The Beveridge Curve, which describes the relationship between the unemployment rate and the job opening rate, has steepened considerably. 

 

 

Workers are not returning to their jobs, at least not without considerably more incentives. Some factors that affected labor supply are temporary and should moderate over time, such as the fear of catching COVID-19 and childcare availability, but many people are reassessing their priorities in the wake of the pandemic. They call it the “Great Resignation”.
 

The Great Resignation isn’t just an American phenomenon. The EU has voiced concerns about aggravated labor shortages. The Strait Times reported a one-day strike in South Korea:
 

Tens of thousands of labour union members took to the streets across South Korea on Wednesday (Oct 20) to demand better working conditions for irregular workers and a minimum wage hike.

 

This was despite repeated government warnings that the rally was illegal and violated Covid-19 restrictions.

In Canada, the Globe and Mail reported that a Bank of Canada survey found widespread concerns about labor shortages:
 

The business outlook survey found Canadian companies optimistic about future sales growth, but experiencing significant capacity constraints. Sixty-five per cent of respondents said they would have “some difficulty” or “significant difficulty” meeting an unexpected surge in demand.
 

The biggest issue is labour. Although Canada’s unemployment rate remains elevated, at 6.9 per cent last month, companies are having trouble attracting workers. Just more than a third of respondents to the business survey said labour shortages were restricting their ability to meet customer demand. Moreover, 71 per cent of respondents said labour shortages were more intense than a year ago, while only 7 per cent said they were less intense.

What’s going on? What does that mean for the economy and what are the investment implications of the Great Resignation?
 

 

A Great Reshuffle

The Great Resignation can be viewed through different lenses. First, a Gallup poll revealed that views of the job market are at a historical high. Tightness in the labor market is very real.
 

 

If we segment population by age, the Great Resignation is actually a demographic-related Great Reshuffle, which is what LinkedIn CEO Ryan Roslansky called it, according to Business Insider. Younger workers are taking advantage of the labor shortage to upgrade their careers.

The Great Resignation that you’ve been hearing so much about is really a “Great Reshuffle.”
 

That’s according to LinkedIn CEO Ryan Roslansky in a recent interview with TIME. He said his team tracked the percentage of LinkedIn members (of which there are nearly 800 million) who changed the jobs listed in their profile and found that job transitions have increased by 54% year-over-year.
 

Younger workers are leading the way.
 

Gen Z’s job transitions have increased by 80% during that time frame, he said. Millennials are transitioning jobs at the second highest rate, up by 50%, with Gen X following at 31%. Boomers are trailing behind, up by just 5%.
 

Other research backs up the trend that the early- to mid-level employees quitting are seeking greener pastures in the form of a new job. In late July, a Bankrate survey found that nearly twice as many Gen Z and millennial workers than boomers planned to look for a new job in the coming year. In August, a study by Personal Capital and The Harris Poll found that two-thirds of Americans surveyed were keen to switch jobs. The majority of Gen Zers felt that way (91%), as did more than a quarter of millennials.

 

 

The demographic effect is also evident when wage growth is tracked by age. 

 

 

Workers aren’t just seeking better pay. They’re looking for better flexibility in the wake of the pandemic. Staffing firm Robert Half’s CEO stated in his Q3 earnings call that candidates are seeking premiums if companies want them to work on-site [emphasis added]:

 

It’s at the transactional level, accounting operations, technology operations. Clients are more apt for them to want them to be on site. For the higher-level management resources, for tech developers, database administrators, they’re more inclined or more accepting of remote roles there. So it makes it easier for us with the latter than with the former. Candidates actually want a premium today if you want them to be on site. And many clients will pay that. Some won’t.

 

 

Viewed through a geographic lens, high quit rates were observed in regions with either high Delta variant infections or lower costs of living. In effect, the story is the same. Workers are seeking better quality of life and better pay.

 

 

Further analysis shows that it is the lower-paid and lower-skilled workers who are receiving the highest pay increases.

 

 

 

Creative destruction at work

In the face of widespread worker shortages, companies that thrive in the current environment will have to change their business models. To be sure, the latest NFIB survey was full of complaints from small business owners who are unable to hire qualified workers. If the problem was simply excessively supportive government support, the problem wouldn’t be worldwide. Instead, companies need to change their business models. It’s the free market process of creative destruction at work.
 

Business Insider documented the story of a Florida worker who applied to 60 entry-level jobs from employers who complained about finding qualified employees. He got exactly one interview. This is anecdotal evidence that many employers are used to better bargaining power and they haven’t adjusted their expectations in accordance to changing conditions.
 

Two weeks and 28 applications later, he had just nine email responses, one follow-up phone call, and one interview with a construction company that advertised a full-time job focused on site cleanup paying $10 an hour.
 

But Holz said the construction company instead tried to offer Florida’s minimum wage of $8.65 to start, even though the wage was scheduled to increase to $10 an hour on September 30. He added that it wanted full-time availability, while scheduling only part time until Holz gained seniority.

When large employers like Amazon have boosted the average starting wage to $18 per hour, some small employers with low-skilled workers won’t be able to compete at their current worker intensity levels. They will either have to adjust or go out of business. In addition, Amazon’s wage pledge will put upward pressure on manufacturing jobs, which pay more but reduce the skilled worker wage premium.
 

There are two obvious ways that companies can thrive in the current environment. The ones with already unionized workforces will enjoy a competitive advantage. Bloomberg documented the difference between United Parcel Service, which beat both EPS and sales expectations, and FedEx.
 

The company has weathered a labor shortage better than its key competitor because, unlike FedEx, it has a union workforce and pays the highest wages in the industry. Compensation and benefits rose only 0.6% in the quarter from a year ago. 
 

“I feel really good about our ability to manage through the labor cost inflation that many companies are dealing with today,” Tome told analysts.  

This is not to imply that unionizing a workforce is a quick fix for competitive problems as it is unclear how such transitions would affect a company’s business models and operating practices. 
 

The FRED Blog pointed out that the quit rate between private sector and government workers has diverged dramatically since the pandemic. While government workers are not necessarily unionized, their HR relationship is more regimented and more union-like, and the workers are older. Nevertheless, this is one piece of evidence that a unionized or near-unionized will see greater turnover stability.
 

 

The other way to compete in an era of tight labor markets is to substitute capital for labor through automation. Core capital goods orders have been very strong in this cycle. They should maintain their strength in light of the tight labor market, which should spark a period of productive non-inflationary growth. On top of that, climate change initiatives will result in a surge of investment in new technologies and infrastructure.
 

 

The Great Resignation is likely to set off a violent period of creative destruction. Investors will need to assess the strategies adopted by management in the face of tight labor markets. Some companies will simply not survive. As an example, the market cap of Palm was over $50 billion at the height of the NASDAQ Bubble, but few will shed a tear for its demise today. That’s how free market adjustments work.

 

 

The post-Black Death boom

The recovery from the 2020 pandemic is likely to parallel the historical experience of past pandemics. While COVID-19 isn’t the Black Death, a Bloomberg article outlined the economic effects of the Black Death during the second half of the 14th Century. As the epidemic killed off nearly 60% of Europe’s population, real wages rose.
 

 

History doesn’t repeat itself, but it does rhyme. The recovery from the Black Death sparked a re-focus on personal satisfaction and consumption boom. Sound familiar?

 

The change in behavior was more stark. “The Black Death created not just the means for wider parts of the population for excessive consumption – but the traumatizing experience of sudden decimation in the earthly life also triggered the impetus to enjoy it to the fullest, while still able to,” Schmelzing notes.

 

Products that hadn’t been for mass consumption earlier — such as linen underwear and glass panes in windows — became more widely available as cheap capital rushed to satiate the growing desire to consume, according to “Freedom and Growth,” historian Stephan Epstein’s review of states and markets in Europe between 1300 and 1750. Sumptuary laws that, among other things, sought to limit the height of Venetian women’s platform shoes were the state’s way to rein in conspicuous consumption; eventually the mad spending ended and savings went to bond markets. A republican ethos was born.

The spending boom kicked off a virtuous growth cycle. It began with a spending boom, which the economy recycled into greater savings and pushed interest rates lower.
 

 

Today’s post-COVID economy is undergoing a spending boom characterized by excess demand, which has strained supply chains. The next phase of the recovery should see inflation ease and higher investment spending and higher productivity. In other words, don’t worry about labor shortages or inflationary pressures. Barring unforeseen exogenous events, the next few years should have a boom in the global economy.
 

The two main key risks to this forecast is a series of rolling climate change-related disasters such as floods and heatwaves that disrupt the supply chain (see Not your father’s stagflation threat) and a flare-up of COVID-19. Most of the developed economies have ample supplies of vaccines, but a number of emerging and frontier market economies don’t. The risk is these countries act as a reservoir for the virus that eventually invades other countries. COVID-19 won’t be totally controlled until the world achieves herd immunity.

 

 

A pause in the advance

Posted by Cam Hui -

Mid-week market update: The S&P 500 had been on an upper Bollinger Band ride, but the ride may be over. In the past year, such events have resolved themselves in either a sideways consolidation or pullback. As well, the 14-day RSI has reached levels consistent with a pause in the advance. 
 

 

Based on recent history, we should know about the magnitude of the pullback within a week. Initial support can be found at the breakout level of about 4540.

 

 

Intermediate-term bullish

Regardless of the scale of any stock market weakness, the intermediate-term outlook remains bullish. There is nothing more bullish than fresh highs, and the Dow recently punched its way above resistance to an all-time high. The Transports have surged to test resistance but weakened. Further gains in this index would constitute a Dow Theory buy signal.

 

 

Market breadth is showing signs of strength. The S&P 500, NYSE, S&P 400 Advance-Decline Lines reached all-time highs. Only the NASDAQ and S&P 600 A-D Lines are weak. These are signs of broad underlying strength, not weakness.

 

 

To be sure, small-cap indices are struggling with resistance and they have not staged upside breakouts and they are weak relative to the S&P 500. However, relative breadth is improving (bottom panel) and we are entering a seasonally positive period where small stocks should enjoy some tailwinds.

 

 

 

Sentiment not extreme

Sentiment readings are supportive of further gains. The latest update from Investors Intelligence shows that % bulls are recovering, but % bears remain stubbornly high. There is much more room for sentiment to improve before they reach an overbought extreme.

 

 

 

Bullish and bearish catalysts

I interpret these conditions as conducive to further gains after a brief pause. Possible catalysts for either upside or downside volatility could come from the FOMC meeting next week. The Bank of Canada sounded a hawkish tone today by announcing the end of quantitative easing and pulling forward the calendar for rate hikes. The Canada yield curve went bonkers. 2-yield yields rose the most and the curve flattened in response. While recent Fedspeak has signaled the start of tapering, the risks is next week’s policy response will be skewed hawkish.

 

 

As well, a deal for the Biden fiscal plan may be close this weekend. While a general corporate tax increase is off the table, a 15% corporate minimum tax could be passed. Such a measure would negatively affect Big Tech and pharmaceutical companies with intellectual property held in subsidiaries resident in low-tax jurisdictions. 

 

 

What more could the bulls ask for?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

 

An all-time high

It is said that there is nothing more bullish that an all-time high. The S&P 500 did just that on Thursday. Neither of my warning signals have sounded warnings just yet. The 14-day RSI is not overbought. As well, the VIX Index has not fallen below its lower Bollinger Band.

 

 

What more could the bulls ask for?

 

 

Other bullish signs

There were other bullish signals confirming the fresh high. A comparison of the S&P 500, mid cap S&P 400, and small cap S&P 600 shows that only the S&P 600 hasn’t achieved a fresh high.

 

 

Different versions of the advance-decline lines were also supportive of the bull move. The S&P 500 and NYSE A-D Lines broke out to new highs while the S&P 400 A-D Line is close. Only the NASDAQ and S&P 600 A-D Lines are laggards.

 

 

The latest rally is characterized by value stock leadership. Both the large cap Russell 1000 Value Index and Mid-cap Value have broken out to new highs. Small-cap value is lagging.

 

 

The bulls couldn’t ask for much more than this.

 

 

Uneven legislative progress

On the legislative front, the Democrats continue to squabble over Biden’s Build Back Better legislation. A piece of good news for equity investors is the planned corporate tax increases appears to be off the table. 

 

I am monitoring the infrastructure stocks (PAVE), which have staged an upside relative breakout from a falling trend line. Is that a ray of hope that a more pronounced capex cycle is on the way?

 

 

 

Sentiment not extreme = More room to rally

Sentiment is turning bullish, but levels are not extreme enough to flash contrarian bearish warnings. The combination of strong positive momentum and mild sentiment readings are supportive of further gains.

 

The AAII bull-bear spread is one of many examples of improving sentiment, though conditions don’t indicate a crowded long.

 

 

The Fear & Greed Index is another example.

 

 

I could go on, but you get the idea.

 

 

A pause ahead?

Tactically, the market advance is due for a brief period of consolidation and possible minor pullback. The S&P 500 has been on an upper Bollinger Band ride. At some point in the near future, the ride will end and it may have ended Friday when the S&P 500 was down -0.1%. The market has gone on five upper BB rides in the past year. It has consolidated sideways on three occasions and pulled back on two. The strong underlying strength of the market leads me to believe that a consolidation is the most likely outcome but any pullback should be fairly shallow.

 

 

We are in the heart of earnings season next week. While the response to last week’s reports have mostly been positive, don’t be surprised if the market hits an air pocket from an earnings report. In particular, keep an eye on FB (Monday) and GOOGL (Tuesday) in light of last week’s SNAP comments on  the advertising environment.

 

 

In conclusion, there is nothing more bullish than a fresh high and the S&P 500 has surpassed that hurdle. Tactically, the market can pause its advance at any time but downside risk should be limited. The intermediate term outlook is bullish and traders should be prepared to buy any dip in anticipation of further gains.

 

 

>

Where are we in the market cycle?

Posted by Cam Hui -

Where are we in the market cycle? The accompanying chart shows a stylized market cycle and changes in sector leadership.

  • Bear markets are characterized by the leadership of defensive sectors such as healthcare, consumer staples and utilities.
  • Early-cycle markets are sparked by the monetary stimulus or the promise of monetary stimulus. The market leaders in this phase are the interest-sensitive sectors such as financials and real estate.
  • Mid-cycle markets are characterized by economic expansion. Expect rotation into consumer discretionary stocks, followed by capital-intensive industrials and technology.
  • Late-cycle markets will find investors become increasingly concerned about inflation. Inflation hedge sectors such as energy and materials lead during this phase.
  • In response to rising inflation expectations, either the central bank or the market tightens monetary policy, which resolves in a market top and a bear market.

 

 

Please be aware that while the psychology of a market cycle parallels an economic cycle, they are not the same. Since Wall Street’s attention span approximates that of a 16-year-old, it is not unusual at all to find several market cycles compressed within a single economic cycle.

 

What I have described is an idealized market cycle. This economic and market cycle is very different from others. The last bear market was not sparked by monetary tightening, but the exogenous effect of a pandemic. The market leaders of the 2020 bear were not the usual defensive names. Instead, investors piled into work-from-home beneficiaries consisting mostly of Big Tech stocks.

 

With that preface in mind, where are we in the psychology of the market cycle?

 

 

A late-cycle advance

Signs are accumulating that both the psychological backdrop and market action are pointing to a late-cycle advance. The latest BoA Global Fund Manager Survey found that respondents believe inflation is the biggest tail-risk facing investors.

 

 

In response, global institutions have rotated into inflation hedge vehicles.

 

 

Indeed, commodity prices have staged upside breakouts to fresh highs. The strength isn’t just in the energy heavy headline commodity indices, but the equal-weighted commodity indices too. 

 

 

The acute shortage in some commodities has been insane. As a consequence, backwardation of the futures curve. Normally, most futures contracts are in contango, with futures prices slightly above the spot prices with the difference reflecting the storage and carrying costs. Backwardated markets have the spot price above the futures price, which indicates a physical shortage. As an example, the one-year contango in December oil futures have completely blown out.

 

 

The shortages can also be found in commodities other than crude oil. The LME announced emergency measures to ensure “orderliness and continued liquidity” in the copper market by setting limits on the nearest-term spreads and allowances for holders of some short positions to avoid physical delivery. 

 

 

Inflation: This too will pass

Before everyone gets overly excited about a commodity bubble, the strength in commodity prices is attributed to – you guessed it, supply chain difficulties and their ripple effects. Goldman Sachs commodity analyst Jeff Currie explained the problem in a recent Bloomberg podcast.

 

It starts in China, coal in China, and then that creates tightness in gas that created the problems in Europe — Europe substitutes into oil, creating the problem in oil. You’ve shut down the (aluminum) smelters, the zinc smelters, you know, so a lot of people say, you know, that the ground zero of those problems really was coal in China. So I do want to say the situation in China is very dire, but it’s just one part of the world that can create a solution to it rather quickly and they’re trying to with investments in Mongolia. But I want to be careful about restarting a lot of that shuttered coal. For those of us that are Americans and know what a superfund site is in the U.S., restarting these facilities is going to be a lot more difficult, a lot more expensive than I think what people think it will be. So you really got to focus on the new, more cleaner, sophisticated coal, in some of these mines in places like Mongolia. So bottom line, it’s going to be tight over the next three to six months, but once you get that Mongolian coal up and running, the situation should ease, but no way does it solve it.

The root cause of the current spike in inflation indices is a demand-pull problem attributable to supply chain bottlenecks. When an economy exhibits too much demand and not enough supply of goods, inputs and workers, inflation is the result. Tighter monetary policy will not create more natural gas, copper, shipping, and trucking capacity. It is fiscal policy that can play a greater role.

 

Stephanie Kelton, one of the leading proponents of Modern Monetary Theory (MMT), wrote a NY Times Op-Ed in April on how to think about inflation in connection with fiscal policy, specifically Biden’s Build Back Better plan. In short, it’s all about the capacity of the economy to accommodate demand in the face of fiscal stimulus.
 

The key to responsibly spending vast sums of money lies in carefully managing the economy’s real productive limitations…

 

Depending on how big Congress ultimately decides to go on infrastructure, and how quickly, it may need to unleash a whole suite of inflation-dampening policies along the way…

 

These mostly non-tax inflation offsets could include industrial policies, like much more aggressively increasing our domestic manufacturing capacity by steering investment back to U.S. shores, using even more ‘carrot’ incentives like direct federal procurement, grants and loans, as well as more ‘sticks’ like levying new taxes to discourage the offshoring of plants. Reforming trade policies is another option: Repealing tariffs would make it easier and cheaper for American businesses to buy supplies manufactured abroad and easier for consumers to spend more of their income on products made outside of our borders, draining off some domestic demand pressures.
Despite the recent inflation angst, I am still on Team Transitory. I have shown before how the inflation surge is explained mostly by strength in durable goods demand as people began to work from home and switched their demand from services to goods.

 

 

The University of Michigan consumer survey shows that the buying conditions for durable goods is falling as prices rose. It’s difficult to see how the current inflation surge could sustain itself if households demand falls in response to higher prices.

 

 

Already, we are seeing signs of the transitory nature of the spike in the data. Monthly inflation rates topped out during the April-June period and have been moderating ever since.

 

 

What about inflation expectations? Some Fed speakers and investment strategists have voiced concerns that inflation expectations could soar and become unanchored, which would create the psychology necessary to spark an inflationary spiral.

 

 

Expectations is a red herring, according to a research paper by Fed researcher Jeremy Rudd. He concluded that policy makers should focus on reported inflation rather than expectations. Rudd’s paper also contained a controversial footnote that dismissed the economics profession in the context of forecasting.

 

I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.
A separate Cleveland Fed study found that the accuracy of forecasted inflation fell dramatically as the time horizon lengthened. While the long-term record from 1986 was reasonable, the recent record starting in 2011 showed that the accuracy of inflation forecasts fell dramatically within two months and was virtually useless past a six-month time horizon.

 

 

The market is setting up for a mistake in its inflation and interest rate expectations. Fed Funds futures are indicating a rate hike by the July 2022 FOMC meeting and a second increase at the December meeting. These expectations are likely too aggressive.

 

 

 

Why are stocks rising?

In light of rising expectations for rate increases, why are stocks rallying? Rate hike expectations are being pulled forward and economic growth expectations are falling. The Atlanta Fed’s latest Q3 GDP nowcast has tanked to a minuscule 0.5%.

 

 

John Authers at Bloomberg attributed equity strength to TINA – RIF:

How to explain this? TINA (There Is No Alternative — to stocks), appears to have morphed into her fearsome sister TINA RIF (There Is No Alternative — Resistance Is Futile). With yields low and inflation on the horizon, bonds are regarded as unbuyable. 

To be sure, Q3 earnings season has been strong. Earnings estimates are rising and beat rates are above average. Strong positive fundamental momentum is supportive of higher prices.

 

 

All else being equal, rising EPS estimates allows the forward P/E to fall, which is supportive of valuation and stock prices.

 

 

 

The transition process

At some point in the near future, the market will begin to recognize the transitory nature of the inflation surge. Bonds will no longer be unbuyable and yields will begin to ease. That will mark the transition to the next phase of the market cycle.

 

This next phase will be marked by a leadership rotation from late-cycle inflation hedge and cyclicals back to growth stocks. Growth companies are duration plays and they have the greatest sensitivity to falling bond yields.

 

 

I don’t expect a recession-induced bear market during the transition. Recessions are bull market killers, but there are few signs of a recession on the horizon. New Deal democrat, who monitors the economy using coincident, short leading, and long leading indicators, remains bullish on the economic outlook.

 

All three time frames remain quite positive. Delta continues to recede, and the impact – if any – of the ending of all remaining emergency pandemic benefits last month has been limited.
However, the economy is likely to see a growth scare next year, which could spark a correction.

There are many signs in data that the white-hot Boom is cooling. But nothing to indicate it is actually in any danger of rolling over in the immediate future.

My base case scenario calls for a stock market rally into year-end led by reflation stocks. We are entering a period of positive seasonality and the market has been tracking the seasonal pattern relatively well in 2021. Expect a growth deceleration soon afterward, a rotation into growth, and a possible correction in Q1, but no bear market.
 

 

While it’s impossible to precisely forecast the timing of the inflection point, I can offer the guidepost of the 10-year Treasury yield, which has tracked the value/growth ratio closely in the last two years. If the 10-year yield starts to fall in a decisive way, the rotation from reflation and value to growth has likely begun.
 

 

Another upper BB ride

Posted by Cam Hui -

Mid-week market update: The S&P 500 has been undergoing a ride on its upper Bollinger Band (BB), which historically has been a bullish sign of price momentum. The bigger question is how the tape will behave when the upper BB ride ends.
 

 

Here are some observations:
  • The 5-day RSI is extremely overbought, but overbought markets can stay in a “good overbought” condition as prices advance.
  • The 14-day RSI isn’t overbought yet, and past rallies haven’t stalled until it became overbought or was near overbought.
  • The VIX Index hasn’t fallen below its lower BB yet. In the past, penetration of the lower BB has signaled either a pullback or a period of sideways consolidation.
The initial verdict is short-term bullish, though the S&P 500 will have to contend with the all-time high resistance zone between the closing high of 4537 and intra-day high of 4546.

 

 

A sentiment Rorschach test

Sentiment readings are becoming a Rorschach inkblot test for traders. On one hand, the bull-bear spread from Investors Intelligence has begun to edge up from depressed levels, which indicates a recovery of extreme bearishness and a signal that this rally has room to go. In particular, bearish sentiment edged upwards, which is an indication of continued skepticism and the market climbing the proverbial Wall of Worry.

 

 

On the other hand, Helene Meisler conducts a regular (unscientific) Twitter poll. The results from last weekend saw net bulls-bears over 30. Such an extreme reading is rare and there were only three other instances during the brief history of her poll. The market pulled back on one occasion and continued to rise on the other two. 

 

 

This is what I mean by the Rorschach test of sentiment model interpretation. I consider these models differently. The II sentiment survey tends to have a longer-term time horizon and the intermediate-term outlook for stocks is up. The Meisler survey respondent sample is made up of very short-term traders. Such extreme bullishness could be considered to be contrarian bearish in a conventional fashion or an indication of strong price momentum that could carry the market higher.

 

 

Bullish internals

A consideration of the price momentum factor, which is a stock selection factor that measures whether individual outperforming stocks continue to outperform (as opposed to market momentum, which postulates that a buying stampede will lift the index), using different flavors of the momentum factor shows that returns have been flat to up. This is an indication of a healthy internal rotation between stocks as the market rises.

 

 

Equity risk appetite is constructive. The equal-weighted ratio of consumer discretionary to staples has made a fresh all-time high, which is bullish. However, the ratio of high-beta to low-volatility stocks have lagged, though conditions are not so severe to cause any great concern.

 

 

Credit market risk appetite presents a similar picture. The relative price performance of junk bonds to their duration equivalent Treasuries have made an all-time high, indicating a strong risk appetite. But the relative price performance of investment-grade issues has lagged, though not by such a degree to be alarmed.

 

 

A further bullish catalyst could be an agreement among the squabbling Democrats on Biden’s Build Back Better bill. The current period is reminiscent of the bargaining leading up to the passage of ACA, otherwise known as Obamacare. An agreement in principle could be forthcoming by the weekend. Keep an eye on the infrastructure ETF (PAVE). An upside relative breakout could be a signal for a bullish stampede into cyclical stocks.

 

 

In conclusion, the stock market appears to be starting its melt-up into year-end. As we proceed through earnings season, individual reports may cause hiccups in what is an overbought market, but investors and traders should seize the opportunity to buy the dip.

 

Opportunities in energy and gold

Posted by Cam Hui -

As the CRB Index decisively broke out to a new recovery high while breaking through both a horizontal resistance level and a falling downtrend that began in 2008, a divergence is appearing between crude oil and gold. The oil to gold ratio has strengthened to test a falling trend line. 
 

 

This test of trend line resistance could present some opportunities for traders.
 

 

Extended energy

Has The Economist done it again? Is the latest cover a contrarian signal of a pending top for energy stocks? 

 

 

It’s starting to look that way. As energy stocks test a key absolute resistance zone, they are struggling to overcome relative resistance. At the same time, relative breadth is deteriorating (bottom two panels).

 

 

 

Washed-out gold

By contrast, the technical outlook for gold and gold miners appears far more constructive. Gold prices have traced out a double bottom after testing a support zone. Moreover, TIPs prices are rising again, indicating falling real rates, which is supportive of rising gold prices.

 

 

The washed-out nature of this group is more evident in the gold miners (GDX). GDX rallied through trend line resistance, which is positive. The percentage of bullish stocks fell to an oversold level and they have begun to recycle. In addition, the GDX to gold ratio and the small-cap GDXJ to GDX ratio have both risen through falling trend lines. These are all signals of underlying strength.

 

 

In conclusion, energy stocks may be nearing a climax top while gold and gold stocks are showing bullish signals after several months of dismal performance. Traders should avoid energy exposure and buy gold and gold stocks for better potential performance.

 

However, make no mistake, any gold rally should be treated as a tactical bull rather than a secular bull. The gold to CRB and cyclically sensitive copper to gold ratios are signaling a reflationary regime. Long-term investors should therefore seek exposure to cyclically sensitive base metal and other commodities over the shiny yellow metal for better returns.

 

 

Market liftoff?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

 

To boldly go?

Last week, I characterized the stock market as like a rocket on a launch pad. Last week’s events also featured William Shatner, the actor who played Captain Kirk in the original Star Trek series, being blasted into space. Now that Captain Kirk has gone into space, will equities follow?

 

Let’s take a look. One of the bullish tripwires I outlined was for the S&P 500 to decisively regain its 50 dma. The index convincingly breached the 50 dma and it is now testing a resistance zone, which is positive.

 

 

However, traders are cautioned to monitor the VIX Index. In the past, VIX breaches of the lower Bollinger Band have been overbought signals when market rallies have temporarily stalled in the past.

 

 

Revisiting 2011

In last week’s analysis, I also compared today’s market to summer 2011. 
 

Then, the macro backdrop was characterized by a debt ceiling impasse in Washington and a Greek Crisis in Europe that threatened the very existence of the eurozone. I can remember endless European summits and plans to make plans for Greece. The news flow worsened and it seemed like no one was in charge in Europe, but the S&P 500 tested support multiple times while exhibiting a series of positive RSI divergences. The logjam was finally broken when the ECB stepped in and announced its LTRO program. Stocks bottomed and never looked back.

 

History doesn’t repeat itself, but rhymes. Today, the market has been beset by a debt ceiling impasse in Washington and concerns over inflationary pressures which may or may not be transitory from supply chain bottlenecks. The logjam appears to have been temporarily broken when the Democrats and Republicans agreed to kick the can down the road and revisit the debt ceiling question in December. Stock prices duly staged a relief rally.

Here is how the 2011 rally played out. After the market bottomed after exhibiting a series of positive RSI divergences, advances were temporarily interrupted when the VIX Index fell below its lower BB. These were short-term cautionary signs whose bearish impulses lasted no more than a few days. Nevertheless, they can be useful tactical signals that the advance had run too far too fast and the market was in need of a breather.
 

 

 

Bullish tripwires

I also outlined two other bullish tripwires last week which have not been triggered. I was looking for bullish confirmation from high-beta small-cap stocks. Small-cap indices had been range-bound for most of this year. While they are outperforming their large-cap counterparts, just as they did in 2011, small-cap stocks have not broken out of their trading range yet.
 

 

A market rally sparked by a reflationary narrative should see an upside relative breakout by the growth cyclical semiconductor stocks (bottom panel). For now, semiconductors remain in a narrow range relative to the S&P 500.
 

 

It’s too early to sound the all-clear bullish signal just yet.
 

 

A bullish setup

Despite the lack of bullish confirmation, we are moving into a seasonally positive period. In addition, positive price momentum is supportive of further gains. A backtest of instances when the percentage of S&P 500 stocks above their 10 dma rose from below 20% to above 80% within 20 days in the last five years shows an average gain of 9.81% and a success rate of 86% after 90 days (warning: n=7). The 90-day window roughly coincides with the period of positive seasonality that the market is entering.
 

 

Sentiment appears to be turning up from a depressed level. IHS Markit conducts a monthly survey of about 100 institutional investors and found that risk appetite bottomed out in September and began to turn up, albeit from very depressed levels. The combination of a turnaround from excessively bearish sentiment and positive price momentum creates the conditions ripe for a FOMO risk-on stampede into year-end.
 

 

 

Bullish and bearish catalysts

There are two catalysts that could decide the near-term direction of the stock market and general risk appetite. Q3 earnings could be a pivotal moment for the market. Earnings growth expectations are still very high by historical standards. Fortunately, for the bulls, estimate revisions are still rising. While this bullish fundamental momentum indicator is positive, readings could change quickly if forward guidance turns sour in the coming weeks.
 

 

Street expectations for the S&P 500 are still relatively upbeat. The bottom-up derived 12-month target for the S&P 500 is 5051.70, though the accuracy of this forecast is highly variable. If history is any guide, the S&P 500 will close at between 4567 and 5137 a year from now, which represents a price gain of 2.1% to 14.9%, depending on the choice of lookback period.
 

 

As well, keep an eye on the fate of Biden’s legislative agenda, which is mired by infighting between the progressive and centrist wings of the Democratic Party. There are unconfirmed reports that the White House is aiming for some resolution by the end of October. Any positive outcome would be a signal of another fiscal impulse and could spark a risk-on rally. Keep an eye on the infrastructure stocks, which have tested a double bottom relative to the S&P 500 by remain in a downtrend. A failure by Pelosi, Schumer, and Biden to push through their bill would be disappointing for a market that has partially discounted additional fiscal stimulus.
 

 

In conclusion, my risk-on scenario remains intact but I am not ready to sound the bullish all-clear just yet. The market is poised for a FOMO stampede into year-end. While I am in the bull camp, investors should nevertheless monitor the evolution of earnings estimates as we move through earnings season and the progress of Biden’s legislative agenda for bullish and bearish catalysts.
 

Subscribers received an email alert on Friday indicating that my trading account had taken profits in his long positions and moved to cash. The market is a little extended in the short-term and don’t be surprised if the advance consolidates or pulls back next week. 
 


 

The intermediate-term outlook is still bullish. The market is also started its rally in accordance to its seasonal pattern. If history is any guide, my inner trader expects to buy back in next week if stock prices weaken.