The market risk hiding in plain sight

Posted by Cam Hui -

As the infrastructure and budget bills make their way through Congress, I was surprised to see that the latest BoA Global Fund Manager Survey did not mention a corporate tax increase as a key risk to the S&P 500. 
 

 

The Biden tax proposals have been well telegraphed and most of the details have been known to the public since March. They call for a partial reversal of the Tax Cuts and Jobs Act (TCJA) corporate tax cuts from the Trump era and the imposition of a corporate minimum tax. An analysis of bottom-up 12-month EPS estimates shows that they have been rising steadily for 2021, which is understandable because individual company analysts won’t cut estimates until they see the exact details of the legislation. However, strategists have penciled in top-down earnings cuts based on different tax regimes.

 

 

For investors, a corporate tax increase represents the greatest risk to US stock prices that’s hiding in plain sight.

 

 

The Biden tax proposals

The Biden corporate tax proposals have been known since Q1. They initially called for an increase in the statutory tax rate from 21% to 28% and the imposition of a 15% minimum tax on the book income of large corporations. Further discussions with Democratic Senators indicated there was little support for a 28% tax rate and the consensus expectation is the increase will be scaled back to 25%.

 

The White House believes these proposals are justified for a number of reasons. The TCJA cuts were advertised as a way to spur investment and create jobs. Bloomberg reported that lower corporate taxes were ineffective at raising investment.
 

Government data showw that, outside of housing, private-sector investment averaged 4% annualized growth over the eight quarters of 2018 and 2019 – while the Trump tax regime was in place but before COVID-19. That’s little different from the 3.8% average of the previous five years, and well below the 6.8% pace of the 1990s – when tax rates were higher.
For policymakers, what matters isn’t the statutory rate, but the effective rate, which has been falling for decades.

 

 

In addition, US corporations have the lowest tax burden as a percentage of GDP compared to other major OECD countries. If other major industrialized countries can be persuaded to sign on to a minimum corporate tax, a corporate tax increase should not overly detract from competitiveness.

 

 

 

Winners and losers

While virtually all US companies will be negatively affected by higher corporate tax rates, a more detailed analysis reveals the relative winners and losers. From a factor perspective, the TCJA lowered the tax rate of expensive stocks by valuation far more than the cheapest stocks. In other words, growth stocks benefited from the Trump tax cuts more than value stocks. Expect that to reverse itself under the Biden proposals.

 

 

Credit Suisse also modeled the effects of a corporate tax increase to 28%. The three sectors with above-average hits to earnings are consumer discretionary, healthcare, and technology. 

 

 

However, I expect the net effects on the consumer discretionary sector to be slightly better than this model. The extraordinary level of fiscal support in response to the COVID shock allowed GDP to return to trend growth at a much faster pace than the GFC recovery. Biden’s redistribution policies are designed to put more money in the hands of the poorest Americans, who have a higher propensity to spend extra income, and will disproportionately boost the sales of consumer-oriented businesses. 

 

 

On the other hand, drug and technology companies that hide their IP in low-tax jurisdictions will be the worst affected under the Biden tax proposals. The Credit Suisse analysis found that technology stocks will still have the lowest tax rate under a 28% rate regime, but will endure the largest tax increase.

 

 

 

Pricing the pain

An examination of the most popular market narrative indicates that the effects of a corporate tax increase have not been fully discounted. Sometimes, the anticipation effect is higher than the actual event. Consider the market relative performance of banks stocks as an example. The relative performance of banks has long been correlated to the shape of the yield curve. Since banks borrow short and lend long, a steepening yield curve is favorable to banking profitability. The banks to S&P 500 ratio diverged from the 2s10s yield curve in November 2016 in anticipation that a Trump victory would be positive for the sector. When the market finally rallied in response to the passage of TCJA in late 2017, the magnitude of the TCJA rally was dwarfed by the post-election surge.

 

 

This brings us to the biggest loser under the Biden tax proposals, namely technology companies. The net margins of the tech sector is 23% compared to 8% for the rest of the S&P 500. A higher corporate tax rate has the potential to be an enormous negative surprise.

 

 

In conclusion, the market does not appear to have fully discounted the effects of a corporate tax increase. While all US equities will suffer from lower earnings, relative winners under the current proposals are value stocks and relative losers are growth stocks. Investors with a global focus should consider tilting their equity weight away from the US, which is not exposed to changes in US corporate taxes and exhibit lower forward P/E valuations.

 

 

 

Publication note: I am taking a week off next week. Barring any episodes of market volatility, there will be no mid-week market comment on Wednesday. Regular service will resume next weekend.

 

The USD’s exorbitant privilege

Posted by Cam Hui -

For the crypto folks who embrace the libertarian philosophy of using a medium of exchange not issued by any national government, here are a couple of reminders of what the USD “exorbitant privilege” means in real life. 

 

First, the Canadian extradition hearing for Huawei CFO Meng Wanzhou finally ended yesterday after nearly three years of drama. Huawei was accused of violating America’s sanctions on Iran, and Meng was arrested at the Vancouver airport based on an American extradition request. In the last three years, she had been battling extradition while under house arrest in a multi-million mansion.
 

 

All of this wouldn’t have been possible if the USD wasn’t the dominant currency of global commerce. The US has weaponized the global banking system as a foreign policy tool. 

 

 

Where’s Afghanistan’s money?

The second is a less-noticed effect of the Taliban takeover of Afghanistan. Ajmal Ahmady, the former governor of the Afghan central bank, the DAB, tweeted that the DAB holds about $9 billion in foreign exchange reserves. However, most of the assets are being held either at the Fed or within the US banking system.

 

 

As the Taliban is under international sanctions, little of those reserves are available to the new government. Ahmady states, “We can say the accessible funds to the Taliban are perhaps 0.1-0.2% of Afghanistan’s total international reserves. Not much.”

 

The BBC reported that the IMF has acted to cut off Afghanistan.
 

The International Monetary Fund (IMF) has said Afghanistan will no longer be able to access the lender’s resources…

 

An IMF spokesperson said it was due to “lack of clarity within the international community” over recognising a government in Afghanistan.

 

Resources of over $370m (£268m) from the IMF had been set to arrive on 23 August.

 

These funds were part of a global IMF response to the economic crisis.
The Taliban is coming to realize that its banking system exists mainly in a digital world and there is little or no money it DAB’s vaults. Ahmady concluded.

 

 

Keep the case of the USD’s exorbitant privilege in mind as you watch the chaotic evacuation scenes from Kabul’s airport. Washington has a powerful weapon at its fingertips, well beyond Predator drones and boots on the ground.

 

 

A fear of Delta?

Posted by Cam Hui -

Mid-week market update: Stock prices have taken a minor and uneven risk-off tone this week. The pullback has been attributable to fears over a Delta variant-related slowdown. 
 

I beg to differ. Instead, the weakness can be better explained by market technical conditions. The 5-day correlation between the S&P 500 and VVIX, or the volatility of the VIX, had spiked recently. Past instances have resolved themselves with minor bearish episodes in the last three years.

 

 

Sentiment readings could put a floor on stock prices. Investors Intelligence %Bulls has retreated and %Bears have edged up. The Bull-Bear spread has fallen to levels consistent with short-term bottoms.

 

 

 

Delta slowdown fears

Evidence of a Delta variant surge in cases had been evident for some time. It’s unclear why risk appetite should suddenly take a turn for the worse under these conditions. Using India, where the Delta variant first appeared, and the UK as guides, case spikes have peaked in about two months. Using the same template for the US, this means that cases should peak in early or mid-September and then begin to recede.

 

 

Indeed, data from the NY Times shows that case counts are starting to roll over in some of the more problematical regions, such as Florida and the South.
 

 

To be sure, Calculated Risk’s seven high-frequency indicators show that progress in reopening has either flattened out or started to roll over. Here is Apple mobility:

 

 

And TSA travel.

 

 

However, the plateau in activity has been evident for about a month. If the market narrative is attributing the risk-off tone to slowing growth, then why now instead of one or two weeka ago?
 

 

A final flush

My panel of bottoming indicators are nearing a series of buy signals Some of my bottoming indicators are nearing buy signals, while others are in neutral. The 5-day RSI is oversold and The VIX Index has risen above its upper Bollinger Band, indicating an oversold condition. The NYSE McClellan Oscillator (NYMO) is not oversold, though it is getting close. By contrast, the term structure of the VIX has not inverted, indicating fear and panic. 

 

 

As well, the Zweig Breadth Thrust Indicator is has reached a marginal oversold condition, which has marked short-term bottoms in the past.

 

 

In summary, the stock market is undergoing a shallow pullback. A short-term buying opportunity is near. Market psyhology may need just one more flush and panic.

 

Buy the dip.

 

 

Prepare for a growth stock correction

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.
 

 

Growth leadership faltering

Changes in macro conditions are setting up for a growth stock correction. The strength in the 10-year Treasury yield is putting downward pressure on growth stock leadership. The growth style is a duration play because it is more sensitive to changes in interest rates than value. 

 

 

In addition, I made the case yesterday for a value style revival which is negative for the growth stock leadership (see Constructive value and reflation green shoots). The blogger Macro Charts also observed that ETF flows indicate crowded long positionings in growth and defensive sectors and capitulation in cyclicals. This sets up the potential for a violent rotation should the cyclical and reflation outlook improve.

 

 

 

A short-term warning

The stock market may be vulnerable to a short-term setback. The rising correlation between the S&P 500 and VVIX, or the volatility of the VIX Index, is flashing a tactical sell signal. Such correlation spikes have indicated discomfort in the option market with the market advance. In the past three years, similar conditions have resolved themselves with market weakness of about 4-5% two-thirds of the time.

 

 

However, I expect that any S&P 500 pullback should be relatively shallow. The analysis of the relative performance of the top five sectors tells the story of nascent weakness by growth sectors and strength by value stocks. Technology, communication services, and cap-weighted consumer discretionary (Amazon and Tesla) stocks are all either trading sideways or weakening relative to the market. Financials, which is the only value sector, is gaining relative strength, I interpret these conditions as a setup for an internal rotation from growth to value. Since growth stocks have a higher weight in the S&P 500 than value, the rotation may manifest itself as overall minor market weakness.

 

 

 

Constructive breadth

In other words, the bad news is that growth stocks are weakening. The good news is the weakness is unlikely to significantly drag down the S&P 500 as leadership rotates into value and reflation names. 
That’s because market breadth is starting to improve after a long period of deterioration. The NYSE Advance-Decline Line is rising and testing overhead resistance. The Equal-weighted S&P 500 is outperforming the S&P 500, indicating small and mid-cap relative strength. Market internals, such as the percentage of stocks above their 50 dma, are also recovering.

 

 

Even credit market risk appetite, which measures the relative price performance of junk bonds relative to their duration-equivalent Treasuries, is trying to make a bottom.

 

 

 

Supportive sentiment

Notwithstanding any weakness by growth stocks, sentiment model readings are likely to put a floor on overall stock prices. Ned Davis Research’s daily sentiment index is only in neutral despite the S&P 500 reaching record highs. The market is climbing the proverbial Wall of Worry.

 

 

Jurien Timmer at Fidelity also observed that “the 12-month rolling net flow into stocks is only now turning positive” after a gargantuan S&P 500 rally.

 

 

 

Still a bifurcated market

In conclusion, the 2021 stock market has been characterized by a steady advance by the S&P 500. Beneath the surface, the market remains bifurcated between growth and value and internal rotations between the two styles have served to put a floor on overall market weakness. 

 

 

Value is in the process of regaining the leadership baton from growth. I expect that the trajectory of the market to be flat to up. Investors may have to allow for the possibility that the S&P 500 could start to trade flat to down as large-cap growth has a much larger weight in the index than value.

 

 

Constructive value and reflation green shoots

Posted by Cam Hui -

One of my principal tools of market analysis is the use of trend-following techniques to spot changes in macro conditions. My models are seeing some early green shoots in the value and reflation trade. It began with the stronger than expected July Jobs Report. The subsequent tame core CPI print also helped to reinforce the narrative of non-inflationary growth. As a consequence. the value/growth ratio is turning up after exhibiting a positive RSI divergence and relative internals improved. The Russell 1000 Value Index even rallied to a fresh all-time high.

 

 

The economic winds are shifting and it may be time for investors to trim their sails.

 

 

A value revival

A detailed review of the major value and reflation-sensitive sectors reveals a broad-based recovery. Financial stocks staged an upside breakout from a saucer-shaped bottom. The relative performance of this sector is correlated with the yield curve and a steepening yield curve improves banking profitability because they borrow short and lend long. Relative market internals (bottom two panels) improved sharply in the last week, triggered by the strong July Jobs Report.

 

 

Industrial stocks represent a value and reflation-sensitive sector. These stocks are testing resistance after tracing out a saucer bottom. Relative breadth has been either improving (% Bullish) or already strong (% above 50 dma).

 

 

Material stocks are also showing the familiar pattern of a saucer-shaped bottom while approaching technical resistance. Relative breadth is showing signs of strength.

 

 

Consumer discretionary stocks are a mix of growth and value. The largest weights in the sector are Amazon and Tesla, which have growth characteristics, while the rest of the sector is more reflation and cyclically sensitive. The sector has been on a well-defined uptrend owing to the strength of its growth components. However, the relative performance of the equal-weighted consumer discretionary sector (red dotted line) has been moving sideways. Relative breadth has shown signs of improvement, indicating underlying strength of reflation and cyclical factors.

 

 

Energy is the weakest of the value and reflation sectors. It is testing a relative support zone and relative breadth indicators remain weak.

 

 

In short, most value and reflation sectors are showing strong relative internals. This could be the start of a value and reflation rally. The bullish trigger for the rotation might be an upside breakout by small-cap stocks, which have been range-bound for most of 2021. The relative performance of small to large-caps is small-cap bullish, supportive by a positive RSI divergence and positive relative internals (bottom panel).

 

 

Also keep an eye on the 10-year Treasury yield, which is correlated to the cyclically sensitive base metals/gold ratio. The combination of a rising 10-year yield and a steepening yield curve is a signal that the bond market is buying into the reflation narrative.

 

 

 

The Fed’s response

As the signs of a continued recovery trickle in, a Fed decision to taper its QE purchases appears to be baked-in. Fedspeak from a range of doves and hawks are all pointing in the same direction, though with some important differences in nuance.

 

The Financial Times reported that Mary Daly, President of the San Francisco Fed and an important dove, expressed confidence that the robust recovery in household and business activity would continue to gather momentum as more people returned to work and consumer spending remained buoyant, setting the stage for a policy pivot in the coming months. She added: “Talking about potentially tapering those later this year or early next year is where I’m at.”

 

Robert Kaplan, President of the Dallas Fed and a hawk, indicated in a Bloomberg podcast he is supportive of immediate tapering, but with an important difference. 

 

Tapering could help take some of the pressure off the need to raise interest rates in the future, according to the Dallas Fed president. “Adjusting these purchases sooner might actually allow us to be more patient on the Fed funds rate down the road,” he says. It’s a nice reminder that tightening monetary policy doesn’t have to be a monolithic or even linear activity. 

As we approach the Fed’s annual Jackson Hole conference, investors can expect an outline of a decision framework on a QE taper. An announcement of an actual taper should follow shortly afterward. So far, the markets have not been unsettled by the prospect of a taper, which is supportive of further equity market gains.
 

 

Key risks

The stakes are high if value and reflation stocks don’t recover. Marketwatch reported that Barry Bannister and Thomas Carroll, strategists at Stifel, observed that the cyclical vs. defensive ratio had rolled over. The Stifel team is calling for a summer top for the stock market, followed by weakness for the remainder of the year.
 

 

While Google’s mobility survey of retail and recreational activity shows that most developed markets have shrugged off the effects of the Delta variant…
 

 

…much of Asia has been hard hit. Asian manufacturing PMIs are tanking.
 

 

Even worse, a COVID outbreak in China has created congestion off China’s top two container ports. The port of Ningbo shut down a container terminal when a COVID-19 case was detected this week.  The Meidong terminal suspended all operations since early Wednesday, while other terminals in Ningbo imposed restrictions limiting the number of people and cargo entering port areas. These shutdowns represent about one-quarter of the capacity of the world third largest port and these kinds of supply chain disruptions have the potential to bring global trade to a sudden stop and stall the growth recovery.
 

 

As well, a political storm is brewing in Washington despite the passage of the bipartisan $1 trillion Infrastructure Bill in the Senate, which now goes to the House for consideration. House Speaker Nancy Pelosi has vowed to pass both the Infrastructure Bill and a separate $3.5 trillion budget at the same time, assuming there are no defections among Democrats. The budget is expected to include a corporate tax increase and corporate minimum tax. So far, Q2 earnings season results have been very strong and forward 12-month EPS estimates have risen, but Street analysts have not begun to factor in the possibility of a tax increase. The 2017 Trump tax cut had been well telegraphed in mid-2017, but the market did not respond until late 2017.
 

 

A detailed analysis of changes in quarterly EPS estimates shows the market’s vulnerability. Estimate revisions for the remainder of 2021 are roughly flat, but they are rising strongly in 2022, which is most likely to be affected by any changes in the tax code. While some top-down strategists have tried to estimate the effects of a tax increase, company analysts have not revised their estimates because they cannot make changes without knowing the exact details of the legislation.
 

 

As well, the debt ceiling looms, and the money market is starting to get nervous as the debt-ceiling battle will go down to the wire. Treasury bills maturing in October and November have cheapened relative to the rest of the short-end curve. The risks of a disruptive 2011-style budget and debt ceiling fight are rising.
 

In conclusion, a review of market internals shows that the value and reflation trade is gaining ground. If this trend continues, it would translate into a bullish intermediate-term outlook for equities. However, investors have to be aware of the supply chain disruption risks from the Delta variant, the chances of a political storm in Washington, and the possible negative effects to earnings from a possible corporate tax increase.
 

What are the risks to this market?

Posted by Cam Hui -

Mid-week market update: I have been relatively constructive on the stock market in recent weeks, but I am going to do something different this time. Aside from the obvious negative RSI divergences to the rising S&P 500, what are the downside risks to this bull?
 

 

There are many to consider.

 

 

Technical warnings

An analysis of market internals reveals a number of cautionary signals. None of them can be classified as sell signals by themselves and each of the negative divergences could resolve themselves in benign manners. In aggregate, however, they do form a picture that all is not well with the bull case.

 

One of the technical warnings comes from the action of the Dow and the Transports. While the Dow has been making fresh all-time highs, the DJ Transportation Average has been weak, though the decline was arrested at a key Fibonacci retracement level. While this kind of market action does not constitute a Dow Theory sell signal, it is nevertheless a cautionary flag to keep an eye on.

 

 

There has also been a persistent negative divergence between the S&P 500 and the relative performance of high beta to low volatility stocks. That said, my other equity risk appetite indicator, the equal-weighted ratio of consumer discretionary to staples, is tracking the upward trajectory of the S&P 500.

 

 

Credit market risk appetite is also giving a nagging feeling of risk appetite deterioration. Even as the S&P 500 grinds its way to new highs, credit spreads are widening. The relative price performance of junk bonds to their duration-equivalent Treasuries is deteriorating.

 

 

 

Delta deceleration

From an economic perspective, there are signs that the Delta variant is having an effect on economic growth. The most vulnerable global region to the Delta variant is Asia, where most countries have very low vaccination rates. As a consequence, Asian PMIs are all tanking, indicating a manufacturing slowdown. Will the rest of the world suffer an economic contagion effect?

 

 

In the US, JPMorgan Chase is warning about a spending deceleration in its latest update of card services: “Retail spending outcomes have fallen short of our .. model in recent months. Our US card data reinforces this note of caution, showing a loss of momentum for airline spending and leveling off for restaurant spending this quarter.”

 

 

The slowdown in spending is occurring when leisure and hospitality businesses are being squeezed on labor costs. The ratio of leisure and hospitality wages to manufacturing wages is surging. This will undoubtedly put pressure on service industry operating margins.
 

 

 

Will Powell be reappointed?

Another wildcard is the appointment of the Fed chair. Jerome Powell’s term ends in January. The WSJ reported that a fight is brewing in Washington between the Biden White House and the progressive wing of the Democratic party.

 

Members of President Biden’s economic team generally support nominating Federal Reserve Chairman Jerome Powell to a second term, but growing resistance from prominent Democrats including Sen. Elizabeth Warren (D., Mass.) could lead to his replacement, according to people familiar with the matter.

 

Mr. Powell, who was appointed to his first term by former Republican President Donald Trump, has received high marks from some Democrats for steering the central bank toward a paradigm shift that has placed greater attention on reducing unemployment. That coincided last year with a forceful response to the coronavirus pandemic.

 

But some progressives are unhappy with his bent toward easing financial regulations that were put in place after the 2008 crisis and think the central bank should have someone more in sync with Democratic politics in charge.

 

If Mr. Powell isn’t given a new four-year term next February, when his current term expires, the leading contender for the job is Fed governor Lael Brainard, an economist appointed to the board in 2014 by former President Barack Obama.
Frankly, I don’t understand the dispute. Lael Brainard is the obvious second choice if Powell isn’t reappointed. Her monetary policy views are very similar to Powell’s and the Fed wouldn’t change substantially under Brainard. 

 

If the disagreement is over banking supervision, the solution is to appoint a vice chair with strong views instead of fighting over who is the Fed chair. To be sure, Brainard is a Democrat and Powell is a Republican but that shouldn’t make a big difference in monetary policy. Longer term, a Brainard appointment would be a signal that the Fed is being politicized and a switch could unsettle markets. It opens the door to more overt political manipulation of the Fed in the future, in the same way that Trump nominated Judy Shelton as a Fed governor with the expectation that she could have become the Fed chair had he won a second term.

 

In conclusion, the S&P 500 faces a number of important obstacles as it advances to fresh highs. While I am not implying that the market is about to crash, investors need to consider the risks to this market. 

 

In a future edition, I will outline the upside potential of this market.

 

Trading the gold flash crash

Posted by Cam Hui -

Gold prices crashed overnight when a flood of sell orders hit the illiquid Asian markets. Prices fell below the 1700 mark but recovered. This has the smell of a margin clerk liquidation, which is often the sign of capitulation. 
 

 

Is this an opportunity to buy gold?

 

 

The top-down view

The sudden downdraft took me and a lot of other analysts by surprise. Gold prices had everything going for it. On August 8, 2021 Jason Goepfert of SentimenTrader wrote the following constructive comment on gold miners:

 

Over the past 20 days, an average of fewer than 12% of gold miners were trading above their 50-day moving average, which is now starting to curl higher.

 

 

Gold prices had been the beneficiary of cross-asset price support until last Friday. The USD (inverted scale) had shown signs of weakness. TIPs prices were rising, which meant that real yields were falling. Both factors were bullish for gold prices. Gold had tested the 200 dma resistance. While the tests failed, that technical action could have been interpreted as a consolidation that occurs just before an upside breakout.

 

 

The roof caved in last Friday. The strong July Jobs Report steepened the yield curve, pushed down real yields, and strengthened the USD. Gold prices gapped down to test an important support level (dotted line). It crashed through support today.

 

Is this a buying opportunity?

 

 

Waiting for the washout

Not yet. The technical internals of the gold miners (GDX) has not reached levels that indicate washout and capitulation. I am waiting for the 14-day RSI to become oversold (top panel) and % bullish to fall to 30 or less (bottom panel). GDX is testing a key support zone right now. A true panic bottom is unlikely to form without an oversold condition on RSI and lower % bullish readings.

 

 

Mark Hulbert came to a similar conclusion, based on his interpretation of the Hulbert Gold Newsletter Sentiment Index (HGNSI):

 

The most sustainable rallies in the past have come when the average gold timer was not only extremely bearish, but stubbornly so. This is what happened in February and March of this year, as the chart illustrates: The HGNSI remained in the zone of extreme bearishness for over a month. Gold’s subsequent rally was impressive, with bullion rising over 13% and gold mining shares rising more than 22% (as measured by the VanEck Vectors Gold Miners ETF GDX.

 

In the rally that began in late June/early July, in contrast, neither bullion nor gold mining shares rose more than about 4%.

 

How long will it take until a strong contrarian buy signal? Contrarians typically don’t even attempt an answer, letting the markets tell their own story in real time. If the gold timers in coming days do finally throw in the towel, and then remain bearish in the wake of any initial show of gold strength, then a contrarian buy signal could come sooner rather than later.

 

 

My inner investor was stopped out of his GDX position on Friday. I did not send out a trade alert as GDX is in my investment account on Friday and my standard practice is to only send alerts for trading account activity. I am waiting for more signs of panic before re-entering a long gold position.

 

 

A range-bound August?

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.
 

 

A holding pattern

Regular readers will know that I have been calling for a sideways holding pattern for the S&P 500. That remains my base case scenario for the rest of August. Continuing concerns about the Delta variant stalling growth are likely to put downward pressure on risk appetite. On the other hand, an improving EPS growth outlook is putting a floor on stock prices.

 

 

To be sure, the S&P 500 made a marginal new high on Friday, but the market’s less than enthusiastic reception to Friday’s strong jobs report is indicative of the market’s internals and makes my case that the stock market is likely to be range-bound. On the surface, the S&P 500 advance. Looking under the hood, the yield curve steepened and cyclical and value stocks rallied, while growth stocks fell.

 

 

The virus: Good news and bad news

I have some good news and bad news about COVID-19. The bad news is well-known. Almost every day, the media is full of stories about rising infections, especially among the unvaccinated. Events are being cancelled and people are forced to change their behavior. The good news that is US vaccination rates are slowly rising, and the virulent Delta variant has shown itself to peak after two months.

 

The accompanying chart shows the progress of new case counts per million in India, where the Delta variant first appeared and there were few vaccinated people, and in the UK, which is struggling with the Delta variant but has a highly vaccinated population. In both instances, the infection rate peaks about two months after it first appeared. The rise and fall in the UK case count was steeper than India’s, likely owing to the higher British vaccination rate. In the US, the duration of the ascent in case counts has been a month. Using the India and UK as templates, this puts the US peak in about early September.

 

 

The markets have responded cautiously to these developments. The relative performance of cyclical sectors and industries have stopped falling and they are moving sideways. I interpret these conditions as the market believes the worlds of the growth pause is over, but it is waiting for a new catalyst before launching a new bullish or bearish impulse.

 

 

 

Stellar Q2 earnings

Another bullish consideration is the strength of Q2 earnings results. Both the EPS and sales beat rates are astoundingly high by historical standards and the EPS beat rate would be the highest on record since FactSet started maintaining statistics in 2008. As a consequence, forward 12-month EPS estimates are surging.

 

 

If earnings estimates rise and prices are stable, the forward P/E ratio declines. So far, the S&P 500 forward P/E is nearing the bottom of its post-COVID range, which makes the market more attractive, especially in light of a falling 10-year Treasury yield.

 

 

 

Uncertain leadership

My analysis of the relative performance of the top five sectors of the S&P 500 reveals a story of uncertain leadership. The top five sectors comprise about 75% of index weight and it would be difficult for the market to either rally or drop without the participation of a majority. Of the top five sectors, only healthcare could be described as exhibiting positive relative performance in the last month. The rest are mostly trading sideways or slightly weak compared to the S&P 500.

 

 

These conditions indicate that the market is marking time and waiting for either a bullish or bearish catalyst. I am reserving judgment until the Russell 2000 breaks out of its tight range. One hopeful sign for the bulls is the Russell 2000 to S&P 500 ratio may be trying to turn up against the S&P 500.

 

 

Similarly, the value and growth cycle has been trading sideways in the last month.

 

 

The most likely scenario is a continued sideways pattern for another month until it becomes evident that the worst of the Delta variant has run its course, which would be followed by a cyclical and value stock rally. The bearish scenario is a legislative impasse in Washington, either over the debt ceiling or the infrastructure bill. In that case, watch for renewed concerns over economic growth, dovish Fed, falling bond yields, and rising risk aversion.

 

 

The brewing crisis in Crypto-Land

Posted by Cam Hui -

There has been much debate over the usefulness and viability of crypto-currencies. Notwithstanding my opinion on the topic, the current crypto-currency ecosystem has an Achilles Heel of Lehman Crisis proportions. 
 

 

It’s called Tethers, which is a stablecoin used as a critical piece of plumbing in the offshore crypto markets. This week, I explain:
  • What is a digital token, or stablecoin?
  • Why do stablecoins matter in Crypto-Land?
  • The vulnerability of Tether
  • Possible solutions

 

 

What is a digital token?

There is nothing inherently nefarious about digital token. A digital token is simply a digital way of paying for goods and services that is not issued by a central bank. Unlike a cryptocurrency, a digital token has little price volatility, which is why it’s called a stablecoin.

 

The idea has been around for a long time. For example, frequent flyer miles issued by different airlines is a form of digital tokens. They can be redeemed for services, such as flights, hotel stays, and so on; their value is relatively stable, and they are not issued by a central bank. In China, many vendors do not accept cash as a form of payment. Instead, they take Alipay, which is a payment system administered by Alibaba. Alipay is also a form of digital token not issued by the PBoC. Facebook appears to be trying to go down the Alipay route. Mark Zuckerberg recently characterized the company as a metaverse, which brings up the question of whether anyone wants Facebook to know about all of your digital activities, but that’s another discussion altogether.

 

 

Stablecoins in Crypto-Land
Here is why stablecoins matter in Crypto-Land. In relatively regulated jurisdictions like the US, individuals can buy and sell crypto-currencies using a service like Coinbase with USD. As Coinbase is an onshore entity, it is required to perform “know your client” due diligence inquiries to curb money laundering before anyone opens an account. It’s more difficult to be anonymous with a Coinbase account.

 

So far, so good.

 

Here is where the story gets more interesting. Crypto-currency traders can become more anonymous and access high levels of leverage in offshore exchanges like Binance, Bit-Z, and HitBTC.

 

Here is how the transaction works. You buy your crypto-currency on Coinbase and transfer the proceeds to an offshore exchange. The attraction of offshore exchanges is they allow leverage as much as 100 to 1, which can be useful for magnifying gains for traders willing to gamble on big gains.

 

But offshore exchanges are unbanked, meaning they don’t have direct access to the US financial system. Few US institutions are willing to serve as their correspondent bank for regulatory anti-money-laundering reasons. Most offshore crypto exchanges will not accept USD as deposits. (Binance US, an affiliate of Binance, does allow USD purchases, but its volumes are minuscule and not significant to our story). 

 

The workaround to the problem is a stablecoin. If you sell a crypto-currency in an offshore exchange, you receive a token issued by an offshore entity. The most popular are Tethers, a stablecoin issued by Tether Ltd. The company claims that Tethers are backed one-to-one by USDs.

 

 

The problem with Tethers

Owing to their one-to-one USD relationship, Tethers are in effect a money market fund. The concern is that with little transparency over what’s backing the tokens, there’s a risk that Tether breaks the proverbial buck in a similar way to what happened to the Reserve Primary back in 2008 when its net asset value suddenly dipped below $1 thanks to a mix of huge outflows and the bankruptcy of Lehman Brothers, which rendered its commercial paper suddenly worthless. That sent a shockwave through the wider market as it grappled with the idea of potential losses on money market funds which had always been assumed to be safe and money-like.

 

The company disclosed that most of its reserves are invested in AA-rated USD commercial paper (CP). 

 

 

This makes Tether Ltd. one of the biggest players in the CP market in the world.

 

 

Here is where the conspiracy theories begin to proliferate. Commercial paper is short-term funding for creditworthy corporate borrowers. Tether Ltd. is supposed to be a huge participant in the CP market, but few dealers have heard of it. Either Tether Ltd. is engaged in fraud and the tokens are not fully backed by its reserves, or the company has found a large but unknown issuer. Tether’s reserves are over $60 billion. Assuming the company isn’t engaged in fraud, who could be issuing that much CP in USD?

 

The answer is Chinese paper, specifically troubled property developers like China Evergrande, whose share price has collapsed and whose bonds are trading at over a 50% discount to par. S&P recently downgraded China Evergrande’s rating two notices from B- to CCC, which is the lowest level of junk. Oops!

 

 

Fitch Ratings recently issued a warning about the possible contagion risks of stablecoins.

 

The rapid growth of stablecoin issuance could, in time, have implications for the functioning of short-term credit markets, says Fitch Ratings. Potential asset contagion risks linked to the liquidation of stablecoin reserve holdings could increase pressure for tighter regulation of the nascent sector.

 

Contagion risks are primarily associated with collateralised stablecoins, varying based on the size, liquidity and riskiness of their asset holdings, as well as the transparency and governance of the operator, among other things.

 

 

A Lehman Crisis on the horizon?

Jim Cramer at CNBC issued a warning about Tethers and alleged that Tether is invested in Chinese CP and discussed the risks to Tethers and the crypto-currency ecosystem (YouTube link). Presumably, he would not be making such statements on the air without credible sources.

 

 

Stablecoins are a form of money market funds that are unregulated and trade offshore. In the past, money market funds that have “broken the buck” by failing to redeem at less than par have sparked digital bank runs which turn into disruptive risk-off events like the Lehman Crisis. Cramer discussed this possibility and pointed to a high degree of correlation between Bitcoin prices and Tether assets. This creates a chicken-and-egg question. Could a loss of confidence in Tethers spark a crypto-currency crash, or could a sell-off in crypto-currencies spark a run on Tether? Add leverage of up to 100 to 1 to the mix, and the ingredients for a sudden market dislocation are all there.

 

Here is how a Crypto-Panic might play out. Supposing that you hold a notional $100,000 cryptocurrency in an offshore exchange whose position can only be realized in Tethers and not USD. The news comes across the tape that Tether had invested 30% of its reserves in China Evergrande paper that’s trading at a 50% discount to par. Tether has broken the buck, and each Tether token is only backed by $0.85. Your notional cryptocurrency position is now worth only $85,000 – that’s assuming you are not using leverage.

 

Market players react by selling first and asking questions later. Everyone tries to cash out of their Tether tokens all at the same time. In order to meet redemption requests, Tether is forced to liquidate its portfolio. The bids for Evergrande paper evaporates, and the backing for each Tether token falls to $0.70. At the same time, traders sell out of their cryptocurrency long positions in order to realize Tethers to access USD. Some of the cryptocurrency positions are levered, which sparks a selling cascade. It becomes vicious feedback loop. That’s how market crashes happen.

 

During the Lehman Crisis, the monetary and fiscal authorities stepped in to stabilize the markets. Would they do the same if Tethers crashed? Don’t count on it. Investors chose to trade Tethers offshore and away from the prying eyes of regulators. They made their beds. Fitch Ratings came to a similar conclusion.

 

We believe authorities are unlikely to intervene to save stablecoins in the event of a disruptive event, partly owing to moral hazard. Authorities could step in to support dealers and prime MMFs should stablecoin redemptions lead to or amplify a wider CP sell-off, pressuring market liquidity and impeding new CP issuance.

 

 

Stabilizing the system

The authorities have a solution to the possible crisis of confidence in Tether, namely the creation of a Central Bank Digital Currency (CBDC), or a central banked-backed stablecoin. The Bank of England and the European Central Bank are both seriously considering the issue by conducting studies. The Federal Reserve is also studying the problem by inviting public comment with a view to publishing a discussion paper by September. There is a wide range of views among policymakers. Fed governor Chris Waller has dismissed the utility of a CBDC in a recent speech. On the other hand, Jeanna Smialek of the NY Times reported that Fed governor Lael Brainard has been more supportive in a recent Q&A at the Aspen Economic Strategy Group.
 

“If we saw, in the absence of a central bank digital currency in the U.S., a proliferation of stable coins,” Lael Brainard says, “it could have some risks.” 

 

“There are questions about what backs the stablecoins. There are questions about: Who do you hold responsible?”

 

“If you have the other major jurisdictions in the world with a digital currency” offering, she says, “I just can’t wrap my head around that.” 

 

“I think we need to be in at the very beginning,” she says.
In conclusion, the development of crypto-currencies has been a West West, which is not unexpected in light of the newness of the ecosystem. Notwithstanding the numerous questions about the validity and usefulness of cryptocurrencies as an asset class, history shows that the development of new systems tend to be disorderly and prone to fits and starts, and accompanied by crashes and crises until some stability is imposed. However, the price of stability will come at a cost of greater transparency and regulation, which is contrary to the free-spirited and libertarian crypto-currency philosophy.

 

How all this eventually plays out, I have no idea. The crisis risk in Crypto-Land is a “this will not end well” story with no obvious trigger. I am not implying that Tethers will crash tomorrow and bring down the entire crypto-currency complex with it. In fact, FTX has a credit risk derivative product consisting of short Tether/long USD. It trades at an effective discount of about 2% a year, meaning that the market isn’t pricing a high level of default risk. However, anyone who becomes involved in Crypto-Land should be aware of the risks posed by offshore stablecoins like Tethers.

 

 

 

Can stocks avoid the seasonal swoon?

Posted by Cam Hui -

Mid-week market update: Evidence of a negative seasonal pattern has been circulating on the internet for the S&P 500. As one of many examples, LPL Financial pointed out that the S&P 500 has typically topped out in early August and slides into late September.
 

 

While past performance is no guarantee of future returns, will 2021 repeat the past seasonal pattern? Can the stock market avoid negative seasonality?

 

Here are the bull and bear cases.

 

 

The bear case

In addition to the annual seasonality pattern, Ned Davis Research observed that the seasonal combination of a one-year cycle, four-year Presidential cycle, and 10-year Decennial Cycle patterns looks even uglier.

 

 

The negative seasonal pattern is also lining up with widespread bearish breadth divergences.

 

 

In addition, Marketwatch reported that Citigroup chief strategist Tobias Levkovich is being ultra-cautious:
 

Tobias Levkovich, chief U.S. equity strategist at Citi, says there’s an almost “palpable” sense that every 1% dip is a buying opportunity. “We are less convinced,” he said. “Fund managers fully concede that the rate of profit expansion will slide but most fear more upside and relative performance issues than a double-digit decline at the moment, yet they prefer a higher quality tilt to portfolios.”

 

It can’t last forever, can it? Levkovich is sticking with his 4,000 year-end price target for the S&P 500 — which means he thinks the market may drop by 10%. And he has a specific month in mind when it might, if not fall apart, at least get ropey. “The paucity of immediate catalysts for a pullback is cited regularly, although we worry about higher taxes, cost pressures eating into profitability, tapering and more persistent inflation all coalescing in September (typically the toughest month seasonally for the S&P 500),” he said.
As well, the BoA’s Sell Side Indicator is neutral, but it’s very close to a sell signal.

 

 

Lastly, Fed vice-chair Richard Clarida spooked the markets when he said in a speech today that the “necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022”.

 

While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.

 

 

A dovish Fed

Notwithstanding Clarida’s hawkish remarks, Fed policy has been actually very dovish. This can be seen both from official statements and incoming data.

 

First, there is widespread expectation that the Fed would taper its QE purchases. In all likelihood, Fed policymakers will discuss a framework for tapering at its August Jackson Hole conference. The next question is timing. The July FOMC statement made an important point on this issue [emphasis added]:

 

Last December, the Committee indicated that it would continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward its maximum employment and price stability goals. Since then, the economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings.

The phrase “assess progress in coming meetings” (plural) is an important clue about the timing of a tapering announcement. The FOMC meeting schedule is September, November, and December. The July FOMC statement implies that the earliest that a taper announcement will be at the November meeting. Fed vice-chair Richard Clarida also said today that the Fed has no intention of surprising the market on tapering, though he could see an announcement later this year. 
 

In addition, Fed governor Lael Brainard also gave an important clue about the conduct of monetary policy in a speech to the Aspen Economic Strategy Group. On the subject of labor market recovery, she stated that she “expect[s] to be more confident in assessing the rate of progress once we have the data in hand for September”, indicating that the Fed needs to see confirmation of a labor market recovery in its September data, which will be available in early October.
 

Currently, it is difficult to disentangle the effects on labor supply of caregiving responsibilities brought on by the pandemic, fears of contracting the virus, and the enhanced unemployment insurance that was designed in part to address such constraints. Importantly, I expect to be more confident in assessing the rate of progress once we have data in hand for September, when consumption, school, and work patterns should be settling into a post pandemic normal.

These signals are consistent with the consensus expectation of a tapering announcement in late 2021, with actual action in early 2022.
 

However, recent data is supportive of a more dovish tone. The Citi Economic Surprise Index, which measures whether economic data is beating or missing expectations, has been falling.
 

 

The data has been soft. As an example, today’s release of ADP Non-farm Employment Change badly missed expectations. This raises the likelihood of an NFP payroll miss on Friday.

 

 

As well, the Biden administrations partial eviction ban will serve to lessen the upward pressure on the Owners’ Equivalent Rent portion of CPI, which has a dovish effect on monetary policy.

 

 

Other bullish reasons

In addition to a dovish tone from the Fed, investors also need to consider a number of other bullish data points. Goldman Sachs recently made a “cash on the sidelines” argument in the form of excess savings, which will translate to both investor demand for equities and more consumer demand that drives up sales. The high level of excess saving is evident not only in the US but globally.

 

 

Macro Charts pointed out that markets are jittery. Option traders are extremely negative. These conditions have tended to resolve themselves in a bullish manner in the past.

 

 

 

Resolving the bull and bear cases

Where does that leave us? I continue to believe that the US equity market has bifurcated into a growth and value market. A rotation from value into growth has held the overall market up and the S&P 500 has been range-bound. This should continue until we see some catalyst for either an upside or downside breakout.

 

An upside breakout would likely be the result of a shift in narrative from worries about a Delta variant-related slowdown to renewed global growth. The main risk for a downside breakdown is the news of  higher corporate tax and minimum corporate tax legislation which sideswipes earnings growth expectations. The most vulnerable would be technology and drug companies. In particular, the healthcare sector has been a stellar outperformer in the last few months. These stocks are at risk of a sudden downdraft under such a scenario.

 

 

 

A whiff of rotation in the air

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.
 

 

Unanswered questions

As the S&P 500 advanced to fresh highs despite widespread evidence of negative RSI and breadth divergences, the market faces a number of unanswered questions that may be indicative of possible impending leadership rotation.

 

 

How the market resolves those questions will be clues to the next major leg for stock prices.

 

 

Bearish omens

In addition to the negative breadth divergences, here are other bearish omens for the stock market. One component of my risk appetite model is persistently flashing a warning. While the equal-weighted consumer discretionary to staple ratio has confirmed the market’s highs, the ratio of high beta to low volatility stocks is exhibiting a series of lower lows and lower highs.

 

 

Credit risk appetite is also not behaving well. The relative performance of junk bond prices to their duration-equivalent Treasuries is also displaying a negative divergence.

 

 

Another possible black swan is appearing from overseas. Chinese and Hong Kong equity markets recovered Thursday after regulators convened an emergency video conference to reassure banking executives that crackdowns on the education sector were localized. The measures are not part of a series of broad-based initiatives to hurt companies in other industries. The relief rally didn’t hold as the market sold off Friday.

 

More ominously, the shares of mega cap property developer China Evergrande continued to weaken. 

 

 

UBS pointed out that 77% of Evergrande’s liabilities are due in the next 12 months. This puts pressure on the company to cut sale prices on its product and depress real estate prices.

 

 

Other property developers also weakened and broke major multi-year support in sympathy. As real estate represent a major asset of Chinese households’ savings, skidding property developer shares could be the start of a Chinese Lehman Crisis.

 

 

 

Reflationary green shoots

On the other hand, the cyclically sensitive copper/gold and base metals/gold ratios are strengthening. The 10-year Treasury yield normally tracks these ratios closely, but it remains depressed. Are these reflationary green shoots that investors should take notice of? What does this mean for the 10-year Treasury yield?

 

 

The rise in the copper/gold and base metals/gold ratios is surprising as it is occurring in the face of a rally in gold prices. The market interpreted the FOMC statement and Powell’s press conference comments as dovish. Real yields fell (and TIPs prices rose); the USD Index fell (bottom panel, inverted scale); and gold prices surged to test its 200 dma. This sort of market action is constructive in light of Mark Hulbert‘s read of gold timer sentiment data, which is in the bottom 13-percentile and contrarian bullish.

 

A contrarian analysis of market-timer sentiment reaches a similar conclusion about the near-term outlook for both gold and stocks. The average recommended gold exposure level among short-term gold timers my firm monitors is currently lower than 87% of all daily readings since 2000. This indicates a considerable level of bearish sentiment on gold, which is bullish from a contrarian perspective.

Gold’s ability to regain the 200 dma would be a positive sign. If it holds the breakout in the coming days, it would be bullish for the yellow metal and a signal of the reflationary trade has regained the upper hand. 

 

 

 

The Simone Biles job market?

Finally, keep an eye on the July Employment Report due out on Friday. Barron’s highlighted the problem of labor market shortages in this week’s issue, which is giving employees greater bargaining power. 

 

 

The story isn’t just higher wages, but better working conditions. The employment situation is becoming a Simone Biles job market. For the uninitiated, Simone Biles is the most decorated gymnast in American history with a record haul of Olympic and World Championship medals to her name. She quit at the Tokyo Olympics just before a competition, citing mental health issues. A minor political controversy has erupted about her decision. When viewed through a labor market prism, the fundamental question becomes a worklife balance issue and how much mental health hardship individuals should endure for the sake of their employer.

 

Friday’s release of the Employment Cost Index came in below expectations, which has dovish implications for Fed policy.

 

 

Keep an eye on prime-age EPOP and LFPR, wages, and other signs of tight labor markets in the July Jobs Report. This will affect the market’s view of the inflation outlook (see How to engineer inflation) and be a driver of monetary policy.

 

 

 

Sector review: Balanced leadership and rotation

Posted by Cam Hui -

It`s time for another periodic review of sector leadership. For the purposes of analyzing changes in leadership, 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 changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
 

The latest RRG chart shows growth sectors (technology, communication services) and selected defensive sectors (consumer staples, healthcare, REITs) in the top half of the chart, indicating leadership positions. Value and cyclical sectors are the laggards in the bottom half.

 

 

While the RRG snapshot is technically correct. A more detailed factor and sector review reveal a more nuanced picture of the market`s leadership evolution.

 

 

A reversal of a reversal

The year 2020 marked a dramatic reversal in factor leadership of the Big Three: US over global stocks, growth over value, and large-caps over small-caps (dotted lines). The reversal accelerated last November on Vaccine Monday when Pfizer announced the success of its vaccine. In early 2021, the factor reversal reversed itself. US equities have reasserted their leadership position and staged an upside breakout against the MSCI All-Country World Index (ACWI). Value has struggled against growth, and small-caps have lagged large-caps.

 

 

Keep these factor reversals in mind as I conduct my sector leadership review.

 

 

Sector review

I begin my review with the technology sector, which is the largest in the S&P 500, and the large growth stock sector. The framework for my sector review is an analysis of the relative performance of sector performance by market cap. The top panel shows the relative performance of large-cap technology against the S&P 500 (black line) and the relative performance of small-cap technology against the Russell 2000 (green line). This is meant to be an apples-to-apples comparison by market cap. The middle panel shows the relative performance of the small-cap technology to large-cap technology (green line) and the Russell 2000 to S&P 500 (black line) as a frame of reference. The bottom two panels show the market breadth of the large-cap technology sector by measuring the differences in the percentage of stocks bullish on point and figure charts between technology and the S&P 500, and the difference in the percentage of stocks above their 50-day moving averages between technology and the S&P 500.

 

Based on this analysis, we can see that the technology sector has been improving steadily in relative performance in both large and small-cap since mid-May, as shown by the top panel and the bottom two breadth charts. However, there is no discernible difference in market cap effect as the relative performance of small-cap technology to large-cap technology has tracked the relative performance of the Russell 2000 to S&P 500.

 

 

The communication services sector has no small-cap stocks. I use the relative returns of the equal-weighted sector to the equal-weighted S&P 500 as a substitute (green line). Despite the recent strength of growth stocks, the market internals of communication services is disappointing. Both the equal-weighted relative returns and breadth indicators show a picture of relative weakness.

 

 

Even as the S&P 500 advanced to fresh all-time highs, the defensive sectors have been showing a surprising level of relative strength. The largest defensive sector by weight is healthcare. Both large and small-cap healthcare made relative strength bottoms during the April/May period, though the improvement was evident earlier based on the breadth indicators. However, the relative performance of small-cap to large-cap healthcare has tracked the size factor, indicating no relative leadership in small-cap healthcare.

 

 

The REIT sector is another defensive sector exhibiting relative strength. Both large and small-cap REITs made a relative bottom in January, which was earlier than healthcare. Small-cap REITs are showing better leadership than their large-cap counterparts.

 

 

The relative strength of large-cap utilities (top panel, black line) appears to be trying to make a double bottom. Small-cap utilities (top panel, green line) had already exhibited a relative bottom in the December/January period and small-cap utilities are beating large caps. The improvement in breadth began in March, though there was a brief stumble in late June.

 

 

Consumer staples is the weakest of the defensive sectors. Both large and small caps are trying to make relative strength bottoms.

 

 

The RRG chart showed that the cyclical and value sectors are laggards. Of all the sectors in this group, industrial stocks show the most promise. While large-caps remain in a relative downtrend, small-caps are turning up. As well, large-cap breadth indicators are showing signs of improvement.

 

 

The float-weighted consumer discretionary sector is dominated by the presence of Amazon and Tesla, which gives the sector a growth tilt, and its relative performance (top panel, black line) is flat to down in 2021. However, the equal-weighted and small-cap consumer discretionary sector is more cyclically oriented. and they are performing better than their float-weighted growth counterparts. In addition, relative breadth indicators are showing early signs of a turnaround.

 

 

The rest of the cyclical and value sectors are weak. The largest sector is made up of financial stocks, and both large and small-caps are lagging compared to the S&P 500.

 

 

Energy stocks are also weak, but they may be trying to put in a relative bottom. The relative returns of small to large-cap energy (middle panel, green line) is performing better than the Russell 2000, which is a possible hopeful sign for value and energy bulls.

 

 

Finally, the relative performance of material stocks is highly volatile, but both large and small caps have been tanking since early June.

 

 

 

The evolution of sector leadership

How should investors interpret these sector leadership patterns? Defensive sectors have been exhibiting strength, which is normally a cautionary signal for stock prices. On the other hand, the relative performance of defensive sectors remains mixed, on the whole. 

 

 

Cyclical and value sectors have been lagging growth stocks, but both the value/growth ratio is exhibiting a series of positive RSI divergences. Don’t count the cyclicals out just yet.

 

 

As an illustration of the wide divergences between sectors, this chart of the percentage of stocks above their 50 dma tells the story. The dark line shows the percentage of S&P 500 stocks above their 50 dma at 59%. The leaders are healthcare (81%) and technology (76%). The laggard is energy which recently had no stocks above their 50 dma.

 

 

In addition, the US value/growth ratio is highly correlated to the EAFE value/growth ratio. As the US markets have more growth characteristics, the renewal of US equity leadership can be explained partially by a revival in growth stocks. How long can growth dominance continue? The latest update from Q2 earnings season shows an astounding EPS beat rate of 88% and forward EPS estimates are rising strongly. Keep in mind that my estimate of a 1.81% positive revision in forward EPS means that, unless the S&P 500 were to rise 1.81%, forward P/E would decline. Such a display of earnings beats and positive revisions should create tailwinds for cyclical and value stocks.

 

 

Other cyclical indicators, such as commodity prices and the base metals/gold ratio, are flat to up. 

 

 

While the relative performance of US materials are weak, the relative performance of global materials and mining stocks is showing some signs of life.

 

 

I interpret these conditions as neither bullish nor bearish, but the story of balanced leadership. The high beta components of the S&P 500, growth and value, have been undergoing an internal rotation. As the economy shifted from an early cycle recovery to a mid-cycle expansion (see How to navigate the mid-cycle expansion), market jitters over stalling global growth have risen. As a consequence, investors have rotated from the cyclical and reflation trade back into growth as growth stocks become more valuable when economic growth is scarce. At the same time, the stock market has also been supported by defensive sectors such as healthcare and real estate. Currently, value is showing some signs of  early strength, but a turn in the value/growth relationship hasn’t been confirmed.

 

My base case scenario calls for a choppy range-bound market until the cyclical and reflation trade theme retakes market leadership. If the stock market were to definitively turn upwards, leadership may have to come from high beta small-cap stocks. Keep an eye on the relative performance of small to large caps, which is already exhibiting a positive RSI divergence. Even as the S&P 500 rises steadily, the Russell 2000 has been range-bound. The signs that the bulls have taken control of the tape would be an upside breakout by the Russell 2000 and leadership by small-cap stocks.

 

 

 

The remarkably resilient stock market

Posted by Cam Hui -

The Chinese markets panicked on the news of government crackdowns on technology and education companies. As well, Beijing has been working to restrict the flow of credit to property developers in order to stabilize real estate prices. In reaction, foreigners have been panic selling Chinese tech on high volume.
 

 

Despite all of this carnage, the S&P 500 has been remarkably resilient.

 

 

China’s about face

Here is the best analysis of China’s policy changes that I have encountered (by Tom Westbrook via Reuters):
 

The new model appears to place common prosperity, as President Xi Jinping has put it, ahead of helter-skelter growth, investors say.

 

According to some analysts, it is the most significant philosophical shift since former leader Deng Xiaoping set development as the ultimate priority 40 years ago.

 

“Chinese entrepreneurs and investors must understand that the age of reckless capital expansion is over,” said Alan Song, founder of private equity firm Harvest Capital. “A new era that prioritises fairness over efficiency has begun”…

 

In the nine months that have passed since, developers, commodity speculators, crypto miners, other tech giants and, lately, tutoring firms, have all faced radical rule changes or had regulators aggressively poring over their businesses.

The policy pivot is “common prosperity”. Translated, this means the reduction of inequality in order to better support household sector spending.

 

Zhaopeng Xing, senior China strategist at ANZ, said the raft of policies, unveiled around the Chinese Communist Party’s centenary, underscores the political will to reinforce the Party’s roots.

 

“These policies were announced to reflect the Party’s progressiveness” and appeal to the masses, Xing said. “They send a message that China is not a capitalistic country, but embraces socialism.”

 

The messaging in the months running up to the Party’s July 1 centenary was also unequivocal, analysts say. “Common prosperity” is the over-riding long-term goal, Xi said early this year, and China’s development should be centred on people’s expectations of better lives, urban-rural gaps and income gaps.

Rather than blindly selling everything Chinese, investors should instead focus on the “Three Mountains”.

 

Investors have so far responded with alarm that tipped on Tuesday towards panic. They dumped health stocks (.HSHCI) in anticipation the sector will be next in the firing line, even as the property and education sectors reel.
 

Housing, medical and education costs were the “three big mountains” suffocating Chinese families and crowding out their consumption, said Yuan Yuwei, a fund manager at Olympus Hedge Fund Investments, who had shorted developers and education firms.

The markets have responded relatively rationally. The affected sectors have cratered. In particular, the shares of the “too big to fail” overly indebted property developer China Evergrande continue to skid.

 

 

For some context, China’s property bubble is huge.

 

 

Credit contraction? Property bubble? This should put extreme pressure on financial stability, right? The relative performance of Chinese financial has tracked the relative returns of US and European financials. Remarkably, Chinese financials (red dotted line) have outperformed the Chinese market in the last few days.

 

 

Moreover, anecdotal stories of foreigners fleeing the Chinese market should put pressure on the exchange rate. While the USDCNH rate has weakened slightly, it has been incredibly stable in the month of July. One of the key risks is a major Chinese devaluation. So far, there are few signs of CNH weakness.

 

 

China’s blowup appears to have been contained. This argues for a buying opportunity in selected Chinese equities for investors who avoid the “Three Mountains”.

 

 

The word is “transitory”

Today is FOMC day and the Fed’s continued “stay the course” tone is not a surprise to me. In the FOMC statement and subsequent press conference, the Fed acknowledged progress with the recovery, with the caveat that substantial further progress is required. Moreover, the FOMC “will continue to assess progress in coming meetings” (plural). A taper would be no surprise, but the sequence of a QE taper, followed by rate hikes will take a long time.

 

The good news is the inflation spike is turning out to be transitory. Delivery times have been correlated with CPI, and delivery times and supply chain bottlenecks are beginning to ease. 

 

 

Labor markets are normalizing, though labor shortages are not. Arindrajit Dube, who is an economist at UMass Amherst, analyzed the effects of moving from unemployed to employed in the states that shrunk UI early and found that the UI effect has been modest at best.

 

 

Labor markets are tightening, which is also positive from the Fed’s perspective. The anecdotes from the Dallas Fed’s Texas Service Sector Outlook Survey tell a story reduced labor supply in all tiers.

 

We continue to see improved demand for legal services. The winter storm instigated a lot of legal work. We are continuing to see increases on the transactional side and perhaps a bit of a slowdown in large bankruptcy filings. There is huge competition for talent right now—particularly for corporate lawyers. There is a lot of pressure on associate salaries, and we have implemented a new pay scale for associates that will feature retroactive bonuses.

 

A shortage of technology professionals continues to impact the ability to deliver. Sales look like they’ll pick up in the fall based on more purchasing decisions being made.

 

[Food services] We are hiring a few employees after the federal [unemployment] subsidy ended but continue to lose others oftentimes because they say they don’t want to work or decide to attend a social function and walk off. They know they can get hired again by walking down the street. Hire three, lose four. Hire two, lose one. I have never seen anything like this in my almost-40 years of working. We continue to turn away business due to lack of employees. Raw product prices continue to significantly increase. It is difficult to raise prices, but we will have to soon. Our downtown area remains sparsely populated with little activity, which is critical to our business.
This feeds into the Fed’s objective of running a hot economy in order to reduce inequality. In the press conference, Powell would not be pinned down on the definition of maximum employment: “There is not a signal number.” Eventually, this will lead to inflation, but that’s a problem for 2023 and beyond (see How to engineer inflation). 

 

The Fed is staying the course. In all likelihood, there will be some discussion about the process of tapering QE purchases at Jackson Hole that may cause some temporary volatility. The Fed is staying the course.

 

Equity investors should also stay the course. The S&P 500 staged a classic bounce off its 50 dma and it broke out to another fresh high. The breakout is holding. There will be some individual days of choppiness as we progress through earnings season.

 

 

This is a bull market.

 

Another chance to buy the panic

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

A magazine cover buy signal?

Investors and traders who stepped up and bought into the market panic last Monday profited handsomely when stock prices staged a relief rally. Another panic opportunity may be presenting itself, this time in the energy sector.

 

Historically, The Economist magazine covers have been excellent contrarian market signals (see What a bond market rally could mean for your investments). The Economist may have done it again this week with a focus on the global warming effects of heat waves in North American and floods in Germany.

 

 

Notwithstanding the public policy issues, which are beyond my pay grade, here is what it could mean for selected energy equities.

 

 

The new tobacco

One of the worse culprits of carbon emissions is coal. Coal stocks represent a relatively small part of the market, but here is how this industry has behaved in the last two years. The stocks made a saucer bottom and it is breaking upward, both on an absolute basis and relative to the S&P 500.

 

 

A more detailed analysis of global coal usage shows that OECD countries began to wean themselves off coal as an energy source at the time of the GFC. Chinese coal usage took off in the early 2000s and plateaued about 2014, while other EM coal demand continued to rise. The latest G-20 meeting ended without an agreement on the phaseout of coal powered electrical generation based on objections from China, India, and Russia.

 

 

Unfortunately, there are no easy ways to gain a diversified exposure to the industry. The only listed ETF, the VanEck Coal ETF (KOL), closed in December 2020. The lack of interest could be interpreted a contrarian buy signal.

 

 

Big Oil tests support

The oil and gas industry is another example of the “new tobacco”. The technical picture for energy stocks is not as bullish as coal. The energy sector is testing key support levels, both on an absolute basis and relative to the S&P 500. Relative breadth indicators are trying to bottom but may need some time to definitively take a position of market leadership.

 

 

The medium-term supply/demand outlook is constructive. The COVID-related inventory overhang has been worked off. As the global economy recovers, demand should pick up even as producers hesitate to commit to capex in the face of long-term climate change demand pressures.

 

 

 

A panic bottom and recovery

As for the stock market, conditions are setting up for a recovery from last Monday’s panic bottom. Jason Goepfert at SentimenTrader pointed out that the “Up Volume Ratio cycled from below 15% to above 85% in back-to-back sessions on the NYSE”, which is “a buy signal that has never failed”.

 

Since 1962, the S&P 500 never showed a loss in the month following similar signals. These mostly occurred during momentum markets, and buyers followed through to avoid missing out on the next bull run. A few of them did end up leading to blow-off peaks, but not until month(s) later.

 

 

Technical analyst Walter Deemer observed that Monday’s downdraft represented an 89.4% downside to upside volume day, followed by an 88.0% upside volume day Tuesday and an 83.0% upside volume day on Wednesday. According to the 2002 Dow Award paper by Paul Desmond of Lowry’s Report, consecutive 80% up volume days represent a bullish reversal buy signal after a 90% downside volume panic day.

 

The historical record shows that 90% Downside Days do not usually occur as a single incident on the bottom day of an important market decline, but typically occur on a number of occasions throughout a major decline, often spread apart by as much as thirty trading days…

 

Our 69-year record shows that declines containing two or more 90% Downside Days usually persist, on a trend basis, until investors eventually come rushing back in to snap up what they perceive to be the bargains of the decade and, in the process, produce a 90% Upside Day (in which Points Gained equal 90.0% or more of the sum of Points Gained plus Points Lost, and on which Upside Volume equals 90.0% or more of the sum of Upside plus Downside Volume). These two events – panic selling (one or more 90% Downside Days) and panic buying (a 90% Upside Day, or on rare occasions, two back-to-back 80% Upside Days) – produce very powerful probabilities that a major trend reversal has begun, and that the market’s Sweet Spot is ready to be savored. 

 

 

Zweig Breadth Thrust watch

As part of the same theme of price momentum reversal, we have a potential rare Zweig Breadth Thrust buy signal setup. The ZBT buy signal is a rare momentum-based buy signal that occurs only once every few years and almost never fails. It requires the market to move from an oversold condition to an overbought reading within 10 trading days. The ZBT Indicator went oversold last Monday, and Tuesday, July 20 was day 1 of the ZBT buy signal watch. The window for flashing a buy signal ends on Monday, August 2. 

 

 

This is only a trade setup. I am not holding my breath for the buy signal.

 

 

Key risks

There are a number of key risks to the bullish scenario. First, the S&P 500 has rallied back to an all-time high. On the other hand, the 5 and 14-day RSIs are flashing negative divergences.

 

 

As well, credit market risk appetite is not behaving well. The relative price performance of junk bonds to their duration-equivalent Treasuries is exhibiting a minor negative divergence, which is another concern.

 

 

 

The week ahead

Looking to the week ahead, traders need to distinguish probable market direction based on differing time frames. I am inclined to lean bullish on a 1-2 week time horizon. Helene Meisler conducts a weekend (unscientific) Twitter poll. Sentiment had plunged to negative double-digits the previous week, and such readings had marked tradable bottoms in the past. The latest week’s sentiment survey saw a bullish snapback, but conditions are not at a crowded long, which gives the bulls the run to run.

 

 

As well, option sentiment derived tail-risks are rising, as evidenced by the pricing of August VIX call options. I attribute this to the pricing of event risk based on what might occur at the Fed’s Jackson Hole gathering. As the market is pricing in sizable QE taper style announcements from Jackson Hole, this puts a floor on any taper trantrum risk-off episodes in the coming weeks.

 

 

In the very short-term, breadth is extremely overbought. Even if you are bullish, expect a pause or pullback early in the week.

 

 

In conclusion, coal and energy equities represent potential contrarian buying opportunities for investors. In addition, the stock market appears to have undergone a bullish reversal off a panic bottom, which should resolve in higher prices in the days and weeks ahead.

 

 

What you should and shouldn’t worry about

Posted by Cam Hui -

The S&P 500 took fright last Monday and skidded -1.6% after falling -0.8% the previous Friday. Talking heads attributed the decline to worries about the rising incidence of the Delta variant around the world.
 

 

Fears over the Delta variant slowing economic growth are overblown. However, there are two other key risks that equity investors should be watching.

 

 

Delta variant fears are overblown

There are two reasons why the Delta variant shouldn’t be an impediment to rising stock prices. First, it is well under control in the well-vaccinated developed markets. Consider Spain as an example. Spain’s vaccination rate resides in the middle of the pack of developed economies. It is below the well-vaccinated countries like Israel and the UK, and above the rest of the EU and the US. 

 

 

Here are the infection and hospitalization rates for Spain. While the infection rate has skyrocketed because of the Delta variant, cases are mild and the hospitalization rate has been flat. To be sure, Israel’s Ministry of Health reported last week that the effectiveness of the Pfizer/BioNTech vaccine in preventing symptomatic illness had fallen to 64% from 95% in May before the Delta variant became prevalent. Nevertheless, it is still 93% effective in preventing hospitalizations and serious illness. In short, vaccines work. As long as they are effective and available, the global economic recovery should continue.

 

 

Here is even more good news from the UK. Ian Shepherson of Pantheon Macro pointed out that “UK Covid cases today down 17% compared to a week ago, when they were elevated by Euro 2020 final parties/wakes. The point is that these events seem not to have triggered a further surge.”

 

 

While every COVID-19 death is a human tragedy, the market is far more mercenary and only focuses on growth outlook and interest rates. The risk to stock prices from the Delta variant is the effects on economic growth. Bill McBride at Calculated Risk maintains a monitor of “Seven High Frequency Indicators for the Economy”. Despite the fears of the rising Delta variant infections stalling the recovery, none of the seven indicators are showing any signs of slowdowns. As an example, here is Apple’s tracking of mobility in selected American cities. Activity is not rolling over.

 

 

As the lockdown eased, travel began to return to normal. The 7-day moving average of TSA checkpoint travel has been steadily rising and there are no signs of a stall.
 

 

The same could be said of movie box office receipts.

 

 

I could go on, but you get the idea. The other indicators that McBride monitors are hotel occupancy, gasoline usage, restaurant reservations, and New York City transit usage. From a global perspective, the Goldman Effective Lockdown Index shows that the Delta variant hasn’t slowed progress in reopening.

 

 

The challenge for policymakers is the pace of vaccinations. In particular, Asian economies have lagged in their vaccination rates. Jurisdictions like Taiwan and South Korea implemented lockdown policies that were effective in slowing transmission to a crawl in order to buy time for vaccine development. Now that vaccines are available, most Asian countries have been slow to vaccinate their population. Even Latin America has managed to make better progress than Asia. The headlines from the Olympics in Japan, a major G-7 developed economy, are testament to the slow rollout of Asian vaccinations.

 

 

 

Rising China tail-risk

The lagging ASEAN vaccination rates underline a key risk of an Asian growth stall. The performance of the Chinese stock market and the markets of her major Asian trading partners relative to MSCI All-Country World Index (ACWI) shows that virtually all markets have either broken relative support or are testing relative support. While the weakness of Chinese shares may be attributable to recent policy shifts, all countries in the region are lagging compared to global stocks. It is unclear, however, whether this is attributable to the slow pace of Asian vaccinations or rising tail-risk from China.

 

 

Chinese property developers are showing signs of stress after Beijing implemented a series of measures to curb property lending. China Evergrande (3333.HK) has been the poster child of overleveraged developers and it has been viewed as a “too big to fail” company by many. Its shares tumbled when a Chinese court froze 132 yuan, or USD 20 million, in deposits from Evergrande Real Estate and its subsidiary Yixing Hengyu Real Estate. Subsequent to that event, other Asian lenders stopped providing mortgages to Evergrande’s Hong Kong properties. The company’s share price has tumbled and violated key technical levels. 

 

 

More importantly, selected Evergrande bonds are trading at 50% discounts to par value. The discounts on offshore bonds are greater than domestic issues, indicating a market expectation that foreigners will bear the brunt of any restructuring.

 

 

The shares of other property developers are also getting hit and they have either violated or are testing important long-term support.

 

 

The real estate sector in China absorbs a disproportionate level of savings in that country. Wobbles in the Chinese property market represent a tail-risk that has the potential to destabilize China’s financial system and cause ripples throughout the world. How China Evergrande’s debt will be resolved will ultimately be a political decision made in Beijing, as summarized by the WSJWSJ.
 

Ultimately, Evergrande’s fate rests with Beijing. The government’s drive to curb property sector debt has weakened funding for developers, sparking Evergrande’s current crisis. Given the importance of housing to China’s overall economy, tightening and easing policies usually come in cycles. But reining in the relentless debt-fueled expansion of companies like Evergrande, which pose an increasing systemic risk, seems likely to remain a top policy priority.

 

The government will try to contain any ripple effects to the financial system or home buyers but not all investors will be spared pain.

 

There is one silver lining in the Chinese dark cloud. The commodity markets are holding up well, which is constructive for the global economic outlook as China is the largest consumer of many raw material inputs. Commodity prices are holding above their 50 and 200 dma, and the cyclically sensitive base metals to gold ratio has been trading sideways despite the bearish signals from the 10-year Treasury yield. 

 

 

As well, the relative returns of Chinese material stocks to global materials are strong, which is an implicit signal of cyclical strength from China. Commodity strength is surprising in light of the news that China plans to sell 170,000 tonnes of non-ferrous metals in another round of auctions, according to state media Xinhua.

 

 

Callum Thomas of Topdown Charts confirmed the signs of underlying economic strength in Asia. He pointed out that Asian metal user PMIs have begun to accelerate after lagging the US and Europe.

 

 

These readings are consistent with the observation that global reopening is proceeding with or without the Delta variant.

 

 

Washington sideswipes the markets?

Another key risk to the market comes from Washington. Growth expectations are rising, and legislative maneuvers have the potential to derail growth expectations. 

 

As an example, Marketwatch reported that JPMorgan strategists recently raised their S&P 500 year-end target from 4400 to 4600 and S&P 500 2021 earnings by $5 to $205.

 

“We remain constructive on equities and see the latest round of growth and slowdown fears premature and overblown,” said the JPMorgan team, led by Dubravko Lakos-Bujas. “Even though equity leadership and bonds are trading as if the global economy is entering late cycle, our research suggests the recovery is still in early-cycle and gradually transitioning toward mid-cycle.”

 

The strategists base the S&P 500 upgrade on “strong earnings growth and capital return until 2023.” Their S&P 500 earnings per share estimate for 2021 was lifted $5 to $205 and by the same amount for 2022 to $230, and gross corporate buybacks are seen surpassing a first-quarter 2019 record of $850 billion.
As well, bottom-up earnings estimates continue to rise. While these developments appear bullish and indicative of short-term fundamental momentum, equity investors could be wandering into a minefield in the coming months.

 

 

The first risk is a corporate tax increase, which is not in most analysts’ spreadsheets yet. Bloomberg reported that Treasury Secretary Janet Yellen is setting out a timeline to implement a global corporate minimum tax:

 

U.S. Treasury Secretary Janet Yellen began to put a timeline on when the Biden administration hopes Congress can take up two key portions of a global tax agreement endorsed Saturday by Group of 20 finance ministers in Venice…

 

“The details of pillar 1 remain to be negotiated,” she said. “We will work with Congress — maybe will be ready in the spring of 2022 — and try to determine at that point what’s necessary for implementation.”

 

The accord is on track to be finalized at the G-20 leaders’ summit in Rome in October, and finance ministers have said they foresee global implementation in 2023.

 

No matter what happens with the negotiations, corporate tax rates will rise. Bottom-up company analysts have not adjusted their earnings estimates because it’s impossible to do so without knowing the details of the legislation. Some top-down strategists have begun to pencil in the effects of a tax increase using a variety of scenarios. However, these changes have not crept into the consensus market narrative and could represent a negative surprise in the coming months.

 

In addition, another debt ceiling drama is looming in Washington. The Congressional Budget Office published a report last week which estimates that the Treasury would run out of cash in October or November. While the consensus expectation is the Treasury would not be forced to default on its debt, the political jockeying is already starting and could unsettle markets in Q3 or early Q4. The US Treasury has announced that it will “need to start taking additional extraordinary measures” to prevent default if Congress doesn’t act by August 2.

 

 

Intermediate-term constructive

Despite these risks, I remain intermediate-term constructive on the equity markets. Fathom Consulting recently decomposed the sources of market returns based on cash flow (blue line) and sentiment (green line). While sentiment is elevated and comparable to the dot-com era, equity prices are supported by strong cash flows.

 

 

In conclusion, while there are some risks to the equity outlook to be concerned about for the remainder of 2021, stalling growth from the Delta variant is not one of them for most advanced economies. Nevertheless, investors should monitor rising China tail-risk as overleveraged property developers like China Evergrande wobble financially. As China Evergrande falls into the “too big to fail” category, I expect Beijing would step in to resolve any defaults in an orderly manner to minimize the fallout. In addition, US equity prices may stumble once the market gains greater clarity on Biden’s plan to raise corporate tax rates.

 

From an economic perspective, the global recovery should continue into 2022 and beyond and be supportive of higher stock prices. Expect some volatility over the coming months, but investment oriented accounts should maintain their equity commitments.

 

 

The anatomy of an air pocket

Posted by Cam Hui -

Mid-week market update: I could tell that a panic bottom was near on Monday when how many people had lost their minds when the S&P 500 fell -3.7% from its intraday all-time high, both from my social media feed and emails (see A sudden risk-off panic). The S&P 500 rallied impressively on Tuesday to fill Monday’s downside gap, and today’s follow-up was equally constructive.
 

 

Despite the market’s recovery, the bulls aren’t out of the woods and downside risks remain. Here’s why.

 

 

Down Friday and Mondays

Jeff Hirsch posted a LinkedIn article entitled “DJIA Down Friday/Down Monday: Historically an Ominous Warning” tells the story. The historical record underlines the downside risks to the stock market.

Since January 1, 2000 through todays close there have been 221 DJIA Down Friday/Down Mondays (DF/DM) including todays. From DJIA’s closing high within the next 7 calendar days to its closing low in the following 90 calendar days, DJIA has declined 212 times with an average loss of 7.21%. Declines following the DF/DM were greater in bear market years and milder in bull market years (see page 76 of Stock Trader’s Almanac 2021). The eight times when DJIA did not decline within 90 calendar days after were following DF/DMs on October 7, 2002; May 19, 2003; November 17, 2003; February 3, 2014; October 13, 2014; October 31, 2016; September 25, 2017 and October 9, 2017.

 

 

Hirsch believes the market action in the next few days will yield greater clarity to the market’s intermediate-term direction.

Based upon the above chart, if DJIA recovers its recent losses within about 4-7 trading days, then the DF/DM that just occurred may have been the majority of the decline. However, if DJIA is at about the same level or lower than now after this window, additional losses are more likely over the next 90 calendar days.

 

 

What to watch

Here is what I am keeping an eye on. The fright hasn’t fully receded from the bond and currency markets. The 10-year Treasury yield fell as far as 1.13% on Monday. While it has recovered, it is still in a downtrend, indicating market caution. As well, the USD is a safe haven currency and it is still advancing. These two cross-asset signals represent the most worrisome indicators from a risk appetite perspective.

 

 

Credit market risk appetite is also mildly concerning. The relative price performance of junk bonds to their duration-equivalent Treasuries is flashing a minor negative divergence against the S&P 500. These minor divergences have occurred in the past and they are not actionable signals by themselves. When paired with heightened risk levels, however, this divergence is something that should be monitored.

 

 

Defensive sectors of the market staged brief upside relative breakouts on Monday but retreated to test their breakouts. If the bears are to seize control of the tape, these sectors must regain and maintain their breakout levels.

 

 

The VIX Index rose above its upper Bollinger Band on Monday, which is the signal of an oversold market, and recycled below its upper BB. The S&P 500 duly rallied as a result. However, this condition does not preclude a retest or even an undercut of Monday’s lows. If the past is any guide, any market weakness will begin after the VIX touches its 20 dma.&

 

 

My inner investor remains bullishly positioned. My inner trader is tactically long the S&P 500. He plans to exit most if not all of his position once the VIX falls to its 20 dma. Stay tuned.

 

 

Disclosure: Long SPXL

 

A sudden risk-off panic

Posted by Cam Hui -

The markets opened with a risk-off tone overnight in Asia, The selloff continued in Europe, and now it is in North America. The talking heads on television have attributed the weakness to COVIE-19 jitters over the spread of the Delta variant.
 

Panic is starting to set in as the S&P 500 approaches a test of its 50 dma. The term structure of the VIX futures curve is starting to invert. The 9-day VIX is now above the 1-month VIX (bottom panel), though the 3-month VIX remains above the 1-month VIX. 
 

 

Coincidentally, I also received this morning several emails raising concerns about the stock market. I would argue instead that this is not a time to abandon long positions. Instead, the market weakness represents an opportunity to tactically add to long positions.

 

 

The primary trend

First, keep in mind that the primary trend is up. Jared Woodward at BoA pointed out that “Years that begin this well tend to end well, too. Since 1871, for the 16 years with similar starts, the average second-half return was 8%, with more upside potential than downside risk.”

 

 

 

Bottoming models

Tactically, three of the four of my bottoming models are flashing buy signals. The 5-day RSI is oversold; the VIX Index has spiked above its upper Bollinger Band; and the NYSE McClellan Oscillator is oversold. The only indicator that has not signaled caution is the 1-month to 3-month VIX term structure, though I pointed out that the 9-day to 1-month VIX has inverted, indicating rising fear.

 

 

As well, I monitor the Zweig Breadth Thrust Indicator for a secondary purpose other than the original formulation. As a reminder, a ZBT buy signal is generated when the ZBT Indicator rebounds from oversold to overbought within 10 trading days. This is a rare condition that only happens every few years. What is less rare are ZBT oversold signals – one of which was just generated today.

 

 

I am in no way implying that we will see a ZBT buy signal in the near future. However, the market is sufficiently oversold that a tactical buying opportunity is presenting itself. The real test for the market is how it behaves after the rebound. My base case is still calling for a trading range for the next few weeks. The market is just at the bottom of its range right now.

 

 

Disclosure: Long SPXL
 

A glass half full, or empty?

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.
 

 

Easy to be bearish

As a chartist, it’s easy to be bearish. After all, the market is experiencing numerous negative breadth divergences. 

 

 

Beneath the surface, however, the technical narrative can better be described a “glass half full, or half empty” dilemma.

 

 

An internal rotation

Conventional technical analysis approaches don’t really tell the story of this stock market. The market has been undergoing an internal rotation from value to growth. While the Russell 1000 Value Index has been trading sideways, the Russell 1000 Growth Index has been advancing to fresh all-time highs. However, the value/growth ratio is exhibiting positive RSI divergences, indicating that value stocks may be ready to regain their lead.

 

 

The revival of value stocks can be better seen in small caps. The Russell 2000 Value to Growth ratio has rallied through an important relative resistance level.

 

 

Further evidence of internal rotation can be seen in the relative performance of the top five sectors of the S&P 500. These sectors comprise 75% of index weight and it would be difficult for the index to either rise or fall without the participation of a majority. Large cap growth sectors such as technology and cap weighted consumer discretionary are exhibiting relative uptrends, while the value-oriented financial stocks are lagging.

 

 

 

A glass half full

Evidence of poor market breadth has its silver lining. The widespread evidence of poor breadth has pushed the NYSE and NASDAQ McClellan Oscillators (NYMO and NAMO) to an oversold condition. This is a highly unusual condition because the 14-day RSI just retreated from an overbought reading. In the last four years, there were two episodes when NYMO was oversold and the RSI was overbought or near overbought. Both resolved themselves in benign manners.

 

 

The breadth divergence can also be seen in the percentage of S&P 500 stocks above their 50 and 200 dma. It’s also unusual to see the percentage of S&P 500 stocks above their 200 dma over 90% while the percentage above their 50 dma so low at about 50%. There were nine such episodes in the last 20 years. Four resolved bullishly (blue vertical lines) and five bearishly (red lines). The results can best be described as a coin toss.

 

 

The Fear & Greed Index has fallen to 23, which is at or near levels where this index has bottomed in the past.

 

 

The market appears to be setting up for a short-term bottom. Helene Meisler tracks the number of Wall Street buy recommendations to sell recommendations. This indicator has plunged to an all-time low, which is contrarian bullish.

 

 

As well, Meisler conducts an (unscientific) weekend Twitter poll. This week’s sudden bearish turn nearly is approaching the record low level seen in January. The last time sentiment plunged was four weeks ago, in the wake of the FOMC’s hawkish pivot. The market recovered the following week when Fed speakers softened their remarks.

 

 

So where does that leave us? I continue to believe that the market has bifurcated into two distinct markets, value and growth. In aggregate, it’s difficult to make much of a judgment about the direction of the S&P 500 owing to the divided nature of market internals. The internal rotation is continuing and value is poised to gain the upper hand.

 

Short-term breadth and sentiment readings indicate that a rebound is likely, but the bulls shouldn’t bring out the champagne just yet as the market could just be at the bottom of a trading range. Until we see a definitive bullish or bearish catalyst, my base case calls for a sideways market with a possible minor upward bias. 

 

My inner investor is remains bullishly positioned in value and reflation-themed stocks. Near-term downside risk is relative low and he is not concerned about minor blips in stock prices. My inner trader is tactically long the S&P 500 in order to scalp 1-2%. The market is at the bottom of a short-term trading range and it is expected to rebound over the next week.

 

 

Disclosure: Long SPXL

 

How to engineer inflation

Posted by Cam Hui -

Both the June CPI and PPI came in hot and well ahead of expectations. There was the inevitable debate about the transitory nature of the price increases. Looking longer-term, however, the conventional models for explaining inflation have been unsatisfactory.
 

Notwithstanding the numerous failures by Japanese policymakers, consider the US as another example. Let’s begin with fiscal policy. It is said that deficit spending would lead to currency devaluation and inflation in the manner of the Weimar Republic. Nothing could be further from the truth. The blue line represents federal government deficits as a percentage of GDP. Deficits began to balloon in the early 1980`s with the Reagan Revolution and continued during the Bush I era. Did inflation (purple line) explode upward?

 

Monetary policy had its own failure. Monetarist Theory, as popularized by Milton Friedman, was another model that backtested well but failed out of the box. Friedman postulated that the PQ=MV, where the Price X Quantity of goods and services (or GDP) = Money Supply X (Monetary) Velocity. Friedman theorized that, over the long run, monetary velocity is stable, and therefore money supply growth determines inflation. All central banks had to do was to control money growth in order to control inflation.

 

It worked until about 1980. Monetary velocity had been stable until about then. Money growth didn’t generate inflation because monetary velocity fluctuated wildly. Growth in money supply, as measured by M1, was often matched by declines in velocity. The Fed could engineer money growth and inject liquidity into the financial system without creating inflation.
 

 

In the face of the apparent failure of these conventional models, I offer an alternative vision of inflation and discuss the implications for investors.

 

 

“Hot” inflation prints

How transitory are the latest round of price increases? To be sure, inflation has been surprising to the upside everywhere. 

 

 

In the US, June CPI and PPI came in hot. Headline CPI printed at 5.4%, compared to consensus expectation of 4.9%; Core CPI was 4.5% (vs. 4.0% expected); PPI at 7.3% (6.8% expected); and Core PPI at 5.6% (vs. 5.1% expected). In the wake of the strong CPI report, the Council of Economic Advisers released an analysis showing that “a large part of the increase in Core CPI is due to cars and pandemic-affected services”, which is transitory.

 

 

The CEA is largely correct. An analysis of the double-digit increases in Core CPI came is attributable to temporary shortages or pandemic-related factors:
  • Car rental 87.7%
  • Used cars 45.2%
  • Gasoline 45.1%
  • Laundry machines 29.4%
  • Airfare 24.6%
  • Moving 17.3%
  • Hotels 16.9%
Fortunately, Owners’ Equivalent Rent (OER) remains tame. As a reminder, OER has about a 25% weight in the CPI basket, but it has half that weight in PCE, the Fed’s preferred inflation gauge.

 

 

While the debate over the transitory nature of the current price spike will inevitably continue. None of it matters in the long-term for policymakers. What really matters to the sustainability of inflation is the level of wage increases.

 

 

The Reagan Revolution revisited

Remember the Reagan Revolution? When Ronald Reagan was elected in 1980, a regime change occurred in the returns to capital and labor. While productivity continued to rise, but real wages stagnated. The gains in productivity accrued to the suppliers of capital. In hindsight, the change is attributable to a series of microeconomic policy changes, such as deregulation, and most of all, free trade in the form of NAFTA and the transformation of China into the global factory for the world which forced down US wage rates.

 

 

Monetary policy also played a key role in holding down inflation and wages. In the post-Reagan era, starting with Paul Volcker, the Fed sought to raise rates at the slightest hint of wage pressures. Between 1980 and the GFC, the Fed Funds rate (black line) stayed above annual increases in average hourly earnings (blue line). The Fed especially tightened when AHE rose above CPI (red line). 

 

 

Inflation ran out of control in the 1970’s, and the Fed learned its lesson from that era. The way to stop the cycle ever-rising inflationary expectations is to break it through the wage link. If wage increases stay tame, inflation will stay under control. 

 

The following chart depicts the legacy of the Volcker Fed’s inflation-fighting policy. The blue line is the Fed Funds rate minus changes in Average Hourly Earnings. A positive number is a signal of tight monetary policy from a labor provider’s viewpoint, and a negative number is the opposite. Core CPI (red line) is provided as a reference point for inflation.

 

 

A Grand Experiment occurred in the wake of the GFC. Policymakers responded with a combination of very low-interest rates and quantitative easing. Inflation did not respond to conventional theory. It remained relatively tame and the US did not become the Weimar Republic, Zimbabwe, or Venezuela.

 

 

The Un-Volcker Fed

In April, I wrote that Jerome Powell has transformed Fed policy (see How Powell, the Un-Volcker, is remaking the Fed). It isn’t just FAIT (Flexible Average Inflation Targeting), which is the Fed’s new framework for determining monetary policy, but how the Fed interprets its mandate of price stability and full employment. The new policy is on full display in Powell’s Semiannual Monetary Policy Report to the Congress last week.

 

Most notably, the Powell Fed has continued the Yellen Fed’s focus on inequality. Its main tool is to run the economy hot so that labor shortages can put upward pressure on wage rates, which reduces inequality. While the Fed recognizes that this is a very crude tool and would prefer to see fiscal policy do the heavy lifting to reduce inequality, Powell’s testimony nevertheless emphasizes the Fed’s inequality focus.

 

Conditions in the labor market have continued to improve, but there is still a long way to go…However, the unemployment rate remained elevated in June at 5.9 percent, and this figure understates the shortfall in employment, particularly as participation in the labor market has not moved up from the low rates that have prevailed for most of the past year…

 

Pandemic-induced declines in employment last year were largest for workers with lower wages and for African Americans and Hispanics. Despite substantial improvements for all racial and ethnic groups, the hardest-hit groups still have the most ground left to regain.
Powell also gave a nod to the “Fed Listens” initiative, which is a way of reaching out to the community from a bottom-up basis.
We understand that our actions affect communities, families, and businesses across the country. Everything we do is in service to our public mission. The resumption of our Fed Listens initiative will further strengthen our ongoing efforts to learn from a broad range of groups about how they are recovering from the economic hardships brought on by the pandemic. We at the Federal Reserve will do everything we can to support the recovery and foster progress toward our statutory goals of maximum employment and stable prices.
Can you imagine such remarks from Volcker or Greenspan? The Powell Fed has explicitly downgraded the wage pressure-inflation link in its approach to monetary policy.

 

 

The pendulum swings back

Having established that wages constitute an important component to the inflation equation, I believe the odds of rising wages which puts upward pressure on inflation is high. That’s because the pendulum of returns to the capital versus labor is about to swing back.

 

One key reason for falling wages in the developed world is labor arbitrage. The now-famous Milanovic “elephant” graph of global winners and losers tells the story. As the world globalized its supply chains between 1988 and 2008, the winners were the middle class of emerging market economies (and China in particular) and the very rich because they engineered and profited from the globalization trend. The main losers were the middle class in developed economies who saw their jobs offshored and bargaining power diminish.

 

 

The pendulum is swinging back. It began under the Trump Administration, whose tariff and Buy America policies arrested the offshoring trend. In addition, China was facing its own age demographic challenges and its supply of labor was diminishing. Biden has continued Trump’s Buy America initiatives. In addition, he has proposed an ambitious infrastructure spending program and government spending designed to address inequality. This policy mix should raise wages. Rising wages, especially in poor households, should buoy economic growth and government finances as payroll taxes rise and act to stabilize government debt ratios. 

 

In the short run, there have been numerous accounts of labor shortages putting upward pressure on employee compensation. That’s not unusual. A group of academics published a paper that studied the effects of pandemics on capital and labor markets after wars and pandemics found that wage pressures rise after pandemics, largely owing to a decrease in the labor supply.

 

 

Fast forward to 2021. The pandemic has decreased the labor supply from a combination of early retirement, the inability of women to work because of a lack of childcare, and dissatisfaction with working conditions. Lowly paid workers in hospitality and retail experienced increased customer abuse during the pandemic, and some white-collar workers who worked from home found frustration with their commuting time as they returned to their offices.

 

A recent incident at a Lincoln, Nebraska Burger King where the staff quit en mass recently went viral. Employees complained about working without breaks and in kitchens that were up to 90F.

 

 

The June NFIB small business jobs report showed that labor shortages remains a challenge.
“In the busy summer season, many firms haven’t been able to hire enough workers to efficiently run their businesses, which has restricted sales and output,” said NFIB Chief Economist Bill Dunkelberg. “In June, we saw a record high percent of owners raising compensation to help attract needed employees and job creation plans also remain at record highs. Owners are doing everything they can to get back to a full, productive staff.”

 

A net 39% (seasonally adjusted) of owners reported raising compensation (up five points), a record high. A net 26% plan to raise compensation in the next three months (up four points).

 

Up two points from May’s report, 63% of owners reported hiring or trying to hire in June. A seasonally adjusted net 28% of owners plan to create new jobs in the next three months.

 

Finding qualified workers remains a problem for small businesses as 89% of those hiring or trying to hire reported few or no “qualified” applicants for their open positions in June.

Wage gains are particularly acute in transportation, logistics, and hospitality industries. Moreover, recent wage increases by large employers like Amazon, Walmart, and McDonald’s are putting upward pressure on compensation for unskilled workers.
 

 

Wages are rising. A whole host of circumstances such as a pandemic-induced labor shortage and government policies are putting upward pressure on wages and, by implication, inflation. 

 

 

Investment implications

Putting it all together, the historic imbalance between capital and labor has become extremely stretched and the pendulum is swinging back. For investors, this presents a number of challenges as the returns to capital compress and inflation rise.

 

 

The conventional hedge against inflation is to buy shares of companies that can pass through price increases. This include companies with strong branding or able to extract monopolistic profits, commodities, and resource extraction companies in mining and energy. An unconventional and overlooked investment strategy is trend following, as outlined in a recent paper, “The Best Strategies for Inflationary Times”.

Over the past three decades, a sustained surge in inflation has been absent in developed markets. As a result, investors face the challenge of having limited experience and no recent data to guide the repositioning of their portfolios in the face of heighted inflation risk. We provide some insight by analyzing both passive and active strategies across a variety of asset classes for the U.S., U.K., and Japan over the past 95 years. Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect. Commodities have positive returns during inflation surges but there is considerable variation within the commodity complex. Among the dynamic strategies, we find that trend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability. We also provide analysis of alternative asset classes such as fine art and discuss the economic rationale for including cryptocurrencies as part of a strategy to protect against inflation.

 

 

High expectations for earnings season

Posted by Cam Hui -

Mid-week market update: As the market enters into Q2 earnings season, FactSet reported that consensus estimates are calling for an astounding 63.3% YoY EPS growth.
 

 

While that growth estimate appears to be a high bar, investors have to keep in mind the low base effect. As well, the historical record shows that actual growth has tended to exceed estimates. In other words, the bears shouldn’t count on earnings disappointment as a catalyst for a price downdraft.

 

 

S&P 500 target: 4803.62

FactSet further reported that the bottom-up derived S&P 500 target is 4803.62, which is 11.2% above last Thursday’s closing level (the publication date of the report). 

 

 

How accurate have those estimates been? It depends on what your lookback period is in determining the track record. They’ve been underestimating returns over the past five years but overestimating returns over longer time frames.

Over the past five years, Industry analysts have underestimated the price of the index by 0.5% on average (using month-end values). Over the past 10 years, industry analysts have overestimated the price of the index by 1.5% on average (using month-end values). Over the past 15 years, industry analysts have overestimated the price of the index by 9.1% on average (using month-end values). It is interesting to note that on June 30, 2020, the bottom-up target price was 3327.64. One year later (on June 30, 2021), the S&P 500 closing price was 4297.50. Thus, industry analysts underestimated the closing price at the end of June 2021 by nearly 23% one year ago.

In light of recent results, it’s hard to be too bearish on the stock market.

 

 

Sentiment warnings

This does not mean, however, that the stock market can rise in a straight line. Sentiment models have been flashing warning signs for some time, but sentiment can be an inexact timing signal when readings are overly giddy. As an example, Callum Thomas’ Euphoriameter is at a bullish extreme. The historical record shows that the market has continued to either advance or trade sideways on the occasions when it has been this high.

 

 

NDR’s Crowd Sentiment is similarly stretched. The S&P 500 has exhibited tepid returns when readings have been this high. However, the historical annualized gain of -0.5% is hardly a strong reason to short the market.

 

 

 

The internal rotation continues

Willie Delwiche observed that only a quarter of global markets are above their 50 dma and the S&P 500 has historically struggled under such conditions.

 

 

This time may be different. As I have pointed out endlessly, the market is undergoing an internal rotation between growth and value. US equities have taken on growth characteristics owing to the large weighting in large-cap technology stocks in the S&P 500, while non-US stocks have taken on value characteristics by default. Value is on the ropes, but the value/growth ratio is exhibiting a positive RSI divergence and a nascent breadth turnaround.

 

 

 

Watch small caps!

Where does that leave us? I am not overly concerned about a significant downdraft. The relative performance of defensive sectors are not showing any leadership qualities with the exception of real estate.

 

 

My base case calls for a period of sideways consolidation, but I am watching small-cap stocks as a barometer that the market could stage a surprise rally. The Russell 2000 has been trading sideways in a range-bound pattern since February, but it is testing an important Fibonacci relative support level.

 

 

Interestingly, the S&P 600, the “other” small-cap index, is behaving much better than the widely watched Russell 2000. S&P has much stricter profitability inclusion criteria and it therefore has a higher quality bias. The S&P 600 is in a minor uptrend and it is only testing the 50% retracement level relative to the S&P 500, whereas the Russell 2000 to S&P 500 ratio is testing its 61.8% retracement level.

 

 

Ironically, the widespread evidence of negative breadth has translated into near bullish conditions. Both the NYSE and NASDAQ McClellan Oscillators are nearing oversold levels which have been signals of tradable bottoms.

 

 

Stay tuned for further developments, and don’t get too bearish.