Team Stagflation, or Team Transitory?

Posted by Cam Hui -

Stagflation fears are rising again. It’s a natural reaction to the short-term data. September headline CPI came in hot, though the core CPI print was in line with expectations and PPI was soft. Inflation expectations are spiking…
 

 

…while the Atlanta Fed’s GDP nowcast is plummeting. Consumer confidence is dropping, driven by supply chain bottlenecks and rising costs. The combination of these factors is becoming a threat to corporate profits.

 

 

As a QE taper is more or less baked in for November, these worries have unsettled markets as the narrative is that the Fed could be making a policy mistake. Should investors cast their lot with Team Stagflation, or Team Transitory?

 

 

Rising signs of stagflation

The most visible signs of stagflation can be found in the monthly NFIB small business survey. Small businesses have little bargaining power and therefore the NFIB survey can be a sensitive barometer of the economy. 

 

Let’s start with the good news. Sales is not a problem. Small businesses reporting “poor sales” as their single most important problem fell to a multi-year low.

 

 

However, operating internals is causing some headaches, as summarized by Marketwatch. 

 

Small businesses complain they cannot find enough skilled workers even after raising pay. Nor can they obtain parts and supplies fast enough to keep up with demand. These problems have also affected the largest businesses across the country.

 

“Small-business owners are doing their best to meet the needs of customers, but are unable to hire workers or receive the needed supplies and inventories,” NFIB chief economist Bill Dunkelberg said after the survey results.

 

More than 50% of small businesses said they couldn’t fill open positions last month, a 48-year peak. And the number of companies offering higher pay was also at a 48-year high.
The complaints of NFIB survey respondents sound like the ingredients for stagflation. Hiring plans are peaking despite the complaints about labor shortages. While compensation rates have risen strongly, small businesses are also raising prices to pass along their costs to customers. If even small companies have the pricing power to raise their prices, investors shouldn’t worry too much about margin pressure.

 

 

What about inflationary pressures? Before everyone gets overly excited about the recent hot CPI print, take a deep breath. Most of the inflationary pressure is coming from durable goods attributable to supply chain bottlenecks. August core PCE came in at 3.6%, but durable goods PCE was an astounding 7.0%.

 

Much of the perceived inflation is attributable to a change in the composition of consumer spending. Households shifted spending from services to services in response to the pandemic, which led to excess demand for goods and supply chain bottlenecks. These temporary factors should fade over time.
 

 

Much of the perceived inflation is attributable to a change in the
composition of consumer spending. Households shifted spending from services to
services in response to the pandemic, which led to excess demand for goods and supply
chain bottlenecks.

 

 

Container ship congestion on the US West Coast is peaking, indicating an easing of supply chain bottlenecks.

 

 

In addition, China’s September exports came in ahead of expectations, which is another sign of a falling of global supply chain delays.

 

 

As for services inflation, Marketwatch highlighted the divergence between the US and Sweden’s experience with the pandemic and the effects on inflation.
 

There’s one notable country that didn’t mandate shutdowns or lockdowns — Sweden. And there, services prices did decline. And now, inflation in Sweden is about 3 percentage points less than in the U.S.

 

What the Swedish experience suggests is that prices will eventually stabilize. “The surging demand for durables is correcting. Since March, it is already down by 15% but requires a further 7% decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own,” Joshi said.

 

I would also like to address the concerns of small business owners about rising wages. This analysis of quits by industry shows an inverse relationship between quit rates and pay. As most small businesses tend to be clustered in low-wage industries, it’s no surprise that labor quality and supply is a growing concern.

 

 

Further analysis of the average hourly earnings (AHE) of the three lowest-paid industries relative to aggregate AHE shows that it is the leisure and hospitality, which is the lowest-paid group, have been the standouts in 2021 (red bars). By contrast, excess wage growth in the other two low-paid industries has slightly lagged. 

 

 

The pandemic-related layoffs of 2020 were concentrated in low-paid services businesses such as retail and leisure and hospitality. The spike in average hourly earnings during the recovery is attributable to a compositional effect. In 2021, leisure and hospitality workers are playing wage catch-up. This is the picture of falling earnings inequality, which has become an objective of the Fed, and not an indication of broad-based wage pressures.

 

 

An analysis of JOLTS reveals that the quit rate is especially elevated among firms with 10-249 employees. The competitive position of small businesses are being eroded. Don’t generalize the problem in the NFIB survey to the overall economy.

 

 

 

The bull case

The stagflation story is only one side of the coin. The other side is a growth recovery into 2022 and beyond. Stagflationistas have touted the IMF downgrade of global growth from 6.0% to 5.9% in 2021 as support for their narrative. Less mentioned is the boost to 2022 global growth forecasts. In particular, the IMF raised the US 2022 GDP growth estimate from 4.9% to 5.2%. 

 

 

Already, the US Economic Surprise Index, which measures whether economic data is beating or missing expectations, is rising again. Is it any wonder why there is upward pressure on the 10-year Treasury yield?

 

 

In addition, capital goods orders and shipments are soaring. This is another signal of a strong capex cycle that should increase productivity and support non-inflationary growth.

 

 

What about rising commodity prices? Won’t that act to restrain economic growth? Relax. The energy intensity of the American economy has fallen dramatically since the stagflation era of the 1970’s.

 

 

Worries about collapsing consumer confidence are also overblown. Google searches for consumer credit is surging. As household balance sheets are strong, rising credit demand tells the story of a consumer willing to spend. Watch what they do, not what they say in surveys.

 

 

Stagflation is the combination of high inflation and slow growth. For a long-term perspective, the accompanying chart shows my Stagflation Index, defined as the spread between core PCE and real GDP growth. Even if we were to use the Atlanta Fed’s GDPNow as an input, this indicator is nowhere near the stagflation era of the 1970’s. Consistent with the IMF’s forecast of renewed growth in 2022 and 2023, the Stagflation Index using the FOMC’s Summary of Economic Projections is negative.

 

 

To be sure, the key risk to the bullish scenario can be found in the IMF forecast, which warned that inflation is tilted to the upside while growth is tilted to the downside. Federal Reserve staff economists also highlighted similar risks in their economic assessment during the September FOMC meeting.

 

 

Investment implications

I believe investors should view these stagflation fears in perspective. They are temporary, but such concerns naturally arise during a mid-cycle expansion phase. Historically, the S&P 500 has continued to advance during such phases. Unemployment is falling, but levels are not extreme and there is still slack in the economy.

 

 

Central banks are starting to pivot from emergency stimulus to taking their collective feet off the accelerator. Stocks have historically have also performed well during periods of rising rates.

 

 

Since one characteristic of rising rates is P/E compression, a short-term key for stock prices is Q3 earnings season. It’s difficult to know how earnings season will turn out, but one early sign is constructive. The Guidance Index from Bianco Research remains positive, though it is decelerating. Q3 earnings should beat expectations, though the risk is management’s body language and guidance going into Q4 and beyond.

 

 

For the last word, I offer this comment from former IMF chief economist Olivier Blanchard.

 

 

In conclusion, I am still on Team Transitory. Stagflation fears are temporary and should soften in the coming months. The macro backdrop coming out of the COVID Crisis is nothing like the stagflation era of the 1970’s. The equity bull is still alive, and investors should position themselves for a reflationary rebound. 

 

 

As I have pointed out before (see Not your father’s stagflation threat), the real risk is a series of supply chain disruptions from climate change related events like heat waves and floods that keep inflation elevated and reduce growth.

 

An excess of caution?

Posted by Cam Hui -

Mid-week market update: Is market psychology cautious enough? A recent Deutsche Bank survey of investors reveals that not only is a correction the consensus, correction sentiment rose between September and October.
 

 

SentimenTrader also observed that inverse ETF volume has spike to a record level. Is this cautious enough for you?

 

 

 

Supportive internals

The analysis of market internals reveals a number of supportive elements. A survey of Advance-Decline Lines show that all flavors except for the NASDAQ are exhibiting minor uptrends. The NASDAQ A-D Line is testing support, which is consistent with the recent lagging nature of large-cap growth stocks.

 

 

High beta small-cap stocks are also outperforming, which is another indication of improving equity risk appetite.

 

 

Credit market risk appetite, as measured by the relative price performance of junk and investment grade bonds relative to their duration-equivalent Treasury benchmarks, are showing minor positive divergences.

 

 

In addition, SentimenTrader pointed out that there is extreme pessimism in the IG market.

 

 

In conclusion, market sentiment and internals have risk/reward tilted to the upside. At a minimum, don’t be short.

 

 

Disclosure: Long SPXL

 

What rhymes with 2011?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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


 

 

The 2011 template

The market action today is somewhat reminiscent of 2011. Then, the macro backdrop was characterized by a debt ceiling impasse in Washington and a Greek Crisis in Europe that threatened the very existence of the eurozone. I can remember endless European summits and plans to make plans for Greece. The news flow worsened and it seemed like no one was in charge in Europe, but the S&P 500 tested support multiple times while exhibiting a series of positive RSI divergences. The logjam was finally broken when the ECB stepped in and announced its LTRO program. Stocks bottomed and never looked back.

 

 

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

 

 

Does 2011 rhyme with 2021?

 

 

Supportive sentiment

Sentiment models have been signaling a market bottom. The latest readings from Investors Intelligence showed that bullish sentiment has tanked, which is an indication of capitulation. The S&P 500 has only weakened by only -5% and this level of panic is unusual for such a shallow pullback.

 

 

Even as the market began to rally, the CBOE put/call ratio remained elevated and above 1, which is an indication of fear. I interpret this to mean that the market is climbing the proverbial Wall of Worry.

 

 

 

Growing signs of transitory inflation

In addition, inflation fears may be at a zenith. The latest global PMI report shows that delivery delays may have peaked, indicating an easing of supply chain bottlenecks.

 

 

This is confirmed by reports that the semiconductor shortage problem is peaking.

 

 

The IMF forecasts headline inflation in advanced economies will peak soon and fall to an average of 2%. As the Fed prepares to begin tapering its QE purchases, tamer inflation readings should alleviate the pressure to tighten. In addition, the resignation of Rosengren of the Boston Fed and Kaplan of the Dallas Fed will lower the number of hawks at the FOMC table.

 

 

Nevertheless, I believe the Fed taper is on track at the next FOMC meeting despite the wide headline miss in the September Jobs Report. As a reminder, here is how Powell set the bar for a taper at last FOMC press conference:

So, you know, for me, it wouldn’t take a knockout, great, super strong employment report. It would take a reasonably good employment report for me to feel like that test is met. And others on the Committee, many on the Committee feel that the test is already met. Others want to see more progress. And, you know, we’ll work it out as we go. But I would say that, in my own thinking, the test is all but met. So, I don’t personally need to see a very strong employment report, but I’d like it to see a decent employment report,

Even though the September NFP missed at 194K compared to expectations of 500K, most of the miss was attributable to government job losses, specifically in education owing to unusual seasonal adjustments. August NFP was revised upward. Private employment, as measured by ADP, was strong. So were average hourly earnings and average weekly hours. Ex-government employment and the unusual education seasonal adjustments, the September figure qualifies as a “decent employment report” by Powell’s standards. The Fed will regard the headline report as an anomaly and stay the course on its taper plans.

 

 

 

Supportive valuation

As well, the equity risk premium (ERP) estimate from NYU Stern School professor of finance Aswath Damodaran rose to 4.93% at the end of September.

 

 

This ERP reading is roughly equal to the level on October 1, 2017.

 

 

 

A rocket on the launch pad

I interpret these conditions as a rocket on the launch pad. While the engineers may have ignited the engines, takeoff hasn’t been confirmed but the meltup scenario remains in play (see A Q4 meltup ahead?).

 

Here is what I would like to see to sound the all-clear signal. First, the S&P 500 needs to convincingly reclaim the 50 dma level of 4438. The small-cap Russell 2000 and S&P 600 need to stage upside breakout from their trading ranges. The upside breakouts should preferably be accompanied by small-cap outperformance.

 

 

Finally, I would like to see the growth cyclical semiconductor industry to stage an upside breakout relative to the S&P 500 (bottom panel), which would be a signal of a revival in reflationary market expectations.

 

 

Options expire in the coming week. Historically, October OpEx has been one of the most bullish OpEx weeks of the year.

 

 

In the very short term, the S&P 500 is recycling off an overbought extreme and it could weaken early in the week. Traders should regard any pullback as a buying opportunity.

 

 

In conclusion, the US equity market appears poised for a strong rally into year-end. While last week’s relief rally in the wake of a temporary debt ceiling deal is constructive, I am waiting for further confirmation of technical strength before calling an all-clear signal.

 

 

Disclosure: Long SPXL

 

Will the energy price surge cause a recession?

Posted by Cam Hui -

As energy prices surged around the world, I had an extensive discussion with a reader about whether the latest price spike could cause a recession. This is an important consideration for investors as recessions are equity bull market killers.
 

The evidence isn’t clear. On one hand, every recession in the post-War period (shaded grey zones) has been accompanied by rising oil prices. On the other hand, interest rates were also rising in virtually all of the cases.

 

 

 

Oil shocks and recessions

The guru of oil shocks and recessions is James Hamilton, whose 1983 seminal paper “Oil and the Macroeconomy Since World War II” provided the basis for this research. Hamilton has published extensively on the topic. A 2011 paper, “Historical Oil Shocks”, laid out the history of oil shocks and recessions, as summarized by the abstract:

 

This paper surveys the history of the oil industry with a particular focus on the events associated with significant changes in the price of oil. Although oil was used much differently and was substantially less important economically in the nineteenth century than it is today, there are interesting parallels between events in that era and more recent developments. Key post-World-War-II oil shocks reviewed include the Suez Crisis of 1956-57, the OPEC oil embargo of 1973-1974, the Iranian revolution of 1978-1979, the Iran-Iraq War initiated in 1980, the first Persian Gulf War in 1990-91, and the oil price spike of 2007-2008. Other more minor disturbances are also discussed, as are the economic downturns that followed each of the major postwar oil shocks.
Here is a brief summary starting from the 1970’s.
  • Arab Oil Embargo (1973-74): The Arab Oil Embargo in response to American support of Israel in the Yom Kippur War led to a supply shock and a recession.
  • Iran Revolution and Iran/Iraq War (1978-81): The Iranian Revolution and subsequent war with Iraq drove oil prices up. A recession followed though the slowdown was exacerbated by the Volcker Fed’s tight monetary policy.
  • First Gulf War (1990-91): Prices rose in response to Saddam Hussein’s invasion of Kuwait. The world plunged into recession.
  • Demand shock (1999-2000): Oil prices fell as low as $10 in the wake of the Asian Crisis. As demand recovered, prices surged and the price increase played a role in the subsequent recession.
  • Supply shock (2007-08): Prices rose as high as $147. Hamilton argues that surging oil prices amounted to a tax on consumption and acted as a catalyst in bursting the property bubble which led to the GFC.
Attributing a rising oil price to the 2008 recession was especially surprising. A WSJ article outlined Hamilton’s explanation:
 

But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.
Current conditions appear ominous. Global energy inflation is off the charts in many regions. Natural gas prices are surging in Europe and Asia. Bloomberg reported last week that the latest spike is equivalent to a $190 oil shock.

 

On Thursday, the Japan-Korea Marker, North Asia’s benchmark for spot liquefied natural gas shipments, surged to $34.47 per million British thermal units, the highest on records going back to 2009, according to price reporting agency S&P Global Platts. Converting that into oil units, also gives a price of about $190 per barrel of oil equivalent.

European natural gas prices also spiked based on historically low storage levels going into the winter and the recent unreliability of renewable energy sources. Price pressure was partly relieved when Putin offered more gas exports, though the offer implicitly came with a string of quick approval of the Nord Stream 2 pipeline.

 

 

Is a global energy-induced recession in our near future?

 

 

 

Exploring cause and effect

At first glance, the Hamilton studies are highly convincing. A 2014 Federal Reserve study looked at the data and asked a different question. It is true that every recession has been accompanied by an oil price spike, but do oil price spikes predict recessions? (If every Ford Model-T is black, are all black cars are Fords?)

 

The researchers modeled the effects of changes in oil price in a linear fashion, e.g. running a simple regression of oil price changes to future GDP changes, and in a nonlinear way, e.g. model positive and negative oil shocks differently. The GDP growth effects of oil price changes in the nonlinear model was much larger than the linear model.

 

We quantify the conditional recessionary effect of oil price shocks in the net oil price increase model for all episodes of net oil price increases since the mid-1970s. Compared to the linear model, the cumulative effect of oil price shocks over the course of the next two years is much larger in the net oil price increase model. For example, oil price shocks explain a 3 percent cumulative reduction in U.S. real GDP in the late 1970s and early 1980s and a 5 percent cumulative reduction during the financial crisis.

There was, however, an important caveat to the nonlinear model [emphasis added].

Our findings are that by no means all net oil price increases in our sample appear to have been followed by recessions. The lack of a mechanical relationship between net oil price increases and recessions is consistent with the hypothesis that the recessionary effects of oil price shocks are time-varying. 

In other words, recessions don’t always follow oil shocks in the nonlinear model. It depends. On the other hand, the oil shock effects on growth are very modest, which leads to the conclusion that oil prices don’t matter very much in the causation of recessions.
 

Correlation isn’t causation. Otherwise, governments would be encouraging the consumption of chocolate to win more Nobel Prizes.
 

 

A 1997 paper by Bernanke, Gertler, and Watson, “Systematic Monetary Policy and the Effects of Oil Price Shocks”, came to a similar conclusion. Bernanke et al noted that oil shock recessions were accompanied by rising interest rates. They went on to ask the question, “Is it the oil shock or the rising rates that caused the subsequent recession?” The answer turns out to be monetary policy played a much bigger role.

We find that the endogenous monetary policy response can account for a very substantial portion (in some cases, nearly all) of the depressing effects of oil price shocks on the real economy. This result is reinforced by a more disaggregated analysis, which compares the effects of oil price and monetary policy shocks on components of GDP. Looking more specifically at individual recessionary episodes associated with oil price shocks, we find that both monetary policy and other nonmoney, nonoil disturbances played important roles, but that oil shocks, per se, were not a major cause of these downturns.

 

 

Energy transition = Price volatility

The current surge in prices is attributable to a transition to clean power. While the global economy has dealt with supply squeezes and volatile energy prices in the past, the transition process has exacerbated volatility, which is here to stay over the next decade. Policymakers have discovered the fragility of renewable power. The sun doesn’t always shine. The wind doesn’t always blow. The rain doesn’t always fall. Storage is an issue and so is power grid capacity. Price shocks, both up and down, will be inevitable during the adjustment process.
 

 

 

Recession ahead?

Does that mean there is an energy-induced recession in the near future? It’s unlikely.
 

The Bernanke paper examined the link between oil shocks and monetary policy and concluded that monetary policy dominated the recession causation. Fed policy remains accommodative and so is fiscal policy.
 

James Hamilton has argued that rising gasoline prices act as a tax for consumers, and the increase at the pump may have pushed an already fragile economy into recession in 2008. Today, household balance sheets are strong. While higher energy prices could slow consumer spending, they are unlikely to push the economy into recession.
 

 

 

Investment implications

In conclusion, rising energy prices are unlikely to cause a recession in the near future, though they may act as a brake on consumer spending. The global economy is the process of normalizing after a sudden shock. Fiscal and monetary policy are easy and supportive. Investors should position themselves for the upcoming growth phase by overweighting cyclically sensitive stocks in the portfolio.
 

The accompanying chart shows sector earnings sensitivity to real GDP growth. Two of the top three sectors are classified as value and one, communication services, is growth. However, the recent Facebook whistleblower revelations leave the communication services sector vulnerable to antitrust regulation and oversight risk.
 

 

This analysis wouldn’t be complete with some final words about energy stocks. The energy sector has a number of attractive contrarian characteristics. The clean energy transition has made the sector the new tobacco. Companies are reluctant to invest significantly in capex in light of net-zero initiatives, which is reducing production capacity as cyclical demand rises during the economic recovery. As an example, coal stocks, which is the dirtiest of energy sources, have soared.
 

 

In the short term, oil and gas stocks are highly extended and testing both absolute resistance and relative resistance. While this sector is attractive from a macro viewpoint over the next few years, investors are advised to wait for a pullback before committing funds to these stocks.
 

 

Unsettling news from Crypto-Land

Posted by Cam Hui -
The NY Times recently published a note with the headline, “Crypto regulation heats up”.

 

The wrangling over spending bills and debt-ceiling dramas may be generating the biggest headlines in Washington, but the race to regulate the fast-growing cryptocurrency industry is also ramping up. Here’s a tour of some of the key developments this week:

 

Activist groups target crypto’s environmental impact. Today, more than 70 nonprofit groups, including the Sierra Club, the Open Markets Institute and the Action Center on Race and the Economy, urged Congress to consider crypto’s energy use when writing new rules for the sector. “As you explore legislative and regulatory responses to ensure investor protection in the industry, it is critical that you also consider the financial stability risks that climate change presents,” they wrote in a letter shared exclusively with DealBook that took particular issue with many cryptocurrencies’ energy-intensive “mining” process.
Industry players make the case for balance. The venture capital firm Andreessen Horowitz submitted a proposal to the Senate Banking Committee outlining its view on the future of digital assets and decentralized technology. The firm, which runs a big crypto fund, urged lawmakers to “ensure that the private sector can experiment and build” as it protects against “the real downside risks that might otherwise harm individuals.”
They also complain about burnout. Brian Armstrong, the C.E.O. of Coinbase, a large crypto exchange, tweeted yesterday that company chiefs in the U.S. were under too much pressure from officials, the news media and the public. He likened this to the crackdown on companies in China, “putting something that gets too successful in its place.”
Crypto notches a win. The S.E.C. approved Volt Equity’s exchange-traded fund that tracks companies whose values swing with Bitcoin prices, with an emphasis on firms that hold Bitcoin on their balance sheets. It’s not quite a pure Bitcoin E.T.F., but it brings the industry closer to that long-sought goal. Investors want “exposure to Bitcoin price movement,” Volt Equity’s Tad Park told DealBook, without necessarily buying crypto directly.
There is a more serious problem that they didn’t cover. I recently published a post raising questions about Tether (see The brewing crisis in Crypto-Land). A Tether is a stablecoin used regularly in the offshore market to trade cryptocurrencies. They are supposed to be backed 1-for-1 to the USD. There are now $69 billion Tether in circulation. This would make Tether one of the biggest banks in the US, except that it’s not a bank and not subject to regulation.

 

A recent Bloomberg article traced down Tether’s billions and found some disconcerting results.

 

 

 

 

Tether’s ticking time bomb

For some background on the use of Tether, Bloomberg reporter Zeke Faux went to one of the biggest crypto conferences in Miami in June:

 

The place was full of people who held Tether. Sam Bankman-Fried, a 29-year-old billionaire who was in town to rename Miami’s basketball arena after his cryptocurrency exchange, FTX, told me he’d bought billions of Tethers, using them to facilitate trading other coins. “If you’re a crypto company, banks are nervous to work with you,” he said.

 

His explanation doesn’t make much sense if you still think of Bitcoin as a peer-to-peer currency, an ingenious way to transfer value without an intermediary. But most people aren’t using cryptocurrencies to buy stuff. They’re trading them on exchanges and betting on their value, hoping to make a real money score by picking the next Dogecoin, which spiked 4,191% this year after Elon Musk started tweeting about it, or Solana, up 9,801% in 2021 for seemingly no reason at all.

 

Think of crypto exchanges as giant casinos. Many of them, especially outside the U.S., can’t handle dollars because banks won’t open accounts for them, wary of inadvertently facilitating money laundering. So instead, when customers want to place a bet, they need to buy some Tethers first. It’s as if all the poker rooms in Monte Carlo and the mahjong parlors in Macau sent gamblers to one central cashier to buy chips.

 

The biggest traders on these exchanges told me they routinely bought and sold hundreds of millions of Tethers and viewed it as an industry standard. Even so, many had their own conspiracy theories about the currency. It’s controlled by the Chinese mafia; the CIA uses it to move money; the government has allowed it to get huge so it can track the criminals who use it. It wasn’t that they trusted Tether, I realized. It was that they needed Tether to trade and were making too much money using it to dig too deeply. “It could be way shakier, and I wouldn’t care,” said Dan Matuszewski, co-founder of CMS Holdings LLC, a cryptocurrency investment firm.
If someone gave Tether USD 100 and received 100 Tethers in return, what happens to that $100? After some pressure, Tether published its asset holdings and disclosed, “Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.”

 

 

If half of its assets is in commercial paper (CP), which is short-term paper issued by (usually) top-rated borrowers, that would make the company one of the biggest CP players in the world. But no CP dealer has heard of them. So where are Tether’s billions?

 

Here is the key quote from Faux [emphasis added].
 

I obtained a document showing a detailed account of Tether Holdings’ reserves. It said they include billions of dollars of short-term loans to large Chinese companies—something money-market funds avoid. And that was before one of the country’s largest property developers, China Evergrande Group, started to collapse. I also learned that Tether had made loans worth billions of dollars to other crypto companies, with Bitcoin as collateral. One of them is Celsius Network Ltd., a giant quasi-bank for cryptocurrency investors, its founder Alex Mashinsky told me. He said he pays an interest rate of 5% to 6% on loans of about 1 billion Tethers. Tether has denied holding any Evergrande debt, but Hoegner, Tether’s lawyer, declined to say whether Tether had other Chinese commercial paper. He said the vast majority of its commercial paper has high grades from credit ratings firms, and that its secured loans are low-risk, because borrowers have to put up Bitcoin that’s worth more than what they borrow. “All Tether tokens are fully backed, as we have consistently demonstrated,” the company said in a statement posted on its website after the story was published.

 

Tether’s Chinese investments and crypto-backed loans are potentially significant. If [Tether CFO] Devasini is taking enough risk to earn even a 1% return on Tether’s entire reserves, that would give him and his partners a $690 million annual profit. But if those loans fail, even a small percentage of them, one Tether would become worth less than $1. Any investors holding Tethers would then have an incentive to redeem them; if others did it first, the money could dry up. The bank run would be on.

I supposed the good news is they didn’t lend to China Evergrande, but Chinese USD paper seems awfully dodgy in the current environment. The sympathetic view is Tether’s CFO Giancarlo Devasini has transformed Tether into a Berkshire Hathaway, where he uses the float to earn money for himself and his partners. The less charitable view is the company is now a giant and leveraged hedge fund in which Devasini enjoys the gains and the depositors get stuck with the losses.
 

When will the bank run begin? Your guess is as good as mine.

The risks to Big Tech

Posted by Cam Hui -

Mid-week market update: As the S&P 500 continues its test of support while exhibiting a positive RSI divergence, one important consideration is what happens to large-cap technology stocks. Large-cap tech and FANG+ account for about 45% of S&P 500 weight, and further weakness could prove to be a drag for the overall market, no matter what happens to the rest of the index.
 

 

 

The long-term picture

The recently publish JPM Asset Management’s quarterly book proved to be a useful reference for this question. Indeed, index concentration in the top 10 stocks is very high and exceeds levels seen at the NASDAQ Bubble top. The forward P/E between the top 10 and the rest of the S&P 500 is also very high, though not as high as the dot-com era. The key difference is the top 10 are deserving of a high valuation, as they account for 26.2% of S&P 500 earnings.

 

 

Nevertheless, the relative valuation of growth and value is stretched. The Z-score spread between the forward P/E of growth and value is only exceeded by the dot-com bubble. 

 

 

As well, this chart of the history of sector weights also provides some context of the dominance of technology stocks in the S&P 500.

 

 

 

Facebook’s no good, very very bad day

How bad can it get for large-cap growth? Facebook’s experience this week was an example of the threats facing the company and Big Tech in general. Not only did Facebook and other of its properties go down because of a system glitch, but it was also subject to the Senate testimony of whistleblower Frances Haugen who accused the company of choosing “profits over safety”.

 

Notwithstanding the antitrust threat posed by the issues raised by Haugen to Big Data companies like Facebook, Alphabet, and others, Kevin Roose of the NY Times raised a more important question about the erosion of Facebook’s competitive position.

 

What I’m talking about is a kind of slow, steady decline that anyone who has ever seen a dying company up close can recognize. It’s a cloud of existential dread that hangs over an organization whose best days are behind it, influencing every managerial priority and product decision and leading to increasingly desperate attempts to find a way out. This kind of decline is not necessarily visible from the outside, but insiders see a hundred small, disquieting signs of it every day — user-hostile growth hacks, frenetic pivots, executive paranoia, the gradual attrition of talented colleagues.
Roose posed the question of why the company is going to such desperate measures to expand its audience?

 

You can see this vulnerability on display in an installment of The Journal’s series that landed last week. The article, which cited internal Facebook research, revealed that the company has been strategizing about how to market itself to children, referring to preteens as a “valuable but untapped audience.” The article contained plenty of fodder for outrage, including a presentation in which Facebook researchers asked if there was “a way to leverage playdates to drive word of hand/growth among kids?”
It’s a crazy-sounding question, but it’s also revealing. Would a confident, thriving social media app need to “leverage playdates,” or concoct elaborate growth strategies aimed at 10-year-olds? If Facebook is so unstoppable, would it really be promoting itself to tweens as — and please read this in the voice of the Steve Buscemi “How do you do, fellow kids?” meme — a “Life Coach for Adulting?”
Why is it going to such desperate means to raise engagement by making people angry?
 

Take the third article in The Journal’s series, which revealed how Facebook’s 2018 decision to change its News Feed algorithm to emphasize “meaningful social interactions” instead generated a spike in outrage and anger.
The algorithm change was portrayed at the time as a noble push for healthier conversations. But internal reports revealed that it was an attempt to reverse a yearslong decline in user engagement. Likes, shares and comments on the platform were falling, as was a metric called “original broadcasts.” Executives tried to reverse the decline by rejiggering the News Feed algorithm to promote content that garnered a lot of comments and reactions, which turned out to mean, roughly, “content that makes people very angry.”
Facebook is in the business of surveillance in order to sell advertising. Google’s business model is the same, though it goes about it in a different way. Amazon tries to find out everything about you to sell you more products. Apple does it in a different way, though the Big Data techniques are similar. Haugen’s testimony is another step that invites antitrust scrutiny.

 

How bad could it get? Consider’s China’s crackdown on tech. Stonex Group strategist Vincent Deluard gave an illustration of how far P/E ratios could fall in the face of intense regulatory oversight.

 

 

The numbers are noisy and the circumstances are company-specific, but the worst-case analysis could see forward P/E ratios fall by as much as 50%.

 

 

A light at the end of the tunnel

In the meantime, an analysis of the relative performance of top five sectors of the S&P 500 shows that only financial stocks are experiencing any positive relative strength. The rest aren’t getting love from the markets. As the top five sectors make up about three-quarters of index weight, the market faces a headwind in advancing.

 

 

To be sure, value and cyclical stocks are gaining the upper hand against growth stocks, but value and cyclicals comprise about 32% of S&P 500 index weight compared to 45% for large-cap growth.

 

 

The market faces the uncertainty of a possible government default if the debt ceiling isn’t raised. Some signs of movement may be appearing in the standoff. Senate Minority Leader Mitch McConnell offered President Biden and the Democrats two limited paths today to raising the debt ceiling. While there may be further maneuvering by both sides in the coming days, lawmakers appear to be stepping back from the cliff. 

 

If and when a deal is reached, expect a strong relief rally led by cyclicals as they will have the greatest leverage to renewed economic growth. A light is appearing at the end of the tunnel.

 

 

Disclosure: Long SPXL

 

Q3 earnings season preview

Posted by Cam Hui -

The recent pullback in the S&P 500 has deflated the forward P/E to 20.1 as of close last Thursday, which is in the bottom of the post-COVID Crash recovery range. The P/E derating is not surprising as bond yields have risen to put downward pressure on P/E ratios.
 

 

What’s next? The upcoming Q3 earnings season will be a test for both bulls and bears. The key question for investors is whether the E in the forward P/E ratio rises fast enough to support stock prices and offset rising rates?

 

 

A mixed picture

Wall Street earnings estimate revisions present a mixed picture. S&P 500 EPS estimates had declined for two weeks in a row, though a more updated report from FactSet shows upward revisions in the following week. By contrast, estimates for both the mid-cap S&P 400 and small-cap S&P 600 show strong positive momentum.

 

 

The weakness in S&P 500 revisions may be attributable to USD strength. Large-cap companies tend to have more foreign operations and their sales and earnings are more sensitive to currency fluctuations.

 

 

That said, the S&P 500 has exhibited an uneven correlation with the USD Index in the last 10 years. The USD is a safe haven currency and can experience fund flows during both risk-on and risk-off periods, but relative growth and interest rates are also important factors in determining currency levels.

 

 

 

A detailed estimate revision analysis

The Street is entering the Q3 earnings season on a fairly upbeat note. FactSet reported that Q3 2021 is the fifth consecutive quarter that analysts have shown positive estimate revisions. 

 

 

In more normal times, company analysts tend to be overly optimistic. They initially post high estimates and gradually revise them down as the reporting period approaches, according to FactSet:

In a typical quarter, analysts usually reduce earnings estimates during the quarter. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 2.9%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 3.7%. During the past fifteen years, (60 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.9%. 

To be sure, the rate of revisions has decelerated. The monthly analysis of quarterly estimate revisions shows a gradual downward trajectory for Q3 earnings. The key question for investors is whether expectations are too rosy. 

 

 

 

The bottom-up view

On the other hand, the bottom-up view from companies is still upbeat. The rate of positive to negative guidance is still positive, which is contrary to the historical record of the preponderance of negative guidance.
 

However, the macro summary from The Transcript, which monitors and summarizes earnings calls, sounded a cautionary note about supply chain bottlenecks..

Inflation and supply chain challenges continue to be the most prominent economic theme. It doesn’t appear that supply chain challenges are getting any better.

The previous week’s earnings calls had similar warnings, though it was more upbeat about the waning effects of the pandemic.
Economic weakness driven by the Delta variant appears to have been short-lived. While growth may have slowed some from the euphoric pace earlier this year, the economy continues to benefit from high consumer demand. Supply chain disruptions are not getting better though and inflation is likely to last into next year. The FOMC met last week and decided to keep monetary policy unchanged. However, Jerome Powell was relatively direct in saying that tapering is likely to start at the next meeting.
Where does that leave us? I am cautiously bullish as we enter the Q3 earnings season. Expectations are high but history shows that companies have guided sales and earnings estimates to slightly beat them. The bulls will say that the guidance rate remains positive and the macro environment supportive. The bears will say that the rate of positive estimate revisions has been falling, which is a sign of deceleration.

 

The reporting calendar is very light this week and the Q3 earnings season is to begin in earnest next week. The coming month will be a crucial period to determining the direction of stock prices.

 

 

 

A Q4 meltup ahead?

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.

 

 

Positive seasonality ahead

If history is any guide, stocks are expected to be bottom out in early October and begin a period of seasonal strength into year-end.

 

 

What are the odds of a melt-up for the rest of 2021?

 

 

A reflation bull?

Ned Davis Research recently sketched out a bullish scenario into year-end for global equities by pointing out that Q4 has been the strongest in the last few years.

 

 

Their risk appetite indicators have been steadily improving, but the indicator hasn’t risen sufficiently to flash a buy signal just yet. These readings are consistent with my Q4 sector review which also found signs of cyclical and reflation strength, but no broad-based confirmation.

 

 

 

Supportive sentiment

The sentiment backdrop is becoming more supportive of an advance, though readings haven’t fallen to panic extremes. As an example, the 10 dma of the put/call ratio has spiked to levels where corrections have ended in the post-COVID Crash era, but the ratio has been higher in the past.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs, plunged last week but readings are not below the 26-week Bollinger Band. A penetration of the low BB has been strong buy signals in the past.

 

 

These conditions lead me to believe that risk/reward is tilted to the upside. The maximum drawdown of the S&P 500 from its highs is -5%. It’s conceivable that prices could pull back further, but another 2-3% of weakness is likely to spark panic levels in many sentiment models.

 

 

Bullish tripwires

While I am cautiously bullish, I am not ready to go all-in just yet. Here are some bullish tripwires that I am watching as signs of a reflationary rebound. The blogger Macro Charts argued that energy stocks are the canaries in the cyclical coalmine.

 

 

A Bloomberg headline came across my desk last week that may confirm the bullish outlook for energy: “China Orders Top Energy Firms to Secure Supplies At All Costs”,
 

China’s central government officials ordered the country’s top state-owned energy companies to secure supplies for this winter at all costs, according to people familiar with the matter.
The order came directly from Vice Premier Han Zheng, who supervises the nation’s energy sector and industrial production, and was delivered during an emergency meeting earlier this week with officials from Beijing’s state-owned assets regulator and economic planning agency, the people said, asking not to be named discussing a private matter. Blackouts won’t be tolerated, the people said.
The emergency meeting underscores the critical situation in China. A severe energy shortage crisis has gripped the country, and several regions have had to curtail power to its industrial sector and some residential areas have even faced sudden blackouts.
For some context, China isn’t suffering from an energy shortage. Skyrocketing coal prices have made the cost of electrical power production unprofitable and electric generation companies have cut output as a result. This means Chinese electrical generators will be buying coal at any price

 

Similarly, natural gas prices have soared in Europe because of a lack of renewable output. The sun hasn’t shone as much as expected and the atmosphere has calmed and wind power output has fallen. As natural gas is a feedstock into fertilizer production, this has put upward pressure on fertilizer prices and it will undoubtedly affect food prices as well. 

 

On the other hand, Bloomberg reported that core eurozone consumer sentiment remains surprisingly upbeat despite costs. Strong consumer demand in the face of rising prices is a bullish sign for the economy.

 

 

 

Supply chain bottlenecks

Won’t rising energy prices create inflationary pressure and force the Fed to act? Jerome Powell testified last week that inflationary pressures were expected to be transitory because of supply chain bottlenecks, but allowed that the transitory period may last longer than expected. 

 

The headlines may see rising hysteria over shortages in the coming weeks as Christmas nears and products aren’t available in plentiful supply on shelves. In reality, the shortages are attributable to a supply shock owing to rising demand in the face of limited manufacturing and transportation capacity. Central bankers raising interest rates won’t make the semiconductor shortages go away, nor will it expand shipping and trucking capacity.

 

Some hopeful signs are starting to appear on the horizon on a bottom-up basis. The latest data on port congestion is showing possible signs of easing.

 

 

The best news from a contrarian perspective is this week’s cover of Barron’s.

 

 

Demand for services continue to improve. Airfare purchase are rising while refunds are falling.

 

 

New Deal democrat observed that manufacturing, or the producer side of the economy is performing well after assessing the August durable goods report.
 

Although there are many bottlenecks, in particular in transporting materials to factories, and goods from factories to sellers, orders for goods that will last a (relatively) long time continue to get better. There is simply no downward pressure on the producer sector of the economy at this time.
The next important data release will be the November Jobs Report. How will the juxtaposition of COVID cases, the expiry of emergency assistance programs, supply chain bottlenecks, and widespread reports of labor shortages affect the employment situation? Powell stated after the last FOMC meeting that it would take a large miss on the November report for the Fed to rethink its plans to taper its QE purchases.

 

This is what reflation looks like.

 

 

Fiscal wildcards

On the other hand, investors will have to deal with the confusing fiscal picture out of Washington. This time, there are simply a lot of balls in the air and many moving parts to fiscal policy. Each issue is separate but related and any one of them could go off the rails and affect fiscal policy and unsettle the markets.
  • Funding the federal government, which can be done with a Continuing Resolution in the short run;
  • The debt ceiling;
  • The infrastructure bill; and
  • The budget reconciliation process.
Here is how Biden’s $3.5 trillion proposals could affect future policy and change the lives of Americans:
  • Transportation: Electric vehicle (EV) subsidies, spending for EV infrastructure like public charging stations, public transport subsidies, especially for rail travel.
  • Healthcare: Expand Medicare coverage to dental, vision, and hearing benefits, free Medicaid coverage for more lower-income Americans, lower drug prices.
  • Child Care and Education: Free daycare for lower-income Americans, two years of free preschool before kindergarten and two free years of community college, and 12 weeks of paid family leave to tend to a sick family member.
I have no idea of how this wish list will play out in the tug-of-war in Washington. Make no mistake that the legislative skills are there for a deal to be done. House Speaker Nancy Pelosi is a vote counter par excellence, Democratic Senator Majority Leader Chuck Schumer understands his caucus, and President Joe Biden enjoys a 90% approval among Democrats and he has a strong legislative record in the Senate.

 

In all likelihood, the Democrats’ ambitious agenda will be watered down. As an example, Biden’s original proposal was to raise the corporate tax rate from 21% to 28%, though expectations were scaled back down to 25%. PredictIt odds show that the chances of no tax increase (21%) or a sub-25% tax rate are rising. As a 25% rate has been largely discounted by the market, a lower tax rate would be a welcome surprise for equity investors.

 

 

No analysis of fiscal uncertainty without a word on the German election. Angela Merkel’s CDU/CSU lost their leading status in the Bundestag and came second to the left-of-centre SPD. However, the SPD does not have sufficient seats to form a majority and it will need to seek coalition partners to form a government. The consensus expectation is a “traffic light” coalition of SPD (red), socially liberal but fiscally conservative FDP (yellow), and the Greens.

 

 

For investors, the key question is what happens to Germany’s traditional fiscal conservatism and propensity towards austerity. Both the SPD and Greens favor abandoning Germany’s “debt brake” while the FDP is adamant about keeping it. One trial balloon that has been floated is to give FDP leader Christian Lindner the finance ministry while allowing the Greens to execute their climate initiatives through off balance sheet spending. This solution allows Germany a fiscal boost to foster more growth, but it doesn’t address the issue of a common eurozone budget and greater fiscal integration. In the past, coalition negotiations can take a long time and the public won’t know the results for months.

 

In conclusion, the market may be setting for a period of positive seasonality into year-end, which would be sparked by a reflationary boom. However, a number of important cyclical tripwires have not been triggered. At a minimum and in the short-term, the S&P 500 needs to rally and regain the 50 dma though it is helpfully exhibiting positive RSI divergences as it tests the Evergrande panic lows.

 

 

 

Disclosure: Long SPXL

 

Q4 sector review: Assessing the yield surge

Posted by Cam Hui -

In light of the recent surge in global rates, it’s time for another review of sector leadership. I will conduct the review in two ways. First, the market will be viewed through a cross-asset framework. Rising yields and a steepening yield curve have been bullish for the value/growth cycle in the past, will this time be different?
 

 

As well, the market will be viewed through a conventional technical analysis lens.

 

 

Reflation or mid-cycle pause?

The CRB Index provides some big picture context to the current phase of the economic cycle. The CRB/S&P 500 ratio, which is a useful cyclical indicator. When the ratio is rising, the market is signaling that hard assets are more value than paper assets, which is reflationary. The ratio bottomed out in 2020 and staged an upside breakout through a downtrend in early 2021. This price pattern is similar to late 2000 when the NASDAQ Bubble popped and a recession began to take hold. The commodity/stock ratio rose into late 2000 and prices paused, which is an indication of economic weakness. The key difference between the 2000 episode and today is that stocks were in a bear market in 2000 while they have rebounded strongly today. 

 

 

What happens next? Will commodity prices continue to rally indicating a reflationary rebound, or pause and trade sideways, which will be a signal of a mid-cycle slowdown?

 

The cyclically sensitive copper/gold and base metals/gold ratios are leaning towards the cyclical recovery and a risk-on scenario. The historical record shows that these cyclically sensitive ratios have been correlated to the stock/bond ratio, which is a risk appetite indicator. 

 

The copper/gold ratio topped out in late 2000 and it didn’t bottom out until 2003. Today, the copper/gold ratio is trading sideways, which could be a signal of a growth pause, but that could be a false signal. The more diversified base metals/gold ratio is rising indicating a reflationary rebound.

 

 

 

Sector rotation review

If we were to analyze the market through a more traditional technical analysis prism, the first tool is an RRG chart, which is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

 

The latest chart shows technology and healthcare in the top right leading quadrant with flagging leadership characteristics. Rising sectors in the top left improving quadrant are financials and consumer discretionary. Energy, materials, and industrials are in the left bottom lagging quadrant but they are showing signs of nascent strength.

 

 

Let’s start the analysis with healthcare, which was one of the leading sectors. Healthcare stocks violated a rising trend line in September. Even before the trend line violation, relative performance peaked in August and relative breadth (bottom two panels) has been weakening.

 

 

The remainder of the sectors will be divided between growth sectors and value and cyclical sectors. Technology stocks were also one of the market leaders, but they have been unable to overcome a relative resistance zone (shown in grey). Relative breadth peaked in early August and it has been in decline.

 

 

The stocks in the communication services sector is less homogeneous than other sectors. This sector violated a rising trend line and its relative performance has been range-bound since April. However, relative breadth has been improving, but the recent strength is attributable to some of the smaller stocks in the sector, such as Netflix and selected telecoms, while heavyweights Facebook and Alphabet have been weak.

 

 

Financials is the strongest of the value and cyclical sectors. The sector is tracing out a bullish cup and handle formation, but it hasn’t staged an upside breakout yet. Relative strength is correlated to the 2s10s yield curve. Banks tend to borrow short and lend long and a steepening yield curve increases profitability. Relative breadth has been strong.

 

 

Consumer discretionary stocks can be thought of as both growth and value. The largest weights in the sector are AMZN and TSLA, which are growth stocks and account for about 45% of sector weight and can be represented by the cap weight sector index. The remainder is more conventional cyclically sensitive consumer discretionary stocks and can be better represented by an equal-weighted sample. The relative performance of the cap-weighted sector has been strengthening while the equal-weighted sector has been flat against the S&P 500. However, relative breadth has been rising, which could be interpreted as a signal of better performance by the broader cyclically sensitive stocks.

 

 

Energy stocks have been strong as oil prices rose, but bullishness and bearishness are in the eyes of the beholder. The sector has staged an upside breakout from an inverse head and shoulders pattern, which is bullish, but the latest rally could be forming the right shoulder of a head and shoulders formation, which is potentially bearish. As good chartists know, a head and shoulders pattern is not confirmed until the neckline breaks. Since the neckline broke on the inverse H&S, I am inclined to give the bull case the benefit of the doubt. Unsurprisingly, relative breadth is strong as oil prices rallied.

 

 

The industrial sector is range bound, but its relative performance staged an upside breakout through a falling trend line after testing a relative support zone. This technical pattern is very similar to the relative performance of the capital goods sensitive Infrastructure ETF (PAVE), which is testing a falling relative trend line. Relative breadth of industrials, while still negative, is improving.

 

 

Materials is the weakest sector of the value and cyclical sectors. The sector is testing a key resistance level, though it appears to have staged a marginal upside breakout through a falling relative trend line. However, relative breadth is negative and weak.

 

 

The remainder of the S&P 500 sectors have defensive characteristics. None are showing any signs of relative strength. If the bears were to take control of the tape, their actions would show up as improving defensive sector relative performance.

 

 

In conclusion, a review of market leadership through macro cross-asset and conventional technical analysis viewpoints shows a possible bullish setup for the reflation trade. However, the jury is still out on this bullish scenario. We need to see the cyclical and value sectors exhibit better and broader relative performance as confirmation of reflationary strength. Investors may gain better clarity on market direction once the jitters over the debt ceiling and Biden’s stimulus program are resolved.

 

Will rising yields spook stocks?

Posted by Cam Hui -

Mid-week market update: Last week, the market was rattled by the prospect of an Evergrande default. This week, it’s rising yields. Both the 5 and 10 year Treasury yields surged decisively this week and the 2s10s yield curve has steepened.
 

 

Are rising yields destined to spook stock prices?
 

 

Good news, bad news

The answer to that question is a “good news, bad news” story. Let’s start with the bad news. A Goldman Sachs study reveals that stocks struggle when rates rise too rapidly.
 

 

Equities, as an asset class, compete with fixed income instruments for funds. A simple way of rating the relative attractiveness of stocks and bonds is the Fed model, which compares the E/P ratio with the yield on a default-free Treasury. If bond yields rise. Equity prices can maintain their level or rise even further as long as the E in the E/P is rising faster than the increase in Treasury yields.
 

The latest update shows S&P 500 forward 12-month EPS fell last week. That’s the bad news. The good news is the earnings decline was not confirmed by the midcap S&P 400 or smallcap S&P 600.

 

 

 

Silver linings

Here is one silver lining in the dark cloud. As we approach Q3 earnings season, FactSet reported S&P 500 have issued strong positive earnings guidance:

102 companies in the index have issued EPS guidance for Q3 2021, Of these 102 companies, 47 have issued negative EPS guidance and 55 have issued positive EPS guidance. The percentage of companies issuing positive EPS guidance is 54% (55 out of 102), which is well above the 5-year average of 39%.

 

The bulls can find other constructive signs. The rise in yields looks overdone. The price action of XLU, the utilities ETF which I use as a yield proxy, is testing its 200 dma and wildly oversold on the 5-day RSI. RSI readings are sufficiently stretched and comparable to the initial stages of the COVID Crash to warrant at least a short-term relief rally. In addition, XLU is also testing a key relative support zone (bottom panel) which should hold in light of the oversold condition of the sector.

 

 

Risk appetite indicators are also supportive of high stock prices. The equity risk appetite indicators, comprised of the ratio of high beta to low volatility stocks and the ratio of consumer discretionary to consumer staple stocks, are exhibiting a series of minor positive divergences.

 

 

Credit market risk appetite, as measured by the relative price performance of junk bonds and investment-grade bonds to their duration-equivalent Treasuries, made fresh all-time highs before retreating.
 

 

In addition, the relative performance of defensive sectors and industries to the S&P 500 are weak. The bears haven’t taken control of the tape. Major corrections and bear phases simply don’t look like this.
 

 

Here is some good news from Hong Kong. The shares of China Evergrande is trying to make a bottom.
 

 

Don’t panic about a major correction. Barring some catastrophe such as a default by the US Treasury, the market is unlikely to decline much further. One short-term bullish ray of hope are the minor RSI divergences even as the S&P 500 tested the recent lows.
 

 

 

Positioning for rising rates

The increase in sovereign yields is likely extended in the short run, interest rates have made a turn upwards. That begs the question of how equity investors should position themselves.
 

The 5-year Treasury yield has been moving in lockstep with the cyclically sensitive base metals/gold ratio, which is an indication that the market is discounting a cyclical rebound and a better growth outlook.
 

 

While I would not personally recommend the purchase of the Rising Rates ETF (EQRR) because of its minuscule AUM which is an invitation for the issuer to wind up the fund, the sector exposures of EQRR is nevertheless a useful guide to how investors should position themselves for a rising rate environment, namely cyclical stocks.
 

 

I am also keeping an eye on the semiconductor industry. These stocks are growth cyclicals and have both growth and cyclical characteristics. The industry has been stuck in a sideways pattern relative to the S&P 500 since June (bottom panel). If the market were to truly embrace the cyclical rebound investment thesis, they should stage a relative upside breakout.
 

 

Stay tuned.
 

 

Disclosure: Long SPXL
 

A classic washout bottom

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.
 

 

Panic and recovery

Last week, I wrote, “A tactical low looks near.,,[but] traders should be open to the possibility that the market may need one final panic for a tradable bottom to appear.” What I didn’t expect was the China Evergrande panic that gripped the market, though the subsequent relief rally was not unexpected. 

 

The S&P 500 fell -4% from its all-time high and rebounded by the end of the week to regain its 50-day moving average. The VIX Index flashed a buy signal when it rose above its upper Bollinger Band last week. However, traders should be aware of the caveat that rallies can stall once the VIX recycles from above the upper BB to the 20 dma. This scenario is a very real possibility as market jitters over a debt ceiling impasse, Treasury default, and a widespread government shutdown looms ahead.

 

 

 

Capitulation sentiment

There were signs of capitulation level sentiment everywhere. Starting in Hong Kong, where China Evergrande is listed, Jason Goepfert of SentimenTrader documented how the net advance-decline breadth fell to levels seen at short-term lows.

 

 

Rob Hanna at Quantifiable Edges wrote that his “Quantifiable Edges Capitulative Breadth Index (CBI), which measures short-term capitulative selling among S&P 100 stocks, closed at 11 on Tuesday and 12 Wednesday”.  Readings of 10 or more have historically been short-term buy signals, especially if the S&P 500 is above its 200 dma.

 

 

The NYSE McClellan Oscillator (NYMO) fell to an oversold level last week. With the exception of the COVID Crash, such readings have provided good short-term long entry points for traders in the past.

 

 

Credit market risk appetite, as measured by the relative price performance of junk bonds to their duration-equivalent Treasuries, made an all-time high.

 

 

 

Interpreting the yield breakout

As for market leadership, it is noteworthy that the 10-year Treasury yield staged a decisive upside breakout in the wake of the September FOMC meeting, though the 5-year yield had already shown signs of strength.

 

 

In the wake of the yield breakout, bear in mind the historical record of sector and industry sensitivity to rising yields has been cyclical and value stocks.

 

 

Should yields continue to strengthen, the value stock revival may finally be realized.

 

 

In the very short-term, however, breadth is highly extended. Don’t be surprised if the market rally pauses early next week.

 

 

In conclusion, the stock market made a classic washout bottom last week. While I wouldn’t necessarily discount the possibility of a pause in the advance, the intermediate-term path of least resistance for stock prices is up.

 

Disclosure: Long SPXL
 

 

Time for a mid-cycle swoon?

Posted by Cam Hui -

The S&P 500 fell as much -4% from its all-time high in Evergrande panic pullback last week. Is the recent weakness just typical seasonal weakness or something more serious? The intermediate-term breadth looks disconcerting. The percentage of S&P 500 stocks above their 200-day moving average (dma) had been at the 90% level which indicates a “good overbought” sustained advance. This indicator has retreated below the 75% level. There have been four similar episodes in the last 20 years. Three of the four occasions resolved themselves with substantial drawdowns while the remaining one saw the market trade sideways in a choppy way.
 

 

The odds don’t look good. The market may be setting itself for a mid-cycle swoon.

 

 

A history lesson

For some clues of what the future holds, let’s walk through the history of each of the four episodes. First, we can observe that the market didn’t really bottom out until the percentage of S&P 500 stocks fall to at least 20% (bottom panel). Based on the current reading, it’s not over yet.

 

 

The above chart also shows macro and risk appetite signals in the form of the cyclically sensitive copper/gold ratio and the relative performance of the consumer discretionary to consumer staple stocks. These indicators were important drivers of stock market performance on those occasions. I have also included the 2s10s yield curve as another frame of reference. In all four of the past instances, the yield curve was flattening and conveys no additional information for this analysis.

 

Consider the 2004 period. The stock market had recovered strongly after a prolonged recession. There were no signs of softness from the copper/gold ratio and the equity risk appetite indicator of discretionary to staple stocks. The market consolidated sideways to digest its gains and went on to rise further.

 

The 2010 episode was similar to 2004 inasmuch as they were both rallies off recessionary bottoms. The key difference in 2010 was the weakness shown by the copper/gold ratio and equity risk appetite. Simply put, the stock market pulled back because of a growth scare.

 

The 2011 period was marked by the dual challenges of a Greek Crisis as the eurozone faced an existential crisis. Recall the endless European summits and the crisis was not fixed until the ECB stepped in with its LTRO program. Across the Atlantic, Washington was embroiled in a budget dispute marked by the S&P downgrade of Treasury debt from AAA to AA. Is it any wonder why stock prices skidded?

 

The 2014 episode was unusual as the macro and risk appetite signals were similar to 2004. Both the copper/gold and equity risk appetite indicators were moving sideways and showing few signs of stress, but stock prices experienced a sudden downdraft. At the time, the market had become increasingly concerned over the umbrella protests in Hong Kong and an Ebola outbreak in Africa. The moral of this story is normal market pullbacks can happen at any time and the 2014 correction can be considered a part of normal equity risk.

 

 

The Evergrande fallout

Fast forward to 2021. History doesn’t repeat itself but rhymes. What is the outlook and the challenges for the months ahead? The issues facing investors can be categorized as:
  • The implications of the China Evergrande meltdown;
  • Possible economic weakness in 2022; and
  • Political uncertainties surrounding the impasse over the budget ceiling, as well as Biden’s $3.5 trillion budget proposal.
There have been many calls by analysts dismissing the equivalence of the Evergrande crisis to China’s Lehman Moment. The Lehman Crisis was an institutional bank run, sparked by institutional distrust of one another. They couldn’t be certain that any short-term loans to any financial institution would be paid back. The China Evergrande situation is entirely different. The crisis was manufactured by the government in its efforts to rein in credit growth and to tame real estate speculation. Any crisis of financial confidence could be addressed by Beijing by ordering the banks, which are government-owned, to lend. Even though the Evergrande meltdown won’t result in a disorderly unwind, the economy will nevertheless suffer some fallout.

 

The well-respected China watcher Michael Pettis recently explained how Beijing is pivoting from the build infrastructure growth model to a focus on high-quality growth and what that means.

 

This high-quality growth (to use Beijing’s usual terminology) consists mainly of consumption (driven by increases in household income rather than rising household debt), exports, and business investment. By my estimates, high-quality growth has probably accounted for barely half of China’s GDP growth rate in recent years.

 

But for China to achieve the required GDP growth rates, it needs another source of economic activity, which I will refer to as residual growth. This growth, for the most part, has consisted mainly of malinvestment by the property sector and by local governments building excessive amounts of infrastructure. Whenever high-quality growth declines, as it did last year when China’s growth rate was actually negative, Beijing steps up residual growth to make up for this decline, but whenever the pace of high-quality growth picks up again, Chinese leaders quickly put downward pressure on residual growth, as it seems to be doing this year. 

 

The fact that Beijing regularly tries to constrain residual growth to the minimum amount needed to achieve the GDP growth target suggests that China places little value on this kind of growth. More importantly, China’s debt history provides a concrete reason for recognizing that much recent investment has been malinvested.

 

 

Enough is enough. The latest PBoC clampdown on China Evergrande and other property developers is an important signal that Beijing is pivoting to high-quality growth at the expense of headline GDP growth. Don’t expect Chinese real estate prices to continue to advance strongly over the next few years.

 

This policy pivot presents a problem for the rest of the world. China is a significant source of demand for many commodities relative to its share of the global population. Any shift away from infrastructure spending will put downward pressure on commodity prices.

 

 

Does this put the global cyclical recovery at risk? At a minimum, is the narrative of a bullish commodity supercycle coming to a screeching halt?

 

Not so fast! While selected commodities such as iron ore are tanking, the CRB Index is holding above its 50 and 200 dmas. As well, the cyclically sensitive base metals/gold ratio is holding up well and it is not signaling a downturn.

 

 

Similarly, industrial metal prices are also not showing any signs of weakness.

 

 

To be sure, it’s possible that China is slowing to a more sustainable “quality high-growth” level and commodity demand is falling off. Broad market signals are not indicating a global slowdown. I interpret these conditions as rising recovery demand from the rest of the world is offsetting China’s deceleration.

 

 

A potential slowdown

Another challenge for equity investors is the risk of economic weakness. I have highlighted New Deal democrat’s useful economic forecasting framework of coincident, short-leading, and long-leading indicators. His latest snapshot indicates strength in the shorter term indicators but some weakness by mid-2022, though he is not forecasting a recession.

 

RecessionALERT came to a similar conclusion and his chart is illustrative of NDD’s conclusion. The leading economic data is indicating some softness, but readings are not in worrisome territory.

 

 

Stock prices are known to be leading indicators and the stock market usually looks ahead 6-12 months. It is therefore not surprising that the percentage of S&P 500 above their 200 dma has weakened. A more detailed analysis of the S&P 500 reveals a bifurcated market beneath the surface. As the 2s10s yield curve flattened, indicating expectations of slowing growth, investors rotated into growth stocks as growth became more valuable in a growth-starved environment. At the same time, value stocks, which also have highly cyclical characteristics, traded sideways.

 

 

In many ways, the 2021 backdrop is similar to 2004 and unlike 2010 and 2011. There are no signs of cyclical weakness as measured by the copper/gold ratio and equity risk appetite is holding up well. This should resolve in a period of sideways consolidation in the coming months. There is, however, one key difference. The bifurcated nature of today’s market shows that cyclical and value stocks have been trading sideways since May. Arguably, the market may have already undergone much of its consolidation.

 

There may be some hopeful signs that the economy is about to turn up. The global recovery has struggled with COVID-19 and several waves of infection. The latest readings indicate case rates have topped. In particular, Asian case counts, which have been one of the key global trouble spots, are rolling over.

 

 

In addition, the US Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, had been falling and the decline may be a signal of economic weakness in mid-2022. While it’s too early to break out the bubbly, the latest readings show an uptick and an improvement in the macro outlook.

 

 

Moreover, analysis from The Economist shows that American economic dynamism is still strong. New business applications have surged despite the onset of the pandemic.

 

 

Private non-residential investment is surging indicating the start of a strong capex cycle. In particular, the combination of China’s decoupling initiatives to free its semiconductor supply chain from the West and the West’s desire to open semiconductor manufacturing capacity in friendly countries is sparking an enormous capex revival.
 

 

Don’t count America out.

 

 

Biden’s challenges

In the short run, the Biden White House faces two key challenges that could unsettle risk appetite. The first is the looming debt ceiling. While lawmakers have always come to a last-hour agreement in the past, the Washington Post reported that a default or even a prolonged fight could have catastrophic consequences.

 

Mark Zandi, chief economist at Moody’s Analytics, found that a prolonged impasse over the debt ceiling would cost the U.S. economy up to 6 million jobs, wipe out as much as $15 trillion in household wealth, and send the unemployment rate surging to roughly 9 percent from around 5 percent.
The Bipartisan Policy Center estimates that the government will run out of funds some time between October 15 and November 4. Over at PredictIt, the odds of raising the debt ceiling by October 15 is fading fast.

 

 

The chances of a government shutdown is rising. Historically, the anticipation is worse than the actual pain. On one hand, the stock market hasn’t performed well leading up to debt ceiling showdowns.

 

 

On the other hand, the length of government shutdowns has risen but the stock market has performed well during those events. Sell the rumor, buy the news?

 

 

In addition, the Democrats are embroiled in an internal battle between the centrist wing and the progressive wing over the passage of the $3.5 trillion spending bill. There are two components of the bill of interest to investors. The first is the infrastructure and spending package. The IMF has estimated the jobs multiplier effect of government spending on different economies.

In advanced economies, $1 million of spending can generate an average of 3 jobs in schools and hospitals and over 6 jobs in the energy sector, assuming intermediate labor mobility and labor intensity levels. In low-income developing countries, the estimates are much larger and range from 16 jobs in roads to 30 jobs in water and sanitation. Put differently, each unit of public infrastructure investment creates more direct jobs in electricity in high-income countries and more jobs in water and sanitation in low-income countries.

 

 

The economic effects of the proposed social spending programs is difficult to project. However, some clues can be found in the last stimulus program, which was highly progressive, on differing households. A survey shows that spending was flat to slight up as household incomes categories rose, but the most striking effect is that lower-income households used the funds to pay off debt and strengthen their balance sheets. Unlike past recessions, loan delinquency rates fell instead of rising and poor households didn’t lose their houses and cars as they did in past recessions. If we were to extrapolate those effects, another fiscal impulse in the form of inequality programs such as daycare and tuition subsidies is likely to further strengthen lower-income household balance sheets and encourage more consumption.

 

 

The flip side of the $3.5 trillion coin is a corporate tax increase. Street consensus calls for the corporate tax rate to rise to 25% from 21%. Most top-down strategists are estimating a 5% decline in S&P 500 earnings as a consequence. Over at PredictIt, the market seems to have anticipated that outcome. Moreover, the recent 5% intraday peak-to-trough pullback in the S&P 500 would have discounted a 5% decline in earnings while keeping the forward P/E constant.

 

 

In conclusion, S&P 500 long-term breadth is deteriorating as the percentage of S&P 500 stocks above their 200 dma has retreated from a “good overbought” advance reading of 90%. Past episodes have resolved themselves either with a period of sideways consolidation or sharp pullback. Based on my analysis of the macro and technical backdrop, the sideways consolidation is the more likely scenario. Arguably, stock prices have been undergoing a period of sideways movement beneath the surface owing to the bifurcation between growth and value stocks. 

 

The Evergrande panic bottom?

Posted by Cam Hui -

Mid-week market update: The stock market gapped down on Monday on China Evergrande contagion fears. The technical outlook darkened further Tuesday when a rally attempt failed. The markets took on a risk-on tone this morning when Evergrande issued an ambiguous statement that a coupon due on its yuan-denominated bond. An agreement had been reached with its lenders but the statement didn’t specify the nature of the payment, or when it would be paid. 
 

While today’s rally is constructive for the bulls, the S&P 500 has yet to fill in the gap from Monday’s downdraft.
 

 

Was that the bottom?

 

 

Market bottom models

Three of the four components of my short-term market bottom model flashed signals on Monday. The 5-day RSI was deeply oversold; the VIX had surged above its upper Bollinger Band, and the NYSE McClellan Oscillator had fallen into oversold territory. The near-miss was the failure of the VIX term structure to invert, though it did briefly invert intraday Monday. Barring the appearance of further negative fundamental drivers, historically this has meant that a short-term bottom is near.

 

 

Other historical studies indicate risk/return is skewed to the upside. The % of S&P 500 stocks above their 10 dma is in extreme oversold territory. In the 18 instances over last five years, the 30-day subsequent median return return was 4.6%, wich a success rate of 83% – and that study includes the COVID Crash.

 

 

Rob Hanna at Quantifiable Edges also found that a three-day consecutive decline into an FOMC day has historically resolved bullishly.

 

 

 

Not out of the woods

Even though the historical studies show that risk/reward is skewed to the upside, bullish traders and investors are not totally out of the woods. Washington is still embroiled in a debt ceiling battle and Mark Hulbert has documented that the market does not perform well ahead of such deadlines, which is expected to be September 30.

 

 

I interpret current conditions as a bottom has either been reached, or the market is forming a complex W-shaped bottom. Downside risk should be limited unless the market is presented with another unexpected shock, though traders should be prepared for a retest of the old lows next week as debt ceiling anxiety continues. 

 

As I indicated (see How US equity investors should trade the Evergrande panic), my inner trader dipped his toe in on the long side on Tuesday. He will add to his position should the market retrace and retest the previous lows.

 

 

Disclosure: Long SPXL

 

How US equity investors should trade the Evergrande panic

Posted by Cam Hui -

Global markets have taken a decided risk-off tone today. The spark is the China Evergrande implosion. Fears are rising that Evergrande is turning from a liquidity crisis in which the company doesn’t have enough cash to pay its obligations, to a solvency crisis in which the company’s assets are less than its liabilities if it is forced to fire-sale its properties.
 

 

In the US, the S&P 500 had been largely immune to Evergrande news until today. The index decisively violated its 50 dma. Investors are becoming spooked not only over the possibility of an Evergrande contagion but a looming crisis in Washington over the debt ceiling.

 

Is this a buying opportunity, or a crack in the dam that foretells disaster?

 

 

A domestic crisis

Take a deep breath. An Evergrande collapse is unlikely to spark an emerging market crisis and contagion. That’s because most of the company’s debts are RMB denominated and little is in USD and other foreign currencies. John Authers rhetorically asked the same question:

So here is the key question: What kind of a moment will the Evergrande Moment be? Will it be a Minsky Moment, akin to the Lehman collapse? Or will it be more akin to the LTCM Moment? Or might it just be altogether less momentous? To measure this we need to resuscitate another concept of which many of us thought we had heard the last more than two decades ago: Asian contagion. How much effect will Evergrande’s troubles have on the rest of us?

Global markets have been relatively unscathed by the crisis. There will be little global contagion effect because it will all be contained in China.

So why is there still relative calm? It boils down to a close reading of the Chinese authorities’ intentions. They have no interest in staging their own Lehman. There has been alarm about the possibility of a Minsky moment for years in Chinese circles, frequently voiced out loud. Officials know what could happen and are determined to prevent it if they can. Efforts to rein in credit have been going on for years. And Evergrande is in trouble largely because the government itself decided to clamp down on property developers through the “three red lines” policy last year.

Authers concluded:

To be clear, an LTCM outcome isn’t great. It leaves the risk of more moral hazard. And while the PBOC can probably avert a full-blown credit crisis, it can’t stop the weakness of the property sector turning into disappointing economic growth for China. Many small savers and hopeful property buyers will inevitably be hurt by whatever deal can be thrashed out — and the  precise shape of that deal will matter a lot. But for the moment, world markets are nervous that this could be another LTCM, while comfortable that it won’t be a Lehman. On balance, both of these points look reasonable. Now let’s see what happens.

A number of bearish investors have pointed to plummeting iron ore prices as signs of slowing growth in China, which could have global repercussions. But George Pearkes at Bespoke pointed out that steel and other industrial metal prices are still holding up well.
 

 

Relax. Any contagion effect will be minimal.
 

 

A panic bottom?

In the US, the stock market is starting to flash signs of a panic bottom. The Zweig Breadth Thrust Indicator has plunged into oversold territory, which is often a signal of a short-term bottom.
 

 

My S&P 500 bottom models are starting to flash buy signals. The 5-day RSI is deeply oversold. The VIX Index has surged above its upper Bollinger Band, which is another oversold signal. The term structure of the VIX inverted intraday, indicating fear.
 

 

To be sure, this week (the week after September OpEx) is historically the weakest week of the year, as documented by Rob Hanna at Quantifiable Edges. However, Hanna pointed out that the average weekly “weakest week” drawdown is -2.3%. As the S&P 500 is -1.7% today, the index is nearing its average downside target.
 

 

While oversold markets can become more oversold, a bottom is near. Nevertheless, this market isn’t without risk. Mark Hulbert studied the stock market’s return in the two weeks prior to debt-ceiling showdowns and returns have been disappointing. As well, the FOMC meeting this week could be a source of volatility.
 

 

My inner trader plans to take an initial position on the long side in the S&P 500 at the open tomorrow morning. This is a volatile market and traders should size their positions accordingly. Be prepared for a short-term bounce, followed by a retest of the lows later this week or possibly next week.

 

A correction in time?

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.
 

 

The stealth correction?

For several weeks, I have been calling for a choppy sideways market, but the S&P 500 continues its upward grind. To be sure, the index pulled back about 2% last week and briefly tested its 50 dma, but its upward trajectory has been relentless. 

 

A discussion with another chartist raised the possibility that the market has been undergoing a stealth correction. As good technicians know, corrections can occur in price or in time. Beneath the surface, market internals have been correcting in both price and time. My equity risk appetite models have been trading sideways for much of this year.

 

 

Breadth indicators tell a similar story. While the S&P 500 Advance-Decline line has made fresh highs during the current advance, other versions of the A-D Line have been flat to weak. The weakest have been the NASDAQ and the S&P 600 small-cap A-D Lines. 

 

The tactical outlook is more constructive. Even as the S&P 500 tested the 50 dma and made a marginal low last Friday, all of the A-D Lines except for the S&P 500 did not make a fresh low.

 

 

 

The rolling correction

The rolling correction can be measured in many ways. One is the value/growth cycle. Large-cap growth makes up about 45% of the S&P 500 weight and dominates index movement, while value stocks comprise a smaller 31%. The disparity in weights explains the upward drift in the S&P 500 because of the recent leadership of growth stocks.

 

However, the value/growth ratio may be showing signs of turning up. The ratio is exhibiting a series of positive RSI divergence similar to the value bottom during the July to November period in 2020. In addition, relative breadth (bottom two panels) is showing signs of improvement.

 

 

Another reason for a possible turn in the value/growth cycle is complacency. Technology stocks, which form the bulk of the growth stock universe, are vulnerable to a setback, according to SentimenTrader.

 

 

Another manifestation of the stealth correction in time is the sideways and range-bound price action of small-cap stocks for most of 2021. While the small-cap/large-cap ratio is also exhibiting a constructive positive RSI divergence, I remain unconvinced of the bullish implications of this signal until the Russell 2000 and S&P 600 stage upside breakouts.

 

 

 

A bullish surprise

I encountered a positive surprise from the credit market. The relative price performance of junk bonds to their duration-equivalent Treasuries made a new high last week, indicating a strong credit market risk appetite.

 

 

Brian Reynolds of Reynolds Strategy pointed out that equities look cheap against junk bonds when the equity risk premium is calculated using junk bond yields.

 

 

 

The primary trend is up

These conditions tell me that we are experiencing a bull market. While I have few insights as to when the choppiness will end, short-term downside risk should be relatively limited. The latest AAII sentiment survey shows a dramatic drop in the bull-bear spread. Such a spike in bearishness in the face of a minor 2% peak-to-trough drop in the S&P 500 is bullish from a contrarian basis.

 

 

A tactical low looks near. The S&P 500 tested its 50 dma but the 5-day RSI flashed a minor positive divergence. As well, the VIX Index closed within a hair of its upper Bollinger Band, which would be a short-term oversold signal.

 

 

On the other hand, I was surprised by the inability of the term structure of the VIX to invert despite the recent market weakness. Neither the longer term one-month to three-month ratio nor the nine-day to one-day ratio inverted. I am open to the possibility that the market may need one final panic for a tradable bottom to appear. 

 

 

Next week’s FOMC meeting may be a source of volatility. As well, Mark Hulbert that stock prices tend to struggle ahead of a debt ceiling dispute, which is expected to occur in the next two weeks.

 

 

Investment-oriented accounts should remain bullishly positioned and be prepared to buy any weakness. Traders may wish to wait on the sidelines until a definitive trend becomes evident and be prepared to buy either the panic bottom or the upside breakout.

 

 

Not your father’s stagflation threat

Posted by Cam Hui -

Stagflation worries are rising. A recent analysis of search activity shows that searches for stagflation have spiked compared to other inflation search terms.
 

 

The latest BoA Global Fund Manager Survey also shows that stagflation concerns are rising.

 

 

These fears are misplaced. The conventional mechanisms for stagflation are not present. Instead, investors should be prepared for a different sort of stagflation threat.

 

 

What is stagflation?

When investors think about stagflation, they think back to the 1970s, which was a period of high inflation and anemic economic growth. Arguably, the roots of inflation began with Lyndon Johnson’s “guns and butter” policy in his conduct of the Vietnam War and his Great Society programs. The combination of overly expansive fiscal and monetary policies led to rising inflationary pressures, which eventually manifested themselves in the runaway inflation of the 1970s.

 

 

Fast forward to 2021. Top-down data shows the combination of strong positive inflation surprise and falling economic surprise. The combination of these factors is giving rise to stagflation fears.

 

 

Mohamed El-Erian recently wrote a Financial Times Op-Ed warning about stagflation risks.
 

The culprit is some mix of disrupted supply chains, high transportation costs, container scarcity and congested ports…

 

Fewer chief executives have confidence that such disruptions are temporary and quickly reversible. This will restrain growth plans despite robust demand, and increase pressure to raise prices to offset higher costs…Such reversible factors are accompanied by supply side troubles that could last for one to two years, if not more

 

Added to inflation already in the pipeline, all this translates into stagflationary winds for the global economy that are unfamiliar to those that did not live through the 1970s.

 

 

Misplaced fears

These fears are misplaced. I have argued in the past (see How to engineer inflation), that the conventional models for explaining inflation have been unsatisfactory.
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.

 

 

Instead, investors should focus on the evolution of wage gains as the key factor to inflation pressures. The Fed has stated that it is focused on wage inequality as an additional metric of labor market tightness and it will conduct monetary policy accordingly. 

 

The following factors do not indicate a return to a stagflation environment over the next few years.
  • Inflation pressures are transitory.
  • The economy is embarking on a capital expenditure cycle, which should keep inflation contained.
  • The Misery Index is tame.

 

 

Transitory inflation

Here is why Fed policymakers believe that inflation pressures are largely transitory. Most of the inflation has been concentrated in durable goods, which are subject to supply chain bottlenecks. The August CPI print came in below expectations, which was positive for the doves in the FOMC. Even Owners’ Equivalent Rent, which has a significant weight in CPI and has been a subject of concern for many economists, was tame.

 

 

In addition, IMF Chief Economist Gita Gopinath pointed out that high inflation is correlated with “the speed of recovery and bounce back in demand”. This is indicative of a cyclical effect that is undoubtedly affected by short-term shortages.

 

 

There are signs that the supply chain disruptions are beginning to ease. Bloomberg reported that “Shipping Lines Think Spot Rates Have Peaked”.
 

One of the world’s biggest shipping lines has decided to stop increasing spot freight rates on routes out of Asia to Europe and the U.S. as it sees an end to the rally that has seen prices hit records.

 

Hapag-LLoyd AG thinks spot rates have peaked and further increases are “not necessary,” according to Nils Haupt, the Hamburg-based company’s head of corporate communications. The move comes after French rival CMA CGM SA last week froze rates, saying it was prioritizing long-term relationships following a rally that has seen some spot rates jump more than sixfold in the past year.  

 

 

A new capex cycle

Rising capital expenditures is another factor that should put conventional stagflation fears to rest. 

 

The monthly NFIB report is useful because small businesses are sensitive barometers of the economy because of their lack of bargaining power. The latest report shows that small business plans for raising prices are skyrocketing, indicating short-term inflation pressures. However, capex plans are rising as well, which should increase productivity, raise the growth outlook and act to restrain inflation pressures. 

 

 

From a longer-term perspective, the US economy looks poised to enter a strong capex cycle. If the definition of stagflation is high inflation and weak economic growth, a strong capex cycle will mitigate those concerns.

 

 

 

A tame Misery Index

During the 1970s, economists created the Misery Index by adding the inflation rate to the unemployment rate as a way of measuring the stagflation stresses on the economy. Today, the Misery Index has spiked but started to roll over.

 

 

If the market narrative of transitory inflation is correct and the recovery continues, the Misery Index should continue to fall. Is this what stagflation looks like?

 

 

A different source of stagflation risk

While conventional models indicate that stagflation risk is low, former Fed economist Claudia Sahm (of the “Sahm Rule” fame) proposed a different scenario of stagflation. Sahm acknowledged the temporary inflationary nature of supply chain bottlenecks.

 

It’s also important to keep a historical perspective. Supply chain disruptions are not new, though today’s is more widespread than in the recent past. For example, the earthquake and tsunami that hit Japan in March 2011 disrupted supply chains and risked upward pressures on inflation, as noted by Mohamed A. El-Erian:

 

Third, the Japanese disasters are not happening in isolation. They add to the supply shock that the global economy already faces due to the uprisings in the Middle East and the related increase in oil prices. As such, the risk of a global macro tipping point cannot, and should not, be ignored.
Hawks gonna squawk, people. As with now, the Federal Reserve viewed the supply chain disruption in Japan as a temporary risk to inflation and economic activity in the United States. Accordingly the Fed did not view a change in monetary policy as an appropriate response. The following is from a special section in the staff forecast for the FOMC (now public) on “Economic  Effects of the Earthquake  in Japan”.
 

Dislocations in Japan resulting from the earthquake are likely to affect foreign economies through three main channels:  Diminished Japanese demand for other countries’ exports, lower foreign direct investment and portfolio flows from Japan, and disruptions to cross‐country supply chains.  We expect the first two channels to be fairly minor, given that Japan accounts for a relatively small share of trade and investment inflows for most countries, especially outside of Asia.  Disruptions to supply chains represent the main concern at present.  Some Asian producers, particularly in the high‐tech sector, are highly dependent on intermediate inputs imported from Japan.  However, although production in certain firms and sectors is being disrupted, the aggregate results will likely be limited.  Many of the Japanese plants that shut down in the aftermath of the earthquake are already back on line, though not yet at full capacity, and there is scope for resourcing to alternative suppliers.  All told, we expect the earthquake to shave about ½ percentage point from GDP growth in emerging Asia in the second quarter, with this negative effect unwinding in the second half of 2011 as normalization in activity and Japanese reconstruction increase demand for industrial supplies and capital goods.  The effect on GDP growth in the advanced economies is likely to be even smaller, with modest disruptions reported to production of motor vehicles in the United States, Europe, and Canada because of shortages of auto parts from Japan.
She rhetorically asked, “What if the supply chain disruptions became more frequent as climate change disasters become more commonplace?”
 

We should take today’s disruption as a warning. I heard early in the pandemic someone refer to Covid as our dress rehearsal for climate change. It ain’t looking good. Covid is a global crisis and its toll on human life is crushing. That said, we have a vaccine that works, and we will eventually contain the pandemic enough that we will work around the current economic log jams.

 

Climate change is a whole different ballgame. No company is going to engineer a cure over the weekend. Complain about the FDA now? Get ready for lots more complaining. Supply chain disruptions will not be the biggest problem we have during climate disasters, but Covid underscores some of the economic costs on the horizon. We are interconnected globally and as result, we are in this together. The answer now is to get vaccines to the world community as fast as possible. The United States should be leading with more great urgency. We are not. Climate change? Good luck with that.

Climate change is a controversial subject in many circles and the pros and cons of the topic are beyond the scope of this publication. Nevertheless, the world has seen an unusual series of heatwaves and floods in 2021 which has been attributed to climate change. Should they continue, these disasters raise the risk of further supply chain disruptions in the years ahead. While conventional triggers of stagflation are under control, a rolling series of inflationary spikes could trigger a period of inflationary volatility and slowing growth. Investors need to be prepared for this risk of stagflation for an unusual source.
 

 

The ESG solution

Investors can guard against this unusual source of stagflation risk with diversification into ESG investing. ESG stands for Environmental, Social, and (corporate) Governance, which is used as an ethical investing discipline.

 

The idea of ethical investing is nothing new and it has been around for a long time. The approach was only recently re-branded as ESG investing.  There has been a stampede into ESG investing in the last few years. According to Bloomberg Intelligence, total ESG assets are expected to quadruple by 2025.

 

Global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total assets under management. A perfect storm created by the pandemic and the green recovery in the U.S., EU and China will likely reveal how ESG can help assess a new set of financial risks and harness capital markets.

 

 

Indeed, ESG investing has the potential to become extremely popular. A recent Pew Research survey shows more and more people around world are growing concerned about climate change. 

 

 

However, ESG investing comes with an important caveat. ESG funds tend to have a technology and growth tilt. That’s because it’s far easier for a company like Microsoft to qualify under an ESG screen than Exxon Mobil. The “E” in ESG investing has caused a close correlation of ESG to growth investing.

 

 

There are also short-term risks. The top two categories in the latest BoA Global Fund Manager Survey are long technology and long ESG, which amount to almost the same factor exposure.

 

 

In summary, ESG diversification could be an important source of long-term portfolio stability should climate change spark a rolling series of supply chain disruptions. However, investors who adopt this strategy may face the near-term risks of underperformance.

 

Evergrande catastrophe = Lehman Moment?

Posted by Cam Hui -

13 years ago yesterday, Lehman Brothers fell into bankruptcy. Today, the world is watching China Evergrande collapse in a debt spiral. The overly indebted property developer told China’s major banks that it won’t be able to pay loan interest due Sept. 20. The company has been swamped with protests from individuals who invested in its paper through wealth management products, its employees and suppliers who haven’t been paid, and numerous buyers who paid deposits for properties that haven’t been constructed.
 

 

 

Systemic risk

How did Evergrande get here? The tale is a familiar one. It overindulged on a debt-fueled expansion spree during the boom years. In addition to property development, which is a high leverage business, the company dabbled in non-core businesses like electric cars and bottled water. Reckoning arrived when regulators pressured overly indebted companies like Evergrande to pare its debt, which forced it to sell non-core businesses and cut prices on its properties to raise cash. Then the real estate boom slowed.

 

A Reuters article explained the systemic risk posed by the Evergrande collapse.
 

China’s central bank highlighted in 2018 that companies including Evergrande might pose systemic risks to the nation’s financial system.

 

The leaked letter last year said Evergrande’s liabilities involve more than 128 banks and over 121 non-banking institutions. JPMorgan estimated last week China Minsheng Bank (600016.SS) has the highest exposure to Evergrande.

 

Late payments could trigger cross-defaults as many financial institutions have exposure to Evergrande via direct loans and indirect holdings through different financial instruments.

 

In the dollar bond market, Evergrande accounts for 4% of Chinese real estate high-yields, according to DBS. Any defaults will also trigger sell-offs in the high-yield credit market.

 

A collapse of Evergrande will have a large impact on the job market. It has 200,000 staff and hires 3.8 million people every year for project developments.
The NY Times highlighted an additional systemic risk posed by Evergrande’s deleveraging.

 

Much of the cash that Evergrande has been able to drum up has come from presold apartments that aren’t yet completed. Evergrande has nearly 800 projects across China that are unfinished, and as many as 1.2 million people who are still waiting to move into their new homes, according to research from REDD Intelligence.

 

Evergrande has slashed prices on new apartments but even that has failed to entice new buyers. In August it made a quarter fewer sales than it did a year ago.
Some 70-80% of Chinese household savings have gone into real estate. If Evergrande were to go bankrupt and be unable to deliver on presold apartments, the household sector’s finances would take a major tumble. In addition, Evergrande’s forced liquidation will put downward pressure on property prices. In the past, the way to wealth for the ordinary Chinese is to scrimp together enough of a down payment to buy an apartment and watch prices rise as the real estate boom has become a one-way street. Protests over a falling real estate market have the potential to destabilize the economy and the Chinese Communist Party.

 

 

 

Market fallout

Evergrande’s bonds have collapsed before trading was halted and the bonds of other developers have also significantly weakened.

 

 

The shares of other property developers have fallen in sympathy and violated long-term technical support levels.

 

 

 

Contagion risk

Today, we have the dream scenario of the China bears. The combination of the Evergrande catastrophe and the Huarong Affair should shake the confidence in the Chinese financial system and see contagion risk ripple past its borders. Instead, real-time market signals indicate that contagion risk has been ring-fenced within the Chinese property development sector.

 

The Chinese yuan should be falling. Instead, it has been relatively strong.

 

 

By informing banks that the interest payments due on September 20 will not be paid, an Evergrande default is imminent. That should create stresses in the financial system, right? Instead, the relative performance of Chinese financials (red dotted line) is outpacing the relative performance of US financials (black line) and European financials (green line).

 

 

Another indirect way of measuring the strength of the Chinese economy is through commodity prices as China is a voracious consumer of commodities. Commodity prices reached a fresh all-time high yesterday and the cyclically sensitive base metals/gold ratio has been strengthening.

 

 

Industrial commodities have also been strong.

 

 

Equally surprising is the relative strength of Chinese material stocks relative to global materials.

 

 

In short, contagion risk has been contained. If the Evergrande catastrophe were to become China’s Lehman Moment, these risks would be evident in most of the indicators that I have cited.

 

Does that mean that foreign investors in China should view this as a buying opportunity? Not so fast. Fund flow statistics show that as foreigners pile into China, the locals are selling and taking their money offshore.

 

 

Who is the “smart money” and who is the “dumb money”? 

 

Foreign Devils beware!

 

 

Another test of the 50 dma

Posted by Cam Hui -

Mid-week market update: As the S&P 500 revisits the area around its 50 dma, will the weakness persist or will it be halted? The index has found good support at the 50 dma all of this year. Equally constructive is the bull flag pattern being traced out by the S&P 500, though the index hasn’t staged an upside breakout through the flag yet.
 

 

Bespoke pointed out that the most recent losing streak is just the seventh time since the GFC that the S&P 500 closed at a record high and then fell for five consecutive days. The only time the decline didn’t halt was the COVID Crash.

 

 

 

Bearish enough?

Sentiment models indicate that a deep pullback is unlikely. A recent Deutsche Bank survey of institutional investors shows that a 5-10% correction has become the consensus view.

 

 

An IHS Markit survey of US investment managers also shows that risk appetite is plunging. The survey readings are consistent the results from trade settlement data.

 

The IMI survey results align with the equity trade settlement data we analyze on behalf of our 850 US-listed clients, representing $22T in market capitalization. During the first week of September, institutional investors reduced exposure to nine out of ten macro sectors with the consumer discretionary and industrial sectors experiencing their fifth consecutive week of outflows.

 

 

Bloomberg reported that Jason Goepfert observed a dramatic increase in nervousness in the option market. The spread between the VIX Index and realized volatility is highly elevated.

 

Sundial looked at what happened before when the S&P 500 was within 1% of a record and the Cboe Volatility Index’s divergence from S&P 500 30-day realized volatility was in the upper 75% of its range. 

 

That scenario’s occurrence last week was the ninth time it had manifested going back to at least 1995. Over the previous eight instances, the next one to four weeks saw the S&P struggle to hold any meaningful gains. But over the next two months, it rallied every time, Sundial’s Goepfert said. There were no occasions when major losses hit equities over the longer term.

 

 

In the short run, sentiment is nearing a bearish extreme. Helene Meisler conducts an (unscientific) Twitter poll every weekend. The latest results show a net bull rating of -18. In the brief history of the poll, the market has rallied whenever the reading is -10 or less. Will this week be an exception?

 

 

 

One final flush?

The latest Investor Sentiment poll shows bullishness in retreat, but bearishness hasn’t spiked. The constructive view is the market is ripe for a relief rally. A more skeptical take is the market may need one final flush before it can make a durable bottom.

 

 

Mark Hulbert believes that sentiment isn’t sufficiently bearish for the market to sustainably rally.

 

Don’t expect U.S. stocks to mount anything more than an anemic rally in coming weeks. That’s because there’s still too much bullish sentiment. According to contrarian analysis, the most impressive rallies begin when there is widespread pessimism, just as market risk is highest when there is widespread optimism.

 

The chart below paints the picture. It plots the average recommended equity exposure level among a subset of Nasdaq-focused stock market timers I monitor (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). The HNNSI is my most sensitive barometer of stock market sentiment.

 

 

I am open to the possibility that market psychology may need that final flush to signal a capitulation bottom. My market bottom models aren’t flashing buy signals just yet. We may need one last panic when the S&P 500 breaches its 50 dma before a short-term buying opportunity presents itself. 

 

 

This Friday is quad witching expiry and could be the source of some price volatility. If the S&P 500 fails to stage an upside breakout through the flag pattern, will quad witching be the catalyst for a buy signal?

 

Breadth can show the way

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.
 

 

The BB ride ends

Last week, I pointed out that the S&P 500 had gone on a ride on the upper Bollinger Band. The upper BB ride ended with the market pulling back. What’s next?

 

 

The clues to the next major move in the S&P 500 can be found in breadth indicators.

 

 

A difference in breadth

A review of the different versions of the Advance-Decline Line reveals some key differences. The S&P 500 A-D Line is the strongest and it has confirmed the continued advance of the index. The NYSE and midcap S&P 400 A-D Lines are struggling to overcome overhead resistance. The weakest is the smallcap S&P 600 and the NASDAQ A-D Line, which is a surprise given the strength of NASDAQ stocks.

 

 

The relative performance of the NASDAQ 100 tells the story of large-cap growth leadership. Even as the NASDAQ 100 is in a relative uptrend against the S&P 500, the relative performance of the Equal-Weighted NASDAQ 100 to the cap-weighted NASDAQ 100 and the NASDAQ 100 A-D Line are falling.

 

 

 

Waiting for a small-cap signal

I am also waiting for a signal from the high-beta small-cap stocks, which have been range-bound for most of 2021. The relative performance of small stocks bottomed out mid-August, and so did relative breadth (bottom panel). Since then, progress has stalled.

 

 

While valuation doesn’t matter much in the short term, it does matter in the long term. The relative forward P/E of the S&P 500 compared to the S&P 600 is back to 2001 levels.

 

 

The relative performance of the size factor, or small-caps, is linked to the value/growth cycle. An analysis of the evolution in weights of value sectors in the top 50 and bottom 450 of the S&P 500 is revealing. Value stocks have been falling in the weight of the top 50 in the last 10 years while their weight in the bottom 450 has been relatively stable. A small-cap revival should, all else being equal, provide a tail-wind for value.

 

 

 

Credit market signals

The current environment should be a period when small-caps shine. Since small companies tend to be of lower quality, I have often highighted the relative performance of junk bonds as a credit market risk appetite signal. So far, the junk bond market is tracking the performance of the S&P 500 fairly well in the last two months.

 

 

S&P reported that there have been far more rating upgrades than downgrades in junk bonds, which indicates the positive effects of the recent recovery. This should be supportive of higher stock prices from a cross-asset perspective.

 

 

 

Where’s the bottom?

The S&P 500 has fallen for five consecutive days, but the drawdown over that period is only -1.7%. The market is oversold short-term and should bounce early in the week.

 

 

However, the decline may not be over. Only one of the components of my tactical bottoming model, namely the 5-day RSI, has been triggered. The VIX Index hasn’t spiked above its upper BB’ the term structure of the VIX hasn’t inverted; and NYMO hasn’t fallen into oversold territory.

 

Should the weakness continue, an obvious support level would be the 50 dma at 4424. Pullbacks in 2021 have been shallow and arrested at the 50 dma. Barring a macro or major fundamental trigger, the current episode should not be any different.

 

 

In conclusion, the stock market has begun to pull back after an upper Bollinger Band ride. The clues to the next major directional move can be found in breadth indicators, which are mixed, and small-cap stocks, which remain range-bound. In addition, the small size effect is indirectly linked to value. An upside breakout by small-cap stocks should be bullish for value stocks, while a downside breakdown should see leadership by large-cap growth.

 

Stay tuned.

 

A time for caution, or contrarian buy signal?

Posted by Cam Hui -

Recently, a number of major investment banks have published warnings for the US stock market. The strategists at BoA, Citigroup, Credit Suisse, Deutsche, Goldman Sachs, and Morgan Stanley have issued either bearish or cautionary outlooks. 

On the other hand, Ryan Detrick at LPL Financial documented the effects of strong price momentum on stock prices.

History says that great starts to a year tend to see continued strength the final four months. “Looking at the previous top 10 starts to a year ever, the final four months have gained eight times,” explained LPL Financial Chief Market Strategist Ryan Detrick. “So should we see any seasonal weakness, we’d use it as an opportunity to buy before likely continued strength.”

 

 

In these circumstances, I am reminded of Bob Farrell’s Rule 9, “When all the experts and forecasts agree – something else is going to happen.” How should investors react? Turn cautious, or is this a contrarian opportunity to buy the dip?

 

 

The earnings challenge

As I see it, there are several challenges and open questions for equity bulls. The most important question is whether companies can maintain the forward earnings momentum exhibited in the past year. FactSet reported that forward 12-month EPS estimates are still rising strongly. Rising estimates are supportive of better stock prices because the E in the forward P/E ratio is advancing. Can it continue?

 

 

John Butters of FactSet reported that Q3 estimates have bucked the usual trend of downward estimate revisions and rose instead.
 

In a typical quarter, analysts usually reduce earnings estimates during the first two months of the quarter. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 2.4%. During the past 10 years (40 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.0%. During the past 15 years (60 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.6%.

 

In fact, the third quarter marked the fourth-largest increase in the bottom-up EPS estimate during the first two months of a quarter since 2009. It also marked the fifth straight quarter in which the bottom-up EPS estimate increased during the first two months of the quarter. However, the third quarter is also the first quarter during this current streak in which the percentage increase in the bottom-up EPS estimate was smaller than the previous quarter.

 

 

As we approach the Q3 earnings season which begins in October, can EPS growth maintain its momentum? What will companies say in their earnings calls about the outlook?

 

That’s an important open question that’s yet to be resolved.

 

 

The top-down view

To resolve that question, here is where top-down macro analysis can supplement the bottom-up company analyst view. GDP growth forecasts are stalling. Q3 growth forecasts are rolling over while Q4 growth has flat lined. These are conditions not friendly for the Q3 and Q4 earnings outlook.

 

 

As a second opinion, New Deal democrat’s methodology of coincidental, short-leading, and long-leading indicators is a useful framework for evaluating the economy. His short-term forecast is positive for the rest of 2021, which should be positive for Q3 and Q4 earnings season. 

 

However, he warned that “there are several sectors suggesting the economy is going to weaken substantially by mid year 2022, although no recession is forecast at this point”. Since the stock market is a forward looking indicator, economic softness in mid-2022 could translate into some sloppiness for equity prices in the coming months.

 

 

 

A friendly Fed

One factor that is likely to put a floor on stock prices is the supportive monetary policy of the Fed and other global central bankers. So far, the market has accepted the central banker transitory inflation narrative and taken the recent inflation spike in stride.

 

 

IMF chief economist Gita Gopinath recently outlined her forecasts for transitory inflation spikes in the US and eurozone. Transitory inflation is now defined as quarters and not months. She added, “The difference between US and EA non-energy goods inflation is particularly striking (eg. used car prices).”

 

 

Already, the month-on-month PCE change is decelerating. This will give ammunition to the doves in the FOMC to stay with an easy monetary policy.

 

 

When investors think about rising inflation, the most obvious example is the 1970’s. Arguably, the current environment more resembles the late 1940’s and early 1950’s, when the Fed was more tolerant of inflation as the economy exited World War II and the resulting inflation in the wake of war related shortages.

 

 

The wildcard is government policy. Jerome Powell’s term as Fed chair is expiring. While the White House appears to favor his reappointment, progressive Democrats in Congress are pushing for a tougher bank regulator.

 

 

Fiscal policy: Threats and opportunity

Investors will also have to contend with the threats and opportunity from fiscal policy. David Leonhardt of the NY Times explains that the Democrats want to enact their agenda in anticipation that they will lose control of Congress in the 2022 mid-term elections.

 

Early in Bill Clinton’s presidency, House Democrats voted to pass an energy tax, known as the B.T.U. tax, only to watch the Senate prevent the bill from becoming law. In the next midterm elections, more than 25 of the House Democrats who had voted for the bill lost re-election.

 

Early in Barack Obama’s presidency, history repeated itself. House Democrats voted for a cap-and-trade plan to address climate change, and the Senate blocked the bill. In the next midterms, many House Democrats struggled to defend their votes.

 

That history helps explain the approach that congressional Democrats are taking on the biggest piece of President Biden’s agenda — a $3.5 trillion plan to slow climate change, expand health care and education, cut poverty and increase taxes on the wealthy.

 

Many House Democrats are worried about “getting B.T.U.’d” again, as some have put it. They do not want to take a tough vote that ends up having no policy impact. “Some of us were here in 2010, when we took certain votes,” Henry Cuellar, a Texas Democrat, has said, “and the Senate didn’t take certain votes.”

 

In response, House Democrats are insisting that the two chambers negotiate up front over what bill they can each pass. Only after they have reached a deal will the House vote on it, Speaker Nancy Pelosi has suggested.

 

Those negotiations have begun, and they will proceed quickly over the next few weeks. By the end of September, the fate of the bill — and, by extension, Biden’s bid for a consequential presidency — will probably be clear.
The opportunity is an expansive fiscal policy that will boost consumer confidence and spending. The threat of the proposed corporate tax increases, which Street strategists estimate will cut 5-9% of S&P 500 earnings, all else being equal. Barron’s recently published a warning on the effects of a higher corporate tax rate (see Investors Are Ignoring the Tax Elephant in the Room). As the fears of a corporate tax increase creep into the market narrative, it has the potential to unsettle investors and spark a correction.

 

However, it is unclear whether a complete legislative package will ever be passed. Democratic leaders are negotiating with holdouts like Senator Joe Manchin, who holds the balance of power and has presented a long wish list that may scuttle the deal. The stakes are high. Fiscal drag is forecast to be sharply negative because of the expiry of UI benefits.
 

 

 

A mid-cycle pause?

Putting it all together, how worried should investors be? Here is the big picture. Recessions are bull market killers and there is no sign of a recession in sight. Long-term investors should not panic.

 

 

However, the economy may be due for a mid-cycle pause. If history is any guide, this is the time when consumer confidence starts to stall. The wildcard is fiscal policy. Should Biden and the Democrats be successful in passing a fiscal package, it could provide a boost to consumer spending at the price of higher tax rates.

 

 

Every cycle is different, but this is also the point in the cycle when inflation expectations start to move sideways. The key difference is the determination of the fiscal and monetary authorities around the world to maintain stimulus.

 

 

Callum Thomas at Topdown charts also studied the behavior of upside to downside equity volatility. Spikes in the upside/downside volatility ratio are the characteristic of recoveries off a recessionary bear market. It is usually resolved with either a sideways consolidation or a minor corrective phase.

 

 

The immediate downside risk is probably limited. SentimenTrader recently observed that there is an enormous appetite for downside put protection: “A trader in S&P 500 options would have to go 40% out of the money to buy a put with the proceeds of selling a call that is only 10% out of the money. This is a sign of extreme hedging demand, the highest in several years.”

 

 

My base case scenario calls for a period of market sloppiness for the rest of 2021. After that, forecasting becomes too difficult because of too many uncertainties.

 

 

 

Uncertain leadership

Another open question is what happens to market leadership. The recent spike in the 10-year Treasury yield argues for a rotation from growth to value. Analysis of the proposed tax increases is more negative for technology and drug stocks, which are subject to a corporate minimum tax on intellectual property held in offshore subsidiaries (see The market risk hiding in plain sight).

 

 

On the other hand, recent market action has shown that investors have piled into large-cap growth stocks as a safe haven whenever the growth outlook falters. Indeed, the NASDAQ 100 remains in a well-defined relative uptrend despite rising yields.

 

 

Market leadership depends on a number of questions that need to be answered.
  • How will Q3 earnings season behave? Are expectations too high or will companies continue to beat estimates?
  • What will happen to fiscal policy? If the Democrats pass their $3.5 trillion package, will the positive effects on consumer spending offset the negative effects of a corporate tax increase?
  • What about monetary policy? Will Biden reappoint Powell as the chair of the Federal Reserve?
In conclusion, I expect a period of choppiness and market volatility for the remainder of the year. Long-term investors should remain fully invested. Downside risk shouldn’t be more than a normal 10% correction, which represents typical equity market risk. There are many open questions about market leadership. A prudent course of action would be to hold a diversified portfolio as a way of addressing near-term uncertainties.