Respect the uptrend

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.
 

 

Brace for minor bumpiness

It finally happened. After all of the warnings about negative breadth divergences, it looks like the S&P 500 took a pause from the upper Bollinger Band ride that I identified last week.

 

 

While the stock market may experience some minor bumpiness, investors should nevertheless respect the market’s uptrend and expect any pullback to be relatively shallow.

 

 

Warning signs

The warning signs were all there. In addition to the breadth divergences, sentiment models were indicating capitulation by bearish traders. The latest Investors Intelligence survey were showing that the percentage of bears had fallen to 15.5%, which is a reading that was only exceeded in 2018.

 

 

Despite the renewed NASDAQ leadership, its internals were weak. SentimenTrader observed that the NASDAQ Composite achieved a 52-week high last week on record poor breadth.

 

 

 

Still an uptrend

While short-term breadth has been negative, long-term breadth remains constructive. The percentage of S&P 500 stocks above their 200 dma remains above 90%. This is the characteristic shown by the market in strong uptrends.

 

 

 

Pullbacks should be shallow

Another warning had appeared in the correlation of the S&P 500 with VVIX, or the volatility of the VIX Index. Spikes in correlation have tended to resolve with market weakness about two-thirds of the time (blue vertical lines=continued strength, red=weakness). With only one exception in the last three years, pullbacks have been a relatively shallow -5% or less.

 

 

If the market were to weaken, the bottom has been signaled by a spike by the VIX Index up to its upper Bollinger Band.

 

Another reason for my belief of a shallow market weakness can be found in the lack of cross-asset warnings. The relative performance of junk bonds to their duration-adjusted Treasury counterparts remains benign. Credit markets are not signaling any signs of significant stress.

 

 

To be sure, a minor negative divergence has occurred in one of my equity risk appetite indicators. The ratio of high beta to low volatility stocks is falling more than the S&P 500. On the other hand, the equal-weighted ratio of consumer discretionary to staples, which minimizes the outsized influence of Amazon and Tesla in the consumer discretionary sector, is flashing a neutral reading as it is tracking the movement of the S&P 500.

 

 

If the S&P 500 were to weaken, the tactical window for a decline opens early in the week. Breadth is overbought and the market is ripe for a pullback.

 

 

Q2 earnings season then kicks off Tuesday when the banks begin their reports. Brace for volatility.

 

 

In summary, the stock market may finally be undergoing a minor corrective episode after numerous warnings of negative breadth and excessively giddy sentiment. However, the intermediate-term trend is still up. If history is any guide, downside risk should be limited to -5% or less. 

 

Respect the uptrend. Buy the dip.

 

 

Seven reasons to fade the growth scare

Posted by Cam Hui -

It is astonishing to see the market narrative shift in the space of only a few months from “inflation is coming” to a growth scare. In late March, the 10-year Treasury yield topped at over 1.7% and the 2s10s yield curve was steepening. Today, the 10-year has decisively broken support and the yield curve is flattening, indicating fears of slowing economic growth.
 

 

In late May, I forecasted bond market price strength and called for a counter-trend rally in growth stocks (see What a bond market rally could mean for your investments) but the latest move in both yields and growth appear exhaustive. As evidence of the change in psychology, Bloomberg reported that put option premiums over calls on the 10-Year Treasury Note have vanished. Traders are now paying more for call options than put options.

 

 

Here are seven reasons why investors should fade the growth scare.

 

 

Lack of cross-asset confirmation

As a reminder, I outlined a scenario of decelerating economic growth (see How to navigate the mid-cycle expansion) in last week’s publication.

 

The bearish scenario, which is becoming the consensus one, would see a stalling in economic growth and momentum, causing the Fed to take a more dovish tone, Treasury yields to pull back, the yield curve flattens, put upward pressure on the USD, which would be negative for commodity prices. Growth stocks would regain market leadership as investors pile into growth stocks when growth becomes scarcer, and value stocks lag owing to their high cyclical exposure. 

While investors have bought growth stocks because of the perception that growth is becoming scarce, many other cross-asset signals have not confirmed the growth slowdown. While the 10-year Treasury yield has broken technical support, the USD Index is still trading below a key resistance level. If the global economy is indeed slowing, the USD would be an important safe haven asset that should be rallying hard.

 

 

Commodity prices are also not signaling a major deceleration in growth. Commodities remain in an uptrend and they are holding above their 50 and 200 dma. In addition, the cyclically sensitive and base metals to gold ratio remains firm and exhibiting a positive divergence against the 10-year Treasury yield.

 

 

 

Value poised for a comeback

Another cross-asset signal can be found in equity style performance. The relative performance of growth stocks, as measured by the NASDAQ 100 to S&P 500 ratio, is correlated to bond yields. That’s because growth stocks are high duration assets that are more sensitive to changes in interest rates. Indeed, growth stocks have rallied on a relative basis as bond yields have fallen (inverted scale).

 

 

The relative performance of value to growth has gone global. Not only are value stocks lagging in the US, but internationally as well. A closer look at the Russell 1000 Value to Growth ratio shows a positive RSI divergence in favor of value. As well, the relative breadth of value to growth may also be bottoming.

 

 

 

A value hiccup in an uptrend

Jason Goepfert of SentimenTrader believes the “Pounding of Value Stocks May Be Nearing an End”. The setback experienced by value stocks is occurring in the context of a relative uptrend, as defined by a rising 200 dma.
 

One difference with the recent losses is context – it’s happening in an uptrend. Unlike the large rolling 1-month losses during much of 2020, the 200-day average of the Value/Growth Ratio is rising.

 

If we focus on large declines in the ratio only within uptrends, we can see that losses this large have typically resulted in the trend reasserting itself rather than sliding into another long-term downtrend. The ratio was extremely volatile in the 1930s, so many of the precedents were triggered then.

 

 

 

Growth stocks are highly extended

I recently pointed out (see U-S-A! U-S-A! But for how long?) that investors have piled into US equities as a safe haven in the current growth scare and the relative performance of US equities are highly correlated to the growth/value ratio. The relative performance of the S&P 500 is highly extended, though it staged an upside breakout through relative resistance.

 

 

Mark Hulbert observed that NASDAQ sentiment is at a crowded long condition: “Timers my firm monitors who focus on the Nasdaq in particular are, on average, more bullish now than on 94% of all trading days since 2000. (That’s according to my firm’s Hulbert Nasdaq Newsletter Stock Sentiment Index, or HNNSI.)”

 

One anomaly to the growth leadership is the lagging performance of speculative growth stocks. Even as the relative performance of the NASDAQ 100 rose, the ARK Innovation ETF (ARKK) weakened both on an absolute and relative to the S&P 500.

 

 

 

Earnings Revisions Are Strong

As we approach Q2 earnings reporting season, EPS estimates are also rising strongly. There are no signs of slowdown or deceleration.

 

 

Q2 earnings seasons may be a challenge because forecast growth rates are very high owing to low base effects. However, companies have historically managed expectations well so that they have beaten estimates.

 

 

In addition, FactSet also pointed out that forward guidance is extremely strong. The risk of a disappointing earnings season should be fairly low.
 

For Q2 2021, 37 S&P 500 companies have issued negative EPS guidance and 66 S&P 500 companies have issued positive EPS guidance. If 66 is the final number, it will mark the highest number of S&P 500 companies issuing positive EPS guidance since FactSet began tracking guidance in 2006

 

 

Delta and Lambda: Under control

One of the reasons advanced for a growth scare is the rising prevalence of different COVID-19 variants which could lead to renewed lockdowns that put the brakes on a recovery. Joe Wiesenthal documented the UK experience with the Delta variant, which has ripped through that country. The red line is the five-day moving average of new COVID cases, while the green line is the five-day moving average of COVID deaths. The UK is one of the most vaccinated countries in the developed world. Vaccines work to mitigate the effects of the pandemic.

 

 

As well, concerns over a new Lambda variant is beginning to appear. An article in MedPage Today explains:

 

Yet another SARS-CoV-2 variant is making headlines, but experts reassure that early evidence suggests it can’t substantially evade vaccines — though it does have potential to become a variant of concern, one expert said.

 

The Lambda (C.37) variant, first identified in Peru in December 2020, now accounts for the majority of infections there, and is on the rise in other South American countries, including Argentina, Ecuador, Chile, and Brazil.
MedPage Today interviewed researcher Nathaniel Landau, PhD, a virologist at NYU Grossman School of Medicine, who found the new mutation appears to increase viral transmissibility and it is more resistant to current vaccines:

 

The  novel mutations in spike may contribute to increased transmissibility, and could result in greater reinfection rates or reduced vaccine efficacy, the researchers reported. Their analysis showed that Pfizer serum samples were about 3-fold more resistant to neutralization, and Moderna samples were about 2.3-fold more resistant. Convalescent plasma was about 3.3-fold more resistant, while Regeneron’s monoclonal antibody combination had no loss of antibody titer, the group said.
Alarming? Well, not really.

 

“The typical titer for someone who is vaccinated is 1:2,000,” Landau told MedPage Today. “You can take that down to 1:500 and it will still kill the virus. … Natural infection titers tend to be 1:200, on average, and that’s still protective.”

 

“We’ve done this for Alpha, Beta, Gamma, Delta, and now Lambda,” Landau added. “The results we see are very similar for all these variants. We’re primarily looking at the mRNA vaccines, and vaccine-elicited antibodies do a good job of neutralizing all the variants.”
Bottom line: As long as there is progress in vaccinations, worries about another pandemic-induced slowdown are overblown.

 

 

Here comes the PBoC

Lastly, any growth deceleration will invite a policy response. There are already signs of a growth slowdown in China. Reuters reported that a former PBoC official said he expects the central bank to engage in monetary stimulus in H2.

 

Sheng Songcheng, former head of the statistics department at the People’s Bank of China (PBOC), said China should “reasonably and appropriately” lower interest rate levels in the second half of this year as pace of economic growth might ease to 5-6% against the backdrop of fading low base effect.
Subsequent to the publication of that story, Bloomberg reported that the PBoC announced a surprise cut to banking reserve requirements.
 

The People’s Bank of China will reduce the reserve requirement ratio by 0.5 percentage point for most banks, according to a statement published Friday. That will unleash about 1 trillion yuan (US$154 billion) of long-term liquidity into the economy, the central bank said.

 

The cut will be effective on July 15, according to the statement.

 

 

Monetary accommodation is on the way.

 

 

Why are bond yields falling?

Under normal circumstances, falling bond yields is a signal that the market believes the economy is about to slow. If the fears of a growth scare are overblown, why are yields falling?

 

The market’s confusion can mainly be attributable to a misinterpretation of the apparent hawkish pivot from the June FOMC statement and dot plot. As a reminder, seven Fed officials saw rate hikes in 2022, compared to four at the March FOMC meeting; 13 saw rate hikes in 2023, compared to seven at the June meeting.

 

 

The misinterpretation stems from the mixed message owing to the divide that’s appearing at the Fed between the inflation hawks, who are mainly Regional Fed Presidents, and the doves, who are mainly members of the Board of Governors. The minutes of the June FOMC meeting tells the story [emphasis added]:

 

In their discussions on inflation, participants stated that they had expected inflation to move above 2 percent in the near term, in part as the drop in prices from early in the pandemic fell out of the calculation and past increases in oil prices passed through to consumer energy prices…Most participants observed that the largest contributors to the rise in measured inflation were sectors affected by supply bottlenecks or sectors where price levels were rebounding from levels depressed by the pandemic. Looking ahead, participants generally expected inflation to ease as the effect of these transitory factors dissipated, but several participants remarked that they anticipated that supply chain limitations and input shortages would put upward pressure on prices into next year. 

 

In their comments on longer-term inflation expectations, a number of participants noted that, despite increases earlier this year, measures of longer-term inflation expectations had remained in ranges that were broadly consistent with the Committee’s longer-run inflation goal. Others noted that it was this year’s increases that had brought these measures to levels that were broadly consistent with the Committee’s longer-run inflation goal.
Moreover, there was broad disagreement about inflation risk:

 

In discussing the uncertainty and risks associated with the economic outlook…Although they generally saw the risks to the outlook for economic activity as broadly balanced, a substantial majority of participants judged that the risks to their inflation projections were tilted to the upside because of concerns that supply disruptions and labor shortages might linger for longer and might have larger or more persistent effects on prices and wages than they currently assumed. Several participants expressed concern that longer-term inflation expectations might rise to inappropriate levels if elevated inflation readings persisted. Several other participants cautioned that downside risks to inflation remained because temporary price pressures might unwind faster than currently anticipated and because the forces that held down inflation and inflation expectations during the previous economic expansion had not gone away or might reinforce the effect of the unwinding of temporary price pressures.
Confusion at the FOMC and its communication policy has led to confusion in the markets. 

 

In addition, when I issued the call to buy bonds in May, bond market sentiment and positioning was at a bearish extreme. Long bond sentiment has now surged to a bullish extreme.

 

 

In conclusion, I called for a bond and growth stock market rally in late May and those trades are on their last legs. The market is currently overreacting to a growth scare. Investors have piled into safe haven assets, such as US equities and growth stocks while broad equity market levels have not suffered much of a setback. Equity investors should rotate back into value and cyclical stocks in anticipation of better performance ahead.

 

 

U-S-A! U-S-A! But for how long?

Posted by Cam Hui -

Mid-week market update: The US markets have surged recently relative to global equity markets, as measured by MSCI All-Country World Index (ACWI). Developed markets (EAFE) and emerging markets (EM) have weakened on a relative basis.
 

 

How long can this last? The S&P 500 is testing an important resistance level that could lead to an all-time relative high for US stocks. The renewal of US leadership has coincided with a display of strength of growth over value.

 

 

A style bet by another name

This is a style bet by another name. The relative performance of the Russell 1000 Value to Growth ratio has closely tracked the EAFE Value to Growth ratio. From a technical perspective, the move appears exhaustive as the Russell Value to Growth ratio is exhibiting a positive RSI divergence. While relative breadth appears to be weak for value stocks, they are showing signs of bottoming.

 

 

 

Waiting for the cyclicals

One reader (Ken) has suggested that Q2 earnings season may be the catalyst for a value turnaround. There may be reason for optimism for value bulls. Value stocks have a heavy cyclical component, and forward EPS estimates have been rising steadily as we approach earnings season.

 

 

FactSet reported a record high in quarterly EPS revisions since it starting keeping records.

 

 

First up in the earnings reports are the major banks, which have value characteristics. This will be the first acid test for the market. The bulls will argue that the Fed has allowed the banks to release reserves in order to increase their dividends. The bears will argue that a flattening yield curve is negative for the relative performance of this sector, as banks tend to borrow short and lend long. A flattening yield curve is therefore negative for profitability.

 

 

 

A growth scare

I interpret the flattening yield curve as a sign of a global growth scare. The market is becoming concerned over the rising prevalence of the Delta variant which has the potential of halting the global recovery.

 

The worries are overblown. Vaccinations have been highly protective against the Delta variant. In the UK, case counts are rising owing to the Delta variant, but hospitalizations are not.

 

 

In Israel, which also has a high rate of vaccinations, investors may have been alarmed by the Reuters headline “Israel sees drop in Pfizer vaccine protection against infections”.
 

Israel reported on Monday a decrease in the effectiveness of the Pfizer/BioNTech COVID-19 vaccine in preventing infections and symptomatic illness but said it remained highly effective in preventing serious illness.

 

The decline coincided with the spread of the Delta variant and the end of social distancing restrictions in Israel.
The most important detail was buried in the report [emphasis added]

 

Vaccine effectiveness in preventing both infection and symptomatic disease fell to 64% since June 6, the Health Ministry said. At the same time the vaccine was 93% effective in preventing hospitalizations and serious illness from the coronavirus.

 

The ministry in its statement did not say what the previous level was or provide any further details. However ministry officials published a report in May that two doses of Pfizer’s vaccine provided more than 95% protection against infection, hospitalization and severe illness.
The growth scare should pass. In the meantime, investors have been piling into growth stocks as the perception that economic growth is becoming scarce. It is an open question as to when the US and growth leadership starts to falter.

 

 

Intermediate-term bullish

As for the S&P 500, I remain intermediate-term bullish. Ryan Detrick pointed out that the S&P 500  closed at an all-time high last Friday after a seven consecutive day winning streak. Since 1950, this has happened only eight times and the market has trended higher after three months in every instance.

 

 

Macro Charts came to a similar conclusion. He found that “Initial drawdowns were minimal [and]
in most cases, stocks extended significantly higher for months (even years)”.

 

 

Sure, there have been numerous short-term warnings of negative breadth divergences, but current conditions don’t argue for a massive downdraft in stock prices. Ondra (@overtrader_83) analyzed how the S&P 500 behaved after periods of deteriorating breadth and lagging Russell 2000. The results have been a mixed bag. While the market has resolved itself with corrective episodes, it has also roared higher more often than not.

 

 

Andrew Thrasher also observed that less than 2.2% of stocks are down over 20%. Thrasher does not discount the possibility of a “sentiment-driven correction”, but major market declines have not occurred when this metric has fallen to such low extremes.

 

 

Indeed, sentiment has become a little extreme. The latest release of the TD-Ameritrade Investor Movement Index, which measures the trading sentiment of that firm’s customers, has risen to an all-time high.

 

 

Helene Meisler also pointed out that the DSI for both the S&P 500 and NASDAQ are at highly bullish, which is contrarian bearish.

 

The Daily Sentiment Index (DSI) for Nasdaq and the S&P have both moved to 91. The last time both were over 90 at the same time was late August 2020 as we headed into that peak. As a reminder readings over 90 and under 10 are ones I consider extreme.
In summary, the market is freaking out over a growth slowdown induced by the Delta variant, but those fears are overblown. Investors have reacted by buying growth and US stocks and abandoning the value/cyclical trade but it is unclear how long this trend will persist. In the short term, the market may experience some volatility as sentiment has become a little giddy, but the intermediate-term trend is still bullish.

 

The resiliency of the S&P 500

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

An upper BB ride

Despite all of the warnings about negative breadth, the S&P 500 has been undergoing a ride along its upper Bollinger Band while exibiting a “good” overbought condition.

 

 

While conventional technical analysis would view episodes of negative breadth divergences as bearish, there are good reasons for the bullish resilience of the S&P 500.

 

 

Underlying strength or weakness?

Bob Farrell’s Rule #7 explains the reasoning behind the caution of negative breadth divergences.
Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

 

Translation: Breadth is important. A rally on narrow breadth indicates limited participation and the chances of failure are above average. The market cannot continue to rally with just a few large-caps (generals) leading the way. Small- and mid-caps (troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.
In the short term, however, Farrell didn’t count on is the improvement in sentiment. Helene Meisler conducts an (unscientific) Twitter poll every weekend. The latest results saw net bullishness decline even as the S&P 500 rose to an all-time high. The market is climbing the proverbial Wall of Worry.

 

 

Another factor Farrell didn’t count on the composition effects of the S&P 500. The top five sectors comprise about 75% of the weight of the index, and their relative performance determines the market’s direction. An analysis of the June relative performance of these sectors shows that three of the five representing 43.4% of index weight are exhibiting positive relative strength. This is in turn putting upward pressure on the index. Healthcare is trading sideways, while Financials are weak.

 

 

If we view the market through a style lens, it’s the growth heavyweights of the S&P 500, namely technology, communications services, and consumer discretionary (Amazon and Tesla) which are providing the bullish impulse. Value stocks are weak. 

 

This brings up another weakness in conventional technical analysis techniques. Many technicians rely on the NYSE as a broad metric of the market, but NYSE stocks tend to be more value-oriented while NASDAQ stocks are tilted towards growth. An analysis of the relative breadth of NYSE and NASDAQ breadth reveals relative weakness in NYSE issues, which is masking S&P 500 strength (bottom two panels). However, the value/growth ratio is exhibiting a positive RSI divergence, which has led to a value revival in the past.

 

 

In short, this is a divided and bifurcated market. In this environment, proper market analysis involves the examination of each underlying component.

 

 

A style review

Let’s review the underlying technical conditions of the major growth and value sectors, starting with technology, which is the largest growth sector and has the heaviest weight in the S&P 500. Technology stocks are in a well-defined uptrend, though it appears to be a little extended. The sector violated a relative uptrend in November and it has been trading sideways relative to the index, though it has exhibited some recent relative strength. Relative breadth is strong (bottom panel).

 

 

Communication Services is another growth sector that is exhibiting both absolute and relative uptrends. Relative breadth has surprisingly been negative and only edged into positive territory recently.

 

 

Consumer Discretionary stocks can be classified as both growth and value. On a cap-weighted basis, the sector is dominated by two growth heavyweights, Amazon and Tesla. On an equal-weighted basis, the sector is comprised of companies with more cyclical and value exposure. The cap-weighted sector is in an extended uptrend, as evidenced by its overbought RSI reading. Both the cap and equal-weighted relative performance of the sector showed positive relative strength in June. Relative breadth is negative but improving.

 

 

Turning to the value sectors, the largest sector is the Financial stocks. This sector violated both absolute and relative rising trend lines in June, which are indications of technical damage. The relative performance of financial stocks is closely tied to the 2s10s yield curve. As banks tend to borrow short and lend long, a steepening yield curve improves their profitability.

 

 

Industrial stocks are also displaying a similar pattern of the violation of absolute and relative uptrends in June. Relative breadth is weak.

 

 

The Materials sector also violated its absolute and relative uptrends.

 

 

Energy stocks are the only bright spot among the value sectors. The sector is in an absolute uptrend. However, it is testing its relative uptrend to the S&P 500. Relative breadth is strong.

 

 

 

Why I am not bearish

In short, a review of the major growth and value sectors shows growth to be strong and value weak. But here is why I am constructive on the market overall. None of the defensive sectors or industries with the exception of Real Estate are showing any signs of relative strength. Bearish setups don’t behave this way.

 

 

I began this publication with a rhetorical question of why the S&P 500 is resilient. Ed Clissold of Ned Davis Research wrote, “The back-and-forth leadership is the reason market breadth has been so resilient.”

 

 

Bear in mind, however, that the sideways value and growth rotation will not last forever. It will eventually break one way or the other eventually. My base case calls for a value and cyclical revival. There are two structural reasons for this. First, the weights of the top five stocks in the S&P 500, which are all growth stocks, have fallen even as the S&P 500 has risen to fresh all-time highs. This is a sign that faltering growth leadership.

 

 

Conditions are also setting up for a value and cyclical rebound. In the wake of the Vaccine Monday rally that began in November, investors had been piling into value and cyclical stocks, and their positioning had become extended. Callum Thomas of Topdown Charts documented that speculative futures positioning in the reflation trade has retreated. Sentiment has come off the boil, and this is a setup for another leg up for value and cyclical stocks.

 

 

In the short run, count on more back-and-forth value and growth rotation that supports stock prices. History shows that the DJIA seasonal pattern in July is bullish.

 

 

As well, the credit markets are also signaling a benign environment. Katie Greifeld of Bloomberg reported, “Bond spread have continued to narrow. Investment grade spreads to Treasuries sit at just 80 basis points, and junk spreads have tightened below 270 basis points, both the slimmest pickups in well over a decade.”

 

 

 

How to navigate the mid-cycle expansion

Posted by Cam Hui -

It’s been over a year since the stock market bottom at the height of the Pandemic Panic. The market consensus has evolved from an early cycle recovery to a mid-cycle expansion, as evidenced by the BoA Global Fund Manager Survey.
 

 

What that means for investors? Here are the key questions we focus on:
  • What’s the outlook for the S&P 500?
  • What will be the market leadership?
  • What’s the outlook for commodities, Treasury yields, and the USD?

 

 

Mapping the mid-cycle expansion

What does a mid-cycle expansion mean? We can look at it through several lenses.

 

From a momentum perspective, the G10 Economic Surprise Index, which measures whether economic releases are beating or missing expectations, is decelerating after a V-shaped recovery. However, ESI readings are still positive, indicating there are more positive than negative surprises.

 

 

In the US, ESI is following a similar pattern, though it is nearing the zero line indicating a rough balance between positive and negative surprises.

 

 

From a policy perspective, the need for emergency battlefield surgery is diminishing. The Federal Reserve is starting to contemplate the tapering of its quantitative easing programs as an early prelude to rate hikes. Callum Thomas has highlighted rate hikes by a number of small emerging and frontier market central banks. While these policy initiatives are insignificant when viewed in isolation, Thomas makes the point that changes in EM economies can be sensitive barometers of changes in the global cycle. Rate hikes have been observed in Mozambique, Tajikistan, Zambia, Zimbabwe, Kyrgyzstan, Ukraine, Brazil, Georgia, Turkey, Russia, and Belarus. Even the Bank of Canada has announced a taper of its QE program.

 

For equity investors, it’s far too early to turn overly cautious. As I have pointed out before, past episodes of Fed tapers have resolved in either choppy or advancing stock prices.

 

 

Just as it’s time to start withdrawing monetary accommodation, expect fiscal support to also diminish over the coming quarters. The Hutchins Center on Fiscal and Monetary Policy forecasts that the recent record of fiscal thrust will turn into fiscal drag. Similarly, the historical evidence on fiscal drag episodes has not been equity bearish either.

 

 

Jurrien Timmer of Fidelity Investments had a different viewpoint. He characterizes a mid-cycle expansion as a period where the driver of equity returns is earnings gains rather than P/E multiple expansion: ” The market is transitioning from its valuation-driven early-cycle phase to an earnings-driven mid-cycle phase, so while it remains in an uptrend—with higher highs & higher lows—there hasn’t been much progress since April, a normal part of this adjustment.”

 

 

So far, forward EPS estimate growth is still strong. This should be supportive of further equity price gains.

 

 

Even though it’s far too early to turn bearish on stocks, there are a number of subtle signals beneath the surface that investors should monitor.

 

 

Investment implications

Now that I have made the case that the equity outlooks is benign, the key questions for investors are:
  • Equity Leadership: What will be the leadership, growth or value?
  • Asset Allocation: What’s the outlook for commodities, Treasury yields, and the USD?
From a global macro perspective, the key indicators to watch are the 10-year Treasury yield and the USD. If they move together, it will be an important clue as to the direction of the global economy. So far, they are behaving in a fashion consistent with past global recoveries. Yields have rebounded but progress has stalled, and the USD is volatile but range-bound. 

 

 

What happens next? The bearish scenario, which is becoming the consensus one, would see a stalling in economic growth and momentum, causing the Fed to take a more dovish tone, Treasury yields to pull back, the yield curve flattens, put upward pressure on the USD, which would be negative for commodity prices. Growth stocks would regain market leadership as investors pile into growth stocks when growth becomes scarcer, and value stocks lag owing to their high cyclical exposure. Currency strategist Marc Chandler highlighted the downside risks:

 

The coming fiscal cliff and excesses spurred by the rapid growth, coupled with the doubling of the price of oil since the early last November before the vaccine was announced, seems to point to the risk of an economic downturn in late 2022 or early 2023.  This may not be the baseline view, but it is powerful and dangerous even as a risk scenario.  To the extent that the economy impacts voters’ preferences, how the Fed manages the post-covid economy could influence next year’s mid-term elections and the general election in 2024.  
On the other hand, the current environment could also be similar to the 2003-04 period. The stock market had been rallying for about a year. The USD had been falling but started to reverse its losses. Upward progress in the 10-year Treasury yield had stalled. The major difference is the value/growth relationship. Value stocks were already four years into a steep recovery, while the current episode has only seen the value recovery begin a year ago. History doesn’t fully repeat itself, but rhymes.

 

The economic recovery continued after 2003-04. Even as the value/growth ratio paused and traded sideways for several months, value regained its leadership, and commodity prices continued their ascent.

 

 

My base case scenario calls for several months of sideways range-bound movement in these indicators followed by a period of renewed growth. New Deal democrat, who monitors economic statistics and divides them into coincident, short-leading and long-leading indicators, is constructive on the economic outlook with an important caveat about the pandemic:
 

All of the important metrics for the economy remain positive.

 

But, in addition to supply chain issues, we have to start worrying about COVID again, because the delta variant has now taken hold in up to 8 States with rising new cases. All of those States have fewer vaccinations per capita than the national average, and most of them much below the average. By the end of July, I anticipate that it will be clear there is a new “wave” of cases in the relatively unvaccinated States. Aside from the human cost, it is unclear how much this will retard recovery in the economy as a whole.

Also, keep a close eye on commodity prices and the cyclically sensitive copper/gold and base metal/gold ratios. The copper/gold ratio is consolidating sideways while the more diversified base metals/gold ratio is starting to exhibit a more bullish pattern. Should these two ratios strengthen further, it will be an important signal of global economic strength and put upward pressure on bond yields, steepen the yield curve, and be bullish for the value stocks over growth.
 

 

Stay tuned. The evolution of growth expectations over the next few months will have important implications for the markets. Until then, expect a choppy sideways pattern in all asset classes as the growth uncertainty resolves itself.
 

Why the stock market isn’t going to crash

Posted by Cam Hui -

Mid-week market update: I’ve had a number of questions from readers about the warnings of imminent market declines from SentimenTrader. In this post, Jason Goepfert’s headline was “This Led to Declines Every Time in the Past 93 Years”. He highlighted the market’s poor breadth, as measured by the percentage of stocks above their 50 dma.
 

Going back to the mid-1920’s, there have only been a handful of dates with breaks like this. It happened in 1929, 1959, 1963, 1972, 1998, and 1999, and all of them ended up preceding losses in stocks.

 

 

Relax, the market isn’t going to crash. Here’s why.

 

 

A bifurcated market

Goepfert gave the answer in a separate article, “The Correlation Between Growth and Value Has Never Been Lower`. Even though he interpreted the data in a bearish way, his observation is consistent with my past analysis that this is a highly bifurcated market that’s divided between growth and value stocks.

 

 

The stock market has been rising steadily because growth and value have been undergoing an internal rotation. When growth falters, value takes up the baton of leadership and vice versa. Right now, the value/growth ratio has violated a key relative support line and internals look terrible (negative for value, positive for growth). On the other hand, the ratio is exhibiting a positive RSI divergence. In the past, these negative divergences have led to a bottom and turnaround for value stocks. Don’t be surprised to see history repeat itself in the coming days.

 

 

As the fears of the Delta variant slowing down the economic recovery swept through the markets, it was no surprise that SKEW, which measures the cost of hedging a tail-risk event, spiking. It was also not a surprise to see growth ascendant under such conditions. If growth is becoming scarce, growth stocks attract a bid. 

 

 

On the other hand, Moderna announced that its vaccine is protective against the delta variant (via CNBC). It remains to be seen how the value and growth stocks will react in the coming days as these fears recede.

 

Another supportive element for the strength of the S&P 500 comes from a more nuanced interpretation of breadth readings. Sure, the NYSE A-D Line has not confirmed the index’s recent highs, the market is exhibiting negative RSI divergences, and the percentage of S&P 500 stocks above their 50 dma look terrible. On the other hand, the percentage of NASDAQ stocks above their 50 dma is showing signs of life, which is an indication of the internal growth and value rotation, and the percentage of S&P 500 stocks above their 200 dma is still above 90%.

 

 

Putting it another way, short-term breadth is challenging, but long-term breadth remains solid. I interpret these conditions as the market may see a shallow pullback of -5% or less, but downside risk is limited. My base case scenario is still a sideways choppy market, though I would not discount the S&P 500 undergoing a slow grind-up over the next two or three weeks.
 

 

Bitcoin’s existential threat

Posted by Cam Hui -

I have been asked to comment on Bitcoin. On a short-term basis, BTC is testing support while exhibiting a positive RSI divergence. That’s the good news.
 

 

The bad news is BTC and other cryptocurrencies are facing an existential threat.

 

 

The quantum computing threat

I came across a Decrypt article entitled “Quantum computers could crack Bitcoin by 2022”. While the 2022 time frame is a bit of hyperbole, the point is well taken.
 

If you had a powerful enough computer, you could, theoretically, take control of the Bitcoin blockchain. You could credit your account with free Bitcoin or prevent others from making transactions. Since the private key to each wallet can be derived from a public key, you could access the Bitcoin wallet of whomever you wished. The keys to the $163 billion castle would be yours—of course, in that scenario, Bitcoin’s price would surely plummet as soon as its claims of invulnerability were found to be baseless.

 

Whereas even the most powerful supercomputer would take thousands of years to crack Bitcoin, there are machines that could, theoretically, do so in a matter of seconds. These ultra-fast devices are called quantum computers.

 

And they’re real—currently in development by some of the finest minds on the planet. 

 

Some experts told Decrypt that it’s already too late for Bitcoin; quantum computers, developed in secrecy by governments, could corrupt the blockchain in just a few years’ time.
Here’s why:
 

Bitcoin uses something called the Elliptical Curve Digital Signature Algorithm (ECDSA) to sign digital signatures, and uses a cryptography standard called SHA-256 to hash blocks on the chain. 

 

With Bitcoin, a private key, picked at random, is run through these algorithms to generate a public key. And the Bitcoin protocol uses the hash value of this to create a public Bitcoin address. 

 

A quantum computer could reverse this process and derive the private key from a public one. And voila! Bitcoin’s claim of inviolability and unhackability is gone, and you have access to any Bitcoin wallet you want. 

 

Two major quantum algorithms that threaten the current state of cryptography have already been developed: Grover’s and Shor’s algorithms.

 

Rob Campbell, President at Baltimore, Maryland-based Med Cybersecurity, told Decrypt that quantum computers using both Grover’s and Shor’s algorithm could also “mine much faster than everyone else, and therefore an adversary could insert its own blocks and undermine the entire blockchain.” 

 

What’s the time frame?
It’s estimated that you’d need a quantum computer with at least 4,000 qubits—the unit that denotes the power of a quantum computer—to crack Bitcoin’s code. The thing is, the most powerful quantum computers today are… decidedly less powerful. In October 2019, Google announced a quantum computer with 54 qubits; it’s the most powerful quantum computer announced in the public domain.  
But Campbell said that major companies, such as Google, Amazon, Microsoft and IBM are making “rapid progress,” as are a host of smaller companies. 

 

So how long until the quantum computing threat becomes a problem for Bitcoin? It depends whom you ask. At the World Economic Forum in Davos, Sundar Pichai, CEO of Google’s parent company, Alphabet, was among the first major figures to put a deadline on it. He said: “In a five to 10 year time frame, quantum computing will break encryption as we know it today.”

 

Advances are being made in quantum computing at astonishing rates. A recent article published by the University of Waterloo announced “Combining classical and quantum computing opens door to new discoveries”.
Researchers have discovered a new and more efficient computing method for pairing the reliability of a classical computer with the strength of a quantum system.

 

This new computing method opens the door to different algorithms and experiments that bring quantum researchers closer to near-term applications and discoveries of the technology.

 

“In the future, quantum computers could be used in a wide variety of applications including helping to remove carbon dioxide from the atmosphere, developing artificial limbs and designing more efficient pharmaceuticals,” said Christine Muschik, a principal investigator at the Institute for Quantum Computing (IQC) and a faculty member in physics and astronomy at the University of Waterloo.

 

Wallet security

These factors put into question the security of a cryptocurrency wallet. Occasionally, there have been stories about investors losing control of their wallets owing to irregularities at a cryptocurrency platform. A recent example occurred in South Africa:
Two brothers associated with one of South Africa’s largest cryptocurrency investment platforms, along with their $3.6 billion USD in Bitcoin, have vanished, according to Bloomberg.

 

The outlet reported that Hanekom Attorneys, a law firm in Cape Town, said they cannot locate Ameer and Raees Cajee, the founders of Africrypt, and have filed missing person reports to the Hawks, the country’s national police force. The firm also informed crypto exchanges across the world in case there is any attempt to convert the blockchain-backed coins.

 

In April, Africrypt told its investors that it had been hacked and asked that they did not report the incident to authorities, citing that government involvement would “slow down” the recovery of their missing funds.

 

“We were immediately suspicious as the announcement implored investors not to take legal action,” the law firm told Bloomberg. “Africrypt employees lost access to the back-end platforms seven days before the alleged hack.” Hanekom Attorneys discovered that the exchange’s pooled funds had been transferred out of its South African accounts and into “tumblers and mixers,” or larger pools of Bitcoin, which made them virtually untraceable.

In the future, similar problems will occur as quantum computing capabilities advance sufficiently to crack private keys. 
 

If you are a cryptocurrency investor, you are holding hot potatoes whose value could plummet to zero in 5-10 years’ time. You may enjoy the party now, but one day these assets are going to turn into digital beanie babies.
 

Measuring the effects of the Fed’s reversal

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 Fed’s hawkish pivot and reversal

In the wake of the Fed’s unexpected hawkish message, the markets adopted a risk-off tone the week of the FOMC meeting. As Fed officials walked back the aggressuve rhetoric, both the S&P 500 and NASDAQ 100 resumed their advance and climbed to all-time highs.

 

 

Beneath the surface, however, there was some unfinished business as the internal rotation sparked by the FOMC meeting hasn’t unwound itself. Let’s take a more detailed look.

 

 

Bond market response

Starting with the bond market, the 10-year Treasury yield spiked and rose above a key support turned resistance level in reaction to the FOMC message. Yields retreated below support as the Fed moderated its tone but rose again to test resistance on Friday. The 2s10s yield curve, which had begun to flatten starting in late May, continued to flatten during this period.

 

 

Given the high duration and interest rate sensitivity of growth names, the decline in the 10-year yield has put a bid under the NASDAQ 100.

 

 

How persistent is the growth revival?

 

 

The cyclical response

Investors can get some clues from cross-asset analysis. The cyclically sensitive copper/gold and base metal/gold ratios are showing some signs of strength, signaling global reflation. If this trend continues, it should put upward pressure on the 10-year yield.

 

 

Cross-asset analysis of gold and gold-sensitive assets tells a similar story of reflation. The USD strengthened (bottom panel, inverted scale) in the aftermath of the FOMC meeting. The greenback’s rally has reversed itself and weakened. Similarly, TIPs prices fell after the FOMC, but have rallied to test their old highs. Gold prices have been consolidating sideways during this period, but as gold tends to be positively correlated with TIPs prices and negatively correlated with the USD, this environment should be bullish for gold.

 

 

JPMorgan also estimated that CTA positioning in gold is a crowded short extreme. The odds of a bullish reversal is high.

 

 

In addition, Mark Hulbert pointed out that gold newsletter market timers had turned bearish, which is contrarian bullish:

The HGNSI has moved from close to the 90th percentile of the distribution to the 14th. Some may consider that already to be a big enough drop to support a rally; other contrarians may insist on waiting until it drops into the bottom decile — the threshold for which is minus 14.8%. Depending on gold’s action this week, that could happen within a matter of days.

 

 

Over in the stock market, the relative performance of cyclical stocks has largely lagged the market during this period, though deep cyclicals like energy and metals and mining are exhibiting a bit more strength than other cyclical groups. Even news of President Biden’s bipartisan infrastructure deal didn’t move the needle on these stocks.

 

 

 

Value vs. growth response

In short, equity investors are not fully convinced about a revival of the reflation trade. As cyclical sectors have a high overlap with value stocks, we can also see this effect in the value and growth relationship. The value/growth ratio has broken a key relative support level, and breadth is weak for value. However, the ratio is exhibiting a (value) bullish RSI divergence, indicating that a reversal could be near.

 

 

 

Technical vs.  fundamentals

To be sure, the current advance has been marked by numerous worrisome breadth divergences. In particular, the NYSE Advance-Decline Line has failed to confirm the fresh highs.

 

 

As well, SentimenTrader issued a warning about the NASDAQ breadth weakness in the face of new highs.

 

 

On the other hand, FactSet reported a surge in earnings estimates and a record number of companies with positive earnings guidance. This should be supportive of equity valuation and equity price gains.

 

 

RSM US chief economist Joseph Brusuelas pointed out that there is $1.6 trillion in excess savings on household balance sheets, which translates to a tsunamic of post-pandemic consumer demand.

 

 

I interpret this as the stock market may have gotten ahead of itself and it may be due for a period of sideways consolidation and minor weakness, but strong underlying fundamentals will put a floor on stock prices should they correct. Ryan Detrick of LPL Financial observed that this bull has been extraordinarily strong. In the past, the market has experienced some choppiness after robust first year gains. That’s my base case scenario.

 

 

In summary, the “round trip” exhibited by the major averages after the FOMC meeting is hiding a number of rotational reversals. While growth stocks are in ascendancy, cross-asset analysis strongly suggest that the reflation and value trade is about to regain the upper hand. However, negative breadth divergences are flashing warning signs that possible weakness or sideways consolidation is ahead.

 

 

Disclosure: Long GDX

 

The Fed’s next challenge: Wage pressure

Posted by Cam Hui -

Stock markets were rattled by the Fed’s hawkish tone in the wake of the FOMC meeting. Markets took a risk-off tone, but Jerome Powell walked back some of the hawkishness during his Congressional testimony the following week. The Fed Chair stuck to his familiar refrain that inflation is transitory, dismissed the idea of 1970s-style inflation as “very, very unlikely”, and unemployment is transitory but labor markets need continued support.
 

 

In response, the markets rebounded and prices largely made in round-trip in pricing in most asset classes. But in order for the markets to continue accept the Fed’s narrative, the next challenge for the Fed is cost-push inflation in the form of wage pressure. This will become more apparent with the release of the June Employment Report in the coming week.
 

 

The Fed’s dilemma

The June FOMC meeting produced several changes of interest. The Fed stated that downside risks were diminishing as the vaccination rate rose. More importantly, it raised its inflation projection for 2021 and the “dot plot” projected a rate liftoff in 2023. To illustrate the hawkish turn, seven Fed officials see rate hikes in 2022, compared to four at the March FOMC meeting. 13 see rate hikes in 2023, compared to seven at the June meeting.
 

 

In the wake of the FOMC meeting, Joe Wiesenthal at Bloomberg openly wondered if the Fed is pivoting towards its traditional anti-inflation role:

There is a sense in which the recent months of data have activated the inflation-fighting red blood cells at the Fed. During the press conference, Powell was largely optimistic about the trajectory of the economy. But in terms of risks, he’s clearly more concerned about an inflation overshoot than an employment undershoot. This is a change after months and months of being more concerned about weak labor markets. And now there’s some debate about whether the new dots fit with the framework set out at Jackson Hole last year, where the Fed indicated plans to wait to see signs of sustained inflation before raising rates.

In reality, a divide is opening at the Fed. The hawkish tone of the FOMC is probably attributable to some Regional Fed Presidents who are seeing price pressures in their districts. The core voters at the Fed, the Fed governors, and New York Fed President Williams, are continuing to counsel patience.
 

Lisa Abramowicz at Bloomberg summarized the policy dilemma:

In some ways, the Fed has trapped itself in a tight corner that will prove difficult to exit successfully. It wants to see inflation pick up, and yet its every move has unprecedented ramifications for a world awash in debt. If inflation runs too hot, traders will worry about a fast round of tightening that will torpedo growth and puncture asset-price valuations. If central bankers raise rates sooner, traders will price in a slower, cooler longer-term expansion.

Investors have to recognize that the Fed has to contend with two kinds of inflation risks. There is the inflation of a transitory nature attributable to supply chain bottlenecks, such as rising used car prices and airfares. The more insidious risk is a 1970’s style price spiral, where price pressures in one part of the system causes firms to pass on their cost increase, which prompts workers to demand higher wages, which raises further cost pressures for firms, and so on. In the past, the Fed has broken cost-push inflation threats by breaking any potential inflation spiral at the wage pressure link. As soon as wage increases start to get out of hand, the Fed has tightened in order to rein in inflationary expectations.
 

Will the Powell Fed follow the same path? That’s the next policy challenge.
 

 

How broad and inclusive?

The NY Times reported that Powell walked back his hawkish stance at his Congressional testimony, but he qualified his remarks by embracing a “broad and inclusive” labor market recovery.

Speaking before House lawmakers on Tuesday afternoon, Mr. Powell emphasized that the Fed was looking at maximum employment as a “broad and inclusive goal” — a standard it set out when it revamped its policy framework last year. That, he said, means the Fed will look at employment outcomes for different gender and ethnic groups.
 

“There’s a growing realization, really across the political spectrum, that we need to achieve more inclusive prosperity,” Mr. Powell said in response to a question, citing lagging economic mobility in the United States. “These things hold us back as an economy and as a country.”
 

The Fed cannot solve issues of economic inequality itself, he said. Congress would need to play a role in establishing “a much broader set of policies.”

How broad and inclusive? The Atlanta Fed’s Wage Growth Tracker reported that low-skilled workers have already made up much of the pre-pandemic wage growth losses.
 

 

Viewed through the education level prism, which is another proxy for wealth inequality, the wage growth of workers with a high school education was steady while wages of those with bachelor degrees decelerated during this period. Amid the cacophony of complaints from the small business owners at NFIB about the inability of employers to fill job openings, how determined is the Fed prepared to address the inequality problem?
 

 

From a long-term perspective, the providers of capital have enjoyed a generational tailwind at the expense of the providers of labor. The wage share of GDP peaked out in the late 1970’s and it has been declining ever since. By contrast, corporate profits bottomed out in the early 1990’s and they have risen to new generational highs.

 

 

The pendulum is swinging back. The WSJ reported, “Tight Labor Market Returns the Upper Hand to American Workers”.
Low-wage workers found something unexpected in the economy’s recovery from the pandemic: leverage.
Ballooning job openings in fields requiring minimal education—including in restaurants, transportation, warehousing and manufacturing—combined with a shrinking labor force are giving low-wage workers perks previously reserved for white-collar employees. That often means bonuses, bigger raises and competing offers.

 

Average weekly wages in leisure and hospitality, the sector that suffered the steepest job losses in 2020, were up 10.4% in May from February 2020, Labor Department data show, outpacing the private sector overall and inflation. Pay for those with only high school diplomas is rising faster than for college graduates, according to the Federal Reserve Bank of Atlanta.

 

“It’s a workers’ labor market right now and increasingly so for blue-collar workers,” said Becky Frankiewicz, president of staffing firm ManpowerGroup Inc.’s North America operations. “We have plenty of demand and not enough workers.”
In a separate article, the WSJ revealed that manufacturers are having difficulty competing for workers with the fast-food industry.
For years, factory jobs paid significantly more than those in many other fields, especially for less-educated workers. That is changing, according to economists, manufacturers and federal data.

 

[Furniture maker] Haworth has raised wages at factories near its Holland, Mich., headquarters to $15 an hour, plus another dollar for the night shift. It has amenities like a 24-hour gym as well as annual Thanksgiving turkey and Christmas gift giveaways. Haworth still isn’t finding enough workers. That could hold back production at a time of red-hot demand for furniture, vehicles and many other consumer goods.

 

Some workers recently left Haworth’s factory in the nearby town of Ludington for hospitality jobs, Ms. Harten said. Haworth is advertising assembly jobs for $14 at that facility—the same starting pay rate at a nearby Wendy’s restaurant. “Manufacturing can be taxing,” said Ms. Harten, who also believes enhanced Covid-19 unemployment benefits are discouraging some people from taking open jobs.

 

This is creating a labor cost arbitrage problem for employers in different industries. Not all companies have the same flexibility to pass on wage increases to their customers.

Because most factories have been fully operational since last summer, hotels and restaurants are doing comparatively more hiring now as patrons return as Covid-19 restrictions lift. Paul Isely, a professor at Grand Valley State University in Allendale, Mich., who studies the region’s economy, said that manufacturers face more pressure to hold down wages than some service employers because they compete with factories around the world rather than restaurants around the corner.

One simple explanation is that enhanced unemployment benefits are keeping workers at home and decreasing the worker supply. But Indeed’s chief economist Jed Kolko pointed out that job “search activity remains below national trend in twelve states that prematurely opted out of enhanced federal UI benefits on June 12 or 19”.
 

 

The rise of low-wage workers is not strictly an American phenomenon. The Economist reported that the same thing is happening in the UK. The British fiscal response to the pandemic was to provide wage subsidies to employers to keep workers on the payroll. By contrast, the US response was to boost unemployment benefits. In both cases, wage pressures rose at the low end. Therefore the narrative of the lazy worker enjoying Uncle Sam’s largesse at home can’t be the main reason for worker shortage.
 

 

The most likely explanation is a combination of pandemic fears, childcare availability for women, and premature retirement. Goldman Sachs estimated that as many as 1.2 working Americans retired early over the course of the pandemic.
 

 

That’s not a big surprise. The rate of wage growth of older workers has plummeted during the pandemic. By contrast, it’s a terrific time to be a teenage worker during this era (green line).

 

 

Putting this all together, it’s not good news for the suppliers of capital. It will translate into higher wages, which firms may not be able to pass onto their customers, a worker shortage, an operating margin squeeze, and ultimately, higher inflationary pressures. 

It’s also unclear how the Fed plans to resolve the conflict between its full employment and price stability mandates given that wage pressures could spark a potential cost-push inflationary spiral. Investors are well-advised to monitor the evolution of wage pressures after each Employment Report and the body language of Fed officials in response to rising employee compensation. Moreover, wage pressures are occurring in an environment where progress in initial jobless claims have flattened out. This has the potential to put the spotlight on the Fed’s dual mandate of price stability and maximum employment.
 

 

 

The market response

The bond market’s response to the Fed’s qualified hawkishness has been a twist in the yield curve. In the short end, the spread between the 2-year and 3-month yield steepened. The belly of the curve tells a different story. The 2s10s spread flattened. I interpret this to mean that the 2-year is anticipating the Fed will raise rates, but the 2s10s is signaling slowing growth further into the future. The two yield curves have usually moved in tandem in the past. 
 

The sample size is extremely limited as there was only one instance when the two yield curves have diverged since 1990. The S&P 500 underwent periods of sideways consolidation in 2011, but that was a year marked by the Greek crisis in the eurozone. We are really in uncharted waters.
 

 

Investors may find better equity opportunities in light of the valuation gulf between US and non-US equities.
 

 

That said, let’s not get ahead of ourselves. The Fed is only talking about when and the process of tapering its QE program. Historically, the 10-year Treasury yield has fallen whenever the Fed has tapered its QE program. The record for stocks is mixed. The S&P 500 traded sideways during the QE1 and QE2 tapers, but rose during the QE3 taper.
 

 

That’s even before the Fed hikes rates, which is at least two years in the future. Ryan Detrick of LPL Financial pointed out that stocks have continued to advance in the past at the first hike.
 

 

Relax. The bull isn’t dead. It may take a breather, but there are more gains ahead for equity investors.
 

Just a hiccup?

Posted by Cam Hui -

Mid-week market update: The S&P 500 has shown negative seasonality at the end of June. So far, the index has been tracking its historical pattern well in 2021. The market took fright last week from the abrupt hawkish tone of the FOMC statement and subsequent Powell press conference last week. By Friday, it had become deeply oversold (see Boo! Powell scares the children!) and recovered this week.

 

 

Was that it? Is the seasonal weakness over?

 

 

A broad recovery

The analysis of the top five sectors tells the story. As a reminder, the top five sectors account for about three-quarters of the S&P 500 index weight, and it would be difficult for the market to significantly move up or down without a majority of their participation. The relative performance of the top five sectors shows that all sectors except Financials have exhibited positive relative strength. To be sure, these sectors tend to be FANG+ dominated, which argues for a revival of growth leadership. Nevertheless, sector breadth is supportive of more market strength.

 

 

Taking a quick tour around the world, we can also see a rebound in Europe. Both the Euro STOXX 50 and the FTSE 100 have held above their 50 dma and both have recovered.

 

 

Over in Asia, Japan has rebounded.

 

 

The markets of China and her major Asian trading partners have been the global laggards. The Shanghai Index has rebounded. Hong Kong and Singapore are trading below their 50 dma and may be exhibiting bearish trends, but the region has been holding up well overall.

 

 

In short, US and global breadth can be characterized as neutral to bullish. Does that mean all is right with the bulls?

 

 

Key risks

Not so fast. The NASDAQ 100 achieved a fresh all-time high while exhibiting a negative RSI divergence.

 

 

The S&P 500 is testing its previous highs while exhibiting a similar negative RSI divergence. As well, both NYSE and NASDAQ breadth are showing a bearish pattern of lower highs.

 

 

Selected sentiment readings are also flashing warning signs. Bearish sentiment from the Investors Intelligence survey has fallen to historic lows. Is this a sign of bearish capitulation that precedes a selloff?

 

 

 

Resolving the bull and bear cases

Here is how I resolve the bull and bear cases. The market reached an oversold extreme late last week and staged a relief rally. My monitor of the Zweig Breadth Thrust Indicator is instructive. As a reminder, a ZBT buy signal is triggered when the market reaches an oversold condition and rebounds to an overbought reading within 10 trading days. While the official ZBT Indicator, which is based on NYSE breadth, did not become oversold last week, a proxy using S&P 500 components (bottom panel) did. In the past, the market has always enjoyed a strong rebound whenever my version of the S&P 500 ZBT Indicator became oversold, even when the official ZBT Indicator did not.

 

 

That seems to be what is happening now. I am tactically bullish over a 3-5 trading day time frame. However, the combination of sentiment warnings and negative breadth and momentum divergences could combine to keep a lid on stock prices as we move into July.

 

Stay tuned.

 

 

Disclosure: Long SPXL

 

Boo! Powell scares the children!

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 Fed’s hawkish pivot

How should investors interpret the Fed’s unexpected hawkish turn? The 10-year Treasury yield rose dramatically after the FOMC meeting, but retreated after the initial surge. The S&P 500 fell in the wake of the Fed announcement. While did violate an important downtrend, the violation needs to be confirmed in light of Friday’s triple witching expiry volatility.

 

 

Helene Meisler’s weekly (unscientific) Twitter sentiment poll took a 30 point tumble from net bullish to net bearish. Indeed, Fed Chair Jay Powell has managed to the children. 
 

 

Will that be enough to put a floor on stock prices?
 

 

The bears aren’t in control

First, let me put the bearish fears to rest. The bears haven’t seized control of the tape yet. The relative performance of defensive sectors shows that they are not behaving well. With the exception of REITs, none are showing any signs of strong relative strength.

 

 

In addition, my bottom spotting model has flashed three out of four possible oversold signals, indicating that a tactical bottom is near. The 5-day RSI is deeply oversold. The VIX Index has spiked above its upper Bollinger Band, which is also another sign of a possible short-term bottom. As well, the NYSE McClellan Oscillator has declined to levels consistent with past trading bottoms.

 

 

Macro Charts concurs with my analysis. The market is oversold, and cyclicals are extremely oversold.

 

 

 

A tale of two markets

As well, the US market is no longer a monolithic market, but a combination of two markets consisting of growth and value stocks. Each market marches to the beat of its own drummer. The analysis of growth and value across market cap bands shows that growth stocks are dominant, and value is trying to find a relative bottom.

 

 

In the wake of the Fed decision, growth stocks, as represented by the NASDAQ 100, advanced to a new all-time high. The NDX to SPX ratio has recovered strongly after rallying out of a relative downtrend. 

 

 

The relative performance of the Rising Rates ETF (EQRR), which is heavily weighted in cyclical and value stocks, remains in a constructive relative uptrend.

 

 

How all this resolves itself depends on the evolution of the 10-year Treasury yield. Here is an interesting thought. If the market reaction to the Fed’s hawkish tone is to flatten the yield curve, which is the bond market’s signal of a slowing economy, doesn’t that imply that the Fed is on the verge of a policy mistake that erroneously slows the economy?

 

Don’t panic. It’s not the Apocalypse. The market is not about to experience a major risk-off episode.

 

 

What’s ahead for gold

In the wake of the Fed announcement, I received a number of questions about the outlook for gold, especially in light of my bullish view (see Interpreting the gold breakout). It’s difficult to make a high-confidence call when markets are moving, but I can make an educated guess. From strictly a chartist’s viewpoint, gold prices are obviously oversold. It is trading at a support zone between two important Fibonacci retracement levels. 

 

 

Investors can also get some clues from inter-market relationships. Gold is inversely correlated with the USD, and it is highly correlated with real rates, as represented by the TIPS bond ETF (TIP). While there appears to have been panic selling gold, TIP has stabilized and began to recover after the Fed decision. On the other hand, the USD continues to exhibit strength (inverted chart). 

 

In all likelihood, gold prices should begin to find a bottom at or about current levels. The prognosis will depend on how gold behaves once prices stabilize and chop around. Watch for positive or negative RSI divergences as it tests the initial lows.

 

In conclusion, the Fed’s surprising hawkish turn should not be cause for a major risk-off episode in equities. The outlook for gold, however, is less certain because it depends on the market reaction to nominal and real rates and the USD.

 

 

Disclosure: Long GDX

 

China rides to the rescue?

Posted by Cam Hui -

The headlines from last week sounded dire. It began when China’s May economic activity report was disappointing, with industrial production, retail sales, and fixed-asset investment missing market expectations. 
 

 

Then the Federal Reserve took an unexpected hawkish turn. The statement from the FOMC meeting acknowledged that downside risks from the pandemic were receding as vaccination rates rose. It raised the 2021 inflation forecast dramatically, shaded down next year’s unemployment rate, and projected two rate hikes in 2023 compared to the previous forecast of no rate hikes. As well, a taper of its quantitative easing program is on the horizon.

 

Collapsing global trade and growth. Rising interest rates. It sounds like the start of a major risk-off episode.

 

My own reading of cross-asset market signals comes to a different conclusion. China’s slowdown is stabilizing, which may serve to put a floor on global risk appetite and equity prices.

 

 

Mapping China’s slowdown

In the past few months, there has been growing concern over a slowdown in China’s credit growth. Total social financing (TSF) has been rolling over as Beijing normalized policy after the pandemic.

 

 

These conditions have sounded the alarm over a China slowdown. Historically, this has led to negative consequences for global growth and capital market returns.

 

 

China watcher Michael Pettis gave a more optimistic interpretation in a Twitter thread.
TSF will grow 9.3% in 2021. This is roughly equal to consensus nominal GDP growth expectations, in which case we will have seen a stabilization of China’s debt-to-GDP ratio – something Beijing has promised will happen this year. Because we’re all expecting last year’s contraction in consumption to be partially reversed this year – and not just in China – 2021 will be the only year in which Beijing has a real shot at stabilizing Chinese leverage even as GDP continues to grow quickly.

 

Shehzad Qazi of China Beige Book, which monitors the Chinese economy from a bottom-up perspective, noted that “among firms that borrowed new lending (rather than rollovers/credit extensions) did rise”, indicating that credit is going to more productive activities than just rollovers.

 

My own market-based indicators appear constructive. The relative performance of MSCI China and the stock markets of China’s major Asian trading partners relative to MSCI All-Country World Index (ACWI) are all showing signs of stabilization. Most markets are holding relative support levels. Taiwan and Australia are exhibiting nascent relative uptrends.

 

 

The AUDCAD exchange rate is also a useful market-based indicator of the Chinese economy. Both Australia and Canada are resource-exporting countries of similar size. Despite recent trade frictions, Australia is more sensitive to Chinese growth as most of her exports are either to China or the Asia-Pacific Rim, which are levered to China. By contrast, Canadian trade is more sensitive to the US economy. 

 

 

AUDCAD recently bounced off an important technical support level after peaking in March. I interpret this as another sign that the trajectory of Chinese economic deceleration is bottoming.
 

 

Another reason for greater stability in Asia is the buffer provided by foreign exchange reserves. Bloomberg report that Asian EM FX reserves have grown significantly, which makes them more resilient to external shocks.

 

Asia’s emerging economies have accumulated their highest level of foreign-exchange reserves since 2014, offering a powerful buffer against market volatility if the U.S. Federal Reserve changes course. Central bank holdings of foreign currencies in the region’s fast-growing emerging economies hit $5.82 trillion as of May, their highest since August 2014. When China’s cash pile is stripped out, emerging Asian central banks’ reserves stood at an all-time high of $2.6 trillion. In 2013 a signal that the Fed would begin winding down asset purchases sent shockwaves through Asia, an episode that came to be known as the “Taper Tantrum.” Foreign investors fled and bond yields shot up, forcing central banks to burn through their defenses to protect their currencies. 

 

 

The Fed’s hawkish turn

The FOMC took a hawkish turn at its meeting last week. Its Summary of Economic Projections showed that participants significantly marked up the 2021 inflation rate, regardless of how it’s measured. However, inflation is expected to decline next year indicating the transitory nature of the price increases. Moreover, it is now expecting two rate hikes in 2023, compared to none in the March SEP.

 

 

Translated, the Fed believes that pandemic-related downside risks to the economic recovery are falling. It’s seeing signs of transitory inflation. While it’s difficult to forecast policy very far out, it would be prudent to begin removing monetary accommodation and think about raising rates in about two years.

 

The economy is recovering and gaining momentum, it’s time to gradually take the foot off the monetary accelerator. The Citi Economic Surprise Index, which measures whether economic releases are beating or missing expectations, is rising again after bottoming out recently.

 

 

Across the Atlantic, the Eurozone ESI recovered strongly in the second half of 2020 and momentum is strong. The ECB has also signaled that it intends to stay accommodative for a very long time.

 

 

These are signs that the rest of the world has decoupled from China and fears of a China slowdown were not dragging down the global economy.

 

 

Equity market implications

Here is what it means for the equity markets. Market valuation depends on two factors, the P/E ratio, which is a function of interest rates, which are expected to rise, and the E in the P/E, which is also rising too.

 

 

This environment should be bullish for cyclically sensitive equities. The Rising Rates ETF (EQRR), which is tilted toward cyclical and value stocks, is testing a key relative rising trend line. While I would not suggest investing EQRR because of its low AUM which invites a wind-up of the ETF, it is nevertheless a useful barometer of market factor trends.

 

 

In particular, I would focus on the commodity-producing parts of the market. PICK is a global mining ETF that is just testing its long-term uptrend.

 

 

Energy stocks are also exhibiting both absolute and relative uptrends with strong underlying breadth.

 

 

There are several reasons to be bullish on these stocks. First, they exhibit cheap relative valuation.

 

 

These stocks are also enjoying the tailwind of strong demand-supply fundamentals. The WSJ reported that there is little current capacity available to meet rising demand from a global recovery.
 

Languishing commodity prices led producers to slash capital spending on major resources by nearly half over the last decade, shrinking stocks of industrial metals to two-decade lows and reducing supplies across commodities. The crunch is now converging with a buying spree in key markets to supercharge prices—and there is no quick fix.

 

Since 2011, investments to develop the energy and mining sectors have fallen 40%, according to asset manager Schroders, leaving many producers unprepared for a recent boom in manufacturing and spending in the world’s two largest economies. Prices of resources from corn to lumber to battery metals have risen sharply over the past year, in many cases to twice or more from pre-pandemic levels, aided by low interest rates, a weaker dollar and infrastructure building in the U.S. and China.
Normally, producers respond to higher prices by increasing supply. In this cycle, mining and energy capital expenditures have languished. In particular, the energy sector is cautious about expanding capacity when forecasts call for falling demand as users shift to renewables.

 

 

In the short-term, however, investors are already overweight the cyclical and reflation trade. The latest BoA Global Fund Manager Survey shows that respondents are overweight commodities, banks, and cyclically sensitive sectors like industrials. If a pullback were to occur, investors should regard that as a welcome sentiment reset to gain cyclical exposure.

 

 

 

No market crash

In conclusion, investors should not expect the stock market to crash despite the dire headlines. Real-time indicators such as the copper/gold and the broader base metals/gold ratios indicate a sideways pattern in risk appetite. This should not lead to a major risk-off episode.

 

 

From an intermediate-term perspective, the current environment is bullish for cyclical and reflation stocks, and especially resource extraction sectors owing to the lack of a supply response in the face of rising demand. Signs of stabilization and a possible bottom in China’s growth trajectory will also be supportive of commodity demand, as China has been the primary consumer of global commodities. However, investors are already long the cyclical and reflation investment theme, and a pullback would represent a buying opportunity.

 

 

The market’s instant FOMC report card

Posted by Cam Hui -

Mid-week market update: It’s always difficult to make any kind of coherent market comment on FOMC meeting days. The market reaction can be wild and price moves can reverse themselves in the coming days.
 

Nevertheless, experienced investors understand that it’s not the announcement that matters, but the tone announcement compared to market expectations. Bloomberg Economics conducted a survey ahead of today’s FOMC meeting and found the following:
 

  • FOMC will raise inflation, growth forecasts for 2021
  • Forecasts to shift rate liftoff to 2023
  • FOMC to signal bond taper at Jackson Hole in August
  • Taper announcement in December
  • Powell gets reappointed — Brainard is the next option

 

 

Here how the Fed decisions fared compared to Street expectations.

 

 

Market reaction

With that preface, the FOMC statement came in hot today by shading up the growth outlook.

 

 

The major changes were:

  • 3.4% inflation in 2021 (previous forecast: 2.4%)
  • Two rate hikes in 2023 (previous was no hikes)
  • Unemployment 3.8% in 2022 (previously 3.9%)

 

The market`s reaction to the Fed meeting can be measured by changes in the Treasury yield curve. Since the short end is firmly anchored, that effectively means monitoring the behavior of the 10-year Treasury yield. A steepening yield curve (rising 10-year yield) translates to the expectation of tighter monetary policy, while a flattening curve indicates that the market believes the Fed isn’t moving in the near future. The 10-year Treasury yield recently broke technical support but it surged above the support-turned-resistance line after the FOMC meeting.

 

 

Ouch!

 

 

Stock market implications

Bespoke recently published a chart of how the S&P 500 performed on FOMC meeting days under different Fed Chairs since 1994. The track record under Powell is historically bearish, especially after the press conference.

 

 

While the stock market’s reaction was consistent with Bespoke’s historical experience, that’s not the point. The US equity market has become increasingly bifurcated between growth and value. Growth stocks, as measured by the NASDAQ 100, is more sensitive to falling rates than value names. Investors should be thinking about positioning in growth or value, rather than the S&P 500 because it is not a monolithic market.

 

 

Investors need to keep the bifurcated nature of the stock market in mind as the S&P 500 tries to hold its upside breakout while struggling with numerous negative divergences.

 

 

My base case scenario calls for a period of sideways consolidation. I expect that prices will have a flat to slightly negative bias while the market resolves its expectations of Fed policy.

 

What I meant to say was…

Posted by Cam Hui -

After a number of discussions with readers, there appears to have been some misunderstanding over my recent post (see The bond market tempts FAIT). I did not mean to imply that the advance in bond prices is an intermediate-term move, only a tactical counter-trend rally. The decline in Treasury yields can be attributable to:

  • The market’s buy-in to the Fed’s “transitory inflation” narrative, which was discussed extensively in the post;
  • Excessively short positioning by bond market investors, as shown by a JPMorgan Treasury client survey indicating that respondents were highly short duration, or price sensitivity to yield changes; and

 

 

  • A FOMO stampede by corporate defined-benefit pension plans. A recent study showed that pension plans were nearly fully funded from an actuarial viewpoint. Falling rates would raise the value of liabilities, and without asset-liability matching, pension plans were at risk of widening their funding gap.

 

 

In short, the bond market rally is a tactical counter-trend rally. The combination of expansive fiscal and monetary policy will eventually put upward pressure on inflation and bond yields. 

 

That said, there are a number of pockets of uncorrelated opportunities for investors, regardless of how long Treasury yields stay down.

 

 

Gold and gold miners

I turned bullish on gold and gold miners about a month ago (see Interpreting the gold breakout). At the time, I pointed out that the initial point and figure target for the Gold Miners ETF (GDX) was 40. Never did I dream that GDX would reach its target within days of the publication of that post.

 

From a long-term perspective, both gold and GDX had broken out of a multi-month flag formation, which is a bullish continuation pattern and should have further upside potential. From a short-term perspective, both gold and GDX have pulled back and they have been consolidating sideways and GDX is testing the 50% retracement support level. The GDXJ (junior golds) are now outperforming GDX, which is a constructive indication of the return of speculative fever in the group. Look for the group to advance until the % bullish rises into the over 80% overbought zone.

 

 

Zooming out to a multi-year view, gold prices staged an upside breakout in mid-2020, pulled back, and it is now testing overhead resistance at 1900. Cross-asset signals are constructive. Real yields, as represented by TIP, are rising. So is the TIP to IEF ratio, which is correlated to the long-term inflation expectations ETF (RINF).

 

 

The intermediate-term outlook for gold is bullish and the current bout of weakness should be regarded as a buying opportunity.

 

 

Latin America

If the outlook for gold prices is bullish, then the path of least resistance for the USD should be down, since the two are inversely correlated. In particular, emerging market currencies have been strong against the USD.

 

While investors could expose themselves to a falling greenback by buying the EM currency ETF (CEW). Another way is through a bet on Latin American equities, whose relative performance has been correlated to EM currencies. Be aware, however, the Latin American region is highly undiversified. The two biggest weights, Brazil and Mexico, make up the bulk of the weight in the index.

 

 

In conclusion, the decline in Treasury yields represents a tactical counter-trend move. Nevertheless, there are other uncorrelated investment opportunities beyond the interest rate-related plays. Gold and gold miners are poised for another upleg. Latin American equities may be an overlooked USD-weakness-related play.

 

 

Disclosure: Long GDX

 

A new S&P 500 high, but…

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.
 

 

One last high?

The good news is the S&P 500 rallied to a marginal all-time high last week. The bad news is it was accompanied by a bearish RSI divergence.

 

 

There was even more bad news.

 

 

Non-confirmations everywhere

While it is said that there is nothing more bullish than fresh highs, most market internals are not confirming the stock market’s strength. While the NYSE Advance-Decline Line did advance to fresh highs, both NYSE and NASDAQ new 52-week highs are weakening. So are the percentage of S&P 500 and NASDAQ stocks above their 50 dma.

 

 

The small-cap Russell 2000 continues to languish in a trading range. As well, small-caps have violated a relative uptrend and they are now trading sideways against the S&P 500.

 

 

Equity risk appetite, as measured by the equal-weighted performance of consumer discretionary to staples, is exhibiting a strong negative divergence. The ratio of high-beta to low-volatility stocks is showing a minor negative divergence.

 

 

The price momentum factor, however it’s measured, is weak.

 

 

 

Sentiment warnings

A number of sentiment models are also flashing warnings. The latest update of AAII weekly sentiment shows that bearish sentiment remains at an extremely low level. This has been a cautionary sign for investors in the past.

 

 

In addition, the equity-only put/call ratio, which is reflective of individual trader activity, is falling and nearing historic lows again. By contrast, the index put/call ratio, which is more reflective of professional hedging activity, is rising.

 

 

Sentiment models are inexact timing indicators for calling tops. Nevertheless, the combination of sentiment and technical conditions is warning that the stock market advance is unsustainable. Current conditions call for differing ways of approaching the market, depending on the investor’s time horizon.

 

Investment-oriented accounts need to recognize that the primary trend is still up. Stay long equities and don’t worry about minor blips in the market. 

 

On the other hand, traders don’t need to be always aggressively long or aggressively short. This is a time to step to the sidelines. My base case scenario calls for a period of sideways and choppy sideways price action. Pullbacks should be relatively shallow and limited to drawdowns of 5% or less.

 

 

The bond market tempts FAIT

Posted by Cam Hui -

Remember when I called for a bond market rally (see What a bond market rally could mean for your investments). The 10-year Treasury yield broke support last week and shrugged off a hot CPI print. Is the bond market tempting FAIT, or the Fed’s Flexible Average Inflation Targeting framework?
 

 

Here are some of the broad market implications.

 

 

Transitory inflation

May CPI came in ahead of expectations, but more detailed analysis shows that the “hot” components were largely transitory in nature. Here are my main takeaways from that report:

 

  • Headline YoY CPI was boosted by strong energy prices, which was a low base effect increase owing to very low prices a year ago.
  • Standout strength in Core CPI was attributable to used car prices and airfares. The good news is that the pace of these prices increases have decelerated, indicating the transitory nature of these factors. As well, the CPI weights of airfares and used car prices account are relatively small.
  • Other transitory factors include strength in auto insurance, but those price increases have decelerated in the last three months.

 

 

Ahead of next week’s June FOMC meeting, here is what Fed policymakers are seeing on their inflation dashboard. Headline and Core CPI have spiked, but more detailed analysis shows that price increases were attributable to transitory factors. The Cleveland Fed’s median CPI remains tame, indicating that price increases were attributable to outlying noise.

 

 

From a global perspective, China is experiencing a growth deceleration. As the slower growth bleeds into the world economy, it should also put downward pressure on Treasury yields.

 

 

This should be good news for bond prices. But what about stock prices?

 

 

Rising wage pressure

One worrisome development for the suppliers of capital is the undersupplied labor market, which is putting upward pressure on wages.

 

I know that I am repeating myself, but the latest NFIB small business survey complained bitterly about employee recruitment and labor costs. These surveys are important because small businesses have little bargaining power and they are therefore sensitive barometers of economic conditions.

 

A record-high 48% of small business owners in May reported unfilled job openings (seasonally adjusted), according to NFIB’s monthly jobs report. May is the fourth consecutive month of record-high readings for unfilled job openings and is 26 points higher than the 48-year historical reading of 22%.

 

Small business owners continue to report finding qualified employees remains a problem with 93% of owners hiring or trying to hire reported few or no “qualified” applications for the positions they were trying to fill in May. Thirty-two percent of owners reported few qualified applicants for their positions and 25% reported none.
 
Eight percent of owners cited labor costs as their top business problem and 26% said that labor quality was their top business problem, the top business concern.

Could government support be encouraging workers to stay home? Will the economy see a flood of new workers flood the market when job benefits expire? The preliminary answer is no. Indeed tracked the job search activity of states that are cutting enhanced unemployment benefits on June 12. Job searches in these states have not picked up. In fact, they are below the national average.
 

 

Joe Wiesenthal at Bloomberg pointed out an unusual condition in the Beveridge Curve:

One indicator that economists like to look at is the so-called Beveridge Curve, which plots the unemployment rate against the rate of job openings. Historically there’s been a somewhat stable relationship between the two. Job openings go up and the unemployment rate goes down, as you would expect. But as with everything else weird about this recovery, that’s breaking down.
 

As you can see here on the chart from the BLS, job openings are soaring (see the highlighted part) while the unemployment rate holds steady.

 

 

Wiesenthal went on to highlight the analysis of Fed watcher Tim Duy, who believes that labor market shortages are here to stay.
 

In a note to clients this morning, Tim Duy of SGH Macro Advisors notes that this new weird shape of the curve holds true even if you look at alternative measures of non-employment besides the standard U-3 measure: “it appears that labor market frictions not related to unemployment insurance appear to have been increasing. That’s not exactly great news if you are expecting the end of enhanced UI benefits will dramatically ease labor market frictions.”
Translated, these conditions are putting upward pressure on wages. The open question is whether this will result in a wage-price spiral, or if this is a “once and done” upward adjustment in compensation. It’s possible that we are just seeing a one-time effect of wage competition at the low-end as large employers like Amazon and McDonald’s raised their employee pay.

 

Time will tell, but rising compensation costs are putting pressure on operating margins. As well, the risk is that an escalating wage-price spiral will force the Fed to raise rates in order to cool rising inflationary expectations.

 

 

What a bond market rally means

In the meantime, the bond market is buying into the Fed’s narrative of “transitory inflation” and yields are falling. As I pointed out in my May 29, 2021 note (see What a bond market rally could mean for your investments), falling yields will translate into better performance by high-duration interest-sensitive growth stocks. Expect a temporary counter-trend rally by growth names.

 

 

My investment style dashboard shows that the value-growth ratios are correcting across all market cap bands.

 

 

In addition, cyclical stocks are all rolling over in relative performance in some manner.

 

 

 

A global rotation

In addition, investors are rotating out of US equities. Here is a closer look at the relative performance of the major regions against MSCI All-Country World Index (ACWI). As US equities falter, Europe has caught a bid. Even Japan is turning up, and so are emerging markets, especially outside China.

 

 

Willie Delwiche observed a marked difference between industry breadth in the US and abroad. The percentage of US industries making new highs has been declining.

 

 

On the other hand, the percentage of industries in ACWI making new highs has been holding up well.

 

 

Jens Nordvig wrote a Marketwatch opinion piece which argued that “Global investors are losing interest in U.S. stocks and that will be a game changer”. Nordvig pointed out that equity fund flows into US equities fell dramatically in March. He believes “this is all logical since the rest of the world is catching up with the U.S. on the vaccine front”.

 

 

I believe the rotation is attributable to the wage pressures in the US, which will squeeze margins and the expectation that economic growth differentials between the US and Europe will narrow. Eurozone equities have staged a relative upside breakout against ACWI, with strength coming from France, Italy, and Greece. The most notable laggard is Germany.

 

 

The UK is a more complicated situation. Large-cap UK equities have staged a relative breakout, and small-caps performed even better as Brexit jitters have diminished. Nevertheless, disagreements with the EU overfishing and the Irish border are issues specific to that market.

 

 

Over in Asia, the bleeding in China and China-related plays appears to have stopped despite signs of Chinese growth deceleration. Chinese stocks and the markets of her major Asian trading partners are all bottoming relative to ACWI. Selected markets like Taiwan and Australia are exhibiting some signs of relative strength.

 

 

More importantly, Chinese material stocks are bottoming against global materials. I interpret this as an indication that the growth deceleration is over.

 

 

In conclusion, the US Treasury market has shrugged off inflationary worries and has begun to rally. This is creating a short-term tailwind for interest-sensitive growth stocks. The bigger picture that is investors are starting to rotate away from US equities because of lower growth differentials and expectations of margin compression owing to wage pressures.

 

 

The valuation differential between US equities and the rest of the world is finally closing.

 

 

 

Pigs get slaughtered…

Posted by Cam Hui -

Mid-week market update: Traders have an adage, “Bulls make money. Bears make money. Pigs just get slaughtered.” It’s time for equity bulls to be near-term cautious on stocks, though I expect any market weakness to be relatively shallow.
 

In my weekend update, I had set out a number of tripwires (see Time is running out for the bulls). So far, the S&P 500 is struggling to overcome resistance even as it exhibits a negative RSI divergence.
 

 

On the other hand, the 10-year Treasury yield has decisively breached support.

 

 

While this development is likely to be tactically supportive of growth stocks and NASDAQ relative performance, the near-term risk for US equities is rising.

 

 

 

Sentiment and technical warnings

While the AAII bull-bear spread has not been very effective as a sell signal, the level of bearishness (bottom panel) has been more useful and timely. In particular, the market has encountered headwinds whenever AAII bears reached the 20% (last reading: 19.76%).

 

 

Bad industry breadth is raising another warning. Willie Delwiche also observed that the number of industry groups making new highs declined to 22% last week.

 

 

 

Fundamental catalysts

From a chartist’s perspective, the market bull looks tired and needs a rest. From a fundamental and macro perspective, bullish momentum may be waning as earnings estimate revisions start to decelerate as Morgan Stanley strategist Michael Wilson recently warned:

 

We remain concerned that after the most positive earnings revisions quarter on record, next year’s consensus forecasts are now above what our analysis suggests is achievable for the first time since the recovery began. More specifically, we think margin assumptions are too high given the headwinds from inflation and taxes that have not been baked into estimates.

Jurrien Timmer at Fidelity also observed that the rate of earnings estimate revisions is peaking and rolling over.
 

 

Further to yesterday’s note about labor market pressures (see NFIB update: Revenge of the Proletariat?), Joe Wiesenthal at Bloomberg highlighted a comment from Fed watcher Tim Duy about the resilience of labor market shortages [emphasis added].

 

One indicator that economists like to look at is the so-called Beveridge Curve, which plots the unemployment rate against the rate of job openings. Historically there’s been a somewhat stable relationship between the two. Job openings go up and the unemployment rate goes down, as you would expect. But as with everything else weird about this recovery, that’s breaking down.
 

As you can see here on the chart from the BLS, job openings are soaring (see the highlighted part) while the unemployment rate holds steady.
 

In a note to clients this morning, Tim Duy of SGH Macro Advisors notes that this new weird shape of the curve holds true even if you look at alternative measures of non-employment besides the standard U-3 measure: “it appears that labor market frictions not related to unemployment insurance appear to have been increasing. That’s not exactly great news if you are expecting the end of enhanced UI benefits will dramatically ease labor market frictions.”

 

Obviously there are a lot of people who assume that the labor market will go “back to normal” once the UI expansions expire, childcare becomes easier, the pandemic starts to fade and so on. But at the moment, things are still looking pretty unusual.
 

 

In short, Duy believes that labor market shortages are here to stay and wage pressures will continue. Putting it all together, net margins will come under increasing pressure from rising labor costs, inflationary pressures, and rising tax rates. The stock market is likely to get spooked by these factors.

 

Be cautious. Don’t be a greedy pig.

 

NFIB update: Revenge of the Proletariat?

Posted by Cam Hui -

The monthly NFIB update is always useful as a window on the economy. Small businesses tend to have little bargaining power and they are therefore sensitive barometers of economic trends. A month ago, NFIB small business optimism surged (see NFIB conservatives grudgingly turn bullish). The latest report saw optimism stall as readings edged back from 99.8 to 99.6. 
 

 

The biggest complaint was the availability of labor. While the JOLTS report comes to a similar conclusion, it is a survey of April conditions while the NFIB survey period is May. Its headline “Nearly Half of Small Businesses Unable to Fill Job Openings” tells the story.

 

 

Economic strength + labor shortages

Still, the decline in optimism has to be taken with a grain of salt. Of the 10 components that make up the Small Business Optimism Index, six were positive, one was neutral, and three were negative. The single category that dragged down the reading was “expect economy to improve”.

 

 

Seriously? The economy is red hot and just recovering from the sudden stop of a pandemic-induced recession. Sales and sales expectations are rising strongly, and a net -26% of respondents expect the economy to improve? I interpret that as the small business small-c conservative political bias against a Democratic-led White House and Congress.

 

 

Nevertheless, the reports of labor market shortages are worthy of consideration. The NFIB reported:

 

A record-high 48% of small business owners in May reported unfilled job openings (seasonally adjusted), according to NFIB’s monthly jobs report. May is the fourth consecutive month of record-high readings for unfilled job openings and is 26 points higher than the 48-year historical reading of 22%.
Labor market complaints were especially bitter [emphasis added]:
Small business owners continue to report finding qualified employees remains a problem with 93% of owners hiring or trying to hire reported few or no “qualified” applications for the positions they were trying to fill in May. Thirty-two percent of owners reported few qualified applicants for their positions and 25% reported none.

 

Eight percent of owners cited labor costs as their top business problem and 26% said that labor quality was their top business problem, the top business concern.

For investors, the questions to consider is how transitory are these labor problems and how will the Fed react?
 

 

Uneven wage pressures

The Atlanta Fed’s Wage Growth Tracker sheds some light on this problem. Wage growth among low-skilled workers plummeted upon the onset of the recession, though high-skilled wage increases remained steady. As the economy reopened, low-skilled wage growth snapped back.
 

 

Is this a case of the revenge of the Proletariat? Labor market shortages are attributable to a combination of the lack of suitable child care for female workers, fear of the pandemic, and government wage supplement support. Disentangling and quantifying the effects of each of these components is a challenge for policymakers. We will know for sure the effects of government support once those subsidies run out in September. 
 

For Fed policymakers, the issue is whether these wage pressures indicate the start of a cycle of cost-push inflation. For the time being, they will regard these pressures as transitory unless proven otherwise. The Atlanta Fed’s Core Sticky-Price CPI, which is “a weighted basket of items that change price relatively slowly”, has been steady throughout the pandemic. By contrast, the Flexible CPI, which is “a weighted basket of items that change price relatively frequently”, has skyrocketed. 
 

 

This is what transitory inflation looks like.
 

 

The reopening trade

For investors, they can look forward to an economy that’s reopening. The Transcript, which monitors company earnings calls, summarized the latest set of calls as a booming economy.

Summer has started and the US economy is booming. Economic activity is surging past 2019 levels. The numbers are staggering. GDP growth is expected to hit 7% this year led by consumer spending. Bank of America said that its consumer accounts are registering 20% more spend than 2019. There’s still plenty more liquidity too. This all seems incongruent with 10-year treasury yields that are 40 bps below where they were before the pandemic.

The reopening trade can be seen in the relative performance of Leisure and Entertainment stocks against the S&P 500.
 

 

The FOMC is meeting next week. While there will likely some discussion of tapering its QE programs, those actions have largely been discounted by the market. Expect further language about the transitory nature of price pressures.
 

Time is running out for the bulls

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.
 

 

Negative seasonality ahead

While I am not inclined to trade strictly on seasonality, technical conditions agree with the seasonal pattern. If history is any guide, the S&P 500 is scheduled to pause its advance starting about mid-June.

 

 

My base case scenario of record calls for the index to test its old high and possibly make a marginal new high, but the time is running out for the bulls. The coming week is the bulls’ last chance to show their strength.

 

 

Dark clouds on the horizon

The technical tea leaves are not looking very good. The top five sectors make up about three-quarters of S&P 500 weight and it would be difficult for the index to advance or decline without the participation of a majority. A review of the relative performance of these sectors shows that only one, Financials, can be described as being in a relative uptrend. The rest are either weakening or trading sideways compared to the index.

 

 

The high-beta NASDAQ 100 is testing resistance while exhibiting a negative 5-day RSI divergence. Speculative growth stocks as represented by ARK Innovation ETF (ARKK) failed at its 50 dma resistance. As well, the NASDAQ 100 McClellan Oscillator reached a near overbought condition before rolling over.

 

 

The burst of speculative froth by meme stocks have also marked past trading tops in the past. Here are AMC and GME. Will this time any different? Do you feel lucky?

 

 

 

Another warning comes from the spike in the correlation between the S&P 500 and the VIX Index, and the S&P 500 and the VVIX, which is the volatility of the VIX. While readings did not reach sell signal levels, the surge in correlation is nevertheless a warning that the bulls have a narrow window to push prices upward.

 

 

 

Setting tripwires

Here is what I am watching. Can the defensive sectors regain their relative strength in the coming days? If so, it will be a signal that the bears have regained control of the tape.

 

 

Can the 10-year Treasury yield break down through support. A support break would be a signal of a bond market rally that could lend a second wind to growth stocks (see What a bond market rally could mean for your investments).

 

 

Finally, watch to see if the S&P 500 can break resistance or breach support. The challenge for the bulls is to stage an upside breakout in the face of negative RSI divergences. The challenge for the bears is trend line support in the 4180-4190 range.

 

 

Don’t get me wrong. The intermediate-term trend is still up. The market is just due for a pause. My inner investor remains bullishly positioned. My inner trader is getting ready to take profits at a moment’s notice.
 

 

Disclosure: Long SPXL

 

Is the S&P 500 wildly overvalued?

Posted by Cam Hui -

Several readers asked me to address the valuation warning from Jason Goepfert of SentimenTrader, who found that the S&P 500 is wildly overvalued based on a combination of real earnings yield and dividend yield.
 

 

Let’s begin by unpacking Goepfert’s chart (annotations are mine). There were five instances since 1970 when the market appeared overvalued based on this metric. The market had already begun falling in two episodes (red boxes: the Nifty Fifty top and the GFC top), and this indicator signaled tops in three (grey boxes: Volcker induced bear market, 1987 Crash, and the Dot-Com Bubble). Is a success rate of 60% (three out of five top calls) enough for an effective sell signal?

 

 

Differences in opinion

I have a difference of opinion over Goepfert’s methodology. First, he uses the inverse of the trailing P/E ratio instead of forward P/E to calculate real earnings yield “because [forward P/E ratios are] nothing but guesses. And Wall Street analysts are notoriously inaccurate at predicting the future.” While the claim that the Street is notoriously inaccurate at predicting the future is correct, the market is a discounting mechanism, and using last reported earnings can lead to valuation distortions, especially when the economy is emerging from a recession.

 

As the chart below shows, trailing 12-month P/E skyrocketed in 2020 as the economy came to a sudden stop because of the pandemic. The S&P 500 rose after a brief setback and never looked back. Does that mean investors should be worried about valuation based on trailing P/E? The answer is no. As the economy began to improve, earnings rose and the trailing P/E fell.

 

 

Contrast a similar analysis based on forward P/E. While I recognize that forward earnings estimates are a form of fiction, what matters more to the market is the direction of change and not the absolute level of earnings estimates. Using forward P/E allows investors to be forward-looking instead of backward-looking. The forward P/E ratio has been relatively steady since the recovery from the COVID Crash, indicating that EPS estimates have been rising in line with the market. 

 

 

Moreover, the forward 12-month estimates have risen faster than the S&P 500 in recent weeks. The forward P/E ratio fell as a consequence, which improves the valuation picture. FactSet reported that the S&P 500 experienced the largest EPS increase for Q2 to date since 2002, which was the year a new bull market began in the wake of the NASDAQ Crash.

 

 

In addition, Goepfert appears to be mixing real inflation-adjusted valuations with nominal returns.

 

Now that there has been a spike in inflation gauges, the earnings yield on the S&P 500 has turned negative. This is not a condition that investors have had to tackle much over the past 70 years.

 

When an investor in the S&P adds up her dividend check and share of earnings, then subtracts the loss of purchasing power from inflation, she’s barely coming out even. This is a record low, dating back to 1970, just eclipsing the prior low from March 2000. 

 

If we ignore dividends, then there have been five other times when the S&P 500’s inflation-adjusted earnings yield turned negative. The S&P failed to rally more than 7% at its best point within the next two years after all but one signal.
What is the bear case here? If an investor is using inflation-adjusted valuations, shouldn’t that be benchmarked against real returns, rather than nominal returns? If the bear case is a spike in inflation which acts to depress equity valuations, then what alternative asset classes should the investor consider? To be sure, I have pointed out in the past that many non-US equity markets offer more attractive alternatives than the US (see In search of global opportunities), but the case I made was based on relative performance and not an absolute performance.

 

In short, Goepfert’s analysis appears to be a case of torturing the data until it talks.

 

 

ERP and its variants

Notwithstanding Goepfert’s insight, other analysts have highlighted variations of a bearish inflation-adjusted earnings yield valuation thesis. In differing ways, these are all different applications of the Fed Model, which measures the spread between the E/P ratio and interest rates, otherwise known as the Equity Risk Premium (ERP).

 

Morgan Stanley pointed out that an inflation-adjusted equity risk premium, which is the forward earnings to price yield minus a 10-year breakeven rate, has fallen to lows last seen at the height of the NASDAQ top.

 

 

Michal Stupavsky of Conseq Investment Management also observed that the S&P 500 inflation-adjusted earnings yield (without dividends) has set a 40-year low.

 

 

 

Bullish interpretations

There are, however, more benign interpretations of ERP. If investors were to compare the S&P 500 earnings yield minus the BBB real yield, which reflects the corporate cost of capital, valuations appear to be more benign. Arguably, the market looks slightly cheap if measured this way.

 

 

Aswath Damodaran, finance academic at the NYU Stern School, has maintained an ERP model based on nominal equity and bond yields. His latest update shows a reading of 4.24%, which is approximately the level seen at the market’s 2009 bottom.

 

 

Jurrien Timmer at Fidelity Investments calculated a market valuation based on price to total cash, which is the dividend yield plus buyback yield. He concluded, “By this metric, the market looks reasonably priced, right in line with where it was at the same points during the 1949-68 and 1982-2000 secular bull markets.”

 

 

 

Inflation and Fed policy

How can we resolve this valuation debate? Is the stock market about to keel over and crash?

 

For some historical perspective, bear markets are caused by recessions. Of the five instances that Jason Goepfert originally cited, only the 1987 Crash was sparked by excessive valuation. In all cases except for the COVID Crash, the recessions were caused by the Fed tightening monetary policy.

 

 

The global economy just emerged from a massive recession. What are the chances that central banks tighten to cool off overheated economies? BCA Research pointed out that the Fed rate hike came two years after the last QE taper. Various Fed speakers have started to discuss how the Fed may taper its QE program. Market expectations indicate that a taper will begin either late this year or early next year. If the Fed were to follow the script of the post-GFC era, rate hikes won’t begin until late 2023 or 2024.

 

 

Much depends on the Fed’s reaction function to inflation data. So far, the Fed has dismissed the surge in prices as transitory. Core CPI and Core PCE came in hot at 3.0% and 3.1% respectively. On the other hand, the Dallas Fed’s Trimmed Mean PCE, which excludes outlying components, is relatively benign at 1.8%.

 

 

There is a case to be made that the recent price spikes are indeed transitory. Used car prices, which is one element of price increases that have driven the inflation surge, are showing signs of deceleration.

 

 

The Fed is determined to run a hot economy. The prospect of rate increases is far on the horizon, especially in light of two soft consecutive Non-Farm Payroll reports.

 

 

Bullish momentum

From a technical perspective, Willie Delwiche observed that 86% of global markets are above their 50 dma, indicating strong breadth and positive price momentum. While this does not mean that the market is going up in a straight line, similar past signals have been intermediate-term bullish for the S&P 500.

 

 

In conclusion, the fears of a valuation-induced market crash are overblown. Recessions are bull market killers, and there is no sight of a recession on the horizon. Fed policy is accommodative and it is expected to be easy for some time. While I have made the case before that US investors could find better bargains outside America’s borders (see In search of global opportunities), this does not mean that the S&P 500 will experience a bear market in the near future. 

 

This is a bull market. Enjoy it.