Rethinking the Hindenburg Omen

Posted by Cam Hui -

The ominously named Hindenburg Omen was developed by Jim Miekka to spot major stock market tops. Unfortunately, it has also had a history of crying wolf too many times with false positives. Its inconsistency prompted one commentary to call it a warning to avoid traveling by blimp.
 

David Keller recently penned an article that analyzed the Hindenburg Omen in detail. He called it a breadth indicator with three specific components:
  1. The stock market has to be in an established uptrend;
  2. An expansion in both new 52-week highs and lows that indicate indecision; and
  3. The market exhibits a price momentum break.
Keller further explained, “A valid Hindenburg Omen signal needs to have multiple signals within a 30-day window to actually register a valid bearish indication.”

 

A chart of the Hindenburg Omen is shown below. The indicator is displayed in the lower panel and a valid signal has a value of 3. History shows that there were 11 such warnings in the last 10 years. Six saw declines (shown in pink). The market continued to advance or the Omen was too late in warning of declines in four instances (grey). One resolved in a sideways choppy market (grey/pink). While these results are marginally useful, this indicator’s sell signals don’t inspire a high level of confidence.

 

 

The Hindenburg Omen has recently flashed a series of sell signals. How should investors react?

 

 

A condition indicator

I conducted a more detailed analysis of the history of this indicator going back to the 1990’s and found that it spotted most major market declines ahead of time, such as the dot-com top in 1999 and 2000 and the market top in 2007 and subsequent Great Financial Crisis in 2008. The only one it missed was the Long-Term Capital Management Russia Crisis meltdown.

 

 

I conclude that this is an indicator with a spotty success record with a strong left return tail. Despite the record of false positives, it has warned of almost every major past bearish episode. I call this a condition indicator that is a signal of potential large downside risk but needs confirmation from other indicators for investors to turn cautious.

 

As a reminder, I recently pointed out that the Wilshire 5000 and its negative monthly RSI divergence flashed a sell signal. While the Wilshire 5000 sell signal can take anywhere from two months to over a year to resolve bearishly, the combination of these bearish warnings should raise the level of cautiousness for investors.

 

 

 

A Trend Model downgrade

In addition, my Trend Asset Allocation Model has been downgraded from bullish to neutral. As a reminder, the Trend Model is based on a composite of global stock and commodity markets. It has a history of out-of-sample signals since 2013. A model portfolio that varies 20% in weight from a 60/40 benchmark has shown a record of equity-like returns with balanced fund-like risk.

 

 

Investors should interpret the downgrade as a signal to de-risk from an aggressive to a neutral position. It is not the Apocalypse.

 

Let’s take a look. In the US, the S&P 500 has violated its 50-day moving average (dma) and testing its 200 dma. Both the S&P 500 and NASDAQ 100 have begun to lag global stocks, as measured by the MSCI All-Country World Index (ACWI).

 

 

In Europe, the Euro STOXX 50 is struggling to hold its 50 dma. The FTSE 100 has held up well, mainly because of its heavier weighting in energy and financial stocks, which have outperformed. The mid-cap FTSE 250, which is more reflective of the British economy, has violated both the 50 and 200 dma.

 

 

Asian markets, on the other hand, are showing signs of stabilization after a period of poor performance. Both China and Hong Kong have begun to turn up relative to ACWI. The PBoC has begun to ease, though it’s still an open question whether the change in policy will stimulate the Chinese economy or just stabilize the growth downturn from the property developer implosion. Monetary policy will not be able to address the growth challenges posed by China’s zero COVID policy of locking down areas whenever an infection is found. Other Asian markets are also exhibiting constructive signs of forming relative bottoms.

 

 

Commodity prices present a mixed picture. On one hand, they are strong and broke out to new recovery highs. On the other hand, the cyclically sensitive copper/gold ratio has been trading sideways for about a year, indicating neither strong economic strength nor weakness.

 

 

These readings support the Trend Asset Allocation Model’s shift to de-risk, but markets are not a complete disaster.

 

 

Cognitive dissonance

Two recent institutional investor surveys are highlighting a case of cognitive dissonance, the need for caution and the potential of a rush for the exits should risks materialize. The BoA Global Fund Manager Survey found that respondents were piling into value and cyclical sectors.

 

 

The IHS Markit Survey of Managers found a similar preference for cyclical exposure.

 

 

Here is where the cognitive dissonance comes in. The BoA Fund Manager Survey shows that the biggest tail-risk is a hawkish central bank. Why on earth would you stampede into cyclical stocks if you are worried about the Fed raising rates?

 

 

I pointed out before that equity investors face an elevated level of risk with value and cyclical stocks in the current environment (see Fade the value rebound). The market should gain greater clarity on this question after the January FOMC meeting next week. Notwithstanding the geopolitical risk of a Russia-Ukraine conflict, the FOMC meeting could represent an inflection point in risk appetite.

 

In conclusion, I am seeing signs of technical deterioration from a variety of sources, such as the Hindenburg Omen, a long-term Wilshire 5000 sell signal, and a Trend Asset Allocation Model downgrade. At a minimum, investment-oriented accounts should de-risk their portfolios and shift to a neutral equity weighting position consistent with their benchmark targets.

 

 

Painful enough for a bounce?

Posted by Cam Hui -

Mid-week market update: After this week’s brutal sell-offs, the stock market is oversold enough for a bounce. The VIX Index has risen above its upper Bollinger Band, which is an oversold market condition and short-term buy signal.
 

 

If the market action in the past year is any guide, the potential for the S&P 500 is the 4720-4750 zone.

 

 

Relief rally ahead

There are other signs that the market is due for a relief rally. The CBOE put/call ratio spiked to 1 or more in the last two days. These have been good indicators that risk/reward is tilted to the upside in the short run. In the past 18 months, the bullish resolutions of these buy signals (grey bars) have greatly outnumbered the bearish resolutions (pink bars).

 

 

Remember the carnage in the NASDAQ? The ratio of NASDAQ 100 to S&P 500 has become sufficiently oversold that the NDX is due for some better performance.

 

 

 

Not out of the woods yet

Despite the signs that the market is about to undergo a bounce, psychology may not be sufficiently washed out yet. Even as the put/call ratio rose to panic levels, the term structure of the VIX Index is showing a mixed picture. The 9-day to 1-month VIX inverted yesterday, indicating fear, but the 1-month to 3-month ratio remained upward sloping. These readings are not consistent with a durable bottom.

 

 

Similarly, the Fear & Greed Index is on the greedy side of neutral territory. Panic bottoms don’t look like this.

 

 

I had highlighted the sell signal from the intermediate-term breadth momentum oscillator. In the past, declines from this signal have ranged between 5% and 10%. The latest downdraft in the S&P 500 has only been -3.8% since the initiation of the sell signal. The bear leg from this signal may not be over.

 

 

Breadth indicators remain wobbly. All Advance-Decline Lines have broken down below their upside breakout levels, indicating broad-based weakness.

 

 

 

Opportunity and risk

In the short run, the market backdrop is more balanced between opportunity and risk. The effects of the Omicron wave appear to be peaking. Case counts in the UK, US, and Canada are starting to roll over, which is good news.

 

 

Q4 earnings season is proceeding. The market will experience both upside and downside volatility as individual companies report. The good news is forward EPS estimates are rising across all market cap bands.

 

 

On the other hand, Russia-Ukraine tensions are not abating. Russian troops are massing on the Ukrainian border in Belarus. The White House has warned that an attack could happen “on short notice”. US Secretary of State Anthony Blinken is scheduled to meet with Russian Foreign Minister Sergey Lavrov on Friday in Geneva. Neither side has indicated any hope of breakthroughs. The markets are understandably on edge and the tail-risk of an invasion could materialize at any time.

 

 

Don’t forget that the FOMC meeting is next week. Hawkish expectations are rising. The market expects four quarter-point rate hikes this year. Some strategists have even called for a half-point hike in March. Watch for signals about a reduction in the size of the Fed’s balance sheet from either the FOMC statement or from Powell during the press conference.
 

 

Subscribers received an alert this morning that my inner trader had closed his short position and stepped to the sidelines. He believes that the intermediate-term outlook is bearish and he will wait for a rally to re-enter his short position. While the market is oversold, the magnitude of downside risk far outweigh any short-term upside potential.

 

Reversals everywhere

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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.
 

 

Fun with Japanese candlesticks

Last week’s market action in the S&P 500 was a classic lesson in the usefulness of Japanese candlesticks. I wrote last weekend that the market was oversold and due for a rebound. The S&P 500 cooperated on Monday by exhibiting a hammer candle, in which the market tanks but rallied to a level equal to or above the open. Hammer candles are indications of capitulation selling and a possible short-term bottom, but the pattern needs to be confirmed by continued strength the next day. The bottom was confirmed Tuesday when the index advanced and regained the 50 dma.

 

The second candlestick lesson came on Wednesday, when the S&P 500 showed a doji, when the open and closing levels are about the same. Doji candles are signs of indecision and possible reversals but must be confirmed the next day. The S&P 500 duly weakened Thursday and stabilized Friday ahead of the long weekend. All of this is occurring as the S&P 500 forms a triangle, which suggests that a big move is just around the corner.

 

 

In short, it was a master class in trading Japanese candlestick patterns. Not all candlesticks resolve in textbook manners, but they did last week.

 

 

Reasons to be bearish

Now that the bearish reversal is in place, the path of least resistance is down. The intermediate-term breadth momentum oscillator (ITBM) flashed a sell signal when its 14-day RSI recycled from overbought to neutral. In the past, these sell signals have been effective about three-quarters of the time.

 

 

My cautious outlook is supported by negative divergences in equity risk appetite indicators. In particular, speculative risk appetite for high-beta story growth stocks is tanking (bottom panel), which is bearish.

 

 

Breadth indicators are wobbly again. The NYSE Advance-Decline Line has been unable to regain its upside breakout level. Net NYSE highs-lows are negative again. The percentage of S&P 500 stocks above their 50 dma has deteriorated to the critical 50-60% zone that separates bullish and bearish trends.

 

 

Determining downside risk is always a difficult exercise. In the past, ITBM sell signals have resolved with pullbacks in the 5-10% range. In this case, a test of the 200 dma, which stands at about 4420 and represents about a 7% drawdown, is a reasonable guesstimate. However, the sell signal presented by the negative 14-month RSI divergence of the Wilshire 5000 has typically ended with corrections of up to 20%.

 

 

 

The earning season wildcard

A 20% pullback would involve a major bearish catalyst. A possible source of volatility is the Q4 earnings season. So far, consensus EPS estimates have been steadily rising.

 

 

With December headline CPI at 7.0% and headline PPI at 9.7%, one of the key questions for investors is whether companies can pass through increased costs. 

 

 

What about the effect of the Omicron wave? As an example, Bloomberg reported that lululemon revealed Omicron had dented its sales. Was LULU an exception or the start of a trend?

 

The company best known for its yoga pants said that it started the holiday season strongly. But then it suffered from several effects of omicron, including staffing shortages and reduced operating hours in certain locations. Even before the latest variant, consumer-facing companies were grappling with supply-chain snarl ups and not having enough workers. If these pressures continue, Lululemon won’t be the last to highlight the consequences. 

 

So far, companies with strong brands, such as Nike Inc., and with scale, such as Walmart Inc. and Target Corp., have been able to withstand the supply-chain challenges, while weaker firms have struggled to stay afloat. Last week, Bed Bath & Beyond Inc., which is in the midst of a turnaround plan, cut its sales and profit forecast.
Expectations are elevated, but companies have tended to manage expectations so they’ll surprise Street estimates. The very preliminary results are disconcerting. Four large financials reported Friday morning. JPMorgan beat on earnings and sales expecations. Blackrock beat on earnings but slightly missed on sales. Citigroup missed on both. Wells Fargo beat on both. Of the four stocks, only Wells Fargo advanced.

 

 

The geopolitical wildcard

The other major source of market risk is geopolitical instability over Ukraine. US-Russia talks on the issue broke up with the Russian side characterizing the discussions at a “dead end”. Russian troops have been massing on the Ukrainian border and the muddy season is ending soon. The window for an invasion will open as soon as the ground firms.

 

A discussion of whether an invasion is justified is beyond my pay grade, but Adam Tooze of Columbia University recently outlined the challenges the West faces with Russia. Simply put, economic sanctions are not a very useful levers for two reasons. First, Russia has a strong foreign exchange reserve position.
 

Hovering between $400 and $600 billion they are amongst the largest in the world, after those of China, Japan and Switzerland.

 

This is what gives Putin his freedom of strategic maneuver. Crucially, foreign exchange reserves give the regime the capacity to withstand sanctions on the rest of the economy. They can be used to slow a run on the rouble. They can also be used to offset any currency mismatch on private sector balance sheets. As large as a government’s foreign exchange reserves may be, it will be of little help if private debts are in foreign currency. Russia’s private dollar liabilities were painfully exposed in 2008 and 2014, but have since been restructured and restrained.

 

 

As well, Russia is too big to effectively sanction. More importantly, it will continue to accumulate reserves as long as oil prices stay above $44 a barrel.

 

Russia is a strategic petrostate in a double sense. It is too big a part of global energy markets to permit Iran-style sanctions against Russian energy sales. Russia accounts for about 40 percent of Europe’s gas imports. Comprehensive sanctions would be too destabilizing to global energy markets and that would blow back on the United States in a significant way. China could not standby and allow it to happen. Furthermore, Moscow, unlike some major oil and gas exporters, has proven capable of accumulating a substantial share of the fossil fuel proceeds…

 

Putin’s regime has managed this whilst operating a conservative fiscal and monetary policy. Currently, the Russian budget is set to balance at an oil price of only $44. That enables the accumulation of considerable reserves.
Even as the Ukrainian story occupies the front page, an equally important geopolitical development that is on back pages is the recent crisis in Kazakhstan. From the Kremlin’s point of view, Kazakhstan represents a vital Russian interest for a number of reasons. First, it has an enormous border with the Russian Federation. About 20% of the population are ethnic Russian and political instability will create a refugee crisis for Russia. As well, several Soviet-era space launch sites that are still being used by Russia are located in Kazakhstan and the country is a major producer of uranium.

 

 

While Kazakhstan’s independence from the Soviet Union was relatively smooth economically, it has been ranked as one of the top countries for corruption. It is, therefore, no surprise that NGOs such as George Soro’s Open Society Foundation and the US-based National Endowment for Democracy (NED) funded democracy movements in the country. However, the NED has the unfortunate history of being spun out of the CIA during the Reagan years because it was felt that the CIA should not be seen as directly supporting pro-democracy movements in other countries. In the past, the NED has supported “color revolutions” in former Soviet republics, which has cast suspicion on the organization, especially to a former KGB officer like Vladimir Putin.

 

The Russians recently sent about 2,000 paratroopers to stabilize the situation in Kazakhstan when mass protests erupted over fuel price increases and the troops began withdrawing last week after accomplishing their mission. Nevertheless, Putin could view the Kazakh protests as covert American intervention in a former Soviet republic that is of vital interest to Moscow, which raises the temperature of the Ukraine situation.

 

I don’t want to over emphasize Russia’s role in the world. Russian GDP is roughly the same size as Italy’s. However, geopolitical tail-risk is probably higher than the market is discounting and an invasion could spark a major risk-off episode in the markets.

 

In conclusion, the tone of the market is turning bearish. Technical internals are deteriorating and my base case scenario calls for a 5-10% pullback in the coming weeks. A downdraft of 20% represents an outlier case but would need a major bearish catalyst such as severe earnings disappointments or the emergence of geopolitical risk.

 

 

Disclosure: Long SPXU

 

Fade the value rebound

Posted by Cam Hui -

In the past week, several readers have asked whether it’s too late to be buying financials, value, and other cyclical stocks. In reply, I highlighted the recent Mark Hulbert column, “Value stocks now are beating growth by 10 points, but the easy money might be behind us”, namely that the value/growth reversal may not necessarily have legs.
 

I analyzed value’s relative strength back to 1926, courtesy of data from Dartmouth College professor Ken French. On average, a given month’s relative strength persisted for just one month. With holding periods lasting two or more months, value’s performance against growth was only randomly related to what came before…

 

So if you’re keeping score for these three instances in which value beat growth by as much as it has recently, there’s one case in which value relative strength continued, one in which it reversed itself, and one in which there was no trend one way or the other. Good luck extrapolating that into the future.

 

 

Here are some other reasons to fade the value rebound.

 

 

Value’s cyclical beta

First, it’s important to understand how the beta of value stocks to interest rates. The returns of the Rising Rates ETF (EQRR) is highly correlated to the 10-year Treasury yield, both on an absolute basis and relative to the S&P 500. The sector weights of EQRR are also coincidentally concentrated in sectors considered to be cyclically sensitive and value-oriented.

 

 

As well, consider how value stocks are positioned within the S&P 500. Growth sectors, which consist of technology, communication services, and Amazon and Tesla, which are two large-cap stocks within the consumer discretionary sector, make up 44.9% of the S&P 500 index weight. By contrast, value sectors, which are financials, industrials, consumer discretionary ex-AMZN and TSLA, energy, and materials, are only 30.8% of index weight. While value stocks are generally cheaper than growth stocks on a variety of valuation metrics, value stocks are also highly concentrated in cyclical sectors and industries.

 

 

With the index weight analysis in mind, the relative weight difference between growth and value also means that any sudden or large scale rotation from growth to value will produce a sudden spike in relative performance, which is what happened recently.
 

Longer-term, however, there are two key drivers of value and growth stock relative performance, bond yields and the yield curve, and the cyclical outlook for the economy.

 

 

The Fed turns hawkish

Let’s begin with the interest rate outlook. The Federal Reserve has been active in its communication strategy in telegraphing its next move. Monetary policy has pivoted from an accommodative to a tightening stance. Fed Funds futures are now discounting four quarter-point rate hikes in 2022, which is a distinct change from six months ago when expectations called for a possible rate hike at the end of 2022.

 

 

In addition to its restrictive views on interest rate policy, the Fed is also turning hawkish on the withdrawal of balance sheet stimulus. Fed Chair Jerome Powell stated during his Senate re-confirmation hearings last week that while no firm decision has been made on the Fed`s balance sheet, otherwise known as quantitative tightening (QT), “At some point, perhaps later this year, we will start to allow the balance sheet to run off.”

 

Passive QT may sound benign, but it really isn’t. Passive QT calls for allowing securities to mature without reinvesting the proceeds while refraining from active selling the Fed’s holdings. However, its effects of are different from the last passive QT round after the GFC. Alfonso Peccatiello pointed out that the structure of the Fed’s balance sheet is highly concentrated in shorter maturities. A strategy of pure passive QT would see over $1 trillion roll off the Fed’s balance sheet in 2022 and a total of $2 trillion in the 2022 and 2023. That’s a lot of tightening.

 

 

The bond market has reacted to the Fed’s increasingly restrictive bias. Bond yields pulled back after the initial spike. More importantly, the 2s10s yield curve flattened after an initial steepening reaction and the 5s30s have been flattening for about a month. The flattening yield curve is an expectation of slower economic growth.

 

 

Nevertheless, the Fed is facing growing pressures to be more hawkish in the face of rising inflation. A chorus of former Fed officials called for a stronger tightening response. The WSJ reported that former Fed governor Laurence Meyers believes the Fed is at risk of being behind the inflation-fighting curve.

 

It isn’t so much inflation today that’s the problem. What they want to make sure is that they haven’t let the situation get out of hand, where once the supply-based inflation has come down, demand-based inflation tells them they should have gone sooner or faster.

Former New York Fed President Bill Dudley wrote in a Bloomberg Op-Ed that the Fed’s latest economic projections amount to a dovish “fantasy” that inflation can return to 2% with rates gently rising up to 2% over the same three-year timeframe. The Fed may need to raise rates four times this year.

 

Former Fed governor Frederic Mishkin expressed his opinion in the Financial Times that the Fed misjudged demand last year and poorly executed its new flexible average inflation targeting framework.

 

There are no doves left on the FOMC. Even über-dove San Francisco Fed President Mary Daly expressed support last week for a March rate hike. Charles (“don’t hike until you see the whites of inflation’s eyes”) Evans of the Chicago Fed raised concerns about price stability and stated, “Because inflation has stayed higher and longer we have to take action quicker than I thought.”

 

Here is why this matters to value stocks. The relative performance of financial stocks is especially sensitive to the shape of the yield curve. A steepening curve, which is the bond markets signal of a strong economy, is positive for the sector because banks borrow short and lend long. A steepening yield curve is positive for lending margins. Conversely, a flattening yield curve is negative for financial stocks. The Fed’s hawkish pivot on both rate hikes and its balance sheet indicates it has entered a tightening cycle, which is negative for the growth outlook. A tightening cycle is designed to cool off economic growth, which should result in a flattening yield curve, not a steepening one.

 

 

 

The cyclical outlook

Notwithstanding the effects of a tightening cycle, what about the organic cyclical outlook, which is also important to value stocks?

 

The Citigroup US Economic Surprise Index, which measures whether economic data is beating or missing expectations, has rolled over after recovering from a negative reading in Q4.

 

 

Cyclically sensitive industries are not showing any signs of relative strength except for energy stocks. Most cyclical industries are trading sideways relative to the S&P 500. Is this what market leadership looks like?

 

 

Looking globally, the relative performance of the stock markets of the major energy- producing countries has been correlated to oil prices, but they are also trading sideways to down relative to the MSCI All-Country World Index. 

 

 

Moreover, the cyclically sensitive copper/gold ratio has been trading sideways, which is another signal of lackluster economic growth.

 

 

The final nail in the coffin of the cyclical trade comes from Barron’s in the form of the contrarian magazine cover indicator. Barron’s turned bullish on commodities.

 

 

 

Focus on quality

If equity investors were to fade the value rebound, how should they be positioned?

 

In addition to an underweight position in value and cyclical sectors, investors should focus on the quality in their equity portfolios. There are many ways to define quality, one simple way is profitability. Standard & Poors has a stricter index profitability inclusion criteria for stocks than Russell. Comparing S&P and Russell indices, the large-cap quality factor began to outperform in late 2021 and a similar measure rose coincidentally for small-cap stocks.

 

 

Even within the growth and value universes, quality matters. The S&P growth and value indices started to beat their Russell counterparts in November (bottom two panels). In addition, there was a minor divergence between the Russell 1000 Value to Growth ratio and the S&P 500 Value to Growth ratios, indicating that high-quality growth stocks performed better during the value rebound (top panel).

 

 

In summary, the economy is transitioning to a mid-cycle phase of its expansion. Economic and earnings growth momentum are fading after the initial V-shaped recovery in stock prices. Short rate pressures are rising, but cyclical relative strength, as measured by the commodity/stock (CRB/S&P 500) ratio, is flat. Similar episodes in 1994, 2004, and 2010 resolved themselves with sideways and choppy stock markets. Investors should not expect superior performance from value and cyclical sectors. Instead, focus on stocks with quality growth characteristics and defensive names.

 

 

 

A buy signal AND a sell signal

Posted by Cam Hui -

Mid-week market update: In my update last weekend (see Waiting for the sell signal), I observed that the S&P 500 was oversold and due for a relief rally. The market cooperated by printing a hammer candle on Monday, which is a capitulative reversal indicator, and confirmed the reversal with a bullish follow through on Tuesday by recapturing the 50-day moving average. The index finished the move today with a doji candle, which indicates possible indecision.
 

 

That was the buy signal. There was also a sell signal.

 

 

Time to sell?

On the weekend, I also highlighted a possible deterioration in the intermediate breadth momentum oscillator (ITBM). I was waiting for the 14-day RSI of ITBM to recycle from overbought to neutral as a sell signal for the market. 

 

I got the signal on Tuesday. The chart below shows ITBM sell signals in grey for bullish outcomes and in red for bearish outcomes. The sell signals have been correct about three-quarters of the time. 

 

 

In addition, Ed Clissold of Ned Davis Research pointed out that NDR Trading Composite Sentiment is still in neutral. Trader sentiment isn’t washed out yet and there is more room on the downside for stock prices.

 

 

Similarly, all the components of my market bottom model are also neutral. If the stock market were to experience a downdraft, there is lots of downside potential before a bottom can be reached.

 

 

Jason Goepfert at SentimenTrader observed that defensive sector breadth is exhibiting an off-the-charts level of internal momentum. 

 

 

He did add a caveat that these conditions are not necessarily bearish.

 

It’s assumed that if investors are so hyper-focused on defensive stocks, it’s a bad omen for the broader market. Not to be. While the S&P 500 didn’t exactly go gangbusters after these signs of long-term internal momentum in the defensive sectors, it still showed above-average returns. 
I interpret these readings as the bears are seizing control of the tape. The combination of neutral sentiment and a loss of intermediate momentum raises the odds of an air pocket for equity prices in the near term. Subscribers received an email alert today that my inner trader had initiated a short position in the S&P 500.

 

 

Disclosure: Long SPXU

 

Waiting for the sell signal

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.
 

 

No sell signal yet

The S&P 500 took fright last week when the December FOMC minutes revealed a hawkish pivot and the stock market sold off. While I have become more cautious in the past few weeks, technical indicators have not flashed any intermediate-term sell signals just yet.

 

As an example, the NYSE McClellan Summation Index (NYSI) is only recycling from an oversold condition. In the last 20 years, few instances have resolved in a bearish manner (red vertical lines) and most have seen the market advance (black lines).

 

 

The market is increasingly vulnerable to a setback, but there is no need to become overly bearish just yet. Traders should wait for a sell signal first.

 

 

A vulnerable market

As an illustration of the market’s vulnerability, Mark Hulbert reported that newsletter writer sentiment remain stubbornly bullish despite last week’s air pocket, which is contrarian bearish.

 

 

The December Jobs Report provided a picture of an economy at full employment and gave the Fed another reason to tighten rates. The unemployment rate fell to 3.9%, compared to a pre-pandemic level of 3.5%, the Fed’s SEP forecast of 4.3% for 2021, 3.5% for 2022, and a long run unemployment rate of 4.0%. The U6 unemployment rate, which includes discouraged workers, fell to 7.3% compared to a pre-pandemic level of 6.9%. Average hourly earnings was also strong, indicating strong wage pressures.

 

 

For an intermediate-term technical perspective of the market’s outlook, consider the evolution of price momentum. The S&P 500 has enjoyed a remarkable run since the March 2020 bottom. The percentage of S&P 500 stocks above their 200 day moving averages (dma) rose to over 90%. Past episodes (shaded areas) saw the market advance as internals flashed a series of “good overbought” conditions. Momentum began to fade in mid-2021 when the percentage of stocks above their 200 dma deteriorated below the 90% level. If history is to be any guide, this should resolve in a relatively benign manner. Cyclical indicators such as the ratio of consumer discretionary to staple stocks and the copper/gold ratio are trading sideways, indicating little macro stress. Investors should therefore expect a return to an environment of normal equity risk of 10% drawdowns. However, all of these episodes of fading price momentum have not ended until the percentage of S&P 500 stocks above their 50 dma have fallen to 20% or less (bottom panel).

 

 

I am waiting for the next shoe to drop.

 

 

 

Remarkable resilience

To be sure, market internals have begun to deteriorate and the bulls are losing control of the tape but the market remains resilient. The S&P 500 achieved new highs while flashing negative RSI divergences. What is remarkable, however, is the strength in breadth. While breadth internals were negative a month ago, they have recovered since. NYSE highs-lows have risen from negative to positive. In addition, the percentage of S&P 500 stocks above their 50 dma is showing strength and well above the 50-60% zone that indicates short-term weakness.

 

 

Tactically, I am monitoring the intermediate-term breadth momentum oscillator (ITBM) for a sell signal. The 14-day RSI of ITBM is still in the overbought zone and a recycle back to neutral would constitute a sell signal. There have been 20 sell signals in the last five years, The market fell in 14 cases (red lines) and rose in six (grey lines), which is a remarkable record for this indicator. If and when this indicator flashes a sell signal, there will be plenty of downside opportunities left for short sellers to profit from.

 

 

My Trend Asset Allocation Model remains at a risk-on reading for now. As a reminder, trend following models are not designed to spot the exact market top or bottom but to identify the trend. The trend remains weakly bullish. While I am not inclined to front-run model readings, I expect it will be downgraded to neutral in the coming weeks.

 

 

A bounce first?

The stock market may be due for a relief rally before an intermediate-term sell signal. The S&P 500 reached an oversold level on its 5-day RSI as it tested its 50 dma on Friday.

 

 

The recently beaten up growth stocks may be due for a bounce as well. The trailing 12-month return of NASDAQ 100 to S&P 500 is nearing a relative support zone that has seen the NASDAQ 100 rally strongly.

 

 

The health of any possible bounce will depend on the evolution of market internals. I will monitoring them for signs of either positive or negative divergences.

 

 

Bearish tripwires

What does this mean for market participants? Investment-oriented accounts should take the opportunity to sell into strength and de-risk portfolios by reducing equity weights and rotating from high-beta into low-beta stocks. Traders should not turn bearish prematurely and wait for a sell signal first.

 

What could turn the market tone even more bearish?

 

Both Jerome Powell and Lael Brainard are expected to testify before the Senate next week in their confirmation hearings as Fed Chair and Vice Chair. While both are experienced central bankers who are unlikely to unintentionally let slip market moving remarks, anything is possible.

 

As well, all eyes will be on the CPI report due on Wednesday. Any hint of a hot inflation pressure will give the hawks on the FOMC more reasons to tighten. The current consensus expects a core YoY CPI of 5.4% and headline CPI of 7.0%, which are high bars for the inflation rate to clear.

 

In addition, the Omicron variant is running wild throughout the world. Researchers at Columbia University are projecting a rapid surge of US cases that peak between the first and third week of January. US case count is expected to peak at between three and eight million. This has the potential bring the economy to a screeching halt.

 

 

A wildcard is the news that French researchers have identified a new COVID variant B.1.640.2, dubbed IHU because it was found by a team from Méditerranée Infection University Hospital Institute (IHU) in Marseilles.

 

Not much is known about IHU. It was found in a vaccinated male patient who returned to France from Cameroon, developed mild symptoms, and it spread to 11 others. It’s far too early to panic over IHU. It’s unclear whether it’s more virulent or deadly than Omicron. In fact, it may be relatively benign as its identification predates Omicron. IHU was first sequenced on November 4, almost three weeks before Omicron was identified and sequenced.

 

While IHU may not be cause for panic, the real tragedy can be found in the November JOLTS report. Healthcare workers have been quitting in droves and at a higher rate than the overall quits rate, which has already skyrocketed. Healthcare workers are leaving just when we desperately need them and leaves us increasingly vulnerable to the emergence of new variants.

 

 

In closing, the market has become increasingly vulnerable to more setbacks. Equity risk appetite indicators (top panel) began diverging from the S&P 500 in early December. As a measure of extreme risk appetite, the bottom panel shows the relative performance of speculative growth stocks, as proxied by ARK Innovation ETF (ARKK) and the Social Sentiment ETF (BUZZ) against small-cap value stocks, which severely lagged the S&P 500 in 2021. These extreme risk appetite indicators are still falling, indicating further weakness in sentiment and internals. The bears are seizing control of the tape.

 

 

Long-term investors should position themselves cautiously by reducing equity weights. Traders, on the other hand, should not be overly eager to turn bearish. Wait for the tactical sell signal first.

 

2022 = Twenty-Twenty, Too?

Posted by Cam Hui -

As 2021 drew to a close, the broadly based Wilshire 5000 flashed a particularly long-term sell signal in the form of a negative 14-month RSI divergence. The last time this happened was in August 2018 (see Market top ahead? My inner investor turns cautious). Stock prices continued to rise for another two months before it hit an air pocket. In the past, a bearish event can take as long as a year. What does this mean for stocks in 2022?
 

 

The bond market may fare better in the coming year. The Barclays Aggregate Index unusually fell last year and it has never exhibited two consecutive years of negative returns (warning: n=3).
 

 

What does this mean for asset prices? Will 2022 be equity bearish and volatile and become Twenty-Twenty Too?

 

 

A bond tantrum

The latest source of market angst was sparked by the release of the December FOMC minutes. Further bad news came with the release of December Jobs Report, which had all the signs of full employment that allowed the Fed to raise rates. Even San Francisco President Mary Daly, who is viewed as a dove, believes the economy is nearing full employment and was in favor of raising rates: “I’m of the mind that we might need to, likely will need to, raise interest rates … in order to keep the economy in balance”.

 

The Treasury market threw a tantrum last week when both the 10 year Treasury yield broke up through resisance and the 30 year Treasury yield surged above its falling channel. In addition, the 2s10s yield curve steepened, indicating that the market expects better economic growth as the Fed “gently” tightens monetary policy. On the other hand, the 5s30s had the opposite gentle flattening reaction to the FOMC minutes.

 

 

A similar minor divergence is appearing between the Economic Surprise Index, which is stalling, and the 10-year Treasury yield, which is rising.
 

 

I interpret this to mean that investors should fade the bond market’s rising yields. The combination of a hawkish Fed and a loss of economic momentum is a recipe for slower growth and lower rates.

 

 

Defensive stocks take the lead

The stock market’s internals are also telling a similar story of caution. An analysis of the changing leadership of different parts of the stock market was highly revealing. 

 

Starting with the defensive sectors, their relative performance is showing signs of emerging leadership. All are forming saucer-shaped relative bottoms against the S&P 500, indicating that the bears are wrestling control of the tape away from the bulls.

 

 

The leadership pattern of value and cyclical sectors looks a little better. In particular, the relative performance of financial stocks is the most correlated to the shape of the yield curve, mainly because banks borrow short and lend long. A steepening yield curve, therefore, enhances banking profitability. The other value and cyclical sectors are all exhibiting sideways basing patterns, though there have been some short-term recoveries, such as the one shown by energy stocks.

 

 

A more detailed look at the relative performance of cyclically sensitive industries tells a different story. Most have been trading sideways against the market and show no definitive signs of strong leadership.

 

 

From a global perspective, even though commodity prices are holding up well, the relative performance of the equity markets of resource producing countries to the MSCI All-Country World Index (ACWI) are all flat to down. This is additional confirmation that cyclical exposure is to be avoided.

 

 

What about growth stocks? They look downright ugly. Growth sectors are either rolling over or in decline on a relative basis.

 

 

In short, stock market internals are turning risk-off. This is consistent with a hawkish interpretation of Fed policy. The market is already discounting three quarter-point rate hikes this year and a discussion of quantitative tightening, or a reduction in the size of the Fed’s balance sheet, may not be very far behind.

 

 

Investment implications

Here is what this means for investors. Position for slower growth, at least for the first half of 2022. This means:

 

  • A flattening yield curve and long bond duration, or maturity, 
  • Long USD in response to a hawkish Fed;
  • Long defensive sectors of the equity market; and
  • Long large-cap growth stocks as duration plays for their interest rate sensitivity.
Equity investors should also brace for greater volatility. The S&P 500 exhibited a drawdown of only -5.2% in 2021, which is well below average. The S&P 500 rose over 10% for the last three consecutive years, which is an unusual condition. Even on those occasions, which saw the market advance in four out of five instances since 1928, the average drawdown in the fourth year was -13.5% and the lowest was -6.8%.

 

 

To be sure, a flattening yield curve is a signal of slower economic growth. In all likelihood, COVID-19 fueled inflation pressures will begin to fade about mid-year, which will allow the Fed to reverse course on monetary tightening. Prepare for a dovish and cyclical pivot in the summer or autumn. This scenario is consistent with the historical mid-term election year pattern of a choppy market for the first nine months, followed by a rally into year-end.

 

 

 

Why I am cautious

Posted by Cam Hui -

Mid-week market update: As 2022 opens, I have become increasingly cautious about the stock market. The put/call ratio (CPC) is a bit low, indicating rising complacency. Past instances of a combination of a rapidly falling CPC and low CPC have seen the market struggle to advance. While this is not immediately bearish, it is a flag for caution.
 

 

Here are some other reasons why I am cautious.

 

 

Bearish triggers

The current sentiment backdrop can be best described as a “this will not end well” story. Such conditions can persist for months and the stock market can continue to consolidate or even advance if there is no bearish trigger. Here are some possible bearish triggers to consider.

 

Nouriel Roubini worried about the combination of monetary policy normalization and a litany of risks that could unsettle markets in a Project Syndicate essay.

 

As long as central banks were in unconventional policy mode, the party could keep going. But the asset and credit bubbles may deflate in 2022 when policy normalization starts. Moreover, inflation, slower growth, and geopolitical and systemic risks could create the conditions for a market correction in 2022. Come what may, investors are likely to remain on the edge of their seats for most of the year.
Indeed, the FOMC minutes conveyed a hawkish tone, beginning with a faster pace of rate hikes, followed by quantitative tightening, or a reduction in the Fed’s balance sheet [emphasis added].

 

Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures. These participants noted, however, that a measured approach to tightening policy would help enable the Committee to assess incoming data and be in position to react to the full range of plausible economic outcomes.

In particular, the quantitative tightening debate is now on the table at the FOMC.

 

Some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process, especially in light of abundant liquidity in money markets and elevated usage of the ON RRP facility.

Conditions are ripe for a less accommodative monetary policy. The November JOLTS report printed a record level of quits. Moreover, the hires to quits rate have been steady, indicating that people are not quitting to leave the labor force, but to another job. These are the signs of a strong labor market.

 

 

While data history is limited, both temp employment (blue line) and the quits/layoffs ratio (red line) have led non-farm payroll employment (black line). The latest JOLTS report showed that a soaring quits/layoffs ratio. The Fed will interpret these conditions as signals of an economy nearing full employment.

 

 

 

The popping speculative growth bubble

In addition, the popping of the speculative growth stock bubble could be the source of tail risk for the market. Bridgewater outlined the risks in a recent research note.
 

As the Fed has shifted toward tapering and a slowing in the flood of liquidity has begun to get priced in, we are seeing cracks emerge in the bubbliest segments of the market.

 

As we have noted before, the unprecedented flood of liquidity following COVID has caused our bubble measures to flash red in certain pockets of global markets. We have studied bubbles and built measures of whether economies or individual markets are in them. By our measures, there are likely bubbles in emerging technology stocks, SPACs, cryptocurrencies, NFTs, collectibles, etc. These bubbles have been particularly pronounced in the US, where households piled savings into the markets as their incomes were supported by massive government checks, their spending was curtailed by the lockdown, and lower-cost trading driven by competition and technology made investing (and speculation) easier than ever before.

 

 

Of the several key risks that Bridgewater outlined, there are two that I am most concerned about:

  • Forced retail liquidation effect: “If the bubble turns, retail traders, especially those who have used leverage either directly or via options, may be forced to liquidate other positions, widening the breadth of the sell-off.”
  • Cash generative large-cap growth stocks are not immune to a popped bubble. “These [startup] companies, as well as the broader venture capital ecosystem, have important implications for the earnings of the most important companies in the S&P 500. As shown below, early stage companies deploy a significant share of their cash on things like cloud services and online advertising, which then ends up being revenue for the US tech giants… customer acquisition (Facebook, Google) and cloud providers (Amazon, Microsoft), these companies end up earning significant profits from startup spending.”

 

 

 

Santa Claus has left the building

In conclusion, I don’t mean to imply that the market is about to crash, but the stock market is vulnerable to a setback. I don’t know if today’s risk-off reaction to the release of the FOMC minutes is the bearish trigger. 
 

Subscribers received an alert that my inner trader sold all his long positions yesterday and stepped to the sidelines, citing event risks such as the release of the FOMC minutes today and Friday’s NFP report. If this is the start of a major bear leg, my inner trader is waiting for the sell signal and believes there will be sufficient time to profit accordingly in a falling market.
 

A “penny wise, pound foolish” application of the Trend Model

Posted by Cam Hui -

I received a number of responses to the post on the 2021 report card on my investment models. While most were complimentary, one reader asked me for a more aggressive formulation of the Trend Asset Allocation Model. 
 

As a reminder, the signals of the Trend Model are out-of-sample signals, but there are no portfolio returns to publish, mainly because I don’t know anything about you. I know nothing about your return targets, your risk tolerance and pain thresholds, your tax situation, or even the jurisdiction you are in. If I offered an actual portfolio, it would be a formal prospectus document outlining what to expect.

 

Instead, the backtested returns are based on a specific formula for constructing a balanced fund portfolio based on Trend Model scores and reasonable risk assumptions of an average investor with a 60% stock/40% bond asset allocation.

  • Risk-on: 80% SPY (S&P 500), 20% IEF (7-10 Treasuries)
  • Neutral: 60% SPY, 40% IEF
  • Risk-off: 40% SPY, 60% IEF
An advisor or portfolio manager could then change the equity allocation by 20% depending on the Trend Model score without Compliance tapping him on the shoulder.

 

The historical backtest of the Trend Model using this portfolio construction technique yielded excellent results. An investor using this approach could achieve equity-like returns while bearing balanced fund-like risk. Needless to say, this backtest is just a proof of concept. Every investor is different and your mileage will vary.

 

 

A reader then asked me to backtest a more aggressive approach to portfolio construction. Instead of a 60% SPY and 40% IEF benchmark, he suggested a 100% equity position, based on 60% SPY and 40% defensive equity substitute for bonds. The defensive portfolio consists of an equal-weighted portfolio of XLV (Healthcare), XLP (Consumer Staples), XLU (Utilities), and XLRE (Real Estate).

 

The results turned out to be a case of “penny wise, pound foolish”.

 

 

The value of diversification

I re-ran the backtest using the same signals but with different portfolio construction rules. In my results, I dubbed the 60% SPY and 40% defensive equity portfolio the “Hybrid 60/40” and the portfolio constructed using the Trend Model using the defensive equity portfolio component the “All Equity Model”.

 

 

The good news is the Trend Asset Allocation Model worked as expected.
  • The All Equity Model had the best returns. It beat the Hybrid 60/40 and the 100% SPY benchmark over the study period.
  • The All Equity Model outperformed the Hybrid 60/40 benchmark, indicating that it was able to distinguish between risk-on and risk-off episodes.
The bad news is there are major caveats to the results.
  • The outperformance exhibited by the Original Model was far better than the All Equity Model. The Original Model beat its benchmark by 4.2% over the study period compared to 1.6% alpha by the All Equity Model. Moreover, the Original Model’s outperformance was far more consistent than the outperformance of the All Equity Model against its benchmark.
  • The All Equity Model exhibited equity-like maximum drawdowns. Even though returns were better, the maximum drawdown for the All Equity Model was similar to the S&P 500 benchmark.
  • The Original Model had better risk-adjusted returns. Even though the All Equity Model had better returns, an investor using the Original Model could achieve a similar return level by employing modest leverage with lower risk, as measured by either standard deviation or maximum drawdown.
The last point illustrates the value of stock-bond diversification. The Original Model used a combination of stocks (S&P 500) and bonds (7-10 year Treasuries) as portfolio building blocks. Stocks and bonds are less correlated to each other than the S&P 500 and a portfolio of defensive stocks, mainly because the latter are stocks and therefore more correlated to the S&P 500. Applying a market timing model to less correlated assets is more valuable than applying the same timing model to correlated assets.

 

In conclusion, this exercise was a lesson in the value of diversification. Applying a market timing model which works to less correlated assets will add more value than applying the same timing model to correlated assets.

 

The moral of this story? Pay attention to diversification when constructing a portfolio. Even though you may have a tool such as the Trend Asset Allocation Model that works, using it improperly can lead to a “penny wise, pound foolish” result.

 

Don’t overstay the party

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.
 

 

Edge towards the exit

Happy New Year! I hope you are enjoying the seasonal rally, but don’t get overly complacent about the party that the bulls are throwing. Sufficient warning signs are appearing that it’s time to edge towards the exit.

 

Exhibit A is the relative performance of the top five sectors of the S&P 500. These sectors comprise over three-quarters of index weight and it would be impossible for the S&P 500 to rise or fall without the leadership of a majority of sectors. As the accompanying chart shows, none of the sectors are in a relative uptrend. The most bullish pattern is technology, which is trading sideways compared to the S&P 500.

 

 

Once the seasonal strength fades, what happens to the market?

 

 

Warnings everywhere

Despite the recent market strength, warnings are appearing under the hood. The most disturbing development is the long-term sell signal shown by a negative 14-month RSI divergence as the Wilshire 5000 rose to an all-time high. In the past, the MACD histogram rising from negative to positive has been a very good buy signal, and negative 14-month RSI divergences have been reasonable cautionary signals. The last negative divergence occurred in August 2018 (see Major top ahead? My inner investor turns cautious). This is a long-term signal and a market top may not be apparent for some time. The stock market continued to rise for another two months before it hit an air pocket. In the past, the lag can be as much as a year.

 

 

Other market internals are flashing intermediate-term warnings. Equity risk appetite, as measured by the relative performance of equal-weighted consumer discretionary to consumer staples, and the relative performance of high beta to low volatility stocks, are not confirming the fresh highs set by the S&P 500.

 

 

The relative performance of defensive sectors is also raising concerns. The relative returns of these sectors surged and became overextended when the S&P 500 hit an air pocket in mid-December. They have pulled back but their relative performance is improving again. This is a sign that the bears haven’t lost control of the tape.

 

 

A closer look at selected defensive sectors tells the story of lurking bears. Consumer Staples, which is a classic defensive sector, rose to fresh all-time highs and its performance compared to the S&P 500 is forming a saucer bottom. Relative breadth (bottom two panels) is also showing signs of improvement.

 

 

Healthcare is showing a similar pattern of new highs, a bottom in relative performance, and improving relative breadth.

 

 

I could go on, but you get the idea.

 

 

Temporary bullish tailwinds

In the short run, asset prices have also been supported by fresh liquidity from the Federal Reserve. According to the New York Fed, the Fed balance sheet rose by almost $140 billion month-to-date to December 21.

 

 

Wait, what? Isn’t the Fed supposed to be tapering its QE program? Didn’t the FOMC announce that it was reducing its asset purchases from $120 billion to $105 billion per month? Is this some sort of nefarious Deep State plot?

 

Actually, the Fed’s balance sheet faces substantial maturities between December 15 and December 31. The $140 billion in purchases was intended to offset the maturity of assets rolling off the balance sheet before year-end.

 

 

Nevertheless, the purchase of nearly $140 billion by the Fed temporarily injected a substantial amount of liquidity into the system, which should have had a bullish effect on asset prices. This effect will fade in January.

 

 

Wait for the sell signal

I interpret these conditions as the stock market is poised to weaken. Investment-oriented accounts should begin to de-risk now. Returning to the party metaphor, the celebrations are getting out of hand and the neighbors have called the police. It’s time to gather friends and relatives and prepare to leave.

 

I had highlighted an uncanny buy signal in mid-December. The NAAIM Exposure Index, which measures the sentiment of RIAs, had fallen below its 26-week lower Bollinger Band. Virtually all past episodes have been strong tactical buy signals with minimal S&P 500 downside risk. The last buy signal worked out perfectly. In the past, the return of the NAAIM Exposure Index back to its 26-week moving average (wma) has been a good spot to lighten long positions as the bullish momentum begins to fade, which it did last week. Readings have risen higher in the past, but risk/reward becomes less attractive at the 26 wma.

 

 

While investors should begin to lighten equity positions, traders may want to stay at the party for one more round. There may be further upside in January. Historically, the beginning of the year sees strong seasonal flows.

 

 

Tactically, S&P 500 intermediate breadth momentum reached an overbought reading. But selling now may be premature. Historically, a better sell signal occurs when this indicator recycles from overbought back to neutral.

 

 

In conclusion, investment-oriented accounts should begin to de-risk their portfolios by reducing their equity weights and lowering the beta of their equity portfolios. Short-term traders may want to stay at the bulls’ party a little longer and wait for a sell signal to turn bearish.

 

 

Disclosure: Long SPXL

 

>

Don’t fight the (hawkish) Fed

Posted by Cam Hui -
As the S&P 500 rises to fresh all-time highs, an important risk is lurking in the form of a more hawkish Fed. Inflation is running hot. When the Fed was officially in the transitory camp earlier this year, inflation pressures were concentrated in only a few components such as used cars. Today, price increases are broadening and even core sticky price CPI (red line) is rising strongly. As a consequence, the Fed made its hawkish pivot and signaled that it is on pace to end its QE program by March 2022, even though inflation expectations (black line) remain well-anchored.

 

 

The market is now discounting three rate hikes in 2022, with lift-off to begin in March. Here is how the Fed turned hawkish.

 

 

 

A no-surprise Federal Reserve

Former Fed economist Claudia Sahm wrote that the Fed doesn’t like to surprise markets. She outlined the steps it takes to prepare the markets for policy shifts [edited for brevity].
 

Ok, so what does “laying the groundwork” mean? Top Fed officials start ‘dropping hints’ into their speeches, emphasizing the change in economic conditions that warrant the shift. It can be confusing with five Board members and twelve Reserve Bank Presidents who are constantly talking publicly. Here’s my cheat sheet.

 

Order of importance:
  1. Fed Chair (Jay Powell)
  2. Vice-Chair of the Board (Rich Clarida)
  3. Federal Reserve Bank President of New York (John Williams)
A unique feature of the Powell Fed is there’s another key official to watch:

 

Board member, Lael Brainard.

 

Jay elevated Lael to “Troika,” which traditionally includes the Chair and the three roles above. So currently, it’s more of a “Quad” setting the agenda. I would put Brainard’s importance in messaging between Clarida and Williams (2.5).

As inflation pressures rise, the only thing that holds the Fed back from raising rates is its full employment mandate. Powell stated at the December post-FOMC press conference that “the economy has been making rapid progress toward maximum employment”. In short, the labor market is healing on many dimensions.
 

Amid improving labor market conditions and very strong demand for workers, the economy has been making rapid progress toward maximum employment. Job gains have been solid in recent months, averaging 378,000 per month over the last three months. The unemployment rate has declined substantially, falling six tenths of a percentage point since our last meeting and reaching 4.2 percent in November. The recent improvements in labor market conditions have narrowed the differences in employment across groups, especially for workers at the lower end of the wage distribution, as well as for African Americans and Hispanics. Labor force participation showed a welcome rise in November but remains subdued, in part reflecting the aging of the population and retirements. In addition, some who otherwise would be seeking work report that they are out of the labor force because of factors related to the pandemic, including caregiving needs and ongoing concerns about the virus. At the same time, employers are having difficulties filling job openings, and wages are rising at their fastest pace in many years. How long the labor shortages will persist is unclear, particularly if additional waves of the virus occur. Looking ahead, FOMC participants project the labor market to continue to improve, 

Here is why the full employment mandate matters. The December SEP projects the 2021 unemployment rate at 4.3%, falling to 3.5% in 2022 and remaining there for two years. The November unemployment rate is already 4.2%. Already, initial jobless claims normalized to population are at an all-time low.
 

 

Powell couldn’t quite bring himself to say the economy is at full employment during the press conference. Instead, he pivoted to that the jobs market is “not going back to the same economy” new era as a way of justifying the hawkish turn in policy.
 

You know, the thing is, we’re not going back to the same economy we had in February of 2020. And I think early on, that was the sense was that that’s where we were headed. The post-pandemic labor market and the economy, in general, will be different. And the maximum level of employment that’s consistent with price stability evolves over time within a business cycle and over a longer period, in part reflecting evolution of the factors that affect labor supply, including those related to the pandemic. So I would say, look, we’re at 4.2 percent now and it’s been — the unemployment rate has been dropping very quickly. So we’re already in the vicinity of 4 percent. The way in which the — The important metric that has been disappointing really has been labor force participation, of course, where we had widely thought, I had certainly thought that last fall as unemployment insurance ran off as vaccinations increased, that schools reopened, that we would see a significant surge, if you will, or at least a surge in labor force participation. So we’ve begun to see some improvement. We certainly welcome the 2/10 improvement that we got in the November report. But, I do think that it’s — it feels likely now that the return to higher participation is going to take longer. And, in fact, that’s been the pattern in past cycles that labor force participation is — tend to recover in the wake of a strong recovery in unemployment, which is what we’re getting right now. So, you — It could well have been if this cycle was different because of the short nature of it and a very strong — the number of job openings, for example, you would have thought that that would have pulled people back in. But, really, it’s the pandemic, it’s a range of factors. But the reality is, we don’t have a strong labor force participation recovery yet and we may not have it for some time. At the same time, we have to make policy now. And inflation is well above target. So this is something we need to take into account.

Consistent with Claudia Sahm’s thesis that the Fed doesn’t like to surprise markets, Fedspeak is now turning even more hawkish. Governor Christopher Waller recent speech that echoed Powell’s remarks about “meeting the FOMC’s maximum-employment goal”.
 

The economy is set to continue growing very strongly through at least the first half of next year, and I expect employment to keep growing. With the unemployment rate at 4.2 percent in November, I believe we are very close to meeting the FOMC’s maximum-employment goal. For inflation, as I said earlier, the next few months will be crucial in determining whether price increases will begin to moderate, as I still expect in my baseline outlook. However, I will be closely watching indicators of inflation expectations for signs that consumers and investors have come to expect high inflation well into the future, a development that could signal that the moderation in inflation I expect will not be coming soon. 

Waller went further and called for rate hikes to begin in March, shortly followed by a reduction in the Fed’s balance sheet, or quantitative tightening. 
 

In addition, San Francisco Fed President Mary Daly, who is widely considered to be a dove, stated in a NY Times interview that she supports the increased pace of QE taper and could be open to a March rates liftoff.
 

Ms. Daly said she supported ending bond buying quickly so that officials were in a position to begin raising interest rates. A higher Fed policy rate would percolate through the economy, lifting the costs of mortgages, car loans and even credit cards and cooling off consumer and business demand. That would eventually tamp down inflation, while also likely slowing job growth.
 

Ms. Daly said it was too early to know when the first rate increase would be warranted, but suggested she could be open to having the Fed begin raising rates as soon as March.

If the Fed were to continue on this signaling path, watch for more important Fed speakers to turn hawkish in the coming weeks.
 

 

Still data dependent

Despite the hawkish path, the Fed remains data dependent. Policy makers will be closely watching the December Jobs Report due out Friday and the JOLTS report the following week. 
 

The key metrics to watch are the prime-age labor force participation rate (LFPR) and employment to population rate (EPOP). Both haven’t recovered to pre-pandemic levels, but Powell “feels likely now that the return to higher participation is going to take longer”.
 

 

As well, temporary jobs and the quits/layoffs ratio have historically led Non-Farm Payroll and both indicators are flattening out.
 

 

The quits rate will also be closely watched in the JOLTS report. While the historically high quits rate has been dubbed the Great Resignation, the surge has been concentrated in lowly paid leisure and hospitality, and retail industries. In a tight jobs market, participants are quitting and upgrading to better paying positions.

 

 

 

Dovish factors to consider

Even though the Fed is set on a hawkish path, here are some developments that could shift policy in a more dovish direction. The rapid transmission of the Omicron variant could cause a sudden collapse in global economic activity, as demonstrated by the recent widespread flight cancellations due to the infections of flight crews. The announcement from Centers for Disease Control and Prevention to reduce the recommended isolation and quarantine times should alleviate some of the pressure, but the economic effects of these measures remain to be seen.

 

 

In the meantime, the WSJ reported that economists are reducing their GDP growth forecasts because of the effects of the Omicron variant.

 

 

Improvements in the Citigroup Economic Surprise Index, which measures whether economic data is beating or missing expectations, have also begun to stall.

 

 

Similarly, the growth rate of ECRI’s Weekly Leading Index is rolling over.

 

 

As well, a sudden deceleration in fiscal impulse could also dent the growth outlook. In the wake of Senator Joe Manchin’s withdrawal of support of Biden’s Build Back Better fiscal stimulus plan, expected fiscal spending is will be weaker in 2022. Barron’s reported that Goldman cut projected GDP growth. Other strategists won’t be far behind. While Fed officials are mainly focused on their dual mandate of price stability and full employment, they are not completely blind to the effects of fiscal policy.

 

“We had already expected a negative fiscal impulse in 2022 as a result of the fading support from Covid-relief legislation enacted in 2020 and 2021, and without Build Back Better enactment, this fiscal impulse will become somewhat more negative than expected,” a team led by chief economist Jan Hatzius said in a note Sunday. 

 

 

Be cautious (for now)

In conclusion, the Fed doesn’t like to surprise markets and is poised to reinforce its hawkishness in its communication strategy in the coming weeks. The yield curve is already flattening, which is the bond market’s signal that it expects slower economic growth ahead. A flattening yield curve also reflects fears of a policy error. The Fed may be over-tightening and will have to reverse course later.

 

 

FANG+ stocks are the new defensive positioning under such a scenario. In a growth starved world, investors will bid up the prices of cash generative growth companies. The relative performance of the NASDAQ 100 has exhibited a rough inverse correlation with the 10-year Treasury yield.

 

 

However, the expected large-cap growth leadership should begin to fade when inflation pressures begin to abate. Keep an eye on the evolution core PCE as 2022 progresses. The Fed has penciled in a 2022 core PCE inflation rate of 2.6% in its Summary of Economic Projections. If inflation pressures begin to fade and monthly changes in core PCE fall to 0.2% for several months, the Fed would interpret this as a signal that inflation is under control and shift to a more dovish stance. Under such a scenario, the yield curve would begin to steepen again, indicating a better growth outlook, and equity leadership should rotate from large-cap growth into value and cyclical stocks.

 

 

Riding the seasonal bull

Posted by Cam Hui -

Mid-week market update: The Santa Claus rally, which begins just after Christmas and ends on the second day of the new year, began with a bang. The S&P 500 surged 1.4% on Monday to kick off the Santa rally and managed to make another marginal closing high today. The bullish impulse has been relentless.
 

Marketwatch documented a small sample study (n=8) indicating that Santa rallies that began with an advance of 1% or more tended to be strong.
 

 

I pointed out that the S&P 500 staged an upside breakout from an inverse head and shoulders pattern with a measured objective of about 4920 (see The anatomy of a Santa rally) but cautioned that the 4920 target may be overly ambitious. In light of Monday’s surge, 4920 may not be totally out of reach.

 

 

 

A different kind of rally

That said, the internals of this seasonal rally is a little unusual. In the past, low-quality stocks and small caps have led the way. This year, low-quality leadership has mostly fizzled.

 

 

As well, the Russell 2000 remains stuck in a trading range after a failed upside breakout. However, the higher quality S&P 600 is testing resistance and could break up through resistance. Even within small caps, high quality is winning.

 

 

I had also anticipated that the beaten-up speculative growth stocks would rebound after tax-loss selling petered out. There has been no evidence of such a rebound this year.

 

 

I interpret these developments as an indication that the Santa rally is only seasonal in nature and price momentum would start to fade in January.

 

In the meantime, enjoy the ride for a few more days.

 

 

Disclosure: Long SPXL

 

A 2021 report card

Posted by Cam Hui -

The year 2021 is nearly complete and it’s time to issue a report card for my three investment models. Going in order of short to long time horizons, these are:

  • The Trading Model;
  • Trend Asset Allocation Model; and
  • The Ultimate Market Timing Model.
All showed strong results.

 

 

The Trading Model

The weakest result came from the trading model, which was strongly positive but lagged the S&P 500. This was still a solid result as it is arguably an absolute return strategy that should be benchmarked to cash rather than the stock market.

 

After a dismal 2020 in which the model incorrectly shorted the market as stocks rallied, the trading model clawed its way back in 2021. Based on the methodology outlined in My Inner Trader, the trading model returned 19.7% in 2021, assuming no trading costs and dividends. While this was impressive, it nevertheless lagged the S&P 500 capital-only return of 27.6% to December 27, 2021.

 

 

After a difficult 2020, I made an adjustment to the trading model. After realizing most of the past losses were from short positions, I made a decision to forego shorting in 2021 as long as the intermediate trend is up. I expect that 2022 will be more challenging, as the intermediate trend will turn choppy, which will call for some short positions, which will offer both opportunity and risk.

 

 

Trend Asset Allocation Model

The Trend Asset Allocation Model also had a strong year. Using the switching methodology outlined here, the model portfolio showed a total return of 23.7% compared to a 60% SPY/40% IEF benchmark of 16.5%. 
As a reminder, model portfolio returns were backtested based on specified asset allocation rules, but the signals were produced out-of-sample. Past individual year returns during the out-of-sample period also showed a consistent pattern of outperformance.
  • 2020: Model 20.6% vs. 60/40 14.2%
  • 2019: Model 22.3% vs. 60/40 22.6%
  • 2018: Model 1.9% vs. 60/40 -2.7%
  • 2017: Model 17.4% vs. 60/40 13.8%
  • 2016: Model 13.9% vs. 60/40 7.9%
  • 2015: Model 2.5% vs. 60/40 1.4%
  • 2014: Model 14.2% vs. 60/40 12.2%

 

 

The Trend Asset Allocation Model was designed for individual investors and portfolio managers whose objective is to achieve equity-like returns with balanced fund-like risk on a long-term basis. For advisors and portfolio managers who adhere to Investor Policy Statements for individual clients, the Trend Model is a useful tool to achieve superior returns while maintaining the risk profile demanded by each firm’s Compliance department. The idea is to begin with a 60/40 benchmark and either over or underweight equities by 20% depending on model readings. 

 

This model achieved its objective again in 2021.

 

 

The Ultimate Market Timing Nodel

While the Trend Asset Allocation Model usually flashes several signals a year, the Ultimate Market Timing Model only flashes a signal once every few years. 

 

This model combines the risk control elements of trend following models with an economic overlay. Trend following models using moving averages can spot falling markets, but they have the disadvantage of flashing false-positive signals that whipsaw portfolios in and out of positions. By recognizing that recessions are bull market killers, the Ultimate Market Timing Model will only de-risk when the economic model (see my Recesion Watch indicators) warn of a recession and Trend Asset Allocation Model issue a sell signal. It re-enters the market after a recession signal only when the Trend Model returns from bearish to neutral.

 

This model exited the market in the wake of the COVID shock of 2020 and re-entered the market in Q3 2020. It remained 100% long in 2021 and reaped a 27.6% return to the S&P 500.

 

 

This model is designed for investors who don’t want to trade but are willing to bear normal equity risk of 10-20% drawdowns. An investor using this model can then enjoy the benefits of higher long-term equity returns while avoiding the negative returns from major bear markets.

 

In conclusion, I began Humble Student of the Markets to help readers achieve better returns. Unlike most other services, I have not shied away from reporting my results. After a difficult 2020, the models all exhibited strong returns in 2021 and I continue to refine my investment process as needed.

 

The process is working and I hope to report similarly positive results a year from now.

 

 

The anatomy of a Santa rally

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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.
 

 

Has Santa come to town?

Will the real Santa Claus rally, which begins on Monday and lasts until the second trading day of January, now begin in earnest? 

 

I pointed out last week (see A breakout to S&P 4920?) that the S&P 500 was potentially forming an inverse head and shoulders pattern, but head and shoulders patterns are incomplete until the neckline breaks. The market staged a marginal upside breakout through resistance on Thursday. The measured objective of the inverse H&S breakout is about 4920, but that level may be overly ambitious. If the Santa rally has truly begun, one of the tactical indicators that he has returned to the North Pole is whether the VIX Index falls below its lower Bollinger Band, which is an overbought signal to take trading profits.

 

 

Here is what else I am watching.

 

 

Santa rally internals

In my last post (see Was the Grinch in the house?), I outlined some possible characteristics of a year-end market advance. One is the snapback of beaten-up stocks as tax-loss selling season ends. One possible group for a relief rally is speculative growth stocks, which have begun to bottom out relative to both the S&P 500 and NASDAQ 100 in December but tailed off in the last week. Will they pop in the coming week and early January?

 

 

Another hated group is small-cap stocks. While most investors use the Russell 2000 as a small-cap benchmark, which is still stuck in the middle of its trading range, the higher quality S&P 600 is nearing resistance. An upside breakout by the S&P 600 would be a positive sign for the bulls. 

 

However, the market tends to be led by low-quality stocks this time of year. If the seasonal rally is indeed underway, watch for the Russell 2000 to outperform the S&P 600.

 

 

Indeed, an analysis of the quality factor shows that low quality is dominant in both large and small-caps.

 

 

 

How durable is the advance?

If Santa does come to town, how durable is the advance?

 

The relative performance of the top five sectors is revealing. These sectors account for over three-quarters of S&P 500 weight and it would be impossible for the index to significantly rise or fall without the participation of a majority. An analysis of the top five sectors shows that three, technology, consumer discretionary, and communication services, exhibited temporary relative strength that appear to be more of a counter-trend nature. I interpret this to be an early warning for traders not to overstay the party.

 

 

Risk appetite internals are equally troubling. Equity risk appetite indicators are flashing negative breadth divergences.

 

 

Credit market risk appetite shows a mixed picture. While the relative price performance of junk (high yield) bonds compared to their duration-equivalent Treasuries have confirmed the S&P 500 advance, emerging market bonds have not. As the Fed begins its rate hike cycle, fragile EM economies will be the canaries in the global financial system coal mine and the relative performance of EM bonds is not encouraging.

 

 

 

Don`t be prematurely bearish

Before traders turn prematurely bearish, keep in mind that the market staged a rally from an oversold condition and sentiment washout. The NYSE McClellan Summation Index (NYSI) remains oversold on the weekly chart.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs, fell below its 26-week lower Bollinger Band two weeks ago. This model has had a remarkable record of spotting short-term bottoms. Tactically, I am inclined to wait for NAAIM to return to the 26-week moving average. This has historically taken between 2-5 weeks from the time of the buy signal, which puts the time horizon for exiting a tactical long position about the middle of January.

 

 

Analysis by Martin Pring [gated at StockCharts] is also supportive of a 2-4 week rally. Pring pointed out that the KST for the put/call ratio had rolled over. (KST is a momentum oscillator that’s “a weighted average of four different rate-of-change values that have been smoothed”.)

 

Last week, [KST] had started to go flat. Now, it has experienced a decisive peak, which indicates that traders have started to become more optimistic. The arrows show that such action has consistently been followed by a 2-to-4-week rally or more.
This indicator flashed 10 buy signals in the last five years. Of the 10, the S&P 500 rose in seven instances (blue lines), fell in two (red lines), and fell immediately before rising again in one (black line).

 

 

A simple analysis of option sentiment also shows that bearishness has come off the boil but readings are still high. The equity-only put/call ratio has fallen, indicating a retreat in bearishness, but the 10 dma remains elevated. In short, intermediate-term sentiment models are beginning to recycle back to neutral, but conditions are nowhere near crowded long conditions that warrant caution.

 

 

As well, seasonal patterns are supportive of a bullish outcome. The S&P 500 has been tracking its seasonal pattern remarkably well in 2021. If it were to continue, watch for a short-term top about the second week of January.

 

 

 

What if Santa doesn`t call?

Mark Hulbert recently demonstrated that the odds have historically favored a market advance after Christmas and for the first two days of the new year. However, there is still the possibility that the Santa Claus rally doesn’t materialize.

 

 

Short-term breadth is very extended and a pause and pullback would be no surprise in the early part of next week.

 

 

Ryan Detrick of LPL Financial showed the history of returns if the Santa rally fails. While the sample size is small (n=5), the implications for January and the rest of the year are not encouraging.

 

 

In conclusion, the market is poised for a year-end rally with an S&P 500 measured objective of 4920. The key risks are faltering market internals and overbought short-term breadth. If the market were to stage a seasonal advance, historical odds point to a trading top in mid-January.

 

 

Disclosure: Long SPXL

 

Was the Grinch in the house?

Posted by Cam Hui -

Mid-week market update: I am publishing this note one day early ahead of my holiday hiatus. Regular service will return Sunday with a trading note.
 

In the Dr. Seuss children’s story, “How the Grinch Stole Christmas”, the Grinch is a grouchy character who conspired to steal all the Christmas presents from the nearby village. He later has a change of heart and returns all the gifts and participates in the villagers’ Christmas celebrations. 

 

Was the Grinch in the house? It certainly seemed that wau. The Grinch arrived last week in the form of a market pullback accompanied by weak breadth and negative momentum, capped by Omicron shutdown fears and disappointment over delays of Biden’s Build Back Better fiscal stimulus program.

 

 

Even though the Grinch has stolen the presents, we may be nearing the end of the story. The market printed a Turnaround Tuesday and the S&P 500 regained its 50 dma.

 

 

Positive seasonality

Ryan Detrick compiled the likelihood each trading day finishes in the green. We are approaching a seasonally bullish period that ends in early January.

 

 

Rob Hanna at Quantifiable Edges published a “three nights before Christmas” study, which begins after the close today. He found that the optimal holding window ends on day 8, which is January 3, 2022.

 

 

The tax-loss selling activity window is closing this week. The “official” Santa Claus rally window begins in the last five tradings of the year and ends on the second trading day of the new year and the stock market was positive 34 out of the last 45 sessions (75.6%). There are a number of badly beaten-up stocks that should see a rebound next week and in early January. I offer some suggestions.

 

 

A possible short squeeze

Breadth readings were oversold based on Monday’s market action. It was therefore not surprising to see prices turn up today. The real question is, “How durable is the rally?”

 

 

JP Morgan strategist Marko Kolanovic thinks the rally has legs. He recently published a bullish note calling for a short squeeze.

 

Positioning of systematic and discretionary investors has already declined significantly to the bottom third of the historical distribution (~30-35th percentile). CTAs are fully short small cap and many international indices, while S&P 500 positions are not under pressure given the ~25% one-year appreciation of the cap-weighted benchmark. Volatility targeting and risk parity funds started adding exposure, given muted realized volatility and correlation and internally offsetting large stock moves. There will also be buying of equities into month- and quarter-end – particularly for international, SMID, and cyclical benchmarks that are impacted the most. In short, this is not a setup similar to 4Q2018 from a fundamental or technical angle. Yet, there is aggressive shorting, likely in a hope of declines in retail equity position and cryptocurrency holdings – while in fact both of these markets and retail investors have shown resilience in the past weeks. One should note that large short positions likely need to be closed before (the seasonally strong) January, which is likely to see a small-cap, value and cyclical rally. And given that market liquidity is dwindling, the impact of closing shorts may be bigger than the impact of opening them, when liquidity conditions were better.

 

 

Plunging SKEW = bullish

The SKEW Index measures perceived tail-risk by quantifying the price of out-of-the-money call and put options in the S&P 500. The index usually varies between 100 and 150. A high SKEW level indicates a high cost of tail-risk protection and vice versa for a low reading. In effect, the index is a proxy for sentiment and volatility.
 

Many analysts have unsuccessfully used SKEW as a contrarian trading indicator by buying when SKEW is high and selling when SKEW is low. Instead, I introduce a trading model based on the change in SKEW. Whenever the 10-day change in SKEW falls -10% or more, it has been an effective buy signal for the S&P 500. Rapid declines in SKEW indicate alleviation of market anxiety, sort of like a rapid fall in the VIX Index. It can induce market makers to adjust their hedges, usually by buying the index, much like the way the Robinhood crowd created a price momentum effect with massive buying of individual stocks and forcing market makers to hedge by buying the underlying.
 

The chart below shows the five-year record of this short-term trading model, where bullish resolutions are shown in grey and bearish ones shown in pink. Buy signals have been successful roughly two-thirds of the time, and it just flashed a buy signal.
 

 

The SKEW model buy signal is timely in light of seasonal effects and consistent with Kolanovic’s call for a short squeeze rally.
 

 

Rebound candidates

With that preface in mind, here are some short-covering candidates that could benefit as a tax loss selling season ends and a rebound begins. Small-cap stocks have traded sideways for most of 2021. They recently exhibited a failed breakout and they are much hated.
 

 

Even though prices have been flat, forward EPS rose steadily in 2021, which makes their forward P/E valuation less demanding.
 

 

On the other side of the value/growth spectrum, speculative growth stocks have been clobbered recently while high-quality growth FANG+ names have been the leadership. Trading in these stocks has been the province of small individual investors and recent losses could be the catalyst for tax-loss selling. The ETFs ARKK and BUZZ appear to be good barometers of the speculative growth factor. Watch for a short-term rebound.

 

 

With the caveat that this is emphatically not a buy recommendation, I am monitoring Nuvei Corp (NVEI) as an example of the shares of a company with speculative characteristics whose price has skidded. NVEI is a payment processor that went public in September 2020. It was the recent target of activist short-seller Spruce Point, which issued a highly unflattering report about the company.  Surprisingly, Andrew Left at Citron Research, which is another activist short-seller, came to NVEI’s defense (story details here). Subsequent to those events, a number of Street analysts brushed off Spruce Point’s allegations and reaffirmed their buy rankings on the stock. If my scenario of a short-covering and tax-loss rebound were to transpire, the price of NVEI should stage a strong relief rally.

 

 

 

Buy the junk!

Generally speaking, year-end rallies have been dominated by low-quality leadership. The chart below shows the relative performance of the large-cap quality factor (middle panel) and the small-cap quality factor, as measured by the relative returns of the S&P 600 against the Russell 2000. S&P has a much stricter index profitability inclusion criteria than Russell and therefore the S&P 600 has a quality tilt compared to the Russell 2000. 

 

Historically, low-quality stocks have performed well when the stock market advanced at year-end. With the exception of instances when the S&P 500 fell during the year-end period, which are shown by the pink vertical lines, there have been far more low-quality leadership episodes (blue arrows) than high-quality leadership (red arrows).

 

 

Keep in mind, however, that the year-end and early January rallies are short-term trading calls. Don’t overstay the party. 

 

 

Disclosure: Long SPXL

 

A breakout to S&P 4920?

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.
 

Publication schedule next week: There will be no regular strategy publiction next Saturday owing to the seasonal holidays. I will publish a tactical trading comment next Sunday.
 

 

A potential inverse H&S

A potential inverse head and shoulders pattern is forming in the S&P 500? The measured upside objective is roughly 4920. Despite the volatility from Friday’s quadruple witching, the S&P 500 held support at its 50 dma.

 

 

The bulls shouldn’t break out the champagne just yet. Strictly speaking, head and shoulders patterns are incomplete until the neckline breaks. If the index can stage an upside breakout above resistance, then traders can declare a risk-on tone to the market. On the other hand, if the S&P 500 were to undercut the “head” at about 4500 and invalidate the inverse head and shoulders pattern, things could get very ugly.

 

Here are bull and bear cases.

 

 

The bull case: Fearful sentiment

The bull case rests on a recovery from an oversold condition and washed out sentiment. The 14-day RSI of the  DecisionPoint Intermediate-Term Breadth Momentum Oscillator recently recycled off an oversold condition. In the last five years, there have been 23 such signals and 70% of them have resolved bullishly. Do you want to play the odds?

 

 

As well, the NAAIM Exposure Index, which measures the sentiment of RIAs, plunged to 52% last week, which is below its lower 26-week Bollinger Band. Since the inception of this index, this signal has virtually been a foolproof buy signal for equities.

 

 

Still not convinced that the market is near a washout bottom? Macro Charts pointed out that option order flow conditions have reached a crowded short reading, which is contrarian bullish.

 

 

 

The bear case: Weak internals

The bears will argue that breadth has deteriorated sharply. The S&P 500 tested resistance while exhibiting negative 5 and 14 day RSI divergences. The NYSE Advance-Decline Line retreated below its breakout level, which is another sign of weakening breadth; net NYSE and NASDAQ highs-lows are negative; and the percentage of S&P 500 and NASDAQ 100 stocks above their 50 day moving averages are exhibiting a series of lower highs and lower lows.

 

 

As a counterpoint to the poor breadth readings, Washington Service reports that insider buying has spiked and buying levels are the highest since the March 2020 market bottom. As well, insider selling is below this year’s average. If poor breadth is an indication of broad market weakness, then why are insiders, who are thought of as the “smart money”, buying?
 

 

Nevertheless, defensive sectors are staging upside relative breakouts across the board. This is another indication that the bears are seizing control of the tape.

 

 

Moreover, equity risk appetite has plunged, indicating a sharp deterioration of market internals.

 

 

These conditions call for short-term bullishness and intermediate-term caution. Sentiment is too bearish. In particular, the NAAIM Exposure Index has an impeccable short-term market timing for buy signals.

 

Be bullish and enjoy some holiday cheer. But don’t overstay the party as the calendar rolls into January.

 

 

Disclosure: Long SPXL

 

A recession in 2023?

Posted by Cam Hui -

The Fed has spoken by pivoting to a more hawkish trajectory for monetary policy. The FOMC announced that it is doubling the scale of its QE taper, which puts the program on track to end in March. The December median dot-plots show that Fed officials expect three quarter-point rate hikes in 2022 and three quarter-point rate hikes in 2023.
 

 

The 10-year Treasury yield is about 1.4% today. All else being equal, the Fed’s dot-plot puts monetary policy on track to invert the yield curve some time in 2023. Historically, inverted yield curves precede recessions and recessions are bull market killers.

 

 

Is the Fed on course to raise rates until the economy breaks?

 

 

The market reaction

Much depends on how the bond market interprets the Fed’s monetary policy pivot. Consider the following three scenarios for the 10-year Treasury yield, which currently stands at about 1.4%.
  1. Using the 2s10s as a benchmark for the yield curve and assuming that the 2-year yield moves in lockstep with the Fed Funds rate, the 2s10s would flatten and invert in late 2022 or early 2023.
  2. The 10-year yield has been falling in anticipation of the Fed’s hawkish pivot, which is a bond market signal that it expects a slowing economy. If the 10-year yield continues to fall, inversion would occur in H2 2022. 
  3. If the 10-year yield rises, which would be a signal that the market expects the Fed to get inflation under control and sparks a second wind in economic growth and earnings estimates continue to rise, it would be bullish for the equity outlook.
What happens next? Here is what I am watching.

 

What happens to the yield curve? Recent history shows that inverted yield curves have either slightly preceded or been coincidental with stock market tops. Arguably, the minor inversion in 2019 was a false positive as the 2020 recession was attributable to the pandemic, which is an exogenous event.

 

 

While the dynamics of the British economy is unique owing to the fallout from Brexit, the UK yield curve is inverted from 20 years onward. Is the UK the canary in the coalmine or a special case? Will the inversion spread across the developed markets?

 

 

Monitor the growth outlook. Accelerating growth translates to rising EPS estimates, which is equity bullish. So far, the Economic Surprise Index, which measures whether economic data is beating or missing expectations, is rising.

 

 

S&P 500 forward EPS estimates have also been strong, indicating positive fundamental momentum.

 

 

Rate increases are designed to cool off an overheated economy and control inflation. What happens to inflation expectations? 5×5 inflation expectations have been falling, which is positive for the Fed’s inflation-fighting credibility. Will it continue?

 

 

The latest release of global flash PMIs indicate that inflationary pressures look decidedly *ahem* transitory. Supplier delays are rolling over, which should alleviate some of the pandemic-related price pressures.

 

 

In addition, the newly listed Inflation Beneficiaries ETF (INFL) provides the equity market’s view of inflation. The absolute performance of INFL roughly tracks the relative performance of TIPs against their duration-equivalent Treasuries. The relative performance of INFL to the S&P 500 has been falling, which confirms the market signal from 5×5 inflation expectations. Will the trend continue?

 

 

If the Fed raises interest rates until something in the financial system to break, the most sensitive barometers of financial stress are high yield and emerging market bonds. Bloomberg reported that Ken Rogoff warned that EM countries are especially vulnerable to rising rates.

 

“Developing economies are just an accident waiting to happen,” the Harvard University economics professor said on Bloomberg TV on Wednesday, before the Fed’s policy decision. “There are already a lot of problems in what we call the frontier emerging markets.”

 

A full percentage-point of Fed rate increases next year could shut some countries out of markets, further straining already vulnerable fiscal situations. He pointed to Egypt, Pakistan and Ghana as nations already battling large debt obligations, narrower market access and, in some cases, double-digit inflation…

 

Emerging markets are “very sensitive to the hiking-more-quickly scenario,” Rogoff said. “Many, many countries that have access right now, suddenly wouldn’t. That would really be catastrophic.”
Keep an eye on HY and EM spreads. Widening spreads would be bad news for the growth outlook.

 

 

 

A question of credibility

Much depends on the market’s view of the Fed’s inflation-fighting credibility. Here is the FOMC’s Summary of Economic Projections (SEP). 

 

 

While the initial reaction to the publication of the SEP is to focus on its Fed Funds projections or the dot plot, two other forecasts are equally important. The Fed forecasts that core PCE, which is its preferred inflation indicator, falls from 4.4% in 2021 to 2.7% in 2023. While Jerome Powell has abandoned the term “transitory”, the SEP is projecting an outlook consistent with the now-banned term. Moreover, the December FOMC statement contained a nearly identical sentence as the previous month’s and attributing inflationary pressures to the pandemic and reopening factors is another way of saying “transitory” without using the word.

 

Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.
As well, the SEP forecast calls for the unemployment rate to fall from 4.3% in 2021 to 3.5% in 2022 and remain at that level until 2024. The long-term unemployment rate, however, is 4.0%. In other words, the Fed is signaling that it is willing to run the economy a little “hot” and tolerate some inflation pressure to achieve full employment.

 

Both of these forecasts are growth-friendly and equity bullish. For equity investors, I sketch out two possible paths. A hawkish reaction, which would be signaled by a flattening yield curve, translates into slowing growth. Under those conditions, investors flock to quality large-cap growth stocks when growth is scarce. Moreover, the forward P/E spreads of FANG+ stocks against the S&P 500 have fallen since September and valuation premiums are not overly demanding.

 

 

However, investors are best served by avoiding speculative growth stocks as psychology has turned and their bubble seems to have burst. Speculative growth-related ETFs such as ARKK and BUZZ are lagging both the S&P 500 and the high-quality large-cap NASDAQ 100.

 

 

A dovish reaction, or a steepening yield curve, is friendly to value and cyclical stocks. In the current environment, however, a bifurcated market has appeared between large, mid and small-cap value and growth return patterns. The recent dominance of large-cap FANG+ names has meant that growth has been outperforming value among large caps. However, value stocks, which are also concentrated in cyclical sectors, are beating their growth counterparts among mid and small-caps. The bottom panel shows the relative performance of small-cap value against large-cap growth. Based on a head-to-head comparison, large-cap growth remains dominant.

 

 

How should investors position themselves? My Trend Asset Allocation Model remains bullishly positioned in equities. However, I have made the case in the past that the economy and market are transitioning from an early cycle recovery to a mid-cycle expansion. During such periods, rising rates put downward pressure on P/E ratios, which is offset by rising EPS estimates. If history is any guide, stock prices tend to move sideways as the Fed starts to raise rates, but we are still several months from liftoff and the market could continue to advance until then. Remain bullish on equities until the market signals a downside trend break, which hasn’t happened yet.

 

 

Owing to the uncertainty of the market’s reaction to the Fed’s policy pivot, equity investors should adopt a barbell position of large-cap quality growth and small-cap cyclical value. A scenario of slowing growth should see large-cap growth stocks outperform, while signs of accelerating growth should benefit high-beta small-cap stocks.

 

Heightened fear + FOMC meeting = ?

Posted by Cam Hui -

Mid-week market update: I don`t have very much to add beyond yesterday`s commentary (see Hawkish expectations). Ahead of the FOMC announcement as of the Tuesday night close, fear levels were elevated.
 

 

The market`s retreat left it oversold or mildly oversold, such as the NYSE McClellan Summation Index (NYSI).

 

 

Both the NYSE and NASDAQ McClellan Oscillators (NYMO and NAMO) were approaching oversold readings.

 

 

As I pointed out yesterday, anxiety was in the air as the market was discounting a Fed policy error of overtightening. Arguably, the recent pullback is in line with the historical seasonal pattern of mid-December weakness before a year-end rally.

 

 

Here comes the oversold bounce. Tactically, I remain cautiously bullish and I will be monitoring the evolution of the market`s internals and psychology as prices rise before pronouncing judgment on the durability of this rally.

 

 

Disclosure: Long SPXL

 

Hawkish expectations

Posted by Cam Hui -

Ahead of tomorrow’s FOMC decision, market expectations are turning bearish. Even as the S&P 500 consolidated sideways, defensive sectors are all starting to show signs of life by rallying through relative performance downtrends.
 

 

 

Hawkish fears

A CNBC poll found that the consensus expects the Fed to double its taper, which would end QE by March, and three rate hikes each in 2022 and 2023. 
 

The CNBC Fed Survey finds that respondents expect the Fed to double the pace of the taper to $30 billion at its December meeting, which would roughly end the $120 billion in monthly asset purchases by March. The 31 respondents, including economists, strategists and money managers, then see the Fed embarking on a series of rate hikes, with about three forecast in each of the next two years. The funds rate is expected to climb to 1.50% by the end of 2023 from its range near zero today.

Psychology has turned cautious. A Bloomberg survey found that respondents are more worried about a Fed policy error of over-tightening than inflation.
 

 

The BoA Global Fund Manager Survey showed a similar result.
 

 

Positioning has turned defensive in response.

 

 

 

Too bearish?

Are expectations too hawkish and psychology too bearish? A quick Twitter poll by Helene Meisler today shows that the bull-bear spread has turned decidedly negative after a bull-bear spread of +15 on her weekend poll.
 

 

Fear levels are elevated, as measured by the put/call ratio, even as the S&P 500 is less than 1% from its all-time highs.
 

 

Short-term breadth has come off the boil and it is approaching oversold levels.
 

 

This is option expiry week (OpEx) and December OpEx has historically been bullish for stocks. However, the short-term outlook is clouded by the Fed decision wildcard.
 

 

In conclusion, major bear markets don’t begin when psychology is this bearish. Recall that when the November CPI print was in line with market expectations last Friday, the S&P 500 rallied to an all-time high. Even if you believe that the bull trend is rolling over, wait for a relief rally before initiating short positions.
 

 

Disclosure: Long SPXL
 

The Fed’s inflation problem

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.
 

 

A data and political problem

The S&P 500 experienced an air pocket in late November, sparked by a combination of the news of the emergence of the Omicron virus variant and the Fed’s hawkish surprise. Since then, the Omicron news has been mostly benign. While the new variant is more transmissible, its effects appear to be less severe. Pfizer and BioNTech reported that lab tests showed that a third dose of its vaccine protected against the Omicron variant. A two-dose regime was less effective but still prevents severe illness. With the Omicron threat off the table, the market staged a strong relief rally.

 

The second threat of a hawkish Fed still remains. As investors look ahead to the FOMC meeting next week, the Fed faces both a data and political inflation problem. The data problem is that inflation surprise is surging all around the world.

 

 

The closely watched November CPI report came in in line with market expectations, which was a relief for the equity markets. The S&P 500 responded by rallying to a marginal new all-time high. The Dow and the Transports are holding their previous breakouts.

 

 

Despite the market’s relief, there may be further upside pressure on CPI in the coming months. While airfares, used cars, and energy prices are noisy, volatile, and transitory components that have boosted CPI, Owners’ Equivalent Rent (OER) is a large weight in CPI and its outlook is concerning.

 

 

While OER (red line) has been relatively tame, it has historically lagged housing prices by about 12 months. If history is any guide, OER should start to rise next summer, a year after housing prices began their upward climb.

 

 

While the Fed is in theory independent from Congress and the White House, it nevertheless faces a political problem of rising inflation. This can be summarized by the recent plunge in consumer sentiment. For years, consumer sentiment (blue line) and the unemployment rate (red line, inverted) tracked each other closely. Their recent divergence is an indication that households are becoming less concerned about employment than other economic factors, especially when initial jobless claims printed a half-century low last week. The latest University of Michigan survey tells the story of a dramatic shift in consumer focus.

 

When directly asked whether inflation or unemployment was the more serious problem facing the nation, 76% selected inflation while just 21% selected unemployment (the balance reported the problems were equal or they couldn’t choose). The dominance of inflation over unemployment was true for all income, age, education, region, and political subgroups. 

It can also be explained by the Misery Index, which is the sum of the unemployment rate and inflation (black line, inverted). In the post-COVID Crash era, the Misery Index and consumer sentiment track each other more closely, indicating that households are increasingly concerned about inflation.

 

 

These political pressures undoubtedly played a role in the Fed’s recent hawkish pivot. In the wake of Jerome Powell’s Senate testimony, the market is now anticipating that the Fed will announce doubling the pace of its QE taper. At the new anticipated pace, the Fed’s asset purchases will end in March, which allows the Fed the flexibility to begin raising rates at the May FOMC meeting.

 

While investors will be closely watching the pace of the taper, another key indicator to monitor is the dot-plot and the long-term neutral Fed Funds rate. Former New York Fed President Bill Dudley wrote in a Bloomberg Op-Ed that he expects three rate hikes in 2022 and the long-term neutral rate should be as high as 2.5%.

 

For 2022, I expect a median forecast of 0.8%. This would signal three 0.25-percentage-point increases next year – not so many as to require a rate hike in March, but enough to be consistent with the faster taper and the unemployment and inflation outlook.

 

For 2023, I expect officials to project four more rate hikes, taking the median target rate to 1.8% a year earlier than in the September projections. Such gradual, consistent tightening makes sense once the Fed gets started. But policymakers aren’t likely to anticipate moving more quickly as long as they project inflation to remain below 2.5%.

 

For 2024, I expect the projected target rate to reach the 2.5% level judged as neutral. Anything less seems hard to justify, given that the economy will have been running beyond full employment and above the Fed’s 2% inflation target for several years.
If the Fed were to follow the trajectory laid out by Dudley, the yield curve would flatten and invert by late 2022 or early 2023, which would be an early signal of a recession – and recessions are bull market killers.

 

 

Reasons to be bullish

From a technical perspective, the combination of Omicron news and November CPI print represents a short-term bullish dynamic for stock prices.

 

The bulls can point to the strong rebound after a series of severely oversold market conditions and panicked sentiment readings. All components of my market bottom models flashed buy signals at the height of the market weakness when the S&P 500 tested its 50 day moving average.

 

 

The pullback weakened sentiment readings dramatically. Investors Intelligence bullish sentiment weakened and bearish sentiment edged up. The bull-bear spread tanked.

 

 

Similarly, the Citi Panic-Euphoria Model has come off the boil. While readings are still in euphoria territory, they are nowhere as extended as they have been in the past year.

 

 

In many ways, the relief rally was no surprise. Historically, the S&P 500 has shown strong returns whenever the VIX Index spiked above 30, indicating fear.

 

 

The ensuring rally exhibited strong price momentum. A recent backtest of similar momentum readings showed strong returns. Recently, 80% of S&P 500 stocks were at 5-day highs and the 50 dma was above the 200 dma. There have been only 29 similar instances in the last 30 years. History shows that the market was up an average of 14.3% a year later with a 90% success rate. Average drawdown was only -6.1%.

 

 

Notwithstanding those momentum results, the market is undergoing a possible setup for a rare Zweig Breadth Thrust buy signal. ZBT buy signals occur when market breadth surges from an oversold to an overbought condition with 10 trading days. The last day in the window is Wednesday or the day of the FOMC meeting.

 

 

 

Seasonality

Another consideration to keep in mind is seasonality. Seasonality is only of secondary importance as prices are affected by other factors and seasonality charts only show average returns without any recognition of wide historical variations. This year, the market tracked the seasonal pattern well until Thanksgiving. On average, the market begins to weaken now and begins a Christmas rally about mid-December.

 

 

In conclusion, the stock market has shrugged off both the Omicron scare and the Fed’s hawkish pivot scare. My base case scenario calls for further gains until year-end, though traders should be prepared for some FOMC related volatility next week.

 

 

Disclosure: Long SPXL