China gets rich AND old, but…

Posted by Cam Hui -

China has a well-known demographic problem: its working population is aging quickly. For years, many analysts have rhetorically asked whether China can get rich before it gets old. 
 

 

We have the answer. A recent McKinsey study found that China has beaten the US to become the richest nation. McKinsey found that China’s wealth rose from $7 trillion in 2000 to an astounding $120 trillion in 2020. By contrast, the US doubled its wealth to $90 trillion during the same period.

 

Be careful what you wish for. China becoming rich just as it begins to age is like the dog that caught the car but doesn’t know what to do next.

 

 

Unbalanced wealth

Here is the downside to being rich. The Financial Times pointed out that being rich in China is no picnic.

 

Among the 72 billionaires, 15 were murdered, 17 committed suicide, seven died from accidents, 14 were executed according to the law and 19 died from diseases.

As well, the growth in wealth was highly uneven and concentrated in real estate. China watcher Michael Pettis observed “the last time a country’s total wealth exceeded that of the US was in Japan around 1990. Its share of global GDP at the time was roughly the same as China’s today, and it was experiencing an even greater real estate bubble.”

 

 

Can China escape Japan’s fate?

 

 

The middle-income trap

China may be facing the classic middle-income trap problem of development. Few countries have successfully made the migration from middle-income to high-income countries. Most have been small, such as South Korea and Taiwan, or levered their positions as trading, capital, and technology hubs to leap to advanced economy status, such as Hong Kong, Singapore, Cyprus, and Ireland.

 

 

The World Bank explained the challenges of growth for middle-income countries this way:

 

Middle-income countries may face particular challenges because growth strategies that were successful while they were poor no longer suit their circumstances. For example, the reallocation of labor from agriculture to industry is a key driver of growth in low-income economies. But as this process matures, the gains from reallocating surplus labor begin to evaporate, wages begin to rise, and decreasing marginal returns to investment set in, implying a need for a new source of growth. Middle-income countries that become “trapped” fail to sustain total factor productivity (TFP) growth. By contrast, “escapees” find new sources of TFP growth (Daude and Fernández-Arias 2010). Indeed, 85 percent of growth slowdowns at the middle-income levels can be explained by TFP slowdowns (Eichengreen, Park, and Shin 2013). 

The World Bank hit the nail on the head with its formulation of TFP growth as the key to avoiding the middle-income trap. China faces two main challenges in maintaining growth. First, its GDP growth at any cost model has incentivized provincial cadres to focus on unproductive credit-driven real estate growth. The teetering finances of China Evergrande and other property developers have exposed the limits of this growth model.
 

As well, it faces the more conventional problem of migrating up the value-added chain as “the gains from reallocating surplus labor…evaporate”, as per the World Bank. Indeed, the SCMP reported that vice-premier Liu He penned a long article in China’s Daily about Beijing’s plan to avoid the middle-income trap by relying on technological innovation.
 

“Since the end of World War II, there are many countries that have started the industrialisation process and even briefly stepped over the threshold of being a high-income country,” Liu wrote. “Yet only very few countries, such as South Korea, Singapore and Israel, have truly leapt over the middle-income trap.”
 

To become an advanced economy, China has to shift its growth model from a strategy “driven by inputs” to an approach “driven by technological innovation” – a process that is still in progress, according to Liu.
 

Liu’s article, which argues for China to embrace “high-quality” growth and lays out ways to achieve that goal, is consistent with the World Bank and the State Council’s joint report a decade earlier. Worries about the sustainability of China’s growth persists, and the role of innovation in solving that problem is highlighted.

What does “high quality” growth mean? First, it means avoiding low-quality growth such as credit-fueled growth based on investment in unproductive real estate. Moreover, it means a pivot to high value-added technology services from low labor cost manufacturing. 
 

Yukon Huang and Jacob Feldgoise pointed out in an SCMP Op-Ed that virtually all countries have experienced declines in manufacturing. Taking the US as an example, the process of de-industrialization was accompanied by a surge in knowledge-intensive industries, which represented a bright spot in America’s growth path as shown by this Brookings study. As China attempts to move up the value-added chain, they argue that a Sino-American trade agreement for knowledge-intensive services would substantially benefit both sides. Whether there is sufficient political will in Washington and Beijing to complete such an agreement is an open question.
 

 

 

China’s report card

If that is the growth path laid out by Beijing, how is China doing?
 

Let’s start with real estate. The authorities have managed to stabilize the percentage of real estate investment in the economy and they are trying to slowly deleverage the industry.

 

 

China recently cut its reserve ratio by 0.50%, which has been interpreted as an attempt to stabilize the financial system in the wake of the Evergrande default and the fragile finances of other property developers. Bloomberg reported the Poliburo’s concerns have pivoted to potential instability.

 

“The tone has turned much more dovish,” Macquarie Group Ltd. analysts led by Larry Hu wrote in a Monday note. “For the first time, the Politburo meeting uses the phrase ‘stability is the top priority.’ In other words, top leaders are deeply concerned about the risk of potential instability.”

 

 

The key question is whether RRR cut affects the real economy or just asset prices. A discouraging sign comes from bond issuance data, which is rising in all sectors except for services. In the short term, however, strength in real estate and construction financings indicates an easing in financial conditions. As Beijing looks ahead to the Winter Olympics and the 20th Party Congress in 2022, the authorities are easing but for political reasons.

 

 

As a way of addressing the distrust of China’s official economic statistics, I rely on market-based indicators to measure the health of the Chinese economy. A month ago, weakness in commodity prices were signaling weakness in Chinese growth (see Commodity weakness = Global slowdown?).

 

The latest update shows that China is stabilizing. While the relative performances of MSCI China and Hong Kong to the MSCI All-Country World Index (ACWI) are still falling, the relative performances of the stock markets of China’s other major Asian trading are either bottoming or starting to turn up. I interpret this to tactically mean that the worst of the fears of a China downturn is over. For investors, this translates an ungrade from an underweight position to a neutral weight in China and other Asian markets.

 

 

In conclusion, China faces many long-term challenges. In the short run, excess credit-fueled investment in real estate is raising alarms about instability. Longer-term, the economy needs to successfully pivot from reliance on low-cost labor as a source of export-driven growth to higher value-added knowledge industries. Tactically, real-time market-based data shows that China’s economy is stabilizing, which translates to a neutral weight in China and other Asian countries.

 

 

Omi-what?

Posted by Cam Hui -

Mid-week market update: The most recent stock market downdraft was sparked by the news of a new virus variant that was initially identified in South Africa and the Fed’s hawkish pivot. As evidence emerged that Omicron is more transmissible but less deadly, the market staged an enormous rip-your-face-off short-covering rally. Today, Pfizer and BioNTech reported that lab tests showed that a third dose of its vaccine protected against the Omnicron variant. A two-dose regime was less effective but still prevents severe illness. Here we are, the S&P 500 is within 1% of its all-time high again.
 

Omi-what?

 

 

In the wake of the relief rally, the bulls still face the challenge presented by next week’s FOMC meeting. The risk of a hawkish Fed still looms. 

 

Here are the short-term bull and bear cases from a chartist’s perspective.

 

 

The bull case

One positive sign from the market’s exhibition of positive price momentum is the Dow traced out a bullish island reversal pattern, which is defined by the index falling through a downside gap and then reversing through an upside gap. The measured minimum upside target is roughly its all-time high.

 

 

The Omicron/Powell downdraft saw two down days on significant volume which is indicative of strong selling pressure. It began on Black Friday, which had 90.1% of NYSE volume on the downside. It was followed on Monday with a 89.4% downside day (red down arrows). According to Lowry’s, closely spaced downside days can be ominous if not quickly negated by a 90% upside day or two consecutive 80% upside days. Fortunately for the bulls, the market flashed two 80% upside days on Monday (80.0%) and Tuesday (85%, marked by blue up arrows).

 

 

In addition, the market flashed a possible setup for a rare Zweig Breadth Thrust buy signal on December 2, 2021. A ZBT buy signal is triggered when the ZBT Indicator moves from an oversold condition to an overbought reading of 0.615 or more within 10 trading days. In all likelihood, the ZBT buy signal setup will fail. A buy signal would be unabashedly bullish for stocks, but a failure should not be interpreted in a bearish manner.

 

There have been six ZBT buy signals since 2004. The S&P 500 was higher in all cases after a year. The two “momentum failures” saw the market correct before prices rose. The rest continued to rally after the buy signal into further highs.

 

 

The end of the 10-day window is next Wednesday, which coincides with the announcement of the FOMC decision. Brace for possible fireworks.

 

 

The bear case

While the bulls have staged an impressive show of positive price momentum, the bears may still be able to make a goal-line stand and turn the tide. The bulls can argue that the large-cap S&P 500 and mid-cap S&P 400 have held above their breakout levels. The bears can argue that the high-beta small-cap S&P 600 is struggling below resistance after a failed breakout.

 

 

Equity risk appetite indicators are exhibiting a minor negative divergence. Keep an eye on this should these indicators deteriorate further.
 

 

As well, the risk of a hawkish Fed hasn’t disappeared. Fed Funds futures are anticipating three quarter-point rate hikes in 2022, with liftoff at the May FOMC meeting. Since the Fed has signaled that it will not raise rates until the QE taper is complete, all eyes will be on the pace of the taper and the expected pace of 2022 rate increases in the dot-plot next week.

 

 

There is a severe disagreement between stock and bond market option markets. While the VIX Index has fallen dramatically as equities rallied, MOVE, which is the bond market’s VIX equivalent, has risen and remains highly elevated.

 

 

In conclusion, the S&P 500 is undergoing a high-level consolidation as it works off an overbought condition. 

 

 

Much depends on the FOMC decision next week and how much tightening has been priced into the market. My inner trader remains bullish but he is becoming more cautious. Traders should properly size their positions in light of the increasing market.

 

 

Disclosure: Long SPXL

 

About that crypto crash…

Posted by Cam Hui -

Risk-off came to the crypto world on the weekend as all cryptocurrencies took a sudden tumble. Bitcoin fell as much as 20%. Prices slightly recovered and steadied, but all major coins suffered significant losses.
 

 

How should investors analyze the crypto crash and what does it mean for equity investors and other risk assets.

 

 

Asset return profile

Will there be any fallout from the crypto crash? A MAN Institute study of cryptocurrency asset returns found that cryptos are uncorrelated with other asset classes.

 

 

While overall correlations are low, the researchers also found higher correlations during periods of equity drawdowns.

 

In the 6% of instances where the equity market sold off 5% or more over a one month period:
  • The average performance of Bitcoin was -13%;
  • Bitcoin registered a negative return 86% of the time
  • The left tail correlation was 0.3. 

 

 

Although these statistical studies are interesting, they don’t tell the entire story.

 

 

Profile of a crypto investor

To fully analyze the possible fallout of crypto volatility, it’s important to first understand the demographic profile of a crypto investor. A recent Pew Research survey found that “16% of Americans say they have ever invested in, traded or used cryptocurrency”. A closer examination found that crypto investors and traders are mostly young and male. 43% of men ages 18 to 29 are or have been crypto participants. The next largest demographic group are men ages 30 to 49.

 

 

 

Crypto bros ~ YOLO speculators

While they don’t exactly overlap 1 to 1, the young and male demographic is highly similar to the “get rich quick” and “you only live once” (YOLO) psychology Robinhood traders. It is therefore not surprising to see the high correlation between the price of Bitcoin as a proxy for the crypto complex and the relative performance of the ARK Innovation ETF.

 

 

Similarly, the performance of meme stocks as measured by BUZZ is also highly correlated. From a factor perspective, this is all the same trade. Investors should also distinguish between speculative growth and large-cap high-quality growth, as measured by the NASDAQ 100. Speculative growth is breaking down against both the S&P 500 and NASDAQ 100 FANG+ stocks, which are cash generative and enjoy strong competitive positions.

 

 

A sentiment-driven explanation of last weekend’s crypto crash is Crypto.com’s purchase of naming rights to the now “Staples Center” in Los Angeles. A macro explanation is a deceleration in global liquidity, as measured by changes in M2 money supply, which has shown a rough but uneven correlation with Bitcoin prices. The recent hawkish pivot by central bankers around the world is likely to put downward pressure on crypto assets. Add to the mix the 5x and 10x leverage available to crypto traders in offshore markets, downside volatility episodes such as the one this weekend is not a surprise. If leveraged crypto traders need to sell other assets to meet margin calls, the most correlated assets are speculative growth equities, as evidenced by the poor performance of ARKK today.

 

 

 

A Christmas present under the tree?

I suggested yesterday that small-cap stocks are beaten up and could see further selling pressure during the tax-loss selling season, followed by a rebound in late December and January (see In search of the next bearish catalyst). An even more speculative play for traders would be speculative growth stocks, as represented by ARKK and BUZZ, later this year. If leveraged crypto traders are forced to liquidate their stocks to meet margin calls, expect further selling pressure in the coming days, followed by a rebound soon afterward.

 

For small-cap investors, this means the lower quality Russell 2000 should lag the higher quality S&P 600 in the first half of December, followed by a relative relief rally.

 

 

 

In search of the next bearish catalyst

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.
 

 

Another leg down?

Here is some good news and bad news. The good news is that the S&P 500 tested its 50-day moving average (dma) while exhibiting a positive 5-day RSI divergence. That’s bullish, right?

 

 

The bad news is the same pattern occurred during the COVID Crash of 2020. Even though RSI showed a series of higher lows and higher highs, the market continued to fall after a brief relief rally.

 

The moral of this story is that RSI divergences can be more persistent than you expect. Will history repeat itself? Will the market experience another leg down?

 

 

Similarities and differences

Here is what is similar and different between 2020 and today.The market is severely oversold today. All of my market bottom models have flashed buy signals in the past week. But oversold markets can become even more oversold, which is exactly what happened during the COVID Crash of 2020.

 

 

As the market became oversold in 2020, selling was sparked by further bad news. Global markets were suddenly faced with an exogenous shock. A pandemic had gripped the world. While initial models had penciled in a SARS-like outcome, the reality was actually far worse. There were no treatments. China reacted by shutting down its economy. The global economy was collapsing.

 

Here is what’s different today. The markets were surprised by the appearance of a new variant and a hawkish pivot from the Federal Reserve. The markets are already oversold. What’s the next shoe to drop that could spark another down leg?

 

Omicron running out of control? The latest mRNA technology allows pharmaceutical companies to re-program vaccines quickly. In the worst case, a new vaccine could be available within 3-4 months, depending on testing and the regulatory approval process.

 

Government shutdown? House and Senate leaders came to an agreement to continue to fund the US government until February. Crisis averted.

 

A hawkish Fed? The yield curve flattened in the wake of the November Jobs report, indicating that the market believes economic growth is decelerating and a probable Fed policy mistake.

 

 

I know I am tempting fate by asking this question. What’s the worst thing that could happen? The market is already oversold. Oversold markets become more oversold from existential bearish catalysts such as a Russia Crisis, a Lehman collapse that threatens the global financial system, or an unexpected pandemic that shuts down the global economy. What else could go wrong?

 

Otherwise, this market weakness is just a temporary panic and a buying opportunity.

 

 

Poised for a rally

Last week, I observed that the market was oversold, but upon further investigation, sentiment was still complacent. Most traders expected the market to rally after the Black Friday downdraft.

 

This week, the market became even more oversold. Ed Clissold of Ned Davis Research observed that 7.0% of S&P 500 stocks were above their 10 dma, which is below the 7.7% oversold threshold level. Forward returns have historically been strong after similar signals.

 

 

More importantly, evidence of panic is appearing in the markets. The markets are extremely jittery. The Bollinger Band of the VIX Index has spiked above 90. While similar readings have not marked exact market bottoms in the past, they do indicate a heightened state of anxiety.

 

 

The put/call ratio has risen to levels consistent with fear.

 

 

As well, insider buying is starting to look constructive, though this indicator is an inexact market timing tool.

 

 

Another constructive sign is selling pressure may be abating on NYSE stocks. NYSE new lows peaked on November 30, just before the S&P 500 tested its 50 dma. However, NASDAQ new lows are still expanding, which is still bearish. Viewed through a style lens, this is bullish for value (NYSE) over growth (NASDAQ).

 

 

In short, the stock market is sufficiently oversold and washed out that a meaningful relief rally is imminent.

 

 

Looking for opportunity

Under a relief rally scenario, where are the greatest opportunities?

 

The most straightforward way to benefit would be to buy S&P 500 exposure in anticipation of a rebound. A most speculative way to participate would be small-cap stocks. Small-caps are washed out and hated. The small-cap indices staged a failed upside breakout and they are approaching the bottom of their trading range that has been in place for most of this year. Watch for additional selling pressure in the next few weeks as investors harvest tax losses for 2021. Buy them in anticipation of a year-end relief rally into early January.

 

 

Mark Hulbert recently cited a study showing that December tax-loss sale candidates usually turn into January winners. This Santa Claus effect begins just after Christmas and lasts into the new year.

 

 

Notwithstanding the tax-loss selling scenario, portfolio manager Steve Deppe conducted a historical study of the Russell 2000 when the index reached an all-time high weekly close followed by a three-week losing streak. While the sample size is small (n=8), the index has never closed lower a month later.

 

 

In conclusion, the stock market is oversold and there are signs of capitulation. Barring another major negative shock, the market is poised for a relief rally into year-end and possibly January. Small-caps are washed out and could prove to be a worthwhile speculative buy as a way of taking advantage of the Santa Claus rally seasonal pattern.

 

 

Disclosure: Long SPXL

 

Assessing the damage

Posted by Cam Hui -

Stock markets were recently sideswiped by the dual threat of a new Omicron strain of COVID-19 and Jerome Powell’s hawkish pivot. Global markets adopted a risk-on tone and the S&P 500 pulled back to test its 50-day moving average.
 

 

This week, I assess the damage that these developments have done to the investment climate from several perspectives:

 

  • Fundamental and macro;
  • Omicron and Federal Reserve monetary policy; and
  • Technical analysis.

 

 

Fundamental momentum still positive

Let’s start with the good news. Recessions are bull market killers and there is no recession in sight. New Deal democrat maintains a dashboard of coincident, short-leading, and long-leading indicators. His latest update concluded that the “underlying indicators for the economy in all timeframes remain generally positive”.

 

 

Fundamental momentum is still strong. Forward 12-month EPS estimates for both large and small-cap stocks are still rising.

 

 

CEO confidence is on fire. So is the employment and capital spending outlook.

 

 

 

Omicron and the Fed

There is much we don’t know about the Omicron variant of the virus. Some very preliminary data indicate that it is spreading more quickly than previous variants. The data from South Africa’s Gauteng province, which includes Johannesburg, indicates that Omicron related caseloads are rising faster than Delta. Early anecdotal evidence also suggests that infections are mild as hospitalization rates are similar or lower than other waves. On the other hand, early reports indicate that the current generation of vaccines are not as protective against Omicron infection, though they are still effective against serious illness.

 

 

There are two ways of interpreting this preliminary data. A benign scenario of a fast spreading but less deadly virus is equity bullish. Lockdowns measures would be minimal and there would be few supply chain disruptions. As well, a lower mortality wave would have the additional benefit of endowing the infected with some natural immunity. Such an outcome would be bullish for the cyclical and value stocks and beneficial to high-beta small-caps.

 

The cautious view came from the Fed’s Jerome Powell, whose testimony to Congress was initially interpreted by the markets as dovish but turned out to be hawkish [emphasis added]:

 

The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation. Greater concerns about the virus could reduce people’s willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions.
Here is the reasoning behind’s Powell’s phrase, “time to retire the word transitory”.  The Fed recently rolled out its Flexible Average Inflation Targeting framework (FAIT) as a way of addressing criticism that it was chronically undershooting its inflation target. FAIT also served as a way of allowing the Fed to pay more attention to its full employment mandate. 

 

The Fed’s response to the pandemic was a test of FAIT. The downturn in 2020 was highly unusual inasmuch as demand for goods rose while demand for services fell. At the same time, the global economy shut down in response to the pandemic and sparked a supply shock in goods production. As a consequence, durable goods PCE shot up while services PCE was relatively tame. Over time, supply chain bottlenecks should ease and inflation should fall, which was the reasoning behind the “transitory” narrative.

 

 

The emergence of Omicron poses “increased uncertainty for inflation”. Further COVID-19 disruptions to the supply chain mean that the inflation spike is more enduring and less transitory. In effect, the Fed risks being caught behind the inflation-fighting curve by allowing inflation expectations to rise and become unanchored. In other words, the Fed’s nightmare scenario is stagflation caused by slow growth from COVID-19 induced bottlenecks and rising inflation expectations. 

 

 

Stalling price momentum

Even though fundamental momentum remains positive, the combination of the Omicron news and the Fed’s hawkish pivot has turned price momentum negative. The S&P 500 had been held up during most of 2021 by the presence of positive price momentum, but momentum has turned. My momentum indicator, defined as the percentage of S&P 500 stocks above their 50 dma to percentage above 150 dma, rose above 1 and recycled below 0.9. Historically, this has been an intermediate-term cautionary signal to de-risk equity portfolios.

 

 

A longer time horizon price momentum model focuses on the percentage of stocks above their 200 dma. In the last 20 years, there has only been five episodes when this indicator reached 90% and stayed there, indicating a “good overbought” market advance (grey shaded periods). This indicator has also stalled and recycled downwards. Even though macro indicators, such as the copper/gold ratio and the equal-weighted consumer discretionary/staples ratios, appear benign, past stalls have not ended until the percentage of stocks above their 50 dma has reached the oversold levels of 20.

 

 

 

Investment implications

What does this mean for the stock market? The intermediate-term outlook depends on the path of the Omicron wave and the Fed’s reaction function. Ned Davis Research found that stock prices especially struggle if the Fed undergoes a fast tightening cycle. 

 

 

What will the Fed do? Powell testified the FOMC will consider speeding up the taper of its QE program at the December meeting, but nothing is set in stone. Expect the Fed to pivot to the narrative that “tapering does not mean rate hike”. The Fed will remain data-dependent and its reaction function will depend on progress towards economic recovery and the wildcard posed by the Omicron variant.

 

It is appropriate, I think, for us to discuss at our next meeting, which is in a couple of weeks, whether it will be appropriate to wrap up our purchases a few months earlier. In those two weeks we are going to get more data and learn more about the new variant.

Investor reaction function will also be dependent on time horizon. I have been calling for a sloppy range-bound market in H1 2022 (see How small caps are foreshadowing the 2022 market and Time for a mid-cycle swoon?). The latest risk-off episode is probably just a shot off the bow of equity investors.
 

Under these conditions, investment-oriented accounts should practice some scenario planning and risk mitigation. In the coming months, gradually de-risk portfolios by reducing equity risk and raising fixed-income allocations. My Trend Asset Allocation Model remains at a risk-on signal. The model is based on trend following principles and it will not buy in at the bottom and sell at the top. While I am not inclined to front-run model readings, I expect the Trend Model signal will be downgraded from risk-on to neutral in the next few weeks.
 

I would favor a barbell portfolio of FANG+ growth and small-cap value stocks as a way of risk mitigation and scenario analysis. If the Fed’s stagflation fears were to materialize, high-quality FANG+ stocks will outperform in a growth-scarce world. Make sure to focus on quality growth names with strong cash flows and competitive positions. Speculative growth stocks, such as meme stocks and unprofitable but promising growth companies such as the ones held by ARKK, are underperforming.
 

 

On the other hand, if the benign scenario of the Omicron wave is correct, high-beta and cyclically sensitive small-cap value stocks would have the greatest leverage to a recovery.
 

Positioning for short-term traders is a different matter. The market is wildly oversold and there are numerous short-term studies that call for a relief rally. Instead of de-risking, traders should be buying the dip.
 

As one of many examples, 95% of S&P 500 stocks closed down on November 30, 2021. There were 19 similar episodes in the last 10 years and the S&P 500 was higher within 20 trading days every time.
 

 

In conclusion, I have been calling for a transition from an early cycle market to a mid-cycle market marked by more choppiness. The recent air pocket encountered by global stock markets may just be the prelude to such a scenario. Investment-oriented accounts should gradually de-risk portfolios by reducing equity weights and adding fixed income positions. Focus on a barbell portfolio of FANG+ growth and small-cap value stocks as a way of risk mitigation.
 

Traders, on the other hand, are faced with a market that is extremely oversold. The short-term risk/reward is tilted to the upside. Buy the dip in anticipation of gains over the next few weeks.
 

Do you believe in Santa Claus?

Posted by Cam Hui -

Mid-week market update: Last Friday’s Omicron surprise left a lot of bulls off-guard when the markets suddenly went risk-off on the news of a new variant emerging from South Africa. Stocks became oversold and I observed that “To be bearish here means you are betting on another COVID Crash.” (see COVID Crash 2.0?). Even as the market staged a relief rally Monday, my alarm grew when it appeared that the consensus opinion was the bottom was in. It was a sign of excessive complacency.
 

Stock prices were sideswiped Tuesday by the news that existing vaccines may be of limited utility against Omicron and Powell’s hawkish turn. At a Senate hearing, Powell called for the retirement of the “transitory” term as a way to describe inflation, “It’s probably a good time to retire that word and explain more clearly what we mean.” As well, Powell stated that it was time for the FOMC to consider accelerating the pace of QE taper at its December meeting. The S&P 500 tanked and undercut its lows set on Friday.

 

Can the market still manage a year-end Santa Claus rally? Ryan Detrick of LPL Financial argues that history is still on the bulls’ side.

When the S&P 500 is up >20% for the year going into December, the final month of the year is actually stronger than normal.

 

What about you? Do you believe in Santa?

 

 

The bear case

The bear case is easy to make. Much technical damage has been done by the market action in the past week. Even though the S&P 500 stages an initial test of its 50 dma, the Dow fell below its 50 dma several days ago and violated its 200 dma today.

 

 

Equally disconcerting is the downward trajectory of NYSE highs-lows and NASDAQ highs-lows. The deteriorating in the NASDAQ is especially concerning as NASDAQ stocks have been the market leaders.

 

 

Even as the market became oversold, there has been a lack of panic in many quarters. The equity-only put/call ratio rose to only 0.48 on Tuesday, but the reading was below Friday’s level and well below panic levels seen in recent short-term bottoms.

 

 

Moreover, sentiment remains jittery. The market tried to stage a relief rally today, only to be derailed by the news that the Omicron variant had landed on American shores.

 

 

The bull case

The bulls will argue that the recent market action was only a hiccup. The relative performance of defensive sectors are all in downtrends, indicating that the bears haven’t seized control of the tape.

 

 

All four of my bottoming models had flashed oversold signals. In addition, TRIN spiked above 2 Tuesday, which is an indication of market clerk liquidation and price-insensitive selling that often marks short-term bottoms.

 

 

 

Waiting for the rebound

What’s the verdict? Bull or bear?

 

The jury is still out on that score. The market is obviously very oversold. Today’s market action indicates that stock prices are poised for a relief rally. Any trader who initiates short positions at current levels risks getting his head ripped off.

 

I am waiting to see how the market behaves in the next few days to pass judgment. The S&P 500 should find downside support at the current level, which is its 50 dma, and could encounter overhead resistance at its 20 dma at about 4660.

 

 

 

Stay tuned.

 

 

Disclosure: Long SPXL

 

COVID Crash 2.0?

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.
 

 

COVID panic!

Global markets took a risk-off tone on Friday when news of a heavily mutated coronavirus variant labeled B.1.1.529, or Omicron, emerged from Southern Africa. Nature reports that South African scientists recently identified a new strain.
 

Researchers in South Africa are racing to track the concerning rise of a new variant of the coronavirus that causes COVID-19. The variant harbours a large number of mutations found in other variants, including Delta, and it seems to be spreading quickly across South Africa.

 

A top priority is to follow the variant more closely as it spreads: it was first identified in Botswana this month and has turned up in travellers to Hong Kong from South Africa. Scientists are also trying to understand the variant’s properties, such as whether it can evade immune responses triggered by vaccines and whether it causes more or less severe disease than other variants do.

 

“We’re flying at warp speed,” says Penny Moore, a virologist at the University of Witwatersrand in Johannesburg, whose lab is gauging the variant’s potential to dodge immunity from vaccines and previous infections. There are anecdotal reports of reinfections and cases in vaccinated individuals, but “at this stage it’s too early to tell anything,” Moore adds.

 

“There’s a lot we don’t understand about this variant,” Richard Lessells, an infectious disease physician at the University of KwaZulu-Natal in Durban, South Africa, said at a press briefing organized by South Africa’s health department on 25 November. “The mutation profile gives us concern, but now we need to do the work to understand the significance of this variant and what it means for the response to the pandemic.”

 

 

When COVID-19 first came out of nowhere in early 2020, the global economy shut down and the markets crashed. Could we be seeing the start of COVID Crash 2.0?

 

 

2020 parallels

There are some parallels to the 2020 experience. The stock market was already exhibiting technical stress even before the onset of COVID-19.

 

The standard technique for calculating a Bollinger Band (BB) is to put a two standard deviation band around a 20-day moving average (dma). As a demonstration of how strong the recent advance has been, the S&P 500 approached the top of the 200 dma BB and stalled. In the last five years, there have been six episodes of 200 dma BB rides. In five of the instances, the top was signaled by a negative RSI divergence, which is the case today. Half of them resolved with significant downdrafts (circled in red) and the other half ended with a sideways consolidation.

 

 

If the latest round of market weakness is a just plain vanilla pullback, the latest stall is likely to be benign. That’s because the market saw an initial bottom when the NYSE McClellan Oscillator (NYMO) has already reached an oversold level. The caveat is oversold markets can become more oversold. During the COVID Crash, market internals blew past oversold conditions to reach extreme levels very quickly.

 

In fact, three of the four components of my bottoming models have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band, NYMO is oversold, and so is the 5-day RSI. Only the term structure of the VIX hasn’t inverted, but it’s very close. However, the COVID Crash was an exception to the rule for these buy signals,

 

 

Another breadth indicator, the percentage of advancing-declining volumes, fell to an oversold extreme on Friday. This has usually led to short-term bounces. To be bearish here means you are betting on another COVID Crash.

 

 

 

2020 differences

Here are some key differences between today and 2020. Global healthcare systems were completely unprepared when COVID-19 first appeared in early 2020. China reacted by completely shutting down its economy. Hospitals in northern Italy, which is the wealthiest part of the country in a G-7 nation, were overwhelmed and the death rates were horrific. There were no treatments available. The only solution was a lockdown in order to reduce the transmission rates (remember “flatten the curve”) in order to buy time for researchers to find vaccines and treatments.

 

Fast forward to 2021. Vaccines and treatments are available. Any lockdowns are likely to be relatively temporary. However, there are some key unanswered questions about the new Omicron variant.

 

  • How transmissible is it compared to other COVID-19 strains? Higher transmission rates mean greater virulence and ability to spread through the population.
  • Are its symptoms more severe than previous variants?
  • How effective are current vaccines and treatments against Omicron?
  • If current vaccines and treatments are ineffective, which is a big if, mRNA technology allows researchers to react quickly to new variants. How quickly can a new vaccine be tested and approved?
Equally important is the policy reaction. Prior to the emergence of Omicron, Fedspeak had turned hawkish. Two Fed governors and San Francisco Fed President Mary Daly, who is considered to be a dove, all supported a faster taper of QE purchases. In addition, Reuters reported that when Biden announced the re-nomination of Jerome Powell as Fed Chair and Lael Brainard as Vice-Chair, both turned their focus to inflation.

 

“We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials, like food, housing and transportation,” Powell said in comments alongside Biden and Brainard. “We will use our tools both to support the economy – a strong labor market – and to prevent higher inflation from becoming entrenched.”

 

Brainard added she too was committed to putting working Americans at the centre of her agenda. “This means getting inflation down at a time when people are focused on their jobs and how far their paychecks will go,” Brainard said.

 

The November FOMC minutes, which were released last Wednesday, also contained some surprises. It seems that the Fed is reacting to market pressures on inflation, even though the official view remains in the transitory camp.

 

Participants generally saw the current elevated level of inflation as largely reflecting factors that were likely to be transitory but judged that inflation pressures could take longer to subside than they had previously assessed.

 

Last week’s hawkish Fedspeak was confirmed by the minutes, which is signaling an acceleration in the pace of taper.

 

Some participants suggested that reducing the pace of net asset purchases by more than $15 billion each month could be warranted so that the Committee would be in a better position to make adjustments to the target range for the federal funds rate….
In the wake of the Omicron news, the WSJ reported a dramatic shift in Fed Funds expectations.

 

Federal funds futures, a proxy for market expectations of interest rate changes, shifted downward Friday, with the market anticipating that the Federal Reserve will keep interest rates low for longer. CME Group data showed the majority of investors are now pricing in two or three, quarter percentage-point rate increases by the end of 2022, compared with three or four on Wednesday. Equivalent measures of interest-rate expectations for the eurozone and the U.K. also shifted downward.

 

 

Market anomalies

As the markets reacted to the news of the new variant on Friday, some market anomalies have appeared signaling that the latest risk-off episode is a buying opportunity rather than COVID Crash 2.0. Friday’s market action is indicative of an irrational panic rather than reasoned reaction to events.

 

Treasury yields understandably fell dramatically during this risk-off episode. But if the B.1.1.529 is truly a threat to the global economy, expect the Fed to downgrade its hawkish views in light of the downside threats to growth. If that’s the case, why did the yield curve initially experience a parallel shift downwards in the 2-10 year range (though it did flatten later in the day)?

 

 

A survey of case counts shows that the situation had deteriorated badly in Europe compared to other regions. When global markets took a risk-off tone, why did EURUSD surge? The USD is normally a safe haven during periods of crisis. Instead, the greenback weakened.

 

 

 

Sentiment vs. data

Notwithstanding the latest panic, high frequency economic data had been improving. The Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been rising.

 

 

Similarly, the San Francisco Fed’s daily news sentiment index, which tracks the tone of economic news, has recovered after a brief dip.

 

 

In 2021, every variant sell-off has turned out to be a buying opportunity. The latest sell-off is likely to be another. 

 

Take a deep breath and relax. The latest mRNA technology is well-positioned to react to new variants  should current vaccines and treatments fail. Central bankers are poised to ease should growth disappoint. The latest risk-off episode represents a washout panic and a probable near-term bottom. 

 

Buy the dip.

 

 

Disclosure: Long SPXL

 

How small caps are foreshadowing the 2022 market

Posted by Cam Hui -

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

 

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

 

 

A mid-cycle market

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

 

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

 

 

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

 

 

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

 

 

The small-cap template

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

 

 

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

 

 

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

 

 

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

 

 

Interpreting negative breadth divergence

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

 

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

 

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

 

 

 

Trading the seasonal rally

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

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

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

 

Melt-up risk control

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

 

 

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

 

 

A case of bad breadth

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

 

 

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

 

 

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

 

 

 

Momentum still positive

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

 

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

 

 

 

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

 

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

 

 

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

 

 

 

Positive seasonality

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

 

 

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

 

 

 

Climbing a Wall of Worry

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

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

What’s wrong with value stocks?

Posted by Cam Hui -

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

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

 

 

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

 

 

Unbalanced return profiles

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Macro uncertainty

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

 

 

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

 

 

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

 

 

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

 

 

 

Bull case for growth stocks

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

 

 

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

 

 

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

 

 

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

 

 

 

Value or Growth?

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

 

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

 

 

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

 

Consolidating for a rally

Posted by Cam Hui -

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

 

 

Uptrend intact

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

The inflation challenge

Posted by Cam Hui -

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

 

Which side of that bet would you take?

 

 

Rising inflation concerns

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

 

 

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

 

 

 

A glass half full, or half-empty?

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

 

 

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

 

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

 

 

 

BIS: Mostly a bottleneck problem

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

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

 

 

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

 

 

 

Investment implications

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

The seasonal rally is intact

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The most wonderful time of the year?

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

 

 

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

 

 

 

Bull trend still intact

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

 

 

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

 

 

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

 

 

As well, defensive sectors are all in relative downtrends.

 

 

 

A brief setback

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

 

 

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

 

 

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

 

 

Supportive sentiment

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

 

 

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

 

 

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

 

 

All systems go

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

 

 

All systems are go for the seasonal rally.

 

 

Disclosure: Long SPXL

Commodity weakness = Global slowdown?

Posted by Cam Hui -

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

 

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

 

 

 

Commodity warnings

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

 

 

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

 

 

 

Silver linings

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

 

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

 

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

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

 

 

China weakness contained

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

 

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

 

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

 

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

 

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

 

 

A decoupled China

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

 

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

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

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

 

 

Bullish and bearish signals from volatility

Posted by Cam Hui -

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Opportunities in gold

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

 

 

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

 

 

 

Disclosure: Long SPXL

 

A question of leadership

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Nagging questions of leadership

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

 

 

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

 

 

A broad advance?

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Resolving the doubts

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

 

 

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

 

 

Trading the melt-up

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL
 

A Dow Theory buy signal, but…

Posted by Cam Hui -

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

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

 

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

 

 

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

 

 

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

 

 

Bullish confirmations

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Beware of 2022 headwinds

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

A late-cycle bull

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

 

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

 

A no-surprise Federal Reserve

Posted by Cam Hui -

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

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

 

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

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

 

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

 

 

Rising bond yields

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

 

 

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

 

 

 

Small caps break out

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

 

 

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

 

 

 

Year-end rally underway

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

 

 

Risk on!

 

 

Disclosure: Long SPXL

 

Hawkish expectations

Posted by Cam Hui -

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

 

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

 

 

How hawkish?

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

 

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

 

 

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

 

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

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

Focus on productivity

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

 

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

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

 

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

 

 

Waiting for the FOMC

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

An asset rotation review

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

 

 

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

 

 

Global equity market review

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

 

 

 

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

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

 

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

 

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

 

 

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

 

 

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

 

 

 

Emerging markets are weak

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

 

On one hand, valuations are becoming more attractive.

 

 

On the other hand, investors face considerable risks.

 

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

 

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

 

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

 

 

Waiting for the FOMC

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

 

 

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

 

 

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

 

 

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

 

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

 

 

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

 

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

 

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

 

 

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

 

 

What say you, Jerome Powell?