Don’t short a dull market

Posted by Cam Hui -

Mid-week market update: Even as the S&P 500 remains range-bound, market internals are constructive. I interpret these conditions to mean that the market can grind higher in the short-term, and the intermediate-term trend is still up.
 

 

Don’t short a dull market.

 

 

A risk appetite revival

A survey of risk appetite indicators reveals a revival. Regular readers will know that I am not a long-term bull on Bitcoin or any other cryptocurrencies (see Why you should and shouldn’t invest in Bitcoin). Nevertheless, there appears to be a lead-lag relationship between the relative performance of ARK Innovation ETF (ARKK) and Bitcoin. Tactically, this argues for a tactical revival in Animal Spirits, which can propel Bitcoin and other high-beta speculative issues higher.

 

 

I recently wrote about different pockets of investment opportunities around the world (see In search of global opportunities). I pointed out that Europe was enjoying a rebirth in relative strength. Ari Wald recently observed that Europe is staging an upside breakout from a 21-year base. That’s bullish in any chartist’s book.

 

 

In addition, I had identified Turkish stocks as a wash-out emerging market opportunity. Another shoe dropped today. Turkish President Recep Tayyip Erdogan said in an interview on state television that it’s “imperative” that the central bank lowers interest rates, giving a vague reference to summer months as a target date. MSCI Turkey has barely reacted to the news. 

 

 

You can tell a lot about market psychology by the way it reacts to the news. Speculative growth and cryptocurrencies are poised for a rebound, and value pockets of the market like Europe and Turkey are also performing well. In short, the stock market is firing on all cylinders.

 

 

Beware of the June swoon

Before the bulls get overly excited, the S&P 500 is approaching a period of negative seasonality in late June.

 

 

This is consistent with the observation that both the NYSE and NASDAQ 100 McClellan Oscillators are approaching overbought levels. 

 

 

My base case scenario calls for an S&P 500 rally in the next week to test or achieve new highs, followed by a late June swoon. Traders should start to position for a possible short-term top. Investors should regard any market weakness as a welcome pullback to add to positions.

 

 

Disclosure: Long SPXL

 

The wall at S&P 4200

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 S&P 500 tests overhead resistance

The S&P 500 has been trading sideways since mid-April, with overhead resistance at roughly the 4200 level. While the market action in the past week has been frustrating for both bulls and bears, I believe the index should be able to advance past the 4200 level to test the old highs and probably make marginal new highs in early June. My bullish view is supported by the behavior of the VIX Index, which has convincingly fallen below its 20 dma after recycling from above its upper Bollinger Band.

 

 

 

Short-term bullish

So far, the S&P 500 seasonality is tracking well this year. We have seen a March low, followed by an April rally and weakness in May. If the market continues on this roadmap, the index should correct in late June after it rises to an all-time high in the next two weeks.

 

 

As well, the relative performance of defensive sectors have weakened and several have violated relative support levels. These are signals that the bulls have regained control of the tape.

 

 

 

A different kind of rally

As I pointed out in yesterday’s publication (see What a bond market rally could mean for your investments), leadership is expected to shift from value to growth stocks in the near future. The market breadth of value vs. growth is deteriorating, indicating a growth stock revival.

 

 

Macro Charts pointed out that one-third of NASDAQ stocks have flashed MACD buy signals, which is another important indicator of underlying strength.

 

 

Hedgopia pointed out that large speculators (read: hedge funds) are still net short the NASDAQ 100 futures. Growth stocks are poised to climb the proverbial Wall of Worry.

 

 

When might the growth stock rally end? Keep an eye on market breadth, such as the percentage of NASDAQ 100 stocks above their 50 dma or the NASDAQ McClellan Oscillator, to reach overbought levels as signals to become more cautious.

 

 

In light of the rising underlying strength in NASDAQ 100 names but a negative RSI divergence in the S&P 500, the S&P 500 may move sideways in the next two weeks while the market undergoes an internal rotation from value to growth.

 

 

One important test of market psychology will occur Friday with the release of the May Employment Report. As a reminder, the market had expected the gain of 1 million jobs in April and there were whisper numbers that Non-Farm Payroll would come in as high as 2 million. Instead, NFP inexplicably missed expectations with at 266K print. There is a good chance the April figure would be revised substantially upwards and the May NFP gain could bounce back with a gain of over 1 million jobs against a more modest expectation of 620K. How will the stock market react under such a scenario. Will good news be good news or bad news?

 

In summary, I believe the stock market is poised for additional advances in early June. Expect value stocks to take a breather, and a counter-trend rally by the lagging growth names. However, be prepared for the possibility for the S&P 500 to churn sideways for the next two weeks as the market undergoes an internal rotation from value to growth stocks.

 

 

Disclosure: Long SPXL

 

What a bond market rally could mean for your investments

Posted by Cam Hui -

The trader Alex Barrow recently observed that the sentiment backdrop is setting up for a bond market rally.
 

 

While Barron’s is not as reliable as The Economist as a contrarian magazine cover indicator, the stars appear to be lining up for a counter-trend rally in bond prices. Here is what a potential bond market means for the other major asset classes.

 

 

Bond market rally ahead?

Notwithstanding Barrow’s sentiment model observation, a number of other indicators are pointing to downward pressure on bond yields and upward pressure on bond prices. The Citi Economic Surprise Index, which measures whether economic indicators are beating or missing expectations, has been falling. Growing growth disappointments should act to depress bond yields.

 

 

You can tell a lot about market psychology by the way it reacts to the news. Fed vice-chair Richard Clarida raised the possibility of a QE taper in a Yahoo Finance interview.

“It may well be” that “in upcoming meetings, we’ll be at the point where we can begin discuss scaling back the pace of asset purchases,” Clarida said Tuesday in a Yahoo! Finance interview. “I think it’s going to depend on the flow of data that we get.”

In response, the 10-year Treasury yield fell on the news. From a technical analysis perspective, the behavior of the 10-year yield is constructive for bond bulls as it violated a rising trend line and it is in the process of testing an important support level.

 

 

History shows that bond yields have fallen whenever the Fed tapered. This a counterintuitive result but tapering has not been bearish for bond prices.
 

 

The bond market’s reaction can be explained by an acceptance of the Fed’s full employment narrative. The low-income employment recovery is still lagging, which is an indication that the Fed will remain dovish for some time.

 

 

 

Transitory inflation fears

The bond market was briefly jolted Friday when Core PCE, which is the Fed’s favorite inflation indicator, spiked to an above expectations level of 3.1%. However, George Pearkes of Bespoke Investment Group pointed out that only five categories accounting for 3.2% weight in expenditures generated nearly two-thirds of the PCE surge. 

 

 

The Fed is likely to shift its focus from Core PCE to Trimmed Mean PCE, which remains tame. 

 

 

In short, price increases are not widespread and can be explained by supply chain bottlenecks. This is what “transitory” inflation looks like.

 

 

Growth stock counter-trend rally ahead

While it’s difficult to make a call on the direction of the S&P 500 based on a possible bond market rally, market internals are likely to shift, especially in light of this highly bifurcated stock market environment.

 

Growth stocks have long been thought to be high duration instruments. That is to say, they tend to be more sensitive to changes in interest rates. Investors should therefore expect that falling bond yields to benefit growth stocks over value stocks.

 

 

Financial stocks, which comprise a significant portion of the value stock universe, don’t perform well if bond yields are falling. Falling bond yields should flatten the yield curve, as the short-end is already pinned at zero or nearly zero. In the past 10 years, the relative performance of bank stocks has been correlated with the shape of the yield curve. A steepening yield curve has historically boosted bank shares because they have a tendency to borrow short and lend long. This tight relationship diverged in 2017 because of the Trump tax cuts, which raised banking industry profitability.

 

 

Indeed, the performance of the Rising Rates ETF (EQRR), which is overweighted in the value and cyclical sectors of Financials, Energy, Materials, and Industrials, has begun to underperform the S&P 500. Investors should therefore expect a pause in the reflation and cyclical trade should a bond market rally begin to materialize in earnest.

 

 

The market breadth of value against growth is also signaling a turn towards growth stocks. The spread of percentage bullish on point and figure charts and percentage above their 50 dma are all moving against value towards growth.

 

 

So far, the long-term trend of a value turnaround remains intact. The analysis of value and growth ratios by market cap band shows that mid and small-cap value stocks are the most vulnerable to a value/growth reversal owing to the steepness of the recent performance of value stocks in those market cap band groupings.

 

 

The possibility of a counter-trend relative rally by growth stocks does not negate my long-term bullish outlook for value stocks. Nothing goes up or down in a straight line. The history of the value revival in the wake of the dot-com bubble shows that there were brief interruptions in the value rally. I expect that any growth reversal is just a brief interruption. While traders could position themselves for outperformance by NASDAQ and speculative names, investors could regard such an episode as an opportunity to lighten up on their growth positions and rotate into value.

 

 

 

USD and gold

A falling bond yield also has important implications for the USD and gold prices. The yield spread between Treasuries and other major currency debt instruments has been narrowing, especially against Bunds. Further downward pressure on the UST yields will put downward pressure on the USD Index, which is already testing a key support zone (bottom panel). This is greenback bearish. Since gold prices tend to be inversely correlated with the USD, it is by implication gold bullish.

 

 

From a technical analysis perspective, both gold and gold mining stocks have staged upside breakouts from multi-month flag formations, which are bullish continuation patterns. In addition, gold prices are also highly dependent on real rates. TIPS prices (red dotted line, top panel) have been rising steadily and they are forming a bullish divergence. As well, TIP vs. IEF (7-10 year Treasury ETF, grey line, bottom panel) have been rising in lockstep with inflation expectations. I interpret all of these conditions as bullish for gold prices.

 

 

In conclusion, the market is setting up for a bond market rally of unknown magnitude and duration with the following implications for other asset classes:
  • Bullish for growth stocks over value stocks;
  • Expect a pause in the cyclical and reflation trade, which is highly correlated to value; 
  • USD bearish; and
  • Gold bullish.
Tactically, I would watch for a definitive upside breakout in bond prices as the bullish trigger.

 

 

 

Disclosure: Long GDX

 

A test of the old highs?

Posted by Cam Hui -

Mid-week market update: I wrote on the weekend that one of my bullish tripwires were violations of relative support by defensive sectors (see Is the pullback over?). The bulls have largely achieved that task.
 

 

The S&P 500 appears to be on its way to a test of the old highs.

 

In addition, the VIX Index has decisively fallen below its 20 dma, which was another of my bullish tripwires. However, the S&P 500 is exhibiting a negative 14-day RSI divergence. Should the index rally to test its old highs, the signs of deteriorating momentum are likely to limit the market’s upside potential.

 

 

 

Due for a pause

The stock market is acting like it’s due for a pause in its bullish impulse. I have highlighted this chart before. Market breadth, as defined by the percentage of S&P 500 above their 200 dma, has risen above 90%. In the past, this has been a sign of strong price momentum that accompanies a strong bull move (grey shaded areas). However, the advance has paused when the 14-week RSI recycled from an overbought condition, which it did recently.

 

 

Market leadership has been lackluster, which is another argument for a period of either sideways action or minor pullback. The top five sectors comprise above 75% of S&P 500 weight and it would be difficult for the market to either rise or fall significantly without the participation of a majority. Of the five sectors, only Financials are in a relative uptrend, while the rest are either trading sideways or lagging the market. Strong bullish advances don’t look like this.

 

 

Similarly, the relative performance of the market by market cap grouping also shows a picture of uncertain leadership. Mid and small-caps are in relative downtrends, while mega-caps and the NASDAQ 100 had been in relative downtrends, but trying to recover.

 

 

In short, the leadership picture appears unexciting.

 

 

The MTUM shuffle

In the short-run, traders will have to consider market cross-currents as the $16 billion price momentum ETF (MTUM) re-balances its portfolio. Bloomberg reported that the ETF is expected to sell its growth stock holdings and buy value stocks.
 

BlackRock Inc.’s iShares MSCI USA Momentum Factor ETF (ticker MTUM) will see “an astounding” 68% of its portfolio holdings change in order to hold the market’s top performers over the past year, according to Wells Fargo estimates.

 

The rebalancing of the quant strategy, due on or around Thursday, will push the weighting of financial stocks to a third from less than 2% currently, the strategists reckon. The technology sector will slide to 17% from 40%.

 

It all underscores the intensity of the risk-on stock rotation, away from pandemic-induced economic misery to vaccine- and stimulus-fueled optimism. The rolling one-year performance of the value factor — which bets on cheap-looking shares and against expensive peers — is near its strongest since the global financial crisis.

 

“We expect MTUM to morph from an expensive, high-growth play to a higher-mo’ basket with benchmark-like growth/value characteristics,” Wells Fargo analysts led by Christopher Harvey wrote in a note. “The fund’s Quality drops somewhat.”

 

 

My inner investor remains bullishly positioned, though he has sold call options against selected long positions. My inner trader is bullish, and he is waiting for the S&P 500 to test resistance at its old highs before he starts to take some profits.

 

 

Disclosure: Long SPXL

 

 

Is the pullback over?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A slow-motion pullback

I have been writing about the possibility of a blow-off top ever since the S&P 500 rose above its rising trend line (see A blow-off top ahead?). In the past, blow-off top episodes were characterized by a spike upwards in one week, followed by a precipitous drop the next week. 

 

This time, the S&P 500 experienced a slow-motion pullback as it visited the site of the 50 dma during two consecutive weeks.

 

 

Is the pullback over?

 

 

The bull case

Here is the bull case. The S&P 500 ticked off all of my bottoming model criteria, except for a lack of fear as measured by the term structure of the VIX. Is that enough for a bottom?

 

 

The NASDAQ 100, which was one of the worst-hit parts of the market, exhibited a positive RSI divergence. It has since rebounded and trying to regain its 50 dma. As well, the high-octane ARK Innovation ETF bounced off a relative support level against the S&P 500 and it recovering.

 

 

The small-cap Russell 2000 has been mired in a trading range, but its relative performance against the S&P 500 bounced off a 50% retracement level. I interpret that as a constructive sign for this high-beta portion of the market.

 

 

The market is also on a NAAIM buy signal. The NAAIM Exposure Index measures the opinions of RIAs who manage individual clients’ portfolios. In the past, a decline of this index below its 26-week Bollinger Band has been a reliable buy signal that indicates low downside risk.

 

 

From a fundamental perspective, earnings estimates have been surging as an indication of fundamental momentum. Everything else being equal, rising estimates translates to lower forward P/E ratios and more attractive valuations.

 

 

 

The bear case

On the other hand, the bears also have a case for unfinished business to the downside. Despite the stock market rally, the relative performance of most defensive sectors remain above their relative support levels. This is an indication that the bears haven’t lost control of the tape.

 

 

Urban Carmel pointed out that the market is overdue for a pullback and fear spike. The Fear & Greed Index hasn’t fallen below 20 since the March 2020 low, which is an unusual condition.

 

 

As well, J.C. Parets recently contrasted the somber tone of the New Yorker cover from March 2020 at the time of the market bottom, to the optimistic tone of the latest cover. If the first cover represented a contrarian buy signal, does this mean the May 24, 2021 cover is a contrarian sell signal?

 

 

 

The verdict

What’s the verdict, bull or bear? Jurrien Timmer at Fidelity has compared the trajectory of the stock market recovery to the market surge in the wake of the 2009 bottom. If the market were to follow the same path, the S&P 500 is due for a 16% correction.

 

 

Bear in mind, however, that history doesn’t repeat itself. It just rhymes. There is no doubt that the market is due for a pause, but the inconclusive nature of the bull and bear debate leads me to believe that investors are due for a period of choppiness in the coming weeks and possibly months.

 

My base case scenario calls for a range-bound market. Tactically, the market was oversold and it was due for a relief rally. I am open to the possibility that the market could test the old highs and make marginal new highs. I would monitor these bullish tripwires as signals that the bulls have regained control of the tape:
 

  • A wholesale violation of relative support by the defensive sectors of the market.
  • The VIX Index decisively falls through its 20 dma, which would be a signal of bullish momentum.

 

 

On the other hand, if the VIX maintains support at its 20 dma, expect a sideways choppy market and a possible retest of the S&P 500 50 dma.

 

 

Disclosure: Long SPXL

 

In search of global opportunities

Posted by Cam Hui -

It is said that the only free lunch in investing is diversification. That’s especially true for US-based investors in light of the elevated valuations of US equities.
 

 

With that idea in mind, let’s take a quick tour around the world to see where the opportunities are, and where they’re not. Geographically, the world is divided into three major trade blocs consisting of North America, Europe, and Asia, which is represented by Japan in the developed markets and China within emerging markets. For measurement purposes, the performance of each country or region is benchmarked to the MSCI All-Country World Index (ACWI) and returns are all measured in USD.

 

The analysis of relative performance shows that there are few clearly defined market leaders. The US has been a mixed bag. The growth-heavy NASDAQ 100 had been going nowhere against ACWI since last summer. The S&P 500 weakened against ACWI in November, recovered, but it has consolidated sideways in the last two months. Of the other regions, Japan has been weak, and so has all of the emerging markets (EM). Europe has begun to perk up in the last month.

 

 

Let’s examine each of the regions in more detail. The analysis will mainly be from a technical analysis viewpoint for price signal indications of relative changes in growth patterns and outlooks.

 

 

US: The threat from taxes

Starting with the US, the latest BoA Global Fund Manager Survey shows that managers are overweight this important region, but weights have been falling. Readings are neutral but there is a valuation overhang that threatens this market.

 

 

There is another long-term reason to be cautious on US equities: tax increases. The political consensus is turning against laissez-faire economics, and the pendulum is swinging to the left. Former Reagan staffer Bruce Bartlett recently wrote about “trickle-up economics” as a replacement for the supply-side philosophy that took hold during the 1980s.

I believe that we are at the threshold of a fundamental change in our popular economic thought, that in the future we are going to think less about the producer and more about the consumer. Do what we may have to do to inject life into our ailing economic order, we cannot make it endure for long unless we can bring about a wiser, more equitable distribution of the national income.

As well, a NY Times article highlighted the threat of a schism in the Republican Party to business interests. As the GOP becomes divided between the traditional Republican wing, which is losing power, and the Trump wing, which is becoming ascendant, who in Washington will speak up for companies when issues like taxes and income redistribution are discussed? Influence is slowly being draining away from the providers of capital and toward the providers of labor.
Republicans in Washington and around the country have soured on big business, joining Democrats in expressing concern that corporations wield too much influence. The shift has left corporate America with fewer allies in a tumultuous period for American society and the global economy.

 

The erosion of support is evident in opinion polls, on cable news and in political campaigning. It is the continued outgrowth of a populist surge among liberal and conservative Americans alike, but it is particularly pronounced on the right and often linked to the grievances of white voters on racial issues.

 

Republican voters nationwide have grown angry over what they perceive as unwelcome intrusions by corporate leaders into hot-button political debates, including decisions by large social media companies like Facebook and Twitter to remove former President Donald J. Trump from their platforms.
For US investors, diversification away from their home countries is becoming more and more important.

 

 

Europe: The value play

Looking across the Atlantic, Europe can be divided into two major groups, the UK and the eurozone.

 

I had been bullish on the UK in the past, but recent events have made me take a more neutral view. Uncertainty is looming over the Irish question in the post-Brexit environment, which is leading to rising tension in Northern Ireland and the specter of a return of the Troubles. As well, the threat of another Scottish Referendum has the potential to tear the country apart. While both the large-cap FTSE 100 and midcap FTSE 250 are trading above their respective 50 and 200 dma, which indicates uptrends are in place, the FTSE 250 to FTSE 100 ratio has violated a rising relative uptrend and it has begun to consolidate sideways. Consequently, I am taking a more neutral view of UK equities.

 

 

The following chart summarizes the relative performance of European equities against ACWI. Europe and the eurozone have outperformed the UK and ACWI. However, the bottom panel shows that the relative performance of the eurozone, as measured by the Euro STOXX 50, is highly correlated to the value-growth cycle of the EAFE Index. In short, buying the eurozone amounts to an explicit decision to buy value stocks.

 

 

While I am bullish on value investing as a theme, investors should be aware of their implicit exposure if they were to buy eurozone equities.

 

 

China: A decelerating economy

Turning to Asia, I have already shown that Japan, which is the largest developed market in the region, is lagging. Avoid. 

 

The rest of Asia is mostly weighted in EM. EM equities are mostly in Asia, with China at 38% of EM, followed by Taiwan, South Korea, and India, which make up a total of 72.7% of the index.

 

 

With China driving the outlook for Asia, the immediate outlook is cloudy. There are numerous signs that Chinese economic growth is decelerating. There is a well-documented leading relationship between credit growth, as measured by total social financing (TSF), to GDP growth. TSF is dropping quickly, which should lead to a deceleration in GDP by H2 2021. 

 

 

The latest release of Caixin PMI shows that both manufacturing and services PMI are above 50, indicating expansion. However, there is a trend of PMI deceleration since last summer.

 

 

Indirect market-derived signals are equally troubling. The AUDCAD exchange rate is an important indicator of the relative economic strength between China and the US. Both Australia and Canada are major commodity exporters. Even though trade ties between Australia and China have diminished recently, Australian exports go to Asian countries that are more sensitive to the Chinese economy. By contrast, Canada’s trade is more tied to the US. The AUDCAD exchange rate has been weakening. It violated an important support level and it is now approaching secondary support.

 

 

Similarly, the copper/gold and base metal/gold ratios, which are important global cyclical indicators of commodity demand, are rolling over. In response to the recent surge in commodity prices, Beijing announced that it will strengthen its management of commodity supply and demand to curb “unreasonable” increases in prices. Oil, copper, iron ore, and virtually all commodities tanked in response to the announcement.

 

 

The real estate market represents an important destination for Chinese savings. Long-time readers will know that I monitor the price-performance of the shares of major Chinese property developers, which are highly levered, for signs of stress in China’s financial system. Bloomberg reported that Beijing is cracking down on excessive leverage through the shadow banking system by real estate companies:
A tightening of Chinese developers’ use of secretive funding is threatening to curb growth in the world’s second-largest economy.

 

For years, China’s property developers have drawn on shadowy pools of capital to fund their projects. Now, government scrutiny is reining in that system, after already curbing traditional avenues of funding. Debt-laden developers including China Evergrande Group will likely need to scale back growth and resort to other means such as equity financing and spinning off more assets for financing to avoid defaults.

 

“Polarization among Chinese developers will deepen this year, and more developers are likely to suffer from debt failures,” said John Sun, co-managing partner at Aplus Partners Management Co, which focuses on private equity and credit investments. Weaker developers “will need to sell assets to fight for survival, while some will likely default on their debt.”

 

That hunt for new funding is adding pressure on the nation’s cash-strapped developers, which already account for nearly 27% of the more than $20 billion of missed bond payments this year, according to data compiled by Bloomberg. The constraints will dampen investment in property and the pace of construction activity, Macquarie Group’s China analyst Larry Hu predicts.
The charts of selected major developers, such as China Evergrande (3333.HK), China Vanke (2202.HK), and Country Garden Holdings (2007.HK) have all weakened to test major support levels. The good news is these stocks are holding support, which does not indicate rising stress. The bad news is the simultaneous tests of technical support may indicate an implicit PBOC put, which represents a form of intervention that masks the market signal from share prices.

 

 

 

Other EM: The beat of their own drummers

While investors may view EM equities as a bloc, they all have their own unique characteristics and each can march to the beat of its own drummer. 

 

The relative performance of other major EM countries outside China is relatively unexciting. EM xChina (EMXC) has underperformed ACWI this year, and a divergence is opening between EM currencies and the relative performance of EMXC. The two largest countries in the index, South Korea and Taiwan, breached relative support levels and they are now rallying to test relative support now turned resistance. The third-largest, India, had to contend with a severe COVID-19 outbreak. The worst may be over, and Indian equities have rallied to test a relative resistance zone. 

 

 

Latin America is a highly concentrated region. Brazil makes up 58.6% of the index and Mexico is second at 23.7%. The relative performance of the region has shown a high correlation to EM currencies and can be regarded as a play on EM currency strength and USD weakness.

 

 

The fragile EM countries with high current account deficits may offer some speculative but idiosyncratic value. Brazil, South Africa, and Turkey are either bottoming against ACWI, or exhibiting relative uptrends.

 

 

 

The world through a value/growth lens

Before concluding our investor’s trip around the world, I would like to highlight some unique analysis from All Star Charts, which countries by their value and growth exposure based on sector weights. 

 

 

The growth countries are no surprises, consisting of Taiwan and South Korea, based on their high exposure to the semiconductor industry. As well, China is categorized as growth. So is the US, Israel, whose companies are mostly NASDAQ-listed technology stocks, and high-flying Vietnam. At the other end of the spectrum are a handful of small frontier markets. I would also highlight that two of the fragile EM countries, Brazil and Turkey, have high value style exposures, though investors should be cautioned about the specific risks of high current account economies.

 

 

Investment summary

In conclusion, the investor’s tour around the world revealed a number of opportunities and regions to avoid.
  • US: Under threat from high valuation and the prospect of greater re-distribution government policies.
  • Europe: Eurozone stocks are showing leadership qualities, but they are highly correlated to the value style.
  • China, Japan, and Asia: Avoid. The Chinese economy is slowing.
  • Emerging Markets: Selected opportunities available in Latin America as plays on USD weakness, and fragile EM economies as value plays.
The one caveat for investors is decisions on country and region weights in a global portfolio amount to taking exposure in either the value or growth investing style. From a tactical perspective, the jury is out on whether value or growth will be the next leadership. The analysis of the NASDAQ 100 to S&P 500 ratio as a proxy for the relative strength of growth stocks shows that growth has been on a tear since 2007 (dotted red line). However, growth has begun to roll over. The black line shows the relative performance normalized on a 12-month basis. The growth stock skid is reaching a relative support zone where the deterioration has been arrested in the past.

 

 

Longer-term, however, the outlook for value stocks is bullish. The global value discount to growth is near a historic low.

 

The trend of growth stock dominance is also turning. Remember the FANG+ stocks? Their concentration in the S&P 500 is beginning to reverse, which is a long-term bullish indication of value over growth stocks.

 

 

Here comes the retest

Posted by Cam Hui -

Mid-week market update: I wrote on the weekend (see Where’s the fear?) that the relief rally that began last Thursday was unconvincing and my base case scenario called for a retest of the lows. The retest appears to be underway. 
 

 

Spikes of the VIX Index above its upper Bollinger Band (BB) were signals of an oversold market. Such episodes were resolved in two ways. Strong market rallies were characterized by price momentum and definitive violations of the VIX 20 dma (blue arrows). On the other hand, if the VIX was unable to fall below its 20 dma, the S&P 500 advance stalled and weakened again (grey bars). The current situation appears to fall into the latter category.

 

Nevertheless, I believe that any pullback should be shallow and the S&P 500 is likely to successfully test its 50 dma. It is already exhibiting a positive RSI divergence, and other market internals are tilted in a bullish direction.

 

 

A shallow pullback

Consider, for example, small-cap stocks, as represented by the Russell 2000. The chart of the Russell 2000 has been stuck in a trading range. Moreover, it is showing ambiguous formations of both a possible bearish head and shoulders (black), which is bearish and inverse head and shoulders (red) formations. Similarly, the 10-year Treasury yield has also been stuck in a tight range.

 

 

The technical pattern of growth stocks, which have suffered the brunt of the selling, is also constructive. The NASDAQ 100 is also exhibiting a positive RSI divergence. The high-octane ARKK ETF recently bounced off a relative support level and it is beginning to outperform again.

 

 

If and when the market recovers, the odds favor a growth stock revival over the next 1-2 weeks.

 

 

More weakness ahead

Tactically, there may be a little more weakness ahead before this pullback is over. The Russell 1000 Value Index violated a rising trend line, which is a sign of technical damage that needs to be repaired by way of a period of sideways consolidation and basing. By contrast, the Russell 1000 Growth Index is now testing a key support level.

 

 

Sentiment is deteriorating, but panic hasn’t set in yet. The Fear & Greed Index is falling, but readings haven’t reached the sub-30 target zone yet.

 

 

The latest AAII sentiment survey shows the bull-bear spread narrowing, but the bulls still outnumber the bears.

 

 

The same could be said of Investors Intelligence. The number of bulls edged down, but bearish sentiment hasn’t spiked.

 

 

A similar level of complacency can be seen in the options market. The term structure of the VIX hasn’t inverted, which indicates fear. At a minimum, I would like to see the short-term 9-day VIX rise above the 1-month VIX.

 

 

I conclude from this analysis that the bottom is near, but not yet. The odds favor one more flush downwards in the next few days before a durable bottom is made. However, I am open to the possibility that today’s approach of the 50 dma represents a successful test of that support level. Watch for bearish follow-through in the next couple of days. If the market were to decisvely rally from here, then today was “the bottom”.

 

 

Where’s the fear?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A lack of panic

The stock market tumbled last Wednesday on inflation fears from an unexpected “hot” CPI report. It became oversold and rebounded. That bottom seemed a little too easy. The nagging question is, “Where’s the fear?”

 

 

While a number of technical indicators became oversold, sentiment models did not show any signs of panic or the sort of seller capitulation usually found at bottoms.

 

Exhibit A is the bottoming model that I have shown in the past (see The bears take control). While the technical analysis components are flashing oversold signals, the one component that is lacking is a lack of panic. The term structure of the VIX Index hasn’t inverted.

 

 

My Trifecta Bottom Spotting Model, which relies more on real-time sentiment indicators and also uses the VIX term structure, is nowhere near a buy signal. The intermediate-term overbought/oversold model is not oversold. The VIX term structure isn’t inverted, indicating rising fear. TRIN hasn’t spiked above 2, which is usually the sign of a “margin clerk” involuntary liquidation.

 

 

 

Positioning vs. opinion

While the tactical trading signals have been wavering, one intermediate-term sentiment model flashed a buy signal. The NAAIM Exposure Index, which measures the RIA sentiment, fell below its 26-week BB. In the past, this has been a strong buy signal which has indicated relatively limited downside risk. According to this sentiment model, the bottom is close, though it can’t spot the exact day. 

 

 

However, I am inclined to slightly discount the bullish conclusion from the NAAIM readings as it is an opinion survey, while the other sentiment models are price-based that reflect the actual deployment of funds. Here’s why. Estimates of equity positioning has come off the boil, though levels remain elevated. 

 

 

On the other hand, opinions have been jittery. Mark Hulbert observed that his survey of NASDAQ market timers have fallen dramatically, but levels are not yet at the oversold buy signal territory.
 

The sentiment picture that the recent data are painting shows the market timers to be trigger-happy. They are quick to jump on the bullish bandwagon when the market rallies, and then jump on the bearish bandwagon when the market declines. As a result, both rallies and declines tend to be short-lived.

 

A longer-lasting rally will require more extreme bearishness among the market timers, and for them to stubbornly hold onto their bearishness in the wake of the rally’s initial liftoff. Except for that to happen, the market to itself most likely would have to suffer a worse decline than we’ve experienced in recent days. In the meantime, enjoy this rally — while it lasts.

 

 

 

The “value” port in the storm

I had previously indicated that value stocks are likely to outperform and they should be regarded as a port in a storm should the stock market weaken. That analysis turned out to be correct as the Russell 1000 Value Index has beaten the Russell 1000 Growth Index. Even though large-cap growth stocks have decisively violated a key support level, value stocks broke down through a rising trend line. This is an indication of technical damage that can’t be shrugged off.

 

 

The small-cap picture is similarly discouraging. While small-cap value has strongly outperformed growth, the Russell 2000 Value Index has also violated a rising trend line indicating a parallel picture of technical damage.

 

 

The technical damage is also evident in the price action of defensive sectors. Despite the rallies of Thursday and Friday, defensive sectors are holding their relative breakouts against the S&P 500. This is another sign that the bulls haven’t fully seized control of the tape.

 

 

 

Wait for the retest

I interpret these conditions as a sign that the market is likely to retest last Wednesday’s lows in the coming weeks. The S&P 500 reached an oversold condition on Wednesday and staged a relief rally. At the same time, the VIX Index spiked above its upper Bollinger Band (BB), which also indicates an oversold market, and recycled. A template for coming weeks may be the experiences of last June and last September when the VIX recycled below its upper BB as the S&P 500 chopped around and dropped to retest its old low. Keep an eye on the VIX Index. If it has difficulty falling below its 20 dma on the way to the lower BB, the chances are good that the market is destined for another test of last week’s lows.

 

 

While I am keeping an open mind as to the possibilities of both bullish and bearish outcomes, my inclination is to be cautious. The reflex rallies late last week left both the S&P 500 and NASDAQ 100 overbought on a short-term basis. While anything is possible, it’s difficult to envisage further bullish follow-through early next week that can further weaken the VIX Index below its 20 dma.

 

 

Next week is option expiry (OpEx) week. While OpEx weeks have normally seen upward price pressure, the historical evidence is May OpEx is one of the weaker months on a seasonal basis.

 

 

Ed Clissold of Ned Davis Research updated his estimate of the S&P 500 seasonal pattern, which calls for a market low in late May. In light of my reservations about the lack of capitulation, that historical template sounds about right.

 

 

In conclusion, the stock market is recovering from an oversold position, but sufficient technical damage has been inflicted to cast doubt that it can stage a V-shaped recovery. Look for a retest of the previous lows in the coming weeks and watch for signs of capitulation and positive technical divergences as signals of a possible tradable bottom. Otherwise, watch for the VIX Index to decisively fall below its 20 dma, which would translate to a bullish outlook for equities.

 

 

Interpreting the gold breakout

Posted by Cam Hui -

Did anyone notice the upside breakouts in both gold and gold mining stocks? In the short-term, gold may have to contend with overhead resistance at the site of its 200-day moving average (dma). While I am no gold bug, the breakout could be a technical signal of an intermediate bullish phase for precious metals.
 

 

This week, I explore the bull and bear case for gold and the macro implications of this upside breakout.

 

 

Why I am bullish on gold

There are a number of reasons to be bullish on gold. Macro Charts reported that net fund flows into GLD, the gold ETF, had turned sufficiently negative that was consistent with past tactical bottoms.

 

 

As gold is normally thought of as an inflation hedge, a BoA survey of credit investors shows that inflation is their biggest concern, indicating a bullish setup.

 

 

The Citi Inflation Surprise Index is rising everywhere around the world, which should be bullish for gold,

 

 

In addition, the Federal Reserve is increasingly focused on full employment and financial stability at the price of price stability, or inflation, we have the backdrop for rising inflation, which is bullish for precious metals.

 

 

From a long-term technical perspective, gold prices are highly correlated to the TIPS price, or the inflation-index bonds. Gold has either broken out or is on the verge of a breakout of a multi-month bull flag. A bullish divergence between the gold price and TIPS is pointing to higher bullion prices. The gold mining stocks have already staged an upside breakout of a similar bull flag. These are the technical ingredients for an intermediate-term bull phase for the yellow metal.

 

 

 

The long-term big picture

As well, Greg Ip at the WSJ offered the following inflation bullish demographic insight: “An ample global supply of labor helped keep inflation down in recent decades. That’s reversing as China and U.S. record their slowest population growth since at least the 1950s. A diminished supply of workers could start to pressure inflation.” 

 

 

I had highlighted analysis from Jurrien Timmer of Fidelity Investments in the past. Timmer had compared the current macro environment to the ’60s. Then, you had the LBJ “guns and butter” policy that ultimately led to the inflation of the ’70s. Inflation began to pick up in 1967 and the market experienced its first inflation scare in 1968. Today, you have a leftward drift in fiscal priorities and an accommodative Fed that is setting the stage for rising inflation.

 

 

Gold prices were set at $35 during the ’60s as part of an exchange rate policy, but silver prices were freely trading. Silver prices rose from $1.30 in April 1967 to $2.50 in June 1968 – a 92% gain. In the past, the terminal inflationary blow-off phase is the most profitable one for precious metals. If Timmer’s scenario is correct, precious metals are only basing for a bull run, and the parabolic phase and top will occur in 2023. (Please take note that this is not a forecast, only a scenario that outlines the upside potential of precious metal prices.)

 

 

 

Key risks

There are two key risks to the bullish outlook for gold prices. While gold is traditionally thought of as an inflation hedge, it’s really a hedge against unexpected inflation. In fact, gold prices are inversely correlated with real yields.

 

So far, the Fed is getting its way with the market and the economy. Wage growth is rising, but the effect is mostly among lower-income workers, which narrows inequality.

 

 

The breakeven yield curve is steeply inverted, indicating that the market expects any inflationary pressures will be transitory.

 

 

Moreover, real yields are falling. The upside breakout in gold prices is tied to a Goldilocks Federal Reserve of not too hot, not too cold policy of monetary accommodation.

 

 

What if Fed policy were to change? The consensus belief is the Fed will start to discuss the mechanism for tapering its quantitative easing purchases of debt in August at its Jackson Hole meeting. Hints of tapering could upset the bond market, and by extension the gold market. But there may be a much more important Fed policy change this summer. Powell’s term as Fed Chair ends in February 2022. Politico reports that Biden will have to decide if he will reappoint Powell, or replace him.

Some progressive groups are mobilizing against Powell’s reappointment, calling on Biden to pick a more liberal candidate for the country’s most important economic policy job. The groups acknowledge that he has steered the Fed toward promoting “broad-based and inclusive” job gains, a historic shift for the central bank. But they have a litany of complaints: He hasn’t done enough to prepare banks to deal with the financial risks posed by climate change, he has eased regulations on the largest lenders, and he has fallen short on closing the racial wealth gap.

The risk to the markets and gold prices is the nomination of a candidate who is perceived to be too dovish. Such a decision would cause both real and nominal bond yields to spike and cause havoc in both the equity and precious metal markets.
 

If the economy continues to pick up speed and markets keep rising — with inflation in check — dumping a popular Fed chair, even one nominated by a GOP president, will be especially tough to do.

 

Powell is a reassuring presence on Wall Street for his continued easy money policies and refusal to even suggest the Fed might start to pull back on efforts to flood the system with cash in the wake of the Covid-19 pandemic.

 

Even stories suggesting Powell could be on his way out could upset markets. A recent survey of investors by CNBC found that 76 percent believe Biden will re-nominate the Fed chair.
The other risk to gold prices is shorter-term in nature. What if the surge in inflation is indeed transitory? How would gold and other commodity prices react a cooling off in CPI in Q3?

 

Remember the hot April CPI print? Matthew C. Klein made the case in Barron’s that the surge in CPI inflation is attributable to reopening effects, which are “transitory”. The upside surprise in April’s CPI can be attributable to two main factors, used cars and reopening categories such as hotels, food away from home, car rental, admissions, car insurance, and airline fares. 

 

 

Even rising used car prices can be explained by a temporary pandemic-induced supply bottleneck effect. Car rental companies sold their inventory last year, and now they are scrambling to replace their fleet, which is driving up used car prices.
 

 

The transitory nature of the price shock can be demonstrated in a number of other ways. Global backlogs and supply chain bottlenecks are pushing up prices.

 

 

Headline commodity prices can also be deceiving. The reported headline price is the spot price. A glance at the futures curve shows that many of the commodities which have surged are in backwardation. I have constructed a composite curve composed of an average of copper, lumber, WTI crude oil, and soybeans with the cash price normalized starting at 100. All of these commodities are said to be in short supply. A curve in backwardation is one where the cash and near-term prices are higher than the prices further in the future indicating a physical shortage. A more normal futures curve, such as the one shown by gold, is in contango. A contango curve is one where prices increase steadily into the future, and each increase reflects carrying costs, or interest rates, and the price of storage.

 

 

It is an open question of how the markets will react when many of these bottlenecks start to resolve themselves. Maybe the gold market will look through these shortage expectations, or maybe that’s how it stalls at its overhead 200 dma resistance.

 

 

Investment implications

In conclusion, the upside breakout in gold and silver is constructive for the precious metals complex. While there is some debate over whether gold prices have broken out of the flag formation, which is a bullish continuation pattern, on the daily price chart, the upside breakout is more evident on the point and figure chart. Moreover, the measured upside objective based on point and figure charting is between 2000 and 2100, depending on how the box size and reversal parameters are set. Moreover, I have laid out the scenario offered by Jurrien Timmer at Fidelity of how gold prices could go parabolic by 2023.

 

 

Similarly, the point and figure chart pattern is bullish for GDX, and its measured upside objective is about 40.

 

 

Before the gold bulls get all excited, investors need to recognize that the gold and the gold-stock market represent a miniscule portion of the aggregate capital markets. For some context, the total market cap of all the stocks underlying the Gold Miners Index, which is the underlying index of GDX, is roughly equivalent to the market cap of any one of Bank of America, Home Depot, or Nvidia.

 

However, the price action of the precious metals has important macro implications for other asset classes, namely that inflation is on the horizon. This is confirmed by the comments of companies on earnings calls. FactSet reported the highest number of citations of “inflation” on earnings calls in 10 years.

 

 

The bond market has already reacted. The 5×5 forward yield has been rising steadily.

 

 

The challenge for equity investors is to pick stocks and sectors that will benefit in an environment where both rates and growth expectations are rising. Forward 12-month EPS have been moving up strongly, which is constructive for equity valuation.

 

 

In this environment, investors should focus on stocks that can continue to grow earnings in the current environment. This means companies that benefit from a steepening yield curve, such as banks; companies which can pass on their rising input costs; and cyclical sectors and industries that can benefit from strong sales growth.

 

 

 

Disclosure: Long GDX

 

The bears take control

Posted by Cam Hui -

Mid-week market update: I have been saying for several weeks that the stock market is vulnerable to a setback but it is a bifurcated market. Value stocks have held up well, but growth stocks were getting smoked. The bears finally broke through this week and they are showing signs that they are seizing control of the tape. Defensive sectors are exhibiting signs of relative breakouts against the S&P 500.
 

 

 

Time for a pause

Several factors have combined to spark this setback in stock prices. First, retail investors are losing interest in stocks. 

 

 

Remember the retail frenzy as the Reddit crowd whipped up enthusiasm for meme stocks last year? Remember how flash mobs drove up selected issues with call option buying which forced market makers to hedge by buying the underlying stocks? That’s mostly gone. In the short run, there was a lot of hand-wringing about the call buying as a sign of excessive speculation. My longer-term view is a rising equity call/put ratio is a sign of bullish momentum and rising call/put ratios were coincidental with equity bull phases. In the past, a decline of the 50-day moving average (dma) of the call/put ratio below the 200 dma has signaled pauses in bullish advances in the past (top panel).

 

 

Bad news from overseas on the pandemic front may have also contributed to the risk-off tone. Bloomberg reported that “a wave of new restrictions is spreading across Asian countries trying to stamp out small Covid-19 outbreaks”.
 

Taiwan announced limits on crowds, following Singapore’s move to restrict foreign workers, in a wave of new restrictions in Asian countries trying to stamp out small outbreaks after months of keeping Covid-19 contained.

 

The new curbs prompted fears that economic growth could stall out, leading to stock sell-offs in both countries this week. Low vaccination rates in both countries are contributing to concerns that their populations could be vulnerable if faster-spreading variants take hold.

 

Singapore — the city-state that is ranked the best place to be in the coronavirus era by Bloomberg’s Covid Resilience Ranking — has also been tightening up restrictions amid a sudden recurrence of local infections, limiting social gatherings and upping border curbs. The co-chair of Singapore’s virus task force, Lawrence Wong, said Tuesday that companies looking to bring in foreign workers from higher-risk nations could face delays of more than six months because of the greater vigilance. The country has also begun mass testing all hospital staff in an attempt to fence off infections, after a cluster of cases emerged at a medical center.

 

Elsewhere in Asia, cases are also coming back, with India now the epicenter of the global crisis, recording more than 329,000 new cases Tuesday. Malaysia is tightening curbs on people’s movements across the country after daily cases exceeded 3,000 this month for the first time since February.

 

The detection of the one case with Indian Covid-19 variant has added to the risk, and Malaysia is struggling with the pace of vaccinations. Less than 3% of the population had completed their vaccination series as of May 9, data compiled by Bloomberg show. That tally trails Indonesia and Singapore, and puts Malaysia at risk of falling short of its vaccination target for the year.
One reader alerted me that Jason Goepfert at SentimenTrader had highlighted an unusual number of buying climaxes on Monday, which is a bearish signal.
 

The burst of gains and push to new highs early on Monday was reversed during the session, causing a spike in the number of stocks suffering a buying climax. This is triggered when a stock hits a 52-week high then reverses to close below the prior day’s close, potentially a sign of exhaustion among buyers.

 

Our Backtest Engine shows that this is the 6th-largest number of climaxes in a single day since the inception of SPY.

 

Every time more than 95 stocks suffered a buying climax, the S&P 500 showed a loss over the next 1-2 months. There were few losses over the next 6-12 months, and they were relatively small.

 

 

Equally disturbing is the performance of the bellwether growth-cyclical Semiconductor Index (SOX). SOX violated both absolute and relative rising trend lines that stretched back a year. 

 

 

Putting it all together, these are all signs that the bears are taking control of the tape.

 

 

Where’s the bottom?

The S&P 500 pullback is unlikely to be very deep. If I had to guess, a logical support level is the 50 dma at about 4050, which represents a peak-to-trough downside risk of only -4.4% and only -1% from current levels. Some of my bottoming indicators are already starting to come into place.
  • The 5-day RSI is flashing an oversold reading, which is the first sign of a bottoming process.
  • The VIX Index has spiked above its upper Bollinger Band, which is also a short-term oversold indicator for the stock market.

 

 

However, the term structure of the VIX is not inverted, indicating fear. We need panic to set in for a durable bottom. As well, the NYSE McClellan Oscillator (NYMO) has not flashed an oversold condition yet.

 

While the S&P 500 is holding up relatively well and being supported by the relative strength of value stocks, growth stocks show considerably more downside risk. Despite violating its 50 dma and violating an important relative support zone, the NASDAQ 100 (NDX) is not showing any signs of a durable bottom ahead. The % of NDX stocks above their 50 dma is not oversold, and neither is the NASDAQ McClellan Oscillator (NAMO). The most logical support level for NDX is the 200 dma at about 12,500.

 

 

The market was already oversold as of yesterday’s (Tuesday’s) close. Today’s skid will undoubtedly stretch short-term readings further. In all likelihood, the market will bounce tomorrow (Thursday), but how it holds the strength will be a test for both bulls and bears in the coming days.

 

 

My inner investor remains bullishly positioned. He is not overly concerned about minor pullbacks such as the peak-to-trough downside potential of -4.4% on the S&P 500. However, he has sold covered call options on selected positions. My inner trader is stepping aside. The primary trend is still up, and the risk/reward of trying to profit from a counter-trend correction in a bull market is unfavorable.

 

 

NFIB conservatives grudgingly turn bullish

Posted by Cam Hui -

Investors received some data points today that is highly revealing about the economy. The most important was the NFIB small business survey. Small business sentiment is especially important as they have little bargaining power and they are therefore sensitive barometers of the economy. The other is the March JOLTS report of labor market conditions, which is a little dated but nevertheless revealing.
 

Small business owners tend to be small c-conservatives, and their political leanings tilt Republican. We can see that optimism fell in the wake of the election when Biden and the Democrats took control. What is remarkable is the uptick in optimism despite the leftward drift in government policy.

 

 

This is a strong indication of economic strength.

 

 

More NFIB details

It’s no wonder why optimism rose. Sales have strongly recovered.

 

 

The NFIB survey also tells the familiar story of supply chain bottlenecks. Inventories are too low. 

 

 

The supply chain squeeze is confirmed by the difference in ISM backlog and inventories. Backlogs are rising, while inventories are low.  There is, however, a silver lining in that dark cloud. Expect a couple of quarters of inventory accumulation when the supply chain problems are resolved. That translates into a global manufacturing boom.

 

 

What about prices and the labor shortage? There are widespread anecdotal reports of businesses experiencing difficulty in hiring. It appears that price pressures are stronger than compensation pressures. I interpret this to mean that small business are able to pass on their cost increases. 

 

 

The good news is sales are rising and margins don’t appear to be under pressure. The open question is how transitory these inflationary pressures are.

 

 

JOLTS: A strong labor market

The March JOLTS report confirms the March NFP survey of a strong labor market. The headline job openings were strong. More importantly, quits are rising, which is consistent with the April NFP report of rising job leavers.

 

 

The strength in quits can be explained by the combination of a strong labor market and a backlog of “pent-up resignations”, as reported by Bloomberg:

 

Ready to say adios to your job? You’re not alone. “The great resignation is coming,” says Anthony Klotz, an associate professor of management at Texas A&M University who’s studied the exits of hundreds of workers. “When there’s uncertainty, people tend to stay put, so there are pent-up resignations that didn’t happen over the past year.” The numbers are multiplied, he says, by the many pandemic-related epiphanies—about family time, remote work, commuting, passion projects, life and death, and what it all means—that can make people turn their back on the 9-to-5 office grind. We asked Klotz what to expect as the great resignation picks up speed.

 

 

A “Not Enough” recovery

Putting it all together, this is a “not enough” recovery, as characterized by Myles Udland at Yahoo Finance:
 

The post-crisis economy was about too much — too much debt, too much housing, too much interdependence, too much, too much, too much. 

 

The post-pandemic economy is taking shape as one in which there is not enough — not enough housing, not enough workers, not enough cars, chlorine, or crypto. 

 

And this inversion of what is driving this cycle can help explain what we’re seeing from the labor market to the housing market to the stock market and beyond. And perhaps helps make sense of why everyone — professional investors, the general public, politicians, and so on — seems perplexed by today’s state of affairs.  
Fed governor Lael Brainard spoke today, and she is not overly worried about transitory inflation pressures from supply chain bottlenecks:

 

To the extent that supply chain congestion and other reopening frictions are transitory, they are unlikely to generate persistently higher inflation on their own. A persistent material increase in inflation would require not just that wages or prices increase for a period after reopening, but also a broad expectation that they will continue to increase at a persistently higher pace. A limited period of pandemic-related price increases is unlikely to durably change inflation dynamics.

The Fed is sticking with its story that it will “monitor incoming data”, but policy is going to stay accommodative for the time being.
 

I will remain attentive to the risk that what seem like transitory inflationary pressures could prove persistent as I closely monitor the incoming data. Should this risk manifest, we have the tools and the experience to gently guide inflation back to our target. No one should doubt our commitment to do so.
 

But recent experience suggests we should not lightly dismiss the risk on the other side. Achieving our inflation goal requires firmly anchoring inflation expectations at 2 percent. Following the reopening, there will need to be strong underlying momentum to reach the outcomes in our forward guidance. Remaining patient through the transitory surge associated with reopening will help ensure that the underlying economic momentum that will be needed to reach our goals as some current tailwinds shift to headwinds is not curtailed by a premature tightening of financial conditions.

In conclusion, we have a booming economy and signs that the strong recovery will persist for the next few quarters. The Fed is accommodative. Inflation and labor cost pressures should be transitory. With the exception of the semiconductors, which look a little wobbly, investors should stay long the cyclical trade.

 

 

 

Q1 Earnings Monitor: The jobs puzzle

Posted by Cam Hui -

This will be the final Q1 Earnings Monitor as 88% of the S&P 500 has reported and the results are mostly known. It was a solid earnings season and beat rates are well above average. Callum Thomas of Topdown Charts observed that analysts have scrambled to revise their estimates upwards in response to earnings reports and corporate guidance.

 

 

Before the bulls gets too excited, there was one puzzle in a sea of strong earnings reports. If the economy as shown by earnings is so strong, why did the April Employment Report miss expectations so badly? What are the implications for Q2 and Q3 earnings outlook?

 

 

A strong “A”

If I had to grade this earnings season, I would give it a strong “A”. With 88% of S&P 500 having reported, investors have most of the picture. Both the EPS and sales beat rates were well above their historical averages. Street analysts revised forward 12-month EPS up by 1.26% last week, and an 2.68% the previous week. These revisions are extraordinary surges as normal weekly revisions tend to be in the 0.1% to 0.3% range.

 

 

Skyrocketing EPS revisions have meant that the S&P 500 has de-rated. The forward P/E ratio has fallen because prices haven’t caught up to rising EPS estimates, which makes the market more attractively priced.

 

 

The Transcript, which monitors earnings calls, gave an equally upbeat summary of the economy:

 

The economy is booming and everyone should enjoy it. The American economy is benefitting from tremendous amounts of pent-up demand and in some of the hardest-hit industries’ activity is beginning to tick back up above 2019 levels. Along with that boom, there are clear signs of inflation and concerns about overheating. Even Janet Yellen seemed concerned for a few hours last week.

The economy is on fire and demand for services are rising.
 

The boom is good
“The boom is good. Employment is good. Growth is good. Everyone should enjoy it” – JPMorgan Chase (JPM) CEO Jamie Dimon

 

Americans are ready to party like it’s 1929
“Having said that the summer is going to be a free for all, you’ve seen the stats, 73% of Americans are planning a trip and the highest in history was 37. So it’s going to — America is going to party the summer like 19 — like it’s 1929.” – Starwood Property Trust (STWD) CEO Barry Sternlicht

 

People want to see family and friends
“As vaccination rates arise, infections fall and restrictions lift, people quickly breathe sigh of relief and start moving again. There’s pent-up demand to see family and friends. Offices, restaurants and bars are reopening, and even airports are seeing improved traffic” – Uber (UBER) CEO Dara Khosrowshahi

 

“I hope everybody stays healthy and positive during these times and look forward to a summer where hopefully, people can open up a little bit more and start together with loved ones and friends.” – Barings BDC (BBDC) CEO Eric J. Lloyd

 

There’s huge pent up demand for travel and entertainment
“There’s enormous pent-up consumer demand and with the combination of government stimulus and vaccines, that will add yet more fuel to this fire in the economy, this growth in the economy.” – Loews (L) CEO Jim Tisch
“…the booking window is very, very compressed. But again, speaking to the pent-up demand, it’s filling up quickly.” – Norwegian Cruise Line (NCLH) CEO Frank Del Rio

 

“I guess if you’re going to model that out, you’d probably — you’d be thrilled that your first data point is the biggest demand in history….Alongside these trends, we are seeing the effects of significant pent-up demand as fans are buying tickets and events are selling out faster than ever. In the US, Bonnaroo, Electric Daisy and Rolling Loud festivals all sold out in record times at full capacity.” – Live Nation (LYV) CEO Michael Rapino

 

 

The jobs puzzle

The puzzle in an otherwise strong earnings season was the disappointing April Employment Report. If earnings calls are reporting a surge in demand for services, why did the NFP report miss expectations so badly?

 

The expectation was the gain of 1 million jobs. Fed chair Jerome Powell had stated in the past that he would consider either tapering or raising rates if and when the economy saw a string of strong jobs reports like the one in March, which initially came in at 916K but was revised down to 770K when the April report was released. The market interpreted his reports as a string of monthly 1 million job gains, though it wasn’t clear what “a string” meant.

 

Going into last Friday, Street consensus called for Non-Farm Payroll gains of about 1 million jobs, and whisper numbers went as high as 2 million. I had an inkling that expectations would be dashed when ADP Employment missed with a 742K print against expectations of 800K jobs. At a minimum, the 2 million whisper number for NFP was too high. The shocker was the actual 266K job gain against the expected 1 million gain in the NFP report.

 

In the wake of the big miss, analysts scrambled to dissect the internals to see if there was a data blip because of seasonal adjustments. Let’s begin with the bad news. Female employment fell, and so did the female participation rate. This may be an indicator that women cannot return to the labor force because of child care responsibilities.

 

 

As expected, jobs returned in low-paying service jobs like the leisure and hospitality industry, but there were significant declines in manufacturing, transportation and warehousing, and professional and business services. Were those data anomalies, or were the declines related to supply chain bottlenecks?

 

 

Other data anomalies cried for explanations. With lumber prices skyrocketing owing to constraints in mill capacity, why did wood products employment fall? Equally puzzling was the job loss by couriers and messengers.

 

 

If the NFP print was so ugly and below expectations, why were employees leaving their jobs at a higher rate? These data anomalies smell like a data blip or a problem with the seasonal adjustment with the headline NFP release. In all likelihood, these figures will be revised upwards in the coming months.

 

 

There was also the back-and-forth political discussion about the difficulty of finding help. Employers complained about lazy people staying home because of high unemployment benefits, which led to the retort of when demand is greater than supply, prices rise. However, RSM US economist Joseph Brusuelas observed that Treasury Secretary Janet Yellen pointed out that the thesis of UI inhibiting job growth was inconsistent with the data.

 

 

Heather Long at the Washington Post suggested that some of the labor market weakness may be explained by people seeking to upgrade their jobs.
 

There is also growing evidence — both anecdotal and in surveys — that a lot of people want to do something different with their lives than they did before the pandemic. The coronavirus outbreak has had a dramatic psychological effect on workers, and people are reassessing what they want to do and how they want to work, whether in an office, at home or some hybrid combination.

 

A Pew Research Center survey this year found that 66 percent of the unemployed had “seriously considered” changing their field of work, a far greater percentage than during the Great Recession. People who used to work in restaurants or travel are finding higher-paying jobs in warehouses or real estate, for example. Or they want a job that is more stable and less likely to be exposed to the coronavirus — or any other deadly virus down the road. Consider that grocery stores shed over 49,000 workers in April and nursing care facilities lost nearly 20,000.

 

 

Arguably, the wage pressure could be partly attributable to people who lost their jobs during the GFC but were unable to replace them with similar wage levels. They are now taking advantage of the tighter job market to return to their past levels that were previously lost.

 

 

Investment implications

Reading between the lines, I interpret these results to mean a stronger labor market than shown in the headlines. However, wage pressures are rising, and it is an open question whether they will persist, or they are part of a supply chain bottleneck that will be resolved in the coming months. Bottlenecks are not wage-price spirals.

 

The unemployment rate is still elevated at 6.1%. Historically, this has led to strong stock market gains.

 

 

As well, US employment is still well below pre-pandemic levels. There is still considerable slack and a longer runway to recovery.

 

 

This leads me to a nuanced bullish interpretation of equity prices. Forward 12-month EPS estimates have outpaced stock prices in recent weeks, which is constructive. A more detailed analysis by sector shows that the best earnings surprises have mostly been in value sectors, while the worst have been in defensive sectors.

 

 

As the energy sector has no earnings, my analysis has focused on expected Q2 revenue growth. The top four sectors by expected revenue growth have value and cyclical characteristics.

 

 

In conclusion, the Q1 earnings season has been very strong. I wrote last week that the market was priced for perfection (see Q1 Earnings Monitor: Priced for perfection), but this is still a bifurcated market. It’s growth stocks that are most vulnerable to disappointment. By contrast, most of the growth and positive surprises have been in the sectors with value and cyclical characteristics. As EPS estimates rise, they will be compress forward P/E multiples which should be supportive of higher stock prices.  Investors should therefore overweight value over growth as estimate upgrades are coming from predominantly value and cyclical stocks. 

 

 

 

A stealthy growth correction

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

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 are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 
 

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

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

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

 

Growth stocks stumble

Marketwatch reported last week that a meltdown of Cathie Wood’s ARK Innovation ETF (ARKK) may spark a S&P 500 pullback.

 

“Many of the ARK and similar funds that hold high growth stocks are now trading between one and two standard deviations below their 50[-day moving averages] where buyers usually enter,” said technical analyst Andrew Adams in a Wednesday note for Saut Strategy. “I don’t think the market needs to go down any more, so a bounce attempt should occur given all the nearby support levels.”
Since the publication of that article, ARKK and other growth stocks have weakened further relative to the S&P 500.
 

“If the high-growth areas start breaking support and taking the rest of the market down with them, then maybe the 3,980-4,000 zone in the S&P 500 will be retested after all,” Adams wrote. The S&P 500 finished at 4,167.59 on Wednesday, 1% off a record close of 4,211.47 set on April 29.

 

A test of support in the 3,980-4,000 area would mark a pullback of only 5% to 6%, but given the damage seen in other parts of the market could lead to “some huge losses” elsewhere, he said. “I’d rather avoid that, so for now I think we can use yesterday’s lows as a test to see if that represented a selling climax in much of the market.”

The growth-heavy NASDAQ 100 bounced off a test of its 50-day moving average (dma) after being rejected twice at resistance. More worrisome is the breach of the relative support zone of NDX compared to the S&P 500 and ARKK to the S&P 500. Market internals such as the percentage of NASDAQ 100 stocks above their 50 dma is not oversold enough to signal a durable bottom.
 

 

 

Resilient Value

On the other hand, value stocks have been resilient and holding up the market. The value to growth ratio is soaring, though a little overbought. The Russell 1000 Value index remains in a well-defined uptrend while the Russell 1000 Growth index is struggling with a key support line. 
 

 

A review of the relative strength of the top five sectors tells the story of a bifurcated market. In aggregate, these sectors account for roughly three-quarters of S&P 500 weight and it would be difficult for the index to rise or fall without the participation of a majority of these sectors. Growth sectors, such as technology, communication services, and float-weighted consumer discretionary stocks, which are dominated by heavyweights AMZN and TSLA, are underperforming the S&P 500. By contrast, value sectors such as financials and equal-weighted consumer discretionary stocks are strong.
 

 

 

The bears haven’t seized control yet

However, there are no signs of significant technical breakdowns just yet. The relative strength of defensive sectors is strong indicating that the bears haven’t seized control of the tape.
 

 

To be sure, there are some warning signs. Mark Hulbert pointed out that the Shiller Crash Confidence Index, which measures whether investors are worried about a stock market crash, has declined precipitously. Hulbert concluded that ” the outlook for the next six- and 12-month periods would appear to be quite modest”,
 

 

The bond market has caught a bid and it is attempting an upside breakout from a possible inverse head and shoulders formation.
 

 

Both gold and silver have staged upside breakouts. Precious metals tend to be viewed as defensive and negative beta plays.
 

 

Bloomberg also reported that “Sam Zell Buys Gold With Inflation ‘Reminiscent of the ‘70s’”.
 

Billionaire investor Sam Zell is seeing inflation everywhere, and has bought gold as a hedge — something he says he used to knock others for doing.
 

“Obviously one of the natural reactions is to buy gold,” he said in a Bloomberg Television interview. “It feels very funny because I’ve spent my career talking about why would you want to own gold? It has no income, it costs to store. And yet, when you see the debasement of the currency, you say, what am I going to hold on to?”
 

Zell, 79, said he’s concerned not only about the U.S. dollar but other countries printing money as well, and questioned whether inflation will be transitory, as Federal Reserve Chairman Jerome Powell indicated last week.

I conclude from this analysis that while there are downside risks to the S&P 500, the weakness is only confined to growth stocks. Value stocks are still strong and they are holding up the index. My base case scenario calls for a period of choppy sideways consolidation for the S&P 500. Until a bearish catalyst appears for value stocks, which have cyclical characteristics, the overall market should hold up well.

 

In the short-run, the S&P 500 is overbought and due for a pullback early in the week. I am watching to see how the market behaves after the overbought condition is resolved later in the week.

 

 

I will be especially monitoring the price action of the growth-cyclical bellwether Semiconductor Index (SOX). SOX rallied last week after testing a rising uptrend to regain the 50 dma. However, the 50 dma has stopped rising and it is on the verge of falling, indicating the possible start of a downtrend for the group. Moreover, SOX breached an important long-term relative uptrend against the S&P 500.

 

 

 

Do valuations matter anymore?

Posted by Cam Hui -

How expensive are US equities? Fed Governor Lael Brainard warned about “stretched valuations” in the preamble to the May 2021 Financial Stability Report:
 

Vulnerabilities associated with elevated risk appetite are rising. Valuations across a range of asset classes have continued to rise from levels that were already elevated late last year…The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.

By most measures, the market is highly extended. As an example, the S&P 500 trailing P/E looks unreal. But stock markets always look expensive when the economy recovers from a recession because the E in the P/E ratio is compressed.
 

 

Do valuations matter anymore? Yes and no. Let me explain my reasoning.

 

 

An expensive market

There are many ways to value stocks. To make a long story short, the market looks expensive on a price to anything multiple.

 

While the market appears wildly overprice based on trailing P/E, it’s only moderately expensive relative to its history based on forward P/E.

 

 

Tobin Q, which is the market’s price to replacement value ratio, is at an all-time high.
 

 

Shiller CAPE tells a similar story of overvaluation.

 

 

 

Unpacking the equity risk premium

That said, Bob Shiller qualified the excessive valuation readings of CAPE in a Project Syndicate essay by introducing the concept of Excess CAPE yield. He went on to conclude that stocks fairly valued based on this technique.

 

Many have been puzzled that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic and the economic downturn it has wrought. But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.

The Excess CAPE yield compares the market’s CAPE to interest rates by calculating an equity risk premium (ERP) for stock prices.
 

Another way of calculating ERP is the Fed model, which is the market’s forward E/P minus the 10-year Treasury yield. Morgan Stanley found that the ERP calculated this way appears extended (top panel). If the analyst were to substitute the 10-year breakeven yield (because investors are more interested in real returns than nominal returns), valuations are comparable to the dot-com bubble top.
 

 

Does that mean the market is wildly stretched, even on ERP? Not necessarily. Aswath Damodaran, professor of finance at the Stern School, calculates his own ERP using a detailed technique explained in a long paper. Damodaran’s history went back to 1960 compared to Morgan Stanley’s 1998. Damodarn’s latest update on May 1, 2021 showed an ERP of 4.11%. This puts both the Fed Model (Morgan Stanley’s top panel chart) and Damodaran ERP at roughly 2009 levels.
 

 

Wait! Didn’t the stock market make a generational low in March 2009 and take off like a rocket? As well, the longer time horizon of Damodaran’s ERP analysis shows the market to be fairly valued relative to its own history, and cheap compared to the 60’s and 80/s and early 90’s before the onset of the dot-com bubble.

 

 

Household equity holdings

Another way of timing the market is to analyze the household holdings of equities. The analyst writing under the pseudonym Jesse Livermore introduced the of idea the “Average Investor Equity Allocation” model, which forecasts forward 10-year returns based on household allocation to equities.  When no one owns stocks, expect strong returns. When everyone owns stocks, expect weak returns. Stock allocations are currently high, which leads to a conclusion of weak 10-year returns.

 

 

Before you get all excited that this is a sign of irrational exuberance and wild speculation, this doesn’t mean that households have been piling into equities. If an investor owns a passive balanced-fund portfolio that was periodically rebalanced, the S&P 500 outperformed bonds by 61.9% from March 2020 to April 2021. Much of the increased equity allocation can be explained by the upward drift of equity prices relative to bonds.

 

 

 

No correct valuation

Confused yet? Franklin Parker, writing at the CFA Institute’s Enterprising Investor, offers the perspective that there is no correct price for a security. Assuming that all investors have the same expectations for the valuation and volatility of a security, what they are willing to pay depends on each investor’s objectives. Parker cited the case of Bernoulli’s Prisoner’s Dilemma.

 

“A rich prisoner who possesses two thousand ducats but needs two thousand ducats more to repurchase his freedom, will place a higher value on a gain of two thousand ducats than does another man with less money than he.”

Parker concluded, “What becomes immediately clear is that his ducats are dedicated to one objective: getting the heck out of prison!” Now imagine three prisoners:

 

A, B, and C, each of whom has different starting wealth, required ending wealth, and time horizon. For the sake of simplicity, we’ll suppose each has the exact same view of a security’s future volatility and return, which are labeled as s and m in the figure.

 

Each prisoner has different needs and therefore has different prices they are willing to pay, even if all of them have the same valuation and volatility assumptions for the same security.

 

When we place these three prisoners in the marketplace, we would expect Prisoner A and Prisoner B to sell their shares to Prisoner C at the price of 1/c until Prisoner C exhausts his liquidity or Prisoner A and Prisoner B exhaust their inventory. Then, the price drops to 1/b, and Prisoner A continues to sell to Prisoner B. From there, the price drops to 1/a, and Prisoner A would buy, but no one would be willing to sell.

 

Prisoner C is an enigma. Traditional utility models would not expect anyone to accept lower returns in response to higher volatility. But goals-based investors can be variance-seeking when their initial wealth is low enough. Behavioral finance characterizes their goals as “aspirational.” This is why people buy lottery tickets and gamble: Increasing the volatility of outcomes is the only way of increasing their chance of achieving life-changing wealth.

 

What does that mean for today’s markets?
 

A very present example is our current regime of ongoing quantitative easing (QE) from central banks around the world. For investors befuddled by sky-high stock valuations, the difference between Prisoner A and Prisoner B is illuminating. They are exactly the same except for one thing: Prisoner B is wealthier today.

 

In general, then, this means that adding cash to financial markets creates investors who are willing to pay more for the exact same security. Conversely, when excess liquidity is drained from markets, prices should drop, all else equal, because investors with less cash today require higher returns. Thus line B moves back to line A.

 

Another key component of price: each investor’s relative liquidity in the marketplace. If enough aspirational investors, or Prisoner Cs, deploy their cash into a security market, prices can remain elevated or spike until their liquidity is exhausted. Sound familiar, GameStop?

 

 

A secular bull

Enough theory. Let’s return to the real world. Equity valuation matters, but the matter most by defining the downside risk in a bear market. 

 

I am inclined to discount the Fed’s warnings about stretched valuation. Those of us who are old enough remember Greenspan’s characterization of the markets as undergoing “irrational exuberance”, which was in a speech he made in 1996 – just at the start the dot-com bubble. A more modern era version of a warning came from Jerome Powell in 2018, when he stated, “In some areas, asset prices are elevated”. While the stock did consolidate sideways after that remark, it did not crash. In fact, Fed warnings could be construed as contrarian bullish indicators.

 

 

This is a bull market, and fiscal and monetary policy matter more in defining the market’s upside potential.

 

 

Jurrien Timmer at Fidelity offered the 1960’s as a historical template for today’s markets. He believes that the macro backdrop won’t change much until S&P 500 reaches 8000 in about five years’ time.

 

The ‘60s comparison is compelling, especially now that we’re going to have higher capital gains taxes 4-5 years after a cut in income taxes. The parallel is the Kennedy/Johnson tax cut of 1964 followed by the Nixon tax hike in 1969. It was “guns and butter” back then. Now it’s Covid and a progressive capital-to-labor wave. The late ’60s had social unrest and a speculative frenzy in growth stocks—sound familiar? 

 

In my view, our current inflation rate essentially mirrors where things were in the 1966-67 time frame, before inflation really took off.

 

 

Ed Yardeni recognizes the valuation headwinds, but he recently argued that MMT + TINA = MAMU, where MMT = Modern Monetary Theory, TINA = There Is No Alternative (to stocks), and MAMU = Mother of All Melt-Ups. 

 

We have the combination of easy monetary and fiscal policy and a greater acceptance of Modern Monetary Theory (MMT). MMT postulates that a government that can borrow in its own currency is only constrained by the financial market’s willingness to finance its deficits. Here is a more detailed explanation from Wikipedia:

 

MMT argues that governments create new money by using fiscal policy. According to advocates, the primary risk once the economy reaches full employment is inflation, which can be addressed by gathering taxes to reduce the spending capacity of the private sector. MMT is debated with active dialogues about its theoretical integrity, the implications of the policy recommendations of its proponents, and the extent to which it is actually divergent from orthodox macroeconomics.
It’s not that deficits don’t matter, they do. The implication of MMT is governments have a lot more fiscal room than previously thought if they issue debt in their own currency. Arguably, both Republicans and Democrats have embraced MMT when they control both the White House and Congress. Successive Republican administrations have pushed through tax cuts in the past, and now the Biden administration is proposing a large fiscal stimulus program with the acquiescence of the Fed. The principal disagreement has been the details of the fiscal program of tax cuts or social program spending, rather than any actual disagreement over deficits. Megan McArdle explained the change in the political environment in a Washington Post Opinion column:

 

More than anything else, this probably explains larger differences between the Obama and Biden approaches. President Barack Obama operated in a world in which deficits mattered politically. Biden doesn’t. Between the unfunded Trump tax cuts and a year of hog-wild pandemic spending, politicians have largely given up even pretending that they ought to pay for things their constituents want; it’s no longer even a good cudgel with which to beat the opposition when you’re out of power.
In the meantime, the economy has the benefit of two tailwinds, a cyclical recovery out of the pandemic-induced recession, and a second secular trend for infrastructure spending that’s mainly related to Green New Deal style initiatives. The greening of the economy is a secular trend that is going global and cannot be ignored. This is a sea change that requires gargantuan investments in new infrastructure. While business executives have traditionally pushed back against government regulation as detrimental to economic growth, Tom Peters and Robert Waterman argued in their book, In Search of Excellence, that tough regulation can be a source of competitive advantage. This is especially true if the trend, such as the desire to reduce greenhouse gasses, has become global. Lax regulation in a jurisdiction risks that country’s industries being left behind of global trends. Europe has been the leader in climate change initiatives. In Germany, which is the heart of the EU and eurozone, the Greens are polling at all-time highs and their leader Annalena Baerbock could succeed Angela Merkel as the next chancellor (see profile here).

 

 

At the same time, rates are at or near multi-century lows but facing upward pressure, which is bearish for bond prices. This creates a dilemma for income-oriented investors. Do you buy bonds, where you are virtually certain to lose capital over the next 5-10 years, or do you buy dividend-paying stocks and assume equity risk? This is an environment conducive to a TINA (There Is No Alternative to stocks) market. It is therefore no surprise that household equity allocations are so high.

 

 

Investment implications

The combination of these factors leads to the following conclusions:
  • The equity bull has a long way to run.
  • The cyclical recovery is bullish for value-oriented and cyclically sensitive sectors like financials, industrials, consumer discretionary (excluding high flyers like AMZN and TSLA), energy, and materials.

 

 

 

 

  • Balanced fund investors need to be prepared for greater volatility and re-think portfolio construction in an era of rising bond yields (see 60/40 resilience in an inflation age).

 

What “Sell in May” really means

Posted by Cam Hui -

Mid-week market update: Should you Sell in May and go away? While many traders are familiar with the Wall Street adage, what “Sell in May” really means is the six months starting May 1 has experienced subpar returns compared to the six months starting in November 1. It’s not necessarily bearish.
 

 

While it’s not advisable to trade strictly on seasonality, investors might want to be extra cautious with their equity allocations this year.

 

 

The caution zone

So far, what we have are bearish setups, but no definitive signs of downside breaks.

 

Callum Thomas observed that the ratio of leveraged long to short equity ETF volume is highly extended and in the “risk zone”.

 

 

Ryan Detrick pointed out that the stock market has paused its rally about now when coming off the recessions of 1982 and 2008.

 

 

However, these are all only cautionary signs and none of them are signals to sell everything or to go short the market.

 

 

Not bull nor bear, but a roller coaster

Even though I have warned about rising risk in the past few weeks. Neither the bulls nor the bears have gained the upper hand. 

 

The stock market sold off yesterday (Tuesday) when Treasury Secretary and former Fed chair Janet Yellen said, “It may be that interest rates will have to rise somewhat to make sure that our economy doesn’t overheat.” It recovered later in the day when she walked back those remarks and it recovered further today. From a technical perspective, the VIX Index spiked above its upper Bollinger Band yesterday, which is an indication of an oversold market. In the past, such VIX upper BB episodes have either signaled the start of a correction, or a once-and-done downdraft. Today’s recycle of the VIX suggests yesterday’s weakness was of the latter variety. 

 

 

Investors need to be prepared for a roller-coaster market with choppy price behavior. Sure, there are some signs of wobbles. The most worrisome is the violation of the relative uptrend by semiconductor stocks. Semiconductors are growth cyclicals, and they should be beneficiaries of the chip shortage. Their poor relative strength is an early warning that risk appetite is on the decline.

 

 

On the other hand, a review of other cyclical sectors and industries shows that the poor relative strength of semiconductors is an anomaly. Other cyclicals remain in relative uptrends.

 

 

As I have pointed out before, this is an increasingly bifurcated market. Growth stocks are struggling while value stocks are performing reasonably well. The Russell 1000 Value Index remains in an uptrend while the Russell 1000 Growth Index has violated a keys support level.

 

 

 

Watching China for clues

I conclude from this review that the stock market is vulnerable to a setback but it’s not quite ready to correct just yet. In order for the market to correct, the value and cyclical sectors need to face a growth scare.

 

That growth scare may occur as the Chinese economy slows. Real-time market data are suggestive of a China slowdown. The AUDCAD exchange rate is testing a keys support level. Both Australia and Canada are resource exporters. Australia is more sensitive to China while Canada is more levered to the US economy. The weakness in the AUDCAD rate is an implicit signal of slowing Chinese growth.

 

 

As well, the stock markets of China and her major Asian trading partners are not behaving well when measured against the MSCI All-Country World Index (ACWI). MSCI China has violated a relative support line, and so has South Korea. The rest are exhibiting weakening or range-bound patterns. (All prices are in USD).

 

 

The Trend Asset Allocation Model is still bullish and it is not designed to spot minor (5-10%) corrections. My inner investor is therefore bullishly positioned, though he has sold covered call options against selected existing positions.

 

My inner trader is on the sidelines. The long-term trend for stock prices is still up. The risk/reward ratio of trying to short the market without a definitive downside break is unfavorable. 

 

In short, I am cautious, but not bearish.

 

 

Q1 earnings monitor: Priced for perfection

Posted by Cam Hui -

We are well into Q1 earnings season. 60% of the S&P 500 has reported their results and the top and bottom line beat rates are well above average. The V-shaped recovery is complete.
 

 

Here is the more difficult question. The six largest companies in the S&P 500 reported last week and all of them beat consensus EPS expectations. Why was the S&P 500 flat last week?

 

 

 

Supply chain bottlenecks

Even though FactSet reported that the market rewarded EPS beats and punished misses, there was a subtle component that can’t be seen in the statistics. The new focus of the market seems to be concerns over production bottlenecks.

 

 

The market reaction to services companies and companies with manufacturing components is revealing about market psychology. Alphabet and Facebook, which depend mainly on advertising revenue, reported strong sales and EPS figures. The stocks rose after their reports.

 

By contrast, Apple also beat estimates but reported production issues owing to the chip shortage. Its shares closed in the red the next day. Yahoo finance reported that Caterpillar, which is a global cyclical bellwether, also reported strong earnings, but warned about chip shortages constraining sales. Its shares also weakened after the earnings report.
 

Caterpillar Inc. is warning of potential impacts ahead due to a global chip shortage, putting a damper on better-than-expected earnings for the world’s biggest maker of mining and construction equipment.

 

“Although we haven’t been impacted yet, the global semiconductor shortage may have an impact later this year,” Chief Financial Officer Andrew Bonfield said in a Thursday interview. “It’s a risk and obviously we’re keeping a close eye on it.”

 

The cautionary words come after Caterpillar posted first-quarter revenue and profit that topped analysts’ estimates, in what Bonfield described as “very strong performance” for the start of the year fueled by construction growth in the U.S. and China.

 

Caterpillar joins some of the world’s biggest automakers and tech giants in highlighting the impacts of a chip shortage that’s already caused Honda Motor Co. to halt output at Japanese plants and Apple Inc. and Samsung Electronics Co. in flagging production cuts and lost revenue.

 

The shortfall comes as Caterpillar expects a big ramp up in machinery production through the rest of the year. While the company has been able to mitigate the issue so far, Bonfield said such shortages could mean Caterpillar may not be able to fully meet demand from its customers this year.

 

Caterpillar’s quarterly results surpassed Wall Street’s expectations, with sales jumping 12% to $11.9 billion in the period and per-share adjusted earnings of $2.87 topping the $1.95 a share average estimate of analysts’ estimates compiled by Bloomberg.
Not only are shortages of semiconductors creating supply chain bottlenecks, but other shortages such as lumber mill capacity and even chicken production are driving up input prices. 

 

 

The challenge for the bulls

The bulls face a valuation challenge. The S&P 500 forward P/E ratio, which currently stands at 22.0, hasn’t changed much since the onset of the pandemic. 

 

 

On the other hand, the S&P 500 has risen 90.1% since the March lows, excluding dividends. If the forward P/E ratio was largely unchanged during this period, that means it was rising EPS estimates whichhave driven the market rebound. 

 

 

While forward EPS estimates have surged during Q1 earnings season, can they keep rising at their torrid pace as supply chain bottleneck worries emerge?

 

 

Priced for perfection

In short, the market is priced for perfection. Many market participants are already in crowded longs, which is creating headwinds for further price advances. Charlie McElligott at Nomura observed that CTAs are already at a crowded long and their positioning is highly correlated to PMI, which is already extremely elevated. 

 

 

As I pointed out last week (see Q1 earnings monitor: Reopening giddiness), top-down and bottom-up expectations are coming into conflict. While bottom-up estimates are rising, the top-down outlook is more cautious.

 

As one of many examples, the ECRI’s Weekly Leading Indicator is rolling over and coming off the boil.

 

 

I reiterate my warning that risks are rising for the stock market. You can tell a lot about market psychology by how the market reacts to the news. The six largest stocks in the S&P 500 reported last week and they all beat consensus estimates, but the index was flat. This is a classic warning that expectations are too high.

 

Semiconductor stocks are important bellwethers because they are in a growth-cyclical industry. These stocks should be performing well as they are beneficiaries of the chip shortage. Instead, the Semiconductor Index (SOX) violated an important rising relative trend line against the S&P 500, and the violation is more visible when measured against the NASDAQ 100.

 

 

These are all warnings that the stock market is poised for a pullback. Expectations are too high and the market is priced for perfection. A “Sell in May” strategy may be a useful investment template for the next few months.

 

As good as it gets?

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. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

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 are 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.
 

 

What’s wrong with this picture?

The six biggest stocks in the S&P 500 reported earnings last week. Every one of them beat consensus expectations. In addition, the FOMC reiterated its dovish stance after its meeting. These developments should all be bullish. Instead, the S&P 500 only made marginal gains while exhibiting negative divergences.

 

 

From a longer term perspective, the weekly S&P 500 chart shows the index recycling after overrunning  a rising trend line indicating a possible blow-off top. The S&P 500 then printed two consecutive weekly doji candles, each of which are signs of indecision.

 

 

What’s wrong with this picture?
 

 

A failure of leadership?

Where’s the leadership? The top five sectors of the S&P 500 comprise 74% of index weight and it would be difficult for the market to move significantly without the participation of a majority of these sectors. Of the five, the top three sectors are showing flat to declining relative strength, while the bottom two are showing some strength, but in a choppy fashion.

 

 

The leadership of high-beta growth stocks is narrowing. Even as the NASDAQ 100 is barely holding above a key support level, the high-octane ARK Innovations ETF (ARKK) is struggling to hold a relative support zone when measured against the S&P 500.

 

 

Sustained bullish advances simply don’t behave this way.

 

 

A tiring bull

Instead, this market looks like a tiring bull. Ryan Detrick of LPL Financial highlighted the pattern of major market recoveries, in 1982 and 2009. If history is any guide, the market is due to take a breather.

 

 

While history doesn’t repeat but rhymes, the key difference between today and the past may be higher volatility. Tracy Alloway recently wrote a Bloomberg column about the higher propensity of investors to herd today compared to the past [emphasis added].
 

It’s the 10th anniversary of “Margin Call” and yesterday I hosted a live chat with its director, J.C. Chandor, as well as Citigroup strategist Matt King. The film traces a blow-up at a big bank that’s reminiscent of what happened in the 2008 subprime crisis. King famously penned a research note just before the collapse of Lehman Brothers, arguing that the big problem for U.S. banks was short-term funding secured by subprime and other collateral.  

 

In “Margin Call,” the bank’s senior executives don’t realize they’re sitting on a powder keg until a junior risk manager stumbles on the numbers by chance. That scenario always seemed a little far-fetched to me, but King brought up some anecdotes from 2008 that showed just how much senior leaders seemed to be unaware of the scale of the problem they faced. As he put it:

 

“I myself remember having a conversation with desk heads in early 2008 on CDOs of asset-backed securities, and they were being relatively incredulous at the idea that if the junior tranches went, the whole structure was likely to go (I actually wrote another research piece that hardly anyone remembers!)” 

 

So how much has changed on Wall Street in the past decade? We recently saw banks handle another — albeit much smaller — blow-up in the form of Archegos. There were huge losses from that but no broader contagion, a testament to post-crisis regulation on capital and leverage. Is the system safer? King argues that there are some things that give him pause in the current environment, notably the March 2020 drama in the world’s biggest funding market:

 

“More subtly but just as importantly, what the periodic bouts of illiquidity in Treasuries are suggestive of is investor herding. The real recipe for a liquid and stable market is a heterogeneous market: Buyers and sellers, bottom-up investors and top-down investors, mark-to-market investors and buy-and-hold investors.

 

Somehow what we seem to have done post-2008 is to take a whole load of steps, which are individually designed to make the system safer, but collectively have killed off that heterogeneity and made for one-sided markets. The bottom-up, value-based, non-mark-to-market investor — they’ve been killed off by a decade of quantitative easing making everything more expensive and by regulators demanding everyone take a risk-based approach to capital. That gives you a market in which investors get herded into a broad-based reach for yield that they don’t really believe in. And that gives you those pockets of illiquidity: We don’t get one and two-standard-deviation movements any more — we either get zero or we get 16.” 

 

 

Weak, but not catastrophic

A review of market internals shows some signs of weakness, but nothing catastrophic. Value stocks are recovering against growth stocks, indicating that Big Tech leadership may be past its best before date.

 

 

That’s somewhat problematic for the S&P 500 because the weight of growth sectors is 10% greater than the weight of value sectors.

 

 

On a relative basis, defensive sectors are not acting well, indicating that the bears haven’t seized control of the tape.
 

 

One warning comes from the performance of semiconductors, which are growth cyclicals that should be benefiting from the widespread accounts of chip shortages. These stocks violated a key relative uptrend, which may turn out to be an important risk-off signal. The break is more clearly defined when the SOX is charted relative to the NASDAQ 100.

 

 

In conclusion, the tone of the recent market action looks like a tiring bull. The stock market has begun to consolidate and take a breather about now in the history of past major rallies off recessionary bottoms. Value continues to dominate growth, and investors should be able to find better returns in value stocks during this period. 

 

There is no need to panic just yet. The bears haven’t taken control of the tape, but this may be a good time to tactically reduce some equity risk.

 

The inflation red herring

Posted by Cam Hui -

Rising inflation fears are all over the headlines. From a top-down perspective, inflation pressures are clearly rising.
 

 

The Transcript, which monitors earnings calls, documented companies reporting rising inflationary pressures from supply chain bottlenecks and commodity price strength, which have the potential to create margin squeezes.
 

“…the inflationary pressures, particularly surrounding some of our key commodities, looks like it is going to be more of a headwind in ’22” – Coca-Cola (KO) CFO John Murphy

 

“…we’re watching and seeing SG&A inflation in different parts of the world and in different parts of the business, ranging from wage inflation in selective geographies. You’ve got global logistics inflation. You’ve got commodity inflation.” – Genuine Parts (GPC) President William Stengel

 

“In the first quarter, global semiconductors and resin shortages amplified existing supply constraints, and thus impacted our product availability. Further, we are faced with rapidly rising inflationary pressures, primarily in steel and resins. To address these issues, we swift the responses with the necessary actions to protect margins and product availability. We announced significant cost based price increase in various countries across the globe ranging from 5% to 12%” – Whirlpool (WHR) CEO Marc Bitzer
BoA also documented a surge in the mentions of “inflation” on their earnings calls.

 

 

Instead, I would argue that the inflation threat to equity prices is a red herring. Tax policy poses a stronger threat.

 

 

Who’s afraid of inflation?

The inflationary menace for equities has two components. The Fed could raise interest rates in reaction to rising inflation, which makes fixed-income securities more competitive to stocks. If the Fed does not react, it risks setting off an inflationary spiral if it loses control of inflation expectations.

 

Let’s address each of those issues. The Fed will not raise rates until it begins to taper its QE purchases. Fed watcher Tim Duy believes that the Fed is prepared to wait out the “transitory” nature of reopening inflationary first and react later.

My sense is that the Fed intends to wait until we push through the initial rebound of the economy before shifting policy. In the midst of the strongest part of the cycle there is a risk of complacency about the durability and pace of the recovery.

Duy believes that the Fed will not make any public statements about tapering until later this year.
 

 

Marketwatch reported that Joe Lavorgna, the former chief economist for the Trump White House’s National Economic Council, had an even more dovish take on Fed policy. He doesn’t expect the Fed to taper before 2023.
 

Lavorgna isn’t fearful of goods and services inflation, and, as a result, says the Fed won’t begin to taper its bond purchases before 2023 — and won’t lift interest rates before the next presidential election. The New York Federal Reserve’s survey of primary dealers, in March, found Wall Street expecting that the taper would begin in the first quarter of 2022, with the first hike in the third quarter of 2023. “If you’re going into 2022, and growth is a lot slower, the delta is negative, and inflation isn’t really picking up, it’s going to be very hard for the Fed to taper,” the Wall Street veteran says.

In the meantime, a flood of liquidity is hitting the economy. The March personal income report revealed that stimulus payments made up 18.5% of personal income.
 

 

Treasury cash balances are falling quickly and fiscal stimulus will continue until Q3. Equity investors shouldn’t be so worried about inflation.
 

 

The timing of the flood of Treasury cash also makes the point that much of the fiscal stimulus is one-time and transitory in nature. Any surge in demand is likely to top out later this year and so too the associated inflationary pressures. 

 

Already, the Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been slowly decelerating. As growth expectations decline, expect 10-year yields to follow. This leaves the economy in a sweet spot of strong non-inflationary growth, which is equity bullish.

 

 

 

Long-term inflation threats

What about long-term inflation? Pandemic-related inflationary surges have historically been benign. A study of history by Kevin Daly and Rositsa D. Chankova of Goldman Sachs Global Macro Research published at VoxEU and CEPR found that inflation rises much more during wars than pandemics [emphasis added]:

Every war and pandemic is different, and we should be cautious of drawing lessons from events that occurred in the long-distant past and in very different circumstances. One feature of the current pandemic that is clearly distinctive to past episodes is the size of the government response. Equally, however, one can argue that an unusually large government response was necessitated by an unusually large collapse in private sector demand.
 

What is clear is that history provides no evidence that higher inflation or higher bond yields are a natural consequence of major pandemics.

 

 

Even if you are worried about runaway inflation, a historical study of inflation expectations compared to S&P 500 returns finds that the environment is benign. Expectations are in the 2-3% range. Equity returns don’t turn negative until inflation rises to 5-6%, and the Fed can be depended to tap on the brakes well before the economy overheats that much.
 

 

In short, inflation fears are overblown. This is not the time to worry about transitory rising inflation pressures.
 

 

The tax threat

Instead of inflation, the real threat to equity prices is rising taxes. No, equity investors shouldn’t be overly worried about Biden’s proposal to raise taxes on high-income individuals, an end of the carried interest provision, or higher capital gains taxes over $1 million. In fact, there was a flood of analysis showing that capital gains tax rates has little effect on the stock market.
 

 

That’s because equity ownership has increasingly shifted away from taxable individuals to foreigners and deferred-tax accounts.
 

 

I believe the most important threat to equity prices is Biden’s corporate tax proposals. David Fickling hit the nail on the head when he wrote in a Bloomberg Opinion article that “Yellen’s Global Tax Plan Is on the Level of Trump’s Trade War with China”.

 

If you expected the administration of President Joe Biden to be a return to normalcy on trade issues after the drama of Trump-era tariff battles and tweet diplomacy, Treasury Secretary Janet Yellen has other ideas.
 

That’s because her plans announced Monday to introduce a global minimum corporate tax rate represent quite as much of a shock to the international economic order as Trump’s decision to wage trade war on China.
 

The two phenomena are connected as fundamental aspects of the modern global economy. Corporations have cut operating expenses at the top of their income statements by sending manufacturing offshore to China and other emerging economies where labor costs are lower. At the bottom of their income statements they’ve done the same with tax expenses, by offshoring their profits to low-tax jurisdictions such as Bermuda, the British Virgin Islands, the Cayman Islands, Ireland, the Netherlands, Luxembourg, Singapore, and Switzerland. 

In a separate Bloomberg report, Germany and France have come out in support of Yellen’s corporate minimum tax proposal. (They’re looking at you, Ireland.)
 

A corporate tax increase is justified by the Biden administration on the grounds that the Trump tax cuts did not spur investment activity. Corporate CapEx has been falling for years and you have to squint to on the chart to see when the Trump tax cuts occurred.
 

 

While there will be some inevitable bargaining over the statutory tax rate, which is expected to rise from 21% to 25% instead of the proposed 28%, the real story is how effective tax rates will change.
 

 

Notwithstanding the proposal of a corporate minimum tax, the more important component of Biden’s proposal is an increase in GILTI tax from 10.5% to 21%. For the uninitiated, GILTI stands for Global Intangible Low-Taxed Income. A GILTI tax is intended to prevent companies from shifting their IP profits to low-tax jurisdictions. The relative losers are in communication services, technology, and drugs. The relative winners are in the value and cyclically sensitive materials, energy, and industrial sectors.
 

 

A separate analysis by Absolute Strategy Research found that the Trump tax cuts favored growth over value stocks. The tax rates between the most extreme quintiles of value were roughly the same until Trump’s Tax Cuts and Jobs Act. After the implementation of the tax cuts, the cheapest value stocks (blue line) experienced a much smaller tax cut than the most expensive (gold line).
 

 

To conclude, here are my main takeaways from this analysis:

  • Worries about inflation are overblown. While some short-term supply chain bottlenecks are putting upward pressure on prices, they are transient and the Fed is not about to allow inflation to run away to 6%.
  • The bigger threat to equity prices are changes to the effective tax rate in the form of a minimum corporate tax on offshore profits.
  • Major losers under the Biden tax proposals are growth stocks that have offshored their IP: communication services, technology, and drugs.
  • Relative winners under the new tax regime are value and cyclically sensitive sectors: materials, energy, and industrials.

 

Has technical analysis stopped working?

Posted by Cam Hui -

Mid-week market update: Bloomberg recently featured an unusual article titled “Sell Signals All But Useless in Unchartable 2021 Stock Market”.

If you bailed because of Bollinger Bands, ran away from relative strength or took direction from the directional market indicator in 2021, you paid for it.

 

It’s testament to the straight-up trajectory of stocks that virtually all signals that told investors to do anything but buy have done them a disservice this year. In fact, when applied to the S&P 500, 15 of 22 chart-based indicators tracked by Bloomberg have actually lost money, back-testing data show. And all are doing worse than a simple buy-and-hold strategy, which is up 11%.

 

Of course, few investors employ technical studies in isolation, and even when they do, they rarely rely on a single charting technique to inform decisions. But if anything, the exercise is a reminder of the futility of calling a market top in a year when the journey has basically been a one-way trip.

 

“What we’ve seen this year is a very strong up market that didn’t get many pullbacks,” said Larry Williams, 78, creator of the Williams %R indicator that’s designed to capture a shift in a security’s momentum. A long-short strategy based on the technique is down 7.8% since the end of December.

 

Sell signals have failed. Much of this can be explained. Some, like this sentiment signal from BoA’s private client holdings, indicate a record crowded long in equities which is contrarian bearish. However, how much can investors allocate to fixed-income instruments in an era of low and rising rates? Stocks are the only game in town, even for income investors.

 

 

The straightforward view is the strength of momentum has overwhelmed all other technical signals.

 

 

Waning momentum

Another way of explaining momentum is “good overbought” reading. As good technical analysts know, no reversals are guaranteed. Overbought conditions can get more overbought and oversold.  conditions can get oversold.

 

We are reaching conditions when momentum is starting to wane and sell signals may be about to become more effective. The percentage of S&P 500 stocks over their 200-day moving average (dma) exceeded 90% in November. This was a “good overbought” condition indicating a strong and sustained advance. In the past, the rallies did not pause until the 14-week RSI reached an overbought reading of 70 or more, which was achieved in late March. That was the first warning.

 

 

The second warning occurred when the S&P 500 overran its rising trend line on the weekly chart and recycled, which were indications of blow-off tops.

 

 

The daily chart also showed an ominous negative divergence. Even as the S&P 500 made daily marginal all-time highs, both the 5 and 14-day RSI flashed negative divergences. While negative RSI divergences can persist for days before prices react, this was also another warning that the rally is its last legs.

 

 

 

Earnings season uncertainty

It’s always difficult to make short-term market calls on FOMC day. Daily uncertainty is especially problematic when the market is in the heart of Q1 earnings season. On Monday, Netflix missed subscriber growth expectations, and the stock fell after the report. On Tuesday, both Microsoft and Alphabet beat Street expectations. Microsoft fell while Alphabet rose. Even AMD, which reported and came out with extremely strong guidance, saw its stock price retreat. Today (Wednesday), Apple and Facebook beat expectations and rose in the after hours.

 

You can tell a lot about the character of a market by the way it reacts to the news. Even though results have generally been positive, the market reaction has been mixed though not disastrous.

 

 

Q1 earnings monitor: Reopening giddiness

Posted by Cam Hui -

Q1 earnings season is well underway. 25% of the S&P 500 has reported, and a number of large-cap bellwether technology companies will report this week. So far, the EPS and sales beat rates are above their historical averages, and forward 12-month EPS estimates continue to surge.
 

 

However, risks are rising as the sunny bottom-up view is coming into conflict with a more cautious top-down outlook.

 

 

An upbeat earnings season

On the surface, Q1 earnings season looks strong. Not only are analysts revising S&P 500 company earnings upwards, but also earnings for the mid-cap S&P 400 and small-cap S&P 600 are rising.

 

 

The market has been behaving as expected in reaction to earnings reports by rewarding beats and punishing misses.
 

 

The Transcript, which monitors earnings calls, tells the story of a booming economy.

 

The economic dam is bursting and the economy is booming. Demand in the US was described as “very, very strong” and “phenomenal” thanks to strong consumer balance sheets and vaccinations. Supply chains are still disrupted and there are significant inflation pressures.

I had been expecting some giddiness, but the headline “the economic dam is bursting” says it all.

 

Reopening continues around the globe
“…we see continued progress being made in the health crisis. More businesses are now opening up. Unemployment continues to decline. Consumers are spending at record levels. We are optimistic that expanding economic activity will in turn fuel loan growth as companies borrow, build inventory invest and hire more employees.” – Bank of America (BAC) CEO Brian Moynihan 

 

“China appears to be the furthest along in terms of reopening, with activity levels largely back to normal. The US is not all the way back just yet, but is moving in the right direction. And an increase in vaccination rates across the country appear to be driving some of this progress. Europe is improving broadly. And while certain areas have recently experienced setbacks in the process of reopening, we’ve not seen any material impact.” – Danaher (DHR) CEO Rainer Blair 

 

The US is very, very strong
“I would say the U.S. was very, very strong.” – ManpowerGroup (MAN) CFO Jack McGinnis
“I saw some commentary sort of questioning demand. Demand out there is absolutely phenomenal, across almost every sector. Very, very strong and it would appear to be there for the rest of this year going into next…So we see strong demand, tight supply, record low supply chain inventories across the space.” – Steel Dynamics (STLD) CEO Mark Millett

 

“And you heard us before talking about consumer demand, to be honest, in all the years I’ve been doing the earnings call, this is probably the year that I’m most bullish about mid-and long-term consumer demand trends in North America. So I’m not worried about consumer demand. ” – Whirlpool (WHR) CEO Marc Bitzer 

 

Consumers have healthy balance sheets
“Our FICO scores stayed extremely stable as have our debt-to-income levels. So it’s showing us that the buyer and the consumer is healthy today. And there are still plenty of people out there that can afford to buy a house.” – D.R. Horton (DHI) VP, Investor Relations Jessica Hansen

 

The economic dam is bursting
“I think as you see the vaccine spread, this economic dam is really starting to burst and it’s going to be widespread in terms of an increase in activity and revenues across most businesses.” – The Blackstone Group (BX) COO Jon Gray

 

There are rapidly rising inflation pressures
“…the inflationary pressures, particularly surrounding some of our key commodities, looks like it is going to be more of a headwind in ’22” – Coca-Cola (KO) CFO John Murphy

 

“…we’re watching and seeing SG&A inflation in different parts of the world and in different parts of the business, ranging from wage inflation in selective geographies. You’ve got global logistics inflation. You’ve got commodity inflation.” – Genuine Parts (GPC) President William Stengel

 

“In the first quarter, global semiconductors and resin shortages amplified existing supply constraints, and thus impacted our product availability. Further, we are faced with rapidly rising inflationary pressures, primarily in steel and resins. To address these issues, we swift the responses with the necessary actions to protect margins and product availability. We announced significant cost based price increase in various countries across the globe ranging from 5% to 12%” – Whirlpool (WHR) CEO Marc Bitzer

 

 

Reopening giddiness?

The risk to the market is excessive growth expectations from the reopening trade as the top-down outlook is coming into conflict with the bottom-up forecasts. Goldman Sachs recently pointed out that the economic growth rate is expected to peak in Q2 and decelerate into 2022.

 

 

Similarly, ECRI’s weekly leading indicator is topping out indicating the rising probability of decelerating growth.

 

 

Indeed, the Economic Surprise Index (ESI), which measures whether top-down economic figures are beating or missing expectations, has been falling. Growth expectations are decelerating as ESI declines.

 

 

On the other hand, an analysis of bottom-up S&P 500 quarterly EPS shows sequential EPS growth peaking in Q3, with no signs of visible deceleration except for Q1 2022. Are company analysts too bullish, or are top-down strategists too bearish?

 

 

Have reopening expectations become too high? April’s flash PMI reached a blistering 62.2.

 

 

Chris Verrone at Strategas observed that stock prices have historically struggled to advance whenever PMI exceeded the 60 level.

 

 

Jurrien Timmer, the director of global macro Fidelity, wouldn’t be surprised if the stock market were to take a temporary breather from the reopening trade. He offered two analogs from the past. The first is the post-GFC recovery.

 

 

The other is the post-World War II experience.

 

 

 

The tech sector’s acid test

This week sees a number of large-cap technology companies report their results. That may be the acid test for the market as Big Tech accounts for about 45% of the weight in the S&P 500. The market has become increasingly bifurcated. The tech-heavy NASDAQ 100 is struggling to hold support. The high-octane ARK Innovation ETF (ARKK) has been weak relative to the S&P 500, and the near-term progress of that fund will depend heavily on Tesla’s earnings report after the close today.

 

 

Tech investors are already panicking. They yanked $6 billion from QQQ over a 5-day period, which is the largest outflow since the NASDAQ top in 2000. 

 

 

In conclusion, large-cap tech company reports are a source of near-term volatility. Longer-term, the reopening trade is at risk in the US, but not globally. As I recently pointed out (see A pause in the reflation trade?), the market will be uneven in the coming months. Investors can expect better opportunities in Europe as vaccinations ramp-up to supportive reopening. However, China is slowing, and a number of emerging market countries are still struggling with the pandemic, which is a drag on their growth outlooks.

 

 

The top-six stocks in the S&P 500 all report this week. They are all tech companies and account for 23.0% of the S&P 500 and 44.9% of the NASDAQ 100. Brace for daily volatility.