The remarkably resilient stock market

Posted by Cam Hui -

The Chinese markets panicked on the news of government crackdowns on technology and education companies. As well, Beijing has been working to restrict the flow of credit to property developers in order to stabilize real estate prices. In reaction, foreigners have been panic selling Chinese tech on high volume.
 

 

Despite all of this carnage, the S&P 500 has been remarkably resilient.

 

 

China’s about face

Here is the best analysis of China’s policy changes that I have encountered (by Tom Westbrook via Reuters):
 

The new model appears to place common prosperity, as President Xi Jinping has put it, ahead of helter-skelter growth, investors say.

 

According to some analysts, it is the most significant philosophical shift since former leader Deng Xiaoping set development as the ultimate priority 40 years ago.

 

“Chinese entrepreneurs and investors must understand that the age of reckless capital expansion is over,” said Alan Song, founder of private equity firm Harvest Capital. “A new era that prioritises fairness over efficiency has begun”…

 

In the nine months that have passed since, developers, commodity speculators, crypto miners, other tech giants and, lately, tutoring firms, have all faced radical rule changes or had regulators aggressively poring over their businesses.

The policy pivot is “common prosperity”. Translated, this means the reduction of inequality in order to better support household sector spending.

 

Zhaopeng Xing, senior China strategist at ANZ, said the raft of policies, unveiled around the Chinese Communist Party’s centenary, underscores the political will to reinforce the Party’s roots.

 

“These policies were announced to reflect the Party’s progressiveness” and appeal to the masses, Xing said. “They send a message that China is not a capitalistic country, but embraces socialism.”

 

The messaging in the months running up to the Party’s July 1 centenary was also unequivocal, analysts say. “Common prosperity” is the over-riding long-term goal, Xi said early this year, and China’s development should be centred on people’s expectations of better lives, urban-rural gaps and income gaps.

Rather than blindly selling everything Chinese, investors should instead focus on the “Three Mountains”.

 

Investors have so far responded with alarm that tipped on Tuesday towards panic. They dumped health stocks (.HSHCI) in anticipation the sector will be next in the firing line, even as the property and education sectors reel.
 

Housing, medical and education costs were the “three big mountains” suffocating Chinese families and crowding out their consumption, said Yuan Yuwei, a fund manager at Olympus Hedge Fund Investments, who had shorted developers and education firms.

The markets have responded relatively rationally. The affected sectors have cratered. In particular, the shares of the “too big to fail” overly indebted property developer China Evergrande continue to skid.

 

 

For some context, China’s property bubble is huge.

 

 

Credit contraction? Property bubble? This should put extreme pressure on financial stability, right? The relative performance of Chinese financial has tracked the relative returns of US and European financials. Remarkably, Chinese financials (red dotted line) have outperformed the Chinese market in the last few days.

 

 

Moreover, anecdotal stories of foreigners fleeing the Chinese market should put pressure on the exchange rate. While the USDCNH rate has weakened slightly, it has been incredibly stable in the month of July. One of the key risks is a major Chinese devaluation. So far, there are few signs of CNH weakness.

 

 

China’s blowup appears to have been contained. This argues for a buying opportunity in selected Chinese equities for investors who avoid the “Three Mountains”.

 

 

The word is “transitory”

Today is FOMC day and the Fed’s continued “stay the course” tone is not a surprise to me. In the FOMC statement and subsequent press conference, the Fed acknowledged progress with the recovery, with the caveat that substantial further progress is required. Moreover, the FOMC “will continue to assess progress in coming meetings” (plural). A taper would be no surprise, but the sequence of a QE taper, followed by rate hikes will take a long time.

 

The good news is the inflation spike is turning out to be transitory. Delivery times have been correlated with CPI, and delivery times and supply chain bottlenecks are beginning to ease. 

 

 

Labor markets are normalizing, though labor shortages are not. Arindrajit Dube, who is an economist at UMass Amherst, analyzed the effects of moving from unemployed to employed in the states that shrunk UI early and found that the UI effect has been modest at best.

 

 

Labor markets are tightening, which is also positive from the Fed’s perspective. The anecdotes from the Dallas Fed’s Texas Service Sector Outlook Survey tell a story reduced labor supply in all tiers.

 

We continue to see improved demand for legal services. The winter storm instigated a lot of legal work. We are continuing to see increases on the transactional side and perhaps a bit of a slowdown in large bankruptcy filings. There is huge competition for talent right now—particularly for corporate lawyers. There is a lot of pressure on associate salaries, and we have implemented a new pay scale for associates that will feature retroactive bonuses.

 

A shortage of technology professionals continues to impact the ability to deliver. Sales look like they’ll pick up in the fall based on more purchasing decisions being made.

 

[Food services] We are hiring a few employees after the federal [unemployment] subsidy ended but continue to lose others oftentimes because they say they don’t want to work or decide to attend a social function and walk off. They know they can get hired again by walking down the street. Hire three, lose four. Hire two, lose one. I have never seen anything like this in my almost-40 years of working. We continue to turn away business due to lack of employees. Raw product prices continue to significantly increase. It is difficult to raise prices, but we will have to soon. Our downtown area remains sparsely populated with little activity, which is critical to our business.
This feeds into the Fed’s objective of running a hot economy in order to reduce inequality. In the press conference, Powell would not be pinned down on the definition of maximum employment: “There is not a signal number.” Eventually, this will lead to inflation, but that’s a problem for 2023 and beyond (see How to engineer inflation). 

 

The Fed is staying the course. In all likelihood, there will be some discussion about the process of tapering QE purchases at Jackson Hole that may cause some temporary volatility. The Fed is staying the course.

 

Equity investors should also stay the course. The S&P 500 staged a classic bounce off its 50 dma and it broke out to another fresh high. The breakout is holding. There will be some individual days of choppiness as we progress through earnings season.

 

 

This is a bull market.

 

Another chance to buy the panic

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 magazine cover buy signal?

Investors and traders who stepped up and bought into the market panic last Monday profited handsomely when stock prices staged a relief rally. Another panic opportunity may be presenting itself, this time in the energy sector.

 

Historically, The Economist magazine covers have been excellent contrarian market signals (see What a bond market rally could mean for your investments). The Economist may have done it again this week with a focus on the global warming effects of heat waves in North American and floods in Germany.

 

 

Notwithstanding the public policy issues, which are beyond my pay grade, here is what it could mean for selected energy equities.

 

 

The new tobacco

One of the worse culprits of carbon emissions is coal. Coal stocks represent a relatively small part of the market, but here is how this industry has behaved in the last two years. The stocks made a saucer bottom and it is breaking upward, both on an absolute basis and relative to the S&P 500.

 

 

A more detailed analysis of global coal usage shows that OECD countries began to wean themselves off coal as an energy source at the time of the GFC. Chinese coal usage took off in the early 2000s and plateaued about 2014, while other EM coal demand continued to rise. The latest G-20 meeting ended without an agreement on the phaseout of coal powered electrical generation based on objections from China, India, and Russia.

 

 

Unfortunately, there are no easy ways to gain a diversified exposure to the industry. The only listed ETF, the VanEck Coal ETF (KOL), closed in December 2020. The lack of interest could be interpreted a contrarian buy signal.

 

 

Big Oil tests support

The oil and gas industry is another example of the “new tobacco”. The technical picture for energy stocks is not as bullish as coal. The energy sector is testing key support levels, both on an absolute basis and relative to the S&P 500. Relative breadth indicators are trying to bottom but may need some time to definitively take a position of market leadership.

 

 

The medium-term supply/demand outlook is constructive. The COVID-related inventory overhang has been worked off. As the global economy recovers, demand should pick up even as producers hesitate to commit to capex in the face of long-term climate change demand pressures.

 

 

 

A panic bottom and recovery

As for the stock market, conditions are setting up for a recovery from last Monday’s panic bottom. Jason Goepfert at SentimenTrader pointed out that the “Up Volume Ratio cycled from below 15% to above 85% in back-to-back sessions on the NYSE”, which is “a buy signal that has never failed”.

 

Since 1962, the S&P 500 never showed a loss in the month following similar signals. These mostly occurred during momentum markets, and buyers followed through to avoid missing out on the next bull run. A few of them did end up leading to blow-off peaks, but not until month(s) later.

 

 

Technical analyst Walter Deemer observed that Monday’s downdraft represented an 89.4% downside to upside volume day, followed by an 88.0% upside volume day Tuesday and an 83.0% upside volume day on Wednesday. According to the 2002 Dow Award paper by Paul Desmond of Lowry’s Report, consecutive 80% up volume days represent a bullish reversal buy signal after a 90% downside volume panic day.

 

The historical record shows that 90% Downside Days do not usually occur as a single incident on the bottom day of an important market decline, but typically occur on a number of occasions throughout a major decline, often spread apart by as much as thirty trading days…

 

Our 69-year record shows that declines containing two or more 90% Downside Days usually persist, on a trend basis, until investors eventually come rushing back in to snap up what they perceive to be the bargains of the decade and, in the process, produce a 90% Upside Day (in which Points Gained equal 90.0% or more of the sum of Points Gained plus Points Lost, and on which Upside Volume equals 90.0% or more of the sum of Upside plus Downside Volume). These two events – panic selling (one or more 90% Downside Days) and panic buying (a 90% Upside Day, or on rare occasions, two back-to-back 80% Upside Days) – produce very powerful probabilities that a major trend reversal has begun, and that the market’s Sweet Spot is ready to be savored. 

 

 

Zweig Breadth Thrust watch

As part of the same theme of price momentum reversal, we have a potential rare Zweig Breadth Thrust buy signal setup. The ZBT buy signal is a rare momentum-based buy signal that occurs only once every few years and almost never fails. It requires the market to move from an oversold condition to an overbought reading within 10 trading days. The ZBT Indicator went oversold last Monday, and Tuesday, July 20 was day 1 of the ZBT buy signal watch. The window for flashing a buy signal ends on Monday, August 2. 

 

 

This is only a trade setup. I am not holding my breath for the buy signal.

 

 

Key risks

There are a number of key risks to the bullish scenario. First, the S&P 500 has rallied back to an all-time high. On the other hand, the 5 and 14-day RSIs are flashing negative divergences.

 

 

As well, credit market risk appetite is not behaving well. The relative price performance of junk bonds to their duration-equivalent Treasuries is exhibiting a minor negative divergence, which is another concern.

 

 

 

The week ahead

Looking to the week ahead, traders need to distinguish probable market direction based on differing time frames. I am inclined to lean bullish on a 1-2 week time horizon. Helene Meisler conducts a weekend (unscientific) Twitter poll. Sentiment had plunged to negative double-digits the previous week, and such readings had marked tradable bottoms in the past. The latest week’s sentiment survey saw a bullish snapback, but conditions are not at a crowded long, which gives the bulls the run to run.

 

 

As well, option sentiment derived tail-risks are rising, as evidenced by the pricing of August VIX call options. I attribute this to the pricing of event risk based on what might occur at the Fed’s Jackson Hole gathering. As the market is pricing in sizable QE taper style announcements from Jackson Hole, this puts a floor on any taper trantrum risk-off episodes in the coming weeks.

 

 

In the very short-term, breadth is extremely overbought. Even if you are bullish, expect a pause or pullback early in the week.

 

 

In conclusion, coal and energy equities represent potential contrarian buying opportunities for investors. In addition, the stock market appears to have undergone a bullish reversal off a panic bottom, which should resolve in higher prices in the days and weeks ahead.

 

 

What you should and shouldn’t worry about

Posted by Cam Hui -

The S&P 500 took fright last Monday and skidded -1.6% after falling -0.8% the previous Friday. Talking heads attributed the decline to worries about the rising incidence of the Delta variant around the world.
 

 

Fears over the Delta variant slowing economic growth are overblown. However, there are two other key risks that equity investors should be watching.

 

 

Delta variant fears are overblown

There are two reasons why the Delta variant shouldn’t be an impediment to rising stock prices. First, it is well under control in the well-vaccinated developed markets. Consider Spain as an example. Spain’s vaccination rate resides in the middle of the pack of developed economies. It is below the well-vaccinated countries like Israel and the UK, and above the rest of the EU and the US. 

 

 

Here are the infection and hospitalization rates for Spain. While the infection rate has skyrocketed because of the Delta variant, cases are mild and the hospitalization rate has been flat. To be sure, Israel’s Ministry of Health reported last week that the effectiveness of the Pfizer/BioNTech vaccine in preventing symptomatic illness had fallen to 64% from 95% in May before the Delta variant became prevalent. Nevertheless, it is still 93% effective in preventing hospitalizations and serious illness. In short, vaccines work. As long as they are effective and available, the global economic recovery should continue.

 

 

Here is even more good news from the UK. Ian Shepherson of Pantheon Macro pointed out that “UK Covid cases today down 17% compared to a week ago, when they were elevated by Euro 2020 final parties/wakes. The point is that these events seem not to have triggered a further surge.”

 

 

While every COVID-19 death is a human tragedy, the market is far more mercenary and only focuses on growth outlook and interest rates. The risk to stock prices from the Delta variant is the effects on economic growth. Bill McBride at Calculated Risk maintains a monitor of “Seven High Frequency Indicators for the Economy”. Despite the fears of the rising Delta variant infections stalling the recovery, none of the seven indicators are showing any signs of slowdowns. As an example, here is Apple’s tracking of mobility in selected American cities. Activity is not rolling over.

 

 

As the lockdown eased, travel began to return to normal. The 7-day moving average of TSA checkpoint travel has been steadily rising and there are no signs of a stall.
 

 

The same could be said of movie box office receipts.

 

 

I could go on, but you get the idea. The other indicators that McBride monitors are hotel occupancy, gasoline usage, restaurant reservations, and New York City transit usage. From a global perspective, the Goldman Effective Lockdown Index shows that the Delta variant hasn’t slowed progress in reopening.

 

 

The challenge for policymakers is the pace of vaccinations. In particular, Asian economies have lagged in their vaccination rates. Jurisdictions like Taiwan and South Korea implemented lockdown policies that were effective in slowing transmission to a crawl in order to buy time for vaccine development. Now that vaccines are available, most Asian countries have been slow to vaccinate their population. Even Latin America has managed to make better progress than Asia. The headlines from the Olympics in Japan, a major G-7 developed economy, are testament to the slow rollout of Asian vaccinations.

 

 

 

Rising China tail-risk

The lagging ASEAN vaccination rates underline a key risk of an Asian growth stall. The performance of the Chinese stock market and the markets of her major Asian trading partners relative to MSCI All-Country World Index (ACWI) shows that virtually all markets have either broken relative support or are testing relative support. While the weakness of Chinese shares may be attributable to recent policy shifts, all countries in the region are lagging compared to global stocks. It is unclear, however, whether this is attributable to the slow pace of Asian vaccinations or rising tail-risk from China.

 

 

Chinese property developers are showing signs of stress after Beijing implemented a series of measures to curb property lending. China Evergrande (3333.HK) has been the poster child of overleveraged developers and it has been viewed as a “too big to fail” company by many. Its shares tumbled when a Chinese court froze 132 yuan, or USD 20 million, in deposits from Evergrande Real Estate and its subsidiary Yixing Hengyu Real Estate. Subsequent to that event, other Asian lenders stopped providing mortgages to Evergrande’s Hong Kong properties. The company’s share price has tumbled and violated key technical levels. 

 

 

More importantly, selected Evergrande bonds are trading at 50% discounts to par value. The discounts on offshore bonds are greater than domestic issues, indicating a market expectation that foreigners will bear the brunt of any restructuring.

 

 

The shares of other property developers are also getting hit and they have either violated or are testing important long-term support.

 

 

The real estate sector in China absorbs a disproportionate level of savings in that country. Wobbles in the Chinese property market represent a tail-risk that has the potential to destabilize China’s financial system and cause ripples throughout the world. How China Evergrande’s debt will be resolved will ultimately be a political decision made in Beijing, as summarized by the WSJWSJ.
 

Ultimately, Evergrande’s fate rests with Beijing. The government’s drive to curb property sector debt has weakened funding for developers, sparking Evergrande’s current crisis. Given the importance of housing to China’s overall economy, tightening and easing policies usually come in cycles. But reining in the relentless debt-fueled expansion of companies like Evergrande, which pose an increasing systemic risk, seems likely to remain a top policy priority.

 

The government will try to contain any ripple effects to the financial system or home buyers but not all investors will be spared pain.

 

There is one silver lining in the Chinese dark cloud. The commodity markets are holding up well, which is constructive for the global economic outlook as China is the largest consumer of many raw material inputs. Commodity prices are holding above their 50 and 200 dma, and the cyclically sensitive base metals to gold ratio has been trading sideways despite the bearish signals from the 10-year Treasury yield. 

 

 

As well, the relative returns of Chinese material stocks to global materials are strong, which is an implicit signal of cyclical strength from China. Commodity strength is surprising in light of the news that China plans to sell 170,000 tonnes of non-ferrous metals in another round of auctions, according to state media Xinhua.

 

 

Callum Thomas of Topdown Charts confirmed the signs of underlying economic strength in Asia. He pointed out that Asian metal user PMIs have begun to accelerate after lagging the US and Europe.

 

 

These readings are consistent with the observation that global reopening is proceeding with or without the Delta variant.

 

 

Washington sideswipes the markets?

Another key risk to the market comes from Washington. Growth expectations are rising, and legislative maneuvers have the potential to derail growth expectations. 

 

As an example, Marketwatch reported that JPMorgan strategists recently raised their S&P 500 year-end target from 4400 to 4600 and S&P 500 2021 earnings by $5 to $205.

 

“We remain constructive on equities and see the latest round of growth and slowdown fears premature and overblown,” said the JPMorgan team, led by Dubravko Lakos-Bujas. “Even though equity leadership and bonds are trading as if the global economy is entering late cycle, our research suggests the recovery is still in early-cycle and gradually transitioning toward mid-cycle.”

 

The strategists base the S&P 500 upgrade on “strong earnings growth and capital return until 2023.” Their S&P 500 earnings per share estimate for 2021 was lifted $5 to $205 and by the same amount for 2022 to $230, and gross corporate buybacks are seen surpassing a first-quarter 2019 record of $850 billion.
As well, bottom-up earnings estimates continue to rise. While these developments appear bullish and indicative of short-term fundamental momentum, equity investors could be wandering into a minefield in the coming months.

 

 

The first risk is a corporate tax increase, which is not in most analysts’ spreadsheets yet. Bloomberg reported that Treasury Secretary Janet Yellen is setting out a timeline to implement a global corporate minimum tax:

 

U.S. Treasury Secretary Janet Yellen began to put a timeline on when the Biden administration hopes Congress can take up two key portions of a global tax agreement endorsed Saturday by Group of 20 finance ministers in Venice…

 

“The details of pillar 1 remain to be negotiated,” she said. “We will work with Congress — maybe will be ready in the spring of 2022 — and try to determine at that point what’s necessary for implementation.”

 

The accord is on track to be finalized at the G-20 leaders’ summit in Rome in October, and finance ministers have said they foresee global implementation in 2023.

 

No matter what happens with the negotiations, corporate tax rates will rise. Bottom-up company analysts have not adjusted their earnings estimates because it’s impossible to do so without knowing the details of the legislation. Some top-down strategists have begun to pencil in the effects of a tax increase using a variety of scenarios. However, these changes have not crept into the consensus market narrative and could represent a negative surprise in the coming months.

 

In addition, another debt ceiling drama is looming in Washington. The Congressional Budget Office published a report last week which estimates that the Treasury would run out of cash in October or November. While the consensus expectation is the Treasury would not be forced to default on its debt, the political jockeying is already starting and could unsettle markets in Q3 or early Q4. The US Treasury has announced that it will “need to start taking additional extraordinary measures” to prevent default if Congress doesn’t act by August 2.

 

 

Intermediate-term constructive

Despite these risks, I remain intermediate-term constructive on the equity markets. Fathom Consulting recently decomposed the sources of market returns based on cash flow (blue line) and sentiment (green line). While sentiment is elevated and comparable to the dot-com era, equity prices are supported by strong cash flows.

 

 

In conclusion, while there are some risks to the equity outlook to be concerned about for the remainder of 2021, stalling growth from the Delta variant is not one of them for most advanced economies. Nevertheless, investors should monitor rising China tail-risk as overleveraged property developers like China Evergrande wobble financially. As China Evergrande falls into the “too big to fail” category, I expect Beijing would step in to resolve any defaults in an orderly manner to minimize the fallout. In addition, US equity prices may stumble once the market gains greater clarity on Biden’s plan to raise corporate tax rates.

 

From an economic perspective, the global recovery should continue into 2022 and beyond and be supportive of higher stock prices. Expect some volatility over the coming months, but investment oriented accounts should maintain their equity commitments.

 

 

The anatomy of an air pocket

Posted by Cam Hui -

Mid-week market update: I could tell that a panic bottom was near on Monday when how many people had lost their minds when the S&P 500 fell -3.7% from its intraday all-time high, both from my social media feed and emails (see A sudden risk-off panic). The S&P 500 rallied impressively on Tuesday to fill Monday’s downside gap, and today’s follow-up was equally constructive.
 

 

Despite the market’s recovery, the bulls aren’t out of the woods and downside risks remain. Here’s why.

 

 

Down Friday and Mondays

Jeff Hirsch posted a LinkedIn article entitled “DJIA Down Friday/Down Monday: Historically an Ominous Warning” tells the story. The historical record underlines the downside risks to the stock market.

Since January 1, 2000 through todays close there have been 221 DJIA Down Friday/Down Mondays (DF/DM) including todays. From DJIA’s closing high within the next 7 calendar days to its closing low in the following 90 calendar days, DJIA has declined 212 times with an average loss of 7.21%. Declines following the DF/DM were greater in bear market years and milder in bull market years (see page 76 of Stock Trader’s Almanac 2021). The eight times when DJIA did not decline within 90 calendar days after were following DF/DMs on October 7, 2002; May 19, 2003; November 17, 2003; February 3, 2014; October 13, 2014; October 31, 2016; September 25, 2017 and October 9, 2017.

 

 

Hirsch believes the market action in the next few days will yield greater clarity to the market’s intermediate-term direction.

Based upon the above chart, if DJIA recovers its recent losses within about 4-7 trading days, then the DF/DM that just occurred may have been the majority of the decline. However, if DJIA is at about the same level or lower than now after this window, additional losses are more likely over the next 90 calendar days.

 

 

What to watch

Here is what I am keeping an eye on. The fright hasn’t fully receded from the bond and currency markets. The 10-year Treasury yield fell as far as 1.13% on Monday. While it has recovered, it is still in a downtrend, indicating market caution. As well, the USD is a safe haven currency and it is still advancing. These two cross-asset signals represent the most worrisome indicators from a risk appetite perspective.

 

 

Credit market risk appetite is also mildly concerning. The relative price performance of junk bonds to their duration-equivalent Treasuries is flashing a minor negative divergence against the S&P 500. These minor divergences have occurred in the past and they are not actionable signals by themselves. When paired with heightened risk levels, however, this divergence is something that should be monitored.

 

 

Defensive sectors of the market staged brief upside relative breakouts on Monday but retreated to test their breakouts. If the bears are to seize control of the tape, these sectors must regain and maintain their breakout levels.

 

 

The VIX Index rose above its upper Bollinger Band on Monday, which is the signal of an oversold market, and recycled below its upper BB. The S&P 500 duly rallied as a result. However, this condition does not preclude a retest or even an undercut of Monday’s lows. If the past is any guide, any market weakness will begin after the VIX touches its 20 dma.&

 

 

My inner investor remains bullishly positioned. My inner trader is tactically long the S&P 500. He plans to exit most if not all of his position once the VIX falls to its 20 dma. Stay tuned.

 

 

Disclosure: Long SPXL

 

A sudden risk-off panic

Posted by Cam Hui -

The markets opened with a risk-off tone overnight in Asia, The selloff continued in Europe, and now it is in North America. The talking heads on television have attributed the weakness to COVIE-19 jitters over the spread of the Delta variant.
 

Panic is starting to set in as the S&P 500 approaches a test of its 50 dma. The term structure of the VIX futures curve is starting to invert. The 9-day VIX is now above the 1-month VIX (bottom panel), though the 3-month VIX remains above the 1-month VIX. 
 

 

Coincidentally, I also received this morning several emails raising concerns about the stock market. I would argue instead that this is not a time to abandon long positions. Instead, the market weakness represents an opportunity to tactically add to long positions.

 

 

The primary trend

First, keep in mind that the primary trend is up. Jared Woodward at BoA pointed out that “Years that begin this well tend to end well, too. Since 1871, for the 16 years with similar starts, the average second-half return was 8%, with more upside potential than downside risk.”

 

 

 

Bottoming models

Tactically, three of the four of my bottoming models are flashing buy signals. The 5-day RSI is oversold; the VIX Index has spiked above its upper Bollinger Band; and the NYSE McClellan Oscillator is oversold. The only indicator that has not signaled caution is the 1-month to 3-month VIX term structure, though I pointed out that the 9-day to 1-month VIX has inverted, indicating rising fear.

 

 

As well, I monitor the Zweig Breadth Thrust Indicator for a secondary purpose other than the original formulation. As a reminder, a ZBT buy signal is generated when the ZBT Indicator rebounds from oversold to overbought within 10 trading days. This is a rare condition that only happens every few years. What is less rare are ZBT oversold signals – one of which was just generated today.

 

 

I am in no way implying that we will see a ZBT buy signal in the near future. However, the market is sufficiently oversold that a tactical buying opportunity is presenting itself. The real test for the market is how it behaves after the rebound. My base case is still calling for a trading range for the next few weeks. The market is just at the bottom of its range right now.

 

 

Disclosure: Long SPXL
 

A glass half full, or empty?

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.
 

 

Easy to be bearish

As a chartist, it’s easy to be bearish. After all, the market is experiencing numerous negative breadth divergences. 

 

 

Beneath the surface, however, the technical narrative can better be described a “glass half full, or half empty” dilemma.

 

 

An internal rotation

Conventional technical analysis approaches don’t really tell the story of this stock market. The market has been undergoing an internal rotation from value to growth. While the Russell 1000 Value Index has been trading sideways, the Russell 1000 Growth Index has been advancing to fresh all-time highs. However, the value/growth ratio is exhibiting positive RSI divergences, indicating that value stocks may be ready to regain their lead.

 

 

The revival of value stocks can be better seen in small caps. The Russell 2000 Value to Growth ratio has rallied through an important relative resistance level.

 

 

Further evidence of internal rotation can be seen in the relative performance of the top five sectors of the S&P 500. These sectors comprise 75% of index weight and it would be difficult for the index to either rise or fall without the participation of a majority. Large cap growth sectors such as technology and cap weighted consumer discretionary are exhibiting relative uptrends, while the value-oriented financial stocks are lagging.

 

 

 

A glass half full

Evidence of poor market breadth has its silver lining. The widespread evidence of poor breadth has pushed the NYSE and NASDAQ McClellan Oscillators (NYMO and NAMO) to an oversold condition. This is a highly unusual condition because the 14-day RSI just retreated from an overbought reading. In the last four years, there were two episodes when NYMO was oversold and the RSI was overbought or near overbought. Both resolved themselves in benign manners.

 

 

The breadth divergence can also be seen in the percentage of S&P 500 stocks above their 50 and 200 dma. It’s also unusual to see the percentage of S&P 500 stocks above their 200 dma over 90% while the percentage above their 50 dma so low at about 50%. There were nine such episodes in the last 20 years. Four resolved bullishly (blue vertical lines) and five bearishly (red lines). The results can best be described as a coin toss.

 

 

The Fear & Greed Index has fallen to 23, which is at or near levels where this index has bottomed in the past.

 

 

The market appears to be setting up for a short-term bottom. Helene Meisler tracks the number of Wall Street buy recommendations to sell recommendations. This indicator has plunged to an all-time low, which is contrarian bullish.

 

 

As well, Meisler conducts an (unscientific) weekend Twitter poll. This week’s sudden bearish turn nearly is approaching the record low level seen in January. The last time sentiment plunged was four weeks ago, in the wake of the FOMC’s hawkish pivot. The market recovered the following week when Fed speakers softened their remarks.

 

 

So where does that leave us? I continue to believe that the market has bifurcated into two distinct markets, value and growth. In aggregate, it’s difficult to make much of a judgment about the direction of the S&P 500 owing to the divided nature of market internals. The internal rotation is continuing and value is poised to gain the upper hand.

 

Short-term breadth and sentiment readings indicate that a rebound is likely, but the bulls shouldn’t bring out the champagne just yet as the market could just be at the bottom of a trading range. Until we see a definitive bullish or bearish catalyst, my base case calls for a sideways market with a possible minor upward bias. 

 

My inner investor is remains bullishly positioned in value and reflation-themed stocks. Near-term downside risk is relative low and he is not concerned about minor blips in stock prices. My inner trader is tactically long the S&P 500 in order to scalp 1-2%. The market is at the bottom of a short-term trading range and it is expected to rebound over the next week.

 

 

Disclosure: Long SPXL

 

How to engineer inflation

Posted by Cam Hui -

Both the June CPI and PPI came in hot and well ahead of expectations. There was the inevitable debate about the transitory nature of the price increases. Looking longer-term, however, the conventional models for explaining inflation have been unsatisfactory.
 

Notwithstanding the numerous failures by Japanese policymakers, consider the US as another example. Let’s begin with fiscal policy. It is said that deficit spending would lead to currency devaluation and inflation in the manner of the Weimar Republic. Nothing could be further from the truth. The blue line represents federal government deficits as a percentage of GDP. Deficits began to balloon in the early 1980`s with the Reagan Revolution and continued during the Bush I era. Did inflation (purple line) explode upward?

 

Monetary policy had its own failure. Monetarist Theory, as popularized by Milton Friedman, was another model that backtested well but failed out of the box. Friedman postulated that the PQ=MV, where the Price X Quantity of goods and services (or GDP) = Money Supply X (Monetary) Velocity. Friedman theorized that, over the long run, monetary velocity is stable, and therefore money supply growth determines inflation. All central banks had to do was to control money growth in order to control inflation.

 

It worked until about 1980. Monetary velocity had been stable until about then. Money growth didn’t generate inflation because monetary velocity fluctuated wildly. Growth in money supply, as measured by M1, was often matched by declines in velocity. The Fed could engineer money growth and inject liquidity into the financial system without creating inflation.
 

 

In the face of the apparent failure of these conventional models, I offer an alternative vision of inflation and discuss the implications for investors.

 

 

“Hot” inflation prints

How transitory are the latest round of price increases? To be sure, inflation has been surprising to the upside everywhere. 

 

 

In the US, June CPI and PPI came in hot. Headline CPI printed at 5.4%, compared to consensus expectation of 4.9%; Core CPI was 4.5% (vs. 4.0% expected); PPI at 7.3% (6.8% expected); and Core PPI at 5.6% (vs. 5.1% expected). In the wake of the strong CPI report, the Council of Economic Advisers released an analysis showing that “a large part of the increase in Core CPI is due to cars and pandemic-affected services”, which is transitory.

 

 

The CEA is largely correct. An analysis of the double-digit increases in Core CPI came is attributable to temporary shortages or pandemic-related factors:
  • Car rental 87.7%
  • Used cars 45.2%
  • Gasoline 45.1%
  • Laundry machines 29.4%
  • Airfare 24.6%
  • Moving 17.3%
  • Hotels 16.9%
Fortunately, Owners’ Equivalent Rent (OER) remains tame. As a reminder, OER has about a 25% weight in the CPI basket, but it has half that weight in PCE, the Fed’s preferred inflation gauge.

 

 

While the debate over the transitory nature of the current price spike will inevitably continue. None of it matters in the long-term for policymakers. What really matters to the sustainability of inflation is the level of wage increases.

 

 

The Reagan Revolution revisited

Remember the Reagan Revolution? When Ronald Reagan was elected in 1980, a regime change occurred in the returns to capital and labor. While productivity continued to rise, but real wages stagnated. The gains in productivity accrued to the suppliers of capital. In hindsight, the change is attributable to a series of microeconomic policy changes, such as deregulation, and most of all, free trade in the form of NAFTA and the transformation of China into the global factory for the world which forced down US wage rates.

 

 

Monetary policy also played a key role in holding down inflation and wages. In the post-Reagan era, starting with Paul Volcker, the Fed sought to raise rates at the slightest hint of wage pressures. Between 1980 and the GFC, the Fed Funds rate (black line) stayed above annual increases in average hourly earnings (blue line). The Fed especially tightened when AHE rose above CPI (red line). 

 

 

Inflation ran out of control in the 1970’s, and the Fed learned its lesson from that era. The way to stop the cycle ever-rising inflationary expectations is to break it through the wage link. If wage increases stay tame, inflation will stay under control. 

 

The following chart depicts the legacy of the Volcker Fed’s inflation-fighting policy. The blue line is the Fed Funds rate minus changes in Average Hourly Earnings. A positive number is a signal of tight monetary policy from a labor provider’s viewpoint, and a negative number is the opposite. Core CPI (red line) is provided as a reference point for inflation.

 

 

A Grand Experiment occurred in the wake of the GFC. Policymakers responded with a combination of very low-interest rates and quantitative easing. Inflation did not respond to conventional theory. It remained relatively tame and the US did not become the Weimar Republic, Zimbabwe, or Venezuela.

 

 

The Un-Volcker Fed

In April, I wrote that Jerome Powell has transformed Fed policy (see How Powell, the Un-Volcker, is remaking the Fed). It isn’t just FAIT (Flexible Average Inflation Targeting), which is the Fed’s new framework for determining monetary policy, but how the Fed interprets its mandate of price stability and full employment. The new policy is on full display in Powell’s Semiannual Monetary Policy Report to the Congress last week.

 

Most notably, the Powell Fed has continued the Yellen Fed’s focus on inequality. Its main tool is to run the economy hot so that labor shortages can put upward pressure on wage rates, which reduces inequality. While the Fed recognizes that this is a very crude tool and would prefer to see fiscal policy do the heavy lifting to reduce inequality, Powell’s testimony nevertheless emphasizes the Fed’s inequality focus.

 

Conditions in the labor market have continued to improve, but there is still a long way to go…However, the unemployment rate remained elevated in June at 5.9 percent, and this figure understates the shortfall in employment, particularly as participation in the labor market has not moved up from the low rates that have prevailed for most of the past year…

 

Pandemic-induced declines in employment last year were largest for workers with lower wages and for African Americans and Hispanics. Despite substantial improvements for all racial and ethnic groups, the hardest-hit groups still have the most ground left to regain.
Powell also gave a nod to the “Fed Listens” initiative, which is a way of reaching out to the community from a bottom-up basis.
We understand that our actions affect communities, families, and businesses across the country. Everything we do is in service to our public mission. The resumption of our Fed Listens initiative will further strengthen our ongoing efforts to learn from a broad range of groups about how they are recovering from the economic hardships brought on by the pandemic. We at the Federal Reserve will do everything we can to support the recovery and foster progress toward our statutory goals of maximum employment and stable prices.
Can you imagine such remarks from Volcker or Greenspan? The Powell Fed has explicitly downgraded the wage pressure-inflation link in its approach to monetary policy.

 

 

The pendulum swings back

Having established that wages constitute an important component to the inflation equation, I believe the odds of rising wages which puts upward pressure on inflation is high. That’s because the pendulum of returns to the capital versus labor is about to swing back.

 

One key reason for falling wages in the developed world is labor arbitrage. The now-famous Milanovic “elephant” graph of global winners and losers tells the story. As the world globalized its supply chains between 1988 and 2008, the winners were the middle class of emerging market economies (and China in particular) and the very rich because they engineered and profited from the globalization trend. The main losers were the middle class in developed economies who saw their jobs offshored and bargaining power diminish.

 

 

The pendulum is swinging back. It began under the Trump Administration, whose tariff and Buy America policies arrested the offshoring trend. In addition, China was facing its own age demographic challenges and its supply of labor was diminishing. Biden has continued Trump’s Buy America initiatives. In addition, he has proposed an ambitious infrastructure spending program and government spending designed to address inequality. This policy mix should raise wages. Rising wages, especially in poor households, should buoy economic growth and government finances as payroll taxes rise and act to stabilize government debt ratios. 

 

In the short run, there have been numerous accounts of labor shortages putting upward pressure on employee compensation. That’s not unusual. A group of academics published a paper that studied the effects of pandemics on capital and labor markets after wars and pandemics found that wage pressures rise after pandemics, largely owing to a decrease in the labor supply.

 

 

Fast forward to 2021. The pandemic has decreased the labor supply from a combination of early retirement, the inability of women to work because of a lack of childcare, and dissatisfaction with working conditions. Lowly paid workers in hospitality and retail experienced increased customer abuse during the pandemic, and some white-collar workers who worked from home found frustration with their commuting time as they returned to their offices.

 

A recent incident at a Lincoln, Nebraska Burger King where the staff quit en mass recently went viral. Employees complained about working without breaks and in kitchens that were up to 90F.

 

 

The June NFIB small business jobs report showed that labor shortages remains a challenge.
“In the busy summer season, many firms haven’t been able to hire enough workers to efficiently run their businesses, which has restricted sales and output,” said NFIB Chief Economist Bill Dunkelberg. “In June, we saw a record high percent of owners raising compensation to help attract needed employees and job creation plans also remain at record highs. Owners are doing everything they can to get back to a full, productive staff.”

 

A net 39% (seasonally adjusted) of owners reported raising compensation (up five points), a record high. A net 26% plan to raise compensation in the next three months (up four points).

 

Up two points from May’s report, 63% of owners reported hiring or trying to hire in June. A seasonally adjusted net 28% of owners plan to create new jobs in the next three months.

 

Finding qualified workers remains a problem for small businesses as 89% of those hiring or trying to hire reported few or no “qualified” applicants for their open positions in June.

Wage gains are particularly acute in transportation, logistics, and hospitality industries. Moreover, recent wage increases by large employers like Amazon, Walmart, and McDonald’s are putting upward pressure on compensation for unskilled workers.
 

 

Wages are rising. A whole host of circumstances such as a pandemic-induced labor shortage and government policies are putting upward pressure on wages and, by implication, inflation. 

 

 

Investment implications

Putting it all together, the historic imbalance between capital and labor has become extremely stretched and the pendulum is swinging back. For investors, this presents a number of challenges as the returns to capital compress and inflation rise.

 

 

The conventional hedge against inflation is to buy shares of companies that can pass through price increases. This include companies with strong branding or able to extract monopolistic profits, commodities, and resource extraction companies in mining and energy. An unconventional and overlooked investment strategy is trend following, as outlined in a recent paper, “The Best Strategies for Inflationary Times”.

Over the past three decades, a sustained surge in inflation has been absent in developed markets. As a result, investors face the challenge of having limited experience and no recent data to guide the repositioning of their portfolios in the face of heighted inflation risk. We provide some insight by analyzing both passive and active strategies across a variety of asset classes for the U.S., U.K., and Japan over the past 95 years. Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect. Commodities have positive returns during inflation surges but there is considerable variation within the commodity complex. Among the dynamic strategies, we find that trend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability. We also provide analysis of alternative asset classes such as fine art and discuss the economic rationale for including cryptocurrencies as part of a strategy to protect against inflation.

 

 

High expectations for earnings season

Posted by Cam Hui -

Mid-week market update: As the market enters into Q2 earnings season, FactSet reported that consensus estimates are calling for an astounding 63.3% YoY EPS growth.
 

 

While that growth estimate appears to be a high bar, investors have to keep in mind the low base effect. As well, the historical record shows that actual growth has tended to exceed estimates. In other words, the bears shouldn’t count on earnings disappointment as a catalyst for a price downdraft.

 

 

S&P 500 target: 4803.62

FactSet further reported that the bottom-up derived S&P 500 target is 4803.62, which is 11.2% above last Thursday’s closing level (the publication date of the report). 

 

 

How accurate have those estimates been? It depends on what your lookback period is in determining the track record. They’ve been underestimating returns over the past five years but overestimating returns over longer time frames.

Over the past five years, Industry analysts have underestimated the price of the index by 0.5% on average (using month-end values). Over the past 10 years, industry analysts have overestimated the price of the index by 1.5% on average (using month-end values). Over the past 15 years, industry analysts have overestimated the price of the index by 9.1% on average (using month-end values). It is interesting to note that on June 30, 2020, the bottom-up target price was 3327.64. One year later (on June 30, 2021), the S&P 500 closing price was 4297.50. Thus, industry analysts underestimated the closing price at the end of June 2021 by nearly 23% one year ago.

In light of recent results, it’s hard to be too bearish on the stock market.

 

 

Sentiment warnings

This does not mean, however, that the stock market can rise in a straight line. Sentiment models have been flashing warning signs for some time, but sentiment can be an inexact timing signal when readings are overly giddy. As an example, Callum Thomas’ Euphoriameter is at a bullish extreme. The historical record shows that the market has continued to either advance or trade sideways on the occasions when it has been this high.

 

 

NDR’s Crowd Sentiment is similarly stretched. The S&P 500 has exhibited tepid returns when readings have been this high. However, the historical annualized gain of -0.5% is hardly a strong reason to short the market.

 

 

 

The internal rotation continues

Willie Delwiche observed that only a quarter of global markets are above their 50 dma and the S&P 500 has historically struggled under such conditions.

 

 

This time may be different. As I have pointed out endlessly, the market is undergoing an internal rotation between growth and value. US equities have taken on growth characteristics owing to the large weighting in large-cap technology stocks in the S&P 500, while non-US stocks have taken on value characteristics by default. Value is on the ropes, but the value/growth ratio is exhibiting a positive RSI divergence and a nascent breadth turnaround.

 

 

 

Watch small caps!

Where does that leave us? I am not overly concerned about a significant downdraft. The relative performance of defensive sectors are not showing any leadership qualities with the exception of real estate.

 

 

My base case calls for a period of sideways consolidation, but I am watching small-cap stocks as a barometer that the market could stage a surprise rally. The Russell 2000 has been trading sideways in a range-bound pattern since February, but it is testing an important Fibonacci relative support level.

 

 

Interestingly, the S&P 600, the “other” small-cap index, is behaving much better than the widely watched Russell 2000. S&P has much stricter profitability inclusion criteria and it therefore has a higher quality bias. The S&P 600 is in a minor uptrend and it is only testing the 50% retracement level relative to the S&P 500, whereas the Russell 2000 to S&P 500 ratio is testing its 61.8% retracement level.

 

 

Ironically, the widespread evidence of negative breadth has translated into near bullish conditions. Both the NYSE and NASDAQ McClellan Oscillators are nearing oversold levels which have been signals of tradable bottoms.

 

 

Stay tuned for further developments, and don’t get too bearish.

 

 

Respect the uptrend

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

Brace for minor bumpiness

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

 

 

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

 

 

Warning signs

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

 

 

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

 

 

 

Still an uptrend

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

 

 

 

Pullbacks should be shallow

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

Respect the uptrend. Buy the dip.

 

 

Seven reasons to fade the growth scare

Posted by Cam Hui -

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

 

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

 

 

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

 

 

Lack of cross-asset confirmation

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

 

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

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

 

 

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

 

 

 

Value poised for a comeback

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

 

 

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

 

 

 

A value hiccup in an uptrend

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

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

 

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

 

 

 

Growth stocks are highly extended

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

 

 

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

 

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

 

 

 

Earnings Revisions Are Strong

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

 

 

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

 

 

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

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

 

 

Delta and Lambda: Under control

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

 

Here comes the PBoC

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

 

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

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

 

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

 

 

Monetary accommodation is on the way.

 

 

Why are bond yields falling?

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

 

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

 

 

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

Posted by Cam Hui -

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

 

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

 

 

A style bet by another name

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

 

 

 

Waiting for the cyclicals

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

 

 

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

 

 

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

 

 

 

A growth scare

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

 

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

 

 

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

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

 

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

 

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

 

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

 

 

Intermediate-term bullish

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

The resiliency of the S&P 500

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

An upper BB ride

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

 

 

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

 

 

Underlying strength or weakness?

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

 

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

 

 

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

 

 

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

 

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

 

 

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

 

 

A style review

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

The Materials sector also violated its absolute and relative uptrends.

 

 

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

 

 

 

Why I am not bearish

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

How to navigate the mid-cycle expansion

Posted by Cam Hui -

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

 

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

 

 

Mapping the mid-cycle expansion

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

 

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

 

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Investment implications

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

 

 

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

 

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

 

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

 

 

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

All of the important metrics for the economy remain positive.

 

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

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

 

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

Why the stock market isn’t going to crash

Posted by Cam Hui -

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

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

 

 

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

 

 

A bifurcated market

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

 

 

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

 

 

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

 

 

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

 

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

 

 

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

 

Bitcoin’s existential threat

Posted by Cam Hui -

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

 

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

 

 

The quantum computing threat

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

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Wallet security

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

 

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

 

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

 

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

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

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

Measuring the effects of the Fed’s reversal

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The Fed’s hawkish pivot and reversal

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

 

 

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

 

 

Bond market response

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

 

 

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

 

 

How persistent is the growth revival?

 

 

The cyclical response

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

 

 

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

 

 

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

 

 

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

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

 

 

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

 

 

 

Value vs. growth response

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

 

 

 

Technical vs.  fundamentals

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long GDX

 

The Fed’s next challenge: Wage pressure

Posted by Cam Hui -

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

 

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

 

The Fed’s dilemma

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

 

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

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

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

Lisa Abramowicz at Bloomberg summarized the policy dilemma:

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

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

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

 

How broad and inclusive?

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

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

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

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

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

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

 

 

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

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

 

 

The market response

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

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

 

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

 

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

 

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

 

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

Just a hiccup?

Posted by Cam Hui -

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

 

 

Was that it? Is the seasonal weakness over?

 

 

A broad recovery

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

 

 

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

 

 

Over in Asia, Japan has rebounded.

 

 

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

 

 

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

 

 

Key risks

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

 

 

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

 

 

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

 

 

 

Resolving the bull and bear cases

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

 

 

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

 

Stay tuned.

 

 

Disclosure: Long SPXL

 

Boo! Powell scares the children!

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The Fed’s hawkish pivot

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

 

 

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

 

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

 

The bears aren’t in control

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

 

 

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

 

 

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

 

 

 

A tale of two markets

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

 

 

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

 

 

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

 

 

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

 

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

 

 

What’s ahead for gold

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

 

 

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

 

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

 

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

 

 

Disclosure: Long GDX

 

China rides to the rescue?

Posted by Cam Hui -

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

 

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

 

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

 

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

 

 

Mapping China’s slowdown

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

 

 

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

 

 

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

 

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

 

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

 

 

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

 

 

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

 

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

 

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

 

 

The Fed’s hawkish turn

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

 

 

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

 

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

 

 

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

 

 

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

 

 

Equity market implications

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

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

 

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

 

 

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

 

 

 

No market crash

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

 

 

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