Waiting for the FOMC

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

An asset rotation review

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

 

 

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

 

 

Global equity market review

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

 

 

 

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

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

 

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

 

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

 

 

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

 

 

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

 

 

 

Emerging markets are weak

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

 

On one hand, valuations are becoming more attractive.

 

 

On the other hand, investors face considerable risks.

 

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

 

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

 

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

 

 

Waiting for the FOMC

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

 

 

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

 

 

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

 

 

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

 

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

 

 

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

 

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

 

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

 

 

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

 

 

What say you, Jerome Powell?

 

 

Making sense of the Great Resignation

Posted by Cam Hui -

An unusual labor market shift has occurred since the onset of the pandemic. Employers everywhere are complaining about a lack of quality employees. The Beveridge Curve, which describes the relationship between the unemployment rate and the job opening rate, has steepened considerably. 

 

 

Workers are not returning to their jobs, at least not without considerably more incentives. Some factors that affected labor supply are temporary and should moderate over time, such as the fear of catching COVID-19 and childcare availability, but many people are reassessing their priorities in the wake of the pandemic. They call it the “Great Resignation”.
 

The Great Resignation isn’t just an American phenomenon. The EU has voiced concerns about aggravated labor shortages. The Strait Times reported a one-day strike in South Korea:
 

Tens of thousands of labour union members took to the streets across South Korea on Wednesday (Oct 20) to demand better working conditions for irregular workers and a minimum wage hike.

 

This was despite repeated government warnings that the rally was illegal and violated Covid-19 restrictions.

In Canada, the Globe and Mail reported that a Bank of Canada survey found widespread concerns about labor shortages:
 

The business outlook survey found Canadian companies optimistic about future sales growth, but experiencing significant capacity constraints. Sixty-five per cent of respondents said they would have “some difficulty” or “significant difficulty” meeting an unexpected surge in demand.
 

The biggest issue is labour. Although Canada’s unemployment rate remains elevated, at 6.9 per cent last month, companies are having trouble attracting workers. Just more than a third of respondents to the business survey said labour shortages were restricting their ability to meet customer demand. Moreover, 71 per cent of respondents said labour shortages were more intense than a year ago, while only 7 per cent said they were less intense.

What’s going on? What does that mean for the economy and what are the investment implications of the Great Resignation?
 

 

A Great Reshuffle

The Great Resignation can be viewed through different lenses. First, a Gallup poll revealed that views of the job market are at a historical high. Tightness in the labor market is very real.
 

 

If we segment population by age, the Great Resignation is actually a demographic-related Great Reshuffle, which is what LinkedIn CEO Ryan Roslansky called it, according to Business Insider. Younger workers are taking advantage of the labor shortage to upgrade their careers.

The Great Resignation that you’ve been hearing so much about is really a “Great Reshuffle.”
 

That’s according to LinkedIn CEO Ryan Roslansky in a recent interview with TIME. He said his team tracked the percentage of LinkedIn members (of which there are nearly 800 million) who changed the jobs listed in their profile and found that job transitions have increased by 54% year-over-year.
 

Younger workers are leading the way.
 

Gen Z’s job transitions have increased by 80% during that time frame, he said. Millennials are transitioning jobs at the second highest rate, up by 50%, with Gen X following at 31%. Boomers are trailing behind, up by just 5%.
 

Other research backs up the trend that the early- to mid-level employees quitting are seeking greener pastures in the form of a new job. In late July, a Bankrate survey found that nearly twice as many Gen Z and millennial workers than boomers planned to look for a new job in the coming year. In August, a study by Personal Capital and The Harris Poll found that two-thirds of Americans surveyed were keen to switch jobs. The majority of Gen Zers felt that way (91%), as did more than a quarter of millennials.

 

 

The demographic effect is also evident when wage growth is tracked by age. 

 

 

Workers aren’t just seeking better pay. They’re looking for better flexibility in the wake of the pandemic. Staffing firm Robert Half’s CEO stated in his Q3 earnings call that candidates are seeking premiums if companies want them to work on-site [emphasis added]:

 

It’s at the transactional level, accounting operations, technology operations. Clients are more apt for them to want them to be on site. For the higher-level management resources, for tech developers, database administrators, they’re more inclined or more accepting of remote roles there. So it makes it easier for us with the latter than with the former. Candidates actually want a premium today if you want them to be on site. And many clients will pay that. Some won’t.

 

 

Viewed through a geographic lens, high quit rates were observed in regions with either high Delta variant infections or lower costs of living. In effect, the story is the same. Workers are seeking better quality of life and better pay.

 

 

Further analysis shows that it is the lower-paid and lower-skilled workers who are receiving the highest pay increases.

 

 

 

Creative destruction at work

In the face of widespread worker shortages, companies that thrive in the current environment will have to change their business models. To be sure, the latest NFIB survey was full of complaints from small business owners who are unable to hire qualified workers. If the problem was simply excessively supportive government support, the problem wouldn’t be worldwide. Instead, companies need to change their business models. It’s the free market process of creative destruction at work.
 

Business Insider documented the story of a Florida worker who applied to 60 entry-level jobs from employers who complained about finding qualified employees. He got exactly one interview. This is anecdotal evidence that many employers are used to better bargaining power and they haven’t adjusted their expectations in accordance to changing conditions.
 

Two weeks and 28 applications later, he had just nine email responses, one follow-up phone call, and one interview with a construction company that advertised a full-time job focused on site cleanup paying $10 an hour.
 

But Holz said the construction company instead tried to offer Florida’s minimum wage of $8.65 to start, even though the wage was scheduled to increase to $10 an hour on September 30. He added that it wanted full-time availability, while scheduling only part time until Holz gained seniority.

When large employers like Amazon have boosted the average starting wage to $18 per hour, some small employers with low-skilled workers won’t be able to compete at their current worker intensity levels. They will either have to adjust or go out of business. In addition, Amazon’s wage pledge will put upward pressure on manufacturing jobs, which pay more but reduce the skilled worker wage premium.
 

There are two obvious ways that companies can thrive in the current environment. The ones with already unionized workforces will enjoy a competitive advantage. Bloomberg documented the difference between United Parcel Service, which beat both EPS and sales expectations, and FedEx.
 

The company has weathered a labor shortage better than its key competitor because, unlike FedEx, it has a union workforce and pays the highest wages in the industry. Compensation and benefits rose only 0.6% in the quarter from a year ago. 
 

“I feel really good about our ability to manage through the labor cost inflation that many companies are dealing with today,” Tome told analysts.  

This is not to imply that unionizing a workforce is a quick fix for competitive problems as it is unclear how such transitions would affect a company’s business models and operating practices. 
 

The FRED Blog pointed out that the quit rate between private sector and government workers has diverged dramatically since the pandemic. While government workers are not necessarily unionized, their HR relationship is more regimented and more union-like, and the workers are older. Nevertheless, this is one piece of evidence that a unionized or near-unionized will see greater turnover stability.
 

 

The other way to compete in an era of tight labor markets is to substitute capital for labor through automation. Core capital goods orders have been very strong in this cycle. They should maintain their strength in light of the tight labor market, which should spark a period of productive non-inflationary growth. On top of that, climate change initiatives will result in a surge of investment in new technologies and infrastructure.
 

 

The Great Resignation is likely to set off a violent period of creative destruction. Investors will need to assess the strategies adopted by management in the face of tight labor markets. Some companies will simply not survive. As an example, the market cap of Palm was over $50 billion at the height of the NASDAQ Bubble, but few will shed a tear for its demise today. That’s how free market adjustments work.

 

 

The post-Black Death boom

The recovery from the 2020 pandemic is likely to parallel the historical experience of past pandemics. While COVID-19 isn’t the Black Death, a Bloomberg article outlined the economic effects of the Black Death during the second half of the 14th Century. As the epidemic killed off nearly 60% of Europe’s population, real wages rose.
 

 

History doesn’t repeat itself, but it does rhyme. The recovery from the Black Death sparked a re-focus on personal satisfaction and consumption boom. Sound familiar?

 

The change in behavior was more stark. “The Black Death created not just the means for wider parts of the population for excessive consumption – but the traumatizing experience of sudden decimation in the earthly life also triggered the impetus to enjoy it to the fullest, while still able to,” Schmelzing notes.

 

Products that hadn’t been for mass consumption earlier — such as linen underwear and glass panes in windows — became more widely available as cheap capital rushed to satiate the growing desire to consume, according to “Freedom and Growth,” historian Stephan Epstein’s review of states and markets in Europe between 1300 and 1750. Sumptuary laws that, among other things, sought to limit the height of Venetian women’s platform shoes were the state’s way to rein in conspicuous consumption; eventually the mad spending ended and savings went to bond markets. A republican ethos was born.

The spending boom kicked off a virtuous growth cycle. It began with a spending boom, which the economy recycled into greater savings and pushed interest rates lower.
 

 

Today’s post-COVID economy is undergoing a spending boom characterized by excess demand, which has strained supply chains. The next phase of the recovery should see inflation ease and higher investment spending and higher productivity. In other words, don’t worry about labor shortages or inflationary pressures. Barring unforeseen exogenous events, the next few years should have a boom in the global economy.
 

The two main key risks to this forecast is a series of rolling climate change-related disasters such as floods and heatwaves that disrupt the supply chain (see Not your father’s stagflation threat) and a flare-up of COVID-19. Most of the developed economies have ample supplies of vaccines, but a number of emerging and frontier market economies don’t. The risk is these countries act as a reservoir for the virus that eventually invades other countries. COVID-19 won’t be totally controlled until the world achieves herd immunity.

 

 

A pause in the advance

Posted by Cam Hui -

Mid-week market update: The S&P 500 had been on an upper Bollinger Band ride, but the ride may be over. In the past year, such events have resolved themselves in either a sideways consolidation or pullback. As well, the 14-day RSI has reached levels consistent with a pause in the advance. 
 

 

Based on recent history, we should know about the magnitude of the pullback within a week. Initial support can be found at the breakout level of about 4540.

 

 

Intermediate-term bullish

Regardless of the scale of any stock market weakness, the intermediate-term outlook remains bullish. There is nothing more bullish than fresh highs, and the Dow recently punched its way above resistance to an all-time high. The Transports have surged to test resistance but weakened. Further gains in this index would constitute a Dow Theory buy signal.

 

 

Market breadth is showing signs of strength. The S&P 500, NYSE, S&P 400 Advance-Decline Lines reached all-time highs. Only the NASDAQ and S&P 600 A-D Lines are weak. These are signs of broad underlying strength, not weakness.

 

 

To be sure, small-cap indices are struggling with resistance and they have not staged upside breakouts and they are weak relative to the S&P 500. However, relative breadth is improving (bottom panel) and we are entering a seasonally positive period where small stocks should enjoy some tailwinds.

 

 

 

Sentiment not extreme

Sentiment readings are supportive of further gains. The latest update from Investors Intelligence shows that % bulls are recovering, but % bears remain stubbornly high. There is much more room for sentiment to improve before they reach an overbought extreme.

 

 

 

Bullish and bearish catalysts

I interpret these conditions as conducive to further gains after a brief pause. Possible catalysts for either upside or downside volatility could come from the FOMC meeting next week. The Bank of Canada sounded a hawkish tone today by announcing the end of quantitative easing and pulling forward the calendar for rate hikes. The Canada yield curve went bonkers. 2-yield yields rose the most and the curve flattened in response. While recent Fedspeak has signaled the start of tapering, the risks is next week’s policy response will be skewed hawkish.

 

 

As well, a deal for the Biden fiscal plan may be close this weekend. While a general corporate tax increase is off the table, a 15% corporate minimum tax could be passed. Such a measure would negatively affect Big Tech and pharmaceutical companies with intellectual property held in subsidiaries resident in low-tax jurisdictions. 

 

 

What more could the bulls ask for?

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 all-time high

It is said that there is nothing more bullish that an all-time high. The S&P 500 did just that on Thursday. Neither of my warning signals have sounded warnings just yet. The 14-day RSI is not overbought. As well, the VIX Index has not fallen below its lower Bollinger Band.

 

 

What more could the bulls ask for?

 

 

Other bullish signs

There were other bullish signals confirming the fresh high. A comparison of the S&P 500, mid cap S&P 400, and small cap S&P 600 shows that only the S&P 600 hasn’t achieved a fresh high.

 

 

Different versions of the advance-decline lines were also supportive of the bull move. The S&P 500 and NYSE A-D Lines broke out to new highs while the S&P 400 A-D Line is close. Only the NASDAQ and S&P 600 A-D Lines are laggards.

 

 

The latest rally is characterized by value stock leadership. Both the large cap Russell 1000 Value Index and Mid-cap Value have broken out to new highs. Small-cap value is lagging.

 

 

The bulls couldn’t ask for much more than this.

 

 

Uneven legislative progress

On the legislative front, the Democrats continue to squabble over Biden’s Build Back Better legislation. A piece of good news for equity investors is the planned corporate tax increases appears to be off the table. 

 

I am monitoring the infrastructure stocks (PAVE), which have staged an upside relative breakout from a falling trend line. Is that a ray of hope that a more pronounced capex cycle is on the way?

 

 

 

Sentiment not extreme = More room to rally

Sentiment is turning bullish, but levels are not extreme enough to flash contrarian bearish warnings. The combination of strong positive momentum and mild sentiment readings are supportive of further gains.

 

The AAII bull-bear spread is one of many examples of improving sentiment, though conditions don’t indicate a crowded long.

 

 

The Fear & Greed Index is another example.

 

 

I could go on, but you get the idea.

 

 

A pause ahead?

Tactically, the market advance is due for a brief period of consolidation and possible minor pullback. The S&P 500 has been on an upper Bollinger Band ride. At some point in the near future, the ride will end and it may have ended Friday when the S&P 500 was down -0.1%. The market has gone on five upper BB rides in the past year. It has consolidated sideways on three occasions and pulled back on two. The strong underlying strength of the market leads me to believe that a consolidation is the most likely outcome but any pullback should be fairly shallow.

 

 

We are in the heart of earnings season next week. While the response to last week’s reports have mostly been positive, don’t be surprised if the market hits an air pocket from an earnings report. In particular, keep an eye on FB (Monday) and GOOGL (Tuesday) in light of last week’s SNAP comments on  the advertising environment.

 

 

In conclusion, there is nothing more bullish than a fresh high and the S&P 500 has surpassed that hurdle. Tactically, the market can pause its advance at any time but downside risk should be limited. The intermediate term outlook is bullish and traders should be prepared to buy any dip in anticipation of further gains.

 

 

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Where are we in the market cycle?

Posted by Cam Hui -

Where are we in the market cycle? The accompanying chart shows a stylized market cycle and changes in sector leadership.

  • Bear markets are characterized by the leadership of defensive sectors such as healthcare, consumer staples and utilities.
  • Early-cycle markets are sparked by the monetary stimulus or the promise of monetary stimulus. The market leaders in this phase are the interest-sensitive sectors such as financials and real estate.
  • Mid-cycle markets are characterized by economic expansion. Expect rotation into consumer discretionary stocks, followed by capital-intensive industrials and technology.
  • Late-cycle markets will find investors become increasingly concerned about inflation. Inflation hedge sectors such as energy and materials lead during this phase.
  • In response to rising inflation expectations, either the central bank or the market tightens monetary policy, which resolves in a market top and a bear market.

 

 

Please be aware that while the psychology of a market cycle parallels an economic cycle, they are not the same. Since Wall Street’s attention span approximates that of a 16-year-old, it is not unusual at all to find several market cycles compressed within a single economic cycle.

 

What I have described is an idealized market cycle. This economic and market cycle is very different from others. The last bear market was not sparked by monetary tightening, but the exogenous effect of a pandemic. The market leaders of the 2020 bear were not the usual defensive names. Instead, investors piled into work-from-home beneficiaries consisting mostly of Big Tech stocks.

 

With that preface in mind, where are we in the psychology of the market cycle?

 

 

A late-cycle advance

Signs are accumulating that both the psychological backdrop and market action are pointing to a late-cycle advance. The latest BoA Global Fund Manager Survey found that respondents believe inflation is the biggest tail-risk facing investors.

 

 

In response, global institutions have rotated into inflation hedge vehicles.

 

 

Indeed, commodity prices have staged upside breakouts to fresh highs. The strength isn’t just in the energy heavy headline commodity indices, but the equal-weighted commodity indices too. 

 

 

The acute shortage in some commodities has been insane. As a consequence, backwardation of the futures curve. Normally, most futures contracts are in contango, with futures prices slightly above the spot prices with the difference reflecting the storage and carrying costs. Backwardated markets have the spot price above the futures price, which indicates a physical shortage. As an example, the one-year contango in December oil futures have completely blown out.

 

 

The shortages can also be found in commodities other than crude oil. The LME announced emergency measures to ensure “orderliness and continued liquidity” in the copper market by setting limits on the nearest-term spreads and allowances for holders of some short positions to avoid physical delivery. 

 

 

Inflation: This too will pass

Before everyone gets overly excited about a commodity bubble, the strength in commodity prices is attributed to – you guessed it, supply chain difficulties and their ripple effects. Goldman Sachs commodity analyst Jeff Currie explained the problem in a recent Bloomberg podcast.

 

It starts in China, coal in China, and then that creates tightness in gas that created the problems in Europe — Europe substitutes into oil, creating the problem in oil. You’ve shut down the (aluminum) smelters, the zinc smelters, you know, so a lot of people say, you know, that the ground zero of those problems really was coal in China. So I do want to say the situation in China is very dire, but it’s just one part of the world that can create a solution to it rather quickly and they’re trying to with investments in Mongolia. But I want to be careful about restarting a lot of that shuttered coal. For those of us that are Americans and know what a superfund site is in the U.S., restarting these facilities is going to be a lot more difficult, a lot more expensive than I think what people think it will be. So you really got to focus on the new, more cleaner, sophisticated coal, in some of these mines in places like Mongolia. So bottom line, it’s going to be tight over the next three to six months, but once you get that Mongolian coal up and running, the situation should ease, but no way does it solve it.

The root cause of the current spike in inflation indices is a demand-pull problem attributable to supply chain bottlenecks. When an economy exhibits too much demand and not enough supply of goods, inputs and workers, inflation is the result. Tighter monetary policy will not create more natural gas, copper, shipping, and trucking capacity. It is fiscal policy that can play a greater role.

 

Stephanie Kelton, one of the leading proponents of Modern Monetary Theory (MMT), wrote a NY Times Op-Ed in April on how to think about inflation in connection with fiscal policy, specifically Biden’s Build Back Better plan. In short, it’s all about the capacity of the economy to accommodate demand in the face of fiscal stimulus.
 

The key to responsibly spending vast sums of money lies in carefully managing the economy’s real productive limitations…

 

Depending on how big Congress ultimately decides to go on infrastructure, and how quickly, it may need to unleash a whole suite of inflation-dampening policies along the way…

 

These mostly non-tax inflation offsets could include industrial policies, like much more aggressively increasing our domestic manufacturing capacity by steering investment back to U.S. shores, using even more ‘carrot’ incentives like direct federal procurement, grants and loans, as well as more ‘sticks’ like levying new taxes to discourage the offshoring of plants. Reforming trade policies is another option: Repealing tariffs would make it easier and cheaper for American businesses to buy supplies manufactured abroad and easier for consumers to spend more of their income on products made outside of our borders, draining off some domestic demand pressures.
Despite the recent inflation angst, I am still on Team Transitory. I have shown before how the inflation surge is explained mostly by strength in durable goods demand as people began to work from home and switched their demand from services to goods.

 

 

The University of Michigan consumer survey shows that the buying conditions for durable goods is falling as prices rose. It’s difficult to see how the current inflation surge could sustain itself if households demand falls in response to higher prices.

 

 

Already, we are seeing signs of the transitory nature of the spike in the data. Monthly inflation rates topped out during the April-June period and have been moderating ever since.

 

 

What about inflation expectations? Some Fed speakers and investment strategists have voiced concerns that inflation expectations could soar and become unanchored, which would create the psychology necessary to spark an inflationary spiral.

 

 

Expectations is a red herring, according to a research paper by Fed researcher Jeremy Rudd. He concluded that policy makers should focus on reported inflation rather than expectations. Rudd’s paper also contained a controversial footnote that dismissed the economics profession in the context of forecasting.

 

I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.
A separate Cleveland Fed study found that the accuracy of forecasted inflation fell dramatically as the time horizon lengthened. While the long-term record from 1986 was reasonable, the recent record starting in 2011 showed that the accuracy of inflation forecasts fell dramatically within two months and was virtually useless past a six-month time horizon.

 

 

The market is setting up for a mistake in its inflation and interest rate expectations. Fed Funds futures are indicating a rate hike by the July 2022 FOMC meeting and a second increase at the December meeting. These expectations are likely too aggressive.

 

 

 

Why are stocks rising?

In light of rising expectations for rate increases, why are stocks rallying? Rate hike expectations are being pulled forward and economic growth expectations are falling. The Atlanta Fed’s latest Q3 GDP nowcast has tanked to a minuscule 0.5%.

 

 

John Authers at Bloomberg attributed equity strength to TINA – RIF:

How to explain this? TINA (There Is No Alternative — to stocks), appears to have morphed into her fearsome sister TINA RIF (There Is No Alternative — Resistance Is Futile). With yields low and inflation on the horizon, bonds are regarded as unbuyable. 

To be sure, Q3 earnings season has been strong. Earnings estimates are rising and beat rates are above average. Strong positive fundamental momentum is supportive of higher prices.

 

 

All else being equal, rising EPS estimates allows the forward P/E to fall, which is supportive of valuation and stock prices.

 

 

 

The transition process

At some point in the near future, the market will begin to recognize the transitory nature of the inflation surge. Bonds will no longer be unbuyable and yields will begin to ease. That will mark the transition to the next phase of the market cycle.

 

This next phase will be marked by a leadership rotation from late-cycle inflation hedge and cyclicals back to growth stocks. Growth companies are duration plays and they have the greatest sensitivity to falling bond yields.

 

 

I don’t expect a recession-induced bear market during the transition. Recessions are bull market killers, but there are few signs of a recession on the horizon. New Deal democrat, who monitors the economy using coincident, short leading, and long leading indicators, remains bullish on the economic outlook.

 

All three time frames remain quite positive. Delta continues to recede, and the impact – if any – of the ending of all remaining emergency pandemic benefits last month has been limited.
However, the economy is likely to see a growth scare next year, which could spark a correction.

There are many signs in data that the white-hot Boom is cooling. But nothing to indicate it is actually in any danger of rolling over in the immediate future.

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

 

While it’s impossible to precisely forecast the timing of the inflection point, I can offer the guidepost of the 10-year Treasury yield, which has tracked the value/growth ratio closely in the last two years. If the 10-year yield starts to fall in a decisive way, the rotation from reflation and value to growth has likely begun.
 

 

Another upper BB ride

Posted by Cam Hui -

Mid-week market update: The S&P 500 has been undergoing a ride on its upper Bollinger Band (BB), which historically has been a bullish sign of price momentum. The bigger question is how the tape will behave when the upper BB ride ends.
 

 

Here are some observations:
  • The 5-day RSI is extremely overbought, but overbought markets can stay in a “good overbought” condition as prices advance.
  • The 14-day RSI isn’t overbought yet, and past rallies haven’t stalled until it became overbought or was near overbought.
  • The VIX Index hasn’t fallen below its lower BB yet. In the past, penetration of the lower BB has signaled either a pullback or a period of sideways consolidation.
The initial verdict is short-term bullish, though the S&P 500 will have to contend with the all-time high resistance zone between the closing high of 4537 and intra-day high of 4546.

 

 

A sentiment Rorschach test

Sentiment readings are becoming a Rorschach inkblot test for traders. On one hand, the bull-bear spread from Investors Intelligence has begun to edge up from depressed levels, which indicates a recovery of extreme bearishness and a signal that this rally has room to go. In particular, bearish sentiment edged upwards, which is an indication of continued skepticism and the market climbing the proverbial Wall of Worry.

 

 

On the other hand, Helene Meisler conducts a regular (unscientific) Twitter poll. The results from last weekend saw net bulls-bears over 30. Such an extreme reading is rare and there were only three other instances during the brief history of her poll. The market pulled back on one occasion and continued to rise on the other two. 

 

 

This is what I mean by the Rorschach test of sentiment model interpretation. I consider these models differently. The II sentiment survey tends to have a longer-term time horizon and the intermediate-term outlook for stocks is up. The Meisler survey respondent sample is made up of very short-term traders. Such extreme bullishness could be considered to be contrarian bearish in a conventional fashion or an indication of strong price momentum that could carry the market higher.

 

 

Bullish internals

A consideration of the price momentum factor, which is a stock selection factor that measures whether individual outperforming stocks continue to outperform (as opposed to market momentum, which postulates that a buying stampede will lift the index), using different flavors of the momentum factor shows that returns have been flat to up. This is an indication of a healthy internal rotation between stocks as the market rises.

 

 

Equity risk appetite is constructive. The equal-weighted ratio of consumer discretionary to staples has made a fresh all-time high, which is bullish. However, the ratio of high-beta to low-volatility stocks have lagged, though conditions are not so severe to cause any great concern.

 

 

Credit market risk appetite presents a similar picture. The relative price performance of junk bonds to their duration equivalent Treasuries have made an all-time high, indicating a strong risk appetite. But the relative price performance of investment-grade issues has lagged, though not by such a degree to be alarmed.

 

 

A further bullish catalyst could be an agreement among the squabbling Democrats on Biden’s Build Back Better bill. The current period is reminiscent of the bargaining leading up to the passage of ACA, otherwise known as Obamacare. An agreement in principle could be forthcoming by the weekend. Keep an eye on the infrastructure ETF (PAVE). An upside relative breakout could be a signal for a bullish stampede into cyclical stocks.

 

 

In conclusion, the stock market appears to be starting its melt-up into year-end. As we proceed through earnings season, individual reports may cause hiccups in what is an overbought market, but investors and traders should seize the opportunity to buy the dip.

 

Opportunities in energy and gold

Posted by Cam Hui -

As the CRB Index decisively broke out to a new recovery high while breaking through both a horizontal resistance level and a falling downtrend that began in 2008, a divergence is appearing between crude oil and gold. The oil to gold ratio has strengthened to test a falling trend line. 
 

 

This test of trend line resistance could present some opportunities for traders.
 

 

Extended energy

Has The Economist done it again? Is the latest cover a contrarian signal of a pending top for energy stocks? 

 

 

It’s starting to look that way. As energy stocks test a key absolute resistance zone, they are struggling to overcome relative resistance. At the same time, relative breadth is deteriorating (bottom two panels).

 

 

 

Washed-out gold

By contrast, the technical outlook for gold and gold miners appears far more constructive. Gold prices have traced out a double bottom after testing a support zone. Moreover, TIPs prices are rising again, indicating falling real rates, which is supportive of rising gold prices.

 

 

The washed-out nature of this group is more evident in the gold miners (GDX). GDX rallied through trend line resistance, which is positive. The percentage of bullish stocks fell to an oversold level and they have begun to recycle. In addition, the GDX to gold ratio and the small-cap GDXJ to GDX ratio have both risen through falling trend lines. These are all signals of underlying strength.

 

 

In conclusion, energy stocks may be nearing a climax top while gold and gold stocks are showing bullish signals after several months of dismal performance. Traders should avoid energy exposure and buy gold and gold stocks for better potential performance.

 

However, make no mistake, any gold rally should be treated as a tactical bull rather than a secular bull. The gold to CRB and cyclically sensitive copper to gold ratios are signaling a reflationary regime. Long-term investors should therefore seek exposure to cyclically sensitive base metal and other commodities over the shiny yellow metal for better returns.

 

 

Market liftoff?

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.
 

 

To boldly go?

Last week, I characterized the stock market as like a rocket on a launch pad. Last week’s events also featured William Shatner, the actor who played Captain Kirk in the original Star Trek series, being blasted into space. Now that Captain Kirk has gone into space, will equities follow?

 

Let’s take a look. One of the bullish tripwires I outlined was for the S&P 500 to decisively regain its 50 dma. The index convincingly breached the 50 dma and it is now testing a resistance zone, which is positive.

 

 

However, traders are cautioned to monitor the VIX Index. In the past, VIX breaches of the lower Bollinger Band have been overbought signals when market rallies have temporarily stalled in the past.

 

 

Revisiting 2011

In last week’s analysis, I also compared today’s market to summer 2011. 
 

Then, the macro backdrop was characterized by a debt ceiling impasse in Washington and a Greek Crisis in Europe that threatened the very existence of the eurozone. I can remember endless European summits and plans to make plans for Greece. The news flow worsened and it seemed like no one was in charge in Europe, but the S&P 500 tested support multiple times while exhibiting a series of positive RSI divergences. The logjam was finally broken when the ECB stepped in and announced its LTRO program. Stocks bottomed and never looked back.

 

History doesn’t repeat itself, but rhymes. Today, the market has been beset by a debt ceiling impasse in Washington and concerns over inflationary pressures which may or may not be transitory from supply chain bottlenecks. The logjam appears to have been temporarily broken when the Democrats and Republicans agreed to kick the can down the road and revisit the debt ceiling question in December. Stock prices duly staged a relief rally.

Here is how the 2011 rally played out. After the market bottomed after exhibiting a series of positive RSI divergences, advances were temporarily interrupted when the VIX Index fell below its lower BB. These were short-term cautionary signs whose bearish impulses lasted no more than a few days. Nevertheless, they can be useful tactical signals that the advance had run too far too fast and the market was in need of a breather.
 

 

 

Bullish tripwires

I also outlined two other bullish tripwires last week which have not been triggered. I was looking for bullish confirmation from high-beta small-cap stocks. Small-cap indices had been range-bound for most of this year. While they are outperforming their large-cap counterparts, just as they did in 2011, small-cap stocks have not broken out of their trading range yet.
 

 

A market rally sparked by a reflationary narrative should see an upside relative breakout by the growth cyclical semiconductor stocks (bottom panel). For now, semiconductors remain in a narrow range relative to the S&P 500.
 

 

It’s too early to sound the all-clear bullish signal just yet.
 

 

A bullish setup

Despite the lack of bullish confirmation, we are moving into a seasonally positive period. In addition, positive price momentum is supportive of further gains. A backtest of instances when the percentage of S&P 500 stocks above their 10 dma rose from below 20% to above 80% within 20 days in the last five years shows an average gain of 9.81% and a success rate of 86% after 90 days (warning: n=7). The 90-day window roughly coincides with the period of positive seasonality that the market is entering.
 

 

Sentiment appears to be turning up from a depressed level. IHS Markit conducts a monthly survey of about 100 institutional investors and found that risk appetite bottomed out in September and began to turn up, albeit from very depressed levels. The combination of a turnaround from excessively bearish sentiment and positive price momentum creates the conditions ripe for a FOMO risk-on stampede into year-end.
 

 

 

Bullish and bearish catalysts

There are two catalysts that could decide the near-term direction of the stock market and general risk appetite. Q3 earnings could be a pivotal moment for the market. Earnings growth expectations are still very high by historical standards. Fortunately, for the bulls, estimate revisions are still rising. While this bullish fundamental momentum indicator is positive, readings could change quickly if forward guidance turns sour in the coming weeks.
 

 

Street expectations for the S&P 500 are still relatively upbeat. The bottom-up derived 12-month target for the S&P 500 is 5051.70, though the accuracy of this forecast is highly variable. If history is any guide, the S&P 500 will close at between 4567 and 5137 a year from now, which represents a price gain of 2.1% to 14.9%, depending on the choice of lookback period.
 

 

As well, keep an eye on the fate of Biden’s legislative agenda, which is mired by infighting between the progressive and centrist wings of the Democratic Party. There are unconfirmed reports that the White House is aiming for some resolution by the end of October. Any positive outcome would be a signal of another fiscal impulse and could spark a risk-on rally. Keep an eye on the infrastructure stocks, which have tested a double bottom relative to the S&P 500 by remain in a downtrend. A failure by Pelosi, Schumer, and Biden to push through their bill would be disappointing for a market that has partially discounted additional fiscal stimulus.
 

 

In conclusion, my risk-on scenario remains intact but I am not ready to sound the bullish all-clear just yet. The market is poised for a FOMO stampede into year-end. While I am in the bull camp, investors should nevertheless monitor the evolution of earnings estimates as we move through earnings season and the progress of Biden’s legislative agenda for bullish and bearish catalysts.
 

Subscribers received an email alert on Friday indicating that my trading account had taken profits in his long positions and moved to cash. The market is a little extended in the short-term and don’t be surprised if the advance consolidates or pulls back next week. 
 


 

The intermediate-term outlook is still bullish. The market is also started its rally in accordance to its seasonal pattern. If history is any guide, my inner trader expects to buy back in next week if stock prices weaken.
 

 

 

Team Stagflation, or Team Transitory?

Posted by Cam Hui -

Stagflation fears are rising again. It’s a natural reaction to the short-term data. September headline CPI came in hot, though the core CPI print was in line with expectations and PPI was soft. Inflation expectations are spiking…
 

 

…while the Atlanta Fed’s GDP nowcast is plummeting. Consumer confidence is dropping, driven by supply chain bottlenecks and rising costs. The combination of these factors is becoming a threat to corporate profits.

 

 

As a QE taper is more or less baked in for November, these worries have unsettled markets as the narrative is that the Fed could be making a policy mistake. Should investors cast their lot with Team Stagflation, or Team Transitory?

 

 

Rising signs of stagflation

The most visible signs of stagflation can be found in the monthly NFIB small business survey. Small businesses have little bargaining power and therefore the NFIB survey can be a sensitive barometer of the economy. 

 

Let’s start with the good news. Sales is not a problem. Small businesses reporting “poor sales” as their single most important problem fell to a multi-year low.

 

 

However, operating internals is causing some headaches, as summarized by Marketwatch. 

 

Small businesses complain they cannot find enough skilled workers even after raising pay. Nor can they obtain parts and supplies fast enough to keep up with demand. These problems have also affected the largest businesses across the country.

 

“Small-business owners are doing their best to meet the needs of customers, but are unable to hire workers or receive the needed supplies and inventories,” NFIB chief economist Bill Dunkelberg said after the survey results.

 

More than 50% of small businesses said they couldn’t fill open positions last month, a 48-year peak. And the number of companies offering higher pay was also at a 48-year high.
The complaints of NFIB survey respondents sound like the ingredients for stagflation. Hiring plans are peaking despite the complaints about labor shortages. While compensation rates have risen strongly, small businesses are also raising prices to pass along their costs to customers. If even small companies have the pricing power to raise their prices, investors shouldn’t worry too much about margin pressure.

 

 

What about inflationary pressures? Before everyone gets overly excited about the recent hot CPI print, take a deep breath. Most of the inflationary pressure is coming from durable goods attributable to supply chain bottlenecks. August core PCE came in at 3.6%, but durable goods PCE was an astounding 7.0%.

 

Much of the perceived inflation is attributable to a change in the composition of consumer spending. Households shifted spending from services to services in response to the pandemic, which led to excess demand for goods and supply chain bottlenecks. These temporary factors should fade over time.
 

 

Much of the perceived inflation is attributable to a change in the
composition of consumer spending. Households shifted spending from services to
services in response to the pandemic, which led to excess demand for goods and supply
chain bottlenecks.

 

 

Container ship congestion on the US West Coast is peaking, indicating an easing of supply chain bottlenecks.

 

 

In addition, China’s September exports came in ahead of expectations, which is another sign of a falling of global supply chain delays.

 

 

As for services inflation, Marketwatch highlighted the divergence between the US and Sweden’s experience with the pandemic and the effects on inflation.
 

There’s one notable country that didn’t mandate shutdowns or lockdowns — Sweden. And there, services prices did decline. And now, inflation in Sweden is about 3 percentage points less than in the U.S.

 

What the Swedish experience suggests is that prices will eventually stabilize. “The surging demand for durables is correcting. Since March, it is already down by 15% but requires a further 7% decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own,” Joshi said.

 

I would also like to address the concerns of small business owners about rising wages. This analysis of quits by industry shows an inverse relationship between quit rates and pay. As most small businesses tend to be clustered in low-wage industries, it’s no surprise that labor quality and supply is a growing concern.

 

 

Further analysis of the average hourly earnings (AHE) of the three lowest-paid industries relative to aggregate AHE shows that it is the leisure and hospitality, which is the lowest-paid group, have been the standouts in 2021 (red bars). By contrast, excess wage growth in the other two low-paid industries has slightly lagged. 

 

 

The pandemic-related layoffs of 2020 were concentrated in low-paid services businesses such as retail and leisure and hospitality. The spike in average hourly earnings during the recovery is attributable to a compositional effect. In 2021, leisure and hospitality workers are playing wage catch-up. This is the picture of falling earnings inequality, which has become an objective of the Fed, and not an indication of broad-based wage pressures.

 

 

An analysis of JOLTS reveals that the quit rate is especially elevated among firms with 10-249 employees. The competitive position of small businesses are being eroded. Don’t generalize the problem in the NFIB survey to the overall economy.

 

 

 

The bull case

The stagflation story is only one side of the coin. The other side is a growth recovery into 2022 and beyond. Stagflationistas have touted the IMF downgrade of global growth from 6.0% to 5.9% in 2021 as support for their narrative. Less mentioned is the boost to 2022 global growth forecasts. In particular, the IMF raised the US 2022 GDP growth estimate from 4.9% to 5.2%. 

 

 

Already, the US Economic Surprise Index, which measures whether economic data is beating or missing expectations, is rising again. Is it any wonder why there is upward pressure on the 10-year Treasury yield?

 

 

In addition, capital goods orders and shipments are soaring. This is another signal of a strong capex cycle that should increase productivity and support non-inflationary growth.

 

 

What about rising commodity prices? Won’t that act to restrain economic growth? Relax. The energy intensity of the American economy has fallen dramatically since the stagflation era of the 1970’s.

 

 

Worries about collapsing consumer confidence are also overblown. Google searches for consumer credit is surging. As household balance sheets are strong, rising credit demand tells the story of a consumer willing to spend. Watch what they do, not what they say in surveys.

 

 

Stagflation is the combination of high inflation and slow growth. For a long-term perspective, the accompanying chart shows my Stagflation Index, defined as the spread between core PCE and real GDP growth. Even if we were to use the Atlanta Fed’s GDPNow as an input, this indicator is nowhere near the stagflation era of the 1970’s. Consistent with the IMF’s forecast of renewed growth in 2022 and 2023, the Stagflation Index using the FOMC’s Summary of Economic Projections is negative.

 

 

To be sure, the key risk to the bullish scenario can be found in the IMF forecast, which warned that inflation is tilted to the upside while growth is tilted to the downside. Federal Reserve staff economists also highlighted similar risks in their economic assessment during the September FOMC meeting.

 

 

Investment implications

I believe investors should view these stagflation fears in perspective. They are temporary, but such concerns naturally arise during a mid-cycle expansion phase. Historically, the S&P 500 has continued to advance during such phases. Unemployment is falling, but levels are not extreme and there is still slack in the economy.

 

 

Central banks are starting to pivot from emergency stimulus to taking their collective feet off the accelerator. Stocks have historically have also performed well during periods of rising rates.

 

 

Since one characteristic of rising rates is P/E compression, a short-term key for stock prices is Q3 earnings season. It’s difficult to know how earnings season will turn out, but one early sign is constructive. The Guidance Index from Bianco Research remains positive, though it is decelerating. Q3 earnings should beat expectations, though the risk is management’s body language and guidance going into Q4 and beyond.

 

 

For the last word, I offer this comment from former IMF chief economist Olivier Blanchard.

 

 

In conclusion, I am still on Team Transitory. Stagflation fears are temporary and should soften in the coming months. The macro backdrop coming out of the COVID Crisis is nothing like the stagflation era of the 1970’s. The equity bull is still alive, and investors should position themselves for a reflationary rebound. 

 

 

As I have pointed out before (see Not your father’s stagflation threat), the real risk is a series of supply chain disruptions from climate change related events like heat waves and floods that keep inflation elevated and reduce growth.

 

An excess of caution?

Posted by Cam Hui -

Mid-week market update: Is market psychology cautious enough? A recent Deutsche Bank survey of investors reveals that not only is a correction the consensus, correction sentiment rose between September and October.
 

 

SentimenTrader also observed that inverse ETF volume has spike to a record level. Is this cautious enough for you?

 

 

 

Supportive internals

The analysis of market internals reveals a number of supportive elements. A survey of Advance-Decline Lines show that all flavors except for the NASDAQ are exhibiting minor uptrends. The NASDAQ A-D Line is testing support, which is consistent with the recent lagging nature of large-cap growth stocks.

 

 

High beta small-cap stocks are also outperforming, which is another indication of improving equity risk appetite.

 

 

Credit market risk appetite, as measured by the relative price performance of junk and investment grade bonds relative to their duration-equivalent Treasury benchmarks, are showing minor positive divergences.

 

 

In addition, SentimenTrader pointed out that there is extreme pessimism in the IG market.

 

 

In conclusion, market sentiment and internals have risk/reward tilted to the upside. At a minimum, don’t be short.

 

 

Disclosure: Long SPXL

 

What rhymes with 2011?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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


 

 

The 2011 template

The market action today is somewhat reminiscent of 2011. Then, the macro backdrop was characterized by a debt ceiling impasse in Washington and a Greek Crisis in Europe that threatened the very existence of the eurozone. I can remember endless European summits and plans to make plans for Greece. The news flow worsened and it seemed like no one was in charge in Europe, but the S&P 500 tested support multiple times while exhibiting a series of positive RSI divergences. The logjam was finally broken when the ECB stepped in and announced its LTRO program. Stocks bottomed and never looked back.

 

 

History doesn’t repeat itself, but rhymes. Today, the market has been beset by a debt ceiling impasse in Washington and concerns over inflationary pressures which may or may not be transitory from supply chain bottlenecks. The logjam appears to have been temporarily broken when the Democrats and Republicans agreed to kick the can down the road and revisit the debt ceiling question in December. Stock prices duly staged a relief rally.

 

 

Does 2011 rhyme with 2021?

 

 

Supportive sentiment

Sentiment models have been signaling a market bottom. The latest readings from Investors Intelligence showed that bullish sentiment has tanked, which is an indication of capitulation. The S&P 500 has only weakened by only -5% and this level of panic is unusual for such a shallow pullback.

 

 

Even as the market began to rally, the CBOE put/call ratio remained elevated and above 1, which is an indication of fear. I interpret this to mean that the market is climbing the proverbial Wall of Worry.

 

 

 

Growing signs of transitory inflation

In addition, inflation fears may be at a zenith. The latest global PMI report shows that delivery delays may have peaked, indicating an easing of supply chain bottlenecks.

 

 

This is confirmed by reports that the semiconductor shortage problem is peaking.

 

 

The IMF forecasts headline inflation in advanced economies will peak soon and fall to an average of 2%. As the Fed prepares to begin tapering its QE purchases, tamer inflation readings should alleviate the pressure to tighten. In addition, the resignation of Rosengren of the Boston Fed and Kaplan of the Dallas Fed will lower the number of hawks at the FOMC table.

 

 

Nevertheless, I believe the Fed taper is on track at the next FOMC meeting despite the wide headline miss in the September Jobs Report. As a reminder, here is how Powell set the bar for a taper at last FOMC press conference:

So, you know, for me, it wouldn’t take a knockout, great, super strong employment report. It would take a reasonably good employment report for me to feel like that test is met. And others on the Committee, many on the Committee feel that the test is already met. Others want to see more progress. And, you know, we’ll work it out as we go. But I would say that, in my own thinking, the test is all but met. So, I don’t personally need to see a very strong employment report, but I’d like it to see a decent employment report,

Even though the September NFP missed at 194K compared to expectations of 500K, most of the miss was attributable to government job losses, specifically in education owing to unusual seasonal adjustments. August NFP was revised upward. Private employment, as measured by ADP, was strong. So were average hourly earnings and average weekly hours. Ex-government employment and the unusual education seasonal adjustments, the September figure qualifies as a “decent employment report” by Powell’s standards. The Fed will regard the headline report as an anomaly and stay the course on its taper plans.

 

 

 

Supportive valuation

As well, the equity risk premium (ERP) estimate from NYU Stern School professor of finance Aswath Damodaran rose to 4.93% at the end of September.

 

 

This ERP reading is roughly equal to the level on October 1, 2017.

 

 

 

A rocket on the launch pad

I interpret these conditions as a rocket on the launch pad. While the engineers may have ignited the engines, takeoff hasn’t been confirmed but the meltup scenario remains in play (see A Q4 meltup ahead?).

 

Here is what I would like to see to sound the all-clear signal. First, the S&P 500 needs to convincingly reclaim the 50 dma level of 4438. The small-cap Russell 2000 and S&P 600 need to stage upside breakout from their trading ranges. The upside breakouts should preferably be accompanied by small-cap outperformance.

 

 

Finally, I would like to see the growth cyclical semiconductor industry to stage an upside breakout relative to the S&P 500 (bottom panel), which would be a signal of a revival in reflationary market expectations.

 

 

Options expire in the coming week. Historically, October OpEx has been one of the most bullish OpEx weeks of the year.

 

 

In the very short term, the S&P 500 is recycling off an overbought extreme and it could weaken early in the week. Traders should regard any pullback as a buying opportunity.

 

 

In conclusion, the US equity market appears poised for a strong rally into year-end. While last week’s relief rally in the wake of a temporary debt ceiling deal is constructive, I am waiting for further confirmation of technical strength before calling an all-clear signal.

 

 

Disclosure: Long SPXL

 

Will the energy price surge cause a recession?

Posted by Cam Hui -

As energy prices surged around the world, I had an extensive discussion with a reader about whether the latest price spike could cause a recession. This is an important consideration for investors as recessions are equity bull market killers.
 

The evidence isn’t clear. On one hand, every recession in the post-War period (shaded grey zones) has been accompanied by rising oil prices. On the other hand, interest rates were also rising in virtually all of the cases.

 

 

 

Oil shocks and recessions

The guru of oil shocks and recessions is James Hamilton, whose 1983 seminal paper “Oil and the Macroeconomy Since World War II” provided the basis for this research. Hamilton has published extensively on the topic. A 2011 paper, “Historical Oil Shocks”, laid out the history of oil shocks and recessions, as summarized by the abstract:

 

This paper surveys the history of the oil industry with a particular focus on the events associated with significant changes in the price of oil. Although oil was used much differently and was substantially less important economically in the nineteenth century than it is today, there are interesting parallels between events in that era and more recent developments. Key post-World-War-II oil shocks reviewed include the Suez Crisis of 1956-57, the OPEC oil embargo of 1973-1974, the Iranian revolution of 1978-1979, the Iran-Iraq War initiated in 1980, the first Persian Gulf War in 1990-91, and the oil price spike of 2007-2008. Other more minor disturbances are also discussed, as are the economic downturns that followed each of the major postwar oil shocks.
Here is a brief summary starting from the 1970’s.
  • Arab Oil Embargo (1973-74): The Arab Oil Embargo in response to American support of Israel in the Yom Kippur War led to a supply shock and a recession.
  • Iran Revolution and Iran/Iraq War (1978-81): The Iranian Revolution and subsequent war with Iraq drove oil prices up. A recession followed though the slowdown was exacerbated by the Volcker Fed’s tight monetary policy.
  • First Gulf War (1990-91): Prices rose in response to Saddam Hussein’s invasion of Kuwait. The world plunged into recession.
  • Demand shock (1999-2000): Oil prices fell as low as $10 in the wake of the Asian Crisis. As demand recovered, prices surged and the price increase played a role in the subsequent recession.
  • Supply shock (2007-08): Prices rose as high as $147. Hamilton argues that surging oil prices amounted to a tax on consumption and acted as a catalyst in bursting the property bubble which led to the GFC.
Attributing a rising oil price to the 2008 recession was especially surprising. A WSJ article outlined Hamilton’s explanation:
 

But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.
Current conditions appear ominous. Global energy inflation is off the charts in many regions. Natural gas prices are surging in Europe and Asia. Bloomberg reported last week that the latest spike is equivalent to a $190 oil shock.

 

On Thursday, the Japan-Korea Marker, North Asia’s benchmark for spot liquefied natural gas shipments, surged to $34.47 per million British thermal units, the highest on records going back to 2009, according to price reporting agency S&P Global Platts. Converting that into oil units, also gives a price of about $190 per barrel of oil equivalent.

European natural gas prices also spiked based on historically low storage levels going into the winter and the recent unreliability of renewable energy sources. Price pressure was partly relieved when Putin offered more gas exports, though the offer implicitly came with a string of quick approval of the Nord Stream 2 pipeline.

 

 

Is a global energy-induced recession in our near future?

 

 

 

Exploring cause and effect

At first glance, the Hamilton studies are highly convincing. A 2014 Federal Reserve study looked at the data and asked a different question. It is true that every recession has been accompanied by an oil price spike, but do oil price spikes predict recessions? (If every Ford Model-T is black, are all black cars are Fords?)

 

The researchers modeled the effects of changes in oil price in a linear fashion, e.g. running a simple regression of oil price changes to future GDP changes, and in a nonlinear way, e.g. model positive and negative oil shocks differently. The GDP growth effects of oil price changes in the nonlinear model was much larger than the linear model.

 

We quantify the conditional recessionary effect of oil price shocks in the net oil price increase model for all episodes of net oil price increases since the mid-1970s. Compared to the linear model, the cumulative effect of oil price shocks over the course of the next two years is much larger in the net oil price increase model. For example, oil price shocks explain a 3 percent cumulative reduction in U.S. real GDP in the late 1970s and early 1980s and a 5 percent cumulative reduction during the financial crisis.

There was, however, an important caveat to the nonlinear model [emphasis added].

Our findings are that by no means all net oil price increases in our sample appear to have been followed by recessions. The lack of a mechanical relationship between net oil price increases and recessions is consistent with the hypothesis that the recessionary effects of oil price shocks are time-varying. 

In other words, recessions don’t always follow oil shocks in the nonlinear model. It depends. On the other hand, the oil shock effects on growth are very modest, which leads to the conclusion that oil prices don’t matter very much in the causation of recessions.
 

Correlation isn’t causation. Otherwise, governments would be encouraging the consumption of chocolate to win more Nobel Prizes.
 

 

A 1997 paper by Bernanke, Gertler, and Watson, “Systematic Monetary Policy and the Effects of Oil Price Shocks”, came to a similar conclusion. Bernanke et al noted that oil shock recessions were accompanied by rising interest rates. They went on to ask the question, “Is it the oil shock or the rising rates that caused the subsequent recession?” The answer turns out to be monetary policy played a much bigger role.

We find that the endogenous monetary policy response can account for a very substantial portion (in some cases, nearly all) of the depressing effects of oil price shocks on the real economy. This result is reinforced by a more disaggregated analysis, which compares the effects of oil price and monetary policy shocks on components of GDP. Looking more specifically at individual recessionary episodes associated with oil price shocks, we find that both monetary policy and other nonmoney, nonoil disturbances played important roles, but that oil shocks, per se, were not a major cause of these downturns.

 

 

Energy transition = Price volatility

The current surge in prices is attributable to a transition to clean power. While the global economy has dealt with supply squeezes and volatile energy prices in the past, the transition process has exacerbated volatility, which is here to stay over the next decade. Policymakers have discovered the fragility of renewable power. The sun doesn’t always shine. The wind doesn’t always blow. The rain doesn’t always fall. Storage is an issue and so is power grid capacity. Price shocks, both up and down, will be inevitable during the adjustment process.
 

 

 

Recession ahead?

Does that mean there is an energy-induced recession in the near future? It’s unlikely.
 

The Bernanke paper examined the link between oil shocks and monetary policy and concluded that monetary policy dominated the recession causation. Fed policy remains accommodative and so is fiscal policy.
 

James Hamilton has argued that rising gasoline prices act as a tax for consumers, and the increase at the pump may have pushed an already fragile economy into recession in 2008. Today, household balance sheets are strong. While higher energy prices could slow consumer spending, they are unlikely to push the economy into recession.
 

 

 

Investment implications

In conclusion, rising energy prices are unlikely to cause a recession in the near future, though they may act as a brake on consumer spending. The global economy is the process of normalizing after a sudden shock. Fiscal and monetary policy are easy and supportive. Investors should position themselves for the upcoming growth phase by overweighting cyclically sensitive stocks in the portfolio.
 

The accompanying chart shows sector earnings sensitivity to real GDP growth. Two of the top three sectors are classified as value and one, communication services, is growth. However, the recent Facebook whistleblower revelations leave the communication services sector vulnerable to antitrust regulation and oversight risk.
 

 

This analysis wouldn’t be complete with some final words about energy stocks. The energy sector has a number of attractive contrarian characteristics. The clean energy transition has made the sector the new tobacco. Companies are reluctant to invest significantly in capex in light of net-zero initiatives, which is reducing production capacity as cyclical demand rises during the economic recovery. As an example, coal stocks, which is the dirtiest of energy sources, have soared.
 

 

In the short term, oil and gas stocks are highly extended and testing both absolute resistance and relative resistance. While this sector is attractive from a macro viewpoint over the next few years, investors are advised to wait for a pullback before committing funds to these stocks.
 

 

Unsettling news from Crypto-Land

Posted by Cam Hui -
The NY Times recently published a note with the headline, “Crypto regulation heats up”.

 

The wrangling over spending bills and debt-ceiling dramas may be generating the biggest headlines in Washington, but the race to regulate the fast-growing cryptocurrency industry is also ramping up. Here’s a tour of some of the key developments this week:

 

Activist groups target crypto’s environmental impact. Today, more than 70 nonprofit groups, including the Sierra Club, the Open Markets Institute and the Action Center on Race and the Economy, urged Congress to consider crypto’s energy use when writing new rules for the sector. “As you explore legislative and regulatory responses to ensure investor protection in the industry, it is critical that you also consider the financial stability risks that climate change presents,” they wrote in a letter shared exclusively with DealBook that took particular issue with many cryptocurrencies’ energy-intensive “mining” process.
Industry players make the case for balance. The venture capital firm Andreessen Horowitz submitted a proposal to the Senate Banking Committee outlining its view on the future of digital assets and decentralized technology. The firm, which runs a big crypto fund, urged lawmakers to “ensure that the private sector can experiment and build” as it protects against “the real downside risks that might otherwise harm individuals.”
They also complain about burnout. Brian Armstrong, the C.E.O. of Coinbase, a large crypto exchange, tweeted yesterday that company chiefs in the U.S. were under too much pressure from officials, the news media and the public. He likened this to the crackdown on companies in China, “putting something that gets too successful in its place.”
Crypto notches a win. The S.E.C. approved Volt Equity’s exchange-traded fund that tracks companies whose values swing with Bitcoin prices, with an emphasis on firms that hold Bitcoin on their balance sheets. It’s not quite a pure Bitcoin E.T.F., but it brings the industry closer to that long-sought goal. Investors want “exposure to Bitcoin price movement,” Volt Equity’s Tad Park told DealBook, without necessarily buying crypto directly.
There is a more serious problem that they didn’t cover. I recently published a post raising questions about Tether (see The brewing crisis in Crypto-Land). A Tether is a stablecoin used regularly in the offshore market to trade cryptocurrencies. They are supposed to be backed 1-for-1 to the USD. There are now $69 billion Tether in circulation. This would make Tether one of the biggest banks in the US, except that it’s not a bank and not subject to regulation.

 

A recent Bloomberg article traced down Tether’s billions and found some disconcerting results.

 

 

 

 

Tether’s ticking time bomb

For some background on the use of Tether, Bloomberg reporter Zeke Faux went to one of the biggest crypto conferences in Miami in June:

 

The place was full of people who held Tether. Sam Bankman-Fried, a 29-year-old billionaire who was in town to rename Miami’s basketball arena after his cryptocurrency exchange, FTX, told me he’d bought billions of Tethers, using them to facilitate trading other coins. “If you’re a crypto company, banks are nervous to work with you,” he said.

 

His explanation doesn’t make much sense if you still think of Bitcoin as a peer-to-peer currency, an ingenious way to transfer value without an intermediary. But most people aren’t using cryptocurrencies to buy stuff. They’re trading them on exchanges and betting on their value, hoping to make a real money score by picking the next Dogecoin, which spiked 4,191% this year after Elon Musk started tweeting about it, or Solana, up 9,801% in 2021 for seemingly no reason at all.

 

Think of crypto exchanges as giant casinos. Many of them, especially outside the U.S., can’t handle dollars because banks won’t open accounts for them, wary of inadvertently facilitating money laundering. So instead, when customers want to place a bet, they need to buy some Tethers first. It’s as if all the poker rooms in Monte Carlo and the mahjong parlors in Macau sent gamblers to one central cashier to buy chips.

 

The biggest traders on these exchanges told me they routinely bought and sold hundreds of millions of Tethers and viewed it as an industry standard. Even so, many had their own conspiracy theories about the currency. It’s controlled by the Chinese mafia; the CIA uses it to move money; the government has allowed it to get huge so it can track the criminals who use it. It wasn’t that they trusted Tether, I realized. It was that they needed Tether to trade and were making too much money using it to dig too deeply. “It could be way shakier, and I wouldn’t care,” said Dan Matuszewski, co-founder of CMS Holdings LLC, a cryptocurrency investment firm.
If someone gave Tether USD 100 and received 100 Tethers in return, what happens to that $100? After some pressure, Tether published its asset holdings and disclosed, “Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.”

 

 

If half of its assets is in commercial paper (CP), which is short-term paper issued by (usually) top-rated borrowers, that would make the company one of the biggest CP players in the world. But no CP dealer has heard of them. So where are Tether’s billions?

 

Here is the key quote from Faux [emphasis added].
 

I obtained a document showing a detailed account of Tether Holdings’ reserves. It said they include billions of dollars of short-term loans to large Chinese companies—something money-market funds avoid. And that was before one of the country’s largest property developers, China Evergrande Group, started to collapse. I also learned that Tether had made loans worth billions of dollars to other crypto companies, with Bitcoin as collateral. One of them is Celsius Network Ltd., a giant quasi-bank for cryptocurrency investors, its founder Alex Mashinsky told me. He said he pays an interest rate of 5% to 6% on loans of about 1 billion Tethers. Tether has denied holding any Evergrande debt, but Hoegner, Tether’s lawyer, declined to say whether Tether had other Chinese commercial paper. He said the vast majority of its commercial paper has high grades from credit ratings firms, and that its secured loans are low-risk, because borrowers have to put up Bitcoin that’s worth more than what they borrow. “All Tether tokens are fully backed, as we have consistently demonstrated,” the company said in a statement posted on its website after the story was published.

 

Tether’s Chinese investments and crypto-backed loans are potentially significant. If [Tether CFO] Devasini is taking enough risk to earn even a 1% return on Tether’s entire reserves, that would give him and his partners a $690 million annual profit. But if those loans fail, even a small percentage of them, one Tether would become worth less than $1. Any investors holding Tethers would then have an incentive to redeem them; if others did it first, the money could dry up. The bank run would be on.

I supposed the good news is they didn’t lend to China Evergrande, but Chinese USD paper seems awfully dodgy in the current environment. The sympathetic view is Tether’s CFO Giancarlo Devasini has transformed Tether into a Berkshire Hathaway, where he uses the float to earn money for himself and his partners. The less charitable view is the company is now a giant and leveraged hedge fund in which Devasini enjoys the gains and the depositors get stuck with the losses.
 

When will the bank run begin? Your guess is as good as mine.

The risks to Big Tech

Posted by Cam Hui -

Mid-week market update: As the S&P 500 continues its test of support while exhibiting a positive RSI divergence, one important consideration is what happens to large-cap technology stocks. Large-cap tech and FANG+ account for about 45% of S&P 500 weight, and further weakness could prove to be a drag for the overall market, no matter what happens to the rest of the index.
 

 

 

The long-term picture

The recently publish JPM Asset Management’s quarterly book proved to be a useful reference for this question. Indeed, index concentration in the top 10 stocks is very high and exceeds levels seen at the NASDAQ Bubble top. The forward P/E between the top 10 and the rest of the S&P 500 is also very high, though not as high as the dot-com era. The key difference is the top 10 are deserving of a high valuation, as they account for 26.2% of S&P 500 earnings.

 

 

Nevertheless, the relative valuation of growth and value is stretched. The Z-score spread between the forward P/E of growth and value is only exceeded by the dot-com bubble. 

 

 

As well, this chart of the history of sector weights also provides some context of the dominance of technology stocks in the S&P 500.

 

 

 

Facebook’s no good, very very bad day

How bad can it get for large-cap growth? Facebook’s experience this week was an example of the threats facing the company and Big Tech in general. Not only did Facebook and other of its properties go down because of a system glitch, but it was also subject to the Senate testimony of whistleblower Frances Haugen who accused the company of choosing “profits over safety”.

 

Notwithstanding the antitrust threat posed by the issues raised by Haugen to Big Data companies like Facebook, Alphabet, and others, Kevin Roose of the NY Times raised a more important question about the erosion of Facebook’s competitive position.

 

What I’m talking about is a kind of slow, steady decline that anyone who has ever seen a dying company up close can recognize. It’s a cloud of existential dread that hangs over an organization whose best days are behind it, influencing every managerial priority and product decision and leading to increasingly desperate attempts to find a way out. This kind of decline is not necessarily visible from the outside, but insiders see a hundred small, disquieting signs of it every day — user-hostile growth hacks, frenetic pivots, executive paranoia, the gradual attrition of talented colleagues.
Roose posed the question of why the company is going to such desperate measures to expand its audience?

 

You can see this vulnerability on display in an installment of The Journal’s series that landed last week. The article, which cited internal Facebook research, revealed that the company has been strategizing about how to market itself to children, referring to preteens as a “valuable but untapped audience.” The article contained plenty of fodder for outrage, including a presentation in which Facebook researchers asked if there was “a way to leverage playdates to drive word of hand/growth among kids?”
It’s a crazy-sounding question, but it’s also revealing. Would a confident, thriving social media app need to “leverage playdates,” or concoct elaborate growth strategies aimed at 10-year-olds? If Facebook is so unstoppable, would it really be promoting itself to tweens as — and please read this in the voice of the Steve Buscemi “How do you do, fellow kids?” meme — a “Life Coach for Adulting?”
Why is it going to such desperate means to raise engagement by making people angry?
 

Take the third article in The Journal’s series, which revealed how Facebook’s 2018 decision to change its News Feed algorithm to emphasize “meaningful social interactions” instead generated a spike in outrage and anger.
The algorithm change was portrayed at the time as a noble push for healthier conversations. But internal reports revealed that it was an attempt to reverse a yearslong decline in user engagement. Likes, shares and comments on the platform were falling, as was a metric called “original broadcasts.” Executives tried to reverse the decline by rejiggering the News Feed algorithm to promote content that garnered a lot of comments and reactions, which turned out to mean, roughly, “content that makes people very angry.”
Facebook is in the business of surveillance in order to sell advertising. Google’s business model is the same, though it goes about it in a different way. Amazon tries to find out everything about you to sell you more products. Apple does it in a different way, though the Big Data techniques are similar. Haugen’s testimony is another step that invites antitrust scrutiny.

 

How bad could it get? Consider’s China’s crackdown on tech. Stonex Group strategist Vincent Deluard gave an illustration of how far P/E ratios could fall in the face of intense regulatory oversight.

 

 

The numbers are noisy and the circumstances are company-specific, but the worst-case analysis could see forward P/E ratios fall by as much as 50%.

 

 

A light at the end of the tunnel

In the meantime, an analysis of the relative performance of top five sectors of the S&P 500 shows that only financial stocks are experiencing any positive relative strength. The rest aren’t getting love from the markets. As the top five sectors make up about three-quarters of index weight, the market faces a headwind in advancing.

 

 

To be sure, value and cyclical stocks are gaining the upper hand against growth stocks, but value and cyclicals comprise about 32% of S&P 500 index weight compared to 45% for large-cap growth.

 

 

The market faces the uncertainty of a possible government default if the debt ceiling isn’t raised. Some signs of movement may be appearing in the standoff. Senate Minority Leader Mitch McConnell offered President Biden and the Democrats two limited paths today to raising the debt ceiling. While there may be further maneuvering by both sides in the coming days, lawmakers appear to be stepping back from the cliff. 

 

If and when a deal is reached, expect a strong relief rally led by cyclicals as they will have the greatest leverage to renewed economic growth. A light is appearing at the end of the tunnel.

 

 

Disclosure: Long SPXL

 

Q3 earnings season preview

Posted by Cam Hui -

The recent pullback in the S&P 500 has deflated the forward P/E to 20.1 as of close last Thursday, which is in the bottom of the post-COVID Crash recovery range. The P/E derating is not surprising as bond yields have risen to put downward pressure on P/E ratios.
 

 

What’s next? The upcoming Q3 earnings season will be a test for both bulls and bears. The key question for investors is whether the E in the forward P/E ratio rises fast enough to support stock prices and offset rising rates?

 

 

A mixed picture

Wall Street earnings estimate revisions present a mixed picture. S&P 500 EPS estimates had declined for two weeks in a row, though a more updated report from FactSet shows upward revisions in the following week. By contrast, estimates for both the mid-cap S&P 400 and small-cap S&P 600 show strong positive momentum.

 

 

The weakness in S&P 500 revisions may be attributable to USD strength. Large-cap companies tend to have more foreign operations and their sales and earnings are more sensitive to currency fluctuations.

 

 

That said, the S&P 500 has exhibited an uneven correlation with the USD Index in the last 10 years. The USD is a safe haven currency and can experience fund flows during both risk-on and risk-off periods, but relative growth and interest rates are also important factors in determining currency levels.

 

 

 

A detailed estimate revision analysis

The Street is entering the Q3 earnings season on a fairly upbeat note. FactSet reported that Q3 2021 is the fifth consecutive quarter that analysts have shown positive estimate revisions. 

 

 

In more normal times, company analysts tend to be overly optimistic. They initially post high estimates and gradually revise them down as the reporting period approaches, according to FactSet:

In a typical quarter, analysts usually reduce earnings estimates during the quarter. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 2.9%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 3.7%. During the past fifteen years, (60 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.9%. 

To be sure, the rate of revisions has decelerated. The monthly analysis of quarterly estimate revisions shows a gradual downward trajectory for Q3 earnings. The key question for investors is whether expectations are too rosy. 

 

 

 

The bottom-up view

On the other hand, the bottom-up view from companies is still upbeat. The rate of positive to negative guidance is still positive, which is contrary to the historical record of the preponderance of negative guidance.
 

However, the macro summary from The Transcript, which monitors and summarizes earnings calls, sounded a cautionary note about supply chain bottlenecks..

Inflation and supply chain challenges continue to be the most prominent economic theme. It doesn’t appear that supply chain challenges are getting any better.

The previous week’s earnings calls had similar warnings, though it was more upbeat about the waning effects of the pandemic.
Economic weakness driven by the Delta variant appears to have been short-lived. While growth may have slowed some from the euphoric pace earlier this year, the economy continues to benefit from high consumer demand. Supply chain disruptions are not getting better though and inflation is likely to last into next year. The FOMC met last week and decided to keep monetary policy unchanged. However, Jerome Powell was relatively direct in saying that tapering is likely to start at the next meeting.
Where does that leave us? I am cautiously bullish as we enter the Q3 earnings season. Expectations are high but history shows that companies have guided sales and earnings estimates to slightly beat them. The bulls will say that the guidance rate remains positive and the macro environment supportive. The bears will say that the rate of positive estimate revisions has been falling, which is a sign of deceleration.

 

The reporting calendar is very light this week and the Q3 earnings season is to begin in earnest next week. The coming month will be a crucial period to determining the direction of stock prices.

 

 

 

A Q4 meltup ahead?

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.

 

 

Positive seasonality ahead

If history is any guide, stocks are expected to be bottom out in early October and begin a period of seasonal strength into year-end.

 

 

What are the odds of a melt-up for the rest of 2021?

 

 

A reflation bull?

Ned Davis Research recently sketched out a bullish scenario into year-end for global equities by pointing out that Q4 has been the strongest in the last few years.

 

 

Their risk appetite indicators have been steadily improving, but the indicator hasn’t risen sufficiently to flash a buy signal just yet. These readings are consistent with my Q4 sector review which also found signs of cyclical and reflation strength, but no broad-based confirmation.

 

 

 

Supportive sentiment

The sentiment backdrop is becoming more supportive of an advance, though readings haven’t fallen to panic extremes. As an example, the 10 dma of the put/call ratio has spiked to levels where corrections have ended in the post-COVID Crash era, but the ratio has been higher in the past.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs, plunged last week but readings are not below the 26-week Bollinger Band. A penetration of the low BB has been strong buy signals in the past.

 

 

These conditions lead me to believe that risk/reward is tilted to the upside. The maximum drawdown of the S&P 500 from its highs is -5%. It’s conceivable that prices could pull back further, but another 2-3% of weakness is likely to spark panic levels in many sentiment models.

 

 

Bullish tripwires

While I am cautiously bullish, I am not ready to go all-in just yet. Here are some bullish tripwires that I am watching as signs of a reflationary rebound. The blogger Macro Charts argued that energy stocks are the canaries in the cyclical coalmine.

 

 

A Bloomberg headline came across my desk last week that may confirm the bullish outlook for energy: “China Orders Top Energy Firms to Secure Supplies At All Costs”,
 

China’s central government officials ordered the country’s top state-owned energy companies to secure supplies for this winter at all costs, according to people familiar with the matter.
The order came directly from Vice Premier Han Zheng, who supervises the nation’s energy sector and industrial production, and was delivered during an emergency meeting earlier this week with officials from Beijing’s state-owned assets regulator and economic planning agency, the people said, asking not to be named discussing a private matter. Blackouts won’t be tolerated, the people said.
The emergency meeting underscores the critical situation in China. A severe energy shortage crisis has gripped the country, and several regions have had to curtail power to its industrial sector and some residential areas have even faced sudden blackouts.
For some context, China isn’t suffering from an energy shortage. Skyrocketing coal prices have made the cost of electrical power production unprofitable and electric generation companies have cut output as a result. This means Chinese electrical generators will be buying coal at any price

 

Similarly, natural gas prices have soared in Europe because of a lack of renewable output. The sun hasn’t shone as much as expected and the atmosphere has calmed and wind power output has fallen. As natural gas is a feedstock into fertilizer production, this has put upward pressure on fertilizer prices and it will undoubtedly affect food prices as well. 

 

On the other hand, Bloomberg reported that core eurozone consumer sentiment remains surprisingly upbeat despite costs. Strong consumer demand in the face of rising prices is a bullish sign for the economy.

 

 

 

Supply chain bottlenecks

Won’t rising energy prices create inflationary pressure and force the Fed to act? Jerome Powell testified last week that inflationary pressures were expected to be transitory because of supply chain bottlenecks, but allowed that the transitory period may last longer than expected. 

 

The headlines may see rising hysteria over shortages in the coming weeks as Christmas nears and products aren’t available in plentiful supply on shelves. In reality, the shortages are attributable to a supply shock owing to rising demand in the face of limited manufacturing and transportation capacity. Central bankers raising interest rates won’t make the semiconductor shortages go away, nor will it expand shipping and trucking capacity.

 

Some hopeful signs are starting to appear on the horizon on a bottom-up basis. The latest data on port congestion is showing possible signs of easing.

 

 

The best news from a contrarian perspective is this week’s cover of Barron’s.

 

 

Demand for services continue to improve. Airfare purchase are rising while refunds are falling.

 

 

New Deal democrat observed that manufacturing, or the producer side of the economy is performing well after assessing the August durable goods report.
 

Although there are many bottlenecks, in particular in transporting materials to factories, and goods from factories to sellers, orders for goods that will last a (relatively) long time continue to get better. There is simply no downward pressure on the producer sector of the economy at this time.
The next important data release will be the November Jobs Report. How will the juxtaposition of COVID cases, the expiry of emergency assistance programs, supply chain bottlenecks, and widespread reports of labor shortages affect the employment situation? Powell stated after the last FOMC meeting that it would take a large miss on the November report for the Fed to rethink its plans to taper its QE purchases.

 

This is what reflation looks like.

 

 

Fiscal wildcards

On the other hand, investors will have to deal with the confusing fiscal picture out of Washington. This time, there are simply a lot of balls in the air and many moving parts to fiscal policy. Each issue is separate but related and any one of them could go off the rails and affect fiscal policy and unsettle the markets.
  • Funding the federal government, which can be done with a Continuing Resolution in the short run;
  • The debt ceiling;
  • The infrastructure bill; and
  • The budget reconciliation process.
Here is how Biden’s $3.5 trillion proposals could affect future policy and change the lives of Americans:
  • Transportation: Electric vehicle (EV) subsidies, spending for EV infrastructure like public charging stations, public transport subsidies, especially for rail travel.
  • Healthcare: Expand Medicare coverage to dental, vision, and hearing benefits, free Medicaid coverage for more lower-income Americans, lower drug prices.
  • Child Care and Education: Free daycare for lower-income Americans, two years of free preschool before kindergarten and two free years of community college, and 12 weeks of paid family leave to tend to a sick family member.
I have no idea of how this wish list will play out in the tug-of-war in Washington. Make no mistake that the legislative skills are there for a deal to be done. House Speaker Nancy Pelosi is a vote counter par excellence, Democratic Senator Majority Leader Chuck Schumer understands his caucus, and President Joe Biden enjoys a 90% approval among Democrats and he has a strong legislative record in the Senate.

 

In all likelihood, the Democrats’ ambitious agenda will be watered down. As an example, Biden’s original proposal was to raise the corporate tax rate from 21% to 28%, though expectations were scaled back down to 25%. PredictIt odds show that the chances of no tax increase (21%) or a sub-25% tax rate are rising. As a 25% rate has been largely discounted by the market, a lower tax rate would be a welcome surprise for equity investors.

 

 

No analysis of fiscal uncertainty without a word on the German election. Angela Merkel’s CDU/CSU lost their leading status in the Bundestag and came second to the left-of-centre SPD. However, the SPD does not have sufficient seats to form a majority and it will need to seek coalition partners to form a government. The consensus expectation is a “traffic light” coalition of SPD (red), socially liberal but fiscally conservative FDP (yellow), and the Greens.

 

 

For investors, the key question is what happens to Germany’s traditional fiscal conservatism and propensity towards austerity. Both the SPD and Greens favor abandoning Germany’s “debt brake” while the FDP is adamant about keeping it. One trial balloon that has been floated is to give FDP leader Christian Lindner the finance ministry while allowing the Greens to execute their climate initiatives through off balance sheet spending. This solution allows Germany a fiscal boost to foster more growth, but it doesn’t address the issue of a common eurozone budget and greater fiscal integration. In the past, coalition negotiations can take a long time and the public won’t know the results for months.

 

In conclusion, the market may be setting for a period of positive seasonality into year-end, which would be sparked by a reflationary boom. However, a number of important cyclical tripwires have not been triggered. At a minimum and in the short-term, the S&P 500 needs to rally and regain the 50 dma though it is helpfully exhibiting positive RSI divergences as it tests the Evergrande panic lows.

 

 

 

Disclosure: Long SPXL

 

Q4 sector review: Assessing the yield surge

Posted by Cam Hui -

In light of the recent surge in global rates, it’s time for another review of sector leadership. I will conduct the review in two ways. First, the market will be viewed through a cross-asset framework. Rising yields and a steepening yield curve have been bullish for the value/growth cycle in the past, will this time be different?
 

 

As well, the market will be viewed through a conventional technical analysis lens.

 

 

Reflation or mid-cycle pause?

The CRB Index provides some big picture context to the current phase of the economic cycle. The CRB/S&P 500 ratio, which is a useful cyclical indicator. When the ratio is rising, the market is signaling that hard assets are more value than paper assets, which is reflationary. The ratio bottomed out in 2020 and staged an upside breakout through a downtrend in early 2021. This price pattern is similar to late 2000 when the NASDAQ Bubble popped and a recession began to take hold. The commodity/stock ratio rose into late 2000 and prices paused, which is an indication of economic weakness. The key difference between the 2000 episode and today is that stocks were in a bear market in 2000 while they have rebounded strongly today. 

 

 

What happens next? Will commodity prices continue to rally indicating a reflationary rebound, or pause and trade sideways, which will be a signal of a mid-cycle slowdown?

 

The cyclically sensitive copper/gold and base metals/gold ratios are leaning towards the cyclical recovery and a risk-on scenario. The historical record shows that these cyclically sensitive ratios have been correlated to the stock/bond ratio, which is a risk appetite indicator. 

 

The copper/gold ratio topped out in late 2000 and it didn’t bottom out until 2003. Today, the copper/gold ratio is trading sideways, which could be a signal of a growth pause, but that could be a false signal. The more diversified base metals/gold ratio is rising indicating a reflationary rebound.

 

 

 

Sector rotation review

If we were to analyze the market through a more traditional technical analysis prism, the first tool is an RRG chart, which is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

 

The latest chart shows technology and healthcare in the top right leading quadrant with flagging leadership characteristics. Rising sectors in the top left improving quadrant are financials and consumer discretionary. Energy, materials, and industrials are in the left bottom lagging quadrant but they are showing signs of nascent strength.

 

 

Let’s start the analysis with healthcare, which was one of the leading sectors. Healthcare stocks violated a rising trend line in September. Even before the trend line violation, relative performance peaked in August and relative breadth (bottom two panels) has been weakening.

 

 

The remainder of the sectors will be divided between growth sectors and value and cyclical sectors. Technology stocks were also one of the market leaders, but they have been unable to overcome a relative resistance zone (shown in grey). Relative breadth peaked in early August and it has been in decline.

 

 

The stocks in the communication services sector is less homogeneous than other sectors. This sector violated a rising trend line and its relative performance has been range-bound since April. However, relative breadth has been improving, but the recent strength is attributable to some of the smaller stocks in the sector, such as Netflix and selected telecoms, while heavyweights Facebook and Alphabet have been weak.

 

 

Financials is the strongest of the value and cyclical sectors. The sector is tracing out a bullish cup and handle formation, but it hasn’t staged an upside breakout yet. Relative strength is correlated to the 2s10s yield curve. Banks tend to borrow short and lend long and a steepening yield curve increases profitability. Relative breadth has been strong.

 

 

Consumer discretionary stocks can be thought of as both growth and value. The largest weights in the sector are AMZN and TSLA, which are growth stocks and account for about 45% of sector weight and can be represented by the cap weight sector index. The remainder is more conventional cyclically sensitive consumer discretionary stocks and can be better represented by an equal-weighted sample. The relative performance of the cap-weighted sector has been strengthening while the equal-weighted sector has been flat against the S&P 500. However, relative breadth has been rising, which could be interpreted as a signal of better performance by the broader cyclically sensitive stocks.

 

 

Energy stocks have been strong as oil prices rose, but bullishness and bearishness are in the eyes of the beholder. The sector has staged an upside breakout from an inverse head and shoulders pattern, which is bullish, but the latest rally could be forming the right shoulder of a head and shoulders formation, which is potentially bearish. As good chartists know, a head and shoulders pattern is not confirmed until the neckline breaks. Since the neckline broke on the inverse H&S, I am inclined to give the bull case the benefit of the doubt. Unsurprisingly, relative breadth is strong as oil prices rallied.

 

 

The industrial sector is range bound, but its relative performance staged an upside breakout through a falling trend line after testing a relative support zone. This technical pattern is very similar to the relative performance of the capital goods sensitive Infrastructure ETF (PAVE), which is testing a falling relative trend line. Relative breadth of industrials, while still negative, is improving.

 

 

Materials is the weakest sector of the value and cyclical sectors. The sector is testing a key resistance level, though it appears to have staged a marginal upside breakout through a falling relative trend line. However, relative breadth is negative and weak.

 

 

The remainder of the S&P 500 sectors have defensive characteristics. None are showing any signs of relative strength. If the bears were to take control of the tape, their actions would show up as improving defensive sector relative performance.

 

 

In conclusion, a review of market leadership through macro cross-asset and conventional technical analysis viewpoints shows a possible bullish setup for the reflation trade. However, the jury is still out on this bullish scenario. We need to see the cyclical and value sectors exhibit better and broader relative performance as confirmation of reflationary strength. Investors may gain better clarity on market direction once the jitters over the debt ceiling and Biden’s stimulus program are resolved.

 

Will rising yields spook stocks?

Posted by Cam Hui -

Mid-week market update: Last week, the market was rattled by the prospect of an Evergrande default. This week, it’s rising yields. Both the 5 and 10 year Treasury yields surged decisively this week and the 2s10s yield curve has steepened.
 

 

Are rising yields destined to spook stock prices?
 

 

Good news, bad news

The answer to that question is a “good news, bad news” story. Let’s start with the bad news. A Goldman Sachs study reveals that stocks struggle when rates rise too rapidly.
 

 

Equities, as an asset class, compete with fixed income instruments for funds. A simple way of rating the relative attractiveness of stocks and bonds is the Fed model, which compares the E/P ratio with the yield on a default-free Treasury. If bond yields rise. Equity prices can maintain their level or rise even further as long as the E in the E/P is rising faster than the increase in Treasury yields.
 

The latest update shows S&P 500 forward 12-month EPS fell last week. That’s the bad news. The good news is the earnings decline was not confirmed by the midcap S&P 400 or smallcap S&P 600.

 

 

 

Silver linings

Here is one silver lining in the dark cloud. As we approach Q3 earnings season, FactSet reported S&P 500 have issued strong positive earnings guidance:

102 companies in the index have issued EPS guidance for Q3 2021, Of these 102 companies, 47 have issued negative EPS guidance and 55 have issued positive EPS guidance. The percentage of companies issuing positive EPS guidance is 54% (55 out of 102), which is well above the 5-year average of 39%.

 

The bulls can find other constructive signs. The rise in yields looks overdone. The price action of XLU, the utilities ETF which I use as a yield proxy, is testing its 200 dma and wildly oversold on the 5-day RSI. RSI readings are sufficiently stretched and comparable to the initial stages of the COVID Crash to warrant at least a short-term relief rally. In addition, XLU is also testing a key relative support zone (bottom panel) which should hold in light of the oversold condition of the sector.

 

 

Risk appetite indicators are also supportive of high stock prices. The equity risk appetite indicators, comprised of the ratio of high beta to low volatility stocks and the ratio of consumer discretionary to consumer staple stocks, are exhibiting a series of minor positive divergences.

 

 

Credit market risk appetite, as measured by the relative price performance of junk bonds and investment-grade bonds to their duration-equivalent Treasuries, made fresh all-time highs before retreating.
 

 

In addition, the relative performance of defensive sectors and industries to the S&P 500 are weak. The bears haven’t taken control of the tape. Major corrections and bear phases simply don’t look like this.
 

 

Here is some good news from Hong Kong. The shares of China Evergrande is trying to make a bottom.
 

 

Don’t panic about a major correction. Barring some catastrophe such as a default by the US Treasury, the market is unlikely to decline much further. One short-term bullish ray of hope are the minor RSI divergences even as the S&P 500 tested the recent lows.
 

 

 

Positioning for rising rates

The increase in sovereign yields is likely extended in the short run, interest rates have made a turn upwards. That begs the question of how equity investors should position themselves.
 

The 5-year Treasury yield has been moving in lockstep with the cyclically sensitive base metals/gold ratio, which is an indication that the market is discounting a cyclical rebound and a better growth outlook.
 

 

While I would not personally recommend the purchase of the Rising Rates ETF (EQRR) because of its minuscule AUM which is an invitation for the issuer to wind up the fund, the sector exposures of EQRR is nevertheless a useful guide to how investors should position themselves for a rising rate environment, namely cyclical stocks.
 

 

I am also keeping an eye on the semiconductor industry. These stocks are growth cyclicals and have both growth and cyclical characteristics. The industry has been stuck in a sideways pattern relative to the S&P 500 since June (bottom panel). If the market were to truly embrace the cyclical rebound investment thesis, they should stage a relative upside breakout.
 

 

Stay tuned.
 

 

Disclosure: Long SPXL
 

A classic washout bottom

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.
 

 

Panic and recovery

Last week, I wrote, “A tactical low looks near.,,[but] traders should be open to the possibility that the market may need one final panic for a tradable bottom to appear.” What I didn’t expect was the China Evergrande panic that gripped the market, though the subsequent relief rally was not unexpected. 

 

The S&P 500 fell -4% from its all-time high and rebounded by the end of the week to regain its 50-day moving average. The VIX Index flashed a buy signal when it rose above its upper Bollinger Band last week. However, traders should be aware of the caveat that rallies can stall once the VIX recycles from above the upper BB to the 20 dma. This scenario is a very real possibility as market jitters over a debt ceiling impasse, Treasury default, and a widespread government shutdown looms ahead.

 

 

 

Capitulation sentiment

There were signs of capitulation level sentiment everywhere. Starting in Hong Kong, where China Evergrande is listed, Jason Goepfert of SentimenTrader documented how the net advance-decline breadth fell to levels seen at short-term lows.

 

 

Rob Hanna at Quantifiable Edges wrote that his “Quantifiable Edges Capitulative Breadth Index (CBI), which measures short-term capitulative selling among S&P 100 stocks, closed at 11 on Tuesday and 12 Wednesday”.  Readings of 10 or more have historically been short-term buy signals, especially if the S&P 500 is above its 200 dma.

 

 

The NYSE McClellan Oscillator (NYMO) fell to an oversold level last week. With the exception of the COVID Crash, such readings have provided good short-term long entry points for traders in the past.

 

 

Credit market risk appetite, as measured by the relative price performance of junk bonds to their duration-equivalent Treasuries, made an all-time high.

 

 

 

Interpreting the yield breakout

As for market leadership, it is noteworthy that the 10-year Treasury yield staged a decisive upside breakout in the wake of the September FOMC meeting, though the 5-year yield had already shown signs of strength.

 

 

In the wake of the yield breakout, bear in mind the historical record of sector and industry sensitivity to rising yields has been cyclical and value stocks.

 

 

Should yields continue to strengthen, the value stock revival may finally be realized.

 

 

In the very short-term, however, breadth is highly extended. Don’t be surprised if the market rally pauses early next week.

 

 

In conclusion, the stock market made a classic washout bottom last week. While I wouldn’t necessarily discount the possibility of a pause in the advance, the intermediate-term path of least resistance for stock prices is up.

 

Disclosure: Long SPXL
 

 

Time for a mid-cycle swoon?

Posted by Cam Hui -

The S&P 500 fell as much -4% from its all-time high in Evergrande panic pullback last week. Is the recent weakness just typical seasonal weakness or something more serious? The intermediate-term breadth looks disconcerting. The percentage of S&P 500 stocks above their 200-day moving average (dma) had been at the 90% level which indicates a “good overbought” sustained advance. This indicator has retreated below the 75% level. There have been four similar episodes in the last 20 years. Three of the four occasions resolved themselves with substantial drawdowns while the remaining one saw the market trade sideways in a choppy way.
 

 

The odds don’t look good. The market may be setting itself for a mid-cycle swoon.

 

 

A history lesson

For some clues of what the future holds, let’s walk through the history of each of the four episodes. First, we can observe that the market didn’t really bottom out until the percentage of S&P 500 stocks fall to at least 20% (bottom panel). Based on the current reading, it’s not over yet.

 

 

The above chart also shows macro and risk appetite signals in the form of the cyclically sensitive copper/gold ratio and the relative performance of the consumer discretionary to consumer staple stocks. These indicators were important drivers of stock market performance on those occasions. I have also included the 2s10s yield curve as another frame of reference. In all four of the past instances, the yield curve was flattening and conveys no additional information for this analysis.

 

Consider the 2004 period. The stock market had recovered strongly after a prolonged recession. There were no signs of softness from the copper/gold ratio and the equity risk appetite indicator of discretionary to staple stocks. The market consolidated sideways to digest its gains and went on to rise further.

 

The 2010 episode was similar to 2004 inasmuch as they were both rallies off recessionary bottoms. The key difference in 2010 was the weakness shown by the copper/gold ratio and equity risk appetite. Simply put, the stock market pulled back because of a growth scare.

 

The 2011 period was marked by the dual challenges of a Greek Crisis as the eurozone faced an existential crisis. Recall the endless European summits and the crisis was not fixed until the ECB stepped in with its LTRO program. Across the Atlantic, Washington was embroiled in a budget dispute marked by the S&P downgrade of Treasury debt from AAA to AA. Is it any wonder why stock prices skidded?

 

The 2014 episode was unusual as the macro and risk appetite signals were similar to 2004. Both the copper/gold and equity risk appetite indicators were moving sideways and showing few signs of stress, but stock prices experienced a sudden downdraft. At the time, the market had become increasingly concerned over the umbrella protests in Hong Kong and an Ebola outbreak in Africa. The moral of this story is normal market pullbacks can happen at any time and the 2014 correction can be considered a part of normal equity risk.

 

 

The Evergrande fallout

Fast forward to 2021. History doesn’t repeat itself but rhymes. What is the outlook and the challenges for the months ahead? The issues facing investors can be categorized as:
  • The implications of the China Evergrande meltdown;
  • Possible economic weakness in 2022; and
  • Political uncertainties surrounding the impasse over the budget ceiling, as well as Biden’s $3.5 trillion budget proposal.
There have been many calls by analysts dismissing the equivalence of the Evergrande crisis to China’s Lehman Moment. The Lehman Crisis was an institutional bank run, sparked by institutional distrust of one another. They couldn’t be certain that any short-term loans to any financial institution would be paid back. The China Evergrande situation is entirely different. The crisis was manufactured by the government in its efforts to rein in credit growth and to tame real estate speculation. Any crisis of financial confidence could be addressed by Beijing by ordering the banks, which are government-owned, to lend. Even though the Evergrande meltdown won’t result in a disorderly unwind, the economy will nevertheless suffer some fallout.

 

The well-respected China watcher Michael Pettis recently explained how Beijing is pivoting from the build infrastructure growth model to a focus on high-quality growth and what that means.

 

This high-quality growth (to use Beijing’s usual terminology) consists mainly of consumption (driven by increases in household income rather than rising household debt), exports, and business investment. By my estimates, high-quality growth has probably accounted for barely half of China’s GDP growth rate in recent years.

 

But for China to achieve the required GDP growth rates, it needs another source of economic activity, which I will refer to as residual growth. This growth, for the most part, has consisted mainly of malinvestment by the property sector and by local governments building excessive amounts of infrastructure. Whenever high-quality growth declines, as it did last year when China’s growth rate was actually negative, Beijing steps up residual growth to make up for this decline, but whenever the pace of high-quality growth picks up again, Chinese leaders quickly put downward pressure on residual growth, as it seems to be doing this year. 

 

The fact that Beijing regularly tries to constrain residual growth to the minimum amount needed to achieve the GDP growth target suggests that China places little value on this kind of growth. More importantly, China’s debt history provides a concrete reason for recognizing that much recent investment has been malinvested.

 

 

Enough is enough. The latest PBoC clampdown on China Evergrande and other property developers is an important signal that Beijing is pivoting to high-quality growth at the expense of headline GDP growth. Don’t expect Chinese real estate prices to continue to advance strongly over the next few years.

 

This policy pivot presents a problem for the rest of the world. China is a significant source of demand for many commodities relative to its share of the global population. Any shift away from infrastructure spending will put downward pressure on commodity prices.

 

 

Does this put the global cyclical recovery at risk? At a minimum, is the narrative of a bullish commodity supercycle coming to a screeching halt?

 

Not so fast! While selected commodities such as iron ore are tanking, the CRB Index is holding above its 50 and 200 dmas. As well, the cyclically sensitive base metals/gold ratio is holding up well and it is not signaling a downturn.

 

 

Similarly, industrial metal prices are also not showing any signs of weakness.

 

 

To be sure, it’s possible that China is slowing to a more sustainable “quality high-growth” level and commodity demand is falling off. Broad market signals are not indicating a global slowdown. I interpret these conditions as rising recovery demand from the rest of the world is offsetting China’s deceleration.

 

 

A potential slowdown

Another challenge for equity investors is the risk of economic weakness. I have highlighted New Deal democrat’s useful economic forecasting framework of coincident, short-leading, and long-leading indicators. His latest snapshot indicates strength in the shorter term indicators but some weakness by mid-2022, though he is not forecasting a recession.

 

RecessionALERT came to a similar conclusion and his chart is illustrative of NDD’s conclusion. The leading economic data is indicating some softness, but readings are not in worrisome territory.

 

 

Stock prices are known to be leading indicators and the stock market usually looks ahead 6-12 months. It is therefore not surprising that the percentage of S&P 500 above their 200 dma has weakened. A more detailed analysis of the S&P 500 reveals a bifurcated market beneath the surface. As the 2s10s yield curve flattened, indicating expectations of slowing growth, investors rotated into growth stocks as growth became more valuable in a growth-starved environment. At the same time, value stocks, which also have highly cyclical characteristics, traded sideways.

 

 

In many ways, the 2021 backdrop is similar to 2004 and unlike 2010 and 2011. There are no signs of cyclical weakness as measured by the copper/gold ratio and equity risk appetite is holding up well. This should resolve in a period of sideways consolidation in the coming months. There is, however, one key difference. The bifurcated nature of today’s market shows that cyclical and value stocks have been trading sideways since May. Arguably, the market may have already undergone much of its consolidation.

 

There may be some hopeful signs that the economy is about to turn up. The global recovery has struggled with COVID-19 and several waves of infection. The latest readings indicate case rates have topped. In particular, Asian case counts, which have been one of the key global trouble spots, are rolling over.

 

 

In addition, the US Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, had been falling and the decline may be a signal of economic weakness in mid-2022. While it’s too early to break out the bubbly, the latest readings show an uptick and an improvement in the macro outlook.

 

 

Moreover, analysis from The Economist shows that American economic dynamism is still strong. New business applications have surged despite the onset of the pandemic.

 

 

Private non-residential investment is surging indicating the start of a strong capex cycle. In particular, the combination of China’s decoupling initiatives to free its semiconductor supply chain from the West and the West’s desire to open semiconductor manufacturing capacity in friendly countries is sparking an enormous capex revival.
 

 

Don’t count America out.

 

 

Biden’s challenges

In the short run, the Biden White House faces two key challenges that could unsettle risk appetite. The first is the looming debt ceiling. While lawmakers have always come to a last-hour agreement in the past, the Washington Post reported that a default or even a prolonged fight could have catastrophic consequences.

 

Mark Zandi, chief economist at Moody’s Analytics, found that a prolonged impasse over the debt ceiling would cost the U.S. economy up to 6 million jobs, wipe out as much as $15 trillion in household wealth, and send the unemployment rate surging to roughly 9 percent from around 5 percent.
The Bipartisan Policy Center estimates that the government will run out of funds some time between October 15 and November 4. Over at PredictIt, the odds of raising the debt ceiling by October 15 is fading fast.

 

 

The chances of a government shutdown is rising. Historically, the anticipation is worse than the actual pain. On one hand, the stock market hasn’t performed well leading up to debt ceiling showdowns.

 

 

On the other hand, the length of government shutdowns has risen but the stock market has performed well during those events. Sell the rumor, buy the news?

 

 

In addition, the Democrats are embroiled in an internal battle between the centrist wing and the progressive wing over the passage of the $3.5 trillion spending bill. There are two components of the bill of interest to investors. The first is the infrastructure and spending package. The IMF has estimated the jobs multiplier effect of government spending on different economies.

In advanced economies, $1 million of spending can generate an average of 3 jobs in schools and hospitals and over 6 jobs in the energy sector, assuming intermediate labor mobility and labor intensity levels. In low-income developing countries, the estimates are much larger and range from 16 jobs in roads to 30 jobs in water and sanitation. Put differently, each unit of public infrastructure investment creates more direct jobs in electricity in high-income countries and more jobs in water and sanitation in low-income countries.

 

 

The economic effects of the proposed social spending programs is difficult to project. However, some clues can be found in the last stimulus program, which was highly progressive, on differing households. A survey shows that spending was flat to slight up as household incomes categories rose, but the most striking effect is that lower-income households used the funds to pay off debt and strengthen their balance sheets. Unlike past recessions, loan delinquency rates fell instead of rising and poor households didn’t lose their houses and cars as they did in past recessions. If we were to extrapolate those effects, another fiscal impulse in the form of inequality programs such as daycare and tuition subsidies is likely to further strengthen lower-income household balance sheets and encourage more consumption.

 

 

The flip side of the $3.5 trillion coin is a corporate tax increase. Street consensus calls for the corporate tax rate to rise to 25% from 21%. Most top-down strategists are estimating a 5% decline in S&P 500 earnings as a consequence. Over at PredictIt, the market seems to have anticipated that outcome. Moreover, the recent 5% intraday peak-to-trough pullback in the S&P 500 would have discounted a 5% decline in earnings while keeping the forward P/E constant.

 

 

In conclusion, S&P 500 long-term breadth is deteriorating as the percentage of S&P 500 stocks above their 200 dma has retreated from a “good overbought” advance reading of 90%. Past episodes have resolved themselves either with a period of sideways consolidation or sharp pullback. Based on my analysis of the macro and technical backdrop, the sideways consolidation is the more likely scenario. Arguably, stock prices have been undergoing a period of sideways movement beneath the surface owing to the bifurcation between growth and value stocks.