The market’s instant FOMC report card

Posted by Cam Hui -

Mid-week market update: It’s always difficult to make any kind of coherent market comment on FOMC meeting days. The market reaction can be wild and price moves can reverse themselves in the coming days.
 

Nevertheless, experienced investors understand that it’s not the announcement that matters, but the tone announcement compared to market expectations. Bloomberg Economics conducted a survey ahead of today’s FOMC meeting and found the following:
 

  • FOMC will raise inflation, growth forecasts for 2021
  • Forecasts to shift rate liftoff to 2023
  • FOMC to signal bond taper at Jackson Hole in August
  • Taper announcement in December
  • Powell gets reappointed — Brainard is the next option

 

 

Here how the Fed decisions fared compared to Street expectations.

 

 

Market reaction

With that preface, the FOMC statement came in hot today by shading up the growth outlook.

 

 

The major changes were:

  • 3.4% inflation in 2021 (previous forecast: 2.4%)
  • Two rate hikes in 2023 (previous was no hikes)
  • Unemployment 3.8% in 2022 (previously 3.9%)

 

The market`s reaction to the Fed meeting can be measured by changes in the Treasury yield curve. Since the short end is firmly anchored, that effectively means monitoring the behavior of the 10-year Treasury yield. A steepening yield curve (rising 10-year yield) translates to the expectation of tighter monetary policy, while a flattening curve indicates that the market believes the Fed isn’t moving in the near future. The 10-year Treasury yield recently broke technical support but it surged above the support-turned-resistance line after the FOMC meeting.

 

 

Ouch!

 

 

Stock market implications

Bespoke recently published a chart of how the S&P 500 performed on FOMC meeting days under different Fed Chairs since 1994. The track record under Powell is historically bearish, especially after the press conference.

 

 

While the stock market’s reaction was consistent with Bespoke’s historical experience, that’s not the point. The US equity market has become increasingly bifurcated between growth and value. Growth stocks, as measured by the NASDAQ 100, is more sensitive to falling rates than value names. Investors should be thinking about positioning in growth or value, rather than the S&P 500 because it is not a monolithic market.

 

 

Investors need to keep the bifurcated nature of the stock market in mind as the S&P 500 tries to hold its upside breakout while struggling with numerous negative divergences.

 

 

My base case scenario calls for a period of sideways consolidation. I expect that prices will have a flat to slightly negative bias while the market resolves its expectations of Fed policy.

 

What I meant to say was…

Posted by Cam Hui -

After a number of discussions with readers, there appears to have been some misunderstanding over my recent post (see The bond market tempts FAIT). I did not mean to imply that the advance in bond prices is an intermediate-term move, only a tactical counter-trend rally. The decline in Treasury yields can be attributable to:

  • The market’s buy-in to the Fed’s “transitory inflation” narrative, which was discussed extensively in the post;
  • Excessively short positioning by bond market investors, as shown by a JPMorgan Treasury client survey indicating that respondents were highly short duration, or price sensitivity to yield changes; and

 

 

  • A FOMO stampede by corporate defined-benefit pension plans. A recent study showed that pension plans were nearly fully funded from an actuarial viewpoint. Falling rates would raise the value of liabilities, and without asset-liability matching, pension plans were at risk of widening their funding gap.

 

 

In short, the bond market rally is a tactical counter-trend rally. The combination of expansive fiscal and monetary policy will eventually put upward pressure on inflation and bond yields. 

 

That said, there are a number of pockets of uncorrelated opportunities for investors, regardless of how long Treasury yields stay down.

 

 

Gold and gold miners

I turned bullish on gold and gold miners about a month ago (see Interpreting the gold breakout). At the time, I pointed out that the initial point and figure target for the Gold Miners ETF (GDX) was 40. Never did I dream that GDX would reach its target within days of the publication of that post.

 

From a long-term perspective, both gold and GDX had broken out of a multi-month flag formation, which is a bullish continuation pattern and should have further upside potential. From a short-term perspective, both gold and GDX have pulled back and they have been consolidating sideways and GDX is testing the 50% retracement support level. The GDXJ (junior golds) are now outperforming GDX, which is a constructive indication of the return of speculative fever in the group. Look for the group to advance until the % bullish rises into the over 80% overbought zone.

 

 

Zooming out to a multi-year view, gold prices staged an upside breakout in mid-2020, pulled back, and it is now testing overhead resistance at 1900. Cross-asset signals are constructive. Real yields, as represented by TIP, are rising. So is the TIP to IEF ratio, which is correlated to the long-term inflation expectations ETF (RINF).

 

 

The intermediate-term outlook for gold is bullish and the current bout of weakness should be regarded as a buying opportunity.

 

 

Latin America

If the outlook for gold prices is bullish, then the path of least resistance for the USD should be down, since the two are inversely correlated. In particular, emerging market currencies have been strong against the USD.

 

While investors could expose themselves to a falling greenback by buying the EM currency ETF (CEW). Another way is through a bet on Latin American equities, whose relative performance has been correlated to EM currencies. Be aware, however, the Latin American region is highly undiversified. The two biggest weights, Brazil and Mexico, make up the bulk of the weight in the index.

 

 

In conclusion, the decline in Treasury yields represents a tactical counter-trend move. Nevertheless, there are other uncorrelated investment opportunities beyond the interest rate-related plays. Gold and gold miners are poised for another upleg. Latin American equities may be an overlooked USD-weakness-related play.

 

 

Disclosure: Long GDX

 

A new S&P 500 high, but…

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.
 

 

One last high?

The good news is the S&P 500 rallied to a marginal all-time high last week. The bad news is it was accompanied by a bearish RSI divergence.

 

 

There was even more bad news.

 

 

Non-confirmations everywhere

While it is said that there is nothing more bullish than fresh highs, most market internals are not confirming the stock market’s strength. While the NYSE Advance-Decline Line did advance to fresh highs, both NYSE and NASDAQ new 52-week highs are weakening. So are the percentage of S&P 500 and NASDAQ stocks above their 50 dma.

 

 

The small-cap Russell 2000 continues to languish in a trading range. As well, small-caps have violated a relative uptrend and they are now trading sideways against the S&P 500.

 

 

Equity risk appetite, as measured by the equal-weighted performance of consumer discretionary to staples, is exhibiting a strong negative divergence. The ratio of high-beta to low-volatility stocks is showing a minor negative divergence.

 

 

The price momentum factor, however it’s measured, is weak.

 

 

 

Sentiment warnings

A number of sentiment models are also flashing warnings. The latest update of AAII weekly sentiment shows that bearish sentiment remains at an extremely low level. This has been a cautionary sign for investors in the past.

 

 

In addition, the equity-only put/call ratio, which is reflective of individual trader activity, is falling and nearing historic lows again. By contrast, the index put/call ratio, which is more reflective of professional hedging activity, is rising.

 

 

Sentiment models are inexact timing indicators for calling tops. Nevertheless, the combination of sentiment and technical conditions is warning that the stock market advance is unsustainable. Current conditions call for differing ways of approaching the market, depending on the investor’s time horizon.

 

Investment-oriented accounts need to recognize that the primary trend is still up. Stay long equities and don’t worry about minor blips in the market. 

 

On the other hand, traders don’t need to be always aggressively long or aggressively short. This is a time to step to the sidelines. My base case scenario calls for a period of sideways and choppy sideways price action. Pullbacks should be relatively shallow and limited to drawdowns of 5% or less.

 

 

The bond market tempts FAIT

Posted by Cam Hui -

Remember when I called for a bond market rally (see What a bond market rally could mean for your investments). The 10-year Treasury yield broke support last week and shrugged off a hot CPI print. Is the bond market tempting FAIT, or the Fed’s Flexible Average Inflation Targeting framework?
 

 

Here are some of the broad market implications.

 

 

Transitory inflation

May CPI came in ahead of expectations, but more detailed analysis shows that the “hot” components were largely transitory in nature. Here are my main takeaways from that report:

 

  • Headline YoY CPI was boosted by strong energy prices, which was a low base effect increase owing to very low prices a year ago.
  • Standout strength in Core CPI was attributable to used car prices and airfares. The good news is that the pace of these prices increases have decelerated, indicating the transitory nature of these factors. As well, the CPI weights of airfares and used car prices account are relatively small.
  • Other transitory factors include strength in auto insurance, but those price increases have decelerated in the last three months.

 

 

Ahead of next week’s June FOMC meeting, here is what Fed policymakers are seeing on their inflation dashboard. Headline and Core CPI have spiked, but more detailed analysis shows that price increases were attributable to transitory factors. The Cleveland Fed’s median CPI remains tame, indicating that price increases were attributable to outlying noise.

 

 

From a global perspective, China is experiencing a growth deceleration. As the slower growth bleeds into the world economy, it should also put downward pressure on Treasury yields.

 

 

This should be good news for bond prices. But what about stock prices?

 

 

Rising wage pressure

One worrisome development for the suppliers of capital is the undersupplied labor market, which is putting upward pressure on wages.

 

I know that I am repeating myself, but the latest NFIB small business survey complained bitterly about employee recruitment and labor costs. These surveys are important because small businesses have little bargaining power and they are therefore sensitive barometers of economic conditions.

 

A record-high 48% of small business owners in May reported unfilled job openings (seasonally adjusted), according to NFIB’s monthly jobs report. May is the fourth consecutive month of record-high readings for unfilled job openings and is 26 points higher than the 48-year historical reading of 22%.

 

Small business owners continue to report finding qualified employees remains a problem with 93% of owners hiring or trying to hire reported few or no “qualified” applications for the positions they were trying to fill in May. Thirty-two percent of owners reported few qualified applicants for their positions and 25% reported none.
 
Eight percent of owners cited labor costs as their top business problem and 26% said that labor quality was their top business problem, the top business concern.

Could government support be encouraging workers to stay home? Will the economy see a flood of new workers flood the market when job benefits expire? The preliminary answer is no. Indeed tracked the job search activity of states that are cutting enhanced unemployment benefits on June 12. Job searches in these states have not picked up. In fact, they are below the national average.
 

 

Joe Wiesenthal at Bloomberg pointed out an unusual condition in the Beveridge Curve:

One indicator that economists like to look at is the so-called Beveridge Curve, which plots the unemployment rate against the rate of job openings. Historically there’s been a somewhat stable relationship between the two. Job openings go up and the unemployment rate goes down, as you would expect. But as with everything else weird about this recovery, that’s breaking down.
 

As you can see here on the chart from the BLS, job openings are soaring (see the highlighted part) while the unemployment rate holds steady.

 

 

Wiesenthal went on to highlight the analysis of Fed watcher Tim Duy, who believes that labor market shortages are here to stay.
 

In a note to clients this morning, Tim Duy of SGH Macro Advisors notes that this new weird shape of the curve holds true even if you look at alternative measures of non-employment besides the standard U-3 measure: “it appears that labor market frictions not related to unemployment insurance appear to have been increasing. That’s not exactly great news if you are expecting the end of enhanced UI benefits will dramatically ease labor market frictions.”
Translated, these conditions are putting upward pressure on wages. The open question is whether this will result in a wage-price spiral, or if this is a “once and done” upward adjustment in compensation. It’s possible that we are just seeing a one-time effect of wage competition at the low-end as large employers like Amazon and McDonald’s raised their employee pay.

 

Time will tell, but rising compensation costs are putting pressure on operating margins. As well, the risk is that an escalating wage-price spiral will force the Fed to raise rates in order to cool rising inflationary expectations.

 

 

What a bond market rally means

In the meantime, the bond market is buying into the Fed’s narrative of “transitory inflation” and yields are falling. As I pointed out in my May 29, 2021 note (see What a bond market rally could mean for your investments), falling yields will translate into better performance by high-duration interest-sensitive growth stocks. Expect a temporary counter-trend rally by growth names.

 

 

My investment style dashboard shows that the value-growth ratios are correcting across all market cap bands.

 

 

In addition, cyclical stocks are all rolling over in relative performance in some manner.

 

 

 

A global rotation

In addition, investors are rotating out of US equities. Here is a closer look at the relative performance of the major regions against MSCI All-Country World Index (ACWI). As US equities falter, Europe has caught a bid. Even Japan is turning up, and so are emerging markets, especially outside China.

 

 

Willie Delwiche observed a marked difference between industry breadth in the US and abroad. The percentage of US industries making new highs has been declining.

 

 

On the other hand, the percentage of industries in ACWI making new highs has been holding up well.

 

 

Jens Nordvig wrote a Marketwatch opinion piece which argued that “Global investors are losing interest in U.S. stocks and that will be a game changer”. Nordvig pointed out that equity fund flows into US equities fell dramatically in March. He believes “this is all logical since the rest of the world is catching up with the U.S. on the vaccine front”.

 

 

I believe the rotation is attributable to the wage pressures in the US, which will squeeze margins and the expectation that economic growth differentials between the US and Europe will narrow. Eurozone equities have staged a relative upside breakout against ACWI, with strength coming from France, Italy, and Greece. The most notable laggard is Germany.

 

 

The UK is a more complicated situation. Large-cap UK equities have staged a relative breakout, and small-caps performed even better as Brexit jitters have diminished. Nevertheless, disagreements with the EU overfishing and the Irish border are issues specific to that market.

 

 

Over in Asia, the bleeding in China and China-related plays appears to have stopped despite signs of Chinese growth deceleration. Chinese stocks and the markets of her major Asian trading partners are all bottoming relative to ACWI. Selected markets like Taiwan and Australia are exhibiting some signs of relative strength.

 

 

More importantly, Chinese material stocks are bottoming against global materials. I interpret this as an indication that the growth deceleration is over.

 

 

In conclusion, the US Treasury market has shrugged off inflationary worries and has begun to rally. This is creating a short-term tailwind for interest-sensitive growth stocks. The bigger picture that is investors are starting to rotate away from US equities because of lower growth differentials and expectations of margin compression owing to wage pressures.

 

 

The valuation differential between US equities and the rest of the world is finally closing.

 

 

 

Pigs get slaughtered…

Posted by Cam Hui -

Mid-week market update: Traders have an adage, “Bulls make money. Bears make money. Pigs just get slaughtered.” It’s time for equity bulls to be near-term cautious on stocks, though I expect any market weakness to be relatively shallow.
 

In my weekend update, I had set out a number of tripwires (see Time is running out for the bulls). So far, the S&P 500 is struggling to overcome resistance even as it exhibits a negative RSI divergence.
 

 

On the other hand, the 10-year Treasury yield has decisively breached support.

 

 

While this development is likely to be tactically supportive of growth stocks and NASDAQ relative performance, the near-term risk for US equities is rising.

 

 

 

Sentiment and technical warnings

While the AAII bull-bear spread has not been very effective as a sell signal, the level of bearishness (bottom panel) has been more useful and timely. In particular, the market has encountered headwinds whenever AAII bears reached the 20% (last reading: 19.76%).

 

 

Bad industry breadth is raising another warning. Willie Delwiche also observed that the number of industry groups making new highs declined to 22% last week.

 

 

 

Fundamental catalysts

From a chartist’s perspective, the market bull looks tired and needs a rest. From a fundamental and macro perspective, bullish momentum may be waning as earnings estimate revisions start to decelerate as Morgan Stanley strategist Michael Wilson recently warned:

 

We remain concerned that after the most positive earnings revisions quarter on record, next year’s consensus forecasts are now above what our analysis suggests is achievable for the first time since the recovery began. More specifically, we think margin assumptions are too high given the headwinds from inflation and taxes that have not been baked into estimates.

Jurrien Timmer at Fidelity also observed that the rate of earnings estimate revisions is peaking and rolling over.
 

 

Further to yesterday’s note about labor market pressures (see NFIB update: Revenge of the Proletariat?), Joe Wiesenthal at Bloomberg highlighted a comment from Fed watcher Tim Duy about the resilience of labor market shortages [emphasis added].

 

One indicator that economists like to look at is the so-called Beveridge Curve, which plots the unemployment rate against the rate of job openings. Historically there’s been a somewhat stable relationship between the two. Job openings go up and the unemployment rate goes down, as you would expect. But as with everything else weird about this recovery, that’s breaking down.
 

As you can see here on the chart from the BLS, job openings are soaring (see the highlighted part) while the unemployment rate holds steady.
 

In a note to clients this morning, Tim Duy of SGH Macro Advisors notes that this new weird shape of the curve holds true even if you look at alternative measures of non-employment besides the standard U-3 measure: “it appears that labor market frictions not related to unemployment insurance appear to have been increasing. That’s not exactly great news if you are expecting the end of enhanced UI benefits will dramatically ease labor market frictions.”

 

Obviously there are a lot of people who assume that the labor market will go “back to normal” once the UI expansions expire, childcare becomes easier, the pandemic starts to fade and so on. But at the moment, things are still looking pretty unusual.
 

 

In short, Duy believes that labor market shortages are here to stay and wage pressures will continue. Putting it all together, net margins will come under increasing pressure from rising labor costs, inflationary pressures, and rising tax rates. The stock market is likely to get spooked by these factors.

 

Be cautious. Don’t be a greedy pig.

 

NFIB update: Revenge of the Proletariat?

Posted by Cam Hui -

The monthly NFIB update is always useful as a window on the economy. Small businesses tend to have little bargaining power and they are therefore sensitive barometers of economic trends. A month ago, NFIB small business optimism surged (see NFIB conservatives grudgingly turn bullish). The latest report saw optimism stall as readings edged back from 99.8 to 99.6. 
 

 

The biggest complaint was the availability of labor. While the JOLTS report comes to a similar conclusion, it is a survey of April conditions while the NFIB survey period is May. Its headline “Nearly Half of Small Businesses Unable to Fill Job Openings” tells the story.

 

 

Economic strength + labor shortages

Still, the decline in optimism has to be taken with a grain of salt. Of the 10 components that make up the Small Business Optimism Index, six were positive, one was neutral, and three were negative. The single category that dragged down the reading was “expect economy to improve”.

 

 

Seriously? The economy is red hot and just recovering from the sudden stop of a pandemic-induced recession. Sales and sales expectations are rising strongly, and a net -26% of respondents expect the economy to improve? I interpret that as the small business small-c conservative political bias against a Democratic-led White House and Congress.

 

 

Nevertheless, the reports of labor market shortages are worthy of consideration. The NFIB reported:

 

A record-high 48% of small business owners in May reported unfilled job openings (seasonally adjusted), according to NFIB’s monthly jobs report. May is the fourth consecutive month of record-high readings for unfilled job openings and is 26 points higher than the 48-year historical reading of 22%.
Labor market complaints were especially bitter [emphasis added]:
Small business owners continue to report finding qualified employees remains a problem with 93% of owners hiring or trying to hire reported few or no “qualified” applications for the positions they were trying to fill in May. Thirty-two percent of owners reported few qualified applicants for their positions and 25% reported none.

 

Eight percent of owners cited labor costs as their top business problem and 26% said that labor quality was their top business problem, the top business concern.

For investors, the questions to consider is how transitory are these labor problems and how will the Fed react?
 

 

Uneven wage pressures

The Atlanta Fed’s Wage Growth Tracker sheds some light on this problem. Wage growth among low-skilled workers plummeted upon the onset of the recession, though high-skilled wage increases remained steady. As the economy reopened, low-skilled wage growth snapped back.
 

 

Is this a case of the revenge of the Proletariat? Labor market shortages are attributable to a combination of the lack of suitable child care for female workers, fear of the pandemic, and government wage supplement support. Disentangling and quantifying the effects of each of these components is a challenge for policymakers. We will know for sure the effects of government support once those subsidies run out in September. 
 

For Fed policymakers, the issue is whether these wage pressures indicate the start of a cycle of cost-push inflation. For the time being, they will regard these pressures as transitory unless proven otherwise. The Atlanta Fed’s Core Sticky-Price CPI, which is “a weighted basket of items that change price relatively slowly”, has been steady throughout the pandemic. By contrast, the Flexible CPI, which is “a weighted basket of items that change price relatively frequently”, has skyrocketed. 
 

 

This is what transitory inflation looks like.
 

 

The reopening trade

For investors, they can look forward to an economy that’s reopening. The Transcript, which monitors company earnings calls, summarized the latest set of calls as a booming economy.

Summer has started and the US economy is booming. Economic activity is surging past 2019 levels. The numbers are staggering. GDP growth is expected to hit 7% this year led by consumer spending. Bank of America said that its consumer accounts are registering 20% more spend than 2019. There’s still plenty more liquidity too. This all seems incongruent with 10-year treasury yields that are 40 bps below where they were before the pandemic.

The reopening trade can be seen in the relative performance of Leisure and Entertainment stocks against the S&P 500.
 

 

The FOMC is meeting next week. While there will likely some discussion of tapering its QE programs, those actions have largely been discounted by the market. Expect further language about the transitory nature of price pressures.
 

Time is running out for the bulls

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.
 

 

Negative seasonality ahead

While I am not inclined to trade strictly on seasonality, technical conditions agree with the seasonal pattern. If history is any guide, the S&P 500 is scheduled to pause its advance starting about mid-June.

 

 

My base case scenario of record calls for the index to test its old high and possibly make a marginal new high, but the time is running out for the bulls. The coming week is the bulls’ last chance to show their strength.

 

 

Dark clouds on the horizon

The technical tea leaves are not looking very good. The top five sectors make up about three-quarters of S&P 500 weight and it would be difficult for the index to advance or decline without the participation of a majority. A review of the relative performance of these sectors shows that only one, Financials, can be described as being in a relative uptrend. The rest are either weakening or trading sideways compared to the index.

 

 

The high-beta NASDAQ 100 is testing resistance while exhibiting a negative 5-day RSI divergence. Speculative growth stocks as represented by ARK Innovation ETF (ARKK) failed at its 50 dma resistance. As well, the NASDAQ 100 McClellan Oscillator reached a near overbought condition before rolling over.

 

 

The burst of speculative froth by meme stocks have also marked past trading tops in the past. Here are AMC and GME. Will this time any different? Do you feel lucky?

 

 

 

Another warning comes from the spike in the correlation between the S&P 500 and the VIX Index, and the S&P 500 and the VVIX, which is the volatility of the VIX. While readings did not reach sell signal levels, the surge in correlation is nevertheless a warning that the bulls have a narrow window to push prices upward.

 

 

 

Setting tripwires

Here is what I am watching. Can the defensive sectors regain their relative strength in the coming days? If so, it will be a signal that the bears have regained control of the tape.

 

 

Can the 10-year Treasury yield break down through support. A support break would be a signal of a bond market rally that could lend a second wind to growth stocks (see What a bond market rally could mean for your investments).

 

 

Finally, watch to see if the S&P 500 can break resistance or breach support. The challenge for the bulls is to stage an upside breakout in the face of negative RSI divergences. The challenge for the bears is trend line support in the 4180-4190 range.

 

 

Don’t get me wrong. The intermediate-term trend is still up. The market is just due for a pause. My inner investor remains bullishly positioned. My inner trader is getting ready to take profits at a moment’s notice.
 

 

Disclosure: Long SPXL

 

Is the S&P 500 wildly overvalued?

Posted by Cam Hui -

Several readers asked me to address the valuation warning from Jason Goepfert of SentimenTrader, who found that the S&P 500 is wildly overvalued based on a combination of real earnings yield and dividend yield.
 

 

Let’s begin by unpacking Goepfert’s chart (annotations are mine). There were five instances since 1970 when the market appeared overvalued based on this metric. The market had already begun falling in two episodes (red boxes: the Nifty Fifty top and the GFC top), and this indicator signaled tops in three (grey boxes: Volcker induced bear market, 1987 Crash, and the Dot-Com Bubble). Is a success rate of 60% (three out of five top calls) enough for an effective sell signal?

 

 

Differences in opinion

I have a difference of opinion over Goepfert’s methodology. First, he uses the inverse of the trailing P/E ratio instead of forward P/E to calculate real earnings yield “because [forward P/E ratios are] nothing but guesses. And Wall Street analysts are notoriously inaccurate at predicting the future.” While the claim that the Street is notoriously inaccurate at predicting the future is correct, the market is a discounting mechanism, and using last reported earnings can lead to valuation distortions, especially when the economy is emerging from a recession.

 

As the chart below shows, trailing 12-month P/E skyrocketed in 2020 as the economy came to a sudden stop because of the pandemic. The S&P 500 rose after a brief setback and never looked back. Does that mean investors should be worried about valuation based on trailing P/E? The answer is no. As the economy began to improve, earnings rose and the trailing P/E fell.

 

 

Contrast a similar analysis based on forward P/E. While I recognize that forward earnings estimates are a form of fiction, what matters more to the market is the direction of change and not the absolute level of earnings estimates. Using forward P/E allows investors to be forward-looking instead of backward-looking. The forward P/E ratio has been relatively steady since the recovery from the COVID Crash, indicating that EPS estimates have been rising in line with the market. 

 

 

Moreover, the forward 12-month estimates have risen faster than the S&P 500 in recent weeks. The forward P/E ratio fell as a consequence, which improves the valuation picture. FactSet reported that the S&P 500 experienced the largest EPS increase for Q2 to date since 2002, which was the year a new bull market began in the wake of the NASDAQ Crash.

 

 

In addition, Goepfert appears to be mixing real inflation-adjusted valuations with nominal returns.

 

Now that there has been a spike in inflation gauges, the earnings yield on the S&P 500 has turned negative. This is not a condition that investors have had to tackle much over the past 70 years.

 

When an investor in the S&P adds up her dividend check and share of earnings, then subtracts the loss of purchasing power from inflation, she’s barely coming out even. This is a record low, dating back to 1970, just eclipsing the prior low from March 2000. 

 

If we ignore dividends, then there have been five other times when the S&P 500’s inflation-adjusted earnings yield turned negative. The S&P failed to rally more than 7% at its best point within the next two years after all but one signal.
What is the bear case here? If an investor is using inflation-adjusted valuations, shouldn’t that be benchmarked against real returns, rather than nominal returns? If the bear case is a spike in inflation which acts to depress equity valuations, then what alternative asset classes should the investor consider? To be sure, I have pointed out in the past that many non-US equity markets offer more attractive alternatives than the US (see In search of global opportunities), but the case I made was based on relative performance and not an absolute performance.

 

In short, Goepfert’s analysis appears to be a case of torturing the data until it talks.

 

 

ERP and its variants

Notwithstanding Goepfert’s insight, other analysts have highlighted variations of a bearish inflation-adjusted earnings yield valuation thesis. In differing ways, these are all different applications of the Fed Model, which measures the spread between the E/P ratio and interest rates, otherwise known as the Equity Risk Premium (ERP).

 

Morgan Stanley pointed out that an inflation-adjusted equity risk premium, which is the forward earnings to price yield minus a 10-year breakeven rate, has fallen to lows last seen at the height of the NASDAQ top.

 

 

Michal Stupavsky of Conseq Investment Management also observed that the S&P 500 inflation-adjusted earnings yield (without dividends) has set a 40-year low.

 

 

 

Bullish interpretations

There are, however, more benign interpretations of ERP. If investors were to compare the S&P 500 earnings yield minus the BBB real yield, which reflects the corporate cost of capital, valuations appear to be more benign. Arguably, the market looks slightly cheap if measured this way.

 

 

Aswath Damodaran, finance academic at the NYU Stern School, has maintained an ERP model based on nominal equity and bond yields. His latest update shows a reading of 4.24%, which is approximately the level seen at the market’s 2009 bottom.

 

 

Jurrien Timmer at Fidelity Investments calculated a market valuation based on price to total cash, which is the dividend yield plus buyback yield. He concluded, “By this metric, the market looks reasonably priced, right in line with where it was at the same points during the 1949-68 and 1982-2000 secular bull markets.”

 

 

 

Inflation and Fed policy

How can we resolve this valuation debate? Is the stock market about to keel over and crash?

 

For some historical perspective, bear markets are caused by recessions. Of the five instances that Jason Goepfert originally cited, only the 1987 Crash was sparked by excessive valuation. In all cases except for the COVID Crash, the recessions were caused by the Fed tightening monetary policy.

 

 

The global economy just emerged from a massive recession. What are the chances that central banks tighten to cool off overheated economies? BCA Research pointed out that the Fed rate hike came two years after the last QE taper. Various Fed speakers have started to discuss how the Fed may taper its QE program. Market expectations indicate that a taper will begin either late this year or early next year. If the Fed were to follow the script of the post-GFC era, rate hikes won’t begin until late 2023 or 2024.

 

 

Much depends on the Fed’s reaction function to inflation data. So far, the Fed has dismissed the surge in prices as transitory. Core CPI and Core PCE came in hot at 3.0% and 3.1% respectively. On the other hand, the Dallas Fed’s Trimmed Mean PCE, which excludes outlying components, is relatively benign at 1.8%.

 

 

There is a case to be made that the recent price spikes are indeed transitory. Used car prices, which is one element of price increases that have driven the inflation surge, are showing signs of deceleration.

 

 

The Fed is determined to run a hot economy. The prospect of rate increases is far on the horizon, especially in light of two soft consecutive Non-Farm Payroll reports.

 

 

Bullish momentum

From a technical perspective, Willie Delwiche observed that 86% of global markets are above their 50 dma, indicating strong breadth and positive price momentum. While this does not mean that the market is going up in a straight line, similar past signals have been intermediate-term bullish for the S&P 500.

 

 

In conclusion, the fears of a valuation-induced market crash are overblown. Recessions are bull market killers, and there is no sight of a recession on the horizon. Fed policy is accommodative and it is expected to be easy for some time. While I have made the case before that US investors could find better bargains outside America’s borders (see In search of global opportunities), this does not mean that the S&P 500 will experience a bear market in the near future. 

 

This is a bull market. Enjoy it.

 

 

Don’t short a dull market

Posted by Cam Hui -

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

 

Don’t short a dull market.

 

 

A risk appetite revival

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

 

 

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

 

 

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

 

 

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

 

 

Beware of the June swoon

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

The wall at S&P 4200

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The S&P 500 tests overhead resistance

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

 

 

 

Short-term bullish

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

 

 

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

 

 

 

A different kind of rally

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXL

 

What a bond market rally could mean for your investments

Posted by Cam Hui -

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

 

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

 

 

Bond market rally ahead?

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

 

 

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

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

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

 

 

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

 

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

 

 

 

Transitory inflation fears

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

 

 

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

 

 

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

 

 

Growth stock counter-trend rally ahead

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

USD and gold

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

 

 

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

 

 

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

 

 

 

Disclosure: Long GDX

 

A test of the old highs?

Posted by Cam Hui -

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

 

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

 

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

 

 

 

Due for a pause

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

 

 

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

 

 

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

 

 

In short, the leadership picture appears unexciting.

 

 

The MTUM shuffle

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

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

 

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

 

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

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

 

Is the pullback over?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A slow-motion pullback

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

 

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

 

 

Is the pullback over?

 

 

The bull case

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

The bear case

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

 

 

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

 

 

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

 

 

 

The verdict

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

 

 

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

 

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

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

 

 

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

 

 

Disclosure: Long SPXL

 

In search of global opportunities

Posted by Cam Hui -

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

 

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

 

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

 

 

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

 

 

US: The threat from taxes

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

 

 

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

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

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

 

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

 

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

 

 

Europe: The value play

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

 

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

 

 

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

 

 

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

 

 

China: A decelerating economy

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

 

 

Other EM: The beat of their own drummers

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

 

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

 

 

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

 

 

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

 

 

 

The world through a value/growth lens

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

 

 

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

 

 

Investment summary

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

 

 

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

 

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

 

 

Here comes the retest

Posted by Cam Hui -

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

 

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

 

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

 

 

A shallow pullback

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

 

 

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

 

 

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

 

 

More weakness ahead

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Where’s the fear?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

A lack of panic

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

 

 

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

 

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

 

 

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

 

 

 

Positioning vs. opinion

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

 

 

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

 

 

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

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

 

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

 

 

 

The “value” port in the storm

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

 

 

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

 

 

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

 

 

 

Wait for the retest

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Interpreting the gold breakout

Posted by Cam Hui -

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

 

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

 

 

Why I am bullish on gold

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

The long-term big picture

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

 

 

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

 

 

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

 

 

 

Key risks

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

 

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

 

 

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

 

 

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

 

 

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

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

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

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

 

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

 

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

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

Investment implications

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

 

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Disclosure: Long GDX

 

The bears take control

Posted by Cam Hui -

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

 

 

Time for a pause

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

 

 

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

 

 

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

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

 

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

 

 

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

 

 

Where’s the bottom?

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

 

 

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

 

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

 

 

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

 

 

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

 

 

NFIB conservatives grudgingly turn bullish

Posted by Cam Hui -

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

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

 

 

This is a strong indication of economic strength.

 

 

More NFIB details

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

JOLTS: A strong labor market

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

 

 

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

 

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

 

 

A “Not Enough” recovery

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

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

 

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

 

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

 

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

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

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

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

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

 

 

 

Q1 Earnings Monitor: The jobs puzzle

Posted by Cam Hui -

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

 

 

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

 

 

A strong “A”

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

 

 

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

 

 

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

 

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

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

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

 

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

 

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

 

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

 

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

 

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

 

 

The jobs puzzle

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

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

 

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

 

 

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

 

 

Investment implications

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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