The Evergrande panic bottom?

Posted by Cam Hui -

Mid-week market update: The stock market gapped down on Monday on China Evergrande contagion fears. The technical outlook darkened further Tuesday when a rally attempt failed. The markets took on a risk-on tone this morning when Evergrande issued an ambiguous statement that a coupon due on its yuan-denominated bond. An agreement had been reached with its lenders but the statement didn’t specify the nature of the payment, or when it would be paid. 
 

While today’s rally is constructive for the bulls, the S&P 500 has yet to fill in the gap from Monday’s downdraft.
 

 

Was that the bottom?

 

 

Market bottom models

Three of the four components of my short-term market bottom model flashed signals on Monday. The 5-day RSI was deeply oversold; the VIX had surged above its upper Bollinger Band, and the NYSE McClellan Oscillator had fallen into oversold territory. The near-miss was the failure of the VIX term structure to invert, though it did briefly invert intraday Monday. Barring the appearance of further negative fundamental drivers, historically this has meant that a short-term bottom is near.

 

 

Other historical studies indicate risk/return is skewed to the upside. The % of S&P 500 stocks above their 10 dma is in extreme oversold territory. In the 18 instances over last five years, the 30-day subsequent median return return was 4.6%, wich a success rate of 83% – and that study includes the COVID Crash.

 

 

Rob Hanna at Quantifiable Edges also found that a three-day consecutive decline into an FOMC day has historically resolved bullishly.

 

 

 

Not out of the woods

Even though the historical studies show that risk/reward is skewed to the upside, bullish traders and investors are not totally out of the woods. Washington is still embroiled in a debt ceiling battle and Mark Hulbert has documented that the market does not perform well ahead of such deadlines, which is expected to be September 30.

 

 

I interpret current conditions as a bottom has either been reached, or the market is forming a complex W-shaped bottom. Downside risk should be limited unless the market is presented with another unexpected shock, though traders should be prepared for a retest of the old lows next week as debt ceiling anxiety continues. 

 

As I indicated (see How US equity investors should trade the Evergrande panic), my inner trader dipped his toe in on the long side on Tuesday. He will add to his position should the market retrace and retest the previous lows.

 

 

Disclosure: Long SPXL

 

How US equity investors should trade the Evergrande panic

Posted by Cam Hui -

Global markets have taken a decided risk-off tone today. The spark is the China Evergrande implosion. Fears are rising that Evergrande is turning from a liquidity crisis in which the company doesn’t have enough cash to pay its obligations, to a solvency crisis in which the company’s assets are less than its liabilities if it is forced to fire-sale its properties.
 

 

In the US, the S&P 500 had been largely immune to Evergrande news until today. The index decisively violated its 50 dma. Investors are becoming spooked not only over the possibility of an Evergrande contagion but a looming crisis in Washington over the debt ceiling.

 

Is this a buying opportunity, or a crack in the dam that foretells disaster?

 

 

A domestic crisis

Take a deep breath. An Evergrande collapse is unlikely to spark an emerging market crisis and contagion. That’s because most of the company’s debts are RMB denominated and little is in USD and other foreign currencies. John Authers rhetorically asked the same question:

So here is the key question: What kind of a moment will the Evergrande Moment be? Will it be a Minsky Moment, akin to the Lehman collapse? Or will it be more akin to the LTCM Moment? Or might it just be altogether less momentous? To measure this we need to resuscitate another concept of which many of us thought we had heard the last more than two decades ago: Asian contagion. How much effect will Evergrande’s troubles have on the rest of us?

Global markets have been relatively unscathed by the crisis. There will be little global contagion effect because it will all be contained in China.

So why is there still relative calm? It boils down to a close reading of the Chinese authorities’ intentions. They have no interest in staging their own Lehman. There has been alarm about the possibility of a Minsky moment for years in Chinese circles, frequently voiced out loud. Officials know what could happen and are determined to prevent it if they can. Efforts to rein in credit have been going on for years. And Evergrande is in trouble largely because the government itself decided to clamp down on property developers through the “three red lines” policy last year.

Authers concluded:

To be clear, an LTCM outcome isn’t great. It leaves the risk of more moral hazard. And while the PBOC can probably avert a full-blown credit crisis, it can’t stop the weakness of the property sector turning into disappointing economic growth for China. Many small savers and hopeful property buyers will inevitably be hurt by whatever deal can be thrashed out — and the  precise shape of that deal will matter a lot. But for the moment, world markets are nervous that this could be another LTCM, while comfortable that it won’t be a Lehman. On balance, both of these points look reasonable. Now let’s see what happens.

A number of bearish investors have pointed to plummeting iron ore prices as signs of slowing growth in China, which could have global repercussions. But George Pearkes at Bespoke pointed out that steel and other industrial metal prices are still holding up well.
 

 

Relax. Any contagion effect will be minimal.
 

 

A panic bottom?

In the US, the stock market is starting to flash signs of a panic bottom. The Zweig Breadth Thrust Indicator has plunged into oversold territory, which is often a signal of a short-term bottom.
 

 

My S&P 500 bottom models are starting to flash buy signals. The 5-day RSI is deeply oversold. The VIX Index has surged above its upper Bollinger Band, which is another oversold signal. The term structure of the VIX inverted intraday, indicating fear.
 

 

To be sure, this week (the week after September OpEx) is historically the weakest week of the year, as documented by Rob Hanna at Quantifiable Edges. However, Hanna pointed out that the average weekly “weakest week” drawdown is -2.3%. As the S&P 500 is -1.7% today, the index is nearing its average downside target.
 

 

While oversold markets can become more oversold, a bottom is near. Nevertheless, this market isn’t without risk. Mark Hulbert studied the stock market’s return in the two weeks prior to debt-ceiling showdowns and returns have been disappointing. As well, the FOMC meeting this week could be a source of volatility.
 

 

My inner trader plans to take an initial position on the long side in the S&P 500 at the open tomorrow morning. This is a volatile market and traders should size their positions accordingly. Be prepared for a short-term bounce, followed by a retest of the lows later this week or possibly next week.

 

A correction in time?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The stealth correction?

For several weeks, I have been calling for a choppy sideways market, but the S&P 500 continues its upward grind. To be sure, the index pulled back about 2% last week and briefly tested its 50 dma, but its upward trajectory has been relentless. 

 

A discussion with another chartist raised the possibility that the market has been undergoing a stealth correction. As good technicians know, corrections can occur in price or in time. Beneath the surface, market internals have been correcting in both price and time. My equity risk appetite models have been trading sideways for much of this year.

 

 

Breadth indicators tell a similar story. While the S&P 500 Advance-Decline line has made fresh highs during the current advance, other versions of the A-D Line have been flat to weak. The weakest have been the NASDAQ and the S&P 600 small-cap A-D Lines. 

 

The tactical outlook is more constructive. Even as the S&P 500 tested the 50 dma and made a marginal low last Friday, all of the A-D Lines except for the S&P 500 did not make a fresh low.

 

 

 

The rolling correction

The rolling correction can be measured in many ways. One is the value/growth cycle. Large-cap growth makes up about 45% of the S&P 500 weight and dominates index movement, while value stocks comprise a smaller 31%. The disparity in weights explains the upward drift in the S&P 500 because of the recent leadership of growth stocks.

 

However, the value/growth ratio may be showing signs of turning up. The ratio is exhibiting a series of positive RSI divergence similar to the value bottom during the July to November period in 2020. In addition, relative breadth (bottom two panels) is showing signs of improvement.

 

 

Another reason for a possible turn in the value/growth cycle is complacency. Technology stocks, which form the bulk of the growth stock universe, are vulnerable to a setback, according to SentimenTrader.

 

 

Another manifestation of the stealth correction in time is the sideways and range-bound price action of small-cap stocks for most of 2021. While the small-cap/large-cap ratio is also exhibiting a constructive positive RSI divergence, I remain unconvinced of the bullish implications of this signal until the Russell 2000 and S&P 600 stage upside breakouts.

 

 

 

A bullish surprise

I encountered a positive surprise from the credit market. The relative price performance of junk bonds to their duration-equivalent Treasuries made a new high last week, indicating a strong credit market risk appetite.

 

 

Brian Reynolds of Reynolds Strategy pointed out that equities look cheap against junk bonds when the equity risk premium is calculated using junk bond yields.

 

 

 

The primary trend is up

These conditions tell me that we are experiencing a bull market. While I have few insights as to when the choppiness will end, short-term downside risk should be relatively limited. The latest AAII sentiment survey shows a dramatic drop in the bull-bear spread. Such a spike in bearishness in the face of a minor 2% peak-to-trough drop in the S&P 500 is bullish from a contrarian basis.

 

 

A tactical low looks near. The S&P 500 tested its 50 dma but the 5-day RSI flashed a minor positive divergence. As well, the VIX Index closed within a hair of its upper Bollinger Band, which would be a short-term oversold signal.

 

 

On the other hand, I was surprised by the inability of the term structure of the VIX to invert despite the recent market weakness. Neither the longer term one-month to three-month ratio nor the nine-day to one-day ratio inverted. I am open to the possibility that the market may need one final panic for a tradable bottom to appear. 

 

 

Next week’s FOMC meeting may be a source of volatility. As well, Mark Hulbert that stock prices tend to struggle ahead of a debt ceiling dispute, which is expected to occur in the next two weeks.

 

 

Investment-oriented accounts should remain bullishly positioned and be prepared to buy any weakness. Traders may wish to wait on the sidelines until a definitive trend becomes evident and be prepared to buy either the panic bottom or the upside breakout.

 

 

Not your father’s stagflation threat

Posted by Cam Hui -

Stagflation worries are rising. A recent analysis of search activity shows that searches for stagflation have spiked compared to other inflation search terms.
 

 

The latest BoA Global Fund Manager Survey also shows that stagflation concerns are rising.

 

 

These fears are misplaced. The conventional mechanisms for stagflation are not present. Instead, investors should be prepared for a different sort of stagflation threat.

 

 

What is stagflation?

When investors think about stagflation, they think back to the 1970s, which was a period of high inflation and anemic economic growth. Arguably, the roots of inflation began with Lyndon Johnson’s “guns and butter” policy in his conduct of the Vietnam War and his Great Society programs. The combination of overly expansive fiscal and monetary policies led to rising inflationary pressures, which eventually manifested themselves in the runaway inflation of the 1970s.

 

 

Fast forward to 2021. Top-down data shows the combination of strong positive inflation surprise and falling economic surprise. The combination of these factors is giving rise to stagflation fears.

 

 

Mohamed El-Erian recently wrote a Financial Times Op-Ed warning about stagflation risks.
 

The culprit is some mix of disrupted supply chains, high transportation costs, container scarcity and congested ports…

 

Fewer chief executives have confidence that such disruptions are temporary and quickly reversible. This will restrain growth plans despite robust demand, and increase pressure to raise prices to offset higher costs…Such reversible factors are accompanied by supply side troubles that could last for one to two years, if not more

 

Added to inflation already in the pipeline, all this translates into stagflationary winds for the global economy that are unfamiliar to those that did not live through the 1970s.

 

 

Misplaced fears

These fears are misplaced. I have argued in the past (see How to engineer inflation), that the conventional models for explaining inflation have been unsatisfactory.
It is said that deficit spending would lead to currency devaluation and inflation in the manner of the Weimar Republic. Nothing could be further from the truth. The blue line represents federal government deficits as a percentage of GDP. Deficits began to balloon in the early 1980`s with the Reagan Revolution and continued during the Bush I era. Did inflation (purple line) explode upward?

 

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

 

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

 

 

Instead, investors should focus on the evolution of wage gains as the key factor to inflation pressures. The Fed has stated that it is focused on wage inequality as an additional metric of labor market tightness and it will conduct monetary policy accordingly. 

 

The following factors do not indicate a return to a stagflation environment over the next few years.
  • Inflation pressures are transitory.
  • The economy is embarking on a capital expenditure cycle, which should keep inflation contained.
  • The Misery Index is tame.

 

 

Transitory inflation

Here is why Fed policymakers believe that inflation pressures are largely transitory. Most of the inflation has been concentrated in durable goods, which are subject to supply chain bottlenecks. The August CPI print came in below expectations, which was positive for the doves in the FOMC. Even Owners’ Equivalent Rent, which has a significant weight in CPI and has been a subject of concern for many economists, was tame.

 

 

In addition, IMF Chief Economist Gita Gopinath pointed out that high inflation is correlated with “the speed of recovery and bounce back in demand”. This is indicative of a cyclical effect that is undoubtedly affected by short-term shortages.

 

 

There are signs that the supply chain disruptions are beginning to ease. Bloomberg reported that “Shipping Lines Think Spot Rates Have Peaked”.
 

One of the world’s biggest shipping lines has decided to stop increasing spot freight rates on routes out of Asia to Europe and the U.S. as it sees an end to the rally that has seen prices hit records.

 

Hapag-LLoyd AG thinks spot rates have peaked and further increases are “not necessary,” according to Nils Haupt, the Hamburg-based company’s head of corporate communications. The move comes after French rival CMA CGM SA last week froze rates, saying it was prioritizing long-term relationships following a rally that has seen some spot rates jump more than sixfold in the past year.  

 

 

A new capex cycle

Rising capital expenditures is another factor that should put conventional stagflation fears to rest. 

 

The monthly NFIB report is useful because small businesses are sensitive barometers of the economy because of their lack of bargaining power. The latest report shows that small business plans for raising prices are skyrocketing, indicating short-term inflation pressures. However, capex plans are rising as well, which should increase productivity, raise the growth outlook and act to restrain inflation pressures. 

 

 

From a longer-term perspective, the US economy looks poised to enter a strong capex cycle. If the definition of stagflation is high inflation and weak economic growth, a strong capex cycle will mitigate those concerns.

 

 

 

A tame Misery Index

During the 1970s, economists created the Misery Index by adding the inflation rate to the unemployment rate as a way of measuring the stagflation stresses on the economy. Today, the Misery Index has spiked but started to roll over.

 

 

If the market narrative of transitory inflation is correct and the recovery continues, the Misery Index should continue to fall. Is this what stagflation looks like?

 

 

A different source of stagflation risk

While conventional models indicate that stagflation risk is low, former Fed economist Claudia Sahm (of the “Sahm Rule” fame) proposed a different scenario of stagflation. Sahm acknowledged the temporary inflationary nature of supply chain bottlenecks.

 

It’s also important to keep a historical perspective. Supply chain disruptions are not new, though today’s is more widespread than in the recent past. For example, the earthquake and tsunami that hit Japan in March 2011 disrupted supply chains and risked upward pressures on inflation, as noted by Mohamed A. El-Erian:

 

Third, the Japanese disasters are not happening in isolation. They add to the supply shock that the global economy already faces due to the uprisings in the Middle East and the related increase in oil prices. As such, the risk of a global macro tipping point cannot, and should not, be ignored.
Hawks gonna squawk, people. As with now, the Federal Reserve viewed the supply chain disruption in Japan as a temporary risk to inflation and economic activity in the United States. Accordingly the Fed did not view a change in monetary policy as an appropriate response. The following is from a special section in the staff forecast for the FOMC (now public) on “Economic  Effects of the Earthquake  in Japan”.
 

Dislocations in Japan resulting from the earthquake are likely to affect foreign economies through three main channels:  Diminished Japanese demand for other countries’ exports, lower foreign direct investment and portfolio flows from Japan, and disruptions to cross‐country supply chains.  We expect the first two channels to be fairly minor, given that Japan accounts for a relatively small share of trade and investment inflows for most countries, especially outside of Asia.  Disruptions to supply chains represent the main concern at present.  Some Asian producers, particularly in the high‐tech sector, are highly dependent on intermediate inputs imported from Japan.  However, although production in certain firms and sectors is being disrupted, the aggregate results will likely be limited.  Many of the Japanese plants that shut down in the aftermath of the earthquake are already back on line, though not yet at full capacity, and there is scope for resourcing to alternative suppliers.  All told, we expect the earthquake to shave about ½ percentage point from GDP growth in emerging Asia in the second quarter, with this negative effect unwinding in the second half of 2011 as normalization in activity and Japanese reconstruction increase demand for industrial supplies and capital goods.  The effect on GDP growth in the advanced economies is likely to be even smaller, with modest disruptions reported to production of motor vehicles in the United States, Europe, and Canada because of shortages of auto parts from Japan.
She rhetorically asked, “What if the supply chain disruptions became more frequent as climate change disasters become more commonplace?”
 

We should take today’s disruption as a warning. I heard early in the pandemic someone refer to Covid as our dress rehearsal for climate change. It ain’t looking good. Covid is a global crisis and its toll on human life is crushing. That said, we have a vaccine that works, and we will eventually contain the pandemic enough that we will work around the current economic log jams.

 

Climate change is a whole different ballgame. No company is going to engineer a cure over the weekend. Complain about the FDA now? Get ready for lots more complaining. Supply chain disruptions will not be the biggest problem we have during climate disasters, but Covid underscores some of the economic costs on the horizon. We are interconnected globally and as result, we are in this together. The answer now is to get vaccines to the world community as fast as possible. The United States should be leading with more great urgency. We are not. Climate change? Good luck with that.

Climate change is a controversial subject in many circles and the pros and cons of the topic are beyond the scope of this publication. Nevertheless, the world has seen an unusual series of heatwaves and floods in 2021 which has been attributed to climate change. Should they continue, these disasters raise the risk of further supply chain disruptions in the years ahead. While conventional triggers of stagflation are under control, a rolling series of inflationary spikes could trigger a period of inflationary volatility and slowing growth. Investors need to be prepared for this risk of stagflation for an unusual source.
 

 

The ESG solution

Investors can guard against this unusual source of stagflation risk with diversification into ESG investing. ESG stands for Environmental, Social, and (corporate) Governance, which is used as an ethical investing discipline.

 

The idea of ethical investing is nothing new and it has been around for a long time. The approach was only recently re-branded as ESG investing.  There has been a stampede into ESG investing in the last few years. According to Bloomberg Intelligence, total ESG assets are expected to quadruple by 2025.

 

Global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total assets under management. A perfect storm created by the pandemic and the green recovery in the U.S., EU and China will likely reveal how ESG can help assess a new set of financial risks and harness capital markets.

 

 

Indeed, ESG investing has the potential to become extremely popular. A recent Pew Research survey shows more and more people around world are growing concerned about climate change. 

 

 

However, ESG investing comes with an important caveat. ESG funds tend to have a technology and growth tilt. That’s because it’s far easier for a company like Microsoft to qualify under an ESG screen than Exxon Mobil. The “E” in ESG investing has caused a close correlation of ESG to growth investing.

 

 

There are also short-term risks. The top two categories in the latest BoA Global Fund Manager Survey are long technology and long ESG, which amount to almost the same factor exposure.

 

 

In summary, ESG diversification could be an important source of long-term portfolio stability should climate change spark a rolling series of supply chain disruptions. However, investors who adopt this strategy may face the near-term risks of underperformance.

 

Evergrande catastrophe = Lehman Moment?

Posted by Cam Hui -

13 years ago yesterday, Lehman Brothers fell into bankruptcy. Today, the world is watching China Evergrande collapse in a debt spiral. The overly indebted property developer told China’s major banks that it won’t be able to pay loan interest due Sept. 20. The company has been swamped with protests from individuals who invested in its paper through wealth management products, its employees and suppliers who haven’t been paid, and numerous buyers who paid deposits for properties that haven’t been constructed.
 

 

 

Systemic risk

How did Evergrande get here? The tale is a familiar one. It overindulged on a debt-fueled expansion spree during the boom years. In addition to property development, which is a high leverage business, the company dabbled in non-core businesses like electric cars and bottled water. Reckoning arrived when regulators pressured overly indebted companies like Evergrande to pare its debt, which forced it to sell non-core businesses and cut prices on its properties to raise cash. Then the real estate boom slowed.

 

A Reuters article explained the systemic risk posed by the Evergrande collapse.
 

China’s central bank highlighted in 2018 that companies including Evergrande might pose systemic risks to the nation’s financial system.

 

The leaked letter last year said Evergrande’s liabilities involve more than 128 banks and over 121 non-banking institutions. JPMorgan estimated last week China Minsheng Bank (600016.SS) has the highest exposure to Evergrande.

 

Late payments could trigger cross-defaults as many financial institutions have exposure to Evergrande via direct loans and indirect holdings through different financial instruments.

 

In the dollar bond market, Evergrande accounts for 4% of Chinese real estate high-yields, according to DBS. Any defaults will also trigger sell-offs in the high-yield credit market.

 

A collapse of Evergrande will have a large impact on the job market. It has 200,000 staff and hires 3.8 million people every year for project developments.
The NY Times highlighted an additional systemic risk posed by Evergrande’s deleveraging.

 

Much of the cash that Evergrande has been able to drum up has come from presold apartments that aren’t yet completed. Evergrande has nearly 800 projects across China that are unfinished, and as many as 1.2 million people who are still waiting to move into their new homes, according to research from REDD Intelligence.

 

Evergrande has slashed prices on new apartments but even that has failed to entice new buyers. In August it made a quarter fewer sales than it did a year ago.
Some 70-80% of Chinese household savings have gone into real estate. If Evergrande were to go bankrupt and be unable to deliver on presold apartments, the household sector’s finances would take a major tumble. In addition, Evergrande’s forced liquidation will put downward pressure on property prices. In the past, the way to wealth for the ordinary Chinese is to scrimp together enough of a down payment to buy an apartment and watch prices rise as the real estate boom has become a one-way street. Protests over a falling real estate market have the potential to destabilize the economy and the Chinese Communist Party.

 

 

 

Market fallout

Evergrande’s bonds have collapsed before trading was halted and the bonds of other developers have also significantly weakened.

 

 

The shares of other property developers have fallen in sympathy and violated long-term technical support levels.

 

 

 

Contagion risk

Today, we have the dream scenario of the China bears. The combination of the Evergrande catastrophe and the Huarong Affair should shake the confidence in the Chinese financial system and see contagion risk ripple past its borders. Instead, real-time market signals indicate that contagion risk has been ring-fenced within the Chinese property development sector.

 

The Chinese yuan should be falling. Instead, it has been relatively strong.

 

 

By informing banks that the interest payments due on September 20 will not be paid, an Evergrande default is imminent. That should create stresses in the financial system, right? Instead, the relative performance of Chinese financials (red dotted line) is outpacing the relative performance of US financials (black line) and European financials (green line).

 

 

Another indirect way of measuring the strength of the Chinese economy is through commodity prices as China is a voracious consumer of commodities. Commodity prices reached a fresh all-time high yesterday and the cyclically sensitive base metals/gold ratio has been strengthening.

 

 

Industrial commodities have also been strong.

 

 

Equally surprising is the relative strength of Chinese material stocks relative to global materials.

 

 

In short, contagion risk has been contained. If the Evergrande catastrophe were to become China’s Lehman Moment, these risks would be evident in most of the indicators that I have cited.

 

Does that mean that foreign investors in China should view this as a buying opportunity? Not so fast. Fund flow statistics show that as foreigners pile into China, the locals are selling and taking their money offshore.

 

 

Who is the “smart money” and who is the “dumb money”? 

 

Foreign Devils beware!

 

 

Another test of the 50 dma

Posted by Cam Hui -

Mid-week market update: As the S&P 500 revisits the area around its 50 dma, will the weakness persist or will it be halted? The index has found good support at the 50 dma all of this year. Equally constructive is the bull flag pattern being traced out by the S&P 500, though the index hasn’t staged an upside breakout through the flag yet.
 

 

Bespoke pointed out that the most recent losing streak is just the seventh time since the GFC that the S&P 500 closed at a record high and then fell for five consecutive days. The only time the decline didn’t halt was the COVID Crash.

 

 

 

Bearish enough?

Sentiment models indicate that a deep pullback is unlikely. A recent Deutsche Bank survey of institutional investors shows that a 5-10% correction has become the consensus view.

 

 

An IHS Markit survey of US investment managers also shows that risk appetite is plunging. The survey readings are consistent the results from trade settlement data.

 

The IMI survey results align with the equity trade settlement data we analyze on behalf of our 850 US-listed clients, representing $22T in market capitalization. During the first week of September, institutional investors reduced exposure to nine out of ten macro sectors with the consumer discretionary and industrial sectors experiencing their fifth consecutive week of outflows.

 

 

Bloomberg reported that Jason Goepfert observed a dramatic increase in nervousness in the option market. The spread between the VIX Index and realized volatility is highly elevated.

 

Sundial looked at what happened before when the S&P 500 was within 1% of a record and the Cboe Volatility Index’s divergence from S&P 500 30-day realized volatility was in the upper 75% of its range. 

 

That scenario’s occurrence last week was the ninth time it had manifested going back to at least 1995. Over the previous eight instances, the next one to four weeks saw the S&P struggle to hold any meaningful gains. But over the next two months, it rallied every time, Sundial’s Goepfert said. There were no occasions when major losses hit equities over the longer term.

 

 

In the short run, sentiment is nearing a bearish extreme. Helene Meisler conducts an (unscientific) Twitter poll every weekend. The latest results show a net bull rating of -18. In the brief history of the poll, the market has rallied whenever the reading is -10 or less. Will this week be an exception?

 

 

 

One final flush?

The latest Investor Sentiment poll shows bullishness in retreat, but bearishness hasn’t spiked. The constructive view is the market is ripe for a relief rally. A more skeptical take is the market may need one final flush before it can make a durable bottom.

 

 

Mark Hulbert believes that sentiment isn’t sufficiently bearish for the market to sustainably rally.

 

Don’t expect U.S. stocks to mount anything more than an anemic rally in coming weeks. That’s because there’s still too much bullish sentiment. According to contrarian analysis, the most impressive rallies begin when there is widespread pessimism, just as market risk is highest when there is widespread optimism.

 

The chart below paints the picture. It plots the average recommended equity exposure level among a subset of Nasdaq-focused stock market timers I monitor (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). The HNNSI is my most sensitive barometer of stock market sentiment.

 

 

I am open to the possibility that market psychology may need that final flush to signal a capitulation bottom. My market bottom models aren’t flashing buy signals just yet. We may need one last panic when the S&P 500 breaches its 50 dma before a short-term buying opportunity presents itself. 

 

 

This Friday is quad witching expiry and could be the source of some price volatility. If the S&P 500 fails to stage an upside breakout through the flag pattern, will quad witching be the catalyst for a buy signal?

 

Breadth can show the way

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

 

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

 

 

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

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

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

 

The BB ride ends

Last week, I pointed out that the S&P 500 had gone on a ride on the upper Bollinger Band. The upper BB ride ended with the market pulling back. What’s next?

 

 

The clues to the next major move in the S&P 500 can be found in breadth indicators.

 

 

A difference in breadth

A review of the different versions of the Advance-Decline Line reveals some key differences. The S&P 500 A-D Line is the strongest and it has confirmed the continued advance of the index. The NYSE and midcap S&P 400 A-D Lines are struggling to overcome overhead resistance. The weakest is the smallcap S&P 600 and the NASDAQ A-D Line, which is a surprise given the strength of NASDAQ stocks.

 

 

The relative performance of the NASDAQ 100 tells the story of large-cap growth leadership. Even as the NASDAQ 100 is in a relative uptrend against the S&P 500, the relative performance of the Equal-Weighted NASDAQ 100 to the cap-weighted NASDAQ 100 and the NASDAQ 100 A-D Line are falling.

 

 

 

Waiting for a small-cap signal

I am also waiting for a signal from the high-beta small-cap stocks, which have been range-bound for most of 2021. The relative performance of small stocks bottomed out mid-August, and so did relative breadth (bottom panel). Since then, progress has stalled.

 

 

While valuation doesn’t matter much in the short term, it does matter in the long term. The relative forward P/E of the S&P 500 compared to the S&P 600 is back to 2001 levels.

 

 

The relative performance of the size factor, or small-caps, is linked to the value/growth cycle. An analysis of the evolution in weights of value sectors in the top 50 and bottom 450 of the S&P 500 is revealing. Value stocks have been falling in the weight of the top 50 in the last 10 years while their weight in the bottom 450 has been relatively stable. A small-cap revival should, all else being equal, provide a tail-wind for value.

 

 

 

Credit market signals

The current environment should be a period when small-caps shine. Since small companies tend to be of lower quality, I have often highighted the relative performance of junk bonds as a credit market risk appetite signal. So far, the junk bond market is tracking the performance of the S&P 500 fairly well in the last two months.

 

 

S&P reported that there have been far more rating upgrades than downgrades in junk bonds, which indicates the positive effects of the recent recovery. This should be supportive of higher stock prices from a cross-asset perspective.

 

 

 

Where’s the bottom?

The S&P 500 has fallen for five consecutive days, but the drawdown over that period is only -1.7%. The market is oversold short-term and should bounce early in the week.

 

 

However, the decline may not be over. Only one of the components of my tactical bottoming model, namely the 5-day RSI, has been triggered. The VIX Index hasn’t spiked above its upper BB’ the term structure of the VIX hasn’t inverted; and NYMO hasn’t fallen into oversold territory.

 

Should the weakness continue, an obvious support level would be the 50 dma at 4424. Pullbacks in 2021 have been shallow and arrested at the 50 dma. Barring a macro or major fundamental trigger, the current episode should not be any different.

 

 

In conclusion, the stock market has begun to pull back after an upper Bollinger Band ride. The clues to the next major directional move can be found in breadth indicators, which are mixed, and small-cap stocks, which remain range-bound. In addition, the small size effect is indirectly linked to value. An upside breakout by small-cap stocks should be bullish for value stocks, while a downside breakdown should see leadership by large-cap growth.

 

Stay tuned.

 

A time for caution, or contrarian buy signal?

Posted by Cam Hui -

Recently, a number of major investment banks have published warnings for the US stock market. The strategists at BoA, Citigroup, Credit Suisse, Deutsche, Goldman Sachs, and Morgan Stanley have issued either bearish or cautionary outlooks. 

On the other hand, Ryan Detrick at LPL Financial documented the effects of strong price momentum on stock prices.

History says that great starts to a year tend to see continued strength the final four months. “Looking at the previous top 10 starts to a year ever, the final four months have gained eight times,” explained LPL Financial Chief Market Strategist Ryan Detrick. “So should we see any seasonal weakness, we’d use it as an opportunity to buy before likely continued strength.”

 

 

In these circumstances, I am reminded of Bob Farrell’s Rule 9, “When all the experts and forecasts agree – something else is going to happen.” How should investors react? Turn cautious, or is this a contrarian opportunity to buy the dip?

 

 

The earnings challenge

As I see it, there are several challenges and open questions for equity bulls. The most important question is whether companies can maintain the forward earnings momentum exhibited in the past year. FactSet reported that forward 12-month EPS estimates are still rising strongly. Rising estimates are supportive of better stock prices because the E in the forward P/E ratio is advancing. Can it continue?

 

 

John Butters of FactSet reported that Q3 estimates have bucked the usual trend of downward estimate revisions and rose instead.
 

In a typical quarter, analysts usually reduce earnings estimates during the first two months of the quarter. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 2.4%. During the past 10 years (40 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.0%. During the past 15 years (60 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.6%.

 

In fact, the third quarter marked the fourth-largest increase in the bottom-up EPS estimate during the first two months of a quarter since 2009. It also marked the fifth straight quarter in which the bottom-up EPS estimate increased during the first two months of the quarter. However, the third quarter is also the first quarter during this current streak in which the percentage increase in the bottom-up EPS estimate was smaller than the previous quarter.

 

 

As we approach the Q3 earnings season which begins in October, can EPS growth maintain its momentum? What will companies say in their earnings calls about the outlook?

 

That’s an important open question that’s yet to be resolved.

 

 

The top-down view

To resolve that question, here is where top-down macro analysis can supplement the bottom-up company analyst view. GDP growth forecasts are stalling. Q3 growth forecasts are rolling over while Q4 growth has flat lined. These are conditions not friendly for the Q3 and Q4 earnings outlook.

 

 

As a second opinion, New Deal democrat’s methodology of coincidental, short-leading, and long-leading indicators is a useful framework for evaluating the economy. His short-term forecast is positive for the rest of 2021, which should be positive for Q3 and Q4 earnings season. 

 

However, he warned that “there are several sectors suggesting the economy is going to weaken substantially by mid year 2022, although no recession is forecast at this point”. Since the stock market is a forward looking indicator, economic softness in mid-2022 could translate into some sloppiness for equity prices in the coming months.

 

 

 

A friendly Fed

One factor that is likely to put a floor on stock prices is the supportive monetary policy of the Fed and other global central bankers. So far, the market has accepted the central banker transitory inflation narrative and taken the recent inflation spike in stride.

 

 

IMF chief economist Gita Gopinath recently outlined her forecasts for transitory inflation spikes in the US and eurozone. Transitory inflation is now defined as quarters and not months. She added, “The difference between US and EA non-energy goods inflation is particularly striking (eg. used car prices).”

 

 

Already, the month-on-month PCE change is decelerating. This will give ammunition to the doves in the FOMC to stay with an easy monetary policy.

 

 

When investors think about rising inflation, the most obvious example is the 1970’s. Arguably, the current environment more resembles the late 1940’s and early 1950’s, when the Fed was more tolerant of inflation as the economy exited World War II and the resulting inflation in the wake of war related shortages.

 

 

The wildcard is government policy. Jerome Powell’s term as Fed chair is expiring. While the White House appears to favor his reappointment, progressive Democrats in Congress are pushing for a tougher bank regulator.

 

 

Fiscal policy: Threats and opportunity

Investors will also have to contend with the threats and opportunity from fiscal policy. David Leonhardt of the NY Times explains that the Democrats want to enact their agenda in anticipation that they will lose control of Congress in the 2022 mid-term elections.

 

Early in Bill Clinton’s presidency, House Democrats voted to pass an energy tax, known as the B.T.U. tax, only to watch the Senate prevent the bill from becoming law. In the next midterm elections, more than 25 of the House Democrats who had voted for the bill lost re-election.

 

Early in Barack Obama’s presidency, history repeated itself. House Democrats voted for a cap-and-trade plan to address climate change, and the Senate blocked the bill. In the next midterms, many House Democrats struggled to defend their votes.

 

That history helps explain the approach that congressional Democrats are taking on the biggest piece of President Biden’s agenda — a $3.5 trillion plan to slow climate change, expand health care and education, cut poverty and increase taxes on the wealthy.

 

Many House Democrats are worried about “getting B.T.U.’d” again, as some have put it. They do not want to take a tough vote that ends up having no policy impact. “Some of us were here in 2010, when we took certain votes,” Henry Cuellar, a Texas Democrat, has said, “and the Senate didn’t take certain votes.”

 

In response, House Democrats are insisting that the two chambers negotiate up front over what bill they can each pass. Only after they have reached a deal will the House vote on it, Speaker Nancy Pelosi has suggested.

 

Those negotiations have begun, and they will proceed quickly over the next few weeks. By the end of September, the fate of the bill — and, by extension, Biden’s bid for a consequential presidency — will probably be clear.
The opportunity is an expansive fiscal policy that will boost consumer confidence and spending. The threat of the proposed corporate tax increases, which Street strategists estimate will cut 5-9% of S&P 500 earnings, all else being equal. Barron’s recently published a warning on the effects of a higher corporate tax rate (see Investors Are Ignoring the Tax Elephant in the Room). As the fears of a corporate tax increase creep into the market narrative, it has the potential to unsettle investors and spark a correction.

 

However, it is unclear whether a complete legislative package will ever be passed. Democratic leaders are negotiating with holdouts like Senator Joe Manchin, who holds the balance of power and has presented a long wish list that may scuttle the deal. The stakes are high. Fiscal drag is forecast to be sharply negative because of the expiry of UI benefits.
 

 

 

A mid-cycle pause?

Putting it all together, how worried should investors be? Here is the big picture. Recessions are bull market killers and there is no sign of a recession in sight. Long-term investors should not panic.

 

 

However, the economy may be due for a mid-cycle pause. If history is any guide, this is the time when consumer confidence starts to stall. The wildcard is fiscal policy. Should Biden and the Democrats be successful in passing a fiscal package, it could provide a boost to consumer spending at the price of higher tax rates.

 

 

Every cycle is different, but this is also the point in the cycle when inflation expectations start to move sideways. The key difference is the determination of the fiscal and monetary authorities around the world to maintain stimulus.

 

 

Callum Thomas at Topdown charts also studied the behavior of upside to downside equity volatility. Spikes in the upside/downside volatility ratio are the characteristic of recoveries off a recessionary bear market. It is usually resolved with either a sideways consolidation or a minor corrective phase.

 

 

The immediate downside risk is probably limited. SentimenTrader recently observed that there is an enormous appetite for downside put protection: “A trader in S&P 500 options would have to go 40% out of the money to buy a put with the proceeds of selling a call that is only 10% out of the money. This is a sign of extreme hedging demand, the highest in several years.”

 

 

My base case scenario calls for a period of market sloppiness for the rest of 2021. After that, forecasting becomes too difficult because of too many uncertainties.

 

 

 

Uncertain leadership

Another open question is what happens to market leadership. The recent spike in the 10-year Treasury yield argues for a rotation from growth to value. Analysis of the proposed tax increases is more negative for technology and drug stocks, which are subject to a corporate minimum tax on intellectual property held in offshore subsidiaries (see The market risk hiding in plain sight).

 

 

On the other hand, recent market action has shown that investors have piled into large-cap growth stocks as a safe haven whenever the growth outlook falters. Indeed, the NASDAQ 100 remains in a well-defined relative uptrend despite rising yields.

 

 

Market leadership depends on a number of questions that need to be answered.
  • How will Q3 earnings season behave? Are expectations too high or will companies continue to beat estimates?
  • What will happen to fiscal policy? If the Democrats pass their $3.5 trillion package, will the positive effects on consumer spending offset the negative effects of a corporate tax increase?
  • What about monetary policy? Will Biden reappoint Powell as the chair of the Federal Reserve?
In conclusion, I expect a period of choppiness and market volatility for the remainder of the year. Long-term investors should remain fully invested. Downside risk shouldn’t be more than a normal 10% correction, which represents typical equity market risk. There are many open questions about market leadership. A prudent course of action would be to hold a diversified portfolio as a way of addressing near-term uncertainties.

 

Two stealth breakouts you may have missed

Posted by Cam Hui -

Mid-week market update: There have been two breakouts that may be of significance. The first is an upside breakout of the SPY/TLT ratio. The ratio is pulling back to test its breakout. The SPY/IEF already staged a convincing breakout in late June. 
 

 

The second and more obvious breakout is an upside breakout by the 10-year Treasury yield against a falling trend line.

 

 

Here are my interpretations of these events.

 

 

Risk-on?

The SPY/TLT upside breakout should be a risk-on signal. While I am keeping an open mind, I am a little skeptical of this signal.

 

A review of the relative performance of the top five sectors is uninspiring. The top five sectors comprise about three-quarters of the weight of the S&P 500 and it would be difficult for the market to advance or decline without the participation of a majority. Technology, which is the largest sector, is trading sideways relative to the S&P 500 and has unsuccessfully tested a key relative resistance level. Healthcare is in a minor relative uptrend, but all of the others are either flat or falling relative to the S&P 500.

 

 

The relative performance of defensive sectors is not showing a bearish bias either. I have already highlighted the relative uptrend of healthcare, but consumer staples and utilities have not staged upside relative breakouts. Real estate had been in a relative uptrend, but the sector violated a relative uptrend and it is now consolidating sideways.

 

 

Neither the bulls nor the bears have seized control of the tape.

 

 

Rising yields

The more significant upside breakout may be the action by the 10-year Treasury yield. IMF chief economist Gita Gopinath recently discussed the IMF’s forecast of “transitory inflation”, which she defined as quarters and not months. 

 

 

While the current uptick in the 10-year yield has been relatively minor, a prolonged period of elevated inflation readings has the potential to spook the bond market. Historically, changes in yield has corresponded to rising market volatility.

 

 

Subscribers received an email alert that my inner trader had exited his long position in the S&P 500. While I am not bearish, the environment is turning less friendly for the bulls. My base case scenario calls for a sideways market marked by increasing volatility in the coming weeks.

 

 

A consolation prize 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.
 

 

Cautiously bullish

Last week, I alerted readers to a possible rare Zweig Breadth Thrust buy signal (see The Zweig Breadth Thrust Watch). Unfortunately for the bulls, the ZBT failed to materialize, but the S&P 500 remains on an upper Bollinger Band ride while flashing a series of “good overbought” readings on the 5-day RSI. Historically, such advances have not stalled until the 14-day RSI becomes overbought.

 

 

You can tell a lot about the tone of the market by the way it reacts to news. The bears had a golden opportunity to seize control of the tape when presented with a huge Non-Farm Payroll miss on Friday. Instead, the S&P 500 closed roughly flat on the day.

 

 

A possible inflection point

Here are some important charts that give some clues on future market leadership. First, what’s the direction of the 10-year Treasury yield? The 10-year Treasury Note has been testing a falling trend line and it is correlated to the value/growth cycle. A rising yield would be the market’s signal that it expects stronger economic growth. Already, the yield curve is bottoming and starting to steepen, which is another indicator of better growth expectations.

 

 

Recent estimates of hedge fund positioning show that the fast money crowd has unwound its value tilt from last year. The value and reflation trade is no longer a crowded trade and readings are now neutral. 

 

 

In addition, a sustained market advance may need small-cap stocks to lead the next leg upwards. The relative performance of small stocks is improving and breadth internals (bottom panel) is constructive. However, the Russell 2000 and the S&P 600 remain range-bound.

 

 

Small-caps are poised for an explosive rally. Callum Thomas at Topdown Charts pointed out that small-cap fund flows indicate investor capitulation. 

 

 

The stage is set. What will light the fuse?

 

 

More upside potential

Tactically, the current advance can go a little further. While the NYSE and NASDAQ McClellan Oscillators are better at timing bottoms than tops, neither are overbought yet.

 

 

Sentiment models such as the Fear & Greed Index are nowhere near euphoric territory. 

 

 

Similarly, the AAII Bull-Bear spread is showing a neutral reading.

 

 

As well, Helene Meisler’s (unscientific) weekly Twitter poll shows that net bullishness in retreat despite the market’s slow grind-up last week. This looks like a classic case of the market climbing the proverbial “Wall of Worry”.

 

 

In conclusion, the stock market is undergoing a “good overbought” momentum-driven advance. Readings are not overbought yet indicating further upside potential. In addition, cross-asset internals are suggestive of a possible value and growth inflection point ahead in favor of value and cyclical stocks.

 

 

Disclosure: Long SPXL

 

What China decoupling looks like

Posted by Cam Hui -
When Trump began his trade war with China, the Street’s narrative was “decoupling”. It took a few years, but it’s finally happened. As China’s economic outlook and market deteriorated, it did not drag down the economies of Europe and North America.

 

To be sure, the news out of China is grim. A series of “common prosperity” crackdowns, financial restructuring, and a slowing economy have combined to tank Asia’s stock markets. The relative performance of the markets of China and her major Asian trading partners against the MSCI All-Country World Index (ACWI) has been weak. With the exception of Taiwan, all have broken key relative support levels indicating relative underperformance against global equities.

 

 

The good news is other developed markets have held their ground. That’s what decoupling looks like.

 

 

The East is Red

During the Cultural Revolution, the song 东方红 (The East is Red) became the de facto Chinese national anthem in the same way that L’Internationale was the anthem of communist and Marxist revolutionaries. Fast forward to 2021, the East is Red once again, but not in a good way. The combination of “common prosperity” policy changes, financial restructuring of past excesses, and a slowing economy has colored asset returns red.

 

China has undergone a series of dramatic policy changes under the “common prosperity” slogan. It is far beyond the scope of this research article to analyze all the details of Xi’s “common prosperity” campaign, but Bloomberg recently outlined the scope and philosophy behind the initiative by using the province of Zhejiang as a laboratory.

 

To understand what President Xi Jinping envisions in his calls for “common prosperity,” look to the pilot program underway in the wealthy province of Zhejiang, home to 65 million people and some of China’s most successful private companies.
 

Xi’s mounting campaign to spread the wealth has sent shock waves through the economy, triggering market sell-offs and speculation that China will reverse the reforms that lifted incomes nationally — and created a class of powerful billionaires. 
Zhejiang is an ideal test case because it is the home of Alibaba and one of the most prosperous provinces in China.

 

The central coastal area is home to Alibaba Group Holding Ltd. and Zhejiang Geely Holding Group Co., among others. Four of the 10 richest people in China have based their businesses in the capital city of Hangzhou. The private sector accounts for 66% of provincial gross domestic product, compared with around 60% nationally.

The objective of the plan is to address income inequality, but not through a Europe-style redistribution, but growth.
 

The Zhejiang plan suggests Beijing wants to raise incomes through private sector investment in poorer areas, and to encourage rural residents to start their own businesses. Radical wealth redistribution, or a European-style welfare state funded by strong taxes, isn’t in the cards.

Bloomberg outlined the goals of the plan.

  • Rapid Bottom-up Growth: “Zhejiang’s top official Yuan Jiajun has described economic growth as the ‘cornerstone’ of common prosperity, and a growing economy makes it easier to reduce inequalities without causing conflict.”
  • Cooling Housing Prices: “Rising housing costs have been a source of discontent across China since the country created a commercial market two decades ago. Zhejiang, where real estate prices grew at an average annual rate of about 6% over the last decade, doesn’t want to see homes get any more expensive.”
  • Rural Development: “The Zhejiang plan calls for support of existing rural service businesses as well as the return of manufacturing.”
  • Strengthen Education: “Zhejiang will spend more on healthcare and education in order to strengthen the workforce…With healthy, qualified workers, there should be no need for state welfare, officials say. China can’t afford ‘to feed the lazy,’ Han Wenxiu, a senior official in the party’s top economic affairs committee told reporters last week, describing ‘welfarism’ as a ‘trap.'”
  • Charitable Giving: “The plan also calls for wealthy entrepreneurs to donate more of their wealth to society. Zhejiang is home to at least 10 multi-billionaires, according to data collected by Bloomberg, with a combined net worth of $236 billion.”

 

 

The “common prosperity” measures have targeted a series of industries that have shocked the markets, such as for-profit education, technology through data privacy edicts, and gaming by restricting the ability of teenagers to play online games. The list goes on and investors are uncertain as to what will happen next.

 

In addition, the Huarong Affair made market participants reassess what constitutes a “too big to fail” enterprise. For the uninitiated, China Huarong Asset Management Co. was one of China’s “bad banks” designed to clean up the banking losses from the Asian Crisis. Instead, Huarong reported a $15.9 billion loss through mismanagement of assets by its chairman, Lai Xiaomin, who was convicted of corruption and executed in January. After months of bureaucratic infighting, CITIC announced that it would rescue Huarong with an equity injection.

 

 

The Huarong bailout sparked uncomfortable questions about what constituted a safe credit in light of the company being a SOE created by the Ministry of Finance. The elephant in the room is China Evergrande, a private company controlled by billionaire Hui Ka Yan. Evergrande is a highly levered property developer with $300 billion in liabilities to banks, suppliers and homebuyers in an industry is in the crosshairs of the “common prosperity” initiative to control real estate prices. Evergrande is now forced to fire-sale its assets, possibly at large discounts, in order to lighten its debt load. The combination of the Huarong and Evergrande troubles had the potential to spark a Chinese Lehman Crisis.

 

 

In addition, the economy is slowing. The latest release shows that both Manufacturing and Services PMIs have fallen below 50, which indicates contraction.

 

 

Slowing Chinese growth has dragged down most of her Asian trading partners. It also doesn’t help that most of Asia suffer from low vaccination rates, which has been a drag on PMI readings.

 

 

 

European decoupling

In a globalized economy, one would think that a teetering China would throw a scare into global financial markets and become a drag on the economic growth of other trade blocs. That doesn’t seem to be the case. 

 

Consider Europe. The demand for workers has recovered to pre-pandemic levels for most eurozone countries.

 

 

Bloomberg reported that the European banking system is awash with liquidity in a highly unusual way.
 

The Targeted Longer Term Refinancing Operations currently provide more than 2.2 trillion euros of cash to the region’s banks. Demand at the regular Longer Term Liquidity Operations, which provide money for three months has completely evaporated, with the July 1 scheme only attracting 3 million euros from one bidder.

 

Even more unusually, banks are so flush with liquidity, they are now giving the ECB cash as collateral for the loans they receive. Yes, you read that correctly. Banks have borrowed money from the ECB — and given the ECB the money back as collateral for the loan.

 

We can see this in data provided by the weekly financial statement, which has a line item called “deposits related to margin calls.” In any other time, an increase in this line item would be a sign of severe stress, as it would mean the collateral banks had posted with the ECB to secure their lending had fallen so much in value, the ECB has made a margin call — think Greek sovereign bonds circa 2011.

 

 

In many ways, the COVID Crisis is over in Europe.

 

 

Don’t bet against America

Across the Atlantic, the economy is showing signs that it is shifting gears from recovery to mid-cycle expansion. Indeed reported that job posting growth is shifting from low-wage reopening jobs to higher-paid manufacturing and software development positions. 

 

 

Indeed’s readings are consistent with the disappointing August Jobs Report, which showed continued job gains in manufacturing and softness in retail and leisure and hospitality. Another silver lining in the Jobs Report was an increase in the prime age employment to population ratio, which is another sign of labor market healing.

 

 

The latest Chase card spending data shows that recent softness is concentrated in travel-related services, but the other components are holding up well. Travel should recover once the effects of the Delta variant begin to dissipate. Already, new case counts are topping out. Don’t bet against the American consumer.

 

 

The latest ISM print shows that manufacturing is strong.

 

 

From a global perspective, global demand and manufacturing are strong, but supply chain bottlenecks are creating delivery problems that will temporarily spark inflation pressures.

 

 

 

The market’s message

Putting all together, market-based signals paint a picture of China decoupling and global recovery. Willie Delwiche pointed out that three-quarters of ACWI markets have recovered to above their 50-day moving averages despite China’s obvious difficulties.

 

 

The MSCI Emerging Markets Index is suffering because of the one-third weight of China. However, the EM xChina Index is recovering in performance relative to ACWI even though the top two weights in the index are in PacRim Asia.

 

 

Commodity prices have held up. As well, the cyclically sensitive base metals/gold ratio has been trading sideways. In light of China’s voracious appetite for most commodities, this is another indication that the rest of the world is shrugging off China’s slowing growth.

 

 

This is what China decoupling looks like. This is what a global recovery looks like.

 

No breadth thrust, but a slow grind-up

Posted by Cam Hui -

Mid-week market update: I recently highlighted the possible development of a rare momentum-based Zweig Breadth Thrust buy signal (see The Zweig Breadth Thrust watch). The window for the ZBT buy signal closes tomorrow (Thursday). While the S&P 500 has been advancing slowly, we are unlikely to see the buy signal barring some gargantuan melt-up tomorrow.
 

 

However, the failure of the ZBT buy signal doesn’t mean that the outlook has turned bearish. Instead, the stock market appears to be undergoing a slow grind-up.

 

 

Improving internals

From a technical perspective, many of the negative divergences from poor internals have been improving. While the NYSE Advance-Decline Line has not made a fresh high yet despite new highs in the S&P 500, the percentage of S&P 500 and NASDAQ stocks above their 50 dma have been steadily rising.

 

 

Similarly, credit risk appetite, as measured by the relative price performance of junk bonds to their duration-equivalent Treasury counterparts, have also been steadily rising.

 

 

Sentiment readings are likely to put a floor on stock prices should they pull back. The latest Investors Sentiment Survey shows a decline in bullish sentiment and a rise in bearish sentiment. The bull-bear spread is consistent with past trading bottoms, not tops.

 

 

 

Lessons from market history

On the other hand, the lessons from market history are mixed. Almanac Trader pointed out that the month of September is one of the worst for stock market returns since 1950. The poor historical returns appear to be a statistical anomaly. In the last 17 years, he observed that “S&P 500 has advanced 11 times in September and declined six times.”

 

 

Ryan Detrick is another market historian with a different take. The S&P 500 has risen for seven consecutive months. Such episodes have resolved with strong positive returns over a six-month time horizon 13 out of 14 times. 

 

 

Detrick also found that whenever the S&P 500 rose 15% or more by the end of August, the rest of the year tends to have a bullish bias. Price momentum lives (notwithstanding the Crash of 1987).

 

 

I interpret these conditions as the market is ripe for a slow grind-up. While stock prices could weaken at any time, any pullbacks should be shallow and there are few signs of a major correction on the horizon. 

 

 

Disclosure: Long SPXL

 

What’s a safe withdrawal rate?

Posted by Cam Hui -

I was recently asked my opinion on what a safe withdrawal rate for a deferred-tax pension plan managed with the Trend Asset Allocation Model. 

As a reminder, the Trend Model has shown equity-like returns with balanced fund-like risk. The latest update of the model shows another strong month, with a one-month return of 2.5% compared to 1.7% for the 60/40 benchmark and a YTD return of 18.0% compared to a 60/40 return of 12.8% (full details here). Model returns are based on out-of-sample signals, though based on a hypothetical asset mix.
 

 

 

 

The base case

Let’s begin with a base case analysis. In 1994, Bill Bengen originated the 4% rule, which has become the industry standard recommended annual rate of withdrawal.  Since then, Bengen indicated that a 4.5% withdrawal rate as a way of keeping up with inflation.

 

I believe that Bengen has made a critical error in his analysis and the 4.5% withdrawal rate may be overly aggressive because of low rates. Bengen used historical return data to model withdrawal rates when interest rates were much higher during the backtest period. Today, the 10-year Treasury yield is about 1.3%. If we add in Aswath Damordan’s equity risk premium estimate of 4.4%, equities can expect to return 5.7% in the long run.

 

So I made some basic assumptions in modeling a base case scenario:
  • Bond yield and expected return 1.5%
  • Equity return 6.0% (4.5% equity risk premium)
  • Use of low-cost index funds
  • A 60/40 portfolio with a 8% standard deviation volatility
  • Inflation 2%
  • Expected time horizon 25 years (life expectancy of 90 assuming retirement at 65)
  • The withdrawal rate is defined as a percentage of the initial value of the portfolio, adjusted for inflation. For example, if we apply a 4% withdrawal rate to a $1 million portfolio, the withdrawal in year 1 is 40K, and 40K + inflation in year 2, etc.

In an average case, a reasonable real withdrawal rate would be 3.0% to 3.5%, or 5.0% to 5.5% on a nominal basis. However, an investor using an average case runs the risk of running out of money at the end of the 25 year time period. 

 

I modeled a worst case analysis, where the portfolio takes the worst drawdowns during the initial years and enjoys the best returns in the later years. Under those conditions, the safe withdrawal rate is about 1.5% real, or 3.5% nominal.

 

 

Sensitivity analysis

If we assume that the pension plan was to realize equity-like returns with balanced fund-like risk using the Trend Asset Allocation Model, the number improve. In an average case, the safe withdrawal rate is 4.0% to 4.5% real, or 6.0% to 6.5% nominal. In the worst-case analysis, the corresponding figures are 2.0% to 2.5% real, or 4.0% to 4.5% nominal.

 

There are many moving parts to this analysis and your mileage will vary. How much risk you want to take between the average case and the worst case is up to you. There are many portfolio simulators available. Unfortunately, they all use historical data but there haven’t been instances where interest rates begin at such low levels, which would substantially reduce return assumptions.

 

I made my study using US market assumptions. Arguably, investors can realize better long-term equity returns with a globally diversified equity portfolio.

 

 

As another illustration of sensitivity analysis, John Rekenthaler at Morningstar modeled the effects of differing assumptions on withdrawal rates using a portfolio simulator. Although I disagree with some of his basic assumptions, such as a portfolio return of 7%*, this study nevertheless illustrates the effects of changes in return and portfolio volatility assumptions on withdrawal rates.

 

 

*A 60/40 portfolio with a 1.5% bond market return translates to a whopping expected equity return of 10.7% – which is far too aggressive.

 

In conclusion, I have conducted a study of the safe withdrawal rate using relatively conservative assumptions with a base case scenario of no alpha, and a more aggressive scenario using the Trend Asset Allocation Model. Limited sensitivity analysis also outlines the risk and return trade-offs that investors will bear given different return and volatility scenarios.

 

The rest is up to you. Your mileage will vary.

 

 

The Zweig Breadth Thrust watch

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 possible ZBT buy signal

The Zweig Breadth Thrust buy signal is a rare momentum buy signal that only occurs once every few years. Steven Achelis at Metastock explains the indicator this way (emphasis added):

A “Breadth Thrust” occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.
 

According to Dr. Zweig, there have only been [sixteen] Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.

The ZBT window began on Friday August 20, 2021. It has 10 trading days, or until September 2, 2021 to flash a ZBT buy signal.

 

 

Besides a possible ZBT buy signal as an indicator of powerful price momentum, here is what else I am watching.

 

 

Risk appetite indicators

In particular, I am monitoring for signs of risk appetite. As an example, the high-beta small cap indices remain range-bound, but their relative performance is improving. As well, internal breadth (bottom panel) is showing a turnaround. I interpret these as constructive signs for the bull case.

 

 

The relative performance of small cap stocks is an important beacon of the cycle in light of the vast gulf in relative valuation.

 

 

Credit market risk appetite, as measured by the relative price performance of junk bonds against their duration-equivalent Treasury counterparts, is also turning up.

 

 

The 10-year Treasury yield is testing its falling trend line, which is bullish for the cyclical and reflation case. However, the USD Index is testing resistance and an upside breakout would be bearish for cyclicals. Which way will the market turn?

 

 

If the USD were to strengthen further, the first to feel the effects would be the fragile EM countries with large current account deficits. How would their stock markets behave?

 

 

Even if the market fails to flash a ZBT buy signal, these cross-asset indicators serve as possible confirmations of a bullish tone to the market.

 

 

Value and growth

Another important indicator of market direction is the relative performance of value stocks, which are more cyclically sensitive, to growth stocks. Value has been trying to bottom out against growth in the past few weeks, but relative internals (bottom two panels) remain weak. Better relative performance of value would be an important indicator that the reflation bulls have seized control of the tape.

 

 

There are hopeful signs. Patrick Zweifel of Pictet Asset Management pointed out that global trade is turning up, largely owing to resilient trade data from South Korea and Taiwan.

 

 

As well, COVID-19 hospital admissions appear to be peaking, especially in problematical jurisdictions like Florida, Texas, and Arkansas. These are also bullish signs for a cyclical rebound.

 

 

In addition, this Bloomberg Businessweek cover is a classic contrarian magazine cover indicator that is bullish for the cyclical and reflation trade.

 

 

 

Seasonal tailwinds

The cyclical and reflation trade may start to enjoy a period of positive seasonality. Let me explain what may be a complicated but important cross-asset relationship.

 

Much of the value and growth relationship depend on bond yields. The relative performance of the growth-heavy NASDAQ 100 has been correlated to the 10-year Treasury yield.

 

 

The 10-year Treasury yield is correlated to the Economic Surprise Index (ESI).

 

 

However, the ESI Index has shown a high degree of seasonality and it is poised to turn up.

 

 

In addition, the S&P 500 is poised for a period of positive seasonality after some volatility in September.

 

 

In conclusion, the market may be on the verge of an important Zweig Breadth Thrust buy signal, which would be a powerful and bullish indicator of price momentum. Even if the ZBT buy signal were to fail, other indicators makes me constructive on the outlook for US equities.

 

Stay tuned.

 

 

Disclosure: Long SPXL

 

A rate hike roadmap

Posted by Cam Hui -

Now that a QE taper announcement is more or less baked-in for this year, the next question is when the Fed will raise rates. The July FOMC minutes highlighted the point that the criteria for a taper decision is entirely different from that for a rate hike.

 

Several participants emphasized that an announcement of a reduction in the Committee’s pace of asset purchases should not be interpreted as the beginning of a predetermined course for raising the federal funds rate from its current level. Those participants stressed that the Committee’s assessment regarding the appropriate timing of an increase in the target range for the federal funds rate was separate from its current deliberations on asset purchases and would be subject to the higher standard, as laid out in the Committee’s outcome-based guidance on the federal funds rate. 

While the rate hike decision process can be analyzed in terms of the Fed’s Flexible Average Inflation Targeting (FAIT) framework, it also depends on the Powell Fed’s newfound focus on inequality and employment. How does the Fed define full employment? In particular, a comparison of the US prime-age employment to population (EPOP) to Canada’s is a laboratory in monetary and government policies in light of the similarities in age (though not race) demographics. Canadian prime-age EPOP has been higher than the US in the last two expansion cycles and it recovered faster from the pandemic when compared to each country’s respective 2019 peaks.

 

 

All of these questions are important considerations for the analysis of Federal Reserve monetary policy.

 

 

The changing Fed framework

As I have pointed out before (see How to engineer inflation), there has been a significant shift in Fed policy in recent years. The Reagan Revolution of 1980 ushered in an era of laissez-faire economics. As a result, productivity gains have accrued to the suppliers of capital at the expense of the suppliers of labor. As productivity grew, real wage growth remained stagnant.

 

 

The suppression of wage growth was a key component of monetary policy. The Phillips Curve, which postulates a tradeoff between inflation and unemployment, was an important determinant of monetary policy. Fed policymakers targeted the unemployment rate and tightened whenever the economy boomed and unemployment neared an estimated “non-accelerating inflation rate of unemployment” (NAIRU) in order to head off rising inflation and inflationary expectations. As a consequence, Fed policy exacerbated income and wealth inequality by favoring the suppliers of capital over the suppliers of labor.

 

 

 

The Fed discovers FAIT

The recovery out of the GFC recession was an important lesson for the Fed. The Phillips Curve flattened. As unemployment approached a NAIRU estimate, inflation remained tame. There was more slack in the labor market than thought. Inflation was nonexistent. In addition, policymakers learned through a series of “Fed Listens” community outreach meetings of the problems of rising inequality.

 

The solution was the Flexible Average Inflation Targeting (FAIT) framework. The Fed was willing to tolerate some overshoot of its 2% inflation target to run a hot economy in order to reach full employment. The question for investors is, “What is full employment?”

 

A Bloomberg podcast with Neel Kaskari, the President of the Minneapolis Fed, was revealing. While Kaskari is one of the more dovish members of the FOMC, his comments nevertheless provided an important window of thinking around the definition of full employment.

 

Kashkari stated that he believes that there are still 6-8 million workers who are not in the labor force absent the COVID-19 shock. 6-8 million jobs need to return before he can declare the economy has returned to full employment. He is focusing on the labor force participation rate (LFPR) and its sister indicator EPOP as metrics of full employment.

 

 

 

A tight labor market

What about the widespread report of tight labor markets? While there have been many anecdotal explanations for labor shortages, the Atlanta Fed has a useful analytical tool for measuring changes to the labor force. For the two years ending Q3 2021, the decline in LFPR is mainly attributable to retirement, with a decline in the shadow labor force coming in second.

 

 

As the Fed is also focused on inequality, the analysis of changes in LFPR by race is equally revealing. The decline in white LFPR is almost entirely explained by retirement.
 

 

By contrast, retirement plays smaller roles in the decline in Black and Hispanic LFPR.
 

 

These results are not surprising owing to the difference in age demographics of different racial groups. White Americans have a much older age profile compared to Asian, Black, and Hispanic Americans.

 

 

 

Measuring wage growth

In his Bloomberg podcast, Kashkari acknowledged that wage growth has surged, but he rhetorically asked if the increase is a one-time event, which has a transitory effect on inflation, or if it’s sustained, which would drive long-term inflationary expectations. 
The Atlanta Fed’s wage growth tracker shows that median hourly wage growth has surged for low-income and low-skilled workers and high-skilled wage growth remains tame. This is a preliminary sign of transitory wage and inflationary pressures which allows the Fed to stay on the sidelines a little longer. Low-skilled worker wage growth has lagged high-skilled worker wage growth since 1997. Viewed strictly through an income inequality lens, this also argues for running a hot economy for low-income workers to catch up.

 

 

The analysis of wage growth by race tells a story of labor market slack. Non-white wage growth is more volatile and it has exceeded white wage growth during strong labor markets. This also argues for a high degree of slack in the labor market.

 

 

Based on all these metrics, the labor market has a long way before it has healed. The economy is far from full employment.

 

 

Full employment and inflation

Even though Neel Kashkari is viewed as a dove who is focused on labor market dynamics and full employment, he allowed that Fed officials cannot ignore their inflation mandate in determining monetary policy.

 

While inflation indicators have recently spiked, Kashkari is monitoring metrics like wage growth and the sources of inflation by sector. So far, inflationary pressures are attributable to temporary factors such as used car prices and airfares, which are receding after a short-term surge. Trimmed mean PCE, which is now Jerome Powell’s favorite inflation indicator, is still relatively tame.

 

 

As well, 5×5 inflationary expectations are not running away, which should be comforting for policymakers.

 

 

 

The taper and rate hikes

Putting it all together, what does this mean for Fed policy? The July FOMC minutes imply that a taper decision is likely in 2021, though a move during the September meeting is unlikely. Going into Jackson Hole, the BoA Global Fund Manager Survey shows that the overwhelming consensus is the Fed will signal a taper during the August-September period. In other words, the market has fully discounted a taper announcement, though the timing is probably more dovish than market expectations.

 

 

Tactically, that the exact timing of a taper announcement is unlikely this month.  The Fed’s communication strategy is likely to shift towards emphasizing the difference in criteria for taper and rate hikes. This makes a hawkish surprise difficult.

 

As for the timing of the first rate hike, the CME Fedwatch Tool shows that the market is expecting the first increase at the December 2022 meeting. 

 

 

Frankly, it’s difficult to speculate far into the future. In a separate Bloomberg podcast, Dallas Fed President Robert Kaplan called for pulling the QE taper forward, which has the unintuitive effect of pushing a rate hike schedule further into the future.

 

Tapering could help take some of the pressure off the need to raise \interest rates in the future, according to the Dallas Fed president. “Adjusting these purchases sooner might actually allow us to be more patient on the Fed funds rate down the road,” he says. It’s a nice reminder that tightening monetary policy doesn’t have to be a monolithic or even linear activity.
In conclusion, investors need to be data-dependent rather than time-horizon dependent on the timing of Fed policy action. While there may be disagreement among Fed officials, the Neel Kashkari Bloomberg interview outlined many of the metrics that the Fed is monitoring, namely labor market tightness and the guideposts to full employment, and inflation expectations, as well as the interaction between the Fed’s full employment and price stability mandates.

 

The market endures a summer squall

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 risk-off episode

A week ago, I highlighted the risk of stock market weakness because the correlation between the S&P 500 and VVIX, or the volatility of the VIX, had spiked. The pullback duly arrived and the S&P 500 briefly tested its 50 dma.

 

 

In the past, S&P 500 and VVIX correlation spike sell signal sell-offs have bottomed when the VIX Index spiked above its upper Bollinger Band. Barring a new and unexpected shock, market internals have sufficiently deteriorated that a short-term bottom is near.

 

If I am right in my tactical assessment, the minor panic last week was just a brief summer squall.

 

 

An oversold market

The Zweig Breadth Thrust buy signal is a rare momentum-based buy signal that occurs only once every few years and almost never fails. It requires the market to move from an oversold condition to an overbought reading within 10 trading days. The ZBT Indicator went oversold last Thursday, indicating an oversold condition. While I am not holding my breath for a ZBT buy signal, technical conditions are stretched enough to be consistent with a technically driven market bottom. The only recent exception was the COVID panic of March 2020.

 

 

As well, three of my four trading bottom indicators are flashing buy signals. The 5-day RSI became oversold; the VIX Index rose above its upper Bollinger Band; and the NYSE McClellan Oscillator (NYMO) reached an oversold reading.

 

 

The only exception is the term structure of the VIX, which did not invert to indicate panic. To be sure, while my main indicator of the 1-month to 3-month VIX futures did not invert, the 9-day to 1-month VIX briefly did.

 

 

 

A sentiment extreme

I also believe the cyclical and reflation trade is due for a rebound. Defensive sentiment is becoming overly stretched. Ben Breitholtz at Arbor Capital recently observed, “The gap between cyclical vs defensive ETF flows rebounding from an extreme. Cyclical IG credits tend to outperform after these extremes.”

 

 

 

Sector internals favors cyclicals over growth

A brief survey of the market internals of cyclical and growth sectors tells the story. Consider, for example, the performance of material stocks, which is an important cyclical sector. The sector is making saucer-shaped bottoms on both an absolute and market relative basis. In addition, the relative breadth internals has been improving in the past month.

 

 

Industrials stocks is another cyclical sector exhibiting a similar pattern of saucer-shaped absolute and relative bottoms and strong relative breadth internals.

 

 

By contrast, the technology sector, which is the largest growth stock sector in the S&P 500, is testing both absolute and market relative resistance levels while relative breadth internals deteriorate.

 

 

These relative breadth conditions are consistent with the analysis of fund flow data indicating an easing of small cap and value fund redemptions and a rollover of inflows into tech.

 

 

Finally, I offer the cover of Barron’s as a contrarian magazine cover indicator.
 

 

In conclusion, short-term market conditions have become sufficiently oversold that, barring an unexpected negative shock, the stock market should rebound. Based on my analysis of market internals, cyclical and reflation sectors are poised to be the next leadership, and growth stocks have become increasingly vulnerable.

 

 

Disclosure: Long SPXL

 

Publication note: I am taking a week off next week. Barring any episodes of market volatility, there will be no mid-week market comment on Wednesday. Regular service will resume next weekend.

 

The market risk hiding in plain sight

Posted by Cam Hui -

As the infrastructure and budget bills make their way through Congress, I was surprised to see that the latest BoA Global Fund Manager Survey did not mention a corporate tax increase as a key risk to the S&P 500. 
 

 

The Biden tax proposals have been well telegraphed and most of the details have been known to the public since March. They call for a partial reversal of the Tax Cuts and Jobs Act (TCJA) corporate tax cuts from the Trump era and the imposition of a corporate minimum tax. An analysis of bottom-up 12-month EPS estimates shows that they have been rising steadily for 2021, which is understandable because individual company analysts won’t cut estimates until they see the exact details of the legislation. However, strategists have penciled in top-down earnings cuts based on different tax regimes.

 

 

For investors, a corporate tax increase represents the greatest risk to US stock prices that’s hiding in plain sight.

 

 

The Biden tax proposals

The Biden corporate tax proposals have been known since Q1. They initially called for an increase in the statutory tax rate from 21% to 28% and the imposition of a 15% minimum tax on the book income of large corporations. Further discussions with Democratic Senators indicated there was little support for a 28% tax rate and the consensus expectation is the increase will be scaled back to 25%.

 

The White House believes these proposals are justified for a number of reasons. The TCJA cuts were advertised as a way to spur investment and create jobs. Bloomberg reported that lower corporate taxes were ineffective at raising investment.
 

Government data showw that, outside of housing, private-sector investment averaged 4% annualized growth over the eight quarters of 2018 and 2019 – while the Trump tax regime was in place but before COVID-19. That’s little different from the 3.8% average of the previous five years, and well below the 6.8% pace of the 1990s – when tax rates were higher.
For policymakers, what matters isn’t the statutory rate, but the effective rate, which has been falling for decades.

 

 

In addition, US corporations have the lowest tax burden as a percentage of GDP compared to other major OECD countries. If other major industrialized countries can be persuaded to sign on to a minimum corporate tax, a corporate tax increase should not overly detract from competitiveness.

 

 

 

Winners and losers

While virtually all US companies will be negatively affected by higher corporate tax rates, a more detailed analysis reveals the relative winners and losers. From a factor perspective, the TCJA lowered the tax rate of expensive stocks by valuation far more than the cheapest stocks. In other words, growth stocks benefited from the Trump tax cuts more than value stocks. Expect that to reverse itself under the Biden proposals.

 

 

Credit Suisse also modeled the effects of a corporate tax increase to 28%. The three sectors with above-average hits to earnings are consumer discretionary, healthcare, and technology. 

 

 

However, I expect the net effects on the consumer discretionary sector to be slightly better than this model. The extraordinary level of fiscal support in response to the COVID shock allowed GDP to return to trend growth at a much faster pace than the GFC recovery. Biden’s redistribution policies are designed to put more money in the hands of the poorest Americans, who have a higher propensity to spend extra income, and will disproportionately boost the sales of consumer-oriented businesses. 

 

 

On the other hand, drug and technology companies that hide their IP in low-tax jurisdictions will be the worst affected under the Biden tax proposals. The Credit Suisse analysis found that technology stocks will still have the lowest tax rate under a 28% rate regime, but will endure the largest tax increase.

 

 

 

Pricing the pain

An examination of the most popular market narrative indicates that the effects of a corporate tax increase have not been fully discounted. Sometimes, the anticipation effect is higher than the actual event. Consider the market relative performance of banks stocks as an example. The relative performance of banks has long been correlated to the shape of the yield curve. Since banks borrow short and lend long, a steepening yield curve is favorable to banking profitability. The banks to S&P 500 ratio diverged from the 2s10s yield curve in November 2016 in anticipation that a Trump victory would be positive for the sector. When the market finally rallied in response to the passage of TCJA in late 2017, the magnitude of the TCJA rally was dwarfed by the post-election surge.

 

 

This brings us to the biggest loser under the Biden tax proposals, namely technology companies. The net margins of the tech sector is 23% compared to 8% for the rest of the S&P 500. A higher corporate tax rate has the potential to be an enormous negative surprise.

 

 

In conclusion, the market does not appear to have fully discounted the effects of a corporate tax increase. While all US equities will suffer from lower earnings, relative winners under the current proposals are value stocks and relative losers are growth stocks. Investors with a global focus should consider tilting their equity weight away from the US, which is not exposed to changes in US corporate taxes and exhibit lower forward P/E valuations.

 

 

 

Publication note: I am taking a week off next week. Barring any episodes of market volatility, there will be no mid-week market comment on Wednesday. Regular service will resume next weekend.

 

The USD’s exorbitant privilege

Posted by Cam Hui -

For the crypto folks who embrace the libertarian philosophy of using a medium of exchange not issued by any national government, here are a couple of reminders of what the USD “exorbitant privilege” means in real life. 

 

First, the Canadian extradition hearing for Huawei CFO Meng Wanzhou finally ended yesterday after nearly three years of drama. Huawei was accused of violating America’s sanctions on Iran, and Meng was arrested at the Vancouver airport based on an American extradition request. In the last three years, she had been battling extradition while under house arrest in a multi-million mansion.
 

 

All of this wouldn’t have been possible if the USD wasn’t the dominant currency of global commerce. The US has weaponized the global banking system as a foreign policy tool. 

 

 

Where’s Afghanistan’s money?

The second is a less-noticed effect of the Taliban takeover of Afghanistan. Ajmal Ahmady, the former governor of the Afghan central bank, the DAB, tweeted that the DAB holds about $9 billion in foreign exchange reserves. However, most of the assets are being held either at the Fed or within the US banking system.

 

 

As the Taliban is under international sanctions, little of those reserves are available to the new government. Ahmady states, “We can say the accessible funds to the Taliban are perhaps 0.1-0.2% of Afghanistan’s total international reserves. Not much.”

 

The BBC reported that the IMF has acted to cut off Afghanistan.
 

The International Monetary Fund (IMF) has said Afghanistan will no longer be able to access the lender’s resources…

 

An IMF spokesperson said it was due to “lack of clarity within the international community” over recognising a government in Afghanistan.

 

Resources of over $370m (£268m) from the IMF had been set to arrive on 23 August.

 

These funds were part of a global IMF response to the economic crisis.
The Taliban is coming to realize that its banking system exists mainly in a digital world and there is little or no money it DAB’s vaults. Ahmady concluded.

 

 

Keep the case of the USD’s exorbitant privilege in mind as you watch the chaotic evacuation scenes from Kabul’s airport. Washington has a powerful weapon at its fingertips, well beyond Predator drones and boots on the ground.

 

 

A fear of Delta?

Posted by Cam Hui -

Mid-week market update: Stock prices have taken a minor and uneven risk-off tone this week. The pullback has been attributable to fears over a Delta variant-related slowdown. 
 

I beg to differ. Instead, the weakness can be better explained by market technical conditions. The 5-day correlation between the S&P 500 and VVIX, or the volatility of the VIX, had spiked recently. Past instances have resolved themselves with minor bearish episodes in the last three years.

 

 

Sentiment readings could put a floor on stock prices. Investors Intelligence %Bulls has retreated and %Bears have edged up. The Bull-Bear spread has fallen to levels consistent with short-term bottoms.

 

 

 

Delta slowdown fears

Evidence of a Delta variant surge in cases had been evident for some time. It’s unclear why risk appetite should suddenly take a turn for the worse under these conditions. Using India, where the Delta variant first appeared, and the UK as guides, case spikes have peaked in about two months. Using the same template for the US, this means that cases should peak in early or mid-September and then begin to recede.

 

 

Indeed, data from the NY Times shows that case counts are starting to roll over in some of the more problematical regions, such as Florida and the South.
 

 

To be sure, Calculated Risk’s seven high-frequency indicators show that progress in reopening has either flattened out or started to roll over. Here is Apple mobility:

 

 

And TSA travel.

 

 

However, the plateau in activity has been evident for about a month. If the market narrative is attributing the risk-off tone to slowing growth, then why now instead of one or two weeka ago?
 

 

A final flush

My panel of bottoming indicators are nearing a series of buy signals Some of my bottoming indicators are nearing buy signals, while others are in neutral. The 5-day RSI is oversold and The VIX Index has risen above its upper Bollinger Band, indicating an oversold condition. The NYSE McClellan Oscillator (NYMO) is not oversold, though it is getting close. By contrast, the term structure of the VIX has not inverted, indicating fear and panic. 

 

 

As well, the Zweig Breadth Thrust Indicator is has reached a marginal oversold condition, which has marked short-term bottoms in the past.

 

 

In summary, the stock market is undergoing a shallow pullback. A short-term buying opportunity is near. Market psyhology may need just one more flush and panic.

 

Buy the dip.

 

 

Prepare for a growth stock correction

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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.
 

 

Growth leadership faltering

Changes in macro conditions are setting up for a growth stock correction. The strength in the 10-year Treasury yield is putting downward pressure on growth stock leadership. The growth style is a duration play because it is more sensitive to changes in interest rates than value. 

 

 

In addition, I made the case yesterday for a value style revival which is negative for the growth stock leadership (see Constructive value and reflation green shoots). The blogger Macro Charts also observed that ETF flows indicate crowded long positionings in growth and defensive sectors and capitulation in cyclicals. This sets up the potential for a violent rotation should the cyclical and reflation outlook improve.

 

 

 

A short-term warning

The stock market may be vulnerable to a short-term setback. The rising correlation between the S&P 500 and VVIX, or the volatility of the VIX Index, is flashing a tactical sell signal. Such correlation spikes have indicated discomfort in the option market with the market advance. In the past three years, similar conditions have resolved themselves with market weakness of about 4-5% two-thirds of the time.

 

 

However, I expect that any S&P 500 pullback should be relatively shallow. The analysis of the relative performance of the top five sectors tells the story of nascent weakness by growth sectors and strength by value stocks. Technology, communication services, and cap-weighted consumer discretionary (Amazon and Tesla) stocks are all either trading sideways or weakening relative to the market. Financials, which is the only value sector, is gaining relative strength, I interpret these conditions as a setup for an internal rotation from growth to value. Since growth stocks have a higher weight in the S&P 500 than value, the rotation may manifest itself as overall minor market weakness.

 

 

 

Constructive breadth

In other words, the bad news is that growth stocks are weakening. The good news is the weakness is unlikely to significantly drag down the S&P 500 as leadership rotates into value and reflation names. 
That’s because market breadth is starting to improve after a long period of deterioration. The NYSE Advance-Decline Line is rising and testing overhead resistance. The Equal-weighted S&P 500 is outperforming the S&P 500, indicating small and mid-cap relative strength. Market internals, such as the percentage of stocks above their 50 dma, are also recovering.

 

 

Even credit market risk appetite, which measures the relative price performance of junk bonds relative to their duration-equivalent Treasuries, is trying to make a bottom.

 

 

 

Supportive sentiment

Notwithstanding any weakness by growth stocks, sentiment model readings are likely to put a floor on overall stock prices. Ned Davis Research’s daily sentiment index is only in neutral despite the S&P 500 reaching record highs. The market is climbing the proverbial Wall of Worry.

 

 

Jurien Timmer at Fidelity also observed that “the 12-month rolling net flow into stocks is only now turning positive” after a gargantuan S&P 500 rally.

 

 

 

Still a bifurcated market

In conclusion, the 2021 stock market has been characterized by a steady advance by the S&P 500. Beneath the surface, the market remains bifurcated between growth and value and internal rotations between the two styles have served to put a floor on overall market weakness. 

 

 

Value is in the process of regaining the leadership baton from growth. I expect that the trajectory of the market to be flat to up. Investors may have to allow for the possibility that the S&P 500 could start to trade flat to down as large-cap growth has a much larger weight in the index than value.