There are no more bulls and bears, here’s why

Posted by Cam Hui -

Mid-week market update: If you hadn’t known that it was FOMC day, you would have looked at the closing market diary and shrugged. The S&P 500 closed only +0.3% on the day. Beneath the surface, however, a lot has been going on in the past few weeks.
 

Analysts who try to call the direction of the US equity market are facing an especially difficult time as they are encountering a bewildering array of both bullish and bearish sentiment readings. That’s because the stock market has bifurcated into a growth stock market and a value stock market. There is no more single stock market anymore.
 

This chart of the Russell 1000 Value to Russell 1000 Growth ratio tells the story. After value stocks opened a “Vaccine Monday” runaway gap last November, value stocks have made their way higher against growth stocks. The ratio became extended and exhibited a negative 5-day RSI divergence in early January. Both value and growth stocks proceeded to pull back, with value the underperformer. The ratio exhibited another negative RSI divergence in early March. This time, growth stocks rallied with a vengeance while value stocks were mostly flat. The Russell 1000 Growth Index skidded but recovered and its advance is currently testing technical resistance defined by the 61.8% Fibonacci retracement level.

 

 

This account of internal rotation underscores my point that this is a tale of two markets. Indeed, it was the best of times and the worst of time for growth and value. There are no more bulls and bears. You can be a value bull and growth bear, or a growth bull and value bear.

 

 

Will the real bullish or bearish indicator please stand up

Sentiment models are generally useful when readings are extreme. But never in my decades of market analysis have I seen a set of both bullish and bearish extreme sentiment and technical conditions.

 

Consider the NAAIM buy signal that I highlighted last week. The NAAIM Exposure Index, which measures the sentiment of RIAs, plummeted to below its 26-week Bollinger Band. This has been a surefire trading buy model. Out of the 11 buy signals in its 14 year history, it has “failed” only once inasmuch as the market only traded sideways in early 2008.

 

 

As well, Investors Intelligence sentiment conditions have stabilized and appear constructive for the bull case. II bulls expanded after making a bottom, and so did the bull-bear spread. These conditions indicate that a possible tradable bottom.

 

 

Rob Hanna at Quantifiable Edges pointed out after yesterday’s close that the market had pulled back after exhibiting a strong run, indicating a bullish setup for further gains.

 

 

On the other hand, Jason Goepfert at SentimenTrader observed that “Investors are nearing a record in Risk-On behavior”.

 

 

In addition, both the NYSE McClellan Oscillator (NYMO) and the 5-day RSI of the S&P 500 appear streched. Sustained bull legs usually don’t begin under extended conditions like this.

 

 

Technical indicators are usually either bullish or neutral, or bearish and neutral. It’s highly unusual to see so many at both bullish and bearish extremes. This is explained by the violent rotation between growth and value stocks and the market action is creating misperceptions among investors.

 

 

What’s the real story?

To resolve this confusion, it’s useful to think of the stock market in a new framework of growth and value stocks. There is no single market, there are two.

 

Consider the intermediate-term trend for the value/growth ratio. While growth has staged a counter-trend rally, the rebound appears to be petering out and the trend remains value friendly.

 

 

Another tailwind for value stocks is about to appear. Bloomberg reported that price momentum will increasingly tilt toward value names.

Next Tuesday marks the 12-month anniversary of the MSCI AC World Value Index’s eight-year low, a key timeframe that many quantitative models use to screen for momentum shares to buy. May 6 would be the six-month anniversary of the relative low for value stocks against their growth and momentum peers — their outperformance began after the election of U.S. President Joe Biden.

 

 

The recent snapback in growth stocks was a golden opportunity for value investors to buy the dip. While it’s always difficult to look through the market noise on FOMC day, look to the trend as being your friend – and the trend is value stocks.
 

Finally, don’t be afraid of rising rates. The Rising Rates ETF (EQRR) is heavily weighted in value and cyclical sectors. EQRR remains in a well-defined uptrend, both on an absolute basis and relative to the S&P 500.
 

 

The Fed’s statement, dot plot, and the statements from Powell’s press conference all underscore the point that the market backdrop is reflation friendly. Long live the value and cyclical trade!
 

 

Addendum: As a point of clarification, a reader asked me to define what I mean by growth and value. In general, growth stocks can be found in technology, communication service, and AMZN and TSLA in the consumer discretionary sector. Value and cyclical stocks are in financials, industrials, energy, materials, and consumer discretionary excluding AMZN and TSLA.
 

FOMC preview: Dot plot, YCC, and SLR

Posted by Cam Hui -

As the markets remain in risk-on mode, readers should be aware of several lurking risks that may appear from the FOMC meeting. Undoubtedly, Powell will repeat his dovish mantra that the Fed is a long way from neutral and policymakers are focused on the labor market.
 

Nevertheless, here is what I am watching:

 

  • What will the “dot plot” convey about the path of interest rates and how does that differ from market expectations?
  • Will the Fed do anything about the soaring 10-year yield, which has risen above 1.6%, i.e. yield curve control (YCC)?
  • What will happen to the Supplementary Leverage Ratio (SLR), and will the banks get SLR relief after March 31?

 

 

Timing of rate hikes

On Wednesday, the FOMC will release its SEPP, or “dot plot”, of interest rate expectations by members. Fed Funds futures is almost pricing in a full rate hike by the end of next year. What will the “dot plot” say?

 

 

Fed watcher Tim Duy expects a dovish response from the Fed:

The Fed will likely not signal a 2023 rate hike at this week’s meeting. Doing so would call into question the Fed’s commitment to the new policy framework…It would begin the rate hike discussion before the tapering discussion.

Also, keep an eye on the long-term neutral rate. In the past, this rate has acted as a ceiling for the 10-year Treasury yield.
 

 

Based on this model, it is unlikely that the Fed will act or even hint at yield curve control. This is important for financial stocks as the shape of the yield curve determines banking profitability (borrow short, lend long). In the past, the relative performance of this sector has been closely tied to the shape of the yield curve. The only major divergence occurred when the market rallied in anticipation of Trump’s corporate tax cuts, which boosted banking profitability.

 

 

Any hint of yield curve control would dent the performance of financials and create a headwind for a significant portion of value stocks. 

 

 

SLR explained

Then there is the key question of the Supplementary Leverage Ratio (SLR), which is an important component of the plumbing of the credit market. Here is an SLR primer from Bloomberg’s Katie Greifeld:
The latest acronym on Wall Street’s mind is SLR: the supplementary leverage ratio. In normal times, SLR required U.S. banks to hold a minimum level of capital against their assets as a buffer against losses. However, the Federal Reserve exempted Treasuries and deposits at the central bank from those requirements roughly a year ago. Banks took advantage, with balance sheets ballooning by as much as $600 billion as a result of the regulatory relief.

 

 

SLR exemption relief is expected to expire on March 31, 2021. Leading Democrats are adamant against extending the deadline. Elizabeth Warren and Sherrod Brown wrote a letter to U.S. regulators which described extending SLR relief as a “grave error.”

 

The Treasury market is becoming spooked. Dealer Treasury inventories plummeted last week, possibly in anticipation that SLR relief would not be extended.

 

 

Without SLR relief, some analysts, such as Nordea Bank have speculated that the market could see a mass liquidation of up to $700 billion of Treasury holdings.

 

 

Adam Tooze is more relaxed about the prospect of an SLR panic. He pointed to analysis by Zoltan Pozsar of Credit Suisse which showed that large banks have significant capital cushions if SLR exemption expires.

 

 

If there is an earthquake in the money markets or credit markets as a consequence of SLR exemption expiration, the Fed will act to mitigate the damage.
If Pozsar thinks it is incoherent as an overall strategy for G-SIBs [large systemically important banks], if JP Morgan doesn’t think it is risky, if Warren and Brown think it is bad politics and, if the FDIC would have to reverse itself, then, despite worries about Treasury market panics, the SLR exemption should be allowed to expire.

 

If there is turmoil in the repo market, what we have learned from September 2019 and March 2020 is that given our market-based financial system, there is no alternative but for the Fed to intervene as the first responder. No amount of private balance sheet capacity will make a significant difference and it is better to keep the risks out of the G-SIB balance sheets.

 

If we do need Fed intervention, it should be massive and prompt and avoid the market plumbing becoming a political issue. The September 2019 and March 2020 panics were buried. No reason, if necessary, not to bury interventions in 2021.

In other words, don’t turn all Zero Hedge Apocalyptic on the prospect of SLR expiry. CTA hedge funds are already in a crowded short position in bonds. Any positive surprise has the potential to spark a “rip your face off” bond rally.
 

 

In summary, there are several risks that investors should be aware of ahead of the FOMC meeting. My tentative conclusion is we should see a dovish response from the Fed. While these risks do exist and they are always present, the anticipation of any pain may be worse than the event itself.
 

If the markets turn risk-off ahead of the FOMC announcement, don’t be afraid to buy the dip.
 

Here comes the recovery

Posted by Cam Hui -

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

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

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

 

 

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

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

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

 

From shutdown to re-opening

About a year ago, the World Health Organization declared the coronavirus a pandemic. Governments around the world shut down their economies and the global economy crashed into a recession. Fast forward a year, fiscal and monetary authorities have responded with unprecedented levels of stimulus, vaccinations are proceeding, caseloads are dropping, and economies are re-opening again.

 

The Dow Jones Industrials and Transports made new all-time highs last week. That’s a Dow Theory buy signal.

 

 

Here is how to play the bull market. First, recognize that the US equity market has bifurcated into two markets. Value and cyclical stocks should benefit as the economy improves. On the other hand, growth stocks are struggling and should be avoided. Growth has too many speculative excesses and they need to be wrung out before they see a durable bottom.

 

 

Signs of recovery everywhere

There are signs of economic recovery everywhere. JPM’s Google Activity Index is rising all around the world.

 

 

China’s February exports rose an astonishing 60% year/year, which signals a surge in global demand.

 

 

The US inventory to sales ratio has plummeted, indicating that restocking demand is on the way. Add to that the $1.9 trillion in stimulus spending about to hit the economy. We have a good old-fashioned boom on the horizon.

 

 

There was also good news from the JOLTS report that was released last week. Both temporary employment, which is part of the monthly Jobs Report, and the quits/discharges ratio, which come from JOLTS, lead Non-Farm Payroll employment, are turning up. These are additional indications of rising employment as the economy recovers from the pandemic shock.

 

 

 

Momentum everywhere

Bullish momentum is appearing everywhere. Price momentum is evidenced by the new highs made by the major market indices last week. Price momentum begets more momentum, as Renaissance Capital recently pointed out.

 

 

As a sign of fundamental momentum, Wall Street analysts have been raising their forward 12-month earnings estimates after a strong Q4 earnings reporting season.

 

 

But don’t blindly buy everything. Take a look at how stock market internals have responded. NYSE 52-week highs have been surging, while NASDAQ new highs have decelerated. The momentum is flowing away from last year’s growth stock and technology winners into value and cyclical stocks.

 

 

As well, Ed Clissold of NDR Research pointed out that earnings momentum is fading for growth stocks. As the recovery takes hold, cyclical earnings growth is surging and eclipsing growth stock earnings.

 

 

In addition, quantitative price momentum strategies are about to pile into value stocks. Morgan Stanley chief US strategist Mike Wilson stated that stocks with the greatest 12-month price momentum will change as we pass the anniversary of the COVID Crash last March. Quants seeking to buy the price momentum factor will rotate from growth stocks to add value sectors like banks and energy.

 

 

Here is another headwind for growth stocks. Growth stocks are partly yield duration plays inasmuch as they are more sensitive to changes in bond yields. The relative performance of the NASDAQ 100 has shown an inverse correlation to the 10-year Treasury yield.

 

 

As the news from the economic reopening and recovery improves, the Economic Surprise Index has risen and it is putting upward pressure on the 10-year yield.

 

 

However, value investors shouldn’t be spooked by rising rates. The value/growth ratio has been highly correlated to the 10-year Treasury yield. Rising yields represent a signal of better economic growth, which benefits value and cyclical stocks.

 

 

 

Sentiment supportive of gains

In the face of strong momentum, sentiment models are not extended and supportive of further gains. The Fear & Greed Index is in neutral and it has a long way to go before it reaches a greedy reading.

 

 

Willie Delwiche observed that the spread between the Investor Intelligence sentiment ratio and the AAII ratio is near a historic low. Mom and Pop investors are more bullish than the professionals. Such episodes have tended to resolved bullishly in the past.

 

 

Macro Charts observed that growth investors have panicked. QQQ put option activity have spiked to levels consistent with past market bottoms.

 

 

The recent stock market pullback also panicked the NAAIM Exposure Index, which measures RIA sentiment, into a buy signal. This is a powerful contrarian model that has flashed only one false positive (in early 2008) since 2007. If history is any guide, expect a 5-10% advance in the S&P 500 over the next two months.

 

 

The combination of positive price momentum and skeptical sentiment is a strong bullish setup for higher prices.

 

 

Value/growth strength can continue

In the short-run, the value/growth reversal appears extended, especially among small-caps. But don’t be afraid to buy value when it dips against growth.

 

 

As an example, take a look at the relative performance of financial stocks. The relative performance reversal in this sector is global in nature, and the recovery does not appear overly stretched at all.

 

 

The relative performance recovery in energy shows a similar global pattern.

 

 

In the short-run, however, the S&P 500 is wildly overbought and it likely needs a few days to take a breather, either in the form of a mild pullback or sideways consolidation.

 

 

As well, Helene Meisler’s weekly (unscientific) Twitter poll has flashed the most bullish reading since she began polling almost a year ago.

 

 

In conclusion, there is nothing more technically bullish than a market reaching new highs. My inner investor is bullishly positioned in accordance with the buy signal from the Trend Asset Allocation Model. Price momentum is shifting away from growth stocks, which were the winners last year. While the market may be extended in the short-term and a pause in the advance would not be surprising, investors should not be afraid to buy the dip with a focus on value and cyclical names.

 

60/40 resilience in an inflation age

Posted by Cam Hui -
The fiscal and monetary authorities of the developed world are engaged in a great macroeconomic experiment. Governments are spending enormous sums to combat the recessionary effects of the pandemic and central banks are allowing monetary policy to stay loose in order to accommodate the fiscal stimulus. Eventually, inflation and inflation expectations are bound to rise.

 

Here is what that means for investor portfolios. I recently highlighted a relationship from a Credit Suisse chart indicating that 50/50 balanced fund drawdowns rise during periods when stock-bond correlations are high (see Are you positioned for the post Great Rotation era?). Stock-bond correlations tend to rise during periods of rising inflation expectations. Balanced funds composed of simple stock and bond allocations will therefore experience greater volatility and higher drawdowns. Simply put, fixed-income holdings don’t perform well in such environment which lessen their diversification effects against stocks and damage the resilience of balanced fund portfolio to unexpected shocks.

 

 

Bloomberg reported that sovereign wealth funds are becoming anxious about the 60/40 portfolio model.
Two of the world’s largest sovereign wealth funds say investors should expect much lower returns going forward in part because the typical balanced portfolio of 60/40 stocks and bonds no longer works as well in the current rate environment.

 

Singapore’s GIC Pte and Australia’s Future Fund said global investors have relied on the bond market to simultaneously juice returns for decades, while adding a buffer to their portfolio against equity market risks. Those days are gone with yields largely rising.

 

“Bonds have been in retrospect this gift,” with a 40-year rally that has boosted all portfolios, said Sue Brake, chief investment officer of Australia’s A$218.3 billion ($168.4 billion) fund. “But that’s over,” she added, saying “replacing it is impossible — I don’t think there’s any one asset class that could replace it.”

 

Thanks to declining returns from bonds, the model 60/40 portfolio may eke out real returns — after inflation — of just 1%-2% a year over the next decade, said Lim Chow Kiat, chief executive officer of GIC. That compares with gains of 6%-8% over the past 30 to 40 years, he said.

 

Norway, whose SWF is the largest in the world at $1.3 trillion in assets, had already shifted to a 70/30 target asset mix.

Norway’s $1.3 trillion sovereign wealth fund has already made the shift, winning approval to adjust its equity-bond mix to 70/30 in 2017. At the end of last year, it held about 73% in equities, and 25% in bonds.

Inflation expectations will rise in the next market cycle. The only debate is over timing. How can balanced fund investors build resilient portfolios to control risk and enhance returns during such periods?

 

I have some answers.

 

 

An asset return study

The most logical substitute for bonds in a balanced fund portfolio during a period of rising inflation expectation is inflation-indexed notes and bonds. But there is a data problem to testing that conjecture. Inflation-indexed instruments were not widely issued or traded during the inflationary 1970’s.

 

Instead, I analyzed the returns of different asset classes during different inflation expectation regimes using 5×5 forward inflation expectation rates, whose data history began in 2003.

 

 

The following asset classes were used and all returns are total returns, which include continuously re-invested dividends and interest distributions.
  • Equities: As represented by the S&P 500 ETF (SPY).
  • Bonds: As represented by the 7-10 Year Treasury ETF (IEF).
  • Inflation-indexed bonds: As represented by the TIPS bond ETF (TIP).
  • Commodities: As represented by the Invesco DB Commodity ETF (DBC).
Using the above assets, the following balanced fund portfolios were formed, which were rebalanced daily.
  • 60% SPY and 40% IEF.
  • 60% SPY and 40% TIP.
  • 60% SPY and 40% DBC.
  • 60% SPY, 20% IEF, and 20% DBC.
  • 60% SPY, 30% TIP, and 10% DBC.
The study period was limiting as it was a time of flat to lower inflation expectations, I resolved this issue by creating two return buckets, when the smoothed three-month 5×5 inflation expectation rate was rising, and when it was falling. This way, the returns of these portfolios could be measured under conditions of differing expectations.

 

The returns were measured daily, their medians annualized based on the assumption of 255 trading days per year. The standard deviation of returns was also annualized the same way. This technique allowed me to estimate the annualized return and standard deviation of each portfolio under the two inflation expectation regimes. However, it does not imply that investors can realize these returns because they are based on continuous daily portfolio holdings.

 

With those qualifiers in mind, let’s look at the results.

 

 

Diversification, risk, and returns

The first statistic to consider is asset class correlations. In constructing a balanced fund portfolio, the investor is focused on both return and risk. The equity allocation can be thought of as the main driver of return, while the other components are expected to be risk-reducing. Here are the daily correlations of the different asset classes to SPY. Recall from portfolio theory, the lower the correlation, the more diversifying the asset class is to SPY. 

 

 

Along with the individual asset classes to SPY, the accompanying chart shows the returns of SPY and commodities for illustrative purposes. Here are my takeaways from this analysis.
  • Stocks, as measured by SPY, exhibited better returns when inflation expectations are falling than when they are rising.
  • Bonds, as measured by IEF, represent the most diversifying asset class to stocks, as evidenced by their highly negative correlations. But bond yields will rise in an era of rising inflation expectations, which doesn’t address the problem of diminishing balanced-fund returns.
  • Inflation-indexed bonds, as measured by TIP, exhibited bond-like negative correlations to equities. The inflation-indexed nature of their coupons, however, has lessened their correlation when compared to IEF. This makes them a useful inflation hedge in a balanced fund.
  • Commodities are the ultimate and best hedge of inflation expectations. Commodities exhibits a slightly positive but near-zero correlation to SPY during periods of rising inflation expectations, and a slightly negative correlation during periods of falling expectations. In addition, commodities performs better when inflation expectations are rising than falling, which makes the slightly positive correlation useful as an inflation hedge in a balanced fund.
Here are more details about the returns of the individual asset classes and portfolios. My first advice is to focus on return difference under differing regimes and don’t overly focus on the level of returns as the specifics of the study period can color perceptions. Inflation-indexed bonds underperformed 7-10 year Treasuries during this period, it is therefore not surprising that the 60/20/20 portfolio beat the 60/30/10 portfolio. As well, commodity prices exhibited relatively strong returns during the study period, which can also biases return expectations for bullion that may not be realized in the future.

 

The returns of SPY, IEF, and TIP were lower during periods of rising inflation expectations and higher during periods of falling inflation expectations. It was the opposite for commodities, which raises its utility as a diversifying asset. The results were slightly surprising for TIP because they acted more like bonds than a true inflation hedge. However, the spread between the TIP returns during periods of rising and falling inflation expectations was lower at 1.0% than they were for IEF at 2.7%, indicating that TIP did act like a limited inflation hedge compared to 7-10 year Treasuries. 

 

 

Here are my main observations of the return characteristics of the balanced portfolios, based on the criteria of the spread of returns between the rising and falling inflation expectation regimes. As a reminder, the principal objective is to measure risk and not to focus on returns.
  • There were no significant differences between a 60/40 stock-bond allocation using IEF and TIP.
  • Commodities were a strong diversifier and the 60 SPY/40 DBC portfolio performed strongly during periods of rising inflation expectations. However, advocating for such a high allocation to commodities in a balanced fund portfolio is simply not realistic.
  • Both the 60 SPY/20 IEF/20 DBC and 60 SPY/30 TIP/10 DBC portfolios offered the greatest amount of stability by exhibiting similar returns during both rising and falling inflation expectation regimes.
Here are the risk characteristics of the different portfolios as measured by volatility, or standard deviation. In all cases, portfolio volatility is lower during periods of rising inflation expectations and higher otherwise.

 

 

 

An inexact roadmap

Eagle-eyed readers of last week’s publication (see Are you positioned for the post Great Rotation era) will have spotted an inconsistency that reveals the limitations of this asset return study. While my study showed a negative stock-bond price correlation, the historical record shows that stock prices were negatively correlated to the 10-year Treasury yields and therefore positively correlated to bond prices during periods of high CPI. I conclude that my study only represents a broad sketch of asset return characteristics and it does not represent an exact roadmap of what investors might expect during a period of strong inflation.

 

 

There are other limitations to the study. The asset classes chosen represent only a specific instance of a stock-bond balanced fund. Few investors would hold only the S&P 500 and 7-10 year Treasuries in their portfolio. None would rebalance their portfolios on a daily basis. The study was conducted during a period when US equities outpaced their global counterparts, biased balanced fund return estimates. 

 

In other words, your mileage will vary depending on your choice of asset classes, investment objectives, and risk preferences.

 

With those caveats, this study does present some useful portfolio construction tips. During a period of rising inflation expectations, investors should substitute their bond holdings with a combination of bonds, inflation-indexed bonds, and commodities in order to better diversify risk and reduce drawdowns. Despite the lower returns shown by the asset return study, a 60% stock, 30% inflation-index bond, and 10% commodity allocation is a reasonable starting point in thinking about as a replacement for the conventional 60/40 portfolio.

 

This is consistent with a Bloomberg report that Bridgewater had shifted to the use of gold and inflation-indexed bonds instead of sovereign bond holdings as components of its risk-parity fund.
The shift, telegraphed by the firm in a July report, drives a new wedge between Bridgewater and risk-parity purists and speaks directly to concerns that have long dogged the systematic investing approach. 

 

Since the strategy allocates money across assets based on how risky they are — meaning it buys more securities with lower volatility — it typically takes a heavy position in sovereign debt.

 

“It is pretty obvious that with interest rates near zero and being held stable by central banks, bonds can provide neither returns nor risk reduction,” a team led by Co-Chief Investment Officer Bob Prince wrote in the July report.

 

Bridgewater’s famous All Weather portfolio has therefore been moving into gold and inflation-linked bonds, diversifying the countries it invests in and finding more stocks with stable cash flow.
For the sake of completeness, I studied the use of gold instead of commodities in the asset return study. While the results aren’t shown, I found that substituting gold (GLD) for commodities (DBC) did not substantially change the risk and return characteristics of the balanced fund portfolios. I chose to report DBC returns because it represents a more diversified holding in that asset class than gold. Either acts as an excellent diversifying asset for a balanced fund during periods of rising inflation expectations.

 

Growth’s dead cat bounce

Posted by Cam Hui -

Mid-week market update: The rebound in the NASDAQ and growth stocks was not a surprise. Value outperformed growth by the most on record last week – and that includes the dot-com crash that began in 2000.
 

 

Make no mistake. Growth stocks are experiencing an unsustainable dead cat bounce.
 

 

Growth is oversold

Here is another illustration of how much growth is oversold relative to value. No matter how you measure it, large and small-cap value had turned up decisively against growth. The uptrend appears extended, and a pullback was no surprise. Nevertheless, the intermediate-term trend favors value over growth.
 

 

I had pointed out before that the NASDAQ McClellan Oscillator (NAMO) had become deeply oversold. As well, %Bullish on P&F had reached an oversold reading while the NASDAQ 100 was experiencing a positive 5-day RSI divergence. A relief rally was inevitable.
 

 

How far can the rebound run? For some clues, I looked at the behavior of the NASDAQ 100 in 2000 and 2001, which was the period after the dot-com bubble had burst. There were six episode during this period when NAMO had become oversold. The initial relief tally lasted between 4-7 calendar days. In three of the six instances, the index went on to rise further in the days ahead.
 

 

Here is further analysis indicating that the growth rebound is not sustainable. Nautilus Research studied how the NASDAQ 100 performed when it rose at least 3.5% for the first time in three months. The success rate of positive returns after one week was 50%, with an average return of -1.4%. The average after one month was -1.0%.
 

 

 

Growth bullish factors

I don’t mean to sound overly negative, there are some factors supportive of further gains in growth stocks. Risk appetite, as measured by Bitcoin is improving, though the relative performance of ARKK deteriorated today.
 

 

The relative performance of NDX is correlated with the bond market. The 10-year Treasury stabilized after a tame CPI print this morning, and the 10-year Treasury auction was relatively well-behaved.
 

 

Bond prices appear to be bottoming after exhibiting a positive RSI divergence. This should be supportive of growth stocks in the short-term.
 

 

After the recent rise in yields, Treasuries should be attractive to foreign investors on a hedged basis (returns spreads are shown based on holding a 10-year Treasury with a one-year currency hedge).
 

 

 

S&P 500 outlook

As growth and value markets diverge, forecasting the outlook for the S&P 500 is more difficult. Growth sectors represent 44.1% of index weight, while value and cyclical stocks make up 25% of the S&P 500. The 2000 and 2001 market template is not useful. The economy was just entering a recession then, but it is exiting a recession today.
 

 

My best guess is therefore continued choppiness for the S&P 500 but investors should continue to overweight value over growth. The reflation and cyclical trade as represented by the Rising Rates ETF (EQRR) still has legs, and that will put upward pressure on Treasury yields which is bearish for growth.

 

 

As the adage says, the trend is your friend. Buy value and cyclical stocks, avoid growth.
 

Tech’s kryptonite, revealed

Posted by Cam Hui -

In his latest letter to Berkshire Hathaway shareholders, Warren Buffett reported that even Berkshire’s largest publicly listed holding is asset-light Apple, and Berkshire is a very asset-heavy company. Its two major holdings are railroad BNSF and electric utility BNE, which has a large capital project to upgrade the electrical transmission grid in the western US, due to be complete in 2030.

Recently, I learned a fact about our company that I had never suspected: Berkshire owns American-based property, plant and equipment – the sort of assets that make up the “business infrastructure” of our country – with a GAAP valuation exceeding the amount owned by any other U.S. company. Berkshire’s depreciated cost of these domestic “fixed assets” is $154 billion. Next in line on this list is AT&T, with property, plant and equipment of $127 billion.

However, he extolled the virtues of asset-light platform businesses:
Our leadership in fixed-asset ownership, I should add, does not, in itself, signal an investment triumph. The best results occur at companies that require minimal assets to conduct high-margin businesses – and offer goods or services that will expand their sales volume with only minor needs for additional capital. We, in fact, own a few of these exceptional businesses, but they are relatively small and, at best, grow slowly.
In the past decade, investors have bid up the price of technology stocks, which have been the main beneficiaries of the asset-light platform business model. On a relative basis, technology forward P/E ratios are stretched relative to the S&P 500. 

 

 

Recent events have revealed the fatal weakness, or kryptonite, of the asset-light platform company’s business model.

 

 

Efficiency vs. resiliency

At the heart of the asset-light platform company’s kryptonite is a tradeoff between efficiency and resiliency. The offshoring boom was built upon the idea of efficiency. Perform all of the high value-added design work at the home office, and outsource the lower value-added production offshore. This focus on efficiency globalized manufacturing supply chains and sparked the emerging market boom illustrated by Branko Milanovic’s famous elephant graph. The winners were the middles classes in the EM economies and the very rich, who engineered the globalization initiative. The losers were the inhabitants of subsistence economies, who were not industrialized enough to take part in the boom, and the workers in industrialized countries.
 

 

Fast forward to today, what have we learned about the tradeoffs?
 

 

The new OPEC

Consider the vulnerabilities exposed by the combination of the Sino-American trade war and the pandemic in semiconductors. Most American semiconductor companies have moved to the fabless manufacturing business model, as described by Wikipedia.

Prior to the 1980s, the semiconductor industry was vertically integrated. Semiconductor companies owned and operated their own silicon-wafer fabrication facilities and developed their own process technology for manufacturing their chips. These companies also carried out the assembly and testing of their chips, the fabrication.
 

As with most technology-intensive industries, the silicon manufacturing process presents high barriers to entry into the market, especially for small start-up companies. But integrated device manufacturers (IDMs) had excess production capacity. This presented an opportunity for smaller companies, relying on IDMs, to design but not manufacture silicon.
 

These conditions underlay the birth of the fabless business model. Engineers at new companies began designing and selling ICs without owning a fabrication plant. Simultaneously, the foundry industry was established by Dr. Morris Chang with the founding of Taiwan Semiconductor Manufacturing Corporation (TSMC). Foundries became the cornerstone of the fabless model, providing a non-competitive manufacturing partner for fabless companies.

Here is the tradeoff. Bloomberg recently reported that manufacturers have discovered that a chip shortage has made them hostage to Korean and Taiwanese semiconductor companies.

There’s nothing like a supply shock to illuminate the tectonic shifts in an industry, laying bare the accumulations of market power that have accrued over years of incremental change. That’s what’s happened in the $400 billion semiconductor industry, where a shortage of certain kinds of chips is shining a light on the dominance of South Korean and Taiwanese companies.
 

Demand for microprocessors was already running hot before the pandemic hit, fueled by the advent of a host of new applications, including 5G, self-driving vehicles, artificial intelligence, and the internet of things. Then came the lockdowns and a global scramble for computer displays, laptops, and other work-from-home gear.

Now a resulting chip shortage is forcing carmakers such as Daimler, General Motors, and Ford Motor to dial back production and threatens to wipe out $61 billion in auto industry revenue in 2021, according to estimates by Alix Partners. In Germany, the chip crunch is becoming a drag on the economic recovery; growth in China and Mexico might get dinged, too. The situation is spurring the U.S. and China to accelerate plans to boost their domestic manufacturing capacity.
The technological prowess and massive investment required to produce the newest 5-nanometer chips (that’s 15,000 times slimmer than a human hair) has cemented the cleavage of the industry into two main groups: those that own their fabrication plants and those that hire contract manufacturers to make the processors they design. South Korean and Taiwanese companies figure prominently in the first camp. “South Korea and Taiwan are now primary providers of chips like OPEC countries once were of oil,” says Ahn Ki-hyun, a senior official at the Korea Semiconductor Industry Association. “They don’t collaborate like OPEC. But they do have such powers.”
Onshoring manufacturing is not a practical alternative, according to Barron’s.
U.S. companies lead the world in designing microchips. But two Asian players, Taiwan Semiconductor Manufacturing (ticker: TSM) and Samsung Electronics (005930.Korea), control manufacturing. The two account for three-quarters of the complex “logic” chips produced globally, and all of the most advanced chips with a thickness of seven nanometers or less, says James Lim, Korea analyst at Dalton Investments. 
Intel (INTC), the leading U.S. manufacturer, has fallen off the Asians’ pace, and catching up seems like a long shot. “Semiconductors are the most complex things that humans make,” says Brian Bandsma, emerging markets portfolio manager at Vontobel Quality Growth. “It isn’t something you can solve by throwing money at it.”
Do you want efficiency or resiliency? You can’t have both.

 

 

The Texas lesson

The recent power outages in Texas is another lesson in the tradeoffs between efficiency and resiliency. The designers of the system opted to isolate most of the Texas power grid from the rest of the country and the utilities decided not to winterize their system against snowstorms, which was a tail-risk that they decided they could live with. We know the result.

 

This is not a place to point fingers. Every electrical generating system has its vulnerability. In January 1998, Quebec suffered an unforeseen ice storm that left over a million customers without power in a part of the country that should have been cognizant of harsh winter weather. Most of Hydro-Québec’s transmission lines were overhead lines that were overcome by freezing rain and heavy ice, which knocked over numerous trees and took down power lines.

 

Nuclear power has its special vulnerabilities as well. The Japanese earthquake of 2011 took the Fukushima nuclear reactor offline and it was the most significant nuclear accident since Chernobyl. France, which relies heavily on nuclear power for electrical generation, has had to shut down its reactors during summer heatwaves because the local river water used to cool reactors had become overly warm.

 

Renewable energy has its own blemishes. Wind and solar depend on the weather and it is not always on. That leads to fluctuation in power generation and a system that overly depends on renewable energy will not have the same “always-on” electrical power resiliency of other sources such as hydro, nuclear, and carbon-based energy such as coal, oil, and natural gas. There will be times when the grid has too much energy and users may be paid to take power. Other times, there will be shortages when the air is still, or when the sun isn’t shining.

 

 

The pendulum swings back

None of this analysis invalidates the asset-light platform company business model. However, recent events have highlighted the need for these companies to diversify and harden their supply chains and make them more resilient. This will make them less efficient and compress margins.

 

Take a mundane business like apparel. I could walk into a store and buy an off-the-rack men’s designer suit for several thousand dollars. I was in Vietnam in late 2019 and visited a town that operated on the “Hong Kong tailor” model, which offered tailored suits for nearly one-tenth the price of the designer suit on a 24-48 hour turnaround. There are also companies located in North America that measure customers for suits, send the measurements offshore, and have the suit delivered to the customer within weeks. The price point is somewhere between the full retail price and the Vietnamese tailor. What initiatives will companies like that take to harden and diversify their supply chain, and what will it cost?

 

As the focus starts to shift from efficiency to resiliency, expect the P/E premium to compress. That’s the fundamental reason why value investing will shine in the next market cycle.

 

 

 

Momentum crashes, market now oversold

Posted by Cam Hui -

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

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

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

 

 

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

 

Momentum crashes, S&P 500 wobbles

I have been warning for the past few weeks that sentiment was overly frothy and due for a reset. The reset finally began in the last two weeks. The weekly S&P 500 chart shows the index fell, but held a rising trend line support after the 5-week RSI flashed a negative divergence for most of 2021. The high-flying momentum stocks, as represented by the NASDAQ 100 (NDX), were not as fortunate. NDX violated its rising trend line indicating significant technical damage has been done.

 

 

At its deepest, the S&P 500 was -5.7% off its all-time highs. The carnage in the high-octane NASDAQ 100 was even worse. That index was off -11.3% on a peak-to-trough basis indicating a definitive loss of growth stock leadership. As Big Tech comprise nearly half of S&P 500 weight, this has important consideration for the overall market direction.

 

However, the short-term market action indicates an oversold market poised for a relief rally.

 

 

The momentum and growth stock massacre

The carnage can be seen mainly in the price momentum factor, which buys recent price winners. There are four momentum ETFs (MTUM, JMOM, PDP, QMOM). No matter how momentum is measured, the relative performance of this factor has crashed in the past two weeks.

 

 

The same can be said of growth stocks. For several years, growth stocks have been the market leaders, but the growth and value relationship reached an inflection point at about the time of Vaccine Monday in November when Pfizer announced positive news on its vaccine by trading through a rising relative trend line. The growth to value ratio recently broke down by confirming the dominance of the value style last week.

 

 

The growth-heavy NASDAQ 100 is rolling over. Its performance relative to the S&P 500 is nosediving, and so is the relative performance of the speculative growth ETF ARKK. However, NDX and ARKK are all trading at or near absolute and relative support.

 

 

 

An oversold market

In the short-term, the market’s action is oversold and a relief rally may have begun on Friday. Let’s begin with the bond market, which sparked the latest round of market weakness. TLT, which represents the Treasury long bond, is flashing a positive 14-day RSI divergence on high volume, indicating positive momentum on capitulating volume.

 

 

IEF, the 7-10 year Treasury ETF, is showing a similar constructive pattern.

 

 

The NASDAQ 100, which bore the brunt of the selling, is also exhibiting a positive 5-day RSI divergence. As well, the NASDAQ McClellan Oscillator (NAMO) has reached a second oversold reading in the space of a week. The last time this happened, which was in January 2020, the index bottomed and took off to its ultimate peak in February when the news of the pandemic sideswiped all risk assets. In addition, market breadth such as the percentage of stocks with point and figure buy ratings have reached oversold levels.

 

 

Based on the thesis that growth stocks have shifted to a secular period of underperformance, I analyzed the NAMO and percentage bullish indicators during the 2000-2001 Tech Wreck period when the dot-com bubble burst. Based on a study of that difficult period for growth stocks, I found the NASDAQ 100 always staged a short-term relief rally when NAMO became oversold.

 

 

 

Sentiment: Not out of the wood

Before investors rush out to buy the dip on Monday, sentiment models have not sufficiently recycled to indicate a major bottom just yet.

 

The latest Investor Intelligence survey shows a pullback in bullish sentiment, but bearish sentiment has not spiked to levels normally seen at durable bottoms.

 

 

Similarly, the NAAIM Exposure Index, which tracks the sentiment of RIAs, has fallen to 65% from a recent high of 110%. Readings have not fallen below the 26-week lower Bollinger Band, which is the level when my sentiment model flashes a buy signal, though there are no guarantees that sentiment will necessarily reach those levels.

 

 

Mark Hulbert‘s newsletter sentiment models show that while equity sentiment is low, they are not in the extreme pessimism zone. However, gold and bonds are washed out and poised for rallies.

 

 

In summary, equity sentiment models can be best described as constructive. There isn’t enough panic just yet.

 

 

Buy the dip, and sell the rip

In conclusion, the downtrend for the market and growth stocks has been confirmed, but conditions are sufficiently oversold that a relief rally is imminent.

 

Ryan Detrick of LPL Financial offered the following template for the market. If the current bull market follows the pattern of the two strong bull markets that began in 1982 and 2009, it would begin to tire and consolidate about now.

 

 

However, market averages are deceptive. Investors should use rallies to raise cash from the sale of growth stocks rotating into value stocks on weakness. Proshares has a Rising Rates ETF (EQRR) that I would not recommend buying because of its minuscule assets and lack of liquidity. Nevertheless, its sector weights are tilted towards value and cyclical sectors and reflective of the new market leadership, and its relative performance is revealing of what investors should expect in the new market regime.

 

 

 

Disclosure: Long TQQQ

 

Are you positioned for the post Great Rotation era?

Posted by Cam Hui -

Is the US stock market in a bubble? Yes and no, according to Ray Dalio of Bridgewater Associates. Using a proprietary technique to create a “bubble indicator”, Dalio concluded that “the aggregate bubble gauge is around the 77th percentile today”, compared to a 100th percentile reading in 1929 and 2000.
 

 

Dalio qualified his analysis with some parts of the market are indeed very bubbly, but others are not.

There is a very big divergence in the readings across stocks. Some stocks are, by these measures, in extreme bubbles (particularly emerging technology companies), while some stocks are not in bubbles. 

Credit Suisse came to a similar conclusion with their US Exuberance Index. The number of companies with price-to-sales over 10 have surged, but readings are not at the levels seen during the dot-com peak.

 

 

At the same time, the market is undergoing a secular shift from growth to value. Here are some important implications for investor portfolios in the next market cycle.

 

 

A (sort of) frothy market

While the US equity market is looking frothy, the amount of exuberance is limited to certain parts of the market. Bridgewater calculated the required earnings growth rate for stocks to justify current bond yields, and found levels are at the 77th percentile of historical observations. 

 

 

While the exuberance during the dot-com era permeated all parts of the market, the enthusiasm has been largely limited to the public pricing of equities. This time, corporate management is not responding with capital spending and M&A plans based on sky-high expectations.
One perspective on whether expectations have become overly optimistic comes from looking at forward purchases. We apply this gauge to all markets and find it particularly helpful in commodity and real estate markets where forward purchases are most clear. In the equity markets we look at indicators like capital expenditure—whether businesses (and, to a lesser extent, the government) are investing a lot or a little in infrastructure, factories, etc. It reflects whether businesses are extrapolating current demand into strong demand growth going forward. This gauge is the weakest across all our bubble gauges, pulling down the aggregate read. Corporations are the most important entity in terms of driving this piece via capex and M&A. Today aggregate corporate capex has fallen in line with the virus-driven hit to demand, while certain digital economy players have managed to maintain their levels of investment. Similarly levels of M&A activity remain subdued so far.

 

 

 

P/E compression ahead

In light of the secular rotation from growth to value, here are some important market implications for investors.

 

 

First, get ready for P/E compression. The analysis of the S&P 500 for YTD 2021 shows that gains were attributable to rising earnings expectations, while P/E ratios fell.

 

 

Fortunately, forward earnings estimates have been rising steeply across all market cap bands, with small caps the strongest of all.

 

 

On the other hand, forward P/E are likely to compress as inflation expectations rise. However, investors need to distinguish between reflationary forces, which are reflective of positive real economic growth and equity bullish, and inflation, which leads to central bank tightening and equity bearish. As I pointed out last week, the current tactical narrative is reflation (see Will rising yields sideswipe equities?).

 

 

For investors, this has a number of important portfolio positioning implications.
  • Avoid the high-flying growth bubbly growth stocks.
  • Focus on the value parts of the market.
  • Focus on the parts of the market exhibiting better earnings growth, such as mid and small-caps.
  • Focus on non-US markets, which are trading lower forward P/E ratios than the US. With Big Tech comprising nearly half of the weight of the S&P 500, the US P/E premium to the rest of the world is becoming overly stretched and due for some mean reversion.

 

 

 

Portfolio construction: Structural changes in stock-bond correlations

The other portfolio implication is the changing nature of the stock-bond correlation. In his latest letter to Berkshire Hathaway shareholders, Warren Buffett warned about the current level of yields and joined the chorus about the “bleak future” for fixed-income investors.
And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.
As inflationary pressures heat up in the next market cycle, the low to negative stock-bond price correlation experienced since the late 1990’s is going to change. (Note that the chart below shows stock to Treasury yield correlation, and bond prices move inversely to yields).

 

 

If history is any guide, the shift from growth to value will also mean a rising stock-bond correlation.

 

 

This has important considerations for portfolio construction and investment strategy. No longer can investors expect a low or negative correlation between stocks and bonds. While fixed-income holdings will still be diversifying in a balanced portfolio, they are far less likely to act as ballast if stock prices fall. Investors holding the traditional 60% stock and 40% bond portfolio should therefore expect higher volatility. The latest historical study from Credit Suisse shows that the drawdowns from a 50/50 portfolio were significantly higher during the period of high stock-bond correlations.

 

 

In addition, the underlying assumption of portfolio strategies that depend on low and negative stock-bond correlation such as risk-parity will face considerable difficulty. Bloomberg recently documented the headwinds faced by risk-parity funds.

 

 

Risk-parity and other volatility targeting strategies employ leverage to achieve their risk-adjusted returns. While current levels of leverage are relatively low and lessen the risk of a disorderly unwind of positions, the longer-term outlook for such strategies depends on assumptions about asset return correlation that may not exist under a regime change scenario.

 

 

Accounts that invest in such strategies should re-evaluate their long-term commitment to such funds.

 

In conclusion, a secular rotation from growth to value isn’t as simple as it sounds and has important implications for investor portfolios. From a stock selection perspective, investors should:
  • Avoid the high-flying growth bubbly growth stocks.
  • Focus on the value parts of the market.
  • Focus on the parts of the market exhibiting better earnings growth, such as mid and small-caps.
  • Focus on non-US markets, which are trading lower forward P/E ratios than the US. With Big Tech comprising nearly half of the weight of the S&P 500, the US P/E premium to the rest of the world is becoming overly stretched and due for some mean reversion.
From a portfolio constructive perspective, investors should be prepared for rising stock-bond correlations. While stock and bond holdings will still be diversifying, balanced portfolios with are expected to experience higher overall volatility, and volatility targeting strategies such as risk-parity will be less effective in achieving their objectives.

 

 

Bond market panic!

Posted by Cam Hui -

Mid-week market update: Is the bond market panic over yet? The 10-year Treasury yield touched a high of 1.6% last week. It fell when the Reserve Bank of Australia began to engage in yield curve control, but it is edging back towards 1.5% again.
 

 

Based on this week’s market action, I conclude that stock prices have unfinished business, both on the upside and downside.

 

 

Short-term bullish

I pointed out last week how the NASDAQ 100 (NDX), which was the worst hit of the major indices, was oversold on the NASDAQ McClellan Oscillator (NAMO). The NDX staged a strong relief rally on Monday but retraced all of the gains. Is the recovery over? Probably not yet. The historical experience indicates that the relief rally window usually at least a week. The current pattern may be setting up for a double bottom, with further relief rallies in the coming days.

 

 

The analysis of short-term breath is supportive of my case for further strength. While oversold markets can become oversold, significant near-term downside risk is unlikely.

 

 

The market’s risk/reward is tilted to the upside, at least for the next few days.

 

 

Downside risks

When I look beyond the short time horizon of a relief rally, the market faces significant downside risks. Simply put, investor sentiment is too bullish for the market to rise.

 

Helene Meisler conducts an (unscientific) weekend Twitter poll. I was surprised to see that even though stock prices tanked last week, bullish sentiment rose, which is contrarian bearish.

 

 

The surprising net bullish poll readings were confirmed by a similar (unscientific) weekend Twitter poll conducted by Callum Thomas.

 

 

Longer-term, retail bullishness continues rising to new highs. This will eventually need a reset.

 

 

 

The risk of a disorderly ARK unwind

Another key risk to the market is the possibility of a bear raid on Cathie Wood’s ARK holdings. Both NDX and ARKK remain in relative downtrends against the S&P 500, indicating a failure of leadership.

 

 

Bloomberg reported that ARK holds a number of illiquid positions that could be subject to selling pressure by hedge funds and other fast-money participants.
 

Ark now owns more than 10% of at least 29 companies via its exchange-traded funds, up from 24 just two weeks ago, according to data compiled by Bloomberg.

 

Less discussed are holdings of Nikko Asset Management, the Japanese firm with a minority stake in Ark that it has partnered with to advise on several funds.

 

When combined, the pair own more than 25% of at least three businesses: Compugen Ltd., Organovo Holdings Inc. and Intellia Therapeutics Inc. Together they control 20% or more of an additional 10 companies.

The list below shows ARK’s 18 most illiquid holdings, as measured by the number of trading days it would take ARK to exit its position. ARK a precarious liquidity trap with these positions that represent about 20% of NAV. So far, these stocks haven’t seen significant selling pressure yet. In short, the ARK organization is apparent lacking in risk management control, but it may be only a matter of time its holdings experience a disorderly “flash crash” as the combination of selling pressure and redemptions threaten Cathie Wood’s franchise.
 

 

As well, the NYSE McClellan Summation Index (NYSI) reached an overbought reading of over 1000 and recycled late last year. In the past, the stock market has found difficulty finding a base until NYSI reaches a neutral condition of between -200 and 200, which hasn’t happened yet.
 

 

Tom McClellan also observed that the market was close to flashing a Hindenburg Omen this week.
 

 

Despite its name, Hindenburg Omens have had an extremely spotty record at forecasting market crashes. I concluded in 2014 that such signals were indicative of market indecision and potential volatility (see The hidden message of the Hindenburg Omen).

The Hindenburg Omen indicator has a lot of moving parts and it is therefore confusing. I believe that the most important message in the Hindenburg Omen is the expansion of both new highs and low, indicating divergence among stocks and points to market indecision.

The NDX is tracing out a possible head and shoulders formation, but as good technicians know, these patterns are not complete until the neckline actually breaks. The index is now testing neckline support while exhibiting a positive 5-day RSI divergence. My base case scenario calls for a rally, followed by weakness and a likely break of the neckline.
 

 

In summary, there are reasons to be both bullish and bearish, but on different time frames. In the short-run, the relief rally hasn’t run its course just yet and more upside is possible. Once the market works off the momentum from an oversold rally, it faces further downside risk from the combination of excessively bullish sentiment and unfinished business to the downside from a technical perspective. At a minimum, expect choppiness and volatility in the weeks ahead.
 

 

Disclosure: Long TQQQ
 

Q4 earnings: Good news, bad news

Posted by Cam Hui -
With 96% of S&P 500 companies having reported, Q4 earnings season is all but over. For the markets, the earnings reports contained both good news and bad news. 

 

There was plenty of good news. Both EPS and sales beat rates were well above their historical averages. In addition, consensus earnings estimates have been rising steadily, and forward 12-month EPS estimates have nearly recovered to pre-pandemic levels.

 

 

In fact, the pace of Q1 estimate revisions is the second highest in FactSet’s history, second only to Q1 2018.

 

 

 

The bottom-up assessment

The tone from earnings calls is nothing short of giddy, according to The Transcript, which monitors earnings calls.
Covid cases are dropping, vaccines are being administered and warmer weather is coming.  Fatigued consumers are ready to return to normal.  We especially miss traveling.
Barring another wave of rising infections, the consumer is ready to spend.
Covid fatigue is real
“Now after 11 months of pandemic, I think we all know that COVID fatigue is real. People are clamoring for the opportunity to have experience outside their homes. Every day, we see signs of people want to get out and get away” – Royal Caribbean Cruises (RCL) CEO Richard Fain

 

And cases are dropping
“So I must admit every single day I go on the COVID U.S.A. chart on Google, and so how the trend line is and it’s just plummeting. So my sense is, is that we’re getting closer and closer to good news.” – Royal Caribbean Cruises (RCL) CFO Jason Liberty

 

By April vaccines should be available to everyone
“…vaccinations were ultimately going to be the deciding factor. And the quicker we vaccinate where we get to the point of herd immunity, which by most accounts, that timeframe is in the July, August time. So sometime in summer, the experts believe that by the end of April, anyone who wants a vaccine…will have access to one that all bodes well.” – Norwegian Cruise Line (NCLH) CEO Frank Del Rio

 

And we’re getting closer to warmer weather
“…we believe based on all the experts that we talked to, including the Healthy Sail Panel that we’re going to see a continuation of the significant drop in cases as we enter spring summer, as we continue to vaccinate over 1.5 million Americans a day, as more people get infected and recover.” – Norwegian Cruise Line (NCLH) CEO Frank Del Rio 

 

Consumers are ready to get back to normal
“…we’ve already been seeing the leisure recovery pick up since the beginning of the year when it was at its low point. Not only has occupancy been picking up in February, but overall bookings have consistently increased each week so far this year.” – Pebblebrook Hotel Trust (PEB) CEO Jon Bortz

 

People miss traveling more than anything else
“We did a survey recently of American travelers and we found a couple of things. The first thing we found is that people missed traveling, that’s not surprising, but we also found that people missed traveling more than any other out-of-home activity. People missed traveling more in America than going to a restaurant, going to sports, live music or other activities.” – Airbnb (ABNB) CEO Brian Chesky

 

There’s a lot of pent up demand
“Bookings and rebookings of weddings into the second half of 2021 and 2022 have been very strong, and we’re seeing rebookings of group into the second half of 2021 and all of 2022 as well…We’re very encouraged about how well group is shaping up for 2022 at this point.” – Pebblebrook Hotel Trust (PEB) CEO Jon Bortz

 

“…historically, we don’t really talk about 2022. But what we’re seeing continue on is our customers — there’s a lot of pent-up demand for vacations, right? They’re saving more. They bypass many of their vacations. And so they’re trying to eye out when, we’re going to return to service. And they’re going to be able to go and enjoy the vacations that they had previously planned. And so I think when you look at the first half of 2022, again, it’s very, very early, the pricing that we’re seeing relative to like-for-like for 2019 shows that our rates are up with or without any application of future cruise certificates.” – Royal Caribbean Cruises (RCL) CFO Jason Liberty 

 

“…we are very encouraged and very pleased by the strong booking activity driven by pent up demand across all three brands for 2022 voyages…For the first half of 2022 and for all of 2022, in fact, our load factor is currently well ahead of pre-pandemic levels” – Norwegian Cruise Line (NCLH) CEO Frank Del Rio

 

Consumers are flush with cash
“The leisure customer has a humongous amount of money in the bank. There’s huge fiscal stimulus in the system and more coming, the Fed has been pumping capital into the market.” – Pebblebrook Hotel Trust (PEB) CEO Jon Bortz 

 

Limited supply creates pricing power
“…this is a finite capacity business. I can’t cruise with 150% occupancy. So there’s going to be a squeeze play here. That demand is going to exceed supply…you got less supply, you’ve got pent up demand. You’ve got people with money in their pocket. I think this is just the making of a boom time for the cruise industry. And since we can’t expand, supply any faster than it’s coming online, pricing is what’s going to dictate the day. And we’re seeing it. I mean, it’s astonishing to me in the 25-plus years, I’ve been in this business.” – Norwegian Cruise Line (NCLH) CEO Frank Del Rio

 

 

The top-up assessment

The top-down assessment upbeat. New Deal democrat, who monitors high-frequency economic data and splits them into coincident, short-leading, and long-leading indicators, has a highly constructive view of the economy.
(1) The economy is primed for strong takeoff once the pandemic is brought under control, as housing, manufacturing, and more generally production are strong, and commodities are red hot.

 

(2) The pandemic appears to finally be being brought somewhat under control, as about half of people in the high risk groups have received at least one dose, nursing home deaths are already down sharply, and with a third vaccine being approved, we are on track for herd immunity probably by the end of the summer.

 

(3) Seeing all this, together with the likely approval of a large new stimulus bill by Congress, the bond market has reacted by pushing rates higher. This is a “bullish” reaction, as the yield curve is very positive.

 

(4) The weather issues affecting some of the data series are transient and likely to last only one or two more weeks at most.

 

 

The fly in the ointment

Here is the bad news. The market has not reacted well to earnings beats, except for blow-out earnings reports.

 

 

In my recent publication (see Will rising yields sideswipe equities?), I made the case that the market is in a reflation phase of the market cycle. Reflation phases are defined by rising earnings estimates and rising bond yields. The bullish effects of rising estimates overwhelm the bearish effects of higher rates.

 

However, the muted market reaction to earnings beats raises the question of how much has been priced into earnings expectations. This represents a short-term risk to the stock prices, which may need a further sentiment reset before it can sustainably advance higher.

 

 

The Great Rotation continues

Posted by Cam Hui -

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

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

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

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

 

 

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

 

More signs of a Great Rotation

The leadership of the last market cycle was dominated by three main themes, the US over global equities, growth over value, and large-caps over small-caps. Leadership began to change in 2020. Small-cap stocks broke their relative downtrend first. November’s Vaccine Monday, when Pfizer announced its positive vaccine results, sparked a shift in the other two factors.

 

 

Since then, small-cap stocks have roared ahead against their large-cap counterparts. Last week saw another confirmation of the Great Rotation when value/growth relationship broke a key relative support level.

 

 

A great gulf

A great gulf has appeared between the market internals of the high-flying growth names, as represented by the NASDAQ 100, and the broadly-based market. Even as the S&P 500 weakened to test its 50-day moving average (dma), NYSE 52-week highs held up well until Friday while NASDAQ highs deteriorated. As well, the percentage of S&P 500 on point and figure buy signals staged a mild retreat, while the similar indicator for NASDAQ stocks fell to oversold levels.

 

 

The NASDAQ McClellan Oscillator (NAMO), which became near overbought in early February, has retreated to an oversold extreme.

 

 

For some context, here is how the NASDAQ 100 and NAMO behaved during the period leading up to and after the dot-com top of 2000, which is as bad as growth stock got. Oversold conditions in the bull market of 1999 were intermediate-term buy signals, while oversold conditions in the bear market that began in 2000 were tactical buy signals that only resolved in short-term rallies, but the index did bounce.

 

 

In light of the change in leadership from growth to value, expect the latter scenario of short-term tactical rallies to be in play.

 

 

Waiting for a small investor shakeout

While these readings argue for a tactical relief rally, I don’t think the bottom is here just yet because the retail investor remains overly exuberant. Standard indicators of equity risk appetite don’t work well in this environment because the market is undergoing an internal rotation from growth to value.

 

 

We need to see the inexperienced Robinhood investor crowd to become washed out, which has not happened so far. Call option volumes are still rising in a parabolic way. I am reminded of Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

 

 

Deutsche Bank conducted a survey of retail investors, and there is a remarkable difference in bullishness between the Boomers and their younger counterparts. More remarkably, bullishness is concentrated in the least experienced group.

 

 

In a raging bull, it takes a kid with no fear. But this new cohort will learn their lessons about risk when the market turns. When asked if they are willing to buy a dip of 3% or less, investors with less than two years of experience were willing to step into the breach.

 

 

The least experienced investors were less enthusiastic when the pullback deepens to 3-10%.

 

 

One risk appetite indicator reflective of this Robinhood crowd that I am monitoring is Bitcoin (BTC). The returns of BTC have been highly correlated with the relative returns of the high-flying ARK Innovation ETF (ARKK) relative to the S&P 500.

 

 

Jim Bianco observed that the “biggest Bitcoin Fund, Grayscale $GBTC, is trading at a discount for only the 3rd time ever, and its largest.” Is this a buy signal, as it has been in the past, or the start of a significant risk-off episode?

 

 

 

The 56-week pattern in play?

Where does that leave us? I wrote about an intriguing analysis by Gordon Scott about the 56-week pattern in early December (see Melt-up, or meltdown?).
Here is how it works: any time the S&P 500 index (SPX) rises more than five percent within a 20-session stretch, 56-weeks later there is often a sell-off of varying proportions. This happens consistently enough that if you track through the data, you can calculate that the average return for the 40-day period at the end of 56 weeks is almost a full one percent lower than the average return for any other 40-day period over the past 26 years. The reason for bringing it up now is that, as shown in the chart below, the recent pullback came at the beginning of such a pattern. Even more interesting is that three more ending patterns are due to create selling in close proximity during the second quarter of 2021.

 

The 56-week pattern has a simple explanation. To take advantage of favorable tax treatment, many high-net worth investors and professional money managers prefer to hold positions longer than one year. What that means is that if a lot of them buy at the same time, it shows up in the market averages. A little more than a year later, there comes a point where a lot of money is ready to be taken out of one position and moved into another.

 

 

Scott’s analysis calls for market weakness in March, followed by hiccups in May and July. Let’s take this one at a time, starting with March. The market is undergoing an internal rotation from growth to value. Unless another bearish catalyst appears on the horizon (see the risks outlined in No reasons to be bearish?), the most likely outcome is a period of sideways choppiness with limited downside risk for the S&P 500.
 

Tactically, the market may stage a relief rally in the coming days. Both the S&P 500 and NASDAQ 100 are highly oversold and due for a bounce early in the week.
 

 

As well, NYMO has also flashed an oversold reading as the S&P 500 tests its 50 dma.
 

 

But don’t be fooled by any rally. We are in need of a small investor sentiment washout that hasn’t happened yet. These conditions argue for a period of choppiness and growth to value rotation in the coming weeks.
 

 

Disclosure: Long TQQQ
 

Will rising yields sideswipe equities?

Posted by Cam Hui -

Jerome Powell’s Congressional testimony last week made the Fed’s position clear. Monetary policy will remain easy for the foreseeable future. Inflation dynamics change, but not on a dime. While Fed policy will leave short-term interest rates anchored near zero, the market’s inflation expectations have been rising. Last week, the 10-year Treasury yield briefly breached 1.6% and the 30-year Treasury yield rose as high as 2.4%.
 

 

Will heightened inflation expectations and rising bond yields rattle the equity market?

 

 

Reflation, or inflation?

Inflation fears are overdone. Jim Bianco wrote an insightful Bloomberg OpEd advising investors to distinguish between reflation and inflation. Equity markets perform well in under reflation. They face more headwinds with inflation. 
If interest rates are rising on the heels of reflation and real growth, that is positive for risk assets. In the last few decades, when interest rates have risen, it has been due to real growth. The markets have shown they are willing to tolerate the Federal Reserve’s suppression of interest rates in such a scenario.

 

But if interest rates are rising because of faster inflation, then that is not good for risk assets. All else being equal, inflation depresses real economic growth and earnings as purchasing power dwindles. During the inflationary period from 1966 to 1982, stocks lost 65% of their real (after-inflation) value as inflation raged. These real losses were not recouped until the mid-1990s. Inflation has not been a problem since the 1990s.
The current market narrative is reflation, not inflation. Take a look at the difference between nominal yields and inflation expectations. Recently, as nominal yields rose (red line), the 5×5 forward inflation expectations (blue line) actually fell. This is an indication that the bond market isn’t worried about inflation just yet.

 

 

The yield curve is equally revealing. While the market has mainly been focused on the widening spread between the 10-year and 2-year Treasury yield (red line), or the 2s10s curve, the spread between the 2-year and 3-month (blue line) has been flat. The difference in yield curve behavior is reflective of differing expectations. While the market expects longer-term inflation pressuring rates to rise, it doesn’t expect a significant change in short rates over the next two years.

 

 

Contrast the current circumstances with the “taper tantrum” of 2013, when Fed chair Ben Bernanke openly wondered when the Fed might taper its QE purchases. Both yield curves were steepening then.

 

The commodity markets are telling the same story. The ratio of gold to CRB is falling while the copper to gold ratio is rising. These are all indications that the market believes the forces of cyclical reflation are dominant over inflation.

 

 

 

Here comes the YOLO recovery

Other signs indicate reflation is on the way in Q2. The combination of rising vaccinations, warmer weather, fiscal stimulus, and a flood of liquidity to spark a YOLO (You Only Live Once) recovery. Vaccine deliveries are rising, which is positive, and warmer weather has shown itself to lessen the effects of the pandemic. 

 

Bloomberg offered a tantalizing account of what may happen as the pandemic recedes using the model of Australia and New Zealand, which have acted to effectively control the virus.
Australia and New Zealand’s success in suppressing Covid-19 — outside isolated flare-ups — has sparked a snap-back in household and business sentiment, spurring activity and hiring and laying the ground for a sustained recovery. With vaccines being rolled out across the developed world, the prospect of a return to normal is tantalizingly within reach.

 

Households Down Under are cashed up due to government largess and limited spending options during their respective lockdowns. That prompted Aussies and Kiwis to salt away funds, freeing up room to consume. 

 

“Substantial fiscal boosts, combined with an internalization of spending has driven a sharp rebound in spending by households in Australia and New Zealand,” said James McIntyre of Bloomberg Economics in Sydney. “Rising asset prices are delivering a further boost. But both economies could see recoveries whither as fiscal boosts fade and borders reopen.”
More importantly, Bloomberg reported in a separate article that the US Treasury is drawing down its account at the Fed, which will unleash a tsunami of liquidity into the banking system.
The Treasury’s decision — unveiled at its quarterly refunding announcement — will help unleash what Credit Suisse Group AG analyst Zoltan Pozsar calls a “tsunami” of reserves into the financial system and on to the Fed’s balance sheet. Combined with the Fed’s asset purchases, that could swell reserves to about $5 trillion by the end of June, from an already lofty $3.3 trillion now.

 

Here’s how it works: Treasury sends out checks drawn on its general account at the Fed, which operates like the government’s checking account. When recipients deposit the funds with their bank, the bank presents the check to the Fed, which debits the Treasury’s account and credits the bank’s Fed account, otherwise known as their reserve balance.

 

 

The flood of liquidity will have several effects. First, it could push short-term interest rates below zero, as Treasury has fewer needs to issue Treasury bills as it draws down its cash balance at the Fed. Watch for the Fed to announce that it will raise the rates it pays on excess reserves (IOER) to offset the downward pressure on short-term yields. If it does, don’t misinterpret this as tightening. It is only a technical change to the plumbing of the money market to prevent short-term rates from going negative.
 

The next question is what will happen to the billions as Treasury injects cash into the banking system. A rising tide lifts all boats, and undoubtedly some of the funds will find a home supporting consumer spending, and some will support stock prices. This development should be net equity bullish.
 

Here comes reflation.
 

 

Reflation is equity bullish

In the short-run, reflation is dominating the fundamental narrative. During the initial phase of an economic recovery, both earnings estimates and bond yields rise together. Equity prices rise because the bullish effects of rising earnings estimates overwhelm the bearish valuation effects of rising yields. Indeed, Ed Yardeni pointed out that forward S&P 500 revenues and sales are enjoying a V-shaped recovery.
 

 

Equity valuations are not demanding from a long-term perspective. Using a 10-year CAPE to calculate the equity risk premium, stock prices are not excessively expensive even with an elevated 10-year Treasury yield.

 

 

As well, Marketwatch reported that RBC strategist Lori Calvasina observed that the stock market behaves well when the rise in the 10-year Treasury yield is less than 2.75%.

 

 

In short, equity investors shouldn’t worry about rising inflation expectations and bond yields – at least not yet.

 

 

When does the party end?

In conclusion, investors need to distinguish between different phases of the rising rate cycle. There is the reflation phase, which is equity bullish, and the inflation phase, which creates headwinds for equities as central banks tighten the economic cycle. We are currently in the reflation phase, which is very equity bullish.

 

Here is a clue of when the transition might occur. A Bloomberg interview with former New York Fed President Bill Dudley provided some clues. Dudley was one of the triumvirate of monetary policy under the Yellen Fed, and his views reflect the mainstream of Fed thinking. In the interview, Dudley revealed that the Fed will find it difficult to avoid a taper tantrum in late 2021 or early 2022. Mark that in your calendar. Even with a taper tantrum, it doesn’t necessarily mean the equity bull market is over. It will only mean the market will enter a new phase.

 

 

Until then, financial conditions are highly expansionary and the Fed is determined that it stay that way.

 

 

Global liquidity is rising, which should be supportive of more stock market advances. The forecast from this model indicates a gain of 31.2% from the MSCI All-Country World Index.

 

 

Moreover, stock market valuations aren’t overly stretched based on the equity risk premium even with higher Treasury yields, according to Goldman Sachs.

Investors ask whether the level of rates is becoming a threat to equity valuations. Our answer is an emphatic “no.” Although the S&P 500 forward P/E multiple of 22x currently ranks in the 99th historical percentile since 1976, ranking only behind the peak of the Tech Bubble in 2000, our dividend discount model (DDM) implies an equity risk premium (ERP) that ranks in the 28th percentile, 70 bp above the historical average. Similarly, even after the recent rise in yields, the 300 bp gap between the S&P 500 forward EPS yield of 4.6% and the 10-year US Treasury yield ranks in the 42nd historical percentile. Keeping the current P/E constant, the 10-year yield would have to reach 2.1% to bring the yield gap to the historical median of 250 bp. If instead the yield gap remains unchanged, and rates rise to 2.0%, then the P/E multiple would fall by 10% to 20x. But in today’s economic environment, our macro model suggests the ERP should be narrower than average.

 

 

Relax, and enjoy the party.

 

MoMo is losing its mojo

Posted by Cam Hui -

Mid-week market update: About a month ago, I warned that the market was undergoing a regime shift from growth to value (see What would Bob Farrell say?) and compared today’s Big Tech momentum stocks, not to the dot-com mania, but the Nifty Fifty era. On the weekend, I rhetorically asked in a tweet that if Bloomberg TV has to explain r/WSB lingo to its audience, it’s probably a sign that speculative momentum was nearing the end of its run.
 

 

It finally happened this week. The MoMo (momentum) crowd is losing its mojo. The price momentum factor, however it’s measured, is undergoing a sharp correction.
 

 

Here is what that means for the stock market.
 

 

A growth to value rotation

The S&P 500 tested its 50-day moving average (dma) yesterday and recovered. Beneath the surface, however, a strong rotation from growth to value is evident. The growth-heavy NASDAQ 100 (NDX) was not as lucky as the S&P 500 as it violated an important rising trend line. As well, its relative performance breached a rising trend line, and so did the high-flying ARK Innovation ETF (ARKK). The technical deterioration was foreshadowed by a negative divergence in the percentage of NASDAQ stocks above their 50 dma indicator.
 

 

The growth to value rotation can also be seen in the relative performance of different large and small-cap growth and value indices, which are either testing or violating key relative technical support levels.
 

 

 

Market implications

The failure of price momentum and growth to value rotation should translate to a minor headwind for stock prices. The weight of Big Tech growth is roughly 45% of S&P 500 weight, while cyclical stocks account for about 20%, and value sectors 30%. Weakness in Big Tech growth should create mild downward pressure on the S&P 500.
 

 

Cathie Wood’s ARKK saw investors pull $465 million from its fund on Monday (ARKK reports flows t+1 so we won’t know Tuesday’s flows until after the close Wednesday). The redemption was the first major outflow during a period of heavy inflows.
 

 

Here is the risk to the fund. ARKK holds a number of large illiquid positions, measured as a percentage of outstanding shares, in a variety of small and micro-cap stocks. These positions are known on a daily basis. Should the momentum sell-off continue, these illiquid positions are juicy targets for hedge fund bear raids where they drive down the stocks through short sales. Such bear raids have the potential to spark a stampede out of ARKK, which will have to sell its most liquid positions first, such as TSLA, followed by the less liquid ones. This could translate into a flash crash style panic in growth stocks, and small-cap growth in particular.
 

Downward pressure on growth stocks, which comprise about 45% of the S&P 500, will create significant headwinds on the S&P 500. To be sure, funds are rotating into value stocks, but since value sectors only make up 30% of the index, this will be bearish for the index overall.
 

I am not forecasting a stock market crash, though a crash in growth stocks is a possibility depending on how the animal spirits behave. For some sense of scale, the asset size of Fidelity’s Contrafund dwarfs ARKK. The effects of any growth crash will likely be contained.
 

 

 

The road ahead

In conclusion, the market is undergoing a rotation from growth to value, which also manifests itself as a failure of price momentum. This will put minor downward pressure on stock prices. Expect a choppy sideways to down market environment in the next few weeks, but no major downdraft in the S&P 500.
 

This is consistent with the pattern found by Ryan Detrick, who observed that the stock market tends to have a minor bearish bias in March when a new party takes control of the White House.
 

 

As well, II sentiment is recycling from a bullish extreme, which is a constructive development as the market undergoes an internal rotation.
 

 

However, hedge fund positioning is at a crowded long and could use a reset. A retreat in growth stocks may be the catalyst for a normalization in equity sentiment.

 

 

My base case scenario calls for a choppy month of March, with downside potential limited to -5% or less.

 

 

Commodity supercycle: Bull and bear debate

Posted by Cam Hui -

Is it too late to buy into the commodity supercycle thesis? The latest BoA Global Fund Manager survey shows that respondents have moved to a crowded long position in commodities. Many analysts have also hopped on the commodity supercycle train, myself included (see How value investors can play the commodity supercycle).
 

 

As a cautionary note, one reader alerted me to a well-reasoned objection on the commodity supercycle thesis.

 

 

Much depends on China demand

China watcher Michael Pettis raised his objections in a Twitter thread. Simply put, a secular commodity bull doesn’t make sense from the demand side. Much depends on Chinese growth remaining at the current unsustainable levels.
I wonder if they’ve thought through the systemic implications. Given China’s disproportionate share of demand (50% or more of global production of major industrial metals, for example), to predict a new supercycle of rising commodity prices is effectively the same as predicting that China will run another decade or two of 4-6% GDP growth, driven mainly by surging infrastructure and real-estate investment. This in turn implies that China’s debt-to-GDP ratio will rise from 280% today to at least 400-450%. 
This strikes me as pretty unlikely. For those who might argue that “all it would take” is for India to begin to replicate China’s growth story of the past four decades, it would take at least 15-20 years of replicating China before India were big enough to matter to anywhere near the same extent. 

 Pettis concede that we could see a cyclical recovery, but expectations of a secular bull are overblown.

We could of course get a temporary rise in hard-commodity prices as US infrastructure spending kicks in (although this year I expect Chinese hard-commodity consumption to drop temporarily) , but most of the variation in demand depends ultimately on what happens in China, and of course the more hard commodity prices rise because of non-Chinese factors, the harder it will be – and the faster debt must rise – to maintain the needed Chinese growth rate.

 

 

Warren Buffett, commodity bull?

Before abandoning the commodity bullish thesis, investors should consider the recent moves by Berkshire Hathaway (BRK). In August, the company reported that it spent $6.6 billion to purchase positions in five Japanese trading houses. The surprising move was attributed to the low valuations of the trading houses, international diversification, and sector exposure. Specifically, these trading houses offers a window into the cyclical global economy, namely steel, shipping, and commodities. More recently, BRK announced that it bought a $4.1 billion position in Chevron.

 

These portfolio changes by Warren Buffett and his lieutenants are signals that BRK is buying into cyclical and commodity exposure.

 

As the chart below shows, the company’s sector bets were timely. Global materials and mining stocks have outperformed the MSCI All-Country World Index (ACWI) since the Japanese purchases were announced. As well, the relative performance of energy stocks appears to be constructive. Global energy is turning up against ACWI, and it is bottoming when compared to the red-hot global mining sector.

 

 

 

Cyclical or secular bull?

I return to the question raised by Pettis. Is this a secular or cyclical commodity bull?

 

For investors with a 2-3 year horizon, it probably doesn’t matter. The global economy is undergoing a cyclical and reflationary rebound. Conference Board CEO confidence recently reached 17-year highs. Companies are on track to increase their capital spending plans, which translates into high commodity demand.

 

 

While there may be some short-term potholes in the road (see No reasons to be bearish?), this is the start of a new equity bull. Investment-oriented accounts should position themselves accordingly. 

 

I reiterate my view that commodity bulls should look for contrarian opportunities in energy. While the most recent BoA Global Fund Manager Survey showed an excessively long position in commodities, the monthly change indicated that managers bought commodities but sold energy.

 

 

 

Waiting for the sentiment reset

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

In need of a washout

While I am a long-term equity bull, sentiment models are extremely stretched in this market and in desperate need of a reset. The latest BoA Global Fund Manager survey shows that institutional risk appetite is at historically high levels.

 

 

Retail risk appetite is even more stretched. The CBOE equity put/call ratio (CPCE), which tends to measure retail sentiment, is extremely low indicating excessive bullishness. By contrast, the index put/call ratio (CPCI), which measures institutional hedging activity, has been rising indicating cautiousness. Such high spreads between CPCE and CPCI have resolved themselves with market pullbacks in the past.

 

 

This is insane! When’s the sentiment reset?

 

 

The end of the retail frenzy?

In many ways, you can tell that we are nearing the end of the retail trading frenzy when Congress holds hearings into the GameStop Affair.  Bloomberg TV also took steps to educate its viewers on WallStreetBets lingo.

 

 

The WSJ also featured the profile of a 25 year-old security guard who took out a $20,000 loan to play GameStop and lost. These are all typical signs of a mania that’s nearing its end.

 

 

The bear case

Here are some bearish factors to consider. The 10-year Treasury yield has taken off like a rocket and even rose through a rising trend line.

 

 

Ally strategist Callie Cox found that “Quick jumps in the 10-year yield tend to freak out stocks, but stocks tend to do well in the 12 months after….because big jumps in yield often happen at the tail end of recessions or early on in economic recoveries”, which describe current circumstances well.

 

 

As well, simultaneous high correlations between the S&P 500, the VIX Index, and VVIX, which is the volatility of the VIX, have tended to resolve with pullbacks in the 3-5% range in the past.

 

 

The weekly S&P 500 chart is exhibiting a negative 5-week RSI divergence. But this is not an immediate and actionable sell signal. These divergences can persist for several weeks before they resolve themselves.

 

 

 

Earnings Season: What’s priced in?

Another concern is the market’s reaction to Q4 earnings season. According to FactSet, 79% of the S&P 500 has reported, and both the EPS and sales beat rates are well above their historical averages. In response, analysts are revising their EPS estimates upwards. These developments should be equity bullish. As the historical record shows, earnings estimates have moved coincidentally with stock prices.

 

 

The disturbing development is the market response to positive earnings surprises. Stocks have not reacted well to earnings beats, which calls into question what the market has already priced in. In the past, the market either pull back or experience difficulty advancing under similar conditions.

 

 

 

The bull case

On the other hand, the bulls can make the case that the path of least resistance is up. Despite a combination of frothy sentiment and extreme positioning, market internals do not support the case for a pullback. Most technical indicators are confirming the signs of market strength. 

 

The relative performance of the top five sectors to the S&P 500 shows few signs of broad technical breakdowns. The top five sectors comprise 75% of index weight and it is impossible for the market to move up or down significantly without the participation of a majority.

 

 

Equity risk appetite, as measured by the ratio of high beta to low volatility stocks, and the equal-weighted ratio of consumer discretionary to consumer staples, is not showing any negative divergences.

 

 

Credit market risk appetite is also not showing any bearish divergences either.

 

 

Foreign exchange (FX) risk appetite presents a mixed picture. The USD Index has been inversely correlated with the S&P 500 in the last year and it is flashing a minor warning. However, the AUDJPY exchange rate, which is a risk-on indicator, is flashing a bullish signal.

 

 

 

Waiting for the break

Tactically, the market can continue to grind upwards, but it can also break down and correct at any time. I pointed out in my last post (see No reasons to be bearish?) that significant downside breaks need a bearish trigger and story. Despite the presence of technical warnings, no bearish narrative has taken hold. 

 

In the absence of a negative fundamental story that spooks the markets, the best the bears can hope for is a 3-5% pullback, but no sentiment reset. Market psychology has become so overdone that the healthiest scenario is a brief scare and correction to wash out the weak hands. So far, that hasn’t happened.

 

Looking to the longer-term, the big picture market structure favors a sustained advance. The percentage of S&P 500 stocks above the 200-day moving average recently exceeded 90%. This is the sign of a “good overbought” momentum advance that can last for months.

 

 

The market just needs a sentiment reset and correction for the bull trend to continue.

 

 

No reasons to be bearish?

Posted by Cam Hui -

The nature of the market advance has been extraordinary and relentless. From a long-term perspective, the monthly MACD model flashed a buy signal last August for the broadly-based Wilshire 5000 and there are no signs of technical deterioration. This is a bull market, but sentiment has become sufficiently frothy that a reset is overdue.
 

 

The latest BoA Global Fund Manager Survey concluded that “the only reason to be bearish…is there is no reason to be bearish”. As the economic outlook improved and the vaccine rollouts are on track to control the pandemic, the market’s mood has shifted from despondency to mania. An immense amount of speculative froth has appeared. The market has been overrun by small uninformed YOLO (You Only Live Once) investors trading penny stocks and call options. 

 

 

In addition, the market has been presented with the spectacle of cash-starved auto maker Tesla spending its precious cash to buy Bitcoin. Not only that, software maker MicroStrategy $900 million in convertible notes at a 0% yield with the expressed intention of purchasing Bitcoin, after tapping the markets in December with a similar convertible.

 

However, stock prices don’t just fall and sentiment reset without a fundamental narrative that investors can focus on. Here are the key risks to the bullish consensus.
  • A “China is slowing” scare
  • USD strength sparking emerging market weakness and a risk-off episode
  • Rising real yields creating a headwind for equities

 

 

A slowing China?

A key risk to the global growth narrative is a deceleration in Chinese growth. China was the first to enter the pandemic-induced slowdown in 2020 but it led the global economy out of the recession.

 

 

Beneath the surface, the apparent strength Chinese growth has hidden a number of vulnerabilities. A recent Bank of International Settlements (BIS) study used China’s provincial government data to aggregate GDP growth. The authors found that the sources of growth pivoted around 2010 from investment and productivity gains to government spending, credit, and house prices.

Looking at the determinants of Chinese aggregate growth, we find that the drivers have changed both with respect to economic variables and across provinces. Before 2010, growth was driven predominantly by rural population moving to cities, as well as by investments and productivity. After 2010, growth through reallocation of labor has run its course to a large extent and growth has become more dependent on government expenditures, credit growth and house prices. Moreover, these new growth determinants seem to apply more homogeneously to the majority of Chinese provinces. A natural question is whether such determinants can sustain growth persistently?

 

 

In the wake of the pandemic, Beijing went back to its old quick-fix mal-investment playbook to boost growth. Expect that 2021 GDP growth to be driven by more consumption. Under such a scenario, consumer demand should strengthen, and agricultural commodities should be strong, but industrial metal prices could soften. This has the potential to lead to a “China is slowing” scare among investors.
 

Keep an eye on the evolution of credit growth, as measured by Total Social Financing (TSF). TSF growth is already showing signs of slowing. While any slowdown is expected to be temporary, further deceleration could upset the global reflation and cyclical recovery consensus and spark a risk-off episode in the financial markets.
 

 

 

Will USD strength = EM weakness?

Another concern is the upward pressure on the USD, whose strength could spark a period of emerging market asset weakness.
 

There are several reasons for a USD rally. As bond yields have risen, the yield differential between USD assets and EUR and JPY assets has widened. All else being equal, this will attract more funds into Treasuries. Already, the USD Index has bounced off a key support zone and rallied through a falling trend line.
 

 

The pace of relative easing will also be on the mind of market participants. While all major G7 central banks are expected to continue to ease, the pace of asset purchase will diverge. In particular, the European Central Bank is expected to expand its balance sheet at a faster pace than the Fed, which will put downward pressure on the EURUSD exchange rate.
 

 

As well, there is an enormous gulf in the pace of vaccinations between the US and the EU. Several central banks, such as the Federal Reserve and the Bank of Canada, have tied the pace of vaccinations to the path of near-term monetary policy. Therefore a differential in vaccination rates will affect the relative rates of monetary easing. This will undoubtedly widen the rates of pandemic-related growth in 2021, which will show up in the FX markets.
 

 

In addition, the divergence in fiscal policy between the US and the eurozone will also put downward pressure on EURUSD. The Biden administration is planning to inject some $2.8 trillion in 2021 in discretionary fiscal stimulus, consisting of the $900 billion passed in December and a proposed additional rescue package of $1.9 trillion. By contrast, the eurozone, which consensus expectations calls for a double-dip recession, only plans to inject just €420 billion, made up of funds from national fiscal authorities and Next Generation EU (NGEU) borrowing.
 

 

Rising real rates

Finally, rising real rates could be another spark for a risk-off episode. Robin Brooks of the Institute of International Finance pointed out that the 5×5 forward swap rates indicate a sharp rise in real yields.
 

 

Rising real rates is associated with a stronger USD and lower gold and other commodity prices. USD strength, whether it stems from rising real yields or other reasons such as growth and yield differentials, would put downward pressure on EM assets and create headwinds for other risky assets such as equities.

In conclusion, there are several reasons to be cautious in an environment where most market participants have gone all-in on risk. Watch how these risks develop for signs that a sentiment reset is under way.
  • A “China is slowing” scare
  • USD strength 
  • Rising real yields

 

 

Too late to buy small caps?

Posted by Cam Hui -

Mid-week market update: Instead of repeating endlessly the mantra of how frothy this market has become, I thought it would be worthwhile to take a look at one of the market leaders. Small cap stocks have led the market up during this recovery.
 

 

On the other hand, the latest BoA Global Fund Manager Survey shows that institutions are off-the-charts bullish on small cap stocks, which is contrarian bearish.
 

 

What are the risks and opportunities in small-cap stocks?
 

 

Party just getting started

Arguably, the small-cap bull is just getting started. Callum Thomas at Topdown Charts highlighted the weight of the small-cap S&P 600 in the S&P 1500. S&P 600 weight recently made a relative bottom, but it has a long way to go before it even normalizes.
 

 

From a valuation perspective, the relative P/E ratio of the small-cap Russell 2000 to the large-cap Russell 1000 also made a recent cyclical low. The party’s just getting started.
 

 

 

How frothy is this market?

While the long-term outlook for small caps is bright, the elevated sentiment levels begs the question of whether traders should be concerned about the frothiness in the market. Even though small stocks are the market leaders, high beta small caps are not likely to perform well should the market correct.
 

On one hand, bullish sentiment can be interpreted in a bullish way. Arbor Data Science pointed out that the spread between bull and bear searches is extraordinarily high. The last time the readings reached these elevated levels, the market continued to advance. These surges in bullish sentiment is not unusual during the initial phases of a new bull.
 


 

On the other hand, Willie Delwiche observed that the percentage of industry groups making 52-week highs were mostly concentrated in mid and small-cap indices. Though the sample size is small, similar high readings of industry highs have foreshadowed market pullbacks (n=3).

 

 

In addition, Goldman’s Risk Appetite Indicator recently reached a +1 standard deviation sell signal, which is the first time in three years. This is an intermediate-term warning for stock prices.

 

 

 

Due for a sentiment reset

Sentiment readings indicate that this market is eventually due for a reset. I am like the boy who cried wolf so many times that I am not sure if I believe the warnings myself anymore. First, the market reaction to this morning’s PPI and retail sales extremely strong prints were revealing. The immediate reaction was a retreat in both equity prices and bond yields. This calls into question of what was already priced in.
 

In addition, a technical cautionary signal comes from the rising correlation of the S&P 500 and the VIX Index, and the VVIX, which is the volatility of the VIX. In the past, spikes in correlation have resolved with 3-5% pullbacks.
 

 

Should the S&P 500 weaken further and breach the 3800 level, expect a correction of 6-12%.
 

 

From a longer-term perspective, this chart of small to large-cap ratios makes it clear that we are just starting a relative bull cycle for small-cap stocks. The relative performance of microcaps (IWC), the Russell 2000, and the S&P 600, which has a higher earnings quality because S&P has a stricter inclusion criteria than the Russell indices, also show that the market experienced a quality effect for the past few years. Low-quality small caps began to lag as early as 2015, but they have snapped back in a convincing fashion in the past year. As well, the Russell 2000 to S&P 500 14-week RSI has become overbought, and that has been a signal in the past for a tactical reversal in relative performance.
 

 

I remain long-term bullish on small-cap stocks. Your level of commitment will depend on your time horizon. If the market were to go risk-off, small caps are likely to underperform in the short-run.
 

The bulls’ second wind, or last gasp?

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

Still scaling the heights

The S&P 500 remains in an uptrend on the weekly chart. After pulling back and successfully testing the lower bound of a rising megaphone trend line three weeks ago, the index rose to test resistance as defined by the upper megaphone trend line. 

 

 

Should the market break out to the upside, it would represent a blow-off top of unknown magnitude. On the other hand, bulls should be warned that the market is exhibiting a negative divergence on the 5-week RSI. Should the market break the lower megaphone trend line, the experience of the past four years suggests a pullback in the 6-12% range.

 

Does this market action represent the start of a renewed bull or the last gasp of a dying bull? Here is what I am watching.

 

 

Earnings, earnings, earnings!

Keith Lerner at Truist Advisory Services observed that the S&P 500 has been rising since last June, but the market’s forward P/E ratio has been steady. This indicates that forward EPS estimates have been rising in line with stock prices, which is constructive for the bull case. What he neglected to mention is that the 10-year Treasury yield has risen about 0.5% during the same period, which makes fixed-income instruments more competitive with equities. In order for stock prices to rise, EPS estimates need to rise at the same pace or more than the stock index. Otherwise, the strength of the TINA (There Is No Alternative to stocks) investment theme will fade.

 

 

To the relief of the bulls, earnings estimates have been rising. The EPS and sales beat rates of the Q4 earnings season have been ahead of historical averages.
 

 

However, there is some question as to how much of the Q4 earnings beats have been priced in. For the first half of earnings season, the market was not rewarding earnings beats but the situation turned around in the last week. Bespoke reported that stock prices had been falling in reaction to earnings reports but improved sharply in the week ending February 9, 2021. The one-day price reaction to earnings report for that week was a positive 1.34%, which was considerably better than the earlier periods.

 

 

 

Sentiment: Elevated but off the boil

Sentiment model conditions are still excessively bullish but they are mostly off the boil. The Fear & Greed Index is recovering after falling, but readings are still in neutral territory and not excessively bullish.

 

 

AAII sentiment has also recycled back to net bullish, but conditions are not extreme enough to be alarming. In any case, overly bullish AAII sentiment has not shown itself to be a timely sell signal in the past.

 

 

One area of concern arises out of the NAAIM Exposure Index, which is a survey of RIAs managing client funds. The latest survey shows that the most bearish respondents are 80% long the market, which is astounding.

 

 

However, SentimenTrader pointed out that while these readings are concerning, they have not constituted actionable sell signals in the past.

 

 

In addition, the surge in penny stock and option trading volume along with a collapse in SPY volume has a bubbly feel of a stampede of inexperienced small retail traders. One investment professional reported, “Schwab is receiving so many requests to turn on options trading that their usual 24-48 hour application turnaround is now 7-10 days.” Bubbles can persist for a long time but bubbly conditions don’t constitute immediate sell signals.

 

 

These sentiment conditions as worrisome. The market can pull back at any time, but conditions are not excessive enough to preclude additional price gains.

 

 

Market internals: A second wind

A glance at the market internals of the top five sectors shows the bulls getting a second wind. These sectors represent about 75% of S&P 500 index weight, and it would be impossible for the market to advance or decline without the participation of a majority of these sectors. The relative performance of the Big Tech sectors (technology, communication services, and selected consumer discretionary stocks) are all turning up, along with financial stocks.

 

 

In addition, the performance of the high-octane and speculative stocks, as proxied by ARK Innovation ETF, is beating the market.

 

 

On the other hand, leadership is narrowing, and that’s a concern from a longer-term perspective. The percentage of stocks beating the S&P 500 has dropped to historic lows.

 

 

A similar pattern of narrow leadership can be also observed globally.

 

 

 

Waiting for resolution

Where does that leave us? The bulls can point to renewed bullish technical conditions that are supportive of additional gains. Sentiment conditions, while elevated, can rise further before reaching crowded long readings.

 

The bears can highlight selected technical warnings, such as the negative divergence on the 5-week RSI and narrowing leadership. In addition, the combination of SPAC mania and retail meme trading are characteristics of a speculative top that does not end well (see Rip the bandaid off now, or later?).

 

I interpret these conditions as a market that is extended and can correct at any time. However. the market can grind higher in the short-term. Investment-oriented accounts should raise some cash and reduce some risk at these levels. Traders should wait for definitive signs of either an upside breakout of the megaphone, which would indicate a bullish blow-off top, or a breakdown below megaphone support, which signals a correction, before acting.

 

How value investors can play the new commodity supercycle

Posted by Cam Hui -
The investment seasons are changing. Two major factors are emerging in altering the risk and return profiles of multi-asset portfolios in the coming years, rising commodity prices and value investing.

 

There is a strong case to be made that we are on the cusp of a new commodity supercycle. The last time the CRB to S&P 500 ratio turned up, commodity prices outperformed stocks for nearly a decade. The ratio is on the verge of an upside breakout from a falling trend line, supported by the stated desire of the Biden administration and the Federal Reserve to run expansive fiscal and monetary policies.
 

 

In addition, value stocks are exhibiting the start of a multi-year turnaround against growth stocks. 

 

 

Here is how to combine value investing while participating in rising commodity prices. I’ll give you a hint with this mystery chart.

 

 

More on this value opportunity below.

 

 

Here comes inflation

Inflation is on the horizon, and there are good reasons from both a top-down macro policy perspective and a technical perspective. Both fiscal and monetary policy-makers have expressed the willingness to run a “hot” economy. President Biden has proposed a $1.9 trillion fiscal package. As well, the Fed’s Summary of Economic Projections, otherwise known as the dot plot, indicates it will not raise rates until 2023.

 

These policies have set off inflation alarm bells. The concern has not just come from deficit hawks, but thinkers who were former supporters of more deficit spending. Former Clinton-era Treasury Secretary and Obama-era Director of National Economic Council Larry Summers penned a Washington Post OpEd warning that the $1.9 trillion bill would overheat the economy. His views are supported by former IMF chief economist Olivier Blanshard. Former New York Fed President Bill Dudley, who was a dove during his tenure at the Fed, also wrote a Bloomberg Opinion article titled “Four More Reasons to Worry About U.S. Inflation”. 

 

Summers agrees with Biden as to the intention of the spending, which is to do whatever it takes to enable the economy to recover from the pandemic induced recession. His concern is the size of the package exceeds the economy’s “output gap”, which represents the difference between current economic growth and the economy’s growth potential, or “speed limit”. The $1.9 trillion spending initiative would raise aggregate demand well above supply, which overheats the economy and bring on inflationary pressures. Instead, Summer believes the package should spend funds gradually over time and be focused on long-term investments.

 

The Biden administration believes the US faces existential threats in the form of a global pandemic and climate change which necessitates an FDR-era Big Government activist response. Biden learned his lesson from the negotiations over Obama’s 2009 stimulus bill, whose effects were smaller than originally envisaged. As well, the “output gap” is a difficult figure to estimate, much like the natural unemployment rate that the Fed used to steer monetary policy. As an example, a study by ISI-Evercore found that if we use the CBO’s economic potential to estimate output gap but the Fed’s GDP economic growth path, the output gap is closed in 2022.

 

 

In the meantime, inflationary expectations are rising. The 5×5 forward inflation expectation rate is above the Fed’s 2% inflation target and well above the 5-year Treasury yield. 

 

 

The debate started by Larry Summers is over the secular path of inflation. At a minimum, these conditions call for a cyclical rise in inflation. Indeed, the US Inflation Surprise Index (red line) has been elevated since mid-2020, and inflation surprises have recently spiked all over the world.

 

 

For investors, the secular vs. cyclical inflation debate is irrelevant and an academic exercise. From a technical perspective, the chartist could argue that when gold outperforms the CRB Index, it is a sign that inflationary expectations are rising. When gold lags the CRB, and in particular when the copper/gold ratio rises, it is a sign of cyclical reflation.

 

 

 

The value play

The investment hedge to an inflationary environment is to add commodity exposure. Equity investors should add exposure to the commodity producing sectors of the stock market. 

 

It’s time to reveal the mystery chart, which is the ratio of energy stocks to material stocks. Since the materials sector is relatively small and has non-mining companies such as steel, the second panel of the accompanying chart shows the ratio of oil & gas exploration and production companies to mining. The bottom panel shows the ratio of TSX energy to material stocks listed in Toronto, which has a broader sample of companies in both sectors. The patterns are all similar. Energy had been lagging materials, but it is in the process of making a saucer-shaped relative bottom.

 

 

 

Addressing the climate change threat

Value investing is by nature uncomfortable. It’s natural to be leery of energy stocks. From a fundamental perspective, the main reason to avoid the energy sector is the growing acceptance of climate change and global initiatives to lower the carbon footprint. The Intergovernmental Panel on Climate Change’s Global Warming of 1.5°C report laid out what needed to be done. To reach the Paris Agreement’s goal of limiting warming to 1.5° Celsius above 2010 levels, every nation must cut its carbon-dioxide emissions by about 45% by 2030 and reduce to net-zero by 2050.

 

Today, 9 of the 10 largest economies have pledged to reach net-zero emissions by 2050. 29 countries, plus the EU, have net-zero pledges for all greenhouse gases. Some 400 companies, including majors such as Microsoft, Unilever, Facebook, Ford, and Nestle, have signed on with the Business Ambition for 1.5°C pledge. GM announced that it will stop selling internal combustion vehicles by 2035. Royal Dutch Shell boldly stated last week that its production likely reached a high in 2019 and expects it to gradually decline. These initiatives are sounding the death knell for carbon-based energy sources like oil and gas.

 

Here is the bull case for oil prices over the next few years, as outlined by Goldman Sachs commodity strategist Jeff Currie in a Bloomberg podcast.
 

His basic argument has a few parts. One key element is the nature of green stimulus. While moves to electrify and decarbonize the economy will, in the long run, reduce the commodity-intensity of economic growth, these benefits are felt on the back end after years of capital expenditures. In the short run, faster growth and investment will naturally increase demand for commodities by delivering a jolt to growth and consumption. What’s more, because of environmental reasons, and the potential lack of long-term demand for, say, oil, these price increases won’t be met with increased investment in new production/mining/exploration etc. the way they might normally in a price boom. Again, if you think the long-term future is an economy less dependent on hydrocarbons, why invest now, even if prices are moving higher?

 

Currie also notes that Biden has a lot of discretion about taxes on drilling on federal lands and that he can institute a stealth carbon tax, lifting the global price of oil in a bid to make clean energy (wind, solar etc.) even more cost-competitive.,,

 

The other big aspect of his view is economic redistribution. It’s well understood by now that lower-income households have a higher propensity to consume, rather than save, their marginal dollars. So, direct checks, and other forms of wealth redistribution under Biden, will grow the economy faster than, say, the Trump tax cuts. But furthermore, says Currie, the consumption of lower-income households is more commodity-intensive than the consumption of higher-income households. Hence wealth redistribution gives you a double jolt: more growth, and more commodity-intensive growth specifically.
In other words, the supply response to rising oil prices is likely to be muted owing to the expected long-term decline in demand. That said, Bloomberg reported that shale producers are expected to ramp up production as oil prices stay above $50.
American oil explorers will boost drilling and production later this year as crude prices are set to stay above $50 a barrel, according to a U.S. government report.

 

Supply from new wells will exceed declining flows from wells already in service, raising overall crude production from the second half of this year, the Energy Information Administration said in its Short-Term Energy Outlook. The agency increased its forecast for 2022 U.S. crude output to 11.53 million barrels a day, up from January’s estimate of 11.49 million.
Buried in the story is the key expectation of falling aggregate production.

Despite the EIA’s expectation for rising production in the second half, the agency sees U.S. output declining in the coming months, hitting 10.9 million barrels a day in June, with the number of active drilling rigs below year-ago levels. The agency estimated 2021 production at 11.02 million barrels a day this year, down from a previous forecast of 11.1 million.

This chart of projected Chinese oil demand tells the story. Oil demand is expected to rise and peak in the latter part of this decade, followed by long-term decline. Over the next 5-10 years, however, it’s difficult to wean an economy off hydrocarbons.

 

 

The market response to corporate initiatives to diversify into green and alternative energy also tells a bullish story of legacy energy producers. Contrast the attitude of European companies like BP (BP) and Total (TOT), which recently paid substantial premiums to buy into UK offshore wind farms, to the more conservative views of American giants like Chevron (CVX) and Exxon Mobil (XOM). The relative performances of BP and TOT to CVX and XOM also tells the story of the market’s assessment of the two strategies.

 

 

Here is another reason to favor energy over material stocks. Even if you wanted to participate in the upside of a commodity supercycle through resource extraction stocks, the enthusiasm for materials over energy stocks is substantial from a relative value and fund flows perspective. The latest BoA Global Fund Manager Survey shows that global investors have been raising their weights in both sectors, but they are already in a crowded long in materials, while their energy sector weight is only at a neutral level.

 

 

In conclusion, the global economy is poised for a bull market in commodity prices. Within the commodity-producing sectors, there is a substantial value opportunity for investors in energy stocks owing to the reluctance of management to invest in new supply should oil prices rise.

 

The cyclical rebound should translate into higher oil prices over the next 12-24 months. In the past three years, the ratio of energy stock prices to crude oil has been relatively flat. Energy stocks should rise in line with oil prices, which creates considerable profit potential under a bullish oil scenario.

 

 

 

Disclosure: Long XOM

 

Another “good overbought” advance?

Posted by Cam Hui -

Mid-week market update: Despite my warnings about negative divergence, the S&P 500 continued to rise and it is now testing a key trend line resistance level at about 3920. Much of the negative breadth divergence have disappeared, though Helene Meisler observed that about 35% of the NASDAQ new highs are triple counted.
 

 

Is this another instance of a “good overbought” sustained advance?

 

 

The bull case

There is nothing more bullish than a market making new highs, and FOMO (Fear of Missing Out) price momentum has been relentless. Rob Hanna at Quantifiable Edges found that persistent moves to new highs rarely end abruptly.

 

 

Moreover, the price momentum factor, which measures whether market leaders continue to lead the market upwards, is also strong.

 

 

Macro Charts observed that the equity beta of macro hedge funds is in neutral territory, indicating a potential for a beta chase should the stock market rise further.

 

 

 

Extreme giddiness

On the other hand, do you really want to be chasing a market characterized by extreme giddiness? What do you call a market that celebrates a cash-starved car manufacturer like Tesla buying $1.5 billion in Bitcoin (instead of, say, investing in better and more manufacturing)? Bloomberg also reported that former NFL quarterback-turned activist Colin Kaepernick is co-sponsoring a SPAC.

 

What do you call a market when Reuters reported that a 12-year-old South Korean boy with 43% returns is the new retail trading icon?

 

 

Notwithstanding anecdotal stories about Korean youngsters trading the market, BoA reported that private client equity allocation is near cycle highs.

 

 

While overly bullish sentiment is an inexact market timing signal, the atmosphere is becoming reminiscent of the dot-com era of the late 1990s.

 

 

Time for a pause

In the short-run, the market is likely due for a pause. Urban Carmel pointed out that the CBOE equity put/call ratio recently fell below 0.4. If history is any guide, the market has experienced difficulty rising over the short-term. However, most of the episodes in the past year have resolved themselves with sideways consolidations rather than pullbacks.

 

 

In addition, the NYSE McClellan Oscillator reached an overbought extreme on Monday. In the past two years, the market has paused and pulled back after such conditions.

 

 

My base case scenario calls for some sort of sideways consolidation and minor market weakness over the next one or two weeks.