A stealthy growth correction

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

 

Growth stocks stumble

Marketwatch reported last week that a meltdown of Cathie Wood’s ARK Innovation ETF (ARKK) may spark a S&P 500 pullback.

 

“Many of the ARK and similar funds that hold high growth stocks are now trading between one and two standard deviations below their 50[-day moving averages] where buyers usually enter,” said technical analyst Andrew Adams in a Wednesday note for Saut Strategy. “I don’t think the market needs to go down any more, so a bounce attempt should occur given all the nearby support levels.”
Since the publication of that article, ARKK and other growth stocks have weakened further relative to the S&P 500.
 

“If the high-growth areas start breaking support and taking the rest of the market down with them, then maybe the 3,980-4,000 zone in the S&P 500 will be retested after all,” Adams wrote. The S&P 500 finished at 4,167.59 on Wednesday, 1% off a record close of 4,211.47 set on April 29.

 

A test of support in the 3,980-4,000 area would mark a pullback of only 5% to 6%, but given the damage seen in other parts of the market could lead to “some huge losses” elsewhere, he said. “I’d rather avoid that, so for now I think we can use yesterday’s lows as a test to see if that represented a selling climax in much of the market.”

The growth-heavy NASDAQ 100 bounced off a test of its 50-day moving average (dma) after being rejected twice at resistance. More worrisome is the breach of the relative support zone of NDX compared to the S&P 500 and ARKK to the S&P 500. Market internals such as the percentage of NASDAQ 100 stocks above their 50 dma is not oversold enough to signal a durable bottom.
 

 

 

Resilient Value

On the other hand, value stocks have been resilient and holding up the market. The value to growth ratio is soaring, though a little overbought. The Russell 1000 Value index remains in a well-defined uptrend while the Russell 1000 Growth index is struggling with a key support line. 
 

 

A review of the relative strength of the top five sectors tells the story of a bifurcated market. In aggregate, these sectors account for roughly three-quarters of S&P 500 weight and it would be difficult for the index to rise or fall without the participation of a majority of these sectors. Growth sectors, such as technology, communication services, and float-weighted consumer discretionary stocks, which are dominated by heavyweights AMZN and TSLA, are underperforming the S&P 500. By contrast, value sectors such as financials and equal-weighted consumer discretionary stocks are strong.
 

 

 

The bears haven’t seized control yet

However, there are no signs of significant technical breakdowns just yet. The relative strength of defensive sectors is strong indicating that the bears haven’t seized control of the tape.
 

 

To be sure, there are some warning signs. Mark Hulbert pointed out that the Shiller Crash Confidence Index, which measures whether investors are worried about a stock market crash, has declined precipitously. Hulbert concluded that ” the outlook for the next six- and 12-month periods would appear to be quite modest”,
 

 

The bond market has caught a bid and it is attempting an upside breakout from a possible inverse head and shoulders formation.
 

 

Both gold and silver have staged upside breakouts. Precious metals tend to be viewed as defensive and negative beta plays.
 

 

Bloomberg also reported that “Sam Zell Buys Gold With Inflation ‘Reminiscent of the ‘70s’”.
 

Billionaire investor Sam Zell is seeing inflation everywhere, and has bought gold as a hedge — something he says he used to knock others for doing.
 

“Obviously one of the natural reactions is to buy gold,” he said in a Bloomberg Television interview. “It feels very funny because I’ve spent my career talking about why would you want to own gold? It has no income, it costs to store. And yet, when you see the debasement of the currency, you say, what am I going to hold on to?”
 

Zell, 79, said he’s concerned not only about the U.S. dollar but other countries printing money as well, and questioned whether inflation will be transitory, as Federal Reserve Chairman Jerome Powell indicated last week.

I conclude from this analysis that while there are downside risks to the S&P 500, the weakness is only confined to growth stocks. Value stocks are still strong and they are holding up the index. My base case scenario calls for a period of choppy sideways consolidation for the S&P 500. Until a bearish catalyst appears for value stocks, which have cyclical characteristics, the overall market should hold up well.

 

In the short-run, the S&P 500 is overbought and due for a pullback early in the week. I am watching to see how the market behaves after the overbought condition is resolved later in the week.

 

 

I will be especially monitoring the price action of the growth-cyclical bellwether Semiconductor Index (SOX). SOX rallied last week after testing a rising uptrend to regain the 50 dma. However, the 50 dma has stopped rising and it is on the verge of falling, indicating the possible start of a downtrend for the group. Moreover, SOX breached an important long-term relative uptrend against the S&P 500.

 

 

 

Do valuations matter anymore?

Posted by Cam Hui -

How expensive are US equities? Fed Governor Lael Brainard warned about “stretched valuations” in the preamble to the May 2021 Financial Stability Report:
 

Vulnerabilities associated with elevated risk appetite are rising. Valuations across a range of asset classes have continued to rise from levels that were already elevated late last year…The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.

By most measures, the market is highly extended. As an example, the S&P 500 trailing P/E looks unreal. But stock markets always look expensive when the economy recovers from a recession because the E in the P/E ratio is compressed.
 

 

Do valuations matter anymore? Yes and no. Let me explain my reasoning.

 

 

An expensive market

There are many ways to value stocks. To make a long story short, the market looks expensive on a price to anything multiple.

 

While the market appears wildly overprice based on trailing P/E, it’s only moderately expensive relative to its history based on forward P/E.

 

 

Tobin Q, which is the market’s price to replacement value ratio, is at an all-time high.
 

 

Shiller CAPE tells a similar story of overvaluation.

 

 

 

Unpacking the equity risk premium

That said, Bob Shiller qualified the excessive valuation readings of CAPE in a Project Syndicate essay by introducing the concept of Excess CAPE yield. He went on to conclude that stocks fairly valued based on this technique.

 

Many have been puzzled that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic and the economic downturn it has wrought. But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.

The Excess CAPE yield compares the market’s CAPE to interest rates by calculating an equity risk premium (ERP) for stock prices.
 

Another way of calculating ERP is the Fed model, which is the market’s forward E/P minus the 10-year Treasury yield. Morgan Stanley found that the ERP calculated this way appears extended (top panel). If the analyst were to substitute the 10-year breakeven yield (because investors are more interested in real returns than nominal returns), valuations are comparable to the dot-com bubble top.
 

 

Does that mean the market is wildly stretched, even on ERP? Not necessarily. Aswath Damodaran, professor of finance at the Stern School, calculates his own ERP using a detailed technique explained in a long paper. Damodaran’s history went back to 1960 compared to Morgan Stanley’s 1998. Damodarn’s latest update on May 1, 2021 showed an ERP of 4.11%. This puts both the Fed Model (Morgan Stanley’s top panel chart) and Damodaran ERP at roughly 2009 levels.
 

 

Wait! Didn’t the stock market make a generational low in March 2009 and take off like a rocket? As well, the longer time horizon of Damodaran’s ERP analysis shows the market to be fairly valued relative to its own history, and cheap compared to the 60’s and 80/s and early 90’s before the onset of the dot-com bubble.

 

 

Household equity holdings

Another way of timing the market is to analyze the household holdings of equities. The analyst writing under the pseudonym Jesse Livermore introduced the of idea the “Average Investor Equity Allocation” model, which forecasts forward 10-year returns based on household allocation to equities.  When no one owns stocks, expect strong returns. When everyone owns stocks, expect weak returns. Stock allocations are currently high, which leads to a conclusion of weak 10-year returns.

 

 

Before you get all excited that this is a sign of irrational exuberance and wild speculation, this doesn’t mean that households have been piling into equities. If an investor owns a passive balanced-fund portfolio that was periodically rebalanced, the S&P 500 outperformed bonds by 61.9% from March 2020 to April 2021. Much of the increased equity allocation can be explained by the upward drift of equity prices relative to bonds.

 

 

 

No correct valuation

Confused yet? Franklin Parker, writing at the CFA Institute’s Enterprising Investor, offers the perspective that there is no correct price for a security. Assuming that all investors have the same expectations for the valuation and volatility of a security, what they are willing to pay depends on each investor’s objectives. Parker cited the case of Bernoulli’s Prisoner’s Dilemma.

 

“A rich prisoner who possesses two thousand ducats but needs two thousand ducats more to repurchase his freedom, will place a higher value on a gain of two thousand ducats than does another man with less money than he.”

Parker concluded, “What becomes immediately clear is that his ducats are dedicated to one objective: getting the heck out of prison!” Now imagine three prisoners:

 

A, B, and C, each of whom has different starting wealth, required ending wealth, and time horizon. For the sake of simplicity, we’ll suppose each has the exact same view of a security’s future volatility and return, which are labeled as s and m in the figure.

 

Each prisoner has different needs and therefore has different prices they are willing to pay, even if all of them have the same valuation and volatility assumptions for the same security.

 

When we place these three prisoners in the marketplace, we would expect Prisoner A and Prisoner B to sell their shares to Prisoner C at the price of 1/c until Prisoner C exhausts his liquidity or Prisoner A and Prisoner B exhaust their inventory. Then, the price drops to 1/b, and Prisoner A continues to sell to Prisoner B. From there, the price drops to 1/a, and Prisoner A would buy, but no one would be willing to sell.

 

Prisoner C is an enigma. Traditional utility models would not expect anyone to accept lower returns in response to higher volatility. But goals-based investors can be variance-seeking when their initial wealth is low enough. Behavioral finance characterizes their goals as “aspirational.” This is why people buy lottery tickets and gamble: Increasing the volatility of outcomes is the only way of increasing their chance of achieving life-changing wealth.

 

What does that mean for today’s markets?
 

A very present example is our current regime of ongoing quantitative easing (QE) from central banks around the world. For investors befuddled by sky-high stock valuations, the difference between Prisoner A and Prisoner B is illuminating. They are exactly the same except for one thing: Prisoner B is wealthier today.

 

In general, then, this means that adding cash to financial markets creates investors who are willing to pay more for the exact same security. Conversely, when excess liquidity is drained from markets, prices should drop, all else equal, because investors with less cash today require higher returns. Thus line B moves back to line A.

 

Another key component of price: each investor’s relative liquidity in the marketplace. If enough aspirational investors, or Prisoner Cs, deploy their cash into a security market, prices can remain elevated or spike until their liquidity is exhausted. Sound familiar, GameStop?

 

 

A secular bull

Enough theory. Let’s return to the real world. Equity valuation matters, but the matter most by defining the downside risk in a bear market. 

 

I am inclined to discount the Fed’s warnings about stretched valuation. Those of us who are old enough remember Greenspan’s characterization of the markets as undergoing “irrational exuberance”, which was in a speech he made in 1996 – just at the start the dot-com bubble. A more modern era version of a warning came from Jerome Powell in 2018, when he stated, “In some areas, asset prices are elevated”. While the stock did consolidate sideways after that remark, it did not crash. In fact, Fed warnings could be construed as contrarian bullish indicators.

 

 

This is a bull market, and fiscal and monetary policy matter more in defining the market’s upside potential.

 

 

Jurrien Timmer at Fidelity offered the 1960’s as a historical template for today’s markets. He believes that the macro backdrop won’t change much until S&P 500 reaches 8000 in about five years’ time.

 

The ‘60s comparison is compelling, especially now that we’re going to have higher capital gains taxes 4-5 years after a cut in income taxes. The parallel is the Kennedy/Johnson tax cut of 1964 followed by the Nixon tax hike in 1969. It was “guns and butter” back then. Now it’s Covid and a progressive capital-to-labor wave. The late ’60s had social unrest and a speculative frenzy in growth stocks—sound familiar? 

 

In my view, our current inflation rate essentially mirrors where things were in the 1966-67 time frame, before inflation really took off.

 

 

Ed Yardeni recognizes the valuation headwinds, but he recently argued that MMT + TINA = MAMU, where MMT = Modern Monetary Theory, TINA = There Is No Alternative (to stocks), and MAMU = Mother of All Melt-Ups. 

 

We have the combination of easy monetary and fiscal policy and a greater acceptance of Modern Monetary Theory (MMT). MMT postulates that a government that can borrow in its own currency is only constrained by the financial market’s willingness to finance its deficits. Here is a more detailed explanation from Wikipedia:

 

MMT argues that governments create new money by using fiscal policy. According to advocates, the primary risk once the economy reaches full employment is inflation, which can be addressed by gathering taxes to reduce the spending capacity of the private sector. MMT is debated with active dialogues about its theoretical integrity, the implications of the policy recommendations of its proponents, and the extent to which it is actually divergent from orthodox macroeconomics.
It’s not that deficits don’t matter, they do. The implication of MMT is governments have a lot more fiscal room than previously thought if they issue debt in their own currency. Arguably, both Republicans and Democrats have embraced MMT when they control both the White House and Congress. Successive Republican administrations have pushed through tax cuts in the past, and now the Biden administration is proposing a large fiscal stimulus program with the acquiescence of the Fed. The principal disagreement has been the details of the fiscal program of tax cuts or social program spending, rather than any actual disagreement over deficits. Megan McArdle explained the change in the political environment in a Washington Post Opinion column:

 

More than anything else, this probably explains larger differences between the Obama and Biden approaches. President Barack Obama operated in a world in which deficits mattered politically. Biden doesn’t. Between the unfunded Trump tax cuts and a year of hog-wild pandemic spending, politicians have largely given up even pretending that they ought to pay for things their constituents want; it’s no longer even a good cudgel with which to beat the opposition when you’re out of power.
In the meantime, the economy has the benefit of two tailwinds, a cyclical recovery out of the pandemic-induced recession, and a second secular trend for infrastructure spending that’s mainly related to Green New Deal style initiatives. The greening of the economy is a secular trend that is going global and cannot be ignored. This is a sea change that requires gargantuan investments in new infrastructure. While business executives have traditionally pushed back against government regulation as detrimental to economic growth, Tom Peters and Robert Waterman argued in their book, In Search of Excellence, that tough regulation can be a source of competitive advantage. This is especially true if the trend, such as the desire to reduce greenhouse gasses, has become global. Lax regulation in a jurisdiction risks that country’s industries being left behind of global trends. Europe has been the leader in climate change initiatives. In Germany, which is the heart of the EU and eurozone, the Greens are polling at all-time highs and their leader Annalena Baerbock could succeed Angela Merkel as the next chancellor (see profile here).

 

 

At the same time, rates are at or near multi-century lows but facing upward pressure, which is bearish for bond prices. This creates a dilemma for income-oriented investors. Do you buy bonds, where you are virtually certain to lose capital over the next 5-10 years, or do you buy dividend-paying stocks and assume equity risk? This is an environment conducive to a TINA (There Is No Alternative to stocks) market. It is therefore no surprise that household equity allocations are so high.

 

 

Investment implications

The combination of these factors leads to the following conclusions:
  • The equity bull has a long way to run.
  • The cyclical recovery is bullish for value-oriented and cyclically sensitive sectors like financials, industrials, consumer discretionary (excluding high flyers like AMZN and TSLA), energy, and materials.

 

 

 

 

  • Balanced fund investors need to be prepared for greater volatility and re-think portfolio construction in an era of rising bond yields (see 60/40 resilience in an inflation age).

 

What “Sell in May” really means

Posted by Cam Hui -

Mid-week market update: Should you Sell in May and go away? While many traders are familiar with the Wall Street adage, what “Sell in May” really means is the six months starting May 1 has experienced subpar returns compared to the six months starting in November 1. It’s not necessarily bearish.
 

 

While it’s not advisable to trade strictly on seasonality, investors might want to be extra cautious with their equity allocations this year.

 

 

The caution zone

So far, what we have are bearish setups, but no definitive signs of downside breaks.

 

Callum Thomas observed that the ratio of leveraged long to short equity ETF volume is highly extended and in the “risk zone”.

 

 

Ryan Detrick pointed out that the stock market has paused its rally about now when coming off the recessions of 1982 and 2008.

 

 

However, these are all only cautionary signs and none of them are signals to sell everything or to go short the market.

 

 

Not bull nor bear, but a roller coaster

Even though I have warned about rising risk in the past few weeks. Neither the bulls nor the bears have gained the upper hand. 

 

The stock market sold off yesterday (Tuesday) when Treasury Secretary and former Fed chair Janet Yellen said, “It may be that interest rates will have to rise somewhat to make sure that our economy doesn’t overheat.” It recovered later in the day when she walked back those remarks and it recovered further today. From a technical perspective, the VIX Index spiked above its upper Bollinger Band yesterday, which is an indication of an oversold market. In the past, such VIX upper BB episodes have either signaled the start of a correction, or a once-and-done downdraft. Today’s recycle of the VIX suggests yesterday’s weakness was of the latter variety. 

 

 

Investors need to be prepared for a roller-coaster market with choppy price behavior. Sure, there are some signs of wobbles. The most worrisome is the violation of the relative uptrend by semiconductor stocks. Semiconductors are growth cyclicals, and they should be beneficiaries of the chip shortage. Their poor relative strength is an early warning that risk appetite is on the decline.

 

 

On the other hand, a review of other cyclical sectors and industries shows that the poor relative strength of semiconductors is an anomaly. Other cyclicals remain in relative uptrends.

 

 

As I have pointed out before, this is an increasingly bifurcated market. Growth stocks are struggling while value stocks are performing reasonably well. The Russell 1000 Value Index remains in an uptrend while the Russell 1000 Growth Index has violated a keys support level.

 

 

 

Watching China for clues

I conclude from this review that the stock market is vulnerable to a setback but it’s not quite ready to correct just yet. In order for the market to correct, the value and cyclical sectors need to face a growth scare.

 

That growth scare may occur as the Chinese economy slows. Real-time market data are suggestive of a China slowdown. The AUDCAD exchange rate is testing a keys support level. Both Australia and Canada are resource exporters. Australia is more sensitive to China while Canada is more levered to the US economy. The weakness in the AUDCAD rate is an implicit signal of slowing Chinese growth.

 

 

As well, the stock markets of China and her major Asian trading partners are not behaving well when measured against the MSCI All-Country World Index (ACWI). MSCI China has violated a relative support line, and so has South Korea. The rest are exhibiting weakening or range-bound patterns. (All prices are in USD).

 

 

The Trend Asset Allocation Model is still bullish and it is not designed to spot minor (5-10%) corrections. My inner investor is therefore bullishly positioned, though he has sold covered call options against selected existing positions.

 

My inner trader is on the sidelines. The long-term trend for stock prices is still up. The risk/reward ratio of trying to short the market without a definitive downside break is unfavorable. 

 

In short, I am cautious, but not bearish.

 

 

Q1 earnings monitor: Priced for perfection

Posted by Cam Hui -

We are well into Q1 earnings season. 60% of the S&P 500 has reported their results and the top and bottom line beat rates are well above average. The V-shaped recovery is complete.
 

 

Here is the more difficult question. The six largest companies in the S&P 500 reported last week and all of them beat consensus EPS expectations. Why was the S&P 500 flat last week?

 

 

 

Supply chain bottlenecks

Even though FactSet reported that the market rewarded EPS beats and punished misses, there was a subtle component that can’t be seen in the statistics. The new focus of the market seems to be concerns over production bottlenecks.

 

 

The market reaction to services companies and companies with manufacturing components is revealing about market psychology. Alphabet and Facebook, which depend mainly on advertising revenue, reported strong sales and EPS figures. The stocks rose after their reports.

 

By contrast, Apple also beat estimates but reported production issues owing to the chip shortage. Its shares closed in the red the next day. Yahoo finance reported that Caterpillar, which is a global cyclical bellwether, also reported strong earnings, but warned about chip shortages constraining sales. Its shares also weakened after the earnings report.
 

Caterpillar Inc. is warning of potential impacts ahead due to a global chip shortage, putting a damper on better-than-expected earnings for the world’s biggest maker of mining and construction equipment.

 

“Although we haven’t been impacted yet, the global semiconductor shortage may have an impact later this year,” Chief Financial Officer Andrew Bonfield said in a Thursday interview. “It’s a risk and obviously we’re keeping a close eye on it.”

 

The cautionary words come after Caterpillar posted first-quarter revenue and profit that topped analysts’ estimates, in what Bonfield described as “very strong performance” for the start of the year fueled by construction growth in the U.S. and China.

 

Caterpillar joins some of the world’s biggest automakers and tech giants in highlighting the impacts of a chip shortage that’s already caused Honda Motor Co. to halt output at Japanese plants and Apple Inc. and Samsung Electronics Co. in flagging production cuts and lost revenue.

 

The shortfall comes as Caterpillar expects a big ramp up in machinery production through the rest of the year. While the company has been able to mitigate the issue so far, Bonfield said such shortages could mean Caterpillar may not be able to fully meet demand from its customers this year.

 

Caterpillar’s quarterly results surpassed Wall Street’s expectations, with sales jumping 12% to $11.9 billion in the period and per-share adjusted earnings of $2.87 topping the $1.95 a share average estimate of analysts’ estimates compiled by Bloomberg.
Not only are shortages of semiconductors creating supply chain bottlenecks, but other shortages such as lumber mill capacity and even chicken production are driving up input prices. 

 

 

The challenge for the bulls

The bulls face a valuation challenge. The S&P 500 forward P/E ratio, which currently stands at 22.0, hasn’t changed much since the onset of the pandemic. 

 

 

On the other hand, the S&P 500 has risen 90.1% since the March lows, excluding dividends. If the forward P/E ratio was largely unchanged during this period, that means it was rising EPS estimates whichhave driven the market rebound. 

 

 

While forward EPS estimates have surged during Q1 earnings season, can they keep rising at their torrid pace as supply chain bottleneck worries emerge?

 

 

Priced for perfection

In short, the market is priced for perfection. Many market participants are already in crowded longs, which is creating headwinds for further price advances. Charlie McElligott at Nomura observed that CTAs are already at a crowded long and their positioning is highly correlated to PMI, which is already extremely elevated. 

 

 

As I pointed out last week (see Q1 earnings monitor: Reopening giddiness), top-down and bottom-up expectations are coming into conflict. While bottom-up estimates are rising, the top-down outlook is more cautious.

 

As one of many examples, the ECRI’s Weekly Leading Indicator is rolling over and coming off the boil.

 

 

I reiterate my warning that risks are rising for the stock market. You can tell a lot about market psychology by how the market reacts to the news. The six largest stocks in the S&P 500 reported last week and they all beat consensus estimates, but the index was flat. This is a classic warning that expectations are too high.

 

Semiconductor stocks are important bellwethers because they are in a growth-cyclical industry. These stocks should be performing well as they are beneficiaries of the chip shortage. Instead, the Semiconductor Index (SOX) violated an important rising relative trend line against the S&P 500, and the violation is more visible when measured against the NASDAQ 100.

 

 

These are all warnings that the stock market is poised for a pullback. Expectations are too high and the market is priced for perfection. A “Sell in May” strategy may be a useful investment template for the next few months.

 

As good as it gets?

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.
 

 

What’s wrong with this picture?

The six biggest stocks in the S&P 500 reported earnings last week. Every one of them beat consensus expectations. In addition, the FOMC reiterated its dovish stance after its meeting. These developments should all be bullish. Instead, the S&P 500 only made marginal gains while exhibiting negative divergences.

 

 

From a longer term perspective, the weekly S&P 500 chart shows the index recycling after overrunning  a rising trend line indicating a possible blow-off top. The S&P 500 then printed two consecutive weekly doji candles, each of which are signs of indecision.

 

 

What’s wrong with this picture?
 

 

A failure of leadership?

Where’s the leadership? The top five sectors of the S&P 500 comprise 74% of index weight and it would be difficult for the market to move significantly without the participation of a majority of these sectors. Of the five, the top three sectors are showing flat to declining relative strength, while the bottom two are showing some strength, but in a choppy fashion.

 

 

The leadership of high-beta growth stocks is narrowing. Even as the NASDAQ 100 is barely holding above a key support level, the high-octane ARK Innovations ETF (ARKK) is struggling to hold a relative support zone when measured against the S&P 500.

 

 

Sustained bullish advances simply don’t behave this way.

 

 

A tiring bull

Instead, this market looks like a tiring bull. Ryan Detrick of LPL Financial highlighted the pattern of major market recoveries, in 1982 and 2009. If history is any guide, the market is due to take a breather.

 

 

While history doesn’t repeat but rhymes, the key difference between today and the past may be higher volatility. Tracy Alloway recently wrote a Bloomberg column about the higher propensity of investors to herd today compared to the past [emphasis added].
 

It’s the 10th anniversary of “Margin Call” and yesterday I hosted a live chat with its director, J.C. Chandor, as well as Citigroup strategist Matt King. The film traces a blow-up at a big bank that’s reminiscent of what happened in the 2008 subprime crisis. King famously penned a research note just before the collapse of Lehman Brothers, arguing that the big problem for U.S. banks was short-term funding secured by subprime and other collateral.  

 

In “Margin Call,” the bank’s senior executives don’t realize they’re sitting on a powder keg until a junior risk manager stumbles on the numbers by chance. That scenario always seemed a little far-fetched to me, but King brought up some anecdotes from 2008 that showed just how much senior leaders seemed to be unaware of the scale of the problem they faced. As he put it:

 

“I myself remember having a conversation with desk heads in early 2008 on CDOs of asset-backed securities, and they were being relatively incredulous at the idea that if the junior tranches went, the whole structure was likely to go (I actually wrote another research piece that hardly anyone remembers!)” 

 

So how much has changed on Wall Street in the past decade? We recently saw banks handle another — albeit much smaller — blow-up in the form of Archegos. There were huge losses from that but no broader contagion, a testament to post-crisis regulation on capital and leverage. Is the system safer? King argues that there are some things that give him pause in the current environment, notably the March 2020 drama in the world’s biggest funding market:

 

“More subtly but just as importantly, what the periodic bouts of illiquidity in Treasuries are suggestive of is investor herding. The real recipe for a liquid and stable market is a heterogeneous market: Buyers and sellers, bottom-up investors and top-down investors, mark-to-market investors and buy-and-hold investors.

 

Somehow what we seem to have done post-2008 is to take a whole load of steps, which are individually designed to make the system safer, but collectively have killed off that heterogeneity and made for one-sided markets. The bottom-up, value-based, non-mark-to-market investor — they’ve been killed off by a decade of quantitative easing making everything more expensive and by regulators demanding everyone take a risk-based approach to capital. That gives you a market in which investors get herded into a broad-based reach for yield that they don’t really believe in. And that gives you those pockets of illiquidity: We don’t get one and two-standard-deviation movements any more — we either get zero or we get 16.” 

 

 

Weak, but not catastrophic

A review of market internals shows some signs of weakness, but nothing catastrophic. Value stocks are recovering against growth stocks, indicating that Big Tech leadership may be past its best before date.

 

 

That’s somewhat problematic for the S&P 500 because the weight of growth sectors is 10% greater than the weight of value sectors.

 

 

On a relative basis, defensive sectors are not acting well, indicating that the bears haven’t seized control of the tape.
 

 

One warning comes from the performance of semiconductors, which are growth cyclicals that should be benefiting from the widespread accounts of chip shortages. These stocks violated a key relative uptrend, which may turn out to be an important risk-off signal. The break is more clearly defined when the SOX is charted relative to the NASDAQ 100.

 

 

In conclusion, the tone of the recent market action looks like a tiring bull. The stock market has begun to consolidate and take a breather about now in the history of past major rallies off recessionary bottoms. Value continues to dominate growth, and investors should be able to find better returns in value stocks during this period. 

 

There is no need to panic just yet. The bears haven’t taken control of the tape, but this may be a good time to tactically reduce some equity risk.

 

The inflation red herring

Posted by Cam Hui -

Rising inflation fears are all over the headlines. From a top-down perspective, inflation pressures are clearly rising.
 

 

The Transcript, which monitors earnings calls, documented companies reporting rising inflationary pressures from supply chain bottlenecks and commodity price strength, which have the potential to create margin squeezes.
 

“…the inflationary pressures, particularly surrounding some of our key commodities, looks like it is going to be more of a headwind in ’22” – Coca-Cola (KO) CFO John Murphy

 

“…we’re watching and seeing SG&A inflation in different parts of the world and in different parts of the business, ranging from wage inflation in selective geographies. You’ve got global logistics inflation. You’ve got commodity inflation.” – Genuine Parts (GPC) President William Stengel

 

“In the first quarter, global semiconductors and resin shortages amplified existing supply constraints, and thus impacted our product availability. Further, we are faced with rapidly rising inflationary pressures, primarily in steel and resins. To address these issues, we swift the responses with the necessary actions to protect margins and product availability. We announced significant cost based price increase in various countries across the globe ranging from 5% to 12%” – Whirlpool (WHR) CEO Marc Bitzer
BoA also documented a surge in the mentions of “inflation” on their earnings calls.

 

 

Instead, I would argue that the inflation threat to equity prices is a red herring. Tax policy poses a stronger threat.

 

 

Who’s afraid of inflation?

The inflationary menace for equities has two components. The Fed could raise interest rates in reaction to rising inflation, which makes fixed-income securities more competitive to stocks. If the Fed does not react, it risks setting off an inflationary spiral if it loses control of inflation expectations.

 

Let’s address each of those issues. The Fed will not raise rates until it begins to taper its QE purchases. Fed watcher Tim Duy believes that the Fed is prepared to wait out the “transitory” nature of reopening inflationary first and react later.

My sense is that the Fed intends to wait until we push through the initial rebound of the economy before shifting policy. In the midst of the strongest part of the cycle there is a risk of complacency about the durability and pace of the recovery.

Duy believes that the Fed will not make any public statements about tapering until later this year.
 

 

Marketwatch reported that Joe Lavorgna, the former chief economist for the Trump White House’s National Economic Council, had an even more dovish take on Fed policy. He doesn’t expect the Fed to taper before 2023.
 

Lavorgna isn’t fearful of goods and services inflation, and, as a result, says the Fed won’t begin to taper its bond purchases before 2023 — and won’t lift interest rates before the next presidential election. The New York Federal Reserve’s survey of primary dealers, in March, found Wall Street expecting that the taper would begin in the first quarter of 2022, with the first hike in the third quarter of 2023. “If you’re going into 2022, and growth is a lot slower, the delta is negative, and inflation isn’t really picking up, it’s going to be very hard for the Fed to taper,” the Wall Street veteran says.

In the meantime, a flood of liquidity is hitting the economy. The March personal income report revealed that stimulus payments made up 18.5% of personal income.
 

 

Treasury cash balances are falling quickly and fiscal stimulus will continue until Q3. Equity investors shouldn’t be so worried about inflation.
 

 

The timing of the flood of Treasury cash also makes the point that much of the fiscal stimulus is one-time and transitory in nature. Any surge in demand is likely to top out later this year and so too the associated inflationary pressures. 

 

Already, the Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been slowly decelerating. As growth expectations decline, expect 10-year yields to follow. This leaves the economy in a sweet spot of strong non-inflationary growth, which is equity bullish.

 

 

 

Long-term inflation threats

What about long-term inflation? Pandemic-related inflationary surges have historically been benign. A study of history by Kevin Daly and Rositsa D. Chankova of Goldman Sachs Global Macro Research published at VoxEU and CEPR found that inflation rises much more during wars than pandemics [emphasis added]:

Every war and pandemic is different, and we should be cautious of drawing lessons from events that occurred in the long-distant past and in very different circumstances. One feature of the current pandemic that is clearly distinctive to past episodes is the size of the government response. Equally, however, one can argue that an unusually large government response was necessitated by an unusually large collapse in private sector demand.
 

What is clear is that history provides no evidence that higher inflation or higher bond yields are a natural consequence of major pandemics.

 

 

Even if you are worried about runaway inflation, a historical study of inflation expectations compared to S&P 500 returns finds that the environment is benign. Expectations are in the 2-3% range. Equity returns don’t turn negative until inflation rises to 5-6%, and the Fed can be depended to tap on the brakes well before the economy overheats that much.
 

 

In short, inflation fears are overblown. This is not the time to worry about transitory rising inflation pressures.
 

 

The tax threat

Instead of inflation, the real threat to equity prices is rising taxes. No, equity investors shouldn’t be overly worried about Biden’s proposal to raise taxes on high-income individuals, an end of the carried interest provision, or higher capital gains taxes over $1 million. In fact, there was a flood of analysis showing that capital gains tax rates has little effect on the stock market.
 

 

That’s because equity ownership has increasingly shifted away from taxable individuals to foreigners and deferred-tax accounts.
 

 

I believe the most important threat to equity prices is Biden’s corporate tax proposals. David Fickling hit the nail on the head when he wrote in a Bloomberg Opinion article that “Yellen’s Global Tax Plan Is on the Level of Trump’s Trade War with China”.

 

If you expected the administration of President Joe Biden to be a return to normalcy on trade issues after the drama of Trump-era tariff battles and tweet diplomacy, Treasury Secretary Janet Yellen has other ideas.
 

That’s because her plans announced Monday to introduce a global minimum corporate tax rate represent quite as much of a shock to the international economic order as Trump’s decision to wage trade war on China.
 

The two phenomena are connected as fundamental aspects of the modern global economy. Corporations have cut operating expenses at the top of their income statements by sending manufacturing offshore to China and other emerging economies where labor costs are lower. At the bottom of their income statements they’ve done the same with tax expenses, by offshoring their profits to low-tax jurisdictions such as Bermuda, the British Virgin Islands, the Cayman Islands, Ireland, the Netherlands, Luxembourg, Singapore, and Switzerland. 

In a separate Bloomberg report, Germany and France have come out in support of Yellen’s corporate minimum tax proposal. (They’re looking at you, Ireland.)
 

A corporate tax increase is justified by the Biden administration on the grounds that the Trump tax cuts did not spur investment activity. Corporate CapEx has been falling for years and you have to squint to on the chart to see when the Trump tax cuts occurred.
 

 

While there will be some inevitable bargaining over the statutory tax rate, which is expected to rise from 21% to 25% instead of the proposed 28%, the real story is how effective tax rates will change.
 

 

Notwithstanding the proposal of a corporate minimum tax, the more important component of Biden’s proposal is an increase in GILTI tax from 10.5% to 21%. For the uninitiated, GILTI stands for Global Intangible Low-Taxed Income. A GILTI tax is intended to prevent companies from shifting their IP profits to low-tax jurisdictions. The relative losers are in communication services, technology, and drugs. The relative winners are in the value and cyclically sensitive materials, energy, and industrial sectors.
 

 

A separate analysis by Absolute Strategy Research found that the Trump tax cuts favored growth over value stocks. The tax rates between the most extreme quintiles of value were roughly the same until Trump’s Tax Cuts and Jobs Act. After the implementation of the tax cuts, the cheapest value stocks (blue line) experienced a much smaller tax cut than the most expensive (gold line).
 

 

To conclude, here are my main takeaways from this analysis:

  • Worries about inflation are overblown. While some short-term supply chain bottlenecks are putting upward pressure on prices, they are transient and the Fed is not about to allow inflation to run away to 6%.
  • The bigger threat to equity prices are changes to the effective tax rate in the form of a minimum corporate tax on offshore profits.
  • Major losers under the Biden tax proposals are growth stocks that have offshored their IP: communication services, technology, and drugs.
  • Relative winners under the new tax regime are value and cyclically sensitive sectors: materials, energy, and industrials.

 

Has technical analysis stopped working?

Posted by Cam Hui -

Mid-week market update: Bloomberg recently featured an unusual article titled “Sell Signals All But Useless in Unchartable 2021 Stock Market”.

If you bailed because of Bollinger Bands, ran away from relative strength or took direction from the directional market indicator in 2021, you paid for it.

 

It’s testament to the straight-up trajectory of stocks that virtually all signals that told investors to do anything but buy have done them a disservice this year. In fact, when applied to the S&P 500, 15 of 22 chart-based indicators tracked by Bloomberg have actually lost money, back-testing data show. And all are doing worse than a simple buy-and-hold strategy, which is up 11%.

 

Of course, few investors employ technical studies in isolation, and even when they do, they rarely rely on a single charting technique to inform decisions. But if anything, the exercise is a reminder of the futility of calling a market top in a year when the journey has basically been a one-way trip.

 

“What we’ve seen this year is a very strong up market that didn’t get many pullbacks,” said Larry Williams, 78, creator of the Williams %R indicator that’s designed to capture a shift in a security’s momentum. A long-short strategy based on the technique is down 7.8% since the end of December.

 

Sell signals have failed. Much of this can be explained. Some, like this sentiment signal from BoA’s private client holdings, indicate a record crowded long in equities which is contrarian bearish. However, how much can investors allocate to fixed-income instruments in an era of low and rising rates? Stocks are the only game in town, even for income investors.

 

 

The straightforward view is the strength of momentum has overwhelmed all other technical signals.

 

 

Waning momentum

Another way of explaining momentum is “good overbought” reading. As good technical analysts know, no reversals are guaranteed. Overbought conditions can get more overbought and oversold.  conditions can get oversold.

 

We are reaching conditions when momentum is starting to wane and sell signals may be about to become more effective. The percentage of S&P 500 stocks over their 200-day moving average (dma) exceeded 90% in November. This was a “good overbought” condition indicating a strong and sustained advance. In the past, the rallies did not pause until the 14-week RSI reached an overbought reading of 70 or more, which was achieved in late March. That was the first warning.

 

 

The second warning occurred when the S&P 500 overran its rising trend line on the weekly chart and recycled, which were indications of blow-off tops.

 

 

The daily chart also showed an ominous negative divergence. Even as the S&P 500 made daily marginal all-time highs, both the 5 and 14-day RSI flashed negative divergences. While negative RSI divergences can persist for days before prices react, this was also another warning that the rally is its last legs.

 

 

 

Earnings season uncertainty

It’s always difficult to make short-term market calls on FOMC day. Daily uncertainty is especially problematic when the market is in the heart of Q1 earnings season. On Monday, Netflix missed subscriber growth expectations, and the stock fell after the report. On Tuesday, both Microsoft and Alphabet beat Street expectations. Microsoft fell while Alphabet rose. Even AMD, which reported and came out with extremely strong guidance, saw its stock price retreat. Today (Wednesday), Apple and Facebook beat expectations and rose in the after hours.

 

You can tell a lot about the character of a market by the way it reacts to the news. Even though results have generally been positive, the market reaction has been mixed though not disastrous.

 

 

Q1 earnings monitor: Reopening giddiness

Posted by Cam Hui -

Q1 earnings season is well underway. 25% of the S&P 500 has reported, and a number of large-cap bellwether technology companies will report this week. So far, the EPS and sales beat rates are above their historical averages, and forward 12-month EPS estimates continue to surge.
 

 

However, risks are rising as the sunny bottom-up view is coming into conflict with a more cautious top-down outlook.

 

 

An upbeat earnings season

On the surface, Q1 earnings season looks strong. Not only are analysts revising S&P 500 company earnings upwards, but also earnings for the mid-cap S&P 400 and small-cap S&P 600 are rising.

 

 

The market has been behaving as expected in reaction to earnings reports by rewarding beats and punishing misses.
 

 

The Transcript, which monitors earnings calls, tells the story of a booming economy.

 

The economic dam is bursting and the economy is booming. Demand in the US was described as “very, very strong” and “phenomenal” thanks to strong consumer balance sheets and vaccinations. Supply chains are still disrupted and there are significant inflation pressures.

I had been expecting some giddiness, but the headline “the economic dam is bursting” says it all.

 

Reopening continues around the globe
“…we see continued progress being made in the health crisis. More businesses are now opening up. Unemployment continues to decline. Consumers are spending at record levels. We are optimistic that expanding economic activity will in turn fuel loan growth as companies borrow, build inventory invest and hire more employees.” – Bank of America (BAC) CEO Brian Moynihan 

 

“China appears to be the furthest along in terms of reopening, with activity levels largely back to normal. The US is not all the way back just yet, but is moving in the right direction. And an increase in vaccination rates across the country appear to be driving some of this progress. Europe is improving broadly. And while certain areas have recently experienced setbacks in the process of reopening, we’ve not seen any material impact.” – Danaher (DHR) CEO Rainer Blair 

 

The US is very, very strong
“I would say the U.S. was very, very strong.” – ManpowerGroup (MAN) CFO Jack McGinnis
“I saw some commentary sort of questioning demand. Demand out there is absolutely phenomenal, across almost every sector. Very, very strong and it would appear to be there for the rest of this year going into next…So we see strong demand, tight supply, record low supply chain inventories across the space.” – Steel Dynamics (STLD) CEO Mark Millett

 

“And you heard us before talking about consumer demand, to be honest, in all the years I’ve been doing the earnings call, this is probably the year that I’m most bullish about mid-and long-term consumer demand trends in North America. So I’m not worried about consumer demand. ” – Whirlpool (WHR) CEO Marc Bitzer 

 

Consumers have healthy balance sheets
“Our FICO scores stayed extremely stable as have our debt-to-income levels. So it’s showing us that the buyer and the consumer is healthy today. And there are still plenty of people out there that can afford to buy a house.” – D.R. Horton (DHI) VP, Investor Relations Jessica Hansen

 

The economic dam is bursting
“I think as you see the vaccine spread, this economic dam is really starting to burst and it’s going to be widespread in terms of an increase in activity and revenues across most businesses.” – The Blackstone Group (BX) COO Jon Gray

 

There are rapidly rising inflation pressures
“…the inflationary pressures, particularly surrounding some of our key commodities, looks like it is going to be more of a headwind in ’22” – Coca-Cola (KO) CFO John Murphy

 

“…we’re watching and seeing SG&A inflation in different parts of the world and in different parts of the business, ranging from wage inflation in selective geographies. You’ve got global logistics inflation. You’ve got commodity inflation.” – Genuine Parts (GPC) President William Stengel

 

“In the first quarter, global semiconductors and resin shortages amplified existing supply constraints, and thus impacted our product availability. Further, we are faced with rapidly rising inflationary pressures, primarily in steel and resins. To address these issues, we swift the responses with the necessary actions to protect margins and product availability. We announced significant cost based price increase in various countries across the globe ranging from 5% to 12%” – Whirlpool (WHR) CEO Marc Bitzer

 

 

Reopening giddiness?

The risk to the market is excessive growth expectations from the reopening trade as the top-down outlook is coming into conflict with the bottom-up forecasts. Goldman Sachs recently pointed out that the economic growth rate is expected to peak in Q2 and decelerate into 2022.

 

 

Similarly, ECRI’s weekly leading indicator is topping out indicating the rising probability of decelerating growth.

 

 

Indeed, the Economic Surprise Index (ESI), which measures whether top-down economic figures are beating or missing expectations, has been falling. Growth expectations are decelerating as ESI declines.

 

 

On the other hand, an analysis of bottom-up S&P 500 quarterly EPS shows sequential EPS growth peaking in Q3, with no signs of visible deceleration except for Q1 2022. Are company analysts too bullish, or are top-down strategists too bearish?

 

 

Have reopening expectations become too high? April’s flash PMI reached a blistering 62.2.

 

 

Chris Verrone at Strategas observed that stock prices have historically struggled to advance whenever PMI exceeded the 60 level.

 

 

Jurrien Timmer, the director of global macro Fidelity, wouldn’t be surprised if the stock market were to take a temporary breather from the reopening trade. He offered two analogs from the past. The first is the post-GFC recovery.

 

 

The other is the post-World War II experience.

 

 

 

The tech sector’s acid test

This week sees a number of large-cap technology companies report their results. That may be the acid test for the market as Big Tech accounts for about 45% of the weight in the S&P 500. The market has become increasingly bifurcated. The tech-heavy NASDAQ 100 is struggling to hold support. The high-octane ARK Innovation ETF (ARKK) has been weak relative to the S&P 500, and the near-term progress of that fund will depend heavily on Tesla’s earnings report after the close today.

 

 

Tech investors are already panicking. They yanked $6 billion from QQQ over a 5-day period, which is the largest outflow since the NASDAQ top in 2000. 

 

 

In conclusion, large-cap tech company reports are a source of near-term volatility. Longer-term, the reopening trade is at risk in the US, but not globally. As I recently pointed out (see A pause in the reflation trade?), the market will be uneven in the coming months. Investors can expect better opportunities in Europe as vaccinations ramp-up to supportive reopening. However, China is slowing, and a number of emerging market countries are still struggling with the pandemic, which is a drag on their growth outlooks.

 

 

The top-six stocks in the S&P 500 all report this week. They are all tech companies and account for 23.0% of the S&P 500 and 44.9% of the NASDAQ 100. Brace for daily volatility.

 

 

 

Sell in May? Where to hide if you do

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.
 

 

Sell in May?

Is it time to sell in May and go away? Market internals are starting to look wobbly. The relative performance of the defensive sectors is flashing warning signs. Two of the four sectors are testing relative breakouts, and the other two are consolidating sideways after rallying out of relative downtrends.

 

 

If the market does weaken, where can investors hide?

 

 

A vulnerable market

A number of risks are emerging that makes the US equity market vulnerable to a setback. The S&P 500 recently exceeded the Wall Street strategists’ Bloomberg survey average target of 4130. With the exception of the 2017 tax cut related ramp and the 2020 rally, when the Street was chasing market expectations, such episodes have been followed by market weakness or a period of sideways price action.

 

 

Sentiment survey readings are becoming very stretched. Investors Intelligence sentiment is at a crowded long condition.

 

 

So is the AAII survey. While giddy bullishness is not as effective as a sell signal compared to panicked sentiment as buy signals, the stock market has often encountered trouble advancing when sentiment was this bullish in the past.

 

 

Equally disturbing is the negative divergence between the AAII sentiment survey, which measures the sentiment of individual investors, and the NAAIM Exposure Index, which measures the sentiment of RIAs. While both indicators are normally used on a contrarian basis, past negative divergences when have resolved with market corrections.

 

 

I am also seeing negative breadth divergences. While the NYSE Advance-Decline line is confirming the strength in the S&P 500, NYSE and NASDAQ new highs are not. 

 

 

On their own, none of these indicators are immediate and actionable sell signals. In fact, there is a possibility that the S&P 500 could grind its way to another high in the coming week. If we put all these indicators together, they form a picture of a vulnerable market that is poised for a setback.

 

 

Estimating downside risk

What’s the downside target for the S&P 500? It’s difficult to make a projection without knowing the bearish narrative, which hasn’t emerged. That said, initial support can be found at the 3970-4000 level, which coincides with a rising trend line and the 50-day moving average (dma). Further support can be found at the 200 dma at about 3620. My working hypothesis is a peak-to-trough pullback of 5-10%.

 

 

Traders should look for some of these signposts that the market may have bottomed, with the usual caveat that oversold markets can become more oversold if the market panics.
  • An oversold 5-day RSI reading.
  • The VIX Index spiking above its upper Bollinger Band.
  • An inversion in the term structure of the VIX, which is an indication of rising fear.
  • An oversold condition on the NYSE McClellan Oscillator.
Currently, none of these indicators have flagged a bottoming condition. (Market bottoms are like pornography. I’ll know it once I see it.)

 

 

Gold stock: Negative beta plays

In a market pullback, there are few places to hide as virtually all stocks will fall in concert with the market. These opportunities were identified two weeks ago, but they bear repeating (see Internal rotation + Seasonality = More gains).

 

Gold mining stocks (GDX) represent one of the few exceptions of a class of equities with negative beta, or stocks that are negatively correlated with the stock market. GDX recently achieved an upside breakout through a bull flag, and the GDX to gold ratio also exhibited a similar upside breakout. Gold bullion, however, is a laggard and it has not broken out to the upside yet.

 

 

The point and figure chart of GDX shows an upside target of roughly $40, which represents an upside potential of 11% from current levels.

 

 

Treasuries as safe haven plays

Another asset class that has shown a negative equity beta is Treasuries. The 10-year Treasury yield broke a rising trend line and rolled over while exhibiting a negative RSI divergence. (As a reminder, bond prices are negatively correlated to bond yields. As bond yields fall, bond prices rise).

 

 

My concern is the yield reversal has the appearance of a bull flag, which is a bullish continuation pattern indicating that the primary trend in yields is up. Nevertheless, the first Fibonacci retracement level for the 10-year yield is about 1.4%.

 

A point and figure analysis shows the same target of 1.4%.

 

 

In conclusion, the stock market has become increasingly vulnerable and a pullback may have already begun. None of the bottoming indicators have flashed any alerts, which indicates that the lows are not near. Expect some volatility in the coming week as there is an FOMC meeting and major tech companies report earnings. In the near term, traders may be able to find some tactical refuge in negative beta assets such as gold mining equities and Treasuries. My base case scenario calls for a 5-10% correction. Investment-oriented accounts should view market weakness as buying opportunities.

 

 

A pause in the reflation trade?

Posted by Cam Hui -

Recently, a growing narrative in the market is arguing for a pause in the reflation trade for the following reasons:
 

  • Both the cyclically sensitive copper/gold and base metal/gold ratios have moved sideways.
  • The 10-year Treasury yield peaked out in March and it is now falling, which is an indication of the bond market’s belief of a retreat in growth expectations.
  • The Chinese stock market has tanked relative to global stocks, as measured by MSCI All-Country World Index (ACWI).

 

 

If these market signals are indeed pointing to a pause in growth expectations, then investors should be prepared for either a risk-off tone in the markets or some choppiness and consolidation in the months ahead.

 

I beg to differ. The reflation theme is alive and well. 

 

 

A different kind of rotation

My analysis of global markets reveals a different explanation of market action, and it’s attributable to a rotation in global equity markets based on specific regional factors as shown by the chart below of the relative performance of different regions against ACWI.  In the US, the S&P 500 has been outperforming ACWI since late February while the NASDAQ 100 has traded sideways. European markets have been flat against ACWI since December. Asian and emerging markets have lagged.

 

 

Equity markets are moving because of different factors specific to their regions.

 

  • In the US, the S&P 500 has risen too far too fast, and it is due for a period of choppiness and consolidation. The rotation from growth to value remains intact.
  • China is experiencing a slowdown that is dragging down the economies and markets of her major Asian trading partners (see A “value” industry that’s about to be the “Next Best Thing”).
  • The paths of European and other emerging market equities are being driven by progress against the pandemic, which is uneven.

 

 

Too far, too fast

In the US, the stock market is overextended. The S&P 500 overran a rising trend line, and recycled while exhibited a hanging man candlestick indicating a possible reversal. Similar past episodes have marked blow-off tops that resolved with short-term pullbacks. 

 

 

I have also been monitoring the evolution of the equity call/put ratio from a long-term perspective. While most analysts have pointed to the spike in equity call option volume as a sign of excessive speculation by individual traders, past rising equity call/put activity has been coincidental with equity bull phases. Now that YOLO call traders have retreated and retrenched, the 50 dma of the equity call/put ratio has fallen below the 200 dma. In the past, such events have signaled pauses in market advances.
 

 

However, the growth to value rotation remains intact. The 5-day RSI of the Russell 1000 Value to Growth ratio recycled off an oversold condition, which is a buy signal. 

 

 

Moreover, the valuation dispersion between value and growth stocks are still historically high, which gives room for the trade to converge.

 

 

As well, the NY Times had a cautionary message for tech and growth investors. Regulators are going after technology companies all over the world, which will be a headwind for their growth outlook and represents an attack on their business models.
 

China fined the internet giant Alibaba a record $2.8 billion this month for anticompetitive practices, ordered an overhaul of its sister financial company and warned other technology firms to obey Beijing’s rules.

 

Now the European Commission plans to unveil far-reaching regulations to limit technologies powered by artificial intelligence.

 

And in the United States, President Biden has stacked his administration with trustbusters who have taken aim at Amazon, Facebook and Google.

 

Around the world, governments are moving simultaneously to limit the power of tech companies with an urgency and breadth that no single industry had experienced before. Their motivation varies. In the United States and Europe, it is concern that tech companies are stifling competition, spreading misinformation and eroding privacy; in Russia and elsewhere, it is to silence protest movements and tighten political control; in China, it is some of both.

The most convincing argument against a pause in the reflation trade can be seen in commodity prices. Both the CRB Index and equal-weighted commodities made fresh all-time highs. Does a pause look like this? 

 

 

China is slowing

Over in Asia, the markets are showing concerns over the nascent signs of a slowdown in China. Credit growth is rolling over, which usually leads to a deceleration in GDP growth.

 

 

The Huarong debacle has also sparked increasing worries in the bond market. Yield spreads are widening, which is an indication of tightening credit conditions that exacerbate slowdown risk.

 

 

The anxiety can be seen in the relative performance of Chinese stocks against ACWI. The bad news is MSCI China have plummeted on a relative basis. The good news is it is holding a key relative support level, indicating that the market does not expect a disorderly rout in the Chinese economy.

 

 

 

A pandemic driven market

As for the rest of the world, the stock markets of the remaining regions are still driven by the progress of the war against the pandemic. Until the global population reaches herd immunity, either from immunization or the ravages of infection, the world is not protected against the virus and the global economy is at risk of slowdowns and supply chain disruptions.

 

These Financial Times charts illustrate the vaccination effects in different countries. Keep in mind that UK vaccination rates are one of the highest in the world, which explains the dramatic drop in hospitalization.

 

 

Israel is one of the few developed economies that has made the greatest progress in vaccinations, followed by the UK, and the US. The EU is just starting to ramp up after some teething pains, and Asian countries are lagging behind. Large emerging market countries like Brazil and India are still struggling.

 

 

Here is what this means for the relative performance of different regional stock markets and economies in the months ahead. The EU equity outlook should start to improve as it reflects the ongoing vaccination ramp-up in Europe. Both large and small-cap eurozone equities have been flat to up against ACWI. UK equities, however, have been held back by the ongoing Brexit problems in Northern Ireland. 

 

 

European equities could be a source of better relative performance in the months ahead. Eurozone equities are not highly valued and their outlook is expected to improve as vaccinations rise. As well, Germany’s top court handed down a welcome decision last week to allow the country to ratify the EU pandemic recovery fund, which opens the door to more fiscal stimulus. UK equities are cheap by developed market standards. The UK is nearing herd immunity, though investors bear the risk of an unraveling of the Good Friday Accord.

 

 

On the other hand, Asia and emerging markets are areas to avoid for a variety of reasons. Asia is vulnerable owing to a China slowdown, which will affect China’s major trading partners in the region. As well, the pandemic appears to be out of control in India, whose case counts are skyrocketing amid reports of an overwhelmed healthcare system is near collapse.

 

A number of other EM countries are not faring well with the pandemic either. The World Health Organization recently warned about rising infection rates in Argentina, Turkey, and Brazil. In addition, there are over 30 countries that haven’t even begun to vaccinate their populations, most of which are in sub-Saharan Africa. 

 

The world is not protected from this virus until we all are. As the vaccination rates of the developed economies rise, the attention will shift to the vaccination rates in EM countries and their lack of progress. This could be the spark for a global growth scare in the months ahead.

 

 

To recap, I believe that the reflation trade has not paused. Cyclically sensitive indicators of global trade, such as Korean and Taiwanese exports, are surging.

 

 

However, global markets are undergoing a rotation away from an extended US market. Europe offers more attractive opportunities in the months ahead. Asia and the emerging markets should be avoided owing to a combination of China slowdown risk and the re-emergence of the uncontrolled spread of COVID-19 in a number of major EM countries.
 

 

An exhausted bull, or a bear trap?

Posted by Cam Hui -

Mid-week market update: How should investors and traders react to the recent stock market weakness? The bears will argue that the S&P 500 spiked past a trend line resistance and fell back, which is an indication of bullish exhaustion. Moreover, the 5-day RSI recycled from an overbought condition to neutral, which is a tactical sell signal. The logical initial downside target is the 3840-3900 zone, which represents about a 5% pullback.
 

The bulls will argue that the bull trend remains intact. The S&P 500 is rising steadily in a channel, and the recent pullback is just a bull flag, which is a bullish continuation pattern. The market can go higher.
 

 

This is where the interpretative part of technical analysis comes in.

 

 

Bearish market internals

A more detailed analysis of the market internals favors the bear case. Equity risk appetite is turning negative. The equal-weighted ratio of consumer discretionary to consumer staple stocks is falling. As well, the ratio of high-beta to low-volatility stocks has been exhibiting a negative divergence since early April.

 

 

The relative performance of defensive sectors to the S&P 500 is starting to perk up, which I interpret as an equity bearish signal. The real estate sector has staged an upside relative breakout, and utilities are pressing up against a key relative resistance level. The other two defensive sectors, healthcare and consumer staples, are tracing out patterns of rounded bottoms on their relative performance charts.

 

 

 

What to avoid

Instead of focusing on what to buy, I will focus on what to avoid for traders who want to take tactical short positions. The primary short-sale candidates are NASDAQ and growth stocks. The NASDAQ 100 is testing a key support level. The relative performance of the speculative and high-octane ARK Innovation ETF (ARKK) to the S&P 500 is extremely weak, indicating a lack of momentum in growth stocks.

 

 

I interpret the recent NDX strength as a counter-trend rally as a minor hiccup in the recovery in value/growth performance.

 

 

While the small-cap to growth stock ratio remains favorable for small-caps in the long run, traders should also expect further tactical underperformance of small-cap stocks. The small-cap rally became overextended in early 2021 and the Russell 2000 to S&P 500 ratio flashed an overbought reading on the 14-day RSI indicator. Wait for an oversold or near oversold condition before buying small-cap stocks.

 

 

However, I would expect small-cap relative weakness to be only temporary. An analysis of the size factor through a global lens shows that small-caps are either leading or flat with their large-cap counterparts in the other major regions of the world.

 

 

In conclusion, the stock market is starting to exhibit corrective action. My base case scenario calls for a downside target of 3840-3900 on the S&P 500, which represents about a 5% pullback. Pockets of vulnerability are NASDAQ growth stocks, and small-caps, which I expect to underperform during this period of market weakness. Today’s rally was no surprise, breadth readings had become oversold as of last night’s close but any bounce should be temporary.

 

 

 

Q1 earnings season: Sell the news?

Posted by Cam Hui -

Q1 earnings season began with the reports from a number of major banks last week, and it is about to go into full swing this week. Expectations are high, but how much of the good news has been discounted by the market?
 

 

 

Rising estimates = Fundamental momentum

While it’s still very early in Q1 earnings season as only 9% of the S&P 500 has reported, the results were very positive. Both the EPS and sales beat rates were well above their 5-year historical averages. As well, street analysts are unusually bullish on their companies’ outlook. The forward 12-month EPS rose an astounding 1.12% last week.

 

 

EPS revisions were positive on all time horizons. Analysts revised their EPS estimates upward for every quarter for the next six quarters. The most positive revisions were seen for Q1 2021.

 

 

 

Hopeful body language

The Transcript, which monitors earnings calls, is reporting hopeful body language from corporate management,

The economy is booming and companies are expecting robust growth in the second half of 2021 and 2022. Travel is starting to rebound and cities are coming back to life. Stimulus has left consumers with a tremendous amount of liquidity and we are spending. Institutional investors are increasingly concerned about inflationary pressures.

The top-down macro outlook is strong.

 

Companies are expecting robust growth in 2H 2021 and 2022
“I’d state quite clearly, and I said in the prepared remarks, that we think that we’re going to have very, very robust economic growth in the second half of 2021 into 2022 as vaccines continue to accelerate, as we come out of the pandemic, as we move forward. There’s no question that there is meaningful consumer pent-up demand.” – Goldman Sachs (GS) CEO David Solomon

 

“…a significant acceleration of economic activity is anticipated, despite the consistently high numbers of cases around the world and now the introduction of many new variants.” – BlackRock (BLK) CEO Laurence Fink

 

“Certainly, there’s enormous pent-up demand. Consumers have built up a lot of wealth over the pandemic, people have really lost the connection that they look to recreate and get back together, whether that’s for leisure, purpose, or business.” – Delta Air Lines (DAL) CEO Ed Bastian

 

“On the commercial side, what we are seeing is that pipelines are getting stronger really across most areas in most geography. In addition, when we think about the stimulus that’s been put into the system, there’s going to be a lot of consumer spend, especially as the second half of the year develops.” – U.S. Bancorp (USB) CFO Terry Dolan

 

Consumer spending is hitting new records
“The first quarter was a record dollar amount of money moved by Bank of America consumers. The trend is fully on track, even though the economy is not yet fully reopened. March was a record month of spending by Bank of America consumers and led to the highest ever quarter of consumer spending.” – Bank of America (BAC) CEO Brian Moynihan

 

Cities are coming back to life
“What we’re experiencing, almost daily is a regeneration of the cities. New York, San Francisco, LA, Boston are all recovering incrementally and measurably, almost every day. Companies are beginning to announce return to office programs that are actually a little more robust, I would say, than we expected. The housing demand in the cities is now back. The prices are lower, which is a quite stimulating demand, which is good and rentals are down. And that’s pulling people back in as well. There is some movement to Texas, Florida, Wyoming, etcetera, driven probably by tax policy, but also by opportunity. And that hints kind of continue. But it’s not going to be the incremental element that changes a San Francisco or New York in our opinion and observation.” – First Republic Bank (FRC) CEO Jim Herbert

 

Stimulus has led to so. much. liquidity.
“One of the things that I pointed out the savings rate doubled with the national average. We’ve got 15% — and households are holding 15% of GDP in cash. They’re either going to spend it investment or just let it lose value sitting in cash.” – The Bank of New York Mellon (BK) CEO Thomas Gibbons

 

“We think [companies] have something like $2 trillion of excess cash in balance sheets. When they raise money in public markets, they can pay down loans to banks. This is not bad news about loan demand, this is actually good news.” – JPMorgan Chase (JPM) CEO Jamie Dimon

 

To underscore that point, household savings have surged during the pandemic. There is an excess of pent-up liquidity that individuals are waiting to spend.
 

 

Equity investors also received some positive news when Axios reported that Senate Democrats are moving towards a consensus of raising the corporate tax rate from 21% to 25%, instead of the 28% proposed by Biden.
The universe of Democratic senators concerned about raising the corporate tax rate to 28% is broader than Sen. Joe Manchin, and the rate will likely land at 25%, parties close to the discussion tell Axios.

 

The longer-term picture is a 2021 boom, followed by a slowdown next year. New Deal democrat, who keeps an eye on the economy using coincident, short-leading, and long-leading indicators, confirmed evidence of a post-pandemic boom, though rising rates may be telegraphing a slowdown in 2022.
 

Due to increased interest rates, among the long leading indicators. Nevertheless two out of three measures of the yield curve, the Adjusted Chicago Financial Conditions Index and Leverage subindex remain positives, rejoined this week by corporate bonds and (slightly) corporate profits. Mortgage rates and the 2 year Treasury minus Fed funds yield spread are neutral. Mortgage applications, refinancing, US Treasuries, and real estate loans are negative.

 

In two weeks I expect the Q1 GDP report to confirm that we are in a Boom, fueled by mass vaccinations, plus the most extreme monetary and fiscal environment since LBJ’s “guns and butter” policy of 1966.

 

The question for 2022 is whether higher interest rates and steep rises house prices and gasoline may bring that growth to a halt. So far the evidence is tending to deceleration or slowdown rather than halt or downturn.

 

Party on!
 

 

Buy the rumor, sell the news?

I hate to throw cold water on the stock market’s party, but you can tell a lot about market psychology by the way it responds to news. Bank earnings were strong last week. Even though the S&P 500 rose, bank stocks lagged the market. This may be an indication that much of the good news has been discounted.
 

 

However, don’t overreact just yet based on preliminary evidence. Q1 earnings season is just getting started.
 

 

Trust, but verify! Monitor the market reaction to earnings reports for another week before making any conclusions.
 

 

A blow-off top ahead?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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.
 

 

Setting up for a blow-off top

The S&P 500 has been rising steadily since late February. As the stock market advanced, readings became increasingly overbought. The S&P 500 has spent two consecutive weeks above its weekly Bollinger Band (BB). Past upper BB episodes have tended to be signals of positive momentum. that led to further gains. The market spent several months on an upper BB ride in late 2017 and early 2018 before it finally topped out.

 

 

It appears the S&P 500 is undergoing another melt-up, with a blow-off top ahead. In the last four years, overruns of a rising trend line have been signals of an imminent blow-off top that lasts no more than two weeks.

 

A closeup look at the S&P 500 daily chart shows more details. The index has overrun rising trend line resistance, which happened twice since the March low. The market topped out after prices went parabolic within a week of the overruns.

 

 

 

Sentiment not stretched

While the recent historical evidence points to a market top in the middle of next week, the rally could run a little further because a number of key sentiment models are not overly stretched. In particular, the Goldman Sentiment Indicator, which measures positioning instead of just opinion, took a step back from “stretched” territory indicating further room for equities to advance.

 

 

Similarly, the Fear & Greed Index is nowhere next euphoric territory.

 

 

 

Time for a pause?

The big picture points to a temporary pause in the advance. I have highlighted this analysis in the past. The percentage of S&P 500 stocks above their 200 dma is well over 90%, and such readings have been “good overbought” signals that resolved in steady multi-week advances. The rallies usually did not pause or terminate until the 14-week RSI cross the 70 overbought level, which it did last week.

 

 

As for the timing of a top, my working hypothesis is the next one or two weeks. Technical analyst Dean Christians recently pointed out that “the percentage of S&P 500 members trading above their respective 50-day moving average registered an overbought momentum buy signal on the close of trading on 4/8/21. The table below contains all signals that occurred at a 252-day.” As this signal was triggered on April 8, 2021, the historical study (n=22) shows that returns peak out between two weeks and a month after the signal. If history is any guide, this puts the timing of a peak sometime in late April or early May.

 

 

 

A rotation update

Last week, I had highlighted a number of opportunities from a healthy internal market rotation that allowed the broad indices to climb further (see Internal rotation + Seasonality = More gains):

 

  • An opportunity to lighten up on growth stocks;
  • An opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.

 

Those setups have generally worked well. First, I had pointed out that value stocks had become severely oversold against growth stocks and due for a rebound. The value/growth ratio has recycled off an oversold reading and value appears to be headed for renewed leadership after several weeks of relative weakness.

 

 

I also observed that the bond market was poised for a rally, and bond price duly rebounded. You can tell the character of a market by the way it responds to news. Last Thursday, initial jobless claims dropped by an astounding -193,000, blowout prints in retail sales, NY Empire Manufacturing, and Philly Fed Manufacturing. The market reaction was a decline in the 10-year Treasury yield. Bond yields appear to be ready to fall and prices appear to be ready to rise. The risk is this is just a countertrend move and yields are tracing out bull flags they way they did in the last few months.

 

 

Lastly, I had highlighted a bull flag in gold mining stocks (GDX). GDX staged an upside breakout from the bull flag – a buy signal.

 

 

 

Waiting for the top

My base case scenario calls for a possible buying frenzy that traders should sell into. There is no need to panic just yet. The relative strength of defensive sectors have mostly bottomed out and they are trading sideways. However, none have begun relative uptrends that would be cautionary signals.

 

 

Despite my caution, I expect any weakness to be no more than 5-10%. This is still a bull market. Both the Dow Jones Industrials and Transports have achieved fresh all-time highs, which are classic Dow Theory buy signals indicating the long-term trend is up.

 

 

Investors should view any weakness as buying opportunities. Traders should be positioned for a possible blow-off top, followed by a sharp pullback of no more than 5-10%.

 

 

Disclosure: Long IJS

 

A “value” industry that’s about to be the “Next Best Thing”

Posted by Cam Hui -

Recently, an investor aptly characterized value investing as a portfolio of problems with a call option on good news. One sector stands out as a group of value stocks that are taking on growth characteristics. As shown by its relative performance against MSCI All-Country World Index (ACWI), this cyclical industry bottomed out on a relative basis in March 2020 just as the stock market bottomed and it has been on a tear ever since.
 

 

 

 

 

 

That industry is mining and the mystery chart shows the relative performance of the iShares MSCI Global Metals & Mining Producers ETF (PICK) to ACWI. 

 

Here is my bullish thesis on this group.

 

 

The promise of electric vehicles

The electoral win by the Democrats has profoundly changed US climate change policy.  In particular, Biden is pivoting toward green energy initiatives. Green energy is a complex subject for investors, and the supply change is complicated with many players.

 

 

One focus is the auto industry. GM has vowed to produce all-electric vehicles by 2035. Volvo has gone further and promised an all-electric offering by 2030. In fact, EV sales have overrun analyst forecasts.

 

 

Rising EV demand means a secular shift from hydrocarbons to a variety of metals – lots of it. Even the CME has gotten into the act by launching a lithium futures contract.

 

 

Experienced commodity analysts understand that at relatively small swings in the supply-demand imbalances can create large price swings. In the face of escalating metals demand, the supply of many metals is about to fall into a significant deficit. Take aluminum, just as an example.
 

 

Here is copper, which is a key component in wiring, and it is expected to see a structural deficit in the near future.

 

 

As the combination of renewable electrification and EV adoption takes hold over the next decade, the demand for metals is expected to explode. That’s bullish for base metals, and for the mining industry.

 

Metals and mining stocks are perceived to be value stocks. They are about to become growth stocks over the next few years.

 

 

Cyclical cross-currents

However, the industry faces a number of cyclical cross currents over the next 6-12 months. The bull case consists of rising cyclical demand as the global economy re-opens after the pandemic. Numerous indicators signal a V-shaped recovery. Job postings have risen to pre-pandemic levels.

 

 

IHS Markit reported a spike in global input costs and selling prices. Translation: rising input costs mean commodity inflation.

 

 

Global industrial metals PMIs are spiking. Copper PMI shows strength in the US and Europe, but some softness in Asia.

 

 

This brings me the key cyclical risk to the metals complex. China is slowing. A year after it engaged in a bout of emergency stimulus, Beijing is pivoting to a policy approach of quality over quantity growth. Credit growth is rolling over.

 

 

As a sign of Beijing’s policy tightness, corporate borrowings have been falling. In particular, the borrowings of government-backed SOEs have fallen the most.

 

 

In the past, commodity prices have been correlated with changes in Chinese credit. However, investors need in mind the bullish cyclical effects of the global economic recovery as an offsetting bullish factor.

 

 

 

Investment implications

What does this mean for investors?

 

First, my preferred diversified ETF of choice is iShares MSCI Global Metals & Mining Producers ETF (PICK), which allows the investor exposure to a variety of global and non-US mining companies. As the table below shows, the largest US company on the list ranks fifth in portfolio weight, indicating a lack of choice for American investors in this industry.

 

 

From a technical perspective, PICK is in well-defined uptrends, both on an absolute basis and relative to ACWI. In the short-term, some caution may be warranted as it is exhibiting a series of negative RSI divergences as it broke out to an all-time high.

 

 

The deceleration in price momentum is probably attributable to weakness in China. Tactically, I am monitoring the following indicators. First, China’s Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, peaked out last summer and has been falling ever since.

 

 

The relative performance of the Chinese stock market to ACWI and the markets of China’s major trading partners are all either falling or trading sideways. This is an indication of a loss of economic momentum throughout the region.

 

 

Chinese material stocks have been underperforming global materials and testing a relative support zone, indicating weakness in this sector compared to the rest of the world.

 

 

These are all signs of weakness in Chinese infrastructure spending. However, the relative strength of PICK to ACWI is an indication that the market expects the other major regions to become the locomotives of global growth. I am also watching China’s credit market. The Huarong Affair is becoming an acid test as the price of its bonds plunged. The key question is whether Beijing will allow an SOE majority-owned by China’s finance ministry to default on its debt. Should the credit markets become disorderly, the authorities will likely resort to their well-tested method of flooding the financial system with liquidity, which would be supportive of commodity prices.

 

 

In conclusion, the mining industry is currently viewed as value stocks with cyclical exposure, which is bullish as the global economy recovers. In addition, it is a beneficiary of the coming electric vehicle boom, which is expected to give the industry some growth characteristics. A short-term risk is a China slowdown which dampens commodity demand. Investors should view any fears related to a Chinese growth pause as a buying opportunity.

 

 

Trading a possible melt-up

Posted by Cam Hui -

Mid-week market update: Even as selected sentiment models and market internals scream for caution, the S&P 500 is on the verge of melting up as it tests overhead resistance as defined by a rising trend line. The melt-up condition would be confirmed if the index were to rally through the trend line, which it did on two other occasions in the past 12 months. In that case, the regular trading rulebook goes out the window.

 

 

The possible market melt-up can be seen more clearly on the weekly S&P 500 chart. The index is potentially spending two consecutive weeks above its weekly upper Bollinger Band (BB). Past instances of upper BB violations have signaled steady advances that usually terminated with a blow-off top, followed by a sharp sell-off. The most impressive upper BB ride in recent memory occurred in late 2017 and early 2018. That episode lasted about four months.

 

 

When the animal spirits run, you just don’t know where it all ends.

 

 

Warning signals

Overbought advances are accompanied by technical warnings, and the current episode is no exception. Sentiment is extended, as evidenced by the high level of bullishness on the Investors Intelligence survey.

 

 

Market breadth presents a weakish picture of market internals. Both NYSE and NASDAQ new 52-week highs have been falling even as the S&P 500 advanced. Moreover, the NYSE Advance-Decline Line had been lagging the S&P 500, though the A-D Line finally made a marginal all-time high this week.

 

 

 

A healthy rotation

On the other hand, the market has undergone a healthy rotation beneath the surface even as the S&P 500 rose to fresh highs. Value stocks peaked out relative to growth stocks in early March and growth stocks have been the leaders since then. The Value/Growth ratio became oversold on the 5-day RSI and the ratio has since recycled off the oversold condition. This is evidence of a rolling internal correction that can be supportive of further market advances. The risk is a disorderly bullish stampede that leads to a blow-off top and a sharp sell-off.

 

 

In conclusion, the market is undergoing a possible market melt-up. Volatility is likely to explode in the coming weeks, either on the upside or the downside, and perhaps both. Daily volatility will be exacerbated by the earnings reports of the day. Several large banks reported today, and they all beat expectations. While earnings were enhanced by the release of excessive reserve provisions that banks took last year as the pandemic cratered the economy, each of the banks impressively beat top-line expectations.

 

My inner investor is bullishly positioned as he believes the intermediate-term trend is up. My inner trader is long and hanging on, but he is maintaining trailing stops to control his risk. 

 

It’s going to be a wild ride.

 

 

Disclosure: Long IJS

 

Q1 earnings preview: All calm, but what’s next?

Posted by Cam Hui -

Q1 earnings season is about to begin in earnest, with JPMorgan Chase scheduled to report on Wednesday and the rest of the big banks during this week.
 

 

Ahead of the reports, equity volumes have plunged even as the S&P 500 rose to all-time highs.
 

 

It’s quiet, maybe a little too quiet.

 

 

High expectations

Ahead of the earnings reports, consensus earnings expectations have risen strongly. Forward 12-month EPS rose a robust 0.81% last week.

 

 

EPS estimate revisions have been positive on all time horizons. Street analysts have raised estimates not just for Q1 and Q2, but across the board into 2022.
 

 

 

A boom ahead

The Transcript, which monitors earnings calls, reported that preliminary indications call for a re-opening boom. The boom has created a number of supply chain bottlenecks, which is especially evident in the semiconductor industry.

 

Tens of millions of Americans have now been fully vaccinated and the fun is just beginning. Re-opening euphoria and pent-up demand could lead to an economic boom that lasts into 2023. Supply chains, especially semiconductors, are still feeling the effects of Covid, and price pressures continue.
The S&P 500 forward P/E ratio has remained relatively steady since last summer even as the index advanced. This is an indication that it has been forward 12-month EPS estimates drive the market`s gains. 

 

 

Can this continue? How much of the re-opening boom has been discounted?

 

 

A disturbing technical pattern

The re-opening boom should be especially bullish for small-caps as they are more exposed to the US economy, but the small-cap Russell 2000 is tracing out a possible bearish head and shoulders pattern. Does this mean most of the good earnings news has been discounted?

 

 

Before the bears get overly excited, I make several points. First, technical analysis principles specify that a head and shoulders pattern is not complete until the neckline breaks. For example, there was some anxiety among chartists about a potential head and shoulders top in semiconductor stocks this year, especially when SOX broke a rising relative trend line against the S&P 500 (dotted line, bottom panel). As it turns out, the neckline did not break. Instead, SOX rallied to an all-time high. The moral of this story is that head and shoulders patterns are not necessarily bearish. They can be bullish continuation patterns.

 

 

As well, a comparison of the Russell 2000 and the S&P 600, which is another small-cap index, shows the left shoulder of the potential head and shoulders to be less defined. This is reflective of a quality effect. Standard & Poors has stricter profitability inclusion criteria for its indices than Russell.

 

 

If investors were to move up the market cap band to the mid-cap S&P 400, you really have to squint to see a possible head and shoulders formation. The S&P 400 is in a well-defined uptrend.

 

 

In conclusion, the market is poised to report strong Q1 earnings and virtually all macro and fundamental conditions point to a re-opening boom. In all likelihood, Q1 will be another blowout quarter for earnings. I am inclined to give the bull case the benefit of the doubt.

 

Internal rotation + Seasonality = More gains

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.
 

 

Positive April seasonality

I normally only give seasonality secondary consideration in my analysis. But April is the most bullish month of the year for S&P 500 in the last 20 years and positive 80% of the time. Combined with the recent healthy internal rotation in the market, and if seasonality continues to track, the stock market should grind higher for the remainder of the month.

 

 

I conclude from this analysis that the market can continue to rise in April. A healthy internal rotations has occurred that has relieved the pressure of overbought excesses. Several potential opportunities have arisen as a result of the market rotation:
  • A opportunity to lighten up on growth stocks;
  • A opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.

 

 

Opportunities from market rotation

The market has been undergoing a healthy internal rotation, which has created a number of opportunities that I would like to highlight.

 

First, value stocks have broken the long relative downtrend against growth stocks. In the last month, however, growth has made a relative recovery against value. The value/growth ratio has reversed and become oversold on the 5-day RSI. The absolute performance of the Russell 1000 Value and Growth indices are more revealing. While value stocks remain in an absolute uptrend and continues to make new highs, growth stocks have rebounded strongly and they are now testing a key resistance level. I interpret these conditions as a growth counter-trend rally, and an opportunity for investors to rotate out of growth back into value. The trend is your friend, and the trend favors value.

 

 

Further evidence of market rotation can be found in the short-term bottom in bond prices. The 7-10 year Treasury ETF (IEF) recently made a double-bottom while exhibiting a positive RSI divergence. The bond market is poised for a short-term rally and rebound.

 

 

Another opportunity can be seen in gold and gold stocks. Even as inflation expectations rose, gold prices have been pulling back since mid-2020 in a bull flag pattern. Gold recently bottomed while flashing a positive 5-week RSI divergence. This is a setup for higher prices.

 

 

The technical pattern for gold stocks is even more bullish. GDX is testing the top of a bull flag after the percentage of bullish on P&F reached an oversold condition in early March. 

 

 

 

Bullish despite frothy sentiment

Undoubtedly some readers will have noticed that a number of sentiment models have reached excessively bullish readings, and I want to address those concerns. A noticeable difference has recently appeared between sentiment surveys, which ask respondents about their views on the market, and positioning models, which measure how actual funds are deployed.

 

Sentiment surveys have, by and large, been very bullish. As an example, the AAII bull-bear spread is highly elevated. While this model has not shown itself to be an effective actionable trading sell signal (grey zones), its readings are concerning.

 

 

Similarly, Investors Intelligence bulls have jumped and bears have retreated. The bull-bear spread is at or near a crowded long condition.

 

 

On the other hand, the NAAIM Exposure Index, which measures RIA sentiment, flashed a capitulation buy signal in early March. The index rose to 89.95 from a fearful 52.02 the previous week. Readings are neutral and not excessive.

 

 

As well, the equity put/call ratio has been slowly rising indicating a healthy sentiment normalization.

 

 

Helene Meisler’s weekly (unscientific) but timely Twitter poll done yesterday (Saturdy) saw net bullishness retreat after a record high last week despite the market advance. This is another sign the sentiment has reset and stock prices have further room tot rise.

 

 

Market internals indicate that the market can rise further. Neither the NYSE McClelland Oscillator (NYMO) nor the NASDAQ McClellan Oscillator (NAMO) are overbought after reaching oversold conditions in early March. 

 

 

The market’s advance has been orderly so far and characterized by a healthy internal rotation. The key risk is the rally becomes disorderly and excesses appear. If the S&P 500 were to overrun its rising trend line at about 4150-4160, it would be the sign of a blow-off top which is usually followed by a correction. As well, I am monitoring the spike in the correlation between the S&P 500 and the VVIX (volatility of VIX), which has signaled short-term tops in the past. However, the rise in correlation may be a one-time event. Bloomberg reported that a large buyer entered into a VIX call option spread, which undoubtedly elevated VVIX and caused the S&P 500/VVIX correlation to rise.

Somebody shook up options screens Thursday morning with a wager that the VIX Index will rise toward 40 — and won’t be lower than 25 — in July, up from about the 17 level where the volatility gauge currently trades. The trader appears to have made several block trades, buying a total of about 200,000 call contracts. That’s almost as big as the total daily volume of VIX calls, based on the 20-day average, data compiled by Bloomberg show.

 

 

I conclude from this analysis that the market can continue to rise in April. A healthy internal rotations has occurred that has relieved the pressure of overbought excesses. Several potential opportunities have arisen as a result of the market rotation:
  • A opportunity to lighten up on growth stocks;
  • A opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.

 

 

Disclosure: Long IJS

 

How Powell, the Un-Volcker, is remaking the Fed

Posted by Cam Hui -
Jerome Powell may turn out to be the Un-Volcker Fed Chair. Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. By contrast, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove.

 

A considerable gulf has opened up between the Fed’s stated monetary policy path and the market’s expectations. Ed Yardeni recently conducted a LinkedIn poll of interest rate expectations. While the poll is unscientific in its methodology, the results roughly parallel market expectations that the Fed would begin to raise rates in late 2022, and raise them several times in 2023. By contrast, the Fed’s own Summary of Economic Projections doesn’t see any rate hike until late 2023.
 

 

Fed governor Lael Brainard appeared on CNBC soon after the release of the Fed minutes and she addressed the issue of the market’s disbelief of Fed’s interest rate path by distinguishing between outcome and outlook. The Fed is focused on the realized outcome of employment and inflation. The market is focused on expectations, whose forecasts may not be realized.

 

Here is why it matters, not only for the path of interest rates but how the Fed’s outcome-based approach affects the economy and equity prices.

 

 

The roots of the market’s skepticism

This analysis from Cornerstone Macro illustrates how the market isn’t buying into the Fed’s new framework. The market’s projected Fed Funds rate is consistent with a traditional Taylor Rule approach to rate setting. It isn’t consistent with the Fed’s new framework of raising rates until it actually sees the outcomes of monetary policy.

 

 

In other words, the market is highly focused on the conventional Taylor Rule inflation fighting framework and ignoring the Fed’s other mandate of full employment. Hence the market skepticism of the Fed’s new framework.

 

 

Interpreting the FOMC minutes

The Fed implicitly pushed back on market-based expectations of an early rate hike in its March FOMC minutes. While the FOMC acknowledged signs of improvement in the economy, “participants agreed that the economy remained far from the Committee’s longer-run goals and that the path ahead remained highly uncertain, with the pandemic continuing to pose considerable risks to the outlook.” Translation: the economy is far from the Fed’s long-term goals of full-employment and price stability.

 

As an example, the percentage of the unemployed without jobs for 27 weeks or more is still extremely high despite the blowout March Jobs Report. During the IMF’s debate on the global economy, Powell said he wants to see a string of months of a million jobs per month before substantial progress is made towards the Fed’s goals. Notwithstanding parsing what a “string” means, the Fed views this as a clear indication that any discussion of policy accommodation removal is premature.

 

 

As an aside, if you want to understand how Jerome Powell is different from academic economists in his views of the labor market, these remarks tell the story.

 

 

On the key issue of inflation, I have pointed out in the past that equity investors need to distinguish between reflation or real growth which leads to earnings gains, or inflationary growth, which is unproductive and erodes real earnings and margins. While the FOMC minutes revealed that “supply disruptions” could create transitory inflation effects, “factors that had contributed to low inflation during the previous expansion could again exert more downward pressure on inflation than expected”.

 

That said, Lael Brainard allowed in her CNBC interview (at about the 3:00 mark) that inflation will eventually appear. She was just careful not to put a time frame on that forecast.

 

Following those transitory pressures associated with reopening it’s more likely that the entrenched inflation dynamics that we’ve seen for well over a decade will take over then that there will be a sustained surge in inflation for a persistent period.

The FOMC minutes also makes it very clear that it believes higher bond yields is reflective of my reflation scenario of a better economic outlook. This means no yield curve control or another QE Operation Twist, where the Fed directs more Treasury purchases to the belly or long end of the yield curve. Brainard qualified that view by stating that the Fed would intervene should the bond market become disorderly.
 

 

Powell’s Great Policy reversal

Given the growing gulf between the Powell Fed and market expectations, it occurred to me that Jerome Powell may be the Un-Volcker. During the 1980’s, Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. In light of the Fed’s new framework, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove.
 

An Un-Volcker stance may be entirely appropriate in light of the economy’s anemic growth and weak inflation outlook. Former ECB board member Vitor Constâncio pushed back against the inflationistas who believe that runaway inflation is just around the corner and central bankers need to act soon to stamp that out. Constâncio observed that inflation in the US and Euro Area has been stable for the last 25 years. Past episodes of inflation spikes were linked to either wars or oil shocks. A major war is not on the horizon, and the window for another oil shock is narrow as the world transitions away from hydrocarbons to renewable energy in the next 10 years.
 

 

What about all the money growth (PQ=MV) as outlined by Milton Friedman and the monetary economists? Constâncio observed that despite the recent episodes of “runaway” money growth, inflation has been tame.
 

 

Portfolio manager Conor Sen argued in a Bloomberg Opinion article that “a Fed rate hike next year won’t be because of 2022 inflation”.
 

But what we know is that the Fed will largely look past any price increases this year. Even if inflation were to accelerate enough to concern them, Chairman Jerome Powell has said that before the Fed raises rates, it would need to slow down asset purchases, and before that it would give the public plenty of notice. So there won’t be a rate hike in 2021.
 

And that means it’s inflation in 2022 that will determine whether or not we get an interest rate increase. Merely maintaining elevated 2021 prices wouldn’t be enough — it would require additional price increases to reach a concerning rise in the rate inflation. But there’s a reasonable chance that as auto production catches up to demand, used vehicle prices will fall. Sawmills will have time to ramp up, putting downward pressure on lumber, and so on. 
 

Even in a scenario where 2022 economic growth remains robust, the dynamic of production catching up to consumer demand would lead to slowing price growth on a year-over-year basis — and that’s true even if price increases look strong on a trailing two or three-year basis.
 

It might take until 2023 to get past these pandemic-related pricing math quirks, making that the year inflation could become more of an issue should vigorous expansion continue. It may depend more on how the numbers get calculated, but the cycle should keep measures of inflation in check while the Fed evaluates the state of the expansion in 2022.

 

For what it’s worth, Cathie Wood of ARK Investment pointed out that real productivity may be higher than what’s being measured. If it is, then real GDP growth is higher and inflation is lower than reported. Her thesis makes sense from her investment perspective. ARK invests in high-risk, high-reward companies with positive tail-risk that aren’t being appreciated by conventional modeling techniques.

 

 

If my assessment of Powell as the Un-Volcker is correct, what does that mean for investors?
 

 

Market implications

The most obvious implication of the Un-Volcker thesis is the bond market’s inflation expectations may be too high. While the 2s10s yield curve has steepened in anticipation of better economic growth, the spread between the 2-year and 3-month T-Bills has also edged up in anticipation of higher Fed Funds rates. At a minimum, expect lower 2-year Treasury yields and possibly lower 10-year yields.
 

 

From a big picture perspective, steepening yield curves have been equity bullish especially when the economy recovers from a recession. As well, BoA found that small caps perform well during periods of strong GDP growth. Stay with small-cap exposure as the economy recovers from the COVID recession.
 

 

Indeed, GDP growth is expected to be strong. The Atlanta Fed’s GDPNow estimate is 6.2% and the IMF has upgraded global growth to 6.0% in 2021 and 4.4% in 2022.
 

 

Strong economic growth is propelling EPS estimates upwards. Forward 12-month EPS estimates have been rising across the board. Small and mid-cap estimates have recovered more strongly than the large-cap S&P 500, which is supportive of my bullish small cap call.
 

 

Equity price gains in the last year are mainly attributable to rising EPS estimates. The forward P/E ratio has remained steady during this period while the S&P 500 has risen in line with estimates. As the main source of earnings gains have come from cyclical stocks, this argues for an overweight exposure to cyclical sectors, which tend to be more categorizes as value such as financials, industrials, energy, and materials.
 

 

Despite evidence of positive momentum, the cyclical trade is not crowded. Hedge funds are still excessively positioned in defensive sectors and their cyclical exposure is still low.
 

 

For what it’s worth, FactSet reported that bottom-up derived S&P 500 one-year price target is +9.8% even after the recent advance. In the past, analysts have overestimated the price target by 1.3% in the last 5 years, by 2.1% in the last 10 years, and by 9.1% in the last 15 years. However, they underestimated the price target by a whopping 16% a year ago. Based on the experience of the 5 and 10 year overshoots, my expected one-year price return is about 8%.
 

 

Lastly, the potential effects of Biden’s tax proposals are expected to fall heavily on the communication services, technology, and healthcare sectors. For the uninitiated, GILTI stands for Global Intangible Low-Tax Income, and it is a tax intended to prevent erosion of the tax base by discouraging multinationals from shifting profits from intellectual property low-tax jurisdictions such as Ireland. The most affected sectors tend to be comprised of growth companies, and this argues against an overweight position in growth.
 

 

In conclusion, Powell is turning out to be the Un-Volcker Fed Chair. Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. By contrast, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove. For investors, this has several implications:
 

  • The bond market’s inflation expectations are too high, expect lower yields, especially at the short end of the yield curve.
  • Barring any pandemic hiccups, this is a V-shaped recovery. Small caps perform especially well in such environments.
  • Similarly, cyclical and value exposure is expected to outperform.

 

Momentum, meet bullish sentiment

Posted by Cam Hui -

Mid-week market update: What should traders make of this stock market? On one hand, the S&P 500 is exhibiting strong positive price momentum. Not only is the index trading above its daily Bollinger Band (BB), it’s trading above its weekly BB. In the last 10 years, there have been eight occasions when the S&P 500 was above its weekly BB. Most (five out of eight) of those instances were associated with sustained advances indicative of positive price momentum. The market corrected in three of the eight occasions, but in one of the three corrections (in early 2018), the upper BB ride persisted for three weeks before the market exhibited a blow-off top. That’s what strong price momentum looks like.
 

 

On the other hand, short-term sentiment is off-the-charts bullish, which is contrarian bearish.

 

 

Strong momentum

I have highlighted this chart before. The percentage of S&P 500 stocks above their 200 dma is well over 90%. In the past, this has been a sign of a “good overbought” market advance. The market often didn’t pull back until the weekly RSI became overbought or near overbought, as it is today.

 

 

Sure, the market is overbought but that hasn’t stopped stock prices from rising in the past. In the last year, there have been occasions when the market advanced while flashing a series of overbought signals. The readings from this chart are based on last night’s close and today’s sideways consolidation is expected to relieve some of the overbought conditions and set the stage for a further advance. 

 

 

 

Crowded long bullishness

Before the bulls get too excited, a couple of (unscientific) Twitter polls conducted on the weekend raised some concerns. While these polls have definite self-selection sampling problems, they have been good indications of short-term trader sentiment in the past.

 

First, Helene Meisler’s latest bull/bear Twitter poll has sentiment at a record level of bullishness, though the history is somewhat limited.

 

 

The level of excessive bullishness was confirmed by a similar weekend poll conducted by Callum Thomas, which also shows a very high level of equity bullishness.

 

 

I have pointed out before that the stock market has bifurcated into two markets, growth and value stocks. There has been some recent internal rotation between growth and value. Value leadership has paused and growth stocks have staged a recent counter-trend rally. The Russell 1000 Growth Index has filled in a February gap and it is now approaching overhead resistance.

 

 

I conducted my own (unscientific) Twitter poll to see if respondents were bullish on growth or value stocks. My own poll confirmed the low level of bearishness and the level of bullishness between growth and value were roughly similar.

 

 

 

Squaring the circle

How do we square this circle of strong momentum and crowded long sentiment readings? 

 

The bullish interpretation is the S&P 500 is undergoing a melt-up. It is trading above both its daily and weekly upper BB while exhibiting a series of “good overbought” RSI readings. In the past, such rallies have not ended until the market exhibited a blow-off top by overrunning its upper rising trend line. If I had to guess, the upside target for this rally is in the 4140-4160 range.

 

 

Also, keep in mind that next week is April option expiry. According to Rob Hanna at Quantifiable Edges, April OpEx has the strongest bullish risk/return of any month.

 

 

The bearish interpretation is internals are failing, sentiment is too bullish, and this market can correct at any time.

 

 

My inner investor remains bullishly positioned. The intermediate-term trend is still up, and he is not overly worried about minor blips in stock prices. At worse, any S&P 500 weakness shouldn’t exceed -5%. My inner trader is also bullish, but he is bracing for volatility and preparing to exit his long position on the first signs of weakness.

 

 

Disclosure: Long IJS

 

A change in leadership?

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.
 

 

The revenge of the tech nerds?

A reader pointed out an unusual market anomaly last week. Market leadership had shifted significantly some time during Q2 or Q3 2020. The old Big Three leaders of US over non-US stocks, growth over value, and large-caps over small-caps had made unmistakable trend reversals. Recently, even as the S&P 500, the Dow, and the Transports made fresh all-time highs, leadership was shifting back. US equities are dominant against non-US again; NASDAQ stocks are enjoying a minor revival; and small-caps are faltering against their large-cap counterparts.

 

 

Is this the start of a reversal, or just a blip?

 

 

The global big picture

Let’s begin with the global picture. An analysis of the relative performance of the different major regions against the MSCI All-Country World Index (ACWI) reveals a revival in the relative performance of the S&P 500. The major developed market regions, Europe and Japan, had been trading sideways against ACWI, and emerging market equities had weakened somewhat.

 

 

A more detailed analysis of the US (top panel) shows a significant divergence. Even as the S&P 500 had sprinted ahead on a relative basis this year, the NASDAQ 100 was flat to down against ACWI. The difference between the S&P 500 and NASDAQ 100 represents the difference between value and growth. It was the value factor that had been driving the recent US outperformance.

 

In fact, the relative return patterns of the Russell 1000 Value Index against the S&P 500 and the EAFE Value Index against the MSCI EAFE Index (Europe, Australasia, and the Far East) are virtually identical. 

 

 

I interpret this to mean that there have been no recent significant global regional leadership trends, but the value factor has been dominant in global equity returns.

 

What about the reversal in small-cap stocks? An analysis of the global size factor reveals that small-caps have been rising against their large-cap counterparts in a steady but uneven fashion all over the world. The biggest laggards have been Chinese and Japanese small-cap stocks, which had been in relative downtrends until they began to outperform in the last two months.

 

 

The pause in US small-cap outperformance appears to be just that – a brief pause. The long-term leadership of non-US over US, value over growth, and small-caps over large-caps should continue.

 

 

The bond market wildcard

The one wildcard to the continued leadership scenario is the possibility of a bond market rally. The Treasury market has been clobbered recently, and here is why.

 

The chart below shows quarterly changes to the JPMorgan Forecast Revision Index, which measures how economic forecasts have changed either upward or downward over the course of the quarter. The recent upward lurch in the index was the biggest upward move in its entire history, indicating an unprecedented pace of expected economic growth. The expectations of a strong recovery have depressed bond prices.

 

 

The long Treasury bond ETF (TLT) is testing support and exhibiting a positive RSI divergence. There have been three similar episodes in the last 10 years. Bond prices rallied strongly the last time this happened in 2018. On the other two occasions, the selloff was halted and the bond market traded sideways. 
 

As well, the bear flattener reaction of the bond market to Friday’s blockbuster March Jobs Report was constructive. While yields did rise across the board, the yield curve flattened – there may be life in the long bond even in the face of bad bond market news.

 

 

As the relative performance of growth stocks is sensitive to bond yields, a bond market rally could provide the impetus for a reversal of value and growth factor returns.

 

 

 

A bull market

Regardless of what happens to equity factors, investors need to recognize that this is a bull market. There is nothing more bullish than a stock or index making new all-time highs. The Dow and Transports have made fresh highs, which is a Dow Theory buy signal. As well, the market is benefiting from the combination of strong positive price momentum and skeptical sentiment. The percentage of S&P 500 stocks is above 90% again, which is a characteristic of a “good overbought” market advance (grey bars).

 

 

The market is also enjoying a fundamental momentum tailwind. FactSet reported record upward EPS revisions for Q1 2021 earnings.

 

 

The market is also enjoying a top-down macro tailwind from the blowout March Jobs Report. Non-farm payroll employment soared by 916,000 against an expected 647,000. Average hourly earnings was tame, indicating no pressure from wage inflation. Equally important are the leading indicators of employment. As an example, the number of job leavers, which has historically led NFP, soared indicating growing confidence about the strength of the jobs market.

 

 

The bullishness in sentiment surveys is coming off the boil. Investors Intelligence bulls are declining, and so is the bull-bear spread.

 

 

More importantly, the NAAIM Exposure Index, which measures RIA sentiment, retreated to 52 this week. This index fell below its lower Bollinger Band in early March and generated a contrarian buy signal. The current reading is very near the lower BB. If NAAIM sentiment were to deteriorate further next week, it could flash another buy signal. These buy signals have been very effective in the past.

 

 

 

The trend is your friend

In conclusion, investors should heed the adage “the trend is your friend”. The first trend is the pattern of new highs. This is a bull market.

 

Despite some minor hiccups in factor return patterns, give the benefit of the doubt to the trend of value and cyclical leadership. The Rising Rates ETF (EQRR) represents a simple way of measuring the effects of value and cyclical exposure. Notwithstanding the possibility of a bond market reversal, the intermediate-term value and cyclical trends are still intact.

 

 

From a trader’s perspective, the reaction of the equity futures market to Friday’s blowout Jobs Report left S&P 500 futures +0.5% and Russell 2000 futures +2.0% on a fair market value basis. In all likelihood, the market will open strongly on Monday. While the S&P 500 did not experience a negative 5-day RSI divergence on Thursday, keep an eye on whether the VIX Index falls below its lower Bollinger Band in the week ahead. Such incidents have often been signals of short-term tops.

 

 

Both my inner investor and inner trader are bullishly positioned. While the market isn’t showing signs of being too extended just yet, my inner trader is watching for signs of excessive exuberance to sell.

 

 

Disclosure: Long IJS