Biden’s American Rescue Plan: Bullish or bearish?

Posted by Cam Hui -

If you thought that Biden would govern as a centrist, you were wrong. In the wake of the passage of a $1.9 trillion stimulus package, President Joe Biden is planning to attack the enduring challenge of inequality by expanding government spending with a second ambitious $3 trillion economic renewal plan and a revamp of the tax code. It is intended to be a repudiation of the Reagan Revolution and the neoliberal consensus that has dominated economic thinking for decades. He reportedly decided to go big on reform for the following reasons:

  • Biden is enjoying his honeymoon period, and his approval ratings are strong. The New York Times reported that a Republican pollster found that even 57% of Republican voters supported Biden’s recent $1.9 trillion spending package.
  • The Democrats have full party control of Congress, and a short window before the mid-terms to enact legislation.
  • The pandemic recovery is offering both economic and political tailwinds to enact legislation.
What does this mean for investors?

 

While we don’t know the full details of Biden’s American Rescue Plan, its short-term effects are likely to be reflationary, which is equity bullish, while its long-term effects have a possibility of being inflationary, which is equity unfriendly. Much depends on the inflation outlook, which is uncertain at this time. This is not the time to worry just yet. Equity investors should adopt a positioning attitude of “party now, and (maybe) pay later”.

 

 

An attack on inequality

Biden’s plan has been compared to FDR’s New Deal and LBJ’s Great Society program inasmuch as all tried to address the problems of inequality. The philosophical underpinnings of this pivot are well summarized by Foreign Policy article by Adam Tooze outlining the careers of two luminaries of economics, Janet Yellen and Mario Draghi.

The basic framework of 1970s macroeconomics that framed Draghi and Yellen’s training and outlook, like that of the rest of their cohort, was that properly structured markets would take care of growth. Well-regulated financial systems were stable. The chief priority for economists was to educate and restrain politicians to ensure that inflation remained in check and public debts were sustainable.

Tooze argued that the limits of laissez-faire economics are becoming more evident. The economic turmoil of the last two crises was creating a threat to democracy. The markets are not necessarily always dominant and self-correcting, sometimes you need Big Government to step in.

In the 1990s, you didn’t need to be a naïve exponent of the post-Cold War end-of-history argument to think that the direction of travel for global politics was clear. The future belonged to globalization and more-or-less regulated markets. The pace was set by the United States. That enabled technocratic governments to be organized around a division between immediate action and long-term payoff. That was the trade-off that Draghi evaluated in his MIT Ph.D. in the 1970s. The drama of Draghi and Yellen’s final act is that for both of them, and not just for personal reasons, the trade-off is no longer so clear-cut. If the short-term politics fail, the long-term game may not be winnable at all. “Whatever it takes” has never meant more than it does today.

The tide is turning. Even an establishment institution like the International Monetary Fund has made a turn leftward, according to The Guardian.

 

 

Here’s why. During the post-War period, real wages (blue line) and productivity (red line) had tracked each other until the early 1980’s, when they diverged. Productivity grew, but wages didn’t keep up. Around the time of Reagan’s ascension to the White House, the providers of capital began to reap more gains from economic growth than the providers of labor, which kicked off several decades of growing inequality.
 

 

Even well before the Reagan Revolution, tax policy had been favoring the providers of capital over labor. Corporate tax collection had been falling since 1950, while Payroll taxes had risen as a percentage of federal revenue. Corporate income taxes and Payroll taxes actually began to steady as Reagan came to power.

 

 

Since Reagan took power, the rich have gotten a lot richer.

 

 

This is what the progressive wing of the Democratic Party means when it speaks about inequality. In response, Biden has proposed a three-pronged approach to the problem.

 

  • A $2.25 trillion infrastructure plan whose details were announced by the White House last week. The spending would occur over the next eight years, and amount to $250 billion per year, or 1% of GDP. Its main initiatives are:
    1. Fix highways, rebuild bridges, upgrade ports, airports, and transit systems;
    2. Deliver clean drinking water, a renewed electric grid, and high-speed broadband to all Americans;
    3. Build, preserve, and retrofit more than two million homes and commercial buildings, modernize our nation’s schools and child care facilities, and upgrade veterans’ hospitals and federal buildings;
    4. Solidify the infrastructure of our care economy by creating jobs and raising wages and benefits for essential home care workers;
    5. Revitalize manufacturing, secure U.S. supply chains, invest in R&D, and train Americans for the jobs of the future; and
    6. Create good-quality jobs that pay prevailing wages in safe and healthy workplaces while ensuring workers have a free and fair choice to organize, join a union, and bargain collectively with their employers. 
  • A tax plan which is expected to raise $125 billion per year or 0.5% of GDP. Its major provisions include:
    1. Raise the corporate tax rate from 21% to 28%; 
    2. Create a corporate minimum tax; 
    3. Double the tax rate on Global Intangible Low Tax Income from 10.5% to 21%; 
    4. Impose a 12.4% payroll tax on earnings above $400,000; 
    5. Raise the top rate for individual taxable incomes above $400,000 from 37% back to the pre-Trump tax cut level of 39.6%, 
    6. Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% for incomes above $1 million; and
    7. Ramp up IRS enforcement.
  • A second human infrastructure plan, with details to be announced later, with a focus on education, paid leave, and healthcare.

 

 

A supportive Federal Reserve

Jerome Powell, a Republican who was appointed to the Fed Chair by President Trump, has surprisingly been supportive of Biden’s agenda. Former Fed economist Claudia Sahm explained Powell’s transformation in a New York Times OpEd:
One of Mr. Powell’s greatest strengths may be that before joining the Fed he had not spent his career steeped in macroeconomics, as his two predecessors had. He’s been an avid learner, but also a critical thinker. In a 2018 speech that continues to age well, he took a tactful, almost playful, jab at the high priests of macroeconomics, criticizing some key metrics the Fed was using to guide its policymaking. Translated into plain English, he told them that many of the metrics are effectively made-up numbers.

 

It’s no accident that under his leadership the Fed adopted a new framework that emphasizes the employment mandate. It’s grounded in what he learned from people on a review tour called “Fed Listens,” which included community leaders and ordinary workers who pushed him to support more job creation among low- and moderate-income people.

Fed governor Lael Brainard made two speeches on the same day affirming the Fed’s support of Biden’s objectives. The first speech was to the National Association for Business Economics on March 23, 2021 in which she affirmed that the Fed is monitoring “shortfalls from employment” rather than a “maximum employment” benchmark. 

The FOMC has communicated its reaction function under the new framework and provided powerful forward guidance that is conditioned on employment and inflation outcomes. This approach implies resolute patience while the gap closes between current conditions and the maximum-employment and average inflation outcomes in the guidance.
 

By focusing on eliminating shortfalls from maximum employment rather than deviations in either direction and on the achievement of inflation that averages 2 percent over time, monetary policy can take a patient approach rather than a preemptive approach. The preemptive approach that calls for a reduction of accommodation when the unemployment rate nears estimates of its neutral rate in anticipation of high inflation risks an unwarranted loss of opportunity for many of the most economically vulnerable Americans and entrenching inflation persistently below its 2 percent target.11 Instead, the current approach calls for patience, enabling the labor market to continue to improve and inflation expectations to become re-anchored at 2 percent.

Brainard also gave a nod to the labor market inequality problems that the Fed faces in monitoring the jobs market.
Although the unemployment rate has moved down 1/2 a percentage point since December, the K-shaped labor market recovery remains uneven across racial groups, industries, and wage levels. The employment-to-population (EPOP) ratio for Black prime-age workers is 7.2 percentage points lower than for white workers, while the EPOP ratio is 6.2 percentage points lower for Hispanic workers than for white workers—an increase in each gap of about 3 percentage points from pre-crisis lows in October 2019.

 

Workers in the lowest-wage quartile continued to face staggering levels of unemployment of around 22 percent in February, reflecting the disproportionate concentration of lower-wage jobs in services sectors still sidelined by social distancing.5 The leisure and hospitality sector is still down almost 3.5 million jobs, or roughly 20 percent of its pre-COVID level. This sector accounts for more than 40 percent of the net decline in private payrolls since February 2020. Overall, with 9.5 million fewer jobs than pre-COVID levels, we are far from our broad-based and inclusive maximum-employment goal.
In a second speech on the same day to the “Transform Tomorrow Today” Ceres 2021 conference, Brainard announced that the Fed is now monitoring climate change:
The Federal Reserve created a new Supervision Climate Committee (SCC) to strengthen our capacity to identify and assess financial risks from climate change and to develop an appropriate program to ensure the resilience of our supervised firms to those risks.6 The SCC’s microprudential work to ensure the safety and soundness of financial institutions constitutes one core pillar of the Federal Reserve’s framework for addressing the economic and financial consequences of climate change.

 

Climate change and the transition to a sustainable economy also pose risks to the stability of the broader financial system. So a second core pillar of our framework seeks to address the macrofinancial risks of climate change. To complement the work of the SCC, the Federal Reserve Board is establishing a Financial Stability Climate Committee (FSCC) to identify, assess, and address climate-related risks to financial stability. The FSCC will approach this work from a macroprudential perspective—that is, one that considers the potential for complex interactions across the financial system.
Biden is fortunate that the political consensus allows both fiscal and monetary policy to be pushing in the same direction.

 

 

Measuring market impact

For investors, what does Biden’s plan mean for the markets? Here is what I am watching.

 

The main drivers of equity returns are earnings and interest rates. Rates will undoubtedly rise, and the 10-year Treasury yield recently rose as high as 1.75%. Aswath Damodaran at the Stern School of Business at NYU explained the analytical framework this way. 
  • If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments. 
  • If rising rates are primarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power. 
The key question is whether the market interprets the outlook as reflationary or inflationary. John Authers offered an outside-the-box interpretation that the Phillips Curve, which posits a tradeoff between inflation and unemployment has been globalized. The investment implication is to monitor trade policy.
Another issue concerns globalization. A key reason for believing that inflation is about to rise comes from the Phillips Curve, which in simple terms posits a trade-off between unemployment and price increases. Reducing unemployment, as policymakers are determined to do at present, will lead to higher inflation, all else equal. 

 

But all else isn’t equal, and for the last four decades at least we’ve had steady globalization. That means that in an open economy, fewer workers doesn’t mean higher pay, it means a greater likelihood that employers will look overseas. Indeed in Germany, unions negotiate to maintain jobs at the expense of wage rises, because they are aware of competition from abroad. Thomas Aubrey of Credit Capital Advisory in London shows that over time in the U.K., the curve is flatter (meaning there is less of a trade-off) when the economy is more open to trade. And it is a process that can repeat itself. Aubrey points out that textiles jobs in China are leaving for cheaper countries, now that wage demands are growing.

 

All of this suggests that the critical variable to watch in the next few years concerns trade policy, rather than fiscal or monetary policy. If the world really does reset into two rival blocs that attempt to minimize trade with each other, as is possible if U.S.-China relations come out at the worse end of expectations, then the logical consequence would be a return of inflationary dynamics to the West.
I had previously highlighted research from Joseph E. Gagnon at the Peterson Institute which argued that if Biden’s fiscal stimulus is viewed as short-term, the market will not interpret it as inflationary. He compared the fiscal boost during the Korean War compared to Johnson’s guns and butter policy during the Vietnam War and became a permanent feature of the budget. Assuming that the additional bill for Biden’s American Rescue Plan is $3-4 trillion spread over eight years, will the market view such amounts to be large enough to have an inflationary impact?

 

 

Even if we were to embrace Johnson’s Great Society inflationary spiral analogy, the historical precedence wasn’t immediately equity bearish. Marketwatch documented Fidelity’s Jurrien Timmer’s 1960s historical analog to the present era. If history is any guide, the bull market would still have several years to run.

 

 

Timmer also offered an alternative scenario where “Powell and Yellen’s game plan is evocative of the World War II playbook”.

To mobilize against World War II, federal debt tripled, the Fed’s balance sheet swelled by 10-fold and the Fed capped both short- and long-dated interest rates below the rate of inflation. Granted, the current playbook isn’t quite that aggressive — the Congressional Budget Office’s forecast for the national debt in 2030 is only 6% higher than it was before the COVID-19 pandemic — but directionally it is similar.

 

 

Both the 1960s and World War II scenarios are equity bullish for the next few years. If investors were to accept Timmer’s analysis, they shouldn’t be overly worried about unproductive inflation in the immediate future. Don’t forget, the forward markets have a habit of playing Chicken Little in overestimating inflation and the timing of the Fed’s rate hikes. The current forecasts call for a rate hike to occur in late 2022, will traders be right this time?
 

 

What about the threat of higher corporate and individual tax rates? Won’t that spook the stock market? Even Ed Yardeni, who is no fan of liberal economics, has turned pragmatically bullish on equities.
I am raising my S&P 500 operating earnings forecast for 2021 from $175 per share to $180, a 27.8% y/y increase from 2020. I am also raising my 2022 forecast from $190 to $200, an 11% increase over my new earnings target for this year. I would have raised my 2022 estimate more but for my expectation that the Biden administration will raise the corporate tax rate next year…

 

One of my accounts asked me whether I should lower my outlook for the forward P/E given that I am predicting that the 10-year US Treasury bond yield is likely to rise back to its pre-pandemic range of 2.00%-3.00% over the next 12-18 months.

 

Normally in the past, I would have lowered my estimates for forward P/Es in a rising-yield environment. However, these are not normal times. In the “New Abnormal,” valuation multiples are likely to remain elevated around current elevated levels because fiscal and monetary policies continue to flood the financial
As a reminder, the Trump tax cuts boosted S&P 500 earnings by about 9% on a one-time basis and the Biden proposal only partially unwinds some of Trump’s cuts. Ed Clissold of Ned Davis Research estimates that it would cut earnings by 4-13%. Other Wall Street firms have differing estimates clustered in the Ned Davis range. Goldman Sachs has estimated that a full Biden corporate tax increase would cut S&P 500 earnings by 9%.. BoA has estimated a 7% hit to earnings. However, there is speculation that the Democrats would not be able to push through a full tax increase to a 28% rate, but to a reduced level instead. To some extent, some tax increases are already priced into the market. Investors are more open to shrugging off tax increases if the economy is booming.

 

 

In conclusion, while we don’t know the full details of Biden’s American Rescue Plan, its short-term effects are likely to be reflationary, which is equity bullish, while its long-term effects have a possibility of being inflationary, which is equity unfriendly. Much depends on the inflation outlook, which is uncertain at this time. This is not the time to worry just yet. Equity investors should adopt a positioning attitude of “party now, and (maybe) pay later”.

 

 

 

Making sense of the Archegos Affair

Posted by Cam Hui -

Mid-week market update: You can tell a lot about the character of a market by how it reacts to news. In response to the Archegos Affair, the contagion effect has mostly been contained. Other than the share prices of Nomura, Credit Suisse, and the liquidated stocks, the market averages have been steady and this is not a repeat of the Long-Term Capital Management debacle.
 

Still, there are still nagging doubts about pockets of hidden financial leverage in the banking system. Is there another shoe waiting to drop?

 

 

 

An accident waiting to happen

This sort of financial accident is no surprise. Bloomberg reported that the use of leverage is common among the super-rich:

More than 10% of the world’s 500 richest people have committed stock for a combined $163 billion, according to an analysis by the Bloomberg Billionaires Index based on the latest disclosures available. That represents almost a fifth of their public holdings, up from about $38 billion four years ago and double the pledges after last year’s market bottom in March, when 40 of the wealthiest had pledged shares, the data show.

In a bull market, that’s not a problem. From a systemic risk perspective, however, the biggest exposure for banks is Asia:

Committing stock is especially common in Asia, where state-owned banks dominate financial markets and high-growth companies need to find different sources of funding. In mainland China, where top shareholders in initial public offerings typically have their stakes locked for 36 months, the practice can help them get liquidity while maintaining their voting rights.

 

 

A bad year for hedge funds

Archegos’ problems were compounded by the poor returns exhibited by hedge funds this year. While hedge fund returns have historically been correlated to stock prices, 2021 has been an exception. 

 

 

Already, Wall Street is searching for crowded longs in hopes of identifying the next margin liquidation candidate. Here is one list from Jeffries.

 

 

As confirmation of my recent bullish view on value and cyclical stocks, I would point out that there are no banks or energy stocks, which are value favorites, on that list. Surprisingly, there are no semiconductor stocks on the list, which may represent a pocket of opportunity for investors seeking cyclical exposure.

 

 

Still a bull market

I previously observed that this is a bifurcated market and that assertion still stands. Both the Dow and the Transports have made fresh all-time highs, which continue to trigger Dow Theory buy signals.

 

 

Despite today’s rally, the technology-heavy NASDAQ 100 is mired below its 50 dma and it is struggling to hold a key relative support zone.

 

 

The combination of the market’s inability to respond to bad news and positive market internals tells me that it wants to go higher. The percentage of S&P 500 stocks above its 200 dma is above 90% again, which is a “good overbought” condition that is indicative of positive price momentum.

 

 

Stay bullish. Focus on the value and cyclical names and avoid growth stocks. Fund flows into value ETFs (dotted blue line) is just starting. As more value stocks enter price momentum baskets, the price momentum factor will start to turn positive and spark another round of positive fund flows into momentum (read: value) stocks.

 

 

 

Disclosure: Long IJS

 

Turkey: Contrarian opportunity or value trap?

Posted by Cam Hui -

It has been a week since Recep Erdoğan`s decision to fire Turkey`s central-bank governor, Naci Agbal, for raising interest rates. Both Turkey`s stock market and currency, the Turkish lira (TRY), have shown some signs of stabilization after a dramatic drop last Monday. However, TRY weakened today but the fall is likely attributable to the fears of a margin call contagion despite a Bloomberg report that the new central bank governor’s refused to commit to an interest cut.

Turkish central bank Governor Sahap Kavcioglu said markets shouldn’t take for granted that he’ll cut interest rates as soon as April, when he sets monetary policy for the first time since his surprise appointment.
 

“I do not approve a prejudiced approach to MPC decisions in April or the following months, that a rate cut will be delivered immediately,” Kavcioglu said in a written response to questions emailed by Bloomberg News, referring to monetary policy committee meeting next month.
 

“In the new period, we will continue to make our decisions with a corporate monetary policy perspective to ensure a permanent fall in inflation. In this respect, we will also monitor the effects of the policy steps taken so far,” Kavcioglu said.

From an equity perspective, the MSCI Turkey ETF (TUR) is oversold and it is testing a key relative support level.
 

 

Do Turkish stocks represent a contrarian buying opportunity or a value trap?

 

 

The bull case

Here is the long-term bull case. Turkey is a country of 80 million people with very attractive age demographics. It is perched near a very large market, the European Union, with an aging population. The country is incredibly young and offers enormous potential for growth.

 

 

The stock market is statistically cheap based on forward P/E and it has always been that way for 20 years. Note, however, the latest figure was calculated before the currency devaluation. The P/E multiple will experience some flux as it will take some time for analysts to adjust the E in the forward P/E to the devaluation.

 

 

That’s the good news.

 

 

Key risks

The bad news is awful macro-management and a lack of political stability. This Economist article sums up Turkey’s challenges [empahsis added]:
Mr. Erdogan’s macroeconomic muddles and meddling reflect both his own intellectual confusion and the inconsistent demands of his supporters. Turkey’s construction industry, which ensures growth and jobs, thrives on easy credit. That contributes to inflation and a flight from the lira. But Turks, especially merchants and small-business folk, who keep much of their money in dollars or euros, vehemently oppose exchange controls. The result is an unstable currency and unstable prices. Turkey is trying to emulate China’s growth strategy (featuring state-backed credit for property and infrastructure investment) without the benefit of its docile depositors and trapped savings.
Now that 10-year Treasury yields are rising and their spreads against 10-year Bunds and JGBs are widening, this will put upward pressure on the USD, and downward pressure on vulnerable EM currencies like the TRY.

 

 

The article concluded:

[Investors] should heed the country’s cautionary tale: if you rely on foreign capital it is risky to compromise central bank independence, especially when global interest rates are rising. Emerging-market investors will treat Turkey as an unfortunate exception only for as long as emerging-market policymakers learn from its unfortunate example. 

 

 

Blood in the streets?

Contrarians buy when there is blood running in the streets. Is the latest currency devaluation episode enough to warrant a “blood in the streets” call?

 

The market does appear to be cheap relative to MSCI All-Country World ex-US (all figures in USD). TUR is testing an area of key relative support. 

 

 

While elections are not scheduled until 2023, a recent poll done during the period March 7-12 shows Tayyip Erdoğan trailing his potential opponents. Two years is a long time in politics, but the potential for a change in government and greater stability is tantalizing for investors.

 

 

In conclusion, the Turkish market represents an intriguing opportunity for contrarian investors. While I don’t know if last week’s -16% decline in USD terms and subsequent stabilization represents a capitulation bottom, long-term investors can start to accumulate a position at these prices.

 

Will portfolio rebalancing sink equities?

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.
 

 

Theme du jour: Rebalancing

I had a discussion last week with another investment professional about the possible short-term asset price effects of portfolio rebalancing. Equities had handily beaten fixed income investments during the quarter, and balanced fund managers will have to rebalance their portfolios by selling stocks and buying bonds.

 

 

How important is the rebalancing effect? It seems that all the trading desks are talking about it. To add to the confusion, JPMorgan’s derivatives analyst Marko Kolanovic put out a research note stating that “there will be no monthly selling, and indeed there could be buying of equities into month-end. A lack of these flows, and broad anticipation of ‘month/quarter-end’ effect, could result in the market moving higher near term, all else equal.”

 

What’s the real story?

 

To answer that question, I conducted an historical simulation to measure the effects of portfolio rebalancing on stock and bond returns. I conclude from this study that fund flow concerns over quarter-end portfolio rebalancing are overblown. 

 

 

An asset rebalancing study

To answer that question, I conducted a simulation to measure the effects of portfolio rebalancing on stock and bond returns. 

 

I formed a portfolio consisting of 60% SPY (S&P 500 ETF) and 40% AGG (US Aggregate Bond Index). Portfolio weights are rebalanced to 60/40 on the last day of the quarter, but allowed to drift during the quarter. All returns used were total returns, which includes dividends and interest distributions. The study period spans the period September 2003 to December 2020.

 

I measured the possible effects of two rebalancing approaches. The anticipatory approach makes a decision on rebalancing the month-end before quarter-end. The reactionary approach makes the rebalancing decision on the last day of the quarter. In both cases, I measured the returns of SPY and AGG from the decision date.

 

The following chart shows the median one-month SPY returns based on differing decision rules and further disaggregates each decision by the difference between SPY and AGG weights on the decision date. For example, the light blue bars show the returns when the difference in asset weights were +/- 1% or more, while the darkest blue bars show the returns when the weight differences were +/- 4% or more.

 

The surprising result from this study was there was little or no anticipatory rebalancing effect. SPY returns were not significantly different regardless of whether the portfolio approached quarter-end with an overweight or underweight equity position. However, there was a significant catchup effect in the following month if the portfolio was underweight equities. Other anticipatory tests using a two and three week lookahead time horizon, whose results are not shown, also displayed similar results of no rebalancing effect.

 

 

The study also shows that there was no significant rebalancing effect on bond market returns, either before or after quarter-end. Returns weren’t significantly different whether the portfolio was overweight or underweight an asset class. In fact, there was a slight perverse anticipatory effect that bonds outperformed when the portfolio neared quarter-end while underweight equities and overweight bonds. In that case, the normal reaction would be to buy stocks and sell bonds, but bonds showed slightly better returns under those circumstances.

 

 

I conclude from this study that fund flow concerns over quarter-end portfolio rebalancing are overblown. Investors need to recognize that institutional portfolios rebalance in two ways, at the discretion of the manager, and at the discretion of the plan sponsor. Managers will only have the discretion to rebalance a portfolio if they have a balanced fund mandate, and balanced fund mandates are usually only given out by relatively small funds. By contrast, a large asset owner such as a pension plan or an endowment fund hires managers based on individual mandates, such as US small-cap equities, venture capital, and international bonds. Each mandate has a very specific benchmark and managers are expected to be fully invested at all times. The large asset owner only rebalances very infrequently, mainly because the owner needs to undergo the unwieldy process of informing some managers that it is redeeming portions of the funds under management and informing other managers it is re-allocating to their funds.

 

A long-term study of public pension fund allocations shows that their aggregate equity allocations have been on the overweight equities compared to the conventional 60/40 model while fixed-income allocations is mired in the 20-30% range.

 

 

 

A “Great Ball of Money”

In the meantime, traders and investors have to be aware of what Tracy Alloway at Bloomberg calls a “great ball of money”.
Years ago I wrote that “China’s markets resemble nothing if not a great rolling ball of money that moves from asset class to asset class, constantly searching for the next source of sizable returns.” In a country marked by capital controls, excess liquidity is effectively trapped and forced to ricochet like a pinball in a machine. Skilled investors in China’s markets are able to identify where this money will flow to next, scouring policy statements for hints of government initiatives or for signs that authorities might clamp down on a particular company or market, and watching message boards and the like for retail trends.

 

There are signs the U.S. is now going down a Chinese-style ball-of-money path too. Sloshing liquidity courtesy of a dovish central bank will probably end up ping-ponging between U.S. assets. While some of it might leak out of the States, viable alternatives to U.S. assets are limited with yields now low around the world (Chinese bonds and stocks are definitely an alternative, but there’s also limited supply for overseas investors). At the same time, investors will probably do well to eye increased government spending and fiscal stimulus for signs of where money might go to next. Money released by the state doesn’t flow evenly to all things and everyone. Pinpointing exactly where it’s going is getting even more important. In this kind of environment, market bubbles don’t necessarily burst so much as roll from one thing to the next.

 

The “great ball of money” has touched meme stocks, SPACs, and cryptocurrencies. The latest beneficiary appears to be reflation stocks. Compare the technical conditions of the DJIA, which is a proxy for value and cyclical plays, to that of the growth-heavy NASDAQ 100. The DJIA is holding above its 50 dma, while the NASDAQ 100 has been unable to regain its 50 dma. As well, the percentage bullish on point and figure are all significantly better for the DJIA than the NASDAQ 100.

 

 

In addition, more value names are entering the price momentum basket. As the following chart shows, median valuations for the high momentum quintile (top 20%) are actually cheaper than median Russell 1000 valuations. This is an unusual condition that hasn’t happened since early 2017.

 

 

This will create a tailwind for value stocks as momentum players pile into them. 

 

 

An upside breakout

Tactically, the S&P 500 is tracing out an upside breakout from a bull flag within a well-defined uptrend. Value stocks as leaders and growth stocks as laggards. The upside breakout was remarkable in the face of the reported forced large margin liquidation of Tiger Cub Archegos holdings on Friday. The affected stocks were mostly Chinese tech companies such as Baidu, Tencent and Vipshop, though ViacomCBS and Discovery were also hit hard, according to Yahoo Finance.
A liquidation of holdings at several major investment banks with ties to Tiger Cub Archegos Capital Management LLC contributed to an unseen daily decline Friday in shares of stocks including Discovery, Inc. and ViacomCBS Inc., according to people familiar with matter.

 

Shares of media conglomerate ViacomCBS fell 26% while Discovery dropped 27% Friday, recovering from far steeper losses. The degree of the declines was unprecedented and occurred in an otherwise orderly market.

 

Early selling came through so-called block trades from Goldman Sachs & Co., which offered over 30 million shares of ViacomCBS in midday trading. Morgan Stanley, earlier in the day, offered over 15 million shares of Discovery, according to people familiar with the matter.

 

 

The NYSE McClellan Oscillator (NYMO) bounced off an oversold level last week. Historically, such conditions have been reasonably good signals for market bottoms and possible rallies.

 

 

While the market is short-term overbought and 1-2 day outlook probably indicates either a pullback or consolidation, the odds favor higher stock prices in the coming week.

 

 

 

Disclosure: Long IJS

 

Has the reflation trade become too crowded?

Posted by Cam Hui -

In light of last week’s partial NASDAQ reversal, I had a number of discussions with readers about whether the reflation trade has become overly consensus and crowded. To be sure, bond prices have become wildly oversold while the cyclically sensitive copper/gold ratio has surged upward and appears extended.
 

 

Is the reflation trade, which is another shorthand for cyclical and value stocks, due for a reversal?

 

There is a definite risk that the reflation trade is overdone in the short-term and a reversal can happen at any time. However, a bottom-up technical review and a top-down macro review indicate that the reflation investment theme is showing no signs of intermediate-term weakness. Investors should view any weakness in value and cyclical stocks as opportunities to buy the dip.

 

 

A factor and sector review

To answer that question, I conducted a factor and sector review using a framework of analyzing the index representing a factor or sector and the relative return of the index to the S&P 500.

 

Let’s begin with growth stocks, which had been the market leaders. The Russell 1000 Growth Index has violated rising uptrend lines both on an absolute and relative basis. The weakness is particularly striking on the relative performance chart (bottom panel), which shows a well-defined rounded top.

 

 

The technology sector is the largest sector among growth stocks. Technology shows a similar pattern of a troubled uptrend and a relative topping pattern.

 

 

The one bright spot within growth sectors was communication services, which exhibited strong absolute and relative strength owing to the superior performance of its two largest components, GOOG and FB – until recently.

 

 

From a factor perspective, the consumer discretionary sector can be divided into two. The growth heavyweights are AMZN and TSLA, while the remainder can be classified as more traditional cyclical stocks. AMZN has topped out and has been trading sideways since last summer, and the lack of relative strength can be seen clearly in the bottom panel. TSLA began weakening in early 2021, though its relative uptrend remains intact.

 

 

In contrast to the faltering growth names, value stocks are performing much better. The Russell 1000 Value Index remains in a well-defined uptrend. The index also made a relative saucer-shaped bottom last summer and its relative uptrend is intact.

 

 

The technical patterns of sectors in the cyclical and value categories are all very similar to each other. Take financials as an example. Financial stocks remain in an absolute uptrend despite the recent weakness when it flashed a 5-day RSI oversold signal last week and rebounded. Relative to the S&P 500, this sector is showing the typical saucer-shaped relative bottoming pattern of value stocks.

 

 

Energy has recently been another favorite among the value and cyclical crowd. Energy is also in an uptrend after recovering from an oversold condition. It also remains in a relative uptrend.

 

 

Material stocks are also in an absolute uptrend, though the relative uptrend is a bit choppy.

 

 

I wrote earlier that consumer discretionary stocks can be divided into two groups. The heavyweights are growth stocks, AMZN and TSLA, while the remainder represents cyclical plays. An analysis of the equal-weighted consumer discretionary sector which lessens the impact of its growth components shows that this sector is in strong absolute and relative uptrends.

 

 

Industrial stocks are also considered to be value and cyclical plays. This sector is one of the relative laggards within the factor group. The sector is in an absolute uptrend, but its relative performance is more uneven.

 

 

The remaining sectors of the market, namely healthcare, utilities, and real estate, can be classified as defensive in nature. Most have started to bottom relative to the S&P 500 during the January to March period but none are exhibiting leadership characteristics.

 

 

In summary, a technical review of market leadership shows widespread evidence that the reflation trade is strong. There are few signs of technical deterioration that warrant significant caution.

 

 

Top-down support for the reflation bull

In addition, the macro backdrop is also supportive of the reflation trade. Leading indicators of the jobs market such as temporary employment and the quits/discharge ratio are signaling further gains in employment.

 

 

Central banker rhetoric has pivoted from fighting inflation to full employment, which is also supportive of economic growth.

 

 

From a bottom-up perspective, Evercore-ISI’s company surveys are showing a bullish pattern of economic recovery.

 

 

As well, March flash PMIs show that the US continues to lead the major developed economies, but the UK and eurozone are rebounding strongly.

 

 

Lastly, FactSet announced that a record number of S&P 500 companies had issued positive earnings and sales guidance for the next quarter.
 

 

 

Value, growth and rates

More importantly, rising rates haven’t really dented the reflation trade. Take a look at the relative performance of different cyclical industries to the S&P 500 and the 10-year Treasury yield. In particular, interest-sensitive stocks like homebuilding is on fire despite the rise in yields.

 

 

What about the recent reversal in yields? Aren’t growth stocks more sensitive to interest rates and won’t a bond market (price) rally spark a surge in the growth sector? 

 

 

There is no question that the bond market has sold off too quickly and a relief rally may already be underway. The big picture, however, tells another story. An analysis of the history of the 10-year Treasury yield from 1990 shows that there were 14 episodes when the yield became overbought (and therefore bond prices became oversold). Of the 14 episodes, yields fell in six instances (shown in pink) and either stabilized or rose in eight (grey). However, this analysis occurred during a period when yields had been in a long-term downtrend. If we throw out the occasions when yields were above the 10-year trend, yields fell only in one instance and either stabilized or rose in five. Since the current circumstances fall into that category, the odds argue for further increases in yields.

 

 

In conclusion, there is a definite risk that the reflation trade is overdone in the short-term and a reversal can happen at any time. The latest BoA Global Fund Manager Survey shows that positioning has shifted into the cyclical trade in a big way.

 

 

However, a bottom-up technical review and a top-down macro review indicate that the reflation investment theme is showing no signs of intermediate-term weakness. Investors should view any weakness in value and cyclical stocks as opportunities to buy the dip.

 

Year 2 of the bull

Posted by Cam Hui -

Mid-week market update: The equity bull market began about a year ago. Ryan Detrick observed that the second year of past major bulls have averaged gains of 16.9%, though investors should not ignore pullback risk.
 

 

Risk on!

 

 

Animal spirits

Bullish readings are confirmed from a long-term perspective by a combination of strong MACD momentum and the emergence of market animal spirits. Past bullish crossovers of the monthly MACD histogram have marked strong buy signals (blue vertical line), though bearish crossovers (red lines) have been less effective sell signals. In addition, while most analysts have scrutinized option call and put activity for short-term trading signals, a big picture view of the equity call/put (inverse of the put/call ratio, top panel) shows that a steadily rising equity call/put ratio has also defined bull phases. Moreover, a rising 200 dma of the equity call/put ratio (red line) has coincided with MACD buy signals.

 

 

 

What could dent this bull?

 

 

An EM crisis?

Could an emerging market currency crisis halt this bull market? It doesn’t appear so. The Turkish lira came under pressure when Erdogan replaced the head of Turkey’s central bank for raising interest rates. The Turkish lira (TRY) cratered on the news but stabilized within a day.

 

 

BBVA is a Spanish bank that a high degree of Turkish exposure. Its shares fell, but the price action could hardly be described as a crash and it has stabilized.

 

 

The same could be said of the Turkish stock market, which fell dramatically on Monday but it is not trading at a key support level relative to MSCI Emerging Markets ex-China.

 

 

There was also no contagion effect felt in a vulnerable EM currency like the South African Rand.

 

 

The Turkish lira crisis is turning out to be a non-event like the Dubai World restructuring of 2010 when Dubai World teetered on the edge of bankruptcy. Coming so soon after the GFC, there were fears of financial contagion at the time which never materialized.

 

 

Seasonal headwinds

What about the recent market weakness? Mark Hulbert found that major sports events can have a depressing effect on stock prices.
If you are a short-term trader, note that tip-off in the first game of this year’s March Madness is 4 p.m. Eastern time on Mar. 18. The tournament ends with the championship game on the evening of Apr. 5.

 

The correlation between sports and the stock market was documented by a study published a number of years ago to in the Journal of Finance. Entitled “Sports Sentiment and Stock Returns,” its authors were finance professors Alex Edmans of the London Business School; Diego Garcia of the University of Colorado at Boulder; and Oyvind Norli of the BI Norwegian Business School.

 

After studying more than 1,100 soccer matches, the professors found that, on average, a given country’s loss in the World Cup elimination stage is followed by its stock market the next day producing a return that is significantly below average. Though they focused primarily on the World Cup, they also studied cricket, rugby and basketball matches as well.

 

Crucially, the researchers did not find a symmetrically positive stock market impact following a World Cup win. They speculate that this is because a win merely means that a country’s team advances to the next round, while elimination is final. As a result, losing teams’ fans are likely to be more despondent than winning teams’ fans will be exuberant.

 

The logical consequence of this asymmetry: global stock markets should experience abnormal levels of selling during the World Cup and, therefore, below-average returns. And, sure enough, that is exactly what was found by another academic study, this one by Guy Kaplanski of the Bar-Ilan University in Israel and Haim Levy of the Hebrew University of Jerusalem.
Hulbert went on to analyze stock market returns during March Madness and he found a negative effect (caution, n= 7).

 

 

 

An internal rotation

First, equities have performed so well against bonds that large balanced funds are compelled to re-balance their holdings by selling stocks and buying bonds at or around quarter-end.

 

 

We are already seeing some of that re-balancing effect. Bond prices have exhibited positive RSI divergences for several weeks and they are finally turning up. The open question is how long the rally can last. One key test will be tomorrow’s 7-year Treasury auction. If it doesn’t go well the bond rally could reverse itself very quickly.

 

 

Growth stocks have also been bid while value and cyclical names have weakened. This all appears to be part of the re-balancing trade overhanging the market. Despite the strength in growth stocks, the NASDAQ 100 has yet to regain its 50 dma and it has barely rallied above a key relative support zone as measured against the S&P 500. The high-octane ARK Innovation ETF (ARKK) is also struggling relative to the S&P 500.

 

 

By contrast, the Russell 1000 Value Index remains in a well-defined uptrend, both on an absolute basis and relative to the S&P 500.

 

 

In conclusion, the bull is still alive. The recent market weakness is only temporary. Stay with the market leaders of value and cyclical stocks.

 

 

Disclosure: Long IJS

 

A new trading framework

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.
 

 

A tale of two markets

It was the best of times. It was the worst of times. This doesn’t happen very often, but the character of the stock market has made an abrupt turn recently, as evidenced by the performance disparity between the S&P 500 and the NASDAQ 100. 

 

The weekly chart of the S&P 500 shows that it survived a brief corrective scare, but the index went on to fresh highs. By contrast, the growth-heavy NASDAQ 100 is acting like a sick puppy. NDX violated a rising trend line and last week’s rally attempt was rejected at the 50 dma level.

 

 

The violent change in market character, or leadership, has created a two-tiered market of extreme winners and losers. Traders need to be aware of this shift and adjust their analytical framework accordingly.
 

 

The Great Rotation

When bull market cycles mature and end, market leadership changes. This is evident with the behavior of value and growth stocks, which I have called the Great Rotation. Growth had been leading for years, but value bottomed out against growth last summer and began to turn up in late 2020. The effects of the Great Rotation can be seen by the relative strength of the Russell 1000 Value Index (large-cap value) against the S&P 500 (bottom panel). The performance turnaround of small-cap value, as measured by the Russell 2000 Value Index, was even more dramatic.

 

 

In light of these changes in market leadership, the task of analyzing overall market direction, as measured by the S&P 500, becomes especially challenging. Traders are advised to separate the performance of growth and value stocks separately in order to get a clearer view of the technical picture.

 

 

Growth’s stagnant outlook

Let’s begin with growth stocks, which is proxied by the NASDAQ 100 (NDX). From a technical analysis perspective, the growth stock outlook can be analyzed using NASDAQ-only breadth and momentum indicators in order to separate the action of growth and value stocks.

 

NDX bounced off an area of major support while exhibiting a positive 5-day RSI divergence in early March. The index was also oversold as measured by the percentage of stocks above their 50 dma. The rally met but couldn’t overcome overhead resistance at its 50 dma and the index has since pulled back.

 

 

The bull case is speculative risk appetite remains intact. Bitcoin prices are highly correlated to the relative performance of the ARK Innovation ETF to the S&P 500. In the short-term, this is a bullish divergence supportive of better returns.

 

 

On the other hand, the relative performance of NDX is inversely correlated to bond yields. The 10-year Treasury yield has surged above 1.7%, which has to put downward pressure on the attractiveness of growth stocks.

 

 

Is this bullish or bearish for growth stocks? Call it a wash. It’s difficult to discern a strong tradable signal for growth stocks, other than to observe that they are in an intermediate-term relative downtrend.

 

 

Value: The new leadership

Even as growth stocks struggled, value stocks have performed much better. While the relative performance of large-cap value and growth can be measured by the Russell 1000 Value and Russell 1000 Growth Indices, one quick proxy for value and growth would be the relative returns of the Dow against the NASDAQ 100. 

 

The Russell 1000 Growth Index (bottom panel) staged an oversold rally that was halted at the 61.8% Fibonacci retracement resistance level. By contrast, the Russell 1000 Value (middle panel) continues to grind upwards. In short, value stocks are in a well-defined uptrend while growth stocks have faltered.

 

 

The established strength of value stocks makes a “buy the dip” strategy an attractive proposition for traders. The NYSE McClellan Oscillator (NYMO) made a double oversold bottom in late February and early March and the S&P 500 subsequently rallied. NYMO readings have come off the boil and retreated off a near-overbought condition. I interpret this as a constructive intermediate-term bullish condition for value stocks.

 

 

In the short-run, the price weakness seen late last week makes the S&P 500 ripe for a relief rally. 

 

 

Short-term breadth for the DJIA. which as a proxy for value and cyclical stocks, are flashing a similar oversold reading. Expect market strength during the first half of the week.

 

 

In conclusion, the character of market leadership has shifted dramatically, leading to a two-tier market. There is no longer a single stock market, and technicians need to analyze growth and value stocks separately. Growth stocks have been struggling and should generally be avoided. Value stocks are in an intermediate-term uptrend, and traders should adopt a “buy the dip” strategy. Current technical conditions for value are nearing an oversold reading, and the risk/reward for value bulls appear favorable in the coming week.

 

My inner investor is bullishly positioned mainly in value and cyclical stocks. My inner trader is tactically long small-cap value stocks, which have been the recent market leaders.

 

 

Disclosure: Long IJS

 

The sum of all fears: Inflation! Inflation!

Posted by Cam Hui -

The latest BoA Global Fund Manager Survey shows that respondents believe the biggest tail-risks to be inflation and its effects on the bond market.
 

 

Are these worries overblown? How will these concerns affect asset prices?

 

 

How transitory are inflation pressures?

Recently, there has been a spate of reports about rising supply chain bottlenecks and their effects on input prices. As the global economy recovered, delivery delays have risen and so have input prices, which will undoubtedly put upward pressure on inflation statistics.

 

 

Indeed, inflation surprises have appeared all over the world.
 

 

Inflation fever is not just confined to economists and market analysts, but it is seeping into the public’s imagination. Google searches for “inflation” have spiked. 

 

 

The NFIB small business survey of pricing expectations is rising. Historically, this has led to upward pressure on core CPI.

 

 

On the other hand, the economy is arguably not poised for an uncontrolled inflationary spiral. Monetary theorists believe that inflation is purely a monetary phenomenon (PQ =  MV). The M component of that equation, M2 money supply growth has skyrocketed, but the V component, or monetary velocity, remains tame. 

 

 

In addition, Joseph E. Gagnon at the Peterson Institute argued that inflation fears from Biden’s fiscal stimulus program are overblown. For historical parallels, investors should look to the experience of the Korean War, not the Vietnam War. That’s because government spending during the Korean War was short-term and perceived as such. By contrast, LBJ’s Guns and Butter policy during the Vietnam War was long-term and affected expectations accordingly.

 

 

Marketwatch reported that BCA Research also came to the similar conclusion that one-time stimulus payments had negligible inflationary effects.

Dhaval Joshi, chief strategist at BCA Research, says whether the new stimulus is considered wealth or income depends on whether the household receiving it has a low or high income to begin with. But looking at past stimulus checks, there weren’t meaningful shifts in either consumption or inflation.

 

 

 

The Fed’s reaction function

The FOMC statement and Powell’s remarks at the post-FOMC meeting press conference made the Fed’s reaction function very clear. The Fed’s latest Summary of Economic Projections raised GDP growth, inflation, and lowered the unemployment rate. Despite the expectations of stronger growth and inflation, the median trajectory of the Fed Funds rate remained unchanged and it does not expect rate hikes until 2023. However, the “dot plot” did show a few members raising their expectations of rate hikes in 2022. 

 

This is consistent with the framework review that was unveiled at Jackson Hole last summer, which established that the Fed will not raise rates at the first signs of growth. It wants to see maximum employment and evidence of sustained higher inflation. Moreover, the Fed is increasingly focused on the jobs market and the effects of inequality.

 

Here are some of the metrics that Powell is looking at. First, one of the components of the inflationary spiral of the 1970’s was characterized by wage growth and cost-of-living adjustment clauses in union contracts. Today, wage growth is below the pre-GFC peak. Moreover, fourth quartile wage growth is lagging the overall figure, which is widening inequality. These were metrics cited by Janet Yellen when she was Fed chair as progress towards full employment. 

 

 

Keep an eye on the March 29 unionization vote of an Amazon warehouse at Bessemer, Alabama. Amazon is the second-largest employer in the US and its compensation and labor practices have profound effects all over the country. The company has successfully resisted unionization at its facilities in the past, but if unions were to gain a beachhead at Bessemer, it would be an early sign that labor is regaining its bargaining power, put greater upward pressure on wages, and be the setup for an inflationary spiral down the road.
 

In the face of a chorus on inequality, the Fed has begun to acknowledge the uneven expansion in recent years. Powell has stated in the past that he wants to see broad-based gains in employment. Black and Hispanic unemployment rates remain elevated compared to the overall rate. More progress needs to be made before the Fed considers the economy to be at full employment and pivots to tightening monetary policy.

 

 

In the past, Powell has also commented on the plunging labor force participation rates (LFPR) for those without college degrees. LFPR for this demographic began widening in 1995 and it has fallen further with each successive recession. Many job seekers in this group have become discouraged and eventually gave up, leading them to stop being counted as unemployed.

 

 

Viewed from a labor market lens, Powell’s past comments that the economy is far from normal are becoming clear. The Fed will not raise rates until it sees significant improvement in labor market internals and realized inflation rates.

 

 

The market reaction

Powell made it clear last week that he expects better economic growth, rising (transitory) inflation, and no rate hikes. While the Fed has an iron grip on the short end of the yield curve, it does not control the long end. In response, the yield curve steepened and the 10-year Treasury yield surged past 1.7%.

 

 

Rising bond yields and steepening yield curves are not unusual for an economy that recovers from a recession. However, there are several differences between this recovery and past recoveries.

 

In the past, a steepening yield curve was the mark of a stock market top. That’s because past recessions were induced by the Fed. The Fed signaled that it would tighten, and the yield curve steepened based on expectations of more rate hikes. The recession of 2020 was not induced by the Fed, but by an external event. The Fed and other global central banks flooded the system with liquidity. As the economy began to recover from the pandemic, the yield curve steepened based on the expectation of higher growth and inflation.

 

Rising bond yields will undoubtedly put downward pressure on P/E ratios. Indeed, forward P/E ratios have been falling in the last year. 

 

 

However, as long as EPS estimates are rising, the bullish effects of higher earnings will offset the bearish effects of lower P/E ratios.

 

 

For equity investors, this has several implications. When growth was scarce during the recession, investors bid up the price of growth stocks. The growth premium is receding as economic recovery is becoming evident, and investors should focus on cyclical and value parts of the stock market.

 

In particular, financial stocks should be a prime beneficiary of this environment. Banks borrow short and lend long, and a steepening yield curve enhances margins. This relationship has been strong in the past. The only disconnect occurred when the sector rallied strongly owing to the Trump tax cuts, which raised banking profitability. I would add that the Fed’s announcement Friday that it was allowing the Supplemental Leverage Ratio exemption for Treasury holdings on bank balance sheets to expire on March 31 should have minimal effect on the banking sector. I had highlighted analysis from Zoltan Pozsar of Credit Suisse indicating that the large banks had ample capital cushions and SLR expiry is expected to have minimal effects on their balance sheets (see FOMC preview: Dot plot, YCC, and SLR).

 

 

The Rising Rates ETF (EQRR) is another illustration of how investors should position themselves in the current environment. While I would not recommend buying the ETF as its assets are very low and investors run the risk that it will be wound up, the underlying portfolio is heavily weighted in value and cyclical sectors, namely financials, energy, materials, and industrials.

 

 

In conclusion, Powell has made it clear that growth will be strong, inflation is coming but it is expected to be transitory, the Fed will not raise rates, and it will not engage in yield curve control. No matter what happens to inflation expectations or bond yields, equity investors positioned in value and cyclical stocks should look forward to strong returns over the next 12 months.

 

 

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

Posted by Cam Hui -

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

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

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

 

 

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

 

 

Will the real bullish or bearish indicator please stand up

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

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

What’s the real story?

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

 

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

 

 

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

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

 

 

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

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

 

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

 

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

FOMC preview: Dot plot, YCC, and SLR

Posted by Cam Hui -

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

Nevertheless, here is what I am watching:

 

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

 

 

Timing of rate hikes

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

 

 

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

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

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

 

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

 

 

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

 

 

SLR explained

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

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

 

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

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

Here comes the recovery

Posted by Cam Hui -

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

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

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

 

 

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

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

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

 

From shutdown to re-opening

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

 

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

 

 

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

 

 

Signs of recovery everywhere

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

 

 

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

 

 

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

 

 

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

 

 

 

Momentum everywhere

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Sentiment supportive of gains

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Value/growth strength can continue

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

60/40 resilience in an inflation age

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

 

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

 

 

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

 

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

 

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

 

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

 

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

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

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

 

I have some answers.

 

 

An asset return study

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

 

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

 

 

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

 

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

 

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

 

 

Diversification, risk, and returns

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

 

 

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

 

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

 

 

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

 

 

 

An inexact roadmap

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Growth’s dead cat bounce

Posted by Cam Hui -

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

 

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

 

Growth is oversold

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

 

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

 

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

 

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

 

 

Growth bullish factors

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

 

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

 

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

 

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

 

 

S&P 500 outlook

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

 

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

 

 

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

Tech’s kryptonite, revealed

Posted by Cam Hui -

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

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

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

 

 

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

 

 

Efficiency vs. resiliency

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

 

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

 

The new OPEC

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

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

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

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

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

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

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

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

 

 

The Texas lesson

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

 

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

 

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

 

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

 

 

The pendulum swings back

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

 

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

 

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

 

 

 

Momentum crashes, market now oversold

Posted by Cam Hui -

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

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

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

 

 

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

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

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

 

Momentum crashes, S&P 500 wobbles

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

 

 

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

 

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

 

 

The momentum and growth stock massacre

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

 

 

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

 

 

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

 

 

 

An oversold market

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

 

 

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

 

 

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

 

 

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

 

 

 

Sentiment: Not out of the wood

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Buy the dip, and sell the rip

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

 

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

 

 

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

 

 

 

Disclosure: Long TQQQ

 

Are you positioned for the post Great Rotation era?

Posted by Cam Hui -

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

 

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

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

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

 

 

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

 

 

A (sort of) frothy market

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

 

 

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

 

 

 

P/E compression ahead

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Portfolio construction: Structural changes in stock-bond correlations

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

 

Bond market panic!

Posted by Cam Hui -

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

 

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

 

 

Short-term bullish

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

 

 

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

 

 

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

 

 

Downside risks

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

 

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

 

 

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

 

 

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

 

 

 

The risk of a disorderly ARK unwind

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

 

 

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

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

 

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

 

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

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

 

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

 

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

 

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

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

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

 

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

 

Disclosure: Long TQQQ
 

Q4 earnings: Good news, bad news

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

 

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

 

 

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

 

 

 

The bottom-up assessment

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

The top-up assessment

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

 

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

 

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

 

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

 

 

The fly in the ointment

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

 

 

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

 

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

 

 

The Great Rotation continues

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

More signs of a Great Rotation

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

 

 

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

 

 

A great gulf

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

 

 

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

 

 

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

 

 

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

 

 

Waiting for a small investor shakeout

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

The 56-week pattern in play?

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

 

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

 

 

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

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

 

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

 

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

 

Disclosure: Long TQQQ
 

Will rising yields sideswipe equities?

Posted by Cam Hui -

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

 

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

 

 

Reflation, or inflation?

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

 

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

 

 

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

 

 

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

 

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

 

 

 

Here comes the YOLO recovery

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

 

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

 

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

 

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

 

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

 

 

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

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

Here comes reflation.
 

 

Reflation is equity bullish

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

 

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

 

 

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

 

 

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

 

 

When does the party end?

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

 

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

 

 

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

 

 

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

 

 

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

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

 

 

Relax, and enjoy the party.