The Roaring 20’s scenario, and what could go wrong

Posted by Cam Hui -
Happy New Year! Investors were happy to see the tumultuous 2020 come to a close. The past year has been one with little precedent. A pandemic brought the global economy to a screeching halt. The stock market crashed, and it was followed by an unprecedented level of fiscal and monetary response from authorities around the world. As the year came to an end, a consensus is emerging that a cyclical recovery has begun and we are seeing the dawn of a new equity bull. Some have even compared it to the Roaring 20’s, when the world emerged from the devastation of the Spanish Flu and World War I.

 

New bull markets often start with powerful breadth thrusts. As LPL Financial documents, the second year of a new bull can also bring solid returns, albeit not as strong as the first year.

 

 

As I look ahead to 2021, I consider three key issues.
  • The economy and its outlook;
  • Market positioning and consensus; and
  • What could go wrong?

 

 

A recovering economy

Let’s start with the economy. The policy response to the crisis was unprecedented during the post-war period. Even as the unemployment rate spiked to levels not seen since the Great Depression, the combination of fiscal and monetary response put a floor on household finances. Real personal income, which includes fiscal transfers from the government. spiked even as the economy shut down. While the policy response has exacerbated an inequality problem, that’s a future issue that doesn’t concern today’s markets.

 

 

Looking to 2021, there are numerous signs that the US and global economy are recovering. Cyclically sensitive indicators such as the copper/gold and base metals/gold ratios have risen strongly.

 

 

Heavy truck sales, another key cyclical indicator, has traced a V-shaped bottom.

 

 

New Deal democrat follows the economy using a framework of coincident, short-leading, and long-leading indicators. For several months, he concluded that both the short and long-leading indicators are pointing to an economy itching to recover (my words, not his), but short-term health and fiscal policy have weighed down the coincident indicators. The latest analysis is more of the same [emphasis added].
Among the short leading indicators, gas and oil prices, business formations, stock prices, the regional Fed new orders indexes, the US$ both broadly and against major currencies, industrial commodities, and the spread between corporate and Treasury bonds are positives. New jobless claims, gas usage, total commodities, and staffing are neutral. There are no negatives.

 

Among the long leading indicators, corporate bonds, Treasuries, mortgage rates, two out of three measures of the yield curve, real M1 and real M2, purchase mortgage applications and refinancing, corporate profits, and the Adjusted Chicago Financial Conditions Index are all positives. The 2-year Treasury minus Fed funds yield spread and real estate loans are neutral. The Chicago Financial Leverage subindex is the sole negative.

 

While there were no significant changes this week, the good news is that – contrary to expectations – several of the coincident indicators made new YoY highs this week.

 

He concluded, “The pandemic and public policy reactions thereto remain in control of the data”. 

 

The $2.3 trillion spending bill signed by Trump last week, which includes $900 billion in renewed CARES Act 2.0 stimulus, should put a floor on Q1 growth even as the pandemic sweeps through the US and the economy shuts down. After Trump signed the bill into law, Goldman Sachs was the first major brokerage firm out of the gate with an upward revision to Q1 GDP growth to 5.0%.

 

 

Fed watcher Tim Duy wrote in a Bloomberg Opinion article that “Biden is Stepping Into a Dream Economic Scenario”.
The economy is instead poised for a rapid rebound for six main reasons:
First, there is nothing fundamentally “broken” in the economy that needs to heal. And unlike the last two cycles, there was no obvious financial bubble driving excessive activity in any one economic sector when the pandemic hit. There is no excessive investment that needs to be unwound and the financial sector has escaped largely unharmed.

 

Second, the indiscriminate nature of the shutdowns this past spring provides the economy with a solid base from which to grow. The economy collapsed in the spring because in the effort to get ahead of the virus, we shut down about a third of the economy on an annualized basis. That created a lot of opportunity to rebound when the unnecessary causalities of the shutdown came back online and began to grow around the virus. That process will continue.

 

Third, household balance sheets were not crushed like they were in the last recession. Instead, the opposite occurred. Reduced spending, fiscal stimulus, rising home prices and a buoyant equity market have all helped push household net wealth past its pre-pandemic peak.

 

Fourth, the demographics are incredibly supportive of growth. During the last recovery, the economy was still adapting to the Baby Boomers aging out of the workforce with a much smaller cohort of Generation X’ers behind them. The larger Millennial generation was just entering college at the time. Now, the Millennials are entering their prime homebuyer years in force and will be moving into their peak earning years. The resulting strength in housing is fueling higher home prices and durable goods spending, and we are just at the beginning of the trend. Housing activity should hold strong for the next four years.

 

Fifth, household savings have grown by more than a $1 trillion, providing the fuel for a hot economy on the other side of the pandemic. Sooner or later, that money is going to come out of savings and into the economy and I expect it to flow into the sectors like leisure and hospitality where there is considerable pent up demand.

 

Sixth, and most importantly, vaccine is coming. Pfizer Inc. announced its Covid-19 vaccine is 90% effective. Many other vaccines are in development using the same strategy as Pfizer. To be sure, it will take some time for vaccines to be widely available but once they are the sectors of the economy most encumbered by the virus (the same as those for which consumers have pent-up demand) will be lit on fire. Moreover, schools and day cares can reopen allowing parents to return to the workforce.

 

The Roaring 20’s indeed.

 

 

Market positioning and consensus

The global economic recovery is now the consensus opinion. The latest BoA Global Fund Manager Survey shows respondents expect a V-shaped recovery as vaccines become widely available by mid-2021.

 

 

As a consequence, they have piled into high beta emerging market equities for cyclical growth exposure.

 

 

 

What could go wrong?

In light of the emerging consensus of a cyclical economic recovery and new bull market, what could go wrong? I believe there are three key risks;
  • Problems with a vaccine rollout;
  • Rising inflation, which will force central banks to react and raise rates; and
  • An unexpected slowdown in China.
Deutsche Bank recently conducted an investor survey of the biggest risks to the global financial markets in 2021. At the top were fears related to the rollout of vaccines, such as virus mutations, serious vaccine side effects that curtail their use, and the reluctance of people to become vaccinated, which would impede herd immunity. 

 

 

Already, the failures of poor coordination are appearing. The FT FT reported about logistical bottlenecks are emerging in the EU, where the pace of immunization is too slow to keep up with the supply of vaccines. The NY Times lamented that a fumbled rollout has allowed vaccines to go bad in the freezer.

Of the 14 million vaccine doses that have been produced and delivered to hospitals and health departments across the country, just an estimated three million people have been vaccinated. The rest of the lifesaving doses, presumably, remain stored in deep freezers — where several million of them could well expire before they can be put to use.

 

 

From a macro perspective, the unprecedented level of monetary and fiscal stimulus has created the risk of financial instability owing to rising debt levels. Debt-to-GDP has risen to levels last seen during World War II for the developed economies and exceeded those levels for emerging economies. While nominal rates are low to negative and real rates are mostly negative today, rising inflation could put upward pressure on rates and create instability.

 

 

In the short-term, inflationary expectations are under control, and inflation surprises are occurring to the downside.

 

 

Moreover, developed economy inflation expectations are still tame. The problem of inflation, debt, and financial instability are problems in 2024 or 2025, not 2021.

 

 

 

China slowdown ahead?

I believe the key risk that could sideswipe markets is an unexpected slowdown in China. I recently observed that China is experiencing an uneven recovery (see Will Biden reset the Sino-American relationship?).
The rebound was led by fixed-asset investment and construction activity. Retail sales was the laggard. Beijing has returned to the same old formula of credit-fueled expansion. Moreover, Beijing has pivoted towards a state-owned led recovery.
A Bloomberg interview with Leland Miller of China Beige Book International (CBBI) confirmed the thesis of a hollow recovery in China. Miller warned investors to be wary of the bullish recovery signals from the commodity market. There is too much speculation in commodities. Chinese copper and steel firms reported Q3 collapsing sales, collapsing margins owing to higher input prices, e.g. iron ore, in the manner of early 2016.

 

 

In a normal recovery, China’s trade surplus should shrink as consumers spend more in response to improved conditions. Instead, the surplus rose, indicating an export and manufacturing-based recovery at the expense of the household sector. In addition, the Chinese authorities are tightening credit. Domestic credit rejection very high for retailers, indicating an unbalanced and hollow recovery.
Loan rejection rates for retail businesses increased to 38% in the final quarter of 2020 from 14% in the previous quarter, according to the latest quarterly report from CBBI. Rejection rates for small and medium-sized businesses rose to 24% in the final quarter, double the rate posted by large companies during the period.

 

“Large firms continue to gobble up whatever credit was available, enjoying much lower capital costs than their smaller counterparts, alongside higher loan applications and still falling rejections,” CBBI said. “This is the opposite of the quagmire small-and-medium enterprises find themselves in.”

 

 

Don’t be deceived by improvement in services in the PMI surveys. China Beige Book’s survey internals revealed an unbalanced recovery in services.
A recovery in services revenue was driven by businesses in telecommunications, shipping, and financial services, but those in consumer-facing industries, such as chain restaurants and travel, continued to lag behind, according to CBBI.

 

“Don’t confuse fourth quarter’s services recovery with the ‘Chinese consumer is back’ narrative,” said CBBI’s Managing Director Shehzad Qazi. “This is a business services — not consumer-side — recovery. Retail sector data bear this out even more clearly, with spending on non-durables sagging.”
China has led the global recovery, but these imbalances are an accident waiting to happen. I have no idea when this might unwind, but be prepared for a “China is slowing” narrative to sideswipe global risk appetite in the near future. This is a tail-risk that the market is not prepared for.

 

 

Investment implications

While a cyclical recovery and a new equity bull have become the new consensus, I remind readers that both the Dow Jones Industrials and Transports recently achieved new all-time highs, which constitutes a Dow Theory buy signal. This is a powerful indicator that the primary trend is up.

 

 

Should investors be worried about a case of too far, too fast? Variant Perception pointed out that notwithstanding investor sentiment, liquidity conditions are friendly to equity returns for the next six months.

 

 

That said, investors who want to position for a cyclical bull market should look beyond the S&P 500. The index has become very growth and tech-heavy. The weight of cyclical groups within the S&P 500 has dwindled to 24%.

 

 

US tech stocks are likely to face headwinds. Foreign institutions piled into US large-cap growth stocks during the pandemic as the last refuge in a growth-starved world. Now that the growth scare is over, investors are likely to rotate into cyclicals instead.

 

 

SentimenTrader also observed that tech stocks have gone too far, too fast. If history is any guide, don’t expect them to continue their winning streak. By implication, the S&P 500 is likely to face headwinds in advancing if tech and tech-like sectors comprise about half of the index’s weight.

 

 

There are better opportunities for growth investors. A comparison of EM internet and eCommerce stocks (EMQQ) to the NASDAQ 100 (QQQ) and the Asia 50 (AIA), which is very tech and heavy, shows that the NASDAQ 100 has outperformed its EM and Asian counterparts. Both the relative performance of EMQQ and AIA to QQQ are showing signs of relative bottoms, which are constructive for these non-US tech-related issues. This is despite Beijing’s recent scrutiny of Ant Financial, which has depressed the Chinese fintech sector.

 

 

In conclusion, the global economy is undergoing a cyclical rebound. Equity markets have surged in response. In the short-term, sentiment has become stretched, risks are appearing, and the S&P 500 could correct by 5-10% at any time. While the fast retail and hedge fund money has mostly gone all-in, the glacial institutional money remains underweight beta. State Street Confidence, which measures the custodial holdings of institutional managers, is still below the neutral 100 level.

 

 

Investors should look to pullbacks to buy dips, but better investment opportunities can be found in non-US markets.

 

 

My 2020 report card

Posted by Cam Hui -

Now that 2020 has come to an end, it’s time to deliver the Humble Student of the Markets report card. While some providers only highlight the good calls in their marketing material, readers will find both the good and bad news here. No investor has perfect foresight, and these report cards serve to dissect the positive and negative aspects of the previous year, so that we learn from our mistakes and don’t repeat them.
 

2020 was a wild year for equity investors. The S&P 500 experienced 109 days of high volatility days during the year, as measured by daily swings of 1% or more. Measured another way, the stock market had high volatility days 45% of the time in 2020, compared an average of 25% since 1990. This level of volatility was similar to a reading of 53% in 2009 and 41% in 2000.
 

Let’s begin with the good news. The Trend Asset Allocation Model’s model portfolio delivered a total return of 19.7% compared to 16.1% for a 60% SPY and 40% IEF benchmark (returns are calculated weekly, based on the Monday’s close). Total returns from inception of December 31, 2013 were equally impressive. The model portfolio returned 13.8% vs. 10.6% for the benchmark with equal or better risk characteristics.
 

 

 

An unprecedented policy response

Now for the bad news, and there was plenty of it. While the Trend Model was disciplined enough to spot the crash in March and recovery thereafter, it was very late to turn bullish. I attribute this to two critical errors in thinking.

 

The unemployment rate had spiked to levels not seen since the Great Depression. I found it difficult to believe that the economy would not tank into a deep recession. I did not understand the magnitude of the fiscal and monetary response that put a floor under the downturn. The chart below tells the story. Even as unemployment rose to unprecedented levels, personal income rose as well. This was an unusual pattern not seen in past downturns and can be explained by a flood of fiscal support to the household sector.

 

 

We can see a similar effect with the savings rate, which also spiked to absurdly high levels even as unemployment soared. As government money flooded into households, some of the funds were not needed immediately, and the savings rate rose as a consequence. To be sure, the fiscal support was uneven and exacerbated inequality problems, but that’s an issue for another day. The actions can be partially excused by characterizing the legislation as battlefield surgery, which is imperfect but designed to save as many as possible under crisis conditions.

 

 

As well, the Federal Reserve and global central banks acted quickly to flood the global financial system with liquidity and financial stress was contained.

 

 

 

A valuation error

My second error was my assessment of valuation, which was based mainly on the forward P/E ratio, which had risen to historically high levels. I could not initially fathom why that constituted good value for equities.

 

 

Other traditional metrics, such as the Rule of 20, which specifies that the stock market is overvalued if the sum of the forward P/E and inflation rate exceeded 20, were screaming for caution.

 

 

An excessive focus on forward P/E based valuation turned out to be a conceptual error. I addressed those concerns in early October in a post (see A valuation puzzle: Why are stocks so strong?). 
One of the investment puzzles of 2020 is the stock market’s behavior. In the face of the worst global economic downturn since the Great Depression, why haven’t stock prices fallen further? Investors saw a brief panic in February and March, and the S&P 500 has recovered and even made an all-time high in early September. As a consequence, valuations have become more elevated.

 

One common explanation is the unprecedented level of support from central banks around the world. Interest rates have fallen, and all major central banks have engaged in some form of quantitative easing. Let’s revisit the equity valuation question, and determine the future outlook for equity prices.
Soon after, I followed up with a cautious bullish call to Buy the cyclical and reflation trade?. The month of October was still gripped by election uncertainty. I turned unequivocally bullish in November with Everything you need to know about the Great Rotation, but were afraid to ask.

 

Better late than never.

 

 

My inner trader

The trading model had been performing well until 2020. The most charitable characterization was my inner trader caught the coronavirus. The drawdowns were nothing short of ugly. This was attributable to the conceptual error in thinking that I outlined, and a belief that the market would return to test the March bottom. 

 

When the prospect of one or more vaccines and an economic recovery came into view at the end of Q3, I recognized that markets look ahead 6-12 months, and the odds of a retest had become highly unlikely.

 

 

Looking ahead to 2021, tactical trading models used by my inner trader are likely to be less relevant. The point of market timing models is to avoid ugly downturns in stock prices. This is a new cyclical bull market. The costs of trying to avoid corrections, which is a risk that all equity investors assume, are less worthwhile if the primary trend is bullish.

 

Happy New Year, and I look forward to a better 2021.

 

Steady as she goes

Posted by Cam Hui -

Mid-week market update: Not much has changed since my last post, so I just have a brief update during a thin and holiday-shortened week. The S&P 500 remains in a shallow upward channel while flashing a series of “good overbought” conditions during a seasonally positive period for equities. The index staged an upside breakout at […]

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When does Santa’s party end?

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

The seasonal party

In my last mid-week post, I outlined how the combination of an oversold reading and positive seasonality were combining to provide bullish tailwinds for stocks (see The most wonderful time of the year…). So far, the market is behaving according to the script. The VIX Index retreated after breaching its upper Bollinger Band (BB) last Monday, and the market staged an advance. In light of the narrowness of the BB, traders should watch for a breach of the lower BB, which would be a signal of an overbought market.

 

 

Retired technical analyst Walter Deemer observed that the ratio of NASDAQ volume to NYSE volume had spiked, and it would be a “warning sign in days of yore”. However, similar spikes in the last 13 years have signaled FOMO stampedes and investors chasing beta, rather than actionable sell signals. Arguably, these instances should be interpreted as short-term bullish and not contrarian bearish.

 

 

The technical signs indicate that all systems go for the seasonal rally.

 

 

Don’t overstay your welcome

Before you get overly excited, bullish traders face a number of key risks. The most immediate threat is President Trump’s threat to veto a $2.3 trillion pandemic aid and spending package approved by Congress, which contains a $892 billion coronavirus relief package and a $1.4 trillion for normal government spending. If the White House and Congress cannot come to an agreement by Monday, then parts of the federal government will have to shut down. The markets would not react well to such an eventuality.

 

That’s probably an unlikely scenario. Reuters reported that funding for the vaccine rollout depends on the government continuing to operate. Trump would not want his legacy to be marred by a botched vaccine distribution effort, particularly ahead of the upcoming Senate election in Georgia.
The federal government has already purchased 400 million COVID-19 vaccine doses, or enough for 200 million people, from Moderna and Pfizer but needs additional funds to purchase more doses. It also signed contracts with other companies for vaccines that have yet to be authorized. Private companies, including McKesson, UPS and FedEx, are distributing the doses but have been relying on staff in the Department of Defense and the Department of Health and Human Services for support.

 

States have received $340 million from the U.S. government to help offset costs they’ve borne from the vaccine rollout but say they face a shortfall of around $8 billion. A shutdown would halt plans by Congress to distribute funding to make up for that shortfall.

As well, high-frequency indicators are showing signs of weakness. The Goldman Sachs Current Activity Indicator turned negative in December. The combination of incipient weakness and any hiccup in the delivery of fiscal support could be enough to shift investor psychology.
 

 

In addition, market internals are flashing warning signs that the Santa Claus rally may be on borrowed time. One of the bearish tripwires I had been monitoring is the performance of the NYSE McClellan Summation Index (NYSI). In the past, NYSI readings of over 1000 were signals of “good overbought” advances, but rallies tended to falter when NYSI began to roll over. NYSI showed definitive signs of weakness last week, which is a warning for the market.
 

 

 

How far can the rally run?

How far can the seasonal strength last, and what’s the upside potential? I offer three estimates, starting from the lowest to the highest.

 

Jeff Hirsch at Trader’s Almanac defined the Santa Claus rally as the period from Christmas Eve to the second day of the new year. On average, the S&P 500 has gained 1.3% since 1969, which translates to an S&P 500 target of about 3750.

 

Ironically, I had also been watching the behavior of the quality factor. This indicator recently flashed a warning for the bulls, and the past behavior of the market after such signals also yielded some clues on the length and upside potential of the current rally.

 

In the past, market melt-ups led by high-quality stocks tended to persist. But when the low quality “junk” starts to fly, it’s a sign of excessive speculation and froth. I measure quality using the QUAL ETF for large-caps, and the ratio of S&P 600 to Russell 2000 for small caps. S&P has a relatively stringent profitability inclusion criteria for its indices, which Russell doesn’t have. (That also explains why it took Tesla so long to enter the S&P 500 despite its sizable market cap – it just wasn’t profitable.) In the past two episodes of a blow-off top, the time lag between the second warning where both large and small-cap quality underperformed to the ultimate top was about two weeks. Based on those projections (warning, n=2), the timing of a tactical top would occur during the first or second week of January with an average gain of 2.5% to 3%, which means an S&P 500 level of about 3800.

 

 

Lastly, Marketwatch reported that Tom DeMark was targeting 3907 during the first week of January.

 

 

More room to rally

The bulls shouldn’t panic just yet. The seasonal Santa Claus rally is following the script of a rally into early January, followed by a correction.
 

 

Short-term breadth and momentum readings are not overbought, and the market has more room to rally.
 

The percentage of S&P 500 at 5-day lows are more oversold than overbought, which is indicative of more upside potential.
 

 

However, the challenge for the bulls is to overcome the trend of lower highs in breadth and momentum.
 

 

My inner investor remains bullishly positioned. Even though the market may experience a pullback in January, the intermediate-term trend is bullish (see Debunking the Buffett Indicator) and he isn’t overly concerned about minor blips in the market. The near-simultaneous upside breakouts by the Dow and the Transports flashed a Dow Theory buy signal. The primary trend is up, though short-term corrections are not out of the question.
 

 

My inner trader is also long the market. If it all goes according to plan, he will be taking profits in early January and contemplate reversing to the short side at that time. All of the technical projections cite the first or second week of January as the likely peak of the current period of market strength. Upside S&P 500 potential vary from a low of 3750 to a high of 3907. What follows would be a 5-10% correction.
 

 

Disclosure: Long SPXL
 

Debunking the Buffett Indicator

Posted by Cam Hui -

There has been some recent hand wringing over Warren Buffett’s so-called favorite indicator, the market cap to GDP ratio. This ratio has rocketed to new all-time highs, indicating nosebleed valuation conditions for the stock market.
 

 

Worries about this ratio are overblown. Here’s why.

 

 

Dissecting market cap to GDP

Let’s begin by dissecting the market cap to GDP ratio, which is really an aggregated price to sales ratio for all listed companies. While the price to sales ratio is a useful metric for valuation, a more commonly used ratio is the price to earnings (P/E) ratio. The P/E ratio is really price/(sales x net margin). 

 

To understand the market cap to GDP and P/E ratios, we need to decompose net earnings and how it have evolved over time:

 

Net earnings = (Gross earnings [or EBIT earnings] – interest expense) x (1 – tax rate)

 

Over the years, both interest rates and the corporate tax rate have fallen substantially. In addition, Ed Clissold of Ned Davis Research documented how gross margins have risen since the early 80’s.

 

 

The validity of the Buffett Indicator’s valuation warning therefore depends on a mean reversion in net margins. Ben Carlson documented how Charlie Munger, Buffett’s long-term partner, addressed this issue.

 

 

As the economy recovers from the latest recessionary downturn, net margins are expected to rise substantially, which will provide a boost to the E in the P/E ratio.

 

 

Do you feel better now?

 

 

Not out of the woods?

While an explanation of the relationship between the market cap to GDP ratio, net margins, and the P/E ratio provide some comfort about valuation, a nagging problem remains. P/Es are substantially elevated relative to history. The S&P 500 forward P/E ratio of 22.1 is well ahead its 5-year average of 17.4 and 10-year average of 15.7.

 

 

Shiller CAPE (Cyclically Adjusted P/E) readings are above levels seen just before the Crash of 1929.

 

 

A CAPE of 33 implies roughly 0% real returns over the next decade.

 

 

Robert Shiller recently addressed this issue in a Project Syndicate essay. Stock prices are cheap in most regions after adjusting for interest rates.
 

The level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the ten-year real interest rate.

 

This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive. The ECY in the US, for example, is 4%, derived from a CAPE yield of 3% and then subtracting a ten-year real interest rate of -1.0% (adjusted using the preceding ten years’ average inflation rate of 2%).

 

We looked back in time for our five world regions – up to 40 years, where the data would allow – and found some striking results. The ECY is close to its highs across all regions and is at all-time highs for both the UK and Japan. The ECY for the UK is almost 10%, and around 6% for Europe and Japan. Our data for China do not go back as far, though China’s ECY is somewhat elevated, at about 5%. This indicates that, worldwide, equities are highly attractive relative to bonds right now.
At the press conference after the December FOMC meeting, Fed Chair Jerome Powell embraced the equity risk premium, or the Fed Model, as a way of valuing the stock market. For what it’s worth, the Fed Model has liked the market since 2002. 

 

 

Similarly, the Buffett Indicator (inverted) does not appear expensive when investors factor in the level of interest rates, notwithstanding the improvement in net margins.

 

 

In summary, concerns about valuation are overblown. Stock prices are not overvalued in light of the low rate environment. 

 

While low rates can be a risk factor over the long-term, they are not a problem over the next few years. The Fed signaled a form of passive easing after the latest FOMC meeting. It raised its growth projections for each of the next two years, marked down unemployment, and raised core inflation estimates. Despite all that, it is holding rates steady. That’s a medium-term friendly environment for equities. 

 

 

Don’t be afraid to buy.

 

 

The most wonderful time of the year…

Posted by Cam Hui -

Mid-week market update: In my last post (see Trading the pre-Christmas panic), I pointed out that the VIX Index had spiked above its upper Bollinger Band, which is an indication of an oversold market. In the past year, stock prices have usually stabilized and rallied after such signals (blue vertical line). The only major exception was the February and March skid that saw the market become more and more oversold (red line). The market today appears to be following a more typical pattern of stabilization, which should be followed by recovery during the seasonally strong Christmas period.
 

 

Even more constructive for the bull case was how stock prices reacted to bad news. Last night after the market close, President Trump called the latest stimulus package a “disgrace” and threatened to veto the bill. This latest surprise not only threatens the stimulus bill, it also raises the risk of a government shutdown on December 28, 2020. S&P 500 futures initially fell -0.5% overnight on the news but recovered to open green Wednesday morning. 
 

A market’s ability to shrug off bad news is bullish.
 

 

What’s the real Santa rally?

Arguably, the real seasonally positive Santa rally starts now. Mark Hulbert defined it as the six trading days after Christmas. Going back to the Dow’s inception in 1896, Hulbert found that the DJIA rose 76.6% of the time during this period, compared to 55.7% for all other six-day periods.
 

 

Jeff Hirsch defined the Santa rally window as the close on December 23 to the second trading day of the new year. The S&P 500 rose an average of 1.3% over this period. He went on to discuss the adage, “If Santa Claus should fail to call, bears may come to Broad and Wall.”

The “Santa Claus Rally” begins on the open on Christmas Eve day December 24and lasts until the second trading day of 2021. Average S&P 500 gains over this seven trading-day range since 1969 are a respectable 1.3%. This is our first indicator for the market in the New Year. Years when the Santa Claus Rally (SCR) has failed to materialize are often flat or down.

 

 

Rob Hanna at Quantifiable Edges defined the Santa Rally window as starting three days before Christmas. His NASDAQ version of the seasonal study was uniformly strong, with an average gain of 2.5% until the second trading day of the new year.
 

 

Will 2020-2021 be any different?
 

 

A retreat in sentiment

One short-term constructive factor is bullish sentiment readings have come off the boil. While readings are still extended, net bulls have begun to edge down. This is a positive development, especially as we enter the seasonally strong period for stocks.
 

 

My inner trader remains long the market. He is hoping that the party will continue, at least until early in the new year. He will then reassess conditions at that time to make a decision as to what to do next.
 

 

Disclosure: Long SPXL
 

Trading the pre-Christmas panic

Posted by Cam Hui -

What should traders make of the pre-Christmas panic today? S&P 500 futures were down as much as -2.5% overnight. The market opened up down about -1.5%, but recovered most of its losses to a -0.4% retreat today. More importantly, the bulls were able to hold support at 3650.
 

 

The VIX Index surged above its upper Bollinger Band, which is a sign of an oversold market. In the past year, most of the similar instances saw the market either rise or stabilize after VIX upper BB readings (blue vertical lines). The only exception occurred in February, when the market cratered as the news of the pandemic spooked risk appetite (red line). On the other hand, the 5-day RSI (top panel) is nowhere near an oversold condition.

 

 

The start of a major correction?

There is no doubt that sentiment indicators are greatly extended. It would be no surprise to see the stock market correct from these levels. Here is what I am watching.

 

We already had an early warning from my quality factor tripwire. The past two melt-ups have ended with low-quality stock leadership. Low-quality small caps have already flashed a bearish signal. Large cap quality remains in a relative uptrend. Will it signal a correction too? The low-quality factor has been early to warn of market tops in the past.

 

 

I am also watching the NYSE McClellan Summation Index (NYSI). In the last 20 years, NYSI readings of over 1000 have signaled either sideways consolidations or corrections about two-thirds of the time (red vertical lines). But market weakness does not occur until NYSI definitively rolls over. We are not there yet.

 

 

Finally, the % of S&P 500 stocks above their 200 dma surged over 90% recently. In the past, such conditions have been indications of a sustained advance. In most of all instances when this indicator rose about 80%, the market has not topped out until the weekly RSI reached an overbought condition of 70. This argues for further gains into year-end and possibly into 2021.

 

 

I am monitoring these indicators and keeping an open mind. In light of the seasonal tailwinds, my inner trader is giving the bull case the benefit of the doubt.

 

 

Disclosure: Long SPXL

 

Santa rally, Version 2020

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

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

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

 

 

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

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

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

 

The Santa Claus effect

Is Santa coming to town? Historical studies have documented that seasonal strength usually starts about mid-December and continues into January.

 

 

Right on cue, the S&P 500 staged an upside breakout to a fresh all-time high last Thursday, though it pulled back Friday and the breakout held, though just barely.

 

 

 

How to play the Santa rally

How should traders position for seasonal strength? The most straightforward way is to stay long the equity market. Global breadth is surging, and history has shown that to be intermediate-term bullish. 

 

 

 

Georgia on my mind

The market could see an additional boost from the Georgia senate elections, scheduled for January 5, 2021. Currently, the Republicans hold a 50-48 seat edge, and the Democrats need to win both Georgia races to win control, as Vice-President Harris would cast the tie breaking vote in case of a deadlock.

 

According to Strategas, the vast majority of institutional investors expect the Republicans to retain control.

 

 

Over at the PredictIt betting markets, the market is giving a 70% chance that the Republicans will retain control. Individual odds on the Georgia senate election vary between 60-65%. In practice, they may be thought of as a single race since the voting is expected to be correlated with the other.

 

 

FiveThirtyEight’s compilation of polling averages show that the competing candidates are neck-and-neck and within a hair of each other. It wouldn’t take much of a swing for the Democrats to win both races.

 

 

A Democratic win would be interpreted as a somewhat unexpected positive surprise for the markets. Democratic control of all legislative branches of government would translate to a large stimulus bill much in the shape of the $3 trillion package passed by the House.

 

 

What’s the upside potential?

How far can a Santa Claus rally run? Marketwatch reported that technical analyst Tom DeMark has an S&P 500 target of 3907 two weeks from now.
Ask Tom DeMark how confident he is about his most recent equity-market timing call and he will imply that it is almost a no-brainer from his perspective.

 

“I’ve been stubborn and obstinate about 3,907 since November,” DeMark told MarketWatch in an exclusive phone interview Thursday morning.
However, he thinks that the January peak will represent the high for the first half of 2021.

But there is a catch to that late-year equity surge. The technical analyst says that it is likely to represent a top for stocks and estimates that the S&P 500 in the first half of 2021 is likely to decline by 5% to 11%, based on his models and the natural tendencies of assets in a downtrend.

A point and figure chart of the hourly S&P 500 indicates an upside objective of 3939. DeMark’s 3907 target is certainly within that ballpark.

 

 

 

Outperforming the rally

Having established that the odds favor a Santa Claus rally, the issue of outperforming the rally is a little bit trickier. Here are some clues from history. I made a study of the price momentum factor during this period. There are several ways of measuring momentum, the two longest existing momentum ETFs are MTUM and PDP. I analyzed whether MTUM or PDP outperformed the S&P 500 over differing time horizons, starting from December 15. As the chart below shows, there is little or no price momentum or reversal effect 10 trading days (or approximately until year-end) and 15 trading days (first week of January) after December 15. However, momentum begins to assert itself after the first week, and continues to beat the market until the 30 trading days (end of January).

 

 

What about small caps? The return pattern is very different than price momentum. The Russell 2000 has tended to beat the S&P 500 into year-end, but reversed itself in January.

 

 

A word of caution is in order for traders thinking about jumping on the small cap bandwagon in 2020. The Russell 2000 has doubled since the March bottom.

 

 

Analysis from SentimenTrader showed that sudden surges in the Russell 2000 off a major low have resolved themselves with a period of correction and consolidation.

 

 

Trying to beat the market during a Santa Claus rally is at best a guessing game. In the spirit of the season, the following picture epitomizes the trader’s dilemma. Is this a simple nativity scene, or a picture of two T-Rexes?

 

 

 

Disclosure: Long SPXL

 

Will Biden reset the Sino-American relationship?

Posted by Cam Hui -

As the clock ticks down on Trump’s days in the White House, and Biden election has been confirmed by the Electoral College, it’s time to ask if a Biden Administration will reset the Sino-American relationship. The key questions to ask are:

  • What does each side want, and what are the sources of friction?
  • What constraints is China operating under?
  • What’s the likely path forward?
While my main focus is on trade, that’s not the only dimension of friction between the two countries. China’s newly assertive foreign policy and brinksmanship in the South China Sea is also a source of concern for geopolitical stability.

 

 

 

What does each side want?

The first-order interpretation of the Sino-American trade relationship is Trump failed to make much of a dent in China’s trade surplus with America, which rose during his term. But that’s not the whole story.
 

 

Trump had a two-pronged negotiation strategy that was doomed to failure from the start. One complaint was China’s lack of respect for foreign intellectual property, which hampered American companies from operating in China, and the other was the trade deficit.

 

Here is the inherent contradiction. If the Chinese were to totally capitulate on the intellectual property issue and open its economy to foreign companies, the trade deficit would rise as American companies establish more plants in China and offshored jobs there. While President Trump was focused mainly on reducing the trade deficit, his negotiator Robert Lightizer operated with dual objectives, which were at odds with each other.

 

Be careful what you wish for.

 

It’s hard to escape the impression that the Sino-American relationship is damaged beyond repair. Tensions are rising on multiple fronts from trade to foreign policy. It’s useful to assess the current situation with a brief history lesson of how we got here.

 

Let’s go back to the 1990s with China’s ascension into the WTO. A Trumpian interpretation of events is American negotiators were suckered by the Chinese. A kinder version is Clinton’s negotiation team believed that bringing China into the light of WTO rules would force the regime to liberalize both its economic and political systems.

 

There was internal opposition from the Chinese side as well. China’s premier and principal negotiator Zhu Rongji was pilloried in certain quarters for giving away too much. His concessions were compared to the infamous and humiliating “21 points” which imperial Japan had tried to foist on China in 1915.

 

Before further discussion of what each side wants out of the relationship, we need to consider the constraints that China is operating under.

 

 

China’s unbalanced recovery

On the surface, China seems to be leading the world out of the Covid Crash. The latest figures show that its economic recovery strengthened in November. Industrial production rose, and so did retail sales.

 

 

Indeed, the China Exposure Index of US-listed companies with high exposure to the Chinese economy have rebounded strongly.

 

 

Patrick Zweifel at Pictet Asset Management observed that all of China’s main activity indicators are above pre-pandemic levels.

 

 

A closer examination of the above chart shows an unbalanced recovery. The rebound was led by fixed-asset investment and construction activity. Retail sales was the laggard. Beijing has returned to the same old formula of credit-fueled expansion. Moreover, Beijing has pivoted towards a state-owned led recovery. What happened to Deng Xiaopeng’s mantra of “it is glorious to be rich”?

 

China watcher Michael Pettis believes that the Chinese economy is reaching the limits of its growth model. Further credit-fueled growth, especially by the state-owned sector, will dampen productivity.

A GDP growth target that is below the underlying growth rate of the economy (as it was until 10-15 years ago, when GDP growth always exceeded the target) is consistent with a rising private-sector share of the Chinese economy. In that case private sector investment is profitable, and not surprisingly it drives much of the productive growth in the economy. But once the real growth rate of the economy slowed significantly, so that Beijing’s GDP growth target exceeded the country’s real underlying growth rate, the only way it could be met was with an increase in the state-sector share of the economy. In that case the private sector simply could not find enough productive activity to generate the politically-determined GDP growth target, and so the private-sector share of the economy necessarily had to decline.

 

 

Decoupling, by another name

Beijing’s latest solution is a “dual circulation” strategy, which amounts to maintaining global exports while developing a domestic supply chain. The Economist explains.

Enter the newest of China’s big economic policies: the “dual-circulation” strategy. At its most basic it refers to keeping China open to the world (the “great international circulation”), while reinforcing its own market (the “great domestic circulation”). If that sounds rather vague, it is: the government has not spelled out the details.

“Dual circulation” is just another term for decoupling.

That combination—the pursuit both of economic self-reliance and of greater economic leverage over foreign countries—now describes much of what China is doing. Mr Xi refers to changes “unseen in a hundred years” sweeping the global order—a way of saying that, while China is rising, America is declining and trying to stop the new power (see Chaguan). “Where linkages with the global economy create vulnerabilities, China wants to minimise them,” says Andrew Polk of Trivium China, a research firm. “Where the linkages create benefits, China wants to expand them.”

Decoupling is already a reality. Nikkei reported that a splinternet has developed, as cross-border data flow along the China/Hong Kong axis has skyrocketed while leaving the West behind.
 

 

China recently signed a free trade agreement which many interpreted as a counter-weight to the Trans-Pacific Partnership (TPP). The new agreement is called Regional Comprehensive Economic Partnership (RCEP), and it spans 15 countries and 2.2 billion people, or nearly 30% of the world’s population. Before everyone gets too excited, Michael Pettis poured cold water on the idea that RCEP will form a new parallel trade bloc.

The RCEP countries together have been running current account surpluses of more than 2% of their collective GDP, and except perhaps in the cases of Australia and New Zealand, these surpluses are based on structural savings imbalances. They are consequently very hard to eliminate without politically-difficult domestic adjustments that none of them want to accept.
 

This means that the RCEP can only function as a trade bloc either if some of its members are forced into running deficits (in practice only Australia and New Zealand, but they are too small to absorb more than a small fraction of the total), or if the RCEP is simply a surplus trading bloc in search of counterparts willing to run large deficits…
 

That leaves only the US, the UK, and Canada, and if they should take real steps to limit the deficits they are willing or able to run with RCEP, for example by limiting net capital inflows, the RCEP will fall apart as each surplus country tries to protect its all-important exports at the expense of imports and its trade partners.

China bulls believe that the strategy will ultimately compel China to open up its economy, according to The Economist.

Take the semiconductor industry. Caixin, a Chinese financial magazine, reported last month that Huawei, a tech giant, was rushing to create a “not-made-in-America” supply chain by 2022. Initially, however, that would enable it to make chips with transistors spaced 28 nanometres (billionths of a metre) apart, far less dense than the most advanced ones. The bullish case is that China, realising how long it will take to catch up in such areas, will try to boost productivity by cracking on with hitherto slow-moving reforms. Analysts with Huatai Securities, a brokerage, think that could include doing more to loosen the household-registration system known as hukou, which impedes the movement of rural labour to the country’s biggest and most productive cities.

Should China open its economy to foreign companies, the opportunities are still enormous. As an example, the WSJ reported that Wall Street is salivating over the prospect of entering China’s asset management industry, which is grown to about US $18 trillion. Foreign firms only have a minuscule market share at less than 2%.
 

 

 

What will Biden do?

In light of these challenges and opportunities, how will a Biden White House react to China?
 

President-Elect Biden has not outlined the specifics of his policy on China, but we can make some educated guesses. Jeff Bader was the point person for China policy during Obama’s first term. He outlined the issues in a Brookings Institute essay facing the Biden team as it takes office.

  • China’s growing power in all domains.
  • The halt, and in some cases reversal, of market driven reform of the economy and greater emphasis on central control and guidance at a time when Chinese economic power abroad is growing and, in many places, disruptive.
  • The return of stress on ideology, including indoctrination of officials in Marxism, tightening of space for dissent, heightened domestic surveillance enabled through technological advances, mass incarceration and “reeducation” of Uighurs in Xinjiang, and the recent crackdown in Hong Kong curtailing its autonomy and political freedoms.
  • Threats to neighbors through bullying and, in some cases, use of the PLA (People’s Liberation Army), notably the change in the status quo in the South China Sea and recent border clashes with India.
Bader believes that China’s threats may not as serious as initially perceived, especially on the geopolitical realm.

China will not be a global military power able to match the United States for the foreseeable future. America’s nuclear and ballistic missile forces, ability to project power, global system of alliances and bases, and war fighting experience are advantages that are unlikely to be eroded. China’s military poses a regional challenge but is not an instrument designed for an unprovoked attack on the United States. 

China’s economic power will rise, but it will not be globally dominant.

China’s economy will surpass the United States in gross domestic product, but it will lag well behind the United States in GDP (Gross domestic product) per capita for the foreseeable future. That will mean that demands for attention to domestic needs will continue to loom large for Chinese leaders. These domestic demands will provide some restraint on ambitious overseas spending (such as for BRI) that are unpopular in China. Internationally, there is no doubt that China’s spectacular surge to global leadership in trade, investment, and infrastructure development provides the country with greater influence, but China is many years, perhaps decades, away from being a rule maker rather than a rule taker in international finance, capital markets, and currency. It lacks the foundation of rule of law, currency and capital account convertibility, an independent central bank, and deeply liquid markets that international investors seek, all of which will be necessary for it to provide an alternative to the U.S. dollar as an international currency.

From an economic perspective, China is losing the war of ideas in globally. Macro Polo compared and contrasted the rise of Japan and the rise of China. While many countries rushed to emulate Japan’s business and economic development model at the time, none have done the same with China.

Much talk has centered on China’s influence in the West. But one important area where China barely registers influence is on Western industry’s practices and management thinking. In fact, when compared to Japan, China’s influence is notably weak in the corporate realm. 
 

The rise of “Japan Inc.” (~1950-1980) was accompanied by one of the most influential management concepts of the post-World War II era: the Toyota Production System, or commonly referred to as lean production. It wasn’t simply an idea, but an organizing principle with concrete practices that led to a transformation of the prevailing mass production model in the Western auto industry.  
 

In contrast, the rise of “China Inc.” (~1990-2020) has seen no equivalent management philosophy or practice that has come anywhere close to the influence that Japan’s lean production has exerted.  

Bader concluded that China is a competitor, but not an existential threat to American interests in the manner of the Soviet Union during the Cold War. Instead, it is seeking to be a dominant regional power and to carve out a sphere of influence in Asia.

There is no evidence suggesting that China seriously aspires to threaten the United States homeland or seek a global confrontation with the United States replicating the pattern of the U.S.-Soviet Union Cold War. Rather, we can expect to face a China that strives for economic preeminence in East and Central Asia, military security against the United States in the western Pacific, and rising but not predominant influence outside of Asia based largely on economic connections. We should not expect China to build up a network of like-minded or satellite states that pose a security threat to the United States, or to adopt the U.S. role in recent decades as the world’s policeman.
 

China is not an existential threat to the United States, but there is no avoiding the fact that we will be competitors and, in some respects, rivals — economically, politically, militarily, and technologically. That will require the United States to get its house in order in numerous ways that go beyond the scope of this paper, as domestic rejuvenation is the basis for successful competition. Such competition also will compel limitations on cooperation in some areas where the United States and China interacted relatively freely in the past. 

What does this mean for American policy? A consensus has developed in Washington that China represents a threat to US interests. The good old days of rapprochement are gone. The path of least resistance is a continuation of the multi-lateral containment approach last used by Obama. Biden is likely to re-enter TPP, which was a trade agreement designed to contain China’s growing influence. 
 

As well, Bloomberg reported an increased desire to challenge China from a geopolitical perspective.

Biden looks set to maintain or even expand the number of FONOPs [freedom of navigation operations in the South China Sea]. Jake Sullivan, his pick for national security adviser, last year lamented the U.S.’s inability to stop China from militarizing artificial land features in the South China Sea, and called for the U.S. to focus more on freedom of navigation.
 

“We should be devoting more assets and resources to ensuring and reinforcing, and holding up alongside our partners, the freedom of navigation in the South China Sea,” Sullivan told ChinaTalk, a podcast hosted by Jordan Schneider, an adjunct fellow at the Washington-based Center for a New American Security. “That puts the shoe on the other foot. China then has to stop us, which they will not do.”
 

The U.S. has played a key role in maintaining security in Asian waters since World War II. Yet Beijing’s military buildup, combined with moves to fortify its hold on disputed territory in the South China Sea, has raised fears that it could look to deny the U.S. military access to waters off China’s coastline. In turn, the U.S. has increasingly sought to demonstrate the right to travel through what it considers international waters and airspace.

That said, Biden will likely employ a multi-lateral approach to containment.

Biden may also try to get allies to join. A U.K. warship reportedly carried out a sail-by near the Paracel Islands in 2018, and French naval ships have patrolled in the South China Sea. A senior U.S. official said in July that the U.S. “would always like to see more like-minded countries participate” in the FONOPs program to build international consensus and pressure Beijing, the Australian Broadcasting Corporation reported.

How Biden reacts to the following key questions will also be clues to his China policy.
 

How will the new trade negotiator respond to China’s import benchmarks under the Phase One deal negotiated under Trump? Trump’s idée fixe was the trade deficit as a drain on American economic strength and jobs. Will Biden continue to focus on the trade deficit, or will he pivot to greater access to Chinese markets by American companies and intellectual property right protection?

 

How will Biden manage its relations with Australia? The China-Australia relationship has deteriorated badly in the past year. The degree to which Washington supports a key member of the Five Eyes Alliance in its dispute with China will be an important signal of the assertiveness of Biden’s China policy. Australia’s complaints include disagreements over the treatment of Hong Kong legislators, Chinese expulsion of Australian journalists, and an emerging trade war. A Bloomberg article detailed the list of trade sanctions that China has placed on Australian exports, such as beef, barley, coal, lobster, wine and timber, as well as non-tariff barriers on copper ore and concentrate, sugar, cotton, and wheat. Chinese diplomats recently distributed a list of complaints to Australian media about Canberra’s policies. 
“The document says Australia has unfairly blocked Chinese investment, spread ‘disinformation’ about China’s efforts to contain coronavirus, falsely accused Beijing of cyber-attacks, and engaged in “incessant wanton interference” in Hong Kong, Taiwan and Xinjiang.
It also lambasts the Federal Government’s decision to ban Huawei from 5G networks and criticises Australia’s push against foreign interference, accusing it of ‘recklessly’ seizing the property of Chinese journalists and allowing federal MPs to issue ‘outrageous condemnation of the governing party of China’.”

 

 

Investment implications

In the short-term, none of these concerns matters to the markets. The Chinese economy is enjoying a Recovery Renaissance. The yuan is strengthening against the USD.
 

 

The Chinese bond market is one of the few bond markets in the world that’s offering positive real yields. This will undoubtedly attract foreign fund flows, notwithstanding the heightened credit risk as evidenced by rising defaults. The relative performance of Chinese equities to MSCI All-Country World Index (ACWI), as well as most of the markets of China’s major Asian trading partners, are all showing different constructive patterns of positive relative strength.
 

 

In addition, the market is shrugging off the Australia-China trade and foreign policy friction narrative. The AUDCAD exchange rate just rallied to a fresh recovery high. Both Australia and Canada are resource exporting countries. Australian exports are more levered to China, while Canadian exports are more sensitive to the US economy. Strength in the AUDCAD exchange rate is a market signal of Chinese economic strength, and falling concerns over the Australia-China relationship.
 

 

China’s yuan strength and credit-driven recovery are also good news for Europe. European manufacturing is closely linked to the health of the Chinese economy, because China depend on Europe, and Germany in particular, as a source of capital goods. This is bullish for the euro, and bearish for the greenback. As well, a falling USD should provide a boost for commodity prices and emerging markets.
 

 

From a long-term perspective, however, CNY strength will create a headache for Chinese authorities. A strengthening currency will erode export competitiveness. While the PBoC can lean against yuan strength in the short-term, regulators are likely to encourage and accommodate greater capital outflows as a medium-term solution. However, the liberalization of the capital account will raise the risk of systemic instability. But that’s a problem for tomorrow.
 

In conclusion, Trump’s approach to the trade dispute with China was constrained by contradictory objectives. It was impossible to focus on both the trade balance and compel China to open up its markets and respect intellectual property. Should China open its markets, foreign manufacturers would flood in and offshore jobs there, and raise the trade deficit.
 

Biden is likely to pivot from a belligerent to a more multi-lateral approach to dealing with China. However, there is a growing consensus in Washington from both sides of the aisle that China is a strategic competitor. However, it does not represent an existential threat to the US in the manner of the Soviet Union during the Cold War. If the Sino-American relationship is due for a reset, it will be reset to the Obama-Bush-Clinton path of containment and engagement.
 

In the short run, China is leading the global economy out of a recession. Its strength is putting upward pressure on its currency and drawing capital inflows into its market. This momentum is expected to continue, and China and China related investments, such as commodities and Asian markets, should perform well.

 

 

Waiting for the breakout

Posted by Cam Hui -

Mid-week market update: It’s difficult to make a coherent technical analysis comment on the day of an FOMC meeting, but the stock market remains in a holding pattern. While the S&P 500 remains in an uptrend (blue line), it has been consolidating sideways since late November and early December.
 

 

Until we see either an upside breakout or downside breakdown out of the trading range (grey area), it’s difficult to make a definitive directional call either way. The bull can point to a brief spike of the VIX above its upper Bollinger Band on Monday, which is a sign of an oversold market. TRIN also rose to 2 on Monday, which can be an indication of panic selling. As well, the VIX Index is normalizing relative to EM VIX since the election. The US market has stopped acting like an emerging market as anxieties have receded. As the S&P 500 tests the top of the range, these are constructive signs that the market is about to rise. On the other hand, the bears can say that even with all these tailwinds, the stock market remains range-bound and unable to stage an upside breakout, indicating that the bulls are having trouble seizing control of the tape.
 

 

Signs of consolidation

The market is definitely showing signs of consolidation. The Vaccine Monday rally of November 9, 2020 marked a turnaround in risk appetite and factor leadership. Since then, small caps and value stocks have led the way. These “Great Rotation” groups gapped up on Vaccine Monday by exhibiting runaway gaps and haven’t looked back since. 
 

 

The dotted lines in the chart above depicts the relative performance of each of the groups relative to the S&P 500. Both large cap value and small cap value have started to trade sideways relative to the market in the past few weeks. Only small caps have continued their outperformance.
 

These are signs of consolidation and a market digesting its gains.
 

 

A bearish tripwire

What’s next? One of the bearish tripwires that I outlined on the weekend (see Time for another year-end FOMO rally?) has been triggered. The low-quality small cap Russell 2000 is outperforming the high quality S&P 600. This is an early warning of a correction, especially in light of the highly extended nature of sentiment readings. However, the low quality factor signals of impending weakness have tended to be early in the past. Large cap quality are still performing well. These conditions are not an immediate cause for concern.
 

 

In the short run, the market is enjoying some seasonal tailwinds. This is option expiry week, and Rob Hanna at Quantifiable Edges found that December OpEx week has historically been bullish.
 

 

As well, seasonal patterns have tended to be bullish this time of year. I see few compelling reasons why this year would be an exception.
 

 

I interpret these conditions as a market poised for a year-end rally into January. Enjoy the party, but watch out for the hangover in a month.
 

 

Disclosure: Long SPXL
 

How far can stocks pull back?

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

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

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

 

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

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

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

 

The ketchup effect

The bulls suffered a setback when the S&P 500 violated a minor rising uptrend (dotted line), though secondary uptrend support (solid line) is holding at 3640. Before anyone panics, the uptrends in the S&P 500 and breadth indicators are intact. In all likelihood, the market is just undergoing a period of consolidation since the start of December.

 

 

The Swedes call it ketchupeffekt, or the ketchup effect. It’s what happens when you try to pour ketchup on food. Nothing happens for a long time, then it all happens at once. The market weakness of last week is a display of ketchupeffekt. Suddenly, all the bad news is happening at once. If this is indeed the start of a pullback, how bad can it get?

 

Let’s explore the downside scenarios.

 

 

Bearish catalysts

There are a number of catalysts for further market weakness. First and foremost is a possible disappointment out of Washington. Lawmakers are deadlocked on the details of a CARES Act 2.0 stimulus bill. The Washington Post reported that Mitch McConnell had no support from Republicans for the bipartisan compromise negotiated by a group of Republican and Democrat senators.

Staffers for Senate Majority Leader Mitch McConnell (R-Ky.) also told leadership offices in both parties Wednesday night that McConnell sees no possible path for a bipartisan group of lawmakers to reach an agreement on two contentious provisions that would be broadly acceptable to Senate Republicans, according to a senior Democrat familiar with the negotiations.

Investors may also want to brace for a possible disappointment from the Fed’s December FOMC meeting on Wednesday. Expectations are rising that the Fed will ease further by shifting their buying to longer term maturities in the Treasury market, otherwise known as yield curve control (YCC). Fed watcher Tim Duy thinks that the Fed fumbled its communication strategy and YCC is not in the cards.
The Fed kind of screwed up the communications with all the emphasis on downside risk. They didn’t spend enough time explaining that the downside risk was very short-term and they really couldn’t do anything about it. They didn’t spend enough time saying that their tools are still powerful in response to a tightening of financial conditions but the economy fell into a deep hole and they can’t do much beyond create accommodative financial conditions that allow the economy to heal but that healing takes time. They have spent time explaining the importance of fiscal policy in the near term but haven’t until last week explained they couldn’t compensate for a lack of that policy because monetary policy works with a lag and by the time it kicks in we will be on the other side of the surge. That said, last month Clarida was very clear that financial conditions were accommodative and that more wasn’t necessary. I don’t know that anyone was paying attention.
Duy concluded:
It seems to me that the Fed is telling us they are going after the low-hanging fruit of putting some guidance on the asset purchase program at this next meeting. The Fed did discuss in November potential changes such as the duration mix or the size of asset purchase but this discussion regarded policy beyond the current surge of Covid-19 cases. With financial conditions currently easy and the Fed literally unable to impact near-term economic outcomes, there doesn’t seem any reason to change policy next week. Of course, an unexpected tightening of financial conditions would be something that the Fed could address should that occur between now and the meeting.
The stock market has been boosted by a flood of central bank liquidity. Disappointment over expectations of further easing measures could be a catalyst for a risk-off setback.

 

 

Another possible source of risk appetite volatility are the Brexit negotiations. Even though the “final deadline” for negotiations is supposedly Sunday, the absolute “drop-dead” deadline is December 31, which is the date new arrangements and a new relationship between the UK and the EU will come to force assuming there is no extension or a deal has been struck. So far, indicators of Brexit anxiety, as measured by the relative performance of the FTSE 250 to FTSE 100 and the GBP exchange rate, are showing heightened signs of concern, but no panic yet.

 

 

The prospect of a no-deal disorderly Brexit could spark a global risk-off episode.

 

 

What could go right

The widespread concerns raised by technicians over the extended nature of investor sentiment is a concern for the bulls. The cover of Money Week in the UK is an example of a contrarian magazine cover warning.

 

 

However, this chart from Callum Thomas shows that bullish sentiment surges are not unusual during bull phases of the market (annotations are mine).

 

 

As well, bearish warnings from sentiment models are offset by strong bullish momentum conditions. Here is a big picture perspective. Urban Carmel pointed out that the McClellan NYSE Summation Index (NYSI) recently spiked over 1000. “The last time it closed >1000 was early June; [and the S&P 500] promptly lost 8%.” While past episodes have tended to be long-term bullish, about two-thirds of the occasions have resolved themselves with either corrections or sideways consolidations (pink boxes). A closer examination of the correction and consolidation episodes saw the market on average top out roughly a month after the initial signal of a NYSI close above 1000.

 

 

I have also been monitoring the recent surge in correlations between the S&P 500 with the VIX Index, and the VVIX, or the volatility of the VIX. We have seen 14 similar warnings in the past three years. Eight episodes were resolved in a bearish way (red vertical lines), and six saw the market either consolidate sideways or continue to rise (blue lines). On the occasions when the market has pulled, back the average drawdown from the initial date of the signal was -4.9%.

 

 

I would add that while this analysis is tilted towards the bear case, the object of the exercise is to estimate downside risk. The bull case has been made elsewhere (see Time for another year-end FOMO stampede?). On average, the prospect of a 5% drawdown is all the ketchup effect can muster for the bears, Several investment banks have called for a short-term pullback, and if too many traders are waiting to buy the dip, any corrective action should be shallow. Arguably, this is the dip that you should be buying into. Analysis from LPL Research shows that positive December seasonality doesn’t start until the last half of the month.

 

 

In conclusion, the intermediate and long-term outlook for stock prices is up, but there is a possibility that the market could see some short term weakness. Should the S&P 500 break uptrend support at 3640, the estimated average downside risk is about -5%, or 3484.

 

Short-term risk levels are rising. While traders may wish to trim their long positions at these levels, investment oriented accounts should take advantage of any market weakness and buy the dips. In particular, the FOMC meeting on Wednesday is a source of possible volatility that traders should be aware of.

 

 

Disclosure: Long SPXL
 

Time for another year-end FOMO stampede?

Posted by Cam Hui -

In late 2017, the stock market melted up in a FOMO (Fear Of Missing Out) stampede as enthusiasm about the Trump tax cuts gripped investor psychology. The market corrected in early 2018 and rose steadily into October, though the advance could not be characterized as a melt-up. In late 2019, the market staged a similar FOMO stampede and the rally was halted by the news of the pandemic spreading around the world.

In each of the above cases, the Fear & Greed Index followed a pattern of an initial high, a retreat, followed by a higher high either coincident or ahead of the ultimate stock market peak.

Could we see a similar year-end melt-up in 2020?

A new cyclical bull

It’s starting to look that way. Evidence is emerging that the stock market is at the start of a new cyclical bull. Exhibit A is the Dow Jones Industrials Average and Transportation Average. Recently, both made fresh all-time highs. That’s a Dow Theory buy signal, a classic indicator of a new bull market.

The economy is starting to turn up from a top-down macro perspective. The tsunami of monetary stimulus has produced a surge in M2 growth, it was an open question of when any of the money growth would affect the economy. M2 monetary velocity is finally turning up. This is a signal of a growth revival. (Recall PQ = MV).

The latest update from FactSet shows that earnings estimates are recovering strongly.

Marketwatch reported that Goldman Sachs strategists headed by Alessio Rizzi believe that a sizable correction is not on the immediate horizon. To be sure, many sentiment indicators are at historical highs, but that should not be a major concern because of the positive macro environment.

Rizzi and his team said that indicators like put/call ratios tend to provide the most useful signals of where the market is moving when they are extreme, and that “that bullish positioning levels tend to remain strong for a long period if macro remains supportive.”

The macro environment may be headed in that direction. The European Central Bank increased stimulus on Thursday, and Treasury Secretary Steven Mnuchin is offering a $916 billion stimulus package to Congress to try to break a legislative deadlock.

In other words, buy the dip!

Supportive positioning

Indicators of institutional positioning are supportive of further market gains. John Authers recently highlighted the results of a “global survey of institutions by Natixis SA, which interviewed 500 managers” which found an unexpected level of guarded cautiousness among respondents.

Of these, 79% don’t expect GDP to have recovered to its pre-Covid levels by the end of next year, making them more bearish than typical sell-side researchers…There is a belief in a rotation toward value, but that co-exists with a belief that geopolitical tensions will worsen, amid rising social unrest, as democracy weakens. Both socially and economically, the people running very large institutions plainly believe the market is ahead of itself in expecting the effects of the pandemic to soon be vanquished:

Data from State Street, which aggregates the positioning of its institutional custodial clients, confirms this assessment of institutional cautiousness. Overall market beta has improved off the bottom, but readings are still below the historical par level of 100.
As well, BoA reported that S&P 500 e-mini futures positioning by asset managers are only at average levels and well off their historical highs. That’s a lot of potential buying power if and when institutional managers buy into the cyclical bullish revival thesis.
One of the characteristics of the current rotation is US relative equity market weakness, and the emergence of EM stocks as the new leadership.
The rotation is just getting started. While EM equity and bond fund flows are starting to turn positive, they are still negative on a YTD basis.
The risk-on stampede has much more room to run.

Market internals are bullish

If the market is undergoing a FOMO melt-up, market internals indicates that the rally is nowhere near its peak. The breadth and momentum of the current advance are consistent with past instances of strong advances.
We can glean some clues from past market history. I have been monitoring the % of S&P 500 stocks above their 200-day moving average (dma). Readings above 80 have either resolved with sharp corrections (pink) or sustained advances (grey). In the past, only readings above 90 have seen the market continue to rise. Moreover, rallies normally don’t end until the 14-week RSI reaches a 70 overbought level. The market isn’t there yet – it still has room to run.
As well, FOMO melt-ups generally don’t end until low-quality stocks start to shine. An analysis of the quality factor shows that high-quality stocks are still leading the current rally. (For the uninitiated, S&P has a much strictly profitability criteria for index inclusion than the Russell indices, and therefore the S&P 600 to Russell 2000 is a proxy for the small cap quality factor.) In the past, either large-cap or small-cap quality has flashed warning signs of a “junk” stock rally ahead of the actual market peak. That canary in the market coal mine is still healthy.
In conclusion, the stars are lining up for another stock market FOMO stampede. If this is indeed a market melt-up, any weakness is likely to be mild. Chances are it has further to run before the rally is finished.
Risk on!

The bearish window is closing quickly

Posted by Cam Hui -

Mid-week market update: I highlighted this chart as a possible warning on the weekend (see Melt-up, or meltdown?). In the past, high levels of correlation between the S&P 500 and VVIX, the volatility of the VIX, has generally led to market stalls. In addition, high correlations between the S&P 500 and the VIX Index has also been warnings of market tops. We have seen 14 similar warnings in the past three years. nine episodes were resolved in a bearish way (red vertical lines), and five saw the market either consolidate sideways or continue to rise (blue lines).
 

 

The bulls are on the verge of dodging a bullet. All of the bearish instances saw the market decline soon after the signal. It has been a week since correlations spiked on December 2, 2020. While the S&P 500 is testing rising trend line support as NYSE net highs surged, there is no sign of a downside break. Moreover, NYSE breadth, as measured by advances-declines, was surprisingly positive even as the S&P 500 fell -0.8% on the day.

 

 

Tactically, the bearish window is closing very quickly. Today’s decline may be the bears’ last chance.

 

 

Extended sentiment

I think everyone is aware of the warnings from the sentiment models. Technical analysts have to be blind not to see the signs of excessive bullishness, which is contrarian bearish.

 

The latest short interest report tells a story of capitulation by the bears. Shorts are disappearing. While this is an immediate cause for alarm, but it will not put a floor on stock prices if the market hits an air pocket.

 

 

This week’s Investors Intelligence sentiment remains mostly unchanged. Both the %Bulls and the bull-bear spread are stretched, and they remain at the levels last reached at the melt-up top of early 2018.

 

 

SentimenTrader recently highlighted the record level of call option buying by small traders as a sign of frothiness.

 

 

Macro Charts also pointed out that call/put volume ratio is at levels that have signaled market stalls during the post NASDAQ top period. However, he held out the possibility that the market is undergoing a regime shift when this ratio rose steadily during the late 1990’s.

 

 

 

Strong internals

Notwithstanding the warnings from sentiment models, market internals is strong and they are confirming the new market highs.

 

Equity risk appetite, as measured by the equal-weighted consumer discretionary sector, which minimizes the effects of Amazon and Tesla, and the ratio of high beta to low volatility stocks, is confirming the market’s advance.

 

 

Credit market risk appetite is also in risk-on mode. High yield (junk) bond relative performance continues to advance. More importantly, municipal bond relative performance is showing little anxiety in the face of uncertainty over the prospect of little or no help for state and local authorities should a stimulus package is passed by Congress.

 

 

Foreign exchange markets behavior is also supportive of the equity market advance. The USD is weakening, which is equity bullish. As well, the AUDJPY cross, which is a sensitive barometer of FX market risk appetite, is rising.

 

 

What could derail this rally?

The bulls have gained control of the tape, but what are the potential potholes in the road?

 

The most obvious hurdle is the impasse in Congress over a stimulus bill. The news out of Washington is both hopeful and sobering. It is unclear whether both sides can come to an agreement. Even if they do, it is unclear whether President Trump would sign such a bill should it reach his desk. The market has staged minor rallies on positive news, but the magnitude of the reaction has not been large. I interpret this as expectations are not set overly high. Should negotiations fail, any market disappointment is likely to be minor.

 

The Georgia Senate election in early January could be a bullish or bearish catalyst for the market. If the Democrats win both seats, they would control the Senate and set the agenda for the first two years of the Biden Presidency. It would also open the door to the passage of a massive fiscal stimulus, which would be interpreted as risk-friendly. A Republican win, which is the most likely case, would see divided government and the imposition of fiscal brakes on spending and growth.

 

The market is approaching the election and mostly shrugging off the risks. SPY implied option volatility is sloping up into the election, but readings are not exhibiting high levels of anxiety.

 

 

Current conditions indicate that the market is relatively relaxed about the Georgia Senate races. Compare the current conditions to the evolution in implied volatility heading into November Presidential Election.

 

 

Joe Wiesenthal at Bloomberg summarized the market’s mood this way when he addressed the lack of negative reaction to last Friday’s disappointing November Jobs Report:
So what gives? You can’t read the market’s mind, but one plausible explanation is that investors basically accept that it’s going to be a rough winter no matter what, with a substantial slowdown in economic activity as we wait for the masses to get the vaccine. But investors don’t think that any substantial slowdown over the next few months will really become a self-reinforcing recession. A slowdown, yes, but not one that spirals out of control. And then when the vaccine comes, it’s assumed we’ll have a brisk recovery. The other wildcard here is that stimulus negotiations started looking brighter at the end of last week, and it may be that the deceleration in the labor market, just as millions of people are staring down a loss of benefits, make it more likely Congressional leaders agree to a deal.

 

So you have a market that doesn’t see a winter downturn becoming self-reinforcing + the possibility of a stimulus, pushing bond yields higher. In other words, the market is still basically pricing in two outcomes next year: Good (just a vaccine) and better (a vaccine + stimulus). The bad outcome (a true double dip, where activity spirals lower) is not a market concern right now. That doesn’t mean it can’t happen, but investors aren’t concerned about it, and Friday’s Non-Farm Payrolls miss wasn’t bad enough to really make it a worry.
In conclusion, the bears have a dying chance to seize control of the tape. Frothy sentiment is a concern, but excessive bullishness has not proven to be a timely and actionable sell indicator. My inner trader is siding with the bulls, and so has my inner investor.

 

 

Disclosure: Long SPXL

 

Why you should and shouldn’t invest in Bitcoin

Posted by Cam Hui -

In response to my recent publication (see A focus on gold and oil), a number of readers asked, “What about Bitcoin (BTC)?” Indeed, BTC has diverged and beaten gold recently. Even as gold prices corrected, BTC has been rising steadily since early October.
 

 

Here are the reasons why you should and shouldn’t invest in Bitcoin.
 

 

The long-term bear case

Bitcoin and cryptocurrency adherents and enthusiasts have promoted BTC as an alternative currency outside the control of national governments. In doing so, they either missed or forgot the lessons learned in Money and Banking 101, which is usually an upper-level course offered to undergraduate economics students. Let’s compare the characteristics of BTC (and other cryptocurrencies) to gold, which is widely acknowledged to be an alternative currency and asset class.
 

Is BTC a store of value?
Anything is a store of value if human society deems it to be so. Salt was a store of value in ancient societies. The Chinese today channel enormous savings into real estate, some of which are built on leasehold land, and apartments deteriorate over time. In the past, I have in a semi-serious way referred to China’s M4, which is the M3 money supply plus the value of China’s property market.
 

Gold is a store of value. For hard money adherents, a gold standard limits the ability of governments to print money. The global (gold) money supply is determined by how much miners take out of the ground each year. Based on these assumptions, the growth in gold should equal real growth in global GDP in the long run.
 

What about Bitcoin? The growth in BTC is a function of mining cost. Mining cost can be decomposed into the price of electricity and computing power. Over the long run, innovations like quantum computing will pose a threat to cryptocurrencies inasmuch as they make the mining process much easier. As Milton Friedman famously taught us, too much money chasing too few goods and services creates inflation.
 

Is BTC a medium of exchange?
In theory, gold is a medium of exchange, though it’s difficult to buy much with gold coins and bullion. During the civil war that led to the disintegration of Yugoslavia, there were anecdotal reports that gold was a medium of exchange, but the bid-ask spread on gold was wide – as much as 50%. Similarly, South Africans who wanted to emigrate during the apartheid years when the authorities imposed foreign exchange controls on the country could take their wealth out in gold bullion. However, they did have to pay a relatively wide bid-ask spread.
 

Today, BTC is not widely accepted as a medium of exchange. However, that is changing. PayPal announced in October that it would allow customers to use it and other virtual currencies to shop on its network. Reportedly, the S&P Dow Jones Indices will launch specific crypto indexes in 2021. Acceptance is widening.
 

One legitimate criticism of the use of BTC as a medium of exchange is price volatility. Until volatility starts to settle down, it will be difficult to use any cryptocurrency to pay for goods and services. If you are a merchant transacting in BTC, but your costs are in USD or any other conventional currency, why would you accept that kind of exchange rate volatility? Put it another way, what premium should a merchant put on BTC pricing over USD pricing for the same goods or services as compensation for BTC volatility?
 

Banking BTC
If BTC is indeed an alternative currency and medium of exchange, then a whole host of issues surrounding the banking of that currency arises.
 

In many ways, BTC banking resembles the early development of US banking. Today’s BTC owners typically buy and sell the cryptocurrency at an exchange, which charges fees of several percent to deposit funds and trade. Some early exchange ventures failed or saw their cryptocurrency inventory disappear either owing to theft or fraud in the manner of the Wild West of US banking during the 19th Century.
 

As exchanges have matured and become more established, they have become more mainstream. One example of an exchange is Coinbase, which is registered in the US with the Financial Crimes Enforcement Network and has an E-Money License from the UK’s Financial Conduct Authority. Other major exchanges include Kraken, Bittrex, and Binance. However, increasing financial regulation also means that one of the initial reasons behind the creation of an alternative currency beyond the reach of establishment authorities becomes weaker.
 

As well, some crucial questions involving BTC banking arises in the principles of Money and Banking 101.
 

First, if you lend out your BTC, how would you set the proper interest rate (that’s denominated in BTC)? Determining the interest rate on a loan is a function of several factors. The expected inflation rate, term premium, or the term of the loan, and creditworthiness are typical things to consider. In light of the enormous volatility of the exchange rate, what’s the expected inflation rate of a basket of goods and services in BTC?
 

In addition, there are costs to holding BTC and other cryptocurrencies. These currencies are coded in multiple ledgers all around the world on computer systems. Computer systems cost money to maintain and operate. Implicitly, BTC begins with a negative interest rate or storage cost. Similarly, holding gold also has storage costs, but the storage cost is offset by the inflation hedge feature of gold.
 

More importantly, how do you deal with the fractional banking issue of money creation? Here is how money creation works. In a modern banking system, if individual A deposits $100 into a bank. The bank then lends out $90 of that deposit to individual B, keeping $10 in reserve. B then deposits the $90 into his bank account, and the bank then lends out 90% of the $90 ($81) to C, who then deposits the $81 into his account, and so on. 
 

In the BTC world, can someone lend out their BTCs? Can an exchange lend out their BTCs on deposit? If so, how do the new BTCs get created, because each piece of a digital currency is coded in multiple ledgers? When you lend out a new BTC in a fractional banking system, how do the new funds get coded? 
 

One alternative scheme is to require that if a bank or exchange lends out a BTC, those funds are not available to the depositor? In that case, the bank would have to distinguish between a demand deposit, like a checking account where the depositor can access his funds at any time, and bank-issued GIC-like instruments. Such a system would be a classic gold standard-like banking system that limits credit creation and put severe brakes on economic growth. It would also create disincentives for people to transact in that currency because of the inability of the banking system to finance growth.
 

In conclusion, Bitcoins and other cryptocurrencies are the latest digital equivalent of Beanie Babies or sports figure trading cards. It’s difficult to see how they can have value in the long run.
 

 

The FOMO party bull case

On the other hand, there are some good reasons for investors to get involved in BTC. The bid-ask spread on BTC and other cryptocurrencies is substantial. Market making and storage of BTC is a profitable enterprise, as long as proper risk controls are maintained. Invest not in BTC, but in BTC services and infrastructure.
 

In addition, Josh Brown forcefully laid out Five Reasons Why Bitcoin is Going Up which I summarize below (with my comments in parenthesis).
 

Reason one: It’s going up because it’s going up (otherwise known as FOMO).
Reason two: Paypal and Square’s Cash App (or widespread adoption).
Reason three: Wall Street legends are being won over (institutional FOMO).
Reason four: Gold and silver aren’t “working” (momentum trading).
Reason five: More on-ramps, in addition to PayPal and Square, are on their way. Bitcoin in your Fidelity account. Bitcoin on the Robinhood app. Bitcoin in your bank account. Bitcoin as a default option in your payments account, etc.  (see reason two)
 

Brown concluded:

This is changing, slowly but inevitably. More access, cheaper pricing, less fear, less hesitation. Mainstream buy-in and adoption by the Fidelity’s and the PayPal’s of the world removes the counterparty risk concerns and the fear of theft from the front burner. The rise in price will serve as all the confirmation bias the adopters need in order to be spurred on even further into their allocations.

In other words, Bitcoin is becoming the next fad in momentum and FOMO investing. There are profits available in the short and medium-term. Enjoy the party, but don’t mistake it for a durable alternative currency.
 

Melt-up, or meltdown?

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 which 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.
 

 

An overbought market

The S&P 500 closed November above its upper monthly Bollinger Band. This is a rare occurrence and going back to 1990, there were 14 occurrences. Exactly half of the episodes saw the market continue to rise, and the other half fell.

 

 

Virtually all sentiment models are screaming “caution”!

 

 

On the other hand, momentum is extremely strong after the S&P 500 gained 10.8% in November. Are these overbought conditions the signs of a melt-up, or the warnings of an imminent pullback?

 

 

Froth, froth everywhere

SentimenTrader observed that for the first time in 15 years, 60% of its sentiment indicators are exhibiting excessive optimism – which is a record.

 

 

However, sentiment indicators come with an important caveat. They work better at pinpointing bottoms than at calling tops. That’s because investors panic at bottoms, which are easy to spot. On the other hand, investors become complacent at market tops but need a bearish catalyst for the market to fall.

 

 

 

Bullish momentum = Melt-up?

In the meantime, the S&P 500 is roaring ahead after a 10.8% gain in November. Ryan Detrick of LPL Financial found that price momentum tends to persist after 10% monthly gains if you look ahead 6 and 12 months. Results for the next month, which in this case is December, show a positive average and median gain, but the success rate is a coin flip at 50%.

 

 

SentimenTrader also observed that NAAIM active managers are so bullish they’re levered long. However, the “average return 3 months later was 5%, with the 3 precedents all being higher”. The moral of this story: don’t discount the effects of price momentum.
 

I have been monitoring the % of S&P 500 stocks above their 200-day moving averages. Readings have spiked above 80% to over 90%. Past episodes of surges above 80% have been divided into sustained advances (in grey) and pullbacks (in pink). However, only readings above 90% have been signals of “good overbought” rallies. These conditions argue for a market melt-up despite warnings from sentiment models.

 

 

Here is an odd but bullish anomalous sign from sentiment models. Macro Charts observed that traders are selling aggressively, and the “5-Week positioning change is one of the most negative in history – previously only seen at bottoms”.

 

 

These readings are unusual because hedge fund equity futures trading is mainly dominated by Commodity Trader Advisers (CTAs). CTAs are trend followers, and they should be buying, not selling, as prices have been rising. The most likely explanation of significant large speculator selling can be attributable to rebalancing flows by institutions. Equities have outperformed bonds so much in Q4 that large balanced funds need to sell stocks and buy bonds in order to return to their target weights. If the stock market is holding up well in the face of concerted rebalancing selling, then the underlying momentum is stronger than appears.

 

That’s a bullish sign.

 

 

Buy the dip!

Troy Bombardia resolved the bull and bear debate this way.
Something truly rare is happening in financial markets right now. Both sentiment and breadth figures are at multi-year highs (if not multi-decade highs). When this happens, investors and traders split into 2 camps: those who think that stocks will crash (sentiment camp), and those who think that this is only the start of a great bull market (breadth & breakout camp).
Things are never so black and white. The 2 narratives can co-exist if we consider 2 different time frames. 

 

While unimaginably high sentiment can and usually does lead to short term losses and market volatility, incredibly strong breadth is more of a long term bullish sign for stocks.
This year has been extremely unusual in the markets. An anecdotal report from Goldman’s prime brokerage desk revealed that hedge funds approached the November election cautiously and they were underweight equity beta. As a consequence, “both fundamental and systematic L/S equity funds gave up nearly half of their YTD alpha (over MSCI) in November, one of the worst months for alpha performance in 5 years.”

 

This is a classic setup for a market melt-up. With the December quarter-end and year-end approaching, which is a deadline on which the quarterly and annual 20% incentive fees are calculated, there is a temptation for hedge fund traders to engage in a beta chase for better returns. It is noteworthy that the stock market’s reaction to Friday’s big miss in the November Jobs Report was to rise. A market’s ability to shrug off bad news is bullish. This is also an indication of the strength of price momentum. 

 

Callum Thomas of Topdown Charts pointed out that that value-growth seasonality is tilted towards value in December and January. In light of the Great Rotation into value and small-cap stocks, a hedge fund beat chase is likely to benefit these groups should the market melt-up.

 

 

The top-down macro perspective is also supportive of a risk-on environment. Manufacturing PMIs and ISM manufacturing data are all pointing to a global rebound. Historically, such conditions have sparked a fund flows stampede into equities.

 

 

To be sure, some short-term warnings are appearing. The 5-day correlation between the S&P 500 and VVIX, the volatility of VIX, has spiked to over 70%. Past episodes have seen the market stall but pullbacks have tended to be relatively shallow.

 

 

In this environment, investors should be buying dips as the downside risk should be relatively limited.

 

 

How long can the melt-up last?

Under a melt-up scenario, how long can the rally last? I have two ways of estimating the length of an advance. 

 

Macro Charts pointed out that corporate insider selling has risen to levels not seen in four years. However, insiders tend to be early in their trades, and the market usually doesn’t top out for several weeks or months after a spike in selling. Based on this data, pencil in a top during the January to February time frame.

 

 

As well, a reader alerted me to an analysis featuring the 56-week pattern. 
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.

 

The 56-week pattern puts the timing of a significant downdraft in the March to July period. Based on this framework, we should also see some market weakness starting around mid-December 2021.

 

In conclusion, the weight of the evidence is supportive of the melt-up scenario. Any market weakness should be relatively shallow. You should take advantage of dips to add to long positions. The timing of a melt-up market top is less clear, but start to be cautious by late January, but the ultimate top may not arrive until February or March.

 

 

Disclosure: Long SPXL

 

A focus on gold and oil

Posted by Cam Hui -

I received considerable feedback from last week’s publication (see How to outperform by 50-250% over 2-3 years), mostly related to gold and energy stocks.
 

 

In last week’s analysis, I had lumped these groups in with other cyclicals. Examining them further, I conclude that both gold and energy stocks have bright futures over the next 2–3 years. I estimate that gold prices could beat US large-cap growth stocks by about 100% over this period, and I would favor bullion over gold stocks. The upside target for energy stocks is a little bit tricky owing to their declining fundamentals and falling demand from ESG investing. The upside relative performance target is wider at 25–300% for this sector.
 

 

A New Commodity Supercycle

Both gold and oil are major commodities, and we may be seeing the start of a new commodity bull and supercycle for the next 10 years.
 

Commodity prices are very washed-out relative to stock prices. There is little or no institutional memory of what to do if inflation heats up. The last secular commodity bull began in the 1970’s, and there are hardly any portfolio managers working today who remember that era, and how to respond and position portfolios.
 

 

Mark Hulbert recently argued that the next decade could represent a period of mean reversion in asset returns.

Here’s why investors should expect below-average returns over the next decade: the historical data exhibit a strong reversal tendency. To show this, I calculated a statistic known as the correlation coefficient, which would be 1.0 if the best trailing decade returns were correlated with the best subsequent decade returns, and so on down the line. The coefficient would have been minus 1.0 if the best trailing returns were correlated with the worst subsequent returns, and so on, while a coefficient of zero would mean there is no detectable relationship between the two.
 

When focusing on all months since 1881 in Shiller’s database, I calculated this coefficient to be minus 0.35, which is strongly significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.

 

 

At a minimum, it would be no surprise to see commodity prices rise as the global economic recovery gains strength as the COVID pandemic fades.
 

 

China has been a voracious consumer of commodities and the locomotive of global growth. Its November Caixin PMI, which measures the activity of smaller firms, has roared ahead to a decade high. This is supportive of a surge in commodity demand from the Middle Kingdom.
 

 

 

Gold: Inflation hedge
That brings us to the story of gold, which is traditionally viewed as an inflation hedge. Today, a combination of easy central bank policy determined to raise inflation and easy to neutral fiscal policy is likely to ignite a round of asset price inflation.
 

Indeed, inflationary expectations as measured by the 5×5 forward rate are rising. In response, the trade-weighted dollar (inverted scale) is falling. While inflationary expectations are still relatively tame at 1.9%, these readings nevertheless are signaling a rising inflation regime.
 

 

I expect that commodity prices will outpace the S&P 500 in the next few years. The chart below depicts gold prices, the CRB Index, and the ratios of the S&P 500 to gold and to the CRB. In particular, the S&P 500 to gold ratio is an especially sensitive barometer of commodity price strength. The bottom panel shows that we are undergoing a period of falling S&P 500/gold, which is reminiscent of the mid-1990’s and the post-GFC period when the economy was in expansion and commodities outperformed stocks.
 

 

Asset managers are catching on to this new commodity reflation trend. The BoA Global Fund Manager Survey shows fund manager weights in commodities began rising just as the S&P 500 to gold ratio started falling. Commodity weights are not excessive, and they have more room to run should inflationary and growth expectations rise further.
 

 

From a technical perspective, gold prices staged an upside breakout from a multi-year base. They retreated below the breakout as a test. One hint of bullish strength comes from inflationary expectations, which broke out of a declining trend line.
 

 

Moreover, gold sentiment has fallen to bearish extremes to levels last seen when gold was $1200/oz.
 

 

That said, I would favor a direct investment in gold bullion instead of gold stocks. Large and small-cap gold stocks have performed roughly in line with their capitalization benchmarks (top panel). The gold stock to gold ratio (bottom panel) staged an upside breakout in April and remains above the breakout level. Gold stocks are not especially cheap on an historical basis relative to the underlying commodity. As well, small-cap golds are outperforming large-cap golds (middle panel), indicating a heightened level of speculative fever in the sector.

 

 

 

An important caveat for Canadian investors

I would like to add an important caveat for Canadian Dollar denominated investors. Commodities are usually priced in USD, but the CADUSD exchange rate has been highly correlated with commodity prices. While CAD denominated investors should still profit during an era of rising commodities, they will face headwinds if their currency exposure is unhedged.
 

 

A similar warning applies to investors residing in other countries with high levels of commodity exports, such as Australia and New Zealand.
 

 

Oil and gas: The new tobacco

Turning to the energy sector, the fundamentals look terrible. A recent Bloomberg article blared that Peak Oil is upon us, but it’s a Peak Oil of a different sort. The old Peak Oil thesis relied on dwindling global supply and the inability of producers to meet demand. Today’s Peak Oil is all about falling demand.

British oil giant BP Plc in September made an extraordinary call: Humanity’s thirst for oil may never again return to prior levels. That would make 2019 the high-water mark in oil history.
 

BP wasn’t the only one sounding an alarm. While none of the prominent forecasters were quite as bearish, predictions for peak oil started popping up everywhere. Even OPEC, the unflappably bullish cartel of major oil exporters, suddenly acknowledged an end in sight—albeit still two decades away. Taken together these forecasts mark an emerging view that this year’s drop in oil demand isn’t just another crash-and-grow event as seen throughout history. Covid-19 has accelerated long-term trends that are transforming where our energy comes from. Some of those changes will be permanent.

In addition, the widespread of ESG investing will reduce demand for energy stocks. The world is going green. Investment in coal, oil, and natural gas is going to be shunned in different degrees. As an example, the Trump administration rushed an auction of drilling rights inside Alaska’s wildlife refuge. But no oil majors are participating in the auction owing to high extraction costs, and no major American banks have expressed interest in financing these transactions.

 

 

While petroleum products are still useful for transportation because of the internal combustion engine, technological advances in the last 10 years have made solar and wind power highly competitive in many areas for electricity generation. Even the cost of gas peakers, or natural gas power plants that only operate at peak demand hours, have come down. The main hurdle for renewable electricity generation is now battery technology and the cost of storage.

 

 

That said, the performance of the energy sector looks washed-out. The energy sector has become the smallest weight in the S&P 500. Exxon Mobil was recently kicked out of the Dow Jones Industrials Average after nearly a century to make way for Salesforce.com. Bloomberg also reported that the company announced a record writedown of its assets.
 

Exxon Mobil Corp. is about to incur the biggest writedown in its modern history as the giant U.S. oil and gas producer reels from this year’s collapse in energy prices.

 

Exxon — traditionally far more reluctant to cut the book value of its business than other oil majors — on Monday disclosed it will write down North and South American natural gas fields by $17 billion to $20 billion. That could make it the industry’s steepest impairment since BP Plc’s 2010 Gulf of Mexico oil spill that killed 11 workers and fouled the sea for months. Meanwhile, capital spending will be drastically reduced through 2025.
So what did the stock do after it announced these writedowns? It rose on the day.

 

 

The reaction to XOM’s news is indicative of the market action in the sector. While the relative performance of large-cap energy has been dismal as it exhibited a lower low, small-cap energy has been outperforming with a relative return of a higher low. In fact, the high-beta small-cap energy stocks have been outperforming the more stable large caps over the last few months.

 

 

These are the classic signs of a wash-out sector. It is unloved and stops responding to bad news. However, long-term fundamentals present challenges for investors. It is an industry with declining long-term demand and shunned by ESG investors. Energy has become the classic value play, in the manner of tobacco stocks.

 

 

Estimating upside potential

The final step of my analysis is the upside potential for gold and energy investments. I repeat the same exercise shown in last week`s analysis (see How to outperform by 50-250% over 2-3 years).

 

Here is how I quantified the potential relative performance spreads. The following chart depicts the relative returns of the Dow to NASDAQ 100 (old vs. new economy cyclical factor). The top panel of the chart shows the one-day relative returns of the Dow/NASDAQ 100 ratio, which has surged recently. Also shown are the relative returns of the S&P 600/NASDAQ 100 ratio (small caps to large-cap growth), MSCI World xUS vs. NASDAQ 100 (non-US vs. US growth), gold vs. NASDAQ 100 (gold vs. growth), and the energy sector vs. NASDAQ 100 (energy vs. growth).

 

 

The top panel of daily returns shows a pattern that is consistent with the period following the dot-com bubble top, which suggests that the market is undergoing a similar multi-year turn in leadership.

 

In the second panel, I went on to estimate upside relative potential by observing the dot-com experience, which saw the DJIA/NASDAQ 100 plunge and mean revert to a level just above the spot when the ratio began to accelerate downward, indicating the start of an investing mania. The magnitude of the current episode of downward acceleration was not as severe; therefore, the snapback should be less than the dot-com era. The dot-com bust performance snapback occurred over a period of 2-3 years, and I would expect the time frame for a similar reversal to be about the same.

 

Using these techniques, my upside relative return targets for cyclical stocks is 50-60% of outperformance; small-caps 60-70%; non-US stocks had two targets, the first with about 100% of outperformance, and the second of up to 250%; gold bullion about 100%; and two relative performance targets for energy stocks of 25-60% and 300%.

 

In conclusion, both gold and energy stocks have bright futures over the next 2-3 years. I estimate that gold prices could beat US large-cap growth stocks by about 100% over this period, and I would favor bullion over gold stocks. The upside target for energy stocks is a little bit more tricky owing to their declining fundamentals and falling demand from ESG investing. The upside relative performance target is wider at 25-300% for this sector.

 

The bears’ chance to make a stand

Posted by Cam Hui -

Mid-week market update: As the S&P 500 pushed to another fresh high, more cracks were appearing in the market internals, indicating that it may be time for the rally to take a pause. Negative divergences, such as the 5-day RSI and a trend of falling NYSE new 52-week highs, are warning signs for the near-term outlook.
 

 

While the intermediate-term trend is still up, the bears have a chance to make a stand here, at least in the short run.

 

 

Frothy sentiment

Sentiment indicators continue to exhibit signs of froth. The Investors Intelligence survey shows that both %bulls and the bull-bear spread haven’t seen these levels since the melt-up top of early 2018.

 

 

Option sentiment is equally exuberant. The 10 day moving average of the equity put/call ratio has fallen to levels where the market has experienced difficulty advancing in the last year.

 

 

As well, call option volumes are still exploding. The Robinhood retail traders don’t seem to have lost their enthusiasm for single-stock call options.

 

The powder is set. The bears just need an event to light the fuse.

 

 

NFP report the bearish trigger?

The trigger might be the November Non-Farm Payroll report due Friday morning. An abundance of evidence is appearing that the report is likely to miss in a big way.

 

The first sign is the ADP private market sector jobs report, which came in at 307K, compared to an expected 410K. However, ADP has shown itself to be a noisy predictor and has experienced wide variations with the actual NFP figure.

 

The current consensus forecast for November NFP is a gain of 480K jobs. The latest ADP figure  is pointing to a weak but positive NFP print, but there is evidence that we could see an actual negative jobs number. The biggest headwind is a seasonal gain of retail jobs that are unlikely to appear, and won’t be offset by online worker hiring. As well, over 90K in temporary census workers will be lost in government jobs, and state and local employment will continue to come under pressure in the absence of help from the federal government.

 

High-frequency data from outfits like Homebase, Kronos and UI claims point to negative growth in November employment.

 

 

The Census Bureau’s Household Pulse Survey is also calling for a negative NFP print for November.

 

 

In the absence of a positive catalyst such as another vaccine breakthrough or fiscal stimulus package, my best-case scenario is a weak but positive NFP headline report. There is a significant chance that we could see negative job growth for November, though the gains shown by ADP report has mitigated that risk.

 

My inner trader has taken a short position in response to weak technical internals, frothy sentiment, and the downside risk to Friday’s NFP report. At a minimum, traders should not be long risk going into the report.

 

By contrast, my inner investor remains bullishly positioned. The intermediate-term outlook remains bullish, and he would regard any weakness as an opportunity to deploy more cash.

 

Disclosure: Long SPXU

 

Will Powell twist?

Posted by Cam Hui -

Jens Nordvig recently conducted an unscientific Twitter poll on the FOMC’s action at the December meeting/ While there was a small plurality leaning towards a “steady as she goes” course, there was a significant minority calling for another Operation Twist, in which the Fed shifts buying from the short end to the medium and long ends of the yield curve.
 

 

The November FOMC minutes reveal no clear consensus on the prospect of a twist, otherwise known as yield curve control (YCC).

A few participants indicated that asset purchases could also help guard against undesirable upward pressure on longer-term rates that could arise, for example, from higher-than-expected Treasury debt issuance. Several participants noted the possibility that there may be limits to the amount of additional accommodation that could be provided through increases in the Federal Reserve’s asset holdings in light of the low level of longer-term yields, and they expressed concerns that a significant expansion in asset holdings could have unintended consequences.

Here is why that matters.
 

 

Implicit yield curve control?

There are several ways of projecting the 10-year Treasury yield based on cyclical conditions. An analysis of the copper/gold ratio and the base metals/gold ratio indicates a range of 1.4% to 1.8%.
 

 

Nordea Markets observed that the cyclical/defensive sector ratio is pointing to a 10-year yield of over 2%.
 

 

These are all estimates, but they are all giving us the same message. The 10-year Treasury yield should be a lot higher than it is today. While the Fed has not explicitly engaged in YCC, just the threat of YCC may have served to hold down the 10-year yield.
 

 

Equity market implications

Here is why this matters for equity investors. First and foremost, fixed income instruments serve as alternatives for equities. If yields are low, then equities are more attractive by comparison.

 

As well, technology and large-cap growth stocks are forms of duration plays that are more sensitive to bond yields. Even at the current level of the 10-year, the NASDAQ 100 should be underperforming the S&P 500. What happens if the Fed steps back from YCC at the December FOMC meeting? Will growth stocks crash and cyclical and value stocks soar?

 

 

Jerome Powell is testifying before Congress tomorrow (Tuesday). Perhaps we will get more clarify then.

 

A Wall of Worry, or Slope of Hope?

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 which 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.
 

 

The proverbial Wall of Worry

Two weeks ago, I turned decisively bullish on the market (see Everything you need to know about the Great Rotation but were afraid to ask). Since then, major market indices have staged upside breakouts to new highs. The market is overbought and exhibiting a minor negative RSI divergence.

 

 

While I remain intermediate-term bullish, the short-term outlook is less certain. Market sentiment is becoming a little frothy, and the market is vulnerable to a setback should any negative catalysts were to appear.

 

The bulls will say that the market is just climbing the proverbial Wall of Worry. The bears contend that it is nearing a Slope of Hope. What’s the real story?

 

 

What I am worried about

The market can correct at any time, but that doesn’t mean that it will. Here are the major potential problems that I am worried about.

 

  • Excessively bullish sentiment
  • Fund flows and positioning vulnerabilities
  • Fiscal cliff and double-dip recession risk
Let’s consider each of these issues.

 

 

Too euphoric?

The most obvious area of concern is sentiment. Sentiment surveys are becoming increasingly giddy, which is a concern for the bulls. The Citi Panic/Euphoria Model is back at the euphoric highs seen last August.

 

 

The latest Investors Intelligence sentiment survey shows that the percentage of bulls and bull-bear spread reached levels last seen at the terminal phase of the melt-up of early 2018.

 

 

The Fear & Greed Index reached the nosebleed level of 92. It is also screaming warnings of overbought conditions, though the indicator has not proven itself to be an actionable tactical sell signal for traders in the past. Historically, the market has corrected when sentiment has become this greedy, but not necessarily right away.

 

 

Here is my alternate bullish scenario. Severely overbought conditions are usually present in the initial stage of a sustained bullish advance. The percentage of S&P 500 stocks above their 200 day moving average (dma) has surged to over 80%. Past instances have either resolved themselves with “good overbought” rallies (grey) or brief overbought conditions and pullbacks (pink). However, only readings of 90% or more have signaled a strong and sustainable bull phase. Is this a new bull?

 

 

Federal Reserve actions may be blinding technical analysts when they warn of excessively bullish sentiment and overbought conditions. In the past, economic recoveries have been marked by a steepening yield curve as the bond market anticipates better future growth. This time, the Fed and other major global central banks have promised to hold short rates near zero for years, but the yield curve isn’t steepening as strongly as it has in the past. Steepening yield curves have acted as a brake to higher stock prices by offering a higher yield alternative for investors. Indeed, the BoA Global Fund Manager Survey shows that expectations for a steeper yield curve are at all-time highs.

 

 

This time may be different. While the Fed has not explicitly engaged in yield curve control (YCC), the latest FOMC minutes has hinted at such actions and even the threat of YCC may be enough to hold down the belly and long end of the yield curve to support higher stock prices.

 

 

I would add that it isn’t just the Fed concerned about the yield curve. Bloomberg reported that ECB chief economist Philip Lane voiced similar worries, even as the German 2s10s stands at a meager 17bp, the lowest level since 2008.

“While the arrival in the coming weeks and months of further positive signals about progress in the roll-out of vaccine treatments would certainly be highly welcome,“ Lane added, “it is essential that the macroeconomic recovery is not derailed by a premature steepening of the yield curve.”

 

 

Fund flows and positioning vulnerabilities

Another sign of froth has been the stampede into stocks, as evidenced by record fund flows into global equities.

 

 

Despite the recent relative weakness of FANG+ names, retail interest hasn’t abated. Option open interest remains highly elevated.

 

 

As we approach quarter-end and year-end, the strong performance of equities could prompt balanced funds to rebalance by selling their stocks to buy bonds. Bloomberg reported that JPMorgan estimates that rebalancing flows could amount to $300 billion.
Rebalancing flows may lead to an exodus of around $300 billion from global stocks by the end of the year, according to JPMorgan Chase & Co.
Large multi-asset investors may need to rotate money into bonds from stocks after strong equity performance so far this month, strategists led by Nikolaos Panigirtzoglou wrote in a note Friday. They include balanced mutual funds, like 60/40 portfolios, U.S. defined-benefit pension plans and some big investors like Norges Bank, which manages Norway’s sovereign wealth fund, and the Japanese government pension plan GPIF, the strategists said.

 

“We see some vulnerability in equity markets in the near term from balanced mutual funds, a $7 trillion universe, having to sell around $160 billion of equities globally to revert to their target 60:40 allocation either by the end of November or by the end of December at the latest,” the strategists wrote.

 

If the stock market rallies into December, there could be an additional $150 billion of equity selling into the end of the month pension funds that tend to rebalance on a quarterly basis, they added.
For some perspective of the magnitude of fund rebalancing pressure, BoA and EPFR reported a record 3-week global equity fund inflows of $89 billion. The bulls better hope that there is sufficient demand to offset the rebalancing effect.

 

 

Fiscal cliff = Double-dip?

Turning to the Washington ollies, let’s start with the good news. Bloomberg reported that there is a tentative agreement to avoid a government shutdown.
Republican and Democratic lawmakers have reached an agreement on spending levels for the annual spending bill needed to keep the government open after current funding runs out Dec. 11 – The deal between Senate Appropriations Chairman Richard Shelby, an Alabama Republican, and House Appropriations Chairwoman Nita Lowey, a New York Democrat, increases the chances that a giant $1.4 trillion bill to fund the government can pass Congress before the deadline.  The agreement encompasses top-line amounts for all 12 parts of an omnibus appropriations package as well as the level for emergency spending above the $1.4 trillion budget cap set in law in 2019.
However, the political incentives are not in place for a CARE Act 2.0. The latest PCE report shows that personal income growth after CARES Act transfers has been steadily decelerating. 

 

 

The consensus forecast for the November Jobs Report is a gain of 520K jobs, but there is a distinct possibility that the market could be surprised by a negative print. High-frequency data from Homebase and Kronos suggests that the November Jobs Report will be flat to negative.
 

 

The Census Bureau’s Household Pulse Survey is also showing signs of weakness.

 

 

Against a backdrop of rising COVID-19 cases, government-mandated shutdowns, and little or no chance of an interim fiscal package until Biden takes office, when will the market start to focus on a double-dip recession scenario?

 

To be sure, the situation may be as dire as the headlines suggest. Pictet Asset Management estimated that it would only cost $270 billion to keep personal income on-trend. That’s not an extraordinarily high level and well within the reach of negotiators in Washington.

 

 

 

Near-term stall ahead?

Looking to the week ahead, the market rally is starting to show signs of exhaustion. The VIX Index is inversely correlated with the S&P 500, and it is falling towards the 20 level which often defines a normal market environment. However, the VVIX, which is the volatility of the VIX, is nearing an important support level. Moreover, the 9-day to 1-month VIX ratio is in complacency territory. How much more near-term downside is there to the VIX? Conversely, how much more upside is there to the S&P 500?

 

 

In conclusion, the intermediate-term trend for equity prices is up. However, the market faces considerable short-term risks and could correct at any time. However, price momentum is strong, and the market could continue to melt-up into early 2021. If I had to guess, I would put the odds of a continued advance at two-thirds, and a significant correction at one-third.
 

How to outperform by 50-250% over 2-3 years

Posted by Cam Hui -

Investors are increasingly convinced that the cyclical and Great Rotation trade is very real and long-lasting (see Everything you need to know about the Great Rotation but were afraid to ask). That should be bullish for the S&P 500, right?
 

Well, sort of.
 

Despite the cyclical and reflationary tailwinds for stocks, the S&P 500 has a weighting problem. About 44% of its weight is concentrated in Big Tech (technology, communication services, and Amazon). The top five sectors comprise nearly 70% of index weight, and it would be difficult for the index to meaningfully advance without the participation of a majority of these sectors. However, an analysis of the relative performance of the top five sectors does not exactly inspire confidence as to the sustainability of an advance. Technology relative strength, which is the biggest sector, is rolling over. Healthcare is weak. Neither consumer discretionary nor communication services are showing any signs of leadership. Only financial stocks, which represent the smallest of the top five sectors, is exhibiting some emerging relative strength.
 

 

There are better investment opportunities, and investors can potentially outperform by a cumulative 50-250% over the next 2-3 years.
 

 

The Great Rotation Risk-On trade is very real

I believe the cyclical rebound and Great Rotation is long-lasting. First, there is ample evidence that the global economy is reflating. The copper/gold ratio and the more broadly based base metals/gold ratio are both surging, indicating cyclical strength.
 

 

Earnings sentiment is improving in every region of the world.
 

 

Other cyclical indicators, such as heavy truck sales, are turning up in a way that is consistent with an early cycle rebound.

 

 

Over in Asia, the closely watched and highly timely 20-day South Korean export figure jumped in November, indicating an acceleration in global strength.
 

 

An analysis of fast-money positioning shows that hedge funds went into the November election underweight equity market exposure. When the dire forecasts of a contested election and riots in the streets didn’t materialize, they reversed course and bought equities. Current positioning is not excessive. Institutional fund flows, which is glacial but enormous, is only beginning to buy into the cyclical and reflation theme.
 

 

This Great Rotation rally has legs.
 

 

What’s the upside potential?

What are the potential gains from the Great Rotation trade?
 

An analysis of the trade setup indicates that upside potential is significant. Historically, relative style performance such as value/growth is long-lasting and the magnitude of gains significant when the dispersion in style returns are large and begin to mean revert.
 

 

A similar reversal effect can be seen for the size effect, or the small vs. large-cap relationship.
 

 

Marketwatch reported that Jim Paulsen of Leuthold and Ed Yardeni believe that small and mid-cap stocks are relatively cheap, and exhibit superior fundamental momentum compared to large caps.

Smidcaps are relatively cheap
This reflects the fact that they’ve been persistently unpopular, despite the recent gains. “Their price action has not kept up with earnings performance,” says Paulsen. Since the end of October, forward one-year estimates for the S&P 600 small-caps have gone up almost 8%, compared to 1.5% for the S&P 500. 
 

In other words, earnings estimates have gone up over four times as much, but stock prices have only gone up twice as much. 
 

From their lows during May-June, the forward earnings of the S&P 500 grew 17%, compared to 35% for the S&P 400 smidcap stocks and 57% for S&P 600 small-caps, according to Ed Yardeni of Yardeni Research. 
 

As of Nov. 24, large-cap S&P 500 stocks had a forward price earnings ratio of 22 compared to 19.7 for S&P 400 midcap stocks and 19.9 for S&P 600 small-cap stocks, says Yardeni. But the gap is effectively wider, given the greater potential for earnings growth among smidcaps going forward. 
 

The bottom line: small-cap stocks have additional catch-up potential.

Here is how I have quantified the potential relative performance spreads. The following chart depicts the relative returns of the Dow (old economy ) to NASDAQ 100 (large-cap growth). The top panel of the chart shows the one-day relative returns of the Dow/NASDAQ 100 ratio, which has surged recently. The pattern is consistent with the period following the dot-com bubble top, which suggests that the market is undergoing a similar multi-year turn in leadership.

 

 

Here are the main takeaways from this analysis.

  • Relative Return Magnitude Potential: The dot-com experience saw the DJIA/NASDAQ 100 plunge and mean revert to a level just above the spot when the ratio began to accelerate downwards, indicating the start of an investing mania. The magnitude of the current episode of downward acceleration was not as severe, and therefore the snapback should be less than the dot-com era.
  • Cyclical trade: One rough measure of the cyclical trade is the Dow (old economy) to NASDAQ 100 (new economy) ratio. The aforementioned estimate technique of upside relative performance potential is 50-60%. If history is any guide, that relative return potential should be achieved within a 2-3 year time frame.
  • Size Effect, or Small Caps: Large caps have been beating small caps for much of the last market cycle. Based on the same evidence, the upside potential is 60-70% over 2-3 years.
  • Non-US stocks: US stocks have led the market upward since the GFC. There is ample evidence that global leadership is changing. However, it is difficult to estimate the magnitude of the potential relative rebound as there were two plateaus and subsequent downward declines in this cycle. If US to non-US stock relative performance were to recover to the first target level, it would translate to a relative gain of 100%. If it were to bounce back to the higher target, the potential relative gain can be as much as 250%.
In conclusion, there is ample evidence that the global cyclical rebound is very real and sustainable over the intermediate-term. The market is forward-looking. Vaccines are on the way, the recession is over. The leadership of US over non-US, growth over value, and large caps over small caps are all turning in convincing fashions.

 

 

While a rising tide does lift all boats, the S&P 500 is likely to lag owing to the heavy weighting in Big Tech stocks, which are likely to be laggards in the next cycle. Investors can outperform by 50-250% over the next 2-3 years with exposure to a combination of cyclical, value, small caps, and non-US stocks.