Do the bulls have a sentiment problem?

Posted by Cam Hui -

Mid-week market update: (I am publishing my mid-week market update a day early owing to the US Thanksgiving holiday shortened week)
 

Should the bulls be worried? The Greed and Fear Index has surged to 88, which represents a warning of excessive bullishness.
 

 

As well, Willie Delwiche pointed out that his survey of sentiment indicators are all tilted either contrarian bearish or neutral. Delwiche concluded that “everyone knows about (& is positioned for) historical tendency for stocks to rally from here into year-end”.
 

 

 

Asymmetric sentiment signals

Before you turn all bearish, I would warn that sentiment models work much better as buy signals than sell signals. The adage that “bottoms are events, but tops are processes” is especially true in this case. Panic bottoms are easy to spot using sentiment, but excessive bullish sentiment readings are not necessarily actionable sell signals. This char of the AAII bull-bear spread is just one of many examples of this effect.
 

 

Deusche Bank recently observed that its cross-asset momentum analysis showed that virtually everything is in risk-on mode. That should be contrarian bearish, right?
 

Not really. Past episodes of strong cross-asset momentum breadth have been bullish for equities, not bearish. Traders should be jumping on the price momentum bandwagon, and not bet against it.
 

 

Further analysis of futures positioning shows that asset managers and leveraged funds are nowhere near in a crowded long yet, indicating that there is more room for the market to rise.
 

 

 

Be Thankful

So where does that leave us? It has been three trading days (and one weekend) since the Mnuchin announcement that he is withdrawing CARES Act support for a number of programs administered by the Fed. Since then, neither high yield (junk) bonds nor municipal bond spreads have blown out. Instead, the stock market has chosen to focus on good news, such as the upbeat PMI print, vaccine news, and the expected nomination of Janet Yellen as Treasury Secretary.
 

 

The S&P 500 staged an upside breakout through a bull flag and it is testing overhead resistance, which is constructive for the bull case.
 

 

The market has historically enjoyed seasonal tail-winds this week. Jeff Hirsch at Trader’s Almanac pointed out that the Wednesday before Thanksgiving and the Friday after tend to have strong bullish biases. Rob Hanna at Quantifiable Edges observed a similar effect and added that the Monday after Thanksgiving has been historically negative.
 

 

However, he observed that the market performed better when the momentum was weak on the Tuesday before Thanksgiving:

To determine whether the Wednesday – Friday Thanksgiving edge may have been front-run a particular year, you could examine price action. I have repeatedly found that a market that is oversold going into a strong seasonal period will perform better than a market that is overbought going into a strong seasonal period. A very simple metric that could be used in this case would be to see whether the market closed in the top or bottom half of its intraday range on Tuesday of Thanksgiving week. To do this I used SPY instead of SPX, because it had better intraday data.
 

Since 1993, I found that years in which SPY closed in the top half of its intraday range on Thanksgiving Tuesday posted a 9-5 record from Tuesday’s close to Friday’s close. When SPY closed in the bottom half of its range on Tuesday the performance over Wednesday to Friday was 10-1. And the average instance posted a 0.8% gain these years versus a 0.1% average gain the other years. So Tuesday’s action appears worth watching as we approach this potentially seasonally bullish period.

 

In a subsequent post, Hanna found that the market continued to be strong during the Thanksgiving period even if the previous Monday and Tuesday were positive. The win rate was 91%, and the only exception was 1987.
 

 

Subscribers received an alert today that my inner trader may be going long the market for a seasonal trade until Friday’s close should SPY close in the bottom half of its range. Based on the combination of the latest analysis from Rob Hanna, and the strength of the recent price momentum, my inner trader went long the market at the end of the day.
 

Disclosure: Long SPXL
 

Too far, too fast?

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.
 

 

Rainbows and unicorns?

It is said that it’s a recession is when your neighbor loses his job, and it’s a Depression if you lose your job. In other words, economic weakness is only academic until it hits home. The denizens of New York City and Wall Street were jolted last week when the MTA, which operates the NYC subway and commuter services Metro-North and Long Island Rail Road, announced that it may need to dramatically cut services in the absence of fiscal support. The MTA proposed laying off 9,000 employees and cuts to transit services of 40-50%.

 

The bad news is hitting home, and Wall Street is suddenly realizing that the recovery is not all rainbows and unicorns. In addition, the decision by the US Treasury to end a series of emergency CARES Act support programs raises the risk to state and local organizations like the MTA.

 

As well, the latest BoA Global Fund Manager Survey revealed that fund managers were stampeding into equities and the reflation trade.

 

 

Cash levels have dropped dramatically. To be sure, low cash levels have acted only as a warning, and have not been actionable sell signals in the past [annotations in blue are mine].

 

 

Has the rally gone too far, too fast? Is the Great Rotation trade of growth to value and large-caps to small-caps just a mirage?

 

 

Time for a pause?

Is it time for the market rally to pause? The pandemic caseload has been rising dramatically in the US. Different states have responded by entering partial lockdowns, which acts as a brake on economic growth and employment. The slowdown isn’t just restricted to the US, the IMF warned that “the most recent data for contact-intensive service industries point to a slowing momentum in economies where the pandemic is resurging”.

 

 

The jobs recovery is showing some signs of stalling. Last week’s print of initial jobless claims missed expectations. The trend of the last few weeks has seen initial claims flatten out and may be edging up again, which raises the specter of a double-dip recession.

 

 

More worrisome is the bond market’s reaction, which is not buying into the equity market’s reflation thesis. The yield curve steepened in response to the upbeat vaccine news. However, inflation breakeven yields were flat during the same period. This is an indication that the bond market expects growth and inflation will be sluggish.

 

 

The most alarming development is Treasury Secretary Mnuchin’s refusal to extend CARES Act emergency lending programs beyond December 31, as reported by the WSJWSJ.
Treasury Secretary Steven Mnuchin declined to extend several emergency loan programs established jointly with the Federal Reserve that are set to expire on Dec. 31.

 

The Fed’s corporate credit, municipal lending and Main Street Lending programs won’t be renewed, Mr. Mnuchin said Thursday.

 

The central bank signaled disappointment in his decision. “The Federal Reserve would prefer that the full suite of emergency facilities established during the coronavirus pandemic continue to serve their important role as a backstop for our still-strained and vulnerable economy,” the Fed said in a statement.
These programs are the Municipal Liquidity Facility, Main Street Lending Program, and Primary and Secondary Market Corporate Credit Facilities. More importantly, Treasury has asked the Fed to return unused stimulus funds. This is a potentially contractionary fiscal development and a possible preview of the spending tug-of-war between a Biden White House and a Republican-controlled Senate.
Industry analysts have warned that Mr. Mnuchin’s decision would risk unsettling markets—which for various reasons have been volatile around the end of the recent years—by weakening a key source of insurance that fueled investors’ optimism, especially as the pace of the economic rebound that began in May slows amid rising coronavirus cases.

 

Shutting down the programs could also deprive some businesses and governments of access to low-cost credit if market conditions worsen.
Since the March low, risky corporate and municipal credit has rallied on Fed buying and signals that it is prepared to support the market. What happens now when that backstop becomes shaky? How will changes in credit market risk appetite affect equities?

 

 

 

Some cause for optimism

Before the bears get overly excited, there are reasons for optimism. First, the pandemic can be controlled. Europe’s restrictive measures are working. Nordea pointed out that the eurozone Big Four is following the same winter seasonal patterns of Australia and South Africa, which also went into tight lockdowns. With the right policies, the pandemic can be controlled, and any growth slowdown will be temporary.

 

 

In addition, any concerns that market participants have stampeded into a crowded long are misplaced. The BoA Global Fund Manager Survey shows that equity weights have surged, but levels are not excessive by historical standards.

 

 

While the BoA survey is a survey of manager’s attitudes, readings can be volatile because they do not necessarily measure what they are actually doing with their portfolios. State Street conducts an aggregated survey of managers, based on custodial data. The latest update of State Street Confidence of North American equity positions indicates that managers are underweight risk (below 100) in their positioning. This is can hardly be called a crowded long condition.

 

 

 

Possible consolidation ahead

In resolving the bull and bear cases, investors need to put the Great Rotation into context (see Everything you need to know about the Great Rotation but were afraid to ask). The market is undergoing a leadership change, from US to non-US, growth to value, and large-caps to small-caps. Such transitions are rarely smooth. We may have to undergo a period of choppiness and consolidation before the cyclical reflationary bull market reasserts itself.

 

 

Major trend breaches tell us that the crowd is probably right, but market action can stabilize and consolidate after a break. As the history of the ratio of NASDAQ 100 to small-cap S&P 600 after the dot-com bubble shows, the ratio staged a brief counter-trend rally and consolidated for a few months before falling. That experience may be a useful template for the market today. 

 

 

I have highlighted in the past that the percentage of S&P 500 stocks above their 200 dma has risen past 80%, reaching almost 90%. Past instances have either resolved themselves in “good overbought” advances (in grey) or market stalls (in pink). The current episode is unusual inasmuch as the 4-week moving average has not exceeded 80% yet, indicating that perhaps breadth and momentum is not all it’s made out to be. This may be supportive of the consolidation and pullback scenario.

 

 

Mark Hulbert has argued that momentum stocks (read: FANG+) are on track to see a strong December, followed by a reversal in January. Since these large-cap growth stocks have taken on defensive characteristics that would imply a corrective phase into year-end.

 

 

However, don’t get hung up too much on the correction and consolidation scenario. Equity risk appetite indicators, such as the equal-weighted consumer discretionary to consumer staples ratio (equal-weighted to minimize the Amazon weight effect on discretionary stocks), and the high beta to low volatility factor performance ratio, are all behaving in constructive manners.

 

 

It’s possible that most of the correction has already played out. Macro Charts observed that equity futures traders have already dramatically cut exposure. The bulls will contend that there may not be much selling left to do. On the other hand, the bears can argue that the market struggled to maintain positive momentum on vaccine news, which is indicative of a poor sentiment backdrop.

 

 

In conclusion, the long and intermediate-term trends for stocks are still up, and the Great Rotation themes remain intact. However, we may be undergoing a brief period of sideways consolidation before launching the next upleg. My inner trader is leaning bullish, but he is staying on the sidelines because of the high risk of sudden reversals. My inner investor believes that any dips should be regarded as buying opportunities.

 

 

Will Mnuchin and COVID derail the cyclical rebound?

Posted by Cam Hui -

I hope that I haven’t offended the market gods. Just after my bullish call for a cyclical recovery (see Everything you need to know about the Great Rotation but were afraid to ask), a number of contrary data points have appeared to cast doubt on the reflation thesis.
 

The markets were jolted by the news on Thursday that Secretary Treasury Mnuchin has declined to extend CARES Act emergency lending facilities established with the Federal Reserve. In addition, Treasury has asked the Fed to return any unused funds. This is a potentially contractionary fiscal development and a possible preview of the spending tug-of-war between a Biden White House and a Republican-controlled Senate.
 

As well, the ongoing risk posed by a second wave of COVID-19 in Europe, and a third wave in the US derail the cyclical bull? The resurgence of the virus is quite clear in the US, as evidenced by rising policy stringency. In Europe, things have become so bad that even the Swedes have abandoned the Swedish model and announced shutdowns.
 

 

High-frequency data, such as Chase card spending, is turning down.
 

 

Are these sufficient negative surprises for equity investors to be worried about? Let’s consider the bull and bear cases.
 

 

A sudden downturn

The bear case has two components, a sudden and unexpected slowdown in growth, and excessively bullish psychology. The slowdown is evident in the Economic Surprise Index, which measures whether economic indicators are beating or missing expectations.
 

 

One example is the October retail sales report, which missed expectations and rose at the slowest pace in six months. As well, the September figure was revised downwards. The retail sales report was the story of a K-shaped recovery. Affluent households that had the means to spend did so. Demand for eCommerce and home renovations to support the work-from-home trend, and luxury goods like cars and electronics, rose. All other categories were weak. Even food sales were negative, which explains the long lines at some food banks.
 

 

Other high-frequency economic data are also pointing to a plateau and possible rollover in employment in the near future.
 

 

In addition, Treasury Secretary Mnuchin’s refusal to extend CARES Act emergency lending programs beyond December 31 isn`t helping the near-term outlook. To be sure, the Federal Reserve reported that current commitments under the facilities are just under $18 billion, which is relatively small but may have significant symbolic value. On the other hand, bond manager Jeff Gundlach reacted in his colorful fashion and characterized the move as “the training wheels…coming off”.

 

 

If corporate credit support is removed, will spreads start to widen, and the loss of risk appetite leak into other asset prices?
 

 

Are expectations too high?

Despite the recent softness in high-frequency data, the Street revised S&P 500 quarterly earnings upwards across the board. Are expectations too high?
 

 

The magazine cover indicator is also flashing double contrarian warnings. Could the cover of the Economist is setting the bar too high for a vaccine-driven recovery in 2021?
 

 

Just as I made the bull case for the Great Rotation from US to non-US, growth to value, and large-cap to small caps, Barron’s embraced small-cap stocks as the next profit opportunity.
 

 

The latest BoA Global Fund Manager Survey (FMS) shows that respondents have piled into the risk-on and Great Rotation trade.
 

 

 

The bull case

Before you batten down the hatches and turn defensive, here is the bull case for equities. First, any “valley” in the near-term growth path isn’t very deep. New Deal democrat observed that even though the tame retail disappointed, real growth remains positive and leads industrial production by a few months.

Historically consumption has slightly led employment by several months, albeit with a lot of noise. It has almost universally done so for the entire 70+ year history that both measures have been kept. Basically, demand for goods and services drives hiring to fulfill that demand (or at least to an increase in hours employed) typically within a few months later. 

 

 

From a big picture perspective, the recovery in retail sales is remarkable compared to the GFC. The concerns over the October retail sales miss represents only a blip in the recovery.
 

 

Analysis of savings patterns indicates the spending downturn is not expected to be very bad. Bloomberg reported that American household balance sheets are flush with cash as fiscal support raised the savings rate. There is plenty of savings to hold up spending. To be sure, the lack of an additional rescue program will exacerbate inequality and the K-shaped recovery, but the market has ignored the weak leg of the K so far. Why should it be any different now? That’s a problem for policymakers in the future. The additional level of household cash can also be deployed into investing, which would create additional demand for equities.
 

 

If you are expecting a Retail Apocalypse, you can forget about it. Walmart and Target reported strong results last week, aided by eCommerce sales. Just listen to Walmart CEO Doug McMillon in his earnings call (via Yahoo Finance):

A big part of this new behavior is the consolidation of trips, whether these are to Walmart stores or any other. Average ticket sizes at Walmart rose 24% in the quarter while the number of transactions fell 14%.
 

And so the rise of online and hybrid orders is serving as a boost to the company’s top line and creates the impetus for a further investment in keeping these sorts of behaviors in place. McMillon says the company is convinced many of these new shopping habits will last past the pandemic. But it’s also in the company’s interest to make this habit as attractive as possible for customers.
 

“When a customer shops [in-store] and online, they spend about twice as much, and they spend more in-store,” McMillon said on the call. “Those are pre-pandemic stats, we’re not updating those at this moment. But it is important to remember, once [customers are] engaged in the digital relationship and they’re shopping [with] us holistically like that, the value of that customer relationship goes up.”

Here is Starbucks, which was hurt badly by the lockdowns:

I could not be more pleased with our US sales recovery, which progress faster than we anticipated. In our final quarter of fiscal 2020 we finished the quarter with the comparable store sales decline of 4% for the month of September, a vast improvement from the approximately 65% decline we experienced at the depth of the pandemic only 5 months ago.

Here is FedEx, which offers a window into the global freight logistics industry:

The growth that we expected to see over a period of three to five years happened in a period of three to five months.

Macro Charts pointed out that the San Francisco Fed’s Daily News Cycle Index is turning up from a low level. This is the trough of a cyclical recovery that should have legs.
 

 

Lastly, don’t forget about the Dow Theory buy signal. Both the Dow Jones Industrials Average and Transportation Average made fresh all-time highs last Monday. This is a classic and powerful signal of a new bull market.

 

 

 

Will the market look over the valley?

How do we resolve the bull and bear cases? Will the market correct in the face of deteriorating macro conditions?
 

Bill McBride of Calculated Risk summarized the dilemma this way. The vaccine news was already baked into most forecasts. The latest infection surge has analysts scrambling to downgrade the H1 2021 outlook while upgrading H2 2021. CNBC reported that JPMorgan has downgraded Q1 GDP growth to -1%, with a bounceback in Q2 of 4.5% and of 6.5% in Q3. The question for traders and investors is whether the market is willing to look over the valley.
 

 

On the other hand, Andrew Thrasher believes that the market is overbought, over-extended, and vulnerable to a setback. News of a pandemic-induced slowdown or Treasury’s sudden pivot towards austerity might just be the catalyst for a pullback.

Well rarely do we have 5 sectors with more than 90% of their stocks above the long-term moving average. The last time this occurred was after the mini-melt up in January 2018 and before that it’s occurred just three times since 2011. Each of these periods, where metaphorically everyone had already “jumped into the pool,” left little catalyst to give the market its next leg up and instead we say varying degrees of weakness enter the market. Most were not severe, remember in early 2018 we had a swift 10% pullback and then continued higher.

 

Whether you are bullish or cautious will depend on your time horizon, and pain threshold. Bear in mind that the intermediate and long-term bull case for equities can only be invalidated if the vaccine recovery story falls apart. The question is whether the market will correct, and how far.
 

I honestly don’t know. The market can weaken at any time, but corrections should be viewed as buying opportunities. I am watching the value and small-cap indices which recently exhibited upside gaps. These gaps are potential bullish runaway gaps. Pullbacks that fill the gaps would be tripwires of a correction.
 

 

Until then, give the bull case the benefit of the doubt.
 

A crowded long, or a “good overbought” advance?

Posted by Cam Hui -

Mid-week market update: In case you missed it, the Dow Theory flashed a definitive buy signal. Both the Dow Jones Industrial and Transportation Averages made all-time highs on Monday. This is the granddaddy of all technical analysis systems, and investors should sit up and pay attention. Moreover, the Dow may be tracing out a series of “good overbought” conditions that are indicative of a sustained rally.
 

 

On the other hand, sentiment models are flashing crowded long and overbought signals. Is the market ripe for a pullback, or is this the start of a “good overbought” advance?
 

 

The bull case

The bull case is simple. There is nothing more bullish than higher prices. In addition to the Dow, the broadly based Wilshire 5000 is also overbought, and possibly rising on a series of “good overbought” conditions. In addition, the VIX Index has not breached its lower Bollinger Band, which is a warning of an overbought signal and prelude to corrective action.
 

 

 

Frothy sentiment

On the other hand, sentiment models are at or near bullish extremes, which can be contrarian bearish.
 

 

There has been some excitement that the percentage of S&P 500 stocks trading over their 200-day moving averages (dma) have risen above 80%. In the past, such conditions have either been signals of a prolonged bull phase (grey), or corrective action (pink). It’s difficult to know how the latest episode will be resolved. Sentiment models, such as AAII weekly sentiment, are not helpful. AAII has flashed excessive bullish readings during prolonged bull phases and corrective phases.
 

 

As well, NDR Crowd Sentiment is also stretched. The market has historically faced headwinds in rising when NDR Crowd Sentiment is above 66. On the other hand, these readings have stayed “overbought” for considerable periods in the past before correcting.
 

 

 

Resolving the bull and bear cases

So what’s the verdict? Is the market about to take off, or pull back?
 

My inner trader dipped his toe in the water on the long side today, but he was stopped out at the S&P 500 5-day moving average near the close. The trading model signal is neutral.
 

 

The probability of the correction scenario is rising. Keep an open mind to all outcomes.
 

 

Value picks and pans

Posted by Cam Hui -

I recently made a presentation at a virtual conference, and an audience member asked me to name some of my favorite value sectors. I had a few answers, but let me start with what I would avoid, namely financial stocks.
 

 

Financial stocks are statistically cheap and comprise a significant weight in most value indices. However, they have a number of challenges not encountered by other value stocks. Bloomberg reported that the Biden transition team is made up of people with a bias towards greater financial oversight and regulation, such as Gary Gensler:

Gensler is the biggest name with Wall Street ties who’s part of the agency-review process. He is a former Goldman Sachs Group Inc.partner who joined President Bill Clinton’s Treasury Department. Gensler was later appointed CFTC chairman by President Barack Obama.
 

His role in Biden’s transition might make some on Wall Street uneasy. When Gensler led the CFTC, he implemented new rules that made him a scourge of banks’ lucrative swaps-trading desks. He also pushed investigations into the manipulation of benchmark interest rates that resulted in firms paying billions of dollars in penalties.
 

Others on Gensler’s team include Dennis Kelleher of Better Markets, a group that advocates for tougher regulation, and Amanda Fischer, the former chief of staff to California Representative Katie Porter, who also supports tighter market rules.

Banking profitability is also at risk of being eroded by financial repression. While the Fed has committed to holding short-terms down for a long time, it is silent on the longer end of the yield curve. The 10-year Treasury yield is already nearing 1%, how much higher can the Fed tolerate? While the two are not directly comparable, the 10-year Treasury yield now exceeds the 10-year Greek yield. (Yes, that Greece)!

 

 

We have seen how financial repression has devastated the European banking sector, and the underperformance of financial stocks is a global phenomenon. Will the US be any different?

 

 

There are better value opportunities. Avoid.

 

 

Energy skids to the smallest sector in the S&P 500

One of the characteristics of contrarian value is a stock or sector that is so unloved that it makes buyers feel positively queasy. The obvious candidate is energy, which has skidded to the smallest sector weight in the S&P 500. The relative performance of the sector shows some constructive signs. While the relative performance of large-cap energy to the S&P 500 exhibits a lower low, the relative performance of small-cap energy is testing a key relative support level and possibly tracing a double bottom (top panel). In addition, the high beta small-cap energy stocks are outperforming low-beta large caps (bottom panel), which is another constructive sign. As the global economy recovers, energy demand should grow, and the current over-supplied oil market will turn into a deficit.

 

 

 

A different kind of Thanksgiving Turkey

Looking outside the US, there are two cheap emerging equity markets that make investors queasy with potentially large gains. The first is Turkey, which has undergone a currency crisis. Net reserves are negative, and they are at risk of being sanctioned by Biden for purchasing a Russian missile system. Over the last weekend, President Erdogan fired the head of the central bank, and the finance minister, who is Erdogan’s son-in-law, tendered his resignation.

 

Turkish equities are cheap, both on an absolute basis and relative to their own history. This is a washed-out market. The Turkish central bank is expected to meet on Thursday, and the market expects a significant increase in the one-week repo rate. Watch for fireworks.
 

 

Another EM country that is trading at rock-bottom valuations compared to its own history is Malaysia.

 

 

The relative performance of these two countries is tracing out constructive patterns indicating that they are becoming immune to bad news. Turkey rallied and regained a relative support level, and Malaysia is testing a key area of relative support. 
 

 

Buy them if you dare.

 

 

Disclosure: Long TUR
 

Still testing triple-top resistance

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 (upgrade)
  • Trend Model signal: Bullish (upgrade)
  • 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 bulls test triple-top resistance

Last week, I highlighted the possible formation of a rare Zweig Breadth Thrust (ZBT) buy signal coupled with an S&P 500 test at triple-top resistance. As it turns out, equity breadth was not strong enough to trigger the ZBT buy signal. Despite making a marginal new all-time high, the S&P 500 is still effectively testing triple-top resistance.

 

 

What’s next?
 

 

A new equity bull

I pointed out in yesterday’s publication (see Everything you need to know about the Great Rotation but were afraid to ask) that the Asset Allocation Trend Model has flashed a buy signal. So has the Ultimate Market Timing Model. 

 

Global market cap has reached a new high. The intermediate and long term trends are bullish.

 

 

However, the short-term outlook for the S&P 500 is less certain. To be sure, breadth is positive, and the percentage of stocks above their 200 day moving averages have exceeded 80%. Past prolonged periods of strong breadth (shown in grey) are characteristics of bull phases and strong advances. On the other hand, brief flashes of strong breadth (shown in pink) have resolved in short-term tops and corrective action.

 

 

 

Here comes the Great Rotation

Here is how I resolve the bull and bear dilemma. Much depends on the nature of the Great Rotation from value to cyclical and value stocks. A quick way of visualizing this rotation is to analyze the DJIA (old economy cyclical) to NASDAQ 100 (growth) ratio. I see two important takeaways from this analysis.

  • The ratio is at levels last seen at the top of the NASDAQ Bubble in 2000.
  • The rate of daily change of this ratio is also similar to the last bubble top period.

 

 

The Great Rotation is very real, and it’s underway. If growth stocks were to crash, it’s possible the DJIA and value stocks could trade sideways as they did during the 2000-02 bear market. 

 

 

However, there are important differences between the NASDAQ Bubble and the current period. The bulk of the last bubble was dominated by unprofitable internet companies trading on the hope of future cash flow and profitability, while today’s Big Tech growth stocks are mostly established incumbents with strong competitive moats and cash flows. Growth stocks today may underperform, but they are unlikely to crash in the manner of the early 2000’s. 

 

Today’s cyclical and value stocks are poised to recover as health authorities get the pandemic under control and the growth outlook normalizes. However, the S&P 500 has a composition problem. Big Tech growth (technology, communication services, and AMZN) comprise 43.4% of S&P 500 weight, while cyclical stocks (consumer discretionary ex-AMZN, industrials, materials, and energy) are only 19.9% of index weight. It would be difficult to see how the S&P 500 can advance significantly if investors were to rotate from growth to cyclical and value.

 

The greatest opportunities are outside the US. In particular, EM equities are showing signs of emerging leadership.

 

 

 

 

Next week’s tactical market outlook

Looking to the week ahead, the market faces a number of cross-currents. Large-cap growth stocks, as measured by QQQ, exhibited a negative OBV divergence indicating distribution. As well, it violated an important relative uptrend line. While they have staged minor rallies, the technical damage is becoming evident and a period of choppiness is likely to follow. 

 

 

On the other hand, both large and small-cap value indices have gapped up. These are possible indications of bullish runaway gaps which are confirmations of the growth to value rotation. In light of the dominance of Big Tech stocks in the S&P 500, however, it’s hard to see how the S&P 500 can make much headway in the short run.

 

 

Option sentiment models are flashing warning signals. The equity put/call ratio (CPCE) is an indicator of retail sentiment, as retail investors use mostly individual stock options to express their views, while the index put/call ratio (CPCI) is indicative of institutional sentiment because institutions use index options for hedging. In the past, a heightened spread between a high CPCI and low CPCE has marked periods when the market has experienced difficulty advancing. The heightened level of anxiety can also be seen in the ratio of the VIX to EM VIX. The US market is now trading like an emerging market, as measured by implied volatility.

 

 

Despite the promising vaccine news, the global economy isn’t out of the woods. New waves of infection have slowed economic activity, and high-frequency economic data is signaling slowdowns in all major Western countries except for Japan. It is unclear how the markets will react to such a development.

 

 

A recent Goldman Sachs small business survey revealed that survivability is still a major problem. Only 60% of respondents are confident that their business will make it, which is a record low in the brief history of the survey.

 

 

The intermediate-term outlook is bullish, but I am inclined to wait for a pullback and a dissipation of overbought conditions before buying into the cyclical and value groups.

 

 

 

Everything you need to know about the Great Rotation, but were afraid to ask

Posted by Cam Hui -

The market lurched upwards on Vaccine Monday on the Pfizer-BioNTech news that it had found promising results in its vaccine trial. In a “Great Rotation”, investors piled into value stocks and abandoned former growth darlings. The Daily Shot published this chart from Goldman Sachs estimating how a successful vaccine rollout could impact sectors. But that’s not the entire story.
 

 

Here is everything you need to know about the Great Rotation but were afraid to ask, and why it’s the signal for a new bull market.

 

 

A duration trade unwind

For the uninitiated, duration measures the price sensitivity of an investment to changes in interest rates. The higher the duration, the higher the price sensitivity. Low coupon instruments such as zero-coupon bonds and growth stocks that pay little or no dividends have the highest duration.
 

In response to the vaccine news, bond yields surged. The bond market sold off, and the yield curve steepened. It was therefore no surprise that growth stocks weakened, while value stocks were bid. The following chart illustrates the duration effect of growth stocks. The relative performance of the NASDAQ 100 is inversely correlated to the 10-year Treasury yield.
 

 

Here is another way of thinking about the shift brought about by the Great Rotation. In a recession, investors bid up growth stocks when economic growth is scarce. Coincidentally, bond yields also fall in recessions. The vaccine news upended the recession narrative and brought hope for a sustained recovery. Bond yields rose, and a rotation began from growth into value.
 

Correlation isn’t causation, but these macro factors are intricately connected.
 

 

The reflation trade thesis

I have been monitoring the cyclical and reflation thesis for several weeks (see Buy the cyclical and reflation trade?) and I have been waiting for a confirmation that the global economy is on the rebound. My main criteria was a break the leadership of the Big Three factors, namely the US over global stocks, growth over value, and large-caps over small-caps. We now have definitive signs of breaks in all three factors. When the character of the macro environment changes, so does the leadership.
 

 

Drilling down to the changes in global leadership, we can see that US stocks remain in a well-defined uptrend against developed market stocks, as measured by MSCI EAFE. It is against EM equities that the S&P 500 is badly lagging, and against China in particular. Even if we were to eliminate China from the EM index, the S&P 500 broke an uptrend against EM xChina (bottom panel).
 

 

The growth and value relationship break is especially evident in the following analysis, no matter how growth and value stocks are defined. The large-cap growth/value ratios traded sideways since early September in line with the S&P 500. However, the small-cap growth/value ratios provided an early warning of the break, as they have been flat since early July and broke down in late October.
 

 

The reversal by market capitalization factor is equally clear. Both the S&P 600 and Russell 2000 have staged upside relative breakouts against the S&P 500.
 

 

 

Positioning for a cyclical rebound

The market had already been anticipating a global cyclical rebound, and the vaccine news made the thesis more definitive. Commodity prices are behaving better. Commodity indices have recovered above their 50 and 200 day moving averages (dma). More importantly, the cyclically sensitive copper/gold ratio is turning up.
 

 

US cyclical sectors and industries are also tracing constructive patterns in their relative performance. All are turning up. Semiconductors, which are both cyclically sensitive and considered to be growth-cyclicals, are on fire. Even Leisure and Entertainment, which supply consumer services that have been devastated by the lockdown, are ticking up.
 

 

In addition, EPS estimate revisions are extremely strong, indicating positive fundamental momentum.
 

 

The relative performance of European sectors is exhibiting a pattern similar to the US market. The relative strength of technology stocks is rolling over. Industrials and consumer services are turning up, and basic materials are rising in a choppy manner in the same way as the relative performance of the US materials sector. Financial stocks remain laggards.
 

 

 

A Trend Model upgrade

As a consequence of the breadth and scope of market signs of a global rebound, the Asset Allocation Trend Model signal has now been upgraded from neutral to bullish. This also means that the Ultimate Market Timing Model, which turned bearish upon the signs of a recession and a risk-off signal from the Trend Model, is also bullish.
 

None of this depends on the success of the Pfizer-BioNTech vaccine. However, the market response to the Pfizer-BioNTech news is a window of how the market is likely to respond in a world where global health authorities begin to get the pandemic under control and growth returns to some semblance of normality.
 

As a reminder, a simulated portfolio of actual Asset Allocation Trend Model signals using some simple asset allocation rules was able to achieve equity-like returns with balanced-fund like risk.
 

 

 

Equity bullish, with a caveat

With the Trend Model turning bullish, does this mean that investors should raise their equity weights? The answer is a qualified yes. Global market cap has reached an all-time high, which is bullish.
 

 

For US-focused investors, it’s another story. An analysis of the sector breakdown of the S&P 500 highlights a dilemma. Big Tech growth sectors comprise 43.4% of S&P 500 index weight, while cyclical sectors are only 19.9%. If the market experiences a rotation from growth to cyclical and value stocks, how will the S&P 500 be able to rise significantly if large-cap growth make up such a large portion of the index?
 

 

Instead, equity bulls should focus on non-US markets. US stocks have historically traded at a slight forward P/E premium to non-US markets, but the premium began to widen from its historical norms starting in about 2016 and it has become extremely stretched. Investors should be able to find better values elsewhere, especially if the global economy were to recover.

 

 

In conclusion, last week’s Vaccine Monday rally was the spark for a Great Rotation from US into non-US, growth into value, and large-caps into small-caps. While the rotation is not dependent on the specific success of the Pfizer-BioNTech vaccine, the news nevertheless opens the window into what might be possible once health authorities get the pandemic under control and the global economy recovers. The market is only on the initial phase of the Great Rotation, which should usher a stampede into a cyclical and reflation trade that will last for many months.

 

ZBT missed – again!

Posted by Cam Hui -

Mid-week market update: It is ironic that four weeks ago today, I pointed out that the market missed flashing a rare Zweig Breadth Thrust buy signal by one day (see Trading the breadth thrust). Market breadth, as measured by the ZBT Indicator, has to rise from an oversold level of 0.40 to an overbought reading of 0.615 or more within a 10-day window. Four weeks ago, it achieved that in 11 days, and the rally fizzled sooner afterward.
 

The ZBT buy signal is extremely rare, and it has occurred only six times since 2004. In all instances, the market has been higher in 12-months, though it “failed” on two occasions inasmuch as it pulled back before roaring ahead to new highs.
 

 

I observed on the weekend that we are on the verge of another possible ZBT buy signal (see Zweig Breadth Thrust and triple-top watch). The 10-day window ends today. Alas, the ZBT just failed to flash a buy signal. It topped out yesterday (Tuesday) at 0.606, which was just short of its 0.615 target, and it retreated today.
 

Despite the setback, all may not be lost.
 

 

DeGraaf breadth thrust signals

Willie DelWiche observed that the market achieved a DeGraaf breadth thrust signal on Monday.
 

 

DelWiche calculated the returns from past signals, and the results showed a definite bullish bias.
 

 

On the other hand, the market experienced a Whaley Breadth Thrust, which coincided with a short-term top (see Trading the breadth thrust). What should we believe as the market tests upside resistance?
 

 

Testing resistance

The S&P 500 is struggling with overhead resistance. While I am keeping an open mind, near-term market action is more consistent with a stall than an upside breakout to new highs.
 

 

The NASDAQ 100 traced out an outside day on Monday, which is a sign of trend reversal. In addition, its relative uptrend against the S&P 500 was violated, leading to substantial technical damage that needs time to heal. 
 

 

The chart below shows the relative performance of the top 5 sectors in the S&P 500. As Big Tech (technology, communication services, Amazon) comprise 43.4% of S&P 500 weight, it will be difficult for the index to significantly advance without Big Tech participation.
 

 

While I am open to the bullish scenario outlined by the deGraaf Breadth Thrust, I believe that the market needs a few days to pull back and consolidate. The intermediate-term outlook is starting to improve, but the market needs a breather.
 

Zweig Breadth Thrust and triple-top watch

Posted by Cam Hui -

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

The Trend Asset Allocation Model is an asset allocation model 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: Sell equities
  • Trend Model signal: Neutral
  • 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.
 

 

Breadth Thrust, or triple top?

What are we to make of the post-election market advance? The S&P 500 is in the process of approaching triple-top resistance level. At the same time, the possibility of a rare Zweig Breadth Thrust (ZBT) buy signal is on the table.

 

 

 

ZBT history

What’s a Zweig Breadth Thrust? Steven Achelis at Metastock explained the ZBT buy signal this way:
A “Breadth Thrust” occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.
According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. [Ed: there have been a few more since that was written]. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.

The market went oversold on the ZBT Indicator and recycled off an oversold reading on October 29, 2020, which is day 1. The market has until next Wednesday, November 11, to reach an overbought condition at the 0.615 level and flash a buy signal.
 

 

Here is the history of ZBT buy signals since 2004. The signal is rare. There have been six signals in the last 16 years. In all cases, the S&P 500 was significantly higher a year later. In four of the six cases, the market never dipped significantly after the buy signal and surged upwards. Two of the buy signals might have been considered to be weak, as they pulled back to test previous lows before rising further.
 

 

As a reminder, I issued a buy signal in January 2019 when this indicator last flashed a buy signal (see A rare “what’s my credit card limit buy signal).
 

 

Rob Hanna at Quantifiable Edges provided hope that the positive price momentum can continue into next week. He observed that ” strong 4-day win streaks that required at least 3 days close up 1% or more” tended to see the market advance further. Day 1 of the study was last Friday. In that case, there is a good chance that the ZBT buy signal will be triggered next week.
 

 

This is something to keep a close eye on.
 

 

Triple-top resistance

On the other hand, the S&P 500 is approaching a triple-top resistance level, which is defined by tops in September and October. Market internals indicates a mixed picture. Some are supportive of an advance, others are showing signs of weakness.
 

The chart of the large-cap S&P 500, mid-cap S&P 400, and the small-cap S&P 600 shows that strength is concentrated in the smaller companies. The S&P 400 has already broken out, and the S&P 600 is testing a key resistance level. These are constructive signs for the overall market.
 

 

On the other hand, other breadth indicators are flashing bearish divergences. Even as the S&P 500 advanced, the percentage of bullish stocks, and the percentage of stocks in the S&P 500 above their 50 dma are ominously showing lower highs.
 

 

The market experienced an unusual condition last Wednesday, the day after the election. The S&P 500 rose over 2%, but advances were less than declines, and advancing volume lagged declining volume. The blogger Macro Charts pointed out that single-day signs of weakness are not necessarily bearish, but we should watch if market breadth strengthens or weakens in the coming days.
 

 

 

Neutral sentiment

Sentiment models are not helpful in determining market direction. Readings are neutral, and could be supportive of further gains, but there is no rule that states the market has to rise when sentiment is neutral.
 

The Fear and Greed Index stands at 40 after recovering from a near-oversold condition. Arguably, the combination of neutral sentiment and positive momentum is bullish, but I don’t consider that a high conviction call.
 

 

Similarly, II Sentiment is also neutral. The bull-bear spread is falling, and % bulls have retreated from a crowded long condition
 

 

 

A new bull?

In conclusion, the market is testing resistance and it is on the verge of an upside breakout. If the bulls can show further upside momentum, it could be the signal of a fresh cyclical bull. If the S&P 500 were to stage an upside breakout, the point and figure objective on the weekly chart is 4049.
 

 

On the other hand, this could be a fake-out, and the bears could defend key resistance levels. The market is short-term overbought, and the advance looks very extended. Keep an open mind in the coming days, and monitor developments, such as the progress of the ZBT Indicator, closely. 
 

My inner investor is still neutrally positioned at the target asset allocation prescribed by investment policy. My inner trader dipped his toe in on the long side on Friday.
 

Disclosure: Long SPXL

 

Growth, interrupted?

Posted by Cam Hui -

Two weeks ago, I rhetorically asked if investors should be buying into the cyclical recovery theme (see Buy the cyclical and reflation trade?). Global green shoots of recovery were appearing, but I identified the “uncertainty of additional fiscal stimulus” as a key risk to the cyclical rebound thesis. Now that Biden appears to be winning the White House, but constrained by a Republican-controlled Senate, it’s time to revisit the recovery question.
 

Regular readers know that I consider the global economy as three trade blocs, NAFTA, Europe, and Asia dominated by China. It is within that framework that I examine the global reflation question. 
 

Is the global economy emerging from a global recession?
 

 

 

Europe: A new lockdown

Let’s start with the bad news. Europe is experiencing a surge in COVID-19 cases. Member EU states have responded by going into lockdown. The worse afflicted are the Czech Republic, France, and Spain. Even Sweden, which was the poster child for light restrictions, is not immune to the second wave.
 

 

Bloomberg reported that the European Commission downgraded the growth forecast for 2021.

Europe’s economy, freshly battered by coronavirus restrictions, is facing a sluggish recovery next year that leaves it open to rising company failures and long-term unemployment.
 

The European Commission said the euro-area economy will grow 4.2% in 2021, less than previous anticipated. It sees a shallower recession this year, though that doesn’t include the latest government lockdowns, which could push some of the region’s biggest economies back into recession.
 

“Europe’s rebound has been interrupted due to the resurgence in Covid-19 cases,” Paolo Gentiloni, EU commissioner for the economy, said in a statement. “In the current context of very high uncertainty, national economic and fiscal policies must remain supportive.”

The stock market hasn’t reacted to these dire forecasts. The analysis of sector internals tells a different story. Cyclical sectors, such as industrials and consumer services are outperforming the market. Basic Materials stocks are tracing out a relative uptrend in a way that is similar to the Materials sector in the US.
 

 

Why?
 

 

There’s a new sheriff in town

That’s because a new sheriff has come into town. (No, it’s not Joe Biden.) it’s China as a source of growth. 
 

 

A glance at the chart of global relative performance shows that US markets were the former leaders but starting to weaken. Other developed markets, like Europe and Japan, have been trading sideways relative to the MSCI All-Country World Index (ACWI). It is China that has emerged as the new leadership (bottom panel).
 

 

On a relative basis, MSCI China has outperformed the S&P 500 this year, and Chinese technology stocks have beaten the NASDAQ 100, albeit in a choppy manner.
 

 

Within the US, the China Exposure Index, which measures the returns of US stocks exposed to China, has performed well.
 

 

China’s economic recovery has proved to be a source of global demand that has become the locomotive for a global recovery. To be sure, the rebound was powered by a credit-fueled boost to production and not household consumption. Nevertheless, there is a strong lead-lag relationship between China’s credit impulse and German manufacturing PMI. Strength in China begets German, and therefore eurozone growth.
 

 

As the China bears’ favorite chart shows, the debt buildup is unsustainable, but that’s a problem for another day. Today, we party, and worry about tomorrow later.
 

 

 

No Blue Wave = Fiscal cliff?

Turning to the US, the markets had been anticipating a Blue Wave, where the Democrats sweep the White House, Senate, and House in the election. Such an outcome would have produced a large fiscal stimulus plan to boost domestic demand. Instead, Biden eked out a marginal win in the election. Any plans of significant fiscal expansion have been handcuffed by a Republican-controlled Senate. The hopes of the American consumer becoming a significant source of renewed global demand in 2021 were dashed on November 3. The markets melted up in the wake of the election. Has the narrative changed? What happened?
 

The analysis of market factors tells the story. As we approached the election, market anxiety rose, as evidenced by a steady rise in the 1-month VIX against the 6-month VIX. As well, the market began to anticipate the growth boost provided by a large fiscal stimulus of a Democratic sweep, as shown by a steepening 2s10s yield curve. Growth had been dominating Value but they lost their mojo as we approached the election. and growth/value traded sideways.
 

 

When it became evident that Biden was likely to be the new President, and the Republicans control the Senate, the narrative changed. Growth stocks rebounded strongly. As Big Tech stocks (technology, communication services, and Amazon) comprise about 44% of the S&P 500, the index soared. The market internals of the rally tells the story of narrow leadership. Even as the S&P 500 surged by over 2% on Wednesday, declining volume outpaced advancing volume on the NYSE. This has never happened before, ever! In other words, the market isn’t rising, Big Tech and Growth stocks are rebounding.
 

Here is the glass half-full market narrative for equity bulls. Without Trump, the risk of protectionism and trade wars will recede. Investors can look forward to little or no tax hikes, and a legislative status quo. The government’s approach to pandemic control will be more scientifically based, and there is hope for one or more vaccines just around the corner. In addition, the Washington Post reported that Senate Majority Leader Mitch McConnell has opened the door to a compromise stimulus bill of about $1 trillion during the lame-duck Senate session. 
 

As well, the Democratic sweep narrative is not entirely dead. Republican Senate control is not necessarily a done deal. The two Georgia seats are headed to a run-off election on January 5, 2021, and there is an outside chance that the Democrats could capture both seats. While I am not holding my breath for that outcome, it does represent a possible bullish surprise for the fiscal stimulus-induced cyclical rebound theme.
 

A large fiscal stimulus may not be a necessary condition for an economic recovery. Fed watcher Tim Duy reacted to last Friday’s strong October Jobs Report this way, “Solid report…As long as jobs keep growing, there will be support for consumption growth. Fiscal support is important for the speed and equity of the recovery but not necessarily the recovery itself.”

 

 

Key risks

The main risk to the outlook is how the world deals with the pandemic. Fed watcher Tim Duy made an important point that the surprising strength in US retail sales is deceptive because of a shift in spending away from services towards goods. When you’re stuck at home, you spend more on goods than services, which often involve face-to-face interaction. Until the pandemic comes under control, the service sector will have a hard time recovering.
 

The IMF has projected global GDP growth under upside and downside scenarios. 

Under the upside scenario, it is assumed that all things in the fight against COVID-19 go much better than assumed in the baseline. On the treatment front, advances quickly start to reduce the fatality rate, reducing fear and helping to restore confidence. An early and substantial ramp-up in investment in vaccine production capabilities and cooperation agreements in the associated global supply chain lead to earlier, widespread vaccine availability. Complete openness and transparency in the underlying science increase confidence in vaccine efficacy and safety, leading to widespread vaccinations. All these advances will allow activity in the contact-intensive sectors, which have been most adversely affected, to bounce back more quickly than assumed in the baseline. In addition, the overall improvement in confidence will lead to higher spending across other sectors as uncertainty about future income prospects subsides. More buoyant activity will in turn lead to improved prospect for firms and less deterioration in fiscal positions, driving an easing in  risk premiums. Further, the faster bounce-back will lead to fewer bankruptcies, less labor market dislocation, and a milder slowing in productivity growth than assumed in the baseline. The improvements in these supply side factors start in 2023 and grow. On the policy front, with the improvement in activity, fiscal withdrawal is assumed to be only in terms of automatic stabilizers, and monetary authorities everywhere are assumed to be able to accommodate the faster growth without imperiling their price stability objectives. Panel 2 in Scenario Figure 2 contains a decomposition of the impact on global GDP of the three key layers under the upside scenario. 

Here is the downside scenario.

For the downside scenario, it is assumed that measures to contain the spread—either mandated or voluntary—slightly increase the direct drag on activity in the second half of 2020 as the virus proves more difficult to contain. Further, it is assumed that in 2021 progress on all fronts in the fight against the virus proves to be slower than assumed in the baseline, including progress on vaccines, treatments, and adherence to social distancing guidelines to contain the virus’s spread. This leads to a deterioration in activity in contact-intensive sectors, with the associated income effects spilling over to other sectors. These domestic demand effects are then amplified via trade. Financial conditions are also assumed to tighten, with corporate spreads rising in advanced economies and both corporate and sovereign spreads widening in emerging market economies. The increase in 2020 is quite mild but grows to be more substantive in 2021 as the weakness in activity persists. Financial conditions gradually return to baseline beyond 2022. Fiscal authorities in advanced economies are assumed to respond with an increase in transfers beyond standard automatic stabilizers, while those in emerging market economies are assumed to be more constrained, with only automatic stabilizers operating. Monetary authorities in advanced economies with constraints on conventional policy space are assumed to use unconventional measures to contain increases in long-term interest rates. The more protracted weakness in activity is assumed to create additional, persistent damage to economies’

There is considerable variation between the two extreme outcomes. The local economy could recover strongly starting in 2021, or it could be mired in a period of slow growth for years.
 

 

I would also be remiss without highlighting my tail-risk warning of a Chinese invasion of Taiwan (see Emerging tail-risk: An invasion of Taiwan). China recently issued an ominous “Don’t say I didn’t warn you” (勿谓言之不预也) warning to Taiwan through official media. Similar language had been used as a prelude to past conflicts. The SCMP reported on October 18, 2020 that China is preparing for war by upgrading its missile bases.

Beijing is stepping up the militarisation of its southeast coast as it prepares for a possible invasion of Taiwan, military observers and sources have said.
 

The People’s Liberation Army has been upgrading its missile bases, and one Beijing-based military source said it has deployed its most advanced hypersonic missile the DF-17 to the area.
 

“The DF-17 hypersonic missile will gradually replace the old DF-11s and DF-15s that were deployed in the southeast region for decades,” the source, who requested anonymity, because of the sensitivity of the topic. “The new missile has a longer range and is able to hit targets more accurately.”

As an illustration of the seriousness of the threat, the article showed a picture of China’s Southern Command Centre, which featured a prominent 3D relief map of southern Taiwan. This is an important indication that China is putting together the capability to invade, though the political will is uncertain. I reiterate that an invasion of Taiwan represents an elevated tail-risk to the bull case, but it is not part of a base case scenario.
 

 

Much will depend on the evolution of China’s relationship with the rest of the world. A column in The Economist shows that the Chinese leadership believes that it is not receiving the level of respect from the US or the rest of the world.

China wants smoother ties with America, said the official. But given their deep roots, present-day tensions will be hard to reverse unless America comes to a new understanding of the world. Westerners are a self-centred and judgmental lot, he charged. They never expected the Chinese—a diligent, studious people—to rival them so soon. No matter which party runs Washington, the official said, “The us has to answer this question: can the us or the Western world accept or respect the rise of China?”

 

 

The long-term path of regional geopolitical tensions is rising. The American decision to sell drones to Taiwan will not smooth relations. As well, Bloomberg reported that China is considering measures to gives its Coast Guard to fire on foreign vessels in disputed waters is another sign of Beijing’s new assertiveness. Conflict seems inevitable unless cooler heads prevail.

 

 

The verdict

Notwithstanding China’s saber-rattling, the global economy is not running on a single piston of Chinese growth. US growth could surprise to the upside. New Deal democrat has been helpfully analyzing the US economy through the lens of coincident, short leading, and long leading indicators. He concluded that the economy is itching to surge, “All three time frames remain firmly positive”, and “the overall dynamic is that of continuing slow improvementIf the pandemic is brought under control due to effective public policy, possibly including a vaccine, by next spring sometime, then the long- and short-leading indicators will start to reassert their true meaning more or less starting now.”

 

Is the global economy on the path to recovery, and should investors pile into cyclical and reflation themes? 

 

For the final verdict, I turn to the analysis of factor leadership. The market has been dominated by three leadership themes: The US over global stocks, growth over value, and large caps over small caps. New cyclical bulls usually begin with a change in leadership, which we may be starting to see today. 

 

 

While US stocks remain in a multi-year relative uptrend against the MSCI All-Country World Index, its relative performance trended sideways for most of this year, and it is at risk of breaking the uptrend line. As I already indicated, Chinese equities have become the new leadership. A break in the US relative uptrend could be a signal of leadership shift.

 

Growth has been handily beating Value for 2020 as the pandemic-induced recession raged. Investors flocked to growth stocks in a world starved for growth, but that relative uptrend is also being tested. I will be monitoring this relationship for signs of a break.

 

Lastly, small caps have begun to outperform large caps. The relative performance ratio rallied through a long-term relative downtrend. This is the first sign of a break in the leadership of the Big Three leaders.

 

In conclusion, the jury is still out on whether investors should fully embrace the cyclical and reflation investment theme. The trend is positive, but we are not there just yet. Keep an open mind as to the outcome, but if market leadership were to turn, that could be the signal of a new cyclical equity bull market.

 

Interpreting the market’s election reaction

Posted by Cam Hui -

Mid-week market update: It’s always instructive to see how the market reacts to the news. If I had told you that the dual market nightmare scenarios of a contested election and a deadlocked election consisting of a Biden Presidency and a Republican-controlled Senate were to come true, would you expect the market to take a risk-on or risk-off tone?
 

Based on publicly available reports, Biden is on his way to the White House. If he were to win all the states that he is leading in, Biden would win the Presidency. As well, the Republicans have retained control of the Senate, which puts the idea of a Blue Wave sweep to rest. That said, the presidential election is very close and subject to challenge. The likelihood of a contested election that winds up in the courts, and the streets, is high.
 

 

In the face of all this uncertainty, the S&P 500 melted up to regain its 50 dma.
 

 

Market strength in the face of bad news is bullish, but there were some blemishes beneath the surface.
 

 

The good news

Let’s start with the good news. The back-to-back 80%+ upside-to-downside volume on Monday and Tuesday negated the 90% down day from last week, according to Lowry’s. This has to be regarded as a positive development for the bulls. In addition, we have a potential Zweig Breadth Thrust, where the market recycles from an oversold extreme to an overbought condition in 10 trading days. Last Thursday was day 1, and the market has until next Wednesday to achieve the ZBT buy signal.
 

 

ZBT buy signals are extremely rare. The last one occurred in January 2019, and it was extremely successful (see A rare “what’s my credit card limit” buy signal).
 

 

 

Murky internals

On the other hand, short-term market internals is raising cautionary flags. Today’s rally was led by large-cap Big Tech stocks. The NYSE Advance-Decline ratio was only 1.3 to 1, and small-cap Russell 2000 was only up 0.0%, compared to 2.2% for the S&P 500.
 

Longer-term, I have concerns about the health of the bull. New bull markets are usually characterized by changes in leadership. The Big Three leadership themes have been US over international stocks, growth over value, and large caps over small caps. As the chart below shows, only small caps have rallied through a declining trend line, indicating a possible change. While US stocks have been largely flat against global stocks, their relative uptrend is intact. The same could be said about the growth and value relationship, whose trend was tested recently but growth remains dominant.
 

 

Notwithstanding a possible ZBT buy signal, I find it hard to call this the start of a new bull without a definitive signal of changes in market leadership.
 

Oh yeah, it’s also FOMC week

Posted by Cam Hui -

What’s on the calendar this week? Did you forget?
 

Oh yeah, there’s an FOMC meeting this week, and there’s the November Jobs Report on Friday. While not much policy change is expected from the Fed this week, Barron’s has already anointed Jerome Powell as “the winner”. (Has anyone started to call him the Maestro yet?)
 

 

Before everyone gets too excited, here are the challenges facing the Fed in the post-electoral and pandemic era.
 

 

Out of firepower?

Former New York Fed President Bill Dudley penned a Bloomberg Opinion article declaring that the Fed really is running out of firepower. He concluded that while the Fed can still take some steps to ease monetary policy, they won’t be very effective and it’s time for fiscal policy to take up the baton.

No doubt, Fed officials should still commit to using all their tools to the fullest. But they should also make it abundantly clear that monetary policy can provide only limited additional support to the economy. It’s up to legislators and the White House to give the economy what it needs — and right now, that means considerably greater fiscal stimulus.

With rates at the zero lower bound (ZLB), the Fed’s principal tools are forward guidance and quantitative easing. There is a limit to forward guidance because of its asymmetric nature. The Fed has made it clear it won’t raise rates until certain employment and inflation targets are hit. 

 

Notwithstanding the ambiguity about the nature of the targets, the only effect forward guidance will have is the shape of the yield curve. Supposing that the economy turns south again. With the Fed’s commitment to hold rates down, the yield curve adjusts by flattening, and assumptions about the timing of the next rate hike are pushed forward. In that sense, that’s all forward guidance can do. The existing policy doesn’t get any easier, the market is just left with the expectations of an extended easier policy. 

 

To be sure, the Fed can engage in unconventional monetary policy in the form of quantitative easing. But QE also has its limits. As the ECB and BOJ found, the central bank can end up owning a substantial portion of outstanding government debt, and central bankers can only stimulate by going out further on the risk curve by buying MBS, corporate bonds, and stocks.
 

Dudley and other Fed speakers are right. Fiscal policy is the most effective form of stimulus at this point.
 

 

Reacting to a recovery

One of the questions for Fed is its reaction function to the steepening yield curve. Will the FOMC statement or Powell’s press conference address either the issue of rising 10-year Treasury yield, or the steepening yield curve in the form of rising growth and inflationary expectations?
 

Sure, the Fed has said it is targeting an “average inflation rate” of 2%, indicating it is willing to tolerate some overshoot of reported inflation. In that case, it runs the risk of allowing inflationary expectations to run out of control, and become unanchored. Even as the economy emerges from the recession, we are already seeing signs of cyclical rebound in growth and inflationary expectations. Gold prices have pulled back and consolidating just below its breakout level. Inflationary expectations (RINF) have staged an upside breakout from a declining trend line. As well, the copper/gold ratio, which is an important cyclical indicator, is turning up, though it has not broken out of its downtrend to signal a liftoff.
 

 

 

Rose-colored glasses

Let’s put on some rose-colored glasses and consider what might happen under a bullish scenario. The election results in a government that enacts a significant stimulus package. In the next 4-6 weeks several Phase 3 vaccine trials will report, and one or more of them are positive enough to see widespread vaccine availability by late Q1 or Q2. The global economy takes off. Already, 81% of global manufacturing PMIs are in expansion.
 

 

The bottom-up view is the same. The latest update from The Transcript, which monitors earnings reports, tells an upbeat story of an economic recovery.

Most parts of the economy have normalized and the economic winners are booming.  Technology, cloud service and e-commerce are leading the way and other industries are surging as well.  Financial service firms focused on M&A advisory, trading and restructuring are seeing strong business.  The housing market is also on fire with new home sales up 32% y/y.  This week’s election and a renewed wave of COVID could dampen activity, but for now, the economy is doing remarkably well.  COVID may have led to structurally higher productivity. 

All this begs questions about the Fed’s reaction function.

  • How far will it allow the 10-year yield to rise?
  • How much steepening will it tolerate in the yield curve?
  • Even though it is focused on employment and reported inflation targets, how does it address the problem of an upward surge in inflationary expectations? Runaway inflationary expectations risks setting off an inflationary spiral that gets out of control.
All very good questions for the Fed chair in his press conference.

 

Scenario planning ahead of the Big Event

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: Sell equities
  • Trend Model signal: Neutral
  • 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.
 

 

Waiting for the Big Event

The US election is just around the corner, and there isn’t much more to say. I have been monitoring the evolution of SPY implied volatility (IV), and this chart represents the final snapshot before the election. Since I began keeping track in September, IV has spiked at the time of the election and remained elevated into 2021, indicating a high level of anxiety over the results, and the possibility of a contested outcome. It was only recently that contested election anxiety has faded, and IV began to normalize just after the initial spike.

 

 

The IV of other asset classes are following a similar pattern to stocks, as represented by SPY. Gold (GLD) and long bond (TLT) IV both surges at election time, and slowly fall afterward.

 

 

The upcoming week should provide greater clarity of macro developments. While the actual outcomes are difficult to predict, investors can engage in some scenario planning so that they can be prepared.

 

 

The election

First, I would like to point out that this level of anxiety of not unusual. BNP Paribas found that implied volatility – realized volatility also spiked before the election in 2016.

 

 

Here is what to watch for on Election Night. As the level of advance and mail-in voting has been very high, not all states will be able to complete most of their counts on Election Night. Pennsylvania, a key swing state, does not begin to process mail-in ballots at 7am on Election Day, and state officials have stated that they may not be able to report a full count until Friday. I refer readers to the analysis last week (see How the Election held the market hostage). Two key battleground states that are expected to report their results in a timely manner are North Carolina and Florida. FiveThirtyEight has a useful tool (link here) to monitor the odds on Election Night. Both those states are must-wins for Trump. If he loses either of those states, it will be a long night for the President.

 

 

The next question is which party gains control of the Senate? The following graphic shows the likely fiscal effects of different scenarios. The most bullish outcome is a Blue Wave, with a Biden Presidency and Democratic Senate, while the most bearish is a Biden win, coupled with a Republican Senate.

 

 

 

New pandemic waves

In addition to election jitters, market concerns are also rising over the appearance of a second pandemic wave in Europe, and a third one in the US. The Financial Times reported that a new mutation has appeared in Spain, and the new variant is spreading across Europe. France and Germany announced lockdowns last week, joining a host of other European governments.

 

 

Here is the glass-half-full version of the analysis. Lockdowns in Europe are constructive. because case counts fall shortly after they begin. Several vaccine Phase III trials are scheduled to report in the next 4-6 weeks, which are hopeful signs for 2021. However, vaccine approval is not assured, and even if one or more vaccines are approved, production and deployment may not be smooth. Investors have to consider the best and worst-case scenarios of vaccine development.

 

 

 

Earnings season

Lastly, the trajectory of equity prices depends on the earnings outlook. So far, the Q3 earnings season has been a success. Both EPS and sales beat rates are above their historical averages, and EPS revisions are positive.

 

 

In fact, earnings sentiment is positive across all regions.

 

 

However, some of the market’s reaction to earnings reports are disconcerting. Earnings misses are badly punished, but beats are not being rewarded.

 

 

 

Crossroads ahead

The near-term path of equity prices depends on how the macro outlook develops. The market is nearing an important crossroads, and we should get greater clarity in the coming week. Bill Luby of VIX and More found that the VIX Index historically rises into an election, and declines afterward. 

 

 

Analysis from Jeff Hirsch of election year seasonal patterns indicates that no matter who wins, November and December have been strong on average. If history is any guide, investors should view the recent market weakness as a buying opportunity, but averages can hide a lot of variation.

 

 

Investors can only engage in scenario planning, and stay prepared.

 

 

Oversold, but…

Looking to the week ahead, the market is entering the new month in a severely oversold condition. We now have an exacta buy signal from my Trifiect Bottom Spotting Model. As a reminder, the Trifecta Model consists of the following three uncorrelated bottom spotting components:
  1. Inverted VIX term structure indicating fear (Yes)
  2. TRIN > 2, indicating a “margin clerk” market involving price-insensitive selling (No)
  3. Intermediate-term overbought/oversold indicator of stocks above their 50 dma/stocks above their 150 dma < 0.50 (Yes)

 

 

In addition, the NASDAQ 100 is behaving remarkably well despite the poor performance of Big Tech stocks that beat earnings expectations but fell last week. The NASDAQ 100 remains in an uptrend relative to the S&P 500.

 

 

My inner investor is neutrally positioned at the asset allocation weight specified by his investment policy. Were it not for the looming event risk on the horizon, my inner trader would be inclined to take a shot at going long here.

 

 

Emerging tail-risk: An invasion of Taiwan

Posted by Cam Hui -

I am not in the habit of peddling conspiracy theories, but this is inadvertently becoming a Halloween tradition. Last Halloween, I wrote about how China could control Taiwan without firing a shot (see Scary Halloween story: How a weak USD could hand China a major victory). This year, a new geopolitical tail-risk is materializing for investors and for global stability. China’s People’s Daily recently published a “Letter to Taiwan’s Intelligence Organs” warning Taiwanese intelligence agencies against supporting President Tsai Ing-wen’s resistance to China’s unification efforts (article in Chinese here, Facebook summary in English here).

People’s Daily on Thursday urged intelligence agencies in Taiwan to stay away from the “fatal track” of seeking Taiwan’s independence, which only leads to self-annihilation and is doomed to fail.
 

In the released Message to Taiwan’s Intelligence agencies, the Chinese mainland firmly opposed those independence-seeking diehards of the blind to allay their tiger-riding behaviors, and advised them to get a clear understanding of the situation and get back to the correct track, the only correct way of stopping them from dead ends.
 

“Don’t say I didn’t warn you,” said the message.
 

The message also reiterated that the Chinese mainland and Taiwan island share the same blood and same culture, and the mainland always welcomes variety of cooperation through different channels and encourages exchanges and dialogues with people of insight in Taiwan.

The warning was little noticed by most Western media. What was ominous was the phrase, “Don’t say I didn’t warn you” (勿谓言之不预也). Similar language was used by China when it launched military offensives in the past. It used that phrasing when it issued a “surrender or die” ultimatum to the nationalist garrison in Beijing in 1949. it warned American-led forces in Korea not to approach its Yalu River border in 1950; it warned India before attacking in 1962; and it issued a similar warning before the invasion of Vietnam in 1978.
 

 

This is not a drill.
 

 

A newly triumphal China

The Chinese Communist Party held its plenum last week. Deliberations were behind closed doors, but if there is a theme to this year’s session, it would be what Vice Premier Liu said in a recent speech, “Now the bad things are turning into good ones.”
 

The new swagger is shown by China’s latest PMI, which has bounced back strongly compared to the rest of the world.
 

 

The new assertiveness is just part of a long-lived effort by Beijing to flex its geopolitical muscles. Arguably, it began when China established bases on artificial islands in the South China Sea to assert its claim in the region. It is also manifested in China’s increasingly coercive “wolf warrior” diplomacy, which Wikipedia explained as “an aggressive style of diplomacy purported to be adopted by Chinese diplomats in the 21st century. The term was coined from a Rambo-style Chinese action movie, Wolf Warrior.”
 

The result of the “wolf warrior” style can be seen in a Pew Research Center poll of attitudes on China and Xi Jinping. The recent surge in negative ratings is remarkable, especially among Asian trading partners like Australia and South Korea.
 

 

China has already abrogated the “one country, two systems” principles in Hong Kong. What’s next?  A move against Taiwan?
 

 

The bloodless coup

A year ago, I detailed how China could dominate Taiwan in a bloodless coup (see Scary Halloween story: How a weak USD could hand China a major victory). A Bloomberg article detailed Taiwan’s financial vulnerability. The Taiwanese were putting too much of their savings into life insurance products:

Taiwan’s chief financial regulator is urging people to stop using life insurance as a way to make money and he points to his own family as part of the problem.
 

The widespread use of life insurance as a wealth-management product has made Taiwan into the most insured market in the world. But it has also created a level of competition and reckless offers that threaten the stability of an industry with $876 billion in assets, the Financial Supervisory Commission Chairman Wellington Koo said in an interview Monday.
 

“Insurance isn’t the same as savings. It’s not a wealth management product,” Koo said. “You shouldn’t take out an insurance policy instead of a wealth management product just because your bank only offers 1% on your savings.”
 

The problem is one Koo is personally aware of. The 60-year-old readily admits he and his wife, Taiwan’s deputy economics minister Wang Mei-hua, have nine high-return fixed term insurance policies between them. He says they were taken out on his behalf by his mother on the advice of staff at her local bank.

Here is the problem. The liabilities of Taiwanese life insurance is denominated in TWD, but they don`t have enough investment opportunities in Taiwan. The WSJ reported that they have instead invested mostly in US corporate debt.

Asia’s insurance behemoths, particularly in Taiwan, pose a growing risk to the U.S. corporate-bond market after a multiyear binge on greenback debt.
 

Insurers in Asia’s more developed economies have promised returns far greater than their government-bond markets can provide, and they need to hold far more assets than their domestic bond markets can satisfy.
 

That has left them fishing for other sources of returns, most notably in the U.S. corporate-bond market. South Korea, Japan and Taiwan’s holdings of U.S. dollar corporate bonds have more than doubled to over $800 billion in the past five years, according to the International Monetary Fund’s global financial stability report, published last week.
 

Corporate bond markets in the U.S. and the eurozone are 81% and 41% of the size of their life insurers’ total assets, respectively. In Korea, Taiwan and Japan, the respective figures are 10%, 8% and 4%.

While all Asian life insurers have foreign exposure, Marketwatch observed that the size of Taiwan`s exposure dwarfs all others. Taiwanese life insurers’ financial stability came to US$540 billion in foreign assets, that’s nearly Taiwan’s US$600 billion in GDP.
 

 

While some of the foreign currency exposure is hedged, much of the hedge book risk is borne by CBC, Taiwan’s central bank. In effect, any significant depreciation in the USD could collapse the Taiwanese financial system, not just because of life insurers’ exposure, but the implicit cheap hedge provided by the CBC. What’s more, the CBC has actively suppressed the TWD by providing this hedge.
 

Imagine the following scenario. The PBoC begins to sell its USD holdings to buy TWD assets, which drives up the TWDUSD exchange rate. The Taiwanese financial system gets strained. At what point does it implode? 

 

Once Taiwan’s financial system collapses, a friendly China state-owned financial company graciously steps in to offer a lifeline by buying the life insurers and banks at pennies on the dollar. A Chinese SOE now owns the Taiwanese financial system, and Beijing is in control of Taiwan’s entire financial system – all without firing a shot.

 

Taiwan’s GDP is roughly $600 billion. The PBoC’s assets are about $3 trillion. What price will Beijing pay to get Taiwan back?

 

 

The military option

Instead of a soft takeover of Taiwan, Beijing could opt for the hard military option. As the Chinese economy grew, it was inevitable that spending on the People’s Liberation Army (PLA) would dwarf Taiwanese military spending. Indeed, Taiwan’s Ministry of Defense reported in 2013 that China had developed a plan to invade Taiwan by 2020 at the 18th National Congress. Moreover, the 100-year anniversary of the Communist Party in 2021 will raise pressure on Xi to show progress towards “unification”.
 

 

Beijing seems to be entering a new phase in its military actions. In the past, PLA warplanes have probed Taiwan’s air defenses but stopped at the “median line” separating Taiwan and the Mainland that served as an unofficial boundary. In recent months, PLA fighters have sortied in numbers, and ignored the median line as it became more assertive in its sorties.
 

What is China were to invade? DEFCON Warning Systems reported that repeated Pentagon wargames have usually resulted in victories for the Chinese side.

The Red Team, composed of experts on the Chinese military, aims to use all available forces to capture Taiwan, the island 90 miles off the coast that China regards as a renegade province and that it has repeatedly vowed to retake, by force if necessary.
 

The Blue Team, made up U.S. military personnel with operational experience — fighter pilots, cyber warriors, space experts, missile defense specialists – must try to defeat the Chinese invasion.
 

It doesn’t generally go well for the Blue Team.
 

“It’s had its ass handed to it for years,” David A. Ochmanek, a former deputy assistant secretary of defense for force development and now a defense analyst at Rand, told RealClearInvestigations. “For years the Blue Team has been in shock because they didn’t realize how badly off they were in a confrontation with China.”

The assault would begin with airstrikes on American bases in the region.

;If China felt that the U.S. would intervene, military planners from the Pentagon and Rand who have gamed out scenarios believe a war over Taiwan would most likely begin with a massive attack by advanced Chinese missiles against three American targets: its bases on Okinawa and Guam, its ships in the Western Pacific, including aircraft carrier groups, and its air force squadrons in the region. 

The initial landings would be conducted by airborne troops. When the paratroopers have secured beachheads, the follow-up force would then come by sea.

“They are giving off a lot of signals about how this campaign would unfold,” Lyle J. Goldstein, a China and Russia specialist at the Naval War College in Rhode Island, told RCI. “They’re talking a lot about airborne assault in two varieties, by parachute and by helicopters. It’s what’s called vertical envelopment. Amphibious assault is old school. It may be necessary but it’s not the main military effort.  The new school is to bring lead elements over by air, secure the terrain and then bring in more forces over the beach. The intensity and scale of training in the Chinese military now for airborne assault is, to me, shocking.
 

“There would be 15, maybe 20 different landings on the island, east, west, north, and south, all at once, some frogmen, some purely airborne troops,” Goldstein continued, saying he was expressing his own views, not official assessments of the U.S. “The Chinese high command would watch these bridgeheads to see which of them is working, while the Taiwan command is looking at this amid decapitation attempts and massive rocket and air assaults. The Chinese would seize several beachheads and airports.  Their engineering prowess would come into play in deploying specialized floating dock apparatuses to ensure a steady flow of supplies and reinforcements—a key element. My appraisal is that Taiwan would fold in a week or two.”

While Taiwan’s military appears to be impressive on paper, its actual capabilities are suspect. Foreign Policy reported that a recent suicide revealed “the disastrous logistics of an undersupplied army”: Taiwan’s Military Has Flashy American Weapons but No Ammo,

As Taiwanese politicians showcase flashy U.S. weapons bought with taxpayers’ money, the logistics inside the military remain so abysmal that a young army officer killed himself after being pressured to buy repair parts out of his own pocket.
 

Huang Zhi-jie was a 30-year-old lieutenant in the Taiwanese army. Initially serving in the airborne troops as an enlisted soldier, Huang was so committed that he requested officer training—normally considered more work for little reward—and was later commissioned as a lieutenant in charge of a maintenance depot of the 269th Mechanized Infantry Brigade. Huang was supposed to be the model soldier of which Taiwan desperately wanted more: a young, college-educated volunteer who chose to serve the country out of his own volition, at a time when the military was still facing difficult transition from conscription to an all-volunteer military.
 

But on the night of April 16, Huang hung himself on a dark staircase by his base’s mess hall. Initially his death was not even reported in the Taiwanese media, until Huang’s mother took to Facebook in a long open letter appealing to President Tsai Ing-wen for an investigation.
 

In an emotional press conference, Huang’s mother alleged that her son was subjected to hazing by his superior officers, and that he was pressured to procure tools and spare repair parts out of his own pocket. Screenshots of private messages, receipts, and photos of items purchased by Huang were shown to the public as proof. For some time before Huang’s death, the novice lieutenant was desperately trying to make up for the shortages in his depot by buying a variety of items like repair hammers and fire buckets from the civilian market. Huang’s brother even used a U.S. website in Arizona to purchase a pair of spark plug gap gauges for him that used imperial measurements instead of metric ones.

The shocking part of this incident is it occurred at one of Taiwan’s frontline military units, indicating a lack of readiness among Taiwanese forces.

Even worse, the 269th Mechanized Infantry Brigade isn’t some rear-echelon unit but a major combat formation strategically stationed around the outskirt of Taoyuan City, northern Taiwan. It is expected to bear the brunt of ground fighting to stop any invading Chinese troops from reaching the basin of Taipei, Taiwan’s capital. If the 269th is in such bad material shape, how about the rest of the Taiwanese military?

An article in The Economist came to a similar conclusion about military readiness in Taiwan.

Alas, Taiwan’s preparedness and its will to fight both look shaky. “The sad truth is that Taiwan’s army has trouble with training across the board,” says Tanner Greer, an analyst who spent nine months studying the island’s defences last year. “I have met artillery observers who have never seen their own mortars fired.” Despite long-standing efforts to make the island indigestible, Taiwan’s armed forces are still overinvested in warplanes and tanks. Many insiders are accordingly pessimistic about its ability to hold out. Mr Greer says that of two dozen conscripts he interviewed, “only one was more confident in Taiwan’s ability to resist China after going through the conscript system.” Less than half of Taiwanese polled in August evinced a willingness to fight if war came.

 

 

America’s response

Should China decide to invade, how would Washington react? The DEFCON Warning Systems article stated that the cost to American forces would be high, and at a level not seen since the Vietnam War.

“We’re playing an away game against China,” Rand’s Ochmanek said. “When bases are subjected to repeated attacks, it makes it exponentially more difficult to project power far away.”
 

“The casualties that the Chinese could inflict on us could be staggering,” said Timothy Heath, a senior international defense researcher at Rand and formerly a China analyst at the U.S. Pacific Command headquarters in Hawaii. “Anti-ship cruise missiles could knock out U.S. carriers and warships; surface-to-air missiles could destroy our fighters and bombers.”

Much depends on the outcome of the election. President Trump has shown himself to be very transactional in his approach to foreign policy. Would he commit to defending Taiwan under such a scenario? An article in The Atlantic cast Trump as someone in the “Paul Kennedy” school in his conduct of American foreign policy.

When Trump’s first book, The Art of the Deal, was atop best-seller charts in the late 1980s, second on the list was a scholarly work called The Rise and Fall of the Great Powers, by the Yale professor Paul Kennedy. That book warned that the U.S. could not sustain a policy of global supremacy indefinitely while its relative wealth continued to fall. The U.S. had risen to dominance in the aftermath of Europe’s implosion after World War II, but, Kennedy argued, this was an abnormality.
 

The challenge for America, he wrote, was to bring into balance its means and its commitments. In effect, whether it liked it or not, America was moving from being the only power that mattered to the greatest power in a world of them. The book, published in 1987, came out just before the fall of the Soviet Union and America’s unipolar moment of glory. Its central warning, however, has boomeranged back into relevance.
 

Trump may have no idea that he is revealing any of this; he may not even agree with the things he is revealing. Yet he is revealing them nonetheless. “He’s a Paul Kennedy, Rise and Fall of the Great Powersperson,” Fiona Hill, Trump’s former senior director on European and Russian affairs at the National Security Council, told us, before adding: “Though I doubt he ever read the book.”

Trump’s America First philosophy has inadvertently asked some very good and uncomfortable questions about the direction of American foreign policy in the post-World War II era. 
 

After decades of international adventures that have left the U.S. overstretched, overwhelmed, and overburdened, it was Trump who blurted out the uncomfortable truth: American foreign policy was failing, and had been for decades.

 

Through a combination of hubris, ignorance, instinct, and ego, he pointed at the reality and demanded to know why it was being allowed to continue. Why was America still fighting wars in the Middle East and elsewhere? Why wasn’t it partnering with Russia against Islamist jihadists? Why was China allowed to abuse the rules of the game? Why were American workers losing their jobs to poorer countries? And why were so-called allies in Europe allowed to place high tariffs on American produce while American workers paid for their defense? Were these countries even allies at all?
Joe Biden, on the other hand, is a long-time member of a foreign policy establishment. He would be in favor of engagement with America’s allies and recently denounced Xi Jinping as a “thug”. Reading between the lines of the Democratic Party platform, I interpret it to mean that a Biden White House would commit to coming to the aid of Taiwan in case of attack.
Democrats’ approach to China will be guided by America’s national interests and the interests of our allies, and draw on the sources of American strength—the openness of our society, the dynamism of our economy, and the power of our alliances to shape and enforce international norms that reflect our values. Undermining those strengths will not make us “tough on China.” It would be a gift to the Chinese Communist Party…

 

Democrats believe the China challenge is not primarily a military one, but we will deter and respond to aggression. We will underscore our global commitment to freedom of navigation and resist the Chinese military’s intimidation in the South China Sea. Democrats are committed to the Taiwan Relations Act and will continue to support a peaceful resolution of cross-strait issues consistent with the wishes and best interests of the people of Taiwan.

 

That said, a retreat from Taiwan, regardless if it’s voluntary or involuntary, would send shockwaves around the world. It would brand America as a fading global power, in the manner of Britain and France after the Suez Crisis of 1956.

 

 

Threat assessment

Let me make this clear, an invasion of Taiwan is not my base case scenario, but it does represent a significant tail-risk for investors and for global stability. 

 

As we enter November, the weather in the South China Sea becomes too unpredictable to support an immediate invasion. However, China’s “Don’t say I didn’t warn you” warnings have been followed up by military action several months later. 

 

There are some milestones to watch. Keep an eye on how the Oracle and Walmart proposed purchase of in TikTok’s US operation is resolved in the coming days. That transaction requires approval from the US Committee on Foreign Investment after the election, but within a November 12 deadline. The next hurdle is China’s approval to allow ByteDance sell TikTok’s U.S. platform.

 

Notwithstanding the details of the TikTok deal, also monitor the TWDUSD exchange rate for a possible Chinese attack on the Taiwanese financial system. As well, watch for reports of that satellite reconnaissance indicating possible PLA buildup of forces in preparation for an attack.

 

 

Hedging against an attack

For investors, the consequence of a Chinese invasion of Taiwan would be a horrific risk-off episode. However, hedging against such an outcome can be problematic. The behavior of conventional risk-off havens such as the USD, JPY, and gold is dependent on how any potential conflict unfolds. The JPY may not be a safe haven in light of Japan’s geographic proximity. USD assets, such as Treasuries, may serve as a counterweight to risky assets to stocks, but it depends on the level of American involvement in the conflict. Similarly, gold prices may spike during wartime, but it tends to be inversely correlated to the USD, and a USD rally could pose a headwind for gold prices.

 

A better hedging vehicle that acts well in a war, but may not create a drag on portfolio returns is the Aerospace and Defense industry. The long-term relative performance of this group is characterized by a stair-step pattern of relative uptrend, followed by a period of consolidation. These stocks were battered in the last year by the difficulties experienced by Boeing and its 737 Max. From a technical perspective, the relative return of this group against the S&P 500 has exhibited a positive RSI divergence, which is constructive.

 

 

In the ancient Chinese text, The Art of War, Sun Tzu wrote that a general could win by arraying his forces to exploit his enemy`s weaknesses. That way, he can achieve victory without bloodshed if it becomes evident that the enemy will collapse before any fighting begins. Watch the preparations for war, and be prepared to hedge accordingly. That way, you won’t be surprised by developments.

 

Don’t say I didn’t warn you.

 

 

We’re expecting riots…

Posted by Cam Hui -

Mid-week market update: There is an adage that when dentists start to buy, you should be selling. I came upon a tweet by a resident in Los Angeles with a dentist in the Santa Monica area. The dental office is expecting riots next week, regardless of who wins the election.
 

 

FBI firearm background checks are surging. Anecdotally, both sides are arming themselves in preparation for civil unrest.
 

 

Is this peak fear? It is time to buy the panic?
 

 

Peak fear?

Notwithstanding this week’s market weakness, this chart of asset class implied volatility (IV) shows that fear levels spike the week of the election, and retreat afterward.
 

 

Other indications of market panic are evident. The VIX Index has spiked above its upper Bollinger Band (BB), which is a sign that a temporary bottom is near. That said, the VIX went on an upper BB ride during the February-March decline and took some time to actually bottom. The prudent course of action is to buy when the VIX recycles below the upper BB after a spike above.
 

 

As well, my estimate of the Zweig Breadth Thrust Indicator reached an oversold level today, which can be a sign of a short-term bottom. The caveat is this indicator also stayed oversold for some time before bottoming in March.
 

 

The risk-off tone is not solely attributable to election jitters. A second and third wave of the pandemic seems to be taking hold. Across the Atlantic, the DAX skidded through its 200 dma on the news of fresh lockdowns in Germany. The CAC is already trading below its 200 dma, and it weakened today on the news of French lockdowns.
 

 

 

Buy the panic?

When the market panics like this, it’s difficult to call an exact bottom, but we may be nearing a short-term tradable bounce. One of the constructive signs is the behavior of the NASDAQ 100, which has been the market leader for much of this year. The NASDAQ 100 remains in a relative uptrend against the S&P 500, which is a positive sign for the bulls.
 

 

I wrote on Sunday (see How the Election held the market hostage) that it may be time to position for a reversal trade:

Tactically, it may pay to position for a reversal. If the market were to rise in the coming week into the election, a prudent course of action might be to sell ahead of the event, On the other hand, significant market weakness could be construed as a buying opportunity.

I also wrote on Monday (see The momentum vs. seasonality dilemma) that traders are caught between negative momentum, as evidenced by Monday’s 90% down day, and positive seasonality for the last four trading days of October. It seems that momentum is winning out. Is it time to position for a reversal?
 

My inner investor is deploying some cash at these levels. My inner trader is staying on the sidelines until after the election to avoid event risk.
 

The momentum vs. seasonality dilemma

Posted by Cam Hui -

I have some good news and bad news. The good news is the option market isn’t as concerned about the prospect of a contested election. The chart below shows the history of the term structure of at-the-money implied volatility (IV). The latest readings shows that IV spikes just after Election Day, and deflates slowly afterward. The bad news is it took a -1.9% decline in the S&P 500 to invert the term structure to create this condition.
 

 

We can see a similar result from the IV of other asset classes. The chart below shows the at-the-money IV of gold (GLD), and long Treasury bonds (TLT), with the caveat that IV is not applicable to bond prices because and bond price volatility is not constant over time, though IV remains a useful shorthand for expressing volatility for option traders. The shape of the IV curves are all roughly the same across different asset classes. They all spike at the election, and fall off soon after.
 

 

That said, the threat of a disorderly electoral result is very real. Reuters reported that roughly 40% of Democrats and Republicans would not accept a loss by their side and a smaller proportion would resort to violence to assert their displeasure.

More than four in ten supporters of both President Donald Trump and his Democratic challenger, Joe Biden, said they would not accept the result of the November election if their preferred candidate loses, Reuters/Ipsos poll found.
 

The survey, conducted from Oct. 13-20, shows 43% of Biden supporters would not accept a Trump victory, while 41% of Americans who want to re-elect Trump would not accept a win by Biden.
 

Smaller portions would take action to make their displeasure known: 22% of Biden supporters and 16% of Trump supporters said they would engage in street protests or even violence if their preferred candidate loses.

 

 

Negative momentum ahead?

So what are to make of Monday’s price action. The market exhibited a 90.7% down to up volume day. Lowry’s interprets 90% down volume days as bearish, and they have to be negated by either a 90% up volume day, or consecutive 80% up volume days to turn the tape bullish again. 
 

SentimenTrader also observed that recent initial instances of 90% down volume days have tended to be bearish, and resolved with downside follow-through. However, the sample size is small (n=3).
 

 

Does this mean that bearish momentum has the upper hand, and traders should pile in on the short side?
 

 

Positive seasonality

Bearish momentum, meet positive seasonality. Ryan Detrick at LPL Financial observed that the last four days of October is seasonally bullish, and October 28, which falls on Wednesday, has averaged the highest return for the year.
 

 

 

Bull or bear?

How should we react in light of these contradictions?
 

I wrote on Sunday (see How the Election held the market hostage) to watch the NASDAQ 100 because of its S&P 500 leadership. While the NDX did test its 50 dma, its relative uptrend remains intact, which is constructive for the bull case.
 

 

The market is undergoing a jittery phase that is highly dependent on newsflow. While the 90% down volume day is not to totally ignored, we are facing significant event risk ahead, both in the form of the election next week, and earnings reports from several FAAMG stocks this week. My working hypothesis is the current downdraft is temporary and could be subject to a reversal next week, depending on how the market behaves for the rest of this week.
 

Whatever happens, traders need to recognize that volatility is here, and they should size their positions accordingly.
 

Disclosure: Long SPXU
 

How the Election held the market hostage

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: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Bearish

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 stealthy hostage taker

For several months, the market has been gripped by a stealth hostage crisis. The uncertainty of a contested election has gripped the market, and risk premiums have spiked as a result. 
The fever seems to be partially fading. Google searches for “contested election” have fallen dramatically.

 

 

I have also been monitoring option market’s implied volatility (IV) since late September. For much of this period, IV spiked just after the election, and remained elevated into mid-December and beyond. 
 

 

These unusual option market conditions have created confusion among traders, which can lead to erroneous interpretations of market sentiment.

 

 

Explaining the option market anomaly 

The best explanation of current option market conditions can be found in a Bloomberg podcast with volatility arbitrage trader Kris Sidial, co-founder and VP at Ambrus Group. Sidial explained that institutions had become wary of election event risk, and they have largely hedged using volatility derivatives. Since the market is almost fully hedged, it is difficult to envisage a volatility spike in November. 

 

The entire podcast is well worth listening to in its entirety, but what Sidial left unsaid is worth exploring, and can create sources of confusion for technical analysts. First, the trading of volatility derivatives is not for amateurs and should be left to professionals with a thorough understanding of option math. What Sidial addressed is the institutional market. As the chart below shows, the index volume spike (grey line) shows the hedging activity of institutional investors. However, there has been a surge in single stop call option trading (orange line), which is mainly the province of retail traders.

 

 

We can see the divergence in activity between institutional and retail participants in the option market by analyzing the index put/call ratio (CPCI), which is mainly used by institutions, and equity-only put/call ratio, which is used by retail traders. First, the 50 day moving average of the put/call ratio (top panel) is near historical lows, which indicates complacency. In addition, CPCI (red line, bottom panel) is high, indicating institutional nervousness, while CPCE (blue line, bottom panel) is low, indicating retail bullishness. In the past, such high spreads between CPCI and CPCE has resolved with either market pullbacks or sideways consolidations.

 

 

What about Sidial’s remarks that a further volatility spike is unlikely because most players are already hedged? That comment has to be taken in the context that he is a volatility trader. While volatility is unlikely to surge, he was silent on the prices of the underlying stocks, or the market. It is entirely possible for the market to correct while the VIX shows little or no upside movement.

 

Another possible misinterpretation of current market conditions can be found in the analysis of VIX futures positioning. The blogger Macro Charts observed that large speculators have a crowded short in VIX futures. The conventional contrarian interpretation is the market is poised for a spike in volatility, and an abrupt decline in stock prices. As I have already pointed out, IV spikes just after the election, and remains elevated soon after. Traders are therefore taking advantage of the steeply upwards sloping term structure to sell volatility, and that trade makes sense from a mean reversion perspective.

 

 

 

Elevated expectations

Current conditions make me mildly bearish on the equity market. Expectations of a Democrat sweep of the White House, the Senate, and the House of Representatives are high. Such an outcome would facilitate the passage of a large and significant fiscal stimulus bill, which would be equity bullish. However, odds of a sweep have been in retreat recently. The market is unlikely to react well to the prospect of a divided government, as it will make the passage of fiscal relief far more difficult. 

 

 

Much has to go right on Election Night for the bullish scenario to materialize. Any hint of uncertainty, or a contested election, would spark a risk-off sell-off.

 

 

What to watch for on Election Night

The election represents a significant event risk to traders and investors. It is impossible to know what will happen. I have detailed the likely effects of either a Biden or a Trump win (see How to trade the election), but that analysis was based on the assumption of a clean sweep by either party. In all likelihood, the Democrats will retain control of the House. This election is mainly about control of the White House and Senate. Here is what I will be watching on Election Night.

 

Early in-person and mail-in voting levels are very high in light of the pandemic. Astonishingly, the early turnout in Texas is about three-quarters of the total votes cast in 2016, and Texas is a state that has highly restrictive mail-in voting. Other states that have reported early voting at over 50% of their 2016 total are Vermont, Montana, New Jersey, North Carolina, New Mexico, and Florida.

 


 

The two key early states to watch are Florida and North Carolina. Despite the controversy over mail-in voting. Florida has strong systems in place to count early mail-in votes because it is the home to many seniors, who historically have used that method to vote. Florida processes mail-in votes 22 days before Election Day, and a preliminary count should be immediately available on Election Night. North Carolina has reported an early turnout of over 50% of 2016 total votes cast, and it expects that 80% of the votes cast will be counted by the time the polls close at 7:30pm. By contrast, other battleground states like Pennsylvania does not begin to count early voting and mail-in ballots until the polls close, and results from that state are likely to be delayed.

 

The WSJ has a useful article on the paths to victory for each candidate. Florida, with its 29 electoral votes, is a must-win state for Trump. If Biden were to score a decisive victory in Florida, the odds of a Trump re-election becomes extremely slim. If Biden were to win both Florida and North Carolina, he is more or less assured of being the next occupant of the White House.

 

 

Even if Biden were to score a decisive victory, the bulls are not out of the woods until control of the Senate is determined. Currently, the Republicans hold 53 Senate seats to 47 for the Democrats. Assuming that Biden wins, the Democrats need to score a net gain of three seats to control the Senate and pass a fiscal relief package. Most pundits expect the Democrats will take the Maine, Colorado, and Arizona seats from the Republicans, but lose the Alabama seat. To control the Senate, the Democrats will need at least one extra seat. The most likely targets are North Carolina and Iowa, with Montana, the two seats in Georgia, and Alaska as outside possibilities. Any other outcome that leaves Republicans in control of the Senate will be regarded as short-term bearish.

 

In summary, the election represents a significant event risk for the market. All the anxiety could be for nothing, much like Y2K, or we could see any number of surprises that sparks a risk-off episode. Tactically, it may pay to position for a reversal. If the market were to rise in the coming week into the election, a prudent course of action might be to sell ahead of the event, On the other hand, significant market weakness could be construed as a buying opportunity.

 

 

The week ahead

On an interim basis, the week ahead will be a test for Big Tech. The NASDAQ 100 is testing both the 50 dma and a relative support trend line. 

 

 

As I pointed out last week (see The NASDAQ tail wagging the market dog), FANG+ names (technology, communication services, and Amazon) make up nearly 44% of index weight. The rest of FANG+ names will report next week, and the earnings reports will set the temporary tone ahead of Election Day the following week.

 

 

Q3 earnings season earnings and sales beat rates are above their historical averages, though their pace of beats decelerated from the previous week.

 

 

Expectations may be set a little too high. The market has punished earnings misses far more severely than their historical average, though the reward for beats was only in-line.

 

 

If the Big Tech stocks were to exhibit more misses, then the NASDAQ 100 is likely to violate its 50 dma, and its rising relative trend line. Even though any possible technology weakness could signal a healthy rotation into value and cyclical stocks, this would also create headwinds for the overall market due to the heavy weightings of Big Tech in the S&P 500.

 

Stay tuned.

 

 

Disclosure: Long SPXU

 

Buy the cyclical and reflation trade?

Posted by Cam Hui -

The global economy seems to be setting up for a strong recovery. We are seeing a combination of easy monetary policy, slimmed-down supply chains, and a rebound in consumer confidence.
 

 

The cyclical and reflation trade is becoming the consensus view. However, there may still be time to board that train. Futures positioning in the reflation trade is rising, but levels are not excessive.
 

 

What are the bull and bear cases?
 

 

The bull case

The bull case is relatively easy to make. The global economy is showing signs of recovery after the COVID Crash of 2020. Economic momentum is rising, but levels are not overheated.
 

 

Commodity prices are recovering, both on a liquidity-weighted and on an equal-weighted basis. The cyclically sensitive copper price rallied to a new recovery high.
 

 

The equal-weighted ratio of consumer discretionary to consumer staples stocks, which reduces the market cap distortion from Amazon, is rising steadily. This ratio is both an indicator of cyclical strength, and equity risk appetite.
 

 

Full speed ahead! What could possibly go wrong?
 

 

Key risks

There are a number of key risks to the cyclical and reflation thesis. 

  • Another wave of COVID-19 infections;
  • A loss of economic recovery momentum;
  • The uncertainty of additional fiscal stimulus; and
  • The effects of rising inflationary expectations on Fed policy.

First, the global cyclical rebound is showing signs of stalling. Regional Citigroup Economic Surprise Indices, which measure whether economic data is beating or missing expectations, are all turning down after initial surges indicating a recovery.
 

 

 

Additional COVID-19 Waves

Another risk is the threat posed by additional waves of COVID-19 outbreaks. Europe is rapidly experiencing a second wave, and the US is seeing a third wave. The pandemic will not be globally controlled until it is suppressed or eradicated everywhere. Otherwise there will always be reservoirs of the virus that will spark periodic outbreaks.
 

 

The European outbreak is a sign that the virus thrives in colder weather, and the situation is spiraling out of control. Germany’s daily case count has reached record highs. Ireland, Wales, and the Czech Republic have announced full lockdowns, and Ireland’s measures are expected to throw 150,000 people out of work. 

 

To be sure, the fatality rates during these additional waves of infections are significantly lower than the first wave. Arguably, governments may not need to mandate shutting down their economies in order to fight the virus. However, a study by the IMF found that the fear of individual citizens accounts for a significant portion of mobility slowdown, particularly in the advanced economies. 

 

 

In other words, people are afraid. The IMF found that the voluntary component is far more persistent than any government mandates or guidelines.

 

 

Even if a vaccine is available in 2021, a Boston Consulting Group study concluded that the economy won’t fully recover until 2022.

Even with a highly successful vaccine rollout—the bull case—the public will still be wearing masks, maintaining distance, and avoiding crowds for many months after regulatory authorization. In fact, the public will likely be taking these precautions into the second half of 2021 or longer. Testing, tracing, and continuing efforts to reduce the severity of the disease with therapeutics will also remain crucial. If the rollout is less successful—the base and bear cases—such interventions could stay in place for 15 more months or longer.

 

 

Notwithstanding BCG’s sobering study, a second wave is just hitting Europe. A third wave appears to be starting in the US. Can we count on the cyclical recovery to continue under those conditions?

 

 

Waiting for fiscal stimulus

In the US, negotiations between House Democrats, the White House, and Senate Republicans over a fiscal stimulus package have broken down. Even if House Speaker Nancy Pelosi and the White House were to come to an agreement, it is unclear whether the bill would receive sufficient support in the Senate for passage.
 

Fed Governor Lael Brainard made another plea for additional fiscal support in a speech to the Society of Professional Economists Annual Online Conference on October 21, 2020:

Apart from the course of the virus itself, the most significant downside risk to my outlook would be the failure of additional fiscal support to materialize. Too little support would lead to a slower and weaker recovery. Premature withdrawal of fiscal support would risk allowing recessionary dynamics to become entrenched, holding back employment and spending, increasing scarring from extended unemployment spells, leading more businesses to shutter, and ultimately harming productive capacity.

In the last few weeks, the market has pivoted to a consensus view that the Democrats would sweep the election in a Blue Wave by capturing control of the White House, Senate, and the House of Representatives. However, recent polling has seen the race tighten, and the odds of a Democratic sweep at PredictIt has plunged.
 

 

Should the election be resolved with a divided government, such as a Biden Presidency and a Republican-controlled Senate, fiscal austerity becomes the most likely outcome. In the absence of additional spending, can the cyclical rebound continue?
 

 

Rising inflationary expectations

The last risk facing the cyclical and reflation trade is the idea of “catastrophic success”. What if the cyclical upturn is too successful? How would the market react?
 

Already, we are seeing inflationary pressures rise. Gold prices are consolidating at the metal’s long-term breakout level, and the bond market’s inflationary expectations have staged an upside breakout through a falling trend line.
 

 

In addition, the yield curve is steepening, and bond yields are rising. The 10-year Treasury yield has decisively breached the 0.80% level and surged to 0.86%. The 30-year Treasury yield has risen above its 200 day moving average.
 

 

If history is any guide, the 10-year Treasury yield is poised to rise even further. It is following the same path as past global slowdowns.
 

 

These conditions beg a number of important questions. What’s the Fed’s reaction function to rising inflationary expectations? The 10-year yield has decisively breached the 0.80% level. In light of the Fed’s commitment to hold short rates down almost indefinitely, will it tolerate a 1.2% rate? What about 1.5%? At what point do rising yields act to significantly restrain the economic rebound?
 

 

Resolving the risks

In light of the bullish potential of a cyclical rebound, and all of the risks, how should investors position themselves?
 

My Trend Asset Allocation Model readings are in neutral, but they are on the verge of turning bullish. The model was created based on the belief that real-time market prices are the best indicator of future expectations, and the application of trend following principles is the best way of capturing long-lasting economic changes. The model is picking up in the shift in consensus thinking, that the global economy is shifting from recession to recovery, as shown by the latest BoA Global Fund Manager Survey. If that consensus assessment is correct, further sustained returns lie ahead for investors who adopt a risk-on position.
 

 

By design, the Trend Model has a single-dimensional focus, and knows nothing about risk. Plenty has to go right for the bullish scenario to be realized. 

  1. The momentum of economic recovery has to be sustained. 
  2. The pandemic has to come under control in the face of a second wave infection in Europe and a third wave in the US, both of which could crater growth. 
  3. The US electoral outcome is unknown, which will affect the path of fiscal policy, the likelihood of additional stimulus, and therefore the growth outlook. 
  4. Investors have to grapple with the Fed’s reaction function to rising growth and inflationary expectations.

Under these circumstances, investors need to recognize that the sources of alpha are multi-dimensional, and so is risk. While we can always hope for the best, bad outcomes are very possible in these conditions. It is important to repeat the adage that the only free lunch in investing is diversification, and only a diversified portfolio can weather this diverse array of risks. As well, investors can creatively conduct scenario analysis in order to mitigate any risks specific to their investment objectives, situation, and investment capability.
 

As an example of a creative approach, Bloomberg reported that Boaz Weinstein of Saba Capital is arbitrating the spread in equity and bond market volatility:

Never in his 22-year career has Boaz Weinstein seen such a disconnect between the complacency of credit investors and the anxiety of equity investors, and he predicts it could unravel in an “incredible move” around the Nov. 3 U.S. election.
 

While the stock market is pricing in turmoil with the CBOE Volatility Index close to 30, corporate bond spreads have almost recovered to pre-pandemic levels. To Weinstein, the founder of Saba Capital Management and one of the biggest winners in the pandemic selloff in March, something has to give. He’s anticipating a new bout of credit chaos and hoping to add to the 80% return through September in his flagship hedge fund.
 

“It’s like a calm before the storm,” he said in a Bloomberg Front Row interview. “Equity volatility is almost inescapably high. Is that a good form of insurance? The payoff profiles are nothing like they were back in January. Whereas in credit, we’re almost back to where we were in January.”

The NASDAQ tail wagging the market dog

Posted by Cam Hui -

Mid-week market update: One of the key indicators I have been monitoring for the health of the market is the NASDAQ 100 (NDX), which is a proxy for large-cap technology stocks. So far, the NDX has been testing an important rising relative uptrend.
 

 

If the relative uptrend were to decisively break down, it would spell trouble for the overall market.
 

 

Large-cap tech dominance

The analysis of the top five sectors in the S&P 500 tells us about the importance of large-cap growth stocks. The top five sectors comprise roughly 70% of the weight of the index, and the relative strength behavior of these sectors are important signals of market direction. The FANG+ names (technology, communication services, and Amazon) make up nearly 44% of index weight. As the chart below shows, the market leaders are the technology and consumer discretionary sectors. The relative performances of the remainder are either flat or down.
 

 

 

Big Tech’s fundamental headwinds

As we progress through Q3 earnings season, Big Tech stocks are starting to encounter headwinds. Netflix disappointed the market by missing revenue expectations last night, and the Justice Department launched an antitrust action against Google. As well, the strategists at JPMorgan identified a negative divergence between technology stock performance and estimate revision. While the sector has roared ahead in relative returns, estimate revisions in this sector have turned negative.
 

 

In addition, analysis from Absolute Strategy shows that the growth/value trade has been in effect a duration trade. For the uninitiated, duration measures an asset’s interest rate sensitivity. The high the duration, the higher the price sensitivity. 

 

 

The 10-year Treasury yield has risen to test the 0.80% level. Any upward movement in bond yields will ultimately put downward pressure on growth stocks.

 

 

US large-cap tech stocks aren’t exactly cheap. If you are looking for an index of cheaper and equally dominant large-cap companies with strong competitive positions, consider the Asia 50 Index (AIA). The top three stocks in the index are Tencent Holdings, Samsung Electronics, and Taiwan Semiconductors, and they make up about 40% of the index.
 

 

 

Not oversold yet

From a technical perspective, Macro Charts observed that the NASDAQ 100 recycled off an overbought condition in early September. Readings are neutral, but momentum is negative. While the NDX doesn’t necessarily collapse under these conditions, at a minimum, they will trade sideways in a choppy manner.
 

 

In conclusion, the NASDAQ 100 remains in a relative uptrend compared to the S&P 500, but investors need to keep an eye on this index. The NDX is the tail that’s wagging the S&P 500 dog. As we progress through Q3 earnings season, it remains to be seen whether JPMorgan’s warning about lagging technology earnings estimates proves to be a bearish trigger.
 

 

Disclosure: Long SPXU
 

Does the economy even need more stimulus?

Posted by Cam Hui -

House Speaker Nancy Pelosi has set a Tuesday deadline for an agreement for a coronavirus stimulus package before the election. Recent data begs the question of whether more stimulus is even needed.
 

Last Friday’s retail sales print was astonishingly strong and beat market expectations. While retail sales statistics are notoriously noisy, September retail sales rose sequentially in all major categories.
 

 

In addition, consumer confidence improved in early October despite the expiry of the $600 per week stimulus payments.
 

 

 

Stimulus spent, or saved?

A New York Fed study is supportive of the fiscal hawks’ case that more stimulus is not needed. The New York Fed studied how households used the payments, and most of the funds were saved either directly, or indirectly by paying off debt. As of the end of June, “29 percent—was used for consumption, with 36 percent saved and 35 percent used to pay down debt”. A demographic breakdown showed that even the most disadvantaged group in the “non-white” category directly saved 27.2% and indirectly saved 46.4% of payments through debt repayment.
 

 

If a substantial amount of the stimulus was saved, does that mean the CARES Act was too generous. pr unnecessary?
 

 

Fiscal cliff delayed

The New York Fed study was a snapshot in time, and it’s just as important to understand the evolution of household finances during this difficult period. A more detailed analysis from the Becker Friedman Institute at the University of Chicago found that the CARES Act did boost spending by the unemployed. 

 

 

If the stimulus payments were saved, the next question for analysts is, “When will the savings run out?” Further analysis revealed that while much of the $600 per week payments were saved, savings are depleting quickly.

 

 

The University of Chicago study focused on aggregate household behavior, Aneta Markowska and Thomas Simons at Jefferies pointed out that while savings are strong for people at the top of the income ladder, the fiscal cliff is very real for the poorest of households.

 

 

Looking forward to Q4 and Q1, Oxford Economics projects that household finances are going to be increasingly strained without another round of stimulus. The strong September retails sales figures could be the consumer’s last hurrah.

 

 

Anecdotal evidence indicates that the retailing sector is stressed. LUSH Cosmetics recently introduced a payment plan for purchases. This development is a signal that the company’s customer base has become so strained that a significant number need to pay for small luxuries like scented soap and bath oils on a payment plan.

 

 

For the last word, Fed watcher Tim Duy had a different interpretation of the strong September retail sales figure:
I know this is going to be an unpopular opinion, but the fiscal stimulus may have been less important for retail sales than widely assumed. What we see inside the retail numbers – the shift in spending away from the services component – has happened in the economy overall. Spending on goods has remained strong largely because households were unable to spend on their typical basket of services and that extra money had to go somewhere.
Retailing stocks have rallied strongly, and they have outperformed the S&P 500 since the March lows. Assuming that Pelosi cannot come to an agreement with the White House and Senate Republicans by Tuesday, the risk is the chances of a stimulus bill will fade if there is a contested election that ends up in the Courts.

 

 

In conclusion, the fiscal cliff is very real, though its effects are slightly delayed. I wrote in my last post that the market is expecting a cyclical recovery (see How the US is becoming an emerging market). A collapse in household finances is an ever-present threat to the recovery investment theme, and it’s a risk that investors should keep in mind.