MoMo is losing its mojo

Posted by Cam Hui -

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

 

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

 

Here is what that means for the stock market.
 

 

A growth to value rotation

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

 

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

 

 

Market implications

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

 

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

 

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

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

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

 

 

The road ahead

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

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

 

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

 

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

 

 

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

 

 

Commodity supercycle: Bull and bear debate

Posted by Cam Hui -

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

 

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

 

 

Much depends on China demand

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

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

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

 

 

Warren Buffett, commodity bull?

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

 

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

 

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

 

 

 

Cyclical or secular bull?

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

 

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

 

 

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

 

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

 

 

 

Waiting for the sentiment reset

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

In need of a washout

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

 

 

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

 

 

This is insane! When’s the sentiment reset?

 

 

The end of the retail frenzy?

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

 

 

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

 

 

The bear case

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

 

 

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

 

 

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

 

 

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

 

 

 

Earnings Season: What’s priced in?

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

 

 

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

 

 

 

The bull case

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Waiting for the break

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

 

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

 

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

 

 

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

 

 

No reasons to be bearish?

Posted by Cam Hui -

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

 

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

 

 

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

 

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

 

 

A slowing China?

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

 

 

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

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

 

 

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

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

 

 

Will USD strength = EM weakness?

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

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

 

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

 

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

 

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

 

Rising real rates

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

 

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

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

 

 

Too late to buy small caps?

Posted by Cam Hui -

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

 

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

 

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

 

Party just getting started

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

 

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

 

 

How frothy is this market?

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

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


 

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

 

 

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

 

 

 

Due for a sentiment reset

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

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

 

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

 

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

 

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

The bulls’ second wind, or last gasp?

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

Still scaling the heights

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

 

 

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

 

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

 

 

Earnings, earnings, earnings!

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

 

 

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

 

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

 

 

 

Sentiment: Elevated but off the boil

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Market internals: A second wind

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

 

 

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

 

 

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

 

 

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

 

 

 

Waiting for resolution

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

 

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

 

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

 

How value investors can play the new commodity supercycle

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

 

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

 

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

 

 

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

 

 

More on this value opportunity below.

 

 

Here comes inflation

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

The value play

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

 

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

 

 

 

Addressing the climate change threat

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

 

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

 

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

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

 

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

 

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

 

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

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

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

 

 

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

 

 

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

 

 

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

 

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

 

 

 

Disclosure: Long XOM

 

Another “good overbought” advance?

Posted by Cam Hui -

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

 

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

 

 

The bull case

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

 

 

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

 

 

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

 

 

 

Extreme giddiness

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

 

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

 

 

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

 

 

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

 

 

Time for a pause

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

 

 

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

 

 

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

 

 

A good news-bad news earnings season

Posted by Cam Hui -

Q4 earnings season is in full swing, and results are strong. With 59% of the S&P 500 having reported, both the EPS and sales beat rates are well ahead of historical averages. Moreover, forward 12-month EPS estimates surged 3.5% in a single week.

 

 

As well, estimates are surging across all market cap bands.

 

 

But it’s not all good news for earnings and the stock market.
 

 

A surge in estimates

First, the good news. If we drill down to the quarterly EPS level, estimates are rising strongly across the board. In particular, Q4 estimates are seeing a surge in estimate revision. Q4 estimates rose 3.81 to 41.08 last week, an astounding 10.8%. Moreover, FactSet reported that the Q1 positive guidance is 64%, which is well ahead of the 5-year historical average of 33%.

 

 

With the exception of the industrial (8.4% weight in S&P 500) and energy (2.4%) sector, Q4 EPS growth has beaten expectations in all other sectors.

 

 

 

Supply chain bottlenecks constraining growth

The Transcript, which monitors earnings calls, summarized the mood this way:
It’s hard to believe that we’re approaching a year since the U.S. economy shut down due to COVID. Vaccines continue to roll out though and people are ready to have fun. Strong demand is putting pressure on COVID-impacted supply chains and potentially creating inflationary forces.
Demand is strong, but supply chains are stretched, which is leading to inflationary pressure:
Economic activity is stronger than anticipated
“Despite experiencing a series of new COVID-19 related restrictions around the world, our results reflect a stronger market environment than we had anticipated, with revenue growth and new opportunities in select markets.” – ManpowerGroup (MAN) CEO Jonas Prising 

 

Strong demand is stretching supply chains
“I just want to say that the most interesting thing that’s happening is the rate at which demand has increased. We’ve never seen an increase in demand happened as quickly. And that combined with COVID and the pandemic has really stretched the supply chain…The supply base is generally tight, not just semiconductors, which has gotten a lot of press, but many of our components, are on longer lead times. Our suppliers and we are struggling with absenteeism due to COVID.” – Cummins (CMI) President & COO Livingston Satterthwaite

 

“I would tell you on the new car side, we lost unit sales, because…we couldn’t replace the inventory…in December, we had many stores below a 20-day supply and that’s a 20 day supply across all model line. So individual hot models you didn’t have any day supply…we sat here a quarter ago and thought by the end of the first quarter days supply would be back up to normal. But because what’s going on with the microchips and some other things, it’s probably going to bleed well into the second quarter before inventories gets back.” – Asbury Automotive Group (ABG) CEO David Hult

 

The supply chain is not stable
“I think one of the problems that we’re dealing with is that the supply chain is not as stable. You know, we’re finding that, you know, [subcontractors are missing deadlines]. Well, what happened? Well, what happened was they got a [de-commitment] from their supplier. They didn’t get some bundles they were expecting. They couldn’t hire some people, somebody tested positive for COVID. So they had to send 50 people home, who had come in contact with it.” – Microchip (MCHP) CEO Steve Sanghi

 

There’s no slack in the system
“…we expect that the constraints we are currently seeing are likely to continue through much of calendar year 2021 and possibly into calendar year 2022…there is no slack in the system. Everything that gets built, get shipped, there’s absolutely no slack in the system.” – Microchip (MCHP) CEO Steve Sanghi

 

This leads to inflationary pressure
“We are seeing quite a bit of commodity inflation and a larger foreign exchange impact as we go into 2021, particularly in Latin America, in Turkey, in India and in South Africa. And we’ve got some commodity inflation coming through, in particular, tea in India, in palm oil, in liquid oils and in food ingredients. So we’ve got some inflationary pressures coming forward. And we do expect mid- to high single-digit commodity inflation in the first half.” – Unilever (UL) CFO Graeme Pitkethly

 

“We have a situation right now in the supply chain…There’s a huge capacity issue, where there’s not enough capacity, and we know they’re going to have to — they’re going to start spending money around steel, iron ore, mining, copper, plastics, all these things.” – Emerson (EMR) CEO David Farr

 

“Though we are seeing an improvement in our in-stock levels as compared to where we were during Q2, we were not immune to the supply chain disruptions and rising freight costs, which were prevalent across the industry.” – The Container Store (TCS) CFO Jeff Miller
Chris Williamson at IHS Markit confirmed that supply chain constraints are hampering global growth.
Global manufacturing remained encouragingly resilient in January despite rising coronavirus disease 2019 (COVID-19) infection rates and fresh lockdown measures in many countries, according to the latest PMI survey data. Especially strong expansions continued to be reported in the US, Germany and Asia excluding Japan and China, notably in India and Taiwan.

 

However, export growth slowed close to stalling, dampening production growth compared to prior months, with an especially notable renewed fall in exports out of mainland China. Factories worldwide meanwhile also reported that exports and purchasing continued to be dogged by supply delays, which worsened further as demand often outstripped supply and logistics delays caused increased transportation issues. The resulting increase in supplier pricing power and shipping surcharges caused input prices to rise at the fastest rate for almost a decade, with prices charged by factories also hitting a near ten-year high. 
Transportation constraints are becoming a serious problem.

 

 

If supply chain bottlenecks persist, the global economy could be nearing peak growth.

 

 

 

An uneven market reaction

Despite the strong earnings results, the market reaction has been less than enthusiastic. The market has punished earnings misses and it hasn’t rewarded earnings beats, except for blowout results.

 

 

Strong Q4 earnings should be supportive of the reflation and cyclical rebound investment theme. However, cyclical sectors have not performed well relative to the S&P 500 except for semiconductors. The poor relative performance of cyclical groups is probably reflective of supply chain bottlenecks that constrain growth. In particular, the lack of positive reaction of transportation stocks to rising shipping costs is worrisome.

 

 

In conclusion, Q4 earnings season has been a good news and bad news story. The good news is results are strong and the Street is revising estimates upward. The bad news is the muted nature of the market reaction and signs of possible peak growth. A market that struggles to react well to good news is a warning for traders and investors.

 

Rip the bandaid off now or later?

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

A brief storm?

Was the recent bout of r/WSB induced volatility just a brief storm? The S&P 500 remains in an uptrend on the weekly chart, though it is exhibiting a negative 5-week RSI divergence.

 

 

Despite last week’s recovery, technical alarms are ringing everywhere. Will the market gods rip the bandaid off now with a minor pullback or face a major bearish episode later?

 

 

Still frothy

A number of indicators with long horizons are flashing warnings. The Citigroup Panic/Euphoria Model recently reached a record high euphoric level but readings have stabilized after backing off slightly.

 

 

Business Insider reported that BoA’s Sell Side Indicator is showing signs of “dangerous optimism” not seen since August 2007. This indicator is only 2% away from a sell signal.

 

 

 

Cross-asset divergences

The 10-year Treasury yield has been rising steadily and stands at 1.17%. The increase in yields will present bonds as a more attractive alternative to stocks put valuation pressure on equity prices.

 

 

The USD, which has been inversely correlated to stock prices in the last year, is strengthening. This is also setting up as a negative divergence to be concerned about.

 

 

 

Deteriorating internals

Market internals are weak. Leadership is narrowing to levels last seen during the NASDAQ bubble top and the Nifty Fifty top. Just remember Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”

 

 

Momentum is fading. The NYSE McClellan Summation Index (NYSI) surged to over 1000 and recycled. About two-thirds of similar past episodes (red vertical lines) have resolved bearishly. In most of the cases where the market has pulled back, NYSI fell to zero before making a bottom.

 

 

 

The levitating NASDAQ

The one exception to the picture of deteriorating internals is the amazing NASDAQ. The NASDAQ 100 broke out of a relative consolidation range (middle panel) after breaking a relative uptrend in late October and early November. Moreover, the high-octane ARK Innovations ETF (ARKK) appears to have found a second wind relative to the S&P 500 (bottom panel).

 

 

From a purely technical perspective, NASDAQ leadership is well deserved. The NASDAQ Advance-Decline Line broke out of a multi-year base and its performance relative to the S&P 500 has been stunning.

 

 

Are the animal spirits stirring again? Just look at the growth in Reddit groups. These readings suggests that small retail investor trader activity is the root cause of the latest NASDAQ frenzy.

 

 

The WSJ reported that the day trading crowd are moving into SPACs, or blind trust shells with no underlying businesses. I can see that this is going to end well and everyone is going to be rich.
Day traders fueling enormous gains in popular stocks such as GameStop Corp. GME 19.20% are also powering big swings for another suddenly hot investment: so-called blank-check companies.

 

Special-purpose acquisition companies—shell companies planning to merge with private firms to take them public—are rising more than 6% on average on their first day of trading in 2021, up from last year’s figure of 1.6%, according to University of Florida finance professor Jay Ritter. Before 2020, trading in SPACs was muted when they made their debut on public markets.

 

 

If you have to justify NASDAQ strength by pointing to the dot-com bubble, something is seriously wrong.
 

 

 

A complex double top?

What should we make of the market’s continued strength in the face of all these warnings? Alex Barrows recently declared a major monthly sell signal. Barrow then qualified his bearish call by proposing a scenario of a “complex double top”.

 

 

In conclusion, this market is highly extended and can pull back at any time. The market gods can rip the bandaid off now with a minor 5-10% pullback or allow the market to advance further and resolve this in a major bearish episode. 

 

 

While I remain long-term bullish, short-term risk levels are high. Investment-oriented accounts should refrain from deploying new cash and consider lightening up equity positions on rallies. Traders can play the melt-up game, but at their own risk. The more prudent course of action is to stay nimble and watch for a downside break before turning overly bearish.

 

 

Outside-the-box risk control = Better returns

Posted by Cam Hui -

After last week’s wild market swings, it’s time to have a sober discussion about risk control. I know that risk control isn’t a sexy topic, but better portfolio risk control can lead to better overall returns.
 

 

The framework of analysis will not be the conventional description of risk as it is stylistically shown above. Instead, I offer some “outside the box” thinking and focus on the following:

 

  • Mis-specifying investment objectives and risk preferences
  • How to take advantage of volatility
  • Regime change risk in the form of:
    1. Unexpected tail-risk
    2. Changes in market environment (conventional regime change);
    3. Slow changing regimes that investors may be unaware of;
    4. Changes in modeling assumptions.

 

The discussion range from practical suggestions for individual investors to big picture issues more relevant to professional portfolio managers.

 

 

The right and wrongs reasons for trading

Let’s begin with the individual investor. In light of last week’s r/WSB related volatility, a key question that individual investors should ask themselves is why they are trading. Despite the zero commission rates offered by Robinhood and other online brokers, there are costs to trading. Robinhood sells their order flow as a substitute for commission. Their customers’ trading costs, as measured by the impact cost of crossing the bid-ask spread, acts as an implicit cost that is just as relevant as commission.

 

Ben Carlson at A Wealth of Common Sense wrote a timely article, “10 Signs You Are Not a YOLO Trader”. (For the uninitiated, YOLO stands for “You Only Live Once”).

 

  1. It’s money you can’t afford to lose. 
  2. You have no idea what you’re investing in or why.
  3. You’re buying purely based on emotion.
  4. You have no idea what tendies are.
  5. You have a family or other financial responsibilities that are more important than putting on a YOLO trade.
  6. You’re buying a stock because you saw someone talking about it on social media.
  7. You’re buying a stock because one of your friends owns it.
  8. You have no idea when you will sell it.
  9. You’re revenge trading. 
  10. You don’t understand the risk involved in the stock market.

 

The entire article is well worth reading. Some of the reasons relate to investment knowledge, others relate to a lack of understanding of investment objectives and pain tolerance. All of them relate to the misspecification of investment policy.

 

In my many years, I have seen far too many people speculate in the financial markets without regard to their risk tolerance and return objectives. These people are gambling, not investing. Almost without exception, gamblers get hurt. YOLO traders should keep that in mind. In Vegas, gamblers get comp’ed free drinks and other goodies.

 

 

Take advantage of volatility

For a more thoughtful and nuanced look at portfolio management, the Financial Analysts Journal offered an article “Should Mutual Fund Investors Time Volatility?”. Here is the abstract.

Increasing (decreasing) investment in an actively managed mutual fund when fund volatility has recently been low (high) leads to a significant improvement in investment performance. Specifically, volatility-scaled fund returns exhibit significantly higher alphas and Sharpe ratios than the original (unscaled) fund returns. Scaling by past downside volatility leads to even greater performance improvement than scaling by total volatility. The superior performance of volatility-managed mutual fund trading strategies is attributable to both volatility timing and return timing. Fund flows are negatively related to past fund volatility, suggesting that fund investors are aware of the benefit of volatility management.

Specifically, the authors found that raising cash when volatility is high and buying when volatility is low leads to better risk-adjusted returns.

 

 

Conceptually, this is a variation of the VaR (Value At Risk) school of risk control. Traders adjust the size of their books based on forecasted volatility. Much depends on the estimation of VaR. Too often, this approach can lead to a pro-cyclical effect of taking on too much risk when the markets are calm and forcing traders to liquidate when markets are volatile.

 

The authors of the study used longer-term horizons to estimate volatility and found useful results.

 

We estimated a similar regression of one-month-ahead fund returns on past fund volatility. For the predictor variable, we used both past total volatility and past downside volatility. We estimated the regressions fund by fund and report in Table 5 the distribution of Newey–West t-statistics of the regression coefficients.

 

When predicting future volatility with past total volatility, we found that the regression coefficient is positive and statistically significant for all sample funds. The results for downside volatility are similar, with all regression coefficients being positive and statistically significant. The above results are not surprising because volatility persistence is one of the most important stylized facts in the volatility literature. What may be a little surprising is that the relationship is statistically significant for each of the 1,817 sample funds.

 

 

 

Beware of regime changes

One of risk that investors face is a change in the investment environment. In particular, quantitative modelers are especially vulnerable to being blindsided by market regime changes largely because they are trained to think in a linear and technical fashion. Quantitative modeler Dan diBartolomeo of Northfield Information Systems wrote an important paper addressing this topic, “The Four Horsemen of the Investment Apocalypse: Pandemic, War, Corruption, and Climate Change”.

 

In the paper, diBartolomeo addresses two kinds of regime change. The quick ones, war and pandemic, can be thought of as tail-risks, and the slow ones, corruption and climate change, are equally insidious but affect the market environment and returns in a slower fashion.

 

 

Tail-risk of widespread deaths

The paper pointed out that “pandemics and wars share the common theme of widespread death”. The study went on to run an ordinary least squares regression on market returns to mortality for the period starting from 1900, the relationship was negative (wars and conflicts mean lower returns).

We start the analysis with a simple Ordinary Least Squares regression model where market returns are the dependent variable and our mortality metric is the independent variable. Depending on whether you use the “high,” “median” or “low” estimate for conflict, the correlation to the global equity market is between negative 30% and negative 38%, but not statistically significant with only 11 data points. For global bond markets the simple correlation ranges from negative 63 to 71%, which is statistically significant despite the small sample of eleven data points. For a typical 60% equity /40% fixed income institutional portfolio, the correlation averaged around negative 45% which is significant at the 95% confidence interval.

Changing the dependent variable in the regression to the log of mortality produced a much higher fit.
 

The “best fit” is between bond market returns and the “maximum” conflict time series with a correlation of negative 86% (r-squared = .74). This is statistically significant at a greater than 99.9% level. We chose not to control for other effects (inflation, changes in rate of GDP growth) as they may also be outcomes of the real world events, not independent effects. A second benefit of considering the log relationship is to shed light on the possibility that the OLS results are being driven by two large events where casualty rates spiked, World War I and World War II. The small differences in the regression coefficients suggest that the World War decades are not dominant.

 

The tail-risk with wars and rebellions is the permanent loss of capital. The diBartolomeo study was made on a data set of global market returns without survivorship bias inasmuch as the markets that went to zero were taken out, the following examples of country returns underline the need for global diversification and the risks of permanent loss of capital. Here is the German stock market starting in 1930 and ending just after World War II. Risk happens fast and in a discontinuous manner.

 

 

Here is a comparison of the US and Russian markets leading up to the 1917 Revolution when everything went to zero. Markets are forward-looking, but up to a point.

 

 

Despite these tail-risks, the study concluded that bond market returns are far more impacted by widespread deaths than equity returns.

 

Given these empirical results, we can reject the null of our hypothesis that financial market returns will be negatively correlated to conflict mortality for both fixed income markets and the blended 60/40 portfolio. For equities alone, the result has the correct sign but is not significant on eleven observations. We can also confirm that fixed income markets are more acutely impacted.
Turning to the present day, there are two risks that I don’t believe that market is paying attention to. The first is the risk of growing tension in the South China Sea. I outlined the possibility of a Chinese invasion of Taiwan (see Emerging tail-risk: An invasion of Taiwan). While that remains just a tail-risk and not my base case scenario, there have been reports of large Chinese warplane incursions that the Taiwanese have to scramble fighters to intercept. This may be in response to growing American assertiveness in the region in the form of a Freedom of Navigation passage of a carrier task force, and a growing anti-China alliance in Asia.

 

The second unknown is the future path of the Republican Party. My base case scenario had been a Red Wave in 2022 leading to a Republican takeover of the Senate and probably the House. We have experienced these negative partisanship cycles in the past. In 2020, disaffected Democrats turned out in numbers to defeat Trump. In 2016, disaffected Republicans turned out to eject the Democrats from the White House, and Obama had lost his control of the House and Senate well before that. Even going back to 1994, Gingrich engineered a takeover of the House under his “Contract with America” banner. Under normal circumstances, 2022 should be the same.

 

However, the latest schism between the Establishment wing and the Trump wing of the party as exemplified by the division over Marjorie Taylor Greene and Liz Cheney threatens that narrative. A recent poll shows that Trump Republicans are far less likely to favor a compromise with Biden over legislation than Party Republicans, or those who consider themselves more supporters of the Party.

 

 

Should the disagreements within GOP become a widening schism in the weeks and months ahead, retaking control of the Senate and House will more of an uphill battle. Moreover, the Republican Party could bifurcate into an Establishment wing focused on tax cuts and deregulation and a populist MAGA wing that causes disruptions to the body politic. At a minimum, this will change the path for fiscal policy in the third and fourth years of Biden’s term. At worse, it could throw the country into chaos and raise the risk premium of owning USD assets.

 

 

A pandemic under and over-reaction

Turning to pandemics, diBartolomeo assumed the worst case of 60 million worldwide deaths. Assuming that investors have a 10 year time horizon and the death rate effects are similar to war “the expectation of the cumulative return of their [60/40] portfolio would decline by -1.85%”. In other words, the effects are negative but not catastrophic.

 

A recent Ezra Klein podcast with sociologist and social media researcher Zeynep Tufekci yielded a good news and bad news story about the consensus reaction to the COVID-19 pandemic. Tufekci, who describes herself as a “systems thinker”, suggested the following frameworks that she found helpful.
  • Herding effects. The West first under-reacted to the bad news about the virus and it is now over-reacting. When China first downplayed the effects of the pandemic but shut down a city of 11 million, Tufekci realized that the problem is serious. Today, the press is full of stories about the shortcomings of different vaccines, but the fact is Operation Warp Speed was a resounding success. Even the “failures” of the vaccines as specified in research papers meant that patients usually didn’t die and only experienced very mild COVID-19 symptoms. Moreover, the world has reached a milestone of more vaccinations than reported cases despite the uneven manner of vaccination programs around the world. That’s good news that the market consensus is ignoring.

 

 

  • Thinking in exponents. The above chart shows a shortcoming of the human brain. We are simply not hardwired to think in terms of exponential growth outside of a few venture capitalists who are trained to think in that framework when funding startups. Case growth has been growing exponentially. Hence the initial under-reaction to the virus. Vaccinations are now catching up, but the consensus is not thinking in those terms. On the other hand, the growing dominance of the UK strain, which has a higher transmission rate, poses a threat to the global pandemic fight (think in growth rate exponents).

 

 

Corrosive corruption

The diBartolomeo paper went on to explore the corrosive effects of corruption on market returns which “may be imperceptible on a short term basis”.
 

Our empirical investigation began by calculating the ratio of equity market cap to GDP for a sample of about 100 countries for 2012. The correlation of market cap/GDP to the corruption index was negative 45% (r-squared = .21) which is highly statistically significant (T > 5). We repeated the analysis annually starting with 2002. In this case, the number of countries with functional equity markets was only 82, but the correlation of the market cap/GDP ratio was even higher at [negative] 48% (r-squared = .23) which is also highly significant (T > 5).
Keep that in mind when the Corruption Perceptions Index rating of the US fell to 67 in 2020 (rank 25) from 69 in 2019 (rank 23) and 81 (rank 10) in 2016. The top six countries in the index were New Zealand, Denmark, Finland, Switzerland, Singapore, and Sweden.

 

 

 

Climate change risk

The last topic of the diBartolomeo paper addresses climate change. Unlike other kinds of risks, climate change risk is asymmetric to the downside.
 

In some ways, the phrasing of “climate change risk” is a misnomer. In financial markets, the word risk is often used as a proxy for uncertainty. There is little uncertainty about the direction of what is happening in climate. The “risk” is in what the economic effects will be. Against a background of natural variation in temperatures over centuries, the increasing existence of greenhouse gases in the atmosphere has biased the process of global temperature variation toward increases rather than decreases. The world is being made hotter by some amount, and the increased energy levels associated with this greater heat is manifesting in various ways including higher intensity and frequency of extreme weather events. While it will take hundreds or thousands of years to prove to a statistical certainty that the recent changes in average temperatures are the result of human activity, the increasing concern of investors with respect to the environment is clear.
The initial reaction is ESG investing at a company level, with a particular focus on the E (environmental) part of ESG.
The most obvious question facing investors is the future of fossil fuel production and consumption which is widely accepted as the single largest cause of global warming. The most basic question is whether to reduce or eliminate investment in oil, coal, natural gas, and other fossil fuel related enterprises. The first research on this point was published nearly a quarter-century ago. In diBartolomeo and Kurtz (1996) a detailed analysis is done to attribute performance differences in an equity index which had been “screened” for environmental effects against a similar but unscreened equity index (the S&P 500). At the time, approximately 80% the variation in relative performance could be attributed to the inclusion or exclusion of fossil fuel related firms. This study was subsequently updated in diBartolomeo and Kurtz (2011) with similar conclusions. Both papers also illustrate how investors could change company level weights in their portfolios so as to minimize the variations in relative performance over time. 
However, investors need to focus on geography too.

Many asset owners are large investors in geographically bound assets such as real estate and the financing of public infrastructure. Baldwin, Belev, diBartolomeo and Gold (2005) provides a detailed approach to evaluating the risk of real estate and similar assets. A key fact is knowing exactly where that asset is located, down to a specific neighborhood or even street address. A major part of climate change risk is the expectation that sea levels and weather patterns will be changing and these changes will naturally impact some locations more than others (e.g. waterfront cities). 

In addition, ESG risks can be aggregated up to the country or local regional level. Investors should also focus on the credit-worthiness of countries and regions with high levels of climate change exposure, whether because of fossil fuel production, changes in agricultural production from warming temperatures, or cities at risk of flooding from rising sea levels. While the first iteration of ESG investing has been at the company level, expect the next one to focus on ESG sovereign risk.

 

 

Modeling regime change

The last big picture risk that investors should bear in mind is a shift in modeling regime. A paper by Rob Arnott et al, “Reports of Value’s Death May Be Greatly Exaggerated”, is an example of how modeling perspectives can change. 
Conventional value and growth indexes often define value stocks based on their P/B ratio. Put simply, any stocks trading at a low P/B is a value stock, anything else is a growth stock. However, the P/B metric is becoming outdated.

We start our analysis with an examination of the question of the adequacy of the P/B measure to capture the value effect in today’s economic environment. The economy has rapidly moved from agriculture to manufacturing to a service and knowledge economy. Therefore, we have economic reasons to believe that simple measures of value, such as B/P, are problematic. For example, a company presumably undertakes the creation of intangibles (e.g., research and development, patents, and intellectual property) because the managers expect these investments to enhance shareholder value. These investments are typically treated as an expense, however, and are not accounted for as amortizable assets on the balance sheet, which effectively lowers—we would argue understates—book value by the amount invested in the intangibles…Many of these stocks would have been classified as neutral or value stocks if the value of the internally generated intangible investments had been capitalized, thus increasing book value.

In other words, value investing, as measured by P/B, is misspecified. Arnott et al found that adding back intangibles improves the performance of value stocks (where HML stands for book-to-market minus low book-to-market).
 

 

Using alternative measures of value, the authors of the study found that other metrics performed better than the book-to-price ratio.
 

 

My conclusion from this to means that value investing isn’t dead. The dispersion of low and high P/E stocks is highly elevated, indicating that there are opportunities in value investing. The last time the market saw such a high level of P/E dispersion was at the end of the dot-com bubble and shortly thereafter. Growth stocks tanked, and value stock soared then.
 

 

In conclusion, instead of focusing on sources of alpha from stock, sector, or country selection, investors can also add value through better risk control by some “outside the box” analysis of the risk framework. In particular, investors can think about the following:

  • Mis-specification of investment objectives and risk preferences
  • How to take advantage of volatility
  • Regime change risk in the form of:
    1. Unexpected tail-risk
    2. Changes in market environment (conventional regime change);
    3. Slow changing regimes that investors may be unaware of;
    4. Changes in modeling assumptions.

 

WSB squeeze over, sound the all-clear?

Posted by Cam Hui -

Mid-week market update: The fever on the r/WSB squeeze has broken. As well, the elevated nature of sentiment readings has begun to normalize. Does that mean the correction is over?
 

 

In the past few days, I have had an unusual number of people ask me that question. My answer has been, “In the words of technical analyst Walter Deemer, when it comes time to buy, you won’t want to.”

 

Do you still want to buy?

 

 

Bullishness in retreat

To be sure, sentiment readings have come off the boil. Callum Thomas conducts a weekly (unscientific) poll on Twitter every weekend. His latest readings show that sentiment has swung net bearish after several weeks of elevated bullish readings. Similar past episodes of bearish sentiment after prolonged high bullishness have resolved either in either choppy downward action or further corrective action (warning, n=2).

 

 

 

Correlation isn’t causation, but…

There are other disturbing signs that the pullback isn’t over. I know that correlation isn’t causation and correlations can break apart in unexpected ways, but the USD has been strengthening this week even as the stock market rallied. The S&P 500 has been inversely correlated with the USD Index for the last year, and we are starting to see signs of a negative divergence.

 

 

From a technical perspective, the USD Index rallied through a falling trend line and it is poised to strengthen further.

 

 

Investors remain in a crowded short position in the USD. This is a setup for further greenback strength.

 

 

Take a look at the growth differential between the US and the two core eurozone coutnries. The gap could widen further until the EU Recovery Fund really kicks in. This will put downward pressure on EUR and upward pressure on USD.

 

 

Correlation isn’t causation, but this is a negative divergence to be worried about.

 

 

Technical warnings

In addition, market internals is still weak. Even as the S&P 500 rallied back through the rising trend channel, breadth indicators are not confirming the index’s strength.

 

 

SentimenTrader pointed out that portfolio cash levels are low. Mutual fund cash is at historically low levels.

 

 

So is pension fund cash.

 

 

The Fed has flooded the financial system with liquidity as M2 money supply has skyrocketed along with the savings rate. That analysis has led some analysts to conclude that there is cash on the sidelines waiting to be deployed. However, the low levels of mutual fund and pension fund cash leads to the interpretation that the “cash on the sidelines” are precautionary savings rather than funds available for investment.

 

 

 

Choppiness ahead

My base case scenario calls for more flat to down choppiness. Steve Deppe found that when “the S&P 500 falling -3% or more during an uptrend (i.e., positive returns over the trailing 12 weeks) that closes within -10% of our all-time high weekly close”, the market tends to be volatile, with a bearish bias.

 

 

As of the close last night (Tuesday), the % of S&P 500 above their 5 dma had reached a near overbought condition. The reflex rally that began Monday is fizzling out.

 

 

Keep an eye on the market’s reaction to Friday’s NFP report as a way of gauging the market’s psychology. The report is likely to print a strong positive surprise owing to the vagaries of seasonal adjustment. Labor economist Diane Swonk pointed out that the economy has “lost an average of 2.9 million jobs every January” from retail, restaurants and professional services like couriers and messengers. This year, the scale of the layoffs will be far less because of the pandemic, which leads to a strong positive seasonal adjustment. How will the market react to this probable “good” news?

 

The S&P 500 hourly chart shows two gaps. One above with the top at about 3850, and one below at 3780-3790. My inner trader remains short and he has put a stop just above 3850.

 

 

My inner investor is bullishly positioned, but he has mitigated the short-term risk by selling covered calls against some long positions.

 

 

Disclosure: Long SPXU

 

Opportunities from shorts (GME is so last week)

Posted by Cam Hui -

Is this GameStop’s “shoeshine boy” moment? Tracy Alloway pointed out that GME had made it to dog Instagram. 
 

 

If dog Instagram wasn’t enough of a shoeshine boy moment, how about this Michael Bathnick observation?

 

 

Regardless, there are a number of other opportunities in the short squeeze space to consider (other than silver).
 

 

Most shorted ETFs

The short squeeze play is getting played out, especially when short interest is falling to historic lows indicating there is little short covering demand should the market weaken.

 

 

Instead of looking for short squeeze opportunities in individual stocks, have you considered a list of the most shorted ETFs? These represent possible contrarian plays in unloved industries that may be poised to move up. For the purposes of this analysis, I focus on the top four, with the cutoff being 50% or more of the shares sold short.

 

 

The first ETF on the list, XRT, can be ignored as it represents a synthetic way of shorting GME. GME represents roughly 10% of XRT. For what it’s worth, there may be an arbitrage opportunity between XRT and GME put options.

 

 

The second ETF, XBI, is the equal-weighted Biotech ETF. XBI represents a unique growth opportunity. The ETF has been outperforming the S&P 500, and the industry is heavily shorted owing to disbelief over its strength. The ETF recently made a fresh all-time high, both on an absolute and relative to the S&P 500. As an aside, IBB, the cap-weighted Biotech ETF, ranks #8 on the list and IBB is not performing as well as XBI. XBI can be characterized as the growth play among the most shorted ETFs.

 

 

The next two on the list are value turnaround plays. XOP is the Oil & Gas Exploration ETF. The Energy sector has been unloved for most of 2020. Energy went from the biggest sector in the S&P 500 during the early ’80s to the smallest today. The world is shifting away from fossil fuels. GM recently announced that it will only sell zero-emission vehicles by 2035. Energy has become the new tobacco – an industry in decline. 

 

The negatives may be overdone. Despite the secular downtrend in energy demand, oil and gas prices should rise as the economic cycle rebounds. From a technical perspective, XOP rallied through a falling relative trend line and it appears to be forming the constructive pattern of a saucer-shaped relative bottom.

 

 

Similarly, KRE, which represents the regional banks, is forming a better defined rounded relative bottom. This indicates a turnaround for the group and foreshadows further outperformance in the future.

 

 

In conclusion, the analysis of the most shorted ETFs reveals three possible and diversified candidates for superior returns in the weeks and months ahead. Moreover, they don’t need to sponsorship of the r/WSB to rise. One can be thought of as a growth play, and the other two are turnaround value plays. All of them are rising on skepticism, as measured by the high level of short interest. 

 

 

How to spot the correction low

Posted by Cam Hui -

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

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

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

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

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

 

Here comes the pullback

I have been increasingly cautious about the tactical market outlook for the past few weeks (see Take some chips off the table). Last week’s sudden air pocket certainly gave the bulls a fright. Is this the start of a correction, and how can investors and traders spot the bottom?

 

The daily S&P 500 chart shows that the S&P 500 has definitively violated its rising channel and it is now testing support at the 50-day moving average (dma). The VIX Index spiked above its upper Bollinger Band which signals an oversold condition. The VIX appears to be going on an upper BB ride indicating a more prolonged downdraft.

 

 

Looking longer-term, the weekly S&P 500 chart shows that the S&P 500 is just testing its rising trend line. There are nevertheless warnings from the negative 5-week RSI divergence and a rollover in relative strength in the popular ARK Innovation ETF (ARKK).

 

 

Should the market weaken in line with the historical experience of the last four years, it would translate into a pullback of 6-12% or 3200-3640 on the S&P 500.

 

 

Correction ahead

Last week’s downdraft may be a sign that the long-awaited correction may have begun. The VIX Index spiked over 40% last Wednesday, which is a relatively rare occurrence. If history is any guide the risk/reward of such episodes is not favorable. The market tends to recover in the first week but slides looking out 2-4 weeks.

 

 

As well, global breadth and momentum are losing some steam. The percentage of world markets above their 50-day moving averages (dma) peaked and fell to 78%. While this reading is not below the 70% tactical sell signal just yet, it is a warning signal of waning momentum.

 

 

Another area of concern is the market response to Q4 earnings season. The market is not rewarding earnings beats. The inability of a market to respond to positive news is another red flag.

 

 

 

Signposts of a bottom

With that preface, these are some of the signposts of a corrective bottom. First, watch for positive or negative divergences in risk appetite. Equity risk appetite can be measured by the ratio of high beta to low volatility stocks, and the equal-weighted consumer discretionary to consumer staple stocks. Right now, they are exhibiting minor negative divergences.

 

 

Credit market risk appetite, which can be measured by the relative price performance of high yield (junk) bonds to their duration-equivalent Treasuries and leveraged loans to USTs, are also showing minor negative divergences.

 

 

Foreign exchange (FX) market risk appetite can be measured by the inverse of the USD Index, which is also slightly underperforming the S&P 500.

 

 

Last week’s initial downdraft took the market to a sufficiently oversold condition on the S&P 500 McClellan Oscillator to signal the start of a correction. However, the weekly chart shown at the top of this publication indicates that the magnitude of past pullbacks has mostly been in the 7-12% range. Last week’s peak-to-trough drawdown was about -4%. If history is any guide, there is more downside risk over the next few weeks.
 

The most likely pattern is a period of choppiness as the market tries to find a bottom. While V-shaped bottoms are always possible, W-shaped bottoms tend to be the norm. In such instances, look for positive divergences after a re-test of the initial low, such as a flat reading or higher low on RSI or the McClellan Oscillator.

 

 

Should the market be engulfed by a selling panic, my Trifecta Bottom Spotting Model should flash a buy signal. The three components of this model are:
  • The term structure of the VIX Index: An inverted term structure is a signal of option market fear.
  • NYSE TRIN: A spike above 2 is an indication of a price-insensitive forced liquidation, or a “margin clerk” market.
  • Intermediate-term overbought-oversold indicator: A reading below 0.5 is a signal of an oversold market.

 

If all three models flash buy signals within a 2-3 days of each other, I call that a Trifecta buy signal. Sometimes just an exacta (two model) signal is good enough for a bottom.

 

The market flashed an exacta buy signal last Thursday when the VIX term structure inverted and TRIN rose above 2. In all likelihood, that signal should be discounted because of the brief nature of the term structure inversion, and a mean reversion of TRIN. TRIN showed the unusual condition of skidding below 0.5 last Wednesday when the S&P 500 fell -2.6%, indicating a buying stampede. The “buying stampede” and subsequent volatility of TRIN are attributable to the WallStreetBets crowd forcing short-covering of highly shorted stocks like GameStop. This interpretation is confirmed by the buying stampede readings of NASDAQ TRIN and the lack of a NASDAQ TRIN spike during the same period.

 

 

Lastly, timing the following tools from Index Indicators can be useful in timing exact bottoms. Watch for oversold conditions on the percentage of S&P 500 stocks above their 5 dma.

 

 

Also, keep an eye on the percentage of S&P 500 stocks at their 5-day lows.

 

 

W-shaped bottoms will be choppy. The percentage of S&P 500 stocks at their 5-day highs can also be helpful for timing short-term entries and exits for traders who want to reload their short positions. From a tactical perspective, the market is setting up for a bounce early in the week, but too much technical damage has been done and the pullback isn’t over. Any strength would be a good opportunity for traders to short the market in accordance with their risk appetite and preferences.

 

 

In conclusion, the market is likely just starting a pullback in the 6-12% range. My base case scenario calls for some choppiness over the next few weeks, which is consistent with NDR’s seasonal analysis. 

 

 

To summarize, spotting a corrective bottom involves keeping an eye on the following:
  • Positive and negative divergence in risk appetite indicators;
  • Positive and negative divergences in breadth and momentum indicators like the McClellan Oscillator and RSI;
  • The Trifecta Bottom Spotting Model; and
  • Short-term breadth indicators to time the approximate date of the bottom.
My inner investor is bullishly positioned, but he has selectively sold call options against existing long positions in order to mitigate short-term downside risk. My inner trader is short the S&P 500. 

 

 

Disclosure: Long SPXU
 

What could go wrong?

Posted by Cam Hui -

Now that virtually everybody has bought into the reflation and global cyclical recovery trade, and Reddit flash mobs are ganging up on short sellers to drive the most short-sold stocks into the stratosphere, what could go wrong with this bull?
 

 

Notwithstanding the silliness of the WSB flash mobs, here are some key bearish risks to consider.

 

  • The rise of bond vigilantes
  • Continuation of the trade wars
  • Health policy stumbles

 

 

Partying with abandon

Most of the investor surveys have been off-the-charts bullish for weeks. From most indications, retail and fast-money hedge funds are all-in on equities. Today, data is emerging that the slow-moving institutions are also fast becoming long risk.

 

The BoA Fund Manager Survey shows global manager risk positioning is at a record high.

 

 

While investor surveys only ask about attitude, which can change quickly, a more reliable source of sentiment comes from either the market, such as option pricing of risk appetite, or surveys of holdings from custodians and hedge fund prime brokers. The latest monthly survey of State Street Confidence, which aggregates institutional client holdings, shows a surge in North American equity risk appetite. In all likelihood, the next data point will see a further increase in risk positioning.

 

 

The survey of global positioning tells a similar story of rising risk appetite.

 

 

What could possibly go wrong?

 

 

The rise of bond vigilantes

A key macro risk facing equity investors is the rise of the bond vigilantes. The BoA Fund Manager Survey shows that expectations of a Goldilocks scenario of above-trend growth and below-trend inflation have peaked.

 

 

The S&P 500 is trading at a forward P/E ratio of 21.8, which is well above its 5 and 10-year averages. 

 

 

While the stock market appears expensive on most multiple-based valuation techniques, such as P/E, P/CF, EV/EBITDA, and P/B, they can be justified in view of the low extremes in bond yields. If we were to calculate the equity risk premium, defined as 10-year CAPE minus the 10-year bond yield, equity prices appear more reasonable, though the US (red line) is less attractive than other major developed markets.

 

 

What if rates were to rise? The 10-year Treasury yield bottomed last August at 0.5% and it has risen to above 1% today. Arguably, the rise in the copper/gold ratio, which is a sensitive global cyclical indicator, calls for a 10-year yield in the 1.5-2.0% range.
 

 

Where are the bond vigilantes?

 

 

A question of fiscal room

Now that Janet Yellen has been confirmed as the Treasury Secretary, she is expected to work closely with Jerome Powell to coordinate fiscal and monetary policy to dig the economy out of the recession. The key quotes from Powell in the post-FOMC press conference were, “We’re focused on finishing the job” and “frankly we’d welcome some inflation”. Fed watcher Tim Duy summed up Powell’s views this way:

Powell is trying to do two things. First, recognize the improving economic outlook. Second, make clear that this improvement has not yet impacted the Fed’s expected policy path. The new strategy is very clear that forecasts alone are not sufficient to justify reducing policy accommodation. Forecast-based inflation fears failed the Fed in the last recovery and they expect the same would happen now. As a result, the focus is squarely on results. Considerable progress toward goals needs to be made before tapering. Sustained inflation needs to occur before raising interest rates. The Fed will continue to pound on this message. Also, Powell is not impressed with anyone’s concerns about asset bubbles. It’s all about inflation and jobs.

Undoubtedly, that will mean more fiscal stimulus coupled with a very loose monetary policy. The resulting deficits and increases in government debt could be gargantuan.

 

Inflation expectations are already rising. The 10-year breakeven rate (blue line) is above the Fed’s 2% inflation target, and the 10-year Treasury yield (red line) has historically traded at or above the breakeven rate. What happens if the 10-year yield were to rise towards 2%? Won’t that put pressure on the equity risk premium and therefore stock prices?
 

 

The answer to that question is a Keynesian beauty contest, where judges are rewarded for selecting the most popular faces among all judges, rather than those they may personally find the most attractive. 

 

From a policy perspective, there has been a flood of academic papers supportive of greater fiscal spending. The degree of fiscal capacity is higher than expected under standard assumptions.

 

A 2015 paper by Josh Ryan-Collins of the Levy Economics Institute, “Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935–75”, concluded that the coordination of fiscal and monetary policy was not inflationary [emphasis added].
 

We find little empirical evidence to support the standard objection to such policies: that they will lead to uncontrollable inflation. Theoretical models of inflationary monetary financing rest upon inaccurate conceptions of the modern endogenous money creation process. This paper presents a counter-example in the activities of the Bank of Canada during the period 1935–75, when, working with the government, it engaged in significant direct or indirect monetary financing to support fiscal expansion, economic growth, and industrialization. An institutional case study of the period, complemented by a general-to-specific econometric analysis, finds no support for a relationship between monetary financing and inflation. The findings lend support to recent calls for explicit monetary financing to boost highly indebted economies and a more general rethink of the dominant New Macroeconomic Consensus policy framework that prohibits monetary financing. 
A 2017 paper by Huixin Bi of the Kansas City Fed, “Fiscal Sustainability: A Cross-Country Analysis”, examined fiscal capacity in the context of not just debt levels, but government transfers, tax rates, productivity, and other factors. It concluded that the US has more fiscal space than Japan, which has a debt-to-GDP level that is highest of all G-7 economies.

 

 

One assumption of the study is that policymakers won’t increase taxes relative to GDP past a certain point. Current net US federal debt levels of about 100% of GDP aren’t troubling, but raising taxes significantly could be.

 

 

This approach argues for substituting the conventional debt-to-GDP analytical framework for an interest rate vs. nominal growth rate framework.

 

 

Whether any of this matters to the bond market is another question. In a Keynesian beauty contest, it’s not your own opinion that matters, but that of the market.

 

Another risk is the USD and growth differentials. Nordea Markets pointed out that should the US be successful in its stimulus efforts, growth differentials with other major economies are set to rise. This would put upward pressure on the USD, which is contrary to the consensus view of a weak greenback. USD strength would put downward pressure on fragile EM currencies, which could spark a risk-off episode.

 

 

 

The trade war isn’t over

Just when you thought that Trump is out of the White House, his trade wars and protectionist tendencies have receded from government policy. Think again.

 

Marketwatch reported that Janet Yellen had some harsh words for China.
 

Janet Yellen, President Joe Biden’s pick to be U.S. Treasury secretary, made some blistering comments about China this week. It was straight talk the likes of which were rarely heard during her tenure as Federal Reserve chairwoman between 2014 and 2018. 

 

Yellen called China “our most strategic competitor’ and that the U.S. would work with its allies on a coordinated response.

 

“We need to take on China’s abusive, unfair, and illegal practices,” Yellen went on to say.

 

“China is undercutting American companies by dumping products, erecting trade barriers, and giving illegal subsidies to corporations,” Yellen said. 

 

Reuters reported that Biden Commerce nominee vows to protect U.S. networks from Huawei, ZTE:
 

President Joe Biden’s nominee to head the U.S. Commerce Department on Tuesday vowed to protect U.S. telecommunications networks from Chinese companies, but she refused to commit to keeping telecommunications giant Huawei Technologies on a U.S. economic blacklist.

 

“I would use the full toolkit at my disposal to the fullest extent possible to protect Americans and our network from Chinese interference or any kind of back-door influence,” Rhode Island Governor Gina Raimondo said in testimony before the U.S. Senate Commerce Committee, naming Huawei and ZTE Corp. Congress in December approved $1.9 billion to fund the replacement of ZTE and Huawei equipment in U.S. networks.

There is a bipartisan consensus in Washington that China is a clear and present danger on trade. A changing of the guard at the White House will not change that thinking, though the Biden approach is likely to be less confrontational, and seek to gather allies to pressure China to make changes.
 

The early signals from Biden are the level of protectionism is unlikely to fall significantly. One of Biden’s first executive orders was to require the federal government to “buy American” for products and services. This order upset a lot of trading partners, especially within the NAFTA bloc.
 

The market hasn’t really reacted to any of this news. Will the prospect of stabilization in protectionist levels spook the markets and risk appetite?
 

 

The virus is mutating

Even as investors are partying with abandon, so is the virus. The good news is case counts are starting to fall, but they could rise again if the newly infectious variants cause case numbers to rise again, especially if people become blasé about masks and social distancing. In the EU, vaccine supply is getting low. Spain has reported that “its fridges are empty”. A Hong Kong acquaintance informs me that they are unaware of any plans by the authorities to even roll out a vaccine. This pandemic is a global problem. Until the virus is stamped out everywhere and no pockets of infection remain to leak out and infect others, the global economy will not return to normal.
 

 

The New York Times reported that Pfizer and Moderna have scaled back expectations for the effectiveness of their vaccines.

As the coronavirus assumes contagious new forms around the world, two drug makers reported on Monday that their vaccines, while still effective, offer less protection against one variant and began revising plans to turn back an evolving pathogen that has killed more than two million people.
 

The news from Moderna and Pfizer-BioNTech underscored a realization by scientists that the virus is changing more quickly than once thought, and may well continue to develop in ways that help it elude the vaccines being deployed worldwide.

Moderna conceded that it may have to modify its vaccine to cope with new virus mutations. In addition, patients may have to continue to receive additional booster shots.

Moderna and Pfizer-BioNTech both said their vaccines were effective against new variants of the coronavirus discovered in Britain and South Africa. But they are slightly less protective against the variant in South Africa, which may be more adept at dodging antibodies in the bloodstream.
 

The vaccines are the only ones authorized for emergency use in the United States.
 

As a precaution, Moderna has begun developing a new form of its vaccine that could be used as a booster shot against the variant in South Africa. “We’re doing it today to be ahead of the curve, should we need to,” Dr. Tal Zaks, Moderna’s chief medical officer, said in an interview. “I think of it as an insurance policy.”
 

“I don’t know if we need it, and I hope we don’t,” he added.
 

Moderna said it also planned to begin testing whether giving patients a third shot of its original vaccine as a booster could help fend off newly emerging forms of the virus.

 

Another good news and bad news story come from the Johnson & Johnson and Novavax vaccine trials. J&J reported that the efficacy of its single-shot vaccine was 72% in the US and 57% in South Africa. Novavax reported its two-shot vaccine had a nearly 90% effectiveness in the UK but fell to 50% in a small South African trial. The South African variant, known as B.1.351, is raising alarm among health officials. This means new variants could cause more reinfections and require updated vaccines. As well, national health authorities need to put into place a “regulatory process to allow efficient updating to reflect new variants”.
 

 

In addition, the general acceptance of a vaccine is still a bit low. While vaccine acceptance is growing in Europe, the acceptance rate in most countries varies between 50% and 60%, which is not enough to achieve herd immunity. In addition, if governments were to impose continuing precautionary measures even after people are vaccinated, the policies create disincentives for people to vaccinate. Continuing rolling lockdowns would delay the global recovery and push back growth expectations.
 

 

 

Still constructive

Don’t get me wrong. I remain constructive on the market outlook and the base case scenario still calls for a prolonged equity bull market. This chart of IPO activity puts the market cycle into context. Sure, IPO activity is starting to look frothy, but history shows it can take several years before a secular market top is reached.
 

 

I am also indebted to New Deal democrat for the following insight, which shows the high degree of correlation between stock prices (blue line) and initial claims (red line, inverted) before the onset of the pandemic. As long as the recovery continues, the stock market should grind higher.
 

 

In the short-term, however, the market has become a little too giddy and a risk appetite reset may be necessary. A number of potholes are appearing on the road, any of which could be the catalyst for the reset. Investors are advised to focus on value over growth. As well, better value can be found outside the US, which is confirmed by the results of the cross-border equity risk premium analysis.
 

 

 

Risk happens quickly

Posted by Cam Hui -

Mid-week market update: What are we make of this market? In the last four years, the weekly S&P 500 chart shows that we have seen six corrective episodes of differing magnitudes. Risk happens, and sometimes with little or no warning.
 

 

About half of those instances saw negative 5-week RSI divergences, which we are seeing today. Since the start of 2019, when the ARK Innovation ETF (ARKK) started to get hot, the ARKK to SPY ratio roll over every time during those corrections. That ratio is turning down again.

 

The stock market is becoming a market of stocks, instead of a stock market. Individual issues are moving separately instead of together. In the past, low realized individual stock correlations have been warnings of market corrections.

 

 

Will this time be any different? The S&P 500 hasn’t seen a downside break of the rising trend line on the weekly chart yet.

 

 

Reasons for caution

The bear case is easy to make. Signs of froth are appearing everywhere. The PBoC warned about asset bubbles and withdrew liquidity from the financial system. The overnight repo rate spiked as a consequence. The Chinese and HK markets tanked on the announcement Tuesday, but steadied on Wednesday.

 

 

Bloomberg also reported that the “Goldman Team Sees ‘Unsustainable Excess’ in Parts of U.S. Market”.
 

Corners of the U.S. equity universe are showing signs of froth, but that shouldn’t put the broader market at risk, according to Goldman Sachs Group Inc.

 

Very high-growth, high-multiple stocks “appear frothy” and the boom in special-purpose acquisition companies is one of a number of “signs of unsustainable excess” in the U.S. stock market, strategists including David Kostin wrote in a note Friday. The recent surge in trading volumes of stocks with negative earnings is also at a historical extreme, they said.

 

However, the aggregate stock market index trades at below-average historical valuations after taking into account Treasury yields, corporate credit and cash, the strategists added.

 

In a separate article, Bloomberg reported that the NAAIM survey of RIAs shows that the most bearish respondents are 75% long. To explain, NAAIM surveys RIAs from 200 firms overseeing more than $30 billion and asks their investment views. The survey reports an average equity exposure, an average top and bottom quintile exposures, and a maximum and minimum exposure. It is highly unusual to see the minimum at 75%. Most of the time, the minimum is negative, indicating a short exposure to equities. The last time minimum exposure was this high was the market melt-up in late 2017 and early 2018. Tom McClellan recently made the same observation about the NAAIM survey and came away with a similar bearish conclusion.

 

 

As well, money market cash levels are low. Historically this has led to subpar returns.

 

 

From a seasonal perspective, February has historically seen VIX spikes. Since volatility is inversely correlated with the market, this implies lower stock prices ahead.

 

 

Ryan Detrick also observed, “When a new party is in power in the White House, that first year tends to be pretty choppy for the S&P 500.” Negative seasonality starts very soon and ends in March.

 

 

The market is due for a correction.

 

 

Here comes the flash mob bulls

There is no doubt that the market psychology is frothy and giddy. If you are unfamiliar with the Reddit flash mobs, take a look at the article, “11 Things to Know About the Wild GameStop Drama on Reddit WallStreetBets (WSB)”.

 

To recap, small retail traders have identified highly shorted issue and ganged up to push the stocks up. These traders have mostly used call options to maximize their leverage, and to force dealers to hedge their positions by driving up the underlying stock price. Small trader option volume has surged to fresh highs as a consequence.

 

 

Indeed, most shorted stocks have gone wild on the upside. 

 

 

The short squeeze targets are small cap stocks, and there is a linear relationship between the YTD performance of Russell 2000 stocks and their short interest.

 

 

Google searches for “short squeeze” have skyrocketed.

 

 

GameStop (GME) is the poster child of the short squeeze. Yet, even as GME rose like a rocket ship, the overall market reaction has relatively relaxed. The Russell 2000 VIX has risen but not spiked above its recent range, and the shares of CBOE has lagged the S&P 500.

 

 

How long can the WSB flash mobs prevail? Joe Wiesenthal of Bloomberg offered some perspective.
 

If you go back to the dotcom bubble, and you think about what stocks were really representative of it all, you probably think of Qualcomm or Cisco or Yahoo, or perhaps you remember TheGlobe.com. But some of the initial plays were a lot weirder. Back in the spring of 1998, traders went nuts for shares of K-Tel, the purveyor of corny compilation CDs that were sold via infomercials on TV. But when they started selling CDs online, the stock went bonkers, doubling many times over. Still, what seemed like irrational exuberance wasn’t anywhere close to the top of the market mania. It was barely even the beginning. K-Tel was like Hertz or the Scrabble bag.

 

It’s basically impossible to know in real time where you are in the cycle or how big things are going to get. Things can always get more nuts.
Before you think that the WSB pressure is restricted only on the upside, BNN Bloomberg reported that “Short-squeezed hedge funds are now getting hit on their bullish bets too”. Hedge funds have to trim their long positions in order to balance the losses on the short books. In the alternative, some traders are being forced to liquidate because rising volatility is causing VaR (Value at Risk) models to reduce book sizes.
 

Hedge funds are suffering as retail traders whipped up in chat rooms charge into heavily shorted names, fueling squeezes in stocks from Bed Bath & Beyond Inc. to AMC Entertainment Holdings Inc. Fund managers have spent recent weeks paring bearish bets, with hedge fund clients tracked by Goldman Sachs on Friday carrying out the biggest short covering in seven months.

 

But the long sides of their books are starting to feel the pinch too. On Monday morning, when stocks with the highest short interest soared as much as 11 per cent, the GVIP fund tumbled almost 2 per cent.

 

Such a squeeze not only hurts performance for hedge funds, it increases the potential size of a measure known as daily value at risk, both of which would prompt money managers to cut back their risk appetite, according to Kevin Muir of the MacroTourist blog.

 

“The real question is whether this selling starts a negative feedback loop,” Muir wrote Monday. “Even though it might seem like the stock market bulls should be cheering the squeezes, their success might end up being the trigger that brings about the general stock market correction many have been waiting for.”
Should the WSB squeeze continue, it opens up the possibility of one or more hedge fund blowups, such as a repeat of the August 2007 quant meltdown (see Khandani and Lo paper for more details).

 

In order to adapt to the new environment, I am changing my subscription pricing from being paid in USD, to being paid in shares of GME. This change will be immediate and apply to all renewals and new subscriptions*.

 

 

 

Risk levels are high

Tactically, today’s sell-off saw the S&P 500 violate a well-establish rising channel. In addition, the VIX Index surged above its upper Bollinger Band, which is the signal of an oversold market. The bulls need to hold the line here and rally. I am closely watching the behavior of the VIX. Will this a “once and done” spike, or an upper BB ride? Watch if there is any bearish follow-through.

 

 

My inner investor is bullishly positioned, but he has selectively sold covered calls against existing positions as a partial hedge. The long-term trend is still bullish, though short-term risk levels are high. My inner trader is holding his short position in the S&P 500.

 

* No, I am not serious. That’s a joke.

 

 

Disclosure: Long SPXU

 

When new highs aren’t bullish

Posted by Cam Hui -

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

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

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

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

 

 

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

 

An exception to the rule?

The S&P 500 rallied to a fresh all-time high last week. While it is said that there is nothing more bullish than a market making new highs, this may be an exception to that rule, especially when there were more declines than advances on the day of a new high.

 

The S&P 500 kissed the top of a rising channel while exhibiting a negative 5-day RSI divergence. In addition, the VIX Index, which tends to be inversely correlated to stock prices, is testing a key support level at 20-21. More worrisome is the behavior of financial stocks. Large-cap banks reported last week and most beat expectations, but the entire sector is lagging the market.

 

 

 

More signs of froth

Sentiment readings have been extended since last 2020. The latest data point from NAAIM, which measures RIA sentiment, reached a record high of 113. While sentiment models are less useful at tops than bottoms (shaded areas), the last time the NAAIM Exposure Index neared these levels was the melt-up of late 2017 and early 2018.

 

 

These sentiment readings are consistent with the BoA Fund Manager Survey, which showed risk appetite at record levels.

 

 

As well, the Globe and Mail reported that BoA strategist Savita Subramanian observed that their “Sell Side Indicator”, which measures the risk appetite of Street strategists, is nearing a sell signal.

 

Sentiment has been getting more euphoric, as our Sell Side Indicator – a contrarian sentiment model – is at the closest level to the “Sell” threshold since the financial crisis. 

The 10-day moving average of the equity-only put/call ratio is nearing its lows again, indicating excessively bullishness. At a minimum, recent low reading episodes have resolved themselves in pullbacks.

 

 

 

Earnings season

One of the bright spots for the market bulls could be Q4 earnings season. FactSet reported the good news: Both EPS and sales beats are strong and above historical norms. Company analysts are revising their EPS estimates upwards, which should be a sign of strong fundamental momentum and bullish.

 

 

However, the market isn’t responding to good news in the form of earnings beats. FactSet also reported that the market is punishing positive earnings reports, and rewarding negative ones. However, the conclusion of rewarding earnings misses is based on highly preliminary data, and a very small sample size (n=3). I interpret these conditions as the market not rewarding earnings beats, rather than punishing beats and rewarding misses.

 

 

 

Where is the leadership?

The analysis of market leadership is also flashing warning signs. To be sure, the S&P 500 has been led by large-cap growth stocks. The NASDAQ 100 has led the market upwards, though the NDX to SPX ratio violated a rising relative trend line in early November. The latest relative upswing only represents a sideways consolidation within a range. 

 

 

A more detailed look at the relative performance of the top five sectors is more worrisome. These sectors represent 75% of S&P 500 index weight, and it’s virtually impossible for the index to rise sustainably without the participation of a majority of these sectors. The only signs of relative strength come from float-weighted consumer discretionary (AMZN and TSLA) and communications services. None of the other sectors are exhibiting signs consistent strong relative strength. Put simply, the market is being led upwards by a handful of Big Tech stocks. 

 

 

The narrow leadership is also evident in the analysis of market breadth. Even as the S&P 500 reached fresh highs, indicators such as NYSE and NASDAQ new highs, the % of stocks with point and figure buys, and the percentage of stocks above their 50-day moving average are all making patterns of lower highs and lower lows. As we progress through earnings season, the narrowness of the leadership poses a grave stock specific risk to the major indices. Any disappointment has the potential to open the door to a sell-off.

 

 

In conclusion, the market is undergoing a melt-up and a setback can happen at any time. At worse, the market is vulnerable to a violent air pocket of unknown magnitude. Remember Bob Farrell`s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”
 

Brace for volatility in the coming week from individual earning season results and the FOMC meeting.

 

 

 

Disclosure: Long SPXU

 

What would Bob Farrell say?

Posted by Cam Hui -

What would the legendary market analyst Bob Farrell say about today’s markets? I was reviewing the patterns of factor returns recently, and I was reminded of three of Farrell’s 10 Rules of Investing (which are presented slightly out of order).
 

Rule 3: There are no new eras – excesses are never permanent.
Rule 2: Excesses in one direction will lead to an opposite excess in the other direction.
Rule 4: Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

 

Applying those principles to the return patterns to growth and value over the last 20 years, we can see that growth has peaked out relative to value in 2020 (Rules 2 and 3).

 

 

Does that mean that this is the end of an era for growth stocks? Large-cap growth stocks comprise roughly 45% of the weight of the S&P 500. If they were to falter, does this mean investors are facing a major market top?

 

What would Bob Farrell say?

 

 

FANG+ = Nifty Fifty

While Farrell’s 10 Rules is silent on the specifics of today’s FANG+ leadership, they were not silent on investor psychology. One thing is certain, investors are prone to recency bias, and the most likely parallels they might make is the dot-com bubble of the late 90’s. I beg to differ.

 

The mania of the late 90’s was characterized by a flood of unprofitable companies coming to market. I remember sitting through endless presentations of new companies with the mantra of “We expect to be EBITDA positive in two years, and earnings positive in three.” Even paper and forest products companies would not dare go into an institutional presentation without outlining a “broadband strategy”.

 

By contrast, today’s FANG+ stocks tend to be cash flow generative and have substantial competitive advantages, or moats. A more fitting analogy to the recent FANG+ leadership is the Nifty Fifty era of the early 70’s.

 

The Nifty Fifty era was characterized by a “growth at any price” mentality. The investment thesis was to buy good growth stocks and hold them – forever. The blogger writing under the pseudonym Jesse Livermore recently performed a masterful analysis of the Nifty Fifty using the O’Shaughnessy Asset Management (OSAM) database. He took the Nifty Fifty list as of 1972 and analyzed the history from 1963 to 2020. Most of the survivors today have mature growth paths, the key theme of strong competitive moats is emerging from the analysis. Large-cap survivors include pharmaceuticals, along with selected consumer-oriented companies who have been able to maintain their branding (P&G, Disney, Coke, McDonald’s).

 

 

The key similarity between the Nifty Fifty list and the FANG+ list today is their competitive moats, as characterized by their ability to maintain high margins. Companies in industries with high margins will attract competitors. They will not survive unless they have strong competitive positions.

 

 

However, good companies don’t necessarily make good investments. Despite their strong levels of profitability, Nifty Fifty stocks peaked out in relative performance in the early 70’s and never looked back.

 

 

The analysis of P/E multiples tells the story of performance. Nifty Fifty stocks began as highly valued. Multiples collapsed when the investment theme peaked, and normalized to market levels starting in the early 80’s.
 

 

I don’t mean to leave the impression that all of the Nifty Fifty were successful investments. A glance at the top losers reveals companies that lost their competitive moats. Technology companies were at the greatest risk of this (IBM, Digital Equipment, Unisys, Xerox).

 

 

 

Timing the top

What does this mean for investors?

 

First, be aware of Mark Minervini’s 50/80 Rule: “Once a secular market leader puts in a major top, there’s a 50 percent chance that it will decline by 80 percent—and an 80 percent chance it will decline by 50 percent.”
 

Mark Hulbert also recently warned about the possibility of a “valuation bear market”.

 

Take what happened in the wake of the internet bubble bursting, for example. From the stock market’s March 2000 high to its October 2002 low, according to data from Dartmouth’s Ken French, the 10% of all publicly traded stocks closest to the value end of the spectrum outperformed the 10% closest to the growth end by more than 22 annualized percentage points—though they still lost ground on average. But small-cap value stocks—as represented by the Russell 2000 Value Index—actually rose slightly during that bear market.

 

Despite the apparent evidence of a reversal in the relative performance of large-cap growth stocks, we have to allow for the possibility that this is not the top. A more detailed analysis of the relative performance of the Nifty Fifty revealed false bear market positives in the late 60’s.

 

 

However, the length and magnitude of the gains of FAANGM stocks suggests that these issues are due for a secular top.
 

 

Where does that leave us? The weight of the evidence suggests that US large-cap growth stocks are turning down, and their secular bear is just beginning. Value is just starting its cycle of outperformance, and investors should tilt their portfolios towards out-of-favor value stocks.

 

Investors who would like exposure to growth can look outside the US, such as the tech-heavy Asia 50 (AIA) or Emerging Markets eCommerce and Internet ETF (EMQQ). Both of these ETFs have turned up relative to the NASDAQ 100.

 

 

 

In need of a sentiment reset

Posted by Cam Hui -

Mid-week market update: This market is in need of a reset in investor sentiment. In addition to recent reports of frothy retail sentiment, the latest BoA Fund Manager Survey (FMS) indicates that global institutions have gone all-in on risk. The FMS contrarian trades are now “long T-bills-short commodities, long US$-short EM, long staples-short small cap”, or short market beta.

 

 

Along with growing signs of deteriorating market internals, this market is poised for a correction.

 

 

More signs of froth

Here is how frothy sentiment has become. SentimenTrader recently reported sky-high call option activity by retail investors.

 

 

In aggregate, speculators (read: hedge funds) are very, very long equity futures.

 

 

This is the classic definition of a crowded long position by different constituents. Retail, hedge funds, and now institutions are all long risk up to their eyeballs. Who is left to buy?

 

 

Negative divergences

All the market needs to fall is a bearish trigger. Even as the S&P 500 staged an upside breakout to another all-time high, a number of worrisome negative divergences are appearing.

 

  • Technical: A negative divergence from the 5-day RSI.
  • Equity risk appetite: The ratio of high beta to low volatility stocks is trading sideways and not confirming the new high. This ratio is an important indicator of equity risk appetite.
  • Earnings season reaction: Q4 earnings season has begun. Most of the large-cap banks have reported, and most have beaten expectations. However, financial stocks are lagging the market despite the beats. A market that does not react well to good fundamental news is a warning for the bulls.
  • Foreign exchange risk appetite:  The USD has been inversely correlated stock prices. The USD began a counter-trend rally, which would put downward pressure on risk assets.

 

 

Macro Charts recently highlighted the crowded short positioning in the USD Index. This makes the EM assets especially vulnerable, and the long EM trade is a long risk and reflation trade.

 

 

The cyclical and reflation trade is also in need of a reset in sentiment. Callum Thomas observed that the S&P 500 does not perform well when ISM rises above 60. Too far, too fast?

 

 

From a sentiment momentum perspective. the FMS shows that the expectations for the Goldilocks scenario of strong non-inflationary growth is rolling over. These are the kinds of conditions that can spark a correction.

 

 

In conclusion, the combination of giddy sentiment and technical deterioration is not a good recipe for further equity market gains. The short-term risk/reward ratio is negative and the market can correct at any time.

 

 

Disclosure: Long SPXU

 

 

Take some chips off the table

Posted by Cam Hui -

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


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


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


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

 

 

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

 

Not what you see at market bottoms

I have been writing about the extended nature of sentiment for several weeks. Macro Charts highlighted an email from Interactive Brokers on how to build a “balanced” portfolio using fractional shares, consisting of Netflix, Tesla, Alphabet, and Amazon. Either someone forgot the basics of financial planning in constructing a balanced portfolio, or we are back to the go-go days of the dot-com and Nifty Fifty bubbles.

 

 

While it is true that sentiment models are less effective at calling tops than bottoms, there are sufficient signs that investors and traders should be reducing equity risk and taking some chips off the table.

 

 

 

Momentum rolls over

While it is true that bullish sentiment can remain elevated for quite some time, a useful rule of thumb is to wait for downside breaks in technical indicators before turning cautious. Recently, the NYSE McClellan Summation Index (NYSI) rolled over from an overbought extreme, indicating a loss of momentum. Most of these episodes have resolved with market stalls (red vertical lines) while only a small minority have seen the market continue to advance (blue lines).

 

 

 

A bad breadth warning

An analysis of relative performance of the top five sectors of the S&P 500 also reveals the headwinds the index is facing. These sectors comprise over 75% of index weight, and the market would have difficulty rising without the participation of a majority of these sectors. Currently, only the smallest of the top five, financials, is displaying positive relative strength. All of the other sectors are either trading sideways or falling relative to the S&P 500.

 

 

 

Negative RSI divergences

In addition, negative RSI divergences are showing up in market leaders even as they make new relative highs. Since the March low, small cap stocks have been on fire, but the relative performance of the Russell 2000 to S&P 500 is exhibiting an RSI negative divergence even as the ratio makes new highs.

 

 

The enthusiasm for the ARK Innovation ETF (ARKK) is highly reminiscent of the mania surrounding the Janus 20 Fund during the dot com era. Similar to the Russell 2000, the ARKK to SPY ratio is also exhibiting a negative RSI divergence, which is another warning for the bulls.

 

 

Lastly, you can tell the character of a market based on how it reacts to news. The S&P 500 broke short-term support (shaded box) even as Biden unveiled a $1.9 trillion fiscal support package, and Fed chairman Jerome Powell reiterated the Fed’s dovish commitment to maintain the pace of asset purchases. In addition, earnings beats by Citigroup and JPMorgan were met with red ink for their share prices. These reactions are indicative of a heavy tape and a market that’s ready to fall. In the short-term, the path of least resistance is down. Primary support can be found at the rising trend line at about 3750, with secondary support at the Fibonacci retracement levels of 3588 and 3515.

 

 

Also keep an eye on the USD. The USD Index is undergoing a counter-trend rally by rising through a short-term downtrend (dotted line), but the long-term downtrend (solid line) remains intact. Initial resistance can be found at about 91, with key secondary resistance at 92. The USD is an important risk appetite indicator. It has been inversely correlated with both the S&P 500 and emerging markets (bottom panel).

 

 

In conclusion, the seasonal Santa Claus rally that began in December is living on borrowed time. This market is vulnerable to a 5-10% setback, and it can correct at any time. While it’s impossible to call the exact timing of a short-term top, the weight of the evidence suggests that it’s time to tactically reduce equity risk and take some chips off the table. We are into a period of negative seasonality and choppiness until early March.

 

 

Subscribers received an email alert that my inner trader had initiated a short position in the S&P 500. Keep in mind, however, that the primary trend is still bullish, and the utility of trading short positions in a bull market is less useful.

 

My inner investor remains overweight equities. He has selectively sold covered call options against long positions as a way of reducing risk.

 

 

Disclosure: Long SPXU