A Great Rotation region and sector update

Posted by Cam Hui -

In the wake of my Great Rotation publication (see Everything you need to know about the Great Rotation but were afraid to ask), it’s time for an update of how global regions and US sectors are performing. The short summary is the change in leadership of global over US stocks, value over growth, and small caps over large caps are still intact.
 

 

While the long-term trends remain in place, some tactical caution may be in order in certain parts of the market.

 

 

Global leadership patterns

For the purposes of analyzing change in leadership, I use the Relative Rotation Graphs, or RRG charts, as the primary tool for the analysis of sector and style leadership. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

 

The RRG analysis of global regions is clear. Avoid US equities. The only regions in the bottom half of the chart are US indices. 

 

 

A more detailed analysis of relative performance against the MSCI All-Country World Index (ACWI) shows that the S&P 500 and NASDAQ 100 losing steam, major developed markets like Europe and Japan trading mostly sideways, and EM xChina the best relative performer.  EM xChina’s strong relative performance is mainly attributable to that region’s high cyclical exposure, though the region may be vulnerable in the short-run owing to the extended nature of the recent rally.

 

 

 

Sector rotation analysis

The RRG analysis of US sector held few surprises. Large-cap growth sectors such as technology, communication services, and consumer discretionary (AMZN, TSLA) were in the weakening quadrant. Defensive sectors, such as consumer staple, utilities and real estate, were in the lagging quadrant owing to the strong market rally since the November Vaccine Monday rally began. Unloved value sectors such as energy and financials are in the leading quadrant. 

 

 

A closer examination of the two leading sectors, energy and financials, reveal some key differences. Both large and small cap energy stocks are beating their respective benchmarks and showing similar patterns (top panel), but the degree of outperformance of small to large cap energy (bottom panel, green line) lags the relative performance of the Russell 2000 to S&P 500. If energy stocks are to remain market leaders, there may be some opportunity in small cap energy.

 

 

The analysis of large and small cap financial stocks tells a different story. While large cap financials have begun to recover, small caps have not shown the same relative performance pattern (top panel). The yield curve has been steepening, which should be positive for banking profitability, but the lagging leadership of small cap financial stocks is a blemish for the sector.

 

 

The big surprise from the RRG chart was the deterioration in relative strength seen in cyclical sectors such as materials and industrials. In theory these sectors should be performing well as the global economy recovers from the pandemic. Instead, the relative performance of cyclical sectors and industries have begun to flatten out.

 

 

 

A cyclical pause?

Signs are growing that the expectations of a cyclical recovery has grown too far, too fast. In a recovery, companies with high financial and operating leverage should perform well, and indeed the high operating leverage basket has rocketed upwards against the S&P 500 since Vaccine Monday. Cyclical stocks may have risen too far, too fast.

 

 

The global cyclical recovery trade appears ready to take a breather. Callum Thomas observed that industrial metal PMIs are starting to roll over, even though readings are still strongly positive.

 

 

 

 

However, any pause in the cyclical rebound is likely to be short-lived. China has been leading the global recovery. Despite the recent pause, the PBoC has injecting liquidity into the financial system, which should boost the cyclical sector within the next few months.

 

 

I am monitoring the relative performance of Chinese material stocks. This sector has traded sideways relative to other global material companies. While this is a sign that economic momentum is losing some steam, it will also provide a real-time alert of improving economic momentum from China.

 

 

 

Investment implications

What does this mean for the stock market? First, investors should relax. The rally is likely due for a pause but the bull cycle remains intact. The current advance in the Dow is consistent with past historical experience since 1900.

 

 

From a sector perspective, investors should focus on value stocks. The relative performance recovery of large and small cap value, however they are measured, are intact.

 

 

In particular, the energy sector holds promise. This sector has become the smallest sector by weight in the S&P 500, indicating its unloved status. Even within the commodity sector, the crude oil to gold ratio is depressed. Energy stocks are now the new tobacco – unloved value stocks. Their recent relative strength recovery could be a signal of a turnaround for this sector.

 

 

From a global perspective, investors can also consider value candidates that have begun to recover. In the developed markets, small cap UK stocks could be a source of outperformance, now that the uncertainties of Brexit have been resolved.

 

 

Within the emerging markets, EM xChina has been exhibiting strong relative strength, though it is a little extended and could see a short-term pullback.

 

 

However, the analysis of fund flows show that EM xChina equity flows are net negative for 2020. These stocks are still under-owned, indicating substantial potential for outperformance.

 

 

 

One last push, or a downside break?

Posted by Cam Hui -

Mid-week market update: I have been warning about the extended nature of this stock market for several weeks. The latest II sentiment update shows more of the same. Bullish sentiment has come off the boil, but readings are reminiscent of the conditions seen during the melt-up top that ended in early 2018.
 

 

The market can correct at any time, but I also have to allow for the possibility of one last bullish push to fresh highs. Here is what I am watching.

 

 

High levels of speculation

I have written about how low quality stocks have begun to dominate the market. Here is another data point that details the level of speculative activity – the low price factor. On a YTD basis, low priced stocks have outperformed on a monotonic basis. 

 

 

Similarly, option call volume has skyrocketed, indicating rampant speculative activity.

 

 

Consequently, dealer gamma exposure is also sky high, as dealers need to hedge the unprecedented levels of call option activity. Historically, such high levels of gamma have resolved themselves with corrective activity.

 

 

Another risk is the low short interest by historically standards. These levels will not provide the buying demand to put a floor on stock prices if the market corrects.

 

 

 

Waiting for the trading signal

Before turning overly bearish, here is what my inner trader is watching. The S&P 500 recently went on an upper Bollinger Band (BB) ride. Such upper BB rides have either resolved with sideways consolidation and a renewed rally, as the market did in August, or a correction. So far, the market has traded sideways for several days, and he is now waiting for either an upside or downside break out of the trading range (shaded box). Should it break upwards, watch for signs of either confirmation of strength or a negative divergence from the 5-day RSI.

 

 

As well, keep an eye on the USD Index. The USD is important as a risk appetite indictor. A falling USD is helpful to fragile EM economies. As well, a rising USD can be a risk-off indicator because investors stampede into the greenback during period of fear.

 

The USD bottomed in late December and early January while exhibiting a positive RSI divergence. A countertrend rally appears to be underway as the index broke up through a minor downtrend (dotted line), but the major downtrend (solid line) remains intact. Watch for resistance at 91, and further major resistance at 92. (I show UUP, the USD ETF, because the USD Index data update is delayed on StockCharts).

 

 

My inner investor remains overweighted in equities, but he has reduced risk by tactically selling covered call options against selected long positions. My inner trader is on the sidelines, and he is waiting for a bearish signal to make a commitment to the short side.

 

 

Tactically cautious, despite the data glitch

Posted by Cam Hui -

In yesterday’s post, I pointed out that, according to FactSet, consensus S&P 500 EPS estimates had dropped about -0.50 across the board over the last three weeks (see 2020 is over, what’s the next pain trade?).
 

 

The decline turned out to be a data anomaly. A closer examination of the evolution of consensus estimates revealed a sudden drop in EPS estimates three weeks ago. Discontinuous changes like that are highly unusual, and it was traced to the inclusion of heavyweight Tesla in the S&P 500. In this case, analyzing the evolution of consensus earnings before and after the Tesla inclusion was not an apples-to-apples comparison. My previous bearish conclusion should therefore be discounted.
 

 

Nevertheless, I am becoming tactically cautious about the stock market despite resolving this data anomaly.
 

 

Negative seasonality

The first and least important reason is seasonality. Seasonality is a factor I pay attention to, but technical and fundamental factors tend to dominate price action more. We are entering a period of negative seasonality for the markets, and the January-March period tends to be choppy with a flat to down bias.
 

 

 

Extended sentiment

Sentiment models are still extended, though readings have come off the boil. The Citigroup Panic-Euphoria Model remains in euphoric territory and at historic highs.
 

 

Michael Hartnett’s BoA Bull-Bear Indicator is rising rapidly and nearing a sell signal.
 

 

I previously observed that the Fear & Greed Index displays a double peak pattern before the market actually tops out (see Time for another year-end FOMO stampede?). This was one of my bearish tripwires that haven’t triggered yet, though it may well be on its way to a sell signal.
 

 

 

Bearish tripwires

However, a number of my other bearish tripwires have triggered warnings. The low quality (junk) factor has spiked. In the past, low-quality factor surges have foreshadowed short-term tops in past strong market advances.
 

 

As well, the NYSE McClellan Summation Index (NYSI) reached 1000. which indicates a strong advance, and rolled over. There have been 16 similar episodes in the last 20 years, and the market has declined in 11 of the 16 instances.
 

 

I also warned that a rising 10-year Treasury yield could put downward pressure on stock prices. Bloomberg reported that trend following funds could sell T-Note and T-Bond futures and push rates upward.

Quantitative hedge funds are busy liquidating loss-making long Treasuries positions and could begin to establish new short ones if the 10-year yield breaches 1.10%, according to market participants.
 

Momentum funds known as Commodity Trading Advisors likely drove the initial move upward in yields on Wednesday, based on activity in futures markets, Citigroup Inc.’s Edward Acton wrote in a note to clients. The funds have been cutting losses since 10-year yields reached around 1.02%, said Nomura Holdings Inc.’s Masanari Takada.
 

CTA funds “appear likely to keep closing out long positions with yields at 1.02% or higher,” Takada wrote in a note Thursday. “We cannot rule out the possibility that CTAs could turn short,” at yields of 1.10% or higher, he said.

The 10-year yield is well beyond the bearish trigger of 1.02%.

 

 

Vulnerable to a correction

To be sure, price momentum is still holding the upper hand, but the stock market is increasingly vulnerable to a correction. Steve Deppe ran a historical study of last week’s market action and looked for instances when the market fell sharply (last Monday) and ripped to an all-time high. With the caveat that the sample size is relatively small (n=9), the market was choppy to slightly positive in the first week but suffered negative returns 10 and 20 trading days out.

 

 

For now, price momentum is holding the upper hand, but the combination of technical and sentiment conditions call for tactical prudence. Earnings season begins this week. Expect daily volatility to rise as individual reports are issued.

 

My inner trader has stepped to the sidelines and he is waiting for a downside break before taking a short position.

 

 

2020 is over, what’s the next pain trade?

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.
 

 

The next pain trade

Now that 2020 is over, what’s the next pain trade? I have a few candidates in mind. The latest BoA Global Fund Manager Survey taken in early December described the top two most crowded trade as long technology stocks, and short USD.

 

 

Another source of vulnerability is the expectation of a steepening yield curve. If history is any guide, heightened expectations of a steepening yield curve have resolved with market upsets of differing magnitude.

 

 

As a reminder, this survey was taken in December. After the Georgia special Senate elections gave the Democrats the trifecta of the control of the White House, Senate, and House of Representatives, the 10-year Treasury yield surged to over 1%, and the yield curve steepened even further.

 

All of these vulnerabilities are connected from a cross-asset perspective – the steepening yield curve, long technology stocks, and short USD. It’s all the same pain trade, and it’s equity bearish. Here’s why.

 

 

A cross-asset journey

Let’s unpack some of these factor exposures from a cross-asset perspective. Here is the most important chart that investors should consider. In the wake of the Democratic win in Georgia, the 10-year Treasury yield shot up beyond 1%. The 10-year yield broke up through a falling trend line in December, but it has been rising steadily in a channel that began last August.

 

 

Here is why that matters. Equity investors will tolerate higher bond yields as long as they are offset by a better growth outlook. But disappointing economic reports, such as the December Jobs Report miss, is a crack in the better growth narrative. In addition, FactSet reported that the Street has been revising EPS downwards, which is a sign of negative fundamental momentum. Quarterly EPS estimates fell about -0.50 across the board in the last three weeks. When will the combination of a rising 10-year Treasury yield and falling EPS estimates put downward pressure on stock prices?

 

 

Also consider the long technology stock bet, which is a form of growth stock exposure, from a cross-asset perspective. When growth is scarce, rates fall and investors bid up growth stocks. When growth expectations rise, rates rise and value outperforms growth.

 

 

However, Big Tech growth makes up 44.5% of S&P 500 weight, while value sectors are only 30.3%. If growth stocks become a drag on the index, the S&P 500 will face considerable headwinds in trying to advance.

 

 

 

The short USD pain trade

The other crowded short identified by the respondents of the BoA Global Fund Manager Survey is a USD short position. This is another pain trade that is correlated to the others.
 

First, positioning in the USD is at an extreme, and the market is setting up for a rally that could hurt the short-sellers.

 

 

The recent Democratic victory set up the anticipation of better economic growth, which is Dollar positive and pushed up bond yields owing to higher deficits. The spread between the 10-year Treasury yield and the Bund and JGBs are rising, which should attract more funds into the greenback. This is all occurring in a backdrop where the USD Index is testing a key support zone that stretches back to 2018.

 

 

All of these conditions are supportive of a reversal in USD weakness. In the last 18 months, stock prices have been inversely correlated with the USD Index. Dollar strength is likely to spark a risk-off episode, starting with EM risk assets that are sensitive to the USD exchange rate.

 

 

 

Waiting for the bearish catalyst

So far, this discussion of the next pain trade is only a trade setup without a bearish catalyst. The stock market may need a final blow-out before correcting.

 

The latest cover of Bloomberg BusinessWeek could be interpreted as a contrarian bullish magazine cover indicator. Indeed, the stock market rallied the day pro-Trump protesters invaded the Capitol.

 

 

Price momentum has been extremely strong. The S&P 500 is going on an upper Bollinger Band ride and there were no NYSE new lows Friday. The index spent August on upper BB rides. One resolved in a sideways consolidation, and the other ended with a correction.

 

 

As well, I have been monitoring the percentage of stocks in the S&P 500 that are above their 200-day moving average. In the past, readings of 90% or more have signaled sustained market advances and they don’t end until the 14-week RSI becomes overbought or near overbought. Conditions are very close to an overbought condition, but remember Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

 

 

While the current market is dominated by strong price momentum, the clash between positive price momentum and negative EPS fundamental momentum will catch eventually up with the bulls. Despite these cautionary signals, I believe any pullback is likely to be no more than 5-10%. How you position for market weakness is therefore a function of your investment objectives, risk tolerance, and investment time horizon.

 

In summary, the combination of a steepening yield curve, long technology stocks, and short USD are correlated, and constitute the next pain trade. The market is increasingly vulnerable to a 5-10% correction. These conditions are equity bearish, but they lack a bearish trigger. Investment-oriented accounts should be prepared to deploy additional cash should the market pullback. A 5-10% pullback is consistent with normal equity risk and investors who cannot tolerate those levels of drawdowns should rethink their asset allocation. By contrast, traders with shorter-term time horizons should wait to see evidence of a definitive downside break in the face of strong price momentum before turning bearish.

 

 

The Democrats’ trifecta win explained

Posted by Cam Hui -

Last weekend, I conducted an unscientific and low sample Twitter poll on the market perception of the Georgia special Senate elections. The results were surprising. Respondents were bullish on both a Republican and Democratic sweep.
 

 

As the results of the Georgia Senate race became clear, the analyst writing under the pseudonym Jesse Livermore tweeted that these results represent a “fiscal Goldilocks” scenario.

 

 

However, the analysis of the investment risk and opportunity is far more nuanced than just a simple bull and bear question.

 

 

The stock market isn’t the economy

It is trite to say that the stock market isn’t the economy and vice versa. This analysis from JPMorgan Asset Management tells the story. Technology, which includes Communication Services, comprises 6% of GDP, 2% of employment, and 38% of the S&P 500. Add in Amazon and Tesla, and their combined is nearly half of the index weight.

 

 

Here is why this disparity matters. When the market opened on Wednesday after the Georgia special elections, NASDAQ stocks fell even as the rest of the market rose on Wednesday. This was attributable to fears of greater antitrust and regulatory scrutiny of Big Tech companies. While there was an element of truth to that interpretation, there is more to the story of growth stock weakness.

 

As the election results trickled in Tuesday night and a Democratic sweep became apparent, the 10-year Treasury yield spiked to above 1% overnight and the yield curve steepened. These are credit market signals of greater economic growth in anticipation of more fiscal stimulus.

 

More growth should be bullish, right? Not for large-cap growth stocks. Growth stocks are duration plays, and they act like long bonds in response to changes in interest rates. When the yield curve steepened and bond yields rose, large-cap growth stocks underperformed.

 

 

When the yield curve steepened in anticipation of better economic growth, that should be bullish for cyclical stocks. But the cyclical weight in the S&P 500 is only about 20%, while large-cap growth is nearly 44.5%. As growth stocks face headwinds from rising 10-year yields, this index weight disparity makes it difficult to be overly bullish on the S&P 500.

 

 

An analysis of the relative returns of the top five sectors of the S&P 500 tells the story of the headwinds facing the index. Large-cap growth (Technology, Communication Services, Consumer Discretionary) relative performance is best described as flat to down. Healthcare relative performance may be trying to bottom, and financial stocks are starting to turn up. The top five sectors make up about 75% of the index weight, and it’s difficult to see how the S&P 500 can advance sustainably without the participation of a majority of its biggest sectors.

 

 

Notwithstanding the disparity in index weights, a rising 10-year Treasury yield is historically friendly to value stocks. Yields fall in anticipation of declining economic growth and rise in anticipation of better growth. In an environment where growth is scarce, investors will pile into growth stocks, and in an environment when growth is plentiful, investors favor value stocks. Inasmuch as value sectors represent about 30% of the S&P 500 weight, and growth sectors 45%, the style headwinds for the market are lessened should growth stocks become laggards.

 

 

 

Here comes the cyclical rebound

Regardless, there are plenty of signs that the economy is poised for a cyclical rebound. 

 

Household finances are in good shape. Credit card debt (blue line) has fallen dramatically while checking deposits (red line) have soared. The consumer is ready to spend.

 

 

The prospect of even more fiscal stimulus is supportive of even more expansion. As the Democrats tend to be more focused on inequality, the distribution of stimulus money will be tilted towards lower-income Americans, who have a greater propensity to spend additional funds than to save them. Expect a wave of consumer spending to begin in the next six months as the combination of widespread vaccination and stimulus funds reach the wallets of American consumers.

 

 

In light of the large negative surprise in the December Jobs Report, it is worthwhile to consider what might happen next as the economy recovers. The headline loss of 140K jobs was led by weakness in the service sector, which was attributable to to huge declines of -372K in food and beverage jobs, -92K in amusement and recreation, and -63K in private education.

 

Australia is a case study of what pent-up consumer demand looks like in a post-COVID environment. To recap, Australia underwent a full lockdown until late September as a second wave hit. Case counts have since eased dramatically, even without a vaccine. 

 

 

Like other countries, it is the service sector of the economy that collapsed. Take a look at what happened next. Travel demand has fully recovered.

 

 

AirBNB has also enjoyed a revival.

 

 

In light of the Australian experience, imagine what would happen to the US economy if a vaccine and more fiscal stimulus were overlaid on top of that?

 

What’s more, the recovery is global in scope. 82% of manufacturing PMIs are in expansion mode.

 

 

To sum up, the following sectoral balance analysis tells the story of an economy that’s ready to roll. Past recessions have been marked by over-levered household balance sheets (blue line) and corporate sectors that were deleveraging as the economy entered recession. This time, the corporate sector is in reasonably good shape, and weakness in the household sector has been offset by government stimulus. As soon as vaccines becomes widely available, the economy is ready to return to normal.

 

 

 

Too far, too fast?

However, equities may have risen too far, too fast. Willie Delwiche observed that the markets entered 2021 with 96% of global markets above their 50-day moving averages. While these readings have been long-term bullish, the markets are poised for a short-term pause.

 

 

The current market recovery is reminiscent of recoveries from recessionary bottoms, such as 1982 and 2009. If the past is any guide, the market is due for a period of consolidation and choppiness.

 

 

A global cyclical recovery argues for a greater commitment to emerging markets instead of US large-cap growth stocks, which were the winners of the last cycle. An analysis of EM fund flows shows that investors have not fully embraced the EM as a cyclical recovery vehicle just yet. Fund flows are nowhere near a crescendo, which is constructive.

 

 

In conclusion, the Democrats’ trifecta win is bullish for the cyclical revival investment theme, but the S&P 500 may face headwinds because of the excess weighting of large-cap growth stocks in that index. Investors should overweight sectors and groups levered to the cyclical recovery, both within the US and abroad, such as EM. Tactically, the markets are poised to pause their rally in the near-term, and investors should take advantage of any weakness to add to their cyclical exposure.

 

 

Santa has returned to the North Pole

Posted by Cam Hui -

Mid-week market update: The last day of the Santa Claus rally window closed yesterday, and Santa has returned to the North Pole. But he left one present today in the form of an intra-day all-time high for all the good boys and girls who ever doubted him.
 

 

Tactically, today’s rally may be the last hurrah for the bulls. 

 

 

Sentiment warnings

I have been writing about the extended nature of sentiment readings for a while. The Goldman Sachs sentiment dashboard has been stable and elevated for at least a month.

 

 

It is said that while tops are processes, bottoms are events. Excessively bullish sentiment have a way of not mattering until it matters. Deprived of the its seasonal tailwinds, the stock market is increasingly vulnerable to a setback after a period of prolonged frothiness. Mark Hulbert reported last week that his Hulbert Stock Newsletter Sentiment Index is in its 92nd percentile, which is a severe cautionary signal.

Consider the average recommended equity exposure level among the short-term market timers the HFD tracks. (This average is what’s reported by the Hulbert Stock Newsletter Sentiment Index, or HSNSI.) Recently the HSNSI was higher than 92% of daily readings since 2000. In fact, this recent average exposure level is close to being just as high as it was at the bull-market top in February 2020.

The TD-Ameritrade Investor Movement Index (IMX) has returned to a new recovery high, indicating a high level of retail bullishness.
 

 

As well, S&P 500 Gamma exposure is in the top 0.4% of its history. For the uninitiated, gamma measures the degree of exposure option dealers have to the market. The combination of a positive gamma and rising market forces dealers to hedge by buying stock, and vice versa. These nosebleed gamma readings are warning signals of frothiness, which are usually followed by market corrections.
 

 

 

Bearish catalysts

Notwithstanding the scene of protesters storming the chambers of the US Senate, what else could derail this rally?
 

One candidate is a negative surprise from the Jobs Report due Friday. Market consensus calls for 100K new jobs, but the pace of deceleration is becoming alarming. Oxford Economics has a negative estimate, which would be a shocker.
 

 

Today’s ADP miss of -123K compared to expectations of a gain of 75K is consistent with the negative NFP print thesis.
 

 

High frequency data shows that economic activity has fallen off a cliff, not just in the US, but in most advanced economies.
 

 

The Citi Economic Surprise Index, which measures whether economic data is beating or missing expectations, has been slowly fading indicating a loss of macro momentum.
 

 

To be sure, these slowdown effects are temporary. But the pace of vaccinations could be an emerging negative for Q1 and Q2. The market has already discounted the widespread vaccination of the population of developed economies by mid-year. Logistical difficulties with vaccine rollout could be a source of near-term disappointment and spook risk appetite.
 

 

For the last word, I offer this tweet from SentimenTrader.
 

 

While I remain long-term bullish, short-term equity risk is rising. The market can stage a 5-10% correction at any time. Subscribers received an alert yesterday that my Inner Trader had stepped to the sidelines. This is a time for caution. 
 

 

An update on the FOMO seasonal stampede

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

No stampede

Three weeks ago, I rhetorically asked if the market would surge higher during a seasonally favorable time of year (see Time for another year-end FOMO stampede?). I observed that “the Fear & Greed Index followed a pattern of an initial high, a retreat, followed by a higher high either coincident or ahead of the ultimate stock market peak.” (Warning, small sample size of n=4).

 

 

Since I wrote those words, the S&P 500 rose a respectable 2.5% while the Fear and Greed Index fell to 51. It’s not exactly a stampede. The main question is: “Will Fear and Greed exhibit a second peak before the actual market peak?”
 

 

The bull case

Here are the bull and bear cases. The bulls can point out that the S&P 500 staged an upside breakout to fresh all-time highs while trading in an ascending channel, which is constructive.

 

 

Ryan Detrick at LPL Financial found that strong late year momentum carries on into January and the following year. Since the S&P 500 is up 14.3% in November and December, investors can expect further gains (small sample size: n=5).

 

 

I am indebted to Urban Carmel for the idea for a generalized version of Detrick’s study of two-month price momentum. My analysis added a sentiment indicator, which shows that there were 12 episodes where two-month S&P 500 returns reached 10% or more. Only 2 of the 12 resolved in a corrective manner. Moreover, overly bullish sentiment, as measured by the AAII bull/bear spread, did not matter to returns. However, Urban Carmel added a caveat that the current episode is not like the others, which “all happened at major lows (like March of this year); 1987 started after SPX dead flat for 9 months”.

 

 

Analysis from Nomura indicates that hedge fund positioning in developed market equities is not excessive. Should the market engage in a momentum chase, there is more room for this fast money to buy.

 

 

 

Technical warnings

However, a number of ominous warnings are signaling a rising likelihood of a market correction. The NYSE McClellan Summation Index (NYSI) is starting to roll over. NYSI levels of over 1000 were signals of strong momentum, but pullbacks after 1000+ readings are a warning of market weakness. There have been 16 such signals in the last 20 years. 11 of them have resolved bearishly (red vertical lines), while 5 have been bullish (blue lines).

 

 

In addition, the quality factor is also flashing a warning by behaving badly. The relative performance of both large and small-cap quality factors have plunged, indicating a low-quality junk stock rally. Such conditions during past market advances have been indications of excessive speculation, and an imminent market top.

 

 

There is a minor negative divergence from my equity risk appetite indicators. The ratio of high beta to low volatility stocks is starting to fall, which is indicative of poor internals. As well, the equal-weighted consumer discretionary to consumer staple ratio, which minimizes the weights of Amazon and Tesla, is also exhibiting signs of minor weakness.

 

 

In addition, Jeff Hirsch of Trader’s Almanac wrote that the traditional Santa Claus rally, which stretches from December 24 to the second day of January, sees an average S&P 500 gain of 1.3%. The return so far to December 31 have already exceeded expectations at 1.8%. 

 

Sentiment readings continue to be very frothy. In addition to the stretched condition of numerous sentiment surveys, the divergence between the equity-only put/call ratio, which mainly measures retail sentiment and shows excessive bullishness, and the index put/call ratio, which is used for institutional hedging and shows rising cautiousness, is worrisome.

 

 

The current technical and sentiment backdrop is consistent with the seasonal post-election year pattern of a January peak and a bottom in late February. Before the bearish contingent gets all excited, the average pullback is only about  -2%.

 

 

In conclusion, the stock market has behaved as expected during the period of seasonal strength. However, a number of technical warnings are starting to appear. As the market’s period of positive seasonality ends in the coming week, be prepared for the possibility of a short-term top. On the other hand, historical price momentum studies are pointing to further gains.

 

Keep an eye on the Fear and Greed Index for a second peak as a tactical warning of a correction. However, there is a distinct possibility that a second peak in the Fear and Greed Index may not appear this time before the market corrects. In this situation, traders are advised to keep an open mind, and maintain trailing stops as a form of risk control.

 

 

Disclosure: Long SPXL

 

 

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

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

 

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

 

 

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

 

 

A recovering economy

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

The Roaring 20’s indeed.

 

 

Market positioning and consensus

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

 

 

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

 

 

 

What could go wrong?

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

 

 

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

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

 

 

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

 

 

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

 

 

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

 

 

 

China slowdown ahead?

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

 

 

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

 

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

 

 

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

 

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

 

 

Investment implications

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

My 2020 report card

Posted by Cam Hui -

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

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

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

 

 

An unprecedented policy response

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

 

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

 

 

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

 

 

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

 

 

 

A valuation error

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

 

 

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

 

 

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

 

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

 

Better late than never.

 

 

My inner trader

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

 

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

 

 

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

 

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

 

Steady as she goes

Posted by Cam Hui -

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

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When does Santa’s party end?

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

The seasonal party

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

 

 

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

 

 

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

 

 

Don’t overstay your welcome

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

 

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

 

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

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

 

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

 

 

How far can the rally run?

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

 

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

 

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

 

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

 

 

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

 

 

More room to rally

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

 

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

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

 

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

 

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

 

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

 

Disclosure: Long SPXL
 

Debunking the Buffett Indicator

Posted by Cam Hui -

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

 

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

 

 

Dissecting market cap to GDP

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

Do you feel better now?

 

 

Not out of the woods?

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

 

 

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

 

 

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

 

 

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

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

 

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

 

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

 

 

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

 

 

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

 

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

 

 

Don’t be afraid to buy.

 

 

The most wonderful time of the year…

Posted by Cam Hui -

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

 

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

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

 

What’s the real Santa rally?

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

 

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

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

 

 

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

 

Will 2020-2021 be any different?
 

 

A retreat in sentiment

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

 

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

 

Disclosure: Long SPXL
 

Trading the pre-Christmas panic

Posted by Cam Hui -

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

 

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

 

 

The start of a major correction?

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Disclosure: Long SPXL

 

Santa rally, Version 2020

Posted by Cam Hui -

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

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

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

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

 

 

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

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

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

 

The Santa Claus effect

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

 

 

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

 

 

 

How to play the Santa rally

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

 

 

 

Georgia on my mind

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

 

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

 

 

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

 

 

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

 

 

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

 

 

What’s the upside potential?

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

 

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

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

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

 

 

 

Outperforming the rally

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Disclosure: Long SPXL

 

Will Biden reset the Sino-American relationship?

Posted by Cam Hui -

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

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

 

 

 

What does each side want?

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

 

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

 

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

 

Be careful what you wish for.

 

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

 

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

 

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

 

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

 

 

China’s unbalanced recovery

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

 

 

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

 

 

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

 

 

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

 

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

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

 

 

Decoupling, by another name

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

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

“Dual circulation” is just another term for decoupling.

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

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

 

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

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

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

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

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

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

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

 

 

What will Biden do?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

 

Investment implications

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

 

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

 

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

 

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

 

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

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

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

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

 

 

Waiting for the breakout

Posted by Cam Hui -

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

 

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

 

Signs of consolidation

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

 

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

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

 

A bearish tripwire

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

 

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

 

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

 

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

 

Disclosure: Long SPXL
 

How far can stocks pull back?

Posted by Cam Hui -

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

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

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

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

 

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

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

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

 

The ketchup effect

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

 

 

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

 

Let’s explore the downside scenarios.

 

 

Bearish catalysts

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

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

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

 

 

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

 

 

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

 

 

What could go right

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXL
 

Time for another year-end FOMO stampede?

Posted by Cam Hui -

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

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

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

A new cyclical bull

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

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

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

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

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

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

In other words, buy the dip!

Supportive positioning

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

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

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

Market internals are bullish

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

The bearish window is closing quickly

Posted by Cam Hui -

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

 

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

 

 

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

 

 

Extended sentiment

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Strong internals

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

 

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

 

 

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

 

 

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

 

 

What could derail this rally?

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

 

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

 

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

 

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

 

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXL