How the US is becoming an emerging market

Posted by Cam Hui -

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

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

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

 

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

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

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

 

A pre-election stall?

As we approach the November election, the market may be setting up for a pre-election stall. President Trump, otherwise known as “Dow Man”, is fond of benchmarking his performance using the stock market. The S&P 500 (SPY) has returned an impressive 64.5% unannualized since Inauguration. Its performance against the long bond (TLT) is less compelling, but it beat bonds by a total of 12.1% over the same period. 

 

The most disturbing metric is the market’s risk perception. The VIX Index is elevated, and trades at a premium to EM VIX. The market is now pricing US risk like an emerging market. Market nervousness is rising, and traders will have to contend with a heightened risk environment until the November 3 election.

 

 

Elevated risk

I pointed out elsewhere (see How to trade the election) that the option market is exhibiting a heightened sense of anxiety over the uncertainty of a contested election that ends up in the Courts whose results won’t be known until well past the election date. Implied volatility spikes just after November 3, and remains elevated until well into 2021.

 

 

A Marketwatch article reported that the risk of a contested election could send the country into a constitutional crisis. There could be multiple challenges over mail-in voting in a number of important battleground states. The world may not get clarity on Election Night about the victor because of a flood of mail-in votes, and the difficulty in counting them all in time.

Several states, including Pennsylvania and Wisconsin, don’t allow election officials to begin processing mail-in ballots before Election Day. Processing, or pre-canvassing, means taking action to prepare ballots to be counted, like verifying voters’, and in some cases witnesses’, signatures on envelopes. In many states, including Pennsylvania, it also involves checking that ballots are enclosed in a second “secrecy envelope” within the mailing envelope. Finally, processing includes removing ballots from envelopes and stacking them in preparation for the count.

 

If you thought that the Bush-Gore Florida hanging chad controversy created market uncertainty, 2020 could be a repeat, but at a higher order of magnitude because it will occur across multiple state jurisdictions.

 

 

Equally curious is the divergence of the “fundamental” against the market. On one hand, FiveThirtyEight‘s polling average shows Biden’s lead is widening.

 

 

On the other, his market-based betting odds at PredictIt is moving in the opposite direction. A tight race raises the odds of a contested election that ends up in the Courts. What is the market telling us?

 

 

Markets hate uncertainty, and with just under two weeks until the election, the jitters may start to show in the coming days.

 

 

Fundamental momentum is strong

Looking past the election, the fundamentals look strong. The preliminary results from Q3 earnings season are positive. Even though it’s still early and only 10% of the S&P 500 have reported, both the EPS and sales beat rates are well ahead of historical averages. Consensus earnings estimates are rising strongly, which is a sign of positive fundamental momentum.

 

 

A detailed analysis shows that earnings estimates are rising across the board until Q2 2021. 

 

 

Other market signals indicate that the cyclical and reflation trade is still intact. The all-important industrial metals staged an upside breakout to a recovery high indicating global cyclical strength.

 

 

The cyclically sensitive material stocks are also acting well, which is a signal that the global relation trade is still alive.

 

 

The risk to the reflation thesis is another wave of COVID-19 infection would bring growth to a screeching halt. Scientific American reported, “The Institute for Health Metrics and Evaluation currently projects that more than 360,000 Americans will die by the close of 2020, roughly 150,000 more than the current death toll.” Princeton Energy Advisors estimates the US is headed for 80,000 daily new infections by Election Day.

 

 

 

Technical and sentiment warnings

From a technical perspective, there are signs that price momentum may be fading. It was only last week that I highlighted bullish breadth thrust signals (see A Momentum Renaissance and Trading the breadth thrust). Historically, such signals have been equity bullish.

 

 

Instead, the expected breadth thrust buying stampede fizzled out. The S&P 500 peaked out last Monday and fell for the rest of the week while exhibiting weakening RSI readings, indicating a loss of momentum. Moreover, sentiment is becoming a little frothy. The 10-day moving average (dma) of the equity-only put/call ratio (bottom panel) fell to levels consistent with recent short-term tops.

 

 

The sentiment warnings were not just restricted to the option market. Mark Hulbert observed that his index of market timing newsletter writers had reached an excessively bullish condition, which is contrarian bearish.

 

 

SentimenTrader also pointed out that speculators in equity index futures have swung from a crowded short position of $47 billion to a net long position of $25 billion in the space of three weeks. While buying stampedes can be bullish, but not if momentum fades – which is an indication of buying exhaustion. 

 

 

Macro Charts added that aggregate stock to bond futures positioning by large speculators is historically high. He described current conditions at a “significant risk of a large disruption event”.

 

 

My base case scenario calls for market weakness and heightened volatility until the November 3 election. Tracy Alloway at Bloomberg highlighted a warning from Charlie McElligott of Nomura, and to keep an eye on 3389 for the S&P 500 and 284.63 for QQQ.
One of the biggest stories in markets right now has been the explosion in stock options trading and on Friday, a bunch of those contracts are scheduled to expire. The theory has been that buying of options forces dealers to hedge their books, which then forces the underlying stock higher and encourages even more options trading, especially of bullish calls that benefit as the stock goes up. The concern is that this kind of activity can exacerbate moves on the way down, as much as up. That’s something that arguably happened in August and early September, when the big tech stocks fell dramatically and dragged the indexes down with them.

 

The point about “what drives something to go up, must also drive it to go down” was brought home in an overnight note from Nomura’s Charlie McElligott. He argues that tech stocks are getting closer to the level at which dealers will “flip” from needing to buy stocks to maintain a neutral portfolio position, to needing to sell stocks to maintain a neutral portfolio position. He estimates this “Gamma” flipping point with somewhat worrying specificity at 3,389 on the S&P 500 and 284.63 on the QQQ Index of tech. 

 

 

In conclusion, the combination of excessive bullish sentiment and fading momentum are signals of buying exhaustion, which calls for a pullback over the next two weeks. As well, substantial electoral event risk lies ahead. On the other hand, sometimes the anticipation can be worse than the actual event itself. Remember all the anxiety over Y2K? If the market were to crater and panic into the election, it could represent a buying opportunity.

 

What happens after November 3 is up to the election and market gods.

 

 

Disclosure: Long SPXU

 

How to trade the election

Posted by Cam Hui -

With the US election just over two weeks away, it’s time to look past the election and focus on how the economy and markets are likely to behave. Barry Ritholz correctly advised investors in a recent post to check their political beliefs at the door when analyzing markets. Stock prices have done slightly better under Democratic administrations, but the effect is mostly noise in light of the small sample size.
 

 

With that in mind, let’s consider the differences in market environment if Trump were to win, compared to a Biden win.
 

 

Trump: The known quantity

For the purposes of this analysis, I will assume that one side will have control of the White House and Senate. It’s too difficult to fully assess the many electoral permutations. In light of the current backdrop of anemic growth, a scenario of divided government is bearish for equities, as the risk of an impasse over sorely needed fiscal stimulus is high.
 

Let’s begin with the scenario of a Trump and Republican win. After nearly four years, Trump is a known quantity. For investors, four more Trump years will mean:

  • More tax cuts;
  • More business deregulation;
  • More trade frictions; and
  • More restrictive immigration.

 

In other words, a Trump win will be friendlier to the suppliers of capital, and less friendly to the suppliers of labor. Trump came into his first term promising a tax cut, and he will undoubtedly follow the standard Republican playbook of proposing a second. The first tax cut boosted S&P 500 earnings by 7-9% on a one-time basis. While it’s difficult to know exactly what would be in the next tax proposal, the suppliers of capital will find the provisions friendly to them.

 

 

What Trump giveth, Trump can also taketh away. Trump’s America First philosophy has shown itself to be highly protectionist. Not only has the White House started a trade war with China, but trade friction has also risen with America’s allies, from members of the NAFTA bloc to the European Union to Asian allies. 

 

Despite all of the belligerent rhetoric, the trade war hasn’t been very effective. Simon Rabinovitch at The Economist pointed out that China’s trade surplus with the US has actually risen since Trump took office.

 

 

In the meantime, global trade volumes have gone sideways since Trump took office. US policies designed to onshore manufacturing from China have seen only limited success. The Sino-American trade war has mainly shifted supply chains to other Asian low-wage jurisdictions, such as Vietnam.

 

 

Over the course of Trump’s term, Fathom Consulting’s China Exposure Index (CEI), which measures the performance of US companies most exposed to China, has been falling. A falling CEI indicates that companies with the highest China exposure are underperforming the market.

 

 

I would be remiss without a word on immigration policy. While the market mostly regards this issue as largely irrelevant, more restrictive immigration, and especially skilled immigration, can create a drag on an economy’s long-term growth potential. The Department of Homeland Security recently proposed to limit the terms of student visas to no more than two years in length, though students can apply to extend their stay once their visa expires. This creates a high degree of uncertainty for foreign students. Notwithstanding the fact that many universities depend on foreign student tuition for their funding, this proposal has a chilling effect on overseas scholars. What aspiring researcher would commit to a Masters, Ph.D., or post-doc program with short visa windows without assurances that the visas would be renewed? According to Nikkei Asia:
A comparison of 53 high-income economies’ share of immigrants and gross domestic product per capita shows a trend in which GDP per capita is higher where there is a higher proportion of immigrants.
 

The International Monetary Fund in April published a study that said “a one percentage point increase in the inflow of immigrants relative to total employment increases [economic] output by almost one percent by the fifth year.” Having a more diverse workforce makes an economy more robust, according to the IMF.

 

 

 

Biden: The pragmatist

While the economic path of four more years of Trump is well known because of his track record, the details of Biden’s policies are less clear. However, we can expect a philosophical approach that is the complete opposite of Trump.
  • Higher taxes on corporations and wealthy individuals, who are the main providers of capital;
  • More re-distributive policies aimed at reducing income and wealth inequality by favoring Main Street over Wall Street;
  • Reversal of Trump era deregulations; and
  • A less confrontational trade and foreign policy, and rebuilding global institutions like the WTO and NATO.
Despite the rhetoric about a lurch towards socialism, analysis from The Economist concluded that Biden will govern as a centrist and pragmatist on economic policy. While the immediate priority will be to pass a stimulus bill in the order of $2T to $3T, a Biden White House is unlikely to pursue the spending policies advocated by the left-wing of the Party, like those of Bernie Sanders Elizabeth Warren, or Alexandria Ocasio-Cortez. Biden’s tax proposal will fall mainly on the top 1%.

 

 

While Trump’s tax cuts raised S&P 500 earnings by 7-9%, the WSJ reported that BoA estimates the Biden corporate tax plan will unwind those increases. The heaviest burden will fall on technology companies.
 

Democratic presidential nominee Joe Biden has proposed raising the corporate tax rate to 28% from 21%, imposing a new minimum tax on U.S. companies and increasing taxes on foreign income of many U.S.-based multinationals, among other plans.

 

Together, the tax proposals would reduce expected earnings among companies in the S&P 500 by 9.2%, according to estimates from BofA Global Research. The effects would especially hit technology companies.

 

 

In the short run, the market appears to be unfazed by the prospect of a Biden win. Bloomberg reported that “A Clear-Cut Biden Win Is Emerging as a Bull Case for Stocks”, largely owing to the prospect of the enactment of a large fiscal stimulus package. The Democratic propensity towards redistribution is likely to put more money in the hands of lower-income consumers, who have a higher propensity to spend and boost economic growth.

 

What about the long-run effects? Kyle Pomerleau at the conservative think tank the American Enterprise Institute analyzed the effects of Biden’s tax proposal. Here are his key findings [emphasis added]:
  • Using the Tax-Calculator (3.0.0) microsimulation model, we [the AEI] estimate that Joe Biden’s propos­als would raise federal revenue by $2.8 trillion over the next decade (2021–30).
  • The majority of new federal revenue would come from businesses and corporations ($1.9 tril­lion). The remaining revenue would come from individual income and payroll tax increases ($616.8 billion) and an increase in estate and gift taxes ($276.4 billion).
  • In 2021, Biden’s proposals would increase taxes, on average, for the top 5 percent of households and reduce taxes on households in the bottom 95 percent. In 2030, Biden’s proposals would increase taxes, on average, for households at every income level, but tax increases would primarily fall on the top 1 percent of income earners.
  • Using the open-source OG-USA (0.6.2) model, we estimate that Biden’s proposals would reduce gross domestic product (GDP) by 0.16 percent over the next decade, slightly increase GDP the second decade (0.19 percent), and result in a small reduction in GDP in the long run (0.18 percent).

 

The AEI estimates that the long-run effects of Biden’s tax policies on GDP growth over the next decade is -0.16%, and +0.19% for the following decade. Does anyone really believe economic forecasting models are that accurate? In other words, it’s really just a rounding error.

 

Here are the key differences between a Trump and Biden Presidency. The first-order effects of a Trump win (lower taxes, less regulation) are equity friendly, while the second-order effects (protectionism) are equity unfriendly. By contrast, the first-order effects of a Biden win are equity unfriendly (higher taxes), but the second-order effects (broader growth from inequality reduction that boosts Main Street) are growth-friendly.

 

While it is difficult to estimate the exact magnitude of the market-friendly and unfriendly factors, we can be fairly sure that a Biden win would represent a more favorable environment for value over growth stocks. The Biden tax proposals would hit technology stocks harder. Moreover, Congress is already scrutinizing large-cap technology companies through an antitrust lens. If the mood shifts toward re-regulation, the business models of these companies will come under greater pressure.

 

Another reason that favors value over growth is the behavior of stocks under differing economic growth regimes. Imagine a scenario where Congress passes a large stimulus that boosts spending in 2021, and one or more workable vaccine become available some time next year, regardless of who wins the election. The economic growth outlook improves, and the yield curve steepens accordingly. 

 

A recent Federal Reserve study analyzed the returns of different stocks using dividend futures. Stocks with high duration have been outperforming in the 2020 low-growth environment, while low duration stocks have lagged. As a reminder, growth stocks tend to pay no or little dividends, and have high duration, or interest rate sensitivity, while value stocks tend to have higher dividend yields, and therefore have low duration characteristics. A better growth outlook would see a reversal of that trend, and value would revive and beat growth. 

 

 

In other words, investors pile into growth stocks when growth is scarce. They rotate out of growth into value when economic growth recovers. However, there is an important caveat to that forecast. Bank and financial stocks make up a significant weighting in value indices, and banks are likely to face regulatory headwinds should Democrats win the election.

 

 

Market expectations and positioning

In recent weeks, Wall Street strategists have begun to pivot to a Biden sweep being equity bullish because of the likelihood of a large stimulus bill. However, the market remains jittery over the prospect of a contested election. The latest BoA Global Fund Manager Survey showed that a contested election is the second-highest perceived tail-risk for the market, behind COVID-19. Most managers expect a contested election, and such an outcome would be the cause of maximum market volatility.

 

 

The option market’s pricing of risk reflects the market’s nervousness. While implied volatility has risen and fallen, its term structure shows that volatility spikes just after the November 3 election, and remains elevated into 2021.

 

 

Looking longer term past any possible electoral disputes, managers believe the global economy is in an early cycle phase and recovering. Therefore they are taking on more risk in their portfolios to position for a recovery. I would concur with that assessment and any volatility induced sell-off should be regarded as an opportunity to buy. 

 

 

There are, however, several key risks to this bullish scenario. First, a second wave of COVID-19 is emerging, especially in Europe, and any lack of progress against the virus could be the catalyst for a double-dip recession. In addition, a coronavirus relief bill may not be passed until February, especially if the Democrats sweep the election, which could be too little too late to save the economy from another slowdown. 

 

 

Of course, there is always the possibility of divided government, where one party controls the White House, and the other controls one or both chambers of Congress. Under that scenario, the risk of an impasse on spending when a fiscal boost is much needed is high, which creates a dysfunctional spiral of austerity which plunges the economy into a second recession becomes a real possibility.

 

In conclusion, here are my main takeaways from the analysis of the effects of the election.
  • A Republican sweep would translate to an environment friendly to the suppliers of capital, and a less friendly environment to the suppliers of labor.
  • A Democratic sweep would mean a less friendly environment for the suppliers of capital, but a friendlier environment for the suppliers of labor.
  • Neither is expected to be extremely equity bullish or bearish.
  • While I expect that value would outperform growth as an economic recovery proceeds in 2021, a Biden win would be more conducive to value.

 

Trading the breadth thrust

Posted by Cam Hui -

Mid-week market update:  I discovered an error in my last publication (see A Momentum Renaissance). The market did not achieve a Zweig Breadth Thrust buy signal last Thursday as I previously indicated, though it was very close.

As a reminder, the Zweig Breadth Thrust buy signal is triggered when the ZBT Indicator moves from an oversold to overbought reading within 10 trading days. In my previous publication, I misinterpreted the first day of the window as September 25, it was actually September 24. The ZBT reached an overbought condition in 11 days, not 10, therefore the ZBT buy signal was not triggered.
 

 

I apologize for the error. Nevertheless, several other breadth thrust signals with less strict criteria were recently triggered, and it is worthwhile analyzing how to trade such conditions.
 

 

The Whaley Breadth Thrust

While the ZBT buy signal just missed its mark last Thursday, Steve Deppe pointed out that the market flashed a Whaley 2:1 Breadth Thrust (WBT) that day. The history of past WBT buy signals is impressive. In the table provided by Deppe below, I have marked the instances where WBT buy signals coincided with the stricter ZBT buy signal since 1990.
 

 

I further analyzed the history of WBT buy signals that exclude the stricter and more powerful ZBT buy signal, and further excluded signal overlaps in two months. There were 18 such buy signals since 1990, and the results are less impressive than first glance. While this class of signals was a better indication that the S&P 500 would rise in the next month, the median return roughly matched the benchmark. Returns over a 3, 6, and 12-month horizons were better, median return alpha peaks and begins to fall off after three months.
 

 

 

Frothy sentiment

Another disconcerting sign of the latest buy signal is the excessive bullish sentiment, as measured by the 50 day moving average (dma) of the CBOE put/call ratio (CPC). Since the market bottom of 2009, CPC has stayed elevated, and it is unusual to see a WBT buy signal triggered when CPC is so low, indicating excessive bullish sentiment. The last time this happened in early 2014, the market traded sideways.
 

 

The low put/call ratio is attributable to high speculative activity in individual stock options. Single stock option volumes are spiking again, and there are rumors of another “whale” buying large-cap growth stock call options in the market. Bloomberg reported that a single buyer appeared on Monday, and bought $200 million of single-stock call options.
 

 

There are other signs that sentiment is becoming frothy. Callum Thomas conducts a weekly unscientific Twitter poll, and the latest readings are at the top end of the historical range.
 

 

Data from Goldman Sachs Prime Brokerage shows that Equity Fundamental L/S hedge fund leverage already at or near historical highs. These funds are positioned for a Q4 melt-up.
 

 

 

Breadth Thrust, Meets frothy sentiment

How should investors and traders approach this combination of breadth thrust, which tends to be bullish, and excessively bullish sentiment, which is contrarian bearish?

The answer depends on your time horizon. Tactically, the bullish stampede has seen traders pile into call options, which forced market makers to hedge by buying stock and pushing the market upward. Andrew Thrasher observed that dealer gamma, as measured by GEX, is at an off-the-charts high reading. However, GEX tends to peak out before the market peaks.
 

 

This week is option expiry week, and many stock options will expire this Friday. Dealer exposure will change significantly, and gamma is likely to fall dramatically after the close Friday.

Short-term traders can try to get long and buy here for a scalp into a possible market ramp into Friday’s expiry. After that, all bets are off. Today’s market action was constructive. The S&P 500 retreated and filled the opening gap from Monday, but the NASDAQ 100 did not, indicating that large-cap growth leadership remains intact.
 

 

This is a volatile environment, and positions should be scaled accordingly to the expected level of volatility. Otherwise, my intermediate-term outlook remains unchanged. The Asset Allocation Trend Model remains at a neutral reading. The prudent course of action is to stand aside and wait for the volatility to sort itself out.
 

A Momentum Renaissance?

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities
  • Trend Model signal: Neutral (upgrade)
  • Trading model: Neutral

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

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

 

A MoMo revival

Despite my expectations, the market took on a risk-on tone in the past week, and momentum is making a return. The relative performance of price momentum factor ETFs have been strong since their bottom in early September, and most have made new recovery highs.

 

 

 

Bullish breadth thrusts

While the price momentum factor describes relative returns, i.e. whether momentum stocks are outperforming the market, absolute price momentum has made a comeback too. 

 

Ed Clissold of Ned Davis Research pointed out that the market achieved a “breadth thrust”, which he defined as over 90% of stocks over their 10 day moving average (dma). Such conditions have historically been very bullish for stocks.

 

 

The market also flashed a rare Zweig Breadth Thrust buy signal as of the close on Thursday. The market has to become oversold on the ZBT Indicator, and reach an overbought reading within 10 trading days. Breadth conditions eked out an overbought condition last Thursday, which was the last day of the 10 day window. This is a rare buy signal, and there were only two in the last six years. Historically, ZBT buy signals are very bullish, and tend to resolve in bullish manners in the following weeks, and even over a year.

 

 

The most recent “failure” of the ZBT buy signal occurred in 2016, when the market rose weakly after the signal, but soon weakened to re-test its previous lows.

 

 

Trend Model upgrade

Two weeks ago, my Trend Asset Allocation Model was downgraded from “neutral” to “bearish” (see Time to de-risk). At the time, I cautioned that these are trend following models, and these models tend to be slow to react and they will never spot the exact top or bottom. In addition, trend following models run the risk of whipsaw should prices reverse. This is the condition we face today.

 

Since the downgrade, global markets have taken a firmer tone. In addition, cyclically sensitive commodities such as industrial metals have also rebounded to test the old highs after a brief period of weakness.

 

 

In addition, cross-asset signals from foreign exchange markets have also shifting to a marginal risk-on tone. The USD Index has weakened and breached both its 50 dma and a key support level, which was the site of a recent upside breakout. The USD has been inversely correlated to stock prices (bottom panel), and the highly sensitive AUDJPY cross (red line) has also confirmed the bullish recovery.

 

 

New Deal democrat monitors a series of economic indicators and divides them into coincident, short leading, and long leading indicators. His unusual comment this week confirmed the strength spotted by the Trend Model.

This week I added “best” pandemic readings for many of the indicators (in particular except for interest rates), and I will probably add more next week. Doing so has indicated that almost all of them have had their best readings in the past five weeks, and about half of those this week or last week. Thus, while the course of the pandemic continues to be the decisive issue for the economy, for now that indicates slow improvement has continued. 

In short, the Trend Model is capturing the sudden rebound of global asset prices, namely the reversal of the risk-off trend that was evident two weeks ago.

 

 

Key risk: Giddy sentiment

The key risk of this bullish about-face is another whipsaw, as global asset prices have become increasingly volatile and correlated. Short-term sentiment is getting a little giddy, and the market may find it difficult to advance significantly in such an environment.

 

In particular, the signals from the option market are disturbing. Individual investors (dumb money) tend to use single stock options to trade and speculate, while institutions and professionals (smart money) use index options to hedge their positions. The chart below shows that the 50 dma of put/call ratio (top panel) is very low, which is contrarian bearish. As well, the spread between the equity put/call ratio (CPCE) and index put/call ratio (CPCI) is also nearing a historical low, which is also a bearish signal.

 

 

The term structure of implied volatility is also instructive. Last week’s rally pushed near-term option implied volatility down, while longer term volatility remains elevated. Implied volatility rises sharply just after the November 3 election peaks out in mid-December, indicating continuing concerns about the possibility of a contested election with no clear results. The latest sharp decline in near-term volatility may be an indication that risk is not correctly priced.

 

 

Macro Charts observed that large speculators are in crowded short positions in Treasury bonds, and in the USD, “Extreme Bond AND Dollar positioning could be a big source of instability here – impacting all risk assets.” Much of the fast-money crowd is already all-in long the risk-on and reflation trade from a cross-asset analytical perspective.

 

 

The cover of Barron’s featured a story on the cyclically sensitive industrial stocks. Does this represent a contrarian magazine cover warning on the cyclical reflation theme?

 

 

 

Heightened expectations

One of the narratives that have been the catalyst for higher prices is the possible passage of a fiscal stimulus bill. The market tanked when Trump tweeted that he was cutting off negotiations with House Speaker Pelosi over a stimulus package. He then reversed course later in the week and called for an agreement. Bloomberg reported that Republican Senate Majority Leader McConnell shot down that idea and indicated that any deal is unlikely before the election:
Senate Majority Leader Mitch McConnell said the differences are likely too big and the time is too short for Congress to agree on a new comprehensive stimulus package before the election, despite President Donald Trump’s renewed interest in striking a deal.

 

“I believe that we do need another rescue package, but the proximity to the elections and the differences of opinion about what is needed are pretty vast,” McConnell said at an event in his home state of Kentucky.

 

He also said that while both sides agree on the need for aid to U.S. airlines, that too is unlikely to happen in the next three weeks.
Market expectations a fiscal stimulus bill may be too high.

 

Across the Atlantic, the relative return of the small cap FTSE 250 to the large cap FTSE 100 is testing a key relative resistance level (bottom panel). This ratio is an important barometer of Brexit sentiment, as small caps are more sensitive to the UK economy than large caps.

 

 

This is another example of heightened expectations. The deadline for a smooth Brexit is approaching quickly, and negotiators are working furious to arrive at a limited deal, which is a significant retreat from the comprehensive Withdrawal Agreement that UK Prime Minister Boris Johnson backed away from.

 

Expectations may be too high on both sides of the Atlantic.

 

 

More October surprises?

Looking to the week ahead, it’s difficult to know how the stock market will react in the coming weeks. We have seen numerous October Surprises in 2020 to last several elections. Historically, the month of October has not been equity friendly during election years.

 

 

I am monitoring is the NASDAQ 100, which is a key barometer of large cap growth stock leadership. The NASDAQ 100 to S&P 500 ratio is testing an important rising trend line. A trend line violation could be the signal for a risk-off episode, as technology and technology related sectors comprise nearly 50% of S&P 500 weight.

 

 

In conclusion, the renaissance of absolute and relative momentum factors is a positive development for equity prices. However, the combination of event risks, excessively frothy short-term sentiment, and uncertain fundamental underpinnings of the recent rally, the odds of a bullish resolution may be not much better than a coin toss despite the historical evidence.

 

Stay nimble, keep an open mind to all possibilities, and stay tuned for either signs of bullish confirmation, or bearish reversals.

 

A valuation puzzle: Why are stocks so strong?

Posted by Cam Hui -

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.

 

 

Three explanations

I offer three separate and distinct explanations for why equity prices haven’t tanked. The first is from the BDO June 2020 publication, “The Path Ahead, Analysis of Analyst Estimates for Insights on the Economic Recovery”. In that analysis, the BDO team analyzed over 20,000 equity analyst estimates for 428 public companies across 24 industries for the period ending May 31, 2020.

 

The consensus called for a U-shaped recovery. The aggregated data indicated a steeper and longer downturn in sales and earnings. However, the stock market went in a different direction by recovering quickly from its bearish episode. The following chart shows the percentage estimated change in 2020 EBIT and long-term EBIT from March 31, 2020 to May 31, 2020, and the change in total enterprise value (TEV = equity market cap + debt – cash) over the same period.

 

 

The BDO team went on to study relative performance by industry by analyzing relative TEV change against changes in estimated EBIT. The analysis of 2020 estimate EBIT changes showed a relatively tight fit between changes in TEV and EBIT. 

 

 

The analysis of TEV changes against long-term EBIT estimates showed a looser fit, indicating that the market was focused more on short-term EBIT estimates than long-term ones. That’s not an unexpected result. Investors tend to focus more on the short-term in a market panic.

 

The BDO study answered one part of the question. The market was reacting rationally, at least on a relative basis. Industries that were expected to lag underperformed, and industries that were less affected by the pandemic outperformed.

 

 

BIS: Insights from dividend futures

While the BDO analysis satisfied the questions about the effects of relative performance, what about absolute performance? Why haven’t stock prices weakened further in the face of the economic shock from the pandemic.

 

A Bank of International Settlement (BIS) quarterly review published on September 14, 2020, “Markets rise despite subdued economic recovery”, provided an answer. BIS began with addressing the puzzle of stock market behavior.
 

Financial markets recorded further gains during the review period, despite the challenging macroeconomic outlook. A divergence emerged between, on the one hand, elevated stock valuations and tightening credit spreads and, on the other, the reality of an economic recovery that looked incomplete and fragile. While investors did differentiate across sectors, rewarding technology stocks in particular, they seemed to be comforted overall by a stream of economic indicators that turned out better than feared. An accommodating monetary policy stance and news about new fiscal programmes in some jurisdictions also provided critical support for asset prices.

 

Stock markets overall saw a notable rise between July and early September. After recording strong returns in April and May, equity prices moved largely sideways in June but resumed their ascent thereafter. The gains were largest in the United States and China, whose main equity benchmarks by August had surpassed their pre-pandemic valuations, which had already carried signs of overheating (Graph 1, first panel). While other AE and EME stock indices recouped much of their March losses, they still remained some 10% below previous highs. A sell-off at the end of review period cut some of the early gains, particularly in the technology sector.

As part of the BIS study, Fernando Avalos and Dora Xia analyzed dividend futures on the S&P 500 and the Euro Stoxx 50 Index. Finance theory of discounted cash flows hold that equity prices is the sum of all future dividend payments, which are proxies for investor expectations of the fundamentals of individual companies in the respective stock indices.

Avalos and Xia found these dividend futures expiring in 2024 have rebounded strongly from the March bottom than contracts that expire in 2020. While 2020 is expected to be difficult, the long-term corporate earnings outlook isn’t expected to be as bad.
 

 

Avalos and Xia went on to observe that rates have plunged, the net present value of the 2024 dividends are worth much more than the pre-crisis period. Therefore the recovery in stock prices can be attributed to the combination of a strong rebound in long-term expected dividends, and falling interest rates. Had rates remained the same, valuations may be over 15% less than they are now.
 

While the authors don’t directly address the issue, this analytical framework also explains why growth stocks have handily beaten value stocks during the study period. Growth stocks normally don’t pay dividends, and finance theory holds that most of their value comes from their expected corporate value at a far off time in the future. This makes the duration of growth stocks higher than value stocks. (For the uninitiated, duration measures the sensitivity of an asset to interest rates. The longer the duration, the more sensitive the price is to interest rate movements.)
 

Indeed, the forward P/E ratio of FAAMG stocks have diverged from the rest of the S&P 500 far more in 2020 than the pre-crisis era.
 

 

While the BIS approach of studying dividend futures is useful from a finance theory viewpoint, it is unsatisfying from real-time investors’ perspective. Analysis from Goldman Sachs indicate that forward P/E ratios are relatively insensitive to differing inflation regimes – and inflation is a major determinant of interest rates.
 

 

 

Upside-down markets

A third, and more detailed, explanation of market conditions in 2020 comes from the writer under the pseudonym Jesse Livermore. Jesse Livermore has penned a number of very detailed and cogent analysis in the past, and the latest is no different. His latest Opus, “Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes”, was published by O’Shaughnessy Asset Management. The paper is long and extensive at over 40,000 words. He begins by describing an upside-down market:

An upside-down market is a market in which good news functions as bad news and bad news functions as good news. The force that turns markets upside-down is policy. News, good or bad, triggers a countervailing policy response with effects that outweigh the original implications of the news itself.

Here is a stylized though radical example of the events of 2020, though COVID-19 is not incurable and won’t last forever.

To illustrate with a concrete example, imagine a policy regime in which U.S. congressional lawmakers, acting with the support of the Federal Reserve (“Fed”), set a 5% nominal growth target for the U.S. economy. They pledge to do “whatever it takes” from a fiscal perspective to reach that target, including driving up the inflation rate, if the economy’s real growth rate fails to keep up. Suppose that under this policy regime, the economy gets hit with a contagious, lethal, incurable virus that forces everyone to aggressively socially distance, not just for several months, but forever. The emergence of such a virus would obviously be terrible news for humanity.

He went on to describe the economy, and the subsequent policy response.

The virus would force the economy to undertake a permanent reorganization away from activities that involve close human contact and towards activities that are compatible with social distancing. Economically, the reorganization would be excruciating, bringing about enormous levels of unemployment and bankruptcy. But remember that Congress is in-play. To reach its promised 5% nominal growth target, it would inject massive amounts of fiscal stimulus into the economy—whatever amount is needed to ensure that this year’s spending exceeds last year’s spending by the targeted 5%. To support the effort, the Fed would cut interest rates to zero, or maybe even below zero, provoking a buying frenzy among investors seeking to escape the guaranteed losses of cash positions.

The result would be bullish for equity prices, despite the horrible news about the economy.

If you are a diversified equity investor in this scenario, you will end up with a windfall on all fronts. Your equity holdings will be more attractive from a relative yield perspective, more scarce from a supply perspective, and more profitable from an earnings perspective. The bad news won’t just be good news, it will be fantastic news, as twisted as that might sound.

The rest of the paper takes a detailed journey through the drivers of corporate profitability, inflation, the interaction between fiscal and monetary policy, and equity valuation. He concluded that valuation equilibrium is unstable, and therefore equity prices could experience significant volatility [emphasis added].

Imagine that you are in a two-asset market where one asset, cash, earns nothing forever, and the other asset, an equity stream, earns $1 a year forever, with a portion of that amount paid out as a dividend and a portion reinvested to generate future growth. If you buy the equity stream for $10—an earnings yield of 10%—and the enthusiasm of buyers subsequently wanes, you won’t need to sell at a loss. If the price falls, it’s not a big deal, because the 10% yield that you be will earning on the investment is intrinsically worth the temporary loss of access to your money. All you will have to do is wait and let the earnings accumulate, either as dividends that get paid out to you or as investments that compound. Over the long-term, you will end up doing very well, regardless of where the market decides to take the price.
 

But now suppose that the price gets pushed up in a TINA chase to $100—an earnings yield of 1%. If you buy at that price, you’re going to have to remain laser-focused on the market’s subsequent response, keeping the position on a short leash and rapidly exiting if buyer enthusiasm starts to wane, because the 1% earnings yield that you’re going to be accruing is nowhere near enough to compensate you for the loss of access to your money, which is what you will have to endure if the price falls appreciably from where it currently is. If the market decides that it wants to assign a 20 P/E ratio to the security instead of a 100 P/E ratio, the price is going to fall by 80%. You’re going to have to wait a full 80 years to get your money back in earnings. Will the wait be worth the 1% spread over cash that you will have locked in? Absolutely not, which is why you’re going to have to pay close attention and make sure that you don’t get stuck in that kind of a situation.
 

In the same way that you are going to be more sensitive to drawdown risk as a buyer at elevated valuations, everyone else in the market is going to be more sensitive as well, which will make the prices themselves more sensitive, and the investments more risky.
 

Ultimately, the only way that a market can be stable is if everyone is more-or-less happy with what they are holding—willing to transact, but not feeling an urgent need to do so. In the hypothetical market above, is it going to be possible for everyone to be happy with what they are holding? Definitely not. If the equity price in that market is stable or rising, the underinvested individuals earning nothing in cash are going to be unhappy. They will want more equity and will chase prices higher until some counterbalancing disincentive emerges to discourage them, such as the disincentive of a needy, shaky, creaky market that looks and feels more expensive than it deserves to be. If the equity price is falling, then overinvested individuals taking losses in equities will be unhappy, and will chase prices lower in pursuit of the safety of cash, until prices get cheap enough to make the securities attractive as investments for their own sake, because the underlying cash flows are attractive, regardless of the price that they can be sold for.
 

In the end, TINA markets are guaranteed to be difficult and frustrating for large numbers of people. The problem of how to properly invest in them has no easy solution. Chasing ultra-expensive assets, nervously supervising them in the hopes that you haven’t top-ticked them, is stressful and unpleasant. But so is waiting on the sidelines earning negative real returns while everyone else makes money. Time is not on your side in that effort.

Based on the assumption that investors just want to maintain the pre-crisis allocations irrespective of valuation, he arrived at an S&P 500 target of 3900.

Returning to the subject of the current equity market, on the assumption that investors display zero sensitivity to valuation and invest entirely based on a pre-determined asset allocation preference, we can quantify the exact impact that the COVID-19 deficits would be expected to have on prices, if they found their way into markets. We simply assume that investors would bid up on the price of equity until their pre-pandemic allocation to equity was restored. To restore that allocation amid the COVID-19 debt issuance, the market would have to rise by roughly 18%, from its price at the time of the writing of this piece, roughly 3327, to a final price of roughly 3900, a forward 2-yr GAAP price-earnings ratio of 26 times.

The S&P 500 target of 3900 is a best case analysis based on the assumption that investors are totally price insensitive and just want to maintain their asset allocations. Jesse Livermore went on to consider the question of relative valuation a Twitter thread. He began by explaining his analytical framework using a chart of past returns by major developed market region and style.

 

Stock returns by category from Dec 1976 to Dec 2019 for MSCI US, Japan, Europe ex-UK and UK indices, each separated into growth, broad market and value. Description and discussion below, to include charts of different sub-periods. Empty black boxes represent total returns, colored columns represent fundamental returns (annualized dividend growth w/ all dividend payouts recast as share buybacks). When a box is higher (lower) than a column, it means the category grew more expensive (cheaper) over the period.

He qualified the analysis by point out that Japanese fundamental improvement is distorted by the effects of Abemomics.

The depicted fundamental performance for Japan is distorted by the dividend payout ratio increases associated with Abenomics. If we were to measure growth in Japanese fundamentals using other aggregates (sales, earnings, etc.), the growth would not have been as strong.

 

 

Since this technique does not account for starting valuation, it`s best to examine returns on a peak-to-peak basis. Here is the performance from the pre-GFC peak in 2007 to December 2019. While the US outeperformed and stock prices moved roughly in line with their fundamentals, the rest of the world lagged while their fundamentals (colored bars) improved more than prices (black boxes). In other words, the rest of the world became cheaper over this period.

 

 

Jesse Livermore went on to pose the question, “DM rates are expected to remain at or below zero for a very long time. The question arises, how should equities be valued in such a world?” From that perspective, non-US equities appear to be very attractive. You have “high equity yields against zero or negative rates”.

 

He went on to focus on one especially alarming chart, the period from December 2017 to August 2020 with the observation that everything is becoming expensive, “Empty positive boxes, with no color inside them, are bad. Things are getting more expensive”. In particular, he found that US growth is especially vulnerable to drawdown.

I find this chart alarming. For US growth, you have ~22% annualized total return with only ~1% of that coming from fundamentals, the rest from valuation expansion.

 

 

 

The valuation question

In conclusion, what have we learned from a survey of three approaches to equity and valuation analysis? We can conclude that:
  • From BDO: The market was reacting rationally on a relative valuation basis.
  • From BIS: The discounted value of dividend futures revealed that long-term cash flows had recovered, and lower interest rates boosted valuation. However, there may be some limits to the forward P/E to interest rate trade-off as forward P/E ratios have been relatively insensitive to low inflation and interest rates.
  • From Jesse Livermore: Good news can be bad news, and vice versa, in the current fiscal and monetary policy environment. The best case analysis of the S&P 500 results in a target price of 3900. Moreover, US equities, and growth equities in particular, are overvalued compared to US value and the rest of the world.
The S&P 500 is trading at a forward P/E ratio of 21.9, which is well ahead of its 5 and 10 year averages. In light of the BIS analysis, the forward P/E ratio of about 13 reached during the March low represents a reasonable level of bottom of cycle valuation in light of the lower interest rate regime. 

 

 

Investors who missed buying the March low may find a second chance in the near future. From a technical perspective, past recession related equity bear markets have seen an initial low, followed by one or more re-tests of the first low. In some cases, the re-test was unsuccessful and the S&P 500 fell to a lower low before launching into a fresh bull. The time between the first and final low can be as long as over a year. Will 2020 be any different?

 

 

No matter how the fundamental develop, the S&P 500 and US growth stocks have low upside potential compared to value stocks, and other developed market equities.

 

Out of the woods?

Posted by Cam Hui -

Mid-week market update: As President Trump left the hospital and returned to the White House, the message from his doctors was he was doing fine, but he was not “out of the woods”. Numerous outside physicians have made the point that COVID-19 is nothing like the flu. Flu symptoms hit the patient and eventually dissipate and go away. COVID-19 patients often have ups and downs in their infection. They may feel fine, but symptoms flare, dissipate, and return. The process can last weeks, even months. Just because Trump reported feels fine now doesn’t mean that he won’t feel fine by this weekend.

Just like Trump’s COVID-19 infection, neither the equity bulls nor bears are out of the woods. Yesterday (Tuesday), Fed Chair Jerome Powell said in a speech that it was time to go big on fiscal stimulus:

The expansion is still far from complete. At this early stage, I would argue that the risks of policy intervention are still asymmetric. Too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses. Over time, household insolvencies and business bankruptcies would rise, harming the productive capacity of the economy, and holding back wage growth. By contrast, the risks of overdoing it seem, for now, to be smaller. Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.

The September FOMC minutes indicated a consensus that fiscal support is forthcoming, and the economy could tank without a rescue package.
Indeed, many participants noted that their economic outlook assumed additional fiscal support and that if future fiscal support was significantly smaller or arrived significantly later than they expected, the pace of the recovery could be slower than anticipated.
Trump tanked the market by tweeting that he was calling off the negotiations for a stimulus package. While he did tweet later that he was in favor of a standalone bill for a $1200 stimulus payment, his chief of staff Mark Meadows confirmed today that stimulus bill negotiations are dead.

 

 

 

Recovery not out of the woods

Trump’s political pivot to spending his political capital to confirm Judge Barrett to the Supreme Court means that, in all likelihood, there will be no stimulus package passed until February, which is after Inauguration Day and the new Congress is seated. 
Joe Wiesenthal at Bloomberg observed that the recovery in employment isn’t out of the woods either. He pointed out the recovery in jobs that employees can work from home (WFH) have plateaued, and likened these high paying jobs as a “longer-term bet on future business prospects” and “being akin to a capital investment”.
Looking further under the hood of the labor market reveals some other concerning signs. Jed Kolko, chief economist at at the job site Indeed, has been regularly tracking job openings by sector throughout this crisis. It’s notable which sectors are bouncing back, and which ones remain depressed. In areas like retail and construction, which temporarily were forced to shut down in the spring, positions continue to rapidly open up. But in areas such as banking, finance, and software development, job openings remain extremely depressed.
The split makes sense. A software development job isn’t the type of thing you just post one day because a business reopens after a lockdown. It represents some kind of longer-term bet on future business prospects. You can think of a software hire as as being akin to a capital investment. As such, this should raise some concerns about economic productivity going forward, if companies are spending less on long-term investment and projects now.

 

 

The delay in additional stimulus until February, at the earliest, could have a devastating impact on the economy.

 

 

Stock market in holding pattern

In the meantime, the stock market remains range-bound. The S&P 500 is overbought and testing overhead resistance while stuck in a narrow range. This kind of sideways consolidation pattern is not unusual in light of the the index violation of a rising trend line in early September. I am still waiting for either an upside breakout or downside breakdown.

 

 

A House report calling for antitrust investigation of Big Tech was not helpful to large cap NASDAQ 100 stocks either. This index is also testing overhead resistance, while at the same time its relative return is testing a key rising trend line.

 

 

The market was on the verge of a Zweig Breadth Thrust buy signal yesterday (Tuesday) until Trump’s tweet tanked the market. There is still a glimmer of hope for the bulls, as the last day of the ZBT window is tomorrow (Thursday).

 

 

The bears can point to continuing low short interest levels, which will not put a floor on the market should it weaken.

 

 

 

More choppiness ahead

Investors should brace for more choppiness and volatility. The latest update of option implied volatility is telling the same story of election anxiety. Implied volatility spikes in early November, and remains elevated until mid-December. The market is still anxious about the prospect of a contested election and post-electoral uncertainty.

 

 

While I am not fond of historical analogs, but this one opens the door to a test of the March lows in the near term.

 

 

There will undoubtedly be more October surprises. Prepare for more volatility.
Disclosure: Long SPXU

 

The more things change…

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities
  • Trend Model signal: Bearish
  • Trading model: Bearish

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

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

 

Plus ça change…

The market was subjected to an unexpected shock late Thursday when President Trump announced that he had been diagnosed with a COVID-19 infection. What was unusual was the behavior of many market internals – they stayed the same.

 

Plus ça change, plus c’est la même chose. The more things change, the more they stay the same.

 

In light of this development, Trump is forced to quarantine and his campaign activities are suspended or curtailed. This creates a headwind for his electoral chances about a month ahead of the election. The betting odds on a Trump victory fell in the betting markets, but the overall Republican odds of a victory was steady as the odds on the Pence contract rose. Plus ça change, plus c’est la même chose. 

 

Equally puzzling was the behavior of risk. Prior to the news, the option market was discounting heightened odds of a disputed election. Average option implied volatility (IV) spiked just ahead of the November 3 election, and they remained elevated until mid-December. The shape of the implied volatility curve stayed the same after the news. Plus ça change, plus c’est la même chose. 

 

 

The technical behavior of the market was also relatively steady. Both the S&P 500 and NASDAQ 100 rallied last week and regained their respective 50 day moving average (dma) levels. Both indices remained range-bound for the week, bounded by a band of upside resistance and downside support.

 

 

 

A shift in sentiment

However, there were some key shifts in sentiment. While the shape of the option volatility curve was largely unchanged, there were differences between call option and put option IV. The spread between call and put option IV on September 24, 2020 was roughly zero across the board. Fast forward to October 2, and call option IV was higher (more expensive) than put option IV, indicating greater demand for calls than puts.

 

 

Does anyone remember the crowded short by large speculators in equity futures that everyone got excited about? SentimenTrader observed that the latest update shows that about two-thirds of the position was bought back last week.

 

 

Large speculators are still net short the NASDAQ 100 futures contract, but their exposure has been substantially reduced.

 

 

Commitment of Traders data is no longer extreme. The bulls can’t count on the Commitment of Traders data to put a floor on prices should the equity market weaken.

 

 

The week ahead

Looking to the week ahead, the market is retreating from an overbought condition. Barring any more unexpected surprises, equities should continue weaken in the early part of the week.

 

 

Tactically, both the S&P 500 and NASDAQ 100 are exhibiting price gaps begging to be filled on the hourly chart. While anything can happen, the aforementioned price differential between call and put options is contrarian bearish – at least in the short-term.

 

 

The two wildcards to my forecast are the ongoing negotiations between House Speaker Nancy Pelosi and Treasury Secretary Steve Mnuchin over a stimulus package, and how Trump,s diagnosis affects his ability to govern and campaign.

 

Pelosi’s negotiation intentions are unclear. Why are they even discussing a standalone airline relief bill, or any relief bill? I find it difficult to believe that it is to the Democrats’ advantage to pass any stimulus package at all. Trump and the Republicans appear to be on the ropes in the polls. The Democrat controlled House already passed a $2.2 trillion HEROS 2.0 Act last week, knowing full well that it would not be given assent in the Republican controlled Senate. The Democratic strategy was for lawmakers to return to the districts and campaign on the premise that they tried their best and blame the Republicans. There is little political incentive for Pelosi to work towards a compromise bill, which would benefit the Republicans if passed. Even if she could come to an agreement with Mnuchin, it is unclear whether the Republicans have the votes to pass such a bill in the Senate. Moreover, the Senate is going on hiatus until October 19 because of a COVID-19 outbreak. Why even make the effort at all? Regardless, a comprehensive rescue package would be a huge bullish surprise.

 

The other risk is President Trump’s prognosis, which could throw his electoral chances into further turmoil. Bob Wachter, the Chair of UCSF Medicine, gave a sobering analysis of Trump’s condition in a Twitter thread.

Now we’re down a bad loop of the algorithm: not only with symptoms, but symptoms (such as shortness of breath or cough) or signs (such as low oxygen) bad enough that his docs think he needs to be in the hospital. They wouldn’t do that if he only had a fever & muscle aches…

… It might mean he’s now sleepy or confused (25th Amendment!), or, more likely, short of breath, cough &/or low oxygen level, indicating lung involvement. Yes, the threshold to hospitalize the president is probably lower than for average person, but still – it’s not good.

And that it occurred the day after his first symptoms – whereas patients are often stable for 3-10 days before crashing – is worrisome.

The odds on the chart…are for all comers, not necessarily high-risk patients like Trump. At this point, his risk of death is >10%.

Trump’s symptoms puts him in one of the first two phases of COVID-19 treatment as depicted in the chart below. While he may only be in the first phase and the hospitalization decision is because of his position in the government, he is more likely in the second phase. Patients often show few symptoms when first afflicted, and their condition can deteriorate quickly soon afterwards. UK Prime Minister Boris Johnson was hospitalized as “a precautionary measure”. He went into ICU the next day and eventually came close to death. Even if everything goes well, expect Trump to be sidelined for a minimum of 10-14 days, which is a critical window for his election campaign. Can the Republicans make sufficient adjustments in light of the fact that both Trump’s campaign manager Bill Stepien and the RNC Chair Ronna McDaniel have been diagnosed with COVID-19?
 

 

My outlook remains unchanged from last week. My base case scenario calls for near-term volatility and choppiness until the election, with a bearish bias. 

 

Plus ça change, plus c’est la même chose. 

 

 

Disclosure: Long SPXU

 

Broken Trends: How the world changed

Posted by Cam Hui -

The world is changing, but it changed even before Trump’s COVID-19 news.
 

 

In the past few weeks, a couple of key macro trends have reversed themselves. The US Dollar, which large speculators had accumulated a crowded short position, stopped falling and began to turn up. In addition, inflation expectations, as measured by the 5×5 year forward, stopped rising and pulled back.
 

 

These developments have important implications for investors.
 

 

Rising USD = Risk-off

Let’s begin with the USD. The rising USD has put pressure on vulnerable emerging market economies. Indeed, USD strength has coincided with widening junk bond and EM bond spreads, which contributed to the risk-off tone in much of September.
 

 

Historically, weakness in EM currencies and EM bonds has been associated with a reduced equity risk appetite.
 

 

Robin Brooks, Chief Economist at IIF, believes that there are few reasons for the USD to fall further. G10 real rates are already down the most for the US. In addition, the US is reflating the fastest, which should lead to greenback strength, not weakness.
 

 

European stocks already look wobbly. The Euro STOXX 50 has violated both its 50 and 200 day moving average (dma) lines. The FTSE 100 and FTSE 200 are also weak, but the UK market is burdened by the latest Brexit drama, where the EU has charged London with violating its Withdrawal Agreement.
 

 

 

Cyclical rebound doubts

The second important global macro factor to consider is the retreat in inflation expectations. Implicitly, the market is pulling back on the consensus of a robust cyclical rebound. The Citigroup Economic Surprise Indices, which measures whether economic data is beating or missing expectations, are weakening from high levels in all major global regions.
 

 

The all-important cyclically sensitive industrial metal prices is also showing signs of weakness and they are pulling back.
 

 

Equally ominous is the behavior of copper, which is weakening in the face of a large speculator crowded long in the futures market.
 

 

In the US, the relative performance of cyclical industries presents a mixed bag. Homebuilding stocks are on fire, which is reflective of the strength in housing. However, other cyclical groups such as industrial, transportation, and leisure and entertainment stocks, are stalling at relative resistance zones and exhibiting signs of relative weakness.
 

 

Another sign of a stalling or flattening recovery can be found in earnings estimate revisions. FactSet reported that forward 12-month estimates edged down last week. This may be just a data blip, but it’s something to keep an eye on.
 

 

 

The Trend Model is bearish

Putting it all together, I interpret these conditions as signs of caution. There are three major trade blocs in the world. US growth is starting to stall as there are limits to what monetary policy can accomplish. The lack of further fiscal stimulus has the potential to snuff out a recovery. Across the Atlantic, the latest inflation figures came in below expectations. The ECB’s monetary policy response has not been as assertive as the Fed’s. In China, the recovery has been uneven and driven by the production and export sectors. The sustainability of China’s recovery is hampered by a lack of global demand. In addition, Chinese households have not participated in the recovery and their finances are strained, which is proving to be a drag on any consumer driven growth.

As a consequence, my Asset Allocation Trend Model signal has been downgraded from neutral to bearish. A simulation of actual Trend Model signals as applied to a simple over and underweight rules of 20% against a 60/40 benchmark has yielded equity-like returns with balanced fund-like risk.
 

 

For US equity investors, this suggests that growth stocks will continue to dominate value stocks, at least until the growth and cyclical jitters are over. In a growth starved world, investors tend to flock towards established growth names. Expect growth to dominate value, and large caps to dominate small caps.
 

 

I would be remiss without a discussion of the market’s anxiety over the prospect of a contested electoral results after the November 3 election. In the wake of Trump’s diagnosis, the betting odds of his victory fell on PredictIt, but the Pence odds rose about an equal level to compensate. As a consequence, the Republican odds of winning the Presidency was largely unchanged. What is remarkable is the market’s perception was also unchanged compared to readings from the previous week. Implied option volatility spikes in early November, and peaks out mid-December, and slowly falls afterwards.
 

 

While markets usually welcome divided governments, this may be an exception under the current circumstances. The Fed has made it clear that there are limits to what it can do, and monetary may be pushing on a string. Numerous Fed speakers have pleaded for a strong fiscal response. An electoral sweep by either Party can focus Washington on passing a stimulus package, while divided government has the potential to result in weaker fiscal action.

Investors should be cautious, until the results of the election become clearer.
 

Something for everyone

Posted by Cam Hui -

Mid-week market update: The Presidential Debate last night was painful to watch. After the debate, different broadcasters conducted instant polls of who won the debate. The CNN poll showed that 60% believed that Biden had won, and 29% thought that Trump had won. The Fox poll showed that 60% thought Trump had won, and 39% thought Biden had won.

Lol! There was something for everyone*.

In reality, the debate probably didn’t change many minds, and the market’s perception of electoral risk was also largely unchanged. My own survey of SPY’s at-the-money option implied volatility shows that while implied volatility had fallen, the shape of the curve is unchanged. The early November election spike is still there, and risk remains elevated until mid-December.
 

 

For equity traders focused on market direction, there is also something for both bulls and bears.
 

* Please think twice before posting political commentary in the comments section.
 

 

For the bulls

The bulls can point to several constructive developments. Both the S&P 500 and NASDAQ 100 have regained their respective 50 day moving average (dma) lines. In particular, the NASDAQ 100 rallied above its 50 dma and held the upside breakout for three days. In light of the large net short position in NASDAQ futures by hedge funds and CTAs, trend following models could force shorts to cover and push prices higher.
 

 

Another positive technical development is the ongoing bullish recycle of the daily stochastic off an oversold condition. This is a sign of bullish momentum that should propel prices higher.
 

 

There is also the lurking possibility of a Zweig Breadth Thrust buy signal. The market rallied off a ZBT oversold condition last Friday, and it has 10 trading days to become overbought to flash a ZBT buy signal. Today (Wednesday) is day 4. The bulls are ever hopeful.
 

 

 

For the bears

“Not so fast,” say the bears. The intermediate-term outlook is still unsettled.

One of the bottom spotting signals that I identified on Saturday (see How to spot the next market bottom) was a bearish sentiment capitulation. The latest update of Investors Intelligence sentiment shows that while %bulls have retreated and %bears have edged up, bearish sentiment is not at levels consistent with wash-out lows.
 

 

Similarly, the Fear & Greed Index is firmly in neutral territory. Durable market bottoms don’t look this way.
 

 

What about that bullish recycle of the daily stochastic? The weekly chart tells a different story of a bearish recycle. The intermediate term outlook is bearish, not bullish.
 

 

As well, Macro Charts pointed out that the volume of QQQ calls is still highly elevated, indicating either excessive bullishness, which is contrarian bearish, or signs of possible hedging activity that offsets the large short position in NASDAQ 100 futures.
 

 

Where does that leave us? I warned recently about the possibility of rising volatility, which is likely to persist until the November 3 election and possibly beyond. In the short-term, there is event risk, owing to excitement about a stimulus deal and Friday’s the September Jobs Report.

In the absence of a substantive development, such as an agreement on a fiscal stimulus package, I would expect further choppiness with a bearish bias until early November.

Disclosure: Long SPXU
 

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Fun with CoT data

Posted by Cam Hui -

There was some excitement last week when SentimenTrader wrote about the massive aggregate short by large speculators and CTA trend followers in equity futures. Conventional contrarian analysis would be bearish, but this is a lesson for traders and investors to look beneath the surface before jumping to conclusions.
 

 

 

Mitigating conditions

Here are some mitigating conditions to consider. Analysis from Callum Thomas revealed that, when normalized for open interest, the short position is not as extreme. Further analysis shows that large speculators were mostly correct in their positioning just before and during the Great Financial Crisis. This is a lesson not to be contrarian just for its own sake.
 

 

In addition, Goldman Sachs’ positioning studies show that investors, which include institutions, individuals, and foreign investors, are net long equities. Readings are falling from a crowded long and not extreme. These sentiment conditions are consistent with a market that is pulling back.
 

 

 

Cross-asset signals

If you are relying on Commitment of Traders (CoT) futures data to be contrarian, then what would you make of the massive USD short position (via Macro Charts)?
 

 

Large speculators are in a crowded USD short, and the USD Index has just staged an upside breakout from a narrow range and sparking a risk-off episode. The AUDJPY cross, which is a sensitive risk appetite foreign exchange indicator, is confirming the risk-off tone.
 

 

Taking a contrarian position based strictly on CoT data can lead you astray. How do you resolve the inherently contradictory positions of a massive equity short, which leads to risk-on positioning, and an equally massive USD short, which leads to a risk-off conclusion?

I interpret CoT data as trade setups, and not actionable trade signals. I prefer to look for crowded trades, combined with a trading catalyst. As an example, the crowded USD short and upside breakout leads me to adopt a risk-off tone. On the other hand, I am watching if the bulls can rally the NASDAQ 100 above its 50 day moving average. Most of the large speculator short positions are in the NDX, and a decisive upside breakout will lead to a short squeeze. Based on Monday’s close, the NDX has broken up through its 50 dma, though TRINQ shows no signs of panic buying. Trend following CTAs tend not to react instantly to breaches in key levels in order to minimize whipsaw. We will have to watch if the bulls can hold these levels over the next few days.
 

 

However, the market is overbought in the short-term. I will be closely watching the NDX, as well as the behavior of the currency markets in the next couple of days.
 

 

The jury is still out on question of whether today’s market action is the start of a pain trade for the bears, or a bull trap. Stay tuned.

Disclosure: Long SPXU
 

Time to de-risk

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

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Sell equities
  • Trend Model signal: Bearish (downgrade)
  • Trading model: Bearish

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

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

 

Time to be cautious

This is an out-of-sample application of my Asset Allocation Trend Model signals to a model portfolio. If the Trend Model is bullish, the model portfolio will take a 80% position in SPY (stocks) and 20% position in IEF (bonds), neutral at 60% SPY and 40% IEF, and bearish at 40% SPY and 60% IEF. As the chart shows, the model portfolio has been able to achieve equity-like returns over the test period with balance fund-like risk.

 

 

The Trend Model’s signal was upgraded to neutral from bearish on May 15, 2020 and it has remained in neutral ever since. Recent developments have caused it to turn more cautious. Here is why.

 

 

A tour around the world

The Trend Model applies trend following principles to a variety of equity and commodity prices around the world. There have been numerous technical breakdowns that have sparked general risk-off conditions on a global basis. Let’s take a tour around the world and assess conditions.
Starting in the US, we can see that the S&P 500 and NASDAQ 100 have decisively breached their 50 day moving averages (dma). While the NASDAQ 100 is trying to consolidate sideways, the small cap S&P 600 is even weaker, as it is trading below both its 50 and 200 dma.

 

 

Across the Atlantic, the Euro STOXX 50 has also breached both its 50 and 200 dma. The other major core and peripheral stock markets are also showing signs of weakness.

 

 

Across the English Channel, both the large cap FTSE 100 and small cap FTSE 250 are showing signs of weakness. The relative performance of the FTSE 250 to FTSE 100 has pulled back to test a relative support level, largely over increasing anxiety about the collapse in Brexit talks.

 

 

Over in Asia, the performance of China and the markets of her major Asian trading partners are also weak. The Chinese stock market is dominated mainly by retail investors, who treat it like a casino. That’s why I focus mainly on the signals from the other Asian markets. All of them are showing differing signs of weakness. In particular, the downside support violations in Hong Kong and Taiwan are especially ominous.

 

 

Cracks are showing up again in the mountain of debt in China. The plight of China’s largest property developer, China Evergrande, may be the canary in the Chinese coalmine. Reuters reported that Evergrande, which is highly indebted, pleaded with local authorities for debt support:

The time has come for China to confront a too-big-to-fail quandary. In a letter to local government officials, highly indebted property developer China Evergrande contends that if it doesn’t secure approval soon for its reverse merger plan, it will wreak widespread havoc. Although the company says the missive is fake, the questions in it regarding systemic risk are real for investors and Beijing.

Evergrande beseeched officials in its home province of Guangdong for assistance with a so-called back-door listing, according to a copy of the Aug. 24 letter, whose authenticity was confirmed by Reuters sources. The idea, first proposed as part of an October 2016 restructuring, was for subsidiary Hengda to combine with a publicly traded state developer. If the deal doesn’t happen by January 2021, a group of investors can demand repayment of some 144 billion yuan, or about $21 billion, all of Evergrande’s cash as of June 30.

 

 

The one bright spot in Asia is Japan. The Nikkei Index price pattern remains constructive. However, there are three major trading blocs in the world, anchored by the US, Europe, and China. Japan is becoming a peripheral player from a global perspective.

 

 

Commodity prices can also be an important signal of global reflation or deflation. The message from commodities is one of caution. The Invesco-DB Commodity Index, as represented by the ETF DBC, has breached both its 50 and 200 dma. Gold prices have weakened in response to falling inflation expectations as hope fades for a fiscal response from Congress. The cyclically sensitive copper price has retreated to test its 50 dma.

 

 

 

A change in tone

The tone of the market seems to be changing, and such changes are often characterized by a shift in leadership. The old leadership is faltering, but no new market leaders have emerged. 
From a global perspective, the old US leadership has plateaued and begun to trade sideways (top panel), but none of the other major regions have emerged to be the new market leaders.

 

 

From a trend following viewpoint, these are all signs of a change in global trends. Coupled with a general weak tone in global equity and commodity prices, it is time for asset allocators to adopt a more cautious tone and de-risk portfolios. This cautious signal is also consistent with my past observation of a bearish 14-month RSI negative divergence in the Wilshire 5000, just after it flashed a bullish MACD buy signal. As a reminder, the last RSI divergence sell signal occurred in August 2018 (see Market top ahead? My inner investor turns cautious), which resolved with a mini-bear market that ended with the Christmas Eve panic of 2018.

 

 

The key risk to the bearish call is that the Trend Model is already too late in its cautiousness. SentimenTrader pointed out that large speculators and trend following CTAs are already in a crowded short in equity futures, which is contrarian bullish. 

 

 

However, analysis from Callum Thomas showed that when futures positions are normalized for open interest, the net short speculative position isn’t as severe. In fact, large speculators were correct in their positioning at market extremes during and before the GFC.

 

 

\_(ツ)_/¯

 

Trend following models, by their nature, are slow to react to trends. They tend to be late, and they will never get you in and out at the exact top and bottom. This is a feature and not a bug. Investors therefore need to be prepared for relief rallies in the short run. Nothing goes up or down in a straight line.

 

 

The week ahead

The market faces a critical technical test early in the week. The market leadership NASDAQ 100 is testing overhead resistance at the 50 dma. The bulls need to demonstrate some momentum to show that they are regaining control of the tape. The bears need to hold the line at the 50 dma, and preferably to push relative returns below the rising trend line.

 

 

The bulls will have a tough task ahead of them. The market is already overbought on the percentage of NDX stocks above their 5 dma. 

 

 

The percentage of NDX above their 10 dma remains in a falling channel of lower lows and lower highs. A decisive upside breakout will be a positive development.

 

 

In terms of event risk, we have the first scheduled debate between Biden and Trump on Tuesday, September 29. As there are very few undecided voters in this polarized electorate, the debate is unlikely to move the needle, but there is always the possibility of a stumble by one or both candidates. In addition, there is a flood of Fed speakers, and the September Jobs Report is due on Friday.

 

In conclusion, a review of global equity and commodity markets reveals a growing risk-off trend, which is a signal for investors to be more cautious in their asset allocation. This bearish signal is confirmed by a monthly RSI negative divergence sell signal that was triggered in August 2018, just before the market fell by -20% into the Christmas Eve panic bottom of that year. In the short run, the market may be too stretched to the downside, and a relief rally is always possible. Nothing goes up or down in a straight line but the risk/reward is tilted to the downside.

 

Disclosure: Long SPXU

 

How to spot the next market bottom

Posted by Cam Hui -

RealMoney columnist Helene Meisler asked rhetorically in an article where her readers thought we are in the equity sentiment cycle. She concluded that the market is in the “subtle warning” phase, though she would allow that the “overt warning” phase was also possible.
 

 

I agree. This retreat is acting like the start of a major pullback. The S&P 500 recently violated its 50 day moving average (dma). Past major pullbacks that began with 50 dma breaks were marked by the percent of S&P 500 bullish on point and figure charts plunging below 50%. To be sure, this does not assure us of a significant downturn, though it represents a sufficient though not necessary condition for one.
 

 

Two weeks ago, I discussed the magnitude of market weakness (see How far can the market fall?), with the caveat that those were not targets, but estimates of downside potential. This week, I outline some techniques on how to spot a market bottom.
 

 

The retreat is only starting

Evidence is gathering that the market weakness is only starting. From a top-down perspective, the Citigroup US Economic Surprise Index, which measures whether economic data is beating or missing expectations, has topped out and it is rolling over.
 

 

JPMorgan equity strategists pointed out that earnings estimates, are also weakening after peaking out, especially in the US.
 

 

BoA reported that its private client holdings survey of cyclical optimism has peaked out and weakening.
 

 

Equally worrisome is the strength of the USD Index. The USD has been inversely correlated with the S&P 500 since the March low. Moreover, the AUDJPY exchange rate, which is another key foreign exchange risk appetite indicator, is weakening.
 

 

Arguably, USD strength is a sign that the market is growing concerned about the waning growth outlook. In addition, the appearance of a second pandemic wave in Europe has created doubts about the durability of a global cyclical rebound. Consequently, gold prices, which tend to be inversely correlated to the USD, have retreated below an important resistance turned support level, and the inflation expectations ETF was rejected at a falling trend line.
 

 

The market appears to be setting up for a prolonged period of heightened volatility. My survey of SPY at-the-money option pricing shows that implied volatility remains high and peaks out in mid-December, which is well after the election.
 

 

With Joe Biden ahead in the polls, the market is positioning for a loss by the incumbent, though we may get more clarity after next week’s debate. While the economy is not the only variable that affect voter intentions, this JPMorgan analysis shows a correlation between Trump support and employment levels, with key swing states highlighted. As the cyclical outlook weakens, this will creates headwinds for Trump.
 

 

Ed Clissold of Ned Davis Research reported that incumbent Republican losses have historically been unfriendly to equity prices.
 

 

In the year after the election, the stock market has historically not bottomed out until early March in years when the incumbent Republican loses the White House.
 

 

As the large cap NASDAQ leadership breaks down after a terrific run, investors are reminded to heed the following Bob Farrell’s Rules of Investing:

  • Rule #2: “Excesses in one direction will lead to an opposite excess in the other direction”; and
  • Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.

 

 

The combination of technical breakdowns in large cap NASDAQ stocks, retreating cross-asset risk appetite, and nervousness over the election is setting up for a significant drawdown in equity prices over the next few weeks and months.
 

 

Spotting the market bottom

With that preface, here are some signposts of a durable market bottom. These are intermediate term timing indicators. They will not pinpoint the precise bottom, but they will identify attractive levels to be buying. I don’t expect that they will all flash buy signals simultaneously, but a majority should be bullish at a market bottom.

The first is insider buying. This group of “smart investors” have tended to be relatively prescient at market bottoms, though they can be early. Normally, insider selling swamps buying activity. I would look for clusters of insider buying that exceed selling.
 

 

The one caveat about insider activity signals is they are not precise market timing indicators. Insiders were early at the bottom in 2008-09, and they began buying in late 2008 ahead of the final bottom in March 2009.
 

 

Where are we now? There are no signs of feverish insider buying. Instead, Bloomberg reported a flood of insider sales.

Corporate executives and officers at S&P 500 companies were busy unloading shares of their own firms over the last four weeks. The selling picked up so much versus buying that a measure of insider velocity tracked by Sundial Capital Research pointed to the fastest exit from stocks since 2012.

 

 

The second class of bottom spotting indicators is investor sentiment. Sentiment surveys, such as Investors Intelligence, have generally not recycled to a bearish extreme. While the recent decline in bullishness is constructive, I would like to see bearish sentiment soar. In the past, durable market bottoms have not been formed without a spike in bearishness.
 

 

Lastly, I am also watching for signs of an intermediate term oversold extrme. In the past, the combination of an oversold condition in the Zweig Breadth Thrust Indicator (ZBT) and a negative reading in the NYSE McClellan Summation Index (NYSI) has been reasonably a good signal of an intermediate term bottom. Technical purists will recoil at my use of the ZBT Indicator in a non-traditional fashion. Marty Zweig’s original ZBT buy signal looked for a breadth thrust, defined as an oversold condition on the ZBT Indicator, followed by an overbought signal within 10 trading days. Breadth thrusts are extremely rare, but ZBT oversold signals are not. The combination of a ZBT oversold condition and a NYSI negative reading can be good gauges of an intermediate term oversold market, with the caveat that this signal was early during the March decline and flashed a buy signal about halfway through the pullback.
 

 

This indicator appears to be nearing a buy signal, but appearances can be deceiving. StockCharts reports the ZBT Indicator with a one-day delay, and I have created my own real-time estimate. Friday’s market rally lifted the ZBT Indicator off the oversold level. The ZBT Indicator is no longer oversold.
 

 

From a breadth thrust perspective, Friday is day one, and the market has nine more trading days to achieve a ZBT buy signal. I am not holding my breath.
 

 

An orderly decline

So where does that leave us today? So far, the market’s decline has been an orderly affair. Even though the S&P 500 is off about -10% off its highs in less than a month, there have been no signs of investor panic. The CBOE put/call ratio is still relatively low, indicating continued bullishness. In addition, there have been few TRIN spikes over 2, which are often indicative of price insensitive panic “margin clerk” selling that often occur at the end of major price declines.
 

 

Barring a significant fundamental turnaround, investors should be prepared for further stock market weakness. I would monitor the combination of insider trading, investor sentiment, and market technical conditions for signs of an intermediate term bottom.

We are not there yet.
 

The tone is still risk-off

Posted by Cam Hui -

Mid-week market update: I have some good news and bad news. The good news is the performance of the NASDAQ 100,  the market leadership, has stabilized. The relative performance of the NASDAQ 100 against the S&P 500 successfully tested a rising relative trend line, and the relative uptrend is still intact.
 

 

The bad news is the NDX rally failed at the 50 day moving average, and the rest of the market is maintaining a risk-off tone.
 

 

Sentiment not washed-out

There are numerous signs that sentiment is nowhere near a capitulation wash-out. Macro Charts highlighted analysis from Deutsche Bank indicating that equity flows are still strong for technology. These are not signs of fear, but greed.
 

 

Despite the market decline, there are few signs of anxiety in the put/call ratio, which is hardly elevated compared to levels seen at past short and intermediate term bottoms.
 

 

However, the nervousness in the option market can be seen in the term structure of option implied volatility, or premiums. A recent analysis from Goldman Sachs shows that the market expects volatility to be elevated until well after the election. I suggested several weeks ago that a contested election after the November 3 might be possible (see Volmageddon, or market melt-up?). That scenario is being priced into the markets.
 

 

To be sure, short-term retail speculation is starting to wane. Analysis from Callum Thomas shows that the volume ratio of leveraged long to short ETFs has pulled back. Readings are neutral and falling, but they are not at capitulation fear levels yet.

 

 

 

Risk appetite still cautious

Risk appetite indicators are neutral to negative. The ratio of high volatility to low volatility stocks exhibited a minor negative divergence when the market re-tested and broke technical support this week. As well, NYSE A-D Volume exhibited a strong negative divergence on the support break, though the NYSE A-D Line was neutral. These negative divergences were not as strong or clear as the negative divergences when the market broke support on a re-test in March. However, current market internals are nevertheless concerning.
 

 

Weak risk appetite is also evident in the currency markets. The USD Index staged an upside breakout of the 94 level. The USD Index has been highly negatively correlated with the S&P 500 (bottom panel). In addition, the Australian Dollar to Japanese Yen exchange rate (AUDJPY) is an extremely sensitive barometer of currency market risk appetite, and it is also showing signs of weakness.
 

 

In conclusion, investors and traders should brace for a period of sloppiness and volatility until the November election. Sentiment is nowhere near wash-out levels, and risk appetite is weak. The path of least resistance for the stock market is down.

Disclosure: Long SPXU
 

Election jitters are rising

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Bearish

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

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

 

More election volatility

While I am not a volatility trader, my recent calls on the evolution of volatility have been on the mark. Three weeks ago, I raised the possibility of a volatility storm (see Volmageddon, or market melt-up?) owing to rising election jitters. I concluded “I would estimate a two-thirds probability of a correction, and one-third probability of a melt-up, but I am keeping an open mind as to the ultimate outcome”. Two weeks ago, I turned more definitive about rising volatility and called for a volatility storm (see Brace for the volatility storm).
The rising election induced volatility theme has become increasingly mainstream in the financial press. Bloomberg highlighted that the one and three month spread in the MOVE Index, which measures bond market volatility, is spiking.

 

 

Marketwatch also reported that analysis from BNP Paribas shows that the implied equity market volatility over the election window is sky high compared to past realized returns of election results. 

 

 

In addition, all these option readings were taken before the news about the death of Supreme Court Justice Ruth Bader Ginsburg. Should the election results be contested and wind up in the Supreme Court, the odds of a 4-4 deadlocked decision just rose with Ginburg’s death, in which case the lower court’s decision would stand. This raises the odds of judicial and constitutional chaos. Imagine different states with wildly inconsistent decisions on balloting. The Supreme Court nomination fight also raises the political resolve of both sides in Congress. Don’t expect any stimulus bill before the election, and even a Continuing Resolution to fund the federal government beyond September 30 is in jeopardy. Watch for implied volatility to rise in the coming week.
It seems that the bears have taken control of the tape, based on a combination of election uncertainty and a reversal of excessive bullish retail positioning on Big Tech stocks.

 

 

Technical breaks

The S&P 500 and NASDAQ 100 are experiencing major technical breaks from both short and intermediate term perspectives, which is leading to the conclusion that the correction isn’t over.
In the short run, the daily chart of the market leadership NASDAQ 100 violated both a rising trend line and its 50 day moving average (dma), which are important levels of psychological and technical support. As Big Tech sectors (technology, communication services, and Amazon) comprise 44% of S&P 500 index weight, weakness in the tech heavy NASDAQ 100 is an important indicator of the direction of the broader market.

 

 

The S&P 500 also violated an important rising trend line and exhibited a minor break below its 50 dma.

 

 

The weekly chart of the S&P 500 is just as ominous. The index has broken down through a breakout turned support level for two weeks. In addition, the stochastic has recycled from an overbought reading, which is an intermediate term sell signal. 

 

 

The weekly chart of the NASDAQ 100 also flashed a similar stochastic sell signal.

 

 

These conditions lead me to believe that an intermediate term correction has begun, and will not be complete until the election in early November.

 

 

Sentiment still frothy

The second major reason for the bearish break is the unwind of excessive bullish sentiment among retail traders. There has been an explosion of stories about the speculative activity among Robinhood traders due to the attraction of its zero commission policy, and the frenzy has spread to other major online brokerage firms. The froth was quite evident when even TMZ began publishing sponsored articles about day trading.

 

 

Moreover, retail call option activity has exploded. An astute reader pointed out analysis from SentimenTrader showing that while retail call volumes have receded, they are still very high and small traders are still very bullish. Despite the pullback in the popular Big Tech stocks, SentimenTrader wrote that bullish sentiment remains elevated and it has not fully capitulated.

Clearly, there was a big pullback in speculative volume last week, dropping off by more than 50% from the upside panic to start September. But when zooming out, we can see that last week was still higher than any previous record high, by far.

 

 

 

An orderly retreat

The market has been devoid of the panic that marks intermediate term bottoms. The Fear and Greed Index is falling, but the reading is only neutral.

 

 

The weakness in the NASDAQ 100, which had been the market leadership, is especially disconcerting. BoA pointed out that FANG short interest is extraordinarily low, indicating that short covering demand will not put a floor on these stocks as they weaken.

 

 

Moreover, the market’s retreat has been orderly. The percentage of stocks above their 10 dma are in a downward sloping channel of lower lows and lower highs.

 

 

In conclusion, the bears have taken control of the tape. Traders should brace for a period of weak and choppy markets until the November election and beyond. Much will depend on the course of electoral fortunes. The Presidential debates lie ahead, and there is always the possibility of an October surprise. Moreover, there is a high level of uncertainty over whether the election results would be contested in the courts, or even worse, in the streets, after November 3. It is therefore difficult to formulate downside target levels, except to say that the combination of sentiment and technical indicators are not pointing to a bottom today.
Disclosure: Long SPXU

 

A healthy rotation into cyclical stocks?

Posted by Cam Hui -

There is growing evidence that the stock market is undergoing a rotation from large cap technology to cyclical and reflation stocks. Exhibit A is the market action of the tech heavy NASDAQ 100, which violated a key rising channel and also violated its 50 day moving average (dma). By contrast, the broader S&P 500 is testing its 50 dma and only exhibited a minor break.
 

 

Even as the S&P 500 and NASDAQ 100 struggled, Material stocks have been making new all-time highs, and its performance against the S&P 500 has decisively turned up.
 

 

 

A well-telegraphed rotation

The rotation into the reflation and cyclical theme has been in evidence for a few months. The August BoA Global Fund Manager Survey showed that global managers were positioning for global reflation.
 

 

The September survey shows that the shift is continuing. While month-to-month readings can be noisy, managers continued the trend of buying industrial stocks, value over growth, small caps over large caps; and selling tech. In addition, managers regard US large cap tech to be the most crowded trade.
 

 

This weakness in large cap technology is overdue. Sentiment is becoming frothy, as evidenced by this tweet from Jim Bianco of Bianco Research.
 

 

To be sure, US large cap technology profits have outperformed the rest of the economy. The combination of better profitability and investor enthusiasm has made Big Tech now accounts for 44% of the weight of the S&P 500.
 

 

However, Cormac Mullen at Bloomberg pointed out that there are cheaper ways of gaining large cap technology exposure. The S&P Asia 50 Index is just as concentrated in Big Tech names, with Tencent, Samsung Electronics and chipmaker TSMC as its three biggest stocks, accounting for over 40% of index weight. The S&P Asia 50 Index trades at 14x forward earnings compared to 27x for the NASDAQ 100.
 

 

 

Early stealth rotation warnings

There is also extensive evidence of sector rotation under the market’s hood from the behavior of small cap stocks. These sets of charts are designed to disentangle sector and size performance by answering the following questions:

  • How is the large cap sector performing against its large cap benchmark, the S&P 500? (Top panel, black line)
  • How is the small cap sector performing against its small cap benchmark, the Russell 2000? (Top panel, green line)
  • How is the small cap sector performing against its large cap counterpart? (Bottom panel, green line)
  • How are small caps performing against large caps? (Bottom panel, black line)
The first chart shows the divergence between large and small cap technology stocks. Even as large cap technology remains in a tenuous relative uptrend, small cap technology relative returns peaked out in April and have been lagging ever since.

 

Large and small cap industrial stocks are also exhibiting a divergence, but with small caps leading the way upwards. Small cap industrial stocks began to turn up in relative returns in early July, and telegraphed the eventual relative upturn of their large cap counterparts.

 

 

The performance of consumer discretionary stocks make an interesting case study. Amazon dominates the weight of the large cap sector, but the relative performance of both large and small cap consumer discretionary stocks parallel each other, and small caps were able to achieve these returns without the aid of Amazon.

 

 

 

Key risks to rotation thesis

There are several key risks for investors who want to jump on the cyclical and reflation trade. One risk is the global cyclical rebound may be a Chinese mirage. China is a voracious consumer of commodities, and its cyclical rebound has been powered by a policy-driven industrial production revival at the expense of the domestic economy. The signals from commodity prices may therefore be a mirage, and they may not be sustainable if global consumer demand does not rebound. 
Well-known China watcher Michael Pettis explained the nature of China’s unbalanced and uneven recovery in an FT Alphaville article.

Economic recovery in China (and the world, more generally) requires a recovery in demand that pulls along with it a recovery in supply. But that isn’t what’s happening. Instead Beijing is pushing hard on the supply side, mainly because it must lower unemployment as quickly as possible. It is this push on the supply side that is pulling demand along with it…

This recovery isn’t sustainable without a substantial transformation of the economy, and unless Beijing moves quickly to redistribute domestic income, it will require either slower growth abroad or an eventual reversal of domestic growth once Chinese debt can no longer rise fast enough to hide the domestic demand problem.

 

 

The markets are already starting to discount the risks of an unsustainable recovery. The stock markets of China and its major Asian trading partners have flattened out after several months of gains.

 

 

From a global perspective, the Citigroup regional Economic Surprise indices, which measure whether economic data is beating or missing expectations, are peaking and in the process of rolling over. This is an indication that the momentum of the recovery is starting to stall, which is bearish for the cyclical recovery thesis.

 

 

The second key risk for investors is a credit crunch that brings economic expansion to a halt. In the past, the usual sequence of events in a recession is: recession, credit event and blow-up, and banks tighten credit in response. As the extent of the credit event and blow-up becomes known, the stock market anticipates the monetary response and recovers. This time, the stock market rallied even before any signs of a credit blow-up.
To be sure, the Fed has stepped in with an extraordinary level of accommodation, but while the Fed can supply liquidity, it cannot supply solvency. Only the fiscal authorities can make the decision to rescue firms that get into trouble. Fed Chair Jerome Powell made it clear that under the “Main Street Lending Facility”, 13(3) requires good evidence that the borrower is solvent. Dodd-Frank made it more difficult to do emergency lending in 13(3) on purpose. In the absence of further fiscal support, expect mass small and medium business bankruptcies.
The real estate sector is especially vulnerable to a credit crunch. In the past, tightening credit conditions led to softness in commercial real estate prices. In addition, tenant eviction moratoriums puts increasing financial pressures on residential property landlords, and a credit blowup in real estate is on the horizon if Congress doesn’t take action.

 

 

Both large and small cap REITs are lagging the S&P 500, with no bottom in sight.

 

 

The combination of a possible credit event, and financial repression will pressure on banking profitability. The Fed’s Summary of Economic Projections (SEP) from the September FOMC meeting shows that it expects inflation, as measured by core PCE to be 1.7-1.9% in 2022 and 1.9-2.0% in 2023, and its Fed Funds projection to be 0.1% in 2022, and 0.1-0.4% in 2023. While the initial reaction that this was a dovish pivot by the Fed as it is making an implicit promise to not raise rates until 2023, it also implies a significant period of negative real policy rates, which is a form of financial repression that destroys bank margins. As well, if the Fed is to hold rates down until 2023, it will also have to eventually engage in yield curve control to hold down rates further out in the yield curve, which will also pressure bank margins.

 

 

Lastly, investors need to consider why the market would rotate from large cap tech and growth to cyclicals and value. During recessionary and slow growth periods, the market bids up growth stocks in an environment of scarce growth. As a recovery broadens out, sector and style rotation shifts into cyclicals and value as growth becomes more abundant.
This brings up two problems. First, economic recovery depends on the effectiveness of health care policy, fiscal policy, and monetary policy, in that order of importance. The effectiveness of global health care policy remains a question mark, as this pandemic needs to be controlled all over the world to prevent reservoirs of the virus from leaking out to spark periodic outbreaks. In addition, the US fiscal policy response has been uneven, even though monetary policy makers are doing all they can to backstop the economy.
In addition, a rotation out of Big Tech into cyclical sectors presents a liquidity problem. The weight of Big Tech is 44%, which is over double the size of the cyclical sectors. Investors deploying funds out of US Big Tech will need to find better opportunities either abroad or in other asset classes. This will mean lower overall stock prices.

 

 

In conclusion, the market has been undergoing a rotation from US large cap tech into stocks with cyclical and reflationary exposure. Whether the rotation is a “healthy” one remains to be seen. There are several risks if investors were to hop on the cyclical rotation theme. The global cyclical revival may not be sustainable; a credit crunch sparked by tightening lending requirements could stop the recovery in its tracks; and the rotation could put downward pressure on the S&P 500 because of the massive weighting of Big Tech stocks compared to cyclical sectors.
Under these conditions, investors are advised to focus first on risk, rather than return expectations. SKEW, which measures the cost of hedging tail-risk, is elevated indicating a high level of uncertainty as we approach the election in November. Volatility may stay heightened if a clear resolution isn’t known after November 3. 

 

 

As I pointed out before, the path of economic recovery depends on health care policy, fiscal policy, and monetary policy, in that order of importance. Until there is greater clarity about the path of health and fiscal policy, there will be few catalysts that reduces equity implied volatility and tail-risk – and that’s the probable reasoning behind the elevated SKEW.

 

Time to sound the all-clear?

Posted by Cam Hui -

Mid-week market update: Is time to sound the all-clear? The market staged a relief rally after last week’s weakness. Is the stock market ready to resume its uptrend?

A rally to new highs from these levels is unlikely. Last week’s pullback inflicted significant technical damage that, at a minimum, a period of sideways consolidation and base building will be necessary before the bulls can take control of the tape again. The S&P 500 violated a rising trend line that stretched back to April. As well, the 8 day moving average (dma) fell through the 21 dma, which is a bearish crossover. Repairing the damage will take time.
 

 

A similar pattern can also be seen in the NASDAQ 100. The NDX exhibited a similar breach of a rising trend line and a bearish crossover of the 8 dma and 21 dma. In addition, NASDAQ 100 implied volatility, as measured by VXN, rose coincidentally with NDX. This is another indication of a nervous and jittery market, which is not a good sign for stocks that had been the market leadership.
 

 

 

Sentiment is still frothy

Sentiment models are still showing signs of frothiness. Macro Charts pointed out that QQQ call options are still being bought aggressively in the face of last week’s sell-off. The bulls haven’t capitulated yet.
 

 

Moreover, single stock option volume is now 120% of share volume. Market wash-outs don’t look like this.
 

 

 

More headwinds

Today’s market action was distorted by the FOMC announcement, and it’s always difficult to get a decent read on the market on FOMC meeting days. Nevertheless, one possible sign of market direction is the inability of equities to hold their gains even after a dovish FOMC statement. 

In the short run, the NASDAQ 100, which were the market leaders, came into Wednesday overbought in the short-term. While overbought market can become more overbought, the odds favor either some form of pullback or consolidation at these levels.
 

 

 

Disclosure: Long SPXU
 

Some key questions for the Fed

Posted by Cam Hui -

As the FOMC conducts its two-day meeting after its big reveal of its shift in monetary policy, Fed watcher Tim Duy thinks that we won’t get much more in the way of details from the Fed after this meeting:

The odds favor the Fed maintains the status quo at this week’s meeting. It does not appear to have a consensus on enhancing forward guidance nor do I suspect FOMC participants feel pressure to force a consensus on that topic just yet. The general improvement in the data likely removes that pressure. The Fed will likely remain content to use the new strategy as justification for maintaining the current near zero rate path. Powell will continue to lean heavily on downside risks to the economy to entrench expectations that the Fed will stick to that path. The dovish risk this week is that the Fed does surprise with either more specific guidance or an alteration of the asset purchase program to favor longer term bonds. I don’t see a lot of risk for a hawkish outcome unless it was something unintentional in the press conference.

As the Citi Inflation Surprise Index edges up for the US, but remain muted for the other major regions, I have some important questions about the Fed’s new “average inflation target” policy.

 

 
 

Reported inflation or inflation expectations?

While other analysts are focused on the nuances of how the Fed is calculating its average, which admittedly is an important issue, I am more concerned about which inflation metric the Fed is targeting. It is mainly looking at reported inflation, in the form of core PCE and core CPI, or inflationary expectations?

Consider how the 5×5 inflationary expectations indicator has recovered, and it is nearing the Fed’s 2% target. While I understand that the new policy is allowing inflation to overshoot its 2% target, how long will the Fed allow expectations to overshoot before they become unanchored?

 

 

Gold is thought of as an inflation hedge, and gold prices have already staged an upside breakout to all-time highs. While bullion has pulled back to test its breakout level, further gains will create the risk of skyrocketing and “unanchored” inflation expectations. Keep an eye on the inflation expectations ETF (RINF), as it is testing a key falling trend line.

 

 

Should inflationary expectations start to rise, how will the Fed react to rising bond yields? Real rates are already negative, will the Fed engage in some form of yield curve control to suppress rates? We have already seen the effects of the ECB’s policy of financial repression has done to the European financial sector. Are these risks part of the reason why Warren Buffett lightened up on his banking sector positions?
 

 

These are all good questions that investors should ask of the Fed.
 

The bears take control, but for how long?

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Bearish

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

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

A sentiment buy signal?

As last week’s market action demonstrated, the bulls just can’t seem to catch a break. Even though the market was short-term oversold, rally attempts have been rather anemic. More worrisome is the behavior of the NASDAQ 100 (NDX), which had been the market leadership. The NDX convincingly breached a rising channel, and it is now testing its 50 day moving average (dma). While its relative uptrend against the S&P 500 remains intact, the relative performance of semiconductor stocks, which had also been a source of technology related market strength, also violated a rising trend line.

 

 

One bullish ray of hope came from Mark Hulbert, who pointed out that newsletter writer sentiment had plunged precipitously, which is contrarian bullish.

Consider the average recommended equity exposure level among a subset of short-term stock-market timers that I monitor on a daily basis. (This is what’s measured by my Hulbert Stock Newsletter Sentiment Index, or HSNSI.) This average currently stands at 30.1%, which means that the average timer now has 70% of his equity trading portfolio out of the market.

Just three weeks, ago, in contrast, the HSNSI stood at 65.9%. As you can see from the chart below, the HSNSI’s recent plunge rivals what happened during the February-March waterfall decline. That’s amazing, since the market’s early September sell-off — scary as it was — is child’s play by comparison. In contrast to a 34% plunge in the earlier downturn, the S&P 500 SPX, +0.05% from Sep. 2 to Sep. 8 lost less than 7%.

 

 

Hulbert concluded, “So long as the market timers on balance remain lukewarm about the stock market, sentiment for the next few weeks favors higher prices.”
Could this be the reprieve that the bullish traders need?

 

Other indicators begs to differ

Before the bulls get overly excited about Hulbert’s newsletter writer sentiment analysis, I present as this week’s Barron’s as contrarian magazine cover indicator. The cover story characterized the tech bubble as “Not Ready to Pop”, and “…could keep growing, despite recent setback for the stocks”. 

 

 

In light of the still elevated levels of the Citigroup Panic-Euphoria Model, and the NASDAQ 100’s technical trend breaks, “Da Nile isn’t just a river in Egypt”.

 

 

I would also point out that Mark Hulbert warned of a possible long-term market top in a separate Marketwatch article. Hulbert fretted about the wave of M&A activity, which is often the signs of a market top, and blind-trust SPAC financings in particular.

We’re currently in the seventh of those great waves, which began about six years ago. Added Rhodes-Kropf: M&A waves tend to accelerate right before they end. And recent M&A activity does appear to be such an acceleration. “I’m not predicting the end,” he said. “But I wouldn’t be surprised if we’re near the end.” 

One of the factors fueling the acceleration of M&A activity are the SPACs that are falling over themselves going public. There are the Special Purpose Acquisition Companies that are otherwise known as “Blank Check Companies.” SPACs have no business operations; they are created solely to raise money that would enable them to acquire other already-existing companies.

The intermediate term technical outlook doesn’t look very constructive either. Both the S&P 500 and NASDAQ 100 experienced outside reversals on their weekly charts in the first week of September. The bearish reversals were confirmed by weakness in the following week.

 

 

Other indicators suggest that we are nowhere near peak the levels consistent with a panic bottom. Twice in the last week, the equity-only put/call ratio fell, indicating bullishness and complacency, even as the S&P 500 closed near the lows of the day. Capitulation bottoms simply do not act this way.

 

 

The option positioning indicator from Goldman Sachs also points to a crowded long, which is contrarian bearish.

 

 

Another key component of my Trifecta Bottom Spotting Model, namely the term structure of the VIX, is not even inverted indicating a lack of fear. While TRIN did spike above 2 on Thursday as a sign of panic selling, the intermediate term overbought/oversold model has not reached the deeply oversold conditions consistent with an intermediate bottom. In the past, two or more of the components of this model needed to flash simultaneously buy signals before the market can see a durable trading bottom.

 

 

The Zweig Breadth Thrust Indicator is also not even flashing an oversold signal. I use this indicator in two ways, traditionally as a long-term buy signal, and as a short-term oversold indicator. A long-term ZBT buy signal is triggered with the ZBT Indicator falls below 0.40 to become oversold, and rebounds above 0.40 to an overbought condition at 0.615 within 10 trading days. While ZBT buy signals are extremely rare, ZBT oversold conditions are not. The following chart shows the actual ZBT Indicator, which is reported with a lag by StockCharts, and my own real-time estimate of the indicator. Neither is showing an oversold condition indicative of a short-term bottom.

 

 

The week ahead

Looking to the week ahead, the market faces a crucial test. Both the S&P 500 and NASDAQ 100 have violated key rising trend lines, and they are both testing 50 dma support levels. As well, the FOMC meeting next week could also be a source of volatility. Apple’s new product event scheduled for September 15 could also provide some market fireworks.

 

 

Short-term momentum is recovering from an oversold reading, but the bulls have been unable to muster much in the way of relief rallies even given the chance.

 

 

The market can stage a short-term relief market at any time. However, the intermediate term path of least resistance is still down.
Disclosure: Long SPXU

 

How far can the market fall?

Posted by Cam Hui -
Macro Charts recently observed that S&P 500 DSI is turning down from an overbought extreme. Historically, that has led to either sharp corrections or a prolonged period of choppiness.

 

 

In light of these conditions, I have been asked about downside equity risk. Is this the start of a significant downdraft? How far can stocks fall from current levels?

I answer these question in the context of secular leadership change. The Big Three market leadership themes in the latest bull cycle has been US over global stocks, large cap growth over value, and large caps over small caps. Transitions from bull to bear phase act to cleanse the excesses of the previous cycle. Until we see definitive signs of leadership changes, it may be too early to call a market top just yet.

From that perspective, we can see that the relative performance of US against global stocks is consolidating sideways after an uptrend; growth beating value, but pulling back; and small caps still lagging large caps after a brief episode of better relative performance.

 

 

NASDAQ crash?

There are growing, but unconfirmed signs that large cap growth and NASDAQ stocks are weakening. The NASDAQ 100 recently breached its rising trend channel, but its performance compared to the S&P 500 remains in a relative uptrend. In the short run, too much technical damage has been inflicted on these market leaders for them to continue to roar upwards immediately. The most constructive bullish scenario would see them consolidate sideways for several months before resuming their uptrend.
 

 

We can see further evidence of technology weakness from small cap tech stocks. Even as the relative performance of large cap tech against the S&P 500 pulled back but remains in a relative uptrend (black line top panel), small cap tech has dramatically underperformed the Russell 2000 (green line, top panel). These are all signals that an important correction may be brewing for the technology sector.

 

 

If this is indeed the start of a NASDAQ crash, bear in mind Bob Farrell’s Rule #4 as it applies to NASDAQ stocks: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” 

US investors tend to focus on the S&P 500, but there is a composition problem with the index. The top five stocks, which are all Big Tech, make up 23% of index weight. The Big Tech sectors, consisting of technology, communication services, and Amazon, comprise 44% of index weight. Therefore a Big Tech and NASDAQ crash will have an outsized effect on the S&P 500.

Let’s consider what happened last time these stocks deflated. The bear market spared mid and small cap stocks because they did not participate in the dot-com bubble. Non-US stocks crashed along with the NASDAQ because they were also caught in the tech frenzy. Fast forward to 2020, non-US stocks are likely more insulated from a potential NASDAQ crash today as they have gone nowhere since 2014. By contrast, mid and small cap stocks only began to trade sideways since 2018.
 

 

We can see that in the valuation of US large, mid, and small cap stocks. Their forward P/E ratios are either in the high teens or low 20s, which are elevated by historical standards.
 

 

From a global perspective, the forward P/E ratios of non-US regions are far lower than US stocks.
 

 

That said, too many investors are fighting the last war. The latest episode of US large cap growth dominance cannot be compared to the dot-com mania. The late 1990’s boom was led by unprofitable companies trading on price to eyeballs metrics. I would argue that the best comparable period to today is the Nifty Fifty era of the early 1970’s, when investors were willing to pay for quality growth at any price. The growth companies then were highly profitable, just as they are today. As a reminder, the S&P 500 went sideways for roughly a decade after the Nifty Fifty bust, though investors could have profited handsomely through sector and style rotation.
 

 

 

The economic outlook

The dominance of Big Tech growth stocks is evidence that the stock market isn’t the economy, and the economy isn’t the stock market. Looking ahead to the next 12-18 months, the economy should see definitive signs of recovery by Q2 or Q3 2021. New Deal democrat has been keeping an eye on the economy with his suite of coincident, short leading, and long leading indicators. He has been making the point that his indicators tells the story of an economy that wants to recover, subject to progress against the pandemic.

All three time frames are positive, although the nowcast is only slightly so.

It is really unfortunate that right now was the precise time reporting stopped on one of the consumer spending metrics, as the other (Redbook) went just slightly negative this week, “possibly” reflecting the termination of federal emergency unemployment benefits. To reiterate my overall outlook, over the next six months, the coronavirus, and the reactions of the Administration (both present and possibly new in January), the Congress, and the 50 governors to the coronavirus, are going to be the dispositive concerns. Nevertheless, by late next summer – especially if there is a reasonably effective vaccine – I expect the economy to be firmly in expansion.

Several Phase III vaccine trials are underway. Despite the AstraZeneca trials being put on hold, my base case scenario calls for availability of a vaccine by mid-2021. While there will inevitably be some teething problems with distribution, vaccine availability, or the anticipation of availability, should be the catalyst for an economic recovery. I would add that the fight against the pandemic needs to coordinated, and global in nature. As Bill Gates has pointed out, we don’t need the virus to be hiding in some pockets of the world and act as a reservoir for COVID-19 to infect others. Control and eradication needs to be global.
 

 

In the short run, the risk of a double-dip recession is rising due to fiscal inaction. High frequency data shows that the job recovery is stalling,

 

 

Initial jobless claims have bottomed and they are rising again.

 

 

The fiscal stimulus jolt is fading badly. Bloomberg reported that the extra $300 per week authorized under Trump’s Executive Order is running out of funds.

Funding is drying up for the supplemental weekly jobless benefit payments authorized by President Donald Trump at the start of August.

Funding for the Lost Wages Assistance program, which authorized an extra $300 a week from the federal government to most jobless benefit recipients, will not extend beyond the benefit week ending Sept. 5, according to statements by government officials from Montana, Texas and New Mexico. The states said they were informed Wednesday.

That said, most of these problems can be mitigated by a fiscal stimulus bill, either in the next few weeks or by a new Congress after the election.
 

 

Where are the opportunities?

Notwithstanding the short-term risks, a NASDAQ crash argues for a rotation into cyclical and value stocks. We are already seeing constructive patterns of relative performance among material, energy, and industrial sectors.
 

 

From a global perspective, non-US stock markets provide greater opportunities from both valuation and sector exposure perspectives. An analysis of the sector weight differences between the S&P 500 against MSCI EAFE (developed markets) and the MSCI Emerging Market Free Index shows that the S&P 500 is heavily overweight technology and communication services. EAFE is overweight value (financials) and cyclical sectors (industrials, and materials). EMF is overweight value (financials) and cyclical sectors (consumer discretionary, materials, and energy).

 

 

If the market were to experience a rotation from technology into value and cyclicals, non-US markets should benefit substantially from that shift.

 

 

Downside equity risk

We began this journey by posing the question of downside equity risk. If this is the start of a significant pullback, how far can stocks fall?

We can analyze the S&P 500 from several perspectives. While the S&P 500 does not represent the economy, the average stock, as measured by the Value Line Geometric Average, is a better representation. If the two were to converge, fair value for the S&P 500 would be about 2300, with the caveat that markets can overshoot on the downside.
 

 

If we were to analyze the market using the forward P/E ratio, it has historically bottomed out at a forward P/E of 10-15 times, and mostly at about 10. The main exception was the 2002 bottom, which was about 15 times.
 

 

Bottom-up 2021 EPS estimates is 166. At 10 times forward, this makes for an S&P 500 target of 1660; 12 times, about 2000; and 15 times, about 2500. The 2500 figure is also consistent with the analysis of fair value when comparing the Value Line Geometric Average to the S&P 500. FactSet reported that the 5-year average forward P/E is 17.1, and the 10-year average forward P/E is 15.4. The market bottomed out at just a forward P/E of just above 12 at the March panic low.
 

 

Putting it all together, my base case downside risk for the S&P 500 is 2000-2300, with a possible overshoot to about 1700 if the market were to really panic. This does not necessarily mean that the market will fall that far as it is based on the assumption of a NASDAQ and large growth stock crash. US equity investors can be largely insulated from the downdraft and find opportunity in cyclical and value stocks. Global investors will find more upside potential in non-US equities, with a particular focus on emerging markets.

The story of two trend breaks

Posted by Cam Hui -

Mid-week market update: While it may seem like the Apocalypse for people trading the momentum FANG+ stocks, this is not the Apocalypse. Sure, the market has violated its rising trend line, but this trend break is nothing like the COVID Crash experienced earlier this year.
 

 

Before the bears get all excited, there are several key differences between the current trend break and the February trend break. While the NYSE McClellan Summation Index (NYSI) warned of deteriorating breadth in both cases, net NYSE highs have not broken down in the manner of February 2020.

The latest trend break was led to the downside by Big Tech stocks. The analysis of the NASDAQ 100 show similar violations of rising trend lines, and similar warnings by the NASDAQ McClellan Summation Index (NASI), but the NDX/SPX ratio remains in a relative uptrend. We can see the strength of NASDAQ stocks during the COVID Crash by observing that while the SPX broke the uptrend in early February, the NDX uptrend held during that period and did not break down until later in the month. As well, similar the S&P 500 chart, the current readings NASDAQ net new highs are also not showing any signs of signification deterioration.
 

 

Fading momentum

If this is not the start of a significant pullback, what’s going on? It might be a case of fading macro and price momentum. The Economic Surprise Indices, which measures whether top-down economic data are beating or missing expectations, are all starting to roll over all around the world.
 

 

The withdrawal of fiscal stimulus is starting to bite. BoA tracked the card spending of all known unemployment insurance recipients for the month of August, and all have seen significant declines.
 

 

Calculated Risk also reported that timely rent payments slid -4.8% in September compared to August.
 

 

A recent Bloomberg article enumerated the rising risks all around the world:

The world economy’s rebound from the depths of the coronavirus crisis is fading, setting up an uncertain finish to the year.

The concerns are multiple. The coming northern winter may trigger another wave of the virus as the wait for a vaccine continues. Government support for furloughed workers and bank moratoriums on loan repayments are set to expire. Strains between the U.S. and China could get worse in the run-up toNovember’s presidential election, and undermine business confidence.

“We have seen peak rebound,” Joachim Fels, global economic adviser at Pacific Investment Management Co., told Bloomberg Television. “From now on, the momentum is fading a little bit.”

In addition, different indicators price momentum factor are also weakening.
 

 

Negative seasonality

Another explanation might just be seasonality, which is negative for stocks over the next few weeks.
 

 

Renaissance Macro also observed that election year seasonality is turning down just at the right time.
 

 

A bounce, then…

In the short run, the market is due for a bounce of 1-3 days as readings as of last night (Tuesday) have become sufficiently oversold to warrant a relief rally.
 

 

But make no mistake, this decline isn’t over. The equity-only put/call ratio actually fell even as the market closed near the lows of the day yesterday. This is indicative of excessive complacency among option players.
 

 

Watch for a short-term relief rally, followed by a resumption of the pullback.

Disclosure: Long SPXU