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Labor Day is the traditional kickoff of presidential election campaigns. Before that, only die-hard political pundits and devotees pay attention to the election. It is with that in mind we revisit the economic criteria for Trump’s political fortunes that I outlined just after his inauguration (see Forget politics! Here are the 5 key macro indicators […]
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:
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.
Why Are VIX and S&P 500 Moving Together?
Something odd is happening in the equity option market.
Equally puzzling is the disconnect between stock and bond implied volatility. While stock volatility has surged, bond market volatility remains tame. What’s going on?
Historically, high correlations between SPX and VIX have usually led to market sell-offs. Under a minority of circumstances, they have also signaled market melt-ups. How can we explain these unusual conditions in the option market?
I present two explanations for the option market anomaly, which are not mutually exclusive. The Financial Times pointed out the market is pricing in an exceptionally pronounced volatility surge around the US election in early November in anticipation of electoral chaos.
Axios reported that a Mike Bloomberg backed polling firm is warning of potential electoral chaos on election night.
A top Democratic data and analytics firm told “Axios on HBO” it’s highly likely that President Trump will appear to have won — potentially in a landslide — on election night, even if he ultimately loses when all the votes are counted.
Way more Democrats will vote by mail than Republicans, due to fears of the coronavirus, and it will take days if not weeks to tally these. This means Trump, thanks to Republicans doing almost all of their voting in person, could hold big electoral college and popular vote leads on election night.
This scenario has the potential to spark uncertainty an order of magnitude higher than the 2000 Bush-Gore hanging chad Florida electoral controversy.
Hawkfish CEO Josh Mendelsohn calls the scenario a “red mirage.”
- “We are sounding an alarm and saying that this is a very real possibility, that the data is going to show on election night an incredible victory for Donald Trump,” he said.
- “When every legitimate vote is tallied and we get to that final day, which will be some day after Election Day, it will in fact show that what happened on election night was exactly that, a mirage,” Mendelsohn said. “It looked like Donald Trump was in the lead and he fundamentally was not when every ballot gets counted.”
President Trump is already tweeted to alert his supporters about that possibility. A closely contested election with results that are not trusted by one side could spark protests and counter-protests all over the country. The events in Portland and Kenosha are just a preview. Imagine multiplying them by 10, or 100 as armed protesters from both sides flood the streets.
This is hardly a scenario promoted by the radical fringe. Even The Economist devoted an entire issue to this subject.
Are civil wars bullish? Is it any wonder why volatility premiums are elevated around the time of the election?
A shorter term explanation for the dual rise in stock prices and implied volatility is the gamma chase by dealers. The perennially bearish website Zero Hedge reported that Nomura’s cross-asset analyst Charlie McElligott found that there has been a very large buyer of technology stock call options, to the tune of over $1 billion in option premiums.
Over the past few weeks, there has been a massive buyer in the market of Technology upside calls and call spreads across a basket of names including ADBE, AMZN, FB, CRM, MSFT, GOOGL, and NFLX. Over $1 billion of premium was spent and upwards of $20 billion in notional through strike – this is arguably some of the largest single stock-flow we’ve seen in years. “The average daily options contracts traded in NDX stocks to rise from ~4mm/day average in April to ~5.5mm/day average in August (a 38% jump in volume).
As the street got trapped being short vol, other names in the basket saw 3-4 standard deviation moves higher as well – on Wednesday FB rallied 8% (a 3 standard deviation move), NFLX rallied 11% (a 4 standard deviation move), and ADBE rallied 9% (a 3 standard deviation move).
The most natural place to hedge being short single name Tech volatility is through buying NDX volatility. As such, there has been a flood of NDX volatility buyers with NDX vols up about 4 vol points in 2 trading days. And if NDX volatility is going up, SPX volatility/VIX will eventually go up too.”
Dealers became net short as this very large buyer came into the market. Consequently, market makers had to buy the underlying shares in order to hedge their position, which sparked a bullish stampede and NASDAQ melt-up. Zero Hedge concluded:
Putting it all together, we find that a combination of market euphoria, free options trading, and most importantly, few market-makers have sparked the fire. It also means that “a few large hedge funds understood this and have added fuel to the fire by pushing implied higher and higher and putting further pressure on the likes of Citadel and Goldman. With this process helping drive names like Apple and Tesla, this also makes sense why Breadth has been so terrible.
The Financial Times subsequently identified the large buyer as Softbank. Softbank spent roughly $4 billion in call option premiums to control $50 billion of equity assets. The purchases appears to have sparked a bullish stampede. SentimenTrader pointed out that the retail small option buyers continued to pile into their bullish bets despite the late week sell-off.
Maybe some reasons for the market swoon last Thursday was the disappearance of Softbank buying, or just buyer exhaustion.
We can observe the footprints of the call option buyers in the price action of the NASDAQ 100 (NDX) and VXN, which is the implied volatility of the NDX. VXN (top panel) had been basing and began to rise in lockstep with NDX. VXN then went on to stage an upside breakout out of its multi-month base, indicating a possible volatility storm ahead. From a technical perspective, NDX remains in a rising channel, and the relative performance of NDX is still in a relative uptrend. Until we see downside breaks in those trend lines, traders should not turn bearish.
Should we see downside technical breaks, downside risk could be considerable. Analysis from JPMorgan reveals that market participants have completely unwound their equity short positions from March. Short interest is extremely low, and there is little buying support from short covering should stock prices take a tumble.
Tactically, where do we go from here? Is this just a brief pullback, or the start of a major correction? The blogger Urban Carmel observed that when the S&P 500 falls -3% or more, such downdrafts tend to occur in clusters, and the first one from a high doesn’t mark the initial low, and such strong down momentum typically followed by a lower close in the day or two. In the last year, there were two bounce and successful re-tests of the lows, and one market plunge.
What’s the likely outcome? Market internals are deceptive. my high beta to low volatility equity risk appetite indicator is flashing a risk-on signal, but it flashed a similar signal at the bottom of the initial market plunge in March. We are likely to see some sort of short-term bounce early next week, as the market is sufficiently oversold to warrant a relief rally. I am watching the behavior of this indicator, as well as breadth metrics such as the Advance-Decline Line and Volume, for signs of either a positive or negative divergence on the re-test before declaring a bullish or bearish verdict.
Short-term momentum presents a mixed picture. The percentage of stocks in the NASDAQ 100 above their 5 dma is oversold. As NASDAQ stocks have been the tail that wag the dog market leaders, the market is ripe for a bounce early next week.
On the other hand, traders have to be aware of the possibility that this is just the start of a major downdraft. The percentage of S&P 500 stocks above their 5 dma is not oversold, and the pattern has eerie parallels to the major market decline in March.
Sentiment is extremely jittery. Retail traders piled into inverse ETFs late last week. While this is contrarian bullish, it’s difficult to believe that the wild speculative frenzy of the past few weeks could be unwound in two days. Be prepared for more volatility.
In conclusion, there are both short and medium term catalysts for a market volatility storm. Traders should expect heightened volatility and risk premium compression between now and Inauguration Day. Hopefully, any electoral chaos should be settled by then.
Disclosure: Long SPXU
It has been over a week since Jerome Powell’s virtual Jackson Hole speech in which he laid out the Fed’s revised its updates to its Statement on Longer-Run Goals and Monetary Policy Strategy after a long and extensive internal review. There were two changes. one was a shift towards an “average inflation targeting” regime, where the Fed “seeks to achieve inflation that averages 2 percent over time”. The other was an emphasis on to target low unemployment. Instead of minimizing “deviations from the maximum” employment, it will minimize “shortfalls of employment from its maximum level.”
The results of the review were much like a student handing in a term paper after much effort, but the assignment is incomplete, and leaves many questions unanswered.
On the last point, I had a discussion with a reader about the implications for the bond market in the wake of Powell’s speech. Wouldn’t a credible 2% average inflation target translate into a substantial surge in bond yields? How far above 2% does the 10-year Treasury have to trade? What does that mean for equity valuations?
Supposing that you knew for certain that inflation will average 2% over the next 10 years, you would certainly demand a Treasury yield of over 2%, say 2.5%. The 10-year yield needs to rise by at least 1.8%. What would that do to the economy, and the stock market?
Forward P/E ratios are stratospheric compared to their own history, but some investors have justified the high multiple by pointing to low rates. TINA, or There Is No Alternative. Valuations are reasonable based on equity risk premium (ERP), which is some variation of E/P – interest rates. Here is the Q2 2020 ERP calculation of Antonio Fatas, professor of economics at INSEAD. While the stock market appears reasonably priced based on ERP today, raising rates by 1.8% (everything else being equal) would make stocks far less attractive compared to fixed income alternatives.
Something doesn’t add up. The Fed’s review appears incomplete. There are too many unanswered questions.
The Fed needs to work on its communication policy. Reuters reported that, one day after the Powell speech, regional Fed presidents had wildly differing interpretations of what the average inflation target policy meant.
Dallas Fed President Robert Kaplan said he would be comfortable with inflation running a “little bit” above the Fed’s 2% inflation target if the economy were to once again be running near full employment.
“And for me, a little bit means a little bit,” or about 2.25%, Kaplan said during an interview with Bloomberg TV. “I still think price stability is the overriding goal and this framework doesn’t change that.”
St. Louis Fed President James Bullard, who along with Kaplan and their 15 policymaker colleagues will carry out the Fed’s new strategy, had a different answer.
“Inflation has run below target, certainly by half a percent, for quite a while, so it seems like you could run above for a half a percent for quite a while,” Bullard told CNBC.
And Philadelphia Fed President Patrick Harker had yet another view.
“It’s not so much the number. … It’s really about the velocity,” Harker said during a separate interview with CNBC, adding that inflation “creeping up to 2.5%” is different from inflation that is “shooting past 2.5%.”
A subsequent speech by Vice Chair Richard Clarida was equally unclear about the Fed’s plans, other to convey the impression that the FOMC intends to steer monetary policy by the seat of its pants.
To be clear, “inflation that averages 2 percent over time” represents an ex ante aspiration, not a description of a mechanical reaction function—nor is it a commitment to conduct monetary policy tethered to any particular formula or rule.
Fed governor Lael Brainard was equally ambiguous when she described Flexible Average Inflation Targeting (FAIT) in a separate speech.
Flexible average inflation targeting is a pragmatic way to implement a makeup strategy, which is essential to arrest any downward drift in inflation expectations.While a formal average inflation target (AIT) rule is appealing in theory, there are likely to be communications and implementation challenges in practice related to time-consistency and the mechanical nature of such rules. Analysis suggests it could take many years with a formal AIT rule to return the price level to target following a lower-bound episode, and a mechanical AIT rule is likely to become increasingly difficult to explain and implement as conditions change over time. In contrast, FAIT is better suited for the highly uncertain and dynamic context in which policymaking takes place.
In practice, the new monetary policy framework means that the Fed will be slower to tighten to allow the economy to run “hot” and ensure that inflation rises above 2% and averages at 2%. The key indicator to watch is inflation expectations, which needs to stay anchored at 2%.
After over a decade of sub-2% inflation, the new policy framework does nothing to address how the Fed plans to raise inflation to the 2% average. For that, the central bank needs the cooperation of its lab partner, fiscal policy.
Lael Brainard’s recent speech pleaded for help from fiscal policy as she acknowledged that monetary policy could not do all the heavy lifting by itself.
Looking ahead, the economy continues to face considerable uncertainty associated with the vagaries of the COVID-19 pandemic, and risks are tilted to the downside. The longer COVID-19-related uncertainty persists, the greater the risk of shuttered businesses and permanent layoffs in some sectors. While the virus remains the most important factor, the magnitude and timing of further fiscal support is a key factor for the outlook. As was true in the first phase of the crisis, fiscal support will remain essential to sustaining many families and businesses.
In the short run, political gridlock has gripped Washington as both sides have been unable to agree on a CARES Act 2.0 fiscal relief package. In addition, a second important deadline is approaching, as the government faces a shutdown on October 1st in the absence of interim funding legislation. Fortunately, Treasury Secretary Mnuchin and House Speaker Pelosi appear to be agreeable to working together to avoid a government shutdown.
In short, the Fed’s lab partner, fiscal policy, is nowhere to be seen, and the Fed’s policy review is not very meaningful without the partner’s presence.
Notwithstanding the short-term battles on Capitol Hill, chances are that policy direction will move towards a Modern Monetary Theory (MMT) framework no matter who wins in November. How will that play out?
For some clues of how the combination of fiscal and monetary policy might work, we can consider the Abenomics experiment, named after Japanese Prime Minister Abe Shinzo, who recently announced his resignation. Abe’s decade-long efforts to halt Japan’s deflation consisted of the “three arrows” of Abenomics, fiscal stimulus, monetary stimulus from the BoJ, and structural reform of the Japanese economy. The results was a mixed bag of successes and failures.
The initial thrust of the BoJ’s aggressive monetary policies briefly pushed the CPI inflation above 3%. But loose monetary policy was offset by tight fiscal policy, as the government imposed a sales tax increase. So much for inflation.
Despite the decline in headline CPI inflation, inflationary expectations rose, which was constructive.
Abenomics was also able to partially revive capital expenditures.
History doesn’t repeat, but rhymes. Undoubtedly there will be some bumps along the way as political regimes change in Washington over the next 10 years, but investors can use the same Abenomics template and should expect similar mixed results in the US economic outlook over the next decade.
What does all this mean for investors? Over the next 6-12 months, the key variables are the election, the path of fiscal policy, and how the Fed reacts to rising bond yields. Inflation expectations, as measured by the 5×5 forward bond yield, had been rising steadily and peaked at 1.91% last week before retreating. This put upward pressure on the 10-year Treasury yield.
At some point, higher Treasury yields will threaten the fragile economic recovery, and it will also put downward pressure on stock prices. A recent Bloomberg article, “Treasury Yields Will Become A head For Stocks Around 1%”, tells the story. Higher rates will put downward pressure on equity prices.
How far will the Fed allow yields to rise? Can it act to hold down yields and maintain the credibility of an average 2% inflation target? Richard Clarida rejected the notion of yield curve control (YCC) in his recent speech, but left the door open for further action in the future.
Most of my colleagues judged that yield caps and targets were not warranted in the current environment but should remain an option that the Committee could reassess in the future if circumstances changed markedly
The Fed is engaged in a tight-wire act with its YCC tool. If it doesn’t suppress rates, it risks snuffing the recovery and stock prices. Suppress rates too much, and it will devastate the banking system by compressing interest rate margins, raise inflationary expectations and run the risk of them becoming unanchored beyond the 2% targeted level. Should it have to resort to YCC, the Fed will begin with jawboning, or forward guidance, before actually intervening in the bond market. Sometime the threat of action is more powerful the actual action itself.
For investors, this means returns in Treasury market are asymmetric. The Fed will allow yields to fall as the market dictates. Fixed income investors should expect returns to be reasonable. There will not be significant downside risk in bond prices. On the other hand, the path of equity prices will be more dependent on more variables: how the world controls the pandemic, the path of fiscal policy, and the evolution of earnings expectations.
In conclusion, the Fed’s policy review raises more questions than answers. The Fed has a limited ability to boost the economy, but it’s known that it has the power kill it. This review has softened the “kill the economy because it’s overheating” policy, but there are many questions about the mechanisms for boosting growth. I expect there will be short-term hiccups between now and the Presidential Inauguration in January, but expect some form of Abenomics like policy over the next decade. The results will be uneven, and will depend largely on the path of fiscal policy, rather than monetary policy.
Mid-week market update: One of the defining characteristics of the current bull run is the dominance of US large cap growth stocks. Joe Wiesenthal wrote about the problem of the effect of the “superstar companies” on the economy in a Twitter thread and in a Bloomberg commentary. The “superstar companies” have few employees, and therefore high labor productivity.
But if labor productivity is all that matters, and you don’t need any workers, where is the demand going to come from?
If you think that the key thing is demand, and that demand drives investment, driving productivity, then it’s not about declaring some tech companies winners and declaring everyone else as zombies that should die, it’s about fostering income equality to drive spending.
Something nobody ever seems to point out is how it’s interesting that productivity growth is historically quite low, even though we have an economy that’s dominated by some of the most productive companies in human history. Maybe more ultra-productive companies aren’t the answer?
While Big Tech and large cap growth are still red hot, more cracks are showing up in the growth stock armor. The chart below shows an unexpected divergence in relative performance between large cap and small cap growth (top panel). If we were to benchmark US large and small cap stocks against global stocks, as measured by the MSCI All-Country World Index (ACWI), we can see that large cap growth remains in a relative uptrend against ACWI (middle panel), but the relative performance of small caps and small cap growth have flattened in the past few months.
While these are not immediate bearish signals, they represent “under the hood” warnings of pending trouble in US equities.
As for the rest of the stock market, there are plenty of warnings from sentiment models. The Citi Panic-Euphoria Model is wildly euphoric, though readings are not as high as they were during the height of the dot-com bubble.
One reader alerted me to Willie Delwiche’s analysis of sentiment, where six out of eight models are bearish, with two in neutral. That’s another sign of extreme bullishness, which is contrarian bearish.
Other signals of market headwinds come from the behavior of the “smart money” crowd. One measure of “smart money” are corporate insiders, who have shown little tendency to step up and buy the shares of their companies. To be sure, insider trading works best mainly as a buy signal, when buying swamps selling as it did in March.
Another savvy investor is billionaire distressed investor Sam Zell, who said in a CNBC interview that “it’s really too early for the normal clearing process” to be buying right now, and “there will be significant opportunities probably in Q4 or first quarter of next year”. Zell’s remarks about the “clearing process” is code that the market is being held up by fiscal and monetary support, and he is not ready to buy until he sees signs of distress.
Warren Buffett also told a similar story. He stated earlier in the year that while he saw signs of distress during the March COVID Crash, Berkshire Hathaway was unable to react and use its cash horde to make distressed buys because of official intervention.
Nevertheless, we have important signals from Buffett’s recent actions. Some gold bugs got very excited recently when Berkshire bought a position in Barrick Gold, but the position was relatively small and the decision was likely made by one of the Buffett’s lieutenants. More importantly, Berkshire recently disclosed new positions in five Japanese trading companies. Here is what we know about the purchases:
I interpret these statements to a decision to gain exposures into commodity business in a way that minimizes the cyclicality of the sector. I also recently pointed out the beaten up nature of energy stocks (see Here’s a way to energize your portfolio). Callum Thomas observed that the energy sector is now the smallest weight in the S&P 500 index, which is another signal of wash-out sentiment.
In conclusion, sentiment models are at crowded long extremes, and smart investors are not ready to buy yet. While US large cap growth is still dominant, cracks are appearing in its leadership, and smart investors like Warren Buffett are focusing on positions in the unloved commodity sector.
As a reminder, Big Tech comprises nearly 50% of S&P 500 weight, while the cyclical sectors are only 13% of the index. If and when we see a rotation from growth the value, financial stocks, which can be considered value stocks, are unlikely to participate significantly as long as the Fed suppresses interest rates and interest margins. While history doesn’t repeat, but rhymes, a leadership failure of US large cap growth will rhyme with the 2000 dot-com bubble top owing to the sheer differential in growth and value index weights.
Analysis from BCA Research shows that the S&P Growth to Value ratio is the highest it’s been, ever. Moreover, rotations from growth to value have coincided with recessions and bear markets.
We are just waiting for the bearish trigger.
Disclosure: Long SPXU
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:
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.
An unusual condition has occurred in the last week, as both stock prices and the VIX Index have been rising together. The VIX has been making a saucer bottom, which could be setting up for a volatility surge, and lower stock prices. While past episodes of high correlation have resolved in short or medium term pullbacks, there have been other occasions, such as late 2017, when these signals marked market melt-ups.
Are we poised for a Volmageddon, or a market melt-up?
Let’s consider the evidence. There are plenty of warnings of an extended market. I have pointed out before how the price performance of high yield (junk) bonds relative to their duration-adjusted Treasury prices have not confirmed the stock market rally (red line). Now investment grade bonds (green line) are flashing a similar negative divergence. Credit market and stock market risk appetites are in disagreement. Usually, the bond market turns out to be right.
Equity market breadth is also not buying into the market advance, as there are numerous negative divergences.
Sentiment is becoming stretched and overly bullish, which is contrarian bearish. SentimenTrader pointed out that call to put volume trading reached all-time highs last week, and conditions far exceeded the levels seen at the 2018 melt-up highs (annotations are mine). He characterized current conditions as a “combustible combo of musical chairs, Russian roulette, and five finger fillet”.
That said, while sentiment models can warn of elevated risk conditions, they don’t necessarily represent actionable sell signals. The Investors Intelligence sentiment survey shows that bears (blue line) have capitulated to late 2017 levels, and the bull-bear spread have similar crowded long readings. However, this did not prevent the market from marching upward until it reached its January 2018 blow-off highs.
There are signs that the market is undergoing a momentum driven melt-up. The S&P 500 experienced a seven day winning streak, and Steve Deppe found that such winning streaks combined with all-time highs have tended to be bullish.
As well, Urban Carmel observed that the market has undergone a five week winning streak. Past winning streaks of six weeks or more have also tended to be bullish, with the exception of 2015.
While absolute price momentum, defined as the market rising which leads to further gains, is evident, stock price momentum, or individual stock rising leading to further gains, is faltering. The stock price momentum factor as measured by different momentum ETFs has been weakening. However, the momentum factor also failed during the late 2017 and early 2018 melt-up, and it was an inexact timing signal. Decelerating price momentum can be regarded as a warning, much like how a ball slows its ascent at the top of its parabolic when thrown into the air.
I have made the point before that Big Tech is dominating the behavior of the stock market. The top five stocks comprise 22% of the weight of the S&P 500, and the combination of technology, communication services, and consumer discretionary (AMZN) sectors make up about half of the index. What’s the market message from Big Tech?
The NASDAQ 100 (NDX) is a good proxy for Big Tech, and it is also experiencing a similar pattern of high correlation with VXN, which is the NASDAQ volatility index. VXN is also forming a rounded base and poised for a volatility surge. While past episodes of high NDX and VXN correlation have been bearish in the past, we also had an experience in early pre-COVID 2020 when the NASDAQ 100 melted up despite high correlation readings.
We are seeing some early warnings signs of a downside break. While the NASDAQ 100 is still behaving well, the relative performance of semiconductor stocks are showing some chinks in the Big Tech armor. Semiconductors have been on a tear for over a year, and their relative performance breached an uptrend last week, which I interpret as an early warning that not all is well. I will be watching whether VXN (top panel) can break out of resistance after forming a multi-month base.
Before the bears get all excited, the relative performance breach was relatively minor, and the absolute and long-term uptrend of the SOX Index remains intact.
These trend breaks doesn’t necessarily portend an immediate pullback. The NDX is indeed highly extended, but extended markets can rise further. The index has reached 2.7 standard deviations above its 20-month moving average. While this is not unprecedented, the last time this happened was in late 1998 as the market melted up.
So where does that leave us? The stock market is undoubtedly overbought and numerous warnings leave it poised for a decline. On the other hand, strong momentum can carry prices higher into a melt-up, to be followed by an abrupt collapse.
Next week will provide some clues to the Volmageddon vs. market melt-up question. That’s because the market may be overreacting to dovish comments from Fed chair Jay Powell last Thursday, and a post-convention polling bounce by the Republicans in the wake of their convention. While he is still trailing, the odds of a Trump electoral win has been improving at PredictIt.
Equally revealing are the odds of Senate control. The Democrats’ lead has evaporated, and the odds are now even.
These developments have have been perceived as equity bullish, as Republicans have been thought to be more market friendly than Democrats. However, this may be a blip owing to post-convention bounces, which are common, and we won’t really know how the polling will settle out for another couple of weeks.
In the short run, the all important NASDAQ 100 is overbought, but levels are below the melt-up peak of early 2018. If the market is indeed undergoing a melt-up, it has room to rise further.
If I had to guess, I would estimate a two-third probability of a correction, and one-third probability of a melt-up, but I am keeping an open mind as to the ultimate outcome.
Disclosure: Long SPXU
This is war! A global war against the pandemic. Analysis from the IMF showed that government debt levels have spiked to levels not seen since World War II.
How will the world win the peace in a post pandemic era, and what does that mean for investors?
Morgan Housel at Collaborative Funds recently offered a hopeful and uplifting message. He believes that crises spurs panic driven innovations, and the pandemic provides an environment that sparks new discoveries and breakthroughs.
A broader point that applies to everyone is that the biggest innovations rarely occur when everyone’s happy and safe, or when the future looks bright. They happen when people are a little panicked, worried, and when the consequences of not acting quickly are too painful to bear.
That’s when the magic happens.
In particular, Housel cited the Great Depression as a crisis period that sparked innovation and productivity growth.
The number of problems people solved, and the ways they discovered how to build stuff more efficiently, is a forgotten story of the ‘30s that helps explain a lot of why the rest of the 20th century was so prosperous.
Here are the numbers: Measuring total factor productivity – that’s economic output relative to the number of hours people worked and the amount of money invested in the economy – hit levels not seen before or since:
FDR’s highway infrastructure program was just one example of how productivity soared.
The New Deal’s goal was to keep people employed at any cost. But it did a few things that, perhaps unforeseen, become long-term economic fuels.
Take cars. The 1920s were the era of the automobile. The number of cars on the road in America jumped from one million in 1912 to 29 million by 1929.
But roads were a different story. Cars were sold in the 1920s faster than roads were built. A new car’s novelty was amazing, but its usefulness was limited.
That changed in the 1930s when road construction, driven by the New Deal’s Public Works Administration, took off…
The Pennsylvania Turnpike, as one example, cut travel times between Pittsburgh and Harrisburg by 70%. The Golden Gate Bridge opened up Marin County, which had previously been accessible from San Francisco by ferry boat.
Multiply those kinds of leaps across the nation and 1930s was the decade that transportation truly blossomed in the United States. It was the last link that made the century-old railroad network truly efficient, creating last-mile service that connected the world. A huge economic boon.
Fast forward to 2020. What’s happening in stress induced innovation today?
But think of what’s happening in biotech right now. Many have pessimistically noted that the fastest a vaccine has ever been created is four years. But we’ve also never had a new virus genome sequenced and published online within days of discovering it, like we did with Covid-19. We’ve never built seven vaccine manufacturing plants when we know six of them won’t be needed, because we want to make sure one of them can be operational as soon as possible for whatever kind of vaccine we happen to discover. We’ve never had so many biotech companies drop everything to find a solution to one virus. It’s as close to a Manhattan Project as we’ve seen since the 1940s.
And what could come from that besides a Covid vaccine?
New medical discoveries? New manufacturing and distribution methods? Newfound respect for science and medicine?
Morgan Housel’s rather optimistic view of the current environment is underpinned by a key assumption. In order for discoveries innovations to occur, a society needs strong institutions to ensure the rule of law and protect property rights. The incentives to bring new discoveries to market are blunted unless you know that what you do won’t be taken away from you.
Consider the following historical period that is within the lifetimes of most investors today. When the Berlin Wall came down, the Soviet Union and the East Bloc economies collapsed, what key innovations emerged from that crisis that are in common use today?
I’ll wait.
To explain the lack of crisis driven innovation during the Soviet collapse, let’s go back to 1865 and track the stock markets of two emerging market economies. The Russian market handily beat the American market for over 50 years, until investors lost everything (and probably their lives) during the Russian Revolution.
The key distinguishing feature is the nature of institutions in Russia. In 19th Century Russia, the tsar owned everything. You could make money by getting a license from the tsar to say, fish in the Baltic Sea, but that license could be taken away at any moment. The “property right” to fish did not exist. Consequently, there were few incentives to invest in new equipment, but to employ a harvesting strategy to exploit as much as you can while you held the license. Fast forward to 2020, the institutions that assure investors of property rights in Russia are still weak. The culture and mindset are not very different from 150 years ago. The primary motivation of Russian oligarchs is to exploit their “license” as much as possible, with minimal incentives to re-invest in the business.
Turning to the US, the key risk for American investors today is the erosion of institutions and trust in US institutions. The protests in Kenosha, Wisconsin are just a symptom of the malaise that afflicts American society. Each side is convinced that a victory in November by the other represents an existential threat to the Republic and American democracy. I have speculated in the past about the possibility of electoral chaos in November if the vote is close, and one side thinks that the election was stolen from them. Kenosha, and Portland before that, are just previews. A Pew Research Center poll found that Americans are unique in how divided and polarized they are in the wake of the pandemic.
Equally worrisome is Trump’s ambiguous answers about whether he would respect the results of the election. Trump is preparing to contest the election, both in the Supreme Court, and in the court of public opinion. Some commentators have felt assured that they expect, in the event of a Trump electoral loss, the military would do their job and escort him out of the White House. These comments open a frightening door. This question of “What would the Army do?” is usually not asked in a stable G-7 country. It’s the sort of question asked in nations with histories of fragile democracies. Has America become Egypt, or Indonesia? Asking “What would the Army do” is another sign of the erosion of institutions.
The events in Kenosha are another example of the disintegration of institutions. In what Western democracy do the police tolerate the appearance of armed civilians in camouflage uniforms in the streets? Does the police recognize that their authority rests on trust in the institution of policing itself?
The erosion of institutions could also have dire implications in the fight against the pandemic. A Bloomberg article raised the question of declining trust in the FDA in light of the politicization of that organization.
In America, whenever you open a medicine bottle, put a pill in your mouth and swallow, you’re engaging in an act of trust. It’s the promise that, thanks to the men and women of the Food and Drug Administration, there’s been a rigorous examination of how safe and effective it is.
That trust isn’t to be taken for granted.
Now, instead, imagine a world where you open that bottle, take out the pill, and before you put it on your tongue, you pause. You question whether you should, because you don’t trust the political party that was in power when it was approved.
The real world consequences of the politicization of an agency like the FDA could manifest itself in the lack of trust in a vaccine. As there is already a part of the population who are skeptical about vaccines, the lack of trust in the FDA is likely to retard the kinds of widespread vaccination that leads to herd immunity. The lack of herd immunity will put downward pressure on the economic growth outlook, which is bearish for equities and other risk assets.
Another factor that is slowly gnawing away at the foundation of institutional respect is the growing inequality gap laid bare by the pandemic. For a perspective of the growing inequality between capital and labor, consider this chart of the number of hours an average worker needed to buy one share of the S&P 500. A gap opened in the mid-1990’s during the Clinton years, and continued through both Republican and Democratic presidencies.
A recent paper found that increased corporate power is mainly responsible for all of the negative financial and economic trends of the past few decades, such as stagnant wages, rising inequality, more household debt and financial instability. The source of the paper was a surprise, it came from the Federal Reserve. Here is the abstract from the Fed paper entitled “Market Power, Inequality, and Financial Instability”.
Over the last four decades, the U.S. economy has experienced a few secular trends, each of which may be considered undesirable in some aspects: declining labor share; rising profit share; rising income and wealth inequalities; and rising household sector leverage, and associated financial instability. We develop a real business cycle model and show that the rise of market power of the firms in both product and labor markets over the last four decades can generate all of these secular trends. We derive macroprudential policy implications for financial stability.
Since Janet Yellen became the Chair, the Fed has become increasingly concerned about the problem of labor market inequality. In this paper, the Fed raised the alarm because rising inequality is sparking a “keeping up with the Joneses” effect of credit-driven spending, which creates higher leverage, and raises financial instability risk.
Jerome Powell’s Jackson Hole speech signaled the Fed’s willingness to focus on employment at the price of higher inflation and to address the inequality problem. Powell stated that “maximum employment is a broad-based and inclusive goal” and “this change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.”
Before the pandemic hit, the economy was experiencing a low unemployment rate, which was bringing most disadvantaged Americans into the labor force. But this was a very inefficient way of addressing the inequality problem. The most marginalized and least paid workers do not find jobs until employers must work hard to get workers. Fiscal policy can play a much bigger role to level the playing field. While serving Fed officials need to couch their words in calling for fiscal support, former Fed Chair Janet Yellen minced few words when she co-authored a NYT Op-Ed entitled “The Senate’s on Vacation While Americans Starve”.
Enter the pandemic, and the job gains by the bottom rung of society have quickly reversed. Job losses have been concentrated among lowly paid workers in the hospitality and services industries. Even worse, the WSJ pointed out that the pandemic is accelerating automation and worsen the job market outlook.
What’s making things worse for these workers and their families is that the pandemic is also accelerating the arrival of remote work and automation. It is a turbo boost for adoption of technologies that, according to some economists, could further displace lower-wage workers. It could also help explain the “K” shaped recovery many pundits have observed, in which there are now two Americas: professionals who are largely back to work, with stock portfolios approaching new highs, and everyone else.
Even before the pandemic, “Automation can explain labor share decline, stagnant median wages and declining real wages at the bottom,” says Daron Acemoglu, a professor of economics at the Massachusetts Institute of Technology. “It’s the bottom that’s really getting hammered.”
The tax system already has substantial incentives in place for companies to replace labor with capital. This argues for a corporate tax overhaul to address the imbalance between capital and labor, especially if Biden were to win and the progressive wing of the Democratic Party take control of both the House and Senate in November.
Notwithstanding the simmering class war between the suppliers of capital and labor, the suppliers of capital are also experiencing a stratified inequality effect. Small businesses are bearing the brunt of the pandemic recession. High frequency data shows that consumer spending patterns have flattened out, but small business revenues is declining. The competitive advantages of corporate size and economies of scale are manifesting themselves, and the COVID Crash is increasing big business concentration at the expense of small businesses.
Inequality matters, and at multiple levels. Longer term, it is eroding confidence in institutions.
We began this journey by observing that government debt levels had risen to levels not seen since World War II. While the debts appeared alarming, post-war debt to GDP gradually fell from a combination of real growth and the willingness of monetary authorities to engage in financial repression by capping interest rates. How will the global economy win the Pandemic Peace, and what does that mean for investors?
I don’t mean to denigrate Morgan Housel’s optimistic view of crisis induced innovation and productivity growth. His scenario is very plausible. Even if trust in American institutions is significantly eroded, which is not my base case, Housel’s scenario can be played out in other G-7 countries with well-established institutional stability.
This may not necessarily be bullish for equity investors. Even if Housel’s era of crisis driven innovations were to be realized, it is less clear how the pie from the spoils of productivity growth will be divided. After several decades where the supplier of capital has enjoyed the lion’s share of the gains, it would not be unusual to see some mean reversion of the division between the suppliers of capital and labor.
This would have negative implications for equity prices. In addition, US equities have a valuation problem. Big Tech is dominating the US equity market, but the rest of the index is not exactly cheap on forward P/E even if we exclude the top five stocks. Some other options on raising expected returns are value stocks, gold, and non-US equities, as well as the use of tactical asset allocation (see A bleak decade for US equities).
If the monetary authorities were to continue engaging in financial repression, it should be bullish for gold and other commodities. I have highlighted the stock to gold ratio, and a comment by Joe Wiesenthal of Bloomberg of how the ratio is a measure of confidence in the markets and the economy. This ratio is falling, and argues for a higher than normal position in gold and commodities in asset allocation.
Despite my long-term bullish view on gold and commodity prices, I believe a well diversified portfolio should still consist of some stocks, and bonds. Cullen Roche at Pragmatic Capitalism demonstrated that bonds still provide important diversifying characteristics in balanced portfolios.
This era of high bond returns is over. But it doesn’t necessarily mean that bonds are a bad diversifier. For instance, from 1940-1980 interest rates rose steadily from about 2.5% to 15%. This seems counterintuitive to what most of us are led to believe about rising rates, but your average annual return over this period was 3% in a 10 year T-Bond. Bonds weren’t nearly as beneficial to a portfolio as they have been in recent decades, but that doesn’t mean they weren’t a good diversifier.
In short, go ahead and hold some gold and commodities, but don’t go overboard and forget the role of bonds for diversification.
Mid-week market update: I have written about how Big Tech is dominating the market. Here is another perspective of how tech stocks are eating the market. The combined market cap of FANGMAN (Facebook, Apple, Nvidia, Google, Microsoft, Amazon, Netflix) is reached all-time highs and nearing a total of $8 trillion.
The angst over Big Tech is growing, and until the parabolic rise reverses, major stock market averages are likely to continue to grind higher.
The dominance of Big Tech in the top five stocks is presenting portfolio construction and risk control problems for portfolio managers. The top five stocks comprise 22.1% of index weight. Since they tend to move together, even holding a market weight in these stocks creates a high degree of concentration risk for the portfolio and can violate portfolio construction constraints, e.g. “no more than 20% in any one sector”.
Big Tech dominance also creates a portfolio construction problems from a stock picking perspective. Managers have some process for ranking stocks as buy, hold, or sell. The portfolio construction process would typically have some rules, such as holding index plus x% if a stock is a buy, index weight if it’s a hold, and index minus x% for a sell. The level of x% will depend on the manager’s stock selection process. A quantitative manager that relies on models to bet across an array of factors would seek to minimize stock specific risk and maximize model risk, so x% is not likely to exceed 2%. A fundamentally oriented investment manager would seek to maximize his stock picking skills, and x% might be 5%, or even 10%.
These kinds of portfolio construction rules run headlong into risk control constraints. Suppose that x is 5%. If Apple were to be ranked as a buy, the target weight would be 12%, which is excessively high for an individual position. A 10% move in Apple stock would move the portfolio’s returns by 1.2%. If all of the top five were to be ranked buys, total weight would come to 22% (index weight) + 25% (overweight) = 47%, which is an astounding level of portfolio concentration risk.
This level of concentration is creating a business problem for mutual fund and other investment managers. Mutual fund managers have been underweight these stocks even as the stocks have outperformed this year.
Don’t blame your fund manager if he’s lagging the market this year. His risk control process is holding him back, and for good reason.
Holding an index tracking ETF like SPY is no panacea as it exposes you to a high level of concentration risk. One way is to analyze tracking error, defined as the difference in performance between a portfolio and a benchmark. The tracking error of not owning the top five stocks in the index has skyrocketed to levels no seen since the dot-com bubble.
Big Tech is certainly looking frothy and bubbly. Macro Charts warned that speculative call option activity on Apple, the top stock in the index with a 7% weight, is “spiking into the stratosphere”.
Macro Charts also observed a developing base in VXN, the NASDAQ 100 volatility index, and it is poised for a disorderly rise. Past similar episodes has been signals of market corrections.
There are other signs that the current Big Tech bubble has exceeded dot-com bubble levels. Maverick’s Q2 investment letter pointed out that the difference in relative performance between the price momentum factor and value factors have skyrocketed to highs that well exceed past bubble peaks.
That said, all of these warnings are only trade setups, but we don’t have a bearish trigger just yet. Conceivably, this bubble could last longer than anyone expects. I am still keeping an eye on the all important NASDAQ 100 and semiconductor stocks. Neither has shown signs of sustained weakness, either on an absolute or relative basis.
From a tactical perspective, short-term breadth on the NASDAQ 100 was already overbought as of last nights close, and today’s advance makes the market especially ripe for a pullback.
Jerome Powell’s virtual Jackson Hole speech tomorrow presents the market with event risk. Unexpected remarks from the Fed Chair could be the catalyst for more market volatility.
Be vigilant.
Ho hum, another record in the major market indices. If you want to play catch-up, here is a lower risk idea to energize your portfolio. The most recent BoA Global Fund Manager Survey showed that managers are dramatically underweight energy stocks. The sector is hated, unloved, and beaten up.
Whether you are bullish or bearish on the stock market, energy stocks might be a contrarian way of making a commitment to equities with a favorable asymmetric risk/reward profile.
Energy stocks are performing well on a relative basis. The Energy SPDR ETF (XLE) is tracing out a constructive double bottom pattern relative to the market. This pattern is confirmed by the relative performance of European energy stocks (green line, top panel), and the relative performance of individual energy industries within the sector. I interpret these conditions as the sector is wash-out and poised for a rebound.
Investors may be in a position to get paid for waiting for a rebound. The indicated dividend yield on XLE is 11%, but dividends are being cut, and the annualized yield based on the last quarterly dividend is 5.5%, with the caveat that dividends could be cut further.
From a top-down perspective, the IEA has also documented how the COVID Crash has crashed energy demand that is largest since the end of World War II.
I am not making any forecasts about when the recession ends, and when energy demand normalizes. However, the combination of wash-out sentiment, constructive relative return patterns, and the upside potential of a demand recovery makes the energy sector a classic contrarian and value selection for equity investors.
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:
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.
The sentiment backdrop is making it easy to be cautious about the stock market. Bloomberg reported that the bears are going extinct as the market rallied.
Skeptics are a dying breed in American equities. It’s another illustration of how risky it has become to doubt the resilience of the market’s $13 trillion surge since late March.
Going by the short positions of hedge funds, resistance to rising prices is the lowest in 16 years. Bears pulled out as buying surged among professional investors who were forced back into stocks despite a recession, stagnating profits and the prospect of a messy presidential election.
If that’s not enough, TMZ published an article with the headline “Day Trading on the Stock Market Is Easier Than You Think”.
Yet the stock market grinds higher. Even as bearish warnings of excessive bullish sentiment and deteriorating breadth, the bulls are holding steadfast, like the outnumbered Greeks at the Battle of Thermopylae.
Even as the stock market rose and made new all-time highs, the advance is being made on deteriorating breadth. Breadth indicators, such as the A-D Line, 52-week highs-low, percentage bullish, percentage of stocks above their 50 and 200 dma, are all not confirming the new highs.
The NASDAQ 100 has led this market upwards, but even NASDAQ breadth is showing similar signs of negative breadth divergence.
When I see broad breadth divergences like this, I am reminded of Bob Farrell’s Rule #7, “Bull markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names,”
Other risk appetite indicators are also not confirming the market advance. The ratio of high beta to low volatility stocks is an indicator of risk appetite, and it fell below a key relative support line even as the market made new highs. So did different version of the Advance-Decline Line.
Credit market risk appetite, as measured by the relative performance of high yield (junk) bonds and leverage loans, are also not buying into the new stock market highs.
In light of all these dire warnings, it’s natural to be cautious about the market outlook. But why is the market defying gravity?
The answer is easy when you look under the surface and analyze the relative performance of the top five index sectors. Big Tech sectors, namely technology, consumer discretionary (AMZN), and communication services make up nearly half of index weight, and Big Tech has been extremely strong on a relative basis. It is difficult to see how the stock market could decline without Big Tech weakness.
Some of the leadership can be explained by the dominance of the megacap growth stocks. Take Apple as an example. The market cap of Apple now matches the entire market cap of the Russell 2000 small cap index. The stock broke up through a rising channel last week, which could either be the sign of a blowoff top, or signs of further market strength. Until leading stocks like Apple weaken, the bulls will retain control of the tape.
Big Tech dominance can also be seen on an equal weighted basis, which minimizes the contribution of heavyweight FANG+ stocks. The equal-weighted analysis of the relative performance of the top five sectors also shows that the Big Tech sectors are in relative uptrends.
The analysis of the relative performance of large and small cap technology stocks does show some cracks in the phalanx of tech leadership. The relative performance of small cap technology (green line, top panel) peaked out in April and rolled over even as large cap tech roared upwards. In addition, the relative performance of small cap to large cap tech (green line, bottom panel) mirrors the relative performance of small cap to large cap stocks, indicating that the size effect is more important that the sector effect.
In light of this analysis, it is no wonder why the bulls’ phalanx is holding ground, just like the Greeks at the Pass of Thermopylae. For readers who are unfamiliar with the Battle of Thermopylae, a small Greek force held off an enormous Persian army at the Pass of Thermopylae, which was a very narrow passage, for three days. For two days, Persians sent wave after wave of soldiers at the Greek defenders in the narrow passage, and the assaulting force all returned bloodied. On the third day, the Persians found a narrow path around the pass and encircled the Greeks.
Historical analogies only go so far. What will crack these stubborn bulls? Watch for the answer in the leadership of the NASDAQ 100, and semiconductor stocks. The bears are not going to take control of the tape as long as the relative performance of these stocks are holding up.
For a study in contrasts, here is the percentage of stocks in the S&P 500 above their 5 dma. This indicator has breached a short-term uptrend and should be a bearish warning for traders.
Here is the same indicator for the NASDAQ 100. The uptrend remains intact. Are these conditions short-term bullish or bearish in light of Big Tech market dominance?
In conclusion, investors with intermediate and long term time horizons should be cautious about the stock market outlook, but it is unclear what bearish catalyst will reverse the market advance. Short-term traders, on the other hand, can give the bull case the benefit of the doubt, as long as the NASDAQ and semiconductor bull trends are holding up.
Disclosure: Long TQQQ
Now that stock prices have recovered from their March lows to all-time highs, it’s time to admit that I was wrong about my excess cautiousness. I present a new framework for analyzing the stock market. While the new framework is useful for explaining why the major US market indices have reached fresh highs, it does not necessarily have bullish implications.
My previous excessive cautiousness was based on two factors, valuation and a weak economic outlook. The market is trading at a forward P/E ratio of 22, which is extremely high by historical standards. Moreover, it was difficult to believe that the economy and stock prices could recover that strongly in the face of the second worst economic downturn since the Great Depression.
While there has been much discussion over the letter shapes of the recovery, whether it’s a V, W, L or some other shape. The reality is a K-shaped bifurcated rebound. This bifurcation is occurring in two separate and distinct dimensions, the stock market and the path of economic growth.
The K-shaped recovery analytical framework has important implications for how investors should view the market’s future outlook.
I highlighted analysis last week (see A Potemkin Village market?) that Big Tech has become dominant in the weight of the index. The combination of technology, communication services, and consumer discretionary, which is dominated by Amazon, comprise about 50% of S&P 500 index weight. The adage that the stock market isn’t the economy is especially true in this case. Large cap growth stocks were becoming the stock market. Where Big Tech went, the rest of the market followed.
I also identified a nascent rotation out of large cap growth into cyclical sectors (see Sector and factor review: Not your father’s cycle). From a technical perspective, rotation in a bull phase is normally healthy, but the current market weighting of the index makes such rotations problematical. Cyclical sectors only make up 13% of index weight. If you include healthcare, which assumes the successful deployment of vaccines and therapeutic drugs, the combined index weight is only 27.8%. A rotation out of the Big Tech sectors with half the index weight into smaller sectors with 13% is not possible without the funds moving elsewhere, such as foreign markets or other asset classes.
I would also add that financial stocks, which represent a major sector, are unlikely to participate in a market recovery. That’s because the Federal Reserve is engaged in financial repression to hold down interest rates, which has a detrimental effect on banking margins.
The cyclical rotation theme was confirmed by the latest BoA Global Fund Manager Survey. Global managers were buying cyclical, value, and eurozone stocks while selling growth and US stocks.
We can also observe a similar rotational effect in regional allocations. In response the COVID Crash, managers had piled into US equities and made the region the top overweight because US large cap growth stocks were the last refuge of growth in what was a growth starved world. The latest survey shows that eurozone stocks had taken over the top spot in equity weighting as managers shifted from US growth to eurozone stocks, which are more cyclical in nature.
However, a chart of the relative performance of different regions to the MSCI All-Country World Index (ACWI) shows that most regions have been trading sideways since early July. If there is a rotation from US Big Tech into cyclical growth, that play may be petering out.
That’s the challenge for US equity bulls. If there is a rotation into cyclical stocks in anticipation of a global economic recovery, there isn’t sufficient liquidity in the market to accommodate the rotation. Funds will move offshore or into other asset classes, and that will depress US stock prices.
For American equity investors, the NASDAQ 100 (NDX) is effectively the only liquid game in town. The troublesome part of this game is the NDX losing momentum, as evidenced by a series of negative RSI divergences even as the index pushed to fresh highs.
From a top-down economic perspective, the economy hit a brick wall and came to a sudden stop with the COVID Crash. At the height of the downturn, 6.7% of the population had filed for unemployment, which dwarfs the ~2% level during past recessionary peaks. Viewed in that context, it was hard to believe the economy could recover that quickly after such an unprecedented shock.
What was missing from that 10,000 foot top-down analysis was most of the job losses were in low paying service industries. The defining characteristic of this crisis is the inequality of the experiences it’s inflicting on the population. The bottom 40% of households by income account for 22% of consumption, so the drop in spending does not affect the economy as severely if the job losses were distributed uniformly across the board.
The trajectory of the housing industry is a good example of the highly bifurcated nature of the economic recovery. The teal line depicts homebuilder traffic of prospective customers, which is at record levels. On the other hand, the white line shows mortgage delinquencies, which have also soared. In normal times, these two data series should not be moving together. These conditions represent a “best of times, worst of time” snapshot of widening inequality. People with secure and good paying jobs are buying houses, and they may be expanding their housing demand because of the work-from-home effect. In fact, the latest July NAR report of existing home sales shows that the proportion of second home buyers rose to 15%, highest since March 2019 and at pre-pandemic levels. On the other hand, the lower income and economically stressed parts of American society are losing their homes to foreclosures and evictions.
The K-shaped bifurcated recovery can also be seen in this Bloomberg article contrasting the earnings reports of Walmart, which is focused on affordable prices and caters to a lower income demographic, and Target, whose customer base is more affluent.
Walmart Inc. said Tuesday that government stimulus checks provided a boost in its second quarter, but the benefit faded by July. In contrast, [Target CEO] Cornell said that although relief checks helped goose demand, Target’s shoppers kept buying well into July even as the stimulus’ impact waned. “The stimulus was a factor, but even as it waned we saw strong comparable-sales growth in June and July,” he said. “And we are off to a very solid start in August.”
The Federal Reserve and major global central bankers have responded to the COVID Crash with enormous quantitative easing (QE) liquidity injections. Money supply growth has surged as a consequence. While the flood of liquidity has stabilized financial markets, it is unclear how much money is actually finding its way into the Main Street economy. We saw a similar surge in M2 growth in the wake of the GFC, but monetary velocity has been slowly declining in the last decade. As the monetary equation PQ = MV implies, a falling monetary velocity (V) in the face of rising money supply growth (M) is not helpful to stimulating economic growth.
Central bankers call this dilemma a broken transmission mechanism. Callum Thomas at Topdown Charts observed that even as global central bankers have pushed down interest rates, lenders have responded to the crisis by tightening lending standards.
However, the latest round of QE is not like the GFC version of QE. In the wake of the GFC, the Fed injected reserves into the banking system by buying bonds. Such market operations experienced difficulty pushing the new liquidity into the Main Street economy. As a consequence, monetary velocity slowed, growth was relatively sluggish despite the size of the monetary stimulus, and there were few inflationary pressures.
Fast forward to 2020. The latest version of global QE is accompanied by fiscal stimulus. The US, federal budget deficits is at levels last seen in World War II.
The bond market has interpreted the combination of fiscal and monetary stimulus as potentially inflationary. Inflation expectations, as measured by the 10-year breakeven rates, were tame during the last crisis, but they have risen and diverged from nominal rates in this crisis.
This is what financial repression looks like. The Fed and other central banks are deliberately holding down rates to below market levels even as fiscal authorities spend wildly. For another perspective, the 10-year Treasury yield has historically tracked the Citigroup Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations. The recovery since the March low has seen ESI skyrocket, but bond yields remain tame. This is another picture of financial repression.
Longer term, these policies should be bullish for gold and other inflation hedge vehicles. In the short-term, however, gold sentiment has become excessively bullish and the metal may need a period of consolidation or correction. As well, the bond market should provide reasonable returns, as the Fed’s medium term policy is to hold down rates for a very, very long time.
As for the currency market, I am not especially bearish on the USD outlook under these circumstances. While USD positioning is at a crowded short, it is unclear what catalysts can drive additional dollar weakness. Yield differentials against major currencies are already relatively low. These high level of expectations of dollar weakness leaves the market in a jittery and highly news sensitive. Examples include the reaction of USD strength to last week’s July FOMC minutes of a rejection of yield curve control, and the unexpected weakness in eurozone PMIs.
As well, Sebastian Dypbukt Källman at Nordea Markets pointed out that China and Europe are closely linked. “Chinese financial conditions often influence the direction of European equities. The micro tightening that happened after China’s rapid macro comeback suggests less smooth sailing for European cyclicals in coming months.”
The equity market implications are a bit trickier. Much depends on the behavior of large cap growth stocks. I have two scenarios in mind.
The first scenario is the development of a large cap growth stocks market mania. All bubbles begin with some reasonable assumptions that eventually get out of hand. In response to the pandemic, a handful of companies have profited handsomely. One example is Amazon, which benefited from the WFH theme in two ways. Both demand for its retail services and its Amazon Web Services division rose, as internet-based customers’ demand for support their WFH services soared.
In a bubble, no one knows how far prices can rise. The Russell 1000 Growth Index P/E is 34.1, which is high, but below the levels seen at the dot-com bubble peak. We will only know in hindsight. Needless to say, market bubbles don’t deflate in an orderly manner, but with a crash.
The second scenario would see the market converge to Main Street fundamentals. In this case, much will depend on the path of the pandemic, and whether the cyclical rebound theme is durable. The latest update of Google G-7 mobility reports indicate that the recovery in mobility trends is decelerating, which calls into question of the sustainability of a cyclical rebound.
Similarly, the latest update from Indeed of US job postings shows that they are rolling over. While high paying jobs are showing some softness, it is the low wage job titles that appear the weakest.
In the end, much depends on the path of the pandemic in the coming months. Reuters reported that Trond Grande of Norway’s sovereign wealth fund, the largest sovereign wealth fund in the world, is expecting some near term market turbulence.
The pandemic is not under control “in any shape or form” and remains the biggest issue for investors, said deputy CEO Trond Grande, after presenting the half-year results of the world’s largest sovereign wealth fund.
The fund lost $153 billion between January and March as markets plunged, its worst quarter ever, but earned back $131 billion from April to the end of June amid a rebound, its best quarter on record.
“We could be in for some turbulence this fall as things unfold and whether or not the coronavirus pandemic recedes, or gains some force,” Grande told Reuters.
“We have already seen some sort of V-shaped recovery in the financial markets. I think there is a slight disconnect between the real economy and the financial markets,” he said, noting that government support for economies could only be sustained for so long.
If the S&P 500 were to converge to Main Street fundamentals, how far could it fall? Here is one rule of thumb that may be useful. The ratio of equal weighted consumer discretionary to consumer staples stocks has underperformed the market and it is not buying into the rally to new highs. This ratio is often used as a metric of equity risk appetite. While it is lagging the S&P 500, it has been tracking the Value Line Geometric Index (XVG) almost perfectly.
If we were to chart the S&P 500 and XVG over a 10 year time frame, we can observe periods of convergence and divergence. XVG represents the average listed stocks and therefore more representative of the Main Street economy. A convergence of the S&P 500 and XVG today would put the S&P 500 at just under 2400, which roughly amounts to a re-test of the March lows. Bear in mind, however, that any hypothetical convergence only represents a fair value target estimate, and the S&P 500 could overshoot to the downside. In addition, XVG fundamentals could either improve or deteriorate, which would move the target either up or down.
In the worst case, a downside target of 1650-2000 is within the realm of possibility. Past major market bottoms have occurred with a forward P/E ratio of 10. Currently, the bottom-up aggregated 2021 estimate is about $165. If we apply a 10 to 12 times multiple, we arrive at a range of 1650 to 2000.
If I had to choose, the second convergence scenario is the more likely outcome. It is also consistent with my past observation of the unusual and simultaneous buy and sell signals from the Wilshire 5000’s MACD (buy) and negative RSI divergence (sell). In the past, RSI divergence sell signals have taken 1-6 months before the market topped out. The last time this happened, the market topped out two months after the signal.
In summary, I present a new framework for analyzing the stock market in light of the push to new highs. While the new framework is useful for explaining why the S&P 500 and NASDAQ Composite have rallied, it does not necessarily have bullish implications.
That’s because both the market and economy are undergoing K-shaped and two-paced rebounds. These bifurcated recoveries are creating imbalances that will have to be resolved at some point in the future. One possibility is the formation of a NASDAQ bubble, which would end in a disorderly market crash. The other scenario postulates an orderly convergence between Wall Street and Main Street fundamentals, where I penciled in a re-test of the March lows as a downside objective.
Tactically, investors should watch the NASDAQ 100 and global regional indices for signs of changes in market leadership. Monitoring these indicators will give an idea of how the market is evolving within these two disparate scenarios.
Mid-week market update: About two weeks ago, I identified an emerging theme of a rotation out of large cap growth stocks into cyclicals (see Sector and factor review: Not your father’s cycle). The latest BoA Global Fund Manager Survey (FMS) confirms my analysis. The rotation is attributable to managers buying into the reflation trade.
Does that mean you should hop on the reflation train? Is there sufficient momentum behind this shift?
Actually, the shift into the reflation trade is mis-named. It’s not that inflationary expectations that are rising that much, but growth expectations.
The growth to cyclical rotation can be seen in regional weightings. For several months, managers had been piling into US equities as the last source of growth in a growth starved world. The FMS had shown the US as the top weight in equity portfolios for some time. In the latest survey, the top regional overweight is now the eurozone, as managers have latched onto the reflation and cyclical theme.
How are cyclical stocks are performing. First, it’s unclear how well the rotation into eurozone equities will work out. High frequency data shows that the recovery is stalling on the Continent.
In the US, the relative performance of cyclical stocks presents a mixed picture. While homebuilding stocks are on fire, the relative performance of other cyclical sectors and industries show constructive but limited signs of market leadership. Material stocks are turning up relative to the market, but industrial, transportation, and leisure and entertainment are only exhibiting bottoming patterns.
I have made this point before, this is not a normal economic cycle and interpreting it that way can bring trouble for investors. Instead of a normal Fed induced slowdown, the global economy encountered a pandemic driven sudden stop. The pandemic is still ranging all over the world, and the recovery in demand will depend mainly on how well the human race can control the COVID-19 outbreak. Therefore the recovery will not follow the normal patterns of past economic cycles (see Sector and factor review: Not your father’s cycle).
I believe that equity risk and return are asymmetrically tilted to the downside. Conventional sector and factor analysis is pointing towards a rotation out of US large cap growth stocks into cyclical and EM equities. However, this is not a normal cycle and many of the usual investment rules go out the window. Historical analogies are of limited use. This is not 2008 (Great Financial Crisis), 1999 (Dot-com Bubble), 1929 (Great Depression), or 1918 (Spanish Flu).
Investors have to consider the bearish scenario that a rotation out of US large cap growth does occur because of a crowded long positioning, but the rotation into cyclical and EM does not occur. Instead, the funds find their way into Treasuries and other risk-off proxies because of either the failure of early vaccine trials, or teething problems with deploying vaccines and therapeutics. In that case, the growth path falls considerably from the current consensus, and a risk-off episode and valuation adjustment follows.
Under these conditions, investors are advised to focus first on risk, than return. Mark Hulbert observed that his Hulbert Stock Newsletter Sentiment Index is higher than 95% of all daily readings since 2000. That’s a crowded long condition, which is contrarian bearish. While the market can continue to advance under such conditions in the past, intermediate term risk and reward are not favorable for equity investors.
In the short run, the NASDAQ leadership remains intact. While the 5-day RSI continues to flash negative divergences for the NASDAQ 100, the index has shrugged off these warnings and continued to rise. Until we see signs of trend breaks, either on an absolute or market relative basis, it would be premature to be bearish.
The market can continue to grind higher in the short-term, but investors who focus on risk and reward are advised to be cautious. There’s probably turbulence ahead.
Risk takers are fond of the line, “No guts, no glory”. With that in mind, I present three cases of risks, and possible opportunities.
In late June, I highlighted analysis from Research Affiliates of country values by CAPE relative to their own history. At the top of the most attractive list was Turkey, followed by Malaysia, Poland, South Korea, and Thailand (see A bleak decade for US equities). Turkish equities represents a classic Rorschach inkblot test of risk and opportunity for investors.
While Turkish stocks are cheap on a statistical basis, they are not without risk. The Turkish lira (TRY) is under severe pressure because of a falling current account. Bloomberg summarized TRY’s challenges:
The Turkish lira is weakening to all-time lows, and that’s even before the USD has shown any signs of strength as greenback positioning is at a crowded short.
The Big Mac Index from the Economist shows the TRY to be considerably undervalued against the USD. However, currencies can take years, and even decades to converge to purchasing power parity.
In the short run, rising geopolitical tensions in the Eastern Mediterranean will not help sentiment. Turkey recently dispatched an exploration ship with a naval escort to disputed waters off the southwest coast of Cyprus, This is provoking a possible confrontation with the Greek and French navy, which is raising the temperature with EU relations and causing fractures within NATO. The Eastern Mediterranean has significant natural gas potential. Cyprus, Israel, Egypt, and now Turkey are trying to secure shares of the resource.
I have been monitoring the progress of the MSCI Turkey ETF (TUR). TUR has been testing a support zone. The relative performance of TUR relative to MSCI All-Country World Index (ACWI) is testing a relative support level, and so is the relative performance of TUR relative to EM xChina.
On a relative basis, Turkish equities looks washed out and presents a contrarian opportunity for investors. On the other hand, SentimenTrader pointed out that USD positioning is at a crowded short. The TRY exchange rate is at severe risk should the USD ever strengthens.
No guts, no glory?
In the US, the recent dispute over the Post Service highlights the rising risk of electoral chaos. Ian Bremmer and Cliff Kupchan of the Eurasia Group characterized this political risk as “American Brexit”.
In January, risk #1 described how US institutions would be tested as never before, and how the November election would produce a result many would see as illegitimate. If President Donald Trump won amid credible charges of irregularities, the results would be contested. If he lost, particularly if the vote was close, same. Either scenario would create months of lawsuits and a political vacuum, but unlike the contested George W. Bush-Al Gore election of 2000, the loser was unlikely to accept a court-decided outcome as legitimate. It was a US version of Brexit, where the issue wasn’t the outcome but political uncertainty about what people had voted for.
The Eurasia Group’s January forecast of American Brexit effects are already being felt today.
Meaningful (France-style) social discontent becomes more likely in that environment, as does domestic, politically inspired violence. Also, a non-functioning Congress, with both sides using their positions to maximize political pressure on the eventual election outcome, setting aside the legislative agenda. That becomes a bigger problem if the US is entering an economic downturn, on the back of expanded spending and other measures to juice the economy in the run-up to the election.
How would the markets behave under an “American Brexit” scenario? Let’s consider how the markets reacted after the Brexit vote surprise in 2016. The chart below depicts the FTSE 100, which consists mainly of UK large cap global companies, and the FTSE 250, which are small companies that are more exposed to the local economy. As ways of measuring a “pure” Brexit market effect, I also show the relative performance of the FTSE 250 to FTSE 100, the performance of UK large caps to ACWI, and the performance of UK small caps to ACWI. The markets rallied into the Brexit vote, thinking that the Remain side would win but fell dramatically after the unexpected result. Once we normalize the relative prices before and after the vote, downside risk varied from -4% to -14%, depending on the metric used.
This is a key risk for the US equity market. I have not seen any Wall Street strategists discuss the possibility of electoral chaos after November. Based on the Brexit event study, expect a similar range of downside risk of -4% to -14% in during the November to February period.
Speaking of Brexit, the region has been the most hated in the BoA Global Fund Manager Survey for some time.
I know that the details of Britain’s divorce from the EU are not finalized yet, but UK equities look washed out and unloved. But the ratio of the FTSE 250 to FTSE 100 has been rising steadily before the COVID Crash, and it has been recovering steadily since the March low. From a global perspective, while UK large caps (EWU) continue to lag ACWI, UK small caps (EWUS) have been range bound, which is a more constructive pattern.I interpret these readings as the market has largely discounted Brexit risks, and there may be opportunity for superior performance in UK small caps, which are more exposed to the British economy.
One long-term bullish factor for the UK that few talk about is Prime Minister Boris Johnson’s decision to open the citizenship doors to Hong Kong residents with British National (Overseas) passports. This has the potential to inject the country with a group of English speaking, well-educated immigrants that could boost growth potential.
No guts, no glory.
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:
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.
I have been writing about bearish setups for several weeks. In particular, risk appetite indicates have been sounding warnings. For example, the ratio of equal weighted consumer discretionary to consumer staples stocks, equal weighted to minimize the dominant weight of AMZN in the consumer discretionary sector, have been trading sideways and not buying into the equity rally.
As well, credit market risk appetite, as measured by the relative performance of high yield (junk) bonds and leveraged loans to their duration equivalent Treasuries, are also not buying into the equity risk-on narrative.
The divergence between the VIX Index and the TED spread, which is one of the credit market’s indication of risk appetite, is another worrisome sign.
In the short run, none of this matters. Here is what traders should really be paying attention to.
I wrote about how Big Tech stocks are dominating market action (see A Potemkin Village market?). Indeed, the Big Tech sectors (technology, communication services, and consumer discretionary/Amazon) comprise roughly half of S&P 500 index weight. It would be virtually impossible for the market to move without the significant participation of these top sectors. So far, technology has been in a well-defined relative uptrend, consumer discretionary stocks have been strong on a relative basis, and communication services relative strength has been moving up in a choppy pattern.
The NASDAQ 100 remains in an uptrend, though breadth indicators are sounding negative divergence warnings. Until the NASDAQ 100 breaks its trend line, it would be premature to turn bearish despite the widespread warnings.
There are also warnings from a top-down macro perspective. Disposable income had been held up in this recession by fiscal support.
The expiry of the $600 per week supplemental unemployment insurance at the end of July has caused UI outlays from Treasury to fall off a cliff. Undoubtedly that will show up in falling confidence and retail sales in the near future.
Banks are responding predictably by tightening credit standards. We have the makings of an old-fashioned credit crunch, which will crater economic growth in the absence of further significant fiscal and monetary policy support.
The narrative for the economy is turning from bounce back rebound to a stall. Historically, the stock market has encountered headwinds when growth expectations disappoint, as measured by the Citi Economic Surprise Index (ESI).
Here is a close-up look at ESI, which is showing signs of topping out.
This trend of stalling ESI is evident globally. Here is Eurozone ESI.
Here is China ESI.
In the short run, none of this matters until the major market indices, and the NASDAQ 100 in particular, experience breaks to the rising trend lines. Short term momentum remains positive as the percentage of stocks in the S&P 500 above their 5 dma is exhibiting a series of higher lows.
A similar pattern can be found for the NASDAQ 100.
In conclusion, the negative divergence concerns that I raised in the past few weeks are still valid. However, nothing matters until we see trend line breaks, especially in the NASDAQ. Traders could try to buy dips in this environment. However, intermediate term downside risk is considerable, and buying here would be akin to picking up pennies in front of a steamroller.
While the adage that the stock market isn’t the economy and vice versa is true. one of the puzzles facing investors is why the US equity market testing its all-time highs even as the economy suffered its worst setback since the Great Depression. This market seems like a Potemkin Village, which shows an external façade of calm while hiding the real trouble behind the scenes.
The Fed isn’t entirely responsible for the market’s strength. The Fed has taken steps to stabilize markets so they can function in an orderly way. A Fed Put can put a floor on prices, but it cannot make asset prices skyrocket the way they did.
A more reasonable explanation is the unprecedented level of fiscal support to support growth. This recession is completely unlike past slowdowns. The government’s safety net has allowed consumers to maintain their spending to prevent a complete collapse in demand.
In that case, why hasn’t the stock market skidded as it became clear that Congress could not agree on a second stimulus package, and that Trump’s Executive Order and Memoranda designed to do and end run around Congress appears to be ineffectual (see a detailed analysis in Earnings Monitor: Slower growth ahead). The Washington Post reported that the Street generally agrees with my analysis.
“If this is all we get for fiscal policy for the rest of the year it would represent a significant downside risk to our growth outlook,” JPMorgan Chase chief U.S. economist Michael Feroli wrote in a Monday note. “These executive orders likely will provide stimulus of less than $100 billion, while we have been expecting Congress to add at least $1.0-1.5 trillion of spending once an agreement is reached.”
The team at Oxford Economics comes to a similar conclusion, finding “the relief is inadequate, legally questionable and falls dramatically short of the booster shot the economy desperately needs,” per a note from senior U.S. economist Lydia Boussour. “In the absence of a more comprehensive stimulus package, economic activity will be constrained just as the recovery plateaus.”
Barry Ritholz offered a different sort of explanation, based on a radical difference between the construction of the market indices and the economy, in a Bloomberg opinion piece. Big Tech comprise a gargantuan weight in most major US indices.
The so-called FAANGs (along with Microsoft) derive about half — and in some cases even more — of their revenue from abroad. Beyond that, the pandemic lockdown in the U.S. has benefitted the giant tech companies’ sales and profits. No wonder the Nasdaq Composite 100 Index, which is dominated by big tech companies, is up about 26% this year.
Simply put, the rest of the market really doesn’t matter no matter how badly the underlying sectors and industries perform.
Take the 10 biggest technology companies in the S&P 500 and weight them equally, and they would be up more than 37% for the year. Do the same for the next 490 names in the index, and they are down about 7.7%. That shows just how much a few giants matter to the index.
On some level, it’s completely understandable why many people believe that markets are no longer tethered to reality because the performance doesn’t correspond to their personal experience, which is one of job loss, economic hardship and personal despair. But what’s important to understand is that indexes based on market-cap weighting can be — as they are now — driven by the gains of just a handful of companies.
This week, we explore the outlooks and performance of two groups, Big Tech, and the rest of the market.
How big and dominant is Big Tech? The chart below of the relative performance of the top five sectors in the S&P 500 tells the story. These five sectors comprise 74% of index weight, and it would be difficult for the market to significantly rise or fall without the participation of a majority. The weight of Big Tech sectors (technology, communication services, and consumer discretionary) make up about half of index weight. Consumer discretionary stocks is dominated by Amazon, and the chart shows the relative performance of equal-weighted consumer discretionary (in green), which minimizes the effect of heavyweights, as an illustration of how Amazon has dominated the sector. The equal weighted relative performance is far less impressive than its float weighted counterpart.
How long can Big Tech dominance last? Here are the short and intermediate term perspectives. In the short term, one shorthand for measuring the performance of Big Tech is the NASDAQ 100. The NASDAQ 100 remains in well-defined absolute and relative uptrends. While there are warnings of negative RSI divergences indicating a loss of momentum, there are no bearish trendline breaks to be concerned about.
Another way of measuring the strength of Big Tech is through the price momentum factor. Price momentum factor portfolios become highly concentrated because of the strong performance of technology stocks. The relative performance of a variety of price momentum ETFs indicate that momentum remains in choppy but positive uptrends. One factor that may exacerbate the price momentum effect is a greater commitment to indexing. This technique creates a self-reinforcing cycle of positive money flows that mechanically buys more and more Big Tech heavyweights and creates a self-reinforcing price momentum effect.
A longer term way of thinking about the dominance of Big Tech is to measure the relative returns of banks, which represent an important component of the economy, to the NASDAQ 100. This is another way of measuring the value to growth performance ratio. Bank stocks have been beaten up so badly that they are overweight in most value indices, while the NASDAQ 100 is the poster child of growth. The Bank Index to NASDAQ 100 ratio has flashed a positive RSI divergence, which is bullish for banks and value stocks, but historically this ratio has not bottomed out until its annual relative performance nears -70%. This analysis suggests that there may be one final leg down for this ratio, and one final leg up for Big Tech.
To be sure, the dominance of Big Tech has strong fundamental underpinnings. It’s a winner-take-all competitive environment, and the winners have been able to create competitive moats because of their dominance in their business. These companies have then been able to extract strong profits and high margins behind their moat fortifications.
However, strong corporate dominance invites antitrust scrutiny. CNBC analyzed the emails submitted to Congress in their antitrust investigation of Amazon, Apple, Facebook, and Google and highlighted some key vulnerabilities for each company.
Facebook: Experts speculate that an antitrust case against Facebook would center largely around its acquisition strategy and whether it broke merger laws by buying up a nascent competitor or violated anti-monopoly law by taking anti-competitive actions to build or maintain dominance in its market.
Amazon: An antitrust case for Amazon may resemble the line of thinking Sen. Elizabeth Warren, D-Mass., offered in her presidential campaign platform on breaking up Big Tech. Warren argued large tech companies designated as “Platform Utilities” should not be able to control and participate on their own platforms. The FTC has been talking to third-party sellers on Amazon’s platform, according to Bloomberg, following concerns that Amazon undercuts sellers on its marketplace.
A recent Wall Street Journal investigation found that Amazon employees had used internal data to inform their private-label brand strategy and compete with other sellers. Though the employees reportedly used aggregated reports combining multiple sellers’ performance, they sometimes contained as few as two sellers, making it easy to extrapolate a single seller’s data. Amazon has said it was launching an internal investigation into the allegations by the Journal but said it didn’t believe the claims to be true.
Apple: The antitrust theory against Apple centers on its control of the App Store. While iPhones are prevalent throughout the U.S., Apple ranks only third in worldwide market share for smartphones at 13.3%, according to IDC, while the market leader, Samsung, holds a 21.2% share.
A potential case against Apple could look similar to one against Amazon, focusing on the fact that it both owns a marketplace (the App Store) and has its own pre-loaded apps such as Apple Music and Apple Podcasts that compete with other apps on its platform, such as Spotify.
Some developers who offer their apps through the App Store — the only way Apple allows for apps to be added to users’ devices — have complained about Apple’s opaque and sometimes seemingly arbitrary process for accepting new apps.
Google: Google’s sprawling business has attracted antitrust scrutiny on multiple fronts. Regulators have looked into Google’s search business, online advertising platform and Android mobile operating system. Here’s what they might be looking for in each:
– Search: Vertical search competitors such as Yelp and TripAdvisor, which offer search engines for specific purposes such as local businesses or travel, have complained for years that Google prioritizes its own services over their own, including by offering its own competing services above theirs in relevant Google search results.
– Advertising: Google’s advertising business has attracted scrutiny over a variety of concerns that essentially boil down to the question of whether Google’s expansive control over the digital media supply chain allows other companies to compete. While Google has competitors across many functions of the advertising marketplace, it operates in both the buy side and sell side of transactions, leading to some questions about whether it remains objective about where it routes advertising dollars. Competitors also argue that Google’s prices are hard to match because it bundles its ad tools. And on YouTube, Google eliminated the ability to buy ads through third-party services, funneling all spend through its own tools.
– Android: With its Android mobile operating system, Google requires device manufacturers who use its platform to pre-install its app store and other native apps such as Gmail and its Chrome web browser. The European Commission required Google to stop bundling its apps on Android phones and allow EU users to select their default search engine after fining the company $5 billion over alleged antitrust abuse.
In the short run, the Trump administration’s Executive Order against TikTok and WeChat has the potential to crater Apple’s earnings. A recent Bloomberg article explains the challenges for Apple, which makes up 5.8% of the S&P 500, and 12% of the NASDAQ 100. If the company is forced to remove WeChat globally from its Apps Store, it could have devastating consequences.
[WeChat] connects a billion users globally and is used for everything from chatting with friends to shopping for movie and train tickets to paying restaurant and utility bills. While questions remain on how Trump’s orders will be implemented, any ban on the use of WeChat threatens to cut off a key communication link between China and the rest of the world and prevent U.S. companies like Starbucks Corp. and WalMart Inc. from reaching consumers in the world’s second-largest economy…
If Apple was forced to remove the service from its global app stores, iPhone annual shipments will decline 25% to 30% while other hardware, including AirPods, iPad, Apple Watch and Mac computers, may fall 15%-25%, TF International Securities analyst Kuo Ming-chi estimated in a research note. Apple didn’t immediately respond to Bloomberg News’ requests for comment.
A survey on the twitter-like Weibo service asking consumers to choose between WeChat and their iPhones has drawn more than 1.2 million responses so far, with roughly 95% of participants saying they would rather give up their devices. “The ban will force a lot of Chinese users to switch from Apple to other brands because WeChat is really important for us,” said Sky Ding, who works in fintech in Hong Kong and originally hails from Xi’an. “My family in China are all used to WeChat and all our communication is on the platform.”
So far, the market appears to be ignoring both the short and long term risks to Apple and other Big Tech stocks.
What about the rest of the market? I wrote last week (see Sector and factor review: Not your father’s cycle) that as the momentum in Big Tech falters, the market is poised for a rotation into cyclical stocks. I had identified consumer discretionary (6.7% ex-AMZN) and materials (2.6%) are showing some signs of life. But those sectors comprise just under 10% of index weight, and they can’t possible do all the heavy lifting if Big Tech were to falter. Andrew Thrasher raised an important caveat about sector rotation.
Traditionally rotation is bullish. It allows the market to “reload” to so speak as new leadership emerges. But the weighting we have today is different than what the market’s used to. It’s like replacing a sumo wrestler on a teeter-totter with a 3rd grader, not the same.
While the stock market isn’t the economy, and vice versa, the non-Big Tech market is a reasonable approximation of the economy. New Deal democrat, who monitors coincident, short leading, and long leading indicators, recently assessed the economic this way.
The bottom line from the short and long leading indicators is that the economy “wants” to improve, but over the next six months, the coronavirus, and the reactions of the Administration, the Congress, and the 50 governors to the virus are going to be the dispositive concerns.
Left to its own, the economy “wants” to improve. However, there are two key issues to be addressed before a recovery can be achieved. The first is the passage of another rescue package, which NDD assumes will happen. The White House and the Democratic leadership is deadlocked, and no deal is in sight. The economy is starting to go over a fiscal cliff. A key study concluded that 30-40 million Americans are at risk of eviction, which will spark a homelessness crisis and another consumer death spiral.
Federal emergency unemployment benefits have now stopped. Driven by panic by GOP members of the Senate up for re-election this year, I expect a deal to be struck to extend them.
The other major issue is progress against the pandemic. No matter how hard any individual country tries to control the virus, the pandemic is global in scope, and growth will not return until there is substantial progress around the world. Even in countries that appeared to have controlled their outbreaks, second waves of community infection are appearing in disparate countries like Spain, Israel, Japan, and Australia. Even a vaccine may not be a magic bullet. Russia recently announced that it had a vaccine based on promising animal tests but before extensive human trials,but even if it were widely available, how many people outside Russia would take the risk of being inoculated?
In addition, Reuters reported that Dr. Anthony Fauci cautioned about the effectiveness of early vaccines:
An approved coronavirus vaccine could end up being effective only 50-60% of the time, meaning public health measures will still be needed to keep the pandemic under control, Dr. Anthony Fauci, the top U.S. infectious diseases expert, said on Friday.
“We don’t know yet what the efficacy might be. We don’t know if it will be 50% or 60%. I’d like it to be 75% or more,” Fauci said in a webinar hosted by Brown University. “But the chances of it being 98% effective is not great, which means you must never abandon the public health approach.”
John Authers detailed some of the practical considerations in vaccine development and deployment in a Bloomberg Opinion piece. The main points are summarized below.
Mid-week market update: As the market tests resistance at the old highs, is sentiment greedy enough? The Fear and Greed Index stands at 73, and recently peaked at 75. While readings at these levels can indicate high risk environments, they have also been inexact market timing signals.
Andrew Thrasher pointed out that VIX sentiment has fallen below 10%, which is bullish for volatility and bearish for equities.
Hedge fund positioning is another matter. A recent survey of JPM and GS prime brokers that act as HF custodians reveals that the fast money crowd has gone all-in on risk.
Speculative retail positioning, as measured by leveraged ETFs, is bullish. However, readings may not be extreme enough to be described as a crowded long (via Callum Thomas).
Does that mean that stocks are about to experience a risk-off episode?
Not necessarily. I have been warning about a bearish setup for several weeks, but I was not ready to act until we saw some risk-off triggers. I had identified three tripwires to monitor. The first was the Treasury market, whose prices broke up in an inverse head and shoulders pattern, and whose yields broke down in a head and shoulders formation.
Time to turn bearish? Bond prices and yields dramatically reversed themselves yesterday, and the reversal continues today. From a technical perspective, there is nothing worse than a failed breakout or breakdown.
As the Treasury bond market closed, another opened. I had been monitoring the parabolic move in gold and silver prices. In the past, reversals in silver after a parabolic surge have not been equity friendly. We began to see a major reversal in precious metal prices yesterday.
Here is a close-up look at gold and silver. It’s impossible to know the magnitude of the stock market weakness ahead of them. In the past, some reversals have resolved themselves in minor stock market hiccups, others in major pullbacks.
The third and final bearish tripwires is a reversal of USD weakness. USD positioning is screaming “crowded short”, and we just need some sort of catalyst to push it upwards.
USD strength will create stress in the offshore dollar market, which negatively affects vulnerable EM economies and global risk appetite. The USD Index appears to have formed a double bottom and it is trying to rally. EM currencies are starting to show signs of weakness, which is not a good sign for equity prices.
Does this mean that traders should turn bearish? Not necessarily. Price momentum remains strong. Rob Hanna at Quantifiable Edges documented what happens when the DJIA experiences a seven-day consecutive win streak, which it did until yesterday. While short-term returns can be volatile, returns over a one month time horizon have a bullish tilt.
Despite the intermediate term warnings, traders have to be open to the possibility that the market is advancing on a series of “good overbought” readings.
If the market were to undergo a period of weakness, traders should await tactical bearish triggers before making a commitment to the short side. Triggers include a recycle of the 5-day RSI from overbought territory to neutral, as it has already flashed a negative divergence signal. As well, watch for a breach of the lower Bollinger Band by the VIX Index as an indication of an extreme overbought condition.
My inner investor is nervous, but holding at a neutral asset allocation. My inner trader can best be described as cautious, but not bearish (yet).
Q2 earnings season is nearly done. So far 89% of the market has reported. FactSet reported the EPS beat rate fell to 83% from 84% the previous week. The sales beat rate was fell to 64% from 69% the previous week. Both the EPS and sales beat rates are ahead of their 5-year averages.
The bottom-up consensus forward 12-month estimate continued to rise strongly at 1.62% last week after 1.03% the previous week The market is trading at a forward P/E of 22.3, which is well ahead of historical norms.
As 89% of the index has reported, this will be the final Earnings Monitor of Q2 earnings season.
The Street continues to be upbeat on the outlook of individual companies. Though the weekly changes in quarterly EPS estimates can be noisy, analysts have upgraded quarterly earnings estimates across the board, except for Q4 2020.
Company earnings guidance continues to be positive. FactSet reports that “11 [companies] have issued negative EPS guidance and 34 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 24% (11 out of 45), which is well below the 5-year average of 69%.” However, over half of the companies have withdrawn guidance, citing pandemic-related uncertainty.
The Transcript reported that companies have adopted a cautious tone in their earnings calls:
Many companies and individuals have been hard hit by the pandemic and are having a tough time. All eyes are on another stimulus package to try to cushion them. Worryingly, cases are rising worldwide even in areas that were thought to have contained the virus. The picture from July and early August is one of a mixed and uneven recovery.
Here is a brief summary of the macro outlook:
The story of Q2 earnings season has been a rapid climb in earnings and outlook, but the economy appears to be transitioning to a period of slower growth. The July Jobs Report was revealing in many ways. Even though some of the dire forecasts of negative jobs growth was averted and job growth came in at 1.8 million, which was slightly ahead of expectations, the trajectory of growth is slowing. Even though the unemployment rate fell, the unemployment rate for workers unemployed for 15 weeks or more continued to climb. This is an indication of a rising long-term unemployment problem.
Notwithstanding the slight Nonfarm Payroll beat, high frequency data is pointing to a pattern of stalling growth. As an example, new online job postings are pulling back after a period of rapid recovery.
The impasse in Washington over CARES Act 2.0 is not helping matters. Ironically, the constructive nature of the July Jobs report provided reasoning for Republican budget hawks in the Senate to resist pressures for additional stimulus. While there has been some discussion, the Democrats and Republicans are far apart on a number of major issues.
President Trump stepped in on Saturday and signed orders to try and break the logjam. He spoke at a signing ceremony at his Bedminster golf course, “We’re going to be signing some bills in a little while that are going to be very important, and will take care of, pretty much, this entire situation”.
However, his actions are problematical and they are reminiscent of the travel ban Executive Orders (EOs) when he first took office. Those EOs were challenged in court and it took several revisions before they could be implemented. Similarly, the some of the latest initiatives are subject to constitutional challenge, and others represent more glitz than substance.
Trump signed one EO and three Memoranda to extend the eviction moratorium; extend the supplemental weekly unemployment insurance support, which was reduced from $600 to $400 per month; defer the collection of the payroll tax; and to extend student loan relief. Let’s examine them one at a time.
Here is the Executive Order relating to evictions. Despite Trump’s announcement that he is extending the eviction moratorium, the EO is nothing of the sort. It directed various federal agencies to find ways to halt evictions, which is distinctly different from an eviction moratorium [emphasis added].
Eviction and homelessness is becoming a looming problem. An estimated 27% of Americans missed July rent payments. Of those, 39% were not confident they would be able to make their August payments.
More crucial to the growth outlook, here is the Memorandum to extend the supplemental unemployment insurance payments by $400 per week, down from the now expired $600 per week. The Trump Administration “declared an emergency” and raided the FEMA budget of $50 billion to pay for the extension. The measures were problematical in a number of way. First, state governors cannot pay the extra unemployment insurance without spending authorization from Congress, which the Memorandum does not. As well, under the law that governs FEMA, if the federal government declares a disaster, the state will have to request aid and pay 25% of the cost. It is unclear how many states would actually implement such a measure, and many states do not have the budget for the extra $100 per week. Even Ohio’s Republican governor Mike DeWine has expressed doubts about whether his state could participate in the program.
If this measure is fully implemented, the $50 billion would be used up in 4-5 weeks. For some perspective on the economic effects, of this measure, former Treasury official Ernie Tedeschi estimated that a $300 per week UI relief would reduce employment by 800,000 by year-end and GDP by -1%. A full expiration of $600 weekly support would reduce unemployment by 1.7 million and GDP by -2%. At best, the implementation of this measure will be highly uneven, and will depend on the legal interpretation and budget constraints at the state level.
In addition, the 2020 hurricane season is expected to be more severe than average, and FEMA would be left without a budget for disaster relief. This measure is likely to spark a constitutional crisis, as Congress is the only arm of government authorized to spend and tax. The President has no authority to extend the payment of unemployment benefits.
The Memorandum on payroll tax deferral is equally problematical. It directs the IRS to temporarily suspend the collection of payroll taxes until December. It is not a tax holiday. Trump has promised to forgive all of the suspended payroll taxes owing if he is reelected. This measure presents a quandary for employers. Since this is only a tax deferral, do they continue to deduct payroll taxes from employees until December? The prudent course of action would be to put these deferred taxes into a separate account until they are payable. In that case, there is no stimulus effect. If the employer does not deduct the payroll tax, he may be put into a position of trying to claw back the taxes from employees and former employees in the future. The hope of the policy is the employer either does not collect the tax, or does collect the tax and uses the funds for other purposes. But that course of action creates many legal uncertainties for both employers and employees.
As payroll taxes are used to fund Social Security and Medicare, Joe Biden was quick to jump on Trump’s measure as “defunding Medicare”. Undoubtedly, this will spark a healthcare funding debate in the coming days. In addition, this measure is also subject to a constitutional court challenge, as it is Congress that has taxing authority.
Of all the measures, the Memorandum on student loan relief has the least problems. The Secretary of Education does have the authority to defer student loan payments in hardship cases.
In summary, these measures are not well-written, and they are highly reminiscent of the ill-fated travel bans early in Trump’s term. Nebraska Republican Senator Ben Sasse called them “constitutional slop”. Despite Trump’s efforts to take the helm, at best these efforts will cause confusion over their implementation. At worst they will be mired in court challenges. In all cases, their economic effects will be minuscule compared to the proposals tabled by either the Senate Republicans, or by the Democrats. For an idea of the difference in scale, the $50 billion from FEMA to fund more unemployment insurance relief, even if fully implemented, is dwarfed by the sized of Republican $1 trillion relief bill, and the over $3 trillion HEROS Act passed by House Democrats. Moreover, Trump runs the risk of politically “owning” the coming slowdown with these half-measures ahead of the election.
In conclusion, Q2 earnings season has been upbeat, and Street analysts are busy raising their earnings estimates. However, the economy is likely to undergo a phase of slower growth. The CARE Act 2.0 impasse is exacerbating the effects of the slowdown, and could bring the economy to a dead stop. Wall Street has not recognized those risks, and estimate revisions are poised to lurch downwards.
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:
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.
I wrote a week ago that I had an uneasy feeling about the stock market’s intermediate term outlook. This was owing to a combination of global market weakness, and cross-asset warning signals. Last week, US equities continued to grind upwards. Let’s review how those signals evolved.
Starting with the US, the SPX broke up through a rising trend line to a new recovery high. Internals were mixed. While Advance-Decline Lines staged upside breakouts to all-time highs, the ratio of high beta to low volatility stocks, which is a risk appetite indicator was range-bound and did not confirm the market’s strength. Neither the the NYSE Advance-Decline Volume (bottom panel).
The NASDAQ 100, which had been the market leaders, broke out through resistance to a new all-time high, and the breakout held despite a pullback late in the week.
It is unclear how much good news and bad news is in the market. President Trump’s announcement on Saturday that he would sign an Executive Order and several Memorandums to extend supplemental unemployment insurance payments at the rate of $400 per week, down from $600 per week, suspend the collection of payroll taxes, defer student loan payments, and extend the federal moratorium on evictions. CFD futures, which is admittedly thin and prices are only indicative, did not react to the news.
The action in overseas markets was not as bullish. European markets (all indices are measured in local currency) pulled back and were unable to recover above their 50 day moving averages (dma). All were below their 200 dma.
Turning to Asia, Japan’s Nikkei Index was also unable to rally much, and ended the week below its 50 and 200 dma.
The technical condition of the Chinese market and the markets of China’s major Asian trading partners were mixed. Shanghai was never able to recover and break out above resistance after an initial surge and pullback. The Hong Kong market weakened below its 50 dma. Taiwan and South Korea were strong, but that’s mainly attributable to the leadership of semiconductor stocks. Singapore and Australia remain regional laggards.
What about commodity prices? They are important barometers of the global cycle, and Chinese demand as China has been an voracious consumer of commodities. The CRB Index has been rising steadily, but it remains caught between its 50 and 200 dma despite the recent stellar performance of precious metals.
Some words of caution are in order for commodity and gold prices. First, the USD has shown an inverse relationship to both commodity and gold prices, and Macro Charts pointed out that the USD Index (DXY) DSI is wildly oversold. He went on to say, “Since 2011 this was a near-perfect bottoming signal.”
I previously identified a USD reversal as one of my equity bearish tripwires. Not only is a rising dollar bearish for commodity prices, it’s also puts pressure on vulnerable EM economies that are dependent on USD financing. There are two worrisome signs from a technical perspective. The USD may be in the process of tracing out a double bottom. A greater concern are EM currencies, which are weakening even as the USD fell. This is a negative divergence that investors should keep an eye on.
As well, gold is poised for a correction. Alex Barrow observed that gold prices are 4 standard deviations above its 200 dma. He added, “This has only happened two other times in the last 30-years, in Jan 03′ and May 06′. Both prior instances led to sharp pullbacks of 18% and 25%, respectively. ”
Lastly, silver has soared against gold prices. Nautilus Research found that past similar episodes have been bearish for silver prices.
These conditions are setting for a disorderly sell-off in precious metals. One possible catalyst is the CARES Act 2.0 impasse in Washington. Arguably, gold and silver prices have been rising because of the reflationary effects of a combination of easy fiscal and monetary policy. As the agreement for fiscal support has stalled, the Fed may be left pushing on a string. These conditions are potentially bearish for gold and silver prices. As I wrote before, a correction in silver after a parabolic rally is another one of my bearish triggers for equities. Watch gold and silver prices carefully for signs of a downside break.
The third, and final bearish tripwire that I identified in the past is a rally in the Treasury bond market. The long Treasury bond ETF (TLT) staged an upside breakout out of an inverse head and shoulders pattern last week, and that breakout has held. Similarly, the 10-year Treasury yield broke down through a head and shoulders pattern, and that breakdown has also held.
This is the most concrete equity bearish signal to be concerned about.
The market broke up out of a short-term wedge, as measured by the percentage of stocks above their 5 dma, which is short-term bullish. Readings are not overbought, which is an indication that there may be further upside potential.
Looking a little longer term, the percentage of stocks above their 10 dma is neutral and rising. Readings are also not overbought, which is also an indicator of possible upside potential.
In conclusion, the intermediate term concerns that I raised a week ago remain in place. Global stock prices are not confirming the strength in US equities. Commodity prices are at risk of falling because of an oversold USD, and excessively bullish sentiment in precious metals. The Treasury market is already sounding a warning. The next 10% move in US stocks is likely to be down rather than up.
In the short run, however, price momentum is positive and the market can go higher. However, there is considerable event risk from growing US-China trade frictions, and constitutional uncertainty over Trump’s Executive Order and Memorandums.
Disclosure: Long SPXU
It’s time for one of my periodic reviews of the market from a factor and sector perspective. These reviews are useful inasmuch as they can reveal insights about the character of a market.
Let’s begin with how different regions are performing relative to the MSCI All-Country World Index (ACWI). The top panel shows the S&P 500 rolling over relative to global stocks. Even the NASDAQ 100, which had been the market leaders, may be losing relative momentum and starting to trade sideways. The middle panel shows the relative performance of two major developed market regions. Japan is underperforming, and Europe is not showing signs of market leadership as it is trading sideways on a relative return basis. The bottom panel shows the relative performance of emerging market equities. Both EM and EM xChina are starting to bottom and exhibit relative strength, which is a possible sign of a global cyclical rebound, as EM equities tend to be high beta and highly cyclically sensitive.
The analysis of EM risk appetite shows that EM currencies and EM bond prices are trending up, and their movements are correlated with the S&P 500.
The key risk to the EM bull narrative is a USD rally. There is already a crowded short in the USD. Weak EM sovereigns and companies have limited capacity to finance in their own currencies and borrow in USD. A falling USD therefore provides a tailwind for EM assets. Bloomberg reported that BoA currency strategist David Woo distilled a short USD position implies optimism about quick vaccine availability.
A bet on the U.S. dollar declining in the medium term makes the key assumption that a vaccine against the novel coronavirus will be available comparatively soon, according to Bank of America Corp.
That’s because Europe and Asia have a higher chance of fresh waves of infections the longer it takes for a vaccine to be found, a scenario that’s bullish for the dollar, said David Woo, a strategist at the bank…
A prolonged path to an inoculation would boost the odds “that liquidity support from central banks will not be enough to shore up financial markets,” he said. That could spur risk aversion and benefit the dollar given its status as a safe haven.
Several vulnerable EM are already in trouble. Turkey is in trouble again. Turkish companies have USD debt equivalent to roughly one-third of GDP. The Turkish Lira is falling, indicating rising stress for the Turkish economy.
Then there is the tragedy in Lebanon. An unexpected explosion rocked Beirut and severely damaged the port and its economy. Even before the explosion, Lebanon was already seeking IMF aid, as Bloomberg explains.
Unable to generate foreign significant support, oversee an economic recovery or guarantee public safety, Prime Minister Hassan Diab’s administration, cobbled together in January after mass protests brought down the previous government, may not last. Though Lebanon’s problems are an accumulation of nepotistic policies and public mismanagement over the decades, he’s facing criticism for doing too little to manage the country’s multiple crises.
After defaulting on a $90 billion debt pile, and before the latest disaster, Lebanon was seeking $10 billion in aid to support its financial turnaround. Beirut governor Marwan Abboud has told local media the repair bill for the capital alone will cost up to$5 billion that the government simply can’t afford.
“Large elements of the public no longer believes the government is able to manage,” Ayham Kamel, head of Middle East and North Africa research at Eurasia Group, said in a note. “The economic crisis will also deepen as the port is the main trade valve and base for many stored goods awaiting clearance.”
Talks with the IMF had stalled as it became clear that politicians and bankers could not agree even on the magnitude of financial losses let alone who should pay for them. The government has lost key advisers and officials and the foreign minister resigned this week, frustrated that political elites were too busy protecting their own interests to take the steps demanded by potential lenders to save the economy from ruin.
These economies are already teetering, even under a weak USD regime. What happens if the greenback were to strengthen?
Know your implicit exposures. This is one example of how cross-asset analysis can disentangle the macro bets investors are making.
Turning to sector analysis, our primary tool for sector analysis is the Relative Rotation Graph (RRG). As a reminder, Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership of different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
Here is the RRG chart of the US market.
Here are some of the key takeaways of the RRG sector analysis.
The first surprise is technology and communication services, which are some of the key drivers of the FANG+ leadership, have migrated from the leading quadrant to the weakening quadrant. Upon closer inspection, while technology stocks are in a well-defined relative uptrend, RSI has been weakening, indicating a loss of momentum. This is consistent with the previous observation that NASDAQ 100 is starting to weaken against ACWI.
Further weakness in technology stocks may be hastened by Trump’s recent Executive Order against TikTok and WeChat. It is unclear what the exact meaning of the EO, but it could devastate the video gaming industry as WeChat owner Tencent has ownership stakes in US companies that make popular games like “League of Legends”, “Fortnite”, and “World of Warcraft”. In addition, if the EO mandates the removal of WeChat from Apple’s App Store on a global basis, it would devastate Apple’s business in China.
The second surprise is the presence of material and consumer discretionary stocks in the leading quadrant, which implies the market’s belief that a cyclical rebound is under way. There is no question that rising but choppy relative strength in material stocks appears bullish, but bear in mind that this is the second smallest sector in the index with a weight of 2.6%.
The composition of the consumer discretionary sector is dominated by heavyweight Amazon. While the relative performance of the float weighted sector has been strong, the equal weighted performance of this sector is less impressive, but it is nevertheless strong.
Beyond the market leadership of cyclical materials and consumer discretionary stocks, what up-and-coming sectors can investors consider? For that, we analyze the three sectors in the improving quadrant, namely industrial, financial, and energy stocks. The relative chart patterns of these three sectors shows a bottoming process, but they may need more time to consolidate before they can strengthen to become market leaders. That said, I have reservations about two of the sectors. The trajectory of energy stocks on the RRG chart suggests that they are likely to roll over and fall into the lagging quadrant. In addition, it is difficult to see how financial stocks can assume a leadership position during an era when the Fed is effectively engaged in financial repression, which directly squeezes the companies in the sector.
Before embarking on an analysis of factor leadership, let’s review the status of the big three factor leaders so far. Major changes in long-term leadership often occur during transitions from bull to bear markets.
Here is the RRG analysis of some of the commonly used quantitative factors.
The weakening quadrant contains large cap growth and price momentum, which is mainly made up of large cap growth stocks. This is consistent with the previous observation of the picture of weakening NASDAQ 100 leadership.
The leading quadrant contains high beta and small cap growth. In theory, leadership by these factors should be bullish because they represent high beta stocks. However, their relative performance patterns show limited relative strength that have not yet breached key relative resistance levels yet.
The other factors in the improving quadrant can mainly be classified as different flavors of value. A revival of value over growth may be a sign of leadership transitions that occur during bull/bear phase changes.
Putting all of the sector and factor review together, what do we have?
The BoA Global Fund Manager Survey shows that global managers have been piling into US equities as the last source of growth in a growth starved world.
Sector and factor rotation analysis indicates that US large cap growth stocks are about to hand over the market leadership to cyclical and EM stocks. In a normal market, this would be the sign of a healthy rotation.
However, Vincent Deluard of Intl FC Stone pointed out that there is a problem with US large cap growth concentration. The weight of FAANMG is now greater than the combined weight of financial, energy, industrial, and material sectors.
FAANMG stocks have been on a tear. The funds flow implications of a rotation out of large cap growth is likely to put downward pressure on the overall market because of the sheer size of these stocks. The size of the cyclical sectors are unable to cope with the fund flows, and will likely leak to other asset classes, such as non-US equities, and fixed income instruments. Much will depend on the perceived catalyst of the fund flow shift. Please be reminded of Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
While cyclical sectors appear to be poised to rise, their ascendancy into the next market leaders is complicated by the fact that this is not a normal market and economic cycle where normal rules apply. The COVID Crash and subsequent recovery was sparked by an unexpected global macro shock, and not a normal downturn owing to central bank tightening that eventually leads to a recession.
Howard Marks at Oaktree explained why this is not a normal cycle.
Two of the questions I get most often these days are, “What kind of cycle are we in?” and “Where do we stand in it?” My main response is that the developments of the last five months are non-cyclical in nature, and thus not subject to the usual cycle analysis.
The normal cycle starts off from an economic and market low; overcomes psychological and capital market headwinds; benefits from gathering strength in the economy; witnesses corporate results that exceed expectations; is amplified by optimistic corporate decisions; is reinforced by increasingly positive investor sentiment, and thus fosters rising prices for stocks and other risk assets until they become excessive at the top (and vice versa on the downside). But in the current case, a moderate recovery – marked by reasonable growth, realistic expectations, an absence of corporate overexpansion and a lack of investor euphoria – was struck down by an unexpected meteor strike.
He concluded:
I’m convinced cycles will continue to occur over time, highlighted by excessive movements away from “normal” and toward extremes – both high and low – that are followed by corrections back to normalcy, and through it to excessive in the opposite direction. But that’s not to say that every event in the economy or markets is cyclical. The pandemic is not.
Here is what we know. The pandemic caused an economic downturn that ranks second in scale to the Great Depression. The monetary and fiscal authorities have responded with unprecedented level of support. However, US fiscal support may be fading. Return to normalcy therefore depends on the fight against the virus, and the availability and effective deployment of vaccines and therapeutics. Official health policies matter less than confidence. A recent study concluded that consumer fears led to a drop in business visits regardless of whether lock-down measures were in place.
The collapse of economic activity in 2020 from COVID-19 has been immense. An important question is how much of that resulted from government restrictions on activity versus people voluntarily choosing to stay home to avoid infection. This paper examines the drivers of the collapse using cellular phone records data on customer visits to more than 2.25 million individual businesses across 110 different industries. Comparing consumer behavior within the same commuting zones but across boundaries with different policy regimes suggests that legal shutdown orders account for only a modest share of the decline of economic activity (and that having county-level policy data is significantly more accurate than state-level data). While overall consumer traffic fell by 60 percentage points, legal restrictions explain only 7 of that. Individual choices were far more important and seem tied to fears of infection. Traffic started dropping before the legal orders were in place; was highly tied to the number of COVID deaths in the county; and showed a clear shift by consumers away from larger/busier stores toward smaller/less busy ones in the same industry. States repealing their shutdown orders saw identically modest recoveries–symmetric going down and coming back. The shutdown orders did, however, have significantly reallocate consumer activity away from “nonessential” to “essential” businesses and from restaurants and bars toward groceries and other food sellers.
So where does that leave us? I believe that equity risk and return are asymmetrically tilted to the downside. Conventional sector and factor analysis is pointing towards a rotation out of US large cap growth stocks into cyclical and EM equities. However, this is not a normal cycle and many of the usual investment rules go out the window. Historical analogies are of limited use. This is not 2008 (Great Financial Crisis), 1999 (Dot-com Bubble), 1929 (Great Depression), or 1918 (Spanish Flu).
Investors have to consider the bearish scenario that a rotation out of US large cap growth does occur because of a crowded long positioning, but the rotation into cyclical and EM does not occur. Instead, the funds find their way into Treasuries and other risk-off proxies because of either the failure of early vaccine trials, or teething problems with deploying vaccines and therapeutics. In that case, the growth path falls considerably from the current consensus, and a risk-off episode and valuation adjustment follows.
One of the key signposts of the bearish scenario is the price of precious metals. Both gold and silver have been soaring. While they are overbought, their fundamentals are inversely correlation to real interest rates. However, investor sentiment and positioning is at an extreme crowded long. Should precious metals fail to respond to further signs of falling real rates, then the bearish scenario becomes a strong possibility.
Mid-week market update: The July Employment Report has the potential to be a game changer in how the market perceives the recovery. Estimates of job gains are all over the place, and the median stands at 1.5 million.
High frequency economic data has been weakening, and I am inclined to taken the “under” consensus on the print. This could be a big negative surprise for the market and spark a risk-off episode.
There is a flood of high frequency data that suggests a soft Nonfarm Payroll (NFP) report. Much of the gains in employment in recent reports are attributable to the return from furlough of low-wage service workers. A new study and poll of over 6,400 US respondents shows that workers previously laid off and re-hired are being laid off again.
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Using high frequency Census data, former Treasury official Ernie Tedeschi estimated the NFP print to be a loss of -2.2 to -4.7 million jobs, which would be a huge negative shock.
The market’s reaction to the current economic outlook has been mixed. The risk-on rally from the March lows is largely attributable to the expectations of a V-shaped recovery, not just in the US but globally. One useful cyclical indicator is the copper/gold ratio, which has closely tracked the 10-year Treasury yield. These two indicators have diverged recently. The copper/gold ratio rose, and then fell. The reversal can be partly explained by the strength in gold prices. At the same time, the 10-year Treasury yield fell to all-time lows, which is a risk-off signal. Which is right?
The decline in bond yields and rally in bond prices are technically significant. The 10-year yield broke a significant support while tracing out a head and shoulders formation, with a target of 0.23%. Similarly, the long bond ETF (TLT) staged an upside inverse head and shoulders breakout with an upside target of 188. Both breakouts are holding so far.
As I pointed out before, the SPX appears to be tracing an Elliot Wave diagonal triangle, which is an ending pattern. As well, the higher highs are not being confirmed from a momentum or breadth perspective.
The NASDAQ 100, which have been the market leadership, has staged an upside breakout through resistance.
We could see some real fireworks this Friday from both the NFP report and the soft deadline of CARES Act 2.0 negotiations.
Q2 earnings season is now past the halfway mark. So far 63% of the market has reported. FactSet reported the EPS beat rate rose to 84% from 81% the previous week. The sales beat rate was fell to 69% from 71% the previous week. Both the EPS and sales beat rates are ahead of their 5-year averages.
The bottom-up consensus forward 12-month estimate rose 1.03% last week after a strong 1.05% the previous week The market is trading at a forward P/E of 22.0, which is well ahead of historical norms.
Wall Street analysts have been increasing upbeat on the outlook of individual companies. Though the weekly changes in quarterly EPS estimates can be noisy, analysts have upgraded quarterly earnings estimates across the board, except for Q4 2020 earnings. Q2 2020 revisions were especially strong.
Company earnings guidance offered a “good news, bad news” message. The good news is guidance has been extremely positive, compared to the historical experience of negative earnings guidance has swamped positive ones. The bad news is over half of the companies have withdrawn guidance, citing pandemic related uncertainty. Deprived of guidance, many analysts are flying blind, which creates greater uncertainty in EPS estimates.
Courtesy of The Transcript, which monitors the earnings calls, the main feature last week was Big Tech strength.
There were a lot of major data points about the economy last week but the biggest news of all seemed to be just how well tech companies did despite the massive economic dislocation. In a quarter where GDP fell at a 33% annualized rate, Apple managed to grow revenue by 11%! Stimulus probably played some role in tech companies’ strong performance, but beyond the stimulus is the fact that COVID has pushed everyone to spend even more time at home and on the internet. The behavioral shifts appear to be long-lasting too. 20 years after the dot com bubble, the internet is still not done reshaping society.
Here is a brief summary of the macro outlook:
One nagging issue with the equity rebound off the March lows is valuation. The market is trading at a forward P/E of 22.0, which is well ahead of the 5-year average of 17.0 and 10-year average of 15.3. There has been much discussion whether these historically high valuations are justified.
One way of thinking about the market is to separate the large cap FANG+ names from the rest of the market. Assuming that 2020 earnings are a disaster that can be ignored and investors should consider 2021 earnings for a more normalized view of P/E multiples, the top 5 stocks in the index trade at a FY2 P/E of 31, compared to 18 for the rest of the index. We can make a couple of observations from this analysis.
One signal of an overvalued market is excessive equity financings. If stocks are expensive, then companies prefer financing with cheap equity over expensive debt. That was one characteristic of the dot-com era, whose financing landscape was flooded with IPOs that skyrocketed on the first day of trading. FactSet reported that IPO activity is not excessively high by historical standards.
However, the froth in this market has turned from IPO to the SPAC, or “Special Purpose Acquisition Company”. The Economist explained the SPAC this way:
An empty vessel can accommodate all manner of dreams. This trait helps explain the growing allure of the “special purpose acquisition company” (SPAC), a shell company listed on the stock exchange with a view to merging it with a real business. Ventures such as Virgin Galactic, in space tourism, and Nikola, in electric vehicles, have become listed companies by this route. Silicon Valley’s dream factory spies a way to sidestep the trials of an initial public offering (IPO). Bill Ackman, a shrewd hedge-fund manager, has just raised a $4bn mega-SPAC. He is looking for a unicorn to make a home in his empty store.
The view in Silicon Valley is that an IPO is a rotten process. There is typically a fixed fee, of up to 7% of the sum raised. And the value of the company is lowballed, say tech types, to allow for a satisfying first-day “pop” in the share price. Yet cost is not the only bugbear—and, perhaps, not even the main one. What entrepreneurs and their venture-capital backers hate about the IPO is the loss of control. They are used to being big shots in Silicon Valley. They do not like deferring to Wall Street types at all.
In effect, the SPAC is an IPO hack. It’s a way to get around the fees of the IPO.
Enter the SPAC, which is a sort of pre-cooked IPO. A shell company is set up by a sponsor. The SPAC is listed on the stock exchange via an IPO. The sponsor then finds a private business for the SPAC to acquire with the proceeds. Typically this will be a late-stage (ie, fairly mature) private company, whose owners and venture-capital backers are looking to cash out. The private company merges with the SPAC, following a shareholder vote. It is then a public company.
The usual fee for the sponsor is 20% of the equity, which is a way of compensating him and the SPAC management team. The concept of the SPAC is not new. At the height of the South Sea Bubble, one company raised money “for carrying out an undertaking of great advantage, but nobody to know what it is”. For investors, they are bearing the risk of writing a blank check to a sponsor, and hoping that he can find the next Virgin Galactic, Nikola, or “undertaking of great advantage”.
Barron’s this week featured an article highlighting the issues surrounding SPACs. Reuters also reported that Billy Beane, of Moneyball fame, is looking to raise a $500-million SPAC.
Is the SPAC frenzy the 2020 version of the dot-com IPO bubble? Is SPAC activity a signal equity capital has become too cheap?
Another bull case for elevated P/E valuations is low interest rates. BCA Research pointed out that falling real rates are not only bullish for gold, but they are also bullish for P/E multiples as well.
John Hempton at Bronte Capital had the following thoughts about P/E ratios, interest rates, and valuations. It’s understandable why high growth companies like AAPL and GOOG attract high P/E multiples, but what about boring businesses like KO?
Interest rates are indeed low. If you believe that interest rates stay at zero forever then stocks whose earnings are unlikely to decline much (such as say The Coca Cola Company) should be valued at very high PE ratios.
Rather than just focus on P/E multiples, Hempton thinks that earnings are at risk:
We think – instinctively – that the aggregate earnings capacity of US business is at risk…
The corollary is that profit share is at historic highs, indeed, astonishing highs. Almost everywhere you look in the US you see companies that earn more than you would expect. Our personal favorite is Lamb Weston, which makes wholesale potato chips (fries to Americans) delivered to restaurants that wind up on your plate/hips. The 2019 operating margin of Lamb Weston is almost 18 percent. The operating margin of Apple, by comparison, is under 25 percent. The idea that a company whose sole job is to buy potatoes from farmers, chop them up, freeze them and deliver them to restaurants can earn margins even close to Apple is astonishing.
But what we see for Lamb Weston we see right across American society.
The American market is at above-average multiples of massively-above-average profits. Competition should usually drive down profit share, and democratic politics has – at least in theory and cyclically – some kind of redistributive effect.
While Hempton is concerned about the long-term trajectory of operating margins and earnings, the near term earnings outlook also faces downside risk. US households are falling off a fiscal cliff (see Fiscal cliff = Double dip). At publication time, the White House is still negotiating with the Democrats on a rescue package, but there is an enormous gulf in each side’s budget priorities.
Setting aside the economic and political pros and cons of each side’s proposals, here is the legislative math. There are about 15-20 Republican Senators who are adamantly against any further stimulus for philosophical reasons. To pass a rescue bill, the White House and Republican Senate leadership will need substantial support from the Democrats. As an illustration of Republican disunity, former Fed governor nominee Stephen Moore wrote a WSJ op-ed that blamed both the Democrats and Senate Republicans for the failure to pass a relief bill [emphasis added].
President Trump needs to reset the debate on the latest coronavirus relief bill. Senate Republicans have scuttled their best pro-growth idea—a payroll tax cut—and instead released a $1 trillion spending bill. Last week Mr. Trump acknowledged that compromising with Speaker Nancy Pelosi is a fool’s errand, because the House won’t agree to anything that boosts growth and job creation. The Democratic plan includes a six-month extension of the $600-a-week unemployment bonus and $3 trillion in new spending. It would sink the economy and imperil Mr. Trump’s re-election.
The lack of a Republican united front puts the Democrats in the driver’s seat if a CARES Act 2.0 is to be passed. What will they ask in return? How about most of the provisions of the $3 trillion HEROS Act passed in the House? What about funding for the Post Office to facilitate universal mail-in voting in November?
The Washington Post reported that “Pelosi, Mnuchin and Meadows all appeared on talk shows Sunday morning and indicated they were not close to a deal”. At some point, each side will have to make the political calculation of what they want and what they are willing to give up in order to a rescue package, compared to allowing the economy to go over a cliff and blame the other side. Viewed from that perspective, the odds of a deal are slim.
Stresses are already appearing in the economy in the form of skyrocketing bankruptcies, and that’s before the economy fell off the fiscal cliff.
The July Jobs Report has the potential to be a big negative surprise. Indeed.com reported that, even in an outperforming industry like tech, job growth has been stagnant.
Something’s gotta give. Street analysts have been revising EPS estimates upward, but the near-term downside risk in EPS estimate revisions is enormous. If and when they start falling, expect stock prices to adjust downwards accordingly.