Why you should and shouldn’t invest in Bitcoin

Posted by Cam Hui -

In response to my recent publication (see A focus on gold and oil), a number of readers asked, “What about Bitcoin (BTC)?” Indeed, BTC has diverged and beaten gold recently. Even as gold prices corrected, BTC has been rising steadily since early October.
 

 

Here are the reasons why you should and shouldn’t invest in Bitcoin.
 

 

The long-term bear case

Bitcoin and cryptocurrency adherents and enthusiasts have promoted BTC as an alternative currency outside the control of national governments. In doing so, they either missed or forgot the lessons learned in Money and Banking 101, which is usually an upper-level course offered to undergraduate economics students. Let’s compare the characteristics of BTC (and other cryptocurrencies) to gold, which is widely acknowledged to be an alternative currency and asset class.
 

Is BTC a store of value?
Anything is a store of value if human society deems it to be so. Salt was a store of value in ancient societies. The Chinese today channel enormous savings into real estate, some of which are built on leasehold land, and apartments deteriorate over time. In the past, I have in a semi-serious way referred to China’s M4, which is the M3 money supply plus the value of China’s property market.
 

Gold is a store of value. For hard money adherents, a gold standard limits the ability of governments to print money. The global (gold) money supply is determined by how much miners take out of the ground each year. Based on these assumptions, the growth in gold should equal real growth in global GDP in the long run.
 

What about Bitcoin? The growth in BTC is a function of mining cost. Mining cost can be decomposed into the price of electricity and computing power. Over the long run, innovations like quantum computing will pose a threat to cryptocurrencies inasmuch as they make the mining process much easier. As Milton Friedman famously taught us, too much money chasing too few goods and services creates inflation.
 

Is BTC a medium of exchange?
In theory, gold is a medium of exchange, though it’s difficult to buy much with gold coins and bullion. During the civil war that led to the disintegration of Yugoslavia, there were anecdotal reports that gold was a medium of exchange, but the bid-ask spread on gold was wide – as much as 50%. Similarly, South Africans who wanted to emigrate during the apartheid years when the authorities imposed foreign exchange controls on the country could take their wealth out in gold bullion. However, they did have to pay a relatively wide bid-ask spread.
 

Today, BTC is not widely accepted as a medium of exchange. However, that is changing. PayPal announced in October that it would allow customers to use it and other virtual currencies to shop on its network. Reportedly, the S&P Dow Jones Indices will launch specific crypto indexes in 2021. Acceptance is widening.
 

One legitimate criticism of the use of BTC as a medium of exchange is price volatility. Until volatility starts to settle down, it will be difficult to use any cryptocurrency to pay for goods and services. If you are a merchant transacting in BTC, but your costs are in USD or any other conventional currency, why would you accept that kind of exchange rate volatility? Put it another way, what premium should a merchant put on BTC pricing over USD pricing for the same goods or services as compensation for BTC volatility?
 

Banking BTC
If BTC is indeed an alternative currency and medium of exchange, then a whole host of issues surrounding the banking of that currency arises.
 

In many ways, BTC banking resembles the early development of US banking. Today’s BTC owners typically buy and sell the cryptocurrency at an exchange, which charges fees of several percent to deposit funds and trade. Some early exchange ventures failed or saw their cryptocurrency inventory disappear either owing to theft or fraud in the manner of the Wild West of US banking during the 19th Century.
 

As exchanges have matured and become more established, they have become more mainstream. One example of an exchange is Coinbase, which is registered in the US with the Financial Crimes Enforcement Network and has an E-Money License from the UK’s Financial Conduct Authority. Other major exchanges include Kraken, Bittrex, and Binance. However, increasing financial regulation also means that one of the initial reasons behind the creation of an alternative currency beyond the reach of establishment authorities becomes weaker.
 

As well, some crucial questions involving BTC banking arises in the principles of Money and Banking 101.
 

First, if you lend out your BTC, how would you set the proper interest rate (that’s denominated in BTC)? Determining the interest rate on a loan is a function of several factors. The expected inflation rate, term premium, or the term of the loan, and creditworthiness are typical things to consider. In light of the enormous volatility of the exchange rate, what’s the expected inflation rate of a basket of goods and services in BTC?
 

In addition, there are costs to holding BTC and other cryptocurrencies. These currencies are coded in multiple ledgers all around the world on computer systems. Computer systems cost money to maintain and operate. Implicitly, BTC begins with a negative interest rate or storage cost. Similarly, holding gold also has storage costs, but the storage cost is offset by the inflation hedge feature of gold.
 

More importantly, how do you deal with the fractional banking issue of money creation? Here is how money creation works. In a modern banking system, if individual A deposits $100 into a bank. The bank then lends out $90 of that deposit to individual B, keeping $10 in reserve. B then deposits the $90 into his bank account, and the bank then lends out 90% of the $90 ($81) to C, who then deposits the $81 into his account, and so on. 
 

In the BTC world, can someone lend out their BTCs? Can an exchange lend out their BTCs on deposit? If so, how do the new BTCs get created, because each piece of a digital currency is coded in multiple ledgers? When you lend out a new BTC in a fractional banking system, how do the new funds get coded? 
 

One alternative scheme is to require that if a bank or exchange lends out a BTC, those funds are not available to the depositor? In that case, the bank would have to distinguish between a demand deposit, like a checking account where the depositor can access his funds at any time, and bank-issued GIC-like instruments. Such a system would be a classic gold standard-like banking system that limits credit creation and put severe brakes on economic growth. It would also create disincentives for people to transact in that currency because of the inability of the banking system to finance growth.
 

In conclusion, Bitcoins and other cryptocurrencies are the latest digital equivalent of Beanie Babies or sports figure trading cards. It’s difficult to see how they can have value in the long run.
 

 

The FOMO party bull case

On the other hand, there are some good reasons for investors to get involved in BTC. The bid-ask spread on BTC and other cryptocurrencies is substantial. Market making and storage of BTC is a profitable enterprise, as long as proper risk controls are maintained. Invest not in BTC, but in BTC services and infrastructure.
 

In addition, Josh Brown forcefully laid out Five Reasons Why Bitcoin is Going Up which I summarize below (with my comments in parenthesis).
 

Reason one: It’s going up because it’s going up (otherwise known as FOMO).
Reason two: Paypal and Square’s Cash App (or widespread adoption).
Reason three: Wall Street legends are being won over (institutional FOMO).
Reason four: Gold and silver aren’t “working” (momentum trading).
Reason five: More on-ramps, in addition to PayPal and Square, are on their way. Bitcoin in your Fidelity account. Bitcoin on the Robinhood app. Bitcoin in your bank account. Bitcoin as a default option in your payments account, etc.  (see reason two)
 

Brown concluded:

This is changing, slowly but inevitably. More access, cheaper pricing, less fear, less hesitation. Mainstream buy-in and adoption by the Fidelity’s and the PayPal’s of the world removes the counterparty risk concerns and the fear of theft from the front burner. The rise in price will serve as all the confirmation bias the adopters need in order to be spurred on even further into their allocations.

In other words, Bitcoin is becoming the next fad in momentum and FOMO investing. There are profits available in the short and medium-term. Enjoy the party, but don’t mistake it for a durable alternative currency.
 

Melt-up, or meltdown?

Posted by Cam Hui -

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

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

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

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

 

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

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

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

 

An overbought market

The S&P 500 closed November above its upper monthly Bollinger Band. This is a rare occurrence and going back to 1990, there were 14 occurrences. Exactly half of the episodes saw the market continue to rise, and the other half fell.

 

 

Virtually all sentiment models are screaming “caution”!

 

 

On the other hand, momentum is extremely strong after the S&P 500 gained 10.8% in November. Are these overbought conditions the signs of a melt-up, or the warnings of an imminent pullback?

 

 

Froth, froth everywhere

SentimenTrader observed that for the first time in 15 years, 60% of its sentiment indicators are exhibiting excessive optimism – which is a record.

 

 

However, sentiment indicators come with an important caveat. They work better at pinpointing bottoms than at calling tops. That’s because investors panic at bottoms, which are easy to spot. On the other hand, investors become complacent at market tops but need a bearish catalyst for the market to fall.

 

 

 

Bullish momentum = Melt-up?

In the meantime, the S&P 500 is roaring ahead after a 10.8% gain in November. Ryan Detrick of LPL Financial found that price momentum tends to persist after 10% monthly gains if you look ahead 6 and 12 months. Results for the next month, which in this case is December, show a positive average and median gain, but the success rate is a coin flip at 50%.

 

 

SentimenTrader also observed that NAAIM active managers are so bullish they’re levered long. However, the “average return 3 months later was 5%, with the 3 precedents all being higher”. The moral of this story: don’t discount the effects of price momentum.
 

I have been monitoring the % of S&P 500 stocks above their 200-day moving averages. Readings have spiked above 80% to over 90%. Past episodes of surges above 80% have been divided into sustained advances (in grey) and pullbacks (in pink). However, only readings above 90% have been signals of “good overbought” rallies. These conditions argue for a market melt-up despite warnings from sentiment models.

 

 

Here is an odd but bullish anomalous sign from sentiment models. Macro Charts observed that traders are selling aggressively, and the “5-Week positioning change is one of the most negative in history – previously only seen at bottoms”.

 

 

These readings are unusual because hedge fund equity futures trading is mainly dominated by Commodity Trader Advisers (CTAs). CTAs are trend followers, and they should be buying, not selling, as prices have been rising. The most likely explanation of significant large speculator selling can be attributable to rebalancing flows by institutions. Equities have outperformed bonds so much in Q4 that large balanced funds need to sell stocks and buy bonds in order to return to their target weights. If the stock market is holding up well in the face of concerted rebalancing selling, then the underlying momentum is stronger than appears.

 

That’s a bullish sign.

 

 

Buy the dip!

Troy Bombardia resolved the bull and bear debate this way.
Something truly rare is happening in financial markets right now. Both sentiment and breadth figures are at multi-year highs (if not multi-decade highs). When this happens, investors and traders split into 2 camps: those who think that stocks will crash (sentiment camp), and those who think that this is only the start of a great bull market (breadth & breakout camp).
Things are never so black and white. The 2 narratives can co-exist if we consider 2 different time frames. 

 

While unimaginably high sentiment can and usually does lead to short term losses and market volatility, incredibly strong breadth is more of a long term bullish sign for stocks.
This year has been extremely unusual in the markets. An anecdotal report from Goldman’s prime brokerage desk revealed that hedge funds approached the November election cautiously and they were underweight equity beta. As a consequence, “both fundamental and systematic L/S equity funds gave up nearly half of their YTD alpha (over MSCI) in November, one of the worst months for alpha performance in 5 years.”

 

This is a classic setup for a market melt-up. With the December quarter-end and year-end approaching, which is a deadline on which the quarterly and annual 20% incentive fees are calculated, there is a temptation for hedge fund traders to engage in a beta chase for better returns. It is noteworthy that the stock market’s reaction to Friday’s big miss in the November Jobs Report was to rise. A market’s ability to shrug off bad news is bullish. This is also an indication of the strength of price momentum. 

 

Callum Thomas of Topdown Charts pointed out that that value-growth seasonality is tilted towards value in December and January. In light of the Great Rotation into value and small-cap stocks, a hedge fund beat chase is likely to benefit these groups should the market melt-up.

 

 

The top-down macro perspective is also supportive of a risk-on environment. Manufacturing PMIs and ISM manufacturing data are all pointing to a global rebound. Historically, such conditions have sparked a fund flows stampede into equities.

 

 

To be sure, some short-term warnings are appearing. The 5-day correlation between the S&P 500 and VVIX, the volatility of VIX, has spiked to over 70%. Past episodes have seen the market stall but pullbacks have tended to be relatively shallow.

 

 

In this environment, investors should be buying dips as the downside risk should be relatively limited.

 

 

How long can the melt-up last?

Under a melt-up scenario, how long can the rally last? I have two ways of estimating the length of an advance. 

 

Macro Charts pointed out that corporate insider selling has risen to levels not seen in four years. However, insiders tend to be early in their trades, and the market usually doesn’t top out for several weeks or months after a spike in selling. Based on this data, pencil in a top during the January to February time frame.

 

 

As well, a reader alerted me to an analysis featuring the 56-week pattern. 
Here is how it works: any time the S&P 500 index (SPX) rises more than five percent within a 20-session stretch, 56-weeks later there is often a sell-off of varying proportions. This happens consistently enough that if you track through the data, you can calculate that the average return for the 40-day period at the end of 56 weeks is almost a full one percent lower than the average return for any other 40-day period over the past 26 years. The reason for bringing it up now is that, as shown in the chart below, the recent pullback came at the beginning of such a pattern. Even more interesting is that three more ending patterns are due to create selling in close proximity during the second quarter of 2021.

 

The 56-week pattern has a simple explanation. To take advantage of favorable tax treatment, many high-net worth investors and professional money managers prefer to hold positions longer than one year. What that means is that if a lot of them buy at the same time, it shows up in the market averages. A little more than a year later, there comes a point where a lot of money is ready to be taken out of one position and moved into another.

 

The 56-week pattern puts the timing of a significant downdraft in the March to July period. Based on this framework, we should also see some market weakness starting around mid-December 2021.

 

In conclusion, the weight of the evidence is supportive of the melt-up scenario. Any market weakness should be relatively shallow. You should take advantage of dips to add to long positions. The timing of a melt-up market top is less clear, but start to be cautious by late January, but the ultimate top may not arrive until February or March.

 

 

Disclosure: Long SPXL

 

A focus on gold and oil

Posted by Cam Hui -

I received considerable feedback from last week’s publication (see How to outperform by 50-250% over 2-3 years), mostly related to gold and energy stocks.
 

 

In last week’s analysis, I had lumped these groups in with other cyclicals. Examining them further, I conclude that both gold and energy stocks have bright futures over the next 2–3 years. I estimate that gold prices could beat US large-cap growth stocks by about 100% over this period, and I would favor bullion over gold stocks. The upside target for energy stocks is a little bit tricky owing to their declining fundamentals and falling demand from ESG investing. The upside relative performance target is wider at 25–300% for this sector.
 

 

A New Commodity Supercycle

Both gold and oil are major commodities, and we may be seeing the start of a new commodity bull and supercycle for the next 10 years.
 

Commodity prices are very washed-out relative to stock prices. There is little or no institutional memory of what to do if inflation heats up. The last secular commodity bull began in the 1970’s, and there are hardly any portfolio managers working today who remember that era, and how to respond and position portfolios.
 

 

Mark Hulbert recently argued that the next decade could represent a period of mean reversion in asset returns.

Here’s why investors should expect below-average returns over the next decade: the historical data exhibit a strong reversal tendency. To show this, I calculated a statistic known as the correlation coefficient, which would be 1.0 if the best trailing decade returns were correlated with the best subsequent decade returns, and so on down the line. The coefficient would have been minus 1.0 if the best trailing returns were correlated with the worst subsequent returns, and so on, while a coefficient of zero would mean there is no detectable relationship between the two.
 

When focusing on all months since 1881 in Shiller’s database, I calculated this coefficient to be minus 0.35, which is strongly significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.

 

 

At a minimum, it would be no surprise to see commodity prices rise as the global economic recovery gains strength as the COVID pandemic fades.
 

 

China has been a voracious consumer of commodities and the locomotive of global growth. Its November Caixin PMI, which measures the activity of smaller firms, has roared ahead to a decade high. This is supportive of a surge in commodity demand from the Middle Kingdom.
 

 

 

Gold: Inflation hedge
That brings us to the story of gold, which is traditionally viewed as an inflation hedge. Today, a combination of easy central bank policy determined to raise inflation and easy to neutral fiscal policy is likely to ignite a round of asset price inflation.
 

Indeed, inflationary expectations as measured by the 5×5 forward rate are rising. In response, the trade-weighted dollar (inverted scale) is falling. While inflationary expectations are still relatively tame at 1.9%, these readings nevertheless are signaling a rising inflation regime.
 

 

I expect that commodity prices will outpace the S&P 500 in the next few years. The chart below depicts gold prices, the CRB Index, and the ratios of the S&P 500 to gold and to the CRB. In particular, the S&P 500 to gold ratio is an especially sensitive barometer of commodity price strength. The bottom panel shows that we are undergoing a period of falling S&P 500/gold, which is reminiscent of the mid-1990’s and the post-GFC period when the economy was in expansion and commodities outperformed stocks.
 

 

Asset managers are catching on to this new commodity reflation trend. The BoA Global Fund Manager Survey shows fund manager weights in commodities began rising just as the S&P 500 to gold ratio started falling. Commodity weights are not excessive, and they have more room to run should inflationary and growth expectations rise further.
 

 

From a technical perspective, gold prices staged an upside breakout from a multi-year base. They retreated below the breakout as a test. One hint of bullish strength comes from inflationary expectations, which broke out of a declining trend line.
 

 

Moreover, gold sentiment has fallen to bearish extremes to levels last seen when gold was $1200/oz.
 

 

That said, I would favor a direct investment in gold bullion instead of gold stocks. Large and small-cap gold stocks have performed roughly in line with their capitalization benchmarks (top panel). The gold stock to gold ratio (bottom panel) staged an upside breakout in April and remains above the breakout level. Gold stocks are not especially cheap on an historical basis relative to the underlying commodity. As well, small-cap golds are outperforming large-cap golds (middle panel), indicating a heightened level of speculative fever in the sector.

 

 

 

An important caveat for Canadian investors

I would like to add an important caveat for Canadian Dollar denominated investors. Commodities are usually priced in USD, but the CADUSD exchange rate has been highly correlated with commodity prices. While CAD denominated investors should still profit during an era of rising commodities, they will face headwinds if their currency exposure is unhedged.
 

 

A similar warning applies to investors residing in other countries with high levels of commodity exports, such as Australia and New Zealand.
 

 

Oil and gas: The new tobacco

Turning to the energy sector, the fundamentals look terrible. A recent Bloomberg article blared that Peak Oil is upon us, but it’s a Peak Oil of a different sort. The old Peak Oil thesis relied on dwindling global supply and the inability of producers to meet demand. Today’s Peak Oil is all about falling demand.

British oil giant BP Plc in September made an extraordinary call: Humanity’s thirst for oil may never again return to prior levels. That would make 2019 the high-water mark in oil history.
 

BP wasn’t the only one sounding an alarm. While none of the prominent forecasters were quite as bearish, predictions for peak oil started popping up everywhere. Even OPEC, the unflappably bullish cartel of major oil exporters, suddenly acknowledged an end in sight—albeit still two decades away. Taken together these forecasts mark an emerging view that this year’s drop in oil demand isn’t just another crash-and-grow event as seen throughout history. Covid-19 has accelerated long-term trends that are transforming where our energy comes from. Some of those changes will be permanent.

In addition, the widespread of ESG investing will reduce demand for energy stocks. The world is going green. Investment in coal, oil, and natural gas is going to be shunned in different degrees. As an example, the Trump administration rushed an auction of drilling rights inside Alaska’s wildlife refuge. But no oil majors are participating in the auction owing to high extraction costs, and no major American banks have expressed interest in financing these transactions.

 

 

While petroleum products are still useful for transportation because of the internal combustion engine, technological advances in the last 10 years have made solar and wind power highly competitive in many areas for electricity generation. Even the cost of gas peakers, or natural gas power plants that only operate at peak demand hours, have come down. The main hurdle for renewable electricity generation is now battery technology and the cost of storage.

 

 

That said, the performance of the energy sector looks washed-out. The energy sector has become the smallest weight in the S&P 500. Exxon Mobil was recently kicked out of the Dow Jones Industrials Average after nearly a century to make way for Salesforce.com. Bloomberg also reported that the company announced a record writedown of its assets.
 

Exxon Mobil Corp. is about to incur the biggest writedown in its modern history as the giant U.S. oil and gas producer reels from this year’s collapse in energy prices.

 

Exxon — traditionally far more reluctant to cut the book value of its business than other oil majors — on Monday disclosed it will write down North and South American natural gas fields by $17 billion to $20 billion. That could make it the industry’s steepest impairment since BP Plc’s 2010 Gulf of Mexico oil spill that killed 11 workers and fouled the sea for months. Meanwhile, capital spending will be drastically reduced through 2025.
So what did the stock do after it announced these writedowns? It rose on the day.

 

 

The reaction to XOM’s news is indicative of the market action in the sector. While the relative performance of large-cap energy has been dismal as it exhibited a lower low, small-cap energy has been outperforming with a relative return of a higher low. In fact, the high-beta small-cap energy stocks have been outperforming the more stable large caps over the last few months.

 

 

These are the classic signs of a wash-out sector. It is unloved and stops responding to bad news. However, long-term fundamentals present challenges for investors. It is an industry with declining long-term demand and shunned by ESG investors. Energy has become the classic value play, in the manner of tobacco stocks.

 

 

Estimating upside potential

The final step of my analysis is the upside potential for gold and energy investments. I repeat the same exercise shown in last week`s analysis (see How to outperform by 50-250% over 2-3 years).

 

Here is how I quantified the potential relative performance spreads. The following chart depicts the relative returns of the Dow to NASDAQ 100 (old vs. new economy cyclical factor). The top panel of the chart shows the one-day relative returns of the Dow/NASDAQ 100 ratio, which has surged recently. Also shown are the relative returns of the S&P 600/NASDAQ 100 ratio (small caps to large-cap growth), MSCI World xUS vs. NASDAQ 100 (non-US vs. US growth), gold vs. NASDAQ 100 (gold vs. growth), and the energy sector vs. NASDAQ 100 (energy vs. growth).

 

 

The top panel of daily returns shows a pattern that is consistent with the period following the dot-com bubble top, which suggests that the market is undergoing a similar multi-year turn in leadership.

 

In the second panel, I went on to estimate upside relative potential by observing the dot-com experience, which saw the DJIA/NASDAQ 100 plunge and mean revert to a level just above the spot when the ratio began to accelerate downward, indicating the start of an investing mania. The magnitude of the current episode of downward acceleration was not as severe; therefore, the snapback should be less than the dot-com era. The dot-com bust performance snapback occurred over a period of 2-3 years, and I would expect the time frame for a similar reversal to be about the same.

 

Using these techniques, my upside relative return targets for cyclical stocks is 50-60% of outperformance; small-caps 60-70%; non-US stocks had two targets, the first with about 100% of outperformance, and the second of up to 250%; gold bullion about 100%; and two relative performance targets for energy stocks of 25-60% and 300%.

 

In conclusion, both gold and energy stocks have bright futures over the next 2-3 years. I estimate that gold prices could beat US large-cap growth stocks by about 100% over this period, and I would favor bullion over gold stocks. The upside target for energy stocks is a little bit more tricky owing to their declining fundamentals and falling demand from ESG investing. The upside relative performance target is wider at 25-300% for this sector.

 

The bears’ chance to make a stand

Posted by Cam Hui -

Mid-week market update: As the S&P 500 pushed to another fresh high, more cracks were appearing in the market internals, indicating that it may be time for the rally to take a pause. Negative divergences, such as the 5-day RSI and a trend of falling NYSE new 52-week highs, are warning signs for the near-term outlook.
 

 

While the intermediate-term trend is still up, the bears have a chance to make a stand here, at least in the short run.

 

 

Frothy sentiment

Sentiment indicators continue to exhibit signs of froth. The Investors Intelligence survey shows that both %bulls and the bull-bear spread haven’t seen these levels since the melt-up top of early 2018.

 

 

Option sentiment is equally exuberant. The 10 day moving average of the equity put/call ratio has fallen to levels where the market has experienced difficulty advancing in the last year.

 

 

As well, call option volumes are still exploding. The Robinhood retail traders don’t seem to have lost their enthusiasm for single-stock call options.

 

The powder is set. The bears just need an event to light the fuse.

 

 

NFP report the bearish trigger?

The trigger might be the November Non-Farm Payroll report due Friday morning. An abundance of evidence is appearing that the report is likely to miss in a big way.

 

The first sign is the ADP private market sector jobs report, which came in at 307K, compared to an expected 410K. However, ADP has shown itself to be a noisy predictor and has experienced wide variations with the actual NFP figure.

 

The current consensus forecast for November NFP is a gain of 480K jobs. The latest ADP figure  is pointing to a weak but positive NFP print, but there is evidence that we could see an actual negative jobs number. The biggest headwind is a seasonal gain of retail jobs that are unlikely to appear, and won’t be offset by online worker hiring. As well, over 90K in temporary census workers will be lost in government jobs, and state and local employment will continue to come under pressure in the absence of help from the federal government.

 

High-frequency data from outfits like Homebase, Kronos and UI claims point to negative growth in November employment.

 

 

The Census Bureau’s Household Pulse Survey is also calling for a negative NFP print for November.

 

 

In the absence of a positive catalyst such as another vaccine breakthrough or fiscal stimulus package, my best-case scenario is a weak but positive NFP headline report. There is a significant chance that we could see negative job growth for November, though the gains shown by ADP report has mitigated that risk.

 

My inner trader has taken a short position in response to weak technical internals, frothy sentiment, and the downside risk to Friday’s NFP report. At a minimum, traders should not be long risk going into the report.

 

By contrast, my inner investor remains bullishly positioned. The intermediate-term outlook remains bullish, and he would regard any weakness as an opportunity to deploy more cash.

 

Disclosure: Long SPXU

 

Will Powell twist?

Posted by Cam Hui -

Jens Nordvig recently conducted an unscientific Twitter poll on the FOMC’s action at the December meeting/ While there was a small plurality leaning towards a “steady as she goes” course, there was a significant minority calling for another Operation Twist, in which the Fed shifts buying from the short end to the medium and long ends of the yield curve.
 

 

The November FOMC minutes reveal no clear consensus on the prospect of a twist, otherwise known as yield curve control (YCC).

A few participants indicated that asset purchases could also help guard against undesirable upward pressure on longer-term rates that could arise, for example, from higher-than-expected Treasury debt issuance. Several participants noted the possibility that there may be limits to the amount of additional accommodation that could be provided through increases in the Federal Reserve’s asset holdings in light of the low level of longer-term yields, and they expressed concerns that a significant expansion in asset holdings could have unintended consequences.

Here is why that matters.
 

 

Implicit yield curve control?

There are several ways of projecting the 10-year Treasury yield based on cyclical conditions. An analysis of the copper/gold ratio and the base metals/gold ratio indicates a range of 1.4% to 1.8%.
 

 

Nordea Markets observed that the cyclical/defensive sector ratio is pointing to a 10-year yield of over 2%.
 

 

These are all estimates, but they are all giving us the same message. The 10-year Treasury yield should be a lot higher than it is today. While the Fed has not explicitly engaged in YCC, just the threat of YCC may have served to hold down the 10-year yield.
 

 

Equity market implications

Here is why this matters for equity investors. First and foremost, fixed income instruments serve as alternatives for equities. If yields are low, then equities are more attractive by comparison.

 

As well, technology and large-cap growth stocks are forms of duration plays that are more sensitive to bond yields. Even at the current level of the 10-year, the NASDAQ 100 should be underperforming the S&P 500. What happens if the Fed steps back from YCC at the December FOMC meeting? Will growth stocks crash and cyclical and value stocks soar?

 

 

Jerome Powell is testifying before Congress tomorrow (Tuesday). Perhaps we will get more clarify then.

 

A Wall of Worry, or Slope of Hope?

Posted by Cam Hui -

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

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

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

 

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

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

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

 

The proverbial Wall of Worry

Two weeks ago, I turned decisively bullish on the market (see Everything you need to know about the Great Rotation but were afraid to ask). Since then, major market indices have staged upside breakouts to new highs. The market is overbought and exhibiting a minor negative RSI divergence.

 

 

While I remain intermediate-term bullish, the short-term outlook is less certain. Market sentiment is becoming a little frothy, and the market is vulnerable to a setback should any negative catalysts were to appear.

 

The bulls will say that the market is just climbing the proverbial Wall of Worry. The bears contend that it is nearing a Slope of Hope. What’s the real story?

 

 

What I am worried about

The market can correct at any time, but that doesn’t mean that it will. Here are the major potential problems that I am worried about.

 

  • Excessively bullish sentiment
  • Fund flows and positioning vulnerabilities
  • Fiscal cliff and double-dip recession risk
Let’s consider each of these issues.

 

 

Too euphoric?

The most obvious area of concern is sentiment. Sentiment surveys are becoming increasingly giddy, which is a concern for the bulls. The Citi Panic/Euphoria Model is back at the euphoric highs seen last August.

 

 

The latest Investors Intelligence sentiment survey shows that the percentage of bulls and bull-bear spread reached levels last seen at the terminal phase of the melt-up of early 2018.

 

 

The Fear & Greed Index reached the nosebleed level of 92. It is also screaming warnings of overbought conditions, though the indicator has not proven itself to be an actionable tactical sell signal for traders in the past. Historically, the market has corrected when sentiment has become this greedy, but not necessarily right away.

 

 

Here is my alternate bullish scenario. Severely overbought conditions are usually present in the initial stage of a sustained bullish advance. The percentage of S&P 500 stocks above their 200 day moving average (dma) has surged to over 80%. Past instances have either resolved themselves with “good overbought” rallies (grey) or brief overbought conditions and pullbacks (pink). However, only readings of 90% or more have signaled a strong and sustainable bull phase. Is this a new bull?

 

 

Federal Reserve actions may be blinding technical analysts when they warn of excessively bullish sentiment and overbought conditions. In the past, economic recoveries have been marked by a steepening yield curve as the bond market anticipates better future growth. This time, the Fed and other major global central banks have promised to hold short rates near zero for years, but the yield curve isn’t steepening as strongly as it has in the past. Steepening yield curves have acted as a brake to higher stock prices by offering a higher yield alternative for investors. Indeed, the BoA Global Fund Manager Survey shows that expectations for a steeper yield curve are at all-time highs.

 

 

This time may be different. While the Fed has not explicitly engaged in yield curve control (YCC), the latest FOMC minutes has hinted at such actions and even the threat of YCC may be enough to hold down the belly and long end of the yield curve to support higher stock prices.

 

 

I would add that it isn’t just the Fed concerned about the yield curve. Bloomberg reported that ECB chief economist Philip Lane voiced similar worries, even as the German 2s10s stands at a meager 17bp, the lowest level since 2008.

“While the arrival in the coming weeks and months of further positive signals about progress in the roll-out of vaccine treatments would certainly be highly welcome,“ Lane added, “it is essential that the macroeconomic recovery is not derailed by a premature steepening of the yield curve.”

 

 

Fund flows and positioning vulnerabilities

Another sign of froth has been the stampede into stocks, as evidenced by record fund flows into global equities.

 

 

Despite the recent relative weakness of FANG+ names, retail interest hasn’t abated. Option open interest remains highly elevated.

 

 

As we approach quarter-end and year-end, the strong performance of equities could prompt balanced funds to rebalance by selling their stocks to buy bonds. Bloomberg reported that JPMorgan estimates that rebalancing flows could amount to $300 billion.
Rebalancing flows may lead to an exodus of around $300 billion from global stocks by the end of the year, according to JPMorgan Chase & Co.
Large multi-asset investors may need to rotate money into bonds from stocks after strong equity performance so far this month, strategists led by Nikolaos Panigirtzoglou wrote in a note Friday. They include balanced mutual funds, like 60/40 portfolios, U.S. defined-benefit pension plans and some big investors like Norges Bank, which manages Norway’s sovereign wealth fund, and the Japanese government pension plan GPIF, the strategists said.

 

“We see some vulnerability in equity markets in the near term from balanced mutual funds, a $7 trillion universe, having to sell around $160 billion of equities globally to revert to their target 60:40 allocation either by the end of November or by the end of December at the latest,” the strategists wrote.

 

If the stock market rallies into December, there could be an additional $150 billion of equity selling into the end of the month pension funds that tend to rebalance on a quarterly basis, they added.
For some perspective of the magnitude of fund rebalancing pressure, BoA and EPFR reported a record 3-week global equity fund inflows of $89 billion. The bulls better hope that there is sufficient demand to offset the rebalancing effect.

 

 

Fiscal cliff = Double-dip?

Turning to the Washington ollies, let’s start with the good news. Bloomberg reported that there is a tentative agreement to avoid a government shutdown.
Republican and Democratic lawmakers have reached an agreement on spending levels for the annual spending bill needed to keep the government open after current funding runs out Dec. 11 – The deal between Senate Appropriations Chairman Richard Shelby, an Alabama Republican, and House Appropriations Chairwoman Nita Lowey, a New York Democrat, increases the chances that a giant $1.4 trillion bill to fund the government can pass Congress before the deadline.  The agreement encompasses top-line amounts for all 12 parts of an omnibus appropriations package as well as the level for emergency spending above the $1.4 trillion budget cap set in law in 2019.
However, the political incentives are not in place for a CARE Act 2.0. The latest PCE report shows that personal income growth after CARES Act transfers has been steadily decelerating. 

 

 

The consensus forecast for the November Jobs Report is a gain of 520K jobs, but there is a distinct possibility that the market could be surprised by a negative print. High-frequency data from Homebase and Kronos suggests that the November Jobs Report will be flat to negative.
 

 

The Census Bureau’s Household Pulse Survey is also showing signs of weakness.

 

 

Against a backdrop of rising COVID-19 cases, government-mandated shutdowns, and little or no chance of an interim fiscal package until Biden takes office, when will the market start to focus on a double-dip recession scenario?

 

To be sure, the situation may be as dire as the headlines suggest. Pictet Asset Management estimated that it would only cost $270 billion to keep personal income on-trend. That’s not an extraordinarily high level and well within the reach of negotiators in Washington.

 

 

 

Near-term stall ahead?

Looking to the week ahead, the market rally is starting to show signs of exhaustion. The VIX Index is inversely correlated with the S&P 500, and it is falling towards the 20 level which often defines a normal market environment. However, the VVIX, which is the volatility of the VIX, is nearing an important support level. Moreover, the 9-day to 1-month VIX ratio is in complacency territory. How much more near-term downside is there to the VIX? Conversely, how much more upside is there to the S&P 500?

 

 

In conclusion, the intermediate-term trend for equity prices is up. However, the market faces considerable short-term risks and could correct at any time. However, price momentum is strong, and the market could continue to melt-up into early 2021. If I had to guess, I would put the odds of a continued advance at two-thirds, and a significant correction at one-third.
 

How to outperform by 50-250% over 2-3 years

Posted by Cam Hui -

Investors are increasingly convinced that the cyclical and Great Rotation trade is very real and long-lasting (see Everything you need to know about the Great Rotation but were afraid to ask). That should be bullish for the S&P 500, right?
 

Well, sort of.
 

Despite the cyclical and reflationary tailwinds for stocks, the S&P 500 has a weighting problem. About 44% of its weight is concentrated in Big Tech (technology, communication services, and Amazon). The top five sectors comprise nearly 70% of index weight, and it would be difficult for the index to meaningfully advance without the participation of a majority of these sectors. However, an analysis of the relative performance of the top five sectors does not exactly inspire confidence as to the sustainability of an advance. Technology relative strength, which is the biggest sector, is rolling over. Healthcare is weak. Neither consumer discretionary nor communication services are showing any signs of leadership. Only financial stocks, which represent the smallest of the top five sectors, is exhibiting some emerging relative strength.
 

 

There are better investment opportunities, and investors can potentially outperform by a cumulative 50-250% over the next 2-3 years.
 

 

The Great Rotation Risk-On trade is very real

I believe the cyclical rebound and Great Rotation is long-lasting. First, there is ample evidence that the global economy is reflating. The copper/gold ratio and the more broadly based base metals/gold ratio are both surging, indicating cyclical strength.
 

 

Earnings sentiment is improving in every region of the world.
 

 

Other cyclical indicators, such as heavy truck sales, are turning up in a way that is consistent with an early cycle rebound.

 

 

Over in Asia, the closely watched and highly timely 20-day South Korean export figure jumped in November, indicating an acceleration in global strength.
 

 

An analysis of fast-money positioning shows that hedge funds went into the November election underweight equity market exposure. When the dire forecasts of a contested election and riots in the streets didn’t materialize, they reversed course and bought equities. Current positioning is not excessive. Institutional fund flows, which is glacial but enormous, is only beginning to buy into the cyclical and reflation theme.
 

 

This Great Rotation rally has legs.
 

 

What’s the upside potential?

What are the potential gains from the Great Rotation trade?
 

An analysis of the trade setup indicates that upside potential is significant. Historically, relative style performance such as value/growth is long-lasting and the magnitude of gains significant when the dispersion in style returns are large and begin to mean revert.
 

 

A similar reversal effect can be seen for the size effect, or the small vs. large-cap relationship.
 

 

Marketwatch reported that Jim Paulsen of Leuthold and Ed Yardeni believe that small and mid-cap stocks are relatively cheap, and exhibit superior fundamental momentum compared to large caps.

Smidcaps are relatively cheap
This reflects the fact that they’ve been persistently unpopular, despite the recent gains. “Their price action has not kept up with earnings performance,” says Paulsen. Since the end of October, forward one-year estimates for the S&P 600 small-caps have gone up almost 8%, compared to 1.5% for the S&P 500. 
 

In other words, earnings estimates have gone up over four times as much, but stock prices have only gone up twice as much. 
 

From their lows during May-June, the forward earnings of the S&P 500 grew 17%, compared to 35% for the S&P 400 smidcap stocks and 57% for S&P 600 small-caps, according to Ed Yardeni of Yardeni Research. 
 

As of Nov. 24, large-cap S&P 500 stocks had a forward price earnings ratio of 22 compared to 19.7 for S&P 400 midcap stocks and 19.9 for S&P 600 small-cap stocks, says Yardeni. But the gap is effectively wider, given the greater potential for earnings growth among smidcaps going forward. 
 

The bottom line: small-cap stocks have additional catch-up potential.

Here is how I have quantified the potential relative performance spreads. The following chart depicts the relative returns of the Dow (old economy ) to NASDAQ 100 (large-cap growth). The top panel of the chart shows the one-day relative returns of the Dow/NASDAQ 100 ratio, which has surged recently. The pattern is consistent with the period following the dot-com bubble top, which suggests that the market is undergoing a similar multi-year turn in leadership.

 

 

Here are the main takeaways from this analysis.

  • Relative Return Magnitude Potential: The dot-com experience saw the DJIA/NASDAQ 100 plunge and mean revert to a level just above the spot when the ratio began to accelerate downwards, indicating the start of an investing mania. The magnitude of the current episode of downward acceleration was not as severe, and therefore the snapback should be less than the dot-com era.
  • Cyclical trade: One rough measure of the cyclical trade is the Dow (old economy) to NASDAQ 100 (new economy) ratio. The aforementioned estimate technique of upside relative performance potential is 50-60%. If history is any guide, that relative return potential should be achieved within a 2-3 year time frame.
  • Size Effect, or Small Caps: Large caps have been beating small caps for much of the last market cycle. Based on the same evidence, the upside potential is 60-70% over 2-3 years.
  • Non-US stocks: US stocks have led the market upward since the GFC. There is ample evidence that global leadership is changing. However, it is difficult to estimate the magnitude of the potential relative rebound as there were two plateaus and subsequent downward declines in this cycle. If US to non-US stock relative performance were to recover to the first target level, it would translate to a relative gain of 100%. If it were to bounce back to the higher target, the potential relative gain can be as much as 250%.
In conclusion, there is ample evidence that the global cyclical rebound is very real and sustainable over the intermediate-term. The market is forward-looking. Vaccines are on the way, the recession is over. The leadership of US over non-US, growth over value, and large caps over small caps are all turning in convincing fashions.

 

 

While a rising tide does lift all boats, the S&P 500 is likely to lag owing to the heavy weighting in Big Tech stocks, which are likely to be laggards in the next cycle. Investors can outperform by 50-250% over the next 2-3 years with exposure to a combination of cyclical, value, small caps, and non-US stocks.

 

Do the bulls have a sentiment problem?

Posted by Cam Hui -

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

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

 

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

 

 

Asymmetric sentiment signals

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

 

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

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

 

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

 

 

Be Thankful

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

 

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

 

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

 

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

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

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

 

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

 

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

Disclosure: Long SPXL
 

Too far, too fast?

Posted by Cam Hui -

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

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

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

 

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

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

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

 

Rainbows and unicorns?

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

 

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

 

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

 

 

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

 

 

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

 

 

Time for a pause?

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

 

 

Some cause for optimism

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

 

 

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

 

 

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

 

 

 

Possible consolidation ahead

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Will Mnuchin and COVID derail the cyclical rebound?

Posted by Cam Hui -

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

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

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

 

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

 

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

 

A sudden downturn

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

 

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

 

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

 

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

 

 

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

 

Are expectations too high?

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

 

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

 

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

 

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

 

 

The bull case

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

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

 

 

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

 

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

 

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

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

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

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

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

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

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

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

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

 

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

 

 

 

Will the market look over the valley?

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

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

 

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

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

 

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

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

 

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

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

Posted by Cam Hui -

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

 

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

 

The bull case

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

 

 

Frothy sentiment

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

 

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

 

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

 

 

Resolving the bull and bear cases

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

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

 

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

 

Value picks and pans

Posted by Cam Hui -

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

 

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

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

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

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

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

 

 

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

 

 

There are better value opportunities. Avoid.

 

 

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

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

 

 

 

A different kind of Thanksgiving Turkey

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

 

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

 

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

 

 

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

 

Buy them if you dare.

 

 

Disclosure: Long TUR
 

Still testing triple-top resistance

Posted by Cam Hui -

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

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

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

 

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

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

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

 

The bulls test triple-top resistance

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

 

 

What’s next?
 

 

A new equity bull

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

 

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

 

 

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

 

 

 

Here comes the Great Rotation

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

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

 

 

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

 

 

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

 

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

 

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

 

 

 

 

Next week’s tactical market outlook

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

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

Posted by Cam Hui -

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

 

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

 

 

A duration trade unwind

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

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

 

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

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

 

The reflation trade thesis

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

 

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

 

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

 

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

 

 

Positioning for a cyclical rebound

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

 

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

 

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

 

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

 

 

A Trend Model upgrade

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

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

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

 

 

Equity bullish, with a caveat

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

 

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

 

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

 

 

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

 

ZBT missed – again!

Posted by Cam Hui -

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

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

 

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

Despite the setback, all may not be lost.
 

 

DeGraaf breadth thrust signals

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

 

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

 

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

 

Testing resistance

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

 

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

 

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

 

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

Zweig Breadth Thrust and triple-top watch

Posted by Cam Hui -

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

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

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

 

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

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

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

 

Breadth Thrust, or triple top?

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

 

 

 

ZBT history

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

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

 

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

 

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

 

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

 

This is something to keep a close eye on.
 

 

Triple-top resistance

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

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

 

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

 

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

 

 

Neutral sentiment

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

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

 

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

 

 

A new bull?

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

 

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

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

Disclosure: Long SPXL

 

Growth, interrupted?

Posted by Cam Hui -

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

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

Is the global economy emerging from a global recession?
 

 

 

Europe: A new lockdown

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

 

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

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

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

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

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

 

Why?
 

 

There’s a new sheriff in town

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

 

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

 

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

 

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

 

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

 

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

 

 

No Blue Wave = Fiscal cliff?

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

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

 

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

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

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

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

 

 

Key risks

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

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

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

Here is the downside scenario.

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

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

 

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

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

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

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

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

 

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

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

 

 

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

 

 

The verdict

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

 

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

 

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

 

 

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

 

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

 

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

 

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

 

Interpreting the market’s election reaction

Posted by Cam Hui -

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

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

 

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

 

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

 

The good news

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

 

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

 

 

Murky internals

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

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

 

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

Oh yeah, it’s also FOMC week

Posted by Cam Hui -

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

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

 

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

 

Out of firepower?

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

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

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

 

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

 

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

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

 

Reacting to a recovery

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

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

 

 

Rose-colored glasses

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

 

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

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

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

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

 

Scenario planning ahead of the Big Event

Posted by Cam Hui -

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

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

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

 

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

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

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

 

Waiting for the Big Event

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

 

 

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

 

 

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

 

 

The election

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

 

 

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

 

 

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

 

 

 

New pandemic waves

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

 

 

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

 

 

 

Earnings season

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

 

 

In fact, earnings sentiment is positive across all regions.

 

 

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

 

 

 

Crossroads ahead

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

 

 

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

 

 

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

 

 

Oversold, but…

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

 

 

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

 

 

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