Emerging tail-risk: An invasion of Taiwan

Posted by Cam Hui -

I am not in the habit of peddling conspiracy theories, but this is inadvertently becoming a Halloween tradition. Last Halloween, I wrote about how China could control Taiwan without firing a shot (see Scary Halloween story: How a weak USD could hand China a major victory). This year, a new geopolitical tail-risk is materializing for investors and for global stability. China’s People’s Daily recently published a “Letter to Taiwan’s Intelligence Organs” warning Taiwanese intelligence agencies against supporting President Tsai Ing-wen’s resistance to China’s unification efforts (article in Chinese here, Facebook summary in English here).

People’s Daily on Thursday urged intelligence agencies in Taiwan to stay away from the “fatal track” of seeking Taiwan’s independence, which only leads to self-annihilation and is doomed to fail.
 

In the released Message to Taiwan’s Intelligence agencies, the Chinese mainland firmly opposed those independence-seeking diehards of the blind to allay their tiger-riding behaviors, and advised them to get a clear understanding of the situation and get back to the correct track, the only correct way of stopping them from dead ends.
 

“Don’t say I didn’t warn you,” said the message.
 

The message also reiterated that the Chinese mainland and Taiwan island share the same blood and same culture, and the mainland always welcomes variety of cooperation through different channels and encourages exchanges and dialogues with people of insight in Taiwan.

The warning was little noticed by most Western media. What was ominous was the phrase, “Don’t say I didn’t warn you” (勿谓言之不预也). Similar language was used by China when it launched military offensives in the past. It used that phrasing when it issued a “surrender or die” ultimatum to the nationalist garrison in Beijing in 1949. it warned American-led forces in Korea not to approach its Yalu River border in 1950; it warned India before attacking in 1962; and it issued a similar warning before the invasion of Vietnam in 1978.
 

 

This is not a drill.
 

 

A newly triumphal China

The Chinese Communist Party held its plenum last week. Deliberations were behind closed doors, but if there is a theme to this year’s session, it would be what Vice Premier Liu said in a recent speech, “Now the bad things are turning into good ones.”
 

The new swagger is shown by China’s latest PMI, which has bounced back strongly compared to the rest of the world.
 

 

The new assertiveness is just part of a long-lived effort by Beijing to flex its geopolitical muscles. Arguably, it began when China established bases on artificial islands in the South China Sea to assert its claim in the region. It is also manifested in China’s increasingly coercive “wolf warrior” diplomacy, which Wikipedia explained as “an aggressive style of diplomacy purported to be adopted by Chinese diplomats in the 21st century. The term was coined from a Rambo-style Chinese action movie, Wolf Warrior.”
 

The result of the “wolf warrior” style can be seen in a Pew Research Center poll of attitudes on China and Xi Jinping. The recent surge in negative ratings is remarkable, especially among Asian trading partners like Australia and South Korea.
 

 

China has already abrogated the “one country, two systems” principles in Hong Kong. What’s next?  A move against Taiwan?
 

 

The bloodless coup

A year ago, I detailed how China could dominate Taiwan in a bloodless coup (see Scary Halloween story: How a weak USD could hand China a major victory). A Bloomberg article detailed Taiwan’s financial vulnerability. The Taiwanese were putting too much of their savings into life insurance products:

Taiwan’s chief financial regulator is urging people to stop using life insurance as a way to make money and he points to his own family as part of the problem.
 

The widespread use of life insurance as a wealth-management product has made Taiwan into the most insured market in the world. But it has also created a level of competition and reckless offers that threaten the stability of an industry with $876 billion in assets, the Financial Supervisory Commission Chairman Wellington Koo said in an interview Monday.
 

“Insurance isn’t the same as savings. It’s not a wealth management product,” Koo said. “You shouldn’t take out an insurance policy instead of a wealth management product just because your bank only offers 1% on your savings.”
 

The problem is one Koo is personally aware of. The 60-year-old readily admits he and his wife, Taiwan’s deputy economics minister Wang Mei-hua, have nine high-return fixed term insurance policies between them. He says they were taken out on his behalf by his mother on the advice of staff at her local bank.

Here is the problem. The liabilities of Taiwanese life insurance is denominated in TWD, but they don`t have enough investment opportunities in Taiwan. The WSJ reported that they have instead invested mostly in US corporate debt.

Asia’s insurance behemoths, particularly in Taiwan, pose a growing risk to the U.S. corporate-bond market after a multiyear binge on greenback debt.
 

Insurers in Asia’s more developed economies have promised returns far greater than their government-bond markets can provide, and they need to hold far more assets than their domestic bond markets can satisfy.
 

That has left them fishing for other sources of returns, most notably in the U.S. corporate-bond market. South Korea, Japan and Taiwan’s holdings of U.S. dollar corporate bonds have more than doubled to over $800 billion in the past five years, according to the International Monetary Fund’s global financial stability report, published last week.
 

Corporate bond markets in the U.S. and the eurozone are 81% and 41% of the size of their life insurers’ total assets, respectively. In Korea, Taiwan and Japan, the respective figures are 10%, 8% and 4%.

While all Asian life insurers have foreign exposure, Marketwatch observed that the size of Taiwan`s exposure dwarfs all others. Taiwanese life insurers’ financial stability came to US$540 billion in foreign assets, that’s nearly Taiwan’s US$600 billion in GDP.
 

 

While some of the foreign currency exposure is hedged, much of the hedge book risk is borne by CBC, Taiwan’s central bank. In effect, any significant depreciation in the USD could collapse the Taiwanese financial system, not just because of life insurers’ exposure, but the implicit cheap hedge provided by the CBC. What’s more, the CBC has actively suppressed the TWD by providing this hedge.
 

Imagine the following scenario. The PBoC begins to sell its USD holdings to buy TWD assets, which drives up the TWDUSD exchange rate. The Taiwanese financial system gets strained. At what point does it implode? 

 

Once Taiwan’s financial system collapses, a friendly China state-owned financial company graciously steps in to offer a lifeline by buying the life insurers and banks at pennies on the dollar. A Chinese SOE now owns the Taiwanese financial system, and Beijing is in control of Taiwan’s entire financial system – all without firing a shot.

 

Taiwan’s GDP is roughly $600 billion. The PBoC’s assets are about $3 trillion. What price will Beijing pay to get Taiwan back?

 

 

The military option

Instead of a soft takeover of Taiwan, Beijing could opt for the hard military option. As the Chinese economy grew, it was inevitable that spending on the People’s Liberation Army (PLA) would dwarf Taiwanese military spending. Indeed, Taiwan’s Ministry of Defense reported in 2013 that China had developed a plan to invade Taiwan by 2020 at the 18th National Congress. Moreover, the 100-year anniversary of the Communist Party in 2021 will raise pressure on Xi to show progress towards “unification”.
 

 

Beijing seems to be entering a new phase in its military actions. In the past, PLA warplanes have probed Taiwan’s air defenses but stopped at the “median line” separating Taiwan and the Mainland that served as an unofficial boundary. In recent months, PLA fighters have sortied in numbers, and ignored the median line as it became more assertive in its sorties.
 

What is China were to invade? DEFCON Warning Systems reported that repeated Pentagon wargames have usually resulted in victories for the Chinese side.

The Red Team, composed of experts on the Chinese military, aims to use all available forces to capture Taiwan, the island 90 miles off the coast that China regards as a renegade province and that it has repeatedly vowed to retake, by force if necessary.
 

The Blue Team, made up U.S. military personnel with operational experience — fighter pilots, cyber warriors, space experts, missile defense specialists – must try to defeat the Chinese invasion.
 

It doesn’t generally go well for the Blue Team.
 

“It’s had its ass handed to it for years,” David A. Ochmanek, a former deputy assistant secretary of defense for force development and now a defense analyst at Rand, told RealClearInvestigations. “For years the Blue Team has been in shock because they didn’t realize how badly off they were in a confrontation with China.”

The assault would begin with airstrikes on American bases in the region.

;If China felt that the U.S. would intervene, military planners from the Pentagon and Rand who have gamed out scenarios believe a war over Taiwan would most likely begin with a massive attack by advanced Chinese missiles against three American targets: its bases on Okinawa and Guam, its ships in the Western Pacific, including aircraft carrier groups, and its air force squadrons in the region. 

The initial landings would be conducted by airborne troops. When the paratroopers have secured beachheads, the follow-up force would then come by sea.

“They are giving off a lot of signals about how this campaign would unfold,” Lyle J. Goldstein, a China and Russia specialist at the Naval War College in Rhode Island, told RCI. “They’re talking a lot about airborne assault in two varieties, by parachute and by helicopters. It’s what’s called vertical envelopment. Amphibious assault is old school. It may be necessary but it’s not the main military effort.  The new school is to bring lead elements over by air, secure the terrain and then bring in more forces over the beach. The intensity and scale of training in the Chinese military now for airborne assault is, to me, shocking.
 

“There would be 15, maybe 20 different landings on the island, east, west, north, and south, all at once, some frogmen, some purely airborne troops,” Goldstein continued, saying he was expressing his own views, not official assessments of the U.S. “The Chinese high command would watch these bridgeheads to see which of them is working, while the Taiwan command is looking at this amid decapitation attempts and massive rocket and air assaults. The Chinese would seize several beachheads and airports.  Their engineering prowess would come into play in deploying specialized floating dock apparatuses to ensure a steady flow of supplies and reinforcements—a key element. My appraisal is that Taiwan would fold in a week or two.”

While Taiwan’s military appears to be impressive on paper, its actual capabilities are suspect. Foreign Policy reported that a recent suicide revealed “the disastrous logistics of an undersupplied army”: Taiwan’s Military Has Flashy American Weapons but No Ammo,

As Taiwanese politicians showcase flashy U.S. weapons bought with taxpayers’ money, the logistics inside the military remain so abysmal that a young army officer killed himself after being pressured to buy repair parts out of his own pocket.
 

Huang Zhi-jie was a 30-year-old lieutenant in the Taiwanese army. Initially serving in the airborne troops as an enlisted soldier, Huang was so committed that he requested officer training—normally considered more work for little reward—and was later commissioned as a lieutenant in charge of a maintenance depot of the 269th Mechanized Infantry Brigade. Huang was supposed to be the model soldier of which Taiwan desperately wanted more: a young, college-educated volunteer who chose to serve the country out of his own volition, at a time when the military was still facing difficult transition from conscription to an all-volunteer military.
 

But on the night of April 16, Huang hung himself on a dark staircase by his base’s mess hall. Initially his death was not even reported in the Taiwanese media, until Huang’s mother took to Facebook in a long open letter appealing to President Tsai Ing-wen for an investigation.
 

In an emotional press conference, Huang’s mother alleged that her son was subjected to hazing by his superior officers, and that he was pressured to procure tools and spare repair parts out of his own pocket. Screenshots of private messages, receipts, and photos of items purchased by Huang were shown to the public as proof. For some time before Huang’s death, the novice lieutenant was desperately trying to make up for the shortages in his depot by buying a variety of items like repair hammers and fire buckets from the civilian market. Huang’s brother even used a U.S. website in Arizona to purchase a pair of spark plug gap gauges for him that used imperial measurements instead of metric ones.

The shocking part of this incident is it occurred at one of Taiwan’s frontline military units, indicating a lack of readiness among Taiwanese forces.

Even worse, the 269th Mechanized Infantry Brigade isn’t some rear-echelon unit but a major combat formation strategically stationed around the outskirt of Taoyuan City, northern Taiwan. It is expected to bear the brunt of ground fighting to stop any invading Chinese troops from reaching the basin of Taipei, Taiwan’s capital. If the 269th is in such bad material shape, how about the rest of the Taiwanese military?

An article in The Economist came to a similar conclusion about military readiness in Taiwan.

Alas, Taiwan’s preparedness and its will to fight both look shaky. “The sad truth is that Taiwan’s army has trouble with training across the board,” says Tanner Greer, an analyst who spent nine months studying the island’s defences last year. “I have met artillery observers who have never seen their own mortars fired.” Despite long-standing efforts to make the island indigestible, Taiwan’s armed forces are still overinvested in warplanes and tanks. Many insiders are accordingly pessimistic about its ability to hold out. Mr Greer says that of two dozen conscripts he interviewed, “only one was more confident in Taiwan’s ability to resist China after going through the conscript system.” Less than half of Taiwanese polled in August evinced a willingness to fight if war came.

 

 

America’s response

Should China decide to invade, how would Washington react? The DEFCON Warning Systems article stated that the cost to American forces would be high, and at a level not seen since the Vietnam War.

“We’re playing an away game against China,” Rand’s Ochmanek said. “When bases are subjected to repeated attacks, it makes it exponentially more difficult to project power far away.”
 

“The casualties that the Chinese could inflict on us could be staggering,” said Timothy Heath, a senior international defense researcher at Rand and formerly a China analyst at the U.S. Pacific Command headquarters in Hawaii. “Anti-ship cruise missiles could knock out U.S. carriers and warships; surface-to-air missiles could destroy our fighters and bombers.”

Much depends on the outcome of the election. President Trump has shown himself to be very transactional in his approach to foreign policy. Would he commit to defending Taiwan under such a scenario? An article in The Atlantic cast Trump as someone in the “Paul Kennedy” school in his conduct of American foreign policy.

When Trump’s first book, The Art of the Deal, was atop best-seller charts in the late 1980s, second on the list was a scholarly work called The Rise and Fall of the Great Powers, by the Yale professor Paul Kennedy. That book warned that the U.S. could not sustain a policy of global supremacy indefinitely while its relative wealth continued to fall. The U.S. had risen to dominance in the aftermath of Europe’s implosion after World War II, but, Kennedy argued, this was an abnormality.
 

The challenge for America, he wrote, was to bring into balance its means and its commitments. In effect, whether it liked it or not, America was moving from being the only power that mattered to the greatest power in a world of them. The book, published in 1987, came out just before the fall of the Soviet Union and America’s unipolar moment of glory. Its central warning, however, has boomeranged back into relevance.
 

Trump may have no idea that he is revealing any of this; he may not even agree with the things he is revealing. Yet he is revealing them nonetheless. “He’s a Paul Kennedy, Rise and Fall of the Great Powersperson,” Fiona Hill, Trump’s former senior director on European and Russian affairs at the National Security Council, told us, before adding: “Though I doubt he ever read the book.”

Trump’s America First philosophy has inadvertently asked some very good and uncomfortable questions about the direction of American foreign policy in the post-World War II era. 
 

After decades of international adventures that have left the U.S. overstretched, overwhelmed, and overburdened, it was Trump who blurted out the uncomfortable truth: American foreign policy was failing, and had been for decades.

 

Through a combination of hubris, ignorance, instinct, and ego, he pointed at the reality and demanded to know why it was being allowed to continue. Why was America still fighting wars in the Middle East and elsewhere? Why wasn’t it partnering with Russia against Islamist jihadists? Why was China allowed to abuse the rules of the game? Why were American workers losing their jobs to poorer countries? And why were so-called allies in Europe allowed to place high tariffs on American produce while American workers paid for their defense? Were these countries even allies at all?
Joe Biden, on the other hand, is a long-time member of a foreign policy establishment. He would be in favor of engagement with America’s allies and recently denounced Xi Jinping as a “thug”. Reading between the lines of the Democratic Party platform, I interpret it to mean that a Biden White House would commit to coming to the aid of Taiwan in case of attack.
Democrats’ approach to China will be guided by America’s national interests and the interests of our allies, and draw on the sources of American strength—the openness of our society, the dynamism of our economy, and the power of our alliances to shape and enforce international norms that reflect our values. Undermining those strengths will not make us “tough on China.” It would be a gift to the Chinese Communist Party…

 

Democrats believe the China challenge is not primarily a military one, but we will deter and respond to aggression. We will underscore our global commitment to freedom of navigation and resist the Chinese military’s intimidation in the South China Sea. Democrats are committed to the Taiwan Relations Act and will continue to support a peaceful resolution of cross-strait issues consistent with the wishes and best interests of the people of Taiwan.

 

That said, a retreat from Taiwan, regardless if it’s voluntary or involuntary, would send shockwaves around the world. It would brand America as a fading global power, in the manner of Britain and France after the Suez Crisis of 1956.

 

 

Threat assessment

Let me make this clear, an invasion of Taiwan is not my base case scenario, but it does represent a significant tail-risk for investors and for global stability. 

 

As we enter November, the weather in the South China Sea becomes too unpredictable to support an immediate invasion. However, China’s “Don’t say I didn’t warn you” warnings have been followed up by military action several months later. 

 

There are some milestones to watch. Keep an eye on how the Oracle and Walmart proposed purchase of in TikTok’s US operation is resolved in the coming days. That transaction requires approval from the US Committee on Foreign Investment after the election, but within a November 12 deadline. The next hurdle is China’s approval to allow ByteDance sell TikTok’s U.S. platform.

 

Notwithstanding the details of the TikTok deal, also monitor the TWDUSD exchange rate for a possible Chinese attack on the Taiwanese financial system. As well, watch for reports of that satellite reconnaissance indicating possible PLA buildup of forces in preparation for an attack.

 

 

Hedging against an attack

For investors, the consequence of a Chinese invasion of Taiwan would be a horrific risk-off episode. However, hedging against such an outcome can be problematic. The behavior of conventional risk-off havens such as the USD, JPY, and gold is dependent on how any potential conflict unfolds. The JPY may not be a safe haven in light of Japan’s geographic proximity. USD assets, such as Treasuries, may serve as a counterweight to risky assets to stocks, but it depends on the level of American involvement in the conflict. Similarly, gold prices may spike during wartime, but it tends to be inversely correlated to the USD, and a USD rally could pose a headwind for gold prices.

 

A better hedging vehicle that acts well in a war, but may not create a drag on portfolio returns is the Aerospace and Defense industry. The long-term relative performance of this group is characterized by a stair-step pattern of relative uptrend, followed by a period of consolidation. These stocks were battered in the last year by the difficulties experienced by Boeing and its 737 Max. From a technical perspective, the relative return of this group against the S&P 500 has exhibited a positive RSI divergence, which is constructive.

 

 

In the ancient Chinese text, The Art of War, Sun Tzu wrote that a general could win by arraying his forces to exploit his enemy`s weaknesses. That way, he can achieve victory without bloodshed if it becomes evident that the enemy will collapse before any fighting begins. Watch the preparations for war, and be prepared to hedge accordingly. That way, you won’t be surprised by developments.

 

Don’t say I didn’t warn you.

 

 

We’re expecting riots…

Posted by Cam Hui -

Mid-week market update: There is an adage that when dentists start to buy, you should be selling. I came upon a tweet by a resident in Los Angeles with a dentist in the Santa Monica area. The dental office is expecting riots next week, regardless of who wins the election.
 

 

FBI firearm background checks are surging. Anecdotally, both sides are arming themselves in preparation for civil unrest.
 

 

Is this peak fear? It is time to buy the panic?
 

 

Peak fear?

Notwithstanding this week’s market weakness, this chart of asset class implied volatility (IV) shows that fear levels spike the week of the election, and retreat afterward.
 

 

Other indications of market panic are evident. The VIX Index has spiked above its upper Bollinger Band (BB), which is a sign that a temporary bottom is near. That said, the VIX went on an upper BB ride during the February-March decline and took some time to actually bottom. The prudent course of action is to buy when the VIX recycles below the upper BB after a spike above.
 

 

As well, my estimate of the Zweig Breadth Thrust Indicator reached an oversold level today, which can be a sign of a short-term bottom. The caveat is this indicator also stayed oversold for some time before bottoming in March.
 

 

The risk-off tone is not solely attributable to election jitters. A second and third wave of the pandemic seems to be taking hold. Across the Atlantic, the DAX skidded through its 200 dma on the news of fresh lockdowns in Germany. The CAC is already trading below its 200 dma, and it weakened today on the news of French lockdowns.
 

 

 

Buy the panic?

When the market panics like this, it’s difficult to call an exact bottom, but we may be nearing a short-term tradable bounce. One of the constructive signs is the behavior of the NASDAQ 100, which has been the market leader for much of this year. The NASDAQ 100 remains in a relative uptrend against the S&P 500, which is a positive sign for the bulls.
 

 

I wrote on Sunday (see How the Election held the market hostage) that it may be time to position for a reversal trade:

Tactically, it may pay to position for a reversal. If the market were to rise in the coming week into the election, a prudent course of action might be to sell ahead of the event, On the other hand, significant market weakness could be construed as a buying opportunity.

I also wrote on Monday (see The momentum vs. seasonality dilemma) that traders are caught between negative momentum, as evidenced by Monday’s 90% down day, and positive seasonality for the last four trading days of October. It seems that momentum is winning out. Is it time to position for a reversal?
 

My inner investor is deploying some cash at these levels. My inner trader is staying on the sidelines until after the election to avoid event risk.
 

The momentum vs. seasonality dilemma

Posted by Cam Hui -

I have some good news and bad news. The good news is the option market isn’t as concerned about the prospect of a contested election. The chart below shows the history of the term structure of at-the-money implied volatility (IV). The latest readings shows that IV spikes just after Election Day, and deflates slowly afterward. The bad news is it took a -1.9% decline in the S&P 500 to invert the term structure to create this condition.
 

 

We can see a similar result from the IV of other asset classes. The chart below shows the at-the-money IV of gold (GLD), and long Treasury bonds (TLT), with the caveat that IV is not applicable to bond prices because and bond price volatility is not constant over time, though IV remains a useful shorthand for expressing volatility for option traders. The shape of the IV curves are all roughly the same across different asset classes. They all spike at the election, and fall off soon after.
 

 

That said, the threat of a disorderly electoral result is very real. Reuters reported that roughly 40% of Democrats and Republicans would not accept a loss by their side and a smaller proportion would resort to violence to assert their displeasure.

More than four in ten supporters of both President Donald Trump and his Democratic challenger, Joe Biden, said they would not accept the result of the November election if their preferred candidate loses, Reuters/Ipsos poll found.
 

The survey, conducted from Oct. 13-20, shows 43% of Biden supporters would not accept a Trump victory, while 41% of Americans who want to re-elect Trump would not accept a win by Biden.
 

Smaller portions would take action to make their displeasure known: 22% of Biden supporters and 16% of Trump supporters said they would engage in street protests or even violence if their preferred candidate loses.

 

 

Negative momentum ahead?

So what are to make of Monday’s price action. The market exhibited a 90.7% down to up volume day. Lowry’s interprets 90% down volume days as bearish, and they have to be negated by either a 90% up volume day, or consecutive 80% up volume days to turn the tape bullish again. 
 

SentimenTrader also observed that recent initial instances of 90% down volume days have tended to be bearish, and resolved with downside follow-through. However, the sample size is small (n=3).
 

 

Does this mean that bearish momentum has the upper hand, and traders should pile in on the short side?
 

 

Positive seasonality

Bearish momentum, meet positive seasonality. Ryan Detrick at LPL Financial observed that the last four days of October is seasonally bullish, and October 28, which falls on Wednesday, has averaged the highest return for the year.
 

 

 

Bull or bear?

How should we react in light of these contradictions?
 

I wrote on Sunday (see How the Election held the market hostage) to watch the NASDAQ 100 because of its S&P 500 leadership. While the NDX did test its 50 dma, its relative uptrend remains intact, which is constructive for the bull case.
 

 

The market is undergoing a jittery phase that is highly dependent on newsflow. While the 90% down volume day is not to totally ignored, we are facing significant event risk ahead, both in the form of the election next week, and earnings reports from several FAAMG stocks this week. My working hypothesis is the current downdraft is temporary and could be subject to a reversal next week, depending on how the market behaves for the rest of this week.
 

Whatever happens, traders need to recognize that volatility is here, and they should size their positions accordingly.
 

Disclosure: Long SPXU
 

How the Election held the market hostage

Posted by Cam Hui -

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

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

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

 

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

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

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

 

The stealthy hostage taker

For several months, the market has been gripped by a stealth hostage crisis. The uncertainty of a contested election has gripped the market, and risk premiums have spiked as a result. 
The fever seems to be partially fading. Google searches for “contested election” have fallen dramatically.

 

 

I have also been monitoring option market’s implied volatility (IV) since late September. For much of this period, IV spiked just after the election, and remained elevated into mid-December and beyond. 
 

 

These unusual option market conditions have created confusion among traders, which can lead to erroneous interpretations of market sentiment.

 

 

Explaining the option market anomaly 

The best explanation of current option market conditions can be found in a Bloomberg podcast with volatility arbitrage trader Kris Sidial, co-founder and VP at Ambrus Group. Sidial explained that institutions had become wary of election event risk, and they have largely hedged using volatility derivatives. Since the market is almost fully hedged, it is difficult to envisage a volatility spike in November. 

 

The entire podcast is well worth listening to in its entirety, but what Sidial left unsaid is worth exploring, and can create sources of confusion for technical analysts. First, the trading of volatility derivatives is not for amateurs and should be left to professionals with a thorough understanding of option math. What Sidial addressed is the institutional market. As the chart below shows, the index volume spike (grey line) shows the hedging activity of institutional investors. However, there has been a surge in single stop call option trading (orange line), which is mainly the province of retail traders.

 

 

We can see the divergence in activity between institutional and retail participants in the option market by analyzing the index put/call ratio (CPCI), which is mainly used by institutions, and equity-only put/call ratio, which is used by retail traders. First, the 50 day moving average of the put/call ratio (top panel) is near historical lows, which indicates complacency. In addition, CPCI (red line, bottom panel) is high, indicating institutional nervousness, while CPCE (blue line, bottom panel) is low, indicating retail bullishness. In the past, such high spreads between CPCI and CPCE has resolved with either market pullbacks or sideways consolidations.

 

 

What about Sidial’s remarks that a further volatility spike is unlikely because most players are already hedged? That comment has to be taken in the context that he is a volatility trader. While volatility is unlikely to surge, he was silent on the prices of the underlying stocks, or the market. It is entirely possible for the market to correct while the VIX shows little or no upside movement.

 

Another possible misinterpretation of current market conditions can be found in the analysis of VIX futures positioning. The blogger Macro Charts observed that large speculators have a crowded short in VIX futures. The conventional contrarian interpretation is the market is poised for a spike in volatility, and an abrupt decline in stock prices. As I have already pointed out, IV spikes just after the election, and remains elevated soon after. Traders are therefore taking advantage of the steeply upwards sloping term structure to sell volatility, and that trade makes sense from a mean reversion perspective.

 

 

 

Elevated expectations

Current conditions make me mildly bearish on the equity market. Expectations of a Democrat sweep of the White House, the Senate, and the House of Representatives are high. Such an outcome would facilitate the passage of a large and significant fiscal stimulus bill, which would be equity bullish. However, odds of a sweep have been in retreat recently. The market is unlikely to react well to the prospect of a divided government, as it will make the passage of fiscal relief far more difficult. 

 

 

Much has to go right on Election Night for the bullish scenario to materialize. Any hint of uncertainty, or a contested election, would spark a risk-off sell-off.

 

 

What to watch for on Election Night

The election represents a significant event risk to traders and investors. It is impossible to know what will happen. I have detailed the likely effects of either a Biden or a Trump win (see How to trade the election), but that analysis was based on the assumption of a clean sweep by either party. In all likelihood, the Democrats will retain control of the House. This election is mainly about control of the White House and Senate. Here is what I will be watching on Election Night.

 

Early in-person and mail-in voting levels are very high in light of the pandemic. Astonishingly, the early turnout in Texas is about three-quarters of the total votes cast in 2016, and Texas is a state that has highly restrictive mail-in voting. Other states that have reported early voting at over 50% of their 2016 total are Vermont, Montana, New Jersey, North Carolina, New Mexico, and Florida.

 


 

The two key early states to watch are Florida and North Carolina. Despite the controversy over mail-in voting. Florida has strong systems in place to count early mail-in votes because it is the home to many seniors, who historically have used that method to vote. Florida processes mail-in votes 22 days before Election Day, and a preliminary count should be immediately available on Election Night. North Carolina has reported an early turnout of over 50% of 2016 total votes cast, and it expects that 80% of the votes cast will be counted by the time the polls close at 7:30pm. By contrast, other battleground states like Pennsylvania does not begin to count early voting and mail-in ballots until the polls close, and results from that state are likely to be delayed.

 

The WSJ has a useful article on the paths to victory for each candidate. Florida, with its 29 electoral votes, is a must-win state for Trump. If Biden were to score a decisive victory in Florida, the odds of a Trump re-election becomes extremely slim. If Biden were to win both Florida and North Carolina, he is more or less assured of being the next occupant of the White House.

 

 

Even if Biden were to score a decisive victory, the bulls are not out of the woods until control of the Senate is determined. Currently, the Republicans hold 53 Senate seats to 47 for the Democrats. Assuming that Biden wins, the Democrats need to score a net gain of three seats to control the Senate and pass a fiscal relief package. Most pundits expect the Democrats will take the Maine, Colorado, and Arizona seats from the Republicans, but lose the Alabama seat. To control the Senate, the Democrats will need at least one extra seat. The most likely targets are North Carolina and Iowa, with Montana, the two seats in Georgia, and Alaska as outside possibilities. Any other outcome that leaves Republicans in control of the Senate will be regarded as short-term bearish.

 

In summary, the election represents a significant event risk for the market. All the anxiety could be for nothing, much like Y2K, or we could see any number of surprises that sparks a risk-off episode. Tactically, it may pay to position for a reversal. If the market were to rise in the coming week into the election, a prudent course of action might be to sell ahead of the event, On the other hand, significant market weakness could be construed as a buying opportunity.

 

 

The week ahead

On an interim basis, the week ahead will be a test for Big Tech. The NASDAQ 100 is testing both the 50 dma and a relative support trend line. 

 

 

As I pointed out last week (see The NASDAQ tail wagging the market dog), FANG+ names (technology, communication services, and Amazon) make up nearly 44% of index weight. The rest of FANG+ names will report next week, and the earnings reports will set the temporary tone ahead of Election Day the following week.

 

 

Q3 earnings season earnings and sales beat rates are above their historical averages, though their pace of beats decelerated from the previous week.

 

 

Expectations may be set a little too high. The market has punished earnings misses far more severely than their historical average, though the reward for beats was only in-line.

 

 

If the Big Tech stocks were to exhibit more misses, then the NASDAQ 100 is likely to violate its 50 dma, and its rising relative trend line. Even though any possible technology weakness could signal a healthy rotation into value and cyclical stocks, this would also create headwinds for the overall market due to the heavy weightings of Big Tech in the S&P 500.

 

Stay tuned.

 

 

Disclosure: Long SPXU

 

Buy the cyclical and reflation trade?

Posted by Cam Hui -

The global economy seems to be setting up for a strong recovery. We are seeing a combination of easy monetary policy, slimmed-down supply chains, and a rebound in consumer confidence.
 

 

The cyclical and reflation trade is becoming the consensus view. However, there may still be time to board that train. Futures positioning in the reflation trade is rising, but levels are not excessive.
 

 

What are the bull and bear cases?
 

 

The bull case

The bull case is relatively easy to make. The global economy is showing signs of recovery after the COVID Crash of 2020. Economic momentum is rising, but levels are not overheated.
 

 

Commodity prices are recovering, both on a liquidity-weighted and on an equal-weighted basis. The cyclically sensitive copper price rallied to a new recovery high.
 

 

The equal-weighted ratio of consumer discretionary to consumer staples stocks, which reduces the market cap distortion from Amazon, is rising steadily. This ratio is both an indicator of cyclical strength, and equity risk appetite.
 

 

Full speed ahead! What could possibly go wrong?
 

 

Key risks

There are a number of key risks to the cyclical and reflation thesis. 

  • Another wave of COVID-19 infections;
  • A loss of economic recovery momentum;
  • The uncertainty of additional fiscal stimulus; and
  • The effects of rising inflationary expectations on Fed policy.

First, the global cyclical rebound is showing signs of stalling. Regional Citigroup Economic Surprise Indices, which measure whether economic data is beating or missing expectations, are all turning down after initial surges indicating a recovery.
 

 

 

Additional COVID-19 Waves

Another risk is the threat posed by additional waves of COVID-19 outbreaks. Europe is rapidly experiencing a second wave, and the US is seeing a third wave. The pandemic will not be globally controlled until it is suppressed or eradicated everywhere. Otherwise there will always be reservoirs of the virus that will spark periodic outbreaks.
 

 

The European outbreak is a sign that the virus thrives in colder weather, and the situation is spiraling out of control. Germany’s daily case count has reached record highs. Ireland, Wales, and the Czech Republic have announced full lockdowns, and Ireland’s measures are expected to throw 150,000 people out of work. 

 

To be sure, the fatality rates during these additional waves of infections are significantly lower than the first wave. Arguably, governments may not need to mandate shutting down their economies in order to fight the virus. However, a study by the IMF found that the fear of individual citizens accounts for a significant portion of mobility slowdown, particularly in the advanced economies. 

 

 

In other words, people are afraid. The IMF found that the voluntary component is far more persistent than any government mandates or guidelines.

 

 

Even if a vaccine is available in 2021, a Boston Consulting Group study concluded that the economy won’t fully recover until 2022.

Even with a highly successful vaccine rollout—the bull case—the public will still be wearing masks, maintaining distance, and avoiding crowds for many months after regulatory authorization. In fact, the public will likely be taking these precautions into the second half of 2021 or longer. Testing, tracing, and continuing efforts to reduce the severity of the disease with therapeutics will also remain crucial. If the rollout is less successful—the base and bear cases—such interventions could stay in place for 15 more months or longer.

 

 

Notwithstanding BCG’s sobering study, a second wave is just hitting Europe. A third wave appears to be starting in the US. Can we count on the cyclical recovery to continue under those conditions?

 

 

Waiting for fiscal stimulus

In the US, negotiations between House Democrats, the White House, and Senate Republicans over a fiscal stimulus package have broken down. Even if House Speaker Nancy Pelosi and the White House were to come to an agreement, it is unclear whether the bill would receive sufficient support in the Senate for passage.
 

Fed Governor Lael Brainard made another plea for additional fiscal support in a speech to the Society of Professional Economists Annual Online Conference on October 21, 2020:

Apart from the course of the virus itself, the most significant downside risk to my outlook would be the failure of additional fiscal support to materialize. Too little support would lead to a slower and weaker recovery. Premature withdrawal of fiscal support would risk allowing recessionary dynamics to become entrenched, holding back employment and spending, increasing scarring from extended unemployment spells, leading more businesses to shutter, and ultimately harming productive capacity.

In the last few weeks, the market has pivoted to a consensus view that the Democrats would sweep the election in a Blue Wave by capturing control of the White House, Senate, and the House of Representatives. However, recent polling has seen the race tighten, and the odds of a Democratic sweep at PredictIt has plunged.
 

 

Should the election be resolved with a divided government, such as a Biden Presidency and a Republican-controlled Senate, fiscal austerity becomes the most likely outcome. In the absence of additional spending, can the cyclical rebound continue?
 

 

Rising inflationary expectations

The last risk facing the cyclical and reflation trade is the idea of “catastrophic success”. What if the cyclical upturn is too successful? How would the market react?
 

Already, we are seeing inflationary pressures rise. Gold prices are consolidating at the metal’s long-term breakout level, and the bond market’s inflationary expectations have staged an upside breakout through a falling trend line.
 

 

In addition, the yield curve is steepening, and bond yields are rising. The 10-year Treasury yield has decisively breached the 0.80% level and surged to 0.86%. The 30-year Treasury yield has risen above its 200 day moving average.
 

 

If history is any guide, the 10-year Treasury yield is poised to rise even further. It is following the same path as past global slowdowns.
 

 

These conditions beg a number of important questions. What’s the Fed’s reaction function to rising inflationary expectations? The 10-year yield has decisively breached the 0.80% level. In light of the Fed’s commitment to hold short rates down almost indefinitely, will it tolerate a 1.2% rate? What about 1.5%? At what point do rising yields act to significantly restrain the economic rebound?
 

 

Resolving the risks

In light of the bullish potential of a cyclical rebound, and all of the risks, how should investors position themselves?
 

My Trend Asset Allocation Model readings are in neutral, but they are on the verge of turning bullish. The model was created based on the belief that real-time market prices are the best indicator of future expectations, and the application of trend following principles is the best way of capturing long-lasting economic changes. The model is picking up in the shift in consensus thinking, that the global economy is shifting from recession to recovery, as shown by the latest BoA Global Fund Manager Survey. If that consensus assessment is correct, further sustained returns lie ahead for investors who adopt a risk-on position.
 

 

By design, the Trend Model has a single-dimensional focus, and knows nothing about risk. Plenty has to go right for the bullish scenario to be realized. 

  1. The momentum of economic recovery has to be sustained. 
  2. The pandemic has to come under control in the face of a second wave infection in Europe and a third wave in the US, both of which could crater growth. 
  3. The US electoral outcome is unknown, which will affect the path of fiscal policy, the likelihood of additional stimulus, and therefore the growth outlook. 
  4. Investors have to grapple with the Fed’s reaction function to rising growth and inflationary expectations.

Under these circumstances, investors need to recognize that the sources of alpha are multi-dimensional, and so is risk. While we can always hope for the best, bad outcomes are very possible in these conditions. It is important to repeat the adage that the only free lunch in investing is diversification, and only a diversified portfolio can weather this diverse array of risks. As well, investors can creatively conduct scenario analysis in order to mitigate any risks specific to their investment objectives, situation, and investment capability.
 

As an example of a creative approach, Bloomberg reported that Boaz Weinstein of Saba Capital is arbitrating the spread in equity and bond market volatility:

Never in his 22-year career has Boaz Weinstein seen such a disconnect between the complacency of credit investors and the anxiety of equity investors, and he predicts it could unravel in an “incredible move” around the Nov. 3 U.S. election.
 

While the stock market is pricing in turmoil with the CBOE Volatility Index close to 30, corporate bond spreads have almost recovered to pre-pandemic levels. To Weinstein, the founder of Saba Capital Management and one of the biggest winners in the pandemic selloff in March, something has to give. He’s anticipating a new bout of credit chaos and hoping to add to the 80% return through September in his flagship hedge fund.
 

“It’s like a calm before the storm,” he said in a Bloomberg Front Row interview. “Equity volatility is almost inescapably high. Is that a good form of insurance? The payoff profiles are nothing like they were back in January. Whereas in credit, we’re almost back to where we were in January.”

The NASDAQ tail wagging the market dog

Posted by Cam Hui -

Mid-week market update: One of the key indicators I have been monitoring for the health of the market is the NASDAQ 100 (NDX), which is a proxy for large-cap technology stocks. So far, the NDX has been testing an important rising relative uptrend.
 

 

If the relative uptrend were to decisively break down, it would spell trouble for the overall market.
 

 

Large-cap tech dominance

The analysis of the top five sectors in the S&P 500 tells us about the importance of large-cap growth stocks. The top five sectors comprise roughly 70% of the weight of the index, and the relative strength behavior of these sectors are important signals of market direction. The FANG+ names (technology, communication services, and Amazon) make up nearly 44% of index weight. As the chart below shows, the market leaders are the technology and consumer discretionary sectors. The relative performances of the remainder are either flat or down.
 

 

 

Big Tech’s fundamental headwinds

As we progress through Q3 earnings season, Big Tech stocks are starting to encounter headwinds. Netflix disappointed the market by missing revenue expectations last night, and the Justice Department launched an antitrust action against Google. As well, the strategists at JPMorgan identified a negative divergence between technology stock performance and estimate revision. While the sector has roared ahead in relative returns, estimate revisions in this sector have turned negative.
 

 

In addition, analysis from Absolute Strategy shows that the growth/value trade has been in effect a duration trade. For the uninitiated, duration measures an asset’s interest rate sensitivity. The high the duration, the higher the price sensitivity. 

 

 

The 10-year Treasury yield has risen to test the 0.80% level. Any upward movement in bond yields will ultimately put downward pressure on growth stocks.

 

 

US large-cap tech stocks aren’t exactly cheap. If you are looking for an index of cheaper and equally dominant large-cap companies with strong competitive positions, consider the Asia 50 Index (AIA). The top three stocks in the index are Tencent Holdings, Samsung Electronics, and Taiwan Semiconductors, and they make up about 40% of the index.
 

 

 

Not oversold yet

From a technical perspective, Macro Charts observed that the NASDAQ 100 recycled off an overbought condition in early September. Readings are neutral, but momentum is negative. While the NDX doesn’t necessarily collapse under these conditions, at a minimum, they will trade sideways in a choppy manner.
 

 

In conclusion, the NASDAQ 100 remains in a relative uptrend compared to the S&P 500, but investors need to keep an eye on this index. The NDX is the tail that’s wagging the S&P 500 dog. As we progress through Q3 earnings season, it remains to be seen whether JPMorgan’s warning about lagging technology earnings estimates proves to be a bearish trigger.
 

 

Disclosure: Long SPXU
 

Does the economy even need more stimulus?

Posted by Cam Hui -

House Speaker Nancy Pelosi has set a Tuesday deadline for an agreement for a coronavirus stimulus package before the election. Recent data begs the question of whether more stimulus is even needed.
 

Last Friday’s retail sales print was astonishingly strong and beat market expectations. While retail sales statistics are notoriously noisy, September retail sales rose sequentially in all major categories.
 

 

In addition, consumer confidence improved in early October despite the expiry of the $600 per week stimulus payments.
 

 

 

Stimulus spent, or saved?

A New York Fed study is supportive of the fiscal hawks’ case that more stimulus is not needed. The New York Fed studied how households used the payments, and most of the funds were saved either directly, or indirectly by paying off debt. As of the end of June, “29 percent—was used for consumption, with 36 percent saved and 35 percent used to pay down debt”. A demographic breakdown showed that even the most disadvantaged group in the “non-white” category directly saved 27.2% and indirectly saved 46.4% of payments through debt repayment.
 

 

If a substantial amount of the stimulus was saved, does that mean the CARES Act was too generous. pr unnecessary?
 

 

Fiscal cliff delayed

The New York Fed study was a snapshot in time, and it’s just as important to understand the evolution of household finances during this difficult period. A more detailed analysis from the Becker Friedman Institute at the University of Chicago found that the CARES Act did boost spending by the unemployed. 

 

 

If the stimulus payments were saved, the next question for analysts is, “When will the savings run out?” Further analysis revealed that while much of the $600 per week payments were saved, savings are depleting quickly.

 

 

The University of Chicago study focused on aggregate household behavior, Aneta Markowska and Thomas Simons at Jefferies pointed out that while savings are strong for people at the top of the income ladder, the fiscal cliff is very real for the poorest of households.

 

 

Looking forward to Q4 and Q1, Oxford Economics projects that household finances are going to be increasingly strained without another round of stimulus. The strong September retails sales figures could be the consumer’s last hurrah.

 

 

Anecdotal evidence indicates that the retailing sector is stressed. LUSH Cosmetics recently introduced a payment plan for purchases. This development is a signal that the company’s customer base has become so strained that a significant number need to pay for small luxuries like scented soap and bath oils on a payment plan.

 

 

For the last word, Fed watcher Tim Duy had a different interpretation of the strong September retail sales figure:
I know this is going to be an unpopular opinion, but the fiscal stimulus may have been less important for retail sales than widely assumed. What we see inside the retail numbers – the shift in spending away from the services component – has happened in the economy overall. Spending on goods has remained strong largely because households were unable to spend on their typical basket of services and that extra money had to go somewhere.
Retailing stocks have rallied strongly, and they have outperformed the S&P 500 since the March lows. Assuming that Pelosi cannot come to an agreement with the White House and Senate Republicans by Tuesday, the risk is the chances of a stimulus bill will fade if there is a contested election that ends up in the Courts.

 

 

In conclusion, the fiscal cliff is very real, though its effects are slightly delayed. I wrote in my last post that the market is expecting a cyclical recovery (see How the US is becoming an emerging market). A collapse in household finances is an ever-present threat to the recovery investment theme, and it’s a risk that investors should keep in mind.

 

 

How the US is becoming an emerging market

Posted by Cam Hui -

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

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

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

 

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

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

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

 

A pre-election stall?

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

 

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

 

 

Elevated risk

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

 

 

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

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

 

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

 

 

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

 

 

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

 

 

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

 

 

Fundamental momentum is strong

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Technical and sentiment warnings

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

 

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

 

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

 

 

Disclosure: Long SPXU

 

How to trade the election

Posted by Cam Hui -

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

 

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

 

Trump: The known quantity

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

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

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

 

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

 

 

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

 

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

 

 

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

 

 

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

 

 

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

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

 

 

 

Biden: The pragmatist

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

 

 

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

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

 

Market expectations and positioning

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

Trading the breadth thrust

Posted by Cam Hui -

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

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

 

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

 

The Whaley Breadth Thrust

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

 

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

 

 

Frothy sentiment

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

 

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

 

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

 

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

 

 

Breadth Thrust, Meets frothy sentiment

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

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

 

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

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

 

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

A Momentum Renaissance?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

 

A MoMo revival

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

 

 

 

Bullish breadth thrusts

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

 

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

 

 

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

 

 

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

 

 

Trend Model upgrade

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

 

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

 

 

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

 

 

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

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

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

 

 

Key risk: Giddy sentiment

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

 

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

 

 

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

 

 

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

 

 

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

 

 

 

Heightened expectations

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

 

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

 

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

 

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

 

 

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

 

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

 

 

More October surprises?

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

 

 

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

 

 

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

 

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

 

A valuation puzzle: Why are stocks so strong?

Posted by Cam Hui -

One of the investment puzzles of 2020 is the stock market’s behavior. In the face of the worst global economic downturn since the Great Depression, why haven’t stock prices fallen further? Investors saw a brief panic in February and March, and the S&P 500 has recovered and even made an all-time high in early September. As a consequence, valuations have become more elevated.
 

 

One common explanation is the unprecedented level of support from central banks around the world. Interest rates have fallen, and all major central banks have engaged in some form of quantitative easing. Let’s revisit the equity valuation question, and determine the future outlook for equity prices.

 

 

Three explanations

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

 

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

 

 

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

 

 

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

 

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

 

 

BIS: Insights from dividend futures

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

 

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

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

 

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

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

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

 

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

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

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

 

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

 

 

Upside-down markets

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

 

 

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

 

 

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

 

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

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

 

 

 

The valuation question

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

 

 

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

 

 

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

 

Out of the woods?

Posted by Cam Hui -

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

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

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

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

 

 

 

Recovery not out of the woods

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

 

 

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

 

 

Stock market in holding pattern

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

 

 

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

 

 

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

 

 

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

 

 

 

More choppiness ahead

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

 

 

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

 

 

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

 

The more things change…

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

 

Plus ça change…

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

 

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

 

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

 

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

 

 

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

 

 

 

A shift in sentiment

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

 

 

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

 

 

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

 

 

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

 

 

The week ahead

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

 

 

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

 

 

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

 

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

 

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

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

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

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

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

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

 

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

 

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

 

 

Disclosure: Long SPXU

 

Broken Trends: How the world changed

Posted by Cam Hui -

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

 

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

 

These developments have important implications for investors.
 

 

Rising USD = Risk-off

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

 

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

 

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

 

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

 

 

Cyclical rebound doubts

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

 

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

 

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

 

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

 

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

 

 

The Trend Model is bearish

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

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

 

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

 

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

 

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

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

Something for everyone

Posted by Cam Hui -

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

Lol! There was something for everyone*.

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

 

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

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

 

For the bulls

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

 

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

 

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

 

 

For the bears

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

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXU
 

.

Fun with CoT data

Posted by Cam Hui -

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

 

 

Mitigating conditions

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

 

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

 

 

Cross-asset signals

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

 

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

 

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

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

 

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

 

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

Disclosure: Long SPXU
 

Time to de-risk

Posted by Cam Hui -

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

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

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

 

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

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

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

 

Time to be cautious

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

 

 

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

 

 

A tour around the world

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

 

 

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

 

 

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

 

 

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

 

 

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

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

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

 

 

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

 

 

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

 

 

 

A change in tone

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

 

 

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

 

 

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

 

 

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

 

 

\_(ツ)_/¯

 

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

 

 

The week ahead

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

 

 

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

 

 

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

 

 

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

 

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

 

Disclosure: Long SPXU

 

How to spot the next market bottom

Posted by Cam Hui -

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

 

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

 

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

 

The retreat is only starting

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

 

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

 

Spotting the market bottom

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

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

 

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

 

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

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

 

 

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

 

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

 

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

 

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

 

An orderly decline

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

 

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

We are not there yet.
 

The tone is still risk-off

Posted by Cam Hui -

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

 

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

 

Sentiment not washed-out

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

 

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

 

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

 

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

 

 

 

Risk appetite still cautious

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

 

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

 

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

Disclosure: Long SPXU