Q1 earnings season: Sell the news?

Posted by Cam Hui -

Q1 earnings season began with the reports from a number of major banks last week, and it is about to go into full swing this week. Expectations are high, but how much of the good news has been discounted by the market?
 

 

 

Rising estimates = Fundamental momentum

While it’s still very early in Q1 earnings season as only 9% of the S&P 500 has reported, the results were very positive. Both the EPS and sales beat rates were well above their 5-year historical averages. As well, street analysts are unusually bullish on their companies’ outlook. The forward 12-month EPS rose an astounding 1.12% last week.

 

 

EPS revisions were positive on all time horizons. Analysts revised their EPS estimates upward for every quarter for the next six quarters. The most positive revisions were seen for Q1 2021.

 

 

 

Hopeful body language

The Transcript, which monitors earnings calls, is reporting hopeful body language from corporate management,

The economy is booming and companies are expecting robust growth in the second half of 2021 and 2022. Travel is starting to rebound and cities are coming back to life. Stimulus has left consumers with a tremendous amount of liquidity and we are spending. Institutional investors are increasingly concerned about inflationary pressures.

The top-down macro outlook is strong.

 

Companies are expecting robust growth in 2H 2021 and 2022
“I’d state quite clearly, and I said in the prepared remarks, that we think that we’re going to have very, very robust economic growth in the second half of 2021 into 2022 as vaccines continue to accelerate, as we come out of the pandemic, as we move forward. There’s no question that there is meaningful consumer pent-up demand.” – Goldman Sachs (GS) CEO David Solomon

 

“…a significant acceleration of economic activity is anticipated, despite the consistently high numbers of cases around the world and now the introduction of many new variants.” – BlackRock (BLK) CEO Laurence Fink

 

“Certainly, there’s enormous pent-up demand. Consumers have built up a lot of wealth over the pandemic, people have really lost the connection that they look to recreate and get back together, whether that’s for leisure, purpose, or business.” – Delta Air Lines (DAL) CEO Ed Bastian

 

“On the commercial side, what we are seeing is that pipelines are getting stronger really across most areas in most geography. In addition, when we think about the stimulus that’s been put into the system, there’s going to be a lot of consumer spend, especially as the second half of the year develops.” – U.S. Bancorp (USB) CFO Terry Dolan

 

Consumer spending is hitting new records
“The first quarter was a record dollar amount of money moved by Bank of America consumers. The trend is fully on track, even though the economy is not yet fully reopened. March was a record month of spending by Bank of America consumers and led to the highest ever quarter of consumer spending.” – Bank of America (BAC) CEO Brian Moynihan

 

Cities are coming back to life
“What we’re experiencing, almost daily is a regeneration of the cities. New York, San Francisco, LA, Boston are all recovering incrementally and measurably, almost every day. Companies are beginning to announce return to office programs that are actually a little more robust, I would say, than we expected. The housing demand in the cities is now back. The prices are lower, which is a quite stimulating demand, which is good and rentals are down. And that’s pulling people back in as well. There is some movement to Texas, Florida, Wyoming, etcetera, driven probably by tax policy, but also by opportunity. And that hints kind of continue. But it’s not going to be the incremental element that changes a San Francisco or New York in our opinion and observation.” – First Republic Bank (FRC) CEO Jim Herbert

 

Stimulus has led to so. much. liquidity.
“One of the things that I pointed out the savings rate doubled with the national average. We’ve got 15% — and households are holding 15% of GDP in cash. They’re either going to spend it investment or just let it lose value sitting in cash.” – The Bank of New York Mellon (BK) CEO Thomas Gibbons

 

“We think [companies] have something like $2 trillion of excess cash in balance sheets. When they raise money in public markets, they can pay down loans to banks. This is not bad news about loan demand, this is actually good news.” – JPMorgan Chase (JPM) CEO Jamie Dimon

 

To underscore that point, household savings have surged during the pandemic. There is an excess of pent-up liquidity that individuals are waiting to spend.
 

 

Equity investors also received some positive news when Axios reported that Senate Democrats are moving towards a consensus of raising the corporate tax rate from 21% to 25%, instead of the 28% proposed by Biden.
The universe of Democratic senators concerned about raising the corporate tax rate to 28% is broader than Sen. Joe Manchin, and the rate will likely land at 25%, parties close to the discussion tell Axios.

 

The longer-term picture is a 2021 boom, followed by a slowdown next year. New Deal democrat, who keeps an eye on the economy using coincident, short-leading, and long-leading indicators, confirmed evidence of a post-pandemic boom, though rising rates may be telegraphing a slowdown in 2022.
 

Due to increased interest rates, among the long leading indicators. Nevertheless two out of three measures of the yield curve, the Adjusted Chicago Financial Conditions Index and Leverage subindex remain positives, rejoined this week by corporate bonds and (slightly) corporate profits. Mortgage rates and the 2 year Treasury minus Fed funds yield spread are neutral. Mortgage applications, refinancing, US Treasuries, and real estate loans are negative.

 

In two weeks I expect the Q1 GDP report to confirm that we are in a Boom, fueled by mass vaccinations, plus the most extreme monetary and fiscal environment since LBJ’s “guns and butter” policy of 1966.

 

The question for 2022 is whether higher interest rates and steep rises house prices and gasoline may bring that growth to a halt. So far the evidence is tending to deceleration or slowdown rather than halt or downturn.

 

Party on!
 

 

Buy the rumor, sell the news?

I hate to throw cold water on the stock market’s party, but you can tell a lot about market psychology by the way it responds to news. Bank earnings were strong last week. Even though the S&P 500 rose, bank stocks lagged the market. This may be an indication that much of the good news has been discounted.
 

 

However, don’t overreact just yet based on preliminary evidence. Q1 earnings season is just getting started.
 

 

Trust, but verify! Monitor the market reaction to earnings reports for another week before making any conclusions.
 

 

A blow-off top ahead?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

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

 

 

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

 

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

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

 

Setting up for a blow-off top

The S&P 500 has been rising steadily since late February. As the stock market advanced, readings became increasingly overbought. The S&P 500 has spent two consecutive weeks above its weekly Bollinger Band (BB). Past upper BB episodes have tended to be signals of positive momentum. that led to further gains. The market spent several months on an upper BB ride in late 2017 and early 2018 before it finally topped out.

 

 

It appears the S&P 500 is undergoing another melt-up, with a blow-off top ahead. In the last four years, overruns of a rising trend line have been signals of an imminent blow-off top that lasts no more than two weeks.

 

A closeup look at the S&P 500 daily chart shows more details. The index has overrun rising trend line resistance, which happened twice since the March low. The market topped out after prices went parabolic within a week of the overruns.

 

 

 

Sentiment not stretched

While the recent historical evidence points to a market top in the middle of next week, the rally could run a little further because a number of key sentiment models are not overly stretched. In particular, the Goldman Sentiment Indicator, which measures positioning instead of just opinion, took a step back from “stretched” territory indicating further room for equities to advance.

 

 

Similarly, the Fear & Greed Index is nowhere next euphoric territory.

 

 

 

Time for a pause?

The big picture points to a temporary pause in the advance. I have highlighted this analysis in the past. The percentage of S&P 500 stocks above their 200 dma is well over 90%, and such readings have been “good overbought” signals that resolved in steady multi-week advances. The rallies usually did not pause or terminate until the 14-week RSI cross the 70 overbought level, which it did last week.

 

 

As for the timing of a top, my working hypothesis is the next one or two weeks. Technical analyst Dean Christians recently pointed out that “the percentage of S&P 500 members trading above their respective 50-day moving average registered an overbought momentum buy signal on the close of trading on 4/8/21. The table below contains all signals that occurred at a 252-day.” As this signal was triggered on April 8, 2021, the historical study (n=22) shows that returns peak out between two weeks and a month after the signal. If history is any guide, this puts the timing of a peak sometime in late April or early May.

 

 

 

A rotation update

Last week, I had highlighted a number of opportunities from a healthy internal market rotation that allowed the broad indices to climb further (see Internal rotation + Seasonality = More gains):

 

  • An opportunity to lighten up on growth stocks;
  • An opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.

 

Those setups have generally worked well. First, I had pointed out that value stocks had become severely oversold against growth stocks and due for a rebound. The value/growth ratio has recycled off an oversold reading and value appears to be headed for renewed leadership after several weeks of relative weakness.

 

 

I also observed that the bond market was poised for a rally, and bond price duly rebounded. You can tell the character of a market by the way it responds to news. Last Thursday, initial jobless claims dropped by an astounding -193,000, blowout prints in retail sales, NY Empire Manufacturing, and Philly Fed Manufacturing. The market reaction was a decline in the 10-year Treasury yield. Bond yields appear to be ready to fall and prices appear to be ready to rise. The risk is this is just a countertrend move and yields are tracing out bull flags they way they did in the last few months.

 

 

Lastly, I had highlighted a bull flag in gold mining stocks (GDX). GDX staged an upside breakout from the bull flag – a buy signal.

 

 

 

Waiting for the top

My base case scenario calls for a possible buying frenzy that traders should sell into. There is no need to panic just yet. The relative strength of defensive sectors have mostly bottomed out and they are trading sideways. However, none have begun relative uptrends that would be cautionary signals.

 

 

Despite my caution, I expect any weakness to be no more than 5-10%. This is still a bull market. Both the Dow Jones Industrials and Transports have achieved fresh all-time highs, which are classic Dow Theory buy signals indicating the long-term trend is up.

 

 

Investors should view any weakness as buying opportunities. Traders should be positioned for a possible blow-off top, followed by a sharp pullback of no more than 5-10%.

 

 

Disclosure: Long IJS

 

A “value” industry that’s about to be the “Next Best Thing”

Posted by Cam Hui -

Recently, an investor aptly characterized value investing as a portfolio of problems with a call option on good news. One sector stands out as a group of value stocks that are taking on growth characteristics. As shown by its relative performance against MSCI All-Country World Index (ACWI), this cyclical industry bottomed out on a relative basis in March 2020 just as the stock market bottomed and it has been on a tear ever since.
 

 

 

 

 

 

That industry is mining and the mystery chart shows the relative performance of the iShares MSCI Global Metals & Mining Producers ETF (PICK) to ACWI. 

 

Here is my bullish thesis on this group.

 

 

The promise of electric vehicles

The electoral win by the Democrats has profoundly changed US climate change policy.  In particular, Biden is pivoting toward green energy initiatives. Green energy is a complex subject for investors, and the supply change is complicated with many players.

 

 

One focus is the auto industry. GM has vowed to produce all-electric vehicles by 2035. Volvo has gone further and promised an all-electric offering by 2030. In fact, EV sales have overrun analyst forecasts.

 

 

Rising EV demand means a secular shift from hydrocarbons to a variety of metals – lots of it. Even the CME has gotten into the act by launching a lithium futures contract.

 

 

Experienced commodity analysts understand that at relatively small swings in the supply-demand imbalances can create large price swings. In the face of escalating metals demand, the supply of many metals is about to fall into a significant deficit. Take aluminum, just as an example.
 

 

Here is copper, which is a key component in wiring, and it is expected to see a structural deficit in the near future.

 

 

As the combination of renewable electrification and EV adoption takes hold over the next decade, the demand for metals is expected to explode. That’s bullish for base metals, and for the mining industry.

 

Metals and mining stocks are perceived to be value stocks. They are about to become growth stocks over the next few years.

 

 

Cyclical cross-currents

However, the industry faces a number of cyclical cross currents over the next 6-12 months. The bull case consists of rising cyclical demand as the global economy re-opens after the pandemic. Numerous indicators signal a V-shaped recovery. Job postings have risen to pre-pandemic levels.

 

 

IHS Markit reported a spike in global input costs and selling prices. Translation: rising input costs mean commodity inflation.

 

 

Global industrial metals PMIs are spiking. Copper PMI shows strength in the US and Europe, but some softness in Asia.

 

 

This brings me the key cyclical risk to the metals complex. China is slowing. A year after it engaged in a bout of emergency stimulus, Beijing is pivoting to a policy approach of quality over quantity growth. Credit growth is rolling over.

 

 

As a sign of Beijing’s policy tightness, corporate borrowings have been falling. In particular, the borrowings of government-backed SOEs have fallen the most.

 

 

In the past, commodity prices have been correlated with changes in Chinese credit. However, investors need in mind the bullish cyclical effects of the global economic recovery as an offsetting bullish factor.

 

 

 

Investment implications

What does this mean for investors?

 

First, my preferred diversified ETF of choice is iShares MSCI Global Metals & Mining Producers ETF (PICK), which allows the investor exposure to a variety of global and non-US mining companies. As the table below shows, the largest US company on the list ranks fifth in portfolio weight, indicating a lack of choice for American investors in this industry.

 

 

From a technical perspective, PICK is in well-defined uptrends, both on an absolute basis and relative to ACWI. In the short-term, some caution may be warranted as it is exhibiting a series of negative RSI divergences as it broke out to an all-time high.

 

 

The deceleration in price momentum is probably attributable to weakness in China. Tactically, I am monitoring the following indicators. First, China’s Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, peaked out last summer and has been falling ever since.

 

 

The relative performance of the Chinese stock market to ACWI and the markets of China’s major trading partners are all either falling or trading sideways. This is an indication of a loss of economic momentum throughout the region.

 

 

Chinese material stocks have been underperforming global materials and testing a relative support zone, indicating weakness in this sector compared to the rest of the world.

 

 

These are all signs of weakness in Chinese infrastructure spending. However, the relative strength of PICK to ACWI is an indication that the market expects the other major regions to become the locomotives of global growth. I am also watching China’s credit market. The Huarong Affair is becoming an acid test as the price of its bonds plunged. The key question is whether Beijing will allow an SOE majority-owned by China’s finance ministry to default on its debt. Should the credit markets become disorderly, the authorities will likely resort to their well-tested method of flooding the financial system with liquidity, which would be supportive of commodity prices.

 

 

In conclusion, the mining industry is currently viewed as value stocks with cyclical exposure, which is bullish as the global economy recovers. In addition, it is a beneficiary of the coming electric vehicle boom, which is expected to give the industry some growth characteristics. A short-term risk is a China slowdown which dampens commodity demand. Investors should view any fears related to a Chinese growth pause as a buying opportunity.

 

 

Trading a possible melt-up

Posted by Cam Hui -

Mid-week market update: Even as selected sentiment models and market internals scream for caution, the S&P 500 is on the verge of melting up as it tests overhead resistance as defined by a rising trend line. The melt-up condition would be confirmed if the index were to rally through the trend line, which it did on two other occasions in the past 12 months. In that case, the regular trading rulebook goes out the window.

 

 

The possible market melt-up can be seen more clearly on the weekly S&P 500 chart. The index is potentially spending two consecutive weeks above its weekly upper Bollinger Band (BB). Past instances of upper BB violations have signaled steady advances that usually terminated with a blow-off top, followed by a sharp sell-off. The most impressive upper BB ride in recent memory occurred in late 2017 and early 2018. That episode lasted about four months.

 

 

When the animal spirits run, you just don’t know where it all ends.

 

 

Warning signals

Overbought advances are accompanied by technical warnings, and the current episode is no exception. Sentiment is extended, as evidenced by the high level of bullishness on the Investors Intelligence survey.

 

 

Market breadth presents a weakish picture of market internals. Both NYSE and NASDAQ new 52-week highs have been falling even as the S&P 500 advanced. Moreover, the NYSE Advance-Decline Line had been lagging the S&P 500, though the A-D Line finally made a marginal all-time high this week.

 

 

 

A healthy rotation

On the other hand, the market has undergone a healthy rotation beneath the surface even as the S&P 500 rose to fresh highs. Value stocks peaked out relative to growth stocks in early March and growth stocks have been the leaders since then. The Value/Growth ratio became oversold on the 5-day RSI and the ratio has since recycled off the oversold condition. This is evidence of a rolling internal correction that can be supportive of further market advances. The risk is a disorderly bullish stampede that leads to a blow-off top and a sharp sell-off.

 

 

In conclusion, the market is undergoing a possible market melt-up. Volatility is likely to explode in the coming weeks, either on the upside or the downside, and perhaps both. Daily volatility will be exacerbated by the earnings reports of the day. Several large banks reported today, and they all beat expectations. While earnings were enhanced by the release of excessive reserve provisions that banks took last year as the pandemic cratered the economy, each of the banks impressively beat top-line expectations.

 

My inner investor is bullishly positioned as he believes the intermediate-term trend is up. My inner trader is long and hanging on, but he is maintaining trailing stops to control his risk. 

 

It’s going to be a wild ride.

 

 

Disclosure: Long IJS

 

Q1 earnings preview: All calm, but what’s next?

Posted by Cam Hui -

Q1 earnings season is about to begin in earnest, with JPMorgan Chase scheduled to report on Wednesday and the rest of the big banks during this week.
 

 

Ahead of the reports, equity volumes have plunged even as the S&P 500 rose to all-time highs.
 

 

It’s quiet, maybe a little too quiet.

 

 

High expectations

Ahead of the earnings reports, consensus earnings expectations have risen strongly. Forward 12-month EPS rose a robust 0.81% last week.

 

 

EPS estimate revisions have been positive on all time horizons. Street analysts have raised estimates not just for Q1 and Q2, but across the board into 2022.
 

 

 

A boom ahead

The Transcript, which monitors earnings calls, reported that preliminary indications call for a re-opening boom. The boom has created a number of supply chain bottlenecks, which is especially evident in the semiconductor industry.

 

Tens of millions of Americans have now been fully vaccinated and the fun is just beginning. Re-opening euphoria and pent-up demand could lead to an economic boom that lasts into 2023. Supply chains, especially semiconductors, are still feeling the effects of Covid, and price pressures continue.
The S&P 500 forward P/E ratio has remained relatively steady since last summer even as the index advanced. This is an indication that it has been forward 12-month EPS estimates drive the market`s gains. 

 

 

Can this continue? How much of the re-opening boom has been discounted?

 

 

A disturbing technical pattern

The re-opening boom should be especially bullish for small-caps as they are more exposed to the US economy, but the small-cap Russell 2000 is tracing out a possible bearish head and shoulders pattern. Does this mean most of the good earnings news has been discounted?

 

 

Before the bears get overly excited, I make several points. First, technical analysis principles specify that a head and shoulders pattern is not complete until the neckline breaks. For example, there was some anxiety among chartists about a potential head and shoulders top in semiconductor stocks this year, especially when SOX broke a rising relative trend line against the S&P 500 (dotted line, bottom panel). As it turns out, the neckline did not break. Instead, SOX rallied to an all-time high. The moral of this story is that head and shoulders patterns are not necessarily bearish. They can be bullish continuation patterns.

 

 

As well, a comparison of the Russell 2000 and the S&P 600, which is another small-cap index, shows the left shoulder of the potential head and shoulders to be less defined. This is reflective of a quality effect. Standard & Poors has stricter profitability inclusion criteria for its indices than Russell.

 

 

If investors were to move up the market cap band to the mid-cap S&P 400, you really have to squint to see a possible head and shoulders formation. The S&P 400 is in a well-defined uptrend.

 

 

In conclusion, the market is poised to report strong Q1 earnings and virtually all macro and fundamental conditions point to a re-opening boom. In all likelihood, Q1 will be another blowout quarter for earnings. I am inclined to give the bull case the benefit of the doubt.

 

Internal rotation + Seasonality = More gains

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

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

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

 

 

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

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

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

 

Positive April seasonality

I normally only give seasonality secondary consideration in my analysis. But April is the most bullish month of the year for S&P 500 in the last 20 years and positive 80% of the time. Combined with the recent healthy internal rotation in the market, and if seasonality continues to track, the stock market should grind higher for the remainder of the month.

 

 

I conclude from this analysis that the market can continue to rise in April. A healthy internal rotations has occurred that has relieved the pressure of overbought excesses. Several potential opportunities have arisen as a result of the market rotation:
  • A opportunity to lighten up on growth stocks;
  • A opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.

 

 

Opportunities from market rotation

The market has been undergoing a healthy internal rotation, which has created a number of opportunities that I would like to highlight.

 

First, value stocks have broken the long relative downtrend against growth stocks. In the last month, however, growth has made a relative recovery against value. The value/growth ratio has reversed and become oversold on the 5-day RSI. The absolute performance of the Russell 1000 Value and Growth indices are more revealing. While value stocks remain in an absolute uptrend and continues to make new highs, growth stocks have rebounded strongly and they are now testing a key resistance level. I interpret these conditions as a growth counter-trend rally, and an opportunity for investors to rotate out of growth back into value. The trend is your friend, and the trend favors value.

 

 

Further evidence of market rotation can be found in the short-term bottom in bond prices. The 7-10 year Treasury ETF (IEF) recently made a double-bottom while exhibiting a positive RSI divergence. The bond market is poised for a short-term rally and rebound.

 

 

Another opportunity can be seen in gold and gold stocks. Even as inflation expectations rose, gold prices have been pulling back since mid-2020 in a bull flag pattern. Gold recently bottomed while flashing a positive 5-week RSI divergence. This is a setup for higher prices.

 

 

The technical pattern for gold stocks is even more bullish. GDX is testing the top of a bull flag after the percentage of bullish on P&F reached an oversold condition in early March. 

 

 

 

Bullish despite frothy sentiment

Undoubtedly some readers will have noticed that a number of sentiment models have reached excessively bullish readings, and I want to address those concerns. A noticeable difference has recently appeared between sentiment surveys, which ask respondents about their views on the market, and positioning models, which measure how actual funds are deployed.

 

Sentiment surveys have, by and large, been very bullish. As an example, the AAII bull-bear spread is highly elevated. While this model has not shown itself to be an effective actionable trading sell signal (grey zones), its readings are concerning.

 

 

Similarly, Investors Intelligence bulls have jumped and bears have retreated. The bull-bear spread is at or near a crowded long condition.

 

 

On the other hand, the NAAIM Exposure Index, which measures RIA sentiment, flashed a capitulation buy signal in early March. The index rose to 89.95 from a fearful 52.02 the previous week. Readings are neutral and not excessive.

 

 

As well, the equity put/call ratio has been slowly rising indicating a healthy sentiment normalization.

 

 

Helene Meisler’s weekly (unscientific) but timely Twitter poll done yesterday (Saturdy) saw net bullishness retreat after a record high last week despite the market advance. This is another sign the sentiment has reset and stock prices have further room tot rise.

 

 

Market internals indicate that the market can rise further. Neither the NYSE McClelland Oscillator (NYMO) nor the NASDAQ McClellan Oscillator (NAMO) are overbought after reaching oversold conditions in early March. 

 

 

The market’s advance has been orderly so far and characterized by a healthy internal rotation. The key risk is the rally becomes disorderly and excesses appear. If the S&P 500 were to overrun its rising trend line at about 4150-4160, it would be the sign of a blow-off top which is usually followed by a correction. As well, I am monitoring the spike in the correlation between the S&P 500 and the VVIX (volatility of VIX), which has signaled short-term tops in the past. However, the rise in correlation may be a one-time event. Bloomberg reported that a large buyer entered into a VIX call option spread, which undoubtedly elevated VVIX and caused the S&P 500/VVIX correlation to rise.

Somebody shook up options screens Thursday morning with a wager that the VIX Index will rise toward 40 — and won’t be lower than 25 — in July, up from about the 17 level where the volatility gauge currently trades. The trader appears to have made several block trades, buying a total of about 200,000 call contracts. That’s almost as big as the total daily volume of VIX calls, based on the 20-day average, data compiled by Bloomberg show.

 

 

I conclude from this analysis that the market can continue to rise in April. A healthy internal rotations has occurred that has relieved the pressure of overbought excesses. Several potential opportunities have arisen as a result of the market rotation:
  • A opportunity to lighten up on growth stocks;
  • A opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.

 

 

Disclosure: Long IJS

 

How Powell, the Un-Volcker, is remaking the Fed

Posted by Cam Hui -
Jerome Powell may turn out to be the Un-Volcker Fed Chair. Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. By contrast, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove.

 

A considerable gulf has opened up between the Fed’s stated monetary policy path and the market’s expectations. Ed Yardeni recently conducted a LinkedIn poll of interest rate expectations. While the poll is unscientific in its methodology, the results roughly parallel market expectations that the Fed would begin to raise rates in late 2022, and raise them several times in 2023. By contrast, the Fed’s own Summary of Economic Projections doesn’t see any rate hike until late 2023.
 

 

Fed governor Lael Brainard appeared on CNBC soon after the release of the Fed minutes and she addressed the issue of the market’s disbelief of Fed’s interest rate path by distinguishing between outcome and outlook. The Fed is focused on the realized outcome of employment and inflation. The market is focused on expectations, whose forecasts may not be realized.

 

Here is why it matters, not only for the path of interest rates but how the Fed’s outcome-based approach affects the economy and equity prices.

 

 

The roots of the market’s skepticism

This analysis from Cornerstone Macro illustrates how the market isn’t buying into the Fed’s new framework. The market’s projected Fed Funds rate is consistent with a traditional Taylor Rule approach to rate setting. It isn’t consistent with the Fed’s new framework of raising rates until it actually sees the outcomes of monetary policy.

 

 

In other words, the market is highly focused on the conventional Taylor Rule inflation fighting framework and ignoring the Fed’s other mandate of full employment. Hence the market skepticism of the Fed’s new framework.

 

 

Interpreting the FOMC minutes

The Fed implicitly pushed back on market-based expectations of an early rate hike in its March FOMC minutes. While the FOMC acknowledged signs of improvement in the economy, “participants agreed that the economy remained far from the Committee’s longer-run goals and that the path ahead remained highly uncertain, with the pandemic continuing to pose considerable risks to the outlook.” Translation: the economy is far from the Fed’s long-term goals of full-employment and price stability.

 

As an example, the percentage of the unemployed without jobs for 27 weeks or more is still extremely high despite the blowout March Jobs Report. During the IMF’s debate on the global economy, Powell said he wants to see a string of months of a million jobs per month before substantial progress is made towards the Fed’s goals. Notwithstanding parsing what a “string” means, the Fed views this as a clear indication that any discussion of policy accommodation removal is premature.

 

 

As an aside, if you want to understand how Jerome Powell is different from academic economists in his views of the labor market, these remarks tell the story.

 

 

On the key issue of inflation, I have pointed out in the past that equity investors need to distinguish between reflation or real growth which leads to earnings gains, or inflationary growth, which is unproductive and erodes real earnings and margins. While the FOMC minutes revealed that “supply disruptions” could create transitory inflation effects, “factors that had contributed to low inflation during the previous expansion could again exert more downward pressure on inflation than expected”.

 

That said, Lael Brainard allowed in her CNBC interview (at about the 3:00 mark) that inflation will eventually appear. She was just careful not to put a time frame on that forecast.

 

Following those transitory pressures associated with reopening it’s more likely that the entrenched inflation dynamics that we’ve seen for well over a decade will take over then that there will be a sustained surge in inflation for a persistent period.

The FOMC minutes also makes it very clear that it believes higher bond yields is reflective of my reflation scenario of a better economic outlook. This means no yield curve control or another QE Operation Twist, where the Fed directs more Treasury purchases to the belly or long end of the yield curve. Brainard qualified that view by stating that the Fed would intervene should the bond market become disorderly.
 

 

Powell’s Great Policy reversal

Given the growing gulf between the Powell Fed and market expectations, it occurred to me that Jerome Powell may be the Un-Volcker. During the 1980’s, Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. In light of the Fed’s new framework, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove.
 

An Un-Volcker stance may be entirely appropriate in light of the economy’s anemic growth and weak inflation outlook. Former ECB board member Vitor Constâncio pushed back against the inflationistas who believe that runaway inflation is just around the corner and central bankers need to act soon to stamp that out. Constâncio observed that inflation in the US and Euro Area has been stable for the last 25 years. Past episodes of inflation spikes were linked to either wars or oil shocks. A major war is not on the horizon, and the window for another oil shock is narrow as the world transitions away from hydrocarbons to renewable energy in the next 10 years.
 

 

What about all the money growth (PQ=MV) as outlined by Milton Friedman and the monetary economists? Constâncio observed that despite the recent episodes of “runaway” money growth, inflation has been tame.
 

 

Portfolio manager Conor Sen argued in a Bloomberg Opinion article that “a Fed rate hike next year won’t be because of 2022 inflation”.
 

But what we know is that the Fed will largely look past any price increases this year. Even if inflation were to accelerate enough to concern them, Chairman Jerome Powell has said that before the Fed raises rates, it would need to slow down asset purchases, and before that it would give the public plenty of notice. So there won’t be a rate hike in 2021.
 

And that means it’s inflation in 2022 that will determine whether or not we get an interest rate increase. Merely maintaining elevated 2021 prices wouldn’t be enough — it would require additional price increases to reach a concerning rise in the rate inflation. But there’s a reasonable chance that as auto production catches up to demand, used vehicle prices will fall. Sawmills will have time to ramp up, putting downward pressure on lumber, and so on. 
 

Even in a scenario where 2022 economic growth remains robust, the dynamic of production catching up to consumer demand would lead to slowing price growth on a year-over-year basis — and that’s true even if price increases look strong on a trailing two or three-year basis.
 

It might take until 2023 to get past these pandemic-related pricing math quirks, making that the year inflation could become more of an issue should vigorous expansion continue. It may depend more on how the numbers get calculated, but the cycle should keep measures of inflation in check while the Fed evaluates the state of the expansion in 2022.

 

For what it’s worth, Cathie Wood of ARK Investment pointed out that real productivity may be higher than what’s being measured. If it is, then real GDP growth is higher and inflation is lower than reported. Her thesis makes sense from her investment perspective. ARK invests in high-risk, high-reward companies with positive tail-risk that aren’t being appreciated by conventional modeling techniques.

 

 

If my assessment of Powell as the Un-Volcker is correct, what does that mean for investors?
 

 

Market implications

The most obvious implication of the Un-Volcker thesis is the bond market’s inflation expectations may be too high. While the 2s10s yield curve has steepened in anticipation of better economic growth, the spread between the 2-year and 3-month T-Bills has also edged up in anticipation of higher Fed Funds rates. At a minimum, expect lower 2-year Treasury yields and possibly lower 10-year yields.
 

 

From a big picture perspective, steepening yield curves have been equity bullish especially when the economy recovers from a recession. As well, BoA found that small caps perform well during periods of strong GDP growth. Stay with small-cap exposure as the economy recovers from the COVID recession.
 

 

Indeed, GDP growth is expected to be strong. The Atlanta Fed’s GDPNow estimate is 6.2% and the IMF has upgraded global growth to 6.0% in 2021 and 4.4% in 2022.
 

 

Strong economic growth is propelling EPS estimates upwards. Forward 12-month EPS estimates have been rising across the board. Small and mid-cap estimates have recovered more strongly than the large-cap S&P 500, which is supportive of my bullish small cap call.
 

 

Equity price gains in the last year are mainly attributable to rising EPS estimates. The forward P/E ratio has remained steady during this period while the S&P 500 has risen in line with estimates. As the main source of earnings gains have come from cyclical stocks, this argues for an overweight exposure to cyclical sectors, which tend to be more categorizes as value such as financials, industrials, energy, and materials.
 

 

Despite evidence of positive momentum, the cyclical trade is not crowded. Hedge funds are still excessively positioned in defensive sectors and their cyclical exposure is still low.
 

 

For what it’s worth, FactSet reported that bottom-up derived S&P 500 one-year price target is +9.8% even after the recent advance. In the past, analysts have overestimated the price target by 1.3% in the last 5 years, by 2.1% in the last 10 years, and by 9.1% in the last 15 years. However, they underestimated the price target by a whopping 16% a year ago. Based on the experience of the 5 and 10 year overshoots, my expected one-year price return is about 8%.
 

 

Lastly, the potential effects of Biden’s tax proposals are expected to fall heavily on the communication services, technology, and healthcare sectors. For the uninitiated, GILTI stands for Global Intangible Low-Tax Income, and it is a tax intended to prevent erosion of the tax base by discouraging multinationals from shifting profits from intellectual property low-tax jurisdictions such as Ireland. The most affected sectors tend to be comprised of growth companies, and this argues against an overweight position in growth.
 

 

In conclusion, Powell is turning out to be the Un-Volcker Fed Chair. Paul Volcker wrung all the inflation expectations out of the system and convinced everyone that the Fed is an inflation hawk. By contrast, Jerome Powell is attempting a mirror image policy of convincing everyone the Fed is an inflation dove. For investors, this has several implications:
 

  • The bond market’s inflation expectations are too high, expect lower yields, especially at the short end of the yield curve.
  • Barring any pandemic hiccups, this is a V-shaped recovery. Small caps perform especially well in such environments.
  • Similarly, cyclical and value exposure is expected to outperform.

 

Momentum, meet bullish sentiment

Posted by Cam Hui -

Mid-week market update: What should traders make of this stock market? On one hand, the S&P 500 is exhibiting strong positive price momentum. Not only is the index trading above its daily Bollinger Band (BB), it’s trading above its weekly BB. In the last 10 years, there have been eight occasions when the S&P 500 was above its weekly BB. Most (five out of eight) of those instances were associated with sustained advances indicative of positive price momentum. The market corrected in three of the eight occasions, but in one of the three corrections (in early 2018), the upper BB ride persisted for three weeks before the market exhibited a blow-off top. That’s what strong price momentum looks like.
 

 

On the other hand, short-term sentiment is off-the-charts bullish, which is contrarian bearish.

 

 

Strong momentum

I have highlighted this chart before. The percentage of S&P 500 stocks above their 200 dma is well over 90%. In the past, this has been a sign of a “good overbought” market advance. The market often didn’t pull back until the weekly RSI became overbought or near overbought, as it is today.

 

 

Sure, the market is overbought but that hasn’t stopped stock prices from rising in the past. In the last year, there have been occasions when the market advanced while flashing a series of overbought signals. The readings from this chart are based on last night’s close and today’s sideways consolidation is expected to relieve some of the overbought conditions and set the stage for a further advance. 

 

 

 

Crowded long bullishness

Before the bulls get too excited, a couple of (unscientific) Twitter polls conducted on the weekend raised some concerns. While these polls have definite self-selection sampling problems, they have been good indications of short-term trader sentiment in the past.

 

First, Helene Meisler’s latest bull/bear Twitter poll has sentiment at a record level of bullishness, though the history is somewhat limited.

 

 

The level of excessive bullishness was confirmed by a similar weekend poll conducted by Callum Thomas, which also shows a very high level of equity bullishness.

 

 

I have pointed out before that the stock market has bifurcated into two markets, growth and value stocks. There has been some recent internal rotation between growth and value. Value leadership has paused and growth stocks have staged a recent counter-trend rally. The Russell 1000 Growth Index has filled in a February gap and it is now approaching overhead resistance.

 

 

I conducted my own (unscientific) Twitter poll to see if respondents were bullish on growth or value stocks. My own poll confirmed the low level of bearishness and the level of bullishness between growth and value were roughly similar.

 

 

 

Squaring the circle

How do we square this circle of strong momentum and crowded long sentiment readings? 

 

The bullish interpretation is the S&P 500 is undergoing a melt-up. It is trading above both its daily and weekly upper BB while exhibiting a series of “good overbought” RSI readings. In the past, such rallies have not ended until the market exhibited a blow-off top by overrunning its upper rising trend line. If I had to guess, the upside target for this rally is in the 4140-4160 range.

 

 

Also, keep in mind that next week is April option expiry. According to Rob Hanna at Quantifiable Edges, April OpEx has the strongest bullish risk/return of any month.

 

 

The bearish interpretation is internals are failing, sentiment is too bullish, and this market can correct at any time.

 

 

My inner investor remains bullishly positioned. The intermediate-term trend is still up, and he is not overly worried about minor blips in stock prices. At worse, any S&P 500 weakness shouldn’t exceed -5%. My inner trader is also bullish, but he is bracing for volatility and preparing to exit his long position on the first signs of weakness.

 

 

Disclosure: Long IJS

 

A change in leadership?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

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

 

 

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

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

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

 

The revenge of the tech nerds?

A reader pointed out an unusual market anomaly last week. Market leadership had shifted significantly some time during Q2 or Q3 2020. The old Big Three leaders of US over non-US stocks, growth over value, and large-caps over small-caps had made unmistakable trend reversals. Recently, even as the S&P 500, the Dow, and the Transports made fresh all-time highs, leadership was shifting back. US equities are dominant against non-US again; NASDAQ stocks are enjoying a minor revival; and small-caps are faltering against their large-cap counterparts.

 

 

Is this the start of a reversal, or just a blip?

 

 

The global big picture

Let’s begin with the global picture. An analysis of the relative performance of the different major regions against the MSCI All-Country World Index (ACWI) reveals a revival in the relative performance of the S&P 500. The major developed market regions, Europe and Japan, had been trading sideways against ACWI, and emerging market equities had weakened somewhat.

 

 

A more detailed analysis of the US (top panel) shows a significant divergence. Even as the S&P 500 had sprinted ahead on a relative basis this year, the NASDAQ 100 was flat to down against ACWI. The difference between the S&P 500 and NASDAQ 100 represents the difference between value and growth. It was the value factor that had been driving the recent US outperformance.

 

In fact, the relative return patterns of the Russell 1000 Value Index against the S&P 500 and the EAFE Value Index against the MSCI EAFE Index (Europe, Australasia, and the Far East) are virtually identical. 

 

 

I interpret this to mean that there have been no recent significant global regional leadership trends, but the value factor has been dominant in global equity returns.

 

What about the reversal in small-cap stocks? An analysis of the global size factor reveals that small-caps have been rising against their large-cap counterparts in a steady but uneven fashion all over the world. The biggest laggards have been Chinese and Japanese small-cap stocks, which had been in relative downtrends until they began to outperform in the last two months.

 

 

The pause in US small-cap outperformance appears to be just that – a brief pause. The long-term leadership of non-US over US, value over growth, and small-caps over large-caps should continue.

 

 

The bond market wildcard

The one wildcard to the continued leadership scenario is the possibility of a bond market rally. The Treasury market has been clobbered recently, and here is why.

 

The chart below shows quarterly changes to the JPMorgan Forecast Revision Index, which measures how economic forecasts have changed either upward or downward over the course of the quarter. The recent upward lurch in the index was the biggest upward move in its entire history, indicating an unprecedented pace of expected economic growth. The expectations of a strong recovery have depressed bond prices.

 

 

The long Treasury bond ETF (TLT) is testing support and exhibiting a positive RSI divergence. There have been three similar episodes in the last 10 years. Bond prices rallied strongly the last time this happened in 2018. On the other two occasions, the selloff was halted and the bond market traded sideways. 
 

As well, the bear flattener reaction of the bond market to Friday’s blockbuster March Jobs Report was constructive. While yields did rise across the board, the yield curve flattened – there may be life in the long bond even in the face of bad bond market news.

 

 

As the relative performance of growth stocks is sensitive to bond yields, a bond market rally could provide the impetus for a reversal of value and growth factor returns.

 

 

 

A bull market

Regardless of what happens to equity factors, investors need to recognize that this is a bull market. There is nothing more bullish than a stock or index making new all-time highs. The Dow and Transports have made fresh highs, which is a Dow Theory buy signal. As well, the market is benefiting from the combination of strong positive price momentum and skeptical sentiment. The percentage of S&P 500 stocks is above 90% again, which is a characteristic of a “good overbought” market advance (grey bars).

 

 

The market is also enjoying a fundamental momentum tailwind. FactSet reported record upward EPS revisions for Q1 2021 earnings.

 

 

The market is also enjoying a top-down macro tailwind from the blowout March Jobs Report. Non-farm payroll employment soared by 916,000 against an expected 647,000. Average hourly earnings was tame, indicating no pressure from wage inflation. Equally important are the leading indicators of employment. As an example, the number of job leavers, which has historically led NFP, soared indicating growing confidence about the strength of the jobs market.

 

 

The bullishness in sentiment surveys is coming off the boil. Investors Intelligence bulls are declining, and so is the bull-bear spread.

 

 

More importantly, the NAAIM Exposure Index, which measures RIA sentiment, retreated to 52 this week. This index fell below its lower Bollinger Band in early March and generated a contrarian buy signal. The current reading is very near the lower BB. If NAAIM sentiment were to deteriorate further next week, it could flash another buy signal. These buy signals have been very effective in the past.

 

 

 

The trend is your friend

In conclusion, investors should heed the adage “the trend is your friend”. The first trend is the pattern of new highs. This is a bull market.

 

Despite some minor hiccups in factor return patterns, give the benefit of the doubt to the trend of value and cyclical leadership. The Rising Rates ETF (EQRR) represents a simple way of measuring the effects of value and cyclical exposure. Notwithstanding the possibility of a bond market reversal, the intermediate-term value and cyclical trends are still intact.

 

 

From a trader’s perspective, the reaction of the equity futures market to Friday’s blowout Jobs Report left S&P 500 futures +0.5% and Russell 2000 futures +2.0% on a fair market value basis. In all likelihood, the market will open strongly on Monday. While the S&P 500 did not experience a negative 5-day RSI divergence on Thursday, keep an eye on whether the VIX Index falls below its lower Bollinger Band in the week ahead. Such incidents have often been signals of short-term tops.

 

 

Both my inner investor and inner trader are bullishly positioned. While the market isn’t showing signs of being too extended just yet, my inner trader is watching for signs of excessive exuberance to sell.

 

 

Disclosure: Long IJS

 

Biden’s American Rescue Plan: Bullish or bearish?

Posted by Cam Hui -

If you thought that Biden would govern as a centrist, you were wrong. In the wake of the passage of a $1.9 trillion stimulus package, President Joe Biden is planning to attack the enduring challenge of inequality by expanding government spending with a second ambitious $3 trillion economic renewal plan and a revamp of the tax code. It is intended to be a repudiation of the Reagan Revolution and the neoliberal consensus that has dominated economic thinking for decades. He reportedly decided to go big on reform for the following reasons:

  • Biden is enjoying his honeymoon period, and his approval ratings are strong. The New York Times reported that a Republican pollster found that even 57% of Republican voters supported Biden’s recent $1.9 trillion spending package.
  • The Democrats have full party control of Congress, and a short window before the mid-terms to enact legislation.
  • The pandemic recovery is offering both economic and political tailwinds to enact legislation.
What does this mean for investors?

 

While we don’t know the full details of Biden’s American Rescue Plan, its short-term effects are likely to be reflationary, which is equity bullish, while its long-term effects have a possibility of being inflationary, which is equity unfriendly. Much depends on the inflation outlook, which is uncertain at this time. This is not the time to worry just yet. Equity investors should adopt a positioning attitude of “party now, and (maybe) pay later”.

 

 

An attack on inequality

Biden’s plan has been compared to FDR’s New Deal and LBJ’s Great Society program inasmuch as all tried to address the problems of inequality. The philosophical underpinnings of this pivot are well summarized by Foreign Policy article by Adam Tooze outlining the careers of two luminaries of economics, Janet Yellen and Mario Draghi.

The basic framework of 1970s macroeconomics that framed Draghi and Yellen’s training and outlook, like that of the rest of their cohort, was that properly structured markets would take care of growth. Well-regulated financial systems were stable. The chief priority for economists was to educate and restrain politicians to ensure that inflation remained in check and public debts were sustainable.

Tooze argued that the limits of laissez-faire economics are becoming more evident. The economic turmoil of the last two crises was creating a threat to democracy. The markets are not necessarily always dominant and self-correcting, sometimes you need Big Government to step in.

In the 1990s, you didn’t need to be a naïve exponent of the post-Cold War end-of-history argument to think that the direction of travel for global politics was clear. The future belonged to globalization and more-or-less regulated markets. The pace was set by the United States. That enabled technocratic governments to be organized around a division between immediate action and long-term payoff. That was the trade-off that Draghi evaluated in his MIT Ph.D. in the 1970s. The drama of Draghi and Yellen’s final act is that for both of them, and not just for personal reasons, the trade-off is no longer so clear-cut. If the short-term politics fail, the long-term game may not be winnable at all. “Whatever it takes” has never meant more than it does today.

The tide is turning. Even an establishment institution like the International Monetary Fund has made a turn leftward, according to The Guardian.

 

 

Here’s why. During the post-War period, real wages (blue line) and productivity (red line) had tracked each other until the early 1980’s, when they diverged. Productivity grew, but wages didn’t keep up. Around the time of Reagan’s ascension to the White House, the providers of capital began to reap more gains from economic growth than the providers of labor, which kicked off several decades of growing inequality.
 

 

Even well before the Reagan Revolution, tax policy had been favoring the providers of capital over labor. Corporate tax collection had been falling since 1950, while Payroll taxes had risen as a percentage of federal revenue. Corporate income taxes and Payroll taxes actually began to steady as Reagan came to power.

 

 

Since Reagan took power, the rich have gotten a lot richer.

 

 

This is what the progressive wing of the Democratic Party means when it speaks about inequality. In response, Biden has proposed a three-pronged approach to the problem.

 

  • A $2.25 trillion infrastructure plan whose details were announced by the White House last week. The spending would occur over the next eight years, and amount to $250 billion per year, or 1% of GDP. Its main initiatives are:
    1. Fix highways, rebuild bridges, upgrade ports, airports, and transit systems;
    2. Deliver clean drinking water, a renewed electric grid, and high-speed broadband to all Americans;
    3. Build, preserve, and retrofit more than two million homes and commercial buildings, modernize our nation’s schools and child care facilities, and upgrade veterans’ hospitals and federal buildings;
    4. Solidify the infrastructure of our care economy by creating jobs and raising wages and benefits for essential home care workers;
    5. Revitalize manufacturing, secure U.S. supply chains, invest in R&D, and train Americans for the jobs of the future; and
    6. Create good-quality jobs that pay prevailing wages in safe and healthy workplaces while ensuring workers have a free and fair choice to organize, join a union, and bargain collectively with their employers. 
  • A tax plan which is expected to raise $125 billion per year or 0.5% of GDP. Its major provisions include:
    1. Raise the corporate tax rate from 21% to 28%; 
    2. Create a corporate minimum tax; 
    3. Double the tax rate on Global Intangible Low Tax Income from 10.5% to 21%; 
    4. Impose a 12.4% payroll tax on earnings above $400,000; 
    5. Raise the top rate for individual taxable incomes above $400,000 from 37% back to the pre-Trump tax cut level of 39.6%, 
    6. Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% for incomes above $1 million; and
    7. Ramp up IRS enforcement.
  • A second human infrastructure plan, with details to be announced later, with a focus on education, paid leave, and healthcare.

 

 

A supportive Federal Reserve

Jerome Powell, a Republican who was appointed to the Fed Chair by President Trump, has surprisingly been supportive of Biden’s agenda. Former Fed economist Claudia Sahm explained Powell’s transformation in a New York Times OpEd:
One of Mr. Powell’s greatest strengths may be that before joining the Fed he had not spent his career steeped in macroeconomics, as his two predecessors had. He’s been an avid learner, but also a critical thinker. In a 2018 speech that continues to age well, he took a tactful, almost playful, jab at the high priests of macroeconomics, criticizing some key metrics the Fed was using to guide its policymaking. Translated into plain English, he told them that many of the metrics are effectively made-up numbers.

 

It’s no accident that under his leadership the Fed adopted a new framework that emphasizes the employment mandate. It’s grounded in what he learned from people on a review tour called “Fed Listens,” which included community leaders and ordinary workers who pushed him to support more job creation among low- and moderate-income people.

Fed governor Lael Brainard made two speeches on the same day affirming the Fed’s support of Biden’s objectives. The first speech was to the National Association for Business Economics on March 23, 2021 in which she affirmed that the Fed is monitoring “shortfalls from employment” rather than a “maximum employment” benchmark. 

The FOMC has communicated its reaction function under the new framework and provided powerful forward guidance that is conditioned on employment and inflation outcomes. This approach implies resolute patience while the gap closes between current conditions and the maximum-employment and average inflation outcomes in the guidance.
 

By focusing on eliminating shortfalls from maximum employment rather than deviations in either direction and on the achievement of inflation that averages 2 percent over time, monetary policy can take a patient approach rather than a preemptive approach. The preemptive approach that calls for a reduction of accommodation when the unemployment rate nears estimates of its neutral rate in anticipation of high inflation risks an unwarranted loss of opportunity for many of the most economically vulnerable Americans and entrenching inflation persistently below its 2 percent target.11 Instead, the current approach calls for patience, enabling the labor market to continue to improve and inflation expectations to become re-anchored at 2 percent.

Brainard also gave a nod to the labor market inequality problems that the Fed faces in monitoring the jobs market.
Although the unemployment rate has moved down 1/2 a percentage point since December, the K-shaped labor market recovery remains uneven across racial groups, industries, and wage levels. The employment-to-population (EPOP) ratio for Black prime-age workers is 7.2 percentage points lower than for white workers, while the EPOP ratio is 6.2 percentage points lower for Hispanic workers than for white workers—an increase in each gap of about 3 percentage points from pre-crisis lows in October 2019.

 

Workers in the lowest-wage quartile continued to face staggering levels of unemployment of around 22 percent in February, reflecting the disproportionate concentration of lower-wage jobs in services sectors still sidelined by social distancing.5 The leisure and hospitality sector is still down almost 3.5 million jobs, or roughly 20 percent of its pre-COVID level. This sector accounts for more than 40 percent of the net decline in private payrolls since February 2020. Overall, with 9.5 million fewer jobs than pre-COVID levels, we are far from our broad-based and inclusive maximum-employment goal.
In a second speech on the same day to the “Transform Tomorrow Today” Ceres 2021 conference, Brainard announced that the Fed is now monitoring climate change:
The Federal Reserve created a new Supervision Climate Committee (SCC) to strengthen our capacity to identify and assess financial risks from climate change and to develop an appropriate program to ensure the resilience of our supervised firms to those risks.6 The SCC’s microprudential work to ensure the safety and soundness of financial institutions constitutes one core pillar of the Federal Reserve’s framework for addressing the economic and financial consequences of climate change.

 

Climate change and the transition to a sustainable economy also pose risks to the stability of the broader financial system. So a second core pillar of our framework seeks to address the macrofinancial risks of climate change. To complement the work of the SCC, the Federal Reserve Board is establishing a Financial Stability Climate Committee (FSCC) to identify, assess, and address climate-related risks to financial stability. The FSCC will approach this work from a macroprudential perspective—that is, one that considers the potential for complex interactions across the financial system.
Biden is fortunate that the political consensus allows both fiscal and monetary policy to be pushing in the same direction.

 

 

Measuring market impact

For investors, what does Biden’s plan mean for the markets? Here is what I am watching.

 

The main drivers of equity returns are earnings and interest rates. Rates will undoubtedly rise, and the 10-year Treasury yield recently rose as high as 1.75%. Aswath Damodaran at the Stern School of Business at NYU explained the analytical framework this way. 
  • If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments. 
  • If rising rates are primarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power. 
The key question is whether the market interprets the outlook as reflationary or inflationary. John Authers offered an outside-the-box interpretation that the Phillips Curve, which posits a tradeoff between inflation and unemployment has been globalized. The investment implication is to monitor trade policy.
Another issue concerns globalization. A key reason for believing that inflation is about to rise comes from the Phillips Curve, which in simple terms posits a trade-off between unemployment and price increases. Reducing unemployment, as policymakers are determined to do at present, will lead to higher inflation, all else equal. 

 

But all else isn’t equal, and for the last four decades at least we’ve had steady globalization. That means that in an open economy, fewer workers doesn’t mean higher pay, it means a greater likelihood that employers will look overseas. Indeed in Germany, unions negotiate to maintain jobs at the expense of wage rises, because they are aware of competition from abroad. Thomas Aubrey of Credit Capital Advisory in London shows that over time in the U.K., the curve is flatter (meaning there is less of a trade-off) when the economy is more open to trade. And it is a process that can repeat itself. Aubrey points out that textiles jobs in China are leaving for cheaper countries, now that wage demands are growing.

 

All of this suggests that the critical variable to watch in the next few years concerns trade policy, rather than fiscal or monetary policy. If the world really does reset into two rival blocs that attempt to minimize trade with each other, as is possible if U.S.-China relations come out at the worse end of expectations, then the logical consequence would be a return of inflationary dynamics to the West.
I had previously highlighted research from Joseph E. Gagnon at the Peterson Institute which argued that if Biden’s fiscal stimulus is viewed as short-term, the market will not interpret it as inflationary. He compared the fiscal boost during the Korean War compared to Johnson’s guns and butter policy during the Vietnam War and became a permanent feature of the budget. Assuming that the additional bill for Biden’s American Rescue Plan is $3-4 trillion spread over eight years, will the market view such amounts to be large enough to have an inflationary impact?

 

 

Even if we were to embrace Johnson’s Great Society inflationary spiral analogy, the historical precedence wasn’t immediately equity bearish. Marketwatch documented Fidelity’s Jurrien Timmer’s 1960s historical analog to the present era. If history is any guide, the bull market would still have several years to run.

 

 

Timmer also offered an alternative scenario where “Powell and Yellen’s game plan is evocative of the World War II playbook”.

To mobilize against World War II, federal debt tripled, the Fed’s balance sheet swelled by 10-fold and the Fed capped both short- and long-dated interest rates below the rate of inflation. Granted, the current playbook isn’t quite that aggressive — the Congressional Budget Office’s forecast for the national debt in 2030 is only 6% higher than it was before the COVID-19 pandemic — but directionally it is similar.

 

 

Both the 1960s and World War II scenarios are equity bullish for the next few years. If investors were to accept Timmer’s analysis, they shouldn’t be overly worried about unproductive inflation in the immediate future. Don’t forget, the forward markets have a habit of playing Chicken Little in overestimating inflation and the timing of the Fed’s rate hikes. The current forecasts call for a rate hike to occur in late 2022, will traders be right this time?
 

 

What about the threat of higher corporate and individual tax rates? Won’t that spook the stock market? Even Ed Yardeni, who is no fan of liberal economics, has turned pragmatically bullish on equities.
I am raising my S&P 500 operating earnings forecast for 2021 from $175 per share to $180, a 27.8% y/y increase from 2020. I am also raising my 2022 forecast from $190 to $200, an 11% increase over my new earnings target for this year. I would have raised my 2022 estimate more but for my expectation that the Biden administration will raise the corporate tax rate next year…

 

One of my accounts asked me whether I should lower my outlook for the forward P/E given that I am predicting that the 10-year US Treasury bond yield is likely to rise back to its pre-pandemic range of 2.00%-3.00% over the next 12-18 months.

 

Normally in the past, I would have lowered my estimates for forward P/Es in a rising-yield environment. However, these are not normal times. In the “New Abnormal,” valuation multiples are likely to remain elevated around current elevated levels because fiscal and monetary policies continue to flood the financial
As a reminder, the Trump tax cuts boosted S&P 500 earnings by about 9% on a one-time basis and the Biden proposal only partially unwinds some of Trump’s cuts. Ed Clissold of Ned Davis Research estimates that it would cut earnings by 4-13%. Other Wall Street firms have differing estimates clustered in the Ned Davis range. Goldman Sachs has estimated that a full Biden corporate tax increase would cut S&P 500 earnings by 9%.. BoA has estimated a 7% hit to earnings. However, there is speculation that the Democrats would not be able to push through a full tax increase to a 28% rate, but to a reduced level instead. To some extent, some tax increases are already priced into the market. Investors are more open to shrugging off tax increases if the economy is booming.

 

 

In conclusion, while we don’t know the full details of Biden’s American Rescue Plan, its short-term effects are likely to be reflationary, which is equity bullish, while its long-term effects have a possibility of being inflationary, which is equity unfriendly. Much depends on the inflation outlook, which is uncertain at this time. This is not the time to worry just yet. Equity investors should adopt a positioning attitude of “party now, and (maybe) pay later”.

 

 

 

Making sense of the Archegos Affair

Posted by Cam Hui -

Mid-week market update: You can tell a lot about the character of a market by how it reacts to news. In response to the Archegos Affair, the contagion effect has mostly been contained. Other than the share prices of Nomura, Credit Suisse, and the liquidated stocks, the market averages have been steady and this is not a repeat of the Long-Term Capital Management debacle.
 

Still, there are still nagging doubts about pockets of hidden financial leverage in the banking system. Is there another shoe waiting to drop?

 

 

 

An accident waiting to happen

This sort of financial accident is no surprise. Bloomberg reported that the use of leverage is common among the super-rich:

More than 10% of the world’s 500 richest people have committed stock for a combined $163 billion, according to an analysis by the Bloomberg Billionaires Index based on the latest disclosures available. That represents almost a fifth of their public holdings, up from about $38 billion four years ago and double the pledges after last year’s market bottom in March, when 40 of the wealthiest had pledged shares, the data show.

In a bull market, that’s not a problem. From a systemic risk perspective, however, the biggest exposure for banks is Asia:

Committing stock is especially common in Asia, where state-owned banks dominate financial markets and high-growth companies need to find different sources of funding. In mainland China, where top shareholders in initial public offerings typically have their stakes locked for 36 months, the practice can help them get liquidity while maintaining their voting rights.

 

 

A bad year for hedge funds

Archegos’ problems were compounded by the poor returns exhibited by hedge funds this year. While hedge fund returns have historically been correlated to stock prices, 2021 has been an exception. 

 

 

Already, Wall Street is searching for crowded longs in hopes of identifying the next margin liquidation candidate. Here is one list from Jeffries.

 

 

As confirmation of my recent bullish view on value and cyclical stocks, I would point out that there are no banks or energy stocks, which are value favorites, on that list. Surprisingly, there are no semiconductor stocks on the list, which may represent a pocket of opportunity for investors seeking cyclical exposure.

 

 

Still a bull market

I previously observed that this is a bifurcated market and that assertion still stands. Both the Dow and the Transports have made fresh all-time highs, which continue to trigger Dow Theory buy signals.

 

 

Despite today’s rally, the technology-heavy NASDAQ 100 is mired below its 50 dma and it is struggling to hold a key relative support zone.

 

 

The combination of the market’s inability to respond to bad news and positive market internals tells me that it wants to go higher. The percentage of S&P 500 stocks above its 200 dma is above 90% again, which is a “good overbought” condition that is indicative of positive price momentum.

 

 

Stay bullish. Focus on the value and cyclical names and avoid growth stocks. Fund flows into value ETFs (dotted blue line) is just starting. As more value stocks enter price momentum baskets, the price momentum factor will start to turn positive and spark another round of positive fund flows into momentum (read: value) stocks.

 

 

 

Disclosure: Long IJS

 

Turkey: Contrarian opportunity or value trap?

Posted by Cam Hui -

It has been a week since Recep Erdoğan`s decision to fire Turkey`s central-bank governor, Naci Agbal, for raising interest rates. Both Turkey`s stock market and currency, the Turkish lira (TRY), have shown some signs of stabilization after a dramatic drop last Monday. However, TRY weakened today but the fall is likely attributable to the fears of a margin call contagion despite a Bloomberg report that the new central bank governor’s refused to commit to an interest cut.

Turkish central bank Governor Sahap Kavcioglu said markets shouldn’t take for granted that he’ll cut interest rates as soon as April, when he sets monetary policy for the first time since his surprise appointment.
 

“I do not approve a prejudiced approach to MPC decisions in April or the following months, that a rate cut will be delivered immediately,” Kavcioglu said in a written response to questions emailed by Bloomberg News, referring to monetary policy committee meeting next month.
 

“In the new period, we will continue to make our decisions with a corporate monetary policy perspective to ensure a permanent fall in inflation. In this respect, we will also monitor the effects of the policy steps taken so far,” Kavcioglu said.

From an equity perspective, the MSCI Turkey ETF (TUR) is oversold and it is testing a key relative support level.
 

 

Do Turkish stocks represent a contrarian buying opportunity or a value trap?

 

 

The bull case

Here is the long-term bull case. Turkey is a country of 80 million people with very attractive age demographics. It is perched near a very large market, the European Union, with an aging population. The country is incredibly young and offers enormous potential for growth.

 

 

The stock market is statistically cheap based on forward P/E and it has always been that way for 20 years. Note, however, the latest figure was calculated before the currency devaluation. The P/E multiple will experience some flux as it will take some time for analysts to adjust the E in the forward P/E to the devaluation.

 

 

That’s the good news.

 

 

Key risks

The bad news is awful macro-management and a lack of political stability. This Economist article sums up Turkey’s challenges [empahsis added]:
Mr. Erdogan’s macroeconomic muddles and meddling reflect both his own intellectual confusion and the inconsistent demands of his supporters. Turkey’s construction industry, which ensures growth and jobs, thrives on easy credit. That contributes to inflation and a flight from the lira. But Turks, especially merchants and small-business folk, who keep much of their money in dollars or euros, vehemently oppose exchange controls. The result is an unstable currency and unstable prices. Turkey is trying to emulate China’s growth strategy (featuring state-backed credit for property and infrastructure investment) without the benefit of its docile depositors and trapped savings.
Now that 10-year Treasury yields are rising and their spreads against 10-year Bunds and JGBs are widening, this will put upward pressure on the USD, and downward pressure on vulnerable EM currencies like the TRY.

 

 

The article concluded:

[Investors] should heed the country’s cautionary tale: if you rely on foreign capital it is risky to compromise central bank independence, especially when global interest rates are rising. Emerging-market investors will treat Turkey as an unfortunate exception only for as long as emerging-market policymakers learn from its unfortunate example. 

 

 

Blood in the streets?

Contrarians buy when there is blood running in the streets. Is the latest currency devaluation episode enough to warrant a “blood in the streets” call?

 

The market does appear to be cheap relative to MSCI All-Country World ex-US (all figures in USD). TUR is testing an area of key relative support. 

 

 

While elections are not scheduled until 2023, a recent poll done during the period March 7-12 shows Tayyip Erdoğan trailing his potential opponents. Two years is a long time in politics, but the potential for a change in government and greater stability is tantalizing for investors.

 

 

In conclusion, the Turkish market represents an intriguing opportunity for contrarian investors. While I don’t know if last week’s -16% decline in USD terms and subsequent stabilization represents a capitulation bottom, long-term investors can start to accumulate a position at these prices.

 

Will portfolio rebalancing sink equities?

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

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

 

 

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

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

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

 

Theme du jour: Rebalancing

I had a discussion last week with another investment professional about the possible short-term asset price effects of portfolio rebalancing. Equities had handily beaten fixed income investments during the quarter, and balanced fund managers will have to rebalance their portfolios by selling stocks and buying bonds.

 

 

How important is the rebalancing effect? It seems that all the trading desks are talking about it. To add to the confusion, JPMorgan’s derivatives analyst Marko Kolanovic put out a research note stating that “there will be no monthly selling, and indeed there could be buying of equities into month-end. A lack of these flows, and broad anticipation of ‘month/quarter-end’ effect, could result in the market moving higher near term, all else equal.”

 

What’s the real story?

 

To answer that question, I conducted an historical simulation to measure the effects of portfolio rebalancing on stock and bond returns. I conclude from this study that fund flow concerns over quarter-end portfolio rebalancing are overblown. 

 

 

An asset rebalancing study

To answer that question, I conducted a simulation to measure the effects of portfolio rebalancing on stock and bond returns. 

 

I formed a portfolio consisting of 60% SPY (S&P 500 ETF) and 40% AGG (US Aggregate Bond Index). Portfolio weights are rebalanced to 60/40 on the last day of the quarter, but allowed to drift during the quarter. All returns used were total returns, which includes dividends and interest distributions. The study period spans the period September 2003 to December 2020.

 

I measured the possible effects of two rebalancing approaches. The anticipatory approach makes a decision on rebalancing the month-end before quarter-end. The reactionary approach makes the rebalancing decision on the last day of the quarter. In both cases, I measured the returns of SPY and AGG from the decision date.

 

The following chart shows the median one-month SPY returns based on differing decision rules and further disaggregates each decision by the difference between SPY and AGG weights on the decision date. For example, the light blue bars show the returns when the difference in asset weights were +/- 1% or more, while the darkest blue bars show the returns when the weight differences were +/- 4% or more.

 

The surprising result from this study was there was little or no anticipatory rebalancing effect. SPY returns were not significantly different regardless of whether the portfolio approached quarter-end with an overweight or underweight equity position. However, there was a significant catchup effect in the following month if the portfolio was underweight equities. Other anticipatory tests using a two and three week lookahead time horizon, whose results are not shown, also displayed similar results of no rebalancing effect.

 

 

The study also shows that there was no significant rebalancing effect on bond market returns, either before or after quarter-end. Returns weren’t significantly different whether the portfolio was overweight or underweight an asset class. In fact, there was a slight perverse anticipatory effect that bonds outperformed when the portfolio neared quarter-end while underweight equities and overweight bonds. In that case, the normal reaction would be to buy stocks and sell bonds, but bonds showed slightly better returns under those circumstances.

 

 

I conclude from this study that fund flow concerns over quarter-end portfolio rebalancing are overblown. Investors need to recognize that institutional portfolios rebalance in two ways, at the discretion of the manager, and at the discretion of the plan sponsor. Managers will only have the discretion to rebalance a portfolio if they have a balanced fund mandate, and balanced fund mandates are usually only given out by relatively small funds. By contrast, a large asset owner such as a pension plan or an endowment fund hires managers based on individual mandates, such as US small-cap equities, venture capital, and international bonds. Each mandate has a very specific benchmark and managers are expected to be fully invested at all times. The large asset owner only rebalances very infrequently, mainly because the owner needs to undergo the unwieldy process of informing some managers that it is redeeming portions of the funds under management and informing other managers it is re-allocating to their funds.

 

A long-term study of public pension fund allocations shows that their aggregate equity allocations have been on the overweight equities compared to the conventional 60/40 model while fixed-income allocations is mired in the 20-30% range.

 

 

 

A “Great Ball of Money”

In the meantime, traders and investors have to be aware of what Tracy Alloway at Bloomberg calls a “great ball of money”.
Years ago I wrote that “China’s markets resemble nothing if not a great rolling ball of money that moves from asset class to asset class, constantly searching for the next source of sizable returns.” In a country marked by capital controls, excess liquidity is effectively trapped and forced to ricochet like a pinball in a machine. Skilled investors in China’s markets are able to identify where this money will flow to next, scouring policy statements for hints of government initiatives or for signs that authorities might clamp down on a particular company or market, and watching message boards and the like for retail trends.

 

There are signs the U.S. is now going down a Chinese-style ball-of-money path too. Sloshing liquidity courtesy of a dovish central bank will probably end up ping-ponging between U.S. assets. While some of it might leak out of the States, viable alternatives to U.S. assets are limited with yields now low around the world (Chinese bonds and stocks are definitely an alternative, but there’s also limited supply for overseas investors). At the same time, investors will probably do well to eye increased government spending and fiscal stimulus for signs of where money might go to next. Money released by the state doesn’t flow evenly to all things and everyone. Pinpointing exactly where it’s going is getting even more important. In this kind of environment, market bubbles don’t necessarily burst so much as roll from one thing to the next.

 

The “great ball of money” has touched meme stocks, SPACs, and cryptocurrencies. The latest beneficiary appears to be reflation stocks. Compare the technical conditions of the DJIA, which is a proxy for value and cyclical plays, to that of the growth-heavy NASDAQ 100. The DJIA is holding above its 50 dma, while the NASDAQ 100 has been unable to regain its 50 dma. As well, the percentage bullish on point and figure are all significantly better for the DJIA than the NASDAQ 100.

 

 

In addition, more value names are entering the price momentum basket. As the following chart shows, median valuations for the high momentum quintile (top 20%) are actually cheaper than median Russell 1000 valuations. This is an unusual condition that hasn’t happened since early 2017.

 

 

This will create a tailwind for value stocks as momentum players pile into them. 

 

 

An upside breakout

Tactically, the S&P 500 is tracing out an upside breakout from a bull flag within a well-defined uptrend. Value stocks as leaders and growth stocks as laggards. The upside breakout was remarkable in the face of the reported forced large margin liquidation of Tiger Cub Archegos holdings on Friday. The affected stocks were mostly Chinese tech companies such as Baidu, Tencent and Vipshop, though ViacomCBS and Discovery were also hit hard, according to Yahoo Finance.
A liquidation of holdings at several major investment banks with ties to Tiger Cub Archegos Capital Management LLC contributed to an unseen daily decline Friday in shares of stocks including Discovery, Inc. and ViacomCBS Inc., according to people familiar with matter.

 

Shares of media conglomerate ViacomCBS fell 26% while Discovery dropped 27% Friday, recovering from far steeper losses. The degree of the declines was unprecedented and occurred in an otherwise orderly market.

 

Early selling came through so-called block trades from Goldman Sachs & Co., which offered over 30 million shares of ViacomCBS in midday trading. Morgan Stanley, earlier in the day, offered over 15 million shares of Discovery, according to people familiar with the matter.

 

 

The NYSE McClellan Oscillator (NYMO) bounced off an oversold level last week. Historically, such conditions have been reasonably good signals for market bottoms and possible rallies.

 

 

While the market is short-term overbought and 1-2 day outlook probably indicates either a pullback or consolidation, the odds favor higher stock prices in the coming week.

 

 

 

Disclosure: Long IJS

 

Has the reflation trade become too crowded?

Posted by Cam Hui -

In light of last week’s partial NASDAQ reversal, I had a number of discussions with readers about whether the reflation trade has become overly consensus and crowded. To be sure, bond prices have become wildly oversold while the cyclically sensitive copper/gold ratio has surged upward and appears extended.
 

 

Is the reflation trade, which is another shorthand for cyclical and value stocks, due for a reversal?

 

There is a definite risk that the reflation trade is overdone in the short-term and a reversal can happen at any time. However, a bottom-up technical review and a top-down macro review indicate that the reflation investment theme is showing no signs of intermediate-term weakness. Investors should view any weakness in value and cyclical stocks as opportunities to buy the dip.

 

 

A factor and sector review

To answer that question, I conducted a factor and sector review using a framework of analyzing the index representing a factor or sector and the relative return of the index to the S&P 500.

 

Let’s begin with growth stocks, which had been the market leaders. The Russell 1000 Growth Index has violated rising uptrend lines both on an absolute and relative basis. The weakness is particularly striking on the relative performance chart (bottom panel), which shows a well-defined rounded top.

 

 

The technology sector is the largest sector among growth stocks. Technology shows a similar pattern of a troubled uptrend and a relative topping pattern.

 

 

The one bright spot within growth sectors was communication services, which exhibited strong absolute and relative strength owing to the superior performance of its two largest components, GOOG and FB – until recently.

 

 

From a factor perspective, the consumer discretionary sector can be divided into two. The growth heavyweights are AMZN and TSLA, while the remainder can be classified as more traditional cyclical stocks. AMZN has topped out and has been trading sideways since last summer, and the lack of relative strength can be seen clearly in the bottom panel. TSLA began weakening in early 2021, though its relative uptrend remains intact.

 

 

In contrast to the faltering growth names, value stocks are performing much better. The Russell 1000 Value Index remains in a well-defined uptrend. The index also made a relative saucer-shaped bottom last summer and its relative uptrend is intact.

 

 

The technical patterns of sectors in the cyclical and value categories are all very similar to each other. Take financials as an example. Financial stocks remain in an absolute uptrend despite the recent weakness when it flashed a 5-day RSI oversold signal last week and rebounded. Relative to the S&P 500, this sector is showing the typical saucer-shaped relative bottoming pattern of value stocks.

 

 

Energy has recently been another favorite among the value and cyclical crowd. Energy is also in an uptrend after recovering from an oversold condition. It also remains in a relative uptrend.

 

 

Material stocks are also in an absolute uptrend, though the relative uptrend is a bit choppy.

 

 

I wrote earlier that consumer discretionary stocks can be divided into two groups. The heavyweights are growth stocks, AMZN and TSLA, while the remainder represents cyclical plays. An analysis of the equal-weighted consumer discretionary sector which lessens the impact of its growth components shows that this sector is in strong absolute and relative uptrends.

 

 

Industrial stocks are also considered to be value and cyclical plays. This sector is one of the relative laggards within the factor group. The sector is in an absolute uptrend, but its relative performance is more uneven.

 

 

The remaining sectors of the market, namely healthcare, utilities, and real estate, can be classified as defensive in nature. Most have started to bottom relative to the S&P 500 during the January to March period but none are exhibiting leadership characteristics.

 

 

In summary, a technical review of market leadership shows widespread evidence that the reflation trade is strong. There are few signs of technical deterioration that warrant significant caution.

 

 

Top-down support for the reflation bull

In addition, the macro backdrop is also supportive of the reflation trade. Leading indicators of the jobs market such as temporary employment and the quits/discharge ratio are signaling further gains in employment.

 

 

Central banker rhetoric has pivoted from fighting inflation to full employment, which is also supportive of economic growth.

 

 

From a bottom-up perspective, Evercore-ISI’s company surveys are showing a bullish pattern of economic recovery.

 

 

As well, March flash PMIs show that the US continues to lead the major developed economies, but the UK and eurozone are rebounding strongly.

 

 

Lastly, FactSet announced that a record number of S&P 500 companies had issued positive earnings and sales guidance for the next quarter.
 

 

 

Value, growth and rates

More importantly, rising rates haven’t really dented the reflation trade. Take a look at the relative performance of different cyclical industries to the S&P 500 and the 10-year Treasury yield. In particular, interest-sensitive stocks like homebuilding is on fire despite the rise in yields.

 

 

What about the recent reversal in yields? Aren’t growth stocks more sensitive to interest rates and won’t a bond market (price) rally spark a surge in the growth sector? 

 

 

There is no question that the bond market has sold off too quickly and a relief rally may already be underway. The big picture, however, tells another story. An analysis of the history of the 10-year Treasury yield from 1990 shows that there were 14 episodes when the yield became overbought (and therefore bond prices became oversold). Of the 14 episodes, yields fell in six instances (shown in pink) and either stabilized or rose in eight (grey). However, this analysis occurred during a period when yields had been in a long-term downtrend. If we throw out the occasions when yields were above the 10-year trend, yields fell only in one instance and either stabilized or rose in five. Since the current circumstances fall into that category, the odds argue for further increases in yields.

 

 

In conclusion, there is a definite risk that the reflation trade is overdone in the short-term and a reversal can happen at any time. The latest BoA Global Fund Manager Survey shows that positioning has shifted into the cyclical trade in a big way.

 

 

However, a bottom-up technical review and a top-down macro review indicate that the reflation investment theme is showing no signs of intermediate-term weakness. Investors should view any weakness in value and cyclical stocks as opportunities to buy the dip.

 

Year 2 of the bull

Posted by Cam Hui -

Mid-week market update: The equity bull market began about a year ago. Ryan Detrick observed that the second year of past major bulls have averaged gains of 16.9%, though investors should not ignore pullback risk.
 

 

Risk on!

 

 

Animal spirits

Bullish readings are confirmed from a long-term perspective by a combination of strong MACD momentum and the emergence of market animal spirits. Past bullish crossovers of the monthly MACD histogram have marked strong buy signals (blue vertical line), though bearish crossovers (red lines) have been less effective sell signals. In addition, while most analysts have scrutinized option call and put activity for short-term trading signals, a big picture view of the equity call/put (inverse of the put/call ratio, top panel) shows that a steadily rising equity call/put ratio has also defined bull phases. Moreover, a rising 200 dma of the equity call/put ratio (red line) has coincided with MACD buy signals.

 

 

 

What could dent this bull?

 

 

An EM crisis?

Could an emerging market currency crisis halt this bull market? It doesn’t appear so. The Turkish lira came under pressure when Erdogan replaced the head of Turkey’s central bank for raising interest rates. The Turkish lira (TRY) cratered on the news but stabilized within a day.

 

 

BBVA is a Spanish bank that a high degree of Turkish exposure. Its shares fell, but the price action could hardly be described as a crash and it has stabilized.

 

 

The same could be said of the Turkish stock market, which fell dramatically on Monday but it is not trading at a key support level relative to MSCI Emerging Markets ex-China.

 

 

There was also no contagion effect felt in a vulnerable EM currency like the South African Rand.

 

 

The Turkish lira crisis is turning out to be a non-event like the Dubai World restructuring of 2010 when Dubai World teetered on the edge of bankruptcy. Coming so soon after the GFC, there were fears of financial contagion at the time which never materialized.

 

 

Seasonal headwinds

What about the recent market weakness? Mark Hulbert found that major sports events can have a depressing effect on stock prices.
If you are a short-term trader, note that tip-off in the first game of this year’s March Madness is 4 p.m. Eastern time on Mar. 18. The tournament ends with the championship game on the evening of Apr. 5.

 

The correlation between sports and the stock market was documented by a study published a number of years ago to in the Journal of Finance. Entitled “Sports Sentiment and Stock Returns,” its authors were finance professors Alex Edmans of the London Business School; Diego Garcia of the University of Colorado at Boulder; and Oyvind Norli of the BI Norwegian Business School.

 

After studying more than 1,100 soccer matches, the professors found that, on average, a given country’s loss in the World Cup elimination stage is followed by its stock market the next day producing a return that is significantly below average. Though they focused primarily on the World Cup, they also studied cricket, rugby and basketball matches as well.

 

Crucially, the researchers did not find a symmetrically positive stock market impact following a World Cup win. They speculate that this is because a win merely means that a country’s team advances to the next round, while elimination is final. As a result, losing teams’ fans are likely to be more despondent than winning teams’ fans will be exuberant.

 

The logical consequence of this asymmetry: global stock markets should experience abnormal levels of selling during the World Cup and, therefore, below-average returns. And, sure enough, that is exactly what was found by another academic study, this one by Guy Kaplanski of the Bar-Ilan University in Israel and Haim Levy of the Hebrew University of Jerusalem.
Hulbert went on to analyze stock market returns during March Madness and he found a negative effect (caution, n= 7).

 

 

 

An internal rotation

First, equities have performed so well against bonds that large balanced funds are compelled to re-balance their holdings by selling stocks and buying bonds at or around quarter-end.

 

 

We are already seeing some of that re-balancing effect. Bond prices have exhibited positive RSI divergences for several weeks and they are finally turning up. The open question is how long the rally can last. One key test will be tomorrow’s 7-year Treasury auction. If it doesn’t go well the bond rally could reverse itself very quickly.

 

 

Growth stocks have also been bid while value and cyclical names have weakened. This all appears to be part of the re-balancing trade overhanging the market. Despite the strength in growth stocks, the NASDAQ 100 has yet to regain its 50 dma and it has barely rallied above a key relative support zone as measured against the S&P 500. The high-octane ARK Innovation ETF (ARKK) is also struggling relative to the S&P 500.

 

 

By contrast, the Russell 1000 Value Index remains in a well-defined uptrend, both on an absolute basis and relative to the S&P 500.

 

 

In conclusion, the bull is still alive. The recent market weakness is only temporary. Stay with the market leaders of value and cyclical stocks.

 

 

Disclosure: Long IJS

 

A new trading framework

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

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

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

 

 

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

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

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

 

A tale of two markets

It was the best of times. It was the worst of times. This doesn’t happen very often, but the character of the stock market has made an abrupt turn recently, as evidenced by the performance disparity between the S&P 500 and the NASDAQ 100. 

 

The weekly chart of the S&P 500 shows that it survived a brief corrective scare, but the index went on to fresh highs. By contrast, the growth-heavy NASDAQ 100 is acting like a sick puppy. NDX violated a rising trend line and last week’s rally attempt was rejected at the 50 dma level.

 

 

The violent change in market character, or leadership, has created a two-tiered market of extreme winners and losers. Traders need to be aware of this shift and adjust their analytical framework accordingly.
 

 

The Great Rotation

When bull market cycles mature and end, market leadership changes. This is evident with the behavior of value and growth stocks, which I have called the Great Rotation. Growth had been leading for years, but value bottomed out against growth last summer and began to turn up in late 2020. The effects of the Great Rotation can be seen by the relative strength of the Russell 1000 Value Index (large-cap value) against the S&P 500 (bottom panel). The performance turnaround of small-cap value, as measured by the Russell 2000 Value Index, was even more dramatic.

 

 

In light of these changes in market leadership, the task of analyzing overall market direction, as measured by the S&P 500, becomes especially challenging. Traders are advised to separate the performance of growth and value stocks separately in order to get a clearer view of the technical picture.

 

 

Growth’s stagnant outlook

Let’s begin with growth stocks, which is proxied by the NASDAQ 100 (NDX). From a technical analysis perspective, the growth stock outlook can be analyzed using NASDAQ-only breadth and momentum indicators in order to separate the action of growth and value stocks.

 

NDX bounced off an area of major support while exhibiting a positive 5-day RSI divergence in early March. The index was also oversold as measured by the percentage of stocks above their 50 dma. The rally met but couldn’t overcome overhead resistance at its 50 dma and the index has since pulled back.

 

 

The bull case is speculative risk appetite remains intact. Bitcoin prices are highly correlated to the relative performance of the ARK Innovation ETF to the S&P 500. In the short-term, this is a bullish divergence supportive of better returns.

 

 

On the other hand, the relative performance of NDX is inversely correlated to bond yields. The 10-year Treasury yield has surged above 1.7%, which has to put downward pressure on the attractiveness of growth stocks.

 

 

Is this bullish or bearish for growth stocks? Call it a wash. It’s difficult to discern a strong tradable signal for growth stocks, other than to observe that they are in an intermediate-term relative downtrend.

 

 

Value: The new leadership

Even as growth stocks struggled, value stocks have performed much better. While the relative performance of large-cap value and growth can be measured by the Russell 1000 Value and Russell 1000 Growth Indices, one quick proxy for value and growth would be the relative returns of the Dow against the NASDAQ 100. 

 

The Russell 1000 Growth Index (bottom panel) staged an oversold rally that was halted at the 61.8% Fibonacci retracement resistance level. By contrast, the Russell 1000 Value (middle panel) continues to grind upwards. In short, value stocks are in a well-defined uptrend while growth stocks have faltered.

 

 

The established strength of value stocks makes a “buy the dip” strategy an attractive proposition for traders. The NYSE McClellan Oscillator (NYMO) made a double oversold bottom in late February and early March and the S&P 500 subsequently rallied. NYMO readings have come off the boil and retreated off a near-overbought condition. I interpret this as a constructive intermediate-term bullish condition for value stocks.

 

 

In the short-run, the price weakness seen late last week makes the S&P 500 ripe for a relief rally. 

 

 

Short-term breadth for the DJIA. which as a proxy for value and cyclical stocks, are flashing a similar oversold reading. Expect market strength during the first half of the week.

 

 

In conclusion, the character of market leadership has shifted dramatically, leading to a two-tier market. There is no longer a single stock market, and technicians need to analyze growth and value stocks separately. Growth stocks have been struggling and should generally be avoided. Value stocks are in an intermediate-term uptrend, and traders should adopt a “buy the dip” strategy. Current technical conditions for value are nearing an oversold reading, and the risk/reward for value bulls appear favorable in the coming week.

 

My inner investor is bullishly positioned mainly in value and cyclical stocks. My inner trader is tactically long small-cap value stocks, which have been the recent market leaders.

 

 

Disclosure: Long IJS

 

The sum of all fears: Inflation! Inflation!

Posted by Cam Hui -

The latest BoA Global Fund Manager Survey shows that respondents believe the biggest tail-risks to be inflation and its effects on the bond market.
 

 

Are these worries overblown? How will these concerns affect asset prices?

 

 

How transitory are inflation pressures?

Recently, there has been a spate of reports about rising supply chain bottlenecks and their effects on input prices. As the global economy recovered, delivery delays have risen and so have input prices, which will undoubtedly put upward pressure on inflation statistics.

 

 

Indeed, inflation surprises have appeared all over the world.
 

 

Inflation fever is not just confined to economists and market analysts, but it is seeping into the public’s imagination. Google searches for “inflation” have spiked. 

 

 

The NFIB small business survey of pricing expectations is rising. Historically, this has led to upward pressure on core CPI.

 

 

On the other hand, the economy is arguably not poised for an uncontrolled inflationary spiral. Monetary theorists believe that inflation is purely a monetary phenomenon (PQ =  MV). The M component of that equation, M2 money supply growth has skyrocketed, but the V component, or monetary velocity, remains tame. 

 

 

In addition, Joseph E. Gagnon at the Peterson Institute argued that inflation fears from Biden’s fiscal stimulus program are overblown. For historical parallels, investors should look to the experience of the Korean War, not the Vietnam War. That’s because government spending during the Korean War was short-term and perceived as such. By contrast, LBJ’s Guns and Butter policy during the Vietnam War was long-term and affected expectations accordingly.

 

 

Marketwatch reported that BCA Research also came to the similar conclusion that one-time stimulus payments had negligible inflationary effects.

Dhaval Joshi, chief strategist at BCA Research, says whether the new stimulus is considered wealth or income depends on whether the household receiving it has a low or high income to begin with. But looking at past stimulus checks, there weren’t meaningful shifts in either consumption or inflation.

 

 

 

The Fed’s reaction function

The FOMC statement and Powell’s remarks at the post-FOMC meeting press conference made the Fed’s reaction function very clear. The Fed’s latest Summary of Economic Projections raised GDP growth, inflation, and lowered the unemployment rate. Despite the expectations of stronger growth and inflation, the median trajectory of the Fed Funds rate remained unchanged and it does not expect rate hikes until 2023. However, the “dot plot” did show a few members raising their expectations of rate hikes in 2022. 

 

This is consistent with the framework review that was unveiled at Jackson Hole last summer, which established that the Fed will not raise rates at the first signs of growth. It wants to see maximum employment and evidence of sustained higher inflation. Moreover, the Fed is increasingly focused on the jobs market and the effects of inequality.

 

Here are some of the metrics that Powell is looking at. First, one of the components of the inflationary spiral of the 1970’s was characterized by wage growth and cost-of-living adjustment clauses in union contracts. Today, wage growth is below the pre-GFC peak. Moreover, fourth quartile wage growth is lagging the overall figure, which is widening inequality. These were metrics cited by Janet Yellen when she was Fed chair as progress towards full employment. 

 

 

Keep an eye on the March 29 unionization vote of an Amazon warehouse at Bessemer, Alabama. Amazon is the second-largest employer in the US and its compensation and labor practices have profound effects all over the country. The company has successfully resisted unionization at its facilities in the past, but if unions were to gain a beachhead at Bessemer, it would be an early sign that labor is regaining its bargaining power, put greater upward pressure on wages, and be the setup for an inflationary spiral down the road.
 

In the face of a chorus on inequality, the Fed has begun to acknowledge the uneven expansion in recent years. Powell has stated in the past that he wants to see broad-based gains in employment. Black and Hispanic unemployment rates remain elevated compared to the overall rate. More progress needs to be made before the Fed considers the economy to be at full employment and pivots to tightening monetary policy.

 

 

In the past, Powell has also commented on the plunging labor force participation rates (LFPR) for those without college degrees. LFPR for this demographic began widening in 1995 and it has fallen further with each successive recession. Many job seekers in this group have become discouraged and eventually gave up, leading them to stop being counted as unemployed.

 

 

Viewed from a labor market lens, Powell’s past comments that the economy is far from normal are becoming clear. The Fed will not raise rates until it sees significant improvement in labor market internals and realized inflation rates.

 

 

The market reaction

Powell made it clear last week that he expects better economic growth, rising (transitory) inflation, and no rate hikes. While the Fed has an iron grip on the short end of the yield curve, it does not control the long end. In response, the yield curve steepened and the 10-year Treasury yield surged past 1.7%.

 

 

Rising bond yields and steepening yield curves are not unusual for an economy that recovers from a recession. However, there are several differences between this recovery and past recoveries.

 

In the past, a steepening yield curve was the mark of a stock market top. That’s because past recessions were induced by the Fed. The Fed signaled that it would tighten, and the yield curve steepened based on expectations of more rate hikes. The recession of 2020 was not induced by the Fed, but by an external event. The Fed and other global central banks flooded the system with liquidity. As the economy began to recover from the pandemic, the yield curve steepened based on the expectation of higher growth and inflation.

 

Rising bond yields will undoubtedly put downward pressure on P/E ratios. Indeed, forward P/E ratios have been falling in the last year. 

 

 

However, as long as EPS estimates are rising, the bullish effects of higher earnings will offset the bearish effects of lower P/E ratios.

 

 

For equity investors, this has several implications. When growth was scarce during the recession, investors bid up the price of growth stocks. The growth premium is receding as economic recovery is becoming evident, and investors should focus on cyclical and value parts of the stock market.

 

In particular, financial stocks should be a prime beneficiary of this environment. Banks borrow short and lend long, and a steepening yield curve enhances margins. This relationship has been strong in the past. The only disconnect occurred when the sector rallied strongly owing to the Trump tax cuts, which raised banking profitability. I would add that the Fed’s announcement Friday that it was allowing the Supplemental Leverage Ratio exemption for Treasury holdings on bank balance sheets to expire on March 31 should have minimal effect on the banking sector. I had highlighted analysis from Zoltan Pozsar of Credit Suisse indicating that the large banks had ample capital cushions and SLR expiry is expected to have minimal effects on their balance sheets (see FOMC preview: Dot plot, YCC, and SLR).

 

 

The Rising Rates ETF (EQRR) is another illustration of how investors should position themselves in the current environment. While I would not recommend buying the ETF as its assets are very low and investors run the risk that it will be wound up, the underlying portfolio is heavily weighted in value and cyclical sectors, namely financials, energy, materials, and industrials.

 

 

In conclusion, Powell has made it clear that growth will be strong, inflation is coming but it is expected to be transitory, the Fed will not raise rates, and it will not engage in yield curve control. No matter what happens to inflation expectations or bond yields, equity investors positioned in value and cyclical stocks should look forward to strong returns over the next 12 months.

 

 

There are no more bulls and bears, here’s why

Posted by Cam Hui -

Mid-week market update: If you hadn’t known that it was FOMC day, you would have looked at the closing market diary and shrugged. The S&P 500 closed only +0.3% on the day. Beneath the surface, however, a lot has been going on in the past few weeks.
 

Analysts who try to call the direction of the US equity market are facing an especially difficult time as they are encountering a bewildering array of both bullish and bearish sentiment readings. That’s because the stock market has bifurcated into a growth stock market and a value stock market. There is no more single stock market anymore.
 

This chart of the Russell 1000 Value to Russell 1000 Growth ratio tells the story. After value stocks opened a “Vaccine Monday” runaway gap last November, value stocks have made their way higher against growth stocks. The ratio became extended and exhibited a negative 5-day RSI divergence in early January. Both value and growth stocks proceeded to pull back, with value the underperformer. The ratio exhibited another negative RSI divergence in early March. This time, growth stocks rallied with a vengeance while value stocks were mostly flat. The Russell 1000 Growth Index skidded but recovered and its advance is currently testing technical resistance defined by the 61.8% Fibonacci retracement level.

 

 

This account of internal rotation underscores my point that this is a tale of two markets. Indeed, it was the best of times and the worst of time for growth and value. There are no more bulls and bears. You can be a value bull and growth bear, or a growth bull and value bear.

 

 

Will the real bullish or bearish indicator please stand up

Sentiment models are generally useful when readings are extreme. But never in my decades of market analysis have I seen a set of both bullish and bearish extreme sentiment and technical conditions.

 

Consider the NAAIM buy signal that I highlighted last week. The NAAIM Exposure Index, which measures the sentiment of RIAs, plummeted to below its 26-week Bollinger Band. This has been a surefire trading buy model. Out of the 11 buy signals in its 14 year history, it has “failed” only once inasmuch as the market only traded sideways in early 2008.

 

 

As well, Investors Intelligence sentiment conditions have stabilized and appear constructive for the bull case. II bulls expanded after making a bottom, and so did the bull-bear spread. These conditions indicate that a possible tradable bottom.

 

 

Rob Hanna at Quantifiable Edges pointed out after yesterday’s close that the market had pulled back after exhibiting a strong run, indicating a bullish setup for further gains.

 

 

On the other hand, Jason Goepfert at SentimenTrader observed that “Investors are nearing a record in Risk-On behavior”.

 

 

In addition, both the NYSE McClellan Oscillator (NYMO) and the 5-day RSI of the S&P 500 appear streched. Sustained bull legs usually don’t begin under extended conditions like this.

 

 

Technical indicators are usually either bullish or neutral, or bearish and neutral. It’s highly unusual to see so many at both bullish and bearish extremes. This is explained by the violent rotation between growth and value stocks and the market action is creating misperceptions among investors.

 

 

What’s the real story?

To resolve this confusion, it’s useful to think of the stock market in a new framework of growth and value stocks. There is no single market, there are two.

 

Consider the intermediate-term trend for the value/growth ratio. While growth has staged a counter-trend rally, the rebound appears to be petering out and the trend remains value friendly.

 

 

Another tailwind for value stocks is about to appear. Bloomberg reported that price momentum will increasingly tilt toward value names.

Next Tuesday marks the 12-month anniversary of the MSCI AC World Value Index’s eight-year low, a key timeframe that many quantitative models use to screen for momentum shares to buy. May 6 would be the six-month anniversary of the relative low for value stocks against their growth and momentum peers — their outperformance began after the election of U.S. President Joe Biden.

 

 

The recent snapback in growth stocks was a golden opportunity for value investors to buy the dip. While it’s always difficult to look through the market noise on FOMC day, look to the trend as being your friend – and the trend is value stocks.
 

Finally, don’t be afraid of rising rates. The Rising Rates ETF (EQRR) is heavily weighted in value and cyclical sectors. EQRR remains in a well-defined uptrend, both on an absolute basis and relative to the S&P 500.
 

 

The Fed’s statement, dot plot, and the statements from Powell’s press conference all underscore the point that the market backdrop is reflation friendly. Long live the value and cyclical trade!
 

 

Addendum: As a point of clarification, a reader asked me to define what I mean by growth and value. In general, growth stocks can be found in technology, communication service, and AMZN and TSLA in the consumer discretionary sector. Value and cyclical stocks are in financials, industrials, energy, materials, and consumer discretionary excluding AMZN and TSLA.
 

FOMC preview: Dot plot, YCC, and SLR

Posted by Cam Hui -

As the markets remain in risk-on mode, readers should be aware of several lurking risks that may appear from the FOMC meeting. Undoubtedly, Powell will repeat his dovish mantra that the Fed is a long way from neutral and policymakers are focused on the labor market.
 

Nevertheless, here is what I am watching:

 

  • What will the “dot plot” convey about the path of interest rates and how does that differ from market expectations?
  • Will the Fed do anything about the soaring 10-year yield, which has risen above 1.6%, i.e. yield curve control (YCC)?
  • What will happen to the Supplementary Leverage Ratio (SLR), and will the banks get SLR relief after March 31?

 

 

Timing of rate hikes

On Wednesday, the FOMC will release its SEPP, or “dot plot”, of interest rate expectations by members. Fed Funds futures is almost pricing in a full rate hike by the end of next year. What will the “dot plot” say?

 

 

Fed watcher Tim Duy expects a dovish response from the Fed:

The Fed will likely not signal a 2023 rate hike at this week’s meeting. Doing so would call into question the Fed’s commitment to the new policy framework…It would begin the rate hike discussion before the tapering discussion.

Also, keep an eye on the long-term neutral rate. In the past, this rate has acted as a ceiling for the 10-year Treasury yield.
 

 

Based on this model, it is unlikely that the Fed will act or even hint at yield curve control. This is important for financial stocks as the shape of the yield curve determines banking profitability (borrow short, lend long). In the past, the relative performance of this sector has been closely tied to the shape of the yield curve. The only major divergence occurred when the market rallied in anticipation of Trump’s corporate tax cuts, which boosted banking profitability.

 

 

Any hint of yield curve control would dent the performance of financials and create a headwind for a significant portion of value stocks. 

 

 

SLR explained

Then there is the key question of the Supplementary Leverage Ratio (SLR), which is an important component of the plumbing of the credit market. Here is an SLR primer from Bloomberg’s Katie Greifeld:
The latest acronym on Wall Street’s mind is SLR: the supplementary leverage ratio. In normal times, SLR required U.S. banks to hold a minimum level of capital against their assets as a buffer against losses. However, the Federal Reserve exempted Treasuries and deposits at the central bank from those requirements roughly a year ago. Banks took advantage, with balance sheets ballooning by as much as $600 billion as a result of the regulatory relief.

 

 

SLR exemption relief is expected to expire on March 31, 2021. Leading Democrats are adamant against extending the deadline. Elizabeth Warren and Sherrod Brown wrote a letter to U.S. regulators which described extending SLR relief as a “grave error.”

 

The Treasury market is becoming spooked. Dealer Treasury inventories plummeted last week, possibly in anticipation that SLR relief would not be extended.

 

 

Without SLR relief, some analysts, such as Nordea Bank have speculated that the market could see a mass liquidation of up to $700 billion of Treasury holdings.

 

 

Adam Tooze is more relaxed about the prospect of an SLR panic. He pointed to analysis by Zoltan Pozsar of Credit Suisse which showed that large banks have significant capital cushions if SLR exemption expires.

 

 

If there is an earthquake in the money markets or credit markets as a consequence of SLR exemption expiration, the Fed will act to mitigate the damage.
If Pozsar thinks it is incoherent as an overall strategy for G-SIBs [large systemically important banks], if JP Morgan doesn’t think it is risky, if Warren and Brown think it is bad politics and, if the FDIC would have to reverse itself, then, despite worries about Treasury market panics, the SLR exemption should be allowed to expire.

 

If there is turmoil in the repo market, what we have learned from September 2019 and March 2020 is that given our market-based financial system, there is no alternative but for the Fed to intervene as the first responder. No amount of private balance sheet capacity will make a significant difference and it is better to keep the risks out of the G-SIB balance sheets.

 

If we do need Fed intervention, it should be massive and prompt and avoid the market plumbing becoming a political issue. The September 2019 and March 2020 panics were buried. No reason, if necessary, not to bury interventions in 2021.

In other words, don’t turn all Zero Hedge Apocalyptic on the prospect of SLR expiry. CTA hedge funds are already in a crowded short position in bonds. Any positive surprise has the potential to spark a “rip your face off” bond rally.
 

 

In summary, there are several risks that investors should be aware of ahead of the FOMC meeting. My tentative conclusion is we should see a dovish response from the Fed. While these risks do exist and they are always present, the anticipation of any pain may be worse than the event itself.
 

If the markets turn risk-off ahead of the FOMC announcement, don’t be afraid to buy the dip.
 

Here comes the recovery

Posted by Cam Hui -

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

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

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

 

 

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

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

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

 

From shutdown to re-opening

About a year ago, the World Health Organization declared the coronavirus a pandemic. Governments around the world shut down their economies and the global economy crashed into a recession. Fast forward a year, fiscal and monetary authorities have responded with unprecedented levels of stimulus, vaccinations are proceeding, caseloads are dropping, and economies are re-opening again.

 

The Dow Jones Industrials and Transports made new all-time highs last week. That’s a Dow Theory buy signal.

 

 

Here is how to play the bull market. First, recognize that the US equity market has bifurcated into two markets. Value and cyclical stocks should benefit as the economy improves. On the other hand, growth stocks are struggling and should be avoided. Growth has too many speculative excesses and they need to be wrung out before they see a durable bottom.

 

 

Signs of recovery everywhere

There are signs of economic recovery everywhere. JPM’s Google Activity Index is rising all around the world.

 

 

China’s February exports rose an astonishing 60% year/year, which signals a surge in global demand.

 

 

The US inventory to sales ratio has plummeted, indicating that restocking demand is on the way. Add to that the $1.9 trillion in stimulus spending about to hit the economy. We have a good old-fashioned boom on the horizon.

 

 

There was also good news from the JOLTS report that was released last week. Both temporary employment, which is part of the monthly Jobs Report, and the quits/discharges ratio, which come from JOLTS, lead Non-Farm Payroll employment, are turning up. These are additional indications of rising employment as the economy recovers from the pandemic shock.

 

 

 

Momentum everywhere

Bullish momentum is appearing everywhere. Price momentum is evidenced by the new highs made by the major market indices last week. Price momentum begets more momentum, as Renaissance Capital recently pointed out.

 

 

As a sign of fundamental momentum, Wall Street analysts have been raising their forward 12-month earnings estimates after a strong Q4 earnings reporting season.

 

 

But don’t blindly buy everything. Take a look at how stock market internals have responded. NYSE 52-week highs have been surging, while NASDAQ new highs have decelerated. The momentum is flowing away from last year’s growth stock and technology winners into value and cyclical stocks.

 

 

As well, Ed Clissold of NDR Research pointed out that earnings momentum is fading for growth stocks. As the recovery takes hold, cyclical earnings growth is surging and eclipsing growth stock earnings.

 

 

In addition, quantitative price momentum strategies are about to pile into value stocks. Morgan Stanley chief US strategist Mike Wilson stated that stocks with the greatest 12-month price momentum will change as we pass the anniversary of the COVID Crash last March. Quants seeking to buy the price momentum factor will rotate from growth stocks to add value sectors like banks and energy.

 

 

Here is another headwind for growth stocks. Growth stocks are partly yield duration plays inasmuch as they are more sensitive to changes in bond yields. The relative performance of the NASDAQ 100 has shown an inverse correlation to the 10-year Treasury yield.

 

 

As the news from the economic reopening and recovery improves, the Economic Surprise Index has risen and it is putting upward pressure on the 10-year yield.

 

 

However, value investors shouldn’t be spooked by rising rates. The value/growth ratio has been highly correlated to the 10-year Treasury yield. Rising yields represent a signal of better economic growth, which benefits value and cyclical stocks.

 

 

 

Sentiment supportive of gains

In the face of strong momentum, sentiment models are not extended and supportive of further gains. The Fear & Greed Index is in neutral and it has a long way to go before it reaches a greedy reading.

 

 

Willie Delwiche observed that the spread between the Investor Intelligence sentiment ratio and the AAII ratio is near a historic low. Mom and Pop investors are more bullish than the professionals. Such episodes have tended to resolved bullishly in the past.

 

 

Macro Charts observed that growth investors have panicked. QQQ put option activity have spiked to levels consistent with past market bottoms.

 

 

The recent stock market pullback also panicked the NAAIM Exposure Index, which measures RIA sentiment, into a buy signal. This is a powerful contrarian model that has flashed only one false positive (in early 2008) since 2007. If history is any guide, expect a 5-10% advance in the S&P 500 over the next two months.

 

 

The combination of positive price momentum and skeptical sentiment is a strong bullish setup for higher prices.

 

 

Value/growth strength can continue

In the short-run, the value/growth reversal appears extended, especially among small-caps. But don’t be afraid to buy value when it dips against growth.

 

 

As an example, take a look at the relative performance of financial stocks. The relative performance reversal in this sector is global in nature, and the recovery does not appear overly stretched at all.

 

 

The relative performance recovery in energy shows a similar global pattern.

 

 

In the short-run, however, the S&P 500 is wildly overbought and it likely needs a few days to take a breather, either in the form of a mild pullback or sideways consolidation.

 

 

As well, Helene Meisler’s weekly (unscientific) Twitter poll has flashed the most bullish reading since she began polling almost a year ago.

 

 

In conclusion, there is nothing more technically bullish than a market reaching new highs. My inner investor is bullishly positioned in accordance with the buy signal from the Trend Asset Allocation Model. Price momentum is shifting away from growth stocks, which were the winners last year. While the market may be extended in the short-term and a pause in the advance would not be surprising, investors should not be afraid to buy the dip with a focus on value and cyclical names.