Opportunities from shorts (GME is so last week)

Posted by Cam Hui -

Is this GameStop’s “shoeshine boy” moment? Tracy Alloway pointed out that GME had made it to dog Instagram. 
 

 

If dog Instagram wasn’t enough of a shoeshine boy moment, how about this Michael Bathnick observation?

 

 

Regardless, there are a number of other opportunities in the short squeeze space to consider (other than silver).
 

 

Most shorted ETFs

The short squeeze play is getting played out, especially when short interest is falling to historic lows indicating there is little short covering demand should the market weaken.

 

 

Instead of looking for short squeeze opportunities in individual stocks, have you considered a list of the most shorted ETFs? These represent possible contrarian plays in unloved industries that may be poised to move up. For the purposes of this analysis, I focus on the top four, with the cutoff being 50% or more of the shares sold short.

 

 

The first ETF on the list, XRT, can be ignored as it represents a synthetic way of shorting GME. GME represents roughly 10% of XRT. For what it’s worth, there may be an arbitrage opportunity between XRT and GME put options.

 

 

The second ETF, XBI, is the equal-weighted Biotech ETF. XBI represents a unique growth opportunity. The ETF has been outperforming the S&P 500, and the industry is heavily shorted owing to disbelief over its strength. The ETF recently made a fresh all-time high, both on an absolute and relative to the S&P 500. As an aside, IBB, the cap-weighted Biotech ETF, ranks #8 on the list and IBB is not performing as well as XBI. XBI can be characterized as the growth play among the most shorted ETFs.

 

 

The next two on the list are value turnaround plays. XOP is the Oil & Gas Exploration ETF. The Energy sector has been unloved for most of 2020. Energy went from the biggest sector in the S&P 500 during the early ’80s to the smallest today. The world is shifting away from fossil fuels. GM recently announced that it will only sell zero-emission vehicles by 2035. Energy has become the new tobacco – an industry in decline. 

 

The negatives may be overdone. Despite the secular downtrend in energy demand, oil and gas prices should rise as the economic cycle rebounds. From a technical perspective, XOP rallied through a falling relative trend line and it appears to be forming the constructive pattern of a saucer-shaped relative bottom.

 

 

Similarly, KRE, which represents the regional banks, is forming a better defined rounded relative bottom. This indicates a turnaround for the group and foreshadows further outperformance in the future.

 

 

In conclusion, the analysis of the most shorted ETFs reveals three possible and diversified candidates for superior returns in the weeks and months ahead. Moreover, they don’t need to sponsorship of the r/WSB to rise. One can be thought of as a growth play, and the other two are turnaround value plays. All of them are rising on skepticism, as measured by the high level of short interest. 

 

 

How to spot the correction low

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: Bearish

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

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

 

Here comes the pullback

I have been increasingly cautious about the tactical market outlook for the past few weeks (see Take some chips off the table). Last week’s sudden air pocket certainly gave the bulls a fright. Is this the start of a correction, and how can investors and traders spot the bottom?

 

The daily S&P 500 chart shows that the S&P 500 has definitively violated its rising channel and it is now testing support at the 50-day moving average (dma). The VIX Index spiked above its upper Bollinger Band which signals an oversold condition. The VIX appears to be going on an upper BB ride indicating a more prolonged downdraft.

 

 

Looking longer-term, the weekly S&P 500 chart shows that the S&P 500 is just testing its rising trend line. There are nevertheless warnings from the negative 5-week RSI divergence and a rollover in relative strength in the popular ARK Innovation ETF (ARKK).

 

 

Should the market weaken in line with the historical experience of the last four years, it would translate into a pullback of 6-12% or 3200-3640 on the S&P 500.

 

 

Correction ahead

Last week’s downdraft may be a sign that the long-awaited correction may have begun. The VIX Index spiked over 40% last Wednesday, which is a relatively rare occurrence. If history is any guide the risk/reward of such episodes is not favorable. The market tends to recover in the first week but slides looking out 2-4 weeks.

 

 

As well, global breadth and momentum are losing some steam. The percentage of world markets above their 50-day moving averages (dma) peaked and fell to 78%. While this reading is not below the 70% tactical sell signal just yet, it is a warning signal of waning momentum.

 

 

Another area of concern is the market response to Q4 earnings season. The market is not rewarding earnings beats. The inability of a market to respond to positive news is another red flag.

 

 

 

Signposts of a bottom

With that preface, these are some of the signposts of a corrective bottom. First, watch for positive or negative divergences in risk appetite. Equity risk appetite can be measured by the ratio of high beta to low volatility stocks, and the equal-weighted consumer discretionary to consumer staple stocks. Right now, they are exhibiting minor negative divergences.

 

 

Credit market risk appetite, which can be measured by the relative price performance of high yield (junk) bonds to their duration-equivalent Treasuries and leveraged loans to USTs, are also showing minor negative divergences.

 

 

Foreign exchange (FX) market risk appetite can be measured by the inverse of the USD Index, which is also slightly underperforming the S&P 500.

 

 

Last week’s initial downdraft took the market to a sufficiently oversold condition on the S&P 500 McClellan Oscillator to signal the start of a correction. However, the weekly chart shown at the top of this publication indicates that the magnitude of past pullbacks has mostly been in the 7-12% range. Last week’s peak-to-trough drawdown was about -4%. If history is any guide, there is more downside risk over the next few weeks.
 

The most likely pattern is a period of choppiness as the market tries to find a bottom. While V-shaped bottoms are always possible, W-shaped bottoms tend to be the norm. In such instances, look for positive divergences after a re-test of the initial low, such as a flat reading or higher low on RSI or the McClellan Oscillator.

 

 

Should the market be engulfed by a selling panic, my Trifecta Bottom Spotting Model should flash a buy signal. The three components of this model are:
  • The term structure of the VIX Index: An inverted term structure is a signal of option market fear.
  • NYSE TRIN: A spike above 2 is an indication of a price-insensitive forced liquidation, or a “margin clerk” market.
  • Intermediate-term overbought-oversold indicator: A reading below 0.5 is a signal of an oversold market.

 

If all three models flash buy signals within a 2-3 days of each other, I call that a Trifecta buy signal. Sometimes just an exacta (two model) signal is good enough for a bottom.

 

The market flashed an exacta buy signal last Thursday when the VIX term structure inverted and TRIN rose above 2. In all likelihood, that signal should be discounted because of the brief nature of the term structure inversion, and a mean reversion of TRIN. TRIN showed the unusual condition of skidding below 0.5 last Wednesday when the S&P 500 fell -2.6%, indicating a buying stampede. The “buying stampede” and subsequent volatility of TRIN are attributable to the WallStreetBets crowd forcing short-covering of highly shorted stocks like GameStop. This interpretation is confirmed by the buying stampede readings of NASDAQ TRIN and the lack of a NASDAQ TRIN spike during the same period.

 

 

Lastly, timing the following tools from Index Indicators can be useful in timing exact bottoms. Watch for oversold conditions on the percentage of S&P 500 stocks above their 5 dma.

 

 

Also, keep an eye on the percentage of S&P 500 stocks at their 5-day lows.

 

 

W-shaped bottoms will be choppy. The percentage of S&P 500 stocks at their 5-day highs can also be helpful for timing short-term entries and exits for traders who want to reload their short positions. From a tactical perspective, the market is setting up for a bounce early in the week, but too much technical damage has been done and the pullback isn’t over. Any strength would be a good opportunity for traders to short the market in accordance with their risk appetite and preferences.

 

 

In conclusion, the market is likely just starting a pullback in the 6-12% range. My base case scenario calls for some choppiness over the next few weeks, which is consistent with NDR’s seasonal analysis. 

 

 

To summarize, spotting a corrective bottom involves keeping an eye on the following:
  • Positive and negative divergence in risk appetite indicators;
  • Positive and negative divergences in breadth and momentum indicators like the McClellan Oscillator and RSI;
  • The Trifecta Bottom Spotting Model; and
  • Short-term breadth indicators to time the approximate date of the bottom.
My inner investor is bullishly positioned, but he has selectively sold call options against existing long positions in order to mitigate short-term downside risk. My inner trader is short the S&P 500. 

 

 

Disclosure: Long SPXU
 

What could go wrong?

Posted by Cam Hui -

Now that virtually everybody has bought into the reflation and global cyclical recovery trade, and Reddit flash mobs are ganging up on short sellers to drive the most short-sold stocks into the stratosphere, what could go wrong with this bull?
 

 

Notwithstanding the silliness of the WSB flash mobs, here are some key bearish risks to consider.

 

  • The rise of bond vigilantes
  • Continuation of the trade wars
  • Health policy stumbles

 

 

Partying with abandon

Most of the investor surveys have been off-the-charts bullish for weeks. From most indications, retail and fast-money hedge funds are all-in on equities. Today, data is emerging that the slow-moving institutions are also fast becoming long risk.

 

The BoA Fund Manager Survey shows global manager risk positioning is at a record high.

 

 

While investor surveys only ask about attitude, which can change quickly, a more reliable source of sentiment comes from either the market, such as option pricing of risk appetite, or surveys of holdings from custodians and hedge fund prime brokers. The latest monthly survey of State Street Confidence, which aggregates institutional client holdings, shows a surge in North American equity risk appetite. In all likelihood, the next data point will see a further increase in risk positioning.

 

 

The survey of global positioning tells a similar story of rising risk appetite.

 

 

What could possibly go wrong?

 

 

The rise of bond vigilantes

A key macro risk facing equity investors is the rise of the bond vigilantes. The BoA Fund Manager Survey shows that expectations of a Goldilocks scenario of above-trend growth and below-trend inflation have peaked.

 

 

The S&P 500 is trading at a forward P/E ratio of 21.8, which is well above its 5 and 10-year averages. 

 

 

While the stock market appears expensive on most multiple-based valuation techniques, such as P/E, P/CF, EV/EBITDA, and P/B, they can be justified in view of the low extremes in bond yields. If we were to calculate the equity risk premium, defined as 10-year CAPE minus the 10-year bond yield, equity prices appear more reasonable, though the US (red line) is less attractive than other major developed markets.

 

 

What if rates were to rise? The 10-year Treasury yield bottomed last August at 0.5% and it has risen to above 1% today. Arguably, the rise in the copper/gold ratio, which is a sensitive global cyclical indicator, calls for a 10-year yield in the 1.5-2.0% range.
 

 

Where are the bond vigilantes?

 

 

A question of fiscal room

Now that Janet Yellen has been confirmed as the Treasury Secretary, she is expected to work closely with Jerome Powell to coordinate fiscal and monetary policy to dig the economy out of the recession. The key quotes from Powell in the post-FOMC press conference were, “We’re focused on finishing the job” and “frankly we’d welcome some inflation”. Fed watcher Tim Duy summed up Powell’s views this way:

Powell is trying to do two things. First, recognize the improving economic outlook. Second, make clear that this improvement has not yet impacted the Fed’s expected policy path. The new strategy is very clear that forecasts alone are not sufficient to justify reducing policy accommodation. Forecast-based inflation fears failed the Fed in the last recovery and they expect the same would happen now. As a result, the focus is squarely on results. Considerable progress toward goals needs to be made before tapering. Sustained inflation needs to occur before raising interest rates. The Fed will continue to pound on this message. Also, Powell is not impressed with anyone’s concerns about asset bubbles. It’s all about inflation and jobs.

Undoubtedly, that will mean more fiscal stimulus coupled with a very loose monetary policy. The resulting deficits and increases in government debt could be gargantuan.

 

Inflation expectations are already rising. The 10-year breakeven rate (blue line) is above the Fed’s 2% inflation target, and the 10-year Treasury yield (red line) has historically traded at or above the breakeven rate. What happens if the 10-year yield were to rise towards 2%? Won’t that put pressure on the equity risk premium and therefore stock prices?
 

 

The answer to that question is a Keynesian beauty contest, where judges are rewarded for selecting the most popular faces among all judges, rather than those they may personally find the most attractive. 

 

From a policy perspective, there has been a flood of academic papers supportive of greater fiscal spending. The degree of fiscal capacity is higher than expected under standard assumptions.

 

A 2015 paper by Josh Ryan-Collins of the Levy Economics Institute, “Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935–75”, concluded that the coordination of fiscal and monetary policy was not inflationary [emphasis added].
 

We find little empirical evidence to support the standard objection to such policies: that they will lead to uncontrollable inflation. Theoretical models of inflationary monetary financing rest upon inaccurate conceptions of the modern endogenous money creation process. This paper presents a counter-example in the activities of the Bank of Canada during the period 1935–75, when, working with the government, it engaged in significant direct or indirect monetary financing to support fiscal expansion, economic growth, and industrialization. An institutional case study of the period, complemented by a general-to-specific econometric analysis, finds no support for a relationship between monetary financing and inflation. The findings lend support to recent calls for explicit monetary financing to boost highly indebted economies and a more general rethink of the dominant New Macroeconomic Consensus policy framework that prohibits monetary financing. 
A 2017 paper by Huixin Bi of the Kansas City Fed, “Fiscal Sustainability: A Cross-Country Analysis”, examined fiscal capacity in the context of not just debt levels, but government transfers, tax rates, productivity, and other factors. It concluded that the US has more fiscal space than Japan, which has a debt-to-GDP level that is highest of all G-7 economies.

 

 

One assumption of the study is that policymakers won’t increase taxes relative to GDP past a certain point. Current net US federal debt levels of about 100% of GDP aren’t troubling, but raising taxes significantly could be.

 

 

This approach argues for substituting the conventional debt-to-GDP analytical framework for an interest rate vs. nominal growth rate framework.

 

 

Whether any of this matters to the bond market is another question. In a Keynesian beauty contest, it’s not your own opinion that matters, but that of the market.

 

Another risk is the USD and growth differentials. Nordea Markets pointed out that should the US be successful in its stimulus efforts, growth differentials with other major economies are set to rise. This would put upward pressure on the USD, which is contrary to the consensus view of a weak greenback. USD strength would put downward pressure on fragile EM currencies, which could spark a risk-off episode.

 

 

 

The trade war isn’t over

Just when you thought that Trump is out of the White House, his trade wars and protectionist tendencies have receded from government policy. Think again.

 

Marketwatch reported that Janet Yellen had some harsh words for China.
 

Janet Yellen, President Joe Biden’s pick to be U.S. Treasury secretary, made some blistering comments about China this week. It was straight talk the likes of which were rarely heard during her tenure as Federal Reserve chairwoman between 2014 and 2018. 

 

Yellen called China “our most strategic competitor’ and that the U.S. would work with its allies on a coordinated response.

 

“We need to take on China’s abusive, unfair, and illegal practices,” Yellen went on to say.

 

“China is undercutting American companies by dumping products, erecting trade barriers, and giving illegal subsidies to corporations,” Yellen said. 

 

Reuters reported that Biden Commerce nominee vows to protect U.S. networks from Huawei, ZTE:
 

President Joe Biden’s nominee to head the U.S. Commerce Department on Tuesday vowed to protect U.S. telecommunications networks from Chinese companies, but she refused to commit to keeping telecommunications giant Huawei Technologies on a U.S. economic blacklist.

 

“I would use the full toolkit at my disposal to the fullest extent possible to protect Americans and our network from Chinese interference or any kind of back-door influence,” Rhode Island Governor Gina Raimondo said in testimony before the U.S. Senate Commerce Committee, naming Huawei and ZTE Corp. Congress in December approved $1.9 billion to fund the replacement of ZTE and Huawei equipment in U.S. networks.

There is a bipartisan consensus in Washington that China is a clear and present danger on trade. A changing of the guard at the White House will not change that thinking, though the Biden approach is likely to be less confrontational, and seek to gather allies to pressure China to make changes.
 

The early signals from Biden are the level of protectionism is unlikely to fall significantly. One of Biden’s first executive orders was to require the federal government to “buy American” for products and services. This order upset a lot of trading partners, especially within the NAFTA bloc.
 

The market hasn’t really reacted to any of this news. Will the prospect of stabilization in protectionist levels spook the markets and risk appetite?
 

 

The virus is mutating

Even as investors are partying with abandon, so is the virus. The good news is case counts are starting to fall, but they could rise again if the newly infectious variants cause case numbers to rise again, especially if people become blasé about masks and social distancing. In the EU, vaccine supply is getting low. Spain has reported that “its fridges are empty”. A Hong Kong acquaintance informs me that they are unaware of any plans by the authorities to even roll out a vaccine. This pandemic is a global problem. Until the virus is stamped out everywhere and no pockets of infection remain to leak out and infect others, the global economy will not return to normal.
 

 

The New York Times reported that Pfizer and Moderna have scaled back expectations for the effectiveness of their vaccines.

As the coronavirus assumes contagious new forms around the world, two drug makers reported on Monday that their vaccines, while still effective, offer less protection against one variant and began revising plans to turn back an evolving pathogen that has killed more than two million people.
 

The news from Moderna and Pfizer-BioNTech underscored a realization by scientists that the virus is changing more quickly than once thought, and may well continue to develop in ways that help it elude the vaccines being deployed worldwide.

Moderna conceded that it may have to modify its vaccine to cope with new virus mutations. In addition, patients may have to continue to receive additional booster shots.

Moderna and Pfizer-BioNTech both said their vaccines were effective against new variants of the coronavirus discovered in Britain and South Africa. But they are slightly less protective against the variant in South Africa, which may be more adept at dodging antibodies in the bloodstream.
 

The vaccines are the only ones authorized for emergency use in the United States.
 

As a precaution, Moderna has begun developing a new form of its vaccine that could be used as a booster shot against the variant in South Africa. “We’re doing it today to be ahead of the curve, should we need to,” Dr. Tal Zaks, Moderna’s chief medical officer, said in an interview. “I think of it as an insurance policy.”
 

“I don’t know if we need it, and I hope we don’t,” he added.
 

Moderna said it also planned to begin testing whether giving patients a third shot of its original vaccine as a booster could help fend off newly emerging forms of the virus.

 

Another good news and bad news story come from the Johnson & Johnson and Novavax vaccine trials. J&J reported that the efficacy of its single-shot vaccine was 72% in the US and 57% in South Africa. Novavax reported its two-shot vaccine had a nearly 90% effectiveness in the UK but fell to 50% in a small South African trial. The South African variant, known as B.1.351, is raising alarm among health officials. This means new variants could cause more reinfections and require updated vaccines. As well, national health authorities need to put into place a “regulatory process to allow efficient updating to reflect new variants”.
 

 

In addition, the general acceptance of a vaccine is still a bit low. While vaccine acceptance is growing in Europe, the acceptance rate in most countries varies between 50% and 60%, which is not enough to achieve herd immunity. In addition, if governments were to impose continuing precautionary measures even after people are vaccinated, the policies create disincentives for people to vaccinate. Continuing rolling lockdowns would delay the global recovery and push back growth expectations.
 

 

 

Still constructive

Don’t get me wrong. I remain constructive on the market outlook and the base case scenario still calls for a prolonged equity bull market. This chart of IPO activity puts the market cycle into context. Sure, IPO activity is starting to look frothy, but history shows it can take several years before a secular market top is reached.
 

 

I am also indebted to New Deal democrat for the following insight, which shows the high degree of correlation between stock prices (blue line) and initial claims (red line, inverted) before the onset of the pandemic. As long as the recovery continues, the stock market should grind higher.
 

 

In the short-term, however, the market has become a little too giddy and a risk appetite reset may be necessary. A number of potholes are appearing on the road, any of which could be the catalyst for the reset. Investors are advised to focus on value over growth. As well, better value can be found outside the US, which is confirmed by the results of the cross-border equity risk premium analysis.
 

 

 

Risk happens quickly

Posted by Cam Hui -

Mid-week market update: What are we make of this market? In the last four years, the weekly S&P 500 chart shows that we have seen six corrective episodes of differing magnitudes. Risk happens, and sometimes with little or no warning.
 

 

About half of those instances saw negative 5-week RSI divergences, which we are seeing today. Since the start of 2019, when the ARK Innovation ETF (ARKK) started to get hot, the ARKK to SPY ratio roll over every time during those corrections. That ratio is turning down again.

 

The stock market is becoming a market of stocks, instead of a stock market. Individual issues are moving separately instead of together. In the past, low realized individual stock correlations have been warnings of market corrections.

 

 

Will this time be any different? The S&P 500 hasn’t seen a downside break of the rising trend line on the weekly chart yet.

 

 

Reasons for caution

The bear case is easy to make. Signs of froth are appearing everywhere. The PBoC warned about asset bubbles and withdrew liquidity from the financial system. The overnight repo rate spiked as a consequence. The Chinese and HK markets tanked on the announcement Tuesday, but steadied on Wednesday.

 

 

Bloomberg also reported that the “Goldman Team Sees ‘Unsustainable Excess’ in Parts of U.S. Market”.
 

Corners of the U.S. equity universe are showing signs of froth, but that shouldn’t put the broader market at risk, according to Goldman Sachs Group Inc.

 

Very high-growth, high-multiple stocks “appear frothy” and the boom in special-purpose acquisition companies is one of a number of “signs of unsustainable excess” in the U.S. stock market, strategists including David Kostin wrote in a note Friday. The recent surge in trading volumes of stocks with negative earnings is also at a historical extreme, they said.

 

However, the aggregate stock market index trades at below-average historical valuations after taking into account Treasury yields, corporate credit and cash, the strategists added.

 

In a separate article, Bloomberg reported that the NAAIM survey of RIAs shows that the most bearish respondents are 75% long. To explain, NAAIM surveys RIAs from 200 firms overseeing more than $30 billion and asks their investment views. The survey reports an average equity exposure, an average top and bottom quintile exposures, and a maximum and minimum exposure. It is highly unusual to see the minimum at 75%. Most of the time, the minimum is negative, indicating a short exposure to equities. The last time minimum exposure was this high was the market melt-up in late 2017 and early 2018. Tom McClellan recently made the same observation about the NAAIM survey and came away with a similar bearish conclusion.

 

 

As well, money market cash levels are low. Historically this has led to subpar returns.

 

 

From a seasonal perspective, February has historically seen VIX spikes. Since volatility is inversely correlated with the market, this implies lower stock prices ahead.

 

 

Ryan Detrick also observed, “When a new party is in power in the White House, that first year tends to be pretty choppy for the S&P 500.” Negative seasonality starts very soon and ends in March.

 

 

The market is due for a correction.

 

 

Here comes the flash mob bulls

There is no doubt that the market psychology is frothy and giddy. If you are unfamiliar with the Reddit flash mobs, take a look at the article, “11 Things to Know About the Wild GameStop Drama on Reddit WallStreetBets (WSB)”.

 

To recap, small retail traders have identified highly shorted issue and ganged up to push the stocks up. These traders have mostly used call options to maximize their leverage, and to force dealers to hedge their positions by driving up the underlying stock price. Small trader option volume has surged to fresh highs as a consequence.

 

 

Indeed, most shorted stocks have gone wild on the upside. 

 

 

The short squeeze targets are small cap stocks, and there is a linear relationship between the YTD performance of Russell 2000 stocks and their short interest.

 

 

Google searches for “short squeeze” have skyrocketed.

 

 

GameStop (GME) is the poster child of the short squeeze. Yet, even as GME rose like a rocket ship, the overall market reaction has relatively relaxed. The Russell 2000 VIX has risen but not spiked above its recent range, and the shares of CBOE has lagged the S&P 500.

 

 

How long can the WSB flash mobs prevail? Joe Wiesenthal of Bloomberg offered some perspective.
 

If you go back to the dotcom bubble, and you think about what stocks were really representative of it all, you probably think of Qualcomm or Cisco or Yahoo, or perhaps you remember TheGlobe.com. But some of the initial plays were a lot weirder. Back in the spring of 1998, traders went nuts for shares of K-Tel, the purveyor of corny compilation CDs that were sold via infomercials on TV. But when they started selling CDs online, the stock went bonkers, doubling many times over. Still, what seemed like irrational exuberance wasn’t anywhere close to the top of the market mania. It was barely even the beginning. K-Tel was like Hertz or the Scrabble bag.

 

It’s basically impossible to know in real time where you are in the cycle or how big things are going to get. Things can always get more nuts.
Before you think that the WSB pressure is restricted only on the upside, BNN Bloomberg reported that “Short-squeezed hedge funds are now getting hit on their bullish bets too”. Hedge funds have to trim their long positions in order to balance the losses on the short books. In the alternative, some traders are being forced to liquidate because rising volatility is causing VaR (Value at Risk) models to reduce book sizes.
 

Hedge funds are suffering as retail traders whipped up in chat rooms charge into heavily shorted names, fueling squeezes in stocks from Bed Bath & Beyond Inc. to AMC Entertainment Holdings Inc. Fund managers have spent recent weeks paring bearish bets, with hedge fund clients tracked by Goldman Sachs on Friday carrying out the biggest short covering in seven months.

 

But the long sides of their books are starting to feel the pinch too. On Monday morning, when stocks with the highest short interest soared as much as 11 per cent, the GVIP fund tumbled almost 2 per cent.

 

Such a squeeze not only hurts performance for hedge funds, it increases the potential size of a measure known as daily value at risk, both of which would prompt money managers to cut back their risk appetite, according to Kevin Muir of the MacroTourist blog.

 

“The real question is whether this selling starts a negative feedback loop,” Muir wrote Monday. “Even though it might seem like the stock market bulls should be cheering the squeezes, their success might end up being the trigger that brings about the general stock market correction many have been waiting for.”
Should the WSB squeeze continue, it opens up the possibility of one or more hedge fund blowups, such as a repeat of the August 2007 quant meltdown (see Khandani and Lo paper for more details).

 

In order to adapt to the new environment, I am changing my subscription pricing from being paid in USD, to being paid in shares of GME. This change will be immediate and apply to all renewals and new subscriptions*.

 

 

 

Risk levels are high

Tactically, today’s sell-off saw the S&P 500 violate a well-establish rising channel. In addition, the VIX Index surged above its upper Bollinger Band, which is the signal of an oversold market. The bulls need to hold the line here and rally. I am closely watching the behavior of the VIX. Will this a “once and done” spike, or an upper BB ride? Watch if there is any bearish follow-through.

 

 

My inner investor is bullishly positioned, but he has selectively sold covered calls against existing positions as a partial hedge. The long-term trend is still bullish, though short-term risk levels are high. My inner trader is holding his short position in the S&P 500.

 

* No, I am not serious. That’s a joke.

 

 

Disclosure: Long SPXU

 

When new highs aren’t bullish

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: Bearish

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

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

 

An exception to the rule?

The S&P 500 rallied to a fresh all-time high last week. While it is said that there is nothing more bullish than a market making new highs, this may be an exception to that rule, especially when there were more declines than advances on the day of a new high.

 

The S&P 500 kissed the top of a rising channel while exhibiting a negative 5-day RSI divergence. In addition, the VIX Index, which tends to be inversely correlated to stock prices, is testing a key support level at 20-21. More worrisome is the behavior of financial stocks. Large-cap banks reported last week and most beat expectations, but the entire sector is lagging the market.

 

 

 

More signs of froth

Sentiment readings have been extended since last 2020. The latest data point from NAAIM, which measures RIA sentiment, reached a record high of 113. While sentiment models are less useful at tops than bottoms (shaded areas), the last time the NAAIM Exposure Index neared these levels was the melt-up of late 2017 and early 2018.

 

 

These sentiment readings are consistent with the BoA Fund Manager Survey, which showed risk appetite at record levels.

 

 

As well, the Globe and Mail reported that BoA strategist Savita Subramanian observed that their “Sell Side Indicator”, which measures the risk appetite of Street strategists, is nearing a sell signal.

 

Sentiment has been getting more euphoric, as our Sell Side Indicator – a contrarian sentiment model – is at the closest level to the “Sell” threshold since the financial crisis. 

The 10-day moving average of the equity-only put/call ratio is nearing its lows again, indicating excessively bullishness. At a minimum, recent low reading episodes have resolved themselves in pullbacks.

 

 

 

Earnings season

One of the bright spots for the market bulls could be Q4 earnings season. FactSet reported the good news: Both EPS and sales beats are strong and above historical norms. Company analysts are revising their EPS estimates upwards, which should be a sign of strong fundamental momentum and bullish.

 

 

However, the market isn’t responding to good news in the form of earnings beats. FactSet also reported that the market is punishing positive earnings reports, and rewarding negative ones. However, the conclusion of rewarding earnings misses is based on highly preliminary data, and a very small sample size (n=3). I interpret these conditions as the market not rewarding earnings beats, rather than punishing beats and rewarding misses.

 

 

 

Where is the leadership?

The analysis of market leadership is also flashing warning signs. To be sure, the S&P 500 has been led by large-cap growth stocks. The NASDAQ 100 has led the market upwards, though the NDX to SPX ratio violated a rising relative trend line in early November. The latest relative upswing only represents a sideways consolidation within a range. 

 

 

A more detailed look at the relative performance of the top five sectors is more worrisome. These sectors represent 75% of S&P 500 index weight, and it’s virtually impossible for the index to rise sustainably without the participation of a majority of these sectors. The only signs of relative strength come from float-weighted consumer discretionary (AMZN and TSLA) and communications services. None of the other sectors are exhibiting signs consistent strong relative strength. Put simply, the market is being led upwards by a handful of Big Tech stocks. 

 

 

The narrow leadership is also evident in the analysis of market breadth. Even as the S&P 500 reached fresh highs, indicators such as NYSE and NASDAQ new highs, the % of stocks with point and figure buys, and the percentage of stocks above their 50-day moving average are all making patterns of lower highs and lower lows. As we progress through earnings season, the narrowness of the leadership poses a grave stock specific risk to the major indices. Any disappointment has the potential to open the door to a sell-off.

 

 

In conclusion, the market is undergoing a melt-up and a setback can happen at any time. At worse, the market is vulnerable to a violent air pocket of unknown magnitude. Remember Bob Farrell`s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”
 

Brace for volatility in the coming week from individual earning season results and the FOMC meeting.

 

 

 

Disclosure: Long SPXU

 

What would Bob Farrell say?

Posted by Cam Hui -

What would the legendary market analyst Bob Farrell say about today’s markets? I was reviewing the patterns of factor returns recently, and I was reminded of three of Farrell’s 10 Rules of Investing (which are presented slightly out of order).
 

Rule 3: There are no new eras – excesses are never permanent.
Rule 2: Excesses in one direction will lead to an opposite excess in the other direction.
Rule 4: Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

 

Applying those principles to the return patterns to growth and value over the last 20 years, we can see that growth has peaked out relative to value in 2020 (Rules 2 and 3).

 

 

Does that mean that this is the end of an era for growth stocks? Large-cap growth stocks comprise roughly 45% of the weight of the S&P 500. If they were to falter, does this mean investors are facing a major market top?

 

What would Bob Farrell say?

 

 

FANG+ = Nifty Fifty

While Farrell’s 10 Rules is silent on the specifics of today’s FANG+ leadership, they were not silent on investor psychology. One thing is certain, investors are prone to recency bias, and the most likely parallels they might make is the dot-com bubble of the late 90’s. I beg to differ.

 

The mania of the late 90’s was characterized by a flood of unprofitable companies coming to market. I remember sitting through endless presentations of new companies with the mantra of “We expect to be EBITDA positive in two years, and earnings positive in three.” Even paper and forest products companies would not dare go into an institutional presentation without outlining a “broadband strategy”.

 

By contrast, today’s FANG+ stocks tend to be cash flow generative and have substantial competitive advantages, or moats. A more fitting analogy to the recent FANG+ leadership is the Nifty Fifty era of the early 70’s.

 

The Nifty Fifty era was characterized by a “growth at any price” mentality. The investment thesis was to buy good growth stocks and hold them – forever. The blogger writing under the pseudonym Jesse Livermore recently performed a masterful analysis of the Nifty Fifty using the O’Shaughnessy Asset Management (OSAM) database. He took the Nifty Fifty list as of 1972 and analyzed the history from 1963 to 2020. Most of the survivors today have mature growth paths, the key theme of strong competitive moats is emerging from the analysis. Large-cap survivors include pharmaceuticals, along with selected consumer-oriented companies who have been able to maintain their branding (P&G, Disney, Coke, McDonald’s).

 

 

The key similarity between the Nifty Fifty list and the FANG+ list today is their competitive moats, as characterized by their ability to maintain high margins. Companies in industries with high margins will attract competitors. They will not survive unless they have strong competitive positions.

 

 

However, good companies don’t necessarily make good investments. Despite their strong levels of profitability, Nifty Fifty stocks peaked out in relative performance in the early 70’s and never looked back.

 

 

The analysis of P/E multiples tells the story of performance. Nifty Fifty stocks began as highly valued. Multiples collapsed when the investment theme peaked, and normalized to market levels starting in the early 80’s.
 

 

I don’t mean to leave the impression that all of the Nifty Fifty were successful investments. A glance at the top losers reveals companies that lost their competitive moats. Technology companies were at the greatest risk of this (IBM, Digital Equipment, Unisys, Xerox).

 

 

 

Timing the top

What does this mean for investors?

 

First, be aware of Mark Minervini’s 50/80 Rule: “Once a secular market leader puts in a major top, there’s a 50 percent chance that it will decline by 80 percent—and an 80 percent chance it will decline by 50 percent.”
 

Mark Hulbert also recently warned about the possibility of a “valuation bear market”.

 

Take what happened in the wake of the internet bubble bursting, for example. From the stock market’s March 2000 high to its October 2002 low, according to data from Dartmouth’s Ken French, the 10% of all publicly traded stocks closest to the value end of the spectrum outperformed the 10% closest to the growth end by more than 22 annualized percentage points—though they still lost ground on average. But small-cap value stocks—as represented by the Russell 2000 Value Index—actually rose slightly during that bear market.

 

Despite the apparent evidence of a reversal in the relative performance of large-cap growth stocks, we have to allow for the possibility that this is not the top. A more detailed analysis of the relative performance of the Nifty Fifty revealed false bear market positives in the late 60’s.

 

 

However, the length and magnitude of the gains of FAANGM stocks suggests that these issues are due for a secular top.
 

 

Where does that leave us? The weight of the evidence suggests that US large-cap growth stocks are turning down, and their secular bear is just beginning. Value is just starting its cycle of outperformance, and investors should tilt their portfolios towards out-of-favor value stocks.

 

Investors who would like exposure to growth can look outside the US, such as the tech-heavy Asia 50 (AIA) or Emerging Markets eCommerce and Internet ETF (EMQQ). Both of these ETFs have turned up relative to the NASDAQ 100.

 

 

 

In need of a sentiment reset

Posted by Cam Hui -

Mid-week market update: This market is in need of a reset in investor sentiment. In addition to recent reports of frothy retail sentiment, the latest BoA Fund Manager Survey (FMS) indicates that global institutions have gone all-in on risk. The FMS contrarian trades are now “long T-bills-short commodities, long US$-short EM, long staples-short small cap”, or short market beta.

 

 

Along with growing signs of deteriorating market internals, this market is poised for a correction.

 

 

More signs of froth

Here is how frothy sentiment has become. SentimenTrader recently reported sky-high call option activity by retail investors.

 

 

In aggregate, speculators (read: hedge funds) are very, very long equity futures.

 

 

This is the classic definition of a crowded long position by different constituents. Retail, hedge funds, and now institutions are all long risk up to their eyeballs. Who is left to buy?

 

 

Negative divergences

All the market needs to fall is a bearish trigger. Even as the S&P 500 staged an upside breakout to another all-time high, a number of worrisome negative divergences are appearing.

 

  • Technical: A negative divergence from the 5-day RSI.
  • Equity risk appetite: The ratio of high beta to low volatility stocks is trading sideways and not confirming the new high. This ratio is an important indicator of equity risk appetite.
  • Earnings season reaction: Q4 earnings season has begun. Most of the large-cap banks have reported, and most have beaten expectations. However, financial stocks are lagging the market despite the beats. A market that does not react well to good fundamental news is a warning for the bulls.
  • Foreign exchange risk appetite:  The USD has been inversely correlated stock prices. The USD began a counter-trend rally, which would put downward pressure on risk assets.

 

 

Macro Charts recently highlighted the crowded short positioning in the USD Index. This makes the EM assets especially vulnerable, and the long EM trade is a long risk and reflation trade.

 

 

The cyclical and reflation trade is also in need of a reset in sentiment. Callum Thomas observed that the S&P 500 does not perform well when ISM rises above 60. Too far, too fast?

 

 

From a sentiment momentum perspective. the FMS shows that the expectations for the Goldilocks scenario of strong non-inflationary growth is rolling over. These are the kinds of conditions that can spark a correction.

 

 

In conclusion, the combination of giddy sentiment and technical deterioration is not a good recipe for further equity market gains. The short-term risk/reward ratio is negative and the market can correct at any time.

 

 

Disclosure: Long SPXU

 

 

Take some chips off the table

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: Bearish

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

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

 

Not what you see at market bottoms

I have been writing about the extended nature of sentiment for several weeks. Macro Charts highlighted an email from Interactive Brokers on how to build a “balanced” portfolio using fractional shares, consisting of Netflix, Tesla, Alphabet, and Amazon. Either someone forgot the basics of financial planning in constructing a balanced portfolio, or we are back to the go-go days of the dot-com and Nifty Fifty bubbles.

 

 

While it is true that sentiment models are less effective at calling tops than bottoms, there are sufficient signs that investors and traders should be reducing equity risk and taking some chips off the table.

 

 

 

Momentum rolls over

While it is true that bullish sentiment can remain elevated for quite some time, a useful rule of thumb is to wait for downside breaks in technical indicators before turning cautious. Recently, the NYSE McClellan Summation Index (NYSI) rolled over from an overbought extreme, indicating a loss of momentum. Most of these episodes have resolved with market stalls (red vertical lines) while only a small minority have seen the market continue to advance (blue lines).

 

 

 

A bad breadth warning

An analysis of relative performance of the top five sectors of the S&P 500 also reveals the headwinds the index is facing. These sectors comprise over 75% of index weight, and the market would have difficulty rising without the participation of a majority of these sectors. Currently, only the smallest of the top five, financials, is displaying positive relative strength. All of the other sectors are either trading sideways or falling relative to the S&P 500.

 

 

 

Negative RSI divergences

In addition, negative RSI divergences are showing up in market leaders even as they make new relative highs. Since the March low, small cap stocks have been on fire, but the relative performance of the Russell 2000 to S&P 500 is exhibiting an RSI negative divergence even as the ratio makes new highs.

 

 

The enthusiasm for the ARK Innovation ETF (ARKK) is highly reminiscent of the mania surrounding the Janus 20 Fund during the dot com era. Similar to the Russell 2000, the ARKK to SPY ratio is also exhibiting a negative RSI divergence, which is another warning for the bulls.

 

 

Lastly, you can tell the character of a market based on how it reacts to news. The S&P 500 broke short-term support (shaded box) even as Biden unveiled a $1.9 trillion fiscal support package, and Fed chairman Jerome Powell reiterated the Fed’s dovish commitment to maintain the pace of asset purchases. In addition, earnings beats by Citigroup and JPMorgan were met with red ink for their share prices. These reactions are indicative of a heavy tape and a market that’s ready to fall. In the short-term, the path of least resistance is down. Primary support can be found at the rising trend line at about 3750, with secondary support at the Fibonacci retracement levels of 3588 and 3515.

 

 

Also keep an eye on the USD. The USD Index is undergoing a counter-trend rally by rising through a short-term downtrend (dotted line), but the long-term downtrend (solid line) remains intact. Initial resistance can be found at about 91, with key secondary resistance at 92. The USD is an important risk appetite indicator. It has been inversely correlated with both the S&P 500 and emerging markets (bottom panel).

 

 

In conclusion, the seasonal Santa Claus rally that began in December is living on borrowed time. This market is vulnerable to a 5-10% setback, and it can correct at any time. While it’s impossible to call the exact timing of a short-term top, the weight of the evidence suggests that it’s time to tactically reduce equity risk and take some chips off the table. We are into a period of negative seasonality and choppiness until early March.

 

 

Subscribers received an email alert that my inner trader had initiated a short position in the S&P 500. Keep in mind, however, that the primary trend is still bullish, and the utility of trading short positions in a bull market is less useful.

 

My inner investor remains overweight equities. He has selectively sold covered call options against long positions as a way of reducing risk.

 

 

Disclosure: Long SPXU

 

A Great Rotation region and sector update

Posted by Cam Hui -

In the wake of my Great Rotation publication (see Everything you need to know about the Great Rotation but were afraid to ask), it’s time for an update of how global regions and US sectors are performing. The short summary is the change in leadership of global over US stocks, value over growth, and small caps over large caps are still intact.
 

 

While the long-term trends remain in place, some tactical caution may be in order in certain parts of the market.

 

 

Global leadership patterns

For the purposes of analyzing change in leadership, I use the Relative Rotation Graphs, or RRG charts, as the primary tool for the analysis of sector and style leadership. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

 

The RRG analysis of global regions is clear. Avoid US equities. The only regions in the bottom half of the chart are US indices. 

 

 

A more detailed analysis of relative performance against the MSCI All-Country World Index (ACWI) shows that the S&P 500 and NASDAQ 100 losing steam, major developed markets like Europe and Japan trading mostly sideways, and EM xChina the best relative performer.  EM xChina’s strong relative performance is mainly attributable to that region’s high cyclical exposure, though the region may be vulnerable in the short-run owing to the extended nature of the recent rally.

 

 

 

Sector rotation analysis

The RRG analysis of US sector held few surprises. Large-cap growth sectors such as technology, communication services, and consumer discretionary (AMZN, TSLA) were in the weakening quadrant. Defensive sectors, such as consumer staple, utilities and real estate, were in the lagging quadrant owing to the strong market rally since the November Vaccine Monday rally began. Unloved value sectors such as energy and financials are in the leading quadrant. 

 

 

A closer examination of the two leading sectors, energy and financials, reveal some key differences. Both large and small cap energy stocks are beating their respective benchmarks and showing similar patterns (top panel), but the degree of outperformance of small to large cap energy (bottom panel, green line) lags the relative performance of the Russell 2000 to S&P 500. If energy stocks are to remain market leaders, there may be some opportunity in small cap energy.

 

 

The analysis of large and small cap financial stocks tells a different story. While large cap financials have begun to recover, small caps have not shown the same relative performance pattern (top panel). The yield curve has been steepening, which should be positive for banking profitability, but the lagging leadership of small cap financial stocks is a blemish for the sector.

 

 

The big surprise from the RRG chart was the deterioration in relative strength seen in cyclical sectors such as materials and industrials. In theory these sectors should be performing well as the global economy recovers from the pandemic. Instead, the relative performance of cyclical sectors and industries have begun to flatten out.

 

 

 

A cyclical pause?

Signs are growing that the expectations of a cyclical recovery has grown too far, too fast. In a recovery, companies with high financial and operating leverage should perform well, and indeed the high operating leverage basket has rocketed upwards against the S&P 500 since Vaccine Monday. Cyclical stocks may have risen too far, too fast.

 

 

The global cyclical recovery trade appears ready to take a breather. Callum Thomas observed that industrial metal PMIs are starting to roll over, even though readings are still strongly positive.

 

 

 

 

However, any pause in the cyclical rebound is likely to be short-lived. China has been leading the global recovery. Despite the recent pause, the PBoC has injecting liquidity into the financial system, which should boost the cyclical sector within the next few months.

 

 

I am monitoring the relative performance of Chinese material stocks. This sector has traded sideways relative to other global material companies. While this is a sign that economic momentum is losing some steam, it will also provide a real-time alert of improving economic momentum from China.

 

 

 

Investment implications

What does this mean for the stock market? First, investors should relax. The rally is likely due for a pause but the bull cycle remains intact. The current advance in the Dow is consistent with past historical experience since 1900.

 

 

From a sector perspective, investors should focus on value stocks. The relative performance recovery of large and small cap value, however they are measured, are intact.

 

 

In particular, the energy sector holds promise. This sector has become the smallest sector by weight in the S&P 500, indicating its unloved status. Even within the commodity sector, the crude oil to gold ratio is depressed. Energy stocks are now the new tobacco – unloved value stocks. Their recent relative strength recovery could be a signal of a turnaround for this sector.

 

 

From a global perspective, investors can also consider value candidates that have begun to recover. In the developed markets, small cap UK stocks could be a source of outperformance, now that the uncertainties of Brexit have been resolved.

 

 

Within the emerging markets, EM xChina has been exhibiting strong relative strength, though it is a little extended and could see a short-term pullback.

 

 

However, the analysis of fund flows show that EM xChina equity flows are net negative for 2020. These stocks are still under-owned, indicating substantial potential for outperformance.

 

 

 

One last push, or a downside break?

Posted by Cam Hui -

Mid-week market update: I have been warning about the extended nature of this stock market for several weeks. The latest II sentiment update shows more of the same. Bullish sentiment has come off the boil, but readings are reminiscent of the conditions seen during the melt-up top that ended in early 2018.
 

 

The market can correct at any time, but I also have to allow for the possibility of one last bullish push to fresh highs. Here is what I am watching.

 

 

High levels of speculation

I have written about how low quality stocks have begun to dominate the market. Here is another data point that details the level of speculative activity – the low price factor. On a YTD basis, low priced stocks have outperformed on a monotonic basis. 

 

 

Similarly, option call volume has skyrocketed, indicating rampant speculative activity.

 

 

Consequently, dealer gamma exposure is also sky high, as dealers need to hedge the unprecedented levels of call option activity. Historically, such high levels of gamma have resolved themselves with corrective activity.

 

 

Another risk is the low short interest by historically standards. These levels will not provide the buying demand to put a floor on stock prices if the market corrects.

 

 

 

Waiting for the trading signal

Before turning overly bearish, here is what my inner trader is watching. The S&P 500 recently went on an upper Bollinger Band (BB) ride. Such upper BB rides have either resolved with sideways consolidation and a renewed rally, as the market did in August, or a correction. So far, the market has traded sideways for several days, and he is now waiting for either an upside or downside break out of the trading range (shaded box). Should it break upwards, watch for signs of either confirmation of strength or a negative divergence from the 5-day RSI.

 

 

As well, keep an eye on the USD Index. The USD is important as a risk appetite indictor. A falling USD is helpful to fragile EM economies. As well, a rising USD can be a risk-off indicator because investors stampede into the greenback during period of fear.

 

The USD bottomed in late December and early January while exhibiting a positive RSI divergence. A countertrend rally appears to be underway as the index broke up through a minor downtrend (dotted line), but the major downtrend (solid line) remains intact. Watch for resistance at 91, and further major resistance at 92. (I show UUP, the USD ETF, because the USD Index data update is delayed on StockCharts).

 

 

My inner investor remains overweighted in equities, but he has reduced risk by tactically selling covered call options against selected long positions. My inner trader is on the sidelines, and he is waiting for a bearish signal to make a commitment to the short side.

 

 

Tactically cautious, despite the data glitch

Posted by Cam Hui -

In yesterday’s post, I pointed out that, according to FactSet, consensus S&P 500 EPS estimates had dropped about -0.50 across the board over the last three weeks (see 2020 is over, what’s the next pain trade?).
 

 

The decline turned out to be a data anomaly. A closer examination of the evolution of consensus estimates revealed a sudden drop in EPS estimates three weeks ago. Discontinuous changes like that are highly unusual, and it was traced to the inclusion of heavyweight Tesla in the S&P 500. In this case, analyzing the evolution of consensus earnings before and after the Tesla inclusion was not an apples-to-apples comparison. My previous bearish conclusion should therefore be discounted.
 

 

Nevertheless, I am becoming tactically cautious about the stock market despite resolving this data anomaly.
 

 

Negative seasonality

The first and least important reason is seasonality. Seasonality is a factor I pay attention to, but technical and fundamental factors tend to dominate price action more. We are entering a period of negative seasonality for the markets, and the January-March period tends to be choppy with a flat to down bias.
 

 

 

Extended sentiment

Sentiment models are still extended, though readings have come off the boil. The Citigroup Panic-Euphoria Model remains in euphoric territory and at historic highs.
 

 

Michael Hartnett’s BoA Bull-Bear Indicator is rising rapidly and nearing a sell signal.
 

 

I previously observed that the Fear & Greed Index displays a double peak pattern before the market actually tops out (see Time for another year-end FOMO stampede?). This was one of my bearish tripwires that haven’t triggered yet, though it may well be on its way to a sell signal.
 

 

 

Bearish tripwires

However, a number of my other bearish tripwires have triggered warnings. The low quality (junk) factor has spiked. In the past, low-quality factor surges have foreshadowed short-term tops in past strong market advances.
 

 

As well, the NYSE McClellan Summation Index (NYSI) reached 1000. which indicates a strong advance, and rolled over. There have been 16 similar episodes in the last 20 years, and the market has declined in 11 of the 16 instances.
 

 

I also warned that a rising 10-year Treasury yield could put downward pressure on stock prices. Bloomberg reported that trend following funds could sell T-Note and T-Bond futures and push rates upward.

Quantitative hedge funds are busy liquidating loss-making long Treasuries positions and could begin to establish new short ones if the 10-year yield breaches 1.10%, according to market participants.
 

Momentum funds known as Commodity Trading Advisors likely drove the initial move upward in yields on Wednesday, based on activity in futures markets, Citigroup Inc.’s Edward Acton wrote in a note to clients. The funds have been cutting losses since 10-year yields reached around 1.02%, said Nomura Holdings Inc.’s Masanari Takada.
 

CTA funds “appear likely to keep closing out long positions with yields at 1.02% or higher,” Takada wrote in a note Thursday. “We cannot rule out the possibility that CTAs could turn short,” at yields of 1.10% or higher, he said.

The 10-year yield is well beyond the bearish trigger of 1.02%.

 

 

Vulnerable to a correction

To be sure, price momentum is still holding the upper hand, but the stock market is increasingly vulnerable to a correction. Steve Deppe ran a historical study of last week’s market action and looked for instances when the market fell sharply (last Monday) and ripped to an all-time high. With the caveat that the sample size is relatively small (n=9), the market was choppy to slightly positive in the first week but suffered negative returns 10 and 20 trading days out.

 

 

For now, price momentum is holding the upper hand, but the combination of technical and sentiment conditions call for tactical prudence. Earnings season begins this week. Expect daily volatility to rise as individual reports are issued.

 

My inner trader has stepped to the sidelines and he is waiting for a downside break before taking a short position.

 

 

2020 is over, what’s the next pain trade?

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.
 

 

The next pain trade

Now that 2020 is over, what’s the next pain trade? I have a few candidates in mind. The latest BoA Global Fund Manager Survey taken in early December described the top two most crowded trade as long technology stocks, and short USD.

 

 

Another source of vulnerability is the expectation of a steepening yield curve. If history is any guide, heightened expectations of a steepening yield curve have resolved with market upsets of differing magnitude.

 

 

As a reminder, this survey was taken in December. After the Georgia special Senate elections gave the Democrats the trifecta of the control of the White House, Senate, and House of Representatives, the 10-year Treasury yield surged to over 1%, and the yield curve steepened even further.

 

All of these vulnerabilities are connected from a cross-asset perspective – the steepening yield curve, long technology stocks, and short USD. It’s all the same pain trade, and it’s equity bearish. Here’s why.

 

 

A cross-asset journey

Let’s unpack some of these factor exposures from a cross-asset perspective. Here is the most important chart that investors should consider. In the wake of the Democratic win in Georgia, the 10-year Treasury yield shot up beyond 1%. The 10-year yield broke up through a falling trend line in December, but it has been rising steadily in a channel that began last August.

 

 

Here is why that matters. Equity investors will tolerate higher bond yields as long as they are offset by a better growth outlook. But disappointing economic reports, such as the December Jobs Report miss, is a crack in the better growth narrative. In addition, FactSet reported that the Street has been revising EPS downwards, which is a sign of negative fundamental momentum. Quarterly EPS estimates fell about -0.50 across the board in the last three weeks. When will the combination of a rising 10-year Treasury yield and falling EPS estimates put downward pressure on stock prices?

 

 

Also consider the long technology stock bet, which is a form of growth stock exposure, from a cross-asset perspective. When growth is scarce, rates fall and investors bid up growth stocks. When growth expectations rise, rates rise and value outperforms growth.

 

 

However, Big Tech growth makes up 44.5% of S&P 500 weight, while value sectors are only 30.3%. If growth stocks become a drag on the index, the S&P 500 will face considerable headwinds in trying to advance.

 

 

 

The short USD pain trade

The other crowded short identified by the respondents of the BoA Global Fund Manager Survey is a USD short position. This is another pain trade that is correlated to the others.
 

First, positioning in the USD is at an extreme, and the market is setting up for a rally that could hurt the short-sellers.

 

 

The recent Democratic victory set up the anticipation of better economic growth, which is Dollar positive and pushed up bond yields owing to higher deficits. The spread between the 10-year Treasury yield and the Bund and JGBs are rising, which should attract more funds into the greenback. This is all occurring in a backdrop where the USD Index is testing a key support zone that stretches back to 2018.

 

 

All of these conditions are supportive of a reversal in USD weakness. In the last 18 months, stock prices have been inversely correlated with the USD Index. Dollar strength is likely to spark a risk-off episode, starting with EM risk assets that are sensitive to the USD exchange rate.

 

 

 

Waiting for the bearish catalyst

So far, this discussion of the next pain trade is only a trade setup without a bearish catalyst. The stock market may need a final blow-out before correcting.

 

The latest cover of Bloomberg BusinessWeek could be interpreted as a contrarian bullish magazine cover indicator. Indeed, the stock market rallied the day pro-Trump protesters invaded the Capitol.

 

 

Price momentum has been extremely strong. The S&P 500 is going on an upper Bollinger Band ride and there were no NYSE new lows Friday. The index spent August on upper BB rides. One resolved in a sideways consolidation, and the other ended with a correction.

 

 

As well, I have been monitoring the percentage of stocks in the S&P 500 that are above their 200-day moving average. In the past, readings of 90% or more have signaled sustained market advances and they don’t end until the 14-week RSI becomes overbought or near overbought. Conditions are very close to an overbought condition, but remember Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

 

 

While the current market is dominated by strong price momentum, the clash between positive price momentum and negative EPS fundamental momentum will catch eventually up with the bulls. Despite these cautionary signals, I believe any pullback is likely to be no more than 5-10%. How you position for market weakness is therefore a function of your investment objectives, risk tolerance, and investment time horizon.

 

In summary, the combination of a steepening yield curve, long technology stocks, and short USD are correlated, and constitute the next pain trade. The market is increasingly vulnerable to a 5-10% correction. These conditions are equity bearish, but they lack a bearish trigger. Investment-oriented accounts should be prepared to deploy additional cash should the market pullback. A 5-10% pullback is consistent with normal equity risk and investors who cannot tolerate those levels of drawdowns should rethink their asset allocation. By contrast, traders with shorter-term time horizons should wait to see evidence of a definitive downside break in the face of strong price momentum before turning bearish.

 

 

The Democrats’ trifecta win explained

Posted by Cam Hui -

Last weekend, I conducted an unscientific and low sample Twitter poll on the market perception of the Georgia special Senate elections. The results were surprising. Respondents were bullish on both a Republican and Democratic sweep.
 

 

As the results of the Georgia Senate race became clear, the analyst writing under the pseudonym Jesse Livermore tweeted that these results represent a “fiscal Goldilocks” scenario.

 

 

However, the analysis of the investment risk and opportunity is far more nuanced than just a simple bull and bear question.

 

 

The stock market isn’t the economy

It is trite to say that the stock market isn’t the economy and vice versa. This analysis from JPMorgan Asset Management tells the story. Technology, which includes Communication Services, comprises 6% of GDP, 2% of employment, and 38% of the S&P 500. Add in Amazon and Tesla, and their combined is nearly half of the index weight.

 

 

Here is why this disparity matters. When the market opened on Wednesday after the Georgia special elections, NASDAQ stocks fell even as the rest of the market rose on Wednesday. This was attributable to fears of greater antitrust and regulatory scrutiny of Big Tech companies. While there was an element of truth to that interpretation, there is more to the story of growth stock weakness.

 

As the election results trickled in Tuesday night and a Democratic sweep became apparent, the 10-year Treasury yield spiked to above 1% overnight and the yield curve steepened. These are credit market signals of greater economic growth in anticipation of more fiscal stimulus.

 

More growth should be bullish, right? Not for large-cap growth stocks. Growth stocks are duration plays, and they act like long bonds in response to changes in interest rates. When the yield curve steepened and bond yields rose, large-cap growth stocks underperformed.

 

 

When the yield curve steepened in anticipation of better economic growth, that should be bullish for cyclical stocks. But the cyclical weight in the S&P 500 is only about 20%, while large-cap growth is nearly 44.5%. As growth stocks face headwinds from rising 10-year yields, this index weight disparity makes it difficult to be overly bullish on the S&P 500.

 

 

An analysis of the relative returns of the top five sectors of the S&P 500 tells the story of the headwinds facing the index. Large-cap growth (Technology, Communication Services, Consumer Discretionary) relative performance is best described as flat to down. Healthcare relative performance may be trying to bottom, and financial stocks are starting to turn up. The top five sectors make up about 75% of the index weight, and it’s difficult to see how the S&P 500 can advance sustainably without the participation of a majority of its biggest sectors.

 

 

Notwithstanding the disparity in index weights, a rising 10-year Treasury yield is historically friendly to value stocks. Yields fall in anticipation of declining economic growth and rise in anticipation of better growth. In an environment where growth is scarce, investors will pile into growth stocks, and in an environment when growth is plentiful, investors favor value stocks. Inasmuch as value sectors represent about 30% of the S&P 500 weight, and growth sectors 45%, the style headwinds for the market are lessened should growth stocks become laggards.

 

 

 

Here comes the cyclical rebound

Regardless, there are plenty of signs that the economy is poised for a cyclical rebound. 

 

Household finances are in good shape. Credit card debt (blue line) has fallen dramatically while checking deposits (red line) have soared. The consumer is ready to spend.

 

 

The prospect of even more fiscal stimulus is supportive of even more expansion. As the Democrats tend to be more focused on inequality, the distribution of stimulus money will be tilted towards lower-income Americans, who have a greater propensity to spend additional funds than to save them. Expect a wave of consumer spending to begin in the next six months as the combination of widespread vaccination and stimulus funds reach the wallets of American consumers.

 

 

In light of the large negative surprise in the December Jobs Report, it is worthwhile to consider what might happen next as the economy recovers. The headline loss of 140K jobs was led by weakness in the service sector, which was attributable to to huge declines of -372K in food and beverage jobs, -92K in amusement and recreation, and -63K in private education.

 

Australia is a case study of what pent-up consumer demand looks like in a post-COVID environment. To recap, Australia underwent a full lockdown until late September as a second wave hit. Case counts have since eased dramatically, even without a vaccine. 

 

 

Like other countries, it is the service sector of the economy that collapsed. Take a look at what happened next. Travel demand has fully recovered.

 

 

AirBNB has also enjoyed a revival.

 

 

In light of the Australian experience, imagine what would happen to the US economy if a vaccine and more fiscal stimulus were overlaid on top of that?

 

What’s more, the recovery is global in scope. 82% of manufacturing PMIs are in expansion mode.

 

 

To sum up, the following sectoral balance analysis tells the story of an economy that’s ready to roll. Past recessions have been marked by over-levered household balance sheets (blue line) and corporate sectors that were deleveraging as the economy entered recession. This time, the corporate sector is in reasonably good shape, and weakness in the household sector has been offset by government stimulus. As soon as vaccines becomes widely available, the economy is ready to return to normal.

 

 

 

Too far, too fast?

However, equities may have risen too far, too fast. Willie Delwiche observed that the markets entered 2021 with 96% of global markets above their 50-day moving averages. While these readings have been long-term bullish, the markets are poised for a short-term pause.

 

 

The current market recovery is reminiscent of recoveries from recessionary bottoms, such as 1982 and 2009. If the past is any guide, the market is due for a period of consolidation and choppiness.

 

 

A global cyclical recovery argues for a greater commitment to emerging markets instead of US large-cap growth stocks, which were the winners of the last cycle. An analysis of EM fund flows shows that investors have not fully embraced the EM as a cyclical recovery vehicle just yet. Fund flows are nowhere near a crescendo, which is constructive.

 

 

In conclusion, the Democrats’ trifecta win is bullish for the cyclical revival investment theme, but the S&P 500 may face headwinds because of the excess weighting of large-cap growth stocks in that index. Investors should overweight sectors and groups levered to the cyclical recovery, both within the US and abroad, such as EM. Tactically, the markets are poised to pause their rally in the near-term, and investors should take advantage of any weakness to add to their cyclical exposure.

 

 

Santa has returned to the North Pole

Posted by Cam Hui -

Mid-week market update: The last day of the Santa Claus rally window closed yesterday, and Santa has returned to the North Pole. But he left one present today in the form of an intra-day all-time high for all the good boys and girls who ever doubted him.
 

 

Tactically, today’s rally may be the last hurrah for the bulls. 

 

 

Sentiment warnings

I have been writing about the extended nature of sentiment readings for a while. The Goldman Sachs sentiment dashboard has been stable and elevated for at least a month.

 

 

It is said that while tops are processes, bottoms are events. Excessively bullish sentiment have a way of not mattering until it matters. Deprived of the its seasonal tailwinds, the stock market is increasingly vulnerable to a setback after a period of prolonged frothiness. Mark Hulbert reported last week that his Hulbert Stock Newsletter Sentiment Index is in its 92nd percentile, which is a severe cautionary signal.

Consider the average recommended equity exposure level among the short-term market timers the HFD tracks. (This average is what’s reported by the Hulbert Stock Newsletter Sentiment Index, or HSNSI.) Recently the HSNSI was higher than 92% of daily readings since 2000. In fact, this recent average exposure level is close to being just as high as it was at the bull-market top in February 2020.

The TD-Ameritrade Investor Movement Index (IMX) has returned to a new recovery high, indicating a high level of retail bullishness.
 

 

As well, S&P 500 Gamma exposure is in the top 0.4% of its history. For the uninitiated, gamma measures the degree of exposure option dealers have to the market. The combination of a positive gamma and rising market forces dealers to hedge by buying stock, and vice versa. These nosebleed gamma readings are warning signals of frothiness, which are usually followed by market corrections.
 

 

 

Bearish catalysts

Notwithstanding the scene of protesters storming the chambers of the US Senate, what else could derail this rally?
 

One candidate is a negative surprise from the Jobs Report due Friday. Market consensus calls for 100K new jobs, but the pace of deceleration is becoming alarming. Oxford Economics has a negative estimate, which would be a shocker.
 

 

Today’s ADP miss of -123K compared to expectations of a gain of 75K is consistent with the negative NFP print thesis.
 

 

High frequency data shows that economic activity has fallen off a cliff, not just in the US, but in most advanced economies.
 

 

The Citi Economic Surprise Index, which measures whether economic data is beating or missing expectations, has been slowly fading indicating a loss of macro momentum.
 

 

To be sure, these slowdown effects are temporary. But the pace of vaccinations could be an emerging negative for Q1 and Q2. The market has already discounted the widespread vaccination of the population of developed economies by mid-year. Logistical difficulties with vaccine rollout could be a source of near-term disappointment and spook risk appetite.
 

 

For the last word, I offer this tweet from SentimenTrader.
 

 

While I remain long-term bullish, short-term equity risk is rising. The market can stage a 5-10% correction at any time. Subscribers received an alert yesterday that my Inner Trader had stepped to the sidelines. This is a time for caution. 
 

 

An update on the FOMO seasonal stampede

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.
 

 

No stampede

Three weeks ago, I rhetorically asked if the market would surge higher during a seasonally favorable time of year (see Time for another year-end FOMO stampede?). I observed that “the Fear & Greed Index followed a pattern of an initial high, a retreat, followed by a higher high either coincident or ahead of the ultimate stock market peak.” (Warning, small sample size of n=4).

 

 

Since I wrote those words, the S&P 500 rose a respectable 2.5% while the Fear and Greed Index fell to 51. It’s not exactly a stampede. The main question is: “Will Fear and Greed exhibit a second peak before the actual market peak?”
 

 

The bull case

Here are the bull and bear cases. The bulls can point out that the S&P 500 staged an upside breakout to fresh all-time highs while trading in an ascending channel, which is constructive.

 

 

Ryan Detrick at LPL Financial found that strong late year momentum carries on into January and the following year. Since the S&P 500 is up 14.3% in November and December, investors can expect further gains (small sample size: n=5).

 

 

I am indebted to Urban Carmel for the idea for a generalized version of Detrick’s study of two-month price momentum. My analysis added a sentiment indicator, which shows that there were 12 episodes where two-month S&P 500 returns reached 10% or more. Only 2 of the 12 resolved in a corrective manner. Moreover, overly bullish sentiment, as measured by the AAII bull/bear spread, did not matter to returns. However, Urban Carmel added a caveat that the current episode is not like the others, which “all happened at major lows (like March of this year); 1987 started after SPX dead flat for 9 months”.

 

 

Analysis from Nomura indicates that hedge fund positioning in developed market equities is not excessive. Should the market engage in a momentum chase, there is more room for this fast money to buy.

 

 

 

Technical warnings

However, a number of ominous warnings are signaling a rising likelihood of a market correction. The NYSE McClellan Summation Index (NYSI) is starting to roll over. NYSI levels of over 1000 were signals of strong momentum, but pullbacks after 1000+ readings are a warning of market weakness. There have been 16 such signals in the last 20 years. 11 of them have resolved bearishly (red vertical lines), while 5 have been bullish (blue lines).

 

 

In addition, the quality factor is also flashing a warning by behaving badly. The relative performance of both large and small-cap quality factors have plunged, indicating a low-quality junk stock rally. Such conditions during past market advances have been indications of excessive speculation, and an imminent market top.

 

 

There is a minor negative divergence from my equity risk appetite indicators. The ratio of high beta to low volatility stocks is starting to fall, which is indicative of poor internals. As well, the equal-weighted consumer discretionary to consumer staple ratio, which minimizes the weights of Amazon and Tesla, is also exhibiting signs of minor weakness.

 

 

In addition, Jeff Hirsch of Trader’s Almanac wrote that the traditional Santa Claus rally, which stretches from December 24 to the second day of January, sees an average S&P 500 gain of 1.3%. The return so far to December 31 have already exceeded expectations at 1.8%. 

 

Sentiment readings continue to be very frothy. In addition to the stretched condition of numerous sentiment surveys, the divergence between the equity-only put/call ratio, which mainly measures retail sentiment and shows excessive bullishness, and the index put/call ratio, which is used for institutional hedging and shows rising cautiousness, is worrisome.

 

 

The current technical and sentiment backdrop is consistent with the seasonal post-election year pattern of a January peak and a bottom in late February. Before the bearish contingent gets all excited, the average pullback is only about  -2%.

 

 

In conclusion, the stock market has behaved as expected during the period of seasonal strength. However, a number of technical warnings are starting to appear. As the market’s period of positive seasonality ends in the coming week, be prepared for the possibility of a short-term top. On the other hand, historical price momentum studies are pointing to further gains.

 

Keep an eye on the Fear and Greed Index for a second peak as a tactical warning of a correction. However, there is a distinct possibility that a second peak in the Fear and Greed Index may not appear this time before the market corrects. In this situation, traders are advised to keep an open mind, and maintain trailing stops as a form of risk control.

 

 

Disclosure: Long SPXL

 

 

The Roaring 20’s scenario, and what could go wrong

Posted by Cam Hui -
Happy New Year! Investors were happy to see the tumultuous 2020 come to a close. The past year has been one with little precedent. A pandemic brought the global economy to a screeching halt. The stock market crashed, and it was followed by an unprecedented level of fiscal and monetary response from authorities around the world. As the year came to an end, a consensus is emerging that a cyclical recovery has begun and we are seeing the dawn of a new equity bull. Some have even compared it to the Roaring 20’s, when the world emerged from the devastation of the Spanish Flu and World War I.

 

New bull markets often start with powerful breadth thrusts. As LPL Financial documents, the second year of a new bull can also bring solid returns, albeit not as strong as the first year.

 

 

As I look ahead to 2021, I consider three key issues.
  • The economy and its outlook;
  • Market positioning and consensus; and
  • What could go wrong?

 

 

A recovering economy

Let’s start with the economy. The policy response to the crisis was unprecedented during the post-war period. Even as the unemployment rate spiked to levels not seen since the Great Depression, the combination of fiscal and monetary response put a floor on household finances. Real personal income, which includes fiscal transfers from the government. spiked even as the economy shut down. While the policy response has exacerbated an inequality problem, that’s a future issue that doesn’t concern today’s markets.

 

 

Looking to 2021, there are numerous signs that the US and global economy are recovering. Cyclically sensitive indicators such as the copper/gold and base metals/gold ratios have risen strongly.

 

 

Heavy truck sales, another key cyclical indicator, has traced a V-shaped bottom.

 

 

New Deal democrat follows the economy using a framework of coincident, short-leading, and long-leading indicators. For several months, he concluded that both the short and long-leading indicators are pointing to an economy itching to recover (my words, not his), but short-term health and fiscal policy have weighed down the coincident indicators. The latest analysis is more of the same [emphasis added].
Among the short leading indicators, gas and oil prices, business formations, stock prices, the regional Fed new orders indexes, the US$ both broadly and against major currencies, industrial commodities, and the spread between corporate and Treasury bonds are positives. New jobless claims, gas usage, total commodities, and staffing are neutral. There are no negatives.

 

Among the long leading indicators, corporate bonds, Treasuries, mortgage rates, two out of three measures of the yield curve, real M1 and real M2, purchase mortgage applications and refinancing, corporate profits, and the Adjusted Chicago Financial Conditions Index are all positives. The 2-year Treasury minus Fed funds yield spread and real estate loans are neutral. The Chicago Financial Leverage subindex is the sole negative.

 

While there were no significant changes this week, the good news is that – contrary to expectations – several of the coincident indicators made new YoY highs this week.

 

He concluded, “The pandemic and public policy reactions thereto remain in control of the data”. 

 

The $2.3 trillion spending bill signed by Trump last week, which includes $900 billion in renewed CARES Act 2.0 stimulus, should put a floor on Q1 growth even as the pandemic sweeps through the US and the economy shuts down. After Trump signed the bill into law, Goldman Sachs was the first major brokerage firm out of the gate with an upward revision to Q1 GDP growth to 5.0%.

 

 

Fed watcher Tim Duy wrote in a Bloomberg Opinion article that “Biden is Stepping Into a Dream Economic Scenario”.
The economy is instead poised for a rapid rebound for six main reasons:
First, there is nothing fundamentally “broken” in the economy that needs to heal. And unlike the last two cycles, there was no obvious financial bubble driving excessive activity in any one economic sector when the pandemic hit. There is no excessive investment that needs to be unwound and the financial sector has escaped largely unharmed.

 

Second, the indiscriminate nature of the shutdowns this past spring provides the economy with a solid base from which to grow. The economy collapsed in the spring because in the effort to get ahead of the virus, we shut down about a third of the economy on an annualized basis. That created a lot of opportunity to rebound when the unnecessary causalities of the shutdown came back online and began to grow around the virus. That process will continue.

 

Third, household balance sheets were not crushed like they were in the last recession. Instead, the opposite occurred. Reduced spending, fiscal stimulus, rising home prices and a buoyant equity market have all helped push household net wealth past its pre-pandemic peak.

 

Fourth, the demographics are incredibly supportive of growth. During the last recovery, the economy was still adapting to the Baby Boomers aging out of the workforce with a much smaller cohort of Generation X’ers behind them. The larger Millennial generation was just entering college at the time. Now, the Millennials are entering their prime homebuyer years in force and will be moving into their peak earning years. The resulting strength in housing is fueling higher home prices and durable goods spending, and we are just at the beginning of the trend. Housing activity should hold strong for the next four years.

 

Fifth, household savings have grown by more than a $1 trillion, providing the fuel for a hot economy on the other side of the pandemic. Sooner or later, that money is going to come out of savings and into the economy and I expect it to flow into the sectors like leisure and hospitality where there is considerable pent up demand.

 

Sixth, and most importantly, vaccine is coming. Pfizer Inc. announced its Covid-19 vaccine is 90% effective. Many other vaccines are in development using the same strategy as Pfizer. To be sure, it will take some time for vaccines to be widely available but once they are the sectors of the economy most encumbered by the virus (the same as those for which consumers have pent-up demand) will be lit on fire. Moreover, schools and day cares can reopen allowing parents to return to the workforce.

 

The Roaring 20’s indeed.

 

 

Market positioning and consensus

The global economic recovery is now the consensus opinion. The latest BoA Global Fund Manager Survey shows respondents expect a V-shaped recovery as vaccines become widely available by mid-2021.

 

 

As a consequence, they have piled into high beta emerging market equities for cyclical growth exposure.

 

 

 

What could go wrong?

In light of the emerging consensus of a cyclical economic recovery and new bull market, what could go wrong? I believe there are three key risks;
  • Problems with a vaccine rollout;
  • Rising inflation, which will force central banks to react and raise rates; and
  • An unexpected slowdown in China.
Deutsche Bank recently conducted an investor survey of the biggest risks to the global financial markets in 2021. At the top were fears related to the rollout of vaccines, such as virus mutations, serious vaccine side effects that curtail their use, and the reluctance of people to become vaccinated, which would impede herd immunity. 

 

 

Already, the failures of poor coordination are appearing. The FT FT reported about logistical bottlenecks are emerging in the EU, where the pace of immunization is too slow to keep up with the supply of vaccines. The NY Times lamented that a fumbled rollout has allowed vaccines to go bad in the freezer.

Of the 14 million vaccine doses that have been produced and delivered to hospitals and health departments across the country, just an estimated three million people have been vaccinated. The rest of the lifesaving doses, presumably, remain stored in deep freezers — where several million of them could well expire before they can be put to use.

 

 

From a macro perspective, the unprecedented level of monetary and fiscal stimulus has created the risk of financial instability owing to rising debt levels. Debt-to-GDP has risen to levels last seen during World War II for the developed economies and exceeded those levels for emerging economies. While nominal rates are low to negative and real rates are mostly negative today, rising inflation could put upward pressure on rates and create instability.

 

 

In the short-term, inflationary expectations are under control, and inflation surprises are occurring to the downside.

 

 

Moreover, developed economy inflation expectations are still tame. The problem of inflation, debt, and financial instability are problems in 2024 or 2025, not 2021.

 

 

 

China slowdown ahead?

I believe the key risk that could sideswipe markets is an unexpected slowdown in China. I recently observed that China is experiencing an uneven recovery (see Will Biden reset the Sino-American relationship?).
The rebound was led by fixed-asset investment and construction activity. Retail sales was the laggard. Beijing has returned to the same old formula of credit-fueled expansion. Moreover, Beijing has pivoted towards a state-owned led recovery.
A Bloomberg interview with Leland Miller of China Beige Book International (CBBI) confirmed the thesis of a hollow recovery in China. Miller warned investors to be wary of the bullish recovery signals from the commodity market. There is too much speculation in commodities. Chinese copper and steel firms reported Q3 collapsing sales, collapsing margins owing to higher input prices, e.g. iron ore, in the manner of early 2016.

 

 

In a normal recovery, China’s trade surplus should shrink as consumers spend more in response to improved conditions. Instead, the surplus rose, indicating an export and manufacturing-based recovery at the expense of the household sector. In addition, the Chinese authorities are tightening credit. Domestic credit rejection very high for retailers, indicating an unbalanced and hollow recovery.
Loan rejection rates for retail businesses increased to 38% in the final quarter of 2020 from 14% in the previous quarter, according to the latest quarterly report from CBBI. Rejection rates for small and medium-sized businesses rose to 24% in the final quarter, double the rate posted by large companies during the period.

 

“Large firms continue to gobble up whatever credit was available, enjoying much lower capital costs than their smaller counterparts, alongside higher loan applications and still falling rejections,” CBBI said. “This is the opposite of the quagmire small-and-medium enterprises find themselves in.”

 

 

Don’t be deceived by improvement in services in the PMI surveys. China Beige Book’s survey internals revealed an unbalanced recovery in services.
A recovery in services revenue was driven by businesses in telecommunications, shipping, and financial services, but those in consumer-facing industries, such as chain restaurants and travel, continued to lag behind, according to CBBI.

 

“Don’t confuse fourth quarter’s services recovery with the ‘Chinese consumer is back’ narrative,” said CBBI’s Managing Director Shehzad Qazi. “This is a business services — not consumer-side — recovery. Retail sector data bear this out even more clearly, with spending on non-durables sagging.”
China has led the global recovery, but these imbalances are an accident waiting to happen. I have no idea when this might unwind, but be prepared for a “China is slowing” narrative to sideswipe global risk appetite in the near future. This is a tail-risk that the market is not prepared for.

 

 

Investment implications

While a cyclical recovery and a new equity bull have become the new consensus, I remind readers that both the Dow Jones Industrials and Transports recently achieved new all-time highs, which constitutes a Dow Theory buy signal. This is a powerful indicator that the primary trend is up.

 

 

Should investors be worried about a case of too far, too fast? Variant Perception pointed out that notwithstanding investor sentiment, liquidity conditions are friendly to equity returns for the next six months.

 

 

That said, investors who want to position for a cyclical bull market should look beyond the S&P 500. The index has become very growth and tech-heavy. The weight of cyclical groups within the S&P 500 has dwindled to 24%.

 

 

US tech stocks are likely to face headwinds. Foreign institutions piled into US large-cap growth stocks during the pandemic as the last refuge in a growth-starved world. Now that the growth scare is over, investors are likely to rotate into cyclicals instead.

 

 

SentimenTrader also observed that tech stocks have gone too far, too fast. If history is any guide, don’t expect them to continue their winning streak. By implication, the S&P 500 is likely to face headwinds in advancing if tech and tech-like sectors comprise about half of the index’s weight.

 

 

There are better opportunities for growth investors. A comparison of EM internet and eCommerce stocks (EMQQ) to the NASDAQ 100 (QQQ) and the Asia 50 (AIA), which is very tech and heavy, shows that the NASDAQ 100 has outperformed its EM and Asian counterparts. Both the relative performance of EMQQ and AIA to QQQ are showing signs of relative bottoms, which are constructive for these non-US tech-related issues. This is despite Beijing’s recent scrutiny of Ant Financial, which has depressed the Chinese fintech sector.

 

 

In conclusion, the global economy is undergoing a cyclical rebound. Equity markets have surged in response. In the short-term, sentiment has become stretched, risks are appearing, and the S&P 500 could correct by 5-10% at any time. While the fast retail and hedge fund money has mostly gone all-in, the glacial institutional money remains underweight beta. State Street Confidence, which measures the custodial holdings of institutional managers, is still below the neutral 100 level.

 

 

Investors should look to pullbacks to buy dips, but better investment opportunities can be found in non-US markets.

 

 

My 2020 report card

Posted by Cam Hui -

Now that 2020 has come to an end, it’s time to deliver the Humble Student of the Markets report card. While some providers only highlight the good calls in their marketing material, readers will find both the good and bad news here. No investor has perfect foresight, and these report cards serve to dissect the positive and negative aspects of the previous year, so that we learn from our mistakes and don’t repeat them.
 

2020 was a wild year for equity investors. The S&P 500 experienced 109 days of high volatility days during the year, as measured by daily swings of 1% or more. Measured another way, the stock market had high volatility days 45% of the time in 2020, compared an average of 25% since 1990. This level of volatility was similar to a reading of 53% in 2009 and 41% in 2000.
 

Let’s begin with the good news. The Trend Asset Allocation Model’s model portfolio delivered a total return of 19.7% compared to 16.1% for a 60% SPY and 40% IEF benchmark (returns are calculated weekly, based on the Monday’s close). Total returns from inception of December 31, 2013 were equally impressive. The model portfolio returned 13.8% vs. 10.6% for the benchmark with equal or better risk characteristics.
 

 

 

An unprecedented policy response

Now for the bad news, and there was plenty of it. While the Trend Model was disciplined enough to spot the crash in March and recovery thereafter, it was very late to turn bullish. I attribute this to two critical errors in thinking.

 

The unemployment rate had spiked to levels not seen since the Great Depression. I found it difficult to believe that the economy would not tank into a deep recession. I did not understand the magnitude of the fiscal and monetary response that put a floor under the downturn. The chart below tells the story. Even as unemployment rose to unprecedented levels, personal income rose as well. This was an unusual pattern not seen in past downturns and can be explained by a flood of fiscal support to the household sector.

 

 

We can see a similar effect with the savings rate, which also spiked to absurdly high levels even as unemployment soared. As government money flooded into households, some of the funds were not needed immediately, and the savings rate rose as a consequence. To be sure, the fiscal support was uneven and exacerbated inequality problems, but that’s an issue for another day. The actions can be partially excused by characterizing the legislation as battlefield surgery, which is imperfect but designed to save as many as possible under crisis conditions.

 

 

As well, the Federal Reserve and global central banks acted quickly to flood the global financial system with liquidity and financial stress was contained.

 

 

 

A valuation error

My second error was my assessment of valuation, which was based mainly on the forward P/E ratio, which had risen to historically high levels. I could not initially fathom why that constituted good value for equities.

 

 

Other traditional metrics, such as the Rule of 20, which specifies that the stock market is overvalued if the sum of the forward P/E and inflation rate exceeded 20, were screaming for caution.

 

 

An excessive focus on forward P/E based valuation turned out to be a conceptual error. I addressed those concerns in early October in a post (see A valuation puzzle: Why are stocks so strong?). 
One of the investment puzzles of 2020 is the stock market’s behavior. In the face of the worst global economic downturn since the Great Depression, why haven’t stock prices fallen further? Investors saw a brief panic in February and March, and the S&P 500 has recovered and even made an all-time high in early September. As a consequence, valuations have become more elevated.

 

One common explanation is the unprecedented level of support from central banks around the world. Interest rates have fallen, and all major central banks have engaged in some form of quantitative easing. Let’s revisit the equity valuation question, and determine the future outlook for equity prices.
Soon after, I followed up with a cautious bullish call to Buy the cyclical and reflation trade?. The month of October was still gripped by election uncertainty. I turned unequivocally bullish in November with Everything you need to know about the Great Rotation, but were afraid to ask.

 

Better late than never.

 

 

My inner trader

The trading model had been performing well until 2020. The most charitable characterization was my inner trader caught the coronavirus. The drawdowns were nothing short of ugly. This was attributable to the conceptual error in thinking that I outlined, and a belief that the market would return to test the March bottom. 

 

When the prospect of one or more vaccines and an economic recovery came into view at the end of Q3, I recognized that markets look ahead 6-12 months, and the odds of a retest had become highly unlikely.

 

 

Looking ahead to 2021, tactical trading models used by my inner trader are likely to be less relevant. The point of market timing models is to avoid ugly downturns in stock prices. This is a new cyclical bull market. The costs of trying to avoid corrections, which is a risk that all equity investors assume, are less worthwhile if the primary trend is bullish.

 

Happy New Year, and I look forward to a better 2021.

 

Steady as she goes

Posted by Cam Hui -

Mid-week market update: Not much has changed since my last post, so I just have a brief update during a thin and holiday-shortened week. The S&P 500 remains in a shallow upward channel while flashing a series of “good overbought” conditions during a seasonally positive period for equities. The index staged an upside breakout at […]

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When does Santa’s party end?

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 seasonal party

In my last mid-week post, I outlined how the combination of an oversold reading and positive seasonality were combining to provide bullish tailwinds for stocks (see The most wonderful time of the year…). So far, the market is behaving according to the script. The VIX Index retreated after breaching its upper Bollinger Band (BB) last Monday, and the market staged an advance. In light of the narrowness of the BB, traders should watch for a breach of the lower BB, which would be a signal of an overbought market.

 

 

Retired technical analyst Walter Deemer observed that the ratio of NASDAQ volume to NYSE volume had spiked, and it would be a “warning sign in days of yore”. However, similar spikes in the last 13 years have signaled FOMO stampedes and investors chasing beta, rather than actionable sell signals. Arguably, these instances should be interpreted as short-term bullish and not contrarian bearish.

 

 

The technical signs indicate that all systems go for the seasonal rally.

 

 

Don’t overstay your welcome

Before you get overly excited, bullish traders face a number of key risks. The most immediate threat is President Trump’s threat to veto a $2.3 trillion pandemic aid and spending package approved by Congress, which contains a $892 billion coronavirus relief package and a $1.4 trillion for normal government spending. If the White House and Congress cannot come to an agreement by Monday, then parts of the federal government will have to shut down. The markets would not react well to such an eventuality.

 

That’s probably an unlikely scenario. Reuters reported that funding for the vaccine rollout depends on the government continuing to operate. Trump would not want his legacy to be marred by a botched vaccine distribution effort, particularly ahead of the upcoming Senate election in Georgia.
The federal government has already purchased 400 million COVID-19 vaccine doses, or enough for 200 million people, from Moderna and Pfizer but needs additional funds to purchase more doses. It also signed contracts with other companies for vaccines that have yet to be authorized. Private companies, including McKesson, UPS and FedEx, are distributing the doses but have been relying on staff in the Department of Defense and the Department of Health and Human Services for support.

 

States have received $340 million from the U.S. government to help offset costs they’ve borne from the vaccine rollout but say they face a shortfall of around $8 billion. A shutdown would halt plans by Congress to distribute funding to make up for that shortfall.

As well, high-frequency indicators are showing signs of weakness. The Goldman Sachs Current Activity Indicator turned negative in December. The combination of incipient weakness and any hiccup in the delivery of fiscal support could be enough to shift investor psychology.
 

 

In addition, market internals are flashing warning signs that the Santa Claus rally may be on borrowed time. One of the bearish tripwires I had been monitoring is the performance of the NYSE McClellan Summation Index (NYSI). In the past, NYSI readings of over 1000 were signals of “good overbought” advances, but rallies tended to falter when NYSI began to roll over. NYSI showed definitive signs of weakness last week, which is a warning for the market.
 

 

 

How far can the rally run?

How far can the seasonal strength last, and what’s the upside potential? I offer three estimates, starting from the lowest to the highest.

 

Jeff Hirsch at Trader’s Almanac defined the Santa Claus rally as the period from Christmas Eve to the second day of the new year. On average, the S&P 500 has gained 1.3% since 1969, which translates to an S&P 500 target of about 3750.

 

Ironically, I had also been watching the behavior of the quality factor. This indicator recently flashed a warning for the bulls, and the past behavior of the market after such signals also yielded some clues on the length and upside potential of the current rally.

 

In the past, market melt-ups led by high-quality stocks tended to persist. But when the low quality “junk” starts to fly, it’s a sign of excessive speculation and froth. I measure quality using the QUAL ETF for large-caps, and the ratio of S&P 600 to Russell 2000 for small caps. S&P has a relatively stringent profitability inclusion criteria for its indices, which Russell doesn’t have. (That also explains why it took Tesla so long to enter the S&P 500 despite its sizable market cap – it just wasn’t profitable.) In the past two episodes of a blow-off top, the time lag between the second warning where both large and small-cap quality underperformed to the ultimate top was about two weeks. Based on those projections (warning, n=2), the timing of a tactical top would occur during the first or second week of January with an average gain of 2.5% to 3%, which means an S&P 500 level of about 3800.

 

 

Lastly, Marketwatch reported that Tom DeMark was targeting 3907 during the first week of January.

 

 

More room to rally

The bulls shouldn’t panic just yet. The seasonal Santa Claus rally is following the script of a rally into early January, followed by a correction.
 

 

Short-term breadth and momentum readings are not overbought, and the market has more room to rally.
 

The percentage of S&P 500 at 5-day lows are more oversold than overbought, which is indicative of more upside potential.
 

 

However, the challenge for the bulls is to overcome the trend of lower highs in breadth and momentum.
 

 

My inner investor remains bullishly positioned. Even though the market may experience a pullback in January, the intermediate-term trend is bullish (see Debunking the Buffett Indicator) and he isn’t overly concerned about minor blips in the market. The near-simultaneous upside breakouts by the Dow and the Transports flashed a Dow Theory buy signal. The primary trend is up, though short-term corrections are not out of the question.
 

 

My inner trader is also long the market. If it all goes according to plan, he will be taking profits in early January and contemplate reversing to the short side at that time. All of the technical projections cite the first or second week of January as the likely peak of the current period of market strength. Upside S&P 500 potential vary from a low of 3750 to a high of 3907. What follows would be a 5-10% correction.
 

 

Disclosure: Long SPXL
 

Debunking the Buffett Indicator

Posted by Cam Hui -

There has been some recent hand wringing over Warren Buffett’s so-called favorite indicator, the market cap to GDP ratio. This ratio has rocketed to new all-time highs, indicating nosebleed valuation conditions for the stock market.
 

 

Worries about this ratio are overblown. Here’s why.

 

 

Dissecting market cap to GDP

Let’s begin by dissecting the market cap to GDP ratio, which is really an aggregated price to sales ratio for all listed companies. While the price to sales ratio is a useful metric for valuation, a more commonly used ratio is the price to earnings (P/E) ratio. The P/E ratio is really price/(sales x net margin). 

 

To understand the market cap to GDP and P/E ratios, we need to decompose net earnings and how it have evolved over time:

 

Net earnings = (Gross earnings [or EBIT earnings] – interest expense) x (1 – tax rate)

 

Over the years, both interest rates and the corporate tax rate have fallen substantially. In addition, Ed Clissold of Ned Davis Research documented how gross margins have risen since the early 80’s.

 

 

The validity of the Buffett Indicator’s valuation warning therefore depends on a mean reversion in net margins. Ben Carlson documented how Charlie Munger, Buffett’s long-term partner, addressed this issue.

 

 

As the economy recovers from the latest recessionary downturn, net margins are expected to rise substantially, which will provide a boost to the E in the P/E ratio.

 

 

Do you feel better now?

 

 

Not out of the woods?

While an explanation of the relationship between the market cap to GDP ratio, net margins, and the P/E ratio provide some comfort about valuation, a nagging problem remains. P/Es are substantially elevated relative to history. The S&P 500 forward P/E ratio of 22.1 is well ahead its 5-year average of 17.4 and 10-year average of 15.7.

 

 

Shiller CAPE (Cyclically Adjusted P/E) readings are above levels seen just before the Crash of 1929.

 

 

A CAPE of 33 implies roughly 0% real returns over the next decade.

 

 

Robert Shiller recently addressed this issue in a Project Syndicate essay. Stock prices are cheap in most regions after adjusting for interest rates.
 

The level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the ten-year real interest rate.

 

This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive. The ECY in the US, for example, is 4%, derived from a CAPE yield of 3% and then subtracting a ten-year real interest rate of -1.0% (adjusted using the preceding ten years’ average inflation rate of 2%).

 

We looked back in time for our five world regions – up to 40 years, where the data would allow – and found some striking results. The ECY is close to its highs across all regions and is at all-time highs for both the UK and Japan. The ECY for the UK is almost 10%, and around 6% for Europe and Japan. Our data for China do not go back as far, though China’s ECY is somewhat elevated, at about 5%. This indicates that, worldwide, equities are highly attractive relative to bonds right now.
At the press conference after the December FOMC meeting, Fed Chair Jerome Powell embraced the equity risk premium, or the Fed Model, as a way of valuing the stock market. For what it’s worth, the Fed Model has liked the market since 2002. 

 

 

Similarly, the Buffett Indicator (inverted) does not appear expensive when investors factor in the level of interest rates, notwithstanding the improvement in net margins.

 

 

In summary, concerns about valuation are overblown. Stock prices are not overvalued in light of the low rate environment. 

 

While low rates can be a risk factor over the long-term, they are not a problem over the next few years. The Fed signaled a form of passive easing after the latest FOMC meeting. It raised its growth projections for each of the next two years, marked down unemployment, and raised core inflation estimates. Despite all that, it is holding rates steady. That’s a medium-term friendly environment for equities. 

 

 

Don’t be afraid to buy.