An uneasy feeling

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Good news, bad news

I have some good news, and some bad news for equity bulls. The month is complete and the month-end data is in. The good news is the broadly based Wilshire 5000 strengthened sufficiently to flash a monthly MACD buy signal. In the past, similar buy signals have been followed by multi-month bull phases.
 

 

The bad news is the buy signal coincided with a negative RSI divergence just as the index made a closing high. This represents a warning for investors to exit a bull trend after a monthly MACD buy signal. The last sell signal occurred in August 2018, and the market topped out two months later (see Market top ahead? My inner investor turns cautious).

A sell signal just as the system flashes a buy signal? Should investors view this as bullish or bearish?
 

Bearish warnings

My inclination is to be cautious about the equity outlook. Risk appetite is deteriorating on global scale, and the deterioration is multi-asset in scope.

Let’s consider what’s happening in the US market. The bond market staged a rally late last week, and bond yields conversely fell. The long bond ETF (TLT) staged an upside breakout of of an inverse head and shoulders pattern. As good technicians know, a head and shoulders formation is not confirmed until the price breaks the neckline. The approximate measured target for TLT is 188. The 10-year Treasury yield similarly broke down in a head and shoulders formation, with an approximate measured target of 0.23%. Bond market price rallies are usually signals of risk-off episodes, which is bearish for equity prices.
 

 

Other credit market indicators have been flashing negative divergences for a while, though the signals are more ambiguous. The relative price performance of high yield bonds and leverage loans relative to their duration-equity Treasuries have lagged stock prices, but they did not flash actionable sell signals the way the Treasury market did last week.
 

 

Equity risk appetite indicators are telling a similar story as the high yield market. The consumer discretionary to staples ratio is a commonly used risk appetite indicator. I use the relative performance of equal-weighted consumer discretionary stocks to equal-weighted consumer staple stocks as a way of filtering out the outsized weight of AMZN. The equal-weighted ratio has exhibited a negative divergence against the market for several weeks, but there has been no obvious bearish trigger.
 

 

USD weakness has been a tailwind for stock prices. The USD Index has been steadily weakening for the entire month of July, which is supportive of EM assets as they are the most vulnerable to offshore dollar funding pressures. However, EM currencies fell last week even as the greenback weakened. This may be just a blip, but it’s something to keep an eye on.
 

 

The USD is poised to stage a rally, which would be negative for risky assets. Market positioning in the USD has reached a crowded short, but the challenge for dollar bears is finding a catalyst for further weakness. The rate differential against the Bund, for example, is being squeezed to levels last seen in 2014. In effect, relative economic weakness and aggressive Fed easing is already in the price. What drives the dollar lower?
 

 

Global weakness

Bearish breaks can be seen in other global equity markets. Eurozone equities fell last week after the euphoria over the €750bn Recovery Fund wore itself out. To be sure, periphery yield spreads have tightened considerably, but equity bulls were unable to follow through after the initial rally. Most equity indices have breached their 50 day moving averages, which is not a good sign considering the historic and unprecedented good news for the European Project.
 

 

Turning our sights to Asia, the Chinese stock market rally has fizzled out and retreated below the recent upside breakout level. It appears that the Chinese authorities are do not want the stock market to repeat the experience of 2014-15 when prices soared and subsequently crashed. Looking across the equity markets of China’s major Asian trading partners, Hong Kong was never able to stage an upside breakout as it did in 2014-15. Taiwan and South Korea are strong, but their strength is more attributable to the weight of semiconductor stocks, which have been market leaders. Singapore and Australia are weak, and they did not confirm the Chinese stock market’s strength.
 

 

Narrowing NASDAQ leadership

The only thing that’s holding the US stock market up is a handful of FANG+ stocks. It is a testament of their fundamental strength that four of these stocks reported earnings last Thursday (AAPL, AMZN, GOOG, FB), and all of them beat Street expectations.

The NASDAQ 100 remains in a well-defined uptrend and it is approaching a key resistance level. While resistance has not been tested yet, a test next week could see the 5-day RSI exhibit a negative divergence.
 

 

It’s possible that NASDAQ leadership could continue for a bit longer. The Banks to NASDAQ 100 ratio, which is one way of measuring the value/growth relationship, is plunging. The long-term pattern shows a positive divergence in favor of bank stocks, but if history is any guide, the ratio may need to see a final capitulation low before it can turn up.
 

 

A similar pattern can be seen in the ratio of small caps to NASDAQ stocks, which is another extreme indicator of the current market leadership. This ratio is also exhibiting a positive RSI divergence, but may also need a waterfall decline and wash-out before it can turn up.
 

 

I resolve the combination of global and cross-asset weakness and NASDAQ strength with the following base case scenario. The path of least resistance for stock prices for the next few weeks is down. As stock prices fall, investors will respond by taking refuge in the FANG+ names as the last bastion of growth. In all likelihood, this means a 5-15% correction over the 1-2 months.
 

Growth at any price

Unless the megacap FANG+ stocks falter, downside risk is limited to a minor correction, and not a major market decline. However, the growth/value stock relationship is highly stretched, and market sentiment is becoming reminiscent of the Nifty Fifty growth-at-any-price stock investing theme of the early 1970’s. The narrative of the Nifty Fifty era was to buy solid large cap growth stocks, and the returns will take care of themselves. Price didn’t matter. Does anyone remember Avon Products, Digital Equipment, Eastman Kodak (!), ITT, Revlon, Schering Plough, and others from those bygone days?

Fast forward to 2020, Bloomberg reported that Blackrock has assembled a quantitative investing group that doesn’t even consider price as a factor when stock picking. Instead, the focus is mainly on alternative data as a source of alpha.

The good news is money managers can now turn to a whole new world of alternative data, says [Jeff] Shen, a finance PhD who joined BlackRock through its 2009 acquisition of Barclays Global Investors.

“Once you get that data, you should look for alpha opportunity associated with that rather than put that data over a price number,” he said. “Once you put the price number in, it potentially destroys the effectiveness of that new data source.”

Shen’s systematic group hasn’t conducted research on the U.S. value factor for years now. In their view, price is fickle. It naturally dominates all valuation formulas. And that means such ratios become the product of historical returns rather than predictors of future moves.

To build portfolios, the group taps into social media to gauge employee sentiment, parses online job postings to see which firms are hiring and uses machine-learning algorithms to figure out how the myriad variables in their models interact with one another.

That approach can be useful as long as the price momentum factor is strong. The chart below shows different versions of the price momentum factor, and investors in this style are enjoying positive returns. If momentum were to roll over, the returns to growth-at-any-price investing could be catastrophic and career ending.
 

 

However, momentum has a highly undiversified bet on big technology stocks. The concentrate of this group dwarfs past instances of sector concentration, including the dot-com era.
 

 

This is a long-term study, and it is silent on when these kinds of stretched relationships reverse themselves. A reasonable guess on time horizon might be 1-3 months. The aforementioned study of the Bank/NASDAQ ratio and the Small cap/NASDAQ ratio suggests that NASDAQ stocks have another upleg which historically lasts another 1-3 months. As well the early warning provided by the negative monthly RSI divergence of the Wilshire 5000 after the MACD buy signal have also signaled tops after 1-3 months.

This scenario is also coincides with the historical pattern of a 3 month period of rising volatility in an election year.
 

 

The week ahead

Looking short-term, equity sentiment is extended, but excessively bullish readings are not necessarily actionable sell signals.
 

 

That said, the rally in Treasury prices is a bearish trading signal. Subscribers received an email alert last Thursday that the trading model had turned bearish. Moreover, the daylight to overnight market relative price uptrend that I identified in the past has now been breached (see My inner trader returns to the drawing board). Past breaches have been signals that the market has become less headline sensitive and more focused on longer term trends. Anecdotally, I have noticed that the market hardly responds to positive news on the vaccine and therapeutics anymore. As well, these trend breaks have signaled changes in market direction, which is likely to resolve from a rising market to a sideways or falling market.
 

 

The market action next week will be a key test for both bulls and bears. Short-term breadth is neutral, but tracing a converging wedge that could go either way. A breach of either trend line will be an important signal to near-term market direction.
 

 

My inner investor is neutrally positioned. My inner trader initiated a short position last week. The S&P 500 is testing the top of a narrow range while exhibiting a negative 5-day RSI divergence. He will set a stop just above resistance at the top of the range, and he will add to his short should the index break support – all on a closing price basis.
 

 

Disclosure: Long SPXU

 

Fiscal cliff = Double-dip

Posted by Cam Hui -

The coronavirus has imposed both a supply shock and a demand shock to the global economy. The supply shock was in the form of disruption to supply chains as factories were shuttered. The supply shock has largely been corrected.

The demand shock was in the form of a loss of demand as lockdown and stay-at-home orders cratered demand. Governments around the world acted to cushion some of the demand shock by way of fiscal support. In the US, a significant part of the fiscal cushion is expiring, which is the risk of a double-dip slowdown.

One puzzle of the stock market rally since the March lows is how stocks can strengthen in the face of the worst economic slowdown since the Great Depression. Sure, central bankers took steps to mitigate the worst of the damage. While they can print money, they cannot print sales or customers for businesses, nor can they print equity.

While some of the risk-on tone could be attributable to central bank action, the real reason for the market’s strength is fiscal policy. While the stock market isn’t the economy, and the economy isn’t the stock market, the two are nevertheless connected. I pointed out last week (see Analyzing the bull case) that US fiscal support had strengthened household incomes to pre-pandemic levels. Retail sales were therefore recovering strongly as a consequence.
 

 

All that is about to end as the $600 per week supplemental unemployment insurance payments expire at the end of July. Congress has failed to act to extend the benefits, and the economy is going over a cliff. Brace for the double-dip recession.
 

Differences in policy time horizon

The differences in monetary and fiscal policy response to the pandemic represent a stark contrast in time horizons. The Federal Reserve believes the effects of the COVID Crash are medium to long term in nature. The most recent July FOMC statement shows the Fed’s believes the pandemic will be a key driver of the medium term growth outlook.

The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term.

The economic recovery will be long and drawn out. Interest rates are going to be on hold for a very long time.
 

 

When asked about the triggers to raising rates during the press conference, Jerome Powell replied that they were not even thinking about raising rates. He also pleaded with Congress to enact another stimulus bill to keep the economy from going off a cliff as the Fed cannot do the heavy lifting all by itself [emphasis added].

It will take a while to get back to the levels of economic activity and employment that prevailed at the beginning of this year, and it will take continued support from both monetary and fiscal policy to achieve that.

By contrast, the fiscal response has been short-term in nature. Congress viewed the pandemic as a short-term shock to the economy. A short-term shock meant a short-term response. It was therefore no surprise that the extended $600 per week unemployment insurance benefits in the CARES Act expired at the end of July.

The short-term view was wrong. After raging through Washington State, northern California, New York, and New Jersey, the pandemic went on a rampage through the Sun Belt states. Setting aside the uneven stay-at-home responses of state governors, the populace did not feel safe enough to return to normalcy in the face of infection risks. So much for the reopening and the V-shaped recovery.
 

Assessing the damage

The main damage of the fiscal response can be seen in the expiry of the $600 per week supplemental unemployment insurance that expired July 31. The deadline was no surprise. House Democrats had passed a $3 trillion relief bill in May. No one expected that the Republican controlled Senate would pass the bill in its entirety. The bill represented the Democrats’ opening gambit in bargaining and it was a signal of its priorities, which were especially important in an election year. The Republican controlled White House and Senate did not take up the relief issue until mid to late July. When it did, it was unclear whether the resulting $1 trillion bill could muster sufficient Republican support in the Senate to pass.

While all sides are continuing to negotiate, there will be a discontinuous break in disaster relief, which could be catastrophic for some of the population. If we were to continue the cliff and precipice metaphor, it’s easier to limit the damage by preventing people from going off the cliff, than to try and rescue them after they’ve fallen.

For some perspective of the economic cliff, over 30 million Americans will see a sudden income cut of 50% to 75% if the $600 weekly benefits disappear. The Republican bill proposed a temporary supplement of $200 per week, to be replaced by two-thirds of the worker’s previous wages, which would be implemented later so that state governments could re-program their computer systems. George Pearkes of Bespoke Investment Group estimated that the Republican proposal represents a -3.2% reduction in GDP.

The economic damage is not just limited to household incomes. Depending on the jurisdiction, hastily enacted eviction moratoriums are either expiring, or have expired. The Intelligencer reported:

At midnight on Friday [July 31], a federal moratorium on evictions will end. Similar bans by state and local governments have already passed or will soon expire. With tens of millions of Americans seeking jobless benefits, and the federal unemployment-insurance bonus set to expire, many American renters will soon be at risk of losing their homes…

[The CARE Act] protected people from eviction if they live in homes or apartments with a federally backed mortgage. According to one estimate, that amounted to roughly 12.3 million units, home to just over a quarter of the country’s renters. There were problems with the law, though. Apart from leaving three-quarters of the country’s renters exposed to evictions, there was also no enforcement mechanism or penalty for landlords who attempt illegal evictions.

Even if Congress were to agree to a rescue package later in August, the discontinuous loss of unemployment benefits has the potential to become a homelessness crisis with dire consequences. Over 40% of renters are at risk of eviction.
 

 

The lack of a rescue package has other repercussions. One glaring problem is the hole that the pandemic has blown in state and local budgets.
 

 

Without federal aid, state and local governments will have no choice but to cut employment. Despite the improvement in Nonfarm Payroll (NFP) for the past few months, government employment has not recovered. Expect it to drop in the coming weeks and months.
 

 

If you thought that employment rebound was a bright spot in the recovery, be prepared for a negative surprise. Former Treasury official Ernie Tedeschi observed that high frequency Census data shows a softening in the jobs market. The market consensus for the July NFP to be released this coming Friday is a gain of about 2.3 million jobs. Tedeschi estimated that, after adjusting for definition differences, timing, and seasonality effects, July NFP is likely to come in at a loss of -2.2 to -4.7 million jobs. Prepare for a jobs report shocker.
 

 

Economic data reports are turning sour. Initial jobless claims rose last week for a second consecutive week, indicating a stall in the recovery. The preliminary Q2 GDP fell -9.5% quarter/quarter, or at an annualized rate of -32.9%, which was ahead of expectations but still deeply negative.

The stock market had been rallying on positive economic surprises. The Citigroup Economic Surprise Index, which measures whether top-down data is beating or missing expectations, appears to be peaking out and turning down. To be sure, there is some good news on the horizon, as it appears that the new infection counts are topping out in the Sun Belt. Fatality rates will stop rising and begin to decline in about a week.

Nevertheless, the economic damage is becoming apparent. How will the market behave in the face of the economic cliff and disappointing macro releases?
 

 

Other risks

In addition to the economic risks that have been mentioned, there are also other risks that the markets could interpret to be unfriendly.

First, assuming that Congress does cobble a rescue deal together at some point in the future, the economy will need fiscal support after the November election. If the support period of the new package does not last until late January, it may be virtually impossible to pass any legislation between Election Day and Inauguration Day. This raises the risk of another fiscal cliff and sudden stop in economic growth.

In addition, the effects of this economic cliff could affect the election. CNBC reported that 62% of swing state voters support the extension of the $600 per week unemployment insurance. Since this is contrary to the Republican position, it could degrade the Republicans’ electoral odds. As well, the Washington Post reported that Wall Street is showering the Democrats with campaign contributions. Such a level of defection is unusual considering how the Democratic agenda is unfriendly to financiers. A Biden and Democrat victory is likely to translate into higher corporate taxes and a reduced earnings outlook for 2021 and beyond.
 

 

There is an electoral silver lining for Trump and the Republicans. Despite the steady drumbeat of polls showing Biden leading Trump, the odds of a Biden victory have been trading sideways at PredictIt for about a month. Biden is not gaining ground in the betting markets, and Trump is not losing ground.
 

 

The risk of electoral chaos is also rising. Remember the Florida hanging chad controversy? The US could see a similar episode, but at a higher order of magnitude. President Trump has already questioned the possible legitimacy of the election and raised the possibility of a delay, which is legally questionable and rejected by his Republican allies.
 

 

Trump can’t legally delay the election, but he can take steps to question the legitimacy of the results. Business Insider reported that cybersecurity experts believe it could take weeks to determine the winner after November 3.

  • Election cybersecurity experts said Tuesday that “the electorate may not be prepared for how long it’s going to take” for winners to be declared after the general election on November 3rd.
  • A panel that included two cybersecurity experts who served in the White House agreed that simply counting ballots may take a week or two.
  • Any litigation that follows that counting could postpone results for much longer in a scene reminiscent of the 2000 election, when results were delayed until January.
  • The experts also said voters’ loss of trust in the system may be the biggest risk in the upcoming election.
  • Despite fears of foreign interference, hacked voting machines, and disinformation campaigns, there is some optimism that the country is better prepared than in 2016.

Max Boot wrote in the Washington Post that he participated in a “war game” that postulated different electoral scenarios. Most of the time, it resulted in chaos and “near civil war in the streets”.

The danger of an undemocratic outcome only grows in other scenarios that were “war gamed” by other participants. For instance, what if there is no clear-cut winner on election night, with Biden narrowly ahead in the electoral college but with Michigan, North Carolina and Florida still too close to call? The participants in that war game concluded the result would be “near civil war in the streets.” Far-fetched rumors are enough to bring out armed right-wing militias today; imagine how they would respond if they imagined that there was an actual plot afoot to steal the election from their hero.

Such an outcome would create uncertainty, both politically and in the financial markets. Risk premiums would rise substantially under such a scenario and markets would tank.
 

A second demand shock

In conclusion, the pandemic has imposed both a supply and a demand shock to the global economy. The supply shock was in the form of disruption to supply chains as factories were shuttered – this has largely been corrected.

The demand shock was in the form of a loss of demand as lockdown and stay-at-home orders cratered demand. Governments around the world acted to cushion some of the demand shock by way of fiscal support. In the US, a significant part of the fiscal cushion is expiring, which is sparking dire consequences in the following forms:

  • Over 30 million Americans will see an immediate 50% to 75% loss of income. A moderate scenario, based on the Republican proposal of a reduction of the $600 per week unemployment insurance to $200 per week, would result in a -3.2% fall in GDP. Even if Congress were to come to an agreement on a rescue package at a later date, the fiscal cliff damage will be difficult to undo.
  • The expiry of eviction moratoriums has the potential to spark a homelessness crisis.
  • Without federal aid, state and local governments are poised to start mass layoffs.

Even without the fiscal cliff, what reopening recovery was already flattening out, and the July Employment Report has the potential to see a large negative surprise. In addition, the economy is likely to need further support between Election Day and Inauguration Day, which will be virtually impossible to achieve.

Say goodbye to the V-shaped recovery. Wall Street has penciled in a steep earnings recovery for the rest of 2020. Get ready for downward estimate revisions as the prospect of a double dip recession gets factored into analysts’ models.
 

 

What gold tells us about Fed policy expectations

Posted by Cam Hui -

Mid-week market update: It can be difficult to discern the market’s short-term outlook on an FOMC meeting day, but the Fed has spoken, and the market reaction has important signals for equity investors from an inter-market, or cross-asset, analytical basis.

The first important signal comes from gold prices. Gold staged an upside breakout to a fresh high from a multi-year base that stretches back to 2011. Point and figure charting shows upside targets in a range of 2440 to 2670, depending how the box size and reversal parameters are set.
 

 

The Fed’s dovish tone is a statement of policy that it intends to keep rates low until employment returns to pre-pandemic levels. As well, it has not ruled out yield curve control to suppress rates in longer Treasury maturities. Real yields are falling as a consequence, and real yields (blue line) have been inversely correlated with gold prices (red line, inverted scale).
 

 

Separating the real yield into the 10-year nominal Treasury yield and the 10-year breakeven yield reveals a divergence in market expectations. On one hand, the stubbornly low level of the 10-year yield indicates that the Fed is expected to be on hold for a long time. On the other hand, a rising breakeven indicates expectations of successful reflationary policies over the next few years. The risk is the economy fails to reflate, or reflationary expectations fizzle in the future. Both outcomes would deflate gold prices.
 

 

To be sure, gold sentiment is at an off-the-charts bullish extreme, which is contrarian bearish. SentimenTrader pointed out that the current rally represents a seven week winning streak for the shiny metal. “Outside of the late 1970’s run-up, every single signal showed a loss over the next month. Only one of them showed a gain even three months later.”
 

 

The same goes for silver prices. One of the bearish tripwires that I mentioned on the weekend is weakness in silver prices, which serves as a risk-off signal for equities (see Warnings. warnings everywhere, but bears should not drink…). That sell signal has not been triggered yet.
 

 

Brace for volatility

As well, there are warnings of a possible spike in volatility. Macro Charts observed that rate volatility (MOVE Index) has reached an all-time low. Low volatility episodes have been followed by volatility spikes in all asset classes.
 

 

Long bond prices (TLT) are tracing out a possible inverse head and shoulders pattern, though it has not broken up through the neckline. The 10-year Treasury yield has been testing a key support level. In light of the environment of suppressed volatility, a bond price rally could be a signal for an explosive risk-off episode.
 

 

The explosion in gold and silver prices, and the weakness in the USD, are all becoming one big macro trade. Cross-asset correlation is rising, indicating herding behavior. We have a crowded long in gold and silver, and a crowded short in the USD. With sentiment so stretched, this is setting up for a possible explosive reversal.
 

 

Stalling confidence

I wrote back in May that the falling stock/gold ratio is a sign of long-term headwinds for equity prices (see What gold tells us about confidence) and I stand by those remarks.
 

 

In the short run, however, gold prices are highly extended. A likely outcome of this upside breakout is a pullback into a cup and handle pattern, which is still long-term bullish.
 

 

Tactically, we don’t have the bearish triggers yet. Near-term event risk is high, as roughly 40% of the weight of the NASDAQ 100 report tomorrow. My inner trader is staying on the sidelines but monitoring the situation carefully. He is prepared to jump in on the short side should we see a bearish trigger. My inner investor remains neutrally positioned at roughly his investment policy targets for each asset class.

 

Earnings Monitor: A qualified upbeat tone

Posted by Cam Hui -

Q2 earnings season is now in full swing. So far 26% of the market has reported. FactSet reported the EPS beat rate rose to 81% from 73%, last week which was well above the 5-year average. The sales beat rate was fell to 71% from 78% last week, but it remains ahead of the 5-year average of 60%.

The bottom-up consensus forward 12-month estimate rose 1.05% last week The market is trading at a forward P/E of 22.2, which is well ahead of historical norms.
 

 

A qualified upbeat tone

So far, earnings reports have taken on an upbeat tone. Both the EPS and sales beat rates are well ahead of their historical averages. As a consequence, analysts have upgraded quarterly earnings estimates across the board, except for Q2 2020 earnings.
 

 

Earnings visibility is improving. More companies are now providing earnings guidance in Q2 compared to Q1. The sectors in which there are more companies with guidance exceed those without are healthcare and technology.
 

 

The percentage of companies issuing negative guidance is 22%, which is well above the 5-year average of 69%. That said, 53% of companies are still not issuing or have withdrawn guidance. They cite the uncertainty surrounding the pandemic as the reason for their cloudy outlook.

Is this an upbeat earnings season, or a case of “if you can’t say anything positive, don’t say anything at all”?
 

From the ground up

Courtesy of The Transcript, which monitors the earnings calls, the tone of the earnings calls had turned negative last week.

The economy was rebounding in May and June, but the recovery seems to have stalled out as infections have rebounded. CEO commentary was particularly negative last week. Business leaders are rapidly losing confidence and do not see a V-shaped recovery materializing. There’s a sense that government stimulus appears to be the only thing propping up the economy and it’s creating distortions in unemployment and financial markets. Still (perhaps because of this stimulus) the hot housing market suggests that consumers may not actually be in such bad shape after all–just spending on different things.

Here is a summary of the macro outlook.

  • The economy was rebounding, but activity is slowing with the surge in infections (Southwest Airlines, Blackstone)
  • Optimism is fading (Marriot International, Delta Air Lines)
  • CEOs are losing confidence in a V shaped recovery (Manpower Group, Neogen, Unilever)
  • The world has been turned upside down (Southwest Airlines)
  • Businesses are breaking (Airbnb, Southwest Airlines)
  • And life is unlikely to return to normal until there is a vaccine (Accenture, American Airlines, Unilever)
  • We’re facing a very, very bumpy ride (Goldman Sachs)
  • But government stimulus is keeping the economy afloat for now (Everbrite, Capital One)
  • It’s also creating distortions (Manpower Group)
  • The biggest distortion of all is probably in financial markets (Goldman Sachs)
  • A new generation of day traders has been born (Interactive Brokers)

From a sector perspective, there were downbeat assessments from consumer services, oil and gas, and materials. On the other hand, the housing market is on fire, and the technology sector outlook is holding up well.

“We spent 12 years building our business and within six weeks, lost about 80% of it. When a business drops that quickly, not only is there this feeling of losing much of what you created, but things start breaking.” – Airbnb (AIRB) CEO Brian Chesky

“We’re in an environment where it’s almost like we’re starting our business from scratch” – Southwest Airlines (LUV) CEO Gary Kelly

“We believe that North America production is likely to remain structurally lower in the foreseeable future and has slower growth going forward. The shrinking demand for shale oil and limited access to capital markets, the inevitable rationalization will continue, and we expect to see a more disciplined market with stronger operators and service companies.” – Halliburton (HAL) CEO Jeff Miller

“I am very pleased to report that the recovery in new home demand that we experienced over the course of the second quarter was nothing short of outstanding. Our second quarter results show a remarkable rebound in demand as April net new orders fell 53% from last year, only to see year-over-year orders increased 50% for the month of June. Led by strong demand among first-time buyers, we saw meaningful improvement across all buyer groups and geographies as the quarter advanced. This improvement culminated in June orders increasing 77% for first time, 48% for move up and 21% for active adult over June of last year…buyer demand is clearly experienced a dramatic recovery in the quarter and has remained strong through the first three weeks of July.” – PulteGroup (PHM) CEO Ryan Marshall

“…we continue to see good mortgage activity in the U.S. In fact, in the second quarter, we saw mortgage growth, and we actually had record mortgage loan balances at the end of the quarter ” – UBS (UBS) CFO Kirt Gardner

“I am optimistic, because the combination of low mortgage rates, still in under supplied markets and the broader nesting trend which we see across consumers, I think spells good news for the builder channel” – Whirlpool (WHR) CEO Marc Bitzer

“The combination of strong demand and limited inventory has also allowed us to raise prices across many of our communities. In fact, more than half of our divisions report raising prices in 50% or more of their communities. The typical price increase is in the range of 1% to 3% and includes changes in base price and/or reductions in incentives” – PulteGroup (PHM) CEO Ryan Marshall

“The last months have accelerated the shift to digital, which was already underway..” – eHealth (EHTH) CEO Scott Flanders

“…we’ve seen an acceleration in adoption rates of technology initiatives with multiple years of consumer adoption being compressed into 10 or 12 weeks’ time.” – Tractor Supply (TSCO) CEO Harry Lawton

“I would say, in the last five months is that digital technology is no longer viewed as just new project starts, but it’s becoming perhaps the most key for business resilience.” – Microsoft (MSFT) CEO Satya Nadella

“…we are also already seeing evidence that this crisis is accelerating the technical and soft skills transformations that we have been tracking and predicting for some time. Acute skills shortages in tech, cyber security, software development, and data analysts for example continue unabated, reinforcing that the need for skills revolution is here in force” – ManpowerGroup (MAN) CEO Jonas Prising

 

Valuation still elevated

The market valuation is still elevated. The forward 12-month P/E ratio is 22.2. which is well above its 5-year average of 17.0, and 10-year average of 15.3. I estimate what would happen if we to eliminated the technology, consumer discretionary (AMZN), and communication services (GOOG, NFLX) sectors from the P/E calculation. The forward P/E would be 18.6, which is still above the market’s 5 and 10 year averages.
 

 

The market reaction

For the companies that have reported earnings, the market reaction has been positive. The market has rewarded earnings beats at a rate above the historical average, and even earnings misses have seen prices fall less than average.
 

 

Despite the upbeat tone of the earnings reports, the S&P 500 traded with a heavy tone last week. In particular, the equal-weighted S&P 500 diverged and underperformed the float-weighted S&P 500 since early July, which is the period coinciding with earnings season.
 

 

The tone of earnings calls indicate that the macro outlook is turning sour.  As I pointed out last week (see Earnings Monitor: Waiting for Congress), the “elephant in the room of the earnings outlook is what happens when the fiscal support from CARES Act expires at the end of July”.

High frequency data is increasingly telling a story of a softening economy. The CARES Act support is expiring, and so are tenant eviction moratoriums. Last weekend was the deadline for an agreement so that states can re-program their computers to conform to a new support package.

The Democratic controlled House passed a $3 trillion rescue package two months ago as the opening offer in negotiations. The Republicans were scheduled to table a proposal last Thursday, but they have been divided and unable to present a united front. In all likelihood, there will be a rescue package, but the market will be focused on the details and the level of support.

Time is of the essence. Small businesses are failing or operating at low capacity, which results in a job shortage. If a rescue bill makes further cuts to aggregate household income, it will depress demand, and add to a death spiral of more failing businesses, more job losses, and further nosedive demand.
 

 

State and local government budgets are under tremendous pressure. Without aid, employment in that sector will collapse. Previews of the upcoming July Employment Report outlook is already starting to look ugly.
 

 

The rest of the FANG+ stocks are expected to report this week, namely Facebook (FB), Apple (AAPL), Amazon (AMZN) and Alphabet (GOOG). Their reports will probably be overshadowed by events in Washington.

Stay tuned.

 

Warnings, warnings everywhere, but bears should not drink…

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Sentimental warnings

There are two kinds of sentiment models. Some sentiment readings come from investor surveys, and others are derived from investor positioning. I prefer the latter because it shows how people are behaving with their money instead of just expressing opinions.

Intermediate term option sentiment models are flashing warnings everywhere. It is a sign of froth in this market when individual stock volumes have exceeded the volumes of the underlying stocks.
 

 

In addition, the 50 day moving average (dma) of the put/call ratio (top panel) is extremely low. Past episodes have seen the market either correct or stall. As well, there is an enormous gap between the equity-only put/call ratio (CPCE) and the index put/call ratio (CPCI). Individual traders (dumb money) tend to express their exposure preferences through individual stock options, while professionals (smart money) use index options for hedging. Such extreme differences in option opinion between the two groups have created headwinds for stock prices in the past.
 

 

Although this is an opinion survey, the NAAIM Exposure Index, which measures the opinions of RIAs, has returned to bullish extremes. I would caution, however, that this indicator has only worked well as a buy signal when RIAs panic, but it has not flashed actionable sell signals in the past. Nevertheless, it does show that sentiment has reached high levels of bullishness.
 

 

The Investors Intelligence Survey shows that the bull-bear spread has returned to the pre-pandemic levels seen before the COVID Crash.
 

 

The State Street’s North American confidence, which measures how institutional managers are positioned using aggregate custodial data, shows that institutional bearishness has evaporated. That said, readings are not at bullish extremes.
 

 

I would warn, however, that these excessively bullish sentiment readings are only contrarian bearish setups. While the intermediate term risk/reward for the stock market is subpar in light of these conditions, short-term conditions have suddenly flipped from bullish to bearish. After two weeks of faltering NASDAQ price momentum, the tone in my social media feed has turned to a panicked “this is the start of a major correction” narrative. While the NASDAQ 100 has violated a support level (dotted line), the index remains in an uptrend.
 

 

Short-term breadth is recycling from an overbought reading, but it is still tracing out a pattern of high lows.
 

 

A relief rally may be in order early next week.
 

Cross-asset bearish tripwires

While we certainly have the elements of a bearish setup, we don’t have a definitive sell signal for the stock market yet. Here are some inter-market, or cross-asset, bearish triggers that I am monitoring.

First, bond prices and, its inverse, bond yields are useful risk-off indicators. The 10-year Treasury yield has been testing a key support level, which it has failed to violate. Conversely, the long bond ETF (TLT) appears to be forming an inverse head and shoulders formation. As good technicians know, a head and shoulders pattern is not confirmed until the price breaks the neckline. If either the 10-year yield were to violate support, or TLT stages an upside breakout through the neckline, it would be a risk-off signal.
 

 

One sign of froth present in the market is the surge in silver prices, which is a bullish cyclical indicator. Troy Bombardia observed that call option volume on SLV, the silver ETF, has spiked to an all-time high. Call option volume on GLD, the gold ETF, is also at one of its highest levels ever (not pictured).
 

 

Past episodes of price reversals after silver goes parabolic have usually not been good for stock prices. I am watching for an inflection point in silver’s 52-week rate of change (bottom panel). Again, we have a bearish setup, but not a sell signal for equities.
 

 

As well, recent weakness in the USD has been supportive of emerging market equities. The strength in EM currencies and EM bonds has put a bid under fragile EM economies with large current account deficits.
 

 

What if the USD were to reverse upwards? Callum Thomas of Topdown Charts pointed out that speculative positioning in the USD is at a crowded short. In addition, the USD Index is testing key rising uptrend support. This is the perfect combination for a dollar rally.
 

 

The market’s focus on the USD Index (DXY) may be misleading. While the technical condition of DXY appears weak, the technical condition of the broad-based trade weighted dollar (TWD) is far more benign. The TWD has retreated after a spike back to test a key resistance turned support level, which is a far more constructive technical pattern than DXY.
 

 

Were the USD to turn around and begin to rally, it would create an additional headwind for risk appetite.
 

Waiting for Congress

Last week’s market action may be indicative of a change in psychology. The market’s focus appears to be shifting towards how Congress will respond to the economic cliff of the expiry of the $600 per week unemployment insurance payments on July 31.

More and more high frequency data is pointing to a softening in economic growth, such as the Census Bureau’s Household Pulse Survey of employment.
 

 

The New York Fed’s Weekly Economic Index is stalling and may be starting to roll over.
 

 

Data from Yelp shows that permanent business closures are rising, with restaurants and retailers the hardest hit.
 

 

A renewal of the expiring CARES Act fiscal stimulus is therefore of high urgency if the economy were to avoid falling off a cliff. Lawmakers have already missed the July 25 deadline for states to re-program their computers to implement a new stimulus plan. The Republicans are in disarray and have not been able to present a united front. Republican Senate majority leader Mitch McConnell is expected to unveil a proposal Monday, which is necessary before they even begin to negotiate with the Democrats in Congress.

Expectations are rising for a deal. This week’s cover of the Economist could be interpreted as a contrarian magazine cover indicator.
 

 

The market’s risk-off tone last week was probably in reaction to the latest uncertainty in Washington. Market psychology is very jittery and headline sensitive. As well, several major large cap FANG+ stocks, namely Facebook (FB), Apple (AAPL), Amazon (AMZN) and Alphabet (GOOG),  are expected to report earnings in the coming week. Brace for volatility.
 

 

While I am intermediate term cautious, my inner trader is inclined to wait for bearish confirmation of a break before taking action on the short side.

 

Analyzing the bull case

Posted by Cam Hui -

Regular readers will know that I have been cautious about the equity markets over the past few months. Good investors cannot be overly dogmatic, and in that spirit, I contemplate what the bull case may be,

From a strictly technical perspective, price momentum has been strong. The Wilshire 5000 is on the verge of flash a monthly MACD buy signal, depending on what level the index closes at month-end. Past signals have usually seen the market rise strongly afterwards.
 

 

Let’s put on our rose-colored glasses, and consider all the elements of the bull case.
 

The V-shaped recovery

One of the puzzles of the recovery since the March bottom is the market’s ability to shrug off bad news. This is the worst recession since the Great Depression, but the market is behaving as if the economy executed a V-shaped recovery.

Joe Wiesenthal at Bloomberg solved the puzzle by pointing that both retail sales (yellow line) and wages plus unemployment insurance (green line) have recovered to above their pre-pandemic levels. These are clear V-shaped recoveries.
 

 

While many investors have pointed to the Fed supporting the market with a put, which is partially correct. Wiesenthal’s analysis shows that it has been fiscal policy that has been the real put option for the economy.
 

A cyclical recovery in 2021

In addition, there are reasons to be optimistic about the growth outlook. Viewed in the context of a V-shaped recovery, 2020 earnings are expected to be a disaster, but the market is looking ahead to 2021. FactSet reports that bottom-up derived 2021 earnings is 163.77, making the 2021 P/E 19.6, which is elevated but more reasonable.

Here are some factors that could further boost 2021 earnings, which makes valuation more attractive. First. we could see the widespread availability of a vaccine by mid-year. There are many groups racing to develop a vaccine. Several leading candidates are entering phase three trials while simultaneously setting up production. Should any of them be successful, we would see positive results by late 2020, initial availability in early 2021, and widespread availability by mid 2021. This would allow the world to start relaxing and start returning to normal by mid to late 2021. The markets would start to discount a cyclical rebound and rising earnings by Q4 or Q1.

As well, we can count on more fiscal stimulus after the election, no matter who wins. If Trump were to regain the White House, the most likely course of action is more deregulation and fiscal stimulus in the form of another tax cut. The 2017 tax cut provided a 7-9% one-time boost to earnings. Pencil something similar in for Trump’s second term. A Biden presidency would have different priorities, but expect more government spending in the form of infrastructure, green initiatives, and redistribution policies that boost middle and lower class spending. Both Trump and Biden are likely to be Modern Monetary Theory adherents, and both would spend (in different ways) with Fed support. The combination of easy fiscal and monetary policies are growth positive, regardless of the winner.

Across the Atlantic, we have already seen the EU’s €750 billion Recovery Fund. Without going into too many details, the EU has agreed to borrow up to €750 billion in the market, and disburse the funds to member states, partly as grants, and partly as loans. One often cited weakness of the euro common currency is it monetary integration without fiscal integration. The Recovery Fund represents a useful step towards fiscal integration, in the manner that the US federal government supports the activities of state and local governments with funds and services.
 

 

In short, the global economy is turning Japanese, but in a good Abenomics sort of way. Japan’s Prime Minister Abe outlined his “Three Arrows” strategy to revive the economy, and the playbook seems to be adopted in slightly different forms by countries around the world.

  • Dramatic monetary easing;
  • A “robust” fiscal policy, with particular focus on individual welfare, servicing the debt, and public works; and
  • Policies to spur growth and private investment.

 

What about valuation?

Still, isn’t the market expensive based on traditional valuation methods? Maybe not. Callum Thomas of Topdown Charts compared and contrasted the market’s forward P/E ratio to its equity risk premium (ERP), which compared the earnings to price ratio to prevailing interest rates. While the market appears expensive based on P/E, it is quite reasonably priced based on ERP.
 

 

Lisa Abramociz at Bloomberg pointed out that the size of negative yielding bonds has grown to levels last seen in early March. This is a sign that global central banks are pushing down rates and engaging in financial repression.
 

 

Real 10-year yields are negative. Under those circumstances, high P/E ratios can be justified in the face of low and negative real bond yields. TINA – There Is No Alternative to stocks.
 

 

Another reason why equity prices might not be that expensive can be seen in issuer behavior. During the dot-com bubble, the cost of equity was low, and companies rushed to finance at the equity window. This time, we have seen a flood of borrowing, but not that much new supply of new equities. In fact, IPO activity is not that elevated by historical standards. This is an indication that companies that need funds do not find equity financing to be an extremely attractive option.
 

 

Stocks may not be that cheap, but they don’t look wildly expensive by these measures.
 

A healthy rotation

To be sure, there are pockets of froth in the market. Marketwatch reported that billionaire Mark Cuban was asked by his niece for stock tips, which is a sure sign of a bubbly market.

My 19 year-old niece is asking me what stocks [she] should invest in…Everybody’s a genius in a bull market and everybody’s making money now because you have the Fed put.

The NASDAQ 100 to S&P 500 ratio looks very extended. It has breached the Tech Bubble highs while exhibiting a 14-week RSI negative divergence, in the same way it did at the March 2000 high.
 

 

However, a recovery in the economy will allow a health rotation out of the NASDAQ leaders into value and cyclical names. The cyclically sensitive copper/gold and platinum/gold ratios are turning up, indicating that the recovery is broad based and global in nature.
 

 

The stock market can continue to advance under such a scenario.
 

The fine print

In summary, the bull case rests on the assumptions of a continued V-shaped cyclical recovery, supported by easy fiscal and monetary policy, the discovery of vaccines and treatments, and a mis-interpretation of P/E as a valuation metric. There are many moving parts to this scenario, and stocks can only advance based on a number of key assumptions.

One key assumption is the continuation of fiscal and monetary stimulus. While global central banks have signaled their willingness to be accommodative, the continuation of fiscal support in the US remains an open question. The $600 per week unemployment insurance benefits is set to expire at the end of July. The White House and Senate Republicans have not agreed on a common position, and the Republican and Democrat positions are far apart. As the analysis from Joe Wiesenthal pointed out, much of the V-shaped rebound is attributable to fiscal support. Consumer confidence is facing a cliff if lawmakers cannot come to an agreement. Moody’s recently issued a stark warning:

A reduction in federal support from current levels, which is likely, would constitute a financial shock for many households and businesses given still-high levels of unemployment and depressed economic activity

While we had our rose colored glasses on, we forgot about the possibility of tax increases should Biden win in November. Biden has vowed to unwind the some Trump 2017 corporate tax cuts, impose a corporate minimum tax, and proposed other investor unfriendly tax measures that are likely to compress P/E ratios.

Even if Trump were to win, the bullish scenario assumes that he does not escalate his trade wars with China, the EU, and other trading partners. Rising trade tensions would serve to dampen the global growth outlook, which also puts the V-shaped recovery into jeopardy.

The bullish scenario also assumes no vaccine development stumbles. While initial test results are promising, projecting the successful development of a vaccine at these early stages is like evaluating a promising eight yield-old dancer and thinking that she will become a successful ballerina. There are two leading vaccine candidates in the West. Based on what we know so far, the AstraZeneca-Oxford vaccine has shown itself to be protective in animal tests, but it does not prevent infection. The vaccine is likely to mitigate COVID-19 in inoculated patients, but the patients could still transmit the virus to others. As well, the vaccine needs to be injected in two stages, which creates challenges for production and deployment.

The Moderna vaccine is based on a totally news and unproven technology, which can make production difficult. In addition, the widespread insider selling of Moderna stock in the face of positive vaccine development news is disconcerting.

Any successful development of a vaccine will be too late if there is a COVID second wave in the fall. A second wave of infection would once again crater the economy, which would mean a double-dip recession. Say goodbye to the V.

As for the question of valuation, the TINA narrative of equities competing with bonds at negative real yields makes logical sense. However, investors have yet been able to explain the spread in valuation between US and non-US equities.

The BoA Global Fund Manager Survey shows that managers have piled into US equities, and FANG+ stocks in particular, as the last source of growth in a growth starved world. A rotation out of the high flying NASDAQ names into cyclical stocks is likely to see rotation out of US into other regions. US stocks would lag and may see limited upside under such a scenario.
 

 

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.” Each decade seems to experience a mania of some sort, and we are very late in the latest FANG+ mania. If and when it deflates, is it reasonable to expect cyclical stocks, value stocks, and non-US stocks can pick up the slack?
 

 

Finally, while the pending monthly MACD buy signal is a constructive development, the buy signal can be negated by a negative RSI divergence. A negative RSI divergence is only triggered if the MACD model is on a buy signal, and the index breaks or tests a previous high while the 14-month RSI makes a lower high. This model flashed a sell signal in August 2018, just ahead of the late 2018 top (see Market top ahead? My inner trader turns cautious). If the Wilshire 5000 were to flash a monthly MACD buy signal at the end of July, and if it were to test the old highs in August, there is a strong possibility that the market would then exhibit a similar sell signal. This is something to keep an eye on.
 

 

In short, while the bull case does make some sense, but much has to go right before the market can blast off into a renewed bull phase.

 

A market in transition

Posted by Cam Hui -

Mid-week market update:I observed in the past that the market had undergone a regime shift, and most of the gains were occurring overnight, while prices were lagging during daylight hours (see My inner trader returns to the drawing board). This is an indication of a jittery market sensitive to headlines that were released after the market close. In the past, past breaks of the overnight to daylight return ratio marked a change in market direction.

As the chart below shows, the overnight to daylight ratio is testing a key rising trend line and it may be on the verge of breaking down through the uptrend. While I am not ready to definitively declare a break, there are signs of unusual market behavior that suggest a phase shift is under way.
 

 

Unusual response to news

You can tell a lot about market psychology when it responds to news. Over the weekend, the European Union agreed to a €750bn Recovery Fund after a marathon summit. Former ECB vice president Vitor Constâncio described in superlative terms as historic, unprecedented, and essential. One of the weaknesses of the euro common currency was monetary integration without fiscal integration. While is is not perfect, this Recovery Fund is the first step towards EU fiscal integration, which is extremely positive news for the European Project.

This was very good news, but the market reaction was disappointing. The Euro STOXX 50 roared upwards out of the gate on Tuesday morning after the announcement, but it slowly weakened over the day and traded sideways Wednesday. The euro exchange rate did a bit better. It rallied strongly on Tuesday, but retraced some of its gains Wednesday.
 

 

Market indecision

The market’s reaction to the good news from Europe could be seen as a sign of a lack of risk appetite, which is bearish. However, other market reactions were confusing, which I interpret as signs of indecision.

As an example, the news that the State Department ordered China to close its Houston consulate in 72 hours was a shocker, and a sign of deteriorating Sino-American relations. The Chinese yuan weakened in response, the Hang Seng closed poorly, and overnight ES futures sold off. But the US stock market shrugged off the news to open in the green.

Today, we have the following seemingly contradictory cross-asset market signals:

  • Stocks up (risk on)
  • Bond prices up, and the 10-year Treasury yield testing a keys support level (risk off)
  • Gold up (usually risk off)
  • USD down (risk on and supportive of EM assets)

I outlined how the US is facing an economy cliff as the CARES Act stimulus expires at the end of July, and the deadline for states to re-program their computers for any new payment schemes is July 25 (see Earnings Monitor: Waiting for Congress). The situation looks dire, with eviction moratoriums expiring, a survey by Apartment List revealed that 32% of American households missed their July housing payments.
 

 

While I have no doubt that lawmakers understand the gravity of the situation and both sides of the aisle are working diligently to come to an agreement on a rescue package, time is not on their side. The White House and Republican Senators cannot even come to an agreement. CNBC reported that Republican House leader believes that legislation will not be forthcoming until early August, which is after the deadline expires.

The top Democrat and Republican in the House cast doubt Tuesday on whether Congress can pass a coronavirus relief bill in time to avoid disrupting a key financial lifeline.

“I envision that this bill doesn’t get done by the end of July,” House Minority Leader Kevin McCarthy, R-Calif., told CNBC’s “Squawk Box.” He said he expects Congress to approve legislation “probably in the first week of August.”

If lawmakers cannot pass a plan by the end of the month, a $600 per week federal unemployment insurance benefit buoying millions of Americans will at least temporarily expire. The GOP wants to change the policy or reduce the sum, while Democrats hope to extend the assistance as the unemployment rate stands above 11%.

In light of the high level of event risk, and indecisive market action, my inner trader has opted to stand aside. Do all the technical and sentiment analysis that you want, but there is a high risk that unexpected headlines can sideswipe a trading position.

 

Earnings Monitor: Waiting for Congress

Posted by Cam Hui -

We are starting our coverage of the Q2 earnings season. Let’s begin with the big picture. FactSet reported that, with 9% of the companies reported, the EPS beat rate was 73%, which was slightly above the 5-year average. The sales beat rate was 78%, which was well above the 5-year average of 60%.

The bottom-up consensus forward 12-month estimate rose 0.51% last week The market is trading at a forward P/E of 22.3, which is well ahead of historical norms.
 

 

A detailed look

A detailed analysis of quarterly EPS estimates shows a consensus for a V-shaped rebound. Though these trends can be noisy, weekly revisions indicate that the Street had dramatically upgraded Q2 EPS estimates, but reduced H2 estimates. The trend in revisions for 2021 quarterly estimates was mixed.
 

 

The main theme of earnings calls is uncertainty. As an example, CNBC reported that JPMorgan Chase CEO Jamie Dimon remarked that the outlook depends mainly on the course of the pandemic.

“The word unprecedented is rarely used properly,” Dimon said this week after JPMorgan reported second-quarter earnings. “This time, it’s being used properly. It’s unprecedented what’s going on around the world, and obviously Covid itself is a main attribute.”

The economy would be in shambles without the safety net of the CARES Act.

That’s because the $2.2 trillion CARES Act injected billions of dollars into households and businesses, masking the impact of widespread closures. As key components of that law begin to phase out, the true pain may begin. As many as 25.6 million Americans will lose enhanced unemployment benefits by the end of July, and it’s unclear if Congress will extend the $600 per week in additional payments that has buoyed so many households.

“In a normal recession unemployment goes up, delinquencies go up, charge-offs go up, home prices go down; none of that’s true here,” Dimon said. “Savings are up, incomes are up, home prices are up. So you will see the effect of this recession; you’re just not going to see it right away because of all the stimulus.”

The bank has provided forbearance on 1.7 million accounts; so far, more than half of credit card and mortgage customers in the programs have made at least one monthly payment. But these vulnerable customers could stop paying altogether as their federal benefits lapse.

The Transcript provided more color with themes from last week’s earnings calls:

  • The economy rebounded in May and June (JPMorgan Chase, Carnival, Johnson & Johnson, Bank of America, Delta Air Lines)
  • But the recovery is slowing down as infections rise (JPMorgan Chase, Goldman Sachs, Delta Air Lines, Domino’s Pizza, Fastenal)
  • Businesses are beginning to plan for this slowdown to last much longer than initially expected (JPMorgan Chase, Bank of America, Goldman Sachs, Citigroup, Wells Fargo, Carnival)
  • Government stimulus has softened the impact of a major blow to the economy but what happens when it runs out? (JPMorgan Chase, PepsiCo, Citigroup)
  • The moment of truth is approaching quickly (JPMorgan Chase, Citigroup, Wells Fargo, DBS Group)
  • Markets are betting on more stimulus (Citigroup)
  • There’s a big disconnect between markets and the current reality, but remember markets discount the future (Citigroup)
  • The election cycle is not playing a big role yet (Goldman Sachs)

The New York Times summarized the views of other CEOs. All had similar cautious outlooks.

“I’m less optimistic today than I was 30 days ago,” said Arne Sorenson, chief executive of Marriott International. “The virus is in so many different markets of the United States.”

“Most C.E.O.s today believe that until there is a more effective treatment or a vaccine, that work and life are not going to go back to normal,” said Julie Sweet, chief executive of Accenture.

Ms. Sweet said even in Europe, where the virus is largely under control, business leaders are anticipating flare-ups that could disrupt the economy again. “In Europe, we have clients saying, ‘We want you back,’ and in the next breath saying, ‘Of course, that will change,’” she said.

“It’s going to be one step forward, two steps back,” said Julia Hartz, chief executive of Eventbrite, the ticketing website.

There is a general feeling that Congress needs to act.

Rich Lesser, the chief executive of Boston Consulting Group, argued that it was imperative for Congress to provide more relief for the most vulnerable members of society, particularly essential workers, the elderly and those with compromised immune systems.

“Without the federal government doing something, we will miss the window,” Mr. Lesser said, adding that the virus was spreading rapidly and becoming entrenched in communities. “We need the government to say we are focused on protecting the vulnerable. If we wait to September, it will be too late.”

Mr. Sorenson of Marriott and Mr. Bastian of Delta — both of whom have large workforces vulnerable to buyouts, furloughs or layoffs if the economy does not recover swiftly — called for the expansion of unemployment coverage.

And Ms. Hartz of Eventbrite said that she wanted to see more support for small businesses.

“Something is going to have to give,” she said. “If there is not federal relief that is usable and tuned to the needs of these small businesses, they’ll go out of business.”

 

The elephant in the room

The elephant in the room of the earnings outlook is what happens when the fiscal support from CARES Act expires at the end of July. If Congress were to pass an additional stimulus bill, the soft deadline for state governments to re-program their computers is July 25, which is less than a week away. A Bloomberg article outlined the timeline for an economic crash landing if Congress doesn’t act.
 

 

The Washington Post reported that the White House has outlined its wish list of a payroll tax cut and business liability protection.

President Trump sought to draw a hard line on the coronavirus relief bill Sunday, saying it must include a payroll tax cut and liability protections for businesses, as lawmakers prepare to plunge into negotiations over unemployment benefits and other key provisions in coming days.

“I would consider not signing it if we don’t have a payroll tax cut,” Trump said in an interview on “Fox News Sunday.” Democrats strongly oppose a payroll tax cut, and some Republicans have been cool to it, but Trump said “a lot of Republicans like it.”

The Republicans have yet to present a united front in negotiations. The leadership has been found it difficult to persuade conservatives to sign on to extra spending. As well, CNBC reported that Senate Republicans are pushing back on a Trump proposal to cut back funding for virus testing.

The White House is trying to block billions of dollars for coronavirus testing and contact tracing in the upcoming stimulus relief bill, two Republican sources told NBC News, even as infections surge across the country and Americans face long wait times to receive test results amid high demand.

Senate GOP lawmakers, in a break with the administration, are pushing back and trying to keep the money for testing and tracing in the bill, the sources told NBC News. Some White House officials reportedly believe new money shouldn’t be allocated for testing because previous funds remain unspent.

Democrats in the House had already passed a $3 trillion relief bill, with very different priorities. In general, the Democrats’ approach can be summarized as creating a stronger safety net. The Republicans believe the current CARES Act creates too many incentives for people to stay home on unemployment, and their relief proposals focuses on limited spending and more incentives to return to work.

Can both sides come to an agreement in time?

Numerous economists and think tanks have warned about the dire effects of an abrupt stop in fiscal support. Former Obama economic advisor Jason Furman projected a further -2.5% reduction in H2 2020 GDP and 2 million additional jobs lost if the expanded unemployment insurance benefits were to expire. While he doesn’t directly come out and say it, a -2.5% decline in GDP amounts to a double-dip recession. It would also upend the Wall Street consensus of a V-shaped rebound in quarterly EPS.

The abrupt expiration of any form of expanded unemployment insurance at the end of July 2020 would create problems both for the workers directly affected and for the economy as a whole, reducing GDP by about 2.5 percent in the second half of 2020—more than a typical year’s worth of economic growth.

The Chicago Booth School conducted a survey of academic economists through its IGM Forum, and all agreed with the following three propositions.

  1. Employment growth is currently constrained more by firms’ lack of interest in hiring than people’s willingness to work at prevailing wages.
  2. Reducing supplemental levels of unemployment benefits so that no workers receive more than a 100% replacement rate would be a more effective way to balance incentives and income support than simply stopping the supplement at the end of this month.
  3. A well-designed unemployment insurance system would tie federal contributions to states on the basis of each state’s economic and public health conditions.

To be sure, some respondents were “unclear” about the propositions, though none disagreed. Posturing aside, these propositions form some realistic principles of relief policy design.

Will Congress listen? Legislators have a lot of work to do. Decisions in Washington in the next week could create a lot of event risk to the H2 earnings outlook.

 

Pockets of opportunity in an uncertain market

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Still range-bound

The market ended the week at the top of a tight range between 3000 and 3240. For the bulls, they can point to:

  • The market shrugging off bad news about the rising US infection rate and death rate.
  • Hopeful news on vaccine development, despite some of my doubts (see A Covid recovery?).
  • Constructive signs from breadth indicators and cyclical stocks.

The bears can point to:

  • Nagging cautionary flags from inter-market, or cross-asset, analysis, such as the persistent downward pressure shown by the 10-year Treasury yield, which continues to test the 0.60% support level even as stocks test upside resistance.
  • Faltering momentum from Chinese stocks (see Double bubble, double trouble?).
  • Elevated bullishness on sentiment models, which is contrarian bearish.

 

 

There is no point in wringing my hands about the range-bound market. The market will gives us some clue on direction once it stages a breakout, either on the upside or downside. Instead, I outline some of the pockets of opportunity, and other corners of the market to avoid.
 

The bull case

Let’s briefly summarize the bull case. You can tell a lot about a market by the way it responds to news. The market seems to be ignoring the bad news about the deteriorating COVID-19 in the US. (Caution: The figures may be understated because of the new HHS guidelines for data.)
 

 

Market leadership rotated from the high flying technology names to cyclical stocks. Virtually all of the cyclical industries except for leisure and entertainment caught bids. Semiconductor stocks remain in a well-defined relative uptrend.
 

 

The S&P 500 Advance-Decline Line made a fresh all-time high.
 

 

The bear case

On the other hand, inter-market, or cross-asset, analysis is raising some doubts about the bull run. The Japanese Yen, which is a classic risk appetite indicator, is not buying the equity advance. In addition, the 10-year Treasury yield keeps trying to test support even as the stock market tests resistance. A significant downside breach of the 0.60% level would be a risk-off signal. Which is right, the stock market, or the currency and bond markets?
 

 

The Advance-Decline Line is also flashing a negative divergence. The strength of the NYSE A-D Line is offset by the weakness in A-D Volume. Even as stocks advanced broadly, there was more selling volume than buying volume. This is a sign of distribution that should be watched.
 

 

Lastly, bullish sentiment appears to be elevated. The II sentiment bull-bear spread has normalized to 40%, which is the roughly the level when the market peaked this year and in 2019. However, the spread was higher in early 2018 when it rose about the 50% mark.
 

 

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Energy: The contrarian play

In the short run, it is difficult to know where the market will go. However, there are pockets of opportunity for superior performance for long-only accounts. Bear in mind that these are investment themes, not trading themes. There are no immediate triggers that cry out for an immediate commitment to any of these ideas.

A washed-out and unloved sector to consider is energy. The BoA Global Fund Manager Survey shows that positioning in this sector is sufficiently underweight and for a long enough duration to warrant a tactical contrarian bullish position.
 

 

From a technical perspective, the relative performance of US and European energy stocks have tracked each other. These stocks are exhibiting a constructive higher low after an initial panic low in March. There is little to choose between the different industry groups within the sector, though oil services may appear slightly better technically.
 

 

For investors who believe the energy sector may represent a value trap, they may consider ESG clean energy as the momentum play. One word of warning, though. Most of the clean energy ETFs hold a large weighting in Tesla (TSLA), which has been on a tear. However, the Cleantech ETF (PZD), which has no TSLA, managed to stage an upside relative breakout without help from Elon Musk.
 

 

Is WFH theme peaking?

The second investment theme that I would highlight is the “work from home” (WFH) theme, which may be nearing a peak. A recent WSJ interview with staffing company Adecco’s CEO Alain Dehaze raised some doubt as to how far companies can take the WFH trend.

“Remote work is unfortunately creating a social distance that we should not have,” said Mr. Dehaze, though he sees no return to workplace normalcy until a vaccine is widely available.

Dehaze explained:

There are very positive aspects regarding remote work. You don’t have to commute, so you save time and money. For some, it is very convenient to work from home. But for many others, it’s a nightmare. There is the question of the quality of broadband infrastructure, computer screens and separation between private life and work.

Then there is the question, Who will pay for all the digital infrastructure work needed? Who will take the benefit of time and money saved not commuting—the employee or employer? And there is the third part, which, for me, is very important: What about the culture—the social proximity—you have in a company?

Much depends on the model of work. Are employees considered to be individual widgets, interchangeable, and expected to perform limited tasks? In cases like a call center, a WFH model is very viable given the state of current technology. But if employees are expected to be creative and collaborate, then corporate culture matters.

The question is physical distance versus social proximity. By being with colleagues, you align, you share a lot of things. You cultivate your values, you cultivate your purpose. If you are permanently alone, I don’t know how you can cultivate this.

It’s like friendship and love. You cannot cultivate friendship and love only from souvenirs, from memory. You need presence, you need to nurture. And with culture, it’s also about nurturing through experience. This social proximity will remain important.

I agree. One of the questions that I used to ask when interviewing with a company as a way of understanding the corporate culture was, “Do you socialize together after work?” Without the personal relationships, it’s far more difficult to collaborate, be creative, and add value.

This brings into question the longevity of the WFH investment theme, and the bearishness towards REITs, and office REITs in particular. From a fundamental perspective, REITs are starting to look cheap again.
 

 

From a technical perspective, the relative performance of REITs appear to be attempting a double bottom.
 

 

Gold: Too far, too fast

Lastly, gold prices have been on a tear as they staged a convincing upside breakout through the $1800 level. However, both the gold price and the inflation expectations ETF (RINF) are testing key resistance zones, and some breathers are probably in order.
 

 

Mark Hulbert pointed out that his Hulbert Gold Newsletter Sentiment Index is at an off-the-charts bullish reading, which is contrarian bearish. If history is any guide, gold prices and gold stocks are due for a correction and pullback.
 

 

While I am long-term bullish on gold. The Fed is embarking on a program of financial repression, which will depress real rates and should bullish for bullion (see Can a bull market begin without the banks?). BoA pointed out that global government bond yields are nearing Japanese yields, and the process of Japanese style financial repression is upon us.
 

 

However, gold prices have risen too far too fast. This is not the time to be all-in bullish on the metal.
 

The week ahead

From a tactical perspective, the market begins the week overbought, with short-term breadth indicators rolling over.
 

 

As well, the S&P 500 exhibited two spinning top candlesticks while testing resistance, which are signals of indecision. These are signals that the near-term outlook is down, but the bears have not been able to make much of such opportunities in recent weeks.
 

 

Traders also need to be aware that Q2 earnings season is in full swing. Important large cap companies are reporting, and it could mean volatility in the market.
 

 

My inner trader remains short, but only during daytime hours (see My inner trader returns to the drawing board).

Disclosure: Long SPXU

 

Can a bull market begin without the banks?

Posted by Cam Hui -

Earnings season has kicked off with reports from the major banks. The market reaction has been mixed so far. From a big picture perspective, history shows that whenever the relative performance of banking stocks have breached a major support level, such events have usually signaled periods of financial stress and bear markets.
 

 

This time, the Covid Crash saw the market fall and recover in the space of a few short months. This begs two important questions for investors.

First, the financial sector is the third largest weight in the index, behind technology and healthcare. Can a bull market begin without the participation of a major sector like this?
 

Brian Gilmartin pointed out that the sector represents about 10% of S&P 500 weight, but 17% earnings weight, indicating that financial stocks are value stocks. What does the lagging performance of these stocks mean for the growth/value dynamic?
 

How cheap are banks?

Financial stocks have lagged the market, not just in the US, but globally. The relative performance of this sector has been synchronized globally in the last two years. Even in China, banking stocks staged a relative rally when the Chinese market surged, but their relative returns have retreated as the market cooled off.
 

 

How cheap are they? Callum Thomas at Topdown Charts found that global banks are indeed very cheap by historical standards, whether measured by a relative PB ratio, or relative PE10 ratio. He observed that global banks have never been cheaper based on both absolute and relative valuation, and they trade at a “massive 60% discount to the rest of the market on a PE10 basis”.
 

 

That may not be enough from a sentiment perspective. The BoA Global Fund Manager Survey reported that managers are underweight banks, but sentiment does not appear to be panicked in the manner of the Great Financial Crisis of 2007-09.
 

 

Waiting for the next shoe to drop

I would argue that this sector has not seen the capitulation event needed for a turnaround. In the past, periods of financial stress has been associated with banking crises. We have not had the credit event that sparks a banking crisis just yet. The latest BoA Global Fund Manager Survey shows that investors are overly focused on the COVID-19 Crisis, and the risk of a credit event is barely in the spotlight.
 

 

That may be about to change. Just when you thought the banks had “kitchen sinked” by writing off all of the bad loans in Q1, Bloomberg reported that JPM, C, and WFC have set aside about $28 billion in loan loss provisions in Q2.
 

 

Is this as bad as it gets? I am not sure. Just consider some of these comments from banking CEOs during the earnings calls.

“This is not a normal recession. The recessionary part of this you’re going to see down the road,” JPMorgan Chief Executive Officer Jamie Dimon said Tuesday. “You will see the effect of this recession. You’re just not going to see it right away because of all the stimulus.”

“I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst is absolutely behind us and it’s a rosy path ahead,” Citigroup CEO Michael Corbat told analysts. “We don’t want people leaving the call simply thinking the world is a great place and it’s a V-shaped recovery.”

Banking executives are echoing the message of the Fed. The path of the recovery depends on progress against the pandemic. This is not your father’s recession.

The number of corporate bankruptcies has spiked to levels last seen during the last crisis, though the value of liabilities in bankruptcy is still relatively tame.
 

 

The slowdown is also starting to bite into the household sector. A study by the nonpartisan consumer advocacy group Families USA found that a record 5.4 million Americans had lost their health insurance between February and May. In addition, high frequency economic data shows that consumer spending began to roll over mid-June. What’s more even worrisome is the high-income households are leading the decline. This may be an indication that layoffs are reaching the better paying white collar jobs.
 

 

Mortgage delinquencies, which were the first signs of the last housing crisis, have surged.
 

 

The CEO of Apartment List gave further details about housing market stress in the latest earnings call:

During the first week of this month, 19 percent of Americans had made no housing payment, while an additional 13 percent paid only a portion of their monthly bill… From June to July, the share of renters who are either “very” or “extremely” concerned about being evicted rose from 18 percent to over 21. Similarly, the share of homeowners concerned about foreclosure ticked up from 14 percent to 17 percent.

So far, the fiscal support provided by the CARES Act is creating a limited safety net for consumer spending. Joe Wiesenthal at Bloomberg observed that despite record job losses, total compensation for unemployed workers actually rose because of the CARES Act, whose provisions are set to expire at the end of July. For some perspective on the scale of fiscal support, George Pearkes at Bespoke estimated that a full expiry of the $600 per week unemployment insurance payment would cost the household sector 4.8% of Q1 nominal GDP at an annualized rate.
 

 

Whether any fiscal support is forthcoming is an open question. The latest tentative proposal from the administration calls for a reduced level of support that is capped at $1 trillion, plus a payroll tax cut. The House Democrats passed a $3 trillion relief bill with very different spending priorities. It is unclear whether both sides of the aisle can come to an agreement before the Congress recess in August.
 

Financial repression ahead

How is the Fed likely to react? Fed watcher Tim Duy analyzed a recent speech by Fed governor Lael Brainard and concluded that the Fed is likely to engage in yield curve control. Brainard began with an assessment of the path of recovery, and provided a Fed policy roadmap.

Looking ahead, it will be important for monetary policy to pivot from stabilization to accommodation by supporting a full recovery in employment and returning inflation to its 2 percent objective on a sustained basis. As we move to the next phase of monetary policy, we will be guided not only by the exigencies of the COVID crisis, but also by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support.

She went on to open the door to yield curve control (YCC) as an additional policy tool.

Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree of familiarity with their use. Given the downside risks to the outlook, there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve.

Duy concluded:

The Fed will feel pressure to do more without expanding the balance sheet further. That leaves yield curve control as the next likely path forward. [Though] they have to talk it out first.

The Fed last engaged in YCC during World War II, which forced savers to subsidize the government’s finances. Let’s call it what it really is, financial repression. We have seen what different forms of financial repression does to the banking system. In the eurozone, the ECB pushed rates deeply negative, and it cratered bank profitability. The difference becomes obvious when we compare the performance of US and European banking stocks in the last decade (all figures in USD).
 

 

We also have a real-time price signal for the degree of financial repression. The price of gold responds to real interest rates. If the Fed were to artificially push down real rates, it puts upward pressure on gold. As the following chart shows, the relative performance of bank stocks are inversely correlated to gold.
 

 

Brace for more pain

In conclusion, investors should expect more pain ahead for the banking sector. The credit cycle is not yet complete for the latest expansion cycle, and banks are bracing for a wave of bankruptcies. The Fed is about to engage in financial repression that will depress banking profitability. From a technical perspective, the relative performance of the NASDAQ 100 to the Bank Index isn’t washed out yet, indicating that growth is likely to dominate value for the time being. Historically, the relative performance of this ratio has not bottomed out until the 52-week rate of change reaches -70%. That said, the 14-week RSI is exhibiting a positive divergence, which is a signal that the final capitulation is near.
 

 

The banks will have their day, but not yet. By implication, there is one more leg down for this bear market, and one more leg up for the growth/value trade before it’s all over.

 

A Covid recovery?

Posted by Cam Hui -

Mid-week market update: The market has taken on a risk-on tone as news of a promising Moderna vaccine trial hit the tape. While the relative performance of healthcare stocks haven’t done much for several weeks, they did catch a recent bid.
 

 

As well, cyclical stocks have also perked up as they responded to the hopes of a post-pandemic world.
 

 

Is this the start of a COVID recovery? I analyze the issues surrounding vaccine development and provide a framework for evaluation.
 

The approval process

Vaccines have historically taken years to develop. Dr. Anthony Fauci recently laid out the criteria for approval in a Bloomberg article:

“You’ve got to be careful if you’re temporarily leading the way vs. having a vaccine that’s actually going to work,” he told the BBC recently. Most vaccines in development fail to get licensed. Unlike drugs to treat diseases, vaccines are given to healthy people to prevent illness, which means regulators set a high bar for approval and usually want to see years’ worth of safety data. In the Covid-19 pandemic, it’s not yet clear what regulators will accept as proof of a successful and safe vaccine. The U.S. Food and Drug Administration has said a vaccine would need to be 50% more effective than a placebo to be approved and would need to show more evidence than blood tests indicating an immune response. Regulators in other countries haven’t spelled out what would be acceptable.

History is littered with instances of over eager drug developments. Just look up the Guillain-Barré syndrome, which was an unexpected side effect of the 1978-79 flu vaccine that President Ford rushed into production. Then there is thalidomide, which was promoted for anxiety, insomnia, “tension”, and morning sickness . The drug was found to cause severe birth defects. Babies were born with either no arms or legs or horribly disfigured limbs. That’s why the drug approval process takes so long. Take shortcuts and you don’t know about the long-lived side effects like birth defects.

Investors need to temper their expectations and not overreact like a puppy chasing after a new squeaky toy whenever a company announces a promising result.
 

The leading candidates

Courtesy of a useful vaccine tracker website, here are the outlines of four leading candidates that are in either phase II or phase III trials.

Two potential vaccines that are furthest in development are Chinese. Reuters reported that China’s Sinovac has a potential vaccine in a phase III trial in Brazil. Even so, the phase III trial is not expected to be completed until the last half of 2021.
 


 

Reuters separately reported that China’s CanSino has a promising candidate. The company is contacting Russia, Brazil, Chile, and Saudi Arabia for phase III trials involving 40,000 patients. As well, the vaccine is being given to Chinese troops on an experimental basis. The timeline for the completion of phase III trials is also late 2021.
 

 

The two remaining lead candidates are being developed in the West. The Moderna vaccine, which the market got all excited, emerged from a phase I trial with promising preliminary results. Before everyone gets all excited, the trial only consisted of 45 healthy volunteers aged 18-55, and the trial was designed to test whether the vaccine is safe, not whether it’s effective. Nevertheless, the study showed that all subjects showed the production of neutralizing antibodies against SARS-CoV-2, though there is no indication how long the antibodies lasted in patients.

The company is now going into a phase III trial by recruiting 30,000 patients. Still, this process can’t be rushed. Even the process of recruiting 30,000 appropriate subjects can take months. For some perspective, 30,000 is roughly the size of the 101st Airborne Division. Imagine if you had to create the 101st from scratch. What’s the bureaucracy to recruit that many people, induct them, and put them through the first level of basic training. As with the other vaccine candidates, it is unrealistic to expect robust results until 2021.
 

 

There are other issues with the Moderna vaccine, it is based on mRNA technology which may be difficult to scale in production. As well, an analysis of insider activity in the stock finds mass selling. In the last six months, there was one timely insider buy by a director in February, and a whopping 78 sales by officers and directors. If insiders are so confident about the vaccine, why are they selling?
 

 

Finally, there is the Oxford vaccine backed by AstraZeneca. The vaccine is in a phase III trial that is not expected to be complete until the second half of 2021.
 

 

There is also some controversy over the Oxford vaccine. A Forbes article cast some doubt over the effectiveness of the vaccine in animal tests. All of the rhesus monkeys became infected when exposed to SARS-CoV-2, and the level of neutralizing antibodies was very low. However, the vaccine did protect the animals when they were afflicted with COVID-19. In other words, the vaccine does not protect a patient from infection, but it does stop you from going to the hospital and dying if you become ill. It is unclear whether vaccinated patients acquire immunity should they become infected, though the vaccine seems to mitigate the effects of the virus.

The hurdles facing the Oxford vaccine may not be an overwhelming problem. Not all vaccines prevent infection. As an example, the Salk polio vaccine also doesn’t prevent infection, but it does mitigate the effects of the illness.

Assuming that Oxford vaccine is successful, it creates a public health policy problem. Vaccinated patients who become afflicted with COVID-19 could in theory infect others. Authorities would need to effect a high vaccination rate in order to create herd immunity. This begs the question of whether enough people are willing to be vaccinated.

Bottom line, temper your expectations. Even with promising results and shortened approval process, a realistic timeline for a vaccine to be available is probably mid to late 2021.
 

Limited upside potential

In the meantime, sentiment appears extended in the short run. Jason Goepfert at SentimenTrader pointed out option sentiment is at a bullish extreme, which is contrarian bearish.
 

 

Brokerage firm sentiment has also become extreme. This indicator measures the percentage of stocks with buy ratings, and the last time it was this high was 2014.
 

 

As well, FactSet calculates a bottom-up aggregated target price. The 12-month target is 3,352. Historically, analysts have over-estimated the actual prices by 3.6% in the last 5 years, by an average of 2.7% in the 10 years, and by 9.7% in the last 15 years. This makes the 12-month target range 3,027 to 3,261, which represents very little upside potential from current levels.
 

 

In addition, there are two sources of near-term uncertainty. We are entering Q2 earnings season, and most companies have withdrawn guidance. That’s like sailing in fog with possible icebergs in the water. In addition, it is unclear whether Congress with agree to a compromise bill for more fiscal stimulus. The latest round of CARES Act stimulus ends July 31, and states will have trouble re-programming their computers to effect new payments after July 25, which is only 10 days away. The Republicans, who control the Senate, and the White House have not even agreed on the details of a package. The lack of a united front has prevented them from presenting a proposal to the Democrats, who control the House.

My inner investor remains neutrally positioned at the asset allocation weights specified by his investment policy. My inner trader is short, but only during daylight hours (for more details, see My inner trader returns to the drawing board). He has set a stop just above the top of the island reversal at 3240.

Disclosure: Long SPXU

 

Another equity valuation warning

Posted by Cam Hui -

As Elon Musk passes Warren Buffett in net worth, it is time to sound one more warning about the market’s valuation. FactSet reported that the stock market is trading at a forward 12-month P/E of 22.0, which is well above its 5 and 10 year averages.
 

 

Here is why these circumstances are highly unusual.
 

The historical record

The following chart compares the forward P/E ratio to the Misery Index, which is the sum of the unemployment rate and inflation rate. In the past, P/E multiples have have been inversely correlated with the Misery Index. P/Es have weakened whenever the Misery Index rose to a local peak, usually because of the recessionary stress of rising unemployment. Today, the unemployment rate spike to levels only exceeded by the Great Depression, and the forward P/E rose instead of falling.
 

 

Earnings do matter. Callum Thomas presented a long-term perspective of stock prices and forward EPS. The only significant divergence that occurred between since the two series began in 1985 is today.
 

 

One explanation is US equity market leadership has been concentrated in a handful of large and profitable technology names. The stock market isn’t the economy, and the economy isn’t the stock market. Nevertheless. forward earnings are still highly correlated with business sales, which have tanked.
 

 

Stress levels are already evident in the especially vulnerable small cap stocks. 42% of the Russell 2000 are not profitable, which is a level consistent with recessionary conditions.
 

 

Is it any wonder why small caps are continuing to lag large caps?
 

 

Health care warnings

Can the development of a vaccine be cause to celebrate, in light of the recent hopeful news?

The economy may not be able to take much comfort in the development of a vaccine. The Guardian reported a UK (non-peer reviewed) study found that antibody protection fade rather quickly over time. This means that it man be difficult to achieve herd immunity. At best, vaccinations will require annual booster shots. At worst, they won’t provide much protection at all.

In the first longitudinal study of its kind, scientists analysed the immune response of more than 90 patients and healthcare workers at Guy’s and St Thomas’ NHS foundation trust and found levels of antibodies that can destroy the virus peaked about three weeks after the onset of symptoms then swiftly declined.

Blood tests revealed that while 60% of people marshalled a “potent” antibody response at the height of their battle with the virus, only 17% retained the same potency three months later. Antibody levels fell as much as 23-fold over the period. In some cases, they became undetectable.

 

To be sure, some vaccines are not designed to prevent infection, but to mitigate symptoms once a patient is infected. An Italian study found that patients with post-COVID infections suffer symptoms two months after recovery. Only 13% had no symptoms after two months (ht George Pearkes).
 

 

If the results from these studies hold up, it implies that this virus will have a far more lasting impact on the growth outlook than consensus expectations. COVID-19 will have a long-term negative effect on productivity. Analysts will have to downgrade their growth and earnings expectations – with a corresponding downward revision in equity price targets.

 

Risk levels elevated, but no signs of panic

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

A holding pattern

After several weeks of back-and-forth, the stock market remains in a range-bound holding pattern. A breakout or breakdown may be depending on upcoming news in the form of Q2 earnings season, and the resolution of negotiations in Congress over a second round of fiscal stimulus.
 

 

How will the headlines develop over the next couple of months? Will the narrative be an out-of-control pandemic, no or inadequate fiscal stimulus, an economic disaster, and skyrocketing bankruptcies; or will it be a vaccine by late 2020, renewed fiscal stimulus, and an economic revival in 2021? Long-dated implied option volatility and the SKEW Index, which measures the price of tail-risk hedge, are telling the story of mildly elevated risk, but there are no signs of outright panic,
 

Waiting for earnings season

How far has the market discounted a slowdown as we approach Q2 earnings season? FactSet reported that forward 12-month EPS is rising, indicating positive fundamental momentum. On the other hand, the forward P/E is highly elevated at 22.0, indicating valuation risk.
 

 

High frequency economic data from Tracktherecovery.org shows that consumer spending peaked out and began to retreat mid-June, followed by stabilization in late June and early July.
 

 

Chase card spending shows a similar pattern of flattening sales.
 

 

More worrisome is the health of small businesses, which peaked out in the same time frame, but saw no signs of stabilization. Instead, the number of open small businesses are plunging.
 

 

Much of the progress in reopening depends on the pandemic, and the news isn’t good. The COVID Tracking Project reported that case counts are skyrocketing. As expected, hospitalizations lag the new case count, and fatalities are turning up as they lag hospitalizations.
 

 

At its peak, New York reported 595 new cases per million on April 15. Arizona (580) and Louisiana (568) are nearing that figure. As the case counts surge, other states are likely to follow. This is what Dr. Anthony Fauci meant when he said that we are in the middle of the first wave, not the second, as the lagging regions catch up with Washington State, New York, and New Jersey. Fear is rising, and expect consumer sentiment to get worse before it gets better.
 

 

Back on Wall Street, a more detailed analysis of quarterly estimate revisions shows that the Street dramatically cut Q2 estimates last week, raised H2 estimates, and cut 2021 estimates. The lack of H2 downgrades indicates that consensus estimates have not fully incorporated the downdraft seen in the high frequency data.
 

 

Discounting a mild slowdown

Real-time market signals are telling the story of a mild slowdown. I am seeing numerous signs of minor negative divergences, or warning flags but no outright sell signals. As an example, the relative performance of the equal-weighted consumer discretionary stocks to equal-weighted consumer staples is rolling over. (The indicator uses equal-weighted indices in order to minimize the massive weight of Amazon in the consumer discretionary sector). This rollover is a minor negative divergence and a sign of waning equity risk appetite.
 

 

Similar minor negative divergences can be seen in the credit markets. The relative price performance of high yield (junk) bonds and leveraged debt to their respective duration equivalent Treasures are also signs of reduced credit market risk appetite. More worrisome is the behavior of the 10-year Treasury yield, which tested and bounced off support last Friday. A violation of support would be a potential trigger for the risk-off trade.
 

 

Waiting for Washington

In addition to Q2 earnings season, there are two developments of importance to investors in the month of July. First, the deadline for filing income taxes is coming up on July 15. Historically, the stock market experiences brief weakness as taxpayers scramble for liquidity around the tax deadline date.

More importantly, the $600 CARES Act individual weekly payments expires on July 31, and there are no signs that the Democrats and Republicans have come to any agreement for another round of fiscal stimulus. Despite the better than expected June Employment Report, permanent job loss has spiked to recessionary levels. Notwithstanding the debate about whether additional support represents a disincentive to work, or a necessary or essential support for people, the macro outlook appears dire without a second round of fiscal stimulus.
 

 

The Payroll Protection Program (PPP) was not the best designed rescue package. You can’t really fault the drafters of the CARES Act. It was battlefield surgery, and battlefield surgery is imperfect. PPP is paying companies to artificially lower the unemployment rate, and now the media and politicians are bickering over the interpretation of the results. The focus is now over who received the loans, e.g. the aha! moment for the libertarian Ayn Rand Institute, and who is deserving of them. These details miss the big picture of the urgency of a second round of stimulus, without which the economy could enter a death spiral.

What about the Fed? Can’t the Fed step in and play a role? This NY Times account of the Fed’s troubled Main Street lending program which had little take-up from small and medium business borrowers is a cautionary tale of dysfunctional bickering bureaucratic institutions.

The central bank and the Treasury, which is providing money to cover any loans that go bad, spent months devising the program, negotiating over credit risk and vetting terms. Many officials within the Fed wanted to create a program that businesses would actually use, but some at Treasury saw the program as more of an absolute backstop for firms that were out of options. Steven Mnuchin, the Treasury secretary, has resisted taking on too much risk, saying at one point that he did not want to lose money on the programs as a base case.

What has emerged after three months, two overhauls and more than 2,000 comments filed with the Fed is a program that seems to be incapable of pleasing much of anyone.

The latest update from CNBC indicates that the Trump administration favors a reduced and targeted fiscal stimulus package.

As the end of July draws closer, tens of millions of Americans are set to lose the $600 a week in federal unemployment benefits meant to tide them over during the coronavirus pandemic. Though some lawmakers have suggested the benefits could be extended, they likely will not be as generous in the next stimulus package, according to Treasury Secretary Steve Mnuchin.

In the next stimulus package, the Trump administration wants to cap the benefits so that workers don’t receive more in unemployment than they did at their jobs, Mnuchin said Thursday on CNBC. With the extra $600 per week, an estimated two-thirds of displaced workers are eligible for benefits in excess of their normal wages, according to a recent paper from the National Bureau of Economic Research.

This means extended unemployment insurance, but at a lower $200-$300 level; another $600 style stimulus payment, also at a lower level; some state and local government aid; and some small business aid. Whether House Democrats can agree to such a package is anyone’s guess, as both sides will undoubtedly be jockeying for political advantage this close to an election.

As Congress grapples with what will be in the next relief package, CNBC reported that almost 32% of households missed their July housing payments, and eviction moratoriums are either set to expire or have expired about now. Tens of millions of households are facing an imminent income cliff.

The idea of creating incentives for people to return to work in the face of weak demand, or to force people to work in the face of a local pandemic wave will be disastrous health policy and further tank the economy. Congress has 10 legislative days left before households go over the income cliff. No pressure at all.
 

The week ahead

Looking to the week ahead, I continue to have a slight bearish bias. II sentiment has normalized, and readings have returned to levels just before the COVID Crash, which makes the market vulnerable to a downdraft.
 

 

The Citigroup Panic/Euphoria Model remains in euphoric territory, which is intermediate-term bearish but tells us nothing about the short run market outlook.
 

 

The NYSE Summation Index (NYSI) has rolled over from an overbought reading after bouncing from a deeply oversold condition in March. This is a rare condition that has occurred only three times in the last 20 years, and the market has weakened in two of the three. Even in the one episode in 2019 when stocks continued to advance, the index paused and pulled back briefly before resuming its advance.
 

 

Here is a close-up look at the relationship between the NYSI and S&P 500.
 

 

Let Q2 earnings season begin!
 

 

Disclosure: Long SPXU (daylight hours only)

 

Double bubble, double trouble?

Posted by Cam Hui -

When a stock market shifts from a bull to a bear market, leadership usually changes. Bear markets are often periods of catharsis. The old leaders get tired, and they have been bid up to excessive valuations. A reality check sets in and they fall. As the old leaders fail, new market leaders emerge to guide a new bull upward.

It is therefore with great interest that we have been monitoring the Big Three leadership themes in the US market, namely US over non-US, growth over value, and large caps over small caps. Of the three, growth continues to be extremely strong, US stocks have temporarily plateaued and they may be turning down, and small caps are resuming their underperformance after a brief three-month turnaround.
 

 

From a global perspective, the leadership mantle of US stocks is faltering. The following chart shows the returns of different regions relative to MSCI All-Country World Index (ACWI). All returns are in USD so currency effects are already included in performance. Within the US equity market, the S&P 500 is rolling over on a relative basis, but the NASDAQ 100 continues to soar. A look at the developed markets (middle panel) shows no sustainable trends. Japan has weakened after a short-lived rally, and Europe’s relative performance has chopped around for the past few months. It is the emerging markets (bottom panel) that has shown the greatest promise in leadership. While it is true that EM equities have soared in relative performance, EM xChina stocks are tracing out a constructive but unexciting saucer bottoming pattern. By inference, it is China that has become the global market leader.
 

 

If this is the start of a new bull, or a continuation of the old bull, can it rest on the narrow leadership of a handful of NASDAQ stocks and the Chinese market?

Is this just a double bubble, and does that imply double trouble ahead?
 

NASDAQ leads the way

Let’s begin by considering the internals of the US equity market. We all know by now how the FANG+ and NASDAQ 100 have been on a tear. Here is a recent heat map of the S&P 500, with individual boxes sized by weightings. Notice anything about the biggest stocks that dominate the index?
 

 

Once we exclude the NASDAQ leaders, things don’t look as exciting. As the chart below shows, the S&P 500 is trying to stage a bullish impulse after a bearish island reversal after successfully testing its 200 day moving average (dma). However, a glance under the hood of broad market indices tell a story of weak participation. The equal-weighted S&P 500, the equal-weighted Value Line Geometric Index, the NYSE Composite, as well as the mid and small cap indices are all showing patterns of lower highs since early June. Some of these indices have exhibited bearish island reversals that have not not been challenged. All are trading below their 200 day moving averages.
 

 

I have voiced my concerns in these pages about the excessive valuation of the US equity market. Forward 12-month P/E ratios are in the nosebleed region of well over 20. Even if investors were to look over the 2020 earnings valley, the P/E ratio based on 2021 earnings is 19 or more.

Goldman Sachs recently performed some revealing analysis of stock market valuation by quintile. The valuation of the cheapest quintile is only average, or not excessive, but the market’s high market valuation is mainly attributable to the sky-high multiples posted by the most expensive quintile, which are mainly the NASDAQ names.
 

 

If the US market is being held up by the FANG+ and NASDAQ stocks, how long can this narrow leadership continue? Arguably, many of the shares of these companies have benefited from the pandemic as the recent “staying in” theme.
 

 

FT Alphaville recently offered a perspective on “staying in” theme by focusing on cloud computing, or SaaS (Software as a Service) companies. Among the leaders in this group are Zoom Video and Shopify, which trade at sales multiples of 30 or more.

It’s important to note that some of the valuation premiums for these companies is justified. The idea is that once these businesses have established themselves as an intrinsic part of a company’s enterprise software stack, they can effectively extract rents from their customers — either through price increases or cross-selling. All, we should add, at an almost zero marginal cost. Theoretically, these economics should make the businesses extremely cash-generative, and capital-light, once they have fully matured.

These companies must be enjoying terrific sales growth in the current environment, right? Don’t be so sure. The FT Alphaville article cited a Morgan Stanley survey of CIOs about their SaaS spending expectations. The expected spending growth in 2020 is a measly 2.8%. Does that sound like the sort of growth that would drive stratospheric valuations?
 

 

While the fundamentals argue for a pause, the long-term technical picture is signaling a possible continuation of the NASDAQ frenzy. Consider two extremes of the current market leadership, namely growth (NASDAQ) and small cap stocks. The small cap to NASDAQ ratio is falling again after a brief recovery. We saw a similar episode in 1999 when the ratio became extremely oversold on a 14-week RSI and recycled. Then the ratio resumed its decline until the ultimate bottom in March 2000. If that incident is any guide, the analogous moment today is only mid-1999.
 

 

China’s “I can’t lose” melt-up

Over on the other side of the world, China’s stock market has gone parabolic. Bloomberg documented the “I can’t lose” mentality among retail traders.

Like millions of amateur investors across China, Min Hang has become infatuated with the country’s surging stock market.

“There’s no way I can lose,” said the 36-year-old, who works at a technology startup and opened her first trading account in Beijing on Tuesday. “Right now, I’m feeling invincible.”

Five years after China’s last big equity boom ended in tears, signs of euphoria among the nation’s investing masses are popping up everywhere. Turnover has soared, margin debt has risen at the fastest pace since 2015 and online trading platforms have struggled to keep up. Over the past eight days alone, Chinese stocks have added more than $1 trillion of value — far outpacing gains in every other market worldwide.

While it would be easy to dismiss as a replay of this year’s Robinhood rally in the U.S., China’s budding equity mania could in many ways be more consequential. Unlike in most major markets, the nation’s individual investors account for the lion’s share of local stock trading and have been prone to extreme swings in sentiment that can have ripple effects on the economy and monetary policy.

For now, indicators of market overheating are still comfortably below levels reached during the height of equity bubbles in 2007 and 2015. The risk is that breakneck gains — stoked in recent days by bullish articles in state-run media — could eventually result in a destabilizing crash.

Indeed, the Shanghai Composite went vertical until Friday, when two state-owned funds began selling to signal that the rally was overdone. Regardless, the Chinese market’s advance began well before last week’s frenzy. A glance at the stock markets of China’s major Asian trading partners shows that the nearby Hong Kong market has also staged a strong rally, and so has Taiwan, but that’s mainly attributable to the strength of the semiconductor group. The charts of the other markets, such as South Korea, Singapore, and Australia, appear to be less exciting.
 

 

How sustainable is the Chinese market rally? John Authers at Bloomberg offered the following “glass half full” perspective.

The best guess is that China has pressed the pedal on expanding credit once more, but not by using orthodox monetary policy and not in a way that weakens the currency. The following chart, from CrossBorder Capital LLC of London tells the story of the remarkable expansion of Chinese credit over the last quarter of a century as well as anything:

The stimulus applied by Shanghai’s big equity bubble in 2007, and then by the huge extra spending and credit easing that started in late 2008 to deal with the last global financial crisis, was on a different scale from the stimulus that is now being applied. Much of that was achieved via shadow banks, shown by the yellow line, whose opaque structures led to concerns that China could stage its own repeat of the Lehman crisis. The People’s Bank of China has spent the last few years in an explicit attempt to avert this risk, and now appears to have shadow banking under control. That has allowed them to unleash a 20% increase in liquidity, through traditional banks and through the bond and equity markets.

For the short term, this can only be positive. Questions will rightly continue about whether the Chinese regime, attempting to use a communist command structure to regulate a capitalist economy, can possibly endure. It is only a few months since the Communist Party’s inadequate response to the early stages of the pandemic appeared to be heralding major change. But for the short term, China appears to have been able to right its ship, and to find the money to keep its economy nicely afloat.

 

 

Greg Ip at the WSJ offered the following “glass half empty” perspective, based on the recent book by Matthew Klein and Michael Pettis, Trade Wars are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace.

Like South Korea and Japan before it, China grew rapidly by channeling its people’s savings into high-return investments in education, public infrastructure and export-oriented industries. It did so through an undervalued exchange rate and a financial system that subsidized industrial borrowers by paying savers next to nothing. Both have been reformed, but Messrs. Klein and Pettis note that many features of China’s economy still discriminate against workers and consumers: adversarial unions are illegal, taxes on labor and consumption are high, and millions of migrant workers are deprived of social benefits for lack of residential permits.

By definition, surpluses in one country must equal deficits in another, so the trade surpluses generated by China and Germany force the U.S. (and other low-saving countries such as the U.K.) to run deficits. Trade deficits don’t necessarily reduce employment, but they change its composition. In the 2000s, Chinese imports wiped out millions of U.S. jobs while Chinese savings helped inflate the housing bubble. In that sense, Messrs. Klein and Pettis write, inequality in China contributed to inequality in the U.S.

The authorities in Beijing implemented policies that suppress consumption and encouraged savings and investment. The savings and investment went into infrastructure and export industries, which channeled goods to import hungry markets like the US. The gains from the excess investments accrued to those who engineered the globalization and export boom, namely the top tier of Chinese and American society. The exports devastated manufacturing in the developed markets. Klein and Pettis concluded that Chinese inequality contributed to American inequality and those effects persists today. China’s household consumption rate is lower than it was when it entered the WTO.
 

 

Enter the pandemic. How have events developed since then? Not good.

But events are now going in the wrong direction. Through May, Chinese purchases of U.S. goods are running at just half its commitment, according to Chad Bown of the Peterson Institute for International Economics.

Spending by Chinese tourists abroad, which had offset some of the goods trade surplus, has been shut down by the pandemic. Its manufacturing has recovered faster than retail sales, suggesting surpluses are about to re-emerge. Yet the world is in no mood to absorb China’s production glut: demand is depressed everywhere. These are the ingredients of a global fight for market share fueled by protectionism and currency devaluation.

The bounce back in China was sparked by an official decision to ramp up manufacturing at the expense of consumption. With the global economy in a pandemic-induced slowdown, there is little demand for Chinese exports, and the household sector is not in a position to support economic growth. Ip concluded.

The root cause of the U.S.-China trade war is Chinese under-consumption which leads to Chinese trade surpluses. Those imbalances aren’t going away, and so risk of trade wars won’t, either.

In the meantime, China’s Great Ball of Liquidity has rolled into the local stock market, and they’re having a party on the local exchanges. The market looks technically extended in the short run. Despite Friday’s short-term cautionary signal, these bull runs can last longer than anyone expects, especially if there is official policy support.
 

 

Should traders fade China’s market rally or is it the start of a sustainable upturn? History offers uncertain clues. The Chinese stock market saw a melt-up in 2014-15. Other regional stock markets participated in that rally, though the magnitude was different. This time, while the Shanghai Composite has staged an upside breakout, the technical conditions of the other markets are less supportive of a broad based rally.
 

 

The tension between Bob Farrell’s Rules

Where does that leave us? I have no idea. What I do know is global stock market leadership has increasingly become narrow. It consists of a handful of NASDAQ stocks and a frenzied FOMO stampede in China. I am torn between Bob Farrell’s Rule No. 4:

Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

And Rule No. 7.

Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

Investors need to be aware of the tension between Rule No. 4, which raises the possibility of a stock bubble, and the risks posed by the narrow leadership warned by Rule No. 7. Tail-risk is high in both directions. In this environment, it is worthwhile to return to basics and revisit investment objectives and risk tolerances in order to balance risk and reward. There are no perfect answers, and each will be different.

Regardless of which direction the market takes, investor can count on a climate of high volatility for the rest of 2020.

 

My inner trader returns to the drawing board

Posted by Cam Hui -

Mid-week market update: To paraphrase Emperor Hirohito when he broadcast the Japan’s decision to surrender in World War II to the nation, “My inner trader’s returns have not necessarily developed to his advantage in 2020”. While the trading system was correct in spotting the major downdraft this year and the initial recovery, it was wrong to stay short as the market rallied.
 

 

With that in mind, he has gone back to the drawing board and analyzed the three key elements of the current market.

  • Conventional macro, fundamental, and technical analysis.
  • The bull case, based on a flood of central bank liquidity, and skeptical sentiment.
  • An analysis of how market regimes shift, and what to do going forward.

 

Conventional analysis

Here is how conventional analysis has played out. I don’t want to sound like a broken record, so I’ll just summarize my views. It’s difficult to believe that the stock market could just stage a brief sharp pullback and recover so quickly in the face of the second worse recession of the last 100 years. By many measures, the magnitude of the Covid Crash on the economy has only been exceeded by the Great Depression.
 

 

I have voiced my concern about equity valuation for some time. While stock prices are less predictable in the short run, the long-term equity outlook appears dismal owing to the stratospheric forward P/E ratio. Even if investors were to look ahead to 2021, the FY2 P/E ratio is about 19, and could be in the 20-21 range if Biden were to win in November and enacts his tax proposals (see Fun with technical analysis on the 4th of July).
 

 

In the short run, the trajectory of the recovery is also stalling. High frequency economy numbers are pointing to a plateau and retreat of the recent economic recovery (see Why there is no V).

Market sentiment looks stretched. One example often cited is the extreme low in the equity-only put/call ratio (CPCE). Equity options are mainly used by individual stock traders to take positions (dumb money), while index options are mainly used by professionals to hedge their positions (smart money). The spread between CPCE and the index put/call ratio (CPCI) is another warning sign for equity prices. Past episodes of similar extreme readings have seen stock prices either stall or correct.
 

 

Implied volatility is elevated despite the recent stock market rally. Goldman Sachs documented a disturbing divergence between the VIX Index and past returns. The high level of the VIX either makes the market vulnerable to a pullback, or a volatility spike. To be sure, rising volatility can be bullish. Stock prices can either crash or surge higher. Keep in mind, though, that stocks are historically inversely correlated with the VIX, and rising VIX usually means lower stock prices.
 

 

The Fed bubble

The bullish view is anchored by the belief that central bank liquidity is propelling stock prices upward. Famed hedge fund manager Stan Druckenmiller recently said that he was humbled by the market. He turned bullish and explained that he had underestimated the impact of the Fed’s flood of liquidity on the market. What is less known is how Druckenmiller learned his trading process from his first mentor, Speros Drelles.

I recently wrote about the “wisdom of the crowds” in Fun with technical analysis on the 4th of July. There is a second level to that story about the independence of views in the crowd, and herding.

  • A diverse crowd will always predict more accurately than any individual.
  • A crowd is usually smarter than even the best analyst.
  • But the crowd’s predictive ability depends on the diversity of views.

Drelles taught Druckenmiller that traders should be trend followers when there’s a lot of disbelief about the trend, and contrarian when the trend becomes the consensus view. That’s where the art and the science of trading comes in. Mechanical trading systems only gets you so far.

Are we near such an inflection point in sentiment? Strategist Ed Yardeni recently threw in the towel on valuation as a metric:

From February to the end of June, total assets held by the three major central banks (ECB, Fed, BOJ) soared $5.6 trillion to a record $20.1 trillion — with the Fed now holding over $7 trillion, data from Yardeni Research show. …. The big picture: Value metrics like P/E ratios must be re-evaluated in light of the current situation, Ed Yardeni, president and chief investment strategist of Yardeni Research, writes in a note to clients. “What should the forward P/E of the S&P 500 be when the federal funds rate is zero, the 10-year US Treasury bond yield is below 1.00%, and the Fed is providing plenty of liquidity to facilitate the resulting rebalancing from bonds to stocks?”

This quote is from our Morning Briefing today, which concluded: “Notice that we didn’t ask what the ‘fair value’ of the forward P/E is, which would imply that the market operates freely enough—unaffected by Fed interventions—to determine that value. Clearly, that’s no longer the case. Frankly, we don’t know the answer to this question, since there is no precedent for the current situation. However, we do know that prior to the GVC, we all thought that the S&P 500’s fair-value P/E was around 15.0. Could it be double that now? Maybe.”

You tell me. If this is a late 1990’s style market bubble, then Mark Hulbert believes that sentiment is far from irrationally exuberant. In a WSJ opinion piece, Hulbert came to that conclusion by citing the work of Malcolm Baker, of Harvard Business School, and Jeffrey Wurgler, of New York University. The academics analyzed these factors for signs of irrational exuberance.

  • The low number of IPOs, and the low level of first day IPO returns;
  • The low level of equity funding activity compared to borrowing, as bubble style valuations would encourage companies to tap the markets for cheap equity funding;
  • The valuation spread between dividend paying (mature) companies, and non-dividend payers; and
  • The low average closed-end fund discounts to NAV.

Based on these metrics, Hulbert concluded that today’s market mood is nowhere near the giddiness of the dot-com era. If this is the start of a bubble, then the bull has a long way to run.

On the other hand, Bloomberg reported that long/short hedge funds are closing their doors because the short side isn’t generating alpha, and it’s creating an existential crisis for hedge fund managers.

The closures reinforce the bruising reality that such funds have captured most of the market’s downside in recent years, but very little of the upside. They also beg the question: If the arrival of a deadly pandemic that’s pummeled the world’s economies can’t work in short-sellers’ favor, then what can?

“The existential crisis is real,” said Andrew Beer, founder of New York-based Dynamic Beta investments. “This is not a new phenomenon, but has gotten worse over time. When markets go down, hedge fund stocks go down more.”

This sounds like capitulation by the short-selling crowd that marks the end of an advance.
 

A new framework

These contrasting views begs the question of whether an investor should adhere to the traditional conventional style of analysis and exercise caution, or jump into equities with both feet because of the global central bank put is creating a market bubble.

My tactical trading analysis yielded an important insight. I noticed that the most of the market gains came from overnight market, which was painful when my trading account was short and could not react. This is an indication that the market was moving on news that hit the tape after the market close. I went on to study how the market performed during daylight hours when the market was open, and the overnight market, from the close to next day’s open.

The results were remarkable. Most of the gains from the stock market’s rally since the March bottom came in the overnight session (black line), while the daylight sessions (blue line) were mostly flat. In addition, the market has gone through several periods where the overnight to day ratio (grey line) had trended up, which I characterize as jittery markets driven by unpredictable news. Past breaks in this ratio saw a marked change in market behavior. The market changed from either a falling or sideways market to one that trended upwards. In the most current instance, the market is trending up, and I would expect a ratio trend break to signal a change to either a corrective or a sideways and choppy consolidation.

Equally remarkable are the characteristics of the market since the March bottom. The percentage of days that the market was positive was identical at 55.9%, but the average and median returns of the overnight sessions beat the daylight sessions.
 

 

I conclude that my inner trader needs to focus on regime change dynamics by watching for a break in the uptrend in the overnight to daylight ratio.

When I focus on trading performance, the recent uptrend in the overnight to day ratio coincided with the return drawdown. The trading systems was affected mainly by overnight news to which the system was unable to react.
 

 

While this is not meant to be an excuse, or one of those backtests that work well in the lab but not necessarily in real life, this chart illustrates what would have happened had the same trading signals been only applied to the daylight hours, and the trading system went flat to cash overnight. This is meant purely as a proof of concept of my regime change analysis. The trading system would have been choppy but flat during this period, compared to the skid had it held the mainly short positions in both daylight and overnight sessions.
 

 

What’s next?

So what are the takeaways and action items in light of this analysis?

First, the market has undergone a regime change since the March bottom as it has become extremely headline sensitive. After-hour news events have moved the markets overnight, and the overnight e-mini futures are thin, and may be problematical to trade for some participants. Good investors and traders don’t get better without acquiring scars. This latest drawdown is the scar tissue that helps me improve my investment and trading process.

This regime shift creates a dilemma for my inner trader on how to trade this market. It’s one thing to attribute lack of performance to a regime shift, it’s another to create a rule, or a set of rules, on how to react to the change, and when to change back.

One course of action is to step to the sidelines until the overnight to day rising trend breaks down. That would be an advisable course of action for many who follow my inner trader’s signals.

The other course of action is to continue trading, but only follow the trading signals during daylight hours. This means closing out the position at the close, re-entering the position at the open, and staying in cash in the overnight session. This approach involves high trading costs. The biggest component of trading cost is the uncertain execution slippage, defined as the difference between actual price executed and the reported opening and closing prices, as well as commission costs. For measurement purposes, I will begin to report my inner trader’s trading starting tomorrow (July 9, 2020) until it is evident that the market regime has returned to normal.

Tactically, I am inclined to maintain my short trading position (during daylight hours) and put a stop loss order just above the top of the island, as per the primer outlined in An island reversal update.
 

 

Good luck, everyone.

Disclosure: Long SPXU (daylight hours only)

 

Why there is no V

Posted by Cam Hui -

The market has been getting excited by the prospect of a V-shaped recovery. It points to data such as the ISM Manufacturing PMI, which rose from 43.1 in May to 52.6 in June, indicating expansion. The employment index improved from 32.1 to 42.1, and the new orders index increased from 31.8 to 56.4..
 

 

While those are positive developments, this is not indicative of a V-shaped rebound. PMIs are designed to measure month-to-month changes. The economy is still in a big hole it’s trying to dig out of, and there are signs the recovery is stalling.
 

June Employment Report

Let’s begin by analyzing the June Employment Report. The economy added 4.8 million jobs, which was well ahead of expectations. In addition, the diffusion index spiked, indicating a broad rebound. That’s good news.
 

 

The picture looks far less rosy beneath the surface. Here are the good, the bad, and the ugly parts of the report.

  • Good: Low-wage positions like retail and leisure and hospitality, were devastated by the shutdown, and they have bounced back strongly.
  • Bad: The high-wage white collar job recovery is stagnant.
  • Ugly: Government job growth skidded during the pandemic, and state and local governments are facing urgent budget pressures. Without federal aid, there will be another wave of layoffs in that sector.

 

 

The story is the same within the blue and pink collar job sector. Low paying retail jobs have bounced back nicely. The rebound in high paying manufacturing jobs has been less strong, and transportation and warehousing job growth is stagnant.
 

 

So far, the jobs recovery can be seen in the reversal of temporary furloughs. The unfortunate news is the number of permanent jobs lost.
 

 

The V-shaped recovery can only be found in low-wage positions. The rest of the jobs market faces a far cloudier outlook.
 

The consumer pulls back

The June Employment Report is a snapshot of the economy in mid-June. High frequency data since then has shown a stalling in consumer activity. Morning Consult reported that consumer confidence is starting to roll over. The weakness began just after mid-June, which was just after the data date of the Employment Report.
 

 

The ECRI Weekly Leading Index has flattened out in the last two weeks.
 

 

As well, Chase reported that consumer card spending is also weakening.
 

 

Blame the pandemic

The slowdown is probably related to a rise in COVID-19 cases in the US south and southwest. Mobility is slowing in the states showing high case growth rates.
 

 

The surge in case counts in a number of states is well-known.
 

 

Deaths have not risen so far, which is attributable to a number of reasons. First, young people are being infected, and they tend not to be as vulnerable as the older population, which was the group that was the most affected initially. There is also a lag in the data. The sequence of reports is case count, followed by hospitalization, and deaths. The lag between case count and death is roughly four weeks. Hospitalizations exacerbate the fatality rate, because hospitalization is a signal that a case is serious, and at risk of death or serious complications. However, there is no national database of hospitalizations, and some states, like Florida, do not report hospitalization. Nevertheless, hospitalization rates are rising, with Texas and Arizona being the most seriously affected states.
 

 

The death rate has not risen for now. If the lagged sequence of case count, hospitalization, and death were to hold, the daily fatality rate in the key states is expected to rise to 1,000 per day or more by late July.
 

 

Regardless of what happens with the virus, the high frequency data shows that the consumer is already reacting with greater caution. State and local authorities are also reacting to the rising infection rates with new edicts. Texas is the first state to re-impose a lockdown after reopening its economy. The mayor of Jacksonville, Florida, began requiring face masks to be worn in public last week, and the measure could jeopardize the Republican National Convention, which is scheduled for August 24-27 in that city.

Forget about the V. Business Insider reported that Christophe Barraud, who was ranked by Bloomberg as the most accurate forecaster of US economic data eight years in a row, said the US won’t return to its fourth quarter 2019 real GDP level until at least 2022. For some European countries, a recovery won’t happen until 2023.
 

Investment implications

Looking ahead, the trajectory of stock prices will depend mainly on investor reaction to the Q2 earnings season, and the official policy response.

As we enter the Q2 earnings season, companies will undoubtedly discuss their near-term outlook. The latest update from FactSet shows that the Street is lower near-term 2020 estimates, while raising longer term 2021 estimates. Much will depend on the companies’ body language this earnings season, though an extraordinary number of withdrawn guidance owing to high levels of uncertainty.

The Transcript, which monitors earnings calls, gives us an early glimpse of the tone of Q2 earnings reports. The latest update shows reports of a rebounding economy combined with nervousness from executives about rising virus cases in some states and countries.
 

 

Policy response has several elements: fiscal policy, monetary policy, and health care policy. The economy has been supported by what amounts to “battlefield surgery” fiscal support, which runs out at the end of July. It is clear the economy needs further support beyond July, but it is unclear whether the Republicans and Democrats can agree on a second rescue package so close to an election.
 

 

The June FOMC minutes gave the market some direction on the path of monetary policy. The Fed is clearly concerned about the pandemic response, and it stands ready to act.

Participants all agreed that the effects of the pandemic would weigh on economic activity in the near term and that the duration of this period of weakness was uncertain. They further concurred that the unpredictable effects of the coronavirus outbreak were a source of major downside risks to the economic outlook…Participants stressed that measures taken in the areas of health care policy and fiscal policy, together with actions by the private sector, would be important in shaping the timing and speed of the U.S. economy’s return to normal conditions. Participants agreed that the Federal Reserve’s efforts to relieve stress in financial markets would help limit downside near-term outcomes by supporting credit flows to households and businesses, and that a more accommodative monetary policy stance would provide support to economic activity beyond the near term.

The effectiveness of the Fed’s response is in the eyes of the beholder. The Fed’s balance sheet shrank for a third week in a row. The reduction in the first two weeks was mainly attributable to the unwind of USD swap lines with foreign central banks, and the latest decline can be traced to a reduction of bank repos that injected liquidity into the banking system. The repo unwind should continue for a few more weeks. The Fed is continuing its purchase of Treasuries and other fixed income instruments during this time.

There has been an apparent near-term correlation between stock prices and the size of the Fed’s balance sheet. Arguably, the recent stall in the market can be explained by a rollover in balance sheet size. On the other hand, the size of the Fed’s balance sheet had flattened and began to fall in 2017, and stock prices continued to rise.
 

 

As for health care policy, NBC News reported that the White House is pivoting to a “learn to live with it” message in battling the virus:

At the crux of the message, officials said, is a recognition by the White House that the virus is not going away any time soon — and will be around through the November election.

As a result, President Donald Trump’s top advisers plan to argue, the country must figure out how to press forward despite it. Therapeutic drugs will be showcased as a key component for doing that and the White House will increasingly emphasize the relatively low risk most Americans have of dying from the virus, officials said.

However, there is some hope on the therapeutics front.

Next week administration officials plan to promote a new study they say shows promising results on therapeutics, the officials said. They wouldn’t describe the study in any further detail because, they said, its disclosure would be “market-moving.”

Stay tuned for the new “market moving” announcement. Will it be any more than a one-day wonder, or will it have a sustained effect on the outlook?

Trading note: The market has been strong today owing to a melt-up in the Chinese markets. I am conducting a more detailed analysis of the trading framework, which I will publish in the next one or two days.
 

Can the bulls breach the island’s moat?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

The moat around the island

I have been highlighting in these pages the bearish island reversal which formed in mid-July. Although stock prices haven’t fallen significantly, the bulls have been unable to breach the gap that defines the island reversal. Conversely, past market advances since the downside break from the island has stalled at resistance at about 3150-3160.
 

 

Is there a moat around the island?
 

A NASDAQ stall?

The intermediate term internals continue to tilt bearishly. Let’s begin with the NASDAQ, which achieved all-time highs on Thursday. However, the fresh highs were accompanied by negative 5 and 14 day RSI divergences, as well as negative divergences from the percentage of NASDAQ 100 stocks above their 50 and 200 day moving averages. That said, these negative divergences are not necessarily actionable trading signals, as they can persist for some time before the market turns down. What they do show is that the intermediate term outlook is not favorable for the bulls.
 

 

Similarly, the relative performance of NDX to SPX is also exhibiting a negative RSI divergence.
 

 

Macro Charts voiced a similar warning on the NASDAQ. Stay cautious, but wait for the downside break before turning too bearish.
 

 

A long-term monthly chart of the NASDAQ 100 reveals that the index is testing a key rising trend line. The advance is likely to stall despite the bullish development of the latest new highs.
 

 

Trouble under the hood

If we were to move beyond the NASDAQ leaders, the chart patterns of mid and small cap stocks are cause for concern. The chart below shows the S&P 500, the equal-weighted S&P 500, the Midcap S&P 400, and the Small cap S&P 600. Three interesting patterns emerge from this analysis.

  • All indices, except for the equal-weighted S&P 500, show a bearish island reversal.
  • All of other indices show a pattern of lower highs even as the large cap S&P 500 rallied up to test resistance at 3150-3160.
  • All of the other indices are below their 200 dma, while the large cap S&P 500 is holding above its 200 dma.

 

 

The pattern of lower lows and lower highs in the percentage of stocks above their 50 dma is another worrisome sign.
 

 

These are all signs of trouble under the hood, but they are only warning signs that will stay “under the hood” until the bears can muster a downside break in the major market indices.
 

Top of the range

Short term breadth is overbought and the market is due for a pullback. The confluence of bearish intermediate term internals and overbought readings argue for a range-bound market, where we are at the top of the range.
 

 

The stock exchange was closed on Friday July 3, but the futures market was open. Equity futures closed Friday in the red. While the after-hour futures is thin, Friday’s market action is nevertheless an indication that the bulls failed yet once again at a key resistance level.
 

 

My inner investor remains neutrally positioned at the asset allocation targets specified by investment policy. While he is cautious for fundamental and valuation reasons, he is mindful of the possibility that we are witnessing the start of a market bubble that could take stock prices to heights that he hasn’t imagined.

My inner trader is bearishly positioned. His base case scenario is the market will stay between 3010-3020 on the downside and 3150-3160 on the upside. Until the market breaks out from that range, he will endeavor to buy the dips and sell the rips.

Disclosure: Long SPXU

 

Fun with technical analysis on the 4th of July

Posted by Cam Hui -

On this 4th of July Independence Day weekend, let’s try a change of pace and indulge in some technical analysis of a different sort. The behavioral finance basis for technical analysis is the wisdom of the crowds.

Francis Galton observed a competition at a local fair in 1906 where about 800 people tried to guess the weight of an ox. To Galton’s surprise, the average of all the guesses was 1,197 lbs. The actual weight came in at 1,198 lbs. Other studies have confirmed that a diverse crowd is better at estimates than any single expert.

This adage, “the wisdom of the crowds” is really another formulation of the Efficient Market Hypothesis, in which it is difficult for any single analyst to gain a consistent edge. Technical analysis is one way of listening to the markets, and applying its message to understand what the market is discounting.

With that preface in mind, consider this mystery chart. Would you buy, hold, or sell this security?
 

 

The mystery chart is the price chart of the Trump contract on PredictIt, which pays off at $1 if Trump were to win the election in November. The contract exhibited several support violations on high volume, which are worrisome signs for Trump bulls. As always, this analysis is not intended to be an endorsement of any candidate or political party, only to estimate the market effects of an electoral outcome.

For completeness, here is the Biden contract, which has staged multiple upside breakouts on strong volume, indicating conviction. That’s why my base case scenario increasingly tilts towards a Biden victory in November, which has important implications for equity investors.
 

 

I conclude that the market has not fully discounted the prospect of a Biden win just yet. If and when it does, it may act to de-rate equities based on the prospect of a lower 2021 earnings outlook. A Biden victory will mean a 6-12% fall in 2021 earnings, which translates to a 6-12% decline in stock prices if P/E multiples stay the same. Should the market see P/E compression from the current lofty levels, downside risk could be considerably higher.
 

A referendum on Trump

A recent Pew Research poll is highly revealing about the internals of the race. Instead of the usual “horse race” asking respondents who they would vote for, the poll probed voter attitudes about each candidate. What is clear is that the race is becoming a referendum on Trump. Prospective Trump voters are mainly voting for Trump, while prospective Biden voters are voting against Trump, and not for Biden.
 

 

Even though the election is four months away, and four months is a long time in politics, Trump’s electoral problems seem intractable compared to 2016. Here is how Trump won in the last election. Even though he lost the popular vote to Hillary Clinton, he won enough of a plurality in a handful of swing states to eke out a path to the White House.

The 2016 election was highly unusual inasmuch as both major candidates had high negative ratings. Voters viewed both Trump and Clinton more negatively than positively. Trump waged a masterful campaign to drive up Clinton’s negatives, and to encourage defections to third-party candidates. As the consensus was a Clinton win, there were sufficient voters who dislike her sufficiently to cast protest votes for the likes of Green Party candidate Jill Stein that Trump was able to gain a plurality in key battleground states.

Fast forward to 2020. The polling data shows that Biden voters are voting against Trump, instead of for Biden. Trump is entering this election with high negative support, while Biden’s ratings are slightly positive. Here are the ways that Trump can find a path to victory.

  • Energize the base (not sure how much more juice there is left in that lemon).
  • Drive up Biden’s negatives.
  • Change the focus from a referendum on Trump.
  • Encourage the emergence of a third-party candidate.

Another headwind is the Never Trump contingent within the Republican Party have become far more vocal in its opposition. Reuters reported that former George W. Bush officials have formed a Political Action Committee to raise funds to elect Biden, though the former president is not involved in the campaign.

Hundreds of officials who worked for former Republican President George W. Bush are set to endorse Democratic White House hopeful Joe Biden, people involved in the effort said, the latest Republican-led group coming out to oppose the re-election of Donald Trump.

The officials, who include Cabinet secretaries and other senior people in the Bush administration, have formed a political action committee – 43 Alumni for Biden – to support the former vice president in his Nov. 3 race, three organizers of the group told Reuters. Bush was the country’s 43rd president.

As well, a group of Republicans at the Lincoln Project have been running anti-Trump ads in key battleground states. If you haven’t seen them, check out their YouTube lineup of ads to see how they are driving up Trump’s negatives.

To be sure, the Trump campaign still has a funding advantage. Despite the news that the Biden and Democrats had better fundraising success than Trump and the Republicans for both the months of May and June, the Trump-RNC fund reported $295 million in its account at Q2. The Biden-DNC campaign did not report its cash for June yet, but it had about $122 million at the end of May.

While nothing is impossible, those are indeed formidable challenges for the Trump campaign. The Pew Research poll asked respondents what soured voters on Trump. The disapproval ratings on Trump rose for people who are younger, have lower income, and more likely to live in areas most affected by COVID-19. He has to improve his performance in those areas, especially among the key low-income demographic and in the COVID-19 regions.
 

 

As well, Trump’s falling poll numbers are likely to affect the Republicans down ballot too. The consensus is the Democrats will retain control of the House, but the real battle will be the Senate. Biden needs to control both chambers of Congress to push through his programs should he win in November. The Pew Research poll shows that approval among Republican supporters is tanking, which is an ominous sign for GOP Senators in November.
 

 

The PredictIt odds for Senate control has been steadily rising for the Democrats. While the price action is not as definitive as the Biden contract, this contract did stage an upside breakout on strong volume.
 

 

These results call for a base case scenario of a Biden win, accompanied by a Blue Wave where the Democrats take both the House and Senate in November.
 

Investment implications

Here are the investment implications for equity investors. In the past, the market performs much better if the incumbent wins, compared to if the incumbent loses the election. With Biden starting to pull away in the polls, will the market start to follow the incumbent loss pattern in 2020?
 

 

I reiterate my conclusions in my past publication (see What would a Biden Presidency look like?).

A Biden victory is expected to be a net mild negative for equity prices. Much depends on the degree of control by the Democrats should Biden win the White House. The chance of a Blue Wave sweep is possible, and it would embolden the progressives within the Democratic Party to steer policy further to the left with bearish consequences for the suppliers of capital.

The most immediate effect of a Biden win would see higher taxes. Expect a higher corporate tax rate, and the imposition of a minimum corporate tax. As well, the top rate is expected to rise, and so will the capital gains and dividend tax rates. High income earners will also face higher social security taxes.

The market will focus mainly on those immediate negative factors. Consensus bottom-up 2021 earnings currently stand at $163.39. Unwinding the 2017 tax cuts would reduce about $10 off 2021 earnings, and second-order effects of potential Biden proposals, such as the corporate minimum tax, changes to the global intangibles tax, and so on, could reduce 2021 earnings by another $10. This translates to a 2021 P/E ratio of 20.5 to 22.0, which are stratospheric for FY2 P/E multiples.
 

 

From a practical perspective, the immediate effect of a Biden victory will mean a 6-12% fall in 2021 earnings, which translates to a 6-12% decline in stock prices if P/E multiples stay the same. Should the market see P/E compression from the current lofty levels, downside risk could be considerably higher.

To be sure, there will be long-term positive effects of the Democrats’ re-distribution policies. We have the results of a real-time experiment of fiscal support and re-distribution policies. When the CARES Act gave households a flat dollar amount, the spending recovery rose faster for low-income households than high-income households. That’s because lower-income workers have a higher propensity to spend extra income, while higher income workers have a lower propensity to spend and a higher propensity to save and invest the government’s fiscal support.
 

 

Over time, re-distribution should lead to higher GDP growth, though that may not necessarily be bullish for equities. Other government measures, such as higher tax rates, re-regulation, and labor friendly legislation like a higher minimum wage are likely to squeeze profit margins. Wage growth has not kept pace with productivity gains since 1970, and much of the excess gains have gone to the suppliers of capital. Expect the returns to capital to fall, and returns to labor to rise under a Democrat-led administration.
 

 

What to watch

Here is what to watch for over the next four months.

  • How are the political odds evolving on betting sites like PredictIt and UK based sites like Betfair?
  • Can health policy bring the pandemic under control? Will there be an effective vaccine before year-end?
  • Who will Biden pick as his vice-president? Biden is view as dull by most voters. The right VP candidate can act to energize the Democratic base.
  • Can Trump either drive up Biden’s negatives, or drive up his own positives?

The market has not fully discounted the prospect of a Biden win just yet. If and when it does, it may act to de-rate equities based on the prospect of a lower 2021 earnings outlook. A Biden victory will mean a 6-12% fall in 2021 earnings, which translates to a 6-12% decline in stock prices if P/E multiples stay the same. Should the market see P/E compression from the current lofty levels, downside risk could be considerably more.

Don’t forget to stay tuned for our tactical market analysis to be published tomorrow.

 

A 2020 year

Posted by Cam Hui -

Mid-week market update: It is said that the adage “hindsight is 2020” may have been a garbled warning from a future time traveler. This year is certainly turning up like that.

The S&P 500 fell -20% in Q1 2020, and recovered 20% in Q2. It’s been that kind of year. Tactically, the index is backtesting the violation of the rising channel, but the bearish island reversal remains intact, and the market has been unable to breach the moat surround the island at about 3160.
 

 

To say that 2020 has been an unusual year is an understatement.
 

Wobbly internals

Market internals still look wobbly under the hood. Equity risk appetite, as measured by the high beta to low volatility ratio, and different versions of Advance-Decline breadth, are all showing lower highs, and, in some cases, lower lows.
 

 

Credit market risk appetite, as measured by high yield (junk) bond prices to duration-equivalent Treasuries, and by leveraged loans, are also exhibiting minor negative divergences. This is a somewhat surprising result in light of the Fed`s efforts to keep credit spreads from blowing out.
 

 

In addition, Troy Bombardia pointed out that SKEW is spiking, which may be a warning of heightened tail-risk going forward.
 

 

Volatility ahead

I interpret these conditions as warnings of rising uncertainty and likely volatility. Jerome Powell highlighted the high level of uncertainty about the future outlook in yesterday`s testimony to Congress [emphasis added].

While recent economic data offer some positive signs, we are keeping in mind that more than 20 million Americans have lost their jobs, and that the pain has not been evenly spread. The rise in joblessness has been especially severe for lower-wage workers, for women, and for African Americans and Hispanics. This reversal of economic fortune has caused a level of pain that is hard to capture in words as lives are upended amid great uncertainty about the future.

Output and employment remain far below their pre-pandemic levels. The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in containing the virus. A full recovery is unlikely until people are confident that it is safe to reengage in a broad range of activities.

As another measure of uncertainty leading up to Q2 earnings season, my former Merrill Lynch colleague and small cap specialist Satys Pradhuman observed that small cap earnings estimate dispersion has spiked, and readings are above the levels seen at extremes of the GFC.
 

 

At the same time, the VIX Index, as well as the term structure of the VIX, are relatively benign and show no signs of volatility fears.
 

 

Sideways consolidation

I wrote on the weekend (see A shallow or deep pullback?) that while I was tactically bearish, but I was keeping an open mind about the possibility of a sideways consolidation after the trend break of the rising channel. It appears that the market is resolving itself with a period of sideways choppiness.

Short-term breadth was already at overbought extremes based on Tuesday night’s closing prices. Despite today’s market advance, the roughly even balance between advances and declines is likely to slightly ease the overbought reading.
 

 

My inner investor remains neutrally positioned. My inner trader is still short the market. His base case scenario is now a range-bound consolidation, and he expects to cover his short if and when the market reaches the bottom of the recent range and becomes oversold.

Disclosure: Long SPXU

 

Q2 earnings preview: Flying blind

Posted by Cam Hui -

As Q2 earnings season is about to begin, it would be useful to assess the level of expectations going into reporting season, and the risks ahead. According to FactSet, forward 12-month EPS estimates have been bottoming and begun to turn up after a massive downdraft.
 

 

On the surface, this appears to be a constructive backdrop going into earnings season. While I would normally agree, the current environment is anything but “normal”, and there are plenty of risks ahead.
 

Flying blind

Indeed, a summary of this week’s view from The Transcript, which monitors and summarizes earnings calls, reveals a feeling of cautious optimism based mainly from a top-down perspective.

  • Economies around the world are reopening even as cases increase (IMF)
  • People seem willing to accept higher infection rates (BlackRock)
  • Even travel may rebound faster than people expect (TravelZoo)
  • But there are still 20m unemployed and many won’t go back to work (Palo Alto Networks)
  • A vaccine would be a game-changer (Bain Capital, IMF)

However, The Transcript from the previous week was far more cautious, though the perspective was more bottom-up.

  • Demand continues to bounce back (GM, McDonald’s, Federal Reserve, Union Pacific)
  • But uncertainty about the future is still very high (Federal Reserve, IMF)
  • A huge number of people are still unemployed (The Kroger)
  • Travel restrictions will probably remain in place for a while (Anthony Fauci, US National Institute of Allergy and Infectious Diseases)
  • And there are signs that a second wave may be building (McDonald’s, Food and Drug Administration Former Ex-Commissioner Dr. Scott Gottlieb)

In other words, nobody knows anything, and the level of uncertainty is very high. FactSet reported that the level of corporate guidance going into earnings season has plummeted. Even though forward 12-month EPS estimates are rising, the confidence level of the estimates is low. Wall Street is flying blind.
 

 

The risks ahead

The main risks surrounding Q2 earning season are the difficulties and extra costs of reopening, the expected level of reopening, and rising liquidity risks due to low capacity utilization.

Tracktherecovery.org reported that the spending recovery has continued, but low-income household spending has recovered faster than high-income households. That’s not surprising, because low-income workers have a higher propensity to spend their stimulus payments. This begs the question of whether there will be another round of fiscal stimulus when the CARES Act payments ends at the end of July. The Senate is not expected to take up the question until mid-July. Both the Democrats and Republicans have their own political agenda in crafting stimulus plans. With the election only four months away, the risk is both sides of the aisle cannot come to an agreement and the economy goes over a cliff.
 

 

A real-time snapshot shows that small business revenue recovery has flattened out. Anyone expecting a V-shaped recovery is likely to be disappointed.
 

 

The US COVID-19 case counts are climbing again. While other developed economies have bent their curves, the unfortunate fact is US conditions are on par with EM countries like Brazil, India, and Iran.
 

 

The S&P 500 is at a technical crossroad as it tests its 200-day moving average and backtests its broken trend line. The VIX term structure is not signaling extreme fear. I interpret these conditions as that the market is cautious, but no panic. It may not fully discounting the risks and possible bad news from Q2 earnings season.
 

 

The WSJ observed that the market has already assigned a risk premium to companies that withdrew guidance, but will that be enough?

Many companies that have pulled their guidance represent the industries most affected by the coronavirus pandemic and most damaged in the stock market. On average, shares for the companies that have withdrawn or withheld guidance are down 18.2% year to date. By comparison, the S&P 500 is down 6.9%.

Investors need to be prepared for the risks of a change in the market narrative in the weeks ahead.