A shallow or deep pullback?

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.
 

Bearish tripwires

I have been cautious about the equity outlook for several weeks, and the market triggered several bearish tripwires last week. First, the S&P 500 violated a rising trend channel, and fell through its 200 day moving average (dma). Other trend line violations observed were the high beta to low volatility ratio, which is an equity risk appetite indicator, and the NYSE Advance-Decline Volume Line, though the NYSE A-D Line remains in an uptrend.
 

 

Is this the beginning of a minor pullback where the market consolidates sideways, or the start of a major correction?
 

Shallow pullback and consolidation?

Here is the case for a minor pullback. The market is becoming oversold in the short run, and due for a bounce.
 

 

Ukarlewitz observed that heavy sell-offs like Friday’s -2.4% weakness tend to mark the end of short-term corrections. The exceptions are downdrafts that are part of a major correction like the one we experienced in February and March.
 

 

These conditions set up circumstances where the average calls for a relief rally, but with an extreme tail-risk of further downside. How should play those odds?
 

Long-term warnings

Let’s consider the longer term picture to assess the chances of a major downdraft. I have highlighted plenty of warnings, or bearish setups, in the past few weeks. Many analysts have observed that the equity-only put/call ratio (CPCE) has been extremely low, indicating complacency. Less noticed has been the index put/call ratio (CPCI) has become elevated, indicating cautiousness. This sets up a bearish divergence between retail traders, who mainly trade equity options, against professionals who hedge with index options. Past extremes in a dumb (retail) money/smart (professional) money dichotomy has seen the market either correct, or experience difficulty advancing.
 

 

Arguably, the weakness from the June 8 top was an unwind of retail speculative fever. Bespoke found that the returns to the share price factor fell almost monotonically by price decile. The stocks with the smallest share prices did the worse, while the ones with the highest share prices fell the least. This is an indirect signal that the small retail speculative traders, who tend to favor low-priced stocks, got long and hurt in the pullback.
 

 

Troy Bombardia at SentimenTrader also issued a number of warnings. The percentage of stocks with MACD sell signals were spiking across the board, indicating a broad technical deterioration in market internals. These signals were seen across a broad swath of indices: the S&P 500, NASDAQ, Euro STOXX 50, and Nikkei.
 

 

He also observed that Street analysts have been chasing the rally by upgrading their price targets in a FOMO-like stampede. Such instances have usually been resolved by pullbacks and corrections in the next 2-3 months.
 

 

An exhausted Fed?

In the past few weeks, a number of market commentators have attributed the rally from the March low to Fed intervention. While I have not been a fan of singular reasons for market moves, there are good reasons why Fed induced liquidity can buoy asset prices. Moreover, there is an empirical relationship between the size of the Fed’s balance sheet (blue line) and stock prices (black line).
 

 

We can see that Fed’s balance sheet contracted for a second week in a row, and the contraction was attributed to the unwind of USD swap lines by foreign central banks. Open market operations continue to inject liquidity into the market.  The latest week’s report shows that Fed holdings of Treasuries and other paper rose by 53.2 billion to 6.1 trillion, though that represented a deceleration from the previous week.

None of this means that the Fed is about to stop supporting the market with additional liquidity. Jerome Powell has made it clear that the Fed is focused on normalizing employment levels while asset price levels are only a secondary consideration (see A bleak decade for US equities). There is a Powell Put, but only indirectly. Recent continuing jobless claims figures (red line, inverted scale) are pointing to further improvement in the upcoming June Employment Report on July 2. While the recent surge in COVID-19 cases will undoubtedly be a concern for the Fed as they could result in a second wave of unemployment, the expected improvement in Non-Farm Payroll will make for a second consecutive month of “less awful” jobs numbers. These conditions are unlikely to prompt Fed policy makers to press harder down on the quantitative easing accelerator, and that could act as a brake on stock prices.
 

 

The unwinding of foreign central bank swap lines are indicative of a reduction of offshore USD shortages, and this development could also create some headwinds for equity prices. The swap line unwind coincided with the greenback catching a bid during the same period, which has also manifested itself in EM currency weakness. EM currencies are the most vulnerable to offshore dollar funding pressures and act like canaries in the cross-asset risk appetite coalmine. The combination of USD strength and EM currency weakness raises a warning flag for the price of risky assets like stocks.
 

 

The week ahead

So where does that leave us? Is this just a minor market setback, or the start of a major correction? I am leaning towards the major corrective scenario, but I am keeping an open mind as to the outcome.

The market could see further selling pressure on Monday and Tuesday from portfolio rebalancing flows as managers sell equities and buy bonds to re-weight their portfolios back to their targets. While we may see some further minor violations of support levels, the bulls need to hold the line here. The next support level for the S&P 500 is the 50 dma at 2980, with further support at the Fibonacci retracement level of ~2845.
 

 

My inner investor is neutrally positioned at his investment policy asset allocation targets. My inner trader remains short the market.

Disclosure: Long SPXU
 

A bleak decade for US equities

Posted by Cam Hui -

Some analysis has recently emerged pointing to a bleak decade for equities, and US equities in particular. Mark Hulbert highlighted a model outlined in the Philosophical Economics blog, entitled “the single greatest predictor of future stock market returns”. The model is based on US household allocation to equities and uses the levels as a contrarian indicator.

Notice that the household equity allocation is the flip side of the coin from household cash — sometimes referred to as sideline cash. Higher cash levels are therefore bullish and, sure enough, household cash allocations have risen markedly as equity allocations have fallen. But backtesting has shown that household equity allocation is the better predictor. In fact, according to Ned Davis Research, it is able to explain 77% of the variation in the stock market’s return in all 10-year periods since 1951. I am aware of no other indicator that does as well.

 

 

Hulbert continued:

Consider a simple econometric model I constructed from quarterly household equity allocation data since 1951 and the stock market’s subsequent inflation-adjusted total return at each step along the way. Based on the year-end 2019 allocation level, that model projected a 10-year inflation-adjusted return of negative 1.3% annualized.

That -1.3% expected real return was based on year-end 2019 data. Q1 2020 figures are in, and we all know what happened in March, namely the COVID Crash. According to Hulbert, projected annualized real returns improved to a positive 2.3% based on March 31 levels. Fast forward to today, the market has recovered most of its losses, and expected inflation-adjusted returns are undoubtedly negative again.

The news is even worse than that. The projected returns are calculated before fees. If an investor were to create a balanced portfolio consisting of some stocks and bonds. Add in some trading costs and management fees, diversification and frictional costs could easily subtract another 1%-2% from overall returns.
 

The Bridgewater warning

Bloomberg reported that Ray Dalio’s Bridgewater Associates has a different take on long-term equity returns. The firm is projecting a possible “lost decade” for US equities:

A reversal of the strong growth seen over the years in U.S. corporate profit margins could lead to a “lost decade” for equity investors, Ray Dalio’s Bridgewater Associates warns.

The margins, which have provided a big chunk of the excess return of equities over cash, could face a shift that would go beyond the current cyclical downturn in earnings, Bridgewater analysts wrote in a note to clients dated June 16.

“Globalization, perhaps the largest driver of developed world profitability over the past few decades, has already peaked,” the analysts said. “Now the U.S.-China conflict and global pandemic are further accelerating moves by multinationals to reshore and duplicate supply chains, with a focus on reliability as opposed to just cost optimization.”

The pandemic-induced collapse in demand has already resulted in a huge fall in profit margins in the short term, the analysts added.

The Bridgewater thesis is based on margin mean reversion. Branko Milosovic’s famous elephant chart showed that the winners of globalization were the middle class in the emerging economies, and the top 1% of population, who engineered the globalization boom.
 

 

The reshoring trend outlined by Bridgewater isn’t just attributable to the desire to duplicate supply lines and focus on reliability over cost optimization. Bloomberg reported that the Trump administration’s non-tariff barriers against Chinese competition have prompted a scramble by American companies to comply with the unexpected fallout of new legislation.

Aerospace, technology, auto manufacturing and a dozen other industries are engaged in a lobbying frenzy ahead of an Aug. 13 deadline to comply with a far-reaching provision that was tucked into a defense spending bill two years ago.

The broadly written defense law could implicate virtually all companies that count the federal government as a customer, including global subsidiaries and service providers deep in a firm’s supply chain. Excluding subcontractors, more than 100,000 companies provided $598 billion in goods and services directly to the U.S. government last year, according to a Bloomberg Government tally.

To date, measures taken by the Trump administration against Huawei and other Chinese tech companies have been aimed at cutting off their access to American components and networks. This law would ratchet up the pressure even more, putting the onus on U.S. government contractors to comb through their businesses to ensure they have no connections to banned Chinese companies.

Just as America weaponized its dominance in finance to force any bank doing business with sanctioned entities access to the US banking system, this law weaponizes the procurement process to deny any company doing business with Huawei and ZTE from business with America.

Section 889, part B, of the National Defense Authorization Act would require companies to certify that their entire global supply chain — not just the part of the business that sells to the U.S. government — is devoid of gear from Huawei, ZTE, Hikvision and other targeted Chinese tech firms.

The measure could apply to virtually all companies that count Uncle Sam as a customer, including subsidiaries and service providers deep in a firm’s supply chain. Excluding subcontractors, more than 100,000 companies provided $598 billion in goods and services directly to the U.S. government last year, according to a Bloomberg Government tally.

Imagine a company has a foreign office. That office will naturally have a phone system which connects to the local phone network. If the phone network has any component that uses Huawei equipment, the company is not compliant. That’s how far reaching these measures are.

There are alternatives to Huawei equipment. Singapore recently announced its decision to use Nokia and Ericsson to supply its 5G systems. They’re just more expensive, which puts pressure on margins.
 

Gold as a confidence indicator

These low equity return expectations are consistent with my previous publication highlighting gold as a confidence indicator (see What gold tells us about confidence). The relative downtrend of the stocks to gold ratio is an ominous sign for long-term equity returns.
 

 

Here is one explanation for the lack of confidence. One of the bedrocks of long-term return expectations is valuation. While valuation tells us little about what stock prices will do over the next year, they are highly predictive of long-term returns. Global forward P/E ratios are back to dot-com like valuations.
 

 

Much of the heightened valuation is attributable to US equities, which account for roughly half the weight of global stocks. But US equity valuations have soared against their non-US counterparts.
 

 

Equity overvaluation cannot be just explained by expensive US stocks, though. Bloomberg reported that Longview Economics found that “80% of the markets [they] track have a valuation in the upper quartile relative to the market’s history — the greatest percentage on record using data since the mid-1990s”. Everything is expensive.
 

 

It’s not just stocks that are expensive, bonds can hardly be described as cheap on an absolute basis. Austria recently issued another 100-year bond at a yield of 0.88%. The offering was well subscribed, which is another sign of a bond bubble.

In short, this is a low-return environment, and there are few attractive alternatives.
 

Where can investors hide?

This begs the question: Where investors can hide in such a low return environment?

Much of the answer depends on the degree of monetary accommodation that global central bankers are willing to provide. The intermediate term outlook is based on the Fed’s focus on unemployment irrespective of asset prices. Consider this exchange at the last post-FOMC press conference between Bloomberg reporter Michael McKee and Fed Chair Jerome Powell.

I came across a statistic the other day that amazed me. Since your March 23rd emergency announcement, every single stock in the S and P 500 has delivered positive returns. I’m wondering, given the levels of the market right now, whether you or your colleagues feel there is a possible bubble blowing that could pop and setback the recovery significantly, or that we might see capital misallocation that will leave us worse off when this is over?

Here is how Powell responded:

So, we — we’re not looking to achieve a particular level of any asset price. What we want is investors to be pricing in risk, like markets are supposed to do. Borrowers are borrowing, lenders are lending. We want the markets to be working. And again, we’re not looking to — to a particular level. I think our — our principal focus though is on the — on the state of the economy and on the labor market and on inflation.

The Fed is signaling a “whatever it takes” moment to bring down unemployment. The Fed has an array of tools to achieve those goals, such as asset purchases, yield curve control, and even negative interest rates. Translated, the Fed is willing to engage in financial repression. Other central banks are either following suit, or ahead of the Fed’s curve. The ECB has already experimented with negative rates.

A bet for financial repression, at least for the next 2-3 years, is a bullish bet on gold. Historically, real 10-year TIPS yields (inverted scale) have been highly correlated with gold prices. As long as the Fed is willing to engage in suppressing rates and yield curve control, it should put upward pressure on gold prices.
 

 

Is it any wonder why the stock/gold ratio is falling? However, standard portfolio construction solutions call for the weight of gold in a well-diversified medium-risk portfolio to be no more than high single digit or low double digits percentages. I agree with that assessment. That means investors still need some exposure to equities as a source of growth.

One option is boost long-term returns to consider beaten up value stocks. The growth to value performance ratio has gone parabolic, and the growth to value relationship is extremely stretched.
 

 

A commitment to value investing comes with two caveats. First, value style portfolios are generally overweight in financial stocks, and financial stocks don’t perform well under conditions of financial repression. As well, the growth/value ratio is still skyrocketing and showing no signs of a rollover. From a tactical perspective, it may be wise to wait for a pause and reversal of the ratio before making a full commitment to value investing.

There are a number of other alternatives for US investors considering the value style. One is Barclays Shiller CAPE ETN (ticker CAPE), which buys the top four cheapest sectors based on CAPE that exhibits relatively strong price momentum. Another is the shares of Berkshire Hathaway, which is not strictly value investing, but quality (wide-moat) companies at a reasonable price. Both CAPE and BRK have lagged the market in the past year, but they have outperformed the value style over the last few years. As well, the last time Warren Buffett was this widely ridiculed for his performance was in 1999, which was a year before the dot-com bubble popped. That said, Buffett has become so successful with Berkshire that the company has a size problem and it has trouble deploying its cash as efficiently as it did in the past. In effect, it has become a cash generative conglomerate, with a sizable position in Apple, and a large cash hoard.
 

 

Another option for US equity investors is to look abroad. Rather than simply ranking countries by CAPE, which can lead investors into value traps, such as Europe where stocks appear cheap because of lower growth potential, Research Affiliates ranked country valuations relative to each country’s own historical range of CAPE. Based on this analysis, US large cap stocks are wildly expensive, with Switzerland coming in second place, and US small caps in third. At the other end of the spectrum, Turkey, Malaysia, Poland, South Korea, Thailand, and South Africa are the cheapest countries, in that order.
 

 

Before plunging into some of these small and somewhat illiquid markets, it’s one thing to buy cheap stocks and markets, and it’s another to watch the markets become cheaper as fundamentals further deteriorate, which is otherwise known as a value trap. To avoid that problem, we overlaid a relative price filter to look for price stabilization in order to avoid the value trap problem. Looking at the relative performance of these countries compared to the MSCI All-Country World Index (ACWI), Turkey and South Korea are the standouts. They have tested relative support and they are forming bases by consolidating sideways. The relative performance of Thailand may be constructive and bears watching. Thai stocks are trying to form a bottom after breaking a key relative support level. The other three are all in relative downtrends and should be avoided for now.
 

 

As well, the degree of non-US commitment will partly depend on the outcome of the November elections. Current polling indicates a Biden lead over Trump, and recent victories by progressives in primaries is likely to push the Democrat agenda leftward. A Blue Wave victory in November, which is becoming the base case scenario, will mean MMT-style stimulus, and increased US corporate taxes. These developments will be USD negative, and non-US equity, especially EM, positive.

In addition to a buy-and-hold strategy, investors can consider allocating funds to tactical asset allocation as a way of enhancing returns. While I am not claiming that my Trend Asset Allocation Model represents the Holy Grail of investing, an asset allocation switching strategy that uses the out-of-sample signals of the Trend Model has achieved equity-like returns with 60/40 like risk. The usual caveats about how past performance is not indicative of future returns apply.
 

 

In conclusion, investors are facing a low return setting in the next decade. However, there are a number of pockets of opportunity for investors. Gold, value stocks, selected cheap foreign markets, and the use of tactical asset allocation are all ways of enhancing returns in a difficult investing environment.
 

Good news, bad news about a second wave

Posted by Cam Hui -

Mid-week market update: I have some good news, and bad news about a second wave. The bad news is new case counts are rising dramatically in the US. The good news is fatalities are not rising.
 

 

Here is some more bad news. Marketwatch reported that Dr. Anthony Fauci, head of infectious diseases at the National Institute of Health, said that “We are still in the middle of the first wave. So before you start talking about what a second wave is, what we’d like to do is get this outbreak under control over the next couple of months.”

For investors, this matters for a couple of reasons.
 

Explaining the falling fatality rate

The falling fatality rate seems to be a puzzle, at first glance. Consider the more problematical states where new cases have been rising.
 

 

Even in those states, death rates have been mostly flat, except for Texas. The death rate in Texas has been rising slowly, but they have not spiked in line with the new case rate.
 

 

One possible explanation can be found from the Florida data. The median age of COVID-19 patients have been falling dramatically. Since the young tend to have fewer vulnerable conditions, their survival rate is higher than an older population.
 

 

That’s the good news. The bad news is COVID-19 survivors are often saddled with chronic health conditions, which will be a long-term drag to productivity, and those people will be a burden to the healthcare system for years to come. Moreover, they will face higher cost for medical insurance because of their pre-existing conditions. That said, hospitalizations in a number of the surge states are rising dramatically. Here is Arizona.
 

 

Here is Texas.
 

 

A second economic wave

The pandemic is unquestionably a human tragedy, but what matters to investors is the outlook for economic growth and corporate earnings. How would a second pandemic wave affect the economy?

Most of the surge states are under the control of Republican state governments, which have shown great reluctance to shut down their economies again. While the authorities may not necessarily want to reimpose stay-at-home orders, local economies may still slow because of individuals choosing to stay home.

Trump’s less than full capacity at his Tulsa rally serves as a useful case study. The Tulsa fire marshal attendee count was just under 6,200 attendees in an indoor stadium with a capacity of 19,000, and when the campaign touted that it had expressions of interest from over a million people for tickets. From an investor’s point of view, the most bullish explanation is a swarm of youth coordinating on TikTok overwhelmed the booking system with ticket requests. The NY Times reported that Trump campaign managers Brad Pascale attributed the low turnout to the media instead of “leftists and online trolls”.

“Leftists and online trolls doing a victory lap, thinking they somehow impacted rally attendance, don’t know what they’re talking about or how our rallies work,” Mr. Parscale said. “Registering for a rally means you’ve RSVP’d with a cellphone number and we constantly weed out bogus numbers, as we did with tens of thousands at the Tulsa rally, in calculating our possible attendee pool.”

Instead, he blamed the news media for the low turnout.

“The fact is that a week’s worth of the fake news media warning people away from the rally because of Covid and protesters, coupled with recent images of American cities on fire, had a real impact on people bringing their families and children to the rally,” he said.

The most bearish explanation is that die-hard Trump supporters, who tend to be skeptical that COVID-19 poses a threat to themselves, decided that it was not worth the risk to travel to Tulsa for the rally. If such a dedicated group turns out to be so risk-averse that they won’t attend a rally featuring their hero, what does that tell us about the prospect for reopening the economy in the face of such skittishness?

The Open Table data for Houston serves as a cautionary tale for bulls who are enthusiastic about a V-shaped recovery. For some context, the Houston Chronicle reported that 40 Houston restaurants have closed temporarily because some staff had tested positive for COVID-19.
 

 

IHS Markit’s US June Services PMI printed at 46.7, which missed expectations of 48, and the reading was below 50 indicating contraction. The services economy dwarfs manufacturing, and further weakness are signaling an anemic recovery.
 

 

Small businesses are especially vulnerable to the slowdown. As the chart below shows, revenue growth has stalled after the initial gains from reopening.
 

 

Their cash buffers are low.
 

 

They are important to the economy. Small businesses with less than 500 workers employ 47% of total workers, and cover 40% of total payroll.
 

 

Jerome Powell showed concern in his Senate testimony last week that “the longer the downturn lasts, the greater the potential for longer-term damage from permanent job loss and business closures”. That’s precisely the scenario that the American economy is facing should the pandemic force a second round of shutdowns, either by edict, or by individuals choosing to avoid interaction with the public.

Any further slowdown is likely to spark another round of layoffs. Here are some estimates of the jobs most at risk in a second wave. While the first wave of job losses were concentrated among low-paid workers, the second wave is likely to affect better paid white-collar workers. The top five on list are admin and support services, professional, scientific, and technical services, wholesale trade, education, and insurance. All of these industries tend to be much better paying than the restaurants and hospitality job layoffs of the first wave.
 

 

For investors, that’s the true downside risk represented by a second wave.
 

Internals are still weak

Looking towards Wall Street, the market continues to chop sideways this week. The “island” of the island reversal is acting as if it’s surrounded by a moat. While the bulls have been unable to rally to close the gap and rally the market to the island, the bears haven’t been able to seize control of the tape either. The hourly chart shows a second bearish island reversal, which is an interesting formation that I haven’t seen before.
 

 

Many of the internals that I have been monitoring are still exhibiting negative divergences. The high beta to low volatility ratio is still falling, indicating a reduced equity risk appetite.
 

 

The reopening pairs are also pointing south. Both the global pair (global airlines to Chinese healthcare) and the US pair (Leisure and entertainment to healthcare) are declining. If the market is getting excited about a reopening sparked V-shaped recovery, these factors are certainly not showing much signs of enthusiasm.
 

 

As well, the relative price performance of high yield, or junk, bonds relative to their duration-adjusted Treasuries is also flashing a minor but persistent negative divergence, which is a signal of unenthusiastic credit market risk appetite.
 

 

As we approach quarter-end, Market Ear reported estimates of re-balancing required for portfolios to return to their target allocations. All estimates involve the sale of equities, though not all of the sales will be US equities.

Key points via JPM, according to us, the best on the street when it comes to estimating these flows.

“we estimate around -$70bn of negative equity rebalancing flow by balanced mutual funds globally into the current month end….

we estimate that the pending equity rebalancing flow by US defined benefit pension funds into the current quarter end is likely modestly negative at around -$65bn….

Norges Bank into the current quarter end is likely modestly negative at around -$10bn….

SNB to sell around $15bn of equities given the recovery from March lows…

GPIF into the current quarter end is likely negative at around $25bn…created a need for negative rebalancing flow, i.e. equity selling, of around $170bn into the current month/quarter end. This $170bn should be thought of as an upper estimate as it is possible that same of this equity selling was done before quarter end.”

My inner trader is bearish, but positioning is light. He will not become an enthusiastic bear until the market break down out of the rising channel, and that break should coincide with a violation of the 200 day moving average.
 

 

The 3020 level will be a key test for both the bulls and the bears. I wrote in the past (see An island reversal update) that the minimum target for the (first) bearish island reversal is about 3020, which is also the level of the 200 dma. Expect the bulls to try to make a stand to defend that level, but the market overran the bullish island reversal target in March to levels much higher than the minimum target. Keep an open mind about the outcome.

Disclosure: Long SPXU

 

Bearish warnings, but no trigger

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.
 

Island reversal signal intact

A little over a week ago, the market traced out a bearish island reversal formation after violating a rising trend line. While the bullish island reversal signal in April saw the market advance immediately afterwards, the aftermath of the most recent signal resolved itself in a sideways consolidation, indicating that the bulls still had some life left in them, and they were struggling to maintain control of the tape.
 

 

Nevertheless, market internals revealed a number of bearish setups, with no obvious trigger. As an example, there is a divergence between the VIX Index and VVIX, which is the volatility of the VIX. I interpret this to mean that VVIX is not buying the recent fall in the VIX, and it is discounting an increase in volatility, which tends to be inversely correlated with stock prices.
 

Bearish setups

I can cite a number of other bearish setups, or divergences. The advance off the March bottom had been led by cyclical stocks. Indeed the relative performance of cyclical to defensive stocks had been rising steadily. The cyclical to defensive ratio rolled over even as the market tried to rally and trade sideways last week, which is a negative divergence.
 

 

A similar relationship can be seen in the ratio of equal-weighted consumer discretionary stocks, which I use to minimize the sizable weight of Amazon in the cap weighted consumer discretionary sector, to equal-weight consumer staples stocks. This ratio has long been used as a risk appetite indicator. The equal-weighted discretionary to staples ratio rolled over and continued to fall even as stocks consolidated sideways last week, which is another negative divergence.

There have been a number of warnings sounded about the extended nature of the put/call ratio, indicating crowded long positioning. These words of caution from SentimenTrader is just one of several examples.
 

 

There is also an ominous divergence between the equity-only put/call ratio (CPCE) and the index put/call ratio (CPCI). It is commonly believed that CPCE measures retail sentiment, as retail traders focus mainly on options on individual stocks, while CPCI measures dealers and institutions sentiment because they use those instruments for hedging purposes. The CPCE-CPCI spread has reached an extreme, and, if history is any guide, such episodes tend to resolve themselves bearishly.
 

 

That said, these divergences can only be regarded as bearish setups. Last week’s sideways market action was a signal that the bulls were not fully defeated. The bears need a trigger before they can seize control of the tape.
 

Don’t blame the Fed

So what might be a bearish trigger? First, I would not look to the Fed for a durable excuse for the stock market to rise or fall.

Consider the market reaction on June 11, 2020, the day after the FOMC meeting. The financial press reported that market skidded -6% because the Fed’s economic outlook was insufficiently upbeat. On the other hand, Jerome Powell made it clear in the post meeting press conference that the Fed was not concerned about the level of stock prices, and it was focused primarily on reviving the job market [emphasis added].

MICHAEL MCKEE. Mr. Chairman, Michael McKee with Bloomberg Television and Radio. I came across a statistic the other day that amazed me. Since your March 23rd emergency announcement, every single stock in the S and P 500 has delivered positive returns. I’m wondering, given the levels of the market right now, whether you or your colleagues feel there is a possible bubble blowing that could pop and setback the recovery significantly, or that we might see capital misallocation that will leave us worse off when this is over?

CHAIR POWELL. What we’ve targeted is broader financial conditions. If you go back to the end of February and early March, you had basically the world markets realized at just about the same time, I remember that Monday, that there was going to be a global pandemic and that this possibility that it would be contained in one province in China, for all practical purposes, was not going to happen. It all — it was — you know, it was Iran, Italy, Korea, and then it became clear in markets. From that point forward investors everywhere in the world for a period of weeks wanted to sell everything that wasn’t cash or a — a short term treasury instrument. They didn’t want to have any risk at all. And so, what happened is markets stopped working. They stopped working and companies couldn’t — couldn’t borrow, they couldn’t roll over their debt. People couldn’t borrow. So, that’s — that’s the kind of situation that can be fair — financial turbulence and malfunction. A financial system that’s not working can greatly amplify the negative effects of what was clearly going to be a major economic shock. So, what our tools were — were put to work to do was to restore the markets to function. And I think, you know, some of that has really happened, as I — as I mentioned in my opening remarks, and that’s a good thing. So, we — we’re not looking to achieve a particular level of any asset price. What we want is investors to be pricing in risk, like markets are supposed to do. Borrowers are borrowing, lenders are lending. We want the markets to be working. And again, we’re not looking to — to a particular level. I think our — our principal focus though is on the — on the state of the economy and on the labor market and on inflation. Now inflation, of course, is — is low, and we think it’s very likely to remain low for some time below our target. So, really, it’s about getting the labor market back and getting it in shape, that’s — that’s been our major focus. 

It’s difficult to see how much more dovish Powell could have been, but the market cratered on Thursday/

By contrast, the market rallied on Monday when the Fed announced that, in addition to buying corporate bond ETFs, it planned to create an index of corporate bonds and buy the individual issues. Stock prices rallied on the announcement, even though the Fed had already announced that it would buy individual bonds several weeks ago.

Did any of that market reaction make sense? Be wary of attributing market moves to the Fed.

That said, the Fed is scheduled to publish the results of bank stress tests next week. The NY Times reported that while it will publish a system-wide report card under different stress scenarios, individual bank results will not be part of the disclosure.

The central bank’s vice chair for supervision, Randal K. Quarles, said the Fed would determine capital requirements — essentially the financial cushions that banks must keep to withstand losses — based on economic scenarios developed before the pandemic took hold. While the Fed is testing the strength of banks against multiple dire scenarios that reflect how the virus might play out, the central bank will not publish bank-specific results.

“We don’t know about the pace of reopening, how consumers will behave or the prospects for a new round of containment,” Mr. Quarles said. “There’s probably never been more uncertainty about the economic outlook.”

Powell has warned about what delayed bankruptcies could mean for bank balance sheets. The Fed’s lack of transparency on individual bank stress tests may mean there are hidden fault lines in the system. In the past, breaches of relative support of bank and regional bank stocks have signaled market dislocations. How bad will things be this time, and why is the Fed not telling us?
 

 

A second wave

The market has shown itself to still be sensitive to COVID-19 news. As an example, stock prices gapped up at the open on Friday by about 1%, but it sold off dramatically when Apple announced it was closing selected stores in Arizona, Florida, and the Carolinas over COVID-19 concerns.
 

 

Confirmed new case counts are spiking again, especially in the south and southwest. In particular, new case counts reached all-time highs in Arizona, California, Florida, and North and South Carolina.
 

 

The relative performance of healthcare stocks have begun to perk up again, possibly in response to heightened COVID-19 concerns. After lagging the market for several weeks, these stocks have begun to revive and lead the market again. The only laggard in the sector are healthcare providers, which probably reflects investor concerns about hospital profitability during the pandemic.
 

 

Q2 earnings season surprise?

Another possible negative trigger may come from reports from Q2 earnings season. FactSet reported that earnings estimates are rising again, even though prices and estimates had diverged in a major way since the crisis began.
 

 

The latest weekly update showed some an unusual estimate revision pattern. Analysts are becoming more optimistic this year, while less optimistic next year. The chart below shows the current level of quarterly estimates, plus the weekly revisions for each quarter. The Street has revised near-term estimates upwards, especially for Q2 and Q3, while longer term estimates in 2021 are flat to down.
 

 

The revival of near-term optimism is setting up the potential for disappointment. As the economy begins to reopen again, corporate guidance may turn to the increased cost structure that companies have to face in the new environment. As an example, Bloomberg reported that a Deloitte Consulting study concluded that the money banks will have to spend as much as 50% more for each employee to work in their office towers in the post covid-era.

As well, CNBC reported that retailers will have to compete with the liquidation sales of competitors.

Going-out-of-business sales are getting ready to be, well, basically everywhere this summer.

Retailers that have been forced shut for weeks because of the coronavirus pandemic are beginning to reopen their doors as cities such as New York reopen. That means liquidation sales that had been upended by the pandemic are starting again, or just getting ready to kick off. And that will be added to the usual seasonal sales by retailers looking to get rid of old inventory.

“I have never seen so many [liquidations] happening at the same time, ever,” said Scott Carpenter, president of retail solutions in B. Riley Financial’s Great American Group. “It’s one after another, after another, after another. And there’s more to come.”

Lastly, Biden has been steadily gaining on Trump, both in the polls and the betting markets.
 

 

Biden has promised to reverse the Trump 2017 corporate tax cuts, which would subtract about $10 from 2021 S&P 500 earnings. The strategy team at Goldman Sachs estimates an additional negative secondary order effect of $10, which reduces earnings by a total $20. To be sure, I made the point that there will be offsetting positive earnings effects as Biden’s anti-inequality proposals broaden out consumer spending (see What will a Biden Presidency look like?), but the market is likely to shoot first and ask questions later by focusing on the negatives.

The market’s P/E ratio based on 2021 earnings is already very elevated. How would it react if it begins to discount a Biden victory?
 

 

Waiting for the downside break

Looking to the week ahead, the market is in wait-and-see mode. Short-term breadth has recovered from a deeply oversold reading, and it could go either one of two ways. The pattern is reminiscent of the pattern in March when the market staged a brief relief rally before plunging further, or it could resolve with a sideways consolidation as it did last August.
 

 

The Fed’s balance sheet surprisingly shrank last week, and the shrinkage was attributable to reduced swap lines with other central banks, and lower liquidity demand for repos from the banking system. The Fed’s QE asset purchase program remains intact.
 

 

While the reduction in dollar swap lines is an indication of falling offshore dollar funding stress, the USD Index did catch a bid last week, and EM currencies weakened. Further greenback strength and conversely EM weakness could be the proverbial canaries in the coalmine that puts downward pressure on risk appetite.
 

 

However, the S&P 500 remains in a rising channel, and until we see a breakdown, it would be premature to be wildly bearish. My inner investor is neutrally positioned at roughly the levels specified by his investment policy statement. My inner trader is short, but positioning is light.
 

Disclosure: Long SPXU

 

The bears are capitulating

Posted by Cam Hui -

Last week, I discussed the professional career risk challenges in this market (see What professional career risk looks like).

During these unusual periods of severe bifurcation between valuation and macro risk and price momentum, the investment professional is forced to make a decision based on what he believes the dominant investment regime will be in order to minimize career and business risk. This amounts to the classic Keynesian investing beauty contest, where investors do not try to determine the winner based on some investment criteria, but based on what he believes other investors think will be the winner.

I highlighted the differences in thinking between the fast-moving hedge fund manager, Stanley Druckenmiller, and the cautious approach of Jeremy Grantham, whose firm, GMO, reduced its target equity weight from 55% to 25%.

This week, it seems that even Grantham has capitulated and called this market a bubble in a CNBC interview.

“My confidence is rising quite rapidly that this is the fourth ‘Real McCoys’ bubble of my investment career,” Grantham, co-founder of GMO, told CNBC’s Wilfred Frost on Wednesday in an interview which aired on “Closing Bell.” “The great bubbles can go on for a long time and inflict a lot of pain.”

The previous three bubbles Grantham referred to were Japan in 1989, the tech bubble in 2000 and the housing crisis of 2008.

Not only has Jeremy Grantham capitulated and called this market a bubble, but also the latest BoA Global Fund Manager Survey shows signs of capitulation by cautious bears. Even though a record net 78% of survey respondents acknowledged that equities are overvalued, which is the highest reading since the survey began in 1998, their investment outlooks turned less bearish between the May and June survey.
 

 

As global stock prices continue to grind upward, managers are giving greater weight to their career risk, and reluctantly turning bullish. The bears are capitulating. How should investors approach this market?

I am not prepared to call the current market environment the start of a bubble just yet. Technical price momentum indicators are insufficiently bullish to declare this a new mania. Our bubble trigger is the monthly MACD indicator. Until the monthly MACD histogram turns positive, our inclination is to still call this a bear market rally.

If I am wrong and this is a new bubble, we may need a second aftershock of rising insolvencies and white-collar layoffs for investor psychology to change.
 

Fundamental and macro backdrop

Let’s begin with the fundamental and macro backdrop of the market. Federal Reserve Jerome Powell’s Senate testimony last week tells us everything we need to know about the economic outlook.

Recently, some indicators have pointed to a stabilization, and in some areas a modest rebound, in economic activity. With an easing of restrictions on mobility and commerce and the extension of federal loans and grants, some businesses are opening up, while stimulus checks and unemployment benefits are supporting household incomes and spending. As a result, employment moved higher in May. That said, the levels of output and employment remain far below their pre-pandemic levels, and significant uncertainty remains about the timing and strength of the recovery. Much of that economic uncertainty comes from uncertainty about the path of the disease and the effects of measures to contain it. Until the public is confident that the disease is contained, a full recovery is unlikely.

Moreover, the longer the downturn lasts, the greater the potential for longer-term damage from permanent job loss and business closures. Long periods of unemployment can erode workers’ skills and hurt their future job prospects. Persistent unemployment can also negate the gains made by many disadvantaged Americans during the long expansion and described to us at our Fed Listens events. The pandemic is presenting acute risks to small businesses, as discussed in the Monetary Policy Report. If a small or medium-sized business becomes insolvent because the economy recovers too slowly, we lose more than just that business. These businesses are the heart of our economy and often embody the work of generations.

Here are the main takeaways from his testimony:

  • There are signs of stabilization, but
  • Economic activity levels are far below pre-pandemic levels.
  • Much depends on the trajectory of the pandemic, and efforts to control the disease.
  • The longer the downturn, the bigger the risk of permanent damage.
  • Low-income Americans, and small and medium sized businesses are especially vulnerable in a prolonged slowdown.

To put the current recession into some perspective, a World Bank report pointed out that this is the four global recession as measured by per capita GDP growth since 1876, exceeded only by the Great Depression, and slowdowns sparked by two World Wars, and it is worse than double-dip of 1917-1921, which was exacerbated by the Spanish Flu.
 

 

In terms of sheer global breadth, this is the worse recession ever.
 

 

Meanwhile, the market is trading at a forward P/E ratio of 21.9, which is a level last seen in 2002. Past major market bottoms have seen the forward P/E at about 10. Even if we were to look forward to 2021 by acknowledging the utter devastation in 2020, the market is trading at a 2021 P/E of 19.1, which is not cheap.
 

 

The stock market response has only a brief hiccup, which sounds like fantasy in light of the global macro disaster. So, why are we seeing the formation of a possible bubble, and signs of capitulation from the bears?
 

A study of psychology

We will never know why bubbles form, but one possible reason can be found in human psychology. The investor class has largely been insulated from the bulk of the economic shock, and they reacted by shortening their time horizons and focusing on short-term fundamental momentum.

Let me explain. The study of economics is based on homo economicus, a race of people with rational expectations. As the study of behavioral finance discovered, people are not always rational. Morgan Housel at Collaborative Funds observed that people behave differently based on their own experiences. He described Pavlov’s famous experiment where he conditioned dogs to drool by ringing a bell, because he rang a bell before he fed them. What is less known is what happened next.

A massive flood in 1924 swept through Leningrad, where Pavlov kept his lab and kennel. Flood water came right up to the dogs’ cages. Several were killed. The surviving dogs were forced to swim a quarter mile to safety. Pavlov later called it the most traumatic thing the dogs had ever experienced, by far.

Something fascinating then happened: The dogs seemingly forgot their learned behavior of drooling when the bell rang.

The dogs were suffering from PTSD because of the flood, and their behavior changed.

Ever the curious scientist, Pavlov spent months studying how the flood changed his dogs’ behavior. Many were never the same – they had completely different personalities after the flood, and learned behavior that was previously ingrained vanished. He summed up what happened, and how it applies to humans:

Different conditions productive of extreme excitation often lead to profound and prolonged loss of balance in nervous and psychic activity … neuroses and psychoses may develop as a result of extreme danger to oneself or to near friends, or even the spectacle of some frightful event not affecting one directly.

People tend to have short memories. Most of the time they can forget about bad experiences and fail to heed lessons previously learned.

But hardcore stress leaves a scar.

Here is how Housel generalized this experience to human behavior.

It’s why the generation who lived through the Great Depression never viewed money the same. They saved more money, used less debt, and were weary of risk – for the rest of their lives…

It’s why countries that have endured devastating wars have a higher preference for social safety nets…

It’s why baby boomers who lived through the 1970s and 1980s think about inflation in ways millennials can’t fathom.

 

The economy isn’t the stock market

Here is why this analysis matters. The economy isn’t the stock market, and the investor class is not reacting to economic shock because it has largely been insulated from job losses. The burden of unemployment has fallen unevenly among the American population. It was mainly the low-wage workers who lost their jobs, or were furloughed. It has been the low-wage workers who would be suffering from economic PTSD.
 

 

Investment managers belong to the white-collar worker class who have largely been untouched by pandemic-related layoffs. While the work-at-home regime may be an inconvenience, their economic circumstances are less affected than low-wage workers who have either lost their jobs, or need to risk their health to go into work. It is therefore little surprise that CNBC reported that the middle class used some of their stimulus money to play the stock market.
 

 

The white-collar investor class, which includes retail investors, and institutional and hedge fund managers, are reacting by staging a bullish stampede by focusing on the Fed stimulus, and the momentum of the recovery.
 

What could pop the bubble?

If this is indeed a market bubble, then what could pop the bubble?

The Citigroup US Economic Surprise Index (ESI), which measures whether top-down economic releases are beating or missing expectations, has surged to its highest level ever, buoyed by upside surprises such as the May retail sales month-over-month advance of 17.7%. Past ESI retreats from elevated levels have usually seen stock prices stall with minimal upside potential. One bearish trigger would be a deterioration in ESI readings.
 

 

One trigger for ESI to fall is another wave of layoffs. Politico reported that Powell urged Congress to engage in more fiscal stimulus, and pointed out that state and local authorities are running out of money. Without federal support, this could mean mass layoffs, which would affect higher paying white-collar workers as well as low-paying positions.

He declined to give specific recommendations on further spending by Congress, but noted that millions of people are employed by state and local governments, many of which are experiencing fiscal crunches.

“It’s certainly an area I would be looking at if I were you,” he said. “That’s going to weigh on the economy.

Jerome Powell’s stated in his Senate testimony that the Fed is taking steps “to support the flow of credit in the economy”, but Fed policy has its limits. Quantitative easing does not prevent defaults, it only postpones them. Already, corporate defaults are rising. As defaults rise, so will job losses that hit broad swaths of the labor market.
 

 

Similarly, household sector finances are coming under increasing stress. Credit card delinquency rates are also rising to levels last seen during the GFC.
 

 

Remember, a well-functioning market needs price signals, and too much Fed support can obscure the process of creative destruction. Already, the number of zombie firms, defined as those whose debt servicing costs are higher than their profits but kept alive by easy credit, is rising rapidly. If allowed to proliferate, zombie firms are a drag on productivity. They seldom hire people; they shun new business investments; and they create a “dead zone” in the economy.
 

 

Another negative trigger could be a second pandemic wave, especially in the US. American public health policy has lagged other developed economies. The US population is roughly 330 million, while the EU’s population is 446 million. Europe has decisively bent the curve, while America has flattened the curve. What happens in a second wave, and what are the economic consequences? As a reminder, Jerome Powell stated in his Senate testimony, “The longer the downturn lasts, the greater the potential for longer-term damage from permanent job loss and business closures.”
 

 

Politico reported that Powell reminded lawmakers during his testimony that Fed projections assumes there is no second wave of infections.

Powell also said the Fed’s projections for economic performance this year, including a 9.3 percent unemployment rate by the end of 2020, didn’t factor in a potentially worse outcome if there is a second major outbreak of the coronavirus.

 

Not a bubble (yet)

Is this the start of a new market bubble? I am not prepared to make that call just yet. Technical price momentum indicators are insufficiently bullish to declare this a new mania. My bubble trigger is the monthly MACD indicator. Until the monthly MACD histogram turns positive, my inclination is to still call this a bear market rally.
 

 

Nevertheless, the adage that the economy isn’t the stock market may be especially true today. Despite enduring the fourth worse recession since 1876, the stock market reaction to the slowdown has been extremely mild. While the Fed has been swift to cushion the shocks, it cannot prevent bankruptcies and insolvencies, otherwise policy makers risk the rise of a class of nearly dead zombie companies which will be a drag on productivity.

Moreover, the burden of losses has been uneven, which is a factor that’s affecting investment psychology. The brunt of the economic shock has largely been borne by low-wage workers, and the investor class, consisting of middle and high-income households, have mainly been spared.

If I am wrong and this is a new bubble, we may need a second aftershock of rising insolvencies and white-collar layoffs for psychology to change. Investors are focused on the prospect of a V-shaped rebound today.
 

 

They should be wary of the risks of a pandemic second wave, or an economic second wave of rising insolvencies and layoffs. Already, weekly job postings are falling off after a business reopening related surge. Is this just a data blip, or something more serious? Stay tuned.
 

 

Also please stay tuned for our tactical trading publication tomorrow.

 

An island reversal update

Posted by Cam Hui -

Mid-week market update: Remember the island reversal? The market gapped down and skidded last Thursday after Wednesday’s FOMC meeting, creating an island reversal. It opened down on Friday, but managed to close in the green on the day. And it has rallied back to the bottom of the gap this week.
 

 

Have the bearish implications of the island reversal been negated?
 

Island reversals explained

Let’s begin with a basic primer on island reversal formations. TradingSim explained the formation this way:

An island reversal is a chart formation where there is a gap on both sides of the candle. Island reversals frequently show up after a trending move is in its final stages. An island reversal gets it name from the fact that the candlestick appears to be all alone, as if on an island. A key sign of a valid island reversal is an increase on volume on both the first gap, and then the subsequent gap in the opposite direction. An island reversal formation is often attributed to news driven events that occur in the pre-market or after-hours trading.

 

 

To develop a minimum target for the reversal pattern, you “measure the distance between the lowest candle of the general price action and the lowest candle of the Island pattern”. As a reminder, this is a minimum target. The bullish reversal observed in SPY in early April overran its target.
 

 

For risk control purposes, put a stop loss at the bottom of the island, if it’s a bullish reversal, and at the top of the island, it’s a bearish reversal.
 

 

Based on these criteria, the bearish reversal remains intact, and the measured downside minimum target is about 3020.
 

Some perspective

Here is some perspective on the current market environment. This is a very skittish market. Cross-asset correlation is at a 20-year high, indicating investor herding. The market has shown a pattern of reacting violently to news items.
 

 

The market looks extended from an intermediate term technical perspective. SentimenTrader pointed out that a record number of stocks are on MACD sell signals, indicating negative momentum.
 

 

Yesterday’s rally was sparked by an upside surprise in retail sales. An unusual aspect of the market reaction can be found in the behavior of the coronavirus pairs. These pairs should have been rallying, but they instead fell in reaction to the positive reopening news.
 

 

Sentiment remains a concern. The latest BoA Global Fund Manager Survey showed that hedge funds are in a crowded long in equities. Macro Charts showed that past episodes have generally resolved themselves in a bearish manner.
 

 

Cautiously bearish

My inner trader is cautiously bearish. The market appears to be rolling over after being in an uptrend. I have said before that you don’t know the strength of a bull trend until it is tested – and it is being tested now.

While short and intermediate term indicators are starting to flicker red, my inner trader is only tactically bearish for now. The SPX remains above its 200 day moving average, and all of the different versions of the Advance-Decline Lines remain in uptrends. The bears cannot be said to be in full control of the tape until those lines in the sand are crossed.
 

 

Disclosure: Long SPXU

 

China’s tough policy choices

Posted by Cam Hui -

The Buttonwood column in The Economist had this to say about the recovery in metal prices (before the most recent risk-off episode):

A pattern in markets is that a lot happens by rote. China’s response to a weak economy is to build; investors’ response to the Fed’s easing is to buy stocks; the algorithms’ response to a weaker dollar is to buy commodities. Higher prices beget higher prices. The sceptics, the too-sooners, note that this also works in reverse. Quite so. But the momentum is now with the believers.

Even as the copper/gold ratio recovers, there are reasons to be skeptical. As a reminder, this ratio is a useful indicator of global cyclicality. Both copper and gold are commodities, and respond to hard asset inflationary pressures. Copper has more industrial uses, and therefore the ratio can be a way of filtering out the hard asset inflation element out of copper prices.
 

 

There is a speculative element to the rise in metal prices, too. Buying or selling copper futures is a popular way to express a view about the world economy. Indeed copper can be all about belief, says Max Layton of Citigroup, a bank. Many of the bets laid on it are by trading algorithms, which mechanically respond to financial signals that have worked well in the past. The dollar, which has fallen by 6% against a basket of currencies since March, is usually part of the semaphore. A weaker dollar allows for easier terms of finance in emerging markets. Anything that helps emerging-market economies is generally good for commodity prices. So the algorithms buy.

The complex of price changes becomes self-reinforcing. Higher ore prices bring higher-cost producers back to the market. But their profit margins are then squeezed as their home currency appreciates, because that raises the cost of labour in dollars, in which commodities are priced. To restore margins, prices must go up. Moreover, marginal costs rise when the prices of steel (used for mining parts) and oil (used for energy and chemicals) go up. These higher costs push up prices further, says Mr Layton.

What policy choices does China have to revive its economy?
 

China’s challenges

From a long-term perspective, China has a demographic problem. Its population is aging rapidly. The engine of its growth miracle, which was initially based on the widespread availability of cheap labor, is starting to sputter.
 

 

The second problem is debt. Its debt burden has grown to gargantuan levels, and its debt to GDP ratio has plateaued at levels where other countries have experienced crises.
 

 

These headwinds are well known, and Beijing has worked to address these issues for some time. Then policy makers got blindsided by COVID-19, and the authorities chose to respond by putting the entire country into quarantine and shutting the economy down. Now that activity is restarting, growth has become even more unbalanced. Industrial activity has revived, but consumers continue to struggle. Just as consumer activity appeared to rebound, it fell again.
 

 

China’s policy makers chose to restart the economy by focusing on production, whose growth potential depends mainly on exports. The pandemic has spread around the world, and the ensuing shutdowns have cratered demand. If global demand is weak, China’s export led strategy has limited upside potential.

What can policy makers do?
 

Difficult choices

One option is to double down on the export strategy through devaluation. There are two problems with a devaluation strategy. First, it would invite capital flight, and raise doubts about the RMB as a stable reserve currency. As well, it is unclear whether devaluation confers any net growth benefits. The policy is just a subsidy for exporters at the expense of domestic producers and the Chinese household sector. It would also run counter to Beijing’s objective of rebalancing growth towards consumers.

The PBOC’s exchange rate policy recently shifted to a currency basket. Since that shift, the Yuan has been remarkably stable against its benchmark basket, which is a sign that China does not want to pursue the devaluation path. Nevertheless, the volatility of its exchange rate against the USD has increased, but that’s a USD effect, not a CNY policy effect.
 

 

The combination of USDCNY volatility and the collapse of China’s imports from the US under the Phase One trade deal has the potential to raise trade friction with Washington.
 

Wolf Warrior diplomacy

What does a government do when its economy is sputtering and it can’t find a solution? One of the usual approaches is to adopt a nationalist approach in its foreign policy as a way of distracting from problems at home. Indeed, China has pivoted to “wolf warrior” diplomacy to defend its interest. Minxin Pei, Professor of Government at Claremont McKenna College, explains in a Project Syndicate essay:

For example, in mid-March, the foreign ministry’s newly appointed deputy spokesman, Zhao Lijian, promoted a conspiracy theory alleging that the US military brought the novel coronavirus to Wuhan, the pandemic’s first epicenter.

Similarly, in early April, the Chinese ambassador to France posted a series of anonymous articles on his embassy’s website falsely claiming that the virus’s elderly victims were being left alone to die in the country. Later that month, after Australia joined the United States in calling for an international investigation into the pandemic’s origins, the Chinese envoy in Canberra quickly threatened boycotts and sanctions.

In addition, Beijing has taken steps to assert more control over Hong Kong’s affairs, which has rankled many Western capitals. The China-India conflict is heating up. There are reports that Chinese troops have encroached on the Line of Control (LOC) between the two countries, and established positions and artillery emplacements on the Indian side of the LOC.

A Bloomberg article suggests that China actually prefers a Trump win in November despite his “tough on China” reputation as Chinese foreign policy as a signal of prioritizing geopolitical over trade objectives:

Interviews with nine current and former Chinese officials point to a shift in sentiment in favor of the sitting president, even though he has spent much of the past four years blaming Beijing for everything from U.S. trade imbalances to Covid-19. The chief reason? A belief that the benefit of the erosion of America’s postwar alliance network would outweigh any damage to China from continued trade disputes and geopolitical instability…

“If Biden is elected, I think this could be more dangerous for China, because he will work with allies to target China, whereas Trump is destroying U.S. alliances,” said Zhou Xiaoming, a former Chinese trade negotiator and former deputy representative in Geneva. Four current officials echoed that sentiment, saying many in the Chinese government believed a Trump victory could help Beijing by weakening what they saw as Washington’s greatest asset for checking China’s widening influence.

 

Confrontations ahead?

Here is the risk for the markets. It’s not just Chinese policy makers who are subject to pressures in their own country. In the US, Trump’s poll numbers have been sinking in the past few weeks. Even if you don’t believe the polls, market based indicators, such as the odds on PredictIt of a Trump win has also been falling. In addition, the stock market has been wobbly in the last few days.
 

 

So far, Washington has largely held its fire over the failure of China’s Phase One commitments and the Hong Kong situation. In light of Trump’s deteriorating poll figures, there will be a temptation to pivot to a similar nationalist political response.
 

 

Our “trade war” factor is showing very little stress, but the potential for a spike is high. The markets will not respond well to another shock like this, especially when they are already burdened with COVID-19 related uncertainty.

 

A major correction, or just a flesh wound?

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.
 

Just a flesh wound?

Was the market’s -5.9% one-day swoon last Thursday the start of a major correction, or just a flesh wound?
 

 

The S&P 500 exhibited an island reversal last week while violating a key rising trend line that went back to the March bottom, which are bearish. On the other hand, it successfully tested its 200 day moving average (dma), and the VIX Index (bottom panel) recycled from above its upper Bollinger Band (BB), which is an oversold reading, to below, which are constructive signs for the bull case.
 

 

What’s next? The market had been rising steadily so long that it’s difficult to ascertain the short or intermediate term trend. The strength of an uptrend is not known until it is tested in a pullback.
 

The bull case

Here is the bull case. Risk appetite indicators are still intact. The price relative performance of high yield, or junk, bonds and municipal bonds to their duration-equality are holding up well.
 

 

EM risk appetite, as measured by EM currencies and the relative price performance of EM bonds to their UST duration-equivalents, have been holding up well.
 

 

Equity risk appetite, as measured by the ratio of high beta to low volatility stocks, is still in a relative uptrend. So are the different versions of the Advance-Decline Lines. More importantly, the NYSE A-D Line made a fresh all-time high last week, which is bullish.
 

 

The market is exhibiting a recovery in fundamental momentum, and strong breadth and price momentum. Fundamental momentum can be measured by estimate revisions, which has bottomed and starting to rise.
 

 

The percentage of stocks above their 50 dma recently rose above the 90% level. Such episodes have tended to be bullish in the past. Of the 10 signals seen in the last 19 years, seven have resolved bullishly, one was neutral, and two were bearish.
 

 

That’s bullish, right?
 

The bear case

Not so fast! A dated but useful analysis from OddStats for 1923-2018 shows that, on average, the market rises 60% of the time on a one-month horizon and 63% of the time one a three-month horizon. A success rate of 70% for the percentage above 50 dma signal (n=10) is encouraging, but cannot said to be a wildly predictive.
 

 

Here are my other concerns. I have been monitoring the NYSE McClellan Summation Index (NYSI) for several weeks. In the past, whenever the NYSI has become oversold enough to fall below the -1000 level, its weekly slow stochastic had always rebounded from an oversold to an overbought reading. The stochastic has now reached its upside objective, indicating limited upside potential. Moreover, two of the last three rebound episodes were bear market rallies where the final lows of the bear markets were not in yet.
 

 

The most worrisome aspect of the intermediate term outlook is excessively bullish sentiment. Mark Hulbert attributed the market’s air pocket to a simple case of too many bulls. He pointed out that his Hulbert Stock Newsletter Sentiment Index (HSNSI) recently rose to a high of 62.5%, which was at the 91st percentile of the distribution of daily HSNSI readings since 2000.
 

 

Once HSNSI starts to drop from these crowded long levels, it doesn’t stop until it becomes oversold and fear creeps in.

The typical pattern is that, once the HSNSI rises into this zone of extreme bullishness, it drops significantly. It often falls back to the 10th percentile or lower. The threshold for that zone of extreme bearishness is minus 2.7%, a reading that would indicate that the average timer is allocating 2.7% of his short-term equity trading portfolio to going short.

We’re far from that now. In the wake of Thursday’s plunge, the HSNSI dropped back just to 53.6%, which is still at the 77th percentile of the historical distribution.

Troy Bombardia concurred with Hulbert’s observation about bearish momentum by pointing out that the recent bullish momentum evidenced by the numerous recent breadth thrusts have been negated by bearish momentum. Market breadth is rolling over, which has historically been bearish, and this development has the potential to negate the bullish effects of the recent breadth thrusts.
 

 

John Authers of Bloomberg offered another explanation for Thursday’s pullback, namely the perceived declining fortunes of the Republicans in November. The PredictIt odds of Trump winning the White House, and Republican control of the Senate have been falling rapidly.
 

 

These are not market friendly outcomes for equity investors. I wrote last week (see What would a Biden Presidency look like?) that investors should pencil in about a $10 drop to S&P 500 2021 earnings from the unwinding of the 2017 corporate tax cuts. Goldman Sachs produced further analysis indicating that the secondary effects a Democrat win, such as rising minimum wages, the imposition of a minimum corporate tax, and so on, has the potential to add another $10 cut to 2021 earnings.
 

 

None of these developments are intermediate term equity bullish.
 

Bearish tripwires

Where does that leave us? The weight of the evidence suggests that this is the start of a deeper correction, and not just a hiccup in an uptrend. From a trader’s perspective, however, I am inclined to give the bull case the benefit of the doubt until most of the following bearish tripwires are triggered.

  • Violation of 200 dma support.
  • Violation of the rising trend lines formed by the different A-D Lines, and the high beta to low volatility ratio.
  • Weakness in the relative performance of high yield bonds.
  • The 10-year yield violating support at 0.6%, and an upside breakout by the USD Index through the falling trend line.

 

 

Despite Friday’s relief rally, short-term breadth is very oversold. The stock market could rally further early in the week, though there are no guarantees that an oversold market cannot become even more oversold.
 

 

My inner investor is neutrally positioned, though he is leaning towards a bearish intermediate term outcome. Subscribers received an email alert on Friday indicating that my inner trader had initiated a short position in the market. While he believes that the intermediate term path of least resistance is down, he is open to all possibilities in the short run, and he is waiting for the triggers of the bearish tripwires before becoming more aggressive on the short side.

Disclosure: Long SPXU

 

What professional career risk looks like

Posted by Cam Hui -

This is a market that defines professional career and business risk. Should investors adopt a momentum approach, or maintain caution in the face of valuation and macro risk?

The stock market has recovered from the COVID-19 crash. The NASDAQ has made a fresh all-time high, and the SPX was briefly positive for 2020. Price momentum has been strong, and broad. Analysis from Topdown Charts shows that 74% of countries are now in bull markets.
 

 

On the other hand, the macro outlook and valuations are stretched. The market is trading at a forward P/E ratio of over 21. Even with headline CPI at -0.1%, the Rule of 20 is flashing a warning for the stock market.
 

 

The current market environment raises the level of career and business risk for investment managers. Traditional investing approaches would call for prudence in the face of elevated valuation and heightened macro risk. On the other hand, if the strong market breadth were to continue, it would mean an investment environment reminiscent of the go-go days of the dot-com bubble, and the Nifty Fifty era. A defensive posture in the face of an investment bubble risks the loss of clients and career damage. Adopting a price momentum approach to investing while ignoring valuation also risks the perception of recklessness that can forever stain a career.

What should an investment professional do in the face of such career risk volatility? There are no easy answers.

During these unusual periods of severe bifurcation between valuation and macro risk and price momentum, the investment professional is forced to make a decision based on what he believes the dominant investment regime will be in order to minimize career and business risk. This amounts to the classic Keynesian investing beauty contest, where investors do not try to determine the winner based on some investment criteria, but based on what he believes other investors think will be the winner.

My base-case scenario calls see a period of “revenge consumption” euphoria, followed by further signs of stagnant recovery. Investors will also have to face the risk of a second wave of infection in the fall, which will result in either another partial or full lockdown that slows economic growth and raises financial stress. Even if the authorities opt to forego a lockdown for political reasons, there may be a sufficient number of individuals who choose to stay home for precautionary reasons, which will have the same effect as a partial lockdown.

Let’s consider how two well-known investors have approached the problem.
 

The quick bull

One example of a quickly adapting investor is Stanley Druckenmiller, who said on CNBC that he was “humbled” by the market comeback. He initially voiced his cautious view in a May 12 speech to the Economic Club of New York.

He said worries over the corporate debt bubble was what led him to tell the Economic Club of New York in mid-May that the stock market was overvalued.

“The risk-reward for equity is maybe as bad as I’ve seen it in my career,” Druckemiller said on May 12. “The wild card here is the Fed can always step up their (asset) purchases.”

Druckenmiller made an about-face in reaction to the market comeback.

“I would say since that time, a couple things have happened technically. I would also say I underestimated how many red lines, and how far, the Fed would go,” he said.

That Fed stimulus, combined with investor excitement about the gradual reopening of U.S. business, is leading to broad outperformance among those stocks hit the hardest in March, he said. He added that the technical momentum the market has right now, what he called “breadth thrust,” could carry equities even higher.

“What is clearly happening is the excitement of reopening is allowing a lot of these companies that have been casualties of Covid to come back and come back in force. With a combination of the Fed money and, in particular, a vaccine where the news has been very, very good,” Druckenmiller said.

 

The cautious value investor

At the other end of the spectrum is GMO, which is known as a cautious value investment firm. Its Q2 2020 investment letter declared that it had “reduced [its] net equity exposure in [its] Benchmark-Free Allocation Strategy from around 55% to about 25%.”

Jeremy Grantham explained the firm’s cautious view in terms of past investment bubbles. In the past three major bubbles, they were overly early in two, which created a high degree of business risk.

There are no certainties here. At GMO we dealt with three major events prior to this crisis, and rightly or wrongly, we felt “nearly certain” that sooner or later we would be right. We exited Japan 100% in 1987 at 45x and watched it go to 65x (for a second, bigger than the U.S.) before a downward readjustment of 30 years and counting. In early 1998 we fought the Tech bubble from 21x (equal to the previous record high in 1929) to 35x before a 50% decline, losing many clients and then regaining even more on the round trip. In 2007 we led our clients relatively painlessly through the housing bust. In all three we felt we were nearly certain to be right. Japan, the Tech bubbles, and 1929, which sadly I missed, were not new types of events. They were merely extreme cases akin to South Sea Bubble investor euphoria and madness.

GMO’s cautiousness is justified by the combination of excessive valuation and poor macro outlook.

Everyone can see and feel that this is different and can sense the bizarre nature of the market response: we are in the top 10% of historical price earnings ratio for the S&P on prior earnings and simultaneously are in the worst 10% of economic situations, arguably even the worst 1%!

The firm recognizes that it can be early in its defensiveness, and it is prepared to lose clients and assets because of its investment convictions. Are other investment managers prepared to take the same risk?
 

The Keynesian beauty contest

The key difference between Druckenmiller and Grantham is time horizon. Stan Druckenmiller is a hedge fund manager who is prepared to pivot on a dime. Grantham positions himself as a long-term investor, and he is prepared to ride out short and medium term bumps in the market.

Both involve high levels of career and business risk in the current environment of heightened uncertainty and volatility. What should you do as an investor?

During these unusual periods of severe bifurcation between valuation and macro risk and price momentum, the investment professional is forced to make a decision based on what he believes the dominant investment regime will be in order to minimize career and business risk. This amounts to the classic Keynesian investing beauty contest, where investors do not try to determine the winner based on some investment criteria, but based on what he believes other investors think will be the winner.

Here is the key short run question that you have to answer. Over the next few months, as we progress into Q2 earnings season, will the market narrative and focus be healing, re-hiring, increased capital expenditures, and low cost of capital, or an unexpected layer of costs to reopen, lower capacity and reduced demand, and continuing uncertainty?

Here is the bull case. The NFIB small business survey is a useful indicator, because small businesses have little bargaining power and their views are a sensitive barometer of the economy. Small business confidence staged a small rebound in May. As well, sales expectations have bottomed and begun to rise from the lowest level in the survey’s 46 year history.
 

 

Capital expenditure plans have bottomed and they are edging up.
 

 

Hiring plans have also rebounded.
 

 

Renaissance Macro pointed out that high propensity business applications, defined as businesses likely to result in a payroll, rose 3.9% year-over-year in May.
 

 

A study by economists at the St. Louis Fed of real-time signals from the job market found continued healing in June.

We then repeated the same exercise for the week ending on June 5 to get the most up-to-date reading of the labor market. We predict that the recovery has continued at a healthy pace and employment is now down 8.75% relative to January.

 

 

The case for caution

Here are some reasons for caution. In contrast to the healing tone of the NFIB survey, Evercore ISI’s CFO survey (conducted 5/17-6/7) of capex plans for 52 companies is tanking. Capex plans for this year are the worst in their history. CFOs are focused mainly on increasing liquidity, not capex.
 

 

The key risk is whether the consensus expectation of a V-shaped recovery in earnings is realistic.
 

 

Sure, we are seeing signs of healing and labor market recovery. Investors have to distinguish between the first phase of the recovery, which brings back the workers who are temporarily laid off, and the second phase of the recovery, which will be much slower and could see the economic aftershocks of the crisis. As an example, even if the unemployment rate were to fall by year-end to the range between the Fed’s 9.3% projection and the Congressional Budget Office’s 11.7% projection, the economic pain would still be considerable compared to the recessions of the post-War era.
 

 

Joe Wiesenthal of Bloomberg proposed an alternative but stylized framework of flattening the curve, employment style. Investors should distinguish between the gains in employment that return from the mandated lockdown, and the losses in employment from the recession caused by the lockdown.
 

 

Recessionary unemployment could be considerable. A University of Chicago Becker Friedman Institute paper estimates that “42 percent of recent layoffs will result in permanent job loss”. A similar study by Bloomberg Economics decomposed job losses into demand and supply shocks, search, and reallocation shocks. It found that roughly 30% of losses are attributable to reallocation, meaning that those jobs won’t return quickly and inflict long-term damage to the employment market.
 

 

All of these models are based on the assumption that there is no second wave of infection necessitating either a partial or full lockdown of the economy. Already, case counts are rising in a number of states, such as Arizona, Arkansas, California, Florida, Georgia, Kentucky, Nevada, New Mexico, North and South Carolina, Texas, and Utah, just to name a few. The situation in Houston has deteriorated so much that officials are close to reimposing stay-at-home orders again.
 

 

The FIFO China model

How can we resolve these competing narratives? One useful template is to see how China’s economy evolved as it emerged from lockdown. While circumstances are not the same, China’s growth trajectory after its COVID-19 crisis can serve as a useful model of how growth may evolve based on a first-in-first-out principle.

Chinese statistics reveal a bifurcated economy. Industrial production has snapped back quickly.
 

 

By contrast, the retail sales recovery has not been as strong.
 

 

China is trying to boost its economy through stimulating the industrial sector, mainly through exports. But the global economy is weak, and demand anemic. Reuters reported that May exports were down, and imports were the worst in four years.

Overseas shipments in May fell 3.3% from a year earlier, after a surprising 3.5% gain in April, customs data showed on Sunday. That compared with a 7% drop forecast in a Reuters poll.

While exports fared slightly better than expected, imports tumbled 16.7% compared with a year earlier, worsening from a 14.2% decline the previous month and marking the sharpest decline since January 2016.

It had been expected to fall 9.7% in May.

“Exports benefited from the ASEAN (Association of Southeast Asian Nations) market and exchange rate depreciation, while imports were affected by insufficient domestic demand and commodity price declines,” said Wang Jun, chief economist of Zhongyuan Bank.

While China watcher and Beijing resident Michael Pettis reported some anecdotal evidence of post-lockdown “revenge consumption”, Chinese consumer demand is still weak. If Chinese consumer pattern is representative of what will happen in the US, we are just seeing reports of “revenge consumption” stage, which will be followed by flattening sales growth.
 

 

Unlike China, American manufacturers are not going to bail out the economy. A recent Barron’s article reported that exports are weak, and so is the trade balance.
 

 

Unless the global economy can recover, exporters will suffer from a lack of demand. Until COVID-19 is defeated, it is difficult to see how demand can recover. The latest fatality growth shows most of the growth is coming from EM countries and south of the equator, indicating a possible seasonal and temperature effect. This suggests that a second wave of infection will hit the northern hemisphere in the fall, which will necessitate either full or partial stay-at-home edicts until a vaccine becomes widely available.
 

 

In conclusion, the decision between an investment approach based on price momentum versus valuation and macro risk assessment depends on how the market narrative will develop over the next few months. As we progress into Q2 earnings season, will the market narrative and focus be healing, re-hiring, increased capital expenditures, and low cost of capital, or an unexpected layer of costs to reopen, lower capacity and reduced demand, and continuing uncertainty?

My base case scenario calls see a period of “revenge consumption” euphoria, followed by further signs of stagnant recovery. Investors will also have to face the risk of a second wave of infection in the fall, which will result in either another partial or full lockdown that slows economic growth, and raises financial stress. Even if the authorities opt to forego a lockdown for political reasons, there may be sufficient number of individuals who choose to stay home for precautionary reasons, which will have the same effect as a partial lockdown.

 

Trading sardines, or eating sardines?

Posted by Cam Hui -

Mid-week market update: Experienced investors know the story about the difference between trading sardines and eating sardines. Here is how Seth Klarman recounted the story:

There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”‘

Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading. Speculation offers the prospect of instant gratification; why get rich slowly if you can get rich quickly?

Klarman continued:

Speculation involves going along with the crowd, not against it. There is comfort in consensus; those in the majority gain confidence from their very number. Today many financial-market participants, knowingly or unknowingly, have become speculators. They may not even realize that they are playing a “greater-fool game,” buying overvalued securities and expecting—hoping—to find someone, a greater fool, to buy from them at a still higher price.

There is great allure to treating stocks as pieces of paper that you trade. Viewing stocks this way requires neither rigorous analysis nor knowledge of the underlying businesses. Moreover, trading in and of itself can be exciting and, as long as the market is rising, lucrative. But essentially it is speculating, not investing.

In light of the surprising and powerful stock market rally off the March bottom, you have to ask yourself, “Am I looking for trading sardines, or eating sardines?”
 

The trader’s bull case

Traders and speculators have far shorter time frames than investors. One example of a successful speculator is Stan Druckenmiller, who admitted on CNBC that he was humbled by the market comeback, and he had said made just 3% during the market’s 40% rally off the March bottom

The bull case can be summarized by the strong breadth exhibited by the advance. The NYSE Advance-Decline line has already made an all-time high. The beleaguered small caps, which had been lagging the market on the way down, has revived.
 

 

In addition, the ratio of cyclical to defensive stocks have turned up dramatically and made a new recovery high.
 

 

These are all market signals of a cyclical revival off the recession bottom. The market is rising while flashing a series of “good overbought” RSI signals. It’s time to buy.
 

 

The bear case

The bear case consists of cautionary signals from sentiment and valuation. The Citi Panic/Euphoria Model has risen to euphoric levels last seen in 2002.
 

 

That’s no surprise, because the market’s forward P/E and median stock’s forward P/E have risen to levels not seen since 2001, which was the descent from the dot-com bust.
 

 

The degree of retail speculation has become rampant. Here is another example. Robinhood traders have been piling into the common shares of Hertz, which recently filed for Chapter 11 bankruptcy protection. The shares have bounced sharply off their bottom, and nimble speculators could have made ten-bagger gains.
 

 

At last report, Hertz unsecured bonds, which rank ahead of common shareholders on liquidation, were trading at at between 12c and 33c on the dollar. If the market believes the unsecured bondholders are that unlikely to be fully paid out, common shareholders are certain to be wiped out in any restructuring. (By the way, if anyone wants to dive into the Hertz financials to figure out their capital structure, please let me know the results of your analysis.)
 

 

It seems that bankruptcy is now the new buy signal. While sardine traders don’t care about intrinsic value, sardine eaters have to be concerned about the sentiment implications of this development.

As another example of the retail frenzy, this tweet from Jesse Felder requires no further explanation.
 

 

The action of small option traders are also raising red flags about market frothiness. Remember back in February, small traders were actively plotting bull raids on stocks using call options on Reddit (via Bloomberg):

When shares keep rising, managing the hedge entails buying more stock. That’s where the Reddit set perceives a weakness. A favorite tactic on r/WSB is to swamp the market with call purchases early in the morning in an attempt to force dealers to keep buying stock. Up and up everything goes—supposedly. As the stock price rises, so does the value of the calls, often by far more.

In this worldview, the only constraint on success is the force of one’s own conviction and willingness to act upon it. An added attraction: It’s all relatively cheap in terms of an option’s simple dollar cost. For the price of one share of Amazon.com Inc.—about $1,965 on Feb. 25—a decent-size campaign can be waged in long-shot options trading for pennies. That matters nowadays, when the rise of exchange-traded funds and mutual funds has convinced U.S. companies that they no longer need to split their stocks to keep the share price manageable for retail investors. Many companies now trade for three or four figures a share.

SentimenTrader pointed out last Friday that small traders are back to their old tricks.

At the peak of speculative fervor in February, small traders bought to open 7.5 million call contracts.

This week, they bought 12.1 million.

Watch what people do, not what they say. They’re full-bore bullish, on steroids.

 

As well, the Market Ear pointed out that long/short equity betas are also showing a crowded long positioning.
 

 

These kinds of sentiment excesses have to be concerning, even for sardine traders who are purely focused on price momentum.
 

Resolving the bull and bear cases

Here is how I resolve the short-term bull and bear cases. The signs of excessively bullish sentiment is a warning, or a bearish trade setup, but it’s too early to go short just yet.

The equity-only put/call ratio reach a low of 0.37 on Monday, and its 10 dma reached 0.44 on Tuesday. In the past, such readings have signaled limited upside potential, but the market did not retreat until either RSI recycled below an overbought level, or flash negative divergences with the price action.
 

 

Should RSI flash “sell”, the next question is whether the signal is calling for a minor correction, or a deeper pullback. From a technical perspective, I would be inclined to give the bull case the benefit of the doubt until the rising trend line on the ratio of high beta to low volatility are violated. It is difficult to judge the strength of a trend until it pulls back, and you can gauge its strength by the scale of its short-term weakness.
 

 

My inner trader is in cash, but he is watching for the setup to jump in on the short side for a scalp. It is always difficult to discern a viable signal on an FOMC day, but if the market were to weaken tomorrow, my trading account would enter a small initial short position in the market.

 

Buy the breadth thrusts and FOMO stampede?

Posted by Cam Hui -

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

The Trend Asset Allocation Model is an asset allocation model 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.
 

Breadth thrusts are bullish

Last week, technical analyst Walter Deemer pointed out that the market had flashed a “breakaway momentum” buy signal. He did qualify the condition, “Supposed to get it near the beginning of a powerful move, not after a 42% advance (altho did have late signals Jul 12 2016 and Nov 20 1950). Definitely not its finest moment…”
 

 

As well, Deemer reported on Friday that the market achieved both a Whaley Breadth Thrust and a Whaley Volume Thrust.

Could this be the start of a new bull leg? On one hand, the market’s animal spirits are stirring, and breadth thrusts like Deemer’s breakaway momentum signal have historically been bullish. There are usually signals of a full-fledged Fear of Missing Out (FOMO) stampede, especially in light of the surprisingly strong May Jobs Report (see May Jobs Report: Back from furlough). If you only believe technical analysis is all that matters, then you should be bullish.

On the other hand, the market is trading at a stratospheric forward P/E of 22.4, and at a 2021 P/E of 19.5. To buy now means adopting the late 1990’s go-go mentality that earnings don’t matter, and all that matters is price momentum.

Careers were made and severely damaged during the dot-com era. Should traders throw caution to the wind?
 

Analyzing market psychology with factors

To answer that question, we use factor analysis to delve into market psychology. The dot-com bubble of the late 1990’s was characterized by the frenzy of the belief in a new era. Earnings didn’t matter, what mattered were eyeballs and addressable market for a product or service. Low quality stocks with negative earnings and cash flow outperformed high quality stocks with positive earnings and cash flows.

A similar effect can also be observed at the recessionary market bottoms. The shares of beaten down nearly dead zombie companies stage a furious rally as they act like out-of-the-money call options. I made a speculative call to buy the so-called Phoenix stocks a week before the ultimate bottom in March 2009 (see Phoenix rising?).
 

 

An analysis of current factor rotation reveals an anomalous story of market psychology. As a reminder, our primary tool is the Relative Rotation Graph (RRG). Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership of different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
 

 

In light of the strong market rally, some factor returns were no surprises. Large cap growth, which were the FANG+ market leaders, is starting to falter. So was price momentum, which is also dominated by FANG+ names. Up and coming leadership consisted of high beta and small cap stocks, though the emerging leadership of small cap growth stocks is a minor surprise.

Here is the bigger surprise. Why are the high quality and shareholder yield factors performing so well if Phoenix stocks would normally outpace the market in a recessionary rebound?
 

 

We can see a similar set of circumstances at play in small caps. The bottom panel shows the now familiar small to large cap ratio (black line) indicating a small cap revival. The Russell 2000 (RUT) to S&P 600 (SML) is a quality, or junk, factor at play within the small cap universe. The S&P 600 has a much stricter profitability criteria for index inclusion compared to the Russell 2000, and the RUT/SML ratio therefore represents a small cap junk factor. So why were the small cap junk stocks tanking on a relative basis since the market broke out through its 61.8% retracement level since mid-May?
 

 

Here is a long-term perspective of the small cap junk, or low quality, factor. Low quality small caps unsurprisingly lagged as the market fell from the dot-com market top, and turned up coincidentally with the market at the 2002 bottom. Low quality bottomed ahead of the market bottom in 2008, and coincidentally with the market in 2016.
 

 

Recently, some anomalies have appeared. Low quality bottomed in 2018 just as the stock market topped out. We saw a second bottom in September 2019 just as the market began its melt-up. From a strictly technician’s perspective, the combination of the  latest parabolic rise of this factor from September 2019. along with the stock market could be interpreted as just a sustained bull market. The COVID-19 crash and subsequent recovery was therefore just a correction within a secular bull.

In that case, the S&P 500 point and figure upside target ranges from 3384-3779, depending on how the analyst sets the parameters.
 

 

A go-go melt-up ahead?

How realistic is the melt-up scenario?

The intermediate term bull case depends on accepting the thesis of a go-go mentality as manifested by the breakaway momentum signal. This breadth thrust is unusual inasmuch as it was not accompanied by low quality stock leadership that accompanied past recessionary equity market rebounds.

In addition, sentiment is becoming frothy. The normalized equity-only put/call ratio is at a crowded long extreme, which is contrarian bearish. Similar past reading, even during the dot-com bubble era, resolved themselves with short-term pullbacks. None of the bullish sentiment extremes coincided with breakaway momentum signals.
 

 

Helene Meisler wrote a RealMoney column analyzing the recent incidence of low put/call ratio extremes: She concluded:

In the big picture, out of these six readings, four of them were part of a topping process. One gave you an immediate plunge and nice rebound (2010) and one gave you a mild correction that then went on to rally for months (2009). It’s a matter of whether you think now is like August 2009, August 2010 or some other time.

Another sign of excessive speculation is the spike in the ratio of Nasdaq to S&P volume. There have been reports of Robinhood traders buying low priced Nasdaq stocks, which is a reason for the skew in this ratio.
 

 

Estimates of hedge fund positioning indicate that global macro and long/short hedge funds are roughly neutrally positioned in equities, and CTAs are in a crowded long. Fast money retail traders are stampeding into the market, encouraged by the zero-commission regime offered by online brokers. The analysis of the stock/bond ratio shows that it has returned to above its 52-week moving average, indicating that a portfolio which did little or nothing in reaction to the COVID-19 crash would have roughly the same asset allocation as pre-crash levels. Therefore there is no need to rebalance, and little demand for equities from long-term investors.
 

 

In conclusion, the breakaway momentum and breadth thrust bullish thesis just doesn’t feel right. It is difficult to reconcile a breadth thrust, which is built on the idea of a FOMO stampede by investors jumping on a bullish bandwagon, with the observation of the lack of low quality and zombie stock participation, and extreme bullish sentiment. A FOMO stampede depends on drawing in more traders who can pour money into the market, but the put/call ratio is signaling a bullish sentiment extreme. In that case, where are the buyers?

Consequently, it is difficult to buy into the breakaway momentum bull case. My base case scenario calls for a corrective period to begin in the next few weeks. How the market behaves after the correction is highly dependent on news flow, but at a forward P/E of 22.4, and a 2021 P/E of 19.5, the market is priced for perfection. The bulls better pray that nothing goes wrong.
 

The week ahead

Looking to the week ahead, it’s difficult to know how far the market’s animal spirits can carry stock prices. Don’t forget that, even before last Friday’s Jobs Report shocker that propelled the stock market higher, equities were advancing even as riots were erupting in American cities. The Fear and Greed Index closed Friday at 66, which is well below the giddy greed levels of 80 or more. Arguably, this rally has more legs.
 

 

On the other hand, the percentage of stocks above their 50 dma is topping and it’s starting to roll over. The last two times this happened, the market topped out soon after. The 14-day RSI is overbought, and coincided with short-term tops when the % of stocks above their 50 dma weakened. Should the market push higher, watch for negative divergences from the 5 and 14 RSI as warning signs.
 

 

The analysis of breadth also presents a mixed picture and some nagging doubts. While the A-D Line was strong and confirmed market strength, both NYSE and NASDAQ new highs weakened even as the market surged on Friday.
 

 

I outlined on Friday some of my reservations about the blowout Jobs Report (see May Jobs Report: Back from furlough). I would also like to add that we don’t know whether the job gains were artificially boosted by PPP incentives for employers to rehire workers while keeping them idle, which would be negative sign that demand isn’t there, or a genuine need to reopen businesses. As well, government jobs fell by -585K in May after declining by -963K in April. This is a worrisome trend, indicating strains on state and local government budgets, which will ultimately show up in the muni market.
 

 

In the short run, none of the Jobs Report details matter. The next major market moving event to watch for is the FOMC meeting on Wednesday. The market will be watching closely to see how the Fed reacts to the employment surprise. Trump economic advisor Larry Kudlow stated on Fox that the third quarter “could be the fastest-growing quarter in U.S. history.”, which would reduce the urgency of further fiscal stimulus. Will the Fed feel the same way?

Watch the USD, and bond yields for important clues. The USD Index is testing a key support zone, and the 10-year yield is testing a key resistance level.
 

 

My inner investor is neutrally positioned. While my bias is to call for weakness in the next few weeks and into Q3, I would guesstimate a 30% chance that the surge continues and the S&P 500 continues rising to test its old highs.

My inner trader is confused by the cross-currents. He does not see a trading edge, so he has stepped to the sidelines for now.

 

What would a Biden presidency look like?

Posted by Cam Hui -

Joe Biden has officially clinched the Democratic nomination for president, and his odds of winning the Presidency in November have been steadily rising, and he is now at 54% on PredictIt. For the uninitiated, the contract pays off at $1.00 if a candidate wins, so buying the Biden contract at $0.54 implies a 54% of a Biden victory.
 

 

The consensus view has the Democrats retaining control of the House. The PredictIt odds of the Democrats gaining control of the Senate has been steadily improving over the past few months, and now shows a slight edge for the Democrats. In the case of a 50-50 divided Senate, the vice-president casts the tie-breaker and the winner of the White House has control.
 

 

While this is not meant to be an endorsement of any candidate or political party, it is time to contemplate what a Biden victory might mean for the economy and the markets. If Biden were to win, there is also a decent chance that the Democrats might capture control of both chambers of Congress. How should investors react to that outcome?
 

The law and order card

In response to the current bout of unrest, President Trump has played the law and order card to assert control of the situation. This could be evocative of Richard Nixon’s successful 1968 campaign to win the White House based on a similar law and order theme. For those who can remember, 1968 was marked by incredible political turmoil, marked by:

  • The Tet Offensive in the Vietnam War, which broke the illusion of a quick victory.
  • LBJ’s surprising address to the nation, in which he stated that he would not run for another term.
  • The assassination of Martin Luther King, Jr..
  • The assassination of Robert Kennedy.
  • The riots outside the Democratic Convention in Chicago.

Nixon’s gamble worked, and he won. Moreover, the stock market shrugged off most of these events and rose in 1968.
 

 

Could Trump repeat the Nixon experience? Probably not. A recent Morning Consult poll showed that the law and order stance (or at least Trump’s version) is not playing well with the electorate, and an ABC-Ipsos poll came up with similar results. When asked if the respondent approved of President Trump’s handling of the protests and demonstrations in response to the death of George Floyd, the spread between “Excellent/Very Good” and “Only Fair/Poor” among all registered voters was -35%. Even among respondents who already approve of Trump’s performance, the spread was only +29%. Normally, he should be winning this demographics by 50% or more.
 

 

Even among evangelical voters, which have been a bedrock of Republican support, the spread was -13%. Fox News report that 700 Club evangelical leader Pat Roberson chided Trump’s actions.

Evangelical leader Pat Robertson criticized President Trump Tuesday for berating governors and threatening to deploy the military amid the racially charged protests and riots sweeping the nation following the death of George Floyd.

“It seems like now is the time to say, ‘I understand your pain, I want to comfort you, I think it’s time we love each other,'” Robertson said on “The 700 Club.”

“But the president took a different course. He said ‘I am the president of law and order’ and he issued a heads-up. He said, ‘I am ready to send in military troops if the nation’s governors don’t act to quell the violence that has rocked American cities.’ Matter of fact, he spoke of them as being ‘jerks.’ You just don’t do that, Mr. President! It isn’t cool!”

The law and order card isn’t working, and Trump’s support is eroding. There are five months until the election. While five months is a long time is politics, current polling is not favorable for Trump’s electoral chances.
 

Biden’s economic policy

For investors, the most important focus is economic policy. While we don’t know the exact makeup of Biden’s economic team, we can get some clues of the philosophical direction by analyzing the writings of Jared Bernstein, who was Biden’s former chief economist. Bernstein penned a Washington Post OpEd in December outlining what he believed to be the “big economic lessons of the decade”. He followed up with further details in a blog post, with my interpretation in brackets.

  • The unemployment rate can fall a lot lower than most economists thought without triggering inflationary pressures (run a hot economy, keep rates low).
  • Budget deficits cannot be assumed to place upward pressure on interest rates (implicitly supports Modern Monetary Theory, or MMT, which states that a country can borrow in its currency as long as the bond market signals support).
  • Weak worker bargaining power has long been a factor driving inequality. In the last decade, the increasing clout of certain employers has joined the mix (expect the returns to capital to compress, and the returns to labor to rise).
  • Progressive health care reform, wherein the government plays a larger role in coverage and cost control, works (support expansion of Obamacare, and Medicare for All remains an open question).
  • [Lesson re-learned] Trickle-down tax cuts don’t work (watch for higher taxes).
  • Antipoverty programs don’t just reduce poverty today; they improve the outcomes of their beneficiaries many years hence (bad news: higher taxes, good news: more spending by lower income Americans to support growth). .

The most immediate effect of these implicit policy prescriptions is higher taxes and lower operating margins from inequality initiatives. The Trump tax cuts of 2017 boosted earnings by 7-9%. While Biden’s official position is he will unwind some, but not all, of Trump’s corporate tax cuts, expect greater regulatory burden and inequality policies such as higher minimum wage laws to cut into operating margins under a Biden Presidency. Pencil in a $10 to $20 cut to S&P 500 2021 earnings from Biden’s tax policy.
 

 

Longer term, the following are all likely under a Biden presidency, and they are not mutually exclusive.

  • Higher taxes for both individuals and corporations
  • Profit margin compression from higher labor costs
  • Higher GDP and sales growth from a broadened consumer base

Until we know the exact makeup of Congress and the cabinet, it is impossible to forecast the exact magnitude of those factors.
 

The rise of the bomb throwers

Should the Democrats win in a landslide, or Blue Wave, and gain control of the White House, the Senate, and the House of Representatives, there is a distinct possibility of a radical shift in the Overton Window, or the range of acceptable political discourse. A Blue Wave would embolden the progressive wing of the party to bring in the radical thinkers and metaphorical bomb throwers into government.

One of the leading candidates for a bomb thrower to challenge orthodoxy in a Biden administration is Stephanie Kelton, who is a leading advocate of MMT. As I pointed out before, MMT postulates that a country can borrow in its currency as long as the bond market signals support. Instead of asking “how will you pay for that” when proposing a government spending program, the question turns to “can we finance it at a reasonable rate?” When the market is willing to lend to the federal government for 10 years at well under 1%, the question is an easy one to answer. The implementation of MMT as policy will become a Grand Experiment, just as the Laffer Curve was under Reagan. Expect greater expansion of government spending programs. We will find out in a decade whether inflation pressures rise significantly, as the Austrian economists predict, or if the MMTers are right.

A more radical economic bomb thrower is Mariana Mazzucato, who questioned the fundamental question of how value is created, and the policy implications of the answer. This YouTube video of her TED talk raised the following provocative questions:

  • Who are the value creators? Who doesn’t create value, the couch potatoes, the value extractors? 
  • What happens to the economy if it becomes dominated by unproductive value extractors? This begs the question of how you define value extraction.
  • During the agrarian era 300 years, François Quesnay produced the Tableau Economique broke down the value chain into the farmers, or the “productive class”, the merchants, the “proprietors” who effect transactions, and the landowners, the “sterile class”.
  • During the industrial revolution of the 1800s, economists like Smith, Ricardo, and Marx focused on an industrial theory of value. Adam Smith’s landmark book, The Wealth of Nations, had an example of a pin factory where a single worker could produce one pin a day, but sufficient investment into capital equipment and the division of labor could see 10 workers produce 4800 pins a day. Smith went on to define “unproductive” activities as churchmen, lawyers, physicians, men of letters, players, buffoons, musicians, opera singers, and opera dancers.
  • Neo-classical economics came next, and changed the definition of value creation from “objective” to “subjective”. A subjective definition of value is based on an individual’s view of value, individual utility maximization and firm profit maximization. While past thinkers viewed the value creation process objectively by trying to determine value, neo-classical economics determines value from the price of a good or service. Anomalies can arise if you measure GDP when a good or service has a price. Mazzucato cited the examples of someone who marries their babysitter, GDP falls because there is no price is paid for babysitting services; or if a company pollutes, GDP rises because there is a cost to the cleanup.

 

 

Mazzucato believes governments to be more ambitious in ensuring the public good. She cited the as an example difference between airline bailouts in Austria and the UK. Austrian airlines received bailouts on the condition of meeting emissions targets, while the UK government bailed out airlines without no conditionality.

Bottom line: There is a distinct possibility that policy could take a dramatic lurch to the left after the election.
 

Healthcare policy

Biden is on record as stating that healthcare reforms should be made slowly. He would begin by improving on the ACA, or Obamacare, and then by possibly adding a public option. He is pragmatic about Medicare for All, and does not believe the Democrats have the political capital to fight another healthcare battle in the space of 10 years. However, the pandemic induced recession has exposed the cracks in the American system of employer funded health insurance, and that may induce greater popular support for a single-payer or public health insurance option.

Healthcare stocks are currently moving more ore less in lockstep with each other, but a Biden win is likely to put greater downward relative pressure on healthcare providers in particular. At a minimum, investors who want exposure to this sector during the COVID-19 era should focus on the healthcare momentum ETF (PTH)/
 

 

Trade: The silver lining

The one silver lining under a Biden Presidency is trade policy. Biden has made it clear that he does not favor Trump’s America First approach, and he would work with allies through international organizations built since the post-World War II era to resolve trade and other frictions. While that does not necessarily mean a softer line with China, the nature of the dialog will be very different.

As an example, Obama negotiated the Trans Pacific Partnership as a multi-lateral firewall against Chinese trade dominance, and Biden would return to that approach. One of the contradictions in Trump’s trade conflict with China is the tension between lowering the trade deficit and the desire to open the Chinese market to American companies through the protection of intellectual property rights. If China were to fully open its economy to foreign companies, FDI would rise, and American companies would pour into China. American owned Chinese factories would produce goods for export back to the US, and raise the trade deficit. So what does Trump really want, a lower trade deficit, or expanded protection for IP?

The Biden approach would tone down the trade rhetoric, but the strategic competition between the two countries will remain, which has the possibility to turn into a new cold war. However, expect the level of trade friction between the US and other countries and regions like the EU to fall significantly.

The trade war factor, which measures the relative performance of domestic companies to the index, should see a dramatic decline in tensions. While Biden’s tax policy is likely to reduce earnings, his trade policy is the silver lining that lowers uncertainty.
 

 

In conclusion, 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.

Stay tuned tomorrow for our tactical market analysis.

 

May Jobs Report: Back from furlough

Posted by Cam Hui -

I don’t usually offer instant reactions to economic news, but the May Jobs Report was a shocker. Non-Farm Payroll gained 2.5 million jobs, compared to an expected loss of -8 million. The Diffusion Index bounced back strongly, indicating breadth in job gains.
 

 

This was a positive and highly constructive report for the economy. Before everyone gets overly giddy, the report also highlighted some key risks to the outlook.
 

Where the jobs came from

Nearly all of the 2.5 million in job gains came from the “private services providing” sector. Half of that was attributable to “leisure and hospitality”, with additional major gains from “retail trade” and “health care and social assistance”. Equally constructive was the 39.1K increase in temporary employment, which is a leading indicator of employment and shows rising labor market tightness. As well, average weekly hours and overtime hours rose across the board, which is another sign of a healing economy.

The unemployment rate was consistent with the direction, though not the magnitude, of the continuing jobless claims data. In the past, the red line (unemployment rate) was above the blue line (continuing claims). While the unemployment rate fell in a direction that was consistent with continuing claims, there is a discrepancy in magnitude.
 

 

Companies are calling furloughed employees back, mainly in the hospitality and retail industries. Another interpretation of this report is the Paycheck Protection Program (PPP) worked to encourage employers to keep paying workers, and returned many back onto the payroll.
 

Key risks

Here are some of the key risks. First, the unemployment rate for Blacks and Asians rose, which is not helpful in light of the latest round of protests.
 

 

One of the key questions is how the Fed reacts to this report. There is an FOMC meeting next week. Will they start to change their body language and hint at taking their foot off the QE accelerator? Watch the USD and interest rates. The USD Index is nearing a key support zone, and yields are rising. Rising yields and a bullish reversal in the USD could be a headwind for equity prices.
 

 

The callback of workers is a good news, bad news story. The good news is many workers are closely linked to their employers, and the callback in hospitality and retail industries is encouraging. The risk is the emergence of a second pandemic wave that prompts another shutdown. The daily graph of new confirmed cases have been edging up in a number of states, such as California, Florida, Louisiana, Washington State, Arizona, Tennessee, and Vermont, just to name a few. As different jurisdictions have reopened their economies, the revival in case count might be enough to prompt re-impositions of stay-at-home orders again, which would shut down the local economies. This has the potential to batter an already fragile small business sector, and prompt a second wave of layoffs and unemployment.
 

 

Finally, how will Congress react? The strong May Jobs Report could prompt lawmakers to drag their feet on another stimulus package. The U6 unemployment rate, which includes discouraged workers, did not show as much improvement. It fell from 22.8% to 21.2%, which is still very high. PPP payments expire at the end of July. If the program is not renewed, the economy is likely to face significant headwinds to a sustained recovery.
 

 

The stock market is roaring ahead today on the good employment news, but investors should keep in mind the key risks facing the growth outlook.
 

Trading the Energizer Bunny rally

Posted by Cam Hui -

Mid-week market update: As regular readers are aware, I have been increasingly cautious about the equity outlook for the past few weeks as the market advanced. This has become the Energizer Bunny rally that keeps going beyond expectations.

Where will it stop? One of the indicators that I have been keeping an eye on is the NYSE McClellan Summation Index (NYSI). In the past, whenever the NYSI has fallen to an oversold extreme of -1000 or less, the indicator has rebounded so that the weekly stochastic bounced from an oversold to an overbought level. We are now overbought on the weekly stochastic.
 

 

To be sure, past rebounds have seen the weekly stochastic become even more overbought. These conditions suggests that there may be one or two weeks of more upside on NYSI, this relief rally is running on borrowed time.
 

The bull case

Here is the bull case for more upside, either on a tactical or sustained basis. First, equity risk appetite continues to be positive. The ratio of high beta to low volatility stocks is rising in the context of a relative uptrend.
 

 

Price momentum has been impressive. Ryan Detrick of LPL Financial observed that this is the greatest 50-day equity market rally, and similar strong rallies have led to further strength in the past. The market recently staged upside breakouts through its 200 dma, and the strength may be indicative of a FOMO stampede.
 

 

Even as the FANG+ and NASDAQ stocks lose their momentum, market leadership has broadened to cyclical sectors and industries, indicating the expectation of an economic rebound.
 

 

Small and microcaps have also been turning up in relative performance.
 

 

The bear case

Here is the bear case. First, it seems that analysts are turning bullish to catch up with price. Helene Meisler has a pinned tweet that may fit the current environment well.
 

 

As an example, John Authers documented Goldman’s sanguine outlook, though admittedly the market is priced for perfection.

If next year’s earnings turn out to be in line with Goldman’s baseline forecasts, then the market is trading at a high but reasonable 18 times 2021 earnings. It is higher than that if the more bearish estimates from buy-side firms are right; and at an all-time high of 26, significantly above even the worst excesses of 2000, if the worst-case scenario is correct. So the market is plainly working on the assumption that things will turn out about as well as can reasonably be expected:

 

If any of the risks that I outlined in the past (see Brace for the second waves) were to appear, then it’s game over for the rosy outlook. These kinds of justifications seem to be a case of grasping at bullish straws.

John Authers also pointed out an anomaly in the cyclical and small cap rebound bullish thesis. If the market truly believes that the economic is turning up, then why are the stocks with good balance sheets beating the stocks with poor balance sheets? In a cyclical rebound, highly levered companies, some with zombie-like characteristics, should skyrocket because they behave like out the money call options on the economy.
 

 

Price momentum effects may be starting to peter out. I had pointed out that the rally off the March bottom was mainly attributable to short covering (see A bull market with bearish characteristics), it was unclear what kind of market players are willing and able to take up the baton. Fast money and trend following Commodity Trading Advisers (CTAs) are now at their maximum long positioning in stocks.
 

 

Who will buy next?
 

When do retail investors pull back?

We have all heard about the frenzied trading of naive retail traders entering the market. Jim Cramer observed that even small trader sentiment is becoming very frothy, which is a cautionary signal.
 

 

One clue came from a historian who studied how the rich reacted to the Black Death. So far, the main job losses have come from lower paying service jobs. Better educated workers have been largely insulated because they can work from home.

The coronavirus can infect anyone, but recent reporting has shown your socioeconomic status can play a big role, with a combination of job security, access to health care and mobility widening the gap in infection and mortality rates between rich and poor.

The wealthy work remotely and flee to resorts or pastoral second homes, while the urban poor are packed into small apartments and compelled to keep showing up to work.

Social reaction to the Black Death provides a rough model of what may happen today.

One key issue in “The Decameron” is how wealth and advantage can impair people’s abilities to empathize with the hardships of others. Boccaccio begins the forward with the proverb, “It is inherently human to show pity to those who are afflicted.” Yet in many of the tales he goes on to present characters who are sharply indifferent to the pain of others, blinded by their own drives and ambition.

People with sufficient savings to play the stock market today belong mainly to the class of educated workers. In this case, the adage that it’s a recession if your neighbor loses his job and a depression if you lose yours may ring especially true for the investor class. Sentiment may not break until we start to see widespread white collar job losses and salary cuts. Bloomberg Economics’ estimates of second wave job losses shows management jobs rank second in layoff potential. That may provide the catalyst for individual investors to de-risk because of their own employment conditions.
 

 

Leuthold Group: Still a bear market

Analysis from the Leuthold Group provides some context as to why this is still a bear market. Leuthold had set out a criteria of five conditions for a cyclical market low, and the March 23 low met none of those conditions.
 

 

The Leuthold Group went on to observe that “the 30% surge off the low met 0-of-3 dynamics that usually accompany the first leg of a bull market”. In total, 0 for 8 is not exactly comforting for the bull case.

I interpret these conditions as a bear market rally, though short-term momentum may carry the market somewhat higher in the next one or two weeks. My base case scenario calls for a short-term peak, but investors should be prepared for rising downside risk afterwards. I have no idea how far the current FOMO rally can run, but my inner trader is standing aside because the intermediate term risk/reward is tilted bearishly.

 

Brace for the second waves

Posted by Cam Hui -

As we progressed through the pandemic induced recession, there have been much discussion about a second wave. Second waves appear in many forms, and they can threaten the current consensus expectation of a V-shaped rebound.
 

 

Here are some of the second wave risks the market faces.

  • A second wave of COVID-19 infections
  • A second wave of layoffs and wave cuts
  • A second wave of bankruptcies

Finally, investors have to face the risk of permanent economic scarring that impair long-term growth potential. Under that scenario, slower growth rates will persist even after any recovery, and affect asset prices in ways that the market hasn’t fully discounted.
 

A second wave of infections

In all likelihood, there will be a second wave of COVID-19 infections. The Center for Infectious Disease Research and Policy (CIDRAP) conducted a study and believes the latest pandemic most resembles influenza pandemics in infectious characteristics. CIDRAP went on to examine eight major influenza outbreaks and found that there was always a second wave. The more disturbing finding was that pandemics since 1918 had larger second waves.

Of eight major pandemics that have occurred since the early 1700s, no clear seasonal pattern emerged for most. Two started in winter in the Northern Hemisphere, three in the spring, one in the summer, and two in the fall (Saunders-Hastings 2016).

Seven had an early peak that disappeared over the course of a few months without significant human intervention. Subsequently, each of those seven had a second substantial peak approximately 6 months after first peak. Some pandemics showed smaller waves of cases over the course of 2 years after the initial wave. The only pandemic that followed a more traditional influenza-like seasonal pattern was the 1968 pandemic, which began with a late fall/winter wave in the Northern Hemisphere followed by a second wave the next winter (Viboud 2005). In some areas, particularly in Europe, pandemic-associated mortality was higher the second year.

The current pandemic will likely last 18-24 months.

Key points from observing the epidemiology of past influenza pandemics that may provide insight into the COVID-19 pandemic include the following. First, the length of the pandemic will likely be 18 to 24 months, as herd immunity gradually develops in the human population. This will take time, since limited serosurveillance data available to date suggest that a relatively small fraction of the population has been infected and infection rates likely vary substantially by geographic area. Given the transmissibility of SARS-CoV-2, 60% to 70% of the population may need to be immune to reach a critical threshold of herd immunity to halt the pandemic (Kwok 2020).

CIDRAP postulated three separate scenarios for COVID-19.
 

 

Here is the most worrisome development. Different US states are reopening their economies at different paces. The worst hit states like New York and New Jersey have constructively bent their new case curves downward. Many other states, like California, have only flattened their curves instead of bending them down.
 

 

What if a vaccine were to appear? CBS reported that a poll revealed that only half of Americans would get a COVID-19 vaccine, which is not enough to achieve herd immunity.

Only about half of Americans say they would get a COVID-19 vaccine if the scientists working furiously to create one succeed, according to a new poll from The Associated Press-NORC Center for Public Affairs Research.

That’s surprisingly low considering the being put into the global race for a vaccine against the coronavirus that’s sparked a pandemic since first emerging from China late last year. But more people might eventually roll up their sleeves: The poll, released Wednesday, found 31% simply weren’t sure if they’d get vaccinated. One-in-five said they’d refuse.

Here are some of the reasons cited.

Among Americans who say they wouldn’t get vaccinated, seven-in-ten worry about safety…about four-in-ten say they’re concerned about catching COVID-19 from the shot. But most of the leading vaccine candidates don’t contain the coronavirus itself, meaning they can’t cause infection.

And three-in-ten who don’t want a vaccine don’t fear getting seriously ill from the coronavirus.

While some of the issues cited could be addressed to raise the vaccination rate, this is nevertheless a disturbing development from a public health policy viewpoint. For investors, any hint of a second wave of infection will evoke a reaction from the health authorities to re-impose tighter stay-at-home policies, which would elongate the economic slowdown.
 

Layoffs and wage cuts ahead

In addition to the more obvious COVID-19 public health issues, investors have to be concerned about a second wave of economic damage. The effects of the first wave of layoffs are well-known. So far, most of the job losses have been concentrated among the low paying workers. Now reports are piling up that white-collar layoffs are ahead. The NY Times reported that Boeing is cutting 16,000 jobs. Bloomberg reported that Deloittes is preparing to lay off 2,500 employees. The list goes on, but you get the idea.

As well as layoffs, we now to worry about a new second wave, namely wage cuts. The Fed’s Beige Book reported a “second wave” of wage cuts is hitting the economy.

Wages and other benefits were lower than in our previous report; a payroll company reported a “second wave” of wage cuts, and reports across industries have mentioned cuts to benefits, including employer 401k matching. Some companies, especially those in competitive fields, have promised to repay lost wages at the end of the crisis; and others have increased wages to maintain morale and lure back hesitant workers.

The NY Times reported that some companies are considering wage cuts in lieu of layoffs.

Even as American employers let tens of millions of workers go, some companies are choosing a different path. By instituting across-the-board salary reductions, especially at senior levels, they have avoided layoffs.

The ranks of those forgoing job cuts and furloughs include major employers like HCA Healthcare, the hospital chain, and Aon, a London-based global professional services firm with a regional headquarters in Chicago. Chemours, a specialty chemical maker in Wilmington, Del., cut pay by 30 percent for senior management and preserved jobs. Others that managed to avoid layoffs include smaller companies like KVH, a maker of mobile connectivity and navigation systems that employs 600 globally and is based in Middletown, R.I.

None of these developments are conducive to a V-shaped recovery.
 

A second bankruptcy wave

In addition, we have barely seen the start of a bankruptcy wave in this recession. The combination of temporary fiscal rescue measures and Fed policy has served to put in a temporary cushion on the wave of bankruptcies that is likely to hit the economy. Unless Congress acts to extend PPP, the payments expire in July.

Already, credit quality is deteriorating.
 

 

A second wave of bankruptcy is almost impossible to avoid.
 

 

As the damage of these business failures hit the economy, the effect of this second bankruptcy wave is likely to be persistent.
 

The risk of permanent economic scarring

The persistence of economic damage is especially a worrisome problem for economists. A new IMF Working Paper addressed this issue of “hysteresis”.  For the uninitiated, hysteresis in economics is the persistence of effect after the initial shock of the effect is gone.

The IMF paper is mainly a survey of past research, and there were many papers cited. In particular, the authors referenced the well-known Reinhart and Rogoff study of past financial crises:

Reinhart and Rogoff (2014) examine the evolution of real per capita GDP around 100 systemic banking crises and found that a significant part of the costs of these crises lies in the protracted and halting nature of the recovery. On average it takes about eight years to reach the pre-crisis level of income; the median is about 6.5 years. In a sample that covers 63 crises in advanced economies and 37 in larger emerging markets, more than 40 percent of the postcrisis episodes experienced double dips.

The IMF study concluded:

In the last 25 years we have seen the development of an alternative model of business cycle that emphasizes the effects that business cycles can have on the drivers of long-term economic growth. In these models GDP is history dependent and all shocks can have permanent effects on output, what we refer to as hysteresis. This represents a change from the traditional cycle-trend decomposition that defined cycles as deviations from a trend that was independent of any of the traditional demand shocks that could be responsible for economic fluctuations…

In the presence of hysteresis, the costs of cyclical shocks or the lack of action of policy makers are much larger because of the permanent scars they can leave on GDP through their interactions with the endogenous forces that drive long-term growth or the dynamics of labor markets. Aggressive and fast action during recessions becomes optimal policy. And during expansions, the cost of acting too early on fears of inflationary pressure can also be very costly as it can either reduce the potential growth of the economy or hinder positive developments in the labor market. In this new framework, policy makers should understand the likely large supply costs of not being as close as possible to potential output by running a “high-pressure” economy.

In practical terms, here is what hysteresis, or the persistence of economic shock, means in real life. A recent Goldman Sachs survey of small business participants by Babson College and David Binder Research reveals small firms have already suffered considerable damage from COVID-19. 9% are permanently closed, and only about half are fully open. Looking out over the next six months, respondents believe that 71% of customers will return, at a rate of only 63% of revenues.
 

 

What was not asked was how many and how long can small businesses survive at 63% of previous revenue levels.
 

The burden of reopening

Some clues to that question came from a survey done in late April by the Chicago Fed in association with the local chambers of commerce. Even though the survey was restricted only to the Chicago Fed’s Seventh District states, the survey does provide a window into the outlook for small business in the US. Survey respondents were predominantly small businesses: “About 60% of the respondents were from firms with fewer than ten employees and another 25% were from firms with ten to 49 workers.”

One of the biggest concern expressed in the survey was the extra costs involved in reopening after the lockdowns are lifted. As we move into Q2 and Q3, watch the narrative from companies start to change to “we are burdened with an extra layer of costs in reopening, along with reluctant customers”. The Chicago Fed survey found companies that would experience financial distress under “moderate” social distance measures and gatherings of 50 people or less if the operate at 75% capacity range from 38% for manufacturing to 88% for restaurants.
 

 

The survey also asked whether companies were concerned about different metrics of financial health over the next three months. Cutting to the chase, about 30% to 40% of most companies were concerned about their own financial solvency over this period. Companies in finance were in the best shape, while restaurants were in the worst.
 

 

In short, expect at least one-third of small businesses to fail in the next three months, even with massive fiscal and monetary support, and assuming that there is no second wave of infection. This is a level of business failure that does not appear to have been fully discounted by the financial markets.

Lastly, the recent wave of protests springing up around the US will hamper the prospect for a V-shaped rebound. Depending on how long the protests last, can anyone really believe that business will return to normal with rioters in the streets? Here are some reactions from analysts of the effects of the riots, as reported by Bloomberg.

“I think people are coming to the realization that their jobs may not be coming back or coming back quickly. This is all conflating with the racial tensions and completely boiling over,” said Mark Zandi, chief economist at Moody’s Analytics. “This highlights the depth of despair in America,” he added, citing 20% unemployment and 50 million workers who’ve lost their jobs or had pay cuts…

“The impact of the riots may be greater on the daily and weekly measures of consumer confidence, which were trending slightly upward since mid-April, but which may now post a pull-back into early June,” said Mike Englund, chief economist at Action Economics, which provides financial-market commentary.

In conclusion, even though market analysts have discussed “second waves”, I do not believe they fully appreciate the multi-factor nature of the second waves that threaten the growth outlook. While all of these risks may not fully materialize, the current consensus market narrative does not seem to have fully discounted many of these risks.
 

A bull market with bearish characteristics

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.
 

A new bull?

Is this the start of a new bull market? Ed Clissold of Ned Davis Research got a lot of people excited when he pointed out that the percentage of stocks above their 50 day moving average (dma) had exceeded 90%. Such events are intermediate term breadth thrusts with bullish implications.
 

 

Does this mean we are witnessing the birth of a new bull market?
 

Bull or bear?

Not so fast. Urban Carmel observed there is a disparity between the percentage of stocks above their 50 dma, which is high, and the percentage of stocks above their 200 dma, which is not as high. The difference can be explained by the strong rally mounted by stocks since the March low.

When the difference of the two indicators (second bottom panel) is high, the signals can be somewhat hit-and-miss. It is an effective buy signal (shown in green) when stocks are in a bull market, and less effective (shown in red) when stocks in a bear market. So we are left scratching our heads. Is this a bull or bear market, and should we buy or sell? The new 52-week high indicator (bottom panel), which is weak, does not inspire a lot of confidence.
 

 

If this is a new bull, then it looks like a bull market with bearish characteristics.

On the other hand, if this is a bear market rally, there may not be much gas left in the tank of this rally. Going back to 1998, whenever the NYSE McClellan Summation Index (NYSI) has reached the unusual condition of -1000 or less, the weekly stochastic has always rebounded from an oversold to an overbought reading. We are nearly there.
 

 

Unfortunately, these signals (red for buy, blue for sell) tell us little about whether we are in a bull or bear market. Of the four signals, two were bullish, and two were bear market rallies.
 

How psychology changes

When a market transitions from bull to bear and back to a new bull market, the old leadership weakens to reflect the purging of excesses of the old bull. New leadership emerges to reflect the hope of the new bull. Instead, the analysis of market cap leadership shows that megacap stocks are plateauing. Mid and small caps are trying to turn up on a relative basis, but remain in long-term downtrends. NASDAQ stocks may be rolling over on a relative basis, but remain in a long-term uptrend. In short, the old leadership is still intact. If this is indeed a new bull, then this is another way the market looks an awful lot like the old bull, or a new bull with bearish characteristics.
 

 

As well, most measures of price momentum are still in relative uptrends, indicating that the old trends remain intact. Bull/bear/bull transitions usually don’t look like this.
 

 

The consensus V-shaped recovery

To be sure, the psychological tone of the market has changed since the March low. The prevalent view has gone from blind panic, to a belief that this rally is a bear market rally, to grudging acceptance of a more constructive view of stock prices. A May 12-27 Reuters poll of 250 strategists around the world found that 68% of analysts now do not believe the March lows will be revisited, and an overwhelming majority expect earnings will trough in either Q2 or Q3 2020. In other words, a V-shaped recovery is now the consensus view.
 

 

What drove this change in psychology? Certainly the tone of the newsflow. as measured by the San Franncisco Fed Daily News Sentiment Index, has bottomed and begun to improve, but there is still a high degree of uncertainty over the course of the pandemic and the likelihood of a second wave.
 

 

The change in psychology was attributable to rising stock prices, and analysts and managers hopping on the FOMO train. However, analysts at Citigroup discovered that most of the rally was driven by short covering. Is a short covering rally, however powerful, sufficient reason for analysts to turn as bullish as they did in the Reuters poll?
 

 

A more worrisome development is the Citigroup Panic/Euphoria Model is firmly into euphoric territory, which is contrarian bearish. As a reference, the Panic/Euphoria Model is reportedly based on the following factors:

  1. NYSE short interest ratio, 
  2. Margin debt, 
  3. Nasdaq daily volume as a percentage of NYSE volume, 
  4. A composite average of Investors Intelligence and the AAII bull/bear data, 
  5. Retail money funds, 
  6. The put/call ratio, 
  7. CRB futures index, 
  8. Gasoline prices, and 
  9. The ratio of price premiums in puts versus calls.

 

Other traditional market based sentiment indicators, such as the equity-only put/call ratio, is very low, which is contrarian bearish.
 

 

Jonathan Krinsky of Bay Crest Partners pointed out that the stock market has historically not performed well when the put/call ratio is this low after a strong 10-day advance.
 

 

More puzzles

Here is another chart that lends to differing interpretations. The ratio of high beta to low volatility stocks have been an effective short-term leading indicator of market direction in the recent past. The ratio is rolling over, which is short-term bearish, but it remains in an uptrend, which is supportive of the bull case. This is another indication of a bull with bearish characteristics. In all likelihood, we will see a near-term pullback, but the market can push higher until the rising trend line is violated.
 

 

Short-term breadth is overbought and rolling over, which suggests market weakness early in the week.
 

 

However, the bulls may have one last gasp after an initial bout of weakness, and the bears should not get overly excited just yet. The different flavors of the Advance-Decline Line flashed negative divergences by failing to make new highs even as the S&P 500 broke above resistance and its 200 dma, which is bearish. However, as long as the A-D Lines remain in uptrends, the bulls still have control of the tape.
 

 

My inner investor is underweight equities, and he is slowly moving towards a neutral weight by considering buy-write opportunities (long stock or index, short call option) as a way of mitigating downside risk. My inner trader is standing aside and awaiting a better trading opportunity.

 

Back to basics: Is this market overvalued?

Posted by Cam Hui -

There has been a recent continuing controversy about the usefulness of forward P/E as a valuation tool in the current recessionary environment. On one hand, past bear markets have typically bottomed out at a forward P/E ratio of 10, with a low of 7 (1982) and a high of 14 (2002). FactSet‘s reported market rating of 21.5 forward earnings is very stretched by historical standards.
 

 

On the other hand, Liz Ann Sonders at Charles Schwab observed that stock prices and earnings estimates have shown a correlation of over 0.90 in the last 20 years and the recent correlation is a mirror image -0.90 as stock prices rose and earnings estimates fell. She then qualified that analysis by allowing the same negative correlation occurred during the GFC.
 

 

Do forward P/E ratios matter at this stage of the cycle? Is the market forward looking and discounting the current weakness and valuing the market at its “intrinsic value”? To answer those questions, let’s get back to basics by considering the drivers of equity valuation.
 

Back to basics

Aswath Damodaran of the Stern School at NYU offered this follow analytical framework for analyzing companies.
 

 

Here are the key questions to consider:

  • How will this crisis affect the company in the near term (2020)?
  • How will this crisis affect the business the company is operating in, and its standing, in the long term?
  • How will the crisis affect the price of risk, including the likelihood of default, equity risk premium, and default spreads?

 

Current operating environment

Let’s begin with the current operating environment. I am not sure people appreciate how deep this recession is.

Consider, for example, the scale of the job losses. Continuing jobless claims peaked two weeks ago at 24.9 million, or 7.6% of the population. Imagine a best case scenario where two-thirds of the jobs lost during the pandemic came back relatively quickly. After normalizing for population, this would see the continuing claims to employment ratio falls from 7.8% to 2.9%. But 2.9% would still be worse than the levels reached during recessions of the GFC (2.1%), the Volcker tight money era of 1982 (2.0%), and Arab oil embargo and oil shock recession of 1975 (2.1%). That’s how deep this recession is.
 

 

As well, one of the more worrisome developments is the emergence of the fiscal hawks in the current environment. Former Trump chief of staff Mick Mulvaney appeared on CNBC and declared that people are being trained to believe government is free, and debts and deficits will come back to bite Americans. Mulvaney’s remarks could be interpreted in a partisan way as a way to lay the groundwork to oppose the Democrats’ agenda in the event of a Biden victory in November. Nevertheless, the premature withdrawal of fiscal stimulus will be highly contractionary, and would short-circuit any nascent recovery in 2021.
 

A second wave

The risk of a second wave of economic shock is still present. So far, job losses have mostly been restricted to low paid workers. College educated workers have largely been insulated from the worse of the carnage.
 

 

There is mounting evidence that a second wave of white collar job loss is about to hit the economy. Bloomberg reported that a wave of layoffs is impacting Silicon Valley.

Bloomberg analyzed the data on job cuts, working with Layoffs.fyi, which compiles public layoff announcements in the technology industry. While the pandemic fallout has cut hard across the economy, tech merits particular attention. In recent years it’s juiced stock market gains, boosted U.S. gross domestic product and created services that helped other sectors grow. The hobbling of tech companies will have an outsized effect on the pace of the overall American recovery.

 

 

As tech companies have cut jobs, so has the rest of the country. Recent U.S. layoffs now exceed those during the Great Depression in sheer numbers, and could end up rivaling the 1930s in percentage terms. At the Depression’s height in 1933, almost a quarter of Americans were unemployed, according to estimates from the Bureau of Labor Statistics. Currently, about 15% of Americans are unemployed, up from 3.6% in January.

Although technology companies often employ fewer workers than their counterparts in other industries, tech makes up the biggest chunk of the stock market, meaning its performance has a disproportionate impact on individual retirement portfolios and other assets. At the end of the first quarter, seven of the top 10 companies ranked by market capitalization globally were technology giants.

The WSJ reported on the job losses from an anecdotal perspective.

Hours after Joe Taylor was laid off by Uber Technologies Inc., as part of the ride-sharing company’s far-reaching cost-cutting, the hardware engineer began looking for a new job. What he’s seeing is a Silicon Valley job market that has lost its spark.

The tech industry has been one of the most resilient sectors of the economy during the Covid-19-induced economic downturn. Microsoft Corp. and Amazon.com Inc. reported strong sales growth for the first quarter even as quarantining measures came into effect. But major layoffs at big companies including Uber and Airbnb Inc., as well as a host of smaller startups, have shaken any sense that the tech industry is insulated from the broader employment destruction—and, for many, undermined hope that jobs lost would be easily replaced.

“Everyone’s just a little more wary,” said Mr. Taylor, 38 years old, who was let go earlier this month. Fewer recruiters have gotten in touch than in past job hunts, he said, as he’s scoured opportunities at large and small firms. The message from many recruiters, he said, has been: “I don’t have anything right now, but let’s stay in touch.’”

The following observation is purely speculative, but if technology companies are more comfortable with the work-from-home trend, then what’s to stop them from outsourcing jobs to cheap wage jurisdictions like India? How long before the Joe Taylors of the article start to compete with Indian software engineers?

American corporations’ growing comfort with remote work has also led Mr. Taylor, the former Uber engineer, to look for jobs farther afield, including in Denver. He plans to remain in the Bay Area, working remotely if needed, but the trappings of a nearby tech-company office no longer feel essential.

That’s how dark the outlook could turn.
 

A balance sheet recession?

Looking longer term, the growth outlook could further be impaired by a change in household consumption preferences. Gavyn Davies recently raised the specter of a nascent balance sheet recession in an FT article.

One thing that seems different this time is that much of the slump in US consumer spending has been accompanied not by declining personal incomes but by a surge in savings, which suggests consumers may remain cautious during the recovery.

Congress showered the economy with fiscal largess in the form of the CARES Act, but people are saving instead of spending the proceeds.

Despite this income support, consumer spending has collapsed, especially in service sectors and on discretionary goods such as autos. As a result, the savings ratio could well rise to about 20 per cent of household income.

The key question for the economic recovery is how much of this increase will be reversed as the lockdowns are eased. Part of the decline in spending has been involuntary and will be restored as restaurants and stores re open and work patterns return to normal. But the decline in discretionary spending on big-ticket and other items may last longer, especially if the emergency rise in unemployment benefits ends after the end of July, as planned.

The direct US fiscal stimulus in response to the virus has been about 13 per cent of GDP, and this has maintained household incomes as unemployment has soared. Nevertheless, households have curtailed spending causing a recession. Any withdrawal of the fiscal stimulus, at a time when precautionary savings remain high, could continue to depress spending and prolong the recession.

The behavior of households has been a complete mirror opposite of the GFC. During the GFC, investors yanked money from banks and began a bank run. This time, individuals are stuffing their cash into banks to create precautionary cushions against pandemic related liquidity needs.
 

 

Here is another way of thinking about the interaction between economic growth, Fed policy, and the savings rate. Fed stimulus has caused money supply growth to rise dramatically, but the saving rate spiked as well. Monetary velocity has tanked, and the economy is not growing.
 

 

The dean of the balance sheet recession thesis is Nomura chief economist Richard Koo. Koo made the following points in a Bloomberg podcast.

  • Fiscal and monetary policy has put a floor on the economy, but much depends on public health policy and medical advances.
  • Households and corporations with weak balance sheets could be psychologically scarred from taking on debt, and saving rates will rise. Rising corporate savings translates into lower propensity for business investment. Koo cited the example of the 1990-91 credit crunch and recession, which restrained companies that survived the experience from assuming debt for close to a decade. People who survived the Great Depression also learned to be frugal and avoid debt, which raised their saving rate.
  • The current recession has seen a rush for borrowing. Financial conditions have tightened, and the Fed was correct in flooding the system with liquidity.
  • Trade will continue to be a drag on growth. Post-pandemic, Koo expects a short-lived bout of pent-up consumer spending on services, but the lack of global growth owing to slowing trade will lower global growth potential.

If the savings rate stays elevated, we can expect a balance sheet recession to occur, which will depress long-term growth potential compared to the pre-pandemic era. The Great Depression saw a -26% decline in real GDP, and took six years from the 1929 Crash for real GDP to recover its former peak. Real GDP fell -4% during the GFC recession, and recovered its previous level in about three years. While I am not forecasting a Great Depression style downturn, even the expectation of a GFC-style recovery may not be entirely realistic should a balance sheet recession take hold.
 

The Fed backstop and the price of risk

What about the Fed? There seems to be a belief that Fed intervention can put a floor on stock prices, but the stock market ultimately responds to the economic outlook, which drives earnings. Can we truly see a V-shaped earning recovery if the employment picture is that dismal? Where will demand come from?
 

 

Jerome Powell’s 60 Minutes interview provided some clues. Powell declined to make a forecast of when the recession would end. His response was “it really does depend…on what happens with the coronavirus”.

SCOTT PELLEY, CBS NEWS / 60 MINUTES: There’s only one question that anyone wants an answer to, and that is: when does the economy recover?

JEROME POWELL, CHAIRMAN OF THE FEDERAL RESERVE: It’s a good question. And very difficult to answer because it really does depend, to a large degree, on what happens with the coronavirus. The sooner we get the virus under control, the sooner businesses can reopen. And more important than that, the sooner people will become confident that they can resume certain kinds of activity. Going out, going to restaurants, traveling, flying on planes, those sorts of things. So that’s really going to tell us when the economy can recover.

Powell went on to elaborate on the Fed’s estimate of the length of the recession. “It may take a while. It may take a period of time. It could stretch through the end of next year. We really don’t know.” He expressed concerns about the damage to households and businesses in a prolonged slowdown.

So the risk is that there could be longer run damage to the productive capacity of the economy and to people’s lives. And I’ll give you an example. If workers are out of work for a long period of time, it becomes harder for them to find their way back into the labor force. Their contacts get old and cold, their skills can atrophy, and they just lose their relationship network. And it can be hard to get back to work. And the longer you’re unemployed, the more that it’s a factor. So you want to avoid that.

You want unemployment to be relatively short and if people can go back to their same job, that’s great. And a lot of that can happen here. The same thing is true with businesses. At times when there are high levels of business failures, even very good businesses that are failing because of something like this, that can do longer run damage to the economy and make the recovery slower and weaker.

The Fed can do what it can, but its powers are limited [emphasis added].

It can weigh on the economy for years. So we have tools to try to minimize that longer-run damage to the supply side of the economy. And those tools just involve keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months.

And the same thing with businesses. Keeping them away from Chapter 11 if it’s avoidable. It’s not going to be avoidable in many cases. But if it’s avoidable, the more of that we can do, the stronger the recovery will be. The less this period will weigh on economic growth going forward.

I have said this before but it bears repeating for emphasis. The Fed can supply liquidity, but it cannot supply equity if a firm were to fail. Quandl has created a Late Payment Index. The latest update shows that companies are stretching out the accounts payable, which is a signal of  deteriorating liquidity and rising financial risk. Just ask J.Crew, Neiman Marcus, and Hertz, all of which have filed for Chapter 11 protection. The insolvency cockroaches are crawling out from under the cupboard, and there is never just one cockroach.
 

 

The last expansion cycle was unusual in its debt behavior. Households delevered their balance sheets after their debt binge leading up to the GFC. Corporations were not as exposed entering the GFC as households, and corporations increased leverage in the post-GFC era in response to falling interest rates. The latest crisis has dramatically exposed the corporate sector’s vulnerability to financial accidents.
 

 

The Fed is doing what it can to mitigate risk premiums, but its powers are limited. I interpret this to mean that while the risk-free rate will stay low, and the Fed will do everything it can to cap out risk premiums, market forces will act to force up risk premiums as the aftershocks of the financial crisis become evident. As the crisis drag on into 2021, expect mass small and large business failures, and the price of risk to rise.
 

Market punishment doesn’t fit the crime

Marketwatch recently reported that Doug Ramsey, the chief investment officer of The Leuthold Group, warned that the stock market punishment doesn’t fit the crime. Even if you don’t believe that the forward P/E ratio is a valid measure of valuation because of depressed earnings, Ramsey pointed out that the market is expensive based on the price-to-sales ratio too.

“The depth and duration of this economic calamity are unknowable, but values don’t yet reflect it,” he told clients in a recent note. “S&P 500 valuations are 30-40% higher than seen at even the comparatively-shallow market low of 2002.”

Ramsey went on to show that the median S&P 500 stock is still historically pricy based on several metrics, including price-to-sales and price-to-earnings.

“If the median S&P 500 stock traded down to the average valuation seen at the last three bear market bottoms, it would have to decline another 46% from April 30th levels” he said. “If we play along and assume that valuations bottom at the ‘richest’ levels ever seen at a bear market low, there’s still 32% downside remaining in the median S&P 500 stock.”

The stock market reacted to the initial COVID-19 shock when prices skidded in March, but it hasn’t even begun to discount recessionary aftershocks. The depth of this slowdown is unprecedented, at least in the lifetimes of investment professionals who are working today. But the width of the recession also matters. Anyone who thinks that the Fed can solve all problems with unconventional monetary policy is dreaming.
 

 

We began this journey by going back to the basics of equity valuation with the following questions:

  • How will this crisis affect the company in the near term (2020)?
  • How will this crisis affect the business the company is operating in, and its standing, in the long-term?
  • How will the crisis affect the price of risk, including the likelihood of default, equity risk premium, and default spreads?

The current operating environment is dismal, and there is little hope of relief over the next few years. Credit conditions are deteriorating. Unless some miracle medical advance appears in the immediate future, we are likely to see widespread business failures over the next 12 months that will cripple the economy and, in Jerome Powell’s words, “make the recovery slower and weaker”. The Fed is doing what it can to put a cap on risk premiums. It can print liquidity, but it cannot print sales, nor can it print equity for failing firms.

One (Fed support) out of three isn’t good enough. Current valuation is discounting a V-shaped recovery, and strong Fed support. It has not even begun to discount the aftershocks of the COVID-19 crisis. Equity risk and reward is tilted to the downside.

 

The knife fight at the 200 dma

Posted by Cam Hui -

Mid-week market update: For the last two days, the SPX tested the 3000 level and its 200 day moving average levels and finally broke up today. However, market breadth presents a mixed picture. Fresh 52-week highs have been understandably strong for NASDAQ stocks, as they have been the recent leadership. However, new highs for both large and small caps are less than impressive, which calls into question the sustainability of this rally.
 

 

Who wins the knife fight at the 3000 and 200 dma? Here are bull and bear cases.

 

The bull case: The rally broadens

The main bull case rests on the constructive nature of the changing market leadership. The old price momentum leaders of US over global, growth over value, and large caps over small caps have faltered. In the place, leadership is broadening out to previous laggards such a small cap, cyclical, and value stocks.
 

 

Cyclical stocks are turning up on a relative basis.

 

The relationship between the reopening stocks and stay-at-home stocks is stabilizing, and may be turning up, indicating a renewal of risk appetite.
 

 

The breadth of the market strength is indeed impressive. Eurozone stocks are attempting an upside breakout, though the leadership is narrow and only limited to Germany.
 

 

The UK is also testing a key resistance level.
 

 

Ed Clissold, chief strategist at Ned Davis Research, makes the case that the broadening breadth is supportive of a sustained advance. 90% of stocks are now above their 50 dma, which is a bullish development.
 

 

The bear case: What cyclical turnaround?

The bear case begins with long-term concerns. Some technicians have pointed to the nascent small cap as a possible sign of an economic revival, which has signaled cyclical recoveries and major market bottoms. While I am sympathetic to that view, this indicator has shown hit-and-miss results and produced false positive signals in the past.
 

 

I know that traders aren’t supposed to care about valuation, but the small cap leadership is a sign of a cyclical recovery thesis is undermined by the highly stretched valuation of small stocks. The forward P/E ratio of the small cap Russell 2000 is literally at an off-the-charts high because of a low E in the P/E ratio. Instead, we can analyze the forward P/E ratio of the S&P 600 small cap index, which has a more stringent profitability index inclusion criteria. The S&P 600 also trades at a historical high at 22.0 times forward earnings.
 

 

Speaking of valuation, value stocks are not exactly cheap from a historical perspective either. While investors can expect some valuation refuge in value names, downside risk is still considerable should the market mood turn negative.
 

 

Despite the recent rally, the bulls still have much work to do from a long-term technical perspective. The monthly MACD indicator is a long way from flashing a buy signal, and such buy signals have been extremely effective at calling fresh bull markets in the past.
 

 

The idea of broadening leadership is an attractive idea from a conceptual perspective, there is no sign of new leadership from a global perspective. US stocks have stalled relative to the MSCI All-Country World Index (ACWI), but the same could be said of Europe, Japan, and emerging markets. All regions have been moving sideways on a relative basis for the past 4-8 weeks.
 

 

The fickle narrative

So where does that leave us? It might just up the market’s animal spirits to decide on the market narrative of the day. Joe Wiesenthal at Bloomberg is watching how some of the more aggressive US states are reopening their economy, and the change in COVID-19 cases as a way of monitoring the market’s mood.

The green lines show OpenTable seating data for restaurants in Georgia, Florida, and Texas (three of the earliest and most aggressive states in terms of reopening). The red lines show the daily percentage change in total coronavirus cases in each of those states. The key thing is that all the lines keep going in the right direction. If the return to normal starts setting off a new wave of cases, that will be a red flag. Or if dining activity stalls out at a very depressed level, that would be ominous as well. And it’s certainly possible that service sector activity could just hit a ceiling as a substantial portion of the public changes their behavior. But for now, all the lines are going in the right direction.

 

 

As traders have learned in the past couple of months, the market’s mood can be very fickle. While the market’s focus today might be focused on the progress of reopening efforts, it might shift its gaze tomorrow to the deterioration in Sino-American relations tomorrow. Secretary of State Pompeo has declared that Hong Kong is no longer autonomous from China, signaling a possible end to special trade relationship with the territory. As well, Reuters just reported that a Canadian court has ruled against Huawei CFO Meng Wanzhou’s case against extradition.

Meng’s lawyers argued that the case should be thrown out because the alleged offences were not a crime in Canada.

But British Columbia’s Superior Court Associate Chief Justice Heather Holmes disagreed, ruling the legal standard of double criminality had been met.

“Ms. Meng’s approach … would seriously limit Canada’s ability to fulfill its international obligations in the extradition context for fraud and other economic crimes,” Holmes said.

The ruling paves the way for the extradition hearing to proceed to the second phase starting June, examining whether Canadian officials followed the law while arresting Meng.

There is also the prospect of quantitative tightening as the Fed eases its foot off the QE pedal.
 

 

In the short run, market breadth was already overbought based on Tuesday night’s close. While the odds favor a pullback, the market has also been known to advance on a series of “good overbought” readings.
 

 

I am closely watching the signals from the credit market. The relative price performance of high yield (junk) bonds and municipals are exhibiting minor negative divergences against stock prices. This is especially important in light of the lack of earnings in the Russell 2000, which is indicative of the low credit quality of that index’s constituents. The relative strength of small caps and the relative performance of HY bonds is an important relationship to keep an eye on.
 

 

The Trend Asset Allocation Model’s readings have turned from bearish to neutral, and my inner investor is reluctantly and slowly adding equity exposure from an underweight to a neutral position by focusing on buy-write strategies (long stock, short call option) to mitigate downside risk. If I had to guess, the range of my market scenarios for the next six months calls for a 40% chance that the market would revisit its March lows, 40% chance of a wide range-bound market, and a 20% chance that the market would push higher.

My inner trader is confused by this market action. He is standing on the sidelines.
 

Waiting for the inflection point

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.
 

Don’t count on the Fed

There is a belief among the bullish contingent that Fed intervention can solve everything that’s wrong with the stock market. While liquidity injection can boost equity prices, they do not represent a permanent solution. Otherwise, the Japanese and European markets would have been the clear leaders in the past decade.
 

 

Instead, the recent surge in stock prices has created a mini-bubble which is at risk of bursting.
 

Warnings of froth

I have written about the sudden surge in small investor trading that has been supporting this advance. Linette Lopez at Business Insider called a “perfect storm of stupid”.

  • Close to 800,000 people have created new brokerage accounts on three of America’s top brokerage platforms since the coronavirus pandemic hit the US.
  • That means tons of new people are playing the markets at a time when things are so uncertain that hundreds of companies canceled their 2020 earnings guidance. There is no model that can predict what’s about to happen to the economy or the market.
  • That means tons of new people desperate for a coronavirus vaccine are now betting on potential treatments and cures. Just this week the market handed billions to two companies that made headlines without showing any real data.
  • This is very stupid, and people are going to get played.

A much shared chart shows that the trading activity at discount broker Robinhood has rocketed upwards.
 

 

CNBC reported that consumers used much of their stimulus payments to trade the stock market.

Securities trading was among the most common uses for the government stimulus checks in nearly every income bracket, according to software and data aggregation company Envestnet Yodlee. For many consumers, trading was the second or third most common use for the funds, behind only increasing savings and cash withdrawals, the data showed.

Yodlee tracked spending habits of Americans starting in early March and found that behaviors diverged around mid-April — when the checks were sent — between those that received the stimulus and those that didn’t. Individuals that received a check increased spending by 81% from the week prior, and data show some of the spending went to buying stocks.

People earning between $35,000 and $75,000 annually increased stock trading by 90% more than the prior week after receiving their stimulus check, data show. Americans earning $100,000 to $150,000 annually increased trading 82% and those earnings more than $150,000 traded about 50% more often. “Securities trading” encompasses the buying and sells of stocks, ETFs or moving a 401k.

 

SentimenTrader extremes

Jason Goepfert at SentimenTrader recently issued his own warnings of sentiment extremes. First, the stampede into growth and technology is as overbought as 1980, 1999, and 2015. All of these episodes ended badly soon afterwards.
 

 

That warning was addressed not only at the small investors dabbling in the FANG+ names, but institutional investors too. The latest BAML Global Fund Manager Survey revealed that global institutions were underweight stocks, but they compensated by overweight high beta sectors like technology and communication services (GOOGL, NFLX).
 

 

From a tactical perspective, Goepfert also observed that the stock market is likely to staging a volatility breakout. Past breakouts have tended to resolve themselves in a bearish manner.

The S&P 500 has been stuck in a range for a month, above its medium-term 50-day moving average but below its long-term 200-day average. Based on other long streaks of being stuck between time frames, there has been a higher likelihood it will break the streak by falling below its 50-day average. But future returns were weak, no matter which way it broke.

He also issued a warning based on volume behavior.
 

 

How much gas is there left in the tank?

How much gas is there left in the bulls’ tank? Traditional sentiment models are unhelpful. AAII weekly sentiment has is retreated to neutral from a crowded short condition.
 

 

Same with the NAAIM Exposure Index, which measures the sentiment of RIAs.
 

 

Investors Intelligence sentiment has also returned to neutral territory.
 

 

However, two major investment firms’ sentiment indicators are unusually giving off wildly contradictory readings. The BAML Bull-Bear Indicator is flashing an off-the-charts buy signal.
 

 

On the other hand, the Citi Panic-Euphoria Model pushed further into euphoric territory this week.
 

 

Someone is going to be wildly incorrect and have egg on his face.
 

The week ahead

Looking to the week ahead, the market still appears to be range-bound. The possibility exists that the S&P 500 could strengthen further to test its 200 dma at about 3000, but that only represents an upside potential of 1.5%. Different versions of the advance-decline lines remain in uptrends. Until those trend lines are broken, the bears cannot be said to have seized control of the tape.
 

 

The week starts with a slight bearish bias. Short-term breadth is falling, and momentum is negative, but readings are neutral and the market could turn up from here.
 

 

Longer term breadth is recycling off an overbought condition.
 

 

My inner trader remains short the market. For the purposes of risk control, his line in the sand is 2970 on a closing basis.

Disclosure: Long SPXU, TZA
 

What gold tells us about confidence

Posted by Cam Hui -

How badly has the pandemic affected the global economy? The United Nations Development Programme (UNDP) has some answers in a recent report. It expects global human development to decline for the first time this year, and EM economies will bear the brunt of the impact. The International Labour Organization (ILO) estimates that up to half of global workers could lose their jobs.

New UNDP estimates Global human development – as a combined measure of the world’s education, health and living standards – is on course to decline this year for the first time since the concept was developed in 1990. The decline is expected across the majority of countries – rich and poor – in every region.

  • Global per capita income is expected to fall four percent. The World Bank has warned that the virus could push between 40 and 60 million into extreme poverty this year, with sub-Saharan Africa and South Asia hardest hit.
  • The International Labour Organization (ILO) estimates that half of working people could lose their jobs within the next few months, and the virus could cost the global economy US$10 trillion.
  • The World Food Programme says 265 million people will face crisis levels of hunger unless direct action is taken.

While the human development is falling this year, the market’s perceived decline of confidence did not begin with the COVID-19 pandemic. Last week, I highlighted a comment by Joe Wiesenthal at Bloomberg when he focused on the stock/gold ratio as a barometer of optimism and pessimism (see Checking the small business economic barometer). I would go further to characterize the ratio as a barometer of investment confidence in human ingenuity.

It’s such a pure and simple expression of optimism versus pessimism. When you bet on stocks you’re betting on humans endeavoring to do productive things. When you bet on a shiny inert metal you’re betting on a shiny inert metal.

The chart of the stock/gold ratio surprisingly revealed that it peaked in the summer of 2018 and it has been falling ever since. Since that 2018 peak, both stock and gold prices have climbed, but gold has outpaced stocks. The decline in the stock/gold ratio is worrisome for long-term equity investors.
 

 

The stock/gold ratio outside the US, as represented by the MSCI World xUS Index, looks even worse. The MSCI World xUS Index never recovered its pre-GFC peak. Gold, as priced in euros, has reached all-time highs. The post-GFC equity market recovery is entirely attributable to the outperformance in the US.
 

 

What is the market telling us about optimism and pessimism, and global investment confidence?
 

I conclude that the outlook for equities faces a number of long-term headwinds, namely de-globalization, rising protectionism, and a difficult growth outlook. Gold represents an insurance policy against falling investment confidence. Investors should re-evaluate their portfolio allocation policy in light of these factors affecting asset returns over the next decade.
 

America’s sugar high

Arguably, the S&P 500/gold peak in 2018 is attributable to the wearing off of the sugar high of the corporate tax cuts enacted in 2017. The history of forward 12-month EPS tells the story. Earnings took a one-time jump in the wake of the tax cuts and rose steadily until late 2018. Since then, estimate growth has been mostly flat until the recent pandemic shock.
 

 

We can see the valuation effects of the advance off the Christmas Eve bottom in 2018. The forward P/E ratio rose steadily, until it peaked at 19 just before the COVID-19 crisis.
 

 

Elevated valuations have sparked Rule of 20 warnings, which flashes a sell whenever the sum of the forward P/E ratio and inflation rate exceeds 20. The market was already overvalued based on the Rule of 20 even before the onset of the pandemic. Stock prices duly retreated as the COVID-19 crisis evolved, but the latest recovery is flashing another Rule of 20 sell signal.
 

 

Is there any wonder why the stock/gold ratio is turning down? Earnings had been stagnant, but stock prices were rising. It is therefore no surprise that the market began to discount this negative divergence and gold price outperformed in response.
 

Depression in Europe and Japan

Outside the US, economic depressions are evident. Jerome Powell was asked about the possibility of a second great depression in his recent 60 Minutes interview.

PELLEY: 25% is the estimated height of unemployment during the Great Depression. Do you think history will look back on this time and call this the Second Great Depression?

POWELL: No, I don’t. I don’t think that’s a likely outcome at all. There’re some very fundamental differences. The first is that the cause here– we had a very healthy economy two months ago. And this is an outside event, it is a natural disaster, in effect. And that’s one big difference. In the ’20s when the Depression, well, when the crash happened and all that, the financial system really failed. Here, our financial system is strong has been able to withstand this. And we spent ten years strengthening it after the last crisis. So that’s a big difference. In addition, the last thing I’ll say is that the government response in the ’30s, the central banks were trying to raise interest rates to keep us on the gold standard all around the world. Exactly the opposite of what needed to be done.

In this case, you have governments around the world and central banks around the world responding with great force and very quickly. And staying at it. So I think all of those things point to what will be — it’s going to be a very sharp downturn. It should be a much shorter downturn than you would associate with the 1930s.

There are a few points to unpack in Powell’s response. First, he was correct that fiscal and monetary authorities were overly tight in the wake of the 1929 Crash and tightened policy, all in the name of the gold standard. It was therefore unsurprising to see the stock/gold ratio plunge in response during the 1930’s.

He was incorrect that the fiscal and monetary responses are always sufficient to prevent another depression. While the US has not experienced a depression since the Dirty Thirties, parts of Europe have been in a depression in the last decade. The EU and eurozone unemployment rates rose steadily in the wake of the GFC. While they have recovered to their pre-crisis lows, absolute levels remain elevated. In particular, peripheral country unemployment rates are still horrendous. The adjustment in Greece was borne mainly by an internal devaluation of wages.

In addition, youth unemployment in Europe remains in double digits, and it is especially high in peripheral countries. This is creating a lost generation, which has negative effects on productivity and has the potential to create social and political turmoil.
 

 

The ECB’s initial LTRO response in 2011 did take away the tail-risk of the breakup of the eurozone, and put a floor on the price of risk assets. ECB policies were designed to buy time for member states to reform and restructure their economies. At the time, Mario Draghi referred to labor market reforms to create greater economic dynamism, and to break the perception of lifetime security for the older generation, so that youth unemployment could decline. But reforms were either too slow or not forthcoming. The ECB did what it could to support markets and hold the eurozone together, but its policy of negative interest rates was a bridge too far. The negative interest rate policy has devastated the European banking sector.
 

 

While recessions are well-defined, there is no standard definition of a depression. That said, it is difficult to characterize peripheral Europe as being anything but a depression since 2011.

Similarly, Japan’s Nikkei Index has gone nowhere for decades despite fiscal and monetary support. Gold in JPY has broken out to fresh all-time highs.
 

 

Trade and globalization in retreat

Looking ahead, what’s the outlook for the next decade and beyond? The crystal ball is a little hazy, but the latest BAML Global Fund Manager Survey provided some clues of investor expectations.
 

 

The biggest theme is rising protectionism and de-globalization. The Economist devoted an entire issue on the topic.

Trade will suffer as countries abandon the idea that firms and goods are treated equally regardless of where they come from. Governments and central banks are asking taxpayers to underwrite national firms through their stimulus packages, creating a huge and ongoing incentive to favour them. And the push to bring supply chains back home in the name of resilience is accelerating. On May 12th Narendra Modi, India’s prime minister, told the nation that a new era of economic self-reliance has begun. Japan’s covid-19 stimulus includes subsidies for firms that repatriate factories; European Union officials talk of “strategic autonomy” and are creating a fund to buy stakes in firms. America is urging Intel to build plants at home. Digital trade is thriving but its scale is still modest. The sales abroad of Amazon, Apple, Facebook and Microsoft are equivalent to just 1.3% of world exports.

The flow of capital is also suffering, as long-term investment sinks. Chinese venture-capital investment in America dropped to $400m in the first quarter of this year, 60% below its level two years ago. Multinational firms may cut their cross-border investment by a third this year. America has just instructed its main federal pension fund to stop buying Chinese shares, and so far this year countries representing 59% of world gdp have tightened their rules on foreign investment. As governments try to pay down their new debts by taxing firms and investors, some countries may be tempted to further restrict the flow of capital across borders.

FT Alphaville outlined several defenses of globalization, starting with theory of comparative advantage. The defense also offers a glimpse of what might happen if globalization were to retreat and trade barriers go up around the world.

Economics offers more rational reasons why it doesn’t make sense to source everything close to your doorstep. Take, for instance, nineteenth-century economist David Ricardo’s theory of comparative advantage. If England can produce cloth far more efficiently than Portugal due to mechanisation, and Portugal wine far easier due to its geography, is it not in the interest of both nations to focus on specialisms in which they can thrive? (Though this argument became somewhat overdone in the era of hyper-globalisation.)

Although the pandemic has exposed the vulnerabilities of the low-cost and just-in-time model of global supply chains, unwinding those relationships will raise costs, and compress margins.

Clearly transportation is easier and less vulnerable if suppliers are close by. While this could be overcome by building up stockpiles of parts, this would add additional costs or be impossible in the case of perishable goods.

Just-in-time production has become emblematic of the pre-Covid 19 economy. Supply chains had become so efficient that goods often went straight from the delivery bay and on to shelves. That may have to be reassessed if we make a choice that we want the supply of some goods to be more robust.

De-globalization would reduce also innovation.

Without open borders and global networks, many innovations would cease to exist. That – say Anna Stellinger, Ingrid Berglund and Henrik Isakson of the Confederation of Swedish Enterprise – includes drugs and other medical goods

 

 

In the end, the biggest question is what price the inhabitants of the developed market are willing to pay for the supply security.

At its core, the debate about global value chains right now is not about growth. It is about how society provides goods deemed essential in times of crisis…

In times marked by fear and protectionism, there are risks to relying on borders remaining open and global value chains delivering. But it is in the best interests of us all that they do.

Current consensus opinion seems to be tilted towards greater supply security. It won’t matter who wins the election in November. The US view on China from both sides of the political aisle is becoming increasingly antagonistic. In addition, the COVID-19 crisis has laid bare the vulnerabilities of global supply lines, especially in pharmaceuticals and medical equipment. At a minimum, expect greater pressure to onshore more production in all industries in 2021.

In the short run, China is falling far short of the targeted purchase of US goods under the Phase One trade agreement, largely owing to a collapse in demand as the Chinese economy tanked.  This has the potential to create more trade friction and spook the markets over the next few months.

From a practical point of view, Brad Setser at the Council on Foreign Relations distilled the American experience with globalization over the last 40 year.

  • A rising trade deficit in manufacturing.
  • Growing offshore profits (mostly in tax havens).
  • And large exports of bonds to make the sums balance.

 

As shown by Setser’s analysis and by Branko Milanovic’s famous elephant graph, the benefits of globalization have accrued to the EM rising middle class, developed market manufacturers that can offshore production, and producers of intellectual capital that can offshore production and dam the profits in offshore tax havens. The main losers have been the developed market middle class.
 

 

Estimating the COVID-19 fallout

Another long-term trend to consider is the generational effects of the COVID-19 pandemic, which has the potential to create a lost generation and political turmoil. Deutsche Bank analyzed what happened during the Spanish Flu and other pandemics and found the following:

  • Studies have found that the cohort born around the time of the Spanish flu in 1919 had worse educational outcomes throughout their lives.
  • Pandemics have long been associated with conspiracy theories, and in turn have been connected with lower levels of social trust. For example, today’s conspiracy theory has been about 5G but there were suggestions that Spanish flu was spread by Germans of some form of biological weapon at the end of WWI.
  • Meanwhile economic downturns have their own lasting legacies. For young graduates who join the workforce in a recession, it can take up to a decade before their earnings recover to where they would have been. And prior recessions suggest it could take years before employment returns to its pre-Covid levels. 

On the last point, the economy is likely to take a considerable time to recover. The latest Congressional Budget Office forecast shows that GDP will still be 2% below the Q4 2019 peak at the end of 2021.
 

 

A University of Cambridge study projects a five year loss of between 0.65% to 16.3% of global GDP, with a mid-range forecast of 5.3% to global GDP.

The GDP@Risk over the next five years from the coronavirus pandemic could range from an optimistic loss of $3.3 trillion (0.65 per cent of five-year GDP) under a rapid recovery scenario to $82.4 trillion (16.3 per cent) in an economic depression scenario, says the Centre for Risk Studies at the University of Cambridge Judge Business School.

Under the current mid-range consensus of economists, the GDP@Risk calculation would be $26.8 trillion or 5.3 per cent of five-year GDP, says a “COVID-19 and business risk” presentation prepared by the Centre for Risk Studies.

It took about 10 years for US GDP to return to potential after the GFC. How long will it take post-COVID?
 

 

The slowness of the recovery will have consequences. Surges in unemployment have been correlated with a spike in bankruptcies. So far, the number of Chapter 11 filings has been limited. While the Fed has offered unprecedented levels of support for the credit markets, it cannot supply solvency, or equity, if a firm were to fail. Will this cycle be any different?
 

 

Gold as confidence insurance

The combination of all these factors point to subpar equity returns over the next decade. Does that mean you should be buying gold to hedge against a decline in stock/gold ratio?

Gold can have a role in portfolios, but I believe that investors should buy gold for the right reasons. Here are some wrong ways to play gold and gold related vehicles.

Forget gold as an inflation hedge. The chart below shows that gold staged an upside breakout in 2018 out of a multi-year base that stretches back to 2013. The price is now approaching a resistance zone, as defined by its all-time high. By contrast, the bond market inflationary expectation ETF (RINF) has been in a downtrend since late 2018. While inflationary expectations have begun to tick up, RINF is just approaching and testing a resistance zone.
 

 

During the current deflationary period marked by a collapse in demand, the world would be lucky to see signs of inflation, which would be a signal of renewed growth. If you want to bet on inflation, buy equities, as they would perform well in periods of moderate inflation. As well, companies with strong pricing power that can pass through price increases would perform well in low but rising inflation environment. One shortcut might be the shares of Berkshire Hathaway. Warren Buffett has assembled a portfolio of companies with strong competitive positions, or moats, that should have better pricing power should inflation and growth return.

Even for more aggressive investors who are seeking greater leverage in the gold price, I would advise against buying gold stocks instead of gold. Despite the commonly held belief that the stocks provide better leverage to the gold price, gold stocks have dramatically lagged gold prices in the last decade
 

 

Here is why. Conceptually, a gold mining company can be thought of as a call option on the price of gold, with the strike price set at the cost of production, combined with the expected amount of gold the company can mine in each year for the term of the mine life, or mine lives. The historical record has shown that as old mines become exhausted, companies have replaced production with new mines with higher production costs. In effect, this creates the effect of changing the strike price of an option upwards, which reduces the value of the option. Unless the gold mining industry can find new lower cost mines, the shares of gold mining companies are likely to continue to lag gold prices in the future.

In the short run, here is another reason to avoid gold stocks. Senior golds, as represented by GDX, have become overbought. The percentage of stocks in the ETF is over 90%. At the same time, the performance of gold golds (GDXJ) are lagging GDX, which is a negative divergence.
 

 

In conclusion, the outlook for equities faces a number of long-term headwinds, namely de-globalization, rising protectionism, and a difficult growth outlook. Gold represents an insurance policy against falling investment confidence. Investors should re-evaluate their portfolio allocation policy in light of these factors affecting asset returns over the next decade.