Election jitters are rising

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.
 

 

More election volatility

While I am not a volatility trader, my recent calls on the evolution of volatility have been on the mark. Three weeks ago, I raised the possibility of a volatility storm (see Volmageddon, or market melt-up?) owing to rising election jitters. I concluded “I would estimate a two-thirds probability of a correction, and one-third probability of a melt-up, but I am keeping an open mind as to the ultimate outcome”. Two weeks ago, I turned more definitive about rising volatility and called for a volatility storm (see Brace for the volatility storm).
The rising election induced volatility theme has become increasingly mainstream in the financial press. Bloomberg highlighted that the one and three month spread in the MOVE Index, which measures bond market volatility, is spiking.

 

 

Marketwatch also reported that analysis from BNP Paribas shows that the implied equity market volatility over the election window is sky high compared to past realized returns of election results. 

 

 

In addition, all these option readings were taken before the news about the death of Supreme Court Justice Ruth Bader Ginsburg. Should the election results be contested and wind up in the Supreme Court, the odds of a 4-4 deadlocked decision just rose with Ginburg’s death, in which case the lower court’s decision would stand. This raises the odds of judicial and constitutional chaos. Imagine different states with wildly inconsistent decisions on balloting. The Supreme Court nomination fight also raises the political resolve of both sides in Congress. Don’t expect any stimulus bill before the election, and even a Continuing Resolution to fund the federal government beyond September 30 is in jeopardy. Watch for implied volatility to rise in the coming week.
It seems that the bears have taken control of the tape, based on a combination of election uncertainty and a reversal of excessive bullish retail positioning on Big Tech stocks.

 

 

Technical breaks

The S&P 500 and NASDAQ 100 are experiencing major technical breaks from both short and intermediate term perspectives, which is leading to the conclusion that the correction isn’t over.
In the short run, the daily chart of the market leadership NASDAQ 100 violated both a rising trend line and its 50 day moving average (dma), which are important levels of psychological and technical support. As Big Tech sectors (technology, communication services, and Amazon) comprise 44% of S&P 500 index weight, weakness in the tech heavy NASDAQ 100 is an important indicator of the direction of the broader market.

 

 

The S&P 500 also violated an important rising trend line and exhibited a minor break below its 50 dma.

 

 

The weekly chart of the S&P 500 is just as ominous. The index has broken down through a breakout turned support level for two weeks. In addition, the stochastic has recycled from an overbought reading, which is an intermediate term sell signal. 

 

 

The weekly chart of the NASDAQ 100 also flashed a similar stochastic sell signal.

 

 

These conditions lead me to believe that an intermediate term correction has begun, and will not be complete until the election in early November.

 

 

Sentiment still frothy

The second major reason for the bearish break is the unwind of excessive bullish sentiment among retail traders. There has been an explosion of stories about the speculative activity among Robinhood traders due to the attraction of its zero commission policy, and the frenzy has spread to other major online brokerage firms. The froth was quite evident when even TMZ began publishing sponsored articles about day trading.

 

 

Moreover, retail call option activity has exploded. An astute reader pointed out analysis from SentimenTrader showing that while retail call volumes have receded, they are still very high and small traders are still very bullish. Despite the pullback in the popular Big Tech stocks, SentimenTrader wrote that bullish sentiment remains elevated and it has not fully capitulated.

Clearly, there was a big pullback in speculative volume last week, dropping off by more than 50% from the upside panic to start September. But when zooming out, we can see that last week was still higher than any previous record high, by far.

 

 

 

An orderly retreat

The market has been devoid of the panic that marks intermediate term bottoms. The Fear and Greed Index is falling, but the reading is only neutral.

 

 

The weakness in the NASDAQ 100, which had been the market leadership, is especially disconcerting. BoA pointed out that FANG short interest is extraordinarily low, indicating that short covering demand will not put a floor on these stocks as they weaken.

 

 

Moreover, the market’s retreat has been orderly. The percentage of stocks above their 10 dma are in a downward sloping channel of lower lows and lower highs.

 

 

In conclusion, the bears have taken control of the tape. Traders should brace for a period of weak and choppy markets until the November election and beyond. Much will depend on the course of electoral fortunes. The Presidential debates lie ahead, and there is always the possibility of an October surprise. Moreover, there is a high level of uncertainty over whether the election results would be contested in the courts, or even worse, in the streets, after November 3. It is therefore difficult to formulate downside target levels, except to say that the combination of sentiment and technical indicators are not pointing to a bottom today.
Disclosure: Long SPXU

 

A healthy rotation into cyclical stocks?

Posted by Cam Hui -

There is growing evidence that the stock market is undergoing a rotation from large cap technology to cyclical and reflation stocks. Exhibit A is the market action of the tech heavy NASDAQ 100, which violated a key rising channel and also violated its 50 day moving average (dma). By contrast, the broader S&P 500 is testing its 50 dma and only exhibited a minor break.
 

 

Even as the S&P 500 and NASDAQ 100 struggled, Material stocks have been making new all-time highs, and its performance against the S&P 500 has decisively turned up.
 

 

 

A well-telegraphed rotation

The rotation into the reflation and cyclical theme has been in evidence for a few months. The August BoA Global Fund Manager Survey showed that global managers were positioning for global reflation.
 

 

The September survey shows that the shift is continuing. While month-to-month readings can be noisy, managers continued the trend of buying industrial stocks, value over growth, small caps over large caps; and selling tech. In addition, managers regard US large cap tech to be the most crowded trade.
 

 

This weakness in large cap technology is overdue. Sentiment is becoming frothy, as evidenced by this tweet from Jim Bianco of Bianco Research.
 

 

To be sure, US large cap technology profits have outperformed the rest of the economy. The combination of better profitability and investor enthusiasm has made Big Tech now accounts for 44% of the weight of the S&P 500.
 

 

However, Cormac Mullen at Bloomberg pointed out that there are cheaper ways of gaining large cap technology exposure. The S&P Asia 50 Index is just as concentrated in Big Tech names, with Tencent, Samsung Electronics and chipmaker TSMC as its three biggest stocks, accounting for over 40% of index weight. The S&P Asia 50 Index trades at 14x forward earnings compared to 27x for the NASDAQ 100.
 

 

 

Early stealth rotation warnings

There is also extensive evidence of sector rotation under the market’s hood from the behavior of small cap stocks. These sets of charts are designed to disentangle sector and size performance by answering the following questions:

  • How is the large cap sector performing against its large cap benchmark, the S&P 500? (Top panel, black line)
  • How is the small cap sector performing against its small cap benchmark, the Russell 2000? (Top panel, green line)
  • How is the small cap sector performing against its large cap counterpart? (Bottom panel, green line)
  • How are small caps performing against large caps? (Bottom panel, black line)
The first chart shows the divergence between large and small cap technology stocks. Even as large cap technology remains in a tenuous relative uptrend, small cap technology relative returns peaked out in April and have been lagging ever since.

 

Large and small cap industrial stocks are also exhibiting a divergence, but with small caps leading the way upwards. Small cap industrial stocks began to turn up in relative returns in early July, and telegraphed the eventual relative upturn of their large cap counterparts.

 

 

The performance of consumer discretionary stocks make an interesting case study. Amazon dominates the weight of the large cap sector, but the relative performance of both large and small cap consumer discretionary stocks parallel each other, and small caps were able to achieve these returns without the aid of Amazon.

 

 

 

Key risks to rotation thesis

There are several key risks for investors who want to jump on the cyclical and reflation trade. One risk is the global cyclical rebound may be a Chinese mirage. China is a voracious consumer of commodities, and its cyclical rebound has been powered by a policy-driven industrial production revival at the expense of the domestic economy. The signals from commodity prices may therefore be a mirage, and they may not be sustainable if global consumer demand does not rebound. 
Well-known China watcher Michael Pettis explained the nature of China’s unbalanced and uneven recovery in an FT Alphaville article.

Economic recovery in China (and the world, more generally) requires a recovery in demand that pulls along with it a recovery in supply. But that isn’t what’s happening. Instead Beijing is pushing hard on the supply side, mainly because it must lower unemployment as quickly as possible. It is this push on the supply side that is pulling demand along with it…

This recovery isn’t sustainable without a substantial transformation of the economy, and unless Beijing moves quickly to redistribute domestic income, it will require either slower growth abroad or an eventual reversal of domestic growth once Chinese debt can no longer rise fast enough to hide the domestic demand problem.

 

 

The markets are already starting to discount the risks of an unsustainable recovery. The stock markets of China and its major Asian trading partners have flattened out after several months of gains.

 

 

From a global perspective, the Citigroup regional Economic Surprise indices, which measure whether economic data is beating or missing expectations, are peaking and in the process of rolling over. This is an indication that the momentum of the recovery is starting to stall, which is bearish for the cyclical recovery thesis.

 

 

The second key risk for investors is a credit crunch that brings economic expansion to a halt. In the past, the usual sequence of events in a recession is: recession, credit event and blow-up, and banks tighten credit in response. As the extent of the credit event and blow-up becomes known, the stock market anticipates the monetary response and recovers. This time, the stock market rallied even before any signs of a credit blow-up.
To be sure, the Fed has stepped in with an extraordinary level of accommodation, but while the Fed can supply liquidity, it cannot supply solvency. Only the fiscal authorities can make the decision to rescue firms that get into trouble. Fed Chair Jerome Powell made it clear that under the “Main Street Lending Facility”, 13(3) requires good evidence that the borrower is solvent. Dodd-Frank made it more difficult to do emergency lending in 13(3) on purpose. In the absence of further fiscal support, expect mass small and medium business bankruptcies.
The real estate sector is especially vulnerable to a credit crunch. In the past, tightening credit conditions led to softness in commercial real estate prices. In addition, tenant eviction moratoriums puts increasing financial pressures on residential property landlords, and a credit blowup in real estate is on the horizon if Congress doesn’t take action.

 

 

Both large and small cap REITs are lagging the S&P 500, with no bottom in sight.

 

 

The combination of a possible credit event, and financial repression will pressure on banking profitability. The Fed’s Summary of Economic Projections (SEP) from the September FOMC meeting shows that it expects inflation, as measured by core PCE to be 1.7-1.9% in 2022 and 1.9-2.0% in 2023, and its Fed Funds projection to be 0.1% in 2022, and 0.1-0.4% in 2023. While the initial reaction that this was a dovish pivot by the Fed as it is making an implicit promise to not raise rates until 2023, it also implies a significant period of negative real policy rates, which is a form of financial repression that destroys bank margins. As well, if the Fed is to hold rates down until 2023, it will also have to eventually engage in yield curve control to hold down rates further out in the yield curve, which will also pressure bank margins.

 

 

Lastly, investors need to consider why the market would rotate from large cap tech and growth to cyclicals and value. During recessionary and slow growth periods, the market bids up growth stocks in an environment of scarce growth. As a recovery broadens out, sector and style rotation shifts into cyclicals and value as growth becomes more abundant.
This brings up two problems. First, economic recovery depends on the effectiveness of health care policy, fiscal policy, and monetary policy, in that order of importance. The effectiveness of global health care policy remains a question mark, as this pandemic needs to be controlled all over the world to prevent reservoirs of the virus from leaking out to spark periodic outbreaks. In addition, the US fiscal policy response has been uneven, even though monetary policy makers are doing all they can to backstop the economy.
In addition, a rotation out of Big Tech into cyclical sectors presents a liquidity problem. The weight of Big Tech is 44%, which is over double the size of the cyclical sectors. Investors deploying funds out of US Big Tech will need to find better opportunities either abroad or in other asset classes. This will mean lower overall stock prices.

 

 

In conclusion, the market has been undergoing a rotation from US large cap tech into stocks with cyclical and reflationary exposure. Whether the rotation is a “healthy” one remains to be seen. There are several risks if investors were to hop on the cyclical rotation theme. The global cyclical revival may not be sustainable; a credit crunch sparked by tightening lending requirements could stop the recovery in its tracks; and the rotation could put downward pressure on the S&P 500 because of the massive weighting of Big Tech stocks compared to cyclical sectors.
Under these conditions, investors are advised to focus first on risk, rather than return expectations. SKEW, which measures the cost of hedging tail-risk, is elevated indicating a high level of uncertainty as we approach the election in November. Volatility may stay heightened if a clear resolution isn’t known after November 3. 

 

 

As I pointed out before, the path of economic recovery depends on health care policy, fiscal policy, and monetary policy, in that order of importance. Until there is greater clarity about the path of health and fiscal policy, there will be few catalysts that reduces equity implied volatility and tail-risk – and that’s the probable reasoning behind the elevated SKEW.

 

Time to sound the all-clear?

Posted by Cam Hui -

Mid-week market update: Is time to sound the all-clear? The market staged a relief rally after last week’s weakness. Is the stock market ready to resume its uptrend?

A rally to new highs from these levels is unlikely. Last week’s pullback inflicted significant technical damage that, at a minimum, a period of sideways consolidation and base building will be necessary before the bulls can take control of the tape again. The S&P 500 violated a rising trend line that stretched back to April. As well, the 8 day moving average (dma) fell through the 21 dma, which is a bearish crossover. Repairing the damage will take time.
 

 

A similar pattern can also be seen in the NASDAQ 100. The NDX exhibited a similar breach of a rising trend line and a bearish crossover of the 8 dma and 21 dma. In addition, NASDAQ 100 implied volatility, as measured by VXN, rose coincidentally with NDX. This is another indication of a nervous and jittery market, which is not a good sign for stocks that had been the market leadership.
 

 

 

Sentiment is still frothy

Sentiment models are still showing signs of frothiness. Macro Charts pointed out that QQQ call options are still being bought aggressively in the face of last week’s sell-off. The bulls haven’t capitulated yet.
 

 

Moreover, single stock option volume is now 120% of share volume. Market wash-outs don’t look like this.
 

 

 

More headwinds

Today’s market action was distorted by the FOMC announcement, and it’s always difficult to get a decent read on the market on FOMC meeting days. Nevertheless, one possible sign of market direction is the inability of equities to hold their gains even after a dovish FOMC statement. 

In the short run, the NASDAQ 100, which were the market leaders, came into Wednesday overbought in the short-term. While overbought market can become more overbought, the odds favor either some form of pullback or consolidation at these levels.
 

 

 

Disclosure: Long SPXU
 

Some key questions for the Fed

Posted by Cam Hui -

As the FOMC conducts its two-day meeting after its big reveal of its shift in monetary policy, Fed watcher Tim Duy thinks that we won’t get much more in the way of details from the Fed after this meeting:

The odds favor the Fed maintains the status quo at this week’s meeting. It does not appear to have a consensus on enhancing forward guidance nor do I suspect FOMC participants feel pressure to force a consensus on that topic just yet. The general improvement in the data likely removes that pressure. The Fed will likely remain content to use the new strategy as justification for maintaining the current near zero rate path. Powell will continue to lean heavily on downside risks to the economy to entrench expectations that the Fed will stick to that path. The dovish risk this week is that the Fed does surprise with either more specific guidance or an alteration of the asset purchase program to favor longer term bonds. I don’t see a lot of risk for a hawkish outcome unless it was something unintentional in the press conference.

As the Citi Inflation Surprise Index edges up for the US, but remain muted for the other major regions, I have some important questions about the Fed’s new “average inflation target” policy.

 

 
 

Reported inflation or inflation expectations?

While other analysts are focused on the nuances of how the Fed is calculating its average, which admittedly is an important issue, I am more concerned about which inflation metric the Fed is targeting. It is mainly looking at reported inflation, in the form of core PCE and core CPI, or inflationary expectations?

Consider how the 5×5 inflationary expectations indicator has recovered, and it is nearing the Fed’s 2% target. While I understand that the new policy is allowing inflation to overshoot its 2% target, how long will the Fed allow expectations to overshoot before they become unanchored?

 

 

Gold is thought of as an inflation hedge, and gold prices have already staged an upside breakout to all-time highs. While bullion has pulled back to test its breakout level, further gains will create the risk of skyrocketing and “unanchored” inflation expectations. Keep an eye on the inflation expectations ETF (RINF), as it is testing a key falling trend line.

 

 

Should inflationary expectations start to rise, how will the Fed react to rising bond yields? Real rates are already negative, will the Fed engage in some form of yield curve control to suppress rates? We have already seen the effects of the ECB’s policy of financial repression has done to the European financial sector. Are these risks part of the reason why Warren Buffett lightened up on his banking sector positions?
 

 

These are all good questions that investors should ask of the Fed.
 

The bears take control, but for how long?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

A sentiment buy signal?

As last week’s market action demonstrated, the bulls just can’t seem to catch a break. Even though the market was short-term oversold, rally attempts have been rather anemic. More worrisome is the behavior of the NASDAQ 100 (NDX), which had been the market leadership. The NDX convincingly breached a rising channel, and it is now testing its 50 day moving average (dma). While its relative uptrend against the S&P 500 remains intact, the relative performance of semiconductor stocks, which had also been a source of technology related market strength, also violated a rising trend line.

 

 

One bullish ray of hope came from Mark Hulbert, who pointed out that newsletter writer sentiment had plunged precipitously, which is contrarian bullish.

Consider the average recommended equity exposure level among a subset of short-term stock-market timers that I monitor on a daily basis. (This is what’s measured by my Hulbert Stock Newsletter Sentiment Index, or HSNSI.) This average currently stands at 30.1%, which means that the average timer now has 70% of his equity trading portfolio out of the market.

Just three weeks, ago, in contrast, the HSNSI stood at 65.9%. As you can see from the chart below, the HSNSI’s recent plunge rivals what happened during the February-March waterfall decline. That’s amazing, since the market’s early September sell-off — scary as it was — is child’s play by comparison. In contrast to a 34% plunge in the earlier downturn, the S&P 500 SPX, +0.05% from Sep. 2 to Sep. 8 lost less than 7%.

 

 

Hulbert concluded, “So long as the market timers on balance remain lukewarm about the stock market, sentiment for the next few weeks favors higher prices.”
Could this be the reprieve that the bullish traders need?

 

Other indicators begs to differ

Before the bulls get overly excited about Hulbert’s newsletter writer sentiment analysis, I present as this week’s Barron’s as contrarian magazine cover indicator. The cover story characterized the tech bubble as “Not Ready to Pop”, and “…could keep growing, despite recent setback for the stocks”. 

 

 

In light of the still elevated levels of the Citigroup Panic-Euphoria Model, and the NASDAQ 100’s technical trend breaks, “Da Nile isn’t just a river in Egypt”.

 

 

I would also point out that Mark Hulbert warned of a possible long-term market top in a separate Marketwatch article. Hulbert fretted about the wave of M&A activity, which is often the signs of a market top, and blind-trust SPAC financings in particular.

We’re currently in the seventh of those great waves, which began about six years ago. Added Rhodes-Kropf: M&A waves tend to accelerate right before they end. And recent M&A activity does appear to be such an acceleration. “I’m not predicting the end,” he said. “But I wouldn’t be surprised if we’re near the end.” 

One of the factors fueling the acceleration of M&A activity are the SPACs that are falling over themselves going public. There are the Special Purpose Acquisition Companies that are otherwise known as “Blank Check Companies.” SPACs have no business operations; they are created solely to raise money that would enable them to acquire other already-existing companies.

The intermediate term technical outlook doesn’t look very constructive either. Both the S&P 500 and NASDAQ 100 experienced outside reversals on their weekly charts in the first week of September. The bearish reversals were confirmed by weakness in the following week.

 

 

Other indicators suggest that we are nowhere near peak the levels consistent with a panic bottom. Twice in the last week, the equity-only put/call ratio fell, indicating bullishness and complacency, even as the S&P 500 closed near the lows of the day. Capitulation bottoms simply do not act this way.

 

 

The option positioning indicator from Goldman Sachs also points to a crowded long, which is contrarian bearish.

 

 

Another key component of my Trifecta Bottom Spotting Model, namely the term structure of the VIX, is not even inverted indicating a lack of fear. While TRIN did spike above 2 on Thursday as a sign of panic selling, the intermediate term overbought/oversold model has not reached the deeply oversold conditions consistent with an intermediate bottom. In the past, two or more of the components of this model needed to flash simultaneously buy signals before the market can see a durable trading bottom.

 

 

The Zweig Breadth Thrust Indicator is also not even flashing an oversold signal. I use this indicator in two ways, traditionally as a long-term buy signal, and as a short-term oversold indicator. A long-term ZBT buy signal is triggered with the ZBT Indicator falls below 0.40 to become oversold, and rebounds above 0.40 to an overbought condition at 0.615 within 10 trading days. While ZBT buy signals are extremely rare, ZBT oversold conditions are not. The following chart shows the actual ZBT Indicator, which is reported with a lag by StockCharts, and my own real-time estimate of the indicator. Neither is showing an oversold condition indicative of a short-term bottom.

 

 

The week ahead

Looking to the week ahead, the market faces a crucial test. Both the S&P 500 and NASDAQ 100 have violated key rising trend lines, and they are both testing 50 dma support levels. As well, the FOMC meeting next week could also be a source of volatility. Apple’s new product event scheduled for September 15 could also provide some market fireworks.

 

 

Short-term momentum is recovering from an oversold reading, but the bulls have been unable to muster much in the way of relief rallies even given the chance.

 

 

The market can stage a short-term relief market at any time. However, the intermediate term path of least resistance is still down.
Disclosure: Long SPXU

 

How far can the market fall?

Posted by Cam Hui -
Macro Charts recently observed that S&P 500 DSI is turning down from an overbought extreme. Historically, that has led to either sharp corrections or a prolonged period of choppiness.

 

 

In light of these conditions, I have been asked about downside equity risk. Is this the start of a significant downdraft? How far can stocks fall from current levels?

I answer these question in the context of secular leadership change. The Big Three market leadership themes in the latest bull cycle has been US over global stocks, large cap growth over value, and large caps over small caps. Transitions from bull to bear phase act to cleanse the excesses of the previous cycle. Until we see definitive signs of leadership changes, it may be too early to call a market top just yet.

From that perspective, we can see that the relative performance of US against global stocks is consolidating sideways after an uptrend; growth beating value, but pulling back; and small caps still lagging large caps after a brief episode of better relative performance.

 

 

NASDAQ crash?

There are growing, but unconfirmed signs that large cap growth and NASDAQ stocks are weakening. The NASDAQ 100 recently breached its rising trend channel, but its performance compared to the S&P 500 remains in a relative uptrend. In the short run, too much technical damage has been inflicted on these market leaders for them to continue to roar upwards immediately. The most constructive bullish scenario would see them consolidate sideways for several months before resuming their uptrend.
 

 

We can see further evidence of technology weakness from small cap tech stocks. Even as the relative performance of large cap tech against the S&P 500 pulled back but remains in a relative uptrend (black line top panel), small cap tech has dramatically underperformed the Russell 2000 (green line, top panel). These are all signals that an important correction may be brewing for the technology sector.

 

 

If this is indeed the start of a NASDAQ crash, bear in mind Bob Farrell’s Rule #4 as it applies to NASDAQ stocks: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” 

US investors tend to focus on the S&P 500, but there is a composition problem with the index. The top five stocks, which are all Big Tech, make up 23% of index weight. The Big Tech sectors, consisting of technology, communication services, and Amazon, comprise 44% of index weight. Therefore a Big Tech and NASDAQ crash will have an outsized effect on the S&P 500.

Let’s consider what happened last time these stocks deflated. The bear market spared mid and small cap stocks because they did not participate in the dot-com bubble. Non-US stocks crashed along with the NASDAQ because they were also caught in the tech frenzy. Fast forward to 2020, non-US stocks are likely more insulated from a potential NASDAQ crash today as they have gone nowhere since 2014. By contrast, mid and small cap stocks only began to trade sideways since 2018.
 

 

We can see that in the valuation of US large, mid, and small cap stocks. Their forward P/E ratios are either in the high teens or low 20s, which are elevated by historical standards.
 

 

From a global perspective, the forward P/E ratios of non-US regions are far lower than US stocks.
 

 

That said, too many investors are fighting the last war. The latest episode of US large cap growth dominance cannot be compared to the dot-com mania. The late 1990’s boom was led by unprofitable companies trading on price to eyeballs metrics. I would argue that the best comparable period to today is the Nifty Fifty era of the early 1970’s, when investors were willing to pay for quality growth at any price. The growth companies then were highly profitable, just as they are today. As a reminder, the S&P 500 went sideways for roughly a decade after the Nifty Fifty bust, though investors could have profited handsomely through sector and style rotation.
 

 

 

The economic outlook

The dominance of Big Tech growth stocks is evidence that the stock market isn’t the economy, and the economy isn’t the stock market. Looking ahead to the next 12-18 months, the economy should see definitive signs of recovery by Q2 or Q3 2021. New Deal democrat has been keeping an eye on the economy with his suite of coincident, short leading, and long leading indicators. He has been making the point that his indicators tells the story of an economy that wants to recover, subject to progress against the pandemic.

All three time frames are positive, although the nowcast is only slightly so.

It is really unfortunate that right now was the precise time reporting stopped on one of the consumer spending metrics, as the other (Redbook) went just slightly negative this week, “possibly” reflecting the termination of federal emergency unemployment benefits. To reiterate my overall outlook, over the next six months, the coronavirus, and the reactions of the Administration (both present and possibly new in January), the Congress, and the 50 governors to the coronavirus, are going to be the dispositive concerns. Nevertheless, by late next summer – especially if there is a reasonably effective vaccine – I expect the economy to be firmly in expansion.

Several Phase III vaccine trials are underway. Despite the AstraZeneca trials being put on hold, my base case scenario calls for availability of a vaccine by mid-2021. While there will inevitably be some teething problems with distribution, vaccine availability, or the anticipation of availability, should be the catalyst for an economic recovery. I would add that the fight against the pandemic needs to coordinated, and global in nature. As Bill Gates has pointed out, we don’t need the virus to be hiding in some pockets of the world and act as a reservoir for COVID-19 to infect others. Control and eradication needs to be global.
 

 

In the short run, the risk of a double-dip recession is rising due to fiscal inaction. High frequency data shows that the job recovery is stalling,

 

 

Initial jobless claims have bottomed and they are rising again.

 

 

The fiscal stimulus jolt is fading badly. Bloomberg reported that the extra $300 per week authorized under Trump’s Executive Order is running out of funds.

Funding is drying up for the supplemental weekly jobless benefit payments authorized by President Donald Trump at the start of August.

Funding for the Lost Wages Assistance program, which authorized an extra $300 a week from the federal government to most jobless benefit recipients, will not extend beyond the benefit week ending Sept. 5, according to statements by government officials from Montana, Texas and New Mexico. The states said they were informed Wednesday.

That said, most of these problems can be mitigated by a fiscal stimulus bill, either in the next few weeks or by a new Congress after the election.
 

 

Where are the opportunities?

Notwithstanding the short-term risks, a NASDAQ crash argues for a rotation into cyclical and value stocks. We are already seeing constructive patterns of relative performance among material, energy, and industrial sectors.
 

 

From a global perspective, non-US stock markets provide greater opportunities from both valuation and sector exposure perspectives. An analysis of the sector weight differences between the S&P 500 against MSCI EAFE (developed markets) and the MSCI Emerging Market Free Index shows that the S&P 500 is heavily overweight technology and communication services. EAFE is overweight value (financials) and cyclical sectors (industrials, and materials). EMF is overweight value (financials) and cyclical sectors (consumer discretionary, materials, and energy).

 

 

If the market were to experience a rotation from technology into value and cyclicals, non-US markets should benefit substantially from that shift.

 

 

Downside equity risk

We began this journey by posing the question of downside equity risk. If this is the start of a significant pullback, how far can stocks fall?

We can analyze the S&P 500 from several perspectives. While the S&P 500 does not represent the economy, the average stock, as measured by the Value Line Geometric Average, is a better representation. If the two were to converge, fair value for the S&P 500 would be about 2300, with the caveat that markets can overshoot on the downside.
 

 

If we were to analyze the market using the forward P/E ratio, it has historically bottomed out at a forward P/E of 10-15 times, and mostly at about 10. The main exception was the 2002 bottom, which was about 15 times.
 

 

Bottom-up 2021 EPS estimates is 166. At 10 times forward, this makes for an S&P 500 target of 1660; 12 times, about 2000; and 15 times, about 2500. The 2500 figure is also consistent with the analysis of fair value when comparing the Value Line Geometric Average to the S&P 500. FactSet reported that the 5-year average forward P/E is 17.1, and the 10-year average forward P/E is 15.4. The market bottomed out at just a forward P/E of just above 12 at the March panic low.
 

 

Putting it all together, my base case downside risk for the S&P 500 is 2000-2300, with a possible overshoot to about 1700 if the market were to really panic. This does not necessarily mean that the market will fall that far as it is based on the assumption of a NASDAQ and large growth stock crash. US equity investors can be largely insulated from the downdraft and find opportunity in cyclical and value stocks. Global investors will find more upside potential in non-US equities, with a particular focus on emerging markets.

The story of two trend breaks

Posted by Cam Hui -

Mid-week market update: While it may seem like the Apocalypse for people trading the momentum FANG+ stocks, this is not the Apocalypse. Sure, the market has violated its rising trend line, but this trend break is nothing like the COVID Crash experienced earlier this year.
 

 

Before the bears get all excited, there are several key differences between the current trend break and the February trend break. While the NYSE McClellan Summation Index (NYSI) warned of deteriorating breadth in both cases, net NYSE highs have not broken down in the manner of February 2020.

The latest trend break was led to the downside by Big Tech stocks. The analysis of the NASDAQ 100 show similar violations of rising trend lines, and similar warnings by the NASDAQ McClellan Summation Index (NASI), but the NDX/SPX ratio remains in a relative uptrend. We can see the strength of NASDAQ stocks during the COVID Crash by observing that while the SPX broke the uptrend in early February, the NDX uptrend held during that period and did not break down until later in the month. As well, similar the S&P 500 chart, the current readings NASDAQ net new highs are also not showing any signs of signification deterioration.
 

 

Fading momentum

If this is not the start of a significant pullback, what’s going on? It might be a case of fading macro and price momentum. The Economic Surprise Indices, which measures whether top-down economic data are beating or missing expectations, are all starting to roll over all around the world.
 

 

The withdrawal of fiscal stimulus is starting to bite. BoA tracked the card spending of all known unemployment insurance recipients for the month of August, and all have seen significant declines.
 

 

Calculated Risk also reported that timely rent payments slid -4.8% in September compared to August.
 

 

A recent Bloomberg article enumerated the rising risks all around the world:

The world economy’s rebound from the depths of the coronavirus crisis is fading, setting up an uncertain finish to the year.

The concerns are multiple. The coming northern winter may trigger another wave of the virus as the wait for a vaccine continues. Government support for furloughed workers and bank moratoriums on loan repayments are set to expire. Strains between the U.S. and China could get worse in the run-up toNovember’s presidential election, and undermine business confidence.

“We have seen peak rebound,” Joachim Fels, global economic adviser at Pacific Investment Management Co., told Bloomberg Television. “From now on, the momentum is fading a little bit.”

In addition, different indicators price momentum factor are also weakening.
 

 

Negative seasonality

Another explanation might just be seasonality, which is negative for stocks over the next few weeks.
 

 

Renaissance Macro also observed that election year seasonality is turning down just at the right time.
 

 

A bounce, then…

In the short run, the market is due for a bounce of 1-3 days as readings as of last night (Tuesday) have become sufficiently oversold to warrant a relief rally.
 

 

But make no mistake, this decline isn’t over. The equity-only put/call ratio actually fell even as the market closed near the lows of the day yesterday. This is indicative of excessive complacency among option players.
 

 

Watch for a short-term relief rally, followed by a resumption of the pullback.

Disclosure: Long SPXU

 

The 5 key macro indicators of Trump’s political fortunes (revisited)

Posted by Cam Hui -

Labor Day is the traditional kickoff of presidential election campaigns. Before that, only die-hard political pundits and devotees pay attention to the election. It is with that in mind we revisit the economic criteria for Trump’s political fortunes that I outlined just after his inauguration (see Forget politics! Here are the 5 key macro indicators […]

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Brace for the volatility storm

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.
 

Why Are VIX and S&P 500 Moving Together?
Something odd is happening in the equity option market.

  • Until the market sold off last Thursday, the VIX and S&P 500 had been rising together. The 10-day correlation of the VIX and SPX spiked to over 0.7, which is highly unusual as the two indices tend to be negatively correlated with each other (top panel).
  • The rise in implied volatility, as measured by the VIX Index, was not matched by rising realized volatility. The second panel in the chart below shows the width of the SPX Bollinger Band as a proxy for implied volatility, which has been tame.
  • Until the market sold off last Thursday, the term structure of the VIX was steeply upwards sloping. The spread between 9-day, 1-month, and 3-month implied volatility was uniformly high by historical standards.
  • The SKEW Index, which measures the price of hedging tail-risk, was also elevated.

 

 

Equally puzzling is the disconnect between stock and bond implied volatility. While stock volatility has surged, bond market volatility remains tame. What’s going on?
 

 

Historically, high correlations between SPX and VIX have usually led to market sell-offs. Under a minority of circumstances, they have also signaled market melt-ups. How can we explain these unusual conditions in the option market?
 

Election jitters

I present two explanations for the option market anomaly, which are not mutually exclusive. The Financial Times pointed out the market is pricing in an exceptionally pronounced volatility surge around the US election in early November in anticipation of electoral chaos.
 

 

Axios reported that a Mike Bloomberg backed polling firm is warning of potential electoral chaos on election night.

A top Democratic data and analytics firm told “Axios on HBO” it’s highly likely that President Trump will appear to have won — potentially in a landslide — on election night, even if he ultimately loses when all the votes are counted.

Way more Democrats will vote by mail than Republicans, due to fears of the coronavirus, and it will take days if not weeks to tally these. This means Trump, thanks to Republicans doing almost all of their voting in person, could hold big electoral college and popular vote leads on election night.

This scenario has the potential to spark uncertainty an order of magnitude higher than the 2000 Bush-Gore hanging chad Florida electoral controversy.

Hawkfish CEO Josh Mendelsohn calls the scenario a “red mirage.”

  • “We are sounding an alarm and saying that this is a very real possibility, that the data is going to show on election night an incredible victory for Donald Trump,” he said.
  • “When every legitimate vote is tallied and we get to that final day, which will be some day after Election Day, it will in fact show that what happened on election night was exactly that, a mirage,” Mendelsohn said. “It looked like Donald Trump was in the lead and he fundamentally was not when every ballot gets counted.”

President Trump is already tweeted to alert his supporters about that possibility. A closely contested election with results that are not trusted by one side could spark protests and counter-protests all over the country. The events in Portland and Kenosha are just a preview. Imagine multiplying them by 10, or 100 as armed protesters from both sides flood the streets.
 

 

This is hardly a scenario promoted by the radical fringe. Even The Economist devoted an entire issue to this subject.
 

 

Are civil wars bullish? Is it any wonder why volatility premiums are elevated around the time of the election?
 

The Softbank NASDAQ ramp

A shorter term explanation for the dual rise in stock prices and implied volatility is the gamma chase by dealers. The perennially bearish website Zero Hedge reported that Nomura’s cross-asset analyst Charlie McElligott found that there has been a very large buyer of technology stock call options, to the tune of over $1 billion in option premiums.

Over the past few weeks, there has been a massive buyer in the market of Technology upside calls and call spreads across a basket of names including ADBE, AMZN, FB, CRM, MSFT, GOOGL, and NFLX. Over $1 billion of premium was spent and upwards of $20 billion in notional through strike – this is arguably some of the largest single stock-flow we’ve seen in years. “The average daily options contracts traded in NDX stocks to rise from ~4mm/day average in April to ~5.5mm/day average in August (a 38% jump in volume).

As the street got trapped being short vol, other names in the basket saw 3-4 standard deviation moves higher as well – on Wednesday FB rallied 8% (a 3 standard deviation move), NFLX rallied 11% (a 4 standard deviation move), and ADBE rallied 9% (a 3 standard deviation move).

The most natural place to hedge being short single name Tech volatility is through buying NDX volatility. As such, there has been a flood of NDX volatility buyers with NDX vols up about 4 vol points in 2 trading days. And if NDX volatility is going up, SPX volatility/VIX will eventually go up too.”

Dealers became net short as this very large buyer came into the market. Consequently, market makers had to buy the underlying shares in order to hedge their position, which sparked a bullish stampede and NASDAQ melt-up. Zero Hedge concluded:

Putting it all together, we find that a combination of market euphoria, free options trading, and most importantly, few market-makers have sparked the fire. It also means that “a few large hedge funds understood this and have added fuel to the fire by pushing implied higher and higher and putting further pressure on the likes of Citadel and Goldman. With this process helping drive names like Apple and Tesla, this also makes sense why Breadth has been so terrible.

The Financial Times subsequently identified the large buyer as Softbank. Softbank spent roughly $4 billion in call option premiums to control $50 billion of equity assets. The purchases appears to have sparked a bullish stampede. SentimenTrader pointed out that the retail small option buyers continued to pile into their bullish bets despite the late week sell-off.
 

 

Maybe some reasons for the market swoon last Thursday was the disappearance of Softbank buying, or just buyer exhaustion.
 

The NASDAQ wobbles

We can observe the footprints of the call option buyers in the price action of the NASDAQ 100 (NDX) and VXN, which is the implied volatility of the NDX. VXN (top panel) had been basing and began to rise in lockstep with NDX. VXN then went on to stage an upside breakout out of its multi-month base, indicating a possible volatility storm ahead. From a technical perspective, NDX remains in a rising channel, and the relative performance of NDX is still in a relative uptrend. Until we see downside breaks in those trend lines, traders should not turn bearish.
 

 

Should we see downside technical breaks, downside risk could be considerable. Analysis from JPMorgan reveals that market participants have completely unwound their equity short positions from March. Short interest is extremely low, and there is little buying support from short covering should stock prices take a tumble.
 

 

More volatility ahead

Tactically, where do we go from here? Is this just a brief pullback, or the start of a major correction? The blogger Urban Carmel observed that when the S&P 500 falls -3% or more, such downdrafts tend to occur in clusters, and the first one from a high doesn’t mark the initial low, and such strong down momentum typically followed by a lower close in the day or two. In the last year, there were two bounce and successful re-tests of the lows, and one market plunge.
 

 

What’s the likely outcome? Market internals are deceptive. my high beta to low volatility equity risk appetite indicator is flashing a risk-on signal, but it flashed a similar signal at the bottom of the initial market plunge in March. We are likely to see some sort of short-term bounce early next week, as the market is sufficiently oversold to warrant a relief rally. I am watching the behavior of this indicator, as well as breadth metrics such as the Advance-Decline Line and Volume, for signs of either a positive or negative divergence on the re-test before declaring a bullish or bearish verdict.
 

 

Short-term momentum presents a mixed picture. The percentage of stocks in the NASDAQ 100 above their 5 dma is oversold. As NASDAQ stocks have been the tail that wag the dog market leaders, the market is ripe for a bounce early next week.
 

 

On the other hand, traders have to be aware of the possibility that this is just the start of a major downdraft. The percentage of S&P 500 stocks above their 5 dma is not oversold, and the pattern has eerie parallels to the major market decline in March.
 

 

Sentiment is extremely jittery. Retail traders piled into inverse ETFs late last week. While this is contrarian bullish, it’s difficult to believe that the wild speculative frenzy of the past few weeks could be unwound in two days. Be prepared for more volatility.
 

 

In conclusion, there are both short and medium term catalysts for a market volatility storm. Traders should expect heightened volatility and risk premium compression between now and Inauguration Day. Hopefully, any electoral chaos should be settled by then.

Disclosure: Long SPXU

 

How the Fed’s Policy Review received an incomplete grade

Posted by Cam Hui -

It has been over a week since Jerome Powell’s virtual Jackson Hole speech in which he laid out the Fed’s revised its updates to its Statement on Longer-Run Goals and Monetary Policy Strategy after a long and extensive internal review. There were two changes. one was a shift towards an “average inflation targeting” regime, where the Fed “seeks to achieve inflation that averages 2 percent over time”. The other was an emphasis on to target low unemployment. Instead of minimizing “deviations from the maximum” employment, it will minimize “shortfalls of employment from its maximum level.”

The results of the review were much like a student handing in a term paper after much effort, but the assignment is incomplete, and leaves many questions unanswered.

  • How will the Fed calculate the average inflation rate? In other words, what decision rules will the Fed adopt to raise interest rates?
  • How credible is the 2% inflation target? How does the Fed expect to raise the inflation rate, when it was unable to do so for many years? Is it because its lab partner, fiscal policy, failed to work on the assignment?
  • How will the Fed manage the bond market’s expectations? If the average inflation target of 2% is credible, how far above 2% will the 10-year Treasury yield be, and what will that do to the economy and stock prices?

On the last point, I had a discussion with a reader about the implications for the bond market in the wake of Powell’s speech. Wouldn’t a credible 2% average inflation target translate into a substantial surge in bond yields? How far above 2% does the 10-year Treasury have to trade? What does that mean for equity valuations?

Supposing that you knew for certain that inflation will average 2% over the next 10 years, you would certainly demand a Treasury yield of over 2%, say 2.5%. The 10-year yield needs to rise by at least 1.8%. What would that do to the economy, and the stock market?

Forward P/E ratios are stratospheric compared to their own history, but some investors have justified the high multiple by pointing to low rates. TINA, or There Is No Alternative. Valuations are reasonable based on equity risk premium (ERP), which is some variation of E/P – interest rates. Here is the Q2 2020 ERP calculation of Antonio Fatas, professor of economics at INSEAD. While the stock market appears reasonably priced based on ERP today, raising rates by 1.8% (everything else being equal) would make stocks far less attractive compared to fixed income alternatives.
 

 

Something doesn’t add up. The Fed’s review appears incomplete. There are too many unanswered questions.
 

Wild confusion

The Fed needs to work on its communication policy. Reuters reported that, one day after the Powell speech, regional Fed presidents had wildly differing interpretations of what the average inflation target policy meant.

Dallas Fed President Robert Kaplan said he would be comfortable with inflation running a “little bit” above the Fed’s 2% inflation target if the economy were to once again be running near full employment.

“And for me, a little bit means a little bit,” or about 2.25%, Kaplan said during an interview with Bloomberg TV. “I still think price stability is the overriding goal and this framework doesn’t change that.”

St. Louis Fed President James Bullard, who along with Kaplan and their 15 policymaker colleagues will carry out the Fed’s new strategy, had a different answer.

“Inflation has run below target, certainly by half a percent, for quite a while, so it seems like you could run above for a half a percent for quite a while,” Bullard told CNBC.

And Philadelphia Fed President Patrick Harker had yet another view.

“It’s not so much the number. … It’s really about the velocity,” Harker said during a separate interview with CNBC, adding that inflation “creeping up to 2.5%” is different from inflation that is “shooting past 2.5%.”

A subsequent speech by Vice Chair Richard Clarida was equally unclear about the Fed’s plans, other to convey the impression that the FOMC intends to steer monetary policy by the seat of its pants.

To be clear, “inflation that averages 2 percent over time” represents an ex ante aspiration, not a description of a mechanical reaction function—nor is it a commitment to conduct monetary policy tethered to any particular formula or rule.

Fed governor Lael Brainard was equally ambiguous when she described Flexible Average Inflation Targeting (FAIT) in a separate speech.

Flexible average inflation targeting is a pragmatic way to implement a makeup strategy, which is essential to arrest any downward drift in inflation expectations.While a formal average inflation target (AIT) rule is appealing in theory, there are likely to be communications and implementation challenges in practice related to time-consistency and the mechanical nature of such rules. Analysis suggests it could take many years with a formal AIT rule to return the price level to target following a lower-bound episode, and a mechanical AIT rule is likely to become increasingly difficult to explain and implement as conditions change over time. In contrast, FAIT is better suited for the highly uncertain and dynamic context in which policymaking takes place.

In practice, the new monetary policy framework means that the Fed will be slower to tighten to allow the economy to run “hot” and ensure that inflation rises above 2% and averages at 2%. The key indicator to watch is inflation expectations, which needs to stay anchored at 2%.
 

The lab partner goes AWOL

After over a decade of sub-2% inflation, the new policy framework does nothing to address how the Fed plans to raise inflation to the 2% average. For that, the central bank needs the cooperation of its lab partner, fiscal policy.

Lael Brainard’s recent speech pleaded for help from fiscal policy as she acknowledged that monetary policy could not do all the heavy lifting by itself.

Looking ahead, the economy continues to face considerable uncertainty associated with the vagaries of the COVID-19 pandemic, and risks are tilted to the downside. The longer COVID-19-related uncertainty persists, the greater the risk of shuttered businesses and permanent layoffs in some sectors. While the virus remains the most important factor, the magnitude and timing of further fiscal support is a key factor for the outlook. As was true in the first phase of the crisis, fiscal support will remain essential to sustaining many families and businesses.

In the short run, political gridlock has gripped Washington as both sides have been unable to agree on a CARES Act 2.0 fiscal relief package. In addition, a second important deadline is approaching, as the government faces a shutdown on October 1st in the absence of interim funding legislation. Fortunately, Treasury Secretary Mnuchin and House Speaker Pelosi appear to be agreeable to working together to avoid a government shutdown.

In short, the Fed’s lab partner, fiscal policy, is nowhere to be seen, and the Fed’s policy review is not very meaningful without the partner’s presence.
 

The Abenomics template

Notwithstanding the short-term battles on Capitol Hill, chances are that policy direction will move towards a Modern Monetary Theory (MMT) framework no matter who wins in November. How will that play out?

For some clues of how the combination of fiscal and monetary policy might work, we can consider the Abenomics experiment, named after Japanese Prime Minister Abe Shinzo, who recently announced his resignation. Abe’s decade-long efforts to halt Japan’s deflation consisted of the “three arrows” of Abenomics, fiscal stimulus, monetary stimulus from the BoJ, and structural reform of the Japanese economy. The results was a mixed bag of successes and failures.

The initial thrust of the BoJ’s aggressive monetary policies briefly pushed the CPI inflation above 3%. But loose monetary policy was offset by tight fiscal policy, as the government imposed a sales tax increase. So much for inflation.
 

 

Despite the decline in headline CPI inflation, inflationary expectations rose, which was constructive.
 

 

Abenomics was also able to partially revive capital expenditures.
 

 

History doesn’t repeat, but rhymes. Undoubtedly there will be some bumps along the way as political regimes change in Washington over the next 10 years, but investors can use the same Abenomics template and should expect similar mixed results in the US economic outlook over the next decade.
 

Investment implications

What does all this mean for investors? Over the next 6-12 months, the key variables are the election, the path of fiscal policy, and how the Fed reacts to rising bond yields. Inflation expectations, as measured by the 5×5 forward bond yield, had been rising steadily and peaked at 1.91% last week before retreating. This put upward pressure on the 10-year Treasury yield.
 

 

At some point, higher Treasury yields will threaten the fragile economic recovery, and it will also put downward pressure on stock prices. A recent Bloomberg article, “Treasury Yields Will Become A head For Stocks Around 1%”, tells the story. Higher rates will put downward pressure on equity prices.

How far will the Fed allow yields to rise? Can it act to hold down yields and maintain the credibility of an average 2% inflation target? Richard Clarida rejected the notion of yield curve control (YCC) in his recent speech, but left the door open for further action in the future.

Most of my colleagues judged that yield caps and targets were not warranted in the current environment but should remain an option that the Committee could reassess in the future if circumstances changed markedly

The Fed is engaged in a tight-wire act with its YCC tool. If it doesn’t suppress rates, it risks snuffing the recovery and stock prices. Suppress rates too much, and it will devastate the banking system by compressing interest rate margins, raise inflationary expectations and run the risk of them becoming unanchored beyond the 2% targeted level. Should it have to resort to YCC, the Fed will begin with jawboning, or forward guidance, before actually intervening in the bond market. Sometime the threat of action is more powerful the actual action itself.

For investors, this means returns in Treasury market are asymmetric. The Fed will allow yields to fall as the market dictates. Fixed income investors should expect returns to be reasonable. There will not be significant downside risk in bond prices. On the other hand, the path of equity prices will be more dependent on more variables: how the world controls the pandemic, the path of fiscal policy, and the evolution of earnings expectations.

In conclusion, the Fed’s policy review raises more questions than answers. The Fed has a limited ability to boost the economy, but it’s known that it has the power kill it. This review has softened the “kill the economy because it’s overheating” policy, but there are many questions about the mechanisms for boosting growth. I expect there will be short-term hiccups between now and the Presidential Inauguration in January, but expect some form of Abenomics like policy over the next decade. The results will be uneven, and will depend largely on the path of fiscal policy, rather than monetary policy.
 

Growth stock wobbles

Posted by Cam Hui -

Mid-week market update: One of the defining characteristics of the current bull run is the dominance of US large cap growth stocks. Joe Wiesenthal wrote about the problem of the effect of the “superstar companies” on the economy in a Twitter thread and in a Bloomberg commentary. The “superstar companies” have few employees, and therefore high labor productivity.
 

 

But if labor productivity is all that matters, and you don’t need any workers, where is the demand going to come from?

If you think that the key thing is demand, and that demand drives investment, driving productivity, then it’s not about declaring some tech companies winners and declaring everyone else as zombies that should die, it’s about fostering income equality to drive spending.

Something nobody ever seems to point out is how it’s interesting that productivity growth is historically quite low, even though we have an economy that’s dominated by some of the most productive companies in human history. Maybe more ultra-productive companies aren’t the answer?

While Big Tech and large cap growth are still red hot, more cracks are showing up in the growth stock armor. The chart below shows an unexpected divergence in relative performance between large cap and small cap growth (top panel). If we were to benchmark US large and small cap stocks against global stocks, as measured by the MSCI All-Country World Index (ACWI), we can see that large cap growth remains in a relative uptrend against ACWI (middle panel), but the relative performance of small caps and small cap growth have flattened in the past few months.
 

 

While these are not immediate bearish signals, they represent “under the hood” warnings of pending trouble in US equities.
 

Sentiment warnings

As for the rest of the stock market, there are plenty of warnings from sentiment models. The Citi Panic-Euphoria Model is wildly euphoric, though readings are not as high as they were during the height of the dot-com bubble.
 

 

One reader alerted me to Willie Delwiche’s analysis of sentiment, where six out of eight models are bearish, with two in neutral. That’s another sign of extreme bullishness, which is contrarian bearish.
 

 

What is the “smart money” doing?

Other signals of market headwinds come from the behavior of the “smart money” crowd. One measure of “smart money” are corporate insiders, who have shown little tendency to step up and buy the shares of their companies. To be sure, insider trading works best mainly as a buy signal, when buying swamps selling as it did in March.
 

 

Another savvy investor is billionaire distressed investor Sam Zell, who said in a CNBC interview that “it’s really too early for the normal clearing process” to be buying right now, and  “there will be significant opportunities probably in Q4 or first quarter of next year”. Zell’s remarks about the “clearing process” is code that the market is being held up by fiscal and monetary support, and he is not ready to buy until he sees signs of distress.
 

What’s Warren doing?

Warren Buffett also told a similar story. He stated earlier in the year that while he saw signs of distress during the March COVID Crash, Berkshire Hathaway was unable to react and use its cash horde to make distressed buys because of official intervention.

Nevertheless, we have important signals from Buffett’s recent actions. Some gold bugs got very excited recently when Berkshire bought a position in Barrick Gold, but the position was relatively small and the decision was likely made by one of the Buffett’s lieutenants. More importantly, Berkshire recently disclosed new positions in five Japanese trading companies. Here is what we know about the purchases:

  • The value of the acquisition was about $6 billion for about 5% stakes in Itochu Corp., Marubeni Corp., Mitsubishi Corp., Mitsui. and Sumitomo Corp.
  • These companies are mainly commodity trading conglomerates.
  • Their valuations are historically cheap, weighed down mainly by their commodity exposure, particularly in energy and natural gas.
  • They offer strong cash flows and dividends.
  • Berkshire Hathaway quoted Buffett in a statement, indicating that it was Buffett and Munger who made the investment decision: “I am delighted to have Berkshire Hathaway participate in the future of Japan and the five companies we have chosen for investment”.

I interpret these statements to a decision to gain exposures into commodity business in a way that minimizes the cyclicality of the sector. I also recently pointed out the beaten up nature of energy stocks (see Here’s a way to energize your portfolio). Callum Thomas observed that the energy sector is now the smallest weight in the S&P 500 index, which is another signal of wash-out sentiment.
 

 

In conclusion, sentiment models are at crowded long extremes, and smart investors are not ready to buy yet. While US large cap growth is still dominant, cracks are appearing in its leadership, and smart investors like Warren Buffett are focusing on positions in the unloved commodity sector.

As a reminder, Big Tech comprises nearly 50% of S&P 500 weight, while the cyclical sectors are only 13% of the index. If and when we see a rotation from growth the value, financial stocks, which can be considered value stocks, are unlikely to participate significantly as long as the Fed suppresses interest rates and interest margins. While history doesn’t repeat, but rhymes, a leadership failure of US large cap growth will rhyme with the 2000 dot-com bubble top owing to the sheer differential in growth and value index weights.
 

 

Analysis from BCA Research shows that the S&P Growth to Value ratio is the highest it’s been, ever. Moreover, rotations from growth to value have coincided with recessions and bear markets.
 

 

We are just waiting for the bearish trigger.

Disclosure: Long SPXU
 

Volmageddon, or market melt-up?

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.
 

An unusual correlation

An unusual condition has occurred in the last week, as both stock prices and the VIX Index have been rising together. The VIX has been making a saucer bottom, which could be setting up for a volatility surge, and lower stock prices. While past episodes of high correlation have resolved in short or medium term pullbacks, there have been other occasions, such as late 2017, when these signals marked market melt-ups.
 

 

Are we poised for a Volmageddon, or a market melt-up?
 

An extended market

Let’s consider the evidence. There are plenty of warnings of an extended market. I have pointed out before how the price performance of high yield (junk) bonds relative to their duration-adjusted Treasury prices have not confirmed the stock market rally (red line). Now investment grade bonds (green line) are flashing a similar negative divergence. Credit market and stock market risk appetites are in disagreement. Usually, the bond market turns out to be right.
 

 

Equity market breadth is also not buying into the market advance, as there are numerous negative divergences.
 

 

Sentiment is becoming stretched and overly bullish, which is contrarian bearish. SentimenTrader pointed out that call to put volume trading reached all-time highs last week, and conditions far exceeded the levels seen at the 2018 melt-up highs (annotations are mine). He characterized current conditions as a “combustible combo of musical chairs, Russian roulette, and five finger fillet”.
 

 

That said, while sentiment models can warn of elevated risk conditions, they don’t necessarily represent actionable sell signals. The Investors Intelligence sentiment survey shows that bears (blue line) have capitulated to late 2017 levels, and the bull-bear spread have similar crowded long readings. However, this did not prevent the market from marching upward until it reached its January 2018 blow-off highs.
 

 

Strong momentum

There are signs that the market is undergoing a momentum driven melt-up. The S&P 500 experienced a seven day winning streak, and Steve Deppe found that such winning streaks combined with all-time highs have tended to be bullish.
 

 

As well, Urban Carmel observed that the market has undergone a five week winning streak. Past winning streaks of six weeks or more have also tended to be bullish, with the exception of 2015.
 

 

While absolute price momentum, defined as the market rising which leads to further gains, is evident, stock price momentum, or individual stock rising leading to further gains, is faltering. The stock price momentum factor as measured by different momentum ETFs has been weakening. However, the momentum factor also failed during the late 2017 and early 2018 melt-up, and it was an inexact timing signal. Decelerating price momentum can be regarded as a warning, much like how a ball slows its ascent at the top of its parabolic when thrown into the air.
 

 

Conflicting messages from Big Tech

I have made the point before that Big Tech is dominating the behavior of the stock market. The top five stocks comprise 22% of the weight of the S&P 500, and the combination of technology, communication services, and consumer discretionary (AMZN) sectors make up about half of the index. What’s the market message from Big Tech?

The NASDAQ 100 (NDX) is a good proxy for Big Tech, and it is also experiencing a similar pattern of high correlation with VXN, which is the NASDAQ volatility index. VXN is also forming a rounded base and poised for a volatility surge. While past episodes of high NDX and VXN correlation have been bearish in the past, we also had an experience in early pre-COVID 2020 when the NASDAQ 100 melted up despite high correlation readings.
 

 

We are seeing some early warnings signs of a downside break. While the NASDAQ 100 is still behaving well, the relative performance of semiconductor stocks are showing some chinks in the Big Tech armor. Semiconductors have been on a tear for over a year, and their relative performance breached an uptrend last week, which I interpret as an early warning that not all is well. I will be watching whether VXN (top panel) can break out of resistance after forming a multi-month base.
 

 

Before the bears get all excited, the relative performance breach was relatively minor, and the absolute and long-term uptrend of the SOX Index remains intact.
 

 

These trend breaks doesn’t necessarily portend an immediate pullback. The NDX is indeed highly extended, but extended markets can rise further. The index has reached 2.7 standard deviations above its 20-month moving average. While this is not unprecedented, the last time this happened was in late 1998 as the market melted up.
 

 

The week ahead

So where does that leave us? The stock market is undoubtedly overbought and numerous warnings leave it poised for a decline. On the other hand, strong momentum can carry prices higher into a melt-up, to be followed by an abrupt collapse.

Next week will provide some clues to the Volmageddon vs. market melt-up question. That’s because the market may be overreacting to dovish comments from Fed chair Jay Powell last Thursday, and a post-convention polling bounce by the Republicans in the wake of their convention. While he is still trailing, the odds of a Trump electoral win has been improving at PredictIt.
 

 

Equally revealing are the odds of Senate control. The Democrats’ lead has evaporated, and the odds are now even.
 

 

These developments have have been perceived as equity bullish, as Republicans have been thought to be more market friendly than Democrats. However, this may be a blip owing to post-convention bounces, which are common, and we won’t really know how the polling will settle out for another couple of weeks.

In the short run, the all important NASDAQ 100 is overbought, but levels are below the melt-up peak of early 2018. If the market is indeed undergoing a melt-up, it has room to rise further.
 

 

If I had to guess, I would estimate a two-third probability of a correction, and one-third probability of a melt-up, but I am keeping an open mind as to the ultimate outcome.

Disclosure: Long SPXU

 

Winning the Pandemic Peace

Posted by Cam Hui -

This is war! A global war against the pandemic. Analysis from the IMF showed that government debt levels have spiked to levels not seen since World War II.
 

 

How will the world win the peace in a post pandemic era, and what does that mean for investors?
 

A hopeful view

Morgan Housel at Collaborative Funds recently offered a hopeful and uplifting message. He believes that crises spurs panic driven innovations, and the pandemic provides an environment that sparks new discoveries and breakthroughs.

A broader point that applies to everyone is that the biggest innovations rarely occur when everyone’s happy and safe, or when the future looks bright. They happen when people are a little panicked, worried, and when the consequences of not acting quickly are too painful to bear.

That’s when the magic happens.

In particular, Housel cited the Great Depression as a crisis period that sparked innovation and productivity growth.

The number of problems people solved, and the ways they discovered how to build stuff more efficiently, is a forgotten story of the ‘30s that helps explain a lot of why the rest of the 20th century was so prosperous.

Here are the numbers: Measuring total factor productivity – that’s economic output relative to the number of hours people worked and the amount of money invested in the economy – hit levels not seen before or since:

 

 

FDR’s highway infrastructure program was just one example of how productivity soared.

The New Deal’s goal was to keep people employed at any cost. But it did a few things that, perhaps unforeseen, become long-term economic fuels.

Take cars. The 1920s were the era of the automobile. The number of cars on the road in America jumped from one million in 1912 to 29 million by 1929.

But roads were a different story. Cars were sold in the 1920s faster than roads were built. A new car’s novelty was amazing, but its usefulness was limited.

That changed in the 1930s when road construction, driven by the New Deal’s Public Works Administration, took off…

The Pennsylvania Turnpike, as one example, cut travel times between Pittsburgh and Harrisburg by 70%. The Golden Gate Bridge opened up Marin County, which had previously been accessible from San Francisco by ferry boat.

Multiply those kinds of leaps across the nation and 1930s was the decade that transportation truly blossomed in the United States. It was the last link that made the century-old railroad network truly efficient, creating last-mile service that connected the world. A huge economic boon.

Fast forward to 2020. What’s happening in stress induced innovation today?

But think of what’s happening in biotech right now. Many have pessimistically noted that the fastest a vaccine has ever been created is four years. But we’ve also never had a new virus genome sequenced and published online within days of discovering it, like we did with Covid-19. We’ve never built seven vaccine manufacturing plants when we know six of them won’t be needed, because we want to make sure one of them can be operational as soon as possible for whatever kind of vaccine we happen to discover. We’ve never had so many biotech companies drop everything to find a solution to one virus. It’s as close to a Manhattan Project as we’ve seen since the 1940s.

And what could come from that besides a Covid vaccine?

New medical discoveries? New manufacturing and distribution methods? Newfound respect for science and medicine?

 

A need for institutions

Morgan Housel’s rather optimistic view of the current environment is underpinned by a key assumption. In order for discoveries innovations to occur, a society needs strong institutions to ensure the rule of law and protect property rights. The incentives to bring new discoveries to market are blunted unless you know that what you do won’t be taken away from you.

Consider the following historical period that is within the lifetimes of most investors today. When the Berlin Wall came down, the Soviet Union and the East Bloc economies collapsed, what key innovations emerged from that crisis that are in common use today?

I’ll wait.

To explain the lack of crisis driven innovation during the Soviet collapse, let’s go back to 1865 and track the stock markets of two emerging market economies. The Russian market handily beat the American market for over 50 years, until investors lost everything (and probably their lives) during the Russian Revolution.
 

 

The key distinguishing feature is the nature of institutions in Russia. In 19th Century Russia, the tsar owned everything. You could make money by getting a license from the tsar to say, fish in the Baltic Sea, but that license could be taken away at any moment. The “property right” to fish did not exist. Consequently, there were few incentives to invest in new equipment, but to employ a harvesting strategy to exploit as much as you can while you held the license. Fast forward to 2020, the institutions that assure investors of property rights in Russia are still weak. The culture and mindset are not very different from 150 years ago. The primary motivation of Russian oligarchs is to exploit their “license” as much as possible, with minimal incentives to re-invest in the business.

Turning to the US, the key risk for American investors today is the erosion of institutions and trust in US institutions. The protests in Kenosha, Wisconsin are just a symptom of the malaise that afflicts American society. Each side is convinced that a victory in November by the other represents an existential threat to the Republic and American democracy. I have speculated in the past about the possibility of electoral chaos in November if the vote is close, and one side thinks that the election was stolen from them. Kenosha, and Portland before that, are just previews. A Pew Research Center poll found that Americans are unique in how divided and polarized they are in the wake of the pandemic.
 

 

Equally worrisome is Trump’s ambiguous answers about whether he would respect the results of the election. Trump is preparing to contest the election, both in the Supreme Court, and in the court of public opinion. Some commentators have felt assured that they expect, in the event of a Trump electoral loss, the military would do their job and escort him out of the White House. These comments open a frightening door. This question of “What would the Army do?” is usually not asked in a stable G-7 country. It’s the sort of question asked in nations with histories of fragile democracies. Has America become Egypt, or Indonesia? Asking “What would the Army do” is another sign of the erosion of institutions.

The events in Kenosha are another example of the disintegration of institutions. In what Western democracy do the police tolerate the appearance of armed civilians in camouflage uniforms in the streets? Does the police recognize that their authority rests on trust in the institution of policing itself?

The erosion of institutions could also have dire implications in the fight against the pandemic. A Bloomberg article raised the question of declining trust in the FDA in light of the politicization of that organization.

In America, whenever you open a medicine bottle, put a pill in your mouth and swallow, you’re engaging in an act of trust. It’s the promise that, thanks to the men and women of the Food and Drug Administration, there’s been a rigorous examination of how safe and effective it is.

That trust isn’t to be taken for granted.

Now, instead, imagine a world where you open that bottle, take out the pill, and before you put it on your tongue, you pause. You question whether you should, because you don’t trust the political party that was in power when it was approved.

The real world consequences of the politicization of an agency like the FDA could manifest itself in the lack of trust in a vaccine. As there is already a part of the population who are skeptical about vaccines, the lack of trust in the FDA is likely to retard the kinds of widespread vaccination that leads to herd immunity. The lack of herd immunity will put downward pressure on the economic growth outlook, which is bearish for equities and other risk assets.
 

The inequality challenge

Another factor that is slowly gnawing away at the foundation of institutional respect is the growing inequality gap laid bare by the pandemic. For a perspective of the growing inequality between capital and labor, consider this chart of the number of hours an average worker needed to buy one share of the S&P 500. A gap opened in the mid-1990’s during the Clinton years, and continued through both Republican and Democratic presidencies.
 

 

A recent paper found that increased corporate power is mainly responsible for all of the negative financial and economic trends of the past few decades, such as stagnant wages, rising inequality, more household debt and financial instability. The source of the paper was a surprise, it came from the Federal Reserve. Here is the abstract from the Fed paper entitled “Market Power, Inequality, and Financial Instability”.

Over the last four decades, the U.S. economy has experienced a few secular trends, each of which may be considered undesirable in some aspects: declining labor share; rising profit share; rising income and wealth inequalities; and rising household sector leverage, and associated financial instability. We develop a real business cycle model and show that the rise of market power of the firms in both product and labor markets over the last four decades can generate all of these secular trends. We derive macroprudential policy implications for financial stability.

Since Janet Yellen became the Chair, the Fed has become increasingly concerned about the problem of labor market inequality. In this paper, the Fed raised the alarm because rising inequality is sparking a “keeping up with the Joneses” effect of credit-driven spending, which creates higher leverage, and raises financial instability risk.

Jerome Powell’s Jackson Hole speech signaled the Fed’s willingness to focus on employment at the price of higher inflation and to address the inequality problem. Powell stated that “maximum employment is a broad-based and inclusive goal” and “this change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.”

Before the pandemic hit, the economy was experiencing a low unemployment rate, which was bringing most disadvantaged Americans into the labor force. But this was a very inefficient way of addressing the inequality problem. The most marginalized and least paid workers do not find jobs until employers must work hard to get workers. Fiscal policy can play a much bigger role to level the playing field. While serving Fed officials need to couch their words in calling for fiscal support, former Fed Chair Janet Yellen minced few words when she co-authored a NYT Op-Ed entitled “The Senate’s on Vacation While Americans Starve”.

Enter the pandemic, and the job gains by the bottom rung of society have quickly reversed. Job losses have been concentrated among lowly paid workers in the hospitality and services industries. Even worse, the WSJ pointed out that the pandemic is accelerating automation and worsen the job market outlook.

What’s making things worse for these workers and their families is that the pandemic is also accelerating the arrival of remote work and automation. It is a turbo boost for adoption of technologies that, according to some economists, could further displace lower-wage workers. It could also help explain the “K” shaped recovery many pundits have observed, in which there are now two Americas: professionals who are largely back to work, with stock portfolios approaching new highs, and everyone else.

Even before the pandemic, “Automation can explain labor share decline, stagnant median wages and declining real wages at the bottom,” says Daron Acemoglu, a professor of economics at the Massachusetts Institute of Technology. “It’s the bottom that’s really getting hammered.”

The tax system already has substantial incentives in place for companies to replace labor with capital. This argues for a corporate tax overhaul to address the imbalance between capital and labor, especially if Biden were to win and the progressive wing of the Democratic Party take control of both the House and Senate in November.
 

 

Notwithstanding the simmering class war between the suppliers of capital and labor, the suppliers of capital are also experiencing a stratified inequality effect. Small businesses are bearing the brunt of the pandemic recession. High frequency data shows that consumer spending patterns have flattened out, but small business revenues is declining. The competitive advantages of corporate size and economies of scale are manifesting themselves, and the COVID Crash is increasing big business concentration at the expense of small businesses.
 

 

Inequality matters, and at multiple levels. Longer term, it is eroding confidence in institutions.
 

Investment implications

We began this journey by observing that government debt levels had risen to levels not seen since World War II. While the debts appeared alarming, post-war debt to GDP gradually fell from a combination of real growth and the willingness of monetary authorities to engage in financial repression by capping interest rates. How will the global economy win the Pandemic Peace, and what does that mean for investors?

I don’t mean to denigrate Morgan Housel’s optimistic view of crisis induced innovation and productivity growth. His scenario is very plausible. Even if trust in American institutions is significantly eroded, which is not my base case, Housel’s scenario can be played out in other G-7 countries with well-established institutional stability.

This may not necessarily be bullish for equity investors. Even if Housel’s era of crisis driven innovations were to be realized, it is less clear how the pie from the spoils of productivity growth will be divided. After several decades where the supplier of capital has enjoyed the lion’s share of the gains, it would not be unusual to see some mean reversion of the division between the suppliers of capital and labor.

This would have negative implications for equity prices. In addition, US equities have a valuation problem. Big Tech is dominating the US equity market, but the rest of the index is not exactly cheap on forward P/E even if we exclude the top five stocks. Some other options on raising expected returns are value stocks, gold, and non-US equities, as well as the use of tactical asset allocation  (see A bleak decade for US equities).
 

 

If the monetary authorities were to continue engaging in financial repression, it should be bullish for gold and other commodities. I have highlighted the stock to gold ratio, and a comment by Joe Wiesenthal of Bloomberg of how the ratio is a measure of confidence in the markets and the economy. This ratio is falling, and argues for a higher than normal position in gold and commodities in asset allocation.
 

 

Despite my long-term bullish view on gold and commodity prices, I believe a well diversified portfolio should still consist of some stocks, and bonds. Cullen Roche at Pragmatic Capitalism demonstrated that bonds still provide important diversifying characteristics in balanced portfolios.

This era of high bond returns is over. But it doesn’t necessarily mean that bonds are a bad diversifier. For instance, from 1940-1980 interest rates rose steadily from about 2.5% to 15%. This seems counterintuitive to what most of us are led to believe about rising rates, but your average annual return over this period was 3% in a 10 year T-Bond. Bonds weren’t nearly as beneficial to a portfolio as they have been in recent decades, but that doesn’t mean they weren’t a good diversifier.

 

 

In short, go ahead and hold some gold and commodities, but don’t go overboard and forget the role of bonds for diversification.

 

Tech is eating the market

Posted by Cam Hui -

Mid-week market update: I have written about how Big Tech is dominating the market. Here is another perspective of how tech stocks are eating the market. The combined market cap of FANGMAN (Facebook, Apple, Nvidia, Google, Microsoft, Amazon, Netflix) is reached all-time highs and nearing a total of $8 trillion.
 

 

The angst over Big Tech is growing, and until the parabolic rise reverses, major stock market averages are likely to continue to grind higher.
 

The manager’s dilemma

The dominance of Big Tech in the top five stocks is presenting portfolio construction and risk control problems for portfolio managers. The top five stocks comprise 22.1% of index weight. Since they tend to move together, even holding a market weight in these stocks creates a high degree of concentration risk for the portfolio and can violate portfolio construction constraints, e.g. “no more than 20% in any one sector”.
 

 

Big Tech dominance also creates a portfolio construction problems from a stock picking perspective. Managers have some process for ranking stocks as buy, hold, or sell. The portfolio construction process would typically have some rules, such as holding index plus x% if a stock is a buy, index weight if it’s a hold, and index minus x% for a sell. The level of x% will depend on the manager’s stock selection process. A quantitative manager that relies on models to bet across an array of factors would seek to minimize stock specific risk and maximize model risk, so x% is not likely to exceed 2%. A fundamentally oriented investment manager would seek to maximize his stock picking skills, and x% might be 5%, or even 10%.

These kinds of portfolio construction rules run headlong into risk control constraints. Suppose that x is 5%. If Apple were to be ranked as a buy, the target weight would be 12%, which is excessively high for an individual position. A 10% move in Apple stock would move the portfolio’s returns by 1.2%. If all of the top five were to be ranked buys, total weight would come to 22% (index weight) + 25% (overweight) = 47%, which is an astounding level of portfolio concentration risk.

This level of concentration is creating a business problem for mutual fund and other investment managers. Mutual fund managers have been underweight these stocks even as the stocks have outperformed this year.
 

 

Don’t blame your fund manager if he’s lagging the market this year. His risk control process is holding him back, and for good reason.

Holding an index tracking ETF like SPY is no panacea as it exposes you to a high level of concentration risk. One way is to analyze tracking error, defined as the difference in performance between a portfolio and a benchmark. The tracking error of not owning the top five stocks in the index has skyrocketed to levels no seen since the dot-com bubble.
 

 

Sentiment warnings

Big Tech is certainly looking frothy and bubbly. Macro Charts warned that speculative call option activity on Apple, the top stock in the index with a 7% weight, is “spiking into the stratosphere”.
 

 

Macro Charts also observed a developing base in VXN, the NASDAQ 100 volatility index, and it is poised for a disorderly rise. Past similar episodes has been signals of market corrections.
 

 

There are other signs that the current Big Tech bubble has exceeded dot-com bubble levels. Maverick’s Q2 investment letter pointed out that the difference in relative performance between the price momentum factor and value factors have skyrocketed to highs that well exceed past bubble peaks.
 

 

Waiting for the trigger

That said, all of these warnings are only trade setups, but we don’t have a bearish trigger just yet. Conceivably, this bubble could last longer than anyone expects. I am still keeping an eye on the all important NASDAQ 100 and semiconductor stocks. Neither has shown signs of sustained weakness, either on an absolute or relative basis.
 

 

From a tactical perspective, short-term breadth on the NASDAQ 100 was already overbought as of last nights close, and today’s advance makes the market especially ripe for a pullback.
 

 

Jerome Powell’s virtual Jackson Hole speech tomorrow presents the market with event risk. Unexpected remarks from the Fed Chair could be the catalyst for more market volatility.

Be vigilant.

 

Here’s a way to energize your portfolio

Posted by Cam Hui -

Ho hum, another record in the major market indices. If you want to play catch-up, here is a lower risk idea to energize your portfolio. The most recent BoA Global Fund Manager Survey showed that managers are dramatically underweight energy stocks. The sector is hated, unloved, and beaten up.
 

 

Whether you are bullish or bearish on the stock market, energy stocks might be a contrarian way of making a commitment to equities with a favorable asymmetric risk/reward profile.
 

Constructive pattern

Energy stocks are performing well on a relative basis. The Energy SPDR ETF (XLE) is tracing out a constructive double bottom pattern relative to the market. This pattern is confirmed by the relative performance of European energy stocks (green line, top panel), and the relative performance of individual energy industries within the sector. I interpret these conditions as the sector is wash-out and poised for a rebound.
 

 

Investors may be in a position to get paid for waiting for a rebound. The indicated dividend yield on XLE is 11%, but dividends are being cut, and the annualized yield based on the last quarterly dividend is 5.5%, with the caveat that dividends could be cut further.

From a top-down perspective, the IEA has also documented how the COVID Crash has crashed energy demand that is largest since the end of World War II.
 

 

I am not making any forecasts about when the recession ends, and when energy demand normalizes. However, the combination of wash-out sentiment, constructive relative return patterns, and the upside potential of a demand recovery makes the energy sector a classic contrarian and value selection for equity investors.
 

Thermopylae bulls

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: Bullish

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

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

Easy to be bearish

The sentiment backdrop is making it easy to be cautious about the stock market. Bloomberg reported that the bears are going extinct as the market rallied.

Skeptics are a dying breed in American equities. It’s another illustration of how risky it has become to doubt the resilience of the market’s $13 trillion surge since late March.

Going by the short positions of hedge funds, resistance to rising prices is the lowest in 16 years. Bears pulled out as buying surged among professional investors who were forced back into stocks despite a recession, stagnating profits and the prospect of a messy presidential election.

 

 

If that’s not enough, TMZ published an article with the headline “Day Trading on the Stock Market Is Easier Than You Think”.
 

 

Yet the stock market grinds higher. Even as bearish warnings of excessive bullish sentiment and deteriorating breadth, the bulls are holding steadfast, like the outnumbered Greeks at the Battle of Thermopylae.
 

A case of bad breadth

Even as the stock market rose and made new all-time highs, the advance is being made on deteriorating breadth. Breadth indicators, such as the A-D Line, 52-week highs-low, percentage bullish, percentage of stocks above their 50 and 200 dma, are all not confirming the new highs.
 

 

The NASDAQ 100 has led this market upwards, but even NASDAQ breadth is showing similar signs of negative breadth divergence.
 

 

When I see broad breadth divergences like this, I am reminded of Bob Farrell’s Rule #7, “Bull markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names,”
 

Weakened risk appetite

Other risk appetite indicators are also not confirming the market advance. The ratio of high beta to low volatility stocks is an indicator of risk appetite, and it fell below a key relative support line even as the market made new highs. So did different version of the Advance-Decline Line.
 

 

Credit market risk appetite, as measured by the relative performance of high yield (junk) bonds and leverage loans, are also not buying into the new stock market highs.
 

 

What’s holding up the market?

In light of all these dire warnings, it’s natural to be cautious about the market outlook. But why is the market defying gravity?

The answer is easy when you look under the surface and analyze the relative performance of the top five index sectors. Big Tech sectors, namely technology, consumer discretionary (AMZN), and communication services make up nearly half of index weight, and Big Tech has been extremely strong on a relative basis. It is difficult to see how the stock market could decline without Big Tech weakness.
 

 

Some of the leadership can be explained by the dominance of the megacap growth stocks. Take Apple as an example. The market cap of Apple now matches the entire market cap of the Russell 2000 small cap index. The stock broke up through a rising channel last week, which could either be the sign of a blowoff top, or signs of further market strength. Until leading stocks like Apple weaken, the bulls will retain control of the tape.
 

 

Big Tech dominance can also be seen on an equal weighted basis, which minimizes the contribution of heavyweight FANG+ stocks. The equal-weighted analysis of the relative performance of the top five sectors also shows that the Big Tech sectors are in relative uptrends.
 

 

The analysis of the relative performance of large and small cap technology stocks does show some cracks in the phalanx of tech leadership. The relative performance of small cap technology (green line, top panel) peaked out in April and rolled over even as large cap tech roared upwards. In addition, the relative performance of small cap to large cap tech (green line, bottom panel) mirrors the relative performance of small cap to large cap stocks, indicating that the size effect is more important that the sector effect.
 

 

The bulls last stand?

In light of this analysis, it is no wonder why the bulls’ phalanx is holding ground, just like the Greeks at the Pass of Thermopylae. For readers who are unfamiliar with the Battle of Thermopylae, a small Greek force held off an enormous Persian army at the Pass of Thermopylae, which was a very narrow passage, for three days. For two days, Persians sent wave after wave of soldiers at the Greek defenders in the narrow passage, and the assaulting force all returned bloodied. On the third day, the Persians found a narrow path around the pass and encircled the Greeks.

Historical analogies only go so far. What will crack these stubborn bulls? Watch for the answer in the leadership of the NASDAQ 100, and semiconductor stocks. The bears are not going to take control of the tape as long as the relative performance of these stocks are holding up.
 

 

For a study in contrasts, here is the percentage of stocks in the S&P 500 above their 5 dma. This indicator has breached a short-term uptrend and should be a bearish warning for traders.
 

 

Here is the same indicator for the NASDAQ 100. The uptrend remains intact. Are these conditions short-term bullish or bearish in light of Big Tech market dominance?
 

 

In conclusion, investors with intermediate and long term time horizons should be cautious about the stock market outlook, but it is unclear what bearish catalyst will reverse the market advance. Short-term traders, on the other hand, can give the bull case the benefit of the doubt, as long as the NASDAQ and semiconductor bull trends are holding up.

Disclosure: Long TQQQ

 

Fresh market highs! What now?

Posted by Cam Hui -

Now that stock prices have recovered from their March lows to all-time highs, it’s time to admit that I was wrong about my excess cautiousness. I present a new framework for analyzing the stock market. While the new framework is useful for explaining why the major US market indices have reached fresh highs, it does not necessarily have bullish implications.
 

 

My previous excessive cautiousness was based on two factors, valuation and a weak economic outlook. The market is trading at a forward P/E ratio of 22, which is extremely high by historical standards. Moreover, it was difficult to believe that the economy and stock prices could recover that strongly in the face of the second worst economic downturn since the Great Depression.
 

 

While there has been much discussion over the letter shapes of the recovery, whether it’s a V, W, L or some other shape. The reality is a K-shaped bifurcated rebound. This bifurcation is occurring in two separate and distinct dimensions, the stock market and the path of economic growth.

The K-shaped recovery analytical framework has important implications for how investors should view the market’s future outlook.
 

A bifurcated stock market

I highlighted analysis last week (see A Potemkin Village market?) that Big Tech has become dominant in the weight of the index. The combination of technology, communication services, and consumer discretionary, which is dominated by Amazon, comprise about 50% of S&P 500 index weight. The adage that the stock market isn’t the economy is especially true in this case. Large cap growth stocks were becoming the stock market. Where Big Tech went, the rest of the market followed.
 

 

I also identified a nascent rotation out of large cap growth into cyclical sectors (see Sector and factor review: Not your father’s cycle). From a technical perspective, rotation in a bull phase is normally healthy, but the current market weighting of the index makes such rotations problematical. Cyclical sectors only make up 13% of index weight. If you include healthcare, which assumes the successful deployment of vaccines and therapeutic drugs, the combined index weight is only 27.8%. A rotation out of the Big Tech sectors with half the index weight into smaller sectors with 13% is not possible without the funds moving elsewhere, such as foreign markets or other asset classes.

I would also add that financial stocks, which represent a major sector, are unlikely to participate in a market recovery. That’s because the Federal Reserve is engaged in financial repression to hold down interest rates, which has a detrimental effect on banking margins.

The cyclical rotation theme was confirmed by the latest BoA Global Fund Manager Survey. Global managers were buying cyclical, value, and eurozone stocks while selling growth and US stocks.
 

 

We can also observe a similar rotational effect in regional allocations. In response the COVID Crash, managers had piled into US equities and made the region the top overweight because US large cap growth stocks were the last refuge of growth in what was a growth starved world. The latest survey shows that eurozone stocks had taken over the top spot in equity weighting as managers shifted from US growth to eurozone stocks, which are more cyclical in nature.
 

 

However, a chart of the relative performance of different regions to the MSCI All-Country World Index (ACWI) shows that most regions have been trading sideways since early July. If there is a rotation from US Big Tech into cyclical growth, that play may be petering out.
 

 

That’s the challenge for US equity bulls. If there is a rotation into cyclical stocks in anticipation of a global economic recovery, there isn’t sufficient liquidity in the market to accommodate the rotation. Funds will move offshore or into other asset classes, and that will depress US stock prices.

For American equity investors, the NASDAQ 100 (NDX) is effectively the only liquid game in town. The troublesome part of this game is the NDX  losing momentum, as evidenced by a series of negative RSI divergences even as the index pushed to fresh highs.
 

 

A bifurcated economic recovery

From a top-down economic perspective, the economy hit a brick wall and came to a sudden stop with the COVID Crash. At the height of the downturn, 6.7% of the population had filed for unemployment, which dwarfs the ~2% level during past recessionary peaks. Viewed in that context, it was hard to believe the economy could recover that quickly after such an unprecedented shock.
 

 

What was missing from that 10,000 foot top-down analysis was most of the job losses were in low paying service industries. The defining characteristic of this crisis is the inequality of the experiences it’s inflicting on the population. The bottom 40% of households by income account for 22% of consumption, so the drop in spending does not affect the economy as severely if the job losses were distributed uniformly across the board.
 

 

The trajectory of the housing industry is a good example of the highly bifurcated nature of the economic recovery. The teal line depicts homebuilder traffic of prospective customers, which is at record levels. On the other hand, the white line shows mortgage delinquencies, which have also soared. In normal times, these two data series should not be moving together. These conditions represent a “best of times, worst of time” snapshot of widening inequality. People with secure and good paying jobs are buying houses, and they may be expanding their housing demand because of the work-from-home effect. In fact, the latest July NAR report of existing home sales shows that the proportion of second home buyers rose to 15%, highest since March 2019 and at pre-pandemic levels. On the other hand, the lower income and economically stressed parts of American society are losing their homes to foreclosures and evictions.
 

 

The K-shaped bifurcated recovery can also be seen in this Bloomberg article contrasting the earnings reports of Walmart, which is focused on affordable prices and caters to a lower income demographic, and Target, whose customer base is more affluent.

Walmart Inc. said Tuesday that government stimulus checks provided a boost in its second quarter, but the benefit faded by July. In contrast, [Target CEO] Cornell said that although relief checks helped goose demand, Target’s shoppers kept buying well into July even as the stimulus’ impact waned. “The stimulus was a factor, but even as it waned we saw strong comparable-sales growth in June and July,” he said. “And we are off to a very solid start in August.”

 

Policy response and asset price implications

The Federal Reserve and major global central bankers have responded to the COVID Crash with enormous quantitative easing (QE) liquidity injections. Money supply growth has surged as a consequence. While the flood of liquidity has stabilized financial markets, it is unclear how much money is actually finding its way into the Main Street economy. We saw a similar surge in M2 growth in the wake of the GFC, but monetary velocity has been slowly declining in the last decade. As the monetary equation PQ = MV implies, a falling monetary velocity (V) in the face of rising money supply growth (M) is not helpful to stimulating economic growth.
 

 

Central bankers call this dilemma a broken transmission mechanism. Callum Thomas at Topdown Charts observed that even as global central bankers have pushed down interest rates, lenders have responded to the crisis by tightening lending standards.
 

 

However, the latest round of QE is not like the GFC version of QE. In the wake of the GFC, the Fed injected reserves into the banking system by buying bonds. Such market operations experienced difficulty pushing the new liquidity into the Main Street economy. As a consequence, monetary velocity slowed, growth was relatively sluggish despite the size of the monetary stimulus, and there were few inflationary pressures.

Fast forward to 2020. The latest version of global QE is accompanied by fiscal stimulus. The US, federal budget deficits is at levels last seen in World War II.
 

 

The bond market has interpreted the combination of fiscal and monetary stimulus as potentially inflationary. Inflation expectations, as measured by the 10-year breakeven rates, were tame during the last crisis, but they have risen and diverged from nominal rates in this crisis.
 

 

This is what financial repression looks like. The Fed and other central banks are deliberately holding down rates to below market levels even as fiscal authorities spend wildly. For another perspective, the 10-year Treasury yield has historically tracked the Citigroup Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations. The recovery since the March low has seen ESI skyrocket, but bond yields remain tame. This is another picture of financial repression.
 

 

Longer term, these policies should be bullish for gold and other inflation hedge vehicles. In the short-term, however, gold sentiment has become excessively bullish and the metal may need a period of consolidation or correction. As well, the bond market should provide reasonable returns, as the Fed’s medium term policy is to hold down rates for a very, very long time.

As for the currency market, I am not especially bearish on the USD outlook under these circumstances. While USD positioning is at a crowded short, it is unclear what catalysts can drive additional dollar weakness. Yield differentials against major currencies are already relatively low. These high level of expectations of dollar weakness leaves the market in a jittery and highly news sensitive. Examples include the reaction of USD strength to last week’s July FOMC minutes of a rejection of yield curve control, and the unexpected weakness in eurozone PMIs.
 

 

As well, Sebastian Dypbukt Källman at Nordea Markets pointed out that China and Europe are closely linked. “Chinese financial conditions often influence the direction of European equities. The micro tightening that happened after China’s rapid macro comeback suggests less smooth sailing for European cyclicals in coming months.”
 

 

Stock market implications

The equity market implications are a bit trickier. Much depends on the behavior of large cap growth stocks. I have two scenarios in mind.

The first scenario is the development of a large cap growth stocks market mania. All bubbles begin with some reasonable assumptions that eventually get out of hand. In response to the pandemic, a handful of companies have profited handsomely. One example is Amazon, which benefited from the WFH theme in two ways. Both demand for its retail services and its Amazon Web Services division rose, as internet-based customers’ demand for support their WFH services soared.

In a bubble, no one knows how far prices can rise. The Russell 1000 Growth Index P/E is 34.1, which is high, but below the levels seen at the dot-com bubble peak. We will only know in hindsight. Needless to say, market bubbles don’t deflate in an orderly manner, but with a crash.
 

 

The second scenario would see the market converge to Main Street fundamentals. In this case, much will depend on the path of the pandemic, and whether the cyclical rebound theme is durable. The latest update of Google G-7 mobility reports indicate that the recovery in mobility trends is decelerating, which calls into question of the sustainability of a cyclical rebound.
 

 

Similarly, the latest update from Indeed of US job postings shows that they are rolling over. While high paying jobs are showing some softness, it is the low wage job titles that appear the weakest.
 

 

In the end, much depends on the path of the pandemic in the coming months. Reuters reported that Trond Grande of Norway’s sovereign wealth fund, the largest sovereign wealth fund in the world, is expecting some near term market turbulence.

The pandemic is not under control “in any shape or form” and remains the biggest issue for investors, said deputy CEO Trond Grande, after presenting the half-year results of the world’s largest sovereign wealth fund.

The fund lost $153 billion between January and March as markets plunged, its worst quarter ever, but earned back $131 billion from April to the end of June amid a rebound, its best quarter on record.

“We could be in for some turbulence this fall as things unfold and whether or not the coronavirus pandemic recedes, or gains some force,” Grande told Reuters.

“We have already seen some sort of V-shaped recovery in the financial markets. I think there is a slight disconnect between the real economy and the financial markets,” he said, noting that government support for economies could only be sustained for so long.

If the S&P 500 were to converge to Main Street fundamentals, how far could it fall? Here is one rule of thumb that may be useful. The ratio of equal weighted consumer discretionary to consumer staples stocks has underperformed the market and it is not buying into the rally to new highs. This ratio is often used as a metric of equity risk appetite. While it is lagging the S&P 500, it has been tracking the Value Line Geometric Index (XVG) almost perfectly.
 

 

If we were to chart the S&P 500 and XVG over a 10 year time frame, we can observe periods of convergence and divergence. XVG represents the average listed stocks and therefore more representative of the Main Street economy. A convergence of the S&P 500 and XVG today would put the S&P 500 at just under 2400, which roughly amounts to a re-test of the March lows. Bear in mind, however, that any hypothetical convergence only represents a fair value target estimate, and the S&P 500 could overshoot to the downside. In addition, XVG fundamentals could either improve or deteriorate, which would move the target either up or down.
 

 

In the worst case, a downside target of 1650-2000 is within the realm of possibility. Past major market bottoms have occurred with a forward P/E ratio of 10. Currently, the bottom-up aggregated 2021 estimate is about $165. If we apply a 10 to 12 times multiple, we arrive at a range of 1650 to 2000.
 

 

If I had to choose, the second convergence scenario is the more likely outcome. It is also consistent with my past observation of the unusual and simultaneous buy and sell signals from the Wilshire 5000’s MACD (buy) and negative RSI divergence (sell). In the past, RSI divergence sell signals have taken 1-6 months before the market topped out. The last time this happened, the market topped out two months after the signal.
 

 

In summary, I present a new framework for analyzing the stock market in light of the push to new highs. While the new framework is useful for explaining why the S&P 500 and NASDAQ Composite have rallied, it does not necessarily have bullish implications.

That’s because both the market and economy are undergoing K-shaped and two-paced rebounds. These bifurcated recoveries are creating imbalances that will have to be resolved at some point in the future. One possibility is the formation of a NASDAQ bubble, which would end in a disorderly market crash. The other scenario postulates an orderly convergence between Wall Street and Main Street fundamentals, where I penciled in a re-test of the March lows as a downside objective.

Tactically, investors should watch the NASDAQ 100 and global regional indices for signs of changes in market leadership. Monitoring these indicators will give an idea of how the market is evolving within these two disparate scenarios.

 

Should you hop on the reflation train?

Posted by Cam Hui -

Mid-week market update: About two weeks ago, I identified an emerging theme of a rotation out of large cap growth stocks into cyclicals (see Sector and factor review: Not your father’s cycle). The latest BoA Global Fund Manager Survey (FMS) confirms my analysis. The rotation is attributable to managers buying into the reflation trade.
 

 

Does that mean you should hop on the reflation train? Is there sufficient momentum behind this shift?
 

Growth expectations revival

Actually, the shift into the reflation trade is mis-named. It’s not that inflationary expectations that are rising that much, but growth expectations.
 

 

The growth to cyclical rotation can be seen in regional weightings. For several months, managers had been piling into US equities as the last source of growth in a growth starved world. The FMS had shown the US as the top weight in equity portfolios for some time. In the latest survey, the top regional overweight is now the eurozone, as managers have latched onto the reflation and cyclical theme.
 

 

A cyclical report card

How are cyclical stocks are performing. First, it’s unclear how well the rotation into eurozone equities will work out. High frequency data shows that the recovery is stalling on the Continent.
 

 

In the US, the relative performance of cyclical stocks presents a mixed picture. While homebuilding stocks are on fire, the relative performance of other cyclical sectors and industries show constructive but limited signs of market leadership. Material stocks are turning up relative to the market, but industrial, transportation, and leisure and entertainment are only exhibiting bottoming patterns.
 

 

I have made this point before, this is not a normal economic cycle and interpreting it that way can bring trouble for investors. Instead of a normal Fed induced slowdown, the global economy encountered a pandemic driven sudden stop. The pandemic is still ranging all over the world, and the recovery in demand will depend mainly on how well the human race can control the COVID-19 outbreak. Therefore the recovery will not follow the normal patterns of past economic cycles (see Sector and factor review: Not your father’s cycle).

I believe that equity risk and return are asymmetrically tilted to the downside. Conventional sector and factor analysis is pointing towards a rotation out of US large cap growth stocks into cyclical and EM equities. However, this is not a normal cycle and many of the usual investment rules go out the window. Historical analogies are of limited use. This is not 2008 (Great Financial Crisis), 1999 (Dot-com Bubble), 1929 (Great Depression), or 1918 (Spanish Flu).

Investors have to consider the bearish scenario that a rotation out of US large cap growth does occur because of a crowded long positioning, but the rotation into cyclical and EM does not occur. Instead, the funds find their way into Treasuries and other risk-off proxies because of either the failure of early vaccine trials, or teething problems with deploying vaccines and therapeutics. In that case, the growth path falls considerably from the current consensus, and a risk-off episode and valuation adjustment follows.

 

Focus on risk, not return

Under these conditions, investors are advised to focus first on risk, than return. Mark Hulbert observed that his Hulbert Stock Newsletter Sentiment Index is higher than 95% of all daily readings since 2000. That’s a crowded long condition, which is contrarian bearish. While the market can continue to advance under such conditions in the past, intermediate term risk and reward are not favorable for equity investors.
 

 

In the short run, the NASDAQ leadership remains intact. While the 5-day RSI continues to flash negative divergences for the NASDAQ 100, the index has shrugged off these warnings and continued to rise. Until we see signs of trend breaks, either on an absolute or market relative basis, it would be premature to be bearish.
 

 

The market can continue to grind higher in the short-term, but investors who focus on risk and reward are advised to be cautious. There’s probably turbulence ahead.

 

Risk and reward: No guts, no glory?

Posted by Cam Hui -

Risk takers are fond of the line, “No guts, no glory”. With that in mind, I present three cases of risks, and possible opportunities.
 

The Turkey in the FX coalmine

In late June, I highlighted analysis from Research Affiliates of country values by CAPE relative to their own history. At the top of the most attractive list was Turkey, followed by Malaysia, Poland, South Korea, and Thailand (see A bleak decade for US equities). Turkish equities represents a classic Rorschach inkblot test of risk and opportunity for investors.
 

 

While Turkish stocks are cheap on a statistical basis, they are not without risk. The Turkish lira (TRY) is under severe pressure because of a falling current account. Bloomberg summarized TRY’s challenges:

  • Official reserves fell $7.7 billion as government-owned banks sold dollars to support the Turkish currency, which weakened more than 13% against the dollar in the first half of the year.
  • Interventions via state lenders continued at a time of volatile capital flows. Non-residents sold $31 million of Turkish stocks and $427 million of government bonds.
  • Net errors and omissions, or capital movements of unknown origin, showed a monthly inflow of $1.98 billion.

The Turkish lira is weakening to all-time lows, and that’s even before the USD has shown any signs of strength as greenback positioning is at a crowded short.
 

 

The Big Mac Index from the Economist shows the TRY to be considerably undervalued against the USD. However, currencies can take years, and even decades to converge to purchasing power parity.
 

 

In the short run, rising geopolitical tensions in the Eastern Mediterranean will not help sentiment. Turkey recently dispatched an exploration ship with a naval escort to disputed waters off the southwest coast of Cyprus, This is provoking a possible confrontation with the Greek and French navy, which is raising the temperature with EU relations and causing fractures within NATO. The Eastern Mediterranean has significant natural gas potential. Cyprus, Israel, Egypt, and now Turkey are trying to secure shares of the resource.

I have been monitoring the progress of the MSCI Turkey ETF (TUR). TUR has been testing a support zone. The relative performance of TUR relative to MSCI All-Country World Index (ACWI) is testing a relative support level, and so is the relative performance of TUR relative to EM xChina.
 

 

On a relative basis, Turkish equities looks washed out and presents a contrarian opportunity for investors. On the other hand, SentimenTrader pointed out that USD positioning is at a crowded short. The TRY exchange rate is at severe risk should the USD ever strengthens.
 

 

No guts, no glory?
 

American Brexit

In the US, the recent dispute over the Post Service highlights the rising risk of electoral chaos. Ian Bremmer and Cliff Kupchan of the Eurasia Group characterized this political risk as “American Brexit”.

In January, risk #1 described how US institutions would be tested as never before, and how the November election would produce a result many would see as illegitimate. If President Donald Trump won amid credible charges of irregularities, the results would be contested. If he lost, particularly if the vote was close, same. Either scenario would create months of lawsuits and a political vacuum, but unlike the contested George W. Bush-Al Gore election of 2000, the loser was unlikely to accept a court-decided outcome as legitimate. It was a US version of Brexit, where the issue wasn’t the outcome but political uncertainty about what people had voted for.

The Eurasia Group’s January forecast of American Brexit effects are already being felt today.

Meaningful (France-style) social discontent becomes more likely in that environment, as does domestic, politically inspired violence. Also, a non-functioning Congress, with both sides using their positions to maximize political pressure on the eventual election outcome, setting aside the legislative agenda. That becomes a bigger problem if the US is entering an economic downturn, on the back of expanded spending and other measures to juice the economy in the run-up to the election.

How would the markets behave under an “American Brexit” scenario? Let’s consider how the markets reacted after the Brexit vote surprise in 2016. The chart below depicts the FTSE 100, which consists mainly of UK large cap global companies, and the FTSE 250, which are small companies that are more exposed to the local economy. As ways of measuring a “pure” Brexit market effect, I also show the relative performance of the FTSE 250 to FTSE 100, the performance of UK large caps to ACWI, and the performance of UK small caps to ACWI. The markets rallied into the Brexit vote, thinking that the Remain side would win but fell dramatically after the unexpected result. Once we normalize the relative prices before and after the vote, downside risk varied from -4% to -14%, depending on the metric used.
 

 

This is a key risk for the US equity market. I have not seen any Wall Street strategists discuss the possibility of electoral chaos after November. Based on the Brexit event study, expect a similar range of downside risk of -4% to -14% in during the November to February period.
 

Brexit, the aftermath

Speaking of Brexit, the region has been the most hated in the BoA Global Fund Manager Survey for some time.
 

 

I know that the details of Britain’s divorce from the EU are not finalized yet, but UK equities look washed out and unloved. But the ratio of the FTSE 250 to FTSE 100 has been rising steadily before the COVID Crash, and it has been recovering steadily since the March low. From a global perspective, while UK large caps (EWU) continue to lag ACWI, UK small caps (EWUS) have been range bound, which is a more constructive pattern.I interpret these readings as the market has largely discounted Brexit risks, and there may be opportunity for superior performance in UK small caps, which are more exposed to the British economy.
 

 

One long-term bullish factor for the UK that few talk about is Prime Minister Boris Johnson’s decision to open the citizenship doors to Hong Kong residents with British National (Overseas) passports. This has the potential to inject the country with a group of English speaking, well-educated immigrants that could boost growth potential.

No guts, no glory.
 

What really matters in this market

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

False negatives?

I have been writing about bearish setups for several weeks. In particular, risk appetite indicates have been sounding warnings. For example, the ratio of equal weighted consumer discretionary to consumer staples stocks, equal weighted to minimize the dominant weight of AMZN in the consumer discretionary sector, have been trading sideways and not buying into the equity rally.
 

 

As well, credit market risk appetite, as measured by the relative performance of high yield (junk) bonds and leveraged loans to their duration equivalent Treasuries, are also not buying into the equity risk-on narrative.
 

 

The divergence between the VIX Index and the TED spread, which is one of the credit market’s indication of risk appetite, is another worrisome sign.
 

 

In the short run, none of this matters. Here is what traders should really be paying attention to.
 

Big Tech dominance

I wrote about how Big Tech stocks are dominating market action (see A Potemkin Village market?). Indeed, the Big Tech sectors (technology, communication services, and consumer discretionary/Amazon) comprise roughly half of S&P 500 index weight. It would be virtually impossible for the market to move without the significant participation of these top sectors. So far, technology has been in a well-defined relative uptrend, consumer discretionary stocks have been strong on a relative basis, and communication services relative strength has been moving up in a choppy pattern.
 

 

The NASDAQ 100 remains in an uptrend, though breadth indicators are sounding negative divergence warnings. Until the NASDAQ 100 breaks its trend line, it would be premature to turn bearish despite the widespread warnings.
 

 

Macro speed bumps

There are also warnings from a top-down macro perspective. Disposable income had been held up in this recession by fiscal support.
 

 

The expiry of the $600 per week supplemental unemployment insurance at the end of July has caused UI outlays from Treasury to fall off a cliff. Undoubtedly that will show up in falling confidence and retail sales in the near future.
 

 

Banks are responding predictably by tightening credit standards. We have the makings of an old-fashioned credit crunch, which will crater economic growth in the absence of further significant fiscal and monetary policy support.
 

 

The narrative for the economy is turning from bounce back rebound to a stall. Historically, the stock market has encountered headwinds when growth expectations disappoint, as measured by the Citi Economic Surprise Index (ESI).
 

 

Here is a close-up look at ESI, which is showing signs of topping out.
 

 

This trend of stalling ESI is evident globally. Here is Eurozone ESI.
 

 

Here is China ESI.
 

 

Pennies in front of a steamroller

In the short run, none of this matters until the major market indices, and the NASDAQ 100 in particular, experience breaks to the rising trend lines. Short term momentum remains positive as the percentage of stocks in the S&P 500 above their 5 dma is exhibiting a series of higher lows.
 

 

A similar pattern can be found for the NASDAQ 100.
 

 

In conclusion, the negative divergence concerns that I raised in the past few weeks are still valid. However, nothing matters until we see trend line breaks, especially in the NASDAQ. Traders could try to buy dips in this environment. However, intermediate term downside risk is considerable, and buying here would be akin to picking up pennies in front of a steamroller.