A Potemkin Village market?

Posted by Cam Hui -

While the adage that the stock market isn’t the economy and vice versa is true. one of the puzzles facing investors is why the US equity market testing its all-time highs even as the economy suffered its worst setback since the Great Depression. This market seems like a Potemkin Village, which shows an external façade of calm while hiding the real trouble behind the scenes.

The Fed isn’t entirely responsible for the market’s strength. The Fed has taken steps to stabilize markets so they can function in an orderly way. A Fed Put can put a floor on prices, but it cannot make asset prices skyrocket the way they did.

A more reasonable explanation is the unprecedented level of fiscal support to support growth. This recession is completely unlike past slowdowns. The government’s safety net has allowed consumers to maintain their spending to prevent a complete collapse in demand.
 

 

In that case, why hasn’t the stock market skidded as it became clear that Congress could not agree on a second stimulus package, and that Trump’s Executive Order and Memoranda designed to do and end run around Congress appears to be ineffectual (see a detailed analysis in Earnings Monitor: Slower growth ahead). The Washington Post reported that the Street generally agrees with my analysis.

“If this is all we get for fiscal policy for the rest of the year it would represent a significant downside risk to our growth outlook,” JPMorgan Chase chief U.S. economist Michael Feroli wrote in a Monday note. “These executive orders likely will provide stimulus of less than $100 billion, while we have been expecting Congress to add at least $1.0-1.5 trillion of spending once an agreement is reached.”

The team at Oxford Economics comes to a similar conclusion, finding “the relief is inadequate, legally questionable and falls dramatically short of the booster shot the economy desperately needs,” per a note from senior U.S. economist Lydia Boussour. “In the absence of a more comprehensive stimulus package, economic activity will be constrained just as the recovery plateaus.”

Barry Ritholz offered a different sort of explanation, based on a radical difference between the construction of the market indices and the economy, in a Bloomberg opinion piece. Big Tech comprise a gargantuan weight in most major US indices.

The so-called FAANGs (along with Microsoft) derive about half — and in some cases even more — of their revenue from abroad. Beyond that, the pandemic lockdown in the U.S. has benefitted the giant tech companies’ sales and profits. No wonder the Nasdaq Composite 100 Index, which is dominated by big tech companies, is up about 26% this year.

Simply put, the rest of the market really doesn’t matter no matter how badly the underlying sectors and industries perform.

Take the 10 biggest technology companies in the S&P 500 and weight them equally, and they would be up more than 37% for the year. Do the same for the next 490 names in the index, and they are down about 7.7%. That shows just how much a few giants matter to the index.

On some level, it’s completely understandable why many people believe that markets are no longer tethered to reality because the performance doesn’t correspond to their personal experience, which is one of job loss, economic hardship and personal despair. But what’s important to understand is that indexes based on market-cap weighting can be — as they are now — driven by the gains of just a handful of companies.

This week, we explore the outlooks and performance of two groups, Big Tech, and the rest of the market.
 

Big Tech dominance

How big and dominant is Big Tech? The chart below of the relative performance of the top five sectors in the S&P 500 tells the story. These five sectors comprise 74% of index weight, and it would be difficult for the market to significantly rise or fall without the participation of a majority. The weight of Big Tech sectors (technology, communication services, and consumer discretionary) make up about half of index weight. Consumer discretionary stocks is dominated by Amazon, and the chart shows the relative performance of equal-weighted consumer discretionary (in green), which minimizes the effect of heavyweights, as an illustration of how Amazon has dominated the sector. The equal weighted relative performance is far less impressive than its float weighted counterpart.
 

 

How long can Big Tech dominance last? Here are the short and intermediate term perspectives. In the short term, one shorthand for measuring the performance of Big Tech is the NASDAQ 100. The NASDAQ 100 remains in well-defined absolute and relative uptrends. While there are warnings of negative RSI divergences indicating a loss of momentum, there are no bearish trendline breaks to be concerned about.
 

 

Another way of measuring the strength of Big Tech is through the price momentum factor. Price momentum factor portfolios become highly concentrated because of the strong performance of technology stocks. The relative performance of a variety of price momentum ETFs indicate that momentum remains in choppy but positive uptrends. One factor that may exacerbate the price momentum effect is a greater commitment to indexing. This technique creates a self-reinforcing cycle of positive money flows that mechanically buys more and more Big Tech heavyweights and creates a self-reinforcing price momentum effect.
 

 

A longer term way of thinking about the dominance of Big Tech is to measure the relative returns of banks, which represent an important component of the economy, to the NASDAQ 100. This is another way of measuring the value to growth performance ratio. Bank stocks have been beaten up so badly that they are overweight in most value indices, while the NASDAQ 100 is the poster child of growth. The Bank Index to NASDAQ 100 ratio has flashed a positive RSI divergence, which is bullish for banks and value stocks, but historically this ratio has not bottomed out until its annual relative performance nears -70%. This analysis suggests that there may be one final leg down for this ratio, and one final leg up for Big Tech.
 

 

The risks to Big Tech

To be sure, the dominance of Big Tech has strong fundamental underpinnings. It’s a winner-take-all competitive environment, and the winners have been able to create competitive moats because of their dominance in their business. These companies have then been able to extract strong profits and high margins behind their moat fortifications.

However, strong corporate dominance invites antitrust scrutiny. CNBC analyzed the emails submitted to Congress in their antitrust investigation of Amazon, Apple, Facebook, and Google and highlighted some key vulnerabilities for each company.

Facebook: Experts speculate that an antitrust case against Facebook would center largely around its acquisition strategy and whether it broke merger laws by buying up a nascent competitor or violated anti-monopoly law by taking anti-competitive actions to build or maintain dominance in its market.

Amazon: An antitrust case for Amazon may resemble the line of thinking Sen. Elizabeth Warren, D-Mass., offered in her presidential campaign platform on breaking up Big Tech. Warren argued large tech companies designated as “Platform Utilities” should not be able to control and participate on their own platforms. The FTC has been talking to third-party sellers on Amazon’s platform, according to Bloomberg, following concerns that Amazon undercuts sellers on its marketplace.

A recent Wall Street Journal investigation found that Amazon employees had used internal data to inform their private-label brand strategy and compete with other sellers. Though the employees reportedly used aggregated reports combining multiple sellers’ performance, they sometimes contained as few as two sellers, making it easy to extrapolate a single seller’s data. Amazon has said it was launching an internal investigation into the allegations by the Journal but said it didn’t believe the claims to be true.

Apple: The antitrust theory against Apple centers on its control of the App Store. While iPhones are prevalent throughout the U.S., Apple ranks only third in worldwide market share for smartphones at 13.3%, according to IDC, while the market leader, Samsung, holds a 21.2% share.

A potential case against Apple could look similar to one against Amazon, focusing on the fact that it both owns a marketplace (the App Store) and has its own pre-loaded apps such as Apple Music and Apple Podcasts that compete with other apps on its platform, such as Spotify.

Some developers who offer their apps through the App Store — the only way Apple allows for apps to be added to users’ devices — have complained about Apple’s opaque and sometimes seemingly arbitrary process for accepting new apps.

Google: Google’s sprawling business has attracted antitrust scrutiny on multiple fronts. Regulators have looked into Google’s search business, online advertising platform and Android mobile operating system. Here’s what they might be looking for in each:

– Search: Vertical search competitors such as Yelp and TripAdvisor, which offer search engines for specific purposes such as local businesses or travel, have complained for years that Google prioritizes its own services over their own, including by offering its own competing services above theirs in relevant Google search results.

– Advertising: Google’s advertising business has attracted scrutiny over a variety of concerns that essentially boil down to the question of whether Google’s expansive control over the digital media supply chain allows other companies to compete. While Google has competitors across many functions of the advertising marketplace, it operates in both the buy side and sell side of transactions, leading to some questions about whether it remains objective about where it routes advertising dollars. Competitors also argue that Google’s prices are hard to match because it bundles its ad tools. And on YouTube, Google eliminated the ability to buy ads through third-party services, funneling all spend through its own tools.

– Android: With its Android mobile operating system, Google requires device manufacturers who use its platform to pre-install its app store and other native apps such as Gmail and its Chrome web browser. The European Commission required Google to stop bundling its apps on Android phones and allow EU users to select their default search engine after fining the company $5 billion over alleged antitrust abuse.

In the short run, the Trump administration’s Executive Order against TikTok and WeChat has the potential to crater Apple’s earnings. A recent Bloomberg article explains the challenges for Apple, which makes up 5.8% of the S&P 500, and 12% of the NASDAQ 100. If the company is forced to remove WeChat globally from its Apps Store, it could have devastating consequences.

[WeChat] connects a billion users globally and is used for everything from chatting with friends to shopping for movie and train tickets to paying restaurant and utility bills. While questions remain on how Trump’s orders will be implemented, any ban on the use of WeChat threatens to cut off a key communication link between China and the rest of the world and prevent U.S. companies like Starbucks Corp. and WalMart Inc. from reaching consumers in the world’s second-largest economy…

If Apple was forced to remove the service from its global app stores, iPhone annual shipments will decline 25% to 30% while other hardware, including AirPods, iPad, Apple Watch and Mac computers, may fall 15%-25%, TF International Securities analyst Kuo Ming-chi estimated in a research note. Apple didn’t immediately respond to Bloomberg News’ requests for comment.

A survey on the twitter-like Weibo service asking consumers to choose between WeChat and their iPhones has drawn more than 1.2 million responses so far, with roughly 95% of participants saying they would rather give up their devices. “The ban will force a lot of Chinese users to switch from Apple to other brands because WeChat is really important for us,” said Sky Ding, who works in fintech in Hong Kong and originally hails from Xi’an. “My family in China are all used to WeChat and all our communication is on the platform.”

So far, the market appears to be ignoring both the short and long term risks to Apple and other Big Tech stocks.
 

Rotation is healthy, but…

What about the rest of the market? I wrote last week (see Sector and factor review: Not your father’s cycle) that as the momentum in Big Tech falters, the market is poised for a rotation into cyclical stocks. I had identified consumer discretionary (6.7% ex-AMZN) and materials (2.6%) are showing some signs of life. But those sectors comprise just under 10% of index weight, and they can’t possible do all the heavy lifting if Big Tech were to falter. Andrew Thrasher raised an important caveat about sector rotation.

Traditionally rotation is bullish. It allows the market to “reload” to so speak as new leadership emerges. But the weighting we have today is different than what the market’s used to. It’s like replacing a sumo wrestler on a teeter-totter with a 3rd grader, not the same.

While the stock market isn’t the economy, and vice versa, the non-Big Tech market is a reasonable approximation of the economy. New Deal democrat, who monitors coincident, short leading, and long leading indicators, recently assessed the economic this way.

The bottom line from the short and long leading indicators is that the economy “wants” to improve, but over the next six months, the coronavirus, and the reactions of the Administration, the Congress, and the 50 governors to the virus are going to be the dispositive concerns.

Left to its own, the economy “wants” to improve. However, there are two key issues to be addressed before a recovery can be achieved. The first is the passage of another rescue package, which NDD assumes will happen. The White House and the Democratic leadership is deadlocked, and no deal is in sight. The economy is starting to go over a fiscal cliff. A key study concluded that 30-40 million Americans are at risk of eviction, which will spark a homelessness crisis and another consumer death spiral.

Federal emergency unemployment benefits have now stopped. Driven by panic by GOP members of the Senate up for re-election this year, I expect a deal to be struck to extend them.

 

The pandemic war

The other major issue is progress against the pandemic. No matter how hard any individual country tries to control the virus, the pandemic is global in scope, and growth will not return until there is substantial progress around the world. Even in countries that appeared to have controlled their outbreaks, second waves of community infection are appearing in disparate countries like Spain, Israel, Japan, and Australia. Even a vaccine may not be a magic bullet. Russia recently announced that it had a vaccine based on promising animal tests but before extensive human trials,but even if it were widely available, how many people outside Russia would take the risk of being inoculated?

In addition, Reuters reported that Dr. Anthony Fauci cautioned about the effectiveness of early vaccines:

An approved coronavirus vaccine could end up being effective only 50-60% of the time, meaning public health measures will still be needed to keep the pandemic under control, Dr. Anthony Fauci, the top U.S. infectious diseases expert, said on Friday.

“We don’t know yet what the efficacy might be. We don’t know if it will be 50% or 60%. I’d like it to be 75% or more,” Fauci said in a webinar hosted by Brown University. “But the chances of it being 98% effective is not great, which means you must never abandon the public health approach.”

John Authers detailed some of the practical considerations in vaccine development and deployment in a Bloomberg Opinion piece. The main points are summarized below.

  • How to develop it? Conventional trials or human challenge trials? Conventional trials take longer, and involve more subjects. In the past, human challenge trials where volunteers are injected with a vaccine and then deliberately infected with the virus, there has been a cure for the illness. In this case, there are no cures, and what are the ethical considerations of such trials?
  • How to pay for it? “A vaccine is meaningless if people are unable to afford it,” said John Young, the chief management officer of Pfizer Inc. Nobody asserts that drug companies should be able to charge whatever the market can bear for a Covid-19 vaccine. 
  • How to ration it? The pharmaceutical industry cannot produce enough vaccine for the entire global population of almost 8 billion all at once. Therefore, rationing is inevitable. Some people will have to wait. Who gets to make these decisions, and by what criteria?
  • How to roll it out? Vaccinations work best when everyone receives them, since germs that can’t infect people tend to wither away. How do you create widespread vaccinations, which lead to herd immunity?

 

Investment conclusions

So where does that leave us? Is the market a Potemkin Village held up by a few Big Tech stocks? 
Big Tech stocks remain the leadership, but there are some early signs of flagging momentum. The market is poised for a rotation into cyclical names, but those stocks comprise less than 10% of index weight, and they cannot be expected to push prices up if Big Tech sectors, which are 50% of market weight, were to fall. In addition, the expiry of fiscal stimulus make a durable cyclical rebound unlikely. The US economy is more likely to fall into a double-dip recession instead. Moreover, there are significant obstacle surrounding the development and global deployment of a vaccine. Without an effective vaccine and treatment, the global economy will suffer from the chronic lack of demand that will make any cyclical recovery very difficult.
From a global perspective, this bull has a long way to go. Callum Thomas of Topdown Charts pointed out that non-US stocks are lagging US equities. As well, global breadth, as measured by proportion of countries with year-over-year positive returns, is still weak.

 

 

Marketwatch reported that Morgan Stanley’s Combined Market Timing Indicator is giving its first sell signal since January 2018 after flashing a timely buy signal in March. The indicator is a combination of valuation, fundamentals, and risk as model inputs.

 

 

These conditions are consistent with my recent observation that the monthly MACD model for the Wilshire 5000 gave both a buy and sell signal at the same time. A bullish MACD crossover indicating positive price momentum accounted for the buy signal. At the same time, the buy signal was negated by a sell signal from a negative 14-month RSI divergence as the index pushed to new all-time highs.

 

 

I interpret these readings as the market is making a top, and prices can stay elevated or push higher for up to 2-3 months. However, a bearish break is imminent, with downside risk of 20% or more.

 

Greedy enough?

Posted by Cam Hui -

Mid-week market update: As the market tests resistance at the old highs, is sentiment greedy enough? The Fear and Greed Index stands at 73, and recently peaked at 75. While readings at these levels can indicate high risk environments, they have also been inexact market timing signals.
 

 

Andrew Thrasher pointed out that VIX sentiment has fallen below 10%, which is bullish for volatility and bearish for equities.
 

 

Hedge fund positioning is another matter. A recent survey of JPM and GS prime brokers that act as HF custodians reveals that the fast money crowd has gone all-in on risk.
 

 

Speculative retail positioning, as measured by leveraged ETFs, is bullish. However, readings may not be extreme enough to be described as a crowded long (via Callum Thomas).
 

 

Does that mean that stocks are about to experience a risk-off episode?
 

A door closes, others opens

Not necessarily. I have been warning about a bearish setup for several weeks, but I was not ready to act until we saw some risk-off triggers. I had identified three tripwires to monitor. The first was the Treasury market, whose prices broke up in an inverse head and shoulders pattern, and whose yields broke down in a head and shoulders formation.

Time to turn bearish? Bond prices and yields dramatically reversed themselves yesterday, and the reversal continues today. From a technical perspective, there is nothing worse than a failed breakout or breakdown.
 

 

As the Treasury bond market closed, another opened. I had been monitoring the parabolic move in gold and silver prices. In the past, reversals in silver after a parabolic surge have not been equity friendly. We began to see a major reversal in precious metal prices yesterday.
 

 

Here is a close-up look at gold and silver. It’s impossible to know the magnitude of the stock market weakness ahead of them. In the past, some reversals have resolved themselves in minor stock market hiccups, others in major pullbacks.
 

 

The third and final bearish tripwires is a reversal of USD weakness. USD positioning is screaming “crowded short”, and we just need some sort of catalyst to push it upwards.
 

 

USD strength will create stress in the offshore dollar market, which negatively affects vulnerable EM economies and global risk appetite. The USD Index appears to have formed a double bottom and it is trying to rally. EM currencies are starting to show signs of weakness, which is not a good sign for equity prices.
 

 

Cautious but not bearish

Does this mean that traders should turn bearish? Not necessarily. Price momentum remains strong. Rob Hanna at Quantifiable Edges documented what happens when the DJIA experiences a seven-day consecutive win streak, which it did until yesterday. While short-term returns can be volatile, returns over a one month time horizon have a bullish tilt.
 

 

Despite the intermediate term warnings, traders have to be open to the possibility that the market is advancing on a series of “good overbought” readings.
 

 

If the market were to undergo a period of weakness, traders should await tactical bearish triggers before making a commitment to the short side. Triggers include a recycle of the 5-day RSI from overbought territory to neutral, as it has already flashed a negative divergence signal. As well, watch for a breach of the lower Bollinger Band by the VIX Index as an indication of an extreme overbought condition.

My inner investor is nervous, but holding at a neutral asset allocation. My inner trader can best be described as cautious, but not bearish (yet).

 

Earnings Monitor: Slower growth ahead

Posted by Cam Hui -

Q2 earnings season is nearly done. So far 89% of the market has reported. FactSet reported the EPS beat rate fell to 83% from 84% the previous week. The sales beat rate was fell to 64% from 69% the previous week. Both the EPS and sales beat rates are ahead of their 5-year averages.

The bottom-up consensus forward 12-month estimate continued to rise strongly at 1.62% last week after 1.03% the previous week The market is trading at a forward P/E of 22.3, which is well ahead of historical norms.
 

 

As 89% of the index has reported, this will be the final Earnings Monitor of Q2 earnings season.
 

Strong positive revisions

The Street continues to be upbeat on the outlook of individual companies. Though the weekly changes in quarterly EPS estimates can be noisy, analysts have upgraded quarterly earnings estimates across the board, except for Q4 2020.
 

 

Company earnings guidance continues to be positive. FactSet reports that “11 [companies] have issued negative EPS guidance and 34 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 24% (11 out of 45), which is well below the 5-year average of 69%.” However, over half of the companies have withdrawn guidance, citing pandemic-related uncertainty.
 

Bottom-up caution

The Transcript reported that companies have adopted a cautious tone in their earnings calls:

Many companies and individuals have been hard hit by the pandemic and are having a tough time. All eyes are on another stimulus package to try to cushion them. Worryingly, cases are rising worldwide even in areas that were thought to have contained the virus. The picture from July and early August is one of a mixed and uneven recovery.

Here is a brief summary of the macro outlook:

  • Most companies and individuals are having a tough time (Square, HSBC, Fannie Mae, Norwegian Cruise Lines)
  • The hope is for another stimulus package (Starbucks, Richmond Fed)
  • The picture of demand trends in July and early August is mixed and uneven (Global Payments, LGI Homes, Henkel, Yelp, Hyatt Hotels, CGP Applied Technologies, Summit Hotel Properties, Brookfield Infrastructure Partners, Planet Fitness)
  • Are we placing too much emphasis on waiting for the vaccine? (St. Louis Fed, Hyatt Hotels)
  • Worryingly, cases are rising again worldwide (Henkel, Fannie Mae)

 

Slower growth ahead

The story of Q2 earnings season has been a rapid climb in earnings and outlook, but the economy appears to be transitioning to a period of slower growth. The July Jobs Report was revealing in many ways. Even though some of the dire forecasts of negative jobs growth was averted and job growth came in at 1.8 million, which was slightly ahead of expectations, the trajectory of growth is slowing. Even though the unemployment rate fell, the unemployment rate for workers unemployed for 15 weeks or more continued to climb. This is an indication of a rising long-term unemployment problem.
 

 

Notwithstanding the slight Nonfarm Payroll beat, high frequency data is pointing to a pattern of stalling growth. As an example, new online job postings are pulling back after a period of rapid recovery.
 

 

Trump tries to take the helm

The impasse in Washington over CARES Act 2.0 is not helping matters. Ironically, the constructive nature of the July Jobs report provided reasoning for Republican budget hawks in the Senate to resist pressures for additional stimulus. While there has been some discussion, the Democrats and Republicans are far apart on a number of major issues.

President Trump stepped in on Saturday and signed orders to try and break the logjam. He spoke at a signing ceremony at his Bedminster golf course, “We’re going to be signing some bills in a little while that are going to be very important, and will take care of, pretty much, this entire situation”.

However, his actions are problematical and they are reminiscent of the travel ban Executive Orders (EOs) when he first took office. Those EOs were challenged in court and it took several revisions before they could be implemented. Similarly, the some of the latest initiatives are subject to constitutional challenge, and others represent more glitz than substance.

Trump signed one EO and three Memoranda to extend the eviction moratorium; extend the supplemental weekly unemployment insurance support, which was reduced from $600 to $400 per month; defer the collection of the payroll tax; and to extend student loan relief. Let’s examine them one at a time.

Here is the Executive Order relating to evictions. Despite Trump’s announcement that he is extending the eviction moratorium, the EO is nothing of the sort. It directed various federal agencies to find ways to halt evictions, which is distinctly different from an eviction moratorium [emphasis added].

  • The Secretary of Health and Human Services and the Director of CDC shall consider whether any measures temporarily halting residential evictions…
  • The Secretary of the Treasury and the Secretary of Housing and Urban Development shall identify any and all available Federal funds to provide temporary financial assistance to renters and homeowners …
  • The Secretary of Housing and Urban Development shall take action, as appropriate and consistent with applicable law, to promote the ability of renters and homeowners to avoid eviction or foreclosure…
  • The Secretary of the Treasury, the Director of FHFA shall review all existing authorities and resources that may be used to prevent evictions and foreclosures 

Eviction and homelessness is becoming a looming problem. An estimated 27% of Americans missed July rent payments. Of those, 39% were not confident they would be able to make their August payments.
 

 

More crucial to the growth outlook, here is the Memorandum to extend the supplemental unemployment insurance payments by $400 per week, down from the now expired $600 per week. The Trump Administration “declared an emergency” and raided the FEMA budget of $50 billion to pay for the extension. The measures were problematical in a number of way. First, state governors cannot pay the extra unemployment insurance without spending authorization from Congress, which the Memorandum does not. As well, under the law that governs FEMA, if the federal government declares a disaster, the state will have to request aid and pay 25% of the cost. It is unclear how many states would actually implement such a measure, and many states do not have the budget for the extra $100 per week. Even Ohio’s Republican governor Mike DeWine has expressed doubts about whether his state could participate in the program.

If this measure is fully implemented, the $50 billion would be used up in 4-5 weeks. For some perspective on the economic effects, of this measure, former Treasury official Ernie Tedeschi estimated that a $300 per week UI relief would reduce employment by 800,000 by year-end and GDP by -1%. A full expiration of $600 weekly support would reduce unemployment by 1.7 million and GDP by -2%. At best, the implementation of this measure will be highly uneven, and will depend on the legal interpretation and budget constraints at the state level.

In addition, the 2020 hurricane season is expected to be more severe than average, and FEMA would be left without a budget for disaster relief. This measure is likely to spark a constitutional crisis, as Congress is the only arm of government authorized to spend and tax. The President has no authority to extend the payment of unemployment benefits.

The Memorandum on payroll tax deferral is equally problematical. It directs the IRS to temporarily suspend the collection of payroll taxes until December. It is not a tax holiday. Trump has promised to forgive all of the suspended payroll taxes owing if he is reelected. This measure presents a quandary for employers. Since this is only a tax deferral, do they continue to deduct payroll taxes from employees until December? The prudent course of action would be to put these deferred taxes into a separate account until they are payable. In that case, there is no stimulus effect. If the employer does not deduct the payroll tax, he may be put into a position of trying to claw back the taxes from employees and former employees in the future. The hope of the policy is the employer either does not collect the tax, or does collect the tax and uses the funds for other purposes. But that course of action creates many legal uncertainties for both employers and employees.

As payroll taxes are used to fund Social Security and Medicare, Joe Biden was quick to jump on Trump’s measure as “defunding Medicare”. Undoubtedly, this will spark a healthcare funding debate in the coming days. In addition, this measure is also subject to a constitutional court challenge, as it is Congress that has taxing authority.

Of all the measures, the Memorandum on student loan relief has the least problems. The Secretary of Education does have the authority to defer student loan payments in hardship cases.

In summary, these measures are not well-written, and they are highly reminiscent of the ill-fated travel bans early in Trump’s term. Nebraska Republican Senator Ben Sasse called them “constitutional slop”. Despite Trump’s efforts to take the helm, at best these efforts will cause confusion over their implementation. At worst they will be mired in court challenges. In all cases, their economic effects will be minuscule compared to the proposals tabled by either the Senate Republicans, or by the Democrats. For an idea of the difference in scale, the $50 billion from FEMA to fund more unemployment insurance relief, even if fully implemented, is dwarfed by the sized of Republican $1 trillion relief bill, and the over $3 trillion HEROS Act passed by House Democrats. Moreover, Trump runs the risk of politically “owning” the coming slowdown with these half-measures ahead of the election.

In conclusion, Q2 earnings season has been upbeat, and Street analysts are busy raising their earnings estimates. However, the economy is likely to undergo a phase of slower growth. The CARE Act 2.0 impasse is exacerbating the effects of the slowdown, and could bring the economy to a dead stop. Wall Street has not recognized those risks, and estimate revisions are poised to lurch downwards.

 

A global and cross-asset market review

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 uneasy feeling

I wrote a week ago that I had an uneasy feeling about the stock market’s intermediate term outlook. This was owing to a combination of global market weakness, and cross-asset warning signals. Last week, US equities continued to grind upwards. Let’s review how those signals evolved.

Starting with the US, the SPX broke up through a rising trend line to a new recovery high. Internals were mixed. While Advance-Decline Lines staged upside breakouts to all-time highs, the ratio of high beta to low volatility stocks, which is a risk appetite indicator was range-bound and did not confirm the market’s strength. Neither the the NYSE Advance-Decline Volume (bottom panel).
 

 

The NASDAQ 100, which had been the market leaders, broke out through resistance to a new all-time high, and the breakout held despite a pullback late in the week.
 

 

It is unclear how much good news and bad news is in the market. President Trump’s announcement on Saturday that he would sign an Executive Order and several Memorandums to extend supplemental unemployment insurance payments at the rate of $400 per week, down from $600 per week, suspend the collection of payroll taxes, defer student loan payments, and extend the federal moratorium on evictions. CFD futures, which is admittedly thin and prices are only indicative, did not react to the news.
 

Overseas weakness

The action in overseas markets was not as bullish. European markets (all indices are measured in local currency) pulled back and were unable to recover above their 50 day moving averages (dma). All were below their 200 dma.
 

 

Turning to Asia, Japan’s Nikkei Index was also unable to rally much, and ended the week below its 50 and 200 dma.
 

 

The technical condition of the Chinese market and the markets of China’s major Asian trading partners were mixed. Shanghai was never able to recover and break out above resistance after an initial surge and pullback. The Hong Kong market weakened below its 50 dma. Taiwan and South Korea were strong, but that’s mainly attributable to the leadership of semiconductor stocks. Singapore and Australia remain regional laggards.
 

 

A commodity price checkup

What about commodity prices? They are important barometers of the global cycle, and Chinese demand as China has been an voracious consumer of commodities. The CRB Index has been rising steadily, but it remains caught between its 50 and 200 dma despite the recent stellar performance of precious metals.
 

 

Some words of caution are in order for commodity and gold prices. First, the USD has shown an inverse relationship to both commodity and gold prices, and Macro Charts pointed out that the USD Index (DXY) DSI is wildly oversold. He went on to say, “Since 2011 this was a near-perfect bottoming signal.”
 

 

I previously identified a USD reversal as one of my equity bearish tripwires. Not only is a rising dollar bearish for commodity prices, it’s also puts pressure on vulnerable EM economies that are dependent on USD financing. There are two worrisome signs from a technical perspective. The USD may be in the process of tracing out a double bottom. A greater concern are EM currencies, which are weakening even as the USD fell. This is a negative divergence that investors should keep an eye on.
 

 

As well, gold is poised for a correction. Alex Barrow observed that gold prices are 4 standard deviations above its 200 dma. He added, “This has only happened two other times in the last 30-years, in Jan 03′ and May 06′.  Both prior instances led to sharp pullbacks of 18% and 25%, respectively. ”
 

 

Lastly, silver has soared against gold prices. Nautilus Research found that past similar episodes have been bearish for silver prices.
 

 

These conditions are setting for a disorderly sell-off in precious metals. One possible catalyst is the CARES Act 2.0 impasse in Washington. Arguably, gold and silver prices have been rising because of the reflationary effects of a combination of easy fiscal and monetary policy. As the agreement for fiscal support has stalled, the Fed may be left pushing on a string. These conditions are potentially bearish for gold and silver prices. As I wrote before, a correction in silver after a parabolic rally is another one of my bearish triggers for equities. Watch gold and silver prices carefully for signs of a downside break.
 

 

Bond rally = Rising risk aversion

The third, and final bearish tripwire that I identified in the past is a rally in the Treasury bond market. The long Treasury bond ETF (TLT) staged an upside breakout out of an inverse head and shoulders pattern last week, and that breakout has held. Similarly, the 10-year Treasury yield broke down through a head and shoulders pattern, and that breakdown has also held.
 

 

This is the most concrete equity bearish signal to be concerned about.
 

The week ahead

The market broke up out of a short-term wedge, as measured by the percentage of stocks above their 5 dma, which is short-term bullish. Readings are not overbought, which is an indication that there may be further upside potential.
 

 

Looking a little longer term, the percentage of stocks above their 10 dma is neutral and rising. Readings are also not overbought, which is also an indicator of possible upside potential.
 

 

In conclusion, the intermediate term concerns that I raised a week ago remain in place. Global stock prices are not confirming the strength in US equities. Commodity prices are at risk of falling because of an oversold USD, and excessively bullish sentiment in precious metals. The Treasury market is already sounding a warning. The next 10% move in US stocks is likely to be down rather than up.

In the short run, however, price momentum is positive and the market can go higher. However, there is considerable event risk from growing US-China trade frictions, and constitutional uncertainty over Trump’s Executive Order and Memorandums.

Disclosure: Long SPXU

 

Sector and factor review: Not your father’s cycle

Posted by Cam Hui -

It’s time for one of my periodic reviews of the market from a factor and sector perspective. These reviews are useful inasmuch as they can reveal insights about the character of a market.

Let’s begin with how different regions are performing relative to the MSCI All-Country World Index (ACWI). The top panel shows the S&P 500 rolling over relative to global stocks. Even the NASDAQ 100, which had been the market leaders, may be losing relative momentum and starting to trade sideways. The middle panel shows the relative performance of two major developed market regions. Japan is underperforming, and Europe is not showing signs of market leadership as it is trading sideways on a relative return basis. The bottom panel shows the relative performance of emerging market equities. Both EM and EM xChina are starting to bottom and exhibit relative strength, which is a possible sign of a global cyclical rebound, as EM equities tend to be high beta and highly cyclically sensitive.
 

 

EM risk appetite rising

The analysis of EM risk appetite shows that EM currencies and EM bond prices are trending up, and their movements are correlated with the S&P 500.
 

 

The key risk to the EM bull narrative is a USD rally. There is already a crowded short in the USD. Weak EM sovereigns and companies have limited capacity to finance in their own currencies and borrow in USD. A falling USD therefore provides a tailwind for EM assets. Bloomberg reported that BoA currency strategist David Woo distilled a short USD position implies optimism about quick vaccine availability.

A bet on the U.S. dollar declining in the medium term makes the key assumption that a vaccine against the novel coronavirus will be available comparatively soon, according to Bank of America Corp.

That’s because Europe and Asia have a higher chance of fresh waves of infections the longer it takes for a vaccine to be found, a scenario that’s bullish for the dollar, said David Woo, a strategist at the bank…

A prolonged path to an inoculation would boost the odds “that liquidity support from central banks will not be enough to shore up financial markets,” he said. That could spur risk aversion and benefit the dollar given its status as a safe haven.

Several vulnerable EM are already in trouble. Turkey is in trouble again. Turkish companies have USD debt equivalent to roughly one-third of GDP. The Turkish Lira is falling, indicating rising stress for the Turkish economy.
 

 

Then there is the tragedy in Lebanon. An unexpected explosion rocked Beirut and severely damaged the port and its economy. Even before the explosion, Lebanon was already seeking IMF aid, as Bloomberg explains.

Unable to generate foreign significant support, oversee an economic recovery or guarantee public safety, Prime Minister Hassan Diab’s administration, cobbled together in January after mass protests brought down the previous government, may not last. Though Lebanon’s problems are an accumulation of nepotistic policies and public mismanagement over the decades, he’s facing criticism for doing too little to manage the country’s multiple crises.

After defaulting on a $90 billion debt pile, and before the latest disaster, Lebanon was seeking $10 billion in aid to support its financial turnaround. Beirut governor Marwan Abboud has told local media the repair bill for the capital alone will cost up to$5 billion that the government simply can’t afford.

“Large elements of the public no longer believes the government is able to manage,” Ayham Kamel, head of Middle East and North Africa research at Eurasia Group, said in a note. “The economic crisis will also deepen as the port is the main trade valve and base for many stored goods awaiting clearance.”

Talks with the IMF had stalled as it became clear that politicians and bankers could not agree even on the magnitude of financial losses let alone who should pay for them. The government has lost key advisers and officials and the foreign minister resigned this week, frustrated that political elites were too busy protecting their own interests to take the steps demanded by potential lenders to save the economy from ruin.

These economies are already teetering, even under a weak USD regime. What happens if the greenback were to strengthen?

Know your implicit exposures. This is one example of how cross-asset analysis can disentangle the macro bets investors are making.
 

Sector analysis

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

Here is the RRG chart of the US market.
 

 

Here are some of the key takeaways of the RRG sector analysis.

The first surprise is technology and communication services, which are some of the key drivers of the FANG+ leadership, have migrated from the leading quadrant to the weakening quadrant. Upon closer inspection, while technology stocks are in a well-defined relative uptrend, RSI has been weakening, indicating a loss of momentum. This is consistent with the previous observation that NASDAQ 100 is starting to weaken against ACWI.
 

 

Further weakness in technology stocks may be hastened by Trump’s recent Executive Order against TikTok and WeChat. It is unclear what the exact meaning of the EO, but it could devastate the video gaming industry as WeChat owner Tencent has ownership stakes in US companies that make popular games like “League of Legends”, “Fortnite”, and “World of Warcraft”. In addition, if the EO mandates the removal of WeChat from Apple’s App Store on a global basis, it would devastate Apple’s business in China.

The second surprise is the presence of material and consumer discretionary stocks in the leading quadrant, which implies the market’s belief that a cyclical rebound is under way. There is no question that rising but choppy relative strength in material stocks appears bullish, but bear in mind that this is the second smallest sector in the index with a weight of 2.6%.
 

 

The composition of the consumer discretionary sector is dominated by heavyweight Amazon. While the relative performance of the float weighted sector has been strong, the equal weighted performance of this sector is less impressive, but it is nevertheless strong.
 

 

Beyond the market leadership of cyclical materials and consumer discretionary stocks, what up-and-coming sectors can investors consider? For that, we analyze the three sectors in the improving quadrant, namely industrial, financial, and energy stocks. The relative chart patterns of these three sectors shows a bottoming process, but they may need more time to consolidate before they can strengthen to become market leaders. That said, I have reservations about two of the sectors. The trajectory of energy stocks on the RRG chart suggests that they are likely to roll over and fall into the lagging quadrant. In addition, it is difficult to see how financial stocks can assume a leadership position during an era when the Fed is effectively engaged in financial repression, which directly squeezes the companies in the sector.
 

 

Factor analysis

Before embarking on an analysis of factor leadership, let’s review the status of the big three factor leaders so far. Major changes in long-term leadership often occur during transitions from bull to bear markets.

  • US over global: Rolling over
  • Growth over value: Very strong
  • Large caps over small caps: A pause in the trend, but large caps are still outperforming

 

 

Here is the RRG analysis of some of the commonly used quantitative factors.
 

 

The weakening quadrant contains large cap growth and price momentum, which is mainly made up of large cap growth stocks. This is consistent with the previous observation of the picture of weakening NASDAQ 100 leadership.

The leading quadrant contains high beta and small cap growth. In theory, leadership by these factors should be bullish because they represent high beta stocks. However, their relative performance patterns show limited relative strength that have not yet breached key relative resistance levels yet.
 

 

The other factors in the improving quadrant can mainly be classified as different flavors of value. A revival of value over growth may be a sign of leadership transitions that occur during bull/bear phase changes.
 

Poised for a cyclical rotation

Putting all of the sector and factor review together, what do we have?

  • Weakening US market leadership
  • Some early signs that NASDAQ 100 and US growth are poised to roll over
  • Emerging EM and cyclical leadership

The BoA Global Fund Manager Survey shows that global managers have been piling into US equities as the last source of growth in a growth starved world.
 

 

Sector and factor rotation analysis indicates that US large cap growth stocks are about to hand over the market leadership to cyclical and EM stocks. In a normal market, this would be the sign of a healthy rotation.

However, Vincent Deluard of Intl FC Stone pointed out that there is a problem with US large cap growth concentration. The weight of FAANMG is now greater than the combined weight of  financial, energy, industrial, and material sectors.
 

 

FAANMG stocks have been on a tear. The funds flow implications of a rotation out of large cap growth is likely to put downward pressure on the overall market because of the sheer size of these stocks. The size of the cyclical sectors are unable to cope with the fund flows, and will likely leak to other asset classes, such as non-US equities, and fixed income instruments. Much will depend on the perceived catalyst of the fund flow shift. Please be reminded of Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
 

Not a normal cycle

While cyclical sectors appear to be poised to rise, their ascendancy into the next market leaders is complicated by the fact that this is not a normal market and economic cycle where normal rules apply. The COVID Crash and subsequent recovery was sparked by an unexpected global macro shock, and not a normal downturn owing to central bank tightening that eventually leads to a recession.

Howard Marks at Oaktree explained why this is not a normal cycle.

Two of the questions I get most often these days are, “What kind of cycle are we in?” and “Where do we stand in it?” My main response is that the developments of the last five months are non-cyclical in nature, and thus not subject to the usual cycle analysis.

The normal cycle starts off from an economic and market low; overcomes psychological and capital market headwinds; benefits from gathering strength in the economy; witnesses corporate results that exceed expectations; is amplified by optimistic corporate decisions; is reinforced by increasingly positive investor sentiment, and thus fosters rising prices for stocks and other risk assets until they become excessive at the top (and vice versa on the downside). But in the current case, a moderate recovery – marked by reasonable growth, realistic expectations, an absence of corporate overexpansion and a lack of investor euphoria – was struck down by an unexpected meteor strike.

He concluded:

I’m convinced cycles will continue to occur over time, highlighted by excessive movements away from “normal” and toward extremes – both high and low – that are followed by corrections back to normalcy, and through it to excessive in the opposite direction. But that’s not to say that every event in the economy or markets is cyclical. The pandemic is not.

Here is what we know. The pandemic caused an economic downturn that ranks second in scale to the Great Depression. The monetary and fiscal authorities have responded with unprecedented level of support. However, US fiscal support may be fading. Return to normalcy therefore depends on the fight against the virus, and the availability and effective deployment of vaccines and therapeutics. Official health policies matter less than confidence. A recent study concluded that consumer fears led to a drop in business visits regardless of whether lock-down measures were in place.

The collapse of economic activity in 2020 from COVID-19 has been immense. An important question is how much of that resulted from government restrictions on activity versus people voluntarily choosing to stay home to avoid infection. This paper examines the drivers of the collapse using cellular phone records data on customer visits to more than 2.25 million individual businesses across 110 different industries. Comparing consumer behavior within the same commuting zones but across boundaries with different policy regimes suggests that legal shutdown orders account for only a modest share of the decline of economic activity (and that having county-level policy data is significantly more accurate than state-level data). While overall consumer traffic fell by 60 percentage points, legal restrictions explain only 7 of that. Individual choices were far more important and seem tied to fears of infection. Traffic started dropping before the legal orders were in place; was highly tied to the number of COVID deaths in the county; and showed a clear shift by consumers away from larger/busier stores toward smaller/less busy ones in the same industry. States repealing their shutdown orders saw identically modest recoveries–symmetric going down and coming back. The shutdown orders did, however, have significantly reallocate consumer activity away from “nonessential” to “essential” businesses and from restaurants and bars toward groceries and other food sellers.

So where does that leave us? 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.

One of the key signposts of the bearish scenario is the price of precious metals. Both gold and silver have been soaring. While they are overbought, their fundamentals are inversely correlation to real interest rates. However, investor sentiment and positioning is at an extreme crowded long. Should precious metals fail to respond to further signs of falling real rates, then the bearish scenario becomes a strong possibility.
 

 

Waiting for the July Jobs Report

Posted by Cam Hui -

Mid-week market update: The July Employment Report has the potential to be a game changer in how the market perceives the recovery. Estimates of job gains are all over the place, and the median stands at 1.5 million.
 

 

High frequency economic data has been weakening, and I am inclined to taken the “under” consensus on the print. This could be a big negative surprise for the market and spark a risk-off episode.

Soft high frequency data

There is a flood of high frequency data that suggests a soft Nonfarm Payroll (NFP) report. Much of the gains in employment in recent reports are attributable to the return from furlough of low-wage service workers. A new study and poll of over 6,400 US respondents shows that workers previously laid off and re-hired are being laid off again.

 

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Small businesses are highly sensitive economic barometers because of their low bargaining power. Homebase indicates that small business employment has flattened out. If we align the Homebase data to the Job Report reporting dates, it suggests a job gain of about 1.5 million, which is with the consensus forecast.

 

 

Using high frequency Census data, former Treasury official Ernie Tedeschi estimated the NFP print to be a loss of -2.2 to -4.7 million jobs, which would be a huge negative shock.
 

 

The ADP report of private sector jobs came in at 167K, which is well below the consensus of 1.5 million jobs. However, the ADP data can be a noisy preview of the NFP report.  I conclude that the risk to the NFP report asymmetrically skewed to the downside, and a big negative print is not out of the question.

 

CARES Act 2.0

The other uncertainty that overhangs the market is the negotiations between Democrats and Republicans over a second stimulus package. There is a soft deadline Friday as the Senate is scheduled to recess on that day. The House is already in recess. However, lawmakers can be recalled to pass a bill with 24 hours notice.
There are some signs of progress, but both sides are reportedly far apart on some key issues. As 15-20 Republican Senators will not approve any further aid, the White House is dependent on the support of a substantial number of Democratic Senators to pass legislation. This gives the Democrats a strong bargaining position. Bloomberg reports that some of the major contentious points are the Democrats’ insistence on state and local government aid, and the Republicans’ desire for liability protection for employers.
The rescue package negotiations of 2020 have become the Sino-American trade negotiations of 2019. I find it hard to believe that Trump would cave to Democratic demands and a humiliating legislative defeat less than 100 days ahead of an election, but I have been wrong on these forecasts before. Bear in mind that even if there is a deal, some precious time has been lost and the aim of new legislation will be to extract the survivors that fell into the fiscal canyon, rather than preventing people from falling off the fiscal cliff. It is unclear the level of damage done to the economy until we know the nature of the rescue package.

 

The market reaction

The market’s reaction to the current economic outlook has been mixed. The risk-on rally from the March lows is largely attributable to the expectations of a V-shaped recovery, not just in the US but globally. One useful cyclical indicator is the copper/gold ratio, which has closely tracked the 10-year Treasury yield. These two indicators have diverged recently. The copper/gold ratio rose, and then fell. The reversal can be partly explained by the strength in gold prices. At the same time, the 10-year Treasury yield fell to all-time lows, which is a risk-off signal. Which is right?

 

 

The decline in bond yields and rally in bond prices are technically significant. The 10-year yield broke a significant support while tracing out a head and shoulders formation, with a target of 0.23%. Similarly, the long bond ETF (TLT) staged an upside inverse head and shoulders breakout with an upside target of 188. Both breakouts are holding so far.
 

 

As I pointed out before, the SPX appears to be tracing an Elliot Wave diagonal triangle, which is an ending pattern. As well, the higher highs are not being confirmed from a momentum or breadth perspective.
 

 

The NASDAQ 100, which have been the market leadership, has staged an upside breakout through resistance.
 

 

We could see some real fireworks this Friday from both the NFP report and the soft deadline of CARES Act 2.0 negotiations.

Disclosure: Long SPXU

Earnings Monitor: Big Tech surprises

Posted by Cam Hui -

Q2 earnings season is now past the halfway mark. So far 63% of the market has reported. FactSet reported the EPS beat rate rose to 84% from 81% the previous week. The sales beat rate was fell to 69% from 71% the previous week. Both the EPS and sales beat rates are ahead of their 5-year averages.

The bottom-up consensus forward 12-month estimate rose 1.03% last week after a strong 1.05% the previous week The market is trading at a forward P/E of 22.0, which is well ahead of historical norms.
 

 

Strong positive revisions

Wall Street analysts have been increasing upbeat on the outlook of individual companies. Though the weekly changes in quarterly EPS estimates can be noisy, analysts have upgraded quarterly earnings estimates across the board, except for Q4 2020 earnings. Q2 2020 revisions were especially strong.
 

 

Company earnings guidance offered a “good news, bad news” message. The good news is guidance has been extremely positive, compared to the historical experience of negative earnings guidance has swamped positive ones. The bad news is over half of the companies have withdrawn guidance, citing pandemic related uncertainty. Deprived of guidance, many analysts are flying blind, which creates greater uncertainty in EPS estimates.
 

 

From the ground up

Courtesy of The Transcript, which monitors the earnings calls, the main feature last week was Big Tech strength.

There were a lot of major data points about the economy last week but the biggest news of all seemed to be just how well tech companies did despite the massive economic dislocation.  In a quarter where GDP fell at a 33% annualized rate, Apple managed to grow revenue by 11%!  Stimulus probably played some role in tech companies’ strong performance, but beyond the stimulus is the fact that COVID has pushed everyone to spend even more time at home and on the internet.  The behavioral shifts appear to be long-lasting too.  20 years after the dot com bubble, the internet is still not done reshaping society.

Here is a brief summary of the macro outlook:

  • The current economic downturn is the most severe in our lifetime (Federal Reserve, BLS)
  • Earnings reports are showing that many companies are under intense pressure (General Electric, Honeywell)
  • But tech and payments companies are booming (Apple, Amazon, Shopify, Paypal)
  • And housing is booming too (Redfin, Boston Properties, Freddie Mac’s)
  • The economy has continued to improve in July (Mastercard, McDonald’s, Starbucks, Redfin)
  • Thank you government stimulus (Apple, Facebook Snap-On, Redfin, United Parcel Service, On Deck Capital)
  • However, the economy is still in a deep, deep hole (CBOE, Boston Properties)
  • And COVID could continue to be with us for a while (Boston Properties)

 

The valuation debate

One nagging issue with the equity rebound off the March lows is valuation. The market is trading at a forward P/E of 22.0, which is well ahead of the 5-year average of 17.0 and 10-year average of 15.3. There has been much discussion whether these historically high valuations are justified.

One way of thinking about the market is to separate the large cap FANG+ names from the rest of the market. Assuming that 2020 earnings are a disaster that can be ignored and investors should consider 2021 earnings for a more normalized view of P/E multiples, the top 5 stocks in the index trade at a FY2 P/E of 31, compared to 18 for the rest of the index. We can make a couple of observations from this analysis.

  • Top 5 stock FY2 P/E ratios are not high compared to the dot-com era. There is a difference between the 1990’s NASDAQ bubble and today. The dot-com bubble was dominated by companies with little or no profitability, which drove up P/E ratios, while today’s FANG+ stocks are profitable with competitive moats.
  • The FY2 P/E of the bottom 495 is still quite elevated by historical standards.

 

 

One signal of an overvalued market is excessive equity financings. If stocks are expensive, then companies prefer financing with cheap equity over expensive debt. That was one characteristic of the dot-com era, whose financing landscape was flooded with IPOs that skyrocketed on the first day of trading. FactSet reported that IPO activity is not excessively high by historical standards.
 

 

However, the froth in this market has turned from IPO to the SPAC, or “Special Purpose Acquisition Company”. The Economist explained the SPAC this way:

An empty vessel can accommodate all manner of dreams. This trait helps explain the growing allure of the “special purpose acquisition company” (SPAC), a shell company listed on the stock exchange with a view to merging it with a real business. Ventures such as Virgin Galactic, in space tourism, and Nikola, in electric vehicles, have become listed companies by this route. Silicon Valley’s dream factory spies a way to sidestep the trials of an initial public offering (IPO). Bill Ackman, a shrewd hedge-fund manager, has just raised a $4bn mega-SPAC. He is looking for a unicorn to make a home in his empty store.

The view in Silicon Valley is that an IPO is a rotten process. There is typically a fixed fee, of up to 7% of the sum raised. And the value of the company is lowballed, say tech types, to allow for a satisfying first-day “pop” in the share price. Yet cost is not the only bugbear—and, perhaps, not even the main one. What entrepreneurs and their venture-capital backers hate about the IPO is the loss of control. They are used to being big shots in Silicon Valley. They do not like deferring to Wall Street types at all.

In effect, the SPAC is an IPO hack. It’s a way to get around the fees of the IPO.

Enter the SPAC, which is a sort of pre-cooked IPO. A shell company is set up by a sponsor. The SPAC is listed on the stock exchange via an IPO. The sponsor then finds a private business for the SPAC to acquire with the proceeds. Typically this will be a late-stage (ie, fairly mature) private company, whose owners and venture-capital backers are looking to cash out. The private company merges with the SPAC, following a shareholder vote. It is then a public company.

The usual fee for the sponsor is 20% of the equity, which is a way of compensating him and the SPAC management team. The concept of the SPAC is not new. At the height of the South Sea Bubble, one company raised money “for carrying out an undertaking of great advantage, but nobody to know what it is”. For investors, they are bearing the risk of writing a blank check to a sponsor, and hoping that he can find the next Virgin Galactic, Nikola, or “undertaking of great advantage”.

Barron’s this week featured an article highlighting the issues surrounding SPACs. Reuters also reported that Billy Beane, of  Moneyball fame, is looking to raise a $500-million SPAC.
 

 

Is the SPAC frenzy the 2020 version of the dot-com IPO bubble? Is SPAC activity a signal equity capital has become too cheap?
 

 

Another bull case for elevated P/E valuations is low interest rates. BCA Research pointed out that falling real rates are not only bullish for gold, but they are also bullish for P/E multiples as well.
 

 

Earnings risk

John Hempton at Bronte Capital had the following thoughts about P/E ratios, interest rates, and valuations. It’s understandable why high growth companies like AAPL and GOOG attract high P/E multiples, but what about boring businesses like KO?

Interest rates are indeed low. If you believe that interest rates stay at zero forever then stocks whose earnings are unlikely to decline much (such as say The Coca Cola Company) should be valued at very high PE ratios.

Rather than just focus on P/E multiples, Hempton thinks that earnings are at risk:

We think – instinctively – that the aggregate earnings capacity of US business is at risk…

The corollary is that profit share is at historic highs, indeed, astonishing highs. Almost everywhere you look in the US you see companies that earn more than you would expect. Our personal favorite is Lamb Weston, which makes wholesale potato chips (fries to Americans) delivered to restaurants that wind up on your plate/hips. The 2019 operating margin of Lamb Weston is almost 18 percent. The operating margin of Apple, by comparison, is under 25 percent. The idea that a company whose sole job is to buy potatoes from farmers, chop them up, freeze them and deliver them to restaurants can earn margins even close to Apple is astonishing.

But what we see for Lamb Weston we see right across American society.

The American market is at above-average multiples of massively-above-average profits. Competition should usually drive down profit share, and democratic politics has – at least in theory and cyclically – some kind of redistributive effect.

While Hempton is concerned about the long-term trajectory of operating margins and earnings, the near term earnings outlook also faces downside risk. US households are falling off a fiscal cliff (see Fiscal cliff = Double dip). At publication time, the White House is still negotiating with the Democrats on a rescue package, but there is an enormous gulf in each side’s budget priorities.
 

 

Setting aside the economic and political pros and cons of each side’s proposals, here is the legislative math. There are about 15-20 Republican Senators who are adamantly against any further stimulus for philosophical reasons. To pass a rescue bill, the White House and Republican Senate leadership will need substantial support from the Democrats. As an illustration of Republican disunity, former Fed governor nominee Stephen Moore wrote a WSJ op-ed that blamed both the Democrats and Senate Republicans for the failure to pass a relief bill [emphasis added].

President Trump needs to reset the debate on the latest coronavirus relief bill. Senate Republicans have scuttled their best pro-growth idea—a payroll tax cut—and instead released a $1 trillion spending bill. Last week Mr. Trump acknowledged that compromising with Speaker Nancy Pelosi is a fool’s errand, because the House won’t agree to anything that boosts growth and job creation. The Democratic plan includes a six-month extension of the $600-a-week unemployment bonus and $3 trillion in new spending. It would sink the economy and imperil Mr. Trump’s re-election.

The lack of a Republican united front puts the Democrats in the driver’s seat if a CARES Act 2.0 is to be passed. What will they ask in return? How about most of the provisions of the $3 trillion HEROS Act passed in the House? What about funding for the Post Office to facilitate universal mail-in voting in November?

The Washington Post reported that “Pelosi, Mnuchin and Meadows all appeared on talk shows Sunday morning and indicated they were not close to a deal”. At some point, each side will have to make the political calculation of what they want and what they are willing to give up in order to a rescue package, compared to allowing the economy to go over a cliff and blame the other side. Viewed from that perspective, the odds of a deal are slim.

Stresses are already appearing in the economy in the form of skyrocketing bankruptcies, and that’s before the economy fell off the fiscal cliff.
 

 

The July Jobs Report has the potential to be a big negative surprise. Indeed.com reported that, even in an outperforming industry like tech, job growth has been stagnant.
 

 

Something’s gotta give. Street analysts have been revising EPS estimates upward, but the near-term downside risk in EPS estimate revisions is enormous. If and when they start falling, expect stock prices to adjust downwards accordingly.
 

An uneasy feeling

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Good news, bad news

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

 

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

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

Bearish warnings

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

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

 

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

 

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

 

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

 

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

 

Global weakness

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

 

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

 

Narrowing NASDAQ leadership

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

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

 

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

 

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

 

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

Growth at any price

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

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

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

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

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

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

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

 

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

 

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

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

 

The week ahead

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

 

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

 

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

 

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

 

Disclosure: Long SPXU

 

Fiscal cliff = Double-dip

Posted by Cam Hui -

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

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

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

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

 

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

Differences in policy time horizon

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

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

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

 

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

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

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

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

Assessing the damage

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

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

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

 

Other risks

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

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

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

 

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

 

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

 

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

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

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

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

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

A second demand shock

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

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

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

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

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

 

What gold tells us about Fed policy expectations

Posted by Cam Hui -

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

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

 

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

 

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

 

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

 

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

 

Brace for volatility

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

 

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

 

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

 

Stalling confidence

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

 

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

 

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

 

Earnings Monitor: A qualified upbeat tone

Posted by Cam Hui -

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

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

 

A qualified upbeat tone

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

 

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

 

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

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

From the ground up

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

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

Here is a summary of the macro outlook.

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Valuation still elevated

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

 

The market reaction

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

 

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

 

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

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

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

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

 

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

 

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

Stay tuned.

 

Warnings, warnings everywhere, but bears should not drink…

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Sentimental warnings

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

A relief rally may be in order early next week.
 

Cross-asset bearish tripwires

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

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

 

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

 

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

 

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

 

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

 

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

 

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

Waiting for Congress

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

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

 

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

 

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

 

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

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

 

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

 

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

 

Analyzing the bull case

Posted by Cam Hui -

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

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

 

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

The V-shaped recovery

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

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

 

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

A cyclical recovery in 2021

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

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

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

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

 

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

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

 

What about valuation?

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

 

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

 

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

 

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

 

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

A healthy rotation

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

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

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

 

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

 

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

The fine print

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

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

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

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

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

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

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

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

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

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

 

Remember Bob Farrell’s Rule #4, “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” Each decade seems to experience a mania of some sort, and we are very late in the latest FANG+ mania. If and when it deflates, is it reasonable to expect cyclical stocks, value stocks, and non-US stocks can pick up the slack?
 

 

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

 

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

 

A market in transition

Posted by Cam Hui -

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

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

 

Unusual response to news

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

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

 

Market indecision

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

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

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

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

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

 

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

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

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

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

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

 

Earnings Monitor: Waiting for Congress

Posted by Cam Hui -

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

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

 

A detailed look

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

There is a general feeling that Congress needs to act.

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

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

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

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

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

 

The elephant in the room

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

 

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

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

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

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

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

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

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

Can both sides come to an agreement in time?

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

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

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

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

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

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

 

Pockets of opportunity in an uncertain market

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Still range-bound

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

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

The bears can point to:

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

 

 

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

The bull case

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

 

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

 

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

 

The bear case

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

 

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

 

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

 

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Energy: The contrarian play

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

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

 

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

 

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

 

Is WFH theme peaking?

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

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

Dehaze explained:

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

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

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

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

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

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

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

 

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

 

Gold: Too far, too fast

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

 

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

 

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

 

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

The week ahead

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

 

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

 

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

 

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

Disclosure: Long SPXU

 

Can a bull market begin without the banks?

Posted by Cam Hui -

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

 

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

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

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

How cheap are banks?

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

 

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

 

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

 

Waiting for the next shoe to drop

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

 

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

 

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

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

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

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

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

 

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

 

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

 

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

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

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

 

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

Financial repression ahead

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

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

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

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

Duy concluded:

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

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

 

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

 

Brace for more pain

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

 

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

 

A Covid recovery?

Posted by Cam Hui -

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

 

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

 

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

The approval process

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

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

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

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

The leading candidates

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

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


 

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

 

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

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

 

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

 

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

 

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

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

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

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

Limited upside potential

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

 

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

 

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

 

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

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

Disclosure: Long SPXU

 

Another equity valuation warning

Posted by Cam Hui -

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

 

Here is why these circumstances are highly unusual.
 

The historical record

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

 

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

 

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

 

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

 

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

 

Health care warnings

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

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

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

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

 

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

 

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

 

Risk levels elevated, but no signs of panic

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

A holding pattern

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

 

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

Waiting for earnings season

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

 

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

 

Chase card spending shows a similar pattern of flattening sales.
 

 

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

 

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

 

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

 

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

 

Discounting a mild slowdown

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

 

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

 

Waiting for Washington

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

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

 

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

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

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

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

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

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

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

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

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

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

The week ahead

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

 

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

 

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

 

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

 

Let Q2 earnings season begin!
 

 

Disclosure: Long SPXU (daylight hours only)