Double bubble, double trouble?

Posted by Cam Hui -

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

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

 

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

 

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

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

NASDAQ leads the way

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

 

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

 

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

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

 

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

 

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

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

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

 

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

 

China’s “I can’t lose” melt-up

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

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

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

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

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

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

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

 

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

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

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

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

 

 

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

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

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

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

 

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

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

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

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

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

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

 

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

 

The tension between Bob Farrell’s Rules

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

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

And Rule No. 7.

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

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

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

 

My inner trader returns to the drawing board

Posted by Cam Hui -

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

 

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

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

 

Conventional analysis

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

 

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

 

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

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

 

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

 

The Fed bubble

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A new framework

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

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

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

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

 

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

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

 

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

 

What’s next?

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

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

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

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

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

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

 

Good luck, everyone.

Disclosure: Long SPXU (daylight hours only)

 

Why there is no V

Posted by Cam Hui -

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

 

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

June Employment Report

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

 

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

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

 

 

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

 

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

 

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

The consumer pulls back

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

 

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

 

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

 

Blame the pandemic

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

 

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

 

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

 

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

 

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

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

Investment implications

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

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

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

 

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

 

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

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

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

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

 

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

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

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

However, there is some hope on the therapeutics front.

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

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

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

Can the bulls breach the island’s moat?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

The moat around the island

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

 

Is there a moat around the island?
 

A NASDAQ stall?

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

 

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

 

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

 

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

 

Trouble under the hood

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

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

 

 

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

 

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

Top of the range

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

 

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

 

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

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

Disclosure: Long SPXU

 

Fun with technical analysis on the 4th of July

Posted by Cam Hui -

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

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

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

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

 

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

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

 

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

A referendum on Trump

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

 

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

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

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

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

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

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

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

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

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

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

 

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

 

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

 

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

Investment implications

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

 

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

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

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

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

 

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

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

 

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

 

What to watch

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

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

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

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

 

A 2020 year

Posted by Cam Hui -

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

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

 

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

Wobbly internals

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

 

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

 

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

 

Volatility ahead

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

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

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

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

 

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

 

Sideways consolidation

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

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

 

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

Disclosure: Long SPXU

 

Q2 earnings preview: Flying blind

Posted by Cam Hui -

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

 

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

Flying blind

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

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

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

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

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

 

The risks ahead

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

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

 

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

 

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

 

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

 

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

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

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

 

A shallow or deep pullback?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Bearish tripwires

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

 

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

Shallow pullback and consolidation?

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

 

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

 

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

Long-term warnings

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

 

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

 

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

 

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

 

An exhausted Fed?

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

 

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

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

 

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

 

The week ahead

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

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

 

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

Disclosure: Long SPXU
 

A bleak decade for US equities

Posted by Cam Hui -

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

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

 

 

Hulbert continued:

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

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

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

The Bridgewater warning

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

Gold as a confidence indicator

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

 

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

 

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

 

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

 

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

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

Where can investors hide?

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

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

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

Here is how Powell responded:

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

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

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

 

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

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

 

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

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

 

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

 

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

 

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

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

 

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

Good news, bad news about a second wave

Posted by Cam Hui -

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

 

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

For investors, this matters for a couple of reasons.
 

Explaining the falling fatality rate

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

 

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

 

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

 

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

 

Here is Texas.
 

 

A second economic wave

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

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

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

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

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

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

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

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

 

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

 

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

 

Their cash buffers are low.
 

 

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

 

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

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

 

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

Internals are still weak

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

 

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

 

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

 

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

 

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

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

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

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

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

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

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

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

 

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

Disclosure: Long SPXU

 

Bearish warnings, but no trigger

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Island reversal signal intact

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

 

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

Bearish setups

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

 

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

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

 

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

 

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

Don’t blame the Fed

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

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

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

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

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

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

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

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

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

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

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

 

A second wave

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

 

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

 

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

 

Q2 earnings season surprise?

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

 

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

 

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

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

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

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

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

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

 

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

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

 

Waiting for the downside break

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

 

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

 

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

 

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

Disclosure: Long SPXU

 

The bears are capitulating

Posted by Cam Hui -

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

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

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

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

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

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

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

 

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

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

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

Fundamental and macro backdrop

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

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

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

Here are the main takeaways from his testimony:

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

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

 

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

 

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

 

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

A study of psychology

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

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

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

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

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

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

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

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

But hardcore stress leaves a scar.

Here is how Housel generalized this experience to human behavior.

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

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

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

 

The economy isn’t the stock market

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

 

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

 

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

What could pop the bubble?

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

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

 

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

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

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

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

 

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

 

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

 

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

 

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

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

 

Not a bubble (yet)

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

 

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

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

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

 

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

 

Also please stay tuned for our tactical trading publication tomorrow.

 

An island reversal update

Posted by Cam Hui -

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

 

Have the bearish implications of the island reversal been negated?
 

Island reversals explained

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

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

 

 

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

 

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

 

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

Some perspective

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

 

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

 

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

 

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

 

Cautiously bearish

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

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

 

Disclosure: Long SPXU

 

China’s tough policy choices

Posted by Cam Hui -

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

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

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

 

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

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

What policy choices does China have to revive its economy?
 

China’s challenges

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

 

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

 

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

 

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

What can policy makers do?
 

Difficult choices

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

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

 

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

Wolf Warrior diplomacy

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

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

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

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

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

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

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

 

Confrontations ahead?

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

 

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

 

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

 

A major correction, or just a flesh wound?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Just a flesh wound?

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

 

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

 

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

The bull case

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

 

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

 

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

 

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

 

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

 

That’s bullish, right?
 

The bear case

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

 

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

 

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

 

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

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

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

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

 

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

 

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

 

None of these developments are intermediate term equity bullish.
 

Bearish tripwires

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

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

 

 

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

 

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

Disclosure: Long SPXU

 

What professional career risk looks like

Posted by Cam Hui -

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

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

 

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

 

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

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

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

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

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

The quick bull

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

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

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

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

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

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

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

 

The cautious value investor

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

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

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

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

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

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

The Keynesian beauty contest

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

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

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

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

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

 

Capital expenditure plans have bottomed and they are edging up.
 

 

Hiring plans have also rebounded.
 

 

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

 

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

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

 

 

The case for caution

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

 

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

 

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

 

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

 

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

 

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

 

The FIFO China model

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

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

 

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

 

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

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

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

It had been expected to fall 9.7% in May.

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

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

 

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

 

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

 

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

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

 

Trading sardines, or eating sardines?

Posted by Cam Hui -

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

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

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

Klarman continued:

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

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

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

The trader’s bull case

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

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

 

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

 

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

 

The bear case

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

 

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

 

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

 

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

 

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

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

 

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

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

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

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

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

This week, they bought 12.1 million.

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

 

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

 

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

Resolving the bull and bear cases

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

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

 

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

 

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

 

Buy the breadth thrusts and FOMO stampede?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Breadth thrusts are bullish

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

 

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

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

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

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

Analyzing market psychology with factors

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

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

 

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

 

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

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

 

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

 

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

 

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

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

 

A go-go melt-up ahead?

How realistic is the melt-up scenario?

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

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

 

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

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

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

 

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

 

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

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

The week ahead

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

 

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

 

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

 

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

 

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

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

 

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

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

 

What would a Biden presidency look like?

Posted by Cam Hui -

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

 

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

 

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

The law and order card

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

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

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

 

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

 

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

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

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

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

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

Biden’s economic policy

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

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

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

 

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

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

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

The rise of the bomb throwers

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

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

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

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

 

 

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

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

Healthcare policy

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

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

 

Trade: The silver lining

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

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

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

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

 

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

Stay tuned tomorrow for our tactical market analysis.

 

May Jobs Report: Back from furlough

Posted by Cam Hui -

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

 

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

Where the jobs came from

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

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

 

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

Key risks

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

 

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

 

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

 

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

 

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