Winning the Pandemic Peace

Posted by Cam Hui -

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

 

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

A hopeful view

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

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

That’s when the magic happens.

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

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

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

 

 

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

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

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

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

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

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

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

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

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

And what could come from that besides a Covid vaccine?

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

 

A need for institutions

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

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

I’ll wait.

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

 

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

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

 

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

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

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

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

That trust isn’t to be taken for granted.

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

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

The inequality challenge

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

 

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

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

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

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

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

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

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

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

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

 

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

 

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

Investment implications

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

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

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

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

 

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

 

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

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

 

 

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

 

Tech is eating the market

Posted by Cam Hui -

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

 

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

The manager’s dilemma

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

 

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

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

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

 

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

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

 

Sentiment warnings

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

 

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

 

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

 

Waiting for the trigger

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

 

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

 

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

Be vigilant.

 

Here’s a way to energize your portfolio

Posted by Cam Hui -

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

 

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

Constructive pattern

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

 

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

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

 

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

Thermopylae bulls

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Easy to be bearish

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

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

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

 

 

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

 

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

A case of bad breadth

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

 

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

 

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

Weakened risk appetite

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

 

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

 

What’s holding up the market?

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

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

 

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

 

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

 

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

 

The bulls last stand?

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

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

 

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

 

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

 

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

Disclosure: Long TQQQ

 

Fresh market highs! What now?

Posted by Cam Hui -

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

 

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

 

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

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

A bifurcated stock market

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

 

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

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

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

 

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

 

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

 

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

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

 

A bifurcated economic recovery

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

 

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

 

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

 

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

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

 

Policy response and asset price implications

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

 

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

 

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

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

 

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

 

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

 

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

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

 

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

 

Stock market implications

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

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

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

 

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

 

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

 

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

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

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

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

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

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

 

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

 

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

 

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

 

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

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

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

 

Should you hop on the reflation train?

Posted by Cam Hui -

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

 

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

Growth expectations revival

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

 

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

 

A cyclical report card

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

 

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

 

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

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

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

 

Focus on risk, not return

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

 

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

 

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

 

Risk and reward: No guts, no glory?

Posted by Cam Hui -

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

The Turkey in the FX coalmine

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

 

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

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

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

 

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

 

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

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

 

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

 

No guts, no glory?
 

American Brexit

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

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

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

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

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

 

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

Brexit, the aftermath

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

 

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

 

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

No guts, no glory.
 

What really matters in this market

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

False negatives?

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

 

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

 

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

 

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

Big Tech dominance

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

 

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

 

Macro speed bumps

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

 

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

 

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

 

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

 

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

 

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

 

Here is China ESI.
 

 

Pennies in front of a steamroller

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

 

A similar pattern can be found for the NASDAQ 100.
 

 

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

 

A Potemkin Village market?

Posted by Cam Hui -

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

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

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

 

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

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

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

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

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

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

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

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

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

Big Tech dominance

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

 

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

 

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

 

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

 

The risks to Big Tech

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rotation is healthy, but…

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

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

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

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

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

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

 

The pandemic war

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

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

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

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

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

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

 

Investment conclusions

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

 

 

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

 

 

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

 

 

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

 

Greedy enough?

Posted by Cam Hui -

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

 

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

 

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

 

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

 

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

A door closes, others opens

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

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

 

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

 

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

 

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

 

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

 

Cautious but not bearish

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

 

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

 

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

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

 

Earnings Monitor: Slower growth ahead

Posted by Cam Hui -

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

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

 

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

Strong positive revisions

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

 

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

Bottom-up caution

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

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

Here is a brief summary of the macro outlook:

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

 

Slower growth ahead

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

 

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

 

Trump tries to take the helm

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

 

A global and cross-asset market review

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

An uneasy feeling

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

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

 

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

 

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

Overseas weakness

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

 

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

 

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

 

A commodity price checkup

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

 

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

 

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

 

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

 

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

 

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

 

Bond rally = Rising risk aversion

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

 

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

The week ahead

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

 

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

 

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

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

Disclosure: Long SPXU

 

Sector and factor review: Not your father’s cycle

Posted by Cam Hui -

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

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

 

EM risk appetite rising

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

 

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

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

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

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

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

 

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

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

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

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

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

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

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

Sector analysis

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

Here is the RRG chart of the US market.
 

 

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

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

 

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

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

 

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

 

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

 

Factor analysis

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

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

 

 

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

 

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

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

 

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

Poised for a cyclical rotation

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

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

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

 

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

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

 

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

Not a normal cycle

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

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

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

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

He concluded:

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

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

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

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

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

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

 

Waiting for the July Jobs Report

Posted by Cam Hui -

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

 

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

Soft high frequency data

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

 

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

 

 

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

 

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

 

CARES Act 2.0

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

 

The market reaction

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

 

 

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

 

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

 

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

 

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

Disclosure: Long SPXU

Earnings Monitor: Big Tech surprises

Posted by Cam Hui -

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

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

 

Strong positive revisions

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

 

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

 

From the ground up

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

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

Here is a brief summary of the macro outlook:

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

 

The valuation debate

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

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

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

 

 

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

 

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

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

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

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

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

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

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

 

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

 

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

 

Earnings risk

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

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

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

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

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

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

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

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

 

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

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

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

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

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

 

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

 

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

An uneasy feeling

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Good news, bad news

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

 

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

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

Bearish warnings

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

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

 

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

 

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

 

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

 

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

 

Global weakness

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

 

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

 

Narrowing NASDAQ leadership

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

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

 

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

 

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

 

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

Growth at any price

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

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

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

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

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

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

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

 

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

 

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

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

 

The week ahead

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

 

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

 

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

 

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

 

Disclosure: Long SPXU

 

Fiscal cliff = Double-dip

Posted by Cam Hui -

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

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

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

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

 

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

Differences in policy time horizon

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

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

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

 

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

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

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

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

Assessing the damage

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

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

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

 

Other risks

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

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

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

 

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

 

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

 

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

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

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

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

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

A second demand shock

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

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

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

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

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

 

What gold tells us about Fed policy expectations

Posted by Cam Hui -

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

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

 

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

 

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

 

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

 

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

 

Brace for volatility

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

 

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

 

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

 

Stalling confidence

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

 

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

 

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

 

Earnings Monitor: A qualified upbeat tone

Posted by Cam Hui -

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

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

 

A qualified upbeat tone

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

 

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

 

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

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

From the ground up

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

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

Here is a summary of the macro outlook.

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Valuation still elevated

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

 

The market reaction

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

 

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

 

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

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

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

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

 

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

 

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

Stay tuned.

 

Warnings, warnings everywhere, but bears should not drink…

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Sentimental warnings

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

A relief rally may be in order early next week.
 

Cross-asset bearish tripwires

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

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

 

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

 

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

 

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

 

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

 

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

 

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

Waiting for Congress

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

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

 

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

 

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

 

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

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

 

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

 

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