Testing the lows

Posted by Cam Hui -

Mid-week market update: My last post (see OK, I’m calling it) in which I called a recession received a lot of attention. As recessions tend to be bull market killers, the challenge for investors and traders is to manage their investments during a recessionary bear market.

In the short run, the SPX is testing the lows set on Monday, while constructively flashing positive RSI divergences. As well, the VIX Index recycled below its upper Bollinger Band Tuesday, which is a tactical buy signal, and it stayed there today despite the support test.

Ripe for a rally

The market is wildly oversold by historical standards. If history is any guide, the readings for % bullish and % of stocks above their 50 day moving average (dma) are consistent with short-term bottoms.

Even in bear markets, similar oversold rebounds in the last 20 years have seen advances of 5-10% that last anywhere from three weeks to three months. Such bear market rallies have either failed and gone on to make new lows, or retraced the rally to the the previous low.

The stock market is ripe for an intermediate term rally. The relative performance of stocks to bonds, as measured by the SPY to TLT ratio, is testing a key relative support zone. During the last major bear market of 2007-2009, the market’s initial fall was also arrested by similar zone of relative support. Count on a bounce, followed by some choppiness.

Another sign of a bottom can be found in TLT, the long Treasury bond ETF. TLT is tracing what my former Merrill colleague Fred Meissner dubbed the “Prussian helmet” formation, which is an indication of buyer exhaustion. Now the price is reversing itself, the logical support zone is the breakout level at roughly 147.50. Since bond prices have been inversely correlated with stock prices, this is a sign that stocks are poised to rise.

Tactically constructive

The tactical outlook remains constructive for the bulls, short-term breadth was oversold despite yesterday’s advance. Readings from last night’s close indicate that readings were still in oversold territory, and it will be even more stretched after today’s market action.

The hourly SPY chart also constructively shows a test of support while exhibiting positive RSI divergences.

My inner investor is at a position of maximum defensiveness. My inner trader is still long the market, but he has set a stop level just slightly below today’s support levels.

Disclosure: Long SPXL

OK, I’m calling it…

Posted by Cam Hui -

While I may be jumping the gun on my model readings, I’m calling a recession.

Remember when oil prices tanked in the second half of 2014? The economy experienced a shallow industrial recession in 2015.
 

 

While history doesn’t repeat but rhymes, the price war that erupted over the weekend between Russia and OPEC is another threat to the growth outlook. Combined with the already fragile state of the economy from the coronavirus induced supply chain slowdown, it is difficult to see how the US economy can avoid a recession. George Pearkes at Bespoke came to a similar conclusion (via Business Insider).
 

Recessions are bull market killers

Remember, the historical evidence indicates that recessions are bull market killers.
 

 

The economy was already weakened by coronavirus induced supply chain disruptions. The latest Fed Beige Book stated that “economic activity expanded at a modest to moderate rate over the past several weeks, according to the majority of Federal Reserve Districts”, with an important caveat:

There were indications that the coronavirus was negatively impacting travel and tourism in the U.S. Manufacturing activity expanded in most parts of the country; however, some supply chain delays were reported as a result of the coronavirus and several Districts said that producers feared further disruptions in the coming weeks…Outlooks for the near-term were mostly for modest growth with the coronavirus and the upcoming presidential election cited as potential risks.

There were 9 references to covid-19 and 48 references to coronavirus in the report.

Now the economy is getting hit with an oil price war. The last time oil prices cratered in 2014, the economy experienced a shallow industrial recession in the following year. Today, earnings estimates are already starting to decline owing to coronavirus related concerns. It is difficult to know the full extent of the damage right now, but we know that it will be negative.
 

 

As a reminder, I highlighted the possible effects of a coronavirus sparked recession based on a 2005 CBO study (see A Lehman Crisis of a different sort):

The Congressional Budget Office conducted a study in 2005-06 that modeled the effects of a 1918-like Spanish Flu outbreak on the economy. The CBO assumed that 90 million people in the U.S. would become sick, and 2 million would die. Those assumptions are not out of line with current conditions. The population of the US is about 330 million, so an infection rate of 27% (90 million infected) and a fatality rate of 2% (1.8 million dead) are reasonable assumptions.

The CBO study concluded that a pandemic of this magnitude “could produce a short-run impact on the worldwide economy similar in depth and duration to that of an average postwar recession in the United States.” A severe pandemic could reduce GDP by about 4.5%, followed by a V-shaped rebound. Demand shocks would also be evident, with an 80% decline in the arts and entertainment industries and a 67% decline in transportation. Retail and manufacturing would drop 10%.

On the weekend (see Has the bull caught the coronavirus), I estimated the downside risk for the S&P 500 at 1600 to 2165, which represents a peak-to-trough drop of -36% to -53%. That is now my base case scenario.

I also observed that the monthly MACD indicator had flashed sell signal, but it is not confirmed until we see the month-end closing price. While I am keeping an open mind, it would take a significant rally to avoid a sell signal by month end.
 

 

A recession is on the way, and so is an equity bear market.
 

For investors

Accounts with long-term horizons should therefore assume maximum defensive positioning, as defined in their investment mandates, in their portfolios.

I have an Ultimate Market Timing Model that is based on the following two components:

  • A Trend Asset Allocation Model which applies trend following techniques to a variety of global equity and commodity prices. That model has flashed a risk-off signal for several weeks.
  • A macro-economic overlay designed to spot a recession. 

In the long run, equities have shown strong returns in the absence of existential social risks, such as war and rebellion. Trend following model signals can be overly frequent and misleading for investment accounts with long-term horizons. The combination of a macro overlay to a trend following model is therefore an ideal solution for long-term investors who don’t want excessive trading in their portfolios.

In light of the recession call, the Ultimate Model signal has moved from risk-on to risk-off. It should remain risk-off until the Trend Model reverses itself.

There will undoubtedly be rallies, and bear market rallies tend to be of the “rip your face off” variety. Investors should take such opportunities to sell into strength and reduce their equity positions.
 

For traders

In the current environment, traders should focus more on risk than return. While this may sound obvious, it bears repeating. Volatility rises in bear markets, and traders should therefore adjust their position sizes accordingly for risk control purposes. As well, traders should pay special attention to above comment about “rip your face off” rallies.

In the short run, the market was already oversold on Friday and the market is poised for a relief rally. While Index Indicators has not updated their readings at the time of publication, short-term breadth will be even more oversold.
 

 

Sentiment readings are so stretched that the market is poised for a 1-2 month face ripping rally (see A stock market roller coaster). We just don’t know when it begins. In light of the negative development on oil prices, it was no surprise that the market fell. What was a surprise was the index exhibited positive RSI divergences while making new lows.
 

 

Chad Gassaway pointed out that the short-term record of post -7% single-day losses has been bullish. If history is any guide, we should see a rebound that peaks out after three days with a high win rate.
 

 

My inner trader initiated a small long position last Friday, and he added to his long today in anticipation of the relief rally.

Disclosure: Long SPXL

 

A stock market roller coaster

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: Buy equities
  • Trend Model signal: Bearish
  • 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.

Here we go again?

For two consecutive Fridays, the market has rallied into the close to exhibit hammer-like reversal candles. The first candle reversal was confirmed by a massive 4.3% surge on the following Monday, will the same happen this coming Monday?

While I am cautiously bullish at a tactical level, it could also be argued that the market has not sufficiently tested the February lows. Should stock prices retreat to test those lows early next week, the bulls can take some comfort that any test would likely be accompanied by positive 5 and 14 day RSI divergences. On the other hand, the bears are likely to defend the highs set in the rally last week, which could make trading the market an interesting challenge.

Investors and traders should brace for more thrills from the market roller coast.

Sentiment buy signals everywhere

Sentiment buy signals are popping up everywhere. One useful sentiment indicator is the capitulation shown by the NAAIM Exposure Index, which measures the views of RIAs managing individual client funds. This index skidded below its 26-week Bollinger Band, which historically has signaled good bullish entry points to the stock market.

Similarly, Market Vane bulls has fallen to the levels last seen in 2010 and 2011. Readings were only exceeded by the market crash of 2008-09.

The normalized equity-only put/call ratio has spiked to levels that has marked tradable bottoms in the past.

The VIX Index spiked over 50 last week, which is extremely high by historical standards. It did not even reach these levels during the Russia Crisis, or the NASDAQ top of 2000. Similarly, the degree of VIX term structure inversion has only been exceeded during the market crash during the Great Financial Crisis.

Sentiment models are very washed out.

Momentum sell sginals

Arguably, this time is different inasmuch as the market pullback is occurring in conjunction with a Fed inter-meeting rate cut. The Fed doesn’t usually just cut rates out of the blue, this was an emergency action. The word “emergency” should be a flashing warning that there is something seriously wrong with the economy.

From a long-term technical perspective, the monthly MACD model has negated a recent buy signal and flashed an interim sell signal for the market, which can only be confirmed if the index closes at these levels at the end of March. Past buy signals have usually led to prolonged bull phases, and this potential bearish development is highly unusual.

MACD sell signals are the result of negative price momentum. As an example of negative price momentum, Jeff Hirsch found that the combination of a down January and down February has led to subpar equity returns for the remainder of the year.

There are also worrisome signs from fundamental and macro perspectives as well. FactSet reported that Street analysts are starting to downgrade their earnings estimates, indicating bearish fundamental momentum.

In addition, some cracks are appearing in the labor market. Despite the blow-out Jobs Report, leading indicators such as temporary employment, and the quits to layoffs rate (which will be updated next week in the JOLTS report), are exhibiting signs of weakness. These troublesome signs are showing up during a period that pre-dates any effects of the COVID-19 outbreak in the US. What happens in March, when the full effects of the coronavirus slowdown hit the economy?

Bull or bear?

Here is how I resolve the bull and bear cases. Arthur Hill at StockCharts questioned the usefulness of traditional technical analysis techniques because he believes that the market environment has switched from bull to bear:

Support levels and bullish retracement zones are questionable, at best, in bear market environments. Why? Because the path of least resistance is down in a bear market. As such, the odds that a support level holds or a bullish retracement zone leads to a reversal are greatly reduced. The odds favor bearish outcomes and bearish resolutions during bear markets.

Even though the S&P 500 is battling its 200-day SMA this week, I am in bear market mode because the breadth models at TrendInvestorPro.com turned bearish for the first time since early September. This means support levels and bullish retracement zones are much less reliable.

If a bear market has indeed begun, one sign of a bottom is insider buying. There were clusters of insider buying during 2008, 2011, and in late 2018. There is no such signs today.

While I am not ready to officially declare a bear market, or a recession just yet, traders should prepare for bear market style volatility, at least for risk control purposes.

Here is how that scenario would play out in the context of my Ultimate Intermediate Bottom Spotting Model. This model flashes a buy signal whenever both the Zweig Breadth Thrust Indicator becomes oversold (check), and the McClellan NYSE Summation Index (NYSI) is negative (check). This model flashed four buy signals during the bear market of 2007-09. In each case, the market staged a relief rally, but the rally failed as stock prices retraced the gains to new lows in each of the cases.

Looking to the week ahead, the market reached an oversold condition consistent with a relief rally. While short-term breadth could weakens slightly further, downside risk is relatively limited.

The hourly S&P 500 chart provides some guides to rally targets. At a minimum, the gap at 3000 should be filled. The 50% retracement level of 3124 had acted at resistance in the past, and the bulls will find it to be a formidable obstacle. Above 3124 is the gap at 3260-3330 that needs to be filled, followed by a test of the old highs. I am not holding my breath for an advance beyond the 50% retracement level.

My inner investor is adopting a risk-off profile in his portfolio, with an underweight position in equities. My inner trader took and initial long position on Friday. Should the market weaken further early in the week and the market continues to exhibit positive RSI divergences, he will add to his long positions.

Disclosure: Long SPXL

Has the bull caught the coronavirus?

Posted by Cam Hui -

Is the bull on his last legs? It is starting to look that way. I alerted readers to an unconfirmed bullish monthly MACD buy signal in late July (see A (deceptive) long term buy signal). The buy signal was confirmed in late October by both the Wilshire 5000 and non-US markets (see Buy the breakout, recession risk limited). In the past, monthly MACD buy signals have usually been very effective and long lasting. The recent market downdraft has brought the indicator to the verge of a sell signal, indicating dying price momentum and the possible end of the bull phase. If the market were to end the month at these levels, the sell signal would be confirmed.

A similar bearish condition can be found in the MSCI World xUS Index.

Is the bull dying? Has it caught the coronavirus?

Possible recession ahead

It may be turning out that way. We are teetering on the edge of a possible recession. The COVID-19 epidemic has spread beyond China’s borders, and efforts to contain and mitigate the effects are creating both supply and demand shocks that are hampering economic growth.

Even worse, Chinese scientists announced that the virus has probably genetically mutated to two variants: S-cov and L-cov. The L-cov variant is more dangerous, featuring higher transmission rates and more harm on the respiratory system (see link to paper). This finding will make efforts to combat the virus more difficult.

Leading economist Ken Rogoff is already forecasting a recession.

It is too soon to predict the long-run arc of the coronavirus outbreak. But it is not too soon to recognise that the next global recession could be around the corner – and that it may look a lot different from those that began in 2001 and 2008.

For starters, the next recession is likely to emanate from China, and indeed may already be under way. China is a highly leveraged economy, it cannot afford a sustained pause today anymore than fast-growing 1980s Japan could. People, businesses and municipalities need funds to pay back their out-size debts. Sharply adverse demographics, narrowing scope for technological catch-up, and a huge glut of housing from recurrent stimulus programmes – not to mention an increasingly centralised decision-making process – already presage significantly slower growth for China in the next decade.

Austan Goolsbee explained the economic risks in a New York Times op-ed this way. The US has a much larger service economy compared to China, and social distancing could tank growth if fear levels spike.

But over all, the United States is substantially more reliant on services than China is. And, on the flip side, agriculture, a sector not noted for day-to-day social interaction and so potentially less harmed by social withdrawal, is a 10 times larger share of China’s economy than it is in the United States.

So for all the talk about the global “supply shock” set off by the coronavirus outbreak and its impact on supply chains, we may have more to fear from an old-fashioned “demand shock” that emerges when everyone simply stays home. A major coronavirus epidemic in the United States might be like a big snowstorm that shuts down most economic activity and social interaction only until the snow is cleared away. But the coronavirus could be a “Snowmaggedon-style storm” that hits the whole country and lasts for months.

Ray Dalio also fretted about a slowdown, which is exacerbated by inequality, the politics of populism, and ineffective policy.

Reactions to the virus (e.g., “social distancing”) will probably cause a big short-term economic decline followed by a rebound, which probably will not leave a big sustained economic impact. The fact of the matter is that history has shown that even big death tolls have been much bigger emotional affairs than sustained economic and market affairs. My look into the Spanish flu case, which I’m treating as our worst-case scenario, conveys this view; so do the other cases.

While I don’t think this will have a longer-term economic impact, I can’t say for sure that it won’t because, as you know, I believe that history has shown us that when a) there is a large wealth/political gap and there is a battle against populists of the left and populists of the right and b) there is an economic downturn, there are likely to be greater and more dysfunctional conflicts between the sides that undermine the effectiveness of decision making, and this is made worse when c) there are large debts and ineffective monetary policies and d) there are rising powers challenging the existing world powers. The last time that happened was during the 1930s leading up to World War II, and the time before that was in the period leading up to World War I. Certainly, the wealth gap and political conflict leading to possible policy changes will be top of mind along with the coronavirus on this Super Tuesday.

Ed Yardeni also issued a warning for the stock market:

The S&P 500 VIX has soared in recent days as it did during numerous previous panic attacks since the start of the current bull market. The risk is that the pandemic of fear unleashed by the global health crisis depresses economic demand and disrupts supply chains. That could squeeze business cash flow and trigger a credit crunch. The result could force companies to lay off workers and cause a recession. Unfortunately, this scenario is becoming increasingly possible. The Fed is likely to lower the federal funds rate to zero and restart QE bond purchases to avert this scenario.

Recessions kill bulls

Recessions are bull market killers through two mechanisms. Corporate earnings fall in a recession, and stock prices fall further because of fears that lead to P/E compression.

Let us consider each of these factors, one at a time. A recent Bloomberg article reported that some top-down analysts are revising their earnings outlook downwards. Bespoke Investment Group outlined a scenario which shrank earnings by 20%. Citigroup Inc. cut their 2020 earnings forecast from $174.25 to $164.25 in 2020, or -5.8%. Carl Quintanilla at CNBC reported that Citigroup would cut its EPS forecast by $30, or -17%, if a recession were to materialize.

The chart of past earnings declines, recessions, and world exports puts the earnings declines into some context. This analytical framework is important because the coronavirus induced slowdown disrupts global supply chains, which puts downward pressure on exports. The last two recessions were historically atypical. The GFC of 2008 was a financial crash. The 2000 slowdown was caused by the bursting of the NASDAQ Bubble fueled by excessive speculation. You would have to go back to 1990-91 and 1981-82 to find more typical recessions. The 1990 experience was sparked by Saddam Hussein’s invasion of Kuwait, which caused an oil supply shock, and the 1982 period was the result of excessively tight monetary policy designed to squeeze inflationary expectations.

In both the 1982 and 1990 recessions, earnings declined by about -10%. A coronavirus induced recession should be relatively short. Therefore projections of -17% (Citigroup) and -20% (Bespoke) in earnings may be excessive.

The other way that recessions kill bull markets is through P/E compression. How far can multiples fall? Analysis from FactSet shows that the forward multiple fell to about 13.5 times earnings at the market bottom in late 2018, and to about 10 times at the 2011 bottom.

My estimate of forward 12-month EPS based on FactSet data stands at 178.17 today. If we assume a cut of -10% to earnings, and apply a 10 to 13.5 multiple to those earnings, it would yield S&P 500 downside targets of 1600 to 2165. This represents a peak-to-trough drawdown of -36% to -53%, or -25% to -45% downside potential from current levels.

Trump’s Waterloo?

There is another bearish factor that investors should consider. Informal polls at a Goldman Sachs events in late January revealed that almost all participants expect Trump to be re-elected in November.

Wall Street is going to have to readjust its expectations going forward. As the purpose of this publication is to deliver alpha, its purpose is to be apolitical and this is not intended to favor one candidate over another. Nevertheless, Trump is likely to face some headwinds over his re-election bid, which would a rude surprise for equity bulls.

At the start of Trump’s term, Newt Gingrich laid out Trump’s re-election chances in a New York Times interview:

“Ultimately this is about governing,” said former House Speaker Newt Gingrich, who has advised Mr. Trump. “There are two things he’s got to do between now and 2020: He has to keep America safe and create a lot of jobs. That’s what he promised in his speech. If he does those two things, everything else is noise.”

“The average American isn’t paying attention to this stuff,” he added. “They are going to look around in late 2019 and early 2020 and ask themselves if they are doing better. If the answer’s yes, they are going to say, ‘Cool, give me some more.’”

Up until recently, the economy had been performing well, but if a COVID-19 induced recession were to begin in Q1 or Q2, it would focus the electorate’s attention on Trump’s economic stewardship. Trump has like to style himself as “Dow Man” and measure his economic success by the stock market. While stock prices have risen during his term, an investor would have outperformed with the long Treasury bond (bottom panel).

Even though Joe Biden won a resounding victory on Super Tuesday, the COVID-19 outbreak is shining a bright spotlight on the GOP’s healthcare initiatives in a way that moves the Overton Window, or range of acceptable political discourse, towards the Sanders/Warren wing of the Democratic Party and greater acceptance of socialized medicine.

The US economic system is designed in a way that is ripe to enhance the spread of a viral outbreak compared to other major developed economies. It has roughly 30 million people without health insurance, and another 80 million who have coverage with high co-pays. (For non-Americans, a co-pay is a deductible that patients pay their doctors and healthcare providers on every visit). In addition, the workforce is composed of an army of hourly wage earners and gig workers with no sick days. These are the service industry workers who stock the grocery shelves, the baristas, the restaurant cooks and servers, and Uber drivers. Moreover, it is unclear who bears the cost if forced into mandatory isolation. An average day in an American hospital costs $4,293, according to the International Federation of Health Plans, and has the potential to bankrupt individuals forced into isolation. This structure creates enormous disincentives for someone who is too ill to work and infect others, and highlight the inequality problem raised by Sanders, AOC, and others.

For a stark reminder of how the healthcare system functions, consider this account from the New York Times about an American who was evacuated from Wuhan.

Frank Wucinski and his 3-year-old daughter, Annabel, are among the dozens of Americans the government has flown back to the country from Wuhan, China, and put under quarantine to check for signs of coronavirus.

Now they are among what could become a growing number of families hit with surprise medical bills related to government-mandated actions.

The American structure of health insurance raises the question of the financial cost of healthcare access. The quarantine was government mandated, but it was unclear who actually pays.

After their release from quarantine, Mr. Wucinski and his daughter went to stay with his mother in Harrisburg, Pa. That’s where they found a pile of medical bills waiting: $3,918 in charges from hospital doctors, radiologists and an ambulance company.

“I assumed it was all being paid for,” Mr. Wucinski said. “We didn’t have a choice. When the bills showed up, it was just a pit in my stomach, like, ‘How do I pay for this?’”

Mr. Wucinski’s employer, a standardized testing company, provided health benefits when he lived in China but does not offer coverage in the United States.

Patients in the United States regularly confront surprise medical bills that are hard to decode. Mr. Wucinski’s case suggests that those held in mandatory isolation for suspected coronavirus may be no exception.

Co-pays, out-of-network providers, and uninsured procedures are problems faced by Americans every day. Is it any wonder why socialized medicine would become a more attractive option should an epidemic hit the US?

As well, the GOP’s efforts to dismantle the Affordable Care Act, or Obamacare, will not help its electoral chances in the current environment. ACA approval has been rising steadily, and the Supreme Court has accepted a case that challenges the ACA, with arguments to be heard in the fall, and a decision rendered in 2021. The timing of the challenge only serves to highlight the GOP’s vulnerability on the healthcare issue in the current environment.

Trump’s “Dow Man” persona is putting him at elector risk. He will have to make a key political choice of trading off economic activity against the health of Americans. How he makes that choice, and how he is perceived to make that choice, could very well be a major campaign issue in the November election. As an example, one key electoral vulnerability for the GOP is Florida, which is a swing state with a high number of aged Americans who have tilted Republican. It is well known that the mortality rate rises with age, and Trump’s trade-off decision could easily tilt how this demographic votes in November.

To be sure, there are no warning signs of recession in the hard data. New Deal democrat‘s monitor of high frequency data shows that consumer spending is still strong. However, as the epidemic progresses, containment and mitigation policies will undoubtedly force more draconian steps, such as school closings, and the curtailment or cancellation of major events like Emerald City Comic Con (in Seattle next week), SXSW, and March Madness. Such steps have the potential to induce panic, or at least a higher level of concern, in the population. Steps to raise social distancing are also likely to cause a demand shock, as spending and travel plans are curtailed.

Watch consumer spending. It’s the key to whether the economy rolls over into recession.

Investment implications

What does all this mean for investors?

I generally try to be disciplined in my investment process, and I don’t like to frontrun my model readings. my inner investor is therefore not calling for an end to the bull market just yet, but risk levels are rising. Notwithstanding whether a recession is in the cards, my Trend Asset Allocation Model already moved to a risk-off reading recently, and my inner investor’s portfolio asset allocation is already becoming more defensively oriented.

The Fed’s emergency rate cut is disconcerting. Inter-meeting rate cuts are emergencies, and emergencies have historically been unfriendly to equity returns. Even before the Fed’s rate cut, I suggested last week that something was seriously afoot in the economy (see A Lehman Crisis of a different sort). While the stock market may stage a short-term relief rally from these levels, historically it has not performed well over a 6-18 month time horizon.

However, my inner trader has a shorter time horizon, and he is operating on the assumption that a bear market may be starting. That means the market will be volatile, and position sizes should be adjusted accordingly. He is shifting to the mindset that the primary trend is down. In that case, any market rallies could be violent counter-trend moves.

While I am not prepared to call a recession just yet, I am going on recession watch. Events are unfolding in the US that could set off panic. Already, one school district in Washington State has closed schools (see notice here).  A recent Harvard Business Review article suggests that we could see widespread operational business disruptions by mid-March.

As a result of events such as the 2002-2003 SARS epidemic, the March 2010 Iceland’s volcano eruption, Japan’s earthquake and tsunami in March 2011, and the flood in Thailand in August 2011, companies increased the amount of inventory they keep on hand. But they still usually carry only 15 to 30 days’ worth of inventory. It is possible that the Chinese New Year week-long vacation motivated some companies to increase their inventory coverage by another week. So, for most companies, the inventory coverage they have will allow them to match their supplies with demand, with no additional supply, for between two to five weeks, depending on the company’s supply chain strategy. If the supply of components is disrupted longer, manufacturing will have to stop.

Supply lead times will also have an impact. Shipping by sea to either the U.S. or Europe takes, on average, 30 days. This implies that if Chinese plants stopped manufacturing prior to the beginning of the Chinese holiday on January 25, the last of their shipments will be arriving the last week of February.

All this suggests that there will be a spike in the temporary closures of assembly and manufacturing facilities in mid-March.

Events like school closings and production disruptions will create widespread psychological impact and affect both business confidence and consumer behavior. I will be monitoring how events unfold, as well as the business environment and retail spending.

So far, high frequency data like retail sales and initial jobless claims remain upbeat. This chart from The Times shows the level of coronavirus fear by country.

So far, the rise in anxiety levels have been limited. Reuters reported that “Americans divided on party lines over risk from coronavirus”. Democrats report a higher level of concern of risk over the COVID-19, while Republicans have shown minimal concern, largely because Trump has downplayed the risks. As the incidence of infections spread, watch for fear levels to rise. that’s when the high frequency economic data will become critically important to how we make a recession call.

Stay tuned.

As well, don’t miss our tactical trading commentary schedule to be published tomorrow.

Waiting for the re-test

Posted by Cam Hui -

Mid-week market update: The hourly SPX chart shows that the index rallied strongly on Monday. The rally filled two downside gaps and it is testing the 50% retracement level..
 

 

While many of the short-term models are screaming “buy”, there are contrary indicators and models that suggest caution. Even though my inner trader has largely been tactically correct in his trading calls, his head is hurting from the wild swings and market volatility.
 

Buy signals everywhere

Short-term buy signals are popping up everywhere. The VIX Index recycled below its upper Bollinger Band after a four-day upper BB ride.
 

 

Such episodes of VIX upper BB recycles have historically been bullish. The bottom rows in the table below shows that signal alpha is positive out to five days, and then starts to flatten out. Tuesday was Day 1.
 

 

As well, my Trifecta Bottom Spotting Model has flashed a trifecta buy signal. The Stockcharts data feed on TRIN has been inaccurate and problematical. My manual calculation based on WSJ closing data shows a TRIN closed Tuesday at 2.33. The market should be ready to rip upwards.
 

 

In addition, my Ultimate Bottom Spotting Model flashed a buy signal based on Tuesday night’s closing data. Stockcharts is slow at producing the Zweig Breadth Thrust Indicator, so I created an estimate of my own (bottom panel). Based on last night’s close, the ZBT Indicator was oversold and NYSI was negative – which calls for an intermediate term buy signal.
 

 

This should all be wildly bullish, right?
 

Fundamental caution

The answer is a qualified yes. As the chart of the Ultimate Intermediate Bottom Model shows, the buy signals still marked short-term bottoms during the last bear market. Current market behavior are suggestive that we may be in the first downleg of a major bear.

Exhibit A is II sentiment. While the bull-bear spread is low enough to signal a relief rally, durable bottoms are not made until bearish sentiment (blue line) spikes.
 

 

Exhibit B is the 4.3% rally on Monday. Markets generally don’t rally that strongly in bull markets, but these wild swings usually occur in bear markets.

As well, the Federal Reserve announced a emergency 50bp rate cut Tuesday. Emergency rate cuts that occurred between FOMC meetings have historically signaled major dislocations. If the Fed found it fitting to cut 50bp, surely there must be more bad news lurking around the corner.
 

 

Analysis from Goldman Sachs shows that emergency cuts have not been friendly to stock prices, especially if you look out six months or more.
 

 

Which historical studies should we believe? If we were to assume that the global economy is undergoing a major dislocation which requires coordinated intervention, can we really rely on historical studies of signals that are mostly based on what happens during bull markets?
 

Chop, chop, re-test

Here is a historical study that may be of value in the current situation. Analysis from ISI/Evercore shows how the market behaved after a 10% weekly correction.
 

 

Here are my takeaways from that study:

  • All of these episodes occurred during periods of great market stress, such as the Great Depression, the Fall of France in 1940, the Crash of 1987, and so on.
  • The market rebounds in the first week, but the returns flatten out between 1 and 4 weeks, indicating a choppy market..
  • When the market did rally after a weekly correction of 10% or more, it tended to retrace between 40% and 44% of the decline. The latest rally touched the 50% retracement level and stalled. This suggests that upside potential to the latest rebound may be capped out.

I therefore expect more short-term choppiness going forward, and a re-test of last week’s lows in the near future. There is no guarantee that the re-test will be successful, but I will be watching to see if we see positive RSI divergences on the re-test.
 

 

My inner trader’s head is hurting from trying to trade all this volatility. Subscribers received an email alert that he took profits in his long positions yesterday (Tuesday). He is stepping to the sidelines and holding 100% cash in wait of a better trading setup.
 

A Chinese glass half full, or half empty?

Posted by Cam Hui -

The data points closely watched this past weekend were the releases of China’s Purchasing Manager Index (PMI) readings. On Saturday, China reported that its February manufacturing PMI had missed expectations and skidded to 35.7, and services PMI also missed and printed at 29.6. Both readings were all-time lows.
 

 

The Caixin private sector PMI also fell to an all-time low on Monday.
 

 

Was these misses surprises? Yes and no. They were surprises inasmuch as the market partly expected the authorities to manipulate the numbers and report a less severe downturn. They were no surprise as the Chinese economy was obviously very weak in the wake of the COVID-19 coronavirus epidemic gripping the country.
 

Returning to work?

On the other hand, there was emerging evidence that China is returning to work. The Credit Suisse estimates of China’s labor utilization rate has been rising.
 

 

A Marketwatch interview with Leland Miller, the CEO of China Beige Book (CBB), indicated that CBB’s bottom-up surveys found that China’s weakness is worse than reported, but the situation is improving.

MarketWatch: What does China’s economic situation mean for the rest of the world – markets, economic growth, supply chains, and so on?

Miller: I would expect the data to get better if only because in March you’ll see firms back to work and the outbreak will hopefully be less terrible. Conditions — and data — should improve. But the implications of data anywhere near this bad is: China is an important cog in the supply and demand chains of the world. Globalization runs through China. Car factories around the world can’t build their cars because they can’t get their inputs from China. China buys a lot of commodities — oil and so on. Even if the outbreak can be contained, which doesn’t look like it, the economic impact can’t be.

As well, the fine print buried in the Saturday PMI report was a survey question for firms which asked when they expect to be back in business. 90.8% by end of March. But then, the Street expected China to be fully back to work by the end of March.

Is the glass half full, or half empty?

You can tell a lot about market psychology by observing how it responds to news. This news could be interpreted in both bullish or bearish ways. Notwithstanding how equity markets have behaved overnight and before the New York open, the more important barometer of sentiment on China is how its currency behaved. The offshore yuan (USDCNH) strengthened after the market opened at the Asian open, and it has remained strong.
 

 

The market thinks the glass is half full. Risk on (at least for now)!

 

Panic City!

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: Buy equities
  • Trend Model signal: Bearish (downgrade)
  • 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.
 

Fun with mystery charts

This time last week, I was cautiously bearish (see Correction ahead?), but I never imagined that stock prices would crater as far as they did. My social media feed is full of narratives of how unprecedented and insane the market decline has been. One such example is the comparison of the “coronavirus crash” to other major market events in the last 100 years.
 

 

This week, rather than just dwell on how extreme last week’s market action was, I would instead like to put on a technical analyst hat and consider the following three mystery daily charts. Which would you buy, or sell? Which is your favorite? Did you wish you had bought one or all of time in the past two weeks?
 

 

The analysis is far more revealing about market internals and likely future action than more hand wringing about how oversold and washed out the stock market has become.

Answer is below – no peeking now!
 

 

Mystery charts revealed

Here are the mystery charts, revealed.
 

 

The top chart is the inverted S&P 500. Sometimes analyzing a chart upside can be more revealing than seeing it right-side up. The upside down chart shows the index in a parabolic and extended move. The index is now encountering a “resistance” zone where the “rally” may stall. If you own stocks, do you feel a bit better about that analysis now?

The middle chart is the price of the long Treasury bond, as represented by the ETF TLT. It is behaving more or less in a way that you would expect an equity market hedge to behave. As stock prices weakened, TLT staged an upside breakout about 10 days ago. Even so, there were some anomalous signals from the bond market that could give equity bulls a ray of hope (more on that below).

The bottom chart is gold. As expected, gold prices shot up when stocks cratered, but a funny thing happened. Gold fell, which is not what you expect an equity hedge to do. Joe Wiesenthal at Bloomberg explained the anomaly this way:

Earlier this week I wrote about gold, and how it’s a good volatility hedge, but only up to a point. It stops being a good volatility hedge when you start getting anxious about managing cash flow and paying your bills. Since the world runs on U.S.-dollar denominated liabilities, when the bill collector (or the tax collector, or the margin clerk, or the landlord) comes knocking, you need cash. And selling gold might be one of your only options. We might be seeing a little bit of that effect emerge. This morning markets are selling off again, and Treasuries are surging, and yet gold is red.

In other words, when the margin calls arise and all correlations go to 1, gold prices will get taken down. Such episodes are usually seen at the tail-end of market sell-offs, when the margin clerks take over and price insensitive selling takes over. That’s usually a signal of a short-term bottom.
 

A climactic reversal?

The market is obvious very oversold. Only 0.4%, or two stocks, in the S&P 500 are above their 10 day moving average. There have only been two similar episodes in the last 5 years, and both saw the market stage relief rallies almost immediately.
 

 

Friday’s market action may be the signals of a possible climactic reversal by tracing out a hammer candlestick on Friday. The market gapped down and fell hard at the open. It proceeded to chop around and strengthened at the end of the day with a close that was significantly higher than the open. While hammer patterns are often signs of selling exhaustion, some doubt could be cast on the pattern because it occurred on a Friday. The end of day rally could be the result of short covering by traders who did not want to enter the weekend with a short position because of event or announcement risk.
 

 

One reason for the late day rally was the central bank response to the market’s risk-off tone. Global central bankers have pumped billions of liquidity into the financial system, and there were rumors of an announcement of coordinated easing on the weekend.
 

 

This possible price reversal that needs to be confirmed by market strength on Monday. Otherwise, all bets are off.
 

Green shoots

The astute technician can find selected green shoots for the bulls if he looked in the right places. I pointed out yesterday that the cyclically sensitive copper price managed to hold support, which is constructive for signs of cyclical strength.
 

 

As well, has anyone been watching the yield curve? The 3m10y had inverted, which was freaking out some traders worried about a recession. But even as stock prices cratered, did anyone notice that the 2s10s and 10s30s were steepening? A steepening yield curve, even when bond prices are rallying (and therefore yields are falling, see above TLT mystery chart), is usually a signal that the market expects accelerating growth.
 

 

The Fear and Greed Index is now below 20, which is a necessary but not sufficient condition for a market bottom.
 

 

In fact, SentimenTrader‘s Fear and Greed proxy reached a reading of 0 on Friday. Past episodes have been resolved with strong positive returns.
 

 

An imminent bounce?

I could go on and on about how stretched fear and technical indicators are to the downside. The blogger Macro Charts wrote this weekend that his core indicators are all “max oversold”. His analysis is well worth reading in its entirety, but here is the summary:

  • One of the steepest 1-week market plunges of all time could be nearly over – Nasdaq futures even briefly exceeded the worst 1-week loss in October 2008, the core of a historic Bear market.
  • Extreme and historic oversold signals are being generated across nearly all core datasets I run & monitor.
  • Based on prior historic signals, there is a chance (no guarantee) markets bottom and reverse very soon – need to monitor for price reversals to confirm the turn.
  • The subsequent rally could very quickly retrace at least half of the decline within a very short period. Again, no guarantees.
  • How the leading Stocks (particularly broad Tech) behave over the next several weeks will be key for the market to repair the damage and re-establish the foundation for a bigger rally into potentially Q2-Q3.

Rob Hanna at Quantfiable Edges observed that his Capitulative Breadth Index (CBI) was on track to spike to 39 on Thursday, where normally a CBI of 10 or more is a buy signal. He went on to list the occasions when CBI was over 20. I have highlighted the three instances when CBI was 30 ore more. Though the sample size is extremely small, my unscientific small sample conclusion is, unless you believe that this is 2008 all over again (and we haven’t had a Bear Stearns or Lehman Brothers failure that could spark a panic), a relief rally is imminent.
 

 

The Trend Asset Allocation Model has turned bearish. This is a trend following model that is slow at turning points, which is a feature, not a bug. My inner investor was already neutrally positioned before the stock market carnage, and the decline has already naturally lowered the equity weight in his portfolio and raised his bond weight. He will maintain a risk-off stance, and he expects to reduce risk on any equity rally that may occur in the near future.

The market may bounce next week, but the rally is unlikely to be durable. One worrisome sign for the bulls is hedge funds are still bullishly positioned. The fast money have not capitulated out of their long positions. The Commitment of Traders report (from Tuesday) shows that large speculators, which are mostly hedge funds, are still net long high beta NASDAQ 100 futures.
 

 

Subscribers received an email alert on Thursday that my inner trader had dipped his toe in on the long side of the market. My inner trader is bullishly positioned, but with a lower than normal position size because of high market volatility.

An analysis of the hourly S&P 500 chart shows that both the 5 and 14 hour RSIs have recycled, which are tactical buy signals. It is difficult to set an upside target as there are many downside gaps that could be filled. A reasonable guesstimate would be a 50% retracement of last week’s move at 3125.
 

 

Needless to say, there are no guarantees in such an uncertain environment.

Disclosure: Long SPXL

 

A Lehman Crisis of a different sort

Posted by Cam Hui -

Remember the Lehman Crisis? The failure of Lehman Brothers marked the start of the Great Financial Crisis that destabilized and almost brought down the global financial system.

What we are seeing is a Lehman Crisis of a different sort. The Lehman Crisis of 2008 was characterized by financial institutions unwilling to lend to each other and banking system liquidity seized up.

Today’s version of the Lehman Crisis is characterized by countries and regions in lockdowns, and the propensity of individuals or groups to increase their social distance, either owing to quarantine, or by fear. This is leading to both supply and demand shocks. It is a supply shock because production and transportation are seizing up, which is leading to a collapse in global trade. Even before the onset of the COVID-19 outbreak, global trade had been weak. It is about to become even weaker.
 

 

It is also a demand shock because when social distance rises, it leads to a collapse in the demand for goods and services. As an example, France’s Finance Minister Bruno Le Maire told CNBC at the G-20 meeting that tourism had fallen 30-40%.
 

The outbreak is not “contained”

The latest update from Johns Hopkins shows that the spread of the COVID-19 virus is growing steadily outside China. Infectious clusters in South Korea, Japan, Italy, and Iran show that the strategy of containment has not been very effective. Much of northern Italy is in lockdown.
 

 

The New York Times reported that CDC officials are warning Americans to prepare for an outbreak:

Federal health officials starkly warned on Tuesday that the new coronavirus will almost certainly spread in the United States, and that hospitals, businesses and schools should begin making preparations.

“It’s not so much of a question of if this will happen anymore but rather more of a question of exactly when this will happen,” Dr. Nancy Messonnier, director of the National Center for Immunization and Respiratory Diseases, said in a news briefing.

She said that cities and towns should plan for “social distancing measures,” like dividing school classes into smaller groups of students or closing schools altogether. Meetings and conferences may have to be canceled, she said. Businesses should arrange for employees to work from home.

“We are asking the American public to work with us to prepare, in the expectation that this could be bad,” Dr. Messonnier said.

The American healthcare system does not appear to be very prepared for an outbreak. To start, virus testing capability is limited. Initially, tests to identify infected patients had to be sent to the CDC lab in Atlanta. The CDC has now sent out test kits to state and local authorities in all 50 states, but at the time of this writing, only three states, California, Illinois, and Nebraska, can actually conduct the tests. The New York Times reported that a California coronavirus patient had to wait days to be tested because of the CDC’s strict screening criteria for conducting tests. If you can’t look for an infection or you are unwilling to look, how will you even find it?

While the CDC has conducted hundreds of tests for the coronavirus, South Korea has tested tens of thousands to identify possible victims.

In addition, Axios reported that much of the supply chain of pharmaceutical drug production is locked up in China. While not all of the pharmaceutical plants are in China, much of the precursor materials are principally sourced from China, and a prolonged Chinese production slowdown could cause worldwide drug shortages.

About 150 prescription drugs — including antibiotics, generics and some branded drugs without alternatives — are at risk of shortage if the coronavirus outbreak in China worsens, according to two sources familiar with a list of at-risk drugs compiled by the Food and Drug Administration.\

An 2019 article by the Council on Foreign Relations made a similar point about supply chain vulnerability:

As Rosemary Gibson noted in her testimony, centralization of the global supply chain of medicines in a single country makes it vulnerable to interruption, “whether by mistake or design.” If we are dependent on China for thousands of ingredients and raw materials to make our medicine, China could use this dependence as a weapon against us. While the Department of Defense only purchases a small quantity of finished pharmaceuticals from China, about 80 percent of the active pharmaceutical ingredients (APIs) used to make drugs in the United States are said to come from China and other countries like India. For example, the chemical starting material used to make doxycycline, the recommended treatment for anthrax exposure, comes from China. When an influential Chinese economist earlier this year suggested that Beijing curb its exports of raw materials for vitamins and antibiotics as a countermeasure in the trade war with the United States, the worries surrounding our API dependence to China seemed to be vindicated. Concern about a disruption in the supply chain could explain why the tariffs on Chinese products proposed by the United States Trade Representative in May 2019, worth approximately $300 billion, excludes “pharmaceuticals, certain pharmaceutical inputs, and select medical goods.”

Indeed, the FDA issued its first notice of a drug shortage due to COVID-19 supply chain disruptions in China:

A manufacturer has alerted us to a shortage of a human drug that was recently added to the drug shortages list. The manufacturer just notified us that this shortage is related to a site affected by coronavirus. The shortage is due to an issue with manufacturing of an active pharmaceutical ingredient used in the drug. It is important to note that there are other alternatives that can be used by patients. We are working with the manufacturer as well as other manufacturers to mitigate the shortage. We will do everything possible to mitigate the shortage.

 

Modeling the economic impact

How bad can things get for the US and global economy?

The Congressional Budget Office conducted a study in 2005-06 that modeled the effects of a 1918-like Spanish Flu outbreak on the economy. The CBO assumed that 90 million people in the U.S. would become sick, and 2 million would die. Those assumptions are not out of line with current conditions. The population of the US is about 330 million, so an infection rate of 27% (90 million infected) and a fatality rate of 2% (1.8 million dead) are reasonable assumptions.

The CBO study concluded that a pandemic of this magnitude “could produce a short-run impact on the worldwide economy similar in depth and duration to that of an average postwar recession in the United States.” A severe pandemic could reduce GDP by about 4.5%, followed by a V-shaped rebound. Demand shocks would also be evident, with an 80% decline in the arts and entertainment industries and a 67% decline in transportation. Retail and manufacturing would drop 10%.

A recent paper by Luo and Tsang at Virginia Tech entitled “How Much Output Has The Coronovirus Reduced?” studied the effects of the outbreak on China and the world. It concluded that Chinese GDP would fall by a minimum of 4%, and there would be considerable spillover effects outside China.

Using a network approach, we estimate the output loss due to the lockdown of the Hubei province triggered by the coronavirus disease (COVID-19). Based on our most conservative estimate, China suffers about 4% loss of output from labor loss, and global output drops by 1% due to the economic contraction in China. About 40% of the impact is indirect, coming from spillovers through the supply chain inside and outside China.

The researchers concluded that the direct and indirect effects of Chinese dislocation alone could amount to 1-2% of global GDP growth.
 

 

A Federal Reserve international finance discussion paper published in October 2019 entitled “Global Spillovers of a China Hard Landing” also yielded some clues on the economic impact of Lehman 2.0. Here is the abstract:

This paper analyzes the potential spillovers of acute financial stress in China, accompanied by a sharp slowdown in Chinese growth, to the rest of the world. We use three methodologies: a structural VAR, an event study, and a DSGE model. We find that severe financial stress in China would have consequential spillovers to the United States and the global economy through both real trade links and financial channels. Other EMEs, particularly commodity exporters, would be hit the hardest. The U.S. economy would be affected to a lesser degree than both EMEs and other advanced economies, and the primary channel of transmission to the U.S. could well be adverse financial spillovers through increased global risk aversion and negative equity market spillovers.

The authors’ estimates based on a Chinese 4% hit from normalized growth (blue) and 8.5% hit (red) indicate considerable damage to US GDP growth.
 

 

Effectiveness of policy response

During the Lehman Crisis, central bankers swung into action and flooded the global financial system with liquidity. In the current crisis, it is unclear whether either fiscal or monetary policy are effective to combat both a supply and demand shock. The authorities can stimulate all they want, but if people are unwilling to, or unable, either go to work, or to brave reducing social distance to spend on goods and services, fiscal and monetary stimulus cannot boost economic growth. These policies are likely to have limited effect until the supply shock begins to wear off, and people return to work.

To be sure, the monetary authorities can act to reduce risk premiums and inflate asset prices. Credit spreads have begun to edge up, and central bankers can act to put a lid on spread expansion.
 

 

However, measures of financial stress remain relatively low, and policy makers will loath to engage to excess stimulus and create another bubble.
 

 

Nevertheless, China is certainly trying the stimulus route. Xinhua reported that the Chinese leadership has turned on the fiscal taps and decreed a series of infrastructure projects to jump start the economy.

The Chinese capital has announced to push forward 300 urban projects in 2020, involving 252.3-billion yuan (around US$35.9 billion) in investment.

The projects will include 100 infrastructure projects, 100 livelihood improvement projects and 100 high-tech industrial projects, according to Beijing’s development and reform commission.

 

Investment implications

What should investors do under these circumstances? A recent Bloomberg article surveyed 10 market strategists. Their views were highly disparate. They ranged from “gold rally” and “risk aversion” to “a short sharp V” and “hello TINA”, or There Is No Alternative (to risky assets). In other words, no one knows anything.

I have experienced a series of market crises during our tenure as a quantitative bottom-up equity manager. While our quantitative factor sets were well diversified across growth, value, momentum and other dimensions, we learned to turn off all of the quantitative factors when faced with a sudden crisis, such as the Russia default or 9/11. As details of the shock became known, the following classes of factors began to add value, in the following order:

  1. Technical Analysis Factors: The market’s price signals were the fastest to respond.
  2. Estimate Revision and Earnings Surprise: When the crisis hits, company analysts will not revise their estimates because they cannot quantify the impact. First, top-down strategists begin to revise their estimates, then the bottom-up company analysts. We saw one such example when the U.S. stock market rallied on Trump’s tax cuts.
  3. Fundamental Factors: As the environment normalizes, fundamental factors such as growth and value begin to add value once again.

Today, the market is only in the first phase, where technical factors are in ascendance. Here is what the market technical outlook is telling us.

The intermediate term outlook is uncertain. The monthly S&P 500 chart printed a doji candle in January, indicating indecision and a possible turning point. The turn was confirmed by a bearish red candle in February. Such patterns have been followed be at least 1-2 months of either sideways or bearish price action.
 

 

In addition, my “Ultimate Intermediate Bottom Spotting Model” has not turned bullish yet. This model flashes a buy signal based on two conditions; when the NYSE McClellan Summation Index (NYSI) turns negative, indicating intermediate bearish momentum, and the Zweig Breadth Thrust Indicator becomes oversold, which is a short-term oversold indicator. We are not there yet.
 

 

In the short run, the market may be setting up for a short-term bounce and all indicators are in maximum oversold territory. The oversold signal flashed by the Zweig Breadth Thrust Indicator has usually been resolved with a relief rally.

As measured by the 5 and 14 day RSI, the market is as oversold as it was at the Christmas Eve bottom of 2018, as more oversold than the VIXmageddon bottom of early 2018. A similar oversold condition occurred in October 2018, which was followed by an interim relief rally.
 

 

Non-US markets are also acting in a constructive manner. I had suggested in the past that investors might be better served to buy commodities and EM equities while avoiding US stocks (see The guerrilla war against the PBOC). It was a contrarian call because of the high sensitivity of commodities and EM to a possible Chinese downturn. Both commodity and EM markets have begun to stabilize and exhibit positive relative strength, indicating a possible turn in market psychology. The worst may be over.
 

 

To be sure, a deeper examination of EM market strength shows that most of it comes from China and India. EMEA and Latin American markets are still lagging. However, EM leadership cannot be dismissed as purely a China and India effect, as frontier markets are also turning up in relative strength.
 

 

There are other signs that the world is edging back to normalcy. The Baltic Dry Index, which measures shipping costs, is showing signs of bottoming after a catastrophic decline. The worst of the global supply shock may be over.
 

 

Finally, copper prices are stabilizing and have not breached their early February lows. Copper is a cyclically sensitive metal that it has been dubbed “Dr. Copper” by traders because it is said to have a Ph.D. in economics.
 

 

A long bottoming process

This bottoming process is just beginning, and it is likely a long process. Nick Maggiulli at Of Dollars and Data compiled the past market reaction after drops of over 6% over two days. On average, the stock market was but volatile for the next 100 trading days before rising again.
 

 

The option market is also signaling a prolonged resolution to this COVID-19 induced Lehman Crisis. The term structure of the VIX Index has inverted, which is not a surprise during these periods of fear. A recent article by Luke Kawa at Bloomberg pointed out what is unusual is the inversion is extending out past the front month:

And what makes this inversion scarier than normal is what’s happening just a bit further out on the curve. Typically, when the front of the VIX curve inverts, the rest stays relatively flat. It’s an acknowledgment that the market tumult is expected to be a relatively short-lived affair.

Not so this time. The April VIX future has closed as much as 1.3 points above May’s during this pullback, the biggest such backwardation between the second and third-month contracts since the idiosyncratic volatility blowup in February 2018. This is an indication that traders expect an environment of heightened volatility to persist for longer than your run-of-the-mill stock market correction.

This dynamic speaks to the evolution of traders’ perception of the coronavirus: what was first a contained supply shock is now morphing into a potent threat of unknown magnitude to a fragile global economy.

Even if the market were to stage a relief rally from current levels, the bearish episode is likely not over. A more typical bottoming pattern would see the markets rally, falter to retrace and retest the previous lows. There are no guarantees whether the retest would necessarily be successful.

The next shoe has yet to drop. While we have seen selected profit warnings from corporate management, such as MasterCard and United Airlines, estimate revisions so far are still positive. As well, the negative Q1 guidance rate is roughly in line with the historical average.
 

 

Historically, analysts have been overly optimistic in forming EPS estimates, and they tend to revise them downwards as the date of the earnings report approaches. The current experience indicates that Street estimate revisions are not especially negative compared to history, indicating that Wall Street has not fully factored in the effects of the coronavirus yet.
 

 

We need to see EPS estimates start to fall, followed by a period of stabilization before the fundamentally driven institutional investors feel more comfortable in taking more risk. Current survey data indicates that institutions are in a crowded long in equities, and they are just beginning to de-risk.

In conclusion, the global economy is undergoing a period of stress that will take some time to resolve. Asset prices are likely to be highly volatile for the next few months until the full extent of the uncertainty is resolved. In the short run, the stock market is extremely oversold and washed out. A relief rally and climatic reversal can happen at any time. However, I expect that any rally would be followed by re-tests of the old lows, which may not necessarily be successful.

Investment oriented accounts should be minimizing risk and aim for asset allocations with below average equity risk. I reiterate my call to overweight emerging market equities and commodities because the market has already embedded low expectations for their outlook, and underweight US equities because of their valuation risk.

Remember to tune in tomorrow for the trading analysis.

 

In search of a market bottom

Posted by Cam Hui -

Mid-week market update: After two consecutive days where the market was down over 3%, I am seeing numerous statistical studies that suggest either an imminent oversold bounce, or a sentiment washout. One example is this analysis from Nomura, as published by Marketwatch.
 

 

Has the sell-off bottomed?
 

The short-term outlook

There are two answers to that question, depending on the time horizon. From a short term perspective, subscribers received an email alert last night that my inner trader was closing his short positions, going to 100% cash, and stepping to the sidelines. My Trifecta Bottom Spotting Model had flashed an exacta signal. The only element that is missing is a TRIN spike over 2, indicating price insensitive market clerk selling that characterizes a washout bottom. Nevertheless, exacta signals have been flagged short-term bottoms in the past.
 

 

In addition, the Zweig Breadth Thrust (ZBT) model reached an oversold condition yesterday. As a reminder, the ZBT buy signal is triggered when the market recycles off an oversold condition and reaches an overbought level within 10 trading days. While I am not necessarily expecting a ZBT buy signal, past oversold ZBT conditions have also marked short-term bottoms in the past.
 

 

The intermediate term outlook

While a short-term bottom may be at hand, the intermediate term outlook is less certain. I had highlighted the failure of the Fear and Greed Index to fall below 20, which is the typical precursor for a durable bottom (see A panic bottom?). The index fell to 21 yesterday and readings have stalled. We are not there yet.
 

 

This tweet from SentimenTrader also puts this week’s price cascade into context. While the sample size is very small (n=2), it nevertheless represents a sobering reminder that the sell-off may not be over yet.
 

 

My base case scenario calls for some sort of tradable bounce to start this week, but the market’s anxiety over the COVID-19 coronavirus outbreak is likely not over. The stock market will undergo a period of choppiness for the next few weeks, and possibly months, before a durable bottom can be made. As well, the market is trading at a forward P/E of 17.5, which is more reasonable multiple, but it is nevertheless high by historical standards.
 

Introducing the Ultimate Intermediate Bottom Spotting Model

This analysis leads me to introduce my “Ultimate Intermediate Bottom Spotting Model” with an accuracy rate of 86% over the last 15 years. In the last 15 years, the market has not seen a decent bottom unless both the NYSE McClellan Summation Index (NYSI) is negative and the ZBT Indicator is oversold. There were only two failures (red arrow), which occurred in 2008 and 2018. In both cases, the model flashed buy signals and the market duly stabilized, but rolled over to an ultimate bear market bottom later. In both of those cases, those failures were followed by subsequent timely buy signals.
 

 

The NYSI is still in positive territory today. If this is a major market downdraft, which I believe it to be, then I would wait for both conditions to be satisfied.

My inner trader took profits in all his short positions today and he is stepping to the sidelines. There is no shame in taking a substantial profit when you don’t think you have an edge. While more nimble traders could buy for a bounce here, he believes that the primary trend is down, and he would rather re-enter his short position at a higher level rather than expose himself to headline risk.

 

A panic bottom?

Posted by Cam Hui -

I should thank my lucky starts. i turned bearish last Wednesday (see Why this time is (sort of) different) and tactically shorted the market just as equities topped out, followed by today’s -3% downdraft.

As today proceeded, I fielded several inquiries from readers with versions of the same question, “Nice call last week. Is it time to buy, or are you covering your short?”

Where is the fear?

The short answer, is no. First of all, there were just too many people who seemed eager to either buy outright, or take profits in their bearish positions.

Mark Hulbert published an article this morning and by observing that his Hulbert Nasdaq Newsletter Sentiment Index had retreated from an over 90th percentile bullish reading to the 83rd percentile. That’s constructive, but hardly the sign of all-out capitulation.

Option sentiment has also been very restrained during today’s sell-off. The CBOE put/call ratio rose to 1.09. While the reading is on the high side by historical standards, it seems unusual for a day when the stock market was down over -3%.

Similarly, the equity-only put/call ratio was only 0.70.

The Fear and Greed Index closed today at 29, which is useful as it shows a retreat in bullishness. Historically, the index has not made a durable bottom until it fell below 20.

Where is the fear?

A short-term bounce

As I write these words, overnight equity futures are strongly positive, and it appears that a bounce is under way. Short-term breadth is oversold, and a brief relief rally is no surprise.

CNBC is also running a “Markets in Turmoil” program, which has historically been a contrarian bullish indicator (h/t Charles Bilello).

The first logical resistance can be found at the 50 dma at about 3275. In the current volatile environment, it would be no surprise to see the rally stall at either Fibonacci retracement levels of 3300 or 3325. As well, there is an enormous gap between 3275 and 3325 that could be filled.

I conclude from an analysis of sentiment that this correction is not over yet. Any rally should be regarded as an opportunity to lighten up positions for investment oriented accounts, or to short into for more aggressive trading accounts.

My inner trader remains short the market.

Disclosure: Long SPXU

Correction ahead?

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 […]

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Don’t count on a V-shaped recovery

Posted by Cam Hui -

The covid-19 coronavirus outbreak is a human tragedy, just like Ebola, MERS, and SARS. For investors, it has an economic impact. Even before the outbreak, world merchandise trade volume had been falling. New data is likely to show that the outbreak disrupted global supply chains sufficiently to further depress global trade.

The market consensus initially expected the effects of the virus to top out in mid or late February, and they consequently penciled in a V-shaped recovery. As China slowly returns to work amidst draconian measures to control the outbreak, doubts are rising on whether China’s economy could bottom out in Q1. The authorities would have to be satisfied that the worst of the infection is over before giving the all-clear for everyone to return to work. An economy as large as China’s will not be able to restart itself overnight, and the process will take time. In the meantime, much damage has been done, both to global supply chains and Chinese company balance sheets, and a wave of insolvencies is likely to follow. The only question is the magnitude.

As well, fear has to fade for business confidence to return to normal. The latest statistics from Johns Hopkins CSSE shows that the growth of covid-19 cases is not under control outside China. Equally disturbing is the challenges faced by two First World economies, Japan and Singapore, to deal with the outbreak. What happens when the infection appears in countries with health care systems that are less prepared?

It is therefore difficult to believe that the economic impact will bottom out in Q1, or the economic recovery will be V-shaped.

Scenes of supply chain disruptions

The SCMP recently published an article that documented the struggles Chinese factories have encountered in reopening their doors.

Choked off from suppliers, workers, and logistics networks, China’s manufacturing base is facing a multitude of unprecedented challenges, as coronavirus containment efforts hamper factories’ efforts to reopen.

Many of those that have been granted permission to resume operations face critical shortages of staff, with huge swathes of China still under lockdown and some local workers afraid to leave their homes. Others cannot access the materials needed to make their products, and even if they could, the shutdown of shops and marketplaces around China means demand has been sapped.

Those who manage to assail the challenges, meanwhile, have found that trucking, shipping and freight services are thin on the ground, as China’s famed logistical machine also struggles to find workers and navigate provincial border checkpoints that have popped up across the country “It really is death by a thousand cuts,” said John Evans, managing director of Tractus Asia, a company that has 20 years’ experience helping firms move to China, but which over the past two has had more enquiries from businesses looking to leave. “This is a black swan event and I don’t think we’ve seen anything like it in recent history, in terms of the economic and supply chain impact in China and across the globe.”

One key indicator of economic disruption shows that few migrant workers have returned to work.

Based on the Baidu Migration Index, analysts at Nomura estimated that only 25.6 per cent of migrant workers had returned to work across 15 sample cities by February 19, compared to 101.3 per cent a year earlier.

One company reported that it had to make special and extraordinary provisions to get their workers back.

Dimitrijevic said he had to charter special buses to transport his workers from other parts of China back to Suzhou, a city west of Shanghai. When they returned, he had to book hotel rooms to house them for another 14 days in quarantine as their neighbours “will not let them go home”. He was paying about 350 yuan (US$50) in accommodation for each employee.

“While work has officially started last week, most employees were still quarantined or just on their way back due to lack of transport,”
Dimitrijevic said. “It would be about a month in production delays by the time we start next week, and by then we would not even be able to run full operations.”

Progress has been uneven, even when factories return to full production, transportation logistics is another bottleneck.

“China is so big, that every city can have vastly different policies,” said Walter Ruigu, Beijing-based managing director at Camal Group, which connects Chinese manufacturers of steel, equipment for construction and mining, and industrial chemicals with buyers in Africa.

“The distance from the epicentre and local government actions have been crucial. In the north and northeast activity has resumed this week. We have seen some movement in Dalian Port and Qingdao Port, but for now the issue has been finding the logistics to get to that point,” Ruigu said.

China tries to get back to work amid coronavirus outbreak There have been reports of cargo ships being marooned at sea, with ports in countries with strict coronavirus quarantine rules such as Australia, Singapore and the United States not permitting shipping personnel to enter their ports if they have been in China over the past 14 days

All of these disruptions will have a cost. Bloomberg reported that some Chinese SMEs can’t afford to pay their employees. We have yet to see the effects of the financial fallout from this outbreak.

A growing number of China’s private companies have cut wages, delayed paychecks or stopped paying staff completely, saying that the economic toll of the coronavirus has left them unable to cover their labor costs…

Across China, companies are telling workers that there’s no money for them — or that they shouldn’t have to pay full salaries to quarantined employees who don’t come to work. It’s too soon to say how many people have lost wages as a result of the outbreak, but in a survey of more than 9,500 workers by Chinese recruitment website Zhaopin, more than one-third said they were aware it was a possibility.

The salary freezes are further evidence of the economic hit to China’s volatile private sector — the fastest growing part of the world’s second-biggest economy — and among small firms especially. It also suggests the stress will extend beyond the health risks to the financial pain that comes with job cuts and salary instability. Unsurprisingly, hiring has all but ground to a halt: Zhaopin estimates the number of job resumes submitted in the first week after the January outbreak was down 83% from a year earlier.“The coronavirus may hit Chinese consumption harder than SARS 17 years ago,” said Chang Shu, Chief Asia Economist for Bloomberg Intelligence. “And SARS walloped consumption.”

Do you still believe in a V-shaped recovery? What about the tooth fairy?

Quantifying outbreak effects

As a way of quantifying the outbreak, an IMF study estimates that a 1% increase in imports of fragile products from a disaster-hit country, such as Japan after the 2015 earthquake that devastated Fukushima, causes a -0.7% supply shock by the importing country. Fragile products are defined as products with presence of central players, a tendency to cluster, and a lack of substitution. The widespread acceptance of just-in-time (JIT) techniques represents a form of operational leverage, which works both on the upside and downside.

FactSet also produced some useful analysis comparing the SARS epidemic to the latest covid-19 outbreak. First, it compared the China exposures of companies in the MSCI All-Country World Index (ACWI) by domicile and by revenue source. Only 4.0% of the companies in ACWI are domiciled in China, while 9.0% are exposed to China based on their revenues. Consumer Discretionary and Technology stocks show the biggest difference between domicile weight and revenue exposure weight.

FactSet went on to stress test three scenarios and their effects on stock market performance.

  • Base Scenario – Events continue like SARS with the coronavirus impact easing within a few months
  • Optimistic Scenario – The coronavirus will be contained before summer with a continued reduction of new cases
  • Conservative Scenario – The severity of the virus will increase and impact markets longer than SARS

The table below summarizes the downside potential of the three scenarios. We can more ore less rule out the “optimistic scenario” based on the anecdotal evidence of supply chain disruptions. Pencil in a 5-10% correction in equities based on FactSet’s analysis.

Prepare for more downside potential

FactSet’s analysis is based on historical patterns and average correlations. I would argue that equity prices in general, and US equities in particular, are even more vulnerable than the conclusions from based on this conventional approach.

First, valuations are highly stretched. The market reached a forward P/E ratio of 19.0, which is a level last seen in 2002 as prices deflated from the Tech Bubble of the late 1990’s..

As well, bullish sentiment is becoming stretched. The latest BAML Global Fund Manager Survey shows that global institutions have been piling into equities, which makes them vulnerable to a negative growth surprise such as the covid-19 outbreak.

In particular, the US market has been a favored destination for equity fund flows.

For investors who need to be invested in equities, I reiterate my case outlined last week (see The guerrilla war against the PBOC) of overweighting EM and commodities and underweighting the US market. If the bulls are right, EM and commodities should benefit from operating and financial leverage exposure of commodities and EM markets. If the bears are right, EM and commodities have already fallen considerably and their downside potential should be lower than the high flying US equity market.

I am also monitoring the relative performance of the US and EM markets against ACWI. Tactically, traders may want to make a commitment to this trade once the EM/ACWI ratio stabilizes on bad news, indicating a washout. As well, weakness in the US/ACWI ratio would be a signal that fears of a global slowdown are beginning to appear for US investors, and the bears are taking control of the tape.

Investors focused on absolute returns may want to consider buying US long Treasuries. The long bond ETF (TLT) broke out of a downtrend in January, and it further rallied to stage another upside breakout, indicating more profit potential.

Gold prices also achieved an upside breakout, but the move is extended, and Commitment of Traders futures data shows a crowded long position. Fear trade buyers could take a position, but they need to be aware of their vulnerability due to excessively bullish sentiment.

Please stay tuned for our tactical trading assessment tomorrow.

Why this time is (sort of) different

Posted by Cam Hui -

Mid-week market update: Some elements of the market have recently taken on a definitive risk-off tone, such as yesterday’s upside breakout in gold that was achieved in spite of a similar upside breakout in the USD Index.     That has to be equity bearish, right? Well…this time is (sort of) different.   Macro headwinds […]

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How to trade a frothy momentum 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: Buy 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.
 

A momentum driven market

As the stock market continues to grind to new all-time highs, there is mounting evidence that this is a strong price momentum driven market, as evidenced by the breach of the upper monthly Bollinger Band. As well, Arthur Hill pointed out that 8 of the 11 equal-weight sector ETFs recorded new highs last week, as did SPY and the equal-weighted equivalent RSP. While such episodes have signaled tops in the past, they have also been a key characteristic of strong uptrends.
 

 

How should investors and traders react to such circumstances?
 

Reasons to be cautious

There are plenty of reasons to be cautious. The market is trading at a forward P/E ratio of 18.9, which is a 10-year high.
 

 

If history is any guide, the market has not performed well in the last 85 years when the P/E ratio has been this elevated.
 

 

To be sure, Q4 earnings season has been reasonably constructive. While the EPS beat rate is only slightly below the 5-year average, the sales beat rate is well above historical norms. More importantly, forward EPS is rising, indicating positive fundamental momentum.
 

 

While the Q1 negative guidance rate is slightly better than average, FactSet reported that a substantial number of companies discussed the impact of the coronavirus outbreak but declined to modify their guidance because they could not gauge its impact. In an ideal world, the market would demand a premium for this uncertainty, but it has not.

While many of these 138 companies discussed the current negative impact or the potential future negative impact of the coronavirus on their businesses, 47 companies (34%) stated during their earnings call that it was too early (or difficult) to quantify the financial impact or were not including any impact from the coronavirus in their guidance. On the other hand, 34 companies (25%) included some impact from the coronavirus in their guidance or modified guidance in some capacity due to the virus.

As well, there has been a cacophony of voices warning of the highly extended nature of the market advance. Macro Charts is just one of many examples.
 

 

SentimenTrader also provided a similar warning of market frothiness.
 

 

This is a market advance that is easy to hate, but it keeps rising.
 

A TINA advance?

I recently advanced the hypothesis that this is a TINA (There Is No Alternative) advance based on fear (see Why the market is rising on fear – Yes, Fear!). Global investors are piling into US equities as a safe haven because of coronavirus fears. US equities are becoming the last source of growth in a growth starved world.
 

 

Despite the numerous bearish warnings, there is support for this hypothesis if you looked in the right places. The USD has been rising in lockstep with the relative performance of US equities, which is evidence of foreign buying.
 

 

US equity leadership is narrowing, as investors have been focused on larger cap NASDAQ and FANG stocks. I interpret this as foreigners buying US growth as a safe haven play.
 

 

More gains ahead?

Despite the bearish tone voiced by many analysts using conventional technical analysis techniques, the Advance-Decline Line made a new high last week, which is supportive of more gains.
 

 

Many sentiment surveys are not flashing warning signs of bullish extremes. The AAII Bull-Bear spread is positive, but readings are nowhere near crowded long levels.
 

 

The same could be said of II sentiment. In fact, bearishness in this survey has ticked up, and major market tops generally do not occur with bearishness at these levels.
 

 

As well, the Fear and Greed Index ins in neutral territory. Where are the excesses?
 

 

The week ahead

This does mean, however, that traders can sound the tactical all-clear for the upcoming week. To be sure, next week is option expiry (OpEx) week. February OpEx has historically shown a bullish bias.
 

 

The hourly S&P 500 chart shows a steady grind up, with upside potential at the resistance level of 3390-3400.
 

 

Here is what I am watching. From a top-down macro perspective, flash PMIs will be released late next week, and supplier deliveries indicators and electronics PMIs will be the proverbial canaries in the coalmine, as any supply chain disruptions from travel restrictions and quarantines are likely to appear there first. Keep an eye on Taiwan export orders, Australia PMI, Thailand, and Hong Kong import data. Also watch for any changes in inventories from Chinese manufacturers, as well as imports by major auto, retail and durable goods companies, as signals of any impact from shutdown affecting the supply chain.

For an uncomplicated one-decision chart, I am monitoring the China Exposure Index, which measures the relative performance of stocks with the greatest exposure to Chinese sales. As long as this index is tanking, USD assets are likely to be well bid.
 

 

From a technical perspective, the market was sufficiently overbought, and short-term breadth indicators are recycling downwards. The market is ripe for a pullback.
 

 

The momentum factor is still rising, which is bullish. But the high beta to low volatility ratio may be rolling over, which would be bearish. Keep an eye out on how these factors evolves.
 

 

I conclude that the US equity market is being supported by strong foreign inflows. It is impossible to know how this situation will evolve, as the market is highly jittery and subject to headline risk. My inner investor is therefore neutrally positioned at the asset allocation weights specified by his investment policy.

My inner trader is bullishly positioned, but he is not inclined to add to his positions due to a combination of headline risk and possibly deteriorating technical conditions. He is keeping his stops tight.

Disclosure: Long SPXL

 

The guerrilla war against the PBOC

Posted by Cam Hui -

The enemy advances, we retreat
In the wake of the news of the coronavirus infection, the Chinese leadership went into overdrive and made it a Draghi-like “whatever it takes” moment to prevent panic and stabilize markets. When the stock markets opened after the Lunar New Year break, the authorities prohibited short sales, directed large shareholders not to sell their holdings, and the PBOC turned on their firehose of liquidity to support the stock market. Those steps largely succeeded. China’s stock markets stabilized and recovered, and so too the markets of China’s Asian trading partners.
 

 

However, there were signs that the market is unimpressed by the steps taken by Beijing to control the outbreak and limit its economic impact. Market participants were conducting a guerrilla campaign against the PBOC by using Mao Zedong’s principles of war. The first principle is “When the enemy advances, we retreat.”

Indeed, when the PBOC flooded the market with liquidity, stock prices went up. But that’s not the entire story.
 

Swim like a fish

Mao counseled the guerrilla fighter to “move among the people as a fish swims in the sea.”. No guerrilla campaign against the PBOC would be successful without the broad popular support. In this case, there is widespread skepticism about China’s announcements surrounding its handling of the coronavirus outbreak.

First, doubts have crept in regarding the infection and fatality rate. In a Valentine’s Day Massacre, Beijing replaced senior officials for Wuhan, and Hubei province. This move was accompanied by a re-classification of what it meant to be infected, which led to a huge leap in the figures. If this was a company, the new management effectively took an enormous writedown and attributed the problems to the previous managers. Is it any wonder why there is no trust for Chinese statistics?
 

 

The World Health Organization (WHO) has warned the coronavirus spread outside China may be the “tip of the iceberg”. It has declared that the outbreak “holds a very grave threat” to the world. I have been monitoring the growth of infected cases outside of China, and there are few signs that growth is leveling off.
 

 

A number of hotspots are appearing outside China, which are signals that the outbreak is not contained globally. The infection aboard Diamond Princess cruise ship docked at Yokohama remains a major concern. Health authorities are also scrambling to identify “patient zero” who spread the virus at a conference in Singapore. As a consequence, the infection spread worldwide, from countries like South Korea to France, where a group of Britons at a ski resort became infected.

The economic effects of the containment efforts are unknown at this point. China was supposed to return to work on February 10, though delays have been announced. Analysts have taken to using offbeat techniques to monitor China. Here is the traffic report for Beijing, current traffic (in orange) is far lighter than the average (light blue).
 

 

Here is the traffic report for Shanghai.
 

 

…and Shenzhen. I could go on, but you get the idea.
 

 

China’s coal usage for power generation, which is a metric of heavy industry activity, tells a similar story of an idled economy.
 

 

The SCMP reported that job loss is becoming a concern for the authorities. Many migrant workers went home over the Lunar New Year holidays after quitting their jobs, expecting to be hired back afterwards. Now that sales are falling, companies are considering laying off or furloughing permanent employees, and there is little work for freelancers. The coronavirus outbreak puts Beijing in a tough spot, as efforts to contain the virus could result in mass unemployment.

China has not released any updated statistics covering employment, with the unemployment figures for January and February not set to be released until March. In December, the official unemployment rate was 5.2 per cent.

In 2003, which included the severe acute respiratory syndrome (Sars) outbreak, around 8 million people lost their jobs, according to official Chinese data, although real job losses may have been much higher because government data did not cover most migrant workers.

The economics of the slowdown are also concerning from a global perspective. That’s because Chinese factories dominate intermediate goods inputs in many supply chains.
 

 

From the ground up, sources indicate that the world’s supply chain is being shaken. Auto manufacturers are warnings that American and European plants are weeks away from shutting down. Nissan, Hyundai, and Kia Motors have already reduced production. Foxconn’s output cuts is threatening Apple’s iPhone sales outlook.
 

The enemy camps, we harass

Mao’s second principle of war is, “When the enemy camps, we harass”. While the bears have retreated in the face of the PBOC’s tsunami of liquidity that have buoyed stock prices, the markets have shown their skepticism in other ways.

While stock markets have been strong, commodity markets have been weak.
 

 

Foreign exchange (FX) markets have also shown their skepticism that all is well in different ways. The offshore yuan (USDCNH) weakened after the news of the outbreak, but did not recover as stock prices did.
 

 

The Australian Dollar has taken a risk-off tone. The AUDCAD cross is also weak. Both Australia and Canada are commodity exporters, but Australia is more sensitive to China, and Canada is more sensitive to the US.
 

 

Market fears have also made the USD well bid. Greenback strength is putting pressure on fragile EM economies with external currency debt.
 

 

In addition, a strong USD will strain the financial capacity of Chinese property developers who have been financing in USD. The PBOC can supply all the yuan liquidity it wants, but it is far more constrained in supplying USD liquidity to Chinese borrowers. The first test comes in March, when $2.1 billion in offshore notes come due.
 

 

Bloomberg reported that the Street is scrambling to revise down Chinese GDP growth forecasts. The average revised Q1 GDP growth rate is now 3.8%. In a separate article, Bloomberg pointed out that China’s annual stress test of its 30 biggest banks showed a five-fold increases in non-performing loans based on a worst case GDP growth rate of 4.15%. You see the problem here.
 

Caixin also reported that Chinese banks have been ordered to extend credit to small and medium enterprises (SMEs), who are suffering from a severe cash crunch during this time of stress. These loans would normally not be made as they would not conform to existing landing standards. A survey of 995 SMEs by Tsinghua and Peking University found that 34% say they can survive for only one month based on current cash reserves; one-third said two months; and 17% said three-months.
 

Who takes the loss if the outbreak doesn’t come under control and these SMEs fail? The PBOC can supply liquidity to the banking system, but it can do nothing for banking system solvency. The performance of financial stocks relative to the Chines market has cratered as a consequence.
 

 

When the enemy camps, we harass.
 

What next?

Mao’s two other principles of war are, “When the enemy tires, we attack”; and “When the enemy retreats, we pursue”. It is unclear whether the market’s guerrilla war against the PBOC will ever reach either of those phases, which implies a major defeat of Beijing’s initiative. The market seems to be pricing in the prospect of a sharp V-shaped recovery, but investors should be mindful that the recovery could be slower U-shaped pattern, or even L-shaped.

I can, however, offer some hints of what investors can do in the current environment. The chart below tells the story. Global investors have been piling into US equities as a safe haven because they believe that America is the last refuge of global growth.
 

 

US leadership is narrowing, led by megacaps and NASDAQ (read: FAANG) stocks. Mid and small caps remain in relative downtrends, which is a signal of negative breadth divergence.
 

 

The advance has left US equities highly exposed from a valuation perspective. The Rule of 20 Indicator, which flashes a warning whenever the sum of the market’s forward P/E and CPI inflation rate exceeds 20, is now at a nosebleed reading of 21.6. These levels were last seen during the NASDAQ Bubble and its subsequent deflation.
 

 

This argues for a contrarian position of long EM, commodities, and commodity producers and short US equities. Aggressive traders could enter into a long and short pairs trade, while more risk-controlled accounts could just overweight and underweight.
 

 

If the bulls are right, and the coronavirus outbreak recedes and comes under control, US equities should begin to underperform as the demand for safe havens, while cyclically sensitive EM and commodities would rally. On the other hand, if the outbreak were to spiral out of control and global growth collapses, then US equities would correct, but there is likely less downside risk in EM and commodity exposure because they have already fallen substantially.

Investors can win either way.

Publication note: I normally publish a weekly tactical trading comment on Sunday. In light of the long weekend, the trading comment will be published on Monday morning. That way I can react to any potential new developments in the coronavirus outbreak.

Please stay tuned.

 

Why the market is rallying on fear – Yes, Fear!

Posted by Cam Hui -

Mid-week market update: What should investors do when faced with competing narratives and historical studies with opposite conclusions?

The major market indices made another all-time high today. Ryan Detrick pointed out that ATHs tend to be bullish. That’s because of the price momentum effect that is in force which propels stock prices to new highs.
 

 

On the other hand, SentimenTrader observed last week that the market has flashed another series of Hindenburg Omens. Subsequent to that tweet, Tom McClellan pointed out that there was another Hindenburg Omen on Monday. Historically, clusters of Hindenburg Omens have resolved with a bearish bias.
 

 

Should traders be bullish or bearish?

Here is some out-of-the-box thinking. I would argue that the stock market rally is actually the result of a fear. Yes, you read that correctly – Fear.
 

The bull and bear cases

There is little doubt that the market is overbought. The bulls will argue, however, that the market could be just starting a series of “good overbought” readings that accompany a slow grind upwards.
 

 

SentimenTrader also warned about the precarious and complacent state of the put/call ratio, which has always resolved with a market decline over the  next two weeks. Some of the excess bullishness to retail buying of TSLA call options, which SentimenTrader referred to as a “speculative spigot”.
 

 

From a broader sentiment context, my suite of non-survey sentiment indicators do not reveal excessive bullishness other than the put/call ratio. In the past, short-term tops have been marked by these indicators flashing complacent readings, or near complacent readings. That does not seem to be the case today.
 

 

A fear trade

Instead, I would argue that the relentless bid in US equities is reflective of fear – yes, fear. Global investors have been piling into US stocks as a safe haven trade in the face of coronavirus risks. The rally has been misinterpreted by American investors as an unsustainable on fundamental, technical, and sentiment metrics.
 

 

Sure, the market is overbought today, and may see a brief 1-2 day pullback. That is why we are seeing the narrow leadership, the Hindenburg Omens which are reflective of a bifurcated market, and selected signs of sentiment excess, such as extreme lows in the put/call ratio.
 

 

It may seem obvious, but when the market doesn’t fall after a rally leg, it usually means it wants continue upwards with the rising trend. My inner trader remains bullishly positioned, but he recognizes that this is an environment characterized by high volatility. Traders should therefore properly adjust their position sizes in light of elevated risk levels.

Disclosure: Long SPXL

 

ESG challenges to energy investing

Posted by Cam Hui -

I received a ton of comments from my post three weeks ago on the energy sector (see Energy: Value opportunity, or value trap?). I engaged in multiple long email discussions with several readers on different aspects of that post. This is a follow-up to the publication address two main issues that were raised:

  • The impact of the solar cycle hypothesis on the Earth’s climate, and as a bullish catalyst for the energy sector
  • How to investing in energy stocks in the new ESG era.

To briefly recap, the solar cycle hypothesis postulates a link between the Earth’s temperatures and the degree of sunspot activity. We may be undergoing a period when sunspot activity is diminishing, which would serve to counteract some or all of the effects of anthropogenic (human made) global warming, or AGW. This assertion upset a number of readers, and made the analysis verge into political territory.

The mandate of this site is a focus on investment, and not politics. I am not here to advocate for candidate X over candidate Y, or party A over party B. Instead, I try to analyze the likely trajectory of each candidate or party, and try to position for how changes in policy might affect asset prices.
 

Solar cycle analysis

I am grateful to a meteorologist reader (thanks Dean) who directed me to an analysis by NASA which studied the relationship between the solar cycle and the Earth’s temperature and concluded: “It is therefore extremely unlikely that the Sun has caused the observed global temperature warming trend over the past half-century.”

I never said that the solar cycle caused warming. However, a review of the chart below (annotations in white are mine) reveals several insights. First, the solar cycle and the Earth’s temperature tracked each other very closely from 1880 to the late 1940s, when the relationship decoupled. This suggests that there was a close correlation and probable cause and effect relationship between the two data series. When the decoupling began, another factor contributed to changes in the Earth’s temperature, which most climate scientists today attribute to AGW. Nevertheless, analysts should not totally ignore the effects of the solar cycle. In particular, the Earth went through a decade of moderation (shown in white box) when temperatures did not rise as forecast in most climate models (though average temperatures kept rising). That decade of moderate could be explained by the cooling effects of the solar cycle.
 

 

A picture tells a thousand words. The solar cycle hypothesis remains valid based on the data, though not proven. A simple glance at the chart supports a simple model is T = S + A, where T=Temperature, S=Solar cycle function, and A=AGW function.

We will note really know for another 5-10 years until we see additional data. Even if the hypothesis is correct, the consensus will not change for another decade. For energy investors, that’s a very long time to wait.

That’s the investment conclusion. Don’t get too excited about the politics about the model. Nothing will happen for another 5-10 years.
 

Sector outlook: An ESG stampede

The recent stampede into ESG (Environmental, Social, and Governance) investing is more interesting. It’s no wonder why asset managers are interested in ESG. Fund flows into these funds have been rising steadily, even as other funds lose assets.
 

 

How important are each of the E, S, and G factors in ESG investing. To answer that question, FactSet showed the returns of companies with good MSCI ESG scores compared to companies with bad ESG scores within sector. While most sectors showed positive selection effects from ESG within sector, it was negative within energy stocks. I interpret this to mean that the entire sector was shunned by ESG investors, indicating that the E (environment) in ESG was far more important for sector selection
 

 

On the flip side, Tesla is the epitome of an ESG darling today. Kevin Muir at The Macro Tourist suggested that the recent parabolic rise in Tesla is attributable to buying by an ESG institutional manager who had an imperative to achieve his desired portfolio weight in the stock.

The moral of the story? When the big accounts come for a stock, it doesn’t matter how stupid the price, they just need to get it in. They are the scariest ones out there because they can keep buying for days, weeks, months and sometimes even years.

Which brings me to today’s Tesla price action. Yes, retail option buying is helping push it higher. And of course, the big short base previously helped the rise accelerate.

But this move is being driven by big real money.

Josh Brown recently featured a chart from technical analyst Jon Krinsky comparing the relative performance of technology and energy stocks. Josh Brown characterized is as the “mean reversion trade of a lifetime”. In light of the continuing flows into ESG investing, and FactSet’s analysis that ESG investors are shunning energy stocks, mean reversion investors may have a lot longer to wait before the trade pays off.
 

 

For now, energy stocks are being shunned by both American and European investors.
 

 

Energy investing in the ESG era

How should energy investors approach the sector?

It depends on your style. Momentum investors can jump on the ESG bandwagon by buying into clean energy stocks. While most of the holdings in clean energy ETFs are comprised of industrial and technology stocks involved in clean energy, e.g. wind power, etc., it is one way of gaining exposure to the theme.

The chart below shows the relative performance of energy stocks and clean energy ETFs. Energy stocks have been lagging the market, and they are likely to continue to lag owing to the secular shift towards ESG investing. However, clean energy ETFs have performed considerably better than the energy sector. The worst ETF is Cleantech (PZD, bottom panel), which lag the others because it does not hold TSLA.
 

 

For patient value investors, consider commitments to well-capitalized integrated oil companies. A recent interview with Bob Dudley, the now former CEO of BP Amoco, reveals the challenges that energy companies have with regards to ESG pressure from investors. Before he became CEO, Dudley headed BP’s ill-fated venture into solar energy, which was devastated when Chinese producers entered the market and drove down the prices of solar panels.

Dudley gave a nuanced response to a question about the pressure on energy companies to meet green targets. Having experienced the disastrous solar venture, Dudley responded that companies need to have a strong enough balance sheet to respond to these challenges, otherwise it may not exist if the technology fails:

Interviewer: There’s pressure on companies like BP to show that long term investment plans are aligned with two degrees on these targets [of providing energy and reducing CO2 emissions]. Even though, most nations not just a Trump administration, most nations policies are not yet ambitious enough to meet those targets, so what does that mean for how fast a company like this thinks about moving?

Bob Dudley: Well we certainly need to move fast and change our mindset to adopt and invest in new kinds of things and experiment, maybe small and then, for us, given our challenge decade after the events in the Gulf of Mexico. I’m of the belief if we understand where the technologies are going and we invest, the best thing we can do strategically is have a very strong balance sheet, so then when it becomes really clear, certain technology is going to move very quickly and be profitable, then we’ll be able to make that shift. So I’m not worried that we may not be fast enough turning over the portfolio, it’s more making sure our balance sheet is strong and then we’ll be able to move in these areas.

Dudley did describe climate change as an existential threat, but waffled about how the Big Five should address the problem, because of the market presence of large national oil companies that are answerable to political masters, e.g. Armaco, Petrobras, etc.

Interviewer: So I want to ask you about what’s not on this timeline, which is where the energy industry is headed in the future and you’ve often talked about the dual challenge of meeting the world’s rising demand for energy and also decarbonization to address the threat of climate change. You said something at ADIPEC in Abu Dhabi this year. On your panel, climate change is an existential threat. If we as leaders don’t leave the companies, right, we could put ourselves out of business and other people will replace us. What’s the role for an oil and gas company like BP in solving climate change?

Bob Dudley: Yeah, it was in response to, you know, my view the great dual challenges, though, as many as 2 billion more people on the planet in the twenties, forties than there are today, the energy needs will be up by a third which is about the equivalent of another United States and another China entering at the world stage in terms of energy demand and I find the debate on climate issue which is and it is also an existential issue, the rising climate conditions, you also have to take care of nations who will improve their prosperity and move people out of poverty and the debate becomes often polarized of Northern European view and West Coast US view as sort of extremes view of the world who are very privileged in this area and don’t really understand when you travel to places across Africa and India, South Asia, all across it and we need to debate it and discuss and decide, make big decisions with both positions in mind.

It’s very easy; it’s very polarized issue, so I think as leaders, the existential thing, a little bit of what we learned back in the Beyond Petroleum days, if you go too fast and you don’t get it right, you can drag yourself out of business. Say the Big Five Energy Companies that we all know, you know, the Exxon’s, the Chevron’s, the Shells, and Total’s, and BP, just take those. We are only responsible for producing about 8% of the world’s oil, so a lot of the focus is on course on these kinds of companies, because working through the corporate governance of it, but if we were all driven out of business, that oil will still be produced and it is National Oil Companies around the world and countries who will do that. So I see we’re being used as leverage and we want to be leaders in this and we do enormous amount as companies, for example, through the Oil and Gas Climate Initiative, OGCI, to try to help develop technologies will change the world going forward, but we’re not the epicenter of these issues.

He eventually conceded that the world needs to put a price on carbon:

So I think the industry together, not just the companies I mentioned, but others as well, including National Oil Companies need to drive towards policies that can actually head towards solving the issue, the dual challenge about providing the energy and reducing emissions. One example is I cannot imagine how we’re going to get there without a price on carbon, you know, that you and I’ve talked about it before, 200 years of economic history says unless something has a price, you can’t change the behaviors around its use. So getting a carbon pricing system, not a global one, I don’t think, some places would be taxation, you can’t have a ultimately global trading system for carbon because as you get into the currency issues effectively, but we need to lead and work and help shape policy issues and we have to enable and work to develop the new technologies. We’ve got to be incredibly responsible at everything we do, methane for example, methane detection, monitoring, reducing, eliminating, flaring all those things. Natural gas has half the co2 of coal, for example and so

Insightful comments from the former CEO of a company whose shares trade at a juicy dividend yield of 6.8%. The dividend yield may rise even more, but the market is still paying for companies with well-proven reserves.
 

 

Value investors should focus on quality. That means strong balance sheets, and paying the right price for proven reserves.
 

Where’s the sentiment reset?

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: Buy 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.
 

Is sentiment too bullish?

Mark Hulbert warned about excessively bullish sentiment leading to a market decline in a Marketwatch column on February 1, 2020. At the time, Hulbert wrote that he would like to see bullish sentiment to retreat and the Wall of Worry to rebuild.

It would be a good sign if they rush to the sidelines and then quickly jump onto the bearish bandwagon. In contrast, it would be a bad sign if they stubbornly hold onto their bullishness in the wake of the decline. In that case, contrarians would expect that an even deeper correction would be necessary to rebuild the Wall of Worry that would support a new leg upwards.

The market did fall briefly, but rallied in the face of massive PBOC market support. In a follow-up column last week, Hulbert issued a second warning about excessive bullishness. His Hulbert Stock Newsletter Sentiment Index fell, but rose again into the top 80% of bullishness. Such readings have historically been resolved with subpar returns over a 1-3 month time frame.
 

 

The stock market advance appears to be unsustainable on an intermediate term basis, but even Hulbert’s analysis shows a return of 0.0% over one month, which is hardly a wildly bearish forecast. The bigger question is, how vulnerable is the market in the short run?

It would be very easy to turn tactically bearish here, but let us turn conventional technical and sentiment analysis on its head. It is entirely possible that we are undergoing a period where sentiment resets briefly, and stock prices rally to even more highs as pictured by my green annotated periods.
 

 

How vulnerable is the market? Has sentiment reset sufficiently for the market to make another run at fresh highs?
 

A “sort of” sentiment reset

It depends on what you mean by sentiment. Survey based sentiment models and market priced based sentiment models are telling very different stories.

One of the most useful measures of trader sentiment is the rather unscientific Callum Thomas weekend Twitter sentiment survey. Last week’s survey showed the second lowest level of bullishness in the short history of the survey. Preliminary results indicate that the extreme level of bearishness has considerably moderated.
 

 

My own sentiment models, which are mainly based on market based and technical data, tell a different story. Fear levels, as measured by option trading, have spiked. In the past, market tops, which are shown in shaded grey, have seen at least one of the five models flash warning signs. Today we have none.
 

 

I interpret these conditions as a market that may hit a mild air pocket next week, but not a major decline.
 

Fragile market internals

A review of market internals reveals a mixed picture. Market leadership by market cap band shows narrowing leadership by NASDAQ and megacap stops, while mid and small caps lag badly. Conventional technical analysis will conclude that this is not sustainable, and caution is warranted. In the short run, however, NASDAQ and megacaps have gone parabolic. In the words if the legendary technical analyst Bob Farrell, “Parabolic advances usually go further than you think, but they do not correct by going sideways.” The question is how much further does the parabolic move go?
 

 

The analysis of the top five sectors tells a similar story. The top five sectors comprise just under 70% of index market cap, and it would difficult to see how the market can make a major move without the participation of a majority of these sectors. The relative performance leader is technology at 23.2% index weight, with healthcare and financial stocks underperforming at a total of 27.2% of index weight. Consumer Discretionary stocks (read: AMZN) at a 9.8% weight staged a brief comeback last week, but relative performance is volatile. This is the picture of narrowing leadership, but also a picture of bulls and bears struggling for control of the tape.
 

 

Cross-asset analysis: A muddy picture

Cross-asset, or intermarket, analysis is a similar mixed bag. The bulls can point to the strength in USDJPY, which has historically been highly correlated to the stock market.
 

 

The bears can highlight the negative divergence from credit market risk appetite. High yield and EM bonds have underperformed their duration equivalent Treasuries, and the price of these instruments have not confirmed the stock market’s highs.
 

 

Cautiously bullish

My inner trader interprets these conditions in a cautiously bullish fashion. The ratio of high beta (SPHB) to low volatility (SPLV) stocks (middle panel) has been a useful signal of tradable market tops in the past, and this ratio is not rolling over. My base case scenario calls for a likely pullback to test support in the 3300 area next week, to be followed by a rally to new highs, and accompanied by a negative NYSI divergence and a rollover of the SPHB/SPLV ratio.
 

 

Short-term momentum is resetting from an overbought reading.
 

 

There is a likely support level at about 3300, which I expect to be tested early next week.
 

 

Disclosure: Long SPXL

 

Is the melt-up back?

Posted by Cam Hui -

What should investors make of the market’s recent air pocket and subsequent recovery? John Autthers, writing at Bloomberg, proposed an analytical framework where investors view the coronavirus outbreak mainly as a China problem. The MSCI World with China exposure (blue line) has been far more volatile than the MSCI World Index (white line). The companies with high China exposure have tanked in response to the virus scare and dramatically underperformed global stocks.
 

 

While global investors fret about the economic impact of China’s slowdown in the wake of the coronavirus infection, the PBOC has responded with a tsunami of liquidity to support the market. Moreover, extraordinary measures have been put in place to forbid short selling, and to discourage major shareholders from selling their shares. In response the Asian stock markets have rocketed upwards after a brief corrective period, and global markets have followed suit with a risk-on tone.
 

 

These policy responses beg two obvious questions. Is the melt-up back? If the market is focused mainly on China and the coronavirus, should investors even try to fight the PBOC?
 

A coronavirus report card

Let’s start with a report card on the progression of the coronavirus. Worldometer maps the growth of cases, and the growth rate is starting to level off, which is good news.
 

 

However, we are now entering the second phase of the outbreak, where the world begins to distrust Chinese statistics, and anecdotal evidence of undercounting and other official misdeeds start to pile up.

Chinese social media was inundated with an outpouring of anger and grief over the death of Dr. Li Wenliang. Li warned other medical staff about the coronavirus, but he was admonished by the police for “making false comments” that had “severely disturbed the social order”. Li caught the virus, and died recently in hospital. He was 34. WeChat has taken steps to censor comments about Li Wenliang, and the protests have the potential to spiral out of control.

The BBC recently reported undercounting of infections in Wuhan (see “We’d Rather Die At Home Than Go Into Quarantine”). While mildly infected cases are quarantined, seriously infected patients cannot find hospital beds and therefore are not counted in official statistics. The Guardian also documented how local party cadres took the best face masks for themselves while doctors and other medical staff had to make do with second rate equipment and protective clothing.

Ambrose Evans-Pritchard at the Telegraph cast doubt on the veracity of official Chinese statistics:

Are they reading dispatches by Caixin and others revealing a desperate shortage of testing kits and tales of the walking afflicted (transport has been stopped) queuing for hours at hospitals, only to be turned away and sent home to die undiagnosed. These glimpses of truth are about to vanish. The propaganda police have ordered those within their direct reach to conduct an “editorial review”.

The coronavirus numbers are fiction. Far more have died than 490. A Lancet study last week by the University of Hong Kong estimated that the Chinese authorities have understated the epidemic tenfold. It calculated even then that the true figure for Wuhan cases was likely to be 76,000, and that Chongqing and Changsha are already riddled with the disease.

“Independent self-sustaining outbreaks in major cities globally may become inevitable,” it said.

Views differ but it is striking how many global experts say it may already be too late to stop the spread. “It’s very, very transmissible, and it almost certainly is going to be a pandemic,” said Anthony Fauci, head of the US National Institute of Allergy and Infectious Disease.

A Johns Hopkins model of the outbreak shows that the modeled infection cases to be far higher than the reported case.
 

 

A Taiwanese website suggested that it found evidence of manipulation of coronavirus statistics, though the account is verging into tinfoil hat conspiracy theory territory.

As many experts question the veracity of China’s statistics for the Wuhan coronavirus outbreak, Tencent over the weekend appeared to inadvertently release what is potentially the actual number of infections and deaths — which are far higher than official figures, but eerily in line with predictions from a respected scientific journal.

As early as Jan. 26, netizens were reporting that Tencent, on its webpage titled “Epidemic Situation Tracker,” briefly showed data on the novel coronavirus (2019-nCoV) in China that was much higher than official estimates, before suddenly switching to lower numbers. Hiroki Lo, a 38-year-old Taiwanese beverage store owner, that day reported that Tencent and NetEase were both posting “unmodified statistics,” before switching to official numbers in short order.

Netizens also noticed an Enron-like fatality rate in official Chinese statistics. The number of deaths worked out to exactly 3.1% on a daily basis for the January 22-24 period, and dropped to 2.1% from January 30 to February 2. The Tencent “leaked” figures were much higher by comparison.

The mortality rates for the numbers briefly shown on Tencent are much higher. The death rate for Jan. 26 was 2,577 deaths out of 15,701 infections, or 16 percent.

The death rate for the Feb. 1 post was 24,589 deaths out of 154,023 infections, which also comes out to 16 percent. The death rates briefly shown are clearly vastly higher than the official percentages and substantially higher than SARS at 9.6 percent, but lower than MERS at 34.5 percent.

There is another solution if you don’t trust Chinese statistics. The Johns Hopkins CSSE website breaks out the growth rate outside China. While the history of the data is short it’s still early, the growth rate has been relatively steady, and results are inconclusive.
 

 

In response to the nervousness over the economic slowdown, the PBOC has unleashed a shock-and-awe liquidity campaign on the financial system. This has put a floor on stock prices, but market internals are mixed. The highly cyclical real estate industry, whose sales have cratered to zero during the outbreak, has seen its relative returns lag the market, but it is stabilizing at a relative support level. By contrast, the relative performance of banking stocks have been plummeting, indicating heightened concerns over financial system stability.
 

 

The view from outside China

The picture outside China has been mixed to positive. The pre-outbreak macro outlook has been mostly positive, as evidenced by the upside surprise in both ISM Manufacturing and Services. The Citigroup Economic Surprise Index, which measures whether economic data is beating or missing expectations, has been surging.
 

 

Last week’s release of Eurozone PMI has also been encouraging for the manufacturing sector. In particular, the new orders-to-inventory ratio, a key forward-looking indicator for factory production, rose to a 2.5 year high.
 

 

The real-time relative performance of cyclical exposure has been mixed. While equity prices corrected and recovered, commodity prices, which are highly sensitive to the global cycle, have fallen dramatically.
 

 

While the weakness in commodity prices could be attributable to economic weakness in China, the relative performance of global cyclicals have been neutral to negative. In particular, the semiconductor stocks, which had been market leaders, have pulled back below a key relative uptrend.
 

 

Climbing a Wall of Worry?

Sentiment model readings are also a mixed bag. On one hand, the latest cover of the Economist may have provided the classic contrarian magazine cover indicator for the markets (see A key test: The Zero Hedge bottom?).
 

 

On the other hand, sentiment readings such as the AAII Bull-Bear spread fell to neutral and reversed bullish again before fully resetting to a bearish extreme.
 

 

Citigroup strategist Tobias Levkovich, who is the keeper of the Citi Panic/Euphoria Model, stated in an interview that too many clients were itching to buy the dip. Capitulation did not occur in the most recent pullback, and there are too many bulls.

Pretty much every client we talk to wants to buy the dip, and that is not comforting. It implies that people are very long the market and are willing to let share prices go higher. When we are asked what factors made the Panic/Euphoria Model move into euphoric territory, we highlight one of the inputs (though several caused the shift), as it looks at premiums paid for puts versus calls, and the prices have dropped for puts. Fewer deem the need to pay up for insurance, which indicates substantive complacency. Accordingly, the qualitative/anecdotal evidence is supporting the more quantitative approaches.

While such a sentiment backdrop could underpin a FOMO buying stampede, the S&P 500 is now trading a forward P/E ratio of 18.8. The Rule of 20 Indicator, which flashes a warning when the sum of the forward P/E and CPI inflation rate exceeds 20, is now at a worrisome bull cycle high of 21.1.
 

 

A renew melt-up?

I began this publication with the rhetoric questions of whether the melt-up has returned, and should investors fight the flood of liquidity from the PBOC. The jury is still out on those questions.

The short-term bull case is supported by abundant central bank liquidity, and emerging evidence of a pre-coronavirus cyclical rebound from non-China economies. On the other hand, bullish sentiment did not fully reset, and valuation is extended.

Should the animal spirits return and drive stock prices upward, watch for fresh highs accompanied by a negative divergence in the NYSE McClellan Summation Index (NYSI). Similar divergences were in evidence at the last two major market highs. Advances under such a “false rally” scenario in the past two tops saw a three-month gap between the first NYSI high and the final stock market top. If the past is any guide, this would put timing of the next major top in April.
 

 

As well, watch sentiment models, such as II sentiment, to return to bullish extremes for the signs of a top.
 

 

On the other hand, the latest rally could just be a simple bull trap. The latest advance was accomplished with negative RSI divergences.
 

 

In light of the risks evident in the market, we suggest that investment oriented accounts maintain a neutral risk position, with an asset allocation roughly in line with policy asset mix.

Stay tuned.

 

An animal spirits revival?

Posted by Cam Hui -

Mid-week market update: The animal spirits are back. Just look at the price action in Tesla.
 

 

In this environment, it is no surprise that the stock market is embarking on a test of the old highs.
 

Lines in the sand

I had set out one line in the sand (see A key test: The Zero Hedge bottom?) of the market might react to news. Notwithstanding the Iowa caucus debacle, in which the results are not fully known yet two days after the event, the market is rallying in the face of news of more uncontrolled spread of the coronavirus. Trinh Ngyugen at Natixis pointed out that this virus is worse than SARS at this point in the outbreak, based on the figures coming out of China.
 

 

To be sure, Asian market spiked upwards overnight on two separate reports that breakthroughs had been achieved by Chinese researchers (CGTN report) and by British researchers (Sky News report). But those accounts are unverified, and CNBC reported that the WHO has played down the possibility of drug breakthroughs.

The World Health Organization (WHO) has played down media reports of a drug breakthrough against the coronavirus outbreak, saying there are “no known” drug treatments against the virus.

“There are no known effective therapeutics against this 2019-nCoV and WHO recommends enrollment into a randomized controlled trial to test efficacy and safety,” WHO said in a statement on Wednesday.

“A master global clinical trial protocol for research and prioritization of therapeutics is ongoing at the WHO,” it added.

Yet, the market continues to take a risk-on tone. The SPX took on a decidedly bearish tone when it broke down through the 3300-3310 zone. Now that the index has rallied through that same region on the hourly, it is now testing the old highs.
 

 

Sentiment models have partially reset, though readings did not fall to capitulation levels.
 

 

On the other hand, Citigroup strategist Tobias Levkovich recently stated in an interview that “Pretty much every client we talk to wants to buy the dip, and that is not comforting.” Bears can interpret his remarks in a contrarian fashion as a signal to be cautious. Bull can see this as the resumption of a FOMO buying stampede.

Pretty much every client we talk to wants to buy the dip, and that is not comforting. It implies that people are very long the market and are willing to let share prices go higher. When we are asked what factors made the Panic/Euphoria Model move into euphoric territory, we highlight one of the inputs (though several caused the shift), as it looks at premiums paid for puts versus calls, and the prices have dropped for puts. Fewer deem the need to pay up for insurance, which indicates substantive complacency. Accordingly, the qualitative/anecdotal evidence is supporting the more quantitative approaches.

These conditions are consistent with the “false rally” scenario I had laid out in the past. Watch for the market to advance to new highs, marked by an NYSI negative divergence.
 

 

From a tactical perspective, the market is short-term overbought, and today’s rally left an unfilled gap below. Some near-term consolidation or shallow pullback would be no surprise. Subscribers received an email alert this morning that my inner trader had covered all shorts and taken a small long position. Any dip towards the 3300 zone would be regarded as an opportunity to add to long positions. However, a definitive violation of the 3300 level would be a risk-off signal.
 

Alternative bull trap scenario

An alternative scenario is the latest test of the old highs is a simple bull trap, where the test of old highs fails, or fails just after a false breakout. One cautionary signal is the negative divergence flashed by the 5 and 14 day RSI.
 

 

Helene Meisler also highlighted the observations of Frank Zorrilla that past blow-off tops in market darlings like Beyond Meat (BYND), Tilray (TLRY), and silver (SLV) has been accompanied by a nearby market peak. Here is BYND.
 

 

TLRY
 

 

SLV
 

 

The price of TSLA has been going parabolic, but it had its first setback today. No one knows what will happen next, or whether these blow-off top templates are necessarily applicable to market timing. What is certain is volatility is high.. Traders should adjust their position sizes accordingly.

Disclosure: Long SPXL