Trading the Energizer Bunny rally

Posted by Cam Hui -

Mid-week market update: As regular readers are aware, I have been increasingly cautious about the equity outlook for the past few weeks as the market advanced. This has become the Energizer Bunny rally that keeps going beyond expectations.

Where will it stop? One of the indicators that I have been keeping an eye on is the NYSE McClellan Summation Index (NYSI). In the past, whenever the NYSI has fallen to an oversold extreme of -1000 or less, the indicator has rebounded so that the weekly stochastic bounced from an oversold to an overbought level. We are now overbought on the weekly stochastic.
 

 

To be sure, past rebounds have seen the weekly stochastic become even more overbought. These conditions suggests that there may be one or two weeks of more upside on NYSI, this relief rally is running on borrowed time.
 

The bull case

Here is the bull case for more upside, either on a tactical or sustained basis. First, equity risk appetite continues to be positive. The ratio of high beta to low volatility stocks is rising in the context of a relative uptrend.
 

 

Price momentum has been impressive. Ryan Detrick of LPL Financial observed that this is the greatest 50-day equity market rally, and similar strong rallies have led to further strength in the past. The market recently staged upside breakouts through its 200 dma, and the strength may be indicative of a FOMO stampede.
 

 

Even as the FANG+ and NASDAQ stocks lose their momentum, market leadership has broadened to cyclical sectors and industries, indicating the expectation of an economic rebound.
 

 

Small and microcaps have also been turning up in relative performance.
 

 

The bear case

Here is the bear case. First, it seems that analysts are turning bullish to catch up with price. Helene Meisler has a pinned tweet that may fit the current environment well.
 

 

As an example, John Authers documented Goldman’s sanguine outlook, though admittedly the market is priced for perfection.

If next year’s earnings turn out to be in line with Goldman’s baseline forecasts, then the market is trading at a high but reasonable 18 times 2021 earnings. It is higher than that if the more bearish estimates from buy-side firms are right; and at an all-time high of 26, significantly above even the worst excesses of 2000, if the worst-case scenario is correct. So the market is plainly working on the assumption that things will turn out about as well as can reasonably be expected:

 

If any of the risks that I outlined in the past (see Brace for the second waves) were to appear, then it’s game over for the rosy outlook. These kinds of justifications seem to be a case of grasping at bullish straws.

John Authers also pointed out an anomaly in the cyclical and small cap rebound bullish thesis. If the market truly believes that the economic is turning up, then why are the stocks with good balance sheets beating the stocks with poor balance sheets? In a cyclical rebound, highly levered companies, some with zombie-like characteristics, should skyrocket because they behave like out the money call options on the economy.
 

 

Price momentum effects may be starting to peter out. I had pointed out that the rally off the March bottom was mainly attributable to short covering (see A bull market with bearish characteristics), it was unclear what kind of market players are willing and able to take up the baton. Fast money and trend following Commodity Trading Advisers (CTAs) are now at their maximum long positioning in stocks.
 

 

Who will buy next?
 

When do retail investors pull back?

We have all heard about the frenzied trading of naive retail traders entering the market. Jim Cramer observed that even small trader sentiment is becoming very frothy, which is a cautionary signal.
 

 

One clue came from a historian who studied how the rich reacted to the Black Death. So far, the main job losses have come from lower paying service jobs. Better educated workers have been largely insulated because they can work from home.

The coronavirus can infect anyone, but recent reporting has shown your socioeconomic status can play a big role, with a combination of job security, access to health care and mobility widening the gap in infection and mortality rates between rich and poor.

The wealthy work remotely and flee to resorts or pastoral second homes, while the urban poor are packed into small apartments and compelled to keep showing up to work.

Social reaction to the Black Death provides a rough model of what may happen today.

One key issue in “The Decameron” is how wealth and advantage can impair people’s abilities to empathize with the hardships of others. Boccaccio begins the forward with the proverb, “It is inherently human to show pity to those who are afflicted.” Yet in many of the tales he goes on to present characters who are sharply indifferent to the pain of others, blinded by their own drives and ambition.

People with sufficient savings to play the stock market today belong mainly to the class of educated workers. In this case, the adage that it’s a recession if your neighbor loses his job and a depression if you lose yours may ring especially true for the investor class. Sentiment may not break until we start to see widespread white collar job losses and salary cuts. Bloomberg Economics’ estimates of second wave job losses shows management jobs rank second in layoff potential. That may provide the catalyst for individual investors to de-risk because of their own employment conditions.
 

 

Leuthold Group: Still a bear market

Analysis from the Leuthold Group provides some context as to why this is still a bear market. Leuthold had set out a criteria of five conditions for a cyclical market low, and the March 23 low met none of those conditions.
 

 

The Leuthold Group went on to observe that “the 30% surge off the low met 0-of-3 dynamics that usually accompany the first leg of a bull market”. In total, 0 for 8 is not exactly comforting for the bull case.

I interpret these conditions as a bear market rally, though short-term momentum may carry the market somewhat higher in the next one or two weeks. My base case scenario calls for a short-term peak, but investors should be prepared for rising downside risk afterwards. I have no idea how far the current FOMO rally can run, but my inner trader is standing aside because the intermediate term risk/reward is tilted bearishly.

 

Brace for the second waves

Posted by Cam Hui -

As we progressed through the pandemic induced recession, there have been much discussion about a second wave. Second waves appear in many forms, and they can threaten the current consensus expectation of a V-shaped rebound.
 

 

Here are some of the second wave risks the market faces.

  • A second wave of COVID-19 infections
  • A second wave of layoffs and wave cuts
  • A second wave of bankruptcies

Finally, investors have to face the risk of permanent economic scarring that impair long-term growth potential. Under that scenario, slower growth rates will persist even after any recovery, and affect asset prices in ways that the market hasn’t fully discounted.
 

A second wave of infections

In all likelihood, there will be a second wave of COVID-19 infections. The Center for Infectious Disease Research and Policy (CIDRAP) conducted a study and believes the latest pandemic most resembles influenza pandemics in infectious characteristics. CIDRAP went on to examine eight major influenza outbreaks and found that there was always a second wave. The more disturbing finding was that pandemics since 1918 had larger second waves.

Of eight major pandemics that have occurred since the early 1700s, no clear seasonal pattern emerged for most. Two started in winter in the Northern Hemisphere, three in the spring, one in the summer, and two in the fall (Saunders-Hastings 2016).

Seven had an early peak that disappeared over the course of a few months without significant human intervention. Subsequently, each of those seven had a second substantial peak approximately 6 months after first peak. Some pandemics showed smaller waves of cases over the course of 2 years after the initial wave. The only pandemic that followed a more traditional influenza-like seasonal pattern was the 1968 pandemic, which began with a late fall/winter wave in the Northern Hemisphere followed by a second wave the next winter (Viboud 2005). In some areas, particularly in Europe, pandemic-associated mortality was higher the second year.

The current pandemic will likely last 18-24 months.

Key points from observing the epidemiology of past influenza pandemics that may provide insight into the COVID-19 pandemic include the following. First, the length of the pandemic will likely be 18 to 24 months, as herd immunity gradually develops in the human population. This will take time, since limited serosurveillance data available to date suggest that a relatively small fraction of the population has been infected and infection rates likely vary substantially by geographic area. Given the transmissibility of SARS-CoV-2, 60% to 70% of the population may need to be immune to reach a critical threshold of herd immunity to halt the pandemic (Kwok 2020).

CIDRAP postulated three separate scenarios for COVID-19.
 

 

Here is the most worrisome development. Different US states are reopening their economies at different paces. The worst hit states like New York and New Jersey have constructively bent their new case curves downward. Many other states, like California, have only flattened their curves instead of bending them down.
 

 

What if a vaccine were to appear? CBS reported that a poll revealed that only half of Americans would get a COVID-19 vaccine, which is not enough to achieve herd immunity.

Only about half of Americans say they would get a COVID-19 vaccine if the scientists working furiously to create one succeed, according to a new poll from The Associated Press-NORC Center for Public Affairs Research.

That’s surprisingly low considering the being put into the global race for a vaccine against the coronavirus that’s sparked a pandemic since first emerging from China late last year. But more people might eventually roll up their sleeves: The poll, released Wednesday, found 31% simply weren’t sure if they’d get vaccinated. One-in-five said they’d refuse.

Here are some of the reasons cited.

Among Americans who say they wouldn’t get vaccinated, seven-in-ten worry about safety…about four-in-ten say they’re concerned about catching COVID-19 from the shot. But most of the leading vaccine candidates don’t contain the coronavirus itself, meaning they can’t cause infection.

And three-in-ten who don’t want a vaccine don’t fear getting seriously ill from the coronavirus.

While some of the issues cited could be addressed to raise the vaccination rate, this is nevertheless a disturbing development from a public health policy viewpoint. For investors, any hint of a second wave of infection will evoke a reaction from the health authorities to re-impose tighter stay-at-home policies, which would elongate the economic slowdown.
 

Layoffs and wage cuts ahead

In addition to the more obvious COVID-19 public health issues, investors have to be concerned about a second wave of economic damage. The effects of the first wave of layoffs are well-known. So far, most of the job losses have been concentrated among the low paying workers. Now reports are piling up that white-collar layoffs are ahead. The NY Times reported that Boeing is cutting 16,000 jobs. Bloomberg reported that Deloittes is preparing to lay off 2,500 employees. The list goes on, but you get the idea.

As well as layoffs, we now to worry about a new second wave, namely wage cuts. The Fed’s Beige Book reported a “second wave” of wage cuts is hitting the economy.

Wages and other benefits were lower than in our previous report; a payroll company reported a “second wave” of wage cuts, and reports across industries have mentioned cuts to benefits, including employer 401k matching. Some companies, especially those in competitive fields, have promised to repay lost wages at the end of the crisis; and others have increased wages to maintain morale and lure back hesitant workers.

The NY Times reported that some companies are considering wage cuts in lieu of layoffs.

Even as American employers let tens of millions of workers go, some companies are choosing a different path. By instituting across-the-board salary reductions, especially at senior levels, they have avoided layoffs.

The ranks of those forgoing job cuts and furloughs include major employers like HCA Healthcare, the hospital chain, and Aon, a London-based global professional services firm with a regional headquarters in Chicago. Chemours, a specialty chemical maker in Wilmington, Del., cut pay by 30 percent for senior management and preserved jobs. Others that managed to avoid layoffs include smaller companies like KVH, a maker of mobile connectivity and navigation systems that employs 600 globally and is based in Middletown, R.I.

None of these developments are conducive to a V-shaped recovery.
 

A second bankruptcy wave

In addition, we have barely seen the start of a bankruptcy wave in this recession. The combination of temporary fiscal rescue measures and Fed policy has served to put in a temporary cushion on the wave of bankruptcies that is likely to hit the economy. Unless Congress acts to extend PPP, the payments expire in July.

Already, credit quality is deteriorating.
 

 

A second wave of bankruptcy is almost impossible to avoid.
 

 

As the damage of these business failures hit the economy, the effect of this second bankruptcy wave is likely to be persistent.
 

The risk of permanent economic scarring

The persistence of economic damage is especially a worrisome problem for economists. A new IMF Working Paper addressed this issue of “hysteresis”.  For the uninitiated, hysteresis in economics is the persistence of effect after the initial shock of the effect is gone.

The IMF paper is mainly a survey of past research, and there were many papers cited. In particular, the authors referenced the well-known Reinhart and Rogoff study of past financial crises:

Reinhart and Rogoff (2014) examine the evolution of real per capita GDP around 100 systemic banking crises and found that a significant part of the costs of these crises lies in the protracted and halting nature of the recovery. On average it takes about eight years to reach the pre-crisis level of income; the median is about 6.5 years. In a sample that covers 63 crises in advanced economies and 37 in larger emerging markets, more than 40 percent of the postcrisis episodes experienced double dips.

The IMF study concluded:

In the last 25 years we have seen the development of an alternative model of business cycle that emphasizes the effects that business cycles can have on the drivers of long-term economic growth. In these models GDP is history dependent and all shocks can have permanent effects on output, what we refer to as hysteresis. This represents a change from the traditional cycle-trend decomposition that defined cycles as deviations from a trend that was independent of any of the traditional demand shocks that could be responsible for economic fluctuations…

In the presence of hysteresis, the costs of cyclical shocks or the lack of action of policy makers are much larger because of the permanent scars they can leave on GDP through their interactions with the endogenous forces that drive long-term growth or the dynamics of labor markets. Aggressive and fast action during recessions becomes optimal policy. And during expansions, the cost of acting too early on fears of inflationary pressure can also be very costly as it can either reduce the potential growth of the economy or hinder positive developments in the labor market. In this new framework, policy makers should understand the likely large supply costs of not being as close as possible to potential output by running a “high-pressure” economy.

In practical terms, here is what hysteresis, or the persistence of economic shock, means in real life. A recent Goldman Sachs survey of small business participants by Babson College and David Binder Research reveals small firms have already suffered considerable damage from COVID-19. 9% are permanently closed, and only about half are fully open. Looking out over the next six months, respondents believe that 71% of customers will return, at a rate of only 63% of revenues.
 

 

What was not asked was how many and how long can small businesses survive at 63% of previous revenue levels.
 

The burden of reopening

Some clues to that question came from a survey done in late April by the Chicago Fed in association with the local chambers of commerce. Even though the survey was restricted only to the Chicago Fed’s Seventh District states, the survey does provide a window into the outlook for small business in the US. Survey respondents were predominantly small businesses: “About 60% of the respondents were from firms with fewer than ten employees and another 25% were from firms with ten to 49 workers.”

One of the biggest concern expressed in the survey was the extra costs involved in reopening after the lockdowns are lifted. As we move into Q2 and Q3, watch the narrative from companies start to change to “we are burdened with an extra layer of costs in reopening, along with reluctant customers”. The Chicago Fed survey found companies that would experience financial distress under “moderate” social distance measures and gatherings of 50 people or less if the operate at 75% capacity range from 38% for manufacturing to 88% for restaurants.
 

 

The survey also asked whether companies were concerned about different metrics of financial health over the next three months. Cutting to the chase, about 30% to 40% of most companies were concerned about their own financial solvency over this period. Companies in finance were in the best shape, while restaurants were in the worst.
 

 

In short, expect at least one-third of small businesses to fail in the next three months, even with massive fiscal and monetary support, and assuming that there is no second wave of infection. This is a level of business failure that does not appear to have been fully discounted by the financial markets.

Lastly, the recent wave of protests springing up around the US will hamper the prospect for a V-shaped rebound. Depending on how long the protests last, can anyone really believe that business will return to normal with rioters in the streets? Here are some reactions from analysts of the effects of the riots, as reported by Bloomberg.

“I think people are coming to the realization that their jobs may not be coming back or coming back quickly. This is all conflating with the racial tensions and completely boiling over,” said Mark Zandi, chief economist at Moody’s Analytics. “This highlights the depth of despair in America,” he added, citing 20% unemployment and 50 million workers who’ve lost their jobs or had pay cuts…

“The impact of the riots may be greater on the daily and weekly measures of consumer confidence, which were trending slightly upward since mid-April, but which may now post a pull-back into early June,” said Mike Englund, chief economist at Action Economics, which provides financial-market commentary.

In conclusion, even though market analysts have discussed “second waves”, I do not believe they fully appreciate the multi-factor nature of the second waves that threaten the growth outlook. While all of these risks may not fully materialize, the current consensus market narrative does not seem to have fully discounted many of these risks.
 

A bull market with bearish characteristics

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

A new bull?

Is this the start of a new bull market? Ed Clissold of Ned Davis Research got a lot of people excited when he pointed out that the percentage of stocks above their 50 day moving average (dma) had exceeded 90%. Such events are intermediate term breadth thrusts with bullish implications.
 

 

Does this mean we are witnessing the birth of a new bull market?
 

Bull or bear?

Not so fast. Urban Carmel observed there is a disparity between the percentage of stocks above their 50 dma, which is high, and the percentage of stocks above their 200 dma, which is not as high. The difference can be explained by the strong rally mounted by stocks since the March low.

When the difference of the two indicators (second bottom panel) is high, the signals can be somewhat hit-and-miss. It is an effective buy signal (shown in green) when stocks are in a bull market, and less effective (shown in red) when stocks in a bear market. So we are left scratching our heads. Is this a bull or bear market, and should we buy or sell? The new 52-week high indicator (bottom panel), which is weak, does not inspire a lot of confidence.
 

 

If this is a new bull, then it looks like a bull market with bearish characteristics.

On the other hand, if this is a bear market rally, there may not be much gas left in the tank of this rally. Going back to 1998, whenever the NYSE McClellan Summation Index (NYSI) has reached the unusual condition of -1000 or less, the weekly stochastic has always rebounded from an oversold to an overbought reading. We are nearly there.
 

 

Unfortunately, these signals (red for buy, blue for sell) tell us little about whether we are in a bull or bear market. Of the four signals, two were bullish, and two were bear market rallies.
 

How psychology changes

When a market transitions from bull to bear and back to a new bull market, the old leadership weakens to reflect the purging of excesses of the old bull. New leadership emerges to reflect the hope of the new bull. Instead, the analysis of market cap leadership shows that megacap stocks are plateauing. Mid and small caps are trying to turn up on a relative basis, but remain in long-term downtrends. NASDAQ stocks may be rolling over on a relative basis, but remain in a long-term uptrend. In short, the old leadership is still intact. If this is indeed a new bull, then this is another way the market looks an awful lot like the old bull, or a new bull with bearish characteristics.
 

 

As well, most measures of price momentum are still in relative uptrends, indicating that the old trends remain intact. Bull/bear/bull transitions usually don’t look like this.
 

 

The consensus V-shaped recovery

To be sure, the psychological tone of the market has changed since the March low. The prevalent view has gone from blind panic, to a belief that this rally is a bear market rally, to grudging acceptance of a more constructive view of stock prices. A May 12-27 Reuters poll of 250 strategists around the world found that 68% of analysts now do not believe the March lows will be revisited, and an overwhelming majority expect earnings will trough in either Q2 or Q3 2020. In other words, a V-shaped recovery is now the consensus view.
 

 

What drove this change in psychology? Certainly the tone of the newsflow. as measured by the San Franncisco Fed Daily News Sentiment Index, has bottomed and begun to improve, but there is still a high degree of uncertainty over the course of the pandemic and the likelihood of a second wave.
 

 

The change in psychology was attributable to rising stock prices, and analysts and managers hopping on the FOMO train. However, analysts at Citigroup discovered that most of the rally was driven by short covering. Is a short covering rally, however powerful, sufficient reason for analysts to turn as bullish as they did in the Reuters poll?
 

 

A more worrisome development is the Citigroup Panic/Euphoria Model is firmly into euphoric territory, which is contrarian bearish. As a reference, the Panic/Euphoria Model is reportedly based on the following factors:

  1. NYSE short interest ratio, 
  2. Margin debt, 
  3. Nasdaq daily volume as a percentage of NYSE volume, 
  4. A composite average of Investors Intelligence and the AAII bull/bear data, 
  5. Retail money funds, 
  6. The put/call ratio, 
  7. CRB futures index, 
  8. Gasoline prices, and 
  9. The ratio of price premiums in puts versus calls.

 

Other traditional market based sentiment indicators, such as the equity-only put/call ratio, is very low, which is contrarian bearish.
 

 

Jonathan Krinsky of Bay Crest Partners pointed out that the stock market has historically not performed well when the put/call ratio is this low after a strong 10-day advance.
 

 

More puzzles

Here is another chart that lends to differing interpretations. The ratio of high beta to low volatility stocks have been an effective short-term leading indicator of market direction in the recent past. The ratio is rolling over, which is short-term bearish, but it remains in an uptrend, which is supportive of the bull case. This is another indication of a bull with bearish characteristics. In all likelihood, we will see a near-term pullback, but the market can push higher until the rising trend line is violated.
 

 

Short-term breadth is overbought and rolling over, which suggests market weakness early in the week.
 

 

However, the bulls may have one last gasp after an initial bout of weakness, and the bears should not get overly excited just yet. The different flavors of the Advance-Decline Line flashed negative divergences by failing to make new highs even as the S&P 500 broke above resistance and its 200 dma, which is bearish. However, as long as the A-D Lines remain in uptrends, the bulls still have control of the tape.
 

 

My inner investor is underweight equities, and he is slowly moving towards a neutral weight by considering buy-write opportunities (long stock or index, short call option) as a way of mitigating downside risk. My inner trader is standing aside and awaiting a better trading opportunity.

 

Back to basics: Is this market overvalued?

Posted by Cam Hui -

There has been a recent continuing controversy about the usefulness of forward P/E as a valuation tool in the current recessionary environment. On one hand, past bear markets have typically bottomed out at a forward P/E ratio of 10, with a low of 7 (1982) and a high of 14 (2002). FactSet‘s reported market rating of 21.5 forward earnings is very stretched by historical standards.
 

 

On the other hand, Liz Ann Sonders at Charles Schwab observed that stock prices and earnings estimates have shown a correlation of over 0.90 in the last 20 years and the recent correlation is a mirror image -0.90 as stock prices rose and earnings estimates fell. She then qualified that analysis by allowing the same negative correlation occurred during the GFC.
 

 

Do forward P/E ratios matter at this stage of the cycle? Is the market forward looking and discounting the current weakness and valuing the market at its “intrinsic value”? To answer those questions, let’s get back to basics by considering the drivers of equity valuation.
 

Back to basics

Aswath Damodaran of the Stern School at NYU offered this follow analytical framework for analyzing companies.
 

 

Here are the key questions to consider:

  • How will this crisis affect the company in the near term (2020)?
  • How will this crisis affect the business the company is operating in, and its standing, in the long term?
  • How will the crisis affect the price of risk, including the likelihood of default, equity risk premium, and default spreads?

 

Current operating environment

Let’s begin with the current operating environment. I am not sure people appreciate how deep this recession is.

Consider, for example, the scale of the job losses. Continuing jobless claims peaked two weeks ago at 24.9 million, or 7.6% of the population. Imagine a best case scenario where two-thirds of the jobs lost during the pandemic came back relatively quickly. After normalizing for population, this would see the continuing claims to employment ratio falls from 7.8% to 2.9%. But 2.9% would still be worse than the levels reached during recessions of the GFC (2.1%), the Volcker tight money era of 1982 (2.0%), and Arab oil embargo and oil shock recession of 1975 (2.1%). That’s how deep this recession is.
 

 

As well, one of the more worrisome developments is the emergence of the fiscal hawks in the current environment. Former Trump chief of staff Mick Mulvaney appeared on CNBC and declared that people are being trained to believe government is free, and debts and deficits will come back to bite Americans. Mulvaney’s remarks could be interpreted in a partisan way as a way to lay the groundwork to oppose the Democrats’ agenda in the event of a Biden victory in November. Nevertheless, the premature withdrawal of fiscal stimulus will be highly contractionary, and would short-circuit any nascent recovery in 2021.
 

A second wave

The risk of a second wave of economic shock is still present. So far, job losses have mostly been restricted to low paid workers. College educated workers have largely been insulated from the worse of the carnage.
 

 

There is mounting evidence that a second wave of white collar job loss is about to hit the economy. Bloomberg reported that a wave of layoffs is impacting Silicon Valley.

Bloomberg analyzed the data on job cuts, working with Layoffs.fyi, which compiles public layoff announcements in the technology industry. While the pandemic fallout has cut hard across the economy, tech merits particular attention. In recent years it’s juiced stock market gains, boosted U.S. gross domestic product and created services that helped other sectors grow. The hobbling of tech companies will have an outsized effect on the pace of the overall American recovery.

 

 

As tech companies have cut jobs, so has the rest of the country. Recent U.S. layoffs now exceed those during the Great Depression in sheer numbers, and could end up rivaling the 1930s in percentage terms. At the Depression’s height in 1933, almost a quarter of Americans were unemployed, according to estimates from the Bureau of Labor Statistics. Currently, about 15% of Americans are unemployed, up from 3.6% in January.

Although technology companies often employ fewer workers than their counterparts in other industries, tech makes up the biggest chunk of the stock market, meaning its performance has a disproportionate impact on individual retirement portfolios and other assets. At the end of the first quarter, seven of the top 10 companies ranked by market capitalization globally were technology giants.

The WSJ reported on the job losses from an anecdotal perspective.

Hours after Joe Taylor was laid off by Uber Technologies Inc., as part of the ride-sharing company’s far-reaching cost-cutting, the hardware engineer began looking for a new job. What he’s seeing is a Silicon Valley job market that has lost its spark.

The tech industry has been one of the most resilient sectors of the economy during the Covid-19-induced economic downturn. Microsoft Corp. and Amazon.com Inc. reported strong sales growth for the first quarter even as quarantining measures came into effect. But major layoffs at big companies including Uber and Airbnb Inc., as well as a host of smaller startups, have shaken any sense that the tech industry is insulated from the broader employment destruction—and, for many, undermined hope that jobs lost would be easily replaced.

“Everyone’s just a little more wary,” said Mr. Taylor, 38 years old, who was let go earlier this month. Fewer recruiters have gotten in touch than in past job hunts, he said, as he’s scoured opportunities at large and small firms. The message from many recruiters, he said, has been: “I don’t have anything right now, but let’s stay in touch.’”

The following observation is purely speculative, but if technology companies are more comfortable with the work-from-home trend, then what’s to stop them from outsourcing jobs to cheap wage jurisdictions like India? How long before the Joe Taylors of the article start to compete with Indian software engineers?

American corporations’ growing comfort with remote work has also led Mr. Taylor, the former Uber engineer, to look for jobs farther afield, including in Denver. He plans to remain in the Bay Area, working remotely if needed, but the trappings of a nearby tech-company office no longer feel essential.

That’s how dark the outlook could turn.
 

A balance sheet recession?

Looking longer term, the growth outlook could further be impaired by a change in household consumption preferences. Gavyn Davies recently raised the specter of a nascent balance sheet recession in an FT article.

One thing that seems different this time is that much of the slump in US consumer spending has been accompanied not by declining personal incomes but by a surge in savings, which suggests consumers may remain cautious during the recovery.

Congress showered the economy with fiscal largess in the form of the CARES Act, but people are saving instead of spending the proceeds.

Despite this income support, consumer spending has collapsed, especially in service sectors and on discretionary goods such as autos. As a result, the savings ratio could well rise to about 20 per cent of household income.

The key question for the economic recovery is how much of this increase will be reversed as the lockdowns are eased. Part of the decline in spending has been involuntary and will be restored as restaurants and stores re open and work patterns return to normal. But the decline in discretionary spending on big-ticket and other items may last longer, especially if the emergency rise in unemployment benefits ends after the end of July, as planned.

The direct US fiscal stimulus in response to the virus has been about 13 per cent of GDP, and this has maintained household incomes as unemployment has soared. Nevertheless, households have curtailed spending causing a recession. Any withdrawal of the fiscal stimulus, at a time when precautionary savings remain high, could continue to depress spending and prolong the recession.

The behavior of households has been a complete mirror opposite of the GFC. During the GFC, investors yanked money from banks and began a bank run. This time, individuals are stuffing their cash into banks to create precautionary cushions against pandemic related liquidity needs.
 

 

Here is another way of thinking about the interaction between economic growth, Fed policy, and the savings rate. Fed stimulus has caused money supply growth to rise dramatically, but the saving rate spiked as well. Monetary velocity has tanked, and the economy is not growing.
 

 

The dean of the balance sheet recession thesis is Nomura chief economist Richard Koo. Koo made the following points in a Bloomberg podcast.

  • Fiscal and monetary policy has put a floor on the economy, but much depends on public health policy and medical advances.
  • Households and corporations with weak balance sheets could be psychologically scarred from taking on debt, and saving rates will rise. Rising corporate savings translates into lower propensity for business investment. Koo cited the example of the 1990-91 credit crunch and recession, which restrained companies that survived the experience from assuming debt for close to a decade. People who survived the Great Depression also learned to be frugal and avoid debt, which raised their saving rate.
  • The current recession has seen a rush for borrowing. Financial conditions have tightened, and the Fed was correct in flooding the system with liquidity.
  • Trade will continue to be a drag on growth. Post-pandemic, Koo expects a short-lived bout of pent-up consumer spending on services, but the lack of global growth owing to slowing trade will lower global growth potential.

If the savings rate stays elevated, we can expect a balance sheet recession to occur, which will depress long-term growth potential compared to the pre-pandemic era. The Great Depression saw a -26% decline in real GDP, and took six years from the 1929 Crash for real GDP to recover its former peak. Real GDP fell -4% during the GFC recession, and recovered its previous level in about three years. While I am not forecasting a Great Depression style downturn, even the expectation of a GFC-style recovery may not be entirely realistic should a balance sheet recession take hold.
 

The Fed backstop and the price of risk

What about the Fed? There seems to be a belief that Fed intervention can put a floor on stock prices, but the stock market ultimately responds to the economic outlook, which drives earnings. Can we truly see a V-shaped earning recovery if the employment picture is that dismal? Where will demand come from?
 

 

Jerome Powell’s 60 Minutes interview provided some clues. Powell declined to make a forecast of when the recession would end. His response was “it really does depend…on what happens with the coronavirus”.

SCOTT PELLEY, CBS NEWS / 60 MINUTES: There’s only one question that anyone wants an answer to, and that is: when does the economy recover?

JEROME POWELL, CHAIRMAN OF THE FEDERAL RESERVE: It’s a good question. And very difficult to answer because it really does depend, to a large degree, on what happens with the coronavirus. The sooner we get the virus under control, the sooner businesses can reopen. And more important than that, the sooner people will become confident that they can resume certain kinds of activity. Going out, going to restaurants, traveling, flying on planes, those sorts of things. So that’s really going to tell us when the economy can recover.

Powell went on to elaborate on the Fed’s estimate of the length of the recession. “It may take a while. It may take a period of time. It could stretch through the end of next year. We really don’t know.” He expressed concerns about the damage to households and businesses in a prolonged slowdown.

So the risk is that there could be longer run damage to the productive capacity of the economy and to people’s lives. And I’ll give you an example. If workers are out of work for a long period of time, it becomes harder for them to find their way back into the labor force. Their contacts get old and cold, their skills can atrophy, and they just lose their relationship network. And it can be hard to get back to work. And the longer you’re unemployed, the more that it’s a factor. So you want to avoid that.

You want unemployment to be relatively short and if people can go back to their same job, that’s great. And a lot of that can happen here. The same thing is true with businesses. At times when there are high levels of business failures, even very good businesses that are failing because of something like this, that can do longer run damage to the economy and make the recovery slower and weaker.

The Fed can do what it can, but its powers are limited [emphasis added].

It can weigh on the economy for years. So we have tools to try to minimize that longer-run damage to the supply side of the economy. And those tools just involve keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months.

And the same thing with businesses. Keeping them away from Chapter 11 if it’s avoidable. It’s not going to be avoidable in many cases. But if it’s avoidable, the more of that we can do, the stronger the recovery will be. The less this period will weigh on economic growth going forward.

I have said this before but it bears repeating for emphasis. The Fed can supply liquidity, but it cannot supply equity if a firm were to fail. Quandl has created a Late Payment Index. The latest update shows that companies are stretching out the accounts payable, which is a signal of  deteriorating liquidity and rising financial risk. Just ask J.Crew, Neiman Marcus, and Hertz, all of which have filed for Chapter 11 protection. The insolvency cockroaches are crawling out from under the cupboard, and there is never just one cockroach.
 

 

The last expansion cycle was unusual in its debt behavior. Households delevered their balance sheets after their debt binge leading up to the GFC. Corporations were not as exposed entering the GFC as households, and corporations increased leverage in the post-GFC era in response to falling interest rates. The latest crisis has dramatically exposed the corporate sector’s vulnerability to financial accidents.
 

 

The Fed is doing what it can to mitigate risk premiums, but its powers are limited. I interpret this to mean that while the risk-free rate will stay low, and the Fed will do everything it can to cap out risk premiums, market forces will act to force up risk premiums as the aftershocks of the financial crisis become evident. As the crisis drag on into 2021, expect mass small and large business failures, and the price of risk to rise.
 

Market punishment doesn’t fit the crime

Marketwatch recently reported that Doug Ramsey, the chief investment officer of The Leuthold Group, warned that the stock market punishment doesn’t fit the crime. Even if you don’t believe that the forward P/E ratio is a valid measure of valuation because of depressed earnings, Ramsey pointed out that the market is expensive based on the price-to-sales ratio too.

“The depth and duration of this economic calamity are unknowable, but values don’t yet reflect it,” he told clients in a recent note. “S&P 500 valuations are 30-40% higher than seen at even the comparatively-shallow market low of 2002.”

Ramsey went on to show that the median S&P 500 stock is still historically pricy based on several metrics, including price-to-sales and price-to-earnings.

“If the median S&P 500 stock traded down to the average valuation seen at the last three bear market bottoms, it would have to decline another 46% from April 30th levels” he said. “If we play along and assume that valuations bottom at the ‘richest’ levels ever seen at a bear market low, there’s still 32% downside remaining in the median S&P 500 stock.”

The stock market reacted to the initial COVID-19 shock when prices skidded in March, but it hasn’t even begun to discount recessionary aftershocks. The depth of this slowdown is unprecedented, at least in the lifetimes of investment professionals who are working today. But the width of the recession also matters. Anyone who thinks that the Fed can solve all problems with unconventional monetary policy is dreaming.
 

 

We began this journey by going back to the basics of equity valuation with the following questions:

  • How will this crisis affect the company in the near term (2020)?
  • How will this crisis affect the business the company is operating in, and its standing, in the long-term?
  • How will the crisis affect the price of risk, including the likelihood of default, equity risk premium, and default spreads?

The current operating environment is dismal, and there is little hope of relief over the next few years. Credit conditions are deteriorating. Unless some miracle medical advance appears in the immediate future, we are likely to see widespread business failures over the next 12 months that will cripple the economy and, in Jerome Powell’s words, “make the recovery slower and weaker”. The Fed is doing what it can to put a cap on risk premiums. It can print liquidity, but it cannot print sales, nor can it print equity for failing firms.

One (Fed support) out of three isn’t good enough. Current valuation is discounting a V-shaped recovery, and strong Fed support. It has not even begun to discount the aftershocks of the COVID-19 crisis. Equity risk and reward is tilted to the downside.

 

The knife fight at the 200 dma

Posted by Cam Hui -

Mid-week market update: For the last two days, the SPX tested the 3000 level and its 200 day moving average levels and finally broke up today. However, market breadth presents a mixed picture. Fresh 52-week highs have been understandably strong for NASDAQ stocks, as they have been the recent leadership. However, new highs for both large and small caps are less than impressive, which calls into question the sustainability of this rally.
 

 

Who wins the knife fight at the 3000 and 200 dma? Here are bull and bear cases.

 

The bull case: The rally broadens

The main bull case rests on the constructive nature of the changing market leadership. The old price momentum leaders of US over global, growth over value, and large caps over small caps have faltered. In the place, leadership is broadening out to previous laggards such a small cap, cyclical, and value stocks.
 

 

Cyclical stocks are turning up on a relative basis.

 

The relationship between the reopening stocks and stay-at-home stocks is stabilizing, and may be turning up, indicating a renewal of risk appetite.
 

 

The breadth of the market strength is indeed impressive. Eurozone stocks are attempting an upside breakout, though the leadership is narrow and only limited to Germany.
 

 

The UK is also testing a key resistance level.
 

 

Ed Clissold, chief strategist at Ned Davis Research, makes the case that the broadening breadth is supportive of a sustained advance. 90% of stocks are now above their 50 dma, which is a bullish development.
 

 

The bear case: What cyclical turnaround?

The bear case begins with long-term concerns. Some technicians have pointed to the nascent small cap as a possible sign of an economic revival, which has signaled cyclical recoveries and major market bottoms. While I am sympathetic to that view, this indicator has shown hit-and-miss results and produced false positive signals in the past.
 

 

I know that traders aren’t supposed to care about valuation, but the small cap leadership is a sign of a cyclical recovery thesis is undermined by the highly stretched valuation of small stocks. The forward P/E ratio of the small cap Russell 2000 is literally at an off-the-charts high because of a low E in the P/E ratio. Instead, we can analyze the forward P/E ratio of the S&P 600 small cap index, which has a more stringent profitability index inclusion criteria. The S&P 600 also trades at a historical high at 22.0 times forward earnings.
 

 

Speaking of valuation, value stocks are not exactly cheap from a historical perspective either. While investors can expect some valuation refuge in value names, downside risk is still considerable should the market mood turn negative.
 

 

Despite the recent rally, the bulls still have much work to do from a long-term technical perspective. The monthly MACD indicator is a long way from flashing a buy signal, and such buy signals have been extremely effective at calling fresh bull markets in the past.
 

 

The idea of broadening leadership is an attractive idea from a conceptual perspective, there is no sign of new leadership from a global perspective. US stocks have stalled relative to the MSCI All-Country World Index (ACWI), but the same could be said of Europe, Japan, and emerging markets. All regions have been moving sideways on a relative basis for the past 4-8 weeks.
 

 

The fickle narrative

So where does that leave us? It might just up the market’s animal spirits to decide on the market narrative of the day. Joe Wiesenthal at Bloomberg is watching how some of the more aggressive US states are reopening their economy, and the change in COVID-19 cases as a way of monitoring the market’s mood.

The green lines show OpenTable seating data for restaurants in Georgia, Florida, and Texas (three of the earliest and most aggressive states in terms of reopening). The red lines show the daily percentage change in total coronavirus cases in each of those states. The key thing is that all the lines keep going in the right direction. If the return to normal starts setting off a new wave of cases, that will be a red flag. Or if dining activity stalls out at a very depressed level, that would be ominous as well. And it’s certainly possible that service sector activity could just hit a ceiling as a substantial portion of the public changes their behavior. But for now, all the lines are going in the right direction.

 

 

As traders have learned in the past couple of months, the market’s mood can be very fickle. While the market’s focus today might be focused on the progress of reopening efforts, it might shift its gaze tomorrow to the deterioration in Sino-American relations tomorrow. Secretary of State Pompeo has declared that Hong Kong is no longer autonomous from China, signaling a possible end to special trade relationship with the territory. As well, Reuters just reported that a Canadian court has ruled against Huawei CFO Meng Wanzhou’s case against extradition.

Meng’s lawyers argued that the case should be thrown out because the alleged offences were not a crime in Canada.

But British Columbia’s Superior Court Associate Chief Justice Heather Holmes disagreed, ruling the legal standard of double criminality had been met.

“Ms. Meng’s approach … would seriously limit Canada’s ability to fulfill its international obligations in the extradition context for fraud and other economic crimes,” Holmes said.

The ruling paves the way for the extradition hearing to proceed to the second phase starting June, examining whether Canadian officials followed the law while arresting Meng.

There is also the prospect of quantitative tightening as the Fed eases its foot off the QE pedal.
 

 

In the short run, market breadth was already overbought based on Tuesday night’s close. While the odds favor a pullback, the market has also been known to advance on a series of “good overbought” readings.
 

 

I am closely watching the signals from the credit market. The relative price performance of high yield (junk) bonds and municipals are exhibiting minor negative divergences against stock prices. This is especially important in light of the lack of earnings in the Russell 2000, which is indicative of the low credit quality of that index’s constituents. The relative strength of small caps and the relative performance of HY bonds is an important relationship to keep an eye on.
 

 

The Trend Asset Allocation Model’s readings have turned from bearish to neutral, and my inner investor is reluctantly and slowly adding equity exposure from an underweight to a neutral position by focusing on buy-write strategies (long stock, short call option) to mitigate downside risk. If I had to guess, the range of my market scenarios for the next six months calls for a 40% chance that the market would revisit its March lows, 40% chance of a wide range-bound market, and a 20% chance that the market would push higher.

My inner trader is confused by this market action. He is standing on the sidelines.
 

Waiting for the inflection point

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Don’t count on the Fed

There is a belief among the bullish contingent that Fed intervention can solve everything that’s wrong with the stock market. While liquidity injection can boost equity prices, they do not represent a permanent solution. Otherwise, the Japanese and European markets would have been the clear leaders in the past decade.
 

 

Instead, the recent surge in stock prices has created a mini-bubble which is at risk of bursting.
 

Warnings of froth

I have written about the sudden surge in small investor trading that has been supporting this advance. Linette Lopez at Business Insider called a “perfect storm of stupid”.

  • Close to 800,000 people have created new brokerage accounts on three of America’s top brokerage platforms since the coronavirus pandemic hit the US.
  • That means tons of new people are playing the markets at a time when things are so uncertain that hundreds of companies canceled their 2020 earnings guidance. There is no model that can predict what’s about to happen to the economy or the market.
  • That means tons of new people desperate for a coronavirus vaccine are now betting on potential treatments and cures. Just this week the market handed billions to two companies that made headlines without showing any real data.
  • This is very stupid, and people are going to get played.

A much shared chart shows that the trading activity at discount broker Robinhood has rocketed upwards.
 

 

CNBC reported that consumers used much of their stimulus payments to trade the stock market.

Securities trading was among the most common uses for the government stimulus checks in nearly every income bracket, according to software and data aggregation company Envestnet Yodlee. For many consumers, trading was the second or third most common use for the funds, behind only increasing savings and cash withdrawals, the data showed.

Yodlee tracked spending habits of Americans starting in early March and found that behaviors diverged around mid-April — when the checks were sent — between those that received the stimulus and those that didn’t. Individuals that received a check increased spending by 81% from the week prior, and data show some of the spending went to buying stocks.

People earning between $35,000 and $75,000 annually increased stock trading by 90% more than the prior week after receiving their stimulus check, data show. Americans earning $100,000 to $150,000 annually increased trading 82% and those earnings more than $150,000 traded about 50% more often. “Securities trading” encompasses the buying and sells of stocks, ETFs or moving a 401k.

 

SentimenTrader extremes

Jason Goepfert at SentimenTrader recently issued his own warnings of sentiment extremes. First, the stampede into growth and technology is as overbought as 1980, 1999, and 2015. All of these episodes ended badly soon afterwards.
 

 

That warning was addressed not only at the small investors dabbling in the FANG+ names, but institutional investors too. The latest BAML Global Fund Manager Survey revealed that global institutions were underweight stocks, but they compensated by overweight high beta sectors like technology and communication services (GOOGL, NFLX).
 

 

From a tactical perspective, Goepfert also observed that the stock market is likely to staging a volatility breakout. Past breakouts have tended to resolve themselves in a bearish manner.

The S&P 500 has been stuck in a range for a month, above its medium-term 50-day moving average but below its long-term 200-day average. Based on other long streaks of being stuck between time frames, there has been a higher likelihood it will break the streak by falling below its 50-day average. But future returns were weak, no matter which way it broke.

He also issued a warning based on volume behavior.
 

 

How much gas is there left in the tank?

How much gas is there left in the bulls’ tank? Traditional sentiment models are unhelpful. AAII weekly sentiment has is retreated to neutral from a crowded short condition.
 

 

Same with the NAAIM Exposure Index, which measures the sentiment of RIAs.
 

 

Investors Intelligence sentiment has also returned to neutral territory.
 

 

However, two major investment firms’ sentiment indicators are unusually giving off wildly contradictory readings. The BAML Bull-Bear Indicator is flashing an off-the-charts buy signal.
 

 

On the other hand, the Citi Panic-Euphoria Model pushed further into euphoric territory this week.
 

 

Someone is going to be wildly incorrect and have egg on his face.
 

The week ahead

Looking to the week ahead, the market still appears to be range-bound. The possibility exists that the S&P 500 could strengthen further to test its 200 dma at about 3000, but that only represents an upside potential of 1.5%. Different versions of the advance-decline lines remain in uptrends. Until those trend lines are broken, the bears cannot be said to have seized control of the tape.
 

 

The week starts with a slight bearish bias. Short-term breadth is falling, and momentum is negative, but readings are neutral and the market could turn up from here.
 

 

Longer term breadth is recycling off an overbought condition.
 

 

My inner trader remains short the market. For the purposes of risk control, his line in the sand is 2970 on a closing basis.

Disclosure: Long SPXU, TZA
 

What gold tells us about confidence

Posted by Cam Hui -

How badly has the pandemic affected the global economy? The United Nations Development Programme (UNDP) has some answers in a recent report. It expects global human development to decline for the first time this year, and EM economies will bear the brunt of the impact. The International Labour Organization (ILO) estimates that up to half of global workers could lose their jobs.

New UNDP estimates Global human development – as a combined measure of the world’s education, health and living standards – is on course to decline this year for the first time since the concept was developed in 1990. The decline is expected across the majority of countries – rich and poor – in every region.

  • Global per capita income is expected to fall four percent. The World Bank has warned that the virus could push between 40 and 60 million into extreme poverty this year, with sub-Saharan Africa and South Asia hardest hit.
  • The International Labour Organization (ILO) estimates that half of working people could lose their jobs within the next few months, and the virus could cost the global economy US$10 trillion.
  • The World Food Programme says 265 million people will face crisis levels of hunger unless direct action is taken.

While the human development is falling this year, the market’s perceived decline of confidence did not begin with the COVID-19 pandemic. Last week, I highlighted a comment by Joe Wiesenthal at Bloomberg when he focused on the stock/gold ratio as a barometer of optimism and pessimism (see Checking the small business economic barometer). I would go further to characterize the ratio as a barometer of investment confidence in human ingenuity.

It’s such a pure and simple expression of optimism versus pessimism. When you bet on stocks you’re betting on humans endeavoring to do productive things. When you bet on a shiny inert metal you’re betting on a shiny inert metal.

The chart of the stock/gold ratio surprisingly revealed that it peaked in the summer of 2018 and it has been falling ever since. Since that 2018 peak, both stock and gold prices have climbed, but gold has outpaced stocks. The decline in the stock/gold ratio is worrisome for long-term equity investors.
 

 

The stock/gold ratio outside the US, as represented by the MSCI World xUS Index, looks even worse. The MSCI World xUS Index never recovered its pre-GFC peak. Gold, as priced in euros, has reached all-time highs. The post-GFC equity market recovery is entirely attributable to the outperformance in the US.
 

 

What is the market telling us about optimism and pessimism, and global investment confidence?
 

I conclude that the outlook for equities faces a number of long-term headwinds, namely de-globalization, rising protectionism, and a difficult growth outlook. Gold represents an insurance policy against falling investment confidence. Investors should re-evaluate their portfolio allocation policy in light of these factors affecting asset returns over the next decade.
 

America’s sugar high

Arguably, the S&P 500/gold peak in 2018 is attributable to the wearing off of the sugar high of the corporate tax cuts enacted in 2017. The history of forward 12-month EPS tells the story. Earnings took a one-time jump in the wake of the tax cuts and rose steadily until late 2018. Since then, estimate growth has been mostly flat until the recent pandemic shock.
 

 

We can see the valuation effects of the advance off the Christmas Eve bottom in 2018. The forward P/E ratio rose steadily, until it peaked at 19 just before the COVID-19 crisis.
 

 

Elevated valuations have sparked Rule of 20 warnings, which flashes a sell whenever the sum of the forward P/E ratio and inflation rate exceeds 20. The market was already overvalued based on the Rule of 20 even before the onset of the pandemic. Stock prices duly retreated as the COVID-19 crisis evolved, but the latest recovery is flashing another Rule of 20 sell signal.
 

 

Is there any wonder why the stock/gold ratio is turning down? Earnings had been stagnant, but stock prices were rising. It is therefore no surprise that the market began to discount this negative divergence and gold price outperformed in response.
 

Depression in Europe and Japan

Outside the US, economic depressions are evident. Jerome Powell was asked about the possibility of a second great depression in his recent 60 Minutes interview.

PELLEY: 25% is the estimated height of unemployment during the Great Depression. Do you think history will look back on this time and call this the Second Great Depression?

POWELL: No, I don’t. I don’t think that’s a likely outcome at all. There’re some very fundamental differences. The first is that the cause here– we had a very healthy economy two months ago. And this is an outside event, it is a natural disaster, in effect. And that’s one big difference. In the ’20s when the Depression, well, when the crash happened and all that, the financial system really failed. Here, our financial system is strong has been able to withstand this. And we spent ten years strengthening it after the last crisis. So that’s a big difference. In addition, the last thing I’ll say is that the government response in the ’30s, the central banks were trying to raise interest rates to keep us on the gold standard all around the world. Exactly the opposite of what needed to be done.

In this case, you have governments around the world and central banks around the world responding with great force and very quickly. And staying at it. So I think all of those things point to what will be — it’s going to be a very sharp downturn. It should be a much shorter downturn than you would associate with the 1930s.

There are a few points to unpack in Powell’s response. First, he was correct that fiscal and monetary authorities were overly tight in the wake of the 1929 Crash and tightened policy, all in the name of the gold standard. It was therefore unsurprising to see the stock/gold ratio plunge in response during the 1930’s.

He was incorrect that the fiscal and monetary responses are always sufficient to prevent another depression. While the US has not experienced a depression since the Dirty Thirties, parts of Europe have been in a depression in the last decade. The EU and eurozone unemployment rates rose steadily in the wake of the GFC. While they have recovered to their pre-crisis lows, absolute levels remain elevated. In particular, peripheral country unemployment rates are still horrendous. The adjustment in Greece was borne mainly by an internal devaluation of wages.

In addition, youth unemployment in Europe remains in double digits, and it is especially high in peripheral countries. This is creating a lost generation, which has negative effects on productivity and has the potential to create social and political turmoil.
 

 

The ECB’s initial LTRO response in 2011 did take away the tail-risk of the breakup of the eurozone, and put a floor on the price of risk assets. ECB policies were designed to buy time for member states to reform and restructure their economies. At the time, Mario Draghi referred to labor market reforms to create greater economic dynamism, and to break the perception of lifetime security for the older generation, so that youth unemployment could decline. But reforms were either too slow or not forthcoming. The ECB did what it could to support markets and hold the eurozone together, but its policy of negative interest rates was a bridge too far. The negative interest rate policy has devastated the European banking sector.
 

 

While recessions are well-defined, there is no standard definition of a depression. That said, it is difficult to characterize peripheral Europe as being anything but a depression since 2011.

Similarly, Japan’s Nikkei Index has gone nowhere for decades despite fiscal and monetary support. Gold in JPY has broken out to fresh all-time highs.
 

 

Trade and globalization in retreat

Looking ahead, what’s the outlook for the next decade and beyond? The crystal ball is a little hazy, but the latest BAML Global Fund Manager Survey provided some clues of investor expectations.
 

 

The biggest theme is rising protectionism and de-globalization. The Economist devoted an entire issue on the topic.

Trade will suffer as countries abandon the idea that firms and goods are treated equally regardless of where they come from. Governments and central banks are asking taxpayers to underwrite national firms through their stimulus packages, creating a huge and ongoing incentive to favour them. And the push to bring supply chains back home in the name of resilience is accelerating. On May 12th Narendra Modi, India’s prime minister, told the nation that a new era of economic self-reliance has begun. Japan’s covid-19 stimulus includes subsidies for firms that repatriate factories; European Union officials talk of “strategic autonomy” and are creating a fund to buy stakes in firms. America is urging Intel to build plants at home. Digital trade is thriving but its scale is still modest. The sales abroad of Amazon, Apple, Facebook and Microsoft are equivalent to just 1.3% of world exports.

The flow of capital is also suffering, as long-term investment sinks. Chinese venture-capital investment in America dropped to $400m in the first quarter of this year, 60% below its level two years ago. Multinational firms may cut their cross-border investment by a third this year. America has just instructed its main federal pension fund to stop buying Chinese shares, and so far this year countries representing 59% of world gdp have tightened their rules on foreign investment. As governments try to pay down their new debts by taxing firms and investors, some countries may be tempted to further restrict the flow of capital across borders.

FT Alphaville outlined several defenses of globalization, starting with theory of comparative advantage. The defense also offers a glimpse of what might happen if globalization were to retreat and trade barriers go up around the world.

Economics offers more rational reasons why it doesn’t make sense to source everything close to your doorstep. Take, for instance, nineteenth-century economist David Ricardo’s theory of comparative advantage. If England can produce cloth far more efficiently than Portugal due to mechanisation, and Portugal wine far easier due to its geography, is it not in the interest of both nations to focus on specialisms in which they can thrive? (Though this argument became somewhat overdone in the era of hyper-globalisation.)

Although the pandemic has exposed the vulnerabilities of the low-cost and just-in-time model of global supply chains, unwinding those relationships will raise costs, and compress margins.

Clearly transportation is easier and less vulnerable if suppliers are close by. While this could be overcome by building up stockpiles of parts, this would add additional costs or be impossible in the case of perishable goods.

Just-in-time production has become emblematic of the pre-Covid 19 economy. Supply chains had become so efficient that goods often went straight from the delivery bay and on to shelves. That may have to be reassessed if we make a choice that we want the supply of some goods to be more robust.

De-globalization would reduce also innovation.

Without open borders and global networks, many innovations would cease to exist. That – say Anna Stellinger, Ingrid Berglund and Henrik Isakson of the Confederation of Swedish Enterprise – includes drugs and other medical goods

 

 

In the end, the biggest question is what price the inhabitants of the developed market are willing to pay for the supply security.

At its core, the debate about global value chains right now is not about growth. It is about how society provides goods deemed essential in times of crisis…

In times marked by fear and protectionism, there are risks to relying on borders remaining open and global value chains delivering. But it is in the best interests of us all that they do.

Current consensus opinion seems to be tilted towards greater supply security. It won’t matter who wins the election in November. The US view on China from both sides of the political aisle is becoming increasingly antagonistic. In addition, the COVID-19 crisis has laid bare the vulnerabilities of global supply lines, especially in pharmaceuticals and medical equipment. At a minimum, expect greater pressure to onshore more production in all industries in 2021.

In the short run, China is falling far short of the targeted purchase of US goods under the Phase One trade agreement, largely owing to a collapse in demand as the Chinese economy tanked.  This has the potential to create more trade friction and spook the markets over the next few months.

From a practical point of view, Brad Setser at the Council on Foreign Relations distilled the American experience with globalization over the last 40 year.

  • A rising trade deficit in manufacturing.
  • Growing offshore profits (mostly in tax havens).
  • And large exports of bonds to make the sums balance.

 

As shown by Setser’s analysis and by Branko Milanovic’s famous elephant graph, the benefits of globalization have accrued to the EM rising middle class, developed market manufacturers that can offshore production, and producers of intellectual capital that can offshore production and dam the profits in offshore tax havens. The main losers have been the developed market middle class.
 

 

Estimating the COVID-19 fallout

Another long-term trend to consider is the generational effects of the COVID-19 pandemic, which has the potential to create a lost generation and political turmoil. Deutsche Bank analyzed what happened during the Spanish Flu and other pandemics and found the following:

  • Studies have found that the cohort born around the time of the Spanish flu in 1919 had worse educational outcomes throughout their lives.
  • Pandemics have long been associated with conspiracy theories, and in turn have been connected with lower levels of social trust. For example, today’s conspiracy theory has been about 5G but there were suggestions that Spanish flu was spread by Germans of some form of biological weapon at the end of WWI.
  • Meanwhile economic downturns have their own lasting legacies. For young graduates who join the workforce in a recession, it can take up to a decade before their earnings recover to where they would have been. And prior recessions suggest it could take years before employment returns to its pre-Covid levels. 

On the last point, the economy is likely to take a considerable time to recover. The latest Congressional Budget Office forecast shows that GDP will still be 2% below the Q4 2019 peak at the end of 2021.
 

 

A University of Cambridge study projects a five year loss of between 0.65% to 16.3% of global GDP, with a mid-range forecast of 5.3% to global GDP.

The GDP@Risk over the next five years from the coronavirus pandemic could range from an optimistic loss of $3.3 trillion (0.65 per cent of five-year GDP) under a rapid recovery scenario to $82.4 trillion (16.3 per cent) in an economic depression scenario, says the Centre for Risk Studies at the University of Cambridge Judge Business School.

Under the current mid-range consensus of economists, the GDP@Risk calculation would be $26.8 trillion or 5.3 per cent of five-year GDP, says a “COVID-19 and business risk” presentation prepared by the Centre for Risk Studies.

It took about 10 years for US GDP to return to potential after the GFC. How long will it take post-COVID?
 

 

The slowness of the recovery will have consequences. Surges in unemployment have been correlated with a spike in bankruptcies. So far, the number of Chapter 11 filings has been limited. While the Fed has offered unprecedented levels of support for the credit markets, it cannot supply solvency, or equity, if a firm were to fail. Will this cycle be any different?
 

 

Gold as confidence insurance

The combination of all these factors point to subpar equity returns over the next decade. Does that mean you should be buying gold to hedge against a decline in stock/gold ratio?

Gold can have a role in portfolios, but I believe that investors should buy gold for the right reasons. Here are some wrong ways to play gold and gold related vehicles.

Forget gold as an inflation hedge. The chart below shows that gold staged an upside breakout in 2018 out of a multi-year base that stretches back to 2013. The price is now approaching a resistance zone, as defined by its all-time high. By contrast, the bond market inflationary expectation ETF (RINF) has been in a downtrend since late 2018. While inflationary expectations have begun to tick up, RINF is just approaching and testing a resistance zone.
 

 

During the current deflationary period marked by a collapse in demand, the world would be lucky to see signs of inflation, which would be a signal of renewed growth. If you want to bet on inflation, buy equities, as they would perform well in periods of moderate inflation. As well, companies with strong pricing power that can pass through price increases would perform well in low but rising inflation environment. One shortcut might be the shares of Berkshire Hathaway. Warren Buffett has assembled a portfolio of companies with strong competitive positions, or moats, that should have better pricing power should inflation and growth return.

Even for more aggressive investors who are seeking greater leverage in the gold price, I would advise against buying gold stocks instead of gold. Despite the commonly held belief that the stocks provide better leverage to the gold price, gold stocks have dramatically lagged gold prices in the last decade
 

 

Here is why. Conceptually, a gold mining company can be thought of as a call option on the price of gold, with the strike price set at the cost of production, combined with the expected amount of gold the company can mine in each year for the term of the mine life, or mine lives. The historical record has shown that as old mines become exhausted, companies have replaced production with new mines with higher production costs. In effect, this creates the effect of changing the strike price of an option upwards, which reduces the value of the option. Unless the gold mining industry can find new lower cost mines, the shares of gold mining companies are likely to continue to lag gold prices in the future.

In the short run, here is another reason to avoid gold stocks. Senior golds, as represented by GDX, have become overbought. The percentage of stocks in the ETF is over 90%. At the same time, the performance of gold golds (GDXJ) are lagging GDX, which is a negative divergence.
 

 

In conclusion, the outlook for equities faces a number of long-term headwinds, namely de-globalization, rising protectionism, and a difficult growth outlook. Gold represents an insurance policy against falling investment confidence. Investors should re-evaluate their portfolio allocation policy in light of these factors affecting asset returns over the next decade.

 

Healing?

Posted by Cam Hui -

Mid-week market update: Is the market exhibiting signs of froth, or is the economy healing? There are signs of both. As Fed chair Powell indicated, the economy has encountered a health related shock, and the Fed can only do so much to stabilize markets. It cannot provide a cure.

Some of the market based indicators of covid related anxiety are showing signs of healing.
 

 

Indeed reported that job postings are stabilizing and starting to improve from their worst levels.
 

 

As the northern hemisphere enters spring and approaches summer, a  non-peer reviewed Harvard study found a weak effect of temperature and humidity on virus transmission.

We show that the delay between exposure and detection of infection complicates the estimation of weather impact on COVID-19 transmission, potentially explaining significant variability in results to date. Correcting for that distributed delay and offering conservative estimates, we find a negative relationship between temperatures above 25 degrees Celsius and estimated reproduction number (R), with each degree Celsius associated with a 3.1% (95% CI: 1.5-4.8%) reduction in R. Higher levels of relative humidity strengthen the negative effect of temperature above 25 degrees. Moreover, one millibar of additional pressure increases R by approximately 0.8 percent (0.6-1%) at the median pressure (1016 millibars) in our sample. We also find significant positive effects for wind speed, precipitation, and diurnal temperature on R. Sensitivity analysis and simulations show that results are robust to multiple assumptions. Despite conservative estimates, weather effects are associated with a 43% change in Rbetween the 5th and 95th percentile of weather conditions in our sample.

A quick glance of the weekly growth of confirmed deaths shows that a trend of acceleration of fatalities in the southern hemisphere, which is becoming colder, and a deceleration in the northern hemisphere, which is turning warmer.
 

 

The US trend is less clear. While the hardest hit states of New York and New Jersey have bent the curve, the fatality rates of most other states have been flat, and not falling. Some states, like Florida, have seen death rates edge up, which is a worrisome sign as different jurisdictions relax their stay-at-home edicts.
 

 

However, Bloomberg reported a disturbing sign from China that the virus may be mutating, and infections are presenting themselves differently. If this strain were to spread, current lockdown approaches of containment and mitigation may be insufficient to combat its effects.

Chinese doctors are seeing the coronavirus manifest differently among patients in its new cluster of cases in the northeast region compared to the original outbreak in Wuhan, suggesting that the pathogen may be changing in unknown ways and complicating efforts to stamp it out.

Patients found in the northern provinces of Jilin and Heilongjiang appear to carry the virus for a longer period of time and take longer to test negative, Qiu Haibo, one of China’s top critical care doctors, told state television on Tuesday.

Patients in the northeast also appear to be taking longer than the one to two weeks observed in Wuhan to develop symptoms after infection, and this delayed onset is making it harder for authorities to catch cases before they spread, said Qiu, who is now in the northern region treating patients.

What about the Moderna vaccine, which got the market all excited? Stat News criticized the Moderna press release because it didn’t show sufficient details. The study states that 45 volunteers received various doses of the vaccine, and eight developed neutralizing antibodies. So what happened to the other 37?

The company’s statement led with the fact that all 45 subjects (in this analysis) who received doses of 25 micrograms (two doses each), 100 micrograms (two doses each), or a 250 micrograms (one dose) developed binding antibodies.

Later, the statement indicated that eight volunteers — four each from the 25-microgram and 100-microgram arms — developed neutralizing antibodies. Of the two types, these are the ones you’d really want to see.

We don’t know results from the other 37 trial participants. This doesn’t mean that they didn’t develop neutralizing antibodies. Testing for neutralizing antibodies is more time-consuming than other antibody tests and must be done in a biosecurity level 3 laboratory. Moderna disclosed the findings from eight subjects because that’s all it had at that point. Still, it’s a reason for caution.

 

Something’s isn’t adding up

While many of these signs of healing are constructive, back on Wall Street, the market is getting frothy. In a commentary written on Tuesday, Joe Wiesenthal of Bloomberg thinks that something isn’t adding up.

A thought I keep having throughout this economic crisis is that it’s extremely weird. For example, let’s start with the obvious that it’s weird that the NASDAQ is solidly up on the year, amid one of the worst economic shocks ever. But it’s not just tech stocks doing well. It’s odd, for example, that we’re experiencing a boom in big ticket items like recreational vehicles (just look at shares of Camping World) at a time when so many people are losing their jobs, or their incomes are so uncertain. It’s odd that we’re seeing surging prices for illiquid collectibles, like vintage Jordan’s or old baseball cards. You don’t normally expect to see that when people are anxious about money. The electronic DJ duo The Chainsmokers are raising a venture capital fund. That’s not a typical crisis headline. And then there’s this whole phenomenon of legendary investors like Warren Buffett or Stan Druckenmiller sounding anxious about this market, while retail traders on Robinhood keep taking the opposite sides of the bet. The list goes on and on, but suffice to say there are many things about this crisis that don’t quite add up.

The latest BAML Global Fund Manager Survey shows a cautious view. The consensus calls for a slow recovery, and the current rally is a bear market rally.
 

 

While this cautious view might suggest the current market rally is becoming the pain trade, global managers are only slightly underweight equities, and they have all piled into the US as the last refuge of growth.
 

 

Something isn’t adding up.
 

A frothy market

In the meantime, the market is becoming frothy. FT reported that stock trading is now the new sports betting. Three of the top online brokerages had nearly 800K new users in March and April .SentimenTrader observed that small option buyers have been piling into call options, which is contrarian bearish. The adage of “young bears and old bulls” certainly fits the current go-go sentiment climate.
 

 

The equity-only put/call ratio hit 0.46 yesterday. In the past, the market has encountered difficulty advancing when it reached these levels in the past.
 

 

The credit markets are not entirely impressed with the equity advance. The price of credit protection is not confirming the stock market rally.
 

 

To be sure, the Fed has stepped in to stabilize markets. As a result, companies rushed to raise cash in the bond market to facilitate their liquidity needs.
 

 

However, the credit risk of outstanding debt is worsening. I don’t want to be Apocalyptic, this just represents a nascent risk should the economy and financial conditions worsen. It does not represent an immediate risk to the markets right now.
 

 

Moody’s also estimates that “Investor recoveries upon default will be lower during the current default cycle than they were during the 2008-09 downturn, with recoveries on first-lien debt likely to be worse than they have been in the past.”
 

 

As well, valuations are extended. The forward earnings yield, or the inverse of the forward P/E, has fallen to levels last seen during the dot-com bubble.
 

 

Top of the range?

Tactically, the market is highly overbought on a 3-5 day time horizon.
 

 

The SPX is testing the 61.8% Fibonacci resistance level while exhibiting a negative 5-day RSI divergence. There is also a minor divergence between the VIX Index and VVIX, which is the volatility of the VIX. The 10-year Treasury yield remains range-bound. This array of market internals suggest that the stock market is also range bound, and at the top of its range.  The bull case scenario calls for a test of the 200 dma at about 3000.
 

 

My inner investor was underweight equities, and he is slowly and opportunistically unwinding his underweight position to a neutral weight.

My inner trader is short the market, and he has set a stop loss zone of 2970 on a closing basis. I was overly distracted at the close writing this publication that I did not have time to act on that trigger, but if the market were to remain at or above these levels in the at the end of the first hour on Thursday, I will be stopped out.

Disclosure: Long SPXU, TZA
 

Earnings Monitor: Digging in for the long haul

Posted by Cam Hui -

We are continuing our coverage of earnings season during these turbulent times. With 90% of the index having reported, this will be the final earnings monitor of the Q1 earnings season. This week, we are seeing greater additional signs of stabilization, but companies are digging for the long haul.

Let’s begin with the big picture. FactSet reported that the bottom-up consensus forward 12-month estimate fell -0.64% last week (vs. -1.4% the previous week), and -20.0% since downgrades began nine weeks ago. The EPS and sales beat rates were both below their 5-year historical averages.
 

 

Good news and bad news

There was more good news, and bad news the FactSet summary of Q1 earnings reports. Let’s start with the good news. The speed of earnings downgrades is decelerating. Forward 12-month EPS fell -0.64% last week, compared to -1.4% the previous week. This is a marked improvement from the experience of the past several weeks, when estimates fell consistently by -1% or more. Estimate revision deceleration can be attributed to the fact that bottom-up EPS estimates are starting to converge to top-down estimates. The 2020 bottom-up consensus estimate of $129.16 is within striking distance of the top-down estimate of $120-$125. However, the bottom-up 2021 estimate of $164.68 is still a little elevated compared to the top-down consensus of $150.
 

 

As well, the market is becoming immune to bad news. Stocks were reacting positively to earnings beats, and negatively to misses. However, it did not punish earnings misses as badly as it has historically.
 

 

However, expectations are high. The Street is expecting a V-shaped recovery in earnings.
 

 

The market is priced for perfection. Forward 12-month P/E is a nosebleed 20.3. Even if you are willing to look over the 2020 valley, the bottom-up derived 2021 P/E ratio is 17.2, and 19.7 on a top-down basis. All of those measures are well above the 5 and 10 year forward 12-month P/E averages.
 

 

Voices from the trenches

What are companies saying? Here is the summary from The Transcript, which summarizes company earnings calls. The decline in sales has stabilized, but a full recovery is going to take a long time. These comments cast doubt on the strong V-shaped earnings recovery forecast by the Street.

Economic activity is trending positively as shelter in place orders are slowly lifted around the economy. The data is better than it was but still very bad for any other environment. Markets have discounted a quick return to normalcy, but this week’s comments suggest that business leaders expect the recovery to take longer. For the hardest-hit industries, it could be years before they are operating at peak levels again. And even if demand snapped back today it could take months for the supply side of the economy to rev back up. Importantly, employment will likely rebound slower than the rest of the economy, which is a big deal for the demand side of the economy given how high unemployment numbers are.

Even Jay Powell hedged when asked about his expectations for a recovery in his weekend 60 Minutes interview. Much depends on the fight against the virus. While he is forecasting a bounce back in the second half of 2020, everything has to go right, and the recovery will take a long time [emphasis added].

The big thing we have to avoid during that period is a second wave of the virus. But if we do, then the economy can continue to recover. We’ll see GDP move back up after the very low numbers of this quarter. We’ll see unemployment come down. But I think though it’ll be a while before we really feel, well recovered.

Much depends on the absence of a second wave of infections.

Well, I think you’ll see, again assuming there’s not a second wave of the coronavirus, I think you’ll see the economy recover steadily through the second half of this year. I do think that people will be careful about resuming their typical spending behavior. So certain parts of the economy will recover much more slowly.

Powell did sound the obligatory optimistic long-term tone (as did Warren Buffett):

In the long run, and even in the medium run, you wouldn’t want to bet against the American economy. This economy will recover. And that means people will go back to work. Unemployment will get back down. We’ll get through this. It may take a while. It may take a period of time. It could stretch through the end of next year. We really don’t know. We hope that it will be shorter than that, but no one really knows. What we can do is the part of it that we can control — is to be careful as businesses go back to work. And each of us individually and as a group, you know, take those measures that will protect ourselves and each other from the further spread of the virus.

Here are the key risks:

There’s a real risk that if people are out of work for long periods of time, that their skills atrophy a little bit and they lose contact with the workforce. This is something that shows up in the data — that longer and deeper recessions tend to leave behind damage to people’s careers. And that weighs on the economy going forward.

You could say the same thing about businesses. The small and medium size businesses that are so important to this country, if they have to go through a wave of avoidable insolvencies, you’ve lost something there that’s more than just a few businesses.

You know, it’s really the job creation machine. And if that happens, it will take some time to recover from it.

Former Fed economist Claudia Sahm had a far darker take of the Powell interview in a Twitter thread, She believes that Powell put too much emphasis on the best case scenario, and she was shocked that he said “recession” and even “depression” on national TV. Federal reserve staff were not even allowed to utter the “recession” word in the building.

absolutely no surprise @federalreserve Chair Powell lays it down, we ain’t bouncing back … I learned real world macro and top notch forecasting at @federalreserve, you know I’m deeply pessimistic, his staff must be running through worst scenarios https://economics.cmail19.com/t/ViewEmail/d/64D116D8576D38CF2540EF23F30FEDED/54DDC383BBB39FD140EE66FE10287772

I know nothing about current staff forecast … even so, I could write a close copy from my 12 years at @federalreserve, I wrote Tealbook twice and know the tools deeply, what Powell’s saying out loud is the most optimistic read on the economy , he’s getting sent to him

when I heard Powell say “ recession” at an emergency presser in March, almost fell over … staff were not allowed to say that word in the building when we put recession call in our forecast in March 2008 … my god, Powell said “depression” on national TV last night

they must be doing Great Depression alt sim for the Federal Reserve officials now … me too, except I’m moving fast toward depression it as my baseline

I feel some comfort knowing that Administration and @WhiteHouseCEA always get the Fed staff forecast (including alt aims) and write up in Tealbook .. Kevin Hassett began on
@federalreserve staff, I’m sure he’s reading it, he better be! and sharing its analysis with the President

NEVER in 2008 recession when it was clearly severe did staff have as baseline a v-shaped recovery NEVER … clearly it 90% forecast of Powell and staff

I can’t imagine ANYONE at @federalreserve in DC saying Cape-Cod in the winter was like our coronavirus crisis … I blew my top when I first saw @LHSummers argue it in
@washingtonpost op ed … no regrets

really lost it as April data came rolling in

so tired of being angry at the world and at macro men who are mentors PS Cape-Cod man is not one .. talked to @DianeSwonk on my show. asked her if I’m being too pessimistic, no, I’m not. macro women have been tragically right again and again http://macromomblog.com/sahmpodcast/ listen to them

lastly I am SO PROUD of @federalreserve staff and leadership .. . blessed that I left in November (was so hard) and can now share the wisdom in that building with the world. they cannot, I can and am … doubly blessed many people have given me a platform I never expected

Bloomberg reported that even Reinhart and Rogoff thinks that this time is indeed different. Forget the V, the pace of recovery is likely to be very slow.

I don’t know how long it’s going to take us to get back to the 2019 per capita GDP. I would say, looking at it now, five years would seem like a good outcome.

What about the vaccine?

The market rallied on a promising Phase 1 trial of a Moderna vaccine (see CNBC story). Before everyone gets too excited, consider the following:

  • It’s only a Phase 1 trial, drug trials often fizzle out in Phase 2 and 3 trials. Possible safety or efficacy problems could arise as the the sample size rises.
  • Even if the vaccine proves to be effective, the first doses won’t be available until Q1 2021 at the earliest. Widespread availability might not be until Q2 or Q3.
  • There will be production issues. As an example, the vaccine involves two doses. Bill Gates has raised the simple problem of the sufficient availability of glass vials.
  • Also consider the possible economic effects. If individuals expect that a vaccine is available early next year, behavior could change as people hunker down and the economy goes into a deep freeze. No one will wants to be the last casualty just before a vaccine saves the day.

In the meantime, the market is priced for perfection. Forward 12-month P/E is over 20, and 2021 P/E is 17.2. The key risks are:

  • A second wave of infection (see the new lockdowns in China, rising new cases in Texas, plateaus in new cases in Sweden and UK).
  • A second wave of layoffs.
  • Avoiding the debilitating effects on individuals and businesses of an extended shutdown (Powell’s comments).
  • Don’t forget the risks of a renewed trade war as the November election approaches.

Best case, we won’t start to see a return to normalcy until Q2 2021. In the interim, the risks of significant damage to the economy are high.

Disclosure: Long SPXU, TZA

The bulls are losing control, what’s next?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A sideways pattern

Stock prices have been chopping sideways and gone nowhere in the past month. After a strong rally off the March low, the rally stalled repeatedly at the 61.8% Fibonacci retracement level while the stochastic recycled from an overbought condition. It is becoming evident that the bulls have lost control. That doesn’t mean, however, that the market is ready to go down. Instead, the sideways consolidation could continue for some time.
 

 

What’s next? Will we see further chop sideways, or have the bears seized control of the tape?
 

Breadth outlook: Flat to down

Breadth signals indicate a flat to down outcome. Here is the case for further sideways consolidation:

  • The S&P 500 remains range-bound.
  • The equal-weighted S&P 500 is holding key support.
  • Both the S&P 500 and NYSE Advance-Decline Lines remain in uptrends. The market is not going to decline significantly until these breadth indicators break their rising trend lines.

Here is the bear case:

  • The equal weighted S&P 500, the S&P 500 A-D Line, and the NYSE A-D Line are all rolling over.
  • % Bullish is exhibiting a negative divergence.

 

 

NASDAQ breadth tells a similar story. The NASDAQ A-D Line remains in an uptrend, but % Bullish is also exhibiting a negative divergence.
 

 

The risks of narrow leadership

The market has been rising mainly on the leadership of the large cap FANG+ stocks. Even the relative performance of healthcare stocks, which should be surging during this pandemic, have faltered and turned range bound.
 

 

The market’s reliance on FANG+ names brings to mind Bob Farrell’s Rule 7. “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”

A bearish catalyst for Big Tech may be on the horizon. In the wake of the Trump Administration’s decision to bar American semiconductor companies from selling chips to Huawei, Chinese official media Global Times reported that Beijing is preparing retaliatory measures. Major targets include companies like Apple and Boeing.

China is ready to take a series of countermeasures against a US plan to block shipments of semiconductors to Chinese telecom firm Huawei, including putting US companies on an “unreliable entity list,” launching investigations and imposing restrictions on US companies such as Apple, and halting purchase of Boeing airplanes, a source close to the Chinese government told the Global Times…

The measures include adding related US companies to China’s “unreliable entity list,” imposing restrictions on or launching investigations into US companies like Qualcomm, Cisco and Apple according to Chinese laws like Cybersecurity Review Measures and Anti-monopoly Law, and suspending the purchases of Boeing airplanes, according to the source.

The US companies mentioned, such as Apple, Qualcomm, Cisco and Boeing, are all highly dependent on the Chinese market.

When the shooting starts in the trade war, Apple makes a big fat target. The stock is the second largest stock in the major market indices, behind Microsoft, and comprise 5.1% of the S&P 500 and 10.1% of the NASDAQ 100.
 

What are “smart investors” doing?

The behavior of smart investors also presents a mixed flat to down narrative. Insider buying spiked when the market hit an air pocket late last week, but sales were above purchase activity. In the past, clusters of strong insider buying have been reasonable buy signals, but high insider selling have not been actionable sell signals. I interpret these conditions as a neutral signal.
 

 

On the other hand, a quirky analysis of US senator trading activity shows a flood of recent sales. This signal was timely going in when senators bought in mid-2018, sold ahead of the COVID-19 crash, and bought afterwards/ What should we make of this sudden flood of sales?
 

 

Sentiment bifurcation

Last week, we discussed the continuing puzzle on the sentiment model front. The weekly AAII sentiment survey shows a crowded short condition, which is contrarian bullish.
 

 

By contrast, most other sentiment models focused on short-term retail “dumb money” traders were in neutral territory.
 

 

One likely explanation is the AAII survey is capturing the sentiment of new low-information traders that have recently entered the market, attracted by zero commission trading. Indeed, online brokerage firms’ Daily Average Revenue Trades (DARTs) have surged across the board.
 

 

Further age demographic analysis shows that most of the new accounts are young millennial traders. Some analysts have also advanced the unproven hypothesis that the current lockdown environment has deprived Americans of live sports, and hyper day trading of stocks is a substitute for sports betting. In that context, the stampede into FANG+ stocks makes sense. No matter how you measure price momentum, the factor is exhibiting positive returns right now.
 

 

A recent Investopedia investor survey confirms the millennial appetite for risk, but also shows a generational bifurcation of risk appetite.

Investopedia’s latest survey of active investors reveals that the recent market turbulence has caused a broad re-thinking of risk: two-thirds of respondents state they have changed their overall investing approach, but how they’re changing appears split down the middle. Those going bigger, buying blue chips on a bargain and grabbing shares in the beaten-down airline sector tend to be Millennials, though there are some Gen Xers and Boomers in the bunch. By contrast those seeking safer havens like money market funds and high-yield savings tend to be Boomers.

The Boomers tend to be more cautious, while younger investors tilt bullish.
 

 

The new young investors are bullish, and they trade more. The Boomers are net sellers, but they are likely to trade less frequently. Who wins this tug of war?

In the end, the big money Boomers are likely to win, but not before the market sees a bearish break and the new investors capitulate. In particular, investors should pay special attention the Fed’s warning in its Financial Stability Report, which was released late Friday after the market close.

Asset prices remain vulnerable to significant declines should the pandemic worsen, the economic fallout prove more adverse or financial system strains re-emerge.

The market could trade sideways for some time as the bulls and bears battle to a stalemate, but watch for a cascade should the dam breaks.
 

The week ahead

Looking to the week ahead, the market tested support late last week and began a relief rally. Short-term breadth is recycling off an oversold extreme. Barring further unexpected bad news, the market should see a bullish bias early in the week.
 

 

Friday’s retail sales print was awful and below market expectations. Many of the retailers report in the coming week, and their reports could prove to be a bearish catalyst for the stock market.
 

 

The challenge for the bears is to defend the trend of lower highs in market breadth.
 

 

My inner trader initiated a short position last Wednesday, and took partial profits Thursday, but he is still short. He is likely to add to his short position on a rally. Until we see a breakout of the trading range between 2740 and 2950, my base case scenario calls for choppiness. Even the high beta to low volatility indicator, which is a measure of equity risk appetite, has been stuck in a narrow trading range.
 

 

The market’s sideways consolidation in the past month has moved the Asset Allocation Trend Model from a bearish to a neutral reading. My inner investor is cautiously positioned, but he will gradually move back to a more neutral view of risk should the choppy range-bound trading continue.

Disclosure: Long SPXU

 

Checking the small business economic barometer

Posted by Cam Hui -

During past major market bottoms, the outperformance of small cap stocks has coincided with economic rebounds. The relative returns of small and microcaps appear to be trying to bottom. It is time to check in on how these stocks are doing.
 

 

One way to monitor the progress of these stocks is to check in on the health of small businesses. Small businesses are the backbone of the economy. According to the Small Business Administration, US small businesses provide 47% of private sector employment. Equally important to the check-up is the poor bargaining power of small firms, as they act as a sensitive barometer of economic health.
 

Good news and bad news

The National Federation of Independent Business (NFIB) April survey had both good news and bad news for investors. Not surprisingly, small business confidence plunged, but the figure was above expectations. The current confidence reading of 90.9 presents a mixed bag. It is roughly the level seen at the bottom of the 1990 recession, and below the 2002-03 bottom, but it is above the levels at the 1981-82 and 2008-09 bottoms.
 

 

A US Census survey provided more details of the health of small business. About 90% of firms reported either a large or moderate impact from the pandemic.
 

 

Equally important but less noticed in the NFIB survey is small business confidence has unwound the ramp up from the 2017 tax cut. As small business owners tend to lean small-c conservative, their souring mood could have electoral implications in November. Marketwatch recently reported on Goldman Sachs strategist David Kostin’s call for an 18% correction. Lost in the headlines is the prospect of a Democrat victory in November, and the possibility that the 2017 tax cuts could be unwound.

Finally, domestic and global politics could conspire to create stock-market volatility going forward. With a U.S. presidential and congressional election just months away, there is a significant chance that Democrats could win enough power to reverse the 2017 corporate tax cut, slashing the 2021 S&P 500 earnings-per-share forecast by $19, in Kostin’s view.

The top-down consensus earnings estimate is about $120-$125 for 2020, and about $150 for 2021. A cut of $19 earnings per share in 2021. Under such a scenario, the market’s 2021 forward P/E of 21.9 would make the stocks very expensive, even for any investor willing to “look over the valley” of this year’s devastation.
 

How stressed are small firms?

In the current crisis, any analysis of small businesses has to begin with the level of stress facing these enterprises. From a top-down perspective, the loan officer survey indicates tightening credit standards. Banks have also reported a spike in outstanding loans, likely the result of borrowers drawing on their credit lines during these difficult conditions.
 

 

Here is some good news. The NFIB survey reported little signs of a credit crunch. Credit conditions are still loose, possibly the courtesy of Fed actions.
 

 

The problem is a lack of sales, not the availability of credit. Sales expectations paint a poor outlook for GDP in the near term.
 

 

This also shows the limitations of the monetary and fiscal policy. The Fed can ease credit conditions, but it cannot magically conjure up sales. Fiscal support like the Paycheck Protection Program (PPP), has been unable to offer much of a safety net. The Small Business Administration has reported that it disbursed emergency loans to 4.2 million small businesses, but that may not be enough. The US Census reported that 75% of small businesses had applied for PPP relief, but only about half, or 38%, had received any funds. In addition, only about half of the small firms had enough cash on hand to cover expenses for more than a month, assuming that sales dropped to zero.  This indicates the poor capitalization of these enterprises.
 

 

Restaurants economics

The restaurant industry is a window into the plight of small businesses. An SF Gate article summarized the rule of thumb of restaurant economics:

Of every dollar a full-service restaurant brings in, it spends roughly a third on food and alcohol; another third on salaries, wages and benefits; up to 10 cents on rent; and up to 20 cents on other costs such as marketing, according to studies by restaurant associations. That leaves about 4 cents of pretax profit.

In other words, the typical EBIDA margin (before financing costs) of an independent restaurant is around 4%. An inspection of the finances of publicly listed restaurants shows slightly higher EBIDTA margins. Cheesecake Factory, which recently told landlords that it wasn’t paying rent, has averaged 7-8% in the past few years. Darden Restaurants, which operates a series of different chains, shows an EBIDA margin of 12-13%.

One reader alerted me to the plight of McDonald’s franchisees, which is a group small business that most of us can understand or relate to. CNBC reported that McDonald’s recently deferred the rent and service fees for some franchisees:

McDonald’s is deferring rent for three months for franchisees to lessen the financial blow of social distancing measures. Only about one-third of its U.S. franchisees will be asked to pay March rent. Operators who have seen the sharpest sales drops are also receiving deferrals on service fees.

However, a request for a delay in April payments was denied.

The National Franchisee Leadership Alliance, which officially negotiates with McDonald’s on behalf of franchisees, asked for a two-week extension on service fees and rent due April 10, citing the uncertainty surrounding the Small Business Administration emergency loans. McDonald’s operators make a base rent payment on the first of the month and then pay rent and fees on the tenth, based on the prior month’s revenue for the location.

McDonald’s management denied the request on April 3.

Nation’s Restaurant News reported that estimates of same-store sales are down 20-25% in the second week of April, though it’s an improvement from a decline of 25-30% in the first week. In light of the economics of operating a restaurant, such levels of sales reductions will make most operators unprofitable. As well, the lump sum deferred payments to McDonald’s will be due soon, and could put further stress on franchisees.

In the latest “McDonald’s Franchisee Survey” by Kalinowski Equity Research, analyst Mark Kalinowski projected same-store sales at the quick-service chain had decreased 20% to 25% in the second week of April. That compares with a projected decline of “25% to 30% in the first week of April,” Kalinowski wrote.

Here are just a few selected anonymous comments from the Kalinowski survey:

  • “My stores that have no drive-thrus are down by about -40%, but my stores with drive-thrus are down by about -15%.”
  • “The ship has a massive hole, right now staying afloat is the priority. Forget growth, it’s gone for a very long time,” one franchisee stated in the survey.
  • “The last half of March was the end of the world, but with the limited menu we’ve been able to speed up our drive-thrus to the point we are now only down about -15%. Many stores are still down -20% or more. Let’s keep the limited menu!”
  • “There is no fun on the business side. Employees have been great during this whole ordeal. The media continues to incite the negative and place uncertainty on life, economy, etc. — they could help by being positive about the future.”
  • “We went from -15% a week ago to -35% the last three days. Won’t come back for a VERY long time in my opinion.”
  • “Other companies are doing FAR MORE for their franchisees than McDonald’s. We get useless rent deferrals; others get rent ABATEMENTS.”
  • “Deferrals only kick the can down the road. When the balloon comes due 25%-35% of Operators will go bankrupt!”
  • “I believe that the McDonald’s system is in a better position to survive than most. Once this is over many ‘mom and pop’ restaurants will not re-open.”
  • “Ninety days of decreases like this and we will lose a lot of the smaller franchisees.”

If McDonald’s franchisees, who operate with proven business plans, are struggling, what does that tell us about less well-run independent operators, especially if they are under-capitalized.
 

How are the customers?

No analysis of small businesses would be complete without channel checks on the health of their customer base. A look at the dynamics of the labor force reveals a good news, bad news story.

The dismal employment picture is well known. Beyond the headline of over 20 million jobs lost in April, and the cumulative initial claims report of over 36 million jobs lost since mid-March, the diffusion index shows the widespread nature of job losses. No industries are safe. There is nowhere to hide.
 

 

Various commentators, including Fed officials, have pointed out that low-skilled and low-pay workers have borne the brunt of the economic pain. Controlling for other demographic factors, 25-64 college educated workers have largely been insulated from the storm.
 

 

Here is the silver lining in the dark cloud. Since the job and income losses are concentrated among poorly paid workers, Goldman estimates that the fiscal income support will offset the effects of the employment income losses for Q2 and Q3 because of the low level of pay that has to be made up.
 

 

Disappointment may lie ahead. The New York Fed’s survey of consumer expectations indicate that job security expectations are plummeting.
 

 

The Fed’s Household Economics and Decisionmaking supplemental survey shows that, of those who lost a job in March 2020, 91% anticipated they would return to work for the same employer. However, a recent University of Chicago Booth School of Business paper estimates that 42% of recent layoffs will become permanent. The biggest and more important question is how long will white collar jobs be insulated from mass layoffs.

Friday’s release of retail sales was particularly ugly. April retail sales plunged -16.4%, which was below Street expectations of -12.0%.
 

 

An economy is an intricate ecosystem, and small businesses cannot thrive or survive if their customers are under stress. As sales plunge, the economic pain will a ripple effect everywhere. As an example, the stress felt by businesses will eventually affect commercial real estate (CRE). CRE investors will struggle to debt payments lenders. Along with failing business, CRE distress will create a cascading effect of loan losses, tightening credit standards, and a credit crunch that creates a negative feedback loop which exacerbates the effects of the downturn. The CRE sector was hit by further bad news last week, when Starbucks announced it was seeking reduced rent for an entire year for its corporate owned US stores. The request was *ahem* not well received.

State and local governments are facing budget pressures of their own. The National League of Cities analysis estimates American cities will lose $360 billion in revenue through 2022 owing to COVIE-19.  The worst hit cities will be in Pennsylvania, Kentucky, Hawaii, Michigan, and Nevada.
 

 

While the Democrats have pushed through a $3 trillion bill with considerable relief for lower levels of government, the bill is likely to die in the Republican controlled Senate. The next round of fiscal support is unlikely to be passed swiftly in the near future, as the squabbles between both sides of the aisle hold up the details of any bill.

The risk of further damage from the economic aftershocks is high.
 

Gold and small caps

What does this mean for investors? From a cross-asset and big picture perspective, Joe Wiesenthal at Bloomberg recently highlighted the importance of the stock-to-gold ratio.

It’s such a pure and simple expression of optimism versus pessimism. When you bet on stocks you’re betting on humans endeavoring to do productive things. When you bet on a shiny inert metal you’re betting on a shiny inert metal. Here’s the long term chart of the two compared.

 

 

Wiesenthal observed that the stock-gold ratio is correlated with the performance of the small cap Russell 2000.

What’s also interesting — and clear in retrospect — is that the optimism cycle that started in 2011 didn’t just come to a screeching end in early March. The optimism cycle ended in the middle of 2018. This was in the wake of the tax cuts (late 2017) and the early 2018 budget deal, which actually boosted spending substantially. Not only did the stocks/gold ratio peak then, but so did the Russell 2000 small cap index, which never regained its 2018 peak. An overlay of the stocks/gold ratio against small cap stocks is shockingly consistent.

 

I began this week’s analysis with a focus on the relative performance of small and microcap stocks as an indicator of the market’s perception of an economic turnaround. While the jury is still out from a bottom-up analysis of small business outlook, real-time cross-asset analysis suggests that the prognosis is not encouraging.
 

The start of a new bear leg?

Posted by Cam Hui -

Mid-week market update: Is this market starting a new bear leg? There are numerous signs that may be happening. The SPX violated the trend line of a rising channel while the stochastic recycled from an overbought reading, which is a sell signal. The chart of the equal weighted index, which filters out the effects of heavyweight leadership, looks worse as that index tests a key support level.
 

 

The market’s narrow leadership is evidenced by the concentration of the current leadership of technology, healthcare, and communication services, which is nearing the highs set during the Tech Bubble.
 

 

Narrow leadership and high concentration are high risk “this will not end well conditions”. Could the latest pullback be the bearish trigger?
 

Sentiment signals

It may be turning out that way. Sentiment signals are flashing contrarian bearish signs. About a month ago, I had highlighted the surprising results of New York Fed’s consumer expectations (see The 4 reasons why the market hasn’t seen its final low). The latest update of the monthly survey shows that expectations of higher stock prices 12 months from now surged even higher.
 

 

These results make me speechless.

I had also discussed the apparent anomalous AAII sentiment survey crowded short reading on the weekend (see Setting up to climb a wall of worry?). I suggested that new low-information traders and investors had rushed into the market. The market’s advance could be partly explained by their stampede into FANG+ and small speculative names. Indeed, CNBC reported that online brokerage firms had seen a surge in new investor accounts in Q1.
 

 

In light of the entrance of new traders, a unusual bifurcation has appeared in the option market. The equity-only put/call ratio, which tends to be the main playground of retail traders, has diverged from the index put/call ratio, which is more used by professional traders and hedgers. In the past, significant gaps between these ratios have been either decent buy signals (in yellow), or high risk signals where the market advance either stalled or fell (in grey). Readings are now at or near a sell signal.
 

 

Other warnings

There are also other warnings about the market. Hedge fund manager Stan Druckenmiller recent warned that the risk-reward calculation for equities is the worst he’s seen in his career, and “I pray I’m wrong on this, but I just think that the V-out [recovery] is a fantasy”.

CNBC reported that Appaloosa Management founder David Tepper said that this is the second most overvalued market he has ever seen, behind 1999. He went on to question the upside potential of the popular FANG+ stocks.

Tepper also called some of the popular tech names including Amazon “fully valued.” Amazon has been one of the first companies to roar back to a new record after the coronavirus sell-off. The e-commerce giant is up 27% this year as investors bet on its resilient business.

“Just because Amazon is perfectly positioned doesn’t mean it’s not fully valued,” he said. “Google or Facebook … they are advertising companies. …They are not rich but they may be fully valued.”

Macro Charts observed that the market has become extremely overbought. Overbought conditions without a breadth thrust (Zweig, Whaley, etc.) tend to be bearish for stock prices.
 

 

The consolidation scenario

Before everyone gets overly excited about a new bear leg, we have to think about the possibility that the bulls losing control of the tape doesn’t necessarily mean that the bears are in the driver’s seat. Two days of market weakness are not definitive signs of a bearish break. We have to consider a scenario of choppy sideways consolidation for a number of reasons.

First, the advance from the March lows was led by FANG+ and momentum stocks. Different measures of the price momentum factor shows that momentum is still alive.
 

 

Short-term breadth had reached a near oversold condition yesterday (Tuesday), and today’s decline pushed readings further into oversold territory. The market is setting up for a near-term bounce, and the last hour rally today is supportive of that thesis.
 

 

I pointed out that the equal-weighted SPX was testing a key support level. Market declines often pauses at the initial test of support. My inner trader is keeping an open mind about whether this is the start of a new bear leg, or the beginning of a period of choppy sideways consolidation.

Subscribers received an alert today (Wednesday) that I had taken partial profits in my short positions in anticipation of a relief rally into Thursday and possibly Friday. If that scenario unfolds as anticipated, my inner trader expects to add to his shorts.

My inner investor remains cautiously positioned.

Disclosure: Long SPXU

 

FIFO: Can China save global growth (again)?

Posted by Cam Hui -

Remember the Great Financial Crisis (GFC)? As the GFC engulfed the global economy, China stepped up with a shock-and-awe campaign of fiscal and monetary stimulus that stabilized not only the Chinese economy, but global growth. Can China save global growth again?

China recently reported surprisingly strong export growth for April, but the closely watched early May trade figures from South Korea badly missed expectations. Exports plunged -46.3% YoY. Exports to China fell -29.4%, which is hardly the picture of a robust economic revival.
 

 

Since China was the first major economy to enter the pandemic crisis, what does that mean for the world, based on a first-in-first-out principle?
 

What stimulus?

As the extent of the COVID-19 outbreak became apparent, Beijing made the deliberate policy decision to shut down the economy. As the pandemic got under control, the next step is economic stimulus. 

Bloomberg reported that the PBOC has announced stimulus measures to support China’s economy, but few details were forthcoming:

The People’s Bank of China said it’ll resort to “more powerful” policies to counter unprecedented economic challenges from the coronavirus pandemic, without giving further details on what measures it will use.

The central bank will “work to offset the virus impact with more powerful policies,” paying more attention to economic growth and jobs while it balances multiple policy targets, the PBOC said in its quarterly monetary policy report, released Sunday. It reiterated that prudent monetary policy will be more flexible and appropriate and it’ll keep liquidity at a reasonable level.

The remarks reflect the PBOC’s growing concern over the unprecedented economic downturn and the risk of a second quarter of contraction, given sluggish domestic demand and the collapsing global economy. While the central bank has increased liquidity supply to banks and eased rules on banks’ buffers to allow them to extend more credit, the scale of the stimulus is limited compared to other major economies globally.

The authorities face a dilemma in crafting a stimulus package. Household debt levels are already stretched. Debt service is already at levels seen by US households just before the GFC collapse. The Chinese consumer has little spending power left to support the economy.
 

 

In fact, Chinese discretionary spending has weakened further since the COVID-19 lockdown was gradually lifted.
 

 

Chinese M1 and M2 growth has ticked up because of stimulus measures. However, growth rates are nowhere near the levels seen in the wake of the GFC shock-and-awe campaign.
 

 

Is Beijing running out of bullets?
 

The limitations of stimulus

There are severe limits to Chinese stimulus this time, according to Peking University finance professor Michael Pettis. In an interview with Swiss periodical The Market, Pettis warned that hopes of a rapid recovery, led by China, will most likely be disappointed.

A lot of people say Covid-19 has changed the world. I don’t agree with that. I think what it has done is it has accelerated a lot of things that were going on anyway. In the case of China, the elephant in the room is the level of total debt. In my view, the real underlying growth rate of China – by that I mean the growth rate that is not artificially inflated by debt-financed overinvestment – has for years been much lower than the officially stated rate. While official growth was around 6%, I’d say the real economic growth rate was less than 3%. The way they got to the official numbers was through the big increase in debt.

The main obstacle to growth is excessive debt that was accumulated in the last cycle.

What about the other two healthy sources of growth, exports and private sector investment?

Chinese exports will be down this year, as they suffer from the global slowdown. Which leaves investment by private companies. But most of that serves either as consumption or exports, at least the good stuff. So private corporations are not going to invest much. All in all, the good type of growth is probably going to be negative this year. Consumption will be down, exports will be down, private sector investment will be down.

Which only leaves the unhealthy sources of growth?

Exactly, and that is public sector investment and real estate development. It’s very simple: Because consumption, exports and private sector investment will be negative, public sector investment will just have to expand in China. There is no other way to keep growth levels in positive territory.

China has a dirty peg to the USD. This raises the impossible trinity problem. You can’t have a fixed foreign exchange rate; free capital movement (in the absence of capital controls); and an independent monetary policy all at the same time.

This is part of the catch with the impossible trinity they’re in. The PBoC has to act with restraint. Remember, they need foreign investment money to flow into China. One way to do that is to keep interest rates high relative to the Dollar and the Euro. And the other way is to limit the volatility of the currency. If you want to attract foreigners, you have to offer them a higher yield, and you have to alleviate their worry of a currency devaluation. So while the Fed reduced interest rates by 150 basis points, the PBoC only reduced theirs by about 20 basis points.

If the PBOC tries to stimulate too much, China risks capital flight. If they allow capital flight, the CNYUSD exchange rate falls, which will exacerbate already tense trade tensions with the US.

That kind of rhetoric from the White House shows that the relationship between the US and China is deteriorating even more. How do you see that playing out?

For at least the past two to three years, my message has always been the same: The relationship between Washington and Beijing is only going to get worse. So, as with other developments, Covid-19 has simply sped up a process that was already in place.

In summary, the policy makers in Beijing are caught between a rock and a hard place. Any stimulus efforts are likely to be small scale and highly targeted.
 

The market response

The market seems to understand the nature of China’s problems. The relative performances of the stock markets of China and her major Asian trading partners against the MSCI All-Country World Index (ACWI) have been unexciting. Relative returns rose starting in mid-February, but most markets gave back most if not all of the relative gains since the global market bottom in late March.
 

 

If there is any excitement over the prospect of Chinese stimulus, it can’t be seen in stock prices. This time, don’t count on China to save global growth again.
 

Earnings Monitor: Stabilization and hope

Posted by Cam Hui -

We are continuing our coverage of earnings season during these turbulent times. Last week, we highlighted the disconnect between earnings expectations and valuation (see Earnings Monitor: Reality bites). This week, we are seeing greater signs of stabilization, and hope for the future.

Let’s begin with the big picture. FactSet reported that the bottom-up consensus forward 12-month estimate fell -1.4% last week (vs. -1.9% the previous week), and -19.5% since downgrades began eight weeks ago. The EPS and sales beat rates were both below their 5-year historical averages.

Signs of stabilization

For the bottom-up view of operating conditions, here is the latest from The Transcript, which monitors and summarizes earnings calls.

Succinct Summary: Companies are reporting signs of improvement in the economy. But the rebound is coming off such a low base that these numbers would still be considered very bad in any other environment. The duration of this rebound will depend heavily on whether or not there’s a second wave of infections. Still, even without the virus it probably will take the economy a long time to recover from such a severe shock.

On an industry basis: private capital markets are searching for price levels; consumers are dreaming of the future; tech is chugging along; and the industrial/energy economy is feeling immense pain.

The good news is the decline is stabilizing and exhibiting some signs of growth. The bad news is the absolute levels are still horrendous. As an example, Hilton’s global occupancy improved from 13% to 21%.

But when business was down 90%, -80% looks good
“Week-to-week comparisons showed a third consecutive increase in room demand, which provides further hope that early-April was the performance bottom. TSA checkpoint numbers, up for the second week in a row, aligned with this rise in hotel guest activity, which still remains incredibly low in the big picture. Overall, these last few weeks can be filed under the ‘less bad’ category ” – STR Senior VP of Lodging Insights Jan Freitag

“We’re also seeing good booking activity in June and July. In June, we’re seeing booking activity in the 13% to 15% range in July, it’s significantly higher.” – Host Hotels & Resorts (HST) CEO James F Risoleo

“In addition, we are starting to see double-digit increases in digital traffic and booking activity across all segments. Global occupancy levels have gone from a low point of 13% to 23% currently. Assuming we start to see mobility and we don’t have a significant recurrence, demand should slowly rebuild in the third quarter.” – Hilton (HLT) CEO Chris Nassetta

“We are starting to see improvements in our sales with global same-restaurant sales being down approximately 10% for the week ended April 26 from down approximately 30% the last week of March.” – Wendy’s (WEN) CEO Todd Penegor

As different jurisdictions reopen their economies, much will depend on whether there will be a second wave of infections.

The recovery will depend heavily on whether or not there is a second wave
…”hopefully, we will not have a second wave but…requiring to go back to sheltering place…would be the largest risk that we’re seeing because…the factories will be shut down, the demand would be low…That I see as the biggest risk.” – Microchip (MCHP) CEO Steve Sanghi

“I fear 2Ws. W number one is war..my second W is the second wave…If I look to the economic consequences of all that, clearly even without the two Ws, I think we have the most unpreceded economic crisis that we have seen in peacetime, and the damage that is inflicting in our economies around the world is really causing damage to families, to jobs, to the capacity to bounce back, and we simply have no real good sense of how badly economies are affected” – European Central Bank (ECB) President Christine Lagarde

Second wave risk

In addition to the risk of a second wave of infections, I am concerned about the prospect of a second wave of negative growth hit the economy.

We have all heard about the joke that it’s a recession when your neighbor loses his job, and it’s a depression when you lose your job. This was starkly illustrated by the April Jobs Report. Non-farm payroll fell by -20.5 million. Lost in the initial shock of the report was the surge in average hourly earnings, which can be explained by the concentration of job losses in lower paid workers.

While this could pivot to a discussion on gaping inequality during this crisis, I do not believe it is appropriate to detour into politics during investment analysis. Nevertheless, it is difficult to believe that average hourly earnings will not converge towards the rate of job losses, rather than the other way around. I recently discussed the vulnerability of small businesses, which operate mainly in the low margin, high volume segment, and not well capitalized. How long can they endure cratering sales?

Bloomberg recently reported that defaults are rising, but many default events are showing up under the radar because of distressed debt exchanges:

The worst recession since the Great Depression is prompting indebted companies to default, and increasingly more will do so in a way that’s harder for investors to detect.

Rating firms predict that more companies will pursue distressed debt exchanges, in which they try to overcome liquidity problems by swapping debt or buying it back at steep discounts. Such moves are less stark than missed payments and can fly under the radar for the general investing public, but often result in losses for creditors and are usually counted as defaults by rating companies…

“Distressed exchanges often are just ‘bandages’ and the firm eventually goes bankrupt,” said Edward Altman, a professor emeritus at New York University’s Stern School of Business and director of credit and debt market research at the NYU Salomon Center. Altman, who developed a widely used method called the Z-score for predicting business failures, estimates that up to 40% of distressed exchanges end in bankruptcy within three years.

The pandemic is driving a surge in distressed debt in the obvious sectors. When will the next shoe drop?

The relative performance of bank stocks is already anticipating a wave of financial distress. So far, the market has been held up by the perception of Fed’s support, but the Fed cannot supply equity to companies that have gone bankrupt. Will this cycle be any different from past cycles?

Challenging valuations

In the meantime, valuations are still challenging. FactSet reported that the market is trading at a forward P/E ratio of 20.4. The last time the market traded at these levels was in 2002, when it deflated from the dot-com bubble.

Much depends on the relationship between valuation and expected growth. I hate to quote the perennially bearish Albert Edwards, but he has a point about the PEG, or P/E to Growth ratio, as reported by Marketwatch:

Yes, the Société Générale economist who refers to himself as an “uber bear,” once again, lived up to his self-billing in his gloomy note to clients on Thursday.

“We are in the midst of a monetary and fiscal ideological revolution. Nose-bleed equity valuations are being supported by nothing more than a belief that a new ideology can deliver,” he wrote. “Meanwhile the gap between the reality on the ground and expectations grows wider.”

Edwards used this chart to show “how ludicrous current equity valuations have become and by implication how vulnerable equities are to a collapse”

As the market rallies, I am seeing an increasing number of articles and observations that investors are in a win-win situation. If the reopening is successful, the growth outlook improves; if it’s unsuccessful, the Fed has your back. Investors can’t lose.

I reiterate my view that there are limits to the Fed’s support. The Fed can supply liquidity to the markets in order to compress risk premiums, but it cannot supply equity if firms were to fail. Investors should be mindful of the risks embedded in market pricing, especially in view of the highly stretched nature of valuations.

Setting up to climb a Wall of Worry?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

An AAII crowded short?

Why is AAII sentiment so bearish? Is that contrarian bullish?

Jason Goepfert at SentimenTrader highlighted how the latest American Association of Individual Investors (AAII) weekly sentiment survey, which showed that bearish sentiment had spiked despite the stock market rally. Readings have become sufficiently net bearish that subsequent returns are bullish.

What’s going on? Is the market climbing the proverbial Wall of Worry?

Sentiment anomalies

There are a number of anomalous sentiment readings that are inconsistent with the AAII weekly survey. For example, Investors Intelligence is returning to a neutral level after a fear spike and shows no bearish extreme.

The same could be said of the NAAIM Exposure Index, which measures RIA sentiment.

The percentage of Sell Side buy ratings is the highest since June 2015. This is not excessive bearishness, but bullishness.

The equity-only put/call ratio is a bit on the low side. This is an indication of mild bullishness, and nearing a crowded long condition.

The AAII survey sample is composed mainly of retail short-term traders. If these traders are so bearish, the bearishness is not showing up in Rydex bear fund activity.

Has something happened to the AAII survey sample? Is the bearishness just a data blip?

A new Tech Bubble?

No, there is nothing wrong with the AAII sentiment survey. It is doing its job by measuring the activity of retail short-term traders. It’s just that retail traders are dominating market movements in the short run.

Retail brokerage Daily Average Revenue Traders (DARTs) tells the story. Powered by the trend to zero commissions, DARTs have exploded upwards across the board. Here is another crazy anecdote. Robinhood had 10 million accounts by Dec 2019, and it added another 3 million new accounts YTD.

This is starting to be reminiscent of late 1990’s Tech Bubble. The zero-cost (except for bid-ask), high confidence and very low knowledge of markets are fueling a contrarian rally based on excessive bearish retail sentiment. While they are bearish on the economy, retail traders are piling into the technology market leaders as the last refuge of growth. As a result, NASDAQ stocks are now positive YTD.

There are early signs that the bears are capitulating. Callum Thomas conducts a weekly (unscientific) poll on Twitter, and the respondent base is probably similar to the AAII sample. As of the time of this publication, the poll is incomplete, but the interim results indicate that bull-bear spread has begun to reset from a record bearish extreme last week to a more neutral level.

Net bullishness is rising on both fundamental and technical dimensions. The fundamental bull-bear spread has retreated from a record low. The technical bull-bear spread has risen into bullish territory, though readings are not extreme.

Lurking volatility

While I have no idea of the exact timing, but the market is setting up for the return of greater volatility. Callum Thomas at Topdown Charts observed that volatility is becoming more volatile. This doesn’t mean that volatility just rises, but it becomes choppier – and so will stock prices.

The following chart has a lot of observations to unpack. Here are my main takeaways:

  • Realized and implied volatility are falling, as measured by the falling Bollinger Band (BB) width and VIX Index.
  • Volatility may be ready to spike. Both VVIX and TYVIX are not buying the decline in the VIX.
  • Stock prices may be nearing an inflection point. The market is testing key resistance levels, as defined by a Fibonacci retracement level, and its upper BB, even as its 5-day RSI exhibits a minor negative divergence.
  • The VIX Index is nearing an extreme. Historically, a VIX close below its lower BB is an overbought signal for the market and a good time to sell stocks. The VIX closed at 27.98 on Friday, which is just a hair above its lower BB at 27.94.

Even as the NASDAQ Index turns positive on YTD basis, broader market indicators such as the Value Line Geometric Index and the NYSE Advance-Decline Line are lagging the broader market advance. This retail supported rally looks like it is on its last legs.

Market breadth is overbought on a 1-2 day horizon, based on the percentage of stocks above their 5 dma.

On a longer time frame, however, they have more room to advance based on the percentage of stocks above their 10 dma.

I interpret these conditions as the market nearing an inflection point, but the most likely resolution is a choppy range-bound consolidation until it can find its next major narrative (see What’s the next market narrative?).

Still a bear market

From a long-term technical perspective, this is still a bear market. Bear markets are defined by monthly negative MACD readings. While the bull market (buy) signals work better than the bear market MACD sell signals, major bear markets have ended with deeply oversold 14-month RSI conditions, which hasn’t happened yet.

As well, we are entering the “Sell in May” period of negative six month seasonality. Jeff Hirsch at Trader’s Almanac showed what happens when the DJIA can’t even rally in the past “best six months” of the year. The following six months tend to resolve themselves bearishly.

Don’t go overboard and get too bullish.

My inner investor is still cautiously positioned. My inner trader is on the sidelines in cash. However, should the market stage another rally on Monday and the VIX closes below its lower BB, he will initiate a short position, purely on the expectation of a 1-2 day scalp.

What’s the next market narrative?

Posted by Cam Hui -

This crisis has so far gone through two phases of market psychology. The first phase was panic, as it became apparent that COVID-19 had become a global pandemic, and economies around the world were shutting down. Stock prices rebounded during the hope phase, supported by a flood of fiscal and monetary stimulus, and the hope that reopening the economy might bring some semblance of normalcy.
 

 

What’s the next phase of the market’s narrative, and how should investor position themselves? Here are a few ideas:

  • Will the economy be able to reopen successfully?
  • Will the trade war return, and what are its implications of the fight against COVID-19?
  • The risks of a wave of bankruptcies, or worse, an Apocalypse of zombie companies.
  • More European theatre: The German constitutional court decision’s threat to eurozone stability.
  • The evolution of a business environment that is increasingly hostile to businesses.

 

A successful reopen?

As various countries have begun to flatten and bend the COVID-19 infection and fatality curve, we are starting to see phased initiatives to reopen economies again all over the world. Within the US, different states are reopening at different speeds, but it is unclear whether the pandemic is fully under control outside of New York State.
 

 

The first risk is that COVID-19 is not under control within US borders. As well, the market is likely to look ahead and recognize that reopening does not equal normalization and growth is unlikely to continue as before. The New York Times reported that most states which are reopening failed to meet Trump Administration recommendations to resume activity.

Even if the reopening efforts were to be successful, Guggenheim Investments analyzed the output gap, which is the difference between actual GDP and potential GDP, and concluded that it will take years for growth to return to potential.
 

 

Assuming that there are no hitches in individual states’ initiatives to reopen their economies, there are plenty of other risks facing investors as well.
 

A trade war revival

One of the key risks is the return of the trade war. Since the onset of the GFC, Douglas Irwin of the Peterson Institute documented globalization was in retreat. Trump’s arrival in the White House accelerated that trend as protectionist tendencies rose.
 

 

The COVID-19 pandemic is just the latest episode in a long trend. The Trump Administration has undertaken a two-pronged attack on China. The first is to blame China for its slow response to COVID-19, and to insinuate that the virus was deliberately released from a lab in Wuhan (via CNBC):

In the U.S., critics allege Beijing wasn’t upfront about the dangers of the virus, was too slow to respond and under-reported the extent of the outbreak within its borders.

In the past week, President Donald Trump said he believed that China’s “mistake” was the cause of the global pandemic, while Secretary of State Mike Pompeo said “a significant amount of evidence” suggested that the virus originated in a Wuhan laboratory.

Secretary of State Mike Pompeo’s language was even more provocative, which was supported by Trump last Sunday in a virtual town hall on Fox News.
 

 

Even as Pompeo cited American intelligence sources for his assertions about the source of the virus from the Wuhan lab, an article in Australia’s Sydney Morning Herald revealed that Australian officials found the source of the claim came from open news sources, and not from intelligence channels.

Senior members of the Australian intelligence community told The Sydney Morning Herald and The Age a research document shared in political circles under the Five Eyes intelligence arrangement was mostly based on news reports and contained no material from intelligence gathering.

A 15-page “dossier” has been widely quoted by local and international media about China’s alleged cover-up of the virus. Australian intelligence officials have since identified a research report which was based entirely on open source material. The officials said it was likely the reports were the same.

The second threat is an escalation of the trade war. To no one’s surprise, China is falling far short of the import targets because of its economic slowdown. Trump has threatened to scuttle the Phase One deal inked in January. American and Chinese negotiators discussed the problem on Friday and issued a statement that “good progress is being made on creating the governmental infrastructures necessary to make the [Phase One] agreement a success” . Trump said on Wednesday that he would decide within the next two weeks if he is happy with how the deal is progressing.
 

 

Notwithstanding the fact that the last thing the global economy needs is more protectionism, this threat creates complications against the fight against COVID-19. A Congressional Research Service report study that Germany and China accounts for 11% and 9%, respectively, of US imports of medical equipment and pharmaceuticals.
 

 

In particular, China accounts for a substantial portion of the supply chain for the many pharmaceuticals and chemical drug precursors.
 

 

While these supply chain vulnerabilities highlight the desire of American negotiator Robert Lightizer to return jobs back to American shores, they nevertheless create gaping holes in the global preparedness in the fight against COVID-19.

The New York Times reported that of the roughly 90 initiatives to find a vaccine against COVID-19, seven are undergoing clinical trials. Notwithstanding the obstacles of these efforts, one roadblock that is likely to slow down research is the Trump Administration’s suspicion of intellectual property theft by Chinese researchers.

In an era of intense nationalism, the geopolitics of the vaccine race are growing as complex as the medicine. The months of mutual vilification between the United States and China over the origins of the virus have poisoned most efforts at cooperation between them. The U.S. government is already warning that American innovations must be protected from theft — chiefly from Beijing.

“Biomedical research has long been a focus of theft, especially by the Chinese government, and vaccines and treatments for the coronavirus are today’s holy grail,” John C. Demers, the assistant attorney general for national security, said on Friday. “Putting aside the commercial value, there would be great geopolitical significance to being the first to develop a treatment or vaccine. We will use all the tools we have to safeguard American research.”

Even if a vaccine were to be found, the resultant risk-on rally may be cut short because of supply chain and production problems.

Even when promising solutions are found, there are big challenges to scaling up production and distribution. Bill Gates, the Microsoft founder, whose foundation is spending $250 million to help spur vaccine development, has warned about a critical shortage of a mundane but vital component: medical glass.

Without sufficient supplies of the glass, there will be too few vials to transport the billions of doses that will ultimately be needed.

Even if there are no production problems, distribution will be a challenge. The Washington Post reported that there is a scramble among American hospitals to get doses of the experimental Gilead drug remdesivir. Can you imagine the chaos if a vaccine became available, but in only limited supply? For policy makers, the next key question after a vaccine is available becomes, “There are over 300 million people in the US, and 7.8 billion people around the world. Who gets the first doses?”

Given the stakes, it is no surprise that while scientists and doctors talk about finding a “global vaccine,” national leaders emphasize immunizing their own populations first. Mr. Trump said he was personally in charge of “Operation Warp Speed” to get 300 million doses into American arms by January.

Already, the administration has identified 14 vaccine projects it intends to focus on, a senior administration official said, with the idea of further narrowing the group to a handful that could go on, with government financial help and accelerated regulatory review, to meet Mr. Trump’s goal. The winnowing of the projects to 14 was reported Friday by NBC News.

There is a significant chance that the breakthrough will not occur on American soil, or by US affiliated researchers. It would be political suicide for the leader of any country whose researchers that develop a vaccine to refrain from export controls before that country’s population receives the first doses.

But other countries are also signaling their intention to nationalize their approaches. The most promising clinical trial in China is financed by the government. And in India, the chief executive of the Serum Institute of India — the world’s largest producer of vaccine doses — said that most of its vaccine “would have to go to our countrymen before it goes abroad.”

In light of the rising level of animosity between Beijing and Washington, a discovery by Chinese researchers is likely to set the stage for a debilitating trade conflict.

In China, the government’s instinct is to showcase the country’s growth into a technological power capable of beating the United States. There are nine Chinese Covid-19 vaccines in development, involving 1,000 scientists and the Chinese military.

China’s Center for Disease Control and Prevention predicted that one of the vaccines could be in “emergency use” by September, meaning that in the midst of the presidential election in the United States, Mr. Trump might see television footage of Chinese citizens lining up for injections.

“It’s a scenario we have thought about,” one member of Mr. Trump’s coronavirus task force said. “No one wants to be around that day.”

If you thought the Sino-American trade war spooked the markets, wait for the second round, if a single country were to develop a vaccine and imposed export controls.
 

Bankruptcy, or Zombie Apocalypse?

Another narrative the market may focus on in the near future is the prospect of a bankruptcy epidemic. In the past, loan delinquency rates have been highly correlated with the unemployment rate, with delinquency either leading or coincident with unemployment. As the economy hit a sudden stop in the latest crisis, this time really is different. Unemployment has spiked, but the delinquency rate has not.
 

 

What about the Fed? Hasn’t central bank action put a floor on markets, and reduced the risk of bankruptcies?

To answer that question, think of the process when a company files for bankruptcy protection under a provision like Chapter 11. The first question that creditors need to decide upon is whether the company has too much debt, or a bad business model. If the business is viable without debt, the solution is some combination of restructuring of the capital structure, composed of debt write-downs and debt-for-equity swaps, and probable layoffs to right size the company. If, on the other hand, the company is not viable because its business has been permanently impaired, no amount of debt restructuring can save it.

Central bank support of such firms will only create a class of walking zombie companies that are so burdened with debt they will collapse the minute policy support is withdrawn. Even if the economy were to recover, don’t count on the zombies to be a source of growth. They are unlikely to expand, hire new employees, or invest in new equipment.

The recent Berkshire Hathaway shareholder meeting was enlightening for investors in many respects. Warren Buffett reported on what Berkshire’s companies are seeing in their businesses. He revealed that some of the sales losses are permanent; some weak businesses are not coming back; some are hurt by customer behavior changes that will stick, e.g. airlines; and not all of the job losses will be recouped. Here is the key point. Buffett is known to invest in companies with a strong moat, or competitive position, at attractive prices. If the business outlook for Berkshire’s portfolio of wide moat companies is so weak, what about all the companies with little or no moats?

One group of especially vulnerable companies without moats are small businesses, which tend to be low-margin and high volume enterprises. Most are not well capitalized. While there is an array of government support to help keep them alive, these programs are only band-aids. Even if the reopening efforts are successful and there is no second wave of infections, sales are not going to rebound strongly. We are likely to see either a wave of small business bankruptcies in the coming months, or a herd of small businesses operating as zombies that will not be a source of employment or business investment growth.

A recent working paper by some academics at the Becker Friedman Institute at the University of Chicago outlined the risks posed by small business failures to the economy. The team used ADP employment data to analyze employment changes during the initial phases of the pandemic and concluded that mass small business failures is likely to depress the speed of the subsequent recovery.

While the majority of the employment decline occurred among continuing businesses, measured business exit—or temporary suspension of operations—plays a substantial role in the overall collapse, particularly among smaller businesses. This is an alarming pattern which may have relevance for the pace of recovery. One would hope that many of the businesses we observe suspending activities will resume operations in the near future. If not, the jobs destroyed by exiting businesses are permanently gone, requiring extra growth among surviving businesses or extra business entry to replace them. Jobs and the associated personal toll of unemployment are not the only costs of business failure. From the perspective of business owners, the failure of a business means the loss of income and probably a large share of household assets. From the perspective of the macroeconomy, business failures mean the destruction of intangible capital and even the loss of some physical capital, particularly in light of costly capital allocation. From the perspective of communities and neighborhoods, business failure means dramatic, sometimes irreversible changes to the local physical economic landscape. While some recessions see elevated failure of low-productivity businesses (thereby enhancing aggregate productivity), we have no reason to expect exit selection to function constructively in the current environment, where business revenue losses are determined by the rapid onset of a health crisis.

The study also found that job losses are affecting the lowly paid workers disproportionately:

These employment declines are not evenly spread throughout the wage distribution. The overwhelming brunt of the employment decline is concentrated among lower-wage workers. The bottom 20 percent of wage-earners account for nearly 36 percent of all job loss. These differences persist even after controlling for differential declines by industry, business size, worker age, and location. The large exit of low-wage workers from the labor market has resulted in average wage per worker rising by five percent in the weeks following the start of the recession. However, all of this is driven by selection effects. Following a given worker through the start of the recession, we find that the wages of continuing workers have been flat. At this point of the recession, essentially all of the adjustment has occurred on the quantity margin. Most of the quantity adjustment has been on the extensive margin of labor supply. However, the intensive margin of labor supply has also declined slightly.

The uneven effects on employment will cascade through the economy. The St. Louis Fed modeled the effects of the loss of income on individual households. For every $100 of income loss, the drop in consumption varies from $26.80 for the richest households (Q1) to $45.00 for the poorest (Q5). Watch for a crash in consumption, and a wave of personal bankruptcies in the near future.
 

 

The April Employment Report shows a loss of -20.5 million jobs and the unemployment rate spike to 14.7%, both of which were better than expectations pf =22/0 million and 16% respectively. Before everyone gets overly excited about the NFP beats, the plunging Diffusion Index is far more worrisome, because it is an indication of the widespread nature of job losses that is far worse than past recessions.
 

 

In short, the Fed can’t solve all the problems. Greg Ip of the WSJ rhetorically asked recently, “Is This a Liquidity Crisis or a Solvency Crisis? It Matters to Fed”.

In a liquidity crisis, otherwise healthy firms collapse because they can’t access credit. The Fed can resolve such a crisis because it can print and lend unlimited amounts of money. In a solvency crisis, companies can’t survive no matter how much they can borrow: they need more revenue. The Fed can’t solve that.

 

Another threat to eurozone stability

Another issue bubbling under the surface comes from across the Atlantic in the EU. Just when you thought the problem had been resolved, the COVID-19 pandemic is raising the threat of eurozone stability all over again.

The ruling of the German constitutional court that the ECB’s bond buying program is contrary to the German constitution, and the ECB must justify its actions was a shocker. The decision is a challenge to the supremacy of the European Court of Justice and creating a parallel legal order for the Bundesbank. It also puts Jens Weidmann, the head of the Bundesbank and a member of the ECB governing council, in a difficult position. Wiedmann has been a hawk and frequently opposed the ECB’s bond buying programs, but he now has to justify to the German court the programs that he opposed in the past.
 

Bloomberg reported that there is no shortage of ECB rebuttals to the German constitutional court.

The constitutional court’s demand on Tuesday that the ECB justify its multi-trillion-euro bond-buying plan within three months took investors and economists by surprise. They largely expected Germany to follow the assessment by the European Union’s highest tribunal that the program is legal.

Instead, the judges cited numerous arguments against ultra-loose monetary policy, including that it unduly benefits the banks, supports zombie firms, and penalizes savers.

Yet those charges have already been tested by researchers, and the ECB has published hundreds of pages on the impacts of its crisis-fighting measures.

ECB president Christine Lagarde short-circuited the response Thursday by stating the central bank was answerable to the European parliament and  not to the German constitutional court. In the meantime, uncertainty has risen, and so have the peripheral bond spreads which threatens debt sustainability.
 

 

In another words, it’s another act in the usual European theatre. In the past, back room deals are made while the crisis plays out in the news. The participants are all very European in their outlook and no one wants the EU to fall apart.

Will that happen again this time, and what damage will that inflict on the markets and eurozone stability?
 

An increasingly hostile business environment

Finally, the most worrisome trend investors will have to look forward to is an increasing hostile environment for businesses, starting with rising labor costs. Scott Grannis at Calafia Beach Pundit complained that the minimum wage is now $25 an hour because of government support and subsidies:

Thanks to the generosity of Congress (it’s always easy to spend other people’s money, isn’t it?), the average weekly unemployment check now resides in the princely neighborhood of $1000 per week, or $25 per hour. Congress has effectively raised the minimum wage to $25/hr. by boosting weekly unemployment checks by $600/wk through the end of July.

What, you say?! Consider: for any business in trouble because of the shutdown, the very best solution is to fire or lay off employees, since most, if not all, of them will be able to collect unemployment benefits which are the equivalent of $25 per hour through the end of July. The 30-million-strong army of the recently unemployed now work for the government, you see. Their job? To stay at home and watch TV all day, or whatever else suits their fancy. Do nothing, and the government will pay you $25 per hour. Not a bad job, if you can just get fired or laid off! Think of it as a paid vacation with time-and-a-half! And it’s all for a good cause: to win the war against the coronavirus.

Here is Warren Buffett’s indirect counterpoint to Grannis’ complaint. CNBC reported that Buffett responded to a question from actor Bill Murray.

Murray asked via Quick: “This pandemic will graduate a new class of war veterans:  Health care, food supply, deliveries, community services. So many owe so much to these few. How might this great country take our turn and care for all of them?”

Buffett: “We won’t be pay to pay, actually. It’s like people that landed at Normandy…The poor, the disadvantaged… They suffer, there’s an unimaginable suffering and at the same time they’re doing all these things. They’re working 24-hour days and we don’t even know their names…If we go overboard on something, we ought to do things that can help those people.”

While Grannis is correct that front-line workers will have a temporary minimum wage that is equivalent to $25 an hour. On the other hand, Buffett compared today’s front-line low-wage workers to soldiers who stormed the beach at Normandy. These are the delivery drivers who bring you the groceries while you work at home, the line cooks and restaurant servers who risk their lives by exposing themselves to infection, the meat cutters working at the shuttered and partially shuttered meat processing plants, and so on. Shouldn’t they be paid a risk premium for risking their lives to show up to work?

Regardless of your political opinion, the economic reality is labor’s bargaining power is rising, and employers will see upward wage pressures that compress operating margins. Already, Payday Report has identified 175 wildcat strikes since the beginning of March. This is the kind of labor action last seen that kind of labor action since the 1970’s and early 1980’s.
 

 

The terms of capitalism are changing. Bloomberg reported that Blackrock CEO Larry Fink expects a wave of bankruptcies and rising taxes.

Fink said on the call with clients of a wealth advisory firm that bankers have told him they expect a cascade of bankruptcies to hit the American economy…lifting the 21% corporate rate signed into law as part of 2017’s tax overhaul to about 28% or 29% next year…[and\ tax rates for individuals going up.

CNBC reported that Leon Cooperman also higher tax rates, as well as tax code changes like the elimination of carried interest and the ability to roll over real estate sales tax free, and rising capital gains rates.

Billionaire investor Leon Cooperman said Thursday on CNBC’s “Squawk Box” that the coronavirus crisis will “likely” change capitalism forever and that taxes will need to be raised soon.

“When the government is called upon to protect you on the downside, they have every right to regulate you on the upside,” Cooperman said. “So capitalism is changed.”

The pandemic has changed the Overton window of acceptable political discourse. The fault lines of economic inequality have been exposed by the pandemic, which evaporated over 20 million jobs almost overnight. If die-hard capitalists like Fink and Cooperman believe that capitalism is changing, who are mere mortals like us to disagree? More importantly, when will the market begin to focus on these changes?
 

Investment implications

This is a recession, and recessionary bear markets take more than just a few weeks to resolve themselves, regardless of how much the Fed or Congress stimulates the economy. That said, this is not a long drawn-out economic depression. There are about 90 different initiatives to find a COVID-19 vaccine, and in all likelihood, at least one of them will be successful. The panic will pass, and economic growth will recover.

The stock market has recovered and it is stabilizing after its initial panic phase. It is now caught between a bullish perception of the Fed’s unlimited liquidity and the bearish perception of uncertainty over the economic economy and resolution of the pandemic. If the bulls were really in charge and Fed liquidity were dominant, the index would be in an uptrend, but it broke down from its uptrend line in April and it is now trading sideways. We are likely in for a period of consolidation until psychology starts to focus on the next narrative, after the hopes for reopening and recovery play out.

From an intermediate term perspective, global stock markets have much work to do before they can show that the bulls are in charge. Macro Charts pointed out that virtually all global markets are in downtrends, as defined by a falling 200 day moving average.
 

 

Barring the discovery of a miracle treatment or vaccine, the next likely market narrative will have a bearish tone. With the S&P 500 trading at a forward P/E of 20.4, which is a level last seen in 2002 when the market deflated from the Tech Bubble, investors are at risk of a disorderly adjustment in stock prices over the next few months.

 

A clash of sentiment

Posted by Cam Hui -

Mid-week market update: What should one make of sentiment readings? Credit Suisse reported that long/short hedge funds are now in a crowded long position:

One result of April’s latter month short covering is an all-time high net long exposure among equity long/short managers globally, albeit on a historically low gross exposure.

 

That’s contrarian bearish, right? Yes, but that snapshot isn’t the whole story. 

 

Sentiment is very diverse, and different market participants have different views of the market. Bloomberg also reported on the Credit Suisse findings of long/short fund positioning, but also highlighted a very different position taken by global macro hedge funds and commodity trading advisors:

As for macro managers and commodity trading advisors, which mostly speculate with futures, net equity exposure is the lowest in about a year, according to the bank’s data.

As hedge funds can take either long or short positions, I interpret low net equity exposure as a neutral and not bearish positioning. Indeed, CoT reports of large speculator positions in equity futures like the NASDAQ 100 are not extreme. 

 

 

The retail investor enigma

The retail investor is another story. the T-D Ameritrade Investors Movement Index (IMX), which measures the risk appetite of the firm’s retail investors, shows a deeply defensive condition that was only surpassed in late 2011. 

 

 

While IMX shows excessive cautiousness, which is contrarian bullish, data from the AAII sentiment surveys are a bit of a puzzle. On one hand, the weekly sentiment survey normalized from a bearish extreme to a slightly bearish, but neutral reading. 

 

 

On the other hand, a supplemental survey of AAII members of what how they are coping with market volatility shows a bullish bias. 

 

 

Here is another head scratcher. Callum Thomas’ weekly Twitter poll has moved to an all-time low in net bearishness, despite the market rally. In the past, sentiment has moved more or less in line with price momentum. Not this time. Bearishness has been rising for fundamental reasons, while the technical view has been roughly neutral. 

 

 

Resolving the contradictions

Here is how I resolve the contradictory conditions from the different sentiment models. First, most of the models cited focus on actual positioning, or what different investors are doing with their money. Sentiment surveys, like the AAII weekly survey, are more volatile because it only asks the respondents’ opinions about the market. Opinion surveys are therefore less reliable than positioning surveys.

Sentiment readings are not extreme. While there are some pockets of excessive bullishness or bearishness, market players are diverse and their aggregate views cannot be characterized as extreme panic or greed. However, the bullishness expressed by the AAII supplement survey suggests there is a group of short-term retail traders who were whipsawed by selling out at the bottom, and now don’t want to miss the rally. On the other hand, the record level of bearishness shown by the Callum Thomas weekly FinTwit survey is also likely to put a floor on market prices should the market weaken.

In the short run, my base case scenario calls for a trading range between 2750 to 2950 as the battle of bulls and bears rages on. The S&P 500 breached an uptrend line and started to trade sideways on April 21, and the range-bound pattern is starting to be defined. In addition, the daily stochastic recycled from an overbought condition into neutral territory on April 30, indicating a loss of momentum and the bulls had lost control of the tape, but market’s failure to test the 50 dma is an indication that the bears do not have control of the tape either. 

 

 

The market became extremely oversold on a 1-2 day time horizon last Friday, and it was not surprising to see price recover. However, the bullish impulse failed soon afterwards, which is supportive of the trading range scenario.

Until we see either an upside breakout or downside breakdown, the current environment calls for a strategy of selling the overbought rips, and buying the oversold dips. As the market is neither overbought nor oversold on a short-term basis, my inner trader is content to stay on the sidelines in wait of better opportunities.

 

Earnings Monitor: Reality bites

Posted by Cam Hui -

Now that we are slightly over halfway through Q1 earnings season, it would be useful to see what we have learned, and how market expectations have developed through this pandemic period.

Let’s begin with the big picture. FactSet reported that the bottom-up consensus forward 12-month estimate fell -1.9% last week, and -18.3% since downgrades began seven weeks ago. I have been monitoring the evolution of forward 12-month EPS for several years, and this level of revision is extraordinarily high. In the past, the magnitude of weekly revisions was usually about 0.1%, and swings of 0.2% would be considered high. Now, revisions are an order of magnitude higher at 1% or more. In addition, estimates have been falling while stock prices have been rising.
 

 

Companies gave little in the way of earnings guidance during this earnings season. In fact, 47 companies withdrew their 2020 EPS guidance for the full year as management as uncertainty rose. However, there is a remedy for investors looking for greater clarity on the earnings outlook.
 

Top-down vs. bottom-up estimates

When the market experiences an unexpected shock, bottom-up earnings estimates are always slower to change. That’s because company analysts cannot quantify the shock to estimates without further discussions with management, and that process takes time. By contrast, top-down strategists can use economic models to estimate the effects of the shock on earnings, and top-down estimates are quicker to adjust.

We can see that in late 2017, when Congress passed a substantial corporate tax cut. Top-down strategists quickly coalesced around a one-time upward impact of 7-9% to earnings, while bottom-up company analysts were slower to react.

The same process is occurring today. Top-down S&P 500 estimates for 2020 is about 120-125, and about 150 for 2021. The bottom-up consensus is falling at different rates to converge to the top-down estimate. The bottom-up 2020 estimate of 133.83 is nearing the top-down range, but bottom-up estimates for 2021 are still far too optimistic compared to the top-down consensus.
 

 

Expect further bottom-up downgrades, but at a slower pace for 2020. How the 2021 estimates evolve will be of intense interest to investors, especially if they want to look over the valley of a dismal 2020.
 

What are companies saying?

EPS guidance is not the only way that corporate management communicates with the Street. Their primary tool of communication has been the earnings call, and their description of business conditions. The Transcript, which monitors earnings call, shows a severe decline, signs of stabilization at a low base, but an uncertain outlook for recovery.

It’s still tough to fathom the magnitude of the economic declines
“…we’re continuing to see record low passenger demand and revenue trends here in April and May, with operating revenue down roughly 90% to 95% year-over-year and single-digit load factors.” – Southwest Airlines (LUV) President Thomas Nealon

“…since the third week of March when we initiated widespread closures of stores in the U.S. we’ve seen the comps which include the impact of closures based on how we’ve defined comps for this period of time, it’s been fairly steady in the range of minus 60 to minus 70.” – Starbucks (SBUX) CFO Pat Grismer

“…in the United States, physician office visits across various areas of medicine are currently running down in the neighborhood of 70% versus pre-COVID-19 levels. – Merck (MRK) CFO Robert Davis

“We’re going to see economic data for the second quarter that’s worse than any data we’ve seen for the economy.” – US Federal Reserve Chair Jerome Powell

It’s different from the financial crisis. It’s more severe
“One is the early demand patterns, which we see coming out of the China market, some European markets clearly point toward the U-shape. And it’s very different from financial recession because the depth of the crisis is more severe than financial crisis” – Whirlpool (WHR) CEO Marc Bitzer

“…this is very different from ’08, ’09 for a bunch of reasons. I mean, first and foremost, it hit the entire economy, and it’s very dependent on the psychology of the consumer economic actors as to the rate and speed of the recovery.” – Lazard (LAZ) CEO Kenneth Jacobs

 We are starting to see some leveling off of declines
“…you saw our decline of between 50% to 55% towards the end of the quarter in terms of volume in the last several weeks of March, and we’ve seen that kind of level off” – Laboratory Corporation of America (LH) CEO Adam Schechter

“…we’re seeing some early signs at this point that users are returning to more commercial behavior” – Alphabet (GOOG) CFO Ruth Porat

“It is too early to tell if this uptrend in the second-half of April is the start of a recovery…The reason it’s different in the last two weeks of April, is what we have seen is that as some of these stimulus payments have come through, people are prioritizing pent-up demand in areas like automotive, like home improvement, and they’re not spending it on lower ticket categories, like entertainment and restaurants.” – Visa (V) CEO Vasant Prabhu

“…we’re starting to see a little bit of that stabilization impact come through, for example, in markets like Italy, Germany, Poland, Australia – Austria.” – Mastercard (MA) CFO Sachin Mehra

“…we’ve seen a strong improvement in comparable sales over the course of the month of April.” – Restaurant Brands International (QSR) CEO Jose Cil

“We are already seeing green shoots suggesting that economies and industries around the world are either rebooting or preparing to reboot in the coming weeks.” – Stanley Black and Decker (SWK) President & CEO James M. Loree

“The high-yield bond market has begun to reopen, especially at the higher end of the speculative grade rating scale” – Moody’s (MCO) President & CEO Raymond W. McDaniel, Jr.

However, our desire for normalcy may be outpacing reality. This may be the rare time that we don’t get a V shaped recovery.
“I remain very concerned that this health emergency and therefore the economic fallout will last longer than people are currently anticipating. And while there are massive societal costs from the current shelter-in-place restrictions, I worry the reopening in certain places to quickly before infection rates have been reduced to very minimal levels, will almost guarantee future outbreaks and worse, longer-term health and economic outcomes.” – Facebook (FB) CEO Mark Zuckerberg

“…realistically, we just can’t expect that things are going to be back to normal in 6 or 12 months. I don’t believe that for a minute.” – Southwest Airlines (LUV) Chairman & CEO Gary Kelly

“…what I would exclude right now, I would say, very low probability, the V-shaped recovery.” – Whirlpool (WHR) CEO Marc Bitzer

The Berkshire Hathaway virtual shareholder meeting on the weekend was also instructive for investors. Here are some important takeaways from that meeting:

  • Berkshire made new sales in its equity portfolio and cash and equivalents rose to $137.3 billion, up from $128.0 billion three months ago.
  • When asked why he hasn’t bought anything, in the manner of buying preferred shares of distressed companies at the bottom of the GFC, Buffett replied, “We have not done anything because we haven’t seen anything that attractive,” (Translation: Nothing is cheap.)
  • Berkshire sold its entire position in airline stocks. Buffett: “When we bought [airlines], we were getting an attractive amount for our money when investing across the airlines…I don’t know that 3-4 years from now people will fly as many passenger miles as they did last year …. you’ve got too many planes.” (Good luck to Boeing, Airbus, and the entire airline industry.)
  • On underlying business conditions: Some of the losses in sales are permanent, such as See’s Candy’s Easter inventory, some already-weak businesses are not coming back, and not all job losses will be recovered.

While Buffett was always upbeat about the long-term outlook and warned not to bet against America, this was a sobering outlook from a legendary investor known as the Oracle of Omaha.
 

Valuation warnings

FactSet also reported that, as of last Thursday, the S&P 500 was trading at a forward bottom-up derived P/E of 20.3, which is well ahead of its 5-year average of 16.7 and 10-year average of 15.0. As a reminder, forward 12-month EPS is falling, so forward P/E should rise even if stock prices remain steady. Moreover, valuations were already stretched even before the onset of the COVID-19 pandemic.
 

 

From a long-term historical viewpoint, the forward P/E of 20.3 was last exceeded when the market deflated from the Tech Bubble of the late 1990’s.
 

 

These extraordinary levels of valuation brings to mind the warnings from the Rule of 20, which flashes a sell signal whenever the sum of the forward P/E and inflation rate exceeds 20. Even if we were to assume no inflation, the Rule of 20 warning would be triggered by the P/E component alone. As CPI inflation is backward looking, we substituted the 5×5 inflation expectations from the bond market of 1.4%, and arrived at a Rule of 20 reading of 21.7.
 

 

What about the Fed, and low rates? Doesn’t that justify a higher P/E ratio? Aswath Damodaran at the Stern School at NYU calculated an equity risk premium, and a COVID ERP based on a 30% drop in 2020 earnings, and a 75% recovery by 2025 (h/t Callum Thomas). The COVID ERP is not very different from the levels when the crisis began, and equity valuations were already stretched then.
 

 

In conclusion, the increasing level of bifurcation between stock prices and earnings estimates is raising valuation risk for the equity market. Forward P/E ratios are already at the levels last seen when the Tech Bubble burst, and long-term valuation techniques like the Rule of 20 and ERP also point to heightened downside risk based on pure valuation approaches. As well, there is little signs of fundamental momentum. Comments from management during Q1 earnings season has been downbeat, and the level of uncertainty is high.

Long-term investors should take note, and assume a position of maximum defensiveness.
 

Buy the dip, or sell the rip?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Buy or sell?

Looking to the week ahead, the recent market action presents a mixed picture. The SPX, DJIA, and NYSE Composite all broke above their 50 day moving averages (dma), which are positives. But they remain under the broken rising trend lines, which are signs that the bulls have lost control of the tape.
 

 

Should traders be buying the dips, or selling the rips? Here are the bull and bear cases.
 

Bull case

Let’s start with the bull case. In the last 20 years, the NYSE McClellan Summation Index (NYSI) has never recovered from an oversold condition without bouncing back to an overbought reading (warning, n=2).
 

 

I wrote about the risks of narrow leadership last week (see Factor review: Narrow leadership and its implications). The leadership of the FANG+ stocks have begun to pause, and other groups, such as small cap stocks are starting to turn up on a relative basis. This could be interpreted as a healthy rotation in an uptrend.
 

 

The bear case

Here is the bear case. The market is exhibiting signs of bullish exhaustion, as evidenced by a possible stochastic recycle from overbought to neutral territory, which is a sell signal. As well, the NYSE Advance-Decline Line has been lagging the market, which is a negative divergence.
 

 

Inter-market, or cross-asset, analysis shows that gold, which has acted as a bear market hedge, is holding its upside breakout. Moreover, it is tracing out a bull flag, which is a bullish continuation pattern.
 

 

Bond prices, which are also hedges against equity declines, staged an upside breakout about a week ago. They pulled back and they are holding below their breakout level.
 

 

Keep an on on gold and bonds. Bullish breakouts by these assets will represent bearish tripwires for stock prices.
 

Waiting for clarity

My inner trader covered his short positions last week for risk control reasons. He must have displeased the market gods, because stock prices fell sooner afterwards. Despite the late week market weakness, he is still waiting for signs of clarity on short-term market direction.

Short-term breadth, as measured by % of stocks above their 5 dma, is oversold. Looking over a 1-3 day time horizon, the market is due for a bounce.
 

 

Looking out slightly longer term to the % of stocks above their 10 dma, however, the market is not oversold, and readings are in neutral territory. If the market were to stage a relief rally early in the week, recent episodes of turnarounds with this indicator at similar levels have resolved themselves with further market advances. The weakness late last week could be just a pause within an uptrend.
 

 

As well, new highs – new lows readings are dead neutral, indicating little momentum.
 

 

Sentiment readings, such as NAAIM, are normalizing after falling below its lower Bollinger Band, which has been a reasonable buy signal in the past.
 

 

My inner investor remains cautiously positioned. As I pointed out yesterday (see The recovery scenario), turning bullish at these levels requires too many courageous assumptions about how the global economy is likely to develop.

My inner trader remains on the sidelines in cash, waiting for greater clarity from the tape behavior next week. The risk/reward ratio is unfavorable for taking a directional bet at this stage, especially in light of the high level of uncertainty in today’s volatile environment.

 

The recovery scenario

Posted by Cam Hui -

The San Francisco Fed recently created a Daily News Sentiment Index, which is derived from 16 major newspapers. In the space of a few weeks, market psychology has turned from “the market is going to retest the March lows” to “the Fed is supporting prices, valuation doesn’t matter, the economy is recovering, – Buy”.

Regular readers are well aware of my increasing cautiousness about taking equity risk (see The 4 reasons why the market hasn’t seen its final lows and The bull case and its risks). While the economic recovery thesis is emphatically not my base case scenario, its’ time to conduct a review for investors and traders who would like to take that walk on the Dark side. How should investors position for an environment driven by Fed liquidity, and improving COVID-19 news. Even if you are cautious, these recovery candidates offer signposts of the market’s perception of the economic recovery theme.

I conclude that investors who would like to participate in the economic recovery investment theme should consider:

  • Technology and Healthcare as price momentum plays
  • Cyclical stocks as recovery plays
  • Value stocks, and bank stocks in particular, as turnaround plays
  • Diversifying US equity holdings into Europe and EM

However, there are a number of key risks to such an investment position. Even if the economy were to successfully reopen, the Fed has voiced its concerns about the economic aftershocks that could last for several years.

From a historical perspective, a similar fake-out rally occurred in Q2 2008 after the failure of Bear Stearns. Stock prices bounced, but later went on to make significant new lows after investors became overly complacent after believing the Bear Stearns failure took systemic risks off the table.

In light of the highly stretched nature of equity valuations and uncertain growth visibility in the current environment, the risks of a repeat of that episode is high.

Improving internals

From a factor return perspective, there are signs of a shift in tone. Most importantly, the leadership of US over international stocks, growth over value, and large caps over small caps are all showing signs of possible reversals. Changes in leadership often accompany major market bottoms, with the caveat that they are necessary conditions, but not sufficient conditions for a turnaround.

Similar signs of a possible turn can be observed in the currency markets. In particular, EM currencies, EM bonds, and EM stock and even frontier markets relative performance have all begun to stabilize.

Credit market risk appetite is a little more mixed. Both the relative performance of HY (junk) bond and municipal market are flattening out.

Even the ratio of cyclical to defensive stocks appear to be turning up, albeit in a very choppy fashion, which is also supportive of the recovery scenario.

Momentum winners

What should investors buy if they believe in the economic recovery theme? Here are some suggestions, and some factors to monitor.

Let’s start with the momentum winners, which should continue to beat the market regardless of whether the bulls or bears are in control. One winner is the technology sector, both in large and small cap stocks. Both large and small cap technology stocks have beaten their respective benchmarks. As small caps have begun to show some life, small cap technology stocks have also begun to lead their large cap brethren, though this is still a nascent theme that should be watched carefully. Within the technology sector, one standout has been the cyclically sensitive semiconductor stocks, which have been on a tear.

Another winning sector to watch are the healthcare stocks. While the performance of this sector has come off the boil, this sector has been a winner in the current environment, which is not surprising. There isn’t much to distinguish between the returns of the industry groups within this sector, and even healthcare providers are leading the market. One ETF to watch is Healthcare Momentum (PTH), which could also be an interesting candidate for investors who want to buy this sector.

Cyclical turnaround candidates

Investors who believe in a recovery can also consider cyclical stocks. Industrial, home building, transportation, and even leisure and entertainment stocks have all begun to exhibit better relative strength. Watch these industries for signs of a cyclical turnaround.

As well, late cycle resource extraction stocks are also showing signs of life. Even energy stocks are turning up on a relative basis. In particular, European basic industries are outperforming, and, to a lesser extent, US mining stocks. The one fly in the ointment is Chinese materials, which have been lagging global material stocks. The relative weakness of Chinese material stocks is disappointing, as China has been early in coming out of the pandemic.

One of the leadership themes that had been performing well, but has begun to roll over, is US over international stocks. Investors who are looking for a recovery can also consider allocating funds out of the US into non-US equities. Nascent relative strength winners are Europe, and EM.

Another factor that has been turning up is value/growth relationship. Value stocks have been lagging for so long that the relative performance ratio has become extremely stretched. Here are the biggest sector exposures of large cap value stocks against the index. The biggest overweight positions are financial and healthcare stocks, and the biggest underweight positions are consumer discretionary (AMZN) and technology stocks.

Since we have already discussed the healthcare sector, a discussion of the financial services sector is in order. As the following chart shows, the relative performance of bank stocks, and regional banks in particular, has been highly sensitive to bull and bear cycles. Investors who expect a recovery scenario are also betting on a revival of banking profitability. In the past, recessions have seen credit crises. With the Fed all-in on monetary policy support, the market is discounting that there will be no credit crisis this cycle. With rates at the zero bound, an overweight position in financial services is also a bet that the Fed will not resort to negative rates as a policy lever. We have seen how negative interest rates have devastated banking margins in Europe.

In summary, investors who would like to participate in the economic recovery theme should consider:

  • Technology and Healthcare as price momentum plays
  • Cyclical stocks as recovery plays
  • Value stocks, and bank stocks in particular, as turnaround plays
  • Diversifying US equity holdings into Europe and EM

Key risks

Here are the key risks of the bullish investment theme. The biggest risk was outlined by the Federal Reserve in an unusual observation about the COVID-19 pandemic in its latest FOMC statement:

The ongoing public health crisis will weigh heavily on…the economic outlook over the medium term.

In other words, while the Fed is prepared to stay easy over the next few years, it is worried about the economic aftershocks of the pandemic. Reopening the economy does not mean recovery.

Here are some tough questions that those who want to buy into the recovery theme need to answer. If reopening the economy does mean recovery, why are capital expenditure plans so weak? For investors, what does this mean for cyclical stocks?

In addition, the jobs market has been devastated. The Conference Board’s Consumer Confidence Labor Differential, defined as jobs hard to get – jobs easy to get, hit a brick wall and plunged. Can efforts to reopen the economy restart employment that quickly compared to historical experience?

In the wake of the FOMC meeting, Jay Powell stated that while the Fed has plenty of bullets left to fight the slowdown, there are limits to Fed policy. The Fed can extend loans and make loans cheaper, but it cannot issue grants, nor can it supply equity to failing businesses, or repair individuals’ balance sheets. As the economy hit the COVID-19 brick wall, companies drew on their bank credit lines and commercial loans surged. This begs the question of whether the market can avoid a default crisis in the face of the loan demand spike and cratering economic conditions.

As well, can the profit cycle be radically shortened compared to historical experience?

The Bear Stearns fake-out

What about the risk-on rally?

Ben Hunt at Epsilon Theory offered a historical parallel from 2008, the Bear Stearns fake-out.

Bear Stearns was enduring an old-fashioned run on the bank in March of 2008 (it was hedge funds taking their money out of the prime brokerage that killed the company), the overall market was in a severe correction. Not a bear market, mind you (no pun intended), but a severe correction. When Bear went out, the S&P 500 was down 18% from the October highs and down 12% from the Jan. 1 year start…

And then we had the Bear Stearns Bounce.

The overall market came roaring back over the next 8 weeks, so that by May 19 the S&P was only off 1% for the year. Still down 8% or something like that from the highs of 2007, but no one cared about that. Long or short, you get paid in this business on the calendar year, and every January 1 is a clean slate. Shorts like me who were feeling pretty pleased with themselves on March 17 were enduring a crisis of confidence on May 19, and the longs who were despondent in March were feeling prettay, prettay good in May.

Why did the market come roaring back from mid-March to mid-May? Because narrative.

Because according to every market media Missionary, Bear Stearns was the bad Wall Street apple in an otherwise reasonably decent Wall Street barrel. Oh sure, there were still problems here and there in mortgage portfolios, and sure we were in a recession, but there was no longer a risk of the system falling down. Eliminating Bear didn’t mean that the tough times were over for the financial system, but it did mean that the crisis was over.

Sacrificing Bear Stearns to the regulatory gods meant that – and I’ll never forget this phrase – “systemic risk was off the table.”

What happened next was, as they say, history. Hunt made a Bear Stearns analogy to the improvement in COVID-19 cases and deaths in today’s news backdrop.

It’s the fact that we really and truly flattened the curve and we really and truly avoided a healthcare disaster in San Francisco and Kansas City and Nashville and Los Angeles and Birmingham. It’s the fact that New Orleans and Houston did not become New York City. It’s the fact that NO city in the United States suffered an overwhelmed medical system except New York City.

And now that the worst is over even in the uniquely hard-hit area of New York/New Jersey … now that our daily death rate has peaked at 2,000+ Americans dying every freakin’ day from this disease, so that improvement to “only” 1,000+ Americans dying every freakin’ day becomes the “good news” that allows markets to climb a wall of worry …

“Yay, systemic risk is off the table!”

Indeed, there are parallels between the Bear Stearns bounce and factor performance today. As the market rallied during the Bear Stearns bounce, market leadership began to change, just as we are seeing today.

Even some of the narrative sound familiar. Bloomberg reported that Goldman Sachs justified its bullish about-face by pointing out that the market is looking through the economic damage of 2020. Look through the valley, because tail-risk is off the table.

U.S. stocks may be able to look through a dismal earnings season or two, and the deepest economic contraction in modern history, according to analysis by Goldman Sachs Group Inc.

That’s based on historical analysis that suggests equities price in macroeconomic performance over a two-year horizon. As long as projections are — as they indeed are now — for the economy to rebound after the current and coming period of pain, then stocks don’t need to fall, the Wall Street bank concluded.

“Investors usually discount at least the next two years of macroeconomic performance, suggesting markets may continue to look through bad news over the near term if it can reasonably be expected to reverse in the coming quarters,” Zach Pandl, co-head of global FX and EM strategy, wrote in a research note Monday.

Consensus top-down EPS estimates for 2021 is about 150, which makes the FY2 P/E 18.9. If you believe that buying the market at that earnings multiple is perfectly valid in light of all the risks, I have a few technology darlings from the late 1990’s left in my desk I can sell you. They’re really cheap – you can have them at the special price of a 50% discount from their Tech Bubble highs. The list includes Lucent, Nokia and, Nortel Networks, among many others.

Investment implications

In conclusion, investors who would like to participate in the economic recovery investment theme should consider:

  • Technology and Healthcare as price momentum plays
  • Cyclical stocks as recovery plays
  • Value stocks, and bank stocks in particular, as turnaround plays
  • Diversifying US equity holdings into Europe and EM

However, there are a number of key risks to such an investment position. Even if the economy were to successfully reopen, the Fed has voiced its concerns about the economic aftershocks that could last for several years.

From a historical perspective, a similar fake-out rally occurred in Q2 2008 after the failure of Bear Stearns. Stock prices bounced, but later went on to make significant new lows after investors became overly complacent after believing the Bear Stearns failure took systemic risks off the table.

In light of the highly stretched nature of equity valuations and uncertain growth visibility in the current environment, the risks of a repeat of that episode is high.

Please stay tuned for our tactical market comment tomorrow.