Looking through the FOMC meeting noise

Posted by Cam Hui -

Mid-week market update: It is always to discern short-term market direction on the day of an FOMC meeting, but a number of trends have developed that can support a short-term risk-on tone.

The most notable is the possible change in leadership. For quite some time, the trends of US over global stocks, growth over value, and large caps over small caps have been the leadership in the past bull market. I am starting to see signs of possible reversals.
 

 

In the past, changes in market leadership have marked market bottoms, and the emergence of new bull markets. This interpretation comes with the important caveat that leadership changes are usually necessary, but not sufficient conditions for major bullish reversals.
 

Better sentiment

The tone of sentiment surveys are also improving. II Sentiment is normalizing. Levels are returning to neutral, but not extreme enough for a crowded long reading. In light of the market’s positive momentum, prices have the potential for further upside.
 

 

Similarly, the Fear and Greed Index has recover to only 46 and it is not even about the neutral 50 line yet Momentum is positive and bullish enthusiasm could run much higher before sentiment becomes a concern.
 

 

What to watch

Here is what I am watching over the next few days. Short-term breadth is becoming overbought again, and the market could be due for a breather for the rest of the week.
 

 

The next resistance can be found at about 3000, which is roughly the site of the 200 dma, as well as the market’s upper Bollinber Band (BB). How will it behave at those resistance levels? Upside potential may only be capped at 2% if the market is rejected at that resistance level.
 

 

Lastly, the VIX Index is nearing a breach of its lower BBB, which is a market overbought signal indicating a possible pullback.

Subscribers received an email alert yesterday indicating that my inner trader had covered his short position. While the trading model had timed the sell-off and initial rebound well, it badly missed the magnitude of this latest rally. My inner trader is temporarily staying on the sidelines in cash in order to re-evaluate the technical picture. If my intermediate term assessment of a second bout of market weakness is correct, there will be plenty of opportunity to re-enter a short position. However, we need the advance to exhaust itself first, and then to assess whether the most likely path is a period of sideways and choppy consolidation, or another panic sell-off to re-test the March lows.

 

Do earnings matter anymore?

Posted by Cam Hui -

FactSet reported last week that bottom-up aggregated earnings estimates have been skidding rapidly for both 2020 and 2021.
 

 

Forward 12-month EPS estimates are falling even as stock prices rose.
 

 

Do earnings matter anymore?
 

Flying blind

What is the market discounting? At this point, any estimates that analysts make are only wild guesses. No one can tell you the future (sorry, my time machine is still in the shop). We are all flying blind.

Those of us who are old enough may remember the 1996 plane crash of Clinton era Commerce Secretary Ron Brown on a hillside just outside Dubrovnik (see Politico story). The weather was bad, and the aircrew was unfamiliar with the navigation aids in the area.

Yes, today’s market conditions are like that. The WSJ reported that even Charlie Munger, Warren Buffett’s longtime partner, sounded a cautious tone:

In 2008-09, the years of the last financial crisis, Berkshire spent tens of billions of dollars investing in (among others) General Electric Co. and Goldman Sachs Group Inc. and buying Burlington Northern Santa Fe Corp. outright.

Will Berkshire step up now to buy businesses on the same scale?

“Well, I would say basically we’re like the captain of a ship when the worst typhoon that’s ever happened comes,” Mr. Munger told me. “We just want to get through the typhoon, and we’d rather come out of it with a whole lot of liquidity. We’re not playing, ‘Oh goody, goody, everything’s going to hell, let’s plunge 100% of the reserves [into buying businesses].’”

To be sure, there is a variety of opinions. An article in Barron’s pointed out an unusual reading in the University of Michigan Sentiment Survey. While sentiment for current conditions had deteriorated, future expectations are still bright. Is that what’s holding up stock prices?
 

 

What are companies saying?

As we go through Q1 earnings season, companies usually offer guidance for Q2, as well as for the rest of the year. What are companies saying about the outlook?

FactSet reported that, as of April 24, 122 companies have reported, and 50 companies had commented on EPS guidance. Of the 50 companies, 30 (60%) were either withdrawing guidance or had withdrawing previous guidance for the year. The two sectors that had the biggest ratio of withdrawn guidance to providing guidance are industrial and healthcare companies.
 

 

For more color, I turn to The Transcript, which transcribes earnings calls. Here is what some executives said two weeks ago about business conditions.

Consumer spending is getting crushed
“We’ve entered into a world we haven’t seen before. Much of the economy is essentially closed. Consumer spend is down over 25% year-over-year this past week with food and drug increasing and other spend down significantly. New auto sales in the month of March were down at 32%” – Wells Fargo (WFC) CEO Charlie Scharf

“if I think about kind of the last week of March. the card spend activity, just broadly for us was down about 30%, U.S. spend by category down total of 30%. The big categories, if you will, impacted are not going to be of any surprise to you, travel down 75%, dining and entertainment down some 60%, discretionary retail, which would include apparel, department stores, etc, down 50%, essentials were up 10%.” – Citigroup (C) CFO Mark Mason

Most companies seem to be modeling a recovery by the second half of the year
“Both scenarios, though, do include a recovery in the back half of the year.” – JPMorgan Chase (JPM) CFO Jennifer Piepszak

“we see the environment showing near-term disruption and turbulence, but expect the longer-term to present opportunities to capitalize on many of our existing priorities” – J B Hunt Transport Services (JBHT) CEO John Roberts

“based on the data that we’re seeing from – that we’re collecting on a daily basis, is that we can see a recovery into Q3 and into Q4, especially for these more elective procedures…our modeling here suggest the kind of recovery that I’ve just described.” – Abbott Laboratories (ABT) Wyatt Decker

However, there are many reasons why this may not be a V-Shaped recovery
“It is not going to be what happened then, which was a very, very quick return to normalcy. That is not going to happen. At best, we’ll have kind of a rolling way out. As far as travel is concerned, while I’m absolutely optimistic that at some point, but I don’t think soon, I don’t think it’s until probably September, October, November, December, really get life back. And in order to travel, you’ve got to have that. So, they’re totally different situations. This is not analogous. I don’t think it’s analogous to anything. Certainly not analogous to 9/11 and to the financial crisis in ’08″” – Expedia (EXPE) Chairman Barry Diller

Here are some excerpts from the latest week’s earnings calls, which show a more nuanced interpretation of the gloom, as well as some signs of stabilization.

The question is how long will the decline last?
“our earnings will be driven by the answers to two questions that no one can now – no one yet can answer. First, when and how strongly does spending rebound as the global economy recovers? Second, how long do the challenges of high unemployment levels and small business shutdowns last, perhaps softened by the record levels of government support and what does that mean for our credit losses?” – American Express (AXP) CEO Stephen Squeri

The major forces at play are non-economic
“A lot of what will happen in the coming weeks and months will be dictated by governments, medical experts and circumstances that are completely unpredictable and out of our control.” – Moelis & Company (MC) CEO Ken Moelis

Some hard hit industries are seeing trends stabilize
“Delivery and carryout mix are holding relatively steady on average. Weekday sales have been significantly up, while weekends have generally been more pressured. Lunch and dinner dayparts are up, while late night had been more pressured, and we are seeing larger order sizes throughout the week.. we’re finding, at Domino’s, and I think some of our peers in the restaurant industry are finding, people are ordering extra food to have leftovers around also, which is a really interesting dynamic in the market today.” – Domino’s Pizza (DPZ) CFO Jeffrey D. Lawrence

“I’m pleased to report that only about 100 restaurants are fully closed at this time. These are mainly inside malls and shopping centers as well as 17 locations in Europe, while the rest of our restaurants remain open…as COVID-19 restrictions became more prevalent, our comps deteriorated and ended up declining 16% for the month, with the week ending March 29 being the trough at down 35%…April has seen our comps improve with the most recent week adjusted for Easter being in the negative high-teens range.” – Chipotle (CMG) CEO Brian Niccol

“Thus far through April, our in-patient admissions are running about 30% below the prior year. Our emergency room visits are running about 50% below prior year as our in-patient surgeries. Our hospital based outpatient surgeries are running about 70% below our prior year as most elective procedures have been deferred. We have started to see these volume declines stabilize over the past week.” – HCA Healthcare (HCA) CFO Bill Rutherford

As different countries and US states tiptoe towards reopening their economies, FT Alphaville reported that Jeffries had commissioned a private poll of 5,500 consumers in 11 countries about their spending intentions in a post-lockdown environment. As FT Alphaville put it, “For those hoping for a uniform V-shaped recovery, look away now.”
 

 

The challenges of forecasting

I recognize that forecasting the trajectory of the global economy for the next two years is a tremendous challenge right now.

FactSet reported that forward 12-month P/E is now at the nosebleed level of 19.1, with earnings estimates still falling. Even if you accept the premise that investors are looking over the 2020 valley, the P/E ratio based on 2021 estimates is 16.6, which is just below the 5-year average of 16.7, and above the 10-year average of 15.0.
 

 

Still this makes no sense, as valuations are clearly elevated. Why would you buy the market at about the 5-year average forward P/E given the high level of uncertainties facing investors?

The FT’s Martin Wolf recently unpacked the IMF’s forecasts for 2020 and 2021 before the virus, and after the crisis. The outlook does not look good, especially for the advanced economies.
 

 

Moreover, there is considerable uncertainty around the forecasts, depending on differing scenarios.
 

 

The WTO’s trade forecasts are all over the place.
 

 

Could that explain the disconnect between the stock market’s elevated levels? Is the market just discounting the best case scenario and ignoring the risks of the worst case?
 

Narrow leadership and market concentration

Here’s is how I square the circle of dire economic outlooks and buoyant stock prices. The stock market isn’t the economy, largely because of the narrow leadership of the megacap stocks and their market concentration.

I wrote yesterday about the risks of narrow leadership (see Factor review: Narrow leadership and its implications). Michael Batnick documented how the top five stocks in the index equal the weight of the bottom 350.
 

 

Zero Hedge (bless their eternally bearish and Apocalyptic hearts) seized upon a report from Goldman Sachs calling for an imminent momentum crash owing to narrow leadership, but I consider that a “this will not end well” story that can last a long time.

High market concentration is not necessarily bearish. This kind of concentration is unusual in today’s era, but it was not unusual back in the 1960’s and 1970’s. That’s why the DJIA was an important market benchmark back then, because the big stocks were the market.
 

 

I asked rhetorically at the beginning of this publication whether earnings matter. Yes, earnings matter, but the analysis so far confuses the market with the economy. The stock market does not represent the economy because of the narrow market concentration, and the leadership of the megacap stocks.

The megacap leadership stocks are reporting earnings this week, namely Alphabet (Tuesday), Microsoft and Facebook (Wednesday), and Apple and Amazon (Thursday). Analysis from Morgan Stanley concluded that the index gains by the top five companies have “been driven more by relative earnings resilience rather than valuation as forward net income estimates have come down far less than the market”. These earnings reports may determine the short and medium term tone of the market.
 

 

In the short run, that’s how earnings matter.

 

Factor review: Narrow leadership and its implications

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: 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 factor review

The past few weeks have seen much market volatility and confusion among market participants. One way of cutting through the noise is to see what market factors are leading and lagging.

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

The chart of recent factor leadership is shown below.
 

 

Leaders and laggards

Here is the relative performance chart of the leaders, as shown in the top right leading group quadrant. The winners consist of FANG+, and large and small cap growth. Bringing up the rear among the leadership group is price momentum (bottom panel).
 

 

The following factors that had shown some strength, but they are now rolling over.

  • High beta;
  • Russell 2000 small caps;
  • Shareholder yield; and
  • Small cap value.

The remainder are the laggards, which never really gained much traction.

  • Low volatility;
  • Dividend Aristocrats;
  • Large cap value;
  • Quality; and
  • Buybacks.

Do you notice a pattern here? Growth stocks, and large cap growth in particular in the form of FANG+ names, have been the leaders. Not much else has worked as a factor selection technique in the past few weeks. In particular, the difficulty shown by the high beta factor even as the market advanced is worrisome.
 

 

A stylistic warning

A recent warning came from a Marketwatch article highlighted analysis by Style Analytics, which found notable differences when it looked at past bear markets and rebounds.

Style Analytics, a research firm based in Boston and London, has studied both the crash and recovery, and compared them to other crashes — the global financial crisis, the dot-com bubble and the 1987 crash.

The COVID-19 crash was similar to the crashes from the global financial crisis and 1987 in how stocks of various styles and factors reacted.

But the recovery hasn’t been.

“The only factor to beat the overall market in the current rally is momentum, indicating that investors are doing little more than chasing returns (mostly in tech stocks),” the firm says.

 In other words, there has been no change in leadership.

By contrast, value and small cap — normally two of the most outperforming factors in recoveries — are the two worst underperformers during the current rally.

“While this may partially be explained by the fast cash stimulus propping up previous winners, it raises questions about whether the recovery has begun or whether this rally is part of an overall larger market decline yet to materialize,” they write.

The leadership of the Big Three remains unchanged. US over global stocks; Growth over value; and large caps over small caps. This kind of market action suggests that the latest rally is a bear market rally, instead of a rally off a sustainable bottom. Market leadership usually changes during bear markets, and new ones emerge in the fresh bull. That’s not the pattern we are seeing today.
 

 

Before everyone gets overly bearish because of the market’s narrow breadth, Goldman Sachs found that typically these periods of narrow breadth lasts a median of three months, and as long as 27 months during the Tech Bubble in 1998-2000.
 

 

Sentiment: Bullish or bearish?

Sentiment models are flashing mixed signals. Short-term AAII (mostly day and swing traders) sentiment is normalizing off a bearish extreme, which is constructive for stock prices.
 

 

Investors Intelligence sentiment is normalizing in a similar fashion. %Bears is receding off a crowded short level, but readings have not returned to neutral yet.
 

 

On the other hand, Mark Hulbert worried that newsletter writers were far too quick to jump on the bullish bandwagon. He concluded that the latest rally is likely to be a bull trap.
 

 

My assessment of sentiment concludes that it is a mixed picture, characterized by short-term positive momentum but at risk of a significant reversal. Hedge fund CTAs are roughly neutrally positioned. Retail traders are recovering from an extreme, which is bullish. The BAML Fund Manager Survey shows global institutions are defensively positioned with high cash and low equity weights, but managers have piled into the US equities as the last source of growth.
 

 

From that perspective, the US market’s narrowing leadership, and crowded global manager long position indicate a market that is at risk of a reversal. In that case, the retail momentum players could be seen as late to the party, and trying to pick up pennies in front of a steamroller.

Interpreting sentiment is more an art than science. I would point out there are different sentiment indicators that measure different parts of the market. Sentiment is not monolithic. Here are just a few examples:

  • Retail investor sentiment (AAII asset allocation survey, done monthly, BAML)
  • Retail swing/day trader sentiment (AAII weekly sentiment survey)
  • Advisor sentiment (II, NAAIM)
  • Global institutional (BAML Fund Manager Survey, monthly)
  • US institutional (Barron’s Big Money, quarterly)
  • Institutional positioning (State Street)
  • Hedge fund, which can be further broken down into different groups, such as market neutral, long short, global macro, etc. (e.g., COT, option data, JPM’s Kovanovic)
  • Insiders, whose signals are generally useful at bottoms and not at tops

The sentiment of all these groups don’t all move together, and keep in mind each group has its unique investment time horizon. Institutions are the elephants. Their moves are glacial, but when they shift, the fund flows are relentless. Hedge funds have turnover rates that can be an order of magnitude higher than institutional investors, and they can really move markets in the short run. Retail sentiment is becoming less important, but retail investors can be important at the margin.

Survey data is less reliable than positioning data because surveys only tell you how a respondents feel about the market, and do not tell you anything about what they are actually doing with their money. Some surveys, such as the BAML Fund Manager Survey, address that problem by asking how the managers are positioned. Others, such as the weekly AAII sentiment and Barron’s Big Money, do not.
 

Possible bullish exhaustion

There are signs that the market is experiencing bullish exhaustion. The S&P 500, DJIA, and NYSE Composite broke down through rising trend lines just as the indices approached their 50 dma from below.
 

 

The one major exception is the NASDAQ 100, which broke out above its 50 dma and remains in a rising channel.
 

 

The week ahead

Looking to the week ahead, the short-term outlook presents a mixed picture despite the weight of intermediate term bearish evidence. The bulls can highlight a possible bull flag that is forming, and about to break up. The bears can point to the negative divergence from the NYSE Advance-Decline Line, as well as a daily stochastic that is recycling from an overbought condition, which is a sell signal.
 

 

The analysis of the top five sectors presents a picture of narrow but bullish leadership that is exhibiting positive momentum. As a reminder, the top five sectors comprise nearly 70% of index weight, and the market cannot significantly move up or down without the participation of a majority of these sectors. Three of the five sectors, Technology, Healthcare, and Consumer Discretionary, are either in bullish relative uptrends or they are staging relative breakouts. These three strong sectors represent 48.3% of index weight and their strength cannot be ignored. However, the Consumer Discretionary chart (bottom panel) is reflective of the strength of AMZN. The equal weighted relative performance line (in green), which discounts the weight of AMZN, is far weaker than the cap weighted chart.
 

 

From a longer term weekly perspective, last week was an inside week, indicating that a big move may be coming. RSI momentum has been falling, and appears to be rolling over.
 

 

In other words, much depends on the earnings reports the FANG+ stocks next week of Facebook and Microsoft (Wednesday), and Apple and Amazon (Thursday).
 

 

In conclusion, signs are growing that the bulls are starting to lose control of the tape. Despite my longer term reservations about this market, this does not necessitate an immediate retest of the March lows. Any bullish break could resolve itself with a period of sideways and choppy consolidation. If I had to guess, I would assign a 30% chance of an immediate downdraft and retest in the next month, and 50% chance of choppy consolidation, and 20% chance that the bulls will push prices higher.

My inner investor’s portfolio is in a position of maximum defensiveness. A discussion with a reader led to an interesting idea of writing a collar, where the investor sells a call option to finance the purchase of a put option to guard against the possible retest of the March lows. My inner trader remains short the market, but he is keeping an open as to different possibilities.

Disclosure: Long SPXU

 

Why this volatility isn’t unprecedented

Posted by Cam Hui -

I have heard comments from veteran technical analysts who have become bewildered by the market’s action. The word “unprecedented” is often used.

I beg to differ. The violence of the sell-off, and subsequent rebound is not an unprecedented event. Recall the NASDAQ top of 2000. The NASDAQ 100 fell -39.8% from its March 2000 high, and rebounded 40.1% to its 61.8% Fibonacci retracement level in just four months. The index proceeded to lose -49.7% in that year, and ultimately -80.8% at the 2002 bottom, all from the July reaction high.
 

 

I am not implying that the NASDAQ pattern in 2000 represents any market analog to today’s action. Barring some other unforeseen catastrophe, such as the Big One taking down California and decimating Silicon Valley, the market is not going to fall -80% from the reaction high.

In the past, I outlined my concerns about the stock market (see The 4 reasons why the market hasn’t seen its final lows). This week, I register additional concerns, mainly from a technical analysis perspective.
 

Repairing technical damage

My first concern is the level of technical damage in the March downdraft. Even if you are bullish, it is difficult to believe a market could rally back and shrug off that level of damage without at least some period of consolidation.

Technical analyst J.C. Parets recently showed numerous examples of technical patterns that needed repair. He compared the price of Carnival Cruise Lines (CCL)
 

 

…to Citigroup before and after the GFC.
 

 

He also highlighted the relative price action of technology stocks after the NASDAQ top.
 

 

There were other examples, but you get the idea. Even if you are bullish, the market needs time to heal. Stock prices were so stretched to the upside that technician Peter L.Brandt, another grizzled veteran, declared that he had sold all his equity holdings.
 

Frothy sentiment

Another concern I have is the frothy nature of sentiment. Greg Ip wrote a WSJ opinion piece which highlighted the lack of perception of the difference between lower tail-risk and the odds of a sustainable recovery:

There is another, less reassuring, explanation for the market’s rally: Investors are translating less-bad incremental news into a much faster economic rebound later this year, perhaps prematurely.

The lockdowns and the fiscal and monetary backstops have eliminated the worst-case scenarios “for hospitalizations, mortalities, and bankruptcy filings,” but not the baseline scenario “which involves a massive negative shock to national income,” said Mr. Thomas. This doesn’t seem consistent with S&P 500 index hovering just 15% below its pre-pandemic high.

Mark Hulbert also issued a similar warning when Goldman Sachs made a public U-Turn and turned bullish.

Consider the average recommended stock market exposure level among several dozen short-term stock market timers I monitor (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at 13.7%, which is more than 40 percentage points higher than where it stood just a few days ago, as you can see from the chart below.

That represents an unusually quick jumping onto the bullish bandwagon. The typical contrarian pattern at market bottoms is for rallies to be greeted by widespread skepticism. That’s not what we’re seeing now.

 

Incidentally, Mark Hulbert issued a second warning based on market seasonality. Historically, the six months beginning in May has been historically weak, and Hulbert observed that it is especially weak if the stock market in the previous six months was down.
 

 

Selling in May and going away is starting to sound good in 2020.
 

Waiting for the credit event

The Economist pointed out how fraud and credit event blow-ups occur in the wake of recessions:

Booms help fraudsters paper over cracks in their accounts, from fictitious investment returns to exaggerated sales. Slowdowns rip the covering off. As Baruch Lev, an accounting professor at New York University, puts it, “In good times everyone looks good, and the market punishes you harshly for not keeping up.” Many big book-cooking scandals of the past 20 years emerged in downturns. A decade before the crisis of 2007-09 the dotcom crash exposed accounting sins at Enron and WorldCom perpetrated in the go-go late 1990s. Both firms went bust soon after. As Warren Buffett, a revered investor, once put it: “You only find out who is swimming naked when the tide goes out.” This time, thanks to a pandemic, the water has whooshed away at record speed.

Setting aside any fraudulent activity, every recession has been followed by a credit event that has disrupted markets. The GFC was sparked by the failure of Bear Stearns, followed by Lehman Brothers. Investors were left holding the bag after the 2000 bear market when Enron, Worldcom, Adelphia, and others blew up. Regulators had to clean up the Savings & Loans crisis after the 1990 recession.

What credit event are we likely to see in 2020-2021? Bad debt provisions are already rising at the major US banks, but we haven’t seen any credit blowups yet. You know that things are bad when Verizon, a phone company, announced that it raised its Q1 bad debt expenses by $228 million.
 

 

What about the carnage in the oil market? Remember Amareth, the hedge fund that imploded when it tried to buy the front month in natural gas but couldn’t take delivery because of the lack of storage? Reuters reported that Singapore oil trader Hin Leong Trading owes $3.85 billion to banks after incurring $800 million in undisclosed losses. This blowup occurred before the front month WTI price fell into negative territory early last week.

Last week’s crash in oil prices may have created some financial damage. Interactive Brokers reported that it is making provisions for losses of $88 million from bad debt stemming from client accounts who were long the crude oil contract that crashed. Bloomberg reported that the Bank of China took a huge hit from a Chinese WTI ETF that it manages, It rolled its May positions forward on the Monday when the price went negative, which created large losses. How large? The market went into the open on Monday with an open interest of about 108,000 contracts, and Tuesday morning’s open interest was about 16,000. The market skidded by $50 per barrel on Monday, which translates to a loss of $4.6 billion for the closed contracts, not all of which are attributable to BoC. BoC has asked ETF holders to make good on the losses which drove the ETF’s NAV into negative territory. Given the highly leveraged and opaque nature of China’s financial system, we will never know the exact details of the losses, the risk is financial instability first shows up in China, and not within America’s shores.

Notwithstanding any oil related blowups, Mohamed El-Erian fretted in a CNBC interview about corporate and sovereign defaults. JC Penney and Neiman Marcus are already on the verge of seeking bankruptcy protection. The Gap announced last week that it was running low on cash, and it had stopped paying rent on stores it has shuttered. If the lockdown were to last until the end of May, other major retailers may have to follow suit. In that case, El-Erian worried that the government will have to make a major decision. Will it bail out all retailers, or will it have to pick winners and losers?

The signals from the credit market indicate a loss of risk appetite. High yield (junk) bonds have underperformed in the last two weeks despite the Fed’s intervention in the credit markets. The Fed can supply liquidity to the market to stabilize spreads and ensure the solvency of the financial system, but it cannot supply equity that was lost because of the crisis. In light of the well publicized difficulty of state finances, municipals have sagged as well.

So much for the bullish narrative of “the Fed is buying HYG”.
 

 

Stresses are also showing up in the offshore dollar market. The Fed has opened up USD swap lines with numerous new countries, in addition to supplying dollars through their existing swap agreements. This flood of dollar liquidity has been unable to stem greenback strength, and EM currency and bond market weakness. In particular, EM currency weakness will pressure countries with weak external balances, especially in the current precarious environment.
 

 

When does the next shoe in the credit drop in this recession, and is the market prepared for that event?
 

Narrow leadership

Another worrisome aspect of the market rebound is the narrowness of the market leadership. Remember Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names”.

The FANG+ and NASDAQ 100 stocks have been on a tear relative to the rest of the market this year.
 

 

SentimenTrader observed that growth stocks are becoming an extremely crowded trade, which usually does not resolve in a benign manner.
 

 

Here is what might derail the momentum of the FANG+ names. In particular, I am watching the Amazon, Google, and Microsoft earnings reports on their cloud services. While many investors have been focused on Amazon’s retail delivery services, which is a beneficiary of the work from home trend ruing the pandemic, their Amazon Web Service (AWS) is the company’s far higher margin business and AMZN’s jewel in the crown. The Information reported that cloud customers were asking for financial relief on their bills:

Public cloud providers like Amazon Web Services, Microsoft Azure and Google Cloud have had to cope with a surge in demand in recent weeks as huge numbers of people work from home. But the cloud providers are also facing requests from many customers for financial relief, while others are cutting their cloud spending.

So far, AWS has been the least willing to offer flexible terms on customer bills, according to numerous customers. That stands in contrast to Microsoft and Google which have shown some flexibility, partners say. How each of the cloud providers responds to customers asking for help has big implications, for both their near-term revenue and their long-term relationships with customers.

AWS has shown itself to be the least willing to give their customers breaks. (Reading between the lines, Lyft is the probably the reference ride sharing customer as it has guaranteed $80 million in payments to AWS.)

Inside AWS, salespeople have been asking managers how they shoudl best respond to requests for a break on payment from customers in travel, retail, real estate and ride ailing. A person who works at one of AWS’ largest customers said the company recently asked AWS for a financial break on its agreement, but AWS declined. An executive at an online real estate company said AWS pushed back on his company’s request for a break while another executive at a different company told The Infomation planned to ask AWS for a price reduction. The latter executive isn’t hopeful that AWS will grant the request, however, as it isn’t known for making pricing concessions.

By contrast, Microsoft has shown greater flexibility. While it is difficult to switch cloud providers during a period of stress as customers’ IT departments faces layoffs and staff reductions, AWS’ recalcitrant behavior risks alienating its client base and long-term relationships once the pandemic ends.

Microsoft has indicated to customers that it is willing to be flexible on pricing and contract terms if the Covid-19 crisis continues to keep the economy on hold, according to Adam Mansfield, director of services at UpperEdge, a firm that helps large companies negotiate contracts with cloud providers.

Customers in a wide range of industry segments have asked Microsoft for financial help since the beginning of March, including companies in consumer packaged goods, oil and gas, and retail, said Mansfield. Some have asked to defer payments for software they’ve used; others are asking for annual price reductions for software they’re planning to use in the future; and still others are asking to reduce the volume of users in agreements without a corresponding rise in per-user pricing.

Already, we are seeing how cloud services are evolving in the current environment from the IBM earnings report. While IBM is reporting strong cloud revenues, customers are delaying major development projects to conserve cash. Existing cloud revenue streams are likely to be untouched, but don’t expect much growth, and don’t be surprised at either delayed revenue recognition, or rising bad debts.

Amazon is scheduled to report earnings Thursday.
 

How a bear market bottoms

In conclusion, this is a recession. Recessionary bear markets take a long time to resolve, largely because of the technical and financial damage suffered in the downturn. As the macro and fundamental problems and uncertainties resolve themselves over the course of the downturn, that’s the mechanism how the stock market returns to retest its initial lows after the first reflex rally.

Consider the problem of reopening the economy. Selected European countries and US states have begun to relax their stay-at-home edicts and reopen their economies. Based on the first in, first out principle, we can see how the Chinese economy has fared in their efforts to reopen. Manufacturing and industrial activity is almost fully back to normal, though the sector is burdened with a lack of foreign demand. However, the consumer and services sector has recovered far more slowly.
 

 

Let us assume for the moment that the efforts to reopen the US economy is successful. The American economy is mainly consumption and services driven. If the consumer is still weak in China, how weak will it be in America, and what will be the effects on economic growth?

Now consider all these markets from a technical perspective. The S&P 500 and DJIA have violated uptrend lines, indicating bullish exhaustion as they approached their 50 dma.
 

 

Similar technical patterns can be seen in the Shanghai Composite, and the stock indices of China’s major Asian trading partners.
 

 

Don’t forget the DAX. Germany is taking small steps to reopening its economy.
 

 

Are the global markets trying to tell us something? I interpret these technical patterns as a setup for a retest of the March lows at some point in the future. Depending on the nature of the fundamental and financial damage, the retest of the lows may not necessarily be successful.

This is the process of how a bear market bottoms. We have only undergone the first stage of the decline.

Stay tuned.

 

Making sense of the oil crash

Posted by Cam Hui -

Mid-week market update: How should investors interpret the crash in oil prices and its effect on the stock market? The most simplistic way of looking at it is to observe that stock and oil prices have diverged. Either oil has to rally hard, or stocks have to fall down – a lot.
 

 

That’s a basic tactical view. While it may be useful for traders, correlation isn’t causation. These gaps in performance can take a lot longer than anyone expects to close.

It certainly isn’t the entire story.
 

A longer term view

Here is the longer term view. Crude oil and natural prices bottomed ahead of the stock market in the last two cycles, with the exception of natural gas in 2009. This is consistent with the effect of commodity prices leading stocks prices at past bottoms (see The 4 reasons why the market hasn’t see its final lows).
 

 

Credit market fallout

Warren Buffett famously said that when the tide goes out, you can see who has been swimming naked. The tide has certainly gone out for a lot of oil traders. Reuters reported that Singapore oil trader Hin Leong Trading owes $3.85 billion to banks after incurring $800 million in undisclosed losses – and this blow-up occurred before the front month WTI price fell into negative territory this week.

Monday’s negative price for the May crude oil contract was a different matter. It was attributable to a record buildup of inventory, and lack of available storage.
 

 

There was much dismissal among market participants that Monday’s negative front month oil price was a technical anomaly, and the May front month contract was thinly traded. But how thin was the May contract? The market went into the open on Monday with an open interest of about 108K contracts. The market skidded by $50 per barrel on Monday, which translates to a loss of $5 billion. To be sure, open interest fell dramatically to about 16K on Tuesday morning, but even at half that figure, that’s a very big loss and some traders would have seen enormous margin calls. Interactive Brokers reported that it is making provisions for losses of $88 million from bad debt stemming from client accounts who were long the crude oil contract that crashed.

Much attention has also been focused on the technical problems with USO. The crude oil ETP is burdened with rolling up its holdings in the front month into the next month, often at substantial cost. Notwithstanding this week’s shenanigans, the NAV of USO has continuously faced these headwinds of rolling forward futures contracts and paying the spread from one month to another. Now another oil ETF has gotten into trouble. This time in Hong Kong. The Samsung GSCI Crude Oil Trust (3175.HK) plunged -46.1% overnight.
 

 

In light of these sudden gargantuan losses, it would be no surprise to see at lease one financial blow up in the coming days. It may be a hedge fund caught off-side on a crude oil trade, a bank that over-lent to the oil patch, or a bank’s trading desk that mismanaged the crude oil hedges it sold to clients.

So far, credit markets are weak, but they show no signs of a credit catastrophe. The relative performance of high yield bonds (red line) is exhibiting a minor divergence to stocks. The relative performance of EM bonds (green line) is exhibiting a greater negative divergence, but no signs of panic. Neither is the relative performance of financial stocks (bottom panel).
 

 

Keep an eye on these indicators.
 

Broken wedges

From a tactical perspective, the S&P 500 has broken down from a rising wedge as it tested overhead resistance at its 50 dma. I interpret this as a sign of bullish exhaustion that will resolve itself with a major downleg in stock prices, or a choppy sideways consolidation.
 

 

The pattern of the broken wedge can also be seen in the DJIA, NYSE Composite, and mid-cap stocks.
 

 

The two exceptions are the NASDAQ 100, and small caps. The NASDAQ 100 had been market leaders and never formed a wedge structure. The weakness earlier this week has changed NASDAQ stocks into a rising channel, which is still constructive.
 

 

The story of the small cap Russell 2000 is different, and the performance of this index can yield some clues as to future market direction. Small caps have been weak and they were too weak to form a rising wedge structure. However, their relative performance (bottom panel) has stabilized in the last few weeks. If you squint, you can also see the hints of a bull flag. Should these stocks either stage an upside breakout through the bull flag, or show better relative performance against large caps, it would be a constructive signal that the more likely outcome is a sideways and choppy consolidation, rather than more equity market weakness.
 

 

Another indicator to keep an eye on are bond prices. Both IEF (7-10 year Treasuries) and TLT (20+ year Treasures) staged upside breakouts yesterday and pulled back. Should bond prices strengthen to break out again, it would be a bearish sign for stock prices from an inter-market analytical perspective.
 

 

Two consecutive days of falling stock prices moved short-term breadth to an oversold condition as of Tuesday night’s close. A reflex rally today was therefore no surprise.
 

 

My inner investor is still highly cautious. My inner trader remains bearishly positioned. He is keeping an open mind and monitoring how small caps and bond prices behave in the next few days.

Disclosure: Long SPXU

 

Back to normal?

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: 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.
 

Returning to normal?

SentimenTrader highlighted a surge in media stories with a “back to normal” theme. He added that “Many of these stories are from the same people calling for another market crash at the bottom in late-March”.
 

 

He also observed that hedgers (not HF speculators) are long equity futures up to their eyeballs. Past episodes have been resolved with market rallies. However, I would note that there is a catch. Past signals have either been coincident with market bottoms, or slightly late.
 

 

Is the market back to normal, or are we just late in the reflex rally?
 

Bullish with a *

The tape has been bullish for the last two weeks, and I would characterize the tone as bullish, with an asterisk. While the short-term action has taken a risk-on quality, there are plenty of intermediate term warnings which have no obvious short-term bearish catalysts.

The S&P 500 has advanced while supported by rising RSI momentum. The stochastic has been unable to recycle from an overbought condition, which could indicate the start of a series of “good overbought” readings that accompany a market grind-up. Arguably, there is a minor negative 5-day RSI divergence, which could be a concern if it develops further.
 

 

The stock/bond ratio has also broken out of an inverse head and shoulders formation. The measured upside target calls for a 6% gain in the stock/bond ratio, which could foreshadow even a greater gain for stock prices. For example, stocks could rise by 8% and bonds fall by -2% and the ratio could reach its target.
 

 

“This will not end well” warnings

On the other hand, the current environment is beset with numerous longer term “this will not end well” warnings that do not have obvious short-term bearish catalysts. One concern is the divergence between stock prices and earnings estimates, especially as Q1 earnings season gets underway. Stock prices have recovered part of their losses, but forward 12-month estimates are skidding badly. Something’s got to give.
 

 

The combination of rising stock prices and falling estimates is bringing the Rule of 20 into play. As a reminder, the Rule of 20 flashes a warning whenever the sum of the market P/E and inflation rate exceeds 20. As of Friday’s close, the market’s forward P/E ratio was 19.0. While I would normally use CPI as a proxy for inflation, CPI is a backward looking number and overstates the inflation rate in a potentially deflationary environment. I substituted the 5-year, 5-year forward inflation rate expectation instead as a more forward looking indication into the Rule of 20 calculation. The result was 20.4, which is above 20 and represents a valuation warning signal for equities.
 

 

Excessive valuation can take some time to resolve. While this is useful to long-term investors, high valuations are not actionable short-term trading signals. However, there are also some warnings from a technical analysis perspective.
 

David Keller pointed out that “secular bull markets have seen monthly RSI remain above 40, while secular bears have seen that level broken early on.  The bad news is the first selloff 1929 didn’t break RSI 40 either 🙂  Just a reminder that selloffs can get a lot worse!”
 

 

From a shorter term perspective, bad breadth is raising a cautionary flag. The NYSE Advance- Decline Line has not confirmed the recent highs and lags the market. In addition, the price momentum factor (bottom panel) is exhibiting a worrisome pattern of lower highs and lower lows. However, these kinds of negative divergences can last for weeks or even months before they resolve bearishly.
 

 

As well, can anyone explain why defensive sectors like consumer staples, utilities, and real estate are in relative uptrends even as the stock markets rose? Defensive stocks are supposed to outperform when the market falls, and lag when the market rises, not the other way around. I fully understand why healthcare stocks are showing relative strength in this environment, but what about the other defensive sectors?
 

 

In addition, Jim Bianco pointed out that while NY and NJ infection rates appear to have stabilized, the same cannot be said about the rest of the country. Another shoe may be about to drop, especially if individual state governors decide to relax social distancing guidelines.
 

 

On a knife edge

Looking to the week ahead, the jury is still out on whether the bulls or the bears have the upper hand. As the SPX tests the 50 day moving average (dma) from below, here are some key questions that need to be answered.

The market is overbought, but is the overbought condition bearish, or a signal of a series of “good overbought” conditions that accompany a grind-up advance?
 

 

Short-term market internals like equity risk appetite are showing mixed signals. Which way will it turn?
 

 

My former Merrill Lynch colleague Fred Meissner suggested that one way to watch for a long-term bullish revival is to monitor the behavior of small cap stocks. Small caps (bottom panel) have usually outperformed as the economy emerges from recession. In fact, fresh bulls are normally marked by changes in leadership, but the old leadership is still intact: US over global stocks, growth over value, and large caps over small caps.
 

 

As the index flirts with its 50 dma, my inner trader is listening to the market to determine its outlook. The rally off the March lows was mainly a short covering rally. Short interest is now at multi-month lows. While a low level of short interest could ultimately prove to be bearish, there is no bearish catalyst on the immediate horizon.
 

 

While we cannot know how all traders are positioned, we do know that commodity trading advisors (CTAs) are roughly neutrally positioned. Economic momentum, as measured by ISM, is negative, but price momentum is positive.
 

 

While my inner trader has been short the market, he is waiting for a sign from the market action early next week. If the rally were to continue, he will cover his short positions and step to the sidelines. On the other hand, the market appeared to be topping out last week until the Gilead drug remdesivir news hit the tape late Thursday.

My inner investor remains highly skeptical of this rally. He is in a position of maximum defensiveness and he has selectively sold call options against existing longs.

Disclosure: Long SPXU

 

The bull case (and its risks)

Posted by Cam Hui -

In the past few weeks, a number of investors and strategists have turned bullish. I would like to address the reasoning for the bull case for equities, and the risks to the reasoning. History shows that recessions are bull market killers, and bear markets do not resolve themselves this quickly without a prolonged period of adjustment.

Here are the bullish arguments:

  • The lockdowns are ending.
  • A possible drug treatment breakthrough.
  • The Fed is coming to the rescue.
  • Investors are looking ahead to 2021, and 2020 is a writeoff.

Easing lockdown = Growth revival

One point made by bullish analysts is the coronavirus induced lockdown and distancing policies are easing. Confirmed COVID-19 case growth and death rates are leveling off and declining. Parts of Europe, such as Germany, are starting to ease their lockdown restrictions, and Trump has issued guidelines for a phased re-opening of the economy. These measures should lead to a growth revival, which would be bullish for stock prices.

The growth revival can be an important bullish catalyst, if it works. Bloomberg reported that there was an important caveat in the much publicized Goldman Sachs bullish U-turn. The bullish call was based on “no second surge in infections”.

A combination of unprecedented policy support and a flattening viral curve has “dramatically” cut risks to both markets and the American economy, strategists including David Kostin wrote in a note Monday. If the U.S. doesn’t have a second surge in infections after the economy reopens, equity markets are unlikely to make new lows, they said.

The Street is already penciling in a V-shaped rebound in consensus earnings expectations. Earnings are expected to bottom out in Q2, and return to normal by Q4.

How realistic are those expectations?

Ask Singapore about what happens if you try to open up an economy prematurely. David Leonhardt outlined the risks in a NY Times Op-Ed. The island nation’s response has been a model for other countries, and it was able to avoid many of the draconian distancing measures imposed elsewhere:

Singapore’s approach has certainly been aggressive — and more effective than the American approach. In January, as the virus was spreading within the Chinese city of Wuhan, Singapore officials began screening travelers arriving in their country and placing anyone who tested positive into quarantine. Singapore also quarantined some travelers who didn’t have symptoms but had been exposed to the virus. And Singapore tested its own residents and tracked down people who had come in contact with someone who tested positive…

Thanks to that response, Singapore had been able to avoid the kind of lockdowns that other countries had put in place. Restaurants and schools were open, albeit with people keeping their distance from each other. Large gatherings were rare. Singapore, in short, looked as the United States might look after the kind of partial reopening many people have begun imagining.

The preventive measures eventually failed, and Singapore has reverted to the standard lockdown methods used elsewhere:

But Singapore doesn’t look that way anymore. Even there, despite all of the successful efforts at containment, the virus never fully disappeared. Now a new outbreak is underway.

The number of new cases has surged, as you can see in the chart above. In response, the country announced a lockdown two weeks ago. Singapore’s “present circumstances,” Carroll writes in a piece for The Times, “bode poorly for our ability to remain open for a long time.”

Even if lawmakers wanted to open up the economy, the inevitable questions come up of how willing are people to return to restaurants, movies, or to send their children to camp this summer. A recent Gallup poll found that only 20% of respondents were willing to return to pre-pandemic normal activity immediately.

Attitudes were most divided among the urban-rural axis, and by party identification. Still, only 23% of rural residents and 31% of Republicans were willing to return to normal immediately. These figures represent significant minorities of the population.

Other polls confirm the Gallup results.

  • An Axios/Ipsos poll found a similar level of skittishness.
  • A Harris poll found that most Americans wanted to wait a month before “starting to return to work and life as normal”.
  • A Seton Hall poll found that 72% would not attend a live sports event like a football game unless a vaccine is found.

The polling data suggest that any effort to reopen the economy will not be instant. Even if the easing measures are successful, growth and employment are likely to return slowly.

For the last word on this topic, I refer you to Wall Street executive and Morgan Stanley CEO James Gorman. Gorman stated in a CNBC interview that he believes the economy will not return to normal until late 2021:

Morgan Stanley CEO James Gorman sees the coronavirus-induced global recession lasting for the entirety of this year and 2021.

When asked about how a potential economic recovery expected in the second half of this year would take shape, Gorman said that while he hopes it will be a sharp “V” recovery, in reality it will probably take longer to reopen cities and factories.

“If I were a betting man, it’s somewhere between a `U’ or ‘L’” shaped recovery, Gorman told CNBC Thursday in an interview. “I would say through the end of next year, we’re going to be working through the global recession.”

A treatment breakthrough?

Some of the expectations about the pace at which the economy can be reopened could change. A report from Stat created some excitement after the market closed Thursday. There were reports of promising results from the Gilead drug remdesivir in the treatment of COVID-19 patients:

The University of Chicago Medicine recruited 125 people with Covid-19 into Gilead’s two Phase 3 clinical trials. Of those people, 113 had severe disease. All the patients have been treated with daily infusions of remdesivir.

“The best news is that most of our patients have already been discharged, which is great. We’ve only had two patients perish,” said Kathleen Mullane, the University of Chicago infectious disease specialist overseeing the remdesivir studies for the hospital.

Before anyone gets overly excited, these results are highly preliminary. This test had no control group. The drug is given intravenously, and hospitals would still be overwhelmed if public health policy allow the infection rate to surge. A New England Journal of Medicine article which outlined the “Compassionate Use of Remdesivir for Patients with Severe Covid-19” had considerably less exciting results, as “clinical improvement was observed in 36 of 53 patients (68%)”.

In addition, Gilead has a limited supply of the drug.

As of January 2020, we were not actively manufacturing remdesivir. The manufacturing supply chain was scaled to periodically make small amounts of product for a compound in early development. We had inventory of finished product to treat just 5,000 patients.

Since then, we have proactively and rapidly scaled our supply chain. As of late March, using the active ingredient we already had in our inventory, we have increased our supply to more than 30,000 patient courses of remdesivir on hand, assuming a 10-day course of treatment for patients. As new raw materials arrive over the next few weeks from manufacturing partners around the world, our available supply will begin to rapidly increase.

Even if the trials were proven to be successful, ramping up production will be a challenge. Gilead’s stated production goal, which may or may not be successful, is shown as:

  • More than 140,000 treatment courses by the end of May 2020
  • More than 500,000 treatment courses by October 2020
  • More than 1 million treatment courses by December 2020
  • Several million treatment courses in 2021, if required

In short, remdesivir is potentially a promising treatment, but production problems may make this a “too little, too late” solution in light of the number of widespread incidence of COVID-19 around the world. The time frame for the widespread availability of this drug isn’t significantly better than a vaccine, assuming that a vaccine could be found in a relatively short time. Moreover, the drug does not protect anyone against infection, or COVID-19. It is just a treatment for patients who are in ICU.

Assuming that remdesivir were to become an effective treatment with limited availability, here is what that means to the US economy over the next 6-12 months. Initial jobless claims have skyrocketed to all-time highs in recent weeks. The continuing jobless claims report, which is released in conjunction with initial claims, measures the devastation to the jobs market. Arguably, reported continuing claims is under-reported because the latest figures are inconsistent with the last few weeks of rising initial claims, and it is difficult to believe that people have magically found jobs in the current environment. In all likelihood, the lower than expected continuing claims figure is attributable to the inability of state bureaucracies to process the flood of claims.

Now imagine a best case scenario where the economy opens up again, and half of the laid off workers suddenly found jobs as the fear of dying from COVID-19 recedes. Even under this rosy scenario, continuing claims would be worse than the highest levels seen during the Great Financial Crisis. Are those recessionary conditions in anyone’s spreadsheet?

The economic impact of the job losses are probably higher than most analysts’ expectations. So far, the initial round of layoffs have largely been concentrated in low-wage service jobs. A recent WSJ article reported that a second round of layoffs is now hitting better paying white collar workers, which will have greater effect on consumer spending because of their (previous) higher spending power. No one is immune, Bloomberg reported that even Google has announced that it is significantly slowing its hiring for the rest of this year, and it has announced selected cost-cutting initiatives.

The Fed has your back

Another point made by the bullish camp is the flood of stimulus that has been unleashed by the fiscal and monetary authorities. In particular, the Federal Reserve and other central banks around the world have acted quickly to provide a tsunami of liquidity for the markets.

That’s bullish, right?

The answer is a qualified yes. Bear in mind, however, this latest crisis is different from previous recessions like the GFC. The COVID-19 recession began on Main Street, while most of the past recessions began on Wall Street. Fiscal and monetary measures can remedy financial recessionary conditions, but they have limited effectiveness if the crisis begins in the physical economy.

The question investors have to ask themselves is what this flood of stimulus will do to the Main Street economy. Congress and the Fed, despite all of their fiscal and monetary powers, cannot find a vaccine or a treatment. If the effect of these measures only act to compress risk premiums, which is important to financial stability, the stimulus is less likely to leak into the real economy.

Remember the monetary equation, GDP = MV, where GDP growth is a function of money supply growth and monetary velocity. During past recessionary periods, the Fed has engaged in monetary stimulus, which boosted M1 growth (blue line), but monetary velocity (red line) fell. Will 2020 be any different?

Can stock prices regain their long-term footing without a revival in economic growth?

Look over the valley

The last major advice made by bullish analysts is to look over the valley. Equity valuation appears expensive now, but 2020 is said to be a writeoff and investors should be looking forward to the recovery in 2021.

Here is the key risk to that bullish argument. The market trades at a forward P/E ratio of 18.5, based on bottom-up derived blended forward 12-month EPS estimates from company analysts. This valuation is higher than the 5-year average of 16.7 and 10-year average of 15.0.

Right now, bottom-up earnings estimates are little better than fiction because company analysts have little guidance from corporate management on the 2020 outlook, never mind 2021. On the other hand, top-down strategists have developed 2021 EPS estimates based on economic models, based on their best guess assumptions of the economy next year. The consensus top-down 2021 estimate is about 150.

Based Friday’s prices, the forward 2021 P/E ratio is a nosebleed 19.2. This begs a number of difficult questions for the bulls:

  • How much more upside do you expect when the market trades at a forward P/E ratio that is higher than its 5 and 10 year averages? That’s assuming that earnings are in recovering in 2021. Should investors start to discount what amounts to a highly uncertain 2022 earnings two years in advance?
  • If you accept that a forward P/E ratio that is above its 5 and 10 year average as appropriate, how do you model the Fed’s withdrawal of stimulus, which would expand risk premiums and therefore depress P/E multiple?

In conclusion, I find the risks presented by the bullish arguments unsatisfying. I continue to believe that, in the absence of a vaccine or immediate availability of a treatment that mitigates the effects of COVID-19, the US equity market faces significant downside risk (see The 4 reasons why the market hasn’t seen its final low).

Please stay tuned for tomorrow’s tactical market update.

Don’t forget about the recession

Posted by Cam Hui -

Mid-week market update: Back on March 9, 2020, which seems like a lifetime ago, I declared a recession (see OK, I’m calling it). The call was based on the combination of a coronavirus epidemic in China that disrupted supply chains that began to spread to other countries, and tanking oil prices due to a Saudi-Russia price war. Since then, stock prices cratered, and recovered to stage a strong rally on the back of fiscal and monetary stimulus.

During this rally, what the market seems to have forgotten about is the recession, which has historically been bull market killers. Moreover, recessionary bear markets take a considerable amount of time to resolve themselves.

In the short run, a number of worrisome divergences and risks have begun to appear during the course of the latest stock market rally.

Can the market ignore $20 oil?

The first divergence is stock and oil prices. Despite the news of a massive OPEC+ deal to cut output by 9.7 million barrels per day, oil prices continue to be weak. Remember, falling oil prices in 2015 led to a mild industrial recession.

As well, CNBC reported that skidding demand from the COVID-19 pandemic has erased 10 years of oil demand growth.

The International Energy Agency (IEA) said Wednesday that it expects the coronavirus crisis to erase almost a decade of oil demand growth in 2020, with countries around the world effectively having to shut down in response to the pandemic.

A public health crisis has prompted governments to impose draconian measures on the lives of billions of people. It has created an unprecedented demand shock in energy markets, with mobility brought close to a standstill.

The price war didn’t help matters, but the truce concluded to cut production may not be enough as demand is still far short of supply. The WSJ reported that oil producers is running out of storage, which is creating the unusual problem of negative prices in some grades.

While U.S. crude futures have shed half of their value this year, prices for actual barrels of oil in some places have fallen even further. Storage around the globe is rapidly filling and, in areas where crude is hard to transport, producers could soon be forced to pay consumers to take it off their hands—effectively pushing prices below zero.

Can the stock market ignore $20 oil? Is this a negative divergence that investors should worry about?

The work from home illusion

As many of us hunker down and work at home, the shares of Amazon and Netflix reached fresh highs as investors piled into these stocks as a work from home (WFH) refuge. Indeed, the NASDAQ 100 and FANG stocks have maintained their leadership during the latest period of market turmoil.

However, there are troublesome signs that this narrow leadership has become increasingly unhealthy for the stock market. The market concentration of the top five names (MSFT, AAPL, AMZN, GOOG/GOOGL, FB) is now higher than it was at the height of the NASDAQ Bubble.

As John Authers of Bloomberg recently warned that an over-reliance on past winners is not necessarily a winning investment strategy:

Generally, buying the largest stock in the S&P 500 over history has been a bad idea. Such stocks have nowhere to go but down. Just in the last 30 years, General Electric Co. and International Business Machines Corp. both spent a lot of time at number one, as more briefly did Coca-Cola Co. and Cisco Systems Inc. In the case of FAMAG, buying the leading juggernauts, holding them, and waiting for them to extend their lead over everyone else has been the right strategy for at least half a decade.

When you buy a stock you are buying a share of its future profits, not its past. Are these companies really going to stay this dominant into the future? A market this narrow suggests that some bad news, or reason to shake confidence in one or more of the FAMAG stocks, could shock the whole market. While confidence in them remains this strong, though, the main index is unlikely to go back to its lows of March.

There are signs that the beneficiaries of the WFH investment theme could be about to break. The WFH trend is mainly a middle class and affluent white collar trend, but these jobs are not immune from the downturn. The WSJ reported that jobs that were previously thought to be safe are now the subject of a second round of layoffs:

The first people to lose their jobs worked at restaurants, malls, hotels and other places that closed to contain the coronavirus pandemic. Higher skilled work, which often didn’t require personal contact, seemed more secure.

That’s not how it’s turning out.

A second wave of job loss is hitting those who thought they were safe. Businesses that set up employees to work from home are laying them off as sales plummet. Corporate lawyers are seeing jobs dry up. Government workers are being furloughed as state and city budgets are squeezed. And health-care workers not involved in fighting the pandemic are suffering.

The longer shutdowns continue, the bigger this second wave could become, risking a repeat of the deep and prolonged labor downturn that accompanied the 2007-09 recession.

The adage that it’s a recession when your neighbor loses his job but a depression when you lose your job is starting to dawn on a lot of people. A Ziprecruiter survey indicates that the slowdown is also hitting white collar jobs, such as professional and business services, finance, and IT.

The slowdown is affecting even previously “safe” professions like law:

Law firms have had to reduce staff and cut pay as courts are largely closed, settlement discussions are on pause and few new deals are being struck.

New York City-based Cadwalader, Wickersham & Taft LLP, a 400-attorney firm specializing in financial services, has reduced associate salaries by 25% and partners are not currently receiving compensation. Firms typically lay off attorneys only as a last resort, but another New York-based firm, Pryor Cashman LLP, is furloughing some associates. A spokesman said it expects to recall them soon.

Baker Donelson, a 700-lawyer firm with some 20 offices in the Southeast and mid-Atlantic region, has reduced compensation for associates and staff by 20%. Timothy Lupinacci, the firm’s chairman and chief executive, said some clients have asked the firm to stop work or defer payments. “Law firms are not going to be top of the priority,” he said.

How we work from home isn’t the problem, said Karen Richardson, executive director at the National Association of Women Lawyers. “It’s: Will there be work for us to do?”

This second wave of layoffs will undoubtedly reduce the demand for WFH services from providers such as AMZN and NFLX. Moreover, March retail sales printed a downside surprise of -8.7% this morning, indicating a weakening economy.

When this all break the stranglehold of the FANG+ names? Watch carefully, and stay tuned.

Bullish exhaustion

From a tactical perspective, SentimenTrader observed that their Optimism Index (Optix) had spiked to an excessively bullish short-term optimism level. Such readings have usually resolved themselves bearishly over a one-week horizon in the past.

In addition, my short-term indicator of High Beta to Low Volatility stocks is turning down, indicating a loss of equity risk appetite.

The combination of last Monday’s failure to flash a Whaley Breadth Thrust buy signal (see Fun with analogs and breadth thrusts) and this week’s market action are indicative of bullish exhaustion. In the short run, the path of least resistance is down.

Disclosure: Long SPXU

Fun with analogs and breadth thrusts

Posted by Cam Hui -

There was an amusing joke tweet that circulated, which overlaid the 2020 market experience over the 2008 bear market and projected a downside target of 125 for SPY. If anyone saw that, it was a joke and not intended to be serious analysis.
 

 

Nevertheless, analogs can be useful in analyzing markets, but with a caveat. As the adage goes, history doesn’t repeat itself, but rhymes. Traders who use analogs often expect the market to follow every single squiggle of the historical analog, which is unrealistic.

Historical analogs can be useful as a template for market action. The 2008 market pattern suggests that after an initial shock, the market rebounds and trades sideways for some time before falling to a final low. As a reminder, I made a bear case in my recent publication (see Why the market hasn’t seen its final lows) that stock prices are vulnerable to further downside risk based on a review of long-term market psychology, technical analysis of the cycle, challenging valuations, and the behavior of smart investors.  The downside potential for stock prices is considerably lower than what they are today.
 

 

Similarly, the 9/11 exogenous shock is also a useful template for thinking about market behavior. The economy was already in recession in 2001, but the market did not bottom until a year later in 2002. Things are different today, the economy was humming along and poised for a solid but unspectacular 2020 when it was hit by the dual broadsides of the COVID-19 pandemic and an oil price war. Stock prices skidded after the 9/11 attack, recovered to trade sideways until it fell into the final lows in late 2002.
 

 

I would also point out that I reviewed past major market bottoms four weeks ago (see 2020 bounce = 1987 or 1929?), I concluded:

After an initial bottom:

  • The market either forms a W-shaped choppy bottom, or a bounce and retest
  • The retest may not necessarily be successful. Failures of retests have usually occurred when the economy was in recession.

Every market is different, and your mileage will vary. The lessons from these bear markets indicate a period of choppy range-bound price action. No one has a crystal ball that can tell you whether the advance will halt at the 50% retracement level, or if it will continue.
 

Breadth Thrusts, reconsidered

As an update to yesterday’s post (see A Dash for Trash countertrend rally), one reader pointed out that my analysis of the Whaley Breadth Thrust (WBT) had referred to the wrong table from Wayne Whaley’s publication. The history of WBTs was on table 2, not table 5.
 

 

Here is a revised analysis of the key differences between the WBT and my preferred signal, the Zweig Breadth Thrust (ZBT) in 2009. There were three WBT signals and one ZBT signal during this period. As the ZBT Indicator (bottom panel) shows, WBT signals only require strong momentum that moves the ZBT Indicator into overbought territory, while the ZBT signal requires the combination of an oversold condition and strong momentum in a short period. During this period, the first WBT signal failed, the second WBT coincided with the ZBT signal, and the third, while successful, was not as strong as the ZBT signal.
 

 

Here is the ZBT Indicator today, which has moved into overbought territory but not within the 10 day window required for a buy signal. By contrast, the WBT model is on the verge of a buy signal.
 

 

Of the three WBT during 2009, one coincided with the ZBT signal and worked well. Of the other two, one failed, and one worked, though subsequent momentum was not extremely strong. We can conclude that the WBT model is less rigorous than the ZBT model, and therefore more prone to failure and more false positives.

As well, Mark Ungewitter compiled the track record of WBT buy signals since 2002. If we we exclude the WBT signals that coincided with ZBT buy signals, the track record is mixed, with a win rate of 50%.
 

 

Brett Steenberger also offered a slightly different perspective on the current strong momentum in a Forbes article:

According to data from the Index Indicators site, over 90% of stocks in the Standard and Poor’s 500 Index closed above their 5, 10, and 20-day moving averages this past Thursday! Moreover, if we look at the shares in the Standard and Poor’s 600 index of small caps, we see the exact same pattern. And the Standard and Poor’s 400 index of mid cap stocks? The same thing: over 90% trading above their 5, 10, and 20-day moving averages. In other words, over the past two weeks, it’s not just that the indexes were higher: almost every single stock in every single market was bought! In a very real sense, the buying has been as broad and extreme as the prior selling.

Steemberger identified 10 occasions of strong buying, namely January 2, 2009; March 23rd and 26th, 2009; March 5, 2010; September 13, 2010; July 1, 2011; August 31, 2011; October 24th and 27th, 2011; October 31, 2014; March 11, 2016; and January 18, 2019. He went on to analyze three past episodes because “they were the dates of broad market rallies where the overall market volatility was similar to today’s market (VIX > 30)”. These were: January 9, 2009, which roughly coincided with the first WBT that failed in our 2009 study; March 23 and 26, 2009, which occurred at about the same time as both the very successful WBT and ZBT; and August 31, 2011, which is shown in the chart below. The 2011 period also saw a ZBT buy signal in October 2011, whose subsequent returns were positive but weaker than usual, and a false breadth thrust observed by Steenberger in late August when the ZBT Indicator went overbought but the market failed to follow through.
 

 

Steenberger went on to tentatively conclude that these signals tend to be better long-term investment buy signals than trading signals.

My main takeaway is, if you are going to trade on breadth thrusts, trust the real thing and only buy ZBT signals. The ZBT model has a more restrictive criteria which raises their short-term success rate. By contrast, other strong momentum breadth signals tend to be more hit and miss affairs, even in the current environment where the VIX Index is highly elevated.

 

A Dash for Trash countertrend rally

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: 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 dash for trash

The recent rally off the March bottom has been impressive and could be nearing an inflection point. The SPX and NDX saw their rebounds pause at their 50% retracement levels.

Andrew Thrasher characterized the rally as a “dash for trash”, an anti-momentum rally where the worst performing stocks led the advance.

The internals of the “dash for trash” rally has a number of important implications for technical analysts, and could color conventional analysis and lead to erroneous conclusions.

Dash for trash internals

What does the “dash for trash” rally mean? First, it means that the price momentum factor got clobbered, and former laggards, such as small cap and bank stocks, turned around and led the market. Such “low quality” rallies are usually short-covering rallies, as traders bought back their short positions.

The outperformance of small cap stocks can also color breadth analysis. Equal-weighted indices give greater weight to small stocks compared to their large cap weighted counterparts. This creates an effect of better breadth participation. The NYSE Advance-Decline Line (red) is exhibiting a positive divergence against the S&P 500, as well as showing higher highs and higher lows.

A possible Whaley Breadth Thrust

The strong market breadth led veteran technical analyst Walter Deemer to observe that the market is on the verge of a “Whaley Breadth Thrust” buy signal.

This Wayne Whaley publication describes the Whaley Breadth Thrust (WBT) and its methodology in detail. Breadth thrusts tend to be defined by strong price momentum, usually off an oversold bottom. Price momentum episodes are often followed by further market strength, as market participants pile into a FOMO buying stampede.

Unless I am reading the Whaley paper improperly, my analysis of the paper found the buy signals to be somewhat unsatisfactory compared to my preferred Zweig Breadth Thrust buy signal, which demands that the market must be oversold and exhibit a breadth thrust rebound within 10 trading days. As an aside, the market saw a recent setup for ZBT buy signal, but failed to achieve the breadth thrust within the allotted time window.

Consider the last two buy signals of this system, which occurred in 2002 and 2008. The Whaley buy signal occurred on July 7, 2002, compared to a ZBT buy signal in May 2004. The WBT was early, and investors would have had to contend with several months of choppy markets before the bulls took control of the tape. The ZBT was also weak, but the drawdown was far less severe than the WBT.

A similar conclusion can be made of the 2008 buy signal. The WBT was early while the ZBT was triggered just after the March 2009 bottom.

The WBT signal appears to be more effective as a long-term buy signal, but investors need to be prepared for short-term disappointment.

What the bull case means

While I have no philosophical  objections to the idea of a short-covering rally which supports a breadth thrust, I am skeptical about the fundamental backdrop from which a bull phase can be sustainable. Here is what you need to believe in order to buy into the bull case.

The economy has hit a brick wall, as evidenced by the skyrocketing initial jobless claims.

In order to be bullish, you have to believe that the combination of fiscal and monetary policy can repair the growth outlook despite the uncertainty of the effectiveness global public health policy. Paying 17.3 times forward earnings is entirely appropriate, even though the multiple is above the 5-year average of 16.7 and 10-year average of 15.0.

The E in the forward P/E is falling. Q1 earnings season is about to begin. Corporate guidance will be ugly. Companies will undoubtedly report as much bad news as they can and attribute it to the COVID-19 pandemic, rightly or wrongly.

Even if you were to accept the current earnings estimates as gospel, you also have to believe that earnings can form a V-shaped rebound, and everything will be back to normal by year-end.

Do those seem to be reasonable assumptions? In the absence of a COVID-19 treatment or vaccine, can we expect the universe to flip a switch and life can return to “normal” if governments were to suddenly relax their lockdowns after “flattening the curve”?

What about the Fed? Didn’t the Fed just throw another kitchen sink at the market? Isn’t that equity bullish? I present Japan as Exhibit A. The Japanese economy topped out in 1990, and the BOJ has tried for decades to stabilize the economy, first by lowering rates, then QE, and then even resorting to buying Japanese stocks. While monetary policy did stabilize the stock market, the Nikkei Average has traded sideways since then, while US and non-Japanese equity markets roared ahead during that period. Central bankers can act as fire fighters, and but they cannot boost stock prices, except in the very short term.

Still a bear market

This rally feels like a counter-trend relief rally, instead of a V-shaped recovery off a major bottom. In a very short period, sentiment has shifted from “this is a W-shaped bottom and we are going to test the lows” to “the bull is back”. Arbor Data Science surveyed Twitter sentiment and categorized respondents into perma-bulls, perma-bears, pragmatists, and economists. The consensus is now bullish, and no one is bearish.

As well, the Market Ear observed that the customers of Robinhood, which is a low-cost discount broker favored by small retail traders, have been piling into the shares of Carnival Cruise Lines.

Some of my cross-asset factors are making me uneasy about this rally. My favorite short-term directional indicator, the ratio of high beta to low volatility stocks, unusually turned down even as the market rallied on Thursday. This ratio has led market turning points by a few days in the recent past. While Thursday’s reading could just be a data blip, I will be watching closely on Monday for a confirmation of factor weakness.

I am not sure how much this matters. My coronavirus pairs did take on a risk-on tone in last week’s rally, but they failed to exhibit higher highs, indicating negative divergences.

In the short run, breadth has reached an overbought extreme. While overbought markets can stay overbought, do you really want to play those odds?

My inner investors remains cautiously positioned. My inner trader is still leaning short.

Disclosure: Long SPXU

The 4 reasons why the market hasn’t seen its final low

Posted by Cam Hui -

Stock prices raced upwards last week on the news that the COVID-19 outbreak is improving in New York and other parts of the US, and on the news that the Fed unveiled another $2.3 trillion bazooka of liquidity. Despite these positives, I am not convinced that this bear market has seen its lows yet.

This week, I analyzed the market using a variety of techniques. All of them lead to the conclusion that a major market bottom has not been reached yet.

  • Long-term market psychology
  • Technical cycle analysis
  • Valuation
  • Smart investor behavior

Let’s start with long-term investor psychology. In the past few weeks, I have received numerous questions from readers to the effect of, “I am a long-term investor, should I be putting some money to work in the stock market here?”

If we were to change our viewpoint from an anecdotal to a more formal data perspective, the New York Fed conducts a regular survey of consumer expectations. One of the survey questions asks if respondents expect higher stock prices in the next 12 months. Instead of fear, investors are exhibiting signs of greed. Investor psychology just doesn’t behave that way at major market lows.
 

 

Mark Hulbert made a similar point about his sample of market timing newsletter writers in a WSJ article. While market timers were fearful at the end of the March quarter, their fear level was nowhere near the levels seen at past market bottoms.
 

 

This is not time to relax. The bear market is not over.
 

No technical signs of a long-term bottom

If I was to put on my technical analysis hat, I see no signs of a long-term bottom. Markets are inherently forward looking, and if stock prices are starting to discount a recovery, we should see hints in cyclical indicators, as well as commodity prices. None of those signals are present.

Consider, for example, the copper/gold and platinum/gold ratios. Copper, platinum, and gold are all commodities and have inflation hedge characteristics. However, copper and platinum have industrial uses, and the copper/gold and platinum/gold ratios should signal upturns in the global cycle. In the last two market bottoms, which are marked by the vertical lines, the platinum/gold ratio bottomed out ahead of the stock market bottom, while the copper/gold ratio was roughly coincident with stock prices. Currently, both of these ratios are plunging, and there is no early signal of a cyclical bottom.
 

 

Commodity prices also led or were coincident with stock prices at the last two major market bottoms. The CRB Index bottom well ahead of stocks in the aftermath of the NASDAQ Bubble bear market, and they slightly led stocks in 2009. The CRB Index is still weak, and shows no signs of a durable bottom.
 

 

Here is a close-up of the pattern in 2009. The CRB Index bottomed out a few days ahead of the stock market’s bottom in March 2009.
 

 

Metal prices also show a similar lead-lag pattern with stock prices. While gold has its unique characteristics and bullion marches to the beat of its own drummer, silver, copper, and platinum all turned up ahead of stock prices at the last two bear market bottoms. There is no evidence of any similar buy signals today from any of these commodities.
 

 

Market bottoms are also characterized by changes in leadership. Bear markets are forms of creative destruction. The old leaders from the last cycle, whose dominance become overdone, falter, and new market leaders emerge. Instead, the old leadership of US over global stocks, growth over value, and large cap over small caps are all still in place.
 

 

I am doubtful that a new bull market can begin with technical conditions like this.
 

Valuation headwinds

Another challenge for the long-term bull case is valuation. The S&P 500 is currently trading at a forward P/E ratio of 17.3, which is above its 5-year average of 16.7 and 10-year average of 15.0. Moreover, we are entering Q1 earnings season, and the E in the forward P/E ratio is going to be revised substantially downwards.

How far down? Consider that FactSet reported consensus bottom-up estimate is 152.81 for 2020, and 178.03 for 2021. By contrast, most of the top-down estimates I have seen for 2020 is in the 115-120 range, and the 2021 estimate is about 150. Those are very wide spreads between top-down and bottom-up estimates. The gap will be closed mainly with falling bottom-up estimates, rather than rising top-down upward revisions.

During my tenure as a quantitative equity portfolio manager, I have learned that whenever a country experiences an unexpected shock, all quantitative factors stop working. They then begin to work again in the following order. First the price technical factors start to convey information about the market. Next comes the top-down strategist estimates, followed by the bottom-up estimates. That’s because everyone knows the shock is bad, but no one can quite quantify the effects. The top-down strategists first run their macro models and come up with some ballpark estimates, but the company analysts cannot revise their estimates until they have fully analyzed the companies and industries to be able to revise their earnings. That’s where we are in the market cycle.

The final stage of the adjustment occurs when most of the damage is known, and fundamental factors like value and growth start to work again. We are far from that phase.

With that preface, let’s then consider the market’s valuation. I went back to 1982 and analyzed the market’s forward P/E ratio at major market bottoms. The 1982 bottom was an anomaly, as the market bottomed out at a forward P/E of about 6 because of the nosebleed interest rates of the Volcker era. The 2002-2003 bottom saw a forward P/E ratio of about 14. Those are the two outliers. The 1987, 1990, 2009, and 2011 bottoms all saw forward P/E ratios of about 10. All of these episodes occurred during backdrops of very different interest rate regimes. Can a new bull market begin today at a forward P/E of 15, with an uncertain E that is dropping quickly?
 

 

Here is how we arrive at the downside potential for the S&P 500, assuming the top-down estimates of 120 for 2020, and 150 for 2021. Supposing that the market bottoms out today, or at the end of March, forward 12-month EPS would be 75% of 120 + 25% of 150 = 127.50. Applying a P/E multiple range of 10-12, we arrive at a range of 1275-1530. Using the same methodology, a June bottom yields a 12-month forward EPS of 135, and a price range of 1350-1620. A September bottom results in a forward EPS of 142.50, and price range of 1425-1710.

For investors who believe that P/E ratios should be adjusted for interest rates, Callum Thomas of Topdown Charts calculated the equity risk premium of the US equity market based on CAPE. While current levels are starting to look cheap, they are nowhere near the compelling readings that are usually found at past major market bottoms.
 

 

What are smart investors doing?

Here is another way of thinking about valuation. Insiders stepped up an bought heavily during the most recent downdraft, but this group of “smart investors” backed away as the market rose.
 

 

To be sure, insider buying is an inexact market timing signal. Insiders were too early and too eager to buy during the initial decline in 2008.
 

 

They were also early in 2018.
 

 

For the last word on this topic, here is all you need to know about “smart investors”. At the bottom of the market during the Great Financial Crisis, Warren Buffett stepped in to rescue Goldman Sachs when the Goldman sold an expensive convertible preferred to Berkshire Hathaway, with share purchase warrants attached to the deal. When the market recovered, Buffett made out like a bandit.

What has Berkshire done today? It is raising cash. It sold its airline stocks, and Bloomberg reported that it is borrowing $1.8 billion in a Yen bond offering. In the current economic environment, there are many companies who need to borrow to shore up their liquidity, cash rich Berkshire Hathaway does not fit into that category.

Does this just make you want to rush out to buy stocks to get ahead of the FOMO stampede?
 

Instant bear, instant bull?

This bear market was the result of an exogenous shock that led to a recession. Ryan Detrick of LPL Financial found that recessionary bear markets last an average of 18 months, mainly because recessions take time to snap back and cannot normalize instantly.
 

 

While we have experienced an instant market, for stock prices to turn around back into an instant bull requires at least a light at the end of the tunnel. Namely, the circumstances that sparked the recessionary conditions are on their way to be resolved.

The markets began to take on a risk-on tone last week when the trajectory of COVID-19 cases and deaths began to improve, both in the US and Europe. While such improvements are to be welcome, they are the necessary, but not sufficient conditions for a re-launch of a new bull. In the absence of a miracle medical breakthrough, it is difficult to envisage how the current recessionary conditions can be resolved quickly. Even if the virus were to be under control, no one can just flip a switch and restart businesses in an instant.

Based on the first-in-first-out principle, we can observe that Asia is beginning to see a second wave of infection as governments ease lockdown restrictions. As an example, Singapore, which was extremely successful at controlling its outbreak, saw new cases spike as soon as restrictions were eased.
 

 

Unless a population were to acquire herd immunity, either allowing COVID-19 to run rampant through its people, or through some medical treatment that controls the outbreak, governments are going to be playing the game of whack-a-mole with this virus for some time. Under such circumstances, even the top-down S&P 500 earnings estimates of 115-120 for 2020 and 150 for 2021 are only educated guesses, and subject to revision based on changes in public health policy.

Despite the gloomy outlook, I have some good news. This recession is not to become a depression. Fed watcher Tim Duy wrote a Bloomberg article explaining the prerequisites for a depression depends on three Ds, depth (of downturn), duration sufficient for a recession or depression, and deflation. Duy observed that we certainly have the depth to qualify as a downturn, though the duration of the weakness is unknown. However, global central banks have sufficiently taken notice that they are doing everything in their power to combat deflation. While this global recession is going to be ugly, it is unlikely to metastasize into a depression.

I would also like to clarify my reference that the shape of this recovery is likely to be a “square-root” shaped (see From V to L: What will the recovery look like?). The Oregon Office of Economic Analysis provided a stylized answer. Expect an initial partial V-shaped bounce back, followed by a slower pace of growth, whose shape will be a function of policy, demand, and the amount of permanent economic damage.
 

 

In conclusion, I have analyzed the market using a variety of techniques. All of them lead to the conclusion that a major market bottom has not been reached yet.

  • Long-term market psychology
  • Technical cycle analysis
  • Valuation
  • Smart investor behavior

 

Don’t press your bullish bets

Posted by Cam Hui -

Mid-week market update: After yesterday’s downdraft and red candle, the bears must be disappointed that there was no downside follow through. Yesterday’s pullback halted at support, which was a relief for the bulls, but I would warn that the current environment is very choppy, and traders should not depend on price trends to continue.

At a minimum, the bulls should not press their bullish bets.
 

Normalizing from panic

The current environment can be characterized as a normalization from blind panic. This chart of the spread between the VIX Index and realized 30-day volatility tells the story. In normal times, VIX trades at a slight premium to realized vol, but we are now seeing an off-the-charts spread between the two. The last episode of such a large spread occurred during the bear market of 2008, when market fear levels receded after the initial shock of the crisis.
 

 

Here is a close-up look. Both realized and implied volatility are rolling over, but implied volatility (VIX) is falling faster than historic realized volatility.
 

 

The analysis of other market based volatility indicators tell a similar story. The top panels show that both VIX and TYVIX, which measures bond market volatility, are falling. As well, VXN, which measures NASDAQ volatility, usually trades above VIX because of the riskier nature of NASDAQ stocks, recently fell to a discount to VIX, indicating that VIX may be trading too high and needs to fall further, which is equity bullish.
 

 

The bears can argue that both VIX and TYVIX seem to be finding a floor. Moreover, the term structure of the VIX (bottom panel) remains inverted, indicating elevated fear levels.

A look back at 2008 yields some clues on how to navigate the current environment of normalization from a panic. While I could not discern any signals from the behavior of VIX and TYVIX during that period, the combination of VXN-VIX and VIX term structure were more interesting. The shaded areas show periods when then VXN-VIX spread was negative, indicating elevated fear levels. During these episodes, rising VIX-VXV spreads, which indicated strong inversions of the VIX term structure, were equity bearish. The two occasions when the the VXN-VIX spread normalized back to positive were equity bullish.
 

 

Neither of those signals are in play today.
 

Playing the odds

From a tactical perspective, here are a couple of reasons why you shouldn’t press your long bets, even if your are bullish. First, Alex Barrow at Macro Ops compiled a list of past bear market rallies and found that “median bear market rally lasted 35 days and rose 19%”. The latest rally lasted 12 days (as of yesterday’s close) and the market is up 25%. While there is wide dispersion in the historical results, this study study suggests that the current bear market rally is living on borrowed time.
 

 

short-term breadth is already overbought, based on Tuesday’s night’s close. While overbought markets can become more overbought, do you really want to play those odds?
 

 

The S&P 500 is nearing resistance at its 50% retracement level of 2780. What’s the short-term upside potential in light of these overbought conditions?
 

 

The NASDAQ 100 tested that level yesterday, and stalled.
 

 

My inner investor is at his maximum defensive position. If he had not been, he would be taking advantage of this rally to lighten up on his equity positions. My inner trader believes that the short-term risk/reward is tilted to the downside, and he is holding on to his short position.

Disclosure: Long SPXU

 

Time to sound the all-clear?

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: 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.

Has market psychology turned?

Urban Carmel made an interesting point last Friday. Despite a string of ugly macro news, the market has not made new lows.

Does that mean it’s time to sound the all-clear for the stock market?

A look at sentiment

Let’s start by analyzing the long-term outlook from a sentiment perspective. Both Marketwatch and Bloomberg reported that an RBC survey of institutional equity investors conducted betweent March 25 and March 31 indicate a surprising level of bullishness. Capitulation has not occurred yet, and the market is therefore vulnerable to negative surprises.

Even as the spread of COVID-19 accelerates in many regions of the U.S., institutional investors are becoming ever more bullish about the prospects for the stock market, according to a survey released Thursday by RBC Capital Markets.

“Our respondents are highly bullish on stocks, the most optimistic they’ve been since we started our survey in the first quarter of 2018,” wrote Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets.

She said that the survey respondents provided three reasons for optimism, including attractive valuations, faith in the Federal Reserve to take actions necessary to support the economy and “a belief that the economic damage from the public health crisis will be manageable.”

What about retail sentiment? I prefer to monitor monthly AAII Asset Allocation Survey, which measures what AAII members are actually doing with their money, as opposed to the weekly survey, which measures opinions. The asset allocation survey shows that while equity allocations have fallen and cash allocations have shot up, readings are not at the extreme levels seen at past major market bottoms. In addition, anecdotal evidence from different sources shows that retail investors are not panicked at all. Instead, they are open to putting new cash into equities. That’s simply not how sentiment at major market bottoms behaves.

As well, the stock market’s relief rally stalled last week just short of its first Fibonacci retracement level, while the Fear and Greed Index recovered off an extreme fear condition to 21. These conditions are more consistent with a short-term relief bear market rally than a major market bottom.

What about the bond market? While credit conditions have tightened, investor appetite for bonds is still healthy. There have been 27 different issuers since March 1, including a cruise line. Most investment grade issuers are borrowing at the long end, at a cost of around 3%.

These are not the signs of blind panic that are found at major market bottoms.

Limited valuation support

FactSet reported that the market is trading at a forward P/E multiple of 15.3, which sounds reasonable at first glance, though it’s not wildly cheap. However, the E in the forward P/E ratio been falling rapidly, and it skidded -7.2% in only three weeks.

Investors can expect the negative EPS estimate momentum to continue. While the pace of quarterly earnings downgrades is ugly, it has not even beaten the pace set in Q1 2016, which was not even a recession. In addition, the rate of Q1 negative guidance is only roughly in line with historical experience, and bottom-up aggregated analyst price targets call for 12-month price target gain of 33%.

Q1 earnings season is just about to begin. While Q1 earnings may not be that bad because they represent stale data, corporate guidance is likely to be very negative. Based on the current rate of negative guidance and aggregated price targets, Street expectations are overly ambitious and need to be further adjusted downwards.

While FactSet’s analysis is from a company bottom-up aggregated perspective, the top-down view is also supportive of my case for further downside before the market can make a durable long-term bottom. A reader pointed out that Ed Yardeni has cut his 2020 S&P 500 EPS estimates to $120, and his 2021 estimates to $150. A brief survey of other Street strategists indicate that Yardeni’s forecast is about the consensus. Consider what this means using our handy forward 12-month P/E analytical technique:

If the market were to bottom out in mid-2020, forward 12-month EPS would be 50% of 120 + 50% of 150 = 135. The market bottomed in 2011 at a forward P/E of 10, and in late 2018 at about 13. Apply a 10-13 times P/E multiple to those earnings, you get 1300 to 1755, which translates to downside risk is -48% to -30% from current levels.

If the market were to bottom out Q3 2020, forward 12-month EPS would be 25% of 120 + 75% of 135 = 142.50, which translates to a range of 1425 to 1852, or downside risk is -43% to -25%.

Still ugly any way you look at it.

Market internals: A mixed bag

In the shorter term, the market’s technical internals present a mixed bag. My recent favorite directional indicator, the high beta to low volatility ratio, has flattened out, indicating indecision.

I had expressed concern in the past that the offshore USD shortage presents a risk to EM stability. The latest indicators of EM market risk appetite is also inconclusive.

The coronavirus pairs of global airlines to Chinese healthcare, and Royal Caribbean (cruise line) to Service Corp (funeral homes) are falling, indicating a risk-off environment, though airline stocks did exhibit a minor rebound on Friday. However, the disclosure after the close that Warren Buffett was selling his airline holdings is unlikely to be supportive of further strength in this pair.

What about the oil price? Could a cessation in the oil price war spark a stock market rally, or at least put a floor on stock prices? The relative performance of energy stocks displayed a strong dead-cat bounce quality from an extremely oversold condition, and there is potential for more upside from this beaten up sector.

On the other hand, the energy sector is now the second smallest sector in the index at 2.6%. A 10% rally in these stocks would only move the index by 0.26%. A double translates to a rally of only 2.6%, everything else being equal.

Signs of stabilization

To be sure, there are signs of stabilization in the market, which is constructive. Not only is the VIX Index falling, TYVIX, which measures bond market volatility, is falling in lockstep. As well, the term structure of the VIX futures curve is beginning to normalize. The 9-day to 1-month VIX ratio has moved from an inverted condition to flat, and the 1-month to 3-month ratio is also flattening. All of these readings indicate that market psychology is transitioning from utter panic to a greater calm.

As well, fund flows are starting to normalize. After a bout of panicked selling, investors are tip toeing back into equities and bonds again.

Where does that leave us? The hourly S&P 500 chart tells the story. The index staged a relief rally by breaking out of a falling trend line, but the rally stalled at 2650. It then gapped down to find support at 2450. The bulls could not rally the market above resistance at 2530 to fill the gap at 2530-2580. On the other hand, the bears could not break support at 2450, whose violation should see the gap at 2250-2350 filled quickly.

It’s time for the market to give us some clues on further short-term direction. While I am leaning bearish, we need to see a decisive breakout from the recent trading range of 2450-2530 for further clues. My base case scenario calls for a choppy range-bound market for the next few weeks. While the market may decline to test the March lows at about 2200 and the relief rally high at 2650, neither the bulls nor the bears will be able to break the deadlock.

Short-term breadth is neutral, but momentum is negative. The odds favor further downside in the next few days, but don’t get too greedy and count on a break of major support.

Disclosure: Long SPXU

From V to L: What will the recovery look like?

Posted by Cam Hui -

I suppose I should be used to it by now. Last week’s initial jobless claims spiked to 6.6 million, and the March headline Non-Farm Payroll printed at a dismal -701K. The unemployment rate would have been even worse had the participation rate not fallen and depressed the size of the labor force. My desk has been flooded with bear porn.

Wall Street economists are racing to downgrade their Q2 GDP growth forecasts. Among many, Goldman Sachs last week reduced their already downbeat forecast to an annualized -34% from -24%, and unemployment to reach an astounding 15%.
 

 

Even more astonishing is the latest White House announced goal of reducing the number of COVID-19 deaths to a range of 100,000 to 240,000.
 

 

Rather than just wallow in more unnecessary bearishness, a more useful exercise is to consider how the economy might evolve from BC (Before Coronavirus) to AD (After the Disease). What will the recovery look like? There is a wide continuum of recovery shapes from V to L.
 

Unemployment at 32.1%?

While the 6.6 million in initial jobless claims translates to an unemployment rate of roughly 10%.  unemployment is likely to be headed into the teens. However, I did not expect St. Louis Fed economist Miguel Faria-e-Castro to pen a “back of the envelope” Q2 unemployment estate of 32.1%.

The estimate comes from two sources. The first is from a blog post from St. Louis Fed economist Charles Gascon, who identified 66.7 million workers in “high risk occupations” that are most exposed to layoffs.
 

 

“In another recent blog post, Matthew Famiglietti, Fernando Leibovici and Ana Maria Santacreu combined individual-level data from the 2017 American Community Survey with information on occupational contact intensity from O*NET to determine how many people work in occupations that require the worker to perform tasks in close physical proximity to other people.” Their estimate came to 27.3 million workers.
 

 

Miguel Faria-e-Castro then arrived at his estimate by averaging the figures from the two papers, and arrived at a potential unemployment rate of 32.1%. This simple “back of the envelope” exercise just shows how bad the COVID-19 disruptions can become.
 

Length matters more than depth

While Wall Street economists and strategists have busily modeled the depth of the recession, I would argue that it is the length of the downturn that matters much more to investors.

Greg Ip at the WSJ made that precise point in a recent article. The longer it goes, the more it hurts.
 

 

SEB-X modeled the EPS impact of a short and long lockdown, and the difference is enormous. The gulf between a two-month difference in PMI trough changes EPS growth from -20% to -60%.
 

 

Under these circumstances, the key questions for investors are how long before the economy troughs, and what’s the shape of the rebound?
 

A continuum of outcomes between V and L

McKinsey recently modeled a matrix of economic recovery scenarios based on two factors, the effectiveness and knock-on effects of fiscal and monetary policy (x-axis), and the virus spread and the effectiveness of the public health response (y-axis), Each outcome led to a different shape of economic recovery. This framework does offer a useful framework for thinking about how the US and global economy might emerge from this crisis.
 

 

Pandemic history lessons

While G7 fiscal and monetary authorities have uniformly gone all-in in their own fashion to combat the economic effects of the recession, the public health response have varied, and some lessons from history may be useful for investors.

A New York Fed study of the Spanish Flu found that, contrary to popular belief, there is no trade-off between non-pharmaceutical intervention (NPI) measures such as social distancing and economic growth.
 

 

With respect to the economic effects of the pandemic, we find that more severely affected areas experienced a relative decline in manufacturing employment, manufacturing output, bank assets, and durable goods consumption. Our regression estimates imply that the 1918 Flu Pandemic led to an 18 percent reduction in manufacturing output for a state at the mean level of exposure. Exposed areas also saw a rise in bank charge-offs, reflecting an increase in business and household defaults. These patterns are consistent with the notion that pandemics depress economic activity through reductions in both supply and demand (Eichenbaum et al. 2020). Importantly, the declines in all outcomes were persistent, and more affected areas remained depressed relative to less exposed areas from 1919 through 1923.

In fact, NPI measures helped growth, not hurt.

Comparing cities by the speed and aggressiveness of NPIs, we find that early and forceful NPIs did not worsen the economic downturn. On the contrary, cities that intervened earlier and more aggressively experienced a relative increase in manufacturing employment, manufacturing output, and bank assets in 1919, after the end of the pandemic.

Our regression estimates suggest that the effects were economically sizable. Reacting ten days earlier to the arrival of the pandemic in a given city increased manufacturing employment by around 5 percent in the post-pandemic period. Likewise, implementing NPIs for an additional fifty days increased manufacturing employment by 6.5 percent after the pandemic.

The study made parallels to the modern era. The positive effects of NPI acted to avoid the tail-risk of severe growth crash effects of a uncontrolled pandemic running through the population.

Anecdotal evidence suggests that our results have parallels in the COVID-19 outbreak. Governments that implemented NPIs swiftly, such as those in Taiwan and Singapore, have not only limited infection growth; they also appear to have mitigated the worst economic disruption caused by the pandemic. For example, economist Danny Quah notes that Singapore’s management of COVID-19 has avoided major disruptions to economic activity without leading to a sharp increase in infections through the use of forceful, early interventions. Therefore, well-calibrated, early, and forceful NPIs should not be seen as having major economic costs in a pandemic.

A Bloomberg article summarizing the economic effects of the Black Death during the second half of the 14th Century documented a period of economic upheaval. As the epidemic killed off roughly 60% of Europe’s population, it was no surprise that real wages rose afterwards.
 

 

Rising wages sparked a consumption boom.

The change in behavior was more stark. “The Black Death created not just the means for wider parts of the population for excessive consumption – but the traumatizing experience of sudden decimation in the earthly life also triggered the impetus to enjoy it to the fullest, while still able to,” Schmelzing notes.

Products that hadn’t been for mass consumption earlier — such as linen underwear and glass panes in windows — became more widely available as cheap capital rushed to satiate the growing desire to consume, according to “Freedom and Growth,” historian Stephan Epstein’s review of states and markets in Europe between 1300 and 1750. Sumptuary laws that, among other things, sought to limit the height of Venetian women’s platform shoes were the state’s way to rein in conspicuous consumption; eventually the mad spending ended and savings went to bond markets. A republican ethos was born.

 

Today’s governments have enacted extensive income and wage supports to buttress their economies against collapse, but history has shown that such deficits have not been followed by rising cost of debt. In fact, real rates fell.

The borrowing costs for large monarchies fell to 8% to 10% by the early 16th century from 20% to 30% before the Black Death, according to Epstein. Florence, Venice and Genoa as well as cities in Germany and Holland saw rates slump to 4% from 15%. Surprisingly, the drops coincided with large increases in sovereign debt to boost military preparedness. 

A recent study of economic history by Jorda, Singh, and Taylor found a similar effect of falling real interest rates after pandemic episodes. This paper examined the history of 12 pandemics that experienced at least 100,000 deaths.
 

 

There was a significant decline in real rates 20 years after the event, though the magnitude of the effect varied by country.
 

 

Not surprisingly, real wages rose after pandemics because of a shift in the labor to capital ratio.
 

 

The key conclusion is, expect low rates to persist to as far as the eye can see, with the caveat that these historical studies occurred when hardly anyone survived to old age:

If the trends play out similarly in the wake of COVID-19—adjusted to the scale of this pandemic—the global economic trajectory will be very different than was expected only a few weeks ago. If low real interest rates are sustained for decades they will provide welcome fiscal space for governments to mitigate the consequences of the pandemic. The major caveat is that past pandemics occurred at time when virtually no members of society survived to old age. The Black Death and other plagues hit populations with the great mass of the age pyramid below 60, so this time may be different.

These studies also imply that, for long-term investment planning purposes, there will be shifts in inequality as returns to labor will rise and returns to capital will fall. Bond yields will stay low, and the equity risk premium is likely to compress.
 

A difficult 2020

From a tactical perspective, my base case scenario calls for a difficult 2020, and perhaps 2021 for the global economy, and equity returns. Using the McKinsey framework, we simply have no idea of the nature of the virus spread, nor the effectiveness of the public health policy response. However, we can make some educated guesses based on the path set by China and other Asian economies.

I would expect that the mitigation strategies adopted by the industrialized countries in Europe and North America to be largely successful in bending and flattening the curve in April and May. As the northern hemisphere enters summer, there is some evidence that heat will retard the progress of the virus. We should see some confirmation of that effect as the southern hemisphere enters their fall and winter seasons. South Africa is already in lockdown. I am monitoring South America to see if the pandemic flares up, and if there is an echo spike in cases in Australia and New Zealand. If so, expect a second peak in the northern hemisphere later this year, which will change the shape of the economic recovery from a V to a W.
 

 

Investors are also well advised to watch China based on the first in-first out principle. Since China was the first to be afflicted with this pandemic, the evolution of its growth pattern will offer clues about the future of the economies of the West. China is slowly returning to work, and both the hard data and anecdotal evidence suggests that the economy is only operating at 60-70% of pre-pandemic capacity, and not all is well with the consumer.

As well, Wuhan re-imposed its lockdown after a brief period of relaxation, which indicates that the infection is not fully under control. Nearby Singapore announced late last week that it was tripping coronavirus “circuit breakers” by closing schools and essential workplaces after briefly relaxing its social distancing edicts.

The analysis of Hong Kong’s February retail sales offers some clues. Spending was concentrated on food, supermarkets, and fuel, while virtually all other categories tanked.
 

 

Bloomberg has reported that a global consumer default wave may be starting in China.

The early indicators from China aren’t pretty. Overdue credit-card debt swelled last month by about 50% from a year earlier, according to executives at two banks who asked not to be named discussing internal figures. Qudian Inc., a Beijing-based online lender, said its delinquency ratio jumped to 20% in February from 13% at the end of last year. China Merchants Bank Co., one of the country’s biggest providers of consumer credit, said this month that it “pressed the pause button” on its credit-card business after a “significant” increase in past-due loans. An estimated 8 million people in China lost their jobs in February.

“These issues in China are a preview of what we should expect throughout the world,” said Martin Chorzempa, a research fellow at the Peterson Institute for International Economics in Washington.

 

A “square root” recovery

Even if the lockdowns in Europe and North America were to be successful over the next two months, the consumption pattern from China and Hong Kong leads me to believe the recovery will sputter. While some consumer spending will revive, households are likely to be focused on repairing their balance sheets rather than splurging on restaurants, leisure, and travel. As well, many small businesses will have either failed, or be near failure, and will require additional support. In the US, state budgets are already under severe stress and will also need federal aid.

Investors should monitor the evolution of earnings estimates, especially for Q3, Q4, and into 2021. If the Street is expecting a V-shaped revival, it faces the risk of disappointment. In that case, watch for a market rebound in the coming months, followed by a retest of the old lows, and quite possibly lower lows if further fiscal stimulus is believed to be insufficient.

In summary, there are many moving parts to my forecast, which depend on the nature of the virus spread, and the effectiveness of public health policy.

  • A relief equity rally to begin in the next 1-2 months on the expectation that governments have “flattened the curve”.
  • An anemic rebound by the household sector, dragged down by SME failures, and rising defaults.
  • A second leg down in stock prices, sparked by a possible fall and winter spike in infections, and the evidence of an anemic recovery.
  • Further announcements of fiscal support. Governments will have to spend until it hurts, and then spend even more.

This is a recessionary bear market. Recessionary bear markets take more time to resolve than anyone expects. Fed watcher Tim Duy characterized the shape of the likely recovery best as a “square root” in a Bloomberg Op-Ed, in which he lamented that hiring freezes will exacerbate the downturn just as employment tanks.

Assuming virus-related concerns will persist over the next year or longer, we might expect a “square root” type of recovery. After an initial jump of hiring that follows the first phase of recovery begins, a less-than-full resumption of activity and uncertainty about future shutdowns threaten to restrain the pace of hiring long into the future;

It’s not a V or L recovery, but a square root. Richard Nixon famously said that “we are all Keynesians now”. In this crisis, we are all geeks and nerds now.

Please stay tuned for our trading commentary, which is scheduled to be published tomorrow.

 

The bear market rally stalls

Posted by Cam Hui -

Mid-week market update: The bear market rally appears to have stalled at the first Fibonacci resistance level of 2650. The bulls also failed to stage an upside breakout through the falling trend line. Instead, it broke down through the (dotted) rising trend line, indicating the bears had taken control of the tape.
 

 

Deteriorating internals

I should have known better. One of the most reliable indicators has been the ratio of high beta stocks to low volatility stocks. This ratio has signaled most of the turning points in the last few months, and it turned down again late last week. (Warning: No model works forever, and relying on any single indicator is hazardous to your bottom line).
 

 

As well, I had expressed concerns about how USD strength was pressuring EM economies. The relative performance of EM bonds and EM currencies have not been reassuring during the recent bear market rally.
 

 

Short-term breadth is recycling from an overbought condition, based on last night’s close. Undoubtedly readings will have deteriorated by today’s close, but not enough to move to an oversold reading.
 

 

My inner investor is at a position of maximum defensiveness. Subscribers received an email alert this morning that my inner trader had sold his long position and reversed short. A logical downside objective is see the gap at 2260-2350 to be filled.

One key test of market psychology will be tomorrow (Thursday) morning’s release of initial jobless claims. While initial claims are likely to spike even further, watch for revisions to last week’s release, which may surprise with further upward revisions. Watch how the market reacts.

Disclosure: Long SPXU

 

For traders: 3 bullish, and 1 cautionary signs

Posted by Cam Hui -

The following note is addressed to short-term traders with time horizons of a week or less. I would like to highlight some three bullish, and one cautionary data points.

First, the latest update of the Citi Panic/Euphoria Model is solidly in panic territory. This is contrarian bullish, but recognize that the bullish call is based on an intermediate term time horizon.
 

 

There is an encouraging sign for short-term traders in this model. Luke Kawa pointed out that sentiment had turned suddenly, and momentum is positive. Tobias Levkovitch, the keeper of the Panic/Euphoria Model, found that “Fund managers and institutional investors went from worrying about their personal safety (‘should I buy a gun?’) to having conversations expressing hope a market bottom had formed in the span of five days”.

These comments show that institutional managers are as human as the rest of us. I conclude from this that the rally is a bull trap, but if institutions are ready to hop on the bullish train, there could be further upside in the short run.

My short-term bullishness is supported by the weekly (unscientific) Twitter poll conducted by Callum Thomas of Topdown Charts. I was surprised to see that overall bearishness had risen despite last week’s price rebound. Such levels of bearishness have signaled tradable rallies in the past.
 

 

Analysis from Chris Prybal of Schaeffer’s Research confirms my interpretation of a sentiment wash-out. Instead of just examining the put/call ratio, Prybal constructed a hedge ratio based on changes in the put/call ratio and market movement.

Using OCC’s volume data, I’ve developed a “hedging ratio,” derived by taking the daily index/other put/call ratio and dividing that by the equity-only daily put/call ratio. The underlying hypothesis is that there may be a rush to hedge or buy index puts during periods of market turmoil — and so, by comparing the index activity against the equity-only reading, we can shed some new light on the underlying dynamics of the options market.

Using a 10-day moving average to smooth out the daily readings, the OCC hedging ratio has clearly plunged. However, the ratio has not set a new low. It’s critical to know that spikes in this OCC hedging ratio have aligned with many market tops in the past, while low hedging ratio readings have usually corresponded with market troughs.

 

 

One word of caution

Despite my short-term bullishness, I noticed a worrisome nascent negative divergence today. The stock market had been highly correlated with the strength of EM currencies, as measured by the EM currency ETF CEW. We saw the USD strengthen today, and CEW fall, even as stock prices rise. CEW and SPX had been moving in lockstep in the past month.
 

 

What about the Fed’s swap lines that alleviated shortages in the offshore dollar market? FT Alphaville recently featured an article by Wenxi Du of the Booth School at the University of Chicago. She explained that the current episode of offshore USD shortage is different from 2008:

The sudden stop in dollar funding in the last couple of weeks accompanied by crashing asset prices and a sharply appreciating dollar evokes memories of the global financial crisis of 2008. However, there is one key difference: then it was about overleveraged banks, now non-banks are a much bigger part of the story.

Post-crisis regulation made low-margin balance sheet intensive market-making and intermediation activities unattractive to banks due to constraints on leverage. In their place came non-banks, including portfolio investors and nonfinancial corporations (NFCs). They are now playing a much bigger role in the market for short-term dollars. Institutional investors such as life insurers and pension funds from around the world have become the key protagonists, especially in the market for dollar-denominated securities.

A life insurance company from the euro area has obligations to its policyholders in euros, but will typically hold a globally diversified portfolio with a substantial portion being dollar-denominated assets. Hedging the currency risk entails finding a bank that will lend dollars in exchange for euros, with an agreement that the dollars will be repaid for euros at a fixed point in the future, and at a pre-agreed exchange rate – known as an “FX swap”.

NFCs are also enmeshed in global value chains and need short-term dollar funding to finance their working capital. When direct dollar funding sources are not readily available, NFCs can raise dollars in the FX swap markets.

As you recall, the Lehman Crisis blew up because financial institutions refused to lend to each other in the overnight market. The Fed was helpless in the face of the crisis because many of the troubled institutions were non-banks, which could not access the Fed’s discount window. It led to the collapse of WaMu and AIG. This time, it’s playing out again, but in the offshore dollar market. Many of the institutions that lack USD funding are non-banks. While the Fed could and did establish swap lines with local central banks to alleviate shortages, the liquidity transmission mechanism is faulty, and may create further tensions.

My inner trader remains nervously long, and he is watching the offshore USD market, and EM currencies in particular for signs of stress.

Disclosure: Long SPXL

 

The dawn of a new bull?

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: Bullish

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

A new bull?

A week ago, I was impatiently waiting for a bear market relief rally (see This is insane! Where’s the bear market rally?).  The market gods heard my pleas, and the market surged 20.3% from intraday trough to peak last week, which is enough to pass the definition of a new bull market.
 

 

Does that mean we just entered a new bull market after exiting the fastest bear market in my lifetime? Let’s consider the issues from a variety of perspectives.
 

Earnings, earnings, earnings!

Let’s begin with the fundamentals. The price of stocks depend on earnings, earnings, and earnings. FactSet reported that the S&P 500 is trading at a forward P/E of 15.5, which is between its 5-year average of 16.7 and 10-year average of 15.0.
 

 

The rise in the forward P/E ratio is attributable to a combination of rising prices and falling forward earnings. Wall Street analysts have finally begun to downgrade EPS estimates, and forward earnings skidded -2.5% in 1 week and a cumulative -4.3% in two weeks.
 

 

Corporate insiders have shown themselves to be highly valuation sensitive during this downdraft. A concentrated cluster of insider buying appeared just as the market fell, but buying evaporated as the market recovered.
 

 

Does that mean that stocks are no longer cheap? Well, sort of. Fathom Consulting recently introduced a valuation model based on cross-asset valuations. It shows that equities are cheap, but they could become even cheaper.
 

 

Macro outlook

So far, the market hasn’t shown much reaction to macro developments. Nevertheless, the major highlight last week in top-down macro data was initial jobless claims. The chart from the from page of the New York Times is certainly a front page for the history books. Wow!
 

 

What does the surge in jobless claims mean? The spike in claims translate to an unemployment rate of roughly 5.2%. Wall Street’s Q2 unemployment rate estimates vary wildly, but the consensus is around 7%. As an aside, please be reminded that next Friday’s Non-Farm Payroll report will not show a jump in unemployment from 3.5% to 5.2% because the jobless claims spike occurred after the reference period.
 

 

The rise in jobless claims triggers the Sahm Rule, which calls for a recession whenever the unemployment rate jumps (see FRED graph after the NFP report).
 

 

Nautilus Research found that sudden surges in jobless claims has historically been unfriendly to stock prices. Even though the sample size is small (n=7), forward returns are especially bearish on a 3-6 month time horizon.
 

 

Technical outlook

What about the outlook based on technical analysis? The indicators are mixed and confusing. Bullishness and bearishness are in the eyes of the beholder.

Short-term breadth is recycling off an overbought extreme, which argues for weakness early in the week.
 

 

On the other hand, longer term breadth indicators are tracing out a bottoming pattern, indicating that this rally could have some more legs.
 

 

Similarly, SentimenTrader observed that 57% of the S&P 500 have triggered a MACD buy signal, which is a bullish price momentum signal. The key caveat to that buy signal is that it has occurred during bear market rallies in the past. While the market may have been higher in a year’s time, the shorter term outlook may not necessarily be as bullish.
 

 

Speaking of price momentum, there is still time for a bullish Zweig Breadth Thrust buy signal to develop. As a reminder, the market has up to 10 trading days after the ZBT Indicator recycles off an oversold reading. Day 1 was last Tuesday. We have another six trading days. Stockcharts is late in updating their ZBT Indicator, so I made my own real-time estimate (bottom panel). Based on current readings, it would only take one more day with a 3%+ price surge to achieve this buy signal.
 

 

While I am not holding our breathes for a ZBT buy signal, the last one (see A rare “What’s my credit card limit” buy signal, published on January 7, 2019) managed to catch the market surge after the 2018 Christmas Eve bottom.
 

 

Still a bear market

So where does that leave us? My working hypothesis is this rally is a bear market rally. Bloomberg’s Canadian reporter Luke Kawa gave readers a history lesson last Friday when he compared last week’s market action to 1933:

Even foreigners — well, at least Canadians — learn what happened stateside during the Great Depression, from the duration and magnitude of the human suffering to the policy prescriptions to try to address it. So when financial markets start rattling off superlatives that end with “since 1933,” it’s time to think about what transpired back then and the results we’d like to avoid. Even when it’s tied to good news. On Tuesday, the Dow Jones Industrial Average posted its biggest one-day gain since March 15, 1933. The latter was the first session markets reopened following an extended bank holiday instituted by President Franklin Delano Roosevelt, because so many of them were failing in the midst of a bank run. In the interim, the Emergency Banking Act was passed. That created the Federal Deposit Insurance Corporation, effectively guaranteeing Americans could trust the banks with their savings. Thursday marked the culmination of the biggest three-day rally in the S&P since the period ending April 20 1933 — when FDR took the radical step of de-pegging the U.S. dollar from the gold standard. These were policy actions that succeeded in chopping off the left tail of systemic financial instability, much like the modern-day Fed’s increasing suite of programs to address liquidity and credit risk. In the 1930s, these measures were accompanied by expansive fiscal policy, as is expected today.

If last week’s market volatility was last found during the time of the Great Depression, it is difficult to believe that we have suddenly exited the shortest bear market in history. Daily index price swings of 3% and 5% simply do not occur in bull markets. This kind of market action is the signpost of a bear market. The 2008 bear market experienced numerous brief and sharp rallies of between 9% and 19% within the space of four months.
 

 

As well, any declaration of a new bull market has to tempered by the observation that the percentage of stocks above their 50 day moving average is only 1.8%, and above their 200 dma is 6.2%. Arguably, equity market strength could be explained by Fed action to establish dollar swap lines. The initiative sparked a decline in the USD which alleviated a lot of the tensions in the offshore dollar funding market.
 

 

I would expect some choppiness early in the week, with a possible test of the resistance zone at the 2650-2700 zone next week. If the bulls are successful in breaking resistance, a test of the 50% retracement level at about 2800 should occur in short order. If the market were to weaken, a logical support level is the 50% retracement of the advance at about 2420.

Once the bear market rally subsides, my base case scenario calls for a retest of the lows in April. The bulls may not be able to hold the line, and the retest may not necessarily be successful. There are no guarantees.

My inner investor remains positioned in a maximum defensive posture. My inner trader is long the market, and waiting to see if the likely test of resistance at 2650-2700 is successful.

Disclosure: Long SPXL

 

Handicapping the odds of a V-shaped recovery

Posted by Cam Hui -

Last week’s stock market rally appears to be based on the hopes of a V-shaped economic recovery, powered by the combination of all-in monetary stimulus, and fiscal stimulus, as evidenced by a $2 trillion bill passed in Congress. Street consensus is now a V-shaped rebound, with a trough in Q2. This Goldman Sachs forecast is just one of many examples.

How realistic is the prospect of a V-shaped recovery? The economy is clearly either in a recession, or entering recession. LPL Financial found that recessionary bear markets last an average of 18 months compared to non-recessionary bears, which last only 7 months. That finding is inconsistent with the current Street expectation of a brief and sharp slowdown.

What are the odds of a V-shaped recovery?

The situation report

We begin by analyzing the current US situation, in the absence of official policy initiatives. We then consider the effects of announced and planned policy responses in the monetary, fiscal, and public health dimensions. This analysis will be conducted within the classic economic framework of the effects of policy on the three factors of economic production, namely capital, land (rents), and labor.

I made a recession call in early March (see OK, I’m calling it… and My recession call explained), which seems a lifetime ago. The global recession had its roots in a Chinese slowdown from the COVID-19 pandemic, which created supply chain disruptions. The global slowdown tanked the price of oil. When OPEC and Russia tried to set production cuts, discussions broke down and sparked a Saudi-Russian price war. The combination of the price war and pandemic induced demand slump has become so bad that Bloomberg reported a small Kansas plant was offering sweet Wyoming crude for $1.75 per barrel. As a reminder, the last time oil prices tanked in 2014, it sparked a mild industrial recession in 2015.

Finally, the COVID-19 pandemic landed on American shores, expanded its beachhead, and spread throughout the country. While the public health response was slow, officials eventually put social distancing edicts into place, which shut down the economy. That’s where we are today.

The FT’s analysis of the growth of confirmed COVID-19 cases in the US is rather alarming. While the first cases appeared in Washington State, the epicenter of the epidemic is now New York State, and the outbreak is spreading to other locations in the country.

The IHS Markit Flash PMI tells the story of the damage to the US economy. Unlike 2008, this recession is about a complete collapse in services. The Composite PMI skidded to an all-time low of 40.5, and Services PMI also cratered to an all-time low of 39.1.

Let us now consider how the losses are distributed within the economy. Morningstar recently studied the effects of the sudden bear market on different kinds of companies. It found that companies with a strong competitive position, otherwise known as a wide moat, outperformed the companies with narrow and no moats.

A Small Business Administration study in late 2018 found that small businesses comprise 44% of GDP. Small businesses tend to be have little or no competitive power. They are price takers, and have little or no bargaining power. Already, evidence from Open Table shows restaurant reservations have fall 100% (yes, that’s not a typo), and Cheesecake Factory has informed its landlords that it will not be paying the rent on April 1.

A recent Goldman Sachs survey shows that 51% of small business can survive for up to three months in the current operating environment. Since small business make up 44% of GDP. If they go under in the next three months, that would crater GDP growth by -22% in a very short period of time.

Last week’s unprecedented surge of initial jobless claims to 3.3 million tells the story of the damage to the household sector. A recent AARP survey of adults whose households with no emergency savings is revealing in highlighting the levels of vulnerability. While the proportion of vulnerable households are roughly the same by age group, 47% of households with incomes of 60-75K group, which is just above the median household income of $61,937, have no emergency funds. Moreover, roughly two-thirds of American households, or those below the median household income cutoff, have no emergency savings.

It is not my intention to sound political, but this survey underscores the highly uneven nature of the post-GFC recovery and subsequent widening level of inequality among Americans. It has left the houshold sector highly vulnerable to tail-risk shocks. This pandemic has the potential to sink the economy into the deepest downturn in the post-War, and possibly post-Depression period.

Another problematical issue is the strain of fighting the virus on state and local budgets. This Medium article outlines budget crunches in Arkansas, Georgia, Hawaii, Ohio, Pennsylvania, Virginia, Nevada, New York, and Texas, as well as numerous local authorities. Much of the funds went to fighting the pandemic, and federal aid to states was insufficient to balance the budget. Cuts have to be made. In the coming months, states and towns will unleash a wave of austerity that will be unhelpful for economic growth.

The policy response

That was the bad news. Here is the policy response. We have seen a combination of monetary, fiscal, and public health policy responses, all of which have to be effective for any economic recovery to be sustainable. As you will recall from Economics 101, the classic factors of production are capital, land (rents), and labor. Each policy has different effects on the factors.

Let’s start with monetary policy. The Fed has lowered interest rates, and announced open-ended quantitative easing to calm the markets. In addition, the FOMC begun to buy municipal paper, and mortgages. Moreover, it announced dollar swap lines with other central banks in order to alleviate the offshore dollar shortage, which was creating instability in emerging market economies that financed in USD debt. All of these actions were designed to compress credit spreads, which had blown out. The principal effect of the Fed’s actions is on the cost of capital, and to a lessor extent, the real estate market as the mortgage market was imploding.

What about the fiscal response? Congress passed the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act last week, with $377 billion support to small businesses in the form of loan guarantees and grants, $550 billion support for individuals in the form of direct payments and enhanced unemployment insurance, and roughly $500 billion support for the corporate bond market.

Make no mistake about it, this is not a stimulus bill, but a bailout plan, designed to partially alleviate the pain suffered by capital and labor providers by sprinkling money in different parts of the economy. Joe Wiesenthal at Bloomberg frame the issue by distinguishing money as a score keeping device, and as a relationship-preserving device, or glue, that holds society together. The CARE Act just provides some temporary glue.

But when you think about the purpose of money on a society-wide scale, it’s a lot more than a score-keeping device. What makes a nation wealthy? Is it the amount of cash it has? Of course not. (Again, Venezuela.) What makes a nation wealthy are things like natural resources, a robust and fair rule of law, the level of education of its people, and the robust functioning of a range of institutions, whether they be governmental, corporate, non-profit, or social. Some of these institutions don’t require money to operate, but for many institutions (particularly companies), money is their lifeblood. Money is what keeps people showing up and working together towards some productive enterprise. Without money the people will stop showing up, and they’ll never reassemble again.

And so we get to the crisis at hand… a crisis that requires us, for a period of time to not show up. If the crisis is left to rage, untold number of businesses will run out of money, lay everyone off, and it will be virtually impossible to put them back together. As such, money isn’t a scorekeeping device, but a relationship-preserving device or institution-preserving device. And, for at least a temporary period, simply creating money out of thin air can preserve socially productive relationships.

The new stimulus bill contains $350 billion for aid to small businesses which employ an overwhelming number of Americans. That sounds like a lot of money, but if it’s not enough to prevent relationships of people from disintegrating and never returning, we’ll all be left unimaginably poorer.

The public health policy response

While Wall Street analysts focus mainly on the monetary and fiscal response to the crisis, the public health response is equally important because it affects the quality and supply of labor. Without labor, the economy loses a key factor of production.

President Trump caused an uproar last week when he suggested that he wanted to dismantle the country-wide shutdown by Easter, or April 12. What was less well-known is a Fox Business report indicating that Trump walked back his desire to re-open the economy by Easter based on pressure from business executives. He has since replaced his Easter re-opening desire with an initiative to label different regions of the country high, medium, and low risk as part of new federal guidelines for states to decide on how to manage their social distancing policies.

Much depends on the trajectory of public health policy, and the evolution of the pandemic within US borders. The prognosis is not good. The US case growth rate is well ahead of other countries in a similar stage of infection. As the count is based on confirmed cases, there is undercounting because of a shortage of testing facilities. Any initiative to reduce the length of the shutdown risks a sudden acceleration of case growth that overwhelms hospital bed capacity and recreate the scenes in Northern Italy throughout the US.

Any effort to shorten the lockdown period risks a second wave of infections. There have been numerous instances of a second outbreak wave as people let down their guards. Science News documented a double peak in the bird flu.

There was a similar incidence of a second wave of H1N1 infections (via PLOS).

The CDC also reported three waves of Spanish Flu infections in the US.

China and Hong Kong are already reporting new incidences of COVID-19 cases from travelers. One interesting parallel for the US might be Iran, both of whose reactions to COVID-19 were late. The Economist described the regimes’s fumbled response to the pandemic. It first ignored the problem, then tried to ignore it by hushing up the death toll, and even rejected aid from Médecins Sans Frontières. The current response can best described as uneven:

The clerics claim they are doing a fine job. Iran has produced more face masks than Italy and tested more people than Britain. Military factories are now making personal protective equipment, oxygen canisters and hospital beds. The government has turned stadiums into isolation centres and increased the number of laboratories testing for the virus from two to almost 60. It has referred 62,000 people to health facilities. Volunteers are distributing hundreds of thousands of food parcels to those who cannot leave their homes. The effort is “unparalleled” in the Middle East—and even much of Europe—says an official at the who.

However, the government is doing little to stop the spread of the virus. Malls are still open. Parks are packed. Popular shrines have at last been closed. Nevertheless, many converged on the holy city of Mashhad for Nowruz, the Persian new-year festival, on March 20th. Hundreds jammed the streets of Tehran three days later to touch the coffin of a prominent soldier. On March 25th President Hassan Rouhani at last promised travel bans between cities, but he has dismissed calls to lock down the country. Other officials deflect blame. “A huge part of the danger Iranians face is due to the United States,” says Muhammad Javad Zarif, the foreign minister.

The rate of new cases seemed to plateau, but it recently accelerated again.

The number of deaths have also followed a similar pattern, which should rise in the near future as it follows the number of cases.

Another risk is the policy response from other countries. What if major trading partners decided that US public health policy poses too great a risk, and closed their borders to Americans, and US trade? A 2009 paper which modeled US border closure in response to a security threat answers that question. It’s not a pretty picture.

  • Cutting all imports by 95% with sticky real wages reduces GDP by 48%.
  • If critical energy imports exempted and real wage are flexible, GDP falls 11%.

A WSJ article provides a similar perspective from China, which had largely returned to work, but the economies of its key trading partners have slowed, which is creating a demand shock.

More than two months after imposing quarantines to counter the coronavirus, China is getting back to work. It is a slow and rocky process, one that rests on the world battling back successfully against the pandemic.

With new infections dwindling, factories are restarting, stores are reopening, and people are venturing outdoors. In some ways, China is where the U.S. and Europe hope to be within weeks or months.

Yet many Chinese factories find demand for their products has evaporated. Consumers in China and elsewhere are reluctant to spend over worries about what they have lost and what lies ahead.

For U.S. businesses tied to global trade, exporters and multinational companies, China’s limited return to normal foreshadows the potential for a sluggish U.S. recovery. Consumption, which makes up more than two-thirds of the American economy, looks to be hobbled by lost jobs, fallen income and diminished confidence for an unknown period. Even countries emerging from national lockdowns later than others will likely see weaker demand among trading partners also hurt.

I don’t mean to be all negative, all the time. Here are some mitigating factors that could improve the public health policy outlook, and improve the quality and availability of labor as a factor of production.

Some re-purposed drugs, such as anti-malaria medications hydroxychloroquine and chloroquine, or the anti-HIV medications Kaletra and Remdesivir, as well as the plasma of recovered patients, may be useful in treating COVID-19 victims. In addition, the Washington Post reported that the onset of warm and humid weather may slow the progress of the virus:

Multiple early studies provide evidence of statistical ties between temperature and humidity ranges and the geographic regions where this virus has thrived. While none of these studies has been peer-reviewed, they all point to the same general possibility: The pandemic could ease in parts of North America and Europe during the summer months, although it could then come roaring back in the fall.

Anthony S. Fauci, the director of the National Institute of Allergy and Infectious Diseases (NIAID) and a visible figure on the White House coronavirus task force, said at a Wednesday press briefing that a seasonal cycle to the pandemic is possible, perhaps even likely.

“… I think it very well might. And the reason I say that is that what we’re starting to see now in the Southern Hemisphere, in southern Africa and in the southern hemisphere countries, is that we’re having cases that are appearing as they go into their winter season. And if, in fact, they have a substantial outbreak, it will be inevitable that we need to be prepared, that we’ll get a cycle around the second time.”

These factors are all causes for cautious optimism. While neither the weather nor the re-purposed drugs represent any panaceas, they can buy some time for medical staff for a vaccine to be found and put into production, which is not likely to happen for another year, at the earliest.

Investment conclusions

I began this report to handicap the odds of a V-shaped recovery. As good students of of Economics 101 recall, the three factors of production are capital, land (rents), and labor. The current crisis has affected each of those factors in different ways, and the combination of monetary, fiscal, and public health policies also have different effects on each of the three factors.

So far, monetary and fiscal policy have bought time so that the economy can stabilize. However, the economy cannot fully recover without a healthy and productive labor force, which mainly depends on public health policy, and possibly a little luck from the weather and medical research. Just as Cheesecake Factory David Overton told landlords when the company would not pay its rent on April 1, “We simply cannot predict the extent or the duration of the current crisis”, there is too much uncertainty, and the jury is still out on the trajectory of the recovery.

That said, the stock market is forward-looking, and historical studies indicate that recessionary bear markets, which this is, tend to last much longer than non-recessionary bears. By implication, the recession is likely to last longer than the current consensus of a V-shaped rebound. As well, my own historical reviews of bear market bottoms since 1929 (see 2020 bounce = 1987, or 1929?) suggests that the current rally is a bear market rally. If history is any guide, the market will retrace the advance and return to retest the lows at some point in the future. There is no guarantee that the retest will be successful.

My base case scenario, based on an assessment of the fundamental risks and market history, calls for a long drawn out bottoming process of some unknown nature.

Please stay tuned tomorrow for our tactical trading analysis.

The makings of a primary low

Posted by Cam Hui -

Mid-week market update: Did the Economist do it again with another contrarian magazine cover indicator? At the top of the market, their issue cover was entitled “Big tech’s $2trn bull run”. Last weekend, their cover featured a “closed” sign on the earth.

The market staged an upside breakout through a falling trend line yesterday, and the upside held today. Notwithstanding the Bernie Sanders induced last hour weakness, it managed to put together two green days in a row, which has not happened since February 11-12. This market action has all the makings of a primary low.

The contrarian in me is worried. I am part of the consensus that this is a bear market rally, whose scenario calls for a retest of the lows, which may not necessarily be successful. What could possibly go wrong?

Historically bearish

The magnitude of yesterday’s gargantuan rally was last exceeded in 1933. Though the sample size is relatively small, Bespoke’s historical analysis of such episodes has not been friendly to the bulls.

The market action in 2008 did show three similar instances of large single-day gains, with mixed subsequent results.

Why I am leaning bullish

On the other hand, the short-term bull case is underpinned by improving internals, and favorable market positioning. The most bullish opens up the possibility is a V-shaped rebound, which would confound everyone expecting a bear market rally that stalls and retests the old lows. Yesterday’s rally started the clock a the Zweig Breadth Thrust (ZBT) buy signal. The ZBT Indicator recycled off its oversold reading, and it has nine more trading days to reach an overbought condition. If it does in the short time window, it would qualify as a ZBT buy signal indicating positive price momentum. While I am open to all possibilities, I am watching the indicator, but I am not holding my breath for that outcome.

As well, market internals have been turning up, even before the latest rally began. Factor returns, as measured by the high beta to low volatility pair trade, and Callum Thomas’ coronavirus pairs consisting of a cruise line (RCL) vs. a funeral home (SCI, but he really had to dig deep to find that pair), and global airlines (JETS) to Chinese healthcare (KURE), are all signaling a return of risk appetite.

In addition, Investors Intelligence sentiment is turning more constructive. The number of bears have finally spiked, and they now exceed bullish sentiment. These conditions form the prerequisite for a market bottom.

Don’t fight the Fed

The Heisenberg Report recently featured the analysis by Charlie McElligott at Nomura, which indicated that the Fed is effectively building a short volatility position in its book.

The Fed is “not just acting as liquidity-, short-term lending- and USD funding-provider of last resort, but also now as the ‘chief risk-taker and CIO’”, McElligott goes on to say, adding that as of Monday, the Fed resumed building a ‘short volatility’ position”.

McElliogott explained the Fed’s short vol trade as not only just supplying liquidity to the market, but trying to narrow credit spreads through their actions in the credit markets. This does not mean, however, that the Fed is actively trading equity volatility derivatives.

We actually see the Fed in the game of not simply suppressing the risk-free rate, and thus term premium, as they did last time, but now buying spread product (beyond MBS alone) with risk assets outright and through the new SPV, it’s reasonable to believe that investors will ‘reverse engineer’ the Jay Powell playbook noted above, and go with their muscle memory from [the] Fed ‘short volatility positioning’ prior conditioning

Indeed, something odd has been going on with volatility in the past few days. The VIX had been falling even as stock prices fell, which could indirectly be attributable to the Fed’s actions. In addition, one helpful sign for equity and risk appetite bulls is the recent collapse in UST volatility. It is difficult to envisage market stabilization without signs of falling volatility in the risk-free asset.

The Fed’s actions have been mostly successful in stabilizing the credit markets. Do you want to fight the Fed?

Lastly, Goldman Sachs estimates that pension funds need to buy $214 billion in equities as part of their month and quarter end rebalancing, which should put a bid in the equity market starting next week.

My inner investor remains defensively positioned. Subscribers received an email alert yesterday that my inner trader had dipped my toe in on the long side. Initial resistance can be found at about 2650, and secondary resistance at about 2790.

The next test of market psychology will occur tomorrow morning with the closely watched initial jobless claims report. There have been numerous reports of surges of jobless claims all over the country, to the extent that state websites are crashing from the load. Initial claims are expected to explode to between 2 and 3 million. Bloomberg reported that unemployment claims spike to 929,000 in Canada. Given the roughly 10 to 1 ratio in population, this translates to 9 million in initial claims, so be prepared for an upside surprise. I will be closely watching this report, and the subsequent market reaction.

Disclosure: Long SPXL

Where to hide in this bear market

Posted by Cam Hui -

There is little doubt that we are in a recession induced bear market. Goldman Sachs published their GDP forecast late last week of a V-shaped slowdown and recovery.

For some context, New Deal democrat raised an important point about a framework for thinking about the recession by flipping the well-known “flatten the curve” chart upside down:

The problem with this from a strictly *economic* point of view is that, so long as we don’t know who is infectious, everybody needs to stay in self-quarantine. This will be catastrophic economically if it must continue for 12 to 18 months.

The inverted curve shows the stylized effects of economic growth based on a government’s choice of public health policy. Do nothing and allow the virus to run wild, and you get a short, sharp slowdown at great human and electoral cost (pink curve). Flatten the curve, and you get a lower death count but longer recession (grey curve), with the hope that a vaccine can be found in the future to cut off the right tail. For an idea of how the Trump White House is grappling with this dilemma, see the WSJ‘s “As Economic Toll Mounts, Nation Ponders the Trade-offs”, and Bloomberg‘s “Trump Weighs Easing Stay-at-Home Advice to Curb Economic Rout”.

Even the experts are only guessing. FiveThirtyEight conducted a survey of infectious diseases experts, and the poll showed wildly varying opinions. Since we know neither the depth nor the length of the slowdown, it’s very difficult to estimate the nature of the recession, and the equity bear market. In that case, where can investors hide?

Time for gold to shine?

The classic hedge against an equity decline is gold, and this may be the time for bullion to shine. Mark Hulbert recently highlighted signs of growing despondency among gold market timers, which is a contrarian bullish indicator for the gold price.

The technical picture confirms Hulbert’s conclusions. The % bullish of stocks in GDM (the index underlying the gold stock ETF GDX), has fallen to a level that has signaled low risk entry points in the past. This signal has worked well in gold bulls, but it’s less effective in bear markets.

I would warn, however, that any allocation to gold should be only tactical in nature. Gold does not perform well in a deflationary recessionary environment. While the tsunami of monetary and (hoped for) fiscal stimulus is theoretically inflationary, the authorities would undoubtedly welcome such a problem. Bond market inflationary expectations are falling on a daily basis, so don’t count on inflation bailing out a long-term commitment to gold. Any commitment should be regarded as a trading position, not an investing position.

US investors

For investors who must hold some US equities by mandate, here is where you can find some outperformers. The analysis of relative strength by market cap groupings tells a clear story of megacap and NASDAQ leadership.

An analysis of the top five sectors reveal two clear winners. Technology stocks have been in a steady relative uptrend, as investors believe that they are the least affected by the COVID-19 pandemic. Healthcare is another winner, which is an obvious choice under the circumstances. The other sectors are either too volatile, or exhibiting overly bearish patterns to be considered.

Putting it another way, it has been large cap growth that has been driving equity performance. While both large and small cap growth has been beating their value counterparts, small caps, and even small cap growth have dramatically lagged global stocks, as measured by the MSCI All-Country World Index (ACWI).

Contrarian investors can consider Berkshire Hathaway. Regular readers know that my main focus is on top-down analysis, and I hesitate to analyze single companies. However, I can’t help but wonder about Berkshire Hathaway, which has been accumulating a big pile of cash. Warren Buffett has shown a historical tendency to be ready to use his cash for the right investment at distressed prices when the right opportunity presents itself.

The stock has fallen, but it beat the market during the latest rout.

Non-US markets

For non-US markets, I turn to Star Capital‘s analysis of Shiller CAPE. Despite its faults, CAPE has shown to be an effective tool to spot cheap national markets (see Meb Faber’s research).

Here are the results by country. Note that the US is the fourth most expensive market.

Some of the countries in the cheap zone, such as Czechia and Poland, do not have US-listed country ETFs. Shown below are the relative returns of selected countries compared to then ACWI in the cheap region.

Here are my main takeaways from this analysis:

  • Russia and Turkey are the “hold your nose and buy” contrarian value plays. They could be interesting for a patient value investor, as these markets are nearing long-term relative support, indicating low relative strength risk.
  • Spain is statistically cheap, but it should probably be avoided as value trap as it struggles with the COVID-19 pandemic.
  • The Asian markets offer some potential. The Asian countries shown in the chart have emerged after their successful battles with COVID-19. While Singapore remains in a relative downtrend, the Hong Kong and Korean markets offer some potential. Hong Kong is already exhibiting some relative strength. The Korean market is testing relative support. Combined with its impressive efforts at controlling its COVID-19 epidemic and its proximity to a recovering China, South Korea offers potential for outperformance.
  • The US market is still expensive, as shown by this chart from Callum Thomas of Topdown Charts.

I would be remiss if I did not mention the pure price momentum plays internationally. China and Japan have been surging as their COVID-19 epidemics have come under control. From a technical perspective, however, they appear to be highly extended and ripe for setbacks. Momentum traders can consider buying them on pullbacks.

As well, I am worried about possible cracks in the Chinese financial system despite their massive stimulus and signs of economic normalization. The highly leveraged property market is a source of concern. Bellwether China Evergrande skidded -17% overnight and violated multi-year support, indicating a rising stress levels among developers.

The charts of other property developers appear serious, but less dire. China Vanke fell -7% overnight, breached short-term support, and it is now testing long-term support.

Country Garden Holdings fell -8% overnight, and it is testing a key support level. These price breakdowns are part of a disturbing pattern and represents a key risk for China that investors need to keep an eye on.

In summary, there are few places to hide for equity investors focused on absolute returns. Stocks fall in a bear market. Gold can provide a temporary hedge against falling equities. However, there are pockets of opportunity for investors who want to be exposed to equity risk. US-focused equity investors can focus on large cap growth, and Technology and Healthcare in particular. Value investors may want to consider Buffett’s Berkshire Hathaway, which has a huge cash horde ready for opportunistic investment. For investors who can roam globally, Russia and Turkey are the contrarian value plays, while Hong Kong and Korea are the cheap markets exhibiting potential upside momentum.

Disclosure: Long EWH, EWY