A valuation puzzle: Why are stocks so strong?

Posted by Cam Hui -

One of the investment puzzles of 2020 is the stock market’s behavior. In the face of the worst global economic downturn since the Great Depression, why haven’t stock prices fallen further? Investors saw a brief panic in February and March, and the S&P 500 has recovered and even made an all-time high in early September. As a consequence, valuations have become more elevated.
 

 

One common explanation is the unprecedented level of support from central banks around the world. Interest rates have fallen, and all major central banks have engaged in some form of quantitative easing. Let’s revisit the equity valuation question, and determine the future outlook for equity prices.

 

 

Three explanations

I offer three separate and distinct explanations for why equity prices haven’t tanked. The first is from the BDO June 2020 publication, “The Path Ahead, Analysis of Analyst Estimates for Insights on the Economic Recovery”. In that analysis, the BDO team analyzed over 20,000 equity analyst estimates for 428 public companies across 24 industries for the period ending May 31, 2020.

 

The consensus called for a U-shaped recovery. The aggregated data indicated a steeper and longer downturn in sales and earnings. However, the stock market went in a different direction by recovering quickly from its bearish episode. The following chart shows the percentage estimated change in 2020 EBIT and long-term EBIT from March 31, 2020 to May 31, 2020, and the change in total enterprise value (TEV = equity market cap + debt – cash) over the same period.

 

 

The BDO team went on to study relative performance by industry by analyzing relative TEV change against changes in estimated EBIT. The analysis of 2020 estimate EBIT changes showed a relatively tight fit between changes in TEV and EBIT. 

 

 

The analysis of TEV changes against long-term EBIT estimates showed a looser fit, indicating that the market was focused more on short-term EBIT estimates than long-term ones. That’s not an unexpected result. Investors tend to focus more on the short-term in a market panic.

 

The BDO study answered one part of the question. The market was reacting rationally, at least on a relative basis. Industries that were expected to lag underperformed, and industries that were less affected by the pandemic outperformed.

 

 

BIS: Insights from dividend futures

While the BDO analysis satisfied the questions about the effects of relative performance, what about absolute performance? Why haven’t stock prices weakened further in the face of the economic shock from the pandemic.

 

A Bank of International Settlement (BIS) quarterly review published on September 14, 2020, “Markets rise despite subdued economic recovery”, provided an answer. BIS began with addressing the puzzle of stock market behavior.
 

Financial markets recorded further gains during the review period, despite the challenging macroeconomic outlook. A divergence emerged between, on the one hand, elevated stock valuations and tightening credit spreads and, on the other, the reality of an economic recovery that looked incomplete and fragile. While investors did differentiate across sectors, rewarding technology stocks in particular, they seemed to be comforted overall by a stream of economic indicators that turned out better than feared. An accommodating monetary policy stance and news about new fiscal programmes in some jurisdictions also provided critical support for asset prices.

 

Stock markets overall saw a notable rise between July and early September. After recording strong returns in April and May, equity prices moved largely sideways in June but resumed their ascent thereafter. The gains were largest in the United States and China, whose main equity benchmarks by August had surpassed their pre-pandemic valuations, which had already carried signs of overheating (Graph 1, first panel). While other AE and EME stock indices recouped much of their March losses, they still remained some 10% below previous highs. A sell-off at the end of review period cut some of the early gains, particularly in the technology sector.

As part of the BIS study, Fernando Avalos and Dora Xia analyzed dividend futures on the S&P 500 and the Euro Stoxx 50 Index. Finance theory of discounted cash flows hold that equity prices is the sum of all future dividend payments, which are proxies for investor expectations of the fundamentals of individual companies in the respective stock indices.

Avalos and Xia found these dividend futures expiring in 2024 have rebounded strongly from the March bottom than contracts that expire in 2020. While 2020 is expected to be difficult, the long-term corporate earnings outlook isn’t expected to be as bad.
 

 

Avalos and Xia went on to observe that rates have plunged, the net present value of the 2024 dividends are worth much more than the pre-crisis period. Therefore the recovery in stock prices can be attributed to the combination of a strong rebound in long-term expected dividends, and falling interest rates. Had rates remained the same, valuations may be over 15% less than they are now.
 

While the authors don’t directly address the issue, this analytical framework also explains why growth stocks have handily beaten value stocks during the study period. Growth stocks normally don’t pay dividends, and finance theory holds that most of their value comes from their expected corporate value at a far off time in the future. This makes the duration of growth stocks higher than value stocks. (For the uninitiated, duration measures the sensitivity of an asset to interest rates. The longer the duration, the more sensitive the price is to interest rate movements.)
 

Indeed, the forward P/E ratio of FAAMG stocks have diverged from the rest of the S&P 500 far more in 2020 than the pre-crisis era.
 

 

While the BIS approach of studying dividend futures is useful from a finance theory viewpoint, it is unsatisfying from real-time investors’ perspective. Analysis from Goldman Sachs indicate that forward P/E ratios are relatively insensitive to differing inflation regimes – and inflation is a major determinant of interest rates.
 

 

 

Upside-down markets

A third, and more detailed, explanation of market conditions in 2020 comes from the writer under the pseudonym Jesse Livermore. Jesse Livermore has penned a number of very detailed and cogent analysis in the past, and the latest is no different. His latest Opus, “Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes”, was published by O’Shaughnessy Asset Management. The paper is long and extensive at over 40,000 words. He begins by describing an upside-down market:

An upside-down market is a market in which good news functions as bad news and bad news functions as good news. The force that turns markets upside-down is policy. News, good or bad, triggers a countervailing policy response with effects that outweigh the original implications of the news itself.

Here is a stylized though radical example of the events of 2020, though COVID-19 is not incurable and won’t last forever.

To illustrate with a concrete example, imagine a policy regime in which U.S. congressional lawmakers, acting with the support of the Federal Reserve (“Fed”), set a 5% nominal growth target for the U.S. economy. They pledge to do “whatever it takes” from a fiscal perspective to reach that target, including driving up the inflation rate, if the economy’s real growth rate fails to keep up. Suppose that under this policy regime, the economy gets hit with a contagious, lethal, incurable virus that forces everyone to aggressively socially distance, not just for several months, but forever. The emergence of such a virus would obviously be terrible news for humanity.

He went on to describe the economy, and the subsequent policy response.

The virus would force the economy to undertake a permanent reorganization away from activities that involve close human contact and towards activities that are compatible with social distancing. Economically, the reorganization would be excruciating, bringing about enormous levels of unemployment and bankruptcy. But remember that Congress is in-play. To reach its promised 5% nominal growth target, it would inject massive amounts of fiscal stimulus into the economy—whatever amount is needed to ensure that this year’s spending exceeds last year’s spending by the targeted 5%. To support the effort, the Fed would cut interest rates to zero, or maybe even below zero, provoking a buying frenzy among investors seeking to escape the guaranteed losses of cash positions.

The result would be bullish for equity prices, despite the horrible news about the economy.

If you are a diversified equity investor in this scenario, you will end up with a windfall on all fronts. Your equity holdings will be more attractive from a relative yield perspective, more scarce from a supply perspective, and more profitable from an earnings perspective. The bad news won’t just be good news, it will be fantastic news, as twisted as that might sound.

The rest of the paper takes a detailed journey through the drivers of corporate profitability, inflation, the interaction between fiscal and monetary policy, and equity valuation. He concluded that valuation equilibrium is unstable, and therefore equity prices could experience significant volatility [emphasis added].

Imagine that you are in a two-asset market where one asset, cash, earns nothing forever, and the other asset, an equity stream, earns $1 a year forever, with a portion of that amount paid out as a dividend and a portion reinvested to generate future growth. If you buy the equity stream for $10—an earnings yield of 10%—and the enthusiasm of buyers subsequently wanes, you won’t need to sell at a loss. If the price falls, it’s not a big deal, because the 10% yield that you be will earning on the investment is intrinsically worth the temporary loss of access to your money. All you will have to do is wait and let the earnings accumulate, either as dividends that get paid out to you or as investments that compound. Over the long-term, you will end up doing very well, regardless of where the market decides to take the price.
 

But now suppose that the price gets pushed up in a TINA chase to $100—an earnings yield of 1%. If you buy at that price, you’re going to have to remain laser-focused on the market’s subsequent response, keeping the position on a short leash and rapidly exiting if buyer enthusiasm starts to wane, because the 1% earnings yield that you’re going to be accruing is nowhere near enough to compensate you for the loss of access to your money, which is what you will have to endure if the price falls appreciably from where it currently is. If the market decides that it wants to assign a 20 P/E ratio to the security instead of a 100 P/E ratio, the price is going to fall by 80%. You’re going to have to wait a full 80 years to get your money back in earnings. Will the wait be worth the 1% spread over cash that you will have locked in? Absolutely not, which is why you’re going to have to pay close attention and make sure that you don’t get stuck in that kind of a situation.
 

In the same way that you are going to be more sensitive to drawdown risk as a buyer at elevated valuations, everyone else in the market is going to be more sensitive as well, which will make the prices themselves more sensitive, and the investments more risky.
 

Ultimately, the only way that a market can be stable is if everyone is more-or-less happy with what they are holding—willing to transact, but not feeling an urgent need to do so. In the hypothetical market above, is it going to be possible for everyone to be happy with what they are holding? Definitely not. If the equity price in that market is stable or rising, the underinvested individuals earning nothing in cash are going to be unhappy. They will want more equity and will chase prices higher until some counterbalancing disincentive emerges to discourage them, such as the disincentive of a needy, shaky, creaky market that looks and feels more expensive than it deserves to be. If the equity price is falling, then overinvested individuals taking losses in equities will be unhappy, and will chase prices lower in pursuit of the safety of cash, until prices get cheap enough to make the securities attractive as investments for their own sake, because the underlying cash flows are attractive, regardless of the price that they can be sold for.
 

In the end, TINA markets are guaranteed to be difficult and frustrating for large numbers of people. The problem of how to properly invest in them has no easy solution. Chasing ultra-expensive assets, nervously supervising them in the hopes that you haven’t top-ticked them, is stressful and unpleasant. But so is waiting on the sidelines earning negative real returns while everyone else makes money. Time is not on your side in that effort.

Based on the assumption that investors just want to maintain the pre-crisis allocations irrespective of valuation, he arrived at an S&P 500 target of 3900.

Returning to the subject of the current equity market, on the assumption that investors display zero sensitivity to valuation and invest entirely based on a pre-determined asset allocation preference, we can quantify the exact impact that the COVID-19 deficits would be expected to have on prices, if they found their way into markets. We simply assume that investors would bid up on the price of equity until their pre-pandemic allocation to equity was restored. To restore that allocation amid the COVID-19 debt issuance, the market would have to rise by roughly 18%, from its price at the time of the writing of this piece, roughly 3327, to a final price of roughly 3900, a forward 2-yr GAAP price-earnings ratio of 26 times.

The S&P 500 target of 3900 is a best case analysis based on the assumption that investors are totally price insensitive and just want to maintain their asset allocations. Jesse Livermore went on to consider the question of relative valuation a Twitter thread. He began by explaining his analytical framework using a chart of past returns by major developed market region and style.

 

Stock returns by category from Dec 1976 to Dec 2019 for MSCI US, Japan, Europe ex-UK and UK indices, each separated into growth, broad market and value. Description and discussion below, to include charts of different sub-periods. Empty black boxes represent total returns, colored columns represent fundamental returns (annualized dividend growth w/ all dividend payouts recast as share buybacks). When a box is higher (lower) than a column, it means the category grew more expensive (cheaper) over the period.

He qualified the analysis by point out that Japanese fundamental improvement is distorted by the effects of Abemomics.

The depicted fundamental performance for Japan is distorted by the dividend payout ratio increases associated with Abenomics. If we were to measure growth in Japanese fundamentals using other aggregates (sales, earnings, etc.), the growth would not have been as strong.

 

 

Since this technique does not account for starting valuation, it`s best to examine returns on a peak-to-peak basis. Here is the performance from the pre-GFC peak in 2007 to December 2019. While the US outeperformed and stock prices moved roughly in line with their fundamentals, the rest of the world lagged while their fundamentals (colored bars) improved more than prices (black boxes). In other words, the rest of the world became cheaper over this period.

 

 

Jesse Livermore went on to pose the question, “DM rates are expected to remain at or below zero for a very long time. The question arises, how should equities be valued in such a world?” From that perspective, non-US equities appear to be very attractive. You have “high equity yields against zero or negative rates”.

 

He went on to focus on one especially alarming chart, the period from December 2017 to August 2020 with the observation that everything is becoming expensive, “Empty positive boxes, with no color inside them, are bad. Things are getting more expensive”. In particular, he found that US growth is especially vulnerable to drawdown.

I find this chart alarming. For US growth, you have ~22% annualized total return with only ~1% of that coming from fundamentals, the rest from valuation expansion.

 

 

 

The valuation question

In conclusion, what have we learned from a survey of three approaches to equity and valuation analysis? We can conclude that:
  • From BDO: The market was reacting rationally on a relative valuation basis.
  • From BIS: The discounted value of dividend futures revealed that long-term cash flows had recovered, and lower interest rates boosted valuation. However, there may be some limits to the forward P/E to interest rate trade-off as forward P/E ratios have been relatively insensitive to low inflation and interest rates.
  • From Jesse Livermore: Good news can be bad news, and vice versa, in the current fiscal and monetary policy environment. The best case analysis of the S&P 500 results in a target price of 3900. Moreover, US equities, and growth equities in particular, are overvalued compared to US value and the rest of the world.
The S&P 500 is trading at a forward P/E ratio of 21.9, which is well ahead of its 5 and 10 year averages. In light of the BIS analysis, the forward P/E ratio of about 13 reached during the March low represents a reasonable level of bottom of cycle valuation in light of the lower interest rate regime. 

 

 

Investors who missed buying the March low may find a second chance in the near future. From a technical perspective, past recession related equity bear markets have seen an initial low, followed by one or more re-tests of the first low. In some cases, the re-test was unsuccessful and the S&P 500 fell to a lower low before launching into a fresh bull. The time between the first and final low can be as long as over a year. Will 2020 be any different?

 

 

No matter how the fundamental develop, the S&P 500 and US growth stocks have low upside potential compared to value stocks, and other developed market equities.

 

Out of the woods?

Posted by Cam Hui -

Mid-week market update: As President Trump left the hospital and returned to the White House, the message from his doctors was he was doing fine, but he was not “out of the woods”. Numerous outside physicians have made the point that COVID-19 is nothing like the flu. Flu symptoms hit the patient and eventually dissipate and go away. COVID-19 patients often have ups and downs in their infection. They may feel fine, but symptoms flare, dissipate, and return. The process can last weeks, even months. Just because Trump reported feels fine now doesn’t mean that he won’t feel fine by this weekend.

Just like Trump’s COVID-19 infection, neither the equity bulls nor bears are out of the woods. Yesterday (Tuesday), Fed Chair Jerome Powell said in a speech that it was time to go big on fiscal stimulus:

The expansion is still far from complete. At this early stage, I would argue that the risks of policy intervention are still asymmetric. Too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses. Over time, household insolvencies and business bankruptcies would rise, harming the productive capacity of the economy, and holding back wage growth. By contrast, the risks of overdoing it seem, for now, to be smaller. Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.

The September FOMC minutes indicated a consensus that fiscal support is forthcoming, and the economy could tank without a rescue package.
Indeed, many participants noted that their economic outlook assumed additional fiscal support and that if future fiscal support was significantly smaller or arrived significantly later than they expected, the pace of the recovery could be slower than anticipated.
Trump tanked the market by tweeting that he was calling off the negotiations for a stimulus package. While he did tweet later that he was in favor of a standalone bill for a $1200 stimulus payment, his chief of staff Mark Meadows confirmed today that stimulus bill negotiations are dead.

 

 

 

Recovery not out of the woods

Trump’s political pivot to spending his political capital to confirm Judge Barrett to the Supreme Court means that, in all likelihood, there will be no stimulus package passed until February, which is after Inauguration Day and the new Congress is seated. 
Joe Wiesenthal at Bloomberg observed that the recovery in employment isn’t out of the woods either. He pointed out the recovery in jobs that employees can work from home (WFH) have plateaued, and likened these high paying jobs as a “longer-term bet on future business prospects” and “being akin to a capital investment”.
Looking further under the hood of the labor market reveals some other concerning signs. Jed Kolko, chief economist at at the job site Indeed, has been regularly tracking job openings by sector throughout this crisis. It’s notable which sectors are bouncing back, and which ones remain depressed. In areas like retail and construction, which temporarily were forced to shut down in the spring, positions continue to rapidly open up. But in areas such as banking, finance, and software development, job openings remain extremely depressed.
The split makes sense. A software development job isn’t the type of thing you just post one day because a business reopens after a lockdown. It represents some kind of longer-term bet on future business prospects. You can think of a software hire as as being akin to a capital investment. As such, this should raise some concerns about economic productivity going forward, if companies are spending less on long-term investment and projects now.

 

 

The delay in additional stimulus until February, at the earliest, could have a devastating impact on the economy.

 

 

Stock market in holding pattern

In the meantime, the stock market remains range-bound. The S&P 500 is overbought and testing overhead resistance while stuck in a narrow range. This kind of sideways consolidation pattern is not unusual in light of the the index violation of a rising trend line in early September. I am still waiting for either an upside breakout or downside breakdown.

 

 

A House report calling for antitrust investigation of Big Tech was not helpful to large cap NASDAQ 100 stocks either. This index is also testing overhead resistance, while at the same time its relative return is testing a key rising trend line.

 

 

The market was on the verge of a Zweig Breadth Thrust buy signal yesterday (Tuesday) until Trump’s tweet tanked the market. There is still a glimmer of hope for the bulls, as the last day of the ZBT window is tomorrow (Thursday).

 

 

The bears can point to continuing low short interest levels, which will not put a floor on the market should it weaken.

 

 

 

More choppiness ahead

Investors should brace for more choppiness and volatility. The latest update of option implied volatility is telling the same story of election anxiety. Implied volatility spikes in early November, and remains elevated until mid-December. The market is still anxious about the prospect of a contested election and post-electoral uncertainty.

 

 

While I am not fond of historical analogs, but this one opens the door to a test of the March lows in the near term.

 

 

There will undoubtedly be more October surprises. Prepare for more volatility.
Disclosure: Long SPXU

 

The more things change…

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.

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

 

Plus ça change…

The market was subjected to an unexpected shock late Thursday when President Trump announced that he had been diagnosed with a COVID-19 infection. What was unusual was the behavior of many market internals – they stayed the same.

 

Plus ça change, plus c’est la même chose. The more things change, the more they stay the same.

 

In light of this development, Trump is forced to quarantine and his campaign activities are suspended or curtailed. This creates a headwind for his electoral chances about a month ahead of the election. The betting odds on a Trump victory fell in the betting markets, but the overall Republican odds of a victory was steady as the odds on the Pence contract rose. Plus ça change, plus c’est la même chose. 

 

Equally puzzling was the behavior of risk. Prior to the news, the option market was discounting heightened odds of a disputed election. Average option implied volatility (IV) spiked just ahead of the November 3 election, and they remained elevated until mid-December. The shape of the implied volatility curve stayed the same after the news. Plus ça change, plus c’est la même chose. 

 

 

The technical behavior of the market was also relatively steady. Both the S&P 500 and NASDAQ 100 rallied last week and regained their respective 50 day moving average (dma) levels. Both indices remained range-bound for the week, bounded by a band of upside resistance and downside support.

 

 

 

A shift in sentiment

However, there were some key shifts in sentiment. While the shape of the option volatility curve was largely unchanged, there were differences between call option and put option IV. The spread between call and put option IV on September 24, 2020 was roughly zero across the board. Fast forward to October 2, and call option IV was higher (more expensive) than put option IV, indicating greater demand for calls than puts.

 

 

Does anyone remember the crowded short by large speculators in equity futures that everyone got excited about? SentimenTrader observed that the latest update shows that about two-thirds of the position was bought back last week.

 

 

Large speculators are still net short the NASDAQ 100 futures contract, but their exposure has been substantially reduced.

 

 

Commitment of Traders data is no longer extreme. The bulls can’t count on the Commitment of Traders data to put a floor on prices should the equity market weaken.

 

 

The week ahead

Looking to the week ahead, the market is retreating from an overbought condition. Barring any more unexpected surprises, equities should continue weaken in the early part of the week.

 

 

Tactically, both the S&P 500 and NASDAQ 100 are exhibiting price gaps begging to be filled on the hourly chart. While anything can happen, the aforementioned price differential between call and put options is contrarian bearish – at least in the short-term.

 

 

The two wildcards to my forecast are the ongoing negotiations between House Speaker Nancy Pelosi and Treasury Secretary Steve Mnuchin over a stimulus package, and how Trump,s diagnosis affects his ability to govern and campaign.

 

Pelosi’s negotiation intentions are unclear. Why are they even discussing a standalone airline relief bill, or any relief bill? I find it difficult to believe that it is to the Democrats’ advantage to pass any stimulus package at all. Trump and the Republicans appear to be on the ropes in the polls. The Democrat controlled House already passed a $2.2 trillion HEROS 2.0 Act last week, knowing full well that it would not be given assent in the Republican controlled Senate. The Democratic strategy was for lawmakers to return to the districts and campaign on the premise that they tried their best and blame the Republicans. There is little political incentive for Pelosi to work towards a compromise bill, which would benefit the Republicans if passed. Even if she could come to an agreement with Mnuchin, it is unclear whether the Republicans have the votes to pass such a bill in the Senate. Moreover, the Senate is going on hiatus until October 19 because of a COVID-19 outbreak. Why even make the effort at all? Regardless, a comprehensive rescue package would be a huge bullish surprise.

 

The other risk is President Trump’s prognosis, which could throw his electoral chances into further turmoil. Bob Wachter, the Chair of UCSF Medicine, gave a sobering analysis of Trump’s condition in a Twitter thread.

Now we’re down a bad loop of the algorithm: not only with symptoms, but symptoms (such as shortness of breath or cough) or signs (such as low oxygen) bad enough that his docs think he needs to be in the hospital. They wouldn’t do that if he only had a fever & muscle aches…

… It might mean he’s now sleepy or confused (25th Amendment!), or, more likely, short of breath, cough &/or low oxygen level, indicating lung involvement. Yes, the threshold to hospitalize the president is probably lower than for average person, but still – it’s not good.

And that it occurred the day after his first symptoms – whereas patients are often stable for 3-10 days before crashing – is worrisome.

The odds on the chart…are for all comers, not necessarily high-risk patients like Trump. At this point, his risk of death is >10%.

Trump’s symptoms puts him in one of the first two phases of COVID-19 treatment as depicted in the chart below. While he may only be in the first phase and the hospitalization decision is because of his position in the government, he is more likely in the second phase. Patients often show few symptoms when first afflicted, and their condition can deteriorate quickly soon afterwards. UK Prime Minister Boris Johnson was hospitalized as “a precautionary measure”. He went into ICU the next day and eventually came close to death. Even if everything goes well, expect Trump to be sidelined for a minimum of 10-14 days, which is a critical window for his election campaign. Can the Republicans make sufficient adjustments in light of the fact that both Trump’s campaign manager Bill Stepien and the RNC Chair Ronna McDaniel have been diagnosed with COVID-19?
 

 

My outlook remains unchanged from last week. My base case scenario calls for near-term volatility and choppiness until the election, with a bearish bias. 

 

Plus ça change, plus c’est la même chose. 

 

 

Disclosure: Long SPXU

 

Broken Trends: How the world changed

Posted by Cam Hui -

The world is changing, but it changed even before Trump’s COVID-19 news.
 

 

In the past few weeks, a couple of key macro trends have reversed themselves. The US Dollar, which large speculators had accumulated a crowded short position, stopped falling and began to turn up. In addition, inflation expectations, as measured by the 5×5 year forward, stopped rising and pulled back.
 

 

These developments have important implications for investors.
 

 

Rising USD = Risk-off

Let’s begin with the USD. The rising USD has put pressure on vulnerable emerging market economies. Indeed, USD strength has coincided with widening junk bond and EM bond spreads, which contributed to the risk-off tone in much of September.
 

 

Historically, weakness in EM currencies and EM bonds has been associated with a reduced equity risk appetite.
 

 

Robin Brooks, Chief Economist at IIF, believes that there are few reasons for the USD to fall further. G10 real rates are already down the most for the US. In addition, the US is reflating the fastest, which should lead to greenback strength, not weakness.
 

 

European stocks already look wobbly. The Euro STOXX 50 has violated both its 50 and 200 day moving average (dma) lines. The FTSE 100 and FTSE 200 are also weak, but the UK market is burdened by the latest Brexit drama, where the EU has charged London with violating its Withdrawal Agreement.
 

 

 

Cyclical rebound doubts

The second important global macro factor to consider is the retreat in inflation expectations. Implicitly, the market is pulling back on the consensus of a robust cyclical rebound. The Citigroup Economic Surprise Indices, which measures whether economic data is beating or missing expectations, are weakening from high levels in all major global regions.
 

 

The all-important cyclically sensitive industrial metal prices is also showing signs of weakness and they are pulling back.
 

 

Equally ominous is the behavior of copper, which is weakening in the face of a large speculator crowded long in the futures market.
 

 

In the US, the relative performance of cyclical industries presents a mixed bag. Homebuilding stocks are on fire, which is reflective of the strength in housing. However, other cyclical groups such as industrial, transportation, and leisure and entertainment stocks, are stalling at relative resistance zones and exhibiting signs of relative weakness.
 

 

Another sign of a stalling or flattening recovery can be found in earnings estimate revisions. FactSet reported that forward 12-month estimates edged down last week. This may be just a data blip, but it’s something to keep an eye on.
 

 

 

The Trend Model is bearish

Putting it all together, I interpret these conditions as signs of caution. There are three major trade blocs in the world. US growth is starting to stall as there are limits to what monetary policy can accomplish. The lack of further fiscal stimulus has the potential to snuff out a recovery. Across the Atlantic, the latest inflation figures came in below expectations. The ECB’s monetary policy response has not been as assertive as the Fed’s. In China, the recovery has been uneven and driven by the production and export sectors. The sustainability of China’s recovery is hampered by a lack of global demand. In addition, Chinese households have not participated in the recovery and their finances are strained, which is proving to be a drag on any consumer driven growth.

As a consequence, my Asset Allocation Trend Model signal has been downgraded from neutral to bearish. A simulation of actual Trend Model signals as applied to a simple over and underweight rules of 20% against a 60/40 benchmark has yielded equity-like returns with balanced fund-like risk.
 

 

For US equity investors, this suggests that growth stocks will continue to dominate value stocks, at least until the growth and cyclical jitters are over. In a growth starved world, investors tend to flock towards established growth names. Expect growth to dominate value, and large caps to dominate small caps.
 

 

I would be remiss without a discussion of the market’s anxiety over the prospect of a contested electoral results after the November 3 election. In the wake of Trump’s diagnosis, the betting odds of his victory fell on PredictIt, but the Pence odds rose about an equal level to compensate. As a consequence, the Republican odds of winning the Presidency was largely unchanged. What is remarkable is the market’s perception was also unchanged compared to readings from the previous week. Implied option volatility spikes in early November, and peaks out mid-December, and slowly falls afterwards.
 

 

While markets usually welcome divided governments, this may be an exception under the current circumstances. The Fed has made it clear that there are limits to what it can do, and monetary may be pushing on a string. Numerous Fed speakers have pleaded for a strong fiscal response. An electoral sweep by either Party can focus Washington on passing a stimulus package, while divided government has the potential to result in weaker fiscal action.

Investors should be cautious, until the results of the election become clearer.
 

Something for everyone

Posted by Cam Hui -

Mid-week market update: The Presidential Debate last night was painful to watch. After the debate, different broadcasters conducted instant polls of who won the debate. The CNN poll showed that 60% believed that Biden had won, and 29% thought that Trump had won. The Fox poll showed that 60% thought Trump had won, and 39% thought Biden had won.

Lol! There was something for everyone*.

In reality, the debate probably didn’t change many minds, and the market’s perception of electoral risk was also largely unchanged. My own survey of SPY’s at-the-money option implied volatility shows that while implied volatility had fallen, the shape of the curve is unchanged. The early November election spike is still there, and risk remains elevated until mid-December.
 

 

For equity traders focused on market direction, there is also something for both bulls and bears.
 

* Please think twice before posting political commentary in the comments section.
 

 

For the bulls

The bulls can point to several constructive developments. Both the S&P 500 and NASDAQ 100 have regained their respective 50 day moving average (dma) lines. In particular, the NASDAQ 100 rallied above its 50 dma and held the upside breakout for three days. In light of the large net short position in NASDAQ futures by hedge funds and CTAs, trend following models could force shorts to cover and push prices higher.
 

 

Another positive technical development is the ongoing bullish recycle of the daily stochastic off an oversold condition. This is a sign of bullish momentum that should propel prices higher.
 

 

There is also the lurking possibility of a Zweig Breadth Thrust buy signal. The market rallied off a ZBT oversold condition last Friday, and it has 10 trading days to become overbought to flash a ZBT buy signal. Today (Wednesday) is day 4. The bulls are ever hopeful.
 

 

 

For the bears

“Not so fast,” say the bears. The intermediate-term outlook is still unsettled.

One of the bottom spotting signals that I identified on Saturday (see How to spot the next market bottom) was a bearish sentiment capitulation. The latest update of Investors Intelligence sentiment shows that while %bulls have retreated and %bears have edged up, bearish sentiment is not at levels consistent with wash-out lows.
 

 

Similarly, the Fear & Greed Index is firmly in neutral territory. Durable market bottoms don’t look this way.
 

 

What about that bullish recycle of the daily stochastic? The weekly chart tells a different story of a bearish recycle. The intermediate term outlook is bearish, not bullish.
 

 

As well, Macro Charts pointed out that the volume of QQQ calls is still highly elevated, indicating either excessive bullishness, which is contrarian bearish, or signs of possible hedging activity that offsets the large short position in NASDAQ 100 futures.
 

 

Where does that leave us? I warned recently about the possibility of rising volatility, which is likely to persist until the November 3 election and possibly beyond. In the short-term, there is event risk, owing to excitement about a stimulus deal and Friday’s the September Jobs Report.

In the absence of a substantive development, such as an agreement on a fiscal stimulus package, I would expect further choppiness with a bearish bias until early November.

Disclosure: Long SPXU
 

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Fun with CoT data

Posted by Cam Hui -

There was some excitement last week when SentimenTrader wrote about the massive aggregate short by large speculators and CTA trend followers in equity futures. Conventional contrarian analysis would be bearish, but this is a lesson for traders and investors to look beneath the surface before jumping to conclusions.
 

 

 

Mitigating conditions

Here are some mitigating conditions to consider. Analysis from Callum Thomas revealed that, when normalized for open interest, the short position is not as extreme. Further analysis shows that large speculators were mostly correct in their positioning just before and during the Great Financial Crisis. This is a lesson not to be contrarian just for its own sake.
 

 

In addition, Goldman Sachs’ positioning studies show that investors, which include institutions, individuals, and foreign investors, are net long equities. Readings are falling from a crowded long and not extreme. These sentiment conditions are consistent with a market that is pulling back.
 

 

 

Cross-asset signals

If you are relying on Commitment of Traders (CoT) futures data to be contrarian, then what would you make of the massive USD short position (via Macro Charts)?
 

 

Large speculators are in a crowded USD short, and the USD Index has just staged an upside breakout from a narrow range and sparking a risk-off episode. The AUDJPY cross, which is a sensitive risk appetite foreign exchange indicator, is confirming the risk-off tone.
 

 

Taking a contrarian position based strictly on CoT data can lead you astray. How do you resolve the inherently contradictory positions of a massive equity short, which leads to risk-on positioning, and an equally massive USD short, which leads to a risk-off conclusion?

I interpret CoT data as trade setups, and not actionable trade signals. I prefer to look for crowded trades, combined with a trading catalyst. As an example, the crowded USD short and upside breakout leads me to adopt a risk-off tone. On the other hand, I am watching if the bulls can rally the NASDAQ 100 above its 50 day moving average. Most of the large speculator short positions are in the NDX, and a decisive upside breakout will lead to a short squeeze. Based on Monday’s close, the NDX has broken up through its 50 dma, though TRINQ shows no signs of panic buying. Trend following CTAs tend not to react instantly to breaches in key levels in order to minimize whipsaw. We will have to watch if the bulls can hold these levels over the next few days.
 

 

However, the market is overbought in the short-term. I will be closely watching the NDX, as well as the behavior of the currency markets in the next couple of days.
 

 

The jury is still out on question of whether today’s market action is the start of a pain trade for the bears, or a bull trap. Stay tuned.

Disclosure: Long SPXU
 

Time to de-risk

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 (downgrade)
  • Trading model: Bearish

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

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

 

Time to be cautious

This is an out-of-sample application of my Asset Allocation Trend Model signals to a model portfolio. If the Trend Model is bullish, the model portfolio will take a 80% position in SPY (stocks) and 20% position in IEF (bonds), neutral at 60% SPY and 40% IEF, and bearish at 40% SPY and 60% IEF. As the chart shows, the model portfolio has been able to achieve equity-like returns over the test period with balance fund-like risk.

 

 

The Trend Model’s signal was upgraded to neutral from bearish on May 15, 2020 and it has remained in neutral ever since. Recent developments have caused it to turn more cautious. Here is why.

 

 

A tour around the world

The Trend Model applies trend following principles to a variety of equity and commodity prices around the world. There have been numerous technical breakdowns that have sparked general risk-off conditions on a global basis. Let’s take a tour around the world and assess conditions.
Starting in the US, we can see that the S&P 500 and NASDAQ 100 have decisively breached their 50 day moving averages (dma). While the NASDAQ 100 is trying to consolidate sideways, the small cap S&P 600 is even weaker, as it is trading below both its 50 and 200 dma.

 

 

Across the Atlantic, the Euro STOXX 50 has also breached both its 50 and 200 dma. The other major core and peripheral stock markets are also showing signs of weakness.

 

 

Across the English Channel, both the large cap FTSE 100 and small cap FTSE 250 are showing signs of weakness. The relative performance of the FTSE 250 to FTSE 100 has pulled back to test a relative support level, largely over increasing anxiety about the collapse in Brexit talks.

 

 

Over in Asia, the performance of China and the markets of her major Asian trading partners are also weak. The Chinese stock market is dominated mainly by retail investors, who treat it like a casino. That’s why I focus mainly on the signals from the other Asian markets. All of them are showing differing signs of weakness. In particular, the downside support violations in Hong Kong and Taiwan are especially ominous.

 

 

Cracks are showing up again in the mountain of debt in China. The plight of China’s largest property developer, China Evergrande, may be the canary in the Chinese coalmine. Reuters reported that Evergrande, which is highly indebted, pleaded with local authorities for debt support:

The time has come for China to confront a too-big-to-fail quandary. In a letter to local government officials, highly indebted property developer China Evergrande contends that if it doesn’t secure approval soon for its reverse merger plan, it will wreak widespread havoc. Although the company says the missive is fake, the questions in it regarding systemic risk are real for investors and Beijing.

Evergrande beseeched officials in its home province of Guangdong for assistance with a so-called back-door listing, according to a copy of the Aug. 24 letter, whose authenticity was confirmed by Reuters sources. The idea, first proposed as part of an October 2016 restructuring, was for subsidiary Hengda to combine with a publicly traded state developer. If the deal doesn’t happen by January 2021, a group of investors can demand repayment of some 144 billion yuan, or about $21 billion, all of Evergrande’s cash as of June 30.

 

 

The one bright spot in Asia is Japan. The Nikkei Index price pattern remains constructive. However, there are three major trading blocs in the world, anchored by the US, Europe, and China. Japan is becoming a peripheral player from a global perspective.

 

 

Commodity prices can also be an important signal of global reflation or deflation. The message from commodities is one of caution. The Invesco-DB Commodity Index, as represented by the ETF DBC, has breached both its 50 and 200 dma. Gold prices have weakened in response to falling inflation expectations as hope fades for a fiscal response from Congress. The cyclically sensitive copper price has retreated to test its 50 dma.

 

 

 

A change in tone

The tone of the market seems to be changing, and such changes are often characterized by a shift in leadership. The old leadership is faltering, but no new market leaders have emerged. 
From a global perspective, the old US leadership has plateaued and begun to trade sideways (top panel), but none of the other major regions have emerged to be the new market leaders.

 

 

From a trend following viewpoint, these are all signs of a change in global trends. Coupled with a general weak tone in global equity and commodity prices, it is time for asset allocators to adopt a more cautious tone and de-risk portfolios. This cautious signal is also consistent with my past observation of a bearish 14-month RSI negative divergence in the Wilshire 5000, just after it flashed a bullish MACD buy signal. As a reminder, the last RSI divergence sell signal occurred in August 2018 (see Market top ahead? My inner investor turns cautious), which resolved with a mini-bear market that ended with the Christmas Eve panic of 2018.

 

 

The key risk to the bearish call is that the Trend Model is already too late in its cautiousness. SentimenTrader pointed out that large speculators and trend following CTAs are already in a crowded short in equity futures, which is contrarian bullish. 

 

 

However, analysis from Callum Thomas showed that when futures positions are normalized for open interest, the net short speculative position isn’t as severe. In fact, large speculators were correct in their positioning at market extremes during and before the GFC.

 

 

\_(ツ)_/¯

 

Trend following models, by their nature, are slow to react to trends. They tend to be late, and they will never get you in and out at the exact top and bottom. This is a feature and not a bug. Investors therefore need to be prepared for relief rallies in the short run. Nothing goes up or down in a straight line.

 

 

The week ahead

The market faces a critical technical test early in the week. The market leadership NASDAQ 100 is testing overhead resistance at the 50 dma. The bulls need to demonstrate some momentum to show that they are regaining control of the tape. The bears need to hold the line at the 50 dma, and preferably to push relative returns below the rising trend line.

 

 

The bulls will have a tough task ahead of them. The market is already overbought on the percentage of NDX stocks above their 5 dma. 

 

 

The percentage of NDX above their 10 dma remains in a falling channel of lower lows and lower highs. A decisive upside breakout will be a positive development.

 

 

In terms of event risk, we have the first scheduled debate between Biden and Trump on Tuesday, September 29. As there are very few undecided voters in this polarized electorate, the debate is unlikely to move the needle, but there is always the possibility of a stumble by one or both candidates. In addition, there is a flood of Fed speakers, and the September Jobs Report is due on Friday.

 

In conclusion, a review of global equity and commodity markets reveals a growing risk-off trend, which is a signal for investors to be more cautious in their asset allocation. This bearish signal is confirmed by a monthly RSI negative divergence sell signal that was triggered in August 2018, just before the market fell by -20% into the Christmas Eve panic bottom of that year. In the short run, the market may be too stretched to the downside, and a relief rally is always possible. Nothing goes up or down in a straight line but the risk/reward is tilted to the downside.

 

Disclosure: Long SPXU

 

How to spot the next market bottom

Posted by Cam Hui -

RealMoney columnist Helene Meisler asked rhetorically in an article where her readers thought we are in the equity sentiment cycle. She concluded that the market is in the “subtle warning” phase, though she would allow that the “overt warning” phase was also possible.
 

 

I agree. This retreat is acting like the start of a major pullback. The S&P 500 recently violated its 50 day moving average (dma). Past major pullbacks that began with 50 dma breaks were marked by the percent of S&P 500 bullish on point and figure charts plunging below 50%. To be sure, this does not assure us of a significant downturn, though it represents a sufficient though not necessary condition for one.
 

 

Two weeks ago, I discussed the magnitude of market weakness (see How far can the market fall?), with the caveat that those were not targets, but estimates of downside potential. This week, I outline some techniques on how to spot a market bottom.
 

 

The retreat is only starting

Evidence is gathering that the market weakness is only starting. From a top-down perspective, the Citigroup US Economic Surprise Index, which measures whether economic data is beating or missing expectations, has topped out and it is rolling over.
 

 

JPMorgan equity strategists pointed out that earnings estimates, are also weakening after peaking out, especially in the US.
 

 

BoA reported that its private client holdings survey of cyclical optimism has peaked out and weakening.
 

 

Equally worrisome is the strength of the USD Index. The USD has been inversely correlated with the S&P 500 since the March low. Moreover, the AUDJPY exchange rate, which is another key foreign exchange risk appetite indicator, is weakening.
 

 

Arguably, USD strength is a sign that the market is growing concerned about the waning growth outlook. In addition, the appearance of a second pandemic wave in Europe has created doubts about the durability of a global cyclical rebound. Consequently, gold prices, which tend to be inversely correlated to the USD, have retreated below an important resistance turned support level, and the inflation expectations ETF was rejected at a falling trend line.
 

 

The market appears to be setting up for a prolonged period of heightened volatility. My survey of SPY at-the-money option pricing shows that implied volatility remains high and peaks out in mid-December, which is well after the election.
 

 

With Joe Biden ahead in the polls, the market is positioning for a loss by the incumbent, though we may get more clarity after next week’s debate. While the economy is not the only variable that affect voter intentions, this JPMorgan analysis shows a correlation between Trump support and employment levels, with key swing states highlighted. As the cyclical outlook weakens, this will creates headwinds for Trump.
 

 

Ed Clissold of Ned Davis Research reported that incumbent Republican losses have historically been unfriendly to equity prices.
 

 

In the year after the election, the stock market has historically not bottomed out until early March in years when the incumbent Republican loses the White House.
 

 

As the large cap NASDAQ leadership breaks down after a terrific run, investors are reminded to heed the following Bob Farrell’s Rules of Investing:

  • Rule #2: “Excesses in one direction will lead to an opposite excess in the other direction”; and
  • Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.

 

 

The combination of technical breakdowns in large cap NASDAQ stocks, retreating cross-asset risk appetite, and nervousness over the election is setting up for a significant drawdown in equity prices over the next few weeks and months.
 

 

Spotting the market bottom

With that preface, here are some signposts of a durable market bottom. These are intermediate term timing indicators. They will not pinpoint the precise bottom, but they will identify attractive levels to be buying. I don’t expect that they will all flash buy signals simultaneously, but a majority should be bullish at a market bottom.

The first is insider buying. This group of “smart investors” have tended to be relatively prescient at market bottoms, though they can be early. Normally, insider selling swamps buying activity. I would look for clusters of insider buying that exceed selling.
 

 

The one caveat about insider activity signals is they are not precise market timing indicators. Insiders were early at the bottom in 2008-09, and they began buying in late 2008 ahead of the final bottom in March 2009.
 

 

Where are we now? There are no signs of feverish insider buying. Instead, Bloomberg reported a flood of insider sales.

Corporate executives and officers at S&P 500 companies were busy unloading shares of their own firms over the last four weeks. The selling picked up so much versus buying that a measure of insider velocity tracked by Sundial Capital Research pointed to the fastest exit from stocks since 2012.

 

 

The second class of bottom spotting indicators is investor sentiment. Sentiment surveys, such as Investors Intelligence, have generally not recycled to a bearish extreme. While the recent decline in bullishness is constructive, I would like to see bearish sentiment soar. In the past, durable market bottoms have not been formed without a spike in bearishness.
 

 

Lastly, I am also watching for signs of an intermediate term oversold extrme. In the past, the combination of an oversold condition in the Zweig Breadth Thrust Indicator (ZBT) and a negative reading in the NYSE McClellan Summation Index (NYSI) has been reasonably a good signal of an intermediate term bottom. Technical purists will recoil at my use of the ZBT Indicator in a non-traditional fashion. Marty Zweig’s original ZBT buy signal looked for a breadth thrust, defined as an oversold condition on the ZBT Indicator, followed by an overbought signal within 10 trading days. Breadth thrusts are extremely rare, but ZBT oversold signals are not. The combination of a ZBT oversold condition and a NYSI negative reading can be good gauges of an intermediate term oversold market, with the caveat that this signal was early during the March decline and flashed a buy signal about halfway through the pullback.
 

 

This indicator appears to be nearing a buy signal, but appearances can be deceiving. StockCharts reports the ZBT Indicator with a one-day delay, and I have created my own real-time estimate. Friday’s market rally lifted the ZBT Indicator off the oversold level. The ZBT Indicator is no longer oversold.
 

 

From a breadth thrust perspective, Friday is day one, and the market has nine more trading days to achieve a ZBT buy signal. I am not holding my breath.
 

 

An orderly decline

So where does that leave us today? So far, the market’s decline has been an orderly affair. Even though the S&P 500 is off about -10% off its highs in less than a month, there have been no signs of investor panic. The CBOE put/call ratio is still relatively low, indicating continued bullishness. In addition, there have been few TRIN spikes over 2, which are often indicative of price insensitive panic “margin clerk” selling that often occur at the end of major price declines.
 

 

Barring a significant fundamental turnaround, investors should be prepared for further stock market weakness. I would monitor the combination of insider trading, investor sentiment, and market technical conditions for signs of an intermediate term bottom.

We are not there yet.
 

The tone is still risk-off

Posted by Cam Hui -

Mid-week market update: I have some good news and bad news. The good news is the performance of the NASDAQ 100,  the market leadership, has stabilized. The relative performance of the NASDAQ 100 against the S&P 500 successfully tested a rising relative trend line, and the relative uptrend is still intact.
 

 

The bad news is the NDX rally failed at the 50 day moving average, and the rest of the market is maintaining a risk-off tone.
 

 

Sentiment not washed-out

There are numerous signs that sentiment is nowhere near a capitulation wash-out. Macro Charts highlighted analysis from Deutsche Bank indicating that equity flows are still strong for technology. These are not signs of fear, but greed.
 

 

Despite the market decline, there are few signs of anxiety in the put/call ratio, which is hardly elevated compared to levels seen at past short and intermediate term bottoms.
 

 

However, the nervousness in the option market can be seen in the term structure of option implied volatility, or premiums. A recent analysis from Goldman Sachs shows that the market expects volatility to be elevated until well after the election. I suggested several weeks ago that a contested election after the November 3 might be possible (see Volmageddon, or market melt-up?). That scenario is being priced into the markets.
 

 

To be sure, short-term retail speculation is starting to wane. Analysis from Callum Thomas shows that the volume ratio of leveraged long to short ETFs has pulled back. Readings are neutral and falling, but they are not at capitulation fear levels yet.

 

 

 

Risk appetite still cautious

Risk appetite indicators are neutral to negative. The ratio of high volatility to low volatility stocks exhibited a minor negative divergence when the market re-tested and broke technical support this week. As well, NYSE A-D Volume exhibited a strong negative divergence on the support break, though the NYSE A-D Line was neutral. These negative divergences were not as strong or clear as the negative divergences when the market broke support on a re-test in March. However, current market internals are nevertheless concerning.
 

 

Weak risk appetite is also evident in the currency markets. The USD Index staged an upside breakout of the 94 level. The USD Index has been highly negatively correlated with the S&P 500 (bottom panel). In addition, the Australian Dollar to Japanese Yen exchange rate (AUDJPY) is an extremely sensitive barometer of currency market risk appetite, and it is also showing signs of weakness.
 

 

In conclusion, investors and traders should brace for a period of sloppiness and volatility until the November election. Sentiment is nowhere near wash-out levels, and risk appetite is weak. The path of least resistance for the stock market is down.

Disclosure: Long SPXU
 

Election jitters are rising

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

 

More election volatility

While I am not a volatility trader, my recent calls on the evolution of volatility have been on the mark. Three weeks ago, I raised the possibility of a volatility storm (see Volmageddon, or market melt-up?) owing to rising election jitters. I concluded “I would estimate a two-thirds probability of a correction, and one-third probability of a melt-up, but I am keeping an open mind as to the ultimate outcome”. Two weeks ago, I turned more definitive about rising volatility and called for a volatility storm (see Brace for the volatility storm).
The rising election induced volatility theme has become increasingly mainstream in the financial press. Bloomberg highlighted that the one and three month spread in the MOVE Index, which measures bond market volatility, is spiking.

 

 

Marketwatch also reported that analysis from BNP Paribas shows that the implied equity market volatility over the election window is sky high compared to past realized returns of election results. 

 

 

In addition, all these option readings were taken before the news about the death of Supreme Court Justice Ruth Bader Ginsburg. Should the election results be contested and wind up in the Supreme Court, the odds of a 4-4 deadlocked decision just rose with Ginburg’s death, in which case the lower court’s decision would stand. This raises the odds of judicial and constitutional chaos. Imagine different states with wildly inconsistent decisions on balloting. The Supreme Court nomination fight also raises the political resolve of both sides in Congress. Don’t expect any stimulus bill before the election, and even a Continuing Resolution to fund the federal government beyond September 30 is in jeopardy. Watch for implied volatility to rise in the coming week.
It seems that the bears have taken control of the tape, based on a combination of election uncertainty and a reversal of excessive bullish retail positioning on Big Tech stocks.

 

 

Technical breaks

The S&P 500 and NASDAQ 100 are experiencing major technical breaks from both short and intermediate term perspectives, which is leading to the conclusion that the correction isn’t over.
In the short run, the daily chart of the market leadership NASDAQ 100 violated both a rising trend line and its 50 day moving average (dma), which are important levels of psychological and technical support. As Big Tech sectors (technology, communication services, and Amazon) comprise 44% of S&P 500 index weight, weakness in the tech heavy NASDAQ 100 is an important indicator of the direction of the broader market.

 

 

The S&P 500 also violated an important rising trend line and exhibited a minor break below its 50 dma.

 

 

The weekly chart of the S&P 500 is just as ominous. The index has broken down through a breakout turned support level for two weeks. In addition, the stochastic has recycled from an overbought reading, which is an intermediate term sell signal. 

 

 

The weekly chart of the NASDAQ 100 also flashed a similar stochastic sell signal.

 

 

These conditions lead me to believe that an intermediate term correction has begun, and will not be complete until the election in early November.

 

 

Sentiment still frothy

The second major reason for the bearish break is the unwind of excessive bullish sentiment among retail traders. There has been an explosion of stories about the speculative activity among Robinhood traders due to the attraction of its zero commission policy, and the frenzy has spread to other major online brokerage firms. The froth was quite evident when even TMZ began publishing sponsored articles about day trading.

 

 

Moreover, retail call option activity has exploded. An astute reader pointed out analysis from SentimenTrader showing that while retail call volumes have receded, they are still very high and small traders are still very bullish. Despite the pullback in the popular Big Tech stocks, SentimenTrader wrote that bullish sentiment remains elevated and it has not fully capitulated.

Clearly, there was a big pullback in speculative volume last week, dropping off by more than 50% from the upside panic to start September. But when zooming out, we can see that last week was still higher than any previous record high, by far.

 

 

 

An orderly retreat

The market has been devoid of the panic that marks intermediate term bottoms. The Fear and Greed Index is falling, but the reading is only neutral.

 

 

The weakness in the NASDAQ 100, which had been the market leadership, is especially disconcerting. BoA pointed out that FANG short interest is extraordinarily low, indicating that short covering demand will not put a floor on these stocks as they weaken.

 

 

Moreover, the market’s retreat has been orderly. The percentage of stocks above their 10 dma are in a downward sloping channel of lower lows and lower highs.

 

 

In conclusion, the bears have taken control of the tape. Traders should brace for a period of weak and choppy markets until the November election and beyond. Much will depend on the course of electoral fortunes. The Presidential debates lie ahead, and there is always the possibility of an October surprise. Moreover, there is a high level of uncertainty over whether the election results would be contested in the courts, or even worse, in the streets, after November 3. It is therefore difficult to formulate downside target levels, except to say that the combination of sentiment and technical indicators are not pointing to a bottom today.
Disclosure: Long SPXU

 

A healthy rotation into cyclical stocks?

Posted by Cam Hui -

There is growing evidence that the stock market is undergoing a rotation from large cap technology to cyclical and reflation stocks. Exhibit A is the market action of the tech heavy NASDAQ 100, which violated a key rising channel and also violated its 50 day moving average (dma). By contrast, the broader S&P 500 is testing its 50 dma and only exhibited a minor break.
 

 

Even as the S&P 500 and NASDAQ 100 struggled, Material stocks have been making new all-time highs, and its performance against the S&P 500 has decisively turned up.
 

 

 

A well-telegraphed rotation

The rotation into the reflation and cyclical theme has been in evidence for a few months. The August BoA Global Fund Manager Survey showed that global managers were positioning for global reflation.
 

 

The September survey shows that the shift is continuing. While month-to-month readings can be noisy, managers continued the trend of buying industrial stocks, value over growth, small caps over large caps; and selling tech. In addition, managers regard US large cap tech to be the most crowded trade.
 

 

This weakness in large cap technology is overdue. Sentiment is becoming frothy, as evidenced by this tweet from Jim Bianco of Bianco Research.
 

 

To be sure, US large cap technology profits have outperformed the rest of the economy. The combination of better profitability and investor enthusiasm has made Big Tech now accounts for 44% of the weight of the S&P 500.
 

 

However, Cormac Mullen at Bloomberg pointed out that there are cheaper ways of gaining large cap technology exposure. The S&P Asia 50 Index is just as concentrated in Big Tech names, with Tencent, Samsung Electronics and chipmaker TSMC as its three biggest stocks, accounting for over 40% of index weight. The S&P Asia 50 Index trades at 14x forward earnings compared to 27x for the NASDAQ 100.
 

 

 

Early stealth rotation warnings

There is also extensive evidence of sector rotation under the market’s hood from the behavior of small cap stocks. These sets of charts are designed to disentangle sector and size performance by answering the following questions:

  • How is the large cap sector performing against its large cap benchmark, the S&P 500? (Top panel, black line)
  • How is the small cap sector performing against its small cap benchmark, the Russell 2000? (Top panel, green line)
  • How is the small cap sector performing against its large cap counterpart? (Bottom panel, green line)
  • How are small caps performing against large caps? (Bottom panel, black line)
The first chart shows the divergence between large and small cap technology stocks. Even as large cap technology remains in a tenuous relative uptrend, small cap technology relative returns peaked out in April and have been lagging ever since.

 

Large and small cap industrial stocks are also exhibiting a divergence, but with small caps leading the way upwards. Small cap industrial stocks began to turn up in relative returns in early July, and telegraphed the eventual relative upturn of their large cap counterparts.

 

 

The performance of consumer discretionary stocks make an interesting case study. Amazon dominates the weight of the large cap sector, but the relative performance of both large and small cap consumer discretionary stocks parallel each other, and small caps were able to achieve these returns without the aid of Amazon.

 

 

 

Key risks to rotation thesis

There are several key risks for investors who want to jump on the cyclical and reflation trade. One risk is the global cyclical rebound may be a Chinese mirage. China is a voracious consumer of commodities, and its cyclical rebound has been powered by a policy-driven industrial production revival at the expense of the domestic economy. The signals from commodity prices may therefore be a mirage, and they may not be sustainable if global consumer demand does not rebound. 
Well-known China watcher Michael Pettis explained the nature of China’s unbalanced and uneven recovery in an FT Alphaville article.

Economic recovery in China (and the world, more generally) requires a recovery in demand that pulls along with it a recovery in supply. But that isn’t what’s happening. Instead Beijing is pushing hard on the supply side, mainly because it must lower unemployment as quickly as possible. It is this push on the supply side that is pulling demand along with it…

This recovery isn’t sustainable without a substantial transformation of the economy, and unless Beijing moves quickly to redistribute domestic income, it will require either slower growth abroad or an eventual reversal of domestic growth once Chinese debt can no longer rise fast enough to hide the domestic demand problem.

 

 

The markets are already starting to discount the risks of an unsustainable recovery. The stock markets of China and its major Asian trading partners have flattened out after several months of gains.

 

 

From a global perspective, the Citigroup regional Economic Surprise indices, which measure whether economic data is beating or missing expectations, are peaking and in the process of rolling over. This is an indication that the momentum of the recovery is starting to stall, which is bearish for the cyclical recovery thesis.

 

 

The second key risk for investors is a credit crunch that brings economic expansion to a halt. In the past, the usual sequence of events in a recession is: recession, credit event and blow-up, and banks tighten credit in response. As the extent of the credit event and blow-up becomes known, the stock market anticipates the monetary response and recovers. This time, the stock market rallied even before any signs of a credit blow-up.
To be sure, the Fed has stepped in with an extraordinary level of accommodation, but while the Fed can supply liquidity, it cannot supply solvency. Only the fiscal authorities can make the decision to rescue firms that get into trouble. Fed Chair Jerome Powell made it clear that under the “Main Street Lending Facility”, 13(3) requires good evidence that the borrower is solvent. Dodd-Frank made it more difficult to do emergency lending in 13(3) on purpose. In the absence of further fiscal support, expect mass small and medium business bankruptcies.
The real estate sector is especially vulnerable to a credit crunch. In the past, tightening credit conditions led to softness in commercial real estate prices. In addition, tenant eviction moratoriums puts increasing financial pressures on residential property landlords, and a credit blowup in real estate is on the horizon if Congress doesn’t take action.

 

 

Both large and small cap REITs are lagging the S&P 500, with no bottom in sight.

 

 

The combination of a possible credit event, and financial repression will pressure on banking profitability. The Fed’s Summary of Economic Projections (SEP) from the September FOMC meeting shows that it expects inflation, as measured by core PCE to be 1.7-1.9% in 2022 and 1.9-2.0% in 2023, and its Fed Funds projection to be 0.1% in 2022, and 0.1-0.4% in 2023. While the initial reaction that this was a dovish pivot by the Fed as it is making an implicit promise to not raise rates until 2023, it also implies a significant period of negative real policy rates, which is a form of financial repression that destroys bank margins. As well, if the Fed is to hold rates down until 2023, it will also have to eventually engage in yield curve control to hold down rates further out in the yield curve, which will also pressure bank margins.

 

 

Lastly, investors need to consider why the market would rotate from large cap tech and growth to cyclicals and value. During recessionary and slow growth periods, the market bids up growth stocks in an environment of scarce growth. As a recovery broadens out, sector and style rotation shifts into cyclicals and value as growth becomes more abundant.
This brings up two problems. First, economic recovery depends on the effectiveness of health care policy, fiscal policy, and monetary policy, in that order of importance. The effectiveness of global health care policy remains a question mark, as this pandemic needs to be controlled all over the world to prevent reservoirs of the virus from leaking out to spark periodic outbreaks. In addition, the US fiscal policy response has been uneven, even though monetary policy makers are doing all they can to backstop the economy.
In addition, a rotation out of Big Tech into cyclical sectors presents a liquidity problem. The weight of Big Tech is 44%, which is over double the size of the cyclical sectors. Investors deploying funds out of US Big Tech will need to find better opportunities either abroad or in other asset classes. This will mean lower overall stock prices.

 

 

In conclusion, the market has been undergoing a rotation from US large cap tech into stocks with cyclical and reflationary exposure. Whether the rotation is a “healthy” one remains to be seen. There are several risks if investors were to hop on the cyclical rotation theme. The global cyclical revival may not be sustainable; a credit crunch sparked by tightening lending requirements could stop the recovery in its tracks; and the rotation could put downward pressure on the S&P 500 because of the massive weighting of Big Tech stocks compared to cyclical sectors.
Under these conditions, investors are advised to focus first on risk, rather than return expectations. SKEW, which measures the cost of hedging tail-risk, is elevated indicating a high level of uncertainty as we approach the election in November. Volatility may stay heightened if a clear resolution isn’t known after November 3. 

 

 

As I pointed out before, the path of economic recovery depends on health care policy, fiscal policy, and monetary policy, in that order of importance. Until there is greater clarity about the path of health and fiscal policy, there will be few catalysts that reduces equity implied volatility and tail-risk – and that’s the probable reasoning behind the elevated SKEW.

 

Time to sound the all-clear?

Posted by Cam Hui -

Mid-week market update: Is time to sound the all-clear? The market staged a relief rally after last week’s weakness. Is the stock market ready to resume its uptrend?

A rally to new highs from these levels is unlikely. Last week’s pullback inflicted significant technical damage that, at a minimum, a period of sideways consolidation and base building will be necessary before the bulls can take control of the tape again. The S&P 500 violated a rising trend line that stretched back to April. As well, the 8 day moving average (dma) fell through the 21 dma, which is a bearish crossover. Repairing the damage will take time.
 

 

A similar pattern can also be seen in the NASDAQ 100. The NDX exhibited a similar breach of a rising trend line and a bearish crossover of the 8 dma and 21 dma. In addition, NASDAQ 100 implied volatility, as measured by VXN, rose coincidentally with NDX. This is another indication of a nervous and jittery market, which is not a good sign for stocks that had been the market leadership.
 

 

 

Sentiment is still frothy

Sentiment models are still showing signs of frothiness. Macro Charts pointed out that QQQ call options are still being bought aggressively in the face of last week’s sell-off. The bulls haven’t capitulated yet.
 

 

Moreover, single stock option volume is now 120% of share volume. Market wash-outs don’t look like this.
 

 

 

More headwinds

Today’s market action was distorted by the FOMC announcement, and it’s always difficult to get a decent read on the market on FOMC meeting days. Nevertheless, one possible sign of market direction is the inability of equities to hold their gains even after a dovish FOMC statement. 

In the short run, the NASDAQ 100, which were the market leaders, came into Wednesday overbought in the short-term. While overbought market can become more overbought, the odds favor either some form of pullback or consolidation at these levels.
 

 

 

Disclosure: Long SPXU
 

Some key questions for the Fed

Posted by Cam Hui -

As the FOMC conducts its two-day meeting after its big reveal of its shift in monetary policy, Fed watcher Tim Duy thinks that we won’t get much more in the way of details from the Fed after this meeting:

The odds favor the Fed maintains the status quo at this week’s meeting. It does not appear to have a consensus on enhancing forward guidance nor do I suspect FOMC participants feel pressure to force a consensus on that topic just yet. The general improvement in the data likely removes that pressure. The Fed will likely remain content to use the new strategy as justification for maintaining the current near zero rate path. Powell will continue to lean heavily on downside risks to the economy to entrench expectations that the Fed will stick to that path. The dovish risk this week is that the Fed does surprise with either more specific guidance or an alteration of the asset purchase program to favor longer term bonds. I don’t see a lot of risk for a hawkish outcome unless it was something unintentional in the press conference.

As the Citi Inflation Surprise Index edges up for the US, but remain muted for the other major regions, I have some important questions about the Fed’s new “average inflation target” policy.

 

 
 

Reported inflation or inflation expectations?

While other analysts are focused on the nuances of how the Fed is calculating its average, which admittedly is an important issue, I am more concerned about which inflation metric the Fed is targeting. It is mainly looking at reported inflation, in the form of core PCE and core CPI, or inflationary expectations?

Consider how the 5×5 inflationary expectations indicator has recovered, and it is nearing the Fed’s 2% target. While I understand that the new policy is allowing inflation to overshoot its 2% target, how long will the Fed allow expectations to overshoot before they become unanchored?

 

 

Gold is thought of as an inflation hedge, and gold prices have already staged an upside breakout to all-time highs. While bullion has pulled back to test its breakout level, further gains will create the risk of skyrocketing and “unanchored” inflation expectations. Keep an eye on the inflation expectations ETF (RINF), as it is testing a key falling trend line.

 

 

Should inflationary expectations start to rise, how will the Fed react to rising bond yields? Real rates are already negative, will the Fed engage in some form of yield curve control to suppress rates? We have already seen the effects of the ECB’s policy of financial repression has done to the European financial sector. Are these risks part of the reason why Warren Buffett lightened up on his banking sector positions?
 

 

These are all good questions that investors should ask of the Fed.
 

The bears take control, but for how long?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

A sentiment buy signal?

As last week’s market action demonstrated, the bulls just can’t seem to catch a break. Even though the market was short-term oversold, rally attempts have been rather anemic. More worrisome is the behavior of the NASDAQ 100 (NDX), which had been the market leadership. The NDX convincingly breached a rising channel, and it is now testing its 50 day moving average (dma). While its relative uptrend against the S&P 500 remains intact, the relative performance of semiconductor stocks, which had also been a source of technology related market strength, also violated a rising trend line.

 

 

One bullish ray of hope came from Mark Hulbert, who pointed out that newsletter writer sentiment had plunged precipitously, which is contrarian bullish.

Consider the average recommended equity exposure level among a subset of short-term stock-market timers that I monitor on a daily basis. (This is what’s measured by my Hulbert Stock Newsletter Sentiment Index, or HSNSI.) This average currently stands at 30.1%, which means that the average timer now has 70% of his equity trading portfolio out of the market.

Just three weeks, ago, in contrast, the HSNSI stood at 65.9%. As you can see from the chart below, the HSNSI’s recent plunge rivals what happened during the February-March waterfall decline. That’s amazing, since the market’s early September sell-off — scary as it was — is child’s play by comparison. In contrast to a 34% plunge in the earlier downturn, the S&P 500 SPX, +0.05% from Sep. 2 to Sep. 8 lost less than 7%.

 

 

Hulbert concluded, “So long as the market timers on balance remain lukewarm about the stock market, sentiment for the next few weeks favors higher prices.”
Could this be the reprieve that the bullish traders need?

 

Other indicators begs to differ

Before the bulls get overly excited about Hulbert’s newsletter writer sentiment analysis, I present as this week’s Barron’s as contrarian magazine cover indicator. The cover story characterized the tech bubble as “Not Ready to Pop”, and “…could keep growing, despite recent setback for the stocks”. 

 

 

In light of the still elevated levels of the Citigroup Panic-Euphoria Model, and the NASDAQ 100’s technical trend breaks, “Da Nile isn’t just a river in Egypt”.

 

 

I would also point out that Mark Hulbert warned of a possible long-term market top in a separate Marketwatch article. Hulbert fretted about the wave of M&A activity, which is often the signs of a market top, and blind-trust SPAC financings in particular.

We’re currently in the seventh of those great waves, which began about six years ago. Added Rhodes-Kropf: M&A waves tend to accelerate right before they end. And recent M&A activity does appear to be such an acceleration. “I’m not predicting the end,” he said. “But I wouldn’t be surprised if we’re near the end.” 

One of the factors fueling the acceleration of M&A activity are the SPACs that are falling over themselves going public. There are the Special Purpose Acquisition Companies that are otherwise known as “Blank Check Companies.” SPACs have no business operations; they are created solely to raise money that would enable them to acquire other already-existing companies.

The intermediate term technical outlook doesn’t look very constructive either. Both the S&P 500 and NASDAQ 100 experienced outside reversals on their weekly charts in the first week of September. The bearish reversals were confirmed by weakness in the following week.

 

 

Other indicators suggest that we are nowhere near peak the levels consistent with a panic bottom. Twice in the last week, the equity-only put/call ratio fell, indicating bullishness and complacency, even as the S&P 500 closed near the lows of the day. Capitulation bottoms simply do not act this way.

 

 

The option positioning indicator from Goldman Sachs also points to a crowded long, which is contrarian bearish.

 

 

Another key component of my Trifecta Bottom Spotting Model, namely the term structure of the VIX, is not even inverted indicating a lack of fear. While TRIN did spike above 2 on Thursday as a sign of panic selling, the intermediate term overbought/oversold model has not reached the deeply oversold conditions consistent with an intermediate bottom. In the past, two or more of the components of this model needed to flash simultaneously buy signals before the market can see a durable trading bottom.

 

 

The Zweig Breadth Thrust Indicator is also not even flashing an oversold signal. I use this indicator in two ways, traditionally as a long-term buy signal, and as a short-term oversold indicator. A long-term ZBT buy signal is triggered with the ZBT Indicator falls below 0.40 to become oversold, and rebounds above 0.40 to an overbought condition at 0.615 within 10 trading days. While ZBT buy signals are extremely rare, ZBT oversold conditions are not. The following chart shows the actual ZBT Indicator, which is reported with a lag by StockCharts, and my own real-time estimate of the indicator. Neither is showing an oversold condition indicative of a short-term bottom.

 

 

The week ahead

Looking to the week ahead, the market faces a crucial test. Both the S&P 500 and NASDAQ 100 have violated key rising trend lines, and they are both testing 50 dma support levels. As well, the FOMC meeting next week could also be a source of volatility. Apple’s new product event scheduled for September 15 could also provide some market fireworks.

 

 

Short-term momentum is recovering from an oversold reading, but the bulls have been unable to muster much in the way of relief rallies even given the chance.

 

 

The market can stage a short-term relief market at any time. However, the intermediate term path of least resistance is still down.
Disclosure: Long SPXU

 

How far can the market fall?

Posted by Cam Hui -
Macro Charts recently observed that S&P 500 DSI is turning down from an overbought extreme. Historically, that has led to either sharp corrections or a prolonged period of choppiness.

 

 

In light of these conditions, I have been asked about downside equity risk. Is this the start of a significant downdraft? How far can stocks fall from current levels?

I answer these question in the context of secular leadership change. The Big Three market leadership themes in the latest bull cycle has been US over global stocks, large cap growth over value, and large caps over small caps. Transitions from bull to bear phase act to cleanse the excesses of the previous cycle. Until we see definitive signs of leadership changes, it may be too early to call a market top just yet.

From that perspective, we can see that the relative performance of US against global stocks is consolidating sideways after an uptrend; growth beating value, but pulling back; and small caps still lagging large caps after a brief episode of better relative performance.

 

 

NASDAQ crash?

There are growing, but unconfirmed signs that large cap growth and NASDAQ stocks are weakening. The NASDAQ 100 recently breached its rising trend channel, but its performance compared to the S&P 500 remains in a relative uptrend. In the short run, too much technical damage has been inflicted on these market leaders for them to continue to roar upwards immediately. The most constructive bullish scenario would see them consolidate sideways for several months before resuming their uptrend.
 

 

We can see further evidence of technology weakness from small cap tech stocks. Even as the relative performance of large cap tech against the S&P 500 pulled back but remains in a relative uptrend (black line top panel), small cap tech has dramatically underperformed the Russell 2000 (green line, top panel). These are all signals that an important correction may be brewing for the technology sector.

 

 

If this is indeed the start of a NASDAQ crash, bear in mind Bob Farrell’s Rule #4 as it applies to NASDAQ stocks: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” 

US investors tend to focus on the S&P 500, but there is a composition problem with the index. The top five stocks, which are all Big Tech, make up 23% of index weight. The Big Tech sectors, consisting of technology, communication services, and Amazon, comprise 44% of index weight. Therefore a Big Tech and NASDAQ crash will have an outsized effect on the S&P 500.

Let’s consider what happened last time these stocks deflated. The bear market spared mid and small cap stocks because they did not participate in the dot-com bubble. Non-US stocks crashed along with the NASDAQ because they were also caught in the tech frenzy. Fast forward to 2020, non-US stocks are likely more insulated from a potential NASDAQ crash today as they have gone nowhere since 2014. By contrast, mid and small cap stocks only began to trade sideways since 2018.
 

 

We can see that in the valuation of US large, mid, and small cap stocks. Their forward P/E ratios are either in the high teens or low 20s, which are elevated by historical standards.
 

 

From a global perspective, the forward P/E ratios of non-US regions are far lower than US stocks.
 

 

That said, too many investors are fighting the last war. The latest episode of US large cap growth dominance cannot be compared to the dot-com mania. The late 1990’s boom was led by unprofitable companies trading on price to eyeballs metrics. I would argue that the best comparable period to today is the Nifty Fifty era of the early 1970’s, when investors were willing to pay for quality growth at any price. The growth companies then were highly profitable, just as they are today. As a reminder, the S&P 500 went sideways for roughly a decade after the Nifty Fifty bust, though investors could have profited handsomely through sector and style rotation.
 

 

 

The economic outlook

The dominance of Big Tech growth stocks is evidence that the stock market isn’t the economy, and the economy isn’t the stock market. Looking ahead to the next 12-18 months, the economy should see definitive signs of recovery by Q2 or Q3 2021. New Deal democrat has been keeping an eye on the economy with his suite of coincident, short leading, and long leading indicators. He has been making the point that his indicators tells the story of an economy that wants to recover, subject to progress against the pandemic.

All three time frames are positive, although the nowcast is only slightly so.

It is really unfortunate that right now was the precise time reporting stopped on one of the consumer spending metrics, as the other (Redbook) went just slightly negative this week, “possibly” reflecting the termination of federal emergency unemployment benefits. To reiterate my overall outlook, over the next six months, the coronavirus, and the reactions of the Administration (both present and possibly new in January), the Congress, and the 50 governors to the coronavirus, are going to be the dispositive concerns. Nevertheless, by late next summer – especially if there is a reasonably effective vaccine – I expect the economy to be firmly in expansion.

Several Phase III vaccine trials are underway. Despite the AstraZeneca trials being put on hold, my base case scenario calls for availability of a vaccine by mid-2021. While there will inevitably be some teething problems with distribution, vaccine availability, or the anticipation of availability, should be the catalyst for an economic recovery. I would add that the fight against the pandemic needs to coordinated, and global in nature. As Bill Gates has pointed out, we don’t need the virus to be hiding in some pockets of the world and act as a reservoir for COVID-19 to infect others. Control and eradication needs to be global.
 

 

In the short run, the risk of a double-dip recession is rising due to fiscal inaction. High frequency data shows that the job recovery is stalling,

 

 

Initial jobless claims have bottomed and they are rising again.

 

 

The fiscal stimulus jolt is fading badly. Bloomberg reported that the extra $300 per week authorized under Trump’s Executive Order is running out of funds.

Funding is drying up for the supplemental weekly jobless benefit payments authorized by President Donald Trump at the start of August.

Funding for the Lost Wages Assistance program, which authorized an extra $300 a week from the federal government to most jobless benefit recipients, will not extend beyond the benefit week ending Sept. 5, according to statements by government officials from Montana, Texas and New Mexico. The states said they were informed Wednesday.

That said, most of these problems can be mitigated by a fiscal stimulus bill, either in the next few weeks or by a new Congress after the election.
 

 

Where are the opportunities?

Notwithstanding the short-term risks, a NASDAQ crash argues for a rotation into cyclical and value stocks. We are already seeing constructive patterns of relative performance among material, energy, and industrial sectors.
 

 

From a global perspective, non-US stock markets provide greater opportunities from both valuation and sector exposure perspectives. An analysis of the sector weight differences between the S&P 500 against MSCI EAFE (developed markets) and the MSCI Emerging Market Free Index shows that the S&P 500 is heavily overweight technology and communication services. EAFE is overweight value (financials) and cyclical sectors (industrials, and materials). EMF is overweight value (financials) and cyclical sectors (consumer discretionary, materials, and energy).

 

 

If the market were to experience a rotation from technology into value and cyclicals, non-US markets should benefit substantially from that shift.

 

 

Downside equity risk

We began this journey by posing the question of downside equity risk. If this is the start of a significant pullback, how far can stocks fall?

We can analyze the S&P 500 from several perspectives. While the S&P 500 does not represent the economy, the average stock, as measured by the Value Line Geometric Average, is a better representation. If the two were to converge, fair value for the S&P 500 would be about 2300, with the caveat that markets can overshoot on the downside.
 

 

If we were to analyze the market using the forward P/E ratio, it has historically bottomed out at a forward P/E of 10-15 times, and mostly at about 10. The main exception was the 2002 bottom, which was about 15 times.
 

 

Bottom-up 2021 EPS estimates is 166. At 10 times forward, this makes for an S&P 500 target of 1660; 12 times, about 2000; and 15 times, about 2500. The 2500 figure is also consistent with the analysis of fair value when comparing the Value Line Geometric Average to the S&P 500. FactSet reported that the 5-year average forward P/E is 17.1, and the 10-year average forward P/E is 15.4. The market bottomed out at just a forward P/E of just above 12 at the March panic low.
 

 

Putting it all together, my base case downside risk for the S&P 500 is 2000-2300, with a possible overshoot to about 1700 if the market were to really panic. This does not necessarily mean that the market will fall that far as it is based on the assumption of a NASDAQ and large growth stock crash. US equity investors can be largely insulated from the downdraft and find opportunity in cyclical and value stocks. Global investors will find more upside potential in non-US equities, with a particular focus on emerging markets.

The story of two trend breaks

Posted by Cam Hui -

Mid-week market update: While it may seem like the Apocalypse for people trading the momentum FANG+ stocks, this is not the Apocalypse. Sure, the market has violated its rising trend line, but this trend break is nothing like the COVID Crash experienced earlier this year.
 

 

Before the bears get all excited, there are several key differences between the current trend break and the February trend break. While the NYSE McClellan Summation Index (NYSI) warned of deteriorating breadth in both cases, net NYSE highs have not broken down in the manner of February 2020.

The latest trend break was led to the downside by Big Tech stocks. The analysis of the NASDAQ 100 show similar violations of rising trend lines, and similar warnings by the NASDAQ McClellan Summation Index (NASI), but the NDX/SPX ratio remains in a relative uptrend. We can see the strength of NASDAQ stocks during the COVID Crash by observing that while the SPX broke the uptrend in early February, the NDX uptrend held during that period and did not break down until later in the month. As well, similar the S&P 500 chart, the current readings NASDAQ net new highs are also not showing any signs of signification deterioration.
 

 

Fading momentum

If this is not the start of a significant pullback, what’s going on? It might be a case of fading macro and price momentum. The Economic Surprise Indices, which measures whether top-down economic data are beating or missing expectations, are all starting to roll over all around the world.
 

 

The withdrawal of fiscal stimulus is starting to bite. BoA tracked the card spending of all known unemployment insurance recipients for the month of August, and all have seen significant declines.
 

 

Calculated Risk also reported that timely rent payments slid -4.8% in September compared to August.
 

 

A recent Bloomberg article enumerated the rising risks all around the world:

The world economy’s rebound from the depths of the coronavirus crisis is fading, setting up an uncertain finish to the year.

The concerns are multiple. The coming northern winter may trigger another wave of the virus as the wait for a vaccine continues. Government support for furloughed workers and bank moratoriums on loan repayments are set to expire. Strains between the U.S. and China could get worse in the run-up toNovember’s presidential election, and undermine business confidence.

“We have seen peak rebound,” Joachim Fels, global economic adviser at Pacific Investment Management Co., told Bloomberg Television. “From now on, the momentum is fading a little bit.”

In addition, different indicators price momentum factor are also weakening.
 

 

Negative seasonality

Another explanation might just be seasonality, which is negative for stocks over the next few weeks.
 

 

Renaissance Macro also observed that election year seasonality is turning down just at the right time.
 

 

A bounce, then…

In the short run, the market is due for a bounce of 1-3 days as readings as of last night (Tuesday) have become sufficiently oversold to warrant a relief rally.
 

 

But make no mistake, this decline isn’t over. The equity-only put/call ratio actually fell even as the market closed near the lows of the day yesterday. This is indicative of excessive complacency among option players.
 

 

Watch for a short-term relief rally, followed by a resumption of the pullback.

Disclosure: Long SPXU

 

The 5 key macro indicators of Trump’s political fortunes (revisited)

Posted by Cam Hui -

Labor Day is the traditional kickoff of presidential election campaigns. Before that, only die-hard political pundits and devotees pay attention to the election. It is with that in mind we revisit the economic criteria for Trump’s political fortunes that I outlined just after his inauguration (see Forget politics! Here are the 5 key macro indicators of Trump’s political fortunes). I followed up a year later with an interim report card (see Trump’s one year report card).

While Trump likes to measure his performance by the stock market, the stock market isn’t the economy, and the economy isn’t the stock market. Historically, the market has shown itself be neutral towards Republicans and Democrats in the White House.
 

 

Instead, I offer the Newt Gingrich criteria, which he laid out in a NYT interview just after Trump’s inauguration:

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

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

The Newt Gingrich criteria is a variation of Ronald Reagan’s “are you better off than you were four years ago” campaign slogan. The economy is one of Trump’s perceived strengths. In survey after survey, voters consistently trust Trump than Biden on the ability to deal with the economy.
 

Assessing Trump on the Newt Gingrich criteria

The following are not cherry picked statistics, but a criteria set out in 2017 when Trump took office. At the time. I concluded:

I urge my readers to cut through the political noise and watch the aforementioned five key indicators of whether Donald Trump can keep his promises to his political base. As well, keep an eye the reaction from Republican members in Congress as a measure of whether the new administration can successfully pass legislation.

Bloomberg Intelligence chief economist Carl Riccadonna had compiled a list of five economic metrics to watch as signs of American prosperity, all without resorting to “phony” statistics like GDP and the unemployment rate. Let’s take a look at how he has done since then.

Prime age labor force participation rate: If prime age discouraged workers can return to the labor force in size, then score a win for Trump. Trump had promised to Make America Great Again by bringing jobs back. The prime age LFPR had recovered to levels reached just before the onset of the Great Financial Crisis.
 

 

Full time workers as a % of the labor force: Trump promised good jobs. That means full-time jobs. Sadly for Trump, full time employment never really recovered to levels seen just before the peak in the last cycle.
 

 

Manufacturing workers in the economy: The point behind bashing Mexico and China on trade was the disappearance of manufacturing jobs, which tend to be well paying. The good news is manufacturing jobs have arrested their decline. The bad news is there has been no meaning revival in manufacturing.
 

 

As for the trade war, China’s trade surplus with the US has grown since Trump took office.
 

 

Capital expenditures: One of the puzzles of this economic expansion has been the tepid pace of capital expenditures. Trump’s tax cut and initiative for the repatriation of offshore corporate cash is intended to address this problem. While the tax cut didn’t seem to address the problem, capex did flatten and rise marginally. Call this a narrow win for Trump.
 

 

Net business births: Net business births is a useful bottom-up derived of economic confidence and business dynamism. I couldn’t find any regularly reported statistics of business formation. However, recent high frequency data shows that the number of small businesses open plunged, recovered, and weakening again.
 

 

That said, NBIB small business optimism index recovered in August. Of the small businesses that have survived the pandemic, they are becoming more confidence about their own outlooks, and their hiring and expansion plans have improved. A longer term analysis of this index shows a spike with Trump’s election, a plateau, followed by a pandemic induced plunge and partial recovery.
 

 

The verdict

Having reviewed the five criteria set out in 2017, what’s the verdict? Before the onset of the pandemic, Trump was getting a marginal passing grade on the economy. The pandemic erased any gains he might have had.

As for Newt Gingrich, he offered the following assessment in a recent NYT article.

“He has to continue focusing on the network of anti-American lawlessness,” former House Speaker Newt Gingrich said of Mr. Trump, urging him to “emphasize American patriotism and history versus the left’s anti-Americanism” and to “turn Biden into McGovern.”

Gingrich has shown himself to be an astute political strategist. His silence on his own criteria set out in 2017 and advice that Trump should pivot to a “law and order” focus speaks volumes about what should one of the President’s strengths – the electorate’s confidence in him to deal with the economy. If Trump is to win the election, his path to victory is not through his management of the economy, and through other means.

 

Brace for the volatility storm

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

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

Why Are VIX and S&P 500 Moving Together?
Something odd is happening in the equity option market.

  • Until the market sold off last Thursday, the VIX and S&P 500 had been rising together. The 10-day correlation of the VIX and SPX spiked to over 0.7, which is highly unusual as the two indices tend to be negatively correlated with each other (top panel).
  • The rise in implied volatility, as measured by the VIX Index, was not matched by rising realized volatility. The second panel in the chart below shows the width of the SPX Bollinger Band as a proxy for implied volatility, which has been tame.
  • Until the market sold off last Thursday, the term structure of the VIX was steeply upwards sloping. The spread between 9-day, 1-month, and 3-month implied volatility was uniformly high by historical standards.
  • The SKEW Index, which measures the price of hedging tail-risk, was also elevated.

 

 

Equally puzzling is the disconnect between stock and bond implied volatility. While stock volatility has surged, bond market volatility remains tame. What’s going on?
 

 

Historically, high correlations between SPX and VIX have usually led to market sell-offs. Under a minority of circumstances, they have also signaled market melt-ups. How can we explain these unusual conditions in the option market?
 

Election jitters

I present two explanations for the option market anomaly, which are not mutually exclusive. The Financial Times pointed out the market is pricing in an exceptionally pronounced volatility surge around the US election in early November in anticipation of electoral chaos.
 

 

Axios reported that a Mike Bloomberg backed polling firm is warning of potential electoral chaos on election night.

A top Democratic data and analytics firm told “Axios on HBO” it’s highly likely that President Trump will appear to have won — potentially in a landslide — on election night, even if he ultimately loses when all the votes are counted.

Way more Democrats will vote by mail than Republicans, due to fears of the coronavirus, and it will take days if not weeks to tally these. This means Trump, thanks to Republicans doing almost all of their voting in person, could hold big electoral college and popular vote leads on election night.

This scenario has the potential to spark uncertainty an order of magnitude higher than the 2000 Bush-Gore hanging chad Florida electoral controversy.

Hawkfish CEO Josh Mendelsohn calls the scenario a “red mirage.”

  • “We are sounding an alarm and saying that this is a very real possibility, that the data is going to show on election night an incredible victory for Donald Trump,” he said.
  • “When every legitimate vote is tallied and we get to that final day, which will be some day after Election Day, it will in fact show that what happened on election night was exactly that, a mirage,” Mendelsohn said. “It looked like Donald Trump was in the lead and he fundamentally was not when every ballot gets counted.”

President Trump is already tweeted to alert his supporters about that possibility. A closely contested election with results that are not trusted by one side could spark protests and counter-protests all over the country. The events in Portland and Kenosha are just a preview. Imagine multiplying them by 10, or 100 as armed protesters from both sides flood the streets.
 

 

This is hardly a scenario promoted by the radical fringe. Even The Economist devoted an entire issue to this subject.
 

 

Are civil wars bullish? Is it any wonder why volatility premiums are elevated around the time of the election?
 

The Softbank NASDAQ ramp

A shorter term explanation for the dual rise in stock prices and implied volatility is the gamma chase by dealers. The perennially bearish website Zero Hedge reported that Nomura’s cross-asset analyst Charlie McElligott found that there has been a very large buyer of technology stock call options, to the tune of over $1 billion in option premiums.

Over the past few weeks, there has been a massive buyer in the market of Technology upside calls and call spreads across a basket of names including ADBE, AMZN, FB, CRM, MSFT, GOOGL, and NFLX. Over $1 billion of premium was spent and upwards of $20 billion in notional through strike – this is arguably some of the largest single stock-flow we’ve seen in years. “The average daily options contracts traded in NDX stocks to rise from ~4mm/day average in April to ~5.5mm/day average in August (a 38% jump in volume).

As the street got trapped being short vol, other names in the basket saw 3-4 standard deviation moves higher as well – on Wednesday FB rallied 8% (a 3 standard deviation move), NFLX rallied 11% (a 4 standard deviation move), and ADBE rallied 9% (a 3 standard deviation move).

The most natural place to hedge being short single name Tech volatility is through buying NDX volatility. As such, there has been a flood of NDX volatility buyers with NDX vols up about 4 vol points in 2 trading days. And if NDX volatility is going up, SPX volatility/VIX will eventually go up too.”

Dealers became net short as this very large buyer came into the market. Consequently, market makers had to buy the underlying shares in order to hedge their position, which sparked a bullish stampede and NASDAQ melt-up. Zero Hedge concluded:

Putting it all together, we find that a combination of market euphoria, free options trading, and most importantly, few market-makers have sparked the fire. It also means that “a few large hedge funds understood this and have added fuel to the fire by pushing implied higher and higher and putting further pressure on the likes of Citadel and Goldman. With this process helping drive names like Apple and Tesla, this also makes sense why Breadth has been so terrible.

The Financial Times subsequently identified the large buyer as Softbank. Softbank spent roughly $4 billion in call option premiums to control $50 billion of equity assets. The purchases appears to have sparked a bullish stampede. SentimenTrader pointed out that the retail small option buyers continued to pile into their bullish bets despite the late week sell-off.
 

 

Maybe some reasons for the market swoon last Thursday was the disappearance of Softbank buying, or just buyer exhaustion.
 

The NASDAQ wobbles

We can observe the footprints of the call option buyers in the price action of the NASDAQ 100 (NDX) and VXN, which is the implied volatility of the NDX. VXN (top panel) had been basing and began to rise in lockstep with NDX. VXN then went on to stage an upside breakout out of its multi-month base, indicating a possible volatility storm ahead. From a technical perspective, NDX remains in a rising channel, and the relative performance of NDX is still in a relative uptrend. Until we see downside breaks in those trend lines, traders should not turn bearish.
 

 

Should we see downside technical breaks, downside risk could be considerable. Analysis from JPMorgan reveals that market participants have completely unwound their equity short positions from March. Short interest is extremely low, and there is little buying support from short covering should stock prices take a tumble.
 

 

More volatility ahead

Tactically, where do we go from here? Is this just a brief pullback, or the start of a major correction? The blogger Urban Carmel observed that when the S&P 500 falls -3% or more, such downdrafts tend to occur in clusters, and the first one from a high doesn’t mark the initial low, and such strong down momentum typically followed by a lower close in the day or two. In the last year, there were two bounce and successful re-tests of the lows, and one market plunge.
 

 

What’s the likely outcome? Market internals are deceptive. my high beta to low volatility equity risk appetite indicator is flashing a risk-on signal, but it flashed a similar signal at the bottom of the initial market plunge in March. We are likely to see some sort of short-term bounce early next week, as the market is sufficiently oversold to warrant a relief rally. I am watching the behavior of this indicator, as well as breadth metrics such as the Advance-Decline Line and Volume, for signs of either a positive or negative divergence on the re-test before declaring a bullish or bearish verdict.
 

 

Short-term momentum presents a mixed picture. The percentage of stocks in the NASDAQ 100 above their 5 dma is oversold. As NASDAQ stocks have been the tail that wag the dog market leaders, the market is ripe for a bounce early next week.
 

 

On the other hand, traders have to be aware of the possibility that this is just the start of a major downdraft. The percentage of S&P 500 stocks above their 5 dma is not oversold, and the pattern has eerie parallels to the major market decline in March.
 

 

Sentiment is extremely jittery. Retail traders piled into inverse ETFs late last week. While this is contrarian bullish, it’s difficult to believe that the wild speculative frenzy of the past few weeks could be unwound in two days. Be prepared for more volatility.
 

 

In conclusion, there are both short and medium term catalysts for a market volatility storm. Traders should expect heightened volatility and risk premium compression between now and Inauguration Day. Hopefully, any electoral chaos should be settled by then.

Disclosure: Long SPXU

 

How the Fed’s Policy Review received an incomplete grade

Posted by Cam Hui -

It has been over a week since Jerome Powell’s virtual Jackson Hole speech in which he laid out the Fed’s revised its updates to its Statement on Longer-Run Goals and Monetary Policy Strategy after a long and extensive internal review. There were two changes. one was a shift towards an “average inflation targeting” regime, where the Fed “seeks to achieve inflation that averages 2 percent over time”. The other was an emphasis on to target low unemployment. Instead of minimizing “deviations from the maximum” employment, it will minimize “shortfalls of employment from its maximum level.”

The results of the review were much like a student handing in a term paper after much effort, but the assignment is incomplete, and leaves many questions unanswered.

  • How will the Fed calculate the average inflation rate? In other words, what decision rules will the Fed adopt to raise interest rates?
  • How credible is the 2% inflation target? How does the Fed expect to raise the inflation rate, when it was unable to do so for many years? Is it because its lab partner, fiscal policy, failed to work on the assignment?
  • How will the Fed manage the bond market’s expectations? If the average inflation target of 2% is credible, how far above 2% will the 10-year Treasury yield be, and what will that do to the economy and stock prices?

On the last point, I had a discussion with a reader about the implications for the bond market in the wake of Powell’s speech. Wouldn’t a credible 2% average inflation target translate into a substantial surge in bond yields? How far above 2% does the 10-year Treasury have to trade? What does that mean for equity valuations?

Supposing that you knew for certain that inflation will average 2% over the next 10 years, you would certainly demand a Treasury yield of over 2%, say 2.5%. The 10-year yield needs to rise by at least 1.8%. What would that do to the economy, and the stock market?

Forward P/E ratios are stratospheric compared to their own history, but some investors have justified the high multiple by pointing to low rates. TINA, or There Is No Alternative. Valuations are reasonable based on equity risk premium (ERP), which is some variation of E/P – interest rates. Here is the Q2 2020 ERP calculation of Antonio Fatas, professor of economics at INSEAD. While the stock market appears reasonably priced based on ERP today, raising rates by 1.8% (everything else being equal) would make stocks far less attractive compared to fixed income alternatives.
 

 

Something doesn’t add up. The Fed’s review appears incomplete. There are too many unanswered questions.
 

Wild confusion

The Fed needs to work on its communication policy. Reuters reported that, one day after the Powell speech, regional Fed presidents had wildly differing interpretations of what the average inflation target policy meant.

Dallas Fed President Robert Kaplan said he would be comfortable with inflation running a “little bit” above the Fed’s 2% inflation target if the economy were to once again be running near full employment.

“And for me, a little bit means a little bit,” or about 2.25%, Kaplan said during an interview with Bloomberg TV. “I still think price stability is the overriding goal and this framework doesn’t change that.”

St. Louis Fed President James Bullard, who along with Kaplan and their 15 policymaker colleagues will carry out the Fed’s new strategy, had a different answer.

“Inflation has run below target, certainly by half a percent, for quite a while, so it seems like you could run above for a half a percent for quite a while,” Bullard told CNBC.

And Philadelphia Fed President Patrick Harker had yet another view.

“It’s not so much the number. … It’s really about the velocity,” Harker said during a separate interview with CNBC, adding that inflation “creeping up to 2.5%” is different from inflation that is “shooting past 2.5%.”

A subsequent speech by Vice Chair Richard Clarida was equally unclear about the Fed’s plans, other to convey the impression that the FOMC intends to steer monetary policy by the seat of its pants.

To be clear, “inflation that averages 2 percent over time” represents an ex ante aspiration, not a description of a mechanical reaction function—nor is it a commitment to conduct monetary policy tethered to any particular formula or rule.

Fed governor Lael Brainard was equally ambiguous when she described Flexible Average Inflation Targeting (FAIT) in a separate speech.

Flexible average inflation targeting is a pragmatic way to implement a makeup strategy, which is essential to arrest any downward drift in inflation expectations.While a formal average inflation target (AIT) rule is appealing in theory, there are likely to be communications and implementation challenges in practice related to time-consistency and the mechanical nature of such rules. Analysis suggests it could take many years with a formal AIT rule to return the price level to target following a lower-bound episode, and a mechanical AIT rule is likely to become increasingly difficult to explain and implement as conditions change over time. In contrast, FAIT is better suited for the highly uncertain and dynamic context in which policymaking takes place.

In practice, the new monetary policy framework means that the Fed will be slower to tighten to allow the economy to run “hot” and ensure that inflation rises above 2% and averages at 2%. The key indicator to watch is inflation expectations, which needs to stay anchored at 2%.
 

The lab partner goes AWOL

After over a decade of sub-2% inflation, the new policy framework does nothing to address how the Fed plans to raise inflation to the 2% average. For that, the central bank needs the cooperation of its lab partner, fiscal policy.

Lael Brainard’s recent speech pleaded for help from fiscal policy as she acknowledged that monetary policy could not do all the heavy lifting by itself.

Looking ahead, the economy continues to face considerable uncertainty associated with the vagaries of the COVID-19 pandemic, and risks are tilted to the downside. The longer COVID-19-related uncertainty persists, the greater the risk of shuttered businesses and permanent layoffs in some sectors. While the virus remains the most important factor, the magnitude and timing of further fiscal support is a key factor for the outlook. As was true in the first phase of the crisis, fiscal support will remain essential to sustaining many families and businesses.

In the short run, political gridlock has gripped Washington as both sides have been unable to agree on a CARES Act 2.0 fiscal relief package. In addition, a second important deadline is approaching, as the government faces a shutdown on October 1st in the absence of interim funding legislation. Fortunately, Treasury Secretary Mnuchin and House Speaker Pelosi appear to be agreeable to working together to avoid a government shutdown.

In short, the Fed’s lab partner, fiscal policy, is nowhere to be seen, and the Fed’s policy review is not very meaningful without the partner’s presence.
 

The Abenomics template

Notwithstanding the short-term battles on Capitol Hill, chances are that policy direction will move towards a Modern Monetary Theory (MMT) framework no matter who wins in November. How will that play out?

For some clues of how the combination of fiscal and monetary policy might work, we can consider the Abenomics experiment, named after Japanese Prime Minister Abe Shinzo, who recently announced his resignation. Abe’s decade-long efforts to halt Japan’s deflation consisted of the “three arrows” of Abenomics, fiscal stimulus, monetary stimulus from the BoJ, and structural reform of the Japanese economy. The results was a mixed bag of successes and failures.

The initial thrust of the BoJ’s aggressive monetary policies briefly pushed the CPI inflation above 3%. But loose monetary policy was offset by tight fiscal policy, as the government imposed a sales tax increase. So much for inflation.
 

 

Despite the decline in headline CPI inflation, inflationary expectations rose, which was constructive.
 

 

Abenomics was also able to partially revive capital expenditures.
 

 

History doesn’t repeat, but rhymes. Undoubtedly there will be some bumps along the way as political regimes change in Washington over the next 10 years, but investors can use the same Abenomics template and should expect similar mixed results in the US economic outlook over the next decade.
 

Investment implications

What does all this mean for investors? Over the next 6-12 months, the key variables are the election, the path of fiscal policy, and how the Fed reacts to rising bond yields. Inflation expectations, as measured by the 5×5 forward bond yield, had been rising steadily and peaked at 1.91% last week before retreating. This put upward pressure on the 10-year Treasury yield.
 

 

At some point, higher Treasury yields will threaten the fragile economic recovery, and it will also put downward pressure on stock prices. A recent Bloomberg article, “Treasury Yields Will Become A head For Stocks Around 1%”, tells the story. Higher rates will put downward pressure on equity prices.

How far will the Fed allow yields to rise? Can it act to hold down yields and maintain the credibility of an average 2% inflation target? Richard Clarida rejected the notion of yield curve control (YCC) in his recent speech, but left the door open for further action in the future.

Most of my colleagues judged that yield caps and targets were not warranted in the current environment but should remain an option that the Committee could reassess in the future if circumstances changed markedly

The Fed is engaged in a tight-wire act with its YCC tool. If it doesn’t suppress rates, it risks snuffing the recovery and stock prices. Suppress rates too much, and it will devastate the banking system by compressing interest rate margins, raise inflationary expectations and run the risk of them becoming unanchored beyond the 2% targeted level. Should it have to resort to YCC, the Fed will begin with jawboning, or forward guidance, before actually intervening in the bond market. Sometime the threat of action is more powerful the actual action itself.

For investors, this means returns in Treasury market are asymmetric. The Fed will allow yields to fall as the market dictates. Fixed income investors should expect returns to be reasonable. There will not be significant downside risk in bond prices. On the other hand, the path of equity prices will be more dependent on more variables: how the world controls the pandemic, the path of fiscal policy, and the evolution of earnings expectations.

In conclusion, the Fed’s policy review raises more questions than answers. The Fed has a limited ability to boost the economy, but it’s known that it has the power kill it. This review has softened the “kill the economy because it’s overheating” policy, but there are many questions about the mechanisms for boosting growth. I expect there will be short-term hiccups between now and the Presidential Inauguration in January, but expect some form of Abenomics like policy over the next decade. The results will be uneven, and will depend largely on the path of fiscal policy, rather than monetary policy.
 

Growth stock wobbles

Posted by Cam Hui -

Mid-week market update: One of the defining characteristics of the current bull run is the dominance of US large cap growth stocks. Joe Wiesenthal wrote about the problem of the effect of the “superstar companies” on the economy in a Twitter thread and in a Bloomberg commentary. The “superstar companies” have few employees, and therefore high labor productivity.
 

 

But if labor productivity is all that matters, and you don’t need any workers, where is the demand going to come from?

If you think that the key thing is demand, and that demand drives investment, driving productivity, then it’s not about declaring some tech companies winners and declaring everyone else as zombies that should die, it’s about fostering income equality to drive spending.

Something nobody ever seems to point out is how it’s interesting that productivity growth is historically quite low, even though we have an economy that’s dominated by some of the most productive companies in human history. Maybe more ultra-productive companies aren’t the answer?

While Big Tech and large cap growth are still red hot, more cracks are showing up in the growth stock armor. The chart below shows an unexpected divergence in relative performance between large cap and small cap growth (top panel). If we were to benchmark US large and small cap stocks against global stocks, as measured by the MSCI All-Country World Index (ACWI), we can see that large cap growth remains in a relative uptrend against ACWI (middle panel), but the relative performance of small caps and small cap growth have flattened in the past few months.
 

 

While these are not immediate bearish signals, they represent “under the hood” warnings of pending trouble in US equities.
 

Sentiment warnings

As for the rest of the stock market, there are plenty of warnings from sentiment models. The Citi Panic-Euphoria Model is wildly euphoric, though readings are not as high as they were during the height of the dot-com bubble.
 

 

One reader alerted me to Willie Delwiche’s analysis of sentiment, where six out of eight models are bearish, with two in neutral. That’s another sign of extreme bullishness, which is contrarian bearish.
 

 

What is the “smart money” doing?

Other signals of market headwinds come from the behavior of the “smart money” crowd. One measure of “smart money” are corporate insiders, who have shown little tendency to step up and buy the shares of their companies. To be sure, insider trading works best mainly as a buy signal, when buying swamps selling as it did in March.
 

 

Another savvy investor is billionaire distressed investor Sam Zell, who said in a CNBC interview that “it’s really too early for the normal clearing process” to be buying right now, and  “there will be significant opportunities probably in Q4 or first quarter of next year”. Zell’s remarks about the “clearing process” is code that the market is being held up by fiscal and monetary support, and he is not ready to buy until he sees signs of distress.
 

What’s Warren doing?

Warren Buffett also told a similar story. He stated earlier in the year that while he saw signs of distress during the March COVID Crash, Berkshire Hathaway was unable to react and use its cash horde to make distressed buys because of official intervention.

Nevertheless, we have important signals from Buffett’s recent actions. Some gold bugs got very excited recently when Berkshire bought a position in Barrick Gold, but the position was relatively small and the decision was likely made by one of the Buffett’s lieutenants. More importantly, Berkshire recently disclosed new positions in five Japanese trading companies. Here is what we know about the purchases:

  • The value of the acquisition was about $6 billion for about 5% stakes in Itochu Corp., Marubeni Corp., Mitsubishi Corp., Mitsui. and Sumitomo Corp.
  • These companies are mainly commodity trading conglomerates.
  • Their valuations are historically cheap, weighed down mainly by their commodity exposure, particularly in energy and natural gas.
  • They offer strong cash flows and dividends.
  • Berkshire Hathaway quoted Buffett in a statement, indicating that it was Buffett and Munger who made the investment decision: “I am delighted to have Berkshire Hathaway participate in the future of Japan and the five companies we have chosen for investment”.

I interpret these statements to a decision to gain exposures into commodity business in a way that minimizes the cyclicality of the sector. I also recently pointed out the beaten up nature of energy stocks (see Here’s a way to energize your portfolio). Callum Thomas observed that the energy sector is now the smallest weight in the S&P 500 index, which is another signal of wash-out sentiment.
 

 

In conclusion, sentiment models are at crowded long extremes, and smart investors are not ready to buy yet. While US large cap growth is still dominant, cracks are appearing in its leadership, and smart investors like Warren Buffett are focusing on positions in the unloved commodity sector.

As a reminder, Big Tech comprises nearly 50% of S&P 500 weight, while the cyclical sectors are only 13% of the index. If and when we see a rotation from growth the value, financial stocks, which can be considered value stocks, are unlikely to participate significantly as long as the Fed suppresses interest rates and interest margins. While history doesn’t repeat, but rhymes, a leadership failure of US large cap growth will rhyme with the 2000 dot-com bubble top owing to the sheer differential in growth and value index weights.
 

 

Analysis from BCA Research shows that the S&P Growth to Value ratio is the highest it’s been, ever. Moreover, rotations from growth to value have coincided with recessions and bear markets.
 

 

We are just waiting for the bearish trigger.

Disclosure: Long SPXU